Concept of Tax

Concept of Tax

A tax is a compulsory levy and liability imposed upon the tax assesses, who may be an individual, group of individual or other legal entities, It is a liability to pay on account of the fact that the tax assesses have income of the specified amount from specified source, or own specified tangible or intangible property, or carry-on certain economic activities which have been legally accepted as criterion for taxation. The taxpayers are to pay taxes irrespective to any direct return or benefit of goods and services from the government. In other words, there is no quid pro quo in taxation.

Features of Tax

  1. Taxes are the main source of government revenue.
  2. Tax is the compulsory contribution.
  3. Tax is imposed only by the government.
  4. Tax is a legal receipt.
  5. There is no quid pro quo in taxation.
  6. Tax payment involves sacrifice by the taxpayers.
  7. Tax is paid out of taxpayers’ income.
  8. Receipt from tax is spent for social welfare.
  9. Tax is one of the fiscal instruments.

Government Revenue

Concept of Government Revenue

The income of government from all sources is generally called government revenue or receipt. But Dalton has defined public income in a broad and narrow sense as public receipt and public revenue. Accordingly, public receipt includes all incomes of the government. Whereas, public revenue includes income from taxes, prices of goods and services supplied by enterprises, revenue from administrative services and gifts and grants.

According to Sundharam & Andley, public revenue may be categorized as:

Study of Public Finance

Significance and scope of government involvement in economic decisions depends upon the political ideology of government structure and roles to a great extent. History has revealed that there have been three types of economic systems.

In a capitalistic economy economic decisions (and thereby the economic activities) are done by the private sector. Each economic unit operates in accordance with the economic rationality being guided by the market mechanism with an objective of income maximizing criteria. In such system government has only limited role, mainly as the facilitator and regulator.

A communist (controlled) economy is dominated by the state where economic decisions and activities would not be guided only by the economic maximizing criteria. Market mechanism is assigned a marginal role. 

In a mixed economy there is the co-existence of both the private and public sectors in economic activities. Government is to perform the role of an investor, facilitator and regulator. However, in modern times, almost all countries have mixed economy where the scope and involvement of public and private sector may vary. It is fairly common to justify the need for and presence of government involvement and intervention in economic activities besides the fundamental (basic) functions.

Public sector economics or Public finance deals with the questions of collective wants (i.e. the wants of the community as a whole) and their satisfaction. Public finance aims at maximizing social welfare or social benefits by efficient use of social goods. Collective wants are those which are demanded by all members of the community in equal or, more or less equal measure. Defense, education, public health, infrastructural facilities like power, transportation and communications, etc. are examples of the collective wants. Goods and services produced to satisfy collective wants are known as social goods. The features of social goods are: 
  • Social goods are not divisible;
  • There is some compulsion in providing social goods; and
  • There is no exclusion in social goods.
The grounds for state involvement and interference in economy are: 
  1. Distortions in production structure and failure to create reasonable employment by market mechanism;
  2. Need for the maintenance of economic stability with control of trade cycles (mainly in the developed countries); and
  3. To promote the rate of economic growth and distributive justice {mainly in the developing countries).

CONCEPT OF PUBLIC FINANCE

Consumer’s Surplus

Consumer’s surplus, the concept was introduced by A. J. Dupit, a French engineer in 1844. But he could not have developed it. The credit goes to Alfred Marshall for developing this concept. Marshall first named this concept as ‘consumer’s rent’ in his book ‘Pure Theory of Domestic Value’ and later renamed consumer’s surplus in the book ‘Principles of Economics’. Prof. K. E. Boulding has named it ‘Buyer’s Surplus’.

In our daily expenditure, we find generally that the satisfaction derived from a commodity is higher than the price we pay for the commodity. So, we are prepared to pay more than we actually have to pay. In other words, consumer’s surplus is the difference between what we are prepared to pay and what we actually pay. As for example, we are prepared to pay $12 per kilo for apple, but the actual price in the market is $10 per kilo. Hence, consumer’s surplus is 12 – 10 = $2. Another way to explain the concept is that consumer’s surplus is the total utility minus total amount spent.

According to Marshall – “The excess of the price which the consumer would be willing to pay rather than go without the thing over that which he actually does pay is the economic measure of his surplus satisfaction. It may be called consumer’s surplus.”

In the words of Watson and Getz – “The difference between the amount a consumer would pay for the quantity of a commodity bought and the amount the consumer does pay is called consumer’s surplus.”

Consumer’s Surplus

Units of orange
P ($)
MU
CS
1
2
3
4
5
6
5
5
5
5
5
5
10
9
8
7
6
5
5
4
3
2
1
0
PU = 6
TE = 30
TU = 45
15

Suppose that the price per unit of orange is $5. The consumer purchases six units of orange. He purchases up to the point where marginal utility is just equal to price. Now comparing total utility with the total cost (expenditure) we can get consumer’s surplus as:

Total utility = sum of marginal utilities
= $10 + 9 + 8 + 7 + 6 + 5 = $45

Total cost = sum of cost of each unit
= $5 x 6 = $30

Consumer’s surplus = Total utility – total cost
= $45 - $30 = $15

The total utility derived by the consumer from 6 units of orange is $45, but the consumer has paid only $30. So, he gets the consumer’s surplus of $15. Hence, the consumer’s surplus is the difference between what the consumer would be willing to pay ($45) and what he actually has to pay ($30). The concept of consumer’s surplus can be illustrated by the help of a figure below.
Consumer's Surplus
In the figure, the addition of the six rectangles reflecting the marginal utilities gives total utility. The area of the large rectangle OPE 6 (p x q) represent the total cost. The striped area (between price line and demand schedule) that remains after subtracting total cost from total utility is the consumer’s surplus.

The first unit costs $5 but MU or the price willing to pay is worth $10. So, CS = $5. The second unit also costs $5, but MU is worth $9. So, CS = $4 and so on. Adding excess of utility over cost on each unit purchased, we get $15. The area between price line and demand schedule shows this. There is no surplus on the last unit purchased. Because, the consumer purchases up to the point where marginal utility of the last unit is equal to price.

This concept can be presented in simple way by the help of a smooth demand curve as shown in the figure below. Here we assume that the commodity is divisible into small units so that smooth demand curve can be drawn.
Consumer's Surplus
The consumer purchases 6 units at a price of $5 per unit. Consumer’s surplus is the triangular area PTE between the demand curve and the price line. It is equal to the areas of rectangle above the price line in figure. But due to the use of smaller and smaller units, we get smooth line rather than discrete steps. In figure, the total utility from OQ units is OTEQ and the total cost is OPEQ. The difference PTE is consumer’s surplus.

Law of Substitution

The law of substitution was at first pointed bout by H. H. Gossen. Hence, this law is called Gossen’s Second Law. This law is also known as law of equi-marginal utility and law of maximum satisfaction. 

We know that human wants are unlimited whereas the means to satisfy those wants are limited. So a consumer tries to get maximum satisfaction out if his expenditure. For this he allocates his expenditure among several uses in such a way so as to maximize satisfaction. According to Watson and Getz –“The best, or optimum allocation is one that causes the marginal utilities in each use to be equal”. He will get maximum satisfaction only when he obtains equal marginal utilities from the consumption of different commodities. If this does not happen, the consumer can improve his satisfaction by reducing expenditure in one use and expanding in another words, he substitutes one commodity for another until the marginal utilities from all commodities are equal. This law can be illustrated by the help of a table below.

Law of Substitution
Units
MU of Orange
MU of Apple
1
2
3
4
5
6
10
8
6
4
2
0
8
6
4
2
0
-2

Suppose that the consumer has $7 to spend on orange and apple. The price of orange is $1 per unit. The utility obtained from different units of orange and apple is presented in table. According to the law, the consumer will purchase that unit of orange and apple, which gives him maximum satisfaction. He will therefore, purchase 4 units of orange and 3 units of apple. The marginal utilities of both orange and apple are same, i.e. 4. He derives total utility = 10 + 8 + 6 + 4 = 28, 8 + 6 + 4 = 18 = 46. So, the total utility is equal to 46.

Any other combination or arrangement will not give him so much satisfaction or utility. As for example, if he purchases 3 units of orange and 4 units of apple, total utility will be equal to only 44 which is less than 46. In brief, the consumer obtains maximum satisfaction when marginal utilities from all goods purchased are equal.

The law of equi-marginal utility can be illustrated by the help of figure below. In the figures below, OX axis represents units of money and OY axis represents marginal utility. Suppose that money can be spent on commodities apple and orange. MUA and MUO curves relate to commodity apple and orange respectively. The shapes of curve MUA indicates that the desire for commodity apple is stronger. This means that the marginal utility of any quantity of money in commodity orange is greater than that of the same quantity in commodity apple. Because MUO curve is farther from the vertical axis than MUO curve. Likewise MUO curve begins from the vertical axis at a higher point than does curve MUA.
Equimarginal Principle
Now suppose that the consumer has $7 to spend on apple and oranges. In the figure, the best allocation is $3 in commodity apple and $4 in commodity orange. Because, with these quantities, the marginal utilities are equal in both commodities, i.e. PM = P’M’. Hence, this is the best allocation of money. Any other combination will give less total satisfaction.

If $4 is devoted to commodity apple and $3 to commodity orange, the gain would be the area between 3 and 4 under MU curve in commodity apple. But there would be loss of area between 3 and 4 under MU curve in commodity orange. It is clear that the loss of utility from reduced consumption of orange is greater than the gain of utility from increased consumption of apple. Hence the total utility of new combination is less. Any other allocation will make a loss in utility greater than gain in utility.

The total utility of any quantity is always the area under the marginal utility curve. When marginal utilities in two commodities are equal, total utility or the entire shaded area in the figure is at a maximum. Any change in allocation of $7 can only reduce total utility.

The equi-marginal principle can be generalized. Any decision maker can obtain maximum return from a given quantity of a resource that has two or more uses of the allocated units of resources in such a way that the marginal returns in each use are equal.

Limitations of the Law of Substitution

There are several limitations of this law, which can be explained as follows:
  1. Increase of marginal returns: For this law to hold, marginal returns must diminish as more and more units of a resource are applied to any one of its uses. Hence, this law may not apply if the marginal utility increases instead of diminishing.
  2. Custom and fashion: When people are influenced by traditions, custom and fashion, they may not behave rationally. They do not try to spend so as to maximize satisfaction. This implies that they spend more where marginal utility is less.
  3. Ignorance: The ignorance of people prevents them from making good uses of money. They cannot judge where utility is higher or where utility is lower. They cannot maximize satisfaction by equalizing marginal utilities in all uses.
  4. Unlimited resources: This law has no use in case of goods available in unlimited quantity. As for example, the free gift of nature like sunshine, air is found in abundance. People need not make rational use of them.
  5. Indivisibility: Some durable consumer goods like motorcar, TV, refrigerator, smartphone is indivisible. For this law to hold goods should be divisible and substitutable. Hence, this law cannot be applied effectively in case of the indivisible goods.
  6. Instability in prices: The consumer may be able to adjust expenditure so as to maximize satisfaction in case of the frequent changes in prices. Because, utility is always weighted in terms of prices of goods.

Importance of the law of substitution

The resources are always limited with the people. So, they should make the best use of available resources. Due to this, the law of substitution has great practical importance. The importance of this law can be explained as follows:
  • Consumption: This law is of special significance to the consumers. The consumers have limited money income. But their wants are unlimited. Hence, they should make the best use of money so as to maximize satisfaction. They should substitute the goods with low utility by goods with high utility.
  • Production: This law holds goods even in production. The aim of a firm or producer is to maximize profit. For this he should select the best combinations of factors of production. He should spend more on the factors, which yield highest returns. He should substitute one factor for another till the marginal productivity of all the factors is equal.
  • Exchange: This law has significance even in exchange. The exchange, in reality, is the substitution of one commodity for other. People get money by selling vegetable. They buy clothes with that money. So, clothes has greater marginal utility to them than vegetable. They have in fact, substituted clothes for vegetable.
  • Distribution: One of the important theories of distribution is that factors of production should be rewarded on the basis of their marginal productivity. A firm uses each factor to the point where the marginal productivity of a factor is equal to the marginal product of other factors. This implies the substitution of one factor for other.
  • Public Finance: This law is relevant even in the field of public finance. The public expenditure is made to as to maximize social welfare. Hence, the government diverts resources from less productive to the more productive sectors. The government imposes more taxes to the rich than to the poor, so that the burden of taxation is equal. Likewise, the government spends more on welfare of the poor than the rich so that benefit of expenditure is equal.

In this way, the law of substitution has wide application in all branches of economic theory. Besides, it has also practical significance. The men follow this law either consciously or unconsciously. As opined by Chapman- “We are not compelled to distribute all income according to the law of satisfaction as a stone thrown into the air is compelled to fall back to earth. But as a matter of fact, we do it in a certain rough fashion because we are reasonable.”

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