ICAI Notes- Unit 1: Fiscal Functions: An Overview, Centre and State Finance | Business Economics for CA Foundation PDF Download

 Page 1


LEARNING OUTCOMES 
 
 
 
UNIT – 1: FISCAL FUNCTIONS: AN 
OVERVIEW, CENTRE AND STATE 
FINANCE 
 
 
 
 
After studying this Chapter, you will be able to – 
? Explain the three-branch taxonomy of the role of government in a 
market economy 
? Analyze the governmental economic actions and classify them 
according to the economic functions of the government 
? Elucidate the nature of finances and responsibilities of the centre and 
state governments 
? Describe the mode of division of resources between the union and 
the states  
PUBLIC FINANCE 
 
 
    
 
 
CHAPTER 
7 
© The Institute of Chartered Accountants of India
Page 2


LEARNING OUTCOMES 
 
 
 
UNIT – 1: FISCAL FUNCTIONS: AN 
OVERVIEW, CENTRE AND STATE 
FINANCE 
 
 
 
 
After studying this Chapter, you will be able to – 
? Explain the three-branch taxonomy of the role of government in a 
market economy 
? Analyze the governmental economic actions and classify them 
according to the economic functions of the government 
? Elucidate the nature of finances and responsibilities of the centre and 
state governments 
? Describe the mode of division of resources between the union and 
the states  
PUBLIC FINANCE 
 
 
    
 
 
CHAPTER 
7 
© The Institute of Chartered Accountants of India
1.  
  
BUSINESS ECONOMICS 
 
 7.2 
Fiscal Functions: An 
Overview, Centre and 
State Finance 
Public Finance 
 
Allocation 
Function 
Redistribution 
Function 
Stabilization 
Function 
 
 
 
 
 
 
 
 
 
 
1.1  INTRODUCTION 
The governments of all nations have important economic functions even where markets 
constitute the basic resource allocation mechanism. The size and scope of government in 
market economies have grown much larger over the past few decades. The primary goal of 
the state is to promote the general welfare of the society.  What governments do, or do not 
do, will obviously have an important impact on the economic performance of an economy 
and the quality of life of its citizens. 
Governments at various levels involve in several operations for running the state. For example; 
the government raises money from various sources, incurs expenditures, consumes goods and 
services, borrows money, employs people, and provides key institutions such as property 
rights. The governments also establish and administer rules and regulations and puts in place 
policies concerning all aspects of life of people. We have experienced in our day-to-day life 
that though governments at various levels impose many rules and regulations in the economy, 
some matters still go unregulated. Similarly, most of the goods and services that we consume 
are provided to us by private producers, but there is broad agreement that certain goods and 
services should be provided exclusively by the government. For a variety of reasons, we believe 
that governments should accomplish some activities and should not do others.  
 
CHAPTER OVERVIEW 
 
© The Institute of Chartered Accountants of India
Page 3


LEARNING OUTCOMES 
 
 
 
UNIT – 1: FISCAL FUNCTIONS: AN 
OVERVIEW, CENTRE AND STATE 
FINANCE 
 
 
 
 
After studying this Chapter, you will be able to – 
? Explain the three-branch taxonomy of the role of government in a 
market economy 
? Analyze the governmental economic actions and classify them 
according to the economic functions of the government 
? Elucidate the nature of finances and responsibilities of the centre and 
state governments 
? Describe the mode of division of resources between the union and 
the states  
PUBLIC FINANCE 
 
 
    
 
 
CHAPTER 
7 
© The Institute of Chartered Accountants of India
1.  
  
BUSINESS ECONOMICS 
 
 7.2 
Fiscal Functions: An 
Overview, Centre and 
State Finance 
Public Finance 
 
Allocation 
Function 
Redistribution 
Function 
Stabilization 
Function 
 
 
 
 
 
 
 
 
 
 
1.1  INTRODUCTION 
The governments of all nations have important economic functions even where markets 
constitute the basic resource allocation mechanism. The size and scope of government in 
market economies have grown much larger over the past few decades. The primary goal of 
the state is to promote the general welfare of the society.  What governments do, or do not 
do, will obviously have an important impact on the economic performance of an economy 
and the quality of life of its citizens. 
Governments at various levels involve in several operations for running the state. For example; 
the government raises money from various sources, incurs expenditures, consumes goods and 
services, borrows money, employs people, and provides key institutions such as property 
rights. The governments also establish and administer rules and regulations and puts in place 
policies concerning all aspects of life of people. We have experienced in our day-to-day life 
that though governments at various levels impose many rules and regulations in the economy, 
some matters still go unregulated. Similarly, most of the goods and services that we consume 
are provided to us by private producers, but there is broad agreement that certain goods and 
services should be provided exclusively by the government. For a variety of reasons, we believe 
that governments should accomplish some activities and should not do others.  
 
CHAPTER OVERVIEW 
 
© The Institute of Chartered Accountants of India
 1.3 
 
 
 7.3 
PUBLIC FINANCE 
As we know, Macroeconomics is the study of the economy as a whole. There are three main 
macroeconomic goals for any nation. The first is economic growth. If the real gross domestic 
product grows at a faster rate than population, then people can enjoy higher standard of 
living. The second goal is high levels of employment which will ensure higher income and 
higher output. When unemployment occurs, it harms not only the unemployed, but the society 
as a whole because there is loss of output that could have been produced. The third 
macroeconomic goal is stable price levels. Inflation reduces real incomes and purchasing 
power of some people, and disproportionately affects lower income families. On the contrary, 
deflation signals a downturn in economic activity which may cause recession or even 
depression and large scale unemployment.  By ensuring stable prices, an economy can avoid 
prolonged inflation and deflation and achieve high levels of economic activity and 
employment.   
The government does not expect the economy to function automatically; rather it intervenes 
to direct them to function in particular directions. Such intervention on the part of the 
government is based on the belief that the objective of the economic system and the role of 
government is to improve the wellbeing of individuals and households. The purpose of this 
lesson is to examine the economic functions of the government and to understand why the 
government should invariably perform them. 
1.2 THE ROLE OF GOVERNMENT IN AN ECONOMIC  
SYSTEM 
We shall first consider why an ‘economic system’ should be in place. The basic economic 
problem of scarcity arises from the fact that wants are unlimited and the resources available 
to any society are limited. Consequently an economy cannot produce all economic goods and 
services that its members desire to have. Therefore, an economic system by which a society 
(households, businesses, and government) makes decisions about allocating resources to 
produce products and about distributing those products should exist to answer the basic 
questions such as what, how and for whom to produce and how much resources should be 
set apart to ensure growth of productive capacity.  
The modern society, in general, offers three alternate economic systems through which the 
decisions of resource reallocation may be made namely, the market, the government and a 
mixed system where both markets and governments simultaneously determine resource 
allocation. Correspondingly, we have three economic systems namely, capitalism, socialism 
and mixed economy, each with different degrees of state intervention in economic activities. 
Adam Smith is often described as a bold advocate of free markets and minimal governmental 
activity. Smith believed that government's roles in society should be limited, but well defined 
© The Institute of Chartered Accountants of India
Page 4


LEARNING OUTCOMES 
 
 
 
UNIT – 1: FISCAL FUNCTIONS: AN 
OVERVIEW, CENTRE AND STATE 
FINANCE 
 
 
 
 
After studying this Chapter, you will be able to – 
? Explain the three-branch taxonomy of the role of government in a 
market economy 
? Analyze the governmental economic actions and classify them 
according to the economic functions of the government 
? Elucidate the nature of finances and responsibilities of the centre and 
state governments 
? Describe the mode of division of resources between the union and 
the states  
PUBLIC FINANCE 
 
 
    
 
 
CHAPTER 
7 
© The Institute of Chartered Accountants of India
1.  
  
BUSINESS ECONOMICS 
 
 7.2 
Fiscal Functions: An 
Overview, Centre and 
State Finance 
Public Finance 
 
Allocation 
Function 
Redistribution 
Function 
Stabilization 
Function 
 
 
 
 
 
 
 
 
 
 
1.1  INTRODUCTION 
The governments of all nations have important economic functions even where markets 
constitute the basic resource allocation mechanism. The size and scope of government in 
market economies have grown much larger over the past few decades. The primary goal of 
the state is to promote the general welfare of the society.  What governments do, or do not 
do, will obviously have an important impact on the economic performance of an economy 
and the quality of life of its citizens. 
Governments at various levels involve in several operations for running the state. For example; 
the government raises money from various sources, incurs expenditures, consumes goods and 
services, borrows money, employs people, and provides key institutions such as property 
rights. The governments also establish and administer rules and regulations and puts in place 
policies concerning all aspects of life of people. We have experienced in our day-to-day life 
that though governments at various levels impose many rules and regulations in the economy, 
some matters still go unregulated. Similarly, most of the goods and services that we consume 
are provided to us by private producers, but there is broad agreement that certain goods and 
services should be provided exclusively by the government. For a variety of reasons, we believe 
that governments should accomplish some activities and should not do others.  
 
CHAPTER OVERVIEW 
 
© The Institute of Chartered Accountants of India
 1.3 
 
 
 7.3 
PUBLIC FINANCE 
As we know, Macroeconomics is the study of the economy as a whole. There are three main 
macroeconomic goals for any nation. The first is economic growth. If the real gross domestic 
product grows at a faster rate than population, then people can enjoy higher standard of 
living. The second goal is high levels of employment which will ensure higher income and 
higher output. When unemployment occurs, it harms not only the unemployed, but the society 
as a whole because there is loss of output that could have been produced. The third 
macroeconomic goal is stable price levels. Inflation reduces real incomes and purchasing 
power of some people, and disproportionately affects lower income families. On the contrary, 
deflation signals a downturn in economic activity which may cause recession or even 
depression and large scale unemployment.  By ensuring stable prices, an economy can avoid 
prolonged inflation and deflation and achieve high levels of economic activity and 
employment.   
The government does not expect the economy to function automatically; rather it intervenes 
to direct them to function in particular directions. Such intervention on the part of the 
government is based on the belief that the objective of the economic system and the role of 
government is to improve the wellbeing of individuals and households. The purpose of this 
lesson is to examine the economic functions of the government and to understand why the 
government should invariably perform them. 
1.2 THE ROLE OF GOVERNMENT IN AN ECONOMIC  
SYSTEM 
We shall first consider why an ‘economic system’ should be in place. The basic economic 
problem of scarcity arises from the fact that wants are unlimited and the resources available 
to any society are limited. Consequently an economy cannot produce all economic goods and 
services that its members desire to have. Therefore, an economic system by which a society 
(households, businesses, and government) makes decisions about allocating resources to 
produce products and about distributing those products should exist to answer the basic 
questions such as what, how and for whom to produce and how much resources should be 
set apart to ensure growth of productive capacity.  
The modern society, in general, offers three alternate economic systems through which the 
decisions of resource reallocation may be made namely, the market, the government and a 
mixed system where both markets and governments simultaneously determine resource 
allocation. Correspondingly, we have three economic systems namely, capitalism, socialism 
and mixed economy, each with different degrees of state intervention in economic activities. 
Adam Smith is often described as a bold advocate of free markets and minimal governmental 
activity. Smith believed that government's roles in society should be limited, but well defined 
© The Institute of Chartered Accountants of India
1.  
  
BUSINESS ECONOMICS 
 
 7.4 
However, Smith saw an important resource allocation role for the government when he 
underlined the role of government in:  
(a) national defence to protect the nation from external violence and invasion,  
(b) establishing a system of justice to provide internal law and order and to protect 
property 
(c) establishment and maintenance of highly beneficial public institutions and public 
works such as roads, bridges, canals, harbours, and postal system that profit-seeking 
individuals may not be able to efficiently build and operate. 
Since the 1930s, more specifically, as a consequence of the great depression, the state’s role 
in the economy has been distinctly gaining in importance, and therefore, the traditional 
functions of the state have been supplemented with what is referred to as economic functions 
(also called fiscal functions or public finance function). While there are differences among 
different countries in respect of the nature and extent of government intervention in 
economies, all of them agree on one point that the governments are expected to play a major 
role in the economy. This comes out of the belief that government intervention will always 
influence the performance of the economy in a positive way. 
Richard Musgrave, in his classic treatise ‘The Theory of Public Finance’ (1959), introduced the 
three-branch taxonomy of the role of government in a market economy. Musgrave believed 
that, for conceptual purposes, the functions of the government are to be separated into three, 
namely, 
(a) resource allocation (to ensure efficiency),  
(b) income redistribution (to guarantee fairness), and  
(c) macroeconomic stabilization (to ensure price stability). 
The allocation and distribution functions are primarily microeconomic functions, while 
stabilization is a macroeconomic function. The allocation function aims to correct the sources 
of inefficiency in the economic system, while the distribution role ensures that the distribution 
of wealth and income is fair. Monetary and fiscal policies, the problems of macroeconomic 
stability, economic growth and maintenance of high levels of employment and price stability 
etc. fall under the stabilization function. 
The national budget, in general, reflects the economic policy of a government and the 
government exercises its economic functions partly through the budget. We shall now discuss 
in detail the conceptual three-function framework of the responsibilities of the government. 
 
© The Institute of Chartered Accountants of India
Page 5


LEARNING OUTCOMES 
 
 
 
UNIT – 1: FISCAL FUNCTIONS: AN 
OVERVIEW, CENTRE AND STATE 
FINANCE 
 
 
 
 
After studying this Chapter, you will be able to – 
? Explain the three-branch taxonomy of the role of government in a 
market economy 
? Analyze the governmental economic actions and classify them 
according to the economic functions of the government 
? Elucidate the nature of finances and responsibilities of the centre and 
state governments 
? Describe the mode of division of resources between the union and 
the states  
PUBLIC FINANCE 
 
 
    
 
 
CHAPTER 
7 
© The Institute of Chartered Accountants of India
1.  
  
BUSINESS ECONOMICS 
 
 7.2 
Fiscal Functions: An 
Overview, Centre and 
State Finance 
Public Finance 
 
Allocation 
Function 
Redistribution 
Function 
Stabilization 
Function 
 
 
 
 
 
 
 
 
 
 
1.1  INTRODUCTION 
The governments of all nations have important economic functions even where markets 
constitute the basic resource allocation mechanism. The size and scope of government in 
market economies have grown much larger over the past few decades. The primary goal of 
the state is to promote the general welfare of the society.  What governments do, or do not 
do, will obviously have an important impact on the economic performance of an economy 
and the quality of life of its citizens. 
Governments at various levels involve in several operations for running the state. For example; 
the government raises money from various sources, incurs expenditures, consumes goods and 
services, borrows money, employs people, and provides key institutions such as property 
rights. The governments also establish and administer rules and regulations and puts in place 
policies concerning all aspects of life of people. We have experienced in our day-to-day life 
that though governments at various levels impose many rules and regulations in the economy, 
some matters still go unregulated. Similarly, most of the goods and services that we consume 
are provided to us by private producers, but there is broad agreement that certain goods and 
services should be provided exclusively by the government. For a variety of reasons, we believe 
that governments should accomplish some activities and should not do others.  
 
CHAPTER OVERVIEW 
 
© The Institute of Chartered Accountants of India
 1.3 
 
 
 7.3 
PUBLIC FINANCE 
As we know, Macroeconomics is the study of the economy as a whole. There are three main 
macroeconomic goals for any nation. The first is economic growth. If the real gross domestic 
product grows at a faster rate than population, then people can enjoy higher standard of 
living. The second goal is high levels of employment which will ensure higher income and 
higher output. When unemployment occurs, it harms not only the unemployed, but the society 
as a whole because there is loss of output that could have been produced. The third 
macroeconomic goal is stable price levels. Inflation reduces real incomes and purchasing 
power of some people, and disproportionately affects lower income families. On the contrary, 
deflation signals a downturn in economic activity which may cause recession or even 
depression and large scale unemployment.  By ensuring stable prices, an economy can avoid 
prolonged inflation and deflation and achieve high levels of economic activity and 
employment.   
The government does not expect the economy to function automatically; rather it intervenes 
to direct them to function in particular directions. Such intervention on the part of the 
government is based on the belief that the objective of the economic system and the role of 
government is to improve the wellbeing of individuals and households. The purpose of this 
lesson is to examine the economic functions of the government and to understand why the 
government should invariably perform them. 
1.2 THE ROLE OF GOVERNMENT IN AN ECONOMIC  
SYSTEM 
We shall first consider why an ‘economic system’ should be in place. The basic economic 
problem of scarcity arises from the fact that wants are unlimited and the resources available 
to any society are limited. Consequently an economy cannot produce all economic goods and 
services that its members desire to have. Therefore, an economic system by which a society 
(households, businesses, and government) makes decisions about allocating resources to 
produce products and about distributing those products should exist to answer the basic 
questions such as what, how and for whom to produce and how much resources should be 
set apart to ensure growth of productive capacity.  
The modern society, in general, offers three alternate economic systems through which the 
decisions of resource reallocation may be made namely, the market, the government and a 
mixed system where both markets and governments simultaneously determine resource 
allocation. Correspondingly, we have three economic systems namely, capitalism, socialism 
and mixed economy, each with different degrees of state intervention in economic activities. 
Adam Smith is often described as a bold advocate of free markets and minimal governmental 
activity. Smith believed that government's roles in society should be limited, but well defined 
© The Institute of Chartered Accountants of India
1.  
  
BUSINESS ECONOMICS 
 
 7.4 
However, Smith saw an important resource allocation role for the government when he 
underlined the role of government in:  
(a) national defence to protect the nation from external violence and invasion,  
(b) establishing a system of justice to provide internal law and order and to protect 
property 
(c) establishment and maintenance of highly beneficial public institutions and public 
works such as roads, bridges, canals, harbours, and postal system that profit-seeking 
individuals may not be able to efficiently build and operate. 
Since the 1930s, more specifically, as a consequence of the great depression, the state’s role 
in the economy has been distinctly gaining in importance, and therefore, the traditional 
functions of the state have been supplemented with what is referred to as economic functions 
(also called fiscal functions or public finance function). While there are differences among 
different countries in respect of the nature and extent of government intervention in 
economies, all of them agree on one point that the governments are expected to play a major 
role in the economy. This comes out of the belief that government intervention will always 
influence the performance of the economy in a positive way. 
Richard Musgrave, in his classic treatise ‘The Theory of Public Finance’ (1959), introduced the 
three-branch taxonomy of the role of government in a market economy. Musgrave believed 
that, for conceptual purposes, the functions of the government are to be separated into three, 
namely, 
(a) resource allocation (to ensure efficiency),  
(b) income redistribution (to guarantee fairness), and  
(c) macroeconomic stabilization (to ensure price stability). 
The allocation and distribution functions are primarily microeconomic functions, while 
stabilization is a macroeconomic function. The allocation function aims to correct the sources 
of inefficiency in the economic system, while the distribution role ensures that the distribution 
of wealth and income is fair. Monetary and fiscal policies, the problems of macroeconomic 
stability, economic growth and maintenance of high levels of employment and price stability 
etc. fall under the stabilization function. 
The national budget, in general, reflects the economic policy of a government and the 
government exercises its economic functions partly through the budget. We shall now discuss 
in detail the conceptual three-function framework of the responsibilities of the government. 
 
© The Institute of Chartered Accountants of India
 1.5 
 
 
 7.5 
PUBLIC FINANCE 
1.3 THE ALLOCATION FUNCTION 
Resource allocation refers to the way in which the available resources or factors of production 
are allocated among the various uses to which they might be put. It determines how much of 
the various kinds of goods and services will actually be produced in an economy.  Resource 
allocation is a critical problem because the resources of a society are limited in supply, 
whereas the wants of the members of the society are unlimited. In addition, any given resource 
can have many alternative uses.  
One of the most important functions of an economic system is the optimal or efficient 
allocation of scarce resources so that the available resources are put to their best use and no 
wastages are there. Economic efficiency indicates a situation in which all resources are 
allocated to serve each person in the best way possible, minimising waste and inefficiency.  
The private sector resource allocation is characterized by market supply and demand and price 
mechanism as determined by consumer sovereignty and producer profit motives. The state’s 
allocation, on the other hand, is accomplished through the revenue and expenditure activities 
of governmental budgeting. In the real world, resource allocation is determined by both 
market and the government. 
A market economy is subject to serious malfunctioning in several basic respects. While private 
goods will be sufficiently provided by the market, public goods and merit goods will not be 
produced in sufficient quantities by the market. Missing markets or nonexistence of markets 
occur in a variety of situations.  Why do markets fail to give the right answers to the questions 
as to how the resources can be efficiently utilised and what goods should be produced and in 
what quantities? In other words, why do markets generate misallocation of resources? 
Allocative efficiency is concerned with utilizing limited resources to produce goods and 
services that would maximize value to the society. Allocative efficiency achieves the largest 
possible output of goods and services from the existing stock of resources and technology. 
Efficient allocation of available resources in an economy is assumed to take place only when 
the markets are perfectly competitive and economic agents make rational choices and 
decisions. In reality, markets are never perfectly competitive. Market failures which hinder 
efficient allocation of resources occur mainly due to the following reasons: 
• Imperfect competition and presence of monopoly power in different degrees leading 
to under-production and higher prices than would exist under conditions of 
competition. Markets may fail to control the abuses of monopoly power.  
• Markets typically fail to provide collective public goods such as defence which are, by 
their very nature, consumed in common by all people. 
• Incomplete markets; markets may fail to produce the right quantity merit goods, such 
© The Institute of Chartered Accountants of India