CA FOUNDATION - MACRO ECONOMICS| PUBLIC FINANCE

CHAPTER 2
PUBLIC FINANCE
UNIT I – FISCAL FUNCTIONS: AN OVERVIEW

The government does not expect the economy to function automatically;

rather it intervenes to direct them to function in particular directions.
Such intervention on the part of the government is based on the belief that
the objective of the economic system and the role of government is to
improve the wellbeing of individuals and households. The purpose of this
lesson is to examine the economic functions of the government and to
understand why the government should invariably perform them.

PUBLIC FINANCE

Fiscal functions: An
overview

Redistribution
Allocation Function Stablization Function
Function

1) The role of Government in an economic system

The basic economic problem of scarcity arises from the fact that on
account of qualitative as well as quantitative constraints, the resources
available to any society cannot produce all economic goods and services

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that its members desire to have. Therefore, an economic system should

exist to answer the basic questions such as what, how and for whom to
produce and how much resources should be set apart to ensure growth of
productive capacity.

Adam Smith is often described as a bold advocate of free markets and

minimal governmental activity. Smith believed that government's roles in
society should be limited, but well defined.

However, Smith saw an important resource allocation role for the

government in national defense, system of justice, establishment and
maintenance of highly beneficial public institutions and public works such
as roads, bridges, canals, harbours, postal system etc

Richard Musgrave, in his classic treatise ‘The Theory of Public Finance’ (1959),
introduced the three-branch taxonomy of the role of government in a
market economy. Musgrave believed that, for conceptual purposes, the
functions of the government are to be separated into three, namely,
Resource allocation (efficiency), Income redistribution (fairness) and
Macroeconomic stabilization. The allocation and distribution functions are
primarily microeconomic functions, while stabilization is a macroeconomic
function.

2) Three-function framework of the responsibilities of the

government.

(i) The Allocation function:

Resource allocation refers to the way in which the available resources or

factors of production are allocated among the various uses to which
they might be put. It determines how much of the various kinds of goods
and services will actually be produced in an economy. Resource allocation
is a critical problem because the resources of a society are limited in
supply, while human wants are unlimited.

Economic efficiency indicates a situation in which all resources are

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allocated to serve each person in the best way possible, minimising

waste and inefficiency.

The private sector resource allocation is characterized by market supply

and demand and price mechanism as determined by consumer sovereignty
and producer profit motives. The state’s allocation, on the other hand, is
accomplishedthrough the revenue and expenditure activities of governmental
budgeting. Efficient allocation of available resources in an economy takes
place only when free and competitive market structure exists and economic
agents make rational choices and decisions. Markets are never perfectly
competitive.

Market failures which hold back the efficient allocation of resources occur
mainlydue to the following reasons:

1) Imperfect competition and presence of monopoly power in different

degrees leading to under-production and higher prices.

2) Markets typically fail to provide collective goods which are, by their

very nature, consumed in common by all people.

3) Markets fail to provide the right quantity of merit goods

4) Common property resources are overused and exhausted in individual

pursuit of self-interest.

5) Externalities.

6) Factor immobility which causes unemployment and inefficiency.

7) Imperfect information.

8) Inequalities in the distribution of income and wealth.

According to Musgrave, the state is the instrument by which the needs and
concerns of the citizens are fulfilled. Therefore, public finance is connected
with economic mechanisms that should ideally lead to the effective and
optimal allocation of limited resources. This logic, in effect, makes it
necessary for the government to intervene in the market to bring about
improvement in social welfare.

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The allocative function in budgeting determines who and what will be

taxed as well as how and on what the government revenue will be spent. The
allocation function also involves the reallocation of society’s resources from private
use topublic use.

A variety of allocation instruments are available by which governments

can influence resource allocation in the economy. For example,

1) government may directly produce an economic good (for example,

electricity and public transportation services)

2) government may use the price mechanism to influence private

allocation through incentives and disincentives (for example, taxes
and subsidies)

3) the government may influence allocation through legislation and

force. For example, ban of single use plastic goods

4) The competition policies, merger policies etc. affect the structure

of industry and commerce (for example, the Competition Act in India
promotes competition and prevents anti-competitive activities)

5) governments’ regulatory activities such as licensing, controls,

minimum wages, and directives on location of industry influence
resource allocation.

6) government sets legal and administrative frameworks

7) governments may adopt any combination of possible remedies

(ii) Redistribution Function:

You might have noticed that over the past decades there has been
tremendous expansion in economic activities resulting in enormous
increase in aggregate output and wealth. However, the outcomes of this
growth have not spread evenly across the households. The distribution
responsibility of the government arises from the fact that, left to the
market, the distribution of income and wealth among individuals in the
society is likely to be skewed and therefore the government has to
intervene to ensure a more desirable and just distribution.

Governments can redistribute income and wealth either through the

expenditure side or through the revenue side of the budget. On the

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expenditure side, governments may provide free or subsidised

education, healthcare, housing, food and basic goods etc. to
deserving people. On the revenue side, redistribution is done through
progressive taxation.

The distribution function of the government aims at:

redistribution of income to achieve an equitable distribution of

societal output among households

advancing the well-being of those members of the society

who suffer from deprivations of different types

providing equality in income, wealth and opportunities

providing security (in terms of fulfilment of basic needs) for

people who have hardships, and

ensuring that everyone enjoys a minimal standard of living

few examples of the redistribution function (or market intervention

forsocioeconomic reasons) performed by governments are:

1) taxation policies of the government whereby progressive taxation of

the rich is combined with provision of subsidy to the poor households

2) proceeds from progressive taxes used for financing public services,

especially those that benefit low-income households (for example,
supply of essential food grains at highly subsidized prices to BPL
households)

3) employment reservations and preferences to protect certain

segments of the population, minimum wages and minimum support
prices for farmers

4) unemployment benefits and transfer payments to provide support to

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the underprivileged, dependent, and physically handicapped, the older

citizens and the unemployed.

5) families below the poverty line are provided with monetary aid and
aid in kind

6) regulation of manufacture and sale of certain products to ensure

health and well-being of consumers,

7) special schemes for backward regions and for the vulnerable

sections of the population

governments’ redistribution policies which interfere with producer

choices or consumer choices are likely to have efficiency costs or
deadweight losses. For example, greater equity can be achieved through
high rates of taxes on the rich; but high rates of taxes could also act as
a disincentive to entrepreneurship and work, and discourage people from
making savings and investments and taking risks. This in turn will have
negative consequences for economic output, productivity and growth of
the economy. Consequently, the potential tax revenue may be reduced in
future and the scope for government’s welfare activities would get
seriously limited

(iii) Stabilization Function:

Macroeconomic stability is said to exist when:

 an economy's output matches its production capacity,

 the economy's total spending matches its total output

 the economy's labour resources are fully employed, and

 Inflation is low and stable.

A market economy does not automatically generate full employment and

price stability and therefore, the governments should pursue deliberate
stabilization policies.

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The stabilization function is one of the key functions of fiscal policy and
aims at eliminating macroeconomic fluctuations arising from suboptimal
allocation of resources.

In the absence of appropriate corrective intervention by government,

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.

The government and the country’s central bank promote full employment
and price stability through prudent fiscal policy and monetary policy.

Monetary policy works through controlling the size of money supply

and interest rate in the economy which in turn would affect
consumption, investment and prices.

Fiscal policy for stabilization purposes attempts to direct the actions

of individuals and organizations by means of its expenditure and
taxation decisions.

During recession, in order to ensure income protection, the government

increases its expenditure or cuts down taxes or adopts a combination
of both so that aggregate demand is kept stable or even boosted up
with more money put into the hands of the people.

On the other hand, to control high inflation the government cuts down
its expenditure or raises taxes.

The stabilization function is concerned with the performance of the

aggregate economy in terms of:

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labour employment and capital utilization,

overall output and income,

general price levels,

balance of international payments, and

the rate of economic growth.

Centre and State Finance

Fiscal federalism, a term introduced by Richard Musgrave, deals with

the division of governmental functions and financial relations among the
different levels of government. According to him, central government
should be responsible for economic stabilization and income
redistribution and the allocation of resources should be the
responsibility of the state and local 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, and the concurrent
list, on which both the parliament and the legislative assemblies can

legislate. In the event of conflicting legislation in concurrent list, the

law passed by the centre prevails.

Taxes are levied by the centre and the states. The central
government has greater revenue raising powers. The union government
can levy taxes such as tax on income, other than agricultural income,

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customs and export duties, excise duties on certain goods, corporation

tax, tax on capital value of assets excluding agricultural land, terminal
taxes, security transaction tax, central GST, union excise duty, taxes
other than stamp duties etc.

The state governments can levy taxes on agricultural income, lands and
buildings, mineral rights, electricity, vehicles, tolls, professions, collect
land revenue and impose excise duties on certain items. The property of
the union is exempt from state taxation. The property and income of
the states are not liable to be taxed by the centre.

Since the states have comparatively less sources of income, their

revenues may not be sufficient to meet their expenditure
responsibilities. There is substantial dependence of states on the
union for securing necessary revenues

A unique feature of the Indian Constitution is that Article 280 provides

for an institutional mechanism, namely the Finance Commission, to
facilitate such transfers. The Finance Commission is a constitutionally
mandated body that is at the centre of fiscal federalism. It is
responsible for evaluating the state of finances of the union and
state governments, recommending the sharing of taxes between them
and laying down the principles determining the distribution of these
taxes among states.

Functions of finance commission are:

1) The distribution of the net proceeds of taxes between the union

and the states (VERTICAL EQUITY) which are to be divided
between them and the allocation between the states
(HORIZONTAL EQUITY) of the respective shares of such proceeds.

2) Determination of principles and quantum of grants-in-aid to states

which are in need of such assistance.

3) recommend to the President on 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.

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The 15th Finance 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

criteria for distribution of central taxes among states for 2021-26 are

a) Income Distance i.e the distance of a state’s income from the state
with the highest income.
b) Area
c) Population (2011)
d) Demographic performance (to reward efforts made by states in
controlling their population)
e) Forest and ecology:
f) Tax and fiscal efforts:

GST
The introduction of GST 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), 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

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.

the Union and state legislatures have “equal, simultaneous and unique
powers “to make laws on Goods and Services Tax (GST) and the

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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

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

During the five-year transition period, the top five GST compensation-
receiving states were Maharashtra, Karnataka, Gujarat, Tamil Nadu,
and Punjab.

RESPOSIBILITIES OF GOVERNMENTS

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 sanitation, local roads, electricity etc.

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