PFTP PostMidsem

Public Revenue-Ch4-Bhatia
DEBASIS PATNAIK
2 ND S E M 2 0 1 9 - 2 0
BITS PILANI K K BIRLA GOA CAMPUS
Intro
Taxes
Income from currency
Market borrowings
Sale of Public assets
Income from PSUs
Fees/Fines/Gifts
Public Receipts and Public revenue
Public Receipts include income from all sources

Public Revenue is a narrower concept and does not
include public borrowing, income from sale of public
assets or income from use of printing press.
Central Govt. Receipts(Art.112)
Revenue Receipts
Capital Receipts
Economic Reasoning behind this classification?
Capital budget covers the creation and disposal of
assets and liabilities, especially connected with various
projects
Revenue Budget covers the current receipts and
running expenses.(Interests/Dividends/Profits)
Revenue Receipts
I-Tax Revenue
a-Taxes on Income and Expenditure
b-Taxes on Property and Capital Transaction
c –Taxes on commodities and services-cess/ basic excise/ taxes
levied by center but collected in UT/tax on foreign travel
II-Non-Tax Revenue
a-Currency, coinage and mint
b – r receipts/dividends and profits from PSUs and contribution
from Railways, posts and telegraphs/profits of RBI transferred
to GOI
c- admin services, PSC, water and power dev services, publicity,
grants, police, jails, agriculture and allied services, industry and
minerals, transport and communications, supplies and disposal,
education, housing.
Capital receipts
Market borrowing-loans of maturity>12months

What if these loans are taken by RBI?
Funding of ad hoc T-bills and its conversion into long
dated loans, bonds through VDS.
External loans
Recovery of loans by centre from states, UT and NGO
Small saving receipts/provident funds
Other K receipts-deposits under Compulsory Deposit
Schemes, US Rupee Balances, railway pension fund, safety
and passenger amenities fund, Accident compensation,
Railway depreciation reserve fund, P&T revenue reserve
fund.
Tax revenue versus non tax revenue
What is a tax? It is a compulsory levy. Those who are

taxed, have to pay irrespective of corresponding
returns. It is not a price paid by tax payer for any
definite service rendered. He does not receive a
definite and direct quid pro quo from the govt.
Tax payer does get benefits, but he has no right to any
benefit on the ground that he is paying. Benefits can go
to anyone.
Tax as generalized exaction
It is a liability imposed on assessees

(individuals/groups/legal entities) Why a liability?
Because irrespective of source, minimal nature, any
economic activities, it can be imposed. So it is a
generalized exaction.
Public receipt containing an element of compulsion
does not automatically become a tax. To be a tax,
absence of quid pro quo is a must.
Element of compulsion
Even in pricing, some compulsion is there.[though

voluntary and in exchange]
If authorities have a monopoly of good /service in
question, and if they choose to charge a price in excess
of PC price (cost+ normal profits), then that excess
price becomes a tax.
When PSUs have high cost of production due to
inefficiency-difficult to separate elements of pure price
and tax.
Where consumers have no choice: street light? Defense
system?
Element of compulsion
Special assessments, fees, fines:

Special assessment or a betterment levy is a special
charge on certain members believed to be
beneficiaries. Ex: Provision of parks and land values go
up. Irrigated lands and land prices increase. Such
benefits are not due to efforts of property owners.
Unearned income. Being a compulsory payment, it is
more like a tax.
But since there is a quid pro quo, (some get benefits),
it is like a price.
Fines (court fines)
Compulsory payments without quid pro quo. But they

are different from taxes because fines are imposed to
curb offences and not to get revenue from state. So
fines are not taxes.
Imports and export duties may be imposed with
different intentions. If intention is to get revenue, then
it is tax. But if intention is to regulate the flow of
imports and exports, then it is different.
Fees
Fees for services like registration of marriages, births

and deaths. If fees are in excess of cost(except in
health services).
To the extent fees charged represent the cost of
services, they are like prices.
But the excess charges are in the nature of tax.
Compulsory levies on public(to a certain extent)
Profits from paper currency and mintage.

In India, for example, notes up to the denomination of
one rupee and coins of all denominations are printed
and minted. The actual cost of creating the currency <
FV. GOI profits from this. This profit is not like other
profits of PSUs. Public faces an element of
compulsion as it has no choice but use this currency.
Deficit financing vs Gifts
Excess of PE over PR. This excess is met by borrowings from

market, borrowings from abroad, or use of printing press.
In case of borrowings from abroad, there cannot be any
compulsion for the lenders; in case of internal borrowings there
can be compulsion. So govt procures loans below market rates.
This is a kind of tax.
If govt uses a printing press, and spends these additional funds,
AD increases and prices are pushed up. Govt purchases away
part of resources and market is left with smaller supplies, i.e.
govt through use of printing press, taxes away some resources
from the market
VERSUS
If voluntary gifts are made to authorities, such as during a war,
then such an income is neither in nature of tax or price.
Base of a tax: Many dimensions or features
1- Legal description of the object with reference to which tax applies.

Ex: Base of an excise duty is the production or packing or processing
any good. Base of an income tax is the income of the assesee defined
and estimated in terms of certain rules laid down. A gift is defined
and made a base for levying a gift tax.
2-So base of a tax has to be defined legally. Each tax payer is a legal
entity.[individual legal entity may be subjected to more than one tax].
3-Tax base has a time dimension. Ex: Income tax on annual basis.
Whether IT be taxed on receipt or accrual?
4-Cost of collection , administration, effects of a tax need to be
considered while determining tax base. Exact coverage of tax base to
be determined by an optimum combination of these considerations.
5-Tax base can grow or shrink with time. As production of excisable
goods increases, base of excise duty would be taken as grown.
6-If by law, new items may be brought under particular taxation, or if
provisions, definitions, rules are changed, coverage or base changes.
Buoyancy or Elasticity of a Tax
These are factors responsible for an increase in the yield of tax over time.
If tax revenue increases with growth of its base, but without extension of tax coverage,
or upward revision of tax rates, then the tax is said to be buoyant. i.e. it has inherent
tendency to yield more tax revenue with growth of its base.
Ex: With given rates of income tax and definition of taxable income, if yield from
Income tax increases as NI increases, it is called buoyant tax.
On Excise duties (levied on production of specified goods). If new items are not
brought under these duties and rates of existing duties remain unchanged, but revenue
from excise duty increases with an increase in the production of excisable items, it is
buoyancy of excise duties.
Numerically, buoyancy of a tax measured as ratio of proportionate increase in tax
revenue to proportionate increase in tax base.[buoyancy in case of individual tax or set
of taxes]
But yield of a tax can increase due to extension of its coverage or revision of its rates.
This is elasticity. This refers to responsiveness to steps taken by authorities in
increasing its yield through extension of its coverage or revision of its rates.
Numerically, elasticity of a tax measured by ratio of proportionate change in yield to
prop change in coverage or rates.
Principles /Canons of taxation
A good tax system adheres/fulfills/justifies some principles such as equality and certainty. But
objectives can be conflictual in nature.
Adam Smith’s canons: Smith was focused on economic growth but wanted the state to have
adequate revenue. So he gave 4 canons:
1- Equality: Subjects should give to state as per individual capacity.[in proportion to incomes that
they enjoy.]Tax should impose equal marginal disutility upon every tax payer. So rich should pay
more taxes.
But hypothetically, if incomes are subject to constant MU, both rich and poor should pay
proportional taxation.
Alt, if incomes are subject to diminishing marginal utility, rich will pay more (progressive taxation)
2- Certainty: This is meant to protect tax payers from unnecessary harassment by tax officials. The
tax that each individual ought to pay be certain as far as amount, time, manner. Otherwise, there is
corrupt tax administration. Small uncertainty is a bigger evil than big inequalities.
3-Convenience:Mode and timing of payment be convenient to tax payer.
4- Canon of Economy: Every tax has a cost of collection and this cost be minimized. No point
imposing widespread and difficult to administer. Productive efforts of people should not be wasted
on too big tax administration. Then evasion will happen. [based on practical experience of tax
administration and its effects.]
Additional principles (based on other objectives of economic
philosophy and problems of the modern state)
5-Canon of Productivity: Fiscal adequacy canon. Tax system should

yield adequate revenue. Govt should not be forced into DF.
6-Buoyancy:Tax revenue should have inherent tendency to increase
along with increase of NI, even if rates and coverage not revised.
7-Flexibility:It should be possible for authorities without much delay,
to revise the tax structure with respect to coverage and rates to suit the
changing requirements of the economy and the Treasury.
8-Simplicity:Tax system should not be difficult to administer and
understand. Not difficult in its legal interpretations.
9-Diversity:There should not be too few sources of tax. That system
will breed uncertainty for the Treasury. It can be inequitable for
different sections. Reduction in revenue from any one source will be
very small is case of few taxes. Yet multiplicity be avoided.
Characteristics of a good tax system
Tax is only one part of the total budget of govt.

Operations of PE should not militate against objectives
of a tax system.
Many dimension: Vol, composition, rate, coverage,
dimension, timing, mode.
Alt sets of these features forms alternative tax systems.
Each system will have effects different from the other.
Conflict will be between different objectives and
effects.[tradeoff between different objectives]
Depending upon value judgements, a particular tax
system is chosen.
Limitations to be overcome
But practical and conceptual difficulties would be

there. Administrative, political and other difficulties
would be there. Ideal tax machinery difficult in
practice. Govt may fail to identify exact effects of
different tax measures.
Attitude of tax payers important. Overall burden is
important to assess. Difficult to develop right attitude
in abnormal times.
Changes in tax system can be gradual.
Fiscal Federalism
-Abinash Singh
BITS Pilani
K K Birla Goa Campus
Federalism
Fisc (Structure (tiers) of
(public treasury) govt)
Decentralized Financial Power
BITS Pilani, K K Birla Goa Campus

Types of Federalism
India
?
Quasi-
Federalism
structure

Indian Federal System
✓ Article 1 of the Constitution states:

“India, that is Bharat, shall be a Union of States
Introduced
in 1993
Three tiers of government in India
Centre State Local govt.

Principles of federal finance (B.P. Adarkar in 1936)
1. Independence and Responsibility

2. Adequacy and elasticity
3. Administrative economy and efficiency
Other principles:
1. Integration and Co-ordination
2. Accountability:

Division of functions
Constitutional provision of distribution of power
The Seventh Schedule of Constitution of India
Subjects
State list (61) Concurrent list

Union list (100)
(52)
➢ Public order ➢ Education

➢ Defense
➢ Police ➢ Forest
➢ Army
➢ Public health and ➢ Trade unions
➢ International Relations
sanitation ➢ Marriage
➢ Ports
➢ Hospitals and ➢ Adoption
➢ Railways
dispensaries ➢ Succession
➢ Banking o
➢ Highways ➢ Betting and both Parliament and state
legislatures have jurisdiction
➢ Communication gambling (in case of conflicts
o Under purview of state
o Under purview of parliament parliament takes over)
legislatures.
Residuary Powers
➢ All matters not mentioned in any of the above list
➢ Cyber Laws
➢ Union legislature has the only power to legislate laws on these matters

Tax list under 7th
schedule
List 2: State list List 3: Concurrent

List 1: Union list
list
➢ Income tax other than agricultural income ➢ Land revenue ➢ Trade and commerce in, and the
➢ Custom duties ➢ Tax on agr income production, supply and distribution of
➢ Excise duty except on liquor, alcohol, ➢ Succession and estate duty to agr land selected items (foodstuffs, including
opium, narcotics ➢ Tax on entry of good to local areatax on edible oilseeds, cattle fodder, raw cotton,
➢ Corporation tax land and building cotton seed, raw jute)
➢ Taxes on capital value of assets exclusive ➢ Tax on mineral rights
➢ Mechanically propelled vehicles
of agricultural land ➢ Excise duties on liquor, alcohol, opium,
including the principles on which taxes
➢ Terminal taxes on goods and passengers narcotics
on such vehicles are to be levied.
carried by railway, sea, air ➢ Tax on consumption and sale of
➢ Stamp duties other than duties or fees
➢ Estate duty on property except agr. Land electricity
➢ Succession duty on property other than agr. ➢ Tax on sale and purchase of goods (other collected by means of judicial stamps, but
Land than newspaper) not including rates of stamp duty.
➢ Taxes other than stamp duties or ➢ Tax on motor vehicle animals, & boats
transactions in stock and future market ➢ Toll taxes
➢ Rates of stamp duty on financial ➢ Taxes ob luxuries (including betting) No item left after
documents. ➢ Capitation fee
➢ Tax on sale and purchase of newspaper ➢ Tax on adv. (other than newspaper)
➢ Tax on sale and purchase of trade in the ➢ Stamp duties except on financial docs 101st Amendment (2016) of the
course of inter-state trade. ➢ Tax on goods & passenger by Constitution of India
board/inland waterways
➢ Taxes on professions, trades, callings, &
employment GST (Article 246-A)

Revenue powers of the Centre
1. Taxes levied & collected by union & the proceeds retained by the union.
✓ Custom duty
✓ Corporation tax
✓ Tax on capital value of assets except agr. land
2. Taxes levied and collected by the union and the proceeds are shared with
the states.
✓ Taxes on income other than agricultural income
✓ Duties on tobacco and other goods manufactured in India, except liquor and narcotics
✓ Excise duties
3. Taxes levied and collected by union & proceeds go wholly to states.
✓ Terminal tax, taxes on railway freight
✓ Succession and estate duty on property except agricultural land
✓ Taxes on transaction and stock exchanges and future market
✓ Taxes on sale and purchase of newspaper
4. Taxes levied by union, but collected and appropriated by the states.
✓ Stamp duty
✓ Excise duty on medical and toilet preparation

Apart from tax revenue we have non-tax revenue:
Centre: receipts from post & telegraphs, railways, banking, broadcasting, Central PSU,
and others.
State: receipts from i) irrigation, forest, fisheries, State PSU, & others.
Inter-Governmental transfers:
Beside sharing taxes, our constitution provides for grants-in-aids from centre
to the state.
1. Statutory grants (states which are need of fin. Asst. – Special category states)
2. Discretionary grants (given under no obligation)

Fiscal Imbalances
Mismatch in the revenue power and expenditure responsibility
✓ Vertical imbalance
✓ revenues do not match expenditures for different levels of govt.
✓ Central government is assigned most of revenue raising power while the State
governments are expected to carry out most of the development and welfare oriented
expenditure
✓ Solution: Vertical devolution ( at 41% - 15th FC)
✓ Horizontal imbalance
✓ revenues do not match expenditures for different regions of the country (same level of
govt)
✓ used to justify equalization transfers or payments to a state from the union government to
offset monetary imbalances among states.
✓ Solution: Horizontal devolution (Demography, Income, Population, Forest, fiscal effort-
15th FC)

Articles related to Federal finance in India
Article no. Subject matter

268 Taxes levied by union, but collected and appropriated by the states.
269 Taxes levied and collected by union & proceeds go wholly to states.
269A levied and collected of GST in interstate trade
270 Taxes levied and collected by the union and the proceeds are shared with the states.
271 Surcharge on certain taxes
273 Grants for export of jute product
275 Statutory grants
280 Set up of FC
282 Discretionary grants

Thank you

Fiscal Federalism
15th Finance Commission
-Abinash Singh
BITS Pilani
K K Birla Goa Campus
Finance Commission
✓ Evolution/ Intro
✓ Composition
✓ Function
✓ Role
✓ 14th & 15th Finance commission

Intro
✓ A quasi judicial
body/constitutional body
(Article 280 of the
Constitution)
✓ Determines the method and
formula for distributing the
tax proceeds between the
center and states
✓ Constituted every 5 year by
President of India (can be
earlier if necessary)
✓ 1st FC (1952-57)

Composition
✓ A chairman and 4 other members to be appointed by president

✓ Selection of the members based on finance commission Act- 1951, by the
parliament
✓ Qualification of the members:
✓ Chairman- A person having sufficient experience in public affair
✓ 4 members:
➢ Judge of high court (having legal knowledge)
➢ A person having specialised knowledge of finance and accounts of the government.
➢ A person having experience in financial matter and administration
➢ A person having special knowledge of economics

Function
✓ Recommendation on: (ToR)

➢ Correction of fiscal imbalance
➢ Distribution of net proceedings of tax revenue (Excluded cess & surcharges)
➢ Principles of grants-in-aid from consolidated fund of India
➢ Measures needed to augment the consolidated fund of a state to supplement resource to
panchayats and municipalities based on state finance commission
➢ Other matters by President in the interest of sound finance
➢ Review the impact of the 14th FC on the fiscal position of the Centre
➢ Review the debt level of the Centre and states, & recommend a roadmap
➢ Recommend performance based incentives for states, based on their efforts to
control population, promote ease of doing business, & control of populist measures
➢ Should there be a provision of revenue deficit grant ?

Role of FC
✓ Recommendation made by FC are only advisory in nature

✓ “Since the finance commission is a constitutional body expected to be quasi
judicial, its recommendations should not be turned down by the govt.
unless there are compelling reasons” – Dr. P.V. Rajamannar (4th FC)
✓ A balancing wheel of fiscal federalism

15th Finance commission
(2021-22 to 2025-26)
➢ Constituted by the president in Nov, 2017

➢ Chairman – Nand Kishore Singh
➢ Deliberation period: 2017- 2019
➢ Recommendation period: 2020- 2025 (now 2021-26)
Major fiscal reforms under 15th FC:

• Replacement of PC with NITI Ayog
• Implementation of GST
• Abolition of planned and non-planned expenditure

Recommendation of 15th FC
ToR for correcting Fiscal imbalance
1. Tax devolution
✓ Vertical devolution at 41% (was 42% in 14th FC)

✓ Horizontal devolution

2. Principles of Grants-in-aid
14th FC 15th FC Gen Category Special Category

Statutory grants 55% 70% Grants 30% 90%
Discretionary grants 45% 30% Loans 70% 10%
Special Category states:

✓ 8 NE State (including Sikkim), Himachal Pradesh, Uttarakhand
✓ Criteria
1. Hilly/difficult terrain
2. Sizable tribal population/low density of population
3. Strategic location along international boarder
4. Non-viable state finance
5. Economic and infrastructure backwardness
✓ Benefits
✓ More grants
✓ Lesser contribution of states in CSS (Gen states- 60:40, Spl cat – 90:10)
✓ Rebates in central taxes
✓ Special funds

ToR for Grants-in-aid
1. Revenue deficit grant

2. Sector specific grant
3. State specific grant
4. Grants to local bodies
5. Grants to disaster management

1. Revenue deficit grant
✓ Awarded ₹ 2.9 lakh Cr. for 17 states
2. Sector specific grant
Health
✓ Total support of ₹ 1.06 lakh Cr.
Education
✓ School education: ₹ 4800 Cr (Enhance educational outcomes- FY 23-26)
✓ Higher education: ₹ 5078 Cr. (promotion of online edu), ₹ 6143 Cr. (Devt. Of professional courses in
regional language)
Agriculture
✓ ₹ 45000 Cr. Performance based
incentives

Maintance of PMGSY roads (All whether road)
✓ Allocated ₹ 27539 Cr. for a period 2021-26
Judiciary
✓ Grants of ₹ 10425 Cr. to fast track courts for speedier justice delivery
Statistics
✓ Total grants to the states of ₹ 1175 Cr. From 2022 to 2026
Aspirational Districts (112 districts)
✓ ₹ 500 Cr. For incentivizing aspirational districts
✓Focuses on
1. Health & nutrition
2. Education
3. Agri & water resource
4. Financial inclusion and skill development
5. Basic infrastructure

3. State specific grant
✓ Recommended ₹ 49599 Cr.
✓ Will be given based on areas:
1. Social needs
2. Administrative governance and infra
3. Water and sanitization
4. Preservation of cultural and historical monuments
5. High cost physical infra
6. tourism
4. Grants to local bodies

✓ Total grants of ₹ 4.36 lakh cr.
1. ₹ 2.4 lakh cr for rural local bodies
2. ₹1.2 lakh cr for urban local bodies
3. ₹ 70,051 cr for health grants through local governments
5. Grants for disaster management
✓ Total of ₹ 1.6 lakh cr.

Fiscal Roadmap- 15th FC
1) The states and Centre should stick to the debt levels recommended by the FRBM
Act- 2003
2) Full disclosure and elimination of extra budgetary borrowings
3) Expert panel to recommend framework for sound public financial management

system

Thank you

COST BENEFIT ANALYSIS
2ND SEM 2020-21
BITS PILANI, K K BIRLA - GOA
CAMPUS
Sandra D’Sa
INTRODUCTION
• History – French engineer – Jules Dupuit coined the

phrase CBA in the 1840s and 100 years later it became
popular with economists. Was used for Infrastructure
appraisal in 19th century France.
• Late 1930s – water related investments
• After WW II – need for efficiency in government-
efficient use of public funds in public investments
leading to new welfare economics – essentially CBA
and practical decision making.
• After 1960s – recognised as the major appraisal
technique for public investments and public policy.
Payback period
• Costs/Benefits = Payback period
• PB period is an expression of how long it will
take you to repay the costs of the decision.
Why use CBA
1. It provides a model of rationality
- Beneficiaries & losers
- Time and space
2. Any project/policy is seen as one of a series of options.
3. It offers a rule for deciding is anything at all should be chosen.
Unlike CEA (cost-effectiveness analysis or MCA (multi-criteria
analysis)
4. If done properly, shows the costs and benefits accruing to different
social groups of beneficiaries and losers.
5. Time needs to be accounted for in a rigorous way – done through
discounting.
6.Individual preferences are counted – indicating the underlying
value judgement through stating pros and cons.
7. Seeks explicit preferences rather than implicit ones.
Theoretical foundations
• The underlying theory of CBA is based on the notion of
human preference – linked to wellbeing or utility.
• Benefits - increases in human wellbeing (utility)
• Costs – reductions in human wellbeing (utility)
• CBA provides rules for aggregating preferences so that
it is possible to arrive at a ‘social’ preference for or
against something.
• Preferences are revealed through decisions to spend
or not to spend, money.
• Hence Willingness to Pay and Willingness to Accept
(WTP and WTA )becomes the means of measuring
preferences and money becomes the measuring rod
that permits aggregation of preferences.
Theoretical foundations
• Preferences are considered as the source of value.
• Preferences are measured by WTP for a benefit and
WTA compensation for a cost.
• Individual preferences can be aggregated - social
benefits (Σ individuals’ benefits) and social costs(Σ
individuals’ costs)
• For a project to qualify – Social benefits > social costs.
• If beneficiaries from a change can hypothetically
compensate the losers from a change, and still have
some net gains left over, then the basic test that
benefits >costs is met – Kaldor-Hicks compensation
test.
Discounting factor
• Costs and benefits accrue over time.
• General rule is : future costs are weighted in such
a way that a unit of cost or benefit in the future
has a lower weight than the same unit of benefit
or cost occurring now. (a bird in the hand....)
• This temporal (time related) weight is called
Discount factor written as
DFt = 1
(1+s)t
Decision Rule
{ΣWTPi,tG.(1+s)-1 - ΣWTPi,tL.(1+s)-1 } > 0
i,t i,t
Where i is the ith individual and t is time. G are gainers and L are Losers.
Benefits are measured by WTP to secure the benefit.
Costs are measured by WTP to avoid the cost.
If Losers have legitimate property rights to what they lose, then WTP
would be replaced by WTA compensation to forgo a benefit.
{ΣWTPi,tG.(1+s)-1 - ΣWTAi,tL.(1+s)-1 } > 0

Decision rules
• Correct criterion for reducing benefits and
costs to a unique value is the Net Present
Value (NPV) or ‘Net benefits” criterion.
• The correct rule is to adopt any project with a
positive NPV
• Rank projects by their NPVs – final decision
Aggregation rules
Rule 1 : Aggregating benefits across different social groups involves
summing willingness to pay (WTP) for benefits or willingness to
accept (WTA) compensation for losses, regardless of the
circumstances of beneficiaries or losers.
Rule 2 : requires that higher weights be given to benefits and costs

accruing to disadvantaged or low income groups. (rationale:
marginal utilities of income will vary : higher for low income
groups)
Aggregating over time involves discounting.

Discounted future benefits and costs are known as present values.
Usually WTP and WTA should not be very different but in reality they
are. Therefore choice of WTA or WTP are important when
conducting CBA.
Stages of CBA
1. Ask relevant questions – what policy/project is being
evaluated?
2. What are the alternatives?
3. For initial screening of the contribution that the project
makes to wellbeing, PV of benefits > PV of costs
4. Determine “standing” – whose costs and benefits are to
count
- time horizon over which Cs and Bs are counted (because
preferences for when C/Bs are received and preferences
for or against an impact may change over time and this
‘relative price’ effect has to be accounted for.
5. Since C/Bs are rarely known with certainty, risk
(probabilistic outcomes) and uncertainty (when no
probabilities are known) have to be accounted for.
6. Identification of the distributional incidence of C ad Bs
have to be considered.
Dealing with costs
• Costs include capital infrastructure and
equipment – therefore believed to be easily
estimated along with certainty. Experience shows
otherwise – can be seriously understated – called
cost pessimism
• For policies, compliance costs are overstated –
cost optimism.
• Therefore – sensitivity analysis is conducted – to
show how the final net benefit figure changes if
costs are increased or decreased by some
percentage.
THE BENEFITS
• For consumers, we need some measure of
society’s valuation of time.
• There are several approaches to measuring
this:
• Market based measures: Wages
• Stated preference measure(Survey based):
• Revealed preference measures:
Total Economic Value (TEV)
• The notion of TEV provides an all-encompassing
measure of the ‘economic value’ of any environmental
asset. It decomposes into use and non-use (or passive
use) values.
TEV = use value + non-use value
TEV is not intrinsic value and unrelated to human
observation or preference.
Any project/policy that destroys or depreciates an env.
asset needs to include in its costs the TEV of the lost
asset.
///ly -Any project/policy that enhances an env. asset
needs to count the change in the TEV as a benefit.
Classification of Valuation Approaches
•Valuation Approaches
•Revealed preference methods
•(use of indirect approach)
•Hedonic price method
•(bundles of characteristics)
•Travel cost method (purchase of goods & services are reqd to access an intangible
good)
•Stated preference methods

•(use of direct survey approach to estimate preferences)
•Contingent valuation method (direct ly report WTP or WTA)
•Choice modelling method (most preferred option from choices given )
2ND SEM 2020-21

BITS PILANI, K K BIRLA - GOA CAMPUS
Sandra D’Sa
Session 2 – 1st April 2021
Total Economic Value (TEV)
• The notion of TEV provides an all-encompassing
measure of the ‘economic value’ of any environmental
asset. It decomposes into use and non-use (or passive
use) values.
TEV = use value + non-use value
TEV is not intrinsic value and unrelated to human
observation or preference.
Any project/policy that destroys or depreciates an env.
asset needs to include in its costs the TEV of the lost
asset.
///ly -Any project/policy that enhances an env. asset
needs to count the change in the TEV as a benefit.
Classification of Valuation Approaches
•Valuation Approaches
•Revealed preference methods
•(use of indirect approach)
•Hedonic price method
•(bundles of characteristics)
•Travel cost method (purchase of goods & services are reqd to access an intangible
good)
•Stated preference methods

•(use of direct survey approach to estimate preferences)
•Contingent valuation method (direct ly report WTP or WTA)
•Choice modelling method (most preferred option from choices given )
Stated Preference methods
• Stated Preference methods are a family of
survey methods
• measure people's preferences based on
decision-making in hypothetical choice
situations
Contingent Valuation Method (CVM)
• CVM is a survey-based economic technique for the
valuation of non-market goods/resources, such as
environmental preservation or the impact of
contamination.
• It is a method of estimating the value that a person

places on a non-market good. The approach asks
people to directly report their willingness to pay (WTP)
to obtain a specified good, or willingness to accept
(WTA) to give up a good, rather than inferring them
from observed behaviours in regular market places.
Contingent Valuation Method (CVM)
• Contingent valuation is a method of asking individuals
to value an option they are not now choosing.
• In some circumstances, this is the only feasible
method for valuing a public good.
• For example, there is no obvious market price to use
to value saving a rare species of an eagle.
• - But there are obviously huge problems with this
approach.
• - It is very hard to design a survey that elicits true
willingness to pay.
• -People can say most anything in a survey that has no
real consequences for their lives.
The contingent valuation method
(CVM) – WHAT?
• is used to estimate economic values for all
kinds of ecosystem and environmental
services.
• It can be used to estimate both use and non
use values, and it is the most widely used
method for estimating non-use values.
• It is also the most controversial of the
non-market valuation methods.
(CVM) – WHAT?
• The contingent valuation method involves directly
asking people, in a survey, how much they would be
willing to pay for specific environmental services.
• In some cases, people are asked for the amount of
compensation they would be willing to accept to give
up specific environmental services.
• It is called “contingent” valuation, because people are
asked to state their willingness to pay, contingent on a
specific hypothetical scenario and description of the
environmental service.
(CVM) – WHAT?
• referred to as a “stated preference” method,
because it asks people to directly state their
values, rather than inferring values from
actual choices, as the “revealed preference”
methods do.
• The fact that CV is based on what people say
they would do, as opposed to what people are
observed to do, is the source of its greatest
strengths and its greatest weaknesses.
(CVM) – WHY?
• Hypothetical Scenario:
A remote site on public land provides important habitat for
several species of wildlife. The management agency in charge of
the area must decide whether to issue a lease for mining at the
site. Thus, they must weigh the value of the mining lease against
the wildlife habitat benefits that may be lost if the site is
developed. Because the area is remote, few people actually visit
it, or view the animals that rely on it for habitat. Therefore,
non-use values are the largest component of the value for
preserving the site.
• Why Use the Contingent Valuation Method?

The contingent valuation method was selected in this case
because of the importance of non-use values, and their potentially
significant levels.
The contingent valuation method (CVM) – HOW?
Step 1: define the valuation problem.
- determining exactly what services are being valued, and who the relevant population is.
Step 2: make preliminary decisions about the survey itself, including
- whether it will be conducted by mail, phone or in person,
- how large the sample size will be,
- who will be surveyed, and other related questions.
The answers will depend, among other things, on the importance of the valuation issue, the
complexity of the question being asked, and the size of the budget.
Step 3 – the actual survey design.
This is the most important and difficult part of the process, and may take six months or more to
complete.
a) The survey design process usually starts with initial interviews and/or focus groups with the
types of people who will be receiving the final survey, in this case the general public.
b) In the initial focus groups, the researchers would ask general questions, including questions
about peoples’ understanding of the issues related to the site. In later focus groups, the
questions would get more detailed and specific, to help develop specific questions for the
survey, as well as decide what kind of background information is needed and how to present
it.
c) pre-testing the survey. The researchers continue this process until they’ve developed a survey
that people seem to understand and answer in a way that makes sense and reveals their
values for the services of the site.
(CVM) – HOW?
Step 4: The actual survey implementation.
The first task is to select the survey sample. Ideally, the sample
should be a randomly selected sample of the relevant population,
using standard statistical sampling methods.
Telephone surveys, In-person surveys – random sampling or
“convenience” samples – asking people in public places to fill out
the survey.
Step 5:-Compile, analyze and report the results. The data must be
entered and analyzed using statistical techniques appropriate for
the type of question.
In the data analysis, the researchers also attempt to identify any
responses that may not express the respondent’s value for the
services of the site. The most conservative way is to assume that
those who did not respond have zero value.
How Do We Use the Results?
• From the analysis, the researchers can
estimate the average value for an individual
or household in the sample, and extrapolate
this to the relevant population in order to
calculate the total benefits from the site.
• For example, if they find that the mean
willingness to pay is Rs. 100 per capita, the
total benefits to all citizens would be Rs. 100x
number of citizens ) Rs. ___ million.
Choice modelling method
• a ‘stated preference’ technique used to estimate non-market environmental
benefits and costs.
• involves a sample of people, who are expected to experience the benefits/costs,
being asked a series of questions about their preferences for alternative future
resource management strategies.
• Each question, called a ‘choice set’, presents to respondents the outcome of
usually three or four alternative strategies. The alternatives are described in terms
of a common set of attributes.
• The alternatives are differentiated one from the other by the attributes taking on
different levels.
• One of the alternatives – that relating to the ‘business as usual’ (BAU) option – is
held constant and is included in all the choice sets.
• Respondents’ choices of their preferred alternatives demonstrate their willingness
to trade-off one attribute against another. So long as one of the attributes used to
describe the alternatives is monetary, it is possible to estimate respondents’
willingness to pay to secure additional units of the non-market environmental
benefits described by other attributes (or to avoid non-market environmental
benefits described by other attributes).
• It is also possible, using the choice data, to estimate the values respondents hold
for the changes from the BAU to some alternative strategy.
Choice modelling method
Uses of CM
• Since the alternatives presented to respondents in the
choice sets are hypothetical, the CM analyst can
design an application to estimate a wide range of
values including use and non-use values of the
environment.
• Studies have also estimated non-market, social values
associated with environmental management
strategies including the impacts of unemployment.
• Where the outcomes of alternatives are sufficiently
complex to require their description using more than
five attributes, the ability of respondents to cope with
the choice sets is likely to be compromised.
Analytical steps of CM
1. Define the issue – interaction with experts,
stakeholders....
2. Define the attributes – including via focus groups
with respondents
3. Define the levels
4. Select an experimental design
5. Design the questionnaire
6. Implement the survey
7. Data analysis
8. Report compilation
Data requirements
• CM, as a stated preference technique, requires the
collection of primary data which requires the use of a
survey.
• The smallest CM exercise would normally require a
sample size of around 1000 valid responses for it to
provide sufficient statistical power.
• However, smaller samples are possible where
respondents may be expected to answer a greater
number (more than eight) of choice sets in each
questionnaire. This is likely to occur when the issue of
interest directly affects respondents (e.g. a local
issue).
End of Class Session 2
SESSION 3
Revealed preference methods
- Hedonic pricing method

- Travel cost method
Revealed preference method
• Another approach to valuing time is to use revealed
preference – allowing the actions of individuals
reveal their valuation.
• For example, if one compared house prices for two
houses, one of which was 5 minutes closer to the
workplace, this would effectively be better due to the
value of saved travel time.
• In practice, this approach runs into problems because
the two homes are not identical.
• Some of the differences (e.g., housing attributes) can
be observed and accounted for with cross sectional
regression. Decomposing a sale price by its attributes
is the basis of hedonic market analysis.
Hedonic price method
Hedonic pricing evaluates the benefit of a non-market characteristic (e.g., pollution,
fatality risk) on market prices - most commonly applied to variations in residential
prices reflecting the value of local environmental attributes.
Examples
• Value of sound walls: The difference in price between houses adjacent to a freeway
with a sound wall and similar houses adjacent to a similar freeway without a sound
wall.
• Value of reduced travel time to central city: The difference in price between similar
houses located at different travel time distances from the central city.
• The basic premise of the hedonic pricing method is that the price of a marketed
good is related to its characteristics, or the services it provides. For example, the
price of a car reflects the characteristics of that car—transportation, comfort, style,
luxury, safety features, fuel economy, etc. The individual characteristics of a car or
other good can be valued by looking at how its price changes when controlling for
other characteristics.
Uses of Hedonic Pricing
• Hedonic pricing is a convenient method for estimating transportation-related
benefits and dis-benefits affecting residential property values. These can be negative
benefits of transportation facilities such as freeway noise, or positive benefits such
as improved access to activities.
Application of the Hedonic Pricing Method Using Residential Prices
Step 1
• The first step is to collect data on residential property sales in the region for a specific time period
(usually one year).
The required data include:
• selling prices and locations of residential properties, property characteristics that may affect selling
prices, such as lot size, number and size of rooms, and number of bathrooms, neighborhood
characteristics that may affect selling prices, such as property taxes, crime rates, and quality of schools,
accessibility characteristics that may affect prices, such as distances to work and availability of public
transportation, environmental characteristics that may affect prices
• Data on housing prices and characteristics are available from municipal offices, multiple listing services,
and other sources.
Step 2
• Once the data are collected and compiled, the next step is to statistically estimate a function that
relates property values to property characteristics . Regression analysis is typically used to estimate the
influence of various property characteristics.
• A model for a set of factors determining house prices could be: P = f (D, S, V, E, H, T)
P = Price, D = Distance from the nearest central business district, S = Size of house, V = Rating of view, E =
School quality,
H = Proximity to highway, T = Proximity to transit
This is called a hedonic price function . The regression typically uses the logarithms of the values for the
various factors. A statistical analysis package such as the Regression function in Microsoft Excel or SPSS
can be used for the computations of the following type of equation:
• ln (P) = ln β 0 + β1 ln (D) + β 2 ln (S) + β 3 ln (V) + β 4 ln (E) + β 5 ln (H) + β 6 ln (T) + e
• The β values represent the role that each factor plays in the value of the residence. For example β 5 is the
value of each unit of proximity to the highway.
Advantages of the Hedonic Pricing Method
• The method's main strength is that it can be used to estimate values based on actual choices.
• Property markets are relatively efficient in responding to information, so they can be good
indications of value.
• Property records are typically very reliable.
• Data on property sales and characteristics are readily available through many sources and can be
related to other secondary data sources to obtain descriptive variables for the analysis.
• The method is versatile, and can be adapted to consider several possible interactions between
market goods and transportation benefits.
Issues and Limitations

• The scope of benefits that can be measured is limited to things that are related to housing prices.
• The method will only capture people's willingness to pay for perceived differences in attributes.
• The method assumes that people have the opportunity to select the combination of features they
prefer, given their income. However, the housing market may be distorted by outside influences,
like taxes or interest rates.
• The method is relatively complex to implement and interpret, requiring a high degree of
statistical expertise.
• The results depend heavily on model specification.
• Large amounts of data must be gathered and manipulated.
Travel cost method
• The travel cost method is used to estimate economic use values
associated with ecosystems or sites that are used for recreation.
• The method can be used to estimate the economic benefits or costs
resulting from:
- changes in access costs for a recreational site
- elimination of an existing recreational site
- addition of a new recreational site
- changes in environmental quality at a recreational site
• The basic premise of the travel cost method is that the time and travel
cost expenses that people incur to visit a site represent the “price” of
access to the site.
Thus, peoples’ willingness to pay to visit the site can be estimated based
on the number of trips that they make at different travel costs. This is
analogous to estimating peoples’ willingness to pay for a marketed good
based on the quantity demanded at different prices.
Why Use the Travel Cost Method?
Hypothetical Situation:
A recreational fishing site is threatened by development in the surrounding area.
Pollution and other impacts from this development could destroy the fish habitat at
the site, resulting in a serious decline in, or total loss of, the site’s ability to provide
recreational fishing services. Resource agency staff want to determine the value of
programs or actions to protect fish habitat at the site.
The travel cost method was selected in this case for two main reasons:
1. The site is primarily valuable to people as a recreational site. There are no
endangered species or other highly unique qualities that would make non-use values
for the site significant.
2. The expenditures for projects to protect the site are relatively low. Thus, using a
relatively inexpensive method like travel cost makes the most sense.
• Alternative Approaches:
Contingent valuation method could also be used in this case. While they might
produce more precise estimates of values for specific characteristics of the site, and
also could capture non-use values, they would be considerably more complicated
and expensive to apply.
Application of the Travel Cost Approach:
• The travel cost method is the simplest and least expensive

approach. It will estimate a value for recreational services of the
site as a whole.
• It cannot easily be used to value a change in quality of recreation
for a site, and may not consider some of the factors that may be
important determinants of value.
• The travel cost method is applied by collecting information on the
number of visits to the site from different distances. Because the
travel and time costs will increase with distance, this information
allows the researcher to calculate the number of visits
“purchased” at different “prices.”
• This information is used to construct the demand function for the
site, and estimate the consumer surplus , or economic benefits,
for the recreational services of the site.
Application - steps
• Step 1: - Define a set of zones surrounding the site.
• Step 2: Collect information on the number of visitors from each zone, and the
number of visits made in the last year.
• Step 3: Calculate the visitation rates per 1000 population in each zone. This is
simply the total visits per year from the zone, divided by the zone’s population in
thousands.
• Step 4: Calculate the average round-trip travel distance and travel time to the
site for each zone. Assume that people in Zone 0 have zero travel distance and
time. Each other zone will have an increasing travel time and distance. Next,
using average cost per mile and per hour of travel time, the researcher can
calculate the travel cost per trip.
• Step 5: Estimate, using regression analysis, the equation that relates visits per
capita to travel costs and other important variables. From this, the researcher can
estimate the demand function for the average visitor.
• Step 6: Construct the demand function for visits to the site, using the results of
the regression analysis.
• Step 7: Estimate the total economic benefit of the site to visitors by calculating the
consumer surplus, or the area under the demand curve.
Data collection (Step 2)
The survey might ask for the following information:
• location of the visitor’s home – how far they travelled to the site
• how many times they visited the site in the past year or season
• the length of the trip
• the amount of time spent at the site
• travel expenses
• the person’s income or other information on the value of their time
• other socioeconomic characteristics of the visitor
• other locations visited during the same trip, and amount of time spent at
each
• other reasons for the trip (is the trip only to visit the site, or for several
purposes)
• fishing success at the site (how many fish caught on each trip)
• perceptions of environmental quality or quality of fishing at the site
• substitute sites that the person might visit instead of this site
Advantages of the Travel Cost
Method:
• The travel cost method closely mimics the more
conventional empirical techniques used by
economists to estimate economic values based on
market prices.
• The method is based on actual behaviour—what
people actually do—rather than stated willingness to
pay—what people say they would do in a hypothetical
situation.
• The method is relatively inexpensive to apply.
• On-site surveys provide opportunities for large
sample sizes, as visitors tend to be interested in
participating.
• The results are relatively easy to interpret and
Issues and Limitations of the Travel
Cost Method:
• The travel cost method assumes that people perceive and respond to
changes in travel costs the same way that they would respond to changes
in admission price.
• The most simple models assume that individuals take a trip for a single
purpose – to visit a specific recreational site. Thus, if a trip has more than
one purpose, the value of the site may be overestimated. It can be difficult
to apportion the travel costs among the various purposes.
• Defining and measuring the opportunity cost of time, or the value of time
spent travelling, can be problematic.
• The availability of substitute sites will affect values.
• The travel cost method is limited in its scope of application because it
requires user participation. It cannot be used to assign values to on-site
environmental features and functions that users of the site do not find
valuable. It cannot be used to value off-site values supported by the site.
• Most importantly, it cannot be used to measure non-use values. Thus,
sites that have unique qualities that are valued by non-users will be
undervalued.
• Many more...............
PUTTING IT ALL TOGETHER
• Since the benefits exceed the costs, we would
recommend the government pursue the project.
• The government needs to consider one additional
factor beyond the benefits and costs of the
project itself: the budgetary cost of raising the
funds to finance the project.
• Economists typically assume some efficiency cost,
or deadweight loss, from raising the tax burden to
finance this spending. If the efficiency cost of
raising the money is too high, some projects will
not survive the cost-benefit analysis.
Other Issues: Discounting Future
Benefits
• A particularly thorny issue for cost-benefit
analysis is that the costs are mostly short term,
while the benefits are mostly long term.
• Global warming is a good example. This may be
problematic because: The choice of discount
rate will matter enormously for benefits that are
far in the future. The benefits are spread out
over current and future generations.
Other Issues in Cost-Benefit Analysis
• Common counting mistakes include:
Counting secondary benefits (like commerce
that is simply shifted from one area to
another). Counting labour (reducing
unemployment, for example) as a benefit
rather than a cost. Double counting benefits
(like the value of an irrigation project to farm
income, and simultaneously the increase in
the value of the land).
Other Issues in Cost-Benefit Analysis
• There are also distributional concerns: The
costs and benefits of a public project do not
necessarily accrue to the same individuals. In
principle, a project that improved social welfare
could then involve redistribution, but in practice
this rarely happens. So one might be concerned
if all the benefits accrue to one group and all the
costs are borne by another, particularly if the
group that benefits is affluent and the group
bearing the costs is poor.
10 questions you should always ask...
Are you considering adopting new technology? Launching a new initiative? Re-evaluating an existing
policy or program?
• 1. What is the problem you are trying to solve? If you can’t identify a clear problem, why are
you doing it?
• 2. How important is that problem? Can you put a value on the benefits you hope to achieve?
• 3. How certain are you that this course of action will address the problem you are trying to
solve? If you are not certain, you may want to discount the benefits you hope to achieve.
• 4. What are the budgetary costs of your approach?
• 5. Will adopting your approach impose any additional costs on the public, including
intangible costs such as loss of privacy, use of force, or racial disparities? Can you value those
costs? Do you have any rough sense of how large they might be?
• 6. What are the things that could go wrong in the roll-out of your approach, or in the public’s
reaction to it? Are there any costs you have not anticipated?
• 7. Can you think of any ways to minimize or avoid some of the costs you anticipate?
• 8. Do you have the right policies and procedures in place to ensure sure you accomplish what
you set out to do, and to avoid any unnecessary costs?
• 9. Are you reasonably confident that the benefits exceed the costs? Are you including both
hard costs and intangibles?
• 10. Can you think of any alternative ways to address the same problem that might achieve the
benefits at a lower cost?
Thank you for your patient listening !
Tax Burden theories-Ch-5
Bhatia
DP-PF3
Intro
Based on characteristics of tax and its burden distribution,

incidence, effects and goals, three bases on which tax
proposals can be developed.
1st set of theories say there need not be any relationship
between tax paid and benefits flowing to tax payers. 1-
Socio political theory; 2- Expediency theory
2nd set of theories links tax liability to state activities. So
justification for imposing taxation and principle for
apportioning its burden.1- Benefits Received 2- Cost of
Service
3rd set links tax liabilities to the paying capacity of tax
payers. i.e. Ability to pay theory.
Expediency Approach
Tax proposal must pass the test of practicability.

[authorities need not consider socio econ objectives or
effects]
So practicability=feasibility and collection cost.
Pluck the goose where feathers are thickest with
minimum amount of squawking.
So Can you critique this? There is always vested
interests, considerations of equity, economic stability,
growth, regional imbalances, etc.
Socio political approach
Wagner favored this saying not expediency but socio

political objectives should be the deciding factors. Wagner
did not believe in the individualistic approach to the
problem. Society was more than sum of individuals. It had
an existence and entity that needs to be preserved. So tax
system should be used to solve societal ills. Wagner
adopted a social welfare approach and advocated that
small incomes be exempt from taxation.
State had right to control ownership of property and
inheritance. His ideas are now hall mark of modern states.
Curbing Cyclical fluctuations, unemployment, undesirable
production, monopolistic and restrictive trade practices
are becoming important objectives.
Is equity belief or fact?
However both of the above cannot be advocated as basic

policies.
Equity has to be the hallmark of any sound tax system.
Without it socio econ political unrest ensues.
But what constitutes fairness? Conflict with other
objectives?
Horizontal equity requires that individuals and families in
similar circumstances bear the same tax. Vertical equity
means people in different circumstances bear appropriate
amount of tax burden.
So is equity belief or fact?
Cost of service approach
If citizens receive benefits they must pay the cost.

So state is asked to give up its protective and welfare
functions.
It must scrupulously recover the cost and implies a
Balanced Budget policy.
State is not concerned with problems of income
distribution. Many sources of public revenue is ruled
out like K gains, gifts, inheritance tax, unearned
increments, windfall gains, excise duties, sales tax, etc.
Welfare activities of the state ruled out.
Conceptual difficulties with this cost of service
approach
How to measure cost of services? How to assign to

proper beneficiaries? No exact proxy is available like
income level, family size? Should cost of inefficiency be
passed to customers? How to estimate net social cost
or benefit? Subsidizing merit goods ruled out.
Jeopardizes process of savings and K accumulation,
exhausts mineral wealth, denudation of forests.
Then will state decide on scope and throw burden on
citizens?
Benefits Received Theory and Lindahl
Based on premise of exchange or contract relationship

between taxpayer and state. Members contribute costs
proportion to benefits.[J S Mills, quid prop quo]
Equitable distribution, growth and stability ignored.
Goods be supplied and financed privately and publicly.
State services in two categories:1-those where
exclusion does not apply. 2- tax payers can reject
services. So here, members pay fees or prices and not
taxes. [i.e. only voluntary exchange and not
compulsory] So this limits state activities.
Problems with Benefit approach
How to estimate benefits derived from expenditure? How to compare these relative benefits?
Through tax, total benefits are changing via changing Y-distribution from same NI.
Rousseau and Sismondi argued that rich needed greater protection(regressive taxation) but
Mill said, poor needed greater protection (Progressive taxation).
Benefit approach showed optimum state-exp approach and optimum distribution of tax
burden.[desired level of exp-ss from state vs distribution of tax among members. Here tax is
price through demand schedule of consumers] Then tax payers would demand different
amount of state services at different levels of taxation.
Mazola- Justice would not demand each tax payer pay the same price. Tax liability for each
tax payer should be in proportion to relative MU of state services. Thus each tax payer begets
MU from his expenditure on public and private goods.
Emil Sax (Austrian) personal collective wants vs collective wants proper. Principle of
exclusion applies to former; fees and tax charged as per services received. Latter case,
exclusion does not apply. He advocates personal income tax as proxy for this relative benefit.
Wicksell 1896, ethical theory-tax system based on voluntary and unanimous action. Tax
payers free to opt out of state service. But critics-equitability is not met. So Wicksell wanted
equitable distribution prima facie. Also lack of mechanism to reveal true preferences. Viti
similar-members consume in proportion to incomes. Did be advocate prop tax? He bought
MU of income.—richer pay more Demarco like smith, brings mixture of benefit and ability to
pay. Richer pay more due to lesser sacrifice involved.
Lindahl
A detailed formulation of benefits received approach was provided

within a framework of voluntary exchange theory of public finance by
Erik Lindahl (sweden-1919).
He discusses the problem in context of two tax payers who reveal their
preferences for state services against corresponding state liability.
So this is a type of voluntary exchange between taxes paid and services
received[determined on basis of preferences or demand schedules of
tax payers for state services] Optimum level of state activities and
corresponding equilibrium of tax burden between the two individuals
is determined simultaneously.
Assuming state of distribution as a given: Lindahl discusses solution of
three problems.
1- Decision about extent of state activity (expenditure and tax levels)
2-Allocate public expenditure among various goods and services
3-Allocation of tax burden among tax payers.
Lindahl-Bowen Diagram
SS1 is supply schedule of state services.(p.c. cost of state supply) This supply
jointly consumed by A and B. A agrees to contribute part of proportions of the
cost of supply.
Larger the supply, smaller is part of per unit cost A (he) is willing to
contribute.[whether his absolute contribution rises or falls, depends on his
elasticity of demand for state services]
So for supply <Ma , A will bear more than half the cost. For supply >Ma , A will
contribute less at NE per unit when supply is ON. So B contributes NF. So
state can collect NQ , Q lying on combined demand schedule for state services.
So by vertical addition of two demand schedules, community demand services
is DiDi. Now at ON, cost of supply is NG per unit.
Assuming state makes no profit, for supply of OM, combined contribution of
tax payers (MJ+MK=MP) equals cost of supply. [point of intersection of dd
and ss curves]
Implication if state services is subject to LDR or LIR: Supply curve is no more
horizontal. No basic difference to the argument is made. The only difference
will be different proportions of taxes contributed by tax payers.
Ta
x
Lindahl
an
d
a
2
m
0 A
t
0 D
D
b P
1 D G
0 a Q
F S
0 S A
E
D D
b
D
a
0 M M
b N Ss &dd
a M services
Lindahl-ss and dd for state services
Lindahl
Can Lindahl be extended to cases of more than 2

individuals and more than 2 state services? Relevant
sets of cost functions of state services and demand
function of each tax payer for each state service is
necessary. The constraints covering the
interdependence of these functions be specified along
with specification of each individual function. Each of
these function be stable. But practically speaking,
there are bound to be information gaps in the
specifications.
Ch-6-Bhatia-Div of Tax Burden-II
Ability to Pay Approach
This approach considers tax liability(compulsory

payment to state without quid pro quo).Does not
assume commercial relation between state and
citizens.
As per this approach: citizen pays taxes because he
can; his relative share in total tax burden is to be
determined by his relative payment capacity.
Burden of taxation should be shared among members
to conform to principles of justice and equity.[this
equity criterion will be satisfied if tax burden is
apportioned as per relative ability to pay]
Few points to remember
Doctrine of ability to pay can be combined with maximum welfare of

society.[happens when index of paying ability is translated in terms of equi
marginal sacrifice. So society undergoes least aggregate sacrifice in meeting
tax liability]
Ability to pay is not an absolute quantity. It is related to expenditure size of
G-budget.
3rdly, different indices are available for determining the relative ability to pay
of tax payers.[income, property, wealth, consumption]
If income index of ability, with objective of equity and welfare, is progressive
taxation only route? No. Conditions determine where proportional or
regressive would be relevant.
Ability to pay is variant.[G exp is not distributionally neutral]
Cost of service approach has a BB [here no such direct implication]
But ability approach can provide a unified picture of overall Fiscal Policy of G.
Ability approach: subjective or objective?
FP have repercussive effects
G policies are bound to affect savings, investment,

production, employment and growth in the economy.
These cause shifts in absolute and relative ability to
pay of citizens.
Ex- Progressive tax rates discourage savings and
investment activity; then income earning activity may
not be pursued beyond a point.
Objective Indices of Ability
Property as an Index of Ability to Pay-It is a good supplement.

Assuming we have private property and inheritance, it follows, tax
system be such that it allows the economy to grow and develop in its
own way. S &I are In hands of pvt individuals and corporates. This
stimulates will to work, S, I.
If taxes are imposed w r t property, such activities will suffer.
But in UDCs where vol of taxable property is low, and inequalities of
wealth great, this revenue resource will be inflexible and inadequate.
Some properties yield more income, some less.
Considering ownership of property to exclusion of others, can be
misleading.
But they indicate potential tax paying capacity of owners. From welfare
pt of view, concentration of economic power not good. So tax gifts and
inheritances. K gains and unearned increments exist. Property owners
enjoy unequal economic opportunities. Or manipulate economy to
their advantage.
C- Exp as Index of Ability
Difficult tax to administer and so to make an index of

it. If excise and sales taxes are used, it means ability is
assessed as per goods they consume. Also some
indirect taxes are regressive.
Our wants are not limited to consumption only. We
leave out our desire for S & I.
Propertied people plough back their earnings into
investments and increase concentration without
incurring tax liability. So use C tax as part of overall
tax system.
Income as an index of ability to pay
Most accepted but well supplemented by other tax indices.
Adam smith-ability in proportion to incomes.
Yet many interpretations. So look deeper into concepts.
Income divided into earned income and unearned income. Latter includes K gains. Net
income be considered.[why? expenses might have been incurred to earn that income] So
various deductions permitted to arrive at taxable income. Overall disutility is considered
as cost of earning.
Ability considers both need and income.
Ability is a function of MUy . This is a tricky problem. 1st know income measure of
ability. 2ndly MUy. So are their subjective considerations to determine tax liabilities?
Which tax? Income, sales? Corporate income is where ownership is not necessarily
positively correlated with income accruing to each stakeholder. An individual or family
may be owning large number of small enterprises and thereby acquire large amount of
income. Large business may be owned by many individuals and each getting small
amount.
Difficult to use indirect taxes. Consumers cannot be homogenous groups based on C.
In rural, even rich farmers may not own a TV or refrigerator/AC as there may be no
electricity. In MDC, C pattern may not correlate with relative ability.
Subjective indices of ability to pay
1-This proceeds on the assumption that a tax payer

undergoes hardship or suffers sacrifice by paying tax.
2-[assumption is he does not feel better by
contributing to state kitty] 3-Assumed that tax payer’s
sacrifice depends upon his own tax liability or tax
liability of others.
Based on first assumption, discuss tax liability in terms
of equity or welfare.
Equity vs welfare vs equal sacrifice
Equity approach dictates each tax payer should be

made to undergo same amount of sacrifice,
irrespective of his income, etc.
Welfare approach dictates that the aggregate sacrifice
of all tax payers should be minimum, so that the
welfare loss to community is minimum.
Equal sacrifice concept admits of many
interpretations; one of which tallies with welfare?
Equity approach
It maintains that each tax payer should be subjected to the same

or equal sacrifice.
This term admits of three interpretations:
Equal absolute sacrifice
Equal proportional sacrifice
Equal marginal sacrifice- leads to Least aggregate or minimum
aggregate sacrifice.
Dalton’s constant inequality of incomes-inequality of incomes as
between different tax payers should remain the same after the
tax as they were before the tax.
So how to choose the right type of meaning of equity?
Therefore know the utility functions of income. That is how MUy
varies as income( y) of a tax payer changes.
Utility
Interpersonal comparisons of utility are difficult when MUy

changes due to time, taste, needs, etc.
Without measuring in interpersonal comparisons of utility
or cardinal measure of utility, not possible to have precise
conclusions regarding division of tax burden between tax
payers in terms of their respective ability to tax.
So similarity of utility schedules more important.
Dalton (on basis of income) versus Lionel Robbins (never
equal, but should be treated as such): Are humans equal?
Lerner-different individuals have different capacities to
enjoy income; but slowly low income category can acquire
more capacities in these directions.
Even if difficult to have objective measures…
Equal absolute sacrifice: Different tax payers made to

sacrifice same amount of utility.
[U(Y) – U(Y-T)] be same for all. Where U is total
utility, Y is income before tax, and (Y-T) is income
after tax.
With this doctrine, each member will pay some tax.
And none will be exempted from contributing.
[U(Y) – U(Y-T)] be same for all. But are tax rates
regressive or progressive or proportional?
Assuming income-marginal utility schedules constant for all

(MU curve runs parallel to X axis), then it follows that each tax
payer shall imcur the same absolute amount of sacrifice. This
means a lower rate of tax as income increases (regressive).
If income utility schedules fall, i.e. if MUy decrease as income
rise, then with rising incomes, tax amount will have to increase
to represent same amount of sacrifice.
When the rate of fall of MUy equals rate of rise in incomes,
proportional taxations will result in equal absolute sacrifice.
On the other hand, if MUy falls at a rate faster than increase in
income, then the equal absolute sacrifice will require progressive
tax rates.
So unless the slope of MU curve is known over a relevant range,
above conclusions cannot be drawn.
Equal Proportional sacrifice
As per this, no one is exempt from sharing tax burden.

Each tax payer is supposed to sacrifice the same percentage of total
satisfaction which he would have derived from his income.
Satisfaction lost in terms of tax payment, bears the same proportion to the
satisfaction from pre tax income in each case.
Tax liability of each individual is determined in such a manner that for his
income Y; ([U(Y)-U(Y-T)]/U(Y) is constant.
Here relative rate of change in marginal and average utility of income is looked
into.
If MUy is constant, then equal proportional sacrifice call for proportional
taxation.
If MUy falls, look into relative %tage shifts in marginal and average utilities
looked into. i.e. if decrease in MU is same rate as AU, then proportional tax
fulfills same objective.
If fall in MU >fall in AU, progressive tax called for.
If fall in MU<fall in AU, regressive tax needed.
Income measured along horizontal axis and MUy along vertical axis.
If MU falls at same rate as rate of rise in income, then MU curve be drawn, such that for
each point, the rectangle formed by abscissa, ordinate and two axis, bears the same
proportion to the area under the curve to the left of this point.
Equation is: U* (Y1)/U* (Y2)=sq root of Y2/Y1. where U* Y1 is MU of incomes Y1.
A st line through origin O, intersecting line of proportion at P and forming angle of 45
degree, with each axis.
Also let rectangular hyperbola APB pass through P. Then line of proportion CPD would
lie below rectangular hyperbola to left of P, and above it to right of P.
For equal proportional sacrifice, conclusions are: If MU coincide with CPD, income tax
rates be proportional. If it falls more rapidly than CPD, then rates be progressive,; if
rate MU curve descends less rapidly, than CPD, then rates be regressive. [so in equal
proportion, tax rates need not have to be progressive, because income is subject to
falling MU.]
NOTE: assumption is slope of MU curve known over entire range of

income.
Equal Marginal Sacrifice/Least aggregate sacrifice
MUy after tax with each tax payer remain the same.
For each tax payer, U* (Y-T) remain the same.
Stress is on community welfare. i.e. greatest happiness of
greatest number.[no consensus on what this aggregate means
for individual sacrifice] To Musgrave and Pigou- It is ultimate
principle of taxation.
Assuming MU schedules are identical and sloping downwards,
tax begins from highest income, and income lopped off to next
highest income, both incomes start sharing tax equally, etc. In
the end, either all incomes left after tax are equal or (if tax
revenue not much) all taxed incomes are left equal, while non
taxed incomes are left smaller than taxed ones. Say all income
above Rs1lakh reduced by tax; and no income less than this is
taxed. [leads to progressive tax]
Equal Marginal Sacrifice/Least aggregate sacrifice
LERNER-Even if MU schedules not correctly known, and

no possibility of inter personal comparisons of utility, still a
shift towards equality in Y-distribution would maximize
aggregate satisfaction of community. [but he bases this
inference on assumption that in absence of definite
information, prob of loss in aggregate satisfaction is same
as gain in aggregate satisfaction when income is
redistributed] But probable loss is> probable gain if
movement after tax is towards more inequality.
So society maximizes probable aggregate satisfaction, when
incomes are distributed equally.
Equity in
Distribution-Ch-6-M&M
DEBASIS PATNAIK
2ND SEM 2020-21
Introduction
Optimal use of resources involves two issues:

1-Secure efficient satisfaction of demands that arise for
a given state of distribution.[pareto efficient as policy
goal]
2-How to secure a just state of distribution.
Note: Since there exists an efficient solution
corresponding to every step of welfare distribution and
so which state is fair or just? So pareto efficiency
doesn’t help.
Problem of distribution is one of evaluating a change
in which one gains and one loses.
Choice of optimum
While rules of pareto efficiency guide one to frontier, choice of

best points traced by frontier involves tradeoff between gains for
A and losses to B or vice versa. Society assigns relative values to
levels of welfare experienced by A and B. These assignments
being known, social indiff curves is1, is2. where each curve shows
mixes of welfare derived by A and B that from society’s point of
view is equally good. Envelope curve , which for any U ranking
of A, picks best position for B made available on output specific
frontiers. This envelope curve is UU*. Pt of tangency of U
frontier with highest possible social IC is B*. This is the bliss
point of all possible solutions.
As a point of U frontier, it meets both requirements of Pareto
efficiency: MRS a,b (consumption) = MRTS (production). As
bliss point, social welfare is maximized through optimal
distribution.
Designing a pattern of is curves
Does equity belong to economics?
Traditionally referred as factor pricing and division of national income among

returns to factors. Latter’s significance lies in efficient allocation. For resource
use to be efficient, factors be applied to equate VMP in all uses.[both in
socialist and capitalist economies]
But this theory of efficient factor use is not a theory of distributive justice.
Proposition that factor allocation be based on efficient factor pricing does not
require final distribution of income among individuals be equal to proceeds
from sales of factor services. Both separated by distribution of Budget.
Ultimate concern of justice is distribution among individuals or families and
not among groups of factors. [factor shares loosely related to interfamily
distribution of income]. K income accrues largely to high income families and
wage income to low income families, but indirectly.
So how to address problem of distribution among individuals or
families directly?
Determinants of Distribution
In the market economy, distribution of income is

determined by sale of factor services. It depends on
distribution of factor endowments.
With regard to labor income, this distribution involves
the distribution of abilities to earn such income, as
well as desire to do so. W.r.t. K –income, it involves
distribution of wealth as determined by inheritance,
marriage patterns and lifetime saving.
Distribution of L and K endowments is linked by I in
education, that in turn affects wage rate which a
person commands.
Given the distribution of endowments…
… distribution of income depends on factor prices. In PC, Y distr

=VMP of a factor.
As such, these prices depend on a set of variables, factor supplies,
technology, and preferences of customers.
In many cases, returns determined in imperfect markets, institutional
factors, like conventional salary structures, family connections, social
status, sex, race, etc. play a role.
So returns to various jobs differ as per status , not MP. Marriage
patterns, bequests determine distribution of family money income.
Thus distribution of income manifests inequality in USA or UDC.
Among forms of income, K income show more inequality.
Why in recent years, more inequality is seen? Is that fair enough?
Distribution as a Policy Issue
Focus shifts from distribution as a market outcome to

distribution as a policy issue. Design of tax and transfer
policies can have policy repercussions. Inflation situation
calls for reduction in AD through rise in sales tax or income
tax or via reduction in PE. Anti trust measures to make
more efficient markets affect returns in K or L in particular
industries as well as real income of consumers. Public I
programs in road construction or regional development
impact economic welfare and patterns of distribution.
Public pricing policies affect real income of subway riders.
Standard economic analysis does not tell us what criteria
of distributive justice should be.
B-Approaches to Distributive Justice
Assumption :1- Utility people derive from income is known

and comparable 2-amount of goods or total income
available for distribution is fixed.
[implications from alt criteria be understood]
Alt Views:
1- Endowment Based Criteria
a- keep what you earn in market
b- keep what you could earn in PC
c–keep labor earned income only
d–keep what you could earn in PC, given equal positions at
the start.
1-Endowment based criteria:

Theories of social contract formulated the problem in
terms of certain rights and duties to which all
members are entitled and committed but differed on
content of contract. Hobbes and Locke postulated a
person’s right to fruits of his labor, thereby giving
ethical support to distribution by factor endowment
and pricing of factors in market. (modern day Robert
Nozick)
1-Endowment based criteria:

Principle of entitlement as in 1a [stated without qualifications] or
limited to earnings in PC as in 1b. Claims to monopoly profits would
not be legitimate, nor would claims to wage or salary incomes in excess
of MP. 1c applies endowment principle only to earned wage or salary
but not to K income. Earning wages involve disutility of work but
drawing r does not [Locke natural resources held in common] British
classicals similarly said unearned or K income should be taxed more
heavily than wage income.
Id, modern version, sanctions such inequality as would remain if all
people were given equal amount at start. In a radical interpretation,
accept inequalities resulting from innate differences in earning ability,
in preferences between income and leisure and in thrift. In contrast,
inequalities arising from inheritance, different educational
opportunities, or family status will not be acceptable. Such constraint
is necessary in a free enterprise system.
Utilitarian Criteria
2-Utilitarian Criteria
Many social philosophers rejected innate inequality in

ability as a legitimate source of difference in economic
wellbeing. It need not be permitted to determine the
state of distribution. Like social status, this high/low
ability is not due to will/action of that individual. This
accident of birth lacks ethical sanction as basis for
distribution. So other principle of assignment like
Utilitarian is discussed.
2a- Total welfare is maximized
2b-Average welfare is maximized.
Fixed Total Income
To Bentham, would distribute income to achieve greatest sum total of happiness.

With respect to division of given pie, A should be given more income than B if A’s Utility level or
ability to derive happiness from personal income is higher.
Only if it is assumed that MU schedule for all individuals are same and are declining, will an equal
distribution of income be called for. The maximum satisfaction view therefore may or may not lead
to egalitarian solution. This is in Fig 6.1. In each diagram, income is measured on horizontal axis,
while the vertical axis records MUy i.e. increment in TU that results as another dollar is added to
income]. Area under curve measures TU derived at various income levels.
Consider distribution of income above a certain minimum level OM.[to bypass difficulty arising out
of possibility of infinite utility] assume Utility comparison among various individuals is possible and
measured in utils. Assume that after providing each with OM, total income available for assignment
between A and B is fixed at MT.
In the upper part, 2 individuals A and B have same MU schedules. To maximize total satisfaction,
this income divided equally between A and B so that A gets MC, B gets MD s.t MC+MD=MT. The
MU s of A and B are set equal at OF, as are their total utilities, reflected by MCGH and MDKL
respectively.
In lower part, assume A’s MU schedule beyond minimum income level OM, lies above B’s. A has
higher capacity to derive additional utility from income above OM. Assuming again a total income of
MT to be available for distribution, total utility is now maximized by assigning larger amount MK to
A and smaller amount MV to B where MK+MV=MT. Marginal utilities are equated at OJ and A’s TU
or MKNH >B’s or MVPL. Having a higher lying utility schedule A is better off for 2 reasons. A not
only derives greater utility from same income but in addition receives a larger income share.
Variable Total Income
Fig 6.1 assume total income available for distribution

is constant. As adverse effects allowed for, max
welfare, as utilitarians stressed, can be short of equal
distribution and even when assumption is shape of all
U schedules of all individuals are same. Also allowance
be made for dead weight losses that arise in processes
of redistribution.
Egalitarian criteria
Society consists of individuals [not sum or average]

Then why should reason(reasonable men)justify
maximizing total welfare? Key issue of distribution as
they perceive it, is one of relative position among
individuals. Equality of positions is seen as goal. This
is focus.
3- Egalitarian criteria-Equality as a goal
3a-Welfare is equalized.
3a posits equality of welfare is inherently desirable.
Based on humanistic view of equal worth of each
individual.[Rousseau, Marx, Christian ethics] Max
Weber pointed to endowment criteria.[Protestant
Ethic]
Distribution of a total given income depends whether
or not individual U schedules are same or not. If so,
upper part of Fig 6.1 applies and income divided
equally between A and B.
Egalitarian criteria
Utilitarian(maximize total welfare) and egalitarian

precepts call for equal distribution of income.
But if utility levels differ, as assumed in lower part of
figure, egalitarian distribution assign MS to A and MR
to B; where MS+MR=MT and MSQH=MRUL. Larger
share of income goes to person whose Utility scale is
lower.[pattern of income inequality is opposite to that
achieved under maximum total satisfaction ]
Sub-serving equality as a goal
Do Rousseau or Marx recognize differences in level of U schedules as

reasons for income inequality?
To Marx, need is due to objective factors like family size and health
and not to subjective differences in capacity to enjoy income.
Although enjoyment capacities differ, egalitarians interpret equal
worth as a call to distribute as equal worth exists in U
Schedules.[subject to qualifications for objective differential in need]
But level of income is not fixed. Both allow for effects of Y- distribution
upon level of earnings. Tax H to transfer to L, reduce income available
for distribution. Further rise in tax on H, narrows gap between H and
L but lessens positional gaps in both.[egalitarian rule carried to
extreme runs into difficulty, unless equality is valued so highly as to
offset decline in average income levels]
3-Egalitarian criteria-Maximizing lowest income
3b- Welfare of the lowest group be maximized.

Rawls permits inequality s.t. it contributes to a higher level of income
at the bottom.
If carried beyond a certain point, a further increase in tax rates
reduces yield, thus becoming counterproductive in permitting
transfers to lower income recipients.
Rawls rule of fairness: individuals placed at initial position where they
do not know their earning potential will be. Then they provide
impartial choice as to what the state of distribution will be.
Knowing that equalization will reduce level of income available for
distribution [but not knowing what their own position on income scale
will be], they will stop short of demanding equalization.
Assuming people to be highly risk averse, they will vote for their degree
of redistribution that maximizes the lowest income.[scope of desirable
redistribution becomes dependent on degree of risk aversion]
3c-Egalitarian criteria-Categorical Equity
3c-Calls for provision in kind.

Concerned with entitlement to minimum levels;
defines the latter not in terms of income but in terms
of specific consumption items.
Thus floor defined as minimum supply of food,
clothing, shelter. [cost of these may be taken to set the
minimum income, or provisions made in kind] This is
considered in Role of Giving. It links merit good
approach to distributive justice.
Ex: low cost housing, food stamp plan to subsidize
products.
Mixed solutions
Is a design of good society determined by reason or values?

Unsolved till further evolution of humanity.
Various approaches are combined.
Equity approach ensures no one suffers from poverty; then
endowment approach can be applied. Recognition of equality at
the start helps provide a value base.
No individual/HH be forced to fall below some minimum
standard of consumption irrespective of production potential.
Endowment based criteria, with entitlement to market earnings,
should apply, but the resulting degree of inequality is to be
limited by setting a floor (4a) to share derived at bottom of
scale.[or endowment with distribution adjusted to maximize
welfare in line with social welfare weights (4b)]
Equity across generations
Advances in S&T made by this generation will be at

disposal for future generation. K-accumulation
bequeathed to future.
Dissaving, exploitation of irreplaceable natural
resources place a burden on future. This asymmetrical
relationship poses questions of intergenerational
equity. That is, introduction of a time dimension adds
to complexities of distribution problem.[social security
finance and PD]
C-Limits to Redistribution
Earlier discussion: what constitutes a just state of

distribution. Problem of practical policy is more
limited. Issue was how to address the problem of
redistribution. So how the existing state of distribution
can be amended?
This can be achieved by voluntary giving; but such
transfers carry minor weight as compared with policies
of redistribution by budget process. Such policies are
met by individual responses who lose/gain. This
affects size of pie for redistribution and impose costs.
Size of Pie
Policies to redistribute can shrink size of pie for

distribution. This is shown w.r.t. effects on L-ss; effects on
S, I and econ gr.
Consider 2 individuals H with high and L with low earnings
capacity.(L=0, say;). Tax imposed on H and transfer paid
to L. So net wage rate of H(return on goods H gets for
selling leisure) is reduced. Initially H responds by working
more and then work less. Revenue got is limited.
Table shows H’s response to rising rates of tax with wage
rate Rs10. H raises work till 15% tax rate, above which
working hours reduced. Beyond 30% tax rate, revenue
begins to fall.
Efficiency Costs
Potential scope for redistribution limited as a further rise

in tax rates hits a revenue ceiling. There is another subtle
cost to redistribution that gets effective from outset.
Withdrawing Rs1 from H leaves H with welfare loss; and
receipt by L imposes a deadweight loss. This factor poses a
problem for design of welfare programs.
Fact that donor loses more than recipient gains does not
mean transaction must have social cost. Weight to be
attributed per rupee loss and per rupee gain matters. Low
income gain of 90p(put under social weighting) can be >
than a loss of 110p.
Efficiency cost
The nature of efficiency equity tradeoff shown in Fig

6.2. for economy with 2 persons A and B. Vertical and
horizontal axes measure A’s and B’s utility levels;
utility rising when moving from O to C or from O to D.
CD is U frontier derived earlier in Fig 5.2; is1, is2 … are
social indiff curves reflecting distributive judgement of
community. B* is bliss point, reflecting the best of all
possible solutions.
Efficiency cost
If prevailing arrangements place the economy at E, movement to points between F and

G on U frontier is efficient (Pareto optimal) since at least one gains and no one loses.
But Pareto efficiency does not tell how to choose between F and G. From a social point
of view, G is best, since it reaches the highest possible IC.
If market function leads to point F, given ICs, social gain generated when movement is
to B* raising social welfare to Is5. This gain happens even when A loses so that the move
is not sanctioned by Pareto efficiency. Moreover, moving to a point off the frontier like
K, may be superior from a social point of view to remaining at F.
How the above bears on efficiency costs of redistribution?
[CBD traces U frontier as it
will look as if redistribution can be achieved without efficiency cost.]
But
given the cost and beginning at F, the actually available frontier is FKZ.
By moving from F to K, redistribution
still pays in social welfare terms(but gain is less as it moves
from IS2 to IS3.) than it would be without an efficiency cost of redistribution.
Society can accept some efficiency loss for an equity gain but distributional adjustments
be made to minimize the cost.
Public Provision for Social
Goods-ch4-Musgrave &Musgrave
DEBASIS PATNAIK, PH.D

2ND SEM 2020-21
Introduction
Theory of social goods provides a rationale for the

allocation function.
Goal is to design a mechanism for provision of social
goods that would be efficient in a democratic setting.
A-Social Goods and market failure
In a market economy, consumers bid for what they wish to

buy and reveal their preferences to producers. Producers
will ensure that mix corresponds to consumer’s
preferences. Producers max profits at least cost.
But markets can be imperfectly comp. Production can be s
.t. LIR, consumers can lack sufficient information due to
deceptive advertising.
But market cannot solve externalities. Society can judge
market orientated distribution as to whether it wants such
a distribution or not. Then there are problems of inflation,
unemployment and growth. So budget policy making has a
big role.
Market for Private Goods
Market function on exclusion principle; i.e. A’s

consumption is contingent on A’s paying the price;
while B, who does not pay, is excluded. Exchange
cannot occur without property rights; and property
rights cannot be used without exclusion.
Benefit is internalized and consumption is rival. A
sweet eaten by one cannot be eaten by another.
But market failure occurs and budgetary provision
needed if C is non rival and exclusion inappropriate.
Market failure due to non rival C
Exclusion is inappropriate in case of social goods as C is non

rival. A‘s partaking of C benefits does not reduce the benefits
derived by others. Hence excluding A would be inefficient. Ex:
Defense. Bridge not crowded and MC of use is zero. Charging a
toll would be inefficient till bridge gets crowded. Broadcast and
jamming can be inefficient if A’s reception interferes with B.
Exclusion can be applied but should not be as C is non rival.
But cost of providing the service is: This cost must be provided
somehow and it must be determined how large a facility should
be provided. With exclusion inappropriate, task cannot be
provided by market. So a political process of budget
determination may be necessary.[permits consumers to reveal
preference and obliges then to contribute]
Market failure due to non excludability
When C is non rival but exclusion not feasible. Ex: Crowded

city in rush hours. The use of available space is distinctly
rival and exclusion would be efficient and should be applied.
Reason is use of crowded space would go to those who value
it most and willing to offer the highest price. But this
exclusion would be too costly to administer. This difficulty is
cause of market failure. Public provision has to be provided
for till proper techniques to apply exclusion is found.
Also, if partaking of consumption is not made contingent on
payment, people will not reveal their preferences in bidding
for social goods. Individual will not affect provision and so
he/s acts as free rider. If all act like this, there is no effective
demand and auction system collapses.
Combined causes of market failure
Consump
Air purification, defense-exclusion cannot and should
not be applied. Both causes of market failure overlap.
Rival
No point asking which cause is primary. Non-rivalrous
C makes exclusion inefficient though technically Non rival
feasible.
Case1=pvt. In other cases, market failure occurs. But
customary to put only 3 and 4 as situation of non rival
C. But case 2 being rival, conditions for efficient
resource use is different.
B-Provision for social goods
(Demand for public and private goods)
The non rival nature of social good C bears on

1-what constitute efficient resource allocation (at least
cost what consumers want most)
2-procedure by which their provision is to be
achieved.
Comparison with private goods
To explore case 1- compare dd and ss fig for pvt and

social in a hypothetical setting.
LHS market for pvt good Da and Db are A’s and B’s dd
curves based on given distribution of income and
prices for other goods. So aggregate market dd curves
Da+b obtained by horizontal addition Da and Db
adding quantities which A and B purchase at any given
price. SS is supply schedule , and equilibrium
determined at E; intersection of dd and ss. Price=OC
and output=OH, with OF purchases by A and OG by B
where OF+OG=OH.
RHS
Corresponding pattern for public good.

Assume consumers willing to reveal their marginal evaluations of social good.
Da and Db are A’s and B’s respective dd curves s.t. same conditions of given
incomes and prices of other goods.
It is unrealistic to assume consumers volunteer their preferences ,such curves
are pseudo demand curves. Assuming consumer preferences are revealed:
Here market dd curve Da+b obtained by vertical addition of Da and Db with D
a+b showing sum of prices A and B are willing to pay for any given amount.
This is because both consume same amount and each is assumed to offer a
price equal to his or her true evaluations of marginal unit. The price available
to cover the cost of service equals the sum of prices paid by each. SS is supply
schedule, showing MC chargeable to A and B combined for various outputs of
social good.
The level of output corresponding to equilibrium output OH in private good
case now equals ON, which is quantity consumed by both A and B. The
combined price equals OK, but price paid by A is OM and price paid by B is
OL, where OM +OL=OK.
Return to pvt good: vertical distance under each
individual curve reflect MB derived from C. at E, both
MB derived by A in consuming OF and MB derived by
B in consuming OG equals MC=HE.
This is efficient solution because MB=MC for each
consumer. If output falls less than OH, MB>MC, and
individuals will be willing to pay more than is needed
to cover cost. Net benefits will be gained by expanding
output so long as MB>MC… and net benefits are max
at OH where MB=MC. Welfare losses would occur
were output >OH, for MC>MB.
Compare with solution of social goods
Vertical distance under each individual’ dd curve

reflects MB obtained, since both share Consumption of
same ss, MB generated by vertical addition. E reflects
equality between sum of MB and MC of social goods. If
output<ON, expands as MB>MC.
Pvt goods…derived by each individual with MC. In
public good, MB by two consumer differs and sum of
MB=MC. (based on MRS)
Demand for public and private goods
Application of pricing rule price=MB, yields diff
result for social good vs pvt goods.
In pvt case, A and B pay same price but buy diff

amounts.
Social good, buy same amount, pay diff prices, both
cases: same pricing rule is applied. Each consumer
pays a single price for successive units of goods
purchased; price=MB that buyer derives.
Lindahl sharing of cost of social good in ss dd
relation
Lindahl-sharing of costs by two consumers of
social good in ss-dd relationship
Budgetary provision
Despite previous explanation of fig 4.1, provision of social good need

not be undertaken as market mechanism. Moreover, pseudo demand
curves are not revealed.
So a political process could be used 1-to obtain revelation of
preferences(tell G what social goods be provided)2- provide fiscal
resources needed to pay for it. Done by voting on tax and expenditure
decisions. Individuals, knowing that they must comply with majority
decision will find it in their best interest to vote for that solution that
will move outcome closer to what they need. Thus they reveal their
preference. So budget decision induces preference revelation and
thereby social good provisioning is determined.
To ensure an efficient mechanism of preference revelation voting
process should link tax and expense decisions. So the political
mechanism is the best technique that is available. Thus various voting
rules are defined and determined. Issues of bias in decision making
towards overexpansion of public sector can be discussed too.
C-Mixed goods-Externality of pvt goods
Sharp distinction is maintained between cases where

benefits are wholly internalized (pvt goods) and wholly
externalized (public goods).
Externalities of private goods:
External benefits: If A derives benefits against vaccine,
others also benefit. Ditto for education. Since large
nos. are affected, bargaining may not work and
budgetary process will be needed. Correct intervention
may involve subsidy for pvt purchases.
Mixed goods-Externality of pvt goods
Externalities of private goods
In Fig 4.2, Dp is market demand schedule got by horizontal addition of demands for pvt
benefits. Dx is supplementary schedule reflect evaluation by others of external benefits.
Dx is got by vertical addition of individual dd curves for such benefits. Adding Dp and
Dx vertically, Dt reflects total benefits including Dp and Dx. So pvt market result in
equilibrium output OQp, since market dd schedule Dp is backed by voluntary
purchases. But this is inefficient since optimal output is Qs , where external or social
benefits are allowed.
To expand output from OQp to OQs, G will pay subsidy equal to Dx. Such subsidy raises
market dd facing supplier from Dp to Dt and output extended to OQs. Consumers pay
net price of OR with subsidy contributing the difference RT. Total cost of subsidy is
RTCF. And paid out of budget, financed by taxes on A and B. Alternatively, subsidy can
be given to producer, lowering his net ss to S‘.
The above is simple if Dx is known; but since it is not so, voting process needed.
Social goods now extended with internal benefits supplemented by external benefits. At
one extreme of pure pvt good, FC is zero and Dx =Dp and no subsidy needed. At other
extreme or purely public good, Dt=Dx and subsidy pays the entire price and so benefits
are wholly external. Good becomes a pure social good and entirely provided for through
the budget. In between , cases of mixed goods to be financed by mix of private payments
and of subsidies. This tax subsidy theory will have subsidies ranking from 0% to 100%.
External costs
Pvt C or Production can generate costs not internalized

and not paid for. So costs imposed on society.
Fig 4.3 where D is market demand for pvt good. Sp is ss
schedule, reflecting firm’ internal or pvt cost with output
equal to OM and price equal to OR.
Efficiency calls for inclusion of external costs given by Se.
To secure output at ON with price equal to OT, G impose
tax on producer equal to EO=TF. Supply schedule is raised
to St reflecting both pvt and social cost. Equilibrium output
is ON. Alt, tax imposed on consumer drops net dd schedule
to Dn.
So external cost calls for penalty tax and leads to problem
of dealing with social bads.
External costs
Bargaining in small group
With large numbers, individual contributions don’t affect total ss and so they
act as free riders. Also, they will not act to prevent external costs.
External benefits: Neighbors get together for tree spraying, municipalities
build garbage disposal plant, national govts cooperate in NATO. Budgetary
decisions is by bargaining among selected representatives. Fig 4.4 have two
consumers share in benefit of common good. Quantities provided are equally
available to both. Da and Db is aggregate dd schedule for social good and SS is
supply schedule. Da+b is vertical addition aggregated. Till OQe max prices
shown by Da+b intersects SS at N. Both A and B pay price equal to marginal
evaluation QeF and QeG.
Alt: If B’s offer is along Db, deduct Db from SS to get QbE[reflects ss schedule
at various levels of output available toA]Moving along Da to its intersection
with QbE at F, A will buy OqE at price QeF. Equilibrium is at Oqe with A
giving QeF and B giving QeG=FN.
This is efficient solution. But the consumers need not behave this way. Both
attempt to get a better deal by offering prices below maximum shown by each
dd schedule. Each will allow for effect of his action on other and engage in all
or nothing bargaining[not marginal adjustments along dd schedules]
Bargaining in small group-external benefit
So how will bargaining proceed? Consider B’s position. If A was not present, B
will buy OQb. But B will not do so if it allows for A;s reaction. It expects A to
buy OQa, if it buys nothing.; but doe not expect A to buy anything, if it buys
OQb .
Given this choice, it will buy nothing if its gain from A’s purchase of OQ a
[measured by OQ aCH] > its purchase of OQ b.[measured by SHD.] Likewise,
A will not be eager to buy OQ a and this deters B from buying OQ b; and A;s
gain from his purchase of OQa[measured by SLK] < gain from B’s purchase of
OQ b [OLMQ b]
Eventually, some one will move, and there will be responses but uncertain
what result will be.
Output can reach OQ b and proceed to OQ e or fall less. Cost shared. If B gains
more from efficient provision if both contribute along their max offer or dd
curves, B need not push to max, if it gets lower price at smaller output.
Outcome depends on bargaining strength and skills of both parties.
Bargaining need not have efficient outcome. Increasing number of
participants leads to PC in pvt case, this may not happen in social goods
provisioning. So political process needed.
Small case-external cost
Airplane flying at night over sky. difficult to negotiate. TC too high.

But in small number case: Rancher R ‘s cattle strays into farmer F’s field and
damages crop. In absence of regulation, F will erect fence or offer R a bribe. F
will do so up to the point where her marginal gain from reduced crop damage
equals her MC of damage payment. R will concur till the point where her MC
of reducing herd, equals her MR from damage receipt. Efficient solution
reached without G intervention.
Outcome will be same, irrespective of whether there are rules and F pays R to
desist; or whether law protects F and so R must pay F to secure permission.
This equivalence is Coase Law. Though herd reduction will be same under
both cases, in distributional terms, it is different. R will be better off if law
entitles him to graze his cattle anywhere and F is better off if law protects her
crop. Bargaining relied upon to secure a settlement. But the legal system while
securing distributive justice will have to decide where to lay the entitlement.
Bargaining need not bring an efficient solution but may be biased in favor of R
or F depending upon their respective bargaining strengths and skills.
Market provision of non rival goods
In social goods, if C is non rival but exclusion is

possible? Monopoly supplier can then provide goods to
various consumers at differentiated prices.[exacting
for successive units which each consumer is willing to
pay] Supplier then appropriates the Consumer Surplus
derived by buyer. Efficient outcome is generated as at
margin, price =benefit derived.
This approach assumes that exclusion can be enforced,
supplier has all information. Both are unrealistic
though.
Congestion
Case of mixed good in relation to local finance where goods

are non rival in C but consumed in equal amounts by all
members of a group. As more users added, quality of
service declines. Ex: Quality of instruction received from
instructor declines if size of group increases. Empty streets
become crowded as traffic increase.
Demand curves still get added vertically but MC of adding
additional consumer is no longer zero. It becomes
appropriate to charge a fee. There will be an additional
problem of determining how large the size of group should
be. All these discussed as part of local finance that is
outside our purview at the moment.
Spatial limitation of benefits
Spatial benefit area is limited for most social goods.

Again a group need not be all inclusive for any social
good . This part is important for application of social
good theory to local G and can logically follow
discussion on fiscal federal finance. This is also outside
scope of our discussion.
Substitutability of Goods
Some wants may be satisfied either through purchase

of private goods or through provision of social goods.
Need for protection may be made by private locks for
each house or by police protection for entire city block.
First route provision left to market.
In 2nd case, budgetary provision needed.
Pvt mode has merit of permitting individual to
consume different amounts. Social goods mode, if it to
be better than previous one, should offer lower cost
per user.
D-Giving as a social good
Problem of social good has immediate application to case of G

provisioning. But in relation to transfers?
Tax and TP viewed as process of taking by those who benefit.
But to the extent, A’s giving to B is based on A’s desire to see B’s
position improved rather than derive pleasure from own giving. A will
derive equal satisfaction from similar giving by C or D. Giving thus
generates externalities not only for recipient but also for others who
see his position improved. Giving assumes social good characteristics
that calls for budgetary implementation.
[In practice, it is difficult to distinguish between giving and taking
aspects of majority based redistribution. But aspects are indeed
present in this]
Rise of welfare state can be interpreted as involving increased
readiness to give and take.
E-Merit good
What is entailed in Merit Goods?

Communal wants?
Premise of Individualistic evaluation?
Monument building?
How do wants for social goods get generated?
So what is nature of merit goods?
Premise of Individualistic evaluation
Non –rivalry and non-exclusiveness are technical characteristic

of public goods. Difference does not depend on psychological
attitude or social philosophy between 2 types of goods.
Utilities derived from social and pvt goods are experienced by
individuals and included in their preference systems. Same
individualistic psychology was applied to both types of goods.
[premise that all wants, pvt & public, are experienced by
individuals and not by groups are compatible with the fact
individuals live in association with others. A’s preference is
affected by B and C. Dominant tastes, cultural values influence
individual preferences and/or determined by them.
Individualistic evaluation do not exclude altruism either.
Utilities are inter-dependent]
Quality of wants can differ.
Communal wants
Premise of wants makes public goods analyzable within same econ

frame as pvt goods.
Communal wants not so easy to analyze. Why? Yet concept of
community existed historically across nations. It is an interest
attributable to the community and that does not involve a mere
addition, vertical or horizontal. Wants are generated by and pertain to
welfare of groups. This raises 2 questions: To whom and how is
community interest revealed. 3rdly, what range of needs can it be
applied?
Nature of communication is an important dimension of communal
wants. People, after an initial period of compulsion, come to accept
these values as their own[removing distinction between private and
collective].
So in the end, are all preferences, socially determined? No.
Inconsistent with democracy?
There is a degree of freedom in individual responses.
Merit goods
Certain obligations fall outside purview of freedom on individual choice. Individual

choice can be limited when 1-Interference is needed to guide children or mentally
disabled.2-provision for certain services like education 3-Corrective action may be
needed when consumer choice is based on false advertising. 4-Govt services to goods
with external benefits and that do not interfere with individual choice. 5- If minority
violations through majority rule inevitable?
In each of the above cases, society undertakes to correct for failures in the process by
which individual choice is implemented effectively.
Move closer to merit goods now: 1-giving in kind; because the giver believes that certain
uses by recipient as meritorius.2- tax payers prefer social programs that provide food
stamps or low cost housing. Supporters believe such uses of these are meritorius.[all the
above can be considered as part of what is fair distribution]
Acceptance of constraints on individual choice may extend beyond the act of giving and
budgetary support. Individuals as members of certain societies may feel obliged to share
certain costs [or prioritize use of their own funds]as a matter of respect for community
values. This consideration applies to pvt or social goods.
Similar consideration of understanding and operationalizing for social bads or demerit
goods like drug use, prostitution, etc.
[However one has to be careful of such strong notions embedded in merit or demerit
goods as they allow inflexibility and serve as vehicle for totalitarian rule.]
How to extend the ecology of Merit goods
Say, look into virtue of sustained association and mutual

sympathy and then come to develop certain common concerns.
Group of people share historical experience or cultural tradition
with which they identify, thereby establishing a common bond
Individuals will not only defend their home but logically enough
defend their territory or say, protect their countryside against
garbage heaps or protect waste recycling projects.
Such common interests or values give rise to common wants-i.e.
wants individuals feel obliged to support as members of
community. These obligations do fall outside the freedom of
individual choice.
But not all such common preferences fall within this area of
what can be called merit goods.
Incidence of Taxes-Bhatia-Ch-7
DEBASIS PATNAIK
2ND SEM 2021-21
Introduction
The economic unit upon which the authorities impose

a tax may not be the ultimate owner of that tax.
Since each economic unit is related to other economic

units through various economic transactions, it may be
possible for a unit on which a tax is
imposed(statutorily liable or made responsible for), to
shift it or collect a part or whole of it from another.
Impact, incidence and effects of a tax
Impact of a tax is its first point of contact with tax

payers. It is upon those who bear the first
responsibility of paying it to authorities.
Incidence of a tax is defined as the final resting place.

[it is to be seen and judged in terms of money burden
of tax]. Incidence being upon those who cannot pass it
on to others. Incidence lies upon that final source from
which tax money comes.
Shifting
A particular tax can be borne by a large number of economic units

which may or may not be divisible into homogenous categories.
Even a single unit of tax, such as excise duty, collected on an item of

production, may be shifted and finally shared by a number of economic
units. It is also likely that the task of tax shifting passes through several
stages and the final incidence of a tax gets scattered.
The money burden of a tax can be shifted, partially or fully, only

through the vehicle of price variations. Price may be raised in sales
transactions or may be lowered in purchase transactions. So in the
process of tax shifting, prices of various goods and services change.
If however, sales transactions of a taxed good or service comes to an

end, there is no possibility of shifting the incidence at all. If the tax
item ceases to be taxed upon, then no incidence.
Effects of a tax
When a tax is imposed and collected, it involves certain

responses from tax payers and the economy. Such responses can
show variety and influence the working of economy in terms of
production, growth, saving, investment, choice of techniques of
production, regional imbalances, inequalities of income and
wealth, etc.
So effects are different from impact and incidence.[impact is on
first point of contact; incidence is on final resting place; effect is
about responses and results/changes in terms of above]. So
effects can come from incidence and shifting.
Ex: Minimum effects of a tax, when it is imposed, will be a
reduction in PDI.
If tax is shifted, then some prices can change.
Effects: Beneficial or Harmful?
Harmful effects of a tax is burden of tax.

It can be money burden and real burden.
Money burden refers to reduction of disposable income of tax payers.
Money burden may be direct or indirect.
Direct money burden refers to the amount of tax being paid by tax payers. This
equals tax collection.
But tax being imposed and collected can cause additional expenses to tax
payers. The latter might go to Treasury or incur search time online. These are
indirect money burden of tax.
Real Burden- Harmful effects of a tax in terms of increasing unemployment or
reduced production. It is equal to loss of welfare to the tax payer or
community. Direct real burden is sacrifice to tax payers. But is not net of
benefits of tax. Indirect real burden of a tax is also not net of benefits of tax.
Indirect real burden is the indirect loss of welfare which results from (a)
interference with consumer choice, (b) changes in factor supply and hence
total output, and (c) changes in employment through changes in aggregate
demand.
How is tax burden calculated?
The most straightforward way to calculate effective tax rate is to divide the
income tax expenses by the earnings (or income earned) before taxes. For example, if a
company earned $100,000 and paid $25,000 in taxes, the effective tax rate is equal to
25,000 ÷ 100,000 or 0.25.
Tax burden ratio:

Tax burden in DuPont analysis is the ratio of a company's net income to its earnings
before taxes. It shows the proportion of earnings before taxes (EBT) and that's left after
income tax charge.
Tax burden effectively equals 1 minus the tax rate.
Interest burden = (EBIT – interest expense) ÷ EBIT;
Tax efficiency = [1 – (tax expense ÷ (EBIT – interest expense))];

and.
Leverage ratio (equity multiplier) = average total assets ÷ average shareholders' equity.
Mrs Hicks’ Formal and Effective Incidence of a
Tax/Musgrave Concepts
Formal incidence of a tax means money burden or its money incidence.

Formal incidence refers to proportion of people’s incomes which goes not to provide incomes of
those who furnish them with goods and services but is paid over to governing bodies to finance
collective satisfaction.
This is referred to activities of authorities for providing public services to the community for which
they need finance. Such financing may be provided not directly by tax payers but through purchase
and sales.
Mrs Hicks therefore implicitly assumes that there is difference between impact and incidence.
Special case in Mrs Hicks is where Impact and Incidence rest upon the same place.
Formal Incidence is equal to amount of tax collected by Treasury. Formal incidence of tax system as
a whole is equal to total tax revenue of authorities. This means final resources that are transferred to
authorities by tax payers.
Effective incidence is equivalent to the effects of taxation in usual sense of term. It means
advantages and disadvantages economy derives from a tax system.[difficult to estimate effective
incidence. But if tax is existent, one can compare situation as it is with tax vis a vis a situation where
tax is not existing].
Musgrave uses word incidence differently. When tax is imposed or rates changed, effects are felt in
different spheres. The incidence is the resulting change in distribution of income available for
private uses. The distributional effects of changes in a particular tax are specific tax incidence.
Musgrave’s differential tax incidence is when distributional changes that result as one where tax is
being substituted for another tax[assuming that govt is interested in choosing between alternative
ways of raising a given amount of real resources by means of taxes].
Forward and Backward Shifting
A tax can be shifted through sales or purchase transactions.

If a producer is asked to pay excise, he can enhance sale price or
force suppliers to reduce prices.
2nd level impact of shifting can happen through change in
demand and supply forces.
But only that change in price is indicative of shift in incidence of
that tax that caused this shifting.[it is not on account of shifting
of demand and ss forces.]
Modern situations:
In a modern economy, difficult to estimate price that would have
been there in absence of tax.
Also tax can be partly shifted in either and both directions.
With changing demand and supply forces, incidence can shift
differently.
Tax capitalization
Durable items like houses and cars that can be subject

to periodic taxes.
For backward shifting of a tax, buyer reduces the
purchase price of a taxed good to an extent that would
cover the extent of tax to be paid periodically in future.
So this equivalence of future tax payments, is found in
terms of PV;[and PP is reduced by part or full amount
of that value.]
This reduction in purchase price(PP) by purchaser is
called tax capitalization.
How buyer works out the offer price for a taxed
but durable item
Let R1, R2,R3, ..Rn be money receipts or (money

equivalents of services)which taxed item is expected to
yield to its owner at times 1, 2,3…n.
Let T1, T2,..Tn amount of taxes to be paid out of
receipts R1,R2,R3..Rn..
Let r1,r2,r3,…rn be interest rates for periods 1,2,3,..n
Then present worth of net receipts from taxed item:
PW=(R1-T1) /(1+r1 ) + (R2-T2)/(1+r2)2 +
…..(Rn-Tn)/(1+rn)n =∑i=1 n (Ri-T1)/(1+ri)I
The price offered by buyer is limited to PW. It falls as tax rises and vice
versa.
Theories of Tax Shifting
Explanations/theories behind who pays the tax in the

final analysis and on whom the final incidence of tax
rests.
Concentration theory
Diffusion theory
Demand and Supply theory.
[All three theories assume that incidence of a tax can
shift only through interaction of dd and ss forces in
market]
Concentration theory
This approach says that there is an inherent tendency for taxes to be absorbed by
certain income classes.[physiocrats and classicals]
Physiocrats believed that in an economy only those could bear taxes who appropriate
surplus.[to them artisans and other classes, except peasants, were not producers of
surplus, since in each case, the value of final output was only equal to value of inputs]
But in case of agriculture, value of proceeds exceeded inputs; and this surplus was
getting appropriated by the landlords as rent.
Peasants were thus left with that much income to maintain themselves and perpetuate
L-ss. Artisans’ income similarly covered their reproduction cost. So the only source
from which tax revenue can come was from rent.
So if a tax was imposed on any other sector of the economy, it would get shifted to
agricultural rent through interdependence of economic sectors; and agri rent would
finally absorb it…i.e. incidence of any tax would rest there.
So it was better if tax was levied on agri rent in the first place itself.
Concentration theory through approach of
classicals
Classicals said that there were two surpluses: rent and profit. So all tax incidences
would get absorbed on these. How?
Land rent arises (as per Ricardo)as agri production is s.t. LDR.; that with increasing
population and demand, supply of agri output rises and also MC of production rises too.
Classicals also believed in subsistence theory of wages and Malthusian theory of

population.
So wage rates in market would settle at subsistence.
Below this, they reduce L-ss.[because L will start dying off].

An increase in wages over subsistence would increase L-ss in LR.
In SR, L-ss will be taken as fixed as long as wages do not fall below subsistence.
Classicals in concentration
If a tax is levied on agri produce: It means that with additional cost of

cultivation, same output is being collected. This will increase MC of
cultivation.
Due to given population in SR, demand for agri goods will not fall. And
so agri prices will increase. This increases cost of subsistence of
workers. Then wages will have to be increased and so this will cut into
profits.
Rent income does not fall because landlords pay tax on agri produce
out of higher sales proceeds collected by them through higher agri
prices. So tax incidence rest on profits.
But if tax is imposed not on agri produce, but on agri rent itself,
landlords cannot push tax incidence on to others because rent does not
form a part of cost of production; MC of cultivation constant; rent
income is constant.
Classical in Concentration
If tax is imposed on wages, workers will have to be compensated through

additional money wages to give them a real subsistence.
[Adam Smith says money wages must rise if money cost of subsistence rises
due to taxation of necessities][Also money wages must rise, if wages are
taxed].
Those who are appropriating profits will not be able to shift the tax incidence.
Higher wages will increase the MC of cultivation and so via higher agricultural
prices, tax incidence will shift to profits.
But if a tax is levied on profit income itself, no shifting takes place, and tax is
absorbed right there.[since wages, already in subsistence, cannot be pushed
down further]
Diffusion Theory
Now, believing/assuming that wage rates do not settle at subsistence level, so

that surpluses exist through-out[say, in SR, rent or surplus exist in earnings of
every factor]; assuming there is interdependence of various economic units in
the economy; it follows that a tax imposed at one place would shift to far flung
sectors in the economy.
Some say, due to constant interaction between sales/purchase transactions, it
becomes impossible to trace the final incidence of any tax and in reality, all
taxes get diffused in the economic system.
Dalton does not agree. He says this is escaping the task of ascertaining tax
incidence and tax effects due to difficulties associated with such exercises.
[Tax diffusion is based on assumption that market is PC and factor mobility in
costless manner.] So it does not matter where tax is initially imposed. Then
there is something wrong in theorising as ‘diffusion’.
Musgrave-Incidence and effects be clearly demarcated at first.
Also, assumptions behind theory is unrealistic. Normally markets are not PC.
Factor mobilities restricted. Tax may be sitting where it is imposed.
Demand and Supply Theory
Price revision is possible and determined by relative
values of dd and ss elasticities.
Tax is shifted through shift in dd and ss curves; and
sharing of incidence determined by dd and ss
elasticities.
General Rule: Irrespective of whether the impact rests
(statutory liability)on buyer or seller, share of tax
borne by seller will be larger when ed is larger; share
of tax borne by buyer is larger when es is larger.
So burden of tax shared between buyer and seller in
the ratio of elasticities of supply and dd.
Case of single commodity tax subject to specific
(per unit) tax: tax on seller
Demand and Supply Theory-Take case of single commodity subjected to
specific tax(per unit)tax. Assume impact of tax is upon the sellers.(Fig7.1)
original dd –ss curves for good be DD‘ and SS‘. With imposition of tax SS1
upon commodity, the supply curve shifts to S1S1‘; and the price of the
commodity rise from PM to P'M‘ .
Out of this P'M‘ , sellers get only AM‘; balance is collected by the govt. as tax.
i.e. incidence upon the sellers is equal to BA per unit. On the other hand,
buyers were paying P‘M‘ instead of PM, an increase of P‘B per unit, which is the
incidence upon them.
It can be shown that this division of tax P‘A between the two shares P‘B and BA
is in the ratio of elasticity of supply to ed. Thus ed is given by proportionate
change in demand divided by proportionate change in price of buyers. So Ed=
(MM‘ /OM)/(P‘B/PM).
Similarly, es given by proportionate change in ss/proportionate change in
price to sellers. i.e. Es= (MM‘ /OM)/(BA/PM).
So Es/Ed = P‘B /BA= incidence on buyers/incidence on sellers.
If tax is imposed on buyers: demand curve would shift left and

downwards to D1D1. Buyers would then pay a price of AM‘ to the sellers
and a tax P‘A per unit to authorities. So the resultant incidence on the
two parties will remain constant.
It can be shown that even when the tax is ad valorem (proportional to
price of commodity), the incidence of the tax will be shared by buyers
and sellers in the ratio of Es/Ed = buyer’s share of incidence/ seller’s
share of incidence.
This formula shows that Es rises in relation to Ed, incidence will be
more on buyer and vice versa. Thus if the commodity tax is being
produced under CRS, it follows the supply curve will run parallel to X
axis; and Es tend to infinity. Then incidence of tax will lie wholly on
buyer. This will happen even when tax is imposed on buyer(so dd
curve will shift downward). Fig 7.2 shows this. And it is seen points A
and B coincide, so that P‘B=P‘A. Here, per unit tax will not vary even
if tax is not specific but ad valorem because the sale price of sellers, net
of tax, remain constant.
Amt of goods demanded and supplied: tax on
buyer
Tax will be fully borne by buyers if Ed=0 (Es/Ed),

denominator =0.
So dd curve will run parallel to y axis.; and upward
shift in supply curve will automatically mean an
equivalent increase in price being paid to buyer. If tax
is ad valorem, say ‘t’%, price will exactly be ‘t’% ,
because Qd=Qs.
In same way, if Es=0, or if Ed is perfect, sellers bear
full incidence of tax. (fig 7.4 and Fig 7.5).
Amt of goods demanded and supplied: ed=0
Amt of goods demanded and supplied:es=0
Ed perfect
elastic
Dalton shows that in absolute terms, the incidence of commodity tax on buyers will be given by [tEd/
(Ed+Es)] where ‘t’ is tax per unit (it may be ad valorem or specific) and share of sellers will be given by [t
Ed/(Ed+Es)]
He generalizes it to the case where different rates are imposed upon number of different sources of
supply. If there are ‘n’ sources of supply with supplies of x1,x2…xn and if they have es as e1, e2,…en and if
the respective tax rates upon these supplies are t1,t2,…tn, then incidence of tax upon buyers given by:
∑i=1 to n ti ei xi / ∑i=1 to n Edixi + ∑i=1 to n eixi. Where Ed is elasticity of demand.
It should be noted that in some cases, price of commodity may increase by more than amount of tax levied
on it. Ex: in case of commodity subject to LIR, Fig 7.6,. Imposition of a tax in this case reduces the amount
supplied and bought, average cost of production increases and that adds to upward shift in price.
In fig 7.6, price to consumer rises by P‘B> tax amount P‘A per unit.
Sellers may try to pass both the tax and the loss of interest they suffer by first paying the tax to authorities
and then collecting it later from buyers.
Dalton says , the share of buyers given (t+i) E s/ Ei+Ed ] where ‘I’ is interest loss to seller. If this price rise
for buyer is more than tax amount, it follows that (t+i) E s/ Ei+Ed > t. i.e. (t+i) /t > (Ed +Es)/Es…..
Meaning i/t >Ed/Es . That is, a greater loss of interest, smaller elasticity of demand and a greater
elasticity of supply will work towards increasing the price more than the tax amount.
Another possibility under which price rise may be more than tax amount will be when the competitive
market is converted into a monopolistic one by sellers through some form of combination. Then they
restrict supply and increase price.
Summary of the ‘Demand and Supply Theory’
Role of demand and supply elasticities in division of

commodity tax incidence between buyers and sellers under
PC,:
1- Greater the Ed, smaller will be share of incidence borne
by buyers. Supply can have positive (upward) or negative
(downward) slope. In the former (upward case)with high
Es, share of buyer will be more. In the latter case, , in case
of IRS, share of buyer will increase as Es is smaller.
[Theory of tax shifting assumes buyers and sellers achieved
their respective equilibrium positions and sellers work
with aim of max profitability].
IRS case

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Public Revenue-Ch4-Bhatia

Public Receipts include income from all sources

Market borrowing-loans of maturity>12months

What is a tax? It is a compulsory levy. Those who are

It is a liability imposed on assessees

Even in pricing, some compulsion is there.[though

Special assessments, fees, fines:

Compulsory payments without quid pro quo. But they

Fees for services like registration of marriages, births

Profits from paper currency and mintage.

Excess of PE over PR. This excess is met by borrowings from

1- Legal description of the object with reference to which tax applies.

5-Canon of Productivity: Fiscal adequacy canon. Tax system should

Tax is only one part of the total budget of govt.

But practical and conceptual difficulties would be

Decentralized Financial Power

BITS Pilani, K K Birla Goa Campus

BITS Pilani, K K Birla Goa Campus

✓ Article 1 of the Constitution states:

Centre State Local govt.

BITS Pilani, K K Birla Goa Campus

1. Independence and Responsibility

BITS Pilani, K K Birla Goa Campus

State list (61) Concurrent list

➢ Public order ➢ Education

BITS Pilani, K K Birla Goa Campus

List 2: State list List 3: Concurrent

BITS Pilani, K K Birla Goa Campus

BITS Pilani, K K Birla Goa Campus

BITS Pilani, K K Birla Goa Campus

BITS Pilani, K K Birla Goa Campus

Article no. Subject matter

269A levied and collected of GST in interstate trade

271 Surcharge on certain taxes

273 Grants for export of jute product

275 Statutory grants

282 Discretionary grants

BITS Pilani, K K Birla Goa Campus

BITS Pilani, K K Birla Goa Campus

BITS Pilani, K K Birla Goa Campus

BITS Pilani, K K Birla Goa Campus

✓ A chairman and 4 other members to be appointed by president

BITS Pilani, K K Birla Goa Campus

✓ Recommendation on: (ToR)

BITS Pilani, K K Birla Goa Campus

✓ Recommendation made by FC are only advisory in nature

BITS Pilani, K K Birla Goa Campus

➢ Constituted by the president in Nov, 2017

Major fiscal reforms under 15th FC:

BITS Pilani, K K Birla Goa Campus

✓ Vertical devolution at 41% (was 42% in 14th FC)

BITS Pilani, K K Birla Goa Campus

BITS Pilani, K K Birla Goa Campus

14th FC 15th FC Gen Category Special Category

Special Category states:

BITS Pilani, K K Birla Goa Campus

1. Revenue deficit grant