Unit I: Fiscal Functions: An Overview | Financial Management & Economics Finance: CA Intermediate (Old Scheme) PDF Download

 Page 1


 
 
  
  
 
PUBLIC FINANCE 
UNIT I: FISCAL FUNCTIONS: AN OVERVIEW 
 
LEARNING OUTCOMES 
 
At the end of this unit, you will be able to: 
? Enumerate the rationale of government intervention in 
markets 
? Explain the three-branch taxonomy of the role of 
government in a market economy  
? Describe the various interventionist measures adopted by 
the government  
? Analyze the governmental economic actions and classify 
them according to the economic functions of the 
government 
CHAPTER 
2 
Page 2


 
 
  
  
 
PUBLIC FINANCE 
UNIT I: FISCAL FUNCTIONS: AN OVERVIEW 
 
LEARNING OUTCOMES 
 
At the end of this unit, you will be able to: 
? Enumerate the rationale of government intervention in 
markets 
? Explain the three-branch taxonomy of the role of 
government in a market economy  
? Describe the various interventionist measures adopted by 
the government  
? Analyze the governmental economic actions and classify 
them according to the economic functions of the 
government 
CHAPTER 
2 
2.2 ECONOMICS FOR FINANCE 
 
 
 1.1 INTRODUCTION 
The following are a few headlines which appeared recently in the leading business 
dailies:  
1. Start-ups will be exempted from income tax for 3 years as part of benefits 
being given to entrepreneurs establishing start-ups. 
2. Government looking at subsidizing R&D to boost foreign investments. 
3. On May 22, 2020, the Monetary Policy Committee (MPC) in an off-cycle 
meeting of the members decides to cut key interest rates to make banks 
increase lending to mitigate the impact of COVID-19 on business and 
industry.     
4. Government announces Rs. 3 lakh Crores ‘collateral-free loan scheme’ for 
businesses, especially micro, small and medium enterprises (MSMEs), as part 
of Rs 20-lakh-crore economic stimulus package to deal with the COVID-19 
pandemic. 
5. Free food kits and essential groceries supplied by government during 
COVID-19 pandemic  
Each of the above statements represents a proactive response on the part of the 
government to achieve certain objectives in the interest of the economy and the 
society.  
Public Finance
Fiscal Functions: An 
Overview
Allocation 
Function
Redistribution 
Function
Stablization 
Function
UNIT OVERVIEW 
Page 3


 
 
  
  
 
PUBLIC FINANCE 
UNIT I: FISCAL FUNCTIONS: AN OVERVIEW 
 
LEARNING OUTCOMES 
 
At the end of this unit, you will be able to: 
? Enumerate the rationale of government intervention in 
markets 
? Explain the three-branch taxonomy of the role of 
government in a market economy  
? Describe the various interventionist measures adopted by 
the government  
? Analyze the governmental economic actions and classify 
them according to the economic functions of the 
government 
CHAPTER 
2 
2.2 ECONOMICS FOR FINANCE 
 
 
 1.1 INTRODUCTION 
The following are a few headlines which appeared recently in the leading business 
dailies:  
1. Start-ups will be exempted from income tax for 3 years as part of benefits 
being given to entrepreneurs establishing start-ups. 
2. Government looking at subsidizing R&D to boost foreign investments. 
3. On May 22, 2020, the Monetary Policy Committee (MPC) in an off-cycle 
meeting of the members decides to cut key interest rates to make banks 
increase lending to mitigate the impact of COVID-19 on business and 
industry.     
4. Government announces Rs. 3 lakh Crores ‘collateral-free loan scheme’ for 
businesses, especially micro, small and medium enterprises (MSMEs), as part 
of Rs 20-lakh-crore economic stimulus package to deal with the COVID-19 
pandemic. 
5. Free food kits and essential groceries supplied by government during 
COVID-19 pandemic  
Each of the above statements represents a proactive response on the part of the 
government to achieve certain objectives in the interest of the economy and the 
society.  
Public Finance
Fiscal Functions: An 
Overview
Allocation 
Function
Redistribution 
Function
Stablization 
Function
UNIT OVERVIEW 
2.3 
 
FISCAL FUNCTIONS: AN OVERVIEW 
seek to revive business and industry in view of the deteriorating outlook for 
economic activity due to the corona virus pandemic and the last one is to bring in 
welfare to the underprivileged sections of the society. The government does not 
expect the economic variables underlying the above mentioned phenomena 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.  
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 certain goods and services are provided 
exclusively by the government. For a variety of reasons, we believe that 
governments should accomplish some activities and should not do others. 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 on account of qualitative 
as well as quantitative constraints, the resources available to any society cannot 
produce all economic goods and services that its members desire to have.  
Therefore, an economic system 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 varying degrees of state intervention in 
economic activities.  
What exactly is the government planning to accomplish by the above measures?  
On close examination, we can find that the first two steps are intended to boost 
up innovation and entrepreneurship; the next two are  policy respons es which 
Page 4


 
 
  
  
 
PUBLIC FINANCE 
UNIT I: FISCAL FUNCTIONS: AN OVERVIEW 
 
LEARNING OUTCOMES 
 
At the end of this unit, you will be able to: 
? Enumerate the rationale of government intervention in 
markets 
? Explain the three-branch taxonomy of the role of 
government in a market economy  
? Describe the various interventionist measures adopted by 
the government  
? Analyze the governmental economic actions and classify 
them according to the economic functions of the 
government 
CHAPTER 
2 
2.2 ECONOMICS FOR FINANCE 
 
 
 1.1 INTRODUCTION 
The following are a few headlines which appeared recently in the leading business 
dailies:  
1. Start-ups will be exempted from income tax for 3 years as part of benefits 
being given to entrepreneurs establishing start-ups. 
2. Government looking at subsidizing R&D to boost foreign investments. 
3. On May 22, 2020, the Monetary Policy Committee (MPC) in an off-cycle 
meeting of the members decides to cut key interest rates to make banks 
increase lending to mitigate the impact of COVID-19 on business and 
industry.     
4. Government announces Rs. 3 lakh Crores ‘collateral-free loan scheme’ for 
businesses, especially micro, small and medium enterprises (MSMEs), as part 
of Rs 20-lakh-crore economic stimulus package to deal with the COVID-19 
pandemic. 
5. Free food kits and essential groceries supplied by government during 
COVID-19 pandemic  
Each of the above statements represents a proactive response on the part of the 
government to achieve certain objectives in the interest of the economy and the 
society.  
Public Finance
Fiscal Functions: An 
Overview
Allocation 
Function
Redistribution 
Function
Stablization 
Function
UNIT OVERVIEW 
2.3 
 
FISCAL FUNCTIONS: AN OVERVIEW 
seek to revive business and industry in view of the deteriorating outlook for 
economic activity due to the corona virus pandemic and the last one is to bring in 
welfare to the underprivileged sections of the society. The government does not 
expect the economic variables underlying the above mentioned phenomena 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.  
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 certain goods and services are provided 
exclusively by the government. For a variety of reasons, we believe that 
governments should accomplish some activities and should not do others. 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 on account of qualitative 
as well as quantitative constraints, the resources available to any society cannot 
produce all economic goods and services that its members desire to have.  
Therefore, an economic system 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 varying degrees of state intervention in 
economic activities.  
What exactly is the government planning to accomplish by the above measures?  
On close examination, we can find that the first two steps are intended to boost 
up innovation and entrepreneurship; the next two are  policy respons es which 
2.4 ECONOMICS FOR FINANCE 
Adam Smith is often described as a bold advocate of free markets and minimal 
governmental activity. However, Smith saw an important resource allocation role 
for government when he underlined the role of government in national defence, 
maintenance of justice and the rule of law, establishment and maintenance of 
highly beneficial public institutions and public works which the market may fail to 
produce on account of lack of sufficient profits. 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 as described above, 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 invariably 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, resource allocation, 
(efficiency), income redistribution (fairness) and macroeconomic stabilization. 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, maintenance of high levels of 
employment and price stability etc fall under the stabilization function. We shall 
now discuss in detail this conceptual three-function framework of the 
responsibilities of the government. 
 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, while human wants are unlimited. 
Moreover, any given resource can have many alternative uses. One of the most 
important functions of an economic system is the optimal or efficient allocation 
Page 5


 
 
  
  
 
PUBLIC FINANCE 
UNIT I: FISCAL FUNCTIONS: AN OVERVIEW 
 
LEARNING OUTCOMES 
 
At the end of this unit, you will be able to: 
? Enumerate the rationale of government intervention in 
markets 
? Explain the three-branch taxonomy of the role of 
government in a market economy  
? Describe the various interventionist measures adopted by 
the government  
? Analyze the governmental economic actions and classify 
them according to the economic functions of the 
government 
CHAPTER 
2 
2.2 ECONOMICS FOR FINANCE 
 
 
 1.1 INTRODUCTION 
The following are a few headlines which appeared recently in the leading business 
dailies:  
1. Start-ups will be exempted from income tax for 3 years as part of benefits 
being given to entrepreneurs establishing start-ups. 
2. Government looking at subsidizing R&D to boost foreign investments. 
3. On May 22, 2020, the Monetary Policy Committee (MPC) in an off-cycle 
meeting of the members decides to cut key interest rates to make banks 
increase lending to mitigate the impact of COVID-19 on business and 
industry.     
4. Government announces Rs. 3 lakh Crores ‘collateral-free loan scheme’ for 
businesses, especially micro, small and medium enterprises (MSMEs), as part 
of Rs 20-lakh-crore economic stimulus package to deal with the COVID-19 
pandemic. 
5. Free food kits and essential groceries supplied by government during 
COVID-19 pandemic  
Each of the above statements represents a proactive response on the part of the 
government to achieve certain objectives in the interest of the economy and the 
society.  
Public Finance
Fiscal Functions: An 
Overview
Allocation 
Function
Redistribution 
Function
Stablization 
Function
UNIT OVERVIEW 
2.3 
 
FISCAL FUNCTIONS: AN OVERVIEW 
seek to revive business and industry in view of the deteriorating outlook for 
economic activity due to the corona virus pandemic and the last one is to bring in 
welfare to the underprivileged sections of the society. The government does not 
expect the economic variables underlying the above mentioned phenomena 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.  
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 certain goods and services are provided 
exclusively by the government. For a variety of reasons, we believe that 
governments should accomplish some activities and should not do others. 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 on account of qualitative 
as well as quantitative constraints, the resources available to any society cannot 
produce all economic goods and services that its members desire to have.  
Therefore, an economic system 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 varying degrees of state intervention in 
economic activities.  
What exactly is the government planning to accomplish by the above measures?  
On close examination, we can find that the first two steps are intended to boost 
up innovation and entrepreneurship; the next two are  policy respons es which 
2.4 ECONOMICS FOR FINANCE 
Adam Smith is often described as a bold advocate of free markets and minimal 
governmental activity. However, Smith saw an important resource allocation role 
for government when he underlined the role of government in national defence, 
maintenance of justice and the rule of law, establishment and maintenance of 
highly beneficial public institutions and public works which the market may fail to 
produce on account of lack of sufficient profits. 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 as described above, 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 invariably 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, resource allocation, 
(efficiency), income redistribution (fairness) and macroeconomic stabilization. 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, maintenance of high levels of 
employment and price stability etc fall under the stabilization function. We shall 
now discuss in detail this conceptual three-function framework of the 
responsibilities of the government. 
 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, while human wants are unlimited. 
Moreover, any given resource can have many alternative uses. One of the most 
important functions of an economic system is the optimal or efficient allocation 
 
 
2.5 
 
FISCAL FUNCTIONS: AN OVERVIEW 
of scarce resources so that the available resources are put to their best use and 
no wastages are there.  
As we know, 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 both market-
determined and government-determined.  
A market economy is subject to serious malfunctioning in several basic respects. 
There is also the problem of nonexistence of markets in a variety of situations.  
While private goods will be sufficiently provided by the market, public goods will 
not be produced in sufficient quantities by the market. 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?  
Efficient allocation of available resources in an economy takes place only when 
free and competitive market structure exists and economic agents make rational 
choices and decisions. Such efficient allocation of resources is assumed to take 
place only in perfectly competitive markets. In reality, markets are never perfectly 
competitive.  Market failures which hold back the 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. These distort the choices available to 
consumers and reduce their welfare.   
• Markets typically fail to provide collective goods which are, by their very 
nature, consumed in common by all people.   
• Markets fail to provide the right quantity of merit goods. 
• Common property resources are overused and exhausted in individual 
pursuit of self-interest. 
• Externalities which arise when the production and consumption of a good 
or service affect people and they cannot influence through markets the 
decision about how much of the good or service should be produced e.g. 
pollution.