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Concept of Tax and Classification of Taxes

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.


Classification of Taxes 


Taxes are classified in different ways. One way of classifying is single and multiple tax system. The single tax system comprises tax on only one source of income. 

In 18th.century, the physiocrats advocated tax only on the agricultural income. Similarly, the Mercantilists, in 19th.century, advocated tax only on the business income. But modern governments have a multiple tax. Since there are many potential areas of taxation, need to minimize the possible ill-effects of individual tax, need to attain multiple objectives and to generate substantial amount of revenue, the multiple tax system is common in practice.

Another way of classification is on the basis of the rates or progression. A tax is regressive when the burden of tax lies relatively more on low income people than the high income people, even though the amount of tax is the same. A tax is proportional when the tax liability increases in the same proportion to the increase in the tax base. 

Tax is progressive when the tax liability increases in both the absolute amount and relative terms (i.e. rates) with the increase in the tax-base. A tax is digressive when the rate is decreasing with the increase in tax-base after certain maximum limit. 

Another way of classification is direct and indirect taxes. The accepted way is on the basis of the determination of tax-liability. Accordingly, in case of direct tax, the liability is determined with direct reference to the tax-paying ability of the taxpayer. Whereas, in case of indirect tax, the liability is determined indirectly. And also, taxes on income and property are accepted as direct, and that on production and consumption as indirect. In case of direct tax the impact and incidence of tax lies on the same person, and in case of indirect tax the impact lies on the person who pays at first, but the incidence is shifted to others (fully or partially).

Objectives of Taxation


The basic objective of taxation is to raise government revenue. Besides, taxes are levied for other economic objectives like:
  1. Protection of local industries against foreign competition
  2. Restriction of general consumption level as well as harmful products
  3. Make contribution to government revenue even by the common people
  4. Promotion of capital formation and economic growth
  5. Maintain economic stability and optimum level of employment
  6. Reduction of inequalities national income and wealth among the people and
  7. Help in environmental protection.
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Government Revenue and Categories of Government Revenues

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:

(i) Revenue based on compulsion 
  • Taxes
  • Fines for offences committed;
  • Compulsory loans, generally raised during war and
  • Tributes and indemnities arising out of war (or for other reasons) from defeated nations (as imposed on Germany after First World War)

(ii) Revenue on voluntary payment
  • Income from public property as royalty
  • Receipts from public enterprises
  • Fees for administrative services and 
  • Voluntary public loans.

(iii) Revenue based on partly compulsion and partly voluntary
  • Income from public enterprises using monopoly power
  • Betterment levy
  • Income from issue of fresh currency and
  • Voluntary gifts.
However, government revenue generally includes Tax revenue and Non-tax revenue.

Tax-revenue
  • Customs duty
  • Taxes on production and consumption of goods and services (excise and VAT)
  • Taxes on income, profit and property and 
  • Taxes on property transfer registration

Non-tax Revenue
  • Fees, fines, forfeiture and escheat
  • Income from sale of government services
  • Royalty & sale of public assets/property
  • Dividend
  • Principal and interest receipt
  • Money creation
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Concept of Public Finance with Its Nature, Scope, Functions and Subject Matter

Concept 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).


DEFINITIONS OF PUBLIC FINANCE


“The term public finance has come by accepted usages, to be confined to a study of funds raised by governments to meet the costs of government.” - Carl C. Plehm

“Public finance deals with the income and expenditure of public authorities, and the manner in which one is adjusted to another.” - Dalton

“Public finance is the study of the principles underlying the spending and raising fund by government”. - Findlay Shirras

“Public finance deals with the finance of the public as an organized group under the institution of government. It thus deals only with the finance of government. The finances of the government including the raising and disbursement of government funds.” - Bastable

“The complex of problem that center around the revenue - expenditure process of government is referred to traditionally as public finance. While operations of public household involve money flows of receipt and expenditure, the basic problems are not the issues of finance. We must think of our task as an investigation into those aspects of economic policy that arise in the operation of the public budget.” - Musgrave

“Public finance is a field of inquiry that treats the income and outgo of governments. In modern times, this includes four major divisions: public revenue, public expenditure, public debt and certain problems of the fiscal system as a whole such as fiscal administration and fiscal policy.” - Harold Grooves

NATURE AND SCOPE OF PUBLIC FINANCE


The nature and scope of public finance has been changing with the changes in the nature and scope of governmental activities as per the need of the economy (society). The scope of governmental activities is to a great extent by the political ideology of the state/government.

In broad sense, the nature of public finance may be categorized as the neutral or non-regulatory and regulatory, mainly on the basis of interfering and influencing the economy. The nature and scope in different periods is determined being guided by different theories.
  1. Pure theory of Public Finance (1776-1880’s): Early classical economists like Seligman, Say, Ricardo advocated the scope of public finance limited to the study and analysis of only the operation of the treasury just for performing the minimum necessary activities by government without any considerations of welfare concept.
  2. Socio-political Theory (1880’s-1930): The neo-classical writers like Wagner, Marshall, Pigou, Edgeworth advocated the social welfare considerations to included in the scope of public finance.
  3. Functional finance Theory: Since 1930’s depression, Keynes, Dalton, Lerner, Hansen like economists advocated government involvement and interference in the economy as per the necessity for maintenance of economic stability, and thus, the nature of public finance being a regulatory one.
  4. Activating finance theory: After the Second World War {mainly since 1d950’s), with the concern about economic development of the developing countries, public finance is to activate the economy with the government involvement as an investor, facilitator and regulator.


FUNCTIONS OF PUBLIC FINANCE

  1. Allocation function: It is concerned with the use of economic resources on what type of goods and services’ production with the objective of growth promotion as well as whether to produce in the public sector or private sector.
  2. Distribution function: It is concerned with the distribution of national income in n equitable way as accepted by the society, mainly to promote the distributive justice.
  3. Stabilizing function: It is concerned with the maintenance of economic stability with the control of economic fluctuations, inflation and correction of adverse balance of payments (BOP).


SUBJECT MATTER OF PUBLIC FINANCE

The subject matter of public finance is the areas of study in relation to the operation of the treasury and the repercussion of different policies operated by the treasury. The subject matter includes:
  1. Public Revenue:- Includes the concept of government revenue and tax, principles of taxation and its effects and role in the economy.
  2. Public Expenditure:- Includes the study of the concept, principles underlying the allocation of public expenditure, and its effects in the economy.
  3. Public Debt:- Includes the study of the concept, sources, need, burden and principles of public debt management.
  4. Financial Administration:- Includes the study of the concept, theories and process of government budgeting.
  5. Fiscal Policy:- Includes the study of mainly the concept and the use and adjustments of the public financial instruments to achieve the desired economic objectives like economic stability, growth and distributive justice.
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Consumer’s Surplus: Concept, Importance and Criticisms

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.

Criticisms of Consumer’s Surplus


The concept of consumer’s surplus has been criticized by many economists like Ulisse Gobbi, Bevenport, Cannan, Nicholson and J. K. Hicks. The criticisms made by them are as follows:
  1. Imaginary concept: The concept of consumer’s surplus has been criticized as an imaginary concept. Because, we have to imagine how much a person is prepared to pay and we will have to deduct the amount he actually pays to get consumer’s surplus. Beside, a man may be prepared to pay different amounts. So, it is an imaginary concept.
  2. Utility is immeasurable quantitatively: We should measure utility obtained by a consumer quantitatively to ascertain that the consumer is willing to pay given sum of money. Utility is a psychological phenomenon. It depends on a person’s mental situation. We cannot there, ascertain the quantity of utility. Some commodity may yield different utility to different persons. So, utility cannot be measured quantitatively.
  3. Bare necessaries: Utility is immeasurable in case of bare necessaries. A man dying of hunger may be prepared to pay any sum of money for a commodity. In such a case, the consumer’s surplus is very high.
  4. Constant marginal utility of money: This concept is based on the assumption that marginal utility of money remains constant. But unlike this assumption, the amount of money declines after expenditure. As a result of this, marginal utility of money to a consumer increases.
  5. Potential price less than actual price: There is a possibility that potential price may be less than the actual price of the commodity. In such a case, there is no consumer’s surplus but loss.

Importance of Consumer’s Surplus


The concept of consumer’s surplus is not imaginary. We feel the operation of this concept in our daily life. It has an important place in economic theory. The importance of this concept can be explained as follows:
  1. Public Finance: This concept is useful in imposing taxes and fixing tax rates. The government should impose taxes on those commodities in which people are prepared to pay more than they actually pay or where consumer’s surplus is large. Such taxes bring more revenue to the government. Because, people do not stop buying commodities because of taxes. Likewise, the imposition of new taxes will not cause any suffering to the people.
  2. Price determination: This concept is useful in price determination of goods and services. It is, therefore, useful to the monopolist and businessmen. The people are prepared to pay more for a commodity having large consumer’s surplus. The sellers, particularly a monopolist can raise price without any fall in sales.
  3. Measurement of the benefit from international trade: This concept also measures the benefit from international trade. We import the commodities for which are paying more in our country. We import the goods since they are cheapest and enjoy consumer’s surplus. Larger the surplus, larger the benefit we get from international trade.
  4. Compare economic condition of people: The concept of consumer’s surplus makes it easier to compare the economic condition of the people of two different countries. The availability of more goods at cheaper rate means that people are enjoying more consumer’s surplus. Hence the people of that country are better off. Likewise, the concept help to compare the advantage of living in two different places. A place with availability of greater amenities at cheaper rates will be better to live in. The consumers there may enjoy larger surplus satisfaction.
  5. Implement law of maximum satisfaction: This concept also helps to implement the law of maximum satisfaction. It guides people to spend the limited money to those goods, which give more consumer’s surplus. This maximizes satisfaction, which is the main aim of the consumer.
  6. Distinction between value-in-use and value-in exchange: This concept tells clearly the distinction between value in use and value in exchange. The commodities like salt, matchbox have great value in use (utility) but have small value in exchange (price). Being necessary and cheaper things, they give large consumer’s surplus.
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Law of Substitution, Equi-marginal Principle

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.

Equi-marginal 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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