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Government Budgeting and Theories of Budgeting

Government Budgeting


Concept and History of Budgeting


Governments undertake different social, economic and political activities and policy measures, which involve finance. The mechanism to manage financial resources for this can be termed as budgeting. Government budget is the nerve center of the public economy. The word budget has been derived from the French word ‘bougette' which literally means a leather bag containing financial proposals of the government.

Some Definitions:


According to Bastable, “The term budget has come to mean the financial arrangements for a given period with the usual implication that they have been submitted to the legislature for approval.”

According to Due and Friedlander, “ A budget may be defined as a financial plan that serves as the basis for expenditure decision making and subsequent control of expenditure. Budget usually contains financial data for the previous year, revised estimated figures for the current year and recommended figures for the coming year, for both the expenditures and revenues.”

According to Philip Taylor, "The budget is the master financial plan of a government. It brings together the anticipated revenues and proposed expenditures for the budget period, and from these estimates the activities to be undertaken and the means of financing can be inferred."

According to World Bank, "The annual budget is usually the legal authority for public spending. It is usually one year slice of a medium term expenditure plan."

Features of a Budget

  1. It is a financial plan or programme guided by the socio-economic policy of the government for coming year;
  2. It is a plan of action with the approval from the legislature;
  3. It is an annual plan being guided by and intended to achieve the socio-economic objectives of the medium plan;
  4. The budgetary process involves formulation, approval, execution, and monitoring & evaluation; and 
  5. It should be comprehensive, and include all estimated revenues and expenditures.

Objectives of Budget

Different writer have pointed out the objectives of budget in different ways. 

According to Musgrave - 
  1. Adjustment of resource allocation for economic growth;
  2. Adjustment of distribution of national income and wealth; and
  3. Maintenance of economic stability.

According to Prem Chand - 
  1. Integration of expenditure decisions with the specified policy objectives and resource at present and future;
  2. Integrate the major budgetary decision with national economic situation;
  3. Make certainty in efficient and effective implementation of governmental programmes; and 
  4. Help in legislative control on different phases of budgetary process.

According to Richard Goode -
  1. Prepares policy formulation structure in the selection of competing objectives;
  2. Means of policy implementation;
  3. Means of legal control of abuse of authority and use of fund extravagantly; and
  4.  Document of public information on governmental activities in past, present and future.

History of Budgeting


History of evolution of budgeting dates back to the promulgation of the Magna Carta by King John in 1215 AD in England. This limited the discriminatory authority of the king over public property. In 1689 AD the Bill of Rights authorized the need for parliamentary approval on raising tax, debt and donations by the government. It was only in 1733 AD the first budget was presented in the parliament in England. The budget practice was introduced in different countries at different times. In Nepal, the first national budget was made public in 1952 AD (2008 BS) after the overthrowing of the Rana regime.

Theories of Budgeting


1. The Classical Approach (Balanced Budget)


The Classical economists favored balanced budget annually. Among the Classical writers there were two opinions regarding the interpretation of the balanced budget. One view relates the balanced budget with the total expenditures and total revenues, and there should be no government borrowings at all. The second view held that the balanced budget relates only with the current or regular expenditures of the government, and they must be covered up only by the current revenues. But the capital expenditures like on the self-liquidating projects, and the emergency expenditures may be financed through borrowings.

The Classical approach of balanced budget was based on the assumption that full employment is the normal condition in the economy. They were of the view that a deficit budget is to be financed only by borrowings. Government borrowings in a situation of full employment withdraw resources from more productive and efficient uses in the private sector to most likely unproductive use in the public sector. The Classical writers were against the expansion of governmental activities, They were of the view that a deficit budget leads to devaluation of the currency. So they always emphasized on the small size of the government and a balanced budget.

The Classical view did not recognize the prevention of unemployment and control of economic fluctuations through the use of budgetary actions. But the Keynesian view held that full employment is not a normal condition, and there remains some frictional or under employment in the economy. So, to ensure higher level of employment and control the economic fluctuations, a flexible budgetary policy is needed.

2. The Modern Approach (Managed Budget)


It has been accepted now that the annual balanced budget as favored by the Classical writers, is irrelevant in a situation of unemployment and other economic instabilities as well as in context of the developing countries. Economists like Keynes, Hansen, Lerner, Dalton and Beveridge argued that the budgetary policy should aim at attaining the optimum level of employment of resources and steady growth of the economy. For this, they advocate a managed approach in budgeting as per the need of the economy.

The Modern approach of budgetary theory developed with the contemporary interest in the problems of economic cycles. The modern approach held that government should not be worried to balance the budget annually. It may be balanced over the entire period of the business cycle. Thus during the period of depression or recession a deficit budget is desirable. Taxes should be decreased and expenditure be increased with mainly by borrowings to stimulate the economy by increasing effective demand. While in the situation of prosperity and boom, a moderate surplus budget is desirable. In such situation, taxes should be increased and expenditure be decreased as far as possible, and the debts are to be repaid with the surplus budget.

So far as the budgeting in the developing countries is concerned, the modern approach relates it with the development objectives. Budget in the developing countries is preferred to be deficit to a considerable extent so as to promote financial resource mobilization and increase investments on greater and productive utilization of the productive resources.

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Debt Management: Concept and Principle of Debt Management

Debt Management: Concept


Debt management is concerned with the determination of the structural characteristics of public debt. They are the size, types, proportions, terms, maturities, ownership patterns of public debt and the methods of its redemption. Debt management should help to achieve the economic objectives and should not have adverse effects on the economy.

Debt management even being a part of fiscal policy, should be well coordinated with the monetary policy as it has direct effects on the monetary system

Principles of Debt Management

Debt management should be guided by the following principles:
  1. The interest cost of debt-servicing should be minimized as far as possible;
  2. The need of the investors of different nature should be satisfied;
  3. The objectives of economic stability and growth should be achieved; and
  4. There should be minimization of the need to enter the market in a situation of inconveniency.

Debt Redemption Methods


Debt redemption refers to be getting rid-off the liability to repay the debt. There are different methods used in practice for this. The liability to repay the debt may be postponed or ended with the actual repayments.

1. Repudiation- It is the total refusal to repay the debt and was practiced after the great political revolutions immediately after the American Independence in 18th century and Bolsovik Revolution of 1917 in the USSR.

2. Postponement of the liability- The liability to pay the debt may be postponed without changing the size of the debt. The methods are:
  • Refunding- In this method government repays the debt to the existing holders by raising the debt from new security holders. Government will have the liability to pay the debt to the new security holders instead of the earlier holders.
  • Conversion- At the time of maturity, when the market rate of interest is lower than the existing rate of interest on the securities, the old loans are converted into the new loans, if the security holders agree.

3. Actual Payment- For actual payment of public debt following methods are in practice:
  • Sinking fund- It is a fund where certain amount of revenue is deposited each year for the repayment of the outstanding debt. The balance in the fund can be invested, and the interest or other income from them is also accumulated in the fund until the debt is matured.
  • Buying up loans- In a situation when government can generate budgetary surplus, mostly in a situation of prosperity, the surplus is used to clear the debt off gradually. It used to be practiced in case of the Console.
  • Capital Levy- This method uses heavy taxes on property and income above certain value as the speculators and other business groups enjoy a huge profit mainly after the war.
  • Serial Bond Redemption- This is the most common method of debt redemption. Government issues the securities maturing at different periods. The maturing securities are determined in a serial order by lottery or fixing certain maturity dates. The maturing securities are repaid with making budgetary provisions every year. 

Redemption of External Debt

The external debt is to be repaid with the increase in foreign exchange reserves. It is possible with increasing the export earnings and/or reducing import payments. So, external loans should be used on productive investments which increase the production of export goods and services and/or import substitution goods and services that increase the foreign exchange reserves. However, some of the foreign loans are converted into grants as debt relief programs for the least developed countries facing financial problems.

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Burden of Public Debt, Sacrifice Imposed on the Taxpayers

The burden of public debt refers to the sacrifice imposed on the taxpayers with the increase in taxation to serve the debt, and the adverse effects on the economy as a whole (like reduction in capacity to consume, reduction in production of high quality goods and services by private sector, increase in price level, increase in inequality of income, inter-generation transfer of burden, outflow of national assets in case of foreign debt, etc.)

The burden is interpreted as financial or direct and real or indirect. Increase in tax level transfers some income of people to government, and the loss in income of people is the financial or direct burden. The other adverse effects on the economy, as mentioned above, are the real or indirect burden.

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However the burden of public debt is determined by the facts as whether it is productive or unproductive / dead-weight debt, whether is internal or external, and the economic situation. Public debt for unproductive purposes is definitely a burden. But that for productive purposes may not be a burden if it is utilized in an effective way. Even the debt for productive purposes will have a burden in the form of increase in price level at least the gestation period. It is said that the internal debt will have no net financial burden to the economy as there will be just transfer on income within the economy. But, the external debt will be a burden as the debt repayment transfers national income to foreign creditors. The debt will not be a burden in a situation of recession or depression and even in an inflationary situation (if it is raised out of the income that is most likely to be used in more consumption). And also, in case of developing countries, the debt used for development purposes will not be a burden; rather it helps in mobilizing financial resources to exploit the un-utilized natural and human resources.

Burden of public debt is also interpreted with its effect as increasing inequality in income. This is why, mostly the holders of government securities are the middle and upper income class in the society and revenue for debt servicing is contributed by all groups in the developed countries and relatively more by the low income groups in the underdeveloped countries. 

The burden is also in the form of inflation. Borrowing from most of the sources, other than the individuals and private organizations, leads to increase in money supply and monetary income of people causing increase in demand. Along with this the government also increases demand. The combined effect will increase the total demand in the economy. But to improve the supply situation it takes certain time. So at least until the gestation period there will be inflation in the economy. 

There are controversial opinions regarding whether it will be a burden to the present generation or the future. On view argues that since the present generation will be deprived of the availability of goods and services as resources will be diverted towards government expenses, the present generation will bear the real burden. Whereas the future generation will bear the financial burden with increase in taxes for debt servicing.

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Sources of Public Debt: Internal and External Sources

Governments may raise public debt from both the internal and external sources. The effects of public debt are determined also by the sources and its size. The sources of public debt are as follows.

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A. Internal Sources

  1. Individuals and Private Organizations - Individuals and private organizations provide loans to government with the purchase of securities like bonds and treasury bills. They provide loans reducing consumption, diverting savings accounts and corporate securities, and out of the funds that would remain idle. This source of debt normally does not exert inflationary pressure, except that from the idle funds, as there will be just a transfer of purchasing power from public to the government and no more money supply.
  2. Financial Institutions – Financial institutions, other than the commercial banks, like Provident Fund, Insurance Companies, Finance and Investment Companies, Co-operatives, Mutual Funds, etc. are the important source of public debt. These institutions normally provide loans to government to reduce their cash-holdings to earn some interests, for the safety of funds and to maintain liquidity. Normally, these institutions prefer to invest on government securities in a situation when there is no sufficient for loan advancements on other activities. Borrowing from this source is likely to inflationary as the funds would not have been spent if it was not loaned to government.
  3. Commercial Banks – Commercial banks provide loans to government out of the excess cash reserves and by credit creation. Like other financial institutions, the commercial banks also provide loans to government in a situation when there is no sufficient demand for bank credit. Borrowing from commercial banks increases money supply in the economy, and is likely to exert inflationary pressure in the economy. 
  4. Central Bank – The Central bank is the lender of the last resort to the government. The central bank, as being the monetary authority of the government, is responsible to manage the public debt on behalf of the government out of its reserve funds and by credit creation against the government securities. bullions and foreign exchange reserves. Borrowing from the central bank has double-fold possibility of credit creation leading to excess money supply in the economy leading to inflation.

External Sources 

Normally, public debt from external sources is raised to finance the development projects and to manage the problem of deficit in the Balance of Payments. Whatever be the sources, borrowing from external sources is likely to exert more inflationary pressure, at least until the gestation period of the projects financed from these sources. The external sources are: 
  1. Foreign Nationals and Private Organizations – Government may borrow from this source by issuing its securities in the international financial market.
  2. Donor Governments – Normally the developed countries’ governments provide loans to the developing countries for development projects in the form of foreign aids.
  3. International Financial Institutions - The international financial institutions like World Bank, IMF, UNCDF, IFC, and ADB, etc. provide loans to governments to finance development projects and to manage the BOP problems.
  4. Funds of Some Countries and Business/Economic Forums – Governments may borrow from the funds created by some countries and business or economic forums like Saudi, Kuwaiti, and OPEC funds.
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Public Debt: Concept and Need for Public Debt

Public Debt: Concept

The practice of raising public debt by the state to finance government expenditure started only since 19th. Century. But the royalties used to borrow on their personal goodwill even since ancient times. These days government borrowing has been almost a normal method of financing government expenditure.

J.L.Hansen, “Public debt is the debt owned by a government to people and institutions within its own borders and/or to foreign creditors.”
Philip E. Taylor, "Government debt arises out of borrowing by the treasury from banks, business organizations and individuals. The debt is in the form of promises by the treasury to pay back the holders of these promises a principal sum and interest on the principal."

Public debt is raised internally by floating the securities like bonds and treasury bills, and overdrafts from the central bank. Externally, it is raised from foreign individuals and organizations, donor governments and international financial institutions. Normally, government borrowing is voluntary in nature, but sometimes it may be coercive or with some influence.

Generally, the classical economists were against public debt. They strongly believed on the laissez-faire policy, and so favored minimum size of the government as far as possible to them. Government borrowings is mostly unproductive, inflationary and burdensome. However, they approved debt financing in the productive projects called as the self-liquidating projects. According to Musgrave, "The self-liquidating projects may be defined as investment on public enterprises that provide a fee or sales income sufficient to serve the debt incurred in their financing. It can be defined in a broader way as expenditure on projects that increase future income and the tax-base. Such projects permit serving of the debt incurred in their financing without requiring an increase in the future level of tax-rates.”

The Keynesian view after the 1930’s Great Depression advocated the need for the use of public financial operations as fiscal policy for maintaining economic stability. To them borrowing may not necessarily be unproductive, inflationary and burdensome always. It is accepted as the best option in a period of depression, and to some extent even to control inflation. According to Lerner, government should borrow only when it wants to make people hold more bonds in place of money. The desirability or otherwise of public borrowing should be judged in terms of its effects on aggregate demand and the economic situation.

The modern view is concerned about its importance in raising and mobilization of financial resources, its management, and relationship with the monetary policy. It has been accepted that debt financing beyond the limit is certain to invite severe economic problems.

Need for Public Debt

Borrowing by the state has been a normal method to finance public expenditure in both the developed and developing countries. In different situations or for different purposes public debt is raised.
  1. To manage current budget deficit: Governments do not have large accumulated reserves or cash balances to meet any current budget deficits. Normally, it is said that the regular expenditure should be financed from revenue sources. But due to many reasons sometimes income from revenue sources may not be sufficient to meet even the regular expenditure as required. Besides, the unexpected emergencies like fire, floods, famines earthquakes and other natural disasters necessitates a large amount of government expenditure for rescue and relief works. In such situation governments are compelled to borrow.
  2. To meet war expenses: Borrowing to finance wars is in practice since ancient times. In modern times, the cost of warfare has been tremendously increased with the development in war technology and techniques. In a situation of war, income from revenue sources will not be sufficient to meet war expenses. Besides, in such situation, economic activities generally decreases leading to low level of national income and low yield from taxation sources. In such situation it is not desirable to increase rate of taxes beyond desirable limits which may create serious socio-economic and even political problems in the country. So, it is better and convenient for government to borrow in a warfare situation.
  3. To maintain economic stability: The idea of compensatory finance and functional finance has recognized the importance of borrowings to maintain economic stability. In a situation of depression. Government is to increase its expenditure, mainly by borrowings, to increase effective demand in the economy. To control inflation, government is to borrow out of the peoples’ fund which is likely to be used for increasing consumption expenditure. At the same time, the borrowed money is to be invested on production of goods and services by itself or private sector, Besides, government may borrow from external sources to manage trade deficit.
  4. To promote the rate of economic growth: One of the main constraints in the process of economic growth in the developing countries is lack of sufficient investment resources. To exploit or utilize the potentiality of natural and human resources, it is necessary to make a significant investments on them. For this, the savings of individuals and private corporate bodies can be increased voluntarily by borrowings with attractive monetary benefits. Borrowing from banking and financial institutions including central bank, is needed for productive use of unused or idle resources. Besides, borrowing from external sources in a wise way and effective investments helps in increasing productive capacity of the economy and national production.
  5. To manage the problem of Balance of Payments: In a situation of deficit in the balance of payments, government may borrow from external sources for funding the import requirements.
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Public Expenditure: Nature and Principles of Public Expenditure

Concept of Public Expenditure

 

“Public expenditure refers to the expenses of the public authorities – central, state and local governments – either for protecting the citizens and/or for promoting their economic and social welfare.” - Sundharam and Andley

 

“Public expenditure refers to the expenses which the government incurs for its own maintenance as also for the society and the economy as a whole. These days governments are also incurring expenditure to help other countries.” - Bhatia.

There are two schools of thoughts or attitudes in relation to the scope of public expenditure. The first is led by Adam Smith and other by classical writers restricted state activities to mainly the primary functions. Adam Smith has pointed out ‘the sovereign has only three duties: protecting the society from violence and invasion from other independent societies; establishing the exact administration of justice; and erecting and maintaining certain public works and certain public institutions.'

J.B.Say said, “The very best of all plans of finance is to spend little.” 

 

H.Parnell says, “Every particle beyond which necessity absolutely requires for the preservation of social order and for protection against foreign attack is waste and unjust oppressive imposition on the public.”

The second school of attitude after 1880’s did not restrict public expenditure only to the primary functions. Writers like Pigou, Dalton advocated public expenditure on social welfare activities. Similarly, after 1930’s depression, writers like Keynes advocated for state role to control economic fluctuations for maintaining economic stability in the developed countries. Prof. Musgrave advocated public expenditure for the activities such as: reallocation of resources, redistribution of national income and wealth, stabilization of economy, and some necessary commercial activities. 

Reasons for Growth in Public Expenditure


Public expenditure in all countries is increasing throughout the passes of time. In this regard, Adolf Wagner, a noted German fiscal theorist, propounded an empirical law named as ‘Law of the increase of state activities’ in the late 19th century. The law is expressed as, “Comprehensive comparisons of different countries and different times show that an increase regularly takes place in the activity of both the central and local governments. This increase is both extensive and intensive. The governments constantly under-take new functions, while they perform both old and new functions more efficiently and completely.”

Similarly, the Italian economist F.S. Nitti observed that whatever be the nature of governments or nations, they have similar tendencies towards marked increase of public expenditure.

The factor behind the increase in state activities, and thus, the public expenditure are of different nature and purposes. They are:

1. Concept of welfare state

In the past, governments were restricted to perform minimum activities just to maintain an environment necessary for efficient working of the private sector economic activities being guided by the market mechanism. Now, governments are to perform so many activities to promote social welfare beside the traditional activities. There is no sphere where the state can not enter or undertake. The basic reason for this is the change in the philosophy of police-state until late 19th century to the welfare-state with the main objective of promoting socio-economic well-being of the citizens. It has been the responsibility of the state to take care of citizens from womb-to-tomb, and so, expenditure of modern governments has increased a lot.

2. War related activities

War and threat of war have compelled governments to be militarily strong with well equipped weapons and technology. The cost of defense due to the progress in war techniques along with the development of science and technology have made the war weapons highly expensive. And also, the rate of obsolesce of the weapons is extremely high. Besides, war obligations for governments even in peace time after war in the form of pensions, relief aids to war veterans and victims, repayment of war debt and reconstruction of war devastated infrastructures.

3. Growth of population

Population growth, mainly in the underdeveloped countries, has necessitated increase in government activities to fulfill the demand for more educational, health, housing, employment opportunities, social security and benefits.

4. Urbanization

The process of urbanization impose additional responsibilities upon governments to provide community benefit which are normally not possible from individual efforts. Such community benefits like supply of safe drinking water, sewage facility, link roads, public parks, sports and recreation centers, communication networks, public security services, etc. are to be provided by the governments.

5. Economic needs

The great depression of 1930’s recognized the need for state intervention in the economy. Accordingly, undertaking of new economic functions by the state to maintain economic stability, encourage economic activities and promotion of economic welfare have increased the volume of public expenditure in the developed countries. In the developing countries, after the Second World War, governments are to play the leading role in the development process performing the role of an investor, facilitator and regulator along with promotion of distributive justice, maintenance of economic stability and environmental protection. All these economic needs have caused increase in public expenditure a lot.

6. Rise in price level

Universal rise in price level has led to increase in public expenditure for purchasing the goods and services by the governments. There is a cause and effect relationship between increase in price level and public expenditure.

7. Political factors

Modern governments have to make expenses on the political institutions, organizations and constitutional bodies. The system of election in the democratic countries needs more expenses. In an authoritarian regime, governments are spending a huge amount to suppress the political opponents and voices, and popularizing the image of the ruler through propaganda.

8. Growth in international relations

Establishment of international organizations like UNO and many agencies under its regional co-operation organizations like European Union, ASEAN, SAARC, OAU, BIMSTEC, etc. have made the member countries to subscribe financial contribution for their operation, expenses on permanent and conference delegates. Besides, establishment of diplomatic missions and the practice of foreign aids are also responsible for increase in expenditure of modern governments.

Principles of Public Expenditure

Principles of public expenditure are the criterion or guidelines for making public expenditure decisions. Prof. Alfred Buckler has made an attempt to state some guidelines for public expenditure to be followed by public authorities. They are:
  1. Public expenditure should promote welfare of the society, even it may be to promote welfare of a particular class or group.
  2. Careful judgment should be exercised to ensure the advantages of expenditure on each public service exceed the costs in comparison to that from the private sector.
  3. Priority should be given to services that will best promote social welfare than the services that promote least social welfare.
The principles of public expenditure can be discussed as the Canons of Public Expenditure and the Principle of Maximum Social Advantage. The canons of public expenditure are accepted as the general guiding principles for overall public expenditure mechanism. The principle of maximum social advantage is accepted as the basic principle of public expenditure.

Canons of Public Expenditure

Prof. Findlay Shirras advocated the following canons of public expenditure: 
  1. Canon of Benefit- The ideal of public expenditure should be the promotion of maximum social benefit or advantage.
  2. Canon of Economy- It refers to be economical in spending public money as well as help to expand its revenue base.
  3. Canon of Sanction- It implies that there should be no public expenditure without proper sanction by the proper authority.
  4. Canon of Elasticity- It refers that public expenditure should be changeable as per the need of the country.
  5. Canon of Equitable Distribution- It implies that public expenditure should be carried out to reduce the inequality in national income distribution.
  6.  Canon of Productivity- It implies that public expenditure should encourage increase in national production.
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Characteristics of an Effective Tax System

The basic objectives of taxation is to generate maximum potential revenue with desirable effects on the economy. For this, the tax system should be based on sound objectives and policies along with overall effective tax system. Due and Friedlander are of the view that a sound tax system should have the following characteristics:
  1. Equality in the distribution of the tax burden
  2. Productivity of the tax-system generating adequate revenue along with encouraging production in the economy
  3. Appreciation of the rights and problems of the taxpayers and
  4. Adaptability of the tax structure to meet the changing needs of the economy.

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- Concept of Tax


The effectiveness of a tax system requires the effectiveness of its components or sub-systems. They can be mentioned as follows:

1. Sound objectives and policies

Taxes should be levied with clear and specific objectives and policies with due considerations of the possible effects in the economy. For this, the tax structure should be designed with careful planning and research. The active participation of the taxation-experts, legal-experts, tax-administrators, taxpayers and other related stakeholders helps in this concern.

2. Simple and specific Taxation Laws

The taxation laws and regulations should be simple and specific about each and every terms, provisions, procedures, etc. They all should be thoroughly examined as to their application and effectiveness. There must be certainty about what the law requires and intends. Complexities and ambiguities in taxation laws should be avoided as they may lead to discriminatory powers to the tax authorities as well as provide more chances for tax evasion by the taxpayers. 

3. Effective Tax Administration

The tax administration mechanism should have effective organization structure, competent personnel, integrated information technology, simple and convenient tax procedures, well organized revenue intelligence mechanism, simplified revenue appeal mechanism and well coordination with the governmental organizations and other stakeholders.

4. Well provision for Reward and Punishment

A well provision of reward and punishment is essential for an effective tax system. Rewards should be provided to the taxpayers who maintain their account honestly and file returns in prescribed time. Similarly, the tax authorities doing their job honestly should be rewarded. On the other hand, both the taxpayers and tax authorities violating the taxation laws should be punished without discretion.

5. Tax Consciousness and Voluntary Compliance

The great asset of a tax system is the higher degree of voluntary compliance on the part of taxpayers. For this, there should be attempts to increase tax consciousness. Tax consciousness and compliance can be increased with the involvement of the taxpayers in policy formulation, tax education, convenient taxation procedures and effective reward provisions.

6. Stable Government and Political Commitment

There is always necessity to reform tax administration for its effectiveness. This is possible, in a true sense, only with a stable government and strong political commitment & consensus mainly on policy making and implementation concerning the broadening the tax-base in a progressive manner.
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Principles of Taxation and Its Strength and Weaknesses

Taxes will have significant effects upon the economic behavior of individuals and functioning of the economy as a whole. This fact must be well considered in designing and execution of the tax structure and policies in a way so that there will be positive or desirable effects, and avoid undesirable or adverse behaviors in achieving the economic goals of the society. And also, the burden of taxes must be distributed among the people in a manner consistent with these goals. The goals accepted for optimum level of economic welfare in a liberal society are:
  1. Maximum freedom of choice consistent with the freedom of others
  2. Optimum level of living standard in terms of available resources and technology in consistent with the consumer and factor owner’s preferences and
  3. Distribution of income in conformity with the standards of equity currently accepted by the society.
Principles of taxation refer to the appropriate criterion for designing and executing the tax structure and policies. Adam Smith was the first writer to prescribe the principles of taxation in the form of canons of taxation. Later writers added some more canons. The canons of taxation are basically accepted as the general guiding principles of over-all tax system. 

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The four canons of taxation advocated by Adam Smith were:

1. Equity: The burden of taxes should be distributed among the people in an equitable way. “The subjects of every state ought to contribute towards the support of the governments nearly as possible in proportion to their respective abilities, that is in proportion to the revenue they enjoy under the protection of the state”.

2. Certainty: The amount, time and mode (procedure) of tax payment should be certain.

3. Convenience: The time and mode of tax payment should be convenient to the taxpayers.

4. Economy: The cost of collection of taxes should be minimized as far as possible.

Later other writers like Bastable added other canons beside that of Adam Smith. They are:

5. Productivity: The tax system should be able to yield enough revenue so that government may not be forced to resort deficit financing, and also promote productivity of the economy.

6. Flexibility: The tax structure needs to be revised as per the need of the economy and the treasury.

7. Simplicity: All provisions and terms related with tax system must be clear and simple so that even a common man can understand, and not have ambiguities.

8. Diversity: It is necessary to have a wide range of taxes to avoid the chances of possible ill-effects some taxes as well as to generate maximum potential revenue.

Besides these canons, principle of taxation is mainly concerned with the distribution of the burden of tax on people (taxpayers) in an equitable way as accepted by the consensus of the society. Equity in the tax system refers to horizontal and vertical equity. The horizontal equity refers to equal treatment to the equals. The vertical equity refers to relative or discriminatory treatment to the unequals, There are two principles of taxation to maintain equity in taxation. They are the Benefit-received and Ability-to- pay principles.

Benefit-received Principle



The principle accepts benefit-received as justification for taxation as well as a standard for apportioning the tax burden among the people. The principle emphasizes on ‘quid-pro-quo’ term in the relationship between people and the state. The obligation to pay and the amount to pay are individualized like in case of market system. Government services (mainly protection) provide certain benefits to the community. The cost of providing the benefits should be apportioned among the individuals and organizations on the basis of relative benefits they enjoy under the protection of the state. The principle has two approaches in determining tax amount on the taxpayers. The first is the cost of service which refers to the cost to provide benefit one enjoys. The second is the value of service, which refers to the value of benefit one enjoys from the government services. 

This principle has its foundation on the Social-contract Theory of State up to the mid 18th. Century. Contract was the basis of the formation of the organized society in the form of the state, mainly for protection. Then, taxes were considered as the price for protection services. 

Sir William Petty, in late 17th. Century, argued that all men should contribute to the public charge according to the share and interest they have in public peace revealed by their estates and riches. Similarly, Adam Smith argued that citizen should contribute to support the government, as nearly as possible, in proportion to their respective abilities that is in proportion to the revenue they enjoy under the protection of the state. 

In late 19th. Century, this principle was considered as an approach for efficient allocation of resources. Since tax impositions for public services involve withdrawal of resources from private sector, tax and expenditure should be joint to maintain general equilibrium. 

Writers like Mazzola and De Marco advocated distribution of tax burden on the basis of marginal utility or benefit an individual get from the government services. So they argued different prices / tax for government services for different persons according to respective marginal benefit they enjoy. 

Strength of the Principle

  1. The principle is based on the assumption that benefit from government services justifies tax imposition.
  2. Since the principle considers both the income and expenditure of government, and so determine the size of government expenditure and tax shares on it at the time, making government cautious in maintaining fiscal balance as far as possible.
  3. The principle is practically applied in cases where benefit from government services can be individualized, and is in practice in the form of fees or charges.

Weaknesses or Limitations of the Principle

  1. Contribution to the government services on the basis of benefit is actually not a tax, rather it is like a price.
  2. In general cases, benefit from government services cannot be individualized.
  3. The principle does not incorporate the modern role of taxes in maintaining economic stability, promotion of economic growth and distributive justice.
  4. It is questionable to assume the income received by individuals is only because of the benefit from government services.
  5. It doesn’t incorporate the externalities of some public goods.


Ability-to- pay Principle


The term ability refers to the economic well-being or over-all standards of living enjoyed by the people. This principle is based on the logic that a person is to pay tax because he can. In other words, it is his duty to pay tax to support the government according to his relative ability. The principle accepts obligation to support the government as a social or collective responsibility. It does not accept the existence of the exchange relationship between the state and taxpayers.

According to this principle, equity in taxation requires that persons with the equal ability are to pay tax at equal rate and amount. Whereas, persons with greater ability are to pay tax at higher rate and amount. And persons, who have no ability need not pay. This principle is based on the assumption that the Law of diminishing marginal utility applies also in case of money or income, and also interpersonal comparison of utility is possible.

It is said that, even though this principle is older than the benefit-received principle, J.S.Mill, in early 19th. Century, was the leading person to advocate this principle strongly. His statement in this concern was, “The equality of taxation means equality of sacrifice. It means apportioning the contribution of each person towards the expense of government in a way so that he will feel neither more nor less inconvenience from his share of payment than every other person experiences from his.” So, in his opinion, taxation will be just and equitable only when the distribution of tax burden will be in such a way so that all the taxpayers incur equal sacrifice. 

The concept of equal sacrifice has been interpreted in three ways. Equal Absolute Sacrifice refers that the total loss of utility (sacrifice) as a result of tax should be equal for all tax payers. Equal Proportional Sacrifice refers to the loss of utility as a result of tax should be proportional the economic status of the taxpayers. Equal Marginal Sacrifice refers to the marginal sacrifice by all the tax payers should be the same. This is also called the least aggregate sacrifice.

Index of Ability-to-Pay

The subjective criteria of sacrifice approach in determining and apportioning the tax burden is difficult to apply in practice. So, the supporters of this principle have developed the objective indices or criterion for assessing one's ability for practical application of this principle. There are three indices to measure ones ability or economic well-being.
  1. Property or Accumulated wealth: Prior to the industrial revolution and development of monetization, property or accumulated wealth was considered the best index of ability. Wealth was accepted as the better index than the income because wealth is not only the source of income but also an indicator of one's social status, power and economic security. Property reflects additional source of income. It is also accepted that the inherited property has a higher ability to pay tax than that from personal efforts. However, with the progress of industrial society and development of monetization, there has been a shift from property to income as the best index of ability. 
  2. Income: Income is universally accepted as the best index of one’s ability. Musgrave emphasized that the relative welfare position on individuals should be measured in terms of their income, and sacrifice is a function of income surrendered for taxation. A family’s well being depends mainly on the income received in a specific time period. Generally, the net income after making allowances to maintain a family in a way as socially accepted is considered as an ability from the taxation point of view. The Classical writers defined taxable income as the clear income, which they meant the income above subsistence level. They advocated complete exemption of tax on low and middle income people and imposition of taxes on higher income people in a proportional rate. And also, imposition of higher rate on unearned income than the earned income, was suggested.
  3. Consumption expenditure: The pattern of consumption expenditure reflects one’s tax paying ability. So, taxes on consumption expenditure emphasized that the taxable capacity should be defined as the share of one’s consumption out of the national production.
All these indices, taken individually as the only index of ability do not cover all the potential sources of taxation. So, in modern times, all these indices are accepted as the indices of ability.

Strengths of the Principle

  1. This principle is justified on three grounds. The first is the ability as the basis of taxation and is quite justifiable.
  2. The second is the equality in sacrifice by all taxpayers which is also quite justifiable.
  3. Thirdly, the principle is justified as an approach for promoting distributive justice in the society.


Weaknesses or Limitations of the Principle

Critics of this principle opined that the assumption of application of the Law of Diminishing Marginal Utility on income and wealth, and inter-personal comparison of utility is quite subjective, and is difficult in practice. 

Application of this principle may cause disincentive to work, save and invest, and may have negative effects on the economy.

But these criticisms cannot be accepted in modern welfare-state thinking.
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