Unit – IV

Public Debt

Q1) What is the meaning of Public Debt and what are its classifications?

A1) Modern governments need to borrow from different sources when current revenue falls short of public expenditures. Thus, public debt refers to loans incurred by the government to finance its activities when other sources of public income fail to meet the requirements. In this wider sense, the proceeds of such public borrowing constitute public income.

However, since the debt has to be repaid along with interest from whom it is borrowed, it does not constitute income. Rather, it constitutes public expenditure. Public debt is incurred when the government floats loans and borrows either internally or externally from banks, individuals or countries or international loan-giving institutions.

What is true about public borrowing is that, like taxes, public borrowing is not a compulsory source of public income. The word ‘compulsion’ is not applied to public borrowing except in certain exceptional cases of borrowing.

Classification of Public Debt:

The structure of public debt is not uniform in any country on account of factors such as categories of markets in which loans are floated, the conditions for repayment, the rate of interest offered on bonds, purposes of borrowing, etc.

In view of these differences in criteria, public debt is classified into various categories:

i. Internal and external debt

ii. Short term and long term loans

iii. Funded and unfunded debt

iv. Voluntary and compulsory loans

v. Redeemable and irredeemable debt

vi. Productive or reproductive and unpro­ductive debt/deadweight debt

i. Internal and External Debt:

Sums owed to the citizens and institutions are called internal debt and sums owed to foreigners comprise the external debt. Internal debt refers to the government loans floated in the capital markets within the country. Such debt is subscribed by individuals and institutions of the country.

On the other hand, if a public loan is floated in the foreign capital markets, i.e., outside the country, by the government from foreign nationals, foreign governments, international financial institutions, it is called external debt.

ii. Short term and Long Term Loans:

Loans are classified according to the duration of loans taken. Most government debt is held in short term interest-bearing securities, such as Treasury Bills or Ways and Means Advances (WMA). The maturity period of the Treasury bill is usually 90 days.

The government borrows money for such a period from the central bank of the country to cover temporary deficits in the budget. Only for long term loans, the government comes to the public. For development purposes, long period loans are raised by the government usually for a period exceeding five years or more.

iii. Funded and Unfunded or Floating Debt:

Funded debt is the loan repayable after a long period of time, usually more than a year. Thus, funded debt is long term debt. Further, since for the repayment of such debt government maintains a separate fund, the debt is called funded debt. Floating or unfunded loans are those which are repayable within a short period, usually less than a year.

It is unfounded because no separate fund is maintained by the government for debt repayment. Since repayment of unfunded debt is made out of public revenue, it is referred to as a floating debt. Thus, unfunded debt is a short term debt.

iv. Voluntary and Compulsory Loans:

A democratic government raises loans for the nationals on a voluntary basis. Thus, loans given to the government by the people on their own will and ability are called voluntary loans. Normally, public debt, by nature, is voluntary. But during emergencies (e.g., war, natural calamities, etc.,) government may force the nationals to lend it. Such loans are called forced or compulsory loans.

v. Redeemable and Irredeemable Debt:

Redeemable public debt refers to that debt which the government promises to pay off at some future date. After the maturity period, the government pays the amount to the lenders. Thus, redeemable loans are called terminable loans.

In the case of irredeemable debt, the government does not make any promise about the payment of the principal amount, although interest is paid regularly to the lenders. For the most obvious reasons, redeemable public debt is preferred. If irredeemable loans are taken by the government, society will have to face the consequence of the burden of perpetual debt.

vi. Productive (or Reproductive) and Unproductive (or Deadweight) Debt:

On the criteria of purposes of loans, public debt may be classified as productive or reproductive and unproductive or deadweight debt. Public debt is productive when it is used in income-earning enterprises. Or productive debt refers to that loan that is raised by the government for increasing the productive power of the economy.

A productive debt creates sufficient assets by which it is eventually repaid. If loans taken by the government are spent on the building of railways, development of mines and industries, irrigation works, education, etc., the income of the government will increase ultimately.

Productive loans thus add to the total productive capacity of the country.

In the words of Findlay Shirras: “Productive or reproductive loans which are fully covered by assets of equal or greater value, the source of the interest is the income from the ownership of these as railways and irrigation work.”

Public debt is unproductive when it is spent on purposes that do not yield any income to the government, e.g., refugee rehabilitation or famine relief work. Loans for financing war may be regarded as unproductive loans. Instead of creating any productive assets in the economy, unproductive loans do not add to the productive capacity of the economy. That is why unproductive debts are called dead­weight debts.

Q2) What are the Methods of Redemption of Public Debt?

A2) Redemption of debt refers to the repayment of a public loan. Although public debt should be paid, debt redemption is desirable too. In order to save the government from bankruptcy and to raise the confidence of lenders, the government has to redeem its debts from time to time.

Sometimes, the government may resort to an extreme step, such as repudiation of debt. This extreme step is, of course, a violation of the contract. The use of repudiation of debt by the government is economically unsound.

Here, instead of concentrating on the repudiation of debt, we discuss below other important methods for the retirement or redemption of public debt:

i. Refunding:

Refunding of debt implies the issue of new bonds and securities for raising new loans in order to pay off the matured loans (i.e., old debts).

When the government uses this method of refund, there is no liquidation of the money burden of public debt. Instead, the debt servicing (i.e., repayment of the interest along with the principal) burden gets accumulated on account of the postponement of the debt- repayment to save future debt.

ii. Conversions:

By debt conversion, we mean reduction of interest burden by converting old but high interest-bearing loans into new but low interest-bearing loans. This method tends to reduce the burden of interest on the taxpayers. As the government is enabled to reduce the burden of debt which falls, it is not required to raise huge revenue through taxes to service the debt.

Instead, the government can cut down the tax liability and provide relief to the taxpayers in the event of a reduction in the rate of interest payable on public debt. It is assumed that since most taxpayers are poor people while lenders are rich people, such conversion of public debt results in a less unequal distribution of income.

iii. Sinking Fund:

One of the best methods of redemption of public debt is sinking fund. It is the fund into which a certain portion of revenue is put every year in such a way that it would be sufficient to pay off the debt from the fund at the time of maturity. In general, there are, in fact, two ways of crediting a portion of revenue to this fund.

The usual procedure is to deposit a certain (fixed) percentage of its annual income to the fund. Another procedure is to raise a new loan and credit the proceeds to the sinking fund. However, there are some reservations ag

iv. Budget Surplus:

By making a surplus budget, the government can pay off its debt to the people. As a general rule, the government makes use of the budgetary surplus to buy back from the market its own bonds and securities. This method is of little use since modern governments resort to a deficit budget. A surplus budget is usually not made.

v. Additional Taxation:

Sometimes, the government imposes additional taxes on people to pay interest on public debt. By levying new taxes—both direct and indirect— the government can collect the necessary revenue so as to be able to pay off its old debt. Although an easier means of repudiation, this method has certain advantages since taxes have large distortionary effects.

vi. Compulsory Reduction in the Rate of Interest:

The government may pass an ordinance to reduce the rate of interest payable on its debt. This happens when the government suffers from a financial crisis and when there is a huge deficit in its budget.

There are so many instances of such statutory reductions in the rate of interest. However, such practice is not followed under normal situations. Instead, the government is forced to adopt this method of debt repayment when the situation so demands.

Q3) What Are the Effects of Public Debt?

A3) A peculiar profile of public borrowing is its voluntary nature, as con­trasted to the compulsory features of taxation. When the govern­ment offers its securities to the public, persons are free to purchase them.

If they subscribe to government bonds, they suffer no net dimi­nution in their wealth, as occurs when they pay taxes. In exchange for liquid cash, they receive bonds or other securities which bear interest and which will ultimately be paid off.

The government in turn receives money for meeting its expenditure but incurs a liability for the payment of interest and the repayment of principal in the future.

The economic effects of a government programme financed by borrowing are different from the effect of a similar programme financed by taxation. This is partly because the lending of money to the gov­ernment is purely voluntary and partly because the making of such loans does not reduce the personal wealth of the lenders but merely changes its form.

A major consequence of these types of fund mobi­lization is that borrowing, on the whole, is likely to have a less contractionary effect upon aggregate demand, than raising an equiva­lent amount by way of taxation.

Hence a programme of expenditure financed by borrowing is likely to have a greater net expansionary effect upon the economy than a programme of the same magnitude financed by taxation.

1. Effect of Borrowing upon Consumption:

In the case of borrowing, curtailment of consumption spending is likely to be slight, except in wartime borrowing programmes in which substantial pressure is applied to individuals to reduce consumption and buy bonds.

Hence compared with taxation, public debt does not have any serious effect on the level of current consumption. In the case of individuals, their consumption pattern is set by their current income. Loans are advanced out of saving, whereas taxes are paid out of income.

Under certain conditions, there is a greater possibility of an increase in the spending on consumption, due to government borrowing. The bondholders regard their bonds as wealth and a source of income.

Moreover, by holding government bond, their li­quidity position is not very much affected because bonds can be converted into cash at any time. Hence there will be a tendency to increase spending on consumption.

2. Effect of Borrowing on Saving and Investment:

The floating of public debt influences saving and investment through the interest rate mechanism. The floating of public debt will raise the rate of interest. Since savings interest elastic, the creation of public debt will raise savings.

Investment expenditure of the bondholders is influenced through the claimed effect on investment. That is through an increase or decrease in interest rate. When bonds are issued, the ratio of the money supply to debt supply will be reduced and as a result rate of interest will increase.

As a result, the effect of public debt will be, reduced investment expenditure. On the other hand when bonds are purchased by the government from the open market, or when government repay public debt, the ratio of the money supply to debt supply increases and the rate of interest declines.

This will lead to an increase in investment. The overall effect on the economy de­pends largely on the way in which the investment is made in the public sector, compared with what could have been achieved in the private sector.

The effect of public debt on investment also depends on the method of raising loans. Suppose if the government borrows from commercial banks and central bank of a country, it will increase the money supply or purchasing power and hence the funds available for investment will not be reduced.

However, if the government bonds are subscribed by the public and financial institutions, out of funds meant for investment, then automatically investment expenditure will be curtailed.

3. Effect of Borrowing on Production:

In general, government borrowing results in enhancing the productive capacity of the economy. If the borrowed money is used by the government to finance developmental projects, it will generate in­come and employment opportunities.

Such investments strengthen the capital base of the economy and help to increase the production of goods and services. Moreover, the government will be able to re­pay the debt and interest charges in future without much difficulty.

Whereas, if the public purchases government bonds, by selling their shares or debentures, invested in private industrial concerns, it will create an adverse effect on private investment.

However, when the borrowed money, as stated above is used for highly productive activities, overall production is not affected badly. Likewise, if the public subscribes to government bonds by withdrawing their bank de­posits, it will adversely affect the lending capacity of commercial banks and thereby private investment activities.

However, if public debt is purchased by the individuals, utilizing their idle funds, it will not adversely affect private investment. Whereas borrowing resorted to meeting current expenditure or for financing a war, would result in the diversion of resources from productive activities to wasteful ex­penditure flows.

4. Effect of Public Debt on Distribution:

Borrowing leads to the transfer of resources from one section of the community to another section. If this transfer takes place from the rich to the poor, the inequality in the distribution of income and wealth would be reduced and as a result, the economic welfare of the com­munity will be enhanced.

On the other hand, if the transfer of wealth takes place from the poor to the rich, the disparity in the income distribution will be aggravated.

Usually, government bonds are subscribed by the richer income group. Whereas, the burden of taxation imposed for financing debt service and repayment of public debt, falls on the poor section. There­fore generally public debt has a tendency to increase economic in­equality.

Whereas suppose the public debt is mobilized through the small savings of lower-income group. Correspondingly debts are serviced and repaid through taxation imposed on the richer income group.

Then public debt will not result in increased income inequality. Hence, loan finance can be used as a means to redistribute income be­tween different segments of the society.

5. Other Effects of Public Debt:

(a) Public debts in the form of government bonds are negotiable credit instruments. They are highly liquid form of assets. The investors can freely convert them into liquid cash at any time to meet their demand for money.

Moreover, as far as financial insti­tutions are concerned, it adds to the liquidity position of these institutions, because of its transparency inconvertibility.

(b) During times of inflation, when the government borrows from the people, the purchasing power in the hands of the public will be reduced. As a result, inflationary pressure in the economy will be reduced.

On the contrary, during the depression, when the borrowed funds are utilized for development projects, it will generate addi­tional purchasing power, employment and income. Hence, dur­ing depression, public debt can be utilized as an effective instru­ment to curb deflationary fluctuations in economic activity.

Hence, in modern times, public debt is used as an important instrument to bring about economic stability in the economy. In fact, one of the major objectives of government borrowing today is to strengthen the economy by freeing it from the evils of depres­sions and also to build up the economy and stable economic growth. Owing to this reason, rapid increase in public debt need not be viewed with concern.

Q4) What is the burden of Public Debt and the traditional view on it?

A4) The burden of public debt is a misleading and highly confusing concept. The 1930s and 1940s witnessed an array of debate over the issue of debt burden. The focus of the debate was between those who feared that the creation of debt in the 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 points 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 the debit-credit relationship.

Every debit has a corresponding credit and this fact is frequently overlooked when considering the burden of public debt. In this context, Taylor points 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 overlooked 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.

The Keynesian approach strongly advocates that public borrowing for the purpose of generating effective demand will not generate any burden. It will help to activate idle savings in the private sector and generate income and employment. However, with the publication of James Buchana’s “Public Principles of Public Debt” in 1958, the debt burden controversy got again activated and fueled.

 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 the burden is shifted to the future genera­tion.

The future generation suffers when the present generation reduces its savings 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 a 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, the 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 necessitates 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.

Q5) What are the Modern Views of Public Debt?

A5) Economists like J.M. Keynes, Harris, Buchanan, Musgrave, and Modigliani are the chief exponents of the modern version of debt burden. The modern theory of public debt is put as “the new ortho­doxy” by Prof. Buchanan.

The worldwide depression of the 1930s 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 a 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 the employment situation and generate effective demand and thereby raising the level of economic activity.

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

However, 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 the 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 the burden of debt should be considered in terms of a reduction in personal satisfaction. When 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.

Buchanan argues that when government debt is serviced there is a burden in the form of a claim on the taxpayer’s income. That is when the debt is repaid; the future generation has to pay tax. This will reduce either their consumption or saving.

This will lead to reduced satisfaction. Hence, the primary burden is shifted to the future generation. This view of Prof. James Buchanan was widely supported by a number of economists. The conclusions emerging from the forgone analysis can be sum­marized as follows. The existence of the large debt is neither a blessing nor an evil. It produces both favourable and adverse effect on the economy.

Public debt should be treated as an important instrument of fiscal policy. Both these conflicting views on the burden of public debt can be easily shown to be misleading. Hence it would be con­venient and useful to adopt Dalton’s distinction between direct and indirect burden of public debt and between money burden and the real burden of public debt, to analyse the overall burden of public debt.

Q6) What is Direct and Indirect Money Burden?

 A6) 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 principal components. In the case of 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 monetary 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.

Direct Real Burden:

The 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 the public debt will help to reduce the inequalities of income in the community. In such circumstances there is no direct burden; instead, there is a direct real benefit to the community.

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 and 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.

Q7) What are Objectives of Fiscal Policy?

A7) Fiscal policy has a number of objectives depending upon the circumstances in a country.

Important objectives of fiscal policy are:

1. Optimum allocation of economic resources. The aim is that fiscal policy should be so framed as to increase the efficiency of productive resources. To ensure this, the government should spend on those public works which give the maximum employment.

2. Fiscal policy should aim at equitable distribution of wealth and income. It means that fiscal policy should be so designed as to bring about reasonable equality of incomes among different groups by transferring wealth from the rich to the poor.

3. Another objective of fiscal policy is to maintain price stability. Deflation leads to a sharp decline in business activity. On the other extreme, inflation may hit the fixed income classes hard while benefiting speculators and traders. Fiscal policy has to be such as will maintain a reasonably stable price level thereby benefiting all sections of society.

4. The most important objective of fiscal policy is the achievement and maintenance of full employment because through it most other objectives are automatically achieved. Fiscal policy aimed at full employment envisages the direction of tax structure, not with a view to raising revenue but with a view to noticing the effects with specific kinds of taxes have on consumption, saving and investment.

The problem is determination of the volume and direction of government spending not only to provide certain services but also to fit public expenditure into the general pattern of total spending currently taking place in the economy.

These objectives are not always compatible, particularly those of price stability and full employment. The objective of equitable distribution of income might come in conflict with the objectives of economic efficiency and economic growth. Fiscal policy can be geared to transfer wealth from the rich to the poor through taxation with a view to bringing about a redistribution of income. But the transfer of income from the rich to the poor will adversely affect savings and capital formation. Thus, equity and growth objectives conflict.

Instruments of Fiscal Policy:

The tools of fiscal policy are taxes, expenditure, public debt and a nation’s budget. They consist of changes in government revenues or rates of the tax structure so as to encourage or restrict private expenditures on consumption and investment.

Public expenditures include normal government expenditures, capital expenditures on public works, relief expenditures, subsidies of various types, transfer payments and social security benefits.

Government expenditures are income-creating while taxes are primarily income-reducing. Management of public debt in most countries has also become an important tool of fiscal policy. It aims at influencing aggregate spending through changes in the holding of liquid assets.

During inflation, fiscal policy aims at controlling excessive aggregate spending, while during depression it aims at making up the deficiency in effective demand for raising the economy from the depths of depression. The following considerations may be noted in the adoption of proper policy instruments.

Q8) What is built-in flexibility and built-in stabilizers?

A8) Built-in-Flexibility:

One practical difficulty of public finance is of making the fiscal tools flexible enough for prompt and effective use. For example, the tempo of business activity may change suddenly manifesting itself in booms and slumps but fiscal tools cannot be geared all at once to meet such situations. To overcome such practical difficulties, built-in-flexibility has to be ensured in the fiscal tools.

A fiscal system has built-in-flexibility if a change in employment in the economy brings about a marked compensating change in the government’s revenues and expenditures. Unemployment insurance schemes have built-in-flexibility on both the spending and taxing sides.

As employment increases, the money spent on dolls is automatically reduced. Price support programmes, some kinds of excise duties, especially those levied on luxuries, also have built-in-flexibility to some extent.

However, built-in-flexibility may prove inadequate to cope with strong deflationary and inflationary pressures. Therefore, formula flexibility (or flexibility by way of executive discretion) is required.

A system of formula flexibility provides for specific changes in the tax structure and the volume of government spending as necessitated by certain clearly-recognised problems in business activity. It requires decision making on the part of the administration about the necessary changes which must be given effect to without delay.

Executive discretion implies the delegation to the chief executive the authority to order whatever changes he thinks fit in government spending and tax structure. These measures are required to supplement the built-in-flexibility of some schemes.

Built-in-Stabilizers:

The fact that both taxes and transfer payments automatically vary with changes in income level is the basis of the belief in built-in-stabilizers. The term ‘stabilizers’ is used because they operate in a manner as counteracts fluctuations in economic activity. They are called ‘built-in’, because these come into play automatically as the income-level changes.

Taxes may act as a stabilizing influence upon the economic system if the tax structure is such that the amount of taxes collected by the government rises automatically with increases in national income, for in this case the effect will be to reduce the expansion of disposable income. From the stabilizing point of view, it means a slower rise in induced consumptions.

If the tax system is such that only the absolute amount of tax revenue but also the percentage of income paid in taxes increases with an increase in income, its stabilizing impact will be greater. That will happen if the rate structure of the tax system is progressive, that is, the effective rates rise as the level of income increases.

Similarly, the various forms of transfer payments also operate in a countercyclical fashion. Only such transfer payments have a stabilising effect as decrease in amount when income increases and increase when income declines.

For example, when employment is falling, payments to the unemployed automatically increase, thereby increasing the disposable income and vice-versa. It would be too much to presume that these stabilizers by themselves can smoothen fluctuations in income but most would agree that these are effective complements to discretionary actions aimed at stabilising the economy.

Q9) Explain the  Financial Relations between Centre and State.

A9) The financial field to the centre is more powerful than the states. In fact, for their development plans the states are purely dependent on the centre. No state can afford to work without active financial assistance of the central government. Undoubtedly in all federations, the units are financially not self-sufficient, but in India economic dependence of the states on the centre is rather too much.

Division of subjects, as provided in the constitution is of such a nature that the states have many more sources of expenditure than those of income.

Of course, there are taxes which are levied and collected either exclusively by the states or centre, but there are also taxes which are collected by the states on behalf of the centre, white some of the taxes are collected by the union government and handed over to the states. On the whole, however, the states are to depend on the grant-in-aid to be given by the central government to the states.

In India system of taxation is very much based on the Act of 1935, with the provision that after every five years President shall appoint a Finance Commission to find out the ways and methods of properly distributing sources of income. The states are empowered to collect taxes, such as stamp duties, excise duties, etc., but are not required to deposit the amount so realised with the Union Government.

The taxes on such items as succession to property, terminal taxes on goods carried by railways, air force or navy, tax on railway fares and freights, tax on transactions in stock exchanges, etc., are to be collected by the Union Government but to be appropriated to the state governments.

It is also provided that the taxes on such items as income other than agricultural income, duties on excise, etc., will be levied and collected by the Union Government and shared between the Union and the States. Since the states have comparatively less sources of income, the central government provides grant-in-aid to them to run their administrative and development expenses.

The states receive grant-in-aid for the development of scheduled castes and scheduled tribes. Similarly the State of Assam receives special grant-in-aid for the administration of tribal areas.

There is no denial that the states are financially dependent on the centre for their financial allocations, but the system of appointing Finance Commissions has brought much flexibility in it.

In the words of Pylee, “No other federal constitution makes such elaborate provision as the Constitution of India, with respect to the relationship between the Union and the States in the financial field. In fact, by providing for the establishment of the Finance Commission for the purpose of allocating and adjusting the receipts from certain sources, the Constitution has made an original contribution in this extremely complicated aspect of federal relationship.”

The states are financially dependent on the Centre.

The distribution of financial resources between the Centre and the States is as under:

1. Taxes Exclusively Assigned to the Union:

(i) Customs and export duties

(ii) Income tax

(iii) Income from railways and postal departments.

(iv) Excise duty on tobacco, Jute cotton.

(v) Estate duty and succession duty in respect of property other than agricultural land.

(vi) Corporation tax

(vii) Taxes on Capital values of both individual and companies assets.

2. Taxes Exclusively Assigned to the States:

a)     Succession and estate duty in respect of agricultural land.

b)    Taxes on Vehicles used on roads, animals, boats. Income from land revenue and Stamp duty except on documents included in the Union List.

c)     Taxes on consumption or sale of electricity.

d)    Taxes on goods and passengers carried by road or inland water.

e)     Toll tax.

f)       Taxes on lands and buildings. Taxes on Professions and traders.

g)    Duties on alcoholic liquors for human consumption. Taxes on opium and narcotic drugs.

h)     Taxes on entry of goods into local areas.

i)       Entertainment and amusement tax.

j)       Taxes on gambling.

3. Taxes Leviable by the Union but to be Collected and Appropriated by the States:

a)     Taxes on luxuries and bettings.

b)    Taxes on bill of lading, letters of credit.

c)     Stamp duties on bills of exchange, cheques and promissory notes.

d)    Excise duty on medicinal toilet preparations.

4. Taxes Levied and Collected by the Union but Assigned to the States:

a)     Duty in respect of succession to property other than agricultural land.

b)    Taxes on railway freights and fares.

c)     Taxes on transactions in stock exchanges.

d)    Terminal taxes on goods and passengers carried by railway, sea or air.

e)     Taxes on sale and purchase of news papers and on advertisements published there in.

5. Taxes levied and collected by the Union but shared with the States.

The basis of distribution in this case is decided by the Parliament by law. The taxes include tax on.

a)     Income other than agricultural income.

b)    Excise duties other than that leviable on medicinal and toilet preparations.

In the financial field a mention may also be made to the office of the Comptroller and Auditor General of India, who is appointed by the President of India. He can direct the state governments to keep their accounts in a particular manner and these are duty bound to obey his instructions. While doing so he need not consult any state government.

Financial Emergency:

But in times of financial emergencies control of the union government over the states is immense. As soon as a financial emergency is declared the Union government becomes so powerful as to direct the state governments to observe certain norms of financial propriety and other necessary safeguards.

It can also direct the state governments to reduce salaries and allowances of its employees and even those of the judges of the High Courts. All money bills passed by the legislature, then are to be reserved for the consideration of the President.

Q10) What is the role of the Finance Commission?

A10) In the Centre state financial relations Finance Commission plays an important role. According to the Constitution the President is empowered to set up a Finance Commission after every five years to make recommendations to him about the distribution of net proceeds of taxes to be divided between the centre and the states.

The Commission is also required to suggest the principles on which grant-in-aid of the revenues should be given to the state governments out of Consolidated Fund of India.

It is also required to give its view on any matter which may be referred to it by the President in the interest of sound finances. So far President of India has been regularly setting up such a commission after every five years and each time its terms of reference has been made wider and wider.

By and large, the Union Government has also been accepting its recommendations and as such it has adopted liberal attitude about the recommendations of the Commission.

The Commission has touched even such subjects as debt burdens of the states, returns of public sector undertakings, etc. But even then there is demand by some states that distribution of resources should be such that these favour relatively poor states.

The role of the Finance Commission has considerably eclipsed the increasing role of the Planning Commission through which more funds are transferred to the states than through the Finance Commission. Not only this but it is the Planning Commission which regulates discretionary grants and not the Finance Commission.