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

Chapter Overview

Unit 1: Fiscal Functions: An Overview, Centre and State Finance Chapter Notes | Business Economics for CA Foundation

Introduction

  • Economic Functions of Government. The government plays a crucial role in ensuring the overall welfare of society, and its actions significantly impact economic performance and citizens' quality of life.
  • Historical Growth. Over the past few decades, the size and scope of government in market economies have expanded considerably, reflecting its increasing importance in economic management.
  • Government Operations. Governments are involved in various operations such as raising money, incurring expenditures, consuming goods and services, borrowing, employing people, and providing essential institutions like property rights.
  • Rule and Regulation. Governments establish and administer rules, regulations, and policies that affect all aspects of people's lives.
  • Macroeconomic Goals. There are three primary macroeconomic goals for any nation: economic growth, high levels of employment, and stable price levels. These goals are essential for improving living standards, ensuring higher income and output, and avoiding the harms of inflation and deflation.
  • Government Intervention. The government intervenes in the economy to direct its functioning towards improving the well-being of individuals and households, based on the belief that markets do not always operate automatically in the best interest of society.
  • Purpose of the Lesson. The lesson aims to examine the economic functions of government and understand why these functions are necessary for societal welfare.

Question for Chapter Notes- Unit 1: Fiscal Functions: An Overview, Centre and State Finance
Try yourself:
Which of the following is NOT a macroeconomic goal for any nation?
View Solution

The Role of Government in an Economic System

  • An economic system is necessary because of the fundamental issue of scarcity. Scarcity arises because people have unlimited wants but the resources available to satisfy those wants are limited. As a result, an economy cannot produce all the goods and services that its members desire. Therefore, an economic system is required to decide how to allocate resources for production and how to distribute the resulting products. This system helps answer basic questions about what to produce, how to produce, for whom to produce, and how much resources should be reserved for future growth.
  • Modern society offers three different economic systems for resource allocation: the market, the government, and a mixed system where both markets and governments play a role. These correspond to capitalism, socialism, and a mixed economy, each with varying levels of government involvement in economic activities.

Adam Smith, often seen as a strong supporter of free markets and limited government intervention, acknowledged the need for government in certain areas:

  • National Defence: Protecting the nation from external threats and invasions.
  • Establishing Justice: Maintaining internal law and order and safeguarding property rights.
  • Public Goods: Creating and maintaining essential public infrastructure such as roads, bridges, canals, harbors, and postal systems that private individuals may not efficiently provide.

Since the 1930s, particularly after the Great Depression, the role of the state in the economy has increased significantly. Governments now play a major role in economic functions, also known as fiscal or public finance functions. While the extent and nature of government intervention vary among countries, there is a common agreement that government involvement positively impacts economic performance.

In his influential work ‘The Theory of Public Finance’ (1959), Richard Musgrave put forth a framework categorizing the role of government in a market economy into three distinct functions:

  • Resource Allocation: This function focuses on ensuring efficiency within the economy. The government intervenes to correct sources of inefficiency, making sure that resources are allocated in a way that maximizes overall welfare.
  • Income Redistribution: This function aims to guarantee fairness in the distribution of wealth and income. The government plays a role in redistributing income to ensure that there is a fair level of equality among citizens.
  • Macroeconomic Stabilization: This function involves maintaining macroeconomic stability, which includes aspects like price stability, economic growth, and high levels of employment. The government uses monetary and fiscal policies to address issues related to macroeconomic stability.

Microeconomic vs. Macroeconomic Functions

  • The allocation and distribution functions are primarily microeconomic in nature, focusing on the efficiency and fairness of resource use and income distribution within the economy.
  • The stabilization function is macroeconomic, dealing with broader issues that affect the economy as a whole, such as inflation, unemployment, and economic growth.

The Role of the National Budget

  • The national budget is a reflection of the economic policy of the government and is a tool through which the government exercises its economic functions. It outlines how resources will be allocated, how income will be redistributed, and how macroeconomic stability will be pursued.

Conceptual Framework of Government Responsibilities

  • Musgrave’s framework provides a conceptual basis for understanding the different roles that government plays in the economy. Each function is essential for the overall health and stability of the economic system, and the government must balance these roles effectively.

The Allocation Function

Resource allocation refers to how available resources or factors of production are distributed among various potential uses. It plays a crucial role in determining the quantity of different goods and services produced within an economy. The challenge of resource allocation arises from the limited supply of resources in society, contrasted with the unlimited wants of its members. Furthermore, any given resource can be utilized in multiple ways.

Economic Efficiency and Resource Allocation

  • A key function of an economic system is the optimal allocation of scarce resources to ensure they are used effectively without waste. Economic efficiency entails allocating resources to serve each individual in the best possible way, minimizing waste and inefficiency.
  • Private sector resource allocation is driven by market supply and demand, guided by consumer preferences and producer profit motives. In contrast, the state allocates resources through government budgeting activities involving revenue and expenditure. In practice, resource allocation involves both market mechanisms and government intervention.
  • Market economies face challenges in providing certain goods. While private goods are adequately supplied by the market, public goods and merit goods are often underproduced. Markets may fail to address these needs, leading to misallocation of resources.
  • Allocative efficiency focuses on using limited resources to produce goods and services that maximize societal value. It aims to achieve the highest possible output from the existing resources and technology.

Conditions for Efficient Resource Allocation

  • Efficient resource allocation is typically associated with perfectly competitive markets and rational decision-making by economic agents. However, in reality, markets are rarely perfectly competitive.
  • Market failures hinder efficient resource allocation due to various factors, including:
  • Imperfect competition and the presence of monopoly power, leading to underproduction and higher prices compared to competitive conditions. Markets may struggle to regulate monopoly abuses.

Market Failure and Government Intervention

Market failures occur when the allocation of goods and services by a free market is not efficient. This can happen for several reasons:

  • Public Goods: Markets often fail to provide public goods like defense, which are consumed collectively by everyone.
  • Incomplete Markets: Markets may not produce enough merit goods, such as education and healthcare, which are beneficial for society.
  • Common Property Resources: Resources like the environment are overused and depleted when individuals act in their own self-interest.
  • Externalities: These occur when the production and consumption of a good or service impact third parties, like in the case of pollution.
  • Factor Immobility: This leads to unemployment and inefficiency when factors of production, like labor, cannot move freely.
  • Imperfect Information: Sometimes, one party may not provide full information to another, leading to suboptimal decisions.
  • Inequalities in Income and Wealth Distribution: Significant disparities can lead to market imbalances and social issues.

According to economist Musgrave, the state plays a crucial role in meeting the needs and concerns of its citizens. Public finance is linked to economic mechanisms aimed at the effective and optimal allocation of limited resources. This rationale supports the idea that government intervention is necessary to enhance social welfare.
Without appropriate government intervention, market failures can result in misallocation of resources, leading to excessive production of some goods and insufficient production of others. For instance, society might produce too many demerit goods (harmful products) and too few merit goods (beneficial products).

The government’s role involves corrective actions when private markets fail to provide the right mix of goods and services. This is known as the government’s allocative function, which is justified by the existence of market failures.

Examples of Government Intervention

  • Property Rights and Contract Enforcement: Governments establish property rights and enforce contracts through law enforcement and judicial systems.
  • Correcting Externalities: When externalities affect the true costs and benefits of goods and services, the government intervenes with corrective measures, such as taxes or subsidies.
  • Providing Merit Goods: The government often provides merit goods that are highly beneficial to society, such as public education and healthcare.
  • Regulating Demerit Goods: The production and consumption of demerit goods are regulated through appropriate policies to protect public welfare.

It’s important to note that government interventions do not replace markets but complement them. The government acts as a partner to the market system, ensuring a more balanced and beneficial allocation of resources in the economy.
The government plays a crucial role in allocating resources within the economy through its expenditure and tax policies. This involves determining how resources are distributed among various uses and ensuring the right mix of social goods, including public and merit goods. The government’s policy aims to enhance economic performance by carefully deciding who and what will be taxed, how government revenue is spent, and the level of public sector involvement in the national economy.

The allocative function in budgeting involves:

  • Determining Taxes and Spending: Who and what will be taxed and how government revenue will be spent.
  • Dividing Resources: The process of dividing the total resources of the economy among various uses.
  • Optimum Mix of Social Goods: Finding the best mix of public goods (like parks, roads) and merit goods (like education, healthcare) that benefit society.
  • Public Sector Involvement: Deciding the level of involvement of the public sector in the national economy.
  • Resource Reallocation: Shifting society’s resources from private use to public use when necessary.

To influence resource allocation, the government has various instruments at its disposal:

  • Direct Production: The government may directly produce economic goods, such as electricity and public transportation services.
  • Price Mechanism: The government can alter market prices through taxes and subsidies to influence private allocation. For instance, tax concessions and subsidies may be offered for the production of goods that promote social welfare, while higher taxes may be imposed on harmful goods like cigarettes and alcohol.
  • Legislation and Force: The government can influence allocation through legislation, such as banning single-use plastic goods, to prevent resources from being used in their production.
  • Competition Policies: Policies like the Competition Act in India promote competition and prevent anti-competitive activities, affecting the structure of industry and commerce.
  • Regulatory Activities: Government regulatory activities, such as licensing, minimum wage controls, and directives on the location of industries, also influence resource allocation.
  • Legal and Administrative Frameworks: The government sets legal and administrative frameworks to guide resource allocation.
  • Combination of Remedies: The government may adopt any combination of these remedies to influence resource allocation effectively.

The Redistribution Function

Economic Growth and Inequality

  • Over the past few decades, there has been significant growth in economic activities, leading to a substantial increase in overall output and wealth. However, this growth has not been evenly distributed among households. The socialist ideology, which focuses on equality, has put pressure on governments to play a stronger role in redistributing income and wealth.
  • The need for government intervention arises because, left to the market, the distribution of income and wealth is likely to be skewed. Governments aim to create a more socially optimal and egalitarian distribution through their redistributive functions.

Distributive Function of the Budget
The distributive function of the budget relates to the fundamental question of "for whom" goods and services should be produced. Governments can redistribute income and wealth through:

  • Expenditure Side: By providing free or subsidized services such as education, healthcare, housing, food, and other basic goods to those in need.
  • Revenue Side: Through progressive taxation, where the wealthy are taxed at higher rates to support social programs.

Effective Demand and Income Distribution
Effective demand is influenced by the income levels of households, which in turn affects the distribution of real output among individuals. The distribution function is connected to how effective demand for economic goods is divided among various individuals and families in society.

Objectives of the Distribution Function

  • Achieve an equitable distribution of societal output among households to enhance overall social welfare.
  • Improve the well-being of individuals facing various deprivations.
  • Ensure equality in income, wealth, and opportunities.
  • Provide security by meeting basic needs for those facing hardships and guaranteeing a minimum standard of living for all.

Examples of Redistribution by Governments

  • Taxation Policies: Implementing progressive taxation where the rich are taxed more, and the proceeds are used to subsidize poor households.
  • Financing Public Services: Using proceeds from progressive taxes to fund public services that benefit low-income households, such as supplying essential food grains at highly subsidized prices to Below Poverty Line (BPL) households.

In modern times, most egalitarian welfare states offer free or subsidized education and healthcare, unemployment benefits, pensions, and other social security measures. However, there is a debate about the potential conflict between efficiency and equity in redistributive policies. For instance, while high taxes on the wealthy can promote greater equity, they may also discourage entrepreneurship, work, savings, investments, and risk-taking. This could negatively impact economic output, productivity, and growth, leading to reduced future tax revenues and limiting the government's capacity for welfare activities. Therefore, an optimal budgetary policy for distributional changes should aim to balance efficiency and equity, minimizing efficiency costs while achieving equity objectives. Redistribution measures should be implemented with careful consideration to avoid significant efficiency losses, striving for a harmonious trade-off between the two goals.

Question for Chapter Notes- Unit 1: Fiscal Functions: An Overview, Centre and State Finance
Try yourself:
Which of the following is an example of a market failure leading to inefficient resource allocation?
View Solution

Stabilization Function

Macroeconomic stability refers to a situation where:

  • The output of an economy aligns with its production capacity.
  • Total spending in the economy matches total output.
  • Labor resources are fully employed.
  • Inflation remains low and stable.

The need for government stabilization comes from the Keynesian view that a market economy does not naturally achieve full employment and price stability. Therefore, governments should actively pursue stabilization policies.

The market system has a tendency to create business cycles, and its ability to prevent or resolve disruptions caused by fluctuations in economic activity is limited.

To promote full employment and price stability, the government and the central bank use prudent fiscal and monetary policies.

Without appropriate government intervention, economic instabilities such as recessions and inflation can persist for extended periods, causing significant hardships, especially for poorer sections of society.

Additionally, there is a risk of stagflation, where inflation and unemployment occur simultaneously, complicating the situation further.

The stabilization function is also affected by the "contagion effect," where increased international interdependence and financial integration allow forces of instability to spread from one country to another.

This function is concerned with the overall performance of the economy in terms of:

  • Labor employment and capital utilization
  • Overall output and income
  • General price levels
  • Balance of international payments
  • Economic growth rate

The stabilization function is a key aspect of fiscal policy, aiming to eliminate macroeconomic fluctuations caused by suboptimal resource allocation. Events like the 2008 economic crisis and the COVID-19 pandemic have underscored the importance of macroeconomic stability and revived interest in countercyclical fiscal policy.

Government stabilization efforts can involve both monetary and fiscal policy. Monetary policy focuses on controlling the money supply and interest rates, which in turn influence consumption, investment, and prices.

Fiscal Policy for Stabilization

  • Fiscal policy aims to stabilize the economy by influencing the behavior of individuals and organizations through government spending and taxation decisions.
  • Government spending injects money into the economy, stimulating demand, while taxes reduce disposable income, leading to decreased demand.

During a recession, the government may increase spending, cut taxes, or use a combination of both to boost aggregate demand and put more money in people's hands.

To combat high inflation, the government may reduce spending or raise taxes. This means:

  • Expansionary fiscal policy is used to address recession.
  • Contractionary fiscal policy is employed to control high inflation.

Budget Types and Economic Activity

  • The type of budget—surplus or deficit—also affects economic activity.
  • Deficit budgets are expected to stimulate economic activity.
  • Surplus budgets tend to slow down economic activity.

Summary of Fiscal Policy Measures

  • High Inflation:To address high inflation, the government may:
    • Decrease government spending
    • Raise taxes
    • Reduce the money supply
  • High Unemployment:In the case of high unemployment, the government might:
    • Increase government spending
    • Reduce taxes
    • Increase the money supply

Conflict of Goals: There is often a conflict between the different goals and functions of budgetary policy. Effective policy design to meet the diverse goals of government is very difficult to conceive and to implement. The challenge before any government is how to design its budgetary policy so that the pursuit of one goal does not jeopardize the other.

Centre and State Finance

Fiscal Federalism, a concept put forth by Richard Musgrave, addresses the division of governmental responsibilities and financial relationships among various levels of government. Musgrave proposed that:

  • The federal or central government should handle functions related to economic stabilization and income redistribution.
  • Resource allocation should be the responsibility of state and local governments.

India comprises 28 states and 8 union territories, functioning as a federation. Federalism in India involves two sets of government:

  • National Level: Responsible for broader functions such as defense, foreign affairs, and economic policy.
  • Regional Level: States and union territories manage local issues like education, health, and infrastructure.

Each government operates autonomously within its sphere of authority. An independent judiciary resolves disputes between the central government and states regarding the division of powers. This system ensures a balance of power and efficient governance at both levels.

The Constitution of India outlines the distribution of powers between the central and state governments. Article 246 classifies these powers into three lists: the Union List, the State List, and the Concurrent List.

  • Union List: Contains subjects on which only the Union Parliament can legislate.
  • State List: Includes subjects on which only state legislative assemblies can legislate.
  • Concurrent List: Covers subjects on which both Parliament and state legislatures can legislate. In case of a conflict in the Concurrent List, the law passed by the Centre prevails.

The allocation of revenue and expenditure responsibilities is crucial in a federation. The sources of revenue for both the Centre and the states are clearly defined, along with their financial responsibilities.

  • Central Government: Has broader revenue-raising powers and can levy various taxes, including income tax (excluding agricultural income), customs duties, excise duties, corporation tax, and various other taxes.
  • State Governments: Can levy taxes on agricultural income, land and buildings, mineral rights, electricity, vehicles, tolls, and certain excise duties. The property of the Union is exempt from state taxation, and state property and income are not subject to central taxation.

Inter-governmental transfers and revenue-sharing are essential components of fiscal federalism to meet diverse national objectives. States, having limited income sources, often rely on the Union for necessary revenues. Articles 268 to 281 of the Constitution outline the distribution of finances among states.

Distribution of Revenue:
Article 268: Duties levied by the Union but collected and appropriated by the states.
Article 269: Taxes levied and collected by the Union but assigned to the states.

Distribution of Financial Resources Between Union and States

  • Article 270: Taxes levied and collected by the Union are distributed between the Union and the States as prescribed in clause 2.
  • Article 271: Surcharge on certain duties and taxes for the purposes of the Union.
  • Article 275: Statutory grants-in-aid from the Union to certain States.
  • Article 282: Grants for any public purpose.
  • Article 293: Loans for any public purpose.

 Finance Commission and Fiscal Federalism 

  • Article 280: The Finance Commission is an institutional mechanism provided by the Indian Constitution to facilitate the transfer of resources from the Centre to the States.
  • The Finance Commission is responsible for:
  • Evaluating the finances of the Union and State governments.
  • Recommending the sharing of taxes between the Union and States.
  • Laying down principles for the distribution of taxes among States.

Functions of the Finance Commission:

  •  Distribution of Tax Proceeds:  Determines the distribution between the Union and States of net proceeds of taxes and allocates shares among States.
  •  Grants-in-Aid:  Determines principles and quantum of grants-in-aid to States in need of assistance.
  •  Augmentation of State Funds:  Recommends measures to augment the consolidated fund of a State to supplement resources of Panchayats and Municipalities.
  •  Other Matters:  Addresses any other matter referred by the President in the interest of sound finance.

Considerations in Transfer Recommendations

  • The Finance Commission considers vertical equity (share of all States in revenue collected by the Centre) and horizontal equity (allocation among States of their share of central revenue).
  • It assesses the overall gross tax revenues of the Union, netting out cesses, surcharges, and non-tax revenue to arrive at the net divisible pool (NDP).
  • Following a constitutional amendment in 2000, the divisible pool consists of all taxes of the Union.
  • The Commission determines the percentage of the NDP to be assigned to State governments, with the balance remaining with the Central government.

The Fifteenth Finance Commission was set up on November 27, 2017, after the Planning Commission was abolished and the goods and services tax (GST) was introduced. The Commission recommended a 41% share of central taxes for states from 2021 to 2026, the same as 2020-21 but lower than the 42% recommended by the previous Commission. This adjustment accounts for the new union territories of Jammu and Kashmir and Ladakh.

Distribution Criteria

  • Income Distance: Measures how far a state's income is from the highest-income state.
  • Area: The size of the state.
  • Population (2011): Based on the 2011 Census.
  • Demographic Performance: Rewards states for their efforts in controlling population growth.
  • Forest and Ecology: Consideration of a state's forest cover and ecological efforts.
  • Tax and Fiscal Efforts: Evaluation of a state's tax and fiscal management.

Impact of GST

  • The introduction of GST on July 1, 2017, transformed the financial relationship between the centre and the states by unifying most indirect taxes like excise, service tax, sales tax, and entry tax.
  • Under GST, states collect State GST (SGST), and the centre collects Central GST (CGST), with equal rates for both. Integrated GST (IGST) applies to inter-state movement and international trade, administered by the centre and shared with states after settling input tax credits.
  • GST now accounts for about 35% of the centre's gross tax revenue and around 44% of states' own tax revenue.

Supreme Court Ruling and GST Framework

  • In May 2022, the Supreme Court ruled that the Union and state legislatures have equal and unique powers to legislate on GST, and the GST Council's recommendations are not binding.
  • GST shifted the tax system from production-based to consumption-based, addressing concerns of manufacturing states by providing revenue compensation for five years through a cess on luxury and demerit goods. This compensation period was extended due to the economic impact of the pandemic.

During the five-year transition period, the states that received the most GST compensation were Maharashtra, Karnataka, Gujarat, Tamil Nadu, and Punjab. In the year 2022-23, the total amount of compensation released to states and union territories was ₹1,15,662 crore.

Expenditure Decentralization

  • Central Government Responsibilities: The central government is responsible for providing services in nationally important areas such as: Defence Foreign affairs Foreign trade and exchange management Money and banking Cross-state transport and communication
  • State Government Responsibilities: State governments are responsible for: Facilitating agriculture and industry Providing social sector services such as health and education Police protection State roads and infrastructure
  • Local Self-Government Responsibilities: Local self-governments, such as municipalities and panchayats, are responsible for providing public utility services like: Water supply and sanitation Local roads Electricity
  • Concurrent List: For items in the concurrent list, both the central and state governments are responsible for providing services.

Borrowing Provisions in the Constitution

  • Government Borrowing: Borrowing by the Government of India and states is defined under Articles 292 and 293 of the Constitution.
  • Central Government: The central government can borrow within limits fixed by Parliament, using the Consolidated Fund of India as security. It can also provide guarantees within these limits.
  • State Governments: State governments can borrow within India, using the Consolidated Fund of the State as security, within limits set by the state legislature. They can also provide guarantees within these limits.
  • Central Loans to States: The central government can lend to states within limits fixed under Article 292 and provide guarantees for loans raised by states.
  • State Indebtedness: States need the central government’s consent to borrow if they are indebted to the centre from a previous loan.
The document Unit 1: Fiscal Functions: An Overview, Centre and State Finance Chapter Notes | Business Economics for CA Foundation is a part of the CA Foundation Course Business Economics for CA Foundation.
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FAQs on Unit 1: Fiscal Functions: An Overview, Centre and State Finance Chapter Notes - Business Economics for CA Foundation

1. What are the main functions of government in an economic system?
Ans.The main functions of government in an economic system include the allocation function, which ensures resources are distributed efficiently; the redistribution function, which aims to reduce inequality through wealth redistribution; and the stabilization function, which focuses on maintaining economic stability through fiscal and monetary policies.
2. How does the allocation function work in an economic system?
Ans.The allocation function of government involves the distribution of resources and services to ensure that public goods, such as education, healthcare, and infrastructure, are available to all citizens. This function aims to correct market failures and ensure that essential services are provided in a way that maximizes social welfare.
3. Why is the redistribution function important in an economy?
Ans.The redistribution function is important as it addresses income inequality and promotes social equity. Governments implement policies such as progressive taxation and social welfare programs to redistribute wealth from richer to poorer segments of society, ensuring that all individuals have access to basic needs and opportunities for improvement.
4. What is fiscal policy, and how does it relate to stabilization?
Ans.Fiscal policy refers to the use of government spending and taxation to influence the economy. It is a key tool for stabilization, as governments can increase spending or cut taxes during economic downturns to stimulate growth, or reduce spending and increase taxes during booms to cool down inflation, thereby maintaining overall economic stability.
5. How do central and state finances interact in the context of fiscal functions?
Ans.Central and state finances interact through a system of revenue sharing and grants. The central government collects a significant portion of taxes and distributes funds to states based on their needs and priorities. This interaction ensures that both levels of government can fulfill their fiscal functions effectively, addressing local needs while maintaining national economic stability.
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