STUDY MATERIAL FOR CLASS X

SUBJECT – ECONOMIC APPLICATIONS

TOPIC- THE STATE AND ECONOMIC DEVELOPMENT (Part I)

Role of the State in economic development

The state plays an active role to promote economic development. The role of the
state to promote economic development can be summarised as:
a) Infrastructure development
b) Eradication of poverty
c) Creating employment opportunities
d) Reducing inequalities in distribution of income and wealth
e) Improving the standard of education for all
f) Controlling the growth of monopolies
g) Introducing special development programmes for the backward regions (hilly, tribal,
drought prone areas)
h) protecting the rights of workers in the country and so on.

INSTRUMENTS OF STATE INTERVENTION

The main instruments of state intervention in order to attain the various economic
objectives like economic development, social justice and economic growth with
stability are Fiscal Policy, Monetary Policy etc.

Meaning of Monetary policy

It is the policy of the Government or Central Bank of the country to regulate the
money supply in the economy through various monetary measures or variables
such as Bank rate, C.R.R, S.L.R, Credit rationing etc. These measures help in
dealing with economic fluctuations and price instability in the country.

Meaning of fiscal policy

The policies pertaining to the income and expenditure programme of the
Government are constituted under Fiscal Policy. These include Taxation, Public
expenditure, Public Debt and Deficit financing.

Taxation policy
Tax policy can be used to affect the Demand for and Supply of goods and
services in the private sector. The Government can influence the pattern of
production in the economy through this policy. Government can also use the
tax policy to redistribute income among the different sectors of the economy.

What is a Tax?
Tax is a compulsory payment or contribution by any citizen (an individual
or an organization) made to the Government Quid pro quo i.e without any
promise on part of the Government to provide benefit to the citizens in
return.
Types of taxes:
Depending on whether the tax burden can be shifted or not, the classification
of taxes is done into the following types:

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 a) Direct tax
b) Indirect tax
A distinction between the above-mentioned types of taxes is made on the basis of
Impact and Incidence of Tax
Impact and Incidence of a tax
It is important to study who ultimately bears the burden of a tax. The incidence

of taxation refers to this question of who and in what proportion bears the

final burden of a tax. It is not necessary that a person or a firm who pays a tax

to the Government or, in other words, bears the initial burden of a tax will also be

one on whom the final burden of the tax rests.

This is because a tax can be shifted or transferred to others. Therefore, in

economics, we distinguish between the impact and incidence of a tax. Whereas

the impact of a tax is said to be resting on the person or firm who pays the

amount of the tax and thus receives the initial burden, the incidence of the

tax tests on the person or firms who ultimately bears the money burden of

the tax. If a person or a firm who pays the tax to the Government is also one who

ultimately bears it, then the impact and incidence of the tax rests on the same

person or firm. In such a case, there is no shift.

Shifting the Burden of a Tax:

The burden of the tax can be transferred to others through a process of

shifting. It may be noted that the whole burden of the tax may not be shifted to

others. It may be that a part of the tax may be shifted to others and a part be

borne by the one who initially pays the tax.

Direct Tax

It is a type of tax wherein the initial impact and final incidence of the tax lies on

the same person. Thus, there is no shifting of the tax burden.

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Examples of direct taxation include income tax, corporation tax (on companies’
profits), capital gains tax (a tax on the profits of sales of certain assets), wealth tax
(which is a tax on ownership of property or wealth) and a capital transfer tax (a tax
on gifts to replace death duties). Direct taxes are mainly collected by the central
government.
Indirect tax
It is the type of tax wherein initial impact and final incidence of tax lie on different
persons. Thus, the tax can be shifted in this case.

Examples of Indirect Taxes include GST (Goods and Services Tax) implemented
from 1st July 2017. Most indirect taxes (previously Excise duty, Value added
Tax, Service Tax) have been subsumed under GST. Few Indirect taxes like
Customs duty, Security transaction Tax, Building and welfare Tax and Electricity
duty levied by State Governments and local authorities still continue to exist
independently outside the radar of GST.

Merits and Demerits of Direct Taxes

Examples of direct taxation include income tax, corpora­tion tax (on companies’
profits), capital gains tax (a tax on the profits of sales of certain assets), wealth tax
(which is a tax on ownership of property or wealth) and a capital transfer tax (a tax
on gifts to replace death duties). Direct taxes are mainly collected by the central
government.

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(A) Merits:
1. Equity:
A direct tax is an equitable tax. Through it the rich can be made to pay more than
the poor. In case of necessity, the poor people can be granted exemption from
payment of such taxes.
A direct tax is equitable in the sense that it is levied according to the taxable
capacity of the people. The rates of direct taxes, like the income tax, can be fixed
in such a way that the higher the income of a man, the greater is the rate at which
he has to pay the tax. Such a system is known as progressive taxation. This helps
in reducing the inequalities in the distribution of income and wealth in the
economy.
2. Certainty:
A direct tax satisfies the canon of certainty. For instance, a person liable to pay
income tax knows how much he will be required to pay; for that purpose, he can
appropriate steps beforehand. The Government can also ascertain the amount of
tax collection with certainty.
3. Elasticity:
A direct tax has elasticity. It can be varied according to the needs of the
government and changes in the income of the people. When the income of the
people goes up, the rate of income tax can also be increased. If the income of the
people falls, the rate of income tax can also be lowered.
4. Economy
Direct taxes are considered to be economical from the viewpoint of tax collection as
the costs of collection are lower comparatively. In many cases within respect to
Income tax, there is TDS where tax is deducted at source from the point of income
generation and the payment is easy and smooth.
5. People’s Consciousness:
A direct tax increases the civic sense of the people. When the people are fully
aware of the payment of taxes, they are also conscious of the way the government
spends the money. They resent unproductive or wasteful expenditure. As a result,
the government becomes careful in its expenditure.

(B) Demerits:
But direct taxes have certain demerits or defects, too.
These are:
1. Lack of Popularity:
First, such taxes are not very popular, because the people have to bear the burden
of such taxes directly. That is why, when the rate of a direct tax is raised, most
people express their resentment against the government. For instance, when the
rate of personal income tax or corporate profit tax is raised, criticism from those
affected becomes very strong.
2. Evasion:
The second disadvantages of a direct tax is that it is liable to be evaded. By
submitting false returns, many people try to evade income tax. Unless the civic

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sense of the people is well — developed and there is spread of education among
them, the administration of direct taxes is very difficult.
3. People’s Indifference:
The third dis-advantage of a direct tax is that it does not develop the civic sense of
those who do not pay such taxes. In the case of income tax, people with incomes
below a certain level are not liable to pay tax. In a low-income country like India,
the majority of the people are not required to pay income tax. When a man directly
bears the burden of a tax, he tries to know how the government spends that
money. Those who are not directly affected by the burden of taxation remain
indifferent as to the way the public expenditure is incurred.
4. Disincentive to Work and Save:
Another disadvantage of direct taxes is that they reduce the desire to work and
save. The rate of direct taxes are usually high. As people with higher income are
taxed at a higher rate it creates a negative inducement to work more for higher
earnings. Many business ventures are not undertaken on the ground that a large
part of the income earned will have to be given to the government in the form of
taxes.
Direct taxation discourage savings because, after paying tax, individuals and
companies have less income available to save. This means that investment, which
relies on the level of savings, is low and this could cause less production and
employment.

Merits and demerits of Indirect Taxes

(A) Merits:
1. Wide Coverage:
The main merit of an indirect tax is that it touches all income groups. Direct tax,
like income tax, is imposed on persons having a certain minimum level of income.
People having income below that level are exempted from the payment of tax. But
indirect taxes, such as sales tax or excise duty, are equally imposed on all
consumers or pur-chasers irrespective of their incomes.
2. Consumption Control of harmful goods:
By imposing an indirect tax, the consumption of an undesirable thing can be
discouraged. For example, by imposing excise duties on wine and opium, the
government discourages the consumption of such harmful products.
3. Popularity:
People are not always conscious of indirect taxes because, in most cases, it is
combined with the price. When people purchase cinema tickets they may well
remain un-ware of the fact that the price of a ticket also includes the amusement
tax. Again, the price of a match-box includes the excise duty imposed on it.
But the consumer does not at all bother to know how much he is paying as price
and how much he is paying as an indirect levy. He thinks that he is paying the
price, although he pays the indirect tax, too. He is not, therefore, consciously
affected by the indirect tax and so he does not resent it much.

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 4. Productivity:
Indirect taxes do not effect productivity since they are not imposed on the earnings
of the tax payer and the propensity to work and propensity to save are not
adversely impacted.
Unlike a direct tax, an indirect tax also enlarges the revenue receipts of the
government. Indirect taxes in India today provide the bulk of government revenue.
Such taxes have been imposed on sugar, cooking gas, textiles, shoes, petrol,
cigarettes, and many other essential articles of consumption. By the levy of
indirect taxes, the tax net is cast wider and all people are made to contribute to
the national fund.
5. Difficulty in Evading Taxes:
It is difficult to evade indirect tax since such tax is included in the price of the
commodity even if the rate of tax is high., people have to pay when they consume
the goods and services. They can avoid payment only in case on non-consumption.

(B) Demerits:
But indirect taxes have certain demerits also.
These are the following:
1. Regressive Character/ Not equitable:
Principle of progressiveness is violated since the burden of an indirect tax falls
upon all persons indiscriminately, irrespective of their ability to pay. As these
taxes are not levied in accordance with the principle of ability to pay, burden of
taxes mostly falls upon the poorer persons.
It is regressive in nature. It affects the poorer section more than the rich. A
commodity tax imposed on foodstuff will affect a poorer family in a much greater
degree than a rich family. A poor man feels the burden of a sales tax/G.S.T much
more than a rich man as both pay the same amount of tax . A rich man does not
at all mind paying a few rupees as G.S.T, but a poor man is greatly burdened by it.
2. Administrative Difficulties/ higher collection cost:
Indirect taxes create various administrative problems. The collection of an indirect
tax like customs duty often involves large expenses. The Government needs to
keep a watch on the sales volume of a product when taxes on a commodity are
imposed or raised.
3. Inelastic in nature/ uncertain revenue earning
It fails to satisfy the Smithian canon of certainty because the revenue accruing
from indirect taxes cannot be estimated properly. As soon as a tax on a commodity
is imposed its price rises. The law of demand states that there will be a fall in
quantity demanded following this price rise.
How much the demand will fall consequent upon the imposition of taxes cannot be
estimated accurately. So is the revenue-yielding capacity of taxes. Thus, an
element of uncertainty is involved in indirect taxes.
4. Civic Consciousness not Created:
These taxes do not create civic consciousness as its burden is not clearly felt by
the taxpayers. They lack interest in making a vigil on government expenditure.

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However, this is not true, particularly when the rate of indirect taxes becomes
high. Excessive dose of taxation often leads to public protest against the
government’s taxation policies.
5. Possibility of Evasion:
Indirect taxes are also evaded by taxpayers. Development of an unholy alliance
between buyers and sellers may result in tax evasion. Usually, buyers evade taxes
by not accepting ‘receipts of sale’ from the sellers. Sellers also evade these taxes by
not maintaining legal accounts book.
6. Wage-Price Push:
Finally, instead of being an anti-inflationary device, increased rates of indirect
taxes have the potentiality of fueling cost-push inflationary pressures in the
economy. Higher prices consequent upon high rate of tax result in higher costs,
higher wages, and again higher prices. A wage-price spiral is thus initiated.

Differences between Direct and Indirect Taxes

Direct tax Indirect tax

Direct tax is referred to as the Indirect tax is referred to as the tax levied
tax which is paid by the on one person and ultimately paid by
person on whom it is levied, another, charged on expenditure on goods
charged on the income, wealth and services consumed.
and property of the person

The incidence (burden) and Impact and incidence of tax lie on different
impact (on whom levied) of tax persons.
lies on the same person

Direct taxes cannot be shifted. Indirect taxes can be shifted.

Cost of collection is Cost of collection is comparatively more

comparatively less.

It cannot be avoided as it is It can be avoided by avoiding the

levied on income and wealth of consumption of the commodity /service on
an individual. which it is imposed.

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 These are generally imposed at These are imposed on different goods and
progressive rates to reduce services in order to broaden the tax base
income and wealth and raise Government revenue.
inequalities in the economy

It helps in reducing inflation It promotes inflation as the prices of goods

by reducing disposable income and services are increased.
and purchasing power.

Examples include Income tax, Examples include excise duty, customs

death duty, property tax etc. duty. GST.

Depending upon the variability of tax rate with income, taxes can be
classified into:
1) Proportional tax
2) Progressive tax
3) Regressive tax
4) Degressive tax

Proportional tax
A tax is called proportional if the rate of taxation remains constant with
change in income of the tax payer. Thus, if a 10% proportional tax is imposed:
a) A person having annual income of 50,000 will pay 10%of 50000 = Rs 5000

as tax.

b) A person having annual income of Rs 1 lakh will pay 10% of 100000= Rs

10000 as tax
This can be explained with the help of the given schedule and diagram:

Annual income (tax Tax rate Tax amount (Rs)

base) in Rs
50000 10% 5000
100000 10% 10000
In this case tax rate remains the same but tax amount paid increases with
increase in tax base.
Examples of Proportional tax includes GST, Customs duty.

Progressive tax
A tax is called progressive if the rate of taxation increases with the
increase in tax payer’s income. i.e. higher incomes shall be charged at higher

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tax rates or percentage of income collected as tax increases with increase in tax
payer’s income. This system takes into account the ability to pay of the tax payer.
This can be explained with the help of the following schedule:

Annual income (Tax Tax rate Tax amount (Rs)

base) in Rs
50,000 10% 5,000
1,00,000 15% 15,000
In this case both tax rate and tax amount paid increases with increase in tax base.
In other words, the tax liability for a taxpayer increases with his income in terms of
proportion of income and in absolute amount.
Examples of progressive tax include Income tax, Death duty. Direct taxes are
usually progressive in nature.

Regressive tax
In the case of regressive tax, the tax rate decreases with increase in
income. Here, the tax liability of the taxpayer decreases with increase in his
income. Or in other words, the proportion of his income to be paid as tax
decreases with increase in income.
This can be explained with the following schedule and diagram:
Annual income (tax Tax rate Tax amount in Rs
base) in Rs
10,000 10% 1000
15,000 7.5% 1125
Tax amount increases in absolute terms though tax rate falls with rise in
income of the tax payer.
Indirect taxes like GST especially in case of necessary goods, Toll tax, etc are
regressive in nature. Though the tax rate remains same for all payers but burden
of tax is more on the poor than the rich.
• Regressive taxes place more burden on low-income earners. Since they are
flat taxes, they take a higher percentage of income on the poor than on high-
income earners.
• Taxes on most consumer goods, sales, gas, and Social Security payroll are
examples of regressive taxes.

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 •

Degressive tax
A tax is called Degressive when the rate of taxation does not increase
in the same proportion as the increase in income. This can be explained with
the given schedule:
Annual income (tax Tax rate Tax amount in Rs
base) in Rs
10,000 10% 1,000
20,000 11% 2,200
30,000 12% 3,600
40,000 13% 5,200
50,000 13% 6,500
Here tax rate increases initially with increase in income at a lesser rate and
then becomes constant with further increase in income. This tax system is thus a
blending of proportional and progressive taxes. The Income tax structure in India
is an example of Degressive taxation.

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Revision Questions
1) Define Fiscal Policy. Distinguish between Monetary and Fiscal policy.
2) Which form of tax discourages consumption expenditure? Explain with
examples.
3) Discuss two merits and two demerits of Direct Taxes.
4) Distinguish between Direct and Indirect Taxes with examples.
5) State two reasons why indirect taxes should be preferred to direct taxes.
6) Classify the following into Direct and Indirect taxes:
a) customs duty b) Professional tax c) Entertainment tax d) House tax e) GST

8) Distinguish between Regressive and Degressive tax.

9) An indirect tax can be made progressive by imposing higher taxes on luxury
goods. Do you agree with this statement? Give reasons.
10) Case study I
ET, Sept 4th, 2012
Terming payment of taxes as ‘mark of civilisation’, Finance Minister P.
Chidambaram has assured that authorities will not ‘rashly’ implement
controversial retrospective tax rules while once again promising a non-adversarial
tax regime for all tax payers. It is the second time in less than a week that
Chidambaram has given assurance of a stable and fair regime, after the tax
department attracted criticisms for ushering in what some have called a ‘Raid raj’
and for introducing a series of measures industry and investors have slammed as
retrograde.
a) Define Direct Tax. Give two examples.
b) State how a direct tax can foster social consciousness?
c) What is meant by a Progressive direct tax? How does its imposition bring about
equity?
d) State two demerits of Direct tax.
11) Explain how Indirect taxes can be both Regressive and Progressive.

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