Tag: Osmania University B.com Notes

The Heckscher–Ohlin model (H–O model) is a general equilibrium mathematical model of international trade, developed by Eli Heckscher and Bertil Ohlin at the Stockholm School of Economics. It builds on David Ricardo’s theory of comparative advantage by predicting patterns of commerce and production based on the factor endowments of a trading region. The model essentially says that countries export products that use their abundant and cheap factors of production, and import products that use the countries’ scarce factors.

The Heckscher-Ohlin model is an economic theory that proposes that countries export what they can most efficiently and plentifully produce. Also referred to as the H-O model or 2x2x2 model, it’s used to evaluate trade and, more specifically, the equilibrium of trade between two countries that have varying specialties and natural resources.

The model emphasizes the export of goods requiring factors of production that a country has in abundance. It also emphasizes the import of goods that a nation cannot produce as efficiently. It takes the position that countries should ideally export materials and resources of which they have an excess, while proportionately importing those resources they need.

Features of the model

Relative endowments of the factors of production (land, labor, and capital) determine a country’s comparative advantage. Countries have comparative advantages in those goods for which the required factors of production are relatively abundant locally. This is because the profitability of goods is determined by input costs. Goods that require locally abundant inputs are cheaper to produce than those goods that require locally scarce inputs.

For example, a country where capital and land are abundant but labor is scarce has a comparative advantage in goods that require lots of capital and land, but little labor such as grains. If capital and land are abundant, their prices are low. As they are the main factors in the production of grain, the price of grain is also low and thus attractive for both local consumption and export. Labor-intensive goods, on the other hand, are very expensive to produce since labor is scarce and its price is high. Therefore, the country is better off importing those goods.

Theoretical Development

The Ricardian model of comparative advantage has trade ultimately motivated by differences in labour productivity using different “technologies”. Heckscher and Ohlin did not require production technology to vary between countries, so (in the interests of simplicity) the “H–O model has identical production technology everywhere”. Ricardo considered a single factor of production (labour) and would not have been able to produce comparative advantage without technological differences between countries (all nations would become autarkic at various stages of growth, with no reason to trade with each other). The H–O model removed technology variations but introduced variable capital endowments, recreating endogenously the inter-country variation of labour productivity that Ricardo had imposed exogenously. With international variations in the capital endowment like infrastructure and goods requiring different factor “proportions”, Ricardo’s comparative advantage emerges as a profit-maximizing solution of capitalist’s choices from within the model’s equations. The decision that capital owners are faced with is between investments in differing production technologies; the H–O model assumes capital is privately held.

Evidence Supporting the Heckscher-Ohlin Model

Although the Heckscher-Ohlin model appears reasonable, most economists have had difficulty finding evidence to support it. A variety of other models have been used to explain why industrialized and developed countries traditionally lean toward trading with one another and rely less heavily on trade with developing markets.

The Linder hypothesis outlines and explains this theory. It states that countries with similar incomes require similarly valued products and that this leads them to trade with each other.

Heckscher-Ohlin Theorem:

According to Ricardo and other classical economists, international trade is based on differences in comparative costs. It is important to note that Heckscher and Ohlin agreed with this fundamental proposition and only elaborated this by explaining the factors which cause differences in compara­tive costs of commodities between different regions or countries. Ricardo and others who followed him explained differences in comparative costs as arising from differences in skill and efficiency of labour alone.

This is not a satisfactory explanation of differences in comparative cots. Ohlin pointed out more significant factors, namely, differences in factor endowments of the nations and difference in factor proportions of producing different commodities, which account for differences in com­parative costs and hence from the ultimate basis of inter-regional or international trade.

Thus, Heckscher-Ohlin theory does not contradict and supplant the comparative cost theory but supple­ments it by offering sufficiently satisfactory explanation of what causes differences in comparative costs.

According to Ohlin, the underlying forces behind differences in comparative costs are two­fold:

1. The different regions or countries have different factor endowments.
2. The different goods require different factor-proportions for their production.

It is a well-known fact that various countries (regions) are differently endowed with productive factors required for production of goods. Some countries posses relatively more capital, some rela­tively more labour, and some relatively more land.

The factor which is relatively abundant in a country will tend to have a lower price and the factor which is relatively scarce will tend to have a higher price. Thus, according to Ohlin, factor endowments and factor prices are intimately associ­ated with each other.

Suppose K stands for the availability or supply of capital in a country, L for that of labour and PK for price of capital and PL for the price of labour. Further, take two countries A and B; in country A capital is relatively abundant and labour is relatively scarce. The reverse is the case in country B. Given these factor-endowments, in country A capital will be relatively cheaper.

In symbolic terms:

Since (K/L)A > (K/L)B

Since (PK/PL)A < (PK/PL)B

Thus, the differences in factor endowments cause differences in factor prices and therefore ac­count for differences in comparative costs of producing different commodities. Together with the difference in factor-endowments, differences in factor proportions required for the production of different commodities also constitute an important force underlying differ­ences in comparative costs as between different countries.

Some commodities are such that their production requires relatively more capital than other factors; they are therefore called capital- intensive commodities. Still other commodities require relatively more land than capital and labour and are therefore called land-intensive commodities.

These differences in factor-productions (or what is also called differences in factor-intensities) needed for the production of different commodi­ties account for differences in comparative costs of producing different commodities. The differ­ences in comparative costs of producing different commodities lead to the differences in market prices of different commodities in different countries.

It follows from above that some countries have a comparative advantage in the production of a commodity for which the required factors are found in abundance and comparative disadvantage in the production of a commodity for which the required factors are not available in sufficient quanti­ties.

Thus, a country A which has a relative abundance of capital and relative scarcity of labour will have a comparative advantage in specialising in the production of capital-intensive commodities and in return will import labour-intensive goods. This is because (PK/PL)A < (PK/PL)B.

On the other hand, a labour-abundant country B with a scarcity of capital will have a compara­tive advantage in specialising in the production of labour-intensive commodities and export some quantities of them and in exchange for import capital-intensive commodities. This is because in this country (PL/PK)B < (PL/PK)A.

If factor endowments in the two countries are the same and factor-productions used in the production of different commodities do not differ, there will be no differences in relative factor prices [i.e. (PK/PL)A < (PK/PL)B] which will mean differences in comparative costs of producing commodities in the two countries will be non-existent. In this situation the countries will not gain from entering into trade with each other.

Let us graphically explain the Heckscher-Ohlin theory of international trade. Take two coun­tries U.S.A. and India. Assume that there is a relative abundance of capital and scarcity of labour in U.S.A. and, on the contrary, there is a relative abundance of labour and scarcity of capital in India. (This is the real situation as well).

By WissensDürster – Own work, CC BY-SA 4.0, https://commons.wikimedia.org/w/index.php?curid=41687581

It is said that an internal debt has no direct money burden since the interest payment on debt and the imposition of taxation to pay interest to the lenders is simply a transfer of purchasing power from one to another. This means that in case of internal debt, money is borrowed from individuals and institutions within the country.

Repayment (raised from taxation) constitutes just a transfer of resources from one group of persons to another. In other words, these are transfer payments and do not affect the total resources of the community Truly speaking, govern­ment collects money through taxation imposed on the richer people who are also the buyers of government bonds.

Burden of public debt is a misleading and highly confused concept. The 1930’s and 1940’s witnessed an array of debate over the issue of debt burden. The focus of debate was between those who feared that the creation of debt in course of deficit finance would burden the future and others who believed that such finance would not do so.

Later on, two extreme views emerged in this regard. The burden con­troversy attained its logical end in the pronouncement of A.C. Pigou, A.P. Lerner, Alwin. H. Hansen and Prof. P.E. Taylor.

In this context, Prof. Taylor point out that “the nature and severity of the burden have however frequently been improperly understood largely because of the temptation to think of public debt in terms of private debt and to apply identical standards to both”.

Moreover, while discussing the burden of public debt, we have to bear in mind not only the amount of debt but also the corresponding credit. As A.P. Lerner point out “the great misconception lies in looking at only one side of debt-credit relationship.

Every debt has a corresponding credit and this fact is frequently over looked when considering the burden of public debt. In this context, Taylor point out “the liability of the debtor to the creditor is matched by the asset value of the creditors claim.

This is a rou­tine fact which is frequently over looked when considering the nature of debt”. The views of these economists remained unchanged for quite a long time. The Keynesian approach disagreed with the clas­sical burden thesis.

Burden of External Debt:

During a given period, the direct money burden of external debt is the interest payment as well as the principal repayment (i.e., debt servicing) to external creditors. The direct real burden of such external borrowing is measured by the sacrifice of goods and services which these payments involve to the members of the debtor country.

There is also indirect money burden of external debt. Loan repayment by the debtor country implies more exports of goods and services to the creditor country. Thus, a debtor country experiences a fall in welfare of the community.

1. Traditional Views on the Burden of Public Debt:

The traditional view is that public debt as in the case of private debt imposes a real burden on the community. The classical view main­tains that if the government expenditure is financed through taxation the present generation bears the burden. But if government expendi­ture is financed through public borrowing, the present generation gets relieved from the cost and burden is shifted to the future genera­tion.

The future generation suffers when present generation reduces its saving in-order to meet the debt finance and leave a smaller amount of capital resources for the future. This will reduce the productive capacity of the future generation and accordingly they will stand to lose.

In a sense, war finance through public debt has double effect. For example, in-order to contribute to war finance, the present gen­eration has either to curtail its consumption or saving or both. If savings are reduced the future generation suffers on account of re­duced inherited capital.

On the other-hand, if the present generation does not reduce its consumption, burden of public debt may pass on to the future generation. This view is held by David Hume, Adam Smith and David Ricardo.

According to the classists public debt necessitate a transfer of resources from the private sector to the government in the form of additional taxation. Secondly, the classist held the view that public debt is a more costly method of financing public expenditure than taxation.

This is so because interest payment is an additional cost burden in the case of public debt. Thirdly as stated earlier, public debt tends to transfer the burden of a particular outlay to the future generation.

Moreover, excess borrowing and mounting public debt of the government may undermine the very creditworthiness of the gov­ernment. Hence the traditional economists strongly argued that public debt should be kept to the minimum and should be redeemed as early as possible.

2. Modern Views:

Economists like J.M. Keynes, Harris, Buchanan, Musgrave, and Modigliani are the chief exponents of the modern version of debt burden. The modem theory of public debt is put as “the new ortho­doxy” by Prof. Buchanan.

The worldwide depression of 1930’s and the emergence of Keynesian economics paved the way for the de­velopment of the new theory of public debt. The new theory is dia­metrically opposed to the classical concept of public debt. Modern theory firmly advocates that large volume of public debt is a national asset rather than a liability. This theory recognizes that persistent deficit spending is a tonic to the economic development of nations.

During periods of depression, the technique of deficit budget financed through borrowing can be fruitfully utilized to improve employment situation and generating effective demand and thereby raising the level of economic activity.

Under the shadow of Says Law, propa­gated the misconception that persistent technique of unbalancing the budget coupled with increasing proportion of public debt endangers the very economic stability of the nation.

However, the modern theories strongly believe that public expenditure is not at all wasteful. To them, public expenditure can be made productive and an impor­tant means to increase employment in the economy.

As a corollary to this concept, Prof. A.H. Hansen, the chief advocate of modern theory states that public debt is an essential means of increasing employment and it has become an instrument of modern economic policy of nations.

Prof. James Buchanan in his book “Public principles of public debt”, states that debt burden implies a compulsory sacrifice. He argued that the primary burden of the internally held public debt is always in the future.

Buchanan held the view that burden of debt should be considered in terms of reduction in personal satisfaction. When a public debt is floated, the lenders voluntarily purchase bonds. There is no loss of satisfaction in the process of exchanging more liquid money for less liquid bonds. Here people prefer government bonds as a good form of investment.

3. Direct Money Burden:

Repayment of public debt involves payment of interest and the prin­ciple by the government. Hence the government will have to raise the necessary resources by way of taxation.

The direct money burden of public debt consists of the tax burden imposed on the public and it is equal to the sum of money payments for interest and the principle components. In the case of an internal debt, there will be no direct money burden because all the money payments and receipts can­cel out.

In this context, Dalton observes “thus all transactions con­nected with an internal debt resolve themselves into a series of transfers of wealth within the community. It follows that there can never be any direct money burden or direct money benefit of an internal debt”. However, in the case of external debt money pay­ments by the debtor nations to the creditor constitute a clear direct money burden.

4. Direct Real Burden:

Real burden of public debt refers to the distribution of tax burden and public securities among the people. In a sense, it is the hardship sacrifice and loss of economic welfare shouldered by the taxpayers on account of increased taxation imposed for repayment of public debt.

It is a fact that people hold public debt and they also pay taxes towards the cost of debt service. If the proportion of taxation paid by the rich towards the cost of debt, service is smaller than the propor­tion of public securities held by them, whereas, if the proportion of taxation paid by the poor and middle-income group towards the cost of debt service is larger than the proportion of public securities held by them, there is a direct real burden from public debt.

Whereas suppose government bonds and securities are held by the working classes, while the taxation towards the cost of debt service is paid by the rich only, then public debt will help to reduce the inequalities of income in the community. In such a circumstances there is no direct burden; instead there is a direct real benefit to the community.

5. Indirect Money Burden and Real Burden:

It is argued that heavy taxation to meet debt service charges may reduce taxpayers ability and willingness to work an save. In turn this will check production. Moreover, heavy debt charges may also force the government to curtail and economies some desirable social ex­penditure, which may promote economic development.

However, if it is possible to neutralize the adverse effect of taxation resulting from the problem of debt service by some favourable effect of public ex­penditure, the indirect burden of public debt can be cancelled out. Dalton observes that practically this is not possible. In the case of external debt, indirect money and real burden arise from its bad effect on production because of additional taxation to pay for debt charges.

Burden of Internal Debt:

Internal debt involves no significant burden on the community as a whole. The payment of interest and increased taxation to meet the servicing and principle component of debt involves a transfer of pur­chasing power from one section of the community to another.

In the case of internal debt, the people owe themselves the debt and the question of the burden need not be treated as raising any major issue. Money does not flow out of the domestic market.

However, if the creditors (bond holders) and the taxpayers belong to different income strata’s, there may occur a change in the distribution of in­come among different sections of the community. But Dalton observes that while estimating the burden of public debt, we should consider the purpose for which the loan is raised.

Suppose if the public debt is floated specifically for raising invest­ment funds for a productive activity, the profit generated from it can be used to pay off the debt, where as a debt raised for financing a war may be a dead weight and it will have to be paid out of increased taxation.

So in the first case there is no burden as such. In the second case also it is argued that the burden imposed by taxation upon the taxpayers will be offset by the benefit which the taxpayers receive in the form of interest on public debt.

However, if the rich pays taxes less than proportionately, to the proportion of public securities held by them, then there will be a direct real burden. The reason is that usually public securities are held mainly by the wealthier class.

Progressive taxation doesn’t tend to be sharply progressive to counterbalance the gain obtained by wealthier class from the possession of public debt. In usual prac­tice, the debt servicing burden will fall upon the poor section in the form of heavy taxation on commodities.

As a result there is a net increase in the burden on the community. Sometimes this may ad­versely affect the power and willingness to work and save and even the productive capacity of the economy.

Hence, the repayment pro­cess of public debt should be managed in such a way that, it may not exert any adverse effect on production and distribution. So it maybe concluded that if not planned and utilized scientifically, inter­nal debt can practically impose a burden on the community, even though theoretically it is not correct.

On several aspects external debts differ from internal debt. Still in the case of burden of debt, both share some similar characteristics. For the payment of internal and external debt, imposition of additional taxation is imperative.

In the words of Prof. Dalton “as a general rule, an internal debt is likely to involve an additional and indirect burden on a community, an external debt does the same”.

But in another sense, external debt involves greater burden than internal debt. In the case of internal debt there is no resource trans­fer to outside the country. The repayment of principle and interest charges doesn’t lead to the transfer of resources from the country to another country.

It merely results in the transfer of income from one section of the community to another section. Moreover, the taxpay­ers and receivers of interest constitute the same class of people. Whereas external debt specifically involves resource transfer to for­eign nation.

By way of interest charges and repayment of principle, resources are transferred to the creditors abroad. Therefore, pay­ment of interest on foreign debt reduces the net income of the debtor country. Internal debt carries with it no such evil effect. Hence, we can safely say that external debt involves a greater burden than internal debt.

Measurement of the Burden of Debt:

Usually, burden of debt refers to financial burden of the government.

But as it does not indicate true burden, we consider following ratios to estimate the burden of debt:

• Income-Debt Ratio:

It is estimated as:

size of public debt/national income = D/Y

If Y remains at a very high level, the burden of debt, D, will be insignificant. However, if the ratio becomes high, debt then poses a great burden.

• Debt-Service Ratio:

This ratio is measured as:

Annual interest payments of borrowing/National income = i/Y

Increase in Y means lower debt-service ratio. However, taxes are collected for the repayment of public debt. Thus, this ratio indicates the necessity of imposing higher taxes.

• Debt Service-Tax Revenue Ratio:

It is worked out as:

Annual interest payments/Aggregate tax revenue = i/T

An increase of this ratio indicates the financial weaknesses of the government.

Government’s fiscal policy has big role in stabilizing the economy during business cycles. The two important phases of business cycles are boom and recession. A recession should not be allowed to grow into a deep recession. Similarly, a boom should not explode bigger. We may say that amplifying the business cycle is dangerous (growing boom and deepening recession).

Practically fiscal policy responses using taxation and expenditure can go in two ways in response to the business cycle: Countercyclical and procyclical.

Countercyclical fiscal policy

Procyclical and countercyclical variables are variables that fluctuate in a way that is positively or negatively correlated with business cycle fluctuations in gross domestic product (GDP). The scope of the concept may differ between the context of macroeconomic theory and that of economic policy–making.

The concept is often encountered in the context of a government’s approach to spending and taxation. A ‘procyclical fiscal policy’ can be summarised simply as governments choosing to increase government spending and reduce taxes during an economic expansion, but reduce spending and increase taxes during a recession. A ‘countercyclical’ fiscal policy takes the opposite approach: reducing spending and raising taxes during a boom period, and increasing spending and cutting taxes during a recession.

A counter-cyclical fiscal policy refers to strategy by the government to counter boom or recession through fiscal measures. It works against the ongoing boom or recession trend; thus, trying to stabilize the economy. Understandably, countercyclical fiscal policy works in two different direction during these two phases.

Countercyclical fiscal policy during recession

Recession is a business cycle situation where there is slowing demand and falling growth in the economy. Here, the Government’s responsibility is to generate demand by fine-tuning taxation and expenditure policies. Reducing taxes and increasing expenditure will help to create demand and producing upswing in the economy.

Countercyclical fiscal policy during boom

In the case of boom, economic activities will be on upswing. Amplifying the boom is disastrous as it may create inflation and debt crisis and the government’s responsibility here is to bring down the pace of economic activities. Increasing taxes and reducing public expenditure will make boom mild. Thus, slowing down demand should be the nature of countercyclical fiscal policy during boom.

Procyclical fiscal policy

Procyclical is the opposite of countercyclical. Here, fiscal policy goes in line with the current mood of the business cycle; amplifying them. For example, during the time of boom, government makes high expenditure and doesn’t hike taxes. Thus, boom grows further. Such a policy is dangerous and brings instability in the economy.

Boom: total government spending as a percentage of GDP goes up and tax rates go down, increasing government deficit.

Recession: total government spending as a percentage of GDP goes down and tax rates go up, decreasing government deficit.

So procyclical fiscal policy is undesirable for the economy.

History shows that governments follow often procyclical fiscal policy more during boom. Such a situation increases government debt and creates inflationary pressure especially in developing countries.

Economic policy making

Procyclical

Procyclical has a different meaning in the context of economic policy. In this context, it refers to any aspect of economic policy that could magnify economic or financial fluctuations. Of course, since the effects of particular policies are often uncertain or disputed, a policy will be often procyclical, countercyclical or acyclical according to the view of the one judging it.

Thus, the financial regulations of the Basel II Accord have been criticized for their possible procyclicality. The accord requires banks to increase their capital ratios when they face greater risks. Unfortunately, this may require them to lend less during a recession or a credit crunch, which could aggravate the downturn. A similar criticism has been directed at fair value accounting rules. The effect of the single Eurozone interest rate on the relatively high-inflation countries in the Eurozone periphery is also pro-cyclical, leading to very low or even negative real interest rates during an upturn which magnifies the boom (e.g. ‘Celtic Tiger’ upturn in Ireland) and property and asset price bubbles whose subsequent bust magnifies the downturns.

Countercyclical

Conversely, an economic or financial policy is called countercyclical if it works against the cyclical tendencies in the economy. That is, countercyclical policies are ones that cool down the economy when it is in an upswing, and stimulate the economy when it is in a downturn.

Keynesian economics advocates the use of automatic and discretionary countercyclical policies to lessen the impact of the business cycle. One example of an automatically countercyclical fiscal policy is progressive taxation. By taxing a larger proportion of income when the economy expands, a progressive tax tends to decrease demand when the economy is booming, thus reining in the boom. Other schools of economic thought, such as new classical macroeconomics, hold that countercyclical policies may be counterproductive or destabilizing, and therefore favor a laissez-faire fiscal policy as a better method for maintaining an overall robust economy. When the government adopts a countercyclical fiscal policy in response to a threat of recession the government might increase infrastructure spending.

Business cycle theory

Procyclical

In business cycle theory and finance, any economic quantity that is positively correlated with the overall state of the economy is said to be procyclical. That is, any quantity that tends to increase in expansion and tend to decrease in a recession is classified as procyclical. Gross Domestic Product (GDP) is an example of a procyclical economic indicator. Many stock prices are also procyclical because they tend to increase when the economy is growing quickly.

Countercyclical

Conversely, any economic quantity that is negatively correlated with the overall state of the economy is said to be countercyclical. That is, quantities that tend to increase when the overall economy is slowing down are classified as ‘countercyclical’. Unemployment is an example of a countercyclical variable.[4] Similarly, business failures and stock market prices tend to be countercyclical. In finance, an asset that tends to do well while the economy as a whole is doing poorly is referred to as countercyclical, and could be for example a business or a financial instrument whose value is derived from sales of an inferior good.

Fiscal Policy is changing the government’s budget to influence aggregate demand. i.e., changing taxes and spending.

These are intentional government policies to increase or decrease government spending or taxation. For example, Keynesian economists might favour a deliberate increase in the size of the fiscal deficit when private sector demand and confidence is low during an economic recession.

Discretionary fiscal policy means the government make changes to tax rates and or levels of government spending. For example, cutting VAT in 2009 to provide boost to spending.

Expansionary fiscal policy is cutting taxes and/or increasing government spending. Lower taxes increase disposable income and in theory, should encourage people to spend.

Discretionary fiscal policy is different to automatic fiscal stabilisers. Automatic stabilisers occur where in a recession a government automatically spends more because there are more claiming unemployment benefits. However, the government may feel these automatic stabilisers are insufficient and so they decide to increase public work spending schemes too.

Types

There are two types of discretionary fiscal policy. The first is expansionary fiscal policy. It’s when the federal government increases spending or decreases taxes. When spending is increased, it creates jobs. It happens directly through public works programs or indirectly through contractors. Spending on public works construction is one of the four best ways to create jobs.

Job creation gives people more money to spend, boosting demand. According to Keynesian economic theory, that increases economic growth.

Supply-side economics says that a tax cut is the best way to stimulate the economy. Stronger economic growth will make up for the government revenue lost. That’s because it generates a larger tax base. But tax cuts only work if taxes were high in the first place. According to the underlying economic theory, the Laffer Curve, the highest tax rate must be above 50% for supply-side economics to work. Tax cuts are not the best way to create jobs.

Expansionary fiscal policy creates a budget deficit. This is one of its downsides. It’s because the government spends more than it receives in taxes. Often there’s no penalty until the debt-to-GDP ratio nears 100%. At that point, investors start to worry the government won’t repay its sovereign debt. They won’t be as eager to buy Treasurys or other sovereign debt. They will demand higher interest rates. This makes the debt even more expensive to pay back. It can create a downward spiral. For example, look at the Greek debt crisis.

Contractionary fiscal policy is when the government cuts spending or raises taxes. It slows economic growth. A spending cut means less money goes toward government contractors and employees. That then reduces job growth.

Discretionary fiscal policy should work as a counterweight to the business cycle. During the expansion phase, Govt. should cut spending and programs to cool down the economy. If done well, the reward is an ideal economic growth rate of around 2% to 3% a year.

In economics, tax incidence or tax burden is the effect of a particular tax on the distribution of economic welfare. Economists distinguish between the entities who ultimately bear the tax burden and those on whom tax is initially imposed. The tax burden measures the true economic weight of the tax, measured by the difference between real incomes or utilities before and after imposing the tax, taking into account how the tax leads prices to change. If a 10% tax is imposed on sellers of butter, for example, but the market price rises 8% as a result, most of the burden is on buyers, not sellers. The concept of tax incidence was initially brought to economists’ attention by the French Physiocrats, in particular François Quesnay, who argued that the incidence of all taxation falls ultimately on landowners and is at the expense of land rent. Tax incidence is said to “fall” upon the group that ultimately bears the burden of, or ultimately suffers a loss from, the tax. The key concept of tax incidence (as opposed to the magnitude of the tax) is that the tax incidence or tax burden does not depend on where the revenue is collected, but on the price elasticity of demand and price elasticity of supply. As a general policy matter, the tax incidence should not violate the principles of a desirable tax system, especially fairness and transparency.

1. The Nature of a Tax:

The nature of a tax as to whether it is a tax on the production or sale of some commodities or it is a personal income or property tax. Tax shifting can easily take place in the case of taxes on the production and sale of commodities. The taxes on pro­duction or sale of commodities are called indirect taxes. The important examples of indirect taxes are excise duties and sales tax. On the other hand, the burden of direct taxes such as income and wealth taxes cannot be shifted.

2. Market Conditions:

Whether commodity is being produced under conditions of perfect competition, monopolistic competition or monopoly goes to determine the extent to which the burden of the tax can be shifted. A monopolist who has a full control over the supply of a commodity is in a better position to shift the burden of a tax on the commodity produced.

Likewise, a producer working under monopolistic competition who produced a product somewhat different from others exercises a good deal of influence over the price of its product and therefore can pass on a part of the burden of the tax to the buyers.

Even the firms working under perfect competition can shift the tax burden as the tax levied on a commodity raises its supply price for all of them. The difference in the three market forms lies in the extent to which the burden of the tax can be shifted.

3. Physical Conditions of Production:

The shifting of the tax burden on a commodity also depends upon whether the commodity is being produced under increasing, constant or diminishing returns. This will be explained in detail a little later.

Factors Determining Incidence of Indirect (Commodity) Taxes:

The questions of tax shifting especially arise in the case of indirect taxes, that is, taxes on the production and sale of goods such as excise duties and sales tax. In this regard, whether and to what extent a tax on commodity can be shifted depends on the price elasticity of demand for and supply of a commodity.

It is these elasticity’s of demand and supply that determine the bargaining strengths of the sellers and buyers of the taxed commodity. Sellers can shift the tax burden to the buyers if they are able to re­duce the supply of the commodity and thereby raise its price.

Thus, the power to shift the tax depends on the elasticity of supply of the taxed commodity. The elas­ticity of reducing supply of a commodity will be relatively smaller if there is excess capacity in the industry producing it. Fur­ther, the elasticity of supply of a commod­ity will be larger in the long run than in the short run.

Apart from the elasticity of supply, power to transfer the tax burden depends on the-elasticity of demand for a commod­ity. The greater the elasticity of demand of the buyers, the smaller the extent to which the tax will be shifted to them.

1. Elasticity of Demand:

Elasticity of demand affects the shifting process. If the taxed com­modity is having perfectly elastic demand price cannot be raised at all.

Hence the incidence will be wholly on the seller. On the other hand, when the demand is perfectly inelastic, the incidence will be wholly on the buyer. In between these two extremes, the incidence of tax will be shared by the buyer and seller.

2. Elasticity of Supply:

Price is determined by the interaction between demand and supply of a commodity. Hence incidence of a tax will be fully borne by the buyer, when the taxed commodity is having perfectly elastic supply. Likewise, when the supply of a commodity is perfectly inelastic, the whole incidence will be on the seller.

3. Price acts an Engine of Shifting:

Price act as a media of shifting. It is the vehicle, which carries money burden of tax from the point of view of legal liability. If the tax is shifted through a raise in price, it is called forward shifting. If the price cannot be rise, tax cannot be shifted. Hence the character of price flexibility is the most important factor that determines the shift- ability of a tax.

4. Tax Area:

The nature of the area in which the tax is imposed also affect shifting of a tax. If the tax is imposed on a commodity, having local market, it will be difficult to shift the tax by raising the price.

In such a case, people can avoid the tax by purchasing a commodity from neighborhood market, where it is cheap. This also gives rise to smug­gling of commodities from non-tax levying locality to avoid taxes.

5. Time Period:

Time factor influence the shift ability of a tax. In the short period supply is inelastic. Hence, during this period greater part of tax bur­den will be borne by the seller.

In the long-run, supply is more elastic. Hence, there is a better scope for shifting tax burden upon the buy­ers. Therefore, in the short period, shifting of a tax is difficult, where as in the long period it is easy to do.

6. Coverage of Tax:

If the tax is general in character, falling on wide range of commodi­ties, it is easy to shift the burden.

For example, if the tax levied on tooth paste is general in nature, covering all brands and kinds, it will be readily shifted.

However, if a tax is imposed on one brand of tooth paste, excluding the other brands, it is not possible to shift the tax burden. So we can say that shifting of a tax is rendered easier in general tax than in non-general taxes.

7. Availability of Substitutes:

Taxes imposed on a commodity having no close substitutes, can be easily shifted to the buyer. Here the buyer cannot find an alternative product as substitute to satisfy his demand.

Hence, he will be ready to purchase the taxed commodity by giving higher prices. On the other hand, if the taxed product has close substitute, shifting the money burden to buyers, is difficult.

Any rise in price due to tax will be opposed by the buyer, and he will go for the non-taxed substi­tutes. So the seller will himself bear the burden of tax, instead of attempting to shift it.

8. Nature of Demand for Commodities:

By this, we mean whether the taxed commodity is falling under the category of necessaries, comforts or luxuries. The nature of demand is different for different commodities. In the case of necessary goods, demand is inelastic.

Hence the burden of tax is higher upon the buyer, than on seller. In the case of comforts, demand is more elas­tic, hence burden of tax will be divided between buyer and seller. Coming to the case of luxuries, demand is elastic. Hence the bur­den of tax is more on the seller. It cannot be easily shifted to the consumers.

9. Business Conditions:

Shifting of a tax is influenced by the existing business condition in the economy. During periods of rising prices and economic prosper­ity, taxes can be shifted more easily. However, during periods of depression, forward shifting of tax liability is very difficult. Depres­sion is a situation of falling prices. Seasonal changes also will affect the shifting of tax.

10. Types of Tax:

Shifting depends upon nature or type of tax imposed. If a tax is imposed on the excess profits of a firm under monopoly or imperfect competition, the incidence will not be shifted. On the other hand, if the tax is levied on the output of the firm, a part of incidence can be shifted on to the consumers.

11. The Policy of the Government:

Shift ability of a tax is determined by the tax laws and public policy. In India, a tax law clearly indicates the price to be charged and to be printed on the product cover. For example, sales tax legislation stipu­lates that the burden of sales tax is to be borne by the consumers.

Likewise, government fixes maximum retail price and through law makers it binding to print it on the product. Then those who charge higher prices are legally punished. Hence, whenever a tax is im­posed the law abiding citizen will pay it rationally.

On the other hand, if prices are increased due to the attempt to shift some taxes to be paid by the seller, awareness of tax laws helps the consumer to resist it.

12. Market Conditions:

Shifting of a tax is influenced by the conditions of market for the product taxed.

The theory of shifting can be analyzed under:

(a) Per­fection competition,

(b) Monopoly, and

(c) Monopolistic competition.

(a) Shifting Under Perfect Competition:

Given the assumptions of perfect competition, the price is deter­mined by the interaction of demand and supply. The demand curve faced by each firm is perfectly elastic. Hence, a tax imposed cannot be shifted forward by increasing the price of the taxed commodity.

Likewise, the tax cannot be shifted backward because the supply of the factors is also perfectly elastic. However, the incidence of tax can be shifted in the long-run by reducing the supply and thereby raising the price of the commodity.

Moreover, if the taxed commodity is perishable, its supply curve is perfectly inelastic and the entire tax burden will be borne by the sellers. If the taxed commodity is of durable nature, the entire tax burden can be shifted forward to the buyers.

(b) Shifting under Monopoly:

Under conditions of monopoly, a tax on the monopolist will certainly increase the cost of production. But the incidence sharing between the monopolists and consumers will depend upon the respective elasticity of demand and supply of the commodity produced by the monopolist.

Theoretically, the profit will be at the maximum, when marginal revenue equals marginal cost and price is higher than ei­ther. Any tax on the monopolist which raises his marginal cost would cause him to reduce his output and raise his price.

The extent to which the monopolist would succeed in shifting the burden of a tax depends on three factors.

They are:

(1) The nature of the tax

(2) The nature of the demand for the article

(3) The cost condition under which production takes place.

If a tax is levied upon profit or sales, the monopolists cannot shift the burden on to the consumers. This is because the position of costs and revenue curves cannot be changed according to his favour.

If the taxed commodity is having inelastic demand, the entire burden of tax will fall on con­sumers. Contrary, if the demand for the taxed commodity is elastic, the entire burden of tax will fall on monopolies.

Likewise if the supply of monopolist product is inelastic, the burden of tax will fall on the monopolist. If supply is elastic, the entire burden of tax will be on the consumer. On the other hand if the demand for the monopolist prod­uct is more elastic than its supply, the burden of tax will fall more on the monopolist, than on consumers.

In a situation, when demand is less elastic than its supply, the monopolist will bear less burden of tax than the consumers. A monopolist can be taxed in three differ­ent ways. A tax can be imposed, proportionate to output, a tax can be imposed independent of output produced or a tax can be im­posed which diminish with an increase in output.

When the tax is independent of production and is levied on profit, it is difficult to shift. The output before the levy of tax would have been adjusted, to yield the minimum profit. The monopolist may have a greater profit after paying the tax by leaving the price unchanged.

When a tax is im­posed in proportion to output, a partial shifting of the tax is possible, as it increases the marginal cost of the monopolists firm. When the tax diminishes with the increase in output, the monopolist will in­crease his output and reduce the price of the commodity, produced by him. In this case the monopolist will bear the entire burden of the tax.

Any definite conclusion cannot be arrived at in the matter of the shifting of the tax under monopoly conditions. The reason is that, perfect monopoly is a very rare phenomenon. Moreover, the mo­nopolist usually will not charge the theoretical monopoly price.

The monopolist will always fix a price lower than this level, owing to the threat of governmental intervention or emergence of competitive ele­ment.

(c) Shifting Under Monopolistic Competition:

Monopolistic competitions is characterized by few firms in produc­tion arena, existence of product differentiation and a situation in which price is determined by the price leaders. In such markets one or two firms may act as the price leaders.

Hence if a tax imposed, affects the cost of production of the price setters, burden can be shifted to the consumers, if the demand for the product is inelastic. However, if the imposition of tax affects the cost of production of only small firms, it cannot be easily shifted to the consumers.

Here the small firms are bound to follow the price determined by the price leaders. Hence small firms have to bear the tax burden. But the process of shifting in its ultimate analysis will be determined by the elasticities of demand and supply of taxed commodity.

(d) Shifting Under Different Cost Conditions:

Commodities can be produced under decreasing, increasing or con­stant cost conditions. The nature of the cost condition also influences the shifting of a tax.

(i) Decreasing cost condition:

If costs are decreasing, any decline in demand and consequent reduction in output will increase cost per unit. If under this condition, a tax is imposed on the producer and the producer attempting to shift the burden by raising the price, the demand for his product will decline and the cost per unit will rise. In that case, price will have to be raised by more than the amount of the tax, to cover increase in cost resulting from output restriction.

(ii) Increasing Cost:

If costs are increasing, a decline in output will lower cost per unit. A tax imposed under this condition, will raise the price of the commodity by an amount less than the amount of tax. As such, only a part of the tax burden will be shifted to the buyers.

This happen because imposition of a tax, will reduce the demand for the taxed commodity. Consequently, supply will have to be reduced. This reduction in supply leads to lower average cost.

(iii) Constant cost:

If a tax is shifted under constant cost conditions, price will rise exactly by the amount of the tax. However, fall in output will vary according to the nature of demand. The supply curve under constant cost condition will be perfectly elastic and as such price will rise to the full amount of the tax. In this situa­tion, entire burden will fall on consumers.

The demand and supply theory of tax shifting is abstract and is entirely based on deductive reasoning. Observations and experimen­tation were never used to approve or disapprove the theory.

The theory ignores the effect of government expenditure. Public expenditure is an important macroeconomic variable affecting the shifting of tax. However, the effects of government expenditure are complicated and very difficult to measure.

Moreover, the demand and supply theory of tax shifting consti­tute only a part of the general theory of value. The modern industrial productive sector is a combination of competitive and monopolistic practices.

Moreover, government function has embraced different economic spheres. Government’s role in development activities of the economy, provision of public goods, price control and other regu­latory measures do affect the working of the price system.

A com­prehensive theory of shifting alone can take into consideration, all these factors influencing the economy. Hence the demand and sup­ply theory cannot be considered as full-fledged incidence theory.

The theory also does not take into consideration the indirect money burden arising from the imposition of a tax. For a balanced analysis of the effect of tax, both direct and indirect money burden should be taken into consideration.

In this sense, the theory is one sided. Shifting power depend upon strength of bargaining power of sellers and buyers. The theory has given insufficient weightage to the strategic factor like bargaining power.

A theory of tax shifting cannot be considered comprehensive and complete unless the above said factors are duly considered in the analysis. In spite of these limitations, the demand and supply theory of incidence is the best available tool to analyses the inci­dence problem in taxation.

Fiscal responsibility implies a government pursues the appropriate level of government spending and tax to:

• Maintain sustainable public finances.
• Ensure fiscal policy aids the optimal rate of economic growth.
• Maintain appropriate levels of public investment.

This means that if the economic cycle is at a stage of ‘normal growth’ then government tax receipts must be greater than government spending. If a government is running a budget deficit, then it will be forced to cut spending or increase taxes to meet the shortfall.

The Fiscal Responsibility and Budget Management Act, 2003 (FRBMA) is an Act of the Parliament of India to institutionalize financial discipline, reduce India’s fiscal deficit, improve macroeconomic management and the overall management of the public funds by moving towards a balanced budget and strengthen fiscal prudence. The main purpose was to eliminate revenue deficit of the country (building revenue surplus thereafter) and bring down the fiscal deficit to a manageable 3% of the GDP by March 2008. However, due to the 2007 international financial crisis, the deadlines for the implementation of the targets in the act was initially postponed and subsequently suspended in 2009. In 2011, given the process of ongoing recovery, Economic Advisory Council publicly advised the Government of India to reconsider reinstating the provisions of the FRBMA. N. K. Singh is currently the Chairman of the review committee for Fiscal Responsibility and Budget Management Act, 2003, under the Ministry of Finance (India), Government of India.

Enactment

The Fiscal Responsibility and Budget Management Bill (FRBM Bill) was introduced in India by the then Finance Minister of India, Mr.Yashwant Sinha in December 2000.

• Firstly, the bill highlighted the terrible state of government finances in India both at the Union and the state levels under the statement of objects and reasons.
• Secondly, it sought to introduce the fundamentals of fiscal discipline at the various levels of the government.

The FRBM bill was introduced with the broad objectives of eliminating revenue deficit by 31 March 2006, prohibiting government borrowings from the Reserve Bank of India three years after enactment of the bill, and reducing the fiscal deficit to 2% of GDP (also by 31 March 2006). Further, the bill proposed for the government to reduce liabilities to 50% of the estimated GDP by year 2011. There were mixed reviews among economists about the provisions of the bill, with some criticising it as too drastic. Political debate ensued in the country. Several revisions later, it resulted in a much relaxed and watered-down version of the bill (including postponing the date for elimination of revenue deficit to 31 March 2008) with some experts, like Dr Saumitra Chaudhuri of ICRA Ltd. (and now a member of Prime Ministers’ Economic Advisory Council) commenting, “all teeth of the Fiscal Responsibility Bill have been pulled out and in the current form it will not be able to deliver the anticipated results.” This bill was approved by the Cabinet of Ministers of the Union Government of India in February, 2003 and following the due enactment process of Parliament, it received the assent of the President of India on 26 August 2003. Subsequently, it became effective on 5 July 2004. This would serve as the day of commencement of this Act.

Objectives

The main objectives of the act were:

• To introduce transparent fiscal management systems in the country
• To introduce a more equitable and manageable distribution of the country’s debts over the years
• To aim for fiscal stability for india in the long run

Additionally, the act was expected to give necessary flexibility to Reserve Bank of India for managing inflation in India.

Fiscal management principles

The Central Government, by rules made by it, was to specify the following:

• A plan to eliminate revenue deficit by 31 March 2008 by setting annual targets for reduction starting from day of commencement of the act.
• Reduction of annual fiscal deficit of the country
• Annual targets for assuming contingent liabilities in the form of guarantees and the total liabilities as a percentage of the GDP

Features of the FRBM Act

• It was mandated by the act that the following must be placed along with the Budget documents annually in the Parliament:
• Macroeconomic Framework Statement
• Medium Term Fiscal Policy Statement and
• Fiscal Policy Strategy Statement
• It was proposed that the four fiscal indicators i.e, revenue deficit as a percentage of GDP, fiscal deficit as a percentage of GDP, tax revenue as a percentage of GDP, and total outstanding liabilities as a percentage of GDP be projected in the medium-term fiscal policy statement.

Solvency, in finance or business, is the degree to which the current assets of an individual or entity exceed the current liabilities of that individual or entity. Solvency can also be described as the ability of a corporation to meet its long-term fixed expenses and to accomplish long-term expansion and growth. This is best measured using the net liquid balance (NLB) formula. In this formula solvency is calculated by adding cash and cash equivalents to short-term investments, then subtracting notes payable.

According to the classical economists, however, fiscal policy should have the minimum range of operations and the budget should be balanced annually. They firmly stuck to the doctrine of laissez faire and Say’s law of markets. As such, they believed that when supply creates its own demand, general overproduction or involuntary unemployment is well-nigh impossible.

According to Adam Smith, economic equilibrium and progress are attained through inherent and self-oriented endogenous forces of the economic system. In classical opinion, thus, when full employment is supposed to reach automatically, productivity of government services in the economic field is nil.

And, since government services are rendered at the cost of the national product (because any government spending causes transfer of resources from the private sector to the government thereby causing reduction in the output of private enterprises), it amounts to a cut in the aggregate national product.

Thus, when government’s productivity is zero in a free enterprise economy, it is desirable that government confines itself only to its primary functions of protection and security of life and property and does not interfere with the free working of the economic system.

Even if government efforts are productive, it cannot increase national income and level of economic activity above the level reached without its intervention. Thus, when full employment, optimal allocation of resources and equitable distribution can be achieved automatically through the operation of free economic forces, fiscal operations have to be of a non-regulatory, non-interfering nature.

As such, the smallest budget was considered to be the best in the classical era. Further, the classicists condemned all budget deficits which necessitated borrowing by the government, for they led to inflation and even if they did not, they caused reduction in the accumulation of private capital (because, the resources in private hands were depleted due to government borrowings), thus, inhibiting the rate of progress.

As such, classicists firmly advocated a balanced budget, in the sense that current annual revenue and expenses of the government must be equal. It, thus, does not provide for borrowings. The balanced budget principle was thus recognised as a principle of sound finance in orthodox economics.

Under the theory of sound finance, classicists favoured a balanced budget criterion for the following reasons:

(i) If the budget is unbalanced, the government has to borrow. The government’s market borrowings cause reduction in loanable funds available to private productive employment and investment activities.

(ii) Unbalanced budgets imply a wide extension of state functions beyond the capacity of the government, which may invite irresponsible governmental action.

(iii) Unbalanced budgets may generate inflation on account of large and unproductive public expenditure.

(iv) A balanced budget, on the other hand, is a limited budget designed in a rational way.

(v) Economic stability is secured by the adoption of a balanced budget policy. Unbalanced budgets, on the other hand, cause economic uncertainty and promote instability.

(vi) A series of unbalanced budgets imply an increase in the burden of public debt.

Furthermore, when the public debts mature, the government will have to impose additional taxes to obtain resources for their repayment. Thus, additional taxation would again tend to have an adverse effect on the incentive to work and save. It would also cause the accentuation of income distribution.

Moreover, government borrowings cause the rate of interest in the money market to rise, as the demand for loanable funds rises. A rise in the rate of interest adversely affects investment activity in the private sector.

In short, according to the principles of sound finance, a budget must be balanced annually and the gap between. revenue and expenditure should be minimum. That is, a government should tax the least and spend the least, and it should not resort to borrowing as far as possible.

Thus, classical economists firmly advocated a laissez faire policy and were confident of the unhampered optimum operations of the free enterprise economic system. Neo-classical economists however, realized the socially undesirable effects of unregulated free enterprise on the economic system.

Marshall stated that in conditions of laissez faire, maximum social advantage is hardly realized. It was argued that careful state action for raising income and public spending was essential to attain maximum social welfare under the concept of welfare state developed in the neo-classical era.

Under the welfare state criterion, it was accepted that the state should take up the responsibility of correcting the misallocation of resources guided by private profit motive. The state has, therefore, to discourage private investment in certain sectors of the economy through fiscal restrictions and encourage private as well as public investment in essential sectors through appropriate public spendings. Pigou and Marshall, in this regard, favoured equimarginal social sacrifice and benefits as essential in the government budget.

The concept of fiscal policy, however, received a new vista with the inception of “new economics” (Keynesian economics) in modern times. Keynesian theory shattered the basic foundations of the classical doctrine when the former asserted that the competitive process of free enterprise economy does not necessarily ensure an effective demand such as to absorb all productive resources at full employment, supply does not create its own demand and the economy may attain equilibrium at underemployment level.

Unemployment may persist due to secular forces causing under-consumption and over-saving in an advanced economy, thereby creating a condition of plenty in the midst of poverty on account of deficiency of aggregate demand. Keynes, therefore, regarded the inevitability of a positive fiscal policy as follows.

At a level of income corresponding to full employment, the gap between total income and total consumption is so high in a mature economy that private investment is inadequate to fill it. If unemployment is to be avoided, the gap must be filled either by government expenditure or by increasing the propensity to consume.

But, in a capitalist economy, which is characterized by wide inequalities in the distribution of income and other institutional factors which make for a high propensity to save, the propensity to consume cannot easily be raised enough to have a significant effect on employment.

Therefore, the chief responsibility for maintaining high levels falls on the public sector expenditure, designed to narrow the gap between income and consumption at full employment. Further, in Keynes’ view, a depression in an advanced industrial economy occurs due to the deficiency of aggregate demand.

Thus, during a depression, when the aggregate spending is inadequate to achieve full employment, the government must increase spending directly by undertaking public works programmes on a large scale and indirectly by inducing people to spend more.

In short, the Keynesian fiscal policy for attaining full employment implies a technique by which total outlay in manipulated, i.e., when private outlays are deficient, public outlays should be increased which ensures the full use of economic resources available in the country.

Functional finance

Though the lead in the development of “functional finance” concept was taken by Keynes, credit goes to Prof. A.P. Lerner for coining this concept. Lerner puts that: The principle of judging fiscal measures by the way they work or function in the economy, we may call functional finance.

He contends that the fiscal operation of the government — taxing, borrowing; public spending, management of public debt, etc., deficit financing, etc. — should be designed with the objective of fulfilling certain functions which have an immediate bearing and far-reaching effects on the economic system as a whole.

In economic philosophy, the term functional finance embraces public expenditure, public revenue and debt management which were regarded as fiscal instruments effectively used to achieve objectives like attainment and maintenance of full employment with economic stability.

As Prof. Chelliah points out, the functional concept of fixed policy, thus, implies that:

(i) the fiscal operations of the government should be conducted on a functional basis and public finance should not be considered as being induced solely by the need for securing social goods meant for collective consumption

(ii) the budget need not always be balanced. As a matter of fact, the fiscal norm of functional finance is the complete antithesis of the orthodox rule of balanced budget. The functional finance norm suggests the formation of large budgets with a wider functional coverage of government spending to promote basic economic goals, e.g., (a) to obtain optimal allocation and efficient use of scarce resources at full-employment level, (b) to achieve economic stability and bring about an equitable distribution of income and wealth in the best possible manner.

Quite contrary to the classical notion, the concept of functional fiscal policy suggests that the state need not and should not assume a passive role in the economic affairs of the country.

It implies that public spending may be incurred not merely for the sake of its direct benefits, but for the sake of indirect effect it produces in raising the level of income, output and employment; and the public revenue may be raised not to meet an anticipated expenditure, but to curtail excessive demand and curb inflationary potentials in the economy. Taxation is, thus, regarded as an important and effective weapon in the hands of government to promote economic progress with stability.

Lerner suggests the following rules for government’s responsibility and activity under functional finance:

(i) The government budget should be directed towards the achievement of full employment and price stability. For this purpose, the government budget need not necessarily be balanced.

(ii) The government should incur public debt by borrowing money from the private sector only during inflation when it is, absolutely essential to mop up the excessive purchasing power from the public, thereby reducing the pressure of excess monetary demand.

(iii) During depression only, public expenditure in excess of current public revenue may be met by deficit financing, i.e., printing additional currency notes.

In short the main tenet of functional finance is the formation of unbalanced budget from time to time for perfecting the counter-cyclical goal of fiscal policy. A surplus budget is recommended during inflation and a deficit budget for recovery through excessive public spending during a deflation or depression.

Functional finance, thus, deliberately aims at unbalancing the budgets with a view to attaining and maintaining full employment level in a developed economy. In an underdeveloped economy, however, the main problem is not one of full employment but that of rapid economic growth. In a developing economy, thus, the functional aspect of fiscal policy is to be conceived in the context of a planned process of economic development.

Public Debt refers to “Obligation of Government particularly those evidenced by securities, to pay certain sums to the holders at some future date.

In simple words, Public Debt can be defined as the amount of debt taken by government from internal as well as external sources to meet out its deficit. Government needs to borrow when current revenue falls short of public expenditure.

Government debt, also known as public interest, public debt, national debt and sovereign debt, contrasts to the annual government budget deficit, which is a flow variable that equals the difference between government receipts and spending in a single year. The debt is a stock variable, measured at a specific point in time, and it is the accumulation of all prior deficits.

Government debt can be categorized as internal debt (owed to lenders within the country) and external debt (owed to foreign lenders). Another common division of government debt is by duration until repayment is due. Short term debt is generally considered to be for one year or less, and long-term debt is for more than ten years. Medium term debt falls between these two boundaries. A broader definition of government debt may consider all government liabilities, including future pension payments and payments for goods and services which the government has contracted but not yet paid.

Governments create debt by issuing government bonds and bills. Less creditworthy countries sometimes borrow directly from a supranational organization (e.g. the World Bank) or international financial institutions.

1. Internal and External Debt:

Public loans floated within the country are called internal debt. Public borrowings from other countries are referred as external debt. External debt represents a claim of foreigners against the real income (GNP) of the country, when it borrows from other countries and has to repay at the time of maturity.

External public debt permits import of real resources. It enables the country to consume more than it produces.

The following points of distinction between internal and external debts are noteworthy:

1. An internal loan may be voluntary or compulsory, but an external loan is normally voluntary in nature. Only in the case of a colony, an external loan can be raised by compulsion.
2. An internal loan is controllable and can be estimated before hand with certainty, while external loans are always uncertain and cannot be estimated so confidently. Its realisation is very much conditioned by international politics and foreign policies of the lending government.
3. Internal loan is in terms of the domestic currency, while external loans are in terms of foreign currencies.

An important feature of external debt is, that usually foreign exchange resources of the borrowing country increase when the loans are received in terms of foreign currencies. But, when there is repayment of such loans, i. e., debt servicing charges, foreign exchange reserve is depleted to that extent.

Sometimes, however, external loans are repayable in the borrowing country’s domestic currency, so that foreign exchange resources are least affected. For instance, in the post-independence period India received loans from U.S.A. under P.L. 480, which were repayable in Indian rupees.

Since under internal debts, borrowing takes place within the country, the availability of total resources does not arise. Simply the resources are transferred from the bond-holders individuals and institutions to the public treasury, and the government can spend, these for public purposes.

Similarly, payment of interest for repayment of principal of internal loans would transfer resources from tax-payers to bond-holders. An internally- held public debt, thus, represents only a commitment to effect a certain transfer of purchasing power among the people within the country. It has, therefore, no direct net money burden as such. It amounts to only a redistribution of income in the community from one section to the other.

External debt, on the other hand, leads to a transfer of wealth from the lender nation to the borrower nation. When the loan is made through the means of external loans the resources available to the borrowing nation increase.

However, when a foreign loan is repaid or interest is paid on such loans, there would be a transfer of resources from the debtor to the creditor countries, causing a decline in total resources of the debtor country.

The Structure of the Internal Public Debt:

The structure of the internal public debt may be constituted by various types of loan instruments/obligations of the government. It may be classified as follows:

In particular, for instance, the government of India’s debt obligations includes:

(1) Dated and non-terminable Rupee loans consisting:

(a) Marketable long-term loans including the portion subscribed by the State Bank of India out of the rupee counterpart funds;

(b) Dated loans issued by the Government to the Reserve Bank of India in exchange for ad hoc Treasury Bills outstanding; and

(c) Miscellaneous debt such as the Prize Bonds issued in 1961.

(2) Treasury Bills: The short-term issues (90/ 180 days) of the Government in order to bridge the gap between revenue and expenditure.

(3) Small Savings: A non-inflationary means of finance effectuated/tapped through instruments such as Post Office Savings Bank Deposits, Cumulative Time Deposits, Post Office Recurring Deposits, National Defence Certificates, 15-year Annuity Certificates, National Savings Certificates, National Savings Annuity Scheme, National Development Banks, National Savings Account, Indira Vikas Patra, Kisan Vikas Patra.

(4) Other miscellaneous obligations of the Central Government constituting the internal public debt in India are: Compulsory Deposit Scheme, Gold Bonds, Public Provident Funds, and items of unfunded debts and special securities issued to the United States Embassy for the Rupee Counterpart funds since 1961, unclaimed balance of State Provident Funds, and other accounts such as General Family Pension Fund, the Hindu Family Annuity Fund, the Postal Insurance, Life Insurance, Life Annuity Fund, etc. and unclaimed balance in respect of three-year Interest-free Prize Bonds.

2. Productive and Unproductive Debt:

Public debt is said to be productive or reproductive, when government loans are invested in productive assets or enterprises such as railways, irrigation, multipurpose projects etc., which yield a sufficient income to the public authority to pay out annual interest on the debt as well as help in repaying the principal in the long run.

As such, a productive public debt is self-liquidating in nature; so the community experiences no net burden of such debt.

An unproductive debt, on the other hand, is one which does not add to the productive assets of a country. When the government borrows for unproductive purposes like financing a war, or for lavish expenditure on public administration, etc., such public loans are regarded as unproductive.

Unproductive loans do not add to the productive capacity of the economy, so they are not self-liquidating. Unproductive public loans thus cast a net burden on the community, as for their servicing and repayment purpose, government will have to resort to additional taxation.

3. Compulsory and Voluntary Debt:

When government borrows from people by using coercive methods, loans so raised are referred to as compulsory public debt. Under the Compulsory Deposit Scheme in India, tax-payers have to compulsorily deposit a prescribed amount and defaulters are punished. This is a case of compulsory debt.

Usually, public borrowings are voluntary in nature. When the government floats a loan by issuing securities, members of the public and institutions like commercial banks may subscribe to them.

4. Redeemable and Irredeemable Debts:

On the criterion of maturity, public debts may be classified as redeemable or irredeemable. Loans which the government promises to pay off at some future date are called redeemable debts. For redeemable debts, the government has to make some arrangement for their repayment. They are, therefore, terminable loans.

Whereas loans for which no promise is made by the government regarding the exact date of maturity, and all that the government does is to agree to pay interest regularly for the bonds issued, are called irredeemable debts.

Their maturity period is not fixed. They are generally of a long duration. Under such loans, society is burdened with a perpetual debt, as tax-payers would have to pay heavily in the end. Therefore, redeemable debts are preferred on grounds of sound finance and convenience.

5. Short-term, Medium-term and Long-term loans:

According to their duration, redeemable loans may further be classified as short-term, medium-term or long­-term debts. Short-term debts mature within a short period say, of 3 to 9 months. For instance, Treasury Bills are an instrument of credit extensively used as a means of short-term (usually 90 days) borrowing by the government, generally, for covering temporary deficits in the budgets. Interest rates on such loans are generally low.

Long-term debts, on the other hand, are those repayable after a long period of time, generally, ten years or more. For development finance, such loans are usually raised by the government. Long-term loans usually bear a high rate of interest.

Similarly, loans of medium-term (in between short-term and long-term) are floated by the government, bearing intermediate interest rates. For war finance, or to meet expenditure on education, health, relief work, etc., such loans are generally preferred.

6. Funded and Unfunded Debt:

Funded debt is, in fact, a long-term debt, exceeding the duration of at least a year. It comprises securities which are marketable on the stock exchange. Funded debt in its proper sense is, however, an obligation to pay a fixed sum of interest, subject to the option of the government to repay the principal. In such debts, the creditor bond-holder has no right to anything but the interest.

Unfunded debts, on the other hand, are for a comparatively short duration. They are generally redeemable within a year. Unfunded debts are, thus, incurred always in anticipation of public revenue, a temporary measure to meet current needs.

Public finance deals with the question how the Government raises its resources to meet its ever-rising expenditure. As Dalton puts it,” public finance is “concerned with the income and expenditure of public authorities and with the adjustment of one to the other.”

Accordingly, effects of taxation, Gov­ernment expenditure, public borrowing and deficit financing on the economy constitutes the subject matter of public finance. Thus, Prof. Otto Eckstein writes “Public Finance is the study of the effects of budgets on the economy, particularly the effect on the achievement of the major economic objects growth, stability, equity and efficiency.”

Further, it also deals with fiscal policies which ought to be adopted to achieve certain objectives such as price stability, economic growth, more equal distribution of income. Economic thinking about the role that public finance is expected to play has changed from time to time according to the changes in economic situ­ation.

Before the Great Depression that gripped the Western industrialised countries during the thirties, the role of public finance was considered to be raising sufficient resources for carrying out the Government functions of civil administration and defence from foreign countries. During this period, the classical economists considered it prudent to keep expenditure to the minimum so that taxing of the people is avoided as far as possible.

Further, it was thought that Government budget must be balanced. Public borrowing was recommended mainly for production purposes. During a war, of course, public borrowing was considered legitimate but it was thought that the Government should repay or reduce the debt as soon as possible.

Economists have a strict definition of a public good, and it does not necessarily include all goods financed through taxes. To understand the defining characteristics of a public good, first consider an ordinary private good, like a piece of pizza. A piece of pizza can be bought and sold fairly easily because it is a separate and identifiable item. However, public goods are not separate and identifiable in this way.

Even though new technology typically creates positive externalities through which one-third to one-half of the social benefit of new inventions spills over to others, the inventor still receives some private return. But what about a situation where the positive externalities are so extensive that private firms could not expect to receive any of the social benefit? This kind of good is called a public good.

Instead, public goods have two defining characteristics: they are nonexcludable and nonrivalrous. The first characteristic, that a public good is nonexcludable, means that it is costly or impossible to exclude someone from using the good. If Larry buys a private good like a piece of pizza, then he can exclude others, like Lorna, from eating that pizza. However, if national defense is being provided, then it includes everyone. Even if you strongly disagree with America’s defense policies or with the level of defense spending, the national defense still protects you. You cannot choose to be unprotected, and national defense cannot protect everyone else and exclude you.

The second main characteristic of a public good that it is nonrivalrous means that when one person uses the public good, another can also use it. With a private good like pizza, if Max is eating the pizza, then Michelle cannot also eat it it the two people are rivals in consumption. With a public good like national defense, Max’s consumption of national defense does not reduce the amount left for Michelle, so they are nonrivalrous in this area.

A number of government services are examples of public goods. For instance, it would not be easy to provide fire and police service so that some people in a neighborhood would be protected from the burning and burglary of their property, while others would not be protected at all. Protecting some necessarily means protecting others, too.

Positive externalities and public goods are closely related concepts. Public goods have positive externalities, like police protection or public health funding. Not all goods and services with positive externalities, however, are public goods. Investments in education have huge positive spillovers but can be provided by a private company. Private companies can invest in new inventions such as the Apple iPad and reap profits that may not capture all of the social benefits.

Key Character

• A public good has two key characteristics: it is nonexcludable and nonrivalrous. These characteristics make it difficult for market producers to sell the good to individual consumers.
• Nonexcludable means that it is costly or impossible for one user to exclude others from using a good.
• Nonrivalrous means that when one person uses a good, it does not prevent others from using it.

It is apparent that public goods will not be adequately supplied by the private sector. The reason is plain: because people can’t be excluded from using public goods, they can’t be charged money for using them, so a private supplier can’t make money from providing them. … Because public goods are generally not adequately supplied by the private sector, they have to be supplied by the public sector.

Economists have often jumped from the observation that public goods are susceptible to underproduction to the conclusion that the government should tax people and use the revenues to provide public goods.

Public goods are regularly supplied by private actors without government coercion. For example:

• Having one’s downtown be free of impoverished beggars is a benefit that is both non-rivalrous and non-excludable, yet privately funded homeless shelters and soup kitchens are common.
• A beautiful, well-kept garden provides a vista that multiple users can enjoy without depletion (non-rivalrous) and from which passersby cannot easily be barred (non-excludable), yet many homeowners in populated areas expend significant sums, not to mention hours of hard labor, tending their yards.
• A highly educated citizenry tends to make better political decisions and to generate a richer cultural environment—both benefits that are non-rivalrous and largely non-excludable—yet people routinely spend great sums educating their children.
• Private groups regularly clean up roadsides, even though the benefit they are creating is not depleted as more drivers use the road (non-rivalrous) and cannot be limited to people who contribute to the clean-up (non-excludable).
• Millions of people make donations on “crowd-funding” websites like Kickstarter to finance projects like community theatre spaces, thereby creating the non-excludable, non-rivalrous benefit of more cultured communities.

Overcoming the Free-Rider

Direct provision of a public good by the government can help to overcome the free-rider problem which leads to market failure

• The non-rival nature of consumption provides a strong case for the government rather than the market to provide and pay for public goods.
• Many public goods are provided more or less free at the point of use and then paid for out of general taxation or another general form of charge such as a license fee.
• State provision may help to prevent the under-provision and under-consumption of public goods so that social welfare is improved.
• If the government provides public goods, they may be able to do so more efficiently because of economies of scale.

Public goods an example of market failure

• Pure public goods are not normally provided by the private sector because they would be unable to supply them for a profit.
• It is up to the government to decide what output of public goods is appropriate for society.
• To do this, it must estimate the social benefits from making public goods available.

Free Rider Problem

• Because public goods are non-excludable it is difficult to charge people for benefitting form a good or service once it is provided
• The free rider problem leads to under-provision of a good and thus causes market failure

Quasi-Public Goods

A quasi-public good is a near-public good i.e. it has many but not all the characteristics of a public good. Quasi-public goods are:

• Semi-non-rival: up to a point, extra consumers using a park, beach or road do not reduce the space available for others. Eventually beaches become crowded as do parks and other leisure facilities. Open access Wi-Fi networks become crowded
• Semi-non-excludable: it is possible but often difficult or expensive to exclude non-paying consumers. E.g. fencing a park or beach and charging an entrance fee; building toll booths to charge for road usage on congested routes
• The air waves – a public good or quasi public good?
• The airwaves used by mobile phone companies, radio stations and television companies are owned by the government.
• Do they count as a pure public good? One person’s use of the airwaves rarely limits how other people can benefit from utilising them.
• At peak times, the airwaves become crowded