BA420ECO-E

B.A.
SECOND YEAR SEMESTER – IV

ECONOMICS
Public Finance and International Economics
(Discipline Specific Course)

“We may forego material benefits of civilization, but we

cannot forego our right and opportunity to reap the benefits
of the highest education to the fullest extent…”
Dr. B. R. Ambedkar

Dr. B. R. AMBEDKAR OPEN UNIVERSITY

HYDERABAD
2019
 COURSE TEAM
Course Development Team (CBCS)

Editor Associate Editor

Prof. N. Linga Murthy Dr. K. Krishna Reddy
Former Vice Chancellor, KU
Course Co-ordinator:
Prof. S. Radhakrishna

Writers: Units
Prof. S. Radhakrishna, Kakatiya University 5, 9 & 10
Prof. NRV. Ramana Reddy, Vikrama Simhapuri University 6&7
Dr. K. Mohan Reddy, Kakatiya University 1&4
Dr. T. Sudharshan Reddy, Yogi Vemana University 3 & 13
Dr. A. Punnaiah, Telangana University 8 & 11
Dr. D. Adeppa, Girraj Govt. Degree College, Nizamabad 12
Dr. K. Krishna Reddy, Dr. BRAOU 2

Cover Design:
G. Venkat Swamy

First Published: 2019

Copyright © 2019 Dr. B. R. Ambedkar Open University, Hyderabad, Telangana.

All rights reserved. No part of this book may be reproduced in any form without permission in
writing from the University.

This text forms part of Dr. B. R. Ambedkar Open University Programme.

Further information on Open University programmes may be obtained from the Director
(Academic), Dr. B. R. Ambedkar Open University, Prof. G. Ram Reddy Marg, Road No.46,
Jubilee Hills, Hyderbad-500033.
Website: www.braou.ac.in
E-mail to: [email protected]
Printed on behalf of Dr. B. R. Ambedkar Open University, Hyderabad by the Registrar.

Lr. No. –

Printed at : ............................................................................................
 P R E FA C E

Dr. B.R.Ambedkar Open University has revised the syllabus of all UG level programmes
under Choice Based Credit System (CBCS) in the semester format being implemented for the
first time from the Academic Year 2017-18. Accordingly, Macro Economics and Public Finance
& International Economics are included in the curriculum of the two semesters in the Second
Year of the Three Year Degree Course in Economics. This publication on Public Finance &
International Economics to be studied in the Semester-IV. The syllabus of this course, for the
sake of convenience, is divided into blocks, each of which comprises two to three units. Each
block generally covers a specific area of the subject. The course on ‘Public Finance &
International Economics’ is covered in five (5) blocks consisting of thirteen (13) units.
The first block provides an introduction to Public Finance, sources, classification of
Public Revenue, different types of taxes and Cannon of Taxation. The second block explains
the Classification, Principles, Determinants and Effects of Public Revenue. The third block
deals with the concept of Fiscal Policy, its objectives and features. It also explains about
Federal Finance, Finance Commission, Central-State Relations and Budget. The fourth and
fifth blocks devoted to International Economics. An introduction to international trade, its
role in economic development and theories of international trade have been discussed in
fourth block. Balance of payments, causes and measures to correct disequilibrium in BOP,
Exchange Rates, Foreign Exchange Markets in India have been analysed in the fifth block.
The units are prepared by specialists and converted into self-instructional material to
enable the learner to read and understand them without difficulty. Each unit begins with the
content, i.e., the aspects to be covered in the unit, followed by objectives of the unit. Subject
matter of the unit starts with an introduction and ends with the summary. Check your progress
exercises are provided in each unit wherever necessary. The university hopes that this material
will help the student to get acquainted with ‘Public Finance & International Economics’.
Any suggestions for improvement of the course material would be highly appreciated.

III
 CONTENTS

Block/Unit No. Title Page No.

BLOCK - I: INTRODUCTION TO PUBLIC

FINANCE AND PUBLIC REVENUE 1-51

Unit-1: Nature and Scope of Public Finance -

The Principle of Maximum Social Advantage 2-22

Unit-2: Public Revenue: Sources and Classification 23-34

Unit-3: Canons of Taxation: Impact, Incidence and Effects of Taxation 35-51

BLOCK - II: PUBLIC EXPENDITURE AND PUBLIC DEBT 52-89

Unit-4: Classification, Principles, Determinants and Effects

of Public Expenditure 53-72
Unti-5: Nature, Sources, Classification, Effects and
Redemption of Public Debt 73-89

BLOCK - III: FISCAL POLICY, FEDERAL FINANCE AND BUDGET 90-117

Unit-6: Fiscal Policy and Federal Finance 91-101

Unit-7: Budget: Concepts, Types and Budgeting in India 102-117

BLOCK - IV: INTERNATIONAL TRADE AND DEVELOPMENT 118-167

Unit-8: International Trade and Economic Development 119-136

Unit-9: Terms of Trade and Gains from Trade 137-155

Unit-10: Balance of Trade 156-167

BLOCK - V: BALANCE OF PAYMENTS 168-201

Unit-11: Balance of Payments 169-179

Unit-12: Disequilibrium in Balance of Payments – Trends in

India's Balance Payments 180-193

Unit-13: Exchange Rates - Foreign Exchange Market in India 194-204

• Model Question Paper 205-207

IV
 BLOCK – I
INTRODUCTION TO PUBLIC
FINANCE AND PUBLIC REVENUE
This block introduces the nature, scope and evolution of Public Finance as a separate
branch of Economics. It also explains the basis for public finance operation through the
principle of Maximum Social Advantage which is an important principle behind public
finance. The second unit deals with the significance, different sources and classifications of
public revenue by different economists’. Apart from these aspects, different types of taxes
and their merits and demerits have been discussed. Cannons of taxation advocated by Adam
Smith and other economists, its incidence and impact have been analysed in unit-3.
This block contains the following units:
Unit - 1: Nature and Scope of Public Finance - The Principle of Maximum Social
Advantage
Unit - 2: Public Revenue - Sources and Classification
Unit - 3: Canons of Taxation - Impact and Incidence of Taxation - Effects of Taxation

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UNIT-1: NATURE AND SCOPE OF PUBLIC FINANCE – THE
PRINCIPLE OF MAXIMUM SOCIALADVANTAGE
Contents
1.0 Objectives
1.1 Introduction
1.2 Meaning and Definitions of Public Finance
1.3 Evolution of Public Finance
1.4 Nature and Scope of Public Finance
1.4.1 Public Revenue
1.4.2 Public Expenditure
1.4.3 Public Debt
1.4.4 Public Financial Administration
1.4.5 Economic Stability and Growth
1.5 Public Finance Vs Private Finance
1.5.1 Similarities
1.5.2 Dissimilarities
1.6 Role of the State in Economic Activities
1.7 The Principle of Maximum Social Advantage
1.7.1 Assumptions
1.7.2 The Principle
1.7.3 Limitations
1.7.4 Tests of the Maximum Social Advantage
1.8 Summary
1.9 Check Your Progress - Model Answers
1.10 Model Examination Questions
1.12 Glossary
1.13 Suggested Books

1.0 OBJECTIVES
The objective of this unit is to examine the meaning, evolution, significance, nature and
scope of public finance and also to explain the role of the state in economic activities and the
principle of maximum social advantage. After reading this unit, you will be able to:
• understand the nature, scope and importance of public finance.
• know the role of the state in economic activities.
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• understand the genesis of the principle of maximum social advantage.

1.1 INTRODUCTION
Public finance is one of the branches of economics. A discussion on public finance has
long history. However, the study of public finance assumed real importance towards the beginning
of the 20th century especially after the great depression of the 1930s. In modern times, public
financial operations play an important role in the economy of a nation. A modern state does not
merely act as a police state but performs a variety of political, social and economic functions.
Thus, there has been an increase in the public expenditure of a modern state. To meet this
expenditure every modern state has to raise large revenues. The tools of fiscal policy i.e.,
taxation, public expenditure and public debt influence production, distribution and consumption
as to achieve the desired socio- economic goals in the economy. The significance of public
finance has also increased on account of the growing use of money in recent times.
Thus, it can be said that government intervention has become necessary to regulate the
economy. The operations of public finance have a deep influence on the economic life of the
community and it should be possible to judge them by some criterion of social benefit. The
best criterion for the purpose is provided by Dalton is known as the “Principle of Maximum
Social Advantage” and by Pigou the “Principle of Maximum Aggregate Welfare.” Most of
the operations of public finance involve transfer of purchasing power from some persons to
others. Taxation causes transfers from certain individuals to public authorities and there are
transfers back from these authorities to other individuals by way of public expenditure. As a
result, changes take place in the volume and pattern of the production of wealth and its
distribution. The best system of public finance is that which secures the maximum social
advantage from the operations which it conducts. Irrespective of the type of government
spending, it provides certain benefits to the community. The benefits and costs of the financial
transactions of government have to be evaluated with utmost care keeping in view to regulate
the economy. The object of public finance is to promote the maximum social advantage, i.e. the
maximum good of the community. All public expenditure, assuming that it is judiciously incurred
by the government, confers some benefit on the community.

Check Your Progress.

Note: a) Space is given below for utilizing your answer.
b) Compare your answer with the one given at the end of the unit.
1. State the importance of public finance.
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1.2 MEANING AND DEFINITIONS OF PUBLIC FINANCE

To understand the meaning of public finance is pre-requisite to have some knowledge of
the words “Public” and “Finance”. The word “Public” is a collective term which stands for the
collection of individuals. In a wider sense, it refers to all the members of a community. The
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ordinary meaning of the term “finance” is money resources or revenues. It signifies money
matters. It does not signify the coins and notes of a country. Rather, it connotes to the resources
of an individual or a group of persons especially of a ruler or State, computed in terms of
money. In the wider sense, the word finance also means credit. From these two terms “public
and finance” one can derive the compound term ‘Public Finance’. According to the meaning of
these two terms, public finance stands for the resources of public authorities.
In another sense, public finance deals with the financial operations of the public
authorities. The word public refers the government or state. The term public authorities include
all types of governments i.e., central, state and local. Financial operations include raising of
revenue, expenditure incurring and borrowings both internal and external. Therefore, it can be
said that public economics is that branch of general economics which deals with the financial
activities of the State or Government at national, state and local levels.
Different economists have defined public finance differently. Some of the well-known
definitions of public finance are follows:
According to Adam Smith, “Public Finance is an investigation into the nature and
principles of the state revenue and expenditure”. Prof Dalton has rightly started, “it is one of
those subjects that lie on the border line between economics and politics. It is concerned with
income and expenditure of public authorities and with the mutual adjustment of one another.
The principles of Public Finance are the general principles which may be laid down with
regard to these matters”. Thus, public finance deals with the problems concerned with the
activities of income and expenditure of the governments.
Prof. Philip E. Taylor gave a detailed definition of public finance. According to him,
“Public finance deals with the finances of the public distribution as an organized group under
the institution of the government. The finances of the government include the raising and
disbursement of governmental funds. Public finance is concerned with the operations of the
public treasury. Hence, to the degree that it is a science, its policies are fiscal policies, and its
problems are fiscal problems.”
According to Mrs. Ursula Hicks, “The Second group is engaged in providing services
whose scope and variety are determined not by the direct wishes of the consumers but by the
decisions of the government bodies in a democracy by the representatives of the citizens”.
Mrs. Ursula Hicks clearly stated that the term state is a convenient short-hand covering
both minor and major governing bodies as well. Thus, the meaning of public finance has become
the principle underlying the acquisition and use of financial resources of the public body. This
meaning is too wide and too general to serve any useful purpose. Thus, the definition of public
finance as given by Mrs. Ursula Hicks is comprehensive and widens the scope of public finance
so as to include it in the whole field of public economics.
Carl C. Plehm regards public finance as “the science which deals with the activity of the
statesman in obtaining and applying of the material means necessary for fulfilling the proper
functions of the state”. In the words of Charles F. Bastable, “For all states – whether crude or
highly developed – some provisions of the kind are necessary, and therefore, the supply and

4
applications of state resources constitute the subject matter of study which is best entitled in
English, Public Finance.”
Richard A. Musgrave defines public finance as “The complex of problems that centre
around the revenue – expenditure process of government is referred to traditionally as public
finance. But, the basic problems are not issues of finance. They are problems of resource allocation,
the distribution of income, full employment, and price stability and growth . . . (It is) an investigation
into the principles of public economy; or more precisely, into those aspects of economic policy
that arise in the operations of the public budget.” In this definition, it can be said that Musgrave
is more apt for modern governments. According to him, the scope of public finance touches upon
the three major functions of the government’s budgetary policy i.e., the allocation of resources,
distribution of income and wealth and economic stability and growth.
Prof. Findlay Shirras defines public finance as “the study of principles underlying the
spending and raising of funds by public authorities. As a positive Science, it is concerned with
facts as they exist, it investigates the intricate flux of these financial events and discovers the
hidden uniformities by means of patient and systematic enquiry which we call research; the
statements of uniformities are expressed as laws”. Prof. J.M. Bucchanan defines public finance
as “the government considered as a unit, may be defined as the subject matter of the study of
public finance. More precisely, public finance studies the economic activity of government as a
unit”. According to J.K. Mehta, “public finance constitutes a study of the monetary and credit
resources of the state.” Prof. B.P. Herber opined “the government means of allocation is
accomplished through the budgetary practices of taxing and spending….In fact the science of
public finance studies and analyses the effects of government budgetary practices of taxing the
spending as (a) allocation of scarce productive resources (b) distribution of income and wealth,
(c) economic stability and full employment, (d) economic growth”.
By and large, from the above definitions, it can be said that there is no substantial and
fundamental difference between various definitions as all of them state that the public finance
is the subject which studies the income and expenditure of the government at the central, state
and local levels.

Check Your Progress.

2. Define public finance.
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3. State the Musgrave’s definition of public finance.
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4. Write the Adam Smith’s definition of public finance.
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1.3 EVOLUTION OF PUBLIC FINANCE
The origin of public finance is deep rooted in antiquity. The classical economists, starting
with Adam Smith, included public finance as an integral part of economic theory. Adam Smith
is credited with having first started a discussion of public expenditure, taxation and public debt
in his well known book, “An Enquiry into the Nature and Causes of the Wealth of Nations”. To
this day, economists refer to Adam Smith’s “Canons of Taxation”. Besides Adam Smith, David
Ricardo and John Stuart Mill also discussed certain aspects of taxation, expenditure and public
debt as part of economic theory. David Ricardo in his book, the Principles of Political Economy
and Taxation, published in 1817 devoted ten chapters to the discussion of the problems of
taxation. Chapter VIII ‘ On Taxes discusses the general effects of taxes while remaining chapters
deal with the effects of particular taxes such as those on rent, houses, profits, wages etc. Ricardo
discussed the problem of public debt in his ‘Essay on the Funding System’. J.S Mill devoted
sufficient space to the discussion on public finance in his well known book entitled ‘Principles
of Political Economy’. The book contains seven chapters and the 5th chapter devoted to the
discussion of general principles of taxation, classification of taxes into direct and indirect taxes
and the various problems of national debt. In short, the classical economists recognized the
importance of public finance and divided the subject matter of public finance into state or
government revenue, expenditure and debt aspects.
As far as the neo classical economists, public finance lacked systematic discussion and
it received scant attention in the Marshall – Edgeworth era. It is fact that Alfred Marshall’s well
known work Principles of Economics does not have any connected discussion of the subject
matter of public finance. Francis Ysidro Edgeworth also thought that the pure theory of taxation
was concerned only with the laws of incidence and the principle of equal sacrifice. By the time
the older discipline of the political economy was displaced systematic discussion of public
finance as a subject has almost disappeared from the important works of the great economists.
However, the first systematic book on public finance was presented by C.F. Bastable in
1892. Thereafter, the other well known studies were by Hugh Dalton’s ‘Principles of Public
Finance’, published in 1922 and then in 1928 A.C. Pigou’s work titled ‘Public Finance’ was
published. Since then several significant studies have been made on the subject public finance.
It was since the publication of J.M. Keynes’ epoch making book, ‘The General Theory of
Employment, Interest and Money’ in 1936, that public finance has assumed great importance.
In fact, Keynes’s New Economics is the new version of Public Finance. Thus, public finance is
no more simply a discussion on government revenue, expenditure and debt but discussion is
now centered round the use of fiscal measures for affecting the macro-level of income,
employment and output. The great depression of the thirties and the world-wide inflation during
the Second World War have given tremendous significance to the government’s financial
operations, and attention is now diverted from Sound Budget to Functional Finance. For this
Public Finance as a compensatory device may be considered worthwhile to remove fluctuations
in the economy and this would further lead to achieve rapid and balanced economic development.

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1.4 NATURE AND SCOPE OF PUBLIC FINANCE
The above definitions throw light on the scope and subject matter of public finance.
Some economists are of the opinion that public finance includes only the income and expenditure
of the government. They take a static view of the subject and do not look at its operational
aspect. This is a narrow view of public finance. According to this group of economists, tax
imposition, its collection and expenditure is to be studied in public finance; and no other things
should be included in the scope of public finance.
Some other economists hold a broad view of public finance. According to them, public
finance should include not only the income and expenditure of the government but the sources
of income and the way of expenditure of various government corporations, public companies
and quasi- governmental ventures should also be included in the scope of public finance. Thus,
this view extends the scope of public finance to the study of various independent bodies acting
under governmental control. Since the Great Depression, the study of public finance has assumed
greater significance owing to the belief that government influences all aspects of economic
activity through its fiscal operations. The modern governments are responsible for maintaining
the stability and expanding the level of employment. Thus, keeping in view of the various
functions, the State has to mobilize its resources and allocating the funds between these activities.
Thus, the scope and subject matter of public finance which has been ever- widening, consisting
the following five important components: i. Public Revenue; ii. Public Expenditure; iii. Public
Debt; iv. Public Financial Administration; and v. Economic Stability and Growth.

1.4.1 Public Revenue

Under this head, one can study the different sources of government’s revenue such as
tax revenue, non-tax revenue, public debt and creation of additional currency. It throws light on
the principles which should govern the public revenue and the various methods of raising it.
Taxation is the main body of this division of public finance and it mainly analyses the problems
of raising the public revenue through taxation. Thus, public finance includes the study of
classification of public revenue, canons of taxation, incidence and impact of taxation and effects
of taxation on production, distribution and employment. It also includes measures taken to do
social justice through taxation and to prevent evasion of taxes.

1.4.2 Public Expenditure

Public expenditure is the end and aim of the collection of state revenues. Under public
expenditure as a sub division of public finance, one can study the principles and problems
relating to the expenditure of public funds. Further, one can study the fundamental principles
governing the flow of government funds into different spending streams and the method of
incurring the actual expenditure of government funds on the various items. One can also study
the classification of public expenditure on different criteria, theoretical setup, and changes in
the pattern of public expenditure over time. At times, it also discusses the normative aspect of
the problem and evaluates the performance of public expenditure on the basis of certain value
judgments and makes suggestions for making improvements in the funds spending policies of

7
the government. This part of public finance deals with the study of the principles and the
effects of public expenditure on the economy as a whole i.e., the effects on production,
distribution and individuals.

1.4.3 Public Debt

Public debt refers to the government borrowings from the public. A government can also
obtain income through raising loans in order to finance the shortfall in its traditional income. In
modern times, public borrowings constitute an important source of raising funds by the
governments. Thus, the study of public debt includes methods and objectives of public
borrowings, management of public debt and burden of public debt both internal and external.
The problems related to the raising and repayment of loans is also studied under this part of
public finance. Further, one can also examine the borrowing policy of the government and
indicate the directions in which improvements could be made.

1.4.4 Public Financial Administration

The scope of public finance is not only confined to public revenue, expenditure and debt
but also have to examine the mechanism by which these processes are carried on. Thus, one
can face the problem of financial administration. Under this part of financial administration, it
is concerned with the government machinery that is responsible for performing the various
financial functions of the state. An efficient, energetic and scientific management is required to
look after the public expenditure, public revenue and public debt. Public servants should be
responsible for public revenue and they must use it according to the provision of law. The
authorities, institutions are there to look after the management, control, auditing and scrutinizing
the funds used by the various agencies of the government and how do they check on the use and
misuse of funds by government departments. The subject matter of financial administration
can answer to all these questions.
The budget is the master financial plan of the government. It brings together the estimates
of anticipated annual revenues and expenditures, implying the schedule of activities to be
undertaken and the means of financing these activities. Execution of the budget is another
important function of financial administration. The entire work starting with the procedure of
preparation of the budget, presentation of the budget before the parliament or assembly, execution
of the budget by the government after it has been passed by the parliament and evaluation of
the budget etc. constitute the subject matter of this part of the public finance.

1.4.5 Economic Stability and Growth

Since the publication of J.M. Keynes’s ‘General Theory of Employment, Interest and
Money’ in 1936, the scope of public finance has been enlarged. The influence of government
fiscal operations on the overall level of economic activity and the level of employment became
an integral part of the study of public finance. Thus, the study of public finance has come to
include fiscal policy of government in dealing with inflationary and deflationary situations,
instability of the price level, promotion of full employment, growth of the economy, welfare of
the people, etc.

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 The main concern of financial administration is to frame and look after the implementation
of various policies required for the economic stabilization and growth.

Check Your Progress.

5. State the important components of public finance.
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1.5 PUBLIC FINANCE Vs PRIVATE FINANCE

The word ‘finance’ is used for both public finance and private finance. In order to bring out
the specific and distinctive features of public finance, it is important to distinguish between public
finance and private finance. Private finance refers the financial problems and policies of an
individual economic unit which includes activities of individuals, co-operatives and corporations.
Public finance refers all economic activities of government- central, state and local. Thus, private
finance emphasizes individual interests while public finance attempts to promote the welfare of
the entire community. Some people believe that the principles of public finance are same as the
principles of private finance, while others believe that the principles of public finance and private
finance are different. Both these views are justified to some extent because of the existence of
similarities and dissimilarities between the public finance and private finance.

1.5.1 Similarities
The similarities of public and private finances are as follows:
1. Both the public and private finances have the same objective of satisfying human wants.
Private finance is to satisfy individual wants, while public finance is to satisfy social
wants.
2. Both the private and public sectors have limited resources at their disposal and both the
sectors always endeavor to make optimum use of these resources.
3. Both private and public finances borrow as and when current incomes are inadequate to
meet current expenditure. Similarly, both the sectors have also to repay loans.
4. Both the private and public sectors have receipts and expenditures and each tries to
balance each other and do their best to get the maximum satisfaction.
5. Both the sectors are engaged in those activities that involve large purchases, sales and
other transactions. They are also engaged in production, exchange, saving, capital
accumulation, investment, etc.

1.5.2 Dissimilarities
The above mentioned facts suggest the similarities between the public finance and private
finance. However, the differences between the two kinds of the finances are more stark than the
similarities between them. Some of the main differences between the two forms of finances are
mentioned hereunder.

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1. Adjustment of Income and Expenditure: Generally an individual tries to live within
his income and adjust his expenditure according to the level of his income. In contrast,
the public authorities adjust its income to its expenditure. According to Hugh Dalton,
“while an individual’s income determines the amount of his possible expenditure, a public
authority’s expenditure determines the amount of its necessary income.” A person prepares
his budget on the basis of the income he expects to receive. On the other hand, the
government first prepares the budget of its expenditure and then investigates into the
resources from where it can raise funds to meet this expenditure.
2. Motive of Expenditure: The main purpose of private individuals or corporations
expenditure is profit for themselves. Contrary to this, the purpose of governments’
expenditure is not to earn profit but to provide maximum benefit to the society. The
modern government thinks for the welfare of the community and not for the benefit of
any particular individual.
3. Nature of Budget: Generally, every individual wishes to save a part of his income and
attempts to secure a surplus budget. On the other hand, the governments have no such
aim and may or may not balance their budgets. To maintain a surplus budget for an
individual is a virtue since only through savings one accumulates capital and becomes
rich. But a surplus budget of government means high level of taxation or low level of
public expenditure. Generally people do not like both these conditions. Thus, a balanced
budget is considered good in normal conditions, and not a surplus or deficit budget.
However, in fact, the modern government prefers always deficit budget for enhancing
the welfare of the community.
4. Sources of Revenue: Public authorities raise funds from many sources. The issue of
currency without any limit, unlimited power of taxation, collection of fees, fines etc.,
profits of public enterprises, internal and external borrowings, etc. So, the government
possesses great power to raise revenue and unlimited sources. On the other hand, sources
of funds for private individuals and corporations are certainly limited. Generally, they
receive income from wages, interest, rent and profits and only internal loans. The private
sector cannot raise loans from foreign countries.
5. Secrecy: Generally private finance has utmost secrecy as an individual does not like to
show his financial affairs to others. An individual always maintains secrecy about his
income and expenditure details. However, in fact, he may be forced to declare his income
and expenditure before the income tax department. This is true to some extent, of private
companies also. Contrary to this, there is no secrecy for public finance operations.
Governments publish budget documents yearly and discussion for open to all. Government
gives the greatest publicity to its budget proposals and keenly examined in the legislature
and also invites criticism and constructive suggestions from the public leaders and also
general public.
6. Coercive Power: Government has coercive power to levy taxes anything on the earth,
to coin money and print notes. No one can refuse to pay taxes, if he is liable to pay them.

10
 On the other hand, private individuals and business corporations can never use force to
get their revenue. Government can raise resources from the society as a whole, even by
force, if necessary. An individual has got no such power to collect money by force.
7. Long Term Perspective: The life of a government is very much longer than that of an
individual. The government is a trustee for the future. Government has a long term view.
It not only satisfies wants and raise welfare of the present generation but also care must
be taken to protect interests of the future generation. The government spends huge funds
on long gestation projects. In contrast, private finance has a short-term view. Individuals
and corporations generally concerned with the immediate gains. Thus, government spends
for future while individual spends for the present.
8. Compulsory Character: The government cannot avoid or postpone certain expenditure,
while this is done in case of individuals. The expenditure on defence, public administration,
etc., is of compulsory nature.

Check Your Progress.

6. Write any two similarities between the public finance and private finance.
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7. State one dissimilarity between the public finance and private finance.
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1.6 ROLE OF THE STATE IN ECONOMIC ACTIVITIES

In all modern states, governmental functions have greatly expanded with the emergence
of government as an active force in guiding social and economic development. In countries
with a command economy, government has a vast range of responsibilities for many types of
economic activities. In those countries favouring social democracy, the government owns or
regulates business and industry. Even in the free-market economy of the United State - where
there remains a much greater attachment than in most societies to the idea that government
should be only an umpire adjudicating the rules by which other forces in society compete -
some level of government regulation, such as the use of credit controls to prevent economic
fluctuations, is now accepted with relatively little question. Government has thus become the
major or even the dominant organizing power in all contemporary societies.
The historical stages by which governments have come to exercise their contemporary
functions make an interesting study in themselves. The scope of government in the ancient
polis involved the comprehensive regulation of the ends of human existence. As Aristotle
expressed it, what was not commanded by government was forbidden. The extent of the functions
of government in the ancient world was challenged by Christianity and its insistence on a
division of those things that belong separately to Caesar and to God. When the feudal world
succeeded the Roman Empire, however, the enforcement of the sanctions of religion became
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one of the first objects of political authority. The tendencies that began in the 18th century
separated Church from the State and State from society, and the modern concept of government
came into being. The American colonies’ Declaration of Independence’ expresses the classic
modern understanding of those ends that governmental functions exist to secure. The first aim
of government is to secure the right to life; this comprehends the safety of fellow citizens as
regards one another and the self-preservation of the country as regards foreign powers. Life
exists for the exercise of liberty, in terms of both natural and civil rights, and these, along with
other specific functions of government, provide those conditions upon which men may pursue
happiness, an end that is finally private and beyond the competence of government.
Keeping in view the analysis of various economic systems, it is argued by various
economists that state should intervene directly or indirectly in all those economic and social
activities where the community as a whole can benefit. Today there is a strong demand by the
people that state should play active role in the social and economic affairs of the country.
However, in general the following services are provided by the government in a modern state:
1. Defence against Foreign Attack: It is the basic duty of the state that it should protect
the country from external invasion. It has to make adequate preparations in the form of
weapons and land, sea and air forces. There should be no fear of external aggression to
the citizen. They must be satisfied that their state has full power to protect the country.
2. Internal Peace and Security: The primary duty of the state is to provide safety and
security of life and property to the citizen. If the life of the people is not safe then they
cannot work efficiently and peacefully. It should enforce law and order in the country. If
society is not satisfied it cannot lead to economic progress. The state maintains peace
and order through police and army.
3. Protection of the Rights of Citizens and Justice: In every state the citizens possess
certain rights like rights of life, property, religion and religious rights, freedom of thought
etc. It is incumbent upon the state to protect these rights, or which it has to formulate
essential laws, arrange for proper administration and organise justice. In this way justice
or the settlement of disputes is a compulsory function of the state. This provides for
obedience of laws in the state, maintains order and protects the rights of everyone.
4. Direct Intervention in Social Services: It is duty of the modern governments that they
should provide free education, free medical facility, pensions and funds to old age persons,
handicapped and unemployed persons. It directly involves in the social welfare
programmes by opening health clinics, parks and libraries. In the modern age, all states
consider that their duty is to make adequate arrangement for the education of their citizens.
Thus, the state makes arrangements for primary schools and colleges and universities,
research centres, libraries, etc. Along with education, modern states try to provide for
the protection of health. Provision is made for sanitation, hospitals, free medicine,
vaccination and essential nutritious food for the poor. Modern governments have also
begun making arrangements for the old age, handicapped and unemployed people. They
are given financial aid like pensions.

12
5. Arrangement of Public Services: The state organizes the railways, postal and telegraphic
facilities, wireless, etc. It is the duty of the state to make arrangements for means of
transportation such as buses, railways, aeroplanes and ships etc. The role of the government
for investing in infrastructure on these services is crucial.
6. Encouraging Trade and Industry: It is also the duty of the state to encourage trade and
industry and to develop it as well. Almost everywhere in the world, it is the state which
controls economic system and the mint. It is the state which standardizes the standards
of measurement and weighing. The country cannot benefit by international trade if it
does not make the proper law for imports and exports. The state should establish factories
of the key industries in order to implement and initiate other industries in the country.
The state should also encourage cottage industries. Modern state also protects the domestic
industries from the foreign competition by imposing the various restrictions.
7. Organization of Labour: The state should direct its efforts to the improvement of
conditions of labourers and lay down rules to obviate the probability of their exploitation.
It is the responsibility of the state to make efforts towards labour welfare. Generally
workers bargaining power is very poor as compared to the employers. The interest of the
workers cannot be safe guarded without the protection of the state.
8. Proper Use of Natural Resources: It is the basic responsibility of the state to make full
utilization of economic resources for the economic welfare of the people. The state should
make proper allocation of resources. A country can become powerful by land, forests,
rivers, minerals and agricultural products. Maximum benefit should be extracted from
them. On this subject, the state should direct the necessary precautionary measures,
research and search for new mineral products and lay down laws for the utilization of
forests, mines, land etc.
9. Financial Support and Fiscal Control: The modern state’s responsibility is that it should
provide good currency supply and to maintain the stability in the prices. Financial sector
is responsible for deploying scarce capital resources in the most efficient way. The
government is concerned with gathering, processing, and dissemination of information
about the areas in which the market failures are witnessed. \
10. Equitable Distribution of Income: It is also the duty of the state to keep an eye on the
income distribution of the public. It should take suitable steps to reduce the inequality of
income in the country. Government redistributes income through programmes as social
security, welfare, employment guarantee, etc. It tries to lift the incomes of the poor by
providing specific goods and services or subsidizing their purchases. The government
may also achieve this objective of redistributing income through its tax system by levying
progressive taxes on the rich people in the country.
11. Economic Planning: In order to speed up the rate of economic development, it formulates
the development programmes. It fixes the targets and priorities and proceeds to complete
them. The most important reason for the adoption of planning was that it was considered
superior way of developing the economy. It was rightly thought that planning was essential
to ensure a quick building of the productive capacity of the country. Planning should
13
 result in greater equality in income and wealth, and that benefits of development should
accrue more and more to the poor.
12. Provision of Employment: It is also the primary function of the modern state that it
should create the employment opportunities in the country and adopt various economic
policies to reduce the rate of unemployment in the country.

Check Your Progress.

8. Briefly state the role of the state in economic activities.
..........................................................................................................................................
...........................................................................................................................................

1.7 THE PRINCIPLE OF MAXIMUM SOCIAL ADVANTAGE

In olden days, when functions of governments were kept at minimum the activities of
spending and raising money by the government did not receive much attention. Because of
limited functions (known as police State functions) less amount used to be raised by way of
taxes and less money used to be spent on public expenditure programme. In the words of J.B.
Say “the very best of all plans to finance is to spend the least and the best of all taxes is that
which is least in amount”. This statement clearly supports the minimum role of government in
the economy. It was imagined by early economists including Adam Smith and Ricardo that
most of the private expenditure which taxation checked, was productive while all public
expenditure which taxes paid for as unproductive’. But as Dalton rightly says “this supposed
distinction has long been discredited. The only economic test of the productiveness of any
expenditure is its productiveness of economic welfare and public expenditure on education and
health is often have productive in this sense than private expenditure on luxuries”. As modern
welfare states have to perform more functions, the argument that public expenditure is
unproductive or all taxes are an evil is not valid now. In modern economies, budgetary and debt
policies have assumed prominence for regulating the economy. The demand and supply factors
for important goods and services are being influenced by the operations of public finance,
which in turn influence the national income of the country. Therefore, public finance operations
should be so designed as to provide maximum advantage or welfare to the people of the society.
The criterion adopted to achieve this objective is known as ‘principle of public finance’ or
‘principle of maximum social advantage’. In other words the marginal social benefit or marginal
utility of public expenditure, like that of everything else, diminishes as the community as more
of it. Therefore, the social advantage is the maximum, if the marginal utility of public expenditure
is equal to the marginal disutility of public expenditure.

1.7.1 Assumptions
The principle of maximum social advantage is based on the following assumptions.
They are:
i. It is assumed that the public revenue of the government consists of only taxes but not the
other forms of revenue like gifts, loans, fees, etc.

14
ii. It is assumed that taxes are subject to increasing marginal sacrifice (marginal social
disutility) while public expenditure is subject to diminishing marginal utility (marginal
social benefit). By making this assumption, we mean that collection of more and more
taxes from the public results in greater marginal social disutility and spending more and
more money by the government results in lower marginal social benefit to the people.
iii. All taxes result in sacrifice and all public expenditures lead to benefits; and
iv. The government has no surplus or deficit budget but only balanced budget.

1.7.2 The Principle

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.”
The ‘Principle of Maximum Social Advantage (MSA)’ is the fundamental principle of
Public Finance. It states that public finance leads to economic welfare when public 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; and 2. Marginal Social Benefits
1. 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.

15
 The Marginal social sacrifice is illustrated Y

Marginal Social Sacrifice

MSS Curve
in the figure-1.
S3
The figure-1 indicates that the Marginal
Social Sacrifice (MSS) curve rises upwards from S2

left to right. This indicates that with each S1

additional unit of taxation, the level of sacrifice
also increases. When the unit of taxation was OM1, O M1 M2 M3
X

the marginal social sacrifice was OS1, and with Units of Tax (Rupee)
Increasing Marginal Social Sacrifice Curve
the increase in taxation at OM2, the marginal social
sacrifice rises to OS2. Figure-1
2. 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 Marginal Social Benefit
B1
commodity to a consumer declines as more and
B2
more units of the commodity are made available B3
to him, the social benefit from each additional MSB

unit of public expenditure declines as more and

X
more units of public expenditure are spent. In M1 M2 M3

the beginning, the units of public expenditure are Units of Public Expenditure (Rupees)
Diminishing Marginal Social Benefit Curve
spent on the most essential social activities.
Figure-2
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-2.
In the figure-2, 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 Y
Advantage: Social advantage is maximised MSS
Marginal Social Benefit

at the point where marginal social sacrifice

R1 P1
and Sacrifice

cuts the marginal social benefits curve.

S2
P
If you observe figure-3, this is at the R P2
point P. At this point, the marginal disutility MSB
or social sacrifice is equal to the marginal S1
Q1 O Q Q2 X
utility or social benefit. Beyond this point, the
marginal disutility or social sacrifice will be Units of Taxation and Expenditure
Maximum Social advantage is obtained at the
higher, and the marginal utility or social Point of Intersection of MSS and MSB Curves
benefit will be lower. Figure-3
16
 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.
By and large, it can be said that the 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.

1.7.3 Limitations
The principle of maximum social advantage suffers from many limitations. Some of
them are as follows:
i. Difficult to put into practice: Utility being subjective in nature, creates a great obstacle
for the state to balance marginal utility and disutility.
ii. Utility is not measurable: Utility cannot be measured quantitatively.
iii. It ignores macro system: Disutility caused to the tax-payer is micro problem, whereas,
marginal utility gained is a macro concept.
iv. Highly unrealistic restrictions: The argument that govt. should not have surplus or deficit
budget is highly unrealistic.
v. Welfare State: Modern states are not police states but are welfare states and have to plan
certain projects.

1.7.4 Tests of the Maximum Social Advantage

i. Preservation of community: The duty of the govt. should be to preserve the community
against internal disorders and external attacks. It creates confidence and promotes
economic life of its citizens.
17
ii. Improvements in Production: Increase in productive power so that large product per
worker shall be obtained- to achieve minimum waste of economic resources- improvement
in pattern of production.
iii. Improvement in Distribution: The inequalities of income, resulting due to unearned
income, should not be tolerated while the skills and efforts may be justified and suitably
rewarded.
iv. Stability and Full Employment: The social advantage to the community can be increased
if economic stability and full employment level is achieved.
v. Provisions of Future: Individuals give more importance to the present than to the future
and, therefore, the responsibility of the state has double responsibility of looking after
the interests of the present as well as future generations.
There are, however, some common indicators to this test on which there is no
disagreement. They are - (i) reduction in inequalities of income and wealth, (ii) reduction in
unemployment (iii) improving the standard of living of the people (iv) increase in the rate of
economic growth and (v) bringing about economic stability etc.
Mrs. Ursula Hicks also has suggested some tests to judge whether the public finance
operations do fulfill the principle of maximum social advantage. She has given two criteria
namely (a) production optimum and (b) utility optimum. The output of any commodity can be
changed by re-allocation of productive resources. According to Mrs. Hicks, production optimum
is reached when it is not possible to increase the output of a commodity without reducing the
output of any other commodity. In practice, it is not possible to achieve such a kind of optimum
level. The production optimum stated by Mrs. Hicks is satisfied only under conditions of full
employment and if then is not wastage of production resources .Normally, public finance
operations may not satisfy their conditions .The second test namely utility optimum Stated by
her relates to the composition of the national output and the relative importance attached to the
various component elements of it. According to Mrs. Hicks it is possible to change the total
Utility of the goods of the people by varying the composition of the national output. So, a
situation may be reached when the total utility to the society is maximised with a given
composition of the national output .To that situation, she calls it, ‘utility optimum’.

Check Your Progress.

9. State the assumptions of the principle of maximum social advantage.
..........................................................................................................................................
...........................................................................................................................................
10. Write the limitations of the principle of maximum social advantage.
..........................................................................................................................................
...........................................................................................................................................
11. State the tests of the principle of maximum social advantage.
..........................................................................................................................................
...........................................................................................................................................
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1.8 SUMMARY
Public finance is one of the important branches of economics. It deals with the financial
activities of the governments- central, state and local. This unit explained the basic concepts of
public finance. The meaning and origin of public finance, various definitions, traditional and
modern, given by economists on the public finance are discussed. The nature and scope and the
developments in the subject matter of public finance is also discussed. We have explained the
similarities between public finance and private finance and how public finance differs with
private finance. Finally, the role and functions of modern governments have been discussed.
This unit explained the nature and subject matter of public finance the increasing role of
the States. As modern welfare states have to perform more functions, the public expenditure
component of government budgets has tremendously .increased. Public finance operations should
be designed to provide maximum advantage or welfare to the people of the society. As we
learnt in this unit, the criteria adopted to achieve this objective is known as “principle of
maximum social advantage”. This principle has based on some assumptions. It has some
limitations. We have tried to analyse these issues in this unit, in spite of the limitations, the
principle has a major role to play in the modern welfare world.

1.9 CHECK YOUR PROGRESS - MODEL ANSWERS

1. Public finance is a branch of economics. The study of public finance assumed real
importance towards the beginning of the 20th century especially after the great depression
of the 1930s. In modern times, public financial operations play an important role in the
economy of a nation. A modern state does not merely act as a police state but performs a
variety of political, social and economic functions. Thus, there has been an increase in
the public expenditure of a modern state.
2. Public finance deals with the financial operations of the public authorities. The word
public refers the government or state. The term public authorities include all types of
governments i.e., central, state and local. Financial operations include raising of revenue,
expenditure incurring and borrowings both internal and external. Therefore, it can be
said that public economics is that branch of general economics which deals with the
financial activities of the State or Government at national, state and local levels.
3. Richard A. Musgrave defines public finance as “the complex of problems that centre
around the revenue – expenditure process of government is referred to traditionally as
public finance. But, the basic problems are not issues of finance. They are problems of
resource allocation, the distribution of income, full employment, and price stability and
growth . . . (It is) an investigation into the principles of public economy; or more precisely,
into those aspects of economic policy that arise in the operations of the public budget.”
4. According to Adam Smith, “Public Finance is an investigation into the nature and
principles of the state revenue and expenditure”.
5. The important components of public finance are: Public revenue; Public expenditure;
Public debt; Public financial administration; and economic stability and growth.
19
6. The two similarities between public finance and private finance are: i. both the public
and private finances have the same objective of satisfying human wants. Private finance
is to satisfy individual wants, while public finance is to satisfy social wants; ii. both the
private and public sectors have limited resources at their disposal and both the sectors
always endeavor to make optimum use of these resources.
7. Generally private finance has utmost secrecy as an individual does not like to show his
financial affairs to others. An individual always maintains secrecy about his income and
expenditure details. However, in fact, he may be forced to declare his income and
expenditure before the income tax department. This is true to some extent, of private
companies also. Contrary to this, there is no secrecy for public finance operations.
Governments publish budget documents yearly and discussion for open to all. Government
gives the greatest publicity to its budget proposals and keenly examined in the legislature
and also invites criticism and constructive suggestions from the public leaders and also
general public.
8. The following services are provided by the government in a modern state: 1) Defence
Against Foreign Attack; 2) Internal Peace and Security; 3) Protection of the Rights of
Citizens and Justice; 4) Direct Intervention in Social Services; 5) Arrangement of Public
Services; 6) Encouraging Trade and Industry; 7) Organization of Labour; 8) Proper Use
of Natural Resources; 9) Financial Support and Fiscal Control; 10) Equitable Distribution
of Income; 11) Economic Planning; 12) Provision of Employment.
9. The principle of maximum social advantage is based on the following assumptions.
They are: i) It is assumed that the public revenue of the government consists of only
taxes but not the other forms of revenue like gifts, loans, fees, etc. ii) It is assumed that
taxes are subject to increasing marginal sacrifice (marginal social disutility) while public
expenditure is subject to diminishing marginal utility (marginal social benefit). iii) All
taxes result in sacrifice and all public expenditures lead to benefits; and iv) The
government has no surplus or deficit budget but only balanced budget.
10. The limitations of the principle of maximum social advantage are: i) difficulty to put
into practice; ii) utility is not measurable; iii) it ignores macro system; iv) highly unrealistic
restrictions; and v) modern states or not police states but are welfare states.
11. The tests of the principle of maximum social advantage are: i) preservation of community;
ii) improvements in production; iii) improvement in distribution; iv) stability and full-
employment; and v) provisions of future.

1.10 MODEL EXAMINATION QUESTIONS

I. Answer the following questions in about 10 lines each.
1. Discuss the evolution of public finance.
2. State the assumptions and limitations of the principle of maximum social advantage.
3. Elucidate the tests of maximum social advantage.

20
II. Answer the following questions in about 30 lines each.
1. Define public finance and distinguish between public finance and private finance.
2. Analyse the meaning, nature and scope of public finance.
3. Examine the role of the state in economic activities.
4. State and explain in the tests of maximum social advantage.
5. Critically examine the principle of maximum social advantage.

III. One mark questions.

A. Multiple choice questions.
1. Which one is not the tool of fiscal policy?
(a) taxation (b) public expenditure (c) public debt (d) demand and supply
2. Public economics is a branch of:
(a) General Economics (b) Micro Economics
(c) Macro Economics (d) Financial Economics
3. Name the author of the book entitled “Principle of Public Finance”.
(a) R.A. Musgrave (b) Hugh Dalton (c) C.F. Bastable (d) Adam Smith
4. The book “General Theory of Employment, Interest and Money” is associated with the
name of:
(a) David Ricardo (b) Bastable (c) J.M. Keynes (d) J.S. Mill
5. The “Principle of Maximum Social Advantage” is advocated by:
(a) Adam Smith (b) A.C.Pigou (c) Hugh Dalton (d) R.A. Musgrave
6. The “Principle of Maximum Aggregate Welfare” is propounded by:
(a) Alfred Marshall (b) A.C.Pigou (c) Leon Walras (d) Hugh Dalton
7. Which one is the test of the principle of maximum social advantage?
(a) Provisions of future (b) Stability & full-employment
(c) Presentation of community (d) All above
Answers: 1. d; 2. a; 3. b; 4. c; 5. c; 6. b; 7. d

B. Fill in the blanks.

1. Public finance is a branch of ___________
2. Public finance deals with the _________ operations of the public authorities.
3. Public debt refers to the __________ borrowings from the public.
4. The budget is the master financial plan of the ________________
5. Private finance refers the financial problems and policies of an ________ economic unit.
6. Private finance is to satisfy ___________ wants.
7. Public finance is to satisfy ________ wants.
8. Both the private and public sectors have __________ resources at their disposal.
9. Dalton’s criterion is known as the _______________
10. Pigou’s criterion is known as the _______________
Answers: 1. economics; 2. financial; 3. government; 4. government;5. individual; 6. individual;
7. social; 8. limited; 9. principle of maximum social advantage; 10. principle of maximum
aggregate welfare.
21
C. Match the following.
A B
(i) Principle of Maximum Social Advantage (a) Branch of Economics
(ii) Principle of Maximum Aggregate Welfare (b) Additional Amount of Social
Sacrifice undergone by public
(iii) Marginal Social Sacrifice (c) Additional benefit conferred on
the society
(iv) Marginal Social Benefit (d) Hugh Dalton
(v) Public Finance (e) A.C.Pigou
Answers: (i) d; (ii) e; (iii) b; (iv) c; (v) a

1.11 GLOSSARY
1. Public Finance: It refers all financial activities, problems and policies of government-
central, state and local.
2. Private Finance: It refers the financial activities, problems and policies of an individual’s,
co-operations and corporations.
3. Surplus Budget: Surplus budget indicates the government revenue is more than the
government expenditure.
4. Deficit Budget: The government revenue is less than the government expenditure is
called deficit budget.
5. Balanced Budget: Balanced budget shows both government revenue and expenditure
are equal.
6. Marginal Social Sacrifice: It refers to that amount of social sacrifice undergone by
public due to the imposition of an additional unit of tax.
7. Marginal Social Benefit: It is the benefit conferred on the society, by an additional unit
of public expenditure.

1.12 SUGGESTED BOOKS

1. B.P. Tyagi (2012): Public Finance, Jayaprakash Nath & Co., Meerut.
2. H.L. Bhatiya (2010): Public Finance, Vikas Publishing House, New Delhi.
3. H. Dalton (1936): Principles of Public Finance, Rowtledge and Kagan Paul Ltd., London.
4. R. A. Musgrove (1959):The Theory of Public Finance, Mc Grew Hill, New York.
5. A.R. Prest (1960): Public Finance in Theory and Practice, English Language Book
Society and Weidenfeld Nicolson.
6. M.C. Vaish and H.S. Agarwal (2008): Public Finance, Wiley Eastern Ltd., New Delhi.

22
UNIT-2: PUBLIC REVENUE: SOURCES AND
CLASSIFICATION
Contents
2.0 Objectives
2.1 Introduction
2.2 Meaning and Significance of Public Revenue
2.3 Various Sources of Public Revenue
2.4 Classification of Public Revenue
2.5 Direct and Indirect Taxes
2.6 Types of Taxes
2.7 Summary
2.8 Check Your Progress - Model Answers
2.9 Model Examination Questions
2.10 Glossary
2.11 Suggested Books

2.0 OBJECTIVES
The objective of this unit is to discuss about various sources from which State or the
Government raises its revenue in order to perform its various functions. It also explains the
views of economists on public revenue and how they classified it; the merits and demerits of
direct and indirect taxes; different types of taxes and the relative merits of each tax etc. After
reading the unit, you will be able to:
• list different sources of public revenue.
• classify the public revenue into different categories.
• explain different public revenue concepts.
• understand classification of taxes.
• analyse the merits and demerits of direct and indirect taxes.
• know different tax structures and their relative merits.

2.1 INTRODUCTION
During the 19th Century, the functions of State were very limited like protecting the
people from external aggression and internal disorders. This is logically based on the thesis of
classical economist like Adam Smith, J.B. Say, etc. They strongly argued a limited role to the
Government. Hence, the less need for Government revenues. Therefore, the revenues required
by the state to carry out its limited activities usually remained small. But in 20th Century, especially

23
after the Second World War, there has been tremendous increase in state activities which need
substantial revenues and hence the importance attached to taxation in the field of public revenue.
There are several sources to the government in any country to get revenue. Modern States
have many functions to perform and therefore, there is every need to raise adequate public revenue
from various sources. The revenue of a public authority may be defined either in a broad and or in
an narrow sense. For instance, H. Dalton distinguished the concept of public receipt as public
income and public revenue. According to him, public income in a broad sense includes all receipts
while in the narrow sense it includes only such of those receipts which are commonly attributed
to taxes, fees etc. These receipts increase the assets of the government without increasing its
liabilities. In the broad sense, the revenue of the State includes not only the amount realized
through taxes of all kinds but also revenues obtained from the sale of commodities produced by
the State as well as the earnings from the departmental undertakings such as Railways, Post
Office etc. and also receipts from public borrowings and paper money created.
Taxes can be divided as direct and indirect taxes. Both direct and indirect have their own
merits and demerits. All the developed nations depend mostly on direct taxes while the developing
nations rely on Indirect taxes. Income tax, Expenditure tax, Wealth tax, Corporation tax are some
important direct taxes; while Excise duties, Custom duties, Sales tax etc., are indirect taxes.
It is worthwhile for us to know the manner in which taxes ought to be imposed. It has
been argued by some economists like the Physiocrats who believed that there should be a
single tax system only instead of multiple tax system. Some have favoured taxes on consumption
while others have favoured taxes on income, wealth and property. Likewise, with regard to the
rate structure also there is hardly any consensus among the economists. While progressive
taxation had been supported by certain economists, proportional taxation also was considered
important in the tax structure of an economy. Among all these divergent opinions, it is necessary
to know what are the various sources, their characteristics and which one of them is better. An
attempt is made in the following sections to provide answers to the above questions.

2.2 MEANING AND SIGNIFICANCE OF PUBLIC REVENUE

Public Revenue is a very important part of Public Finance. It has very close relationship
with Public Expenditure. If Public Expenditure increases Public Revenue should also be
increased. The word Public Revenue is often used interchangeably with Public Income. In
other words, when Government gets its income through different sources is called either as
Public Revenue or Public Income. As stated above Dalton called all Public Receipts as Public
Income and opined that Public Income is a broad term. According to him, Public Receipts =
Public Revenue + Income from all other sources including Public Borrowings and Income
from Public Enterprises. Public Revenue includes only income from Taxes, Prices of Goods
and Services, Revenue from administrative activities, Gifts and Grants. In modern times, Public
Revenue assumed lot of importance in Government Finances. So, let us know more about
various sources of Public Revenue.

24
2.3 VARIOUS SOURCES OF PUBLIC REVENUE
In the modern times, Public Revenue is generated from various sources. They are: (i) the
Taxes (ii) Fines imposed by the government on the offenders, (iii) Compulsory Loans, (iv)
Tributes and Indemnities arising out of war or from other reasons, (v) Income from Public such
as Lease of Government Lands, (vi) Profits of the Public Enterprises, (vii) Fees for the services
rendered by the government, (viii) Receipts from Voluntary Public Loans, (ix) Betterment
Levy and other Assessment, (x) Voluntary Gifts etc.
Government or Public Revenue is generally classified as (1) Tax Revenue and (2) Non-
Tax Revenue. Tax Revenue is derived from two important sources, (a) Direct Taxes and (b)
Indirect Taxes. Income Tax, Expenditure Tax, and Wealth Tax etc are comes under Direct
Taxes; whereas taxes and duties like Sales Tax, Excise Duties, and Customs Duties are the
Indirect Taxes. Besides, Government gets revenue from taxes; non-tax sources like Fees, Special
Assessment, Fines, Forfeitures and Escheats. The following Chart shows the sources of Public
Revenue.
SOURCES OF PUBLIC REVENUE

Tax Revenue Sources Non-Tax Revenue Sources

Direct Taxes Indirect Taxes Fees Fines Prices Forfeitures Gifts Indemnities Escheats
&Grants & Tributes

2.4 CLASSIFICATION OF PUBLIC REVENUE

Before knowing about the concepts and characteristics of various sources of Public
Revenue in detail. Let us examine how different economists viewed Public Revenue and how
they classified it, according to their own perception. Though, there are number of economists
who have classified Public Revenue, the classification of Public Revenue by important
economists like Adam Smith, H.C. Adams, Hugh Dalton and Seligman is presented in the
following sections.
1. Adam Smith’s Classification: Adam Smith classified Public Revenue into two categories
(a) Income derived from the State property and (b) Income derived from the Public. In
the first category, we may have the revenue from public sector undertakings while in the
second category, the revenue received from taxation. As Adam Smith did not give much
importance to the role of the state and public expenditure, so he has given less importance
to public revenue. Further, he has not given any importance to loans and non-tax revenue.
Hence, his classification does not serve the purpose of the modern state.
2. Adams’s Classification: H.C. Adams has divided Public Revenue into three categories
namely (a) Direct Revenue which consists of income from public industries, gifts,
railways, post offices etc., (b) Derivative revenue which refers to taxes, fees, fines etc.
and (c) Anticipating revenue which refers to the income received due to sale of bonds or
25
 other forms of government securities. This last category is nothing but public debt. This
classification has a wide scope of revenues as it includes both commercial and
administrative revenues in one group.
3. Dalton’s Classification: Dalton has classified public revenue into twelve main categories:
(1) tax (2) tributes and indemnities whether arising out of war or otherwise
(3) forced loans which were prevalent in olden days (4) pecuniary penalties for offences
imposed by courts of justice (5) receipts from public property passively held like public
lands leased out to tenants (6) income received from public industries charging not more
than the competitive price (7) fees or payments made for services, not in the nature of
business services performed by public officials such as the registration of births (8)
receipts from voluntary public loans (9) receipts from those industries where the
government charges monopoly price (10) receipts from Special Assessment (11) receipts
from the use of the printing press for the purpose of meeting public expenditure by the
issue of paper money and (12) voluntary gifts. After giving this long list, Dalton felt that
most of the cases, the distinction is not clear because one kind of revenue overlapping
gradually into another.
4. Seligman’s Classification: Seligman’s Public Revenue is of three categories, namely;
(a) Gratuitous revenue (b) Contractual Revenue and (c) Compulsory Revenue.
i. Gratuitous Revenue: The gratuitous income consists of gifts, donations, etc., for
obtaining such incomes the State does not direct any institution or individual. They
are gratuitously made. The importance of this kind of income has considerably
reduced in recent times. But grouping all such incomes as a class by themselves is
justified as they differ from rest of the revenues the State is supposed to get. There
is no obligation on the part of the state to provide something (service or good) in
return to the persons who pay them. Items included in this category like gifts which
are neither very certain nor uniform in amount from year to year. It may also be
observed that the incidence of gifts is not always proportional to the ability of the
persons who make payments in the form of gifts.
ii. Contractual Revenue: The contractual revenue includes the revenues in the form
of rents, sale proceeds from the goods/services sold by the State to the public etc.
The State owns property in the form of land and buildings which are normally leased
out to the people on certain contractual terms. Similarly, the sale of goods produced
by the government enterprises as also of services like the Railways, Post Office etc.
provide the state with certain revenue. For all such type of contractual incomes,
Seligman calls them as ‘prices’, as they resemble very much the prices of goods or
services charged by private-individuals. However, in the modern welfare state the
pricing of such public utilities has been a matter of controversy unlike those private
goods determined by market mechanism.
iii. Compulsory Revenue: The third category relates to compulsory revenue which
broadly includes Taxes, Fees and Fines, Special Assessment etc. The state derives
revenues from its domain, penal and taxing powers. The state has the powers of
26
 eminent domain in the sense that it can expropriate the property of its citizens, if
necessary. But normally this power is not exercised by the state. The state is
empowered to exercise its penal power and therefore, can impose fines and penalties
which should be paid. The taxing power is very important from the revenue point of
view. It was not given importance in the olden days when the State’s activities ‘were
kept at minimum and all taxes were considered as evil. But in the modern days,
most of the State’s revenue comes from various types of taxes imposed on the public.
Seligman defines certain important items of revenues included under this compulsory category:
Fees: A fee is a payment to defray the cost of each recurring service undertaken by the government
primarily in the public interest but conferring a measurable special advantage on the fee-payer.
Tax: A tax is a compulsory payment by the people to the government to defray the expenses
incurred for the provision of Public goods and services in the common interest of all, without
conferring a special benefit conferred to the tax payer.
Special Assessment: A Special Assessment is a payment made once and for all to defray the
cost of a specific improvement to property under-taken in the public interest and levied by the
government in proportion to the particular benefit accruing to the property owner.

Check Your Progress.

Note: a) Space is given below for writing your answer.
b) Compare your answer with one given at the end of the unit.
1. What is Adam’s classification of public revenue?
..........................................................................................................................................
...........................................................................................................................................
2. What are the sources of public revenue?
..........................................................................................................................................
...........................................................................................................................................

2.5 DIRECT AND INDIRECT TAXES

Taxes are divided as direct and indirect taxes on the basis of transferability of the tax
imposed. Several economists opined that those taxes the burden of which can be transferred
are known as indirect taxes and those taxes, the burden of which cannot be transferred are
known as direct taxes. In other words, the tax payer bears the entire burden in the case of direct
taxes which means both impact and incidence of the tax is on the same tax payer. The tax payer
transfers the tax burden to others in the case of an indirect tax. This means, even though the
impact of the tax is on one tax payer, the final burden of the tax is born by another in the case
of an indirect tax. So those taxes for which the impact and incidence of the tax are different are
indirect taxes. The shifting and incidence of the tax is the main basis for dividing the taxes as
direct and indirect taxes.
There is no unanimity among economists in this regard. For example, some economists
27
believed that a tax on production is indirect tax. Some economists opined that a tax on income
and expenditure is a direct tax. J.S. Mill opined that the intention of the Government is very
important to categorize the taxes as direct and indirect. According to Mill, if the tax is paid by
the same person on whom the tax is imposed initially by the government is known as direct tax.
If the government’s intention is to shift the tax by a person on whom the government has
initially imposed the tax is known as indirect tax. According to Dalton if a tax is paid by a
person on whom it is legally imposed is a direct tax, while a tax which is shifted either part1y
or fully from a person on whom it is legally imposed is known as indirect tax. Direct and
Indirect Taxes exist in almost all countries, whatever may be the method of taxation and on
whatever activities they are imposed.
Important Direct taxes: One of the most popular taxes is the Income Tax. Government imposes
a tax on individuals or household income. It is sometimes referred as Personal Income Tax.
Another important direct tax is Corporate Tax. The tax on incomes of the company is known as
corporate tax or company income tax. It shows the ability-to-pay of the company or the
shareholders of the company. The other important direct tax is the expenditure tax imposed
especially in the developed countries. The tax is imposed taking into account the individual’s
or family’s expenditure. Economists like Hobbas, Mill, Fisher and Kaldor justified the imposition
of this tax. In addition, taxes such as Wealth Tax, Gift-tax, Estate Duty and Land Revenue are
some of the direct taxes implemented in several countries
Important Indirect Taxes: Sales tax is an important indirect tax imposed on the sale or purchase
of the goods and services. But in India sales tax is not imposed on services. Sales tax is imposed
either as an advalorem or specific tax. It may be imposed as a single point, double point or
multi-point tax. Excise Duty is another important indirect tax all over the world. This is a tax
imposed on the goods at the production stage which are meant for sale or consumption. While
some of these taxes are advalorem, others are specific nature. Customs duties are another
important indirect taxes. If taxes are imposed on goods imported or exported, they are known
as customs duties. If a government imposes taxes or duties on the imports are known as import
duties while the taxes or duties imposed at the time of exporting is known as export duties.
Value Added Tax (VAT) belongs to the family of sales tax. Under this system a tax is imposed
at various stages on the value added instead of on the gross value of the product. Value added
can be assessed by deducting the value of inputs used or purchased from other establishments
the gross value of the product. The tax imposed on such value is known as Value Added Tax. In
addition, there is another tax known as Service Tax which is imposed on the sale of services
which has been implemented in India since 1994-95.
The merits and demerits of these taxes are presented in the following paragraphs.
1. Merits of Direct Taxes: There are several advantages of direct taxes. Direct taxes can
be imposed on the basis of ability-to-pay of the tax payers. So the canon of equity in the
distribution of tax burden is observed. Direct taxes also help in reducing inequalities of
income and wealth in the economy. They are useful for adopting a progressive tax structure
and all direct taxes are progressive taxes only. It is possible to observe the canon of
certainty in the case of direct taxes. With regard to direct taxes, the individual tax payers
are aware of the amount of the tax in advance when and how to pay the tax etc. Similarly,
28
 the government can also estimate that how much revenue it gets in a particular year. The
other advantages of direct taxes are that they are more productive and elastic. The revenue
can be adjusted according to the requirement of the government. Direct taxes are more
favoured on the grounds of welfare implications as they do not cause any distortions in
the allocation of resources. In spite of several merits, they have some demerits.
2. Demerits of Direct Taxes: Direct taxes are against the canon of convenience as stated
by Adam Smith. Tax payers feel the pinch of paying the taxes in the case of direct taxes
as they have to pay in lump sum amounts knowingly in advance. Moreover, sometimes
tax amount has to be paid in advance causing lot-of inconvenience to the tax payer.
Generally, people oppose the imposition of direct taxes and also the tax rates. Direct
taxes are less favoured because the burden is directly experienced by the people and also
due to lack of direct return. It is widely believed that direct taxes cause adverse effects
on saving and investment. It means some of the direct taxes reduce the individual’s
ability as well as the desire to save and invest. It may be noted that income tax, interest
tax, wealth tax, expenditure tax etc may have an adverse impact on savings and investment
but there are several other factors which are responsible to these effects. Direct taxes
have become less productive and elastic in modern times; this is mainly because of the
corruption that prevails in the administration of the tax and thus, it leads to large scale
tax evasion. Direct tax laws are so complex and rigid that they are not easily
understandable to the tax payer. Direct taxes have a limited scope as these taxes are
imposed on a few people. All individuals and households need not necessarily pay direct
taxes. So compared to indirect taxes, especially in the developing nations, the scope of
direct taxes is much lower
3. Merits of Indirect Taxes: Indirect taxes are convenient to pay as they are collected at
the time of transactions of sale or purchase of goods and services in small amounts along
with the prices. The tax payer pays the tax without feeling the pinch of it as the tax
element is implicit in the price as the tax base is very wide especially in the developing
economies. Indirect taxes generate lot of revenue to the governments. Though tax evasion
exists with indirect taxes also, in relative sense tax evasion is less compared to direct
taxes because it is difficult to evade the payment of indirect taxes like excise duty and
sales tax when the administration is very efficient. The developing economies depend
mostly on indirect taxes for financing their planned economic development as they get
inadequate revenue from direct taxes. The indirect taxes not only regulate the production
and consumption of goods in the economy but also employment and consumption. If the
goods of luxury nature are imposed a high rate of tax, it helps in the reduction of
conspicuous consumption Indirect taxes can be imposed with high progression rates on
those goods which are consumed by the rich people so the principle of equity is fulfilled.
It may be noted that all the merits of indirect taxes mentioned above have their own
limitations.
4. Demerits of Indirect Taxes: One of the important disadvantages of indirect taxes is
their regressive character. In other words both the rich and the poor people pay equal
amount of tax while purchasing a good. Therefore these taxes are against the principle of
29
 ability-to-pay principle and the canon of equity. As far as the indirect taxes are concerned,
the government cannot forecast the exact amount of revenue in a particular year. This is
because people may shift their demand for some goods on which taxes are higher. The
revenue from indirect taxes declines during depression.
Indirect taxes are inflationary in character. These taxes are imposed on goods and services
and on inputs and factors of production at different stages of production leading to an
increase in the cost of production and higher prices. Indirect taxes are often attributed as
an important reason for price rise. Business people and industrialists evade the tax just
like in the case of direct taxes. Tax evasion in indirect taxes takes place due to smuggling,
corruption etc. The cost of collection is higher for administering indirect taxes as it
requires a broad based administrative network.
The Goods and Services Tax
The goods and services tax is a single tax system that will benefit both corporate and the
economy. GST works on the fundamental Principle of “One Country One Tax”. GST is a
comprehensive tax system that will subsume all indirect taxes of states and central governments
and unified economy into a seamless national market.
Genesis of GST: GST was firstly introduced in France in 1954. After France it was
followed by 165 nations and after its implementation in India, India became 166th nation to
adopt it. In India, the reform process of indirect tax regime was started in 1986 by V.P. Singh,
Finance Minister in Rajiv Gandhi’s government, with the introduction of the Modified Value
Added Tax (MODVAT). In 2014, the NDA government came into power, under the leadership
of Narendra Modi. Finance Minister Arun Jaitley introduced the GST Bill in the Lok Sabha, in
February 2015, Jaitley set another deadline of 1 April 2017 to implement GST. In May 2016,
the Lok Sabha passed the Constitution Amendment Bill, paving way for GST, in August 2016,
the Amendment Bill was passed. Over the next 15 to 20 days, 18 states ratified the GST Bill
and the President Pranab Mukherjee gave his assent to it. The Jammu and Kashmir state
legislature passed its GST act on 7 July 2017, thereby ensuring that the entire nation is brought
under a unified indirect taxation system. The Goods and Service Tax Council (hereinafter
referred to as, “GSTC”) comprises of the Union Finance Minister, the Minister of State (Revenue)
and the State Finance Ministers to recommend on the GST rate, exemption and thresholds,
taxes to be subsumed and other matters.
Advantages of GST: 1. The cascading effect of taxation will be controlled by removing
multiple taxes. 2. There will be uniformity in laws, rates of tax, and procedures across states
and so many disputes are eliminated on tax matter. 3. Uniformity in the rates of SGST and
IGST will reduce tax evasion to a large extent. 4. The input tax credit process will be more
accurate and transparent, as electronic matching will be performed.
Disadvantages of GST: 1. Manufacturing states would lose big revenue. 2. There will be
dual control on every business by Central and State Government. So compliance cost will go up.
3. All credit will be available on from online connectivity with GST Network. Hence, small
businesses may find it difficult to use the system. 4. Retail business may oppose because their taxes
will go up and they will also have to deal with Central Government now in addition to States.

30
 GST and Centre-State Financial Relations: GST will affect mainly fiscal relations
between Centre and State. Till date the centre and states were independent on the tax collections.
For the first time, a tax would be placed in the Concurrent list, which our Constitution makers
meticulously avoided so as to ensure smooth Centre-state financial relations. With the
implementation of GST, the taxes now need to be shared by both the governments. Under GST,
the center and state has to agree upon a fixed tax rate.

Check Your Progress.

3. State the merits of direct taxes.
..........................................................................................................................................
...........................................................................................................................................

2.6 TYPES OF TAXES

Taxes are divided in the following way on the basis their of rate schedule. They are: 1.
Proportional Taxation; 2. Progressive Taxation; 3. Regressive Taxation; and 4. Degressive
Taxation.
If the tax rate increases as the tax base increase, it is called progressive tax. If the tax rate
is constant as the tax base increases it is known as proportional taxation. Regressive tax means
the tax rate declines as the tax base increases. If the tax rate progressively declines or becomes
constant after certain level of the tax base as the base increase or becomes broader is known as
degressive tax. These tax systems are explained briefly in the following heads.
1. Proportional Taxation: Under this type of
Table-2.1: Proportional Tax
taxation, the tax rate is constant, as the tax
base increases, as explained above. The Tax Base Tax Rate Amount
proportional tax is explained with the help of (Rs) (Percentage) of Tax (Rs)
presented in table-2.1. 10,000 10 1,000
2. Progressive Taxation: If the tax rate 20,000 10 2,000
increases, as the tax base increase, it is called
30,000 10 3,000
as the progressive taxation. Table-2.2 indicate
that the total tax revenue increases, as the 40,000 10 4,000
income and the tax rate increase. For example, Table-2.2: Progressive Taxation
it may be noted that Rs. 1,000 is accrued to
Tax Base Tax Rate Amount
the Government as tax revenue, when the tax
(Rs) (Percentage) of Tax (Rs)
rate is 10 per cent and the tax base is Rs.
l0,000. When the income base increases to 10,000 10 1000
Rs.40,000, the tax rate has increased to 40 per 20,000 15 3,000
cent resulting in increases tax revenue.
30,000 25 7,500
3. Regressive Taxation: When the tax rate
40,000 40 1,600
declines as the tax base increases, it is called
31
 regressive tax. In other words, in regressive Table-2.3: Regressive Taxation
taxation, the higher the income of a tax payer,
Tax Base Tax Rate Amount
smaller is his contribution towards taxation.
(Rs) (Percentage) of Tax (Rs)
In a way; it is almost a reverse to the
progressive taxation. It may be seen from the 10,000 10 1000
table-2.3 that the tax rate is declining as the 20,000 07 1,400
tax base increases. This tax structure is against 30,000 05 1,500
the principle of equity and the principle of
40,000 04 1,600
Ability-to-Pay principle. If entire tax structure
is regressive, it will not allow the government to achieve the socialistic pattern of society.
However, commodity taxation or indirect taxation is more prevalent in developing countries
and all indirect taxes are regressive.
4. Degressive Taxation: This tax structure is Table - 2.4: Degressive Taxation
applicable to a few selected taxes. Under this Tax Base Tax Rate Amount
system, the tax rate is progressive until a (Rs) (Percentage) of Tax (Rs)
particular level of the tax base and later
10,000 10 1000
becomes constant. Under this tax structure,
the richer sections of the society do not make 20,000 11 2,200
scarifies by paying taxes as expected. 30,000 12 3,600
It may be noted that a degressive tax is a 40,000 13 5,200
combination of both progressive and proportional
50,000 13 6,500
taxes. In general all the direct taxes adopt progressive
tax rates while proportional tax structure is based on the principle of equity and this is the reason
why it has become more popular in the world.

Check Your Progress.

4. What is progressive taxation?
..........................................................................................................................................
...........................................................................................................................................
5. What is degressive tax?
..........................................................................................................................................
...........................................................................................................................................

2.7 SUMMARY
We have learnt the meaning and significance of public revenue, different sources of
public revenue and different kinds of classifications as advocated by different economists. We
understand that each classification has its own merits and also defects. We have also learnt the
nature of direct and indirect taxes, their relative importance, their merits and demerits. It is
concluded that the direct and indirect taxes are more complementary each other than alternatives.
With regard to tax structure, each type of tax structure has its own advantages and disadvantages.
But the most difficult thing is to adopt an appropriate rate structure that really corresponds to
32
different levels of incomes of individuals. It is necessary to adopt a rational mix of both
progressive and proportional taxation in any economy.

2.8 CHECK YOUR PROGRESS - MODEL ANSWERS

1. According to H.C. Adams, Public Revenue is divided into three categories namely (a)
Direct revenue; which consists of income from public industries, gifts, railways, post
offices etc., (b) Derivative revenue; which refers to taxes, fees, fines etc. and (c)
Anticipating revenue; which refers to the income received due to sale of bonds or other
forms of government securities.
2. The sources of Public Revenue are: (i) the Taxes (ii) Fines imposed by the government
on the offenders, (iii) Compulsory Loans, (iv) Tributes and Indemnities arising out of
war or from other reasons, (v) Income from Public such as Lease of Government Lands,
(vi) Profits of the Public Enterprises, (vii) Fees for the services rendered by the
government, (viii) Receipts from Voluntary Public Loans, (ix) Betterment Levy and other
Assessment, (x) Voluntary Gifts etc.
3. The canon of equity as stated by Adam Smith is observed in the case of direct taxes.
They are useful for adopting a progressive tax structure and all direct taxes are progressive
taxes only. It is possible to observe the canon of certainty in the case of direct taxes.
Direct taxes are more favoured on the grounds of welfare implications as they do not
cause any distortions in the allocation of resources.
4. If the tax rate increases as the tax base increases, it is called progressive tax. Economist
Philip E. Taylor strongly advocated a case for progressive type of tax. Moreover, this tax
structure is also supported and justified by the common people also.
5. If the tax rate progressively declines or becomes constant after certain level of the tax
base as the base increase or becomes broader is known as degressive tax.

2.9 MODEL EXAMINATION QUESTIONS

I. Answer the following questions in about 10 lines each.
1. Analyse Seligman’s classification of Public Revenue.
2. Explain the following concepts.
a) Tax b) Fee c) Special Assessment
3. Discuss the demerits of indirect taxes.
4. Explain regressive and degressive taxes?
5. Discuss the differences between progressive taxation and proportional taxation.
II. Answer the following questions in about 30 lines each.
1. Explain the various sources of public revenue.
2. Explain various categories of public revenue.
3. Analyse the merits and demerits of direct taxes.
4. Discuss the Goods and services Tax (GST).

33
III. One mark questions.
A. Multiple choice questions. choose the correct answer.
1. The most important source of revenue to the states is
a) Sales tax b) Service tax c) Excise duty d) None of the above
2. Which of the following is not a direct tax?
a) Personal Income Tax b) Service tax c) Wealth Tax d) Corporate Income Tax
3. Pick out the factor which is not a demerit of indirect taxes.
a) Unjust to poor b) Inflationary in nature
c) A tool of economic policy d) High administrative cost

Answers: 1. a 2. b 3. c
B. Fill in the blanks.
4. __________________ based on the principle ‘higher the income, higher the tax’.
5. Direct tax are ____________________ in nature.
6. A good tax system should ensure ______________________
7. The ______________________are fair to the poor.
Answers: 4. Progressive tax 5. Progressive 6. Maximum social welfare 7. Indirect taxes.

2.10 GLOSSARY
1. Gratuitous Revenue: This revenue is an income which comes from gifts, donations.
2. Escheat: This refers to the properties of people who die without legal heirs or wills.
Such properties are appropriated by the government.
3. Direct Tax: Those taxes the burden of which cannot be transited as director tax. It
includes income tax, corporation tax.
4. Indirect Tax: Those taxes the burden of which can be frams fined as indirect taxes.
They include expenditure tax, sales tax.
5. Corporation Tax: Tax on incomes of the company is known as corporation tax.
6. Sales Tax: Tax imposed on sales or purchase of the goods and services are known sales
tax.
7. Excise Duty: This is a tax imposed on the goods at the tome production stage which are
meant for sale or consumption.
8. Progressive Tax: It is known if tax rate ‘increases as the tax base increases.

2.11 SUGGESTED BOOKS

1. B.P. Thyagi: Public Finance.
2. M.L. Bhatia: Public Finance.
3. Hugh Dalton: Principles of Public Finance.
4. Musgrave R.A. & Musgrave P.B: Public Finance in Theory and Practice.
34
UNIT-3: CANONS OF TAXATION - IMPACT,
INCIDENCE AND EFFECTS OF TAXATION
Contents
3.0 Objectives
3.1 Introduction
3.2 Canons of Taxation
3.3 Impact of Taxation
3.4 Incidence of Taxation
3.4.1 Hugh Dalton’s Definition of Tax Incidence
3.4.2 Hicks’ Classification of Incidence of Tax
3.4.3 Musgrave’s Classification of Tax Incidence
3.5 Effects of Taxation
3.5.1 Effects of Taxation on Production
3.5.2 Effects of Taxation on Distribution
3.5.3 Other Effects of Taxation
3.6 Summary
3.7 Check Your Progress – Model Answers
3.8 Model Examination Questions
3.9 Glossary
3.10 Suggested Books

3.0 OBJECTIVES
The objective of this unit is to discuss various canons of taxation propounded by Adam
Smith and other economists and also explain the impact, incidence, effects of taxation. After
reading this unit, you will be able to:
• know the importance of canons of taxation.
• distinguish between incidence and impact of taxation.
• explain the economic effects of taxation on production, distribution, employment etc.

3.1 INTRODUCTION
The tax revenue is the most important source of public revenue. A tax is a compulsory
payment levied by the government on individuals or companies to meet the expenditure which is
required for public welfare. The government has absolute power to tax anything on the earth. In
fact, there is no limit to this power. However, taxation is one of the sensitive issues to the
government. It requires a balanced strategy to be adopted so as to avoid its negative effects on the
35
socio-economic activities. Taxation brings revenue to the government on the one hand; it may
decrease savings and investment on the other hand. Even though the government has supreme
power to impose various taxes at various rates, the tax authorities should adhere to certain basic
principles while imposing taxes or fixing the tax rate. Then only the tax may be called as a good
tax. Canons of Taxation are the main basic principles set to build a Good Tax System.

3.2 CANONS OF TAXATION

Canons of Taxation were originally laid down by the father of economics, Adam Smith,
in his famous book “An Inquiry into the Nature and Causes of the Wealth of Nations”. In this
book, he gave only four canons of taxation and these are called as the main Canons of Taxation.
In course of time, governance expanded and became more complex than what it was at the
Adam Smith’s time. Soon a need was felt by economists later on to expand Smith’s Canons of
Taxation and as a result they developed some other canons of taxation.

Adam Smith’s Canons of Taxation

1. Canon of Equity: In the words of Adam Smith, “the subjects of every state ought to
contribute towards the support of the government as really as possible in proportion to their
respective abilities, i.e. in proportion to the revenue which they respectively enjoy under the
protection of the state”. The government collects taxes from the people. The amount is spent on
various items of expenditure which provide certain public services to the people. As per the
canon of equality, the burden of taxation should be in accordance with the benefits received by
the people from the state. It is understood that people, who enjoy the benefits, pay the taxes.
The sum of the taxes paid by the people should not be more than the benefits which are provided
to them. It is only for the collective benefit that the taxes are levied but not for the individual’s
benefit. In other words, tax-payers cannot also expect that they would receive the benefit just
equal to the amount of tax they pay. This principle aims at providing economic and social
justice to the people and the burden of taxation should be distributed among tax-payers according
to their ability to pay.
There is some ambiguity in Adam Smith’s statement. According to some economists,
Smith supported the system of proportional taxation. However, some other economists do not
accept that Smith supported proportional taxes. According to them, Adam Smith was a strong
believer of the system of progressive taxation. Smith has written in his book Wealth of Nations,
“It is very reasonable that the rich should contribute to the public exchequer not only in proportion
to their revenue but also something more than that proportion”. This statement clearly explains
the fact that Adam Smith was a supporter of progressive taxation.
In India, personal income tax is the best example for progressive tax and satisfies the
canon of equity. It is based on the principle of “ability to pay”, that is, the tax is not uniform but
rises progressively with the rise in income. According to the budget for the financial year 2013-
14, income tax is not levied on people with annual income less than Rs.2 lakhs. Thereafter, 10
percent of tax is levied on the income group earning between Rs.2 to Rs.5 lakhs, 20 percent for
Rs.5 to Rs.10 lakhs and 30 percent for the people whose annual income is more than Rs.10
lakhs.
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 2. Canon of Certainty: This canon describes that “the tax which each individual has to
pay ought to be certain and not arbitrary. The time of payment, the amount to be paid, ought to
be clear and plain to the contributor and to every other person”. It explains that the tax-payer
should be clearly informed about the time, amount and method of the payment of tax. There
should no ambiguity about the amount, time and mode of payment of tax. If the tax payers
know well in advance about the time of payment of tax, they can pay the tax promptly within
the stipulated period of time and they can’t be misled by any tax authority. Similarly, if the tax
payers are certain about the rate of tax to be paid, they can pay the exact amount of tax. In case,
if the tax payers are not certain about the rate of tax, there will be a scope for the tax officials to
exploit the tax-payers in any manner. When the canon of certainty is observed, even the
government will know the amount of tax it receives. Both the tax-payers and tax authorities
benefit if the tax satisfies the canon of certainty. Hence, the canon of certainty has been given
more priority than the canon of equality by Adam Smith.
The Indian tax system has been criticized as confusing and containing many exemptions
with many loopholes providing large scope for tax evasion. This process gives rise to a lot of
scope for tax officials to be corrupt. Many factors lead to uncertainty situation many a time like
(i) tax laws being amended frequently to include new taxes;(ii) changes in the existing tax
rates; and (iii) new exemptions and withdrawal of existing ones.
3. Canon of Convenience: According to the Adam Smith’s third canon of convenience,
“Every tax ought to be so levied at the time or in the manner in which it is most likely to be
convenient for the contributor to pay it”. It implies that, the time and method of tax payment
should be convenient to the tax payers so that the tax payers are able to pay their taxes within
the stipulated period of time. This canon takes the interest of the taxpayer about the payment of
tax into consideration. This canon suggests that the tax system should be such that it encourages
tax payers to pay tax in time. A convenient tax system increases government revenue as the tax
payers do not feel any inconvenience in paying their taxes. Over a period of time, tax reforms
have taken place in the tax systems and the canon of convenience has been given importance by
the governments. For instance, in India the salaried class pays income taxes at the time of
receiving salaries as it is convenient for them. In case of consumers, paying sales tax (value
added tax) is convenient at the time of purchase of goods and services and hence, it is included
in the price.
4. Canon of Economy: Adam Smith enunciates “every tax ought to be contrived as both
to take out and keep out of the pockets of the people as little as possible over and above what it
brings into the public treasury of the state.” This means that the amount of tax should be
minimal and its cost of collection should be lower than the revenue raised from it. In other
words, the difference between the revenue generated in the form of tax and what government
receives after meeting all expenses for the collection of taxes should be meager. Further, this
canon tells that the taxes should not have adverse effect on production because high tax reduces
savings and capital formation. In contrast, high taxes on harmful commodities like drugs,
cigarettes are regarded as meaningful, because this tax results in the reduction of consumption
of undesirable commodities besides increasing public revenue.

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 Other Economists’ Canons of Taxation: The aforesaid four canons of taxation were
formulated by Adam Smith. He was basically concerned with the ways in which economy
could increase its productive capacity and thereby achieve a higher rate of economic growth
and at the same time he considered the convenience of the tax payers and economy in tax
collection. However, in course of time, keeping in view the increasing activities of the
governments, some other economists have added the following canons of taxation.
5. Canon of Productivity: The canon of productivity was formulated by classical
economist C.F. Bastable. It is also known as the canon of fiscal adequacy. According to this
canon, taxes must be levied in order to accumulate satisfactory amount for the government to
run its administration efficiently. The government should raise adequate revenue to meet its
expenditures to provide enough facilities for the people. If the revenue generated in the form of
taxes is not enough to run the administration efficiently, it is not called as a productive tax.
Hence, it is better to go in for a few productive taxes than to impose large number of unproductive
taxes on the people. Simply, it can be said that only one or few taxes which generate sufficient
revenue should be imposed instead of imposing many taxes yielding less revenue. In other
words, instead of taxing a multitude of items, yielding small revenue and involving high cost of
collection, it would be advisable to depend on a few items of taxation which yield large revenue
with a low cost of collection. This is the reason for abolishing the estate duty and gift tax in
India in 1985 and 1998 respectively as they generate less revenue. Further, the canon of
productivity may assume that taxation should encourage the productive effort of the people
and should not discourage production. It means that a tax should act as an incentive to produce
more. For example, import duties protect and stimulate indigenous industries and output.
6. Canon of Elasticity: The canon of elasticity states that taxation should be elastic in
nature so that the amount to be collected in the form of taxes can be decreased or increased
depending on the requirements of the government. In the interest of the development of the
country or when the country faces adverse conditions like natural calamities, wars etc.
governments may need to generate more revenue. Hence, tax should be adaptable to the changes
in the financial requirements of the government. Generally, the government expenditure increases
every year. Hence, tax should be elastic enough to increase revenue in case of need and also
revisable as and when the circumstances demand. If the government requires more funds, it can
increase its revenue from the same taxes without incurring any additional cost of collection and
reducing the incentive to production. In India, income tax is a good example for the canon of
elasticity. The government can increase revenue by changing the slabs and rates of income tax.
Service tax also is more elastic because of its coverage and rate and revenue has been drastically
growing right from its inception. It covered only 3 services and the tax rate was 5 percent in
1994-95 but it covers 119 services and the tax rate is 12 percent in 2011-12. Similarly, revenue
rose from Rs.550 crores to Rs.1.33 lakh crores during the same period.
7. Canon of Simplicity: According to this canon, tax system and tax forms should be
simple. Tax rates should be precisely laid down. Items of taxation should be such that they can
be easily identifiable. There should be absolute clarity without any ambiguity about tax laws
and a common man should be able to understand them easily without any difficulty. Tax

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exemptions should be defined clearly. If the tax system is too complicated and cannot be easily
understood, the tax payers will have to seek the assistance of tax officials or tax consultants.
Moreover, if a tax is complex, it (a) leads to the evasion of taxes; (b) creates legal disputes; (c)
encourages tax authorities for manipulation and (d) thereby leads to corrupt practices. People
do not hesitate to pay taxes when the tax system is fair and simple and when its implications are
understandable without the help of tax experts or consultants. A complex system of taxation is
always unjust and uneconomic.
In India, unfortunately, some taxes like income tax and value added tax is complex and
they can’t be easily understood by the ordinary tax payers. This is the reason for taking the
assistance of tax consultants at the time of paying their taxes by most of the tax payers in India.
8. Canon of Diversity: The canon of diversity recommends multiple tax system. It
means that all those citizens, who can contribute to the government revenue, should be brought
into tax purview. For instance, taxes should be spread over industries, businesses, services,
professions, transport systems etc. In other words, the diversification of taxes should be practiced
in such a way that every section of community/society and every individual must contribute
something to the government exchequer. If the government follows a single tax system, it is
easy for the people to evade tax or escape from the purview of the tax system. But if the
government imposes multiple taxes, it will be difficult for the people to evade tax or escape
from the tax net. As a result, all the citizens contribute to the government revenue based on
their ability to pay. In line with canon of productivity, canon of diversity also gives importance
to adequate revenue generation. The benefit of diversity of taxes is that any reduction in total
tax revenue on account of any one tax is insignificant. Canon of diversity will also satisfy the
canon of equity by covering as many people as possible and as many items as possible for
taxation. However, too much diversity is not so good because it violates the canon of economy.
9. Canon of Flexibility: The canon of flexibility seems to be similar to the canon of
elasticity. Technically, there is a difference between two of them. The canon of elasticity states
that there should be possibility to increase or decrease the revenue whereas the canon of flexibility
states that the tax system should be flexible but not rigid. The flexibility is needed for elasticity.
If a tax is flexible, it can easily adjust to the new conditions. It is possible to revise the tax
structure so as to fit into the changing requirements of the economy. In brief, the tax system of
a country should be liable to change promptly in case of need. For example, in India, as the tax
system is flexible in nature, central government has replaced the sales tax with VAT in all states
from April 1, 2005 and again many indirect taxes subsumed into GST.
10. Canon of Expediency: According to the Canon of Expediency, tax should be based
on some well-defined principles so that the tax payers accept its desirability. It implies that a
tax should have social, economic and political advisability so that tax payers need no justification
from the government. Sometimes, a tax seems to be desirable and satisfies many canons but
government won’t impose it. It is because of this reason; progressive agriculture income tax in
India is desirable but not expedient.
11. Canon of Co-ordination: This canon states that there should be co-ordination between
different taxes that are levied by various tax authorities. In the federal system of governments
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like India, taxes are levied by Central, State and Local Governments. In all these cases, it is
needed that there should be a definite coordination between the various taxes levied by different
governments. Canon of co-ordination is absolutely important in democratic countries. For
instance, In India, the excise duties have been levied by the central government, the sales tax by
the state governments and the octroi by local governments. In such a kind of the nature of the
tax system, there should be coordination among them.
12. Canon of Development: According to this canon, taxation intends to bring socio-
economic development in the country as a whole. It does not hamper the development of trade
and industry. It reduces the economic inequalities. It does not slow down the rate of investment
in the country. The tax revenue should be utilized for the promotion of welfare of the people.
Taxes should be based on socio-economic policies of the government. In a nutshell, the canon
of development states that the revenue generated in the form of tax should be vested in productive
developmental activities but should not be wasted for undesirable activities.

Check Your Progress.

Note: a) Space is given below for utilizing your answer.
b) Compare your answer with the one given at the end of the unit.
1. Distinguish between canon of elasticity and flexibility.
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3.3 IMPACT OF TAXATION

Normally, tax is paid by the person upon whom it is levied. It means that a person cannot
shift the burden of his tax. Practically it is not possible. In case of multiple taxes, the burden of
the tax does not always lie on the person on whom it is imposed in the first instance; it may also
be a burden to other person. So the person who initially pays the tax, he/she may not bear this
burden and she/he can shift it to other person or persons. Hence, it is necessary to know the
information about a person who bears the immediate burden of a tax and finally who bears the
ultimate burden of a tax.
The problem of the impact of taxation in economics deals with the person on whom the
immediate burden of taxation falls or from whom the government receives the amount of tax. It
is said that the impact of a tax is the first point of contact of the tax with the tax payers. It refers
to the immediate or initial money burden of the tax. The impact of a tax is the immediate result
of the imposition of a tax on the person who pays it in the first instance. Then, it always falls on
the person who is legally responsible to pay the amount of tax to the government in the first
instance. For example, if the government imposes an excise duty of Rs 20,000 per car on the
manufacturer of cars, then the impact of the tax falls on him. This is the immediate money
burden of the tax on the manufacturer who has to arrange to pay it to the government even
before the car is actually sold.
Seligman explains that “the impact of the tax is, therefore, the immediate result of the
imposition of the tax on the person who pays it in the first instance. According to J.K. Mehta,
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“impact of the tax is said to be the immediate money burden. The impact of a tax falls on the
man on whom the tax is imposed. The man who pays the tax to the government bears its impact
only. A tax may be levied on the producer of cloth. The cloth producer pays the tax to the
government. The producer, however, increases the price of his cloth in an attempt to pass the
whole or a part of the tax burden on to the buyers. If he is able to raise the price, it is said that
the tax has been shifted, partly or wholly, to buyers. If the price does not go up to the full extent
of the tax, it is said that some incidence of the tax remains on the cloth producer. This implies
that the impact is only on the producer. For, it is who alone in the above case, in the first place,
bears the entire burden of the tax.”

3.4 INCIDENCE OF TAXATION

The incidence of tax means the final money burden of a tax or final resting place of a tax.
In the words of Edwin R.A. Seligman “the settlement of tax burden on the ultimate tax payer is
known as the incidence of taxation”. It can be said that the person or persons who ultimately
bear the burden of taxation. For instance, when a tax is imposed on Mr. Gopal and if he pays the
tax amount, then, his disposable income gets reduced to the extent of the amount of the tax.
Here, burden of tax falls on Mr. Gopal. When Mr. Gopal shifts the tax amount to Mr. Hari and
if Mr. Hari bears the money burden of the tax, then, Mr. Hari’s disposable income gets reduced
immediately. It is said, thus, the income of Mr. Gopal does not get reduced. If Mr. Hari also
shifts the amount of tax to Mr. Ramu, then, Mr. Ramu bears the “incidence” of the tax. Thus,
Mr. Ramu’s disposable income gets reduced. There is no change in the income of Mr. Hari.
Here, the “incidence of tax” falls on Mr. Ramu because he bears the final money burden of this
tax. Generally, this happens in the case of indirect taxes like excise duty, sales tax (VAT),
service tax etc. For example, sales tax is initially paid by the producer, but he shifts the tax to
the wholesaler, who further shifts it to the retailer and who in turn, collects it from the consumer
in the form of a higher price. Thus, the incidence of sales tax in this example is on the final
consumer who ultimately bears the “final money burden of the tax”. Here, consumer’s disposable
income gets reduced and not of the producer or the wholesaler or the retailer.

3.4.1 Hugh Dalton’s Definition of Tax Incidence

Hugh Dalton defined tax incidence as “to every shilling of revenue raised, there
corresponds a shilling of direct money burden or incidence falling upon someone.” As per
Hugh Dalton, it is to be found out that who ultimately pays this one shilling. All other concerns
relating to tax imposition may be regarded as effects. Hugh Dalton says that the imposition of
a tax causes two types of burden on the people, viz., money burden and real burden.
1. Money Burden: Money burden means the amount of tax which has to be paid by the
tax payer to the government. Money burden can be either direct or indirect. Direct money
burden refers to the actual amount of tax collected in terms of money. Indirect money burden of
a tax may arise when a tax payer may be forced to part with a larger amount than the rate of tax
warrants.
2. Real Burden: Regarding the real burden of a tax, it relates to the sacrifice which the
imposition of a tax entails on the tax payers. It can also be divided into two types namely direct
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real burden and indirect real burden. Direct real burden of a tax refers to the sacrifice of economic
welfare which the tax entails for the tax payers. Indirect real burden relates to the reduction in
the consumption of a commodity due to the imposition of a tax.

3.4.2 Hicks’ Classification of Incidence of Tax

Hicks divides the incidence of tax into two parts: i). Formal incidence and ii). Effective
incidence
1 Formal Incidence: According to her, formal incidence refers to the direct money
burden of the tax. It is similar to Hugh Dalton’s direct money burden of a tax. Formal incidence
is “the proportion of people’s income which is collected by the persons who provide them with
goods and services, but paid over to governing bodies to finance collective satisfaction.” She
says that the formal incidence of direct taxes falls on those who initially pay them but the
indirect taxes are borne by those who buy the commodity.
She further explains that the calculation of formal incidence is of great social interest in
terms of the distribution and redistribution of income. It is also important when the government
plans to maintain a high level of economic growth because it helps the government to understand
the reaction to a given tax change and it may take the form of a restriction of consumption or a
reduction in savings.
If the consumer bears the incidence of the tax, then his consumption gets reduced and so
his welfare suffers. This will also reduce the effective demand in a developed economy where
as it will divert resources from consumption to capital goods in a developing economy. If the
formal incidence falls on the manufacturer, his savings get reduced. Hence, the capital formation
gets affected as a result of the reduction in reinvestment capacity.
2. Effective Incidence: Hicks, further, observes that the calculation of formal incidence
does not tell us directly of the tax payers’ reaction to changes of taxes, and various consequences
of the tax. In this way, she defines the second concept of effective incidence as follows:” In
order to discover the full economic consequences of a tax, we have to draw and compare two
pictures – one of the economic set up (distribution of consumer’s wants and incomes, and
allocation of factors), as it is with the tax in question; the other of a similar economic set up, but
without the tax. Here, Hicks points out that the effective incidence refers to all these different
economic consequences which result from the imposition of each tax and which changes the
pattern of production, demand for goods and services, allocation of resources, volume and
direction of savings and capital formation.

3.4.3 Richard Musgrave’s Classification of Tax Incidence

Richard Abel Musgrave, noted economist and pioneer in Public finance, uses the term
incidence of a tax in a different sense. He defined the term ‘incidence’ as a change in the
distribution of income available for private use; this arises due to changes in budget policy i.e.,
changes in taxation and public expenditure. Here, Richard Musgrave points out the role of both
public revenue and public expenditure, while the traditional writers have completely ignored
the role of public expenditure. As per Richard Musgrave, change in the distribution of income
takes place through the following three different policies.
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1. Changes in tax policy, holding public expenditure constant in real terms.
2. Changes in public expenditure while holding taxes constant; and
3. Changes in tax and expenditure policies which will provide the required changes in
yield.
The changes in distribution brought about by the above policies have been listed and
explained by Richard Musgrave below.
1. Specific Tax Incidence: If the government makes a change in a tax, the resulting
change would be in the distribution of income available for public use, making no changes in
public expenditure is called specific incidence. For example, when the government decides to
reduce income tax, then the disposable income of the people increases and it leads to an increased
demand for goods. As a result, prices also begin to go up and this leads to an inflationary
situation in the economy. Thus, specific tax incidence involves both the initial change in tax
and distributional change in income due to this inflation. On the other hand, if government
increases income-tax rates, the disposable income of the people gets reduced, and this may lead
to reduction in private expenditure, and hence deflationary trends may get generated in the
economy. Therefore, both inflation and deflation influence the distribution of income and wealth.
The effect on the distribution in both the situations is called specific incidence.
2. Differential Tax Incidence: When a tax is substituted by another tax and there is no
change in the total revenue received by the government, then its effect on the distribution of
income available for private use will be termed as differential tax incidence. For example,
government replaces income tax worth Rs. one lakh crores with a car excise duty of same
worth. This tax change does not involve any increase in revenue to public use. However, it
involves redistribution among households. Households, whose income tax is reduced, will
gain while others with car purchases will lose. Car manufactures and workers who work in car
manufacturing industry will also lose as the demand for cars falls. On the other hand, the
disposable income of people, who were earlier paying income tax, increases, as they demand
for goods. Thus, producers, who are selling such goods, will gain. Due to these interdependent
changes, the state of distribution of income in the economy undergoes vast changes. This resulting
change in distribution of income compared to the initial distribution of income is referred as
differential incidence.
3. Specific Expenditure Incidence: The distributional effects taking place due to changes
in the rate of public expenditure, keeping the tax policy unchanged is called as specific
expenditure incidence. When there is an increase or decrease in public expenditure in money
terms, there will be an increase or decrease in resource transfer to public use. Thus, the changes
in income of the people due to changes in public expenditure are referred to as specific
expenditure incidence. If public expenditure is increased at a particular time, this results in the
rise of the income of people and at the same time the prices of goods and services can be
expected to rise and leading to an inflationary situation. Similarly, a fall in public expenditure
will not only lead to a fall in income received by the people but also generates deflationary
forces. Thus, when expenditure changes, distributional consequences arise in two ways i.e.,

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changes due to public expenditure and changes due to inflation and deflation which may be
generated by changes in public expenditure.
4. Differential Expenditure Incidence: To avoid the incidence of inflation and deflation
due to changes in public expenditure, we should consider changes in public expenditure but
within the framework of balanced expenditure in the budget. Thus, there is no change in the
total volume of the public expenditure for private use. This means that the increase in public
expenditure in one direction should be cancelled by a decrease in public expenditure in the
other direction. The distributional effects of such public expenditure may be termed as differential
expenditure incidence.
5. Balanced Budget Incidence: In the balanced budget incidence we have to consider
simultaneous changes in tax and expenditure Policy of government. If government increases
its expenditure by increasing taxes, such type of tax burden is called balanced budget incidence.
In the analysis of Specific tax incidence and differential tax incidence, we considered changes
in tax alone and assumed that there is no change in the public expenditure. But here, we consider
changes in both tax and public expenditure. Changes in tax will bring sufficient revenue to
undertake the proposed changes in public expenditure. Thus, budget incidence is the change in
the distribution of income due to simultaneous changes in tax and expenditure policy. Here the
combined effects of different tax incidences are discussed by taking into account the changes
in both tax policies and expenditure policies on the distribution of income available for private
use, and calls for all the resulting changes as balanced budget incidence.

Check Your Progress.

2. What is the incidence of a tax?
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3.5 EFFECTS OF TAXATION

According to the classical economists, the purpose of taxation is to raise the required
revenue for the state. However, in course of time, the objectives of taxation have also changed.
Therefore, in modern times the purpose of taxation is not only for raising revenue for the
government but also an important instrument for achieving socio-economic objectives like
reduction of income inequalities, promotion of economic growth, regulation of consumption
and production, Price stabilization etc., in the country.
Hence, when a tax is imposed, it will affect the tax payer in terms of reduction in the
disposable income and the working of the economy in terms of production, growth, saving,
investment, income and wealth etc. All these results and changes are collectively called as the
effects of taxation. The effects of taxation may be both beneficial and harmful. Therefore,
when the government frames a tax policy, it keeps in mind not only the revenue considerations
but also the adverse effects of taxes on production, distribution and economic welfare of the
people. According to Hugh Dalton, “The best system of taxation from the economic point of

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view is that which has the best or the least bad economic effects”. The economic effects of
taxation have been discussed by Hugh Dalton in the following three heads.
1. Effects of taxation on production
2. Effects of taxation on distribution
3. Other effects of taxation

3.5.1 Effects of Taxation on Production

Hugh Dalton discusses the effects of taxation on production under three heads. They are
1. Effects of taxation on peoples’ ability to work, save and invest.
2. Effects of taxation on peoples’ willingness to work, save and invest.
3. Effects of taxation on allocation of resources between different industries and regions.

Let us now discuss the above three in detail.

1. Effects of Taxation on Peoples’ Ability to Work, Save and Invest.
Peoples’ ability to work depends upon their standard of living. Higher the standard of
living, higher is the ability to work. Peoples’ standard of living depends upon the availability of
goods and services to them. When a tax is imposed on the consumer, it immediately reduces his
purchasing power due to a part of his income is being paid as taxes to the government.
Consequently, the consumer purchases less quantity of goods and services than before. Then,
the standard of living of tax payers gets declined. So, the imposition of a tax reduces the ability
of the tax payer to work, save and invest.
If the tax burden falls on the poor people, it reduces the consumption of essential goods
and services thus reducing their standard of living and ability to work. On the contrary, if the
tax burden falls on the rich people, it will not reduce the consumption of essential goods but
may reduce the consumption of luxury goods only as a result of which their ability to work will
not suffer though it is certain that their ability to save will be reduced. Sometimes taxation on
certain commodities may increase the efficiency of the tax payers to work. For example, if
taxes are levied on harmful commodities like drugs, liquor, tobacco etc., it leads to reduction of
the consumption of such goods and it will have a healthy effect on peoples’ efficiency to work.
Income determines savings. Taxation reduces income and this result in reduction in
savings. So, taxation reduces person’s ability to save. If the tax reduces peoples’ ability to save,
it will lead to low capital formation because people would spend a major part of their income
on goods and services. The fall in capital formation will lead to low production and low level
of income. This would further reduce the ability of people to save.
The ability to invest depends on the ability to save in the economy. The tax imposed on
consumers’ results in reduction in their savings and the outcome is fewer saving available for
investment. Consequently, the level of aggregate investment in the economy will fall. In the
same way, when the retained profits of the business firms are taxed, their capacity to invest also
gets decreased. Progressive taxes on higher incomes and corporate profits reduce the ability to
save of the investing group and corporations whose internal resources get reduced.
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 However, these negative effects of taxation can be balanced through government
expenditure. Reduction in investment can be compensated by increasing the incomes of the
people with government expenditure. Similarly, the standard of living and the capacity to work
of the tax payers may not fall due to taxation if the various facilities are provided by the
government. Hence, while evaluating the effects of taxation on ability to work, save and invest,
the effects of public expenditure must also be taken into account.

2. Effects of Taxation on Peoples’ Willingness to Work, Save and Invest.

It is easy to find the adverse effects of taxation on the ability to work, save and invest
whereas the effects of taxation on the willingness to work, save and invest are not easy. However,
to analyse the effects of taxation on the willingness to work, save and invest, we should be able
to differentiate the effects of taxation on individuals and firms. The first effect deals with the
incentives to work and save of individuals while the second deals with incentives to save and
invest by the business firms.
Incentives and Individuals: Individuals pay tax out of their income. If a tax payer
wants to maintain the pre-tax income as it is, he works hard and earns more so that tax is paid
out of the increased income and the pre-tax level of income is maintained. Another way is that
the person can maintain the same amount of work and pay the tax out of the same income or
savings. So, it is not easy to say whether the effects of taxation on the willingness to work will
be more or less. This will depend on three things. They are i) Nature of taxes, ii) Rates of taxes
and iii) Psychology of the tax payer
i. Nature of Taxes: Whether the tax is direct or indirect, it will affect the willingness to
work, save and invest. It is a fact that direct taxes, especially income tax, will have adverse
effect on the incentives to work, save and invest as they are visible. Contrary to this, indirect
taxes such as sales tax, excise duty, etc. do not have any direct effect on these incentives of the
individuals because these taxes are included in the prices of goods and services.
ii. Rate of Taxes: The rate of tax also induces individual’s willingness to work, save and
invest. If the tax rates are moderate, tax payers pay the tax without much difficulty, but high
rates of direct taxes which at certain stage may take away much of the tax payer’s income will
definitely affect individual’s willingness to work, save and invest. The high rate of taxes will
not serve as an incentive to the individuals to work more and invest more but these will encourage
people to evade and avoid the tax imposed.
iii. Psychology of the Tax Payer: Incentives to work, save and invest also depend on
the psychology of the tax payers. The psychology of the tax payers depends on their elasticity
of demand for income. If the demand for income is inelastic, they will work more to maintain
the pre-tax level of income. In such a situation, tax acts as an urge to work harder. Generally,
tax payers’ desire for higher standard of living, demonstration effect, maintenance of wealth,
future social security etc., may be the reasons for inelastic demand for income. On the contrary,
if the demand for income is more elastic, his will to work may not be affected adversely by
taxation. Then, he may work less and enjoy more leisure and accordingly his output will decline.
When the elasticity of demand for income is unity, the willingness to work remains constant

46
whatever the level of income. This is the case with many government employees who are
accustomed to work for a given duration of time. So, in their case, the incentives to work will
not be adversely affected.
Incentives and Business Firms: Generally a tax can be considered as an incentive or
disincentive for business firms and entrepreneurs based on their profits which get increased or
decreased. Generally, an enterprise or any business firm faces risk and uncertainty and it has to
work hard to earn profits. If their profits are greatly reduced due to taxation, their willingness
to work hard and take risks will be greatly increased. Of course, profits are not only the driving
force for incentives to work but also some other factors such as the spirit of enterprise, the
thrilling of exploring a new invention or innovation, the ambition to create an industrial empire,
to gain a name and fame in society, capture political power via economic strength influence
incentives to work and invest. But any tax on windfall profits or a lump sum tax on monopoly
surplus will not affect incentives. Commodity taxes like excise and sales taxes are generally
shifted to consumers and are rarely borne by the business firms and these taxes will have no
adverse effect on the business firms so that their production will continue without any reduction.
However, if these taxes are very high, this will rise in prices and consequently reduce in demand
for concerned goods, and then production will be affected adversely.
Effects of Taxation on Willingness to Save: The effects of taxation on willingness to save
will depend on the progressive taxation. A tax system reduces the savings of the people and this
has a negative effect on their willingness to save because of two reasons. Firstly, it reduces the
income out of which savings result, and secondly, income from savings is also taxed and hence,
there will be an increase in the expenditure and as a result save less.
Effects of Taxation on Willingness to Invest: Generally, investment in productive capital
gives large profits. If any tax reduces these profits of individuals and business firms, it will
have adverse effect on their willingness to invest. Thus, they may invest in non-income earning
assets like land, gold etc., as the value of these assets continuously increases. Hence, incentive
to invest will be greatly reduced and capital investment will fall and finally the production
would fall.

3. Effects of Taxation on Allocation of Resources between Different Industries

and Regions.
The government can use its tax policy to divert the scarce resources of the country in the
desired productive activities. Thus, taxation may influence not only the volume of production
and national income but also the pattern and composition of production in the country. Generally
the diversion of resources takes place from a highly-taxed industry or region to a low-taxed or
no-taxed industry or region. The diversion of resources between different industries and regions
as a result of taxation may be beneficial or harmful.
Beneficial Diversion of Resources: High taxation on harmful goods like drugs, liquor, tobacco
etc., will raise the price of such goods so that the demand for these goods falls and profits of
producers will get reduced. Consequently, production of these goods will be discouraged and
resources utilized in their production will be gradually diverted to other industries which are

47
socially desirable and useful for the development of the country. Similarly, tax exemptions and
concessions on industries that are located in backward regions and rural areas can help in
diverting economic resources from industries located in over-crowded centers and urban areas
to backward regions and rural areas. This will help in promoting balanced regional economic
development and leads to an equal distribution of wealth and reduce regional inequalities in the
country.
Harmful Diversion of Resources: Generally, taxation on necessary commodities and mass
consumption goods is not socially desirable. Taxation on these commodities will lead to an
increase in their prices and this reduces the consumption and production of these goods.
Consequently, the demand and production will be shifted to less useful items which are used by
the rich. Likewise, high taxes on domestic industries will encourage the flow of domestic
resources to foreign countries where there is low tax or no tax. In a federal country like India,
harmful diversion may take place when different tax rates are imposed by different states and
this leads to the resources moving from more taxed states to less taxed states. But this is being
prevented in India by introducing Value Added Tax which imposes uniform tax rates.

3.5.2 Effects of Taxation on Distribution

In modern times, the purpose of taxation is not only to raise revenue for the government
but also to reduce the inequalities of income and wealth in the country. So, taxes are powerful
tools to achieve more equitable distribution of income and wealth in the economy. Hugh Dalton
rightly said that “One tax system is better than the other if it has a greater tendency to reduce
inequality”. The effects of taxation on the distribution of income and wealth among the different
sections of the country depend on two things viz. i) nature of taxation and tax rates and ii)
kinds of taxes. Let us now discuss the effect of these two factors.
1. Nature of Taxation and Tax Rates: If we examine the effects of taxation on the
distribution, we should understand the tax system in a country whether it is progressive, regressive
or proportional. A progressive tax system reduces the inequalities of income and wealth in the
society because a huge direct real tax burden falls on the high income groups or the rich. If the
tax system is more progressive, it can easily reduce economic inequalities in the country. Hence,
all most all countries are adopting progressive taxation. On the contrary, a regressive tax system
causes more inequalities in the distribution of income because the poor will have to bear a
relatively higher tax burden. Because of this reason, the modern governments have reduced
regressive taxation and have increased progression in taxation. Under the proportional tax
system, the effect of taxation will be neutral on the distribution of income because it would not
cause any change in the relative position of tax payers. In other words, under proportional tax
rates, inequalities would continue as before, if the income remains the same.
2. Kinds of Taxes: Whether the taxation is progressive, regressive or proportional depends
upon the kind of taxes, i.e., direct or indirect taxes or both. Direct taxes are more progressive
and these are more suitable to reduce inequalities of income. Income tax, wealth tax, corporation
tax etc., are progressive in nature and they bring revenue from higher income groups. Thus,
they help more in bringing about the reduction in the existing inequalities of income and wealth
in the country.
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 In case of indirect taxes, they are regressive in nature. These taxes are borne equally by the
rich and the poor and may promote inequality in the distribution of income. Generally, poor
people spend a larger portion of their income on commodities than that of the rich. So, the burden
of indirect taxes falls more on the poor than on the rich. However, the indirect taxes can be made
progressive; if the necessities are tax exempted or taxed less and taxed high on luxury goods.

3.5.3 Other Effects of Taxation

Taxes can influence the level of employment in an economy through their effect on
consumption, production, savings and investment. Generally, taxation decreases people’s
consumption by reducing their purchasing power. The decline in consumption causes reduction
of demand for goods and services. Consequently, the level of economic activity and employment
is reduced in the economy. The way taxation affects employment is different in case of developed
and developing countries. In the case of developed countries, taxation reduces the level of
consumption and increases savings. As a result, it tends to reduce business activity and
employment. In the case of developing countries, taxation discourages savings and investment.
As a result, it tends to reduce business activity and employment. In fact, this argument is not
valid in all the situations because the revenue collected by the government through taxation is
not wasted and it is spent in the development of projects and welfare programmes, and thus, it
implies a transfer of purchasing power from the people to the government so as to increase
employment in the economy. For instance, in India, the government incurs huge expenditure on
various developmental and welfare programmes especially employment generation programmes
like the Mahatma Gandhi National Rural Employment Guarantee Programme which enhances
the employment opportunities.

Check Your Progress.

3. What are the effects of taxation on distribution of income?
..........................................................................................................................................
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3.6 SUMMARY
The qualities, which a good tax should possess, are termed as canons of taxation. Adam
Smith was the first economist, who stated the four canons of taxation. In 1890, the Irish economist
Charles Bastable and other economists have added some other canons of taxation. Generally,
canons of taxation refer to the administrative aspect of the tax. They relate to the rate, amount,
and method of levy and collection of a tax. The above mentioned canons of taxation are
considered to be the essential requirements of a good tax policy. In practice, it is very difficult
to evolve a tax system which is characterized by the presence of all these canons of taxation.
However, every tax authority should, as far as possible, keep the above canons in view while
devising the tax policy because it is only by doing so that the governments may succeed in
getting the maximum social welfare for the society.
The objective of taxation these days is not only to raise adequate revenue for the
government but also to achieve socio-economic objectives like promotion of economic growth,
49
reduction of income inequalities, controlling inflation and deflation, regulation of consumption
and production etc., in the country. Thus, it is essential for the government to find out who
bears the immediate burden of tax and who bears the ultimate burden of tax or the actual tax
payers. In order to achieve the above said socio-economic objectives, the government has to
know whether the economic effects of taxation are good or bad on production, distribution of
income, employment etc,.

3.7 CHECK YOUR PROGRESS – MODEL ANSWERS

1. The canon of flexibility seems to be similar to the canon of elasticity. Technically, there
is a difference between two of them. The canon of elasticity states that there should be
possibility to increase or decrease the revenue whereas the canon of flexibility states
that the tax system should be flexible but not rigid. The flexibility is needed for elasticity.
If a tax is flexible, it can easily adjust to the new conditions.
2. Tax is paid by the person upon whom it is levied. It means that a person cannot shift the
burden of his tax. Practically it is not possible. In case of multiple taxes, the burden of
the tax does not always lie on the person on whom it is imposed in the first instance; it
may also be a burden to other person. So the person who initially pays the tax, he/she
may not bear this burden and she/he can shift it to other person or persons. Hence, it is
necessary to know the information about a person who bears the immediate burden of a
tax and finally who bears the ultimate burden of a tax.
3. In modern times, the purpose of taxation is not only to raise revenue for the government
but also to reduce the inequalities of income and wealth in the country. So, taxes are
powerful tools to achieve more equitable distribution of income and wealth in the
economy. Hugh Dalton rightly said that “One tax system is better than the other if it has
a greater tendency to reduce inequality”.

3.8 MODEL EXAMINATION QUESTIONS

I. Answer the following questions in about 10 lines each.
1. Explain the Canon of Equity.
2. Discuss the Dalton’s incidence of taxation.
3. Discuss the effects of taxation on employment.

II. Answer the following questions in about 30 lines each.

1. Critically examine the Adam Smith’s Canons of Taxation.
2. Examine the various effects of taxation on production.

III. One mark questions.

A. Choose the correct answer in the following multiple choice questions.
1. Canon of Equity is propounded by [ ]
A) Dalton B) Adam Smith C) Musgrave D) Bastable

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2. The final money burden of a tax is known as [ ]
A) Impact of tax B) Shifting of tax C) Incidence of tax D None of these

B. Fill in the blanks.

1. The Canon of Productivity was formulated by ___________________
2. “The settlement of tax burden on the ultimate tax payer is known as the incidence of
taxation” is defined by __________________

C. Match the following.

List - I List - II
A) Hugh Dalton 1. Formal incidence of tax [ ]
B) Ursula Hicks 2. Money burden of tax [ ]
C) Richard Musgrave 3. Specific tax incidence [ ]

3.9 GLOSSARY
1. Tax: : A tax is a compulsory payment to the government without expectation of direct
benefit to the tax payer.
2. Canons of Taxation: Canons of taxation refer the rules to be observed in formulating
tax structure.
3. Income Tax: It is a direct tax levied on the income of individuals or businesses.
4. Service Tax: It is an indirect tax imposed on service providers on certain service
transactions, but is actually born by the customers.
5. Value Added Tax: It is a sales tax that is placed on a product whenever value is added
at a stage of production and at final sale.
6. Impact of Tax: The impact of tax means the initial money burden of a tax.
7. Incidence of Tax: The incidence of tax refers to the ultimate/ final burden of the tax.

3.10 SUGGESTED BOOKS

1. Musgrave R.A. & Musgrave P.B.: Public Finance in Theory and Practice, (Tata
McGraw- Hill Publishing Company Limited, New Delhi), 2004.
2. Hugh Dalton: Principles of Public Finance, (Routledge & Kegan Paul, London), 1951.
3. B.P. Thyagi: Public Finance, (Jaya Prakash Nath Publications, Meerut, U.P).
4. M.L .Bhatia: Public Finance,(Vikas Publishing House Pvt Ltd., New Delhi), 2003.

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 BLOCK – II
PUBLIC EXPENDITURE AND PUBLIC DEBT
The volume of public expenditure has been increasing in almost all countries of the
world, owing to the continuous expansion of the state activities. This block mainly discusses
about various aspects related to public expenditure and public debt. It consists of two units
i.e., unit-4 deals with the concept, types, classifications and important determinants of public
expenditure. Further, the detailed effects of public expenditure are also analysed in this unit.
Unit-5 deals with the nature, sources, classification and various methods of redemption of
public debt. It also explains various effects of public debt on the economy.
This block contains the following units:
Unit - 4: Classification, Principles, Determinants and Effects of Public Expenditure
Unit - 5: Nature, Sources, Classification, Effects and Redemption of Public Debt

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UNIT-4: CLASSIFICATION, PRINCIPLES,
DETERMINANTS AND EFFECTS OF PUBLIC
EXPENDITURE
Contents
4.0 Objectives
4.1 Introduction
4.2 Classification of Public Expenditure
4.3 Canons of Public Expenditure
4.4 Determinants of Public Expenditure
4.5 Effects of Public Expenditure
4.5.1 Effects of Public Expenditure on Production
4.5.2 Effects of Public Expenditure on Distribution
4.5.3 Effects of Public Expenditure on Economic stability
4.5.4 Effects of Public Expenditure on Economic Development and Growth
4.6 Summary
4.7 Check Your Progress – Model Answers
4.8 Model Examination Questions
4.9 Glossary
4.10 Suggested Books

4.0 OBJECTIVES
The purpose of this unit is to explain the classification, principles and effects of public
expenditure. After reading this unit, you will be exposed to:
• the origin and meaning of public expenditure;
• the classification of public expenditure;
• the canons of public expenditure;
• various determinants of public expenditure; and
• the various effects of public expenditure.

4.1 INTRODUCTION
Public expenditure is the expenditure incurred by public authorities – Central, State and
Local Governments – either for the satisfaction of collective needs of the citizens or for promoting
their economic and social welfare. The volume of public expenditure has been increasing in
almost all countries of the world owing to the continuous expansion of the State activities. In
the 19th century, a theory of public expenditure was not very necessary because the scope of the
53
functions of government was limited. But during the 20th century, the development of the
functions of the State in social matters has increased public expenditure to a large degree. The
scope of public expenditure had also increased owing to its nature and volume and effects on
the economic life of a country in various ways. In fact, public expenditure seeks to maximise
the index of social welfare. It is realised that public expenditure plays a vital role in shaping
the national economy. Today the popular cry is for State intervention in almost every field.
Adolph Wagner, a German economist was in favour of the increasing the State activities. Prof.
R.A. Musgrave advocated public expenditure since a government is forced to do many activities
such as: i. activities to secure a reallocation of resources; ii. redistributive activities; iii. stabilising
activities; and iv. commercial activities. Thus, it can be said that promoting economic
development is one of the major objectives of public expenditure. As a matter of fact, the role
of public expenditure is important in the accumulation of capital that governs the rate of growth
of productive capacity. Many modern governments have assumed the role of welfare states in
the 20th Century and hence the expenditure has been growing over a period. To Wagner, public
expenditure increases as result of increasing economic activities of the government. According
to Peacock and Wiseman, the increase in public expenditure is due to step like growth of
industrial activity. However, the dynamic and complex nature of the modern economies finds
it difficult to restrain the growth of public expenditure for a variety of reasons.

Check Your Progress.

Note: (a) Space is given below for utilising your answer.
(b) Compare your answer with the one given at the end of the unit.
1. State the need for the public expenditure.
..........................................................................................................................................
...........................................................................................................................................

4.2 CLASSIFICATION OF PUBLIC EXPENDITURE

The classification of public expenditure is important for clear understanding of the nature
and effects of various kinds of public expenditure. To Prof. Shirras, the classification of
public expenditure is important to know the relative importance, which has been given to each
head of expenditure in different times.
A number of classifications of public expenditure have been given by different economists,
and there is little agreement between them with regard to this aspect of public finance. In this
regard, Shultz says that “Ninetieth century fiscal writers developed considerable space to the
subject of the proper classification, but no two ever agreed upon the same classification. Most
economists believed that a basis of classification should not be absolute, but it should be relative
to the purpose for which the classification is intended to serve.
1. Test of Good Classification: Classification must be scientific and not ambiguous.
Dr. R. H. Bhargave has rightly observed, “A good classification should satisfy at least
two tests. Firstly, the classes should be mutually exclusive so that data can be allotted to
one class only. This will take the classification exact. Secondly, the basis of classification
54
 should be a necessary attribute of the object classified. This will make it scientific and
sensible.” Therefore, it can be said that a good classification should be exact and without
overlaps.
2. Basis of Classification: Different economists like C.C. Plehn, Nicholson, Adamsimth,
J.S. Mill, Rosher, Dalton and Findlay Shirras have given their own style of classification
of public expenditure. The different basis on which the public expenditure has been
classified is mentioned hereunder:

i. Classification on the Basis of Benefits (C.C. Plehn): On the basis of benefit, the
public expenditure was classified by C.C. Plehn in to four parts. They are:
i) Public expenditure which confers special benefit to certain people: It is the
expenditure which is incurred to provide the benefit of police protection and
justice. These services affect the entire community in general and certain groups
or persons in particular.
ii) Public expenditure which benefits equally to all: All types of public expenditure
incurred and general administration legislatures, defence, education, transport,
medical etc. benefits equally to all.
iii) Public expenditure benefitting people and entire community as well: Public
expenditure which confers a benefit to the certain people and the entire community
as a whole. For instance, special securities, public welfare, un-employment relief,
old age pension etc. are such items which aim at directly helping the particular
section of the society. However, the indirect effect is experienced by the entire
society as a whole.
iv) Public expenditure that specially benefits some individuals: Such expenditure
does not provide advantage to the entire society. Subsidy given to particular
industries is public expenditure of such type.
ii. Classification on the basis of Functions: Adam Smith classified public expenditure
according to the functions of government. Charles F. Bastable also supported this
classification. This classification is mentioned hereunder:
i) Expenditure on protective services for instance expenditure on arms and
ammunition, defence, police, administration of justice and jails, etc.
ii) Expenditure on commercial activities like rail, roads, highways, etc., which are
taken by the government in the public interest.
iii) Development expenditure incurred on social and economic development of the
country like expenditure on education, health, recreation, public utility facilities
to the community.
iii. Classification on the basis of Revenue: This classification of public expenditure had
been developed by F.S. Nicholson who has divided public expenditure into four categories
as follows:
i. Expenditure without direct return of revenue, e.g. poor relief or in some cases
55
 even within direct benefit as well as direct loss, e.g. expenditure on wars.
ii. Expenditure without direct return, that with indirect benefit to revenue, e.g.
expenditure on education, health.
iii. Expenditure with partial direct return, e.g. education for which fees are charged,
subsidised railway services, etc.
iv. Expenditure with full return or even profit like the post office, gas service and
generally public enterprises.
iv. Mill’s Classification: J.S. Mill classified public expenditure into two i.e., optional and
obligatory.
i. Optional Expenditure: Optional expenditure is that which State may or may not
spend. They are education, agriculture and industries etc.
ii. Obligatory Expenditure: Obligatory expenditures are those expenditures which
the State must incurr such as expenditure on defence and other contractual
payments and expenditure on interest payments.
v. Classification on the basis of Importance: This classification was made by Findlay
Shirras who divided the public expenditure into two types:
i. Primary Expenditure: It includes all expenditure which governments worthy of
the name are obliged to undertake e.g., expenditure on defence, law and order
and the payment of debts.
ii. Secondary Expenditure: It includes social expenditure that is expenditure on public
undertakings and certain miscellaneous expenditure like education, public health,
poor relief, unemployment insurance, famine relief and other similar social
services. Under the miscellaneous grants are included pension charges, drawbacks
or refunds.
vi. Dalton’s Classification: Dalton classified public expenditure into two categories grants
and purchase price. When the State spends money and gets in return some service or
commodities, is called a “purchase price” i.e., salaries of government employees and
price paid for purchasing furniture, etc. When the government spends money and does
not get any commodity or service in return is known as grants i.e., relief to the poor.
Dalton says that a purchase price may include an element of grant, when the government
pays a price higher than a price that would have been offered by a private buyer, the
excess can be regarded as grant.
Dalton distinguished between direct and indirect grants. A grant may be said to be
direct, when the whole benefits accrues to the person to whom the grant is made. A grant
may be said to be indirect, if the benefits is passed on in whole, or in part, from the
person to whom the grant is made to some other person. For instance, an old age
pension is a direct grant and a subsidy to a private enterprise is an indirect grant.
vii. Roscher’s Classification: His classification is need based one. Roscher classified public
expenditure into three categories. They are:

56
 i. Necessary Expenditure is that which the State has to incur and which cannot be
postponed.
ii. Useful Expenditure is that which is desirable but can be postponed.
iii. Superfluous Expenditure is that which the State may or may not incur.
viii. Pigou’s Classification: Pigou classified the public expenditure into two parts like
transferable expenditure and non-transferable expenditure.
Transferable expenditure is the expenditure which made on the payment of interest on
government debt, pensions, sickness benefit. Hence, it is implied to purchase current national
resource service. Expenditure is said to be non-transferable public expenditure when it takes
the form of money payment made to people either gratuitously or for the purchase of existing
property rights. For instance, expenditure incurred on maintenance and building of the armed,
naval and airforces, civil services, educational services, judiciary, post office etc. This
expenditure is called exhaustive expenditure and real expenditure.
In the social accounting sense, transfer expenditure does not create any income or output,
while non-transfer expenditure always gives rise to the creation of some output and equivalent
money income.
ix. Mehat’s Classification: Prof. J.K. Mehta classified public expenditure into two types:
viz, i) Constant expenditure; and ii) Variable expenditure.
To him, constant expenditure is that the amount of which does not depend
upon the extent of the use by the people, in whose interest it is incurred, make of the
services that the financed by it. For instance, defence expenditure as this expenditure
is incurred irrespective of the number of people using the services and hence people
have no influence upon the amount that the government decides to spend. Mehta defines
variable expenditure is that which increases with every increase in the use of public
services by the people for whose benefit it is incurred. For instance, expenditure on
postal service.
The newness, which is found in Prof. Mehta’s classification, is that his basis of
classification is cost and not benefit like others.
xi. Economic Classification: The economic classification has been defined as, the scheme
in which “classification of government expenditure and receipts by economic categories
that are of significance for analysing the short-run effects of government transactions in
the working of the economy” are classified. It means under economic classification, the
expenditure and receipts of the government are classified by broad economic categories.
They are: the revenue expenditure and receipts and the capital expenditure and receipts.
In India, an economic classification of budgetary transactions was first followed in 1957-
58 and, therefore, the Government of India budget for 1957-58 was presented on the
basis of the classification.

57
Check Your Progress.
2. State the importance of classification of public expenditure
..........................................................................................................................................
...........................................................................................................................................
3. State the different basis of classification
..........................................................................................................................................
...........................................................................................................................................

4.3 CANONS OF PUBLIC EXPENDITURE

Some economists like Prof. A.G.Buchler made an attempt to lay down certain guidelines
for public expenditure to be followed by public authorities in practical life. To him, the following
guidelines should be followed:
i) It should promote the welfare of the society.
ii) It should stimulate the social welfare.
iii) An eye should be kept whether the funds are properly utilized for conducting social
welfare.
Prof. Shirras has made the unique contribution in suggesting the canons of public
expenditure. Some of them had mentioned hereunder:
1. Canon of Benefit: The ideal of this canon is maximum social advantage. To Prof.
Shirras other things being equal, public expenditure should bring with it important
social advantages, such as increased production, the preservation of social life against
external attack and internal disorders and as for as possible a reduction in the inequalities
of income. In short, public funds must be spent in those directions most conducive to the
public interest i.e., maximum utility is to be attained in public expenditure. Hence, this
law states that the public expenditure should be planned in such a way that it results in
achievement of maximum social advantage. Thus, this canon is synonymous with the
principle of maximum aggregate benefit.
The canon of benefit has no substitute or alternative. The greatest happiness of
greatest number is the sole objective of this canon. However, it is difficult to measure
the benefit from some items of public expenditure. Finally, it can be concluded that the
canon of benefit aims at the improvement of production and distribution system in the
country.
2. Canon of Economy: The canon of economy implies that the State should be economical
in spending money. In the first place, the State should not spend more than the necessary
amount on the items of expenditure. In the second place, the State should develop the
productive powers of the community as much as possible. The first consideration has
reference to the present, whereas the second has reference to the future. The sole aim of
this canon is to avoid extravagance. Prof. Shirras emphasised another aspect as economy
means protecting the interest of the taxpayer not merely in effecting economies in
58
 expenditure, but in developing revenue. Therefore, it implies that the expenditure incurred
by the State should help to expand its revenue.
3. Canon of Sanction: This canon asserts that no public expenditure should be incurred
without proper sanction. Each government body should have the liberty of incurring
expenditure up to a certain limit, on any particular item. For every expenditure beyond
that limit shall be incurred after obtaining the sanction of proper authority. The main
object of this canon is to avoid the portability of unwise and reckless spending. This
canon also includes that the spending authorities should spend the amount for which it
has been sanctioned, and to see that the sanctioned amount is properly utilised. Public
accounts should always be audited at the end of the financial year. This helps to control
unwise and arbitrary spending of public money.
4. Canon of Surplus: This means that governments should avoid deficits and aim at
surpluses in their budgets. They should not spend more than what they earn just as an
individual. Therefore, everybody should live within his means. To Shirras Public
authorities must earn their living and pay their way like citizens. Balanced budgets
must be, as in the private expenditure, be the order of the day. Annual expenditure must
be balanced without the creation of fresh credits unrepresented by the new assets. This
canon seems to be sound and secure.
The canon of surplus has lost the importance in present times, which it occupied lot of
importance in classical days.
Besides the aforesaid canons of public expenditure, there are a few more canons
suggested by some other economists. They are mentioned here under:
5. Canon of Elasticity: This canon implies that the expenditure policy of the government
should be flexible rather than rigid. It must be adjustable to the changing needs of the
economy.
6. Canon of Productivity: This canon implies that the expenditure policy of the State
should be such as to encourage the production of the country. It means that a major
chunk of the country’s public expenditure should be allocated towards productive and
developmental purposes. This canon attained the importance since the wave of
developmental programmes started especially in the under-developed countries. Hence,
it can be said that this cannon is based on the goal of maximum employment, output and
income.
7. Canon of Equitable Distribution: This canon requires that the public expenditure should
be carried out to ensure just and equitable distribution of income among different groups
of the community. This objective can be attained by conferring more benefits on the
poor sections of the society by way of public expenditure in the form of medical, education,
housing and old age pensions etc. This canon is more important for those countries
where glaring inequalities of income and wealth are prevailing. For instance, developing
countries like India have given it a practical shape in the economy of the State and their
fiscal policies.

59
8. Canon of Neutrality: This canon signifies that public expenditure should not disturb or
adversely affect the economic set up like production, distribution and exchange.
9. Canon of Certainty: This canon refers that public authorities should clearly know the
purpose and extent of public expenditure. This requires a proper expenditure plan. The
canon of certainty is followed through the preparation of budget.
10. Canon of Programmes: This canon requires that public expenditure should be planned
according to specific programmes. Without clear cut programme frames, proper and
rational use of public funds cannot be ensured.
11. Canon of Performance: This canon implies the need of performance budgeting. This
canon ensures proper utilisation of funds and realisation of the purpose for which public
expenditure is incurred.

Check Your Progress.

4. State the name of the different types of cannons of public expenditure.
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...........................................................................................................................................

4.4 DETERMINANTS OF PUBLIC EXPENDITURE

1. Welfare States : In modern times, States are the welfare States. They aimed at to
promote the economic, political and social life of the people. To attain this aim, the State has to
undertake so many welfare functions like education, public health etc. This is true in all types of
governments either capitalistic or communistic. The State satisfies many wants of the society
collectively which were earlier satisfied individually. Keynes and others were of the opinion that
State must intervene in the economic system of the country to secure stabilisation in advanced
countries and acceleration of rate of growth in under-developed countries. The new functions are
social insurance, unemployment reliefs, cheap medical facilities, old age pensions, housing facilities
etc. The State has come to reduce the social inequalities in the society. This type of expenditure
is also considered desirable to lift the country out of depression. In this context, Wagner’s law of
increasing State’s activities is universally true in modern times.
2. Industrial Development: After world depression, government took active participation
to promote the industrial development. In fact, it brought a happier life, higher standard of
living, increased the efficiency and raised the production of all commodities to a sufficient
level. Besides, government also took measures to control monopolies and to provide consumer
goods and services at reduced cost. This led to a greater share for public expenditure.
3. Rising Trend of Prices: The rise of price level all over the world since Second World
War is another factor for rising the public expenditure. Rise in the price level has two important
effects on the government (i) the government has to pay higher prices for all goods and services
which it has to buy; and (ii) it has to find larger financial resources to meet its growing expenditure.
4. Development of Agriculture: The development of agriculture is the key factor of the
progress of the economy as a whole especially in developing countries like India. The
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government has come to know the linkage between agricultural and non-agricultural sectors.
The inter-relationship between them causes the development of both the sectors.
The expansion of agricultural sector provides a stimulus to industrialisation. On the
other hand, industrial sector also helps to supply modern tools and implements to it which in
turn are responsible for the rise in agricultural productivity. The governments are spending
huge amounts for the development of agricultural sector. Therefore, the loans, subsidized
fertilizers and pesticides on minimum prices are given for its betterment. They also spend a lot
of money on agricultural research and conservation programmes.
5. Urbanisation: Urbanisation is another factor for the relative growth of public
expenditure in the modern times. There has been increased tendency of expenditure on civil
and administration with the rise of population in these areas. Expenses on water supply,
electricity, transport, maintenance of roads, educational institutions, traffic controls, public
health, play grounds, community halls etc., have increased tremendously in these days.
Therefore, increase in expenditure on civic amenities has led upward increase in public
expenditure.
6. Social Security Measures: Modern governments have taken up the responsibility of
protecting the interests of the community as a whole and promoting the implementation of
welfare programmes. They have taken up the responsibility to see that fair wages are paid to
the workers and sufficient provisions for social security measures are made. Therefore, modern
governments are spending huge amounts for providing benefits like old age pensions, sickness
benefits, accident benefits, outright grants, and dependent benefits, housing facilities,
unemployment reliefs, free educational and medical services for industrial workers. Hence, it
can be said that the State has come to reduce the social inequalities in the society. The welfare
aspect of government activity described by Wagner as the pressure of social progress. All
these functions have necessitated the adoption of the strategy of planned economic development
which involves huge amount of expenditure.
7. War and Military Expenditure: The primary function of the State is to protect its
citizens from external aggrandisement and internal war and disturbances. For this purpose
government has to spend on arms and ammunition to acquire military preparedness. If one nation
wants to strengthen its defence forces, the other countries are compelled to take similar steps in
sheer self-defence. The manufacture of nuclear weapons, training and planning of army is a very
county affair. The technique of war is a changing phenomenon and with the change of technique
of war, new weapons have to be purchased for army. It increases the burden of public expenditure
on the State.
8. Democratic and Socialistic Structure of the Government: It is another important
factor which is responsible for the increase of public expenditure to a greater extent. A democratic
form of government is more expensive than the other forms of government. For example,
democracy in India has become a costly affair. Expenditure on election, by-election and
administrative setup is increasing. By the same token, there is gradual shift of thinking from
capitalism to socialism with the result that State governments have to shoulder larger

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responsibilities to perform social activities. Public sector and nationalisation are equally
responsible to push the public expenses to a larger extent.
9. Growth of Population: It is also responsible for increase in the public expenditure as
the government needs money to perform various functions efficiently. Indeed, increasing
population is a threat to the development of poor countries like India. The State has to bear
additional responsibility of solving problems such as food, unemployment, housing and sanitation
etc. The government has also to check the growth of the population. Therefore, it has to spend
huge amount for the family planning programme every year to persuade people to have small
family.
10. Growth of Transport and Communication: It is also another factor causing for the
increase the public expenditure. With its expansion, the State has to spend to maintain quick
and efficient transport system. Government is supposed to run these services even at no profit
no loss basis. The government in so called developing nations has to make huge investment on
railway, road and communication to cater the needs of the general public.
11. Adoption of Planning: In the modern world, all popular governments have adopted
an economic planning in one form or the other for the development of the country. In a developing
country when public sector is expanding its role, the public expenditure shows an increasing
trend.
12. Rural Development Schemes: The government has to spend huge amount for the
development of rural folk in the developing countries like India, where a majority of population
lives in villages. It has to undertake scheme like community development projects and other
social measures. In developing countries like India, many such schemes have been introduced
to eradicate the poverty. For instance, IRDP, DPAP, NREP, TRYSEM, DDP, SFDA/MFALA
etc. Obviously, they have raised the expenditure of the government multi-fold.
13. Defective Administration: Generally, there are extravagancies and wastage in
administration as these unnecessarily create multiplicity of work in government offices.
Consequently, there is huge increase in the public expenditure to meet these expenses.
14. To Curb Business Fluctuations: Fiscal policy has been recognised as a controlling
measure during cyclical fluctuations. Thus, the government has to spend a huge public
expenditure in the period of depression or recession. In a developed economy, the policy is
designed to maintain full employment. In a less developed economy, the copy of functional
finance requires the growth of public expenditure to attain the full employment.
15. Relief and Rehabilitation: At the time of natural calamities or disasters it becomes
obligatory for the government to spend large amount of funds on relief and rehabilitation works.
In the recent times all governments are resorting to deficit budget programmes and are borrowing
heavily from internal and external sources. Consequently, the repayment of public debt and the
obligations to pay service charges are posing a heavy financial burden. A substantial position
of public expenditure is used for servicing modern governments have to maintain cordial relations
with all the countries and international financial institutions. They have to spend heavily on
the maintenance of Indian embassies in several foreign countries.

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 16. Control of Market Mechanism, Provision of Subsidies: In a mixed economy, it is
the responsibility of the State to minimise the evil effects of market imperfections. It is the
bounden duty of the State to control the market mechanism to ensure the distribution of essential
goods and services to larger section of the society. On the one hand, State has to keep a vigil on
unfair trade practices and on the other hand on distribution system. Establishment and
maintenance of such organisations involve huge expenditure by the State. Welfare State has to
provide a safety net for the weaker and vulnerable sections of the society regarding good security
and providing employment in rural areas. As a part of the planning by inducement efforts, a
State has to offer some subsidies to private sector entrepreneurs, agriculturists through minimum
support prices; a subsidies in the areas of power supply and has to extend financial assistance
to rural youth and women to take up income generating activities. All this expenditure becomes
a heavy burden on the ex-chequer.

Check Your Progress.

5. State the determinants of public expenditure.
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4.5 EFFECTS OF PUBLIC EXPENDITURE

The effects of public expenditure vary over time. Public expenditure needs to be looked
upon as an indispensable fiscal instrument of securing economic stability and social welfare.
As a matter of fact, the policies of taxation and public expenditure are complementary and
supplementary to each other. According to Dalton, the effects of public expenditure can be
broadly classified as mentioned and discussed hereunder:

4.5.1 Effects of Public Expenditure on Production

The nature and the volume of public expenditure are bound to have some effect on the
pattern and amount of production in a country. Therefore, the public expenditure policy is so
devised that other things remaining the same, production is increased and encouraged. To
Dalton the effects of public expenditure on production depend on the effect upon the following
factors:
1. Effects on Ability to Work, Save and Invest: Public expenditure affects the ability
to work, save and invest. With the increase in public expenditure on education, medical services,
cheap housing facilities, means of transportation and communication and recreation facilities
will increase the efficiency of persons to work.
The public expenditure can push up the saving and efficiency of the workers. The
purchasing power of the people will also be increased by such type of public expenditure on
free education facilities, unemployment benefit, sickness benefit, cheap housing facilities etc.,
will be helpful to promote their ability to work and save. This is true in the case of people
whose standard of living is very low. Besides, expenditure for maintaining law and order
creates confidence and faith in the minds of the common people which helps us to encourage
the investment into productive channels. As production increases, income of the people also
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increases, and with larger income in the hands of the people, their ability to work, save and
invest also increases.
If a larger proportion of public expenditure is wasted on social functions, on the production
of intoxicants and other articles, which are harmful for health and efficiency may have negative
effect on the ability to work, save and invest. Similarly, if heavy public expenditure is made on
the construction of film studios, cinema houses, hotels and bars, instead of constructing roads,
bank and other means of transport and communication, training schools for engineering, medical
and other branches, it will prove harmful for production because diversions of public expenditure
will have negative effects on ability to work, save and invest. Therefore, public expenditure
should be incurred in a way in which it is most beneficial to the entire community.
2. Effects on Willingness to Work, Save and Invest: Public expenditure severely affects
the willingness to work, save and invest. It not only affects the present but also in the future.
Hence, public expenditure should be planned in such a way so that it must be more fruitful to
the worker while working than when he is out of job. For instance, old age pension, provident
fund benefit, insurance against sickness and employment at State expense provide security and
safety to persons and therefore willingness to work and save.
The desire to work and save will increase if the common masses are sure that their present
savings and investment are secured and will yield good dividends to them in the years to come.
Similarly, the desire to work can be increased by making the benefits conditional e.g. the people
may be required to contribute something to avail the benefits of sickness or unemployment.
Therefore, it can be said that public expenditure should be incurred systematically and in a planned
manner in order to provide social security to the maximum extent. It should offer greater
opportunities and help so as to bridge the gap between the rich and the poor.
3. Diversion of Economic Resources: Public expenditure through the diversion of
economic resources between different areas and uses can significantly influence the pattern of
production. Public expenditure diverts resources from private to public use in many ways,
e.g. the government expenditure on defence, police, civil administration etc. diverts resources
from private sector to public sector, which are sometimes called an economic waste. The
public expenditure on armaments that reduces economic resources from other uses which in
turn makes a direct contribution to the welfare of the people. But, it is wrong to assume that this
type of diversion of resources from private use to government use reduces the amount of the
consumption of goods with the people, and reduces economic welfare of the people. For
instance, the expenditure on defence is not unproductive, as it is important for internal peace
and external security of a nation. Hence, public expenditure on defence, police and justice, etc.
creates on excellent atmosphere in a country. As a matter of fact, too much public expenditure
on these services may have an adverse effect on production, other things being the same.
Therefore, such public expenditure should neither be too large nor too small, but enough to
maintain internal peace and external security.
Dalton pointed out certain forms of public expenditure which increases productive
power and is socially desirable. The expenditure that belongs to this category is mentioned
hereunder:
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i. expenditure on debt redemption, where most of the money repaid will generally be
reinvested;
ii. many projects like transport development, irrigation, forestation, land reclamation, etc.
may yield large returns in the long run but not in the immediate future and they do not
attract the private investor;
iii. expenditure on education, training, research, invention and information;
iv. expenditure on public health; and
v. expenditure in aid of social security schemes in order to promote efficiency and increase
production.
Dalton was of the view that public expenditure in these forms is socially desirable because
it will increase more productive power than it would have increased if the funds required were
left in the private hands. Increased public expenditure in many of these forms is desirable to
bring about that distribution of the community’s resources between different uses, which will
give the better results, balancing without bias the present and future. Therefore, it can be said
that the diversion of resources plays an important role in increasing production, economic and
social welfare of the country.
i. Diversion of economic resources is also important to maintain economic stability – full
employment and price stability. This aspect is more true for developed countries rather
than developing countries.
ii. Diversion of economic resources through public expenditure as between different
localities with sometimes increase productive power and may reduce regional and
territorial inequalities.
iii. Diversion of resources in different economic system – Dalton rightly pointed out that
the role of public expenditure for the diversion of economic resources from private use
to government use and as between location is important only when the range of economic
activities of public authorities is narrow i.e. in a capitalist economy. In a socialistic
economy, the question of diversion of resources from private use to public use does not
arise. In a mixed economy like India, where both the private and public sectors have
to play an important roles, the public expenditure and its influence on the diversion of
resources, ability and willingness to work, save and invest, is of vital importance for the
economic development of the country as a whole.
To Dalton the effect of public expenditure on production and employment as, whereas
taxation, taken alone, may check production, public expenditure, taken alone, should almost
certainly increase it. Expenditure on police, and armed forces, if not overdone and on the
other opportunities of order and security, creates the conditions under which alone organised
production can take place at all.

4.5.2 Effects of Public Expenditure on Distribution

Public expenditure has its effects not only on production it is also a most powerful tool
in the hands of the government to bring about equitable distribution of income and wealth. To

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bring about equitable distribution of wealth, the government can use not only its taxation policy
but public expenditure policy can also help to a great extent in achieving this objective. As a
matter of fact, the role of taxation and public expenditure, in removing inequalities of income
is complementary and supplementary to each other.
1. Effects of Progressive, Proportional and Regressive Expenditure: To Dalton, just
like taxation, public expenditure can also be regressive, proportional or progressive. He says
that a grant is regressive, if the smaller the recipient’s income, the smaller the proportionate
addition made by the grant; progressive, if the smaller the recipient’s income, the larger the
proportionate addition; proportional, if whatever the size of the recipient’s income the
proportionate addition is the same. If the public expenditure is more benefitting to the people
of higher income group and least to the poorer sections of the community, it is said to be
regressive. It is progressive if it is more benefitting to the poor people and least to the richer
section of the community. If public expenditure is so incurred that it confers benefit on different
groups of the community in proportion to their income, such expenditure is said to be
proportional. In regressive expenditure, the benefits increase at a faster rate as income
increases, while in progressive expenditure, the benefits decrease at a faster rate as income
increase. In proportional expenditure benefits increase with an increase in income, but the
increase in benefits is in proportion to the income. Therefore, it is said that the main aim of
public expenditure is to reduce the disparities of income and maximising the social welfare of
the society. To Dalton, other things being equal, that system of public expenditure is the best,
which has the strongest tendency to reduce the inequality of income. Therefore, a progressive
system of expenditure tends to reduce the inequalities of income as the lower income groups
would be benefitted more than the upper income groups. Hence, a government, which wants to
reduce income inequalities, should resort to progressive expenditure.
There are various forms of progressive expenditure such as cash grants, free or cheap
goods & services. Cash grants cover old age pension, unemployment benefit, sickness benefit,
industrial injury benefits, maternity benefits and accident benefits. On the other hand, free and
cheap goods and services benefit the poorer sections of the community more than the richer.
Public expenditure on the free education and food subsidies, free-ships to the economically
backward classes for higher education, the provision of free milk and meals to school going
children as poor people etc., are the examples.
Despite its merits, the progressive expenditure is also subject to certain limitations. They
are:
i. the public expenditure may discourage the efforts of the people to work and save; and ii.
a heavy and steeply dose of taxation may hamper the desire of tax- payers to work hard
and save more.

4.5.3 Effects of Public Expenditure on Economic Stability

In general, there are two kinds of aggregate economic instability is found – instability of
output and instability of price. To J.M. Keynes, economic instability implies departure from
full employment at stable price levels. It is the deficiency of the aggregate effective demand

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caused by a law of marginal propensity to consume coupled with low marginal efficiency of
investment in advanced economies of the world.
1. Effects of Public Expenditure in Depression: Generally, depression is a condition
when saving exceeds investment which results in lowering of aggregate effective demand and
hence in falling prices. Falling prices cause losses among businessmen and manufactures and
reduce their confidence for further production. This leads them to curtail production and in
employment and to hold their cash resources. Thus, a large number of workers are thrown out
of employment. Consequently, the consumption of these unemployed workers is reduced,
which in turn, again leads to lowering the aggregate effective demand and further curtailment
in production and in employment. This further causes reduction in total consumption and total
demand, and so on. This type of vicious spiral continues which is broken by the intervention of
public expenditure. Such period, the government spends money in public works projects. It not
only creates employment among these labourers but starts a chain reaction of employment in
the economy. These employed workers received wages from the government and thus, increase
the total demand for various commodities. When the demand is increased, then volume of
production will automatically increase. Consequently, more workers will get employment and
this increase in employment will again increase in aggregate effective demand of the workers
and this process will start and go on. In brief, public expenditure with multiple effects can help
to affect the decreased demand, and investment in public works, dams and other amenities
leads to the maintaining stability in a country.
2. Effects of Public Expenditure in Inflation: Public expenditure can also help in
curbing inflationary conditions prevailing in the country. Inflation is a condition when investment
exceeds saving. In this situation, the aim of government should be to have a surplus budget i.e.,
the government should spend less than its revenue. And the funds acquired by means of a
surplus budget, may be used to provide capital to those sectors of the economy which experience
a shortage of capital, so that the total productive capacity of the economy may increase. The
rising prices may also be checked increasing the volume of goods and services in the country.
Under such circumstances the public expenditure should be incurred on those projects which
raise sufficiently the volume of production within a short time. For instance, an expenditure on
minor irrigation projects, provision of fertilisers, seeds, manures etc. to agriculturists, providing
facilities to industrialists for expansion or establishment of industrial units etc. can help in
increasing the production. It helps to check the rising trend of prices. However, public
expenditure during inflation is desirable so long as full employment is not reached; other-wise
surplus budgets are necessary to reduce the purchase on prices.

4.5.4 Effects of Public Expenditure on Economic Development and Growth

Public expenditure has to play an active role in reducing regional disparities, developing
social overheads, creation of infrastructure, education and training, growth of capital goods
industries, research and development etc. in developing economies. In the case of a well
advanced economy, public expenditure maintains a smooth rate of economic growth to get the
stabilisation and stimulation of economic activities. Hence, public expenditure has a great role
to play in the form of stimulating saving and capital accumulation.
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 Public expenditure in the shape of subsidies can prove helpful for attaining economic
growth. It can be used to raise the agricultural production and reducing regional disparities.
Public expenditure in the form of investment on education and various social services leads to
an increase in a consumption rather than savings. Therefore, public expenditure must be
recognised as an economic policy along with taxation, licensing and other economic measures
which can go a long way to achieve the desired economic goals. Hence, it should be pursued
and adopted under proper supervision.

Check Your Progress.

6. What are the effects of public expenditure?
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4.6 SUMMARY
Public expenditure is the expenditure incurred by public authorities – Central, State
and Local governments. The volume of public expenditure has been increasing in almost all
countries of the world owing to the continuous expansion of the State activities. As a matter of
fact, public expenditure seeks to maximise the index of social welfare. The role of public
expenditure is important in the accumulation of capital that governs the rate of growth of
productive capacity.
The classification of public expenditure is important for clear understanding of the
nature and effects of various kind of public expenditure. To Prof. Shirras, the classification of
public expenditure is important to know the relative importance, which has been given to each
head of expenditure, in different times. A number of classifications of public expenditure have
been given by different economists and there is little agreement between them with regard to
this aspect of public finance. Different economists like Plehn, Nicholson, Adam Smith, J.S.
Mill, Rosher, Dalton and Findlay Shirras have given their own style of classification of
public expenditure.
Prof. Shirras has made the unique contribution in suggesting the canons of public
expenditure. Some of them are: Canon of benefit, canon of economy, canon of sanction, canon
of surplus, canon of elasticity, canon of productivity, canon of equitable distribution, canon of
neutrality, canon of certainty, canon of programmes and canon of performance.
The effects of public expenditure vary over time. Public expenditure needs to be looked
upon as an indispensable fiscal instrument of securing economic stability and social welfare.
As a matter of fact, the policies of taxation and public expenditure are complementary and
supplementary. The nature and the volume of public expenditure is bound to have some effect
on the pattern and amount of production in a country. If affects the ability to work, save and
invest. It also affects the willingness to work, save and invest. Public expenditure has its
effects not only on production it is also a most powerful tool in the hands of the government to
bring about equitable distribution of income and wealth.

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 Apart from production and equitable distribution, public expenditure also affects the
economic stability, economic development and growth. Public expenditure has to play an
active role in reducing regional disparities, developing social overheads, creation of
infrastructure, education and training, growth of capital goods industries, research and
development etc. in developing economies.

4.7 CHECK YOUR PROGRESS - MODEL ANSWERS

1. In the 19th century, a theory of public expenditure was not very necessary because the
scope of the functions of government was limited. But during the 20th century, the
development of the functions of the State in social matters has increased public expenditure
in a large degree. The scope of public expenditure had also increased owing to its nature
and volume and effects on the economic life of a country in various ways. In fact, public
expenditure seeks to maximise the index of social welfare. It is realised that public
expenditure plays a vital role in shaping the national economy.
2. The classification of public expenditure is important for clear understanding of the nature
and effects of various kinds of public expenditure. To Prof. Shirras, the classification
of public expenditure is important to know the relative importance, which has been
given to each head of expenditure in different times.
3. Different economists like C.C. Plehn, Nicholson, Adamsimth, J.S. Mill, Rosher, Dalton
and Findlay Shirras have given their own style of classification of public expenditure.
The different basis on which the public expenditure has been classified is Basis of Beneift
(C.C. Plehn), Classification on the basis of functions, Classification on the basis of
Revenue Mill’s classification, Classification on the basis of importance, Dalton’s
classification, Roscher’s Classification, Pigou’s Classification, Mehat’s classififcation,
Economic classification.
4. Prof. Shirras has made the unique contribution in suggesting the canons of public
expenditure. Some of them are: 1. Canon Of Benefit; 2. Canon Of Economy; 3.Canon
Of Sanction;4.Canon Of Surplus;5.Canon Of Elasticity;6.Canon Of Productivity;7.Canon
Of Equitable Distribution;8.Canon Of Neutrality;9.Canon Of Certainty;10.Canon Of
Programmes;11.Canon Of Performance.
5. The determinants of public expenditure are: 1. Welfare States; 2. Industrial Development;
3. Rising Trend of Prices; 4. Development of Agriculture;5. Urbanisation; 6. Social
Security Measures; 7. War and Military Expenditure; 8. Democratic and Socialistic
Structure of the Government; 9. Growth of Population; 10. Growth of Transport and
Communication; 11. Adoption of Planning; 12. Rural Development Schemes; 13.
Defective Administration; 14. To curb Business Fluctuations; 15. Relief and
Rehabilitation; 16. Control of Market Mechanism, Provision of Subsidies.
6. According to Dalton, the effects of public expenditure can be broadly classified as: 1.
Effects Of Public Expenditure On Production; 2. Effects On Ability To Work, Save And
Invest; 3.Effects On Willingness To Work, Save And Invest; 4. Diversion Of Economic
Resources; 5. Effects Of Public Expenditure On Distribution; 6. Effects Of Progressive,
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 Proportional And Regressive Expenditure; 7. Effects Of Public Expenditure On Economic
Stability; 8. Effects Of Public Expenditure In Depression; 9. Effects Of Public Expenditure
In Inflation; and Effects Of Public Expenditure On Economic Development And Growth

4.8 MODEL EXAMINATION QUESTIONS

I. Answer the following questions in about 10 lines each.
1. Elucidate the canons of public expenditure.
2. Explain the effects of public expenditure on ability to work, save and invest.
3. Examine the effects of public expenditure on willingness to work, save and invest.
4. Analyse the effects of progressive, proportional and regressive expenditure.
5. Discuss the effects of public expenditure in depression and in inflation.

II. Answer the following questions in about 30 lines each.

1. Examine the effects of public expenditure on production and distribution.
2. Analyse the effects of public expenditure on economic stability, economic development
and growth.
3. Describe the classification of public expenditure.
4. Analyse the determinants of public expenditure

III. One mark questions.

A. Multiple choice questions.
1. Public expenditure was classified on the basis of benefit by whom:
(a) Admsmith (b) Bastable (c) Shirras (d) C.C. Plehn
2. Which one is the determinant of public expenditure:
(a) Welfare states (b) Industrial Development (c) Urbanisation (d) All of the above
3. Who classified public expenditure according to the functions of government.
(a) Bastable (b) Adm Smith (c) Musgrave (d) Marshall
4. Classification of public expenditure on the basis of revenue is suggested by whom?
(a) J.S.Mill (b) J.M. Keynes (c) F.S. Nicholson (d) Richerdson
5. “The law of increasing state activities” is associated with the name of:
(a) Adam Smith (b) Dalton (c) Musgrave (d) Adolph Wagner
6. The increase in public expenditure occurred in step-like manner or in jerks is advocated
by whom?
(a) Dalton (b) Peacock-Wiseman (c) Wagner (d) J.S.Mill
Answers: 1) d; 2) d; 3) b; 4) c; 5) d; 6) b

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B. Fill in the blanks.
1. Public expenditure seeks to ___________ the index of social welfare.
2. _____________ a German economists was in favour of the increasing the state activities.
3. ____________ classified public expenditure according to the functions of government.
4. J.S. Mill classified public expenditure into two i.e. optional and ____________
5. Pigou classified the public expenditure into two parts like transferable expenditure and
____________
6. J.K. Mehta classified the public expenditure into two types that is constant expenditure
and ________________
7. Canon of surplus means that governments should avoid ________
8. The increase in public expenditure is due to step like growth of industrial activity is
advocated by __________
9. The expenditure which the state must incur is known as _______________
Answers: 1. maximise; 2. Adolph Wagner; 3. Adam Smith; 4. Obligatory; 5. non-transferable
expenditure; 6. variable expenditure; 7. deficits; 8. Peacock-Wiseman; 9. obligatory expenditure

C. Match the following.

A B
(i) Classification of public expenditure (a) Maximum social advantage
on the basis of functions
(ii) Classification of public expenditure (b) Peacock-Wiseman
on the basis of optional and obligatory
(iii) Classification of public expenditure (c) Adolph Wagner
on the basis of grants and purchase prise
(iv) J.K.Mehta (d) Economical in spending
(v) Canon of Economy (e) Avoid deficits
(vi) Canon of Surplus (f) Adam Smith
(vii) Law of increasing state activities (g) J.S.Mill
(vii) The increase in public expenditure (h) Dalton
occurred in step-like manner
(ix) Canon of Benefit (i) Constant expenditure and
variable expenditure
Answers: i-f; ii.-g; iii-h; iv-i; v-d; vi-e; vii-c; viii-b; ix-a

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4.9 GLOSSARY
1. Public Expenditure: Expenditure incurred by public authorities.
2. Classification of Public Expenditure: It gives clear understanding of the nature and
effects of various kinds of public expenditure.
3. Optional Expenditure: It is that which State may or may not spend.
4. Obligatory Expenditure: The expenditure which the State must incur.
5. Necessary Expenditure: It is that which the State has to incur and which cannot be
postponed.
6. Useful Expenditure: It is desirable but can be postponed.
7. Superfluous Expenditure: It is that which the State may or may not incur.
8. Expenditure on Public Goods: The expenditure incurred by the government to provide
public goods like roads, libraries, parks, flood control measures etc.
9. Expenditure on Public Utility Services: The expenditure incurred by the government
to provide services like railways, telephones, posts and telegraphs, electricity, drinking
water, etc.
10. Revenue Expenditure: Expenditure incurred by the government to pay the interest
charges, general services like police and courts; social services like education, medical
and health care; economic services like irrigation facilities, forest, mining etc.
11. Expenditure on Infrastructure: Expenditure incurred by the government to provide social
overheads like transport, communications, power generation, banking services etc.

4.10 SUGGESTED BOOKS

1. B.P. Tyagi (2012): Public Finance, Jayaprakash Nath & Co. Meerut.
2. R.K. Lekhi (2011): Public Finance, Kalyani Publishers, Ludhiana.
3. H.L. Bhatiya (2010): Public Finance, Vikas Publishing House, New Delhi.
4. H. Dalton (1936): Principles of Public Finance, Rowtledge and Kagan Paul Ltd, London.
5. R. A. Musgrove (1959):The Theory of Public Finance, Mc Grew Hill, New York.
6. A.R. Prest (1960): Public Finance in Theory and Practice English Language Book
Society and Weidenfeld Nicolson.
7. M.C. Vaish and H.S. Agarwal (2008): Public Finance, Wiley Eastern Ltd, New Delhi.

72
UNIT-5: NATURE, SOURCES, CLASSIFICATION, EFFECTS
AND REDEMPTION OF PUBLIC DEBT
Contents
5.0 Objectives
5.1 Introduction
5.2 Sources of Public Debt
5.2.1 Borrowing from Individuals
5.2.2 Borrowing from Non-Banking Financial Institutions
5.2.3 Borrowing from Commercial Banks
5.2.4 Borrowing from the External sources
5.3 Classification of Public Debt
5.3.1 Internal and External Public Debt
5.3.2 Productive and Unproductive Public Debt
5.3.3 Redeemable and Irredeemable Public Debt
5.3.4 Funded (permanent) and Unfunded (floating) Public Debt
5.4 Effects of Public Debt
5.4.1 Effects on Consumption
5.4.2 Effects on Liquidity
5.4.3 Effects on Production
5.4.4 Effects on Distribution
5.4.5 Effects on Private Sector
5.5 Burden of Public Debt
5.5.1 Measurement of Debt Burden
5.6 Redemption of Public Debt
5.6.1 Advantages of Debt Redemption
5.6.2 Methods of Repudiation of Public Debt
5.7 Debt Trap
5.8 Summary
5.9 Check Your Progress – Model Answers
5.10 Model Examination Questions
5.11 Glossary
5.12 Suggested Books

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5.0 OBJECTIVES
The purpose of this unit is to explain the concept of public debt, need for and sources of
public debt, classification and effects of public debt. After reading this unit, you will be able to:
• define public debt and understand its sources.
• describe the classification of public debt.
• analyze the effects of public debt.
• know the methods of debt redemption.

5.1 INTRODUCTION
Public debt is the debt which the state (Government) owes to its citizens or of other
countries or to other agencies from whom the government has borrowed. The government may
borrow from banks, business organizations, business houses and individuals. The government
can borrow from within the country or from outside the country or both. Government, in this
context, means central, state and local bodies. Generally, public debt is in the form of bonds
and treasury bills that carry with them the promise or assurance of the government to pay
interest to the bond holders at a prescribed rate. Although the transaction is in the form of a
private contract, one party is the government with sovereign power and the other party is vested
with the right to private property. A government bond cannot be taken as a mortgage and it is a
simple promise to pay. Thus, Philip E. Taylor defines public debt as, “The debt is in the form of
promises by the Treasury to pay to the holders of these promises a principal sum and in most
instances interest on that principal”. The medieval system of public borrowing gave rise to the
modern system. Moreover, during 17th and 18th centuries, the Dutch methods of commerce and
finance were initiated in Britain and this brought into existence of the English funded debt
which became an example to other states. In the 19th century, under the influence of laissez-
faire philosophy, economic life was restricted only to unavoidable minimum duties of the state
with the result that functions performed by the state were only a few essential functions (Police
and Military). But in the modern times, the growth of public debt is the result of changing
economic and political institutions. Prof. J.K. Mehta noted, “Public Debt is a comparatively
modern phenomenon and has come into existence with the development of the democratic
form of government in the world”. Therefore, the growth of public debt is the result of changed
economic and political situation all over the world. The concept of public debt has been defined
by various economists. Prof. J.K. Mehta has rightly mentioned, “Public revenue, therefore,
consists of the money that the government is not obliged to return to the very individual from
whom it is obtained. Public debt, on the other hand, carries with it the obligation on the part of
government to pay money back to the individuals from whom it has been obtained”.
According to Prof. Findlay Shirras, “National debt is a debt which a state owes to its
subjects or to the nationals of other countries”. Similarly, Prof. P.E. Taylor states: “The debt is
the form of promises by the treasury to pay to the holders of these promises a principal sum and
in most instances, interest on that principal. Borrowing is resorted to in order to provide funds
for financing a current deficit”.
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 Prof. Carl S. Shoup defines public debt or government borrowing as: “The receipt
from the sale of financial instruments by the government to individuals or firms in the private
sector to induce the private sector to release manpower and real resources and to finance the
purchase of those resources or to make welfare payments or subsidies”.
Classical economists advocated that the public expenditure is to be minimum and hence
they favored taxation to borrowing. However, they favored public debt to finance productive
activities like capital projects that yield benefits to the society. J. S. Mill propounded the view
that public debt should function as a balancing wheel of the economy. Public debt may be used
on the expenditure projects that increase the future income and tax-base. R.A. Musgrave felt
that such projects permit servicing of the debt incurred in their financing without requiring an
increase in the future level of taxes. Keynes was of the opinion that the utilization of unemployed
resources by using public debt automatically raises the level of aggregate income and output.
A.P. Lerner argued that in the event of falling aggregate demand and shortage of funds for
productive investment, government should lend to the private sector to increase its own
expenditure to arrest the fall in real income and employment. However, he cautioned that the
desirability of public borrowing should be judged in terms of its effect on aggregate demand.
R.A. Musgrave held the view that current budget should be tax financed while capital budget
should be loan financed. Raja J. Chellaiah observed that the ideal situation is one in which
revenues will meet subsidies and greater part of current expenditure, while debt financing will
be used for meeting the capital expenditure.

5.2 SOURCES OF PUBLIC DEBT

Many governments are forced to borrow from different sources to finance their
developmental programmes. Public debt has become necessary to meet various requirements
and temporary deficits of the developing economies.
The financing of developmental programmes of the plan require large amount of funds.
Multi-purpose projects and long gestation projects that yield benefits in the long run, require
massive investment. These projects are to be financed by public debt. Modern governments
assumed the role of welfare state which resulted in the expansion of the functions of the
government. It became obligatory for the governments to borrow funds to finance many welfare
programmes that promote the well-being of the people, like investment in education and health
care in the society. The commitment of the government to promote the rate of growth of the
economy resulted in the expansion of public sector units and investment. Massive investment
in public sector commercial enterprises has been financed by public debt. It has become
obligatory for the government to provide infrastructure facilities to facilitate rapid rate of
economic growth. In view of the limited revenues of the government, infrastructure facilities
are provided largely through public borrowing.
Every government has two major sources of borrowing-internal and external. Internally,
the government can borrow from individuals, financial institutions, commercial banks and the
central bank. Externally, the government borrows from individuals and banks, international
institutions and foreign governments.

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5.2.1 Borrowings from Individuals
When individuals purchase government bonds, they are diverting funds from private
use to government use. Individuals may be able to subscribe to government bonds either through
curtailment of current consumption needs (this may be very rare) or from diversion of funds
meant for one’s own business. To a large extent, the government bonds would be purchased out
of funds that would have been lying idle, so consumption and investment are not affected, if
public debt is voluntary. If public debt is compulsory, then consumption and investment may be
affected.

5.2.2 Borrowing from Non-banking Financial Institutions

When non-banking financial institutions such as insurance companies, investment trusts,
mutual savings banks, etc. buy government bonds, they reduce their idle cash balances by
making investment in government bonds. However, these institutions prefer to invest their
funds in government bonds on account of these bonds being perfectly free from credit-risk, and
also due to their high negotiability and liquidity. The rate of interest paid on government bond
is, however, relatively low. Consequently, many financial institutions prefer to invest in the
high-risk high-returns giving securities, particularly in the equity shares of companies under
the management of familiar and experienced industrialists. When the non-banking financial
institutions purchase government bonds, they do so in order to reduce their cash holdings.

5.2.3 Borrowing from Commercial Banks

Commercial banks can subscribe to government bonds (or loans) through the creation of
money. Whenever, the banking system has excess cash revenues, it can absorb an amount of
government bonds considerably greater than the excess cash reserves. So, if commercial banks
create additional purchasing power and places it at the disposal of the government to finance
the latter’s expenditures, inflationary pressures will be mounted (more so, if previously the
economy was working at full employment level).

5.2.4 Borrowings from the External Sources

Government may borrow from other countries too. These borrowings can be used to
finance war expenditure, or to procure defence equipment, or to pay for development projects,
or to pay off adverse balance of payments. Formerly, the floating of loans for any specific
development projects, like, railway construction, was taken up by individuals and banking and
other financial institutions. However, in recent years, apart from these sources, two important
sources have become prominent. They are: (a) International financial institutions, viz. I.M.F.,
the I.B.R.D., the I.D.A and the I.F.C., which give loans for short-term for overcoming temporary
balance of payments difficulties and for long-term for development purpose; and (b) Government
assistance generally for development projects. For developing countries like India, external
sources of borrowing are becoming considerably important in recent years.

5.3 CLASSIFICATION OF PUBLIC DEBT

Public borrowings differ from one another on the basis of source of borrowing, purpose
of borrowing, nature and condition of borrowing, time of repayment etc. Hence, debt is classified
76
into many categories. Different forms or kinds of public debt are given below.

5.3.1 Internal and External Public Debt

Internal public debt refers to the funds borrowed by the government from its citizens,
financial institutions and other agencies within the country. Loans borrowed by the government
from Reserve Bank of India, Commercial Banks, loans raised in the market at a given rate of
interest, funds mobilized through small savings, postal savings etc. and the amount collected
by selling the bonds to the public constitute the total internal debt. Since under internal debt,
borrowing takes place within the country, the availability of total resources does not arise.
Simply, the resources are transferred from the bond-holders-individuals and institutions-to the
public treasury, and the government can spend these for public purposes. Similarly, payment of
interest and repayment of principal of internal loans would transfer resources from tax-payers
to bond-holders. An internally held public debt, thus, represents only a commitment to effect a
certain transfer of purchasing power among the people within the country. It has, therefore, no
direct net money burden as such. It amounts to only a redistribution of income in the community
from one section to the other.
External loans refer to the funds borrowed by the government from foreign investors,
agencies, financial institutions, multinationals, outside the geographical area under its control.
Loans borrowed by the government from foreign banks, foreign government, international financial
institution like IMF, IBRD, IFC etc. constitute external borrowing. Interest is to be paid on these
debts. However, for a developing country external debt is of immense help, if used productively
to generate additional income in excess of interest payments on borrowings. They will supplement
the available domestic resources for capital formation and accelerate industrialization.

5.3.2 Productive and Unproductive Public Debt

Public debt is said to be productive, if the investment yields an income which will not
only meet the yearly interest payment of the debt but also help to repay the principal over the
long run. For instance, the loans may be used for the construction of railways, power projects,
irrigation and for the establishment of heavy industries, such as, iron and steel, cement and
fertilizers. The principal and the interest both can be repaid out of the income derived from
these projects. Public debt can be said to be productive in another sense too when the government
may undertake certain projects through loans which may not be productive in the sense given
above but which may be useful to the community. For example, a railway line connecting a
backward region, an irrigation work to prevent famine conditions in an area, and so on. In this
sense most debt is productive. Unproductive loans are those which are spent on those projects
which do not yield any income. For instance, loans taken for financing war and for giving relief
in times of flood and drought may be considered as unproductive, because they do not create
any asset, and they are considered as dead weight upon the government.

5.3.3 Reedemable and Irredeemable Debt

On the criteria of maturity, public debt may be classified as redeemable and irredeemable.
Redeemable loans are those loans which the government promises to pay off in the future at a
specified date. They are terminable loans. Irredeemable debts are those which may not be
77
redeemed or repaid at all but the government promises to pay the interest regularly. These loans
may be known as perpetual debt. The redeemable loans may be further classified into short-
period and long-period depending upon the period of redemption. Short term debts may mature
within a period of 3 to 9 months e.g. treasury bills. Interest rates on such loans are usually low.
Likewise, medium term debts may mature between a period of short term and long term period,
say five years or more and bear an interest rate which is lower than long-term. Provident funds,
small saving funds, reserve deposits are the example of irredeemable loans.

5.3.4 Funded and Unfunded Debt

Distinction between these loans is tagged to the duration of repayment of debt. These
loans are also known as unfunded debts and funded debts. Short term loans (unfunded) are
called ‘dated stocks’ as they are to be repaid in 3 months or at most one year. Treasury bills
issued by the government are unfunded debts because they are to be cleared in 3 months or 6
months. In other words, the obligations of short-term or unfunded debts are of a maturity of
less than one year at the time of issue.
Long term loans or funded debts are called “undated stocks”. Such may be repaid at the
option of the government at a fixed date or after words. But, there is no fixed date at which
government must repay these loans. In this case, government obligation is to pay a fixed sum of
interest to the creditor, subject to the option of the government to repay their principal amount.
Hence, the debt becomes a permanent debt. However, long term debt turns into short term debt
as its final date of repayment approaches.

5.4 EFFECTS OF PUBLIC DEBT

Before analyzing the effects of public debt, it is necessary to know the factors on which
the effects of public debt depend. The effects of public debt depend upon such factors as the
sources of loan funds, the purpose for which borrowing is done, the terms and conditions under
which the debt is floated, the volume of the existing public debt, the interest rates, the type of
loan employed and the general economic conditions of the community.
Borrowing from individuals and financial institutions is simply a transfer of resources
from private to government use. Individuals purchase government securities by diverting their
current or previously accumulated savings and institutions after reducing their cash balances.
So the above transfer of resources from individuals or institutions does not create any
expansionary effects on the economy. However, it creates expansionary effects only when
government activities individual’s idle savings. Besides, borrowing from commercial banks
and the Central Bank will also produce such an effect due to increase in additional purchasing
power, as a result of credit expansion. The effects of public debt also depend on the purpose for
which the debt is created. If the borrowed funds are used for wasteful expenditures, which will
not create any social assets then borrowing is indefensible as are the welfare expenditures.
Further, the interest rates have a bearing on the cost of borrowing and consequently upon the
banking system, individuals and corporate investment and economic conditions in general.
The effects of public debt also depend on the amount of loans obtained and the terms on which

78
the loan is floated in the market. In developing economies the dependence on public debt has
been increasing over a period because debt has become an inevitable evil. However, a developing
economy has to decide upon the magnitude of public debt and the sources from which it can be
raised. The size of public debt raised by the government depends upon the absorptive capacity
of the economy and the productivity of the borrowed funds in expanding national income. Let
us now analyze the effects of public debt on consumption, liquidity, production, and distribution
of income and on private sector.

5.4.1 Effects on Consumption

The existence of public debt has an important effect on consumption. Those who hold
government bonds representing the latters’ obligation to pay consider these bonds as personal
wealth. This wealth would not have arisen if the government had financed its expenditure through
taxation. The net result is not only the possession of current income but also in excess of their
current income in the form of interest since they hold wealth. The bondholders usually forget that
bonds also hold claim on them in the form of additional taxation which may be required to repay
the public debt. Consequently, the net effect of public debt is to increase the percentage of total
income spent on consumption and thus exert an expansionary effect on the economy.

5.4.2 Effects on Liquidity

Public debt is represented by bonds which are highly negotiable. Those who have bonds
have highly negotiable and highly liquid form of assets. Whenever, individuals require more
funds for any purpose-transaction, with precautionary or speculative motives-they can easily
convert the bonds into cash. Public debt is thus responsible for the existence of highly liquid
form of assets, which may put limitations before the monetary authorities.
Another important effect of the government bonds is to be found in the case of commercial
banks. These banks hold large amounts of government bonds which can be converted into cash,
whenever cash is required. These bonds would also mean higher reserves with the central bank.
Therefore, they can also create more credit against these reserves. This may make the operation
of monetary policy ineffective, particularly during inflation.

5.4.3 Effects on Production

If people buy government securities by withdrawing money from industrial concerns,
or by selling debentures and shares of industrial concerns, private investment is adversely
affected. The net effect on investment will depend upon how the money is used by government.
If the government utilizes this money in public undertakings, the total investments available
for production may not be adversely affected, but if the government utilizes it on non-productive
works, the total investment may be adversely affected. If the people buy government securities
from idle funds, private investment are not affected, but if they buy from bank deposits, private
investment may be adversely affected, because the lending capacity of the banks may be reduced
due to reduction in deposits.
The governments borrowings may not reduce investment in private sector, provided
there are enough funds in the market and provided the government utilizes the borrowed funds

79
for productive purposes. Moreover, the government will utilize the loans proceeds for making
the payments to contractors for goods and materials purchased and in paying salaries to its
employees. This will release purchasing power and increase bank deposits, which can be utilized
for making loans to private sector. Hence, government borrowings from banks may not affect
investment in private sector.

5.4.4 Effects on Distribution

It is sometimes held that a large amount of public debt increases the inequality of income
distribution in favor of the bondholders. Since bondholders are generally rich, this leads to
more inequality in distribution of income. But this has been contested by Prof. Lerner. He says
that it is because of the inequality in the distribution of income that the bonds are held by the
richer sections in large quantities. In other words, the inequality in the distribution of income is
the cause, not the effect of the concentration of public debt in the hands of a few rich. If the
bond-holders and the tax-payers are the same, then there will be no redistribution of income.
Therefore, the inequalities of income will not increase, but it is generally not true. Hence, some
redistribution of income will take place so long as the tax-payers and the bond holders belong
to different groups and the inequalities of income may increase. If public debt is utilized to
provide more economic welfare to the lower income groups then the inequalities of income
will decrease and a more equal distribution of income among different sections of the community
would take place. However, if loan finance creates inflation some of the good effects upon the
distribution of income may be neutralized because of the rise in prices. Thus, if the loan proceeds
are spent on welfare schemes, the effects on distribution are whole-some.

5.4.5 Effects on Private Sector

Public expenditure increases the demand for goods, because it increases the purchasing
power of the people and puts more money in circulation. If the expenditure is financed through
taxation, current consumption is reduced. On the contrary, when it is financed through
borrowings, idle savings are generally utilized and thus, the current consumption is not reduced.
Generally, a portion of the borrowed funds may be utilized on salaries and wages of government
employees, who may in turn purchase the goods produced in the private sector and demand for
the products of industries in the private sector increases. Hence, the effects of public debt are
said to be favorable.
Some observers, particularly following classical economic thoughts, point out that public
debt crowd out, i.e., reduces private investment because lesser resources are available for the
private sector. However, evidence also exists that there is positive link between public investment,
and private investment. If the government invests the proceeds from public debt for building
economic and social infrastructure, which it should, then private investment will also be
promoted. Thus, it is difficult to state clearly whether the existence of public debt will encourage
or discourage private investment.

5.5 BURDEN OF PUBLIC DEBT

The burden of public debt refers to the sacrifice it will impose and have effects on the
community through a rise in taxation, necessitated at the time of repayment and for paying the
80
annual interests on the government loans. The burden of public debt is represented by the
economic hardships it imposes on different sections of the economy. Debt burden may take the
two forms. One is waste of productive efficiency for the economy as a whole. Second, undesirable
economic burdens imposed on some classes or sections of the people. The burden of public
debt is related to the burden of interest payments and the burden of principle repayment. The
main burden of public debt is the total loss incurred in connection with the transfer of purchasing
power involved in interest payments. These costs are partly money costs and partly subjective
costs. In order to pay the interest charges on public debt government has to increase the level of
taxation. Thus, money income of the people is transferred to the government consequent loss
of this income of the people is called financial burden or primary burden of public debt. Taxation
to pay a given amount of interest amount in depression will be far more burdensome than in
prosperity. The higher level of taxation caused by the rising public debt may have some
repercussions on the economy in the form of adverse effects on the capacity and willingness to
work and on the capacity and willingness to save. These effects may be called real burden or
secondary burden of public debt. The intensity of debt burden is determined by the size of the
National income, nature of the tax system and the degree of dispersion of security (loans) holdings.

5.5.1 Measurement of Debt Burden

Estimated debt burden serves as an indicator to assess the burden of debt. Infact,
magnitude of debt burden enables the government to take up suitable efforts to manage the debt
and also to formulate and design of Debt policy. It guides the government on the matters of
redemption of public debt. To estimate the relative burden of national debt in a country at
different times or in different countries at the same time, various methods have been put forward.
However most commonly adopted methods are given here under:
1. Debt-Income Ratio: It is the ratio of total debt to the National income of the country in
a year. This ratio indicates the strength and efficiency of the economy in terms of National
income in relation to public debt. When national income increases adequately to repay
the public debt, it will not be a burden on the Nation.
Total Public Debt
Debt Income Ratio = ————————————————
National Income (at current prices)
2. Debt-Service Ratio: It is a ratio of annual interest payments on public debt to the
National income at current prices. This is most significant ratio indicating the grass
financial burden imposed by the public debt on the governments’ annual budget. This
ratio is worked out as under.
The Annual Interest Payments in the Public Debt
Debt Service Ratio = ————————————————————
The National Income (at current prices)
3. Interest-Cost Revenue Ratio: This is the ratio of interest charges (cost) to the total tax
revenues. The ratio is important for budgetary purpose. It is measured as follows:

81
 Debt Service Charges (interest cost) of public debt
Interest Cost Revenue Ration = ————————————————————
Aggregate Tax Revenue
4. Interest Cost Revenue Expenditure Ratio (ICRER): It is used to assess the extent to
which the interest charges on public debt impinge upon the socially desirable public
expenditure of the government. It is measured as follows:
Annual Interest Payments
ICRER = ———————————
Total Revenue Expenditure
It indicates what proportion of revenue expenditure is required for meeting debt servicing
only. Increased public borrowings at high interest rates would lead to a rise in this ratio over the
period of time.
5. Interest Cost Profit Ratio: This relates to the problem of productive use of the public
borrowing. It is measured as follows:
Interest Payments of Public Loans
Interest Cost Profit Ratio = ———————————————
Profits of Public Sector Enterprises
It can be worked out if the borrowed funds are used only on directly countable productive
industrial projects.

Check Your Progress.

Note: a) Space is given below for writing your answer
b) Compare your answer with the one given at the end of the unit.
1. What is public debt?
..........................................................................................................................................
...........................................................................................................................................
2. What are the objectives of public debt?
..........................................................................................................................................
...........................................................................................................................................
3. Distinguish between productive and unproductive debt.
..........................................................................................................................................
...........................................................................................................................................
4. Make a distinction between internal and external debt.
..........................................................................................................................................
...........................................................................................................................................
5. What do you mean by debt burden?
..........................................................................................................................................
...........................................................................................................................................
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5.6 REDEMPTION OF PUBLIC DEBT
Redemption means repayment of a debt. Just as the private individual or organization has
to repay the loan, he or it has borrowed, so also the government has to pay not only interest on
the public debt but also repay the principal on the due date. Experience shows clearly that mounting
public debt has a demoralizing effect on the people apart from the fact that the public is subjected
to higher rates of taxation. Therefore, the sooner the debt is cleared, the better for the government.
Hence, every government tries to redeem the loan at the earliest. However, the redemption of
debt or loan depends upon the nature of debt. If debt is taken for productive purposes, it may not
be strictly necessary to redeem it at the earliest because the government is also getting a source of
income to pay off the interest of the debt. On the contrary, if loan is taken for unproductive
purposes such as war debt, the sooner it is paid off, the better both for the government as well as
for the public, because it is a burden without any return.
There are three considerations relating to the redemption of public debt.
(1) Equity consideration influences the debt redemption policy of the government. This
consideration relates to the distribution of debt burden equally among the generations
that enjoy the benefits of public debt. It means the burden of debt servicing and repayment
is to be less on the generation in the initial stages of projects financed by debt and the
burden of debt servicing and repayment is to be more on the generation that enjoys the
benefits of projects financed by the debt.
(2) The consideration that influences the debt redemption policy is diminishing marginal
utility of debt burden. This is based on the principle of minimizing the aggregate sacrifice
in allocating the tax-burden. As long as debt finance contributes for the sustainable rise
in national income, debt policy need not aim at debt redemption.
(3) Any debt is to be redeemed after certain time period, becomes an obligation on the part
of the government. This obligation makes the government to repay the whole debt by
mobilizing the resources.

5.6.1 Advantages of Debt Redemption

i) It saves the government from bankruptcy.
ii) It discourages extravagant expenditure of the government.
iii) It maintains the confidence of the lenders.
iv) It reduces the cost of debt management.
v) It would be easy for the government to float loan in future.
vi) It saves posterity from the burden of debt, when it is redeemed at an early stage.

5.6.2 Methods of Redemption of Public Debt

Various methods are used by a government to redeem its debt. Some of these methods
are extreme once such as repudiation of debt, while others may not be redemption at all, but
payment of one debt with the help of another debt. Let us briefly discuss the few important
methods of debt repayment.
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1. Repudiation of Public Debt: Repudiation of public debt means simply that government
does not recognize its obligation and refuses to pay the interest as well as the principal.
This method was followed by the USA during the civil war and Russia after the 1917
revolution. India in 1991, in order to avoid such a situation borrowed heavily from the
IMF and World Bank accepting certain conditionalities. This method is most undesirable
because: i) It shakes the confidence of the people in public debt; ii) may provoke relation
from the creditor countries; and iii) it is considered immoral and dishonest. Of all the
methods of redeeming the public debt, repudiation is the most severe and extreme but
strictly speaking it is not the redemption.
2. Refunding: Refunding is the process by which the maturing bonds are replaced by new
bonds. In this case new bonds are issued by the government in order to pay off the
matured loans. This process of refunding involves no liquidation of money of the public
debt.
3. Conversion: In this method new debt replaces old debt. The process of conversion
consists generally of converting public debt from a higher to a lower rate of interest. The
government might have borrowed at a time when the rate of interest was high. Now,
when the rate of interest falls, it may convert the old loans into new ones at a lower rate
in order to minimize the burden. Thus, the obvious advantage of such conversion is that
it reduces the burden of interest on the tax-payers.
The success of conversion, however, depends upon the following factors: (i) The
creditworthiness of the government; (ii) The maintenance of adequate stock of securities;
and (iii) The efficiency in managing the public debt.
4. Sinking Fund: This method was first established by Hugh Walpole in England and later
was adopted by most of the countries in the world including India. In this system, the
government creates a separate fund known as ‘Sinking Fund’. Certain amount of money
is credited by the government to this fund. Over a period of time, the fund accumulates
enough amounts to pay off not only the principal amount of the debt but also the interest
on the loan as well.
Sinking fund is of two types as: (i) certain sinking fund, and (ii) uncertain sinking fund.
In ‘certain sinking fund’, the government credits a fixed sum of money annually. While
in other type of ‘uncertain sinking fund’, an amount is credited when the government
secures a surplus in the budget.
In modern times, sinking funds are not accumulated. But some funds are kept every year
for repayment of some part of the debt in the same year. The amount is not put in a fund
allowed to be accumulated but is used every year either to pay off the bonds which are
maturing or to buy off bonds from the market. In short, sinking fund is a slow method of
debt redemption. Thus, Dalton prefers capital levy. He also prefers that sinking fund
should be made from current revenue of the government and not out of loans.
5. Capital Levy: Capital levy refers to a very heavy tax on property and wealth. In fact
capital levy is usually advocated immediately after the war to repay the unproductive
war debts. It is imposed on net assets on progressive scale.
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6. Budget Surplus: Generally policy of surplus budgets may be utilized for clearing off
public debts. But in recent years due to ever – increasing public expenditure, deficit
budget has became the practice and arrangements have been made to repay a part of the
debt from budget revenues.
7. Terminal Annuities: This method of is similar to that of the sinking fund. In this method,
the fiscal authorities clear off a part of the public debt every year by issuing terminable
annuities to the bond holders which mature annually. By this method, the burden of debt
goes on diminishing annually and by the time of maturity, it is fully paid off.

5.7 DEBT TRAP

This concept is very much relevant to the developing countries where the government is
playing a leading role in the process of economic development. Most of the economists are of
the view that the mounting costs of debt servicing is pushing developing countries towards a
situation of debt trap. This is because without borrowing a fresh or without rescheduling of the
payment obligations, the governments are not in a position to meet the cost of debt servicing.
This is what is known as ‘debt trap’. It is a situation where the total indebtedness of the country
keeps on mounting and there is no possibility at its downturn. Most of the developing countries
fall into external debt trap. This is more dangerous than internal debt trap.

Check Your Progress.

6. What is meant by Redemption of Public Debt?
..........................................................................................................................................
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7. Write the advantages of Debt Redemption.
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...........................................................................................................................................
8. What is Debt Trap?
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5.8 SUMMARY
In the words of Prof. J.K. Mehta, “Public debt is a comparatively modern phenomenon
and has come into existence with the development of democratic forms of government in the
world. These days there is probably no nation in the world which does not incur any debt
whether internal or external. The growth of public debt is the result of changing economic and
political institutions.” Public debt can be used in such plans which involve heavy risk and huge
investment of capital. For instance, creation of infrastructure and establishment of basic industries
like iron and steel, coal and power etc. which require heavy investment of capital for a
comparatively longer gestation period. It is possible through long-term public debt policy only.
The financing of developmental programs of the plan is of utmost importance in developing
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countries and it requires large amount of funds. If public debt is used to finance the construction
of productive assets like railways, roads, irrigation projects, capital goods industries, there will
be no real burden of public debt.
Every government has two major sources of borrowing-internal and external. Internally,
the government can borrow from individuals, financial institutions, commercial banks and the
central bank. Externally, the government borrows from individuals and banks, international
institutions and foreign governments. The effects of public debt depend upon such factors as
the sources of loan funds, the purpose for which borrowing is done, the terms and conditions
under which the debt is floated, the volume of the existing public debt, the interest rates, the
types of loan employed and the general economic condition of the community. The Redemption
of Debt depends up on the nature of debt.

5.9 CHECK YOUR PROGRESS – MODEL ANSWERS

1. Public debt is the debt which the state (Government) owes to its citizens or of other
countries or to other agencies from whom the government has borrowed. The government
may borrow from banks, business organizations, business houses and individuals. The
government can borrow from within the country or from outside the country or both.
2. The objectives of public debt are: i) To meet budget deficit to ii) to meet the expenses of
war and other extraordinary situations and iii) to finance development activities which
involve high risk and huge investment capital. For instance, creation of infrastructure
and establishment of basic industries like Iron and Steel and Power etc.
3. Public debt is said to be productive, if the investment yields an income which will not
only meet the yearly interest payment of the debt but also help to repay the principal
over the long run. For instance, the loans may be used for the construction of railways,
power projects, irrigation and for the establishment of heavy industries, such as, iron
and steel, cement and fertilizers. Unproductive loans are those which are spent on those
projects which do not yield any income. For instance, loans taken for financing war and
for giving relief in times of flood and drought may be considered as unproductive, because
they do not create any asset, and they are considered as dead weight upon the government.
4. Internal public debt refers to the funds borrowed by the government form its citizens,
financial institutions and other agencies within the country. External debt refers to the
funds borrowed by the government from foreign investors, agencies, financial institutions,
multinationals, outside the geographical area under its control. Loans borrowed by the
government from foreign banks, foreign government, international financial institution
like IMF, IBRD, IFC etc. constitute external borrowing.
5. The burden of public debt refers to the sacrifice it will impose and have effects on the
community through a rise in taxation, necessitated at the time of repayment and for
paying the annual interest on the government loans.
6. Redemption means repayment of a debt. Just as the private individual or organization
has to repay the loan, he or it has borrowed, so also the government has to pay not only

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 interest on the public debt but also repay the principal on the due date.
7. Advantages of Debt Redemption are as follows: i) it saves the government from
bankruptcy; ii) it discourages extravagant expenditure of the government; iii) it maintains
the confidence of the lenders; iv) it reduces the cost of debt management; v) it would be
easy for the government to float loan in future. vi) it saves posterity from the burden of
debt, when it is redeemed at an early stage.
8. It is a situation where the total indebtedness of the country keeps on mounting and there
is no possibility at its downturn. Most of the developing countries fall into external debt
trap. This is more dangerous than internal debt trap.

5.10 MODEL EXAMINATION QUESTIONS

I. Answer the following questions in about 10 lines each.
1. Internal debt is better than External debt - Discuss.
2. Explain the effects of public debt on Production and Distribution.
3. External debt is more burdensome than the internal debt - why?
4. Describe the classification of public debt.

II. Answer the following questions in about 30 lines each.

1. Define public debt and examine the need for raising public debt in developing countries.
2. Describe various sources of public borrowings.
3. Explain the economic effects of public borrowing.
4. Disscuss the advantages and disadvantages of public borrowing.
5. Explain the methods of debt redemption.
III. One mark Questions.
A. Multiple Choice Questions.
1. Obligations of Unfunded debts one of a maturity of ...
A. One year B. Less than one year C. 5 years D. None of the above
2. Long-term loans are also called:
A. Undated stocks B. Unfunded debts
C. Dated stocks D. None of the above
3. The following economist held the view that national debt is an implement to achieve full
Employment.
A. Keyns B. J.S. Mill C. A.P. Lemer D. Samuelson
4. In which redemption method the new debt replaces old debt.
A. Refunding B. Conversion C. Sinking fund D. Budget surplus
Answers : 1. B 2. A 3. C 4. B

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B. Fill in the blanks.
1. Generally, public debt is in the form of______ and _______
2. Classical economists favoured _______ to borrowing.
3. Raja J. Challaiah opend that the debt financing will be used for meeting the _____
4. Redeemable loans are ______ loans.
5. Short-term debts may mature within a period of ________
6. Debt-income Ratio indicates the _________ of the economy
Answers: 1. Bonds, Treasury bills 2. Taxation 3. Capital expenditure 4. Terminable
5. 3 to 9 months 6. Strength and efficiency.

C. Match the following.

A B
(i) The burden of politic debt a) A process by which the maturing
is represented by bonds are replaced by new bonds
(ii) National debt is an instrument to b) AP Lerner
active full employment opend by
(iii) Sinking fund method of c) Hugh Warpole in england
redemption was first established by
(iv) Refunding method of redemption d) Economic herdships it
imposes on different sections
(v) Public debt classified as e) redeemable and irredeemable
Answers: i) d, ii) b, iii) c, iv) a , v) e

5.10 GLOSSARY
1. Public Debt: The total borrowings of the government from internal and external source.
2. Internal Debt: It is sum of loans borrowed by the government from all sources within
the economy.
3. External Debt: The sum of funds borrowed by the government from foreign bank,
international finance institutions and multinationals.
4. Debt Burden: the burden of public debt refers to the sacrifice it will impose and have
effects on the community through a rise in taxation, necessitated at the time of repayment
and for paying the annual interest on the government loans.
5. Debt Redemption: Payment of interest and repayment of Principal amount by the
Government.

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6. Debt Trap: without borrowing a fresh or without rescheduling of the payment obligations,
the governments are not in a position to meet the cost of debt servicing. This is what is
known as ‘debt trap’. It is a situation where the total indebtedness of the country keeps
on mounting and there is no possibility at its downturn.

5.11 SUGGESTED BOOKS

1. R.A. Musgrave and P.B. Musgrave: Public Finance in theory and practice, MC Grew
Hill, 1976.
2. H.L. Bhatiya: Public Finance, Vikas Publishing House, New Delhi, 2000.
3. B.P. Tyagi: Public Finance, Jai Prakash Nath & Co. Meeruit.
4. J.R. Gupta: Public Economics in India, Atlantic Publishers, (p) Ltd., New Delhi.

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 BLOCK – III
FISCAL POLICY, FEDERAL FINANCE AND BUDGET
Fiscal policy denotes the use of budgetary instruments for advancement of the socio-
economic goals of a country. This block deals with the concept, objectives of fiscal policy in
developing countries. It also discusses the central-state financial relations and the functions
of finance commission in India. Apart from these aspects, the concept, components and
objectives of budget also elaborated in this block.
This block contains the following units:
Unit - 6: Fiscal Policy and Federal Finance
Unit - 7: Budget: Concepts, Types and Budgeting in India

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UNIT - 6: FISCAL POLICY AND FEDERAL FINANCE
Contents
6.0 Objectives
6.1 Meaning of Fiscal Policy
6.2 Classical Concept of Fiscal Policy
6.3 Modern Concept of Fiscal Policy
6.4 Objectives of Fiscal Policy
6.4.1 Fiscal Policy and Developed Countries
6.4.2 Fiscal Policy and Developing Countries
6.5 Federal Finance - Meaning, Features and Principles
6.6 Centre-State Financial Relations
6.6.1 The Union List
6.6.2 State List
6.6.3 Concurrent List
6.7 Finance Commission
6.7.1 Functions of Finance Commission
6.8 Summary
6.9 Check Your Progress – Model Answers
6.10 Model Examination Questions
6.11 Glossary
6.12 Suggested Books

6.0 OBJECTIVES
The purpose of this unit is to explain the concept and objectives of fiscal policy; concept,
features, principles of federal finance and central state financial relations. It also explains the
functions of finance commission. After reading this unit, you will be able to:
• analyze the role of federal finance in economic development;
• identify the central state financial relations; and
• discuss the functions of finance commission.

6.1 MEANING OF FISCAL POLICY

It has been an important component of government's economic policy after the great
depression of thirties. It refers to the policy of the government with regard to the taxation,
spending and borrowing in an economy. Fiscal Policy is essentially concerned with the “Overall”
effects of Government’s fiscal operations, namely, its total expenditure and taxation on macro-
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economic aggregates of national income, output, price stability, etc. What distinguishes fiscal
policy from other aspects of public finance is its central concern, as stated above with the
aggregate variables.
In other words, fiscal policy denotes the use of budgetary instruments (taxation, public
borrowing and public spending) for advancement of the socio-economic goals of a country.
Arthur Smithies defines fiscal policy as “a policy, under which the government uses its
expenditure and revenue programmers to produce desirable effects and avoid undesirable effects
on the national income, production and employment”.
Dirk J. Wolfson Aptly describes fiscal policy as comprising “all measures to increase
the general welfare through the public control of resources by means of public spending, resource
mobilization, and rate setting in public and semi-public enterprises”
It is also useful to make a distinction between fiscal policy and monetary policy, the two
policies which are inter-connected in several ways. Monetary policy is generally defined as a
policy with respect to quantity of money, while fiscal policy is a policy with respect to sources
and uses of funds and their composition.

6.2 CLASSICAL CONCEPT OF FISCAL POLICY

Classical economists had beleived in the policy of Laissez Fair, which means a free operation
of market forces would achieve full employment and ensure the optimum allocation of resources.
They opposed the interference of government in the working of economic system and advocated
the intervention of state in the areas of national defence, and domestic law and order.
Classical economics considered that government expenditure in economic field as
unproductive, because any government spending causes transfer of resources from private sector
to public sector, thereby causing reduction in output of private enterprise and hence, the aggregate
national product is reduced because of government expenditure.
Further, the classical economists advocated the principle of balanced budget and they
considered a surplus or a deficit budget as undesirable.

6.3 MODERN CONCEPT OF FISCAL POLICY

The classical concept of fiscal policy has not been accepted by the modern economists
(Keynes and Learner). They believed that the government has to play a positive role so as to
control the economy by means of taxes and expenditure which they called as the principle of
functional finance which is termed as modern fiscal policy.
Modern Fiscal Policy: Modern fiscal policy is a technique to attain and maintain the level of
full employment by maintaining public expenditure and revenues in such a way so as to keep
an equilibrium between effective demand and supply of goods and services at that time.
Tools and Techniques: The way in which the physical measures work in the economy is called
functional finance (Lerner).The central idea is that the Government’s fiscal policy involves
government spending and borrowing of loans and withdrawal of money from circulation in
economy.
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Rule of Functional Finance: According to the concept of functional finance the public finance
may eliminate the basic cause of deflation and inflation so that the economic stability is
maintained.

Check Your Progress.

Note: (a) Space is given below for writing your answer.
(b) Compare your answer with the one given at the end of the unit.
1. What is the fiscal policy?
..........................................................................................................................................
...........................................................................................................................................

6.4 OBJECTIVES OF FISCAL POLICY

The objectives of fiscal policy are different in different countries. In developed countries,
the focus of fiscal policy is on maintaining full employment and stabilising growth, whereas, in
developing countries the fiscal policy is used to create an environment for rapid economic
growth. The various objectives of fiscal policy are as follows:

6.4.1 Fiscal Policy and Developed Countries

The following are the objectives of fiscal policy in the developed countries:
i. Maintaining Full Employment: In developed countries fiscal policy aims to maintain
full employment through management of its budget. In order to encourage private
investment, it gives grant or bounties or relief in taxation to the people. When private
investment increases too high, the government reduces its own expenditure and increases
taxes so that full employment is maintain.
ii. Control Inflation and Deflation: Fiscal policy aims at reducing price fluctuations and
maintaining stable price level by containing inflationary and deflationary tendencies in
developed countries.
iii. Maintaining Economic Stability: Fiscal policy is often employed, especially in
developed countries to moderate business fluctuations or cycles. During an upswing,
taxes are hiked to curb the rising demand for goods and services, whereas taxes are
lowered in recessionary phase to boost up the level of demand.
iv. Maintaining Price Stability: Economic stability is largely depended on overall price
stability. A stable price level creates possitive environment for production, output and
employment.
v. Maintain a High Rate of Economic Growth: Maintaining a higher rate of economic
growth is one of the important objectives of developed countries by controlling inflation
and deflation and through achieving price stability and economic stability.

6.4.2 Fiscal Policy and Developing Countries

The following are the objectives of fiscal policy in underdeveloping countries:

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i. Increasing Employment Opportunities: The level of employment influences the
aggregate output and income and thus general standard of living of the population. Fiscal
policy in developing countries thus strives at increasing the level of employment as they
are characterized by under employment and unemployment.
ii. Mobilisation and Allocation of Resources: Developing countries are characterized by
a low level of income and investment leading to a vicious circle of poverty. Fiscal policy
aims at breaking this circle by mobilizing and generating resources through taxes and
borrowing, and investing the limited resources in efficient ways.
iii. Minimisation of Inequalities in Income and Wealth: Fiscal policy tools are used with
the objective of bringing about redistribution of income in favour of the poor by taxing
the rich and spending the so raised revenue on various social welfare activities including
education, health, water and sanitation.
iv. Increasing Economic Growth: Fiscal policy aims at directing the resources to socially
desired channels with high yield, so as to boost output and accelerate economic growth.

Check Your Progress.

2. What are the objectives of fiscal policy in developing countries?
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3. What are the objectives of fiscal policy in underdeveloping countries?
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6.5 FEDERAL FINANCE - MEANING, FEATURES AND

PRINCIPLES
1. Meaning of Federal Finance: “Federal Finance” refers to the finances of the central or
federal as well as the state governments and the fiscal relationship between these two
levels of governments. In a federation, both the central and state governments derive
their powers directly from the Constitutions.
2. Features of Federal System: The following are the essential features of federal system:
i. Dual Government: In contrast to a unitary state, in which there is only one National
Government, in a federal state, there are two layers of government, the union government
and the state governments.
ii. Distribution of Powers: A federal system involves a division of functions and resources
between the federal and the state governments. The functions performed by the central
government includes maintaining macroeconomic stability, international relations,
defence, currency which are carried out by central govt alone and some other functions
are carried out with the cooperation of states like inter-state corporations, communications
etc. The functions which have a state wide jurisdiction are assigned to the States and
some other functions performed by both governments which are listed in concurrent list.
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iii. Supremacy of the Constitution: A federal state derives its existence from the constitution.
Every power (executive, legislative or judicial) whether it belongs to the union or the
state is subordinate to and controlled by the constitution.
iv. Authority of Courts: Another feature of a federal system is that there should be no
violation of the provisions of the constitution by any tier of the government. This is
secured by the vesting power of interpretations of constitution by the judiciary.
v. Doctrine of Harmonious Construction: It implies that different entries in different lists
should be interpreted in such a way that the scope and meaning of one entry should not
affect the meaning of the other entry.
vi. Doctrine of Pith and Substance: In a federal set-up, the Central and State Governments
should keep themselves within their respective domain assigned to them.
3. Principles of Federal Finance: There are differences of opinion by many economists
on the various principles of federal finances which sometimes clash with each other.
Therefore, it is necessary for you to understand the important principles of federal finance
put forward by different economists.
i. Efficiency: According to the principle of efficiency, the central, state and local
governments should be able to handle efficiently in order to collect the public revenue
from the different sources in their respective areas. For instance, the Central government
is supposed to collect the taxes like wealth, income, gift taxes, excise duty, customs duty
while the State Governments collect the sales taxes, expenditure taxes and local
governments collect the professional taxes, electricity and water charges in efficient
manner. The specific area of operation among the different layers of governments in
respect of collection of taxes would develop the efficient manner of handling the public
revenue without any difficulty.
ii. Uniformity: The principle of uniformity means that the union government should
perform its responsibility that all the state governments in a federal setup get equal
treatment in respect of obtaining the grant-in-aid, sharing of tax burden or obtaining the
benefits provided to them. No state should be put-up with the higher burden of tax and
no state should be discriminated for anything. All the states should follow the equi-
treatment in respect of taxes collection and pattern of expenditure.
iii. Economy: According to the principle of economy, the Central-State governments should
as much as economise in respect of allocating resources, tax-collections between two
layers of government. The central-State governments should so design to spend the least
and collect the maximum revenue. By doing this exercise, the tax evasion will be
minimized and administrative delays would also be least.
iv. Autonomy: According to this principle, the central-state governments should be
reasonably autonomous in a federal setup, so as to operate the internal financial matters.
It means that the state government should have adequate sources of revenue and also
have reasonable freedom to spend more as per the requirements of the people and also
collect the revenue more as per the requirements of budget. Each government should be

95
 independent to raise its own resources and spend the money according to its own choice
without looking for other neighbouring states for financial help. In a federal setup, the
state governments have a right to discharge some duties entrusted by the central
government observing the central code of conduct. However, the state governments have
to implement certain Central sponsored schemes for which the Central Government
provides grant-in-aid. The state governments should not interfere with the central
government as far as their functions are concerned. The two layers of governments should
have perfect understanding at their sphere of operations.
v. Self-Sufficiency: According to the principle of self-sufficiency, in a federal set up, the
central-state governments should have the fiscal competence in respect of allocating the
financial resources. The financial powers are to be so demarcated among the different
layers of government in such a way that adequate resources are made available for these
governments so as to perform their functions efficiently. If the governments are not
self-sufficient in resources, they will not handle the administration in appropriate manner,
finally leading to instability and stagnation.
vi. Flexibility: According to the principle of flexibility, in a federal set up, the government
should be flexible enough to meet the fast changing requirements of the economy and
the people. The governments should not only be the principle of fiscal competence or
self-sufficient but also flexible in the matter of allocating the resources among the different
layers of governments keeping the changes and requirements in view.
vii. Economic Regulations: In accordance with the principle of economic regulations, in a
federal set up, the government should allocate the financial resources in a manner that
the economic system remains stable, government should not only adopt a policy of
mobilizing the additional resources but also stabilize the inflation and deflation without
giving scope for resorting the economic disparities among the different sections of the
society.
vii. Transfer of Resources: According to the principle of transfer of resources in the federal
governments, there must be a provision to transfer the resources from one state to the
other. Some states are rich in resources while some are poor and thereby there will be
imbalances between two states. In a federal system of government, it is only possible to
transfer the resources from the states which are rich in resources to the resources deficit
states in order to achieve a balanced growth of development.
ix. Adequacy and Elasticity: According to the principle of adequacy and elasticity, the
resources allocated to each level of government should be adequate for the discharge of
duties entrusted to it; such adequacy should to not only meet present needs but also the
future requirements of economy. In a federal setup, it has been observed that the state
governments function with the day to day increased expenditure. In view of certain
financial crises, the governments should possess the quality of elasticity to expand its
activities or contract the pattern of expenditure.
x. Integration and Co-ordination: According to the principle of integration and co-
ordination, the central-state governments ought to integrate and co-ordinate with each
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 other in respect of distributing resources between two layers of governments as it may
lead to promote the economic development. These governments ought to follow the
principle of co-ordination not only in the matter of taxation but also in financial activities
i.e. budget, creation and operation of various activities.
Apart from the principles stated above, the central-state governments should adhere to
the other principles of equity, accountability and fiscal access to ensure the ideal balance of
financial powers, needs and available resources among the states.

Check Your Progress.

4. What are the features of federal finance?
..........................................................................................................................................
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5. What are the principles of federal finance?
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...........................................................................................................................................

6.6 CENTRE - STATE FINANCIAL RELATIONS

India is a country with federal structured; Center-State fiscal relations are recognized as
very important in almost all the federations.
It may be noted that the central government plays an important and key role in achieving
economic development in countries with federal structure in modern times. India was formed
into a federation after Independence. Provisions, thus, necessary were incorporated in the Indian
Constitution. The division of revenues and functions, which is inevitable in a federation, is
provided in the constitution. The Centre-State financial relations which are necessary for the
existence of a federation are governed by federal fiscal relations. Therefore, it is necessary to
know elaborately the financial transfers which make fiscal adjustment between the centre and
states.

6.6.1 The Union List

As per the constitutional division, the union taxes as laid down in the List-I of the VII
schedule are as follows:
1. Income tax on non-agriculture income.
2. Corporation tax.
3. Excise duties on tobacco and other goods manufactured or produced in India except
Alcoholic liquids for human consumption, opium, Indian hemp and other narcotic drugs
and narcotics.
4. Estate duty on non-agriculture lands.
5. Taxes on capital values.
6. Taxes other than stamp duties on transactions in stock exchanges and future markets.
7. Rates of stamp duty in respect of bills of exchange, cheques, promissory notes, bills of
landing etc. 97
8. Taxes on sale or purchase of news papers and on advertisements therein.
9. Terminal taxes on goods or passengers carried by railway, sea, or air; taxes on railway
passenger fares and freights.
10. Taxes on the sale and purchase of goods other than news papers, where such sale or
purchase takes place in course of interstate trade or commerce.
11. Taxes on the consignment of goods where such consignment takes place in course of
inter-state trade and commerce.
12. Customs duty.
6.6.2 State List
Taxes within the jurisdiction of the states as given in List II of the seventh schedule are
as follows:
1. Land revenue.
2. Taxes on sale and purchase of goods excluding news papers.
3. Agriculture income tax.
4. Taxes on property and buildings.
5. Estate duty on agricultural lands.
6. Excise duties on goods containing alcoholic liquors for human consumption, opium.
Indian hemp and other narcotic drugs and narcotics.
7. Taxes on the entry of goods into local area.
8. Taxes on mineral right.
9. Taxes on consumption or sale of electricity.
10. Taxes on animals and boats and vehicles.
11. Rates of stamp duty in respect of documents other than those specified in the Union List.
12. Terminal taxes on goods or passengers carried by railway, sea, or air; taxes on rail
passenger fares and freights.
13. Taxes on luxuries including taxes on entertainments, amusements, betting and gambling.
14. Tolls.
15. Taxes on professions, trades, callings and employment.
16. Capitation taxes.
17. Taxes on advertisements other than advertisements published in news papers.
Apart from the taxes levied and collected by the states, the constitution has provided for
the revenues from certain taxes in the Union list to be allocated partly or wholly to the States.
a) There are certain duties which are levied by the Union, but are collected and appropriated
by the States. These include stamp duties and excise duties on medical preparations
containing alcohol or narcotics.
b) There are certain taxes which are levied and collected by the Union, but the revenue
from these taxes are shared by the Union government with the State governments. Income
tax Union excise duties are such taxes. The proportion in which the revenue from these
taxes is to be shared is determined by the Finance Commission.

98
6.6.3 Concurrent List
The concurrent list includes the subject that gives power to governments subject like
education including Technical Education medical education and Universities, population control
and family planning, criminal law, prevention of cruelty to animals, protection of wildlife, have
given that can be conflict when law passed by the Parliament and state legislature and the same
subject the constitution provides for a central law to override State Law. Since 1950 the seventh
schedule of the Constitution has been a number of amendments the union list and concurrent list
have grown while subjects under the state list have gradually reduced. The 42nd amendment act
was perhaps affected in 1976 during the emergency by then Prime Minister Indira Gandhi the
amendment restricted during that state list subjects like education, forest, protection of wild animals,
and birds, administration of justice, and weights and measurements, were transferred to the
concurrent list. In financial aspect these items are listed in concurrent list bankruptcy and
insolvency, trust and trustees, forests, drugs and poisonous, the population control and family
planning, industrial monopolies, combined centres Industrial and Labour disputes, social security
and social insurance employment and unemployment, Welfare of labour including conditions of
work, provident fund, employees liability, women's compensation, invalidity and old age pension
and Maternity benefits, shipping and navigation, weights and measures, price control electricity,
stamp duties, fees in respect of any list but not include fees taken in any Court, are some items
which related to financial aspects and listed in concurrent list.
In addition to these sources of revenue, the constitution provides grants-in-aid to the
states according to Article 275. Article 282 provides special grants for any public propose of
the States. Article 293 of the constitution provides granting of loans for any purpose to the
State Government. For this purpose, the constitution provides a Finance Commission which
should be appointed by the president of India for every five years.

6.7 FINANCE COMMISSION

Constitution of the Finance Commission: Finance Commission is a quasi-judicial body set
up under Article 280 of the Indian constitution. It was first constituted in the year 1951, to
define the fiscal relationship framework between the Centre and the states. It aims to reduce
the fiscal imbalances between the centre and the states (Vertical imbalance) and also between
the states (horizontal imbalance). It promotes inclusiveness. It consists of a chairman, a secretary
and 4 other members. A Finance Commission is setup for every 5 years. It is normally constituted
two years before the period. Its recommendations become valid for period of five years.
The 14thfinance commission was set up in 2013. Its recommendations were valid for
the period from 1st April 2015 to 31st March 2020. The 15th finance commission has been set
up in November 2017. Its recommendations will be implemented starting 1 April 2020 onwards.
The 15th Finance Commission is chaired by Nand Kumar Singh, Arvind Mehta will be the
Secretary to the commission. Other members of the commission are former Economic Affairs
Secretary Shaktikanta Das and former Chief Economic Advisor Ashok Lahiri, Niti Aayog
Member Ramesh Chand and Georgetown University professor Anoop Singh.

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6.7.1 Functions of Finance Commission
i. Setting up rules regarding the distribution of the tax revenues between the Centre and
the states.
ii. Determining the principles governing the allocation of Grants-in-Aid to the states and
local bodies.
iii. Determining the magnitude of Grants-in-Aid allocated to the states and local bodies.
iv. Any other matter referred to the Commission.
The 14th Finance Commission had recommended an increase in the share of states in the
centre’s tax revenue from 32 per cent to 42 per cent. It was the single largest increase ever
recommended by a Finance Commission.
Check Your Progress.
6. What are the objectives of Finance Commission?
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6.8 SUMMARY
In this unit we have learnt the classical and modern approaches to fiscal policy and
objectives of fiscal policy, the concept, features and principles of federal finance, central state
financial relations and functions of finance commission. Fiscal policy is the policy under which
the government uses its expenditure and revenue programmes to produce desirable effects and
avoid undesirable effects on the national income, production and employment. The central
state relations are very important in the federal system. There have been observed several fiscal
and federal related problems between central and state financial relations in India from the
several decades. The role of finance commission is crucial in federal economy.

6.9 CHECK YOUR PROGRESS – MODEL ANSWERS

1. Fiscal Policy is essentially concerned with the “Overall” effects of Government’s fiscal
operations, namely, its total expenditure and taxation on macro-economic aggregates of
national income, output, price stability, etc.
2. The objectives of fiscal policy for the developed countries are maintain full employment,
control inflation and deflation, maintain economic stability, maintain price stability and
maintain a high rate of economic growth.
3. The objectives of fiscal policy for the underdeveloped countries are increasing
employment opportunities, mobilisation and allocation of resources, minimisation of
inequalities in income and wealth and increasing economic growth.
4. The essential features of federal system are dual government, distribution of powers,
supremacy of the constitution, authority of courts, doctrine of harmonious construction
and doctrine of pith and substance.
5. The important principles of federal finance are efficiency, uniformity, economy, autonomy,
self-sufficiency, flexibility, economic regulations, transfer of resources, adequacy and
elasticity, integration and co-ordination.
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6. Finance Commission is a quasi-judicial body set up under Article 280 of the Indian
Constitution. It aims to reduce the fiscal imbalances between the centre and the states
(Vertical imbalance) and also between the states (horizontal imbalance).

6.10 MODEL EXAMINATION QUESTIONS

I. Answer the following questions in about 10 lines each.
1. Write a note on fiscal policy.
2. List out the features of federal economy.
3. Describe the significance of central and state relations.
4. Discuss the functions of finance commission.
II. Answer the following questions in about 30 lines each.
1. Explain the functions of fiscal policy.
2. State the central state financial relations in brief.
3. What are the functions of fiscal policy?
4. Sate the tax powers of central government.
III. One mark questions.
A. Multiple Choice Questions.
1. Which Article provides special grants for any public propose of the States?
(a) 281 (b) 282 (c) 284 (d) 280
2. Fiscal policy is a policy with respect to -
(a) sources of funds (b) uses of funds
(c) sources funds and uses of funds (d) none of these
B. Fill in the blanks.
1. Monetary policy is generally defined as a policy with respect to quantity of ___________
2. Fiscal policy aim to accelerate _________________

6.11 GLOSSARY
1. Fiscal Policy: It refers to a government’s decisions surrounding spending and taxing.
2. Estate and Gift tax: A tax on people who pass assets to the next generation - either after
death or during life in the form of gifts.

6.12 SUGGESTED BOOKS

1. B.P. Tyagi : Public Finance
2. R.SudarsanaRao : Federal Fiscal Transfers in India
3. Vaish and H.S. Agarwal : Public Finance

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UNIT–7: BUDGET: CONCEPTS, TYPES AND
BUDJETING IN INDIA
Contents
7.0 Objectives
7.1 Introduction
7.2 Meaning of Budget
7.3 Concepts of Budget
7.4. Objectives of Budget
7.5 Classification of Budget
7.5.1 Classification According to Time Factor
7.5.2 Classification According to Function
7.5.3 Classification According to Flexibility
7.6 Types of Government Budget
7.6.1 Balance Budget
7.6.2 Surplus Budget
7.6.3 Deficit Budget
7.6.4 Zero-Based Budget
7.6.5 Performance Based Budget
7.7 Revenue Account
7.8 Capital Account
7.9 Budget Deficits
7.9.1 Types of Budget Deficits
7.10 Budgeting In India
7.11 Summary
7.12 Check Your Progress – Model Answers
7.13 Model Examination Questions
7.14 Glossary
7.15 Suggested Books

7.0 OBJECTIVES
The purpose of this unit is to know the meaning, concepts, objectives, classification,
types, revenue account, capital account budget deficits and the significance of budgeting in
India. After reading the unit, you will be able to:
• know the concepts and objectives of budget.
• analyze the classification of budget.
• explain the types of budget.
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• explain the importance of budgeting in India.

7.1 INTRODUCTION
In present modern welfare state, the activities of the government are fast expanding and
they are trending to cover almost all aspects of the social and economic life of the nation. The
government is now an agency of promoting the general welfare of citizen by positive acts.
Government budgeting is one of the major processes by which the use of public resources are
planned and controlled to attain certain objectives. Budgetary actions of the government affect
production, size, and distribution of income and utilization of human, natural and physical
resources of the country. So the government should prepare a different budget of the various
situations in the economy. Public expenditure should be varied according to the requirement
and urgencies of the business situations and welfare of the people.
The word “Budget” was derived from the Middle English word “bowgette”, which came
from Old French word “bougette meaning a leather bag. The Budget is the most extensive
account of the Government finances, in which revenues from all sources and expenses of all
activities undertaken are aggregated. It includes the revenue budget and the capital budget. It
also comprises estimates for the next fiscal year called budgeted estimates. India’s first budget
was presented on April 7, 1860, when it was under the British colonial rule. It was introduced
by the then Finance Minister of India, James Wilson.

7.2 MEANING OF BUDGET

Budget is a financial statement or a plan of estimated receipts and expenditures of the
Government in a particular financial year. It is prepared by the Budget Division, Department of
Economic Affairs. It may include planned sales volumes and revenues, resource quantities,
costs and expenses, assets, liabilities and cash flows. It is the sum of money allocated for a
particular purpose and the summary of intended expenditures along with proposals for how to
meet them. It may also include a budget surplus, providing money for use at a future time, or a
deficit in which expenses exceed income.

7.3 CONCEPTS OF BUDGET

There are three important concepts in relation to explain Budget i.e., 1. Receipts;
2. Expenditures; and 3. Deficits.
1. Receipts: Receipts refer to revenues collected by the government through various means.
There are two kinds of Receipts: Revenue Receipts and capital receipts.
Revenue Receipts: Revenue Receipts are those receipts (revenues) of government which
do not create a liability or cause reduction in government assets. Examples: Direct Tax (Income
Tax, Corporation Tax, Wealth Tax and Gift), Indirect Tax (excise duty, custom duty, service
tax, sales tax) and Non-Tax Revenue( include: profits and dividends of public enterprises,
interest over loans granted, external aid received, fees and fines, etc).

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 Capital Receipts: Capital Receipts are those receipts which create a liability or cause
reduction in government assets. Examples: Recovery of Loans, Borrowings and Disinvestment
Receipts.
2. Expenditures: Budget expenditure refers to estimated expenditures incurred by the
government under different heads in a year. Receipts are classified as revenue receipts
and capital receipts, similarly budget expenditures are also classified as: Capital
Expenditure: this expenditure include expenses on creation of roads, bridges, buildings
etc.) and Revenue Expenditure: this expenditure include salaries, interest payments,
pensions, subsidies etc.)
3. Deficits: Budgetary deficit is the difference between all receipts and expenses in both
revenue and capital account of the government. Budgetary deficit is the sum of revenue
account deficit and capital account deficit. If revenue expenses of the government exceed
revenue receipts, it results in revenue account deficit. Similarly, if the capital
disbursements of the government exceed capital receipts, it leads to capital account deficit.
Budgetary deficit is usually expressed as a percentage of GDP.
Types of deficits:
• Revenue Deficit = Revenue Expenditures – Revenue Receipts
• Capital Deficit = Capital Expenditures – Capital Receipts
• Fiscal Deficit = (Total Expenditures) – (Total Receipt – Borrowing.

7.4 OBJECTIVES OF BUDGET

1. Redistribution of Income and Wealth: It is one of the most important objectives of the
government budget. The government imposes heavy taxation on a high income groups
and redistribute it among the people of weaker section in the society. The government
can provide subsidies and other amenities to people whose income levels are low. These
increase their disposable income and this intern reduces the inequalities.
2. Reallocation of Resources : Reallocation of resources means the allocation of funds
such that there is a balance between the goals of profit maximization and social welfare.
Government uses budgetary policy to allocate resources. This is done by imposing higher
rate of taxation on goods whose production is to be discouraged and subsidies provided
on goods whose production is to be promoted.
3. Economic Growth: Another purpose of the government budget today is to study the
generation of savings, investment, consumption and capital formation to assess the trend
of growth in the economy to improve the standard of living of the people.
4. Managing Public Enterprises: In the budget government can make various provisions
to manage public sector enterprises and also provides them financial help.
5. Economic Stability: The government of the country is always committed to save the
economy from business cycles. Government budget is a tool to prevent economy from
inflation or deflation and to maintain economic stability. The overall level of employment

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 and prices in the economy depends upon the level of aggregate demand during the time
of deflation, deficit budgetary policy are used to maintain stability in economy.

7.5 CLASSIFICATION OF BUDGET

Different types of budgets have been developed keeping in view the different purposes
they serve. Some of the important classifications of the budgets are discussed below.

7.5.1 Classification According to Time Factor

1. Long term Budgets: The budgets are prepared to show the long term planning of the
organisation. This budget is prepared normally for a period of 5 to 10 years. Example:
capital expenditure budget, research and development, long term finances etc.
2. Short term Budgets: Short term budgets are those which have to be prepared for a
period of one or two years. Example: Cash Budget, Materials Budget etc.
3. Current Budget: Current budget is one which has to be prepared for a very short period
say a month or a quarter year (3 months) is related to the current conditions.

7.5.2 Classification According to Functions

A functional budget is a budget which relates to any of the functions of an organisation.
The following are the functional budgets which are commonly used.
1. Sales Budget : Sales budget is a forecast of total sales during the budget period. It may
contain the information regarding the sales, month wise, product wise, and area wise.
This budget is prepared by the sales manager.
2. Production Budget : Production budget is prepared by the production manager. Its
preparation depends upon the sales budget. The objective of this budget is to determine
the quantity of production for a budgeted period. In other words, it is a quantity of units
to be produced during a budget period. Production units may be calculated in the following
way: budgeted sales + desired closing stock – opening stock.
3. Materials Budget: Material procurement budget is an estimate of quantities of raw
materials to be purchased for production during the budget period. It helps the organisation
to formulate effective purpose policy of raw materials. Materials budget should be
prepared normally taking into account the following factors i.e., availability of finance,
storage facilities, price trends for raw materials in the markets.
4. Labour Budget: Labour budget is a budget which is prepared by the personnel department
of the organisation. It shows the total hours required to complete the production target.
And also it shows the cost incurred for the labour used for the production in particular
budgetary period.
5. Factory Overhead Budget: This budget indicates the estimated costs of indirect
materials, indirect labour and indirect factory expenses incurred during the budget period.
This budget is classified into fixed, variable and semi-variable budgets.

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6. Administrative Expenses Budget: In order to estimate the amount required to meet the
administrative and operational activities of the organisation, the administrative expenses
budget is prepared. This budget will provide proper guidance and estimation for the
expenses incurred in the budget period.
7. Selling and Distribution Overhead Budget: This budget is prepared by the sales
manager of each territory. It indicates an estimate of administrative expenses to be incurred
in the budget period. Preparation of this budget depends upon the sales budget.
8. Capital Expenditure Budget: Capital expenditure budget is a long term planning for
the proposed capital outlay and its financing. Capital expenditure is an expenditure which
has to be incurred for the purpose of acquiring benefit not only for the particular year but
also for the subsequent period of 5 to 10 years. Capital budgeting is the most important
and complicated problem of managerial decisions. Capital budgeting is also known as
investment decision making.
9. Cash Budget : Cash budget is prepared by the chief accountant of the organisation. It
may be prepared either monthly or weekly. Cash budget is a statement to show the
estimated amount of cash receipts and payment and balance during the budget period.
Simply, it represents the estimated cash receipts and payments over the specific future
period.
10. Master Budget: Master budget is a budget which has to incorporate all functional budgets.
The definition of this budget given by the Chartered Institute of Management Accountant,
England is as follows. “The summary budget, incorporating its component functional
budgets and which is finally approved, adopted, and employed.” It is otherwise called as
finalised profit plan. Normally, it has to be approved by the board of directors before it is
put into operational activities.

7.5.3 Classification According to Flexibility

1. Fixed Budget : A fixed budget is drawn for a fixed level of activity and a prescribed set
of conditions. It has been defined as “a budget which is designed to remain unchanged
irrespective of the volume of output or level of activity actually attained”. In the real
sense, it does not consider any change in expenditure arising out of changes in the level
of activity.
2. Flexible Budget: Flexible budget is otherwise called as variable budget. The Chartered
Institute of Management Accountants, England, defines a flexible budget “as a budget
which by recognizing the difference in behaviour between fixed and variable costs in
relation to fluctuations in output, turnover or other variable factors such as number of
employees is designed to change appropriately with such fluctuations”.
Normally, the flexible budget is prepared in any of the following cases:
• Where there are general changes in sales.
• Where the business is a new one and it is difficult to forecast the demand.
• In an industry which has to be influenced by changes in fashion.

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7.6 TYPES OF GOVERNMENT BUDGET
7.6.1 Balanced Budget
A government budget is said to be balanced when its estimated revenues and estimated
expenditure is equal, i.e. government receipts and government expenditure. The concept of a
balanced budget has been evocated by classical economists like Adam smith. A balanced budget
was considered by them as neutral in its effects on the working of the economy and hence they
are regarded it as the best. However, modern economists believe that the policy of balance
budget may not always be suitable for the economy, for instance during the period of depression,
when economic activities are at low level, resulting in unemployment, the government may
come to the rescue of the people. It can borrow money and spend it on public works. This will
increase employment and total demand for goods and services and encourage investment.

7.6.2 Surplus Budget

When estimated government receipts are more than the estimated government expenditures
it is termed as surplus budget. When the government spends less than the receipts the budget
becomes surplus that is estimated government receipts greater than anticipated government
expenditure. A surplus budget is used either to reduce public debt or increase its savings.
A surplus budget may prove useful during the period of inflation. In periods of inflation,
although there is greater employment there is also a tendency for prices to increase rapidly.
This has to be checked particularly in the interest of those who have more or less fixed income.
This inflationary gap can be corrected by lowering the level of effective demand in the economy.
It can be corrected by increasing taxes. This would increase the revenue of the government but
reduce the purchasing power of the people. As a result, the aggregate demand will fall. This
inflation gap can be corrected by lowering the level of public expenditure. The surplus budget
should not be used in a situation other than the inflationary gap as it may lead to unemployment
and low levels of output as an economy.

7.6.3 Deficit Budget

When estimated government receipts are less than the estimated government expenditures,
then the budget is called deficit budget. In modern economies, most of the budgets are of this
nature, that the estimate government receipts are less than anticipated government expenditure.
A deficit budget increases the liability of the government or decreases its reserves.
A deficit budget may prove useful during the period of depression, economic activities
are at a low level of employment, business loss and even bankruptcy and inflation etc. The
government can borrow money and increase the expenditure on public works through deficit
financing; this will increase employment and total effective demand for the goods and also the
services which would then encourage investment. Thus, a deficit budget is useful for removing
depression and unemployment.
Any country in the world is aiming to avoid deficit budget although the surplus budget is
difficult for a country to achieve and that is the reason countries strive for a balanced budget in
order to avoid inflation, unemployment, loss or another consequence.
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7.6.4 Zero-Based Budget
Zero-based budgeting (ZBB) is a method of budgeting in which all expenses must be
justified for each new period. The process of zero-based budgeting starts from a “zero base,”
and every function within an organization is analyzed for its needs and costs. Budgets are then
built around what is needed for the upcoming period, regardless of whether each budget is
higher or lower than the previous one.
Zero Based Budgeting is a reverse approach of traditional planning and decision making
with respect to budgeting. In traditional budgeting, managers begin by reviewing the budget of
the previous year and make corrections (in revenue and expenditures) based on performance
expectations. The budget of the previous year is consequently considered to be the baseline
(starting point). In Zero Based Budgeting all managers are required to justify all budgeted
expenses, not just the changes in the budget of the previous year. The baseline in Zero Based
Budgeting is not last year’s budget.
This type of budgeting usually occurs in the government and non-profit sectors. The
philosophy behind Zero Based Budgeting is good. However, it should be noted that zero based
budgeting requires frequent reviews. In Zero Based Budgeting reviews are carried every year
on account of the fact that it is a time-consuming and costly process. Interim reviews can be
carried out but that is the organization’s choice with respect to time and priority.

7.6.5 Performance Based Budget

A performance budget is a budget that reflects the input of resources and the output of
services for each unit of an organization. This type of budget is commonly used by government
bodies to show the link between taxpayer funds and the outcome of services provided by federal,
state or local governments. The major aim of performance budgeting is to improve the efficiency
of public expenditure, by linking the funding of public sector organizations to the results they
deliver. It adopts organized performance information (indicators, evaluations, program castings)
to make this link.

Check Your Progress

Q1. What is Budget?
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Q2. What are the concepts of Budget?
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Q3. What are the types of Budget?
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7.7 REVENUE ACCOUNT
A revenue account is an account with a credit balance. It includes all the revenue receipts
also known as current receipts of the government. These receipts include tax revenues and
other revenues of the government.
Tax revenues include the revenue earned by the government authorities by levying direct
and indirect taxes and duties. Direct taxes include income tax, corporate tax and so on. Indirect
taxes include Excise duties, customs duties, and service tax. Other revenues include revenues
from other sources of investments like interest, dividends, profits from public sector units,
fees, and fines and so on.
Revenue expenditure includes expenses which are not used for the creation of assets or
repayment of liabilities. These basically include current expenses of the government. For
example, paying salaries, giving grants are instances of revenue expenditure. It can further be
divided into plan and non-plan expenditure. The current budget, however, has not used this
classification.

7.8 CAPITAL ACCOUNT

A capital account is an account that includes the capital receipts and the payments. It
basically includes assets as well as liabilities of the government. Capital receipts comprise of
the loans or capital that are raised by governments by different means. They can also raise
money from the public, such loans are market loans. They could also borrow from banks or
other sources by means of Treasury Bills, also called T-Bills. Loans are also raised from external
sources like foreign governments or international institutions. Another way of raising capital is
by disinvestment in public sector units or other assets.
Capital expenditures are usually one off and they include the substantial investments of
money or capital that a government makes for the purpose of expansion in various sectors and
different business in order to generate profits. These expenditures are generally for the purchase
of fixed assets or assets with a long life. These include machines, manufacturing equipment or
equipment to enhance the infrastructure. These assets generate value throughout their life term
for the government and may or may not have a salvage value. The assets depreciate and their
cost will deduct throughout the life of the asset and not in one go.

7.9 BUDGET DEFICITS

The Budget Deficit is the financial situation where the expenditures are exceed the
revenues. It generally relates to the government’s expenditure and not the business or individual’s
spending. It occurs when expenses exceed revenue and it is an indicator of financial health.
The Budget surplus is opposite of budget deficit where the revenues exceed the expenditures,
and when the spending is equal to the revenues, the budget is said to be balanced. The major
implications of a Government budget deficit are:
• Slower economic growth

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• Increased tax revenue
• High unemployment rates
• High Government spending
• Investors expect higher interest rates for their future loans to the government.

7.9.1 Types of Budget Deficits

There can be different types of deficit in a budget depending upon the types of receipts
and expenditure we take into consideration. Accordingly, there are three concepts of deficit,
namely, Revenue Deficit, Fiscal Deficit and Primary Deficit.
1. Revenue Deficit : Revenue deficit is excess of total revenue expenditure of the
government over its total revenue receipts. It is related to only revenue expenditure and
revenue receipts of the government. Alternatively, the shortfall of total revenue receipts
compared to total revenue expenditure is defined as revenue deficit.
Revenue deficit signifies that government’s own earning is insufficient to meet normal
functioning of government departments and provision of services. Revenue deficit results in
borrowing. Simply put, when government spends more than what it collects by way of revenue,
it incurs revenue deficit. Mind, revenue deficit includes only such transactions which affect
current income and expenditure of the government. Put in symbols:
Revenue deficit = Total Revenue expenditure – Total Revenue receipts.
2. Fiscal Deficit : Fiscal deficit is defined as excess of total budget expenditure over total
budget receipts excluding borrowings during a fiscal year. In simple words, it is amount
of borrowing the government has to resort to meet its expenses. A large deficit means a
large amount of borrowing. Fiscal deficit is a measure of how much the government
needs to borrow from the market to meet its expenditure when its resources are inadequate.
Fiscal deficit = Total expenditure – Revenue receipts – Capital receipts excluding
borrowing.
3. Primary Deficit : Primary deficit is defined as fiscal deficit of current year minus interest
payments on previous borrowings. In other words, whereas fiscal deficit indicates
borrowing requirement inclusive of interest payment and primary deficit indicates
borrowing requirement exclusive of interest payment (i.e., amount of loan).
Primary deficit = Fiscal deficit – Interest payments
4. Monetised Deficit : The Monetised Deficit is the extent to which the RBI helps the
central government in its borrowing programme. In other words, monetised deficit means
the increase in the net RBI credit to the central government, such that the monetary
needs of the government could be met easily. It occurs when the government takes a
monetary support from the RBI to finance its debt obligations and try to reduce its
unnecessary expenditures. It is the part of a fiscal deficit that leads to the inflation in the
economy.

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 The monetized deficit results in the increase in the net holdings of treasury bills by the
RBI and also the RBI contribution towards the government’s market borrowings increases.
With the issue of more money to the government, the money supply in the economy increases,
as a result of which the inflationary pressure prevails.

7.10 BUTGETING IN INDIA

A government Budget is basically as an annual statement of all the estimated receipts
and estimated expenditures of the government in a fiscal year from 1 April to 31 March. Though
the word “Budget” does not finds mention in the Constitution, but it is mandated in Article 112
that the Union government shall present before the Parliament an “Annual financial Statement”
of estimated receipts and expenses of the Government. The Government presents it on the first
day of February so that it could be materialized before the commencement of new financial
year in April. Till 2016 it was presented on the last working day of February by the Finance
Minister of India in Parliament. The budget, which is presented by means of the Finance bill
and the Appropriation bill, has to be passed by both the Houses before it can come into effect
from April 1.

1. Objectives or Functions of Budgeting in India

In a mixed economy like ours, the government plays a significant role along with the
private sector. The three major functions served by this presentation of estimates.
Allocation function: Public goods (national defence, roads, government administration,
measures of lower air pollution, etc.) cannot be provided by Market Mechanism (transaction
between individuals).
Distribution function: Government can alter income distribution by making transfer payments
and collecting taxes, therefore affecting personal disposable income of households. Thus, through
its tax and expenditure policy government tries to achieve a fair income distribution in society.
Stabilization function: Fluctuations in economy may lead to inflation and unemployment.
Government policy measures to stabilize domestic economy.

2. Budgetary Procedure in India

The budgetary procedure in India involves four different operations that are:

i. Preparation of the budget

• The exercise of the preparation of the budget by the ministry of finance starts sometimes
around in the month of September every year.
• There is a budget Division of the Department of Economic affair of the ministry of
finance for this purpose. The ministry of finance compiles and coordinates.
• The estimates of the expenditure of different ministers and departments and prepare an
estimate or a plan outlay. Estimates of plan outlay are scrutinized by the Planning
Commission.

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• The budget proposals of finance ministers are examined by the finance ministry who has
the power of making changes in them with the consultation of the prime minister.

ii. Enactment of the budget

Once the budget is prepared, it goes to the parliament for enactment and legislation. The
budget has to pass through the following stages:
• The finance minister presents the budget in the Lok Sabha. He makes his budget in the
Lok Sabha. Simultaneously, the copy of the budget is laid on the table of the Rajya
Sabha. Printed copies of the budget are distributed among the members of the parliament
to go through the details of the budgetary provisions.
• The finance bill is presented to the parliament immediately after the presentation of the
budget. Finance Bill relates to the proposals regarding the imposition of new taxes,
modification on the existing taxes or the abolition of the old taxes.
• The proposals on revenue and expenditure are discussed in the Parliament. Members of
the Parliament actively take part in the discussion.
• Demands for grants are presented to the Parliament along with the budget These demands
for grants show that the estimates of the expenditure for various departments and they
need to be voted by the Parliament.
• After the demands for grants are voted by the parliament, the Appropriation Bill is
introduced, considered and passed by the appropriation of the Parliament. It provides
the legal authority for withdrawal of funds of what is known as the Consolidated Fund of
India.
• After the passing of the appropriation bill, finance bill is discussed and passed. At this
stage, the members of the parliament can suggest and make some amendments which the
finance minister can approve or reject.
• Appropriation bill and Finance bill are sent to Rajya Sabha. The Rajya Sabha is required
to send back these bills to the Lok Sabha within fourteen days with or without amendments.
However, Lok Sabha may or may not accept the amendment.
• Finance Bill is sent to the President for his assent. The bill becomes the statue after
presidents’ sign. The president does not have the power to reject the bill.

iii. Execution of the budget

• Once the finance and appropriation bill is passed, execution of the budget starts. The
executive department gets a green signal to collect the revenue and start spending money
on approved schemes.
• Revenue Department of the ministry of finance is entrusted with the responsibility of
collection of revenue. Various ministries are authorized to draw the necessary amounts
and spend them.
• For this purpose, the Secretary of minister’s acts as the chief accounting authority.

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• The accounts of the various ministers are prepared as per the laid down procedures in
this regard. These accounts are audited by the Comptroller and Auditor General of India
(CAG).

iv. Parliament Control over Finance

• There is a prescribed procedure by which the Finance Bill and the Appropriation Bill are
presented, debated and passed.
• The Parliament being sovereign gives grants to the executive, which makes demands.
These demands can be of varieties like the demands for grants, supplementary grants,
additional grants, etc.
• The estimates of expenditure, other than those specified for the Consolidated Fund of
India, are presented to the Lok Sabha in the form of demands for grants.
• The Lok Sabha has the power to assent or to reject, any demand, or to assent to any
demand, subject to a reduction of the amount specified. After the conclusion of the
general debate on the budget, the demands for grants of various ministries are presented
to the Lok Sabha.
• Formerly, all demands were introduced by the finance minister; but, now, they are formally
introduced by the ministers of the concerned departments. These demands are not presented
to the Rajya Sabha, though a general debate on the budget takes place there too.
• The Constitution provides that the Parliament may make a grant for meeting an unexpected
demand upon the nation’s resources, when, on account of the magnitude or the indefinite
character of the service, the demand cannot be stated with the details ordinarily given in
the annual financial statement.
• An Appropriation Act is again essential for passing such a grant. It is intended to meet
specific purposes, such as for meeting war needs.

Vote on Account Budget

Vote on account is just an interim permission to spend money as against a full budget
which is an elaborate financial statement of expenditure and receipts. The Vote on Account is
the special provision given to the government to obtain the vote of parliament to withdraw
money when the budget for the new financial year is not released or the elections are underway
and the caretaker government is in the place. Simply the approval given by the parliament to
withdraw sum of money from the consolidated funds of India is called as Vote on Account.
According to the article 266 of the Constitutions, it is mandatory for the Government to
seek approved from the parliament before raising any funds from the consolidated funds of
India. A vote on account stays for 2 months but however, it can be extended. If the year is an
election year to extend 6 months. Generally vote on account budget to proceed when full budget
implemented.

3. History of Indian Budget

The first Union Budget of Independent India was presented by the first Finance Minister
of Independent India, Sir R.K. Shanmugham Chetty, on November 26, 1947. It is noteworthy
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that the first Union Budget was presented amidst widespread riots due to the partition of India.
This budget was meant for seven and a half months, following which the next budget was to be
implemented from April 1, 1948. It was the first Union Budget wherein it was decided that both
India and Pakistan would share the same currency till September 1948. John Mathai, presented
the subsequent Union Budgets of 1949-50 and 1950-51. The budget of 1949-50 was the first
instance of a budget being prepared for a United India, including all princely states.
In 1949-50 and 1950-51, John Mathai presented the Union Budget of the Republic of
India, who also announced the Planning Commission. Mathai’s Budget was also the Budget
that took into account all the princely states, and India as united. In 1957, Krishnamachari-
Kaldor presented the Budget who tried for the distinction between active income (salaries or
business) and passive income (interest or rent). Later in active income (salaries or business)
and passive income (interest or rent), Jawaharlal Nehru became the first Prime Minister to
present the Budget when he held the finance minister portfolio as well.
1959-61 and 1963-64 Union Budgets and interim budget 1962-63 are presented by Morarji
Desai. By this time, the presentation of the Budget had moved to the last day of February but
continued with 5 pm time slot. Interestingly, Morarji Desai got to present two Budgets on his
birthday, on February 29 in 1964 and 1968. Morarji Desai presented budgets that included five
annual budgets and an interim budget during his first stint and three final budgets and one
interim budget in his second tenure when he was both the Finance Minister and the Deputy
Prime Minister of India.
After Morarji Desai resigned, Indira Gandhi who was the Prime Minister also took over
the portfolio of the finance minister and became the first woman to present the Indian Budget
in 1970-71. In 1964-65, TT Krishnamachari introduced voluntary disclosure of concealed income
scheme in India for the first time. The next Budget followed first disclosure scheme for block
money.
The 1973-74 India Budget became the ‘Black Budget’ in India as that year the fiscal
deficit of the country was Rs 550 crore. Pranab Mukherjee, the first Rajya Sabha member to
hold the Finance portfolio, presented the annual budgets for the financial years 1982-83, 1983–
84 and 1984-85. Then, Rajiv Gandhi presented the budget for 1987-89, after VP Singh quit his
government, and in the process became the third Prime Minister to present a budget after his
mother and grandfather. It was Rajiv Gandhi who introduced the Corporate tax (known as
Minimum Alternate Tax) in 1987-88 Budget.
ND Tiwari presented the budget for 1988-89, SB Chavan for 1989-90, while Madhu
Dandawate presented the Union budget for 1990-91. The interim Budget of 1992-1993, presented
by Manmohan Singh after an election was forced, became one of the historically important
Budgets as he announced reducing import duty from over 300% to 50%, paving way for
liberalisation. Manmohan Singh, in his Budget speech, said, “It is said that child is the father of
the man, but some of our taxpayers have converted children into tax shelters for their fathers.”
Following year, Manmohan Singh introduced Service Tax.
After elections in 1996, a non-Congress ministry assumed office. Hence the financial
budget for 1996-97 was presented by P. Chidambaram, who then belonged to Tamil Maanila
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Congress. After the general elections in March 1998 that led to the Bharatiya Janata Party
forming the Central Government, Yashwant Sinha, the then Finance Minister in this government,
presented the interim and final budgets for 1998-99.
After general elections in 1999, Sinha again became the Finance Minister and presented
four annual budgets from 1999-2000 to 2002-2003. Due to elections in May 2004, an interim
budget was presented by Jaswant Singh. He, in 2001, changed the timing of the Budget
presentation from 5 pm to 11 am. Following years, Pranab Mukherjee and P Chidambaram
presented the Union Budget under UPA-1 and UPA-2 governments.
Under the Narendra Modi government, the Union Budget was presented by Finance
Minister Arun Jaitley, who in the year 2017 announced two important decisions; first, merging
Railway Budget with the Union Budget and second advancing the Budget presentation from
the last day of February to the first day of February. Finance Minister Arun Jaitley presented
the Union Budget 2018 on February 1.

Check Your Progress.

Q4. What is Revenue Account?
..........................................................................................................................................
...........................................................................................................................................
Q5. What is Capital Account?
..........................................................................................................................................
...........................................................................................................................................
Q6. What are the types of Deficit in Budget?
..........................................................................................................................................
...........................................................................................................................................

7.11 SUMMARY
To facilitate annual decision-making on expenditures, government prepares a budget.
India’s national budget contains estimates of government expenditure and revenue of the Union
Government for the coming financial year that starts from 1 April and ends with March 31.
Usually, the Union budget is presented by the Finance Minister of India in the Parliament on
the last day of February. A budget may be defined as a financial plan of a nation that serves as
the basis for expenditure decision-making and subsequent control of expenditures. It is a financial
statement of the government’s planned revenues and expenditures for the fiscal year (April-
March). A budget is, therefore, an estimate of income and expenditure for a future period.
“Budgets usually contain financial data for the previous year (or years), estimated figures for
the current year, and recommended figures for the coming year, for both expenditures and
revenues.”

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7.12 CHECK YOUR PROGRESS – MODEL ANSWERS
1. Budget is a financial statement or a plan of estimated receipts and expenditures of the
Government in a particular year. It is prepared by the Budget Division, Department of
Economic Affairs.
2. The concepts of Budget are : i. Receipts , ii. Expenditans, iii. Deficits.
3. The types of Budget are : 1. Balanced Budget, 2. Surplus Budget, 3. Deficit Budget,
4. Zero-Based Budget, 5. Performance Based Budget.
4. A revenue account is an account with a credit balance. It includes all the revenue receipts
also known as current receipts of the government. These receipts include tax revenues
and other revenues of the government.
5. A capital account is an account that includes the capital receipts and the payments. It
basically includes assets as well as liabilities of the government.
6. The major implications of a Government budget deficit are:
1. Slower economic growth
2. Increased tax revenue
3. High unemployment rates
4. High Government spending
5. Investors expect higher Interest rates for their future loans to the government.

7.13 MODEL EXAMINATION QUESTIONS

I. Answer the following questions in about 10 lines each.
1. Discuss the concepts of Budget.
2. Explain the various types of Deficits in Budget.

II. Answer the following questions in about 30 lines each.

1. What are the classifications of Budget?
2. Explain the types of Government Budget.

III. Answer the following multiple choice questions.

A. One mark questions.
1. Budget is an instrument of
(a) Fiscal policy (b) Monetary policy (c) Economic policy (d) Export policy
2. The Union Budget is presented under which Article of the Indian Constitution
(a) 110 (b) 111 (c) 112 (d) 122
3. Which of the following is not a benefit of budgeting?
a) It promotes study, research, and a focus on the future

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 b) It is a source of motivation c) It will prevent net losses from occurring
d) It is a means of coordinating business activities
4. Budget deficit is likely to:
a) Boost aggregate demand b) Lead to less import spending
c) Lead to falling prices d) Leads to more unemployment

7.14 GLOSSARY
Budget : An estimate of income and expenditure for a set period of time.
Revenue receipts : Receipts which are recurring (received again and again) by nature and
which are available for meeting all day to day expenses (revenue
expenditure) of a business concern.
Capital Receipt : Receipts which are non-recurring (not received again and again) by nature
and whose benefit is enjoyed over a long period.
Budget Deficit : A budget deficit occurs when a Government’s expenditure is greater than
its revenue.
Revenue Account : A revenue account is an account with a credit balance. It includes all the
revenue receipts also known as current receipts of the government. These
receipts include tax revenues and other revenues of the government.
Capital Account : A capital account is an account that includes the capital receipts and the
payments. It basically includes assets as well as liabilities of the
government.

7.15 SUGGESTED BOOKS

1. B.P. Tyagi : Public Finance
2. R.Sudarsana Rao : Federal Fiscal Transfers in India
3. MC. Vaish and H.S. Agarwal : Public Finance

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 BLOCK – IV
INTERNATIONAL TRADE AND DEVELOPMENT
This block explains various aspects of international trade viz., basis of international
trade, its role in economic development, classical theories of international trade, concept
and types of terms of trade and gains from trade. Further it also analysed the factors affecting
balance of trade including recent trends in India's balance of trade.
This block contains the following units:
Unit - 8: International Trade and Economic Development
Unit - 9: Terms of Trade and Gains from Trade
Unit -10: Balance of Trade

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UNIT–8: INTERNATIONAL TRADE AND ECONOMIC
DEVELOPMENT
Contents
8.0 Objectives
8.1 Introduction
8.2 Difference between Internal and International Trade
8.3 Salient Features of International Trade
8.4 Reasons for International Trade
8.5 Role of International Trade in Economic Development
8.6 Classical Theories of International Trade
8.7 Adam Smith’s Theory of International Trade
8.8 David Ricardo’s Theory of International Trade
8.9 Summary
8.10 Check Your Progress - Model Answers
8.11 Model Examination Questions
8.12 Glossary
8.13 Suggested Books

8.0 OBJECTIVES
This unit is intended to elucidate the theory of International Trade. After reading this
unit, you will be able to:
• understand the features of International Trade.
• know the reasons for International Trade.
• identify the role of International Trade in economic development.
• examine the Classical theories of International trade.
• illustrate the theory of Adam Smith’s absolute cost advantage.
• discuss the theory of David Record’s comparative cost advantage.

8.1 INTRODUCTION
International trade is the trade between two or more countries. The term trade refers to
exchange of goods and services and when it takes place across national borders or territories
then it is called as international trade. It allows both the buyer and seller to expand their markets
for goods and services that otherwise may not be made available to them.
All countries are not sufficient in all means themselves. Different countries have different
resources or strengths in terms of land, labour, capital, technology and natural resources.
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Generally, while a country has the abundance or surplus of some resources it suffers the scarcity
of certain others. Most countries usually focus on those products and services which they
possess comparative or absolute advantage through specialisation. However, such specialisation
may result in excess production capacity for certain goods and services, but also opportunity
cost for not producing enough of other goods and services.

8.2 DIFFERENCE BETWEEN INTERNAL AND

INTERNATIONAL TRADE
The term trade is generally understood as means of exchange of goods among different
individuals. If such exchange of goods and services takes place between two individuals or
firms of the same country, is defined as ‘internal trade’. Conversely an exchange of goods and
services between individuals living in two different countries is termed as ‘international trade’.
It is defined narrowly as the set of problems that arises from, and in connection with the exchange
of physical commodities between nations. In classical economics the principles which determined
relative values or prices differed between inter-regional and inter-national trade because factors
of production, labour and capital if not land were mobile within a country but immobile between
countries. Some economists point out the difference that inter-regional trade takes place between
economic units using the same money, where as in international trade are national money must
be exchanged into another by means of foreign exchange markets before a transaction can be
completed. The adjustment mechanism works one way within a country and differently between
countries; because regions share among themselves through a national budget where as national
system of transaction and expenditure remain distinct. The several points of emphasis can be
combined into the general statement that inter regional differs from international trade in the
same way that national differs from international policies.
There has been a good deal of debate about that inter regional trade is different from
international trade. While the classical economists had held that international trade had its own
distinctive features that were absent in the case of trade taking place between different regions
in the country. Bertil Ohlin, Haberler and others have argued that it is neither possible nor
essential to draw a sharp distinction between the problem of international trade and domestic
trade. According to Bertil Ohlin, there is no fundamental difference between the domestic and
foreign trade because, nations exchange in trading for the same basic reasons for which
individuals or groups within the country trade with each other, instead of each one producing
own requirements. It is important however to underline one aspect of interregional and
international trade which distinguishes them both from the rest of economies In these sub-
sects, space becomes important. There are several salient features of international trade which
make it different from the exchange of goods and services within the same country.

8.3 SALIENT FEATURES OF INTERNATIONAL TRADE

i. Immobility of Factors of Production: There are several economic reasons for
concentrating our attention on nations as the basic economic units. As a general rule, a vast
difference exists in the degree of mobility of resources between countries as opposed to with

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countries. Human beings, the factor of production labour are often restricted in their freedom
of movement between countries. Although they are free to select their residence within countries.
Immigration laws different licensing requirements for professional people, citizenship
requirements for government employees and other obstacles inhibit the free flow of labour
between countries. Similarly financial transactions within countries are usually unrest rained;
the international capital flows are often prohibited and severely limited by government’s
authorities.
Another important resource, land, is severely restricted as far as its intonations mobility
is concerned. The physical transfer of land between countries is possible only nations change
the size of their territory by war, purchase of territories or land grants and from other nations.
Even the acquisition of title of ownership by foreigners is severely restricted in many nations
that have laws that either exclude or severely limit foreigner: from owning real estate. Also we
will find that economic units located within the same country are subject to same rates of
taxation raise funds in the same capital markets, and use much of the same economic
infrastructure, such as communication, transportation and information facilities. Thus, the whole
economic environment of individual economic units is much more homogeneous within a country
than it is between economic units located different countries.
ii. Different National Policies: Although the socio political environment often differs
greatly between nations, tends to be more uniform within countries. Houses holds and business
firms in the same country operate within the same legal frame work are subject to the same
social institutions and are related to be the same government, similar habits and business custom:
prevail within the national boundaries, making it easier for businessmen to deal with other
economic units. All these conditions hold only rarely and then imperfectly with reference to
trade between different nations.
iii. Differences in the Geographical and Political Factors: The division of markets in
international trade would be guided by factors like geographical and political boundaries. This
would prohibit the measurement of factors of production from one country to another and will
also obstruct the movements of goods. Differences in the customs and tariff laws could also act
as the major determinants of the movement of commodities from one country to another. Further
differences in languages, tastes and habits also reflect in the obstacles to a free movement of
goods between two countries. Further, a country organizes itself into a political unit on the
ground that the people inhabiting it possess a sense of national unity. Fredric List observed
“domestic trade is among us, international trade is between us and them”. On the other hand,
different countries exist as different political units and their citizens also owe their loyalties to
their respective nations.
iv. Differences in Monetary Units: When international trade takes place, the differences
in monetary units and currencies are also accounted for. When trade takes place within the
same country, a uniform method of accounting in terms of an accepted monetary unit is resorted;
such uniformity in terms of accepted monetary unit is resorted to. Such uniformity in the unit
of accounting generally facilitates the exchange of goods and services within the same country.
However, since different monetary units prevail in different countries and therefore, trade

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between nations can take place if only rates of exchange among different countries have already
been determined. Moreover in such situation accounting units will also be different for different
direction of trade.
v. Degree of Competition: Within the same country prices in both the product market
as well as in the factor markets are determined under competitive conditions. Except when
some imperfections appear in either of these two markets, every firm in the country working at
its optimum scale, that is produces commodity at the minimum cost. Also free mobility and
perfect competition ensure the best or optimum allocation resources among different industries
within the same country. When international trade takes place, the theory of dumping and
protection are of much importance rather than the optimum allocation of resources.
vi. Transport Cost: Other distinguishing characters of international trade lies in the
existence of greater geographical distances and the consequent increase in the transport costs.
Henry Sedgwick stated that in international trade not only the goods have to be transported
over longer geographical distances but distinct problems of packing, insurance, banking and
freight which are generally absent in the domestic trade, require a good deal of attention in the
case of international trade.
vii. Importance of Gains from Trade: In the analysis of gains from trade, attention, is
focused in particular boundaries enclosing areas of community of interest and these areas are
generally countries or nation. In the case of international trade the sharing of the gains from
trade is an important macroeconomic issue because international trade involves the exchange
of goods between the different people. It is trade between them and us while internal trade
involves exchange of goods between the same people in the sense that they are all members of
the same nation it is trade between us. In the case of international trade BOP adverse
disequilibrium poses a special problem for the country, while there is no such problem faced in
case of internal trade.

8.4 REASONS FOR INTERNATIONAL TRADE

The major reasons for International trade may occur are pointed out below:
i. Differences in Technology: Advantageous of trade can occur between countries if the
countries differ in their technological abilities to produce goods and services. Technology refers
to the techniques used to turn resources (labour, capital, land) into outputs (goods and services).
ii. Differences in Resource Endowments: Advantageous of trade can occur between
countries if the countries differ in their endowments of resources. Resource endowments refer
to the skills and abilities of a country’s workforce, the natural resources available within its
borders (minerals, farm land, etc.), and the sophistication of its capital stock (machinery,
infrastructure, communications systems).
iii. Differences in Demand: Advantageous of trade can occur between countries if
demands or preferences differ between countries. Individuals in different countries may have
different preferences or demands for various products. For example, the Chinese are likely to
demand more rice than Americans, even if consumers face the same price. Canadians may

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demand more beer, the Dutch more wooden shoes, and the Japanese more fish than Americans
would, even if they all faced the same prices.
iv. Existence of Economies of Scale in Production: The existence of economies of
scale in production is sufficient to generate advantageous of trade between two countries.
Economies of scale refer to a production process in which production costs fall as the scale of
production rises. This feature of production is also known as “increasing returns to scale.”
v. Existence of Government Policies: Government tax and subsidy programs alter the
prices charged for goods and services. These changes can be sufficient to generate advantages
in production of certain products. In these circumstances, advantageous of trade may arise
solely due to differences in government policies across countries.

8.5 ROLE OF INTERNATIONAL TRADE IN ECONOMIC

DEVELOPMENT
International trade contributes a lot for the economic development, thus the role of
international trade in economic development can be identified in many folds as follows:
i. International trade plays very significant role in the economic development of any country.
ii. International trade provides foreign exchange which can be used to remove the poverty
and other productive purposes.
iii. The International trade expands the market and encourages the producers.
iv. International trade encourages the investor to increase the investment to produce more
goods. So the rate of investment increases.
v. Besides the local investment, International trade provides incentives for the foreign
investors to invest in those countries where there is a shortage of investment.
vi. International trade increases the scale of production and national income of the country.
To meet the foreign demand, international trade increase then production on large scale
so GNP also increases.
vii. With the rise in the demand of goods, domestic resources are fully utilized and it increases
the rate of development in the country and reduces the unemployment in the world.
viii. International trade helps to bring stability in the price level. All those goods which are
short and prices are increasing can be imported and those goods which are surplus can
be exported.
ix. There is a difference in the quality and quantity of various factors of production in
different countries. Each country adopts the specialization in the production of those
commodities, in which it has comparative advantage. So all trading countries enjoy profit
through international trade.
x. International trade helps to improve quality of local products and extends market through
changes in demand and supply as International trade can create competition with the rest
of the world.

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xi. International trade provides an opportunity to the people of different countries to meet,
discuss, and exchange views and ideas related to their social, economic and political
problems.
xii. International trade is also responsible for dissemination of knowledge and learning from
developed countries to under developed countries.

8.6 CLASSICAL THEORIES OF INTERNATIONAL TRADE

The classical theory of international trade was first formulated by Adam Smith, David
Ricardo, and John Stuart Mill. They were contributed the classical theories of international
trade. According to the classical theories, while a country enters in International trade, it benefits
from specialization and efficient allocation of resources. The International trade also helps in
bringing new technologies and skills that lead to higher productivity. In this context they were
explained mercantilism, absolute advantage and comparative advantage theories. These three
theories explore and analyze the history, importance, relevance of classical theories in
International Trade. Their ideas relate to the theory of comparative cost or advantage. Adam
Smith, the first classical economist, advocated the principles of absolute advantage as the basis
of International trade which was discarded by Ricardo. These are grouped under classical
theories of international trade.

Classical Theories

Theory of Theory of Absolute Theory of Comparative

Mercantilism Advantage Advantage

Figure - 8.1: Classical Trade Theories

Theory of Mercantilism: Mercantilism is the term that was popularized by Adam Smith,
father of economics, in his book, ‘The Wealth of Nations’. Western European economic policies
were greatly dominated by this theory. The theory of mercantilism holds that countries should
encourage export and discourage imports. It states that a country’s wealth depends on the
balance of export minus imports. According to this theory, government should play an important
role in the economy for encouraging export and discouraging import by using subsidies and
taxes, respectively. In those days, gold was used for trading goods between countries. Thus,
export was treated as good as it helped in earning gold, whereas, import was treated as bad as
it led to the outflow of gold. If a nation has abundant gold, then it is considered to be a wealthy
nation. If all the countries follow this policy, there may be conflicts, as no one would promote
import. The theory of mercantilism believed in selfish trade that is a one-way transaction and

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ignored enhancing the world trade. Mercantilism was called as a zero-sum game as only one
country benefitted from it.
Absolute Advantage: Adam Smith offered people a new trade theory in the late 17th century
that is called absolute advantage, which looked at a country’s ability to produce a good, more
efficiently than another country. Smith argued that trade should not be restricted or regulated
by the government. In fact, trade between countries should happen naturally according to the
market forces. His theory of absolute advantage reasoned that if a country could increase
efficiencies, both countries would benefit and trade would be encouraged.
Comparative Advantage: The theory of comparative advantage was introduced by David
Ricardo in 1817 to address the shortfalls in Smith’s theory of absolute advantage. Ricardo
noticed that there are countries that have an absolute advantage in many areas, where other
countries have no advantages. However, Ricardo pointed out that even if one country has an
absolute advantage over another country in production of both products, both countries can
still specialize and trade can happen. The theory of comparative advantage focuses on the
relative productivity differences, not absolute productivity.

8.7 ADAM SMITH’S THEORY OF INTERNATIONAL TRADE

Adam Smith extolled the virtues of free trade, these are the result of the advantages of
division of labour and specialisation both at the national and international levels. The theory of
absolute advantage in international trade stated that a country should specialize in those products,
which it can produce efficiently. This theory assumes that there is only one factor of production
that is labour. Adam Smith assured that under mercantilism, it was impossible for nations to
become rich simultaneously. He also stated that wealth of the countries does not depend upon
the gold reserves, but upon the goods and services available to their citizens. Adam Smith in
his book “The Wealth of Nations” (1776) stated that, if a foreign country can supply us with a
commodity cheaper than we ourselves can make it, better buy it of them with some part of the
produce of our own industry, employed in a way in which we have some advantage. He further
stated that trade would be beneficial for both the countries if country- A exports the goods,
which it can produce with lower cost than country- B and import the goods, which country- B
can produce with lower cost than it.
Adam Smith’s theory of absolute cost advantage in international trade was evolved as a
strong reaction of the restrictive and protectionist mercantilist views on international trade. He
upheld in this theory the necessity of free trade as the only sound guarantee for progressive
expansion of trade and increased prosperity of nations. The free trade, according to Adam
Smith, promotes international division of labour. Every country tends to specialize in the
production of that commodity which it can produce most cheaply. Undoubtedly, the slogans of
self- reliance and protectionism have been raised from time to time, but the self-reliance has
eluded all the countries even up to the recent times. The free and unfettered international trade
can make the countries specialise in the production and exchange of such commodities in case
of which they command some absolute advantage, when compared with the other countries. In
this context, Adam Smith writes; “Whether the advantage which one country has over another,

125
be natural or acquired is in this respect of no consequence. As long as one country has those
advantages, and the other wants them, it will always be more advantageous for the latter, rather
to buy of the former than to make.”
When countries specialise on the basis of absolute advantage in costs, they stand to gain
through international trade, just as a tailor does not make his own shoes and shoemaker does
not stitch his own suit and both gain by exchanging shoes and suits.
To illustrate, let there are two countries A and B and they produce two commodities X
and Y. The cost of producing these commodities is measured in terms of labour involved in
their production. If each country has at its disposal 2 man-days and 1 man-day is devoted to the
production of each of the two commodities, the respective production in two countries can be
shown through the hypothetically as mentioned in table-8.1.

Table - 8.1: Absolute Cost Differences in Two Countries

Country Units of Labour Commodities Ratio of Exchange
(Man-days) X Y
A 1 20 10 1 Unit of X=0.5 Units of Y
B 1 10 20 1 Unit of X=2 Units of Y
In country A, 1 man-day of labour can produce 20 units of X but 10 units of Y. In country
B, 1 man-day of labour can produce 10 units of X but 20 units of Y. It signifies that country A has
an absolute advantage in producing X while country B enjoys absolute advantage in producing
commodity Y. Country A may be willing to give up 1 unit of X for having 0.5 unit of Y. At the
same time, the country B may be willing to give up 2 units of Y to have I unit of X. If country A
specialises in the production and export of commodity X and country B specialises in the production
and export of commodity Y. both the countries stand to gain.
The absolute cost advantage of country A in the production of X and that of B in the
production of Y can also be expressed as below:
20 Units of X in A 10 Units of Y in A
>1>
10 Units of X in B 20 Units of Y in B
It is possible to explain the cost difference in Y
two countries A and B concerning the commodities
X and Y geometrically through figure-8.2.
B
In figure-8.2, AA1 is the production possibility
Y-Commodity

curve of country A. Given the techniques and factor

A
endowments, if all the resources are employed in
the production of X commodity, it can produce
OA1quantity of X. On the contrary, if all resources
are used in the production of Y, country A can
X
produce OA quantity of Y. BB1 is the production O B1 A1
possibility curve of country B. In case of this country, X-Commodity
Figure-8.2: Production Possibility Curves
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if all resources are employed in the production of X commodity, OB1 quantity can be produced.
Alternatively, if all the resources are used in the production of Y, it is possible to produce OB
quantity of Y. The slope of production possibility curve is measured by the ratio of labour
productivity in X to labour productivity in Y in each country.
Slope of AA1 = LXA/LYA
Slope of BB1 = LXB/LYB
Since slope of AA1 is less than the slope of BB1, it signifies that country A has absolute
cost advantage in the production of X commodity, while country B has the absolute cost
advantage in the production of Y commodity.
Adam Smith also emphasised that specialisation on the basis of absolute cost advantage
would lead to maximisation of world production. The gains from trade for the two trading
countries can be shown through Table 8.3.
Table – 8.3: Gains from Trade
Country Production Production
Before Trade After Trade Gain from Trade
X Y X Y X Y
A 20 10 40 - +20 -10
B 10 20 - 40 -10 +20
Total Production 30 30 40 40 +10 +10
Before trade, Country A produces 20 units of X and 10 units of Y. After trade, as it
specialises in the production of X commodity, the total output of 40 units of X is turned out by
A and it produces no unit of Y. Country B produces 10 units of X and 20 units of Y before trade.
After trade it specialises in Y and produces 40 units of Y and no unit of X. The gain is production
of X and Y commodity each is of 10 units. The gain from trade for country A is +20 units of X
and -10 units of Y so that net gain to it from trade is +10 units of X. Similarly net gain to
country B is +10 units of Y.

Criticisms:
Adam Smith, no doubt, provided a quite lucid explanation of the principle of absolute
cost advantage as the basis of international transactions, yet his theory has certain weaknesses.
Firstly, this theory assumes that each exporting country has an absolute cost advantage
in the production of a specific commodity. This assumption may not hold true, when a country
has no specific line of production in which it has an absolute superiority. In this context Ellsworth
says “Smith’s argument is not very convincing as it assumed without argument that international
trade required a producer of exports to have an absolute advantage, that is, an exporting country
must be able to produce with a given amount of capital and labour a larger output than any
rival. But what if a country has no line of production in which it was clearly superior.”
Most of the backward countries with inefficient labour and machinery may not be enjoying
absolute advantage in any line of activity. So the principle of absolute cost advantage cannot
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provide complete and satisfactory explanation of the basis on which trade proceeds among the
different countries.
Secondly, Adam Smith simply indicated that the fundamental basis on which international
trade rests. The absolute cost advantage had failed to explore in any comprehensive manner the
factors influencing trade between two or more countries.
A more detailed and satisfactory explanation concerning the basis of international trade
has been provided by David Ricardo and J.S. Mill.

Check Your Progress.

Note: a) Space is given below for writing your answer.
b) Compare your answer with the one given at the end of the unit.
1. What is the trade theory of Adam Smith?
..........................................................................................................................................
..........................................................................................................................................
2. What is Absolute Advantage in trade theory?
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8.8 DAVID RICARDO’S THEORY OF INTERNATIONAL

TRADE
In 1817, David Ricardo, an English political economist, contributed theory of
comparative advantage in his book ‘Principles of Political Economy and Taxation’. This
theory of comparative advantage, also called comparative cost theory, is regarded as the
classical theory of international trade.
According to the classical theory of international trade, every country will produce their
commodities for the production of which it is most suited in terms of its natural endowments
climate quality of soil, means of transport, capital, etc. It will produce these commodities in
excess of its own requirement and will exchange the surplus with the imports of goods from
other countries for the production of which it is not well suited or which it cannot produce at
all. Thus all countries produce and export these commodities in which they have cost advantages
and import those commodities in which they have cost disadvantages.
Types of Cost Differences in Production: Economists speak about three types of cost
difference in production, they are: 1. Absolute cost difference; 2. Equal cost difference; and 3.
Comparative cost difference.
1. Absolute Cost Differences: Adam Smith in his book ‘Wealth of Nation’ argued that
international trade is advantageous for all the participating countries only if they enjoy absolute
differences in the cost of production of the commodity which they specialise. As in the case of
individuals where each specialises in the production of that commodity in which he has an

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absolutely superiority in terms of cost, so also each country specialises in production of goods
based on absolute advantage.
The principle of absolute difference in cost can be explained with the help of table-8.4.
Let us assume that we have 2 countries, I and II specialising in the production of X and Y.

Table - 8.4: One Day’s Labour Produces

Country Commodity X Commodity Y Internal Exchange Rate
(in Units) (in Units) X Y
I 20 10 2 1
II 10 20 1 2
In country I, one day’s labour produces 20 X or 10 Y. The internal exchange rate is 2: 1.
In country II, one day’s labour produce 10 X or 20 Y which gives us the domestic exchange rate
of 1: 2. Country I has the absolute advantage in the production of X (as 20 > 10) and country II
in Y (as 10 < 20). If these countries enter into trade with the international exchange of 1:1, both
countries stand to benefit. Country I will have 1Y for 1X as against 1/2y for 1 X within the
country. Similarly country II will have 1 X for 1 Y as against 1/2 X for 1 Y within the country.
Based on this example, according to Adam Smith, for international trade to be beneficial each
country must enjoy absolute difference in cost of production.
2. Equal Difference in Cost: Adam Smith, in order to strengthen his argument in favour of
absolute difference in cost pointed out that trade is not possible if countries operate under equal
difference in cost instead of absolute difference. it can be understood with the help of the
following table 8.5.
Table - 8.5: One Day’s Labour Produces
Country Commodity X Commodity Y Internal Exchange Rate
(in Units) (in Units) X Y
I 20 10 2 1
II 10 05 2 1

The above table gives us the internal exchange rate 2 X : 1 Y in both countries. Since the
exchange ratio between X and Y in both countries is the same; none of them will benefit by
entering into international trade. Based on this example, according to Adam Smith, for
international trade to be beneficial countries must enjoy absolute difference in cost. Trade
would not take place when the difference in cost is equal.
3. Comparative Difference in Cost: David Ricardo agreed that absolute difference in cost gives
a clear reason for trade to take place. He, however, went further to argue that even that the country
has absolute advantage in the production of both commodities it is beneficial for that country to
specialise in the production of that commodity in which it has a greater comparative advantage.
The other country can be left to specialise in the production of that commodity in which it has less
comparative advantage. According to Ricardo the essence for international trade is not the
‘absolute difference’ in cost but ‘comparative difference’ in cost.
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 Ricardo’s Theory of Comparative Advantage: David Ricardo stated a theory that
other things being equal, a country tends to specialise in and exports those commodities in the
production of which it has maximum comparative cost advantage or minimum comparative
disadvantage. Similarly the country’s imports will be of goods having relatively less comparative
cost advantage or greater disadvantage.

1. Ricardo’s Assumptions
Ricardo explains his theory based on the following assumptions:-
i. There are two countries and two commodities.
ii. There is a perfect competition both in commodity and factor market.
iii. Cost of production is expressed in terms of labour i.e. value of a commodity is measured
in terms of labour hours/days required to produce it. Commodities are also exchanged
on the basis of labour content of each good.
iv. Labour is the only factor of production other than natural resources.
v. Labour is homogeneous i.e. identical in efficiency, in a particular country.
vi. Labour is perfectly mobile within a country but perfectly immobile between countries.
vii. There is free trade i.e. the movement of goods between countries is not hindered by any restrictions.
viii. Production is subject to constant returns to scale.
ix. There is no technological change.
x. Trade between two countries takes place on barter system.
xi. Full employment exists in both countries.
xii. There is no transport cost.

2. Ricardo’s Example
On the basis of above assumptions, Ricardo explained his comparative cost difference
theory, by taking an example of England and Portugal as two countries & Wine and Cloth as
two commodities. As pointed out in the assumptions, the cost is measured in terms of labour hour.

Table – 8.6
1 Unit of Wine 1 Unit of Cloth
England 120 100
Portugal 80 90

The data in the table 8.6 shows that Portugal requires less hours of labour to produce
both wine and cloth. One unit of wine in Portugal is produced with 80 labour hours and 120
labour hours required to produce the same in England. In the case of cloth production too, Portugal
requires less labour hours than England. From this it could be argued that there is no need for
trade as Portugal produces both commodities at a lower cost. Ricardo, however tried to prove that
Portugal stands to gain by specialising in the commodity in which it has a greater comparative
advantage. Comparative cost advantage of Portugal can be expressed in terms of cost ratio.
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 Table - 8.7: Cost Ratios of Producing Wine and Cloth
Portugal England
Wine Cloth Wine cloth
80 < 90 120 > 100
120 100 80 90
0.66 < 0.9 1.5 > 1.11
Table-8.7 shows that, the Portugal has advantage of lower cost of production both in
wine and cloth. However, the difference in cost, that is the comparative advantage is greater in
the production of wine (1.5 - 0.66 = 0.84) than in cloth (1.11 — 0.9 = 0.21). Even in the terms
of absolute number of days of labour Portugal has a large comparative advantage in wine, that
is, 40 labourers less than England as compared to cloth where the difference is only 10, (40 >
10). Accordingly Portugal specialises in the production of wine where its comparative advantage
is larger. England specialises in the production of cloth where its comparative disadvantage is
lesser than in wine.

Comparative Cost Benefits both Participants.

Let us explain Ricardian contention that comparative cost benefits both the participants,
though one of them had clear cost advantage in both commodities. To prove it, let us work out
the internal exchange ratio as mentioned in table-8.8.

Table – 8.8
Country Wine Cloth Domestic Exchange Rate
W : C
England 120 100 1 : 1.2
Portugal 80 90 1 : 0.89

Let us assume these 2 countries enter into trade at an international exchange rate (Terms
of Trade) 1: 1. At this rate, England specialising in cloth and exporting one unit of cloth gets
one unit of wine. At home it is required to give 1.2 units of cloth for one unit of wine. England
thus gains 0.2 of cloth i.e. wine is cheaper from Portugal by 0.2 unit of cloth. Similarly Portugal
gets one unit of cloth from England for its one unit of wine as against 0.89 of cloth at home thus
gaining extra cloth of 0.11. Here, both England and Portugal gain from the trade i.e. England
gives 0.2 less of cloth to get one unit of wine and Portugal gets 0.11 more of cloth for one unit
of wine. In this example, Portugal specialises in wine where it has greater comparative advantage
leaving cloth for England in which it has less comparative disadvantage. Thus comparative
cost theory states that each country produces and exports those goods in which they enjoy cost
advantage and imports those goods suffering cost disadvantage.
Following are the important limitations of Ricardian’s Comparative Cost Theory:
1. Restrictive Model: Ricardo’s Theory is based on only two countries and only two
commodities. But international trade is among many countries with many commodities.
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2. Labour Theory of Value: Value of goods is expressed in terms of labour content. Labour
Theory of value developed by classical economists has too many limitations and thus is
not applicable to the reality. Value of goods and services in the real world are expressed
in money i.e. the prices are the values expressed in units of money.
3. Full Employment: The assumption of full employment helps the theory to explain trade
on the basis of comparative advantage. The reality is far from full employment. Cost of
production, even in terms of labour, may change as the countries, at different levels of
employment move towards full employment.
4. Ignore Transport Cost: Another serious defect is that the transport costs are not consider
in determining comparative cost differences.
5. Demand is Ignored: The Ricardian theory concentrates on the supply of goods. Each
country specialises in the production of the commodity based on its comparative
advantage. The theory explains international trade in terms of supply and takes demand
for granted.
6. Mobility of Factor of Production: As against the assumptions of perfect immobility
between the countries, we witness difficulties in the mobility of labour and capital within
a country itself. At the same time their mobility between nations was never totally absent.
7. No Free Trade: Ricardian theory assumes free trade i.e., no restriction on the movement
of goods between the countries. Though it is unrealistic to assume not to have any
restriction. What the real world witnesses is a lot tariff and non-tariff barriers on
international trade. Poor countries find it difficult to enjoy the comparative advantage in
the production of labour intensive commodities due to the protectionist policies followed
by developed countries.
8. Complete Specialisation: In the Ricardian example, England is specialising fully on
cloth and Portugal on wine. Such complete specialisation is unrealistic even in two
countries and two commodities model. It is possible if two countries happen to be almost
identical in size and demand. Again, a complete specialisation in the production of less
important commodity is not possible due to insufficient demand for it.
9. Static Theory: The modern economy is dynamic and the comparative cost theory is
based on the assumptions of static theory. It assumes fixed quantity of resources. It does
not consider the effect of growth.
10. Not Applicable to Developing Countries: Ricardian theory is not applicable to
developing countries as these countries are nowhere near to full employment. They are
in the process of change in quality of their labour force, quality of capital, technology,
tapping of new resources etc. In other words developing countries exhibit all the
characteristics of dynamic economy.
11. Constant Returns to Scale: Another drawback of the Ricardian principle of comparative
costs is that assumes constant Returns to scale and thus constant cost of production in
both the countries. The doctrine holds that if England specialises in cloth; there is no
reason why it should produce wine. Similarly if Portugal has a comparative advantage in
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 producing wine, it will not produce cloth; but import all cloth from England. If we examine
the pattern of international trade in practice, we find it is not so. A time will come when
it will not be reasonable for Portugal to import cloth from England because of increasing
cost of production. Moreover, in actual practice a country produces a particular commodity
and also imports a part of it. This phenomenon has not been explained by the theory of
comparative costs.

Check Your Progress.

3. What is an example of a Comparative Advantage?
..........................................................................................................................................
...........................................................................................................................................
4. What was Ricardo’s greatest contribution to Economic Theory?
..........................................................................................................................................
...........................................................................................................................................
5. What is Ricardo’s Theory?
..........................................................................................................................................
...........................................................................................................................................
6. What is the difference between Comparative Advantage and Absolute Advantage?
..........................................................................................................................................
...........................................................................................................................................

8.9 SUMMARY
International trade is the trade between two or more countries. The term trade refers to
exchange of goods and services and when it takes place across national borders or territories
then it is called as international trade. The major reasons for International Trade are differences
in technology, differences in resource endowments, differences in demand, existence of
economies of scale in production and existence of government policies. International trade
plays very significant role in the economic development of any country. International trade
provides foreign exchange which can be used to remove the poverty and other productive
purposes. Adam Smith, David Ricardo, Robert Torrens and John Stuart Mill were contributed
the classical theories of international trade. According to the classical theories, while a country
enters in International trade, and it benefits from specialization and efficient allocation of
resources. The International trade also helps in bringing new technologies and skills that lead
to higher productivity. In this context they were explained mercantilism, absolute advantage
and comparative advantage theories. These are grouped under classical theories of international
trade. Theory of mercantilism, absolute advantage and comparative advantage are explored
and analyze the history, importance and relevance of classical theories in international trade.

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8.10 CHECK YOUR PROGRESS – MODEL ANSWERS
1. The main concept of absolute advantage is generally attributed to Adam Smith for his
book The Wealth of Nations (1776) in which he countered mercantilist ideas.
2. In economics, absolute advantage refers to the capacity of any economic agent, either an
individual or a group, to produce a larger quantity of a product than its competitors.
Smith also used the concept of absolute advantage to explain gains from free trade in the
international market.
3. Comparative advantage is when a country produces a good or service for a lower
opportunity cost than other countries. For example, oil producing nations have a
comparative advantage in chemicals. Their locally-produced oil provides a cheap source
of material for the chemicals when compared to countries without it.
4. David Ricardo (1772-1823) was a classical British economist best known for his theory
of wages and profit, labour theory of value, theory of comparative advantage, and theory
of rent. David Ricardo and several other economists also simultaneously and
independently discovered the law of diminishing marginal returns.
5. David Ricardo developed the classical theory of comparative advantage in 1817 to explain
why countries engage in international trade even when one country’s workers are more
efficient at producing every single good than workers in other countries.
6. The producer that requires a smaller quantity inputs to produce a good is said to have an
absolute advantage in producing that good. Comparative advantage refers to the ability
of a party to produce a particular good or service at a lower opportunity cost than another.

8.11 MODEL EXAMINATION QUESTIONS

I. Answer the following questions in about 10 lines each.
1. Discuss the causes for International Trade.
2. Discuss Absolute Cost Advantage Theory in detailed.
3. Critically examine Adam Smith’s Theory of International Trade.
4. How does comparative advantage lead to gains from trade?

II. Answer the following questions in about 30 lines each.

1. What is International Trade? Explain the role of International Trade in economic
development of a county.
2. Critically examine David Ricardo’s Theory of International Trade.
3. Is it possible to have a Comparative Advantage in the production of a good but not to
have an Absolute Advantage? Explain.
4. Explain about the Classical Theories in International Trade.

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III. One mark questions.
A. Choose the correct answer in the following multiple choice questions.
1. Which of the following is international trade?
A. Trade between provinces B. Trade between regions
C. Trade between countries D. (B) and (C)
2. Theory of comparative advantage was presented by:
A. Adam Smith B. Ricardo C. Hicks D. Arshad
3. Which is NOT an advantage of international trade?
A. Export of surplus production B. Import of defence material
C. Dependence on foreign countries D. Availability of cheap raw materials
4. If Japan and Pakistan start free trade, difference in wages in two countries will:
A. Increase B. Decrease C. No effect D. Double
5. Trade between two countries can be useful if cost ratios of goods are:
A. Equal B. Different C. Undetermined D. Decreasing
Answers: 1. C; 2. B; 3. C; 4. B; 5. B

B. Fill in the blanks.

6. Modern theory of international trade is based on the views of —————————-
7. Foreign trade creates among ———————————— countries.
8. Net exports equal to ————————————
9. A tariff reduces ——————————— the volume of trade.
10. Mercantilism was called as ——————————— as only one country benefitted
from it.
Answers: 6. Heckcsher and Ohlin; 7. Cooperation; 8. Exports and Imports; 9. Has no effect on
volume of trade; 10. A zero sum game.

8.12 GLOSSARY
1. Classical Trade Theories: The major theories of international trade that were advanced
before the 20th century, which consist of mercantilism, absolute advantage, and
comparative advantage.
2. Opportunity Cost: Given the alternatives (opportunities), the cost of pursuing one activity
at the expense of another activity.
3. Balance of Trade: The aggregation of importing and exporting that leads to the country-
level trade surplus or deficit.
4. Free Trade: A theory that suggests that under free trade, each nation gains by specializing
in economic activities in which it has absolute advantage.

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5. Absolute Advantage: When one country can use favour resources to produce a good
compared to another country; when a country is more productive compared to another
country.
6. Gain from Trade: A country that can consume more than it can produce as a result of
specialization and trade.

8.13 SUGGESTED BOOKS

1. H.L. Batia : International Economics
2. Francis Cherunilayam : International Economics
3. O.S. Shrivastava : International Economics
4. BO. Sodersten : International Economics

***

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UNIT–9: TERMS OF TRADE AND GAINS FROM TRADE
Contents
9.0 Objectives
9.1 Introduction
9.2 Different Concepts of the Terms of Trade
9.2.1 Net Barter Terms of Trade
9.2.2 Gross Barter Terms of Trade
9.2.3 Income Terms of Trade
9.2.4 Single Factoral Terms of Trade
9.2.5 Double Factoral Terms of Trade
9.2.6 Real Cost Terms of Trade
9.2.7 Utility Terms of Trade
9.3 Gains from Trade
9.3.1 Static Gains
9.3.2 Dynamic Gains
9.4 Relationship between the Terms of Trade and the Gains from Trade
9.5 Factors Affecting Terms of Trade
9.5.1 Effects of Demand Shifts
9.5.2 Effect of Tariff and Quota
9.5.3 Devaluation of the Currency
9.5.4 Effects of Economic Development
9.5.5 Tastes and Preferences
9.5.6 Availability of Import Substitutes
9.5.7 Competitive Condition
9.6 Terms of Trade and Gains from Trade in Developing Countries
9.7 Limitations of Terms of Trade
9.8 Summary
9.9 Check Your Progress – Model Answers
9.10 Model Examination Questions
9.11 Glossary
9.12 Suggested Books

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9.0 OBJECTIVES
Foreign trade confers a good deal of benefits on the trading countries. How the gains
from international trade would be shared by the participating countries depends upon the terms
of trade. The concepts of terms of trade, benefits accrued to the nations from the foreign trade,
the status of terms of trade in developing countries and related aspects have been discussed in
this unit. After reading the unit, you will be able to understand and explain:
• different concepts of terms and trade.
• classification of gains from trade.
• factors affecting terms of trade.
• terms of trade and gains from trade in developing countries.

9.1 INTRODUCTION
In international trade, terms of trade are one of the most widely used concepts by the
policy makers, because it is convenient to explain the country’s balance of payment difficulties.
The gains from trade may not be evenly distributed between the participants. Some countries
may gain more, whereas others’ gain may be relatively small. The most important determinant
of the distribution of gain is the terms of trade, i.e., there at which a country’s exports are
exchanged for imports. In recent years the policy discussions about the terms of trade have
been associated more with the problems of the developing countries, because the terms of trade
of the majority of these countries have been deteriorating. Therefore, various issues relating to
the concept of terms of trade and gains from trade and nature of terms of trade in developing
countries and other related aspects have been analyzed in the following pages.

9.2 DIFFERENT CONCEPTS OF THE TERMS OF TRADE

Terms of trade are an important measure to evaluate gains to individual countries from
international trade. In the previous chapter we have seen that the countries would gain from
specializing in the production of commodities and exporting them in which they have lower
comparative cost. Terms of trade are the most important determinant of the distribution of
gains from trade. In this section we will discuss different concepts of terms of trade.
The terms of trade refer to the rate at which one country exchanges its goods for goods of
other countries. Thus, terms of trade determine the international values of commodities.
Obvisiouly, the terms of trade depend upon the prices of exports of a country and the prices of
its imports. When the prices of exports of a country are higher as compared to those of its
imports, it would be able to obtain greater quantity of imports for a given amount of its exports.
In this case, terms of trade are said to be favorable for the country as its share of gain from trade
would be relatively larger. On the contrary, if the prices of its exports are relatively lower than
those of its imports, it would get smaller quantity of imported goods for a given quantity of its
exports. Therefore, in this case, terms of trade are said to be unfavorable to the country as its
share of gain from trade would be relatively smaller.

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 Meier has classified different concepts of terms of trade into the following.
1. Those that relate to the ratio of exchange between commodities:
i. net barter terms of trade.
ii. gross barter terms of trade and
iii. income terms of trade.
2. Those that relate to the interchange between productive resources:
i. single factoral terms of trade. and
ii. double factoral terms of trade.
3. Those that interpret the gains from trade in terms of utility analysis:
i. real cost terms of trade. and
ii. utility terms of trade.

9.2.1 Net Barter Terms of Trade

Net Barter terms of trade measure the relative changes in the import and export prices
and is expressed as.
Tn – Px/Pm
Where, Tn = Commodity terms of trade, Px and Pm are index numbers of exports and
imports respectively.
When we want to know the changes in net barter terms of trade over a period of time, we
prepare the price index numbers of exports and imports by choosing a certain appropriate base
year and obtain the following ratio.
Px1/Pm1: Px0/Pm0
Where Px0 and Pm0 stand for price index numbers of exports and imports in the base year
respectively, Px1 and Pm1 denote price index numbers of exports and imports respectively in
the current year.
Since the prices of both exports and imports in the base year are taken as 100, the terms
of trade in the base year would be equal to one.
Px0/Pm0 = 100/100 = 1
Let us suppose that the price index of imports and exports in India in the base year 2012
is 100 and 2013 the prices indices of imports and exports are 110 and 170 respectively.
Consequently, the net barter terms of trade will be 170/110 * 100/100 = 1.54. It means that in
2012 the net barter terms of trade show an improvement of 54 per cent over the base year.
Consequently, a given amount of exports will fetch 54 per cent more in terms of imports in
2013 compared with that in 2012. If the price index of imports rises relatively to that of exports,
the net barter terms of trade will become unfavorable for the country.
The important limitation of this concept is that it shows nothing about the changes in the
volume of trade and it ignored the impact of factors such as 1) changes in the level or volume

139
of exports and imports 2) changes in the quality of exports and imports 3) changes in the
composition of trade 4) changes in the productivity of export industries and 5) unilateral
payments.

9.2.2 Gross Barter Terms of Trade

The concept of Gross Barter Terms of Trade was introduced by F.W. Taussig and it
taken into account of the volume of imports to the volume of exports. It may be expressed as,
TG = Qm/Qx
Whereas TG stands for the Gross barter terms of trade, Qm and Qx for quantity of imports
and quantity of exports. A rise in TG is considered as a favorable change implies that more
imports are received for a given volume of exports than in the base year. For example, the index
of total imports and total exports in the base year 2011 is 100 and that in 2012 the export index
rises to 147 while the import index rises to 191. In this situation, the gross barter terms of trade
will be equal to 191/147 * 100/100 = 1.30. It means that there is an improvement of 30 per cent
in the gross barter terms of trade of the country in 2012 compared with the base year 2011. In
practical terms, it means that a given quantity of exports in 2011 will bring 30 per cent more
imports in 2012. Even through TG is treated as an improvement over Net barter terms of trade;
it also does not reflect the impact of changes in productivity nor changes in the quality and
composition of foreign trade.

9.2.3 Income Terms of Trade

G.S.Dorrance developed the concept of income terms of trade. It is a modified version
of Net barter terms of trade. The income of terms trade indicates a nation’s capacity to import.
It is the ratio of the total value of exports divided by the price index of imports and can be
expresses as:
Ti = PxQx/Pm
It follows from above that the volume of imports (Qm) which a country can buy (that is,
capacity to import) depends upon the income terms of trade i.e., PxQx/Pm. Since income terms
of trade is a better indicator of the nation’s capacity to import and since the developing countries
are unable to change Px and Pm. Kindlegerger’ thinks it to be superior to the net barter terms of
trade for these countries. However, it may be mentioned once again that it is the concept of net
barter terms of trade that is usually employed.
It may also written as,
Ti = Tn.Qx (because Tn = Px/Pm)
Even when export prices decline and import prices remain constant, the income terms of
trade will improve, if the physical volume of exports increases more than in proportion to the
fall in export prices. This very well demonstrates that a change in the income terms of trade
need not necessarily reflect the real gain or loss. This is a serious drawback of this concept.

9.2.4 Single Factorial Terms of Trade

Jacob Viner has introduced the concepts of single factoral and double factoral terms of
trade. The single factoral terms of trade is the ratio of the export price index and the import
140
price index and adjusted for changes in the efficiency or productivity of country’s factors in its
export industries. If the commodity term of trade index is multiplied by the reciprocal of the
export commodity technical coefficients index, the resultant index is known as the ‘single
factoral terms of trade’ which can be expressed as:
Ts = N.Zx or Ts = Px/Pm . Zx
Where, Ts stands for the single factoral terms of trade. Px/Pm (or N) is the net barter terms
of trade. A rise in S implies that a greater quantity of imports can be obtained per unit of factor-
input used in the production of exportable. Hence a rise in S is regarded as a favorable movement.
We can explain this concept with an example. Let us assume that export price index falls
by 10 per cent but export cost has fallen by 20 per cent. In this situation, the single factoral
terms of trade will be 90/100 * 120 = 108. Thus, the single factoral terms of trade for the
country have improved by 8 per cent and the country is better off although the net barter terms
of trade have deteriorated by 10 per cent. It is so because the fall in the export price index is
more than compensated by an increase in the factor productivity in the export sector.

9.2.5 Double Factoral Terms of Trade

The concept of the double factoral terms of trade takes in to account of the productivity
of factors of production entering into the production of country’s exports as well as country’s
imports. It can be expressed as.
Td = Px/Pm * Zx/Zm
Where, Td stands for Double Factors terms of trade Zx, Zm are: index of factor productivity
of imports and exports respectively. Px and Pm are prices of indices of exports and imports.
Most of the economists opened that both the concepts of the single factoral and double
factoral terms of trade have little utility because it is very difficult to measure the changes is
factor productivity. In addition to this, these concepts do not measure the real gain obtained
from international trade.

9.2.6 Real Cost Terms of Trade

Jacob Viner has introduced the concept of “Real cost terms of trade” to determine the
real gain from international trade. It can be obtained multiplying the single-factoral terms of
trade with the index of the amount of disutility (1rko someness) per unit of productive resources
used in producing exports. Thus it can be shown as:
Tt = Ts . Rs = Px/Pm . Zx . Rx.
Where, Tt stands for the real cost terms of trade, Rs is the index of the amount of disutility
suffered per unit of productive resources employed in producing the exports.

9.2.7 Utility Terms of Trade

To overcome the above defect, Viner has introduced the concept of “Utility Terms of
Trade”, by multiplying the real cost terms of trade with the index of the relative utility of
imports and the forgone commodities (U). Robertson calls the above index as the “true terms
of trade”. Symbolically:
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 Tu = Px/Pm . Fx.Rx.U.
However, the real cost terms of trade and utility terms of trade could not be used in
practice on account of the difficulties of measuring utilities and disutility’s involved in the
above two concepts. To conclude with, we may say that the barter terms of trade, Px/Pm is
commonly employed in practice.

9.3 GAINS FROM TRADE

The gains from foreign trade can be grouped into static and dynamic gains. We can state
that the static gains are those which accrue from international specialization, according to the
doctrine of comparative advantage. The dynamic gains are those which result from the impact
of trade on production possibilities at large. Economies of scale, international investment and
transmission of technical knowledge would be the examples of dynamic gains. In addition,
trade can provide a vent for surplus commodities which brings otherwise unemployed resources
into the employment and also countries can purchase goods from abroad for which there are no
domestic substitutes or importation of these goods would improve the productive power of
economy.
A clear description of gains from trade is traceable in the writings of Adam Smith.
International trade enlarges the horizon of market and creates an outlet for the surplus products
over domestic consumption of the isolated economy. If the isolated economy about to enter
into trade has surplus capacity suitable for export markets it has castles means of acquiring
imports and expanding the aggregate domestic economic activity. When trade takes place
between old countries where total resources are given and are fully employed, the function of
trade is to reallocate these given resources more efficiently between the production of domestic
and export goods in the light of new sets of prices now open to the countries. In this situation,
each country gains when the total output increases as a result of the more extensive application
of division of labour and specialization which became possible when goods are produced on
large as a consequence of trade.
According to Ricardo, the gains from trade accruing to the countries are in the form of
greater magnitude of more kinds and varieties of goods that become available for consumption
in each country as a result of international trade. Malthus viewed that the gains from trade
consists of “the increased value which results from exchange what is wanted less for what is
wanted more” and international trade “by giving us commodities much better suited to our
wants and tastes than those which had been sent away has decidedly increased exchangeable
value of our possession, our means of enjoyment and wealth”. John Stuart Mill calls it the
‘direct-gains’ from trade. Modern economists refer to it as the static gains from trade.
By increasing the size of the market, international trade improves the scope of division
of labour in production and consequently raises the general level of productivity within the
country. This is often referred to as productivity theory of international trade. The productivity
doctrine looks upon internal trade as a dynamic force which, by widening the extent of the
market and the scope of division of labour raises the skill and dexterity of the workmen
encourages technical innovations, overcomes technical indivisibilities and generally enables
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the trading countries to enjoy increasing returns and economic development. Hla Myint regarded
this gain as indirect effect of trade which must be counted as benefits of the higher order. This
type of gains considered as dynamic gains from trade by the modern economists.
The factors determine the gains from international trade are:
i. The gain from international trade depends upon the cost ratios of differences in
comparative cost ratios in the two trading countries. If the differences between exchange
rate and cost of production is lesser, then lesser will be the gains from trade and vice-
verse.
ii. If a country has elastic demand and supply it gives more gains from trade vice-verse with
inelastic demand and supply.
iii. International trade is based on the specialization and a country specializes depending
upon the availability of factors of production. It will increase the domestic cost ratios
and so the gains from trade.
iv. If a country is small in size it’s easy for them to specialize in the production of one
commodity and export the surplus production to a large sized country and can get more
gains from international trade. Whereas if a country is large in size then they have to
specialize in more than one good because the excess production of only one commodity
cannot be exported fully to a small sized country as the demand for good will reduce
very frequently. So smaller the size of the country larger is the gain from trade.
v. Gains from trade will depend upon the terms of trade. If the cost ratio and terms of trade
are closer to each other more will be the gains from trade of the participating countries.
vi. An increase in the productive efficiency of a country also determines its gains from trade
as it lowers the cost of production and prices of the goods as a result the country importing
gains by importing cheap goods.

9.3.1 Static Gains from Trade

As stated earlier, static gains from trade refer to the increase in welfare of the people of
the trading countries as a result of the optimum utilization of their given factor-endowments,
for they specialize on the basis of their comparative costs. Static gains are the result of the
theory of comparative cost in the field of foreign trade. On this principle, countries make the
optimum use of their available resources, so that their national output is greater which also
raises the level of social welfare in the country.
The classical economists maintain that as a result of international division of labour,
world production and welfare would tend to improve. Specialization on the basis of comparative
advantages implies, maximum to be produced from a given amount of factor resources. The
increase in the welfare that trade permit results from the opportunity to obtain the foreign
products more cheaply in terms of real resources scarified than the alternative of domestic
production.
Under the static gains from trade, although as a result of trade the producers in the
country move along the production frontier; however, itself remains unchanged, i.e., the

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production possibility curve of the country is assumed as given. As a result of trade, only the
consumption frontier expands because the consumers are enable to reach on a higher community
indifference curve. Consequently consumers enjoy a higher aggregate satisfaction which
becomes possible partly due to the more favorable terms of trade on which goods are exchanged
partly due to the more efficient use of the given productive resources of the economy.

9.3.2 Dynamic Gains from Trade

Dynamic gains from trade relate to economic development of the economy. Specialization
of the country for the production of best suited commodities, result in a large volume of quality
production which promotes growth. Thus, the extension of domestic market to foreign market
will accelerate economic growth.
Greater division of labour will raise the productivity if its resources through the growth
of specialized skills and the introduction of specialized techniques and the capital equipment in
the export sector. It also allows a country to realize the economies of scale. Dynamic in the
sense that in contrast with static gains they represent an outward shift of the production possibility
boundary in the direction of goods production for export. But the gains from the increased
productivity in the export sector and the raising real incomes they represent are expected to
spread to the rest of the economy resulting in an export lead growth. If as a result of trade,
national income increases and there is a consequent increase in savings and productive
investments, then the ensuing growth of national income can be viewed as yet a further dynamic
gain from international trade.
Dynamic gains which accrue to the developing countries from international trade are as
follows:
1. Through foreign trade, developing countries get material means of production such as
capital equipment, machinery and raw materials which are so essential for economic growth of
these countries. There has been rapid technological progress in the developed countries. This
advanced and superior technology is incorporated or embodied in various types of capital goods.
It is thus clear that developing countries derive tremendous gains from technological progress
in the developed countries through the imports of capital goods such as machinery, transport
equipment, vehicles, power generation equipment, road building machinery, medicines, and
chemicals. It is worth mentioning here that the pattern of import trade of the developing countries
has changed in the last several years and now consists of greater quantity of various forms of
capital goods and less of textiles.
2. Even more important than the importation of capital goods is the transmission of
technical know-how, skills, managerial talents, entrepreneurship through foreign trade. When
the developing countries come to have trade relationship with the developed countries, they
also often import technical know-how, with all their skills, managers, etc., from them. With this
they are also able to develop their own technical know-how, managerial and entrepreneurial
ability. The growth of technical know-how, skill and managerial ability is an important requisite
for economic development of developing countries.
3. The major dynamic gain of trade is that export markets widen the total market for a

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country’s products. If production is subject to increasing returns, total gains from trade will
exceed the static gains from a more efficient allocation of resources. A country may be benefited
from trade irrespective of its terms of trade, if increasing returns are in operation. Hicks laid
great stress on increasing returns because of the close connection between increasing returns
and accumulation of capital. Larger the market, easier becomes capital accumulation if there
are increasing returns to scale. Mint's 'theory of vent for surplus' presents dynamic gains in
the following way. According to this analysis, international trade is the provision of an outlay
for country’s surplus commodities which would otherwise go unsold. Myint pointed out that
this theory is much more applicable than the comparative cost doctrine in planning the rapid
expansion of export production in most parts of the developing world in the 19th century because
of existence of utilized resources. Vent for surplus theory may explain better the original basis
for international trade while the comparative most doctrine explain the pattern of commodity
trade. Another potential gain from international trade is that exports permit imports which may
be more productive than domestic resources both directly and indirectly.
4. Dynamic gains from trade accrue to an underdeveloped economy in the form of an
unending perennial income flows which continue even after the economy has become integrated
into the world economy. “Trade is a dynamic force that stimulates innovation. New ways of
producing and organizing production are spread to the local economy through trade, and the
competitive force of trade stimulates adoption of cost-saving techniques. Trade also makes
possible economical local production of many goods that would otherwise be prohibitive to
produce locally.

Check Your Progress.

Note: a) Space is given below for writing your answer.
b) Compare your answer with the one given at the end of the unit.
1. Define Terms of Trade.
..........................................................................................................................................
...........................................................................................................................................
2. Write a note on Gross Barter Terms of Trade.
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3. Distinguish between Static and Dynamic Gains from Trade.
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9.4 RELATIONSHIP BETWEEN THE TERMS OF TRADE &

THE GAIN FROM TRADE
From the beginning of the classical period, the trend of the commodity terms of trade
has been accepted as an index of the direction of change in the amount of total gain from trade.

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Consequently, economists regard a rise in the prices of country’s exports relative to the prices
of her imports as a “favorable” movement of terms of trade indicating an increase in the total
gain from trade. While David Recardo pointed out that whether or not as improvement in the
terms of trade could be treated as a genuine improvement in the country’s position depended on
how it was caused or brought about. However, J.S. Mill felt that a favorable movement of the
commodity terms of trade did not necessarily indicate an improvement in the amount of gain
from trade. For example, while a protective import tariff caused an improvement in the terms
of trade, this advantage was more than offset by the loss of benefit which had earlier accrued
from importing those goods which are now produced at home under tariff protection. Both
Alfred Marshall and Edgeworth considered changes in the amount of “consumer’s surplus”
rather than changes in the terms of trade as a better index of changes in the amount of gain from
trade. The general position of the leading economists was that an improvement in the commodity
terms of trade in the absence of offsetting factors indicated an increase in the amount of the
gain from trade. Alfred Marshall mentioned increase in the cost of export commodities while
Taussig pointed out a decrease in the desire for import goods as examples of offsetting factors.
International trade makes available to the people of a country a galaxy of goods and
services at the most competitive prices. A country may not have the factor endowments or
technological capability to produce certain goods. If there is no trade with other countries, it
will have to do without such goods but through international trade, it is able to procure them.
The gains from international trade may be summed up as follows:
i) It encourages the development of the most efficient sources of supply.
ii) International trade enables specialization on a large scale because of the expanded market,
which enables the realization of economies of scale. When the size of the market is
limited, certain investments are uneconomical.
iii) International specialization and the economies in production make goods available
comparatively cheaper.
iv) International trade increases real incomes and consumption. This could lead to expansion
of employment and output and foster economic growth.
v) Trade on a global scale makes available even goods that cannot be domestically produced.
vi) Trade enables a country to conserve certain scarce resources as commodities which
embody these scarce resources may be imported from countries where they are abundant.
As said earlier, the gains from trade may not be distributed between the participants and
the terms of trade is the major determinant of the gains from trade for a country.

9.5 FACTORS AFFECTING TERMS OF TRADE

The terms of trade of a country depend on a number of factors. Any change in any one
or all of these factors will affect the country’s terms of trade. The important factors that affect
the terms of trade of a country are: i. Effects of Demand Shifts; ii. Effect of Tariff and Quota;
iii. Devaluation of the Currency; iv. Effects of Economic Development; v. Tastes and Preferences;
vi. Availability of Import Substitutes; and vii. Competitive Condition
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9.5.1 Effects of Demand Shifts
A shift in demand for the exports and imports of a country is one of the causes of changes
in terms of trade. The effect of demand shifts is reflected in a movement of offer curve. If the
demand for imports of the country increases, the prices of imports relative to those of exports
will rise. Consequently, the commodity terms of trade of the country will deteriorate in as
much as for a given quantity of imports the country will have to give away a larger quantity of
exports. Similarly, if the demand for the exports of the country increases, the prices of her
exports to the prices of her imports will rise and the commodity terms of trade of the country
will improve. The relationship between the elasticities and changes in terms of trade varies,
depending upon the type of demand shift.

9.5.2 Effects of Tariffs and Quotas

A tariff and quota may be imposed by a country with a view to improving its terms of
trade. The specific effects of tariff, however, depend on the way the tariff is imposed and on the
elasticities of the offer curves. Tariff shall improve the terms of trade for the tariff-imposing
country if the elasticity of the other country’s trade offer curve is greater than unity and less
than infinity.

9.5.3 Devaluation of Currency

Changes in the rate of exchange of the currency also affect terms of trade. Devaluation
lowers the value of the home currency unit expressed in terms of the currency of foreign country.
If a country’s currency appreciates; the terms of trade of that country will improve. But this
interpretation is not necessarily correct. In reality, the effects of devaluation will depend on the
elasticities of demand for and supply of imports and exports of the country. Devaluation will tend
to improve the terms of trade if the product of the demand elasticities for the country’s imports
and exports is greater than the product of the supply elasticities of her imports and exports.
The terms of trade for the country will deteriorate, remain unchanged or improve as a
result of currency devaluation if:
(i) Sx.Sm > Dx.Dm
(ii) Sx.Sm = Dx.Dm and
(iii) Sx.Sm < Dx.Dm.

9.5.4 Effects of Economic Development

There are two important effects of economic development to be considered, namely, the
demand effect and the supply effect. The demand effect refers to the increase in demand for
imports as a result of the increase in income associated with economic development. The supply
effect refers to the increase in supply of import competing goods or import substitutes. The net
effect on the terms of trade will obviously depend up on the extent of these effects. The net
effect of growth in the combined result of these supply and demand effects:
i) When the income elasticities of demand for the supply of importables are equal to unity,
their combined effect will cause an adverse change in the terms of trade, because there
will be a net rise in the demand for imports.
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ii) If the income elasticity of demand is greater than unity but that of supply is less than
unity, then also the terms of trade will change adversely with economic development as
there will be a net rise in the demand for importables.
iii) When the income elasticity of demand is less than unity but that of supply is greater than
unity, the terms of trade will improve with growth, because there will be a net fall in the
demand for importables.
iv) If the income elasticity of demand is greater than unity and that of supply is also greater
than unity, the net effect of growth depends on the relative size. If there is a net rise in the
demand for importables the terms of trade will improve. The same logic applies to the
case of elasticities being less than unity.
Economic growth will cause an outward shift in the production possibilities curve of a
country allowing for larger aggregate output. The upward shift in the production possibilities
curve may occur due to increase in the supply of the factors of production and technological
improvement allowing the production of larger aggregate output with the given quantity of
resources.

9.5.5 Tastes and Preferences

Changes in tastes and preferences may also cause changes in the terms of trade. A change
in the former in favour of a country’s export goods could help improve its terms of trade and
vice versa.

9.5.6 Availability of Import Substitutes

If import substitutes are available in large quantity, the terms of trade will be unfavorable
for the exporting country. In the absence of availability of close substitutes the bargaining
power of the exporting country will be strong. Consequently the terms of trade will be favorable
for the exporting country.

9.5.7 Competitive Condition

Competitive conditions in the international market are also another important influence
on the terms of trade. If the country enjoys monopoly or oligopoly power in case of its exports
and there are a large number of alternative sources of supply of imports, the country would
have favorable terms of trade. The absence of close substitutes enables a country to sell her
products at high prices. It is the near monopoly power enjoyed by the oil cartel that enabled the
OPEC to improve their terms of trade by hiking the oil prices.

Check Your Progress.

4. Which factors affect Terms of Trade?
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...........................................................................................................................................

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9.6 TERMS OF TRADE AND GAINS FROM TRADE IN
DEVELOPING COUNTRIES
Most of the developing countries in the world are caught in the vicious circle of low
income, low employment, and low technical know-how resulting in mass poverty. No doubt, it
is argued that foreign trade is the life and blood of these economies. “Trade or Perish” has
emerged as an appropriate slogan for their rapid economic development. However, the spokesmen
of the underdeveloped countries argue that international trade which had been an engine of
economic growth for the open lands in the nineteenth century is no more an engine of economic
growth for these countries today. Less developed countries today face unfavorable conditions
contrary to the favorable conditions faced by the open lands in the nineteenth century. In this
context the argument of Raul Prebisch as to the secular deterioration of the terms of trade of
the less developed countries is very much valid.
In his well-known work entitled “Towards a New Trade Policy for Development” Raul
Prebisch states that the prices of the primary products deteriorate in the long run relative the
prices of the manufactured goods. Underdeveloped countries produce primary goods with no
change in product mix for a century on the other hand developed countries produce manufactured
goods such as, automobiles, radios, petroleum refinery equipment etc., and the quality of these
goods has tremendously improved. They fetch relatively higher prices than the primary goods.
This argument is noted corroborated with the empirical data and as such has been rejected by
Richard Lipsey and Jacob Viner.
Singer has given a different explanation for the deterioration of the terms of trade of the
primary products producing countries. According to thim the benefits of technical progress in
the form of lower prices have been made available to the consumers in the developed countries
by the primary products producing countries. But the same benefit of lower prices has been
denied by the developed countries to the less developed ones. Mc Leod has attributed
monopolistic control in the production of finished goods in the developed countries as the
reason for this tendency. Less developed countries compete among themselves as sellers in the
world market and give away a substantial part of their gain in productivity to the developed
countries in the form of lower prices for their exports.
According to Jagdish Bhagwati poor countries know only to produce ultra-export based
products. Lack of complementary resources and frictions in the economy prevent the shifting
of resources to the import competing industries. Linder states that imports kill import-
competiting industries. For example cheap mill-made textile imports from England killed the
Indian handicrafts and traditional textiles. Similarly Irish industry collapsed due to free trade
after 1801. All the gains are lost to the developing countries as they find it difficult to develop
import-competing industries.
In terms of Engel’s Law, as the national income of a country increases, total expenditure
as a proportion of national income on manufactured goods increase while that incurred on
agricultural products and minerals decline. As such the demand for the exports of the less
developed countries grows more slowly in the international market than their demand for

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manufactured goods. Less developed countries produce some goods like oil, rubber, diamonds,
art wares, non-ferrous metals etc., for which income elasticity of demand is high. If they produce
such goods cheaply exports can grow easily. For example Japanese textiles grew due to their
relative cheapness in the international market.
In the developed countries capital is plenty and with technology they can substitute
land and labour. For example they now produce synthetic rubber, artificial silk, cotton, rayon
etc., without importing raw materials from the less developed countries which adversely affect
the terms of trade of the less developed countries. According to Linder, lack of availability of
intermediate goods in the less developed countries blocks their diversification and transformation.
They are constrained to import fuel, iron and steel, cement etc., from the developed countries
to utilize the domestic resources. Growing population and limited import substitution necessitate
larger imports as a result of which terms of trade are unfavorable to the less developed countries.
The growth of exports of the less developed countries is limping and their share in the total
world trade is insignificant. In 1996 US, Germany, Japan, France, UK, Italy and Canada
accounted for more than half of the world merchandise trade, whereas, India with 18 per cent
of the world’s population accounted for 0.7 per cent. Less developed countries are marginalized
in world trade and they are not able to sell their exports at increasing prices due to which trade
has not transmitted growth from the developed countries to the less developed ones.
Rapid increase in the per capita income in the developed countries has failed to generate
a proportional increase in the demand for primary products offered by the less developed
countries. Low income elasticity of consumer demand for many agricultural commodities which
constitute the bulk of exports from the less developed countries, growing agricultural
protectionism in the developed countries growing displacement of natural raw materials by
synthetic and man-made substitutes and economies achieved in industrial use of natural materials
have been responsible for this pathetic situation of unfavorable terms of trade of the less
developed countries.
Deterioration of the terms of trade of less developed countries leads to harmful effects
on their economies. It is often true that in international trade “Exports pay for Imports”. But the
fall in the prices of imports of less developed countries vis-à-vis developed countries has declined
their capacity to import goods with the result that they are confronted with balance of payments
deficits and rising external debts. Declining export earnings against rising import bills have
widened the deficits in the balance of payments. Worsening terms of trade have increased the
foreign debt obligations of the less developed countries. As they cannot increase export earnings
they resort to more borrowings to pay debt and interest there upon and they are caught in a
vicious circle entering into a debt trap. Balance of payments difficulties on one side and mounting
debts on the other lead to fiscal deficits as the less developed countries are not in a position to
meet their development and non-development expenditure. This trend brings in inflationary
pressures and the very process of economic development of the less developed countries gets
distorted and retarded.

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9.7 USES AND LIMITATIONS OF TERMS OF TRADE
9.7.1 Uses of Terms of Trade
Study of the terms of trade became important after the World War-II. Gains from
international trade depend on terms of trade also. Similarly the balance of payment
disequilibrium also depends on terms of trade. Terms of trade affect the volume of national
income and even its distribution. The division of gains between the exporting and importing
countries depends upon the terms of trade which prevail. The more favorable are a country’s
terms of trade, the greater will be its share of the total gains from trade. Terms of trade determine
the net effect of economic forces which affect international economic relations. They are
important from the welfare point of view. They tell us about the net effect of all variables and
forces on balance of payment. Their use is very frequent yet not necessarily always clear.

9.7.2 Limitations of Terms of Trade

i) Changes in Quality: Over the years, the quality of internationally traded goods may
undergo a change and also new goods that are constantly entering into trade, but the
price indices may not reflect this change.
ii) Changes in Composition: Changes in the composition of the goods over a period of
time may also not be reflected in the price indices.
iii) Problem of Index Numbers: Usual problems associated with index number in terms of
coverage, base year and method of calculation arise. Another problem associated with
the price index related to that of assigning appropriate weights to various commodities
that enter the international trade of the country.
iv) Price Differences: The price indices of import and export goods are usually based on
the price declarations made to the customs authorities, which may differ from the actual
market selling price of the imports and exports.

Check Your Progress.

5. What are the Limitations of Terms of Trade?
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...........................................................................................................................................

9.8 SUMMARY
Terms of trade are of vital importance both in the national and international policy making
decisions. However, several technical issues concerned with them need to be resolved to use
them in policy making. Firstly, terms of trade should be measured in foreign currency prices.
However, if the conversion factors and imports they can be measured in local currency. Secondly,
shift in the commodity-mix of exports and imports over a period create complications in
measurement. Thirdly, choice of the base year is to be proper in which export prices are neither
very high nor low. In this connection fitting trend lies to export and import prices and comparing
the two trends helps to avoid the base year problem partly. In such a comparison the overall
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period may become a problem.
Economists have been discussing and analyzing the problem of deterioration or otherwise
of the terms of trade of the less developed countries over the years. Two UNCTAD studies
show a relative decline in the terms of trade of less developed countries in relation to developed
countries.
The objective of protecting the terms of trade from deterioration is commendable. But
the means to achieve that objective are not simple and clear-cut. In the deliberations at the
international conferences, policy makers in the developing countries rely on the developed
countries in maintaining the demand for raw material exports from their countries and taking
appropriate measures to prevent the rising of prices of the industrial goods which are imported
by the less developed countries. But the speeches or appeals have failed in preventing the
unfavorable trends in the terms of trade of the less developed countries.
Oil producing countries had been successful in improving their terms of trade by restricting
output and raising the export prices of oil substantially. They formed themselves into a cartel
(OPEC) and the entire members were solid in their unity. Moreover, the demand for oil is
inelastic due to which OPEC becomes powerful. But other developing countries cannot form
into cartels for commodities as their products have close substitutes over the years the OPEC’s
bargaining power has been diluted.
Stabilization of international commodity prices can solve the secular deterioration of the
terms of trade of the less developed countries. Most of the developing countries earn 85 to 90
per cent of their export earnings through primary products. But the prices of the primary products
constantly fluctuate resulting to instability in foreign exchange earnings creating hurdles to the
planned economic development. If the prices of the primary products are stabilized, an important
obstacle to planned development can be eliminated. Inspite of the efforts of the UNCTAD and
other international bodies in this direction, only a little has been achieved. In the long run
stabilization of the terms of trade between the primary exports of the developing countries and
their principal industrial imports. As Streeten has stated, there are still forces at work for an
uneven distribution of the gains from trade and economic progress. Yes, the Lion’s share goes
to the lions, with the poor lambs themselves are swallowed up in the process.

9.9 CHECK YOUR PROGRESS – MODEL ANSWERS

1. The terms of trade refer to the rate at which one country exchanges its goods for goods of
other countries. The terms of trade depend upon the prices of exports of a country and
the prices of its imports.
2. It is a ratio of volume of imports to volume of exports. It may be expressed as,
TG = Qm/Qx . Whereas TG stands for the Gross barter terms of trade, Qm and Qx for
quantity of imports and quantity of exports.
3. The static gains are those which accrue from international specialization and according
to the doctrine of comparative advantage. The dynamic gains are those which result
from the impact of trade on production possibilities at large. Economies of scale,

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 international investment and transmission of technical knowledge would be the examples
of dynamic gains.
4. The important factors that affect the terms of trade of a country are: i. Effects of Demand
Shifts; ii. Effect of Tariff and Quota; iii. Devaluation of the Currency; iv. Effects of
Economic Development; v. Tastes and Preferences; vi. Availability of Import Substitutes;
and vii. Competitive Condition.
5. Then limitations of terms of trade are: i) Changes in quality; ii) Changes in composition;
iii) Problem of index numbers; and iv) Price differences.

9.10 MODEL EXAMINATION QUESTIONS

I. Answer the following questions in about 10 lines each.
1. Explain the different concepts and measurement of terms of trade with suitable examples.
2. Explain the problems of developing countries relating to terms of trade and gains from
International trade.
3. Explain the relationship between the terms of trade and gains from trade.
4. Explain the views of Singer and Paul towards deterioration of terms of trade in less
developed countries.
5. Define the concept of Terms of Trade and state its limitations.

II. Answer the following questions in about 30 lines each.

1. What are the gains from International Trade?
2. Define the concept of Terms of Trade and explain the factors affecting Terms of Trade.
3. Distinguish between Static and Dynamic Gains from Trade.
4. What do you understand by Commodity Terms of Trade?
5. Mention the uses of Terms of Trade.

III. One mark questions.

A. Choose the correct answer in the following multiple choice questions.
1. The concept of Gross Barter Terms of Trade was introduced by
A) J S. Mill B) Alfred Marshal C) Jocob Viner D) F.W. Taussig
2. Income Terms of Trade can be expressed as
A) Qm / Qx B) PxQx/Pm C) Px/Pm . Zx D) None of the one
3. Examples of Dynamic gains is
A) Economics of scale B) International Specialization
C) Technical knowledge D) A & C

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4. Tariff shall improve the ToT for the tariff-imposing country if the elasticity of the other
country's trade offer curve.
A) >1 B) >1 and < infinity C) <1 D) < infinity
5. The terms of trade for the country will deteriorate as a result of currency develuation if;
A) Sy. Sm > Dx Dm B) Sx. Sm = Dx Dm
C) Sx Sm < Dx . Dm D) Sx . Sm = Dx Dm
6. Vent for surplus theory was advocated by
A) Myint B) Recardo C) Adam Smith D) GS Dorrance
Answers: 1. D; 2. B; 3. A; 4. B; 5. A 6. A

B. Fill in the blanks.

1. Terms of trade are an important measure to evaluate _________________
2. Terms of trade are the most important determinant of ________________
3. Terms of trade are said to be unfavourable if the prices of exports are ___________
4. Gross Barter terms of trade can be expressed as ___________
5. If a country has elastic demand and simply it gives __________
6. Static gains are the result of the theory of _______________
Answers: 1. Gains to individual countries from international trade 2. The distribution of gains
from trade. 3. Relatively lower than those of its imports. 4. TG = Qm/Qx. 5. more gains
from trade 6. Comparetive cost in the field of foreign trade.

C. Match the following.

A B
(i) The terms of trade detarmine a) FW Taussig
(ii) The concept of Gross Terms of b) Jacob Viner
Trade was introduced by
(iii) The concepts of single factoral & c) international values of
double factoral ToT was introduced by commodities
(iv) Dynamic gains from trade d) Alfred Marshal
relate to
(v) Changes in the amount of e) Economic development of the
consumer's surplus is considered economy
as index of gains from trade by
Answers: i) c, ii) a, iii) b, iv) e , v) d

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9.11 GLOSSARY
1. Vent for surplus Theory: it is advocated by Myint to explain the distribution of gains to
all the trading partners.
2. Commodity Terms of Trade: They include gross barter terms of trade, net barter terms
of trade and income terms of trade. Commodity terms of trade are relate to the ratio of
exportables to the importable commodities.
3. Utility Terms of Trade: They interpret the gains from trade in terms of utility analysis.
They include real cost terms of trade and utility terms of trade.
4. Primary Products: Primary products are those products which are relate to agricultural
sector.
5. Income Elasticity of demand: It explains the proportional change in commodity demand
due to change in incomes of the consumers.

9.12 SUGGESTED BOOKS

1. H. Robert Heller : International Trade.
2. P.T. Ellesworth and J Clark Leith : The International Economy.
3. Charles P. Kindleberger : International Economies.
4. Gerald M. Meier : International Trade and Development.
5. B.O. Sodersten : Studies in the Theory of International Trade.
6. M.C. Vaish & Sundar Singh : International Economics, Oxford & 1BH
Publishing Co.,Pvt. Ltd., New Delhi.

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UNIT - 10: BALANCE OF TRADE
Contents
10.0 Objectives
10.1 Introduction
10.2 Factors Affecting Balance of Trade
10.2.1 Factor Endowments and Productivity
10.2.2 Trade Policy
10.2.3 Exchange Rates
10.2.4 Foreign Currency Reserves
10.2.5 Inflation and Demand
10.3 Recent Trends in India’s Balance of Trade
10.3.1 Decadal Variation in the Value of Foreign Trade
10.3.2 Decadal Growth of Imports
10.3.3 Decadal Growth of Exports
10.3.4 Deficit in the Balance of Trade
10.4 Tariffs
10.4.1 Classification of Tariffs
10.5 Quantitative Restrictions (QUOTAS)
10.5.1 Types of Import Quotas
10.6 Summary
10.7 Check Your Progress – Model Answers
10.8 Model Examination Questions
10.9 Glossary
10.10 Suggested Books

10.0 OBJECTIVES
The aim of this Unit is to explain the concept of Balance of Trade, Factors affecting
international trade, recent trends in India’s Balance of trade and different types of tariffs and
quotas.
After reading this unit you are able to:
• understand the concept and types of Tariffs and Quotas.
• know the concepts of Balance of Trade (BOT) and Balance of Payment (BOP)
• examine the factors affecting Balance of Trade
• analyse the trends in India’s Balance of Trade
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10.1 INTRODUCTION
Balance of Trade takes into account only those transactions arising out of the exports
and imports of the visible items, it does not consider the exchange of invisible items such as the
services rendered by shipping, insurance and banking; payment of interest, and dividend or
expenditure by tourists. Therefore Balance of trade is nothing but the difference between the
value of goods exported and imported. A crucial point to note is both goods and services are
counted for exports and imports, as a result of which a nation has balance of trade for goods
(also known as the merchandise trade balance) and a balance of trade for services.
In equation form, the balance of payments is Y = C + I + G + (X – M) which includes all
transactions which give rise to or exhaust national income. The expression in the above equation
denotes the balance. If the difference between X and M is zero, the balance of trade balances.
If X is greater than M, the balance of trade is favourable, or there is surplus balance of trade.
Favourable balance of trade indicates the good economic condition of the economy. On the
other hand, if X is less than M, the balance of trade is in deficit or unfavourable. The difference
between BOP and BOT are as follows:

Balance of Payments Vs Balance of Trade.

Balance of Payments - Balance of Trade
1. It is a narrow term 1. It is a broad term
2. It includes all transactions related 2. It includes only visible items
to visible, invisible and capital transfers
3. It always balances itself 3. It can be favourable or
unfavourable
4. BOP = Current account + Capital 4. BOT = Net earnings on Export
Account + or – Balancing item - Net payment for imports
(errors and omissions)
5. Following are the main factors 5. Following are the main factors
affects BOP affects BOT
a) Conditions of foreign lenders a) Cost of production
b) Economic policy of Government b) availability of raw materials
c) All the factors of BOT c) exchange rate
d) Prices of goods manufactured at home

10.2 FACTORS AFFECTING BALANCE OF TRADE

A country’s balance of trade is influenced by all the factors that affect international
trade. These include; i. Factor endowments and productivity; ii. Trade policy; iii. Exchange
rate; iv. Foreign currency reserves; and v. Inflation and demand.

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10.2.1 Factor Endowments and Productivity
Factor endowments include labour, land and capital. Labour explains the characteristics
of the workforce, land describes the natural resources available and capital resources include
infrastructure and production capacity. For instance, a country like India with an abundance of
unskilled labour produces goods requiring relatively low-cost labour, while a country with
abundant natural resources (like oil exporting countries) likely to export them.
Apart from the abundance of the factors of production in a country, their productivities
are also important. For instance, two countries may have the same amount of labour and land,
but one country may have skilled labour force and highly productive land resources, while the
other has unskilled labour force and relatively low productive land resources. The country
with skilled labour force can generate more production per worker than the country with unskilled
labour. Comparative advantages differ and productive activities also differ. Any country with
skilled labour can take up highly complex productive activities while the country with unskilled
labour force can specialize in simple productive activities. Efficient use of natural resources
can extract more output from the natural endowments.

10.2.2 Trade Policies

Barriers to trade also affect the balance of trade of a given country. Policies that restrict
imports or subsidize exports change the relative prices of those goods, making it more or less
attractive to import or export. For example, subsidies on agricultural imports of fertilizers,
pesticides, spicklers etc. might reduce the cost of production, encouraging more production for
export. Quotas on imports may raise the relative price of imported goods, which reduces demand.
Nations which adopt inward looking policies and have restrictive trade policies, such as high
import tariffs and duties may have longer trade deficits than countries with open trade policies,
since they may be shut out of export markets because of these impediments to free trade.
There are also non-tariff barriers (NTB’s) to trade, some of which are described as new
protectionism measures have grown considerably, particularly since beginning of 1980s. A
study by ADB revealed that the problems of NTBs on Indian exports has been growing. For
example, exports of metal goods and readymade garments from India have suffered on account
of NTBs in developed economies. Examples of NTSs include technical barriers such as health
and safety restrictions and product standards, minimum pricing regulations and the use of price
investigations and price surveillance (World Bank, 1987).

10.2.3 Exchange Rates

When the value of currency is higher in relation to other currencies, it is said to be
overvalued. Opposite is the case of an undervalued currency. Overvaluation of the domestic
currency makes foreign goods cheaper and exports dearer in foreign countries. As a result, the
country imports more and exports less of goods. This leads to unfavourable in balance of
Trade. On the contrary, undervaluation of the currency makes favourable balance of trade for
the country as the exports are encouraging and reducing imports. A domestic currency that has
appreciated significantly may pose a challenge to the cost competitiveness of exporters, who
may find themselves priced out of export markets. This may pressure a nation’s trade balance.

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10.2.4 Foreign Currency Reserves
To compete effectively in extremely competitive international markets, a nation has to
have access to imported machinery that enhances productivity, which may be difficult if forex
reserves are inadequate. Within the major economies running current account deficit, India is
among the largest foreign exchange reserve holder and sixth largest among all countries of the
world (Economic Survey, 2017-2018).

10.2.5 Inflation And Demand

If inflation is running rampant in a country, the price to produce a unit of a product may
be higher than the price in lower – Inflation country. This would affect exports, affecting the
balance of trade .
Demand: Demand for a particular products or services is an important component of
international trade. For example, the demand for oil affects the price and thus the trade balance
of oil exporting and oil importing countries alike. If a small oil importer faces a falling oil
price, its overall imports might fall. The oil exporter, on the other hand might see its exports
fall. Depending on the relative importance of a particular good for a country such demand
shifts can have an impact on the overall balance of trade.

Check Your Progress.

Note: a) Space is given below for writing your answer.
b) Compare your answer with the one given at the end of the unit.
1. Distinguish between Balance of Payments and Balance of Trade.
..........................................................................................................................................
...........................................................................................................................................
2. List the factors which affect the balance of trade of a country.
..........................................................................................................................................
...........................................................................................................................................

10.3 RECENT TRENDS IN INDIA’S BALANCE OF TRADE

Value of foreign trade over the years focuses on the trends in India’s foreign trade.
Value of foreign trade is equal to the value of imports plus exports. The values of the foreign
trade figures presented in table-10.1 have been readjusted to the post devaluation rates of
exchange (devaluation in 1966) to facilitate comparison.

10.3.1 Decadal Variation in the Value of Foreign Trade

Value of imports and exports are added to account for the total value of foreign trade as
stated earlier. As per the figures in table-1, value of foreign trade was Rs.2835 crores in 1960-
61. It increases to Rs.3169 crores in 1970-71 and then to Rs.19,260 crores in 1980-81. From
then onwards, the value of trade increased at a higher pace to Rs.75,751 crores in 1990-91, to
Rs.4,29,663 crores in 2000-01 and to Rs.28,26,389 crores in 2010-11. It touched the peak level

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of Rs.46,33,485 crores in 2014-15 and marginally decreased to Rs.42,06,676 crores in 2015-16
and then increased to Rs.44,27,095 crores in 2016-17. In the first three quarters (April to
December) of 2017-18 the value of foreign trade stood at Rs.36,23,710 crores.

Table – 10.1: Decadal Trends in India’s Foreign Trade (in Rs.)

Year Exports Imports Volume of Trade Trade Balance
1960-1961 1040 2795 2835 - 755
1970-1971 1535 1634 3169 - 99
1980-1981 6711 12549 19260 -5838
1990-1991 32553 43198 75751 - 10645
2000-2001 201356 228307 429663 - 26951
2010-2011 1142922 1683467 2826389 - 540545
2014-2015 1896348 2737087 4633485 - 840739
2015-2016 1716378 2490298 4206676 - 773920
2016-2017 1849429 2577666 4427095 - 728237
2017-2018
(April-Dec) 1441420 2182290 3623710 - 740870
Source: Economic survey Reports, GoI - various issues.
It is clear that in the first two decades, between 1960-61 and 1980-81 value of foreign
trade rose by 579.4 per cent. In other words the increase in 1980-81 is 608 times to the value in
1960-61. Decadal increases between 1980-81 – 1990-91 was 293 per cent while the increase
for 1990-91 – 2000-2001 was 467 per cent. The increase in the following decade ending with
2010-11 was 558 per cent. Increase in the value of foreign trade in 2014-15 over 2010-11 was
63.9 per cent. However there was a decline in 2015-16 by 9.2 per cent. A marginal increase at
5.2 per cent was recorded in 2016-17 over 2015-16. It can be stated that the value of foreign
trade in India has been increasing at a higher rate over the years since 1960-61.

10.3.2 Decadal Growth of Imports

Another significant feature of India’s foreign trade is the ever growing imports. The
total value of imports in 1960-61 was Rs.2795 crores and it increased to Rs.12549 crores in
1980-81 by 349 per cent. Value of imports rose to Rs. 43,198 crores in 1990-91 and to
Rs.2,28,307 crores in 2000-01. The percentages of growth for these two decades were 244 and
428 respectively. Imports further rose to Rs.16,83,467 crores in 2010-11 recording a growth of
637 per cent over 2000-2001. Value of imports touched the peak in 2014-15 at Rs.27,37,087
crores and then marginally decreased in 2015-16 and 2016-17. For the first 9 months of the
fiscal year 2017-18, value of imports stood at Rs.21,82,290 crores. Imports have been increasing
in India due to several factors which include the compelling need to import industrial inputs,
regular import of food grains and edible oil, anti-inflationary imports, periodic hike in the oil
prices and liberal import policy of the government since 1991-92 under Economic Reforms. In
2016-2017 the value of imports was Rs.25,77,666 crores showing a growth rate of 0.35 per
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cent over the previous year. The top five countries from which Indian imports are relatively
more than exports include China, Switzerland, Saudi Arabia, Iran and South Korea.

10.3.3 Decadal Growth of Exports

The growth rate of exports has been sluggish in India over the years. The value of
exports was Rs.1040 crores in 1960-61 and it increased to Rs.6711 crores in 1980-81. The
growth rate was 545.3 per cent for the two decades. Value of exports increased to Rs.32553
crores in 1990-91 and then to Rs.2,61,356 crores in 2000-2001 and the decadal growth rates
were 385 and 518 per cent respectively. Value of exports increased to Rs.11,42,922 by 468 per
cent in 2010-11 over 2000-2001. Exports in 2014-15 were the highest at Rs.18,96,348 crores
and then slightly decreased in 2015-16 to Rs.17,16,378 crores. The value of exports in the First
nine months of 2017-18 was Rs.14,41,420 crores. Indian exports recorded some increase with
the export promotion policies of the government since the devaluation of rupee in 1966. But
the growth in the exports has been inadequate when compared to the growth in imports. This
disparity between exports and imports has widened the trade deficit from year to year.
Unfavorable terms of trade for Indian Agro-based goods, inadequate exportable surplus in the
economy, protection policies of the developed countries, long periods of recession in the
developed countries and regular depreciation of the exchange value of the rupee were the main
factors responsible for the low growth of Indian exports. Further, lack of professionally trained
manpower in export organization, government policies, quality of production, meager
institutional finance to the exporters, export procedures and limited participation in trade fairs
have also been the factors for low growth of exports. Other constraints in this regard include;
lack of export marketing information, inadequate infrastructural facilities, complicated
procedures and inefficient port handling facilities for exports. However, India has surplus
trade balance with USA, UAE, Bangladesh, Nepal and UK implying more exports than imports
to these countries.

10.3.4 Deficit in the Balance of Trade

Higher growth of imports and sluggish growth of exports have led to mounting deficits
in the balance of trade over the years in India. The country has recorded a small surplus only
two times 1972-73 and in 1976-77, ever since 1951. Deficit in the balance of trade was Rs.755
crores in 1961 and it rose to Rs.5838 crores in 1980-81. The increase was 673 per cent. The
increase had been regular in 1990-91 and 2000-2001. The deficit in 2010-11 was Rs.5,40,545
crores recording a growth of 191 per cent over 2000-2001. It reached the maximum level of
Rs.8,40,739 crores in 2014-15 and then decreased marginally to Rs.7,73,92 crores in 2015-16
and to Rs.7,28,237 crores in 2016-17. For the first three quarters in 2017-18 the deficit was
Rs.7,40,870 crores far in excess of the annual deficit of 2016-17. The average annual deficit in
the balance of trade during the First plan was Rs.108 crores and it gradually increased to
Rs.7720 during the seventh plan. The years on deficits in the balance of trade in 2015-16 and
2016-17 have slightly decreased when compared to the deficit in 2014-15. The trend in the
decrease in the deficit due to import compression and export promotion during the Fourth Plan
could not be sustained and economy faced growing deficits in the balance of trade. Recurring
depreciation of the rupee in terms of Dollar has resulted in enhancing the value of imports due
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to which deficits are widening of late, the share of China in India’s trade deficit has increased
from 20.3 per cent in 2012-13 to 43.2 per cent in 2017-18 as most of the Chinese goods are
dumped into the Indian markets. The Indian government is seriously thinking to levy anti-
dumping taxes to counter the Chinese imports.

10.4 TARIFFS
Tariffs in international trade refer to the duties or taxes imposed on internationally traded
commodities when they cross the national borders. Tariff is a very important instrument of trade
protection. Tariffs are generally introduced as a means of restricting trade from particular countries
or reducing the importation of specific types of goods and services. For example, to discourage
the purchase of Italian leather bags, the Indian government could introduce a tariff of 50% that
drives the purchase price of those bags so high that domestic alternatives are much affordable.
The government’s hope is that the added cost will make imported goods much less desirable.

10.4.1 Classification of Tariffs

Tariffs are broadly classified into following four categories:
I. On the basis of the Origin and Destination of the goods crossing the National Boundary:
i. Export Duties: An export duty is a tax imposed on a commodity originating from
the duty – levying country destined for some other country.
ii. Import Duties: An import duty is a tax imposed on a commodity originating abroad
and destined for the duty-levying country.
iii. Transit Duties: A transit duty is a tax imposed on a commodity crossing the national
frontier originating from and destined for other countries.
II. The basis for Quantification of the Tariff:
i. Specific Duties: Specific duty is a fixed amount of duty levied per physical unit of the
commodity imported. For ex: cloth per metre, oil per litre, fertilizers per tone, etc.
ii. Ad-Volrem Duties: It is the most common type of duty. It is levied as a percentage
of the total value of the commodity imported. The import duty is a fixed percentage
of the value (Cost, insurance and freight) of the commodity. Thus specific duty is
based on the quantum of the commodity imported, where as the ad-volorem duty is
based on the value of the commodity imported.
iii. Compound Duties: When a commodity is subject to both specific and ad-valorem
duties, the tariff is generally referred to as compound duty. In this case, units of an
imported commodity are levied a percentage ad-voleram duty plus a specific duty as
each unit of commodity. For instance, a country may impose an import duty on a
car at the fixed rate of Rs.1 lakh + 10% on its price.
iv. Sliding Scale Duty: In this system, the rate of ad-volorem or specific duty increases
with the quantity of commodity imported. For ex: Rs.500/- per piece for first 100
watches, Rs.1000/- per watch for 100 to 500 watches etc.

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III. On the basis of Country-wise Discrimination:
i. Single Column tariff: It is also called as Uni-linear tariff system. In this system, a
uniform rate of duty is imposed on all similar commodities irrespective of the country
from which they are imported.
ii. Double Column Tariff: Under this system, two different rates of duty exist for all
or some of the commodities. Thus, the double-column tariff discriminates between
countries. This system classified into a) general and conventional tariff and b)
Maximum and Minimum Tariff.
a) General and Conventional Tariff: The general tariff is the list of tariffs which is
announced by the government as its annual tariff policy at the beginning of the year.
A country imposes general tariff on imports from all countries other than most
favoured nations and nations with which it has a free trade agreement. The general
tariff is higher tariffs and may harm trade with countries to which it is applied. The
conventional tariff rates are based on trade agreements/commercial treaties with
other countries.
b) Maximum and Minimum Tariffs: Government usually fix two tariff rates for
importing same commodity from different countries. The minimum schedule applies
to those countries who have obtained the concession as a result of the treaty or
through MFN (Most favoured nation) pledge. On the other hand, maximum tariff
rate is imposed on imports from rest of the countries.
iii. Triple-Column Tariff: Under this system, the government usually levied three tariff
rates on each category of commodity viz., general, intermediate and preferential.
The general and intermediate rates are similar to the maximum and minimum rates
mentioned above under the double column tariff system. The preferential rate was
usually applied in the case of trade between the mother country and its colonies.
The preferential rates were levied on goods imported from Britain before
independence which had low rates or were duty free. In recent times, imports among
the SAARC countries carry preferential duties on imports from each other.
IV. On the basis of Purpose: In this type, the tariffs are used for two different purposes- for
revenue and for protection.
i. Revenue Tariff: Revenue tariffs are imposed by the state to obtain revenue.
Generally revenue duties are levied on luxury consumer goods. The lower the import
duties, the larger is the revenue from them. This is because the rise in the price of
the imported goods does not increase much with the imposition of low import duties
and the consumers do not normally shift their demand to other domestically produced
goods.
ii. Protective Tariff: Protective tariff is intended to protect the domestic industries
from foreign competition. The tariff rates in this system to be very high because
only high rates of duty discourage imports to a maximum extent.
iii. Countervailing and Anti-Dumping Duties: Countervailing duty is an additional
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 import duty imposed on imported products (by the importing country) when such
products enjoy benefits like export subsidies and tax concessions in the country of
their origin (i.e. where it is produced and exported). In other words, the additional
duty is levied to raise its price in order to protect producers of the same commodity.
The countervailing duties are also known as anti-subsidy duties imposed under WTO
rules to neutralize the negative effects of subsidies.

10.5 QUANTITATIVE RESTRICTIONS (QUOTAS)

Quantitative restrictions (Quotas) are important means of restricting imports and exports.
A Quota represents a ceiling on the volume of imports/exports. In this section, we will discuss
the Quantitative restrictions on imports, i.e. import quotas.
The import quota means physical limits of the quantities of different products to be
imported from foreign countries within a specified period of time, usually one year. The import
quota may be fixed either in terms of quantity or the value of the product. For example, the
government may specify that 80,000 cars may be imported from Japan. Alternatively, it may
specify that cars of the value of Rs.80 crores can be imported from that country during a given
year. In this way the government may limit the value of imports by providing the importers
with a limited amount of foreign exchange for the purchase of a particular commodity to be
imported by them. For this purpose, the government may issue an import license to the highest
bidder in the open market or many issue the import license on first-cum first-serve basis.
Types of Import Quotas: There are five important types of import quota, including
import licensing. They are briefly explained here under.
1. Tariff Quota: The tariff or customs quota is a widely acclaimed measure. Under this
system a given quantity of a good is permitted to enter duty free or at a relatively low rate
of duty. But imports in excess of this fixed limit are charged a high rate of duty. Thus,
a tariff quota combines the features of a tariff as well as of quota.
2. Unilateral Quota: Under this system, a country unilaterally fixes an absolute limit on
the quantity of import of the commodity concerned during a given period. It is imposed
without prior negotiation with foreign governments. The autonomously fixed quota
may be either global or allocated. Under global quota, the commodity can be imported
from any country upto the full amount of quota. While, under the allocated quota system,
the total quantity of the quota is distributed among specified supplying countries.
3. Bilateral Quota: Under this system, quotas are set through negotiation between the
importing country and the exporting country (or foreign exporting groups).
4. Mixing Quota: This system requires domestic producers in the quota fixing country to
use imported raw materials in certain proportion along with domestic raw materials to
produce finished products. It thus the government sets limits on the proportion of foreign
made raw materials to be imported and used in domestic production.
5. Import Licensing: The mechanism of import licensing has been evolved as a system
devised to administer quota regulations. Under this system, prospective importers are
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 obliged to obtain an import license which is necessary to obtain the foreign exchange to
pay for the imports. Licences are generally distributed among established importers
keeping in view their share in the country’s import trend.

Check Your Progress.

3. Write Four categories of Tariffs.
..........................................................................................................................................
...........................................................................................................................................
4. Write different types of Import Quota.
..........................................................................................................................................
...........................................................................................................................................

10.6 SUMMARY
The balance of trade is the difference between the value of goods exported and imported.
A country’s balance of trade is influenced by all the factors that affect international trade. The
decadal variation in the foreign trade in India reveals that the value of foreign trade has been
increasing at a higher rate over the years since 1960-61. Another significant feature of India’s
foreign trade is the ever growing imports. This is due to the liberal import policy of the
government adopted since 1991-92 under economic reforms. With regards to exports, growth
rate of exports has been sluggish in India over the years. Higher growth of imports and sluggish
growth of exports have led to mounting deficts in the balance of trade over the years in India.
Tariffs and quantitative restrictions(QUOTAS) on imports are important instruments of
trade protection. Several types of tariffs and Quotas are used for different purposes such as
revenue, protection of domestic industries, on the basis of country-wise discrimination and to
discourage the import of unproductive or luxury goods.

10.7 CHECK YOUR PROGRESS – MODEL ANSWERS

1. The difference between balance of payments (BOP) and balance of trade (BOT) are:
1. BOP includes all transactions related to 1. BOT includes only visible
Items visible, invisible and capital
transfers
2. BOP always balances itself 2. BOT can be favourable or
Unfavourable
3. BOP = Current account + Capital 3. BOT = Net earnings on Export
Account + or – Balancing item - Net payment for imports
(errors and omissions)
2. A country’s balance of trade is influenced by all the factors that affect international
trade. These include; i. trade policy; ii. exchange rate; iii. foreign currency reserves; and
iv. inflation and demand.
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3. Tariffs are broadly classified into four categories viz. i. on the basis of the origin and
destination of the goods crossing the national boundary; ii. the basis for quantification
of the tariff; iii. on the basis of country-wise discrimination; and iv. on the basis of
purpose.
4. There are five important types of import quota. They are: i. tariff quota; ii. unilateral
quota; iii. bilateral quota; iv. mixing quota; and v. import licensing.

10.8 MODEL EXAMINATION QUESTIONS

I. Answer the following questions in about 10 lines each.
1. Explain various types of tariffs.
2. What is an import quota? Explain different types of import quotas.
II. Answer the following questions in about 30 lines each.
1. Explain the factors affecting Balance of Trade.
2. Analyse the recent trends in India’s Balance of Trade.
III. One mark questions.
A. Multiple choice Questions.
1. Balance of Trade includes transactions related to:
A) Capital transfers B) Invisable items C) Visible items D) None of the above
2. The percentage increase in the foreign trade between 1960-61 to 1980-81 –
A) 580 per cent B) 250 per cent C) 300 per cent D) 330 per cent
3. The following tax imposed on a commodity crossing the national frontier originating
from and destined for other countries
A) Export duties B) Type of duties C) Transit duties D) Compound duties
4. Revenue duties are levied on
A) Capital goods B) Intermediate goods
C) Luxury consumer goods D) None of the above
5. Under which system a given quantity of a good is permitted to enter duty free and excess
of this fixed limit are charged a high rate of duty?
A) Mixing Quota B) Bilateral Quota C) Unilateral Quota D) Tariff Quota
Answers: 1. C; 2. A; 3. C; 4. C; 5. D
B. Fill in the blanks.
1. Balance of trade takes into account only _________________ items.
2. Balance of Trade = Net earning on Export ________________
3. Undervaluation of the currency makes ___________balance of trade for the country.
4. The value of foreign trade of between 1960-61 and 1980-81 rose by ___________per cent.
5. One of the important factors for increasing import bill __________

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6. India has surplus trade balance with _____, _______ and ________
Answers: 1. Visible 2. Net payment of imports 3. Favourable 4. 579.4 5. hike in the oil prices
6. USA, UAE and Nepal

C. Match the following.

A B
(i) A Country's balance of Trade a) Favourable balance of trade
is influenced by
(ii) Undervaluation of the currancy b) The value of imports plus
makes exports
(iii) Value of foreign trade is equal to c) Factor endowments and
productivity
(iv) In which country Indian imports d) China
are relatively more than exports.
(v) High growth of imports and e) UK
sluggish growth of exports led to
f) Deficits in BOT.
Answers: i) c, ii) a, iii) b, iv) d , v) f

10.9 GLOSSARY
1. Tariffs/Custom Duties: Taxes on imports and exports of a country.
2. Discriminatory Quotas: Quotas which also lay down the sources/source of imports
and/or the importers to whom the Permits are to be issued.
3. Quotas: Upper limits of quantity and/or value of identified export/import items.
4. Quantitative Restrictions: Non-tariff restrictions on exports/imports of a Country.
5. Balance of Trade:The difference between the values of a country’s Imports and exports
for a given period. It’s the most significant component of the current Account in BOP.
6. Favourable Balance of Trade: The value of a nation’s exports in excess of the Value of
its imports.
7. Exchange rate: The price of one currency in terms of another Currency. Visible items:
Visible items in trade are exports and imports of goods like machinery rice, cloth etc.
because they are visible to eyes.

10.10 SUGGESTED BOOKS

H.L. Batia : International Economics
Francis Cherunilayam : International Economics
O.S. Shrivastava : International Economics
BO Sodersten : International Economics

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 BLOCK – V
BALANCE OF PAYMENTS
This block mainly explains the concepts, components, its determinants and reasons
for disequilibrium in the balance of payments. Further, it also discusses the meaning,
significance of exchange rates and the status of foreign exchange market in India.
This block contains the following units:
Unit - 11: Balance of Payments
Unit - 12: Disequilibrium in Balance of Payments – Trends in India's Balance Payments
Unit - 13: Exchange Rates - Foreign Exchange Market in India

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UNIT - 11: BALANCE OF PAYMENTS
Contents
11.0 Objectives
11.1 Concept of Balance of Payments
11.2 Components of Balance of Payments
11.3 Determinants of Balance of Payments
11.4 Equilibrium in Balance of Payments
11.5 Disequilibrium in Balance of Payments
11.6 Summary
11.7 Check Your Progress - Model Answers
11.8 Model Examination Questions
11.9 Glossary
11.10 Suggested Books

11.0 OBJECTIVES
This unit explains the theory of Balance of Payments. After go through this unit, you
will be able to:
• understand the concept of Balance of Payments.
• identify the components of Balance of Payments.
• examine the determinants of Balance of Payments.
• understand the concept of equilibrium, disequilibrium level of Balance of Payments.

11.1 CONCEPT OF BALANCE OF PAYMENTS

All economies have the cross border economic transactions that involve transfer of funds
from one nation to another. Balance of Payments is a statement or record of all monetary and
economic transactions made between a country and the rest of the world within a defined
period (every quarter or year). These records include transactions made by individuals, companies
and the government. Keeping a record of these transactions helps the country to monitor the
flow of money and develop the policies that would help in building a strong economy.
In a perfect scenario, the Balance of Payments should be zero. That is, the money coming
in and the money going out should be balanced. But that doesn’t happen in most cases. A
country’s Balance of Payments statement correctly indicates whether the country has a surplus
or a deficit of funds. The Balance of Payments indicates surplus where a country’s exports are
more than its imports and indicates deficit where a country’s imports are more than exports. An
account of all receipts and payments is termed as Balance of Payments.

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 According to Kindle Berger, “The balance of payments of a country is a systematic
record of all economic transactions between the residents of the reporting country and residents
of foreign countries during a given period of time”.
In the words of Benham, “Balance of payments of a country is a record of the monitory
transactions over a period with the rest of the world”.
According to Bo Sodersten, “the balance of payments is nearly a way of listing receipts
and payments in international transactions for a country”
The balance of payment record is maintained in a standard double-entry book-keeping
method. International transactions enter in to the record as credit or debit. The payments received
from foreign countries enter as credit and payments made to other countries as debit.
Balance of Payment is a record pertaining to a period of time; usually it is all annual
statement. All the transactions entering the balance of payments can be grouped under three
broad accounts are (1) Current Account; (2) Capital Account; and (3) Official Reserve Assets
Account.
Structure of Balance of Payment (BOPs): The following table-11.1 shows the structural
format of receipts and payments.
Receipts (Credits) Payments (Debits)
1) Exports of goods 1) Imports of goods
2) Exports of services 2) Imports of services
3) Interest, profits and dividends received 3) Interests, profits and dividends paid
4) Unilateral receipts 4) Unilateral payments
Current Account Balance (1 to 4)
5) Foreign investments 5) Investments abroad
6) Short term borrowing 6) Short term lending
7) Medium and long term borrowing 7) Medium and long term lending
8) Statistical discrepancies (Errors and Omission)
Capital Account Balance (5 to 8)
9) Change in reserves (+) 9) Change in reserves
Total Receipts = Total Payments
1. Current Account Balance: The current account includes export of services, interests,
profits, dividends and unilateral receipts from abroad, and the import of services, interests,
profits, dividends and unilateral Payments to abroad. There can be either surplus or
deficit in current account. The deficit will takes place when the debits are more than
credits and the surplus will takes place when the debits are less than credits. Trade account
is the part of Current Account. It is the difference between exports and imports of goods,
usually referred as visible or tangible items. It tells as whether a country enjoys a surplus
or deficit on that account. The Balance of Trade is also referred as the ‘Balance of

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 Visible Trade’ or ‘Balance of Merchandise Trade’. It is the difference between the receipts
and payments on account of current account which includes trade balance.
2. Capital Account Balance: It is difference between the receipts and payments on account
of capital account. The capital account involves inflows and outflows relating to
investments, short term, medium and long term borrowing/lending. There can be surplus
or deficit in capital account. The surplus will take place when the credits are more than
debits and the deficit will take place when the debits are more than credits.
3. Official Reserve Assets Account: Official Reserve Assets Account (Check item No.9 in
above figure (table) shows the reserves which are held in the form of foreign currencies
usually in hard currencies like dollar, pound etc., gold and Special Drawing Rights (SDRs).
These reserves are analogous to an individual’s holding of cash. They increase when the
individual has a surplus in his transactions and decrease when he has a deficit. When a
country enjoys a net surplus both in current account & capital account, it increases Official
Reserve Assets. Therefore Official Reserve Assets are used to meet the deficit in the balance
of payments. The entry is in the receipt side as we receive the FOREX for the particular
year by reducing the balance from the reserves. When surplus is transferred to the Official
Reserve Assets, it is shown as minus in that particular year’s balance of payment account.
The minus sign (-) indicates an increase in FOREX and plus sign (+) shows the borrowing
of foreign exchange from the Official Reserve Assets account to meet the deficit.

Errors and Omissions

The errors may be due to statistical discrepancies whereas the omission may be due to
certain transactions may not be recorded. For example: A remittance by an Indian working
abroad to India may not yet recorded, or a payment of dividend abroad by an MNC operating in
India may not yet recorded or so on. The errors and omissions amount equals to the amount
necessary to balance both the sides.

11.2 COMPONENTS OF BALANCE OF PAYMENTS

According to the broad nature of the transactions concerned, the Balance of Payments of
a country is divided into the following three parts: 1. Current Account; 2. Capital Account; and
3. Official Reserve Account.
The schematic BOPs can be identified as mentioned in the Table-11.2:
A. Current Account B. Capital Account C. Balancing Item D. Official Reserve
Account
1. Merchandise Trade a) Long term capital Net Errors and
a) visible exports transactions Omissions
b) Invisible imports b) Short term capital
2. Invisible Trade transactions
a) Invisible exports
b) Invisible imports
3. Other Flows
a) Investment income
b) Unrequited transfers
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(1) The Current Account: The current account of Balance of Payments includes all
transaction arising from trade in currently produced goods and services, from income
accruing to capital by one country and invested in another and from unilateral transfers,
both private and official. The four major components of current account are as follows:
i. Visible Trade: This is the net of export and imports of goods (visible items). The balance
of this visible trade is known as the trade balance. There is a trade deficit when imports
are higher than exports and a trade surplus when exports are higher than imports.
ii. Invisible Trade: This is the net of exports and imports of services (invisible items).
Transactions mainly constitute of shipping, IT, banking and insurance services.
iii. Unilateral transfers to and from abroad: These refer to payments that are not factor
payments. These are ‘one-way’ transactions. For examples, gifts or donations sent to the
resident of a country by a non-resident relative.
iv. Income receipts and payments: These include factor payments and receipts. These are
generally rent on the property, interest on capital and profits on investments.
The current account is usually divided in three sub-divisions, which were clearly presented
in table-11.2.
The first of these is called visible account or merchandise account or trade in goods
account. This account records imports and exports of physical goods. The balance of visible
exports and visible imports is called balance of visible trade or balance of merchandise trade
[i.e., items 1(a), and 2(b) of table-11.2].
The second part of the account is called the invisibles account since it records all exports
and imports of services. The balance of these transactions is called balance of invisible trade.
As these transactions are not recorded in the customs office unlike merchandise trade we call
them invisible items. It includes freights and fares of ships and planes, insurance and banking
charges, foreign tours and education abroad, expenditures on foreign embassies, transactions
out of interest and dividends on foreigners’ investment, and so on. Items 2(a) and 2(b) comprise
services balance or balance of invisible trade. The difference between merchandise trade and
invisible trade (i.e., items 1 and 2) is known as balance of trade.
The third one is the flows in current account that consists of two items [3(a) and 3(b)].
Investment income consists of interest, profit and dividends on bonus and credits. These items
are such that no reverse flow occurs. Or these are the items against which no quid pro quo is
demanded. Residents of a country receive this cost free. Thus unilateral transfers are one way
transactions. In other words, these items do not involve give and take unlike other items in the
Balance of Payments account.
Thus, the first three items of the Balance of Payments account are included in the current
account. The current account is said to be favorable Balance of Payments if receipts exceed
than payments. Unfavourbale of payments if payments exceed than receipts.
(2) The Capital Account: The capital account shows transactions relating to the international
movement of ownership of financial assets. It refers to cross-border movements in foreign
assets like shares, property or direct acquisitions of companies’ bank loans, governments’
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securities, etc. In other words, capital account records export and import of capital from and to
foreign countries.
The capital account is divided into two main subdivisions one is the short term B (a) and
another is the long term B (b) movements of capital in flow table-11.2. A short term capital is
one which matures in one year or less, such as bank accounts. A long term capital is one whose
maturity period is longer than a year, such as long term bonds or physical capital. Long term
capital account is, again of two categories: direct investment and portfolio investment. Direct
investment refers to expenditure on fixed capital formation, while portfolio investment refers
to the acquisition of financial assets like bonds, shares, etc.
The capital account is used to finance the deficit in the current account or absorb the
surplus in the current account. The three major components of capital account:
i. Loans to and borrowings from abroad – These consist of all loans and borrowings
given to or received from abroad. It includes both private sector loans as well as the
public sector loans.
ii. Investments to/from abroad - These are investments made by nonresidents in shares in
the home country or investment in real estate in any other country.
iii. Changes in foreign exchange reserves - Foreign exchange reserves are maintained by
the central bank to control the exchange rate and ultimately balance the BOP if it is not.
(3) Official Reserve Asset Account: In table-11.2, the total of A, B, C and D comprise the
overall balance. The category of official reserve account covers the net amount of transactions
by the government. This account covers purchases and sales of reserve assets such as gold,
convertible foreign exchange and Special Drawing Rights by the central monetary authority.

Now we can summarize the Balance of Payments data:

Current account balance + Capital account balance + Reserve balance = Balance of
Payments (X – M) + (CI – CO) + FOREX = BOP
X is exports, M is imports, CI is capital inflows, CO is capital outflows, FOREX is
foreign exchange reserve balance.

Statistical Discrepancy or Errors and Omissions:

The sum of A and B (flow chart-11.1) is called the basic balance. Since BOP always
balances in theory, all debits must be offset by all credits and vice versa. In practice, rarely it
happens particularly because statistics are incomplete as well as imperfect. That is why errors
and omissions are considered so that BOP accounts are kept in balance (Item C).

Check Your Progress.

Note: a) Space is given below for writing your answer.
b) Compare your answer with one given at the end of the unit.
1. What is the Balance of Payments made up of?
..........................................................................................................................................
...........................................................................................................................................
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2. What is capital account in balance of payment?
..........................................................................................................................................
...........................................................................................................................................
3. What is current account in BOP?
..........................................................................................................................................
...........................................................................................................................................

11.3 DETERMINANTS OF BALANCE OF PAYMENTS

The balance of payments can be affected on two accounts, which briefly explained below:

I. Factors Affecting the Current Account

A country’s current account balance can significantly change its national economy. The
most important factors affecting current account are:
1. Inflation
2. National Income
3. Government Restrictions
4. Exchange Rates.
1. Inflation: If a country’s inflation rate increases relative to the other countries with which
it trades, its current account would be expected to decline. Due to higher prices at home,
consumers and corporations within the country are most likely to purchase more goods
and services overseas (due to high local inflation), while the country’s exports to other
countries will fall.
2. National Income: If the national income of a country rises by a higher percentage than
those of other nations, its current account is expected to decline, other things being
same. As the real income level (adjusted for inflation) rises, so does consumption of
goods also rises. A percentage of that increase in consumption of goods will most likely
reflect an increase in demand for the foreign nation goods.
3. Government Restrictions: If a country’s government imposes a particular type of tax
(often referred to as a tariff tax) on imported goods from foreign countries, the price of
foreign goods to consumers effectively increases. An increase in prices of imported goods
relative to goods produced at domestic country will discourage imports and is expected
to increase its current account balance. In addition to tariffs, a government may reduce
its imports by enforcing a quota, or a maximum limit on imports.
4. Exchange Rates: The value of a country’s currency regarding other currencies is called
the exchange rate. Changes in a currency’s exchange rate brought about by market forces
or actions by national government or government of other countries will influence a
country’s current account balance. An appreciation in a country’s exchange rate vis-a-
vis another country’s currency, other things being equal, is likely to lead to a decline in
the country’s exports and increase in imports.
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 For example, if the exchange rate between Indian Rupee and US Dollar changes from
Rs. 50 to $1 to Rs. 40= $1, the US importer has to pay $25, whereas earlier he would have paid
only Rs. 800 to buy $20 worth of US goods, whereas earlier he would have paid only Rs. 800
to buy $20 worth of goods, whereas earlier he would have spent Rs. 1000. Thus, if Rupee
appreciates in value in vis-a-vis US Dollar, exports are likely to be hit, and imports are likely to
grow. The opposite will be the impact of depreciation on the exchange rate of a country’s
currency, i.e. it is likely to lead to growth in exports and decline in imports.

II. Factors Affecting the Capital Account

Government policies will also change the capital account. A country’s government could,
for example, impose a special tax on income account by local investors who invested in foreign
markets. A tax would discourage people from investing abroad and could, therefore, increase
the country’s capital account. Capital flows are also influenced by capital controls of various
types. Interest rates also affect the capital flows. A hike in interest rates relative to other countries
may affect capital inflows from overseas countries. Conversely, a reduction in domestic interest
rates may induce people to invest overseas.
The anticipated exchange rate movements by investors in securities can affect the capital
account of the country. If a home currency is expected to strengthen, foreign investors may be
willing to invest in the country’s securities to benefit from the currency government. Conversely,
a country’s capital account balance is expected to decrease, if its home currency is expected to
weaken, then other things being equal.
When attempting to assess why a nation’s capital account changed and how it will change
in future, all factors must be considered all together. A country may experience a reduction in
capital account even when its interest rates are attractive to the public if the domestic currency
is expected to depreciate its value.

11.4 EQUILIBRIUM IN BALANCE OF PAYMENTS

The equilibrium of balance of international payment is a statement that takes into an account
the debits and credits of a country on international account during a calendar year. When a country
has unfavourable or adverse balance of payments, it is regarded as herald of disaster because the
country by having deficit in its balance of payments either decreases her balances abroad or
increases her foreign debits. When it has favourable credit balance, it is considered that the country
is heading towards prosperity because by having surpluses, it either increases her foreign credits
or reduces her foreign debits. There is no doubt that a study of country’s balance of payment
reveals much information about its economic position and development of the country. But when
we are to see that a country is heading towards financial bankruptcy or higher standard of living,
we are to examine the balance of payments of many years of that country.
A persistent deficit in the balance of payments on current account certainly leads to
economic and financial bankruptcy. A continued favourable balance on current account is also
disadvantageous because it creates difficulties for other countries. The credit country may
utilize her surplus in advancing short or long term loans to the debtor country. But if it gives no

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opportunity to the debtor country to repay the loan by exporting more, then how can the loans
to be realized.
The hard earned surplus of the credit country will then one day be turned into gifts and
this may create political difficulties for the creditor country. We have seen, thus that a country
should neither have unfavourable nor favourable balance of payment on current account in
perpetuity. It must obtain equilibrium in her balance of payments over a reasonable period of
time. From this it may not be concluded that a country should balance her account every year
with every country with which it has trade relations. A country may have favourable balance of
payment with one country and unfavourable with another but in the long run it must balance
her account. The total liabilities and total assets of all nations related to one currency block
must balance over a reasonable period of time.

11.5 DISEQUILIBRIUM IN BALANCE OF PAYMENTS

Balance of international payment is a summary account of total debits and credits of a
country during a year. It includes both visible and invisible trading terms, i.e., merchandize
imported and exported, interest on dividend received and paid, payments and receipts of transport
services, commission, insurance, brokerage, etc., received and paid money lent abroad or
borrowed, movement of gold, etc. Disequilibrium in the balance, of payments can arise due to
persistently one sided movement of one or more than one trading terms. If, for instance, the
total value of goods exported exceeds the total value of the goods imported over a given period
and this surplus is not offset by the debit balance on invisible item, the country will have
favourable balance of payments. Disequilibrium in the balance arises when exports of a country
fall short of imports because of decrease in production at home, due to stiffer competition
abroad or of an appreciation in the currency or fall of purchasing power of the buyers in the
foreign market. When the imports remain unaffected or increase, then the country will also
face deficit in her balance on invisible items, the country will have disequilibrium in her balance
of payments. Disequilibrium in her balance of payments can also arise over a given period due
to excessive imports not equalized by exports of invisible items and if it is not offset by credit
balance on visible items, the country will face disequilibrium in her balance of payment.

Check Your Progress.

4. Identify the factors effecting current account.
..........................................................................................................................................
...........................................................................................................................................

11.6 SUMMARY
All economies have cross border economic transactions that involve transfer of funds
from one nation to another. Balance of Payment is a statement or record of all monetary and
economic transactions made between a country and the rest of the world within a defined
period (every quarter or year). In a perfect scenario, the Balance of Payments should be zero.
That is, the money coming in and the money going out should balance out. But that doesn’t
176
happen in most cases. A country’s Balance of Payment statement correctly indicates whether
the country has a surplus or a deficit of funds. The Balance of Payments indicates surplus
where a country’s exports are more than its imports and indicates deficit where a country’s
imports are more than exports. Most of the exports and imports involve finance i.e. receipts
and payments in money. An account of all receipts and payments is termed as Balance of
Payments. The balance of payment record is maintained in a standard double-entry book-keeping
method. International transactions enter in to the record as credit or debit. The payments received
from foreign countries enter as credit and payments made to other countries as debit. Balance
of Payment is a record pertaining to a period of time; usually it is all annual statement. All the
transactions entering the balance of payments can be grouped under three broad accounts; (1)
Current Account, (2) Capital Account, and (3) Official Reserve Assets Account.
Government policies will also change the capital account. The equilibrium of balance of
international payment is a statement that takes into accounts the debits and credits of a country
on international account during a calendar year. When a country has unfavourable or adverse
balance of payments, it is regarded as herald of disaster because the country by having deficit
in her balance of payments either decreases her balances abroad or increases her foreign debits.
When it has favourable credit balance, it is considered that the country is heading towards
prosperity because by having surpluses, it either increases her foreign credits or reduces her
foreign debits.

11.7 CHECK YOUR PROGRESS - MODEL ANSWERS

1. These transactions consist of imports and exports of goods, services and capital, as well
as transfer payments such as foreign aid and remittances. A country’s balance of payments
and its net international investment position together constitute its international accounts.
2. The balance of payments of a country contains two accounts: current and capital. The
current account records exports and imports of goods and services as well as unilateral
transfers, whereas the capital account records purchase and sale transactions of foreign
assets and liabilities during a particular year
3. The current account is a country’s trade balance plus net income and direct payments.
The trade balance is a country’s imports and exports of goods and services. The current
account also measures international transfers of capital
4. The most important factors affecting current account are: 1. Inflation; 2. National Income;
3. Government Restrictions; and 4. Exchange Rates.

11.8 MODEL EXAMINATION QUESTIONS

I. Answer the following questions in about 10 lines each.
1. What does a current account deficit do that is positive for a nation?
2. Why are statistical discrepancies in the balance of payments so large?
3. Distinguish between covered and uncovered interest arbitrage.

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4. What is the interest rate parity condition?
5. When the disequilibrium in BOPs arises?

II. Answer the following questions in about 30 lines each.

1. Describe the factors that can contribute to a country’s Current Account deficit?
2. Explain the components of the current account and the capital account.
3. “A current account deficit is not necessarily a bad thing” Discuss.
4. Define and distinguish spot, forward and swap transactions. What is each likely to be
used for?

III. One mark questions.

A. Multiple choice questions.
1. A statement that summarizes an economy’s transactions with rest of world for a specified
time period is known as
a. transfer payments b. balance sheet c. balance of payments. d. summary statement
2. Balance of payments of a country includes:
a. current account b. monetary account c. capital account d. all of above
3. BoP (Balance of Payment) refers to:
a. transactions in the flow of capital
b. transactions relating only to exports and import
c. transactions relating to receipts and payment of invisibles
d. systematic record of all its economic transactions between residents and with the rest
of the world in a certain period.
4. A situation where total credits equals to total debits for a particular measure of the balance
of Payments are
a. balance of trade b. BOP adjustment c. BOP equilibrium d. current account
5. A measure of net flows of goods, services and net transfers between a country and the
rest of the World is
a. balance of trade b. capital account activities
c. current account d. current account balance
6. Invisible items in balance of payments includes:
a. foreign remittances b. income from tourists c. internet charges d. all the three
Answers: 1. c; 2. d; 3. d; 4. c; 5. d; 6. d.

B. Fill in the blanks.

1. IMF represents..................................
2. A statement that summarizes an economy’s transactions with rest of world for a specified
time period is known as....................................
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3. A country that does not trade with other countries is called .......................
4. The difference between a country’s merchandise exports and its merchandise imports
during a given period of time……………………….
5. …………….. reflect the various transactions a country undertakes in the exchange of
financial assets and liabilities with the rest of the world (physical or financial assets).
Answers: 1. International Monetary Fund; 2. Balance of Payments; 3. Closed economy;
4. Balance of trade; 5. Financial account activities.

11.9 GLOSSARY
1. Balance of payments: The balance of payments is a statistical summary of the transactions
of a given economy with the rest of the world.
2. Components of Balance of payment: The balance of payments consists of three main
components -current account, capital account, and financial account.
3. Current Account: The current account monitors the flow of funds from goods and
services trade (import and export) between countries.
4. Capital Account: The capital account monitors the flow of international capital
transactions.
5. Financial Account: The financial account monitors the flow of funds pertaining to
investments in businesses, real estate, and stocks. It also includes government-owned
assets such as gold and Special Drawing Rights (SDRs) held with the International
Monetary Fund (IMF).

11.10 SUGGESTED BOOKS

1. H.L. Batia : International Economics
2. Francis Cherunilayam : International Economics
3. O.S. Shrivastava : International Economics
4. BO. Sodersten : International Economics

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UNIT-12: DISEQUILIBRIUM IN BALANCE OF
PAYMENTS – TRENDS IN INDIA'S BALANCE
OF PAYMENTS
12.0 Objectives
12.1 Introduction
12.2 Measurement and Determination of Disequilibrium
12.3 Different Kinds of Disequilibrium
12.4 Causes for Fundamental Disequilibrium
12.5 Different Methods of Correcting Disequilibrium
12.5.1 Automatic Measures
12.5.2 Deliberate Measures
12.6 Trends in India’s Balance of Payments
12.7 Summary
12.8 Check Your Progress – Model Answers
12.9 Model Examination Questions
12.10 Glossary
12.11 Suggested Books

12.0 OBJECTIVES
After completion of this unit, you will be able to:
• explain the measurement and determination of disequilibrium.
• indentify the different kinds and causes of disequilibrium.
• understand the different methods of correcting disequilibrium. and
• analyze the trends in India’s Balance of payments.

12.1 INTRODUCTION
In this unit an attempt has been made to explain the causes and forms of disequilibrium
in balance of payments and also to understand the different methods which can be employed
for correcting the disequilibrium in the balance of payments. Finally we also be looking into
the trends in India’s balance of payments in recent years and also analyze those trends with
relevance to the present economic situation in the country.

12.2 MEASUREMENT AND DETERMINATION OF

DISEQUILIBRIUM
The international BOP of a country may be in balance in the sense of equality between
total payments and total receipts. More generally, however, it shows either a surplus or deficit. By
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a deficit or surplus in the BOP is usually meant gold movements plus accommodating capital
movements. Hence to measure and determine the actual extent of disequilibrium in the BOP, all
the transactions in the BOP has to regroup into autonomous and accommodating transactions.
The autonomous transactions in the BOP take place regardless of the size of other
items in the BOP. They occur independently by the market mechanism i.e. supply and demand
forces. The category of autonomous receipts would include all merchandise exports, services,
gifts, normal capital flows determined by interest and profit rate (differentials). For example
sale of securities in a foreign country and purchase of securities with the proceeds of the former
in the reporting country because the yield of the second is higher than the first one is an example
of autonomous capital receipts.
On the other hand the accommodating transactions are those which are necessary to
finance the deficit or surplus in the BOP. They may be made by private persons or public
authorities. They may be automatic or planned and foreseen. They take place because other
items in the BOP leave a gap to be filled in accommodating receipts include depletion of
foreign currency reserves of the reporting country, in order to meet increased import demand.
Receipt of funds by the reporting country from foreign governments, either by way of loan or
gift for securing foreign exchange to meet the existing imbalance in the BOP. This may be
made clear with the following statement.

Table-12.1: Autonomous and Accommodating Transactions (Rs. in Crores)

S.No. Receipts S.No. Payments
1 Autonomous receipts 3 Autonomous payments
a) Autonomous exports a) Autonomous imports Rs. 1080
(Visible & Invisible) Rs. 960 b) Autonomous unrequited Rs. 25
b) Autonomous unrequited c) Autonomous capital payments Rs. 40
receipts Rs.20
c) Autonomous capital
receipts Rs. 40
2 Accommodating receipts 4 Accommodating payments
a) Accommodating exports Rs.30 a) Accommodating exports
b) Accommodating unrequited b) Accommodating unrequited
receipts Rs. 50 payments Rs. 15
c) Accommodating capital c) Accommodating capital
receipts Rs. 100 payments Rs. 40
Total Receipts: 1200 Total Payments: 1200

From the above table12.1, it is found that, the balance of autonomous trade shows a
deficit of Rs. 120 crores (960-1080) and the balance of autonomous transfers shows a further
deficit of 5 crores (20+40 – 25+40). The combined deficit in the BOP is the value of Rs. 125
crores and to meet this deficit the balance of accommodating items shows a surplus of Rs. 125
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crores. Thus, the deficit is wiped out. So the BOP deficit is measured by the deficit in autonomous
trade and transfers. This must be matched by accommodating finance.
The above analysis reveals that a nation’s international BOP is in equilibrium when the
autonomous supply of and the autonomous demand of foreign exchange are equal.
Disequilibrium in a country’s external BOP appears either as a surplus or deficit. The BOP
disequilibrium, if favorable when the difference between the autonomous supply of and the
autonomous demand for foreign exchange is positive. When this difference is negative, the
disequilibrium is unfavorable.

12.3 DIFFERENT KINDS OF DISEQUILIBRIUM

The balance of payments is said to be in disequilibrium if the deficit in the current
account is not offset by a surplus in the capital account or a surplus in the current account by a
deficit in the capital account.
The following are the main kinds of disequilibrium in the balance of payments.
1. Cyclical Disequilibrium: It occurs on account of business cycles. Depending upon
the phases of trade cycles like prosperity and depression, demand forces vary, causing changes
in the terms of trade as well as growth of trade and accordingly, a surplus or deficit will result
in the balance of payments. Cyclical disequilibrium occurs either because the patterns of business
cycles in different countries follow different path or because income elasticity’s of demand for
imports in different countries are different.
2. Secular Disequilibrium: When an economy moves from one stage to another of
development, a deep-rooted, long–seated disequilibrium takes place. It may be caused by a
number of factors such as capital formation, technological change growth of population, growth
of markets and changes in resources etc.
3. Structural Disequilibrium: It emerges on account of structural changes in some
sectors of the economy at home or abroad which may alter the demand or supply relations of
export or imports or both. Actual deficit is measured by the extent of accommodating finance
required to meet the deficit. There are no restrictions imposed. Potential deficit is measured by
the amount of accommodating finance which could have been necessary to be provided without
the use of controls. Such controls range from depreciation of the exchange rate, imposition of
import restrictions following of suitable internal policies. Further, time element is important in
measuring disequilibrium in balance of payments.
4. Temporary Disequilibrium: Random or temporary type of factors may lead to a
temporary disequilibrium in the balance of payments. For e.g. floods, droughts and outbreak of
war, etc.
5. Short-term Disequilibrium: The deficit may be of short-run or long run nature.
Sometimes, any deficit may be met by inflow of short-term funds attracted by interest rate
differentials. If circumstances which attracted capital are temporary, the capital may outflow,
and the deficit would appear.

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 6. Long-term Disequilibrium: Hence, any deficit may have to be viewed with reference
to their variations over a long period to eliminate random and seasonal fluctuation. It is this
deficit which is of serious nature, which deserves the attention of any government to be
equilibrated.
7. Fundamental Disequilibrium: When disequilibrium in the BOP continued for a long
time and there is no expectation now or in the future, that the new factors revealed in the BOP
are likely to disappear, it is defined as a case of fundamental or permanent disequilibrium.
Actually most of the non-oil developing countries, including India are facing the problem of
fundamental or permanent disequilibrium in their balance of payment accounts.

12.4 CAUSES FOR FUNDAMENTAL DISEQUILIBRIUM

The causes of disequilibrium differ from country to country, and time to time within a
country. The main causes are economic, political and social in nature. In addition to the above
mentioned structural, cyclical and monetary causes, the other economic causes are developmental
programmes, demonstration effect, natural causes, cyclical fluctuations, income and inflation,
globalization, and growth of population.

ECONOMIC CAUSES
1. Developmental Programmes: Developing countries which have embarked upon
planned development programmes require to import capital goods, some raw materials which
are not available at home and highly skilled and specialized manpower. Since development is a
continuous process, imports of these items continue for a long time landing these countries in
a balance of payment deficit.
2. Demonstration Effect: When the people in the less developed countries imitate the
consumption pattern of the people in the developed countries, their import will increase. Their
export may remain constant or decline causing disequilibrium in the balance of payments.
3. Natural Factors: Natural Calamities like famines, droughts, earthquakes, floods etc.
cause disequilibrium in balance of payment. Imports of a country multiply under the impact of
these calamities leading to disequilibrium in balance of payments. Natural calamities such as
the failure of rains or the coming floods may easily cause disequilibrium in the balance of
payments by adversely affecting agriculture and industrial production in the country. The exports
may decline while the imports may go up causing a discrepancy in the country’s balance of
payments.
4. Cyclical Fluctuations: Business fluctuations introduced by the operations of the trade
cycles may also cause disequilibrium in the country’s balance of payments. For example, if there
occurs a business recession in foreign countries, it may easily cause a fall in the exports and
exchange earning of the country concerned, resulting in a disequilibrium in the balance of payments.
5. Inflation: An increase in income and price level owing to rapid economic development
in developing countries, will increase imports and reduce exports causing a deficit in balance
of payments asked their surplus. The poor marketing facilities of the developing countries have
pushed them into huge deficits.
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 6. Flight of Capital: Due to speculative reasons, countries may lose foreign exchange
or gold stocks People in developing countries may also shift their capital to developed countries
to safeguard against political uncertainties. These capital movements adversely affect the balance
of payments position.
7. Globalization: Due to globalization there has been more liberal and open atmosphere
for international movement of goods, services and capital. Competition has been increased due
to the globalization of international economic relations. The emerging new global economic
order has brought in certain problems for some countries which have resulted in the balance of
payments disequilibrium.
8. Growth of Population: Due to rapid increase in population, aggregate consumption
demand in under developed countries increase. Consequently, export surplus falls down and
balance of payments becomes adverse. Most countries experience an increase in the population
and in some like India and China the population is not only large but increases at a faster rate.
To meet their needs, imports become essential and the quantity of imports may increase as
population increases. Consequently, imports of goods increase and the capacity to export
decreases. In over populated countries, marginal productivity of labor is almost zero or may be
negative. This will create disequilibrium in the BOP of less developed countries.
9. Economic Development Plans: Heavy dose of investment is main cause of
disequilibrium in balance of payments. Developing countries have to depend on developed
foreign countries for their economic development.
10. Political Causes: Political instability of the country may also have adverse affect on
the balance of payments of country. If the international relations of a country are full of tension,
this may have unfavorable effects on the balance of payments. Certain political factors also
produce BOP disequilibrium Factors like war or changes in the world trade routes.
11. Social Causes: social factors like changes in the tastes, preferences and fashions
may effect imports and exports and there by affect the BOP.

12.5 DIFFERENT METHODS OF CORRECTING

DISEQUILIBRIUM
There are a number of measures available for correcting the BOP disequilibrium. They
are two broad groups, namely, automatic measures and deliberate measures.

12.5.1 Automatic Measures

According to the classical economists, any disequilibrium in BOP is corrected
automatically without any corrective measures by the government. This method worked well
under gold standard. The BOP disequilibrium may, however, be automatically corrected under
the paper currency standard also. The theory of automatic correction is that, if the market
forces of demand and supply are allowed to have free plans, in course of time, equilibrium will
be automatically restored. As these conditions are not completely prevailing in the real word,
such an automatic adjustment is not possible. Hence when there is a deficit in the BOP.
Government has to immediately act to introduce deliberate corrective measures.
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12.5.2 Deliberate Measures
The various deliberate measures may be broadly grouped into monetary measures, trade
measures and miscellaneous. The different Monetary Measures are monetary contractions,
devaluation, exchange depreciation and exchange control.
Monetary Contractions: Under monetary contraction, the level of aggregate domestic
demand, domestic price level and the demand for imports and exports may be influenced by
contraction or expansion of money supply so that BOP disequilibrium may be corrected.
Contraction of money supply is likely to reduce the purchasing power and thereby the aggregate
demand. It is also likely to reduce domestic prices. The fall in the domestic aggregate demand
and domestic prices reduces the demand for imports. The fall in domestic prices likely to
increase the exports. Thus the fall in imports and rise in exports would help to correct the
disequilibrium.
Deflation: Deflation refers to that monetary policy under which the volume of currency
is reduced; consequently prices and monetary income of the people are brought down. In India,
Reserve Bank of India, the Central Bank contracts the volume of credit in the economy by
using quantitative and qualitative methods of credit control. (raising the bank rate and open
market operations).
Devaluation: Devaluation means the reduction of the official rate at which the currency
is exchanged for another currency. Devaluation is that monetary measure under which
government of a country lowers the value of it currency in terms of foreign currencies. Therefore,
imports become dearer and exports cheaper. In this way adverse BOP is corrected.
Exchange Depreciation: If in the international sphere, rate of exchange is flexible,
government need not resort to policy of devaluation. Under flexible rate of exchange, in case of
adverse BOP, rate of exchange goes down automatically, as a result, export will increase and
adverse BOP will be corrected.
Exchange Control: Exchange control is a popular method employed in influence the
BOP position of a country. Under exchange control, the government or central bank assumes
complete control over the foreign exchange reserves and earnings of the country. The recipients
of foreign exchange, like exports are required to surrender foreign exchange for domestic
currency. By virtue of its control over the use of foreign exchange the government can control
imports. Central Bank of the country exclusively controls the use of foreign exchange. Without
the permission of RBI, foreign exchange is not made available to anyone. Thus imports are
restricted and controlled under this method and balance of payments of the country is corrected.
Trade Measures: The different trade measures are import duties, export promotion,
encouragement to foreign investment, attraction to foreign tourists, social measures.
Import Duties: To discourage imports, their value is raised by levying new import duties.
In this way, imports become dearer but their demand also goes down and consequently adverse
BOP will be corrected.
Export Promotion: By raising the export, adverse BOP will be corrected. All duties and
restriction should be withdrawn and export industries be given special concession and facilities.
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Intensively publicity and advertisement should be undertaken to increase the demand for
domestic product in foreign countries.
Encouragement to Foreign Investment: Investment of foreign capital in the county
constitutes a credit item and so has a favorable effect on the balance of payment position.
Attraction to Foreign Tourists: In order to attract tourists, government has to develop
recreation parks and entertainment programmes. Foreign tourists bring along with them large
amount of foreign currency which serves the same purpose as the exports.
Social Measures: Balance of Payment can be corrected through the medium of social
psychology. Awakening of Swadeshi spirit had adversely affected the BOP of British India.
Presently import of petrol and petroleum product is one the major causes of adverse balance of
payment of India. If social awareness is aroused the people to make economical use of petrol,
it will have a salutary effect on the balance of payment.
Trade measures include export promotion measures and measures to reduce imports.
Exports may be encourages by reducing or abolishing export duties, providing export subsidy,
encouraging export production and export marketing by giving monetary, Fiscal, physical and
institutional incentives and facilities. On the other hand, imports may be controlled by imposing
or enhancing import duties, restricting imports through import quotas, licensing and even
prohibiting altogether the import of certain inessential items.
A part from the above mentioned monetary and trade measures there are number of other
miscellaneous measures like foreign loans, incentives for foreign investment, tourism
development, infectivity for inward remittances and import substitution to correct the deficits
in the BOP of a country.

Check Your Progress.

Note: a) Space is given below for writing your answer.
b) Compare your answer with one given at the end of the unit.
1) State the importance of Balance of Payments.
..........................................................................................................................................
...........................................................................................................................................
2) What are the causes of disequilibrium of Balance of payments?
..........................................................................................................................................
...........................................................................................................................................

12.6 TRENDS IN INDIA’S BALANCE OF PAYMENTS

India’s balance of payments position was quite unfavorable during the time of country’s
entry into liberalized trade regime .This section therefore, attempts to evaluate the trends of
India’s balance of payments

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India’s Balance of Payments – Historical Perspective
India’s BoP evolved reflecting both the changes in our development paradigm and
exogenous shocks from time to time. In the 66 year span, 1951-52 to 2017-18, six events had a
lasting impact on our BoP: (i) the devaluation in 1966; (ii) first and second oil shocks of 1973
and 1980; (iii) external payments crisis of 1991; (iv) the East Asian crisis of 1997; (v) the Y2K
event of 2000; and (vi) the global financial crisis of 2008.
The first phase can be considered from the 1950s through mid-1960s. In the early 1950s,
India was reasonably open. For example, in 1951-52, merchandise trade, exports plus imports,
accounted for 16 per cent of GDP. Overall current receipts plus payments were nearly 19 per
cent of GDP. Subsequently, the share of external sector in India’s GDP gradually declined with
the inward looking policy of import substitution. Moreover, Indian export basket comprised
mainly traditional items like tea, cotton textile and jute manufactures. During this period, policy
emphasis was on import saving rather than export promotion, and priority was given to basic
goods and capital goods sector.
Notwithstanding the contracting size of the external sector, as imports growth outstripped
exports growth, there was persistent current account deficit (CAD). Emphasis on heavy
industrialization in the second five year Plan led to a sharp increase in imports. On top of this,
the strains of Indo-China conflict of 1962, Indo-Pakistan war of 1965 and severe drought of
1965-66 triggered a major BOP crisis.
During the 1980s, BoP again came under stress. The second oil shock led to a rapid
increase in imports in early 1980s. Oil imports increased to about two-fifths of India’s imports
during 1980-83. At the same time, India’s external sector policy was changing towards greater
openness. Various measures were undertaken to promote exports and liberalize imports for
exporters during this period. However, several factors weighed against external stability. First,
despite a number of export promotion measures, the subdued growth conditions in the world
economy constrained exports growth. Second, the surplus on account of invisibles also
deteriorated due to moderation in private transfers. Third, the debt servicing had increased
with greater recourse to debt creating flows such as external commercial borrowings (ECBs)
and non-resident Indian (NRI) deposits. Fourth, deterioration is the fiscal position stemming
from rising expenditures accentuated the twin deficit risks.
Given the already emerging vulnerabilities in India’s BoP during the 1980s, the incipient
signs of stress were discernible which culminated in the BoP crisis in 1991 when the Gulf War
led to a sharp increase in the oil prices. On top of that, a slowdown in the world trade following
the recessionary conditions in industrialized countries and the economic disruption in Eastern
Europe including the erstwhile USSR had begun to affect India’s exports.
In response to the BoP crisis, a combination of standard and unorthodox policies for
stabilisation and structural change was undertaken to ensure that the crisis did not translate into
generalised financial instability. Such steps included pledging gold reserves, discouraging of
non-essential imports, accessing credit from the IMF and other multilateral and bilateral donors.
While dealing with the crisis through an IMF programme, a comprehensive programme of
structural reforms was undertaken simultaneously with special emphasis on the external sector.
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 The broad approach to reform in the external sector was laid out in the Report of the High
Level Committee on Balance of Payments (Chairman: C. Rangarajan, 1993). Trade policies,
exchange rate policies and industrial policies were recognized as part of an integrated policy
framework so as to boost the overall productivity, competitiveness and efficiency of the economy.
In addition, to contain the trade and current account deficits and enhance export competitiveness,
the exchange rate of rupee was adjusted downwards in two stages on July 1 and July 3, 1991 by
9 per cent and 11 per cent, respectively. A dual exchange rate system was introduced in March
1992 which was unified in March 1993. Subsequently, India moved to current account convertibility
in August 1994 by liberalizing various transactions relating to merchandise trade and invisibles.
The BoP came under some stress again in the first half of 2000-01 due to a sharp rise in
oil prices and increase in interest rates in advanced countries. At the same time, India’s software
exports got a boost following the demands to address the Y2K challenges. This also encouraged
migration of Indian software engineers to the advanced countries. As a result, the surplus in the
services exports and remittance account of the BoP increased sharply which more than offset
the deficit in the trade account. Software exports rose from 0.9 per cent of GDP in 1999-2000
to a peak of 3.8 per cent of GDP by 2008-09. Private remittances also rose from 2.7 per cent of
GDP to 3.8 per cent during this period. Thus, in the 2000s software exports and private
remittances emerged as two main financing items for the current account mitigating to a large
extent the merchandise trade deficit. Owing to a combination of factors, in fact, the current
account recorded a surplus during 2001-04. Subsequently, as international oil prices started
rising and domestic growth picked up, deficit in current account re-emerged during 2004-05 to
2007-08 albeit remained range bound. After a period of stability, India’s BoP came under stress
in 2008-09 reflecting the impact of global financial crisis.
The India’s BOP always under pressure and had huge deficits due to high imports of
food grains and capital goods, the heavy external borrowing and its payment and poor exports.
India’s aim after attaining as well as the external resources. Not only was our technology
backward then, there was food scarcity too. Large account of food grains had to be imported to
feed the huge population. Self reliance was to be achieved through import substitution. For this
basic industries had to be set up which required import of capital goods. Heavy capital goods
were imported were imported but other imports were severely restricted to shut off competition
in order to promote domestic industries. All focus was on import substitution, with gross neglect
of exports. Such inward looking protectionist policies did result in some self – reliance in the
consumer goods industries, but the capital goods industries remained mostly import intensive.
The high degree protection to Indian Industries led to inefficiency and poor quality products
due to lack of competition. The high cost of production further eroded our competitive strength.
These are the some internal factors that causes for the deficit in BOP.
Rising petroleum products demand, the two oil shocks, harvests failure, all put server
strain on the economy. The BOP situation remained weak throughout the 1980’s till it reached
the crises situation in 1990-91, when India was on the verge of defaulting due to heavy debt
burden and constantly widening trade deficit. India had to resort to large scale foreign borrowings
for its developmental efforts in the field of basic social and industrial infrastructure. The
following table-12.2 explains that, the summary of balance of payments.
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 Table-12.2: Summary of Balance of Payments
(US$ million)
S.No. & Item 2012-13 2014-15 2015-16 2016-17 2016-17 2017-18

I. Current Account (H1) (H1P)

1. Exports 3,06,581 3,16,545 2,66,365 2,80,138 1,34,029 1,49,211

2. Imports 5,02,237 4,61,484 3,96,444 3,92,580 1,83,476 2,24,003

3. Trade Balance (1-2) -1,95,656 -1,44,940 -1,30,079 -1,12,442 -49,448 -74,792

4. Invisible (net) 1,07,493 1,18,081 1,07,928 97,147 45,580 52,548

A. Services 64,915 76,529 69,676 67,455 32,040 36,706

B. Income -21,455 -24,140 -24,375 -26,291 -14,363 -14,257

C. Transfers 64,034 65,692 62,627 55,983 27,903 30,098

5. Goods and Services Balance -1,30,741 -68,411 -60,402 -44,987 -17,408c -38,086

6. Current Account Balance (3+4) -88,163 -26,859 -22,151 -15,296 -3,868 -22,244

II. Capital Account

Capital Account Balance 89,300 89,286 41,128 36,482 20,016 42,141

i. External Assistance (net) 982 1,725 1,505 2,013 605 691

ii. External Commercial Borrowing (net) 8,485 1,570 -4,529 -6,102 -3,402 -1,514

iii. Short- term credit 21,657 -111 -1,610 6,467 -493 4,575

iv. Banking Capital (net) of which 16,570 11,618 10,630 -16,616 -6,754 6,340

Non- Resident Deposits (net) 14,842 14,057 16,052 -12,367 3,465 1,948

V. Foreign Investment (net) of which 46,711 73,456 31,891 43,224 29,035 34,088

A. FDI (net) 19,819 31,251 36,021 35,612 20,881 19,570

B. Portfolio (net) 26,891 42,205 -4,130 7,612 8,154 14,518

vi. Other Flow (net) -5,105 1,028 3,242 7,495 1,026 -2,038

III. Errors and Omission 2,689 -1,021 -1,073 364 -668 1007

IV Overall Balance 3,826 61,406 17,905 21,550 15,481 20,903

V Reserves Change -3,826 -61,406 -17,905 -21,550 -15,48 -20,903

(increase (-) / decrease (+))

Source : Reserve Bank of India and Economic Survey 2017-18

P=Preliminary, H1=during the first half

The table-12.2 explains that, not so worrying figures at present India’s balance of payments
situation, which has been benign and comfortable since 2013-14. While the CAD has
progressively contracted to 1.1% in 2015-16 and continued to be so in the first half of 2017-18,
despite some rise in current account deficit (CAD) in the first quarter, with a relatively lower
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CAD in the second quarter. India’s CAD stood at US$ 7.2 Billion (1.2 per cent of GDP) in Q2
of 2017-18, narrowing sharply from US$ 15.0 billion (2.5 per cent of GDP) in the preceding
quarter. On a cumulative basis, India’s CAD increased from US$ 3.8 billion (0.4 per cent of
GDP) in H1 of 2016-17 to US$ 22.2 billion (1.8 per cent of GDP) in H1 of 2017-18. The
widening of the CAD was primarily in account of a higher trade deficit (US$ 74.8 billion)
brought about by a larger increase in merchandise imports owed relative to exports. The surge
in imports owed to the sharp rise in imports of gold, with its volume more than doubling as
uncertainly over GST implementation resulted in front loading of purchases by jewelers in Q1.
This, coupled with the rise in crude oil prices (Indian basket) resulting in increase in oil import
bill, led to the increase in imports. Among the other current account components of BOP, net
invisibles receipts were higher in H1 of 2017-18, mainly due to the increase in net services
earnings and private transfer receipts, While trade deficit widened in H1 of 2017-18 compared
to H1 of 2016-17, the improvement in invisibles balance and the net capital flows dominated
by foreign investment and banking capital was more than sufficient to finance the CAD leading
to accretion in foreign exchange reserves in H1 of 2017-18.

Check Your Progress.

3. What are the major events that impacted the Balance of Payments in India?
..........................................................................................................................................
...........................................................................................................................................

12.7 SUMMARY
The balance of payments is a record of economic transactions of a country with the rest
of the world. It is divided into current account and capital account. Generally the capital account
works as adjusting account. To measure and determine the actual extant of disequilibrium, the
items in the BOP has to be regrouped into autonomous and accommodating transactions and
the disequilibrium is measured by the amount of accommodating finance. The disequilibrium
in the BOP is of different types and among them the most significant one is, fundamental or
permanent disequilibrium for which there are so many economic political and social causative
factors. Also there are automatic and deliberative correcting measures to correct the fundamental
or permanent disequilibrium in BOP. The deliberate correcting measures which are in practice
are further classified as monetary, trade and miscellaneous measures. Balance of payment is
one of the major indicators of country’s progress. BOP shows strengths and weaknesses of
country. It can notably affect the economic policies of a government and the economy itself.
The balance of payment position is an essential measure of the sound health of an economy and
can be studied under the major heads of Current Account, Capital Account and international
reserves. The current position of the components of the Balance of payment of India has also
been looked into. It is observed in the current account that despite moderation in India’s exports,
India’s external sector position has been comfortable, with the current account deficit
progressively contracting from 4.8 per cent of Gross Domestic Product in 2012-13 to 1.1 per
cent of Gross Domestic Product in 2015-16. Thus the ability to face global financial crisis is

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now stronger than earlier years, with greater depth in the financial markets, more foreign
exchange reserves and inflow of foreign investments.

12.8 CHECK YOUR PROGRESS – MODEL ANSWERS

1) Balance payments serves as an indicator of the changing international economic or financial
position of a country. It helps in formulation of a country’s monetary, fiscal and trade policies.
It helps in determining the influence of foreign trade & transactions on the level of national
income of a country .It is useful to banks, firms, financial institutions and individuals which are
directly or indirectly involved in international trade and finance .It is an economic barometer of
nation’s progress vis-à-vis rest of the world.
2) The causes of disequilibrium differ from country to country, and time to time within a country.
The main causes are economic, political and social in nature. Economic causes are developmental
programmes, demonstration effect, natural causes, cyclical fluctuations, income and inflation,
globalization. The social causes may include changes in tastes & preferences due to
demonstration affect, population growth rate, rate of urbanization, etc. The political causes are
political stability / instability in a country, war, change in diplomatic policy.
3) India’s BoP evolved reflecting both the changes in our development paradigm and exogenous
shocks from time to time. In the 66 year span, 1951-52 to 2017-18, six events had a lasting
impact on our BoP: (i) the devaluation in 1966; (ii) first and second oil shocks of 1973 and
1980; (iii) external payments crisis of 1991; (iv) the East Asian crisis of 1997; (v) the Y2K
event of 2000; and (vi) the global financial crisis of 2008.

12.9 MODEL EXAMINATION QUESTIONS

I. Answer the following questions in about 10 lines each.
1. Explain the different kinds of disequilibrium in Balance of Payments.
2. What are the causes of disequilibrium in the Balance of Payments of a country?

II. Answer the following questions in about 30 lines each.

1. Examine the different Methods of correcting Disequilibrium in the Balance of payments.
2. Explain the Trends of Balance of payments in India.

III. One mark questions.

A. Multiple choice questions.
1. A country with fundamental disequilibrium in the BOP may devalue its currency in
order to stimulate.
A. Exports B. Imports C. A & B D. Exchange control
2. Among the following which disequilibrium in the BOP arises from changes in an Economy
as its moves from one stage of growth to another?
A. Cyclical disequilibrium B. Secular disequilibrium
C. Structural disequilibrium D. All the above
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3. Which one of the following causes for fundamental disequilibrium in balance of
payments?
A. Development programmes B. Political instability
C. Deficit in the BOP D. All the above
4. Which one of the following method is not correcting disequilibrium in the Balance of
Payments?
A. Import promotion B. Export promotion C. Devaluation D. Exchange control
Answers: 1-A, 2-B, 3-D, 4-A.

B. Fill in the blanks.

1. ______________________ disequilibrium takes place due to the occurrence of Trade
cycles.
2. The Reduction of the official rate at which currency is exchanged for another currency is
called ____________________________.
3. _________________________ economists, any disequilibrium in BOP is corrected
automatically without any corrective measures by the Government.
Answers: 1. Cyclical 2). Devaluation, 3. Classical

C. Match of the following.

List – I List -II
1. Structural disequilibrium A. Reduce imports
2. Income and price effect B. Structural changes in exports and imports
3. Devaluation C. Causes for Balance of payments.
4. Export promotion D. The official process of reducing the value of
country’s currency in terms of other countries
currrencies
Answers: 1-B, 2-C, 3-D, 4-A.

12.10 GLOSSARY
1. Deflation: Deflation refers to that monetary policy under which the volume of currency
is reduced; consequently prices and monetary income of the people are brought down.
2. Temporary Disequilibrium: Random or temporary type of factors may lead to a
temporary disequilibrium in the balance of payments .
e.g. floods, droughts and outbreak of war, etc.
3. Export Promotion: Export promotion refers to measures taken by the Government to
buildup, encourage, raise and promote exports through a number of special concessions
and programmes.

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4. Fundamental Disequilibrium: When disequilibrium in the BOP continued for a long
time and there is no expectation now or in the future, that the new factors revealed in the
BOP are likely to disappear, it is defined as a case of fundamental or permanent
disequilibrium.
5. Exchange Controls: Exchange controls relate to Government regulation of exchange
rates as well as restriction on conversion of the local currency against foreign currency.

12.11 SUGGESTED BOOKS

1. Carless P Kindleberger: International Economics.
2. David Young: International Economics.
3. James E Meade: The Balance of Payments.
4. Walter, Ingo: International Economics.
5. Developments in India’s Balance of Payments during Fourth Quarter (January-March)
of 2012-13, RBI Monthly Bulletin, September 2013.
6. Economic Surveys 2012-13, 2017-18, Ministry of Finance.

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UNIT-13: EXCHANGE RATES - FOREIGN EXCHANGE
MARKET IN INDIA
Contents
13.0 Objectives
13.1 Introduction
13.2 Meaning and Importance of Exchange Rates
13.3 Determinants of Exchange Rates
13.4 Fixed and Flexible Exchange Rates
13.5 Merits and Demerits of Fixed Exchange Rates
13.6 Merits and Demerits of Flexible Exchange Rates
13.7 The Foreign Exchange Market in India
13.8 Summary
13.9 Check Your Progress - Model Answers
13.10 Model Examination Questions
13.11 Glossary
13.12 Suggested Books

13.0 OBJECTIVES
The objective of this unit is to discuss the exchange rates, its determinants, merits and
demerits of fixed and flexible exchange rates and the status of foreign exchange market in
India. After reading this unit, you will be able to:
• know the meaning and importance of exchange rate.
• discuss fixed exchange rate and its merits and demerits.
• describe the merits and demerits of flexible exchange rate.
• understand the status of foreign exchange market in India.

13.1 INTRODUCTION
Almost all the countries in the world are open economies and thus, every country trades
goods and services with other countries. Here, the problem is currency of one country is not
acceptable across the world. For example, Indian Rupee is not acceptable as a medium of
exchange in other countries, nor is the currency of any other country acceptable as a legal
currency in India. Therefore, international payments are made in the currency of recipient
country. Thus, for payment to other countries, the paying country has to buy the currency of the
recipient country in the foreign exchange market. Here the question is what is the price of one
currency in respect to other currency and how these prices are determined in the foreign exchange
market. To answer these questions, it is important to understand the meaning of exchange rate,
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its determination, various types of exchange rates, its merits and demerits and the foreign
exchange markets in India.

13.2 MEANING AND IMPORTANCE OF EXCHANGE RATES

Meaning of Exchange Rates: In economics, an exchange rate is the rate at which one
Country's currency will be exchanged for another Country's currency. It is also regarded as the
value of one country’s currency in relation to another country’s currency. Thus, the exchange
rate is simply the amount of a nation’s currency that can be bought at a given time for a specified
amount of the currency of another country. Foreign exchange rates are relative and are expressed
as the value of one currency compared to another. When selling products internationally, the
exchange rate for the two trading countries’ currencies is an important factor. For example, an
interbank exchange rate of 72 Indian Rupees to the United States Dollar means that Rs. 72 will
be exchanged for each $1 or that $1 will be exchanged for each Rs 72. In this case, it is said that
the price of a dollar in relation to Rupees is Rs 72, or equivalently that the price of a Rupees in
relation to dollars is $1/72.
Importance of Exchange Rates: Foreign exchange rates, in fact, are one of the most
important determinants of a countries relative level of economic health, ranking just after interest
rates and inflation. Exchange rates play a vital role in a country’s level of trade, which is most
critical to every free market economy in the world. Exchange rates are determined in the foreign
exchange market, which is open to a wide range of different types of buyers and sellers, where
currency trading is continuous.
For centuries, the currencies of the world were backed by gold. Prior to 1971, foreign
exchange rates were fixed by an agreement among the world’s central bank called the Bretton
Woods Accord. This agreement was entered into force after World War II. The world was in a
shambles and the Bretton Woods Accord was established to help to stabilize the volatile situation
by pegging the U.S. dollar to gold and all other currencies of the world to the U.S. dollar. In
1971 a new agreement was formulated to replace the Bretton Woods Accord. After broke down
the Bretton Woods system, the world finally adopted the floating exchange rate system during
the Jamaica agreement of 1976, commonly referred to as the Jamaica Accords. Thus, the use of
the gold standard would be permanently abandoned. Although no longer an official standard,
the U.S. dollar ($) remains dominates in the foreign exchange market with the Japanese Yen (¥)
and close behind European Euro (€).

Check Your Progress.

Note: a) Space is given below for writing your answer.
b) Compare your answer with one given at the end of the unit.
1. What is exchange rate?
..........................................................................................................................................
...........................................................................................................................................

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2. State the importance of exchange rates.
..........................................................................................................................................
...........................................................................................................................................

13.3 DETERMINANTS OF EXCHANGE RATES

The exchange rate is defined as “the rate at which one country’s currency may be converted
into another.” It may fluctuate daily with the changing market forces of supply and demand of
currencies from one country to another. The factors which influence the exchange rates are
briefly presented here under:
1. Country’s Balance of Payments Position: A country’s current account reflects balance
of trade and earnings on foreign investment. It consists of total number of transactions
including its exports, imports, debt, etc. A deficit in current account due to spending
more of its currency on importing products than it is earning through sale of exports
causes depreciation. Balance of payments fluctuate exchange rate of its domestic currency.
When a country has a large international balance of payments deficit or trade deficit, it
means that its foreign exchange earnings are less than foreign exchange expenditures
and its demand for foreign exchange exceeds its supply, so its foreign exchange rate
rises, and its currency depreciates.
2. Comparative Interest Rates: Changes in interest rate affect currency value and dollar
exchange rate. Forex rates, interest rates, and inflation are all correlated. Increases in
interest rates cause a country’s currency to appreciate because higher interest rates provide
higher rates to lenders, thereby attracting more foreign capital, which causes a rise in
exchange rates. Interest rates are the cost and profit of borrowing capital. When a country
raises its interest rate or its domestic interest rate is higher than the foreign interest rate,
it will cause capital inflow, thereby increasing the demand for domestic currency, allowing
the currency to appreciate and the foreign exchange depreciate.
3. Relative Rates of Inflation: Changes in market inflation cause changes in currency
exchange rates. A country with a lower inflation rate than another’s will see an appreciation
in the value of its currency. The prices of goods and services increase at a slower rate
where the inflation is low. A country with a consistently lower inflation rate exhibits a
rising currency value while a country with higher inflation typically sees depreciation in
its currency and is usually accompanied by higher interest rates. The inflation rate of a
country raises, the purchasing power of money declines, the paper currency depreciates
internally, and then the foreign currency appreciates. If both countries have inflation, the
currencies of countries with high inflation will depreciate against those with low inflation.
The latter is a relative revaluation of the former.
4. Fiscal and Monetary Policies: Generally, the fiscal and revenue deficits are caused by
expansionary fiscal and monetary policies and inflation will devalue the domestic
currency. The tightening fiscal and monetary policies will reduce fiscal expenditures,
stabilize the currency, and increase the value of the domestic currency. A country with

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 government debt is less likely to acquire foreign capital, leading to inflation. Foreign
investors will sell their bonds in the open market, if the market predicts government debt
within a certain country. As a result, a decrease in the value of its exchange rate will
follow.
5. Speculation: If a country’s currency value is expected to rise, investors will demand
more of that currency in order to make a profit in the near future. As a result, the value of
the currency will rise due to the increase in demand. With this, increase in currency
value comes a rise in the exchange rate as well. If speculators expect a certain currency
to appreciate, they will buy a large amount of that currency, which will cause the exchange
rate of that currency to rise. Conversely, if speculators expect a certain currency to
depreciate, they will sell off a large amount of the currency, resulting in speculation. The
currency exchange rate immediately fell. Speculation is an important factor in the short-
term fluctuations in the exchange rate of the foreign exchange market.
6. Government Market Intervention: When exchange rate fluctuations in the foreign
exchange market adversely affect a country’s economy, trade, or the government needs
to achieve certain policy goals through exchange rate adjustments, monetary authorities
can participate in currency trading, buying or selling local or foreign currencies in large
quantities in the market.
7. Economic Growth of a Country: In general, high economic growth rates are not
conducive to the local currency’s performance in the foreign exchange market in the
short term, but in the long run, they strongly support the strong momentum of the local
currency.
8. Terms of Trade: Related to current accounts and balance of payments, the terms of
trade is the ratio of export prices to import prices. A country’s terms of trade improves if
its exports prices rise at a greater rate than its imports prices. This results in higher
revenue, which causes a higher demand for the country’s currency and an increase in its
currency’s value. This results in an appreciation of exchange rate.
9. Political Stability: A country’s political state and economic performance can affect its
currency strength. A country with less risk for political turmoil is more attractive to
foreign investors, as a result, drawing investment away from other countries with more
political and economic stability. Increase in foreign capital, in turn, leads to an appreciation
in the value of its domestic currency. A country with sound financial and trade policy
does not give any scope for uncertainty in value of its currency. But, a country prone to
political confusions may see depreciation in exchange rates.

13.4 FIXED AND FLEXIBLE (FLOATING) EXCHANGE RATES

Exchange rate stability has always been the objective of monetary policy of almost all
countries. Most governments in the world had maintained fixed exchange rate till 1973. After
the breakdown of this system marked the beginning of floating exchange rate regimes in several
countries. Hence, exchange rates can be either fixed or floating (Flexible). Fixed exchange
rates are decided by central banks of a country whereas floating exchange rates are decided by
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the mechanism of market demand and supply. In a floating exchange rate system currency rate
is determined by market forces. When the government of a country fixes the rate of exchange
for its own currency, it is termed as fixed exchange rate. This is also known as official rate of
exchange. Fixed exchange rates are fixed by the respective governments from time to time (i.e.
quarterly or yearly) for the betterment of their economy.
The flexible or floating exchange rate is a regime where the currency price is set by the
foreign exchange market based on demand and supply compared with other currencies. With
the change in economic conditions underlying demand and supply, the exchange rate will
automatically change without any intervention by the government. That is why, it is called
flexible or floating exchange rate system. Therefore, if the demand for the currency is high, the
value will increase. This, in turn, will make imported goods cheaper. Under floating exchange
rate system, currency value is allowed to fluctuate in response to foreign exchange mechanisms.
A currency that uses a floating exchange rate is known as a floating currency. In the modern
world, currencies of the many countries are floating like the United States dollar, the euro, the
Swiss Franc, the Japanese Yen, the Indian Rupee, the Australian Dollar and British Pound.
However, central banks often participate in the markets to attempt to influence the value of
floating exchange rates.

13.5 MERITS AND DEMERITS OF FIXED EXCHANGE RATES

I. Merits of Fixed Exchange Rates
1. Stability in the Exchange Rate: Fixed exchange rates ensure stability in the exchange
rate and provides certainty about the future course of exchange rate there by promote
international trade. The main advantage of the fixed exchange rate system is to eliminate
risk caused by uncertainty in the prices of exports and imports. Thus, it provides confidence
among the exporters and importers. Particularly, in the case of developing countries,
fixed exchange rate system prevents the depreciation effects of their currencies and
stabilize balance of payments.
2. Attracts Foreign Capital Investments: Fixed exchange rate system would attract foreign
capital investments because a stable currency does not create any uncertainties about
capital loss on account of changes in exchange rate. If the country’s currency is not
stable, foreign private firms would not be interested to their investments in those countries.
Thus, fixed exchange rate system provides greater certainty and encourages firms to
invest. Since foreign investments play crucial role in the process of economic growth,
the fixed exchange rate system helps to promote rapid economic growth particularly in
the developing nations.
3. Control Speculations: Fixed exchange rate system eliminates the possibility of
speculation and it removes the speculative activities in the foreign exchange market and
promotes international trade and capital. In this system, there is no possibility of panic
flight of capital from one country to another country.
4. Necessary for Small and Developing Countries: Fixed exchange rate system not only
useful for developing nations but also small countries even though they are developed.
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 For example the countries like U.K, Denmark, Belgium etc,. are small but their foreign
trade plays a dominant role in their economies. If exchange rates are fluctuating, it will
seriously affect their exports and resulting low growth in their economies.
5. Maintain Low Inflation: Fixed exchange rates are to check inflationary pressures in
the economy. Governments who allow their exchange rate to devalue may cause inflation
and import prices increase and firms have less incentive to cut costs. Inflation will cause
balance of payments deficits and results in loss of international reserves.
6. Suitable for Currency Area: A case is also made in favour of fixed exchange rate on
the basis of existence of currency area. If the exchange rates of the countries in the
common currency area are flexible, the fluctuations in the leading country will also
disturb the exchange rates of the whole area.

II. Demerits of Fixed Exchange Rates

1. Out Dated System: At present, fixed exchange rate system is out dated because it works
under the favorable conditions of gold standard. Fixed exchange rate system was continued
till 1973. After the breakdown of this system, all the world countries adopt flexible exchange
system. At present no country in the world maintains fixed exchange rate system.
2. Cost- Price Relationship is not Reflected: Fixed exchange rate system does not provide
the cost-price adjustments between the currencies of the countries. Generally any two
countries never follow the same economic policies. Hence, the cost price relationships
between or among the countries go on changing. Thus, fixed exchange rates are not
suitable in present scenario.

13.6 MERITS AND DEMERITS OF FLEXIBLE EXCHANGE

RATES
I. Merits of Flexible Exchange Rates
1. Autonomy in Economic Policies: Flexible exchange rate system provides more
autonomy in respect of domestic economic policies. Under this system, a country is free
to adopt an independent policy to conduct properly the domestic economic affairs. The
monetary policy of a country is not limited or affected by the economic conditions of
other countries.
2. Self Adjustments: The main advantage of this system is that it is self adjusting. A
fluctuating exchange rate system protects the domestic economy from the shocks produced
by the disturbances generated in other countries. Thus, it acts as a shock absorber and
saves the internal economy from the disturbing effects from abroad.
3. Promotes Economic Growth: The flexible exchange rate system promotes economic
development and helps to achieve full employment in the country. The exchange rates
can be changed in accordance with the requirements of the monetary policy of the country
to achieve the desired economic growth.

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4. Automatic Adjustments in Balance of Payments: Flexible exchange rate system
automatically corrects the disequilibrium in the balance of payments. If there is deficit
in the balance of payments, the external value of a country’s currency falls. As a result,
exports are encouraged, and imports are discouraged thereby, establishing equilibrium
in the balance of payment.
5. Increase Free Trade in the World: Flexible exchange rate system does not permit
exchange control and promotes free trade. Restrictions on international trade are removed
and there is free movement of capital and money between countries.

II. Demerits of Flexible Exchange Rates

1. Uncertainty: Flexible exchange rate regime leads to uncertainty in the foreign exchange
market. Exporters will not be able to plan their export revenue or import expenditure
because of changing rate of exchange. Flexible exchange rates create conditions of
instability and uncertainty which, in turn, tend to reduce the volume of international
trade and foreign investment. Long-term foreign investments are greatly reduced because
of higher risks involved.
2. Disturbing the Economy: The system of flexible exchange rates has serious repercussion
on the structure of the economy. Frequent fluctuations in the exchange rates cause changes
in the price of imported and exported goods which, in turn, disturb the economy of the
country.
3. Adverse Effects of Capital Movements: The floating exchange rate system leads to
unnecessary international capital movements by encouraging speculative activities. As a
result there are a large-scale capital outflows and inflows among the countries and it
leads to the disturbing the whole global economy.
4. Inflationary Effect: Flexible exchange rate system involves greater possibility of
inflationary effect of exchange depreciation on domestic price level of a country.
Inflationary rise in prices leads to further depreciation of the external value of the currency.
5. Speculation problems: The floating exchange rate system leads to speculation problem.
A country with continuous deficit has a tendency to devalue its currency. Speculators
will demand foreign exchange by selling their domestic currencies. It leads excess demand
for foreign currencies which may lead to several malpractices of prices of foreign
currencies.

13.7 THE FOREIGN EXCHANGE MARKET IN INDIA

The foreign exchange market is a market where dealers and brokers interact with each
other that who are willing to trade currencies at agreeable exchange rates. The daily volume of
world’s foreign exchange markets is about $5 trillions.
The foreign exchange market in India has started in 1978 when the government allowed
banks to trade foreign exchange with one another. It is regulated by the central government and
all aspects of the trade are defined by national laws. There are many things about this market
that make it distinct from other markets in the world. Like other foreign exchange markets in
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the world, the foreign exchange market in India includes Traders, Banks/Authorized Dealers
(ADs) and Reserve Bank of India (RBI). These three players perform different roles in the
trade. Traders are generally all individuals in the public who are also corporate customers of
the banks. These customers use the banks as authorized dealers to access the foreign exchange
market. There are traders of different kinds but all of them are able to access the market only
through dealers. There are several non-bank financial institutions that are legally authorized to
facilitate trade in the Indian market.
The banks, on the other hand, are the legally authorized institutions to handle the currency.
In India, banks exist in different tiers and there are clear laws that determine which institution
is categorized as a financial institution. From these legal institutions, all those who want to
trade can create accounts, access the market and select products at they would like to trade in.
The trading landscape has changed a lot over the years especially since the 1990’s when the
Indian regulatory authorities liberalized the financial market with the introduction of new
economic reforms.
Reserve bank of India (RBI) is the central financial institution which is responsible for
the monetary policy in India. This institution has been instrumental in shaping the trading
landscape in India. Before 1993, the Indian Rupee had a fixed value which was determined by
the RBI. This meant that the currency only attracted a certain exchange rate even though the
market dynamics were changing. In 1993, though, the RBI repealed the prevailing law at the
time to allow for an exchange rate determined by the market itself. Since then, the Rupee’s
value has changed a lot in relation to different currencies.
There was an external payment crisis in India during 1990-91. This was due to the
macroeconomic imbalances in the second half of mid-eighties such as monetization of fiscal
deficit, overvalued exchange rate, high tariffs and inward looking industrial policy etc.
International factors such as recession in the industrial world, first Iraq war in August 1990,
restriction of external finance by international banks were responsible for the degradation of
international confidence in India. As a result, the current account deficit was around 3.2% of
GDP. To keep the external competitiveness and to restore Balance of Payments (BoP) position,
some structural changes were introduced in Indian economy.
There are several changes in the Indian foreign exchange market in recent decades. The
liberalization of Indian Economy has resulted in substantial inflow of foreign currency capital
into India. Simultaneously, dismantling of trade barriers has also facilitated the integration of
domestic economy with the world economy.
The foreign exchange market in India is quite vibrant in recent years. There has been a
significant growth during the last five decades. The daily average turnover impressed a substantial
pick up from about US $ 5 billion during 1997-98 to US $ 18 billion during 2005-06. The
turnover has risen considerably to US $ 23 billion during 2006-07 with the daily turnover
crossing US $ 35 billion IN 2010. The inter-bank to merchant turnover ratio has halved from
5.2 during 1997-98 to 2.6 during 2005-06, reflecting the growing participation in the merchant
segment of the foreign exchange market. India is among the top ten markets in the world in
terms of the daily volume. As of 2017, the foreign exchange assets in India place it as the 8th

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best market in the world by foreign exchange reserves. The top asset in this market is the
United States as represented by US institutional bonds and government bonds. The Indian
foreign exchange reserves are also held in terms of gold.

Check Your Progress.

3. Specify the determinants of exchange rates.
..........................................................................................................................................
...........................................................................................................................................
4. Distinguish between fixed and flexible (floating) exchange rates.
..........................................................................................................................................
...........................................................................................................................................

13.8 SUMMARY
The exchange rate has been defined as the price of one unit of foreign currency expressed
in terms of the units of domestic currency. The foreign exchange rates play a key role in
determining the volume, composition, and direction of international trade. Foreign exchange
rate systems are of two types viz. fixed and flexible. Both the systems have their own merits
and demerits. Generally central bankers and policy makers favour the fixed exchange rate and
theoreticians favour the flexible exchange rates. The foreign exchange market in India has
started in 1978 and it is regulated by the central government. The main players are Traders,
Banks/Authorized Dealers (ADs) and Reserve Bank of India. There has been a significant
growth in India’s foreign exchange market during the last five decades.

13.9 CHECK YOUR PROGRESS – MODEL ANSWERS

1. In economics, an exchange rate is the rate at which one currency will be exchanged for
another currency. It is also regarded as the value of one country’s currency in relation to
another country’s currency.
2. Foreign exchange rates are one of the most important determinants of a countries relative
level of economic health, ranking just after interest rates and inflation. Exchange rates
play a vital role in a country’s level of trade, which is most critical to every free market
economy in the world.
3. Determinants of exchange rates are 1. Country’s Balance of Payments Position; 2.
Comparative Interest Rates; 3. Relative Rates of Inflation; 4. Fiscal and Monetary
Policies; 5. Speculation; 6. Government Market Intervention; 7. Economic Growth of a
Country; 8. Terms of Trade; and 9. Political Stability.
4. Fixed exchange rates are decided by central banks of a country whereas floating exchange
rates are decided by the mechanism of market demand and supply. When the government
of a country fixes the rate of exchange for its own currency, it is termed as fixed exchange
rate. This is also known as official rate of exchange. The flexible or floating exchange

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 rate is a regime where the currency price is set by the foreign exchange market based on
demand and supply compared with other currencies.

13.10 MODEL EXAMINATION QUESTIONS

I. Answer the following questions in about 10 lines each.
1. Explain the merits of fixed exchange rates.
2. Discuss the merits of flexible exchange rates.
II. Answer the following questions in about 30 lines each.
1. Describe the various determinants of exchange rate.
2. Write about the foreign exchange market in India.

III. One mark questions.

A. Choose the correct answer in the following multiple choice questions.
1. The foreign exchange market in India was started in the year [ ]
A) 1918 B) 1934 C) 1956 D) 1978
2. Which currency dominates in the foreign exchange market [ ]
A) U.S. Dollar B) Japanese Yen C) European Euro D) Indian Rupees

B. Fill in the blanks.

1. ____________________________ system ensure stability in the exchange rate.
2. Fixed exchange rates are decided by _____________________________

C. Match the following.

List - I List - II
A) India Currency 1. Yen [ ]
B) U.K Currency 2. Rupee [ ]
C) Japan 3. Pound [ ]

13.11 GLOSSARY
1. Exchange Rate: the value of one country’s currency in relation to another country’s
currency.
2. Fixed Exchange Rate: The government of a country fixes the rate of exchange for its
own currency; it is termed as fixed exchange rate.
3. Flexible Exchange Rate: Flexible exchange rate is a regime where the currency price is
set by the foreign exchange market based on demand and supply compared with other
currencies.

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13.12 SUGGESTED BOOKS
Mithani D.M : International Economics, Himalaya Publishing House, New
Delhi, 2014.
Cherunilam F. : International Economics, Tata McGraw- Hill Publishing
Company Limited, New Delhi, 2004.
Dwivedi D.N. : International Economics, Vikas Publishing House Pvt Ltd., New
Delhi, 2013.
Desai S.S.M.& Nirmala.B.: International Economics, Himalaya Publishing House, New
Delhi, 2011.

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 DR. B.R. AMBEDKAR OPEN UNIVERSITY
FACULTY OF SOCIAL SCIENCES
B.A. II YEAR - SEMESTER - IV
MODEL EXAMINATION QUESTION PAPER
Subject: ECONOMICS
Course - 4: Public Finance and International Economics
Time: 3 Hours
[Max. Marks: 100]
[Min. Marks: 40]
SECTION – A
[Marks: 5 x 4 = 20]

Instructions to the Candidates:

a) Answer any Five of the following questions in about 10 lines each.
b) Each question carries Four marks.

1. Elucidate the tests of maximum social advantage.

2. Explain regressive and degressive taxes.
3. Discuss the Dalton's incidence of taxation.
4. Discuss the effects of public expenditure in depression and in inflation.
5. Internal debt is better than External debt - Discuss.
6. Do you know the significance of central and state relations?
7. Discuss the causes for International Trade.
8. Define the concept of Terms of Trade and state its limitations.
9. What is an import quota? Explain different types of import quotas.
10. Discuss the merits of flexible exchange rates.

SECTION – B
[Marks: 5 x 12 = 60]
Instructions to the Candidates:
a) Answer all the following questions in about 30 lines each.
b) Each question carries 12 marks.

11. (a) Examine the role of the state in economic activities.

Or
(b) Analyse the merits and demerits of direct taxes.

12. (a) Examine the various effects of taxation on production.

Or
(b) Analyse the determinants of public expenditure.

13. (a) Explain the methods of debt redemption.

205
 Or
(b) Critically examine David Ricardo's Theory of International Trade.

14. (a) Explain the factors affecting Terms of Trade.

Or
(b) Analyse the recent trends in India's Balance of Trade.

15. (a) Describe the various determinants of exchange rate.

Or
(b) Explain the economic effects of public borrowing.

SECTION – C
[Marks: 20 x 1 = 20]
Instructions to the Candidates:
a) Answer all of the following questions.
b) Each question carries One mark.

A. Multiple Choice Questions. Choose the Correct Answer:

16. Which one is not the tool of fiscal policy?
a) Taxation b) Public expenditure
c) Public debt d) Demand and supply
17. The final money burden of a tax is known as:
a) Impact of tax b) Shifting of tax c) Incidence of tax d) None of these
18. Who classified public expenditure according to the functions of government?
a) Bastable b) Adam Smith c) Musgrave d) Marshall
19. Fiscal policy is a policy with respect to -
a) Sources of funds b) Uses of funds
c) Sources funds and uses of funds d) None of these
20. Budget is an instrument of -
a) Fiscal policy b) Monetary policy c) Economic policy d) Export policy
21. Theory of comparative advantage was presented by:
a) Adam Smith b) Ricardo c) Hicks d) Arshad
22. The foreign exchange market in India was started in the year -
a) 1918 b) 1934 c) 1956 d) 1978
23. In which redemption method the new debt replaces old debt?
a) Refunding b) Conversion c) Sinking fund d) Budget surplus

206
24. Pick out the factor which is not a demerit of indirect taxes.
a) Unjust to poor b) Inflationary in nature
c) A tool of economic policy d) High administrative cost
25. The most important source of revenue to the states is -
a) Sales tax b) Service tax c) Excise duty d) None of the above

B. Fill in the Blanks:

26. Dalton's criterion is known as the _______________
27. The canon of productivity was formulated by ___________________
28. Canon of surplus means that governments should avoid ________
29. Fixed exchange rates are decided by _____________________________
30. Public expenditure seeks to ___________ the index of social welfare.

C. Match the Following:

A B
31. Principle of Maximum (a) The form of public debt
Aggregate Welfare
32. Canon of Benefit (b) Economics of scale
33. Bonds and Treasury Bills (c) Maximum social advantage
34. Dynamic gains (d) Canon of surplus
35. Avoid deficits (e) A.C. Pigou

Answers: 31 __, 32 __, 33 __, 34 __, 35 __.

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