Public Economics in India J R Gupta PDF

Public Economics
in India
Theory and Practice
Practice
Second Revised and Enlarged Edition
JANAK RAJ GUPTA

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Preface to the Second Edition
I was greatly delighted to know the exhaustion of the first

edition published in 2007. In the meantime I had received some
suggestions from teachers to incorporate some recent
developments in the field of Public Economics. And as dynamic
changes are always taking place in budgetary and other fiscal
trends, the book also required to be updated.
The first chapter has been rewritten and the Nature and
Scope of Public Economics has been linked with the latest
developments in the subject. Besides, new topics have been
included in this chapter dealing with the Role of the Government
in an Organized Society and the Principle of Maximum Social
Advantage.
A new chapter “Welfare Criteria: The Provision of Public
Goods” has been added, which covers Voluntary Exchange
Theory, Ability to Pay Theory for Optimal Allocation of Public
Goods, Pigou’s and Musgrave’s Approach, Samuelson’s Theory,
etc. Provision of Impure Public Goods, particularly with reference
to Club Goods has also been given in this chapter.
The chapter “Public Choice and Rationale of Public Policy”
has been enriched by incorporating The Theory of Public
Policy. Similarly, Theories of Revealing Social Preference, and
Choice for Public Goods, particularly Arrow’s Theorem have
been explained in a more lucid manner.
In the chapter on Public Expenditure, ineffectiveness of the
predictive value of Wagner’s Law and Wiseman-Peacock
(vi)
Hypothesis has been explained lucidly. Debt Management in

India has been added in chapter VII, entitled “Public Debt”.
Chapter VIII on Fiscal Federalism, now includes Tiebout Model
and Citizens’ Mobility, besides the recommendations of the
13th Finance Commission (2010-2015).
The entire chapter on Indian Public Finances has been
updated. Goods and Service Tax (GST) and Direct Taxes Code
(DTC), to be introduced from 1 April 2012, have been elucidated.
The Global Meltdown of 2008-09 and India’s fiscal response/
stimulus and its consequent effects on economic recovery and
fiscal stability have been dealt with in this chapter, which also
includes budgets 2009-10, 2010-11 and 2011-12.
Chapter XI “Finances of Local Bodies” has been updated by
incorporating the recommendations of the 13th Finance
Commission regarding (i) basic grants, and (ii) performance
grants. Incentive framework comprising fulfillment of nine
conditions to make a State eligible to draw down its performance
grant has been explained in this chapter.
New concepts covered in the present edition have been
explained under the caption “Important Concepts”.
I hope that the teachers and students would be greatly
benefited from this revised and enlarged edition. However,
constructive criticism and suggestions are always welcome.
Janak Raj Gupta
Preface to the First Edition
Role and functions of the Government in an economy have

been changing with the passage of time. Traditionally, the term
‘Public Finance’ has been applied to the package of those
policies and operations which involve the use of tax and
expenditure measures, while budgetary policy is an important
part to understand the basic problems of use of resources,
distribution of income, etc. There is a vast array of fiscal
institutions—tax systems, expenditure programmes, budgetary
procedures, stabilization instruments, debt issues, levels of
government, etc., which raise a spectrum of issues arising from
the operation of these institutions. Further, the existence of
externalities, concern for adjustment in the distribution of
income and wealth, removal of poverty, etc. require political
process for their solutions in a manner which combines individual
freedom and justice. The problem of allocation of resources
between public goods and private goods is a perennial problem.
Then in a democracy there is a political process of voting to
decide about the budgetary policy to be adopted. Therefore,
now more attention is paid to a wider coverage of governing
activities relating to financial aspects and the subject is known
as Public Economics. But the subject is so vast and interrelated
with other branches of social sciences that it is next to
impossible to cover all the relevant topics.
Considering the growing importance of Public Economics,
the UGC has made it a compulsory paper for the post-graduate
students of Economics. However, curriculum for Economics of
(viii)
most of the Indian universities continue to teach Public Finance

and do not make distinction between Public Finance and Public
Economics. Education is a lifelong process and the evolution of
any subject takes some time. To study the intricacies of a
dynamic subject like Public Economics, time would always be a
great constraint. Therefore, one should always welcome addition
to one’s knowledge, whatever and from wherever a little bit is
available.
This book combines a thorough understanding of fiscal
institutions with a careful analysis of the issues which underline
budgetary policies in general and Indian experience in particular.
The book has been divided into various chapters, broadly
based on the recommendations of the UGC, relating to the
paper entitled Public Economics. Sincere effort has been made
to make the book self-contained and comprehensible. However,
suggestions and criticism are most welcome because
improvements are always possible.
This book could not have seen the light of the day without
the moral support of my wife Bimla whose encouragement
enabled me to concentrate on this work. I also place on record
my thanks to Mr. Raj Kumar for most efficiently carrying out
typing and computer work. Last but not least, I am grateful to
Atlantic Publishers and Distributors (P) Ltd., New Delhi, for
publishing this book in a record time.
Janak Raj Gupta
Contents
Preface to the Second Edition ............................ v

Preface to the First Edition ................................ vii
1. Introduction ....................................................... 1-31
Nature and Scope of Public Economics ............. 1
Nature and Scope of Public Finance .................. 4
Role of the Government in an Organised
Society ............................................................... 8
Changing Perspectives about the Role of the
Government ....................................................... 12
2. Role of Government: Public and Private
Sectors ................................................................ 32-72
Government Measures to Promote Economic
Development ...................................................... 34
Rationale of Public Sector in Economic
Development ...................................................... 38
Government as an Agent for Economic
Planning and Development ................................ 41
Private Goods, Public Goods and Merit
Goods ................................................................ 65
3. Welfare Criteria: The Provision of Public
Goods ................................................................ 73-102
The Voluntary Exchange Theory of Optimal
Allocation .......................................................... 74
The Ability-to-Pay Theory of Optimal
Allocation .......................................................... 78
(x)
Public and Private Goods in General

Equilibrium ........................................................ 88
Optimal Allocation of Quasi-Public Goods ....... 90
4. Public Choice and Rationale of Public Policy .... 103-145
Problem of Allocating Resources: Private and
Public Mechanism .............................................. 103
Problem of Revealing Preferences and Their
Aggregation ....................................................... 116
The Political Interaction Costs of Democratic
Voting Theory ................................................... 119
Revealing Social References through Majority
Voting—Arrow’s Impossibility Theorem ........... 121
Point Voting Rule .............................................. 128
Compensation Principle ..................................... 133
Theory of Public Policy ..................................... 134
Alternative Measures of Resource
Mobilisation ...................................................... 137
5. Public Expenditure ............................................. 146-191
The Pure Theory of Public Expenditure ............ 146
Growth of Public Expenditure ........................... 150
Classification of Public Expenditure .................. 157
Canons of Public Expenditure ........................... 163
Incidence of Public Expenditure ........................ 170
Effects of Public Expenditure ............................. 171
Reforms in Expenditure Budgeting (Planning
and Programming Budgeting) ............................ 178
Zero Based Budgeting ........................................ 189
6. Taxation ............................................................ 192-272
Classification or Types of Taxes ........................ 192
Taxable Capacity ............................................... 207
Theory of Tax Incidence .................................... 223
(xi)
Effects of Taxation ............................................ 235

Distribution of Tax Burden (Benefit and Ability
to Pay Approaches) ............................................ 243
Double Taxation ................................................ 262
7. Public Debt ........................................................ 273-308
Causes of Borrowings ........................................ 273
Classical View of Public Debt ............................ 274
Compensatory Aspect of Public Debt ................ 276
Comparison between Private Debt and Public
Debt ................................................................... 277
Classification of Public Debt ............................. 278
Sources of Public Debt and Their Economic
Implications ....................................................... 280
Effects of Public Debt ........................................ 283
The Burden of Public Debt ................................ 286
Redemption or Repayment of Public Debt ........ 296
Management of Public Debt .............................. 300
Public Debt Management in India ..................... 305
8. Fiscal Policy ....................................................... 309-355
Meaning of Fiscal Policy .................................... 309
Fiscal Policy vs. Monetary Policy ...................... 314
Fiscal Policy for Stabilization or Compensatory
Fiscal Policy ....................................................... 328
Alternative Fiscal Policies for Full Employment
and the Balance Budget Multiplier .................... 338
Fiscal Policy for Economic Development ........... 343
Types of Budgetary Deficits and Their
Implications ....................................................... 347
9. Fiscal Federalism ................................................ 356-434
Principles of Federal (Multi Unit) Finance ......... 357
Tiebout Model and Citizens Mobility ............... 359
(xii)
Imbalances in Federal Finance (Vertical and

Horizontal) ........................................................ 361
Fiscal Federalism in India .................................. 364
Problem of Imbalance in States’ Resources and
States’ Indebtedness ........................................... 381
Transfer of Resources from Union and States to
Local Bodies ....................................................... 392
Finance Commissions in India ........................... 395
Summary of Recommendations ......................... 399
Thirteenth Finance Commission (2010-15) ....... 411
10. Indian Public Finances ....................................... 435-542
Indian Tax System: Salient Characteristics ........ 435
Expenditure Tax ................................................ 440
Taxation of Agriculture ..................................... 444
Value Added Tax ............................................... 447
Service Tax ........................................................ 454
Goods and Services Tax .................................... 459
The Model GST ................................................. 467
Dispute Resolution and Advance ....................... 471
Impact of GST on Projections Made by the
Finance Commission .......................................... 483
Finances of the Central Government ................. 483
Reforms in Direct Taxes: New Direct Tax Code
(DTC) ................................................................ 486
Finances of State Governments .......................... 491
GST .................................................................... 498
Public Expenditure in India ............................... 498
Growth in Public Debt: Centre and States ......... 503
Fiscal Crisis of 1991 and the Fiscal Sector
Reforms ............................................................. 506
(xiii)
Fiscal Crisis of 2008-09 (Global Meltdown

and Indian Economy) ......................................... 518
Factors Affecting Indian Economy ..................... 522
Measures takes to Revive the Economy ............. 526
Interim Budget 2009-10 ..................................... 528
Union Budget 2010-11 ....................................... 530
Highlights of Union Budget 2011-12 ................. 531
11. Finances of Local Bodies ................................... 543-566
Urban Area ........................................................ 544
Rural Area ......................................................... 547
Critical Assessment of Local Finance ................. 551
Fiscal Decentralization—73rd and 74th
Constitutional Amendments .............................. 554
Extent of Fiscal (Revenue) Decentralization—
International Scenario ........................................ 555
Tax-GDP Ratio at National, State and Local
Level .................................................................. 556
National Perspective .......................................... 558
Appendices ......................................................... 567-584
Important Concepts ........................................... 585-595
Bibliography ...................................................... 596-602
Introduction 1
NATURE AND SCOPE OF PUBLIC ECONOMICS

Public Economics has a short history of 40-50 years.
Although it is an offshoot of Public Finance, yet its scope and
coverage is much wider and encompasses many disciplines of
social sciences like Political Science (voting behaviour), Public
Administration (devolution of functions and powers, bureaucratic
behaviour, i.e. theory of choice), Law (enforcement of tax laws
and tax evasion), Ethics and Philosophy (welfare and equity
questions). Whereas Public Finance grew out of the market
failures to maximize social welfare, Public Economics also deals
with issues relating to government failure. Public Economics
studies the government and how its policies affect the economy
and society. It considers how the choices of the government are
made and how they can improve or hinder economic efficiency.
Public Economics also investigates the extent to which it is
possible for the government to influence the distribution of
income and wealth and whether this is desirable to undertake
these tasks. Public Economics draws influences from many areas
of economics. This is reflected in the diversity of its subject-
matter which ranges from the traditional study of the effects of
taxation to public choice explanations of the functioning of
government.
The study of Public Economics has a long tradition. It
developed out of the original political economy of Mill and
Ricardo, through the public finance tradition of Musgrave into
the optimal policy analysis of Diamond and Mirrlees, and has
now returned to its roots with the development of the new
political economy. From the inception of economics as a scientific
2 PUBLIC ECONOMICS IN INDIA
discipline, Public Economics has always been one of its core

branches. The explanation for why it has always been so central
is the foundation that it provides for practical policy analysis.
This has always been the motivation of Public Economics, even
if the issues studied and the analytical methods employed have
evolved overtime.
In the broadest interpretation, Public Economics is the study
of economic efficiency, distribution and government economic
policy. The subject encompasses as diverse as responses to market
failure due to existence of externalities, the motives for tax
evasion, and the explanation of bureaucratic decision-making.
In order to reach into all these areas, Public Economics has
developed from its narrow focus upon the collection and
spending of government revenues to its present concern with
aspect of government interaction with the economy. Public
Economics attempts to understand both how the government
makes decisions and what decisions it should make.
To understand how the government makes decision it is
necessary to investigate the motives of decision-makers within
government, how the decision-makers are chosen and how they
are influenced by outside parties. Determining what decisions
should be made involves studying the effects of the alternative
policies that are available and evaluating the outcomes to which
they lead. These aspects are interwoven throughout Public
Economics. The explanation for this interest in Public Economics
is no doubt contained in the close connection of the analysis
with policy and application, which are the ultimate inspiration
of most economists. Exposing a theoretical construction to policy
analysis also highlights its value and provides a test of its
relevance. However, it is true that before a good policy can be
designed, an adequate theory must be developed. One of the
challenges of Public Economics is that much of the subject area
is still in its infancy with considerable work still to be done.
Although a number of partitions could be used to break
down the subject-matter of Public Economics into convenient
portions, the most instructive division is between that of
determining the effects of alternative policies and that of
determining the optimal policy. This division represents the
INTRODUCTION 3
distinction between the exercises in positive economics involved

in calculating the change in equilibrium caused by the
introduction of a policy and the normative exercise of evaluating,
in terms of welfare, the outcome of policy. To achieve the first
objective requires a theory that describes how economic agents
choose their actions and how these actions are affected by
changes in policy. The individual agents must then be combined
to form an economy and a theory of equilibrium provided for
this economy. The evaluation of policy, and the choice of optimal
policy, necessitates the specification of an objective for the policy-
maker that is capable of providing a measure of the performance
of each policy based on the relevant features of the equilibrium
resulting from policy. This evaluation part represents an
application of normative economics. The success of Public
Economics has largely followed from the systematic application
of these methods.
The theory of Public Economics developed mainly since 1970
has built upon developments in micro economics, macro
economics, general equilibrium theory and game theory. One of
its characteristic features is the use of duality techniques to
allow problems to be phrased in the manner most amenable to
solution. These techniques permit optimisation exercise to be
phrased in terms of the natural choice variables. In this context,
the work of Diamond and Mirrlees (1971) was of fundamental
importance into Public Economics.
An emerging trend in the Public Economics literature has
been the use of numerical methods. These have taken the form
of both simulations of economics in order to test their behaviour
and the evaluation of policy proposal using empirical data. The
latter technique indicates a promising convergence between
theory and application and is clearly a direction which the subject
will continue to move. On the other hand, traditionally, Public
Finance deals with the finances of the state, i.e. how the resources
are raised and how these are spent, which is basically a dealing
with the government budgets only from the financial point of
view. On the other hand, Public Economics deals with total
allocation of resources in the public sector from all its
perspectives, besides the optimum level of resource allocation in
the private and public sector. And once the optimum level of
resources is decided for the public sector, what forces push up
the limit of public sector. How the vested interest, bureaucracy
and politicians, are responsible for the ever increasing limits of
the public sector (theory of choice). If confronted with peak and
off-peak demands for public goods, how the theory of price
discrimination developed for private monopolist can be used by
public sector (club theory) also form the core of Public
Economics. Then the issue of trade-off between equity and
efficiency, in a policy framework, is a continuing and central
theme of Public Economics. It is interesting to note that some
economists prefer to call Public Economics as Public Sector
Economics.
Thus, we define Public Economics as a science which deals
with economic activities of the government, which have grown
out of not only the market failures but also from the failures of
the government, though its involvement with the former is far
stronger than the latter, which is still in initial stage.
NATURE AND SCOPE OF PUBLIC FINANCE

Public finance is a compound word, composed of two words,
i.e. ‘public’ and ‘finance’. The word ‘public’ is the antonym of
‘private’, that is, its meaning is directly opposite to that of the
word ‘private’. ‘Private’ usually concerns an individual and is
often used in a singular sense. Its plural version is ‘public’,
which signifies an association or group of two or more than
two individuals. In its widest sense, it means all the members of
a community which is represented by the word ‘public’. In Public
Finance, however, the word ‘public’ is neither used in its widest
sense nor in its narrowest sense of just two or a few individuals.
It is really used in a specific sense—in the sense of government.
Though temples, schools, hospitals and universities are public
institutions, yet we do not study their finances in Public Finance.
It is only the finances of the governments—Central, State and
Local—that are studied in the science of Public Finance. Thus,
the word ‘public’ is used to signify government or state. It would,
therefore, be better to use ‘Government Finance’ or ‘State
INTRODUCTION 5
Finance’ in place of ‘Public Finance’ as that would indicate the

scope of the subject more accurately.
The word ‘finance’ is necessarily connected with money.
When we think of finance we automatically think of money as
well. In the language of the layman, money is used in its very
narrow sense and is identical with the currency in use. However,
in its widest sense money includes anything that can perform
the functions of money or can assume its role. Thus, if a mere
‘thank you’ enables a person to obtain a cup of tea, then this
term performs the same function as money. In Public Finance,
the word ‘finance’ is used in its widest sense. Many a time
government collects taxes and incurs public expenditure not
in terms of cash/money but in kind. Tax revenue or public
expenditure, whether in cash or kind, forms part of the subject-
matter of Public Finance.
The state has a number of wants and to satisfy these wants
it has to perform some activities and requires funds to finance
these activities. These funds can be raised in the form of money
or currency or in kind. Similarly, they can be spent in the form
of money or in kind. In times of war, the state often raises
resources in kind, for example, when it requisitions the services
of individuals or their buildings, transport, etc. Even otherwise
the state may raise resources in kind, for instance, it may raise
taxes from agriculturists in kind in order to acquire command
over a part of the food output to be distributed equitably under
scarcity conditions. In many states, Honorary Magistrates are
employed to dispense justice. In this case, the state raises
resources in the form of their services and pays them a
remuneration in the form of the status and honour conferred on
these Magistrates. According to some people, the science of
Public Finance is concerned with the method of raising finances
and the mode of spending them by the state. Such an
interpretation makes the scope of the science very narrow,
especially if the word finance is interpreted in its narrow sense.
However, as explained above, we use the word ‘finance’ in its
widest sense and would define Public Finance as the study of
the activities of the state or government from the financial
viewpoint. Thus, it will study how finances in cash or in kind
are raised, or should be raised, to enable the state to perform its

activities and how these finances should be spent in the
performance of these activities. As already emphasized, these
finances can be raised in kind as well, though in a modern
community almost all the activities are financed through money
and hence almost all the finances are raised in the form of
money.
As explained, the science of Public Finance takes objectives
as given. The objectives which the state has to achieve are decided
by the people or the government and are given data for the
science of Public Finance, which tries to achieve them through
the raising of resources and using them for financing the
activities, which will enable given needs to be satisfied in the
most economical manner. The method of raising resources and
the activities to be performed by the state are thus dependent
upon the needs of the state,1 which are given objectives for the
science of Public Finance. It is apparent that we study all the
activities of the state, the only restriction being that we study
them from the financial viewpoint to ensure that resources are
raised and spent in the most economical manner and that the
finances are provided only for those activities which will help
us to achieve our ends, again in the most economical manner.
Activities which take us away from our ends, or which delay
the achievement of our ends, or enable us to reach our ends
through a circuitous and uneconomical route, are not justified
because they involve the using up of finances which, like
everything else, are scarce in the world in which we live. We
have to decide how much and to what extent different activities
have to be performed depending on the resources available. We
have also to decide how much finance is to be spent on one
activity as compared to the finances spent on other activities, so
as to achieve a proper balance between the finances spent on
different activities that help to achieve our ends. Only in this
way can we make the most economical use of the finances of
the state. In conclusion, we may define the science of Public
Finance as a study which concerns itself with the activities of
the state or government from the financial viewpoint with a
view to achieving the objectives of the state in the most
INTRODUCTION 7
economical manner. It must be remembered, however, that in

the science of Public Finance, the word ‘public’ has a very narrow
meaning while the word ‘finance’ is used in its widest sense.
The above discussion enables us to lay down the precise
scope of the science of Public Finance. On the one hand, the
scope is restricted in the sense that it studies the activities of
governments—Central, State and Local—only.2 On the other
hand, all their activities are not studied. These, however, are
studied only from the financial viewpoint or the financial aspect.
Other aspects of these activities are studied by sciences other
than Public Finance. To study fully the activities of a government
we will have to study several other sciences besides Public
Finance. Then alone can we make a complete study of the
activities of a government. Thus, obviously the scope of Public
Economics is much wider than that of Public Finance.
It must be observed that the science of Public Finance or for
that matter Public Economics is both positive and normative. It
is positive in the sense that it studies the activities (financial) of
the government they actually occur. A study of tax structure
and expenditure structure, as they are, falls in the realm of
positive science. When we study the financial activities of the
government as they should be according to set goals or norms
of the society, we enter into normative aspect of Public Finance
or Public Economics. Once the objective is given, or determined
by the state in the light of socio-political theories that prevail in
the community, there is only one way in which Public Finance/
Public Economics activities can be planned so as to secure the
maximum achievement of that ideal. The modern state is broad-
based, no matter whether organized on a communist or a
capitalist basis, and has as its objective the welfare of the
community as a whole. It is, thus, essentially a democratic state
where the wishes of the people ultimately prevail. It is another
thing that the voting behaviour of the people, sometimes, does
not lead to any concrete proposal.
A state which is guided with the objective of the welfare of
the entire people is a mere theoretical concept. In practice, the
state tends to place greater emphasis on the welfare of some
people than that of others. The destinies of the state have to be
guided by men, with all their human weaknesses, who may not
always be able to clearly visualize the true interests of the entire
people. They may sometimes exploit the people for their personal
or party advantage. To the extent that they succeed in furthering
personal interests at the cost of the interest of the community,
the state fails in its objective of promoting the interests of the
entire people, known as government failure. In analyzing various
theories we will, however, assume that our state exists for the
welfare of the people as a whole. Our analysis will, therefore,
be directed to the maximum attainment of the objectives of
such a state. With this given objective we can test the different
policies and suggest changes in them, if necessary. This is the
normative aspect of the science of Public Finance or Public
Economics.
ROLE OF THE GOVERNMENT IN AN ORGANISED SOCIETY

The dominant setting for analysis of Public Economics is
within the mixed economy so that individual decisions are
respected but the government intervenes to affect these choices.
The design of policy can then be interpreted as the manipulation
of individual choices by the choice of policy parameters as to
arrive at an equilibrium preferred to that which would otherwise
arise in an unorganized society without any policy direction.
The motivation for the study of Public Economics follows
naturally from the observation that unregulated economic activity
does not lead to a socially optimal outcome. At a very basic
level, an economy could not function effectively if there were
no contract laws since this would inhibit satisfactory exchange.
In addition, although the anarchic equilibrium that would occur
without contracts may be in the core of the economy, but it
needs not be particularly stable. It must, therefore, be accepted
that no economy could operate without law enforcement and
that in order for organized economic activity to take place,
there must be clearly defined and enforced set of contract laws.
These laws cannot be policed free of cost. There is also a need
for the enforcement of more general criminal laws and for the
provision of a means of defence for the nation.
INTRODUCTION 9
Consequently, even the minimum requirements of the

enforcement of contract and criminal laws and the provision of
defence need the collection of revenue to provide the required
finance. This is the case whether these services are provided by
the state or private sector organisations. The coordination of
the collection of revenue and the provision of services to ensure
the attainment of efficient functioning of economic activity
therefore provides a natural role for a central state in any
economy that wishes to develop beyond the most rudimentary
level. In addition, this reasoning also illustrates that to achieve
even the most minimal level of efficiency and organization of
economic activity some unavoidable revenue requirements are
generated and require financing.
Having determined that the organization of economic activity
generates a revenue requirement, one aspect of the role of Public
Economics is to determine how this revenue can be collected at
the least cost of the economy. Although the concept of least
cost has several possible interpretations, both positive and
normative, under any interpretation the aim of the economic
policy design would be that of finding and efficient means of
revenue collection. Such design would involve the identification
of feasible policy instruments to be imposed from amongst those
that are feasible and the calculation of the optimal level of each
instrument. The issue of efficiency in policy design is a continuing
and central theme of Public Economics.
Moving beyond the basic requirements for organised
economic activity, it is arguable that there are other situations
where state intervention in the organised society/economy has
the potential to increase welfare. Unlike the basic revenue
requirements, however, there will always be a degree of
contentioness about further intervention motivated on these
grounds. The situations where state intervention may be
warranted can be divided into two categories: those that involve
market failure and those that do not. With market failure, the
argument for considering whether intervention would be
beneficial is compelling. For example, if economic activity
generates externalities, so that there is divergence between private
and social costs and competition outcome is not efficient, it
may be felt necessary for the state to intervene to limit the

inefficiency that results. This latter point can also be extended
to other cases of market failure such as those connected to the
existence of public goods and of imperfect competition.
Where market failure does not occur, state intervention can
be motivated by the observation that although equilibrium may
be efficient it needs not be optimal according to the state’s welfare
criterion. Such a situation may arise if the equilibrium of the
economy is characterised by the widespread poverty and an
inequitable distribution of income. In such circumstances, the
level of economic welfare viewed by the state may well be raised
by a programme of income redistribution. Similar arguments
can be applied to the provision of state education, social security
programmes and compulsory pension schemes. It should be
stressed that such potential increases are with respect to
normative assessments of welfare, unlike the positive criteria
lying behind the concept economic efficiency.
In cases of both market failure and welfare motivated
policies, policy intervention concerns more than just the efficient
collection of revenue. The reasons for the failure of the economy
to reach the optimal outcome have to be understood and a
policy that can counteract these has to be designed. It must also
be recognised that the actions of the state, and feasible policies
that it can choose, are often restricted by the same features of
the economy that make the competitive outcome inefficient. In
each case, policy intervention can only be justified by proving
that the state can always do should not be taken for granted.
Extending the scope of Public Economics to address such issues
provides the breadth of Public Economics.
In conducting an economic policy, the state will generally
have conflicting aims. On the one hand, it will aim to implement
the policy with the minimum loss to society. The use of policy
will cause a loss due to the resources used in the implementation
process and from the economic distortions that the policy will
cause. Minimising these losses is the efficiency aspect of policy
design. Conversely, the state may also feel that it is desirable to
intervene in the economy in order to attain a more equitable
INTRODUCTION 11
distribution of the economy’s resources. This is often

accompanied by a corresponding reduction in the degree of
concern for the aggregate level of economic activity. This
motivation represents the equity side of policy design.
Due to their distinct natures, it is inevitable that the aims of
equity and efficiency regularly conflict. It is often the case that
the efficiency policy is highly inequitable whilst the equitable
policy would introduce into the economy significant distortions
and disincentives. Given this fact, the design of optimal policy
can be seen as the process of reaching the correct trade-off
between equity and efficiency objectives. This optimum trade-
off will depend upon the concern for equity that is expressed in
the objectives of the policy matter. In many analyses of policy
problems, the resolution of the trade-off between equity and
efficiency is the major determinant of the resulting policy
programme with aspects of the policy being attributable to one
or the other. This distinction is often helpful way in which to
think about optimality problems and their solutions.
To illustrate this discussion, a simple example of the conflict
between equity and efficiency can be found in the optimal
taxation of commodities. It is efficient to tax goods with low
elasticity of demand, as shown by well-known inverse elasticity
rule, since this introduces the least distortion into the pattern of
demand, i.e demand remains almost the same. However, goods
with low elasticity of demand tend to be necessities that are
consumed disproportionately by less well-off households. Taxing
these goods highly would then cause a proportionately greater
reduction in the welfare of poor households. The proposed tax
programme is, therefore, highly inequitable and equity criteria
would shift the taxes on to goods consumed by higher income
groups.
The role of information is central to Public Economics. The
availability of information to private agents determines the nature
of equilibrium with policy intervention and the information set
of the government determined feasible policy instruments. If
information deficiencies, particularly asymmetic information
between agents in the economy, lead the market outcome to be
inefficient, the state can only improve the outcome if it is not

subject to the same informational limitations. To maximize
welfare in Public Economics, dissemination of information is
very essential.
CHANGING PERSPECTIVES ABOUT THE ROLE OF

THE GOVERNMENT
“The very best of all plans of finance is to spend little, and
the best of all taxes is that which is the least in amount”,
remarked J.B. Say, a famous classical economist. For classical
economists, “The best government was that which governed
the least.” In the words of J.S. Mill, “Laissez-faire should be the
general practice: every departure from it, unless required by
some great good, is a certain evil.” Classical economists believed
in invisible hand. They opined that when everyone maximizes
his income, total income in the economy or country would also
be maximized. To them the government was to perform strictly
three functions, viz. (i) protecting the country from foreign
aggression, (ii) maintenance of internal law and order, and
(iii) constructing and maintaining certain public works such as
roads, bridges and canals for promoting trade and commerce.
To meet the expenditure needs of the state for above-mentioned
functions Adam Smith laid down four maxims (canons) of
taxation, viz. canon of equality, canon of convenience, canon of
certainty and canon of economy. But nowhere, he talked about
canons or maxims of public expenditure. To classical economists
perhaps “Taxes were like hails which destroy the crops”. They
never considered the use pattern of taxes. According to classical
economists, taxes kill the private initiative on the one hand and
restrict the resource availability to the private sector on the
other hand.
Prof. R.N. Bhargava while tracing the history of origin of
Public Finance says that the state came into existence primarily
for the purpose of protecting the society/community. The
functions of the state or the government were, therefore, very
limited and narrow. It had to maintain law and order and protect
the community from external aggression. Primarily, the state
was a ‘Police State’. While discharging these protective functions,
INTRODUCTION 13
the government was forced to increase its role gradually. There

was also the fear that autocratic rulers will misuse the funds
placed at their disposal. Hence, people tried to restrict the
availability of funds to the government. This restriction had its
impact on the functions that the state could perform and acted
as a check on their expansion. The classical economists, with
their faith in laissez-faire policy, also advocated minimum
functions for the government. However, there was a gradual
change in the concept of the state and there was a steady increase
in the functions of the state and these functions were extended
to the fields of education, poor relief and later on, sanitation,
medical, etc. If the state protected its citizens against aggression
or internal disorders, it was also the duty of the state to protect
the community against disease, ill-health, poverty and ignorance,
so that the concept of a welfare state gradually evolved. The
objective of such a state is to maximize the welfare of the
community as a whole. Such a view of the state, however,
extended its functions and it had to take up certain public utility
services also to increase the welfare of the community. The
severe depression of the thirties and the publication of Keynes’
General Theory sounded the death knell of laissez-faire policy.
Keynes demonstrated that “it was possible through the fiscal
activities of the state to increase employment and to maintain it
at a high level”. Since then most governments are committed to
the maintenance of stable and expanding levels of employment
and their goal is that the economy should function at the full
employment level as far as possible.
Keynes demonstrated that income has two sides, viz. income
and expenditure. One man’s expenditure is another man’s
income. His famous equations are:
Y = C + S (Income side)
Y = C + I (Expenditure side)
That is income (Y) can either be consumed or saved; or
alternatively income can be spent either for consumption
purposes or investment purposes or both. Consumption (C) being
common in both the equations, therefore, savings (S) will have
to be equal to investment expenditure, in order to maintain
economic stability. But as savings normally exceed investment

expenditure, therefore, a process of downswing in the economy
sets in. In order to maintain economic stability, government
expenditure must compensate the fall in private total expenditure,
that is the expenditure side equation should then become C + I
+ G, where ‘G’ denotes government expenditure. Thus, the role
of Public Finance was recognized as compensatory finance for
the first time. But in the wake of inflationary trends during the
Second World War and the post-War period, the role of the
government to perform anti-inflationary and rehabilitatory
functions was also recognized. And we moved from
‘Compensatory Finance’ to ‘Functional Finance’, the concept
propagated by A.P. Lerner.
While the concepts of ‘Compensatory Finance’ and
‘Functional Finance’ were evolved in the context of developed
countries, in the context of underdeveloped countries considering
that the government should be committed to a programme of
accelerated economic development, a new concept of
‘Development Finance’ took place. Prof. R.N. Bhargava sums
up, “Thus developed and developing states have both to play
an increasing role in the economy and their functions have
considerably expanded. In order to discharge these expanded
functions the state has to increase its draft on the gross national
product…. This expansion in the functions and responsibilities
of the state has considerably increased importance of the science
of public finance and it now plays a vital role in the economic
life of a community and its members.”3
Briefly speaking, one can discuss the changing role of the
government in the context of three important economic systems,
namely capitalist or free enterprise economy, mixed economy
and socialist economy.
Government in a Capitalist Economy
In the context of free enterprise or capitalist economy, the
following are some of the important factors which have played
a key role to popularize the science of Public Finance from time
to time.
INTRODUCTION 15
Breakdown of Laissez-faire Policy

As already stated that the laissez-faire policy failed miserably
during the depression of thirties. Keynes demonstrated that in
order to maintain the level of effective demand so as to achieve
the objective of economic stability the state must intervene
actively. Whenever savings exceed investment so the total
expenditure in the economy falls, then public expenditure must
increase to compensate this fall. Even during inflation the active
role of the government to maintain price stability cannot be
denied. The government has to siphon off the excess purchasing
power either in the form of taxes or loans to reduce the pressure
on demand. Even when the economy is on even keel, the
extension in the role of the government cannot be belittled. A
German thinker, Wagner, projected as early as in 1883 that
there was secular tendencies of increasing state intervention (in
the form of increasing public expenditure both intensively and
extensively). Wiseman and Peacock agreed with the basic
observations of Wagner but they offered different interpretations
for the increasing tendencies of public expenditure. Thus,
although the failure of laissez-faire policy during the great
depression gave a final blow to the doctrine of state non-
intervention, yet the increasing importance of the role of the
government was being recognized much earlier.
Lack of Common Goods and Provision of Public Utilities
Provision of common goods like parks, libraries, schools
and other recreational facilities is urgently required for ever-
increasing population in urban areas. In the absence of such
facilities, the urban life would have been very dull and drudgery.
Therefore, the state (here urban local self-government) must
come forward to make provision for these goods so as to
maximize social welfare. The private sector being solely guided
by profit motive would be least interested in these economic
activities. In fact, the concept of social welfare or welfare state
has further extended the field of public finance. Further, the
provision of public utilities like public health including safe
drinking water, transport and communication, electricity,
sewerage system, etc. is another area of concern in a welfare
state. Because of the externalities of these goods they must be

provided by the state. The private sector either will not undertake
the production and distribution of these goods and services, or
if it is asked to do so, two extreme economic tendencies, viz.
excessive competition or monopoly would develop. Either of
these tendencies is not conducive to maximize the social welfare
which is the main objective of public finance activities.
To Bridge the Gap between Private Interest and Social Interest
To achieve the goal of maximizing social welfare brings us
to another area of concern, i.e. a perennial conflict between
private welfare and social welfare. This divergence in interest
arises due to many factors. While private interest is to maximize
private profits, the social interest intends to maximize social
welfare. Now profits depend on total revenue (total production
× price of the product) and total costs. Prices being determined
by market forces, the producers usually try to minimize costs.
The discharge of industrial wastes and effluents by industries in
the nearby fields is (was) an excellent example. No doubt the
disposal of such toxic wastes, costs nothing to industry, and
therefore, serves the purpose of private interest, but its social
costs, in terms of its adverse effects on health would be
unimaginable. A.C. Pigou, a classical economist but ardent
believer in maximizing social welfare, explains how public
finance activities can be used to bridge this conflict between the
two. During his times, the paper manufacturing units were
usually located near the running streams of water like rivers or
canals so that the industrial wastes produced during the
manufacturing process are discharged in the water at no cost to
the industry. In the process, the water got contaminated. But
that water was invariably used for irrigation, washing and even
for drinking purposes. Thus, the people living along side the
polluted stream of water were the greater sufferers. A.C. Pigou
explained that a system of taxes and public expenditure policies
can partially correct this divergence by taxing the paper-
producing firms and utilizing the proceeds for the purification
of water.4
INTRODUCTION 17
Correcting Inter-personal and Inter-regional Inequalities

Another important feature witnessed by the developed
countries in their initial stages of economic development was
the growing economic disparities. In free enterprise economies
such disparities were tolerated as they provided incentives to
the propertied and entrepreneurial class. In fact, the main reason
for the growing economic inequalities has been the right to own
private property. But no society can tolerate such disparities
beyond a certain point. A combination of tax and expenditure
policies has to be evolved to keep these inequalities under check.
Beside inter-personal inequalities as discussed above, inter-
regional inequalities is another essential feature of
underdeveloped countries like India. Through fiscal incentives
(like subsidies and tax holidays) and disincentives (like heavy
taxes), the dispersal of private enterprises over the vast areas
particularly backward areas can be ensured.
Satisfaction of Social and Merit Wants
In a welfare state, the satisfaction of social/collective wants
and merit wants is another point to the growing importance of
Public Finance or Public Economics. All the wants of the
community can be divided into three categories:
(i) Private wants
(ii) Social wants
(iii) Merit wants
Private wants are those wants which are satisfied by the
people on their own depending upon their affordable capacity.
A rich person may satisfy more of his demands than the poor
person. Social wants are those wants on which all people have
the equal rights. Maintenance of law and order, internal and
external security (defence) and even some minimum amount of
sanitation and other health measures are such examples where
all have to be benefited. Technically speaking, we can say that
here the principle of exclusion does not apply, that is, we cannot
exclude or deprive any person from availing of such facilities.
Those have to be provided by the state by incurring public
expenditure on these items, for which the government can levy
taxes and thereby satisfy these wants. Merit wants, on the other
hand, though are the private wants, yet these have to be satisfied
by the government. Musgrave defines ‘Merit’ wants as those
wants of the poor like minimum housing, food and clothing
and even social security which the state must provide. The poor
people, because of their poverty, cannot afford a minimum
desirable level of these merit wants out of their own income.
Therefore, the state must subsidise partially or wholly such wants.
To Promote and Stabilise the Economic Growth
Problems of economic stability and promoting economic
growth are the major issues with which the government is
confronted with in developed and underdeveloped countries
respectively.
As already stated the concepts of ‘Functional Finance’ and
‘Development Finance’ were developed in this context. While
the former, as advocated by A.P. Lerner, is applicable in the
context of developed countries, the latter conforms to the needs
of underdeveloped or developing countries.
Thus, we can conclude that the importance of Public Finance
cannot be belittled. The subject has travelled a long path before
reaching the present state of affairs. The state is no longer a
police state and the days of laissez-faire are gone. The state has
undergone a fundamental change today. From a protector of its
citizens against internal disorder and external aggression, it has
grown into a welfare state. Its basic objective now is to maximize
social welfare. It has to adjust and extend its tax and expenditure
programmes so as to maximize total social advantage. According
to Pigou-Dalton approach, this point is reached when marginal
benefits from public expenditure are equal to marginal sacrifice
imposed by taxation, which is also called a ‘Principle of Public
Finance’.
Principle of Maximum Social Advantage
This can be explained through the following Fig. 1.1.
In the figure, we measure amount of taxation and public
expenditure on ‘X-axis’, and benefits from public expenditure
and sacrifices imposed by taxation on ‘Y-axis’. The curve ‘MB’
INTRODUCTION 19
Fig. 1.1
stands for marginal benefits from public expenditure, which

falls from left to right like marginal utility curve, indicating
thereby that as more and more is spent marginal benefits from
public expenditure go on decreasing. Contrary to this, ‘MS’
curve stands for marginal sacrifices of taxation, which go
on increasing as more and more taxes are levied on the people.
In order to maximize total social welfare tax-expenditure
programme should be extended upto OM. If tax-expenditure
programme is stopped before OM, marginal benefits from public
expenditure would be more than the marginal sacrifice imposed
by taxation. Therefore, the government can add to the social
welfare by extending the taxation and expenditure levels.
However, if tax-expenditure programme is extended beyond
OM, the marginal sacrifices of taxation on people would be
more than marginal benefits from public expenditure and in the
process total social welfare would suffer. Thus, the public finance
activities, viz. tax-expenditure programme should be extended
upto OM in order to maximize total social welfare.
Musgrave Approach5
A noted economist, Professor R.A. Musgrave, has explained
the principle of maximum social advantage differently.
According to Musgrave, the total social benefit is maximum

where the net social benefit is zero, i.e. NSB=MSB-MSS=0.
Figure 1.2 shows that the MSB curve is downward-sloping,
drawn above the horizontal X-axis showing that MSB declines
as public expenditure is increased. The MSS curve drawn below
the horizontal X-axis shows that MSS is higher at higher rates
of taxes measured on the X-axis. MSS is measured on the Y-
axis from O downwards and MSB is measured on the Y-axis
from O upwards.
NSB (net social benefit) is the difference between MSB and
MSS. In the beginning, the NSB is positive (since MSB>MSS),
till taxation and public expenditure reached point M. After M
any further taxation and expenditure will result in MSS being
greater than MSB (MSS>MSB). Thus, before M, NSB is positive
and after M, NSB becomes negative. At M, NSB is zero and
thus at point M there is maximum total social benefit. Maximum
social advantage is attained until taxation and public expenditure
is carried till NSB is zero.
NSB=MSB–MSS=Zero
Aggregate social benefit is maximised and aggregate social
sacrifice minimised when NSB=zero. So long as NSB is positive,
Fig. 1.2: Principle of Maximum Social Advantage

INTRODUCTION 21
there is further scope to extend both taxation and public

expenditure and to the aggregate benefit. When NSB becomes
negative (after M), there is net social loss as MSS>MSB. It is,
therefore, not desirable to extend taxation and public expenditure
beyond point M.
In Fig. 1.2, taxation and expenditure are measured on the
X-axis. MSS is measured on the Y-axis from O upward. MSS is
measured on the Y-axis from O downward. The MSB curve
shows diminishing MSB, and MSS curve shows increasing MSS.
NSB curve shows net benefit difference between MSB and MSS.
At point M, both MSB and MSS are equal. NSB is zero here.
SB=MK–ML=O
This is the point of maximum social advantage according to
Musgrave.
After a careful study of Musgrave’s explanation, it is
observed that he does not add anything new to what Dalton has
already said. Dalton talks of equality between MSB and MSS,
whereas Musgrave introduces the concept of NSB which should
be O, i.e. MSB–MSS=Zero, which is the same thing when Dalton
says, MSB and MSS should be equal to maximise total social
benefit.
Evaluation of the Principle
Theoretically, the principle of maximum social advantage
seems to be sound but its practical possibility is often doubted.
Whenever we try to apply it actually to the financial operations
of the government, a number of difficulties surround us as
mentioned below:
(i) Utility or sacrifice is a subjective phenomenon. If a
bridge over a railway line is constructed, its utility may
vary from person to person. Some may not like to
divulge their true preferences out of fear that the
government may tax them on the basis of their
preferences. Some enthusiastic person may even
exaggerate the gains derived from the services of the
bridge. Similarly, a nationalist may not mind paying
one rupee extra whereas another may grumble even
paying a single paise. How to take account of all these

personal and conflicting attitudes?
(ii) If we accept the hypothesis of modern welfare
economics that utility cannot be measured quantitatively
and interpersonal comparisons of utility are not
possible, the law falls flat on the ground. Another weak
assumption is that money is supposed to be subject to
the law of diminishing marginal utility. But there is no
dearth of persons who claim that marginal utility of
money remains constant and may even increase over a
certain range.
Even if we accept the cardinal utility hypothesis, a
number of practical problems still confront us. How to
decide whether one extra rupee raised by levying import
duty will be less burdensome than that raised by
imposing excise duty? Whether one extra rupee spent
on minor irrigation will be more beneficial than
spending on fertilizer? How to compare the extra
sacrifice imposed on a businessman of Bombay with
the extra gain by spending that extra rupee on a farmer
of Amritsar?
(iii) The sacrifice of taxation is compound of so many
elements. It may be a function of the amount of the
tax, nature of the tax, time at which the tax is imposed,
the mode of payment, behaviour of the tax authorities
and so on. To take into account the effect of all these
variables on the sacrifice is another hurdle in the
application of the principle. It shows that the principle
of maximum social advantage is not feasible proposition
and the comparison of the marginal benefit and
marginal sacrifice is a very delicate affair.
(iv) The principle is based upon the generalization that
every tax is a burden upon the society and every public
expenditure confers benefit on it. However, it may
not be so in actual practice. For example, a tax on
intoxicants and other harmful drugs cannot be regarded
as a burden on the society. Similarly, public expenditure
INTRODUCTION 23
if overdone or misdirected, may not be advantageous

to the society. In actual practice, a large portion of
public expenditure is incurred according to pulls,
pressures and influences of the vested interests rather
than on strict economic considerations.
(v) The effects of fiscal measures are difficult to foresee as
they are complex and widespread. How consumption,
production, saving, productive power, investment
pattern of the society will be affected by these measures
in the long run is difficult to understand. Hence, the
welfare effects of the financial operations of the
government cannot be determined in terms of the
amounts of taxation and public expenditure alone.
Moreover, effects of the budgetary policy are not
confined to the period of budget only but they extend
to the longer period. Hence, it is not possible to talk of
sacrifice and benefit with reference to a particular
budget only.
(vi) The point of maximum social advantage is not a fixed
point but a moving point. The optimum in respect of
public income and expenditure varies with the size of
national income which itself is determined by the
financial operations of the state. Hence, what is
optimum at one level of income, may not be so at the
other level of income and as such it is not possible to
determine exactly the point of maximum social
advantage.
(vii) A policy of deliberate deficit budgeting is needed to
speed up the pace of economic development of under-
developed countries and contra-cyclical budgetary
policy is followed in developed countries to offset
business fluctuations. However, the principle of
maximum social advantage points to the desirability
of maintaining a balance between income and
expenditure but such a restriction will defeat the very
objective of this policy which is the maximization of
social advantage. Thus, the application of the principle
of public finance is beset with serious limitation in

actual practice.
Government in a Mixed Economy
As already mentioned above, the role of the government in
a free enterprise economy is limited, though various factors have
played a key role in popularizing the science of Public Finance
or Public Economics. However, in a mixed economy the role of
the government is increasingly recognized. Here public sector
has to operate along with the private sector in the decision-
making processes covering economic activities in general and
allocation of resources in particular. In fact, a mixed economy
is one where both private and public sectors operate side by
side. The essential feature of such economies is that here the
role of the government is increasingly recognized. Under the
garb of nationalization, the hold of the government is being
extended and this extension of the role of the government can
take various forms such as:
(a) Direct Participation;
(b) Regulatory or Indirect Measures; and
(c) Direct Physical Controls.
Direct Participation
Government in a mixed economy directly participates in
performing certain economic and social activities. Sometimes,
both public and the private sectors operate simultaneously to
supplement their efforts. And sometimes their objectives may
be different. For example, in India there has been an ever
increasing extension in the government activities. The proportion
of total public expenditure (both of the Union and the State
Governments) to national income has increased to as much as
40 per cent from a meager figure of about 20 per cent when we
embarked on the path of planned economic development. As
already discussed, Wagner, a German thinker, projected as early
as in mid-19th century that there were secular tendencies of
increasing state intervention. Today, there may be no country
in the world which could be characterized as a free enterprise
economy following purely laissez-faire policy. Take the case of
INTRODUCTION 25
India, Industrial Policies of 1948 and 1956 recognize that both

private and the public sectors have key roles to play for the
economic development of the country. Through the Industrial
Policy of 1956, the commanding heights of the economy have
been entrusted to the public sector. Even in the recent past
when the government announced the introduction of New
Economic Policy in 1991 and embarked upon the drives of
privatization, liberalization and globalization, the role of the
public sector did not get diluted. The government continued to
have a monopoly on the social sector like education, social
security and medical and public health. Even certain economic
activities, particularly those directed towards poverty alleviation
programmes, remained the sole privilege of the public sector.
Many a times the direct participation by the government
necessitates the operation of indirect regulatory measures such
as taxes and duties, tariffs, subsidies (public expenditure),
availability of bank credit, etc. Take the example of deficit
financing. Although deficit financing gives a virtual confiscatory
power to the government to purchase whatever it likes without
resorting to mobilization of resources through taxes and non-
tax measures, yet it disturbs the equilibrium in the monetary
market, which necessitates the application of regulatory measures
like credit regulation. Thus, the application of regulatory
measures is another manifestation of government intervention
in a mixed economy.
Regulatory or Indirect Measures
Sometimes, government can use indirect measures to achieve
the planned targets in a mixed economy. Suppose the government
wants to discourage imports and encourage exports. Then the
government can resort to increasing import duties and giving
export subsidies. Similarly, for affecting the desired changes in
production pattern tools of taxes and public expenditure can be
employed. Availability and restriction of bank credit is another
form of regulatory mechanism to control the private sector in a
mixed economy. Likewise regulatory pricing mechanism is
another indirect form for containing the private sector in mixed
economy. Thus, the activities of the government do not stop at
having a proper and effective public sector only. In a mixed

economy, the government also tries to regulate the working of
the private sector so as to achieve the set social objectives and
planned targets. Sometimes, the regulatory mechanism takes
the shapes of direct physical controls like licensing, quotas, etc.
with which we are quite familiar.
Now whether these measures succeed or not it depends upon
a number of other factors, yet the fact remains that the
government in a mixed economy tries to influence economic
activities through these measures.
Direct Physical Controls
For the economic fields, where the government itself does
not want to enter or where even regulatory devices fail, the
government resorts to direct physical controls. The government
may not issue license for economic activities which it does not
want to promote. Quota and rationing systems are other such
manifestations through which the government tries to allocate
the scarce resources. Import and export restrictions also fall in
this category. It is another thing that such physical controls
often promote economic inefficiencies and breed corruption.
That is the main reason that India is now bidding farewell to
these regulatory mechanisms when we talk about privatization
and liberalization of the Indian economy.
From the above discussion we can conclude that despite
some shortcomings the modern governments find that the need
of state intervention has been constantly increasing. Even when
the economy is a free enterprise economy and depends on price
mechanism, there is a need to regulate its working. Left to itself
free market system would promote inequalities in the distribution
of income and wealth on the one hand and monopolistic
tendencies on the other. A free market economy is also subject
to violent fluctuations which the government should protect by
actively participating in the economic system. We have already
discussed this problem of ensuring economic stability. Besides,
it is also contended that the growth of industrialization and
urbanization creates a lot of economic problems. The problems
of health, education, recreation, housing, social security, etc.
INTRODUCTION 27
increase automatically. These problems can be tackled only at

the local level and the local self-governments are important
organs of the state in countries like India. With the 73rd and
74th Amendments of the Constitution these problems have been
tackled to some extent.
Another essential feature which distinguishes the mixed
economies from free enterprise economies is the incorporation
of planning for economic development. The role of the
government is all the more important to usher in a new era of
economic development. Mixed economies are invariably beset
with numerous problems of underdevelopment. Raja J. Chelliah
explains how in such economies the government can supplement
the private efforts and act as a catalytic agent to promote
economic development. In these countries, there is lack of savings
because of widespread poverty. And whatever little savings exist
these are channelised not into productive investment but in less
risky channel like real estates and jewellery. The main stumbling
block in productive investment is the lack of infrastructure.
Private sector does not invest in social and economic
infrastructure like education, public health, means of transport
and communication, power, financial markets, etc. This is mainly
because of the poor return from such investments. And also
lack of initiatives on the part of private investors prohibit them
from going for these investments in a big way. Raja J. Chelliah
explained how the governments of underdeveloped countries
can perform this gigantic task of promoting economic
development.
The most important task before the underdeveloped countries
which have opted for a mixed economic system is not only the
lack of resources but also their mobilization for building capital
assets. The main problem before the government is to find the
economic surpluses and then mobilize these surpluses for
economic development. Raja J. Chelliah in this regard
distinguishes between three forms of economic surplus:6
(a) Existing Economic Surplus,
(b) Potential Economic Surplus, and
(c) Additional Economic Surplus.
While the first two are static concepts, the third one is a
dynamic concept.
By existing economic surplus, we mean the excess of current
income over current consumption provided it is not productively
invested. At any given time the nationals of a country would be
consuming less than their current income. If the difference is
not productively invested, then it becomes the duty of the
government to mobilize this existing economic surplus. The best
channel of mobilization is taxation. If this is not possible, then
the government must resort to borrowings to mobilize these
surpluses. Symbolically, one can define the existing economic
surplus as:
Y – (C + I)
where ‘Y’ is the current income and ‘C’ and ‘I’ are
current consumption and investment respectively. The current
consumption, however, may be higher than minimum essential
consumption required for maintaining good health so that
efficiency for production is not adversely affected. In other words,
there may be always such cases as enjoying non-functional
consumption, i.e. wasteful consumption, which does not add to
productivity and promote efficiency. And in these cases there
may be potentials to contribute still more resources for the
economic development of a country. If these sections of the
society are not allowed to consume more than what is absolutely
essential for living so that excess is mobilized by the government
and investing these surpluses in productive channels the era of
economic development can be ushered in more quickly.
Symbolically, potential surplus means:
Y – (Cm + I)
where ‘Y’ and ‘I’ are current income and investment respectively
as before and ‘Cm’ is minimum level of consumption as defined
above.
It may be mentioned here that there may be some sections
of the society whose actual consumption may be less than the
minimum consumption. If these sections are allowed to continue
with their existing consumption levels, then potential economic
surplus may be little higher.
INTRODUCTION 29
Coming lastly to the economic surplus in a dynamic sense

or mobilization of additional economic surplus. As these
countries start developing, their current income goes on
increasing. Being poverty-ridden their marginal propensity to
consume (ΔC/ΔY) is very high and in most of the cases it is close
to unity, which implies that as they start experiencing increase
in their income, they tend to increase their consumption standards
by the same levels. That is, left to themselves every additional
income would be spent away and nothing would be left for
investment. Therefore, it becomes the duty of the government
not to allow increase in consumption to the same level as that
of additional increase in income. A substantial part of the
additional increase in income must be mobilized by the
government.
Another important function of mobilizing additional
economic surplus is to reduce economic inequalities. As the
process of economic development starts in mixed economies
there are in-built tendencies of increasing income inequalities.
Since income and wealth inequalities are socially intolerable
beyond a particular limit, it becomes the duty of the government
to initiate some progressive tax and expenditure policies so as
to contain them. It must be noted that since taxes adversely
affect ability to work, save and invest and willingness to work,
save and invest, therefore, progressivity in their case should not
be very steep. The Indian example bears testimony to this fact
that over successive years we have reduced progressivity in our
tax system without any adverse effect on the tax yield. Rather
public expenditure should be made more progressive so as to
promote ability and incentives for increasing production.
Another essential characteristic of these economies is that
they have adopted planning for development. The main difference
in planning for socialist and mixed economies is that while in
the former, it is by command, in the latter, it is mostly by
inducements. In socialist economies, planning for development
has to be through command approach. There is no question of
incentives or disincentives. But in a mixed economy to achieve
planned targets, particularly set for the private sector, planning
has to be done through various incentives and disincentive
measures. Planning for the public sector may be through

command, but for the private sector planning has to be through
inducements. Then the short-term (or annual) planned targets
have to be interwoven with long-term planned targets. Similarly,
regional planning has to be integrated with national planning.
For which an apex planning machinery has to be constituted by
the government.
Sometimes, the government in mixed economies find that
the private sector is not cooperating in achieving the set planned
targets. In such circumstances, the government may resort to
nationalization, i.e. takeover of the private sector. These measures
further extend the role of the government in a mixed economy.
Although this measure is fraught with many dangers, yet it helps
the state to achieve certain goals set for the society. The famous
measure of bank nationalization of 14 major commercial banks
in 1969 is a well-known example in India.
The increasing role of the government in mixed economies
is also due to lack of private initiatives. The private sector is
always guided by the principle of profit maximization. The
private sector would not invest in activities which do not yield
direct economic returns. The government sector, on the other
hand, is guided by the long-term objectives. There may be certain
activities which do not yield any direct return, yet in these cases
externalities or external benefits may be so much as to require
immediate attention of the government. Investment in economic
and social infrastructure is one such example. Availability of
power, means of transport and communication, education,
including technical education, medical and public health facilities,
etc. have to be provided. Since the private sector may not be
interested in these activities, therefore, it becomes the duty of
the government to come forward and invest in these channels.
Government in a Socialist Economy
Finally, before we conclude about the role of the government
in a mixed economy, a few words about the role of the
government in socialist economies. As already elaborated that
in a free enterprise economy because of certain factors the
government has to play a key role in the form of levying taxes
INTRODUCTION 31
and incurring public expenditure. Similarly, in a mixed economy,

by definition, public sector has to operate side by side with the
private sector. But socialist economies are entirely different. Here
whole of the economy is under socialist control. Therefore, the
government may not have to play the key role as it does in a
capitalist or mixed economy. But this appears to be a misnomer.
Because even in such economies taxes are levied and public
expenditure incurred the same way as it is done in capitalist or
mixed economies. For example, in the erstwhile USSR, turnover
tax on commodities was levied whenever the state found that
demand was likely to exceed supply. Therefore, in order to
equate demand and supply turnover tax was levied. Similarly,
various fiscal incentives in the form of better housing and living
conditions were assured to encourage the workers to improve
upon their productivity by receiving higher education.
To conclude the government has to play a key role in all
forms of the economic system, though the objectives of
government intervention may be different.
NOTES
1. We use the phrase “needs of the state” in the sense of individual
needs reflected in the State. Compare, “The doctrine that the ‘state
has needs of its own,’ which can only be satisfied through public
expenditure…is a piece of Hegelian nonsense…. The truth is, of
course, that only individuals have needs, but some of these needs
can be most effectively satisfied through the agency of the State and
by means of public expenditure.” Hugh Dalton, Principles of Public
Finance (Fourth edition), p. 140.
2. Accordingly ‘Government Finance’ is preferable to ‘Public Finance’.
Incidentally, the former term is the title of a book written by John F.
Due.
3. R.N. Bhargava, Theory and Working of Union Finance in India,
Chaitanya Publishing House, Allahabad, 1972.
4. A.C. Pigou, A Study in Public Finance, MacMillan and Company,
London, 1962.
5. R.A. Musgrave, The Theory of Public Finance, McGraw Hill,
Kogakhusa, Tokyo, 1959.
6. Raja J. Chelliah, Fiscal Policy in Underdeveloped Countries, George
Allen and Unwin, London, 1971.
Role of Government: 2
Public and Private Sectors
As already stated that state participation in economic activity

can hardly be a matter of disagreement. The free play of
economic forces, even in highly developed capitalist countries,
has often meant large unemployment and instability of the
system. Hence, there is a considerable dilution of the laissez-
faire principle and the governments are now called upon to
intervene in economic fields which were considered sacrosanct
for the private sector. In these advanced countries, state
intervention has been invoked to ensure economic stability and
full employment of productive resources of the community.
But state action is all the more inevitable in underdeveloped
economies. Here the state has to play a vital and ever-expanding
role to accelerate the process of economic growth. These
countries are struggling hard to get rid of poverty and to attain
higher living standards. In an underdeveloped economy, there is
a circular constellation of forces tending to act and react upon
one another in such a way as to keep a poor country in a
stationary state of underdeveloped equilibrium. The vicious circle
of underdeveloped equilibrium can be broken only by a
comprehensive government planning of the process of economic
development.
It is obvious that high rate of investment and growth of
output cannot be attained in an underdeveloped country simply
as a result of the functioning of the market forces. Even the
operation of these forces is hindered by the existence of economic
rigidities and structural disequilibria. Economic development is
not a spontaneous or automatic process. On the contrary, it is
evident that there are automatic forces within the system tending
ROLE OF GOVERNMENT: PUBLIC AND PRIVATE SECTORS 33
to keep it at a low level. Thus, if an underdeveloped country

does not wish to remain caught up in a vicious circle of poverty,
government must interfere with the market forces to break that
circle.
In the initial phase, the process of development in an under-
developed country is held up primarily by the lack of the basic
social and economic overheads such as schools, technical colleges
and research institutes, hospitals and railways, roads, ports,
harbours and bridges. Provision of these overheads requires very
large investments. Such investments will lead to the creation of
external economies, which in their turn, will provide incentives
for the expansion of private enterprise in the field of industry as
well as of agriculture.
Private enterprise will not undertake investments in social
overheads, because the returns from them in the form of an
increase in the supply of technical skills and higher standards of
education and health can be realized only over a long period.
Also, these returns will accrue to the whole society rather than
to those entrepreneurs who incur the necessary large expenditure
on the creation of such costly social overheads. Therefore,
investment in them is not profitable from the standpoint of the
private entrepreneurs, howsoever productive it may be from the
broader interest of the society. This indicates the need for direct
participation of the government by way of investment in social
overheads, so that the rate of development is quickened.
Investments in economic overheads require huge outlays
on capital which are usually beyond the capacity of private
enterprise. Besides, the returns from such investments are quite
uncertain and take very long to accrue. Private enterprise is
generally interested in quick returns and will seldom be prepared
to wait so long.
Nor can private enterprise easily mobilise resources of
building up all these overheads. The state is in a far better
position to find the necessary resources through taxation,
borrowing and deficit financing—sources not open to private
enterprise. Thus, private enterprise lacks the capacity
to undertake large scale and comprehensive development
programme. Not only that, it also lacks the necessary approach

to development.
The role of government in development is further highlighted
by the fact that underdeveloped countries suffer from a serious
deficiency of all types of resources and skills, while the need for
them is so great. In these circumstances, what is needed is a
wise and efficient allocation of limited resources. This only the
state is best fitted to do through central planning, according to
a scheme of priorities well suited to the country’s conditions
and needs. Until the country has attained the stage of self-
sustained growth, the government must make determined and
conscious efforts to push the economy through the ‘take-off’
period of development.
Besides, the conditions in the underdeveloped countries are
not conducive to rapid economic growth. “The tendency towards
the formation of monopolistic organizations under the free
enterprise system, the unpreparedness and reluctance on the
part of entrepreneurs to make investments in schemes of
collective value, the lack of attention to the long-run problems
of the economy and too much concentration on the immediate
prospects of profits, the absence of integration among the various
sectors of the economy and the possibility of adverse economic
results arising from uncoordinated economic decisions, constitute
the major defects of the private enterprise system.”1
GOVERNMENT MEASURES TO PROMOTE

ECONOMIC DEVELOPMENT
In a view of the peculiar circumstances in which politically,
socially and economically the underdeveloped countries are
placed, there is not only a great urgency about economic
development but also an infinitely much greater effort is required
to generate the forces of economic growth. This effort is
obviously beyond private enterprise in such countries, owing to
adverse political, economic and social factors, these countries
have been for long in a state of economic stagnation. They are
now becoming painfully aware of the widening disparity between
their economic condition and that of the advanced countries,
which are getting richer every day whereas they are caught up
in the vicious circle of poverty. This necessitates a comprehensive

set of measures to be adopted by the government not only to
rouse them up from the state of economic slumber but also to
see them march quickly on the road to development.
The following are the principal measures, which are
necessary for the government of an underdeveloped country to
take in order to accelerate the process of economic growth.
I. Mobilisation of Economic Surpluses
As already discussed for promoting economic development,
the government has to mobilize economic surpluses for
investment. In this context, we distinguish between three types
of economic surpluses:
(i) Existing economic surplus,
(ii) Potential economic surplus, and
(iii) Economic surplus in a dynamic sense.
Their detailed discussion has already been given in Chapter 1.
II. Provision of Economic and Social Overheads
If economic growth is to be accelerated, it is necessary for
the government to provide inadequate measure of economic
and social overhead facilities also called the overhead capital
and services or infrastructure. Economic infrastructure includes
transports facilities, e.g. railways, roads, harbours, air fields,
etc., means of communications, e.g. postal, telegraph and
telephone facilities, electric and even atomic energy, irrigation
facilities, etc. The social overheads of infrastructure consist of
educational institutions (schools, colleges and universities) both
for general education and technical training, public supply and
other welfare schemes. “The availability of adequate overhead
facilities brings about external economies to other industries,
lowers their capital coefficient and by thus improving the
efficiency of general investment, makes possible a more rapid
rate of economic growth.”2
The underdeveloped countries are woefully suffering from
the lack of such facilities on account of which their rate of
growth has been slow and tardy. Only the government can have
the ability and willingness to make investments in these

directions, where the private investor cannot hope to get any
tangible return and remove a big hurdle in the way of economic
growth. Actually, the governments in underdeveloped countries
are making large investments in the provision of overhead
facilities. Of total public investment they have ranged from
54 per cent in Sri Lanka, 56 per cent in India, 66 per cent in
Burma and 72 per cent in Thailand.
III. Provision of Financial Facilities
Finance is the crux of the problem of development. We
know that the underdeveloped countries suffer from scarcity of
capital which is the greatest handicap in their economic growth.
No doubt that their savings are meager but even the meager
savings are not available for economic development. To mobilize
these savings, a sound banking system is essential and other
financial institutions are required to canalize these savings into
investments and supply the credit needs of trade and industry.
The government is to see that appropriate financial institutions
are set up to meet the requirements of the entrepreneurs.
In India, for instance, the government took steps to reform
the banking system and put it on a sound footing. Fourteen
major commercial banks were nationalized in 1969. In the
agricultural sector to meet the short-term credit needs of the
farmers, co-operative societies were set up and, for long-term
credit land mortgage banks or land development banks have
been organized. Two funds were set up: National Agricultural
Credit (Long-term) Operations Fund and National Agricultural
Credit (Stabilization) Fund. The former is meant to give long-
term loans to State Government to enable them to buy shares of
co-operatives and to grant medium-terms loans to co-operatives
and long-term loans to land development banks and the latter
fund to give medium-term loans to state co-operatives banks to
enable them to convert short-term loans into medium-term loans.
Agricultural Refinance Corporation was set up to serve as a
refinancing agency for agricultural credit and to give assistance
for reclamation of land, development of special crops, mechanical
farming, poultry, etc. Small Farmers Developments Agencies
(SFDA’s) were established and Marginal Farmers and

Agricultural Labour (MFAL) schemes were taken up. Micro
finance is made available to Self Help Groups (SHGs) to bring
the poor out of poverty trap. Agro-industries corporations have
also been set up to give loans for the purchase of tractors and
agricultural machinery.
In the industrial sector too, financial and other institutions
were established to promote industrial development. To assist
the small scale and cottage industries several boards were set up
such as the Cottage Industries Board, All India Handicrafts
Board, Central Marketing Organisation, Inventions Promotion
Board, State Financial Corporations, National Small Industries
Corporation, etc. For the large-scale industries, the Industrial
Finance Corporation of India and the Industrial Development
Bank of India were set up. Unit Trust of India was created
to promote investment. National Industrial Development
Corporation was established to grant special loans for the
rehabilitation and modernization of cotton textile mills and jute
mills. Industrial Credit and Investment Corporation was set up
to assist the creation, expansion and modernisation of industrial
enterprises in the private sector. For re-lending facilities,
Refinance Corporation for Industry was set up. Export Credit
and Guarantee Corporation was created to insure against export
risks, and to furnish guarantees to banks to assist exporters to
secure liberal credit facilities. This gives some idea as to what a
government in an underdeveloped country can do in the matter
of provision of financial facilities.
IV. Institutional Changes
Outmoded institutions and legal and social structure too
stand in the way of economic development of the under-
developed countries. Lot of reforms and reorganizations are
essential to initiate and accelerate the process of growth. These
institutional changes include land reforms like the abolition of
the feudal system, abolition of absentee land lordism, tenancy
reform to give security to the tenants and fix fair rent payable
by them, ceilings on land holdings, community development
project in the rural areas to promote self-reliance and local
leadership, etc. In the sphere of trade and industry, government

encourages small industries and prevent the creation of
monopolies. To improve labour efficiency, technical institutes
are set up, social security schemes are introduced and housing
schemes and welfare activities are undertaken. Producers’ co-
operatives are also encouraged.
The state also regulates relations between labour and capital
to maintain industrial peace by means of labour legislation to
increase output and minimize losses. The government also
promoted marketing to enable the producers to get a fair price
for his products.
These measures accelerate economic growth by improving
the organization of production and building up non-material or
intangible capital which assist productive effort as much as
material capital.
RATIONALE OF PUBLIC SECTOR IN ECONOMIC DEVELOPMENT

We have already referred to the direct participation of the
government in industrial enterprises with a view to promoting
economic growth in the country. This means the launching of
public sector enterprises. The rationale of the public sector lies
in a large number of imperatives of development which may
now be dealt with at some length.
The raison d’être or a rationale for the public sector
undertakings is to be found in the inadequacies or weaknesses
of the price system. The price system, as it actually functions, is
far from being an ideal mechanism of the efficient running of an
economy—especially, in terms of the three vital considerations
of resource allocation, income distribution and employment
generation.
(i) The Compensatory or Substitutive Role. The participation
of the public sector undertakings in the economic activities is
called for when it has a compensatory role to perform. The
compensatory role, in turn, would be necessitated when there is
a need to compensate for the deficiencies or shortfalls of the
price system.
When the public sector assumes a compensatory role it serves

to provide a substitute for the private sector of the economy. In
fact, the public sector enterprises then perform the functions of
a corrective activity or device. This itself provides a rationale
for the participation of public enterprises in economic activity.
In the same way, where the price mechanism hinders the
full utilisation of resources due to the existence of monopolistic
tendencies or externalities, e.g. power sector in the public sector
has to step in to remedy the situation. The public sector, in such
cases, makes up for the deficiency by its direct participation in
the productive and distributive activities of the economy.
Again the compensatory role of the public sector becomes
necessary where the price system left to itself, fails to achieve
some socially desirable objectives. For instance, if education,
health and other welfare activities were in the purview of the
private sector, it will lead to both inadequate quantity and
inequitable distribution of the service. The public sector can
compensate for these deficiencies by undertaking these activities.
(ii) The Adjunctive or Added Role. The price system may
not only fail to function satisfactorily, but also in a number of
situation it may fail altogether. And when the market mechanism
fails to operate, certain goods and services would not be produced
in the economy. Under such a situation, it is necessary for the
public sector to undertake to produce these goods and services.
These public activities would, in effect, be an addition to the
overall level of economic activity of the economy. That is how
an adjunctive role is assumed by the public sector undertakings.
In general, the public sector performs its adjunctive role
when it aims at producing ‘public goods’ or what is the same
thing satisfying ‘public (or social) wants’. The market mechanism
fails to register the true preferences of individuals for public
goods (e.g. roads, bridges, courts, police, etc.). Since no private
enterprise can afford to undertake activities aimed at satisfying
‘public (or social) wants’, the public sector has necessarily to
step-in in this direction.
(iii) The Competitive Role. Competition between private
sector and public sector is very rare. Public sector either plays
a substitutive or supportive or adjunctive role. Only when

private sector, in case of goods with positive external effects
(externalities) resort to monopolist characteristics that the public
sector intervene and may play a competitive role. In case of
merit goods, the public sector plays a role to keep the private
sector (or price mechanism or market forces) under check to
satisfy the merit wants like low cost housing, education,
minimum food, etc., to the vulnerable sections of the society.
The government may subsidise the efforts of the private sector
in this regard or can directly participate in the production of
these goods.
To sum up it is only in case of pure private goods having
externalities that there may be indirect control of the private
sector or there may be competition between the two. In case of
merit goods (which though are private goods), there may be
supplementary or substitutive efforts. In case of pure public
goods, no competition is involved between the private sector
and the public sector.
Role of Public Sector Enterprises in Economic Development
It is now recognised that in the underdeveloped countries,
the vicious circle of underdevelopment can be broken only by a
bold intervention by the government in the form of public sector
enterprises.
The role of public enterprises both in accelerating
development and realising the avowed social objectives of
underdeveloped countries can be brought as: (a) achieving
socialistic pattern, (b) building industrial base, (c) capital
formation, (d) optimum allocation of resources strategies,
(e) balanced and unbalanced growth, (f) balanced regional
development, and (g) achieving social objectives.
Some other ways in which public sector can promote
economic development are as under:
diversification of economic structure,
enlargement of employment,
bridging the entrepreneurial gap,
generating foreign exchange earnings,
supporting private enterprise, and

checking against malefficient tendencies.
GOVERNMENT AS AN AGENT FOR ECONOMIC PLANNING

AND DEVELOPMENT
Popularity of Planning
In the previous part, we have discussed the theory of
economic development. But economic development has been
closely linked with planning. Economic planning has become a
buzz-word in modern times especially in underdeveloped or
developing countries. The idea of planning acquired a tremendous
support after the end of World War II when advanced but
disrupted economies had to be rehabilitated and the under-
developed economies were fired with the ambition of rapid
economic development. This idea was not taken up kindly in
some countries by some people. It was perhaps due to the fact
that planning came to be most actively associated with socialist
economics. Hatred of socialism was transferred to planning too.
But such unreasoned opposition to planning has now almost
vanished. On the other hand, remarkable achievements of Nazi
Germany and Soviet Russia popularised the idea of economic
planning.
Even in capitalist countries, where the economy is governed
and directed by market forces, planning is being practiced more
or less in one or the other sector of the economy. Planning has
become popular owing to the basic defects of capitalism and
free enterprise and owing to the realisation that, unless a free
enterprise economy is regulated and controlled, it would not
ensure stable growth or maximise social welfare. Although the
distinction between planned and unplanned economy exists, yet
planning has been universally accepted and the planned sector
almost everywhere is expanding.
For the underdeveloped countries, desirous of accelerating
development after achieving political freedom planning is a sine
qua non of progress. As Robbins puts it, “planning is the grand
panacea of our age”. It is no longer a forbidden fruit. The
popularity of planning may be summed up in these works: “The
change in ideology of the people, their growing social and

economic evils of misdistribution of income and wealth have
drawn attention to the need for directing economic growth in a
manner that but would bring about not only increased
production but would ensure more equitable distribution of the
larger output; egalitarian measures have, therefore, been called
for, and regulation of economic mechanism has become necessary
to ensure social justice and equality.”
Although both advanced capitalistic countries and the under-
developed countries have adopted planning, yet there is this
difference between the two: in the former it is corrective planning
to ensure economic stability, in the latter, it is developmental
planning to secure rapid growth. Public expenditure which now
comprises nearly 30-40 per cent of GDP in free enterprise
economies like USA, has to be incurred in a planned way.
Meaning of Planning
There is lack of unanimity among economists as to what
planning means. No precise and universally acceptable definition
can be offered. The idea underlying planning is a conscious and
deliberate use of the resources of the community with a view to
achieving certain targets of production. The state, through a
planning authority, takes the responsibility of planning. It
represents a complete break from the policy of laissez-faire.
Prof. H.D. Dickinson defines economic planning as “the
making of major economic decisions—what and how much
is to be produced and to whom it is to be allocated by the
conscious decision of determinate authority, on the basis of a
comprehensive survey of the economics system as whole”.3 In
the words of the Second Five-Year Plan of India, economic
planning is “essentially a way of organising and utilising
resources to maximum advantage in terms of defined social
ends. The two main constituents of the concept of planning are:
(i) A system of ends to be pursued, and (ii) Knowledge as to the
available resources and their optimum allocations”.4 Thus,
planning is a technique for achieving certain self-defined and
pre-determined goals laid down by a central planning authority.
The idea of planning will be clear by drawing a distinction

between a planned economy and an unplanned economy.
Distinction between Planned and Unplanned Economy
The unplanned economy relies on market forces for the
utilisation of the community’s resources. The market mechanism
interprets consumer’s preferences to the producer through the
medium of level of prices and promise of higher profits. A
planned economy, on the other hand, represents a much more
determinate organisation of resources and specifying goals to
be achieved and the commodities to be produced. The state is
vested with the necessary powers to pursue these goals and
exploit the resources along the pre-determined channels in
conformity with the goals already fixed.
Thus, the main objectives of planning are:
(a) Formulation of objective or goals;
(b) Fixing targets to be achieved and priorities of
production for each sector of the economy;
(c) Mobilisation of the financial and other resources
required for the execution of the plan;
(d) Creation of the necessary organisation or agency for
the execution of the plan; and
(e) Creating assessment machinery for evaluating the
progress made.
It is immaterial whether there is public ownership and/or
control of resources or not, although public ownership and
control would be more conducive to effective planning. State
initiative and state regulations and control are, however, essential
for successful execution of a plan. Robbins says: “Planning in
the modern jargon involves government control of production
in some form or the other.” A central economic authority
regulates output, prices, etc.
In the words of Barbara Wootton, planning may be defined
as the conscious and deliberate choice of economic priorities by
some public authority. But the public authority must also carry
out these priorities through some government agency.
Thus, planning, in short, may be defined as conceiving,

initiating, regulating and controlling economic activity by the
state according to set priorities with a view to achieving well-
defined objectives within a given time.
Types of Planning
Authoritarian and Democratic Planning

The type of planning that has been adopted by Soviet Russia,
China and other socialist countries is authoritarian planning
and that in India and other democratic countries it is democratic
planning. In authoritarian planning, the government is the sole
centralised agency which draws the plan and implements it. It is
more comprehensive, systematic and rigid and therefore more
efficient. In democratic planning, the plan is prepared by an
expert body called the planning commission, which is outside
the government or the executive and it is finally approved by
legislature which represents the people. It is based on the system
of free enterprise, but economic activity outside the public sector
is sought to be regulated and guided indirectly by providing
incentives for investment through fiscal, monetary and trade
policy.
General and Partial Planning
Several varieties of planning are now known to the students
of economics. There is general planning in which a
comprehensive and integrated plan is conceived, initiated and
executed by a central authority. The plan covers all aspects of
the economy and the central authority completely controls the
investment and utilisation of resources.
As against general planning, there is partial planning, a sort
of piecemeal planning in which the plan covers only some
important sectors or sub-sectors of the economy. Strictly
speaking, partial planning is no planning.
Functional and Structural Planning
Planning may be attempted within the existing socio-
economic framework or it may seem to change the existing
order radically. The former is known as functional planning
which assumes that planning is possible even in a capitalistic

economy, whereas advocates of structural planning think that
planning and capitalism are incompatible. For instance, Dr. Von
Mises is of the view that “planning and capitalism are utterly
incompatible”. On the other hand, Professor Landauer holds
the opinion that planning and capitalism could be reconciled to
agree with the latter view and hold that even capitalist countries
can have a measure of planning and benefit from its technique
in order to carry the economy forward on the road of economic
progress or eliminate serious imbalances in the economy.
Planning by Inducement and Planning by Direction
Sometimes the governments try to achieve objectives of
planning in an indirect manner. There is private enterprise
throughout the economy and market mechanism is in full
operation. The state just offers certain inducements and
incentives. This is what a predominantly capitalistic economy
like the American economy would do. As against induced
planning or indicative planning, there is compulsory planning
or planning by direction under a central directing authority.
Indicative Planning or Planning by Inducement. In this type
of planning, the planner either subsidises production or controls
prices, if it is intended to increase the consumption of a
commodity. The first acts on the supply side and the latter on
the demand side. Cheaper price is an inducement for the
consumer and subsidy an inducement for the producer. This is
planning through the market mechanism. The citizens want
freedom of choice in consumption. This freedom exerts pressure
for free adjustment of production to consumption. Similarly,
the worker demands freedom to choose his own job. This means
that besides consumer market there must also be a labour market.
This leaves a narrow sphere for state control.
The basic idea is that the market controls the entrepreneur
and state can control the entrepreneur by controlling the market.
The state tries to manipulate the market by means of incentives
and inducements through price fixation, taxation and subsidies.
The government seeks to influence economic and investment
decisions by offering incentives and does not control or regulate
the functioning of the economy directly. Planning by inducements

avoids swollen bureaucracy. Thus, it is planning by persuasion
rather than compulsion. There is freedom of enterprise, freedom
of production and consumption, subject to some regulation or
control by the state.
However, immobility of resources imposes serious limitations
on planning by inducement. This immobility creates shortages
which cannot be eliminated merely by price control and
rationing. Measures have to be taken not only to distribute
supplies equitably but also to augment supplies. There are
economists who are not prepared to consider indicative planning
as planning in the real sense of the word. According to them,
there can be no planning without direct controls or directions
so as to compel economic activities to conform to the plan
programmes and objectives.
The merits of indicative planning are: (a) consumer’s
sovereignty remains intact; (b) there is freedom of enterprise;
(c) it is flexible; and (d) it is democratic.
As against these merits, there are some demerits too: (a) it
fails to achieve the objectives of planning or targets of
production; (b) the private entrepreneurs care more for profit
than for the growth of the economy; (c) the fiscal and monetary
policies of the government are not so successful in the
underdeveloped countries; (d) the producers may not find the
incentives offered by the state attractive enough to follow the
state guidelines. The disincentives for the consumers may not be
deterrent enough to curb wasteful consumption; (e) the working
of the market forces fail to bring about proper adjustment
between demand and supply and thus create imbalances in the
economy; and (f) it may lead to controls the black markets.
As Prof. Dobb observes, “Without large public sector and
large government investment the plan targets may remain pious
hopes that are unrealised in practice.”
Planning by Direction. It implies minute and detailed
instructions being given both to producers and consumers. A
list of all commodities to be produced with the quantity of each
has to be prepared as well as a separate list for each of the
complements and substitutes. Planning by direction is very

comprehensive. It covers the entire economy. There is complete
concentration of economic authority in the state. There is one
authority which is in sole charge of planning, directing and
execution of the plan in accordance with pre-determined targets
and priorities. Only planning by direction can guarantee the
success of the plan, otherwise the targets would turn out to be
mere pious wishes. This means that the economic planning should
have at its back the full authority of the state. As Dr. Oskar
Lange observes, “With regard to the socialist sector the national
plan represents a binding directive. The targets of the national
plan and its financial provisions represent orders to be carried
out by the various ministries and the enterprises. They are duty
bound to carry out the directives of the plan.”
Planning by direction suffers from certain demerits or
shortcomings: (i) It is undemocratic since the people are ignored
all along. It is bureaucratic and totalitarian and, as such, involves
the treatment of human beings as mere pegs in a big bureaucratic
machine. There is no economic freedom. Rationing and control
result in black marketing and corruption. (ii) Owing to the
complexity and many-sidedness of modern economic system,
planning by direction does not yield satisfactory results. It is
too formidable a task. No person or body of persons can perform
this task satisfactorily. (iii) There is bound to be shortage of
some and surplus of other commodities. (iv) Besides, this sort of
planning is bound to be inflexible. The plan once prepared must
be adhered to, no part of the plan can be altered affecting the
whole plan. (v) The fulfilment of the plan cannot be anticipated,
because conditions keep changing. Black markets emerge to
overcome the imperfections of the plan. (vi) Planning by direction
also leads to excessive standardisation which impinges on
consumer’s sovereignty. (vii) It also involves huge administrative
costs, elaborate censuses, numerous forms and army of clerks.
As Lewis remarks, “When government is doing only a few
things we can an eye on it, but when it is doing everything it
cannot even keep an eye on itself.” There are a few difficulties
or shortcomings of planning by direction. But the choice between
these two types of planning is determined by the system of
government prevailing in the country. A democratic government

adopts indicative planning whereas a socialist state will adopt
planning by direction.
Centralised Planning and Decentralised Planning
Some other forms of planning may be (a) centralised
planning; and (b) decentralised planning. In the case of the
former, planning is done by a central authority. It is done from
the top. Each citizen, producer or consumer, has simply to carry
out the instructions or the job or duty assigned to him. In the
case of decentralised planning, however, we plan from the
bottom. For instance, each village panchayat may be asked to
prepare a plan for the economic development of the village and
each industry may be asked to prepare its own plan. Out of
these plans, an integrated plan may then be evolved for the
country as a whole. For example, village level planning may be
integrated with block level planning, which may be tied with
district planning and ultimately with state planning.
Physical and Financial Planning
Here we come to the question whether we fix the size of
investment in terms of real resources which is known as physical
planning or in terms of money which is known as financial
planning. Ultimately, however, financial resources will have
to be translated into real resources, for money as such serves
no purpose. If adequate finance is not available, it can be
created through deficit financing. In underdeveloped countries,
there always exist unutilised or under-utilised resources, e.g.
uncultivated land, unemployed labour, hoarded wealth, etc.
These resources can be mobilised by ‘creating’ money.
In the case of financial planning, the planners determine
how much money will have to be invested in order to achieve
the pre-determined objectives or targets. Total outlay is fixed in
terms of money on the basis of growth rate to be achieved, the
various targets of production, estimates of the required quantity
of consumer goods and the various social service, expenditure
on the necessary infrastructure, etc. as well as revenue from
taxation, borrowings and savings. The financing of economic
development through mobilisation of economic surpluses has

been discussed earlier.
This money is then used to mobilise the required resources.
There has thus to be an integration between physical planning
and financial planning. Indian planning has been mostly financial
planning although some targets have been set in concrete and
real terms, e.g., the output of foodgrains.
A merit of financial planning is that it facilitates adjustment
between demand and supply. As India’s Second Five-Year Plan
states: “The essence of Financial Planning is to ensure that the
demands and supplies are matched in a manner which exploits
physical potentialities as fully as possible without major and
unplanned changes in the price structure.”5
Finance holds the key to the success of a plan. If the country
is able to raise adequate financial resources, the success of the
plan is assured. But failure to raise the required resources will
spell its failure. It will not be able to achieve the targets set out
for it.
Limitations of Financial Planning. Financial planning has
its own limitations: (a) An attempt to raise taxes to a very high
level will adversely affect the ability and incentives of the people
to work, save and invest which may hamper the development
process. (b) Owing to smallness of organised money sector and
the existence of a larger non-monetised sector, the estimates for
financial resources may go wrong. Even the physical targets
may be upset. Imbalances between the monetised and non-
monetised sectors may result in shortages and in inflationary
pressures. Hence, financial planning is more suitable for sector
planning than for overall planning. (c) Financial planning may
not provide for the expansion of employment opportunities at a
scale so as to absorb the new entrants to the labour market.
Hence, people’s needs both for work and employment may
remain unsatisfied.
Physical Planning. In physical planning, the planning
authority has to work out how much land, labour, materials
and capital equipment will be required to implement the plan
and achieve the targets set out for it. Physical planning makes
for concreteness in planning. As is stated in India’s Second Five-

Year Plan, physical planning is “an attempt to work out the
implications of the development effort in terms of factor
allocation and product yields, so as to maximise incomes and
employment”.6 It is an input-output analysis and planning and
performance budgeting is the corolary of physical planning. It
implies proper evaluation of the relationship between investment
and output. In physical planning, the planners have to determine
not only the amount of investment but also work out its
composition in terms of the various goods and services required
to obtain a certain increase of output of product, e.g. it has to
be worked out as to how much of cotton, coal or electric power
and other ingredients will go into an output of 1,000 metres of
cloth. That is how calculations have to be made for each types
of investment. Financial planning is only a means to achieve the
various targets laid down in the plan.
Thus, in physical planning, we make an overall assessment
of the available real resources like raw materials, manpower
and capital equipment and devise ways and means to mobilize
them in amounts sufficient to enable us to achieve the various
targets of production. These targets are laid in physical terms,
e.g. so many tons of steel, foodgrains, coal, sugar and so many
million metres of cloth, etc., in agricultural and industrial sectors
and also for economic overheads like roads and rail kilometrage,
etc., or so many million jobs to be created, so many doctors and
engineers to be trained and the number and type of educational
institutions needed, and so on. But the various targets have to
be properly matched and balanced. The test of the soundness of
planning lies in the avoidance of imbalance, stresses and strains
of any type in the economy.
Limitations of Physical Planning. It is not to be understood
that physical planning is a straight and simple affair and presents
no difficulties. Rather, there are formidable difficulties in its
way: (a) In the underdeveloped countries, adequate and reliable
statistics regarding the various types of real resources are lacking.
It, therefore, becomes really difficult to lay down with any degree
of certainty the targets. (b) To build up a sound sectoral balance
is also a tight rope job. That is why when the plan is being
implemented all sort of stresses and strains, bottlenecks, shortages

and gluts and inflationary pressures appear to thwart the
planner’s effort. (c) Physical planning is not enough to prepare
a sound plan for economic development. It has to be
supplemented with financial planning. If this is not done, the
economic plan will go down against financial rocks. Lack of
adequate financial resources has been a major cause of the failure
of planning in India.
Thus, both physical and financial planning are necessary
to assure the success of the plan. They are complementary to
each other just as the right and left legs are needed for
walking. There has to be a proper balance between the two.
Both techniques must be integrated in the development process.
Conclusion
We have in the world today the above main types of planning
or their permutations and combinations. In Soviet Union and
China there was a general, structural and directional planning.
In Nazi Germany and Fascist Italy, planning was general and
directional. In the USA and the UK whatever planning is there it
is partial, functional and by inducement. In India, it is general
and partly structural and a combination planning by inducement
and planning by direction. Also, physical and financial planning
go side by side.
Importance of Planning
An unplanned economy is like a ship moving rudderless on
uncharted seas with no fixed destination and unlikely to reach
it, if there is any. Such an economy works blindly and
haphazardly. It works for the rich and makes them still richer.
It ignores the real wants of the people and fails to promote
general well-being. It is the profit motive rather than service of
the masses which is the mainspring of economic activity in such
an economy. How it operates is no guarantee of economic
progress for the less developed economies. The economically
advanced countries may not like the idea of planning but for
the underdeveloped economies it is a stark necessity as economic
development is now regarded as imperative. Majority of the
underdeveloped countries realize very clearly that they must

develop economically and that too very soon.
As Galbraith says, “There is much that market can usefully
encourage and accomplish. But the market cannot reach forward
and take great strides when these are called for. As it cannot
put a man in space so it cannot bring quickly into existence a
steel industry when there was little or no steel making capacity
before…. To trust the market is to take an unacceptable risk
that nothing or too little will happen”.7 It is planning alone
which can guarantee quick economic growth in the under-
developed countries. This explains why there is a clear and
pronounced swing of opinion in favour of planning.
We shall now put forward a few arguments for economic
planning. Some of these arguments are in favour of planning in
general for all countries and some of them apply with a special
reference to underdeveloped economies:
(i) Planning is advocated on the ground that the judgment
of the state is superior to that of the citizen, however,
wise and able he may be. As Arthur Lewis remarks,
“The state now claims to know better than its citizens
for how many years they should send their children to
school, between what hours they should drink, what
proportion of income should be saved, whether cheap
houses are better than cigarettes, and so on.”8 Economic
development is a more serious matter and should not
be left to the individual entrepreneurs. The state
represents the accumulated wisdom of centuries and
provides talent and experience beyond the capacity
of individual and isolated businessmen. Planning by
collective action is indispensable if a country is to
develop economically on the right lines and develop at
the desired speed.
(ii) Planning also becomes necessary for equitable
distribution of economic power. The price mechanism
rewards people according to the resources they possess
but contains in itself no mechanism for equalization of
the distribution of those resources. There is no wonder,
therefore, that there are wide gaps between the ‘haves’

and ‘have-nots’ which seriously goes against the sense
of social justice. Shocking economic inequalities are a
marked feature of an unplanned economy. Inequalities
result in heart burning and social tensions. They also
paralyse some of the ablest members of the society.
Reduction of inequalities income, wealth and economic
opportunities is, therefore, now the avowed aim
of modern welfare states and it is impossible of
achievement without the instrument of planning. In
the absence of planning, inequalities will not only be
perpetuated but also accentuated from generation to
generation.
(iii) It has been seen that labour legislation alone cannot
protect labour and harmonise wage relations when
market mechanism is permitted to operate freely. A
planning authority must step in to regulate the economic
growth of the country so as to ensure to the actual
workers the fruits of their labour if there was perfect
competition and full employment, the price mechanism
would have afforded due protection of labour rights.
But this is a big ‘if’. The state is a more effective
guardian of labour rights than self adjusting and
automatic economic forces. By proper planning, it will
be possible to provide perfect social security to all
workers.
(iv) Planning has also proved to be powerful instrument
for eliminating instability which is necessary
concomitant of free market economy. Private enterprise
left to itself would produce trade cycles, unemployment
and misery. As Barbara Wootton remarks, “the progress
of an unplanned capitalist economy has always been
liable to interruptions from the tendency of the system
to fall over its own toes, from a certain continued
instability in its gait.” It is now generally agreed that
planning of economic activity goes a long way in
smoothening the violent fluctuations in business, thus
preventing undeserved gains and undue hardships. It is
on this ground that planning is advocated even for

developed and advanced economies. These countries
may not need any further economic development, but
they certainly need a mechanism which would prevent
violent ups and downs in the movements of business
activity and smoothen the course of business. During
the depression of thirties, every country suffered except
Russia, which was a planned economy.
(v) Again, it is planning alone which can ensure that the
terms of trade remain favourable to a country. The
volume and direction of foreign trade in a country
admittedly plays a very important part not only in
economic development but also in determining the level
of general well-being in a community. But handling
of foreign trade by the market has proved utterly
inadequate. Foreign trade must be thoroughly planned,
if fruits of economic development are not to be thrown
away. This aspect of economic development has been
paid special attention by planners everywhere.
(vi) Without the aid of planning no country can cope with
major economic changes. Such changes, e.g. industrial
revolution or rationalization movement, are bound to
turn the economy topsy-turvy. The economic system
may be thrown out of gear altogether. Private enterprise
will feel helpless and stand simply aghast. The planning
authority with its resources of men and money can
meet all such situations and control the disturbing
factors. Major changes can even be anticipated and
provided against in good time. The market mechanism
cannot move the resources in the desired directions in
quantity and with speed which a major change may
necessitate. Only a planning authority can eliminate
bottlenecks. Under a free market economy, a few person
receive abnormally large incomes at public expense and
the scarce commodities are unjustly distributed.
Overproduction is a common phenomenon bringing
suffering to the poor. A planned action to speed up the
movement of resources at times of major changes is

absolutely essential.
(vii) Planning eliminates wasteful competition. The merit of
the free market lies in competition being perfect; but in
actual life perfect competition is a rare phenomenon.
There is always a tendency for monopoly, oligopoly
and monopolistic competition to develop. There is
nothing in the market mechanism that establishes or
maintains competition. Only state action can ensure
fair competition. Hence, market economy can also be
helped to function adequately with the positive support
of the planning authority. Huge manpower need not
be dissipated in distributional trades nor huge funds
frittered away in advertisement and salesmanship.
Planning can be combined with a market economy in
various degrees. Only by means of planning by direction
rather than by means of persuasion or inducement can
an economy achieve a desired objective. That is the
only way to direct economic life economically, wise
and safely.
(viii) Only a planned economy provides for proper co-
ordination and avoids unnecessary duplication of staff
and equipment. In an unplanned economy, millions of
producers work in an independent and isolated fashion
without bothering as to what the other businessmen
are doing. The cumulative consequence may be
confusion and chaos. An unplanned economy, according
to Lerner, is like “an automobile without a driver but
in which many passengers keep reaching over to the
steering wheel to give it a twist. It will be a miracle
indeed if the automobile reaches its destination safely.”
On the whole, therefore, economic decisions in an
unplanned economy are likely to be irrational,
shortsighted, self-frustrating and socially disastrous. A
planning authority, on the other hand, can take
farsighted decisions and produce a balanced economy.
It can take an overall view, whereas in an unplanned
economy each entrepreneur looks to his own interest
and nobody bothers about the economy as a whole as

a central planning authority can do. As Prof. Durbin
remarks, “the general officers on the hill must be able
to see more than the ensign in the line of battle”.
(ix) Planning makes for optimum utilization of a country’s
resources. A planning authority is able to lay down
what is essential and what is non-essential activity,
encouraging the former and sharply cutting down the
latter. On the other hand, private enterprise is guided
by the profit motive regardless of social benefits or
evils. Only a planning authority can ban luxury items,
otherwise valuable national resources will be directed
towards the production of useless luxuries for the rich
and starve the masses of the necessaries of life. It is to
the obvious advantage of a country to concentrate on
the production of essentials and avoid wasting its
resources on the non-essentials.
(x) A planned economy will prevent artificial shortages
being created by profit-greedy businessmen. By means
of trusts, cartels, price agreements and market sharing
they increase their profits at the expense of the society.
The planning authority can smash such designs by
positive action in favour of the community. It possesses
enough power to ensure the working of the economy
in a healthy manner in the best interest of all rather
than for the benefit of the few.
(xi) By planning it is possible to keep down or eliminate
social costs which usually take the form of industrial
disease, industrial accidents, overcrowding and
insanitary conditions and cyclical unemployment. These
social costs are the by-products of capitalism. Since
planning extends the sphere of public ownership and
control, the evils of capitalism are mitigated. Full co-
operation of labour can be secured and anti-social
‘go slow’ tactics rendered unnecessary resulting in
increase in national output.
(xii) Planning also results in higher rate of capital formation.
Private enterprise is more interested in on immediate
gain rather than future good. It takes a shortsighted

view of things. On the contrary, the planning authority,
as the custodian of the national interests, takes a
farsighted view. It can look more to the distant future
than to the immediate present. It is in a position to
sacrifice petty present gains for the future substantial
benefits. The surpluses of the public undertakings
add to the capital assets of the nation instead of going
into the pockets of private persons and spent on
consumption goods. That is why under planning capital
formation receive a great fillip.
(xiii) Planning protects the posterity. Market mechanism fails
to protect the interest of future generations. It is guided
by immediate gains. It will not invest in activities like
forestation, basic education, environment protection,
etc., whose benefits to the society would accrue in the
distant future.
Planning as a Special Case for Underdevelopment Countries
The arguments given above apply to all countries at all
stages of economic development. They largely take their stand
on the failure of laissez-faire policy. It is now realized that lack
of co-ordination, recurrence of business cycles, economic
inequalities, social parasitism, economic insecurity, wastes of
competition, absence of industrial peace and huge social costs
which characterize an unplanned economy, can be done away
by resorting to planning. An unplanned economy must act in an
erratic and irrational manner.
But planning has a specially strong case for the under-
developed economies. In their case, it is not merely necessary to
maintain the country’s economy in sound health and to ensure
a rational and optimum use of the community’s resources but
also to speed up economic development. They are lagging behind
in the race and they are keen to catch up with the advanced
economies or at any rate reduce dependence on them as fast as
possible. This impatience for accelerating economic development
leads inevitably to economic planning. The achievements of the
Russian and Chinese economies under planning serve as an

example.
The private enterprise in India has not taken India any far
on the road of economic progress. It has left untouched and
undeveloped some of the vital sectors of the Indian economy.
The entrepreneurial ability is lacking in India or exists only in
an insignificant measure. The Indian entrepreneurs are more
interested in on rich quick methods and pursue speculative profits
rather long-term industrial development. They have been
attracted more by commerce than by industry. In such countries,
it becomes necessary for the state to intervene and provide
the right type of entrepreneurship to bring about economic
development.
Even in advanced countries the edge of price-mechanism
has been blunted. It has failed to function efficiently on account
of economic rigidities and structural disequilibria. But in the
underdeveloped countries, bent upon accelerated economic
development, little reliance can be placed on price-mechanism
for the optimum utilization of resources and for giving a right
direction to the productive machine of the community. It will
only function erratically, fitfully and irrationally. There will be
no guarantee that the quality and quantity of production is
what the nation needs. Much more positive action is needed to
give right direction to productive activity. In order to speed up
the rate of economic development, price-mechanism, as an
instrument of economic development must go, if its functioning
is confined to unimportant sectors of the economy like the
purchase and sale of consumer goods. Only than the
underdeveloped countries will come out of the morass of poverty
and objectives be attained and targets of production achieved.
At every five-year period, progressively higher targets can be
fixed and effective means to achieve them adopted.
Capital formation and skill formation are of crucial
importance for any stage of economic development. These two
determinants of economic growth have a very tardy and
unsatisfactory development in backward and underdeveloped
economies. Planning is essential to build up these necessary
elements of productive power. Planning authority can launch a
vigorous savings drive and guide investment of the mobilized

resources in the desired channels. Normally in backward
countries, rich people prefer investment in land, housing property
and jewellery. This sort of investment is no good for speedy
economic development of the country. That is why Indian
Government has come hard upon the gold hoardings. Drastic
measures have to be taken to takeover hoarded wealth lying
idle. This can be only done under planning.
According to Raja J. Chelliah, economic surpluses must be
mobilised for capital for nation. Voluntary savings can be
supplemented by revenue surplus. ‘Disguised unemployment’,
which is a special feature of an underdeveloped economy, is
another source that can be tapped. We have surplus labour in
agriculture which represents disguised unemployment. Such
labour can be withdrawn from agriculture and put to more
productive employment. The state, in an underdeveloped country,
can also resort to deficit financing and thus increase the financial
resources (in a concealed form) available for economic
development.
Even then foreign aid may become necessary. For planned
economic development, foreign aid is readily made available. A
country which has no plan and which may rightly be considered
as going nowhere, cannot hope to secure foreign financial
assistance, but planned economies can. Colombo Plan and
foreign aid given to Pakistan and India are the examples which
can be cited. These are a few measures by means of which
financial resources of a country can be built up under planning.
Glaring inequalities of wealth and income and of economic
opportunities is another painful feature of underdeveloped
countries. These inequalities can also be reduced through
planning. Slogan of equality whips up the enthusiasm of the
people and induces them to put in their best effort.
The demographic factor is another hindrance in backward
countries which can also be overcome by planning. A country
with increasing population must run fast in order to keep up its
present position. Increase in national wealth is swallowed up by
still many more mouths. There is no escape from planning in
such countries.
The socio-religious attitudes of the people also call for an

effective government action to make them act in a more rational
manner. It is well known that social and religious institutions of
India have hindered economic growth in the past. A planned
programme is essential to neutralize the adverse effect of such
obsolete notions and institutions.
The paucity of trained, competent and host administrators
in backward countries has also to be made up and calls for a
planned endeavour.
Conclusion
These are some of the special problems which an under-
developed country has to tackle. It is now already realized and
universally admitted that these problems can be effectively
tackled by planning and by planning alone. Planning in such
countries is needed, above all, for accelerating economic
development. There is need in such countries, as Galbraith says,
not only for development “but an urgent demand that it should
occur promptly”.
Prof. D.R. Gadgil indicates the need for, and justification
of, planning in these words, “Planning for economic development
is undertaken presumably because the pace or direction of
development taking place in the absence of external intervention
is not considered to be satisfactory and because it is further held
that appropriate external intervention will result in increasing
considerably the pace of development and directing it properly.
Planning seeks to bring about a rationalization and, if possible
and necessary, some reduction of consumption to evolve and
adopt a long-term plan of appropriate investment of capital
resources with progressively improved techniques, a programme
of training and education through which the competence of
labour to make use of capital resources is increased, and a better
distribution of the national product so as to attain social security
and peace. Planning, therefore, means, in a sense, no more than
better organization, consistent and far-seeing organization and
comprehensive all-sided organization. Direction, regulation,
controls on private activity, and increasing the sphere of public
activity, are all parts of organizational effort.”9
Pre-requisites of Successful Planning

Although planning has been almost universally adopted, yet
the development plans have not invariably been successful. The
successful implementation of the plan requires the existence of
certain preconditions:
(i) It needs a strong and efficient government and a clean
administration to ensure the success of the plan. It is
the government which has to get the plan prepared
and it is the government machinery through which
the plan is to be implemented. Weak and inefficient
government and corrupt administration will distort
everything and the plan will end in a smoke. Planning
will be a farce and not a reality.
(ii) Besides a sound and strong political frame, the economic
organization of the country should also be sound and
susceptible to rapid growth. That is why stress is
laid on reorganization of the agrarian system or
restructuring of the industrial system of the country to
ensure success of planning. In India, zamindari system
had to be abolished and tenants given tenancy right to
make agriculture efficient. There was reform also of
the banking system and of company organization.
(iii) The objectives of planning should be well-defined and
co-ordinated. Confused and conflicting objectives will
lead the economy nowhere. For instance, it should be
clear whether the plan aims at increasing output or at
more even distribution of wealth and income or whether
food self-sufficiency is the aim or rapid industrialization
is the objective.
(iv) For the successful implementation of a plan, a whole-
hearted co-operation of the people is essential. People
are no dumb-driven cattle. Unless they co-operate
nothing can be achieved. It is necessary that the people
at large should have the necessary will to carry out the
plan and behave in a disciplined and patriotic manner.
They should be convinced that their self-interest
coincides with the broad objectives of the plan.
(v) It is also very necessary for the formulation of the plan

that the government provides the necessary statistical
data. The data should be adequate, up-to-date and
correct. In the absence of correct statistical information,
planning will merely be a leap in the dark.
(vi) Successful planning requires that reasonable and
appropriate targets should be fixed. If the targets are
too ambitious, their non-achievement may cause
frustration, and, if they are too low, the pace of
development may be less than it can be. Similarly, it is
necessary that since the resources at the disposal of the
country are limited, a proper order of priorities should
be laid down so that first things are tackled first. Only
in this way, the limited available productive resources
will be put to the best use.
(vii) To ensure success of planning, it is also very necessary
that there should be proper balance in the various parts
of the plan or sectoral planning. If the plan does not
provide for proper balances, bottlenecks or shortages
and gluts are bound to appear upset the plan.
(viii) Proper development policy farmed by the government
is another pre-requisite of successful planning. Proper
development policy should embrace careful survey of
national resources, scientific research, market research,
building up of adequate infrastructure (transport and
communications, irrigation and power, etc.), provision
of specialized training and educational facilities, suitable
legal framework, assistance for the entrepreneurs,
promoting saving and investment, and so on.
Conclusion
Very few underdeveloped countries fulfil the above
conditions. That is why there is generally a wide gap between
promise and performance. It is seldom that the targets are fully
achieved. People get despaired and disgusted and planning loses
credibility. If planning is to succeed, government should make
earnest efforts to create the conditions which will be conducive
to the success of planning.
Objectives of Planning
Planning is regarded as a panacea for all economic ills. It is,
therefore, advocated for the achievement of a variety of
objectives. It may be introduced for the removal of poverty, or
increasing national income, or raising living standards, or to fill
up gaps in economic structure, or to achieve self-sufficiency in
food and raw materials, or for bringing about rapid and adequate
industrialization, or to correct serious imbalance or lopsidedness
in economic development, or to reduce inequalities and establish
a socialistic pattern of society, and so on. The objectives are not
the same for all countries or the same for a country at all times.
What precisely are the objectives placed by the planners before
them it depends on the stage of economic development, socio-
economic conditions prevalent at the time and the requirements
of a particular political system. It may be pointed out at the
same time that all these objectives are inter-related and
complementary rather than mutually exclusive. We may now
say a few words about some major objectives of planning.
Achieve Full Employment
In economically advanced countries, the aim of the state
is to provide full employment. All modern states consider
unemployment as the by-product of capitalism and the biggest
headache of a modern capitalistic society. If capitalism cannot
be ended, at any rate unemployment must be ended. In such
cases, efforts of planned development are directed to those
directions and those sectors where unemployment is found to
exist. The state can redistribute labour and create work
opportunities. Unemployment leads to frustration, social
disorders like, theft, terrorism, etc.
We, in India, may not be able to create conditions of full
employment at any foreseeable future but we can certainly reduce
the incidence of unemployment. For instance, India’s Five-Year
Plans have aimed at providing additional employment
opportunities for millions of additional hands. Thus, creating
employment or reducing unemployment may well be a major
objective of planning.
Maximisation of National Income and Raising Living Standards

From a Hindu rate of 2 per cent the country is now set to
achieve as growth rate of 8-10 per cent. The unplanned
development does not register any substantial progress in this
direction, because the productive effort is diffused.
Rapid Industrialisation
This is another important objective which the planners try
to pursue. This objective assumes importance in countries which
have been left behind in the race of industrialization. South
America had this objective before it while framing its
development plans. India also aimed at rapid industrialization
in the various plans. It is realized that industrialization makes
more significant contribution to the raising of national income
and to the solution of the problem of unemployment. Few
countries can become prosperous by ignoring industry in the
past. Economies, predominantly agricultural, are bound to
remain backward. Rapid industrialization is, therefore, a very
desirable aim of planning.
Self-sufficiency in Food and Raw Materials
As a preparation for more systematic and intensive planning,
it may be considered necessary first to make the country self-
sufficient in food and essential raw materials. That would provide
a solid and sound base for the economy and prepare it for
further building up. India, in the First Plan, concentrated mainly
on agriculture. Dependence on foreign food is dangerous. The
first duty of a nation is to feed its people. Political freedom may
prove a farce without freedom from foreign food, especially
when war clouds may be hovering overhead. It is understandable,
therefore, that the objective of food security may take precedence
over other objectives when a plan is being conceived.
Reduction of Inequalities
It is now realized that political equality is illusory unless it
is accompanied by economic equality. Glaring inequalities of
wealth, income and opportunities are shocking to the democratic
conscience. Socialism has a very wide appeal in modern times.
In poor countries, it is a painful sight that the masses of people

should be on the border line of starvation, whereas a few rich
people should be rolling in all conceivable luxuries. It is natural,
therefore, that the planners, who are custodians of general
welfare, should so shape their plans as to make the poor people
less poor and the rich a little less rich, so that the gulf between
the two is narrowed down as much as is humanly possible. The
Indian planners have before them the establishment of socialistic
pattern of society as one of the objectives.
Redressing Imbalances in the Economy
It is sometimes found that the economic development
in a country is lopsided, for instance, an economy may be
predominantly agricultural. In India, nearly three-fourths of the
population was engaged in agriculture, when we started planned
economic development and this ratio has not declined. This is
an example of an unbalanced economy. The planning authority
cannot ignore this aspect of development.
It is not necessary that the planning authority should adopt
only one objective. That perhaps may be possible for countries
like the USA and European countries which are economically
well advanced and they have not much to seek now. But the
underdeveloped countries suffer from several shortcomings and
planners must pay attention to various important objectives
simultaneously. Their plans are generally multi-objective.
However, lest the effort should get diffused, it is necessary to
confine to a few principal objectives at one time, choosing those
which may be felt to be most essential in the context of the
economic situation prevailing at the time.
PRIVATE GOODS, PUBLIC GOODS AND MERIT GOODS
The distinction between the public and private goods can
be well understood on the basis of the following characteristics
of goods:
(a) Product divisibility
(b) Externalities
(c) Zero marginal cost
(d) Decreasing average cost

(e) Non-profit considerations.
(a) Product Divisibility
There are goods which are priced in the market and their
use is exclusively restricted for those who are willing to pay the
stipulated price. The use of such commodities is governed by
the principle of exclusion. All those who are not inclined to pay
its market price or those who cannot afford to pay that price
are excluded from its consumption. Thus, the commodity
becomes divisible insofar as its use is concerned. Such goods are
termed as private goods. On the opposite, there are certain other
goods called as public goods for the use of which no
discrimination is made amongst the users. All the members of
the society, whether they are capable of paying for them or not,
indiscriminately make use of them. For instance, the defence
services are equally utilized by all the inhabitants of a country.
No section of the society can be excluded from their use. It
means the defence services are indivisible. These cannot be priced
in the market and their use is not governed by the principle of
exclusion. In such cases, market forces totally fail to determine
the demand and supply.
In case of divisible products, since the supply can be made
available only to those who can pay for them, the consumers of
such goods voluntarily pay for maintaining a requisite level of
their supply. In case of these goods, the demand preferences
and the price which the consumers are willing to pay provide
good indication of the type of commodity which should be
produced. Thus, all decisions about the divisible goods such as
the type of commodity and its quantity to be produced are
dictated by the market forces. But in case of the indivisible
goods, the market mechanism fails to help make such vital
decisions and all these decisions are made by the society. As
mentioned above, the divisible goods are paid by the individuals
who use them. But the indivisible goods, like defence services,
pose the problem of financing him. In case of these services,
everyone knows that even if he does not pay for them, these
will still be available to him. This creates a tendency to avoid
payment towards them. As a result most of the people will not

pay voluntarily on the assumption that the supply of these
services will continue owing to the payments made by others.
Buchanan has referred to this as the problem of free riders.10 It
means that everybody is inclined to enjoy the benefit of such
services without having to contribute voluntarily towards the
cost of supplying these services. In such a situation, their
financing becomes a problem. To overcome this difficulty, a
provision for compulsory contribution by the members of the
society through taxation is made. Thus, it is clear that in case of
indivisible goods or services not only the decisions concerning
their production are left to the government or to its agencies
but the financing of their production is also carried through
taxation.
Such goods as are indivisible and the benefits of which are
not governed by the principle of exclusion are called as the pure
public goods. On the opposite, the pure private goods are those
which are completely divisible and in case of which the principle
of exclusion applies in full measure.
The mere fact that a good is indivisible does not necessarily
mean that the benefit of it is shared by all the members of the
society in an equal measure. For instance, the people in the
border areas may be relatively less protected than others and
hence receive more benefits from expenditure on defence.
Similarly in a metropolitan city, the people having their houses
near public parks are better served by them than those who live
at relatively farther away places. The important thing in this
connection is not whether all the individuals have the equal
opportunities to use them or not but that their production is
financed through taxation.
(b) Externalities
A pure public good can be distinguished from a pure private
good on the basis of the existence or otherwise of externalities.
The term externalities refers to the economic effects that arise
due to the production or use of the good to other parties or
economic units. These are in the form of an economic gain or
an economic loss and are responsible for creating a divergence
between their private and social marginal costs and benefits.

The process of production may create certain bad effects on the
society, although this may be completely disregarded by the
individual producing units. For instance, a manufacturing plant
may emit smoke or smells which are a disutility to the workers
and the people living in the close proximity of the plant. Similarly,
an oil refinery may pose health hazard for the people living
nearby and damage the buildings through its effluents. The noise
created by automobiles, railway trains and jet planes, may cause
disturbance and loss to the efficiency of the people who are
continuously exposed to it. The consumption of petrol also
involves similar bad effects. A free concert or orchestra in the
common park is enjoyable to those who come to hear it but
may be a source of much annoyance for the captive audience or
nearby residents who would like to sleep.
When there are such bad or negative externalities, the society
has to bear some social costs that may be somewhat reduced by
the government through taxation.
Just as there are bad social effects of certain goods and
services, similarly, there are externalities in the form of economic
gains or benefits to the society. The construction of a railway
line or road linking a steel plant benefits not only the steel plant
but also the people of the entire area through which that line
passes. Bernard P. Herber has put such externalities into two
categories—market and non-market external effects.
(i) Market External Effects. When the external effects—both
social costs and social benefits—can be priced in the market
with reference to the supply and demand behaviour, they are
known as the market external effects. For instance, an irrigation
project is started in an area, the net increase in the production
of agricultural crops and the area rendered unavailable for
cultivation due to the construction of dam or erosion of land by
the canal tributaries and a consequent fall in production,
determine the market external effects of the project.
(ii) Non-market External Effects. When the external effects
of goods and services produced cannot be priced with reference
to the demand and supply behaviour, these are termed as the
non-market external effects. For instance, a new road is

constructed but it is difficult to determine the extent to which
different economic entities derive benefit from it. Certain
categories of beneficiaries can, of course, be identified. But if
the benefits of such categories of road users, called primary
beneficiaries, alone are taken into account, that will exclude
other secondary and tertiary beneficiaries. Thus, the pricing
principle cannot strictly be applied in case of such projects or
goods and services.
Such goods and services, as have non-market external effects
or where market forces totally fail, should be preferably produced
and distributed through public authorities because they can take
economic decisions irrespective of profit considerations. Thus,
we arrive at the conclusion that such pure public goods as have
non-market external effects should be included in the public
sector and those having market external effects may be left to
the private sector. This rule, of course, cannot be applied rigidly.
Even such goods and services that are left to the private sector
may in certain cases be reallocated to the public sector provided
the government is convinced that such course of action is
likely to promote social welfare. Alternatively, the government
may subsidise their production in the private sector if their
consumption is necessary for health and efficiency and will thus
promote social welfare.
(c) Zero Marginal Cost
In case of a private good, the consumer has to pay something
to be entitled to its use, i.e. marginal cost of the commodity or
service to its user is always positive. On the contrary, the case
of pure public good, the marginal cost is either zero or close to
zero. It means that an additional member of the community can
derive the benefit of its use without causing any increase in its
total cost to the society. When broadcasting services are provided,
an increase in the number of radio and TV owners does not
bring about any increase in the total cost. Similarly, if a road or
a bridge has been constructed, an additional auto-vehicle may
pass over it without causing any addition to the total cost to
society. Since such goods and services as transport system and

broadcasting are indivisible, these should be included in the
public sector. However, the principle of zero marginal cost can
be applied only to a limited extent. If one more vehicle passes
over a road or a bridge or one more individual tunes to his
radio, the marginal cost to the society may be zero. But as the
number of road users or the users of broadcasting services
increases the total cost to society is bound to go up. Similarly,
the defence budget has to be expanded with the growth of
population in a country.
(d) Decreasing Average Cost
The pure private goods may be made available by the
manufacturers under different cost conditions. In certain
industries, while the production is governed by the law of
increasing costs, in others the law of decreasing cost may be
applicable. On the contrary, the pure public good is one which
is invariably subject to the law of decreasing average cost. Since
such a good is indivisible or lumpy, it is subject to the economies
of scale. If left in the hands of the private sector they will exploit
the common man. To reap the full benefits for the society private
sector must be given subsidy. The supply of telegraphic facilities
over a very small area must be at a tremendously high average
cost. Similarly, the average cost of operating a sewerage in the
whole city is certainly lower than when it serves only a small
part of the city.
(e) Non-profit Considerations
In case of public goods, the output decisions are not guided
by the considerations of maximizing profits. But the optimum
solution is arrived at by off-setting losses if any, through
government subsidies. Therefore, pure public goods can be
defined as those, which are lumpy and indivisible. These have
non-marketable externalities and generally in this case MC is
zero and AC is declining. Unlike private goods, whose production
is guided by the principle of profit maximization, pure public
goods are produced not to earn profits but to maximize social
welfare.
Merit Goods
There are certain goods which, on the basis of the above-
mentioned criteria, may be regarded as private goods. The state
may, however, in the larger interest of society include them in
the public sector. Such goods are termed as the merit goods as
their use is considered desirable for all the members of the society
but some sections, because of their poor resources, may not be
able to offered them. Normally in case of private goods, all the
basic economic decisions concerning their production and
distribution are guided by individual preferences. But the
meritorious characteristics of the merit goods makes it obligatory
for the public authorities to deliberately interfere in individual
choices and modify the choice pattern of society. For instance,
the government may subsidise low cost housing, provide free
education to the people or provide mid-day meals to the poor
students (to encourage the poor to send their children to schools).
Undoubtedly, the state interference in supplying these goods
and services will be viewed as an encroachment upon the freedom
of choice. But the broader objectives of public policy will justify
such a course of action on the part of the state. If education is
left to the private sector, many brilliant children belonging to
the poor families will be forced to seek work rather than
schooling for want of funds. Education, therefore, is the merit
good. The want for education is the merit want which almost
every member of the society must be able to satisfy. Similarly, if
health services in a country are left to private agencies, only
those members of the society can avail of them who are better
off while the poor may have to go without them. The public
authority in case of this merit good also will have either to take
upon itself the responsibility of its supply or it should supplement
its availability in cooperation with the private agencies. In all
such cases of merit goods, the considerations of maximum social
benefit override ideological or any other consideration against
state interference in economic choices. In fact, this interference
is most desirable for it attempts to correct distortions in the
market and in the exercise of consumer choices. Thus, merit
goods are those goods which are provided publicly like social
goods but whereas the latter are meant for all sections of the
community, the former are considered desirable for certain

sections of the society. Further, for merit goods public sector
play a compensatory or substitutive role for the private sector
because the latter is guided sole consideration of profit
maximization.
NOTES
1. D. Bright Singh, Economic Development, Asia Publishing House,
1966.
2. Ibid.
3. H.D. Dickinson, Economics of Socialism, 1939.
4. Government of India, Second Five Year Plan, 1956.
5. Ibid.
6. Ibid.
7. John Kenneth Galbraith, Economic Development in Perspective,
Harvard University, Cambridge, 1964.
8. W.A. Lewis, Development Planning, George Allen and Unwin,
London, 1966.
9. D.R. Gadgil, Planning and Economic Policy in India, Gokhale
Institute Studies, Poona, 1962.
10. J.M. Buchanan, The Public Finances, Richard D. Irwin, Homewood,
1970.
Welfare Criteria: The Provision 3
of Public Goods
After an economic case for the existence of government or

the public sector has been established (Chapter 2), the question
arises on what scale should a government perform its functions,
i.e. what should be the size of the public sector? As Rolph and
Break observe, “One must immediately deny that there exists or
promises to exist any principle or set of principles that would
provide such a definite pattern for government behaviour. The
topic is too complicated and nebulous for simple solutions.”1
The scope and limitations of government action involve questions
of the “ought” type, i.e. ethical issues inescapably crop up. The
related and even more comprehensive question of inter-sectoral
optimal allocation between the public and private sectors is
likewise a complicated one. It involves the complex area of
knowledge called welfare economics which, in the words of
Herber, “consider the performance of the economy in terms of
its ability to achieve certain desirable goals”,2 again an ethical
matter.
A controversial question no dobt, but a society must decide
the basic economic question of resource allocation between the
public and private sectors, i.e. the issue of social balance, which
is primarily concerned with a satisfactory overall division of
output between the two sectors*. Here, in a broader sense, we
would be concerned with both the allocation and distribution
branches of Public Economics, particular emphasis would, of
course, be laid on the former.
The established concept of distribution provides two
important approaches for the achievement of allocative efficiency
*For greater details about “social balance”, see Chapter 4.
in the public sector. These concepts of distribution are “Benefits-

Received”, and “Ability-to-Pay” approaches of taxation in
particular and of fiscal action in general. The “Benefit Approach”
has been refined into the “Voluntary Exchange Theory of
Allocation” by later economists like Horward Basen. The
“Ability-to-Pay Approach to Allocation” is developed by an
other economist, A.C. Pigou, and somewhat improved by
Richard A. Musgrave. In their initial and unpolished form the
two approaches were given by Adam Smith, i.e. maximum of
equity. Yet even in their improved forms, the two approaches
to allocation efficiency contain theoretical as well as operational
weaknesses. The issue of allocation efficiency has been more
clearly analysed by Paul A. Samuelson as social welfare function
in his Theory of Public Expenditure. All these approaches to
optimal allocation of society’s resources—the Voluntary
Exchange, Ability-to-Pay and Samuelson Model—will be
examined one by one in this chapter.
THE VOLUNTARY EXCHANGE THEORY OF

OPTIMAL ALLOCATION
As a background to the voluntary exchange theory, the
benefit rule of taxation may first be seen. This rule in principle
says that, in a society, the amount of taxes paid by each person
should be equal to the value of the services provided by
government activity. The principle, which lies behind the
benefit rule, is that the status quo in respect of income
distribution should continue undisturbed as a consequence of
enjoyment of service and tax payment. The result is as if the
government service were priced and sold on a cost basis. As for
various technical reasons pricing cannot be applied, the
government instead charges a tax equal to the value of the
benefit provided.
As a principle, the benefit rule is quite attractive, but it fails
for lack of applicability. For example, the benefits of a
government service cannot be assigned to individuals; the
principle implies definite value judgment that the existing
distribution of income should not be disturbed by the government
WELFARE CRITERIA: THE PROVISION OF PUBLIC GOODS 75
interference and this is not a proposition entirely within the

power of the economist.*
The voluntary exchange theory insists that resources be
allocated to the public sector in a manner analogous to that of
the market and its pricing system. An individual, according to
this theory, should purchase public goods by paying taxes as he
purchases private goods by paying market prices. The consumer
tries to maximise his utility by paying taxes for public goods in
accordance with the benefits received from them and thus he
equates the ratios of the marginal utilities received by him to
the tax prices of the public goods paid by him as well as equates
these ratios between public and private goods. The doctrine of
consumer sovereignty is applied to the provision of social goods
insofar as the consumer buys national defence, police service,
fire protection and electricity or water supply from the public
sector of his own choice and according to the benefits received
just as he buys food, clothes, fuel, tooth brushes and automobiles
from the private producers.
To explore the problem of the non-rival nature of public
good consumption, it is helpful to compare the demand and
supply diagram for private goods with a corresponding diagram
for public goods. To simplify matters, we presume that only
one social or public good is produced just as one private good is
produced, and there are only two consumers (buyers or
taxpayers) A and B and they reveal their true preferences. The
assumptions may be unrealistic, but they are useful in bringing
out the essential differences between the two situations. Figure
3.1 shows the voluntary exchange approach to optimal allocation
for the private good, on the left side, and for the public good,
on the right side. In both cases, D1 and D2 are consumer A’s and
B’s demand curves respectively. The market demand curve Dt
for the private good is obtained by horizontal addition of D1
and D2. S is the supply curve in both cases. For the private
good, E is the equilibrium point where the market demand curve
Dt and the market supply curve S intersect each other. At OF
price, OC amount is produced, out of which OA is bought by A
*For greater details about “Benefit Approach to Taxation”, see Chapter 6.

and OB is purchased by B, so that OA+OB=OC. Obviously, in

the market because of competition, the same price OF or CE
prevails at which different quantities of the private good are
purchased by consumers A and B. The exclusion principle is
applicable and both the consumers are rival to each other for
the consumption of the good in question.
Fig. 3.1
The right side of the figure shows a corresponding position
for the public good. Both the consumers A and B consume the
public good equally and the exclusion principle is not applicable
in the sense that there is no rivalry in the consumption of the
public good so that either of the consumers cannot be excluded
from consumption on the basis of not paying for it or for paying
less than the other. It means that if one consumer pays more of
the total cost of supplying the good, the other consumer may
pay less, i.e. each offers a price equal to his evaluation of the
marginal unit and the price available to cover the total cost
equals the sum of prices paid by each. For the public good the
aggregate demand curve Dt is obtained by vertical addition of
D1 and D2, which is its main and crucial difference from the
private good case. S is again the supply curve showing the
marginal cost chargeable to both A and B combined, for various
quantities of the public good. The equilibrium point E is attained
by the intersection of S and Dt curves and the equilibrium output
is OM which is the quantity consumed by both A and B. The
combined price is ME or OJ, while the price paid by A is OL

and by B is OK so that OL+OK=OJ.
In the case of the private good, at equilibrium point E, the
marginal benefit derived by A in consuming OA and that derived
by B in consuming OB equals the marginal cost CE. This is,
therefore, the efficient solution because marginal benefit equals
marginal cost for each consumer. If output falls short of OC,
net benefits will be gained by expanding output to the level of
OC, and if output expands beyond OC, welfare losses would
occur till it is contracted again to the level of OC.
In the case of the public good, the equilibrium point E reflects
the equality between the sum of the marginal benefits obtained
by both A and B and the marginal cost of the public good. If
output falls short of OM, it would be beneficial to expand it to
OM, and if output exceeds OM, it would increase welfare to
contract it to the level of OM where the sum of marginal benefits
equals the marginal cost. Thus, the important and the crucial
difference of the public good from the private good is that while,
for the latter, the marginal benefit derived by each consumer
equals marginal cost, for the former, the marginal benefits
derived by the consumers differ and the sum of the marginal
benefits equals marginal cost. Whereas for the private good, A
and B pay the same price and purchase different amounts; for
the public good, they pay different prices but purchase the same
amount. In the case of the public good, as the demand curves
are based on unrealistic assumption that consumers reveal their
preferences, they are, therefore, referred to as “pseudo-demand
curves”.
The case of the public good has been presented in a
somewhat different way by the Swedish economist Erik Lindahl.4
There are two consumers (taxpayers) A and B consuming the
same public good and the unit cost of producing the public
good in question is presumed to be constant and the government
will recover only the full cost (hundred per cent) of producing
public good, neither more nor less. The two consumers would
be entitled to the amount of public good in proportion to the
costs they are willing to pay.*
*For the details of Erik Lindahl’s model, see Chapter 6.

There are several weaknesses in the voluntary exchange

theory, the most important of which is the presumption that the
consumers reveal their true preferences. Actually in the case of
a pure public good, revelation of true preferences is impossible,
because the exclusion principle is inapplicable and each consumer
can consume or take advantage of the total quantity supplied,
regardless of the payment made by him. By not revealing his
true preference a consumer can avoid or minimise payment,
thus making others to pay for its supply. A political (voting)
approach becomes a must for compelling consumers to reveal
their preferences.
Another Achilles heel of this theory is that government
programmes should be decided upon in a manner analogous to
that of the market system. But if public goods were to be
allocated in a manner perfectly similar to the market allocation
of private goods, then consumers with greater income and wealth
and hence greater purchasing power, should have greater voting
influence in the political process than available to the poor. But
the prevailing democratic political process provided an equal
vote for all, regardless of their means. Hence, this theory is
criticized as an attack on democratic ideals.
A third shortcoming of this theory is that it is stated in
partial rather than general equilibrium terms. Rather than
simultaneously taking both public and private goods and the
social balance between them, this theory directly takes only
public goods.
However, the voluntary exchange approach to optimal
allocation possesses the merit of being symmetrical, because
both the tax and expenditure sides of the budget are considered
and are related to each other.
THE ABILITY-TO-PAY THEORY OF OPTIMAL ALLOCATION

The ability-to-pay theory is another approach which tries
to solve in its own way the problem of efficient inter-sectoral
resource allocation in a society. Originally, this principle was
developed to provide cannons for positive taxation and was,
therefore, applied in an asymmetrical, imbalanced, incomplete
or disproportionate manner insofar as it emphasized only the
tax side of the budgetary process. The payment of tax was

considered to be systematically related to some measure of ability
of the taxpayer, so that persons with greater ability were to pay
absolutely as well as relatively more than those with less ability.
Justice or equity in the distribution of tax burdens was thought
to be attained by minimizing the individual taxpayer’s and the
society’s total sacrifice in the payment of taxes as tax payment
meant loss of utility. In other words, the expenditure side of
the budgetary process which rendered utility to residents was
completely ignored. Also this approach concentrated upon the
allocation of resources by the public sector alone, thus ignoring
the resource by the private sector as well as the important social
balance issue of optimal resource allocation between the public
and private sectors. Thus, ability-to-pay approach was initially
a partial equilibrium approach.
A.C. Pigou improved upon the earlier ability-to-pay theory
and made it symmetrical as well as workable under general
equilibrium condition. He provided a comprehensive concept
including both the revenue and expenditure sides of the budget.
The tax side of the budgetary process indicates incurring of
disutility or sacrifice in tax payment. This represents an
opportunity cost to the private sector in the form of goods
which would have been bought had the tax not been paid. The
expenditure side of the fiscal process renders utility or benefits
flowing from the consumption of public goods. Thus, the
Pigovian ability-to-pay approach is symmetrical as both the tax
and expenditure sides of the budget are considered. Pigou’s
version encompasses both public and private goods and is,
therefore, valid under general equilibrium conditions. Hence, it
removes the defect of the voluntary exchange approach of being
workable only under partial equilibrium conditions as the latter
dealt with a single public good.
Figure 3.2 shows Pigou’s ability-to-pay approach. According
to this approach, optimal inter-sectoral resource allocation takes
place at the equilibrium point where the marginal utility attained
in the public as well as the private sector by the use of the
last unit of resources becomes equal. Also, optimal resource
allocation is attained at the equilibrium point where the marginal
utility rendered by public expenditure equals the marginal

sacrifice or disutility borne in the payment of tax revenue, just
as optimal allocation in the private sector takes place where
marginal utility equals marginal cost. In other words, optimal
resource allocation in the society becomes possible when
marginal utilites of the various goods within the public sector
become equal as also when the marginal utilities between the
two sectors attain equality. Thus, right goods are allocated by
the right sector in accordance with consumer preferences. Pigou’s
approach is sometimes called the “Marginal Utility Principle of
Social Balance”. It is noteworthy that in Pigou’s approach only
aggregate utilities and disutilities of the community are taken
into consideration unlike the voluntary exchange approach which
equates individual benefits and sacrifices.
Fig. 3.2
Figure 3.2 (a) represents private sector resource allocation
and Fig. 3.2 (b) indicates public sector resource allocation. The
quantity of product output and of resource use is shown along
the horizontal axis in both cases and the marginal utility is
measured along the vertical axis. If resource allocation in the
private sector provides OL output, OQ is the marginal utility. If
OL′ is the output of the public sector, the marginal utility yielded
is OQ′. As marginal utility OQ in the private sector exceeds the
public sector marginal utility OQ′, there is over allocation of
resources in the public sector and under allocation of resources
in the private sector. If, on the other hand, the resource allocation
in the private sector yields ON output, providing OR marginal
utility and, in the public sector, the resource allocation is at

ON′ output, providing OR′ marginal utility, the marginal utility
OR′ in the public sector exceeds the private sector marginal
utility OR, meaning thereby an under allocation of resources in
the public sector and an over allocation of resources in the
private sector. Therefore, optimality requires an expansion of
output in the private sector from OL towards OM and a
contraction of output in the public sector, from OL′ to OM′, in
the former case; and a contraction of output in the private sector
from ON toward OM and an expansion of output in the public
sector from ON′ toward OM′ in the latter. Only when private
sector allocates OM output, yielding OP marginal utility, and
the public sector allocates OM′ output, yielding OP′ marginal
utility, the marginal utilities in the two sectors equate, satisfying
the general equilibrium conditions of optimal resource allocation
for the society. At output OM for the private sector and OM′
for the public sector, total utility for the society is maximized
because the inter-sectoral marginal utilities OP and OP′ are equal.
Any reallocation away from this equilibrium point where private
marginal utility equals social marginal utility (i.e. PMU=SMU)
will mean reduction in total utility available to the society.
An alternate method of displaying Pigou’s ability-to-
pay approach to optimal resource allocation is provided in
Fig. 3.3. This graphical approach was developed by Richard A.
Musgrave.5 The conceptual framework is the same as in Fig.
3.2 except that the tax and expenditure sides of the budget are
more clearly depicted. The marginal utility derived from the use
of public goods made possible by incurring public expenditure
and the marginal disutility incurred in tax payment are measured
vertically along OY and OY′ and the budget size in rupees is
shown along the horizontal axis. The marginal utility of public
expenditure, allocated optimally between various public goods,
is shown by curve AA, and the marginal disutility of tax
payments, in accordance with the ability to pay so as to minimize
total sacrifice, is displayed by curve CC. Curve BB shows net
marginal utility for different budget sizes between O and E and
net marginal disutility beyond E. As long as the marginal utility
of resources allocated by the public sector exceeds the marginal
disutility, total utility derived by the society goes on increasing

with increase in the government budget size. This takes place
for the range of allocation indicated by OE along the horizontal
axis, and beyond E, net losses are incurred if allocation by the
public sector still continues. At point E, which is the equilibrium
position, net benefits are zero, because marginal utility is equal
to marginal disutility. For budget size OE, total utility of the
society reaches the maximum, because at E, marginal private
utility equals marginal social utility.
Fig. 3.3: Pigovian Ability-to-Pay Approach to Resource Allocation:

Symmetrical Application
An essential precondition for the ability-to-pay approach to
be valid is full employment of resources in the society. If there
exists unemployed resources which can be used to maintain the
production of private goods at a given level while at the same
time the production of public goods can be increased, no
opportunity costs in the form of private goods foregone are
involved. With sufficient unused resources being available, the
utility derived from the additional production of both public
and private goods may go on increasing, resulting in a higher
total utility to the society. Only at the level of full employment

of resources in a very strict sense, greater allocation of resources
by one sector would require less allocation by the other sector,
thus generating the real problem of optimal resource allocation
for the society.
Among the several weaknesses of the ability-to-pay approach,
the foremost which confronts us is how to quantify or measure
utility and disutility in an objective manner. In the absence of
even a satisfactory measuring rod, optimal resource allocation
would become impossible. The proponents of this approach
accept the impossibility of cardinal or absolute measurement of
utility and disutility, but they pin their faith on an cardinal or
relative measurement, which can be helpful in a very limited
way.
A related shortcoming arises out of the inability to make
interpersonal utility comparisons. The ability-to-pay concept
presumes that marginal utility of income falls as income increases,
and, therefore, the ability to pay taxes increases more than
proportionately with increases in income, implying thereby
progressive taxes. But this gives rise to another problem of
the extent of progressiveness of taxes. The philosophy of
egalitarianism or equalitarianism lying behind the ability-to-
pay principle that all individuals are equal in some sense is
rejected by the new welfare economists who do not accept
interpersonal utility comparisons. The answer given to this
objection is that interpersonal utility comparisons of utility
should not be totally rejected, because the behavioural similarities
among the individuals of a given community may well include
diminishing income utility with rising income.
Another weakness of this approach is a value judgments
regarding the proper distribution of utilities and disutilities
among different consumers, required by the interpersonal utility
comparisons. Value judgments and not positive economic criteria
are needed to solve the distribution problem.
Moreover, the basic objection raised against the assumption
that the consumers reveal their true preferences is not fully met,
though the relative or ordinal measurement of the ability to
reveal community preferences may partially meet the need.
Samuelson’s Theory of Optimal Allocation

A more refined approach to optimal allocation as compared
to either the voluntary exchange theory or the ability-to-pay
theory is provided by Samuelson.6 The weakness of the other
two theories regarding the inability to apply the exclusion
principle to the consumption of pure public goods has been
aptly met. Moreover, the importance of the value judgment, a
pre-requisite to optimal allocation, has been emphasized. It needs
not be said that Samuelson’s is a symmetrical approach
applicable to general equilibrium conditions.
Samuelson presents a polar or extreme case of the public
sector resource allocation. His extreme case for public goods
may be seen in either an authoritarian (totalitarian) or democratic
political set-up. The totalitarian group mind has no economic
implications and is based on political value judgments, and is,
therefore, beyond the scope of our analysis here. The second
approach is based on individualism, the keynote of democratic
political economies.
The individualistic approach is further divided into
(1) conditions where interpersonal utility comparisons are
rejected and (2) conditions where such comparisons are accepted.
If interpersonal utility comparisons cannot be made, then social
welfare is merely a heterogeneous collection of individual
welfares. In such conditions, the only possibility is Pareto
optimality where community welfare can increase only if one
person gains without involving another person into a loss as a
result of reallocation. Under this restrictive approach, if one
person gains while another loses, no judgment about social
welfare can be made. Pareto optimality, however, emphasizes
the basic problem of scarcity in economics and the difficulty of
choice or division in such conditions.
The second individualistic approach, which accepts
interpersonal utility comparisons, believes in the ethics of value
judgments whereby individual welfares are aggregated to get
community welfare. This exactly is approach followed by
Samuelson who applies these value judgments to a Pareto
optimum norm.
As already seen, a pure private good is divisible among

consumers, i.e. its consumption is rival. An orange eaten by A
cannot be eaten by B, i.e. exclusion principle is readily applicable.
Under conditions of full resource employment, if some consumers
use more of such a good, the rest must use less of it. On the
other hand, a pure public good is consumed equally by all and
is not divisible among consumers, i.e. its consumption is non-
rival. If some consumers consume more of it, there is no way
whereby they can cause others to consume less of it, i.e. exclusion
principle is not applicable.
In the case of private goods, assuming that there are two
products X and Y in an economy of two consumers A and B,
the conditions of efficient allocation in the Pareto sense are:
(1) any given amount of X should be produced in such a way as
to permit the largest possible amount of Y to be produced at the
same time. This can be shown by the construction of the
production possibility frontier as between X and Y; (2) the
marginal rate of substitution in consumption between X and Y
must be the same for A and B, i.e. the rate at which A and B
will be willing to trade the last unit of X for additional units of
Y should be same; and (3) the marginal rate of substitution of X
for Y in consumption should equal their marginal rate of
transformation in production, the latter being defined as the
additional units of X that can be produced if production of Y is
reduced by one unit.
When both social or public and private goods are produced,
assuming only one public good S and one private good X and
only two consumers A and B in the economy, the allocation
efficiency conditions as developed by Professor Samuelson are:
(1) condition 1 is the same as in case of private goods and can
be shown with a resource possibility, production possibility or
transformation curve between S and X; (2) consumers’ marginal
rates of substitution of public for private goods may differ, as
the consumers now consume equal amounts of S; and (3) the
marginal rate of transformation in production should be equal
to the sum of their marginal rates of substitution in consumption,
because both consumers share in consuming the same units
of S.
Figure 3.4 displays the optimal allocation of resources as

between public and private goods.7 Private good X is measured
along the vertical axis and the public good S is shown along the
horizontal axis in all the three parts of the figure. The upper
part of the figure gives the production possibility curve RS which
records the combinations of X and S that may be produced
with available resources. The middle part of the figure shows
the quantities of X and S consumed by consumer A and the
lower part gives the corresponding picture for consumer B. Since
both consumers A and B consume the same quantity of public
good S, both will be at the same point on the horizontal axis,
but they may consume different quantities of private good X
and be at different points on the vertical axis, provided the sum
of the quantity of X consumed by A and that consumed by B
equals the total output of X. To illustrate this point, if A is at E,
he consumes OF of S and FE of X. From the upper part of the
figure, it is clear that in that case, both A and B consume OD of
S (which is equal to OF of S for A) and DC of X. Since FE of X
is consumed by A, the remaining amount DC–FE=HG of X is
consumed by B who also consumes OH of S as is shown in the
lower part of the figure. As is evident OH of S for B=OF of S
for A=OD of S for both A and B, whereas the quantities of X
consumed by A (i.e. FE) and by B (i.e. HG) are different, and
the sum total of FE and HG=DC.
Let us choose a particular level of welfare for A, say that
indicated by his indifference curve Ia. In that case all the
combinations of S and X indicated by points Q, J, N, E and W
on the indifference curve Ia yield equal amount of satisfaction to
A. If A moves through these points along Ia, the corresponding
most preferred points for B are T, K, P, G and V. The best point
for B where his welfare is maximized is given by P where TKPGV
is tangent to B’s highest indifference curve Ib, leaving A at the
corresponding point N. The optimal allocation position is that
where total output includes OM of S and ML of X, divided
between A and B so that A consumes MN and B consumes MP.
In accordance with Pareto optimality, A’s position remains intact
when he moves from E to N (both being on the same indifference
curve Ia) whereas B’s position improves when he moves from G,
which is on a lower indifference curve, to P which is on the

highest possible indifference curve Ib. It should be noted here
that for different welfare levels for A indicated by his indifference
curves Ia, I′a, etc., there would be a new locus of B’s positions.
Thus, a set of solutions corresponding to various levels of welfare
for A and B would be reached. All these solutions are efficient
Fig. 3.4: Samuleson’s Model of Optimal Allocation

in the Pareto sense and meet the allocation efficiency condition

of equality between the marginal rate of transformation in
production and the sum of marginal rates of substitution in
consumption, for the social or public good. Any deviation from
this position would harm A or B.
PUBLIC AND PRIVATE GOODS IN GENERAL EQUILIBRIUM

Since the notion of optimal state of distribution is necessarily
dependent upon a particular value judgment of society, for
different value judgments there can be, in principle, infinite Pareto
optimum points. For comparing these points, a normative social
welfare function is needed. Such a function can be determined
through ethical judgments on the basis of inter-personal utility
comparisons. Figure 3.5 shows the utility function and welfare
function of the society for optimal allocation.
Fig. 3.5: Utility Function and Welfare Function of Society Determining

Optimal Allocation
The society is supposed to consist of two consumers A and

B, utility possibilities for whom are measured, in an ordinal
manner, along horizontal and vertical axes respectively. Curve
JF indicates the utility frontier of Pareto optimum points for the
two consumers, so that any point within this curve toward the
origin represents a less than Pareto optimum point. The
conflicting consumption interests of the two consumers are
indicated by the Pareto optimum curve sloping to the right.
This means that if, through budget reallocation, one consumer’s
position is improved, it can be possible only at the cost of the
other consumer whose position would worsen. For the
community as a whole, the optimum welfare points lie on the
utility frontier JF. The question, however, is how to arrive at
the exact optimal allocation point along JF. Obviously, the
optimal allocation point will be reached at the equilibrium point
E where the utility frontier JF is tangent to the highest possible
social indifference curve I2. Indifference curves I1, I2, and I3 reflect
the various preference combinations of the consumers in the
society, A and B. The social indifference curves I1, I2, and I3 may
be designated as the welfare function of the society.
One thing is noteworthy here that only economic analysis
through social welfare function cannot reveal true ordering of
preferences without the establishment of the state of ex-ante
distribution for the society. Only when ex-ante distribution is
given, one of the social indifference curves will show the effective
demand of the society for public and private goods. The voting
power of income and wealth distribution determines effective
demand for private goods in the market and political voting
power determines the effective demand for public or social goods.
This effective demand for public and private goods results in
actual resource allocation and indicates the ultimate real income
distribution, which may be referred to as ex-post distribution.
Thus, in effect, ex-ante distribution locates the relevant social
indifference curve which is tangent to the utility frontier and
results in actual resource allocation between public and private
goods as well as ex-post distribution of these goods among
consumers. Ultimately, actual allocation and ex post distribution
become synonymous. The role of the value and ethical judgments
has, therefore, to be emphasized in the determination of the
soical welfare function and the relevant social indifference curve.
These value judgments may be made by economists, politicians
or the legislature.
The ex-ante state of distribution meets the need of the

revelation of true preferences of the consumers for pure public
good as the exclusion principle is not applicable to them. In the
case of public goods, when consumers are in large numbers, the
potential use of strategy increases and the allocation efficiency
becomes complicated. The larger the number of consumers, the
more the possibility of use of strategy, the easier it becomes to
consume the public good equally with others and avoid altogether
or reduce payment for it. Thus, compulsion, i.e. taxation becomes
the only method of financing a pure public good.
OPTIMAL ALLOCATION OF QUASI-PUBLIC GOODS

So far we have dealt with the problem of optimal allocation
of pure public goods (Musgrave’s social wants) which involve
the difficulty of the revelation of true preferences by the
consumers. Public Economics has also to solve the problem of
optimal allocation of quasi-public (quasi-private) goods which
are called ‘merit wants’ by Musgrave. Such goods are mostly
allocated by the market, but often not in sufficient quantities.
Considering their highly desirable nature, often decreasing
production costs and other traits of publicness, however, it may
be in public interest to allocate them in the public sector or to
subsidize their private production. Similarly, in the case of
undesirable goods, or what are called “social bads” by
Musgraves,9 or in the case of uniquely scarce resources, the
imposition of a tax penalty may be required to reduce their
quantities and improve allocation.
A sharp distinction has so far been made between pure
private goods, the benefits of which are entirely internalized
and their consumption is rival, and pure public goods the
consumption of which is non-rival and external benefits flow
from them. This polar or extreme view of goods the consumption
of which is non-rival and external benefits flow from them is,
however, unrealistic. Rather mixed or quasi-public or quasi-
private goods are more of a reality. When external benefits are
generated by private consumption or production activities,
problems of the public good type arise. For example, if a person
gets inoculated against an infectious disease, not only he himself
benefits but also other with whom he comes in contact are

benefited. Similarly, a person derives personal benefits out of
his education and others are also benefited by association. In
such cases, full budgetary provision may not always be needed
rather only subsidization of private activity may suffice. Optimal
allocation of those economic activities which yield external
benefits may not be possible without subsidization.
Fig. 3.6: Optimal Allocation in the Resource of

External Benefits Quasi-Public (Quasi-Private) Goods
Figure 3.6 shows the market allocation of a good which
yields external benefits and its optimal allocation with the help
of a government subsidy. Quantities produced and consumed of
the good concerned are measured along the horizontal axis and
its price level is shown along the vertical axis. S represents its
supply position at different prices. Dm is the market demand
curve, which is obtained by horizontal addition of individual
demand curves of the good in question. Dp is the pseudo demand
schedule reflecting supplementary demand for external benefits
generated by private consumption and is obtained by vertical
addition of individual demand curves of such benefits. Dt is
obtained by adding Dm and Dp vertically and it reflects total
benefits represented by both Dm and Dp, i.e. market benefits and
external benefits. The private market equilibrium is represented
by E′ where the equilibrium output is only OQm. The optimal

output is QQ1 corresponding to the intersection of S and D1.
In a market economy, optimum output OQt will not be
possible of its own accord. To expand output from OQm to
OQ1 the government should pay a subsidy equal to the difference
between D1 and Dm. At optimum output OQt, this difference is
equal to EF, which is the amount of subsidy required to be paid.
In such a case, consumers would be required to pay OC price
and the government would subsidize the output to the extent of
CP per unit. The total amount of subsidy would be equal to
CFEP. The determination of the proper rate of subsidy, on the
basis of an evaluation of external benefits, gives rise to exactly
the same type of problem of the revelation of consumers’
preferences as is faced in the case of pure public goods and
hence involves the use of a similar political process.
In the polar case of a pure private good, the distance FE
would become zero because Dt and Dm would merge into each
other and the amount of subsidy would vanish. In the extreme
case of a pure public good, on the other hand, Dt and Dp would
merge into each other and the whole project would have to be
financed from the budget so that the entire price is paid by
government subsidy. The mixed or quasi-public or quasi-private
goods would have to be financed partly by private payments
and partly by government subsidy as is displayed in Fig. 3.7.
Often it may be possible to meet certain needs either through
the market process or through budgetary provision. Since the
market process permits consumption of different quantities of
the same good, the budgetary provision method would be
preferred only when this advantage offered by private process is
outweighed by offering the good at a lower cost per unit.
The other side of the coin represented by undesirable goods
or social bads, which result in external costs, remains to be
considered. While budget policy may not supply social bads,
the private producers or consumers may generate external costs.
The solution of this problem may nevertheless necessitate
budgetary action. For example, a manufacturing unit may emit
smoke or spread dirt-causing disutility to neighbouring people.
A jagarata or loud recitation of devotional songs throughout
night on the common land may cause great disturbance to nearby

captive residents. These are external costs which are a reality
from social point of view, but the same are not counted as costs
by producers and hence are not internalized. Since the private
producers do not account for these external costs, their products
tend to be oversupplied. Similar external costs may be generated
in the process of consumption, e.g. automobile pollution.
The case of externalities caused by social bads is analogous
to that of external benefits and is displayed in Fig. 3.7. D is the
market demand curve for the product concerned and Sm is its
industry supply curve. S m includes only internalized costs
representing actual outlays. OQm quantity is demanded and
supplied at OPm or QmF price. Se represents external costs
generated in the process of production. This fact is not taken
into consideration by the market, but optimal allocation must
allow external costs. The external cost at output OQm is QmL. St
is obtained by vertical addition of Sm and Se curves. The new
point of equilibrium attained by the inter-section of St and D
curves is E which raises the price of the product to OPt or QtE,
resulting in a contraction of supply from OQm to OQt. To allow
fully for social costs represented by St curve, a tax at the rate of
HE or QtK per unit should be levied, so that the sum of private
Fig. 3.7: Optimal Allocation in the Face of External Costs

cost QtH and the tax rate HE is equal to QtE. The role of the
tax is to reduce the quantity of the product supplied. This is
similar to the role of the subsidy in Fig. 3.6.
Clearly, the tax imposition does not fully eliminate the
undesirable element, but the amount of external cost is reduced
from QmL to QtK. The idea is to reduce the external cost to its
efficient level, where marginal cost of production no longer
exceeds the marginal benefits derived by consumers. In actual
practice, however, the problem may not be solved so easily as
indicated here, because it is not only one of adjusting the level
of output for a given technology, but also of adapting the
technology so as to reduce external costs. Therefore, public policy
should encourage the choice of a better technology. Moreover,
as in the case of external benefits, the true level of external costs
is not readily revealed. Again a political process is needed to
determine true costs.
Public Goods
When a public good is provided, it can be consumed
collectively by all households. Such collective consumption
violates the assumption of the private nature of the goods in a
competitive economy. The existence of public goods then leads
to a failure of the competitive equilibrium to be efficient. This
implies a potential role for the state in public good provision to
overcome the failure of the market.
The formal analysis of public goods began with Samuelson
(1954) who derived the rule characterizing efficient levels of
provision for public goods. Now efficient provision will be
considered for pure public goods and for public goods subject
to congestion. The theme of efficiency is continued into the
study of Lindahl equilibria with personalized prices. Following
this, the analysis of private provision demonstrates the nature
of the outcome when prices are uniform and illustrates why a
competitive market fails to attain efficiency.
If government provision is to be justified, it must be shown
that the government can improve upon the market outcome. In
seeking the attainment of an efficient outcome, the government
is faced with informational constraints of which the lack of
knowledge of household preferences is the most significant.
As already said, a public good can be distinguished from a

private good by the fact that it can provide benefits to a number
of user simultaneously whereas a private good can, at any time,
only benefit a single user. If the public good can accommodate
any number of users then it is said to be pure. It is impure when
congestion can occur. This section defines a public good, clarifies
the distinction between pure and impure and develops its
economic implications.
Pure Public Goods
The pure public good has been the subject matter of most
of the economic analysis of public goods. In some ways, the
pure public good is an abstraction that is adopted to provide a
benchmark case against which other results can be assessed.
Before proceeding, it should be noted that public goods can
take the form of inputs into production in addition to their
more commonly presented role as objects of consumption. A
simple translation of the comments below can be made in order
to allow them to describe the public good as an input. As already
said, a pure public good has the following two properties.
Non-excludability
If the public good is supplied no household can be excluded
from consuming it except, possibly, at infinite cost.
Non-rivalry
Consumption of the public good by one household does not
reduce the quantity available for consumption by any other.
The implication of non-excludability is that consumption cannot
be controlled efficiently by a price system since no household
can be prevented from consuming the public good if it is
provided. It is evident that a good satisfying this condition does
not fit into the framework of the competitive economy.
From the property of non-rivalry it can be deduced that all
households can, if they so desire, simultaneously consume a
level of the public good equal to its total supply. If it is possible
for households not to consume the public good, then some may
consume less. In the latter case, the public good may satisfy free
disposal, so that consumption can be reduced at no cost, or else
disposal can be costly. When all households must consume, or

want to consume, to the maximum, the welfare level of each
household is dependent on the total public good supply.
In reality, it is difficult to find any good that satisfies both
the conditions of non-excludability and non-rivalry precisely.
For example, the transmission of a television signal will satisfy
non-rivalry but exclusion is possible at finite cost. Similar
comments apply, for example, to defence spending which will
eventually be rivalrous and from which exclusion is possible.
Impure Public Goods10
It has been assumed so far that all goods fall into one of
two categories. Pure public goods are non-rivalrous in
consumption, meaning that one person’s consumption of any
of these goods does not interfere with any other person’s
consumption of the same good. The clarity of your radio
reception, for example, is independent of the number of other
listeners. Private goods are rivalrous in consumption, meaning
that only one person can consume each unit of these goods.
Food and clothing are examples of goods in this category. But
there are many other goods, including parks and recreational
facilities, police and fire protection, and roads and bridges, that
do no fit into either category. Consumption of one of these
goods by another person reduces, but does not eliminate, the
benefits that other people receive from their consumption of the
same good. These goods are called impure public goods, and
are said to be partially rivalrous or congestible.
Impure public goods also differ from pure public goods in
that they are often excludable. Access to many recreational
facilities is controlled, and toll roads and toll bridges are not
unfamiliar. Fire and police protection are more problematic.
Controlling access to these services is more difficult, and even if
it were feasible, it would raise serious ethical questions.
The possibility of controlling access to impure public goods
has two important implications. First, provision by private firms
or by governments on a “fee for service” basis becomes possible,
because free riding can be eliminated. Second, the provider of
the good can influence the degree of congestion by regulating

either the number of people who use the good, or the frequency
with which they use the good, or both.
The study of impure public goods has centered on two broad
classes of goods: the club goods, first studied by Buchanan,11
and the variable-use public goods, first analyzed by Oakland12
and Sandmo.13 Club goods include such facilities as swimming
pools, fitness clubs, and tennis courts. It is generally assumed
that the number of users (or members) of each facility is
controlled, but that the frequency of each member’s use is not.
These goods are assumed to be replicable, can be repeated, so
that individuals who are excluded from one facility (or club)
can become members of another equivalent club. Variable-use
public goods are goods such as roads, bridges and public transit
system. They can be either excludable or non-excludable, but if
they are excludable, frequency of use rather than number of
users is controlled. They are not replicable, so one facility must
provide the service to all potential users. Let us examine these
two classes of goods.
Club Goods
The benefit received by each club member depends upon
the size of the club’s facilities and the club’s membership. This
benefit can be described by the equation
B=b (s.m)
where B is each member’s benefit, s is the size of the facility,
and m is membership. This equation contains a general functional
form: it asserts that B is determined by s and m, but does not
give definite instructions for calculating the benefit. The form
of the functions b must be restricted so that the relationship
between B and its determinants, s and m, is a sensible one. But
we cannot know what restrictions should be placed on the
function unless we know what kind of behaviour we want to
depict. Let us imagine a particular kind of club, a tennis club—
and consider how the typical member would respond to a change
in the club’s size and membership.
First, imagine that the membership is fixed, and that a bigger

facility means one with more tennis courts. Members meet, find
other players with whom they are compatible, and try to book
court time. If the club has only a few courts, the most desirable
time slots, are quickly booked, and the remaining players must
either accept inconvenient time slots or cancel their matches.
Building another court increases the number of desirable time
slots, so more matches are played, and more matches are played
in desirable time slots. The benefits associated with the additional
court are large. However, if the club has many courts, an
additional court yields quite small benefits. The members are
already playing as much tennis as they would like, and the
additional court simply allows them to obtain bookings in slightly
more convenient time slots. Arguably, the benefit associated
with each increase in facility size declines as the facility size
rises.
Now imagine that the club’s size is fixed and that the
membership is changing. When the membership is small, each
member faces difficulty in finding fellow players who have
roughly equal skills and compatible schedules. Adding members
increases the likelihood that any given member will be able to
find a satisfactory partner, increasing the benefit that he obtains
from club membership. But adding members also increases the
competition for time slots, and this congestion reduces the benefit
that each member obtains from club membership. The first effect
is likely to dominate when the membership is small, because
there are few compatible pairs, and therefore little demand for
more courts. Increasing the membership creates more compatible
pairs who readily find court time. The second effect is likely to
dominate when the membership is large. A large membership
implies that there are already many compatible pairs, and that
the courts are highly congested. Increasing the membership does
not markedly increase the number of matches that each member
would like to play, but the greater congestion forces each member
to play in less convenient time slots. Thus, the benefit received
by each member first rises and then falls as the number of
members rises.
BC
C
B
m* m* m
Fig. 3.8: Optimal Membership of a club of given size. The assumption that
clubs are replicable implies that it is socially optimal to maximize the net
benefits of each club member. The optimal membership is m.*
Members prefer bigger facilities to smaller facilities, but
successive increases in facility size bring smaller and smaller
increases in benefits. The second condition state that the marginal
benefit of an additional member gets smaller as the membership
rises. If the marginal benefit of an additional member is zero
when there are ‘M’ members, it must be positive when there are
fewer than ‘M’ members, and negative when there are more
than ‘M’ members. This relationship is shown in Fig. 3.8.
The assumption that the clubs are replicable implies that
the social net benefits of a system of clubs are maximized when
an individual member’s net benefit is maximized. Which is the
Samuelson condition in another guise. The facility is of the
optimal size if the sum of the members marginal benefits from a
unit of facilities is equal to its marginal cost.*
*People excluded from one club are accommodated by building more

clubs, so it is socially optimal to design each club to maximize the net
benefits of its members. If clubs were not replicable, people excluded from
the club would not be accommodated elsewhere and hence would receive
no benefits. The social net benefits of the club would then be equal to
number of members multiplied by NB (Net Benefit). The socially optimal
membership would trade-off the gain from providing one more person
with a membership, against the loss that his membership imposes upon the
other members.
Variable-Use Public Goods

In case of variable-use public good which is made available
to everyone with different frequencies, but each person can
choose the frequency with which he uses it. Each person’s use
creates congestion which adversely affects every other person
who uses the facility, and reduces the frequency with which the
others use it. Each person’s frequency of use therefore depends
upon every other person’s frequency of use.
Imagine, for example, that the public good is a road
connecting a suburb to a city center. Each user believes that
trips to the city (for work, otherwise) are rewarding, but that
each additional trip has a smaller value than the last. Congestion
in this case can be controlled through tolls.
Thus, the act of travelling to the city imposes (potentially)
two types of costs on the user. There might be a monetary cost,
e.g. a ‘toll’ might be charged for each use of the road. Travellors
might also experience delays, or be exposed to accidents when
road use is high. These costs are referred to as congestion costs
which depend upon the capacity of the road system and the
number of trips made by the other users. An increase in use
raises each person’s congestion costs, while an increase in
capacity reduces the costs.
However, sometimes the provider of the public good might
choose not to impose a toll for a number of reasons. The resource
cost of collecting the toll may be very high. The act of collecting
toll may further increase congestion at the collection centre.
Moreover, toll constitutes regressive taxation as it falls equally
both on the rich and the poor. But the decision not to impose a
toll also affects society’s welfare adversely. Then it must adopt
different rules to choose capacity. Given the number of trips
taken by each user, an increase in size reduces congestion but
exhausts scarce resources. The social net benefit rises if the
reduction in congestion costs is greater than the resource cost.
However, each person will respond to the reduced congestion
by travelling more. Each person will receive the benefit of extra
trips, but will also bear higher congestion costs. The equilibrium
will be reached when marginal congestion cost is equal to
marginal resource cost.
Impure Public Goods and Congestion

In practice, public goods tend to eventually suffer from
congestion when usage is sufficiently great. Obvious examples
include parks and roads. Congestion results in a reduction in
the return the public good gives to each user as the use of a
given supply by households increases. Such public goods are
termed impure. The utility derived by each household from an
impure public good is an increasing function of the level of
supply and a decreasing function of its use.
In a nutshell, the central issue in the discussion of impure
public goods is the control of congestion. Congestion of club
goods is controlled by limiting the membership of each facility
and replicating the facility to accommodate everyone who wants
a membership. Congestion of variable use public goods is
controlled by regulating the frequency of use through tolls, or
failing which, through the choice of facility size.
NOTES
1. E.R. Rolph and G.F. Break, Public Finance (1961), p. 74.
2. B.P. Herber, Modern Public Finance (1967), Footnote on p. 49.
3. H.R. Bowen, Toward Social Economy (1948), pp. 176-78.
4. Erik Lindahl, “Just Taxation: A Positive Solution” in Masgrave,
R.A. and Peacock, Alan (eds), Classics in the Theory of Public
Finance (1958), pp. 168-77.
5. R.A. Musgrave, The Theory of Public Finance (1959), Fig. 5.4,
p. 114.
6. P.A. Samuelson, “The Pure Theory of Public Expenditure”, Review
of Economic and Statistics, November 1954, pp. 387-89;
“Diagrammatic Exposition of a Theory of Public Expenditure”,
Review of Economics and Statistics, November 1955, pp. 350-56;
and “Aspects of Public Expenditure Theories”, Review of Economics
and Statistics, November 1958, pp. 332-38.
7. P.A. Samuelson, “Diagrammatic Exposition of a Theory of Public
Expenditure”, Reveiw of Economics and Statistics, Nov. 1955,
adaptation from Charts 1, 2 and 3, p. 351.
8. Ibid., adaptation from Chart 4, p. 352.
9. R.A. Musgrave and P.B. Musgrave, Public Finance in Theory and
Practice, 2nd edition, 1976, p. 59.
10. This section is based on John Leachs’, A Course in Public Economics,

Cambridge University Press, New York, 2006.
11. James Buchanon, 1965, “An Economic Theory of Clubs”, Economica,
No. 32, pp. 1-14.
12. William Oakland, 1972, “Congestion, Public Goods and Welfare”
Journal of Public Economics, Vol. I, pp. 339-57.
13. Agnar Sandmo, 1993. “Public Goods and the Technology of
Consumption”, Review of Economic Studies, No. 40, pp. 701-06.
Public Choice and Rationale 4
of Public Policy
PROBLEM OF ALLOCATING RESOURCES: PRIVATE AND

PUBLIC MECHANISM
The problem of optimum allocation of productive resources
between the public and the private sectors of an economy is an
important part of the allocation goal in Public Economics. It
was also called as the problem of social balance. Galbraith used
the term “social balance” in his book The Affluent Society.1 He
describes it as a satisfactory relationship between the supply of
privately produced goods and those supplied by the public sector.
The determination of an exact social balance point is fraught
with significant theoretical and practical difficulties. It is, no
doubt, a problem to give any precise definition of the social
balance point. However, it does not in any way reduce the basic
importance of the social balance concept. Undoubtedly, it is not
very easy to find out the precise point of social balance in theory,
but when it comes to practice, a much more intricate task is
faced.
In terms of marginal utility analysis, the social balance
point may be explained in the words of John F. Due who says,
“Were it possible to compare satisfactions of individuals.... The
criterion for governmental activities would be maximization of
satisfaction: the adjustment of all activities to the level at which
marginal satisfactions from the last units of expenditure on all
goods and services provided by private or governmental sectors
were equal.”2 Just as the law of equi-marginal utility is applied
by an individual to his personal consumption expenditure in
order to maximize his total satisfaction, the application of the
same law has been extended not only to each of the public
sector and the private sector but also to the whole economy,
consisting of the public and the private sectors. But unfortunately,
because interpersonal utility comparisons are not possible, the
concept of an optimum based upon equi-marginal satisfaction
and sacrifice becomes meaningless.
The Pigovian approach may also be applied in order to
define a precise social balance point. If the society were a unitary
being, Pigou observed that, “expenditure should be pushed in
all directions up to the point at which the satisfaction obtained
from the last shilling expended is equal to the satisfaction lost
in respect of the last shilling called up on government service”.3
This approach is the same as given above except that, in one
case, equalisation of marginal utilities is said to be the aim,
while, in the other, the process of substitution is utilised for
the attainment of the aim of equi-marginal utilities. The same
insurmountable hurdle of the impossibility of interpersonal utility
comparisons is encountered.
If the optimal allocation of societal productive resources is
attained, say, at a point which indicates their division between
the public and the private sectors in 40:60 ratio, then the social
balance point is indicated by point A in Fig. 4.1. Theoretically,
Fig. 4.1
PUBLIC CHOICE AND RATIONALE OF PUBLIC POLICY 105
the social balance point A is a true reflection of community

preferences for resource allocation between the two sectors. The
percentage of total public sector output is measured along
Y-axis and the percentage of total private sector output along
X-axis. If A is the social balance point and it reflects the actual
allocation by the society, actual allocation and social balance
coincide and there is no social imbalance. Any reallocation of
the community’s resources would not enhance community’s
welfare.
But if A is social balance, and if actual allocation takes
place at B or C, then social imbalance exists and reallocation
between sectors is required to reach the optimal point. Actual
allocation at B indicates an over allocation of resources to the
public sector to the extent of YY1, and under allocation of
resources to the private sector by XX1 amount. Similarly, if
actual allocation is at C it represents an over allocation of
resources to the private sector of the magnitude of XX2, and an
under allocation of resources to the public sector of the amount
of YY2. With the passage of time, such imbalances may either
reduce and vanish or may widen or even reverse. It is not only
actual allocation which may change over time, but the social
balance point also may undergo a change with a change in the
pattern of preferences of the members of society. The social
balance concept can also be displayed in terms of indifference
curves.
Indifference Curve Approach and Optimal Resource Allocation
The inter-sectoral optimal resource allocation can be shown
with the help of indifference curve technique. Figure 4.2
illustrates the optimum allocation of resources in inter-sector of
the economy.
In Fig. 4.2, AB is the production possibility curve of an
economy, showing the marginal rate of transformation between
private goods and public goods with a given productive resources.
The higher position of the production possibilities indicates
greater production potential due to superior quality of its given
total productive resources. At point B, society’s entire resources
are allocated to the private sector while at point A, all resources
Fig. 4.2
are allocated to the public sector. The production possibility

curve AB is concave to the origin which means that the scarce
resources cannot be substituted with equal efficiency between
the production of the public and private goods. Therefore, any
re-allocation of resources along with the upper part of the
production possibility curve (AB), as from C to D, would add
more to the private sector output. For additional private sector
output has been measured by the distance MN. As a result,
amount of goods sacrificed in the public sector output is shown
by the distance EF. This is because of the existence of diminishing
returns in the production of public goods. On the contrary,
along the lower portion of the production possibility curve, as
from G to H, will add more to the public sector output than the
loss suffered in the private sector. This is found due to the
existence of diminishing returns in the production of private
sector output. In short, unequal trade between the output of the
public goods and private goods occur on account of following
reasons:
1. Some economic goods are produced more efficiently
with less input cost per unit in one sector than the
other.
2. Increasing cost tends to work when too many goods

are produced by one sector due to diminishing returns
and it always comes into operation in the long run
period.
Social Indifference Curve Map and Optimum Allocation of
Resources
Being familiar with community production possibility curve,
let us study the optimal inter-sectoral resource allocation
involving social or community indifference curves. In Fig. 4.3, a
map of social indifference curves IC1, IC2, IC3, IC4, etc. has been
drawn showing society’s MRS between consumption of private
goods and public goods. It means that each indifference curve
shows the various alternative combinations of private and public
goods giving the same welfare to the society. We also know
that higher social indifference curve means higher level of social
welfare since a higher level of output (both private and public)
would be consumed by the society on a higher social indifference
curve.
Fig. 4.3
The social indifference curves are convex to the origin which

shows that along each curve there is a diminishing marginal
rate of substitution between public goods and private goods at
a given level of social welfare. Toward the upper end of the ICs,
quantity of public goods that the society would be willing to
sacrifice to attain an additional unit of private goods is greater
than towards the lower end of the same curve. For instance, a
downward movement on the social indifference IC1, from point
A to B yields greater loss of EF amount of public goods for the
smaller portion of gain PL amount of private goods. As the
society starts consuming more private goods toward the lower
end of the social indifference curve, it would be willing to give
up a less than proportionate amount of public goods to get a
larger quantity of private goods. This has been shown by a
movement from C to D along with the same indifference curve
(IC1) as it shows the small loss of MN of public goods and a
larger gain of RS amount of private goods. Its main reason
is diminishing marginal rate of substitution between the
consumption of private and public goods. It is due to: (i) marginal
utility of the scarce goods increases relative to the marginal
utility of the other goods which becomes relatively plentiful
and (ii) social indifference curve is convex and significant loss
of both political and economic freedom are incurred as
government allocation becomes dominant near the upper end of
the curve.
Figure 4.4 combines two earlier figures showing the point
of optimal inter-sectoral resource allocation through the social
indifference curve approach. In this figure, the production
potential of the society at a given level of resources and
technology is brought into a relevant relationship with society’s
preferences for the public and private goods. At point E, where
production possibility curve AB is tangent to the social
indifference curve IC3, is the point of optimum inter-sectoral
resource allocation. Here, allocation of resources in an economy
provides OP output in the private sector and OM output in the
public sector. In other words, at point E, marginal rate of
transformation (MRT) in the production of private goods and
public goods is equal to the marginal rate of substitution (MRS)
Fig. 4.4
in the consumption of these goods. Therefore, E can be called

the condition of Pareto optimality which is satisfied.
It is, however, kept in view that actual inter-sectoral division
of resources may not take place at the point of optimal resource
allocation due to market imperfections. Therefore, actual inter-
sectoral allocation resource can be anywhere on the production
possibility curve or inside of it like G, K or L. These points are
the sub-optimal inter-sectoral division of resources in the
economy. It means that effective preferences for economic goods
are not being accurately focused by the market and government
institutions of allocation. There are also chances that even points
G and K where social imbalance exists, may be the situation of
full employment of resources. This can be possible as society is
enjoying total use of resources even at the lowest social
indifference curve.
So, points G and K represent the situation of full-resource
utilisation but not efficient resource utilisation. To conclude, it
is only at point E where optimal inter-sectoral resource allocation
is possible, otherwise there is either social imbalance or less
than optimum allocation of productive resources in the economy.
Now a word about the shape of the two curves is necessary.
The production possibility curve AB is concave to the origin
meaning thereby that the productive resources cannot be
substituted with equal efficiency between the goods produced

by the two sectors. The marginal rate of substitution, instead of
being constant, would be either increasing or diminishing. Two
reasons may be given for this concavity: (1) some economic
goods (e.g. national defence) can be produced more efficiently
(i.e. with less real input costs per unit of output) by one sector
(e.g. the public sector) of the economy than by the other, and
(2) when too many goods are produced by either sector,
increasing costs tend to appear because of the applicability of
the principles of diminishing returns and decreasing returns to
scale. As against this, the social indifference curves are convex
to the origin, meaning thereby that the private and public goods
do not have perfect substitutability in providing a given level of
satisfaction to the society. Again there are two reasons for the
convexity: (1) some economic goods (e.g. cotton textiles) are
provided best by the market and others (national defence) best
by the government, and (2) as government allocation approaches
100 per cent toward the upper end of the indifference curve, the
increasing costs of freedom, both economic and political, are
incurred, while toward the lower end of the curve when market
allocation approaches 100 per cent, the increasing costs of
anarchistic state devoid of basic law and order are incurred.
Therefore, some combination of private and public goods as
indicated by the social balance point would ultimately be
desirable for a society which is interested in optimal allocation
of the productive resources as also economic and political
freedom of its people.
Elasticity and Inter-sectoral Allocation
If social balance has any sense, the co-existence of both the
public and private sectors is a necessity. In that case, total
economic production in the society is the sum total of the private
sector and the public sector output.
By using the concept of elasticity, trends in inter-sectoral
resource allocation may be shown by relating changes in the
real per capita output of an allocating sector to changes in real
per capita income over a period of time. If, over a period of
time, the increase in the real per capita output of public goods
is higher than the increase in real per capita income, the growth
in public goods output is called elastic. Conversely, if the increase
in the real per capita production of public goods is less than
proportionate to the increase in real per capita income, the output
growth for public sector is inelastic. Hence, if the real per capita
output of public goods and the real per capita income grow by
the same proportion, the elasticity coefficient for public sector
output growth would be unitary. In this last case, the demand
for private sector would also be unitary because the sum total
of changes in the outputs of both sectors is equal to the total
change in output.
It follows from the above that if the growth in the real per
capita output of public goods is elastic, the growth in the real
per capita output of private goods would necessarily be inelastic.
And when the elasticity coefficient for the growth in the real per
capita production of public goods is inelastic, the elasticity
coefficient for private goods would necessarily be elastic.
The elasticity concept, therefore, brings out another
dimension of the economic issue of allocation that the public
and the private sectors compete for the scarce resources of the
economy. If the amount of resources remains constant or
unchanged, an absolute increase in the output of one sector will
result in absolute decrease in the output of the other sector.
The percentage of the total resource usage by the former sector
would increase and by the latter sector would relatively decline.
Of course, when resources expand in quantity and/or quality,
both sectors may have absolute increase in output, but the relative
proportions could either change or remain constant. If the relative
percentages of growth of the two sectors remain constant over
time, it would be a case of unitary elasticity coefficient.
The Controversy
As we have already seen above, the issue of social balance is
not a new one and it can be traced in writings of the classical
economics; it is true that the issue was not christened as such.
In recent years, the social balance controversy has been brought
in limelight by the writings of Hansen and Gailbraith. Other
writers joined it later. Hansen favours the use of public sector
for promoting the educational and cultural development of the

Americans.4 He feels that it is essential to raise the living standard
of the “submerged tenth”, the bottom ten per cent of America’s
population. According to him, in an advanced society, economic
policy must not be tied down to maximum production and full
employment instead, it should pay greater attention to efficient
resource allocation and “social priorities”. In such economies,
the primary aim of economic policy, instead of being maximum
production, should be to produce goods most needed by the
common people, and for this purpose, the suitable sector for the
allocation of these goods should be chosen. For example, Hansen
felt that the scope of the public sector in the allocation of
productive resources in the United States should be expanded in
order to correct social imbalance.
When Hansen wrote his book in 1957, he found that there
were 80 lakh families and individual households with annual
money incomes below $ 1,000 and an additional 65 lakh families
and individual households between $ 1,000 and $ 2,000 money
incomes in America. He also observed that a large number of
these people lived in economically underdeveloped or stagnated
communities or regions unable to provide sufficient educational
and other public services. This caused a vicious circle of poverty
which, according to Hasen, was for the public sector to break.
He attacked the allocation of only half as much funds to schools
including school buildings and other capital works as allocated
to only automobilies excluding roads. He was not satisfied with
quantitative goals alone and emphasizd that “the problem of
social priorities is hard upon us”.5
Galbraith also noticed an under allocation of productive
resources by the public sector and hence a social imbalance.6
The cause of this imbalance, according to him, was a dependence
effect caused by the forces of production which created consumer
wants through emulation and advertisement. Before the industrial
revolution, mankind felt only more urgent wants essential for
survival, namely food, clothing, shelter, and law and order
conditions, the first three provided by the private sector and the
last one by the government. As government was largely unstable
in those days, according to Galbraith, a bias was created against
the government and for the private sector. This imbalance in

favour of the private sector is widened by the modern methods
of advertisement. Thus, in the opinion of Galbraith, the consumer
is not able to make a rational and independent choice between
the private and the public goods due to the dependence effect.
Through advertisement and emulation the production process
is creating its own demand by generating wants of low urgency.
Galbraith, therefore, favoured an increase in the relatives size
of the public sector at all levels of government. America’s main
problem, to him was not one of maximizing aggregate output
but one of disaggregation, i.e. an improvement in resource
allocation by allocating the most needed economic goods.
Wallich by and large agrees with the views of Hansen and
Gailbraith that too many “wrong-wants” are being satisfied in
a modern economy. However, this resource misallocation does
not necessarily indicate the desirability of a higher allocation by
the public sector. It should not essentially be concluded,
according to him, that “the only alternative to foolish private
spending is public spending. Better private spending is just as
much of a possibility”. Rather than choosing between means,
i.e. between private and public resource allocation, the ends or
objectives of private sector allocation itself should be changed,
if the present market allocation itself is unsatisfactory. Wallich
is of the firm opinion that when either sector can provide for
wants with comparable efficiency, the private sector allocation
should be preferred because of greater freedom and higher
incentives which accompany private sector allocation. In other
words, according to Wallich, public sector allocation implies
extra “costs in the form of reduced freedom and lost incentives”.7
The Swedish economist Myrdal disagrees with Wallich and
asserts that a properly implemented government welfare state
enhances rather than restricts freedom.8 In his own words, “as
the material and social limitations upon the individual’s freedom
to act and move are broken down, and replaced by rules laid
down by legislation and collective agreements, they pass under
democratic control, and can be changed by a process where
nobody is without a voice”. When a welfare state, according to
him, attains maturity, an infrastructure of organised society with
its sub-units is established. Collective decisions are taken through

this infrastructure and the degree of direct legislation is reduced.
Thus, Myrdal favours a widening of the public sector as a part
of a welfare state.
Another European economist Hayek is particularly opposed
to the dependence effect concept of Galbraith. According to
Hayek, all wants except the innate ones for food, shelter,
clothing, etc. arise from emulation as we see others satisfying
them. He observes, “To say that a desire is not important because
it is not innate is to say that the whole cultural achievement of
man is not important.”9 To him, very few wants are absolute,
or indispensable for survival, or independent of social
environment. By applying Galbraith’s dependence effect to the
arts, e.g. music, literature, painting, Hayek proves the illogic of
his argument. Hayek asserts, “Surely an individual’s want for
literature is not original with himself in the sense that he would
experience it if literature were not produced. Does this mean
that the production of literature cannot be defended as satisfying
a want because it is only the production which provokes the
demand?” The urgency or utility of cultural wants is not zero
only because they are not spontaneous or innate wants. Actually,
the contention between the viewpoints of Galbraith and Hayek
requires that zero marginal utility should be distinguished from
low marginal utility. According to Galbraith, because of the
existing social imbalance, the public sector can allocate with
higher marginal utility than the private sector; private sector
need not have zero marginal utility.
The American economist Milton Friedman’s viewpoint on
social balance10 is almost similar to that of Henry C. Wallich.
Friedman believes in minimal government intervention. Economic
welfare may not necessarily be enhanced by more and more
resort to public sector allocation. Better and fuller utilization of
the market mechanism through private sector allocation may
enhance both economic welfare and freedom. Thus, Friedman
favours fuller and better private sector allocation.
Petiti holds a viewpoint somewhat similar to that of Mydral.
In a modern industrial society, according to him, only when the
government creates an orderly political atmosphere, economic

freedom would be possible. Petiti argues that “economic freedom
and economic order have a reciprocal relationship. We cannot
have one without the other, and each is as much the cause of
the other as it is its effect”.11
A clear distinction between economic and political freedom
is nevertheless essential in order to fully understand the issue of
social balance. For example, Wallich and Friedman have
emphasized the loss of freedom. Does it mean the loss of
economic freedom or of political freedom or of both, and if so,
in what proportions? Political freedom incorporates a
representative government, free speech, free practice of religion,
right of free association and assembly and the like. Economic
freedom includes the right to own property, the right to free use
of factors of production without undue restraint (e.g. land and
capital), and the right to free use of one’s labour factor. Clearly,
economic and political freedoms are not synonymous; nor do
they change in identical manner with greater or lesser public
sector resource allocation. For example, fascist Germany under
Hitler retained substantial economic freedom in the shape of
private ownership of factors, but the loss of political freedom
was tremendous. Under Russian socialism, on the other hand,
both economic and political freedoms have been substantially
slashed. Therefore, economic and political freedom do not change
proportionally, i.e. economic freedom can be reduced without
seriously impairing political freedom and vice versa.
Obviously, the controversy is a never-ending one. In a most
free society, the co-existence of both the public and the private
sectors has come to stay. The practical determination of an
exact social balance point is more or less impossible as already
observed earlier in this chapter. Even if it were determinable the
precise point of social balance cannot be decided on pure
economic considerations as political thinking is bound to colour
judgment in this regard. As value judgment, both economic and
non-economic, affects the issue of social balance, the viewpoints
cannot but differ, thus giving rise to a perpetual debate and
controversy.
PROBLEM OF REVEALING PREFERENCES AND

THEIR AGGREGATION
Individual preferences for goods and services differ, but there
is no problem of reconciliation of varying preferences in the
market sector of the economy because effective demands are
summed up by the market and production adjusts accordingly.
But in the case of public goods, automatic summation does not
take place because amounts to be produced are determined by a
single non-market decision. In case of identical preference
patterns, there is no difficulty. But the individual preferences
for public goods also differ while the quantity available to each
individual is the same as the principle of exclusion is not
applicable. Because of the indivisible nature of public goods,
amounts cannot be adjusted to each individual’s wants. To
resolve this conflict and to attain optimal societal allocation of
resources, the political process of voting is extremely important.
In other words, budget determination involves a political rather
than a market process. Individual preferences may now be known
and translated into budgetary decision through a political process
which involves the individual’s preferences as recorded by his
vote.
If the value judgment of the society prefers a political process
of the democratic type, the revelation of true preferences is
importantly dependent on the institutional set-up. The situation
differs in accordance with the voting rules applicable. There are
two aspects of the situation which indicate the importance of
voting: (1) the distribution of votes helps to determine the
effective social indifference curve which is tangent to the
production possibility curve, and (2) the voting techniques help
to reveal true preferences. In a modern democratic political set-
up, it is normally agreed that each person should be given one
vote, i.e. one person, one vote. The principle of uniform vote
distribution is widely accepted these days. But particular voting
rule must be chosen.
The Unanimity Rule
As an extreme, the unanimity or full consensus rule, could
be employed, i.e. only those public goods on which there is
complete agreement should be produced. This rule is closely

related to Pareto’s optimum whereby economic welfare increases
if one person gains without anyone else undergoing any loss.
Given rational behaviour, such a change should receive
unanimous applause and support. This rule avoids consideration
of external cost of change, e.g. injury to persons who are against
change. Moreover, this rule provides maximum protection to
the interests of the minority. Under this rule, to make any scheme
feasible, persons with divergent views will be required to reach
a compromise, possibly through vote trading. For example, I
may agree to your proposal in order to get your approval for
my proposal. This may be more easily and expeditiously done
by representative committees and small groups.
But for governmental schemes, the unanimity rule is generally
unacceptable and is never employed. First of all, the time and
effort required to obtain unanimity through compromise, vote
trading and bargaining would be disproportionately enormous
and hence intolerable and wasteful. Secondly, the unanimity
rule unduly empowers the small minority to block change,
resulting in inertia and inaction. In any society, there may exist
a few fanatics whose irrational behaviour may always block
any decisions. In the ultimate analysis, if strictly adhered to,
this rule amounts to dictatorship of the minority. Finally, the
rule would not work for distributional functions of the
government because these involve transfer of wealth and income
from the rich to the poor.
Simple Majority Rule
The most commonly used rule is that of simple majority.
Each individual has one vote, the ‘yeas’ and ‘nays’ are counted,
and the simple majority wins. In a modern democratic society,
this majority rule is normally accepted except in particular
circumstances such as a constitutional amendment. Fiscal (tax
and expenditure) decisions are generally made by simple majority
vote. If a simple majority of 51 per cent of the democratically
elected representatives of the people approve a project, it has to
be undertaken by the government according to this rule.
The merit of this rule is that it is workable, it does not

favour inertia, and it does not block the interests of the majority
to protect a minority. Rather it serves the interests of the largest
number in society insofar as more people are satisfied than
dissatisfied with any one fiscal decision. But the simple majority
rule is far from a perfect approximation of market decision-
making, because this rule cannot claim maximization of
economic welfare, since benefits received and losses incurred by
various individuals cannot be compared. Any such comparison
involves a value judgment. This value judgment is nevertheless
accepted in most societies today and considerable fiscal activity
does take place accordingly.
Qualified Majority Rule
The Swedish economist Knut Wicksell favoured an ‘equal
vote for all’ as an individualistic democratic ideal and the benefit
approach to allocative efficiency.12 But he doubted if true
preferences could be revealed by simple majority voting.
According to him, preferences could best be revealed through
qualified majority voting, which is also known as “relative
unanimity”. He argued that fiscal decisions should be accepted
only if approved by more than a simple majority of 51 per cent
of the democratically elected representatives. Though he did
not provide a specific qualified majority percentage for all times
and all circumstances, yet he preferred a percentage as close to
100 per cent as practicable. His ideal was complete unanimity,
but the impracticable nature of this rule and its resultant inactive
budgetary policy forced Wicksell to plead for qualified majority
voting. He argued that two-thirds, three-fourths, or seven-eights
majority percentage “approximates market decision-making
more closely and protects individualism to a greater extent than
does the simple 51 per cent majority.”13 For example, a qualified
majority voting (i.e. two-thirds) is required for constitutional
amendments in India and USA.
Wicksell also believed in a symmetrical approach to fiscal
decision-making in the sense that tax and expenditure decisions
should be made simultaneously. He reasoned that marginal
benefit should be related to marginal cost and then qualified
majority voting be applied to a particular decision in a manner

similar to cost-benefit analysis.
But the Wicksellian approach to budgetary decision-making
becomes difficult to approve because, like the unanimity rule, it
works against the will of the majority and unduly favours the
minority, besides resulting in an inactive fiscal system.
THE POLITICAL INTERACTION COSTS OF DEMOCRATIC

VOTING THEORY
More recent analysis by James M. Buchanan and Gordon
Tullock has added further insight concerning the economic issues
involved in the process of revealing individual economic
preferences through a democratic political system. Figure 4.5
demonstrates some of these issues. The expected political
interaction costs (discounted to present value) from collective
democratic decision-making are measured on the vertical axis,
while the percentage of the group required for the approval of a
collective fiscal decision is measured along the horizontal axis.
The political interaction costs are twofold in nature: (1) the
voter externality cost component, and (2) the decision-making
cost component.
A voter externality cost, refers to the cost incurred by a
voter who has voted against a fiscal choice, which nonetheless
has been approved by the required proportion of voters necessary
to carry the decision for approval. Such an individual must
abide by the collective decision even though his or her individual
preferences did not opt for its approval. Assume a group of 100
voters. If the proportion of voters required to approve a collective
action is only 1 per cent, then 1 of the 100 voters can oblige the
remaining 99 voters to abide by a political decision which they
do not approve. Quite obviously, the potential negative voter
externalities incurred by the remaining 99 voters, who oppose
the decision are considerable under this “dictatorship” sort of
rule. However, the potential voter externalities would continually
decline as the percentage required to approve a political decision
increase. Ultimately, at an absolute (complete) unanimity rule
of 100 per cent approval, voter externality costs would reach
zero, since no voter could be bound by the collective political
decision of other voters. In other words, a single voter would

retain the right to voter any proposed decision. The nature of
vote for externality costs is represented by curve VE in Fig. 4.5.
A decision-making cost, in political interaction terms, refers to
the bargaining cost required to reach a group political consensus
or agreement. Essentially, these are real resource costs in terms
of direct labour, material, and capital outlay, as well as
opportunity cost considerations such as the value of time spent
in bargaining. Decision-making costs may be expected to increase
as the proportion of the voting group required to approve a
decision becomes larger, i.e. under conditions requiring higher
percentage approval, more effort is normally required to gain
agreement. The highest cost would be expected at the point of
100 per cent approval (absolute unanimity) since the potential
for strategy would reach a peak at this point. This would be
true because a single voter would be capable of negating a choice
which conceivably every other voter would prefer. The curve
DM in Fig. 4.5 represents the nature of decision-making costs.
Fig. 4.5: Political Interaction Costs

Assuming a group of 100 voters, a 1 per cent approval rule

would incur little, if any, bargaining cost, since one voter (like
a dictator) could approve a policy without considering the other
voters. Meanwhile, approval by all 100 voters is likely to incur
substantial decision-making costs, as strategy, among voters
would become extensive.
Curve P1 in Fig. 4.5 reflects the peformance of the overall
political interaction costs. The curve is a summation of its two
components, the voter-externality cost curve (VE) and the
decision-making cost cure (DM). In this particular figure, the
character of the voter externality and decision-making of cost
functions, the most efficient proportion of the group required
for political approval is 70 per cent. That is, this proportion
yields the lowest political interaction cost per voter for a
particular fiscal decision.
REVEALING SOCIAL REFERENCES THROUGH MAJORITY

VOTING—ARROW’S IMPOSSIBILITY THEOREM
Kenneth Arrow has provided additional insight into the
problems involved in making societal decisions consistent with
individual preferences through group voting in a democratic
political process. Although Arrow’s observations pertain, in
general, to the problems encountered under any democratic
voting rule based on individualism, their most relevant
application is to the majority voting rule which is the mainstay
of democracies. He argues that the following conditions must
be met if a collective decision reached under majority voting
conditions is to accurately reveal the individual economic
preferences which constitute the effective social indifference curve
(the social welfare function):
(i) Social choices must be transitive (consistent). That is,
a unique social ordering must exist which will yield a
clear-cut winning alternative regardless of the ordering
sequence in which alternative choices are voted on.
(ii) The social welfare function must be non-perverse in
the sense that an alternative policy, which might
otherwise have been chosen by the society, must not be
rejected because any individual has changed the relative

ranking of that alternative.
(iii) The rankings of the choices in the social welfare
function between two alternatives must be independent
of the ranking by individuals of other alternatives which
are irrelevant to the choice between the two alternatives.
That is, the elimination of any one alternative must
not influence the ranking of the other alternatives in
the social welfare.
(iv) Voters must have free choices among all alternative
policies.
(v) Social choices must not be dictatorial. That is, they
must not be based solely on the preferences of one
individual, independent of the choices of other
individuals.
Table 4.1 and Fig. 4.6, show a situation in which majority
voting violates the set of conditions necessary for consumer
sovereignty to be maintained in collective democratic decision-
making. Condition 1, the transitivity condition, in particular, is
violated, leading to what is known as the impossibility theorem
or voting paradox. Assume that three voters (A, B, and C) are
selecting among three budgetary policies (X, Y, and Z). Policy
alternative X represents a decision to build three public libraries;
policy Y, a decision to have two libraries, and policy Z, a decision
to build one library. Since a majority of the voters (in this
example, two out of three) prefer policies X to Y, Y to Z, and
Z to X, the result is intransitive (inconsistent) in that there is no
winner. In this situation, the “sequence” in which the voting
occurs, would determine the final outcome an obviously illogical
result.
For example, if we first pair policy X versus policy Y, X
wins since two of the three voters prefer X to Y. If we then pair
policy X versus policy Z, Z wins since two of three voters prefer
Z to X. Thus, a pairing sequence beginning with X versus Y
results in Z as the ultimate winner. On the other hand, if we
first pair policy Y versus policy Z, Y is favoured by two of three
voters. Thus, a pairing sequence beginning with Y versus Z
results in X as the ultimate winner.
Table 4.1: Example of Majority Voting: Individual Preferences for
Alternative Budget Policies
(4.1A) Result: Intransitive
Policy Alternatives
Voter Preferences 1 Preferences 2 Preferences 3
A X Y Z
B Y Z X
C Z X Y
(4.1B) Result: Transitive
Policy Alternatives
Voter Preferences 1 Preferences 2 Preferences 3
A X Y Z
B Y Z X
C Z Y X
Finally, an initial pairing of X versus Z winning over X, but
the subsequent pairing of Z versus Y finds Y winning over Z—
each winning vote representing a two out of three voters
preference. Thus, a pairing sequence beginning with X versus Z
results in Y as the ultimate winner. To summarize, the outcome
is arbitrary since either Z, X, or Y will win depending on the
ordering of the voting sequence.
A close inspection of the above paradox reveals that
intransitivity occurs because one voter C prefers the two extreme
policies (Z for one library and X for three libraries) over the
median or intermediate alternative Y. Yet this is an unlikely
position for a voter to take, i.e. to prefer three libraries as a
second choice instead of two libraries—which is closer to the
voter’s top-ranked choice of one library. When a graph is plotted,
the result is the twin-peaked preference function for voter C
that is demonstrated in Fig. 4.6a.
Instead, if voter C behaves in a more rational manner and
prefers two libraries as a second choice, the intransitivity problem
disappears and the solution becomes determinate. This transitive
outcome is depicted in Table 4.2B and Fig. 4.6b, with latter
showing a single-peaked preference function for voter C. Now,
if the first pairing is X versus Y, Y defeats X and then also
defeats Z. Or, if we begin with a pairing of Y versus Z, Y wins
over Z and also defeats X. Finally, a pairing of X versus Z finds

Z the winner, but, of course, Y wins over Z as observed in the
previous pairing. Thus, Y is the clear-cut winner despite the
ordering of the voting sequence.
Fig. 4.6: Examples of Majority Voting—Individual Perference for

Alternative Budget Policies
It may be observed further that the three policy alternatives
in the above example consist of three different quantities of the
same economic good (number of public libraries). However, the
same results would tend to hold for overall budget considerations
such as budgetary size. For example, if policy X represents a
large-sized budget, rational voting behaviour would result in
the median policy, Y, as the winner. However, this example
would hold to a lesser degree on heterogeneous policy alternatives
such as would be the case if policy X represents one public
library, policy Y represents one fire station, and policy Z
represents one public school—all of equal cost to the tax-payer.
Nevertheless, even here the median policy could be the winner
as the result of voting coalitions and platforms.
Although Arrow’s requirements for rational collective
decision-making through majority voting are rigorous, his
analysis nonetheless indicates some basic problems prevalent in
democratic political decision-making. However, one condition

seems unduly rigorous, condition 3, which says that the
elimination of any one alternative policy shall not influence the
ranking of the other alternative policies in the social welfare
function. There can be no interdependencies among alternative
policies. Or, stated differently, the relative intensities of
preference among voters for different policies cannot be a
relevant consideration. Thus, in the above example, the intensities
of preferences for three, two, or one library could not affect the
outcome.
Or, consider another example: One half of the community
prefers improved highways and streets to solve traffic congestions
in an urban area, while the other half prefers a government-
subsidized mass transportation system to meet the problem.
Assume the cost to be equal for both traffic congestion solutions.
If those who prefer the highway solution, rank traffic congestion
as a lower priority program among various alternatives than
those who prefer the mass transportation system, then the
particular traffic congestion solution selected (provided money
is to be spent for this purpose) should be the mass transportation
system; those who prefer it exhibit higher relative intensities of
preference. Condition 3, however, essentially stipulates that a
consideration of preference intensity is irrelevant. Arrow’s
approach thus tends to understate the intensity of desires among
alternative policy choices. It is difficult for a system of social
choice which ignores these basic preference considerations to
interpret accurately individual demands expressed in the political
process.
In summary, the Arrow Impossibility Theorem seems too
pessimistic concerning the efficiency of the democratic political
process, though it does point out some weaknesses. This
pessimism stems mainly from the two points described, namely
(i) the irrational voter depicted in the twin peaked preference
function (Table 4.1A) and (Fig. 4.6a) the assumption which
precludes the ability of the democratic process to reveal voters’
preference intensities among policy alternatives.
Arrow’s Impossibility Theorem

The work of Kenneth Arrow has brought out the problems
involved in making social decisions consistent with individual
preferences when a simple or qualified majority voting technique
is used.14 According to Arrow, certain conditions must be met if
collective decisions are to be rational in revealing the true
individual preferences so that the effective social welfare function
is known.
One essential condition is that social choices must be
consistent or transitive. A unique social ordering must exist
whatever may be the manner in which individuals order their
choices. For example, if there are three individuals A, B and C
in a community and there are three alternative policies X, Y
and Z (large, medium and small budgets) for which they have
to express their preferences. Suppose A prefers X to Y to Z; B
prefers Y to Z to X; and C prefers Z to X to Y.
i.e. A’s preference pattern: X > Y > Z
B’s preference pattern: Y > Z > X
C’s preference pattern: Z > X > Y
In this case, a majority, i.e. two out of three individuals
prefer policy X to Y, Y to Z and Z to X.
The result is, therefore, inconsistent or intransitive. Majority
voting violates Arrow’s condition necessary for consumer
sovereignty to be maintained in social decision-making. Arrow,
therefore, holds that it is often impossible to make social decisions
consistent with individual preferences in case of more than two
alternatives and majority voting technique.
Arrow’s second condition is that the social welfare function
must be non-perverse in the sense that an alternative which
would have been selected by the society should not be rejected
because some individuals have taken strategies and have changed
their relative rankings of other alternatives. For example, if in
the above example, C individual prefers Z to Y to X, and if the
alternatives are voted in pairs, then Y will be the choice regardless
of the order of presentation, because two individuals A and B
prefer Y to Z, which is the majority decisions.
The third Arrow condition is that the society, in selecting

between two choices, must consider all other choices as
irrelevant. In other words, the rankings of the choices in the
social welfare function between two alternatives must not be
dependent on the ranking by individuals of other alternatives
which are irrelevant to the choice between the two alternatives.
For example, individual C prefers X to Y to Z, then X will
receive a clear majority no matter how the voting is conducted.
Here one alternative clearly receives a majority when each policy
is voted on separately.
Another Arrow condition is that social choices must not be
dictatorial, i.e. must not be imposed from within or from outside
the community by any one or a few individuals. The individuals
in the society should vote freely among all alternatives. Like
other conditions laid down by Arrow, this is also a rigorous
one. Fulfilment of all these conditions being quite difficult,
analysis of the problems involved in making community decisions
consistent with individual preferences, using a majority voting
technique, is called as Impossibility Theorem. According to
Coleman,15 the Arrow problem can vanish if voters are allowed
to express their intensity of preferences.
Plurality Voting Rule or Aggregate Voting by Ranking
Though the intensity of relative preferences of various
persons for governmental services cannot be compared, yet the
variations in the intensity of preferences are significant. One of
the rules which allows for such variations is plurality voting.
Under this rule, each voter ranks all relevant alternative choices
according to his preferences. The rankings assigned to each
alternative by each voter in the society are aggregated. The
alternative with highest total score based on the rankings would
be selected in preference to others. This presumes that: (1) each
vote gains an equal increment of utility by moving up one rank
between any two ranks, and (2) the utility increments between
the voters are equal. This rule would improve the revelation of
true social preferences by offsetting the rigorous requirement of
the third Arrow’s condition that in selecting between two choices,
all other choices are irrelevant.
If, as before, the three voters A, B and C constitute the

community and they have to select between choices X, Y and Z.
Suppose voter A ranks his preferences as X, Y and Z in that
order, so that X scores three points, Y two points, and Z gains
one point. Similarly, voter B ranks his preferences as Y, X and
Z, so that Y scores three points, X two points, and Z again one
point. Likewise, voter C ranks the alternatives as Z, X and Y,
so that Z receives three points, X two points, and Y one point.
Aggregating the results, alternative X gets seven points, Y gets
six points and Z gets five points. Thus, alternative X receives
the highest total points and should, therefore, be selected. No
doubt, this is an improvement over the earlier majority technique,
but this technique also does not preclude the intransitive or
inconsistent results as observed in Arrow’s condition number
one.
POINT VOTING RULE

Another method of detecting social preferences is the
adoption of point voting rule. As against the emphasis on
rankings in plurality voting rule, this rule emphasises the intensity
of preferences. Under this rule, each voter is allowed a certain
number of total points that he may allocate in any manner he
likes among the various alternatives, for example, all to any of
the alternatives, or he may distribute the points among various
alternatives. Suppose voters A, B and C are each allowed ten
points, and they are to express their relative intensities of desire
among three alternatives X, Y and Z. Also suppose that voter A
allots eight points to alternative X, and one point each to
alternatives Y and Z; voter B gives five points to alternative Y,
four points to alternative Z and one point to alternative X; and
voter C awards four points each to alternatives X and Y, and
two points to alternative Z. Aggregating the results, alternative
X scores thirteen points, alternative Y ten points and alternative
Z seven points. Alternative X is thus selected. Even under this
rule, intransitivity, in terms of Arrow’s first rationality condition,
could result.
To compare the various voting rules, if each voter records
his or her true preferences regardless of the attitude of other
voters, it is obvious that point voting is the best approach,

followed by plurality and majority voting in that order. Under
majority rule, voters can only express their ranking between
pairs of policies; they cannot express their intensities of
preferences, nor can they relate policies appearing in different
pairs. Under the plurality rule, they can relate all policies to one
another, but this relationship can be expressed in terms of ranking
alone. But the difference of the intensity of desire may be very
large between two policies while it may be quite small between
the other two. It is, therefore, only under point voting that the
intensity of preferences is directly allowed. Hence, consumer
sovereignty is approximated more closely in point voting than
in majority voting. Why, then, should not the point voting rule
be increasingly used in preferences?
In fact, in the real world, when political strategies are used,
the outcome comes to depend on political link skills. Thus, in
the absence of strategy, point voting is the best method to record
the intensity of desires. But point voting allows many
opportunities for the use of strategy and so the usefulness of
this method is reduced. To put in general terms, the better the
rule in the absence of strategy (i.e. the more sensitive the voting
rule to intensities of preference), the greater tends to be the
scope which it leaves for the use of strategy.16 When strategy is
apprehended, a crude method which is less open to manipulation
such as majority voting, may be the best voting technique for
revealing true community preferences.
Once, however, the true preferences of the individuals for
social goods are known, then the determination of an optimum
budget in the allocation branch is nothing basically different
from the determination of an optimum amount of production
by a private producer under conditions of perfect competition.
The government should provide social goods up to that quantity
where the individuals’ aggregate demand for social goods would
be equal to the supply. The tax liability of individuals in the
allocation branch of the budget would also be simultaneously
determined, the greater the preference of an individual for social
goods, the greater being his tax liability. The fulfilment of these
requirements, it should however be remembered, presupposes
that the consumers’ true preferences for social goods will be

known somehow or other.
Theory of Representative Democracy
Individual voters rarely participate directly in the decision-
making process. No doubt, the degree of direct participation
differs among countries, and it is only at the local level that
fiscal decisions may be made in the referendum manner.
Normally, the decision-making is delegated to the legislative
representatives such as members of parliaments or of legislative
assemblies. These representatives seek election as nominees of
political parties. This naturally affects the decision-making
process.
An explanation of particular interest to the economist draws
an analogy between the fir’s competition for consumers in the
market and the politician’s competition for voters in the political
arena. Just as economic competition, under certain assumptions,
guides producers to supply in line with preferences of consumer,
so does political competition under certain assumptions guide
representatives to act in line with the interests of the voters.17
This model was sketched by Schumpeter 18 and has been
developed by Anthony Downs.19 As in economics, it is assumed
that political action is rational and both politicians and voters
act in their self-interest. Politicians try to maximize votes in
order to come to and stay in power. The voter tries to maximize
the net benefits accruing to him from the fiscal actions, i.e. the
excess of benefits from government expenditures over his tax
costs. Voters vote for those politicians who best represent their
interest, and politicians put forward programmes and support
legislation best suited to the interests of their voters. Politicians
who come closest to so doing become successful.
Not only it is necessary for politicians to put forward
attractive programmes and policies in order to win, but also it
is essential to get the same implemented efficiently, having come
to power. Moreover, politicians operate in a world of uncertainty
where voter preferences are not known. Uncertainty becomes
still greater because voter preferences may go on changing. Also,
the politician is called upon not only to respond to voter
preferences but also to generate new preferences which he thinks

to be desirable. Thus, the political reward goes to the most
skilful politicians just as the financial reward goes to the most
skilful entrepreneur. For the same reasons, competing parties
arise and governments may change in successive elections,
because competition for votes does not always lead to a single
position.
As the intensity of voters’ preferences continues to change,
a politician, in order to win, must keep abreast of such changes.
This ability at the political level may be compared with the
capability of a successful entrepreneur for maximizing profits in
the economic field. For the same reason, an alert politician has
to resort to logrolling in the sense of vote trading, which is a
constructive factor in the decision-making process. The political
parties cannot confine themselves to fiscal issues alone and they
have to combine the fiscal with non-fiscal issues, which increases
the complexity of the problem of decision-making.
When final decisions are delegated to relatively small number
of representatives, the final decisions are made in the small-
number setting where negotiations can occur. But this does not
obviate the consideration of the large-number case where a
political process is needed, because the preferences of the large
number of voters are important in the process by which the
representatives are elected. The bargaining process of the small-
number case applies at the level of the legislature, while the
preferences of the large number of constituents are significant
for each legislator or representative.
Just as in the market case, optimal results presume (1) a
proper distribution of income, (2) the presence of competition,
and (3) the absence of externalities, so also for the political
process. Even though the principle of equal voting power is
accepted, the questions of voting age, literacy requirements, and
the availability of registration and voting facilities may affect
people’s ability to exercise their voting rights. The assumption
of a competitive political system, consisting of many independent
politicians struggling for voters’ favour, is more or less unrealistic,
because politicians operate within the framework of their
respective parties, are subject to party discipline, and may,
therefore, be unable to reflect the preferences of their

constituencies. Moreover, because political campaigning is costly
and a politician has to obtain financial support, in so doing he
may accept constraints on particular issues. The voters, therefore,
may not be able to vote for representatives reflecting their
position. Finally, political competition is not always a rational
process because of lack of information about the cost of
alternative programmes and about its incidence on individual
voters.
The perfection of the political process is thus a matter of
degrees. The more open and competitive the political process
and the more homogeneous the preference patterns of voters,
the better it will work. In the alternative, the system may collapse
or be reduced to a dictatorship, if the political process is not
open and competitive.
A word may here be added about the role of bureaucracy—
a term not being used in any derogatory sense which has to
analyse and present the implications of alternative policies and
then administer policies, once they have been decided upon.
The voters can at best influence only the general nature of an
activity, e.g. victory in a war, while the bureaucracy determines
the details, i.e. techniques used for accomplishing this goal. On
the one hand, the bureaucrats may be motivated by a desire to
maintain position and gain promotion—some performing their
duties with as little change as possible and others emphasizing
innovation and change to demonstrate their capacities—and,
on the other, they may act responsibly in the interests of society.
The legislators must, therefore, exercise independent judgment
in decision-making, keeping in view the costs involved and
benefits expected in the pursuit of any scheme.
In the ultimate analysis, voting is not a perfect method of
revealing true individual and community preferences, i.e. the
true social welfare function. Future hope thus lies in: First, in
interdisciplinary research which may improve the means of
revealing a social welfare function more consistent with
individual preferences and less dependent on ethical judgments.
Secondly, a new line of research is opening up in attempts to
apply quantitative aspects of expenditure or tax structure to
measure the role of political variables such as voting behaviour.

However, this empirical approach to the study of fiscal behaviour
is still in its early stages.
COMPENSATION PRINCIPLE
As already seen, the Pareto optimum norm holds that social
welfare will be improved if one person gains from an economic
reorganization while others remain unaffected. This norm merely
states the economic problem of scarcity. In order to improve on
this principle and to reduce value judgments, Hicks, Kaldor and
Scitovsky propounded the compensation principle. According
to this principle, the welfare of society increases if those who
gain from a resource reallocation evaluate their gains at a higher
monetary figure than those who lose evaluate their losses, still a
net gain for society will be experienced and the social welfare
increases, if gainers compensate the losers for their losses. Actual
compensation may not be undertaken in practice. It would suffice
if potential compensation can more than make good the losses.
This Hicks-Kaldor version of the compensation principle is
considered to the inconsistent by Scitovsky who says that a
given resource reallocation may result in a higher gain for the
gainers than the loss to the losers, but a reversal of process may
provide a higher gain to the previous loser than to the previous
gainers. Scitovsky is, therefore, not satisfied with the attainment
of a discrete best position, but asserts that the compensation
principle should satisfy the double criterion of an improvement
in situation as a result of both the initial resource reorganization
and its reverse reallocation.
In spite of this refinement of the compensation principle, it
still possesses both theoretical and practical shortcomings. It is
inconsistent because monetary values are incapable of measuring
exactly the interpersonal differences in utility. Inequalities of
income and wealth distribution render monetary values to be
inadequate for measuring true utility differences. For example,
a poor consumer may experience much more disutility from a
loss of ` 100 than a rich consumer. In practice, no market
mechanism is available for evaluating gains and losses. In case
the true preferences are not revealed, a political process becomes
a must for making ethical judgments regarding the amounts of

compensations payments. But if true preferences are revealed,
the compensation principle becomes applicable and solves the
problem.
Interdisciplinary Approach to Social Welfare Function
Jerome Rothenberg points out that a concept of social choice
stressing the high degree of culturally implemented “Value
Consensus” existing in any society is being developed by
interdisciplinary approach and research by social psychologists,
anthropologists, sociologists, political scientists, etc. Rothenberg
argues that the interacting and interdisciplinary characteristics
of group behaviour in a society may determine a social
welfare function in a somewhat satisfactory manner. The value
consensus tries to integrate the several institutional networks in
a society. Thus, values are not externally imposed on a system
of social institutions, but “values and institutions are mutually
engendering, mutually reinforcing, mutually sustaining”.
Rothenberg suggests that welfare economics should be
interrelated with intellectual findings of cultural anthropology,
psychoanalysis, sociological theory, individual and group field
theory, political theory and social psychological theory in order
to be able to reveal the social welfare function in a better way.
Thus, interdisciplinary research may help to better reveal the
social welfare function which is consistent with individual
preferences.
THEORY OF PUBLIC POLICY

Public policy is an important mechanism in the hands of the
government for moving a social system from the past to the
future. It help us to cope with the problems expected to be
arisen in the future. The rise in the expectations of the people
has compelled the government to adopt policies for alleviating
poverty and improving the quality of life of all sections of the
society. Public policy deals with the description and explanation
of the causes and consequences of government activity. The
important parts of public policy are: policy making, its
implementation and evaluation.
The concept of ‘Public Policy’ is an important part of Public

Economics and is more frequently used term. We often hear the
terms like fiscal policy, monetary policy, new economic policy,
industrial policy, agricultural policy, new education policy and
so on. The concept of public policy presupposes that there is a
domain of life which is not private but public-common.*
Insofar as the concept of ‘policy’ is concerned, it may take
the form of:
(i) Declaration of goals or outcomes.
(ii) Declaration of course of action or policy approach to
achieve goals.
(iii) Evaluation of policy approach so as to suggest changes
to achieve the desired outcomes.
Therefore, we may define the ‘policy’ as a “purposive course
of action taken or adopted by the government to achieve certain
gorals or objectives”.
Generally, a public policy covers a major portion of its
activities which are consistent with the development policy such
as social security, equality, poverty alleviation, etc. Public policy
may be narrow covering a specific activity such as poverty
alleviation or may be wide in scope such as empowering women
covering many activities like their education, employment,
devolution of power, etc. In a federal set-up each layer of the
government—central, state or local—may have its own policies.
Public policies in modern socio-political systems are
purposive or goal-specifics. In the domain of Public Economics,
public policy is specifically concerned with the objectives of
efficient allocation of resources, achieving economic stabilization
and equitable income distribution.
Public policy can be either positive or negative in form. In
its positive form, it may involve some sort of overt governmental
action to deal with a particular problem. For example, in the
event of rising food prices public distribution system may be
activated to rein in the rising price level. On the other hand, in
its negative form, it involves a decision by public servants not
* The word ‘public’ has already been discussed in detail in Chapter 1.

to take action on some matter until and unless the governmental

permission is sought. Public policy has a legally coercive quality
that citizens accept as legitimate, e.g. taxes, fees and other
administration charges must be paid unless one wants to run
the risk of fines and other penalties. This legally coercive quality
of public policies makes governmental organization distinct from
the private organizations. Further, the nature of public policy as
a purposive course of action can be better understood in the
context of objectives which public policy tend to achieve. Public
policies involve a deliberate choice of actions designed to achieve
those goals.
Scope of Public Policy
The sheer size of the public sector has grown manifold.
Today the governments’ role is not only to keep peace (as
stipulated by classical economists), and maintaining economic
stability, its has also to ensure maximum social welfare.*
In many developing countries, like India, there is a great
pressure on the government to accelerate the process of economic
development, make use of latest and relevant technological
innovations, adopt and facilitate necessary institutional and other
changes to ensure all inclusive growth. In democratic countries
added tasks for the governments is to ensure fair and free election.
Then in order to promote an efficient and honest administration,
proper policy framework has to be designed.
In the modern time of globalization, public policy now takes
place both in the context of national and world political systems.
Poverty alleviation, population growth, environment, trade, etc.
have become the global issues. In developing democratic
countries, policy agendas are now driven by global forces. The
drive for privatization, liberalization and globalization,
commonly known as New Economic Policy, is an important
recent example. These trends and developments have, therefore,
enhanced both the size and scope of public policy. In the domain
of Public Economics, public policy is specifically concerned
with:
*For details on “Role of the Government” see Chapter 2.

(i) Efficient allocation of resource in order to maximise

social welfare.
(ii) Economic stabilization.
(iii) Equitable distribution of income and wealth.
Planning and Public Policy
Policy-making must be distinguished from planning. Broadly
speaking, a plan is a programme of action for attaining certain
goals or objectives. In this sense, a plan is a policy statement
and planning implies policy-making. Often the policies are not
explicitly mentioned in the plan documents. Policies may be
stated only in general or vague terms. Generally, national
development plan contains specifications of the targets and the
resource allocation required to achieve those targets. However,
it is rightly pointed out that a plan needs a proper policy
framework to move towards the chosen path.
Targets must be drawn within the framework of policies.
Only then the allocation of resources or investments made can
achieve the set targets. Successful policies make for successful
plans and administration.
ALTERNATIVE MEASURES OF RESOURCE MOBILISATION

The modern governments mobilize resources from various
sources to perform different activities to achieve the wider
objectives of a welfare state. It is not so easy to give a complete
list of all the sources of public revenue, some of which would
include taxes, fees, fines, income from currency and sale of
public goods, market borrowings, income from the sale of public
assets, etc. The income of the government from all its sources is
called public income in a broad and a narrow sense.
Following Dr. Dalton, public income in its broad sense may
be called ‘public receipts’, while in a narrow sense it may be
called ‘public revenue’. Whereas public receipts would include
income from all sources, public revenue does not include public
borrowings, income created by printing of currency and income
from the sale of public assets.
Sources of Public Revenue
(A) Taxes
This is the most important source of revenue of a modern
state. The importance of taxes can be well understood in the
words of Ursula Hicks: “Tax bankruptcy was an important
contributing factor to fall of Roman Empire. Unjust and
inefficient taxes set the French Revolution aflame. An important
part of the explanation of Germany’s failure in the war of 1914-
1918 was her antiquated tax structure…inefficient taxes helped
Britain to lose the American colonies.” In India also the Dandi
March for the abolition of salt tax changed the entire scenario
of freedom struggle.
There are many definitions of tax. In the words of
Seligman, a tax is “compulsory contribution from a person
to the government to defray the expenses incurred in the
common interest of all, without reference to special benefits
conferred”. Similarly, in the words of Bastable, tax is “a
compulsory contribution of the wealth of a person or body of
persons for the service of public powers”. Indian Taxation
Enquiry Committee 1924-25 defines: “Taxes are compulsory
contribution made by member of a community to the governing
body of the same towards the common expenditure without
any guarantee of a definite measured service in return.” All
these definitions bring out the true nature of a tax which can be
analysed as under:
(i) A tax is a compulsory levy imposed by a public
authority for reasons of residence or property and the
person on whom the tax is levied must pay it. However,
a tax on commodity may be avoided by avoiding the
consumption of that commodity. For instance, the state
can force an individual to pay the tax on liquor only so
long as he consumes it. But if he gives up its use, he
cannot be forced to pay this tax. Thus, tax is just like
any other payment which must be made to the
government.
(ii) Another characteristic of a tax is that it imposes a
personal obligation on the taxpayer to pay the tax if
he is liable to pay it and in no case he should try to

evade it. For example, the sources of income of an
individual may be many and the public authorities may
not be knowing all these sources. However, it is the
duty of the individual to take into account his entire
income while paying the tax on income.
(iii) The proceeds from the taxes are spent for the general
purposes of the state in the common interest and not
to confer benefits on an individual or a group of
individuals. For instance, the land tax paid by the
agriculturists may not be spent by the state for their
benefit alone but for the benefit of the entire country.
(iv) The taxpayer cannot claim any direct benefit for the
tax he pays. In the words of Taussing, “The essence
of a tax, as distinguished from other charges by
government, is the absence of any direct quid pro quo
between the tax-payer and the public authority.” The
word direct is significant here. The taxpayers do get
many benefits from the public authorities but no
taxpayer can claim direct benefit as a matter of right
on the ground that he is paying a tax. In other words,
there is no relationship between what you pay and
what you get. While taxes are levied on different
principles, benefits from public expenditure are
distributed on different principles.
(v) A tax may be imposed on income, property or
commodities but it is actually paid by persons and not
by things.
(vi) It is leviable by the government only.
Thus, we can redefined a tax as a “contribution which the
state raises from the citizens for meeting partly or wholly its
revenue requirements and which the government is under no
obligation to return to the person who pays it, except
through public expenditure which confers benefits which
are not necessarily related to the burden imposed by this
contribution”.
Implications of Taxes. Taxes constitute a major source of

revenue for the government nearly 75-80 per cent of the
government revenue comes from taxes and depending upon the
stage of economic development one may find different mixes of
direct and indirect taxes in different countries. Direct taxes,
being progressive, are helpful for reducing inequalities in the
distribution of income. But their effects on ability and incentive
to work, save and invest may be harmful. Indirect taxes, on the
other hand, being concealed in the prices of the commodities,
would not adversely affect the ability and willingness to work,
save and invest. But if these are imposed on inputs, then they
would add to inflation. Being regressive indirect taxes also
promote inequalities in the distribution of income. There is a
general tendency of increasing the ratio of direct taxes in the
world. In order to curtail the adverse effects of direct taxes, the
rate structure should be moderate, simple and stable, though
their scope/base may be widened.
(B) Prices or Commercial Revenue/Surpluses from PSUs
The prices are also paid for specific services provided by
the state and public enterprises. Such income may be called
commercial revenue which has much resemblance with private
commercial revenue. In this category of revenue are included
postal charges, electricity charges, charges for railway traveling,
etc. The modern states are welfare states and they aim at
preventing concentration of wealth in a few hands and secure
equitable distribution of income and wealth and for that they
own and operate many undertakings of economic and
commercial nature and the surplus from them forms a source of
state revenue.
The difference between tax and price is that unlike taxes,
prices are charged for a specific benefit an individual gets from
a service. However, if the public authorities have a monopoly
and charge a price in excess of the competitive one, then the
excess price being charged is equivalent to tax. Similarly, if the
public undertakings have a high cost of production on grounds
of inefficiency, the price being paid by the consumers contains
an element of tax. But in such situations, it is not easy to find
out the extent of taxation concealed in the price.
Like private sector, the government also earn from public

enterprises/undertakings in the form of prices. Postage receipts/
railway receipts and income from other public sector
undertakings like steel industry, coal mines, gas and petroleum
products, etc., constitute different types of commercial revenue.
However, it should be emphasized that unlike private enterprise,
the public sector enterprises are established to meet certain social
and economic goals. They are usually not operated on
commercial lines, i.e. in order to maximize profit their break-
even point is not where marginal cost is equal to marginal
revenue. Public enterprises may sell their products at losses if it
is felt that their increasing consumption would promote social
welfare, e.g. availability of economic and social infrastructure.*
However, if it is felt that their consumption entails a huge social
cost, then the government may charge considerably more than
the commercial cost, e.g. selling of forest products, coal, etc.
Thus, there is no fix economic principle for determining the
prices of public goods. Sometimes, public sector undertaking
might be used to keep the prices of essential commodities at
reasonable stable level. And depending upon the type of income
distribution government wants to promote, there may be different
set of prices for persons with different income groups.
(C) Administrative Revenue: Fees, Fines, Etc.
In the course of running the administration the government
may receive different types of fees, fines, forfeitures, etc.
Sometimes government may impose special levy and special
assessment in order to promote the administrative services. It
may be noted, however, that while paying taxes, the taxpayer
may or may not receive any thing in return, i.e., there is not
direct relationship between what the taxpayer pays to the
government and what he gets from the government by way of
benefits from public expenditure. While in case of commercial
revenue there is a direct relationship between what one pays to
and what one gets in the form of good and services from the
government. In case of administrative revenue, one normally
* For detail analysis on “Pricing of Public Services and Return on
Investment” see Appendix I.
receives some privilege from the government to perform certain

function/activities, e.g. licensing fees. Sometimes one may
partially pay to the government in lieu of performing certain
functions or administrating certain services for their benefits.
User charges from an important source of administrating revenue
of the government.
Fees and Fines. A fee is a compulsory payment in return for
a service rendered by the state. In the words of Plehn, “A fee
may be defined as a compulsory contribution of wealth made
by a person, natural or corporate, under the authority of public
power to defray a part or all of the expenses involved in some
action of the government which, while creating a common
benefit, also confers a special benefit, or one that is arbitrarily
so regarded.” Thus, a fee is payment charged by the public
authorities to defray the cost of administrative services rendered
primarily in the public interest, but providing special benefits to
the individuals.
The fees are generally charged for issuing licences, permits,
passports, etc., which confer a special privilege on the fee-payers.
Generally, the fee charged is less than the cost of service rendered
as public purpose is kept in view in the service performed. The
example of educational fees can be cited in this regard. The
following points of difference between the fee and the tax may
be noted:
(i) A fee is payment for a special service performed by a
public authority but a tax is a payment for collectively
provided services.
(ii) The payment of tax is compulsory in the sense that
otherwise you will be penalised and may be put behind
the bars, but that of fee is optional. But some element
of compulsion is there in the payment of fee also because
otherwise you will not avail the service or the privilege.
(iii) Unlike the tax, there is some relationship between what
you pay and what you get in the case of a fee.
It may be noted that if the fee charged is more than the cost
of service, it contains an element of tax to that extent but if the
fee is less than the cost of service, the special benefit becomes a
common benefit.
Like prices, fees are paid for a good or service supplied to
the individual by the public authorities. The difference between
the two lies in the fact that public purpose is more prominent in
fees as for example is the case with educational fees but prices
are a payment for a service of business character. In case of
payment of prices we get something concrete in return, in case
of payment of fee we get some privilege only. Prices are always
voluntary payments whereas fees may have an element of
compulsion, though both are made for special services.
Fines also serve as a source of income of the state. They are
imposed on those who break laws in one form or another. Like
taxes the payment of fines is also compulsory but they are
different from taxes as the underlying idea of fines is to prevent
the occurrence of crimes and not to get revenue for the state.
Hence, fines are not taxes.
Special Assessment
Special assessment refers to the levy imposed upon the people
of a particular locality or region for the improvements to their
property or a special service provided to them by the public
authority. For example, if a municipality constructs a new street
in a new area, the value of the property in the neighbourhood
will appreciate in value and the municipality will secure a part
of this unearned income in the value of property by means of
special assessment. Similarly, as a result of the provision of
irrigation facilities, the productivity of the irrigated land increases
and its value also goes up. There is ample justification for the
imposition of special assessment on the beneficiaries as the
benefits that accrue to the property owners are not due to their
personal efforts. They in a way get an ‘unearned increment’.
In the words of Prof. Seligman, special assessment is “a
compulsory contribution, levied in proportion to the special
benefit derived to defray the cost of a specific improvement to
property undertaken in the public interest”. According to him,
special assessment has the following characteristics:
(i) There is an element of special purpose.

(ii) They are imposed for the special local improvements
made by the public authorities.
(iii) The special benefits made available by public activity
are measurable.
(iv) Special assessment is proportional to the benefit
received. It may not be progressive.
Like a tax, a special assessment, sometimes called
development charges, is a compulsory payment but it differs
from a tax in that there is direct quid pro quo in case of special
assessment. The purpose of levying special assessment is mostly
to finance capital development schemes or to meet the running
expenses of the public development authorities or both. The
basis of levying special assessment is benefit whereas the basis
of assessment of a tax are many such as income, expenditure,
property, etc. Besides, the range of a tax is wide but special
assessment is imposed for a specific improvement.
A special assessment though resembles price but it differs
from it in that where price is optional but special assessment is
compulsory.
There are certain other sources of public revenue such as
the profits from currency and coinage. The actual cost of creating
currency and mintage is much less than its face value and thus
the government makes a profit out of it. Similarly, the
government can directly add to its income by deficit financing
which should be rarely used except under exceptional
circumstances as it is full of dangerous inflationary potentialities.
Besides these, there are other minor sources of revenue of
the state such as escheat, forfeitures, tributes and indemnities,
gifts and grants, etc.
NOTES
1. G.K. Galbraith, The Affluent Society, 2nd edn., Houghton Mifflin,
Boston, 1968.
2. John F. Due, Government Finance, Economics of the Public Sector,
4th edn., Richard D. Irvin, USA, 1968.
3. A.C. Pigou, Economics of Welfare, 4th edn., MacMillan and

Company Ltd., London, 1952.
4. A.H. Hanson, The American Economy, 1957.
5. Ibid.
6. Galbraith, op. cit.
7. H.C. Wallaich, The Cost of Freedom, 1960.
8. Gunnar Myrdal, Beyond the Welfare State, 1960.
9. F.A. Hayek, “The Non-Sequtor of the Dependent Effect”, Southern
Economic Journal, Apirl 1962, p. 346.
10. Milton Friedman, Capitalism and Freedom, 1962.
11. T.A. Petit, Freedom in the American Economy, 1964.
12. Wicksell Knut, Lectures on Political Economy. Translated by
E. Classen and Ed. by Lionel Robbins, Routledge and Kegan Paul,
London, 1935.
13. Ibid.
14. J. Keneth, Social Choice and Individual Values, 1951.
15. J.S. Coleman, “The Possibility of a Social Welfare Function”, The
American Economic Review, Vol. 56, December 1966, pp. 1105-22.
16. R.A. Musgrave and P.B. Musgrave, Public Finance in Theory and
Practice, McGraw Hill Book Company, Kogakhusa, Tokyo, 1959.
17. Ibid.
18. J.A. Schumpeter, Capitalism, Socialism and Democracy, 4th edn.,
Allen and Unwin, London, 1954, p. 282.
19. A. Downs, Economic Theory of Democracy, Harper Row, New
York, 1957.
Public Expenditure 5
THE PURE THEORY OF PUBLIC EXPENDITURE

The pure theory of public expenditure seeks to analyse the
determination of optimum public expenditure and the optimum
allocation of resources for public goods. The theory essentially
rests upon the benefit approach as developed by the continental
writers, like Mazzola, Pataleoni, Wagner and Eric Lindahl and
the ability approach as developed the Anglo-Saxon writers
including Pigou, Mill, Dalton and Samuelson.
The benefit approach poses the issue of optimum public
expenditure on the market principle: Just as private spending
optimally meets the subjective wants of individual consumers,
the same principle should be applied to the wants satisfied by
the government. But the proponents of this school immediately
recognized that market rule is not applicable to public goods as
these are indivisible and are consumed in equal amounts by all.
The existence of externalities—positive and negative—also
exposes the failure of the market mechanism to determine
accurately the optimum public expenditure. The wayout
suggested was that the consumer’s equilibrium condition in case
of public goods may be fulfilled by the consumption of equal
quantities of the commodity at different prices such that there is
equi-proportionality between the utility to every individual and
the price paid by him. No doubt, in this way, the optimum
distribution of the consumer expenditure between public and
private goods can be distributed but it fails to provide answer
to the question as to how much resources should be provided
by the government for the provision of public goods. Lindahl
attempted to determine simultaneously the optimum amount of
PUBLIC EXPENDITURE 147
public spending and the optimum distribution of tax burden on

the cost of benefit principle. The Lindahl model,* however,
encounters some difficulties. Firstly, the individuals will not
readily reveal their true preferences for public goods. Secondly,
even when they reveal their true preferences, the optimum
quantity of public goods to be provided cannot be determined
without first determining the optimum distribution of income.
The Anglo-Saxon writers, in contrast with the simultaneous
determination of optimum public expenditure and optimum
distribution of tax burden—the approach followed by the
continental writers, maintained that the primacy should be given
to the determination of optimum public expenditure. Once the
government expenditure is determined, the optimum distribution
of tax burden can be determined by an equitable tax formula
based on the ability-to-pay principle. However, the ability-to-
pay approach is considered as one-sided and deficient because it
seeks to determine the magnitude and pattern of public spending
without in any way trying to link the same to the preference
pattern of the individuals and also to the contribution that the
individuals are required to make for the provision of such goods.
By the proponents of ability-to-pay approach—Pigou and
Dalton—an attempt was made to determine simultaneously the
optimum expenditure and tax revenues through the principle of
least aggregate sacrifice and the break-even point is sought to
be established at a point where the social benefit derived from
an additional dose of government expenditure becomes equal to
the social cost of additional amount of taxation required for
financing the expenditure as given in Fig. 5.1.
The Pigou-Dalton approach emphasizes that the public
expenditure should be optimally planned. But there are serious
difficulties in the planning of optimum public expenditure. Firstly,
the optimum size of government spending cannot be determined
without knowing the true preference pattern of individuals for
public goods. Secondly, the optimum tax pattern cannot be
devised without making inter-personal comparisons of utility.
The new welfare economics has highlighted the practical
* For the details analyses of Lindahl’s model-approach, see ‘Benefit
Approach’ in Chapter 6.
Fig. 5.1
problems in knowing the true preferences of individuals and the

inter-personal comparisons of utility. Unless there is prior
determination of the optimum distribution of income of the
community, there can be no hope for the determination of
optimum level of public spending and the optimum distribution
of tax burden. Neither the benefit approach nor the ability-to-
pay approach, from this angle, has succeeded in providing a
satisfactory solution for the determination of optimum public
expenditure and the optimum distribution of tax burden.
Moreover, modern state does not incur public expenditure on
providing ‘pure’ public goods alone but on innumerable services
also with a view to influence the economic life of a country.
Hence, attempts to develop a ‘pure’ theory of public expenditure
have not been very successful.
Under the policy of laissez-faire when the state was regarded
as a police state, the role of public expenditure in the economic
life of the people and community remained neglected. Its effects
on production and distribution were ignored and it was also
held that public expenditure should be kept at the minimum.
But today, with the change in the nature of state from a police
state to a welfare state, the swing of the pendulum has moved
to the other side. The theory of public expenditure has come

into prominence as a result of the failure of the market
mechanism to respond fully to the true needs of the society and
create conditions of full employment of human and natural
resources.
The increased participation of the government in economic
activities has brought public spending to the forefront among
the fiscal instruments. The appropriate variations in public
expenditure can have a more direct effect upon the level of
economic activity than the variations in taxes. The increased
public expenditure has a multiple effect upon income, output
and employment exactly in the same manner as an increase in
investment does. A reduction in public spending, on the contrary,
can reduce the level of economic activity through the reverse
operation of the government expenditure multiplier.
During the time of inflation, the basic cause of inflationary
pressures is the excessive aggregate spending. Both private
consumption and investment spending are abnormally high.
Therefore, the proper public expenditure policy is to attempt to
reduce the government spending through the abandonment of
some of the schemes and the postponement of some others. In
case, public spending has to be reduced, the care should be
taken that the productive spending is not shelved, since that
will further aggravate the inflationary dangers in future due to
decreased flow of goods and services. The expenditure reducing
policies during inflation thus play a balancing role in the
economic system.
It is during recession or depression that the deficiency of
demand due to sluggish private consumption and investment
expenditure can be met through the additional public expenditure
equivalent to the deflationary gap. The multiplier effect of public
spending will neutralize the depressing effects of lower private
spending and pave the way for economic recovery. Thus, business
fluctuations can be controlled by an appropriate variations in
public expenditure. Besides, a carefully and wisely planned public
expenditure by creating social and economic overheads can go
a long way in creating necessary environment for the growth of
the economy. Hence, public expenditure is now regarded as one
of the most potent weapons in the hands of the state to secure
economic development of the underdeveloped economies. This

tendency has been further reinforced by the increasing interest
of governments in the problems of distributive justice, planning,
regional disparities, etc. To sum up, we may say that public
expenditure has now stability and accelerating the pace of
economic development as also the main objectives.
GROWTH OF PUBLIC EXPENDITURE

Public expenditure has increased manifold in recent times
and it continues to be increasing with the passage of time due to
the following factors:
(i) For Promoting Economic Development and Economic
Stabilization
Modern states are not police states but welfare states. The
days of laissez-faire are gone. The belief of the classical
economists that economic system can function smoothly without
state intervention and is capable of creating conditions of full
employment of human and economic resources has been falsified.
On the other hand, the penetrating analysis of Keynes has shown
beyond any shadow of doubt that the state must intervene in
the economic system to secure economic stabilization in
developed countries. In the Keynesian analysis, effective demand
has two sides—income and expenditure. On the income side,
Y = C+S, and on the expenditure side Y = C+I. Since ‘C’ is
common on both the sides, therefore, for equilibrium S must be
equal to ‘I’. But as marginal propensity to consume is less than
one, therefore, ‘I’, i.e. investment expenditure always falls short
of ‘S’ and this gap must be filled by ‘G’, i.e. government
expenditure. Therefore, for economic stabilization the
expenditure side (Y) must be equal to C+I+G. Similarly, in
underdeveloped countries, the adoption of the strategy of planned
economic development necessitates huge government
expenditure. In a welfare state also the role of public expenditure
cannot be belittled.
(ii) Democratic Governments
Twentieth century was an age of democracy and democratic
governments are for the people. They have to perform an
increasing number of functions to satisfy the diverse needs of

the people. In democracy, there are a number of political parties
in the country and each party is anxious to win the support and
sympathy of the people. The supporters of each party clamor
for more and more facilities and benefits in the form of more
education, more schools and colleges, more hospitals, more
roads, greater transport facilities, etc. Besides huge expenditure
on election, ballot papers and other staff has to be incurred in
democratic countries. All this has led to a phenomenal increase
in public expenditure.
(iii) War and Prevention of War
This is another factor which has increased public expenditure
to astronomical heights. Modern wars are very expensive. The
nature of warfare has fundamentally changed. The weapons of
mass destruction costing crores and crores of rupees are being
manufactured. The conventional weapons have lost their
importance. Even if there is no war, the constant fear of war
and the measures to prevent it have obliged the governments to
maintain large armies and spend the major portion of their
national income on the manufacture of war weapons. According
to Wagner, there is always an arms race going on between the
countries. This has obviously led to a huge increase in public
expenditure.
(iv) Collective Satisfaction of Wants
Many wants which were formerly satisfied through private
expenditure are now met by the government with a view to
reap the advantages of large scale production and avoiding
exploitation, wastefulness and duplication. This has led to a
phenomenal increase in public expenditure. Moreover, goods
having positive externalities have to be produced by the public
sector.
(v) Increase in National Income
With economic development, the national income of the
countries has increased many times. Consequently, public revenue
by way of taxation has also increased and this has led to an
increase in public expenditure.
(vi) Increase in Territory and Population

The physical boundaries of modern states have expanded
and small states of the old times have disappeared through the
process of unification. Only big states can survive these days
and make economic progress. The increase in area of the states
has resulted in an increase in the cost of administration. Even
the conversion of bigger states into smaller state as it is in India
(Uttaranchal, Jharkhand, Chhattisgarh, etc.) increases the total
expenditure in the country because of duplication of bureaucracy
and other government machinery. Even if the area has remained
the same, the increase in population has contributed to the
increase in public expenditure as the governments have to cater
to the needs of ever increasing population.
(vii) Urbanization
With economic development, there is urbanization of
population on a large scale which implies larger per capita
expenditure on civic amenities by the municipalities and hence
an increase in public expenditure.
(viii) Nationalisation of Industries and Trade
There is a manifestation of a tendency on the part of modern
governments to provide goods and services to the people on a
more or less commercial basis. The governments are doing so
with a view to prevent the exploitation of consumers by private
monopolies; to secure equitable distribution of wealth; to provide
a yardstick for private operation and to earn profit for the
treasury. But the setting up and the management of these
enterprises and the payment of compensation has resulted in a
tremendous increase in public expenditure.
(ix) Public Debt
Inherent deficiencies of the free market economy have
resulted in economic instability and widespread unemployment
and under-employment. Consequently, the state is called upon
to undertake various regulatory and anti-cyclical measures which
have led to enormous increase in public expenditure. To meet
this expenditure, the governments are obliged to borrow on a
large scale and this has led to an increase in public expenditure

in the form of increasing cost of debt servicing and repayment
of the public debts.
(x) Increase in the Price Level
Under the impact of the factors, discussed above, the prices
of all goods and services have increased very considerably in
recent times. Consequently, the governments have to pay more
for the goods and services it purchases from the market to meet
its requirements and hence an increase in public expenditure.
As a consequence of the above factors, public expenditure
has grown considerably. Now the government spends, apart
from performing the traditional functions, more for promoting
the welfare of the society. A major chunk of public expenditure
in a welfare state is now spent for removal of poverty,
unemployment and inequalities in the distribution of income
and for providing social security, educational and medical
facilities. Public utilities and goods providing more externalities
have to be produced in the government sector. Even merit goods,
as already stated, are receiving more and more attention from
the government. The Wagner’s law of increasing state activities
states that public expenditure has increased both intensively
and extensively.
Wagner’s Law of Increasing State Activities
A German economist, Adolph Wagner (1835-1917) in 1883,
gave a law called the “law of ever increasing state activity”
which was based on historical facts, primarily of Germany. He
based his law on “pressure for social progress” and pointed out
that there is a persistent tendency for the activities of different
layers of a government—central and state and local bodies—to
increase both intensively and extensively. By intensive increase
in public expenditure, he means more of public expenditure on
the same items on which the government has been incurring
expenditure, i.e. defence, law and order, etc. By extensive increase
in public expenditure, he means public expenditure on more
and more items like education, medical and public health, poverty
alleviation, etc.
Wagner divided public expenditure into two categories:

(i) expenditure for internal and external security, and (ii) that
for “culture and welfare” which implies education, health,
transport, recreation, banking, etc. With the change in the nature
of the use of force by the state from simple aggression to the
prevention of attack and use of more sophisticated weapons,
the expenditure for external security would increase. Similarly,
according to Wagner, the expenditure on internal security would
also increase due to greater friction between economic units
and people as urbanization would progress.
Wagner assumed that income elasticity of demand for public
goods and services is greater than one and, therefore, whenever
there is an increase in income, demand for public goods increase
proportionately more. In other words, he assumed a smooth
rise in public expenditure with increase in income, yet the relative
increase in the former would be more than the latter. We
can also illustrate Wagner’s law with the help of Fig. 5.2.
Fig. 5.2
In Fig. 5.2, line A represents a situation in which the public

expenditure maintains a constant proportion of the total national
income (Y) over time. In other words, while the real per capita
income increases due to the economic development of the
country, the proportion of public expenditure to national income
remains constant. This constant proportion line A1 can be used
as a reference point to explain the Wagner’s law by A2 curve. A2
curve shows that as the real per capita income increases in the
economy the proportion of public expenditure to national income
also increases.
Wiseman and Peacock Hypothesis
In their study of the growth of public expenditure in Great
Britain (pertaining to the period 1900 to 1950), Professors Alen
Peacock and Wiseman have developed some interesting
hypotheses. They suggest that the failure of non-defence spending
to return to pre-war levels in post-war periods may be explained
by what they call a displacement effect. In normal times, the
possible extension of the public sector is broadly limited by
what the general public considers to be a reasonably tolerable
level of taxation. A major disturbance such as a war changes
this tolerance limit, and invariably the economy is found to be
capable of supporting heavier tax loads than had previously
been deemed acceptable. In a world dominated by a politico-
economic philosophy of expansion in the public services,
governments will tend to utilize post-war or post-disturbance
periods to expand ordinary services rapidly. And this expansion
will be general throughout the public sector. This displacement
effect will also be supported by other changes wrought by the
major disturbance. Such periods create new and emergency
demands on government, even in civilian sector. Government
gain experience in administration and regulation. The
bureaucracy is increased in both size and in power. Vested
interests emerge in bureaucracy itself, and people come to expect
a greater degree of regulatory activity by government. This
displacement hypothesis is supplemented by a scale hypothesis
which suggests that the same factors tend to cause a
concentration of financial responsibility in the government. This

is called ‘Concentration Effect’.
These two hypotheses are suggestive, and they do offer quite
plausible explanations for the observed data about public
spending over time. They suggest that, in the 20th century,
major disturbances explain much of the increase in the relative
importance of the public sector. On the other hand, in the absence
of major disturbance the public sector may be predicted
to increase only gradually and within reasonably prescribed
limits.
The difference between Wagner’s law and Wiseman-Peacock
hypothesis is only a matter of degree. Both predict increase in
public expenditure. While Wagner predicted a smooth rise in
public expenditure, Wiseman-Peacock hypothesis finds a zig-
zag or step-like increase in public expenditure. According to
this hypothesis, if public expenditure increases because of some
disturbances then it tends to concentrate there for some period
(years) till new development takes place which pushes up the
level of public expenditure (and taxation) to new heights where
Fig. 5.3
it will be stabilized. And the process will go on as it is clear

from Fig. 5.3.
However, both the hypotheses have been considered
inadequate to explain the ever increase in Public Expenditure.
While Wagner’s law, though generally true is rejected on the
ground that it lacks evidence and the assumption that income
elasticity for government expenditure is always greater than
unity, may not always be true. Wiseman-Peacock’s hypothesis
has been rejected on the ground that it is deductive and is based
on one countries experience only and that for the period in
which two famous world wars took place. It has, therefore, a
very limited scope. This theory/hypothesis has no predictive
value. It ignores social and culture factors. The role of public
expenditure to achieve the broader goals of economic stability
and equality in the distribution of income are not taken into
account. Growth in public expenditure has never been like a
step-wise fashion.
CLASSIFICATION OF PUBLIC EXPENDITURE

In order to examine the structure of public expenditure and
make useful comparison and interpretation, it is always
important to classify the data into various classes/groups
according to some predetermined characteristics. This will also
help in developing clear thinking and understanding of the
various structural aspects of the data.
Before we proceed further, it should be remembered that a
good classification is always guided by the principle of mutual
exclusive classes. For example, if you have expenditure to be
classified as developmental and non-developmental, then
different items therein must be such as are clearly definable
into developmental and non-developmental category. Then,
another feature of an ideal classification relates to the basis of
classification which should always be a necessary attribute or
characteristic of the object (population) which is to be classified.
For example, the necessary attribute of public expenditure is
to distribute benefits to the different sections of the society
through public expenditure on various items. Thus, before
examining the various classifications, it must be noted that their
applicability and usefulness will be examined keeping in view

the characteristics of an ideal classification.*
Carl C. Plehn’s classification. He has given the following
classification. Public expenditure providing: (a) common
benefit on all, e.g. defence expenditure; (b) special benefit
on certain classes, i.e. treated as a common benefits, e.g.
expenditure on poor relief; (c) special benefit on certain persons
but common benefits on others, e.g. public expenditure on roads;
(d) which confers only special benefits, e.g. public expenditure
on industries.
It may be mentioned that the second and third categories
are very comprehensive and will probably include all public
expenditure incurred by the state. Therefore, classes are not
mutually exclusive, though basis of classification, i.e. benefit
may be alright. Hence, we cannot use this classification.
J.S. Nicholson’s classification. He has classified public
expenditure according to the amount of revenue the state realizes
in return for the services which it performs through public
expenditure: (a) expenditure without direct return of revenue,
e.g. expenditure on poor relief; (b) expenditure without
direct return of revenue but with indirect benefit to revenue,
e.g. expenditure on free education, medical facilities, etc.;
(c) expenditure with partial return of revenue, e.g. public
expenditure on education for which fees are charged; and
(d) expenditure with full return of revenue or even earning profit,
e.g. expenditure on post office, railways, etc.
It may be mentioned that the basis of classification (i.e.
revenue) is not necessary attribute of public expenditure. Public
expenditure is never incurred to earn revenue. Secondly, classes
are not mutually exclusive because all public expenditures,
interpreted in a wider sense leads to full return of revenue for
the society as a whole. Even expenditure on poor relief
and medical facilities would lead to better living standard and
hence the society as a whole would be benefited. Therefore, we
cannot use this classification.
*For details see R.N. Bhargava’s book The Theory and Working Union
Finance in India.
Professor Adam’s classification. He has given a functional

classification based on the various functions actually performed
by public authorities. For example, (a) protective public
expenditure on defence and police; (b) commercial public
expenditure helps for the promotion of trade and commerce in
the country, e.g. expenditure on subsidies, exhibitions, etc.;
(c) developmental expenditure that helps the development of
resources of the country such as education, roads, railways,
post and telegraphs.
In this classification, interaction between different types of
expenditure is quite common. Protective public expenditure helps
commerce to grow which also helps in its turn to promote
development of the economy. This in turn helps defence
personnel to fight war more vigorously. Thus, classes are not
mutually exclusive. However, the basis of classification may be
considered alright since classification is based on the affect of
public expenditure on the welfare of the community. The basis
of classification is the type of benefit which public expenditure
confers, i.e. whether it benefits the community by maintaining
peace and thus promoting undisturbed its productive activities.
Or whether it benefit the community by helping trade and
commerce or by developing its resources.
J.S. Mill’s classification. He has classified public expenditure
into: (a) optional public expenditure; (b) obligatory or necessary
public expenditure.
Obligatory expenditure is that “in respect of which owing
to past contracts or other legal commitments” the state is not
free to decide whether to incur that expenditure or not. Or else
optional expenditure is that which the government is not obliged
to spend or it can avoid without any legal obligation.
In fact, the distinction between optional and obligatory
expenditure is only of a degree. The obligatory expenditure can
be made optional and vice versa through appropriate legislation.
Expenditure which is considered optional may not be so if
political conditions demand that it must be incurred. In a way
the very word optional seems inappropriate. The state never
incurs any expenditure which can be strictly regarded as optional.
It incurs only that expenditure which is necessary. Mill might

have thought that expenditure on poor relief and free education
is optional. But modern economists feel that these expenditures
are necessary to maximize social welfare. Probably when Mill
talked of optional and compulsory expenditure, he might have
thought that the benefit from the former are less than those
from the latter. Thus, benefits have entered through the backdoor
and hence the basis of classification may be considered
appropriate yet classes are not mutually exclusive. Hence, this
classification is not perfect.
Rosecher’s classification. He has classified public expenditure
as:
(a) Necessary,
(b) Useful, and
(c) Superfluous.
Necessary expenditure is that which the state must incur
and which the state cannot postpone. Useful expenditure is that
which is desirable but perhaps can be postponed. And superfluous
expenditure is that which should be avoided. We doubt that
whether state ever incurs superfluous expenditure. In fact, the
state incurs only upto the point where marginal benefit from
public expenditure is equal to marginal sacrifice of taxation.
Till this point no expenditure is superfluous. Further classes are
not mutually exclusive. Whatever expenditure is necessary is
useful to incur, and whatever is useful must necessarily be
incurred. So classes are overlapping.
However, if we believe that the benefits conferred by
necessary and useful expenditure are more, then basis of
classification, i.e. benefits can be considered appropriate.
Findlay Shirras’s classification. His classification is based
on the functions performed by the government. According to
him, government has primary functions and secondary functions.
“Primary expenditure includes all expenditures which
government worthy of the name are obliged above anything
else to undertake”, e.g. expenditure on police, law, and defence.
This expenditure is necessary for the existence of the state. On
the other hand, secondary expenditure includes social
expenditure, expenditure on public undertakings, etc. However,

it may be pointed out that primary and secondary are relative
terms that which is primary is less secondary and vice versa.
According to our modern idea of the functions of the state and
of social justice, we consider the provision for basic amenities,
health services, removal of illiteracy, etc. as the primary functions
of the state. They are as much important as the maintenance of
law, internal and external security. Thus, classes are relative
and cannot be clearly defined. However, considering that benefits
from primary expenditure are relatively more than the secondary
expenditure, the basis of classification (i.e. benefits) may be all
right. However, we cannot use this classification.
Dalton’s classification. According to Dalton, public
expenditure can be divided into two categories: (a) grants and
(b) purchase price. Grants can be direct as well as indirect.
Direct grants accrue to the persons directly, e.g. scholarship. In
case of indirect grants, other persons are also benefited, e.g.
subsidies on inputs or output. If the government pays a higher
price than required, then partly it is a grant and partly a purchase
price.
Dalton considered pensions and interest payments on public
debt as grants. Moreover, time factor is also important to
distinguish between purchase price and grant. Pensions
considered from the present viewpoint are grants. But they are
in lieu of the services rendered in the past. Similarly, interest on
public debt is paid on account of the purchase of commodities
(financed through loans) in the past. But this time lag is present
in all the government payments, e.g. salaries are paid after
working for 30 days. But salaries cannot be considered as grants.
Thus, the element of lag is more in some cases and less in other
cases.
Again, the services rendered by expenditure financed out of
loans may be continuous, e.g. if the loans are spent on capital
assets like railways, houses, etc. In this case, the government
receive services continuously and the payment of interest may
be treated as a purchase price for the services which the state
receives currently. Therefore, such payments can be considered
as purchase price. However, the concepts of grants and purchase

price are very useful in the social accounting sense.
Pigou’s classification. Exactly like Dalton, his classification
is useful in the social accounting sense, though his terminology
is better. Pigou has divided public expenditure into (a) exhaustive
or non-transfer or real expenditure and (b) transfer expenditure.
Exhaustive public expenditure is that which purchases current
services of productive resources for the use of authorities, i.e.
expenditure on army, civil service, educational service, etc. This
is also called real expenditure or non-transfer expenditure. By
implication transfer expenditure consists of payments made either
gratuitously or in purchase of existing property rights, i.e. interest
on public bonds or public debt, pensions, etc.
As already stated this classification is also useful in the social
accounting sense, because transfer expenditure does not create
any income or output while non-transfer expenditure always
gives rise to the creation of some output and equivalent money
income. Non-transfer expenditure always implies the actual using
up of commodities and services that otherwise would have been
available for other purposes. This classification is alright but
not comprehensive. Like Dalton’s classification interest and
pension may contain the element of real expenditure. So long
as Pigou talks about non-transfer expenditure it is alright,
yet when he says real expenditure then pension contains an
element of real expenditure because of the services rendered in
the past.
Ursula Hicks’s classification. Her classification is also
functional classification. She has classified public expenditure
into following categories: (a) defence expenditure; (b) civil or
administrative expenditure; (c) public expenditure towards
economic ends; and (d) social expenditure.
Defence expenditure includes expenditure on army personnel,
armaments, capital equipment, armament factories, etc. Civil
or administrative expenditure is incurred on law and order and
justice in the country. Public expenditure on economic ends
includes subsidies to private industries, provision of benefits
through nationalized industries, etc. Social expenditure, which
is now become an important item, includes expenditure on

education, public health, social insurance, etc.
We can conclude that depending on one’s objectives,
classification may be any. If we take into account various
objectives of public expenditure, it can be divided into (a) defence
expenditure, (b) administrative expenditure, (c) developmental
expenditure, (d) distributional expenditure, (e) fiscal expenditure,
etc. In India, we use the following functional classification of
public expenditure:
1. Defence services
2. General services (general administration)
3. Fiscal services (cost of tax collection)
4. Economic services (agriculture and industry)
5. Social service (education and medical and public health)
6. Others (grants, interest payment, loan repayment, etc.).
Then we have an economic classification of public
expenditure, i.e. public expenditure on (a) revenue account, and
(b) capital account. While expenditure on revenue account is
consumption expenditure, capital account expenditure is for
building and maintaining capital assets.* When the above-
mentioned functional classification is superimposed on economic
classification, we get economic and functional classification,
which is now widely used in different countries.
CANONS OF PUBLIC EXPENDITURE

The Canon of Benefits: Public expenditure should be
incurred, or so regulated on the various items, so as to secure
maximum benefits for the society as a whole. Maximum social
welfare is achieved “when marginal utility of the marginal
expenditure in each case in equal”. Theoretically, the state should
spend on different items in such a way that marginal benefits
are equal in each case. In fact, this is the principle of public
expenditure. It may also be called the principle of equi-marginal
social utility.
* For details see the portion on different concepts of deficits in Chapter 8.

To achieve this canon in actual practice or to follow equi-

marginal social benefit principle, Shirras has laid down three
criteria. He says that no amount of public expenditure should
be spent to benefit a particular person or region until and unless:
(a) the amount of expenditure involved is small, (b) a claim for
the amount could be enforced in a court of law, and (c) the
expenditure is in pursuance of a recognised policy or custom.
So far as the first item is concerned, the word “small” is a
relative term. What does it mean? A small percentage of annual
expenditure or a small lump-sum amount. There is then the
question as to why even only a small amount of public
expenditure should be incurred on a particular person or section
of the community? The state has to spend in accordance with
the principle of maximum social welfare and the amount to be
spent on any particular person or section of the community has
to be justified on this principle. If, the government spends a
small amount on any particular person or section we should
oppose it, provided it is not in accordance with this principle.
If, however, to maximize social welfare a large amount of
expenditure has to be incurred on a particular section of the
society, then it is fully justified. This would be so when the
social benefit derived by diverting it to some other item of
expenditure is less.
As far as second item is concerned, it is an obligatory
expenditure which the state must incur, otherwise the authority
of the law will be used to compel the state to incur this
expenditure. Therefore, this expenditure occupies a high priority
and confer a relatively greater social benefit. In its absence the
rule of the law will be broken and community will suffer a great
loss in social welfare.
So far as third item is concerned, Shirras seems to think that
expenditure sanctioned by custom and usual practice is justified.
If this expenditure confers relatively greater social welfare and,
therefore, the state and the community wants to incur it, then it
is justified. However, if it confers a relatively smaller benefit
then it will be in violation of the principle of equi-marginal
social utility and would not be justified. It is true that due to
the pressure of tradition or custom we have to incur some
expenditure which we would otherwise avoid, but then the

pressure is so great that the benefit derived by incurring the
expenditure is more than that derived from diverting this
expenditure to some other item. In such a case the expenditure
is not in violation of the principle of public expenditure.
We thus see that all the instances mentioned by Shirras are
taken into account by the principle of public expenditure, which
has no exception. Further, this canon says the same thing which
the principle of public expenditure says and, therefore, it is not
a canon at all.
Canon of Economy. “Every one is less prudent with other’s
income.” Public expenditure should be incurred in such a manner
so as to minimize the waste of public money. The best thing
will be to avoid all waste of public money and then alone we
secure economy in its use. However, the word “economy” can
be interpreted in a narrower or a wider sense. Economy may
mean that while spending money the state should see that, very
little is wasted, i.e. it should not pay ` 100 where ` 50 can serve
the purpose. In its wider sense even if we are paying just as
much as we should, it may still be uneconomical expenditure
provided the benefit derived from it is smaller than the benefit
that could have been derived if this money was spent on some
other object or service.
Strictly speaking for the state, economy in expenditure means
that it spends its money in such a manner that the maximum
benefit is derived from each unit of money. This is so when
principle of public expenditure, i.e. principle of equi-marginal
social benefits is followed. Shirras seems to attach narrower
meaning to the word economy as he talks of avoiding
“extravagance and corruption”. He says that social benefit would
be maximized when there is no waste. However, this canon is
not independent canon and is merely a corollary of the first
canon, i.e. canon of equi-marginal social benefit.
In the context of this canon, Shirras also says that “economy
means protecting the interest of the taxpayers not merely in
effecting economies in expenditure, but in developing revenue”.
Even though it may be desirable that the expenditure incurred
by the state should also help to expand its revenue, the later
objective belongs to be sphere of expenditure and revenue
both and, therefore, cannot be considered to be the canon of
expenditure alone.
The Canon of Sanction. Shirras says that “no public
expenditure should be incurred without proper authority”. This
means that we cannot leave it to every individual public official
(officer) to spend the money in the manner he likes. He must
obtain the sanction of the proper authority before he incurs
expenditure. The reason for this is that we want to ensure that
the public money is put to the best use and that it is not misused
or wasted. The objective is that nothing should be spent in a
manner that does not help to maximize social benefit. It is also
necessary to put this check on spending so that too much is not
spent on some item of expenditure or on some particular region
so that the other items or regions are starved. This ensures that
the principle of maximum welfare is followed and, therefore, all
expenditures must be sanctioned in the final resort by a supreme
authority which takes into account the interest of all regions
and sections of the society. Once the allocation of public money
between different regions or items of expenditure is broadly
decided, the authority to sanction the actual incurring of
expenditure can be delegated to subordinate administrators. It
is only the highest authority, say Planning Commission in India,
which can take an overall view of the entire community and
can sanction expenditure in the light of the principle of maximum
social benefit. The canon of sanction is, therefore, a good
practical rule of the principle of public expenditure.
While further elaborating this canon, Shirras says that no
expenditure by an authority beyond its own powers of sanction
should be incurred. This is quite correct. Because otherwise a
subordinate authority may incur obligation beyond the sanction
already conveyed and may even force the supreme authority to
spend more on some items, which may not be in the broader
national interest and would thus not maximize social welfare.
Shirras further says that “loans should be spent only on
those objects for which money may be so borrowed”. His
intention is to prevent the raising of loans for financing
expenditure that has to be met from the revenue. The orthodox

view was that normally all current expenditure should be
financed from tax revenue, while capital expenditure may be
financed from loans, which could be gradually repaid. This is
no longer a rigid rule to be followed by the state. Whether the
state should borrow or tax, depends upon the economic
conditions prevailing in the economy. If there are inflationary
conditions then the state may finance even capital expenditure
out of taxes or it may preferably build up revenue surpluses to
sterilize purchasing power and thus reduce private consumption
and investment. Similarly, for financing economic development
it is necessary to increase the rate of savings and therefore,
revenue surpluses would enforce extra savings. We have followed
this policy since planning. It was only after eighties that we
have been having revenue deficits.
However, in deflationary conditions when demand has
slackened and there is unemployment, the state may raise loans
to meet its expenditure and thus activate idle savings of the
individuals. The state may even reduce taxes and increase
budgetary deficits so that private disposable incomes are
increased. This will increase the consumer demand of the private
sector. Reduced taxes will also encourage private investment
and further increase the aggregate effective demand. Whether
the state should have a surplus or deficit on revenue account, or
should achieve a fine balance between revenue and expenditure,
depends upon the exigencies of the prevailing economic situation.
The orthodox theory of public finance advocated only
balanced budgets or a small surplus of income over expenditure.
Following the Keynesian revolution, we know that the state
should have a surplus or deficit or a balanced budget depending
upon the state of the economy. If there is surplus employment
in the economy, so that demand is excessive, state should have
a surplus budget. If there is unemployment because of the fall in
effective demand, the state should incur deficits. When there is
full employment and the economy is on an even keel, the state
may tax just enough to meet its expenditure.
The choice between taxes and loans also depends on the
volume of savings in the community. If savings are excessive,
the state should borrow them and spend them so that aggregate
effective demand is maintained at high level. On the other hand,
if the volume of savings is insufficient to meet the investment
requirements of the economy as in underdeveloped economies,
then through budgetary surpluses the state should increase
the savings of the economy. This will help to finance larger
investment expenditure. The reduction in consumer expenditure
through such a policy will also keep the inflationary forces in
check.
Canon of Surplus. Public authorities should raise enough
revenue to meet their expenditure and leave some surplus over
that. They should not have deficits. Shirras says that “public
authorities should earn their livings and pay their way like
ordinary citizens. Balanced budgets must, as in private
expenditure, be the order of the day”. Surplus means that there
should be an excess of income over expenditure. Thus, this is a
canon of income and expenditure and not of expenditure alone
and it should find a place in the canon of Public Finance. Further,
whether there should be a surplus or deficit, it depends on the
economic conditions prevailing in the country. If there is excessive
boom then the government should collect more tax revenue
than it spends in order to siphon of the excessive purchasing
power. On the contrary, if recessionary conditions are prevailing
then government should incur more expenditure than the revenue
which it collects from the people. Therefore, it should find a
place in the canons of Public Finance, if any. It could as well be
a canon of income or public revenue. Further, there is no reason
why the state should always have a surplus. In the case of an
individual it may be that he should have a surplus so that he
can use it when he is unemployed, older, sick or his expenses
increase. However, this argument is not applicable in the case
of state finance. Strictly speaking, whether the state should have
a surplus or deficit or balanced budget, it depends upon the
economic conditions prevailing in the country. We, therefore,
conclude that the canon of surplus has no place in modern
Public Finance.
In conclusion, we may say that there is only one principle of
public expenditure which states that the state should incur its
expenditure in such a manner as to achieve maximum aggregate

benefit for the community as a whole. The first canon of Shirras
really amounts to this principle. His cannons of economy and
sanction are good practical rules dictated by this principle. They
do not exhaust the list of such rules and many more can be
added, e.g. canon of elasticity, canon of equitable distribution,
canon of productivity, etc.
Canon of Elasticity. This canon requires that the expenditure
policy of the state should be able to change itself with the change
in circumstances of the country, i.e. the public expenditure should
be able to adjust according to the circumstances of the country.
In fact, this canon aims that the policy of public expenditure
should possess such an elasticity as it may not fail in times of
emergency like war or in financing large development
programmes. In other words, public expenditure should be
carried out in such a way that the diversion of resources in
times of emergency from one head to another may not upset the
economic life of the country, e.g. the construction of houses
may be postponed in times of war.
Canon of Equitable Distribution. This canon requires that
the public expenditure should be incurred in such a way as
inequalities in the distribution of income are reduced. Public
expenditure should ensure just and equitable distribution of
income among different groups of the society, i.e. more for
education, medical and public health, housing, etc., for the poor.
This canon is particularly more significant in countries like India
where large inequalities exist. That is why special attention is
paid to start schemes which create employment and income for
the poor, e.g. MFALA, SFDA, CSRE, TRYSEM, REGS, etc.
Canon of Productivity. Public expenditure should encourage
the production of the country as a whole. Obviously, more and
more public expenditure should be directed towards production
and development purposes, i.e. creating social and economic
overheads. This is particularly true for underdeveloped countries.
Canon of productivity implies that public expenditure should
be so incurred that it adds to total production in the economy
so that it leads to increase in government revenue. This will
further enable the state to finance the increasing volume of public

expenditure.
In fact, the latter canons are also the practical guidelines to
achieve the basic principle of public expenditure. Finally, the
cannon of surplus has no place in the theory of public finance.
INCIDENCE OF PUBLIC EXPENDITURE

Unlike tax incidence, the theory of expenditure incidence is
yet in initial stages. Although some attempts have been made to
estimate empirically the expenditure incidence as a by-product
of budget incidence, yet a full-fledged theory of expenditure
incidence is still to be developed.
Broadly, there are three approaches to estimate incidence
of public expenditure: (i) money flow approach, (ii) benefit
approach, and (iii) behaviour approach. The money flow
approach concentrates on the recipients of direct payments made
by the government, without considering who ultimately benefits
from the services supplied through the public expenditure. The
benefit approach emphasizes the services rendered by the public
expenditure and those who in the final analysis benefit from
those services. In the behavioural approach, the services provided
by the public sector are valued according to their appraisal by
the alleged beneficiary. To estimate the benefits of public
expenditure, normally benefit approach is used. Further, the
quantum of benefits can be assumed to be equal to the amount
of expenditure incurred.1
For the purpose of incidence, public expenditure can be
customarily divided into (i) expenditure providing general
benefits, and (ii) expenditure providing specific benefits.
Expenditure on general benefits is incurred on providing social
goods or those goods for which private allocation of resources
is inefficient because of their joint consumption. Defence, justice,
diplomacy and general administration are usually considered to
be in this category. Their incidence is usually worked out either
on the basis of income or population or both.
Specific benefit expenditures include those on roads,
education, medical and public health, industry, agriculture, etc.
The beneficiaries of these services are theoretically identifiable,

though practically adequate data are seldom available to allocate
their incidence. However, we can distinguish between two types
of beneficiaries: (i) beneficiaries as they are intended by the
public authorities, and (ii) beneficiaries to whom the benefits
ultimately flow. For example, developmental expenditure meant
initially to benefit agriculture may ultimately benefit the
consumer and even industry by lowering the price of wage goods.
In other words, there is always a spillover of benefits from one
sector to another. Since in this unending relationship it will be
difficult to draw a line, the analysis is usually restricted to the
first-level beneficiaries, i.e. beneficiaries as they are intended by
the public authorities. The second difficulty is that “public
expenditures are usually financed in addition to the funds
collected from taxes, from the resources mobilised from sources
like public debt, deficit financing, etc. When public expenditures
are met from the funds raised through deficit financing or
through public debt, any net transfer of money income from
one section of population to another would be more difficult to
establish than when public expenditures are met entirely from
tax resources.”2
Thus, to ascertain the expenditure incidence is more difficult
than to apportion the tax incidence.
EFFECTS OF PUBLIC EXPENDITURE

Under the impact of laissez-faire policy, the study of public
expenditure remained neglected during the eighteenth and
nineteenth centuries because of the mistaken belief that public
expenditure was unproductive and a waste. The government
was supposed to undertake minimum essential functions like
defence, police protection, judiciary, transport, etc. In the words
of Parnell, “Every public expenditure beyond what necessity
absolutely requires for the preservation of social order and for
protection against foreign attack is waste and an unjust and
oppressive imposition on the public.” Hence, it was held that
money would fructify more in the hands of the people than in
those of the state. But today with the change in the nature of
the state from a police state to a welfare state, the swing of the
pendulum has moved to the other direction and public

expenditure is regarded as one of the most potent weapons in
the hands of the state to produce the most desirable economic
effects. Public expenditure may effect total production if the
government directly enter into production process by establishing
its own enterprises.
However, following Dr. Dalton, we may discuss the effects
of public expenditure under three heads, namely (1) effects on
production, (2) effects on distribution, and (3) other economic
effects.3
1. Effects of Public Expenditure on Production
Dalton holds the view that the level of production and
employment in any country depends on ability and desire of the
people to work, save and invest and the diversion of economic
resources between various uses and areas. The public expenditure
can influence all these factors either for the better or for the
worse.
(i) Effects of Public Expenditure on Ability to Work, Save and Invest
The public expenditure will increase a man’s ability to work
if it increases his efficiency. This opens a wide field for socially
desirable expenditure such as expenditure designed to provide
unemployment benefits, sickness benefits, free medical and
educational facilities, cheap housing facilities, etc. This type of
public expenditure will help to increase the efficiency of the low
income groups and their ability to work and save would rise.
The supply of skilled and efficient labour would also increase.
Thus, all such expenditures which increase the people’s ability
to work will obviously help to increase their income and savings
and hence the national output and income.
It may be mentioned here that public expenditure which
provides various social services is more beneficial from the point
of view of increasing the efficiency of the people than equal
amounts of expenditures in the form of cash benefits because
the recipients may not spend the money on goods and services
which promote efficiency. Moreover, the provision of socially
desirable services will increase the efficiency not only of the
present beneficiaries but also the efficiency of their children.
(ii) Effects of Public Expenditure on Incentives or Desire to Work,

Save and Invest
Certain type of public expenditure which takes the form of
unconditional grants may adversely affect people’s desire to work
and save. Pensions and interest on loans can be cited as good
examples in this regard. But other forms of public expenditure
such as unemployment and sickness benefits may not reduce the
desire to work and save because these benefits are conditional.
Such benefits may increase in some cases, the desire to work by
raising the morale of the people. Similarly, the prospect of a
grant which is not fixed but increases with the increase in work
and the volume of savings would increase the desire to work
and save unless the demand for income in inelastic. However,
such grants may not be feasible in practice.
(iii) Effects of Public Expenditure on Diversion of Economic
Resources between Different Uses and Areas
Public expenditure can significantly influence the level and
pattern of production through the diversion of economic
resources between different uses and areas. Public expenditure
itself means diversion of resources from private use to public
use. Secondly, through public expenditure inter-regional diversion
of resources take place. Thirdly, public expenditure, if spent on
conservation of resources or capital formation, can lead to
diversion of resources from the present generation to future
generations.
The provision of economic and social overheads is beyond
the capacity and resources of private individuals but their
availability on an adequate scale is a sine qua non for increasing
the productive capacity of the country. Hence, public expenditure
in these directions can go a long way in building the necessary
infrastructure for raising the level of production and employment.
To quote Dr. Dalton, “From the point of view of production,
those forms of public expenditure are socially desirable which
will increase productive power more than it would be increased,
if the funds required were left in private hands. To this category
belongs expenditure on: (1) debt redemption, where most of the
money repaid will generally be reinvested; (2) many projects of
transport development especially in new countries, irrigation,

afforestation, etc., which may be expected to yield large returns
in the long run, but not in the immediate future, and which do
not, therefore, attract the private investor; (3) the increase of
knowledge, by the encouragement of research and invention
and, as regards opportunities of employment, by the maintenance
of employment exchanges; (4) education and training; (5) public
health; and (6) expenditure in aid of social security schemes,
insofar as these promote efficiency and hence increase
production.”4
The public expenditure to build up economic and social
overheads would serve as an incentive to private investment
because this would widen the size of market for the industrial
goods and hence the level of production and employment would
increase.
Similarly, diversion through public expenditure of economic
resources between different areas and regions can increase
production. For example, through public expenditure industrial
estates may be started in underdeveloped areas or industries
shifted to backward regions. This will induce the new
entrepreneurs to start industries in those areas and thus bring
about increase in production and employment. Similarly, the
provision of technical advice to agriculturists, industrialists and
businessmen together with loans, grants and subsidies can
go a long way in assisting private enterprise and stimulating
production.
It is sometimes held that in modern times a large part of
public expenditure is incurred on armed forces which is
unproductive and hence it adversely affects production. But such
an expenditure also, unless it is over done, creates the conditions
under which alone organized production can take place. By
preventing invasion, it diminishes the economic as well as the
non-economic loss which invasion or defeat would otherwise
have caused. Moreover, feeling of security alone creates the
conditions under which organized production can take place.
What is required is that expenditure on armed forces must not
be over done and for that all-out efforts must be made to reach
an international agreement to limit the size of the armed forces
and the amount of expenditure to be spent on their maintenance.

To sum up, we may say that public expenditure if wisely planned
and executed, can add to the productive capacity of the economy
and help raise the level of production and employment in the
country.
(2) Effects of Public Expenditure on Distribution
A wisely planned public expenditure can go a long way in
reducing inequalities in the distribution of income and wealth
which is the bane of modern capitalist society. Consideration of
distribution obviously point out to the most sharply progressive
grant system. But if public expenditure is regressive or
proportional in nature, it will benefit the high income groups
more than the low income groups. But if it is most sharply
progressive, the inequalities would be reduced greatly because
in such a system, the low income groups would be benefited
more than the upper income groups. Thus, from the point of
view of distribution, a highly progressive grant system is most
desirable. In the words of Dr. Dalton, “The principle of minimum
sacrifice in the distribution of taxation runs parallel to the
principle of maximum benefit in the distribution of grants…. A
rough approximation to the latter principle would be a grant
system which brought all incomes below a certain level up to
that level, and added nothing to any income above that level.”5
The considerations of production, however, will stand in the
way of such scheme of public expenditure. But the case for a
considerable defence of progressivity may be taken to be firmly
established. Further, as far as possible grants must be given in
kind and not in cash because the latter may not be used for the
purpose for which these are given. Cash grants can also effect
the incentives to work, save and invest adversely.
A government may reduce income inequalities through
various forms of progressive public expenditure which are meant
to help the low income groups. A number of welfare measures
like free education, free medical care, etc., would raise people’s
educational level and efficiency which would enable them to get
into better paid jobs and thus the gap between the rich and
poor would be reduced. Similarly, grants like unemployment
benefits, sickness benefits, etc., when adjusted according to

individual and family needs can help reduce income inequalities.
Since the expenditure on food forms a major proportion of the
income of the poor people, public expenditure in the form of
food subsidies and making efficiency necessaries of life like milk
and milk products available at subsidized rates to the poor, will
prove to be a great equalizer.
It may be mentioned here that the reduction of income
inequalities through progressive public expenditure will
necessitate the imposition of high tax rates and it may adversely
affect the incentives to work, save and invest. Hence, all possible
measures must be adopted to avoid such a situation. Tax rates
should not be very steep and marginal rates should be moderate.
Further, before incomes are transferred to the low income groups,
there must take place an increase in production so that a larger
proportion of the additional income is transferred to them.
Government may also establish its own enterprises to avoid the
conflict between the effects of public expenditure on production
and distribution of income.
(3) Other Economic Effects of Public Expenditure
In more recent years public expenditure has come to occupy
a central position in the fiscal operations of modern governments.
Its role as an instrument of economic stabilisation in developed
countries and that of economic growth in developing countries
has assumed new dimensions.
The increased participation of the government in economic
activities has brought public spending to the forefront among
the fiscal instruments. The appropriate variations in public
spending can have a more direct effect upon the level of economic
activity than even those in taxes.
During inflation the basic cause of inflationary pressures is
the excessive aggregate spending. Hence, the expenditure-
reducing policies by the state can play a balancing role in the
economic system in such a situation. However, during recession
or depression the deficiency of demand due to sluggish private
consumption and investment spending can be met through the
additional public expenditure equivalent to the deflationary gap.
The multiplier effect of public spending will neutralize the

depressing effects of lower private spending and pave the way
for economic recovery.
In underdeveloped countries, there is lack of basic facilities
such as transport, power, irrigation, education, etc. and also of
basic and key industries. Hence, a carefully and wisely planned
public expenditure is required for creating an appropriate
environment for the growth of the economy.
It may be mentioned here that the public expenditure policy
of a government constitutes only one part of its total economic
policy. In fact, the effects of public expenditure cannot be assessed
in isolation of other policy measures such as taxation, borrowing,
monetary measures, economic controls, etc. We must bear it in
mind that they are closely inter-related and mutually affect each
other. However, they are studied separately for the sake of
convenience.
Undesirable Effects of Public Expenditure
As discussed above, a wisely planned public expenditure
can confer a number of advantages on the community and add
to its welfare. However, it is also possible to err in the wrong
direction. The following cases may be mentioned in this
connection.
1. The defence of the country against external aggression
and the protection of the life and property against internal
disorder is one of the primary objectives of a civilized state. But
more money might be spent on this object which may do more
harm than good to the interests of the nation.
2. The state may spend huge amounts of money in developing
and protecting certain industries which may not be able to a
stand on their own legs later on. Similarly, certain railways,
roads or buildings may be constructed or institutions established
which may not be of much use. In other words, the principle of
equi-marginal social benefit may not be satisfied. Of course,
nothing is totally useless but some other equally costly projects
may be more advantageous to the community.
3. Transference of wealth is desirable from the rich to the
poor. But if it is done in haste and in a manner that the
beneficiaries are unable to make the right use of money, it will

obviously lead to vices and idleness and its very purpose would
be defeated.
4. The state may be spending huge amounts of money in
changing the attitudes of the people towards other states which
may create in the hearts of the people an ill-will for others and
the nation may have to pay too heavy a price for it. The example
of German Government is quite apt on this point when it instilled
into the young minds that the Germans were the superior people
and were meant to rule the world.
This shows that public expenditure should be very carefully
planned and its adverse effects avoided as far as possible.
REFORMS IN EXPENDITURE BUDGETING

(Planning and Programming Budgeting)
The word “budget” has been derived from the French word
“Bougettee’ which means leather bag. The word budget was
used for the first time in 1773 in England to describe the bag
containing the financial proposals of the government and carried
by the Chancellor of Exchequer (person in-charge of government
treasury). Since then the process of budgeting has covered a
long way and budgeting has now become much more efficient
and result-oriented than in the past. Today, the budget is an
informative document, showing how the departments and their
agencies spend their money.
Although it is the general political process that determines
government expenditures, it is through budgeting that the specific
decisions are reached. A budget is a detailed statement of a
government’s expenditure and revenue. In traditional budgeting,
the executive branch of the government prepares its expenditure
and revenue proposals and the legislative branch considers these
proposals and votes the fiscal plans (i.e. revenue and expenditure
sides) of the government into law. Once the budget becomes the
law, it is referred to administrative officers for enforcement. In
traditional budgeting system, a major emphasis is laid on the
financial aspects of government activities. Budgets usually contain
financial data for the previous year (or years), estimated figures
for the current year, and recommended (budgeted) figures for

the coming year, for both revenue and expenditure.
Drawbacks of Traditional Budgeting
A primary function of the budget system is to facilitate
evaluation of proposals and to compare their relative merits/
demerits. Unfortunately, the traditional presentation of the
budget does not facilitate this task.
First, the usual budget is organized on the basis of various
agencies or departments independently of one another, i.e.
without regard to the interdependencies among agencies or
the conduct of closely related works by other agencies. As a
consequence, all costs of particular activities are not properly
revealed and the estimation of benefits is made difficult.
Second, in the traditional budget a major emphasis is usually
put on inputs, i.e. purchase of various types of items, hiring
of various classes of personnel, etc., without reference to
the activities or outputs produced by them. Accordingly,
relationships between inputs and outputs (i.e. achievements or
accomplishments) are not established and no basis is provided
for comparing the relative effectiveness of various programmes
from year to year, or in a federal set-up between different states.
The traditional budget also fails to recognize that to achieve the
same end result there may be various alternative means (like
private individual who is confronted with scarce resources having
alternative uses) and the chosen path may not be the most
efficient one.
Thirdly, the typical budget is usually formulated on a year-
to-year basis, without regard to future prospects or commitment
arising out of the proposals included in this year’s budget.
In fact, in traditional budgeting the primary objective is to
check legal abuses. Traditional budget is not designed to facilitate
comparisons in terms of priorities. More and more attention is
now focused upon programmes in relation to needs, the task
which Performance and Programming Budgeting can handle
much more easily.
Performance and Programme Budget

The above deficiencies have been recognized for decades.
Many suggestions have been made for remedying them. The
principal approach suggested in this regard is the replacement
of the traditional budget having input emphasis by the
performance or programme budget.
The Hoover Commission (USA) also recommended that in
the interest of intelligibility, “The whole budgetary concept of
federal government be refashioned by the adoption of a budget
based upon functions, activities, and projects. This we designate
a ‘performance budget’.”6 The Commission went on to explain
that the performance budget should focus attention on the
accomplishment of objectives rather than on allocation to
agencies.
Performance budgeting focuses upon workloads such as tons
of garbage collected, number of school children graduated,
number of income tax returns processed, etc. It is especially
useful in administrative management and in appraising various
proposals. In the defence department, performance budgeting
takes the form of what is called programming in which a
calculation is made of what constitutes adequate defence in terms
of physical units providing a retaliatory striking force of a certain
magnitude. The programme approach, which has now been
extended to other sectors which stress the end product such as
the elimination of poverty, reducing the drop-out rates, public
housing, flood controls, etc., rather than the inputs of various
types of men and material.
Secondly, programme budgeting stresses the relationship
between various outputs or programmes and the necessary inputs
to produce them. The work of each department is classified into
programmes, which are broken into sub-categories. Programmes
include all works seeking to obtain the same objective. This in
turn facilitates the use of PPBS (Planning-Programme-Budgeting
System) and cost-benefit analysis (discussed later).
The primary advantage of the programme budget structure
is obvious from its nature. It provides a more useful basis for
evaluation of various proposals by concentrating on the end
products rather than on inputs and by providing better

information about costs and benefits. Use of this structure forces
the various agencies in preparing their budget proposals to lay
more emphasis on input-to-output, input-to-input and other
relationships and to give attention to a wider range of benefits
and costs.
Difference between Programme and Performance Budgeting
Although most of the scholars use programme budgeting
and performance budgeting as synonymous terms, yet there does
exist a thin line of demarcation between the two. The programme
budgeting is forward looking. It is a projection of the government
activities. It tells us how amongst the alternative activities, the
best should be chosen. Performance budgeting must be based
on the past, i.e. what has actually been achieved. The UNO has
made the distinction between the two in the following words: In
programme budgeting the principal emphasis is on a budget
classification in which functions, programmes and their sub-
divisions are established for each agency and these are related
to accurate and meaningful financial data. Performance
budgeting involves the application of more refined management
tools such as unit costs, work measurement and performance
standards.
Planning-Programming-Budgeting System (PPBS)
The programme budget is merely a form of budgetary
presentation—a particular type of budget document. However,
the introduction of programme budget has followed by a growing
use of Planning-Programming-Budgeting System (PPBS),
first introduced in the defence department of the USA and
subsequently extended to other sectors.7
This system tries to integrate long-range planning of
governmental activities and programming specific activities with
annual budgeting, making use of programme-budget structure
and of various quantitative techniques, with quantification of
costs and benefits. This helps in the selection of best alternatives.
Planning involves the statement of the relationships of inputs
and outputs, under various alternatives, to achieve the desired
objectives. This approach is helpful in defining the goals and in

choosing among the goals, in specifying alternative programmes
to attain the goals, in choosing the best alternatives, and finally,
in measuring performance. Emphasis is placed on trade-offs
within and between programmes. Cost-benefit analysis stresses
marginal relationships rather than mere overall or average
figures. Planning is extended forward for several years. Because
of long-range approach, advance planning is possible, and a
better picture is given for all costs and benefits over a period of
several years. Steps involved in Planning-Programming-Budgeting
System can be briefly summarized as below:
(i) To define the budget in terms of the final product or
goals of the government, e.g. flood control, elimination
of poverty, developing a tactical defence force, etc.
(ii) To make explicit comparisons and trade-offs among
final goals and make explicit comparisons among
alternative ways of attaining any one goal.
(iii) To look at the full costs and benefits of their alternative
proposals.
(iv) To undertake long range planning by making explicit
costs of various projects over a number of years.
Limitations of PPBS
One of the greatest difficulties in PPBS centres around the
specification of outputs. Many government activities involve
outputs or services which are not clearly distinguished from the
activities themselves (e.g. education, police protection) and hence
are not easily defined or measured. The ultimate objective of
police protection is to reduce crime, but this accomplishment is
not easily measured or compared. The result is to use some
proxy measures such as the number of arrests, yet maximization
of these is not the ultimate objective at all. Similarly, many
government activities (e.g. education, construction of dams, etc.)
serve more than one objective. And it may be difficult to lay
stress on one objective at the cost of other objectives.
Secondly, apart from the measurement of output, there is
the problem of defining objectives and establishing priorities of
objectives. These decisions require value judgment and being

mostly subjective are not susceptible to scientific interpretations.
Even actual costs are often difficult to ascertain and the overhead
or fixed costs are arbitrarily allocated to various activities. Then
in the face of uncertainty benefits from various services cannot
be estimated with any degree of accuracy. This is particularly
true for activities having cross-country ramifications, e.g. defence
and foreign field. Thus, the application of PPBS involves many
inherent conceptual problems which have only arbitrary
solutions.
Another criticism against PPBS is that it tends to centralize
decision-making in government, thereby lessening the chances
of innovation. To some observers, the PPBS relies undue on
economic efficiency alone and ultimately the decision may be
arrived at by the computers. This rules out the process of political
decision-making. Thus, too much significance to the quantitative
magnitude produced by PPBS may depersonalize government
programmes from the people whom they tend to serve.
Then, sometimes non-economic benefits which could be
covered under PPBS, may be more relevant than the economic
ones. Suppose the goal is to reduce the drop out from school.
Now the drop out from school by a private individual is an
economic choice. The person thinks that the gains in terms of
expected earnings after finishing school are less than the costs
to be incurred on completing education. Now public expenditure
on extra counselling and special help to reduce the drop-out
rate may not pass the test of PPBS. But its non-economic benefits
in terms of reducing the crime rate or breaking the circles of
poverty that trap families from generation to generation may be
more significant for the society.
On the whole, programme budgeting and PPBS may make
very significant contributions to rational decision-making about
governmental activities and expenditures, but they cannot solve
all problems. They do little to define objectives in the light of
the preference pattern of the society. Then there are uncertainties
particularly on the front of benefits. However, PPBS does increase
the rational element in governmental decision-making.
Cost-Benefit Analysis
An essential element of PPBS is the careful comparison of
benefits and costs of various programmes and alternative means
of attaining the objectives. Cost-benefit analysis is a technique
that can help the government to choose among the various
objectives it is considering. Cost-benefit analysis helps the
government by (i) making clear that the net benefits of each
project are so that those with the largest net benefits are chosen,
and (ii) assuring that resources are not taken from higher valued
uses in the private sector. In other words, cost-benefit analysis
can be used as a test to indicate whether resources being
transferred from the private to the public sector are being
transferred to a higher valued use. Cost-benefit analysis first
developed in the field of water resources, is now being
increasingly applied to investment in human resources
(education) and in other physical resources. Like PPBS, cost-
benefit analysis takes into account all benefits and costs—direct
and indirect. It also evaluates alternative approaches as well as
the overall project in the light of set objectives.
Elements in a Cost-benefit Analysis8
Cost-benefit analysis is undertaken within a particular
government department as a preliminary to budget preparations
or as a continuing programme to ascertain optimum expenditure
patterns and budget recommendations. A study of cost-benefit
analysis involves the following steps:
1. Statement of Objectives or Goals. Obviously, the goals of
the particular programme must be defined. The goal may be
very specific such as that of an irrigation project, with the
immediate objective of bringing 5,000 acres of land under
cultivation by providing adequate water. The long range objective
may be to increase the country’s potential food supply. Some
projects have multiple goals, e.g. dams may have flood control,
irrigation, navigation and recreational objectives. Others may
have goals which are difficult to define specifically. The more
sharply the goal can be defined, the greater will be the utility of
cost-benefit analysis in decision-making.
2. Statement of Alternatives. With many types of activities,

there are various alternative ways of attaining the goals, e.g.
different locations/sources for irrigation facilities (one large dam
now versus many small dams built successively over a period of
time), different methods of construction, etc. Cost-benefit analysis
seeks to determine the relative benefits and costs of the major
alternatives. Cost-benefit analysis is itself costly, therefore, the
number of alternatives considered must be held to a tolerable
limit. Alternatives considered inferior should be outrightly
rejected.
3. Analysis of Benefits. After defining the objectives and
establishing alternatives, the cost-benefit analysis proceeds to
the estimation of benefits. Determination of benefits involves
two major questions: (i) which benefits are to be considered?
and (ii) how are these to be evaluated? The answer to these
questions have been attempted briefly as:
(i) Direct and Indirect Benefits: With many projects there
are two types of benefits—those accruing directly to the users
of the service provided and the indirect benefits or externalities,
i.e. those accruing to others. For example, the construction of a
new bye-pass offers direct benefits to those who use it and
externalities to others such as reduced congestion for those who
continue to drive on less-crowded main roads.
(ii) Valuation of Benefits: The direct benefits to the users of
many services can be calculated on the basis of the amounts the
users are willing to pay or on the basis of prices prevailing in a
perfect market situation. But the problem is that such conditions
are seldom met. Government goods are often provided on
monopoly basis. How much a person is willing to pay is difficult
to know until and unless he is provided with such facilities. In
the absence of this, the valuation of benefits would be arbitrary.
Then apart from valuation difficulties, estimation of benefits
is always accompanied by uncertainties about future conditions.
The uncertainties in some activities (e.g. foreign matters) are so
great that any precise conclusions are impossible.
Further, valuation of externalities may encounter even more
difficult problems.
Estimation of Costs
Costs of the project may be defined as the present value of
resources that will be used in the project, valued mostly at their
opportunity cost, i.e. the amount that would be paid for them
for alternative use. Although future costs are more easily
calculable, yet analysis of costs involves the same type of problem
as that of benefits. The direct costs include capital costs and
operating and maintenance costs. Indirect costs include those
created for other governmental agencies and overall costs to
society not directly borne by the government. In a sense these
are negative benefits. For example, additional fast local bus
service in urban areas will increase air pollution, aggravate traffic
congestion and increase delays and accidents. Without cost-
benefit analysis, indirect costs are often not taken into account.
But there are obvious difficulties in measuring and evaluating
them.
Need for Discounting
Cost-benefit analysis is primarily employed for the
long-range projects. Benefits are obtained over a number of
years, while costs are incurred presently as well as in future.
Because of time preference, benefits in subsequent years are of
less importance than in the current year. Similarly, because of
positive interest rate, costs incurred now are more significant
than costs to be incurred in the later years. Therefore, some
method must be used to adjust benefit and cost figures on the
basis of the year in which they occur. This process is called
discounting.
Discount Rate
The benefits from projects that lend themselves to cost-
benefit analysis, e.g. water and development projects will be
obtained over a period of time. Some of the costs will be incurred
at the time the programme is undertaken while others will be
undertaken in subsequent years. But a rupee of benefits now is
worth more than a rupee of benefits say 10 years hence because
interest can be earned on money. Therefore, in order to evaluate
a particular project and to compare alternatives a discount rate
must be used to determine the present value of benefits and

costs.
There are several possible alternative rates:
(i) Marginal productivity of capital investment.
(ii) Social rate of time preference.
(iii) Government borrowing rate without reference to time
preference.
(i) Marginal Productivity of Capital Investment (Return on
Private Equity Share)
The opportunity cost may be defined as the rate of return in
private investment, i.e. on an equity basis what rate of return in
private investment would be earned. However, there are several
objections to this proposal. First, risk involved in private
investment is far greater than government investment. If private
investment fails, one loses the entire amount. But this is not the
case with government investment. It is true that the government
projects too involve some risks, but these risks are of different
nature. Moreover, government investment is fully backed by its
taxing power, which is not true in the case of private investment.
Second, capital markets are by no means perfect. Sometimes the
bulls and the bears may distort the true picture of the market
trends. Third, the use of this discount rate is based on the
assumption that the resources taken by the government are
diverted from private investment. But this may not be necessarily
true. If the project is financed through taxes then the resources
are diverted from consumption and not from investment and as
such the opportunity cost of the use in investment is not relevant.
However, it should be emphasized that since this approach
implies comparatively high discount rate, therefore, it is used
by persons who advocate minimum government investment
activity. This approach may also provide maximum pressure
towards efficiency in the use of resources in government activities.
(ii) Social Rate of Time Preference
The second alternative is to use the rate of time preference
as the discount rate, i.e. rate of compensation which is necessary
to induce the private consumers to refrain from consumption
and induces him to save. This rate would be equal to the marginal
productivity of capital in private investment in a risk-less society
with perfect capital market. However, there may be several
problems of calculation in applying this approach. In the real
world, the only risk-less investment is in government bonds.
Then people save not merely to postpone consumption. There
may be other motives. Thus, the use of time preference may not
be an appropriate discount rate to be used in cost-benefit analysis.
(iii) Government Borrowing Rate Without Reference to Time
Preference
The complexities and inadequacies of the above approaches
suggest the use of simple rule: the rate of interest at which a
particular government can borrow, without any reference to
time preference. In a sense this is the direct cost to the government
in obtaining funds and thus the risk element involved is that of
the government. However, this would be an artificial figure
because of the influence of the monetary policy. However, it
would be substantially lower than the first but closer to the
second rate of discount. Of all the three approaches, it is the
simplest one.
Limitations of Cost-Benefit Analysis
There are several limitations to the effective use of
cost-benefit analysis. Like Planning-Programming-Budgetary
System (PPBS) it does not solve all problems, relating to the
determination of government investment expenditures. In
evaluating programmes having wide scope and implications
it has limited use. Similarly to compare programmes having
different objectives, cost-benefit analysis may not be of much
use. To establish priorities for various goals (e.g. national defence
versus education) the analysis may not be of any use. Then
comes the problems of measurement of benefits and uncertainties.
With many programmes these problems are so serious that exact
quantification is not possible. In fact, the technique of cost-
benefit analysis tends to over emphasize those benefits and costs
which can be quantified compared to those that which cannot.
Lastly, many government programmes have redistributive effects,
benefiting some persons at the cost of others. Cost-benefit
analysis cannot make any contribution towards the establishment

of social welfare function based on the desirability of various
patterns of income distribution. However, the technique may
be useful in measuring distributional effects of alternative
programmes.
To conclude one can say that the cost-benefit analysis is
useful in stressing the need for considering means of achieving
given ends. The analysis can be used wherever reasonable
quantification can be made of benefits and costs. With clearly
defined objectives and measurable benefits and costs, the analysis
is useful in selecting most useful programmes in terms of given
objectives. As long as too much is not expected from cost-benefit
analysis, it can make, and is making, significant contributions
toward government decision-making in general and Planning
Programming Budgeting System in particular.
ZERO BASED BUDGETING

Zero based budgeting (ZBB) is an innovative technique to
guard against wastage in public expenditure. The technique
works not through auditing which is a post-operative check,
but an examination of the very rationale of an expenditure item
under consideration. It is a method which is sought to be
transplanted from the commercial world. The management of a
commercial enterprise, in an effort to maximize its profitability
should be interested in a detailed investigation of each item of
expenditure and see whether it is really needed, or whether it
should be revised or even totally deleted. To this end each section
of the enterprise is to start with an assumed position of its own
non-existence (and therefore no provision for it in the budget)
and compare it with alternative levels of its operation with
corresponding budgetary provisions. If a section is not able to
justify its own existence, it would be closed down. And if its
existence is justified, the optimum level of its operations and
the corresponding budgetary provisions have also to be defended.
In other words, in ZBB no section of business is supposed to be
essential. It has to prove its worthwhileness. The justification as
to why money should be spent has to be proved by the spender.
Every time, this exercise has to start afresh.9
In the sphere of public budgeting, ZBB was first tried by

Jimmy Carter in 1973 when he was the Governor of Georgia.
Later on, it was adopted by a number of States in the USA.
Currently, this line of thinking is being extended to India
as well—though in a guarded and uncertain manner. The
Government of India, faced with mounting non-plan expenditure
and the declining public savings, is eager to apply the technique
of ZBB. The prevailing circumstances lend a support to this
philosophy. Interest payments, subsidies and defence account
for a major chunk of the non-plan expenditure of the Centre. A
number of departments and sections are accused of being
redundant, particularly in the context of move towards
debureaucratisation and liberalization of the economy. Quite a
few cost-effective procedural reforms are being adopted. Our
public sector undertakings (PSUs) are notorious for their
inefficiency in resource utilization, high Incremental Capital
Output Ratio (ICOR) and mounting losses. There are no two
opinions that we have a good deal of wasteful expenditure which
should be avoided.
In our country, the existing system of scrutinizing
expenditure proposals are quite elaborate. Plan proposals
have to be cleared by the Finance Department before they are
presented and cleared by the Planning Commission. This system
causes a lot of delays and in the process cost increases. But
equally important is the fact that there is hardly any mechanism
to evaluate non-plan expenditure. The efforts of the Centre to
introduce ZBB in a meaningful way have not met with a success.
A beginning in this regard was made in the budget 2001-02,
when the then Finance Minister, Yashwant Sinha, proposed to
merge many ministries serving the same objectives.
However, an effective adoption of ZBB is not an easy task.
The methodology of ZBB needs a lot of understanding and
detailed working out at different levels. The risk is that such a
task itself may become an additional expenditure wing of each
ministry and act as a barrier to normal procedure of expenditure
sanction and flow. But a far more formidable hurdle lies in
the fact that no department likes to vote for its own closure
or reduction. Instead it would find arguments to justify its
expansion—more so when the results of its existence cannot be

put in tangible terms. Further, the socio-political atmosphere in
our country does not favour closing down of any department if
it leads to retrenchment of some persons. The current drive
towards disinvestment points towards this direction.
NOTES
1. Janak Raj Gupta, Burden of Tax in Punjab, Inter-Sector and Inter-
Class Analysis, Concept Publishing Company, New Delhi, 1982.
2. Ibid.
3. Hugh Dalton, Principles of Public Finance, Routledge and Kegan
Paul, London, 1936.
4. Ibid.
5. Ibid.
6. The Hoover Commission Report (New York: McGraw-Hill Book
Company, 1949), p. 36, as quoted in H.M. Groves: Financing
Government (Sixth Edition).
7. L.R. Jones and L. McCaffery Jerry, “Reform of the Planning
Programmes Budgeting System, and Management Control in US
Department of Defense: Insights from Budget Theory”, Public
Budgeting and Finance, Vol. 25, Fall 2005, No. 3, pp. 1-19.
8. E.J. Mushan, Cost-Benefit Analysis: An Informal Introduction,
George Allen and Unwin, London, 1982.
9. P. Phrr, Zero Base Budgeting: A Practical Management Tool for
Evaluating Expenses, John Wiley, New York, 1970.
Taxation 6
CLASSIFICATION OR TYPES OF TAXES

Like classification of public expenditure, the classification
of taxes or type of tax-base, tax-rates, etc., also holds the key to
analyse the effects of taxes on income distribution, allocation of
resources, economic stability and growth, cost of tax collection,
incentives to work, save and invest, etc.
Direct and Indirect Taxes
Classification of taxes into direct and indirect categories
has always occupied a prominent place into the study of Public
Economics/Public Finance. But unfortunately no standard terms/
definitions exist for these terms. Dalton defines that “a direct
tax is really paid by a person on whom it is legally imposed,
while an indirect tax is imposed on one person, but paid partly
on wholly by another”.
According to J.S. Mill, “A direct tax is demanded from the
very persons who it is intended or desired should pay it. Indirect
taxes are those which are demanded from one person in the
expectation and intention that he shall indemnify himself at the
expense of another.”
Bastable defined direct taxes as those “which are levied on
permanent and recurring occasions” and indirect taxes as those
which are levied “on occasional and particular events”. Bastable
definition is rather vague and may lead to confusing conclusions.
For instance, according to this definition death duty would be
regarded as an indirect tax as it is levied on occasional events.
But generally death duty is regarded direct tax.
TAXATION 193
According to Prof. Antonio De Marco, if the income of an

individual is appraised directly, it is a direct tax. On the other
hand, when income is appraised indirectly when it is spent, it is
an indirect tax. In other words, a tax on income is a direct tax
and a tax on consumption expenditure is an indirect tax. Some
economists have also defined that direct taxes are those which
are levied on production and indirect taxes as those which are
levied on consumption. Some say that taxes which are obvious
in their application are direct taxes and taxes which are hidden
are indirect taxes.
Thus, we can say that most of the fiscal economists have
tried to define direct taxes and indirect taxes in their own way.
But the most acceptable definition appears to have been given
by Dr. Dalton who says that “Direct tax is really paid by a
person on whom it is legally imposed, while an indirect tax is
imposed on one person, but paid partly or wholly by another.”
Thus, direct tax can be defined as one whose impact and
incidence are on the same person, while an indirect tax as one
whose impact and incidence are on different persons.
Merits of Direct Taxes
1. Economy. Since direct taxes are paid directly to the
government, therefore, every paisa that is taken out of the pockets
of the taxpayers is deposited with the treasury. Indirect taxes,
on the other hand, are collected from the consumers by sellers
who might take away a part of the tax collection.
2. Ability to Pay. Direct taxes can be more easily based on
ability to pay and hence they are more equitable than indirect
taxes. Moreover, the principle of progressivity can be easily
introduced in direct taxes, therefore, they fall more heavily on
rich people than indirect taxes.
3. Reduce Inequalities. As already pointed out, the direct
taxes are progressive in nature, and therefore, rich people are
made to pay higher taxes than the poor. Even poor people can
be exempted from paying the direct taxes at all. Therefore,
these taxes help to reduce inequalities.
4. Certainty. These taxes also satisfy the canon of certainty.
The taxpayer is certain as to how much he is expected to pay,
and similarly, the government is certain as to how much the tax

receipts would be (because there is no intermediate agencies to
collection).
5. Revenue Elasticity. Another point in favour of direct taxes
given is that they are income elastic, i.e. as the income of the
community goes up, yield from direct taxes also goes up.
However, it may be pointed that as the economy grows, yield
from indirect taxes also goes up. But empirically it has been
found that direct taxes are comparatively more elastic as there
are less chances of tax avoidance here than in case of direct
taxes.
6. Civic Consciousness. The advocates of direct taxes point
out that these taxes create a spirit of civic responsibility among
taxpayers. Taxpayers try to be more vigilant about the manner
in which their money is spent. In a democratic country, this
civic consciousness can check the wastage in the public
expenditure.
Demerits of Direct Taxes
1. Unpopular. The direct taxes are not shiftable, and hence,
they are generally painful to the taxpayers. Therefore, such taxes
are generally unpopular and opposed by the taxpayers. On the
other hand, indirect taxes are hidden in the price of the
commodity. Therefore, the consumers does not feel burdensome
or painful in paying the indirect taxes.
2. Arbitrary. Direct taxes tend to be arbitrary because it is
difficult to have an objective base of ability. For example, the
rate of income tax will depend upon the political complexion of
the government. A capitalist government may impose regressive
tax structure, while a socialist government may impose a steeply
progressive tax structure. Every time one has to start with a
clean slate to work out the tax rates.
3. Tax Evasion. Direct taxes in fact are taxes on honesty
and they encourage people to evade them by concealing their
income and wealth.
4. Inconvenient. Direct taxes are inconvenient in the sense
that the taxpayer has to prepare and supply income returns
TAXATION 195
disclosing all the source of his income to the tax authorities.

Accounting procedures are so numerous and so difficult that in
most cases the individual taxpayer may have to seek the help of
tax professionals or lawyers.
5. Costlier. Direct taxes are often regarded as expensive to
collect because each and every taxpayer will have to be separately
contacted by tax officials. Elaborate tax machinery will have to
be employed to contact and assess taxpayers and also to prevent
tax evasion.
6. Exemption of Low Income People. If the entire amount
of needed tax revenue is collected through direct taxes, the poor
people may not be approached at all because they are generally
exempted from paying direct taxes. But justice demands that
every individual must pay some amount of tax, however, the
small amount may be.
7. Disincentive: The willingness to work, save and invest
is adversely affected in this case.
Merits of Indirect Taxes

1. Difficulty of Evasion. Since indirect taxes are included in
the price of the commodity, therefore, they are difficult to evade.
To avoid the payment of indirect tax, one will have to give up
(forgot) the purchase of the taxed commodity. However, indirect
taxes can be avoided by falsification of accounts by the traders/
producers.
2. Elastic. Some of the indirect taxes like direct ones can be
elastic. If taxes are imposed on commodities whose income
elasticity is high, i.e. whose demand increases with increase in
income, tax revenue will also increase.
3. Convenient. Indirect taxes are regarded as more convenient
because they are imposed at the time of purchase of a commodity
or services so that the taxpayers do not feel the burden of the
tax. Besides, the burden of indirect taxes is not completely felt,
since the tax amount is actually hidden in the price of the
commodity. They are also convenient because generally they
are paid in small amounts and at intervals, i.e. when the
taxpayers buy the commodity. Even from the point of view of
the government, they are convenient since the tax amount is
collected in a lump sum amount from the manufacturer/seller/

importer.
4. Canon of Ability. Indirect taxes can be made to fulfil the
cannon of ability if they are imposed at a higher rate on
commodities consumed by the high income groups and at a low
rate on commodities consumed by the poor people.
5. Universal. Indirect taxes enable everyone, even the poorest
citizens to contribute something towards the expenses of the
state. Since direct taxes leave lower income groups from their
scope, indirect taxes make them to share in the financial burden
of the state.
6. Social Benefit. Indirect taxes perform a social and
economic service to the community in general and the poorer
sections in particular, when they restrict the consumption of
such articles as drugs and stimulants.
7. To Achieve Planned Production. Through suitable
modifications, indirect taxes can be used to achieve planned
structure of production. For example, to encourage the
production of cheap cloth and other articles consumed by the
poor, such articles can be exempted from indirect taxes. Similarly,
to balance demand and supply, indirect taxes are a better
measures. Turnover tax in Russia is a case in point.
8. Productive. The income from indirect taxes can be made
productive as few indirect taxes can yield large revenue. Further,
if taxes are imposed on commodities having inelastic demand a
greater amount of revenue can be realized.
9. Incentive-oriented. They do not provide disincentives for
work, savings and investment like direct taxes.
Demerits of Indirect Taxes
1. Unjust and Inequitable: Indirect taxes are generally
regarded as inequitable since they fall on all persons without
any discrimination, i.e. without considering their ability to pay.
When taxes are imposed on goods consumed by the general
masses, the burden is felt more by the poor than by the rich. It
is true that indirect taxes can be made progressive by their levy
on goods consumed by the rich people, yet by and large they do
not do so.
TAXATION 197
2. Uncertainty. Indirect taxes are mostly uncertain in their

yield particularly when they are imposed on goods having elastic
demand. Because in such cases, a higher amount of indirect
tax will mean a higher price which will affect the commodity
demanded.
3. Do Not Create Social Consciousness. Indirect taxes do
not create any social consciousness as generally the taxpayers
do not feel that they are paying taxes.
4. Regressive. Indirect taxes are generally regressive in nature
as they fall more heavily upon the poor than upon the rich.
Thus, we can conclude that both the direct taxes and indirect
taxes have their merits as well as demerits. Gladstone was
perhaps right while comparing direct and indirect taxes with
two attractive sisters between whom he was indifferent.
Therefore, many believe that there should be a balance between
direct taxes and indirect taxes. However, there is a definite
superiority of direct taxes over indirect taxes especially if the
general public is politically conscious and direct taxes are
progressive. It is generally believed that the ratio of direct taxes
to total tax revenue increases as the country moves along the
road of economic development. But in a poor country the indirect
taxes are a necessity particularly because population is illiterate
and politically not so conscious. Besides, modern governments
require so much revenue both for defence and nation-building
activities that all types of taxes become necessary.
Comparison between Direct Taxes and Indirect Taxes
Direct and indirect taxes may be compared with each other
in respect of: (a) allocation of resources; (b) administrative point
of views; and (c) distributional effects.
Allocative Aspect. Traditionally, it is maintained that direct
taxes are better than indirect taxes so far as the allocation
of income is concerned. With the help of indifference curve
technique it can be shown that the consumer is better off by
paying the same amount of direct taxes than indirect taxes.
In Fig. 6.1, AB is the price line before any tax and the
consumer is at equilibrium at T1 and IC1. He purchases, OM or
AR1 commodity by paying R1T1 price (because at T1 on IC1 he
Fig. 6.1
has OM of commodity and MT1 of income). Suppose an excise

duty on X is levied. As a consequence, the price of X increases.
Let the new price line be AB1 and the consumer is in equilibrium
at T2 on IC3. So the tax is T1T2. Suppose an income tax to the
same amount is levied so that the new income-price line is A1B2
this will be parallel to AB which shows that relative prices are
unchanged, only the consumer is left with low income. Now as
it is clear with new income-price line, i.e. A1B2 the consumer can
reach a higher indifference curve, i.e. IC2 than IC3. Thus, it is
maintained that an income tax of an equal amount is preferable
to a commodity tax from the consumer’s point of view. In other
words, a direct tax has less harmful effects on the allocation of
resources than an indirect one.
But the above point of view is now widely challenged. As
pointed out by A.R. Prest if the resources are not optimally
allocated before the imposition of indirect tax, its imposition
might improve upon the allocation of resources. Income tax on
the other hand leaves the allocation of resources unchanged. To
illustrate this point, let us assume that we have a two
TAXATION 199
commodities (X and Y) model. Let the price of X be ` 4 per unit

and that of Y ` 2 per unit so that their relative prices are 4:2 or
2:1. Let us further assume that we live in a world where there is
tax on X say to the extent of ` 1 per unit. Now the relative
prices would be 5:2. To retain the old price ratio, it will be the
tax on Y only (i.e. indirect tax) to the extent ` 0.50 per unit
which will be more appropriate than tax on income which will
leave unaltered the price ratio.
Administrative Aspect
Direct and indirect taxes may be compared from the point
of view of administrative cost and efficiency. Since direct taxes
involve a large number of exemptions granted to low income
people, whereas no such exemptions are needed for indirect
taxes. So obviously from administrative point of view indirect
taxes are easy to administer. They are convenient and difficult
to evade.
Prof. A.R. Prest maintains that there are some special
circumstances when administrative agreement in favour of
indirect taxes becomes very strong. For example, there may be
a very large number of small, independent producers; or many
may be illiterate and incapable of keeping accounts. These factors
are specially applicable to underdeveloped countries and they
are responsible for the predominance of indirect taxation in
these countries.
However, it should be noted that though indirect taxes are
superior to direct taxes from the administrative point of view,
yet they are inequitable because they do not discriminate between
the rich and the poor.
Distributional Aspect
A comparison may be made between the direct and indirect
taxes on the ground of distribution of income and wealth. Since
the former fall at a higher rate on higher income groups, hence
they are generally progressive. Indirect taxes on the other hand
fall on all the income groups and, therefore, they are generally
regressive.
But as maintained by the modern economists, indirect taxes
particularly which fall at a higher rate on luxuries and other
items consumed by the richer sections of the society, be as much
progressive as direct taxes are. Only the process of adjustment

will be different. While direct taxes achieve equality in the
distribution of income directly, indirect taxes can achieve the
same end in an indirect way.
Thus, we can conclude that both direct taxes and indirect
taxes are supplement to each other. In the modern times, when
the needs of the government are growing, we cannot depend
upon either of the two taxes. While direct taxes are needed to
promote a just distribution of income and wealth, indirect taxes
are required to supplement them.
Role of Indirect Taxes in Underdeveloped Countries
As already stated there are certain administrative and their
special reasons which call for the predominance of indirect taxes.
Because of widespread poverty, it is difficult for the government
to impose direct taxes on income and wealth. Private initiative
is almost conspicuous of its absence. Government will have to
come forward to directly participate in the economic activity,
particularly to finance social and economic infrastructure. For
this the government will have to mobilize resources from every
conceivable source, therefore, poor sections of the society are
not spared. In other words, their poverty itself is responsible for
the predominance of indirect taxes. Direct taxes may not yield
sufficient revenue. Besides poverty, illiteracy also contributes
towards the greater dependence on indirect taxes. Direct taxes
presuppose that the literacy level is sufficiently high so that the
taxpayers can fill up the necessary forms, which sometimes may
be highly complicated. Indirect taxes being concealed in prices
are convenient to pay. They may appear to be less burdensome
and, therefore, more popular than direct taxes.
Revenue from indirect taxes, if properly enforced, may be
more than that of direct taxes because the former are mostly
imposed on commodities of mass consumption. For promoting
regional development indirect taxes, in the form of tax
concessions on the production of commodities in less developed
regions, can also be used. Although indirect taxes are considered
anti-inflationary, yet in underdeveloped countries, where there
is demand inflation, they can act as anti-inflationary measures.
TAXATION 201
It is only in case of cost-push inflation that indirect taxes or

commodity taxes add more to the inflationary pressures, because
of their cascading effects. But this adverse effect too can be
avoided if a single commodity tax say VAT is imposed.
In less developed countries, there is lack of initiative. Direct
taxes affect the incentive to work, save and invest adversely,
which the underdeveloped countries cannot afford and hence
more reliance is put on indirect taxes.
The only point of criticism against the indirect taxes is their
regressiveness. Being uniform they put more burden on the poor
(having low income) than the rich (having higher income). Even
this objection can be met by imposing indirect taxes according to
ability-to-pay principle. In other words, commodities consumed
by the poor should be taxed at lower rates and those produced
by the rich at higher rates. All said and done, however, the
development experience shows that as the country moves along
the development path, the share of direct taxes must increase.
Progressive, Proportional, and Regressive Taxes
Net income is considered to be the best measure of ability
to pay taxes. Therefore, it can be taken as the base to levy
different tax burdens on the different sections of the society.
But the question, after selecting income as the basis for tax-
burden allocation, is that of fixing the rates of taxation: should
it (rate) increase with increase in income, or should it remain
constant or should it decrease with increase in income?
Depending upon these we can distinguish between progressive
taxes, proportional taxes and regressive taxes:
Progressive taxes
Proportional taxes
Regressive taxes
Sometimes a distinction is made between progressive taxes

and digressive taxes. Whereas in case of progressive taxes,
marginal tax rates (MTR) increase with increase in income. In
case of digressive taxes, marginal rates of tax do not increase as
steeply, they can be constant or even decreasing as is clear from
Table 6.1.
Table 6.1
Level of Income (Rs.) Progressive Taxes Digressive Taxes
Rates of Tax MTR Rates of Tax MTR Rates of Tax MTR

Less than 1 lakh 10% — 10% — 10% —
1-2 lakh 15% 5% 15% 5% 11% 1%
2-3 lakh 21% 6% 18% 3% 12% 1%
3-4 lakh 30% 9% 20% 2% 13% 1%
4-5 lakh 40% 10% 21% 1% 14% 1%
And so on
Sometimes we may have different marginal rates within the

same tax structure.
Critical Evaluation
Of all these three types of taxes, a choice is always between
proportional and progressive taxes because proportional tax
TAXATION 203
structure carries the same advantages as those of regressive taxes.

Therefore, if a choice is to be made between proportional and
regressive taxes, the government will prefer the former, because
they will fetch more revenue.
Merits of Proportional Taxes

1. They do not alter the relative position of taxpayers.
2. They are simple and not arbitrary.
3. Willing to work is not adversely affected.
4. There may be lesser tendency of tax evasion.
5. Canon of equality (interpreted in terms of proportion of
their respective abilities, i.e. horizontal equality) is fulfilled by
proportional taxes.
6. Canon of expediency, which is vital in democratic
countries, is also fulfilled. Government can easily impose such
taxes. They are not opposed by the people.
Demerits
1. It may fail to provide enough sources to the government.
Tax revenue increases less rapidly than in case of progressive
taxes. Hence, canon of productivity may not be fulfilled.
2. If we believe that marginal utility of money decreases
with increase in income than proportional taxes cannot be
equitable.
3. Tax revenue is usually less elastic. Because if the
government requires more revenue than all sections of the society
will have to be taxed at the same rate. If poor people are already
taxed to the maximum, then rich people will have to be taxed
at higher rates, i.e. there may not be a way out from progressive
taxes.
4. We cannot achieve equality in the distribution of income
through proportional taxes.
5. They are less economical than progressive taxes.
6. They fail to achieve the objective of stability and growth.
Merits of Progressive Taxes
1. They are more productive, buoyant and elastic. This is
because government revenue automatically increases with
increase in income. And many a times no change in tax structure

may be required to meet the growing needs of the government.
2. To reduce inequalities in the distribution of income,
progressive taxes are the only alternatives.
3. Canon of economy is also achievable through progressive
taxes because they are economical in the sense that cost of tax
collection is less in their case.
4. Direct taxes distribute the burden of tax more equitably.
Principle of equi-marginal sacrifice or minimum aggregate
sacrifice is achieved through progressive taxes. To achieve vertical
equity also progressive taxes are the only alternatives.
5. For promoting stability and growth progressive taxes
are preferable because during inflation tax revenue would
automatically increase and this will curtail the effective demand.
Similarly during deflation tax revenue automatically decreases,
which will increase the disposable income.
6. To achieve certain social objectives like discouraging the
consumption of undesirable commodities like intoxicants,
progressive taxes may be more desirable.
7. Assuming demand for income is inelastic progressive taxes
may compel people to work more, i.e. incentives to work, save
and invest may not be adversely effected by progressive taxes.
8. The criticism that proportional taxes are simpler whereas
progressive taxes are complicated (because tax rates vary with
variations in income) can be met by making progressive tax
system simple as it is now, i.e. 10 per cent, 20 per cent, and
30 per cent.
Demerits of Progressive Taxes
1. They are entirely arbitrary because they are based on the
assumption that marginal utility of money is declining. But
marginal utility being subjective is not measurable.
2. The assumption that marginal utility of money is declining
may not be true. Sometimes marginal utility of money increases
with increase in income because better-off sections of the society
are able to allocate resources more rationally. Sometimes
TAXATION 205
marginal utility of money may be constant and equal for all the
taxpayers.
3. Progressive taxes may adversely affect the incentive to
work, save and invest. This will adversely affect capital formation
in underdeveloped countries.
4. They punish hard work and reward extravagance and
idleness.
5. In their case there is a greater danger of tax evasion.
6. They are less expedient because people oppose the
imposition of progressive taxes.
To conclude we can say that generally progressive taxes
are preferred to proportional taxes because of their inherent
characteristics to achieve stability, reduce inequality and
productivity. But as they adversely affect incentives to work,
save and invest, rates of taxation should not be very steep, say
97.5 per cent as we had earlier in our income tax structure.
However, it may be difficult to introduce progressiveness in
indirect taxation. So here proportional taxes are inevitable. If
possible, progression should be introduced here also, i.e.
commodities consumed by the richer sections of the society
should be taxed at higher rates.
Ad-Valorem and Specific Taxes
Sometimes a distinction is made between ad-valorem and
specific taxes depending upon the fact that whether taxes are
based on the basis of the value/price of the commodity or on
the basis of its physical measure like weight, length, etc. If a tax
is levied on the basis of the value of commodity or goods or
service it is called ad-valorem. But if the tax is levied on the
basis of a physical measure, e.g. weight of the commodity or on
some external measures (say per unit), per meter, per kg, per
litre, etc., it will be called specific taxes.
Merits of Specific Taxes
1. They are easy to administer. They fulfil the canons of
expediency, simplicity and convenience.
2. Since they are fixed, unlike ad-valorem taxes, they do not

add to inflation. During inflation value of commodities goes on
increasing, so do the ad-valorem taxes. This leads to higher
values and hence ad-valorem taxes also increase. Thus, there is
a vicious circle.
3. They fulfil the canon of certainty because quantities on
the basis of which tax is levied, are also certain. They are not
subjective and, therefore, may not be arbitrary like value of the
commodities.
4. They are more expedient to collect than the ad-valorem
taxes.
5. It may be difficult to evade the specific taxes, as people
may not be able to conceal the weight/measure of the commodity.
Demerits of Specific Taxes

1. They are less productive and less elastic because whereas
the value of the commodities goes up during inflation, so will
be ad-valorem taxes, specific taxes will remain static.
2. They are regressive and hence inequitable because the
rate of tax is the same irrespective of the value of the
commodities. In order to make them progressive we can assign
value to the commodities according to their size, e.g. refrigerators,
television sets, etc. However, that would mean that we are putting
value to the commodities in an indirect way.
3. They are also less economical during the period of rising
prices when value of the commodities and hence tax thereon
would also increase.
Merits of Ad-valorem Taxes
1. They are highly productive and elastic. As prices increase
revenue from them will also increase.
2. They are economical.
3. To achieve equity ad-valorem taxes are most suitable
than specific taxes because they can be made progressive.
Demerits of Ad-valorem Taxes

1. They are difficult to administer. Valuation of commodities
may be arbitrary and not simple.
TAXATION 207
2. Though generally it is considered that ad-valorem taxes

add to inflation, yet this point has been challenged. It is said
that only in case of cost-push inflation that ad-valorem taxes
are inflationary. In case of demand-pull inflation, ad-valorem
taxes by increasing the price of the commodities would lead to
fall in demand.
3. They are arbitrary because values are always subjective
and hence they do not fulfil the canon of certainty.
4. Sometimes it may be very inconvenient to ascertain the
value of the commodities and hence the canon of convenience
may also not be achieved. And there may be efforts to conceal
the value of the commodity and hence tax evasion.
Thus, we can conclude that as the economy develops specific
taxes are substituted by ad-valorem taxes. L.K. Jha Committee
on Indirect Taxes (Indirect Taxation Enquiry Committee Report,
1978) has also suggested that as far as possible we should have
ad-valorem taxes instead of specific taxes. This will increase
revenue elasticity as well as provide a measure of stability in the
tax system.
TAXABLE CAPACITY
In a general sense taxable capacity means the limit to which
the state can impose taxation on a person or group of persons.
But to define taxable capacity in a precise sense, we must
distinguish between two concepts of taxable capacity:
1. Absolute taxable capacity.
2. Relative taxable capacity.
It is easy to define relative taxable capacity which is the
extent of tax burden that should be imposed on different persons
to finance a common expenditure. To define absolute taxable
capacity is so difficult that Dr. Dalton asserts that the phrase
taxable capacity should be banished from all serious discussion
of Public Finance.
It is indeed useful and necessary for a state to know to what
extent its people could bear taxation, just as it is desirable to
find out in what proportion a common fiscal burden should be
shared between different states to finance expenditure undertaken

for certain common purposes. Amongst others, Sir Josiah Stamp
and Professor Findlay Shirras consider these concepts to be very
useful in the theory of Public Finance. Professor Adarkar says:
“In federal finance, a satisfactory analysis of the concept is
essential to the solution of the various problems connected with
the financial relations between the states and federal government
and with the granting of subsidies and subventions”,1 though
terminologically he occupies a completely opposite position and
rejects both the concepts. He goes on to add that in a federal
system comparison has to be made between the different
contributors in order not only to allocate the burdens of taxation
but also to facilitate...corrective transferences. He further adds
that rough justice indeed may be done by levying a higher money
burden of taxation on richer in a federal or a unitary state, and
which has to be achieved between different individuals and not
between different localities. “When equity between different
individuals is achieved there is equity between different families,
localities and States automatically. When, however, equity
between different localities is achieved there may still be inequity
between individuals, unless such a scheme of taxation is framed
which achieves equity between taxpayers also.” The entire
scheme 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. Similarly, equity between persons with dissimilar
abilities has to be achieved irrespective of the state in which
they reside.
When the British Association asked in 1921, ‘How is the
taxable capacity of a nation ascertained?’ Edwin Cannan replied
‘No how’, Dr. Dalton maintains that, “The thing is an illusion,
Cannan’s ‘No how’ is the last word”, but concludes that,
“Relative taxable capacity is a reality, which can, however, be
equally, well expressed in other terms while absolute taxable
capacity is a myth, which is apt to endanger grave errors. In the
interest of clear thinking, it would be well that the phrase ‘taxable
capacity’ should be banished from all serious discussions of
public finance”. Professor Adarkar criticizes Dr. Dalton for
TAXATION 209
accepting the concept of relative taxable capacity and says,

“True, relatives are often regarded as unimpeachable where
absolutes are dubious, but if the latter themselves are non-
existent, the former must become a dubiety.”2 With such
divergent views it is necessary to examine these controversial
concepts carefully.
However, fiscal authorities like Sir Josiah Stamp and
Professor Findlay Shirras consider the concept of taxable capacity
to be very useful in theory of Public Finance and they have put
forwarded various definitions particularly those of absolute
taxable capacity.
Sir Josiah Stamp defines absolute taxable capacity as the
maximum amount which the citizens of a country can contribute
towards the expenses of public authorities “without having
a really unhappy and downtrodden existence and without
dislocating the economic organization too much”. Although
this definition has some precision, yet we cannot quantify the
concepts like unhappiness and downtrodden existence and
dislocation of economic organization. Happiness or unhappiness
is a subjective phenomenon and hence cannot be measured.
Further, it does not depend only upon economic factors like tax
there are many other factors which have profound influence on
the state of mind of a person which causes happiness. One may
feel more happy even while paying higher amount of tax if he
feels that money is properly used. On other occasions he may
feel sad even while paying lower amount of taxes. Similarly,
downtrodden existence may be caused by other forces than tax.
Then what is meant by ‘dislocation of economic organization’.
Economic organization, i.e. production pattern, consumption
pattern, distribution of income, etc., depends more on other
factors than the tax. Tax is only a small element which may or
may not have any influence on the above factors. Hence, in
practice, it is difficult to put this definition in use.
Professor Shirras has tried to clarify the above definition by
asserting that “It is the optimum taxability of a nation, the
maximum amount of taxation that can be raised and spent to
produce the maximum of economic welfare in that community.”
Here, there seems to be a confusion between optimum and

maximum. Tax limit is optimum when the marginal utility of
public expenditure is equal to marginal disutility of taxation.
This is dictated by the principle of Public Finance. Thus, the
concept of absolute taxable capacity is another name for the
principle of Public Finance, and is obviously not proper.
Secondly, if it denotes the maximum amount of taxation which
can be raised, one is likely to cross the limit of optimum taxation.
What is maximum may not be optimum, and what is optimum
may not be maximum. To remove this confusion, Shirras has
given another definition and says: “Briefly, absolute taxable
capacity is the limit of squeeze-ability.” But it is difficult to
know what is meant by squeeze-ability. Following Professor
R.N. Bhargava if we take the analogy of an orange or lemon,
this limit would mean that the last drop of juice is extracted
and not a single drop remains. This would suggest that taxation
should be carried to that limit where not even a penny remains
with the taxpayers. In other words, it means the total national
income because this is the limit of what can be collected by the
state. Absolute taxable capacity, thus becomes another name
for the national income and hence a superfluous concept. If
taxation is carried to that limit people will die. But along with
the right to taxation we should also consider state’s obligation
to spend. If state provides all goods and services, i.e. food,
clothing, education, housing and other amenities of life so that
there is no need of private expenditure, government can tax up
to 100 per cent of the income of the people. Obviously, taxable
capacity would be hundred per cent. Secondly, such a scheme
of taxation would not maximize social welfare because then we
would have exceeded the optimum which is dictated by the
principle of Public Finance.
Shirras adds another definition. It (absolute taxable capacity)
is the surplus of production over the minimum of consumption
required to maintain that volume of production per head of the
population keeping the essential standard of living remaining
unchanged over a number of years. There are two basic
objections against this approach. Firstly, total production in a
TAXATION 211
country means national income, whereas minimum consumption

implies that there is no further possibility of reducing
expenditure. The difference between the two is the maximum
capacity of a nation to save. It is the annual social savings in the
Keynesian sense. Now to maximize social welfare sometimes
adjustments have to be made between savings and consumption.
If the state taxes up to the limit of maximum capacity to save,
the balance between savings and consumption will be distorted
until and unless the state spends the amount equivalent to
national capacity to save just to maintain the level of effective
demand. Thus, there is no sanctity in taxing a nation only up to
the limit of maximum capacity to save. Sometimes, the state has
to spend more than the maximum capacity to save. On occasions
the state may have to tax more or less. Another objection levied
against this definition is about the standard of living which has
to remain unchanged over a number of years, i.e. Public Finance
should not alter the standard of living or distribution of income.
This is the very negation of the subject. Government performs
various activities to promote the general social welfare or to
raise the standard of living. It is true that in doing so the standard
of living of one section (rich people) may be lowered, yet there
is always a net increase in the aggregate standard of living.
Otherwise there will be no need to extend the field of Public
Finance.
From the above discussion it is clear that the concept of
absolute taxable capacity is very vague. In the words of Dalton,
it is a dim and confused concept. Every time one tries to explain
it, one is likely to give it a different interpretation. The main
difficulty seems to arise from the fact that we have confined
our analysis to taxation only and have not considered the
corresponding benefits of public expenditure. In order to decide
how much should the state tax, we have to consider how much
should it spend? The two are inter-related and absolute taxable
capacity is a problem of Public Finance, not of taxation alone.
The state should go on taxing and spending so long as the
marginal benefits of public expenditure are greater than the
marginal sacrifices of taxation. This is clear from Fig. 6.2.
Fig. 6.2: Amount of Taxation and Public Expenditure
X-axis shows the amount of taxation and public expenditure,

while Y-axis shows benefits from public expenditure and
sacrifices imposed by taxation. MB is a curve showing margin
benefits from public expenditure and MS shows marginal sacrifice
of taxation. Obviously while the former is slopping downward,
the latter rises from left to right. The optimum of taxation is the
point where the two curves intersect, i.e. OM. Here the state
should stop because social welfare is maximum. The absolute
limit of taxation can be placed which the state should impose.
Thus, theoretically, one can identify the amount of absolute
taxable capacity which is indicated by the principle of Public
Finance and should be called optimum of Public Finance. The
absolute taxable capacity or simply taxable capacity depends
on a number of factors, viz.:
1. Size of national income.
2. Size and rate of growth of population.
3. Distribution of income and wealth.
4. Pattern of taxation.
5. Stability of income.
6. Nature and structure of public expenditure.
TAXATION 213
7. Psychology of the taxpayers.

8. Standard of living of the people.
9. Administrative efficiency.
10. Economic situation.
11. Political conditions.
12. Volume of international trade.
13. Monetization of the economy.
But before we discuss these factors, reference may be made
of relative taxable capacity.
Relative Taxable Capacity
Relative taxable capacity indicates how a common
expenditure should be financed, i.e. in what proportion should
the different parties to that common expenditure bear the cost
of financing it. This implies as to how the burden of taxation
should be distributed within a community. If we consider the
apportionment of tax burdens between the different taxpayers
in a state, then the correct and scientific way of raising taxes
from them is in accordance with the principle of taxation, i.e.
taxes should be so levied that marginal sacrifice should be the
same for all the taxpayers. Relative taxable capacity is their
relative ability to pay taxes, which is indicated by the principle
of taxation. Similarly, when we are considering several nations,
then their relative taxable capacity to finance a common
expenditure is also determined by their respective abilities, which
means that a common expenditure should be financed by them
in such a manner that their marginal sacrifices are equal. It is
only then that the aggregate sacrifice of these communities is
the least.
Thus, we conclude that both absolute and relative taxable
capacity can be given an intelligible meaning. As explained above,
absolute taxable is just another name for “optimum taxation
and its limit is indicated by the principle of public finance. On
the other hand, relative taxable capacity means that tax burden
on different individuals be imposed according to the principle
of taxation”.3
Factors Determining Taxable Capacity
Size of National Income

Taxable capacity of a country is positively related to its size
of national income. Higher the level of national income, higher
will be the taxable capacity. But the size of national income
alone is not the determining factor of taxable capacity. As is
clear from the following analysis, taxable capacity depends more
on other factors.
Size and Rate of Population Growth
Usually taxable capacity is negatively correlated with the
size of population. Given the size of national income, a larger
size of population means a lower per capita income and hence
greater propensity to consume or low taxable capacity. Again,
if the population grows at a higher rate than national income
the taxable capacity goes on declining.
Distribution of Income and Wealth
The distribution of income and wealth influences the taxable
capacity. It is usually believed that greater equality of income
or wealth means greater consumption and hence taxable capacity
declines. Therefore, greater inequality in the distribution of
income and wealth increases taxable capacity. But against this
argument it is pointed out that if there is equality in the
distribution of income and wealth, then government may not
require huge amount of tax revenue because no public
expenditure is required to remove inequalities.
Pattern of Taxation
Simple tax structure with wider coverage and efficiency of
tax administration may enable to collect a higher amount of
tax. It may be possible to raise a greater revenue through a
well-planned tax structure than through the ill-planned one. If
taxes are simple and elastic, tax administration is honest people
will readily pay the taxes. According to Eckstein, one of the
reasons for the higher tax-income ratio in the USA (28%) is
that the taxes are simple and the tax administration is not
corrupt. But if there are loopholes in tax system and tax
TAXATION 215
administration is not honest, people may feel that they are

deliberately discriminated and the taxable capacity will be low.
Stability of Income
Stability of income also influences taxable capacity. If
income fluctuates from year to year as is the case with less
developed agricultural countries, taxable capacity would be low.
But in industrially developed advanced countries income is
comparatively stable over the period and hence it is possible to
raise a greater sum of tax revenue.
Nature and Structure of Public Expenditure
Pattern of public expenditure also influences the taxable
capacity. If tax revenue is spent on economic and social overheads
which facilitate the increase of national income, taxable capacity
will automatically increase. However, if tax revenue is spent for
non-productive purposes, taxable capacity may rather decline.
Similarly, if tax revenue is spent to pay off external public debt
the resources would be transferred to the other countries and
hence taxable capacity will decline. But if the same tax revenue
is spent to pay off the internal public debt, the disposable income
in the country will increase which will increase the taxable
capacity.
Psychology of the Taxpayers
Psychology of the taxpayers also goes a long way to
determine the taxable capacity. If they feel that they are being
oppressed and harassed, this will kill their initiative to pay the
taxes. If they feel that a proper use of their tax contribution is
not being made, they may try to avoid the tax. Further as direct
tax payment always appears to be more burdensome, a greater
amount of tax revenue may be collected through indirect taxes
as happened in India. Besides, a greater amount of taxation can
be collected on patriotic and sentimental grounds.
Standard of Living or Consumption Expenditure of the People
Apart from income, consumption expenditure is also said
to be an important determining factor of taxable capacity.
Sometimes, people withdraw from past savings or eat away
their capital stock in order to maintain their standard of living.

So in these cases even if the current income is low, yet
consumption expenditure is very high and this shows their
potential taxable capacity. It is because of this that Professor
Kaldor recommended expenditure tax instead of income tax in
India.
Efficiency of Tax Administration
Taxable capacity is also influenced by the efficiency of tax
administration. If tax collecting machinery is efficient and the
tax burden is distributed without any discrimination, this may
encourage people to pay their tax obligations. On the contrary,
if tax machinery is inefficient and corrupt, and people observe
that the persons in equal economic circumstances pay unequally
(there is horizontal inequity), they will also try to avoid tax
payment and hence taxable capacity may be low.
Volume of International Trade
Volume of international trade also determines the taxable
capacity. A greater volume of imports and exports enables a
country to levy more custom duties and hence taxable capacity
would be more. Moreover, a greater volume of foreign trade
means commercialization of production (to face international
competition) and production on commercial basis facilitates the
imposition of certain direct taxes, viz. corporation tax, profit
tax, etc., and indirect taxes, viz. sales tax, excise duty, etc.
Monetization of the Economy
Monetization of the economy has a positive impact on
taxable capacity. A greater volume of barter system means that
goods and services are not brought into the market for exchange
and hence there would be less scope to levy taxes on such goods.
This is perhaps the major reason of low taxable capacity in
countries like India.
Economic Situation
Economic phases of prosperity and depression also determine
the taxable capacity. During boom when there is all-round
prosperity and businessmen make huge profits, taxable capacity
TAXATION 217
increases. Contrary to this during depression when there is

all-round miseries and people’s income declines, taxable capacity
also declines. Pure inflation also leads to the fall in real income
and the taxable capacity generally falls.
Political Conditions
Political conditions also determine taxable capacity. If
such conditions are stable and planned economic development
is a success people may be willing to pay their tax obligation.
If political conditions are unstable and planned economic
development is also not successful, people may feel that the
money they pay to the government is not properly used and
hence they may resort to tax evasion.
To sum up taxable capacity is the surplus of production
over minimum consumption. Thus, taxable capacity depends as
much on income as on consumption and the psychology of the
consumer and political conditions. As these conditions do not
remain stable, so taxable capacity is also not fixed for all times
to come.
Limits of Taxable Capacity
There is no unanimity of opinion regarding the limits of
taxable capacity and different views have been expressed
regarding the symptoms of taxable capacity having crossed.
Sir Josiah Stamp mentions two symptoms in this connection:
(a) adverse effect on total production, and (b) adverse effect on
total revenue yield. But they cannot be regarded as the reliable
tests because there are many factors which influence production
and revenue, and taxation is just one of them. For example,
level of production or revenue yield may fall as a result of
natural factors such as failure of crops, earthquakes, floods,
etc., or due to political factors or instability in the country.
According to Ellinger, “The limits would be reached when
so much is taken out of the taxpayer’s pockets that the incentive
to produce is reduced and when insufficient remains to produce
the necessary capital.” This view about the limit of taxable
capacity is also not satisfactory. Firstly, there are many factors
such as political, social and economic which influence incentives
to produce and taxation is only one of them. Secondly, the use

of the term ‘necessary capital’ is vague and cannot be
quantitatively expressed. Thirdly, Ellinger does not take into
consideration the beneficial effects of public expenditure on
production.
Prof. Colin Clark has pointed out that for Britain and
for most other countries the maximum taxable capacity is
25 per cent of national production. According to him, if taxation
exceeds this limit, for a couple of years, a devaluation of the
currency and a rise in prices will occur and this can be checked
only if the ratio of taxation to national income is again below
this level. He assigns three reasons for this phenomenon:
(i) When both employers and wage-earners are so heavily taxed,
it adversely affects their incentives to work, save and investment
and hence production naturally slows down. (ii) The existence
of very high taxation rates makes expenditure extravagantly
on entertainment, furnishing, travelling, advertising, etc. and
(iii) The imposition of such a high taxation has its political
effects also. The legislators start thinking that inflation is a
“lesser evil than the enormous taxation which they are asked to
impose, and so they become tolerant of all sorts of measures,…all
tending in the direction of increasing prices”.
It may be pointed out here that the limit of 25 per cent
cannot be a valid limit for all countries under all circumstances.
In fact, it may vary from time to time in the same country and
from country to country at the same time. Moreover, in
developing economy there need not be such a fixed limit. Besides,
Clark seems to have ignored the beneficial effects of public
expenditure. The disincentive effects of a high level of taxation
may be reduced through wise expenditure by the government.
Then it is possible to collect higher amount of taxation with
simple tax structure than with complicated tax structure. Hence,
in the words of Dr. Dalton, “It is quite impossible to fix any
definite sum, or any definite proportion of a community’s
income, which could be said to represent the limits of its taxable
capacity at any particular time.”4 The fact is that taxable capacity
in whatever way we may define, is not a rigid and constant
TAXATION 219
entity. It is a moving point and is bound to change through

saving, investment, production pattern, economic growth, etc.
It may also be mentioned that some economists have defined
taxable capacity as the limit beyond which people may start
borrowing. But it must be remembered that people borrow not
only for consumption purposes but also for investment and other
needs. Further, borrowing is a function more of income than
tax.
Measurement or Estimation of Taxable Capacity
The pioneering study of estimation of relative taxable
capacity in India is that of Ved P. Gandhi.5 He has done this
with respect to agricultural (A) and non-agricultural (N) sector
separately. He has worked out the minimum consumption
requirements assuming that “the 30th percentile of the
population in the two sectors” had no taxable capacity. It had
only “subsistence or below subsistence income”. Since
considerable data have been generated after this study,
particularly relating to the subsistence requirements, above
method of Gandhi could be modified.
Shetty has also worked out the absolute and relative taxable
capacity of the farm and non-farm sectors. His estimates appear
to be more objective. He has defined the absolute taxable capacity
as follows:
t = (Y – Cm) – I = ( S – I )
where t, Y, Cm, S and I stand for taxable capacity, income,
minimum consumption requirements, potential surplus and
allowance for minimum investment respectively. All these
variables were in per capita terms. He applied this approach
and calculated the taxable capacity and potential surplus of the
two sectors. However, he observed that this approach implies
that the average minimum consumption requirements per person
are uniformly applicable to the entire population. The aggregate
potential surplus of a sector, therefore, took the following
form:
S = (Y – Cm)P
= YP – CmP
where S is the aggregate potential surplus, P is the aggregate

sectoral population and Y and Cm are defined as above.
In reality, there might be a considerable number of
households in each sector whose actual consumption was less
than the estimated minimum consumption requirements. Thus,
the potential surplus might be concentrated in the remaining
households. Shetty further observes that “the consumption deficit
of the former is not compensated by the latter households.
Therefore, the equation of aggregate potential surplus should
get modified as:
S = Y – (CP1 + CmP2)
where Y represents aggregate sectoral income, C the actual
per capita consumption of deficit households with population
P1 and Cm the estimated per capita minimum consumption
requirements for the surplus households with population P2”.
Shetty has also calculated the per capita relative taxable
capacity of the two sectors, which he defined as:
tb
t=
Ta
where tb and Ta are per capita taxable capacities of the non-
farm and farm sector respectively.
Taxable Capacity in India
As already stated, taxation potential of any country depends
on number of factors like per capita income, degree of inequality
in the distribution of income and wealth, effects of taxation,
impact of public expenditure on economic growth, stability and
distribution of income, readiness for sacrifice and efficiency of
tax collecting machinery, etc. Examining from this angle, India,
being underdeveloped country, possesses low taxable capacity.
There is not much improvement in the net per capita income
since long. In India, the combined tax-income ratio of states
and the Union is around 15 per cent while in well advanced
countries like UK or Germany, etc., according to Colin Clark, it
is between 25 to 40 per cent. This means that India has not
TAXATION 221
exploited its tax potentials and there is ample scope for enhancing
the tax yields by deepening and broadening the tax system
through rationalisation of tax rates and re-organisation of tax
structure.
Causes of Low Taxable Capacity
(i) Low Standard of Living

The foremost cause is that majority of the people in India
are having low per capita income. About 30 per cent of
population is living below the poverty line. Under these
circumstances, there is very dim scope of additional taxation. If
taxation is raised on these sections of people, it would adversely
affect their consumption which in turn results in widespread of
miseries and sufferings. Their ability to work will be adversely
affected. In short, low level of income is responsible for low
standard of living and hence low tax revenue.
(ii) Non-monetised Sector
Another factor for the low taxable capacity is the existence
of non-monetised sector, which involves barter exchange. A
substantial part of the production does not come into the market
which is consumed by the farmers themselves or is exchanged
for goods. Wages are also paid in kind. Even in urban areas
goods produced in household sector are not often marketed.
According to one estimate, about 35 per cent of the consumption
is out of the purview of money economy. Such non-cash
transactions (non-monetised sector) are not subject to taxes like
sales tax and it again restricts the taxable capacity of the people
to lower level.
(iii) Rising Population
Rising population also adversely affects the taxable capacity.
The main cause of this increase is the fall in death rate, better
health conditions, effective control of epidemics, general
improvements in health standard, etc. The rapid increase in
population reduces the per capita income of the individuals thus,
lowers the taxable capacity.
(iv) Low Volume of International Trade

Foreign trade offers a good scope for commodity taxation
but unfortunately in India, proportion of foreign trade to national
income is small as compared to advanced countries. The ratio
of foreign trade to NSDP in India is hardly one per cent.
Therefore, it limits the scope of taxation because the commercial
sector is small and tax revenue from this sector cannot be
enhanced much.
(v) Other Reasons
Other reasons like lack of banking facilities, better facilities
of education and training are also responsible to lower the tax
revenue. Tax administration is corrupt and tax evasion is a
common feature. Moreover, Indian economy is predominated
by small-scale producers and manufactures who have low taxable
capacity.
All said and done the taxable capacity in India, or for that
matter in any other country is not static. It has been increasing
particularly in the post-reform period. Tax revenue from old
taxes is increasing and new taxes (like service tax) are being
imposed.
Has India Reached Its Taxable Capacity?
Now a very legitimate question arises whether India has
reached its taxable capacity or there is any possibility to raise
its limit. The Taxation Enquiry Commission (1953-54) has
rightly observed that taxable capacity was reached to the limit
before independence. But now circumstances have changed
altogether. In fact, taxable capacity depends upon the nature of
public expenditure, which is now development-oriented. It was
mentioned by the Taxation Enquiry Commission that if proceeds
were utilized for economic development and expansion of infra-
structure, the taxable capacity would be greater. Contrary to
this, if taxes are used on unproductive purposes, the taxable
capacity will automatically decline. However, since we embarked
upon the path of economic development, the taxable capacity
in the country has been increasing because of the following
factors:
TAXATION 223
(i) The use of public expenditure is now mostly for the

economic development, and on the creation of economic
and social infrastructure.
(ii) National income of the country has been rising
continuously. As a result, people can afford to pay
more taxes.
(iii) Since disparities in income and wealth are rising, to
reduce them more progressive taxes can be imposed.
(iv) Though the growth rate of population is higher as
compared to advanced countries, yet it is still lower
than the growth rate of national income. This is adding
to the per capita income of the people, which leads to
higher purchasing power of income and taxable
capacity.
(v) The scope of money economy is also increasing as the
non-monetized sector is being converted into monetized
sector. Therefore, more taxes on market transactions
and income can be levied.
(vi) Post-liberalization and economic reforms have opened
new scope for levying diverse taxes. Besides this, the
nature and structure of the economy has also been
rapidly changing enabling a wide tax structure.
To conclude, we can say that these factors lead to still more
scope for higher taxes. New taxes can be imposed and rates of
existing taxes can be rationalized to exploit the increasing taxable
capacity. In short, the taxable capacity in India has not reached
the limit. The phenomenal growth of the economy and rise in
per capita income has raised the hope for additional taxation in
the country. The tax-income ratio for both Central and State’s
taxes is increasing and with newer taxes (like service tax) and
widening the tax base it is further expected to rise.
THEORY OF TAX INCIDENCE

Alternative Concepts
The importance of the concept of incidence of taxation was
realized as early as 1899 when two out of fifteen questions
relating to the reforms of local taxation in England were

concerned with it.6 One of these questions was related to
determining the real incidence of taxation as distinguished from
its primary or apparent incidence. The other dealt with the real
incidence in the case of: (a) inherited house duty, (b) rates levied
on houses and trade premises, (c) rates levied on agricultural
land, (d) taxes on transfer of property, (e) taxes on trade and
profits, and (f) death duties.
According to Seligman, a pioneer in the field of tax shifting
and incidence, “The problem of the incidence of taxation is one
of the most neglected, as it is one of the most complicated,
subjects in economic science…. Yet no topic in public finance is
more important; for in every system of taxation, the cardinal
point is its influence on the community. Without a correct
analysis of the incidence of a tax, no proper opinion can be
formed as its actual effect or justice.”7
In traditional economic theory the imposition of tax has
two types of effect: impact and incidence. Incidence involves
shifting of tax, in part or full. The impact is generally understood
to refer to the immediate result of a tax and is said to fall on the
person who pays it in the first instance while the incidence is
usually used to indicate the point where the final burden of the
tax ultimately stays put. Musgrave and Musgrave have called
these terms as ‘statutory incidence’ and ‘economic incidence’,
the former indicating the impact point and the latter final resting
point.8
Hugh Dalton has stated that the problem of incidence is
just a problem of finding on whom the direct money burden of
a tax falls.9 According to Dalton, when a tax is imposed two
types of burden are involved: (i) money burden (ii) real burden.
Money burden and real burden can be further divided as direct
money burden and indirect money burden: and direct real burden
and indirect real burden. The concept of tax incidence relates to
‘direct money burden’, which is equal to the amount of tax or
yields of tax in money terms. All other concepts fall in the
wider realm of effects of taxation.
Ursula Hicks has observed that the word ‘incidence’ is used
in two senses, in social accounting sense and economic working
TAXATION 225
sense.10 In the first sense, the term ‘burden’ is also used. But
according to Ursula Hicks, the term ‘burden’ is confusing, since
it is likely to be employed in a much wider and looser sense.
Therefore, she prefers the term ‘formal incidence’ to ‘burden’ as
a social accounting concept, and the term ‘effective incidence’
as an analytical concept.
Expatiating on the concept of ‘formal incidence’, which is
the ‘king-pin’11 of many an estimation, Hicks writes that in
economics, we are concerned with two concepts of the falling
of taxes on taxpayers, or as it is called, the incidence of taxes.
She explains the concepts of incidence as follows: “In the first
place, there is the statistical calculation of the way in which the
revenue collected from any particular tax over a given period
(usually a year), namely, the difference between the factor cost
and the market price of the product on which the tax is assessed,
is distributed between the citizens (for convenience grouped
according to their income levels); or, alternatively, the proportion
of people’s incomes which goes not to provide the incomes of
those who furnish them with goods and services, but is paid
over to governing bodies to finance collective satisfactions. The
result of this calculation may be called the Formal Incidence of
the tax….”12
She further observes that “Important as it is, however, the
calculation of formal incidence, tells us nothing directly of the
taxpayer’s reaction to a change of tax, and its consequences; it
is precisely with these questions in mind that the second concept
of incidence is concerned. In order to discover the full economic
consequences of a tax we have to draw and compare two
pictures—one of the economic set-up (distribution of consumer’s
wants and incomes, and allocation of factors), as it is with the
tax in question in operation; the other of a similar economic
set-up, but without the tax. It is convenient to call the difference
between these two pictures the Effective Incidence of the tax. It
will be seen that it must often be a very complicated picture;
and moreover, since both situations cannot exist together, one
of the pictures must be hypothetical, established by reasoning
and not by observation.”13
Musgrave divides tax effects into three groups: (a) resource

transfer; (b) output effects, and (c) distributional effects. He
uses the term ‘incidence’ only for the distribution effects of a
tax. Two of his important concepts of incidence used extensively
in the tax literature are: (i) absolute incidence, and (ii) differential
incidence. While in the former case, a comparison is made
between the actual income distribution and the one which would
prevail assuming there to be no taxes and/or expenditure, in the
latter a comparison is made with a situation where a specific
tax (or expenditure) is replaced by a different tax (or expenditure)
of the same real amount. The result is a ‘differential incidence’
estimate. The third type of incidence, ‘balanced budget incidence’,
traces the distributional change that results when taxes and
expenditures are increased or decreased by equal amounts.14
According to Mahler, “Initially, economists tended to limit
the problem of incidence to one ascertaining the effect of the
tax on the price of the taxed article—all other reactions to the
tax being classified as effects. Modern economists have tended
to consider the problem of incidence as encompassing the
distributional results of the tax. Thus, incidence is denied as the
pattern of the final distribution of the burden of the tax among
various income groups.”15
According to George Break, “Modern incidence theory
makes a basic distinction between the tax incidence on the
sources of income side of household budgets and incidence on
the uses-of-income side. Of fundamental importance is how the
burdens of different taxes are distributed vertically according to
family income.”16
Although to some “the concept of ‘incidence’ means too
many things to be of much use to either tax specialists or students
of general fiscal economics:”17, it must be noted that the concept
has come to stay and the “interest in the effect of the government
budget on income distribution has stimulated many researchers
to undertake tax and benefit incidence studies.”18
Thus, in the modern incidence analysis, it is now increasingly
realized that both tax and expenditure sides are to be studied to
have a correct and balanced view of budgetary impact on the
TAXATION 227
income distribution. “Usually now, the total redistributive effect

on individual or group real incomes that a tax occasion is called
simply its incidence.”19 “One should not really speak of tax
burdens and gains from government expenditures as if these
were separable identifiable concepts. Only their combined effects
can be observed and measured.”20 Musgrave and Musgrave have
also emphasized that “while taxes impose a burden, this is only
one side of the fiscal transaction. To obtain the total picture,
the expenditure side of the budget must be considered as well.”21
It should be noted that the term (incidence), if ever used in
the broadest sense, that is, in the sense of economic effects rather
than formal incidence, “It deals with all the (macro) economic
repercussions of a tax….”22 In other words, it is not then
“restricted to an investigation of who pays, either primarily or
ultimately, but is also concerned with the effects upon the
structure of demand, unemployment,…prices, etc.”23
In Daltonian sense, this refers to ‘direct money burden’.
Types of Shifting
According to Prof. Philip E. Taylor, tax is shifted in three
ways:
(1) Changes in commodity price.
(2) Changes in price of factor inputs.
(3) Changes in quality.
Economists speak of these directions of tax shifting as
forward, backward and a combination of the two. Forward
shifting—an important form of tax shifting is said to take place
when the producer of a good is able to shift the money burden
of the tax completely on to someone else, e.g. manufacturer to
wholesaler who in turn transfers it to retailer who ultimately
passes the burden to consumers. Backward shifting occurs when
a tax on the commodity is shifted back to the factors of
production. Suppose a tax is imposed on the wholesaler who
does not succeed to raise the price of his product (may be the
demand for the product is elastic). Then he will try to compel
the producer to accept the low price. The producer in turn may
reduce wages or pay less to other factors of production because
otherwise the demand for the product will be curtailed. Thus,

backward shifting takes place when the price of the commodity
which is taxed remains the same and the burden has to be borne
by the seller or the factors of production. Finally, a combination
of forward and backward shifting may take place when a
producer of a taxed commodity is able to pass on a part of the
money burden to consumers through a partial price rise and the
other part of the burden to the factors of production by
compelling them to accept low wages and other rewards. It is
also possible that the producer of the taxed commodity may
have to absorb part of the money burden.
Sometimes, the producer may conceal the shifting of a tax
by resorting to changes in quality or quantity of the commodity.
These days the producers go on reducing the weight or quality
of the commodity instead of raising the price of his product.
For example, the producers of toothpaste may reduce the
contents say from 100 gms to 95 gms, while apparently keeping
the price unchanged. Sometimes the producers may even lower
the quality of the product.
Factors Affecting Incidence of Taxation
Broadly speaking, shifting of a tax depends upon the nature
of demand and supply curves. If the demand for a product is
perfectly inelastic, whole of the incidence will fall on the buyers,
as they would not be able to curtail demand. If the demand
curve is perfectly elastic, the whole incidence will be on sellers.
Likewise if the supply curve is perfectly inelastic, seller will
have to bear the entire tax since they will not be able to curtail
production. When the supply curve is perfectly elastic, the whole
incidence will be on the buyers. In all other cases, it will be
shared between the buyers and sellers in the ratio of their
respective elasticities. In fact, the entire theory of incidence can
be explained in Fig. 6.3.
In this figure, DD is the demand curve of a commodity and
SS is the supply curve before it is taxed. Now the state imposes
a tax and collects it from the producers of the commodity. Let
S´S´ be the supply curve after the tax. The price rises to MN, the
increase in price being MP, they have to pay so much more. The
TAXATION 229
Fig. 6.3
incidence on the sellers is PQ, they get so much less. Total

incidence = MP+PQ, which is equal to the tax MQ. The
proportion of the tax, that is, shared between the buyers and
sellers can be expressed as a relationship between their respective
elasticities, as under:
Elasticity of demand Burden on seller
=
Elasticity of supply Burden on buyer
That is the incidence of a tax is divided between the buyers
and the sellers in the ratio of the elasticities of the supply and
demand. We can sum up the above analysis:
(1) If ed = , or es = 0, the entire burden of the tax will be
upon the sellers;
(2) If es = , or ed = 0, the entire burden of the tax will be
upon the buyers;
(3) If es = ed, the burden of the tax will be equally divided
between the buyers and sellers;
(4) If es > ed, the burden of the tax will be in higher
proportion upon the buyers than upon the sellers;
(5) If es < ed, the burden of tax will be in higher proportion

upon the sellers than upon the buyers.
So we conclude that es and ed are the two major factors
which influence incidence or shifting or taxation. Besides, the
following factors were also influenced the shifting of a tax:
1. Form of quoting the price
2. Rate of the Tax and Type of the Market
3. Availability of Substitutes
4. Geographical Coverage
5. Time allowed for tax shifting
6. General business conditions
7. Familiarity of the consumers with a particular set of
prices.
Form of Quoting the Price. If prices are quoted net of taxes
and after the bargaining is struck, tax (e.g. sales tax) is added
later, this breaks the resistance of buyers who will have to pay
the entire amount of tax. If prices are quoted inclusive of tax,
and the buyer succeeds in lowering the price, a part of the tax
will have to be borne by the seller.
Rate of Tax and Type of the Market. The shifting of a tax
depends to a great extent upon the tax rate. If the tax rate is
low and the market is competitive, the sellers may absorb the
whole amount of the tax in order to maintain goodwill of the
buyers. This is unlikely the case if the tax rate is very high and
the market is imperfect.
Availability of Substitutes. It is difficult to shift the burden
of tax on to buyers in case of commodities having close
substitutes. Because in this case buyers will shift to the substitutes.
But it may be noted that in case of commodity having close
substitutes, the elasticity of demand is also higher. Further, if all
the substitutes are taxed, then the pattern of shifting will depend
on the elasticity of demand for the group of these commodities
vis-à-vis their elasticity of supply.
Geographical Coverage. If the tax is imposed on goods
bought and sold in a particular locality, buyers will resist any
increase in price, because untaxed goods will be available in the
TAXATION 231
neighbouring areas. On the other hand, state taxes are easily

shifted because buyers cannot purchase untaxed goods from the
adjoining states, which may be difficult to import. Still more
easy is to shift the central taxes on commodities like Union
excise duty which is imposed in the entire country.
Time Allowed for Tax Shifting. Time horizon is another
important factor which effects the shifting of the tax. The shorter
the period of time, the lesser is the scope of adjusting the supply
because of the non-possibility of changing the fixed factors of
production. Therefore, the supply curve in the short period will
be less elastic and hence a greater part of the tax burden will be
on the seller. But in the long run supply curve is relatively elastic
and, therefore, the tax is likely to be shifted on to the buyers.
General Economic Conditions. In periods of rising prices
and prosperity, when there is all-round increase in income and
employment, shifting of taxes is possible because tax along with
other costs of production can be charged from the buyers. But
during the period of depression, commodity taxes are difficult
to shift because of falling demand and all-round recession.
Familiarity of Consumers with a Particular Set of Prices. If
the consumers are familiar with a particular price of commodity,
any imposition of the tax may be difficult to shift, for example,
restaurant charges. People know that a cup of tea or coffee
costs this much. Therefore, it may be difficult for the seller to
shift the tax burden and charge higher price. However, the only
possibility to shift the tax is that the seller may reduce the size
or quality of the product so that the consumers continue to
associate that product with the same price. This is what the
producers are doing these days.
Criticism of the Traditional Theory and the New Concept of
Incidence
The theory of tax incidence as explained above, commonly
known as traditional concept or demand and supply approach
of tax incidence does not stand the test of criticism. The above
theory has been criticized on the following grounds:
1. The theory is based on the demand and supply curves.
But a tax is only one of the many factors that will affect the
supply of a commodity. The new supply curve may be completely

different from the one that is assumed in the above illustration,
because as a result of the imposition of the tax many other
factors may change, affecting the supply price of the commodity.
Similarly, the demand curve may also change. The tax is bound
to result in a reduction of incomes and, therefore, will change
the demand curves for many other products. But we do not
record any change in the demand scheme. The tax may be only
a small factor as compared to other influences determining the
shape of the demand and supply curves. In the words of Prof.
Bhargava, “A tax tends to cause movements in the economic
situation just as a stone causes movements when thrown into a
pool. It will be a drastic assumption that when a stone is thrown
into a pool the ripples and disturbances are caused by it alone.
Actually, the ripples and the disturbances may cause such other
disturbances in the pool whose effect may be more prominent,
such as it may cause fishes to move about and create fresh
ripples and disturbances, so that before the new position of rest
is achieved many other changes would have taken place.”24
2. It is a partial theory since it takes into consideration only
the receipt side of the budget and it ignores the effects of public
expenditure. A true incidence theory must deal with the net
budget incidence, i.e. tax burden minus expenditure benefits.
Most of the modern researchers while dealing with incidence of
taxation have also considered the expenditure benefits.
3. It is true that the term ‘money burden’ is precise, but the
qualifying word ‘direct’ is too ambiguous and vague to be given
any scientific precision. Let us suppose that a tax is levied
and collected from the manufacturers of sugar. We have first
to consider the sugar manufacturers and wholesale buyers.
Thereafter, we have to consider the demand and supply curves
of the wholesale dealers, the retail dealers and other
intermediaries, and finally the consumers. Where are we to stop
in these series of exchanges and say that incidence can travel
thus far and not further. It is said that we should carry the
analysis up to the consumer the difficulty is that there is no
person who is only a consumer and not a producer. The
consumer of sugar may be a producer of syrups or potatoes and
TAXATION 233
the money burden of the tax on sugar may be shifted by him to

the purchaser of syrups or potatoes. Similarly, the purchaser of
potatoes may be producer of wheat and he may shift the tax to
the consumer of wheat and thus there is no end to these series
of transfers. Thus, Prof. Bhargava concludes that “Incidence of
taxation is indeterminate not because adequate information is
not available, but because even in theory, it cannot be isolated”.
It is because of this that many economists have disliked the
term ‘incidence of taxation’. Cannan maintained that “I have
no doubt that it is desirable to eschew the use of the term
‘incidence of taxation’. It unduly restricts enquiries into the justice
and expediency of taxes.” It is perhaps the vagueness of the
term which compelled Edgeworth to say that “incidence denotes
all those effects of taxation with which the economist is
concerned”. Professor Robertson also deplores “an unfruitful
discussion between the incidence of a tax and its effects”. This
doubt seems to exist in the mind of Dr. Dalton also when he
says: “It is doubtful whether these cases…properly belong to
the theory of incidence as distinguished from the more general
theory of the effects of taxation.”
4. Another weakness of the conventional concept of incidence
is its wrong assumption that every tax has an ultimate burden.
It is pointed out that taxes may be imposed, removed or
substituted but no burden may be involved in the sense that no
resources have been transferred from private use to public use.
In other words, there can be two types of taxes—taxes which
involve transfer of resources from private to public use and
those which do not involve any fresh transfer of resources for
public use. The conventional concept of incidence as locating
the ultimate burden of a tax may not apply to the record type of
taxes.
It is, thus, clear that the traditional concept of incidence is
defective and that it would be better to give it a broader meaning
in the context of compensatory system of finance.
A New Concept of Incidence
Swedish economists, particularly Wicksell, have given a new
interpretation to the concept of incidence free from all
ambiguities associated with the traditional concept. Following

him, Musgrave and others have redefined the incidence in terms
of redistribution of income. To these economists, ‘incidence’
means changes in the distribution of income which prevails as a
result of changes in taxation and public expenditure (i.e. changes
in budget policy). It is pointed out that whenever budget policy
is changed, four important effects come into existence:
(a) changes in resource transfer (from public to the government),
(b) output effects, (c) employment effects, and (d) effects in the
distribution of income. The term ‘incidence’ is used to denote
the last type of effects. This is clearly different from the
traditional concept of incidence which means, the money burden
of a tax, i.e. (a). Besides, the new concept speak of the
distributional changes which may arise due to changes in both
revenue and expenditure of public authorities, while the
traditional concept completely ignored the role of public
expenditure.
Musgrave have distinguished five different concepts of
incidence depending upon the type of budget policies considered.
Tax Incidence. It can be: (i) specific or absolute tax incidence,
(ii) differential tax incidence.
Specific Tax Incidence. Public expenditure remaining
constant, changes or modifications may be introduced in a tax.
For example, income tax rates may be reduced or increased.
The resulting change in distribution is called specific tax
incidence. For example, if income tax rates are reduced, this
will increase the disposable income of the people. Assuming full
employment, this will generate inflationary pressures which will
transfer resources from the poor to the rich. Likewise if income
tax rates are increased, deflationary impact will be generated
and resources will be transferred from the rich to the poor.
Differential Tax Incidence. This refers to the distributional
changes that may result when one tax is substituted for another
assuming that the money (yield) burden of the two taxes is the
same. Thus, the differential tax incidence considers the difference
in the distributional results of two taxes that provide for equal
yield. Obviously when progressive income tax is substituted by
TAXATION 235
sales tax of equal yield, a different income distribution will

result.
Expenditure Incidence. Like tax incidence, we can also define
expenditure incidence. If taxes are held constant, while public
expenditure changes, certain distributional effects will come into
existence. These may be known as expenditure incidence. If
public expenditure on a particular item is increased or decreased
the resulting change in the distribution of income may be called
‘specific or absolute expenditure incidence’.
Similarly when an increase in public expenditure in one
direction is cancelled by decrease in public expenditure in other
direction, the resulting change in the distribution of income is
called ‘differential expenditure incidence’.
Balanced Budget Incidence. Finally, we can speak about
distributional changes that involve adjustments in both tax and
expenditure policy. A consideration of tax burdens without
inclusion of expenditure benefits (or vice versa) remains one-
sided approach. This may be considered as the best concept of
incidence since it reveals who benefits directly or indirectly from
public finance activities.
EFFECTS OF TAXATION
Taxes by withdrawing resources from the private sector
would necessitate the reallocation of the remaining resources by
the private sector and at the same time, the government will
think about their optimum allocation. Taxes can also alter the
distribution of income. According to Professor Dalton, “the best
system of taxation from the economic point of view is that
which has the best, or the least bad, economic effects”.
Traditionally, the economists who are opposed to the concept
of incidence are always interested in the wider effects of taxation.
Dr. Dalton has categorized three such economic effects of
taxation:25
(1) Effects on Production;
(2) Effects on Distribution;
(3) Other Economic Effects.
1. Effects on Production: Dr. Dalton has further divided the

effects of taxation on production into effects on: (a) production
as a whole, (b) the composition or pattern of production or
diversion of economic resources.
Dalton has pointed out that production depends upon three
conditions:
1. Ability to work, save and invest;
2. Willingness or desire to work, save and invest; and
3. Diversion of resources between industries and the
regions.
While the first two conditions affect the volume of
production, the third condition influences the pattern of
production or diversion of economic resources.
Taxation and Ability to Work, Save and Invest: All taxes
reduce the income of the individuals. This means people may
not be able to afford necessities, comforts or luxuries which
they were previously availing. Thus, their ability to work will
be adversely affected. This is true even in respect of indirect
taxes which raise the prices of commodities. It is only in
exceptional cases that the ability to work can increase if taxes
are imposed on intoxicants being consumed by the poor people
and these taxes reduce the consumption of harmful commodities
and thereby improve their efficiency. However, it may be noted
that the richer sections of society may like to reduce their savings
instead of reducing their consumption standards because they
have surplus income and they are used to higher level of
consumption. Thus, taxation will reduce the ability to work of
the poor people and not of the rich people. But in case of rich
people, it will be their ability to save and invest which will be
adversely affected.
Thus, generally both, ability to work and ability to save
and invest, are adversely affected by taxation.
Taxation and the Desire to Work, Save and Invest. While
it is easy to find the adverse effects of taxation on the ability to
work, save and invest, but its effects on the willingness or desire
to work, save and invest are not certain. However, to analyse
TAXATION 237
the effects of taxation on the willingness to work, save and

invest, we can distinguish between the effects pertaining to
individuals and those pertaining to firms. While the first effect
deals with the incentives to work and save of individuals, the
second deals with incentives to save and invest of business firms.
Incentives and Individuals. In the case of an individual, a
tax is paid out of the income earned. The anticipation of tax
and the necessity to pay it out of the given income may induce
a person to work hard and earn more so that tax is paid out of
the increased income and the pre-tax level of income is
maintained. The second alternative is that the worker can
maintain the same amount of work and pay the tax out of the
same income or savings. The third, which may happen rarely, is
that he may reduce his income in order to avoid the payment of
tax. Thus, it is difficult to say that whether the effect of taxation
on the willingness to work will be more or less. Broadly, this
will depend on three facts: (1) Nature of Taxes (Direct or
Indirect); (2) Rates of Taxes; and (3) Psychology of the Taxpayer.
Nature of Taxes. Incentives to work, save and invest also
depend on the nature of taxes. Direct taxes would adversely
affect the incentives to work, save and invest because they are
visible. On the other hand, indirect taxes being hidden in the
prices of commodities may not have such disincentive effects.
Rates of Taxes. A very high rate of tax would adversely
affect the incentives to work, save and invest. Marginal rates of
tax should not be very high as was the case in India in 1970’s
when the marginal rate of tax was as high as 97.5 per cent. A
steeply high marginal rates would either lead to incentives to
work, save and invest or might induce the tendency of tax
evasion.
Psychology of the Taxpayer: The psychology of the tax-
payers depend on his nature of demand for income which may
also determine the incentives to work. If demand for income is
inelastic, then he will work more to maintain the pre-tax level
of income. In case the demand for income is more elastic, then
he may work less and enjoy more leisure. Since payment of tax
will mean undergoing sacrifices and because the demand for
income is elastic, individuals will work less. This will give them
more leisure as well as they will not have to pay the tax. When
the elasticity of demand for income is unity, the desire to work
remains constant whatever the level of income. This is the case
with many government employees who are accustomed to work
for a given duration of time. So in their case the incentives to
work will not be adversely affected. Even for most of the
businessmen elasticity of demand for income is unity. They
continue to work for the same number of hours, irrespective of
the tax payment.
Thus, if a person has an elastic demand for income, his
incentives to work and save may be diminished and accordingly
production will decline. On the other hand, if a person has an
inelastic demand for income, the incentive to work and save
will not be affected adversely by taxation. It may rather increase.
Usually, elasticity of demand for income is inelastic because of
the following reasons:
1. The desire for higher standard of living.
2. To earn a definite amount of income in future for social
security purposes.
3. Demonstration effects.
4. To accumulate wealth—Individuals are usually
interested to have more economic power so that they
can enjoy distinction in the society and can create an
independent empire. Some persons accumulate wealth
for their children. Some may be interested to accumulate
wealth to enjoy political power through economic
power.
5. New Inventions and Innovations—Constantly, new
inventions and innovations are taking place. Civilization
goes on developing. New products and gadgets are
being invented. All this necessitates to earn more in
order to enjoy these facilities.
Incentives and Business Firms. In order to understand the
effect of taxation on the willingness to work, save and invest by
the entrepreneurs, it is essential to understand their behaviour
which induce them to undertake the risks of business. The spirit
of enterprise, the motive for profit, the spirit of competition,
TAXATION 239
the thrill of exploiting a new invention or innovation, the

ambition to create a business or industrial empire, the desire to
accumulate, to gain power and prestige in society, to own
political power through economic power, etc. are some of the
motives which influence incentives to save and invest. Western
economists assert that personal gain is a dominant force behind
the spirit of enterprise. Other things being equal, whatever forces
raise the hopes of personal gains, i.e. profits will promote enterprise
and the forces which hinder profits will reduce enterprise. Profits
depend on two things:
(a) Cost of production, i.e. prices paid to factors of
production.
(b) Revenue, i.e. prices of final output.
If taxes are imposed on the final product (i.e. indirect tax)
and the producer is able to shift the tax on the buyers, profits
will not decline and hence incentives to save and invest would
also not be affected. But if the producer is not able to shift the
tax, because of elasticity of demand for his product, then this
will reduce the incentive to save and invest because of low profits.
Similarly, if subsidies are given on the use of inputs, i.e. negative
taxes are levied on inputs, this will reduce the cost of production
Fig. 6.4
and hence profits would increase. This will affect his incentives
to work and save favourably. On the other hand, if inputs are
taxed, which reduce the profits, his incentives to work and save
would be adversely affected. On the other hand, if taxes are
imposed on monopoly profits which is a surplus, there is no
possibility of shifting. However, in case of lump sum tax on
monopoly profits, or windfall gains although there is no
possibility of shifting, yet incentives to save and invest are hardly
affected because monopoly profits are always in the nature of a
surplus. And taxes on surplus do not alter the allocation of
resources as is clear from Fig. 6.4.
Let ‘TC’ and ‘TR’ be the total cost and total revenue curves.
OM is the optimum level of output because here the difference
between total cost and total revenue curve is the maximum.
Suppose a lump sum tax, irrespective of the level of output,
amounting to ‘AB’ is levied. This will raise the total cost or
reduce the total revenue by the amount of the tax. Suppose new
cost curve after the tax is imposed is TC1. Now, even in the
post-tax situation, the optimum level of output will remain the
same (OM) because here the difference between the total cost
and the total revenue continues to be maximum. Thus, we
conclude that the allocation of resources remain unaltered if
taxes are imposed on surpluses.
Taxes and Diversion of Resources. While the volume of
production depends upon the ability and willingness to work,
save and invest, the pattern of production depends upon the
way economic and human resources are allocated. Taxation
can influence the way these resources are allocated and hence
the pattern of production is directly affected by the tax structure.
Further, the influence of tax on pattern of production can be
both harmful and beneficial.
Beneficial Diversion of Resources. Tax on harmful drugs
and liquor can divert the resources from the production of these
commodities to the production of other commodities which may
be socially useful. Similarly, tax on luxury and comfortable
goods can divert resources from their production to the
production of necessities. Further, tax concessions on industries
TAXATION 241
established in rural areas or backward region or heavy tax on

industries in congested urban areas can lead to balanced
development in the economy and hence the diversion of resources
will be beneficial.
Harmful Diversion of Resources. If taxes are imposed on
commodities consumed by the poor, this will amount to harmful
diversion of resources because this will encourage the production
of goods consumed by the richer section of society. Similarly, if
taxes are indiscriminately imposed on industries, the development
of backward and rural areas will suffer. Rather resources will
shift from these areas to developed urban areas which are nearer
to markets and where other facilities like finance, trained
manpower, etc. are available. Again a heavy taxation in domestic
country will induce the flight of domestic resources to other
countries where no such taxes are in existence. This flight of
resources can take place within a federal country also if different
states resort to different taxes. Resources would move from
more taxed state to less or no taxed states. This practice will
generally lead to harmful or uneconomic allocation of resources.
To encourage the allocation of resources according to the
resource endowment of the states, there should be uniform taxes,
that is why we have finally adopted VAT (valued added tax).
Effects on Distribution. According to Dalton, “one tax system
is better than the other if it has greater tendency to reduce
inequality”. Direct taxes are considered to be more suitable to
reduce the inequality in the distribution of income. For this
direct taxes have to be progressive. A proportional direct tax on
income or expenditure would lead the distribution of income
unchanged. In order to reduce the inequality in the distribution
of income even the potential sources of inequality like property
would have to be taxed and should take away all income beyond
a certain maximum. Indirect taxes, on the other hand, because
of their uniformity, would have regressive and hence promote
inequality in the distribution of income. But according to certain
economists like R.N. Tripathy, indirect taxes can be used to
reduce inequality if they are imposed on luxury items at a
comparatively steeper rates.
Trade-off between Equity and Efficiency (Conflict between the

Effects of Taxes on Production and Distribution)
Taxation, as has been seen, may influence the distribution
as well as production. But a sharply progressive tax system is
required for the socially desirable distributional effects, which
may, however, discourage the ability and willingness to work,
save and invest and thereby curb production and growth. Thus,
if the egalitarian objective of taxation is carried to the extreme,
it may discourage production and growth, and thus reduce
equality in distribution to merely an “equal distribution of
poverty” rather than prosperity. As such there may be trade-off
between improvement in production and distribution. Therefore,
these two conflicting motives of taxation are to be reconciled.
The tax system may be so devised that it should not have any
unduly adverse effect on production, at the same time, it should
also be able to achieve its egalitarian goal of reducing the
inequalities in income and wealth.
Further, in a mature economy, where production is
maximum, the basic goal of fiscal policy would be to achieve an
equal distribution of income. Thus, the redistributional aspect
of taxation carries more weight in a developed country. But in
a underdeveloped country, the problem is a very complex one.
It is the problem of improvement in production and rapid
economic growth as well as improvement in distribution. In
poor countries, though the level of economic activity is very
low, as compared to the developed countries, the gap of
inequalities in income and wealth is very high. Masses in these
countries are poor, and the wealth is concentrated in a few
hands. Thus, in a poor country, it is very difficult to tackle the
problem of growth as well as reduce the disparities in the
distribution of income. Both these motives always come into
conflict in these countries. A poor country needs high capital
formation for its economic growth, which calls for realization
of savings on a large scale, while a progressive direct taxation
designed for achieving equitable distribution tends to discourage
savings. The Indian tax structure is criticized exactly on this
ground. Regarding direct taxation, India is known to be the
most heavily taxed nation with a marginal tax rate as high as
TAXATION 243
97.5 per cent in the seventies. Therefore, on account of the low

per capita income and a comparatively low overall national
income, there is little scope for resorting to further increase in
the rate of direct taxes in a poor country like India, where since
the economic reforms of nineties direct tax rates are being
slashed. Hence, these countries have to resort to indirect taxes
of regressive character which may lead to further inequalities in
income and wealth. But, as has been mentioned earlier, the
effects of taxation should not be judged in isolation. A wise
public expenditure, can more than offset the unhealthy effects
of taxation and provide net social advantages.
In fine, taxation is perfectly justified only when it is
progressive in effect and if revenue earned from it is spent for
the welfare of the poor sections of the society. Both taxation
and expenditure have to be progressive and must be integrated
in a fiscal policy, so as to achieve prosperity and equality of
income distribution.
Other Economic Effects
Effects of taxation on production may also, in turn, affect
the level of employment in the economy. It is said that taxes
may reduce the level of effective demand and hence employment
level in the economy. But it is pointed out the tax revenue when
respent may compensate more than the loss in effective demand.
Sometimes, it is also said that different types of taxes have
different effects on the cost of tax collection. The government
should levy those taxes which minimize the cost.
DISTRIBUTION OF TAX BURDEN

(Benefit and Ability to Pay Approaches)
Tax is an unwelcome baby whose burden every body likes
to be transferred or shifted. So, it is interesting to know how
the burden of tax should be distributed over different sections
of the society or what principles should govern the distribution
of tax burden. It may be mentioned that here we deal with only
money burden of taxation and not the wider effects of taxation.
Taxation can have wider implications than simply money burden.
As already explained, taxes can effect incentives to work, save
and invest and distribution of income. In the distribution of tax

burden, we limit our analysis to only the money burden. Second
thing to be noted about the distribution of tax burden or principle
of taxation is that here we consider that the sole objective of
taxation is to raise the revenue and we have to decide how best
could this revenue be raised so as to conform to certain criteria
of distribution of tax burden or social justice. With regard to
the distribution of tax burden, following types of approaches
are mainly recommended.
I. The Expediency Approach
II. The Socio-Political Approach
III. The Benefits Received Approach
IV. Cost of Benefits/Service Approach
V. Ability to Pay Approach.
I. The Expediency Approach. Every tax must pass the test
of practicability. If a tax is not practicable, it is foolish to impose
it, i.e. tax burden should be so distributed as it causes the least
resentment among the taxpayers. Naturally, this approach
implies a heavy tax burden on the poor since they are unable to
oppose it. Richer sections of the society—being more vocal
particularly in a democratic form of government would resist
any increase in their tax burden, e.g. in India big farmers resist
any change in the existing tax structure because that would
mean a heavier tax burden on them. Thus, this principle goes
against the canon of justice. Nor this would promote the
economic welfare, the existing inequalities in the income
distribution would not only be allowed to prevail rather they
would accentuate. Regional disparities are also likely to be
accentuated. An important objective of taxation that it should
stabilize the economy would also be thwarted. So, it is pointed
out that although it is true that practicability should be the
guiding principle of tax system, but it should not be the sole
consideration. Other objectives of taxation, namely stabilization,
equitable distribution of income and wealth, promoting economic
development and economic welfare should be more in the minds
of taxing authorities.
TAXATION 245
II. The Socio-political Approach. This approach is associated

with the name of Adolph Wagner, a German economist, whose
law of public expenditure is well known. According to this
approach, it is not the practicability, but it is the socio-political
objectives of the government which determine an ideal tax
structure. Since in the modern welfare states, equitable
distribution of income is the major objective, therefore, the
burden of taxation should be distributed so as to achieve this
objective. Similarly, tax burden can be so distributed so as to
remove the cyclical fluctuations, unemployment, production of
undesirable goods, monopolistic tendencies and regional
inequalities.
This approach too is not acceptable because most often it
ignores the principle of equity in the distribution of tax burden.
It is true that the other objectives of the state should weigh in
the minds of authorities but equity in the distribution of tax
burden should be the guiding principle. But the problem is how
to define equity—horizontal or vertical. Should equity in the
distribution of tax burden mean that tax burden be linked with
benefits enjoyed from public expenditure or with one’s ability
to pay. This brings us to other sets of theories.
III. Benefits Received Approach. Tax burden should be in
relation to the benefits received from public expenditure. This
theory assumes that basically there is a contract relationship
between the people and the government. The state provides
various goods and services to the members of the society and
they contribute to the cost of these supplies in proportion to the
benefits received. It may be mentioned that public goods can be
divided in two categories: (i) to which the principle of exclusion
applies. The principle of exclusion implies that depending upon
the discretion of people or the government certain categories of
people can be excluded from the provision of certain goods and
services, e.g. no free education to rich children or no free medical
aid to rich patients, (ii) those goods to which the principle of
exclusion does not apply, e.g. defence and military services,
maintenance of law and order. Benefits received approach is
applicable to the former types of goods only.
Fig. 6.5
The benefits received approach has a long history and has

different interpretations. According to Sismondi, the richer
sections of the society need greater protection from the
government, so they should bear a greater tax burden. But
according to J.S. Mill, it is the poor people, who need more
protection from poverty, hunger, unemployment, etc., therefore,
they should pay more taxes. Thus, this principle appears to
advocate regressive taxation.
This approach further advocates that every individual has a
demand schedule. Likewise the state has a supply schedule. So
the state should charge according to the demand schedule of the
private individuals. Benefits received approach can be explained
through Fig. 6.5.
In the figure, SS is the supply curve for public goods. Let
there be two individuals in the society—poor (a) and the rich
(b). Da is the demand curve of the poor for social goods, while
Db is the demand curve of the rich. Dt is the sum total demand
schedule. While the poor will consume OA amount of social
goods, the rich will consume OB so that OA+OB = OT (total
optimum amount of social goods). The total benefits received
by the poor and the rich would be OACM and OBDN
TAXATION 247
respectively, while the total amount of benefits distributed by

public expenditure would be OTEK. The tax amount on the
poor and the rich should be OACM and OBDN respectively.
Criticism
1. Tax burden according to benefit received is not a tax in
strict terms. It is a price because, by definition, there is no
relationship between the tax payment and the benefit received
from the public expenditure.
2. Benefit approach has different interpretations. As already
explained, according to Sismondi, the richer sections of the
society receive greater protection from the government and
therefore, they should pay more taxes. But according to
J.S. Mill, it is the poor people who need more protection from
poverty, hunger, unemployment and other economic ills. Thus,
this principle appears to advocate higher taxes on the poor.
3. There are certain services on which the principle of
exclusion is not applicable. This approach cannot be applied.
Thus, this approach is not uniformly applicable.
4. Then the question is how to measure benefits. Like
marginal utility benefits are subjective and hence not measurable.
Let us take income as the index of benefits received. Then the
benefits from income earned (on government farms or state
enterprises) are not equal to the benefits received from the
pension of the same amount given by the government. Further,
in case of unemployment, there may be no or negligible amount
of benefits from expenditure on education.
5. This principle of taxation is sometimes contradictory.
Suppose from the present angle, we consider that the whole
amount of pension given by the government constitutes benefits.
It does not mean that the government should take away with
one hand which it has given through other hand.
6. This theory assumes that benefits are independent of each
other. But this is not true. What satisfaction we derive from
income is not dependent only on our income, but also on the
income of others. According to Professor Pigou, “No body wants
to be rich but richer than his neighbour.” Further, there may be
interrelationship between various benefits, e.g. medical facilities
and education. A better educated person would be able to enjoy

better government medical facilities.
7. People may be unaware of the benefits conferred by
particular services like injections of preventive measures for
public health. For example, people in the rural areas do not
realize the benefits of small-pox vaccination or cholera
vaccination. So, it would be difficult to compel them to avail of
such facilities and then pay for it.
8. Problems of economic growth or economic stabilization
has been ignored by the benefit principle.
9. This principle, or theory of taxation, assumes that the
distribution of income and wealth is already proper such as to
collect taxes only in proportion to the benefits received and not
according to their respective abilities.
10. This approach assumes that the relationship between
the people and the government is semi-commercial. Like the
private sector, they should pay for what they receive from the
government. But the government is the custodian of the interest
of the present as well as the future generations. It is just possible
that benefits from certain public expenditure may not accrue to
the present generation, e.g. expenditure on forestation. Why the
present generation pay for the benefits of future generation.
Thus, this approach would not recommend such type of public
expenditure.
11. This approach takes into consideration only primary
benefits and not secondary or tertiary benefits. For example,
expenditure on rural expenditure would benefits not only the
passengers directly but also the transportation of various goods
(which may be intermediaries or even finished articles) would
be facilitated. Improvement in the means of transportation and
communication would benefit even those people who are living
in the remote areas. They would have access to latest goods and
services. And also, their products might fetch better prices
because of the increased number of buyers/traders from the urban
areas.
12. If it is revealed that taxes would be imposed in
proportion to one’s demand schedule which is based on the
benefits received, no one would reveal his demand schedule.
TAXATION 249
Fig. 6.6
IV. Cost of Benefit Approach. Similar to benefit received

approach, cost of benefit approach also emphasizes the semi-
commercial relationship between the state and the citizens. The
implication of this approach is that the citizens are not entitled
to any benefits from the state and if they do receive any, they
must pay the cost thereof. Thus, this approach implies a balanced
budget policy. However, in case of benefit received approach,
the government may receive more than the cost of benefits
distributed.
This approach is advocated by Lindahl who, by means of
his voluntary exchange principle based on a two-person, single
social goods model has shown that it is possible to determine
uniquely how much resources should be allocated for the
provision of social goods and how the tax burden towards
meeting the cost of the goods be distributed among the persons
who receive benefits from the social goods. 26 Lindahl’s
formulation of cost of benefit approach can be explained through
Fig. 6.6.
Suppose, the amount of social goods which is provided by
the state are measured on the horizontal axis, the ‘aa’ curve
shows on the left vertical axis the percentage share of the cost
which individual A is willing to bear as larger amounts of social
goods are provided. The ‘bb’ curve shows on the right inverted
vertical axis the percentage share of the cost which individual B
is willing to bear as larger amounts of social goods are provided.
The curves have been drawn on the usual assumption of
diminishing marginal utility which an individual derives from
successive increments of the consumption of any commodity.

Supposing that initially AB amount of social goods are provided
by the state then individual A is actually willing to contribute a
higher percentage share of the cost, viz. BC. Similarly, B is also
willing to contribute a higher percentage share, viz. HD. If, on
the other hand, AN amount of social goods are provided, A will
be willing to contribute only NM percentage share of the cost
and B will be willing to contribute only LK percentage share of
the cost so that their total voluntary percentage share of the
contribution, NM+LK will be less than 100 per cent of the cost.
Thus, by a process of trial and error, it will be found that only
at AE amount of social goods, the percentage share of the cost
willingly contributed by A and B, viz. EF+GF will be exactly
equal to 100 per cent of the cost, or in other words, only at AE
output the total cost of provision of the social goods would be
just covered by the contributions willingly made by A and B.
Hence, AE will be the optimum amount of social goods and EF
and GF would be the percentage share of the cost, i.e. the
optimum tax liability of A and B respectively.
Criticism of Cost of Benefits Approach
Like the benefit received approach, the cost of benefits
approach suffer from all the drawbacks mentioned above.
In addition, there would be certain (conceptual) difficulties in
applying this approach.
(a) How to measure the cost of production? Quite a few
services are those for which the principle of exclusion
cannot be applied. Therefore, their cost of production
for different individuals cannot be measured.
(b) Most of the state services are produced at a loss because
of inherent inefficiency of the public sector, for example,
bus services. Should the cost of inefficiency be also
passed on to the consumers?
(c) This approach states that the government should
scrupulously cover only the cost of production of
service. Obviously, if a service does not cover its cost
of production, it should not be provided to the private
individuals. But the government is to compare not only
TAXATION 251
the commercial costs and commercial benefits but also

social costs and social benefits. If a service provides
more social benefits in terms of external economies
(externalities), e.g. banking services, means of
transportation and communication, educational
institutions, etc., then even if such services do not cover
their own commercial cost of production, they should
be provided by the state. Similarly, sometimes, the
government must cover more than the commercial costs,
if social costs are higher. Then the government must
cover more than the commercial cost. For example, in
the production of coals, in order to conserve the coal
deposits for future generations, the government should
charge more than the commercial costs. Similarly, in
the removal of forest, the government can charge
substantially more because of the social losses due to
deforestation.
(d) Another question is which services should be provided
by the government? Should the state decide on its own
or should it ask the individuals? First is not obviously
desirable as recommended by the cost of benefit
approach. The second is not practicable because if the
people know that they will be charged the cost of
production, they will not reveal their preferences.
(e) Then which cost to cover—average costs or marginal
costs. Many a times, as already explained, government
charges more or less than the average costs depending
upon the social benefits. Likewise, marginal cost is not
applicable like the private sector because it is not the
objective of the government to maximize profits.
Merits of Benefit Approach
1. The benefit approach takes into account both the taxation
side and the expenditure side of the budget and as such it is a
fuller approach than the ability to pay approach which stresses
only the taxation side and ignores the expenditure side.
2. The benefit approach (particularly its voluntary exchange
variant as advocated by Lindahl) provides a technique by which
the amount of public goods and the distribution of tax burden

might be simultaneously determined.
3. In dealing with the allocation branch of the budget, the
benefit approach has the great merit of linking the provision of
public goods to the preference pattern of the individuals. This
linking is an essential requirement for a normative theory of
budget determination in a democratic setting.
4. This approach is recommended even on equity grounds
because only those persons should pay taxes who receive benefits
from the government. Why to tax a person at the cost of others?
5. Benefit approach is an incentive-oriented approach. Unlike
ability to pay approach, it would not affect the incentives to
work, save and invest adversely.
From the above discussion, it should not be concluded that
the principle of benefit approach is not applicable at all. For
certain services, it can be and should be applied. For example, if
the government is to develop a certain area, then the government
can charge for the cost of development depending upon the
benefits which are expected to be enjoyed by the different
residents. In case of local finance, benefit approach is highly
useful.
V. Ability to Pay Approach. J.S. Mill rejected the benefit
principle of taxation as it would mean that the poor would
have to pay most of the taxes since they receive the major portion
of the benefit of the government expenditure. This is the soundest
and the most widely accepted principle of securing justice in
taxation. Unlike the cost of service approach to the distribution
of tax burden, the ability approach does not imply that the
government should try to have a balanced budget. Besides, it
can admit the interdependence of the government expenditure
and the ability to pay of the taxpayers. This approach considers
the payment of taxes in its true form as a compulsory payment
to the state for which no direct benefit can be claimed.
This theory envisages that every one should pay taxes
according to his ability or faculty to pay, i.e. those who are
more prosperous should pay larger amounts as taxes than those
who are less prosperous. But what is the measure of a man’s
TAXATION 253
ability to pay? In the search for a proper criterion of a person’s

ability to pay we can proceed on two lines—subjective and
objective. In the subjective approach, the sacrifice theory has
been evolved to measure ability, whereas in the objective
approach, the faculty theory has been formulated.
Sacrifice approach. The sacrifice approach to the ability to
pay is based on the psychological or mental reactions of the
taxpayers. It rests on the assumption that the payment of taxes
involves a certain burden or sacrifice on the part of the tax-
payers and as such justice in taxation demands that taxes should
be so imposed that equality of sacrifice among the taxpayers is
brought about. This approach further assumes that (i) taxes
impose sacrifice, (ii) the marginal utility of income is cardinally
measurable, (iii) all persons have the same relationship between
their units of income and units of marginal utility whatever be
their levels of income, i.e. everybody—rich or the poor—has
the same capacity to derive utility out of all levels of income.
According to this approach equity demands that tax burden
should be so distributed that it causes equal sacrifice to all the
taxpayers. In this context, we can distinguish three types of
equity approach: (i) Equal absolute sacrifice approach, (ii) Equal
proportional sacrifice approach; and (iii) Equal marginal sacrifice
approach. Further depending upon the assumption that whether
marginal utility of money is constant or decreasing, we will
have different types of tax systems.
Equal absolute sacrifice approach. If we assume that
marginal utility of money is constant, then everybody must pay
an equal amount of tax, irrespective of his level of income. For
example, if marginal utility of one rupee is 50 and the
government decides to impose a sacrifice of 1,000 on every
individual, then everybody will be paying ` 20 (20×50=1,000)
irrespective of his level of income. Hence, this tax system will
be regressive because rich will be paying a far less proportion of
his income as tax than the poor. However, if we assume that
the marginal utility of money is declining, then we may have a
little bit of progressive tax structure. Thus, it follows that if we
adopt equal absolute sacrifice approach then we will have
regressive tax system assuming marginal utility of money is

constant.
Equal proportional sacrifice approach. If we assume that
marginal utility of money is constant, then equal proportional
sacrifice approach will distribute the tax burden in proportion
to the distribution of income. Suppose, marginal utility of money
is 50 and the government decides to impose a sacrifice of 10 per
cent of one’s income, then a person with income of ` 5,000 will
pay ten units, while person with ` 1,000 income will pay two
units. And the ratio of the tax burden 10:2 or 5:1 will be same
as that of income distribution. And hence, we will have a
proportional tax system. However, if we assume that marginal
utility of money is declining then even equal proportional sacrifice
approach may yield a progressive tax system.
Equal marginal sacrifice approach. This approach is based
on the assumption that marginal utility of money is declining
because marginal sacrifice or disutility of income (because of
tax payment) can be equated if marginal utility of money is
declining. Otherwise, in case of constant marginal utility of
money, the point of equalization would be infinity. The equal
Fig. 6.7
TAXATION 255
marginal sacrifice approach is considered as the best approach

because it would not only equate the marginal sacrifice of all
the taxpayers, but it would also mean the minimum aggregate
sacrifice for the society as a whole. This approach is called
‘least aggregate sacrifice approach’ by R.N. Bhargava, ‘least
sacrifice approach’ by A.C. Pigou, ‘equi-marginal sacrifice
approach’ by Edgeworth, ‘minimum aggregate sacrifice
approach’ by Cannan and ‘principle of minimum sacrifice’ by
Hugh Dalton.
All the above approaches can be explained through
Fig. 6.7.
In Fig. 6.7, income is measured on the horizontal axis and
utility derived from income is measured vertically—the lower
panel measuring vertically the marginal utility and the upper
panel measuring the total utility. Suppose that the MU and TU
schedules show respectively the marginal and total utilities
derived by two individuals (who would be called “rich man”
and “poor man”, the former having an income larger than the
latter) which they derive from income, the same schedules, by
assumption, applying to both. Suppose further that, to begin
with the rich man has an income of OR and the poor man has
an income of OP, the total utility derived by them from their
income being respectively AB and CD. Let us assume that the
state has decided to raise from the two individuals a total sum
of Rt in tax. Under equal absolute sacrifice principle, the tax
liability of the rich man will be RR1 and that of the poor man
will be PP1 (note, RR1+PP1=Rt), for in that case the absolute
loss of sacrifice made by the two individuals (defined as the
absolute reduction in the total utility derived by the individuals
from their income) will be the same, the reduction of total utility
from income of the rich man in the post-tax situation being BE,
the corresponding amount of the poor man being DF; and
BE=DF. But note that though BE=DF, BE/BA ≠ DF/DC. In other
words, in this method of distribution of the tax burden though
the equal absolute sacrifice principle is being satisfied, equal
proportional sacrifice principle is not being fulfilled. In order,
therefore, to raise the same amount of tax according to equal
proportional sacrifice principle, the rich man’s tax liability should
be increased to RR2, and the poor man’s liability should be

reduced to PP2 (note, RR2+PP2=Rt), so that in the post-tax
situation BG/BA (i.e. the rich man’s proportional sacrifice)=DH/
DC. But, again, note that in this distribution of the tax share
though the equal proportional sacrifice principle is being satisfied,
the equal marginal sacrifice principle (and ipso facto the least
aggregate sacrifice principle) is not being satisfied, for in the
post-tax situation the marginal utility of income of the rich man
is not equal to that of the poor man (see the lower panel of
Fig. 6.7). Therefore, if the equal marginal sacrifice principle is
accepted, the rich man’s tax burden should be increased further
to RR3 and the poor man’s share should be reduced further to
PP3 (note, RR3+PP3=Rt) so that in the post-tax situation, the
marginal utility of income of both the individuals becomes
equal, viz. R3/P3I. The relative tax liability and the relative
progressiveness of the tax structure under the different sacrifice
principles may be summarized in the following table.
Principle of Sacrifice Tax Liability of Relative progressivity of the
Rich man Poor man tax structure
(i) Equal absolute sacrifice Least Most Least

(ii) Equal proportional sacrifice More Less More than (i) but less than (iii)
(iii) Equal marginal sacrifice Most Least Most
It should be carefully noted that the third column of the

table shows only the relative progressiveness of the tax structure
under different sacrifice principles. Of all the three approaches,
equal marginal sacrifice approach would promote equality in
the income distribution. This approach is also best suited for
economic stabilization. Progressive taxes, as advocated by equi-
marginal sacrifice approach, would automatically increase the
tax revenue (or decrease the disposable income) during the boom
period and would decrease the tax revenue or increase the
disposable income during the period of falling income.
Mathematical presentation of the subjective/sacrifice approach
Equal absolute sacrifice approach
Absolute sacrifice = U(Y) – U(Y – T);
TAXATION 257
where U(Y) is the total utility of income before tax and U(Y – T)
is utility of income after the tax. Therefore, U(Y) – U(Y – T) is
the loss in total utility or sacrifice, which is nothing else than
the total sacrifice. Equal absolute sacrifice approach states that
total sacrifices should be equal for all the taxpayers, i.e.
[U(Y) – U(Y – T)]A = [U(Y) – U(Y – T)]B=….. [U(Y) – U(Y – T)] N
Equal proportional sacrifice approach
If we divide the absolute loss in total utility, i.e. sacrifice by
total utility of income, we would get the proportionate change
in sacrifice, i.e.
Total sacrifice
Total utility of income
In other words, U(Y) – U(Y – T)/U(Y) is the proportionate
sacrifice which should be equal for all the taxpayers, i.e.
[U(Y) − U(Y − T)]A [U(Y) − U(Y − T)]B [U(Y) − U(Y − T)]N
= =
U(Y)A U(Y)B U(Y)N
Equi-marginal sacrifice approach

Mathematically, if we take the first derivative with respect
to absolute change in utility of income after paying the tax, i.e.
U(Y – T).
dU(Y − T) Change in utility after tax
Then , i.e. should be
d(Y − T) Change in income after tax
equal for all the taxpayers.
Now this change in utility is nothing else than the marginal
change in sacrifice or loss of utility or disutility of income.
Criticism of the sacrifice approach. The subjective approach
is beset with certain difficulties which undermine its importance.
The main drawbacks are as follows:
(i) The sacrifice undergone by a taxpayer is a psychological
phenomenon as it concerns the state of mind and it is
not possible to measure a person’s state of mind or
compare it with other person’s state of mind. Hence,
interpersonal comparisons of utility or sacrifice cannot
be made and as such it is very difficult to equalize the

sacrifice of all the taxpayers.
(ii) The sacrifice that a taxpayer undergoes depends not
only on the amount of tax paid but also on the source
and character of income earned. For example, earned
income will have greater utility to an individual than
unearned income. But the subjective approach does not
take note of these facts while measuring the ability to
pay.
(iii) It is not possible to measure exactly the decline in the
marginal utility of money as income increases and as
such the progression involved in the rate of taxation is
all arbitrary and hence it fails to secure equal sacrifice
for all.
(iv) The assumption that the income utility function of every
individual has exactly the same characteristics is
untenable because all people do not possess equal
capacities for the enjoyment of incomes.
In view of the fact that hardship or sacrifice cannot be
measured and interpersonal comparisons of utility are not
possible, some economists point out that the conclusions of the
sacrifice approach are not scientifically based. In the words of
R.A. Musgrave, “It remains to be seen whether a workable and
reasonably meaningful measure of utility can be developed in
time and whether thereby the subjective concept of ability-to-
pay can be given an operational meaning. At this stage, we
do not possess a universally accepted measure of utility by
which to apply one or the other sacrifice formula”. Hence, it is
not possible to base a tax system on the concept of sacrifice.
That is why the objective approach to the ability to pay is
adopted.
Objective Approach
In view of the practical difficulties of the sacrifice approach,
some writers, specially in America, have made an objective
approach to measure the ability to pay. Prof. Seligman uses the
term ‘faculty’ to indicate ability in the objective sense.
TAXATION 259
Contrary to the subjective approach, the objective approach

considers the ‘money value of the taxable capacity’ of the tax-
payer rather than his feelings and sufferings. In this approach,
several objective criteria such as property, consumption,
expenditure, income, etc. have been suggested as measures of
the ability to pay.
(i) Property as the Index of Ability to Pay
Formerly, property or wealth of the taxpayers was considered
to be the correct index of one’s ability to pay. However, this
criterion suffers from many limitations and conceptual difficulties
and as such it cannot be regarded as just basis of taxation. This
principle is applicable only in the countries where right to own
private property exists, i.e. capitalist countries. Now the right
to private property in those countries is granted to induce people
to save and invest more. If taxes are imposed in proportion to
private property, obviously this will amount to disincentives.
Thus, this principle is contradiction in terms. Secondly, taxes in
proportion to property imply that property yields income thereby
one’s ability to pay tax increases. But all properties do not yield
equal income. Depending upon the location of the property
some yields more, some less and some may not yield any income
at all. Thus, to consider only property as a source of income
and ignoring others would not be a proper index of ability to
pay. Thirdly, in case of an inherited property, ability to pay tax
would be more than in case of property built through one’s
own labour.
However, it does not mean that property cannot be used as
an objective measure for distributing the tax burden. The
ownership of property confer special privileges on its owners.
Though some properties may not be yielding any income, yet
they do indicate the potential tax paying ability of a person.
Since the ownership of private property is the main cause of
inequality in the distribution of income and wealth, so in order
to achieve the latter objective, tax burden should be distributed
in proportion to the ownership of property. Of course, it is not
the only index of ability to pay, this should be supplemented by
other indices.
(ii) Consumption Expenditure as the Index of Ability to Pay

Many economists have suggested expenditure as the basis
of ability to pay. Prof. Kaldor holds the view that a person’s
spending power, rather than income, is the true index of his
taxable capacity. Moreover, the expenditure tax, unlike the
income tax, stimulates the desire to work, save and invest and
restricts tax-evasion. Higher consumption means people are rich
to afford higher tax burden. A low consumption standard implies
that people are poor. But there are conceptual difficulties to
administer this principle. Consumption expenditure differs from
family to family not only because of the difference in their
economic status, but also because their size is different, their
needs are different. It is also pointed out that our needs are
restricted not only to the present consumption but also to future
consumption, i.e. saving and investment. To tax one alternative
of disposal of income and exempt others, would be unjust. This
will also accentuate inequalities as this would encourage people
to divert their income from consumption to savings and building
up of properties through savings would breed inequality.
Propertied class particularly will plough back their income.
(iii) Income as the Index of the Ability to Pay
In modern times, a person’s money income has come to be
accepted as the most important and comprehensive single
criterion of ability to pay, though it is usually supplemented by
other tax indices also. Income from all sources—property,
investment, shares, etc.—is taken into account at the time of
assessment. However, income can serve as the basis of ability to
pay only if the following guidelines are taken into account:
1. The source of income, i.e. whether income is obtained
from property/unearned income or work. If the source
of income is property, it should be taxed at a higher
rate than if it is obtained from work.
2. The nature of income, i.e. whether it is regular or
irregular. The persons with regular income have greater
ability to pay than those with irregular income of the
same amount as in the underdeveloped countries where
TAXATION 261
agriculture is the main source of income, which is

irregular, the ability to pay tax is low.
3. The size of the family must be taken into consideration
and rebates should be permitted for large families.
4. There must be a minimum exemption limit and incomes
below it must not be taxed.
5. The period of time during which an income is earned
should also be taken into account. Two persons earning
the same income but not over the same period cannot
be said to have equal ability to pay.
6. It is net and not gross income which should be taken
into account while estimating the ability to pay because
expenses have to be incurred to earn the income. That
is why various deductions are allowed from taxable
income.
7. A heavy tax on incomes which are of the nature of
surplus or windfalls should be levied.
8. The income tax should be based on the principle of
progression. However, if progression is carried too
far, it may adversely affect the people’s ability and
willingness to work, save and invest and encourage tax
evasion.
In spite of the above shortcomings income is considered as
one of the most accepted indices of ability to pay though it is
usually supplemented by other indices. Adam Smith while
formulating his canon of ability to pay, probably had income in
his mind.
From the above discussion it is clear that both the
approaches—subjective and objective—present some difficulties.
A great shortcoming of the objective approach is that it can lay
down no exact method of bringing about conformity between
taxation and ability to pay. The equal marginal sacrifice theory
does lay down such a measure, but it is all theoretical and lacks
practical application.
The most obvious drawback of this approach, whether
considered subjectively or objectively, is that it does not take
into account the benefits from public expenditure. The ability

to pay, taken by itself, cannot serve as a dependable basis for
taxation without considering at the same time the benefits from
public expenditure. Ability to pay is not an absolute quantity; it
is not rigid and fixed. It is related among other things, to the
system of public expenditure. Pigou and Dalton have taken into
consideration both taxation and expenditure in laying down the
principle of public finance—the Principle of Maximum Social
Advantage but it is not easy to apply it in practice.
It may be pointed out that even if every effort is made to
make the tax system as equitable as possible, it is not so easy to
attain it. Equity is a matter of opinion and it has no generally
accepted definition. It is, in the words of Dr. Dalton, “an elusive
mistress, whom perhaps it is only worth the while of philosophers
to pursue ardently and of politicians to watch warily”.
For securing justice in taxation, however, it is desirable to
impose various types of direct taxes such as income tax, wealth
tax, tax on unearned increments, etc. It is equally important for
the system of taxation to include both direct and indirect taxes
to attain the wider socio-economic objectives of tax policy. In
the words of Dr. Dalton, “…the rich should pay more taxation
than they think, while the poor should think they pay more
than they do. This double illusion, it is argued, will keep the
rich contended and the poor virtuous, and will tend to maximize
work harder to maintain, such as unstable equilibrium of errors”.
In the end, it may be pointed out that the distribution of the
tax burden is only one of the considerations involved in assessing
taxation policies. In fact, the effects of taxation on production,
distribution and the general level of economic activity are more
important considerations in judging tax policy.
DOUBLE TAXATION
With the extension of the functions of modern welfare states,
they are under a persistent pressure to spread, as wide as possible,
their tax net, so that adequate revenues are raised to meet their
needs. Modern governments have to impose several taxes so
that the tax system as a whole becomes sufficiently productive
and equitable. But under a multiple tax system, it is but natural
TAXATION 263
that many people will have to pay more than one tax. In this
way almost every taxpayer is subject to double or multiple
taxation.
In the field of taxation, three entities have a basic significance:
(i) tax authority, (ii) taxpayer, and (iii) tax base. When a person
has no contact with the tax base, he cannot be taxed. For
instance, a person who does not own any property, has simply
not to pay any tax imposed on the basis of property. Similarly,
a person who abstains from drinking cannot be subjected to a
tax on liquors. If there is a single taxing authority and a person
has his contact with diverse tax bases, he may be exposed to a
number of taxes. For instance, government imposes a tax on
income, wealth and inheritances and an individual has to pay
taxes on all these bases, provided his income from different
sources is above the exemption limit; he owns property; and he
inherits wealth. Although the person concerned is subject to
different taxes imposed by the same authority, yet, strictly
speaking, this is not double taxation.
The term ‘double taxation’ is used in Public Finance in a
restricted sense. It implies the taxation of the same thing or the
same base twice or more in the same period. It does not mean
taxation of the same man twice. In the words of Prof. J.K.
Mehta, “Double taxation means today the taxing of a person
twice by two authorities in the same way, that is, on the same
thing, or the taxing of the same base twice by the same
authority.”27
The principal types of double or multiple taxation under
single taxing authority are as follows:
(i) The property may be taxed, on the basis of income
yielded by it and again on the basis of its capital value.
In this case, the same property is subject to taxation on
the basis of two different criteria.
(ii) The income may be taxed when it is received and also
when it is spent. In this case, the tax base is income
which is taxed at two different stages.
(iii) A tax may be imposed on the corporate profits and
again on the dividends received by the shareholders. In
this case, the tax base is profits and the shareholders

are subjected to taxes on two different stages—pre-
distribution and post-distribution of dividends.
(iv) A tax may be levied on those who receive income and
also on those from whom it is received. For instance, a
tax may be imposed on rental incomes or interest
received and then it may be imposed upon those who
make these payments.
It is important to know as to what taxation of the same
thing twice means. In this connection, Prof. J.K. Mehta observes,
“In one way, taxes are always paid out of income unless they
are very heavy in which case they have to be paid out of capital.
Normally, all taxes are paid out of income. In abnormal times
again it may be necessary to pay some taxes out of our savings.
But in normal times all taxes are in general paid out of our
income. But that does not constitute a case of double or multiple
taxation in the sense in which we are using the word here. All
taxes, or almost all fall on income. But that does not make any
two of them a case of double taxation. What is required is that
they should be levied on the same thing and not paid out of the
same thing.”
Another point we have to be clear is that the two taxes
should have reference to the same period of time. In the words
of J.K. Mehta, “The government of a country taxes you on
your income this year and again the next year. That does not
constitute double taxation for it is not really the same income
that is twice taxed. It is sufficient, therefore, to say that double
taxation involves taxation of the same thing twice either by the
same authority or by different authorities.”
Double or multiple taxation is objected on the following
grounds: Firstly, it imposes an excessively high tax burden upon
those individuals and groups on whom it falls. Secondly, it is
likely to have an adverse effect on the people’s incentives to
work, save and invest. Thirdly, it does not ensure equity between
different taxpayers and, therefore, violates the basic canon of
justice. Where there is a single taxing authority, the avoidance
of double taxation and inequity can be possible through
TAXATION 265
appropriate amendments in the tax structure of the country.

However, if in an attempt of making the tax system more
equitable, certain amount of double taxation is involved, it
should not be objected; rather it should be regarded as socially
desirable.
A more important source of double taxation is the plurality
of tax authorities. In federal countries, the Central and State
Governments may impose taxes on the same base or the tax
policies of different independent countries may create such a
situation. For instance, if the government imposes a wealth tax
which includes a tax on property on the basis of its capital
value and at the same time, the local administration in a town
or city also imposes a tax on buildings on the basis of their
rental values, this is a situation involving double taxation.
Similarly, double taxation may arise between different countries
when their governments impose tax on the incomes not only of
their own citizens but also on the foreigners who earn the whole
or a part of their income within the taxing country. When these
foreigners remit their incomes to their home countries, these
may again be taxed. This constitutes double taxation of such
incomes which imposes much higher burden on them. Double
taxation has always an adverse effect on FDI. Since double
taxation tends to penalize foreign enterprises, the free flow of
capital and other resources like the services of technical and
managerial specialists among different countries is hindered.
Findlay Shirras writes in this connection that double taxation
“tends to keep capital within national frontiers and to prevent
it from flowing freely over such frontiers”. Such a situation
hampers the maximum or optimum utilization of the global
resources and does not permit the countries to maximize social
welfare. Double taxation by different independent countries
works to the detriment of the underdeveloped countries
particularly because they have to draw heavily upon foreign
capital and technical assistance in quite a substantial measure
in the earlier stages of their development. Prof. Pigou, however,
does not believe that double taxation lowers the level of world
welfare. To quote him, “Insofar as aggregate government
expenses are really higher in respect of a man who resides in
one country and earns or invests in another than in respect of

one whose all activities are confined to the same country, such
a barrier corresponds to a true cost, and is prima facie desirable
from the standpoint of world welfare”. Pigou’s assumption that
the burden of double taxation corresponds to the true cost can
be true only in rare circumstances. However, there is reason to
suppose that the governments impose taxes on foreigners to the
extent of the true cost.
Avoidance of double taxation. Double taxation imposes
excessive tax burden which has very serious repercussions on
the expansion of economic activity and welfare. The need for
avoiding double taxation was actually felt first during the First
World War, when many governments, under heavy strain of
expenditure, started exploiting excessively the progressive direct
taxes on incomes and inheritances. Besides, with the coming
into existence of big business and the expansion in the activities
of such concerns as shipping, air transport, banking and
insurance companies, the solution of the problem of international
double taxation assumed added significance. Consequently, the
International Finance Conference held at Brussels in 1920
recommended that the problem should be tackled by the League
of Nations and urged “an international understanding which
while ensuring the due payment by every one of his full share of
taxation, would avoid the imposition of double taxation which
is at present an obstacle to the placing of investments abroad”.
The avoidance of double taxation arising from the plurality
of tax authorities can be achieved in different ways. But in this
connection, it is important to see whether the tax authorities
belong to the same (federal) country or they belong to different
countries.
Avoidance of Inter-State and Union-State Double Taxation (Intra-
Country Double Taxation)
If double taxation arises on account of taxes imposed by
different States in a federation or by the Centre and the State
governments, the following methods may be suggested for
overcoming this problem:
TAXATION 267
(a) Centralisation of Finance

The inter-state double taxation can be avoided through the
centralization of finance as has been done in Russia where the
Central Government holds control on the finances of the regional
governments. In Switzerland, the Supreme Court has been
authorized to determine the criteria for the imposition of taxes
such that the possibility of double taxation is avoided. In the
arrangement of centralization of finances, all taxes may be
imposed by the Union (Central) Government and the tax
proceeds allocated between the Union Government and the states
keeping in view their population, resources, economic
performance and certain other special problems. Although such
a system is convenient for the taxpayer and involves less cost of
collection, yet some of the states may oppose such an
arrangement on the ground that it infringes upon their financial
independence.
(b) Evolution of Uniform Tax Criteria
The Central and State Governments may evolve through
mutual negotiations a uniform set of criteria and a model
legislation may be prepared for adoption by all the concerned
governments. This can go a long way in removing this problem
and infuse greater understanding and co-operation among
various governments. If any state suffers loss due to such an
arrangement, the Central Government should make efforts to
compensate it.
(c) Reciprocal Tax Agreements
If collective agreements among different states cannot be
evolved, double taxation may be avoided through reciprocal
tax agreements among them. The Canadian states could tackle,
with some measure of success, the problem of double taxation
in case of inheritance and company taxes. Similarly, a number
of States in America have entered into reciprocal arrangements
in respect of income tax and death duty.
(d) Exclusive Assignments of Tax Jurisdiction
Another technique to avoid double taxation in federal
countries is through specifying the exclusive tax jurisdiction of
the Union and State Governments. In this way, both of them

levy taxes without transgressing their tax jurisdictions and the
possibility of double taxation is avoided. The Indian Constitution
makes this type of provision. While the Union Government has
exclusive right to levy taxes on income and capital, it has no
authority to tax agricultural income and property. In the matter
of commodity taxation, the Union Government has the exclusive
authority to tax commodities while they are in the process of
manufacture, export or import. The taxes on the sale and
purchase of goods fall in the domain of the State Governments.
No doubt, this arrangement avoids double taxation in the
technical sense, but it leads to competitive taxation resulting in
excessive tax burden on the people. This method is, however,
not applicable to inter-state double taxation which can be best
avoided through the evolution of uniform tax criteria and
reciprocal tax agreements.
Avoidance of International Double Taxation (Inter-Countries
Double Taxation)
It is not difficult to avoid double taxation by the same
authority or by the different authorities in the federal countries.
In case the taxing authorities are two or more national
governments, the avoidance of double taxation, is however,
somewhat difficult. The following methods may be adopted for
the avoidance of international double taxation.
(a) Stipulation of the Basis of Taxation
There are generally two basis of taxation—source of income
and residence. If a person works in country A and earns his
income there, the government of country A is entitled to tax
him. Now if that person is the citizen of country B, the
government in country B is also entitled to impose tax upon
him. When both the governments have the right to impose tax
upon his income, the problem of double taxation arises. The
avoidance of double taxation in such cases requires the
stipulation of the basis of taxation either according to residence
or according to the place of origin of income or according to
the location of property.
TAXATION 269
If the policy of taxing according to residence is followed, a

peculiar situation may arise. Suppose many citizens of country
A have property in country B but no citizen of country B has
property in country A. Now the government of country A would
be taxing all those persons who are citizens of country A, but
work and earn their incomes in country B. At the same time,
the government of country B cannot tax those of her citizens
living in country A because these people do not have any property
there (in country B). The loss to country B under this tax
arrangement cannot be neutralized. This is, however, a
theoretical possibility because the citizens of both the countries
will normally have some property abroad.
Sometimes double taxation is sought to be avoided through
the adoption of a mixed basis, that is, both on the basis of
residence and of location. For instance, the immovable property
may be taxed on the basis of location and other types of property
may be taxed on the basis of residence. The rental income may
be taxed by one government, while non-rental income by the
other government.
The fundamental principle that should guide any satisfactory
arrangement for the avoidance of double taxation is that of
economic allegiance. When a person owes allegiance to two
governments, naturally both should tax him. The double taxation
can, however, be avoided through some such arrangement that
he may be taxed only once on his whole income and the proceeds
be divided between the two governments in proportion to the
economic allegiance he owes to them. But this will pose a
practical problem of determining the extent of economic
allegiance that a person owes to a government.
Several plans have been suggested from time to time for the
avoidance of international double taxation. The committee of
technical experts on double taxation and tax evasion, appointed
by the League of Nations in 1927 met at Geneva in 1928. The
Geneva Convention made some important recommendations to
tackle this problem. It proposed separate treatment of personal
and impersonal income taxes such that the immovable property
and mortgages thereon should be taxed in the state of origin.
Incomes from shares too should be taxed in the same way.
Similarly, incomes from bonds, incomes from industries,

commerce and agriculture should be taxed by the country of
origin. Wages should be taxed in the state of residence while
pensions should be taxed in the state of origin. The International
Chamber of Commerce recognized the principle of residence as
the best method for avoidance of double taxation. It, however,
recommended that the countries should enter into bilateral
agreements and evolve mutually beneficial arrangements for the
avoidance of this problem.
(b) Provision of Bilateral Reliefs
Under this method, the two countries decide to impose tax
both on their respective subjects and foreigners earning their
incomes within their respective frontiers. To eliminate double
taxation, they enter into an agreement for the provision of
relief to their subjects taxed in the other country. Under this
arrangement, in certain situations the actual tax liability of an
economic unit may be lower than that envisaged under full
avoidance of double taxation. Suppose, the tax rates in country
X are much higher than the tax rates in country Y. Further, the
tax relief in country X may be higher than that in country Y.
Now an economic unit earning its income in country X would
be subject to a higher rate of tax. In case, the economic unit
earns income in country Y and is subjected there to a lower tax
rate but at the same time secures relief in country X at a higher
rate, both the countries would be having low tax bills. The net
tax liability on an economic unit would thus turn out to be
smaller than in case of full avoidance of double taxation.
Recently, SAARC (South Asian Association for Regional
Cooperation) countries comprising India, Pakistan, Sri Lanka,
Nepal, Bangladesh, Bhutan and Maladives at 13th Summit held
at Dhaka in November 2005, signed limited multilateral
agreement on avoidance of double taxation in respect of custom
duties.
(c) Unilateral Tax Relief
When no bilateral arrangement exists for the avoidance of
double taxation, a country may decide to provide a unilateral
tax relief to its own citizens.
TAXATION 271
In this connection, it must be mentioned that India has

concluded bilateral agreements for the avoidance of double
taxation with a host of countries during the recent decades. In
addition, she has made allowance for tax relief to compensate
the Indian citizens for any disparities in tax rates.
NOTES
1. As quoted in R.N. Bhargava, Theory and Working of Union
Finance in India, Chaitanya Publishing House, Allahabad, 1972.
2. Ibid.
3. Ibid.
4. Hugh Dalton, Principles of Public Finance, Routledge and Kegan
Paul, London, 1936.
5. Ved P. Gandhi, Tax Burden on Indian Agriculture., Ph.D. Thesis
presented to the Harvard University, Cambridge, Massachusetts,
May 1964.
6. Minutes of Royal Commission and Local Taxation (1899) in
Readings in the Economic of Taxation, (ed.), American Economic
Association, London, George Allen and Unwin Ltd., 1959,
pp. 171-201.
7. E.R.A. Seligman, Introduction to the Shifting and Incidence of
Taxation, Ibid.
8. Richard A. Musgrave and Peggy B. Musgrave, Public Finance in
Theory in Practice, New York, McGraw Hill Book Company, 1973,
p. 355.
9. Hugh Dalton, op. cit., p. 51.
10. Ursula K. Hicks, “The Terminology of Tax Analysis” (Reprinted
from Economic Journal, 1966), American Economic Association,
op. cit., pp. 214-26.
11. K.S.R.N. Sarma and M.J.K. Thavaraj, “Estimation of Tax
Incidence in India”, Economic and Political Weekly, May 8, 1971,
pp. 957-64.
12. Ursula K. Hicks, Public Finance, James Nisbet and Co. Ltd.,
Cambridge, 1959, p. 138.
13. Ibid., p. 139.
14. R.A. Musgrave, “On Incidence”, The Journal of Political Economy,
Vol. LXI, No. 4, August 1953, pp. 306-23.
15. R. Mahler Walter, Sales and Excise Taxation in India, New Delhi,
Orient Longman Limited, 1970, p. 51.
16. F. Break George, “Incidence and Economic Effects of Taxation”, in

The Economics of Public Finance, Alan S. Blinder et al. (ed.),
Washington, D.C., The Brooking Institutions, 1974, p. 120.
17. Stockfisch, “On the Obsolescence of Incidence”, Public Finance,
Vol. XIV, 1959, pp. 125-48.
18. Luc De Wulf, op. cit., p. 96.
19. Dosser Douglas, “Tax Incidence and Growth”, Economic Journal,
Vol. LXXI, September 1961, pp. 572-91.
20. Marian Krzyaniak and Suleyman Ozmucur, The Distribution of
Income and the Short-run Burden of Taxes in Turkey, 1968, op. cit.,
p. 9.
21. Richard A. Musgrave and Peggy B. Musgrave, op. cit., p. 357.
22. Johannes Weitenberg, “The Incidence of Social Security Taxes”,
Public Finance, Vol. XXIV, No. 2, pp. 193-208.
23. Ibid.
24. R.N. Bhargava, op. cit.
25. Dalton, Hugh, op. cit.
26. Irik Lindahl, Studies in the Theory of Money and Capital, George
27. J.K. Mehta, Public Finance Including Federal Finance, Chaitanya
Publishing House, Allahabad, 1971.
Public Debt 7
Public debt is the debt which the state (government) owes

to its citizens, or citizens of other countries or to other agencies
from whom the government has borrowed. The government
may borrow from banks, business organizations, business houses
and individuals. The government can also borrow from within
the country or from outside the country.
CAUSES OF BORROWINGS
(a) Just like private individuals, the government may
borrow when its current revenue is less than its current
expenditure. But as would be explained further, there
are fundamental differences between the two.
(b) To meet sudden and unforeseen expenditures when tax
revenue cannot be increased or tax revenue cannot be
increased to the same extent.
(c) To finance capital expenditure for economic
development. Underdeveloped countries, being short
of funds, have to exploit every conceivable source to
mobilize resources for economic development. Being
poor, people have very low taxable capacity. But they
can encourage to postpone their consumption through
an appropriate borrowing policy. Further, these
countries are very prone to inflation, therefore, as far
as possible monetized debt (which leads directly to
increase in money supply) should be discouraged.
(d) To stabilize the economy. Whereas undeveloped
countries resort to borrowing to speed up the process
of economic development, public debt forms an
important instrument for economic stabilizations in

developed countries. As a matter of economic policy,
public debt is raised to reduce inflation by resorting to
compulsory borrowings. Similarly during depression
borrowings of ideal funds which are unspent in the
hands of private individuals are borrowed by the
government and are respent to add to the effective
demand.
CLASSICAL VIEW OF PUBLIC DEBT

It is pointed out that the classical and neo-classical position
on public debt was by no means uniform throughout the late
eighteenth, the nineteenth, and the early twentieth centuries,
that is, from Adam Smith through Bastable and Dalton.
Let it be noted that views on public debt and views on
budget balancing are often only opposite sides of the same coin.
Some persons may be concerned about failure of government to
balance its budget (in the sense of covering all expenditures in a
given period with taxes and revenue from the sale of government
services) because they have reservation about government’s
increasing its debt.
The classical economists viewed the economy as always being
or tending to be fully employed. Hence, their thinking on public
debt (as in other areas of economics) stressed real rather than
monetary aspects. In an economy in which all resources are in
use government cannot acquire resources by borrowing save at
the expense of the private sector. Borrowings must divert scarce
means of production from the private sector to the public sector
of the economy.
Now, not even the most extreme of the classical economists
proposed that society should get along without government in
order that all economic resources might remain for private use.
Rather, the point was that transfer of resources to government
should be held to a minimum since (at least on a ceteris paribus
basis) individual consumer and business firm could more
efficiently employ these resources than could government.
It may be argued that in a fully employed society taxation
and borrowings are alike in that both transfer resources (or
PUBLIC DEBT 275
command over them) from the private use to government use,

and that the argument just presented is not so much an argument
against public debt as an argument against public spending,
howsoever, that spending may be financed. This, of course, is
true; but the classical point of view went further between taxation
and borrowing, the former was in most cases to be preferred.
First, deficit financing, with its accompanying increase in
debt was viewed as being (at least in the beginning) a deceptively
easy method of financing the government. Because of this
seeming ease, government could be led to extravagance and
irresponsibility, with debt becoming a definite burden for the
economy as a whole.
Second, to the extent that additional taxes might be required,
for the purpose of servicing the debt, future financing could be
made more difficult. If a government’s tax potentials are limited
(because, for example, of constitutional or statutory restrictions),
an increasing need for taxes to service debt might produce an
uncomfortable and inflexible budgetary situation in future. This
argument assumed, of course, that the debt, once incurred would
be serviced from future tax collections and not from fresh
borrowings.
Third, an objection to borrowing was that it would usually
require interest payments. Interest payments, being compulsory
expenditure, would add to the total cost of the government
functioning.
A fourth objection was the possibility that unbalanced
budgets and resultant increases in public debt might produce
currency deterioration and price inflation.
Finally, as marginalism came to be grafted into classical
economics in the course of the nineteenth century, a balanced
budget (and the consequent avoidance of additional public debt)
could be justified on the ground that such a budget afforded
a better guide to the transfer of resources from private to
government sector. Marginalism in public finance meant that
an increment of public expenditure would be justified when the
marginal benefit to the community exceeded (or at least equalled)
marginal cost of raising resources to the community. The
balancing of marginal community benefits against marginal

community cost of outlay would be put in sharper perspective
when such outlay was tax-financed.
Notable in such orthodox thinking is the idea, expressed or
implied, that somehow government borrowing diverts resources
from “useful” or “productive” use in the private sector to
“wasteful” public use. Hence, properly restrained borrowing
and debt are recognized as major contributors to the growth of
the private sector.
COMPENSATORY ASPECT OF PUBLIC DEBT

Early Keynesian Views. Even during the nineteenth century,
classical views on public debt did not prevail in all quarters.
The dissenter Malthus objected to any blanket denunciation of
public debt. He argued that the groups sustained by borrowed
funds and interest payment (statesmen, soldiers, bondholders,
etc.) contributed to the effective demand for the products of the
economy. The General Theory of Employment, Interest, and
Money, which Keynes published in 1936, attacked the classical
idea that a free enterprise economy is self-equilibrating at full-
employment level. Instead, he argued, such an economy may
tend toward an underemployment equilibrium, in which case
there are resources in the private sector that may be unemployed
for relatively long period of time in the absence of corrective or
compensatory action by government.1
It follows that government employment of resources does
not necessarily deprive the private sector of anything. On the
contrary, government spending (either for current output or for
transfers) if not at the expense of private spending, may raise
the level of total production and income by drawing into use
otherwise idle resources.
When it comes to financing these government income-
creating expenditures, we may well consider borrowing,
especially when it takes the form of selling securities to the
banking system. The monetary authority can keep the banking
system supplied with reserves so that the banks’ lending to
government does not deprive the private sector of funds. In this
PUBLIC DEBT 277
way there is an excellent chance that government spending (to

the extent that it is deficit-financed) may compensate the fall in
private effective demand. Thus, it follows that private spending
is not affected by public debt. This may follow from:
1. By borrowing idle funds of the people.
2. By borrowing from banks in which case private
financing will not suffer.
3. Still it is better if public debt is financed through
borrowings from the Central Bank.
COMPARISON BETWEEN PRIVATE DEBT AND PUBLIC DEBT

Both borrow when current income falls short of current
expenditure needs. Similarly in both the cases, diversion of
economic resources from one type to another takes place.
However, there are more differences than the similarities.
1. The government possesses both external and internal
sources for borrowings. But individuals do not possess
such diverse types of resources.
2. Funds borrowed by the government are to be used for
the benefit of the community, while the proceeds of
private loan are used for the benefits of the individuals.
3. The government can compel the people to lend money.
Compulsory borrowings may be resorted to meet the
urgent expenditure needs of the government. But no
private individual can compel other to lend him the
money.
4. Generally, because of the credibility and lesser risk
involved in case of public debt, the rate of interest
would be less.
5. Government generally borrows for productive purposes,
the private individual can borrow for consumption
purpose also. Although government can borrow for
consumption purposes, yet as far as possible, it should
be avoided because then it will be difficult for the
government to repay the amount (principal plus
interest).
6. Government debt is repaid through surplus income,

surplus from public enterprises as well as through fresh
borrowings. But private debt is repaid only through
private income.
7. Government may borrow even if it does not need
the money, i.e. government borrows as a matter of
economic policy both during the inflation and
depression. But the private individuals borrow only
when they need it.
CLASSIFICATION OF PUBLIC DEBT

Public debt has been classified in many ways, though all the
classifications are not very useful. However, to analyse the
economic effects of public debt, these classifications may be
useful.
1. Internal and External public debt.
2. Productive and Unproductive public debt.
3. Redeemable and Irredeemable public debt.
4. Funded (Permanent) and Unfunded (Floating) public
debt.
5. Voluntary and Compulsory public debt.
1. Internal and External Public Debt. One very common
classification is between internal and external public debt.
Internal public debt refers to the public loans floated within the
country (private individuals, business houses, commercial banks,
central bank, non-banking financial institutions, etc.). External
public debt refers to the obligations of a country to foreign
government, or foreign nationals or international institutions
(IMF, World Bank, IBRD, etc.). Though these days there is a
general tendency for the external debt to increase, yet foreign
loans are unpopular and a general prejudice exists against them
because political independence of a country may be at stake.
During 1990’s a large amount of public debt in India from IMF
and the World Bank is said to have been raised by accepting the
certain conditions of these agencies, noteably the adoption of
privatization, liberalization and globalization, commonly known
as New Economic Policy in the country.
PUBLIC DEBT 279
2. Productive and Unproductive Public Debt. Public debt is

said to be productive if the investment yields an income which
will not only meet the yearly interest payment of the debt but
also help repay the principal over the long run. Public debt
can be said to be productive in another sense too when the
government may undertake certain projects through loans which
may not be productive in the sense given above but which may
be useful to the community—as for example, a railway line
connecting a backward region, an irrigation work to prevent
famine conditions in an area, etc. In this sense, most public debt
is productive. But public debt may be contracted during war-
time to finance wars. Such debt is unproductive because it does
not create any asset, it is a dead weight debt or a useless burden
on the community.
3. Redeemable and Irredeemable Public Debt. Redeemable
loans are those loans which the government promises to pay off
in the future at a specified date. They are terminable loans.
Irredeemable debts are those which may not be redeemed or
repaid at all but the government promises to pay the interest
regularly. These loans may be known as perpetual debt. The
redeemable loans may be further classified into short-period
and long-period depending upon the period of redemption.
4. Funded and Unfunded Public Debt. The public debt has
also been classified into funded (permanent) and unfunded
(floating). Funded debt are long-term debts. The payment of
these loans may be made at least after a year or more or may
not be made at all. In other words, funded debts are those
that are redeemable after a year or are not redeemable at all.
Unfunded debts are those that are paid off within a year.
Treasury bills are unfunded debts, because they are for three or
six months and are never for a longer period than a year.
However, it should be noted that in case of funded debt, the
government obligation is to pay a fixed sum of interest to the
creditor, subject to an option of the government to repay the
principal before the expiry of the date. Hence, the creditor
(bondholder) has no right to any thing except the interest on
the amount that he has credited to the government.
5. Voluntary and Compulsory Public Debt. Generally,

government debt is of a voluntary nature, the individuals and
the institutions are invited to purchase government bonds.
However, compulsory loans are not uncommon in modern times.
The government may have to exercise its authority or pressure
for getting loans during an emergency such as war, drought,
etc. and during an inflationary period so that the volume of
purchasing power in the hands of people may be reduced and
the rising prices may be checked. In most of the cases, the loans
floated by the government are over-subscribed, because the
government has a much better credit worthiness than a private
individual or a company, and that is why the rate of interest on
the government securities is lower than other types of securities.
The government securities are known as the best securities (or
class-I securities) for investment. However, if the rate of interest
on government securities is very low then it may find difficult
to get loans voluntarily from the public, it may have to exercise
its authority.
Among other classifications, mention may be made between
marketable and non-marketable debt depending upon the
negotiability of government loans; interest bearing and non-
interest bearing public debt; gross and net public debt, etc.
SOURCES OF PUBLIC DEBT AND THEIR ECONOMIC

IMPLICATIONS
A. Public Borrowings from Individuals (Including Business
Houses). When individuals purchase government bonds, they
are diverting funds from private use to government use.
Individuals may be able to subscribe to government bonds either
through curtailment of current consumption needs (this may be
very rare) or from diversion of funds meant for one’s own
business. Normally, sale of government bonds to individuals
should not curtail either consumption or business expansion.
To a large extent, the government bonds would be purchased
out of funds that would have been lying idle, so consumption
and investment are not affected, if public debt is voluntary. If
public debt is compulsory then consumption and investment
may be affected.
PUBLIC DEBT 281
B. Public Borrowings from Non-Banking Financial

Institutions. More important than individual subscribers to
government bonds are the financial institutions such as insurance
companies, financial trusts, etc., also known as non-banking
financial intermediaries. These non-banking financial institutions
prefer government bonds because of the security provided by
the latter and also due to their high negotiability and liquidity.
But the rate of interest is low and hence in many cases these
financial institutions may prefer high-risks, high return securities
particularly equity. When non-banking financial institutions take
up government bonds they do so to reduce their cash holdings.
C. Public Borrowings from Commercial Banks. While
individuals and non-banking financial institutions take up
government bonds out of their own funds, the commercial banks
can do so by creating additional purchasing power—known as
debt through credit creation or created money. The banking
system as a whole, can make additional loans up to an amount
several times more than the excess cash reserves with them.
This is possible because the loans, the bankers/banks give are
typically book entries in the names of borrowers who pay in the
form of cheques to others who have also bank accounts. The
result is that so long as cash is not withdrawn from the banks,
it serves as the basis for the expansion of loans.
Thus, commercial banks can subscribe to government bonds
(or loans) through the creation of money. They need not contract
their other loans and advances. Whenever the banking system
has excess cash reserves, it can absorb an amount of government
bonds considerably greater than the excess cash reserves. So if
commercial banks create additional purchasing power and places
it at the disposal of the government to finance the latter’s
expenditures, inflationary pressures will be generated (more so,
if previously the economy was working at full employment level).
D. Public Borrowings from the Central Bank. The Central
Bank of the country can also subscribe to government loans.
This action will be exactly similar to the system of creation of
additional purchasing power by the commercial banking system.
By purchasing government bonds, the Central Bank credits the
account of the government. The latter pays to its creditors out
of its account with the Central Bank. Those who receive cheques
from the government drawn on the Central Bank (Reserve Bank
of India) will deposit the amounts in their accounts in their
banks. These banks will find themselves with large cash reserves
or deposits which would become the basis for additional loans
and advances. It will be seen that the borrowings from the
Central Bank is the most expansionary of all the sources for not
only the government secures funds for its expenditure but the
commercial banking system gets additional deposits which can
be used as the basis for further credit creation, i.e. additional
money is created in the process. To curtail the unlimited facility
of the government to borrow from the Central Bank, most of
the countries have passed laws to put a cap on this source of
public borrowings. The Central Government in India has already
passed the FRBMA (Fiscal Responsibility and Budget
Management Act) and many State Governments have also
followed suit.
While the borrowings from individuals and financial
institutions are simply transfer of funds from private to
government use and, therefore, will not be expansionary in their
effect on the economy (unless the funds were previously lying
idle and are being activised through government borrowing),
borrowings from the commercial banking system and the Central
Bank will have expansionary effect. This type of public debt is
also known as debt through created money.
E. Public Borrowings from External Sources. Government
can borrow from other countries too. These borrowings can be
used to finance war expenditure (or to procure defence
equipment) or to pay for development projects or to pay off
adverse balance of payments. Formerly, the floating of loans
for any specific development project like railway construction
was taken up by individuals and banking and other financial
institutions. However, in recent years, apart from these sources,
two important sources have become more prominent. They are
(a) international financial institutions, viz. IMF, IBRD, IDA and
IFC, and (b) the government assistance. For developing countries
like India, external sources of borrowing are becoming
considerably important in recent years.
PUBLIC DEBT 283
A very peculiar effect is observable in case of foreign loans.

These can act as anti-inflationary devices if are in kind. But
when the amount is respent in the country (like PL 480 loans),
they act as inflationary and may retard economic development.
As in case of India PL 480 Aid (in sixties), by providing free
foodgrains, suppressed the agricultural prices and thereby delayed
the process of Green Revolution in the country.
EFFECTS OF PUBLIC DEBT

A. Public Debt and Consumption. The existence of public
debt has an important effect on consumption. Those who hold
government bonds representing the latters’ obligation to pay
consider these bonds as personal wealth. This wealth would not
have arisen if the government had financed its expenditure
through taxation. The net result is that the possession of
government bonds will induce them to spend not only their
current income but also in excess of their current income since
they hold wealth. The bondholders usually forget that bonds
also hold claim on them in the form of additional taxation
which may be required to repay the public debt. Consequently,
the net effect of public debt is to increase the percentage of total
income spent on consumption and thus exert an expansionary
effect on the economy.
B. Public Debt, Liquidity and Price Level. Public debt is
represented by bonds which are highly negotiable. Those who
have bonds have highly negotiable and highly liquid form of
assets. Whenever individuals require more funds for any
purpose—transaction, precautionary or speculative motives—
they can easily convert the bonds into cash. Public debt is thus
responsible for the existence of highly liquid form of assets,
which may put limitations before the monetary authorities.
Another important effect of the government bonds is to be
found in the case of commercial banks. These banks hold large
amounts of government bonds which can be converted into cash
whenever cash is required. These bonds would also mean higher
reserves with the central bank. Therefore, they can also create
more credit against these reserves. This may make the operation
of monetary policy ineffective, particularly during inflation.
C. Public Debt and Crowding-Out Private Investment. The

effect of public debt on investment is not always very clear.
Two apparently contradictory effects can be visualized. On the
one hand, the existence of huge public debt and the consequent
high rates of taxation to service the debt will generate fear and
uncertainty in the minds of investors. Besides, the existence of
huge debt involving huge interest payments may suggest the
possibility of the government introducing capital levy (special
taxes) or the extreme method of repudiation of public debt. All
this will affect adversely long-term investments. On the other
hand, the existence of large public debts will force the
government to maintain a low rate of interest in order to keep
its interest obligations at the lower amount possible. Accordingly,
borrowing and investment will be encouraged. Some observers,
particularly following classical economic thoughts, point out
that public debt crowd-out, i.e. reduces private investment
because lesser resources are available for the private sector.
However, evidence also exists that there is positive link between
public investment, and private investment. If the government
invests the proceeds from public debt for building economic
and social infrastructure, which it should, then private investment
will also be promoted. Thus, it is difficult to state clearly whether
existence of public debt will encourage or discourage investments.
D. Public Debt and Production. We can study the effects of
public debt on production by using Dalton’s three criteria on
which production depends, i.e. ability to work, save and invest;
incentive to work, save and invest and; diversion of economic
resources.
The ability to work, save and investment will be increased
when the funds lying idle or borrowings from the banking system
are used by the government to increase productivity (through
development projects). Again, funds spent on the workers (on
their education, health, housing, water facilities, etc.) will
promote the ability of workers to work and save. But then,
taxation to repay debts or to pay off interest charges will have
adverse effects on the ability to work, save and invest. Thus, the
net effect will be either way.
PUBLIC DEBT 285
As regards the desire or incentives to work and save (invest),

public debt will generally tend to reduce it. On the one hand,
public debt, by providing safe and steady channel of investment
in government bonds, may encourage savings. But taxation which
is necessary to pay principal and interest charges will discourage
savings. Moreover, the receipt of interest by the bondholders of
government bonds may reduce their desire to work and save. So
the effect will be either way.
Finally, as regards diversion of resources, public debt involves
the use of funds on those expenditures considered essential and
more useful than those on which these funds otherwise would
have been spent. If idle funds are used for the construction of
railways, irrigation projects, power projects, etc., the diversion
will be really justified. The same may be said if borrowing from
the banking system is used to create permanent and productive
assets. The only harmful diversion will take place when
funds which otherwise would have been used for productive
purposes are used for defence. But again this depends upon the
circumstances.
In general, following Dr. Dalton’s reasoning, public debt
can be said to be generally favourable to promote production,
income and employment. But the fear created by plausible higher
doses of taxation or even capital levy in future to repay the
public debt may discourage the investors.
E. Public Debt and Distribution of Income. Public debt is
said to promote inequality in the distribution of income. It is
sometimes held that a large amount of public debt increases the
inequality of income distribution in favour of the bondholders.
Since bondholders are generally rich, this leads to more inequality
in distribution of income. But this has been contested by Prof.
Lerner.2 He says that it is because of the inequality in the
distribution of income that the bonds are held by the richer
sections in large quantities. In other words, the inequality in the
distribution of income is the cause, not the effect, of the
concentration of public debt in the hands of a few rich. At
the most one can say that public debt may accentuate
inequalities.
It should be noted that though the floating of public debt is

generally deflationary since it creates stringency in the money
market (i.e. less money is left in the hands of public to spend),
the existence of a large amount of public debt may set in motion
an inflationary tendency at any time. This is so because
government bonds or securities are near money and may be
converted into true money readily at the discretion of the bond-
holders. This may make the economy very much sensitive to
inflation. In fact, the existence of a large amount of public debt
makes the instruments of monetary policy less effective. These
types of secondary burden of public debt should also be taken
into account.
THE BURDEN OF PUBLIC DEBT

The question relating to the burden of public debt is a very
controversial issue, namely whether public debt imposes any
burden on the community concerned or any portion thereof;
and also whether the burden, if any, of the public debt can be
shifted to a subsequent generations.
An extreme form of opinion on the issue is that an internally
held public debt imposes a burden just like a private debt. This
is, however, obviously wrong, for in the case of private debt the
debtor has to pay the interest and the principal to the creditor
who is a different person whereas in the case of public debt the
taxpayers pay the interest and the principal to the bondholders,
and since both the taxpayers and the bondholders belong to the
same state this imposes no burden on the state as a whole in the
sense a private debt does on the debtor.
Another extreme form of opinion on the issue is that since
an internally held public debt requires a transfer of funds from
the taxpayers to the bondholders in the same state, it is virtually
equivalent to the transfer of money from one pocket to another
pocket of the same person, with the result that such debt imposes
no burden whatsoever. This view is also equally wrong, as though
the taxpayers and the bondholders belong to the same state,
they are different groups of people and the satisfaction lost by
one group may not be compensated by the satisfaction gained
PUBLIC DEBT 287
by the other group and, therefore, the society as a whole may

suffer a net loss. Even if the taxes are imposed only on the
bondholders (in proportion to the interest they will earn on
government bonds), it will involve a burden because people buy
the government bonds in the expectation of earning a positive
rate of interest and not to pay the tax. Tax payment will impose
sacrifice while interest receipts may not mean any additional
benefits. Therefore, utility loss will be more than the utility
gains. Hence, the public debt will impose the burden.
The relevant factors which should, therefore, be taken
into account in considering as to whether an internally held
public debt imposes a burden and if so how much, are set forth
below:
1. The nature of the burden of an internally held public
debt is different from that of an externally held public
debt. In the case of an externally held public debt, the
interest and the principal are required to be paid by
the debtor countries to the creditor countries by means
of export surplus and, as such, by the transfer of real
resources from the debtor countries to the creditor
countries. In the case of an internally held public debt,
on the other hand, the resources remain within the
country but are only required to be transferred from
the taxpayers to the bondholders in the form of interest
payments to the latter.
2. If the burden of an internally held public debt is
measured by the amount of interest transfers to be made
annually from the taxpayers to the bondholders then it
follows that the burden is not measured by the absolute
amount of the public debt, but by the rate of interest
stipulated on the bonds. Thus the burden of a given
amount of public debt with, say, a 2 per cent interest
rate is half the burden of the same amount of debt
with a 4 per cent interest rate, since in the former case
the required money transfer from the taxpayers to the
bondholders by the state is one-half compared with
the latter case.
3. If the burden of public debt consists in the raising of

taxes for paying interest to the bondholders then the
burden is measured by the amount of the strains and
frictions which are imposed on the economy as a result
of the tax raising and interest payment programme
and the ultimate limit of the size of the public debt is
determined by the strains and frictions which can be
imposed upon the community in this manner, i.e. the
amount of such strains and frictions which the
community is in a position to bear. If, for example, the
bonds are held predominantly by the richer section and
the tax is raised from the poorer people then these
strains and frictions will be greater than if the bonds
are held by the poorer people and the taxes are imposed
on the richer. However, even if a tax system could be
so devised (though it is almost impossible) that all
bondholders were to pay in tax just the amount they
received as interest, still then there will be a burden of
public debt in the shape of frustration of the
bondholders in as much as such bondholders had
expected to get some returns by the purchase of the
government bonds. In the words of Ratchford, “An
internally held public debt is an economic burden even
when taxes are paid to service the debt in the same
ratio as the bonds are held. This is true because of the
frictions of levying and collecting taxes and because of
differences in the subjective effects of paying taxes and
receiving interest. Most important, however, is the fact
that such a debt is a burden because, when joined with
a progressive tax system, it substantially restricts
investment and thus lowers national income. Other
elements of the burden are the facts that a debt limits
a government’s freedom of action, and may preclude
effective control of the monetary and banking systems.”3
4. Prof. Domar holds that the burden of public debt should
be defined as the ratio of the total debt to the total
national income, i.e. total debt/total national income.
If the total amount of national income remains constant
PUBLIC DEBT 289
and the total amount of public debt increases year after

year, the burden of the debt would increase.4 But if the
national income also rises, say, by a constant absolute
amount together with the increase in the amount of
public debt by a constant amount, then in spite of the
increase in the volume of public debt, the burden of
public debt, defined as the total amount of public debt
divided by the total amount of national income will
actually fall. This will be more so if the national income
rises by a constant relative amount along with the rise
in the amount of public debt. In other words, as the
national income rises the total amount of tax collected
by the state rise automatically, and thus larger and
larger amounts of public debt may actually impose lesser
and lesser amounts of burden. This finding has led
Domar to opine that if all the people and organizations
who work and study, write articles and make speeches,
worry and spend sleepless nights—all because of the
fear of debt—could forget about it for a while and
spend even half their efforts trying to find ways of
achieving a growing national income, their contribution
to the benefit and welfare of humanity and to
the solution of debt problem would have been
immeasurable.
Domar’s argument that the burden of public debt (defined
as the ratio of public debt to national income) may be reduced
even with an increase in the absolute volume of the public debt
can be shown by means of the following simple example.
Let us conceive of three cases, namely case I where national
income remains constant over years; case II where national
income increases over years; and case III where national income
rises at a faster rate than in case II. Suppose also that in all
cases 20 per cent of the national income is debt financed and
that a given amount of national income obtained by debt
financing in a particular year lasts for that year only and hence
to generate the same amount of income during the next year an
additional amount of debt financing and hence public debt
creation will be necessary.
Case I (when national income is constant at, say Rs. 500)
Year I Year II Year III The ratio at the end of the

third year
Public Debt 100 100 100 300
National Income 500 500 500 500
Case II (when national income increases by Rs. 100 per annum)

third year
Public Debt 100 120 140 360
Case III (when national income increases by

Rs. 200 per annum)
third year
Public Debt 100 140 180 420
From the table, it appears that though the absolute amount

of the public debt increases from case I to case II to case III
from Rs. 300 to Rs. 360 to Rs. 420 each at the end of the third
year, the burden of debt (defined as the ratio of public debt to
national income) decreases from greater than half to half and to
less than half in the cases in that order.
5. Dr. Lerner is of the opinion that when unemployment
is fought by deficit spending and as such the amount
of public debt increases, the so-called burden of the
debt should be weighed against the burden of
unemployment which would be there if the deficit
spending programme had not been undertaken. And if
this is done, the burden of the debt may appear to be
much smaller and even nil or negative.
6. It should be noted that though the floating of public
debt is generally deflationary since it increases
stringency in the money market, the existence of a large
amount of public debt may set in motion an inflationary
tendency at any time. This is so because the government
securities are near-monies and if the monetary
authorities and the government follow a stable bond
PUBLIC DEBT 291
and/or bill market policy the government securities may

be converted into true money readily at the discretion
of the holders of such securities. This may make the
economy very much inflation sensitive. In fact, a large
public debt very much limits the possibility of a vigorous
exercise of the central banking credit control techniques
which might increase the rate of interest, since this
might lead to a fall in the prices of the outstanding
government securities and create disorderly conditions
in the government securities market. These types of
secondary burden of public debt should also be taken
into account.
7. A large amount of public debt requires a
correspondingly large amount of tax collection and
this may adversely affect work incentives and savings
and risk-taking propensities, which under certain
circumstances may mean a worse allocation of the
economic resources.
8. It is sometimes held that a large amount of public debt
increases the inequality of income distribution in favour
of the bondholders since the bondholders are generally
the richer people whereas there is a definite limit upto
which taxes may be made progressive without seriously
detrimental effect on work, incentives, etc. This point
of view has, however, been contested by Dr. Lerner
who holds that it is because of the inequality of income
distribution that public debt is held by the richer section
in larger quantities. In other words, the inequality of
income distribution is the cause, not the effect, of the
concentration of public debt in the hands of the richer
few.
Public Debt and the Posterity (Future Generations)
Another question which has given rise to a great deal of
controversy in recent years is whether the system of financing a
project by means of public debt shifts the burden to the future
generation. One traditional argument is this: If taxes are used
to finance a project, persons pay for the projects now; if funds
are raised by borrowing, the present generation escapes the cost

and the burden is shifted to the future generation which pays
the interest and the principals. Hence, the public debt shifts the
burden to future generations.
The above argument is stated to be wrong for the following
reasons: The real burden of governmental activities must be
borne in the period in which expenditure is made since it is in
this period that resources are diverted from private to public
use. The real burden of a war, e.g. consists of the use of materials,
manpower and the like to produce war materials instead of
civilian goods, and this is borne during the period of the war in
the form of reduced consumption, regardless of the method of
financing employed.
The borrowing method as we have seen, certainly creates
some problems for the future generations in the shape of adverse
effects on the economy from the necessary taxes to pay interest
and principal to the bondholders, inflationary effects of the
existence of the debt, etc. But there is no shifting of the basic
burden to the future; while the future generations inherit the
obligation to pay interest and principal on the debt, they also
inherit the bonds themselves and as such receive the interest
payments and principal repayments. In other words, in the future
generation when interest and principal payments are made, there
occurs only a transfer within the future generation and hence
no real burden is imposed to such future generation.
This view, however, does not take into account that even if
the real burden of financing a project consists in the sacrifice of
private consumption, the same may be out of present or future
consumption. The burden cannot be the same in the two cases.
The theory of shifting of burden has thus been revived in new
forms discussed below:
1. Ricardo-Pigou Thesis.5 According to it, if the government
expense is financed by taxation the first generation hands on to
the second generation nothing but tax receipts; if by bond issue,
the first generation bequeaths the bonds to the second generation,
but along with them, a tax liability represented by the annual
charge on the debt for interest, and, if the bonds are not
PUBLIC DEBT 293
perpetuities, for redemption or amortization. The welfare of the

second generation, however, depends not on whether it inherits
tax receipts or government bonds, but on what it inherits in the
way of real stock of capital; and this latter inheritance depends
on the reaction of the first generation to the taking away of real
resources by the government. The first generation is likely to
cut its consumption more and investment less, if it receives only
tax receipts from the government, than if it receives bonds,
because it fails to give full weight to the task ahead of servicing
the bonds. This failure is due to the fact that no one individual
can be sure of the amount of tax he will have to pay towards
the servicing of the bonds each year in the future. Every
individual, feeling richer, may cut his consumption less. As a
result, a smaller amount of capital stock will be handed down
to the second generation. The burden in this case consists in
inheriting by the second generation a smaller amount of capital
stock than otherwise.
2. Buchanan Thesis.6 Prof. Buchanan holds that the financing
of a project by the government by means of borrowing does
shift a burden to the future generations. According to him, the
concept of burden should be interpreted in terms of the individual
attitudes towards their economic well-being rather than in terms
of changes in private sector outputs and real income because of
the inheritance by the latter generations of a larger or smaller
amount of capital instruments. Buchanan argues that during
the period in which the project is financed and borrowing takes
place, no burden of any kind is created; individuals who give
loans to the government voluntarily exchange liquid funds for
less liquid government bonds instead of using the funds for
acquiring consumption and/or investments goods. Since this is
done voluntarily by the individuals concerned, they do not feel
themselves to be any worse off. When, however, the bonds are
repaid in the future funds are transferred from the taxpayers to
the bondholders; as a result, the taxpayers feel themselves to be
worse off, but the bondholders do not feel better off since they
have now merely changed bonds for cash. In other words, as
the bondholders are not worse off by changing cash into bonds
so also they cannot be better off in the latter generations by the
changing of bonds into cash. But in the latter generations the

taxpayers are worse off since tax is a compulsory payment. As
a result, the society as a whole becomes worse off during the
future generations. In this sense, a burden is shifted to the future
generations.
3. Musgrave Thesis of Inter-generation Equity. 7 Prof.
Musgrave constructs a case in which, regardless of the reaction
of generation I to tax finance or loan finance, loan finance
always divides the cost among generations and tax finance can
never do so. In this sense, loan financing does shift the burden
to the generations to come.
Musgrave is concerned with a long-lived government facility,
the cost of which is to be distributed equitably amongst those
who make use of it. Suppose that the project has a life of three
periods and each generation has a life span of three periods. As
period I opens, generation I, already in its last period, is on the
scene; so also are generation II with one more period to go, and
generation III, in its initial period. In the second period, there
exist generation II in its last period as also generations III
and IV. In the third period there will be generations III, IV
and V respectively in their third, second and first periods.
The problem is how to take from the generations in question
their “due” shares of the cost of the project. This depends upon
the number of periods for which a generation enjoys the facilities,
which is as follows:
Generation I 1/9th
Generation II 2/9th
Generation III 3/9th
Generation IV 2/9th
Generation V 1/9th
The “due” share being proportional to the period or periods
for which the service of the facility is enjoyed by each generation.
Musgrave’s solution is to require generation I to pay 1/9th of
the cost in taxation and so on. As to financing the project in its
year of construction, 6/9ths must be covered by loan; but no
part of the loan can be demanded from generation I, since it is
already in its last period, and thus could never be repaid.
PUBLIC DEBT 295
Generation I is vanishing at the end of the first period. So,

6/9ths is financed by loans from generations II and III, who are
repaid before they vanish. Thus, everybody gets his money back,
except to the extent that he is required to pay tax, and the tax
is distributed over time in accordance with the degree of service
use.
4. B.D.K. Thesis. A corollary of the Ricardo-Pigou thesis is
that a project (financed by public debt) will not shift any burden
to the future generation if initially it is financed wholly by a
reduction in private consumption. This contention has, however,
been disputed by Bowen, Davis and Kopf, 8 who have
demonstrated that even if a project is financed wholly by a
reduction in consumption by generation I, a burden is
nevertheless shifted to the future generation(s). Thus, suppose,
in a country producing only timber, in year 1900, a quantum of
100 tons of timber is consumed by the government for meeting,
say, war needs and the ‘project’ is ‘financed’ wholly by a
reduction of 100 tons of timber consumption by generation I.
Supposing that the life span of each generation is 50 years and
assuming that the reduction in the consumption of timber made
by each generation at the time of its appearance is met by a
corresponding increase in its consumption before it passes away,
the pattern of timber consumption by three generations will be
as follows:
Year Generation Timber consumption in tons
1900 I –100
1950 I +100
II –100
2000 II +100
III –100
It should be noted from the above illustration that though

the government consumption of timber has been financed wholly
by a reduction in the consumption of timber by generation I,
still the consumption of every generation is deferred by 50 years;
and this will be continued until the debt floated by the
government for consuming the timber initially is amortised. This
deferring of consumption, according to BDK, is a burden, even
though the whole of the initial consumption of timber by the
government is matched by a corresponding decrease in the private

consumption.
REDEMPTION OR REPAYMENT OF PUBLIC DEBT

Just as the private individual or organization has to return
the loan it has borrowed, so also the government has to pay not
only interest on the public debt but also repay the principal.
Experience shows clearly that mounting public debt has a
demoralizing effect on the people apart from the fact that the
public is subjected to higher rates of taxation. Therefore, the
sooner the debt is cleared, the better for the government. It may
also be observed here that if public debt has been contracted for
productive purposes, it may not be strictly necessary to redeem
it since the government is getting a source of income to pay off
the interest of the debt. But if public debt consists mostly of
unproductive or dead weight debt (e.g. war debt) the sooner it
is paid off, the better, both for the government and for the
public.
Different methods are used by the government to redeem its
debt. Some of these methods are extreme ones such as repudiation
of debt, while others may not be a redemption at all, but payment
of one debt with the help of another debt.
1. Repudiation of Public Debt. Repudiation of public debt
means simply that the government does not recognize its
obligation and it refuses to pay the interest as well as the
principal. Repudiation is not (in fact) paying off a loan but
destroying it. Normally, the government does not repudiate its
debt, for this will shake the confidence of the general public in
the government. For instance, internally, the country may be
facing a financial ruin and bankruptcy, and externally, it may
be faced with shortage of foreign exchange. Generally, the
government may not repudiate its internal debt lest it should
lead to internal revolt. Those who have lent money to the
government would obviously rise against government. However,
the temptations of a government to repudiate its external debt
obligations may be strong in certain times. Of all the methods
of redeeming the public debt, repudiation is the most severe and
extreme but strictly speaking it is not the redemption of public
debt. However, this method has been tried in many countries in
PUBLIC DEBT 297
the past. America during the Civil War and Russia after the
revolution resorted to this method in order to wash off their
hands from the public debt raised earlier. In the recent times,
Latin American countries declared bankruptcy and disowned
the external public debt raised earlier. India, in 1991, in order
to avoid such a situation, borrowed heavily from the
international agencies such as IMF and the World Bank accepting
certain conditionalities.
2. Conversion of Loans and Refunding of Debt. Another
method of redemption of public debt is known as conversion of
loans, i.e. an old loan is converted into a new loan. Conversion
may be resorted to: (a) When at the time of redemption of loan,
the government has not the necessary funds, and or (b) When
the current rate of interest is lower than the rate which the
government is paying for its existing debt, so that the government
can reduce its interest payments. Debt swapping scheme
introduced by the Government of India in 2002, is in fact
refunding of debt by the State Governments which they owed to
the former. Conversion of a loan is always done through the
floating of a new loan. Hence, the volume of public debt is not
reduced. Therefore, strictly speaking conversion of debt is not
redemption of debt.
Sometimes, distinction is made between refunding and
conversion of debt, though sometimes, both the terms are used
to mean the same thing. Strictly speaking, refunding refers to
the method of paying off a loan carrying higher interest through
a new loan carrying a lower interest rate. Refunding, therefore,
is the repayment of debt through fresh loans. On the other
hand, conversion involves a change in the rate of interest or
other details on the same loan. For instance, at the time of
maturity of a loan, the government may give an option to the
existing bondholders either to receive money in cash or give
them an opportunity to convert their old bonds for new bonds.
Broadly, refunding and conversion are similar.
3. Serial Bond Redemption or Terminal Annuity or Annuity
Deposit Scheme. The government may decide to pay off every
year a certain portion of the bonds issued previously. Therefore,
a provision may be made so that a certain portion of public
debt may mature every year. And decision may also be made in
the beginning about serial numbers of bonds which are to mature
in each year. For example, National Savings Certificates (VI
series) mature or terminate every sixth year. A variant of this
type of bond redemption is to determine the serial number of
bonds to mature every year through draw or lottery. While
under the first variant, the bondholders know when the different
sets of bonds would mature and could take up the bonds
according to their convenience, under the second variant, the
bondholders are uncertain about the time of repayment and
they may get back their money at the most inconvenient time.
4. Buying Up Loans. The government may redeem its debt
through buying up loans from the market. Whenever the
government has surplus income, it may spend the amount to
buy government bonds from the market where they are bought
and sold. It is a good system provided the government can secure
budget surpluses. The only defect of this method of repaying
public debt is that it is not a systematic method. This method is
applicable only when the government has a surplus budget and
the public debt is marketable. Moreover, it will adversely affect
the rate of interest. There is always an inverse relationship
between bond prices and the rate of interest. If government
resorts to buying back the public loans from the market, then
the market will be flooded with increase in money supply and
hence the rate of interest will decline. On the other hand, bonds’
prices will increase because of fewer bonds in the market.
Assuming that the rate of interest is 10.0 per cent, then a bond
worth of ` 100 will earn ` 10.0. If rate of interest falls to
5.0 per cent, then to earn ` 10.0, bonds worth ` 200 will have
to be purchased. That is bond prices double when interest rate
halves.
5. Sinking Fund. Sinking fund method is probably the most
systematic and, therefore, the best method of redeeming public
debt. It refers to the creation and the gradual accumulation of a
fund which will be sufficient to pay off public debt. There are
many varieties of sinking fund. The most common method is as
follows:
PUBLIC DEBT 299
Suppose, the government floats a loan of ` 100 crores

redeemable in, say, 10 years for the purpose of road construction.
At the time the public debt is raised, the government may levy
a tax on petrol or a toll tax, the proceeds of which would be
credited to a fund to be known as sinking fund. Year after year,
the tax proceeds as well as interest on investments (made through
tax proceeds) will make the fund to grow till after ten years, it
becomes equivalent to the original amount borrowed plus the
interest obligations. At that time, the debt will be paid off.
One danger of the sinking fund method is that a government,
in need of money, may not have the patience to wait till the end
of the period of maturity but may utilize the fund for purposes
other than the one for which originally the sinking fund was
instituted.
In modern times, sinking funds are not accumulated and
continued from year to year as we have described above. Instead,
some funds are earmarked each year for repayment of some
part of the debt in the same year. The amount earmarked is not
put in a fund and allowed to accumulate but is used every year
either to pay off the bonds which are maturing every year or to
buy government bonds from the market. To solve the problem
of states’ indebtedness, the Twelfth Finance Commission has
suggested the sinking fund method to the states.
6. Capital or Special Levy. Public debt may be redeemed
through a capital levy which may be imposed once a while with
the special objective of redeeming public debt. It is generally
advocated to repay the public debt immediately after the war
for the following reasons: (a) Heavy public debt has been incurred
during the war to fight it and hence public debt burden is very
heavy after the war. (b) War debt is unproductive and a dead
weight debt on the community necessitating heavy taxation year
after year. It will be better to wipe it out once for all by imposing
a special levy. (c) Due to war time inflation, businessmen,
producers and speculators would have amassed large fortunes
and hence it is easier for them to contribute to a capital levy
and, in a sense, it is just that they bear a part of the war burden.
(d) Redemption of public debt through capital levy will leave
the higher income groups almost in the same old position, since
they will be receiving back from the government what they will
have paid by way of the special levy. Thus, capital levy has a
neutral effect.
Redemption through a special levy is said to be superior to
the method of sinking fund, as it is levied only once. While, for
purposes of the sinking fund, taxes have to be imposed year
after year. The greatest merit of capital levy is that it will reduce
a continuous heavy tax burden which will otherwise be necessary
to redeem the public debt. But the danger of a capital levy is
that the government may be tempted to resort to it too often,
which would have adverse effects on ability and incentives to
work, save and invest.
Redemption of External Public Debt
The redemption of external public debt can be made only
through accumulated necessary foreign exchange to pay for it.
This can be done by creating export surpluses. Towards this
end, foreign loans should be carefully invested in those industries
which have high productive potentialities and which will promote
exports directly or indirectly. At the same time, export surpluses
should consist of goods which can be readily accepted by
foreigners. Of course, temporarily redemption of an old debt
can be made through floating of new loans. This is what the
modern governments are doing these days.
To conclude, there is nothing to choose amongst the various
methods except that we should not use repudiation. Every
method has advantages as well as disadvantages. The best
method is that which redeems a part of the public debt every
year so that it does not continue to mounting year after year,
i.e. terminal annuity and sinking fund method. Capital levy too
is good, if resorted to occasionally.
MANAGEMENT OF PUBLIC DEBT

Debt management refers to the debt policy which seeks to
achieve certain economic objectives while raising and repaying
the public debt.
The most important pre-requisite for an efficient
management of the public debt is that the debt should be so
PUBLIC DEBT 301
issued, pattern of maturity structure of the bonds should be so

determined, the interest rates should be so fixed, taxes to repay
the public debt should be so devised and the bonds should be so
redeemed that the strains and frictions imposed on the economy
are kept at the minimum so as to gain the greatest economic
advantages or the least economic disadvantages. In the words
of Philip E. Taylor, three general principles of debt management
can be identified: (1) The policies pursued must be able to extract
from the public, without undue coercion, the necessary loans to
finance a deficit or to replace maturing securities, and this should
usually be done at the lowest feasible interest cost. (2) The
extraction of loanable funds from the market, and the repayment
of funds to the market when debt is retired, should serve and
not frustrate the economic objective of stable growth. (3) The
debt should be so placed as to minimize the need to enter the
market when it is inconvenient or unpropitious to do so.9
1. Debt management must be capable of providing the
necessary funds from the lending market at reasonable cost to
government. This requires an arsenal of debt instruments capable
of tapping all possible loanable funds at terms including
maturities and interest rates which serve the monetary needs of
economic stability.
One of the important requirements of an efficient
management of public debt is that the interest rates on the
government loans should be kept as low as possible and the
pattern and structure of interest rates on government loans of
different maturities should be so determined that it conforms,
as far as possible, to the preference pattern of the individuals. If
the rate of interest is low on the government securities, it will
impose less burden by way of transferring resources from tax-
payers to the bondholders and as such the strains and frictions
associated with a given amount of public debt will be much less
than if the rate of interest were high. The general approach of
all the governments including India in this connection has been
to maintain a low rate of interest on the short-term loans and to
increase the rate gradually as the maturity period of debt
lengthens.
Since the individuals and institutions prefer to hold debts of

different maturities to secure an optimum balance between
liquidity and solvency on the one hand and the highest possible
income from interest on the other, the monetary authority should
so determine the pattern of interest rates that it conforms, as
nearly as possible to their preference pattern. To achieve this
objective, the government usually resorts to what is known as
‘swapping operation’. The operation consists in the simultaneous
purchase and sale by the monetary authority of government
securities of varying maturities, leaving the total volume of the
securities unaltered and hence leaving the bank reserves intact,
but changing the composition of the securities and thereby the
pattern of interest rates on such securities.
No doubt, every government wants to keep the interest
burden of its debt at the minimum possible level but when this
objective comes into conflict with other objectives, it may be
abandoned. The short-term debts carry comparatively smaller
interest obligation but in case of such debts the ratio of mature
debt to total debt at any point of time is greater and as such the
obligation of the government to pay back the debt at any point
of time will be greater. This will require either fresh taxes and/
or fresh floating of debts. This disadvantange of short duration
debts should be carefully weighed against the advantage of the
comparatively small interest payment on such debts. On the
other hand, the incidence of the repayment obligation of the
long-term debts is smaller at any particular point of time but
this advantage has to be viewed vis-à-vis the higher interest
obligation on such debts.
2. To manage the debt in the service of stable economic
growth requires great flexibility in policy. During depression,
new or refunding debt issues must be so planned as to have no
adverse effect upon private demand for goods and services. This
means that the state should not withdraw funds from those
with high spending propensities but instead borrow from those
sections of the people with whom the funds are lying idle so as
to avoid undesirable effects on private spending. Further, to
have the desired effects on the economy, the state borrowing
programme must not increase the difficulties of the private
PUBLIC DEBT 303
borrowers in any way. In such a situation, the state may borrow

from the central bank directly. This method is certainly good
during depression as it has a positive multiplier effect and it
does not in any way reduce the public’s spending power.
Besides, the maturity structure of the debt may be suitably
varied as an anti-cyclical measure. Thus, in times of depression,
public debt should be funded into short-term debt so that the
long-term funds released may be driven into capital formation.
The reverse is true when the problem is one of over-spending
duration inflation. In this situation, public debt should be
managed in such a way as to restrict monetary demand,
transferring funds from potential spenders, lengthening the
average maturity period of the existing volume of public debt
and certainly not creating new funds in the system.
For attaining the objective of stability and growth, debt
management policy (as and instrument of fiscal policy) and
monetary policy must work in close cooperation and there must
be a complete harmony between the two. The debt management
policy is also designed to secure an optimum use of the economic
resources of the economy. Besides, the central bank by
maintaining stability in the prices of government bonds/securities
helps greatly in securing orderly condition in the government
security market which is conductive to the smooth functioning
of the economic system. Thus, close cooperation between the
monetary policy and debt management policy is essential for
attaining the objective of stability and growth.
3. The third principle can be served best by lengthening the
maturity period for public bonds. The ideal public debt from
this point of view would be made up of instruments which
never mature. In any case, the managers of the public debt
should be in a position to repay the debt at a time when lower
interest or stable growth is dictated. If the holders of the debt
are free to monetize their debt obligations at any time or before
their maturity period, it would create more problems for the
monetary authority than if such freedom is limited or absent.
Besides burdening the central bank with unnecessary strain, it
reduces the effectiveness of the monetary policy. To overcome
this problem, various proposals have been made. One such
proposal is to float non-marketable securities but here the

advantage of non-monetisation should be weighed against the
disadvantage of higher rates of interest that would have to be
offered on such securities. Another suggestion is to combine the
system of non-marketability of the securities for a specified period
from the date of their floation with the adoption of progressive
interest rates, i.e. the rate of interest increases with the increase
in the period for which the security is held. Or still another
device that can be followed with advantage is to fix interest rate
in such a way that it is low in the first one or two years but later
on it increases progressively with the increase in the period for
which the security is held. In this case, though the holder of the
security can get it monetized at any time, he would be penalized
in the shape of getting very low interest income if he actually
monetizes it too early. Thus, in the interest of the effective
management of public debt, the monetary authority must work
out a plan which does not induce the holders of the government
bonds to monetize before their maturity period.
We may sum up the principles of public debt management
as under:
1. The cost of servicing public debt should be the
minimum, i.e. the public debt should be raised and
repaid at a minimum rate of interest. However, such a
cheap money policy may generate inflationary pressures
in the economy if it is already operating near full
employment level.
2. The public debt should be managed in such a manner
that the needs of the investors with regard to the types
of the government securities and the terms of issues
are complied with, failing which there may be
disturbances in the security markets.
3. If the debt is redeemed by issuing new currency, it may
create inflation. If it is serviced through additional
taxation, it may lead to deflationary effects. Therefore,
to avoid both these effects, a proper mix between
the methods of public debt redemption should be
followed.
PUBLIC DEBT 305
4. There must be a close coordination between public debt

and fiscal and monetary policies so that all the three
policies help in securing economic stability and growth.
In conclusion, it can be said that an efficient management
of public debt can go a long way in attaining growth with
stability.
Public Debt Management in a Federal Country
Public debt management poses a serious problem in a federal
country where there are different layers of the government
because both the Centre and the States and even Local
Governments will have to borrow from the same market and
they have different credit worthiness. While the Centre enjoys
more financial powers and hence has greater credit worthiness,
it can borrow from the money/capital market at much lower
rate of interest. Whereas the State Governments will have to
offer a higher rate of interest in order to compete with the
Centre for taping resources from the money/capital market.
Still it is more difficult to borrow for the Local Government
because it has very poor financial base and until and unless
backed by the Centre or the States, it will not be able to borrow
from the market. Moreover in countries like India the Central
Government enjoys unlimited powers to raise the public debt,
the State Governments’ powers are mostly restricted and they
may have to obtain the sanction of the Central Government to
raise fresh borrowings. This unduly creates conflicts between
different layers of the government in a federation. In some
countries, this problem of conflict has been solved by creating
independent borrowing agencies to coordinate the borrowing
process of the Centre and the States. Australian Loan Council is
one such agency operating in the Australian Federation.
PUBLIC DEBT MANAGEMENT IN INDIA10

The need for separation of monetary and debt management
functions/objectives is recognized internationally. The IMF, in
its guidelines on Public Debt Management (2001), discussed
that clarity in the roles and objectives for debt management and
monetary policy minimizes potential conflicts. Reserve Bank of
Australia (1993) discussed how monetary policy implementation

was made difficult by unpredictable net contribution of
government to the amount of cash in money market and yields
fixed by authorities on Commonwealth governments securities.
At a theoretical level also, advantages of clear separation between
debt management and monetary policy have been discussed
extensively in the literature on this subject. For instance, Mohanty
(2002) discussed that, in general, open market operations
function most effectively when a clear division is maintained
between debt management and monetary policy operations.11
Monetary policy’s major objective is price stabilization, whereas
government debt management is designed to search for an
optimal trade-off between the cost of government debt and the
risk involved and the two are potentially conflicting goals.
In India, the debt management function is presently dispersed
over several agencies. Broadly, external debt and non-marketable
debt and other liabilities are largely managed by the Ministry of
Finance through various departments and marketable debt is
largely managed by the Reserve Bank of India. In course of
managing the government debt and financing requirement by
the Reserve Bank, however, the fiscal operations have been
perceived to be overburdening the monetary policy and even
leading to blurring of distinction between fiscal and monetary
policy operations. Ways and means agreement of the Reserve
Bank with the government in 1997 and prohibition of direct
borrowings by the Central Government from the Reserve Bank
under the Fiscal Responsibility and Budget Management Act,
2003 have provided greater transparency and operational
autonomy to the monetary policy framework. In the changed
framework as noted in Reserve Bank’s Annual Report 2000-01,
the extent of monetization and the terms of such monetization
would depend on the judgment of the Reserve Bank in regard to
overall stability. It also underlined that such operational freedom
is essential to assure the system that conduct of monetary policy
balances the three relevant elements, viz. the fiscal needs of the
government, the compulsion of a deregulated interest rate regime
and requirements of a more open external sector. In this
backdrop, the Report mentioned that “the separation of the
PUBLIC DEBT 307
functions of debt management and monetary management is

regarded as a desirable medium-term objective, conditional upon
development of the government securities market, durable fiscal
correction and an enabling legislative environment”.
Subsequently, the issue was examined extensively by various
groups/committees. The Report of the Internal Expert Group
on the Need for a Middle Office for Public Debt Management,
2001, chaired by Dr. Arvind Virmani, recommended establishing
a centralized middle office in the Department of Economic Affairs
to develop a comprehensive risk management framework as the
first stage of this process. It recommended establishing an
autonomous public debt office as the second stage. The Kelkar
Report (July 2004) while recognizing the conflicts of interest
that arise between the multiple roles of RBI, recommended the
creation of a new independent agency which may be called the
National Treasury Management Agency (NATMA).12 The Percy
Mistry Committee (HPEC, 2007) suggested setting up a debt
management office which may operate either as an autonomous
agency or under the Ministry of Finance.13 The Rajan Report
(CPSR, 2009) suggested to expedite process of establishing debt
management office in India.14
The Union Finance Minister stated in the Budget for 2007-
08 that “World over, debt management is distinct from monetary
management. The establishment of a Debt Management Office
(DMO) in the Government has been advocated for quite some
time. The fiscal consolidation achieved so far has encouraged
us to take the first step. Accordingly, I propose to set up an
autonomous DMO and in the first phase, a Middle Office will
be set up to facilitate the transition to a full-fledged DMO.”
Following the announcement, the Middle Office was established
within the Ministry of Finance.
It may be mentioned that IMF, in its guidelines on Public
Debt Management (2001), discussed that operational
responsibility for debt management is generally separated into
front and back offices with distinct functions and accountabilities,
and separate reporting lines. This separation helps to promote
the independence of those setting and monitoring the risk
management framework for debt management in India. The

group submitted its report “Establishing a National Treasury
Management Agency” in October 2008 which was placed in
the public domain for comments.
NOTES
1. J.M. Keynes, The General Theory of Employment, Interest, and
Money, MacMillan and Company Ltd., London, 1957.
2. A.P. Lerner, Economics of Employment, McGraw Hill Book
Company, New York, 1951.
3. B.U. Ratchford, “The Burden of Domestic Debt”, Readings in Fiscal
Policy, American Economic Association, George Allen and Unwin,
London, 1995.
4. E. Domar, “The Burden of Debt and National Income”, Ibid.
5. Davis Bowen and Kopf, “The Public Debt: A Burden on Future
Generation”, American Economic Review, September 1960.
6. J.M. Buchanan, Public Principles of Public Debt, A Defence and
Restatement, Richard D. Irwin, Homewood, 1958.
7. R.A. Musgrave, The Theory of Public Finance, McGraw Hill,
8. Davis Bowen, and Kopf, op. cit.
9. Phillip E. Taylor, The Economics of Public Finance, Oxford and
IBH Publishing Company, New Delhi (3rd edn.), 1961.
10. This section is broadly based on Economic Survey, MoF, GoI,
2008-09.
11. M.S. Mohanty, 2002, Improving liquidity in government bond
markets: What can be done? in Bank for International Settlements,
paper No. 11 “The Development of Bond Markets in Emerging
Economies”.
12. MoF (2004) Paper of the Task Force on MoF for the 21st Century,
Technical Report, Ministry of Finance.
13. HPEC (2007) Mumbai: An International Financial Centre: Technical
Report Ministry of Finance. Government of India.
14. CFSR (2009), A Hundred Small Steps: Report of the Committee on
Financial Sector Reforms, Planning Commission, GoI.
Fiscal Policy 8
MEANING OF FISCAL POLICY

It has been now fully recognized that the state has a vital
role to play in the regulation of economic activity along the
desired lines. The government has started employing increasingly
the instruments like taxes, public spending, borrowing and debt
management in recent decades for the achievement of economic
stability and higher levels of economic growth. All the budgetary
instruments cited above constitute the fiscal policy. Harvey and
Johnson define fiscal policy as “changes in government
expenditure and taxation designed to influence the pattern and
level of activity”.1 G.K. Shaw has defined it in a rather more
elaborate way. He says: “We define fiscal policy to encompass
any decision to change the level, composition or timing of
government expenditure or to vary the burden, structure or
frequency of the tax payment.”2 The deliberate use of fiscal
instruments for the realization of economic ends is essentially
an outcome of the contributions of Keynes to macroeconomics
particularly during the Depression of 1930s. The emergence of
fiscal policy as the primary instrument for stabilization was on
account of three important developments. Firstly, the apparent
ineffectiveness of monetary instruments to tackle unemployment
and depression created so widespread a confusion and
helplessness that the government had to abandon its lofty laissez-
faire policy and step in the economic arena equipped with fiscal
armoury. Secondly, Keynes’ General Theory, a great landmark
in macroeconomics, with its explicit emphasis on raising the
level of aggregate demand, socialization of investment and public
works appeared during the thick of Great Depression and
attracted worldwide attention of the academicians and the policy-
framers. Thirdly, the increasing importance of taxation and

government expenditure in economy’s aggregate income and
output also assisted fiscal policy to come into its own. Since the
Depression of 1930s, the reliance of the government upon fiscal
measures to control recession and inflation has consistently
increased. It ultimately culminated in the enactment of the
Employment Act of 1946 in the United States. The formulation
of economic plans in almost all the developing countries of the
world at present is a clear reflection of the deep commitment of
the state to the maintenance of and increase in the level of
economic activity.
The Instruments of Fiscal Policy
The measures or instruments employed by the state
to influence the general level of economic activity constitute
the core of fiscal policy. They include a nation’s budget,
taxes, spending and borrowing. In fact, the word ‘fisc’ means
government treasury. A skilful management of a nation’s budget
can go a long way in maintaining economic stability and ensuring
higher rates of economic growth. Taxes are important not only
because the government, through this fiscal instrument, can
secure revenues to meet its expenses, but also because they can
very effectively cut down the disposable income of the people
and have a decisive impact upon the level of aggregate spending.
The appropriate changes in the rates and structure of taxes can
promote or restrict private spending on consumption and
investment and can thus give desired orientation to the economic
system. A more direct instrument at the disposal of the
government to affect the level of economic activity is public
expenditure which is income-creating in character. It includes
the normal civil and military spending, capital expenditure on
public works, grant of subsidies, transfer payments, relief
payments, social insurance payments and spending on account
of price support programmes. The public borrowing has emerged
during the last few decades as a major fiscal instrument. It
attempts to influence the level of aggregate spending through
changes in the liquid asset position.
FISCAL POLICY 311
What role should be assigned to fiscal instruments in a system

has been a matter of serious controversy among the traditional
writers, Keynes and the later theorists. We discuss below these
controversies.
The Traditional Fiscal Neutrality
Prior to the Depression of 1930s, the predominant view of
economic theorists was that the government interference in the
economic system should be minimum possible so that the free
working of the market mechanism is not hindered. Assuming
that the existing resource-allocation brought through unrestricted
competition and free working of price system is optimum, the
traditional writers felt that the fiscal arrangements should not
go beyond the point where the optimum allocation gets disturbed.
In other words, they repeatedly stressed that the fiscal policy
should be neutral in its impact upon the economic system.
The principle of fiscal neutrality meant the imposition of
taxes in such a way that the allocative behaviour of private
sector remains unchanged. Since the original allocative behaviour
was optimal, the tax measures altering the allocative behaviour
must necessarily introduce allocative inefficiency. The traditional
principle of fiscal neutrality, according to A.H. Hansen, envisages
two things:
(i) the reduction of public spending to the utmost possible
limit; and
(ii) a tax structure that leaves the product and factor prices
undisturbed, so that the relative income distribution
remains intact as in the case of a tax-free system.
Samuelson has outlined the whole traditional system of
neutral public finance in the following way:
(i) Annually balanced budget at a low level of expenditure.
(ii) As the public debt is an evil and a burden, it should be
avoided. Even when it is considered unavoidable, it
should be incurred only for productive purposes and
should be repaid at the earliest possible by increasing
such taxes as impinge on current consumption.
(iii) The nation’s budget should be administered on the same

lines as the private budget.
(iv) The tax system should not cause distributional changes.
(v) Taxation should fall on current consumption so that
private savings and investment are encouraged and a
higher rate of economic growth ensured.
The traditional maxim of fiscal neutrality was so bitterly
attacked during and after the years of depression that it now
stands almost completely abandoned. The attack on this principle
was mounted on the following lines:
(i) Assumption of Optimum Resource Allocation. This
principle presupposes that the existing resource
allocation is the optimum so that fiscal operations
would necessarily result in a distortion of the ideal
allocation. This assumption is, in fact, unfounded. The
recurring slumps and inflations in a free capitalist
economy display the frequent misallocations of
resources that can be corrected through taxation and
public spending.
(ii) Ill-suited for Underdeveloped Countries. The
traditionalist notion of fiscal neutrality is altogether
irrelevant for the poor and less developed countries.
The free working of the market mechanism remains
frequently blocked due to economic and social rigidities,
structural deficiencies of the economy and serious
imperfections of the market. The impediments in growth
are so formidable that the government cannot escape
from paying a very active role in the operation of the
system. The recourse has to be taken to taxation to
ensure compulsory savings to depress wasteful private
consumption and to curb the inflationary pressures.
The tax measures have also to be adopted for ensuring
a more equitable income distribution and to reallocate
resources in productive channels. In this context,
A.H. Hansen has remarked, “As the ‘high’ capitalistic
period receded before the advance of the state
interventionism, taxation was seized upon as a
FISCAL POLICY 313
convenient and highly effective instrument of regulation

and control of economic life.” It is not only important
for the state to manipulate tax measures to realize
development priorities; the consideration of sustained
growth in poor countries makes it incumbent to increase
public spending to overcome depression and
unemployment, to promote maximum production and
private investment, to encourage scientific and technical
research and to take upon herself the pioneering role,
when the private investment is not forthcoming. The
deficit financing as a source of resource mobilisation
has become almost inevitable for most of the
underdeveloped countries. The government and the
people in these countries, are eager to accelerate the
pace of development, whatever the costs involved in
this great venture. Hence, there is no place for state
non-intervention and fiscal neutrality, when the choice
has to be made between quick development and stark
poverty.
(iii) Non-neutral Effect of a Balanced Budget. The
traditional writers advocated balanced budgets at low
level of expenditure because they believed that the
budget deficits due to excessive public spending reveal
the extravagance on the part of government. They cause
a maldistribution of factor inputs and also intensify
the inflationary pressures. The deficits also saddle the
community with excessive burden of public debts. In
view of such apprehensions, they advocated annually
balanced budgets at low level of public spending. They
believed that the balanced budgets are neutral in their
impact on the economy because whatever is taken out
of the income stream is poured back through equivalent
public spending. In this connection, it must be stated
that the budget deficits are not necessarily associated
with such adverse effects as had haunted the
traditionalists. Moreover, the balanced budget theorem
has proved that even the balanced budgets are
expansionary. The idea of small public spending has
failed to impress the economists. At a time when the

business activity is depressed and the marginal efficiency
of capital is low, larger doses of public spending become
absolutely necessary to revive the system from
depression and unemployment.
(iv) Public Debt is not an Evil. The traditional fear that
public debt is an evil is also unfounded. The public
borrowings, when raised internally and used for
productive purposes, can pay for themselves. The public
borrowings, as a means for generating development
finance, have come to stay in the modern international
economic order.
(v) Redistributive Effect of Taxation. The view that the
tax system should not cause a change in income
distribution was prompted by their deep bias in favour
of profit-taking groups. It was, however, ignored that
pro-capitalist tax system results in a state of over-saving
and economic stagnation. If the economic system is
confronted with slump and unemployment, the tax
system, on the one hand, should provide incentive
to the private entrepreneurs and, on the other hand,
stimulate private consumption. This necessitates
a progressive tax and expenditure system which
redistributes incomes from high-saving to high-
consuming groups. The classical tax policy designed
to favour the rich is the negation of the principle of
maximum social welfare to which every modern
government is deeply committed.
FISCAL POLICY VS MONETARY POLICY

Ever since the publication of Keynes’ General Theory, a
controversy has arisen on the basic question of the cause of
fluctuations in prices and incomes. A large number of issues
have emerged out of it. However, the most fundamental issue
among them is the role of money in causing economic
fluctuations and the policy instruments most suited to counteract
them. The economists, over a considerable period, held two
divergent views on these issues. One school of thought, known
FISCAL POLICY 315
as Monetarists, upheld the view that “only money matters”. It

treats the variations in economic activity as caused principally
by the changes in the supply of money. The Monetarists School
is led by Milton Friedman. Its other prominent spokesmen are
Karl Brunner, David Fand, Allan Meletzer, Phillip Cagan, James
Schlesinger and Leonall Anderson. The rival school of Fiscalists’
thought attributes the changes in prices and output to the flows
of income and expenditure through the system. The followers
of this school, at times, seemed to suggest that, “money does
not matter”. They include the galaxy of economists like James
Tobin, Paul Samuelson, Walter Heller, Lawrence Klien, Franco
Modigliani and Arthur Okun. Since 1930s, this debate has
contributed with varying degrees of intensity and the economic
events have frequently led the economists to shift from one
extreme position to the other till most of the issues involved
underwent the process of analysis, assimilation and rejection.
Presently, the academic opinion has converged more and more
round the monetary-fiscal policy mix. Before we proceed further
a brief description about the nature of monetary policy may in
order.
Monetary Policy
Monetary policy refers to the policy of the monetary
authority towards the availability of money. In other words, it
means whether the monetary authority is making more money
available for the economy or it is exercising some restrictive
measures towards the supply of money. Further this monetary
authority is usually associated with the central bank of the
country. In our country, e.g. the Reserve Bank of India is a
central bank through which the government implements various
measures to control the supply of money. These measures which
are used to control money supply are referred as instruments of
monetary policy. These instruments are of two types:
(i) Quantitative instruments.
(ii) Qualitative instruments.
While quantitative instruments regulate the total quantity
of money in the economy, qualitative instruments regulate the
qualitative controls of money. In other words, the qualitative
measures regulate the use of money for selective purposes, while

a plenty of money may be available for other purposes. That is
why they are also known as instruments of selective credit
control.
The important quantitative instrument of monetary policy
are:
(i) Changes in reserve requirements,
(ii) Open market operations, and
(iii) Changes in discount rate.
Coming first to the working of reserve requirements. The
central bank of every country requires that the banks must
maintain a certain percentage of their deposits as reserves. This
limits the ability of banks to lend out funds or what we generally
call credit creation. It may be referred here that the banks lend
out money much in excess of their deposits because most of the
lendings given by banks are simply book entries. Thus, money
supply changes with changes in the reserve requirements. The
lower the reserve requirements more funds will be available for
loans, higher the reserve requirements less funds are available.
By open market operations we mean the buying and selling
of government bonds in order to influence indirectly the reserve
position of the banks. When the central bank sells the government
bonds or securities to the public, it receives payments either in
cash or in the form of cheques drawn on the banks. While the
former directly reduce the quantity of money with the public,
the latter will reduce the cash reserves of the banks held with
the central bank, and thus their ability to create credit will be
curtailed.
The central bank can also exert some indirect control over
the reserves of the member banks by its willingness or
unwillingness to lend money to them, and the rates at which
these lendings will be made. The central bank usually lend against
approved securities which are discounted at a certain rate at the
time of lending. The rate at which these securities are discounted
is called the ‘discount rate’. Sometimes this rate is also known
as ‘bank rate’. By lowering or raising the discount rate, the
central bank can encourage or discourage such lendings and
FISCAL POLICY 317
thus affect the level of bank reserves. It may be mentioned that

the bank rate and the interest rate are directly correlated because
a high bank rate means less cash reserves with the banks and
hence the rate of interest will rise.
In any situation, these three quantitative instruments of
monetary policy can be used singly or in combination. Although
all of them need not be used in every case, yet their use must be
coordinated to achieve the maximum results. Without proper
coordination they may work in contradiction with one another.
For example, if the central bank wishes to pursue a tight money
policy and restrict credit, it would raise the reserve requirements,
sell securities, increase the discount rate, or use some combination
of the three.
Now coming to the qualitative instruments or instruments
of selective credit control. They are:
1. Margin requirements.
2. Regulation of consumers credit.
3. Moral persuasion.
By margin requirements we mean the difference in the market
value of the security pledged with the banks and the amount
which the banks lend to its customers. During inflation,
businessmen and speculators try to get credit by pledging gold
or other securities with the banks. Banks do not lend money to
the full extent of these securities. While lending, they usually
keep a margin of 20 per cent to 30 per cent. Therefore, by
increasing these margin requirements, the advances by the banks
can be controlled. The higher the margin requirements, the lower
is the amount of loan which one can get by pledging a security
of certain value. In India, we have often used this instrument to
check the speculation or hoarding in essential commodities like
foodgrains, oils and oilseeds, etc.
Sometimes the central bank directly regulates the consumers
credit for certain purposes. Regulation of consumers credit was
first tried in USA in 1941. This was done with a view to keep
the consumption spending low during the war period. Under
this method, the central bank lays down the rules and regulations
under which credit can be given for consumption purposes
particularly for the purchase of consumer durables. During

inflation, by increasing the amount of minimum down payment
and reducing the amount of credit, the central bank can reduce
the volume of credit.
Sometimes the central bank simply uses its moral authority
to persuade the commercial banks not to give loans for particular
purposes. But this method has great limitations as the commercial
banks may or may not heed to the advice of central bank.
Further the effectiveness of these instruments of monetary
policy in general is impaired because of the time lags in the
conduct of monetary policy. The lags in the effects of monetary
policy can be divided into two broad classifications: (i) inside
lags, and (ii) outside lags. Inside lags refer to all the steps and
time it takes to go from the first recognition that a problem
exists to the point where the policy begins to effect the economy.
Outside lags, on the other hand, are concerned with the response
of the economy to the changed monetary conditions resulting
from the monetary policy. Monetary authorities may react to a
situation by altering money market conditions, but it is other
economic units in the economy, viz. consumers, producers,
traders, etc., who have to change their plans in the face of
changed conditions. In the words of Professor Crowther, a horse
can be taken to water but it cannot be forced to drink.
Last but not least is the working of the monetary policy
vis-à-vis other economic policies say fiscal policy. To achieve
any economic objectives these policies must be properly
coordinated otherwise they will work at cross-purposes.
The Monetarist Model of Economic Process
The central point in the monetarist model of the economic
process is the quantity theory of money. Milton Friedman points
out that the quantity equation MV=PT was never disputed by
Keynes. What he had said was that in condition of under-
employment, V is a highly unstable and passive magnitude. But
Friedman argues that an increase in M accompanies a fall in V
and a decrease in M is associated with an increase in V and
their product will not change.3 Thus, Friedman suggests that
FISCAL POLICY 319
the point at issue is not theoretical. It is concerned with empirical

research.
The monetarists were, however, forced to make
modifications in the quantity theory under the influence of
Keynes’ liquidity preference approach. Milton Friedman’s
restatement of the quantity theory tends to treat money as an
asset. This emphasis on money as an asset led the economic
thinking in two directions. Firstly, it led to an emphasis on
near-moneys as is evident from Gurley and Shaw’s analysis of
financial intermediaries as a source of money substitutes. The
Radcliffe Committee went much further to identify money with
liquidity itself. Secondly, it resulted in the development of a
theory of demand for money on the same lines as the theory of
demand for other products, services or other assets. In this
connection, it is important to point out that Friedman explicitly
takes the cash balances in the sense of real balances and not the
nominal balances. In this theory of demand for money, the
important variable is wealth which exerts a restraining impact
on the former. The other significant variable is the rate of return
on alternative forms of holding money. The monetarist viewpoint
is that the economic process is vitally affected by the variations
in the stock of money and the demand for cash balances
determined through a large spectrum of rates of return on the
substitute of money. The most important issue in this controversy
is how the monetarists trace out the transmission process of
changes in money supply upon the variations in output, income
and prices.
The monetarists hold that a change in the money supply
affects the rate of return on different types of assets. The changes
in the rate of return bring about changes in the aggregate demand
and the variations in the latter affect the gross national product.
The Monetarists believe that the individuals hold their wealth
in the form of cash and various other substitutes of it such as
capital goods, consumer durables, bonds and stocks. While
making investment, the marginal rupee is invested in such a
manner that each asset yields equal amount of return. As the
central bank increases the supply of money, there is an expansion
of monetary assets. Assuming that there is a prior equilibrium
in respect of the distribution of wealth among the assets of

different types, an increase in money supply will cause the rate
of return on money in the form of cash to fall below the rate of
return from other assets. This will lead to the use of additional
money supply for the purchase of different types of assets. The
purchases of assets will influence the change in aggregate
demand. If a larger part of additional money supply is exchanged
with consumer durables and capital goods, the aggregate demand
rises directly. Even if other assets are purchased, the aggregate
spending will rise, although in an indirect way.
Despite these changes, the system will continue to be in
equilibrium. The increase in gross national income along with
demand pressure causes a tendency for the prices to rise. As
prices increase, the real value of nominal balances will fall and
thus the rates of return will revert to the original equilibrium
level. Thus, in the monetarist model of the economic process,
the change in the price level constitutes the equilibrating factor.
In explaining the monetarist transmission view, it is not
proper to omit the St. Louis Model.4 This model shows that the
change in money supply influences total spending which affects
output both directly and indirectly through the changes in price
level. The total spending affects the price level through the current
and anticipated demand pressures. In this monetarist model,
the money supply, total spending, output and price level are
assumed to exert influence upon the market rate of interest. But
the latter has not been assigned any direct role influencing the
magnitudes of spending, output and prices.
The most striking aspect of this model is not the force but
the speed with which money begins to act on the economy. The
magnitude of St. Louis Multiplier was computed as only 1.6
after one quarter but as high as 6.6 after four quarters.5
The Fiscalist Model of Economic Process
The alternative model of economic process, which is
identified as propagating that “money does not matter” is
popularly termed as the Keynesian or fiscalist model. Much of
the monetarist attack was, therefore, naturally directed at
J.M. Keynes. It is rather ironic that Keynes should be the target
FISCAL POLICY 321
of this unwarranted monetarist fury. In his General Theory,

Keynes was actually attempting to enlarge the scope of monetary
theory rather than restricting it.
In fact, it was the ridiculous performance of monetary policy
both during the Depression of 1930s and in the post-war years
that led to an abject disbelief in monetary apparatus by the
post-Keynesian academicians.
The transmission process, according to Keynesians, occurs
through the variations in interest rate. A rise in money supply,
the money demand remaining the same, bring about a fall in the
interest rate which through greater investment activity brings
about a rise in aggregate demand. It, in turn, causes an expansion
in the GNP.
A decline in interest rate raises the volume of aggregate
demand via: (i) interest rate effect, and (ii) wealth effect.
The interest rate effect implies that a fall in interest rates
increases consumption, investment, through discouraging saving
and lowering the cost of credit for the purchase of consumer
durables, stimulates consumption. It almost promotes investment
activity, since the marginal investments become profitable.
Moreover, lower interest rates tend also to expand the
government expenditure as the construction projects of the
federal, state or local governments are mostly financed through
the borrowed funds. A reduction in the cost of borrowing makes
a significant impact on the construction investment.
The wealth effect, on the other hand, implies the stimulating
effect of a fall in the interest rate upon the economy through a
rise in the prices of stocks and bonds. The consequent increase
in wealth of the community results in a rise in consumption and
aggregate demand. It leads, on the one side, to a rise in income
and output and, on the other, to a rise in costs, wages and
prices.
In the Keynesian model, there are two basic assumptions.
Firstly, investment function is relatively less interest-elastic.
Secondly, the demand for money function is stable and highly
interest-elastic.
A high degree of sensitiveness of money demand to changes

in the rate of interest creates difficulty in the automatic working
of the economic system. The Keynesian skepticism about the
effectiveness of the monetary policy during depression had
emanated from what they considered to be the infinite elasticity
of demand for money at some conventional minimum rate of
interest or a state of liquidity trap. The monetarist presumption
of greater interest-elasticity of investment function has also been
frequently objected to by the Keynesians. The problems of
liquidity trap and interest-inelasticity of investment function
obstruct completely the transmission effect of increased money
supply upon the GNP. The Keynesian position is that the
emphasis must be placed upon raising the private consumption,
investment and government spending above the volume of
savings rather than increasing the money supply for the
achievement of higher levels of income, output and employment.
In the vast area of disagreement between monetarists and
Keynesians, we find a striking identity in respect of the theoretical
structure of transmission effect analysed by two contending
groups. Firstly, both the groups agree that money is an asset
whose demand is shaped exactly in the same manner as in the
case of any other asset. Secondly, both hold that, like any other
asset, the demand for money to hold is determined by weighing
the return from holding money against the alternative cost
of holding it. Thirdly, there is also an agreement that the
transmission process works through a broad range of rates of
return and the reactions of different spending groups concerning
the holding or otherwise of money and other assets.
Differences between Monetarists and Fiscalists
The differences between the monetarists and Keynesians,
however, extended over a wide area of economic theory and
economic policy.
(i) Real and Nominal Stock of Money. The monetarists draw
a sharp distinction between the real and nominal stock of money.
They treat nominal money stock as a supply-determined policy
variable and the real money stock as a demand-determined
endogenous variable. David Fand recognizes that this is a
FISCAL POLICY 323
paradoxical feature because the monetarist model allows the

effective control of authorities over the nominal stock, while
simultaneously severely limits the circumstances where they
influence the stock of real balances. Such a situation does not
arise in the Keynesian model because this group allows less
control of authorities over money supply and greater control
over real balances.
(ii) Effects on Aggregate Spending. The monetarists point
out that the additional money supply can have both direct and
indirect effects upon the aggregate spending. Keynesians, on the
other hand, recognize only the indirect effect of money supply
upon aggregate spending through the variations in interest rates.
(iii) Rate of Interest. The Keynesians treat the interest rates
as the most vital link between the money supply and aggregate
demand. The modern version of the monetarist viewpoint
underlines the fact that the two are linked through a large
structure of rates of return including the market rate of interest.
In this connection, it must, however, be pointed out that
St. Louis Model does not assign any significant role to the rate
of interest as a factor influencing the aggregate spending.
(iv) Stability of Relationship between Money Supply and
GNP. A strong point of disagreement between the Keynesians
and monetarists relates to the stability or instability of the
relationship between the money supply and GNP. Keynesians
consider the relationship between the money supply and interest
rates as unstable because of the instability of demand for money.
Secondly, the relationship between the money supply and GNP
is also unstable because of a not well-defined relationship
between interest rates and aggregate demand. The monetarist
position is that a stable relationship exists between the money
supply and the GNP. This has been confirmed by a number of
empirical studies including those by Milton Friedman and David
Meiselman.
(v) Permanent Effects of Nominal Money. Both monetarists
and Keynesians acknowledge that a rise in nominal money may
have a permanent effect on output, prices, interest rates or some
combinations of them. The point of difference, however, is quite
significant. While the monetarists emphasize the permanent

effects on the price level and output, the Keynesians consider
that the permanent effects will be on interest rates and output.
In the monetarists scheme of things, the price level is the
equilibrating mechanism between demand for and supply of
money. In contrast, the Keynesian model treats interest rates as
the equilibrating mechanism and price level is explained in terms
of mark-up factors. This gives rise to the line of thinking that
the Keynesians have a monetary theory of rate of interest and a
non-monetary theory of the price level. This line of approach
needs to be somewhat modified, when we consider large scale
econometric models. No doubt, these models take cognizance
of some feedback from money to prices, yet they establish a
negative association between money and interest rates.
(vi) Time Element. The Keynesians stress that the increase
in money supply affects both prices and output in the long run
when the economy operates at full employment. In a state of
full employment, the price level alone rises due to the inelasticity
of output. It is not clear whether the monetarists associate long
period with full employment or not. Changes in money supply,
in their analysis, bring about changes in prices only. In their
analytical framework, the long run changes in output are
supposed to be independent of changes in money supply. These
are determined by such non-monetary factors like natural
resources, stock of capital, state of technology, labour force,
etc.
Monetary Policy vs. Fiscal Policy
The divergent theoretical views on the relationship of money
supply and level of economic activity resulted in the formulations
of different sets of policies for the control of economic
oscillations. In fact, the entire debate centred on the point
whether monetary or fiscal policies are appropriate for inducing
desired changes in economic activity.
The doubts have been frequently raised about the monetary
policy from the angles of its effectiveness, the desirability of the
ways in which the policy works and the value of the actual
compatibility of its aims.
FISCAL POLICY 325
The effectiveness of monetary policy is firstly limited by the

decisions of the individuals and business units about the income,
spending and assets. Secondly, the effectiveness of monetary
action will be determined by the interest-elasticity of the demand
for and the supply of capital. Although the long-term investment
on residential and industrial construction and public utilities
is sensitive to the changes in interest rates, the short-term
borrowings are not so interest-elastic and the econometric studies
of investment behaviour have yielded unsatisfactory results.
Thirdly, the perverse reactions of market to changes in the
velocity of circulation are likely to generate a greater destabilizing
effect. Both Radcliffe Committee Report in England and Eckstein
Report in the United States maintain that induced velocity
changes in the course of economic fluctuation render monetary
controls impotent or virtually so. Milton Friedman and Schwartz
in their statistical enquiry, however, found that the velocity, in
response to cyclical changes, has shown a systematic and stable
movement in the United States about the trend—rising during
expansion and falling during contraction. Similarly, the
Commission on Money and Credit in the context of upward
trend of velocity since 1946, observed, that “the increase of
velocity need not negate the effectiveness of monetary policy”.6
A very significant factor which affects the effectiveness of
monetary policy is the duration of the lags of monetary policy.
Even Prof. Friedman recognized that a longer time lag does not
necessarily stabilize but contributes often to accentuate the
violence of fluctuations. The Eckstein Committee made a
somewhat conservative comment that the longer monetary lags
create difficult problems. The uncertainty concerning timing has
made Milton Friedman and Shaw to abandon discretionary
monetary controls altogether. This naturally led to a greater
reliance upon the budgetary measures and direct controls. In
addition, there are certain institutional difficulties in the effective
operation of the monetary policy. The most significant among
them is the growth of non-bank financial intermediaries. These
institutions restrict the effective control of the central bank upon
liquidity. Another problem is created by the federal lending
policies. Still another factor to account for the limited efficacy
of the monetary policy is inflation and particularly the cost-

push inflation.
In the contemporary situation, many economists have given
major prominence to this view of inflation. No doubt, some
monetarists suggest that a tough restrictive monetary policy can
blow off such an inflation, yet the persistent 5 to 6 per cent
unemployment greatly restricts the scope of such a course of
action.
Second weakness of the monetary policy is concerned with
the desirability of the way in which the policy works. Many
economists such as S.E. Harris and J.K. Galbraith have argued
that the incidence of monetary control is discriminatory and
this limits the usefulness of such a policy. They point out
that the tight money policy of 1955-57 in the United States
discriminated against residential construction and borrowing
by local government, small business and consumers. Such a policy
is surely unjustifiable both from the economic and social points
of view. Further the greater reliance upon interest rate variations
causes difficulties for the government in planning the federal
borrowing programme.
Third objection against the monetary policy is in respect of
its incapacity to achieve different economic goals like stable
prices, higher levels of output and employment, balance of
payments equilibrium and growth, apart from some other
objectives like equitable distribution of income and proper
allocation of resources. A particular monetary action directed
towards the achievement of any one of these goals may hinder
the achievement of some other goals.
James Tobin, while attempting an assessment of the
monetary operations in the U.S. economy during the 1970s,
conceded that the record of demand management monetarist
measures was rather dismal. In his words, “The 1970s were
tough for demand management of any brand. But monetarists
are in a poor position to shift blame to the inflationary legacy
of the 1960s, or to OPEC, or to fiscal policies. Their own
doctrines—stressing sharp dichotomies between real and
monetary stocks between relative and absolute prices, and
FISCAL POLICY 327
between past trends and future expectations—disqualify as vulgar

fallacies of these popular explanations of inflation and
stagflation.”7
The fiscal policy too has its weaknesses. It is often considered
to be quite rigid, cumbersome and insensitive.
We shall now consider which of the two policies is relatively
more effective.
Tests of Economic Policies
Andersen and Jordan laid down tests to provide answer
to the question whether monetary or fiscal influences were:
(i) stronger, (ii) more predictable, and (iii) faster.
(i) Strength. For measuring the relative strengths of the two
policies, they computed the beta co-efficients and it was found
that for the entire period from 1919 to 1968, the monetary
influence is large and statistically significant, while the fiscal
influence is negative and statistically insignificant. This result
was applicable in various sub-periods except the World War II
and early post-war sub-periods. During the World War II years,
the monetary influence was statistically insignificant and negative
and the fiscal influence was positive and significant. During the
post-war years (1947-52), fiscal influence was negative and
statistically significant.
(ii) Predictability. As regards the relative predictability of
the two policies, Michael W. Keran computed co-efficients as
indicators of confidence limit for the period between 1919 and
1969. For the entire period, the value of the monetary variables
was found to be substantially larger than the value of the fiscal
variables. The same trend persisted for all the sub-periods except
the years 1939 to 1952. This indicated that the monetary policy
was relatively more predictable.
(iii) Promptness. As regards the relative promptness of the
two policies, it was found that the fiscal variables had almost
the same impact as the monetary variables during the entire
period from 1919 to 1969.
These tests signify that monetary policy has a relatively
greater effectiveness than the fiscal policy.
Present State of Debate

The debate between the monetarists and fiscalists has
presently reached a stage where the attitudes of the two divergent
groups of economists have been considerably softened. The
economists now do not wrangle over the questions like “only
money matters” and “money does not matter”. Both the groups
have come to realize the truth that an appropriate monetary-
fiscal policy mix must be evolved for the achievement of different
macroeconomic goals. The economic opinion has veered round
the view that monetary action proves somewhat ineffective
during depression. The revival of economic activity requires the
prime reliance upon fiscal action. During the period of boom or
inflation, the fiscal restraints are likely to generate greater
unemployment. Therefore, the monetary action is likely to tackle
the situation much more effectively. In between these two
extreme economic situations, the expansion of income and output
and the maintenance of price stability can be ensured through a
proper mix of monetary and fiscal action. In such a monetary-
fiscal policy mix, relatively more emphasis has to be laid upon
fiscal measures than the monetary measures. When the economy
is in a state of recession or depression, the easy money supply
should be supplemented by a policy of tax reduction and
expansion in government expenditure. When the system is close
to a boom, the greater reliance upon monetary rather than fiscal
action can yield desired results. If the economy is to achieve
other economic goals like poverty reduction, removal of
inequalities, correcting the imbalance in balance of payment,
etc. fiscal policy is more powerful than monetary policy.
FISCAL POLICY FOR STABILIZATION OR

COMPENSATORY FISCAL POLICY
Taxation, public expenditure, public borrowings/debt, deficit
financing and operation of public enterprises, constitute some
important instruments of fiscal policy. Classical economists
advocated the policy of laissez faire, i.e. non-government
intervention in general economic activities. They believed that
supply creates its own demand. So according to them general
overproduction or involuntary unemployment was not possible.
FISCAL POLICY 329
They believed that a free operation of market forces would

achieve full employment which was supposed to reach
automatically and there was no necessity of state intervention.
Thus, full employment automatically followed in a scheme of
laissez faire which the classical economists recommended. This
left no scope for the governments to think about the various
fiscal tools to regulate the economy.
However, the Depression of 1930s proved the futility of
laissez faire policy. Private investment and consumption
expenditure was found to be inadequate to maintain full
employment. It was felt that the state should increase its own
expenditure and induce the private units to increase their
expenditure by tax reductions or more transfer payments.
Thus, the events like Great Depression and the post-Second
World War proved that fiscal tools were more effective in
controlling both deflation and inflation. In this development,
Keynes’ General Theory played an important role. Although in
the immediate post-Keynesian period the emphasis was on short-
run stability, yet more recently a shift has taken place in favour
of long-run stability. Broadly speaking, the primary objective of
fiscal policy in advanced countries has been conceived to be one
of the promoting conditions of stable growth.
As already stated, the fiscal operations might be conducted
under conditions of both depression and inflation, i.e. both under
conditions of unemployment and under conditions of full
employment since the crux of the problem in the stabilization
of the economy is to maintain full employment without an
inflationary or deflationary gap, compensatory fiscal policy
occupies the central place in the stabilization branch of the
government budget.
The techniques of the compensatory fiscal policy are of
comparatively recent origin. During the Great Depression days
of the 1930s, economists became increasingly sceptic about the
effectiveness of monetary policy in controlling business cycles,
particularly the depressions. In fact, even during the booming
twenties Keynes had vehemently opposed the contention of
Hawtrye that fluctuations in the short-term rates of interest
were sufficient to control the business upswings and downswings

by controlling the cost of credit to the dealers. Keynes shifted
the emphasis from the short-term to the long-term rates of
interest for controlling business cycles as, according to him,
long-term investments which were the prime movers of the
upswings and downswings were sensitive only to the long-term
rates of interest. He also recognized the presence of the so-
called “bearishness function” which might prevent any fall in
the long-term rates of interest in times of deep depression.
In General Theory, Keynes’s scepticism regarding the
possibility and effectiveness of interest rate reductions in
stimulating private investment was complete—a skepticism which
led to his now-famous advocacy for state partnership in a private
enterprise capitalist system, under which if the state was unwilling
to compete with private investors in traditional lines, it might
embark upon a programme of an investment of the most
“unproductive” kind, namely digging holes in the ground and
filling them up again. Even such “unproductive” investment
would lead to an increase in employment and income through
the familiar multiplier process.
Keynes and his followers felt that the decision to invest, on
which the amount of effective demand and hence the volume of
national income and employment depended, was not very much
sensitive to changes in the rates of interest or in the availability
of money supply. Investment rather appeared to be more
dependent on the prospective yields or the marginal efficiency
of capital and the expectation of the investors regarding the
prospective yields. To make the matter worse, it was found by
Keynes that in periods of deep depression the liquidity preference
schedule becomes absolutely interest-elastic signifying that under
the circumstances no amount of increase in money supply, say,
by the central bank in the form of open market purchase of
government securities would induce the recipients of the new
money supply to switch over from cash to bills or bonds. In
other words, there was an ‘institutional minimum’ below which
the long-term rate of interest, in particular, never fell, whereas
in a deep depression it might actually be necessary to establish
a negative rate of interest in order to strike an equality between
FISCAL POLICY 331
the intended investment and intended savings at the full

employment income level. To cap up all the troubles, the
Keynesian assumption of the stickiness of the money wage rate
in the downward direction even in the face of large-scale
unemployment made depression an almost insoluble problem
by means of monetary policy alone.
Thus, fell during the thirties, monetary policy from its pride
of place, and fiscal policy developed assiduously by Keynes,
Hansen and Lerner, took its place as the most powerful
instrument for affecting the total amount of effective demand
and thus the level of national income, employment and price
level.
Fiscal policy primarily seeks to influence the amount of
effective demand and thus maintain full employment without
inflationary or deflationary tendencies by
1. changes in the amount of government expenditure;
2. changes in the amounts of taxes and transfer payment;
and
3. changes in the amounts of budget deficit and surplus.
Thus, if, for example, the government anticipates that the
total amount of private demand for consumption goods and
investment goods plus the existing amount of government
expenditure would be inadequate to maintain full employment
and there would consequently be a deflationary tendency within
the economy then the government should:
(i) increase its own expenditure with taxes constant; or
(ii) keep its own expenditure constant and reduce taxes or
increase transfer payments so that the disposable
incomes in the private hands increase which in their
turn would boost up private consumption and
investment expenditures; or
(iii) combine the policy of increasing its own expenditure
with that of decreasing taxes or increasing transfer
payments.
In each of the aforesaid cases, it should be noted that the
budget deficit would be increased, or surplus reduced, and the
new purchasing power which, as a result, would be injected

into the economy would boost up the effective demand, and
national income and employment would consequently increase
by a multiplier of the original budget deficit through the familiar
multiplier process. The expansionary mechanism of the deficit
budget is shown in Fig. 8.1 where with income at OY0 and
employment (consequently) at ON0 the budget is balanced since
the CT line, showing the tax receipt at different levels of national
income, cuts the C+I+G line, showing the actual private
consumption plus investment plus government expenditure, on
the 45 line at the actual income level, namely Y0. But at N0
there is (suppose) unemployed labour equal to NfN0, and in
order to absorb the same national income should increase to
OYf, or the total effective demand should be equal to YfG'.
That is to say, the government expenditure should increase by
GG' and a budget deficit equal to DG' be incurred, DG' being
the excess of the additional government expenditure over the
additional tax receipts (GD).
Fig. 8.1
Note that Y0Yf>G′ D, i.e. the increase in the national income

is greater than the budget deficit, this being the result of the
operation of the multiplier with positive marginal propensity to
consume.
FISCAL POLICY 333
If, on the other hand, the government anticipates that the

total amount of private consumption and investment
expenditures plus government expenditure would be more than
adequate to maintain full employment and, as a result, there
would be an inflationary gap in the economy, the government
can (i) either reduce its own expenditure with taxes constant; or
(ii) increase taxes or reduce transfer payments so that private
disposable incomes are reduced and hence private consumption
and investment expenditures are curtailed; or (iii) combine a
policy of reducing its own expenditure with that of increasing
taxes or reducing transfer payments thereby reducing private
disposable income and private spending.
In fine, the core of the compensatory fiscal policy is that
during the business upswings taxes should rise and government
expenditures should be reduced and, as a result, there should be
a budget surplus which would tend to draw out purchasing
power from the economy and hence curtail the effective demand
and hence the upswings. During the business downswings, taxes
should fall and government expenditures should rise and, as a
result, there should be a budget deficit which would inject
additional purchasing power into the economy and thus boost
up the total effective demand and hence output and employment.
In this way, by means of fiscal policy the economy is sought to
be kept on an even keel without upswings and downswings, i.e.
inflation and unemployment.
Automatic versus Discretionary Stabilization
In the compensatory fiscal policy, the above-mentioned
adjustment can be done through three devices called (a) built-in
flexibility; (b) formula flexibility; and (c) discretionary action
i.e. functional finance approach.
Under the built-in flexibility system, the tax rates are so
fixed that in the upward phase of the business cycle with every
increase in the national income the tax yield going to the
government exchequer would automatically go up at a faster
rate than the increase in national income without any changes
in the tax rates, while the government expenditures on
relief, unemployment benefits, etc., would tend to go down
automatically with the rise in the national income. At a result

of the two forces operating simultaneously, the budget would
automatically tend to show a surplus without any effort on
the part of the legislators and thus the upswing would be
automatically controlled. Similarly, in the downswing phase of
the cycle, without any changes in the tax rates, the tax yield
would fall at a faster rate than the fall in the national income,
and government expenditures on relief and unemployment
benefits would tend to go up and thus the budget would
automatically show a deficit which would tend to counteract
the downswing. The built-in flexibility works without changes
in the tax rates and thus avoids elaborate legislative procedure
which such rate changes involves.
Clearly, the effectiveness of the built-in flexibility depends
upon the elasticity of the tax receipts, i.e. the rate at which the
tax receipts change with the changes in the national income. In
other words, the greater the elasticity of tax receipts and the
larger the ratio of tax-yield to income, the greater will be the
effectiveness of the built-in flexibility in curbing the upswings
and downswings.
Formula flexibility becomes necessary because the experience
of fiscal authorities show that even in advanced countries with
sufficiently developed tax collection machinery, the elasticity of
the tax receipt is not sufficiently high to warrant an automatic
controlling of the business cycle by means of the built-in
flexibility approach. Such measures, therefore, often require to
be supplemented by formula flexibility under which the tax
rates are also increased in the upswing phase of the business
cycle and reduced during the downswing phase according to
some predetermined formula which links the variations in tax
rates with the fluctuations in national income. Since under
formula flexibility the elasticity of the tax receipts is likely to be
greater than under the built-in flexibility, the former is likely to
be more effective in controlling the business swings than the
latter. Similarly, the government expenditure may be varied
counter-cyclically according to some predetermined rule (such
as if the national income increases by such and such percentage,
the government expenditure should be decreased by such and
FISCAL POLICY 335
such percentage). In the case of built-in flexibility, the parameters

of fiscal policy like the tax rates are kept constant and the
budget is made to work anti-cyclically through changes in the
endogenous variables like the tax yield, following the change in
the tax base, whereas in the case of formula flexibility the
parameters themselves are varied in a counter-cyclical manner.
In the case of formula flexibility, however, the parameter
manipulations are not left to the discretion of the executive;
such manipulations are made, unlike in the case of discretionary
action, according to some predetermined rules linking the
parameter manipulations to the fluctuations in income,
employment, price level, etc.
Discretionary Action or Functional Finance Approach
The compensatory fiscal policy has been given an extreme
form by Dr. A.P. Lerner in his functional finance approach. The
functional finance approach rejects the traditional doctrine of
“sound” finance and the principle of balancing the budget over
a year or any other period. The core of this approach is that
government expenditure, taxation, borrowing and creation and
destruction of money should all be used in an appropriate way
to eliminate unemployment or inflation in an economy.8 Thus,
when there is unemployment, government expenditure should
be increased and/or tax should be reduced so that private
expenditure is increased and/or public debt should be repaid so
that interest rates are lowered and private investments are thereby
stimulated and, finally, the budget deficit should be financed by
the creation of new money. Exactly opposite policies should be
pursued when there are inflationary tendencies—government
expenditure should be reduced and/or taxes should be increased
so that private consumption and investments are curtailed and
the budget surplus thus created would exert a depressing effect
on the economy and would thus check the inflationary tendency.
Under this policy money may be destroyed, if necessary.
Stated alternatively, according to the functional finance
approach there are three pairs of fiscal instruments at the disposal
of the government.
1. (a) Government buying and (b) government selling.

2. (c) Government giving more money to the citizens in
the form of reduced taxes and increased pensions,
unemployment benefits, etc. and (d) government giving
less money to the citizens in the form of higher taxes
and less pensions, unemployment benefits, etc.
3. (e) Government lending to the public or repaying loans
and (f) government borrowing from the public.
The instruments (a), (c) and (e) are appropriate in times
of deflation when total spending is too low; and instruments
(b), (d) and (f) are appropriate when total spending is too high.
Thus, according to the functional finance approach, the
government fiscal policy, its spending and taxing, its borrowing
and repayment of loans, its issue of new money and its
withdrawal of money should also be undertaken with an eye
only to the results of these actions on the economy and not to
any established traditional doctrine about what is dogmatically
treated as sound or unsound. The functional finance judges the
fiscal measures by the way they work or function.
Lerner says that one possible criticism of the functional
finance approach is that if unemployment is persistent a budget
deficit may have to be incurred year after year and, as a result,
the total amount of public debt may even exceed the total amount
of national income. Lerner gives three answers to this possible
criticism:
(a) A large public debt may be an evil, but it is definitely
better than its alternative evil of unemployment.
(b) The budget deficit may be financed by the creation of
new money without any increase in the public debt.
(c) Even if the volume of public debt increases over time,
the debt-holders’ liquidity is increased thereby and their
consumption, as a result, is boosted because of the
wealth effect. This will tend to bridge the deflationary
gap in the economy.
We may end up the discussion on compensatory fiscal policy
by noting some of the criticisms which have been levelled
against it:
FISCAL POLICY 337
(i) For a successful application of the compensatory fiscal

devices a correct forecasting of the future course of
business cycles is indispensable. Such forecasting is,
however, seldom possible, or, in any case, an extremely
difficult job which makes the use of the compensatory
fiscal techniques a rather difficult art.
(ii) Fiscal policy assumes that government investment
programmes have no significant effect on private
investments. This is not likely to be true particularly if
the public and private investments are competitive or
if public borrowings deprive the private sector from
investible funds.
(iii) A vigorous pursuing of the compensatory fiscal policies
for fighting unemployment may very much adversely
affect the psychology of private investors and this may
frustrate the very objectives of these policies. In
particular, in deep depressions as also in run-away
inflations fiscal policy may be impotent because of the
peculiar business psychology.
(iv) A vigorous pursuing of the fiscal remedies of
unemployment may give rise to balance of payments
difficulties in an “open” economy since a part of new
purchasing power created may spill over to the purchase
of foreign goods.
(v) Adjustments of government expenditures on public
projects for curing inflation or deflation may not always
be possible, since such expenditures are guided more
by broader social, economic and even political
considerations.
(vi) Changes in taxation and public debt policies may be
such a time-consuming process particularly in a
democratic country that the practical application of
the compensatory fiscal techniques may be very difficult.
In fact, the administrative and operational lag of fiscal
policy is definitely more than that of monetary policy,
and this often tends to neutralize the advantage of the
former policy over the latter policy.
(vii) A vigorous pursuing of the anti-depressionary fiscal

policy may lead to a vast increase in the public debt
with the associated problems of debt management.
ALTERNATIVE FISCAL POLICIES FOR FULL EMPLOYMENT

AND THE BALANCE BUDGET MULTIPLIER
In an economy with unemployed resources and manpower
due to a deficiency in the volume of effective demand fiscal
policy may be used in any of the following three ways to attain
full employment:
1. Deficit Spending. When the sum of private consumption,
private investment, government consumption and government
investment is less than full employment income and as
such there is a deflationary gap in the economy causing
unemployment, the government may increase its expenditure
either on consumption or on investment without an increase in
taxation and thereby incur a deficit in the budget, the deficit
being covered either by the creation of new money or by
government borrowing. Assuming that the marginal propensity
to consume of the economy is 4/5 and hence the multiplier is 5,
a 100 rupees additional government expenditure (which injects
100 additional rupees in the economy) would create a 500 rupees
additional national income and this would consequently increase
employment. This result is quite likely in view of the fact that if
the budget deficit is financed by the creation of new money,
there would be no reduction in the consumption of any other
section, and if the deficit is covered by borrowing the
bondholders’ marginal propensity to consume is not likely to be
reduced thereby since the bonds are in all probability held out
of funds which would otherwise have been saved. The
expansionary effect of deficit spending may be shown in
Fig. 8.2 where curve C shows the consumption function of the
community and an increase in government expenditure (shown
by the vertical difference between C curve and the C+G curve)
increases income by ΔY. Now ΔY = ΔC+ΔG or ΔY/ΔG>1. Hence,
a deficit spending programme is always expansionary, for the
budget multiplier (defined as ΔY/ΔG) is always greater than
unity.
FISCAL POLICY 339
Fig. 8.2
2. Deficit without Spending. The second device by which

the government can remedy unemployment is by the reduction
of taxation without any increase in government expenditure
and thereby creating a budget deficit. If taxes are reduced the
disposable income in the hands of the public increases and since
at least a part of the increased income in the hands of the public
is likely to be consumed, the total consumption of the community
would be boosted up and this would increase income and
employment. This is shown in Fig. 8.3 where a tax reduction of
amount AB boosts up the consumption function, and income,
as a result, rises by AC.
3. Spending without Deficit (or the Balanced Budget
Multiplier). The third type of expansionist fiscal policy, namely
Fig. 8.3
the balanced budget multiplier, is most interesting. Here an

increase in government expenditure is matched by an equal
increase in taxes but still there is a net increase in the national
income. This may be illustrated as follows: Suppose that the
marginal propensity to consume of all persons in an economy,
having unemployed resources, is 4/5. Now, if government
expenditure is increased by, say, ` 100, the increase in the
national income by the successive respending of the money spent
by the government would be ` 500 (initial increase in government
expenditure × the multiplier, i.e. ` 100 × 5). If simultaneously a
sum of ` 100 is also raised in additional taxes to cover the cost
of the government financing of the additional amount so that
the budget is exactly balanced, the taxpayers’ initial consumption
would be reduced not by ` 100 but by ` 80 only as out of every
` 100, only ` 80 are consumed since our assumption is that the
marginal propensity to consume of all members of the community
is 4/5 and reduction in the consumption of the taxpayers would
as a result be ` 100 × 4/5 = ` 80. A reduction of ` 80 consumption
of the taxpayers would lead to an ultimate fall in the national
income by ` 400 (i.e. initial fall in the consumption of the
taxpayers × multiplier or, 80 × 5). Thus, the increase in the
national income as a result of the rise in the government
expenditure would be as follows:
100+80+64+52 … = 500 (in `)
The reduction in the national income as a result of the tax-
payers’ reduced consumption would be as follows:
–80–64–52 … = –400 (in `)
Hence, there would be a net increase in the national income
as a result of the tax-expenditure programme of ` 100 (i.e.
` 500 minus ` 400). In this case, the balanced budget multiplier,
defined as the net increase in national income divided by the
initial increase in government expenditure, will be 100/100=1.
Thus, assuming that the recipients of income out of government
expenditure and the taxpayers have the same marginal propensity
to consume, an increase in government expenditure financed by
an equal increase in taxes leads to a net increase in the national
income and hence in employment and output.
FISCAL POLICY 341
As in the previous two cases, the expansionary effect on

national income of a programme of spending without deficit
(i.e. the balanced budget multiplier theorem) can be shown by
means of the 45° – line (Fig. 8.4) where curve C shows the
consumption function of the community before the tax-
expenditure programme and curve C′´ shows the same after the
taxation programme, DE being the tax receipt. If the DE amount
of the tax receipt is spent by the government, the total
expenditure curve of the community would be the C′´+G curve
(DE being equal to EF) and as a result the national income will
rise by AB. But note that AB = DE = EF. Since AB is the increase
in the national income (DY), DE is the increase in the tax receipt
(DT) and EF is the increase in the government expenditure (DG),
we may write the following:
ΔY = ΔT = ΔG
ΔY/ΔG = ΔY/ΔT = 1
Fig. 8.4
However, we should take note of the fact that 1:1 version

of the balanced budget multiplier theorem assumes that the
recipients of government expenditure and the taxpayers have
the same marginal propensity to consume (MPC) and on this
basis a multiplier equal to unity is derived. If, however, the
taxpayers’ MPC is different from the MPC of the recipients of
government expenditure, the multiplier will be greater or lesser

than one. If the MPC of the recipients of government expenditure
is greater than that of the taxpayers, the balanced budget
multiplier will be more than one. On the other hand, if MPC of
the former is less than that of the latter, the balance budget
multiplier will be less than one.
Secondly, the alternative fiscal policies assume that a
government expenditure programme has no secondary effect on
private investment and consumption expenditures. This is clearly
unrealistic. If government investment expenditure, for example,
competes with the private investment expenditure, the latter
may be so much depressed that the government expenditure
programme may have little, no, or even negative expansionary
effect on the economy. Similarly, the entry of government in
the field of investment activities traditionally dominated by
the private investors then the expansionary effect of public
investments may be largely offset by the contractionary effect
of a fall in private investments. As against the latter possibility,
account should, however, be taken of another alternative
possibility that the public investment programme may be looked
upon by the private investors as a symbol of the determination
of the government to fight the depression with all seriousness.
As a result, government investment will work as a catalytic
agent and therefore, good time will come back soon and hence
the private investment may thereby be stimulated following an
upward shift of the marginal efficiency of investment schedule.
Thirdly, the alternative fiscal policies do not take into
account the differences in the effect of the possible ways in
which the budget deficits are financed. But actually this may
considerably affect the expansion of income and employment.
If, for example, the budget deficit is covered by the creation of
new money, the effect is likely to be more expansionary than if
it is financed by the creation of public debt through government
borrowing. This would be so because in the former case the
increase in the money supply is likely to depress interest rate
and so stimulate private investment, but in the latter case since
the government competes with the private investors for funds,
the rate of interest is likely to go up and this is likely to depress
FISCAL POLICY 343
private investment, commonly known as crowing-out effect of

public investment.
FISCAL POLICY FOR ECONOMIC DEVELOPMENT

It may not be out of context to mention here that when the
idea of government intervention was being revolutionized in
western countries, some economists in underdeveloped countries
including India, began to recommend the application of
Keynesian techniques and prescriptions for the solution of
economic problem in their own countries. That such
recommendations are unrealistic and fraught with danger is now
clearly realized by all the developmental economists. The
conditions in most of the underdeveloped countries differ vastly
from those postulated by Keynes and his followers. A realistic
and sound fiscal policy can be worked out only in relation to
the economic conditions that exist in a country and the objectives
that are to be achieved. Its formulation for the country concerned
must take into account the stage of economic development of
the country, the degree of elasticity or response of the system to
economic stimuli, and the state of the economy at any given
time. Some economists argue that, in a sense, the objectives of
fiscal policy are, more or less the same, in developed and
underdeveloped countries. In their opinions, for instance, the
objectives of tax and other budgetary policies in underdeveloped
countries are to maintain stability, promote investment and
reduce income inequalities. These objectives are not basically
different from economic goals of allocative efficiency, economic
growth, stability and optimum income distribution, which guide
fiscal policy in advanced countries of a free enterprise basis.
However, such statements are quite misleading and serve no
useful purpose since the tasks to be performed in developed
and underdeveloped countries are essentially different. In
underdeveloped countries unemployment exists not because of
the lack of effective demand. Rather here the pent up demand is
very high. The marginal propensity to consume is close to unity.
What is lacking here is of the availability of investible resources.
Broadly speaking, whereas the maintenance of stability will be
assigned first priority in an advanced economy like United States,
capital accumulation would have to be given a top priority in

underdeveloped countries.
We cannot but better summarise the objectives of fiscal policy
in the words of Professor Raja J. Chelliah. He has assigned the
following objectives to be performed by fiscal policy in his much
celebrated book entitled Fiscal Policy in Underdeveloped
Countries. These objectives are:
1. Increasing the rate of investment by checking actual
and potential consumption;
2. Encouraging the flow of investment into channels
judged to be the most desirable from the social point
of view;
3. In a quasi-planned economy, regulating the flow of
purchasing power in accordance with the overall pattern
laid down in the plan; and
4. Where large inequalities of income and wealth exist,
modifying the distribution of income and wealth in a
manner and to the extent that are consistent with the
long-term interests of the population as a whole.
The first objective relates to increasing the overall flow of
resources into investment. Over a period of time this is achieved
by raising the incremental saving ratio. According to Raja
J. Chelliah, this condition is must to break the vicious circle of
poverty. The second objective relates to the socially optimum
pattern of investment. The third objective is relevant where the
quantum as well as the pattern of investment is centrally planned
to some extent. In this sense, fiscal policy becomes an adjunct
to investment policy.
The fulfilment of all these three objectives will lead to rise
in national income. The fourth objective relates to the distribution
of raising national product. It is needless to highlight the
importance of the distributional considerations. A mere increase
in per capita income does not necessarily lead to an increase in
the welfare of all sections of the people, unless an equitable
distribution of the rising national product is assured. An equitable
distribution is usually taken to mean a reduction in the existing
inequalities of income and wealth. To what extent inequalities
FISCAL POLICY 345
should be reduced in partly a matter of value judgement, and

partly a matter of socio-economic and political system that is
adopted. In most of the developing countries today the reduction
of inequalities is given a top priority. Policies that do not take
any note of this objective are unlikely to be acceptable to the
broad masses of the people in these countries. Therefore, it
is not easy to agree with Nurkse that “Not a change in the
interpersonal income distribution but an increase in the
proportion of national income devoted to capital formation that
should be the prime concern in underdeveloped countries”.
Nurkse’s statement that “…using taxation as means of mitigating
the inequalities of wealth is a revolutionary and essentially
socialist idea” is not tenable. Thus, both the objectives of capital
formation and reducing inequalities cannot be neglected. In fact,
some inter-relationship is now found between these two
objectives and if it is properly understood, a satisfactory
reconciliation of the two may not be difficult to achieve. A
widespread use of labour intensive technologies in such countries
is the outcome of this realization. The demand for increased
output (resulting from capital formation) cannot be sustained if
income is not properly distributed.
Thus, in a developing country, fiscal policy can seek to
influence the economy, on the one hand, by the amount of
public income that is raised, and on the other, by the amount
and direction of public expenditure. The important fiscal tools
by which resources can be raised for the public exchequer are
(a) taxation, (b) borrowing from individuals, (c) borrowing from
banks, and (d) deficit financing. These tools must be used in
harmonious combination so as to produce the best overall effects
in terms of economic progress with stability.
Of all the fiscal tools, taxation is the most important if
wisely conceived and skilfully used, it can become a very effective
instrument of fiscal policy. As a part of a general programme of
development taxation may be used to accomplish the following
objectives:
(i) restraining or curtailing consumption and thus creating
economic surplus and transferring resources from
consumption to investment;
(ii) increasing the incentives to save and invest;

(iii) transferring resources (economic surplus) from the
hands of the public to the hands of the state to make
possible investment;
(iv) modifying the pattern of investment through tax
incentives and disincentives; and
(v) mitigating economic inequalities.
All these objectives are related to the ultimate goals of
rapid increase in national income and improvement in its
distribution. The problem is to design a tax-expenditure
structure that will be conducive to the accomplishment of these
objectives.
In the end, we can say that in underdeveloped countries
there are special reasons for the growing importance of fiscal
policy. In such economies, there is a general lack of private
enterprise. Lack of resources with private entrepreneurs compel
them to invest in safe and tried channels of investment having
short gestation period. They would not invest in basic capital
goods industries which alone can generate forces for rapid
economic development. Tax and expenditure policies of the state
must fill this gap by diverting resources from private consumption
to public investment. Besides, in such countries, there is a general
lack of economic and social overheads. Now private enterprise
would not invest here because of no or negligible direct return.
But the lack of such facilities discourage the incentives to work
and invest. Therefore, it becomes the duty of the state to provide
such facilities on its own so that all-round atmosphere for
economic development is generated. This would be possible if
huge amount of public expenditure is spent on the creation of
such facilities. Last but not least, is the increasing amount of
foreign assistance received on government basis. The receipt of
such foreign assistance on government basis naturally necessitates
an increase in public expenditure which essentially is a tool of
fiscal policy. To conclude, we can say that the economic salvation
of developing countries lies in the increasing and judicious use
of different tools of fiscal policy.
FISCAL POLICY 347
TYPES OF BUDGETARY DEFICITS AND THEIR IMPLICATIONS

In the Western sense, financing of the budgetary deficits
denotes the technique of financing a deliberately created gap
between public revenue and public expenditure, the method of
financing resorted to is being borrowing of a type which results
in a net addition to aggregate expenditure. However, in the
Indian sense, we have been defining deficit financing in terms of
the overall budgetary deficit which means the aggregate of the
deficit on both the revenue account and capital account. The
First Five-Year Plan has stated that:
The term ‘deficit financing’ is used to denote the direct
addition to gross national expenditure through budget deficits,
whether the deficits are on revenue account or on capital account.
The essence of such a policy lies, therefore, in government
spending in excess of the revenue it receives in the shape of
taxes, earnings of state enterprises, loans from the public deposits
and funds and other miscellaneous sources. The government
may cover the deficit either by running down its accumulated
balances or by borrowing from the banking system (mainly from
the central bank of the country and thus ‘creating’ money).
The government may cover this deficit by: (a) running down
its accumulated cash balances, (b) borrowings from the central
bank, and (c) creating new money.
Thus, in advanced countries, deficit financing mostly takes
the form of additional credit creation through the banking
system. Hence, borrowing by government either results in the
activisation of idle deposits held in banks or by the private
individuals themselves or in the creation of deposits by banks
which purchase government securities or bonds. Therefore, in
the Western sense, deficits budget means excess of expenditure
over current revenue, i.e. market borrowings do not constitute
part of government revenue, whereas in the Indian sense, market
borrowings are considered part of government receipts.
From the above discussion, it is clear that the concept of
budgetary deficit may involve different technicalities which may
give rise to different interpretations, though in a layman
language, it implies excess of public expenditure over public
revenue. The few concepts of ‘deficit’ which are currently in

vogue are discussed below.9
Revenue Deficit or Deficit on Revenue Account
The traditional budgeting is divided into two accounts, viz.
revenue account and capital account. Revenue account implies
the current revenue or revenue on current account. It includes
the usual receipts of the government from tax and non-tax
sources. While tax receipts are obvious, non-tax sources include
the usual administrative revenue, commercial revenue from
public enterprises including revenue from social and economic
services, fees including court fees, fines, etc. which the
government usually receives in a particular year.
Expenditure on revenue account or current account is the
component of government expenditure which it has to incur for
purchasing goods and services for consumption purposes in a
particular year. That is why sometimes this expenditure is also
called consumption expenditure. The main components of
revenue account expenditure are salaries including pensions,
interest payments and subsidies. In fact, the concept of revenue
account might become clearer when we define capital account.
Revenue deficit implies excess of revenue account expenditure
over revenue account receipts. Since expenditure on interest
payments is considered to be due to the past action of the
government, therefore, revenue account deficit net of interest
payments is sometimes termed as primary revenue deficit.
Capital Deficit or Deficit on Capital Account
In India, the main source of capital account receipts has
been public borrowings which were resorted to by the
government in the past to build capital assets. In developing
countries like India, where the government has to play a crucial
role to build economic and social infrastructure, the government
may have to generate enough surpluses on its own for investible
purposes. It goes to the credit of the Government of India that
in spite of widespread poverty it has been generating more
revenue than expenditure on revenue account up to 1970s. And
these surpluses, i.e. excess of receipts over expenditure on revenue
FISCAL POLICY 349
account were being transferred to capital account to be used for

building capital assets. But the government resorts to borrowings
since it cannot finance its entire expenditure on capital account,
which includes expenditure on: (a) gross fixed capital formation,
i.e. building and construction as well as machinery and
equipment, (b) increase in inventories including store and stock
of foodgrains, (c) repayment of public debt, and (d) capital
transfers, i.e. grants for capital formation to the States, Union
Territories or the Local Governments, gratuity and commuted
value of pensions and other capital transfers. Therefore,
borrowings are the major source of revenue on capital account.
The other sources of revenue on capital account may be selling
of assets or what we call now is disinvestment of public sector
enterprises.
To understand the distinction between expenditure on
revenue account and capital account, it would be better if these
expenditures are defined in terms of the quantum of assets and
liabilities created during a particular period. Receipts which
increase the government liabilities (like public borrowings) or
reduce the public assets (like receipts from disinvestment of public
sector expenditures) should be termed as receipts on capital
account. Conversely, any public expenditure which increases
public assets like expenditure on investment, renewals, repairs,
increase in inventories, etc. or reduces the public liabilities (like
repayment of public debt and payment of commuted value of
pension and gratuity) should be termed as expenditure on capital
account. All other usual types of expenditure and receipts should
be termed as those on revenue account. For example, take the
case of payment of pension. The payment of regular pension is
like payment of regular salary. Therefore, this expenditure is
termed as expenditure on revenue account. But payment of
commuted value of pension (in lump-sum) reduces the liability
of the government in future, therefore expenditure on commuted
pension is termed as capital account expenditure. It should be
born in mind that because of its nature capital account has to
be in deficit, particularly in developing countries like India, which
is no harm.
Budget Deficit
The total budget is defined as the sum-total of revenue
account budget and capital account budget. Obviously, total
budgetary receipts would include receipts both on revenue
account and those on capital account. And total budgetary
expenditure would mean the sum-total of expenditure on both
revenue account and capital account. In this context before 1991,
we have been talking about total budgetary deficit, which was
financed by drawing down of previous balances, borrowings
from the Reserve Bank of India, printing of new money, etc.
These moves always led to net addition in money supply/money
expenditure in the economy and was termed as deficit financing.
Obviously, deficit financing was always inflationary that is why
it was mostly dreaded.
Fiscal Deficit
Fiscal deficit is the difference between total receipts
(excluding net borrowings) and total expenditure. In other words,
borrowings are not considered as part of government receipts.
As already stated in the beginning, this is what deficit financing
means in the Western sense. For example, as per Keynesian
prescription to fight Great Depression government should create
the deficit budget which may be either financed through the
creation of new money or through borrowings of idle funds
which were lying idle with the people or banks and need to be
activated.
In a free enterprise economy, the government’s income is
from taxation; any expenditure in excess of tax receipts must be
financed by borrowings or newly created money.
Obviously, deficit financing defined in the Indian context
and in the Western sense carried different economic connotations
having different economic implications. For example, deficit
financing defined in the Western sense has to be less inflationary.
Coming specifically to the concept of fiscal deficit reduction
of which carries the hallmark of every sound budget. As already
stated broadly it denotes the difference between total receipts
(net of borrowings) and total expenditure. That is part of the
FISCAL POLICY 351
budget which is financed through public borrowings is termed

as fiscal deficit.
Gross fiscal deficit is defined as the difference between
revenue receipts (net) plus non-debt capital receipts and the
total expenditure including loans net of repayments. This is a
measure, which captures the entire shortfall in the non-debt
resources for financing the Central Government operations.
To some commentators, however, “fiscal deficit is defined
as the difference between total government expenditure (current
and capital) and revenue receipts. It may be decomposed into
debt-financed deficit and money-financed deficit depending on
whether it is met by borrowing from the public or Reserve Bank
of India”. Thus, if we deduct monetized deficit from the fiscal
deficit, this may show debt-financed deficit. This view is useful
for monitoring the growth of public debt which may lead to a
situation of debt-trap after a certain limit. The recent decision
of the Government of India to introduce the Fiscal Responsibility
and Budget Management Act, 2003, which seeks to put a cap
on government borrowing is a step in the right direction.
To reduce the fiscal deficit the two sides, i.e. receipts and
expenditure, must match. Now let us see what the government
is doing. Coming to the management of public expenditure first.
Total expenditure has two sides: revenue account expenditure
and capital account expenditure. As already said expenditure
on revenue account comprises mainly salaries (nearly 60-70 per
cent), interest payments (30 per cent) and subsidies. Expenditure
on interest payments on public debt, because of past commitment
cannot be curtailed. So far the government has failed to downsize,
therefore, the axe has to fall on subsidies. One must have come
acrossed the often repeated rhetoric of the government while
presenting every budget that it would slash the quantum of
subsidies so as to get hold over ever burgeoning fiscal deficit.
But this measure has its own political compulsions and the result
is ever increasing swelling of fiscal deficit. Thus, revenue account
expenditure being broadly committed and of non-plan nature is
very difficult to curtail.
Coming to the second component of public expenditure, i.e.
expenditure on capital account. It is the major casualty. The
public expenditure on capital account has been witnessing a

downward trend. Not only public expenditure on economic
infrastructure, viz. power, transport, communication, etc., is
being slashed even social infrastructure like education and public
health are getting step motherly attention of the government.
While the former is being handed over to the private sector, the
neglect of the latter has been causing a great social and economic
tensions. In fact, when one examines the trends of public
expenditure of the State Governments one would find that the
states have found an easy way to cut capital expenditure and
plan expenditure since they have no control over non-plan
expenditure, which is of committed nature.
Now coming to the receipts side of fiscal deficit, which
include tax and non-tax sources as well as receipts from
disinvestment of public sector enterprises. Tax revenue of the
Central Government as proportion to GDP has fallen from
8.0 per cent to 7.0 per cent, while non-tax revenue like fees and
fines is mainly realized by the State Governments.* Now what
the Central Government is doing and even Finance Ministers
are admitting that in order to reduce the fiscal deficit, they are
showing an increasing proceeds from disinvestment of public
sector enterprises. It is another thing that these proceeds are not
being materialized. Now the point to debate is that proceeds
from disinvestment are receipts on capital account because these
proceeds directly lead to the depletion of government assets.
Therefore, a simple logic demands that these capital account
receipts should be used for capital account expenditure, i.e. either
for retiring the public debt or for reinvestment in remaining
public sector enterprises. However, presently the government
has been using these receipts to meet the needs of current
expenditure so that fiscal deficit is contained. The critics have
rightly termed this as a ‘Myopic Approach’ to managing fiscal
deficit. In the process, we are eating our own assets. The main
sufferers would be the future generations. The government which
is a custodian of the interest of future generations appears to
have become callous to their interest.
* Of late, tax-income ratio in the case of the Union Government is on the
rise.
FISCAL POLICY 353
Insofar as the other receipts are concerned, i.e. tax and non-
tax receipts, which are broadly receipts on revenue account,
these have their own economic logic. In India, already the tax
rates have been quite high (though there is a scope to widen the
tax-net) and in view of the globalization, privatization and
liberalization these have to be further slashed, therefore, the
government will have to look towards non-tax sources.
Primary Deficit
Primary deficit which is defined as revenue deficit minus
interest payments is usually termed as the main culprit of fiscal
mismanagement. Interest payments are said to be due to the
past action of the government and hence unavoidable. But other
items of expenditure are due to the current action of the
government and are, therefore, controllable to some extent.
However, it may be emphasized that interest receipts are also
due to the past contract of the government. Therefore, the correct
definition of the primary deficit should be:
Primary Deficit = Fiscal Deficit – Interest Payment
+ Interest Receipts.
However, in the Reserve Bank of India Bulletins, primary
deficit does not take into account interest receipts. Therefore,
primary deficit figures as shown by the government are
underestimates to some extent.
Net Fiscal Deficit and Net Primary Deficit
Sometimes, for analytical use a distinction is made between
gross fiscal deficit and net fiscal deficit, and gross primary deficit
and net primary deficit. While fiscal deficit, defined as above,
could be termed as gross fiscal deficit, net fiscal deficit may be
defined as fiscal deficit net of ‘loans and advances’, mentioned
in capital account of the budget. That is ‘loans and advances’
are not meant for consumption purposes. By the same logic,
one can say that other expenditure on capital account which is
meant for the creation of capital assets should also be taken
into account. If that is done, it will again bring us close to the
earlier classification of deficit budget, i.e. deficit on revenue
account and deficit on capital account. Similarly, one can work
out the net primary deficit by subtracting ‘loans and advances’

from the primary deficit.
Monetized Deficit
To finance the deficit budget, the Central Government, apart
from other measures, borrows from the Reserve Bank of India
which directly add to money supply. This is due to the fact that
borrowing from the Reserve Bank of India by the Central
Government are simply book entries against which the latter
can make the necessary payments.
Thus, monetized deficit is the increase in net Reserve Bank
of India credit to the Central Government which is the sum
total of net increase in the holdings of treasury bills of the
Reserve Bank of India and its contribution to the market
borrowings of the government. But it should be remembered
here that the monetized deficit, defined as above, may not be a
perfect index to measure the inflationary pressure of the Central
budget, because loans from the general banking sector also add
to the liquidity and hence to the inflationary pressure of the
economy. Similarly, overdrafts to the states have also similar
inflationary tendencies to generate.
Structural Deficit
The Eleventh Finance Commission considers that the
structural deficit is the main bane of fiscal mismanagement. It is
defined as a product of “the discretionary policy actions of an
expansionary fiscal stance of the government”. Obviously,
structural deficit is expected to persist when the government
resorts to competitive populism resulting to needless subsidies
without commensurate efforts to raise the required resources.
Rising interest rates on public borrowings in the eighties was
another structural factor contributing to fiscal imbalance. This
has led to unsustainable growth of public expenditure. On the
revenue side also virtual stagnation in the level of non-tax
revenues and falling buoyancies of gross tax revenue from 1.15
during the eighties to 0.91 during the nineties in case of the
Centre, and from 1.12 to 1.04 in case of the states would provide
valuable insight into the character of the balances in the public
FISCAL POLICY 355
finances in India. It brings out clearly that deficits at both levels

of the governments are mainly structural. Until and unless
corrective long-term measures are undertaken, structural deficit
is expected to persist. According to the XI FC, structural deficit
registered “an increase during the 1980s accounting for more
than 100 per cent of the FD of the Centre in the late eighties.
Following the reforms initiated in the wake of the balance of
payments crisis of 1991, the structural deficit went down, yet
accounted for over 80 per cent of the FD. Structural factors
were found to be dominant in the case of States also”.
From the above discussion, it is clear that one can define
the term of ‘deficit’ in a number of ways. Each definition or
concept of deficit has its own logic and analytical use. Depending
upon the policy perspective for sound fiscal management and
the stage of the economy each concept has its own relevance
and limitations.
NOTES
1. J. Harvey and M. Johnson, An Introduction to Macro Economics,
1971.
2. G.K. Shaw, An Introduction to the Theory of Economic Policy,
Vikas Publications, New Delhi, 1971.
3. M. Friedman, “Postwar Trends in Monetary Theory and Policy” in
A.D. Entine (ed.), Monetary Economics Readings.
4. L.C. Anderson, and K.M. Carison, “A Monetarist Model for
Economic Stabilization”, Monthly Review, Federal Reserve Bank of
Louis, April 1970.
5. R.G. Davis, “How Much Does Money Matter? A Look at Some
Recent Evidence”, Monthly Review, Federal Reserve Bank of
New York, June 1969.
6. Commission on Money and Credit: Money and Credit: Their
Influence on Jobs, Prices and Growth, USA, 1961.
7. J. Tobin, “The Monetarist Counter-Revolution”, Economic Journal,
Vol. 91, March 1981, p. 33.
8. A.P. Lerner, Economics of Employment, McGraw Hill Book
9. Janak Raj Gupta (Ed.), Fiscal Deficits of States in India, Atlantic
Publishers, New Delhi, 2000.
Fiscal Federalism 9
A federation is an association of two or more states. The

member states of a federation have the Union or the Central
Government for the entire country and there are State
Governments for parts of the country. Thus, in a federal set up,
there are at least two layers of government. The top-most layer
is the Central or Federal (or Union) Government and below it
lies the layer of State Governments. Also, there are likely to be
local or municipal governments within each state. However,
generally, the discussion of the problems of federal set-up is
confined to the Central and State Governments only. Federation
is defined by Professor K.C. Wheare as “…an association of
states, which has been formed for certain common purposes but
in which the member states retain a large measure of their
regional independence”.1 According to Sir Robert Garran,
federation is “a form of government in which sovereignty or
political power is divided between the central and local
governments so that each of them within its own sphere is
independent of the other”.2 A perusal of the above definitions
reveals that federation is multi-jurisdictional union with a
national government superior, either politically or financially
or both with an element of internal autonomy for member states.
The national government enjoys a higher degree of efficiency in
certain fields like defence and foreign policy but it also suffers
from those widely recognized dangers which result from a heavy
concentration of power. On the other hand, a decentralized
political structure allows wide-spread participation of the people
in the affairs of government. Professor Wheare argues that
“federal government stands for multiplicity in unity. It can
provide unity where unity is needed, but it can also ensure that
FISCAL FEDERALISM 357
there is variety and independence in matters where unity and

uniformity is not essential”.3 A federal government, therefore,
is in a position to resolve the economic problems in the best
possible way consistent with maximum political freedom.
PRINCIPLES OF FEDERAL (MULTI UNIT) FINANCE

1. Principle of Financial Independence and Responsibility.
2. Principle of Adequacy and Elasticity.
3. Principle of Administrative Economy and Efficiency.
4. Principle of Equity.
5. Principle of Integration and Coordination.
6. Principle of Accountability.
7. Principle of Uniformity.
8. Principle of Fiscal Access.
Principle of financial independence and responsibility means
that both the Centre and the states should be given such sources
of revenue as they can meet the expenditure needs without
depending upon one another, that is, their income should be
sufficient to perform the functions assigned to them. Further,
both the layers should be answerable to their respective houses
of representatives, e.g. in Indian federation, the Centre should
be responsible and answerable to the Parliament and the states
to the State Legislatures. By principle of adequacy and elasticity,
we mean that not only the resources should be adequate to
meet their respective expenditure needs but they should be elastic
so as to change according to the changed circumstances. For
example, if the Centre is in the need of raising immediate revenue
due to war or any other natural calamity, it should be free to
raise the revenue from different sources, i.e. borrowing, deficit
financing, etc. Similarly, when the states are in need of money
they should also be free to raise revenue from different sources
like state tax and non-tax revenue sources. By administrative
economy and efficiency, we mean that the functions and sources
of revenue which are assigned to the different layers of the
government meet the canon of economy, that is, the sources of
revenue and the functions which can be performed more
efficiently and in an economical manner by the centre should be

assigned to it. For example, functions which are of national and
international importance like defence, foreign affairs, currency,
etc. should be assigned to the Centre. Similarly, functions which
are of local importance like agriculture, small scale industry,
education, medical and public health, etc. should be assigned to
the states. Likewise, the sources of revenue like import and
export duties, income tax, etc. should be assigned to the Centre.
The states should have the exclusive right to tax the agriculture,
local sales and purchase, etc. Principle of equity demands that
justice should be done both in respect of the Centre and the
states. The taxpayers should also be treated equitably irrespective
of the fact that they are the residents of different states.
Horizontal and vertical equities should be ensured both in respect
of taxpayers and in respect of different layers of the government.
Both the Centre and the states should work in a coordinated
manner and must ensure the integrity of the country. They should
have the urge to accommodate the viewpoints of each other. As
already stated different layers of the government must be
accountable. Accountability is pre-requisite in a democratic form
of federal government. Democracy and federalism go hand in
hand. In India, the accountability is ensured through Parliament
in the case of the Centre and State Assemblies in the case of
states. Since all the taxpayers in a federation belong to the same
country, therefore, they should be treated uniformly. No
discrimination should be done to them on the basis of religion,
caste and creed and place of residence. Each layer of the
government should have the freedom to access new sources
of revenue, of course, within the limits enshrined in the
Constitution. Finally, in a successful federation, no permanent
principle can be laid down. Rigidity in a federation is always
counter-productive. With new developments and with the passage
of time, some adjustments and re-adjustments will have to be
made to make the working of federal finance successful. No
solution can hold true for all times to come. Therefore, the
principle of adaptability and flexibility should be the guiding
principle in a successful federation.
TIEBOUT MODEL AND CITIZENS MOBILITY

One of the persistent problems in public economics is how
to achieve efficient outcomes through market mechanism in the
presence of public goods. The Lindahl equilibrium as formalized
by Samuelson (1954) is not in itself a satisfactory solution.
Decentralizing efficient allocations through the Lindhal
equilibrium notion requires that the prices faced by agents depend
upon their preference patterns. As a consequence, self-interested
agents may prefer not to reveal their true preferences, relying
instead on others to provide the public goods. Solving this “free
rider” problem in pure public goods economies typically requires
appealing to non-market mechanisms.
In his seminal paper, Tiebout (1956) proposed an alternative
model. Charles Tiebout suggested that local public goods could
be decentralized in a way that was immune to the free-rider
incentive problem. He observed that many types of public goods
are “local” rather than “pure”. Tiebout suggested that when
public goods are provided to agents (persons) by a large number
of jurisdictions, competition among these jurisdictions for
members will lead to market-type efficiency. In effect, agents
reveal their preferences by their choice of jurisdiction.
Consequently, the free-rider problem disappears and the
equilibrium outcome is efficient. Therefore, we could find a
market-type decentrization.4
Tiebout’s original contribution has led to two major strands
in the literature: local public goods economies and the theory of
clubs. The theory of clubs has already been discussed in chapter.
Authors who write on club economies usually have in mind
a private membership club such as a country club. They are
concerned about the extent to which private clubs can effectively
provide public goods traditionally supplied by governments.
Most papers consider the problem from the standpoint of one
profit-maximizing and price-taking club. The general equilibrium
question of how to allocate all agents in the economy to clubs
does not necessarily arise in this context.
Perhaps the most important feature distinguishing the club
from the local public goods approach is that club membership
is not particularly associated with the physical location of agents.

As a consequence, agents are typically allowed to join more
than one club or no club at all. Questions of variable usage of
club facilities and how this affects crowding and pricing naturally
arise.
Studies of local public goods economies are typically
motivated by locational models. We imagine optimizing
jurisdictions that competitively offer bundles of public goods
and associated tax prices. Agents express their demands indirectly
by “voting with their feet”, i.e. by moving to the locality with
their most preferred mix of taxes and public goods. The fact
that agents can live in only one location motivates the restriction
that agents join exactly one of these local public goods “clubs”.
Local public goods models usually focus on the general
equilibrium question of how the entire population allocates itself
to various jurisdictions in response to market signals. Interesting
questions associated with local public goods models include the
effects of property rights assignments and how variable land
consumption choice and capitalization of the present value of
public goods consumption affect the nature and efficiency of
the equilibrium.5
Recent Trends in Federal Finance. All the world over, the
following trends in the federal finance are visible: (1) Federal
Government mobilizes more and more revenue whereas the
regional governments execute the development programmes.
Federal Governments have emerged financially stronger than
the states. (2) There is an increasing tendency of transfer of
resources from the centre to the states. Federations like U.S.A.,
Australia, Canada and India are no exception. (3) As a result
the Federal or the Centre Government has acquired a large
measure of control over the expenditure of the states. (4) In
some of the countries, planning is resorted as a measure to
promote economic development and planning in most of the
countries, is a central subject. This has further strengthened the
position of the Central Government viz-à-viz the State
Governments. However, changes are too often introduced in
different federation. No system of federal finance would long
survive which is incapable of being adjusted to the changing

needs of the federal country.
IMBALANCES IN FEDERAL FINANCE

(Vertical and Horizontal)
As already stated all over the world there is an increasing
tendency for the concentration of resources in the hands of the
Centre. In almost all the federations and India is no exception,
all the elastic sources of revenue are allocated to the Centre. As
a result vertical imbalance in the resource position has developed.
Concentration of resources in the hands of Central Government
has made the states to approach the Centre with a begging bowl
because they have to perform developmental functions which
require more and more allocation of resources.
Then, in a federal set-up there is another type of imbalance
called horizontal imbalance. Since all the units or states in a
federal set-up would differ in their economic status, therefore,
provision of public goods and services would also differ. In
fact, there is a vicious circle of horizontal imbalance to continue,
and to break this vicious circle Federal/Central Government has
to play the role of the head of a family. More developed states
in a federation are in a better position to collect higher amount
of tax and non-tax revenue. As a result these states provide
better economic and social infrastructure, which enables them
to realize higher growth rate of their gross state domestic product
(GSDP). And a higher GSDP would mean more tax and non-tax
revenue and hence the circle is complete. The dent in this vicious
circle is possible only through the active intervention of the
Centre.
How to Remove the Imbalance
The question naturally arises how one can remove these
imbalances in a federal set-up. The simplest way is to assign
more functions to the centre by transferring them from the states.
But this would not be desirable because division of functions in
a federal set-up is done on certain principles, i.e. functions which
are of local importance are assigned to states, and functions
which are of national and international importance are assigned
to the centre. Similarly, transferring more tax items from the

centre to the states would mean ignoring certain principles of
federal finance like the principle of economy and efficiency.
Therefore, all over the world a mechanism for the transfer of
resources from the centre to states has been evolved. Following
are the main channels of transferring resources from the centre
to the states.
(i) Distribution of Tax Proceeds. Since major and elastic
sources of tax revenue are with the centre, therefore, it should
transfer a certain share of tax revenue to the states. This is the
simplest method to remove the vertical imbalance and it would
not violate the principles of federal finance and at the same
time the superior position of the centre is maintained. Then the
share of states from the total divisible pool can be so worked
out so that equitable distribution of national wealth is ensured.
But before adopting this method one will have to answer certain
questions. Which taxes should be shared? In India, an answer
to this question was found by deciding the sharing of union
excise duty and income tax. Then the next question comes what
proportion to share? Then what criteria should be adopted to
decide the share of each state? There can be many criteria like
backwardness, population, poverty, per capita income, tax
collection, etc. and each would affect the functions of different
states differently.
(ii) Supplementary Levies. The Central Government may
impose supplementary levies or surcharges on its existing sources
of revenue and the entire proceeds from such levies may be
transferred to the states. Contrary to this, in India the Central
Government has been levying surcharges for its own benefits
only, though these surcharges are levied to meet certain exigencies
like war, draught, earthquake, floods, etc.
(iii) Provision of Grants. To remove both the vertical and
horizontal imbalances, the provision for grants from the centre
to the states has been made almost in all the federations. In
India, grants-in-aid from the Consolidated Fund of India to the
states under Articles 275, 278 and 282 have been designed for
the purpose. Further, these grants can be special purpose or
conditional grants and general purpose or unconditional grants.
Sometimes matching grants are given to the states to encourage

them to mobilize additional resources. Such types of grants are
very common from states to the local bodies. But the main
problem remains as to what should be the basis of providing
such grants to different states. Should the budgetary needs or
budgetary deficits be used to work out the share of each state?
This will unduly put premium to extravagance. To provide
uniform level of social and administrative services in all the
states can be another criterion to decide the amount of grants
for each state. Then special purpose grants, considering the local
needs, like fighting the natural calamities, terrorism, etc. can be
given to deserving states. As already stated, in order to provide
an element of incentives to states to mobilize and use their own
resources, sometimes matching grants can be given to the states.
In fact, a choice between the canon of equity and the canon of
efficiency has become the bone of contention amongst the states
in a federal set-up in order to corner maximum grants from the
Centre.
(iv) Provision of Inter-governmental Institutions. In order
to provide a permanent platform to tackle the issue of resource
imbalance, most of the federal governments have established
inter-governmental institutions dealing with the resource transfers
from the centre to the states. Such inter-governmental institutions
are also used for consultation and cooperation between
different layers of the government and make a regular
process of adjustment in the financial arrangements to meet
the new challenges. In Australia, two separate bodies, viz.
Commonwealth Grants Commission for determining the grants
and the Loan Council for coordinating public borrowings have
been constituted. In India, there are two bodies, viz. Planning
Commission and the Finance Commission which deal with the
transfer of grants from the Centre to the states. There is no
institution which deals specifically with inter-governmental
borrowings, though the Planning Commission deals with loan
component also along with grants while deciding the transfer of
resources from the Union to the states. Then there are other
bodies like National Developmental Council, Inter-zonal
Councils, Inter-state Council, etc. which deal with other inter-

governmental issues.
FISCAL FEDERALISM IN INDIA

Evolution
Before the enactment of the Indian Constitution in 1950,
the evolution of federal fiscal relations India can be seen in
gradual steps. The entire analysis has been divided into the
following four convenient periods:6
1. The period before the Government of India Act, 1919
(first period).
2. The period between the Government of India Act, 1919,
and the Government of India Act, 1935 (second period).
3. The period between the Government of India Act, 1935,
and the Indian Constitution 1950 (third period).
4. Present Constitutional Provisions.
First Period: The Period before the Government of India
Act, 1919. Since the British India had a unitary constitution,
the Indian Federal Finance prior to the First World War can be
more precisely termed as unitary type. This centralization was
introduced by Charter Act of 1833 according to which all
decisions regarding administration and finance of centre as well
as provinces were handed over to Governor General of India in
Council.
During this centralized system of finance, transfer of funds
to provinces was based upon their relative claims and pressure
upon Centre and was just like a premium to them.
Due to First War of Independence in 1857, administration
of India was transferred to British-Crown from East India
Company. But even then, the Indian Council Act of 1861
maintained the control of the Central Government over financial
matters. Centralization was still the prime feature of Indian
administration and finance. The system of federal finance, as it
is nowadays in India, strictly speaking, was introduced with the
implementation of Montague Report on Constitutional Reforms,
1919.
Second Period: The Period between the Government of India

Acts, 1919 and 1935. In an announcement made on August 20,
1917, it was clearly indicated that the Government of India was
keenly interested in gradual development of self-governing
institutions. In this connection, Mr. Montague visited
India during November 1917 and submitted his report on
Constitutional Reforms on April 22, 1918, which formed the
basis of Government of India Act, 1919.
The Montague Reforms introduced, through abolishing
‘divided-heads’, much financial autonomy to provinces, when
certain departments in the provinces were transferred to the
ministers appointed by Governors from among the elected
members and consequently the control of the Secretary of State
for India was relaxed. Under the scheme of Montague Reforms,
land revenue, irrigation, excise, forests, judicial stamps were
given to provincial governments and customs, commercial
stamps, railway receipts, salt, etc. entirely to the Centre. Due to
this new scheme of distribution heavy annual deficit of ` 9.5
crore accrued to the Central Government and provinces were
called upon to meet contribution to the Government of India.
Third Period: The Period between the Government of India
Act, 1935 and the Indian Constitution, 1950. The Government
of India Act, 1935, was an important landmark in the history
of India which to a large extent fulfilled the desires of the people
of a federation, though native states were kept outside of its
scope. It came into effect from April 1, 1937. It opened a new
chapter in the Central-provincial financial relations. The Act
was the largest in the History of British Parliament. It contained
321 Sections and 10 Schedules. The financial provisions were
mainly mentioned in the Seventh Schedule of the Act. Under
this Act, the sources of revenue were divided into four categories,
namely:
1. Taxes levied and retained by the Federal Government.
2. Taxes levied and collected by the provinces.
3. Taxes levied and collected by the Federal Government
but assigned to the provinces.
4. Taxes levied and collected by the Federal Government

but shared with the provinces.
This Act made the following salient arrangements for
financial adjustments between the Centre, the provinces and
those princely states who agreed to join the federation:
1. Agricultural income tax was assigned to the provinces
and to the acceding princely states.
2. The net proceeds of taxes on income other than
agricultural income were partly to be assigned to the
provinces and the princely states.
3. The Centre retained part of the proceeds of the income
tax.
4. Excise and export duties would be levied and collected
by the federation but would be distributed to the
provinces and princely states by an Act of the legislature
in accordance with the principles laid down by the
1935 Act.
5. There was provision for payments of grants-in-aid on
a ‘need’ basis.
6. The Act provided for the levy of stamp duties,
succession levies, terminal taxes on goods and
passengers carried by rail or air and taxes on railway
fares and freight by Federal Government. The proceeds
were to be distributed to the provinces and the princely
states.
7. Fifty per cent or a higher proportion of the proceeds of
the export duty on jute and jute products was to be
given to the jute-growing provinces in proportion to
the amount of jute grown in them.
The federal list comprised of customs and excise duties other
than on alcohol, corporation tax and salt apart from the items
mentioned earlier. The provincial list included agricultural
income tax, land revenue, excise on alcohol, opium and medicinal
preparations, tax on sales of goods and services, professions,
gambling and betting.
The Act of 1935 had not only embodied the basic principles
of federal finance but had also endowed the provinces with
financial power and authority which constituent units in a
federation normally enjoyed.
Present Constitutional Provisions (Assignment of Functions and
Sources of Revenue)
When constitutional provisions relating to Union-state
financial relations were debated in the Constituent Assembly,
there was no dearth of doughty champions of state autonomy
in the financial sphere. These spokesmen of states’ rights missed
no opportunity of raising their voice against provisions which,
in their opinion, would have the effect of placing the states in
the position of financial subordination to the Centre or leave
them with inadequate resources. Thus, K. Santhanam asserted
that “Provinces will be beggars at the doors of the Centre”.
Others like Biswanath Dass pleaded particularly on behalf of
the ‘poorer’ provinces. Speaking on the Experts Committee
Report, the same members laid stress on the need for providing
adequate resources to the states. They declared that the needs
of states are almost unlimited, particularly in relation to welfare
services and general development. If these services, on which
the improvement of human well-being and increase of the
country’s productive capacity so much depend, are to be properly
planned and executed, it is necessary to place at the disposal of
State Governments adequate resources of their own without
their having to depend on the affluence of the Centre.
What we want to stress is the fact that the allocation of
financial resources between the Centre and states received a
great deal of attention at the hands of the Constitution-makers.
While the desire to have a ‘strong’ Centre was more or less
universal, the viewpoint of state autonomy was by no means
inadequately represented. The pattern of financial relations which
finally emerged may now be summarized.
Following the precedent set in the Government of India
Act, 1935, the Constitution seeks to make a more or less clear
division of financial resources between the Centre and the states.
(Detail is given in the Appendix II.) There are as many as nineteen
items of revenue in List II of the Seventh Schedule. These sources

of revenue belong exclusively to the states. The states are free to
determine the rates of these taxes and duties, to collect them
and to appropriate their proceeds for their own use.
Only a few of the tax items enumerated in the Union List
are exclusively assigned to the Centre in the sense that they are
wholly appropriated for the use of the Union Government. These
are customs including export duties, corporation tax, and taxes
on the capital value of the assets exclusive of agricultural land,
of individuals and companies. As for the other taxes mentioned
in the Union List, their proceeds are (or may be) shared or
wholly appropriated by the states. There is, for example, the
income tax. The Centre has the power to levy this tax, to
determine its rate and to collect it. However, the Constitution
provides that the Centre must share the net proceeds of this tax
with the states and that the share of states has to be determined
by the President by order after considering the recommendations
of the Finance Commission.
In the third category stands Union duties of excise (other
than those allotted to the states under entry 51 of List II of the
Seventh Schedule) which are levied and collected by the
Government of India but may be shared with the states if
Parliament so decides. The Constitution authorizes Parliament
to decide whether a share of these duties should be given to the
states and to lay down the principles in accordance with which
the share of the states should be distributed among them.
The fourth category of taxes are those which the Centre can
levy and collect but the entire proceeds of which (except those
attributable to Union Territories) go to the states in accordance
with such principles as may be laid down by Parliament by law.
These include succession and estate duties; terminal taxes on
passengers and goods carried by railway, sea or air; taxes on
railway fares and freights; taxes other than stamp duties on
transactions in stock exchange and future markets; taxes on the
sale or purchase of newspapers; sale or purchase taxes on inter-
state trade.
The fifth and the last category of taxes enumerated in the
Union List are those which are to be levied by the Centre but
are to be collected by the states and appropriated by them for

their own purposes. These are stamp duties and excise duties on
medicinal and toilet preparations containing alcohol. This means
that the Centre levies the tax and determine the rate of the duty
to be paid on the alcohol in medicinal and toilet preparations
while the tax is collected by each state which appropriates its
proceeds for its own purposes (except that these taxes are
collected and appropriated by the Government of India insofar
as they are leviable in any Union Territory).
Power of Borrowings
The Constitution confers the power of borrowing on both
the Union and the states though the two are not placed on equal
footing in this matter.
The Union Government has unrestricted powers of
borrowing in India and abroad subject only to such limits as
may from time to time be fixed by Parliament by law. On the
contrary, the borrowing powers of the states are both territorially
and otherwise limited. They have no power to raise loans outside
India. Within India a state may receive loans from the
Government of India or float public loans. However, a state
cannot raise a public loan without the consent of the Government
of India if there is still outstanding any part of a loan which has
been advanced to it by the Government of India or in respect of
which a guarantee has been given by the Government of India.
It was realized by the Constitution-makers that the financial
balance of power established in the Constitution would leave
the states with inadequate resources from meeting their manifold
responsibilities in respect of social services and welfare activities.
Provision has, therefore, been made for Central grants-in-aid to
the states. Article 142 of the Government of India Act, 1935,
had provided for grants-in-aid to the provinces by the Central
Government. Under this provision, grants were made to certain
provinces on the recommendations of Sir Otto Nieymier. In
making his recommendations Sir Otto took into consideration
the increased share of the duties on the export of jute products
to Bengal, Orissa, Bihar and Assam and the benefits accruing to
these provinces and the N.W.F.P. from the cancellation of their
debt to the Government of India. All these grants, which were

paid till the partition of India in 1947 were unconditional.
The new Constitution provides for grants-in-aid for the
revenues of states on a much larger scale than the Government
of India Act, 1935. Article 273 provides for grants-in-aid to
Assam, Bihar, West Bengal and Orissa in lieu of the export duty
on jute and jute products. Article 275 provides for grants-in-aid
of the revenue to such states as Parliament may determine to be
in need of assistance and different sums may be fixed for different
states. This Article provides for grants-in-aid to states to meet
the cost of such schemes of development as may be approved by
the Union Government for promoting the welfare of scheduled
tribes or raising the level of administration of the scheduled
tribes areas. Grants under Article 275 are to be determined on
the basis of the recommendations of the Finance Commission.
Under Article 282, the Union Government and the states
are authorized to make grants for any public purpose
notwithstanding that the purpose is not one with respect to
which Parliament or the Legislatures of the states, as the case
may be, may make laws. The Finance Commission has nothing
to do with these grants.
A brief reference may be made here to the emergency
provisions of the Constitution under which the financial
autonomy of the states can be temporarily restricted and some
of the sources of their revenue brought under Central control.
Thus, during the operation of a Proclamation of General
Emergency, the President of India, “may…by order direct that
all or any of the provisions of Articles 268 to 279 shall have
effect to such exceptions or modifications as he think fit”.
Besides, the President’s power under Article 352 can be used to
alter or modify the distribution of revenues made in the Seventh
Schedule of the Constitution. Further, during the operation of a
financial emergency, the executive authority of the Union extends
to the giving of directions to any state to observe such canons
of financial propriety as may be prescribed in the direction and
to the giving of such other directions as the President may deem
necessary and adequate for the purpose. These directions may
require reduction of salaries and allowances of any or all classes
of state employees and submission to the President of all money

bills passed by the State Legislature for his consideration.
The Finance Commission and the Planning Commission
The devolution of resources from the Union to the states is
a salient feature of the system of federal finance in India. Apart
from their share of taxes and duties, the State Governments
receive various grants and loans from the Centre for various
development and non-development purposes. Central assistance
is significant because about one-half of the total expenditure of
State Governments is met by Central assistance. In India, federal
financial transfers are made through three channels, i.e. Finance
Commission, Planning Commission and Central ministries.
Finance Commission. It was generally recognized that
although the Constitution listed all possible sources of taxation
and allotted them either to the Centre or to the states, the division
of revenue heads would create a built-in-surplus position for
the Centre and that the financial resources of the states would
not be adequate to meet the requirements of expanding functions
like education, health, medical relief, etc. It was also felt that,
unless provisions to that end were made, a mere distribution of
sources of revenue between the Centre and the states might
perpetuate existing economic disparity between the states as
such. It was with a view to mitigating the anticipated financial
weakness of the states and the likely effect of this weakness on
their autonomy that the framer of the Constitution incorporated
provisions for obligatory as well as permissive sharing of some
of the Union taxes between the Centre and the states and for
Central grants-in-aid to the latter. To ensure that this transfer
of funds from the Centre to the states should be made in such a
way as not to impair the state autonomy, it was provided that
the quantum of such devolution of funds and the principles of
their distribution among the states should not be left entirely to
the discretion of Central authorities but should be determined
on the recommendations of an independent and impartial agency
which would assess the changing needs of the states and take
into account imbalance between the high income states and less
prosperous ones in making its recommendations. Hence, the
provisions for establishment, at more or less regular intervals,

of the Finance Commission to advise the President with regard
to the devolution of funds to the states. The Finance Commission
is a quasi-arbitral body whose function is to do justice between
the Centre and the states. The establishment of this rather unique
institution which is the most important body to regular, co-
ordinate and integrate the finance of the Government of India
and the State Governments, “may indeed be described as India’s
original contribution to the theory and practice of federalism”.
The significant thing to note that financial assistance, whether
by devolution or grants under Article 275, which the states
receive on the basis of Finance Commission is of statutory
character and does not involve Central control over its utilization.
Accordingly, it does not affect the autonomy of the states. The
Finance Commission was thus conceived as the major instrument
for periodic readjustments of Union-state financial relations,
with a view to strengthening the financial position of the states
without compromising their autonomy. While the basic approach
of the Finance Commission has been that “the prosperity of the
state must rest on the solid foundation of a reasonably strong
and financial stable centre”. It has recognized the financial
inadequacy of the states and has shown “a strong awareness of
their growing needs in fulfilling a complementary role in the
development of national economy and in the provision of higher
level of social services”.
There is another aspect of the Finance Commission’s work
which has important bearing on the working of the Indian federal
system. In assessing the needs of the states and determining the
proportions in which the states, individually, should share the
central assistance, the Finance Commission has been guided,
inter alia, by the principle that the scheme of distribution should
attempt to lessen the inequalities between the states. Marked
disparities of economic development and standards of
social services in the constituent units is a striking but by no
means exclusive feature of the Indian federation. Through
its recommendations, the Finance Commission has made a
significant contribution towards correcting, to some extent, the
disequilibrium of resources not only as between the Union and
the states but also as between the states inter se. Keeping before
itself the ideal of maximum national welfare, the Commission
has, in some measures, geared its proposals to the need of
equalizing the standards of social services in different states.
This naturally means that central assistance should be relatively
larger in the case of backward states since a principle of
proportionate allocation will merely perpetuate under-
development in these states. Thus, the First Finance Commission
observed, “Grants-in-aid may be given to help a state to meet
special burdens and obligations of national concern, although
within the state sphere, if they involve an undue burden on its
finance.” This principle has also been followed by the Finance
Commission in regard to the devolution of tax revenues. An
attempt has thus been made in the Constitution to safeguard
the autonomy of the states while providing for Central assistance.
The Finance Commission has regarded it as one of its functions
to safeguard the position of the states and to counteract the
tendency of a Central assistance to be discretionary or arbitrary
in character and “not on the principle of uniform application”.
The Finance Commission has been only partially successful
as a balancing wheel of the Union-state financial relations
because of extra-constitutional developments like “the emergence
of the Planning Commission as the supreme economic authority”,
in the country and increasingly large use of ‘plan’ grants under
Article 282. This has resulted not merely in the orientation of
state fiscal policies to national purposes but also as many State
Governments complain, in a perceptible trend of centralization
of resources in addition to centralization of certain state
functions.
Planning Commission. The emergence of Planning
Commission which was set up by a resolution of the Government
of India, added a new chapter in Centre-state financial
relationship. The ‘Economic and Social Planning’ is a concurrent
subject. It means, Centre as well as State Governments are equally
responsible for formulating, financing and executing the plans
for the development of the economy. As a result, the states have
to share the burden of execution of five-year plans. But federal
principle allows comparatively more elastic and lucrative
resources to Union Government than the states. This necessitates

Central plan assistance to states for implementing and carrying
out the state plans.
Before starting the process of planned development through
five-year plans in India, Central assistance was given to states
for financing development schemes. During the year 1947-48
to 1950-51, i.e. after Second World War, State Governments
received some resources for certain development projects like
post-war development projects and “Grow More Food
Campaign”, etc.
Since the inception of Planning in India, it has been the
main objective of each five-year plans that the operation of
economic system should not induce concentration of wealth
and means of production in few hands. Keeping this objective
in view, former Prime Minister Nehru stated once that the main
objective of first plan was to ensure balanced and rapid
development of all parts of the country.
The realization of the objective of balanced development of
all parts of the country requires that each region/state should
get its share in total Central plan assistance on the basis of their
respective need of development. The relative economic position
of a state/region in comparison to other state/region can be
well-estimated on the basis of many quantifiable and non-
quantifiable indicators like per capita income, population, socio-
economic conditions, availability of infrastructural facilities, etc.
Similarly, in order to rectify the existing regional economic
disparities, the scheme of resource transfer from Centre to states
must necessarily provide incentive to states in such a way that
they put their best regarding resource mobilization through ‘tax
effort’ and ‘economy in expenditure’.
Centre-State Financial Relations in India (Present Position)
Devolution of Resources and Grants (Criteria). The Finance
Commission recommends the shares from income tax and Union
excise duty to the states. In fact, income tax and union excise
duties are the important taxes which are shared between
the states and the Centre. According to Article 270 of the
Constitution, income tax is to be levied and collected by the
Centre and the proceeds are to be compulsorily shared between

the Union and the states. The percentage share of all the states
in income tax has gone up from 55% (as recommended by the
First Finance Commission) to 85% (as recommended by
Ninth and Tenth Finance Commissions) and then reduced to
80% (as recommended by the Eleventh Finance Commission).
First, Third and Fourth Finance Commissions have given
greater weightage to tax-collection, i.e. 20% and 80% to
population, hence states like Maharashtra, West Bengal, Punjab,
Gujarat and Tamil Nadu were the gainers. However, in the
Second, Fifth, Sixth and Seventh Finance Commissions
population criterion has been given a higher weightage, i.e. 90%
and 10% to tax collection. Hence, more populated and backward
states like U.P., M.P., Bihar, Orissa, Andhra Pradesh, Assam,
Karnataka, Kerala and Rajasthan became the gainers. For the
first time, the Eighth Finance Commission introduced a new
formula for distribution of proceeds among the states. For income
tax (a) 10% would continue to be distributed among the states
on the basis of collection of income tax, (b) 90% of the proceeds
of income tax would be distributed among the states on the
following criteria:
(i) 25% on the basis of population.
(ii) 25% on the basis of inverse of per capita income of the
state multiplied by population.
(iii) 50% on the basis of distance of the per capita income
of the state from the highest per capita income state
multiplied by the population of the state. For the union
excise duties of 45%, 40% was distributed on the basis
of the same new formula as was for income tax and
5% to deficit states.
Hence, the lower per capita income states like Bihar, U.P.,
Orissa, M.P., Meghalaya and Assam have received larger shares.
On the other hand, states like Maharashtra, Gujarat, Punjab
and Haryana have lost their shares in the divisible pool. Same
trend was followed by Ninth, Tenth and Eleventh Finance
Commissions.
For Union excise duties also a different criterion was adopted.

In the First Finance Commission, 100% Union excise duties
were distributed on the basis of population but after that, the
trend changed and more weightage had been given to other
factors such as economic backwardness, distance from per capita
income, tax efforts, area adjusted, etc. In the Tenth Finance
Commission, 60% weightage was given to distance; 20% to
population, 5% to area adjusted, 5% to infrastructure, and
10% to tax efforts.
First few Finance Commissions brought more and more
commodities under the divisible pool whereas they reduced the
percentage share of the states (from 40% duties in three
commodities under the First Finance Commission to 20% of
duties on all commodities by the Sixth Finance Commission).
From the Eighth Finance Commission onwards the percentage
share was steadily raised by the successive Commissions (from
40% under the Seventh Finance Commission to 52% under the
Eleventh Finance Commission).
The share of states like U.P., Bihar and M.P., has increased
on account of higher weightage given to population and
backwardness, while the advanced states such as Maharashtra,
Punjab are the losers.
The percentage of total central resources transferred to states
from the First Finance Commission to Eleventh Finance
Commission increased from 17.75% to 29.5%. The share of
developed states such as Punjab, Gujarat, Maharashtra,
decreased from 4.9%, 3.4%, 10.4% in First Finance Commission
to 1.14%, 2.82%, 4.63% in the Eleventh Finance Commission
report. On the other hand, the percentage share of backward
states such as Bihar, U.P., M.P., increased from 9.07%, 13.5%,
6.87% to 14.59%, 19.79%, 8.83% in the Eleventh Finance
Commission report.
If we see criteria adopted by the last four Finance
Commissions, we will find that the percentage share of developed
states (Punjab, Maharashtra, Haryana, Gujarat) has decreased
from 13.83% to 10.32%, on the other hand, percentage share
of backward states (Bihar, U.P., Orissa, M.P., and Rajasthan)
has increased from 52.16% to 58.12%.7
In India, grants-in-aid to different States are given by two

independent agencies, viz. Finance Commission and Planning
Commission. The Finance Commission gives grants-in-aid mostly
under Article 275 and are called statutory grants. The Planning
Commission gives grants to achieve certain national objectives.
In 1938 All India Committee, set up a National Planning
Commission under the Chairmanship of Late Pt. Jawaharlal
Nehru. With the appointment of this committee, the concept of
planning assumed special significance in India. In its reports,
the National Planning Committee sought a compromise between
the private sector and socialism. In 1950, the Planning
Commission was established under the Chairmanship of Prime
Minister. It was to assess the physical, capital and human
resources of India and accordingly formulate a plan for economic
development. Since 1951 a continuous process of Five Year
Plans has been in operation. By far we have completed Eleven
Five-Year Plans and Five One-Year Plans. The Twelfth Five-
Year Plan will commence on 1 April 2012.
The Planning Commission decides about plan expenditure
of the states. In India, in the total budgetary resources of the
Centre and states, two-thirds accrue to Centre and one-third to
states. But in the expenditure, the share of Centre and states is
almost equal. In this way a bulk of state expenditure is met by
devolution of funds from the Centre. The total devolution
of funds from the Centre to states was ` 1431 crore in the
First Plan that constituted 42.7% of total expenditure of State
Governments. This amount increased to ` 5603 crore in the
Third Plan and reached to ` 1,86,235 crore in Eighth Plan.
Before 1969, the devolution of Central Plan Assistance was
on ad hoc basis. This was resented by the states. Then the Deputy
Chairman of National Planning Commission Prof. Gadgil
worked out a set of formula for the devolution of Central Plan
Assistance; popularly known as ‘Gadgil Formula’. According to
the Gadgil Formula, 30% of the plan assistance was given by
the Planning Commission to the states as grants and 70% as
Central loans. This formula was modified in 1980, in order to
make it more progressive in the direction of removal of inter-
state disparities. In the original formula, 10% weightage was
given to backwardness and 90% to population. But in the

modified formula 20% weightage has been given to back-
wardness.
The Central Plan Assistance in relation to economic position
of the states remained retrogressive in First, Second and Third
Plans and turned to be progressive in the three Annual Plans
and Fourth, Fifth, Sixth, Seventh, Eighth and Ninth Five-Year
Plans. To make it more explicit the states in a relatively better
position received higher per capita Central Plan Assistance up
to the Third Plan period. But the trend tilted in favour of poor
states subsequently. The Central Plan Assistance became
relatively more favourable to poor states from the Sixth Plan
period onwards.
Areas of Conflict between the Centre and the States
New Economic Policy and the Federal Relations. To quote,
“Economic reforms in a broader sense would also encompass
realigning of relative functions of Centre and states towards
achieving economic prosperity and improving the quality of life.
In our context, it means greater emphasis on development of
social infrastructure and physical infrastructure. Most of the
social, and a significant part of physical infrastructure lies
in the domain of states compared to centre. Expenditure
responsibility of states is likely to grow in social sectors;
particularly education, health, sanitation and nutrition, even
after reckoning with some unbundling as also scope for private
provision. Economic reform is not sustainable if expenditure of
state governments is not buoyant in desired directions and this
has a bearing on vertical distribution of resources.”8
There are some other recent developments which are likely
to have far-reaching implications for the federal financial set-up
in the country. Take globalization first. Hither to exports and
imports, or for that matter import-export duties were the Central
subjects. Now the states have been asked to step up their exports
to reap the benefits of globalization. To do so the states
will have to undertake measures to make their products
internationally competitive. And in the process states will have
to shed off many levies. Take, for example, the export of rice
from Punjab, which levies 4 per cent purchase tax on rice, besides
2 per cent market fee, 2 per cent rural development charges and
1 per cent infrastructure cess. In addition, there are some
transport costs. Now the rice of Punjab does not stand the
competition in international market not because of quality but
mainly because of price differentials. In case Punjab rice has to
be made internationally competitive, Punjab must lose about 8-
10 per cent. The same will be the case with other states. The
Centre, therefore, will have to make some financial adjustment
with the states in order to induce them to make their products
export-oriented. It would be appropriate that no international
agreement involving the state subjects be implemented till
ratification by the state assemblies.
Similarly, privatization or liberalization cannot go beyond
a limit until and unless inter-state trade barriers are broken.
Both the Centre and the states will have to reduce their micro-
economic controls so as to unleash the economic forces at the
grassroot levels.
Then as part of its ongoing economic reforms, the Central
Government has been toeing with the idea of a simple and
uniform domestic trade taxation. Value Added Tax (VAT) is
considered to be a panacea for all the ills from which our
commodity taxation is suffering. We have been hearing the
imposition and postponement of VAT for quite some time. But
with great persuasions the states agreed to implement VAT w.e.f.
1 April 2005.
One of the questions pertaining to the issue which is yet to
be debated relates to constitutional provision. Should it be a
Centre’s subject? States would not agree to this proposal, as
this will deprive them of their legitimate power. If it were a
states’ subject, it would lead to the similar problems which we
have been facing now. It has no place in the concurrent list
because the same commodity/services cannot be taxed twice.
Then another problem, which agriculturally dominated and low
industrial-based states would be facing, is that here value addition
component is very small. Therefore, the imposition of VAT
would mean an immediate fall in their revenue. Who will
compensate such states?
Then one of the arguments favouring VAT is the fact that

in modern times service sector has grown so much that value
addition after the production stage in terms of service, warranty,
installation charges, etc., is quite substantial. In fact, now the
distinction between the production of goods and services has
been blurred. The service sector now occupies over 50 per cent
share of the GDP. And this sector has to be brought under the
tax net. In every year’s budget more and more service items
were brought under the tax net.9
Thus, the financial relations between the Union Government
and the State Governments, which were evolved about 55 years
back, have undergone a sea change. New political and economic
developments have taken place. A single party rule, both at the
Centre and the state levels, has given way to multi-party rules.
Regional parties have developed a national outlook. New
concepts like cooperative federalism is being propagated. At the
economic front, already more than a decade of new reforms has
passed. And now we are talking about the second generation
reforms, of which the state reforms are an integral constituent.
Privatization or liberalization demands the reduction of micro-
economic controls both at the Centre and the state levels, so as
to unleash the economic forces at the grassroot levels. And
globalization is not only throwing a great challenge but also
provides large opportunities for agriculture and industrial growth
of the economy. Tax harmonization of internal trade through
the ultimate adoption of a single commodity tax, say, Value
Added Tax (VAT) would give rise to a number of problems.
But it must be kept in mind that in any federation, much less in
a developing federation like ours no permanent solutions to all
inter-state or Union-state economic problems are possible. After
30 years of experience, it was Sarkaria Commission and now
after 50 years, it is the National Commission to review the
working of the Constitution that the working of the Union-state
financial relations has been reviewed. It may be recalled that
federation is a compromise between national unity and
regional interests and this compromise must be maintained at
all costs.
PROBLEM OF IMBALANCE IN STATES’ RESOURCES

AND STATES’ INDEBTEDNESS
As already stated, there is an in-built constituted bias in
favour of the Union Government as far as financial resources
are concerned. But over the period, the Union has further
strengthened its position and encroached upon the rights of the
states w.e.f. 1957. First of all, sales tax (which is a state subject)
on certain items, viz. textiles, sugar and tobacco was replaced
by additional excise duty. Then tax on railway fare (whose 100
per cent proceeds should go to the states) was merged with
railway fare. In 1959, the nomenclature of tax on company’s
income was changed to corporation tax and thus brought out
of the divisible pool and thereby the states were deprived of
their rightful share. Later on, another tax whose 100 per cent
proceeds should go to the states, viz. estate duty was abolished
in 1985. It is another thing that with the latest Constitutional
Amendment (Eightieth Amendment Act, 2000) the distinction
between shareable and non-shareable taxes has become irrelevant
since almost 29-30% of all the net tax collections (which exclude
surcharges and cesses) would go to the states. But then what
should be the criteria for determining the share of individual
state is another bone of contention.
Closely related with the problem of inadequacy of states’
resources is the constitutional restrictions on the borrowing
powers of the states. The states have been forbidden to float
loans without the permission of the Government of India, if the
formers have already borrowed from the latter or the latter has
given guarantees for the loans raised by the former. In this
regard, Sarkaria Commission has observed that “Some state
governments as well as experts have complained that the
borrowing powers of the states have been unduly restricted by
the Constitution. The Constitution does not permit states to
borrow outside India.”10 Even internally, the states are not free
to borrow, i.e. if the Union Government has guaranteed an
outstanding loan of the state without the consent of the Union
Government…. It is argued that restrictions do not obtain in a
federation like USA. If it is felt that in a planned economy like
India there is need for some such restrictions, it should apply
only to long- and medium-term borrowing from the open market

and not to the borrowing from financial institutions or to short-
term loans for less than one year. In fact, the state Governments
or even enterprises should be allowed to access markets on the
basis of their financial strengths and viability rather through
tax incentives which distort the allocation of resources. The
Sarkaria Commission also cites another example from USA and
other countries where tax-free municipal bonds have greatly
helped urban development works.
The above Constitutional hurdle has made the states
dependent on the Centre even in respect of internal loans.
However, in order to provide incentives to the states to raise
resources through borrowings internally, the Centre promised
to transfer 80% of collections through small savings to the states.
But since the rate of interest on these and other Central loans
was very high, this has placed the different states almost in a
debt trap. Interest payments now constitute nearly 25-30 per
cent of states’ revenue expenditure and if we add the salary and
pension component which is nearly two-third to one-fourth of
total revenue expenditure, then almost all the revenue receipts
and even more than that are exhausted, so that nothing is left
for developmental and socio-economic infrastructure needs. But
it is a happy augury that for the past few years rate of interest
has been on the decline. The Union Government has evolved a
scheme of ‘Debt-Swap’ w.e.f. the budget 2002-03, whereby the
State Governments can change their old debt obligations to the
Centre, raised at the higher rate of interest with new loans raised
at lower rate of interest. The problem of states’ indebtedness
has become so acute that the XIIth Finance Commission, under
the Chairmanship of Dr. C. Rangarajan, has specifically been
asked that “after making an assessment of the debt position of
the states as on the 31st March, 2004, suggest such corrective
measures, as are deemed necessary, consistent with macro-
economic stability and debt sustainability. Such measures
recommended will give weightage to the performance of the
states in the fields of human development and investment
climate”.11
States’ Indebtedness12
The fiscal situation of states has deteriorated drastically since
mid-1990s and state finances held in total disarray. The
combined revenue deficit of all the states zoomed from
` 5,309 crore in 1990-91 to ` 5,00,000 crore in 2003-04. Their
fiscal deficit increased from ` 18,787 crore to ` 1,16,000 crore
during the same period. The outstanding liabilities of states
increased relatively from ` 1,60,077 crore in 1993-94 to
` 8,00,000 crore in 2003-04. The debt GSDP ratio increased
from 18.6 per cent to 29.1 per cent over the same period. The
growth of debt and deficit of states has been a matter of great
concern.
Structure and Growth of State Governments’ Debts
State loans are classified as follows:
(1) Internal debt: It has five components, viz. (a) market
loans, (b) compensation and other bonds, (c) ways and means
advances from RBI, (d) loans from banks and other institutions,
and (e) special securities issued to NSSF; (2) Loans and Advances
from the Centre; (3) Total provident funds: (a) State Provident
Funds, and (b) Insurance and Pension Fund Trust and
Endowments.
More than 57 per cent of the loans of the states are from
the Central Government. Total provident funds account for
19 per cent and market loans for 17 per cent. Till March 31,
1999 collection of loans by the Centre under small savings and
provident funds were recorded as borrowing of the Central
Government. Centre transferred 80 per cent of these collections
to the states as long-term loans with effect from 15 January
1999. In April 1999 Centre established a National Small Savings
Fund and accordingly all small savings collection including Public
Provident Fund are now credited to this fund. The result of the
establishment of the fund is a slow down in the accumulation of
indebtedness of states’ to the Centre with a corresponding
increase in the states indebtedness to the market since these
funds are counted as part of the market borrowing.
The outstanding debts of the states increased from about 16
per cent of the GSDP in the mid-1970s to 27.7 per cent in 2002-
03. In several states outstanding debts accounted for 30 per

cent of their respective Gross States Domestic Product. For many
states, debt liabilities as a proportion of revenue receipts exceed
200 per cent. With growing debt stock, interest burden on state
budgets increased sharply. The interest payments pre-empted
21.6 per cent of the revenue receipts of the states in 2000-01 as
against 13 per cent in 1990-91.
As debt service pre-empting much of state revenue, even
essential public services and capital expenditures shrunk sharply
and in most of the states even salaries of employees are not
being paid regularly.
Contingent Liabilities of the States
States have been resorting to issuing larger amounts of
guarantees on behalf of the public sector entities, undertaking
infrastructure investment and other development activities.
Guarantees represent a direct liability on state budgets. The
rising guarantees and assured payment arrangements at the state
level pose issue of sustainability of state finances. Governments’
off-budget liabilities could be a potential threat to the fiscal and
financial stability of the states.
The major contingent liabilities at the state level include
guarantees on loans on behalf of public enterprises, various
state insurance (such as crop insurance and social security
schemes payment assurances), letters of credit, default of
100 per cent public entities on non-guaranteed debt or other
obligation, failure of guaranteed public pension schemes and
natural calamities.
The aggregate guarantees outstanding for 17 major states
was ` 40,318 crore in 1992, which rose to ` 1,05,739 crore at
the end of 1999-2000 (average amount growth of 12.2%). The
true measure of states’ deficits emerges when one adds the
possible additional burden of ‘hidden’ contingent liabilities to
the traditional measure of public debt.
Causes for the States’ Indebtedness
The origin of states’ indebtedness could be traced back to
the pattern of plan expenditure followed by them over the last
54 years. With the birth of planning, grants from the Centre for
their annual plan assumed a major role. However, the plan
grants were never meant to meet the entire revenue component
of the states. With the introduction of Gadgil Formula in 1969,
plan assistance were given to non-special category states in the
form of 30 per cent grants and 70 per cent loans. The plan
assistance has been passed on to the states without any
assessment of the ability of the states to repay the loan
component. As plan grants did not match revenue expenditure,
a large segment of plan revenue expenditure was met out of
borrowing in most of the states.
The non-plan revenue budget of states has to bear the burden
of running assets created during the earlier plans. The practice
of mingling revenue and capital components in plan outlay and
financing a large part of plan revenue expenditure by borrowing
seems to be a common practice. States usually try to secure
approval for larger plan outlays from Planning Commission
every year, despite their adverse impact on the fiscal imbalances
on the revenue account. The Planning Commission is morally
responsible for the growing fiscal deficit and the resulting debt
burden. It approves larger plan outlay without the matching
resources.
Rakesh Mohan Committee (2000) points out that increasing
debt service payments and inadequate returns from government
spending are the major factors behind the deteriorating fiscal
conditions of the states. Since there is no link between the
capacity to borrow and the return on services provided by the
government, there does not exist much incentive for the State
Government to levy appropriate user charges. In fact, the lack
of connection between fiscal health and ability to borrow has
encouraged fiscally irresponsible behaviour on the part of the
states.
The overall fiscal situation of the states has undergone
substantial deterioration over the last decade. Substantial upward
revision of salaries of the employees in the states has been the
principal cause. There has been a deceleration of the growth of
revenue. The tax-GSDP ratio of all states combined has been
stagnating around 6 per cent for the past several years. Resorting
to massive borrowing has filled the resultant revenue gap and

consequently the debt burden of states has reached unsustainable
levels.
Hard Budget Constraints
States should have a hard budget constraint and there should
be a credible commitment from the Centre to a ‘no bailout’
policy. Recently, the Centre has been weak and happend to be
coalitions of log rolling (vote trading) political parties and
regional interest groups. Therefore, strict adherence to ‘no
bailout’ stance is very difficult for the Centre, and the states
may ignore it.
Article 293 of the Constitution enables the Centre to exercise
control over borrowing of the states already under debt. Thus,
in theory, states cannot spend more than their revenue plus
borrowing limits approved by the Centre. However, in practice,
there are several ways in which states could have recourse to
additional borrowings. These include small savings, ways and
means advances from RBI, public accounts (provident fund),
and public sector enterprises.
The single most important source of borrowing of the state,
free from Central control, is the share of deposits in small saving
schemes. Although the cost of borrowing through this route is
relatively high (in 1998-99), the rate charged on small saving
stood at 14%. States have found this route a convenient way of
meeting their budgetary needs regardless of high costs and
potential future problems.
Accretions to provident fund of employees constitute another
source of states’ borrowing. Employees provident fund registered
a sharp growth in the last few years owing to the impounding
of the salary arrears of employees after retrospective pay
revisions.
Another source of borrowing of states is borrowing through
PSEs under their control. With the removal of such loans from
the purview of overall borrowing limits in 1994-95, there has
been a surge in such borrowing by state PSEs. Special purpose
vehicles have been launched for funding urban infrastructure
projects by municipalities. Such bond issues and borrowings by

PSEs by-pass normal scrutiny and do not encounter problems in
raising funds from domestic market.
The Reserve Bank of India provides ways and means
advances and also overdraft facility to get over temporary cash
flow problems. Many states use overdrafts to overcome their
budget constraint by rolling them over.
Debt Relief Recommended by the Finance Commissions
The growth of debt of states was a serious concern and
many Finance Commissions have provided various forms of
debt related relief, viz. write-offs, rescheduling of loans with a
view to shifting the timing of repayments, consolidation of past
loans on common terms, and reducing the interest rate.
The Second Finance Commission was asked to make
recommendation to reduce the states’ debt problem, and the
Commission recommended, inter alia, the postponement of
repayments but did not help to tackle the problem. The Fourth
Finance Commission expressed its inability to suggest a lasting
solution in a short period of time at its disposal. The Fifth
Finance Commission recommended that the Centre should pay
the amount of state unauthorized overdrafts to RBI by adjusting
that amount against the grants. The Sixth Finance Commission
recommended moratorium on the repayment of central loans
and write-offs of a few old loans of small amount. The Eighth
and Ninth Finance Commissions recommended debt reliefs of
` 2285 crore (for the period 1984-89) and ` 494 crore (1990-
95) respectively. The debt relief scheme of the Tenth Finance
Commission had two parts: (a) a scheme for general debt relief
for all states linked to fiscal performance, and (b) specific relief
for state with high fiscal stress.
The Eleventh Finance Commission (EFC) was required to
make an assessment of the debt positions of the states as on
March 31, 1999 and suggested such corrective measures as are
deemed necessary keeping in view the long-term sustainability
of the debt of the Centre and states. However, the
recommendations of the EFC did not address the question of
long-term sustainability of debt of either the Centre or the states.
The debt relief package recommended by the EFC worked out

to around ` 700 crore for 2000-05.
Debt Relief under Twelfth Finance Commission (TFC)
Thus, the state finances have been under deep stress on
account of the high interest payment obligation of the states.
One of the major attempts to reduce the pressure, the Centre
introduced the debt swap scheme in September 2002. Under
this scheme high cost debts, i.e. debts carrying an interest rate
of 13 per cent or above on state plan loans or small savings,
could be exchanged for market borrowings and small savings
securities, which at that point carried interest of around 7 per
cent. This scheme helped to reduce the average interest rate
paid by states and also changed the maturity profile and
composition of the State debts. Under this scheme, ` 1,03,000
crore of state debt was swapped till the end of 2004-05.
The Twelfth Finance Commission was asked to make an
assessment of the debt position of the states as on March 31,
2004, and suggested such corrective measures as are deemed
necessary, consistent with macroeconomic stability and debt
sustainability. For which the TFC recommended that the Centre
should not act as an intermediary in the borrowing programme
of the states. States have been asked to rely on market rather
than the Centre for their borrowing. As the states are increasingly
exposed to the market for borrowing, the markets would
increasingly assess their fiscal position. Therefore, the TFC relied
on two mechanisms for fiscal correction: self-evaluation under
Fiscal Responsibility Act (FRA) and exposure to the market.
The major recommendation of the TFC, which has been
accepted by the Union Cabinet, related to the stipulation that
any transfer from Centre to the states would henceforth
(including the plan assistance) not take the form of loans. While
recommending the doing away of the loan component of Central
assistance, the TFC had asked states to mobilize the same amount
directly from the market. It should be noted that market
borrowings have their own limitations. Apart from depriving
the poorer states, the increased borrowings by states is likely to
increase the interest rates. This has actually happened. Further,
the repayment of market borrowings would cause problems in

the long run, as huge repayment would be required to be made
in the coming years and at that time the economy may not be
able to bear the quantum of market borrowings required to be
raised then. Therefore, an appropriate mix of various aspects
introduced a package for debt reduction with two main
components.
The first is the consolidation of all states debt outstanding.
Under this scheme as soon as a state passes a Fiscal Responsibility
Act, the entire loan owed by it to the Centre as on March 31,
2004 gets consolidated into a single loan with a fresh term of
20 years and at an interest rate of 7.5 per cent. This debt
consolidation is expected to provide a relief to the states to the
extent of ` 33,000 crore spread over five years (2005-10). One
drawback of the scheme is that the TFC recommendation for
providing such large debt relief to the states is for doing no
more than passing a law. A front-loaded debt consolidation is
necessary to give the states a fighting chance to get out of the
debt trap.
The second and much more problematic proposal of the
TFC is a new debt relief scheme linked to the reduction in the
revenue deficits of states. Under this scheme, the repayment due
on Central loan from 2005-06 to 2009-10 will be eligible for
write-off. But the amount of write-off a repayment will be linked
to the absolute amount by which the revenue deficit is reduced
in each successive year over the entire period. The enactment of
the Fiscal Responsibility Act is the precondition for the eligibility
of this scheme. Accordingly, this scheme will be available to the
states only from the year they refrain from borrowings including
institutional borrowings.
Overdraft of the States
Another related issue of state indebtedness was resorting to
unauthorized overdrafts by the states in the 1970s. Section 17(5)
of the RBI Act, 1934 provides that RBI should make advances
to the State Government repayable in each case not later than
three months from the date of advance. As regards procedures
governing State Governments borrowings from the RBI, the loan

transaction may take mainly two forms:
(i) Ways and Means Advances. These advances are made
without any collateral and are provided upto certain
limits prescribed by the RBI. At present these limits are
fixed at thrice the level of the minimum balances that
the State Governments are required to maintain with
the RBI.
(ii) Special Ways and Means Advances. These advances
are made against pledge of Central Government
securities and are sanctioned up to twice the level of
normal ways and means advances. The RBI, at its
discretion, also allows additional special ways and
means advances beyond these limits.
Both normal and special ways and means advances are
granted at 1 per cent below the bank rate. These two types of
accommodation with the RBI are pre-arranged and their limits
are fixed.
Unauthorised Overdrafts. The extraordinary form of
borrowings commonly known as unauthorized overdrafts, is
unauthorized in the sense that no prior arrangements are entered
into between the borrowing State Government and the RBI.
Such borrowings arise, either because the limits agreed to
between the state and the RBI for ways and means advances
and special ways and means advances are exceeded or because
these advances are not repaid within a period of three months
as per the rules. When a State Government resorts to such
unauthorized overdrafts the RBI draws the attention of State
Government to this fact and requests the latter to clear the
overdrafts as quickly as possible. RBI also keeps the Central
Government informed.
Why do State Government resort to unauthorized overdrafts?
In most cases, the State Governments are simply unable to raise
resources to finance their plan projects. Further many of them
violate all canons of financial managements.
Actually these overdrafts do not constitute resources at all.
Unauthorised overdrafts have the same effect as that of deficit
financing of Union Government. Both raise the money supply

in the country and are responsible for pushing up price level.
There is, however, one slight difference. Deficit financing initially
consists of a short-term borrowings in the form of treasury bills
but is made permanent by converting the treasury bills into
long-term securities. On the other hand, unauthorized overdrafts
have to be repaid ultimately by the State Government or by the
Centre, if the State Government does not have the necessary
finances.
The overdrafts are cleared through adjustment against
Central assistance to the concerned state for plan schemes
sanctioned by the Government of India or through advance
payment made by Centre to the states in respect of the states’
share of taxes and grants-in-aid. Sometimes the Centre may
grant ways and means assistance to states to enable them to
clear their unauthorized overdrafts. For this purpose, the Centre
may sell ad hoc treasury bills to the RBI to clear the overdrafts
of a State Government. In other words, a loan by the RBI to the
State Government becomes ultimately a loan from the Central
Government to the State Government. The amount of overdraft
thus cleared by Central Government is treated by the Centre as
an ad hoc loan to the states.
The Fifth Finance Commission condemned the system of
unauthorized overdrafts on the ground that no country with a
unified currency system could afford to have more than one
independent authority taking measures, which result in increase
in money supply. In other words, unauthorized overdrafts run
counter to the principle of sound monetary management. The
problem of unauthorized overdrafts became quite serious during
the middle of the Fourth Plan. From ` 240 crore in 1969-70,
ways and means advances rose to a record high of ` 600 crore
by end-March 1972 due to extensive unauthorized overdrafts.
The Central Government took a serious view of the situation
and ordered the RBI to discontinue overdrafts to the states as
from May 1970 except for a temporary period of seven days.
By March 1973, the ways and means advances of RBI to the
states declined from ` 600 crore to ` 94 crore.
Despite stringent measures taken by the Union Government

unauthorized overdrafts gradually increased again and in 1981-
82, they were as high as ` 1060 crore. But if we added the ways
and means advances taken by the states, their debt to the RBI
came to a huge amount of ` 1741 crore. This entire liability
was taken over by the Central Government which asked the
RBI to keep a strict watch on the ways and means advances of
states. The financial discipline imposed by RBI unauthorized
overdrafts came down to about ` 60 crore at the end of 1982-
83. This stress on the financial discipline on the part of the
states was the compulsion of the IMF loan, under which the
government had committed itself to a limit for net bank
borrowing, naturally. The states could not go about merrily
piling up the overdrafts.
TRANSFER OF RESOURCES FROM UNION AND STATES

TO LOCAL BODIES
The 73rd and 74th Amendments of the Constitution passed
in 1993 are another milestone in the evolution of a true federal
set-up in India. While the 73rd Amendment deals broadly with
the Panchayati Raj Institutions (PRIs), 74th Amendment’s main
concern is with the governance of Urban Local Bodies (ULBs).
These Amendments are likely to have far-reaching implications
on the emerging scenario of federal finance in India. However,
it must be mentioned that decentralization in a federal set-up is
different from the one practiced in a unitary form of government.
In a federation, decentralization is in-built and statutory.
Different layers of the government (Central, State and Local
bodies) are given independent financial powers to execute the
functions assigned to them as per the Constitution. Till the 73rd
or 74th Amendment, the Constitution of India recognized only
two layers of the government, viz. Central and the State
Governments, as far as the financial autonomy was concerned.
The financial and other powers of the local bodies, viz. PRIs
and Nagarpalika (ULBs), depended solely on the discretion of
the states.
However, with the above-mentioned Amendments these local
bodies have been accorded a statutory status. While PRIs have
been credited with 29 functions, municipalities or Nagarpalika

will hold 18 functions. These functions can be divided into 4 or
5 categories, viz. socio-economic schemes, beneficiary-oriented
schemes and state or Centrally-sponsored schemes. However, it
must be mentioned that in order to ensure the proper execution
of these functions, the PRIs will have to be given independent
sources of revenue.
Presently, the states’ revenue consists of: (i) state’s own
revenue (tax and non-tax), (ii) share in Central taxes, viz. income
tax and Union excise duties, and (iii) grants from the Union
Government, apart from other transfers. Local-self governments,
likewise, are intended to get permanent sources of revenue so
that they are not left to the mercy of the State Governments. In
fact, it is a corollary of the State Governments’ demand that
much of resources from the Union Government should come in
the form of statutory commitments where the Union Government
could not exercise its discretionary power.
But the difficult question is what resources should be assigned
to the local-self governments. The various sources which can be
assigned to the local governments on the pattern of Union-state
financial relations can be categorized as under:
(i) Assignment of Taxes: Already there are such taxes as
chulla tax, octroi, etc., which have been assigned to
the local bodies. Similarly, tax on rents particularly on
property rented by the government/semi-government
offices can also be a productive source of revenue for
the local bodies.
(ii) Sharing of Taxes: Like the Union Government, the states
too can share the proceeds from some taxes with the
local bodies. State excise duty and sales tax can be
included in this category. The local bodies can also be
involved in the registration of immovable property from
which a sizeable share can be transferred to them
immediately. If these proposals are not acceptable, a
special surcharge on these and some tax items can be
imposed for the exclusive use of the panchayats/
municipalities. Similarly, a proportion of the market
fees collected on agricultural produce can also be

transferred to the village panchayats.
(iii) Grants and Donations: To ensure horizontal equity,
grants from the states will have to come. Donations
from individuals and institutions can also form a good
source of revenue for the local bodies. For this purpose
suitable amendment in the Income Tax Act can be made
so that such donations are exempted from the income
tax payments.
(iv) Lastly a permanent fund for the exclusive use of local
government, on the pattern of National Calamity Fund,
which has been established for the benefit of the states,
can be created.
Although many eyebrows are being raised over the success
of this Constitutional amendments, yet a day not be far off
when this amended arrangement would look like an extension
of Union-state financial relations. If the division of functions
between the Union and the states can work successfully there
should be no room for despair that these would fail in case of
local governments and the states.
It must be mentioned here that since the 73rd and 74th
Constitutional Amendments, the Central Finance Commissions
have been exclusively devoting attention to the transfer of
resources directly to the local bodies—Panchayats and
Municipalities. To encourage the decentralization process and
strengthening the local bodies financially, the Eleventh Finance
Commission decided to determine, inter se, share of states in
the grants provided for the Panchayats and Muncipalities by
giving 20 per cent weightage to the index of decentralization
and 10 per cent to the revenue efforts of the local bodies. Now
one of the three terms of reference of the Twelfth Finance
Commission relates to “the measures needed to augment the
Consolidated Fund of a State to supplement the resources of the
Panchayats and Muncipalities in the State on the basis of
recommendations made by the Finance Commission of the
State”. It has now become obligatory for every state to appoint
the State Finance Commission, to determine the transfer of
resources from the states to local bodies on the pattern of Central
Finance Commission.
FINANCE COMMISSIONS IN INDIA

The Article 280 of the Constitution has the provision to
establish the institution of Finance Commission. This is the main
departure from the scheme of the GoI Act, 1935 regarding the
financial relations between the Union and the states. The
Commission is charged with the tremendous responsibility of
making requisite recommendations to the President of India.
Under the Article 280(i), the President shall, within four years
from the commencement of the Constitution, and thereafter at
the expiry of every fifth year or at such earlier time as the
President considers necessary, constitute a Finance Commission
which shall consist of a Chairman and four members to be
appointed by the President.
• Parliament may by law determine the qualifications
which shall be required for the appointment as members
of the Commission and manner in which they shall be
appointed.
• It shall be the duty of the Commission to make
recommendations to the President as to the distribution
between the Union and the states on net proceeds of
taxes which are to be, or may be, divided between
them and the share of the proceeds be allocated to the
states.
• The principles which should govern the grants-in-aid
of revenue of the states out of the Consolidated Fund
of India.
• Any other matter referred to the Commission by
President in the interest of sound finance.
• The Commission shall determine the procedure and
shall have such powers in the performance of their
functions as Parliament may confer on them by law.
Suggestive Functions of the Finance Commission
• To suggest the criteria of distribution between the Union
and the states for the net proceeds which are to be or
may be divided between them.
• It determines the allocation of net proceeds between

different states according to their respective shares of
proceeds.
• Any modification or continuance of the term of any
arrangement entered into by the Union Government
with any state in part B of the first schedule under
clause (v) of the Article 178.
• The principles which should govern the grants-in-aid
to different states out of the Consolidated Fund of
India, including: (a) grants-in-aid to tribal areas, and
(b) special grants for any particular states.
The first Finance Commission was constituted by the
Presidential Order dated 22 November 1951, under the
Chairmanship of K.C. Neogy. So far Thirteen Finance
Commissions have been appointed which are as follows:
Finance Year of Chairman Operational
Commission Establishment Duration
First 1951 K.C. Neogy 1952-1957
Second 1956 K. Santhanam 1957-1962
Third 1960 A.K. Chanda 1962-1966
Fourth 1964 P.V. Rajmannar 1966-1969
Fifth 1968 Mahaveer Tyagi 1969-1974
Sixth 1972 K. Brahmananda 1974-1979
Seventh 1977 J.M. Shellet 1979-1984
Eighth 1983 Y.B. Chawan 1984-1989
Ninth 1987 N.K.P. Salve 1989-1995
Tenth 1992 K.C. Panth 1995-2000
Eleventh 1998 A.M. Khusro 2000-2005
Twelfth 2003 C. Rangarajan 2005-2010
Thirteenth 2007 Vijay Kelkar 2010-2015
Twelfth Finance Commission13
Terms of References
The Twelfth Finance Commission was appointed in
November 2002 under the Chairman of Dr. C. Rangarajan.
The Commission was to make recommendations as to the
following matters:
(i) the distribution between the Union and the states of

the net proceeds of taxes which are to be, or may be,
divided between them under Chapter I Part XII of the
Constitution and the allocation between the states of
the respective shares of such proceeds;
(ii) the principles which should govern the grants-in-aid of
the revenues of the States out of the Consolidated Fund
of India and the sums to be paid to the states which
are in need of assistance by way of grants-in-aid of
their revenues under Article 275 of the Constitution
for purposes other than those specified in the provisions
to clause (1) of that Article; and
(iii) the measures needed to augment the Consolidated Fund
of a state to supplement the resources of the Panchayats
and Municipalities in the state on the basis of the
recommendations made by the Finance Commission of
the state.
• The Commission shall review the state of the finances
of the Union and the states and suggest a plan by which
the governments, collectively and severally, may bring
about a restructuring of the public finances restoring
budgetary balance, achieving macroeconomic stability
and debt reduction along with equitable growth.
• In making its recommendations, the Commission shall
have regard, among other considerations, to:
(i) the resources of the Central Government for five
years commencing on 1 April 2005, on the basis of
levels of taxation and non-tax revenues likely to be
reached at the end of 2003-04;
(ii) the demands on the resources of the Central
Government, in particular, on account of
expenditure on civil administration, defence,
internal and border security, debt-servicing and
other committed expenditure and liabilities;
(iii) the resources of the State Governments, for the
five years commencing on 1 April 2005, on the
basis of levels of taxation and non-tax revenues

likely to be reached at the end of 2003-04;
(iv) the objective of not only balancing the receipts and
expenditure on revenue account of all the states
and the Centre, but also generating surpluses for
capital investment and reducing fiscal deficit;
(v) taxation efforts of the Central Government
and each State Government as against targets, if
any, and the potential for additional resource
mobilization in order to improve the tax-Gross
Domestic Product (GDP) and tax-Gross State
Domestic Product (GSDP) ratio, as the case may
be;
(vi) the expenditure on the non-salary component of
maintenance and upkeep of capital assets and the
non-wage related maintenance expenditure on plan
schemes to be completed by the 31 March 2005
and the norms on the basis of which specific
amounts are recommended for the maintenance of
the capital assets and the manner of monitoring
such expenditure;
(vii) the need for ensuring the commercial viability of
irrigation projects, power projects, departmental
undertakings, public sector enterprises, etc. in the
states through various means including adjustment
of user charges and relinquishing of non-priority
enterprises through privatisation or disinvestment.
• In making its recommendations on various matters,
the Commission will take the base of population figures
as of 1971, in all such cases where population is a
factor for determination of devolution of taxes and
duties and grants-in-aid.
• The Commission shall review the Fiscal Reform Facility
introduced by the Central Government on the basis
of the recommendations of the Eleventh Finance
Commission, and suggest measures for effective
achievement of its objectives.
• The Commission may, after making an assessment of

the debt position of the states as on the 31 March
2004, suggest such corrective measures, as are deemed
necessary, consistent with macroeconomic stability and
debt sustainability. Such measures recommended will
give weightage to the performance of the states in the
fields of human development and investment climate.
• The Commission may review the present arrangements
as regards financing of Disaster Management with
reference to the National Calamity Contingency Fund
and the Calamity Relief Fund and make appropriate
recommendations thereon.
• The Commission shall indicate the basis on which it
has arrived at its findings and make available the state-
wise estimates of receipts and expenditure.
• The Commission shall make its report available
by the 31 July 2004, covering a period of five years
commencing on the 1 April 2005.
SUMMARY OF RECOMMENDATIONS
Plan for Restructuring Public Finances
1. By 2009-10, the combined tax-GDP ratio of the Centre
and the states should be increased to 17.6 per cent,
primary expenditure to a level of 23 per cent of GDP
and capital expenditure to nearly 7 per cent of GDP.
2. The combined debt-GDP ratio with external debt
measured at historical exchange rates should, at a
minimum, be brought down to 75 per cent by the end
of 2009-10.
3. The system of on-lending should be brought to an end
over time and the long-term goal for the Centre and
states for the debt-GDP ratio should be 28 per cent
each.
4. The fiscal deficit to GDP ratio targets for the
Centre and the states may be fixed at 3 per cent of
GDP each.
5. The Centre’s interest payment relative to revenue

receipts should reach about 28 per cent by 2009-10. In
the case of states, the level of interest payments relative
to revenue receipts should fall to about 15 per cent by
2009-10.
6. The revenue deficit relative to GDP for the Centre and
the states, for their combined as well as individual
accounts should be brought down to zero by 2008-09.
7. States should follow a recruitment and wage policy, in
a manner such that the total salary bill relative to
revenue expenditure net of interest payments and
pensions does not exceed 35 per cent.
8. Each state should enact a fiscal responsibility legislation,
which should, at a minimum, provide for:
(a) eliminating revenue deficit by 2008-09;
(b) reducing fiscal deficit to 3 per cent of GSDP or its
equivalent, defined as the ratio of interest payment
to revenue receipts;
(c) bringing out annual reduction targets of revenue
and fiscal deficits;
(d) bringing out annual statement giving prospects for
the state economy and related fiscal strategy; and
(e) bringing out special statements along with the
budget giving in detail the number of employees
in government, public sector, and aided institutions
and related salaries.
Sharing of Union Tax Revenues
9. The share of the states in the net proceeds of shareable
central taxes shall be 30.5 per cent. For this purpose,
additional excise duties in lieu of sales tax are treated
as a part of the general pool of central taxes. If the tax
rental arrangement is terminated and the states are
allowed to levy sales tax (or VAT) on these commodities
without any prescribed limit, the share of the states in
the net proceeds of shareable Central taxes shall be
reduced to 29.5 per cent.
10. If any legislation is enacted in respect of service tax

after the 88th Constitutional Amendment is notified, it
must be ensured that the revenue accruing to a state
under the legislation should not be less than the share
that would accrue to it, had the entire service tax
proceeds been part of the shareable pool.
11. The indicative amount of overall transfers to states
may be fixed at 38 per cent of the Central gross revenue
receipt.
12. The states should be given a share as specified in the
Table 9.1 in the net proceeds of all the shareable Union
taxes in each of the five financial years during the period
2005-06 to 2009-10.
Local Bodies
13. A total grant of ` 20,000 crore for the Panchayati Raj
Institutions (PRIs) and ` 5000 crore for the Urban Local
Bodies may be given to the states for the period 2005-
10.
14. The PRIs should be encouraged to takeover the assets
relating to water supply and sanitation and utilize the
grants for repairs/rejuvenation as also the O&M costs.
The PRIs should, however, recover at least 50 per cent
of the recurring costs in the form of user charges.
15. Out of the grants allocated for the Panchayats, priority
should be given to expenditure on the O&M costs of
water supply and sanitation. This will facilitate
Panchayats to takeover the schemes and operate them.
16. At least 50 per cent of the grants provided to each
state for the ULBs should be earmarked for the scheme
of solid waste management through public-private
partnership. The municipalities should concentrate on
collection, segregation and transportation of solid
waste. The cost of these activities, whether carried out
in house or out sourced, could be met from the grants.
17. Besides expenditure on the O&M costs of water supply
and sanitation in rural areas and on the schemes of
Table 9.1
State Share (all shareable taxes Share of Service
excluding service tax) Tax
(Per cent) (Per cent)
Andhra Pradesh 7.356 7.453
Arunachal Pradesh 0.288 0.292
Assam 3.235 3.277
Bihar 11.028 11.173
Chhattisgarh 2.654 2.689
Goa 0.259 0.262
Gujarat 3.569 3.616
Haryana 1.075 1.089
Himachal Pradesh 0.522 0.529
Jammu & Kashmir 1.297 nil
Jharkhand 3.361 3.405
Karnataka 4.459 4.518
Kerala 2.665 2.700
Madhya Pradesh 6.711 6.799
Maharashtra 4.997 5.063
Manipur 0.362 0.367
Meghalaya 0.371 0.376
Mizoram 0.239 0.242
Nagaland 0.263 0.266
Orissa 5.161 5.229
Punjab 1.299 1.316
Rajasthan 5.609 5.683
Sikkim 0.227 0.230
Tamil Nadu 5.305 5.374
Tripura 0.428 0.433
Uttar Pradesh 19.264 19.517
Uttarakhand 0.939 0.952
West Bengal 7.057 7.150
All States 100.000 100.000
solid waste management in urban areas, PRIs and ULBs

should, out of the grants allocated, give high priority
to expenditure on creation of database and maintenance
of accounts through the use of modern technology and
management systems, wherever possible. Some of the

modern methods like GIS (Geographic Information
Systems) for mapping of properties in urban areas and
computerization for switching over to a modern system
of financial management would go a long way in
creating strong local governments, fulfilling the spirit
of the 73rd and 74th Constitutional Amendments.
18. The states may assess the requirement of each local
body on the basis of the principles stated by us and
earmark funds accordingly out of the total allocation
recommended by us.
19. Grants have not been recommended separately for the
normal and the excluded areas under the fifth and sixth
Schedules of the Constitution. The states having such
areas may distribute the grants recommended by us to
all local bodies, including those in the excluded areas,
in a fair and just manner.
20. The Central Government should not impose any
condition other than those prescribed by us, for release
or utilization of these grants, which are largely in the
nature of a correction of vertical imbalance between
the Centre and the states.
21. The normal practice of insisting on the utilization of
amounts already released before further releases are
considered, may continue and the grants may be
released to a state only after it certifies that the previous
releases have been passed on to the local bodies. The
amounts due to the states in the first year of our award
period, i.e. 2005-06 may be released without such an
insistence.
22. State Governments should not take more than 15 days
in transferring the grants to local bodies after these are
released by the Central Government. The Centre should
take a serious view of any undue delay on the part of
the state.
23. The Central Government should take note of our
views on the issues listed in para 8.23, while formulating
or revising various policy measures. In particular,

action may be taken to raise the ceiling on profession
tax.
24. The state should adopt the best practices listed in para
8.19 to improve the resources of the panchayats.
25. The suggestions made by us in respect of State Finance
Commissions in para 8.29 to 8.37 and 8.54 should be
acted upon with a view to strengthening the institution
of SFCs, so that it may play an effective role in the
system of fiscal transfers to the third tier of government.
Calamity Relief
26. The scheme of CRF be continued in its present form
with contributions from the Centre and the states in
the ratio of 75:25.
27. The size of the CRF for our award period is worked
out at ` 21,333.33 crore.
28. The scheme of NCCF may continue in its present form
with core corpus of ` 500 crore. The outgo from the
fund may continue to be replenished by way of
collection of National Calamity Contingent Duty and
levy of special surcharges.
29. The definition of natural calamity, as applicable at
present, may be expanded to cover landslides,
avalanches, cloud burst and pest attacks.
30. The Centre may continue to make allocation of
foodgrains to the needy states as a relief measure, but
a transparent policy in this regard is required to be put
in place.
31. A committee consisting of scientists, flood control
specialists and other experts be set-up to study and
map the hazards to which several states are subject
to.
32. The provision for disaster preparedness and mitigation
needs to be built into the State Plans, and not as a part
of calamity relief.
Grants-in-aid to States
33. The system of imposing a 70:30 ratio between loans
and grants for extending plan assistance to non-special
category states (10:90 in the case of special category
states) should be done away with. Instead, the Centre
should confine itself to extending plan grants to the
states, and leave it to the states to decide how much
they wish to borrow and from whom.
34. A total non-plan revenue deficit grant of ` 56,855.87
crore is recommended during the award period for
fifteen States.
35. Eight states have been recommended for grants
amounting to ` 10,171.65 crore over the award period
for the education sector, with a minimum of ` 20 crore
in a year for any eligible state.
36. Seven states have been recommended for grants
amounting to ` 5887.08 crore over the award period
for the health sector, with a minimum of ` 10 crore a
year for any eligible state.
37. The grants for the education and health sectors are an
additionality, over and above the normal expenditure
to be incurred by the states in these sectors. These
grants should be utilised only for the respective sectors
(non-plan), specified. No further conditionalities should
be imposed by the Central or the State Government for
the release or utilisation of these grants. Monitoring of
the expenditure relating to these grants will rest with
the State Government concerned.
38. A grant of ` 15,000 crore over the award period is
recommended for maintenance of roads and bridges.
This amount will be in addition to the normal
expenditure which the states would be incurring on
maintenance of roads and bridges. This amount will
be provided in equal instalments over the last four years
(i.e. from 2006-07 to 2009-10) of the award period, so
that the states get a year for making preparations to
absorb these funds.
39. An amount of ` 5,000 crore is recommended as grants

for maintenance of public buildings.
40. The maintenance grants for roads and bridges, and for
buildings, are an additionality, over and above the
normal maintenance expenditure to be incurred by the
states. These grants should be released and spent in
accordance with the conditionalities indicated.
41. A grant of ` 1000 crore spread over the award period
2005-10 is recommended for maintenance of forests.
This would be an additionality over and above what
the states would be spending through their forest
departments. It should also result in increased
expenditure to the extent of this grant, in addition to
the normal expenditure of the forest department.
42. A grant of ` 625 crore spread over the award period is
recommended for heritage conservation. This grant will
be used for preservation and protection of historical
monuments, archaeological sites, public libraries,
museums and archives, and also for improving the
tourist infrastructure to facilitate visits to these sites.
43. An amount of ` 7100 crore has been recommended as
grant for state specific needs. While these grants have
been phased out equally over the last four years, this
phasing should be taken as indicative in nature. The
states may communicate the required phasing of grants
to the Central Government.
Debt Relief and Corrective Measures
44. The scheme of Fiscal Reform Facility may not continue
over the period 2005-10, as the scheme of debt relief,
as described below obviates the need for a separate
Fiscal Reform Facility.
45. Each state must enact a fiscal responsibility legislation
prescribing specific annual targets with a view
to eliminating the revenue deficit by 2008-09 and
reducing fiscal deficits based on a path for reduction
of borrowings and guarantees. Enacting the fiscal
responsibility legislation will be a necessary pre-

condition for availing of debt relief.
46. Debt relief may not be linked with performance in
human development or investment climate.
47. The central loans to states contracted till 31-3-04 and
outstanding on 31-3-05 (amounting to ` 1,28,795 crore)
may be consolidated and rescheduled for a fresh
term of 20 years (resulting in repayment in 20 equal
instalments), and an interest rate of 7.5 per cent be
charged on them. This will be subject to the state
enacting the fiscal responsibility legislation and will
take effect prospectively from the year in which such
legislation is enacted.
48. A debt write-off scheme linked to the reduction of
revenue deficit of states may be introduced. Under the
scheme, the repayments due from 2005-06 to 2009-10
on central loans contracted up to 31-3-04 and
recommended to be consolidated will be eligible for
write-off. The quantum of write-off of repayment will
be linked to the absolute amount by which the revenue
deficit is reduced in each successive year during the
award period. The reduction in the revenue deficit must
be cumulatively higher than the cumulative reduction
attributable to the interest relief recommended by us.
Also, the fiscal deficit of the state must be contained at
least to the level of 2004-05. In effect, if the revenue
deficit is brought down to zero, the entire repayments
during the period will be written off. The enactment of
the fiscal responsibility legislation would be a necessary
pre-condition for availing the debt relief under this
scheme, also with the benefit accruing prospectively.
49. The Central Government should not act as an
intermediary for future lending and allow the states to
approach the market directly. If some fiscally weak
states are unable to raise funds from the market, the
Centre could borrow for the purpose of onlending to
such states, but the interest rates should remain aligned
to the marginal cost of borrowing for the Centre.
50. External assistance may be transferred to states on the

same terms and conditions as attached to such assistance
by external funding agencies, thereby making
Government of India a financial intermediary without
any gain or loss. The external assistance passed through
to states should be managed through a separate fund
in the public account.
51. The moratorium on repayments and interest payments
on the outstanding special-term loan amounting to
` 3772 crore as on 31-03-2000 given to Punjab may
continue for another two years, i.e. up to 2006-07, by
which time the Central Government must finalize the
quantum of debt relief to be allowed in terms of the
recommendations of the EFC.
52. In respect of relief and rehabilitation loans given to
Gujarat from ADB and World Bank through the Central
Government, the Central Government may, if the
Government of Gujarat so desires, alter the terms and
conditions of these loans, so that these are available to
Gujarat on the same terms on which the external
agencies have extended these loans.
53. All states should set-up sinking funds for amortization
of all loans including loans from banks, liabilities on
account of NSSF, etc. The fund should be maintained
outside the Consolidated Fund of the states and the
public account and should not be used for any other
purpose, except for redemption of loans.
54. States should set up guarantee redemption funds
through earmarked guarantee fees. This should be
preceded by risk weighting of guarantees. The quantum
of contribution to the fund should be decided
accordingly.
Profit Petroleum
55. The Union should share the profit petroleum from
NELP areas with the states from where the mineral oil
and natural gas are produced. The share should be in
the ratio of 50:50.
56. There need not be sharing of profits in respect of

nomination fields and non-NELP blocks.
57. The revenues earned by the Central Government on
contracts signed under the coal bed methane policy
may be shared with the producing states in the same
manner as profit petroleum.
58. In respect of any mineral, if a loss of revenue is
anticipated for a state in the process of implementation
of a policy, which involves production sharing, a similar
compensation mechanism should be adopted by the
Central Government.
A Permanent Secretariat for the Finance Commission
59. The Finance Commission division of the Ministry of
Finance should be converted into a full-fledged
department, serving as the permanent secretariat for
the Finance Commissions. This secretariat should be
vested with the powers of a full-fledged department of
the government, with Ministry of Finance only as its
nodal ministry for the purpose of linkage with the
Parliament.
60. The expenditure of Finance Commissions should be
treated as expenditure “charged” on the Consolidated
Fund of India.
61. A research committee should be set up with adequate
funding to organize studies relevant to fiscal federalism.
62. The Finance Commissions should have a tenure of at
least three years to enable them to do their work
adequately.
63. The Thirteenth Finance Commission should be set up
at the beginning of 2007 and appropriate and adequate
arrangements for the office and residence of the
chairman and members of the Commission must be
made before the appointment of the Commission, so
that Commission’s time is not wasted in routine
administrative matters.
Monitoring Mechanism
64. Every state should set up a high level monitoring
committee headed by the Chief Secretary with
the Finance Secretary and the Secretaries/heads of
departments as members for monitoring proper
utilization of Finance Commission grants.
65. The monitoring committee should meet at least once
in every quarter to review the utilization of the grants
and to issue directions for mid-course correction, if
considered necessary.
66. The monitoring committee should be responsible for
monitoring both financial and physical targets and for
ensuring adherence to the specific conditionalities in
respect of each grant, wherever applicable.
67. In the beginning of the year, the monitoring committee
should approve Finance Commission assisted projects
to be undertaken in each sector, quantify the targets,
both in physical and financial terms and lay down the
time period for achieving specific milestones.
Accounting Procedure
68. Central Government should gradually move towards
accrual basis of accounting.
69. In the interim period, additional information in the
form of statements should be appended to the present
system of cash accounting to enable more informed
decision-making. The additional information may relate
to subsidies, expenditure on salaries, expenditure on
pensions, committed liabilities, maintenance
expenditure, segregation of salary and non-salary
portions and liabilities and repayment schedule on
outstanding debts.
70. The definition of revenue and fiscal deficits
be standardized and instructions for a uniform
classification code down to the object head may be
issued to all the states.
71. A National Institute of Public Financial Accountants

be set up by the Government of India and its charter
be decided in consultation with the Comptroller and
Auditor General.
THIRTEENTH FINANCE COMMISSION (2010-2015)14

The Thirteenth Finance Commission (FC-XIII) was
constituted by the President under Article 280 of the Constitution
on 13 November 2007 to make recommendations for the period
2010-15. Dr. Vijay Kelkar was appointed as the Chairman of
the Commission. Dr. Indira Rajaraman, Professor Emeritus,
National Institute of Public Finance & Policy (NIPFP),
Dr. Abusaleh Shariff, Chief Economist, National Council of
Applied Economic Research (NCAER), and Professor Atul
Sarma, Former Vice-Chancellor, Rajiv Gandhi University
(formerly Arunachal University) were appointed full time
Members. Shri B.K. Chaturvedi, Member, Planning Commission
was appointed as a part-time Member. Shri Sumit Bose was
appointed as Secretary to the Commission. Subsequently,
the President appointed Dr. Sanjiv Misra, Former Secretary
(Expenditure), Ministry of Finance as Member of the
Commission in place of Dr. Abusaleh Shariff, who was unable
to join.
Terms of Reference
The Terms of Reference (ToR) of the Commission included
the following: “The Commission shall make recommendations
as to the following matters, namely:
(1) The distribution between the Union and the states of
the net proceeds of taxes which are to be, or may be,
divided between them under Chapter I Part XII of the
Constitution and the allocation between the states of
the respective shares of such proceeds;
(2) The principles which should govern the grants-in-aid
of the revenues of the states out of the Consolidated
Fund of India and the sums to be paid to the states
which are in need of assistance by way of grants-in-aid
of their revenues under Article 275 of the Constitution
for purposes other than those specified in the provisos

to clause (1) of that article; and (iii) the measures needed
to augment the Consolidated Fund of a State to
supplement the resources of the Panchayats and
Municipalities in the state on the basis of the
recommendations made by the Finance Commission of
the state.
(3) The Commission shall review the state of the
finances of the Union and the states, keeping in view,
in particular, the operation of the States’ Debt
Consolidation and Relief Facility 2005-10 introduced
by the Central Government on the basis of the
recommendations of the Twelfth Finance Commission,
and suggest measures for maintaining a stable and
sustainable fiscal environment consistent with equitable
growth.
(4) In making its recommendations, the Commission shall
have regard, among other considerations, to:
(i) The resources of the Central Government, for five
years commencing on 1 April 2010,
(ii) The demands on the resources of the Central
Government, in particular, on account of the
projected Gross Budgetary Support to the Central
and State Plan, expenditure on civil administration,
defence, internal and border security, debt-
servicing and other committed expenditure and
liabilities;
(iii) The resources of the State Governments, for the
five years commencing on 1 April 2010, on the
basis of levels of taxation and non-tax revenues
likely to be reached at the end of 2008-09;
(iv) The objective of not only balancing the receipts
and expenditure on revenue account of all the
states and the Union, but also generating surpluses
for capital investment;
(v) The taxation efforts of the Central Government
and each State Government and the potential for
additional resource mobilization to improve the

tax-Gross Domestic Product ratio in the case of
the Union and tax-Gross State Domestic Product
ratio in the case of the states;
(vi) The impact of the proposed implementation of
Goods and Services Tax with effect from 1 April
2010, including its impact on the country’s foreign
trade;
(vii) The need to improve the quality of public
expenditure to obtain better outputs and outcomes;
(viii) The need to manage ecology, environment and
climate change consistent with sustainable
development;
(ix) The expenditure on the non-salary component of
maintenance and upkeep of capital assets and the
non-wage related maintenance expenditure on plan
schemes to be completed by 31 March 2010 and
the norms on the basis of which specific amounts
are recommended for the maintenance of the
capital assets and the manner of monitoring such
expenditure;
(x) The need for ensuring the commercial viability of
irrigation projects, power projects, departmental
undertakings and public sector enterprises through
various means, including levy of user charges and
adoption of measures to promote efficiency.
5. In making its recommendations on various matters,
the Commission shall take the base of population figures
as of 1971, in all such cases where population is a
factor for determination of devolution of taxes and
duties and grants-in-aid.
6. The Commission may review the present arrangements
as regards financing of Disaster Management with
reference to the National Calamity Contingency Fund
and the Calamity Relief Fund and the funds envisaged
in the Disaster Management Act, 2005, and make
appropriate recommendations thereon.
7. The Commission shall indicate the basis on which it

has arrived at its findings and make available the
estimates of receipts and expenditure of the Union and
each of the states.
8. The following additional item was added to the terms
of reference of the Commission vide President’s Order
published under S.O. No. 2107 dated 25 August 2008.
Having regard to the need to bring the liabilities of the
Central Government on account of oil, food and
fertilizer bonds into the fiscal accounting, and the
impact of various other obligations of the Central
Government on the deficit targets, the Commission may
review the roadmap for fiscal adjustment and suggest
a suitably revised roadmap with a view to maintaining
the gains of fiscal consolidation through 2010 to 2015.
9. The Commission was initially required to submit its
report by 31 October 2009 covering the five-year period
between 1 April 2010 and 31 March 2015. The conduct
of elections to the Fifteenth Lok Sabha and certain
State Legislative Assemblies in April-May 2009
warranted a postponement of visits by the Commission
to some states. The conduct of elections also led to the
delay in the presentation of the regular Budget of the
Union as well as of some State Governments for the
year 2009-10. Consequently, information from the
Centre and some of the states on their fiscal position
and projections for 2010-15 could not become available
to the Commission till August 2009. In view of the
above developments, the Commission was granted
an extension by the President till 31 January 2010
with the condition that its report be submitted by
31 December 2009.
Administrative Arrangements
1. As has been the experience of previous Commissions,
this Commission also faced a number of teething
problems relating to infrastructure availability,
including office space and staff. These difficulties
constrained its initial operational effectiveness. The

Commission could initiate its preliminary tasks only in
January 2008 when it was able to acquire some
temporary office space at Jeevan Bharati Building,
Connaught Place, New Delhi. The Commission could
finally move into its regular office space at the
Hindustan Times House only by May 2008. A special
effort was made to get Central and State Government
officers on deputation to the Commission. The process
for appointing suitable staff on deputation continued
till late 2008. The routine house-keeping functions were
outsourced so that expenditure was minimised.
2. Considering the importance of ensuring that
future Finance Commissions are able to commence their
work as quickly as possible, it is necessary that these
problems, faced by successive past Commissions, are
effectively resolved.
3. The Commission was delegated the powers
of a department of the Central Government. The
Commission’s budget was assigned a separate head of
account. This enabled the Commission to function
independently.
4. Commission’s recommendations have been based
on a detailed assessment of the financial position of
the Central and the State Governments, as well as
substantial information and economic data gathered
through consultations, submissions and research studies.
A public notice was issued in all leading newspapers of
India in December 2007 inviting views/comments from
all interested individuals, knowledgeable persons,
organisations and other sources on various issues related
to the terms of reference of the Commission. The request
for suggestions was also posted on the Commission’s
website.
5. The Commission held its first meeting on 3 January
2008 after the Chairman and three Members had
assumed charge. The fourth Member assumed office
on 31 March 2008. In addition to adopting the Rules

of Procedure of the Commission, the tasks before
the Commission were reviewed in this meeting. The
Commission held altogether meetings which were
held at HT House in the K.C. Neogy Room, which
was designated the Committee Room of the
Finance Commission and named after Shri K.C. Neogy,
the distinguished Chairman of the First Finance
Commission.
Finances of Union and States
1. The Ministry of Finance (MoF) should ensure that the
finance accounts fully reflect the collections under cesses
and surcharges as per the relevant heads, so that there
are no inconsistencies between the amounts released to
states in any year and the respective percentage shares
in net central taxes recommended by the Finance
Commission for that year.
2. The states need to address the problem of losses in the
power sector in a time-bound manner.
3. Initiatives should be taken to reduce the number of
Centrally Sponsored Schemes (CSS) and to restore the
predominance of formula-based plan transfers.
4. A calibrated exit strategy from the expansionary fiscal
stance of 2008-09 and 2009-10 should be the main
agenda of the Centre.
Goods and Services Tax*
5. Both the Centre and the states should conclude a ‘Grand
Bargain’ to implement the Model GST. The Grand
Bargain comprises six elements.
6. Any GST model adopted must be consistent with all
the elements of the Grand Bargain. To incentives
implementation of the Grand Bargain, Finance
Commission recommends sanction of a grant of
` 50,000 crore. The grant would be used to meet the
* For details see Chapter 10.

compensation claims of State Governments for revenue

losses on account of implementation of GST between
2010-11 and 2014-15, consistent with the Grand
Bargain. Unspent balances in this pool would be
distributed amongst all the states, as per the devolution
formula, on 1 January 2015.
7. The Empowered Committee of State Finance Ministers
(EC) should be transformed into a statutory council.
The compensation should be disbursed in quarterly
installments on the basis of the recommendations by a
three-member Compensation Committee comprising
the Secretary, Department of Finance Commission,
Secretary, Department of Revenue, Government of
India; and chaired by an eminent person with experience
in public finance.
8. In the unlikely event that a consensus with regard to
implementing all the elements of the Grand Bargain
cannot be achieved and the GST mechanism finally
adopted is different from the Model GST suggested by
us, this Commission recommends that this amount of
` 50,000 crore shall not be disbursed.
9. The states should take steps to reduce the transit time
of cargo vehicles crossing their borders by combining
checkposts with adjoining states and adopting user-
friendly options like electronically issued passes for
transit traffic.
Union Finances
10. The policy regarding use of proceeds from disinvestment
needs to be liberalised to also include capital
expenditure on critical infrastructure and the
environment.
11. Records of landholdings of PSUs need to be properly
maintained to ensure that this scarce resource is put to
productive use, or made available for other public
projects, or else, sold.
State Finances
12. The practice of diverting plan assistance to meet
non-plan needs of special category states should be
discontinued.
13. With reference to public sector undertakings:
(i) All states should endeavour to ensure clearance of
the accounts of all their Public Sector Undertakings
(PSUs).
(ii) The states should use the flexibility provided by
the Comptroller and Auditor General (CAG) to
clear the backlog of PSU accounts.
(iii) All states need to draw up a roadmap for
closure of non-working PSUs by March 2011.
Disinvestment and privatisation of PSUs should
be considered and actively pursued.
(iv) The Ministry of Corporate Affairs should closely
monitor the compliance of state and central PSUs
with their statutory obligations.
(v) A task force may be constituted to design a suitable
strategy for disinvestment/privatisation and oversee
the process. A Standing Committee on
restructuring may be constituted under
the chairmanship of the Chief Secretary to
operationalise the recommendations of the task
force. An independent technical secretariat may
be set up to advise the finance departments in
states on restructuring/disinvestment proposals.
14. With reference to the power sector:
(i) Reduction of Transmission and Distribution
(T&D) losses should be attempted through
metering, feeder separation, introduction of High
Voltage Distribution Systems (HVDS), metering
of distribution transformers and strict anti-theft
measures. Distribution franchising and Electricity
Services Company (ESCO)-based structures should
be considered for efficiency improvement.
(ii) Unbundling needs to be carried out on priority

basis and open access to transmission strengthened.
Governance should be improved through State
Load Dispatch Centres (SLDCs) and this function
should eventually be made autonomous.
(iii) Proper systems should be put in place to avoid
delays in completion of hydro projects.
(iv) Instead of putting up thermal power plants in
locations remote from sources of coal, states
should consider joint ventures in or near the coal-
rich states.
(v) Case 1 bid process should be extensively used to
avoid vulnerability to high-cost purchases during
peak demand periods.
(vi) Regulatory institutions should be strengthened
through capacity building, consumer education and
tariff reforms like Multi Year Tariff (MYT). Best
practices of corporate governance should be
introduced in power utilities.
15. Migration to the New Pension Scheme needs to be
completed at the earliest.
16. States with large cash balances should make efforts
towards utilising these before resorting to fresh
borrowings.
17. With reference to accounting reforms:
(i) The Government of India (GoI) should ensure
uniformity in the budgetary classification code
across all states. The list of appendices to the
finance accounts of states also needs to be
standardised.
(ii) Details of contra entries as well as the summary
of transactions between the public account and
the consolidated fund should be provided as a
separate annex to the finance accounts of the
states.
(iii) Public expenditure through creation of funds

outside the consolidated fund of the states needs
to be discouraged. Expenditure through such funds
and from civil deposits should be brought under
the audit jurisdiction of the CAG.
(iv) The following statements need to be provided with
the finance accounts of states:
(a) Comprehensive data on all subsidies.
(b) Consolidated information on the number of
employees at each level, along with the
commitment on salary. This statement should
also include information on employees and
their salary where such expenditure is shown
as grants or booked under other expenditure.
(c) Details of maintenance expenditure.
18. Sharing of Union Tax Revenues. The share of states in
net proceeds of shareable central taxes shall be 32 per
cent in each of the financial years from 2010-11 to
2014-15. Under the Additional Duties of Excise (Goods
of Special Importance) Act, 1957, all goods were
exempted from payment of duty from 1 March 2006.
Following this, the Centre had adjusted the basic duties
of excise on sugar and tobacco products. In view of
these developments, the states’ share in the net proceeds
of shareable central taxes shall remain unchanged at
32 per cent, even in the event of states levying sales tax
on these commodities.
19. In the event of notification of the 88th Amendment to
the Constitution and enactment of any legislation
following such notification, it should be ensured that
the revenue accruing to a state under the legislation
should not be less than the share that would accrue to
it, had the entire service tax been part of the shareable
pool of central taxes.
20. The Central Government should review the levy of
cesses and surcharges with a view to reducing their
share in its gross tax revenue.
21. The indicative ceiling on overall transfers to states on

the revenue account may be set at 39.5 per cent of
gross revenue receipts of the Centre.
22. The share of each state in the net proceeds of all
shareable central taxes in each of the financial years
from 2010-11 to 2014-15 shall be as specified in Table
9.2.
Revised Roadmap for Fiscal Consolidation
23. The revenue deficit of the Centre needs to be
progressively reduced and eliminated, followed by
emergence of a revenue surplus by 2014-15.
24. A target of 68 per cent of GDP for the combined debt
of the Centre and states should be achieved by 2014-
15. The fiscal consolidation path embodies steady
reduction in the augmented debt stock of the C e n t r e
to 45 per cent of GDP by 2014-15, and of the states to
less than 25 per cent of GDP, by 2014-15.
25. The Medium Term Fiscal Plan (MTFP) should be
reformed and made a statement of commitment rather
than a statement of intent. Tighter integration is
required between the multi-year framework provided
by MTFP and the annual budget exercise.
26. The following disclosures should be made along with
the annual Central Budget/MTFP:
(i) Detailed breakup of grants to states under the
overall category of non-plan and plan grants.
(ii) Statement on tax expenditure to be systematised
and the methodology to be made explicit.
(iii) Compliance costs of major tax proposals to be
reported.
(iv) Revenue Consequences of Capital Expenditure
(RCCE) to be projected in MTFP.
(v) Fiscal impact of major policy changes to be
incorporated in MTFP.
Table 9.2: Inter Se Shares of States

(Percentages)
States Share of All Share of Service Tax

Shareable Taxes
Excluding Service Tax
Andhra Pradesh 6.937 7.047
Arunachal Pradesh 0.328 0.332
Assam 3.628 3.685
Bihar 10.917 11.089
Chhattisgarh 2.470 2.509
Goa 0.266 0.270
Gujarat 3.041 3.089
Haryana 1.048 1.064
Himachal Pradesh 0.781 0.793
Jammu & Kashmir 1.551 nil
Jharkhand 2.802 2.846
Karnataka 4.328 4.397
Kerala 2.341 2.378
Madhya Pradesh 7.120 7.232
Maharashtra 5.199 5.281
Manipur 0.451 0.458
Meghalaya 0.408 0.415
Mizoram 0.269 0.273
Nagaland 0.314 0.318
Orissa 4.779 4.855
Punjab 1.389 1.411
Rajasthan 5.853 5.945
Sikkim 0.239 0.243
Tamil Nadu 4.969 5.047
Tripura 0.511 0.519
Uttar Pradesh 19.677 19.987
Uttarakhand 1.120 1.138
West Bengal 7.264 7.379
All States 100.000 100.000
(vi) Public Private Partnership (PPP) liabilities to be

reported along with MTFP.
(vii) MTFP to make explicit the values of parameters
underlying projections for receipts and expenditure
and the band within which they can vary while

remaining consistent with targets.
27. Transfer of disinvestment receipts to the public account
to be discontinued and all disinvestment receipts be
maintained in the Consolidated Fund.
28. GoI should list all public sector enterprises that yield a
lower rate of return on assets than a norm to be decided
by an expert committee.
29. The FRBM Act needs to specify the nature of shocks
that would require a relaxation of FRBM targets.
30. In case of macroeconomic shocks, instead of relaxing
the states’ borrowing limits and letting them borrow
more, the Centre should borrow and devolve the
resources using the Finance Commission tax devolution
formula for inter se distribution between states.
31. Structural shocks such as arrears arising out of Pay
Commission awards should be avoided by, in the case
of arrears, making the pay award commence from the
date on which it is accepted.
32. An independent review mechanism should be set-up by
the Centre to evaluate its fiscal reform process. The
independent review mechanism should evolve into a
fiscal council with legislative backing over time.
33. Given the exceptional circumstances of 2008-09 and
2009-10, the fiscal consolidation process of the states
was disrupted. It is expected that states would be able
to get back to their fiscal correction path by 2011-12,
allowing for a year of adjustment in 2010-11.
(i) States that incurred zero revenue deficit or achieved
revenue surplus in 2007-08 should eliminate
revenue deficit by 2011-12 and maintain revenue
balance or attain a surplus thereafter. Other states
should eliminate revenue deficit by 2014-15.
(ii) The General Category States that attained a zero
revenue deficit or a revenue surplus in 2007-08
should achieve a fiscal deficit of 3 per cent of
Gross State Domestic Product (GSDP) by 2011-

12 and maintain such thereafter. Other general
category states need to achieve 3 per cent fiscal
deficit by 2013-14.
(iii) All special category states with base fiscal deficit
of less than 3 per cent of GSDP in 2007-08 could
incur a fiscal deficit of 3 per cent in 2011-12 and
maintain it thereafter. Manipur, Nagaland, Sikkim
and Uttarakhand to reduce their fiscal deficit
to 3 per cent of GSDP by 2013-14. Jammu &
Kashmir and Mizoram should limit their fiscal
deficit to 3 per cent of GSDP by 2014-15.
34. States should amend/enact FRBM Acts to build in the
fiscal reform path worked out. State-specific grants
recommended for a state should be released upon
compliance.
35. Independent review/monitoring mechanism under the
FRBM Acts should be set up by states.
36. Borrowing limits for states to be worked out by MoF
using the fiscal reform path, thus acting as an
enforcement mechanism for fiscal correction by states.
37. Loans to states from National Small Savings Fund
(NSSF) contracted till 2006-07 and outstanding at the
end of 2009-10 to be reset at 9 per cent rate of interest,
subject to conditions prescribed.
38. National Small Savings Scheme to be reformed into a
market-aligned scheme. State Governments are also
required to undertake relevant reforms at their level.
39. Loans from GoI to states and administered by
ministries/departments other than MoF, outstanding as
at the end of 2009-10, to be written off, subject to
conditions prescribed.
40. A window for borrowing from the Central Government
needs to be available for fiscally weak states that are
unable to raise loans from the market.
41. For states that have not availed the benefit of

consolidation under the Debt Consolidation and Relief
Facility (DCRF), the facility, limited to consolidation
and interest rate reduction, should be extended, subject
to enactment of the FRBM Act.
42. The benefit of interest relief on NSSF and the write-off
should be made available to states only if they bring
about the necessary amendments/enactments of FRBM.
Local Bodies
43. Article 280(3)(bb) and (c) of the Constitution should
be amended such that the words “on the basis of the
recommendations of the Finance Commission of the
State” are changed to “after taking into consideration
the recommendations of the Finance Commission of
the State”.
44. Article 243(I) of the Constitution should be amended
to include the phrase ‘or earlier’ after the words ‘every
fifth year’.
45. The quantum of local body grants should be provided
as per Table 9.3. The general basic grant as well as the
special areas basic grant should be allocated amongst
states as specified.
46. State Governments will be eligible for the general
performance grant and the special areas performance
grant only if they comply with the prescribed
stipulations. These grants will be disbursed in the
manner specified.
47. The states should appropriately allocate a portion of
their share of the general basic grant and general
performance grant, to the special areas in proportion
to the population of these areas. This allocation will
be in addition to the special area basic grant and special
area performance grant recommended by us.
48. State Governments should appropriately strengthen
their local fund audit departments through capacity
building as well as personnel augmentation.
Table 9.3: Recommended Grants for Local Bodies

(` crore)
Year BE 2009-10 2010-11 2011-12 2012-13 2013-14 2014-15 2010-15
Percentage of the previous

years’ divisible pool to be
given to all states as grant
under Article 275 of the
Constitution-General Basic
Grant and Total Special
Areas Grant 1.50% 1.50% 1.50% 1.50% 1.50% 1.50%
General Performance Grants 0.50% 1.00% 1.00% 1.00% 0.78%
Aggregate Grants to Local
Bodies 1.50% 2.00% 2.50% 2.50% 2.50% 2.28%
Projected (` crore)
Divisible Pool: 2009-14 545463 636183 746179 880156 1038188 1224595 3846169*
General Basic Grant and
Total Special Areas Grant 8182 9543 11193 13202 15573 57693
General Basic Grant 8022 9303 10873 12883 15253 56335
General Performance Grant 0 3181 7462 8802 10382 29826
General Basic Grant &
General Performance Grant 8022 12484 18335 21685 25635 86161
Total Special Areas Grant 160 239 319 319 319 1357
Special Areas Basic Grant 160 160 160 160 160 798
Special Areas Performance
Grant 0 80 160 160 160 559
Aggregate Grants to Local
Bodies 8182 12724 18654 22004 25955 87519
*Period 2009-10 to 2013-14. Totals may not tally due to rounding off.
49. The State Governments should incentivize revenue

collection by local bodies through methods such as
mandating some or all local taxes as obligatory at non-
zero rates of levy, by deducting deemed own revenue
collection from transfer entitlements of local bodies,
or through a system of matching grants.
50. To buttress the accounting system, the finance accounts
should include a separate statement indicating head-
wise details of actual expenditures under the same
heads as used in the budget for both Panchayati Raj
Institutions (PRIs) and Urban Local Bodies (ULBs). We
recommend that these changes be brought into effect
from 31 March 2012.
51. The Government of India and the State Governments
should issue executive instructions so that their
respective departments pay appropriate service charges

to local bodies.
52. Given the increasing income of State Governments from
royalties, they should share a portion of this income
with those local bodies in whose jurisdiction such
income arises.
53. State Governments should ensure that the
recommendations of State Finance Commissions (SFCs)
are implemented without delay and that the Action
Taken Report (ATR) is promptly placed before the
Legislature.
54. SFCs should consider adopting the template suggested
by the 13th Finance Commission as the basis for their
reports.
55. Bodies similar to the SFC should be set up in states
which are not covered by Part IX of the Constitution.
56. Local bodies should consider implementing the
identified best practices.
57. A portion of the grants provided by us to urban local
bodies be used to revamp the fire services within their
jurisdiction.
58. Local Bodies should be associated with city planning
functions wherever other development authorities are
mandated this function. These authorities should also
share their revenues with local bodies.
59. The development plans for civilian areas within the
cantonment areas (excluding areas under the active
control of the forces) should be brought before the
district planning committees.
60. State Governments should lay down guidelines for the
constitution of nagar panchayats.
Disaster Relief
61. The National Calamity Contingency Fund (NCCF)
should be merged into the National Disaster Response
Fund (NDRF) and the Calamity Relief Fund (CRF)
into the State Disaster Response Funds (SDRFs) of the

respective states. Contribution to the SDRFs should be
shared between the Centre and states in the ratio of
75:25 for general category states and 90:10 for special
category states.
62. Balances as on 31 March 2010 under state CRFs and
the NCCF should be transferred to the respective SDRFs
and NDRF.
63. Budgetary provisions for the NDRF need to be linked
to expenditure of the previous year from the fund. With
cesses being subsumed on introduction of the GST;
alternative sources of financing need to be identified.
64. The total size of the SDRF has been worked out as
` 33,581 crore, to be shared in the ratio given above,
with an additional grant of ` 525 crore for capacity
building.
65. Assistance of ` 250 crore to be given to the National
Disaster Response Force to maintain an inventory of
items required for immediate relief.
66. Provisions relating to the District Disaster Response
Fund (DDRF) in the Disaster Management (DM) Act
may be reviewed and setting up of these funds left to
the discretion of the individual states.
67. Mitigation and reconstruction activities should be kept
out of the schemes funded through FC grants and met
out of overall development plan funds of the Centre
and the states.
68. The list of disasters to be covered under the scheme
financed through FC grants should remain as it exists
today. However, man-made disasters of high-intensity
may be considered for NDRF funding, once norms have
been stipulated and the requisite additional allocations
made to the NDRF.
69. The administrative mechanism for disaster relief to be
as prescribed under the DM Act, i.e. the National
Disaster Management Authority (NDMA)/National
Executive Council (NEC) at the Centre and the State

Disaster Management Agency (SDMA)/State Executive
Council (SEC) at the state level. Financial matters to
be dealt with by the Ministry of Finance as per the
existing practice.
70. Prescribed accounting norms should be adhered to for
the continuance of central assistance to the SDRFs.
Grants-in-aid to States
71. Total non-plan revenue grant of ` 51,800 crore is
recommended over the award period for eight states.
72. A performance grant of ` 1500 crore is recommended
for three special category states who have graduated
from a Non-plan Revenue Deficit (NPRD) situation.
Elementary Education
73. A grant of ` 24,068 crore is recommended for
elementary education over the award period.
74. The education grant will be additionality to the normal
expenditure of the states for elementary education.
Environment
75. An amount of ` 5,000 crore is recommended as forest
grant for the award period.
76. Grants for the first two years are untied but priority
should be given to the preparation of working plans.
Release of grants for the last three years is linked to
progress in the number of approved working plans.
77. Twenty-five per cent of the grants in the last three
years are for preservation of forest wealth. These grants
are over and above the non-plan revenue expenditure
on forestry and wildlife and shall be subject to certain
conditionalities. Seventy-five per cent of the grants
in the last three years can be used by states for
development purposes.
78. An incentive grant of ` 5,000 crore is recommended
for grid-connected renewable energy based on the states’
achievement in renewable energy capacity addition from

1 April 2010 to 31 March 2014. The performance of
states in this regard needs to be reviewed on the basis
of data published by GoI on capacity addition by states.
79. An amount of ` 5,000 crore is recommended as water
sector management grant for four years, i.e. 2011-12
to 2014-15 of the award period.
80. Release of water sector grants would be subject to
setting up of a Water Regulatory Authority and
achieving the normatively assessed state-specific
recovery of water charges.
81. Water sector grants should be an additionality to the
normal maintenance expenditure to be undertaken by
the states and shall be released and monitored in
accordance with the conditionalities.
Improving Outcomes
82. States should be incentivised to enroll such of their
residents who participate in welfare schemes within
the Unique Identification (UID) programme. A grant
of ` 2,989 crore is proposed to be given to State
Governments in this regard.
83. States should be incentives to reduce their Infant
Mortality Rates (IMR) based upon their performance
beyond 31 December 2009. A grant of ` 5,000 crore is
recommended for this purpose.
84. A grant of ` 5,000 crore is proposed to support
improvement in a number of facets in the administration
of justice. These include operation of morning/evening
courts, promotion of Alternate Dispute Resolution
(ADR) mechanisms, enhancing support to Lok Adalats,
as well as legal aid and training.
85. A grant of ` 20 crore is recommended for promotion
of innovation by setting up a Centre for Innovation in
Public Systems (CIPS) to identify, document and
promote innovations in public services across states.
The second grant of ` 1 crore per district is for the

creation of a District Innovation Fund (DIF) aimed at
increasing the efficiency of the capital assets already
created.
86. To enhance the quality of statistical systems,
we recommend a grant of ` 616 crore for State
Governments at the rate of ` 1 crore for every district
to fill in statistical infrastructure gaps in areas not
addressed by the India Statistical Project (ISP).
87. A grant of ` 10 crore will be provided to each general
category state and ` 5 crore to each special category
state to set up an employees’ and pensioners’ data base.
We also urge GoI to initiate a parallel effort for
preparing a data base for its own employees and
pensioners.
Maintenance of Roads and Bridges
88. An amount of ` 19,930 crore has been recommended
as grant for maintenance of roads and bridges for four
years (2011-12 to 2014-15) of the award period.
89. The maintenance grants for roads and bridges will be
an additionality to the normal maintenance expenditure
to be incurred by the states.
State-specific Needs
90. A total grant of ` 27,945 crore is recommended for
state-specific needs.
91. State-specific grants are subject to the following
conditionalities (Table 9.4):
(i) No funds from any of the state-specific grants
may be used for land acquisition by the states.
Wherever land is required for a project/
construction, such land may be made available by
the State Government.
(ii) The phasing of the state-specific grants would be
given in phases. The grant may be released in a
maximum of two installments per year.
Table 9.4: Grants-in-Aid for state-specific Needs

(` crore)
Year 2010-11 2011-12 2012-13 2013-14 2014-15 2010-15s
1 2 3 4 5 6 7
Andhra Pradesh 20.00 312.00 312.00 312.00 312.00 1270.00
Arunachal Pradesh 0.00 75.00 75.00 75.00 75.00 300.00
Assam 0.00 150.00 150.00 150.00 150.00 600.00
Bihar 0.00 461.25 461.25 461.25 461.25 1845.00
Chhattisgarh 0.00 320.25 320.25 320.25 320.25 1281.00
Goa 0.00 50.00 50.00 50.00 50.00 200.00
Gujarat 0.00 325.00 325.00 325.00 325.00 1300.00
Haryana 0.00 250.00 250.00 250.00 250.00 1000.00
Himachal Pradesh 0.00 87.50 87.50 87.50 87.50 350.00
Jammu and Kashmir 1000.00 87.50 87.50 87.50 87.50 1350.00
Jharkhand 0.00 356.25 356.25 356.25 356.25 1425.00
Karnataka 0.00 325.00 325.00 325.00 325.00 1300.00
Kerala 0.00 375.00 375.00 375.00 375.00 1500.00
Madhya Pradesh 0.00 307.75 307.75 307.75 307.75 1231.00
Maharashtra 0.00 308.75 308.75 308.75 308.75 1235.00
Manipur 0.00 75.25 75.25 75.25 75.25 301.00
Meghalaya 0.00 62.50 62.50 62.50 62.50 250.00
Mizoram 0.00 62.50 62.50 62.50 62.50 250.00
Nagaland 0.00 62.50 62.50 62.50 62.50 250.00
Orissa 0.00 436.25 436.25 436.25 436.25 1745.00
Punjab 30.00 362.50 362.50 362.50 362.50 1480.00
Rajasthan 0.00 300.00 300.00 300.00 300.00 1200.00
Sikkim 0.00 100.00 100.00 100.00 100.00 400.00
Tamil Nadu 0.00 325.00 325.00 325.00 325.00 1300.00
Tripura 0.00 125.00 125.00 125.00 125.00 500.00
Uttar Pradesh 0.00 419.75 419.75 419.75 419.75 1679.00
Uttarakhand 0.00 175.00 175.00 175.00 175.00 700.00
West Bengal 0.00 425.75 425.75 425.75 425.75 1703.00
Total States 1050.00 6723.75 6723.75 6723.75 6723.75 27945.00
(iii) Accounts shall be maintained and Utilisation

Certificates (UCs)/Statements of Expenditure
(SOEs) provided as per General Finance Rules
(GFR), 2005.
Monitoring
92. The High Level Monitoring Committee headed by the
Chief Secretary to review the utilization of grants and to take
corrective measures, set up as per the recommendation of
FC-XII, should continue.
93. The total grants-in-aid recommended for the states over

the award period are given in Table 9.5.
Table 9.5: Grants-in-Aid to States
(` crore)
(I) Local Bodies 87519

(II) Disaster Relief (including for capacity building) 26373
(III) Post-devolution Non-plan
Revenue Deficit 51800
(IV) Performance Incentive 1500
(V) Elementary Education 24068
(a) Protection of Forests 5000
(b) Renewable Energy 5000
(c) Water Sector Management 5000
(VI) Environment 15000
(VII) Improving Outcomes 14446
(a) Reduction in Infant Mortality Rates 5000
(b) Improvement in Supply of Justice 5000
(c) Incentive for Issuing UIDs 2989
(d) District Innovation Fund 616
(e) Improvement of Statistical Systems at State
and District Level 616
(f) Employee and Pension Data Base 225
(VIII) Maintenance of Roads and Bridges 19930
(IX) State-specific 27945
(X) Implementation of model GST 50000
Total 318581
NOTES
1. K.C. Wheare, Federal Government, 3rd edition, Oxford University
Press, London, 1953.
2. Report of the Royal Commission on the Australian Constitution,
(1929), p. 230.
3. K.C. Wheare, op. cit.
4. Davis A. Starrett, Foundations of Public Economics, Cambridge
University Press, Cambridge (New York), 1991, pp. 77-78.
5. John P. Conley and H. Wooders Myrna, “Anonymous Pricing in
Tiebout Economics and Economies with Clubs”, in David Pines,
Efraim Sadka and Itzhak Zilcha (Eds.), Topics in Public Economics,
Cambridge University Press (U.K.), 1997, pp. 89-120.
6. R.N. Bhargava, Theory and Working of Union Finance in India,

7. However, with 80th Amendment Act, 2000, the Centre transfers a
certain proportion of the net proceeds from all taxes to the states.
According to the Tenth, Eleventh and Twelfth Finance Commissions
these proportions were 29.0, 28.0 and 29.5 per cent respectively.
8. Y.V. Reddy, “Restructuring of Public Finances and Micro-Economics
Stability”, in Raj Kapila and Uma Kapila (ed.), A Decade of
Economic Reforms in India, the Present and the Future, Academic
Foundation, New Delhi, 2002.
9. For more details on VAT, see Chapter 9.
10. Government of India, Sarkaria Commission Report, 1987.
11. Government of India, Twelfth Finance Commission Report, 2004.
12. This part is primarily based on G. Karunakaran Pillai’s paper on
“Unsustainability of the Debts of States and Twelfth Finance
Commission’s Proposed Debt Reduction Package”. Conference
Volume Part-II The Indian Economic Association 27-29 December,
2006.
14. Government of India, Thirteenth Finance Commission Report
(2010-15).
Indian Public Finances 10
INDIAN TAX SYSTEM: SALIENT CHARACTERISTICS

Taxes are like hails which destroy the crop…. The best
tax system is that which has the least bad economic effects
—J.S. Mill
Thus, tax policy of a country must be very sound and in the
context of developing countries it must be geared towards
accelerating the rate of economic growth. Taxation must raise
the level of savings and in the words of Dr. Raja J. Chelliah, it
must mobilize the economic surplus. A sound tax system must
help in increasing the amount of economic surplus. Therefore,
the general emphasis in tax system must be on curtailing the
consumption standards. Further, whenever savings are promoted
through tax system, they should also be diverted in desired
channels.
A necessary feature of all developing countries is that
development process is always accompanied by growing
inequalities. Therefore, as far as possible, a sound tax system
must make an attempt to reduce these inequalities. However,
care should be taken that tax rates are not unduly high which
discourage the incentives to work, save and invest.
Further, since the development needs of developing countries
are unsatiable, therefore, here even the poorest will have to pay
some taxes. However, as far as possible, the principle of ability
to pay must be observed while collecting taxes from different
individuals. A person’s ability to pay or (contribute) can be
measured in terms of that part of economic surplus accruing to
him which he is not utilizing for productive investment. The
greater the surplus which a person has above his minimum

necessary requirements, the greater should be his contribution.
Another important objective of a sound tax policy in a
developing economy is to check inflationary tendencies. Inflation
is inherent in all developing countries. In the initial stages of
economic development since large investments are undertaken
and there is always a time lag between investment and output,
the prices rise in the meantime. It is now generally believed that
taxation can play a vital role in checking these inflationary
tendencies. Taxes, both direct and indirect, by reducing the
disposable income can exercise restraints on demand. In the
words of Taxation Enquiry Commission (1953-54):
Taxes that fall directly on the large additional incomes,
and commodity taxes that fall on the increase in general
purchasing power resulting from inflation have a
significant part to play in anti-inflationary policy.
Finally, in a sound tax policy nobody feels that he is being
discriminated. Tax evasion is almost non-existent. Tax
administrations is very honest and tax system is very simple.
In the light of the above discussion, we will now examine
the salient features of Indian tax system. If we carefully study
the Indian tax system, the following features will emerge:
1. In India tax rates are generally higher. Contrary to
common belief, India has emerged as one of the highest taxed
nations in the world. Ever since the advent of planning, we have
been imposing new taxes. The rates on existing taxes are
sometimes raised to astronomical figures (97.5 per cent).
Consequently, little is left as incentives to work, save and invest.
People are now crying under the crushing burden of taxes—
both direct and indirect. Realising the fact that in India tax
burden is unbearable, in the post-1990s period, there is a trend
to lower the tax rates—both for direct and indirect taxes.
2. Multiplicity of Taxes/Tax Bases. During the five years
plans, taxation has been used in India as one of the main
instruments to raise revenue and to achieve the various socio-
economic objectives. New taxes have been imposed and tax
rates have been increased to mobilize a large part of the income
INDIAN PUBLIC FINANCES 437
created as a result of economic development. Tax structure in

India has been formulated in such a manner that all relevant
ability indices are taxed.
All conceivable bases of taxes—both direct and indirect
taxes—have been exploited. Direct taxes on income (from various
sources including interest and profits), wealth, property,
(including land and houses), capital gains, gifts, etc. have been
imposed. Then there is a multiplicity of indirect taxes imposed
both by the Centre and the states such as export and import
(custom) duties, tax on production (Union excise duty), tax on
services, tax on the sale and purchase of goods, tax on the
movement of goods from one state to another, entry tax on
goods entering from one state to another and even entering a
particular municipal area within the state, i.e. octroi, state excise
duty, etc. Recently, VAT has been imposed by many states; but
all other indirect taxes are still continuing. Apart from these,
there are many other levies imposed at the local level.
A taxpayer has to pay income tax when he earns income, he
has to pay wealth tax when he holds accumulated income, he
has to pay Gift Tax when he transfers that income to others
and has to pay Estate Duty (abolished recently) if he dies and
leaves his accumulated income to his heirs. During 1957-58 to
1961-62 and 1963-64 to 1965-66, he had to pay Expenditure
Tax if he spent more than the specified amount. This might
appear taxation with vengeance. In the field of indirect taxes
also, duties have been levied on the new items and increased
on old items so as to tax more heavily those commodities
which are consumed by the relatively well-to-do classes. Even
commodities of mass consumption have not been spared.
3. Revenue Surpluses or Deficits. Another noteworthy feature
of Indian tax system has been excess of its collections compared
with requirements till mid-seventies. To be specific we have
been having surpluses on revenue account and these surpluses
were partly used to finance capital expenditure. It is only on
capital account that our budgets were deficits. On both the
accounts taken together, however, our budgets turned out to be
deficits. However, since the mid-seventies because of increasing
revenue expenditure, a chronic tendency of revenue deficit has

been developed.
4. Complicated Tax Structure. As already stated, years after
years we have been imposing new taxes and raising the rates of
existing taxes. Consequently, our tax structure has become very
complicated. As compared to this our population is very illiterate.
People cannot understand this complicated tax structure. This
has led to various malpractices. Tax administration has become
dishonest and corrupt. An average taxpayer has fallen victim to
the corrupt tax officials who have earned huge amounts of black
money. Sometimes tax administration in collusion with the tax-
payers exploit the government treasury.
5. Inequitable Tax Structure. Although we impose a large
number of taxes, yet our tax structure lacks equity. According
to Raja J. Chelliah, our tax system does not have either horizontal
equity or vertical equity. By horizontal equity we mean that all
taxpayers with the same level of income, irrespective of the
source of income, must pay the same amount of taxes. But we
know that our agricultural sector, pays less taxes than the
industrial sector. In the industrial sector one has to pay direct
taxes like income tax, corporation tax, etc., from which the
agricultural sector is exempted. Even in case of indirect taxes
agricultural sector pays less taxes because it consumes only those
commodities which it produces. Naturally, these commodities
do not carry any tax burden, since they are not brought into the
market.
According to Raja J. Chelliah, even vertical equity is
conspicuous by its absence from our tax structure. By vertical
equity, we mean persons having different levels of income must
pay differently, i.e. persons with higher income must pay higher
amount of taxes and persons with low income must pay lower
amount of taxes. But this is not the case in India because of the
predominance of indirect taxes which are regressive in nature.
6. Imbalance between Direct and Indirect Taxes. The main
reason for our inequitable tax structure is the preponderance of
indirect taxes. The documents on Long Term Fiscal Policy
showed that the proportion of indirect taxes in total tax revenue
had increased to as high as 82 per cent in the mid-sixties.

Consequently, the ratio of direct taxes has declined to 18 per
cent. In developed countries like U.S.A., U.K., Japan, etc. reverse
is the case. The burden of indirect taxes as we know mostly
falls on the poor. Consequently, inequality in the distribution of
income has increased in India. It is a happy augury that in the
post-reform period of 1990s, emphasis is now being shifted to
direct taxes. Consequently, the ratio of direct taxes to total tax
revenue is on the rise and presently this has reached nearly
24-25 per cent.
7. Our Tax Structure is not Anti-Inflationary. As already
stated in the introduction inflation is in-built in the development
process in a developing country. An ideal tax structure must
cure this evil. Unfortunately, because of preponderance of indirect
taxes, our tax structure is not anti-inflationary. Rather it has
added fuel to the fire of inflation.
8. Imbalance in the Tax Sources of States vs. Union: Another
unhealthy feature of our tax system is the increasing dependence
of the states on the Union Government, for their resource
requirements. There is no denying the fact that of all the
federations in the world (U.S.A., Australia, Canada, etc.) Indian
Federation is the best in the sense that there is clear-cut division
of resources between the Centre and the states. But while
demarcating these resources, our Constitution makers appeared
to have forgotten about the development needs of the states.
While the states have to incur increasing amount of expenditure
on such items as education, medical and public health,
agriculture, industry, etc., they do not have much resources.
The elastic sources of revenue like income tax, custom duty,
excise duty, corporation tax, etc., are in the hands of the Centre.
Consequently, the states have to look towards the Centre for
more and more resources. The Central Government often
discriminates one state from the other in the matter of allocating
funds.
9. Apathy of the State Government to Exploit Resources.
The fault does not lie entirely with the Centre. Even the State
Governments do not exploit the tax resources assigned to them
in our Constitution. For example, taxes on agricultural income
lie in the sphere of State Governments. But the State Governments

do not levy these taxes since agriculturists constitute the biggest
vote bank. During elections even many tax concessions are
announced so as to brighten the prospects of winning elections.
Thus, the State Governments too are to be blamed for this failure.
10. Tax Evasion. Last but not least is the considerable
amount of tax evasion generated by our tax system. It is almost
impossible to ascertain correctly the extent of tax evasion in the
country because of numerous difficulties involved in the process.
Any such estimate can only be a guess and would involve an
element of subjectivity. However, the Wanchoo Committee
estimated that the extent of only income tax evaded was
` 470 crore in sixties some conservative estimates show that
black money has reached even the level of 25-30 per cent of
National Income.
Therefore, there is an urgent need to reform our tax system.
Although a number of initiatives to reform both the direct and
indirect taxes have been undertaken since 1991, yet much more
needs to be done. On direct tax front, tax rates have been slashed.
Tax net has been widened by adopting 1/6th criteria (abolished
in the budget 2006-07). Tax system has been simplified and
rationalized. PAN (Permanent Account Number) for every tax-
payer has been made compulsory. Yet measures like taxing
agriculture income and wealth, making distinction between
earned and unearned income, etc., need to be incorporated.
Similarly, on indirect taxes’ front the adoption of State-VAT
and CEN-VAT separately will not serve the purpose. Efforts
should be made to have a single VAT-system in the country,
wherein service tax is also included. Then keeping in view the
growing needs of the states to spend on social sector like
education, medical and public health, social security, poverty
alleviation programmes, etc., there should be a fair distribution
of resources between the Centre and the states.
EXPENDITURE TAX
In a developing economy, a direct tax on the basis of
aggregate consumption or aggregate expenditure is often
recommended in order to promote savings in the economy.
The early advocates of expenditure tax like J.S. Mill, based

their case on the ‘double taxation’ of savings involved in the
levy of income tax. On equity grounds also, the expenditure tax
was preferred because the principle of taxing income confers
differential benefit on property owners as against those who
derive their income from personal labour and who cannot treat
the whole of their income as ‘spendable’ as the capitalists can.
Moreover, since taxable income from property can be converted
into capital gains in numerous ways, income was considered a
defective measure of taxable capacity as it could be manipulated
by taxpayers.
Professor Nicholas Kaldor, who vehemently argued of
substituting income tax by expenditure tax, favoured it in the
context of Keynesian framework also. To him the expenditure
tax provides a more efficient instrument for controlling the
economy in the interests of economic stability and progress than
taxes levied on income. However, this line of thinking has only
a limited validity in relation to developing countries like India
because economic fluctuations in these countries occur at
relatively lower level of output.
The proposal to adopt expenditure tax in India was first
made by Professor Kaldor in the mid-1950s when he was invited
to suggest some reforms in the Indian tax structure. It was almost
at the same time (1955) that he published his book entitled An
Expenditure Tax.1 His mind was naturally preoccupied with
finding a suitable economic environment in which he could test
his ideas. Consequently, expenditure tax came to be levied in
India in 1957 only to be abolished in 1962. It was reintroduced
in 1964 and abolished again in 1966.
It will not be out of place to mention here that in the context
of British economy, Kaldor himself was fully aware of the
difficulties inherent in the replacement of personal income tax
by expenditure tax. He, therefore, suggested the substitution of
expenditure tax in place of surtax—a tax on exceptionally higher
incomes. However, surtax was merged with the general income
tax with effect from 1970. Thus, it appears that the record of
expenditure tax is not very encouraging. As at present, there is
only one country (Sri Lanka) in the world that levies a personal
expenditure tax. In many developing as well as developed

countries, Kaldor’s work received more attention for its careful
analysis of concepts of income than for its arguments in favour
of tax on expenditure. In India also, although his personal view
for levying an expenditure tax was considered administratively
complex, yet the income tax base has been sufficiently widened
to include gifts, capital gains, notional income from owner-
occupied houses, etc. This has made replacement of personal
income tax by expenditure tax almost redundant.
It may be stated that the replacement of income tax base by
expenditure base has two constituents: (i) personal income tax,
and (ii) corporate tax. As regards replacement of personal income
tax, the main task is to make a choice between the two forms of
tax so as to step up the rate of savings in the economy. As
things are now, there does not appear to be much scope for
increasing the aggregate rate of savings. Personal income tax is
already sufficiently conducive to savings. Currently, the rate of
savings of the upper income groups in the non-corporate sector
is quite high. This has been brought about either by direct
concessions on current savings or indirect concessions on interest,
income and wealth. There are already loud protests that such
concessions are promoting inequalities as they act as stimulant
for accumulation of wealth by the richer classes who have a
higher propensity to save. Thus, total exemption of all savings
from income tax would clearly be inequitable.
It may be mentioned here that expenditure tax was suggested
for India when there was no tax on capital gains, and when
notional income from self-occupied property was excluded from
personal taxation. Presently, we include not only such gains
but also casual earnings like lottery wins within the net of
income tax. As such, the need for expenditure tax is less than
obvious.
Administratively also, the expenditure tax is too complex to
be handled by the country’s tax administration and revenue
intelligence system. Presently, about 80-90 per cent of income
tax revenue is collected by way of advance tax or deduction of
tax at source, i.e. on the principle of PAYE (pay as you earn).
How will the expenditure tax handle this aspect? For the proper
administration of expenditure tax, we would need additional

data on stocks, opening balances of all types of assets including
borrowing, lending, bank accounts, etc. This would create
additional problems of an unknown magnitude. Further,
expenditure needs of different families are different depending
upon such factors as the number of dependents, the number of
aged and chronically sick persons, etc. To tackle this issue, Kaldor
proposed that the tax administration should work out the
aggregate family expenditure on per capita basis to be used as
some sort of index. The crux of the problem here is, would it
not add to the burden of tax administration and make the tax
structure still more cumbersome? We had earlier dispensed with
such concessions in the 1970s so as to make our tax structure
less complicated.
The second constituent in the scheme of replacing income
tax by expenditure tax is the corporate tax. It is here that there
appears to be some scope for experiment. It is an open secret
that the corporate sector of the economy tends to inflate its
expenditure in order to reduce the level of corporate as well as
personal income. Many perquisites, which do not fall within
the purview of their salary, are given to the directors and other
executives in order to reduce the level of corporate profits. Often
times, even family expenditure on conveyance and entertainment
is debited to the firm. Thus, expenditure tax on firms—it would
be better to call it cost-based tax—may be worth trying. But
even here a number of safeguards have to be provided for. In a
labour surplus economy, it is just possible that the firms
may reduce the use of labour in order to reduce their aggregate
cost. Further, industries like mining where labour input is
exceptionally high would be discriminated against capital-
intensive low-cost industries. Therefore, different yardsticks will
have to be applied to arrive at the aggregate taxable expenditure
of different firms. Anyway, the problem of reforming corporate
tax is a different one and should not be mixed up with that of
personal income tax.
The main conclusion that follows is that there is hardly an
effective substitute for personal income tax. The objectives which
we want to realize through expenditure tax in an indirect manner
can be directly achieved through the existing income tax

structure. It is only in the case of corporate tax that there is
some scope for replacing it with the expenditure tax. The problem
is one of reforming the corporate tax and not of levying
expenditure tax in lieu of tax on income for all categories of
taxpayers.
TAXATION OF AGRICULTURE
Agriculture contributes nearly half of the national income
(now 25-30 per cent) and nearly 60-70 per cent of population
is engaged in this sector. In the early stages of economic
development, other sectors being non-existing, taxation of
agriculture, therefore, plays a crucial role. The mobilization of
resources from agriculture has come to occupy a place of central
importance in the current theory of economic development. In
most of the countries, the channeling of resources from
agriculture has been considered responsible for their take-off.
The examples of Japan since 1868, USSR since 1917 and China
since 1948 have proved how agriculture plays a dynamic role in
economic development.
Japan was the first Asian country, which despite its
traditional form of agriculture, primitive methods of cultivation
and very small size of landholdings, succeeded in bringing a
striking phase of agricultural development with the help of
revenue derived from agricultural taxation. In Japan, land tax
siphoned off much of the surplus generated within agriculture
and was the principle source of revenue for the government.
Resources extracted by the government by way of land taxes
were applied to economic development including the provision
for service to the agricultural sector.
In Japan, a substantial increase in agricultural production
was attained by the adoption of increased irrigation facilities,
improved seeds, advanced knowledge, etc. Thus, the dynamic
nature of the Japanese society and greater efforts taken to
enhance the agricultural production yielded quick results. It was
all due to this that the required surpluses from the agricultural
sector were siphoned off in an indirect way by the imposition of
heavy land tax which amounted to 63.7 per cent of the aggregate
tax yield in 1868, 93.2 per cent in 1873 and 83.2 per cent in
1877.
In the erstwhile USSR, inadequate agricultural production
was a major impediment in the process of industrialization. But
the enforcement of collectivization largely changed the picture.
The basic reasons for the introduction of collectivization were
political rather than economic. As far as political reasons were
concerned, the Soviet Government wanted to set up a socialist
society by nationalizing all lands. Insofar as economic reasons
were concerned, the transition of the Soviet village to large
agricultural farms meant a great revolution in economic relations
in the whole way of life of the peasantry. Collectivization put
an end for ever to the exploitation of the peasants by large
farmers (Kulaks). Also all the advantages of large-scale farming
could be reaped by the introduction of collective farms, which
were required to hand over a significant proposition of their
produce to the government at a price which was much below
the market price.
Similarly, the rate of capital formation in China today was
closely related to the extent of tax, primarily in the form of tax
in kind, imposed on the peasants. In addition to the taxes payable
in kind, the peasants were bound to sell a large quantity of
cereals and certain other agricultural goods to the state. This
was a form of disguised taxation.
Thus, for promoting economic development in less developed
countries heavier taxation of agriculture is generally
recommended. Some studies have used the argument of existence
of inter-sectoral inequality as the basis for building a case for
additional taxation on Indian agriculture. As Ved P. Gandhi
puts it, “There is inter-sectoral inequality in India in favour of
the agricultural sector, which must be corrected on grounds of
equity between sectors either by additional taxes on the
agricultural sector or by reducing the taxes levied on the non-
agricultural sector.”2
In India, land revenue is the major source of agricultural
taxation, though a few states also levy a tax on agricultural
income. Land revenue is assessed at a flat rate, i.e. the rate of
tax does not vary with the area of land or income therefrom.
The levy varies with grades of land, as it is related to net produce.
But this is not satisfactory as land of equal fertility can be used
to raise different crops. The result is that the burden of land
revenue could be comparatively heavy in cereal growing tracts
than on land where commercial crops are grown. Further
the burden of land revenue was comparatively low in the
permanently settled areas as the state demand had remained
fixed. This led to inequity between permanent and temporary
settled areas. In brief, the system of land taxation in India is not
based upon any satisfactory criterion of ability.
The Taxation Enquiry Commission (1953-54) has suggested
certain steps to improve the system of land revenue:
1. Disparities in the rates of land revenue in different states
should be removed and a uniform rate be adopted as a
standard method for cultivation in each state.
2. Rate of land revenue should be revised at an interval
of time (say 10 years) and the revision should be based
on the price-index of agricultural produce.
3. Rates may be revised any time if a situation of
exemption occurs.
4. Local bodies such as panchayats and district boards
should be authorized to levy surcharges to meet the
local financial needs.
5. Fifteen per cent of land revenue collected from each
local area should be given to the local bodies of the
area.
In 1972, Government of India appointed a committee under
the chairmanship of Professor K.N. Raj (commonly known as
the Committee on Taxation of Agricultural Wealth and Income)
to investigate the question of agricultural wealth and income
taxes from all angles.
The main recommendation of the Raj’s Committee which
received widespread attention was the replacement of land
revenue by Agricultural Holding Tax (AHT).
The AHT was to be imposed on the rateable value of land,

which was to be determined not on the assessor’s actual income,
but on what he ought to earn from this operational holding, i.e.
on the basis of productivity of land. For the determination of
AHT, land has to be divided into homogeneous regions according
to soil and climate conditions. Norms of output per acre (i.e.
productivity norm) are to be determined for each year for each
such region or district on the basis of actual yields, for the
previous 10 years. The value of the output so estimated has to
be multiplied by the average harvest prices of the preceding
three years. This amount has to be used to calculate the
rateable value for the purpose of calculating the AHT. The figure
has to be revised every year to account for the changing
developments. Further, in order to find out the rateable value
for the purpose of tax calculation, costs of cultivation are to be
deducted from the gross value of output. On this reduced gross
value, a further rebate of 20 per cent, subject to a maximum of
` 1,000, is to be allowed to account for the vagaries of nature,
i.e. failure of monsoons. There was a further provision that if
the total yield during any year is half of the average yield during
the previous 10 years, then the rateable value should be treated
as zero or non-taxable.
VALUE ADDED TAX

As part of its ongoing economic reforms, the Central
Government has been toeing with the idea of a simple and
uniform domestic trade taxation. Value Added Tax (VAT) is
considered to be a panacea for all the ills from which our
commodity taxation is suffering. We have been hearing the
imposition and postponement of VAT since 1 April 2001. But it
was implemented w.e.f. 1 April 2005.
Presently, the system of domestic trade taxation is complex
and characterized by multiplicity and non-uniformity of rates,
increasing compliance cost both on the part of the government
and the taxpayers, and cascading effect of taxes which
discourages specialisation.3
In the pursuit of resource mobilization, both the Centre and
states have been taxing different commodities at different rates
and even the same commodity at different stages. Then different

states try to tax the citizens of other states by exporting tax
burden by taxing commodities on the origin principle, which
create artificial channel of distribution by sending goods through
consignments. Often different states offer large number of
incentives to woo the producers and in the process those states,
themselves suffer because the moment incentives are withdrawn
production is stopped and the allocation of resources again follow
the natural economic principles. The present system of trade
taxation has also led to an increasing compliance cost for the
taxpayers particularly in respect of inter-state trade and even
for the government it does not achieve the principle of economy.
However, the greatest drawback of the present system of
commodity taxation is that it has cascading effect, i.e. tax on
tax, which discourages specialisation by promoting vertical
integration of industries and firms. Even the recent Report of
the Task Force on Implementation of the Fiscal Responsibility
and Budget Management Act, 2003 commonly known as,
Kelkar Committee Report II, has remarked that “These
difficulties have led to substantial distortions...and the choice of
production technologies and inputs in the country has become
distorted.”4
It is not for the first time that these and many other problems
have been realized. In the past also many attempts have been
made to rectify these ill-effects. As far back as in 1957 the
additional excise duties on three key commodities, viz. tobacco,
sugar and textiles were imposed in lieu of the sales tax on the
pretext of simplicity and uniformity. Later on in 1986
V.P. Singh, the then Finance Minister tried to extend this list,
but he had to retreat before the stiff opposition of the State
Governments. However, he succeeded in introducing modified
form of VAT (MODVAT) by granting credit on certain central
excises already paid on inputs so as to avoid the cascading
effect of central excise duty.
VAT is preferred because unlike excise duty it is levied not
only production stage but also at different stages of value
addition. In the modern days when many durable commodities
are sold for prices which include service, warranty and
installation charges, VAT would fetch considerable more revenue

than general sales tax.5 Having uniform rate structure throughout
the country, it would encourage the free flow of internal and
inter-state trade, besides promoting optimum allocation of
resources and plugging the artificial channels of distribution of
goods which are a consequence of non-uniform commodity
taxation. Having no cascading effect of taxes it would improve
the production efficiency. Presently, more than 100 countries
in the world have opted for VAT and European Economic
Committee members are the forerunners.
But before we go for a comprehensive VAT in India many
issues have to be debated. First of all, it must be borne in mind
that there are a number of alternatives to arrive at the value
added component on which the tax is to be levied. And each
alternative has its own administrative and economic implications.
Almost there are eight forms of VAT. Briefly, it is a tax
levied on business on the value they add to their purchases of
raw materials, and goods and services (leaving aside the problem
of capital and stocks). We can represent this by writing value
added (V/A), as total output (O) minus total input (I), i.e.
V/A = O – I (i)
Clearly, the difference between output and the inputs of
raw materials, energy interest and rent paid, etc. is the payments
of wage and salaries (W), and the residual, which we call profit
(P), i.e.
O–I = W+P (ii)
Or V/A = O – I = W + P (iii)
That is value added can be derived either by subtraction
(O – I) or by addition (W + P). These forms of calculations
sometimes are called subtractive method and additive method.
The tax rate (t) on value added, i.e. t(V/A) can then be
applied in atleast four ways:
t(V/A) = t (W + P) (iv)
t(V/A) = tW + tP (v)
t(V/A) = t(O – I) (vi)
t(V/A) = tO – tI (vii)
The last one (vii) is the most common method used, also
called (sometimes) the credit method. MODVAT or CENVAT
is based on this principle. According to this method, gross tax
liability (of business) is calculated by applying the pertinent
statutory rate to total sales or output or turnover. From this
figure, the amount of tax already paid on the purchase of inputs
or intermediate goods is deducted.
Coming back to (iv) – (vii), though they appear
mathematically identical, i.e. (iv) = (v) and (vi) = (vii), yet
administratively they are not. For example (vi) and (vii); while
in (vii) indirect method called invoice method is used to work
out the tax liability, in (vi) tax is applied directly to the
component of (V/A).
Table 10.1 will make the distinction between addition and
subtraction methods.
Table 10.1: Distinction between Addition and Subtraction Methods
Input Price (`) VAT Rate VAT Paid Price
excluding (`) including
any tax tax (`)
Raw Materials 100 20% 20 120
Energy, etc. 100 20% 20 120
Total Input 200 40 240
Value Added 100 20% 20 120
(Wages and Profit)
Output 300 20% 60 360
Table 10.1 shows that the tax liability by additive method

t(W + P) or subtractive method t(O – I) and by commonly used
invoice or credit method (tO – tI) would be the same, i.e. ` 20.
But the most serious problem arises when VAT is imposed on
price of inputs which may include some element of tax. For
example, if VAT on various farms products (floor, bread,
biscuits, etc.) made from wheat which includes market fee, rural
development charges, etc. is imposed, then the effective rate
would be different from and higher than the nominal rate
(20 per cent). Amongst the EEC members France has adopted
this method.6 Thus, the above-mentioned four forms of VAT
[(iv – vii)] would give birth to eight forms of VAT.
It may be added that there is no difference of opinion insofar

as the subtractive method is concerned and this may be the
reason for its widespread acceptability. The only variation is
whether to adopt direct approach, i.e. t(O – I) or indirect
approach, i.e. tO – tI. But while calculating the VAT liability
through additive procedure, some fiscal experts prefer to treat
sum of the firm’s payments to the factors of production used in
producing the goods. Under this scheme VAT rate is applied to
the firms costs in terms of wages, interest, rent and profits.7
Now coming to the various issues which need to be debated
in the Indian context. Apart from the form of VAT which we
should adopt, in a federal set-up like ours where lies its place?
Should it be a Centre’s subject? States would not agree to this
proposal, as this will deprive them of their legitimate power. If
it were a states’ subject, it would lead to the similar problems
which we have been facing now. It has no place in the concurrent
list because the same commodity/service cannot be taxed twice.
Then another problem which agriculturally dominated states
would be facing is that here value addition component is very
small. Therefore, the imposition of VAT would mean an
immediate fall in their revenue. Who will compensate such states?
Whereas coastal states would gain if import duty is replaced by
VAT, which it should be, then there may be a large number of
small-scale producers in the unorganised sector who may not be
approachable for the levy of VAT. For such producers and the
agricultural sector Canada has found a solution where VAT is
accompanied by last stage sales tax.
The most important thing to remember is that VAT means
there is only one tax on the production, transaction and
distribution of goods. In the Indian federal set-up, there is a
clear-cut division of tax items between the Centre and the states.
While commodity taxes like Union excise duty (at the production
or manufacturing stage) and import or export duty are levied
by the Centre, a large number of taxes at the distribution/sale,
entry, entertainment, etc. stages are levied by the states. With
effect from 1994, the Centre has also introduced tax on services
which has widened its net to cover 58 services (now raised to
71) at the uniform rate of 8 per cent (now raised to 10 per cent
in the budget 2004-05). Besides, the inter-State trade is governed

by the uniform central sales tax. Thus, there is plethora of
taxes on goods and services, which have to be abolished and
replaced by VAT. Besides, there is jurisdictional problem, i.e.
constitutional bottlenecks, of dividing these taxes between the
Centre and the states.
Realising the constitutional bottleneck, the Union
Government in 1986 introduced MODVAT (later on called CEN-
VAT), whereby the credit was given for already paid Union
excise duty on selected intermediate goods while calculating the
total excise burden of final output. Now the Centre wants that
the states should also make a beginning with the introduction
of state-VAT in lieu of sales tax. Haryana is said to be the
pioneer state in this regard by introducing State-VAT and it is
said to have experienced an increase in sales tax revenue, which
is inherent in the way Haryana implemented VAT.8
The main features of State-VAT in Haryana are:
(i) The facility of input credit is granted only in the event
of purchases made from within the state from VAT
dealers.
(ii) The manufacturers who earlier could buy most of the
capital goods from within the state without payment
sales tax would now under the VAT system have to
pay tax at the time of their purchase.
(iii) To bring all kinds of utensils and wares made up of
brass, copper and kanse under the list of 12.5 per cent
tax as against the decades old policy of levying
concessional tax rate on these goods.
No other state can afford to go the way Haryana has done
it. Moreover, it is against the true spirit of VAT. Then it is the
problem of integration of goods tax with service tax which is
becoming the major source of revenue. The proposed dual model
of CEN-VAT and State-VAT would keep out the taxation of
services. Thus, cascading effect of taxation would continue to
operate.9 A way out has been suggested by the Task Force
on Implementation of the Fiscal Responsibility and Budget
Management Act,10 commonly known as Kelkar Committee
Report II. The Task Force recommended that both the Central
Government and the State Governments should come to an
agreement in respect of a comprehensive tax on goods and
services. There should be a “concurrent but independent
jurisdiction over common or almost common tax bases
comprehensively extending over all goods and services and in
both cases going up to the final consumer”.11 However, the
Task Force suggested the following three ad valorem rates, in
addition to zero rate on selected key commodities. The proposed
rate structure is:
Levels of rate Centre State
Floor 6 4
Standard 12 8
Higher 20 14
However, the proposal of the Task Force has been criticised

on two accounts.12 First of all, the integration of taxes on goods
and services (GST) and its enactment both by the Centre and
the states assumes that the states would give up their taxation
powers in exchange of taxing services. Secondly, there would be
an agreement on the part of all the states to have a uniform
rate of taxation. Otherwise, the enactment of different rates by
different states, though within the suggested rate structure, would
effect our domestic trade with all the ills from which it is suffering
now. Then there is problem of double taxation.
It may the concluded that VAT has certain inherent
advantages, and in the changed domestic and global
economic scenario, we have to adopt it sooner or later. Let
the Centre continue to levy VAT up to the production base
and manufacturing stage and the states at subsequent stages.
But all the states must agree to adopt a uniform VAT policy
so that the allocation of resources throughout the country is
optimum. All the taxes including service tax have to abolished.
Since it is a distant but realizable dream, we should go step
by step till a complete switchover to full-fledged VAT is
possible. The states are expected to be at the receiving end,
therefore, the Centre should adopt a persuasive and pragmatic
approach. It is a happy augury that the Centre has already
constituted an Experts Panel to draw up a strategy required for

education, training and publicity for implementing VAT in the
country.
SERVICE TAX
The service tax is important for accelerating the growth
process in the economy as it helps agriculture and industry.
‘Services’ constitute a very heterogeneous spectrum of economic
activities. Today services cover wide range of activities such as
management, banking, insurance, hospitality, administration,
communication, entertainment, wholesale distribution, and
retailing including R&D (Research and Development) activities.
Service sector is now occupying an important stage of the
economy so much so that in the contemporary world,
development of service sector has become synonymous with the
advancement of the economy.
Broadly defined, the service sector includes all economic
activities whose output is not a physical product. This sector
encompasses the major areas of trade, finance, insurance,
communications, public utilities, transportation, government
administration, healthcare, education, business (accountants,
consultants) and personal service. There are three sectors
in an economy, viz. primary sector, secondary sector and tertiary
sector or service sector. Primary sector includes agriculture,
forestry and fisheries. Secondary sector includes mining,
manufacturing and electric supply and construction. Tertiary
sector or service sector covers trade, transport, communication,
finance, real estate and community, social and personal services.
Economists say that as the economy develops, the share of
primary sector in GDP declines and that of secondary and tertiary
sector increases. The growth of service sector and its contribution
to income and employment generation are indicators of economic
development.
Table 10.2 gives a cross-section view of the countries ranked
in the ascending order of their PCI to reflect the level of
development. It depicts the sectoral shares in GDP. It shows
Table 10.2: International Comparison
Country Share of Different Sectors in GDP (%) in 1990
Agriculture Manufacturing Services

Bangladesh 38 9 46
India 31 19 40
China 27 38 31
Indonesia 22 20 38
Malaysia 21 19 44
Mexico 9 23 61
Brazil 10 26 51
United States 2 17 69
Japan 3 28 56
clearly that as income rises, the share of agriculture declines, as

income increases; further, the share of manufacturing declines
and that of services increases.
The service sector in the Indian economy accounted for
29 per cent of the GDP in 1950-51 (Table 10.3). This share
increased to around 32 per cent in 1970-71 and to 36 per cent
in 1980-81. This is as high as nearly 50 per cent in 1999-2000.
The primary sector accounted for around 56 per cent of the
GDP in 1950-51. This share decreased to 44.5 per cent in 1970-
71 and 38.10 per cent in 1980-81. This was 23.5 per cent in
1999-2000. The secondary sector accounted for around 15 per
cent of GDP in 1950-51. This share increased to 23.60 per cent in
Table 10.3: Shares of Different Sectors in GDP in India
Year Primary Secondary Tertiary/Services Sector
1950-51 55.80 15.20 29.00
1960-61 45.80 20.70 33.50
1970-71 44.50 23.60 31.90
1980-81 38.10 25.90 36.00
1989-90 32.40 28.10 38.50
1990-91 30.90 30.00 39.10
1997-98 26.74 27.75 45.50
1998-99 26.82 27.01 46.17
1999-2000 23.50 27.40 49.10
2007-08 19.00 25.00 56.00
Source: Government of India, Economic Survey, Various Issues
1970-71 and to around 26 per cent in 1980-81. It became nearer

to 28 per cent in 1999-2000. This means that the services sector
has been the major beneficiary from the falling share of the
agricultural sector.
Table 10.4A: Sectoral Growth Rates
Year Sectoral Growth Rates
Primary Secondary Tertiary GDP
1996-97 9.6 6.8 6.6 7.5
1997-98 1.9 4.9 9.2 5.0
1998-99 6.5 3.3 8.8 6.9
1999-2000 0.7 6.0 9.4 6.4
2000-01 0.0 6.8 5.7 4.4
2001-02 5.9 2.8 8.2 5.8
2002-03 -5.9 6.9 8.7 3.8
2003-04 9.3 7.8 8.7 8.5
2004-05 0.8 10.5 9.7 7.5
New Series at 2004-05 prices
2005-06 4.7 10.2 12.4 9.5
2006-07 4.3 13.2 13 9.7
2007-08P 4.6 10.1 12.0 9.2
2008-09Q 1.6 4.1 9.8 6.7
Source: Government of India, Economic Survey, Various Issues
P=Provisional; Q=Quick Estimtes
The service sector as a whole has been growing at more
than 7-8 per cent a year during the nineties (Table 10.4A).
What is more important is the fact that whereas the primary
and secondary sectors witnessed a lower growth rate than the
overall growth rate, the service sector always outshined the
national average growth rate. However, this was never visualized
by our Constitution framers and policymakers with the result
that tax on services does not find any place in the Constitution
of India. And any tax, which has not been mentioned in the
Constitution belongs to the Union Government.
From a modest beginning in 1994-95, service tax has grown
into a significant source of revenue, with ` 14,200 crore realised
in 2004-05. It was budgeted at ` 17,500 crore in 2005-06,
though actual realisation was ` 23055 crore. In 2008-09 as
much as ` 65,000 crore were realised from service tax (Table

10.4B).13 A part of the budgeted growth is attributable to the
two-percentage point increase in the rate of tax. Continuing
with the practice of bringing additional services into the tax
net, the Budget for 2005-06 added the following nine items to
the list of taxable services: transport of goods through pipeline
or other conduit; site preparation and clearance, excavation,
earth moving and demolition services other than those provided
to agriculture, irrigation and watershed development; dredging
services of rivers, ports, harbours, backwaters and map making
other than by government departments; cleaning services other
than in relation to agriculture, horticulture, animal husbandry
or dairying; membership of clubs or association; packaging
services; mailing list compilation and mailing; and construction
of residential complexes having more than twelve residential
units of apartments together with common areas and other
apartments.
Table 10.4B: Service Tax—A Growing Revenue Source
Year Number of Number of Tax rate Revenue Growth
Services Assesses (per cent) (` crore) (Per cent)
2002-03 52 232048 5 4122 24.8
2003-04 60 403856 8 7891 91.4
2004-05 75 740267 10 14200 80.0
2005-06 84 806585 10 23055 62.4
2006-07 99 918746 12 37598 63.1
2007-08P 106 NA 12 51301 36.4
2008-09 (RE) NA 12* 65000 26.7
Source: Budget Documents
With effect from 24-2-2009 the rates were reduced to 10 per cent.
P: Provisional
Besides, the scope of existing services has also been expanded.
These were: commercial or industrial construction service to
include renovation of such building or civil structure, post-
construction completion and finishing services for such building
or civil structure construction, repair, alteration renovation or
restoration of pipeline or conductions; erection, commissioning
or installation services to include specified installation services;
maintenance or repair services to include maintenance or
management of immovable properties, maintenance or repair

including reconditioning or restoration undertaken as part of
any contract or agreement; broadcasting services to include
charges recovered by broadcasting agencies from multi-system
operator and provision of direct to home signals to the customers;
sound recording to include recording of sound on any media
and includes post-production services such as sound mixing or
re-mixing; video-tape production to include recording of any
programme, event or function on any media and includes post-
production services; taxable services provided by authorized
service station to include reconditioning or restoration of motor-
cars, two-wheeler and light motor vehicles, beauty parlours
service to include all services provided by beauty parlours;
manpower recruitment service to include supply of manpower,
temporary or otherwise; franchisee service to cover all agreements
by which, the franchisor grants representational rights to
franchise to sell or manufacture goods or provide services
identified with the franchisor; business auxiliary service to include
production or processing of goods for or on behalf of the client;
and outdoor catering service, to include catering from a place
or premises provided, by way of tenancy or otherwise by the
person receiving such services. Such measures as widening the
tax base and procedures that facilitate voluntary compliance,
going forward, would make service tax a buoyant source of
revenue commensurate with its high share in GDP. The Budget
2006-07 besides increasing in the rate of service tax from 10 to
12 per cent, brought additional services under the tax net. These
services are: ATM operations, maintenance and management,
registrars, share transfer agents and bankers to an issue, sale of
space or time of other than in the print media, for advertisements,
sponsorships of events, other than sports events by companies,
international air travel excluding economy class passenger,
container services on rail excluding the railway freight charges;
business support services, auctioneering; recovery agents, ship
management services, travel on cruise ships and public relation
management services.14
However, considering the growing importance of service
tax, the states have started demanding the right to tax the sale
and purchase of services just like the sale and purchase of goods.
Therefore, there is now a move to impose an integrated tax on
goods and services in the country as a whole, which may called
Goods and Services Tax (GST). Various experts’ committees
and the Thirteenth Finance Commission have been recommened
to implement the GST w.e.f. 1 April 2010.
GOODS AND SERVICES TAX*

Thirteenth Finance Commission was required to consider
“the impact of the proposed implementation of Goods and
Services Tax with effect from 1st April 2010 including its
impact on the country’s foreign trade”, while formulating its
recommendations. The changeover to the Goods and Service
Tax (GST) is be a game-changing tax reform measure which
will significantly contribute to the buoyancy of tax revenues
and acceleration of growth, as well as generate many positive
externalities. Three other items of consideration in the Terms of
Reference (ToR), viz. (i) “…estimation of the resources of the
Central and State Governments”; (ii) “…the objective of not
only balancing the receipts and expenditure on the revenue
account but also to generate surpluses in the capital account”;
and (iii) “…to improve the tax-gross domestic product ratio of
the Center and the States” will also be influenced by the GST.
The Commission therefore recognised the need to holistically
examine all the issues relating to the implementation of GST.
The first phase of reform of indirect taxation occurred when
the Modified Value Added Tax (MODVAT) was introduced for
selected commodities at the central level in 1986, and then
gradually extended to all commodities through Central Value
Added Tax (CENVAT). The introduction and integration of
service tax into CENVAT deepened this effort. Reform at the
state level occurred through introduction of Value Added Tax
(VAT) by all the states in the country in a phased manner between
April 2003 and January 2008.
Buoyed by the success of VAT, and mindful of the need for
further improvement, the Government of India (GoI) indicated
in Feb. 2007 that a roadmap for introduction of destination-
* This is based on the Thirteenth Finance Commission Report.
based GST in the country by 1 April 2010 would be prepared in

consultation with the Empowered Committee (EC) of State
Finance Ministers. This commitment was reiterated in February
2008 and July 2009. The origin-based Central Sales Tax (CST)
was successively reduced from 4 to 3 per cent and 2 per cent
during 2007 and 2008, respectively, as part of this reform
process. In November 2007, a Joint Working Group consisting
of representatives of the Empowered Committee and the
Government of India prepared a report on the changeover to
GST. This report was discussed by the EC, which then prepared
‘A Model and Road Map for Goods and Service Tax in India’
in April 2008. The model and roadmap, while recommending
that a dual GST be put in place, also provided preliminary
views on the state and central taxes to be subsumed within the
GST. The model detailed the operational issues which needed
to be addressed, including the number of rates, the exemptions
and exclusions from GST, as well as the treatment of inter-state
transactions. The roadmap outlined the legal and administrative
steps which needed to be taken in order to comply with the
April 2010 time line. The Government of India’s response to
this document formed the basis of the second round of discussions
and reviews. This culminated in the release of the ‘First
Discussion Paper on Goods and Service Tax in India’ in
November 2009. This discussion paper provides details of the
taxes to be subsumed, while at the same time, outlining the
modalities of implementation of the tax. It also makes
recommendations on a number of building blocks of the GST,
including taxation of inter-state trade, Thirteenth Finance
Commission provision of compensation, treatment of area based
schemes and the additional steps required to be taken. It,
however, does not provide any guidance on the Revenue Neutral
Rates (RNR) which need to be adopted at the central and state
level. This discussion paper is expected to spark a public debate,
leading to possible modification of the design and implementation
modalities of the GST. Commendable progress has been made
over the past three years in generating a national consensus on
GST. Agreement on the broad framework of this tax has now
been reached. GST will be a dual tax, with both central and
state GST components levied on the same tax base. All goods
and services, excluding the agreed upon exemptions, will be

brought into this base. No distinction between goods and services
will be made, with a common legislation applying to both.
However, a number of issues remain to be resolved. These need
to be addressed carefully. Only if a model GST is put in place,
can all its potential benefits be fully exploited. Given the large
positive economic and fiscal externalities of the GST reform,
putting in place an incentive structure to motivate all stakeholders
to design and implement such a model GST was, therefore,
a prime concern of the Commission. A number of State
Governments and industry associations communicated to the
Commission their concerns on the design and implementation
of GST. To address these and other GST related issues including
the mandate in our ToR, the Commission sponsored three
independent studies. One, undertaken by the National Council
for Applied Economic Research (NCAER) studied the impact of
GST on international trade. The second was undertaken by a
task force (TF) which examined the whole gamut of GST-related
issues, from design to implementation and made suitable
recommendations. Both these studies have been published on
the website of the Finance Commission. The Commission
reviewed below their main findings and recommendations after
briefly highlighting the concerns expressed by the State
Governments.
Views of State Governments
The State Governments expressed their views on the structure
of GST as well as its implementation modalities to the
Commission during our state visits. Nine State Governments
gave their views in their respective memoranda and some
expressed their views through letters to the Commission. While
all the states broadly supported the introduction of GST, the
major concerns expressed by them are detailed hereunder.
Determination of the tax base: Some State Governments pointed
to the importance of accurately assessing the tax base that would
be available to them under GST. They noted that with regard to
service tax, figures presently available were those pertaining to
the point of collection, rather than to the point of incidence.
Also, the rules of supply for services have not yet been finalised.
States which presently have a high tax effort apprehended that

the RNR finally agreed upon would not be favourable to them.
Manufacturing states would suffer additionally due to the
abolition of CST. They suggested that the GST rates should,
therefore, be used as a floor rate. Low income states argued
that as their consumption base was low, and they had increased
their tax effort significantly after implementing VAT, there was
little scope for them to increase their revenues under the proposed
GST regime.
Vertical Imbalance
It was apprehended that the GST could possibly accentuate
the vertical imbalance in favour of the Centre through a
proportionally larger Central Goods and Services Tax (CGST)
rate and access to a larger consumption base, hitherto unavailable
to the Centre.
State Autonomy. The GST requires a commitment to a stable
rate structure. This will compromise the fiscal autonomy of
State Governments and deprive them of the only lever of macro-
economic policy available to them.
Single Rate. A single GST tax rate would be regressive, with
the tax levied on items of common consumption increasing,
while providing needless relief to the higher taxed luxury goods.
Compensation Mechanism. Some states currently having a
high tax effort noted the possibility of suffering losses upon
implementation of GST. They requested that an objective
compensation mechanism to support such losses be put in place.
Compensation on loss of CST should also be part of this package.
Small Enterprises. Small enterprises manufacturing specified
goods with an annual turnover of less than ` 1.5 crore are
presently exempt from excise. The GST will bring them into the
tax net, rendering them uncompetitive and enhancing their
compliance cost.
Cesses and Surcharges. All cesses and surcharges levied by
both Centre and the states should be subsumed into the GST.
Taxes to be Excluded from GST. Electricity duties; purchase
tax; and taxes on crude oil, motor spirit (MS), high speed diesel
(HSD), alcohol and tobacco should be excluded from the purview

of GST.
Compliance Mechanism. The GST law should be subject to
rigorous compliance and deviations should not be permitted.
Changes should be made only with the consent of all the states.
Selective Rollout. States should be given the option to adopt
GST at their convenience and the possibility of implementation
of GST in only some states should be incorporated in the design.
Dispute Resolution. An independent dispute resolution
mechanism should be put in place.
Implementation Modalities. All tax returns, assessment and
audit procedures should be harmonised across the country. A
comprehensive information technology (IT) based infrastructure
should be put in place to track inter-state transactions.
Adequate preparation for the changeover, rather than an
arbitrary fixed schedule, should be the sole criterion for deciding
the timing for introduction of GST.
The CST Act should be abrogated such that the provision
for notifying declared goods is not available to the Centre.
The rules of supply for inter-state sales should be finalised
expeditiously, in an objective manner. Further, the modalities
for levying GST on imports, textiles and sugar should be agreed
upon.
Views of the Central Government
The Central Government has expressed concerns about the
following issues:
(i) The recommendation in the Discussion Paper that GoI
maintain the CGST threshold at ` 1.5 crore, while the
State Goods and Services Tax (SGST) composition
threshold would be ` 40 lakh.
(ii) The importance of agreeing upon a uniform and limited
list of exempted items for the Centre and for all the
states.
(iii) The criticality of promoting the power sector and the
importance of subsuming electricity duty into GST.
(iv) The need to subsume purchase tax into GST to ensure

that it remains a consumption-based tax and is not
exported across tax jurisdictions.
Impact of GST on Foreign Trade

A NCAER study has evaluated the possible impact of GST
on India’s international trade in a Computable General
Equilibrium (CGE) framework. It notes that the differential
multiple tax regimes across sectors of production are leading to
distortions in the allocation of resources as well as production
inefficiencies. Complete offsets of taxes are not being provided
to exports, thus affecting their competitiveness. It estimates that
implementation of a comprehensive GST across goods and
services will enhance the nation’s Gross Domestic Product (GDP)
by between 0.9 and 1.7 per cent. This works out to between
` 52,600 crore and ` 99,450 crore on the basis of GDP figures
for 2009-10. Such benefits would accrue every year. It would
also lead to efficient allocation of the factors of production,
with a fall in the overall price level. The report identifies a
number of sectors which would directly benefit from the
implementation of GST. The study estimates the gain in exports
to vary between 3.2 and 6.3 per cent. Imports are expected to
gain between 2.4 per cent and 4.7 per cent, thus improving the
trade balance.
The study estimates the revenue-neutral GST rate across
goods and services to be between 6.2 and 9.2 per cent, depending
upon the assumptions made. This value was conservatively
arrived at, ignoring the existence of tax thresholds and
composition limits. The study assumes that the GST adopted
will be a truly consumption-based tax which will: (i) eliminate
all origin based taxes; (ii) subsume all the other presently levied
indirect taxes on goods and services (excluding customs) and
(iii) not be exported across tax jurisdictions. To exploit the
benefits of GST fully, the Commission also needed to ensure
that tax compliance costs are low and tax credits are available
seamlessly across tax jurisdictions. Apart from uniform tax rates,
this will also require harmonisation of procedures for levy,
assessment, appropriation and even audit, between the states
and the Centre, as well as amongst the states themselves. This is
best done through a model GST, the characteristics of which

are outlined further.
Report of the FC-XIII Task Force
The task force, appointed by the Commission,
comprehensively analyzed all GST related issues and made a
number of recommendations. The key points are summarised
below:
(i) Following the present VAT, the GST should be levied
on consumption and computed on the basis of the
invoice credit method.
(ii) All major indirect taxes (excluding customs) and all
cesses and surcharges should be subsumed into the
central and state GST. Specifically, stamp duty, taxes
on vehicles, taxes on goods and passengers and taxes
and duties on electricity should be subsumed into the
GST.
(iii) Transmission fuels, High Speed Diesel (HSD), Motor
Spirit (MS) and Aviation Turbine Fuel (ATF) should
be brought under a dual levy of GST and an additional
levy with no input tax credit available on the additional
levy. This would protect the existing revenues from
these sources. However, all other petroleum products
should be brought within the ambit of the GST as
should natural gas.
(iv) The sumptuary goods of tobacco and alcohol should
be taxed through GST as well as an additional levy,
with no input tax credit being provided on the
additional levy.
(v) The entire transportation sector should be included in
the GST, and taxes on vehicles, goods and passengers
should be subsumed into the GST. Similarly, the power
sector should be included in the tax base and electricity
duty subsumed.
(vi) The real estate sector (both residential and commercial)
should be included in the tax base and stamp duty
levied by State Governments should be subsumed into
GST. A threshold of ` 10 lakh in this regard will permit

exemption of small residential and business properties.
(vii) The entire financial services sector should be brought
under the tax base.
(viii) Capital goods should be treated like all other goods
and services, with no restrictions on availment of input
tax credit at purchase,and a corresponding liability for
GST on subsequent sale.
(ix) No exemptions should be allowed, except for a common
list applicable to all states as well as the Centre, which
should only comprise:
(a) unprocessed food items;
(b) public services provided by all governments
excluding railways, communications, public sector
enterprises;
(c) service transactions between an employer and
employee and
(d) health and education services.
(x) ‘Place of supply’ rules for goods and services should be
based on international best practice, and be carefully
framed to ensure consistency, credibility and relevance.
(xi) An exemption threshold of ` 10 lakh should be adopted,
with a composition limit of ` 40 lakh, above which
GST would be mandatorily applicable. The present
excise exemption upto ` 1.5 crore should be withdrawn.
However, in the case of certain high value goods
comprising:
(i) gold, silver and platinum ornaments;
(ii) precious stones and
(iii) bullion, the dealers may, subject to the threshold
limit of ` 10 lakh but without the ceiling of ` 40
lakh, also be allowed to opt for the composition
scheme.
(xii) Area-based exemptions should be withdrawn and the
tax paid reimbursed wherever considered necessary.
(xiii) Inter-state transactions should be treated through a

mechanism which permits sellers in one state to charge
SGST from buyers in another state. The seller shall
furnish the transaction related information and
composite payment of tax in respect of both intra- and
inter-state transactions, to nodal bank. This SGST
should then be immediately credited to the consuming
state by the bank where such payment is made.
(xiv) Harmonisation should be ensured in registration, return
filing, assessment, and audit across states.
(xv) The GST tax base has been estimated at ` 31,25,325
crore. This is the average of five different estimations
of the tax base obtained by following as many
approaches. These estimates are given in Table 10.5.
Table 10.5: Estimates of the Tax Base of GST by Different Approaches
(` crore)
1. Subtraction Method 30,73,037

2. Consumption Method
(a) Task Force Method 37,43,077
(b) NCAER Method 30,77,952
3. Shome Index Method 27,82,809
4. Revenue Method 29,49,748
Average 31,25,325
(xvi) The consequent Revenue-Neutral Rate works out to

11 per cent (5 per cent for CGST and 6 per cent for
SGST). This excludes the additional levies which would
be imposed on petroleum and sumptuary goods. The
task force has recommended that all goods and services
should be subject to tax at the single positive GST rate
of 12 per cent (i.e. 5 per cent for CGST and 7 per cent
for SGST) other than exports.
THE MODEL GST

Outline of the Model GST
Keeping in mind the recommendations of the task force,
Finance Commission has outlined the design and modalities of
a model GST law. Such a model GST would not distinguish

between goods and services. It should be levied at a single positive
rate on all goods and services. Exports should be zero-rated.
Tax compliance costs should be low and tax credits should be
available seamlessly across tax jurisdictions. The other design
and operational modalities of a model GST are outlined below.
Taxes to be Subsumed
For the GST to be purely consumption based, all related
indirect taxes and cesses should be subsumed into it. Thus, the
Central GST portion would subsume the following taxes:
(i) Central excise duty and additional excise duties
(ii) Service Tax
(iii) Additional Customs Duty (Countervailing Duty)
(iv) All surcharges and cesses.
The SGST portion would subsume the following taxes:
(i) Value Added Tax
(ii) Central Sales Tax
(iii) Entry Tax, whether in lieu of octroi or otherwise
(iv) Luxury Tax
(v) Taxes on lottery, betting and gambling
(vi) Entertainment Tax
(vii) Purchase Tax
(viii) State Excise Duties
(ix) Stamp Duty
(x) Taxes on vehicles
(xi) Tax on goods and passengers
(xii) Taxes and duties on electricity
(xiii) All state cesses and surcharges.
Special Provisions for Certain Goods
The taxation of petroleum products and natural gas would
be rationalised by including them in the tax base. HSD, MS,
and ATF could be charged GST and an additional levy by both
Central and State Governments. No input credit would be

available against either CGST or SGST on the additional levy.
A similar treatment would be provided to alcohol and tobacco.
Such an arrangement would ensure protection of existing
revenues while taking care of environmental concerns.
Exemptions
No exemptions should be allowed other than a common list
applicable to all states as well as the Centre, which should only
comprise: (i) unprocessed food items; (ii) public services provided
by all governments excluding railways, communications and
public sector enterprises; (iii) service transactions between an
employer and employee and (iv) health and education services.
A threshold of ` 10 lakh and a composition limit of ` 40
lakh have been agreed upon by the EC for SGST in the first
discussion draft. It is desirable that these limits be applied to
CGST as well. Sales of goods of local importance will fall within
these threshold limits, thus keeping them out of the ambit of
GST.
Dealers with turnover below ` 1.5 crore were previously
exempt from CENVAT. As thresholds need to be consistent
across SGST and CGST, such exemptions should not continue.
Under the GST regime, dealers with turnovers between ` 10
lakh and ` 40 lakh will have to pay both CGST and SGST.
Their compliance burden will increase. This issue can be
addressed if both CGST and SGST are levied and collected from
such dealers by a single agency, viz. the State Government, which
would then remit the CGST portion to the Central Government.
State Government will be responsible for assessment, levy,
collection and audit, with Central Government retaining it right
to exercise these functions in respect of CGST in specific cases.
State Governments could be reimbursed the collection charges
for this effort. Wherever the additional levy is likely to cause
hardship, a scheme for reimbursement to economically vulnerable
dealers could be considered by the government.
The present area-based exemption schemes are not consistent
across the states where they are applicable. They differ in the
admissibility of CENVAT credit as well as the sunset clause.
Since it would be difficult to subsume these schemes into the

GST structure, it is recommended that they be terminated. The
existing schemes should not be grandfathered. Alternative options
like refunding taxes paid by industries in these locations could
be considered.
Treatment of Inter-state Sales
All transactions across tax jurisdictions should be free from
tax. While exports will be zero rated, inter-state transactions
should be effectively zero-rated so as to ensure that the tax is
collected by the consuming state consistent with the destination
principle. Therefore, any model adopted must allow accurate
determination and efficient transfer of input tax credit across
tax jurisdictions. Further, the model should not impose any
undue restrictions on tax credit set-off or increase in compliance
costs.
Formulation of Rules of Supply
The ‘place of supply’ rules for services need to be carefully
framed to ensure consistency and credibility. It should be based
on international best practices.
GST on Imports
Imports from outside the country would be subject to GST
on the destination principle. This will require that proof of
consumption at a predetermined destination state should be
provided. The procedure for collection and appropriation of
this tax needs to be put in place. Rules for transferring this tax
burden in the case of importers who sell to a consumer in a
third state after the import is made, need to be clarified.
Operational Modalities
To reduce compliance costs and increase collection efficiency,
all state GST laws should be harmonised. All stages of the
taxation chain, from levy of the tax to its assessment, collection
and appropriation, should be similar across states. This would
involve similar rules across states, dealing not only with
assessments, audit and refunds, but also with more basic issues
like registration, filing of returns, treatment of transportation
of goods, etc. While CST will be reduced to zero, the necessity

of stipulating documentation for inter-state trade needs to be
carefully examined. The model for taxing inter-state sales finally
adopted should provide clarity on the jurisdiction of states while
facilitating inter-state trade and stock transfers. Given the volume
of such transactions, this system necessarily has to be IT-based.
Such an IT network should enable the sharing of information
between states and assist in the plugging of revenue leakages. A
system to facilitate inter-state verification of dealers and
transactions is also necessary. The present system, viz. Tax
Information Exchange System (TINXSYS), does not appear to
be fully operational across all states. There are asymmetric
benefits to states in putting in place such infrastructure and this
appears to be affecting their incentives to do so. A system which
will uniformly incentivise all states to participate in and
contribute to the verification system needs to be put in place.
Alternately, one central agency could be charged with
maintaining this system. The existing TINXSYS infrastructure
should be updated and strengthened.
DISPUTE RESOLUTION AND ADVANCE

Ruling Mechanism
An effective, efficient and uniform system for redressal of
anomalies in the legislation should be put in place. This could
be an independent and quasi judicial authority with full powers
to look into all disputes related to GST implementation, both at
the Centre and state level. Such an authority could issue
guidelines, administer and enforce agreement between states and
the Centre, and between the states themselves. A common
Advance Ruling Authority for both the Centre and the states
should also be put in place.
Refunds
Prompt refunds from the core of an effective GST framework,
especially as cross-utilisation of input tax credit across CGST
and SGST, are not envisaged. Delayed payment of refunds
enhances the cost of dealer operations and reduces the efficiency
of the tax system. The experience with refunds under the VAT
regime is not reassuring, even though VAT laws in a number of

states mandate payment of interest for delay. State Governments
must adopt a more effective refund system. They could consider
an electronic system where refunds are directly credited to the
eligible dealer’s bank account.
Selective Rollout
VAT was introduced in a phased manner by State
Governments over a period of nearly three years, between April
2003 and January 2008. VAT dealt purely with the treatment
of intra-state sales and states were not explicitly disadvantaged
if they did not implement VAT. Transactions between VAT and
non-VAT states did not warrant special treatment. However,
GST changes the rules of the game. It requires inter-state trade
to be zero rated. It empowers states by including services as
well as the manufacturing stage in their tax base. It thus creates
an uneven balance between states which implement GST and
those which do not. Goods and services sold between complying
and non-complying states would thus require to be treated
differently in the wake of selective implementation of GST. If
CST were to continue to apply in non-complying states, inter-
state sales would become further complex. Goods passing
through a non-complying state, to be finally sold in a complying
state, would be burdened by a cascading tax which would
adversely affect the price to the final consumer. The seamless
flow of Input Tax Credit (ITC) on inter-state transactions would
be interrupted. Further, rate mismatches may encourage trade
diversion and cost of compliance would become extremely high
for inter-state dealers. This would discourage economies of scale.
We, therefore, feel that the model GST should be implemented
by all states and the Centre at one time, and not be partially
implemented in some states. It is for this reason that we
recommend that proper preparation for the GST and generating
of a consensus amongst all states is a greater priority than
complying with the 2010 deadline. However, as has been
suggested in some quarters, it is possible for the Centre alone to
transform the CENVAT into a GST at the manufacturing stage
at any time. It could unify the CENVAT rates and impose a
general tax on all services, while adopting a common threshold.

As mentioned earlier, a dual tax on petroleum products, tobacco
and alcohol could be levied—a GST component and an
additional levy component with no input credit being provided
on the latter.
Transition Provisions
A number of transitional issues will arise. Provisions to
address such issues must be consistent with the model GST.
Benefits from Supporting the Model GST
This Commission supports the implementation of a model
GST for the following reasons:
(i) The NCAER study computed the present value of
GST-reform induced gains in GDP as the present
value of additional income stream based on the discount
rate of 3 per cent representing the long-term real
rate of interest. The present value of total gain in
GDP is estimated as between ` 14.69 lakh crore and
` 28.81 lakh crore. The corresponding dollar values
are US$ 325 billion and $637 billion. This represents
between 25 and 50 per cent of the 2009-10 GDP gained
through this major tax reform. The all-government tax
revenue will also increase by about 0.20 per cent of
GDP, a significant increment to revenues through
implementation of the model GST.
(ii) The task force report estimated that such a GST would
have a tax base of around ` 31,00,000 crore. It further
estimated that this would require a revenue-neutral rate
of only 12 per cent (5 per cent for the Central GST and
7 per cent for the State GST). This is a substantial
decrease from the present 20.5 per cent (8 per cent for
CENVAT and 12.5 per cent for VAT). This should be
the target.
(iii) Adoption of such a model GST would make India a
dynamic common market and also result in generation
of positive externalities. Despite lower levels of taxes,
the revenue of the Union and the states will be buoyant.
Subsumation of all major indirect taxes will result in

removal of inefficient taxes. Our manufacturers will
become more competitive and consequently exports will
grow. Provision of seamless input tax credit across all
transactions will avoid tax cascading, eliminate double
taxation and improve resource allocation. It will foster
a common market across the country, reorient supply
chains and remove the present bias towards backward
integration. Further, it will also inhibit tax induced
migration of investment. It will, thus, support the
growth of lagging but resource-rich regions. A single
rate across all goods and services will eliminate
classification disputes and make tax assessment more
predictable. The harmonisation of tax assessment, levy
and collection procedures across states proposed under
the GST will reduce compliance costs, limit evasion,
enhance transparency and improve collection efficiency.
(iv) Successful implementation of GST also offers the
possibility of strengthening the revenue base of local
bodies that form the third tier of government.
(v) The inclusion of real estate in the GST tax base will
constrain the parallel economy with consequent
positive spillovers into governance and the development
of land markets.
(vi) The NCAER model suggests that GST could lead to
better environmental outcomes.
Concerns of State Governments
The principal concerns of states are related to revenue from
certain products, loss of autonomy in a GST framework,
possibilities of states entering GST in a phased manner and
treatment of small enterprises.
Revenue from Certain Products
The model GST will accommodate the concerns of
governments with regard to maintenance of their revenues from
transmission fuels and sumptuary goods by allowing the
imposition of an additional levy over and above the GST.
Dilution of Fiscal Autonomy of States

Concerns have been expressed by some state governments
that the GST regime will constrict their fiscal autonomy and
further tilt the vertical imbalance. However, this argument should
be viewed in the following perspective:
(i) While the states will normally not be able to deviate
from the nationally agreed model for the GST, such
constraints will apply to the Centre as well. Further,
the states still have fiscal headroom available. They
can impose an additional levy on transmission fuels as
well as sumptuary goods and the authority to levy
temporary cesses and surcharges in case of emergencies,
remains. They can also continue to levy user charges
for services provided to citizens. Expenditure policy
will continue to remain as a powerful fiscal instrument.
Further, the strengthening of their fiscal base will
improve their access to capital markets, enhancing their
borrowing capacity.
(ii) The tax base of State Governments will significantly
increase with the inclusion of the tax on services as
well as the tax on manufacture. The tax base of the
Centre, on the other hand, will increase only to the
extent of tax on sales. Thus, it cannot be said that the
vertical imbalance will increase in favour of the Centre.
(iii) States will benefit from the abolition of the cesses and
surcharges presently being levied by the Centre, as the
size of the divisible pool will rise. Presently, this
amounts to about 15 per cent of the divisible pool.
(iv) Tax policy is tax administration, and significant scope
exists for improving tax collection efficiency through
implementation of GST.
(v) The GST grant recommended by this Commission
compensates for the seeming limitation in fiscal
autonomy by enhancing expenditure autonomy through
compensation payments and additional formulaic
transfers.
(vi) The GST will be a landmark effort by the states and

the Union to further co-opertive federalism with all
stakeholders contributing to national welfare by
accepting its framework.
Compensation Mechanism
An objective compensation mechanism incorporated in the
‘Grand Bargain’ will provide reassurance to both the Central
and State Governments checkposts. Most states have put in
place a system of checkposts on their border roads. There are a
number of reasons for putting in place such physical barriers to
trade. These include (i) enforcement of state excise, market cess,
forest and vehicle fitness regulations; (ii) applicability of lower
taxes on inter-state trade than on intra-state trade; (iii) there
being no tax on stock transfers; (iv) levy of entry tax on specified
goods; (v) levy of octroi by some municipalities; and (vi) internal
security. The onset of GST will not obviate all these reasons,
and therefore, checkposts on state borders may remain. However,
it must be recognised that such checkposts, by the very nature
of their operations, generate enormous delays in road traffic.
The arrangement also encourages rent-seeking behaviour. It may
be difficult to eliminate checkposts, given the valid concerns of
State Governments. But what appears to be egregious is that the
same vehicle has to pass through two checkposts—the exporting
state’s checkpost and the importing state’s checkpost—while
crossing one border. Both these checkposts are often located
within a couple of kilometres of each other and a transport
vehicle has to spend considerable time at both. Perhaps, it may
be possible for both states to put up a combined checkpost.
Officials of both states could sit together and conduct their
verifications in a single check post. Alternately, one state could
handle traffic in one direction and the other state in the other
direction, essentially ensuring that there would be only one check
per border for a goods vehicle. Such an arrangement would
significantly reduce travel time and we recommend it for
consideration. There is an overwhelming retionale for minimising
delays and thus reducing transaction costs. States could be
encouraged to consider user-friendly options like electronically
issued passes for transit traffic in order to reduce truck transit

time through their states.
The Grand Bargain
The Commission has proposed that both the Centre and the
states conclude a ‘Grand Bargain’ to implement the model GST.
Keeping the experience of the implementation of VAT in
mind, we suggest that the six elements of the Grand
Bargain comprise: (i) the design of the GST; (ii) its operational
modalities; (iii) binding agreement between Centre and states
with contingencies for change in rates and procedures;
(iv) disincentives for non-compliance; (v) the implementation
schedule and (vi) the procedure for states to claim compensation.
The design of the model GST has already been suggested.
Binding Agreement between Centre and States
Compliance of states with the previously agreed upon
guidelines for VAT has not been very uniform. A number of
states have deviated from the three-tier VAT rates, thus indicating
the need to put in place an enforcement mechanism. States are
equally apprehensive that the Centre may unilaterally raise tax
rates without consulting them. The Constitution does not
envisage sharing of tax bases. Taxation powers are listed either
in the State List or in the Central List, but not in the Concurrent
List. For the first time since the Constitution was enacted, a tax
base is proposed to be shared between the Centre and the states.
It is, thus, necessary that a firm arrangement be put in place for
implementing the GST to prevent deviations from the agreed
upon model by either the Centre or the states.
One option is the possibility of a Constitutional provision
to facilitate a tax agreement between the Centre and the states
on the lines of the erstwhile Article 278. One suggestion is that
the new Article 278 could read: “Notwithstanding anything in
this Constitution, the Government of a state may enter into an
agreement with the government of any other state or the union
government with respect to the levy and collection of any tax or
duty leviable by them, and during the period such agreement is
in force, the power of such states and union as the case may be,
to make laws to impose any tax shall be subject to the terms of

such agreement.” It has been argued that such a provision will
eliminate the need to amend the taxing powers entrusted to the
Union and the states through Schedule VII of the Constitution.
Such an agreement (between the 28 states and the Centre as
parties) could specify the tax rates adopted as well as the
conditions under which the agreed tax rates can be changed.
The agreement can be made part of Goods and Service Tax
laws which the Center and all the states will separately enact.
The agreement will, amongst other things, specify the rates
to be adopted in these enactments and the implementation
schedule. For amending the rates subsequently, it is proposed
that all states would need to agree to a proposal to decrease
rates. Only three quarters of the number of states would need
to agree if the rates have to be increased. The Centre would
have a veto power. All amendments to the agreement should be
consistent with (i) maintaining the integrity of the GST base;
(ii) providing for administrative simplicity; and (c) minimising
compliance costs for taxpayers. The agreement will need to be
monitored by the Empowered Committee which could be
transformed after the implementation of GST into a Council of
Finance Ministers with statutory backing.
Disincentives for Non-Compliance
Keeping in mind the experience under VAT it may become
necessary to deter violations of agreement by visiting a penalty
on non-complying states. We recommend that Finance
Commission’s state specific grants and the state’s share of the
GST incentive grant be withheld for the period during which a
state is in violation of the agreement. If a state is in violation for
only part of a year, its grant should be reduced to a proportionate
extent.
Compensation/Incentive Grants
This Commission is aware that the tenor of the ongoing
discussions on the GST model and implementation modalities
does not include some of the major elements of the model GST
outlined above. In our view, any major deviation from the
concept of the model GST would dilute its positive externalities,

significantly reduce its benefits and reduce the incentive to switch
over. To incentivise implementation of such a Grand Bargain
between the states and the Centre, this Commission recommends
the sanction of a grant of ` 50,000 crore to be provided to all
states in the aggregate, subject to the GST framework adopted
being consistent with the Grand Bargain. We recognise
that while GST on the whole will be revenue neutral, there
may be some winners and losers during the initial years of
implementation. This grant will accommodate claims for
compensation from the adversely affected states and balance
will be distributed amongst states as per the devolution formula.
The grant of ` 50,000 crore would be used for meeting the
compensation claims of State Governments between 2010-11
and 2014-15.
Unspent balances in this pool would be distributed amongst
all the states as per the devolution formula, on 1 January 2015.
To allow for the possibility of implementation of GST during
2010-11, the Commission proposed that the grant be initially
allocated as given in Table 10.6.
Table 10.6: Scheduling of GST Grant
2010-11 ` 5000 crore

2011-12 ` 11250 crore
2012-13 ` 11250 crore
2013-14 ` 11250 crore
2014-15 ` 11250 crore
The Commission viewed allocation as substantial for two

reasons. First, the task force estimation of RNR provides
assurance that such a level of compensation may not be required.
Second, the amount of compensation required will depend upon
the year in which GST is implemented. The total amount of
` 50,000 crore may be earmarked for GST compensation
and incentive provided the model GST is implemented before
31.3.2013. Unspent grants at the end of a year will be carried
forward to the next year if GST is implemented before
31.3.2013. If GST is implemented during 2013-14, the grant
will be restricted to ` 40,000 crore. If GST is implemented
during 2014-15, the grant will be restricted to ` 30,000 crore.
To be eligible to draw down this grant, all the elements of

the Grand Bargain outlined will need to be adopted. If the GST
framework adopted is not consistent with this, then this
Commission recommends that this grant of ` 50,000 crore not
be disbursed. Thus, if the Grand Bargain is not concluded, this
grant will not mean any net fiscal outgo. If a model GST is
implemented and the grant is disbursed, then the resultant
increase in GDP and tax revenue will fully finance it. If the
Grand Bargain is not put in place, then the grant lapses. There
are, thus, no fiscal risks with this grant—only advantages.
Implementation Schedule of the Model GST
The Commission has recognised that building consensus on
implementing the model GST may be an involved process but
equally appreciate that the requirement of a good design is
paramount and should not be subordinated to a deadline.
International experience tells us that flaws in design are extremely
difficult to correct subsequently. The Commission therefore
recommend that marginal rescheduling of the time-table for
implementation should be acceptable if the design adopted is
consistent with the model GST.
The objective of the model GST is to optimise tax collection
with minimal economic distortions. The Model GST should,
inter alia, comprise: (i) a uniform rate for goods and services
(ii) a uniform rate across states (iii) a zero rate for exports and
(iv) for all other goods and services a single rate, excluding the
rate for precious metals. There could be two possible approaches
to the implementation of the Model GST: the ‘big-bang’ approach
and the ‘incremental’ approach. The introduction of the GST is
the last mile in the reform of the indirect tax system of this
country initiated in 1986 with the introduction of the MODVAT.
All stakeholders stand to gain from a swift comprehensive
changeover to the GST. To the extent the switchover is staggered,
the potential gains from the comprehensive GST would remain
unrealised. Therefore, the Commission recommend that
all the elements of the model GST should be implemented
comprehensively at one instance.
However, the Commission is aware that two essential

elements of the model have not yet been formally discussed by
the states and consensus needs to be built before they are adopted.
These are the inclusion of stamp duty in the GST tax base to
enable the taxation of real estate and the use of a single rate in
the GST framework. More time may be required for these
elements to be included in the GST framework. Given that the
terminal year of the period covered is 2014-15, the Commission
proposed as follows. If found necessary, the GST may be initially
implemented without these two elements provided that:
(i) At the time of its implementation, the road map for
their inclusion in the framework before 31 December
2014 is announced.
(ii) The GST is introduced with not more than two rates.
iii) Properties other than individually owned residential
properties are brought into the ambit of GST within
two years of its implementation.
This contingency does not preclude the possibility of the
Centre implementing GST at an accelerated pace.
Modalities for Disbursing Compensation
As already mentioned, states had requested that an objective
compensation mechanism to support possible revenue losses after
implementing GST be put in place. We recommend the following:
(i) The present Empowered Committee be transformed
into a statutory Council of Finance Ministers with
representation from the Centre and states. A GST
Compensation Fund should be created under the
administrative control of this Council.
(ii) The Central Government shall transfer to the GST
Compensation Fund amounts as indicated in Table 10.7
and subject to the conditionalities already indicated.
(iii) The amounts in the Fund should be used for
compensating states for any revenue loss on account of
adoption of the model GST and the Grand Bargain as
indicated above. The balance, if any, remaining on
1 January 2015, will be distributed amongst the states
on the basis of the devolution formula, used for

distributing resources in the divisible pool amongst
states.
(iv) The amount will be disbursed in quarterly instalments
on the basis of the recommendations made by a three-
member Compensation Committee comprising the
Secretary, Department of Revenue, Government of
India; Secretary to the EC and chaired by an eminent
person with experience in public finance. This person
would be appointed by the Union Government.
The Way Forward
A number of legal and administrative steps need to be taken
prior to the implementation of GST. These include stakeholder
consultations, amendments to the Constitution and state laws,
administrative reorganisation, preparation of GST registration,
assessment and audit manuals, staff training and conduct of
awareness campaigns amongst stakeholders. We have not
touched upon these milestones in our discussion, but are aware
that these processes may take substantial time. This is also a
reason why we have earlier recommended that the putting in
place an excellent design and operational framework for the
GST should be given priority, even if this implies rescheduling
the previously announced implementation time-table.
We recognise that the process of generating a consensus to
implement the Grand Bargain as outlined by us may be difficult
and involved. However, we believe that such a consensus can,
and should be, generated to fully exploit the potential of GST
and reap the benefits of its positive externalities. While we would
like to support this model GST, which is fully consumption
based, has provision for seamless credit and imposes low
compliance cost, we must allow for the possibility that political
economy considerations may will otherwise. In the unlikely event
that such a consensus cannot be achieved and the GST
framework finally adopted is different from the Grand Bargain
suggested by us, this Commission recommends that the grant
amount of ` 50,000 crore shall not be disbursed.
IMPACT OF GST ON PROJECTIONS MADE BY

THE FINANCE COMMISSION
Though GST requires that all cesses and surcharges be
abolished, and this Commission recommends that GST be
implemented as early as possible, we have, in our projections,
assumed continuing revenue for the Central Government
from cesses for the period 2010-15. This has been done for the
following reasons:
(i) Ignoring the positive externalities of GST, the
Commission has conservatively assumed that GST will
be revenue-neutral. Thus, income from cesses and
surcharges will be included in the computation of
RNR. In the scenario when GST is implemented, the
aggregate revenue figures in our projections will remain
unchanged, though the accounting heads under which
they are reported may change. Since the catalysing effect
of GST on the economy has not been factored in our
projections, they can be seen as conservative.
(ii) A number of critical sectors, including roads, education,
and calamity relief, are being funded from the proceeds
of cesses levied by the Government of India. The
transition plan to the GST must ensure that budget
provisions are made to support such initiatives.
The model, the modalities as well as the timing of
implementation of the GST have not yet been finalised. Making
projections over a five-year period, assuming the implementation
of the GST during this period, would, be a hazardous exercise.
This Commission has, thus, for the purpose of our financial
projections, assumed that the impact of GST will be revenue-
neutral and that the gross revenues of the Centre and states will
not be lower than those projected even after GST is implemented.
FINANCES OF THE CENTRAL GOVERNMENT15

As Table 10.7 shows the Central Government revenue
as a proportion of GDP has been on the decline. Although budget
estimates for 2004-05 and 2005-06 have put this ratio at
9.9 per cent and 10.0 per cent respectively (compared with
Table 10.7: Finances of the Central Government (` Crore)
484
1990-91 2000-01 2001-02 2002-03 2003-2004 2004-05 2005-06 2006-07 2007-08 2008-09 2008-09
(B.E.) (R.E.)
1. Revenue receipts (a+b) 54954 192605 201306 230834 263813 305991 347077 434387 541925 602935 562173
(a) Tax revenue (net of state’s
share) 42978 136658 133532 158544 186982 224798 270264 351182 439547 507150 465970
(b) Non-tax revenue 1976 11976 55947 677774 72290 76831 81193 76813 83205 102378 95785 96203
2. Revenue expenditure of which 73516 277838 301468 338713 362074 384329 439376 514609 594494 658118 803446
(a) Interest payments 21498 99314 107460 117804 124088 126934 132630 150272 171030 190807 192694
(b) Major subsidies 9581 25860 30447 40716 43535 44753 44480 53495 67498 67037 122728
(c) Defence expenditure 10874 37238 38059 40709 43203 43862 48211 51682 54219 57593 73600
3. Revenue deficit (2–1) 18562 85233 100162 107879 98261 78338 92299 80222 52569 55183 241273
4. Capital receipts (a+b+c) 31971 132987 161004 182414 207390 192261 158661 149000 170807 147949 338780
(a) Recovery of loans* 5712 12046 16403 34191 67165* 62043* 10645 5893 5100 4497 9698
(b) Other receipts (mainly PSU
disinvestment) 0 2125 3646 3151 16953 4424 1581 534 38795 10165 2567
(c) Borrowings and other liabilities $ 26259 118816 140955 145072 123272 125794 146435 142573 126912 133287 326515
5. Capital expenditure 24756 47754 60842 74535** 109129** 113923** 66362 68778 118238 92766 97507
6. Total expenditure
[2+5=6(a)+6(b)] of which 98272 325592 362310 413248 471203 498252 505738 583387 712732 750884 900953
(a) Plan expenditure 28365 82669 101194 111470 122280 132292 140638 169860 205082 243386 282957
(b) Primary deficit investment 9750 –3453 –2685 –11339 348923 365960 365100 413527 507650 507498 617996
7. Fiscal deficit [6–1–4(a)–4(b)] 37606 118816 140955 145072 123272 125794 146435 142573 126912 133287 326515
8. Primary deficit [7–2(8)=(a)+8(b)] 16108 19502 33495 27268 –816 –1140 13805 –7699 –44118 –57520 133821
(a) Primary deficit consumption 6358 22955 36180 38607 25037 –275 250 –28557 –75870 –91731 89256
(b) Primary deficit investment 9750 –3453 –2685 –11339 –25853 –865 13555 20858 31752 34211 44565
(As Per Cent of GDP)

1. Revenue receipts (a+b) 9.7 9.1 8.8 9.4 9.6 9.7 9.7 10.5 11.5 11.3 10.6
(a) Tax revenue (net of states’ share) 7.6 6.5 5.9 6.5 6.8 7.1 7.5 8.5 9.3 9.5 8.8
(b) Non-tax revenue 2.1 2.7 3.0 3.0 2.8 2.6 2.1 2.0 2.2 1.8 1.8
PUBLIC ECONOMICS IN INDIA
1990-91 2000-01 2001-02 2002-03 2003-04 2004-05 2005-06 2006-07 2007-08 2008-09 2008-09
(B.E.) (R.E.)
2. Revenue expenditure 12.9 13.2 13.2 13.8 13.1 12.2 12.2 12.5 12.6 12.4 15.4
3. Revenue deficit (2–1) 3.3 4.0 4.4 4.4 3.6 2.5 2.6 1.9 1.1 1.0 4.5
4. Capital receipts (a+b+c) 5.6 6.3 7.1 7.4 7.5 6.1 4.4 3.6 3.6 2.8 6.4
(a) Recovery of loans* 1.0 0.6 0.7 1.4 2.4 2.0 0.3 0.1 0.1 0.1 0.2
(b) Other receipts (mainly PSU
disinvestment) 0.0 0.1 0.2 0.1 0.6 0.1 0.0 0.0 0.8 0.2 0.0
(c) Borrowings and other liabilities $ 4.6 5.6 6.2 5.9 4.5 4.0 4.1 3.5 2.7 2.5 6.1
5. Capital expenditure 4.4 2.3 2.7 3.0 4.0 3.6 1.9 1.7 2.5 1.7 1.8
6. Total expenditure
INDIAN PUBLIC FINANCES
[2+5=6(a)+6(b)] of which 17.3 15.4 15.9 16.9 17.1 15.8 14.1 14.1 15.1 14.1 16.9
(a) Plan expenditure 5.0 3.9 4.4 4.6 4.4 4.2 3.9 4.1 4.3 4.6 5.3
(b) Non-plan expenditure 12.3 11.5 11.4 12.3 12.7 11.6 10.2 10.0 10.7 9.5 11.6
7. Fiscal deficit [6–1–4(a)–4(b)] 6.6 5.6 6.2 5.9 4.5 4.0 4.1 3.5 2.7 2.5 6.1
8. Primary deficit [7–2(8)=(a)+8(b)] 2.8 0.9 1.5 1.1 0.0 0.0 0.4 –0.2 –0.9 –1.1 2.5
(a) Primary deficit consumption 1.1 1.1 1.6 1.6 0.9 0.0 0.0 –0.7 –1.6 –1.7 1.7
(b) Primary deficit investment 1.7 –0.2 –0.1 –0.5 –0.9 0.0 0.4 0.5 0.7 0.6 0.8
Memorandum items
(a) Interest receipts 8730 32811 35538 37622 385338 32387 22032 22524 21060 19135 19036
(b) Dividend and profit 564 4225 7940 10910 12326 15934 18549 18969 21531 24758 21641
(c) Non-plan revenue expenditure 60896 226762 23811 267144 283436 296835 327518 372191 420922 448351 561790
** Includes repayment to National Small Savings Fund.

Note:
The figures may not add up to the total because of rounding approximations.
Primary deficit consumption=Revenue deficit–interest payments+interest receipts+dividend and profits.
Primary deficit investment=capital expenditure–interest receipts–dividend and profits–recovery of loans–other receipts.
Figures are exclusive of the transfer of state’s share in the small savings collections.
Source: Economic Survey, 2005-2006 and 2009-10.
485
9.7 per cent in 1990-91), yet the actual figures might believe
this achievement. The failures on revenue mobilization front
are mainly due to shortfall from tax collection. As far as non-
tax sources are concerned, these appear to perform better than
tax resources.
It is unfortunate that the revenue expenditure of the Central
Government has as always been more than revenue receipts,
with the result that revenue deficit has been on the rise.
Expenditure on interest payments and major subsidies are the
main villain of revenue deficit. Further, capital receipts of
the Central Government have almost been more than capital
expenditure, which may have serious implications for social
sector and privatization of the economy. Then of the total
expenditure, plan expenditure is the major casualty, because
non-plan expenditure, being committed in nature, will have to
be incurred.
Coming to the sources of tax revenue of the Central
Government (Table 10.8). The most healthy feature of the
Central Government tax structure has been the shift from indirect
taxes to direct taxes. Direct taxes constituted only 19.1 per cent
of total tax revenue in 1990-91. But it has been consistently on
the rise and has crossed the 40 per cent limit and is expected to
touch the magic figure of 50 per cent. In case of indirect taxes
under the pressure of globalization, the excise duty and
customs-GDP ratios have been on the decline. But service tax
has been emerging as a major source of revenue.
REFORMS IN DIRECT TAXES: NEW DIRECT TAX CODE (DTC)

The main aim of DTC is to eliminate distortions in the tax
structure, introduce moderate levels of taxation, expand the tax
base, improve tax compliance, simplify the language and lower
tax litigations. Thus, the introduction of DTC with effect from
1 April 2010 will be a milestone in the area of fiscal reforms in
general and direct tax reforms in particular.
New DTC is a welcome step because the existing Income
Tax Act, 1961, with over 3300 amendments, has become
outdated. Therefore, in order to ensure simplicity and
transparency, some fundamental changes are urgently required
Table 10.8: Sources of Tax Revenue (` Crore)
1990-91 2000-01 2001-02 2002-03 2003-04 2004-05 2005-06 2006-07 2007-08 2008-09 2008-09
Actuals Actuals Actuals Actuals Actuals (B.E.) (R.E.)
Direct (a) tax 11024 33563 69197 83085 105082 132181 165202 219722 295938 365000 345000
Personal income 5371 15592 32004 36866 41379 49268 63629 75093 102644 138314 122600
Corporation tax 5335 16487 36609 46172 63562 82680 101277 144318 192911 226361 222000
Indirect (b) 45158 76806 116125 131284 147294 170936 199348 241538 279031 321264 281359
Customs 20644 35757 40268 44852 48629 57611 65067 86327 104119 118930 108000
INDIAN PUBLIC FINANCES
Excise 24514 40187 72555 82310 90774 99125 111226 117613 123611 137874 108359
Service tax 0 862 3302 4122 7891 14200 23055 37598 51301 64460 65000
Gross tax revenue# 57576 111224 187060 216266 254348 304958 366151 473512 593147 687715 627949
Percentages
Direct (a) 19.1 30.2 37.0 38.4 41.3 43.3 45.1 46.4 49.9 53.1 54.9
Personal income tax 9.3 14.0 17.1 17.0 16.3 16.2 17.4 15.9 17.3 20.1 19.5
Corporation tax 9.3 14.8 19.6 21.3 25.0 27.1 27.7 30.5 32.5 32.9 35.4
Indirect (b) 78.4 69.1 62.1 60.7 57.9 56.1 54.4 51.0 47.0 46.7 44.8
Customs 35.9 32.1 21.5 20.7 19.1 18.9 17.8 18.2 17.6 17.3 17.2
Excise 42.6 36.1 38.8 38.1 35.7 32.5 30.4 24.8 20.8 20.0 17.3
Service tax 0.0 0.8 1.8 1.9 3.1 4.7 6.3 7.9 8.6 9. 4 10.4
(Contd...)
487
1990-91 2000-01 2001-02 2002-03 2003-04 2004-05 2005-06 2006-07 2007-08 2008-09 2008-09
488
Actuals Actuals Actuals Actuals Actuals Actuals (B.E.) (R.E.)

Percentages to GDP
Direct (a) 1.9 2.8 3.0 3.4 3.8 4.2 4.6 5.3 6.3 6.9 6.5
Personal income tax 0.9 1.3 1.4 1.5 1.5 1.6 1.8 1.8 2.2 2.6 2.3
Corporation tax 0.9 0.9 1.6 1.9 2.3 2.6 2.8 3.5 4.1 4.3 4.2
Indirect (b) 7.9 7.9 5.1 5.4 5.3 5.4 5.6 5.8 5.9 6.0 5.3
Customs 3.6 3.0 1.8 1.8 1.8 1.8 1.8 2.1 2.2 2.2 2.0
Excise 4.3 3.4 3.2 3.4 3.3 3.1 3.1 2.8 2.6 2.6 2.0
Service tax 1.0 0.1 0.1 0.2 0.3 0.5 0.6 0.9 1.1 1.2 1.2
Total# 10.1 9.4 8.2 8.8 9.2 9.7 10.2 11.5 12.6 12.9 11.8
@Provisional and unaudited as reported by Controller General of Accounts, Department of Expenditure, Ministry of Finance.
#Includes taxes referred in (a) and (b) and taxes of Union Territories and “other” taxes.
. Refers to gross domestic product at current market prices.
Note:
1. Direct taxes also includes taxes pertaining to expenditure, interest, wealth, gift and estate duty.
2. The ratios to GDP for 2005-06 (B.E.) based on CSO’s Advance Estimates. GDP at current market prices prior to 1999-2000 based
on 1993-94 series and from 1999-2000 based on new 1999-2000 series.
Source: Economic Survey 2005-06 and 2008-09.
in our direct tax structure. There should be no loose threads in

the Direct Tax Laws, which can be misinterpreted leading to
unnecessary litigations because of the whimsical attitude of the
taxing authorities.
Our country is one of the highest taxed nations in the world.
More open and honest an employer is in terms of disclosing
remunerations, worse it is for the employees because taxable
income goes up. The present system thus rewards dishonesty
and non-disclosure of income by way of lower tax. The Direct
Tax Code will try to address these issues by significantly lowering
income tax and by disallowing all tax-free perks. It has proposed
exemption of income tax on specified savings up to ` 3 lakh a
year as against the present deduction limit of ` 1 lakh for all
types of savings under 80C of the IT Act. The budget 2010-11
raised the limit to ` 1.20 lakh including ` 20,000 in infrastructure
funds.
According to the DTC proposal, a taxpayer will pay tax at
the rate of 10 per cent for income above ` 1.60 lakh and up
to ` 10 lakh, at 20 per cent on income between ` 10 lakh and
` 25 lakh and at 30 per cent for income beyond ` 25 lakh.
Presently, while the basic exemption limit remains at
` 1.60 lakh a year, the limit for tax slabs are much lower—one
pays 10 per cent tax on income ranging between ` 1.60 lakh
and ` 3 lakh, 20 per cent between ` 3 lakh and ` 5 lakh and
30 per cent beyond ` 5 lakh. However, in the budget 2010-11
the respective limits are up to ` 5 lakh, ` 5-8 lakh and above
` 8 lakh respectively.
To ensure that there are not many avenues to avoid taxes,
therefore, as a rider, the Tax Code proposes to add all perquisites
enjoyed by a taxpayer to income for the purpose of tax
calculations. In other words, allowances like leave travel,
furnishings, entertainment expenses, conveyance, medical, etc.,
will be added to income.
Wealth Tax Benefits
The proposed Tax Code has sought to make major changes
in wealth tax calculations and rates also. The threshold limit
for wealth tax will be raised to ` 50 crore from the present
` 30 lakh and the tax rate reduced from 1 per cent to 0.25 per
cent. But in a smart move, to expand the scope of taxation the
Tax Code will include financial assets like shares, corporate
bonds, fixed deposits, etc. in wealth tax. The valuation of these
assets will be done at cost or at market price, whichever is
lower. In case of capital gains tax too, the Tax Code has proposed
some sweeping changes. It has done away with the present system
of short-term and long-term capital gain tax, and replaced it
with a uniform structure and the gains will be taxed at the
marginal tax rate as applicable to the taxpayer. The implications
of these changes are clear: The period of holding has no bearing
on the tax payable and bigger investors will be taxed at higher
rates than the smaller ones.
For the corporate world, the proposed reduction in the tax
rate to 25 per cent from the existing 30 per cent is certainly
good news and will help lowering the tax burden of India
companies in a big way. But at the same time the Tax Code
proposes to do away with many exemptions that help lowering
the tax. In a significant policy change, the Tax Code plans to
discontinue all profit linked incentives for area-based investments
like setting up plants in a backward area or in the north-east
with investment-linked incentives in specific sectors like
infrastructure, power, exploration and oil production, etc.
Moreover, under the new proposal, tax holiday will not be for
a specific period, as is the case now, but will be equal to all
capital and revenue expenditure barring land, goodwill and debts.
Once a firm recovers the permitted investments, profits will be
taxed. This change is aimed at incentivising capital formation
in critical areas and remove incentives to shift profits from the
taxable unit to the exempted unit.
On the MAT
The Tax Code has also proposed changes in the calculation
of minimum alternate tax (MAT) payable by the corporate.
MAT will now be levied at 2 per cent of the value of gross
assets of a firm in case of all companies except for banks which
will pay tax at 0.25 per cent. This shift in MAT from book
profits to gross assets is aimed at encouraging optimal utilisation
and increased efficiency of assets.
Carrot and Stick

If the Tax Code is generous in giving relief to taxpayers, it
will also make life miserable for those who evade tax through
fraudulent means. As the Tax Code prescribes stiff penalties
and prosecution for non-compliance with the tax laws, it
proposes that every tax offense under the Code will be punishable
by both imprisonment and fine.
Apart from defaulters, the Tax Code proposes to punish tax
consultants who help in tax evasion. It gives sweeping powers
and blanket protection to Income Tax officials for initiating
court proceedings on matters relating to tax offences.
FINANCES OF STATE GOVERNMENTS16

The finances of State Governments traditionally follow a
pattern similar to that of the Centre, albeit with a lag. Recently
with states’ own tax receipts stagnant at around 5-6 per cent of
GDP and declining transfers from Centre on the one hand and
high level of growth of total disbursement (around 15-19 per
cent of GDP) on the other, the deterioration in revenue and
fiscal deficits could not be reversed significantly. As a proportion
of GDP, revenue deficit of the states shot up from 0.9 per cent
of GDP in 1990-91 to 2.5 per cent in 2000-01 (Table 10.9). The
proportion declined to 2.2 per cent in each of the two years
2002-03 and 2003-04 and is placed at 1.4 per cent in 2004-05.
Following the TFC award, which includes a quantum jump
in grants-in-aid, the position is budgeted to improve to
0.7 per cent of GDP in 2005-06. As a proportion of GDP, fiscal
deficit, after increasing from 3.3 per cent in 1990-91 to 4.5 per
cent in 2003-04, declined to 4.0 per cent in 2004-05. It is
budgeted at 3.1 per cent of GDP in 2005-06. The budgeted
revenue and fiscal deficit as proportion of GDP are very
proximate to the fiscal consolidation goals enunciated by the
TFC. The outstanding liabilities of states were ` 10,40,834 crore
(33.3 per cent of GDP) in 2004-05 and are placed at ` 11,52,530
crore (32.7 per cent of GDP) in 2005-06 (B.E.) (Table 10.10).
With the TFC’s debt consolidation and write-off scheme in place,
the position might improve further.17
Table 10.9: Receipts and Disbursements of State Government (` Crore)
492
1990-91 2001-02 2002-03 2003-04 2004-05 2005-06 2006-07 2007-08 2008-09

(B.E.) (R.E.)
I. Total receipts (A–B) 91,160 3,73,886 40,50,73 5,14,829 5,63,661 5,95,629 6,73,604 7,63,377 8,95,141
A. Revenue receipts (1–2) 66,467 2,55,675 2,80,339 3,09,187 3,63,513 4,31,022 5,30,555 6,28,742 7,19,835
1. Tax receipts of which State’s 44,586 1,80,312 1,98,798 2,21,115 2,60,577 3,06,332 3,72,841 4,41,526 5,09,957
own tax revenue 30,344 1,28,097 1,42,143 1,54,037 1,82,027 2,12,307 2,52,548 2,93,392 3,36,810
2. Non-tax receipts of which interest 21,881 75,363 81,541 88,072 1,02,936 1,24,690 1,57,714 1,87,216 2,09,878
receipts 2,403 9,205 9,502 7,748 8,648 9,380 11,825 13,041 12,686
B. Capital receipts of which 24,693 1,18,211 1,44,734 2,05,642 2,00,148 1,64,607 1,43,049 1,34,635 1,75,306
Recovery of loans and advances 1501 7,766 3,905 16,158 8,039 8,904 7,579 6,212 5,172
II. Total disbursements (a–b–c) 91,088 3,77,311 4,20,461 5,14,303 5,53,427 5,61,682 6,57,281 7,87,489 8,92,783
(a) Revenue 71,776 3,14,863 3,35,450 3,72,594 4,02,670 4,38,034 5,05,699 6,06,216 6,91,409
(b) Capital 13,556 50145 70,664 1,19,899 1,34,235 1,09,224 1,37,793 1,64,507 1,85,282
(c) Loans and advances 5,756 12,303 14,347 21,810 16,522 14,424 13,789 16,766 16,092
III. Revenue deficit 5,309 59,188 55,111 63,406 39,157 7,012 –24,856 –22,526 –28,426
IV. Gross fiscal deficit 18,797 95,994 1,02,123 1,20,631 1,07,774 90,084 77,508 1,07,958 1,12,653
(As Per Cent of GDP)

I. Total receipts (A–B) 16.0 16.4 17.4 18.7 17.9 16.6 16.3 16.2 16.8
A. Revenue receipts (1–2) 11.7 11.2 11.4 11.2 11.5 12.0 12.8 13.3 13.5
1. Tax receipts of which 7.8 7.9 8.1 8.0 8.3 8.5 9.0 9.3 9.6
state’s own tax revenue 5.3 5.6 5.8 5.6 5.8 5.9 6.1 6.2 6.3
2. Non-tax receipts of which 3.8 3.3 3.3 3.2 3.3 3.5 3.8 4.0 3.9
interest receipts 0.4 0.4 0.4 0.3 0.3 0.3 0.3 0.3 0.2
B. Capital receipts of which 4.3 5.2 5.9 7.5 6.4 4.6 3.5 2.9 3.3
Recovery of loans and advances 0.3 0.3 0.2 0.6 0.3 0.2 0.2 0.1 0.1
II. Total disbursements (a–b–c) 16.0 16.5 17.2 18.7 17.6 15.7 15.9 16.7 16.8
(a) Revenue 12.6 13.8 13.7 13.5 12.8 12.2 12.2 12.8 13.0
(b) Capital 2.4 2.2 2.9 4.4 4.3 3.0 3.3 3.5 3.5
(c) Loans and advances 1.0 0.5 0.6 0.8 0.5 0.4 0.3 0.4 0.3
III. Revenue deficit 0.9 2.6 2.2 2.3 1.2 0.2 –0.6 –0.5 –0.5
IV. Gross fiscal deficit 3.3 4.2 4.2 4.4 3.4 2.5 1.9 2.3 2.1
Note: The ratios to GDP for 2005-06 (B.E.) are based on CSO’s Advance Estimates. GDP at current market prices prior to 1999-2000 based on 1993-94 series and from 1999-
2000 based on new 1999-2000 series. Capital receipts (including public account) are on a net basis.
Capital disbursements exclude heads of public account.
Source: Economic Survey, 2005-06 and 2008-09.
While the most recent indicators of state finances show a

somewhat improved picture, the causative factors of fiscal
deterioration have to be addressed to sustain this progress and
keep the balance at the desired level. The causative factors are
growing burden of interest payment, pensions liabilities, losses
of state PSUs, lack of proper user charges, and lack of buoyancy
in taxes. With the successful introduction of VAT by 25 states/
UTs and the TFC’s incentive to enact state level FRBM
legislations, the deepening of state level reforms contributed to
the foundation of fiscal reform and their sustainability in the
states.
State Level Reforms
On the recommendation of the Eleventh Finance Commission
(EFC), Government of India implemented a scheme called the
‘States Fiscal Reforms Facility (2001-01 to 2004-05)’ to
incentivise the states to undertake fiscal reforms. Under this
scheme, which came to an end on March 31, 2005, all the
28 states had submitted their medium-term fiscal reforms
programme and all but Government of Goa entered into
memorandum of understanding with Government of India,
individually. As on March 31, 2005, an amount of ` 7,217
crore was released to states from incentive fund (Total fund
` 10,608 crore) on the basis of improvement in revenue deficit
as a proportion of revenue receipts. States (excluding NCT
Delhi), in aggregate, have registered an improvement of 17.95
percentage points in the ratio of revenue deficit to total revenue
receipts during EFC award period (2000-01 to 2004-05), over
the base year 1999-2000.
As per the latest information available for 2004-05 (pre-
Actual), some states, namely Bihar, Chhattisgarh, Jammu and
Kashmir, Karnataka, Madhya Pradesh, Manipur, Mizoram,
Nagaland and Sikkim, are expected to be revenue surplus. The
TFC discontinued this facility beyond March 31, 2005 and
suggested a debt consolidation and waiver scheme. The TFC’s
recommendations for restructuring public finances envisage a
positive growth dividend through fall in dissavings. The
major reform initiative that underpins the TFC award is this
recommendation for a debt consolidation and waiver scheme

for states linked to fiscal responsibility. Under the general debt
relief scheme applicable to all states during the award of the
TFC, all Central loans, contracted till March 31, 2004 and
outstanding as on March 31, 2005, get consolidated as loans
for a fresh period of 20 years payable in 20 equal annual
instalments at reduced interest rate of 7.5 per cent effective
from the year in which their FRBM legislation is enacted by the
states. TFC has estimated that this would benefit the states in
the entire period of its award through lower interest payments
of ` 21,276 crore and through relief on deferment of principal
repayment of ` 11,929 crore. A second scheme of debt write-off
under the TFC award linked to fiscal performance is calibrated
Table 10.10: Outstanding Liabilities of States
Year Total liabilities Col (2) as per cent

(` Crore) of GDPs
1 2 3
1990-91 128095 22.5
1991-92 146966 22.5
1992-93 168293 22.5
1993-94 187912 21.9
1994-95 217023 21.4
1995-96 250813 21.1
1996-97 286704 21.0
1997-98 336347 22.1
1998-99 397370 22.8
1999-2000 505009 25.0
2000-01 592743 28.1
2001-02 685474 30.0
2002-03 797684 32.6
2003-04 922263 33.4
2004-05 (R.E.) 1040834 33.3
2005-06 (R.E.) 1152530 32.7
# The ratios to GDP for 2005-06 (B.E.) are based on CSO’s Advance
Estimates. GDP at current market prices prior to 1999-2000, based on
1993-94 series and from 1999-2000 based on new 1999-2000 series.
Note: Total liabilities have been revised by broadening its composition to include
reserve funds, deposits and advances and contingency funds.
Source: Reserve Bank of India.
in a manner that incentivises a self-laid down fiscal correction

path on a year-on-year basis leading to elimination of revenue
deficit by 2008-09 and containing fiscal deficit.
Table 10.11: State Governments’ Revenue Deficit as a
Proportion of Total Revenue Receipts (RD/TTR)
1999-00 2000-01 2001-02 2002-03 2003-04 2004-05
RD/TTR 26.88 23.79 24.22 20.89 20.51 12.29
As on February 2, 2006, 18 State Governments had passed

their FRBM Acts and 13 states had drawn up their fiscal
correction path. States have also strived to explore all possibilities
of revenue generation, while at the same time trying to prioritize
their expenditure needs. A Central Monitoring Committee, set
up for the purpose, has recommended consolidation of Central
loans to 12 states, namely Andhra Pradesh, Assam, Haryana,
Chhattisgarh, Karnataka, Kerala, Madhya Pradesh,
Maharashtra, Manipur, Orissa, Rajasthan and Tamil Nadu.
Besides debt liability, there has been a significant increase in the
outstanding guarantees given by State Governments during
the past few years. However, to control the proliferation of
State Government guarantees, as per the latest information
available, nine states have imposed cap on guarantees—six
(Goa, Gujarat, Karnataka, Kerala, Sikkim and West Bengal)
of the statutory variety, and three (Assam, Orissa and Rajashtan)
of the administrative kind in pursuance of the accepted
recommendations of the TFC. External loans to State
Governments are now to be given on a back-to-back basis, i.e.
on the same terms and conditions (including interest rate maturity
commitment charges and foreign exchange variation-risk) as it
is received by the Central Government.
Value Added Tax (VAT)
Following the June 18, 2004 decision of the Empowered
Committee (EC) of State Finance Ministers to implement state-
level VAT from April 1, 2005. Twenty-five states/UTs had
introduced VAT to replace the sales tax by December 31, 2005.
Andaman & Nicobar Islands and Lakshadweep do not
have a sales tax. The eight states/UTs yet to introduce the
VAT are Chhattisgarh, Gujarat, Jharkhand, Madhya Pradesh,
Pondicherry, Rajasthan, Tamil Nadu and Uttar Pradesh. Since

sales tax/VAT is essentially a state subject, the Central
Government is playing the role of a facilitator for the successful
implementation of VAT. A formula has also been finalized in
consultation with the states for providing compensation to them,
during the first three years, for any loss on account of
introduction of VAT. Technical and financial support has also
been provided to the states for VAT computerization, publicity
and awareness and other related aspects. Despite the initial
transitional problems and lack of clarity, the implementation of
VAT has been smooth and the results encouraging. The EC
constantly review the progress and tries to sort out the difficulties.
The EC has advised the states to constantly interact with trade
and industry to remove their apprehensions, if any, and to ensure
that the benefits of VAT due to input tax credit and reduction
in tax rates (wherever applicable) are passed on to the consumers.
The EC is also persuading the remaining states/UTs to implement
VAT at the earliest.
The initial trend in revenue collection in the VAT
implementing states is quite encouraging. During the first
seven months of VAT implementation (April-October 2005),
the total revenue (provisional) for VAT implementing states
showed an increase of around 14.4 per cent, which is higher
than the compound annual growth rate of these states for the
last five years. Up to January 15, 2006, VAT compensation
claims for about ` 1,674 crore had been filed by eight states,
out of which claims for ` 1,317 crore had been settled. Based
on trends so far, the compensation liability for the year 2005-
06 is likely to be contained within BE. The non-implementation
of VAT by eight states/UTs is creating complications and may
also lead to undesirable diversion of trade and business from
one state to another. Further, the benefits of the VAT system
like simple and uniform tax structure all over the country and
achieving a common market for goods would not accrue until
all the states/UTs implement VAT. In view of this, it is imperative
that the remaining eight states/UTs also implement VAT at the
earliest. While the VAT Acts of the states follow a broadly
uniform pattern, there is a considerable amount of diversity in
the VAT rules and procedures. The internationally accepted

coding system is the harmonized system of commodity
description and coding (HS). While foreign trade and tariffs
associated are based on HS, VAT system is not. The EC is
looking into this issue of aligning the classification system of
VAT with HS.
With input tax credit being allowed in respect of locally
purchased inputs involved in inter-state transactions, the Central
Sales Tax (CST) reforms have already begun. However, the
CST is basically inconsistent with the concept of VAT and needs
to be phased out. In fact, it has already been decided, in principle,
to phase out the CST. But before doing that, it is essential that
the system of information exchange between the states, namely
TINXSYs, is put in place. Further, successful implementation
of CST reforms would require that all the states/UTs first
successfully implement the state-level VAT. Another critical issue
involved in phasing out CST is that of compensating the states,
particularly the developed states where a lot of inter-state sales
originate, for revenue losses on account of such a phase out.
During 2004-05, the total revenue collection from CST for all
states was around ` 15,100 crore. If CST is phased out, this
revenue will be permanently loss and, hence, their insistence on
a compensation mechanism on a permanent basis through
alternative taxation powers. The Empowered Committee is
deliberating on this issue. The EC is expected to finalize its
recommendations and place the same before the Central
Government, after which the Government of India will take an
appropriate decision.
Central Government in consultation with the Empowered
Committee of State Finance Ministers (Empowered Committee
of State Finance Ministers) chalked out the roadmap for phasing
out Central Sales Tax (CST) to coicide with the introduction of
the proposed GST, which included the critical component of
compensating the states for the resultant revenue lossess. The
scheme finalized in consultation with the Empowered Committee
of states provides for new revenue generating measures for states
as the primary source of compensation. It also provides for
meeting 100 per cent of the residuary lossess to a state, if any,
thereafter, through the budgetary resoruces of the Centre. An

amount of ` 5.979 crore has been released to the states till
December 31, 2009 in financial year 2009-10. A total amount
of ` 10,098 crore has been released to the states so far on
account of CST compensation claims of states for financial years
2007-08 and 2008-09.*
GST
In the Budget for 2007-08, an announcement was made to
the effect that GST would be introduced from April 1, 2010
and that the Empowered Committee of State Finance Minister
prepared to report on a model and road map for GST. The
comments of Governemnt of India on the proposed design of
GST (for greater details on GST see Chapter 9).
PUBLIC EXPENDITURE IN INDIA

Public expenditure is an essential part of the welfare states.
Since independence public expenditure has gained a significant
place in the country to pull the economy out of turmoils. Public
expenditure regulates the economic activities and helps to attain
the long-run and short-run objectives of economic development.
This is the reason that there is a continuous upward trend in
both revenue and expenditure of the Indian Government.
Actually, the government has been widening its activities in
social and economic spheres to bring economic growth as early
as possible. Even in the post-reform period public expenditure
on social sector has been on the rise. Government cannot leave
the provisions like education, medical and public health, social
security and poverty alleviation programmes in the hands of the
private sector.
Broadly, public expenditure in India can be classified into
two parts:
A. Expenditure on Revenue Account.
B. Expenditure on Capital Account.
* Economic Survey 2009-10.

A. Expenditure on Revenue Account of the Central Government

Generally, major heads of revenue expenditure are being
shown in the budget of the Cenral Government as defence
services, civil services, grants-in-aid, interest payments, fiscal
services and economic services. Revenue expenditure are
generally met out of the revenue receipts of the government like
tax revenue and non-tax sources. However, since eighties an
unhealthy trend has developed whereby even capital account
receipts like borrowings and disinvestment proceeds are used
for meeting revenue expenditure needs.
(a) Defence Expenditure. According to Adam Smith,
“Defence is more important than opulence.” Therefore,
it is the most important item in the case of every
government. For national wealth to save against
external aggression and internal disorder, defence
expenditure is a must. It is constantly increasing as the
modern warfare instruments are becoming costlier and
more sophisticated.
(b) Civil Services. Before Independence, the aim of the
government was the maintenance of law and order
whereas after Independence, it was sought to change
from “law and order state” to “welfare state”. Thus,
expenditure in this sector has been rising continuously.
It includes expenditure on general administration,
justice, election and on the Office of Comptroller and
Auditor General. Besides, other types of expenditure
are on Secretariat and attached offices of Ministries of
Education and Social Welfare, Health and Family
Welfare, etc.
(c) Grants-in-Aid to States. State Governments cannot work
properly without the help of Central Government as
the expenditures of State Governments have gone up
because of the fact that most of the welfare programmes
fall within the jurisdiction of the states, whereas all
elastic and growing sources of revenue rest with the
Central Government.
(d) Interest Payments. This includes expenditure on the
payment of interest on the outstanding debt. In the
recent years, these payments have shown the rising trend

on account of the fact that the government borrowed
extensively in the past, which has necessitated the
interest payment now.
(e) Fiscal Services. Collection of taxes and other duties
also entail huge public expenditure. Directorate of
Customs and Excise Duties, and Directorate of Income
Tax are the two major departments of the Central
Government involved in the collection of taxes.
(f) Economic Services. After Independence, it has become
the foremost need of the government to spend on
economic services to develop the economy at a rapid
speed. It includes the expenditure on Department of
Commerce, Shipping and Transport, Irrigation, Energy,
Chemicals and Fertiliser, Company Affairs and
Electronics, Industry, Agriculture, etc.
(B) Expenditure on Capital Account
Expenditure on capital account consists of expenditure for
the acquisition of assets such as land, buildings, machinery,
equipments, etc. Expenditure on renewals and repairs of
machinery, increase in foodgrain stocks and inventories,
commuted pensions, etc. also constitute capital account
expenditure.
Here, we must remember that revenue and capital account
expenditure is known as economic classification. As already
mentioned this economic classification can be converted into
economic and functional expenditure depending upon the break-
up of total expenditure into various functions like civil, fiscal,
economic, etc. performed by the government (Chapter 5).
A brief break-up of the data on total public expenditure
into revenue account and capital account is given in Table 10.12.
It may also be mentioned that public expenditure in India
sometimes is also divided into plan and non-plan expenditure
or development and non-developmental expenditure. This
has been explained under the heading, “Classification of Public
Expenditure” (Chapter 5).
Table 10.12: Break-up of Public Expenditure of the Central Government

(`. Crores)
Revenue Expenditure
Years Interest Major Defence Total* Capital Total
payments subsidies expenditure Expenditure
1990-91 21498 9581 10874 73516 24756 98272
1999-2000 90294 22678 35216 249078 48975 298053
2000-01 99314 25860 37238 277838 477754 325592
2001-02 107460 30447 38059 301468 60842 362310
2002-03 117804 40716 40709 339628 74534 414162
2003-04
(R.E.) 124261 43569 42597 362887 110628 474255
2004-05
(B.E.) 129500 42214 43517 385493 92336 477829
* This includes other revenue expenditure like salaries, pensions, goods and
services, etc.
Source: GOI, Economic Survey, 2004-05.
Expenditure Restructuring
In restructuring expenditures, there is need to make reference
to the basic objectives of government intervention in economic
activities, as also to the basic objectives for assignment
of responsibilities as between Central and sub-national
governments. It is also important to relate government
expenditures to outcomes in terms of the quality, reach and
impact of government services. This would be facilitated if
governments focus more on their primary responsibilities rather
than spreading resources thinly in many areas where the private
sector can provide the necessary services. The primary role of
government is to provide public goods like defence, law and
order and general administration. This represents one kind of
market failure. The role of governments extends to merit goods
and services with large positive externalities like education and
health. The services should be assigned to the State Government
if the scope of public goods is limited to regions or if externalities
are more local in character like the health services. Admittedly,
there may be many examples of benefit spillovers, some of which
can be internalized to the state level decision-makers by a suitable
scheme of grants. There is a felt need to examine whether the
Central Government is not partaking in many responsibilities

that legitimately belong to the domain of the states. Governments
at both levels have also stepped into the provision of many
private goods, which adversely affects the quantum and quality
of service in regard to public and merit goods. Two key elements
of restructuring government expenditure relate to public-private
partnership in providing infrastructure and a reduction of
Central Government’s expenditures on subjects listed as state
responsibilities.18
From Expenditure to Outcomes
The conventional budget exercises have focused on allocation
of resources to different heads, without taking into account
how these government expenditures get translated into outputs
and outcomes. Outputs are the direct result of government
expenditure and outcomes are the final results. Thus, in the
context of education, opening a new school or appointing a
new teacher is an output and reduction in the rate of illiteracy is
an outcome. Issues of efficiency require consideration whether
the same outcome can be achieved at lower costs and whether
the same costs can produce better outcomes. A critical part of
budgetary reforms must include information on the relationship
between expenditures and the corresponding performance in
producing real results. As in the past, there have been attempts
at introducing performance budgeting; such endeavours have
receded in importance. There is need to bring back performance
budgeting as an integral part of the preparation and evaluation
of budgets, both for the Centre and the states. Thus, the
management of public expenditures should be guided by
economy, efficiency and effectiveness.
According to Kelkar Committee Report, the broad strategy
for expenditure reforms may be summarized as comprising four
elements.19
1. Public Goods versus Subsidies. A greater portion of
expenditure needs to devoted to legitimate public goods, as
opposed to transfers and subsidies. The plan versus non-plan or
the capital versus revenue classifications need to be re-examined
in this light.
2. Central versus Local Public Goods. In the spirit of the

73rd Amendment, resources that are used for the production of
local public goods such as water, sanitation, and primary
education, should be transferred to Panchayati Raj Institutions,
who have better incentive to spend effectively, and have better
knowledge about local preferences, local problems and
alternative production technologies.
3. Focus on Public Goods Outcomes. The public finance
system in India has traditionally focused on expenditure. There
is a need for a greater focus on public goods outcomes.
4. Improvements in Institutional Mechanisms. The provision
of public goods can often be achieved more effectively through
the use of the private sector in production. The role of public-
private partnership needs to be extended into a broader range
of public goods.
GROWTH IN PUBLIC DEBT: CENTRE AND STATES20

The combined debt-GDP ratio of the Central and State
Governments at the end of 2002-03 was about 76 per cent of
GDP, subject to some qualifications. First, the government budget
documents give the Centre’s external debt as evaluated at the
historical exchange rates, i.e. exchange rates in the years in
which the debt was incurred. Since the exchange rate has
depreciated over the years, it makes a difference if external debt
is evaluated at the current exchange rates. This difference was
as large as nearly 11 per cent in 1991-92. However, over the
years, this difference has steadily come down. In 2002-03, if
external debt is evaluated at the current exchange rates, about
5.6 per cent would need to be added to the debt-GDP ratio in
2002-03 to 81.6 per cent. The second qualification is that in
accounting for the liabilities of the State Governments, certain
liabilities of reserve funds and deposits are not included. In
2002-03, about 3.4 percentage points of GDP needs to be added
on this account, taking the overall debt-GDP ratio to 85 per
cent. These figures do not include contingent liabilities, which
amount to more than 11 per cent of GDP.
Even if we focus on the more conventional budgetary figure
of debt without these qualifications, it is striking how the growth
in debt-GDP ratio has accelerated since 1996-97 when it was

56.3 per cent, which was only marginally above the EFC’s
stipulated target. During the period of 1995-96 to 2002-03, the
combined debt-GDP ratio rose from 56.3 per cent to 76 per
cent in 2002-03, i.e. an increase of a little less than 20 percentage
points in a span of 6 years. This is an unprecedented increase in
the growth of the debt-GDP ratio in such a short span of time.
One way of looking at the source of increase in the debt-GDP
ratio during this period is to decompose the increase in terms
of the contribution of cumulated primary deficits and that of
the differential between growth and interest rate. For three
consecutive years, viz. 2000-01, 2001-02 and 2002-03, the
nominal growth rate fell below the effective interest rate. In
these years, instead of absorbing the impact of primary deficits,
the growth-interest differential, being negative, worked in the
reverse by adding to the debt-GDP ratio. For the period
1996-97 to 2002-03, therefore, the excess of growth over interest
could not absorb any part of the impact of cumulated primary
deficits, the benefit in the first three years being negated by the
opposite effect in the later three years. The entire increase,
therefore, was due to accumulation of primary deficits, which
remained unabsorbed by any excess of growth over interest
rates.
High levels of debt-GDP ratio result in high interest payments
relative to revenue receipts. Since interest payments are
committed expenditures, revenue deficits are bound to increase
when revenue receipts to GDP ratios remain sluggish. This has
the effect of lowering the saving rate on the one hand and
increasing the fiscal deficit on the other to maintain primary
expenditures. Eventually, these changes have the potential of
developing into a spiral of rising fiscal deficit. This gives rise to
the issue of sustainability of debt.
Government debt is the outcome of accumulation of
borrowings which are used to finance fiscal deficits. If the revenue
account is balanced, the entire fiscal deficit would be spent on
capital expenditures. Such investment can provide direct as well
as indirect returns. The direct returns are in the form of interest
receipts or dividends. The indirect returns are in the form of
returns when government investment stimulates growth, which

also results in higher revenue receipts. Debt becomes a problem
when the increase in revenue receipts, whether direct or indirect,
is not adequate to cover the interest liabilities that are required
to service the debt. When large interest payments, remaining
uncovered by an increase in revenue receipts, result in growing
revenue deficits, the portion of fiscal deficit that is used for
revenue expenditures becomes progressively larger and any
revenue increases linked with increased expenditures remain
small. Eventually, debt becomes unsustainable and the country
is said to have entered the stage of debt trap.
Does India Face a Debt Trap?
If we examine the breakdown of public debt into internal
and external the country seems to be in comfortable position as
far as the external debt is concerned.
For example, the external public debt of India was $ 101.97
billion in September 2002 which amounted to 20.1 per cent of
the GDP. The debt servicing burden was 13.8 per cent of current
receipts in 2001-02. This is a comfortable position when
compared to countries which have run into debt problems. The
component of short-term debt too has been declining, easing
the repayment schedule. The external balance has significantly
improved and foreign exchange reserves are now nearly more
than $ 150 billion or for more than one year import requirements.
After 24 years there was a current account surplus in 2001-02.
In fact, India has recently become a creditor to the International
Monetary Fund. According to all indicators, India does not have
any problem with its external public debt. This has been
recognized even by credit rating agencies. But it should be
mentioned here that India has already entered a debt-trap like
situation in 1991, when it accepted the conditional loans from
the IMF and World Bank.* However, the country’s internal
public debt presents a different picture.
A continuous and sharp rise in budgetary deficit
and consequently internal public debt poses a serious problem.
* For detail analysis, see the section on ‘Fiscal Crisis of 1991 and Fiscal
Sector Reforms’ in this Chapter.
The size of the Central Government’s debt was ` 2,865 crore

at the end of 1950-51, ` 1,021,029 crore in 1999-2000
and an estimated ` 17,80,063 crore in 2003-04. Adding
State Government borrowing, the total debt may exceed the
GDP.
The combined budget deficit of the Central and State
Governments is more than 10 per cent of the GDP.
The debt servicing bill of the Centre in 2003-04 was
` 2,88,599 crore and out this, interest payments took away
50 per cent of the revenues.
A major part of the borrowings go to meet current
consumption expenditure such as salaries, pensions and interest
payments and do not add to capital assets. This is due to poor
revenue collections which are inadequate to cover even routine
expenditure.
The combined tax-GDP ratio of the Centre and states shows
a declining trend from 16 per cent in 1999-2000 to an estimated
14 per cent in 2005-06, though some improvements were
expected in 2006-07.
It is true that the government has not so far defaulted on
any of its payment obligations. But the threat of a debt trap is
to be examined over the medium and longer time span. All the
indicators reveal a trend of growing mismatch between revenue
and expenditure and the resultant mismatch between increase
in fiscal deficits and the capacity to service the growing debts
without jeopardising growth. If the present sluggishness in
revenue mobilization and uncontrolled, unproductive and
inefficient spending continue, public debt is likely to pose a
problem in the medium term. However, the country can still
avoid such a contingency if it acts now to correct the fundamental
weaknesses in the fiscal policy and management. The recently
enacted Fiscal Responsibility and Budget Management Act
provides an opportunity to address these issues..
FISCAL CRISIS OF 1991 AND THE FISCAL SECTOR REFORMS21

The Structural Adjustment Programme (SAP) or New
Economic Policy Reforms (NEP) were adopted in 1991 in
response to a severe, unprecedented crisis in the Indian economy.

It was considered basically an external payments crisis. The
crisis was reflected in the loss of international investor-financier
confidence as India was put on credit watch by several rating
agencies. It became more difficult to borrow from the
international markets. There was a sharp decline in the foreign
exchange reserves, which despite sizeable borrowing from the
IMF and World Bank, touched a low of ` 3,414 crore in 1991-
92 which was barely equal to the import bill for less than a
fortnight. The drying up of commercial loans in 1990-91 was
accompanied by a net outflow of NRI deposits which began in
October 1990 and was reversed only in January 1992. It was
officially recognized that this crisis was not however, due simply
to a deterioration in the trade account, it was accompanied by
other adverse developments on the capital account.
As a result of large scale withdrawal of NRI deposits and
fall in remittances, the reduced surplus on the invisible account
was no longer able to meet India’s huge trade deficit. The outflow
of Foreign Currency Non-Resident (FCNR) deposits increased
from $ 59 million a month in October-December 1990 to
$ 76 million in January-March 1991 and $ 310 million in April-
June 1991. The Indian exporters were delaying the bringing in
of their receipts in expectation of a devaluation. As much as 30
to 40 per cent of India’s export earnings during the 1980s had
to be earmarked for debt-servicing, while India’s exports were
able to pay for just a little over 65 per cent of the import bill
during 1985-90. In such a situation as fresh borrowing had
dried up, India seemed to be heading “for the first time in our
history towards default on debt servicing in June 1991”. This
was considered at the government level an unmitigated disaster
as it was believed that its ramifications are never confined to
debt alone, leading to a breakdown in credit availability, severe
trade disruption and severe and prolonged import compression
which results in shortages and industrial dislocation and in
very high inflation. Clearly, efforts and methods of avoiding
the dreaded default received a high priority for Indian
economic management of continued borrowing from the rest of
the world.
Related to the BOP crisis India faced a huge fiscal deficit

including a large and growing component of deficit on the
revenue account.* It disturbed the macroeconomic balance and
crippled state capability to lead and manage the economy. This
trend became stronger during mid-1980s and continued unabated
as the liberalized, debt-financed growth processes were
continued. By 1990-91, the combined fiscal deficit of the Union
and states became 10.1 per cent of GDP and the level of the
former was 8.2 per cent. Under these conditions, price stability
was seriously undermined and while the wholesale price index
increased by 12.1 per cent in 1990-91, the consumer price index
increased at even faster rate of 13.6 per cent. The price situation,
eroding people’s purchasing power, was putting pressure on the
macroeconomic stability, public finance and external balance
and also posing a political threat to the government.
Faced with this three-pronged crisis, the government went
in for frequent borrowing accommodation and withdrawals from
the IMF aggregating to $ 4366 million or ` 9423 crore during
July-September 1990 and March 1992. These borrowings
involved the acceptance by the Indian Government of the IMF
conditionalities, which have broadly been defined as the idea
that international public resources should be used to induce
policy reform. It is implied that under this kind of policy lending
the international institutions have the “ownership of policies”.
They make the crisis of default-facing countries dependent on
continued, growing borrowing to accept these policies. In any
case two major lendings by the IMF to India during the 1980s
had already made India “dependent on high conditionality
borrowing”.
There were some other attendant developments in early
1990s, which exacerbated the crisis syndrome. One is the political
instability at the Union Government level. There was a short-
lived minority government, which was followed by a hung
parliament leading to another minority government in which
both the Prime Minister and the Finance Minister were elected
* For the definition of terms ‘Fiscal Deficit’ and ‘Revenue Deficit’, see
Chapter 8.
to Parliament after assuming office. Then the imports of

petroleum products increased from an average of ` 499 crores
per month in June-August 1990 to ` 1221 crore per month
during the rest of 1990. This was in part owing to a sharp rise
in world oil prices following the Gulf Crisis. Meanwhile the
Soviet collapse removed both a sizeable export market and an
ideological prop of the Indian variant of statism. With a sharp
fall in the foreign exchange reserves, “emergency action” was
mounted to prevent default. The government sold in May 1991,
20 tonnes of gold abroad with an option to repurchase it after
six months. In July 1991, another 47 tonnes of gold was shipped
to Bank of England in order to raise $ 600 million. In view of
this type of factors, along with the poor prospects for the growth
of India’s exports and adverse global economic circumstances
facing India, India’s credit rating was lowered to BA2 in
December 1991 and did not change even up to 1994. The
external imbalance and crisis have to be seen in the context of
the continuous rise in both trade deficit and current account
deficit after 1988-89, the disappearance of the cushion of net
invisible earnings and increasing the role of external borrowing.
But the composition and terms and conditions of external
borrowings also contributed to the intensification of the external
liquidity crisis. The proportion of short-term loans to long-term
loans has reached a very high level during the 1980s, especially
in the later half it ranged between 27 per cent and 54 per cent.
Similarly, the ratio of undisbursed private debt to disbursed
private debt during the period 1985-86 to 1989-90 ranged
between 326 per cent to 382 per cent. In addition, interest
chargeable went up following her downgrading by the credit
rating agencies. So much so that India borrowed from abroad
on variable rates of interest as well. Then a good deal of
borrowing was done without regard to the impact of this
borrowing on the borrower’s capacity to repay. As Bimal Jalan,
the former RBI Governor, brings out that, “External commercial
borrowings were permitted liberally to meet foreign exchange
requirements of capital intensive investment. Commercial
borrowings became a substitute for domestic savings to finance
low productivity in investment, with a low export-potential in
public and private sector.” Clearly, export earnings inadequate

to finance imports could hardly provide any means of debt-
servicing and necessitated further borrowings. Thus, India clearly
entered a debt-trap.
These indeed were some really daunting difficulties. The
need for continued borrowing was so intense that default would
have made the perennially foreign exchange deficient Indian
economy face large scale dislocation. More or less inelastic
import demand for energy, raw material components, equipment,
technology, etc. limited the options available to India. Thus,
re-opening the blocked channels of borrowing and re-established
the ability to borrow became the major concern of the
government. However, it may be noted that the default is as
much a matter of concern to the borrowers as it is to lenders, in
the sense that the contagion of default spreads and disrupts
both financial and real economy in the latter countries as well.
Thus, the recent experience of Russia, Indonessia, Argentina,
etc. discloses the lender too rush in to avoid/reduce the default
by rescheduling or fresh large lending with or without
conditionality. The question basically boils down to on what
terms and who is able to extract what price for the mutually
beneficial act to avoiding large scale disruption of international
financial markets. The Indian authorities seem to have
overlooked this concern and anxiety of the lenders. India accepted
in haste the conditionalities of IMF and World Bank and adopted
the New Economic Policy (NEP).
Now Coming to Specific Factors which Led to the Fiscal Crisis
As already stated the fiscal deterioration had started in 1990
with inadequate nature of tax receipts and almost nil return
from public sector investments. However, fiscal consolidations
after a promising beginning in the early 1990, started faltering
from 1997-98. Fiscal deficit of the Central Government as a
proportion of Gross Domestic Product, after its decline from
6.6 per cent in 1990-91 to 4.1 per cent in 1996-97, rose every
year to reach 6.2 per cent in 2001-02. Progress in fiscal
consolidation resumed in 2002. According to provisional data,
in 2003-04, the ratio of fiscal deficit at 4.6 per cent was lower
than the budget estimate of 5.6 per cent. A further improvement

in this ratio to 4.4 per cent was budgeted for 2004-05.
The fiscal deficit during the 2004-05 period stood at a
whopping sum of ` 1,51,144 crores, i.e. 4.4 per cent of the
Gross Domestic Product as on March 2005. The curve has risen
sharply from the year 1997-98 and assumed uncontrollable
proportions. All economic experts including World Bank,
International Monetary Fund, Moody’s Standard & Poor’s, Fiscal
Commission and the Reserve Bank of India agree that high
fiscal deficit lowers growth. The government also believes so
and, therefore, the Parliament adopted the Fiscal Regulation
and Budget Management (FRBM) Act in July 2004 which
requires the government to try and lower revenue deficit to
zero and fiscal deficit to 3.0 per cent by progressively reducing
revenue deficit every year by 0.5 per cent and fiscal deficit by
0.3 per cent. However, the 2005-06 budget fell short of FRBM
requirement. The revenue deficit remained static at 2.7 per cent,
though fiscal deficit declined by 0.3 per cent.
Revenue Deficit at the Centre
After witnessing a trend similar to that in fiscal deficit until
1996-97, the deterioration in revenue deficit was much sharper
in subsequent years. The rise in revenue deficit continued till
2001-02, when it reached 4.4 per cent of Gross Domestic
Product. Revenue deficit declined to 3.6 per cent of Gross
Domestic Product in 2003-04, but even at this level, it was
higher than the level of 3.3 per cent of Gross Domestic Product
observed in the pre-reform year of 1990-91. The increasing
share of revenue deficit in fiscal deficit distinctly reveals the
deterioration in the composition of the fiscal deficit and in the
quality of expenditure. The share of revenue deficit in fiscal
deficit had risen from 49.4 per cent in 1990-91 to 78.0 per cent
in 2003-04, which was sought to be reversed in 2004-05 by
targeting a lower revenue deficit of 2.5 per cent of Gross
Domestic Product in the Budget estimates.
The government had to borrow in order to finance current
expenditure which lead to an increase in public debt. Interest
payments swallow a major part of the tax revenue. Reduction
in revenue deficit increase national savings. When savings are

used for investment, it leads to increases in national income.
Fiscal Situation of States
The Gross Fiscal Deficit of states had not assumed alarming
proportion till 1989-90. The Gross Fiscal Deficit of states started
rising from 1990-91, especially for states like Bihar, Gujarat,
Andhra Pradesh, Karnataka, Maharashtra, Uttar Pradesh and
West Bengal. The rise was not sharp upto 1997-98 in most of
the states except in case of Andhra Pradesh, Madhya Pradesh
and Tamil Nadu where it doubled from ` 2,427.80 crore,
` 1,820.60 crore and ` 2,121.70 crore respectively in 1997-98
to ` 5,705.60 crore, ` 4,126.70 crore and ` 4,777.10 crore
respectively in 1998-99.
With the combined Gross Fiscal Deficit of states reaching
` 74,253.80 crore in 1989-99, the situation called for stringent
measures so that the Gross Fiscal Deficit of States is reduced,
and does not go beyond control. There was, in fact, a reduction
in the Gross Fiscal Deficit of states like Andhra Pradesh,
Haryana, Himachal Pradesh, Madhya Pradesh and Punjab from
1998-99 to 1999-2000. But the reduction was marginal and
was offset by an increase in other states to take the combined
figure from ` 74,253.80 crore to ` 91,480.30 crore in the said
years.
The current position of Gross Fiscal Deficit of states shows
an alarming situation. Uttar Pradesh and West Bengal show a
Gross Fiscal Deficit of ` 19,803.20 crore and ` 12,383 crore
respectively. Gujarat, Andhra Pradesh, Maharashtra, Karnataka
and Tamil Nadu continued to show a high Gross Fiscal Deficit.
Even rich states like Punjab and Haryana showed a rising trend
in their Gross Fiscal Deficit.
Primary Deficit of States
The primary deficit is the deficit which does not take
into account the interest liability. It would be pertinent to
mention that primary deficit of most of the states is not very
high. In the year 1995-96, only four Indian States, i.e.
Maharashtra, Rajasthan, Uttar Pradesh and West Bengal showed
a primary deficit of over ` 1,000 crore. Six Indian states,

i.e. Arunachal Pradesh, Bihar, Jammu & Kashmir, Punjab,
Tamil Nadu and Tripura had no primary deficit. The total
primary deficit of all the states was ` 9,493.20 crore in the said
year.
During the year 2003-04, the states of Haryana, Jammu &
Kashmir, Sikkim and Uttar Pradesh had a positive primary
deficit. The primary deficit in Gujarat, Karnataka, Rajasthan
and West Bengal was on the higher side. The combined primary
deficit of all the states was ` 33,255.40 crore.
It will be noted that the interest component in the gross
fiscal deficit is very high. Most of the states are unable to service
their debts. The situation calls for a strict fiscal discipline. The
states must find ways and means not to let the interest element
overburden their Gross Fiscal Deficit.
The average interest cost of states’ borrowings which was
9.2 per cent in 1990-91 rose to 13.3 per cent in 1999-2000. The
combined effect of growth in debt stock and rise in the cost of
borrowing has been the heavy burden of interest. If we calculate
the interest liability of all the states put together, we will find
that it has increased phenomenally during the last ten years—
from less than ` 9,000 crore to over ` 54,000 crore.
Revenue Deficit of States
The revenue deficit, which accounted for less than 30
per cent of the Gross Fiscal Deficit in the early 1990s, reached
a shocking 60 per cent of the Gross Fiscal Deficit by the year
1999-2000. This implied that out of every ` 100 borrowed ` 60
were being used for meeting current expenditure. The revenue
gaps are increasing and so too the gulf between expenditure
and revenue receipts. During the year 2004-05, the interest
payment accounted for more than 10 per cent of revenue receipts.
It was just 3 per cent in 1980.
Then there is no earnings from the PSUs in the states. In an
important study made by the Planning Commission on State
Public Sector Undertakings (SPSUs), it was pointed out that
more than 80 per cent of total SPSUs’ losses in 1988-89 were
shared by the states of Andhra Pradesh, Uttar Pradesh, West
Bengal, Tamil Nadu, Maharashtra, Karnataka, Gujarat, Kerala

and Delhi. States of West Bengal, Uttar Pradesh, Tamil Nadu,
Maharashtra, Orissa, Karnataka, Kerala, Andhra Pradesh and
Delhi account for 90 per cent of the accumulated losses. The
RBI Report 2003-04 also spoke with deep concern of the growing
interest burden, mounting pension liabilities, alarmingly high
increase in administrative expenditure and huge losses by the
SPSUs. The situation was reported to aggravate with very low
user charges and the progressive decline in Central transfers.
Factors Responsible for Fiscal Deficit
Fiscal deficit has resulted partly in response to external
pressure and natural disaster and partly due to policy measures
adopted by the government. The following paragraphs describe
the main causes of fiscal deficit.
(a) Government Policies
(i) Populist Measures. In the yearly Union Budgets, the
Finance Ministers are more concerned about providing a bit of
everything for everybody to please the public and satisfy their
alliance partners rather than following the prudent principles.
No efforts are being made to trim the bourgeoning fiscal deficit.
Fiscal deficit is broadly net borrowings by the government.
It may look harmless like borrowings by companies. But there
is a basic difference. Companies borrow to invest productively
and earn an income which would be more than the rate of
interest they have to pay, governments, on the other hand,
borrow mostly to fund consumption. Consequently, there are
no assets against and no income from the outlays. Interest
becomes a dead burden. To pay the interest, the governments
have to borrow once again. That is what has blown public debt
of the Centre and the states.
The problem affects the whole economy. The diversion of
public savings to government consumption reduces private
investment and consequently pulls down rate of growth. Had
the budgets been balanced, there would have been enough
resources for a 10 per cent growth instead of 7 to 8 per cent,
which would have generated more employment and improved

the income of the people further.
The real cause of the problem lies in the fact that the Central
and State Governments are more interested in populist measures
than any agenda for economic upliftment of the people. Such
measures block many already meager resource. Some examples
of populist schemes initiated by some State Governments are
enumerated below:
• Free power for farmers has been announced in Andhra
Pradesh, Tamil Nadu, Karnataka and Maharashtra.
Earlier, Punjab on many occasions had given free
electricity to farmers and to even certain sections of
the society. Haryana also followed suit for some time.
• The State Electricity Boards (SEBs) which were once
reeling under heavy debts of ` 40,000 crore, were
supposed to become solvent again when their debts
were partly written off and partly transferred to the
Centre. The Economic Survey, 2004-05 estimates that
the SEBs will lose another ` 21,700 crore this year,
thanks mainly to free supply of electricity to farmers
or supply at a nominal-rate.
• The government subsidies have been rising fast. The
rise in subsidy bill in 2002-03 and 2003-04 was on
account of higher allocation for food for work
programme to soften the adverse impact of drought on
the poor and small and marginal farmers. There was
also an enhanced coverage under the ‘Antyodya Anna
Yojana’ and other welfare schemes. The undulating
pattern observed in the subsidies arises primarily from
the expenditure on food subsidies, which is determined
increasingly by the minimum support price of food
grains, operational efficiency of the Public Distribution
System, highly subsidised welfare schemes and special
interventions in the drought affected areas. As a
proportion of total expenditure, after declining
from 12.4 per cent in 1991 to 7.5 per cent in 1995-96,
government subsidies maintained a rising trend till
1998-99 when it reached 9.02 per cent of the total

expenditure.
• The open-ended subsidy for LPG gas and kerosene could
exceed ` 10,000. An attempt to recoup some revenue
by raising the cooking gas prices by ` 5 every month
till subsidy was eliminated was rolled back when the
Left Front objected to it. It is the height of political
jugglery that the governments announce populist
measures to build a sizeable vote bank but when they
feel it necessary to take some necessary steps to
strengthen the economy or build up resources through
taxation or levies; the coalition parties dissuade them
from doing so showing their loyalty to masses.
• The Common Minimum Programme (CMP) of the
United Progressive Alliance (UPA) government promises
to increase education spending from 3.4 per cent of
Gross Domestic Product to 6 per cent of Gross Domestic
Product and health spending from 0.9 per cent to 3 per
cent of the Gross Domestic Product. The National
Employment Guarantee Programme which envisages a
minimum of hundred days employment to at least one
member in each family will cost the exchequer at least
one per cent of the Gross Domestic Product.
• The price of urea fertilizer is fixed by the government.
In order to ensure adequate availability of fertilizers to
farmers at reasonable rates, subsidy is provided by the
government. Urea, the most consumed fertilizer, is
subsidized under the New Urea Price Scheme (NUPS),
whereas potash and phosphate are decontrolled but
covered under the subsidy of ` 4,830 per metric tonne.
The existing scheme for special freight subsidy has been
continued for supplies to the north-eastern states and
Jammu & Kashmir.
(ii) Dependence of Agriculture on Weather and Agriculture
Insurance Scheme
• If the government goes ahead with the restructuring of
National Agricultural Insurance Scheme proposed by
the Agriculture Minister, it will have to shell out

` 2,000 crore to cover the subsidy component. An equal
amount will have to be set aside by the State
Governments which would share the burden of subsidy.
The amount of subsidy by the states will depend upon
the crops, the number of farmers and land acreage
covered under the scheme. The subsidy will have to be
made available to the Agriculture Insurance Company
of India which will underwrite the subsidy scheme and
cover the risks hundred per cent. The revamp of the
scheme has been pushed in the wake of 13 per cent
shortfall in rainfall during 2004-05 which affected the
growth of agriculture. The Economic Survey, 2004-05
has shown the growth in Agriculture and Allied Sector
at a meager 1.1 per cent during the year.
The experts, however, feel that instead of propping
agriculture, which is the mainstay of Indian economy, on
subsidies, we should develop it per se and make it as independent
of monsoons as far as possible.
Although populist measures are initiated with good
intentions, yet they may have dubious outcomes. The government
at the Centre should not resort to political jugglery of announcing
populist schemes near the elections in some states in order to
woo the voters in favour of their political parties. The State
Governments should not announce populist schemes with
political intentions ignoring the financial health of the state and
the adverse impact of such announcements.
For example, there is no need to give free-power to farmers
when such an act would push the State Electricity Boards
knee deep in the red. Such an act not only blocks a regular
revenue channel for the State Government but also leads to
misallocation of resources and makes it necessary to provide
for accumulated losses subsequently divesting the state of its
meager resources.
If the government is that serious about helping the farmers,
there are several other ways like developing adequate storage,
transportation and marketing facilities, setting up agro-industrial
units, freeing them from the stranglehold of private money-
lenders, facilitating research to develop high yielding varieties

of seeds, providing regular irrigation facilities and developing
allied activities in agriculture to supplement the income of the
farmers.
To conclude we can say that the fiscal deficits at the Centre
as well as in states have reached an alarming level. It is high
time that serious thought be given to curtail fiscal deficits by
following rational tax and non-tax measures, avoiding populist
measures, etc. Further, while increasing salaries in pursuance to
the recommendations of the Pay Commission, consideration
should also be paid to the productivity of the workers.
FISCAL CRISIS OF 2008-09

(GLOBAL MELTDOWN AND INDIAN ECONOMY)
We all know that fiscal crisis is harmful to the extent, it
reduces out our capability to spend public resources and improve
governance. So every government tries to control the fiscal crises.
Indian Present Situation
Thanks to the Global Crisis of finance, the fiscal monster
once again raised its ugly head in 2008. Like plummeting growth,
the fiscal worsening is also synchronised across the globe.
Slowing down of growth has shrunk revenues while the
unprecedested size of discretionary fiscal (prolonged in advance)
stimulus has bloated expenditure in most major economies. The
deterioration in government finances is more marked and
expected to be more prolonged in advance economies in
comparison with emerging countries. High deficit and debt levels
can crowd out private investment, reduce the fiscal latitude for
investment in human development and infrastructure and create
difficulties for the implementation of monetary policies. Once
economies across the globe begin to recover, the increased size
of the government is bound to crowd out private investment.
India embarked on a fiscal consolidation on a fiscal
consolidation programme in the early nineties and strengthen it
through Fiscal Responsibility and Budget Management Act
(FRBMA).
Despite the lack of expenditure reform, the sharp rise in

revenue buoyancy (aided by high growth, excellent corporate
performance and tax reforms) was enough to trigger a fast
steadily improving fiscal balances after 2003-04.
Indeed, the Central Government achieved the FRBM target
of a 3 per cent fiscal deficit in 2007-08, a year ahead of the
mandated. The more critical paramenter the revenue deficit,
however, could not be trimmed to zero and the debt-to-GDP
ratio continued to remain high.
All this got decisively reversed in reversed in 2008-09. The
fiscal deficit of the Central Government (including off budget
liabilities) touched 7.8 per cent of GDP as against the initial
target of 2.5 per cent.
The sharp and sudden worsening of India’s public finances
can be attributed to domestic developments as well as external
shocks.
On the domestic front, the implementations of the Sixth
Pay Commission report, the National Rural Employment
Guarantee Act, the farm loan waiver and various subsidies has
increased government expenditure.
The impact of global developments can be categorized in
two parts. The first was the commodity price shocks in the first
half of 2008-09. It resulted in a ballooning of the oil, fertiliser
and food subsidy bills.
The second shock came from the global financial crises. As
the crisis deepened and started affecting Indian’s real economy,
the government provided some fiscal stimulus by reducing
different taxes and duties and also by raising expenditures. The
FRBM targets were postponed to ensure the economy did not
have a very sharp contraction in growth.
The key issue was whether the current fiscal worsening was
temporary in nature or whether it was a structural and will
pressurise government finances over the medium-term.
This distinction was important as transitory factors would
correct themselves, but structural factors would have a lasting
impact on fiscal sustainability.
The fiscal stress due to the sharp global slowdown and its
impact on economic growth, the subsidy shock from the high
oil and commodity prices and the additional spending on the
fiscal stimulus could all the broadly classified as transitory in
nature they would self-correct when the cycle twins.
On the structural side, the key positive developments in the
last few years have been the disciplining impact of the FRBM
and the widening coverage of the services sector tax.
But the unformed subsidy regime and the persistence of
populist measures like the farm loan waiver and the structural
factor which accentuate the impact of cyclical factors, and make
the fiscal situation vulnerable.
Origin of Global Meltdown
To begin with it was the financial crisis that began in the
industrialised nations in the 2007 and spread to the real economy
across the world. Wall street in USA is worldwide known as the
largest financial market. It is old and the fourth largest investment
bank Lehman Brothers Holdings Inc. bust while Merrill Lynch,
famous for its iconic bull statue in the New York city financial
district, sold out before it was too late.
The troubles at Lehman and some other major investment
banks including at Merrill Lynch, were rooted in the sub-prime
crisis and were fairly well-known to the markets and the
regulators. However, the realisation that these two institutuions
were worse off than what was indicated by their public posturing
and disclosures dawned on them later. As their shares started
sinking, it became clear that some exceptional efforts employing
unconventional means were needed for the survival.
An extreme loss of market confidence was also responsible
for the downfall of Lehman, despite the last-minute efforts of
the US Treasury Secretary to work out an arrangement.
Even before the fact of major US investment bank Lehman
Brothers going bankrupt could be digested and its repercussions
fully understood, the market faced an even larger crisis that
loomed over America’s largest insurer of assets, American
International Group (AIG).
Quick on the heels of the announcement of the demise of

Lehman Brothers and the buyout of Merrill Lynch by Bank of
America, the news received was that Goldman Sachs and Morgan
Stanley will perforce have to become regulated banks. Goldman
Sachs and Morgan Stanley were granted approval on September
21, 2008, to become bank holding companies regulated by the
US Federal Reserve.
An eventful week of turmoil had begun in the global financial
scenario as share prices plunged across much of the globe on
news that investment bankers, Lehman Brothers Holdings had
filed for bankruptcy and Merrill Lynch’s forced sale to Bank of
America. To add to the worsening situation, AIG, the world’s
largest insurance company, asked the US Federal Reserve for an
emergency funding before announcing a major restructuring plan.
The severity of the crisis was such as no country was spared.
The advanced economies witnessed the biggest contraction in
60 years. The US economy shrunk by 1.5 per cent, the Euro
Zone by 2 per cent, and Japan by 2.5 per cent. Developing
countries, though more resilient than before also suffered.
The investment in Indian firms by some US investment
bankers was a major worry for Indian investors. Investor
confidence was at its lowest ebb. Investors worried that all these
was likely to trigger another round of troubles for banks and
fianacial institutions around the globe.
Impact on Indian Economy
The worldwide slowdown hit the key sectors of the Indian
economy and growth was expected to lower down to 5-7 per
cent or less in 2008-09.
The IMF in its recent update of the World Economic Outlook
forecasted that global economy would grow at just 0.5 per cent
in 2009, the slowest since the Second World War. The projected
rate was 1.7 percentage points lower than what the IMF had
forecasted in November 2008.
Reflecting the severe impact of the global meltdown, India’s
economic growth slumped significantly during 2008-09.
There was a significant slowdown in the growth rate in the

second half of 2008-09, following the financial crisis that began
in the industrialized nations in 2007 and spread to the real
economy across the world. The growth rate of the gross domestic
product (GDP) in 2008-09 was 6.7 per cent, with growth in the
last two quarters hovering around 6 per cent. There was
apprehension that this trend would persist for some time, as the
full impact of the economic slowdown in the developed world
worked through the system. It was also a year of reckoning for
the policymakers, who had taken a calculated risk in providing
substantial fiscal expansion to counter the negative fallout of
the global slowdown. Inevitably, India’s fiscal deficit increased
from the end of 2007-08, reaching 6.8 per cent (budget estimate,
BE) of GDP in 2009-10. A delayed and severely sub-normal
monsoon added to the overall uncertainty. The continued
recession in the developed world, for the better part of 2009-
10, meant a sluggish export recovery and a slowdown in financial
floss into the economy. Yet over the span of the year, the
economy posted a remarkable recovery, not only in terms of
overall growth figures but, more importantly, in terms of certain
fundamentals, which justify optimism for the Indian economy
in the medium to long term.*
FACTORS AFFECTING INDIAN ECONOMY
Fall in Aggregate Demand

Aggregate demand in the Indian economy is primarily
domestically driven, though exports have also been gaining
progressively higher importance in recent years. The internal
demand and fiscal stimulus introduced by the government
succeeded in insulating the Indian economy from the foreign
turmoil to some extent. The economic slowdown during the
second quarter vis-à-vis the first quarter of 2008-09, was
primarily driven by a moderation of consumption growth and
widening of trade deficit, offset partially by acceleration in
investment demand. On the other hand, the government
consumption expenditure increased during the same period.
* GoI, Ministry of Finance, Economic Survey 2009-10.

The main reasons for the fall in aggregate demand were:

(a) Fall in private investment expenditure due to: (i) low
expected returns, owing to low demand; (ii) higher cost of
borrowing. The investment in Indian firms by the US investment
bankers were a major worry for Indian investors. Investor’s
confidence was at its lowest ebb. So, aggregate demand fell due
to reduction in private investment expenditure.
(b) Private final consumption expenditure which constitutes
an important component of aggregate demand, fell due to
reduction in propensity to consume as there was reduction in
income. Worker in MNCs had developed a fear of job loss due
to financial turmoil in the US and consequent low investments,
so they saved more to secure their future. They further reduced
consumption expenditure.
Global recession continued to worsen with output and
trade declining sharply during the last few months of 2008.
Government policies failed to dispel uncertainty, which resulted
in households and business postponing expenditures and this in
turn reduced the demand for consumer durables and capital
goods.
The IMF recommended stronger policy actions to mend the
financial sector and macroeconomic measures—both monetary
and fiscal—to stimulate aggregate demand.
(c) Indian exports also fell sharply due to recession in the
West, and this contributed to further decline in aggregate
demand. India’s international trade for January 2009 showed a
sharp decline of 15.9 per cent in exports accounting to $ 12.38
billion over exports worth $ 14.72 billion in January 2008. The
sectors which were hit most by the slowdown in demand included
handicraft, carpets, cotton yarn and fabrics, gems and jewellery,
computer software, coal and minerals, and rice.
Athough there was a temporary relief in December 2008
when decline in export growth was relatively lower at 1.1 per
cent, yet the reprieve was short-lived as estimates of January
2009 showed a 22 per cent decline in exports compared to the
same month of the previous year. This double-digit decline was
the biggest decline.
Although the government provided various incentives to the

exporter—like exempting them from paying FBT (Fringe Benefits
Tax), relaxing norms for dollar credit and allowing access to
ECB to write off high cost domestic loans, yet the measures
could not help much in increasing exports when global markets
were on the shrinking mode.
Money Market Scenario
• Monetary and liquidly aggregates that expanded at a
strong pace during the first half of 2008-09 showed
some moderation during the third quarter reflecting
the decline in capital flows and consequent foreign
exchange intervention by the Reserve Bank of India.
• Growth in broad based money (M3), was 19.6 per
cent (` 7,3677 crore) on Janrary 2, 2009 which was
lower than 22.6 per cent (` 6,91,768 crore) a year ago.
• Aggregate deposits of banks expanded 20.2 per cent
(` 6,49,152 crore) on January 2, 2009 as compared
with 24.0 per cent (` 6,21,944 crore) a year ago.
• The growth in bank credit continued to remain high.
Non-food credit by scheduled commercial banks (SCBs)
was 23.9 per cent (` 5,01,645 crore) as on January 2,
2009 compared with 22.0 per cent (` 3,79,655 crore)
a year ago.
• The intensification of global financial turmoil and its
effect on the domestic financial market, and downturn
in headline inflation, necessitated the Reserve Bank of
India (RBI) to ease its monetary policy in mid-September
2008.
• Reserve money growth at 6.6 per cent, as on January
16, 2009 was much lower than that of 30.6 per cent a
year ago, which was partly due to the fall in CRR
(Cash Reserve Ratio).
Increase Dollar Borrowing Rates
Dollar borrowing rates in the London market doubled
overnight to 6.44 per cent, the highest recorded so far. This
happened as banks accumulated cash anticipating more failures
of financial institutions. The central banks of the UK, Switzerland

and Japan, and the European Central Bank (ECB), pumped in
huge funds into the system.
Foreign Institutional Investors (FIIs) Pulling Out from Indian
Market
According to the RBI’s report on Balance of Payments,
portfolio investment witnessed large capital outflows ($ 4.2
billion) in the first quarter of 2008-09 due to large sales of
equities by FIIs in the Indian stock market reflecting bearish
conditions in stock market and slowdown in global economy.
Contrast to this, there was a net inflow of portfolio investment
of $ 7.5 billion in the first quarter of 2007-08.
In the back drop of the global financial turmoil, FIIs pulled
out drastically from the Indian market.
Declining Rupee
The rupee dropped to a record low-closed at 51.92/dollar
on February 27, 2009—its lowest level in two years. Foreigners
sold Indian shares.
Fiscal Scenario
Tax revenue as per cent of budget estimates (BE) was lower
than a year ago on account of lower growth in income tax,
corporation tax and custom duties owing to economic slowdown.
Aggregate expenditure as per cent of BE, was higher than year
ago on account of higher revenue expenditure, particularly,
subsidies, defence other economic services, social services and
plan grants to States/Union Territories. Implementation of the
Sixth Pay Commission, farm loan waiver scheme and NREGA
further complicated the fiscal scenario.
While expenditure was slated to increase on account of the
fiscal stimulus measures undertaken by the government to
address the problem of economic slowdown, growth of tax
revenue decelerated due to moderation in economic activity.
The net cash outgo on account of the two supplementary demand
for grants was placed at ` 1,48,093 crore. This in turn reflected
the non-attainability of the deficit targets for 2008-09, i.e. zero
revenue deficit and 3 per cent fiscal deficit.
MEASURES TAKEN TO REVIVE THE ECONOMY

Fiscal Measures
The government on February 24, 2009 unveiled ` 30,000
crore stimulus package, the third in a row to boost demand in
an economy that was feeling the heat of the global meltdown.
The third stimulus package came on the back of two similar
packages that were announced in December 2008 and January
2009. The package which came a week after the interim budget
was presented by the government, included: A cut in excise
duties and service tax rates by 2 per cent. All the products that
attracted an excise rate of 10 per cent was now subjected to
only 8 per cent while service tax on all products was down to
10 per cent from 12 per cent.
Monetary Measures
The Reserve Bank of India in its bid to help out the ailing
economy announced a string of measures including a one per
cent point cut in short-term rates—repo rate and reverse repo
rate at which it lends and at which it borrows from banks. It
was decided to pump in an additional of ` 11,000 crore to help
the realty and small industry sectors.
The rate at which the apex bank lends overnight funds to
banks, was reduced from 7.5 per cent to 6.5 per cent while the
reverse repo rate, at which it accepts deposits from banks was
slashed to 5 per cent from 6 per cent. Later on the RBI further
cut repo rate by 50 basis points.
RBI also announced a ` 7,000 crore refinancing facility to
Small Industries Development Bank of India (SIDBI) in order to
improve credit flow to the fund-starved micro and small
enterprises. A similar package of ` 4,000 crore was announced
for National Housing Bank. The apex bank also decided to
classify housing loans below ` 20 lakh and above ` 20 lakh
from housing finance companies to individuals under the priority
sector. Reserve Bank of India, indicating a further cut in home,
auto and other loan rates, on March 4, 2009 unveiled a fresh
monetary stimulus that slashed the rates at which it lends and
borrows short-term funds from banks by half a per cent. This
was the fifth monetary stimulus from RBI since mid-September

2008 to stimulate consumer spending, in addition to three fiscal
packages announced by the government since December 2008.
All these measures succeeded to some extent to stem the
downward slide of the Indian economy.
The real turnaround came in the second quarter of 2009-
10 when the economy grew by 7.9 per cent. As per the
advance estimates of GDP for 2009-10 released by the Central
Statistical Organisation (CSO), the economy is expected to grow
at 7.2 per cent in 2009-10, with the industrial and the service
sectors growing at 8.2 and 8.7 per cent respectively. This recovery
is impressive for at least three reasons. First, it has come about
despite a decline of 0.2 per cent in agricultural output, which
was the consequence of sub-normal monsoons. Second, it
foreshadows renewed momentum in the manufacturing sector,
which had seen continuous decline in the growth rate for almost
eight quarters decline in the growth rate for almost eight quarter
since 2007-08. Indeed, manufacturing growth has more than
doubled from 3.2 per cent in 2008-09 to 8.9 per cent in 2009-
10. Third, there has been a recovery in the growth rate of gross
fixed capital formation, which had declined significantly in 2008-
09 as per the revised National Accounts Statistics (NAS). While
the growth rates of private and government final consumption
expenditure have dipped in private consumption demand, there
has been a pick-up in the growth of private investment demand.
There has also been a turnaround in merchandise export growth
in November 2009, which has been sustained in December 2009,
after a decline nearly twelve continuous months.
The fast-paced recovery of the economy underscores the
effectiveness of the policy response of the government in the
wake of the financial crisis. Moreover, the broad-based nature
of the recovery creates scope for a gradual rollback, in due
course, of some of the measures undertaken over the last fifteen
to eighteen months, as part of the policy response to the global
slowdown, so as to put the economy back on to the growth
path of 9 per cent per annum.*
* GoI, Economic Survey, 2009-10.

INTERIM BUDGET 2009-10

In the wake of the General Elections to the Lok Sabha which
were scheduled to be held in April/May 2009, an Interim Budget
was presented to the Parliament on February 16, 2009 to enable
the government to meet all essential expenditure during the first
four months of fiscal 2009-10.
Interim Budget is slightly different from vote-on-account
budget in the sense that it is usually a short period budget but
may contain some fundamental alterations like the regular
budget. Whereas, vote-on-account budget does not contain any
alteration but its passage by the State Legislature/Parliament
Authorities is necessary to allow the State Government/Union
Government to incur the expenditure. The Interim Budget
enumerated the progress made in the last five years of the then
government on the basis of the seven objectives orginally specified
in the Budget for 2004-05. It envisaged an allocation of
` 30,100 crore under NREGS; ` 13,100 crore under SSA;
` 12,070 crore under the Jawaharlal Nehru National Urban
Renewal Mission; and ` 8,000 crore for the Mid-day Meal
Programme. The Interim Budget also extended the interest
subvention of 2 per cent on the pre- and post-shipment credit
for certain employment-oriented sectors beyond March 31, 2009,
i.e. up to September 30, 2009 and assured that the government
would recapitalize the public sector banks over the next two
years to enable them to maintain capital to risk weighted assets
ratio (CRAR) of 12 per cent.
For 2009-10 the gross tax revenues of the Centre was
estimated at ` 6,71,293 crore (11.1 per cent of GDP),
representing a decline of 0.5 per cent over 2008-09 (RE) and
net tax revenue was placed at ` 4,97,596 crore (8.3 per cent of
GDP). As a proportion of GDP, total expenditure was budgeted
to decline by 0.8 per cent in 2009-10 over the level in 2008-09
(RE). Overall the revenue deficit was budgeted at 4.0 per cent
of GDP (4.5 per cent of GDP in RE 2008-09) and the fiscal
deficit was placed at 5.5 per cent of GDP (6.1 per cent in RE
2008-09). The Finance Minister’s speech also indicated that a
further 0.5 per cent to 1 per cent of infrastructure expenditure
could be considered if deemed appropriate at the time of the

full budget.
In terms of the overall expansion, Centre’s fiscal deficit was
placed at 3.3 per cent of GDP in 2008-09 compared with
2.7 per cent in 2007-08. This was composed of a decline in
non-debt receipts of 1.8 per cent of GDP (of which tax revenue
was 0.7 per cent of GDP) and a hike in expenditure of 1.5 per
cent of GDP. The Interim Budget for 2009-10 placed the fiscal
deficit at 5.5 per cent of GDP, which indicated a fiscal expansion
of 2.8 per cent of GDP and a hike in expenditure of 0.7 per cent
of GDP. The decline in tax-GDP ratio was partly on account of
the operation of automatic stabilizers and tax cuts implemented.
In absolute terms this amonted to a decline (RE 2008-09 over
BE 2008-09) of ` 29,515 crore in excise; ` 10,930 crore in
customs; ` 15,714 crore in personal income tax; and ` 4,361
crore in corporate income tax.
The issue of sustainability of such expansionary fiscal policies
is essential about the reversibility of the fiscal expansion. The
fiscal expansion in 2008-09 was on account of four factors,
namely higher levels of food and fertilizer subsidy (1.03 per
cent of GDP), the farm loan waiver (0.3 per cent of GDP), the
implementation of the Sixth Pay Commission award (0.65 per
cent of GDP) and the announced stimuli including higher budget
support for the Eleventh Five Year Plan. Besides, there was a
huge outgo on account of oil and fertilizer bonds due to the
sharp rise in global oil prices in the first half. As far as farm
loan waiver and the Sixth Pay Commission award are concerned,
there were clear timelines. The release of pay arrears was
expected to be completed in full in 2009-10 and the impact of
higher salaries and wages would taper off. Farm loan waiver
had similar timelines. The Eleventh Five Year Plan priorities
also remained intact and it was expected that once the growth
trajectory was restored there is likely to be much headroom
available for the financing of the plan with the introduction of
the goods and services tax. Global commodity prices were also
unlikely to go up significantly for several quarters. These were
expected to provide a stabilizing influence on prices and interest
rates.
UNION BUDGET 2010-11

Union Finance Minister Mr. Pranab Mukherjee presented
the Union Budget 2010 in February in the Lok Sabha and
announced a slew of measures focusing on agriculture,
growth and infrastructure. The corporate, banking
and agriculture sectors got a major boost in the Union Budget
2010.
In the Budget 2010 there was a hike in the Excise Duty
from 8% to 10%. While there Service Tax has been retained at
10%.
Mr. Mukherjee proposed a total expenditure of ` 11,08,749
crore including ` 3,73092 on planned activities for which he
would raise a non-tax and tax revenue of ` 6,82,212 crore
leaving a deficit of ` 3,81,408 crore, which would be bridged
by borrowings. In direct tax, Finance Minister gave much relief
to middle class taxpayers. Mukherjee while presenting the budget
extended the view that the recovery has taken roots, there is a
need to review public spending, mobilise resources and gear
them towards building the productivity of the economy. Towards
this, he proposed to cut down the borrowings from over ` 4.1
lakh crore in revised estimated of 2009-10 to ` 3.81 lakh crore
for 2010-11. During 2010-11 he also proposed to mobilise Rs.
40,000 crore through sale of government equity in PSUs. “Our
economy is in a much better position today. One first challenge
is to quickly revert to high GDP growth of 9%. The second
challenge will be to make development more inclusive”, said
the Finance Minister.
Talking about Food Security and Inflation he said that India
need to strengthen the food security. “Short term global outlooks
would be bleak during FY 2010-11. The south-west Monsoon
undermined our kharif crops. We need to work hard to contain
the inflation”, he said.
Mr. Mukherjee said that the manufacturing growth in 2009-
10 has been the highest in the last two decades. He also said
that “thrust in rural infrastructure spending is a must. We need
to review fiscal stimulus and public spending”.
HIGHLIGHTS OF UNION BUDGET 2011-12

Vision of Objective
• GDP growth to be targeted at 9%.
• Target of ` 25,000 crore disinvestment this year.
• Direct tax code and GST will be implemented from
April 1, 2011.
• Fertilizer subsidy to be reduced.
• GDP to reach 10% in near future.
• To consider Parikh Report on Fuel Prices.
• FDI Regime to be simplified.
• Inflation Rate to be lowered in two months.
• 2% interest subvention for Exports extended for one
year.
• Committed to SEZ Growth.
Banking
• More Private Banks to be encouraged.
• Additional Banking License to Private Player.
• Capital for PSU Banks stands at ` 16,500 crore.
• ` 1,200 crore to be reallocated to PSU Banks.
• Rural Banks to be supported.
• Banks to get ` 6,000 crore to improve fundament
structure.
• Banks for all villages with a population of 2000.
Agriculture
• Four-pronged agricultural strategy to be adopted.
• More help to Food Processing Sector.
• ` 400 crore to be allocated for Green Revolution in
eastern India.
• ` 300 crore for Rashtriya Krishi Vikas Yojana.
• Extended Loan Repayment for drought-hit farmers.
• Farmers, who repay loan on time, will get waiver of
2%.
• Farmers to get loans at 5%.

• To extend farm loan repayment by six months.
• Agriculture loan for farmers increased to ` 3,75,000
crore.
• New Food Policy from April 1, 2010.
• ` 300 crore to be allocated for Pulse Production.
Infrastructure
• ` 1.37 lakh crore for Infrastructure Development.
• Railways to be allocated ` 16,772 crore.
• Road Development allocation increased to ` 19,894
crore.
• 20 km National Highway to be built everyday.
• Proposal to hike allotment for renewable energy by
6%.
• To establish clean energy fund.
• More than double allocation for power sector to ` 5,130
crore.
• Coal Regulatory Authority to be set up. NREGA
Allocation at ` 40,100 crore.
• Bharat Nirman Yojna—` 48,000 crore.
• Solar Energy—` 1,000 crore.
• For Goa ` 200 crore special package.
• To set up 20,000 MW Solar Power by 2022.
• Delhi-Mumbai Industrial Corridor to be set up.
Education
• Allocation for School Education increased from
` 26,800 crore to ` 31,036 crore.
• Allocation fro Health at ` 22,300 crore.
• Sarva Sikha Abhiyaan—` 36,000 crore.
Urban Development and Housing
• ` 5,400 crore for urban development—hike of 75%.
• ` 61,000 crore for rural development.
• Indira Awas Yojna to get ` 10,000 crore.

• House Loans up to ` 10 lakh—1% subsidy extended
for one year.
• Focus on Slum Development.
Social Sector
• National Social Security Fund for unskilled laboureres
to be set up with ` 1,000 crore.
• National Pension Scheme—New Accounts to get
` 1,000 per year from the government.
• National Health Insurance Scheme for Workers, who
work for 15 days in a month.
• Farmer Fund for women—` 100 crore.
• Dalits and poor to get more focus.
Technology
• Unique ID number to be given on time.
• ` 19000 crore allocated for Unique ID project.
• Rupee to have new symbol. A new look Rupee to come
up soon.
• Tech Advisory Group to set up under Nandan Nilekani.
Plan and Expenditure
• Gross Tax Receipts—` 7.46 lakh crore.
• 15% rise in plan expenditure.
• Fiscal Deficit for FY 2010 revised to 6.9% of GDP.
• Fiscal Deficit-5.5% for FY 2011.
• Fiscal Deficit-4.8% for FY 2012.
• Defence Allocation—` 147,344 crore.
Taxation
• Income Tax Form Saral-2 to be re-introdued from next
year.
• No increase in Exemption Unit for the Taxpayers.
• Tax Slabs changed.
• Income up to ` 1.6 lakh—nil.
• Income from ` 1.6 lakh–` 5 lakh—10% tax.

• Income from ` 5 lakh–8 lakh—20% tax.
• Income of above ` 8 lakh—30% tax.
• 60% of the taxpayers to be benefitted.
• ` 20,000 tax exemption for investment in infrastructural
bonds.
• Tax Exemption under 80c will be ` 1.2 lakh instead of
` 1 lakh.
• Corporate surcharge reduced from 10% to 7.5%.
• MAT (Minimum Alternative Tax) increased to 18%
from 15%.
• Excise duty hiked from 8% to 10%.
• Service Tax on News Agencies.
• R&D deduction hiked.
• CET (Central Excise Traiff) on Petroleum Products
hiked by ` 1.
• Petrol, Diesel prices to go up.
• Partial Rollback on Excise duty on Cement, Large Cars.
• Cement and Large cars to be costlier.
Cheaper Products
CNG, Mobile, Medicines, Refrigerators, Medical
Equipments, Farm Equipments, Mobile Phones, Mobile Charges,
Watches, Readymade Garments, Microwave, Ovens, Toys,
Foreign Farm Equipments, Set Top Boxes, Water Purifier, LED
Lights.
Costlier Products
Petrol, Diesel, Coals, Cigarettes, Cement, Large Cars,
Jewellery, Gold, TV Sets, ACs, Silver, Pan Masala.
HIGHLIGHTS OF UNION BUDGET 2011-2012

Taxes
• Standard rate of excise duty held at 10 per cent; no
change in CENVAT rates.
• Personal income tax exemption limit raised to ` 180,000

from ` 160,000 for individual taxpayers.
• For senior citizens, the qualifying age reduced to
60 years and exemption limit raised to ` 2.50 lakh.
• Citizens over 80 years to have exemption limit of
` 5 lakh.
• To reduce surcharge on domestic companies to 5 per
cent from 7.5 per cent.
• A new revised income tax return form ‘Sugam’ to be
introduced for small tax papers.
• To raise minimum alternate tax to 18.5 per cent from
18 per cent.
• Direct tax proposals to cause 115 billion rupees in
revenue loss.
• Service tax rate kept at 10 per cent.
• Customs and excise proposals to result in net revenue
gain of 73 billion rupees.
• Iron ore export duty raised to 20 per cent.
• Nominal one per cent central excise duty on 130 items
entering the tax net. Basic food and fuel and precious
stones, gold and silver jewellery will be exempted.
• Peak rate of customs duty maintained at 10 per cent in
view of the global economic situation.
• Basic customs duty on agricultural machinery reduced
to 4.5 per cent from 5 per cent.
• Service tax widened to cover hotel accommodation
above ` 1,000 per day, A/C restaurants serving liquor,
some category of hospitals, diagnostic tests.
• Service tax on air travel increased by ` 50 for domestic
travel and ` 250 for international travel in economy
class. On higher classes, it will be ten per cent flat.
• Electronic filing of TDS returns at source stabilised;
simplified forms to be introduced for small taxpayers.
• Works of art exempt from customs when imported for

exhibition in state-run institutions; this now extended
to private institutions.
Subsidies
• Subsidy bill in 2011-12 seen at 1.44 trillion rupees.
• Food subsidy bill in 2011-12 seen at 605.7 billion
rupees.
• Revised food subsidy bill for 2010-11 at 606 billion
rupees.
• Fertiliser subsidy bill in 2011-12 seen at 500 billion
rupees.
• Revised fertiliser subsidy bill for 2010-11 at 550 billion
rupees.
• Petroleum subsidy bill in 2011-12 seen at 236.4 billion
rupees.
• Revised petroleum subsidy bill in 2010-11 at 384 billion
rupees.
• State-run oil retailers to be provided with 200 billion
rupee cash subsidy in 2011-12.
FISCAL DEFICIT
• Fiscal deficit seen at 5.1 per cent of GDP in 2010-11.
Spending
• Total expenditure in 2011-12 seen at 12.58 trillion
rupees.
• Plan expenditure seen at 4.41 trillion rupees in 2011-
12, up 18.3 per cent.
Revenue
• Gross tax receipts seen at 9.32 trillion rupees in 2011-
12.
• Non-tax revenue seen at 1.25 trillion rupees in 2011-

12.
• Corporate tax receipts seen at 3.6 trillion rupees in
2011-12.
• Tax-to-GDP ratio seen at 10.4 per cent in 2011-12;
seen at 10.8 per cent in 2012-13.
• Customs revenue seen at 1.52 trillion rupees in 2011-
12.
• Factory gate duties seen at 1.64 trillion rupees in 2011-
12.
• Service tax receipts seen at 820 billion rupees in 2011-
12.
• Revenue gain from indirect tax proposals seen at 113
billion rupees in 2011-12.
• Service tax proposals to result in net revenue gain of
40 billion rupees in 2011-12.
Growth, Inflation Expectations (Inflation remained the principal
concern of the Budget)
• Economy expected to grow at 9 per cent in 2012, plus
or minus 0.25 per cent.
• Inflation seen lower in the financial year 2011-12.
Disinvestment
• Disinvestment in 2011-12 seen at 400 billion rupees.
• Government committed to retaining 51 per cent stake
in public sector enterprises.
Borrowing
• Net market borrowing for 2011-12 seen at 3.43 trillion
rupees, down from 3.45 trillion rupees in 2010-11.
• Gross market borrowing for 2011-12 seen at 4.17
trillion rupees.
• Revised gross market borrowing for 2010-11 at 4.47
trillion rupees.
Policy Reforms
• To create infrastructure debt funds.
• FDI policy being liberalised.
• To boost infrastructure development with tax-free
bonds of 300 billion rupees.
• Food security bill to be introduced this year.
• To permit SEBI registered mutual funds to access
subscriptions from foreign investments.
• Raised foreign institutional investor limit in 5-year
corporate bonds for investment in infrastructure by $20
billion.
• Setting up independent debt management office; Public
debt bill to be introduced in parliament soon.
• Bills on insurance, pension funds, banking to be
introduced.
• Constitution Amendment Bill for introduction of GST
regime in this session.
• New Companies Bill to be introduced in current session.
Sector Spending
• To allocate more than 1.64 trillion rupees to defence
sector in 2011-12 (i.e. 11% hike in defence allocation).
• Corpus of rural infrastructure development fund raised
to 180 billion rupees in 2011-12.
• To provide 201.5 billion rupees capital infusion in state-
run banks in 2011-12.
• To allocate 520.5 billion rupees for the education sector.
` 21,000 crore for Sarva Shiksha Abhiyan.
• To raise health sector allocation to 267.6 billion rupees
(i.e. 20% hike in health budget)
• ` 500 crore more for national skill development fund.
• ` 54 crore each for AMU (Aligarh Muslim University)
centres at Murshidabad and Mallapuram.
• ` 58,000 crore for Bharat Nirman; increase of ` 10,000
crore.
• Mahatma Gandhi National Rural Employment

Guarantee Scheme wage rates linked to consumer price
index; will rise from existing ` 100 per day.
• Increased outlay on social sector schemes. (i.e. Social
sector allocation up by 17%).
• Infrastructure critical for development; 23 percent
higher allocation in 2011-12. (i.e. ` 2,14,000 cr
allocated for infrastructure sector).
Agriculture
• Removal of supply bottlenecks in the food sector will
be in focus in 2011-12.
• Agriculture growth key to development: Green
Revolution waiting to happen in eastern region.
• To raise target of credit flow to agriculture sector to
4.75 trillion rupees.
• Gives 3 percent interest subsidy to farmers in 2011-12
• Cold storage chains to be given infrastructure status.
• Capitalisation of National Bank for Agriculture and
Rural Development (NABARD) of 30 billion rupees in
a phased manner.
• To provide 3 billion rupees for 60,000 hectares under
palm oil plantation.
• Actively considering new fertiliser policy for urea.
• Food storage capacity to be augmented - 15 more mega
food parks to be set up in 2011-12; of 30 sanctioned in
previous fiscal, 15 set up.
• Comprehensive policy on further developing PPP
(public-private-partnership) model.
• Farmers need access to affordable credit.
• Moving to improve nutritional security.
• Necessary to accelerate production of fodder.
On the State of the Economy
• “Fiscal consolidation has been impressive. This year
has also seen significant progress in those critical
institutional reforms that will pave the way for double

digit growth in the near future.”
• “At times the biggest reforms are not the ones that
make headlines, but the ones concerned with details of
governance which affect the everyday life of aam aadmi
(common man). In preparing this year’s budget, I have
been deeply conscious of this fact.”
• Food inflation remains a concern.
• Current account deficit situation poses some concern.
• Must ensure that private investment is sustained.
• “The economy has shown remarkable resilience.”
• Setting tone for newer, vibrant economy.
• Economy back to pre-crisis trajectory.
• Development needs to be more inclusive.
On Governance
• “Certain events in the past few months may have
created an impression of drift in governance and a gap
in public accountability...such an impression is
misplaced.”
• Corruption is a problem, must fight it collectively.
Others
• Govt to move towards direct transfer of cash subsidy
for kerosene, LPG and fertilisers.
• Financial Sector Legislative Reforms Commission, to
be headed by former Supreme Court judge B Srikrishna,
to complete its work in 24 months; to overhaul financial
regulations.
• Five-fold strategy against black money; 13 new double
taxation avoidance agreements; foreign tax division of
CTBT strengthened; strength of Enforcement
Directorate increased three-fold.
• Bill to be introduced to review Indian Stamp Act.
• New coins carrying new rupee symbol to be issued.
• Anganwadi workers salary raised from ` 1,500 to

` 3,000.
• Mortgage risk guarantee fund to be created for
economically weaker sections.
• Housing loan limit for priority sector lending raised to
` 25 lakh.
NOTES
1. Nicholas, Kaldor, An Expenditure Tax, George Allen and Unwin,
London, 1955.
2. Ved P. Gandhi, Tax Burden on Indian Agriculture, Harvard Law
School, Cambridge, 1966.
3. R.K. Bansal and J.R. Gupta, Economic Aspects of Sales Tax,
Atlantic Publishers, 1985.
4. GoI, Ministry of Finance: Report of the Task Force on
Implementation of the Fiscal Responsibility and Budget Management
Act 2003, 16 July 2004.
5. The increasing importance of the service sector and the service tax is
now widely acknowledged.
6. A. Tait Alan, Value Added Tax, McGraw-Hill Book Company
Limited, U.K., 1972.
7. Richard W. Lindholm, Value Added Tax Reforms, Nelson-Hale
Chicago, pp. 30-31 as quoted in R.W. Hafer and Michael E.
Trebing, The Value-Added Tax: A Review of the Issues, Federal
Reserve Bank of Louis, January 1980, pp. 3-10.
8. Union Finance Minister, Mr. P. Chidambaram in his budget speech
on 8 July, 2004, quoted the example of Haryana.
9. Mahesh C. Purohit, “Is Unified VAT Regime Feasible” (debate),
Economic Times, 15 June 2004.
10. GoI, Ministry of Finance, op. cit.
11. Ibid.
12. As reported in The Hindu, 18 July 2004.
13. Government of India, various Economic Surveys.
14. Government of India, Budget, 2006-07.
15. Government of India, various Economic Surveys.
16. Ibid.
18. Government of India, Economic Survey, 2004-05.

19. Government of India, Ministry of Finance, op. cit.
20. Government of India, Twelfth Finance Commission Report, 2004,
pp. 64-65.
21. This section draws heavily from (1) Kabra, Kamal Nayan, “A
Decade of Reforms: The Unfinished Agenda”, The Theme paper for
the Member Annual Conference of the IIPA 2002, and (2) Gupta,
K.R. (Ed.) “Fiscal Deficits in States” in Studies in Indian Economy,
Atlantic Publishers, New Delhi, 2005.
Finances of Local Bodies 11
The importance of local self-governing bodies cannot be

over emphasized. In modern times, the functions of the state
have increased greatly and it is impossible for one unit of
government to perform all its tasks efficiently and effectively.
Any attempt to do so will surely lead to its collapse under sheer
weight of over work. It is for this reason that the Central and
State Governments are forced to delegate some of their functions
to local bodies.
The ultimate aim of Central and State Governments is the
satisfaction of local needs in a balanced and co-ordinated manner
and it is felt that the local problems can be best tackled by the
local people. For example, the construction and maintenance of
local roads, the provision of water and electric supply, sanitation,
maintenance of hospitals and dispensaries, provision of primary
education, libraries, museums, street lights, the laying out of
parks, scavenging and various other such services can be best
left to the care of the local authorities because their performance
needs local attention and adaptation to circumstances.
Further, local self-government can play an important role
in development planning. Both planning and its implementation
can become more effective and realistic with the whole-hearted
and continuous participation of the people at local level in
matters which vitally concern them.
According to Jackson, the term ‘Local Government’ has
certain limitations, “It is concerned with localities and not with
the country as a whole, it must for this reason be subordinate to
the national government. The term further implies (as does any
other form of government) some jurisdiction of activity of public
nature: it implies also the existence of authorities empowered to

exercise that jurisdiction and activity.”1
In India, we have a large variety of local bodies, e.g.
municipal corporation, municipal boards, cantonment boards,
notified area and town committees for urban areas; and zila
parishads, block samitis and village panchayats for rural areas.
Now a word about their functions and finance.
URBAN AREA
1. Municipal Corporation
The Municipal Corporation in India is the highest form of
municipal government meant for the administration of civic
affairs of top class cities in the country having populations more
than a particular limit. The functions of corporations are wider
than those of municipalities. In particular, however, what mainly
distinguishes the corporation from the municipality is the almost
complete separation of legislative and executive powers in the
municipal corporation and vesting of all executive authority in
a Municipal Commissioner who is relatively independent of the
elected body. The pattern of municipal corporations in regard
to the structure and organization is more or less the same in all
the states.
Functions
The corporations perform two types of functions—obligatory
and discretionary. The former it must perform and the latter if
it so desires. The important obligatory functions are as under:
(a) The construction, maintenance and cleaning of drains,
public latrines, urinals and similar conveniences;
(b) The construction and maintenance of works for
providing supply of water for public and private
purposes;
(c) The scavenging, removal and disposal of filth and
rubbish;
(d) The construction or purchase, maintenance and conduct
of street lighting, water supply, and transport;
FINANCES OF LOCAL BODIES 545
(e) The maintenance and regulations of places for the

disposal of the dead;
(f) The registration of births and deaths;
(g) The checking of the spread of dangerous diseases;
(h) The establishment and maintenance of hospitals,
dispensaries and maternity centres;
(i) The construction and maintenance of municipal markets
and slaughter houses;
(j) The naming and numbering of streets and premises;
(k) Primary education; and
(l) The maintenance of municipal office.
The discretionary functions include: (a) the establishment
and maintenance of libraries, parks and museums, (b) the
registration of marriages, (c) the taking of census of populations,
(d) the construction and maintenance of rest houses, poor houses,
children’s homes, shelters for destitutes, and asylums for persons
of unsound mind, and (e) the supply of milk.
Finances
The corporation raises money to perform its functions by
imposing various types of taxes assigned to it under the
Corporation Act. The main taxes levied by the corporations
are: property taxes, tax on vehicles and animals, the tax on
trades, professions, callings and employments, education cess,
the octroi and terminal tax, betterment tax on the increase in
urban land values caused by the execution of any development
or improvement work. Also the Union or State Government
gives grants-in-aid, both recurring and non-recurring. Some
corporations levy a theatre tax. A tax on advertisements is also
imposed by some corporations. The Statute in many cases
prescribes the maximum and minimum of rates for the property
taxes and in some cases, either the maximum or the minimum
rate alone is laid down.
The relative importance of the sources of revenue varies
from corporation to corporation. Some corporations get the
largest part of their revenue from property taxes while others
rely mainly on octroi and terminal taxes.
2. Municipal Committees/Boards
For the management of the civic affairs of towns and small
cities, municipal committees or boards have been set up in all
parts of the country. Municipalities are established under a
general act passed by the Union Parliament or the State
Legislature as the case may be.
Functions
The municipalities have two types of functions—obligatory
and optional. The obligatory functions generally include:
(1) lighting and watering of public streets, (2) regulating of
offensive, dangerous or obnoxious trades, callings and practices,
(3) removing undesirable obstructions and projections in streets
for public safety, health or conveniences, (4) constructing and
maintenance of public streets, (5) providing sufficient supply
of pure and wholesome water, (6) registration of births and
deaths, (7) maintaining or supporting of public hospitals, and
(8) establishing and maintaining of primary schools.
Finance
The municipalities, in order to meet their expenditure levy
various kinds of taxes such as tax on annual value of buildings
and land, tax on trades and callings, tax on vehicles and other
conveyances, tax on animals, octroi and terminal taxes, water-
tax, theatre or show tax, etc. In some states, the share of receipts
from entertainment tax constitutes an important source of
revenue. The Central and the State Government may also give
grants-in-aid, both recurring and non-recurring, to supplement
their income.
3. Cantonment Board
A cantonment board is established for the administration
of the local affairs of an area where military is stationed.
A Cantonment is always under the Ministry of Defence and as
such it is established by an Act of the Union Parliament. The
functions of the cantonment board are similar to those of a
municipality.
4. Notified Area Committee

A notified area is a mini-municipality. Notified area
committee is meant for such municipal areas from which
sufficient income is not expected on account of the predominance
of government property or where there is a small town or
industrial centre the population of which is semi-urban. It
performs only such functions under the Municipal Board Act,
which are permitted to it by the government.
5. Town Area
There is not much difference between the Notified Area and
the Town Area. This type of unit is established generally for
places where the population is more rural than urban. Its
functions mainly relate to public health. Other local bodies like
the port trusts, improvement trust, etc. are specialized local
units with specially demarcated functions. Their sources of
revenue are more or less determined by the statues/rules
establishing them. The above-mentioned type of local authorities
cover the entire urban and semi-urban area of the district.
RURAL AREA
The main institutions of local self-government in rural areas
are: Zila Parishads, Block Samitis and Gram Panchayats.
Zila Parishad
The entire rural area of the district is put under a local
government unit called Zila Parishad. The powers and functions
of Zila Parishad vary considerably from state to state. However,
the following functions are generally performed by them.
(a) General supervision over the samitis and gram (village)
panchayats.
(b) Regulations of cattle markets and fairs, and provision
of higher and better veterinary facilities.
(c) Establishment of centres for training in village and
cottage industries and promotion of cottage industries.
(d) Construction, repairs and maintenance of public roads
and bridges.
(e) Administration and execution of primary education and

establishment and maintenance of libraries.
(f) Construction and maintenance of poor houses, asylums
and orphanages.
(g) Provision of water supply.
(h) Preparation of district plans, review and coordination
of block samiti plans.
(i) Issuance of directives regarding execution of district
plans, distribution of grants, evaluation of programmes,
and periodical review of achievements and targets.
Thus, the functions of Zila Parishad are mainly of
coordination, supervisory and advisory nature.
Finance
The Zila Parishad, like any other body, needs money to
perform its functions effectively and efficiently. The various
sources of finance may be mentioned as under:
(a) Taxes on property and other taxes which the State
Governments may authorise the Parishads to levy.
(b) Grants and loans from the State Governments.
(c) Income from fairs and exhibitions.
(d) Cesses, fees, income from service functions,
remunerative enterprises, a general water tax, if public
water taps have been installed, a pilgrim tax, etc.
However, the major source of income is the government
grants and loans.
Block Samiti
The area under the Zila Parishad is divided into a number
of segments, and each segment is administered by a local
authority called the Block Samiti. The area of the Block Samiti
usually coincides with area of the community development block.
Functions
The block samitis are entrusted with development functions
in all the states. They are made directly responsible for the
implementation of the community development plans. The

functions of a samiti in this regard include development of
agriculture with a view to increasing production, assisting the
establishment of seed stores, soil conservation, land reclamation
and plant protection, development of animal husbandry,
co-operation and cottage industries. Besides, they undertake the
establishment and maintenance of primary health centres,
maternity and child welfare clinics, dispensaries, veterinary
hospitals, primary schools, drainage works, etc. They also
exercise supervision over panchayats and have the right to
scrutinize the budgets of panchayats and make other suggestions.
Finance
The samiti imposes taxes and levies fees such as for studying
in schools, may share a fee for any licence, sanction or
permission. However, the finances of block samiti mainly consist
of the funds drawn from the block budget, and those earmarked
for specific schemes transferred to the samiti as agency of the
State Government for execution, share from the land revenue
and the grants given by the State Government. In some states
the samiti can, subject to certain limits, levy all the taxes which
a gram panchayat is empowered to levy.
Gram Panchayat
In the area of every samiti there are the gram panchayats at
the grassroot level. A gram panchayat is generally for one village
but may cover more than one village of smaller population. It is
elected by the village people and is, therefore, responsible to
them.
Functions
The functions of panchayats range over a wide area including
judicial, police, civic, economic, etc. The main task of the gram
panchayat is to cater to the local needs of the people. The
Panchayat Act lays down a number of obligatory functions which
may include: (a) construction of streets, (b) medical relief,
(c) sanitation and taking curative and preventive measures to
remove and to stop the spread of an epidemic, (d) upkeep,
protection and supervision of any buildings or other property
belonging to Gram Sabha, (e) registration of births, deaths and

marriages, (f) regulation of places for the disposal of dead
bodies, (g) regulation of markets and fairs, (h) establishing
and maintaining of primary schools for boys and girls,
(i) construction, repair and maintenance of public wells, tanks
and ponds for the supply of water for drinking, washing and
bathing purposes, (j) regulation of the construction of buildings,
(k) assisting the development of agriculture, commerce and
industry, (l) maternity and child welfare, (m) allotment of places
for storing manure and for tanning and curing of hides, and
(n) the administration of civil and criminal justice.
The important discretionary functions of panchayats are:
(a) planting and maintaining trees on the sides of public streets
and in other public places, (b) filling in of insanitary depressions
and levelling of land, (c) organizing volunteer force for watch
and ward, (d) assisting and advising agriculturists in obtaining
and distributing the government loans and in the re-payment
thereof and in liquidation of old debts, (e) establishing of
improved seed and implement stores, (f) relief against famine,
floods and other calamities, (g) establishment and maintenance
of Akhara for wrestling and other places of recreation and
games, (h) arranging for public radio-sets and gramophones,
(i) establishment of libraries and reading rooms, and (j) making
arrangements for the seizure and disposal of stray cattle, stray
dogs, wild animals and monkeys.
Finance
Thus, the panchayats have an ever-expanding field of
functions before them, for the performance of which they must
have adequate sources of revenue. Panchayats are vested with
the power of levying a number of taxes but these taxes differ
from state to state. However, the following taxes have been
mainly levied:
(a) General property tax (on the local rate);
(b) House tax;
(c) Taxes on land revenue or rent of land;
(d) Profession tax;
(e) Tax on animals and vehicles; and

(f) Octroi, theatre tax and tolls.
Other sources of income include fees from regulatory and
remunerative enterprises such as markets, slaughter houses, etc.
Grants and loans given by the state constitute important sources
of revenue. However, the sources of income of the panchayats
are too meager to meet their growing financial requirements.
Hence, all-out efforts should be made to supplement their
resources by tapping new sources of income and improving the
existing ones.
Thus, the Zila Parishads, Block Samitis and Gram Panchayats
are the three tiers of the Panchayati Raj system of local self-
government. It is based on the recommendation of the Balwant
Rai Mehta Committee Report. However, with 73rd and 74th
Constitutional Amendments, Panchayati Raj Institutions (PRIs)
and Urban Local Bodies, (ULBs) have been accorded
Constitutional or statutory status and given independent
existence. Before these amendments these institutions derived
their powers from the State Governments and were, therefore,
at their mercy.
CRITICAL ASSESSMENT OF LOCAL FINANCE

It should be noted that the functions of the local bodies
have increased manifold in recent years and they are being
entrusted with more and more of development activities in the
context of planned economic development of the country.
Increasing functions imply need for ever expanding resources.
But unfortunately in India the resources of the local bodies are
too inadequate. Their powers to raise revenues are limited and
with an all-round increase in Central and state taxation, the
local governments are at wit’s end as to how to add to their
incomes. Most of the functions of local bodies are of nation-
building character and hence unremunerative. To guarantee good
health, to provide proper education, to cater to the convenience
of the public—all this demands huge expenditure and increasing
sources of revenue. But from where to get all this money is a
matter of grave concern for the local bodies. Let us look at their
important sources of revenue and suggest measures for

improvement. Their financial resources may conveniently be
divided into two categories—tax revenue and non-tax revenue.
(a) Tax Revenue. The Government of India Act, 1935 (which
forms the basis for federal financial relationships in our
Constitutions) put every local tax into the basket of the tax
resources of the Provincial (State) Governments, whereby the
states handover tax resources to the local bodies out of their
own list. Consequently, there is no standardized list in this regard
and the tax resources of the local bodies differ from state to
state and from one body to the other.
The Taxation Enquiry Commission (1956) made an analysis
of the financial resources of the municipalities in various states
and observed that the municipal revenue is inadequate to meet
the growing expenditure on civic services. To remedy the
situation, the Commission recommended the following tax-field
consisting of six areas which should be exclusively assigned to
the local bodies:
(a) Taxes on lands and buildings.
(b) Taxes on the entry of goods into the area of local
authority for consumption, use or sale therein, popularly
known as octroi.
(c) Taxes on vehicles other than those mechanically
propelled.
(d) Taxes on animals and boats.
(e) Taxes on profession, trades, callings and employments.
(f) Taxes on advertisements other than advertisements
published in newspapers.
Almost all the above taxes are now levied by the local bodies
but their resources are still inadequate because of the low rate
of taxation. We may, therefore, suggest that the municipalities
should increase their rates of taxation and make the tax system
progressive in nature.
One of the important sources of municipal income is property
tax and is imposed on the annual value of the holdings. The
value of the property is going up due to rise in prices, the
implementation of development schemes, and the growing tempo

of urbanization. The law usually provides for a reassessment of
the tax after every five years. But in practice it is not done by
the local bodies. This results in huge loss of revenue to them.
Hence, reassessment of property must be done after regular
intervals for the proper mobilization of resources. But the revision
of annual value must be done with utmost honesty, impartiality
and efficiency. To achieve this objective, the tax-collecting
machinery should be modernized and it must be free from
political influence and pressures. No arrears of tax should be
permitted and cases of default should be strictly dealt with as
provided in the law. But, at the same time, the local bodies
must convince the taxpayers that the money collected by way of
taxes is being spent most efficiently, waste of money is being
avoided and the people are getting the maximum for the money
they pay as tax.
Another important source of revenue of municipalities is
the octroi and terminal taxes. The two taxes are not always
easy to distinguish and the term octroi is often used to cover
them both. Technically, an octroi is a tax on the entry of goods
into a local area for consumption, use or sale in that very area.
The goods so taxed is not expected to leave the area at all, or at
least in its original form. A terminal tax, on the other hand, can
be imposed on goods which either enter or leave the area and
even on goods which pass through the area whereas octroi cannot
be levied on goods which leave or pass through the area, but
only on goods which enter an area. Hence, octroi involves a
system of refunds, remission or rebate if goods on which the tax
has been levied leave the area again. But terminal tax does not
admit of any refund or remission. It may be further pointed out
that terminal tax can be levied on passengers also whereas octroi
is limited only to goods. The local bodies in the hill areas,
pilgrimage centres and tourist centres impose such a terminal
tax to supplement their income so as to provide the tourists the
necessary facilities. However, it may be mentioned that with a
levy of comprehensive VAT in the country, octroi and terminal
taxes have no scope.
FISCAL DECENTRALIZATION—73rd AND 74th

CONSTITUTIONAL AMENDMENTS
As already stated in Chapter 8, a complete decentralization
of governance is ensured in a federal set-up. And this
decentralization is inbuilt in the system. Our Constitution
recognized the division of functions and sources of revenue only
between the Centre and the states. The local bodies derived
their powers at the discretion of the state. But the 73rd and
74th Amendments of the Constitution have accorded them lawful
existence. Every five years elections have to be held for PRIs
and ULBs just as for the State Legislature and the Parliament.
The phenomenon of decentralization is getting popular across
all the developed and the developing countries. The process
of strengthening of local governments is welcome step accepted
by all sections of the society. The decentralization takes
place through devolution of resources and the functional
responsibilities to lower level of governance. It is assumed that
the local self-governance at the lowest level of decision-making
powers would offer socio-economic benefits and help in
mobilizing more resources and efficient delivery mechanism.
The devolution of resources and discharging of the functional
responsibilities have assumed great importance in recent past in
almost all the countries. In the form of these two historical
amendments, India has also initiated the process of
decentralization. The government has implemented the 73rd and
74th Constitutional Amendment Act (CAA) for strengthening
the grassroot level of governments in rural as well as urban
areas.
Till the 73rd and 74th Amendments of the Constitution,
India recognized only two layers of the government, viz. Central
and the State Government as far as the financial autonomy was
concerned. The financial and other powers of the local bodies,
viz. PRIs and ULBs, depended solely on the discretion of the
states.
However, with the above-mentioned amendments these local
bodies have been accorded statutory status. While PRIs have
been credited with 29 functions, Municipalities or ULBs will
hold 18 functions. These functions can be divided into 4 or 5

categories, viz. socio-economic schemes, beneficiary-oriented
schemes, national policy schemes, infrastructure creating schemes
and state or Centrally sponsored schemes (Appendix III).
However, it must be mentioned that in order to ensure the
proper execution of theses functions, the PRIs and ULBs will
have to be given independent sources of revenue.
Presently, the states’ revenue consists of: (i) state’s own
revenue (tax and non-tax), (ii) Share in Central taxes, viz. income
tax and union excise duties, and (iii) Grants from the Union
Government, apart from other transfers.2 Local self-governments,
likewise, are intended to get permanent sources of revenue so
that they are not left to the mercy of the State Governments. In
fact, it is a corollary of the State Governments’ demand that
much of resources from the Union Government should come in
the form of statutory commitments where the Union Government
could not exercise its discretionary power.
EXTENT OF FISCAL (REVENUE) DECENTRALIZATION—

INTERNATIONAL SCENARIO3
Table 11.1 presents the extent of revenue decentralization
across the selected countries having federal structure of three
levels of governments. The share of revenue mobilized through
tax by the Central Governments is less than 50 per cent in
Canada, Germany and Switzerland. In these countries, the State
Governments are stronger. On the other hand, in the countries
of Belgium, South Africa and Colombia, the predominance of
the governments at the Central level exists. The tax revenue
generated by the Central Governments in these countries goes
upto more than 90 per cent of the total tax yield of all the three
levels of governments. The revenue mobilized by the State
Governments through taxes varies from 42 per cent in Canada
to lowest figure of less than 5 per cent in the countries of Belgium,
Bolivia, Colombia and South Africa. The extent of revenue
collected by the lowest level of government in the total tax
income show the level of taxation powers transferred to
the local governments. The local government in Switzerland
seems to be very strong. The revenue mobilized by the local
governments was the highest (21.10 per cent). However, in the

countries of Austria, Belgium, Bolivia, Colombia and Spain, the
revenue generated through tax sources was more than the State/
Province Government. The governments at the local level in
these countries have more taxation powers than the middle level
of governance. In India, the lower level of governance have not
been allocated adequate taxation powers to generate substantial
resources. The GFS (Government Finance Statistics) do not give
any figure of revenue collected by local governments in India.
In the recent past only Eleventh Finance Commission has
emphasised to present the strong data base of local bodies.
However, the revenue raised by the local bodies in India is
almost negligible.
Table 11.1: Revenue Decentralization in Selected Countries in 2000
S.No. Country % Share in total tax revenue
Central State Local
1. Australia 77.68 19.26 3.07
2. Austria 70.92 11.40 17.68
3. Belgium 90.01 3.82 6.17
4. Bolivia 76.55 3.75 19.70
5. Canada 48.28 41.94 9.78
6. Colombia 83.41 5.48 11.12
7. Germany 48.80 39.10 12.10
8. India 62.65 37.35 NA
9. Mexico 75.62 19.02 5.37
10. South Africa 92.26 0.70 7.04
11. Spain 73.47 12.12 14.41
12. Switzerland 48.81 30.09 11.58
13. United States 69.27 19.15 11.58
TAX-GDP RATIO AT NATIONAL, STATE AND LOCAL LEVEL

The tax-GDP ratios computed for different level of
governments in selected countries are given in Table 11.2. The
total tax-GDP ratio was the highest of over 30 per cent in the
countries of Australia, Belgium and Canada. The lower tax-
GDP ratio was observed in the countries of Bolivia, Colombia,
India and Mexico. The extent of fiscal (revenue) decentralization
Table 11.2: Tax-GDP (Central, State and Local Government)
Ratios in 2000
S.No. Country Tax-GDP ratio
Total tax Central-tax State-tax Local tax
1. Australia 30.20 23.46 5.82 0.93
2. Austria 27.65 19.61 3.15 4.89
3. Belgium 30.85 27.77 1.18 1.90
4. Bolivia 16.12 12.34 0.60 3.18
5. Canada 31.17 15.05 13.08 3.05
6. Colombia 16.04 13.38 0.88 1.78
7. Germany 24.70 12.05 9.66 2.99
8. India (1999) 15.56 9.75 5.81 NA
9. Mexico 15.43 11.67 2.94 0.83
10. South Africa 26.95 24.86 0.19 1.90
11. Spain 22.31 16.39 2.70 3.21
12. Switzerland 23.05 11.25 6.94 4.86
13. United States 29.08 20.15 5.57 3.37
Source: Government Finance Statistics, 2005
is fairly shown in the case of Canada, where the Central and

State Governments have mobilized about 15 per cent and 13
per cent of GDP respectively. Tax-GDP ratio at Central level
was more than 20 per cent in the case of Australia, Austria,
Belgium, South Africa and United States. In India, it was less
than 10 per cent. On the other hand, barring Canada, in most
of the countries, the tax-GDP ratio at the state level were less
than 10 per cent. In India, it was 5.81 per cent for the year
1999-2000. The resources mobilized through taxation at the
lower level of governance as, shown in Table 11.2, indicates
that in the countries of Austria, Belgium, Bolivia, Colombia,
South Africa and Spain, the tax-GDP ratios were higher than at
the state level. However, in almost all the countries it was less
than 5 per cent. The local governments in Australia and Mexico,
had generated a abysmally small figure of less than one per cent
through local taxation. Apparently, the taxation powers available
with the local governments must be very less. The case of India
is also not much different. Based on the data provided in the
EFC report, the rural local bodies could raise only 1.40 per cent
of GDP.
NATIONAL PERSPECTIVE
As already stated, the Indian Constitution through 73rd and
74th Amendments defines 29 subject matters for rural local
governments (Panchayati Raj Institutions) and 18 subjects for
Urban Local Governments (Municipalities).
It is a happy augury that the quinquennial Finance
Commissions appointed by the Government of India have already
started incorporating financial provisions for the local self-
Governments in their recommendations.4 The process started
with the Tenth Finance Commission. Although the Tenth Finance
Commission did not have any mandate, in its terms of reference,
to make recommendations regarding the local self-government,
yet it recommended a grant of ` 100 per capita of rural
population to the PRIs and a lump sum grant of ` 1,000 crore
for the ULBs, to be distributed among the states on the basis of
the inter-state ratio of slum population derived from the urban
population. The EFC (Eleventh Finance Commission) had the
finances of local self-government in its terms of reference. The
EFC was asked to make recommendations regarding “the
measures needed to augment the Consolidated Fund of a State
to supplement resources of the Panchayats and Municipalities
in the State on the recommendation made by the Finance
Commission of the State”. It recommended financial allocations
to the various states on the basis of the adoption of 73rd and
74th Constitutional Amendments. The EFC recommended a total
grant of ` 1,600 crore for the PRIs and ` 400 crore for the
ULBs for each of the five years starting from 2000-01. Thus a
sum-total of ` 8,000 crore for the PRIs and ` 2000 crore for the
ULBs was recommended by the EFC. The TFC has further raised
this grant to ` 20,000 crore for the PRIs and ` 5,000 crore for
the ULBs.
As for the inter se allocation of the grants-in-aid among the
states, the EFC had adopted the following factors and weights
for working out the inter se allocation of the grants-in-aid among
the states:
Sl. No. Criterion Weight (Per Cent)
1. Population 40
2. Geographical area 10
3. Distance from highest per capita income 20
4. Index of decentralization 20
5. Revenue effort 10
While population and area were neutral factors, distance

from the highest per capita income had equity aspect. Revenue
efforts made by local bodies had some incentive element to
award those states which had made attempts towards
empowering the PRIs and ULBs to mobilize their own resources.
Index of decentralization had also an element of incentivization
for a state to move towards transferring powers/functions to
institutions of local self-government. Further, the EFC had
selected the following ten parameters for the purpose of arriving
at the index of decentralization:
(i) enactment/amendment of the state/panchayats/
municipal legislation;
(ii) intervention/restriction in the functioning of the local
bodies;
(iii) assignment of functions to the local bodies by state
legislation;
(iv) actual transfer of functions to these bodies by way of
rules, notification and orders;
(v) assignment of power of taxation to the local bodies;
(vi) extent of exercise of taxation powers;
(vii) constitution of the SFCs and the submission of action
taken on their reports;
(viii) action taken on the major recommendations of the SFC;
(ix) elections to the local bodies; and
(x) constitution of the district planning committees as per
the letter and spirit of article 243ZD.
The Twelfth Finance Commission (TFC) decided to
drop the criterion of decentralization in view of the fact “that
almost all states have by now taken effective steps for the
implementation of the 73rd and 74th amendments and have
enacted legislations, held elections, constituted the state finance

commissions and taken action on their reports’.5 The Twelfth
Finance Commission use the following criteria for inter-state
allocation of grants:
Sl. No. Criterion Weight (Per Cent)
1. Population 40
2. Geographical area 10
3. Distance from highest per capita income 20
4. Index of deprivation 10
5. Revenue effort of which
(a) with respect to own revenue of states 10
(b) with respect to GSDP 10
The inclusion of deprivation index in determining the

inter-state share of local bodies grants is commendable
because it will ensure horizontal equity in the provision of core
services, i.e. drinking water and sanitation. However, the
recommendations of the TFC regarding local bodies suffer on
many counts.
First, the basic assumption of the TFC that the 73rd and
74th Constitutional Amendments have been completed, in the
sense that the functions contemplated to be transferred under
the constitutional provision have already been transferred, so
that there is no need to move further in this direction, may be
partially correct. Every effort has to be made to strengthen the
decentralization process in a federal set-up. The EFC was right
in incorporating the decentralization index for deciding inter-
state share in the grants-in-aid to the local bodies so as to
encourage strengthen the decentralization process. Some scheme
of incentivization has to be built up in the system. For example,
decentralization can be redefined in terms of transferring:
(i) functions, (ii) functionaries, and (iii) finance.
Depending upon the actual transfer of any one or a
combination of two or three components mentioned above,
one can judge the degree of decentralization process adopted
by a particular state. And depending upon the degree of
decentralization, the inter-state share of grant can be worked
out.
The contention of the TFC that the criterion of revenue

effort, i.e. the ratio of own revenue of local bodies to states’
own revenue, which has been retained, serves as a proxy for
revenue decentralization may also be partially correct because
actual decentralization can also depend upon the ratio of
expenditure incurred by local bodies to total state expenditure.
Therefore, the ratio of expenditure incurred by local bodies can
also serve as a useful index to induce the states to move towards
decentralization. Then there is a need to incorporate the provision
of incentivization in any system of devolution of funds to states
for the benefits of local bodies. As already stated a composite
index of three Fs can be evolved to work out the exact degree
of decentralization. The implementation of State Finance
Commission report can be another indicator of movement
towards decentralization. While examining the transfer of funds
by the Central Finance Commission, the actual amount
transferred by a state as per the recommendation of SFC should
also the taken into account. For example, in case of Punjab it
has been admitted by the State Finance Minister that during
2001-02 to 2004-05 the local bodies got only ` 512.24 crore
against ` 1813.01 crore as recommended by the Second
SFC. A rough estimate reveals that out of ` 512.24 crore,
approximately ` 210 crore came from the EFC. The point to
emphasize is that while deciding the inter-state share of grants
for the benefit of local bodies the self efforts of the states to
financially strengthen their local bodies should also be taken
into account.
Then, as recommended by many experts there is a need to
incorporate a new list in our Constitution which may be called
Local List, i.e. our Constitution must contain Union List, State
List and Local List. The Concurrent List can be further split
into two, i.e. Concurrent List I (both for the Centre and the
states) and Concurrent List II (for the states and local bodies).
There is also an urgent need to create a special Corpus
Fund for the benefit of PRIs and ULBs. In the beginning, the
Union Government can contribute a small share and slowly and
steadily the fund can be enlarged by transferring unutilized funds
of the states, meant for the benefit of local bodies. The TFC has
observed that “the Finance Commission grants sometime take

long time to reach the local bodies even after the Central
government has released the grants to the States. Often the
State governments were found to use them for their ways and
means comfort and show no Sense of urgencies in passing
them on to the rightful recipients. This results in withholding of
further releases by the Centre and the local bodies suffer the
consequences for no fault of theirs.”6 Therefore, if any State
Government delays the transfer of money/grants to local bodies
say beyond one month, then the Centre can ask the state to
refund the money and deposit in this Corpus Fund.
As already mentioned, the amount of expenditure incurred
by the local bodies, apart from their own tax and non-tax revenue
is equally important to judge the degree of decentralization.
The Thirteenth Finance Commission has adopted the index
of devolution, derived from the non-plan revenue grants
transferred to PRIs and ULBs by the states (Net of Twelfth
Finance Commission grants 2007-08), to determine the inter se
share and assigned a weightage of 15 per cent. Another five per
cent weightage is given to the actual utilization of grants given
to local bodies.
The summary of the criteria and weights allotted by the
Thirteenth Finance Commission is shown in the following table.
Weights Allotted to Criteria for Grants to Local Bodies
Criterion Weights allotted (%)

PRIs ULBs
Population 50 50
Area 10 10
Distance from highest per capita sectoral income 10 20
index of devolution 15 15
SC/STs proportion in the population 10 -
FC local body grants utilization index 5 5
Total 100 100

For the first time total grants have been divided into two
categories—basic grants (` 56.335 crore) and performance grants
(` 29,826 crore)—as an incentive to make states move faster
towards decentralization.7 The total amount of grants would be

substantially higher than ` 25,000 crore recommended by the
Twelfth Finance Commission.
Yet there are some riders on states to be eligible for getting
performance grants. And these conditionalities are:
The state government must put in place a supplement to
the budget documents for local bodies (separately for PRIs
and ULBs) furnishing the details (other than those relating
to Finance Accounts). They should require the PRIs
and ULBs to maintain accounts in specified manner.
To demonstrate compliance with condition, a State
government should: (a) submit the relevant supplement
to the budget documents and (b) certify that accounting
systems as recommended have been introduced in all rural
and urban local bodies.
The State Government must put in place in audit system for
all local bodies (all categories of ULBs and all tiers of PRIs) as
indicated in Para 10.121 above. The CAG must be given TG
and S over the audit of all the local bodies in a state at every
tier/category and his Annual Technical Inspection Report as
well as the Annual Report of the Director of Local Fund Audit
must be placed before the state legislature. Certification from
the CAG will demonstrate compliance with this condition.
The State Government must put in place a system of
independent local body ombudsmen who will look into
complaints of corruption and maladministration against the
functionaries of local bodies, both elected members and officials,
and recommend suitable action. This system should be made
applicable to all elected functionaries and officials in all municipal
corporations, municipalities and zila parishads at least. The
passage of relevant legislation and its notification will
demonstrate compliance with this condition. In the event that
all or a class of the functionaries mentioned above fall under
the jurisdiction of the Lok Ayukta of the state, we leave it to the
state to decide whether to continue with these arrangements or
to shift the functionaries to the jurisdiction of the ombudsman.
Self-certification by State Governments will demonstrate
compliance with this condition.
The State Governments must put in place a system to

electronically transfer local body grants provided by this
Commission to the respective local bodies within five days their
receipt from the Central Government. Wherever this is not
possible due to lack of easily accessible banking infrastructure,
the State Governments must put in place alternative channels of
transmission such that funds are transferred within ten days of
their receipt. Self-certification by the State Governments with
a description of the arrangements in place will demonstrate
The State Government must prescribe through an Act the
qualification of persons eligible for appointment as members
of the SFC consistent with Article 2431(2) of the Constitution.
The passage of relevant legislation and its notification will
demonstrate compliance with this condition.
All local bodies should be fully enabled to levy property tax
(including tax for all types of residential and commercial
properties) and any hindrances in this regard must be removed.
Self-certification by the State Government will demonstrate
State Governments must put in place a state level Property
Tax Board, which will assist all municipalities and municipal
corporations in the state to put in place an independent and
transparent procedure for assessing property tax. The Board
(a) shall, or cause to, enumerate all properties within the
jurisdiction of the municipalities and corporations; (b) shall
review the present property tax system and make suggestion for
a suitable basis for assessment and valuation of properties: and
(c) shall make recommendations on modalities for periodic
revisions. The findings, suggestions and recommendations of
the board will be communicated to the respective urban local
bodies for necessary action. The exact model to be adopted
is left to the respective state. The Board should be staffed
and equipped in such a manner as to be able to make
recommendations relating to at least 25 per cent of the aggregate
number of estimated properties across all municipal corporations
and municipalities in the state by 31 March 2015. The board
should prepare a work plan indication how it proposes to achieve
this coverage target and the human and financial resources it

proposes to achieve this coverage target and the human and
financial resources it proposes to deploy. Passage of the relevant
legislation or issue of the necessary executive instruction by the
State Government for creation of the property Tax Board as
well as publication of the work plan by the Board in the State
Government gazette will demonstrate compliance with this
condition.
Lack of resources often results in local bodies diluting the
quality of services provided by them. State Governments must
gradually put in place standards for delivery of all essential
services provided by local bodies. For a start, State Governments
must notify or cause all the municipal corporations and
municipalities to notify by the end of a fiscal year (31 March)
the service standards for four service sectors-water supply,
sewerage, storm water drainage, and solid waste management
proposed to be achieved by them by the end of the succeeding
fiscal year.
This could be in the form of a declaration of a minimum
level of service for the indicators mentioned against each of
these four service sectors in Handbook on Service Level
Benchmarks published by the Ministry of Urban Development.
For example a state may notify before 31 march 2011 that by
31 March 2012, all municipalities and municipal corporations
in the state will provide a specified minimum level of service for
each of the indicators for the four service sectors of water supply,
sewerage, storm water drainage and solid waste. These levels
may be different for different municipalities. We envisage such
a commitment to be achieved through a consultative process
with the local bodies. Such a notification will be published in
the State Government gazette and the fact of publication will
All municipal corporation with a population of more than 1
million (2001 census) must put in place a fire hazard response
and mitigation plan for their respective jurisdiction. Publication
of these plans in the respective State Government gazettes will
To conclude we can say that the process of decentralization

which gathered some momentum because of the
recommendations of EFC, was somewhat slowed down by the
TFC, although the Report stated that measures for restructuring
of public finances would be complete only if the third tier of the
government is also taken into account. The Thirteenth Finance
Commission has rightly divided total grants into two categories—
basic grants and performance grants so as to incentivise the
states to move faster towards decentralisation.
NOTES
1. W.E. Jackson, “The Structure of Local Government in England and
Wales”, (Longmans, 1960, p. 11. As quoted in S.K. Bhogle, Local
Government and Administration in India (Aurangabad, Parimal
Prakashan, 1977), p. 1.
2. Now the Centre shares the total net proceeds from all taxes as per
the recommendations of the Central Finance Commissions.
3. O.P. Bohra, “Decentralization and Devolution of Resources to
Local Governments: Central Finance Commission Approach”, paper
presented at the seminar on Recommendations of the Twelfth
Finance Commission and Their Implications for the States, Giri
Institute of Development Studies, Lucknow, 6-7 May, 2005.
4. J.R. Gupta and R.K. Bansal, “Strengthening Decentralization Twelfth
Finance Commission Approach”, ibid.
6. Ibid., 2009.
7. Government of India, Thirteenth Finance Commission Report,
December 2009.
Appendices
APPENDIX I
Pricing of Public Services and Return on Investment*
In a welfare state, the pricing of public goods and services
has always occupied a central stage. The typical questions which
are often asked are: Should public services be provided on ‘no
profit no loss’ basis? Or being monopolist the government should
charge on the principle of what the traffic should bear and earn
at least a minimum rate of return both on fixed and operational
cost? Or in a welfare state it is the duty of the government
to provide subsidised services to maximize social welfare, and
so on.
Then the question is what costs should be considered? Should
we consider only the operational cost (as the investment has
been made in the past) or the total cost including fixed cost ? It
is just possible that building of economic and social infrastructure
like roads, railway lines, canals, etc. may be necessary on the
part of the government because of the lack of private initiative.
But its maintenance and operational costs may be covered from
the users. Or being faced with scarcity of resources, the
infrastructure facilities may be provided on BOT (build, operate
and transfer) principle.
Another thing to remember is that answers to the above
questions cannot be given in a static sense. Answers would
* This appendix is based on the paper presented by this author at the
National Seminar on Changing Contours of Financial Administration
in India—Emerging Challenges, organized by the ICSSR and Senior
Citizens Council for Human Resource Development, Chandigarh,
January 28-29, 2005.
vary with changes in the socio-economic and even political

frameworks. Whatever was true in the fifties when we started
on the path of economic development, is not true today when
we have opened up our economy and are dreaming to enter the
developed world very soon, offshoot of which is our claim for a
permanent in the U.N.O. To put it differently the same pricing
criterion for the same service cannot hold true for all times to
come, nor the uniform pricing criteria can hold for all types of
services. The pricing criteria will vary with the nature of the
product, i.e. whether it is pure public goods, merit goods or
nearer to private goods.
The most important thing to take note of is that in this
paper the word ‘public services’ has been used in a wider
economic sense, i.e. in the sense of ‘public goods and services’,
because in economic literature till recently we used to talk about
‘public goods’ vs ‘private goods’. And this distinction would
help us to examine the question of pricing public goods or public
services in a proper perspective.
Private vs Public Goods and Merit Goods
The distinction between the public and private goods can
be well understood on the basis of the following characteristics
of goods:
(a) Product Divisibility
(b) Externalities.
(a) Product Divisibility: There are goods and services which
are priced in the market and their use is exclusively restricted
for those who are willing to pay the stipulated price. The use of
such commodities is governed by the principle of exclusion.
All those who are not inclined to pay its market price or those
who cannot afford to pay that price are excluded from its
consumption. Thus, the commodity becomes divisible in as far
as its use is concerned. Such goods are termed as private goods.
On the opposite, there are certain other goods called as public
goods for the use of which no discrimination is made amongst
the users and all the members of the society, whether they are
capable of paying for them or not, indiscriminately make use of
APPENDICES 569
them. For instance, law and order services, the defence services,
etc. are equally utilized by all the inhabitants of a country. No
section of the society can be excluded from their use. It means
that these services are indivisible. These cannot be priced in the
market and their use is not governed by the principle of exclusion.
In case of divisible products, since the supply can be made
available only to those who can pay for them, the consumers of
such goods, voluntarily pay for maintaining a requisite level of
their supply. In case of these goods, the demand preferences
and the price which the consumers are willing to pay provide
good indication of the type of commodity which should be
produced. Thus, all decisions about the divisible goods such as
the type of commodity and its quantity to be produced are
dictated by the market prices. But in case of the indivisible
goods, the market mechanism fails to help make such vital
decisions and all these decisions are made by the society or the
government. As mentioned above, the divisible goods are paid
by the individuals who use them. But the indivisible goods, like
defence services and police services will pose the problem of
financing them. In case of these services, everyone knows that
even if one does not pay for them, these will still be available to
everyone. This creates a tendency to avoid payment towards
them. As a result most of the people will not pay voluntarily on
the assumption that the supply of these services will continue
owing to the payments made by others. Buchanan has referred
to this as the problem of free riders.1 It means that everybody is
inclined to enjoy the benefit of such services without having to
contribute voluntarily towards the cost of supplying these
services. In such a situation, their financing becomes problem.
To overcome this difficulty, a provision for compulsory
contribution by the members of the society through taxation is
made. Thus, it is clear that in case of indivisible goods or services
not only the decisions concerning their production are left to
the government or to its agencies but the financing of the
production is also carried through taxation.
Such goods as are indivisible and the benefits of which are
not governed by the principle of exclusion are called as the pure
public goods. On the opposite, the pure private goods are those
which are completely divisible and in case of which the principle

of exclusion applies in full measure.
(b) Externalities. A pure public good can be distinguished
from a pure private good on the basis of the existence or
otherwise of externalities. The term externalities refers to the
economic effects that arise due to the production or use of the
good to other parties or economic units. These are in the form
of an economic gain or an economic loss and are responsible
for creating a certain divergence between their private and social
marginal costs and benefits. The process of production may
create certain bad effects on the society, although this may be
completely disregarded by the individual producing units.
When there are such bad or negative externalities, the people
have to bear some social costs that may be somewhat reduced
by the government through taxation.
Just as there are bad social effects of certain goods and
services, similarly, there are externalities in the form of economic
gain or benefits to the society. The construction of a railway
line linking a steel plant benefits not only the steel plant but
also the people of the entire area through which that line passes.
Benard P. Herber has put such externalities into two categories—
market and non-market external effects.
(i) Market External Effects: When the external effects, both
social costs and social benefits, can be priced in the market with
reference to the supply and demand behaviour, they are known
as the market external effects. For instance, if an irrigation
project is started in an area the net increase in the production
of agricultural crops and the area rendered unavailable for
cultivation due to the construction of dam or erosion of land
by the canal tributaries and a consequent fall in production
determine the market external effects of the project.
(ii) Non-Market External Effects: When the external effects
of goods and services produced cannot be priced with reference
to the demand and supply behaviour, these are termed as the
non-market external effects. For instance, a new road is
constructed but it is difficult to determine the extent to which
different economic entities derive benefit from it. Certain
APPENDICES 571
categories of beneficiaries can, of course, be identified. But if

the benefits of such categories of road users, called primary
beneficiaries, alone are taken into account, that will exclude
other secondary and tertiary beneficiaries. Thus, the pricing
principle cannot strictly be applied in case of such projects or
goods and services.
Such goods and services, as have non-market external effects,
should be preferably produced and distributed through public
authorities because they can take economic decisions irrespective
of profit considerations. Thus, we arrive at the conclusion that
such pure public goods as have non-market external effects
should be included in the public sector and those having market
external effects may be left to the private sector. This rule, of
course, cannot be applied rigidly. Even such goods and services
that are left to the private sector may in certain cases be
reallocated to the public sector provided the government is
convinced that such course of action is likely to promote social
welfare. Alternatively, the government may subsidise their
production in the private sector if their consumption is necessary
for health and efficiency and will thus promote social welfare.
Merit Goods
There are certain goods which, on the basis of the above-
mentioned criteria, may be regarded as private goods. The state
may, however, in the larger interest of society include them in
the public sector. Such goods are termed as the merit goods as
their use is considered desirable for certain members of the
society. Normally, in case of private goods, all the basic economic
decisions concerning their production and distribution are guided
by individual preferences. But the meritorious characteristic of
the merit goods makes it obligatory for the public authorities to
deliberately interfere in individual choices and modify the choice
pattern of society. For instance, the government may subsidise
low cost housing, provide free education to the people or provide
mid-day meals to the students. Undoubtedly, the state
interference in supplying these goods and services will be viewed
as an encroachment upon the freedom of choice. But the broader
objectives of public policy will justify such a course of action on
the part of the state. If education is left to the private sector,

many brilliant children belonging to the poor families will be
forced to seek work rather than schooling for want of funds.
Education, particularly primary education, therefore, is the merit
good. The want for education is the merit want which almost
every member of the society must be able to satisfy. Similarly, if
basic health services in a country are left to private agencies,
only those members of the society can avail of them who are
better off while the poor may have to go without them. The
public authority in case of this merit good also will supplement
its availability in cooperation with the private agencies. In all
such cases of merit goods, the considerations of maximum social
benefit override ideological or any other considerations against
state interference in economic choices. In fact, this interference
is most desirable for it attempts to correct distortions in the
exercise of consumer choices. Thus, merit goods are those goods
which are provided publicly like social goods but whereas the
latter are meant for all sections of the community, the former
are considered desirable for certain sections of the society.
Now return on public investment and pricing of impure
public services which are nearer to private goods is the most
crucial issue. There cannot be a simple answer to the whole
issue. We will have to go to the very objectives of making public
investment, which can be manifold, e.g. to keep private sector
at bay by holding monopoly power, to promote economic
development by providing necessary infrastructure, to promote
and maximise social welfare, etc. Then pricing of public services
and return on public investment or for that matter pricing and
return of any investment involves the consideration of costs
also. But in case of public services it would mean commercial
cost and social cost. Similarly, returns would mean commercial
returns or commercial benefits and social returns or social
benefits. We will have to adopt a holistic approach as far as
public services are concerned.
Suppose a public service involves high commercial cost but
if social benefits are equally higher, i.e. even if such services
involve huge commercial losses, we should not hesitate to make
investment in such enterprises.
APPENDICES 573
Coming back to the pricing of public services while

commercial costs and commercial benefits are easy to estimate,
social cost and social returns or social benefits may be difficult
to quantify. But we can easily tell whether the public investment
is set to achieve any social and economic goals like removal of
poverty and hunger, reducing inequalities in the distribution of
income, generation of employment opportunities, etc. Then
public investment or provision of public services may be in terms
of depleting or exhausting natural resources, polluting the
environment and disturbing the ecological balance, or even in
terms of opportunity costs, i.e. withdrawing the resources which
would otherwise might have been used for some other purposes.
Recently, it has been reported that Professor Amartya Sen, Nobel
Laureate, 1998, while advocating huge additional investment in
social sector, viz. education and medical services, cautioned that
this should not mean that resources are diverted from other
sectors.2 In other words, we should have a holistic view of the
entire issue of public pricing considering all aspects of the
problem, i.e. social and economic.
Further already mentioned in the beginning the whole issue
of pricing public services and returns thereon cannot be tackled
in a static sense. For example, when India was facing famine
like conditions in the early sixties, foodgrain production had to
be promoted at all costs. In the mid-sixties, agricultural inputs
including power were highly subsidised in the promising areas
to achieve self-sufficiency in foodgrain production. But that
involved social costs also. Water level was depleted. Ecology
was disturbed. And even inter-regional disparities widened. But
the overall societal consideration to achieve self-sufficiency in
basic food requirements overrided all other negative externalities.
But in the present scenario what social benefits are we now
drawing by subsidising agriculture. There is no increase in
agricultural production, no reduction in poverty or inequalities,
i.e. while there are no social and even economic gains, there are
huge social costs. Last year, and even during the current rabi
season power had to be diverted from other sectors to sustain
the production of wheat and rice.3 Now if the objective is to
sustain the income of the farmers, which it should be because of
their falling income which is already substantially lower than

the non-agricultural sector, then the same objective can be
achieved by spending the same amount of resources through
other means (say by recharging the ground water or by
promoting eco-friendly cropping system), where social costs are
less or social benefits more. That is we should desubsidise the
electric power to farm sector and fix the price accordingly.
Now coming to some individual cases of public services
before we sum up.
Power Sector
Power sector, notable the State Electricity Boards (SEBs),
has shown a most dismal performance. Although when the
idea of states’ owned electricity boards was conceived, these
were expected to earn about 3 per cent rate of return on their
investment. However, because of some extraneous considerations
the average tariff in most of the cases does not even cover the
cost of generation and supply and this gap has progressively
widened over the years. “This in financial terms is reflected by
gross subsidy for the power sector which accounted for 11 per
cent of state government budgets...the gross subsidy enjoyed by
the power sector increased from ` 27,804 crore in 1998-99 to
` 31,941 crore in 2003-04. Accordingly, commercial losses also
mounted upward, resulting in a negative Rate of Return (RoR)
from 12.7 per cent in 1991-92 to 21.2 per cent in 1998-99 to
30.86 per cent in 2003-04.” 4 Since these losses are not
sustainable, an appropriate price policy has to be evolved for
electric power. As already stated that subsidised power supply
to agriculture is not serving any useful social or economic
objectives, further dynamism in the price of power is also revealed
by the fact that whereas electricity charges earlier were inversely
related with its consumptions, i.e. as you consumed more of
electricity the per unit price charged declined. Now these charges
are positively and progressively related with the consumption,
of electricity, i.e. as you consume more of electricity per unit
price will also increase. However, while pricing the public goods
it should be kept in mind that the cost of inefficiency in the
public sector should not be transferred to the consumers. This is
APPENDICES 575
possible, if private sector is allowed to operate side by side with

public sector as the case for banking services, telecommunication
services, etc.
Passenger Road Transport
In 1997-98, there were 71 State Road Transport
Undertakings (SRTUs), having a fleet of nearly 1.1 lakh buses
and these carried nearly 6.4 crore passengers per day. Most of
the SRTUs were incurring losses, estimated at ` 1,108 crore for
the year 1997-98.5 The main reasons for the poor financial
health of the SRTUs were: low fare fixed more or less on political
grounds, absence of regular fare revision due to procedural
delays, concessions in fares to students and other weaker sections
of the society, operation on the uneconomical routes, etc.
According to the Tenth Finance Commission, the SRTUs which
had an investment of ` 3,084 crore at the end of 1994-95 had a
dismal physical and financial working. The Tenth Finance
Commission further observed that “it is a matter of serious
concern that investment in irrigation, power and road transport,
which constitute the bulk of State Government investment, do
not yield enough returns. A shortsighted perception of political
necessity, perhaps, has persuaded state after state to fix user
charges at levels which do not cover even the operation and
maintenance (O&M) expenditure in irrigation and generate
meager surpluses, if at all, in power; several state electricity
boards are over-staffed and run at substantial losses. The
artificially depressed user charges result in criminal waste of
water and electricity—both very scarce resources.”6 The National
Institute of Urban Affairs in one of its study observed that the
under-recovery of charges lead to deterioration in the services.
Therefore, the important issue is to identify the chargeable costs
and general rule for efficient pricing of public services is to set
price equal to marginal cost.7
As compared to road transport railway transport is operated
on more professional lines. Consequently, Indian Railways
perform better. The latest example of construction and operation
of Metro Railway in New Delhi bears testimony to the fact that
given professional freedom and political non-interference public
service can be provided at affordable prices covering both the

operational and the fixed costs.
Education
Education is one of the social services activity representing
around 60 per cent of the total expenses on social services
activities. The budgetary allocation to education, both by the
Centre and states has increased from ` 17,000 crore in 1990-91
to ` 81,000 crore in 2003-04. However, total expenditure on
education in relation to GDP was 3 per cent in early 1990s, the
ratio was lower at 2.7 per cent during mid-1990s and this is
against the goal of 6 per cent set by the National Education
Policy, 1986. The structure of expenditure on education reveals
that although the share of higher education in education
expenditure has fallen sharply in India during 1990s, the adverse
consequences of heavy emphasis on higher education earlier are
still being felt, with high illiteracy of 34-35 per cent and more
than half of the world’s children being out of school. The greatest
pinch has been felt by the poor, with adverse consequence on
equity.
Therefore, education services can be divided into two
categories: merit services and non-merit services. While primary
education is a merit service, higher education can be considered
as non-merit service and dealt with accordingly. Higher education
may be further sub-divided into general education and technical
education. Wherever possible some self-financing schemes for
the students like ‘earn while you learn’ should be introduced.
Social and Public Health
The expenditure on medical and public health by the Centre
and states as proportion to GDP is 0.9 per cent only, whereas
the National Health Policy, 2002 has the objective to raise
it to 2 per cent of GDP. The health care delivery system has
imbalances in terms of under-utilisation at some levels and over-
utilisation at others. Without going into the details what ails
our health care delivery system, for pricing purposes we can
divide medical and public health services again into two
categories, merit services and non-merit services, though by and
APPENDICES 577
large all medical services must fall into the merit category. In
any case, all preventive health care, viz. vaccination, sanitation,
etc., must be termed as merit services and dealt with accordingly.
Whereas the curative health measures may be merit goods for
the underprivileged, who must be identified on some objective
fool proof basis. For others, who could afford to buy these
services from the market, some price may be charged. But care
should be taken that prices charged by the government agencies
are reasonably less than those prevailing in the open market
because of some concealed costs (in terms of inefficiency and
more time consuming) involved in purchasing health services
from the government agencies. Then as far as possible revenue
earned this way must be retained and reinvested in the same
institutions to improve the health services.
Summing Up
There should be no ambiguity that so far as merit services
are concerned these must be provided by the state at less than
the commercial cost since here social benefits should override
all other considerations. So far as pure public goods are
concerned these cannot be priced and have to be financed by
appropriate tax policies. In case of other public services these
should be operated on professional lines. The tragedy of our
system is that we have never given any freedom to the managers
of these enterprises to operate on commercial principles. There
had been political interference to use these PSUs to serve the
political ends. Then lastly no single pricing principle can be
applied for all types of public services nor the same pricing
principle can hold for all times to come, i.e. no static answer
can be given so far as pricing of public goods is concerned. It
must also be borne in mind that non-recovery of O&M costs
leads ultimately to the deterioration of public services.
Finally, what oils our public services and how to get out of
it, Samuel Paul, a noted authority on public services, points out
that it is the external pressure which works.8 In case of private
sector it is competition. Similarly, wherever the external pressure
through privatisation has been introduced public services have
improved, e.g. banking, telecommunication, etc. Where such
external pressure through privatisation is not possible, there the

pressure of civic society can work. But the tragedy here is that
our indifferent attitude and vested interest do not allow us to
move forward. It should also be borne in mind that along with
efficiency of operating public services equity should also be the
concern of the government services. Last but not least, whenever
the need is felt to raise the prices of public services, it should be
in marginal doses so as to ensure a smooth transition.
NOTES
1. J.M. Buchanan, The Demand and Supply of Public Goods, Rand
McNally and Co., Chicago, 1969.
2. Based on the Press Reports.
3. In the kharif season of 2004 the Punjab Government had to buy
power at the rate of about ` 6.0 per unit in order to sustain the
paddy crop and thereby incurred huge losses.
4. Nand Dhameja, “State Governments Finances—Public Services
Finances”, Indian Journal of Public Administration, Vol. L, July-
September 2004, pp. 619-38.
5. Ibid.
6. GoI, Ministry of Finance, Report of the Tenth Finance Commission,
for 1995-2000.
7. As quoted in Indian Journal of Public Administration, op. cit.
8. Samuel Paul, “What Ails Our Public Services”, An abstract from his
book, Holding the State to Account, Books for Change, Bangalore,
2002.
APPENDICES 579
APPENDIX II
The Constitution of India Seventh Schedule (Article 246)
Separation of Financial Powers
List I (Union List)

1. Taxes on income other than agricultural income
(item 82).
2. Duties on customs including export duties (item 83).
3. Duties of excise on tobacco and other goods
manufactured or produced in India except,
(a) alcoholic liquors for human consumption;
(b) opium, Indian hemp and other narcotic drugs and
narcotics, but including medicinal and toilet
preparations containing alcohol or any substance
including in sub-paragraph (b) of this entry
(item 84).
4. Corporation tax (item 85).
5. Taxes on the capital value of the assets, exclusive of
agricultural land, of individuals and companies; tax on
the capital of companies (item 86).
6. Estate duty in respect of property other than agricultural
land (item 87).
7. Duties in respect of succession to property other than
agricultural land (item 88).
8. Terminal taxes on goods or passengers, carried by
railways, sea or air, taxes on railway fares and freights
(item 89).
9. Taxes other than stamp duty on transactions in stock
exchanges and future markets (item 90).
10. Rates of stamp duty in respect of bills of exchange,
cheques, promissory notes, bills of lending, letter of
credit, policies of insurance, transfer of shares,
debentures, proxies and receipts (item 91).
11. Taxes on the sale or purchase of newspapers and on
advertisements published therein (item 92).
12. Taxes on the sale or purchase of goods other than

newspapers, where such sale or purchase takes place in
the course of inter-state trade or commerce (item 92A).
List II (State List)
1. Land revenue, including the assessment and collection
of revenue, the maintenance of land records, survey
for revenue purposes and records of rights, and
alienation of revenue (item 45).
2. Taxes on agricultural income (item 46).
3. Duties in respect of succession of agricultural land
(item 47).
4. Estate duty in respect of agricultural land (item 48).
5. Taxes on land and buildings (item 49).
6. Taxes on mineral rights subject to any limitations
imposed by Parliament by law relating to mineral
development (item 50).
7. Duties of excise on the following goods manufactured
or produced in the state and countervailing duties at
the same or lower rates on similar goods manufactured
or produced elsewhere in India.
(a) Alcoholic liquors for human consumption.
(b) Opium, Indian hemp and other narcotic drugs and
narcotics; but not including medicinal and toilet
preparations containing alcohol or any substance
in paragraph (b) of this entry (item 51).
8. Taxes on the entry of goods into a local area for
consumption, use and sale therein (item 52).
9. Taxes on consumption or sale of electricity (item 53).
10. Taxes on the sale or purchase of goods other than
newspaper, subject to the provisions of Entry 92A of
List I (item 54).
11. Taxes on advertisements other than advertisements
published in the newspaper and advertisements
broadcast by radio or television (item 55).
APPENDICES 581
12. Taxes on goods and passengers carried by road or on

inland waterways (item 56).
13. Taxes on vehicles whether mechanically propelled or
not suitable for use on road including tram cars subject
to the provision of entry 35 of List III (item 57).
14. Taxes on animals and boats (item 58).
15. Tolls (item 59).
16. Taxes on professions, trade, callings and employment
(item 60).
17. Capitation taxes (item 61).
18. Taxes on luxuries including taxes on entertainments,
amusements, betting and gambling (item 62).
19. Rates of stamp duty in respect of documents other than
those specified in the provisions of List I with regard
to rates of stamp duty (item 63).
APPENDIX III
Socio-Economic Schemes
The Schemes of Socio-Economic Development:
(a) Beekeeping.
(b) Seed farms.
(c) Mushroom farming and promotion of sunflower
cultivation.
(d) Floriculture.
(e) Poultry and dairy farms.
(f) Propagation of bio-gas units and other similar functions
entrusted to Gram Panchayats.
(g) Any other function falling under this category and so
entrusted by the government.
The departments would provide assistance such as extension
services, technical assistance and finances in the form of grants
or loans for the execution of these schemes.
Welfare/Beneficiary-oriented Functions
The beneficiary-oriented functions are:
(a) Pension for widows, old persons physically disabled
and the destitute.
(b) Educational and other facilities for Scheduled Castes
and Backward Classes.
(c) Anganwari and Balwari Schemes.
(d) Women and child welfare.
(e) Welfare of handicapped and mentally retarded.
(f) Any other function entrusted by the State Government.
The above functions are implemented by the Department
of Welfare, Department of Welfare of Schedule Castes and
Backward Classes and the Department of Labour. These
schemes are for a particular group of individuals and have been
categorized accordingly.
APPENDICES 583
According to the objectives of each scheme, the beneficiaries

are identified according to a prescribed criteria and policy for
providing assistance, under these schemes.
General Services/State/National Policy Functions
The functions which relate to the general upliftment
of the community are grouped under this category. These
include:
(a) Education, including adult education.
(b) Health and family welfare and sanitation.
(c) Veterinary health services.
(d) Agriculture.
(e) Soil conservation.
(f) Afforestation.
(g) Public works.
(h) Any other function falling under this category entrusted
by the government.
The government has well established field organization and
these functions are being performed by the functionaries of
the government departments. All these functions involve matters
of State or National Policy. The Gram Panchayats will be
increasingly involved in the implementation of schemes falling
under this category.
Assets and Infrastructure Creating Functions
The functions in this category include:
(a) Construction of primary health centres.
(b) Construction of veterinary dispensaries.
(c) Construction of village streets, drains and culverts.
(d) Construction of panchayat ghars.
(e) Construction of multi-purpose community centres.
(f) Construction of other buildings.
(g) Any other function falling under this category entrusted
by the government.
The above functions, involving capital expenditure, create

infrastructure at the grassroot level and the assets so created
have to be maintained by the Panchayati Raj Institutions.
Central/State Sponsored Schemes/Functions
The following schemes fall in this category:
(a) Integrated Rural Development Programme (IRDP).
(b) Training of Rural Youth for Self-Employment
(TRYSEM).
(c) Development of Women and Children in Rural Area
(DWCRA).
(d) Supply of Improved Tool Kits to Rural Artisans.
(e) Scheme for Integrated Wasteland Development Projects.
(f) Strengthening of Infrastructure under TRYSEM.
(g) National Project on Demonstration of Improved
Chullahs in Rural areas.
(h) Jawahar Rozgar Yojna.
(i) Rural Sanitation Programme.
(j) Unnat Gram Scheme.
Important Concepts
Ability to pay. A basis for equitable distribution of tax

burden determined by one’s income or other measures (objective
or subjective).
Ad valorem tax. A tax that is calculated as percentage of
the price or value of the item subject to tax.
Adequacy. Quality of a tax that measures the amount of
revenue it can raise relative to what the government needs, i.e.
canon of adequacy.
Allocation/distribution/stabilization functions. A sorting of
the functions of government developed by economist Richard
Musgrave into those that affect the mix of output or the use of
resources (allocation), the shares of income and wealth by various
groups in the population (distribution), and the macroeconomic
impact of government on the level of output, employment, and
prices (stabilization).
Assessment. The process of determining the value of a taxable
base, i.e. income or asset for purposes of imposing taxes.
Assessment year. Assessment year is the year in which the
income is assessed. It always follows the financial year in which
income has been earned.
Base erosion. The reduction of the base of a tax either as a
result of high rates or as a result of legislative action to exempt
some components of the base.
Benefit principle. The principle that taxes should be levied
in proportion to the benefits received from the government
expenditure.
Benefit tax or cost of benefits. A tax imposed on those who

benefit from the public goods or service financed by the revenue
from the tax. Cost of benefits approach implies only cost to be
covered.
Budget estimates. A statement of expected revenues and
planned expenditures for a period. It can be actual estimates,
revised estimates or budgeted estimates.
Budgetary support. Inclusion of financial accounts of PSUs
in the general budget so as to make provision for their day-to-
day operation.
Capital gains tax. A tax on the gains from the sale and
purchase of an asset, i.e. the price at which the asset was
purchased and the price at which it was sold, of course, making
allowance for the expected inflation.
Cascading of tax. A tax that is imposed at more than one
stage of production and distribution. It is a tax on tax.
Centralization. Concentration of government’s activities at
the federal rather than state/provincial level or at the state/
provincial level rather than the local level.
Classified property tax system. A property tax system in
which different classes of property (residential, industrial, etc.)
are assessed for tax purposes at different rates as percentages of
their market or rental value.
Collection Cost(s). Costs incurred by the government in order
to collect taxes. It is also called fiscal expenditure.
Compensation principle. Developed by Professor Nicholas
Kaldor, whether a change improves or worsens economic welfare
by answering the question “Could the gainers from the change
compensate the losers for their loss and still retain some net
gain?” It is an improvement over Pareto optimality.
Compliance Cost(s). Costs incurred by the taxpayer in
determining the amount of tax he owes to the government
including cost for tax payment.
Congestion charges. Fees charged during periods of peak
usage of certain facilities such as roads and parks to reduce
congestion. It is a by-product of Club theorem.
IMPORTANT CONCEPTS 587
Consolidated fund. Government treasury in which receipts

from different sources including loans raised by it and also its
receipts from recoveries of loans granted by it forms the
consolidated fund in which receipts are first deposited and then
the allocation for different items are made. It may be consolidated
fund of the Centre or state.
Cost-benefit analysis. A technique of project evaluation that
determines and compares expected future costs and benefits from
proposed projects.
Cost-benefit ratio. The ratio of the present value of future
costs to the present value of future benefits, used to evaluate the
desirability of a project.
Cross-subsidy. Using surplus revenues from one activity or
consumer group to help/pay for another. For example, higher
electricity charges from domestic consumers to pay for the
subsidized supply to the agriculture sector.
Custom duties. Taxes imposed by the Union Government
on import (called import duties) and export (called export duties).
Depreciation. Type of allowances made that permits the
reduction in the value of an asset to take place for tax purposes
over the asset’s useful life-time.
Devolution. Assignment of functions and resources formerly
held by a higher level of government to a lower level (federal to
state, and state to local).
Earmarked taxes. Tax revenues that flow into special funds
or are set aside for specific uses rather than being part of the
general consolidated fund of the Centre or state.
Economic efficiency. Simple economic principle that the
allocation of resources should be done so as to maximize welfare
by making marginal cost equal to marginal benefit.
Effective demand. The famous Keynesian principle that sum
total of expenditure incurred by the government and private
consumption and investment (C+I+G) constitutes the effective
demand.
Effective tax rate. In case there is a tax on tax (cascading
type of tax), then the effective tax rate would be more than the
visible nominal rate of tax on commodities.
Effluent charges. Fees charged for the emission of pollutants.

Equal opportunity. The idea that everyone should be ensured
equal access to employment and other means of acquiring income
and wealth through such means as education, skill formation,
health care, etc.
Estate duty/tax. A tax on the transfer of accumulated wealth
to one’s heirs at the time of death, also known as inheritance
tax.
Excise duty/tax. Tax imposed on a specific item or service
such as gasoline, tobacco, or alcohol. Union excise duty is
imposed by the Centre on the production of specific items. State
excise duty is imposed on the production of intoxicants.
Exemptions in income tax. An amount per person or
dependent that is subtracted from adjusted gross income before
computing tax liability.
Expenditure incidence. Who ultimately benefits from public
expenditure.
Externality. A cost or benefit falling on a third party who is
not directly involved in a transaction as buyer or seller.
Filling status. Classification of a household for income tax
purposes based on the membership of the household as an
individual or HUF (Hindu undivided family).
Finance Bill. The proposals of the government for levy of
new taxes, modification of the existing tax structure or
continuance of the existing tax structure beyond the period
approved by Parliament are submitted to Parliament through
this Bill. All proposals regarding taxation are incorporated in
the Finance Bill.
Fiscal autonomy. Resources allocated to the lower level of
governments are sufficient to perform the functions assigned
to them, i.e. for meeting expenditure needs the lower level
governments have not to depend on the higher level governments.
Fiscal (Tax) capitalization. The change in the value of taxable
property that results from expected payment of taxes on local
public services.
Fiscal decentralization. Division of functions and resources

amongst the different tiers of the government, i.e. up to the
grassroot level.
Fiscal federalism. A system of multiple levels of government
(Union, State and the Local) with some distinct areas of
responsibility and sources of revenue as well as some shared
revenues and responsibilities.
Fiscal impact. The effect of a decision or action on the
revenue and expenditures of a particular government.
Fiscal surplus. The excess of benefits from services provided
by a Local, State, or Central Government to an individual or
firm over the value of taxes and fees paid to that government.
Fiscal or Financial year. Period covered by a government’s
budget, i.e. 1 April to 31 March.
Formula grant. A grant based on one or more objective
criteria such as population, poverty rate, per capita income, etc.
Franchise fee. A charge made by a government for the
exclusive privilege of operating a private enterprise in a given
area.
Free rider. A person who takes advantage of non-
excludability non-rivalry by consuming a public good without
contributing to the cost of its production.
Fringe benefits tax (FBT). Tax imposed on the employer on
the ancillary benefits given by him/company to the employees.
General revenue. Funds available for general budgetary
purposes, excluding off-budget and enterprise funds.
Horizontal equalization. Actions to ensure that resources
are distributed more equally among governments at the same
level (state or local) so as to ensure that they can provide at
least minimal standards of services to their citizens.
Horizontal equity. Justice or fairness in the distribution of
benefits or burdens between people or communities in similar
economic circumstances.
Impact of tax. Initial payment of a tax. Impact of the tax is
said to fall on a person who pays the tax in the first instance.
Incidence of tax. The determination of who actually and

ultimately bears the burden of a tax in terms of paying higher
prices or receiving less income or a reduction in the value of
assets.
Inheritance tax. A tax imposed on the receipt of wealth
from a deceased person. It is also known as estate duty.
Intangibles. In property tax, taxable assets other than real
property or tangible personal property such as car and business
equipment. Primarily, these are financial assets.
Inter-generational equity. Justice or fairness in the
distribution of income, assets, or opportunities (even tax burden)
between individuals of different generations.
Inter-governmental grant. A sum of gratuitous money
transferred from one government to another, usually from the
Central Government to the State or Local Governments or from
State to Local Governments.
Interim Budget. Interim Budget implies a temporary and
short-period budget, for less than full year. In the interim budget,
some alterations in tax and public expenditure can be introduced
whereas in vote-on-account budget no such alterations are made.
Internalizing externalities. Actions to make individuals bear
the external costs or receive the internal benefits of their own
actions so that they will make decisions that are both socially
and privately optimal.
Interpersonal equity. Justice or fairness in the distribution
of income, assets, or opportunities (even tax burden) among
individuals at a point of time.
Laffer curve. A diagram showing the relationship between
tax rate and tax revenue that implies that higher rates may
reduce rather than increase revenue beyond some point.
Leviathan. The notion of the government (given by
Musgrave) as an uncontrollable monster that devours resources.
Lindahl prices. Prices for a public goods that are set equal
to the marginal benefit for each use.
Local public goods. Public goods for which most of the
benefits accrue to the residents of a particular local area.
Lump-sum grant: A grant whose amount is not dependent

on any matching effort by the recipient.
Lump-sum tax. The fixed amount of tax, irrespective of the
level of production, sales, or income.
Marginal social benefit. The increase in positive externalities
that results from producing or consuming one more unit of
public good or service.
Marginal social cost. The increase in negative externalities
that results from producing or consuming one more unit of
public good or service.
Marginal tax rate. The additional per cent of tax on an
additional increase in income.
Market failure. An outcome of market process that does
not satisfy the criterion of Pareto optimality.
Matching grant. A grant that requires the guarantee to
contribute a fixed ratio for the purpose of receiving grant from
the higher level of a government.
Multiplier effects. Secondary increases in employment or
income resulting from a primary change such as the location of
a governmental facility or a new private industry or commercial
development in an area.
Municipal bonds. Debt instruments issued by State and Local
Governments for creating a facility or development in an area.
These are mostly exempt from Union Income Tax.
Negative income tax. An income tax system that collects
revenue from taxpayers above a certain income level and pays
to people whose incomes fall below that level.
Non-excludability. The inability to keep non-payers from
consuming a good without incurring a cost. It is an essential
characteristic of pure public goods.
Non-rivalry. It is an essential characteristic of pure public
goods, consumption by one person does not diminish the amount
available to another.
Off-budget accounts. Part of government’s accounts that
are not included in the general budget such as trust funds and
enterprise funds.
Open-ended grant. Grant programme that does not have a

fixed monetary ceiling but is given to all eligible recipients who
meet the criteria.
Origin principle. Taxing commodities by the states of origin.
Own-source revenue (state or local). Funds raised through
taxes, fees, charges, and other sources under the control of the
particular government, i.e. it excludes inter-governmental
transfers.
Pareto optimality. A situation in which no change can be
made that makes some people better off without making at
least one person worse off.
Peak-load pricing. Setting higher prices for periods of peak
demand so as to shift some users to off-peak periods.
Poll tax. A per capita or per-household tax at a flat rate,
simple to administer but highly regressive.
Privatization. Transferring economic activities from the
public sector to the private sector.
Principle of maximum social advantage. The principle says
that in order to get maximum social benefits the marginal
sacrifice of taxation should be equal to marginal benefits from
public expenditure.
Project grant. Inter-governmental grants given on the basis
of invited proposals for particular purposes.
Programme budget. A budget that defines a group of related
governmental activities and specifies the funds to be allocated
to those activities.
Proportional tax. A tax that takes a fixed percentage of
one’s income.
Public choice. A branch of public sector economics that
blends economic preface theory and political science to examine
the behaviour of public officials as self-interested individuals
and the implications of that approach for public policy.
Public Account. Besides, the normal receipts and expenditure
of the government which relate to the consolidated fund, certain
other transactions enter government acts more as a banker, e.g.
transactions relating to provident funds, small savings collections,
other deposits, etc. The moneys thus received are kept in the
Public Accounts. Public Account Funds do not belong to the
government and have to be paid back some time or other to the
persons and authorities who deposited them.
Public debt. Amount of money which the government owes
to its citizens or external agencies.
Public finances. The field of economics that addresses the
revenue and expenditure activities of government.
Public provision. Policies to ensure that a good or service is
available through government support but may not require public
production.
Rational ignorance. The choice by individuals not to be
informed and active in public decisions because the cost of
becoming informed and participating is greater than the benefits
they receive. This explains the apathy of the voters in a
democratic set-up.
Real property. Assets in the form of land, buildings, or
improvements.
Retail sales tax. A broad-based consumption tax levied at
different stages of sale or only at final sale on goods and services
by most of the states.
Revenue bonds. Debt instruments used by State and Local
Governments to build income-generating facilities (dormitories,
stadiums, hospitals, etc.) for which revenue from the facilities
sold is pledged to repay the debt.
Revenue forecasting. The act of predicting government
income in future years on the basis of past experience and current
conditions.
Shadow prices. Imputed prices or estimated values, based
on alternative uses, for sources of benefit or costs that do not
pass through the market.
Shifting of tax. The process of passing on the burden of the
tax from the person who is initially required to pay a tax to a
customer, worker, supplier, etc.
Spatial externalities. Spillover effects that are experienced
by people in nearby areas where activities/facilities are created.
Specific tax. A tax that is expressed as a functions of some

physical measure of quantity (litre, kg., dozens) rather than as a
per cent of the price.
Spillover effects: Secondary or tertiary effects from the
production or consumption of a product.
Standard deductions. Allowances made for various incidental
expenditure, which are deductible from the income before
arriving at the tax liability.
Sumptuary tax. A tax intended to discourage consumption
of the item taxed.
Tax credits. Reductions in tax liability for specific kinds of
expenditure or circumstances, e.g. in case of VAT, tax credit is
given for the tax already paid.
Tax exporting. Shifting of part or all of the tax burden by
the producing states to resident consumers of other states.
Taxable income. In income tax, the amount of income on
which the computation of tax liability is based after adjustments,
deductions, exemptions, etc.
Tiebout hypothesis. A model that predicts that people will
prefer to live in communities wherein the fiscal surplus is higher
resulting in competitive constraints on local governments to hold
down taxes and offer attractive service packages.
Total revenue. Government revenue from all sources,
including tax and no-tax sources like fees, fines, prices, etc.
Transfer payments. Payments by government to individuals
from whom no services are purchased (e.g. expenditure on
welfare, social security). In social accounting sense, transfer
payments do not add to national income.
Unified budget. A government budget that combines all
accounts, including off-budget or enterprises funds.
Value Added Tax. A tax collected at every stage of value
added (production and distribution) with a credit for taxes
already paid at the preceding stages so that no cascading of
taxes occur.
Vertical equity. Justice or fairness in the distribution of

benefits or burdens between people or communities in different
economic circumstances.
Vertical equalization. Actions to ensure that resources are
more equally distributed amongst the different layers of the
government, i.e. Union, State and Local level, so as to ensure
that they have not to depend on higher levels of the government
to spend on the assigned items.
Visibility. The level of awareness of the public of the
existence and amount of tax being collected.
Voting paradox. Associated with the name of Keneth Arrow,
it is the possibility that the ranking of more than two alternatives
is not transitive, so that in paired voting A is preferred to B; B
is preferred to C; and C is preferred to B; and C is preferred to
A.
Vouchers. Grants in the form of papers from government to
individuals (like food stamps) that can be used to purchase certain
specific services from private or public suppliers of their choice.
Workable competition. The existence of enough competition
among buyers and sellers so as to give results that are reasonably
close to those of the perfectly competitive model.
Zero-based budget. Preparing afresh the budget of every
year.
Note: In the above ‘concepts’ only well-known nomenclatures have been

used. It is possible that sometimes the same concepts might be given
a different name, yet conceptually and analytically both may be the
same.
Bibliography
American Economic Association, Readings in Fiscal Policy,

——, Readings in the Economics of Taxation, George Allen
and Unwin, London, 1959.
Anderson, L.C. and K.M. Carison, “A Monetarist Model for
Economic Stabilization”, Monthly Review, Federal Reserve
Bank of Louis, April 1970.
Atkinson, A.B. and J.E. Siglitz, Lectures on Public Economics,
Tata McGraw Hill, New York, 1980.
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Public Economics

JANAK RAJ GUPTA

7/22, Ansari Road, Darya Ganj,

Copyright © Janak Raj Gupta, 2011

All rights reserved. No part of this publication may be

I was greatly delighted to know the exhaustion of the first

Hypothesis has been explained lucidly. Debt Management in

Role and functions of the Government in an economy have

most of the Indian universities continue to teach Public Finance

Preface to the Second Edition ............................ v

Public and Private Goods in General

Effects of Taxation ............................................ 235

Imbalances in Federal Finance (Vertical and

Fiscal Crisis of 2008-09 (Global Meltdown

NATURE AND SCOPE OF PUBLIC ECONOMICS

discipline, Public Economics has always been one of its core

distinction between the exercises in positive economics involved

NATURE AND SCOPE OF PUBLIC FINANCE

Finance’ in place of ‘Public Finance’ as that would indicate the

are raised, or should be raised, to enable the state to perform its

economical manner. It must be remembered, however, that in

ROLE OF THE GOVERNMENT IN AN ORGANISED SOCIETY

Consequently, even the minimum requirements of the

may be felt necessary for the state to intervene to limit the

distribution of the economy’s resources. This is often

inefficient, the state can only improve the outcome if it is not

CHANGING PERSPECTIVES ABOUT THE ROLE OF

the government was forced to increase its role gradually. There

economic stability. But as savings normally exceed investment

Breakdown of Laissez-faire Policy

state. Because of the externalities of these goods they must be

Correcting Inter-personal and Inter-regional Inequalities

stands for marginal benefits from public expenditure, which

According to Musgrave, the total social benefit is maximum

Fig. 1.2: Principle of Maximum Social Advantage

there is further scope to extend both taxation and public

paying a single paise. How to take account of all these

if overdone or misdirected, may not be advantageous

of public finance is beset with serious limitation in

India, Industrial Policies of 1948 and 1956 recognize that both

having a proper and effective public sector only. In a mixed

increase automatically. These problems can be tackled only at

Coming lastly to the economic surplus in a dynamic sense

measures. Planning for the public sector may be through

and incurring public expenditure. Similarly, in a mixed economy,

As already stated that state participation in economic activity

to keep it at a low level. Thus, if an underdeveloped country

programme. Not only that, it also lacks the necessary approach

GOVERNMENT MEASURES TO PROMOTE

in the vicious circle of poverty. This necessitates a comprehensive

the ability and willingness to make investments in these

(SFDA’s) were established and Marginal Farmers and

leadership, etc. In the sphere of trade and industry, government

RATIONALE OF PUBLIC SECTOR IN ECONOMIC DEVELOPMENT

When the public sector assumes a compensatory role it serves

a substitutive or supportive or adjunctive role. Only when

supporting private enterprise, and

GOVERNMENT AS AN AGENT FOR ECONOMIC PLANNING

change in ideology of the people, their growing social and

The idea of planning will be clear by drawing a distinction

Thus, planning, in short, may be defined as conceiving,

Authoritarian and Democratic Planning

which assumes that planning is possible even in a capitalistic