Public Finance

Year-II

INSTRUCTOR- : NEELABH KUMAR

Unit 1

Concept of Public Finance

In order to provide a secure and peaceful environment to its citizens and in order to provide certain goods and services to them, Governments need to incur expenditure on internal administration, internal security, internal law and order, a sound judicial system, external defense of the country and on creating infrastructure of roads etc. These activities involve huge financial investments and expenditure. Governments meet this expenditure partly by charging taxes on its citizens and partly by raising loans. The financial operations of the Governments with regard to raising and disbursement of finances are called Public Finance.

Public Finance is the study of the income and expenditure of the State. It deals only with the finances of the Government. Public finance on the other hand refers to all activities of government in generating and allocating (spending) revenue towards ensuring efficiency of the state and the general well-being of the people, that is, financial operation of public treasury and its implication.

Scope of Public Finance

Public Finance is the study of the income and expenditure of the State. It deals only with the finances of the Government. Scope of Public Finance consists in the study of the collection of funds and their allocation between various branches of state activities which are regarded as essential duties or functions of the State.

There are four major scope of the Public financeKeeping all these factors in view, Public Finance may be divided into following four parts: (1) Public expenditure: It involves the judicious expenditure of public funds on the most important and socially and economically relevant activities of the State.(2) Public Revenue: Revenues includes all the income and receipts, irrespective of their source and nature, which the Government obtains during any given period of time.(3) Public Debt: Public debt is the loans raised by Governments and is a source of public finance which carries with it the obligation of repayment to the individuals, along with interest, from whom the debt was raised.(4) Financial Administration: Financial administration consists of those operations the object of which is to make funds available for the Governmental activities, and to ensure the lawful and efficient use of these funds.

Difference between Public Finance and Private Finance

S. NoBasisPublic FinancePrivate Finance

1ConceptPublic finance studies the income-getting and income-spending activities of the public bodies or the state.Private finance deals with the way a private person gets and spends his income.

2Adjustment of Income and ExpenditureThe public authority generally adjusts its income to its expenditure.An individual usually adjusts his expenditure to his income.

3 Unit of TimeThe public authority balances its budget during a given period which is generally a year.The public authority however has to keep full records of its income and expenditure and the accounts are to be in balance during the financial year.For an individual there is no period of time in the course of which the budget must be balanced. The individual generally continues earning and spending without keeping any record of his budget by a particular date.

4An individual cannot borrow from himselfThe public authority, on the other hand, can borrow internally from its own people and externally from other nations.If at any time an individual is in need of money, he cannot borrow from himself. He can raise the loan from other individuals or can utilize his past savings, but he cannot borrow internally.

5Issue of CurrencyGovernment has full control over the issue of currency in the country. No other person except the state can print notes.If an individual does so, he will be put behind the bars.

6PurposeThe purpose of public/government financing is the overall benefit of the society trough development by investing in development programsThe purpose of private finance is to maximizethe benefitfor the concerned person/persons.

7DisclosureDetails of public finance are published and are easily available for the publicThe privatefinancing details are kept secret.

8 Provision for the Future:The government has to make a solid provision for the future. It spends large amounts of the money on those projects which the future generation is only to benefit.he individuals on the other hand are not generally liberal and far-sighted. They discount the future at a higher rate and so usually make inadequate provisional for the future.

Public Revenue

In a broad sense, Public Revenues includes all the income and receipts, irrespective of their source and nature, which the Government obtains during any given period of time. It will include even the loans raised by the Government. In a narrow sense, it will include only those sources of income of Government which are described as revenue resources.

Sources of Public Revenue1. Taxes: The most common method of financing Government expenditure is by taking resort to taxation. In every country, largest part of the public revenue is raised through taxes. Taxes may be imposed on persons income or wealth or on both, they may be direct or indirect, and they may be of different rates and nature. Tax is a compulsory contribution imposed by a public authority, irrespective of the exact amount of service rendered to the taxpayer in return, and not imposed as a fine for any legal offence.

2. Fees: The other important source of public revenue is the fees charged for rendering certain services by the State. Fee is that revenue which is paid to the Government for the special service rendered by it.

3. Price: The third important source of public revenue is the price. The Government sells some services and goods and receives price in payment for them.

4. Fines and Penalties: Fines and penalties are payments made by citizens for contravention of the laws of land. This is a major source of revenue of modern nation states.

5. Gifts: A small portion of public revenue is generated through gifts made by individuals, corporates and foreign Governments or agencies. Its significance as a source of public revenue has been declining over the years.

6. Borrowings: It is a major source of public revenue to finance large projects or programmes requiring large investments. Borrowings, besides being an important source for financing public expenditure, also help Governments to regulate money supply in the economy.

7. Printing of Paper Money: The Governments, through their Central Banks, may resort to printing of paper money to meet public expenditure. Governments have the ability to create money and assign it legal tender qualities. Modern Governments, however, avoid now using this source for financing public expenditure.

It is the normal practice of the government to classify the receipts into revenue receipts and capital receipts.

Revenue receipts: are those items which are routine and earned ones. Example- tax receipts, interest receipts, dividends and profits, grants, fees and fines etc. On the other hand the capital receipts are those items which are basically of non repetitive in nature.

Revenue receipts are divided into tax and non tax revenue.

1. Tax revenue: it is divided into three sectionsa. Tax on income and expenditure- this section covers all those taxes which are levied on receipts of income and expenditures of taxpayers such as corporate tax, income tax, interest tax, expenditure tax etc.b. Taxes on property and capital transactions: this section covers taxes on specified forms of wealth and its transfers such as wealth tax, gift tax, house tax, land revenue etc.c. Taxes on commodity and services: this section includes taxes on production, sale, purchase, transport, storage, consumption of goods and services.

Alternatively, taxes may be divided into direct tax and indirect tax

2. Non tax revenue of the government may also be divided into three sectionsa. Currency, coinage and mint: this source of non tax revenue is only available to the GOI and not to the state government. It comprises of excess of face value of currency created and sold to the RBI to be issued to the market over its cost of creation.b. Interest receipts, dividends and profits: this section comprises interest receipts on loans by the government to other parties, dividends and profits from public sector companies.c. Other Non Tax revenue: this section covers revenue from various government activities and services such as from administrative services, public service commissions, police, jails, agricultural and allied services, industry, minerals, education, housing, broadcasting, grants in aid and contributions etc.

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

TaxationTax: it is a compulsory levy payable by a legal entity to the government without any corresponding entitlement to receive any specified and equivalent benefits from the government.

Taxation: it is the inherent power of the state, acting through the legislature, to impose and collect revenues to support the government and its recognized objects. Simply stated, taxation is the power of the state to collect revenues for public purpose.

Nature of taxation1. It is an enforced contribution2. It is generally payable in money.3. It is proportionate in character, usually based on the ability to pay4. It is levied on persons and property within the jurisdiction of the state5. It is levied pursuant to legislative authority, the power to tax can only be exercised by the law making body or congress6. It is levied for public purpose7. It is commonly required to be paid a regular intervals

Purpose of TaxationPrimary purpose: is to provide funds or property with which the government discharges its appropriate functions for the protection and general welfare of its citizens.

Non revenue ObjectivesAside from purely financing government operational expenditures, taxation is also utilized as a tool to carry out the national objective of social and economic development.

1. To strengthen anemic enterprises by granting them tax exemptions or conditions or incentives for growth;2. To protect local industries against foreign competition by increasing local import taxes;3. As a bargaining tool in trade negotiations with other countries;4. To counter the effects of inflation or depression;5. To reduce inequalities in the distribution of wealth;6. To promote science and invention, finance educational activities or maintain and improve the efficiency of local police forces;7. To implement police power and promote general welfare.

Canon of TaxationA good system of taxation must satisfy certain general principles. Adam Smith laid down the following four canons of taxation.

(1) Canon of Equality: This is the most important canon of taxation. Equality or equity means that every ax payer should contribute towards the support of the government according to his ability to pay. This does not mean that all people rich or poor should pay equal tax or at equal rate. Equality means equality of sacrifice. The equality of sacrifice can only be maintained when the rich are required to pay tax at a greater rate than the poor people.

(2) Canon of certainty: This canon says that everything about a tax should be definite and certain. According to this canon there must be certainty about the time of payment, the manner of payment and the quantity to be paid. It will give greater confidence to the government about its estimates and that the tax payer will also feel certain about his budget. Uncertainty encourages corruption.

(3) Canon of convenience: This canon implies that every tax ought to be levied at the time or in the manner in which it is likely to be most convenient for the contributor to pay it. If a tax is convenience, the payer will pay it at the proper time without reminder. For example a person drawing a monthly salary likes to pay at the time of receiving his salary every month.

(4) Canon of economy: This canon implies two things. Firstly, the cost of collection of a tax should be small in proportion to yield. Secondly, the tax must not obstruct in any manner the economic development of the country. If a tax is contrary to these two principles it is regarded as costly and uneconomical.

OTHER CANONS: Besides these canons of taxation, there are four other important principles of taxation. They have been added by later economists. They are as follows:

(5) Canon of Productivity: It means that taxes should yield sufficient revenue to the government. A few tax which are fairly productive are much better than a large number of taxes which not so productive.

(6) Canon of elasticity:This principles means that tax system should be capable of expansion and reduction according to the requirements of the state. Taxes which in case of need can be conveniently increase in amount without any additional cost of collection are considered to be good taxes. Income tax is a very good example of an elastic tax.

(7) Canon of simplicity: The system of taxation should not be complicated and difficult to be understood by an average person. The basis of tax and method of calculation should be simple, plain and intelligible.

(8) Canon of Diversity: This principle says that a large variety taxes is always preferable to a small number. Every tax has some defects. In a varied tax system, different taxes tend to cancel to each other. Variety is also desirable from the point of view of yield, stability and justice.

Classification of taxes

Direct TaxA Direct tax is a kind of charge, which is imposed directly on the taxpayer and paid directly to the government by the persons (juristic or natural) on whom it is imposed. A direct tax is one that cannot be shifted by the taxpayer to someone else.

1. Income Tax: Income Tax Act, 1961 imposes tax on the income of the individuals or Hindu undivided families or firms or co-operative societies (other than companies) and trusts (identified as bodies of individuals associations of persons) or every artificial juridical person. The inclusion of a particular income in the total incomes of a person for income-tax in India is based on his residential status. There are three residential status, viz., (i) Resident & Ordinarily Residents (Residents) (ii) Resident but not Ordinarily Residents and (iii) Non Residents. All residents are taxable for all their income, including income outside India. Non residents are taxable only for the income received in India or Income accrued in India. Not ordinarily residents are taxable in relation to income received in India or income accrued in India and income from business or profession controlled from India.

2. Corporation Tax: The companies and business organizations in India are taxed on the income from their worldwide transactions under the provision of Income Tax Act, 1961. A corporation is deemed to be resident in India if it is incorporated in India or if its control and management is situated entirely in India. In case of non resident corporations, tax is levied on the income which is earned from their business transactions in India or any other Indian sources depending on bilateral agreement of that country.

3. Property Tax: Property tax or 'house tax' is a local tax on buildings, along with appurtenant land, and imposed on owners. The tax power is vested in the states and it is delegated by law to the local bodies,

4. Inheritance (Estate) Tax: An inheritance tax (also known as an estate tax or death duty) is a tax which arises on the death of an individual. It is a tax on the estate, or total value of the money and property, of a person who has died. India enforced estate duty from 1953 to 1985.

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

Indirect Tax: An indirect tax is a tax collected by an intermediary (such as a retail store) from the person who bears the ultimate economic burden of the tax (such as the customer). An indirect tax is one that can be shifted by the taxpayer to someone else. An indirect tax may increase the price of a good so that consumers are actually paying the tax by paying more for the products.1. Customs DutyCustom duty is a form of indirect tax. Standard English dictionary defines the term "custom" as duties imposed on imported or less commonly exported goods. This term is usually applied to those taxes which are payable upon goods or merchandise imported or exported. It is also defined as tax imposed by the government on the import of items (goods). The Customs Act was formulated in 1962 to prevent illegal imports and exports of goods. Besides, all imports are sought to be subject to a duty with a view to affording protection to indigenous industries.2. Excise DutyThe tax imposed by the government on the manufacturer or producer on the production of some items is called excise duty. The liability to pay excise duty is always on the manufacturer or producer of goods. The duty being a duty on manufacture of goods, it is normally added to the cost of goods, and is collected by the manufacturer from the buyer of goods. Therefore it is called an indirect tax. This duty is now termed as "Cenvat". There are three types of parties who can be considered as manufacturers- Those who personally manufacture the goods in question. Those who get the goods manufactured by employing hired labor. Those who get the goods manufactured by other parties.In order to attract Excise duty liability, following four conditions must be fulfilled:a) The duty is on "goods".b) The goods must be "excisable"c) The goods must be "manufactured" or produced.d) Such manufacture or production must be "in India".3. Sales TaxTax paid by the consumer on the purchase of some items is called the sales tax. Rates of sales taxdepend upon the nature of the goods purchased by the consumer.

4. VATVAT is the acronym for valued added tax. This tax which is in other words called consumption tax can be defined as the amount charged by the government for every goods or services purchased from time to time. This means it can only be paid when there is consumption of goods or services (It forms part of the price paid for the good or service). Value Added Tax was introduced in 1994 to replace sales tax which until now generated revenue for the state governments. VAT was designed broadly to be levied on imported goods, locally manufactured goods, hotel service, bank transaction etc. It was to be federally-collected.

Characteristics of Value Added TaxThere are three main characteristic spelt out as follows:1. It is a consumption Tax. This is that it can be paid when there is consumption of the good or service.2. Its incidence is borne by the final consumer3. It is multi-stage tax. That is as additional value is created at each stage of production the tax is paid by the consumer of the product at that stage. The total payments make up the consumers price of the product.Requirement of a good tax system1. Fairness The tax system needs to ensure that all taxpayers share the tax burden equally. People with similar financial circumstances should receive the same tax treatment. In other words, all high-income earners, whether they are individuals or corporations, pay their fair share of tax.

Equity: Two Kinds of Tax Fairness When people discuss tax fairness, theyre talking about equity. Tax equity can be looked at in two important ways: vertical equity and horizontal equity.

Vertical equity addresses how a tax affects different families from the bottom of the income spectrum to the topfrom poor to rich. Three terms are used in measuring vertical equity:a. Regressive tax systems require that low- and middle-income families pay a higher share of their income in taxes than upper-income families. Sales taxes, excise taxes and property taxes tend to be regressive.b. Proportional or flat tax systems take the same share of income from all families. c. Progressive tax systems require upper-income families to pay a larger share of their incomes in taxes than those with lower incomes. Personal income taxes are usually progressive.

Horizontal equity is a measure of whether taxpayers with similar circumstances in terms of income, family structures, and age pay similar amounts of tax. For example, if one family pays much higher taxes than a similar family next door, that violates horizontal fairness.

2. Fiscal Adequacy: means that the sources of revenues should be sufficient to meet the demand of public expenditures.3. Simplicity and compliance People will be more willing to comply with tax laws if the system is simple and easy to understand.

4. Transparency: Tax legislation should be based on sound legislative procedures and careful analysis. A good tax system requires informed taxpayers who understand how tax assessment, collection, and compliance works. There should be open hearings and revenue estimates should be fully explained and replicable.

5. Neutrality: The primary purpose of taxes is to raise needed revenue, not to micromanage the economy. The tax system should not favor certain industries, activities, or products.

6. No Retroactivity: As a corollary to the principle of stability, taxpayers should rely with confidence on the law as it exists when contracts are signed and transactions made. Changes in tax law should not be retroactive. As a matter of fairness, taxpayers should rely with confidence on the law as it exists when contracts are signed and transactions are made.

7. Economic growth As a corollary to the principle of neutrality, lawmakers should avoid enacting targeted deductions, credits and exclusions. If such tax preferences are few, substantial revenue can be raised with low tax rates. The tax system should encourage growth through lower tax rates and a broader tax base.

8. Stability The federal government needs a stable and dependable source of tax revenue so it can manage the countrys economy. The aim of tax reform is to make sure the federal government can achieve its economic objectives.

Unit 2

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

Principle of Maximum Social Advantage (MSA)The 'Principle of Maximum Social Advantage (MSA)' is the fundamental principle ofPublic Finance. The Principle of Maximum Social Advantage states that public finance leads to economic welfare when public expenditure & taxation are carried out up to that point where the benefits derived from the MU (Marginal Utility) of expenditure is equal to (=) the Marginal Disutility or the sacrifice imposed by taxation.Hugh Dalton explains the principle of maximum social advantage with reference to :-1. Marginal Social Sacrifice2. Marginal Social Benefits

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

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

The above diagram indicates that the Marginal Social Sacrifice (MSS) curve rises upwards from left to right. This indicates that with each additional unit of taxation, the level of sacrifice also increases. When the unit of taxation was OM1, the marginal social sacrifice was OS1, and with the increase in taxation at OM2, the marginal social sacrifice rises to OS2.Marginal Social Benefit (MSB) While imposition of tax puts burden on the people, public expenditure confers benefits. The benefit conferred on the society, by an additional unit of public expenditure is known as Marginal Social Benefit (MSB).Just as the marginal utility from a commodity to a consumer declines as more and more units of the commodity are made available to him, the social benefit from each additional unit of public expenditure declines as more and more units of public expenditure are spent. In the beginning, the units of public expenditure are spent on the most essential social activities. Subsequent doses of public expenditure are spent on less and less important social activities. As a result, the curve of marginal social benefits slopes downward from left to right as shown in figure below.

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

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

At point P social advantage is maximum. Now consider Point P1. At this point marginal social benefit is P1Q1. This is greater than marginal social sacrifice S1Q1. Since the marginal social sacrifice is lower than the marginal social benefit, it makes more sense to increase the level of taxation and public expenditure. This is due to the reason that additional unit of revenue raised and spent by the government leads to increase in the net social advantage. This situation of increasing taxation and public expenditure continues, as long as the levels of taxation and expenditure are towards the left of the point P.At point P, the level of taxation and public expenditure moves up to OQ. At this point, the marginal utility or social benefit becomes equal to marginal disutility or social sacrifice. Therefore at this point, the maximum social advantage is achieved.At point P2, the marginal social sacrifice S2Q2is greater than marginal social benefit P2Q2. Therefore, beyond the point P, any further increase in the level of taxation and public expenditure may bring down the social advantage. This is because; each subsequent unit of additional taxation will increase the marginal disutility or social sacrifice, which will be more than marginal utility or social benefit. This shows that maximum social advantage is attained only at point P & this is the point where marginal social benefit of public expenditure is equal to the marginal social sacrifice of taxation.Conclusion Maximum Social Advantage is achieved at the point where the marginal social benefit of public expenditure and the marginal social sacrifice of taxation are equated, i.e. where MSB = MSS.This shows that to obtain maximum social advantage, the public expenditure should be carried up to the point where the marginal social benefit of the last rupee or dollar spent becomes equal to the marginal social sacrifice of the last unit of rupee or dollar taxed.Public ExpenditurePublic Expenditure is the end and aim of the collection of State revenues. It involves the judicious expenditure of public funds on the most important and socially and economically relevant activities of the State. The term Public Expenditure refers to the expenses incurred by the Government for its own maintenance and also for the preservation and welfare of society and economy as a whole. It refers to the expenses of the public authorities, Central, State and Local Governments, for protecting the citizens and for promoting their economic and social welfare.Based on benefit accrued, public expenditure may be classified as:1. Expenditure which confers common benefit on all: Public expenditure incurred on general administration, legislatures, defence, education, transport, etc. benefits the entire society in general.2. Expenditure which confers special benefit on some people: Public expenditure incurred on providing police protection, justice, etc. provides security of life and property to the entire community. However, comparatively greater benefit from these services accrues to the weaker sections of the society who need the protection of police and justice more than others. Thus, these services affect the entire community in general and some groups in particular.

3. Expenditure which directly confers benefit on certain persons and indirectly on the entire society: Social security, public welfare, unemployment relief, old age pension, etc. are such items which are administered with the aim of directly helping the particular sections of the society. Public expenditure incurred on these services directly benefits certain persons while indirectly it benefits the whole society.4. Expenditure which confers special benefit on some individuals: Some public expenditure is incurred for the benefit of a particular group of society. Such expenditure dies not confer advantages on the entire society or even on any group other than those for whom it is intended by the Government. Subsidy given to particular industries or individuals subsidized low cost housing provided to the poor is public expenditure of such type.

Canons of Public ExpenditureFollowing are the important canons of public expenditure:1. Canon of Benefit: Public Expenditure should bring with it important social advantages such as increased production, preservation of social whole against external aggression and internal disorder, and as far as possible reduction in income inequalities. In other words, public funds must be spent in those directions which are most conducive to public interest. Public expenditure must result in the achievement of maximum social advantage. Public wealth should not normally be utilized for the benefit of a particular group, it should rather equitably confer benefits on the whole community. Public expenditure in every direction must be carried just so far that the advantage to the community of a further small increase in any direction is just balanced by the disadvantage of a corresponding small increase in taxation and from any other source of public income.

2. Canon of Economy: Economy, here, does not mean miserliness or niggardliness rather it means that wasteful extravagant expenditure should be avoided. The public authorities should not waste the limited resources at their disposal. It is, therefore, necessary that the Government incurs expenditure with greatest care and prudence. Only the minimum necessary amount should be spent on any given head of expenditure. It should aim at maximum benefit.

3. Canon of Sanction: There should be proper procedure of formulating the policy for public expenditure with sufficient safeguards for avoiding arbitrariness and influence of certain vested interests in the matter of public expenditure. The canon requires that there should be in place a proper procedure for authority to incur expenditure out of public funds and that accountability for expenditure should be inbuilt in the scheme of sanction and incurring of expenditure. The spending authority should obtain proper sanction from the authority vested with the power of sanction. The canon also envisages that there should be adequate control and audit of public expenditure to ensure that expenditure is as per sanction and likelihood of avoidable and unscrupulous expenditure and misappropriation of funds is avoided.

4. Canon of Surplus: This canon enjoins that public expenditure should be, as far as possible, met from current public revenues, without resorting to deficits or borrowings.

5. Canon of Elasticity: According to this canon, expenditure policy of the Government should be such that it may be possible to change the size and direction of public expenditure according to requirements of different circumstances.

6. Canon of Productivity: This canon implies that public expenditure should be such that would encourage production and productive efficiency in the country.

7. Canon of Equitable Distribution: This canon is particularly important for the countries where glaring inequalities of income and wealth are present.

Effects of Public ExpenditurePublic expenditure which is incurred by the Government according to sound principles of public finance exerts its important healthy effect on the economy of any country.1. Effects on Production and Employment: The beneficial effect of public expenditure is in the form of greater production of output and more equitable distribution of wealth and income in the society. Public expenditure on generalized social services like health, education, public health, etc. tends to raise the efficiency of the nation. Consequently such expenditure tends to increase the productivity of the nation leading to greater prosperity of individuals. Public expenditure on infrastructure like roads, ports, railways, etc. create tremendous employment avenues for the citizens, raising their income. Increased income translates in higher consumption by citizens of goods and services, resulting in increased demand with increase in industrial and other production. Increased income of citizens also results in increase in savings by citizens which is likely to be channeled in new production facilities through investment. Increased demand for goods and services leads to increased employment and more avenues of increased income for the citizens.

Public expenditure also exerts its effects on what regions or industries are to be provided with abundant productive resources. While incurring public expenditure, the Government has to choose the particular region or area and industry for incurring public expenditure so that it maximizes national production and follows it with maximum community welfare.

2. Effects on DistributionApart from affecting the level and composition of national output, public expenditure is also most powerful fiscal instrument available to the Government to bring about an equitable distribution of income and wealth in the country. While formulating its expenditure policies, government takes into account as to which of the socio-economic group in the country are being specially benefited by it. If greater those activities which specially benefit the poor and weaker sections of the society, it will help bring about a more equal distribution of income and wealth and the consequential removal of existing disparities in peoples living standards in the society.

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

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

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

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

1. Financing Economic DevelopmentAn underdeveloped country is always faced with the shortage of funds. Taxation, as source of public finance, has a limitation in as much as citizens in underdeveloped economies have limited surplus to contribute to Governments taxation measures. Besides, taxes in an underdeveloped economy have an adverse affect on consumption driven demand in the economy. However, the need for finance is imperative in order to take the economy out of the vicious circle of poverty and provide the citizens with minimum acceptable infrastructure. In such situation, public loans are the only way out for Government to raise finances needed for development.2. Unpopularity of TaxationPeople generally do not like to pay taxes to the Government. The citizens generally oppose the imposition of new taxes and enhancement of old taxes. To get over the public opposition, Governments resort to the easy method of resorting to Public Debt.3. Facing Natural CalamitiesSometimes Governments raise loans to meet the cost of repair of infrastructure and to provide immediate succor to the people affected by natural calamities, like floods, earthquakes, etc. It may not be possible to finance such expenditure from the current revenues of the Government.4. Waging Wars for Defending the NationWhen country is engaged in war, the public exchequer is faced with a sudden and large demand for funds to meet the equipment, manpower and other costs. Such expenditure is usually met through public loans raised by Governments.5. Covering Temporary Budget DeficitSometimes, the Government does not think it appropriate to meet its budget deficit by resorting to additional taxation. In such a situation, the Government may resort to borrowing from the public.6. Fighting DepressionBusiness cycles affect all the economies. Cycles of rapid growth are generally followed by cycles of depression, when due to lack of demand, industrial production comes down, employment is at low level and there is an apprehension in the minds of people with surplus funds about avenues of profitable investment. In such a situation Government borrows funds from people with surplus funds and invests these funds to raise the level of aggregate demand in the economy. This method of dealing the cycles of depression have been used effectively in USA and in Europe.7. Controlling InflationBy raising Public Debt, the Government can withdraw a large volume of money from the public and thus prevent prices from rising. Since the monetary policy of Central Bank alone has not been much successful, fiscal policy of which public debt policy constitutes an important part , has been attaining greater importance ever since the great war.

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

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

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

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

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

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

B. Productive and Unproductive Debt

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

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

D. Compulsory and Voluntary Debt

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

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

E. Redeemable and Irredeemable Debt

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

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

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

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

Method of debt redemption

The various methods of public debt redemption are as follows.1. Sinking fund methodThe Government creates a fund called sinking fund by accumulating a part of the public revenue every year for the repayment of debt. This is the most systematic and best method of debt redemption. The burden of debt is spread evenly over the period of accumulation of the fund. Sinking fund creates confidence among the lenders and increases the credit worthiness of the government.2. Capital levyAcapital levyis a tax oncapitalrather thanincome, and is collected once rather than annually.Adirect taxupon thecapitalof the tax payers is called capital levy. It will be generally imposed in times of emergencies. Dalton recommended this method very strongly. It was advocated as a method of liquidating the unproductive war debts. Debt redemption by imposing a very heavy taxation on property has been advocated. However, this method has raised objections as heavy taxes might lead to undesirable effects on the economy.3. ConversionConversion of public debt implies changing the existing loans, before maturity, into new loans at an advantage in servicing charges. In fact, the process of conversion consists generally, in converting or altering a public debt from a higher to a lower rate of interest.A government might have borrowed at a time when the rate of interest was high. Now, when the rate of interest falls, it may convert the old loans into new ones at a lower rate, in order to minimise the burden. Thus, the obvious advantage of such conversion is that it reduces the burden of interest on the taxpayers. Furthermore, lower interest rates on public loans would mean a less unequal distribution of income.The success of conversion, however, depends upon:(a) The creditworthiness of the government,(b) The maintenance of adequate stock of securities,(c) The efficiency in managing the public debt.Furthermore, for a successful conversion, the government will have to offer new low-interest bearing bonds at a discount rate and which will have to be redeemed at full value, causing thereby a capital appreciation (which may be even free of income-tax).

Conversion is not repayment; it is only exchange of new debts for old. This may take place at the time of maturity or before the time of maturity by the voluntary acceptance. The main advantage of conversion is that it reduces the interest burden of the state and relieves tax payers. For this purpose, the government had to maintain an adequate stock of securities for a smooth functioning of this method.4. RefundingRefunding implies the issue of new bonds and securities by the government, to repay the matured loans. The short term securities are replaced by long term securities. The owners of the old debt have the option of subscribing to new debt or opt for cash. Under this method, the burden of repayment of public debt is postponed to a future date.5. Terminable annuitiesThe fiscal authority clears off a part of the public debt every year by issuing terminable annuities to the bond holders which mature annually. It is a method of redeeming debts by instalment. The burden of debt goes on diminishing annually and by time of maturity it is fully paid off.6. Redemption by PurchaseIn this case the government pays off debts by purchasing securities even before the maturity whenever it has surplus budget. However, surplus budget is a rare phenomenon in modern times.7. Additional TaxationThe government imposes new taxes to get revenue to repay the principal and interest of the loan. This is the simplest method of debt redemption. If new taxes are levied to repay long term debts, the burden is imposed on future generation. This method causes a redistribution of income from the tax payers to the bond holders.8. Surplus balance of paymentsExternal debt redemption is possible only by accumulating foreign exchange reserves. Hence it is necessary to create a trade surplus by increasing exports and reducing imports. External debt can also be reduced by changing the terms of repayment. The loans raised must be used productively so that they are self liquidating posing no real burden on the economy.

What is deficit financing?When a government spends more than what it currently receives in the form of taxes and fees during a fiscal year, it runs in to a deficit budget. When the budget deficit is financed by borrowing from the public and banks, it is called deficit financing.Deficit financing refers to the borrowing undertaken by the government to make up for the revenue shortfall. It is the best stimulant for the economy in short term. However, in the long term it becomes a drag on the economy and becomes the reason for rise in interest rateThere is no precise definition of the term deficit financing. It is a method used to finance the overall or net budget deficit. Deficit financing is said to have been practiced whenthe expenditure of the government both development and non- development exceeds its current revenue and capital budget and the deficit is met through government borrowing.Here are some of the problems of deficit financing.1. Leads to inflation: Deficit financing may lead to inflation. Due to deficit financing money supply increases & the purchasing power of the people also increase which increases the aggregate demand and the prices also increases. 2. Adverse effect on saving: Deficit financing leads to inflation and inflation affects the habit of voluntary saving adversely. Infect it is not possible for the people to maintain the previous rate of saving in the state of rising prices. 3. Adverse effect on Investment: deficit financing effects investment adversely when there is inflation in the economy trade unions make demand for higher wages for that they go for strikes and lock outs which decreases the efficiency of Labor and creates uncertainty in the business which a decreases the level of investment of the country. 4. Inequality: in case of deficit financing income distribution becomes unequal. During deficit financing deflationary pressure can be seen on the economy which makes the rich richer and the poor, poorer. The fix wage earners are badly affected and their standard of living deteriorates thus no gap b/w rich & poor increases. 5. Problem of balance of payment: Deficit financing leads to inflation. A high price level as compared to other countries will make the exports more expensive and thus they start declining. On the other hand rise in domestic income and price may encourage people to import more commodities from abroad. This will create a deficit in balance of payment and the balance of payment will become unfavorable. 6. Increase in the cost of production: - When deficit financing leads to the rise in the price level the cost of development projects also rises this means a larger dose of deficit financing is required on the port of government for completion of these projects. 7. Change in the pattern of investment: Deficit financing leads to inflation. During inflation prices rise and reach to a very high level in that case people instead of indulging into productive activities they start doing speculative activities.The main reasons for the use of deficit financing are: Covering the Receipt-Expenditures Gap: the government receipts through taxes and other sources are not adequate to finance the development expenditures. The government has not been able to fill the gap between the total receipt and the total expenditure by levying new taxes or increasing the rates of existing tax beyond a certain limits to avoid displeasure of the people, the government has been choosing an easy path of deficit financing or creation of new currency. Low Savings: The people in LDCs are consumption-oriented. Due to high propensity to consume, the domestic saving rate as a percentage of GNP is very low. As such the government is compelled to use deficit financing as an instrument of economic development. Inadequate Banking Facilities: the financial institutions which mobilize savings particularly in the rural areas are inadequate. The government is therefore, not able to mobilize resources to the desired extent. Rapid Growth of Population: The rapid rate of population growth is swallowing up whatever little economic progress is made. The government is anxious to speed up the economic development in the shortest possible period of time and is using the method of deficit financing. Uncertainty in getting foreign assistance: Though the LDCs have been receiving foreign assistance yet the amount of aid received has always remained uncertain. The government for increasing the rate of investment and coming out of the vicious circle of poverty has no other way but to resort to deficit financing.

Deficit Financing is a useful weapon for stimulating economic development in the country. The main advantages claimed of deficit financing are:1. Mobilizes additional resources for economic development: in LDCs the rate of capital formation is very low due to the unavailability of resources. The rate of economic development is very low. The capital is considered as life blood of the economy. Thus the deficit financing is a source of capital formation.2. Helps up in utilizing our unutilized or underutilized resources: the rate of economic growth of the LDCs is slow because they cant utilize these resources fully due to the lack of capital. Deficit financing creates additional purchasing power in the hands of government with which the government can utilize the underutilized and unutilized resources.3. Helps in building up infrastructure: the LDCs have very low infrastructure facilities like highways, banks, education etc. a big sum is required by the government in providing such facilities like construction of highways, provision of electricity, water & gas, provision of health facilities. In such situations, when the revenue of the government is low, deficit financing is the way to meet the needs of the government for providing these facilities.4. Ensuring higher level of employment in the country:in LDCs, the unemployment is a real problem. The number of unemployed people is increasing day by day as the population increases and also due to the unavailability of capital with the people and government. 5. Thus deficit financing is the way to increase the employment in the country. When the revenue created through deficit financing is spent on different projects like construction of roads, irrigation, hydro-electric generation etc. this will absorb the unemployed portion of the people.

Unit 3

Financial relations between the Central Government, State Government and Local BodiesAll political systems have people with differing and often conflicting demands and different abilities to achieve them. Various groups of people in such systems have, however, common and shared concerns. On the one hand, these groups of people have separate identities and would like to retain their internal autonomy; on the other hand, their deeper socio-economic and cultural interests get articulated through the participative political processes and institutions. The function of government is to mediate between different interest groups within a legal and organizational framework which binds them together. The distinctive feature of such a political system is that public policy decision making and its implementation are divided between a multi-tier system consisting of two governments, i.e., a central government and a set of unit governments. The central government is known as the federal government and the unit governments are known as the state governments. The political system which is characterized by multi-level governments is known as a federation. Sir Robert Garron defined a federation as: "a form of government in which sovereignty or political power is divided between the central and local government so that each of them within its own sphere is independent of each other."Basic Features of Federalism

Independence and CoordinationConventional definitions of a federation usually lay emphasis on the fact that between the two levels of government, there is a division of powers such that the central government is given specified functions and the states enjoy the residual (non-specified) powers.

The central government is seen to be representing the nation and as being directly responsible to the national electorate. On the other hand, the nation is the aggregate of the units which comprise it. The electorate, the members of the central parliament, the bureaucracy and politicians will tend to project demands and attitudes which originate and relate to the units. In such a situation, the central government will serve as the receptacle for the interaction of the interests of the units. In this process, there is bound to be a conflict of interests, in some cases at least, between the central government and the unit governments, or between the-different unit governments. The central government has, therefore, to play a mediatory role as between the units. Institutional mechanisms have to be created to resolve such conflicts particularly between the central government and the state governments. The fundamental process of the formation of a federation is guided by the dual consideration of self-interests of the units as also mutuality and commonality of larger objectives which bind the federating units together. Thus the two way process of guarding self-interest and yet reaching out beyond it for the realization of common aspirations which may be rooted in culture, religion. race, language, internal or external security of a shared history is continually at work. This makes for cooperation, mutual accommodation and compromise. This is the essence of a functioning federation which is characterized not so much by independence as by coordination.

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

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

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

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

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

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

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

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

The Constitutions generally provide for the creation of inter-governmental institutions to act as the forum for the resolution of conflicts. In the ultimate analysis, however, it is the perception of the federating units as regards their long-term interests being served through the membership of the federation that helps resolve these tensions through compromise, accommodation and perhaps some amount of coercion.

Evolution of Fiscal Federalism in India

Mobilization, sharing and utilization of financial resources play a very crucial role in all systems of multi-tier government and can give rise to difficult problems of inter-governmental relations unless handled in a spirit of mutual understanding and accommodation.

Growth of Fiscal Federalism: A highly centralized financial system came into being in India with the take-over of the administration by the British Crown from the East India Company in 1858. The Governor-General-in-Council retained complete control over provincial resources as well as expenditure. The provincial governments remained entirely dependent on annual allotments by the Central Government for the maintenance of their administration. It was soon realized that decentralization was necessary for governing a country of sub-continental dimensions like India and the first step in this direction was taken in 1870. The fiscal history of the next sixty years is very largely a process of gradual devolution of powers to the provinces from the Central government. The Montague-Chelmsford Report which led to the passing of the Government of India Act, 1919, recognized the necessity of separating the resources of the central and provincial governments to support provincial enfranchisement.

Accordingly, under the devolution rules framed under the Act, customs, non-alcoholic excises including salt, general stamp duties, income tax and receipts from railways and posts and telegraphs, were assigned to the Government of India. Land revenue, irrigation charges, alcoholic excises, forest receipts, court fees, stamp duties, registration fees and certain minor sources of revenue were allotted to the provinces. This devolution scheme was criticized on the ground that the resources assigned to the provinces did not have adequate growths potential and were insufficient for their rapidly increasing needs, whereas the central revenues were capable of expansion, although its needs were rel3tively stationary. The working of the financial relations, was, therefore, reviewed by a number of expert committees, particularly, in early 1930's. The provisions incorporated in the Government of India Act, 1935, were based on these reviews.

The Government of India Act, 1935: This Act constitutes the next landmark in the country's financial administration. It divided the revenue sources into three categories: Exclusively Federal. Exclusively Provincial. a) Taxes levied by the Federal government but shared with the provinces or assigned to b) the taxes levied by the Federal Government but collected and retained by the Provinces.

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

That no decentralized government can be established without allocating to it sufficient financial powers. That the central government is the appropriate authority to levy a tax where uniform rate is important and locale is not a guide to its true incidence.

Financial AdministrationIntroductionFinance is the fuel for the engine of Public administration. Mr. Lloyd George is reported to have once remarked that Government is finance. This is quite correct, because almost everything the Government does, require money. According to Kautilya, All undertakings depend upon finance. Hence, foremost attention shall be paid to the treasury. Financial administration consists of those operations the object of which is to make funds available for the Governmental activities, and to ensure the lawful and efficient use of these funds. These operations are performed by the following agencies:

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

Financial-administration is a dynamic process, which falls into five well defined divisions namely: Preparation of the budget, i.e., of the estimates of the revenue and expenditure for the ensuing financial year, Getting these estimates passed by the Legislature called Legislation of the Budget, Execution of the budget, i.e., regulation of the expenditure and raising of revenue according to it, Treasury management, i.e., safe custody of the funds raised, and due arrangement for the necessary payments to meet the liabilities; and Rendering of the accounts by the executive and the audit of these accounts.

The term Financial Administration consists of two words viz. 'Finance' and 'Administration'. The word 'administration' refers to organisation and management of collective human efforts in the pursuit of a conscious objective. The word 'Finance' refers to monetary (money) resource. Financial Administration refers to that set of activities which are related to making available money to the various branches of an office, or an organisation to enable it to carrying out its objectives.

Nature of Financial AdministrationThere are two different views regarding the nature of financial administration. These are i) Traditional view; ii) Modern view.

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

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

Equalizing Role: Under this role financial administration seeks to demolish the inequalities of wealth. It seeks, through fiscal policies, to transfer income from the affluent to the poor. Functional Role: Under normal circumstances the economy cannot function on its own. Under this role, financial administration seeks to ensure, through taxation, public expenditure and public debt, and proper functioning of the economy. It evolves policy instruments to maintain high economic growth and full employment. Activating Role: Under this role financial administration involves the study of such steps that will facilitate a smooth and rapid flow of investment and its optimal allocation to increase the volume of national income. Stabilizing Role: Under this role, the objective of financial administration is the stabilization of price level and inflationary trends through fiscal as well as monetary policies. Participatory Role: According to this view, financial administration involves formulation and execution of policies for making the state a producer of both public and private goods with the objective of maximizing social welfare of the community. It also seeks to promote economic development through direct and indirect participation of the State.

Scope of Financial Administration Financial Planning: planning, in a broad sense; includes the concerns in terms of whole range of government policy and it demands a time frame and a perception of the inter relationships among policies. It looks at a policy in the framework of long-term economic consequences. There is a need to coordinate planning and budgeting. Financial Administration, under this phase, should consider the sources and forms of finance, forecasting expenditure needs, desirable fund flow patterns and so on. Budgeting: This area is the core of financial administration. It includes examination and formulation of such important aspects as fiscal policy, equity and social justice. It also deals with principles and practices associated with refinement of budgetary system and its operative processes. Resource Mobilization: Imposition of taxes, collection of rates and taxes etc. are associated with resource mobilization effort. Due to the ever increasing commitments of government, budgetary deficits have become regular feature of government finance. In this context deficit financing assumes greater importance. Another challenge faced by administration is tax evasion and growth of parallel economy. Finally public debt constitutes yet another element of state resources. The proceeds of debt mobilization effort should be used only for capital financing. Investment decisions: Financial and socio-economic appraisal of capital expenditure constitutes what has come to be known as project appraisal. Since massive investments have been made in the public sector a thorough knowledge of the concepts, techniques and methodology of project appraisal is indispensable for a financial administrator. Expenditure control: Finances of the modem governments are becoming quite inelastic. Almost every government is suffering from resource crunch. Further, the society cannot be taxed beyond a certain point without doing a great damage to the economy as a whole. Thus, there is an imperative need for careful utilization of resources. Executive control is a process aimed at achieving this ideal. Legislative control is aimed at the protection of the individual tax payers interest as well as public interest. There is also the need to ensure the accountability of the executive to the legislature.

Objectives of Financial Administration1) Management of finances of Public Household: Just as in an individual household, the public authorities are concerned with the satisfaction of human wants and their major problem is to ensure the best application of limited means to secure given ends. In this context, a financial manager focuses his/her attention on mobilization of resources and their rational deployment, in conformity with the rising expectations of the people.2) Implementation of projects and programmes: A welcome development in financial administration is related to ensuring optimal public investment decisions through project formulation, appraisal and implementation. The emphasis has shifted from expenditure control to the implementation of projects within the stipulated time schedule and expenditure ceiling.3) Provision for public goods and social services: Since the benefits from public goods and social goods are available to one and all notwithstanding one's contribution to public exchequer, no one will offer payments for the supply of such goods. Provision of public goods like public parks, social services like public health, sanitation cannot be left to the private sector which is motivated by profit rather than service to the people. Budgetary support for such services becomes a legitimate concern for fiscal policy makers.4) Growth, Employment and Price Stability: Modem governments are expected to focus attention on socially desired rate of economic growth, high employment and a reasonable degree of price level stability and a positive balance of payments position. Achievement of these objectives cannot come about automatically. There is need for policy initiatives on the part of public authorities.5) Capital Formation: Economic development of a nation, to a great extent, depends upon the capital formation through increased savings. No amount of State's coercive power can achieve this objective. Appropriate financial and fiscal measures such as discriminatory taxation and monetary policy instruments may be employed to accomplish this objective.6) Productive deployment of funds: A major problem of under-developed countries is the allocation of investible funds between competing projects and programmes. The entrepreneurs may prefer 'risk free' and 'quick yielding' investment rather than those which are essential in national interest. In order to ensure flow of investible funds into desirable channels, Planning Commission lays down guidelines regarding priorities for different types of investment for both public as well as private sector. The finance ministry takes up the task of ensuring adherence to national priorities both in the public sector and the private sector.

7) Facilitating smooth flow of parliamentary processes: The basic tenet of representative governments throughout the world is the supremacy of the representative institutions and their control over executive branch of the government. One of the most important dimensions of this is the control of legislature over use of public funds. Financial administration through its budgetary process and audit function enables and ensures the supremacy of the legislative body over the executive.

8) Achievement of equity and equality: Financial administration, through its fiscal policies, such -as progressive taxation; grants, subsidies etc. can help movement towards greater equality of wealth and opportunities.

Principle of Financial Administration The principle of stability and balance: It is a known fact that the financial administration is characterized by technical expertise and hence cannot be handled by unskilled and non-trained personnel. Therefore, this principle calls upon financial organisations to develop capacity to withstand losses of specific trained personnel without serious consequences to effectiveness, and efficiency. For this purpose, there is need for effective-manpower planning together with a good programme for human resource development. The principle' of simplicity and flexibility: In a democratic era electorate functions as the fountain of all authority. Therefore, it is very essential that the financial system and its procedures should be simplified in such a manner as to become intelligible to the layman. The principle of flexibility implies that the financial organisation should develop capacity to adjust itself. to fluctuations on work flows, human compositions and physical facilities. The principle of conduct, discipline and regularity: The principle of conduct implies that the officials of public financial organisations should act ethically and set high ethical standards and styles to the people. The principle of discipline implies that the objectives, rules and regulations, the policies, procedures and programmes must be honored by each participant of public financial organisation. The principle of regularity implies that no public organisation, including financial organisation, can afford to function at intervals. The principle of Public Trust and Accountability: Financial administration collects and disburses public funds as a public trust. But, it is quite vulnerable and can lead to misuse of these funds for personal interest. Financial administration has therefore to be held publicly answerable for proper use of funds at several levels such as political, legal, administrative, organizational, professional, moral and aspirational. Here accountability implies answerability for one's responsibility and for trust reposed in an official. The Principle of Correspondence: This principle implies that there should be a causal relationship between the objectives of financial administration and the functions, the human and material resources necessary to accomplish such objectives. In other words, the type of functions, the personnel required to handle them and the physical facilities necessary for the purpose should have a rational mutual interrelationship. The principle of primacy of public interest, public choice and public policy: Public interest can be interpreted in various ways such as the common good, the general welfare, and the overall quality of life of contemporary and subsequent generations, the collective realization of social values, rights and privileges. For, fiscal policy and administration, it is imperative to concentrate on those types of activities which make a definite and justifiable contribution to the accomplishment of public interest and public satisfaction as expressed in public policies. It is quite essential to realize that fiscal policy is expected to sub serve the broad aims as spelt out in public policies. One should be clear about the meaning of public choice. Some erroneously try to identify the public choice with the choice of the greatest number or the aggregation of individual and group interests. Public choice is a choice which encompasses common life and is shared by all.

Financial Administration in India

Regulation and control of fiscal deficit: Development efforts in India are characterized by an order of investment much higher than the available domestic resources. The gap should have been met from favorable balance of payments and external remittances. But Indian policy framers met this gap by creation of credit on excessive dosage of money supply. Deficit financing was used as an alternative to resource mobilization including taxation. The annual average rate of deficit financing began, to rise year after year. The government had to take a number of measures for overcoming this crisis. The main objective .was to control fiscal deficit and bring it down to 5 percent of G.D.P. Cutback on non-development expenditure: A substantial portion of Indian resources are frittered away in non-development expenditure which is an unproductive channel. There has been a tremendous increase in non-development expenditure. A significant amount of this expenditure is associated with extravagance, inefficiency and infructuous public policies and activities. Development of zero base perspective: Budgetary decisions in India have been characterized by incrementalist approach. Though no whole scale installation of zero base budgeting was attempted, expenditure policy that evolved during the last five years took into account the basic premises of this new budgetary concept. No area of government spending was sought to be exempted from scrutiny. Non-bureaucratic delivery of public goods and services: Following public choice theorists, the government is thinking in terms of providing public goods and services competitively to avoid the pitfalls of public monopoly. The government, for instance, is seriously thinking in terms of involving private sector in power generation and distribution, electronic media and telecommunications, roads etc. Towards deregulation and liberalization: Union Government m an effort to provide full freedom to market mechanism so as to maximize productive potential of enterprising business people is moving towards a free market economy. Industrial policy has been suitably amended to accommodate genuine requirements of private sector and foreign direct investment. Focus on decentralized responsibility for financing development plans: Union Government has had the responsibility for plan formulation as well as plan financing. The state governments could execute centrally sponsored schemes rather than the schemes supported by their budgetary provisions. This tendency on the part of the State led to a lack of concern for resource mobilization. This syndrome is evident from increasing emphasis of the state governments on populist measures. As a back-up to economic reforms the Union Government has veered round to the concept of "indicative planning". The Union Government is now promoting cooperative federalism and is therefore, seeking an active role for the state government in resource mobilization.

The Finance CommissionFinance Commission and Planning Commission are the two important bodies through which fiscal transfers between the centre and states are effected. The functions of the Finance Commission are to make recommendations to the President in respect of:1) the distribution of net proceeds of taxes to be shared between the Union and the States and the allocation of shares of such proceeds among the States2) the principles which should govern the payment of the Union grants-in-aid of the revenue of the States3) Any other matter concerning financial relations between the Union and the States.

The Finance Commission is a quasi-judicial body and it acts independent of the centre and the states. The specific terms of reference of each Finance Commission are drafted by the Ministry of Finance at the Centre. The state governments are not consulted in the matter.

According to the Constitution, the Finance Commission should consist of a Chairman and four other members. According