Effects of public expenditure

Effects of public expenditure on production The popular idea of public expenditure is that it is money just spent and the mailer ends there. Some people would think that all public expenditure is unproductive. But that is not so. Public expenditure has got far-reaching effects both on production of wealth and on its distribution in the community.

The popular idea of public expenditure is that it is money just spent and the mailer ends there. Some people would think that all public expenditure is unproductive. But that is not so. Public expenditure has got far-reaching effects both on production of wealth and on its distribution in the community.Effects of public expenditure on production
Effects of public expenditure on production
Public expenditure may be productive directly or indirectly. Governments, in every country, are running commercial enterprises which are directly productive. The Indian Government has created solid and lucrative assets in the forms of canals and railways. The State industries make a direct contribution to production in the community. In the same manner, schemes of reclamation and afforest ration are also directly productive.
A great deal of public expenditure is, however, only indirectly productive. In this connection lion we may consider the effects of public expenditure on—
(a)        Power to work and save.
(b)       Will to work and save.
(c)        Diversion of resources as between employments and localities; and

As for power to work and save, it can be spotted out that a great deal of the publicly advantageous public expenditure sustained by current governments undoub­tedly augments the community's industrious power and, as a result, in addition the command to save.(d)       The total volume of employment and income.
As for the willpower to work as well as save, much relies on the nature of public expenditure and the strategy leading it. By providing the people hope of future gains from public expenditure, it can dull the border of the aspiration to work and save.
Regarding the diversion of resources as between employments and locali­ties, public expenditure may have distinctly a beneficial effect on production. Through the system of bounties and subsidies a government may succeed in diverting resources to hitherto neglected channels and thus create new indus­tries. In the same manner, by spending money on the development of backward areas, government may add to the total production in the country. A wisely Conducted policy of public borrowing stimulates saving and the habit of investment in the community which are certainly beneficial to production. It also diverts resources into channels which may add considerably to the wealth of the community.
We may thus safely conclude that wise public expenditure exerts a very wholesome influence on production. It assists production indirectly by adding to the power to work and save and by a profitable diversion of resources. This is besides taking up directly the work of production through State enterprises.

Till recently, the discussion of the effects of public expenditure was mostly confined to the indirect effects discussed above. However, with the Keynesian revolution it has come to be realized that public expenditure can exercise directly an important influence on the level of economic activity. We know that unemployment in the Keynesian system is due to deficiency of effective demand. Public expenditure has a direct influence on the level of effective demand. An increase in public expenditure during a depression helps to create more demand and thereby increases the level of employment and production. Indeed, at times this direct effect may outweigh the indirect effects of public expenditure discussed above.

Public expenditure: Classification and Canons

What is Public Expenditure ? Meaning, Definition

Public expenditure refers to Government expenditure i.e. Government spending. It is incurred by Central, State and Local governments of a country.

Public expenditure can be defined as, "The expenditure incurred by public authorities like central, state and local governments to satisfy the collective social wants of the people is known as public expenditure."

Throughout the 19^th Century, most governments followed laissez faire economic policies & their functions were only restricted to defending aggression & maintaining law & order. The size of pubic expenditure was very small.

But now the expenditure of governments all over has significantly increased. In the early 20^th Century, John Maynard Keynes advocated the role of public expenditure in determination of level of income and its distribution.

In developing countries, public expenditure policy not only accelerates economic growth & promotes employment opportunities but also plays a useful role in reducing poverty and inequalities in income distribution.

Classification of Public Expenditure

Classification of Public expenditure refers to the systematic arrangement of different items on which the government incurs expenditure.

Different economists have looked at public expenditure from different point of view. The following classification is a based on these different views.

1. Functional Classification

Some economists classify public expenditure on the basis of functions for which they are incurred. The government performs various functions like defence, social welfare, agriculture, infrastructure and industrial development. The expenditure incurred on such functions fall under this classification. These functions are further divided into subsidiary functions. This kind of classification provides a clear idea about how the public funds are spent.

2. Revenue and Capital Expenditure

Revenue expenditure are current or consumption expenditures incurred on civil administration, defence forces, public health and education, maintenance of government machinery. This type of expenditure is of recurring type which is incurred year after year.

On the other hand, capital expenditures are incurred on building durable assets, like highways, multipurpose dams, irrigation projects, buying machinery and equipment. They are non recurring type of expenditures in the form of capital investments. Such expenditures are expected to improve the productive capacity of the economy.

3. Transfer and Non-Transfer Expenditure

A.C. Pigou, the British economist has classified public expenditure as :-

1. Transfer expenditure
2. Non-transfer expenditure

Transfer Expenditure :-

Transfer expenditure relates to the expenditure against which there is no corresponding return.

Such expenditure includes public expenditure on :-

1. National Old Age Pension Schemes,
2. Interest payments,
3. Subsidies,
4. Unemployment allowances,
5. Welfare benefits to weaker sections, etc.

By incurring such expenditure, the government does not get anything in return, but it adds to the welfare of the people, especially belong to the weaker sections of the society. Such expenditure basically results in redistribution of money incomes within the society.

Non-Transfer Expenditure :-

The non-transfer expenditure relates to expenditure which results in creation of income or output.

The non-transfer expenditure includes development as well as non-development expenditure that results in creation of output directly or indirectly.

1. Economic infrastructure such as power, transport, irrigation, etc.
2. Social infrastructure such as education, health and family welfare.
3. Internal law and order and defence.
4. Public administration, etc.

By incurring such expenditure, the government creates a healthy conditions or environment for economic activities. Due to economic growth, the government may be able to generate income in form of duties and taxes.

4.1 Productive and Unproductive Expenditure

This classification was made by Classical economists on the basis of creation of productive capacity.

Productive Expenditure :-

Expenditure on infrastructure development, public enterprises or development of agriculture increase productive capacity in the economy and bring income to the government. Thus they are classified as productive expenditure.

Unproductive Expenditure :-

Expenditures in the nature of consumption such as defence, interest payments, expenditure on law and order, public administration, do not create any productive asset which can bring income or returns to the government. Such expenses are classified as unproductive expenditures.

4.2 Development and Non-Development Expenditure

Modern economists have modified this classification into distinction between development and non-development expenditures.

Development Expenditure :-

All expenditures that promote economic growth and development are termed as development expenditure. These are the same as productive expenditure.

Non-Development Expenditure :-

Unproductive expenditures are termed as non development expenditures.

5. Grants and Purchase Price

This classification has been suggested by economist Hugh Dalton.

Grants :-

Grants are those payments made by a public authority for which their may not be any quid-pro-quo, i.e., there will be no receipt of goods or services. For example, old age pension, unemployment benefits, subsidies, social insurance, etc. Grants are transfer expenditures.

Purchase prices :-

Purchase prices are expenditures for which the government receives goods and services in return. For example, salaries and wages to government employees and purchase of consumption and capital goods.

6. Classification According to Benefits

Public expenditure can be classified on the basis of benefits they confer on different groups of people.

1. Common benefits to all : Expenditures that confer common benefits on all the people. For example, expenditure on education, public health, transport, defence, law and order, general administration.
2. Special benefits to all : Expenditures that confer special benefits on all. For example, administration of justice, social security measures, community welfare.
3. Special benefits to some : Expenditures that confer direct special benefits on certain people and also add to general welfare. For example, old age pension, subsidies to weaker section, unemployment benefits.

7. Hugh Dalton's Classification of Public Expenditure

Hugh Dalton has classified public expenditure as follows :-

1. Expenditures on political executives : i.e. maintenance of ceremonial heads of state, like the president.
2. Administrative expenditure : to maintain the general administration of the country, like government departments and offices.
3. Security expenditure : to maintain armed forces and the police forces.
4. Expenditure on administration of justice : include maintenance of courts, judges, public prosecutors.
5. Developmental expenditures : to promote growth and development of the economy, like expenditure on infrastructure, irrigation, etc.
6. Social expenditures : on public health, community welfare, social security, etc.
7. Pubic debt charges : include payment of interest and repayment of principle amount.

Maximum Social Advantage Public Finance

The 'Principle of Maximum Social Advantage' was introduced by British economist Hugh Dalton.

According to Hugh Dalton, "Public Finance" is concerned with income & expenditure of public authorities and with the adjustment of one with the other.

Budgetary activities of the government results in transfer of purchasing power from some individuals to others. Taxation causes transfer of purchasing power from tax payers to the public authorities, while public expenditure results in transfers back from the public authorities to some individuals, therefore financial operations of the government cause 'Sacrifice or Disutility' on one hand and 'Benefits or Utility' on the other.

This results in changes in pattern of production, consumption & distribution of income and wealth. So it is important to know whether those changes are socially advantageous or not.

If they are socially advantageous, then the financial operations are justified otherwise not.

According to Hugh Dalton, "The best system of public finance is that which secures the maximum social advantage from the operations which it conducts."

Principle of Maximum Social Advantage (MSA) ↓

The 'Principle of Maximum Social Advantage (MSA)' is the fundamental principle of Public Finance.

The Principle of Maximum Social Advantage states that public finance leads to economic welfare when pubic expenditure & taxation are carried out up to that point where the benefits derived from the MU (Marginal Utility) of expenditure is equal to (=) the Marginal Disutility or the sacrifice imposed by taxation.

Hugh Dalton explains the principle of maximum social advantage with reference to :-

1. Marginal Social Sacrifice
2. Marginal Social Benefits

This principle is however based on the following assumptions :-

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

Marginal Social Sacrifice (MSS) ↓

Marginal Social Sacrifice (MSS) refers to that amount of social sacrifice undergone by public due to the imposition of an additional unit of tax.

Every unit of tax imposed by the government taxes result in loss of utility. Dalton says that the additional burden (marginal sacrifice) resulting from additional units of taxation goes on increasing i.e. the total social sacrifice increases at an increasing rate. This is because, when taxes are imposed, the stock of money with the community diminishes. As a result of diminishing stock of money, the marginal utility of money goes on increasing. Eventually every additional unit of taxation creates greater amount of impact and greater amount of sacrifice on the society. That is why the marginal social sacrifice goes on increasing.

The Marginal social sacrifice is illustrated in the following diagram :-

The above diagram indicates that the Marginal Social Sacrifice (MSS) curve rises upwards from left to right. This indicates that with each additional unit of taxation, the level of sacrifice also increases. When the unit of taxation was OM₁, the marginal social sacrifice was OS₁, and with the increase in taxation at OM₂, the marginal social sacrifice rises to OS₂.

Marginal Social Benefit (MSB) ↓

While imposition of tax puts burden on the people, public expenditure confers benefits. The benefit conferred on the society, by an additional unit of public expenditure is known as Marginal Social Benefit (MSB).

Just as the marginal utility from a commodity to a consumer declines as more and more units of the commodity are made available to him, the social benefit from each additional unit of public expenditure declines as more and more units of public expenditure are spent. In the beginning, the units of public expenditure are spent on the most essential social activities. Subsequent doses of public expenditure are spent on less and less important social activities. As a result, the curve of marginal social benefits slopes downward from left to right as shown in figure below.

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

The Point of Maximum Social Advantage ↓

Social advantage is maximised at the point where marginal social sacrifice cuts the marginal social benefits curve.

This is at the point P. At this point, the marginal disutility or social sacrifice is equal to the marginal utility or social benefit. Beyond this point, the marginal disutility or social sacrifice will be higher, and the marginal utility or social benefit will be lower.

At point P social advantage is maximum. Now consider Point P₁. At this point marginal social benefit is P₁Q₁. This is greater than marginal social sacrifice S₁Q₁. Since the marginal social sacrifice is lower than the marginal social benefit, it makes more sense to increase the level of taxation and public expenditure. This is due to the reason that additional unit of revenue raised and spent by the government leads to increase in the net social advantage. This situation of increasing taxation and public expenditure continues, as long as the levels of taxation and expenditure are towards the left of the point P.

At point P, the level of taxation and public expenditure moves up to OQ. At this point, the marginal utility or social benefit becomes equal to marginal disutility or social sacrifice. Therefore at this point, the maximum social advantage is achieved.

At point P₂, the marginal social sacrifice S₂Q₂ is greater than marginal social benefit P₂Q₂. Therefore, beyond the point P, any further increase in the level of taxation and public expenditure may bring down the social advantage. This is because; each subsequent unit of additional taxation will increase the marginal disutility or social sacrifice, which will be more than marginal utility or social benefit. This shows that maximum social advantage is attained only at point P & this is the point where marginal social benefit of public expenditure is equal to the marginal social sacrifice of taxation.

Conclusion ↓

Maximum Social Advantage is achieved at the point where the marginal social benefit of public expenditure and the marginal social sacrifice of taxation are equated, i.e. where MSB = MSS.

This shows that to obtain maximum social advantage, the public expenditure should be carried up to the point where the marginal social benefit of the last rupee or dollar spent becomes equal to the marginal social sacrifice of the last unit of rupee or dollar taxed.

TAXABLE CAPACITY

The concept of taxable capacity has been defined .differently by different economists. In the words of Sir Josiah Stamp “Taxable capacity is the maximum amount which the community is in a position-to bear towards the expenses of public authorities without having a really unhappy and down-trodden existence and without dislocating the economic organization too much”. According to Findlay Shiraz: “It is the optimum tax ability of a nation, the maximum amount of taxation that can be raised and spent on the economic welfare in that community”.

Dalton calls it a dim and contused conception”. He writes in his book Principles of Public finance. Absolute taxable capacity is a myth and should be banished from all serious discussions of public finance. For the various definitions of taxable capacity given by eminent writers on Public Finance, we gather that by taxable capacity is meant the maximum amount which a nation can contribute towards the support of the government without inflicting damage on the power and will to produce. The amount of tax burden which the citizens of a country are ready to bear is not rigidly fixed. It can increase or decrease with a change in the distribution of wealth, the size of population, method of taxation, etc. etc. In other words, we can say that the limit of taxable capacity is a relative and not an absolute quantity. The main factors which determine the taxable capacity of a nation are                -

(1)  The size of population: Taxable capacity is very much affected by the increase in national income and by the rate of growth in population. If the increase in national income is greater than the growth in popuLation; the par capita income goes up. The taxable capacity of the individuals rises. If the rate of growth of population is higher than the national income, the taxable capacity decreases.

(2)  The Distribution of national income: Taxable capacity is also influenced by the distribution of national incOme within a country. If there is unequal distribution of wealth in the country, the taxable capacity of the nation will be high, but if the income is equally distributed, then the taxable capacity will be low. A man earning an income of Rs. 50,000 a month is able to .pay more to the government than thirty persons earning Rs. 300. per month.

(3)  Character of taxation: If taxes are devised wisely, then they give less resentment from people and bring forth a large yield.

(4)  Purpose of taxation: Purpose of taxation has a direct bearing on taxable capacity of a nation. If citizens of country are satisfied with purpose of taxation i.e., the increase in welfare of people, then they show greater willingness to pay taxes to government. Whereas, if they find that revenue will be spent for unproductive purposes, they hesitate to pay taxes. “We conclude, therefore, that if state spends revenue for purposes such as education, sanitation, fighting for famine, diseases, etc., then taxable capacity of nation expands to its utmost and if revenue is spent for unproductive purpose like war, then taxable capacity shrinks.

(5)  Psychological factor: Psychological factor is a very important factor in determining taxable capacity of a nation. If people are satisfied that government is doing its utmost to raise standard of living of masses and in maintaining prestige of country, then they try to sacrifice their lives what to say of money for the government. A simple approach to patriotism brings forth tons of gold. •

(6)  Standard of living of people: If standard of living of people is high, they work more efficiently so that they may enjoy a still better standard of living. When they work enthusiastically, they receive higher wages from their employers. Taxable capacity tends to increase then.

(7)  Effect of inflation: If country is in grip of inflation, purchasing power of people is reduced, taxable capacity of nation shrinks considerably. But if value of money is high and country is not faced with unemployment, then taxable capacity of people is quite high. We have discussed above various factor on which taxable capacity of a nation depends. We cannot single out any factor and say that taxable capacity is determined solely by this factor alone. The fact is that various factors influence taxable capacity and we have to take them all into consideration while judging maximum amount which citizens of a country can pay. We cannot deny this fact that it is quite difficult to measure taxable capacity. But this does not mean we should not make an attempt because it is beset With many difficulties. According to Findly Shiraz. “A road leading to an important centre has often many crossings, signposts, danger signals, but this does not lessen its value to cautions sojourner”.

Effect of Taxation

Microeconomics - Effect of Taxes on Supply and Demand

Taxes reduce both demand and supply, and drive market equilibrium to a price that is higher than without the tax and a quantity that is lower than without the tax.

Actual and Statutory Incidence of Tax
Tax authorities usually require either the buyer or the seller to be legally responsible for payment of the tax. Tax incidence is the way in which the burden of a tax is shared among the market participants ("who bears the cost?"). Taxes will typically constitute a greater burden for whichever party has a more inelastic curve – e.g., if supply is inelastic and demand is elastic, the burden will be greater on the producers.

Suppose that a state government imposes a tax upon milk producers of $1 per gallon.

Figure 3.7 shows the original price for milk was $2 per gallon. After imposition of the tax, the supply curves shift up and to the left. Consumers pay $2.60 per gallon. Sellers receive $1.60 per gallon after paying the tax. So sixty cents of the tax is actually paid by consumers, while forty cents is paid by the milk producers.

The triangle ABC above represents the deadweight loss due to taxation, which occurs because now there are fewer mutually beneficial exchanges between buyers and sellers. Deadweight loss stems from foregone economic activity and is a loss that does not lead to an offsetting gain for other market participants; it is a permanent decrease to consumer and/or producer surplus.

Elasticity of Supply and Demand and the Incidence of Tax
If buyers have many alternatives to a good with a new tax, they will tend to respond to a rise in price by buying other things and will, therefore, not accept a much higher price. If sellers easily can switch to producing other goods, or if they will respond to even a small reduction in payments by going out of business, then they will not accept a much lower price. The incidence of the tax will tend to fall on the side of the market that has the least attractive alternatives and, therefore, has a lower elasticity.

Cigarettes are one example where buyers have relatively few options; we would therefore expect the primary burden of cigarette taxes to fall upon the buyers.

A subsidy shifts either the demand or supply curve to the right, depending upon whether the buyer or seller receives the subsidy. If it is the buyer receiving the subsidy, the demand curve shifts right, leading to an increase in the quantity demanded and the equilibrium price. If the seller receives the subsidy, the supply curve shifts right and the quantity demanded will increase, while the equilibrium price decreases.

A quota limits the amounts of a good that can be produced. If the quota is greater than what would be produced under normal market conditions, then it will have no effect. If the amount is less, than the market equilibrium that is achieved will be at a higher price than what would occur without the quota, as consumers will be willing to pay more.

Making a good or service illegally impacts demand, supply and market equilibrium by imposing a cost (prosecution and punishment) on the buyer or seller (or both) of the good/service. Quantities of illegal goods will always be less than if they were legal, but the impact on price is determined by whether the buyer or seller (or both) is punished. If the only the buyer is penalized, the equilibrium price will be lower; the risk of punishment is regarded by buyers as a cost, and reduces the price they will pay to the seller. If the seller is penalized, the equilibrium price will be higher as the cost of punishment is factored into the seller's cost. Prices will remain relatively unchanged if the risk and cost of punishment is shared equally.

Marginal subsidies on production will shift the supply curve to the right until the vertical distance between the two supply curves is equal to the per unit subsidy; when other things remain equal, this will decrease price paid by the consumers (which is equal to the new market price) and increase the price received by the producers. Similarly, a marginal subsidy on consumption will shift the demand curve to the right; when other things remain equal, this will decrease the price paid by consumers and increase the price received by producers by the same amount as if the subsidy had been granted to producers. However, in this case, the new market price will be the price received by producers. The end result is that the lower price that consumers pay and the higher price that producers receive will be the same, regardless of how the subsidy is administered.

Depending on the price elasticities of demand and supply, who bears more of the tax or who receives more of the subsidy may differ. Where the supply curve is more inelastic than the demand curve, producers bear more of the tax and receive more of the subsidy than consumers as the difference between the price producers receive and the initial market price is greater than the difference borne by consumers. Where the demand curve is more inelastic than the supply curve, the consumers bear more of the tax and receive more of the subsidy as the difference between the price consumers pay and the initial market price is greater than the difference borne by producers.

Tax Incidence

Definition of 'Tax Incidence'

An economic term for the division of a tax burden between buyers and sellers. Tax incidence is related to the price elasticity of supply and demand. When supply is more elastic than demand, the tax burden falls on the buyers. If demand is more elastic than supply, producers will bear the cost of the tax.

Investopedia explains 'Tax Incidence'

Tax incidence reveals which group, the consumers or producers, will pay the price of a new tax. For example, the demand for cigarettes is fairly inelastic, which means that despite changes in price, the demand for cigarettes will remain relatively constant. Let's imagine the government decided to impose an increased tax on cigarettes. In this case, the producers may increase the sale price by the full amount of the tax. If consumers still purchased cigarettes in the same amount after the increase in price, it would be said that the tax incidence fell entirely on the buyers.

Incidence of Taxation Notes

Taxes are not always borne by the people who pay them in the first instance. They are often shifted to other people. Tax incidence means the final placing of a tax. Incidence is on the person who ultimately bears the money burden of tax. According to the modern theory, incidence means the changes brought about in income distribution by changes in the budgetary policy.

Impact and Incidence: The impact of a tax is on the person who pays it in the first instance and the incidence is on the one who finally bears it. Therefore, the incidence is on the final consumers.

Incidence and Effects: The effect of a tax refers incidental results of the tax. There are several consequences of imposition of tax, for example, decreased demand.

Money Burden and the Real Burden: The money burden of a tax is represented by the total amount of money received by the treasury. For example, the consumer has to spend Rs. 50 more on sugar monthly, it is the money burden that he has to bear. But if he has to reduce his consumption of sugar it means there is a reduction in economic welfare. This inconvenience, pinching, sacrifice or in short the loss of economic welfare is the real burden of tax.
Theories of Tax Shifting and Incidence

1. Earlier Theories: The earlier theories may be classified into:

(a) Concentration or Surplus theory: According to concentration theory, each tax tends to concentrate on a particular class of people who happen to enjoy surplus from their products.

(b) Diversion or Diffusion theory: The diffusion theory states that the tax eventually got diffused in the entire society. That is, the final placing of tax is not one but multiple. The process of diffusion took place through shifting or through process of exchange.

2. Modern Theory: According to modern theory, the concentration and diffusion theories are partially true. Actually there are both concentration and diffusion of taxes according to the conditions present. The modern theory seeks to analyse the conditions which bring about concentration or diffusion.

Factors determining Tax Incidence

(a) Elasticity: While considering incidence we consider both elasticity of demand and elasticity of supply. If the demand for the commodity taxed is elastic, the tax will tend to be shifted to the producer but in case of inelastic demand, it will be largely borne by the consumer. In case of elastic supply, the burden will tend to be on the purchaser and in the case of inelastic supply on the producer.

(b) Price: Since shifting of the tax burden can only take place through a change in price, price is a very important factor. If the tax leaves the price unchanged, the tax does not shift.

(c) Time: In short run, the producer cannot make any adjustment in plant and equipment. If, therefore, demand falls on account of price rise resulting from the tax, he may not be able to reduce supply and may have to bear the tax to some extent. In the long run, however, full adjustment can be made and tax shifted to the consumer.

(d) Cost: Tax raises the price; rise in price reduces demand and reduced demand results in the reduction of output. A change in the scale of production affects cost and the effect will vary according as the industry is decreasing, increasing or constant costs industry. For instance, if the industry is subject to decreasing cost, a reduction in the scale of production will raise the cost and hence price, shifting the burden of the tax to the consumer.

(e) Nature of tax: The incidence of taxation will definitely depend on the nature of tax. For example, an indirect tax’s burden is fall on the consumer.

(f) Market form: Another factor determining the incidence of taxation is the market form. Under perfect competition, no single producer or single purchaser can affect the price; hence shifting of tax in either direction is out of the question. But under monopoly, a producer is in a position to influence price and hence shift the tax.

Distinction between Direct and Indirect Taxes

A direct tax is not intended to be shifted, whereas an indirect tax is so intended.

Taxes on commodities are generally called indirect taxes as they completely or partially shifted consumers. But it should be remembered that all the commodity taxes are not indirect taxes. A tax is said to be indirect if its burden is shifted finally to the consumer.

Direct tax is the tax in which the commodity is taxed by the government, yet its price remains unaffected or changed. In this case the tax is not shifted to consumer and the tax will be called direct tax. If the tax is shifted, the tax is indirect, otherwise indirect.

Merits and Demerits of Direct and Indirect Taxes

Merits of Direct Tax:

1. Equitable, i.e., the principle of progression is applied
2. Economical, i.e., the cost of collection is small
3. Certain, i.e., the direct tax can be calculated with a fair degree of precision
4. High degree of elasticity, i.e., the direct tax can be raised much easily
5. Civic consciousness, direct tax creates civic consciousness among tax-payers
6. Reduction of inequalities, i.e., the objective of direct tax is to reduce economic inequalities by taxing higher income earners at progressive tax rates.

Demerits of Direct Tax:

1. Inconvenient: for the tax payer to pay and file the income tax return
2. Unpopular tax system
3. Tax evasion is common
4. Unarbitrary tax rates

Merits of Indirect Tax:

1. Convenient: for the tax payer to pay and it requires no filing of returns
2. No tax evasion
3. Unified tax rate
4. Beneficial social effects (in case of harmful drugs and intoxicants)
5. Capital formation
6. Re-allocation of resources
7. Wide coverage

Demerits of Indirect Tax:

1. Uncertain
2. Regressive
3. No civic consciousness
4. Inflationary
5. Loss of economic welfare

Incidence of Some Taxes

Taxes on Personal Income:

1.

Income tax, super tax and excess profit tax are all direct taxes and generally cannot be shifted. 

2.

However, the business is in a strong position and can shift a part of his tax burden to his customers. But this situation is rarely present and the income tax payer must bear the burden of tax. 

3.

If the income tax is extremely heavy, it may discourage saving and investment. However, it will mainly depend on whether the tax falls on average income or marginal income, the effects would be adverse. If the increase in tax is fall on marginal income, it will mean a positive discouragement to the earning of that income. 

Corporate Tax:

1.

Corporate tax discourages investment, level of national income and employment. 

2.

A corporation tax, by reducing the earnings of the existing firms, discourages the entry of new firms into the industry which may result in a monopoly or a semi-monopoly for the existing firms with all the attendant evils. 

3.

A part of corporate tax may be shifted to the buyers through a price rise. 

Tax on Profits:

1.

Some economists are not of the view that the tax on profit should be shifted to buyers. It should be borne by the seller who pays it. 

2.

The second view does not subscribe with the above approach. It is argued that normal profit is a part of the cost and when the entrepreneur is able to influence the price, the tax is generally shifted to the consumer. 

3.

However, the tax on profit in the form of a licence duty will be borne by the producer. 

Wealth Tax:

1.

Wealth tax is imposed on value of a person’s stock of wealth 

2.

By enabling the government not to raise the income tax rates too high, the wealth tax encourages investment in modern industries 

3.

Another obvious effect of wealth tax is the reduction of economic inequalities by reducing the size of inherited wealth 

Property Tax:

1.

The wealth tax is imposed on the net worth of the individual. Whereas, the property tax is levied on the gross amount of assets’ value 

2.

There is no shifting of tax and the incidence is on the person on whom the tax is levied. However, the tax on productive property may be shifted to consumers. 

Land Taxation:

1. The value of land depends on two sets of factors:

(a) Natural factors like the fertility of the soil, the situation of the land, some other natural conditions, and

(b) Investment of capital in drainage schemes, anti-erosion measures, irrigation facilities and other measures necessary to increase and sustain productivity

2.

The tax on the first set is a tax on economic rent and has a tendency to fall on the owners 

3.

But when the owner can vary his investment when the tax increases, he can shift the tax burden to the consumer. 

Tax on Buildings:

1.

If the tax is imposed on the owner, he will try to raise the house rent and thus shift the tax to the occupier or tenant. But he cannot do this during the currency of the lease. 

2.

A heavy tax will check building activity and the remuneration of the builder and of other people engaged in the trade may fall 

3.

The tax may fall partly on the owner, partly on the builder and partly on the occupier 

Death Duty:

1.

Death duty may take two forms, i.e., Estate Duty and Succession Duty 

2.

The Estate Duty is levied on the total value of the estate (i.e., movable and immovable property) left by the deceased irrespective of the relationship of the successor 

3.

The succession duty varies with the relationship of the beneficiary to the deceased. It takes into consideration individual share of the successor and not the total value as in the estate duty. 

Tax on Monopoly:

1. The monopoly tax may be:

(a) Independent of the output of the monopolised product, or

(b) It may vary with the output, i.e., increase or decrease with the output

2.

When the tax is independent of the quantity produced, it may either be lump sum tax on the monopolist or a percentage of the monopoly net revenue (profits). In both cases it will be borne by the monopolist and he cannot shift the same to the consumer, because the monopolist is already on a price with maximum beyond which his profit will decline 

3.

In the second case, the price of the commodity or incidence of taxation will depend on the elasticities of supply and demand, and the influence of laws of returns. 

4.

Taxing of the commodity, therefore raises the price which will tend to reduce the demand 

5.

If, however, the demand is inelastic, it cannot be appreciably reduced and the tax will be borne by the consumer. 

6. If the demand is elastic, the consumers may buy less when the tax has raised the price. Instead of facing a decline in demand the monopolist may reduce the price and decide to bear the tax himself.

Commodity Tax:

1. Taxes on commodities may take several forms:

(a) Tax on manufacture or production of a commodity called excise duties,

(b) Tax on sale of a particular commodity known as sales tax, and

(c) Import or export of commodities known as custom duties.

2.

The commodity tax is tended to be shifted to the consumer and from consumer to the producer 

3.

Tax on production tends to raise the prise and will therefore be normally borne by the consumer 

4.

But the consumption tax is likely to check consumption and tends to be shifted backward to the producer. 

5.

Therefore, the tax on commodity will be partly borne by the producer and partly borne by the consumer 

6. The portions of commodity tax to be borne by the producer and consumer depends on the degree of elasticity of demand and supply:

Elasticity


Incidence

Elastic demand


More tax burden on the supplier / producer

Inelastic demand


More tax burden on the buyer / consumer

Elastic supply


More tax burden on the buyer / consumer

Inelastic supply


More tax burden on the supplier / producer



7.

As a rule, the consumer bears a smaller part of the tax when the demand is more elastic than the supply 

8.

This may happen that the price may not rise at all. This is because the consumers have been able to discover an untaxed supply of the commodity or substitute. In this case, the tax burden will fall on the producer. 





9.

DD and SS intersect at point P and MP is the price determined. Now suppose a sales tax per unit is levied. As a result the supply curve of the commodity will rise upward equal to the tax per unit. The new supply curve will be S’S’. The distance between the two supply curves represents the tax per unit of the commodity. S’S’ cuts the demand curve DD at Q and, therefore, now TQ is the price determined which is higher than the old price PM by RQ. Hence RQ is the burden of tax borne by the consumer even though the tax per unit is LQ. Therefore, RL (LQ – QR) is the burden of the tax borne by the seller or he has RL price less than before (PM being the first price). 

10. Therefore the commodity tax is distributed between the buyers and sellers according to the ratio of elasticities of demand and supply:

RL = Burden of the tax on the seller (producer) .

RQ Burden of the tax on the buyer (consumer)

Ed = Proportionate decrease in quantity demanded

Proportionate increase in price

---------------------------------- (i)

Es = Proportionate decrease in quantity supplied

Proportionate decrease in price

------------------------------------- (ii)

= Elasticity of Demand (Ed)

Elasticity of Supply (Es)

11. In the above equation, RL is the burden of the tax on the seller and RQ is the burden of tax on the buyers. Hence:



RL = Burden of tax on the seller

RQ = Burden of tax on the buyer

= Elasticity of demand (Ed)

Elasticity of supply (Es)

Sales Tax:

1.

The sales tax is levied on the turnover, profits or no profits. It covers a wide variety of commodities. 

2.

The sales tax may make heavy inroads into profits which may lead to retrenchment in the staff and management, restrict enterprise and employment and hamper utilisation of resources. 

3.

Thus, its incidence may fall upon employees, management and landlords. 

Import Duties and Export Duties:

1.

Import Duties are generally borne by the home consumer 

2.

If the demand for the imported product is elastic and the supply is inelastic and the foreign producer has no alternative market, then in such a case the burden of tax may be shifted to foreign seller. This situation is rarely present. 

3.

Export duty is borne by the exporter. The price in the world market is fixed and no individual exporter is in a position to influence the world price. 

4.

There are certain exceptional situations in which the purchaser may bear the burden of export duty. For example, the supplier or the producer has the monopoly of the supply of a commodity. 

Effects of Taxation on Production, Consumption and Distribution

Effects on Production:

1. Production is affected by taxes in two ways:

(a) By affecting the ability to work, save and invest

(b) By affecting the desire to work, save and invest

2.

A tax on necessaries of life, will obviously affect the workers’ productivity and hence reduce production. A heavy tax on income tends to reduce the ability to save and invest on part of individuals. A decrease in investment is bound to affect adversely the level of output in the country 

3.

Normally taxation induces people to work harder, earn more, save more and invest more to increase their income and enjoy the same income after tax 

4.

Some taxes has no adverse effects, for e.g., import duties, tax on monopolists, etc. 

5.

High marginal rates of income tax are likely to affect adversely the tax payers’ desire to work, save and invest 

6.

The reaction varies from individual to individual. It depends on the individual’s elasticity of demand for income. When it is fairly elastic, the tax will lessen his desire to work and save 

7.

Entrepreneurs may avoid the production of goods which are taxed. There is likely to be a diversion of resources from some sectors of economy to others 

Effects on Income Distribution:

1.

The effects of taxes on income distribution depends on the type of taxes and rates of taxes 

2.

Taxation of goods of mass consumption is regressive and redistributes incomes in favour of rich. 

3.

But if such commodities are exempted and luxuries are taxed, and the taxation is made progressive, then the income will be redistributed in favour of poor. 

Effects on Consumption:

1.

By imposing tax on a consumable good which is injurious to health, its consumption can be checked. 

2.

Similarly the tax on luxury goods can decrease their consumption and resources diverted to the production of mass consumption

Read more: Incidence of Taxation Notes - MA Economics Notes http://www.friendsmania.net/forum/ma-economics-notes-assignments/58216.htm#ixzz2maVTLtHC