CHAPTER PUBLIC FINANCE

7 UNIT – 1 : 7.1
AN OVER VIEW OF FISCAL FUNCTIONS

The primary goal of the State or Government  To promote the general welfare of the
society.

Three main macroeconomic goals for any nation are:

1. Economic Growth  People enjoy higher Standard of Living if Real GDP growth Rate
> Population growth Rate.
2. High levels of Employment  Ensures higher income and higher output.
Unemployment = Loss of output that could have been produced.
3. Stable Price Levels  Inflation reduces real incomes and purchasing power.
Inflation disproportionately affects lower income families. Deflation  may cause
recession, depression and large scale unemployment. Inflation and Deflation can be
avoided by Stable prices.

THE ROLE OF GOVERNMENT IN AN ECONOMIC SYSTEM

Basic economic problem  Scarcity.
Reason for Scarcity: Wants are unlimited and the available resources are limited.
Society = Households, Businesses, and Government
An economy CANNOT produce ALL economic goods and services that its members desire
to have.
Economic System:
- Helps for resource allocation.
- Decides what to produce, how to produce and for whom to produce and how much
resources should be set apart to ensure growth of productive capacity.
Three alternate economic systems are:
(1) Market System (Capitalism), the Government (Socialism) and a mixed system.

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Note: In mixed system resource allocation determined by both markets and
governments simultaneously.
Adam Smith supports
7.2 free markets with minimal governmental activity. He believed
that government's roles in society should be limited, but well defined

Adam Smith underlined the following important resource allocation role by Government:
(a) National Defence  to protect the nation from external violence and invasion,
(b) Establishing a system of Justice  to provide internal law and order and to protect
property
(c) Establishment and Maintenance of highly beneficial public institutions and public
works. Reason: Profit-seeking individuals may not be able to efficiently build and
operate. Example: Construction of roads, bridges, canals, harbours, and postal
system
Note: State = Government
Government’s Economic functions is also called as Fiscal functions or Public Finance
Function
Government intervention will always influence the performance of the economy in a
positive way.
Richard Musgrave, in his classic treatise/Essay ‘The Theory of Public Finance’
(1959), introduced the three-branch Taxonomy. Three functions of the government
are:
Resource A llocation Income Redistribution Macroeconomic
Stabilization
To ensure Efficiency To guarantee Fairness To ensure Price stability
Primary Micro-Economic Primary Micro-Economic Macro-Economic function
Function Function
Aim: To correct the Aim: To ensures that the Areas Covered:
sources of inefficiency in the distribution of wealth and Monetary and fiscal policies
economic system income is fair Problems of macro-
economic stability
Economic growth
Maintenance of high levels
of employment P
Price stability etc

Economic Policy of the Government is reflected in the national budget.

THE ALLOCATION FUNCTION

Resource Allocation = Allocation of the available resources or factors of production are
allocated among the various uses to which they might be put.
Economic efficiency  A situation in which all resources are allocated in the best way
possible, minimising waste and inefficiency.
Allocative efficiency  Utilizing limited resources to produce goods and services that
would maximize value to the society. In other words -
Allocative efficiency  achieve the largest possible output of goods and services from
the existing stock of resources and technology.
Efficient allocation  Takes place only when the markets are perfectly competitive and
economic agents make rational choices and decisions. 7.3
In reality, markets are never perfectly competitive.
Resource Allocation is determined by both market and the government
Why Resource allocation is a critical problem?
(1) The resources of a society are limited in supply, whereas the wants of the members
of the society are unlimited.
(2) Any given resource can have many alternative uses  To make their best use and no
wastage.
Determining factors of the private sector resource allocation are:
(a) Market supply and demand and
(b) price mechanism as determined by consumer sovereignty and
(c) producer profit motives.
Determining factors of the state’s / Governments resource allocation are:
(a) the revenue and expenditure activities of governmental budgeting.
Malfunctioning of Market economy:
- Private goods will be sufficiently provided by the market.
- Public goods and merit goods will not be produced in sufficient quantities by the
market.
- Missing markets or nonexistence of markets occur in a variety of situations.
Why do markets fail to give the right answers to the questions as to how the resources
can be efficiently utilised and what goods should be produced and in what quantities? In
other words, why do markets generate misallocation of resources?
Reasons for Market failures for efficient allocation of resources:
1. Imperfect competition and presence of monopoly power  Leading to under-
production and higher prices.
2. Markets fail to provide collective public goods which are consumed in common
by all people. Example: Defence
3. Incomplete markets  Fail to produce the right quantity merit goods. Example:
Education and healthcare
4. Over usage of common property resources for self-interest. Example:
Environment
5. Externalities  Production and consumption of a good or service affect third
parties Example: Pollution.
6. Factor immobility which causes unemployment and inefficiency.
7. Imperfect information and
8. Inequalities in the distribution of income and wealth
Public finance is connected with economic mechanisms that should ideally lead to the
effective and optimal allocation of limited resources - Musgrave.

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This logic, in effect, makes it necessary for the government to intervene in the market to
bring about improvement in social welfare.
In the absence government
7.4 intervention  Market Failures may occur .
Effect of Market Failure = Resources are likely to be misallocated i.e., Too much
production of certain goods or too little production of certain other goods.
Summary: Market failures provide the rationale / basis for Government’s allocative
function / intervention.
These interventions do not imply that markets are replaced by government action.
In other words, i n the allocation role, the government acts as a complement
rather than as a substitute to the market system in an economy.
How the role is played by the Government?  Through Expenditure and Tax policies.
What are the Allocative Functions determined in Budget?
(i) Who and What will be Taxed
(ii) How much revenue will be spent and where it is to be spent
(iii) How the total resources of the economy are divided among various uses
(iv)the optimum mix of various social goods (both public goods and merit goods).
(v) the level of involvement of the public sector in the national economy
(vi)the reallocation of society’s resources from private use to public use.
Various Instruments available to Governments to Influence Allocation:
(1) Direct production of economic goods by Government. Example: Electricity and
public transportation services.
(2) Use the price mechanism (Incentives and Disincentives / Taxes and subsidies).
Example: Higher tax on Cigarettes.
(3) Through legislation and force. Example: Ban on single use plastic covers.
(4) The competition policies, merger policies etc. Example: The Competition Act
prevents anti-competitive activities
(5) Regulatory activities such as licensing, controls, minimum wages, and directives on
location of industry etc.
(6) Setting Legal and Administrative frameworks, and
(7) Any combination of possible remedies

THE REDISTRIBUTION FUNCTION

Economic growth have not spread evenly across the households.
Basic question of the distributive function of budget  ‘For whom’ should an economy
produce goods and services.
How Government redistributes income and wealth in Budget?
(a) Through expenditure side of the Budget. Example: Provide free or subsidised
education, healthcare, housing, food and basic goods etc. to deserving people. or
(b) Through the revenue side of the budget. Example: Progressive taxation

Effective demand is determined by the level of income of the households  Which

means, Level of income determines the distribution of real output among people 
Hence,
Conclusion: 7.5
Distribution function = Manner in which the effective demand of economic goods is
divided among the various individual and family in the society.
Aim of the distribution function by Government:
(1) To achieve an equitable distribution of societal output among households. Purpose:
To Ensure increased overall social welfare.
(2) Advancing the well-being of the suffering members in the society.
(3) Providing equality of income, wealth and opportunities
(4) Providing security (in terms of fulfillment of basic needs) to ensure minimum
standard of living
Examples of the Redistribution Function:
1. Progressive taxation and provision of subsidy to the poor households
2. Using the Government revenue for financing public services  Supply of essential
food grains at highly subsidized prices to BPL households
3. Employment reservations, minimum wages and minimum support prices to farmers
4. Unemployment benefits and transfer payments to the underprivileged, physically
handicapped, the older citizens and the unemployed.
5. Aid in money and kind to families below the poverty line
6. Regulation of manufacture and sale of certain products to ensure the health and well-
being of consumers, and
7. Special schemes for backward regions and for the vulnerable sections of the
population.
Drawback:
In exercising the redistributive function, there would be a conflict between efficiency
and equity. It may likely to have efficiency costs or deadweight losses.
Example: High rates of taxes on the rich  Higher Revenue to Government; But
disincentive to entrepreneurship and discourage people from making savings and
investments and taking risks.
Consequently, the potential tax revenue may be reduced in future and the scope for
government’s welfare activities would get seriously limited.

How to resolve this?

There should be an appropriate Trade-off between the goals of Efficiency and Equity.
In other words, redistribution measures should be accomplished with minimal efficiency
costs by carefully balancing equity and efficiency objectives.

STABILIZATION FUNCTION
Macroeconomic fluctuations arise from sub-optimal Allocation of Resources.
When we can say that the Macro-Economic stability Exists?
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When an Economy’s:
1. Output = Production capacity,
7.6
2. Total spending = Total output
3. Labour resources are fully employed, and
4. Inflation is low and stable.
Keynesian proposition  M arket economy does not automatically generate full
employment and price stability. Therefore, the governments should pursue deliberate
stabilization policies.
The market system has inherent tendencies to create business cycles. In other words,
The market mechanism cannot prevent or to resolve the disruptions caused by the
fluctuations in economic activity.
Who has to resolve?
The government and the country’s central bank.
How?
Fiscal and Monetary Policies to promote full employment and price stability
The stabilization function is one of the key functions of fiscal policy.
What will happen if there is no appropriate Fiscal and Monetary Policies?
a. The instabilities that occur in the economy in the form of recessions, inflation etc.
may be prolonged for longer periods causing enormous hardships to people,
especially the poorer sections of the society.
b . Possible for the situation of STAGFLATION  make the problem more complex.
Note: Stagflation means Both inflation and unemployment exist side by side
c. ‘Contagion Effect’  When a country is having increased international
interdependence and financial integration, the forces of instability in one country
get easily transmitted from one country to other countries.
What are the areas in which the stabilization function is concerned?
1. Labour Employment and Capital Utilization,
2. Overall output and income,
3. General Price levels,
4. Balance of International Payments, and
5. the Rate of Economic Growth.
The stabilization function is one of the key functions of fiscal policy and aims at
eliminating macroeconomic fluctuations arising from suboptimal allocation of resources.
As you might recall, the economic crisis that engulfed the world in 2008 and the more
recent global phenomenon of COVID pandemic-induced economic crisis have
highlighted the importance of macroeconomic stability and have, therefore, revived
immense interest in countercyclical fiscal policy.
Government’s stabilization intervention:
1. Monetary policy  B y controlling the size of money supply and interest rate 
This would affect consumption, investment and prices.
2. Fiscal policy  Expenditure and taxation decisions 
 Government expenditure  injects more money into the economy  Stimulates
demand. Taxes  Reduce the disposable income of people  Reduce effective
demand.
7.7
In other words, an expansionary fiscal policy is adopted to alleviate recession and a
contractionary fiscal policy is resorted to for controlling high inflation.
Effect of surplus and deficit Budget:
Deficit budgets  Expected to stimulate economic activity,
Surplus budgets  Tend to slow down economic activity.
Summary:
If there is high inflation: If there is high unemployment:

Decrease government Increase government spending,

spending,
Reduce taxes, and
Raise taxes and
Increase the money supply
Reduce the money supply

The challenge before any government is how to design its budgetary policy so that the
pursuit of one goal does not jeopardize the other.
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CENTRE AND STATE FINANCE
According to Richard Musgrave the Functions of-
(a) Economic Stabilization and Income Re-distribution should be done by the Federal or
Central Government.
(b) Allocation of Resources should be done by the State and Local Governments.
Indian Federation System:
 India is a federation of 28 states and 8 union territories.
 Federalism is an institutional arrangement to accommodate two sets of
government — one at the national level and the other at the regional level.
 Each government is autonomous in its own sphere.
 An independent judiciary is established to resolve disputes between the central
government and the states on issues related to division of power.
 The constitution of India has provided for the division of powers between the central
and the state governments.
 Article 246 of the Constitution demarcates the powers of the union and the state by
classifying their powers into three lists, namely Union list, State list and the
Concurrent list.
 The union list contains items on which the union parliament alone can legislate.
 The state list has items on which the state legislative assemblies alone can
legislate.
 The concurrent list has items on which both the parliament and the legislative
assemblies can legislate.

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  In the event of conflicting legislation in concurrent list, the law passed by the
centre prevails.
 Allocation of 7.8
revenue and expenditure responsibilities to different levels of
governments is a fundamental matter in a federation.
 Sources of revenue for both the centre and states are clearly demarcated with
regard to the financial relationship and the responsibilities between them.
Taxes Levied by Central Taxes Levied by the State
Government Government
Tax on income, other than agricultural Taxes on
income, (Income Tax) Agricultural income,
Customs and export duties, Lands and buildings,
Excise duties on certain goods, Mineral rights,
Corporation tax, Electricity,
Tax on capital value of assets excluding vehicles,
agricultural land, tolls,
Terminal taxes (on railway passengers) professions
Security transaction tax, Land revenue and
Central GST etc. Excise duties on certain items.
 The property of the union is exempt from state taxation. Similarly, the property and
income of the states are not liable to be taxed by the centre.
 Articles 268 to 281 of the constitution contain specific provisions in respect of
distribution of finances among states.
 Distribution of revenue between the union and states is based on the constitutional
provisions as follows:
Duties levied by the union but collected and appropriated by
Article 268 the States
Article 269 Taxes levied and collected by the union but assigned to the
states.
Taxes levied and collected by the union and distributed between
Article 270 the union and states
Article271 Surcharge on certain duties and taxes for purposes of the union

Article275 Statutory Grants-in–aid from the union to certain states.

Article 282 Grants for any public purpose
Article 293 Loans for any public purpose

FINANCE COMMISSION:
Article 280 of the Indian Constitution enables the transfer of resources from Centre to
the States. The Body which facilitates such transfer is called the Finance
Commission.
The Finance Commission is a constitutionally mandated body that is at the centre of
fiscal federalism.
Responsibilities of Finance Commission:
Finance Commission is responsible for:
(i) Evaluating the state of finances of the union and state governments,
(ii) Recommending the sharing of taxes between them and
(iii) Laying down the principles determining the distribution of these taxes among
states. 7.9
Functions of Finance Commission:
The Finance Commission helps in maintaining fiscal federalism in India by performing
following functions:
(a) The distribution between the union and the states of the net proceeds of taxes.
(b) Determination of principles and quantum of grants-in-aid to states which are in
need of such assistance.
(c) To make recommendations to the President on measures needed to augment /
increase 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.
(d) Any other matter referred to the Commission by the President in the interests of
sound finance.
Sharing of Revenue:
While recommending transfers, the Finance Commission considers issues related to
(1) Vertical Equity  Deciding about the share of all states in the revenue collected by
centre
(2) Horizontal Equity  Allocation among states their share of central revenue.
The Finance Commission broadly assesses
Overall Tax Revenue of the Union xxxxx
Less: Cesses, Surcharge and Non-Tax Revenue xxxx
Net Divisible Pool (NDP) xxxxx
After a constitutional amendment in year 2000, the divisible pool now consists of all
taxes of the union.
 Considering the needs of the central and the state governments, the Commission
determines what percentage out of the net divisible pool should be assigned to the
state governments. The balance remains with the central government.
 The Fifteenth Finance Commission was constituted on 27, November 2017 against
the background of the abolition of Planning Commission and the introduction of the
goods and services tax (GST).
 The commission recommended the share of states in the central taxes (vertical
devolution) for the 2021-26 to be 41%, which is the same as that for 2020-21. This is
less than the 42% share recommended by the 14th Finance Commission for 2015-20.
The adjustment of 1% is to provide for the newly formed union territories of Jammu
and Kashmir, and Ladakh from the resources of the centre.
The criteria for distribution of central taxes among states for 2021-26 period
are same as that for 2020-21. They are:

1) Income Distance i.e the distance of a state’s income from the state with the
highest income.
2) Area

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 3) Population (2011)
4) Demographic performance (to reward efforts made by states in controlling their
population)7.10
5) Forest and Ecology:
6) Tax and Fiscal efforts:
Goods and Service Tax:
 The introduction of GST, which was rolled out across the country on 1 July 2017, has
significantly changed the state of affairs of financial relations between the centre
and states.
 The GST subsumes the majority of indirect taxes – excise, services tax, sales tax,
octroi (entry tax). The GST has made India’s indirect tax regime unitary in nature.
 The states levy and collect state GST (SGST) and
 the union levies and collects the central GST (CGST). An integrated GST (IGST) is
applied on inter-state movement of goods and services and on imports and exports.
 IGST is simply a combination of SGST and CGST administered and collected by the
union government, kept in a separate account, and distributed between the union
and states after settlement of input tax credit and verification of the destination of
the goods and services.
 With many taxes subsumed under it, GST accounts for 35 per cent of the gross tax
revenue of the union and around 44 per cent of own tax revenue of the states.
 As per the supreme court verdict in May 2022, the Union and state legislatures have
“equal, simultaneous and unique powers “to make laws on Goods and Services Tax
(GST) and the recommendations of the GST Council are not binding on them.
 The GST system replaced the then prevailing production-based taxation system with
a consumption based one.
 Since the manufacturing states had apprehension about loss of revenue, it was
decided to provide compensation to states for loss of revenue arising on account of
implementation of the Goods and Services Tax for a period of five years from the
date of its implementation.
 For providing compensation to states, a cess is levied on some luxury goods and
demerit goods and the proceeds are credited to the compensation fund.
 GST compensation was extended beyond five years to enable states to tide over the
pandemic induced economic slowdown.
 During the five-year transition period, the top five GST compensation-receiving states
were Maharashtra, Karnataka, Gujarat, Tamil Nadu, and Punjab. The total amount of
compensation released to the states and union territories during the year 2022 -23
is ₹ 1,15,662 crore.

Decentralization of Expenditure:
 In so far as expenditure decentralization is concerned, the central government is
entrusted with the responsibilities of provision of nationally important areas like
defence, foreign affairs, foreign trade and exchange management, money and
banking, cross-state transport and communication.
 The state governments are entrusted with the responsibility of facilitating agriculture
and industry, providing social sector services such as health and education, police
 protection, state roads and infrastructure.
 The local self governments such as municipalities and panchayats are entrusted
with the responsibility of providing public utility services such as water supply and
7.11
sanitation, local roads, electricity etc.
 For items that fall in the concurrent list, both central and state governments are
responsible for providing services.
Borrowing by Government:
 Borrowing by the government of India and borrowing by states are defined under
Article 292 and 293 of Constitution of India.
 The centre may borrow within the limits fixed by parliament by law upon the
security of the Consolidated Fund of India or give guarantees within such limits, if
any.
 The state governments may borrow within the territory of India upon the security of
the Consolidated Fund of the State within such limits, if any, as may from time to
time be fixed by the Legislature of such state by law, or give guarantees within such
limits.
 The centre may give loans to the states within limits fixed under article 292
and give guarantees in respect of loans raised by the states.
 States need to obtain the centre’s consent in order to borrow in case the state
is indebted to the centre over a previous loan.

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Solve ICAI Book Back MCQs

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