Peacock Wiseman Hypothesis focused on the pattern of public expenditure and stated that public expenditure does not follow a smooth or continuous trend but the increase in public expenditure takes place in jerks or steps. They gave three separate concepts to justify the hypothesis, they are:

• Displacement Effect
• Inspection Effect
• Concentration effect

According to Peacock Wiseman Hypothesis, due to some social or other disturbance in an economy there is a need for increased expenditure as the existing public revenue cannot solve the disturbance.

The fiscal activities of the government rise step by step to successive new higher level during the span of decades to meet successive social disturbances.

Displacement Effect

When a social disturbance occurs the government raises taxes to increase revenue and increases public expenditure to meet the social disturbance.  This creates a displacement effect by which low taxes and expenditures are replaced by higher tax and expenditure levels. However, after the disturbance ends, the newly emerged level of tax tolerance makes the people willing to support higher level of public expenditure since it is capable of bearing heavier tax burden than before. As a result, the new level of public expenditure and public revenue stabilize but are soon destabilized by another new disturbance which causes another displacement effect.

Inspection effect

Even if there is no new disturbance there is no strong motivation to return to lower level of taxation as the increased revenue can be used to support a higher level of public expenditure.  Therefore government expands its fiscal operations partly due to disturbance and partly to expand economic activity and take up new functions that were earlier neglected. This is known as Inspection effect.

Concentration effect

When an economy is experiencing economic growth there is a tendency of central government`s economic activities to grow at a faster rate than that of state and local government`s activities. This is known as concentration effect. It is related to the political set up of the country.

Conclusion

The Peacock Wiseman hypothesis of government spending trend is more convincing than in Wagner`s hypothesis. The natural course of advancement and structural changes in an economy leads to constant and systematic expansion of public expenditure. An increase in public expenditure can also be accredited to urbanization, population growth, awareness of civil rights, awareness of duties by the State government etc.

Also Read: Law of Increasing State Activities Adolph Wagner

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According to Hugh Dalton – The best system of Public Finance is that which secures the maximum social advantage from its fiscal operations. He propounded the Principle of Maximum Social Advantage and stated the following:

• Government should collect money and spend it to maximize the welfare of people
• When taxes are imposed, dis-utility is created and when expenditure is done, utility is created.
• Government must adjust its revenues & expenditures in such a way that the surplus of utility is maximum and dis-utility is minimum.

Assumptions of Principle of Maximum Social Advantage

• All taxes result in sacrifice. All public expenditure lead to benefit.
• Public revenue consists of only taxes and government has no other source of income.
• Government has no deficit or surplus budget
• Public expenditure is subjected to law of diminishing marginal utility therefore Marginal Social Benefit keeps on diminishing.
• Taxes are subjected to increase Marginal Social Sacrifice.

Principle of Maximum Social Advantage

Dalton stated the extent to which public expenditure should be done and taxes should be collected. According to Dalton, public expenditure should be done till the point where the advantage of a unit increase public expenditure to the society is counter balanced by the disadvantage of a unit increase in revenue or taxation.

With every additional unit of tax raised by the public, the burden of tax keeps on increasing while the quantum of benefits keep on decreasing. Hence public expenditure should be carried out till the point of maximum social advantage.

He gave the following two concepts:

MSS – Marginal Social Sacrifice – It is the amount of sacrifice undergone by public (tax payer) due to imposition of one additional unit of tax.

MSB – Marginal Social Benefit – Benefits enjoyed by the public by one additional unit of public expenditure.

Point of Maximum Social Advantage

The point of maximum social advantage is the point where Marginal Social Sacrifice cuts the Marginal Social Benefit curve. This is the optimum limit of State’s Public Finance activity.

It is the point at which the marginal utility from public expenditure equals marginal dis-utility due to taxation. Hence, at this point the benefit derived from the last unit of money spent on public expenditure equals the sacrifice imposed in raising that one addition unit of revenue from the public.

On the basis of the Principle of Maximum Social Advantage

• The resources of the government must be distributed using the Equi-marginal principle i.e. marginal return of satisfaction must be same for all.
• Taxation must be done on the basis of principle of least aggregate sacrifice i.e. the marginal utility of money paid in taxation must be equal to all tax payers.

How to achieve maximum social advantage

In order to achieve the objective of Maximum Social Advantage:

• Marginal Social Benefit = Marginal Social Sacrifice

• Marginal Social Benefit from each unit of public expenditure must be equal

• Marginal Social Sacrifice of each unit of tax must be equal

b = Social Advantage; t = taxation; e = Public Expenditure; d = small change;

s = Social Sacrifice; 1,2,3…n = various sources of taxation

Limitations of Principle of Maximum Social Advantage

• Utility cannot be measured quantitatively.
• It is difficult to measure tax burden
• It is difficult to measure social benefit
• Equi-marginal principle is not applicable to Public Expenditure (Social Benefit)
• Policy of functional finance does not permit MSB=MSS

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Adolph Wagner a German economist propounded the Law of increasing State activities. He gave a relationship between level of development and public expenditure.

According to Wagner as an economy develops overtime, the activities and functions of the state (government) increase. He said this based on a comprehensive comparisons of different countries. The study showed that in progressive societies –

• The Central and Local Government activities keep on increasing regularly.
• They perform both the old and new functions more efficiently & completely.
• The Increase in government activities are both extensive and intensive.
• Government take up new functions in the public interest and to meet economic needs.
• The expansion & intensification of Government function increases public expenditure.

To justify the law of increasing state activities he divided Public Expenditure into two parts; External Expenditure and Internal Expenditure and stated why each will increase with development of an economy.

External Expenditure increases as the strategic approach of a government changes from simple aggression to prevention of attack. It also increases due to the increase in demand for goods and services of the public sector.

Internal expenditure increases due to greater friction between economic units and people, high standard of living of people, easier access to capital, maintenance of large administrative units etc. as a result of economic development.

Adolph Wagner also argued that the income elasticity for government services is greater than unity i.e. Public expenditure will increase more rapidly than increase in income of the public. To substantiate this he gave variables that effect the Demand and Supply of Public Expenditure.

Variables that effect both Demand and Supply of Public Expenditure

• Per capital income
• Density and rate of population growth

Variables that effect demand

• Urbanization & Industrialization
• Distribution of Income
• Literacy level of people
• Age composition
• Alternative put services

Variables that effect supply

• Scale of production of Government
• Quality of production
• Inter government grants and independence of units for funds

Conclusion:

According to Law of increasing state activities as per capita income and output increases in industrial nations, the public sector grows as a proportion of total economic activity.

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• Production
• Distribution
• Inflation
• Depression
• Consumption
• Employment

According to Dalton, “The best taxation from economic point of view is that which has best or the least bad economic effects”

While the classical economists considered tax as a source of revenue only, modern economists regarded it as an important tool for achieving socio-economic objectives.

The main objectives of a taxation system is to regulate the economy. This is achieved by maintaining stability in the economy through proper control over production, distribution, consumption and employment in an economy.

Economic effects of taxation on Production

This can be studies under three sub heads –

(1) Effect on the capacity to work, save and invest

The purchasing power of people reduces when they pay tax and hence it also reduces their consumption. This reduces their overall efficiency to work.

Thus, taxes must aim to increase a person’s ability to work and save, therefore, certain taxes such as taxes on liquor and tobacco are necessary, as they improve a person’s health but taxes on necessities are undesirable as necessities are essential for survival.  This also suggests that people with low income must not be subjected to tax as it will have a negative effect on their ability to work and save.

A person’s capacity to invest depends upon the resources available with him i.e. savings. Since tax reduces the income of a person, he will be able to save less and hence his capacity to invest also decreases.

(2) Effect on desire (will) to work, save & invest

As taxes effect the capacity of person to work, save and invest, a person may be motivated to work more or demotivated to work less on the basis of nature of tax imposed on him.

The effect of tax on desire to work, save & invest can be understood by the following two factors:

(a) Psychological reactions of tax payer due to income elasticity of demand.

• If income elasticity of demand is inelastic – A person will work more and earn more to meet his requirements.
• If it is elastic – A person may not work hard to increase his income.
• If it is unity – The desire to work remains the same irrespective of imposition of tax

(b) Nature of tax

While a progressive tax on income may result is negative effect on the will of a person to work, save & invest, taxes on casual income of a person, inherited property or additional taxes during war do not effect a person’s will to work.

(3) Effect on distribution of economic resources

Production of a country is directly dependent on the amount of resources allocated to different sectors, industries, regions etc. of an economy.

Some economic effects of taxation w.r.t distribution of economic resources:

Taxes on intoxicants will discourage its production and consumption. These resources may be diverted for production of essential commodities. Hence, such a tax is desirable.

Taxes on necessities will discourage a person as it will increase the cost of living. Such tax may divert resources towards production of useless products. Hence, it is undesirable.

If taxes encourage savings and discourages consumption it diverts resources from present to future. If taxes discourage savings and encourage consumption, it results in diversion of resources from future to present.

Resources are also diverted from the state where tax burden is heavy to a state where tax burden is light.

Economic effects of taxation on Distribution

Taxation effects the distribution of income and wealth amongst different sections of the society depending upon (a) the nature of tax and tax rate (b) kind of tax

(a) The nature of tax and tax rate

• Under progressive taxation – The rich bear more burden of taxation than lower income people. Thus inequalities in distribution of income and wealth is less or reduces with time.
• Under proportional tax – Inequalities increase with un-proportional increase in income of individuals and remains the same if income of individuals remain the same.
• Under regressive taxation – Inequalities increase as more tax burden is borne by the poor and less by the rich.

(b) Kind of taxes

• Direct taxes such as income tax are progressive in nature, therefore, the burden of tax lies more on the rich and less on the poor.
• Indirect taxes are regressive in nature, therefore, the burden of tax lies more on the poor and less on the rich.

Taxation and Inflation

Taxes help in reducing the demand for goods and services by restricting the purchasing power of the public thereby keeps a check on inflation.  It helps to fill the gap between demand & supply as subsidies provided by government in form of tax benefits will help producers to produce more and taxes charged by public will reduce their demand.

Taxation and Depression

By adjusting taxes both marginal propensity to consume and amount of investment can be increased (by discouraging savings) which helps in curbing depression.

Taxation and Consumption

While taxes on intoxicants is desirable, taxes on necessities are undesirable.  Thus high taxes can be imposed on unproductive activities & commodities to discourage its consumption and tax relief on necessities can be provided to increase its consumption.

Taxes and Employment

When more revenue is collected by the Government by way of taxes, it can be spent on social and welfare activities and hence increase production and employment.

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Difference between Incidence and Impact of Tax

The impact of tax lies directly on the person who pays the tax but it is not necessary that he will also bear the money burden of tax (incidence of tax).  The money burden of tax (incidence of tax) may be shifted by him on another person who will partially or wholly bear the money burden.

For example – When government charges taxes in form of custom or excise duty from traders and producers of a commodity, they pay the tax directly to the government at the first instance, but may shift the burden of tax on consumers by charging higher prices.

Here the impact and incidence of tax lies on different people i.e. the impact lies on the producer but incidence lies on the consumer.

Elements of Incidence of Tax  

• It refers to the ultimate impact of tax
• It is the money burden of a tax
• The money burden of tax is direct

Shifting of Tax

When the burden of tax is passed on by the tax payer on another person it is known as shifting of tax.

Every person tries to shift the burden of tax to another person, shifting of tax may done in the following two ways –

• Single point shifting – When a producer shifts the burden of tax on his product to the consumer.
• Multi-point shifting – When the burden of tax is shifted at several points like from producer to wholesaler to retailer and then to consumer.

On the basis of tax shifting it may be forward or backward.

For Example – When a producer shifts his tax burden on consumer it is forward shifting.  But, if the retailer pressurizes the producer to cut down prices rather than charging higher prices from consumers (to avoid financial losses due to elastic demand of a product) it is called backward shifting of tax.  Therefore, shifting of tax depends upon the nature of commodity.

• If a commodity has an elastic demand the tax burden will be shifted backwards.
• If a commodity has an inelastic demand the tax burden is shifted forward.

Forms of Tax shifting

Shifting of Tax can be done

• Either by increasing the price of the product
• Or by lowering the quality of product

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Features of Performance Budgeting 

Performance Budgeting provides

• The purpose and objectives for which funds are required
• Costs of programs and related activities proposed to accomplish those objectives
• The output that will be produced under each activity.

Performance Budgeting implies that the budget must clearly indicate the actual achievement or output, expected by spending a particular amount on a particular activity. Hence, It is an output oriented budget that focuses more on achievement rather than means of achievements.

The costs and benefits of each activity are analysed for making decisions regarding allocation of funds.

It involves use of management tools such as – work measurement, bench marking and unit costing etc. to prepare a budget.

This system has been designed to plan for long term.

Process of Performance Budgeting

• Formulation of objectives
• Identifying various programmes and project which will accomplish these objectives
• Evaluation & selection of programmes & projects on the basis of cost benefit analysis
• Development of performance criteria for various programmes
• Preparing financial plans for each program and the final annual budget
• Assessing the performance of each programme an comparing the same with budgeted performance
• Correcting deviations

Advantages of Performance Budgeting

• It states clearly the purpose & objectives for which funds are needed.
• It improves performance of units in a continuous manner
• It brings transparency in the budget formulation process
• It helps in decision making regarding allocation of funds
• It acts as a tool for reviewing efficiency of programs
• It integrates the process of planning, programming & budgeting

Limitations of Performance Budgeting 

• It focuses on quantitative evaluation rather than qualitative evaluation.
• It is ineffective without a proper and systematic accounting and reporting system.
• It is difficult to quantify social benefits.
• It is difficult to accurate estimate benefits arising out of each activity.

Also Read:  Zero-Based Budgeting

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Deficit Financing may be simply defined as the excess of expenditure over and above the total income of the Government.

The term “Budgetary deficit” can be defined in two ways. –

• One from the perspective of advanced countries like USA – Budgetary deficit is the loan financing of all excess government expenditure over its revenue.
• Developing countries like India – Budgetary deficit is the net increase in the treasuring bills and withdrawal of cash balances.

In western countries any expenditure of the government over and above its current income is a deficit and is financed through deficit financing.  Even when the budget gap is covered through loans, from the public and commercial banks, there is deficit financing as loans from public and commercial banks are not considered as income of the government.  Hence there is no difference between Deficit Financing and Budgetary deficit.

However, In developing countries where banking infrastructure is not fully developed, deficits in the budget are financed through borrowings from the Central bank (RBI in India) on creation of new money.  The government sells securities to the central bank on behalf of which the central bank prints paper currency.  Hence deficit financing results in increase of total money supply in an economy.

According to V.K.R.V. Rao, “The financing of a deliberately created gap between public expenditure and public borrowings is of a type that results in a net addition to national outlay or aggregate expenditure.”

According to planning commission – The term deficit financing is used to devote the direct addition to gross national expenditure through the budget deficits in revenue and capital accounts.  The overall budgetary deficit comprises of deficits in revenue and capital accounts of the government.

Revenue Account – It shows the result of current operations of the government.  If there is a deficit in the revenue receipts by way on tax and non tax revenue and expenditure of the government it is said to be a deficit which is carried to the capital account.

Capital Account – The deficit on capital account is the excess of receipts from public borrowings, external loans, savings, P.F. over expenditure such as capital outlay, loans and advances, repayment of debt etc.

The deficit or surplus in both the accounts is combined to express the overall position either surplus or deficit i.e. budgetary deficit. The method of financing this deficit is know as deficit financing.

Objectives of Deficit Financing

• To finance expenditure on war
• To remove depression by raising the level of output and employment
• To mobilize adequate resources for financing development plans
• To mobilize idle or surplus cash and underutilized resources of the country.

Techniques Deficit Financing

Deficit Financing in western countries

It is done through market borrowings(public and commercial banks).

Deficit Financing in India 

It is done through:

• Creation of money i.e. borrowing from central bank
• Running down the cash balances of the government
• Issuing new currency
• Raise receipts by additional tax revenue
• Raising net returns from government services
• Raising domestic loans
• Increasing the volume of foreign loans for securing additional domes receipts.

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A Tax is a compulsory payment made by the citizens of a country to the government to meet expenditures of public authorities and for the common welfare of all, without any expectations of any specified and special returns from the Government.

According to Seligman – “A tax is a compulsory contribution from a person to the government to defray the expenses incurred in the common interest of all without reference to special benefits conferred.”

Characteristics of Tax

• It is a compulsory contribution, a person cannot evade tax but refrain from paying it by not consuming a taxed product or service.
• It is spent on public welfare activities – generally non-tax payers are benefitted more from it than tax payers.
• It does not provide a specific benefit – According to Pigoo – “The essence of tax is the absence of a direct quid-pro-quo between the tax payers and public authorities.”
• It is the duty of a citizen to pay tax.
• It is not a cost for a service.
• The assessment and realization of tax depends upon the constitutional authority.

Objectives of Tax

• To raise revenue for welfare activities and economic development
• To regulate the economy
• To reduce inequality in distribution of income
• To maintain the National Income and control inflation

Canons of Tax | Canons of Taxation

Characteristics of a good tax system

• It must be Equitable i.e. the burden of taxation should be minimum. It must be distributed between different sections of the society in a just and equitable manner and in such a way that the burden of tax lies more on the rich and less on the poor.
• It must be elastic i.e. Proper blend of direct and indirect taxes. By blending a variety of direct and indirect taxes together efforts must be made to reduce the scope for tax evasion to the minimum.
• The government must keep in mind the convenience of the tax payer while devising a tax system.
• Certain sources of income must be reserved for situations like war, floods, natural disasters etc.
• It must follow the objectives of maximum social advantage.
• It must include all the canons of tax.
• It must be productive.

Kinds of Tax | Types of Taxes

According to Bustle, “ Taxes which are levied on permanent and recurring occasions are direct taxes. Taxes which are charged on occasional or particular events are indirect taxes.”

According to Dalton, “A direct tax is really paid by the person on whom it is partially or wholly imposed, while an indirect tax is imposed on one, but paid partially or wholly by another owing to a consequential change in terms of some contract or bargain between them.”

Direct Tax – It is a tax, the burden of which is directly borne by the person on whom it is levied. Thus the impact and incidence of tax lies on the person on whom it is levied. E.g Income Tax, Corporate Tax, Tax on Capital gains.

Indirect Tax – In indirect tax, the burden of tax is partially or wholly borne by a person who does not directly pay the tax i.e. one person pays the tax and another bears the burden of tax. In such a case the impact and incidence of tax fall on more than one person. E.g. Sales Tax, Service Tax, VAT, Custom duties and Octroi, Excise duty

Progressive Taxation –  In Progressive Taxation an exemption limit is fixed by the government and all individuals falling below that limit are granted exemption from tax payment while the rate of tax increases in a progressive manner for those who lie above the exemption limit.

Proportional Taxation – In Proportional Taxation the income of all tax payers taxed at a uniform rate irrespective of their income level. The tax rate does not change with the change in income of a person.

Regressive Taxation – In Regressive Taxation, the rate of tax decreases with increase in tax payer’s income. It is the opposite of progressive taxation.

Digressive Taxation – It is a mixture of progressive and proportional tax. In this the tax rate is progressive up to a certain limit and then becomes proportional after that limit. Thus the tax rate increases with increase in a person’s income up to a certain limit, thereafter becomes constant.

Specific Tax – It is levied on the basis of number, size or weight of a commodity.

Ad-Valorem Tax – It is levied on the basis of price of commodity.

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Fundamental Canons of Taxation

The four fundamental canons of taxation were propounded by Adam Smith in 1776. They were:

Canon of Equity – Every person must pay taxes in proportion to his income. But modern economists support progressive taxation, i.e. more the income more the tax burden.

Canon of Certainty – It states that the tax that is to be paid by a person must be certain and not arbitrary. The tax payer must know in advance –

• How much tax to pay?
• When to pay?
• In what form to pay? (manner of payment)
• How to pay?

Canon of convenience – It states that tax must be levied in such a manner and at such a time that it is convenient to the tax payer as he makes a sacrifice at the time of tax payment.

Canon of Economy – The cost of tax collection should be minimum and the taxes collected must bring maximum revenue to the Government.

Others Canons of Taxation

Canon of Elasticity – Taxes must be elastic in nature i.e. Government must be able to increase or decrease the tax revenue according to the requirements of the country.

Canon of Productivity – A tax must be able to yield sufficient revenue to the government otherwise it will be a unproductive tax. Therefore, few productive taxes are better than imposing many unproductive taxes.

Canon of Variety – A single tax can be easily evaded by a person. Therefore there must be a variety of taxes on people and commodities.

Canon of Simplicity – A tax system must not be complex. It must be simple so that every tax payer can understand it without any special assistance.

Canon of Diversity – It states the principle of multiple taxation (charging various direct and indirect taxes rather than one single tax) so that all sections of the society can be brought under the taxation network. But too much diversity in taxes is undesirable as it increases the cost of tax collection.

Canon of Uniformity – It refers to uniformity in imposition of tax, assessment of tax and realization of tax.

Canon of Expediency or Desirability – A tax must be desirable. A tax payer must be given justification as to why he is paying a particular tax.

Canon of Coordination – It states that tax authorities must be well coordinated.

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