Public Finance (40%)

Course Teacher:
Md. Ahasan Uddin
Assistant Professor
Dept of Accounting & Information Systems
University of Dhaka
Objectives of this Module

 To know about the various economic systems

 To know about the public goods and private goods with its
characteristics

 To know about the scope of Government activities in

providing goods

2
Economic Activites and the State

 The fundamental economic problem of human being is

surrounded by the unlimited wants and the limited resources.
 In the primitive economies, individuals use their resources
to directly satisfy their wants.
 In the subsistence economies, economic activities are
governed by the maintenance of existence and minimum
standard of living.
 In the modern civilized world, maximum satisfaction is
sought to be achieved from the use of limited resources
through specialization of production and distribution systems.

3
 Economic Activites and the State
C--d
Which goods are to be produced, at what quantity, how to be
produced and how the produced goods to be distributed depend
on the type of the economy. Based on the economic systems
of a country, the role of the government of that country is
ascertained.
Economic Systems:
• Capitalist economy
• Socialist economy
• Mixed economy

4
 Economic Activites and the State
c---d
Arguments behind presence of State Sector, because of-
 Market Failures in unregulated market mechanism;

 Have a beneficiary role including allocative, distributive,

regulatory and establishing role;

 Actively contribute to the process of economic growth and

reduction of inequalities;

 Reducing the large scale inequalities of income and wealth;

5
 Economic Activites and the State
c---d
Arguments by Musgrave and Musgrave for presence of State
Sector along with Private Sector:
Firstly, Due to increase of per capita income, people want more goods and
services supplied by both State and the Private Sector;

Secondly, Over a wide range of activities, there is a complementarily between

the State and the Private Sector. So need presence of State Sector along
with the Private Sector. Such kind of activities include- Infrastructure facilities,
Merit goods etc.
So which sector will provide which goods? Need to know
about Public Goods and Private Goods:
6
 Public Goods Vs Private Goods

Can be distinguished based on the following characteristic:

Divisibility:
• Principle of Exclusion (Use can be decided in a discriminatory
manner based on price)
• Divisibility and
• Ability to price a good
Indivisibility-use of things does not reduce its availability to others
(Defense Services, BTV Program etc it can not be priced in order
to deprive some other person of the society from its benefits).
The goods should be equally available to all members of the
society irrespective of their ability or willingness to pay for it.
7
 Public Goods Vs Private Goods

Can be distinguished based on some characteristics:

1. The Product Divisibility-
 Private goods subject of Principle of exclusion.
 It can be priced
 Public good is indivisible and principle of exclusion does not
apply it. As such have a risk- Risk of beneficiaries not paying
for it voluntary, think about others to contribute.
Free Rider Concept: (James M Buchanan)
In case of public good- every one hopping that through the
contribution and efforts of others the supply of the services will
8be maintained which referred to as the problem of free riders.
 Public Goods Vs Private Goods

Free Rider Problem that is the problem of financing the

supply of goods on voluntary basis. For such goods
comes the provision of financing through compulsory
contributions by the member of the society. Financing can
not be left to the market mechanism.
Pure Public Goods:
The indivisible goods, whose benefits can not be priced, to which
the principle of exclusion does not apply are called pure public
goods. Financing of such goods are ensured through Public
expenditure not through market pricing which implies that pure
public goods must be in the hands of public sector only.

9
 Public Goods Vs Private Goods

But which sector should provide Pure Private Goods. Need to

consider the following additional factors:
1. The level of efficiency at which the public or private sector may
be expected to operate;
2. Political and social objectives of the society;
3. Should consider additional characteristics of Pure Public or
Private Goods such as-
i. Externalities
ii. Marginal Cost
iii. Average Cost and
4.Impure
10 Public Goods: Quasi-public, Quasi-private
 Public Goods Vs Private Goods

i. Externalities:
 Economic effects for production or use. Economic
effects may also be called Spill-over effects,
neighbourhood effects or third party effects
 Effects may be pecuniary or technological (non-
pecuniary)
 Effects affect the prices
 Effects (negative) create cost to the Society rather
than Individual undertakings (Pollution by factories,
railways, vehicles etc)
Pure Public Goods- are characterised by the existence of
11 Externalities.
 Public Goods Vs Private Goods

i. Externalities: Are two types-

1. Market-external effect-
 The losers/ (beneficiaries) can be identified and
compensated (Charged) for the same
2. Non-market external effect
 Individual economic units can not be identified and
compensated/(charged) for loss or gains

In these external effect, which sector should provide which

goods?

12
 Public Goods Vs Private Goods

In these external effect, which sector should provide which

goods?

Public Goods:
 With non-market external effect: Should in the hand of
Public Sector
 With market-external effect: May be left in the hand of
Private Sector. Why?

Private Goods:
Supposed not to have any externalities. So Should be
entrusted to the Private Sector.
13
 Public Goods Vs Private Goods

ii. Marginal Cost:

 Marginal cost of Pure public Goods is zero or close
to zero
 This is applicable in large scale production in
Private Sector

iii. Decreasing Average Cost:

 Average cost is decreasing in case of Pure public
goods due to economies of scale.

14
 Scope of Govt Activity

To what extent State should assume the responsibility of supplying the

goods to the economy?
Can be discussed from two angles-
1. Theoretical angles and
2. Historical angle
Theoretical angles: Co-existence between the public and private
sector. But it can be viewed from following point of view –
i. Pure public goods
ii. Quasi public goods
iii. Merit goods
iv. Market failures
15 v. Infrastructures
 Scope of Govt Activity

Theoretical angles:
Constraints for Govt in providing public goods-
1. Resource constraints
2. Inefficiency of administration
3. Lack of incentive and initiative
4. Political and social acceptability of govt policies
So the scope of economic activities by the State can not be
determined only with reference to the publicness of goods.
It is because there is a inevitably an interdependence and
interaction between the State and Private Sectors.
16
 Scope of Govt Activity

Historical angles: (Private Sector Concept)

• Laissez Faire Philosophy by Adam Smith

• State was expected to work for its maximum
advantage

The study of public finance is closely connected with the problem

of the choice of the level of government activity as also the
precise composition of the same.

17
 Objectives of this Session

• To understand the meaning and scope of Public

Finance

• To understand the theory–Principle of Maximum

Social Advantages

18
 Meaning and Scope of Public Finance

Ordinarily, Public Finance denotes the financial activities of the

government. The word Public means ‘something operated by
the government’ and the word Finance means ‘to supply with
fund’. Thus, Public Finance is the funding by government.
According to Harvey S. Rosen (1985), “Public finance, also known
as public sector economics, focuses on the taxing and
spending activities of government and their influence on the
allocation of resources and distribution of income.”
According to Philip E. Taylor (1970), “Public finance deals with the
finance of the public as an organized group under the institution
of government.”

19
 Meaning and Scope of Public Finance

The role of government was not to interfere with the working

of the market forces but to limit its own activities to the
barest minimum necessary-
1. To protect the society from the internal disruption
2. To protect the society from the foreign aggression and
3. To create essential social overheads and infrastructures.
Absence of public sector, essential social overheads would not
come into existence.

20
 The Subject Matter of Public Finance

1. Theory of public revenue

2. Theory of public expenditure
3. Financial administration
4. Stabilization, growth and distributive justice

21
 The Subject Matter of Public Finance

1. Theory of public revenue:

A. Tax Revenue-Taxes on Income and Expenditure, Taxes on
Property, Services etc
B. Non-Tax revenue-Printing currency, Interest, dividend,
profits etc
C. Public Debt
D. Gift, Donation, Grants
E. Special Assessment

22
 Public Finance vs. Private Finance

Similarities:
• Related to satisfying wants
• Borrowing and repayment of debts
• Surrounded by economic activities such as production,
investment and exchanges
• Maximization of welfare from the resources used in
financing
• Creation of financial assets.

23
 Public Finance vs. Private Finance

Dissimilarities:
• Point of Difference
• 1. Income and expenditure policy
• 2. Sources of revenues
• 3. Compulsory acquisition of resources
• 4. Forms of borrowing
• 5. Rate of interest on borrowing
• 6. Creation of currency
• 7. Principle of financing
24
 Public Finance vs. Private Finance

Dissimilarities:
• Point of Difference
• 8. Budget planning
• 9. Environmental influence
• 10. Relationship between expenditure and
welfare
• 11. Time period of expenditure
• 12. Publicity of income and expenditure
account
• 13. Effect of income and expenditure
25 • 14. Provision of insolvency
 Importance of Public Finance

Public Finance is of high importance due to its following roles:

– Controlling unfair competition or monopoly
– Provision of social goods to satisfy ‘merit wants’ (health, education,
etc.)
– Reducing or prohibiting production or consumption of demerit goods
– Redistributing income and wealth
– Maintaining price stability
– Enhancing employment
– Maintaining socially desirable economic growth
– Reducing negative externalities in case of investments as far as
possible
– Maintaining law, order and security
– Forming capital and investment, etc.
26
 Principle of Maximum Social Advantage

 In case of Co-existence of both Public Sector and Private Sector,

this theory will be applicable;

 This theory deals with the question of the Size of public budget or
the boundaries of State activities;

 This theory helps in designing the policy and operation of the

State activities based on maximum possible advantages or
welfare for the society as a whole;

27
 Principle of Maximum Social Advantage-
Assumptions
1. Every tax caused a disutility to the society on account of the fact
of a resource transfer from the society to the State. The welfare
of the society suffered accordingly.
2. All taxes drain economy's resources and that all public expenses
restore these resources to the economy.
3. The public revenue consists of only taxes and the State has no
surplus or deficit budget.
4. Public expenditure is subject to diminishing marginal social
benefits and taxes are subject to increasing marginal social
disutility or cost
Due to increase its taxation and expenditure activities, the social
benefits from each additional money spent fall, while
dissatiosfaction
28 for each additional money taxed increass.
 Principle of Maximum Social Advantage-
Assumptions
This way, a stage will be reached when the raising marginal
dissatisfaction of taxation becomes equal to the falling marginal
benefits of expenditure.
The State should stop expending its activities at this stage.

So here,
Marginal Social Benefits=Marginal Social Costs

29
 Principle of Maximum Social Advantage-
Limitations
1. Capitalistic view is wrong. State is not something external to the
economy
2. State must have basic function with out which very existence of
the society can not be guaranteed (Defense, public overhead
etc). In that case benefit exceeds the cost of maintenance.
3. Every tax is not a burden to the society
4. Spill over effect
5. Do not destroy or creation of resource just transfer
6. Have other source of revenue
7. Committed expenses
8. Balanced budget

30
 Public Revenue-General Consideration

Govt needs fund to finance its activities which raised from various
sources such as taxes, currency, borrowing, fees, fine etc.

Distinction between Public Receipts and Public Revenue: Prof. Dalton

Public receipts includes receipts from all sources while Public revenue
is a narrower concept and excludes public borrowings, income from
sale of public assets, receipts from the use of printing press.

Public receipts can be divided into: Revenue Receipts and Capital

Receipts

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 Public Revenue-General Consideration
Division of Public Receipts
Revenue Receipts Public Capital Receipts
Receipts
Tax Revenue
Non-tax Revenue Market Borrowings

Income Tax Printing currency

External Borrowings

Interest, dividend, Recoveries of loan and

Property Tax profit advances

Grant, donations,
Indirect Tax Others-
deposits, Govt. PF
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 Tax Revenue and Non-tax Revenue:
What is Tax?
“Tax” is derived from French word “taxe” which also means ‘tax’.
Etymologically Latin word “taxare” is related to ‘tax’, which means
“to charge”, i.e., “to demand or exact as a price etc.”

“Taxes are what we pay for a civilized society” – Justice Oliver

Wendell Holmes, Jr. (mentioned in the verdict of Compania de
Tabacos v. Collector case in 1927)

“A tax is purely and simply a contribution, whether direct or masked,

which the public authorities impose upon inhabitants or goods for
the purpose of defraying government expenditure” – Paul Leroy-
Beaulieu (1906).

33
 Tax Revenue and Non-tax Revenue:
What is Tax? Co----d
“… a tax is a compulsory contribution imposed by a public authority,
irrespective of the exact amount of service rendered to the tax
payer in return, and not imposed as a penalty for any legal
offence” – H. Dalton (1971).

“A tax can be defined meaningfully as any non penal yet

compulsory transfer of resources from the private to the public
sector, levied on the basis of predetermined criteria and without
reference to specific benefit received, in order to accomplish
some of nation’s economic and social objectives” – Ray M.
Sommerfeld, H. M. Anderson and H. R. Brock (1980).

34
 Tax Revenue and Non-tax Revenue:
Tax- Characteristics
1. Non-penal
2. Compulsory levy
3. Sources of public revenue
4. Direct unrequited
5. Representation by the Government
6. Transfer of resources from the private to the public sector
7. Predetermined criteria
8. Instrument for achieving special objectives

35
 Various Terms Related to Tax
 
It may be useful to define various terms which are used
interchangeably with the term “tax” as follows:
• Duty: Tax on commodity, i.e., goods and services (e.g., excise duty).
• Toll: Tax given for using property of other person (e.g., toll on use of
road or any bridge).
• Cess: Tax in relation to any goods for specific purpose (e.g., cess on
sugarcane in India).
• Tariff: Tax or duty on goods imported and exported.
• Rate: Tax imposed by a local authority (e.g., municipal authority) on
its inhabitants or on the owners of property situated in the area of
that local authority.
36
 Various Terms Related to Tax
 
• Assessment: The term refers to tax and something in addition to tax. Usually, any tax against which there is a
direct return is called ‘assessment’ (e.g., National Insurance Contribution in the UK).

• Imposition: Any tax or duty imposed according to legislative provisions or any Act passed by the Legislative
Assembly.

• Levy: Any tax, assessment, or fee imposed or collected. But fee is not a tax. The term ‘levy’ may be used for both
‘imposition’ and ‘tax-determination’.

• Charge: The price taken for providing any goods and services. In case of pure public goods (e.g., defense
service), it is difficult to take price. The cost of these services is borne by collecting tax and hence, tax is a charge.

• Impost: Tax given for entry into a country.

• Octroi: Tax given for entry into a city or municipal area.

• Sur-tax/Surcharge: Additional tax given on the basis of usual tax.

•  
37
 Tax Vs Price
 
• Price-Charge for service
• Special assessment- Unearned increment
• Fines
• Fees
• Profit

If voluntary gifts are made to the authorities, such as during a war,

then such an income neither in the nature of a Tax or a Price .

38
 Tax Base 

Tax base of a tax is the legal description of the object with

reference to which the tax is payable
Excise duty: base is production, packaging or processing of specific
goods,
Income tax: Income of the assessee
Property tax: Property value.
So, Legally defined and must be quantifiable for determining tax

39
 Buoyancy and Elasticity of a Tax

Buoyancy: Increase of tax revenue on account growth of its base is

termed is buoyancy. Tax rate remain unaltered. It is one of the
characteristics of tax.
In case of buoyant tax, it has inherent tendency to yield more tax
revenue with the growth of its base.
In case of income tax, if yield from income tax increases as national
income increases, it would be termed as buoyant tax.
With the increase of production of excisable items, if revenue from
excise duties increase with out changing of rates, we can say,
there is buoyancy of excise duty.
Buoyancy of Tax= Proportionate increase of tax revenue /
40
Proportionate increase of tax base i.e ratio
 Buoyancy and Elasticity of a Tax

Elasticity of tax refers to its responsiveness in increasing its yields

through extension of coverage or rates. Numerically it measured
by the ratio of proportionate change in its yield to the
proportionate change in its coverage or rates.

Elasticity of tax = Proportionate increase in tax revenue /

Proportionate increase the coverage or
rate

41
 Principles of Taxation /Canon of Taxation

Four canon of taxation prescribed by Adam Smith:

1. Canon of Equality 2. Canon of Certainty 3. Canon of
Convenience
4. Canon of Economy
Other canon includes-
1. Canon of Productivity
2. Canon of Buoyancy
3. Canon of Elasticity 4. Canon of Simplicity 5. Canon of Diversity
Actually Tax structure is a part of the economic organization of a society
and should therefore, fit in its overall philosophy.
42
 Characteristics of a Good Tax System

Good tax systems depend on various objectives of tax, principles or

canon of a tax systems etc.
1. Equity 2. Efficiency (effort to reduce extra tax burden) 3. Certainty
4. Simplicity and Evidence (simple enough for taxpayers to understand and
should be evident whether taxes represent the costs of public goods
and welfare benefits) 5. Economy
6. Flexibility and Stability (flexibility to alter tax rates and the size and
composition of tax revenues for stabilizing the economy or to fit an
incoming government’s philosophy and to fulfill their promises; stability
enables individuals and companies to plan for tax ahead)
7. Expenditure Restraint (to reduce one taka private expenditure due to
one taka tax, so that public spending can be undertaken without
inflationary
43 pressure)
 Characteristics of a Good Tax System

Good tax systems depend on various objectives of tax, principles or

canon of a tax systems etc.
• (8) Convenience
• (9) Motivation (for effort to work more, savings, investment,
entrepreneurship)
• (10) Consistency
• (11) Productivity
• (12) Macro Economic Consideration
• (13) International Effects

44
 Role of Taxation in Economic Development

1. Achievement of government social objectives

2. Achievement of government economic objectives
3. Discouragement of some consumptions
4. Redistribution of income and wealth
5. Financing public projects/expenditures
6. Ensuring price stability
7. Generation of employment
8. Encourage private sector industrialization
9. Encourage export and discourage imports
10. Encourage savings and investment as well as foreign exchange
remittance
45
 Classification of Taxes

Taxes are of various types, when it is classified on the basis of different things
as follows:
1. Number of taxes:
• Single tax: When a country has only one tax, it refers to single tax.
• Multiple tax: When a country has more than one tax, it refers to multiple
tax.
2. Impact and incidence of taxes:
– Direct tax: When both the impact and incidence of tax fall on same
person or entity, it is called direct tax (e.g., income tax, wealth tax, gift
tax, inheritance tax etc.).
– Indirect tax: When the impact and incidence of tax fall on different
persons or entities, it is called indirect tax (e.g., value added tax,
customs duty, business turnover tax, etc.).
46

 
 Classification of Taxes con--d

Taxes are of various types, when it is classified on the basis of different

things as follows:
3. Structure of tax-rates:
– Proportional tax: When the tax increases (decreases) at a
constant rate with the increase (decrease) in tax-base, the tax is
called proportional tax.
– Progressive tax: With increase (decreases) in tax-base, if the tax
increases (decreases) at a higher (lower) rate than the rate of
increase (decrease) in the tax-base, the tax is called progressive
tax.
– Regressive tax: With increase (decreases) in tax-base, if the tax
increases (decreases) at a lower (higher) rate than the rate of
47increase (decrease) in the tax-base, the tax is called regressive

tax.
 Classification of Taxes con--d

Proportional tax: Tax liability increase in the same proportion as the

increase in income.
Here, Average tax rate = Marginal tax rate
Progressive tax: with increasing income tax liability not only increases
in absolute term but also as proportion of the income.
Here, Average tax rate < Marginal tax rate
Regressive tax: If the tax liability, as a proportion of income, falls with
the increase of income.
Here, Average tax rate > Marginal tax rate
 Average tax rate = Total tax liability/ Total tax base
 Marginal tax rate = Changes in total tax liability/Changes in
total
48 tax base
 Classification of Taxes con--d

Proportional tax:

Tax Base (Tk) Proportional tax

Total Tax Average Marginal
Tax rate Tax rate
10,000 1,000 10% 10%
20,000 2,000 10% 10%
30,000 3,000 10% 10%
40,000 4,000 10% 10%

49
 Classification of Taxes con--d

Progressive tax:

Tax Base (Tk) Progressive tax

Total Tax Average Marginal
Tax rate Tax rate
10,000 1,000 10% -
20,000 2,500 12.5% 15%
30,000 4,500 15% 20%
40,000 7,000 17.5% 25%

50
 Classification of Taxes con--d

Regressive tax:

Tax Base (Tk) Progressive tax

Total Tax Average Marginal

Tax rate Tax rate
10,000 1,000 10% -

20,000 1,900 9.5% 9%

30,000 2,700 9% 8%

40,000 3,300 8.25% 6%

51
 Classification of Taxes con--d

Degressive tax:
When certain amount of tax base is exempted then it can be found
degression of taxation.
Two forms of degression can be seen-
1. Certain amount of tax base is exempted and a single tax rate is
applied to the rest

2. The rate schedule does not raise fast enough as the tax base
increase

52
 Classification of Taxes con--d

Individual Slab tax structure: Say Income Tk 1,400,000

Slab Rate Tax Tax base Total Tax Average Marginal
rate rate
First 0% 0 200,000 0 0 0
200,000
Next 10% 30,000 500,000 30,000 6% 10%
300,000
Next 15% 60,000 900,000 90,000 10% 15%
400,000
Next 20% 60,000 1,200,000 150,000 12.5% 20%
300,000
Remain 25% 50,000 1,400,000 200,000 14.25% 25%
200,000
53 So it is degressive Progressive Tax System
 Classification of Taxes con--d

Taxes are of various types, when it is classified on the basis of different

things as follows:
4. Subject-matter of taxes:
– Personal tax: When tax is imposed on person or entity, then it is
called personal tax.
– In rem tax: When tax is imposed on goods, services, or property
(i.e., other than on person or entity), then it is called in rem tax.
5. Elasticity of taxes:
– Elastic tax: When a tax produces more revenue with increase in
tax rate and/or tax-base, then it is called elastic tax.
– Inelastic tax: When a tax produces equivalent or lower revenue
54with increase in tax rate and/or tax-base, then it is called inelastic

tax.
 Classification of Taxes con--d

6. Classification of tax-bases:
– Tax on income: When tax is imposed on income of the
taxpayer, then it is called tax on income.
– Tax on wealth: When tax is imposed on wealth of a taxpayer
being the owner of the wealth, then it is called tax on wealth.
– Tax on transaction: When tax is imposed on the value of a
transaction or on the quantity of goods or services under a
transaction, then it is called tax on transaction. The tax is called
ad valorem tax if it is imposed on the value of a transaction, and
it is called specific tax if it is imposed on the quantity of goods or
services transacted.
– Tax on people: When a tax is imposed per capita, then it is
55called tax on people or head/poll tax.
 Classification of Taxes con--d

7. Increase or decrease in public revenue:

– Positive tax: When a tax contributes positively towards the
national exchequer (i.e., when government revenue is
increased), then it is called positive tax. This is the real tax.
– Negative tax: When a tax contributes negatively towards the
national exchequer (i.e., when government revenue is
decreased), then it is called negative tax. In economics, this is
called transfer payments.
8. Collector of taxes:
– Central tax: When a tax is collected by a central government, it
is called central tax (e.g., income tax, customs duty or VAT;
– Local tax: When a tax is collected by a local government (e.g.,
56union parishad, municipal authority, or city corporation), it is

called local tax (e.g., holding tax collected by the DCC.)

 Impact, Incidence and Effect of a Tax

Impact of a Tax: Impact of a tax is its first point of contact with the taxpayers.
It is upon those who bear the first responsibility of paying it to the
authorities, that is those have statutory responsibility of paying it to the
Government.
Incidence of a Tax: Incidence of a tax is defined as its final resting place. It is
to be seen and judged in terms of money burden of the tax. To put it
differently, the incidence of a tax is upon those economic units which finally
bear the money burden of it and which are not able to pass it on to others.
Incidence lies upon that final source from which tax money come
Effect of a tax: For tax, it involves certain responses from taxpayers and the
economy. Such responses can be of great variety and can profoundly
influence the working of the economy in terms of production, growth,
savings, investment, choice of techniques of production, regional
imbalances,
57 inequalities of income and wealth, and so on. These responses
and their results are collectively called the effects of that tax.
Various Effect of Tax

Positive Effect Negative

of Tax

Burden of Tax

Money burden Real Burden

Direct In-direct Direct In-direct

58
 Effect of a tax

Burden of a tax has two dimensions: money burden/formal incidence (the

reduction in the disposable income of the taxpayers) and real burden (the
loss of welfare to the taxpayers and the community as a whole, in terms of
increasing unemployment, reduced production, etc.).
Money burden of a tax may be direct or indirect. Direct money burden refers
to the amount of tax being paid by the taxpayers to the tax authorities and
indirect money burden refers to the additional money expenses incurred by
the taxpayers for tax payment.
Real burden of a tax may also be direct or indirect. Direct real burden of a tax
will be the sacrifice of the welfare which the tax itself imposes upon the
taxpayers, but not as net of the benefits, if any. Indirect real burden is the
indirect loss of welfare which results from (a) interference with consumer
choice,
59
(b) changes in factor supply and hence total output, and (c) changes
in employment through changes in aggregate demand.
 Impact vs. Incidence of a tax

• The impact refers to the initial bearing of the tax while incidence
refers to the ultimate bearing of the tax.
• Impact is felt by the taxpayer at the point of imposition of the tax,
while the incidence is felt by the taxpayer at the point of
settlement or rest of the tax.
• The impact of the tax is felt by the person from whom the tax is
collected, while the incidence is felt by the person who actually
bears the tax liability.
• Impact of a tax can be shifted, but the incidence of a tax cannot
be shifted.

60
 Incidence vs. Effect of a tax

• A tax reduces the income of the person on whom the incidence

rests, while the effect of the tax is the pressure or influence of the
incidence (such as forced reduction of consumption and
investment for disposable income reduced by tax incidence).
• The incidence of a tax is the direct money burden, and the effect
of the tax is the indirect money burden.
• The effects of a tax can be the result of the fact of tax imposition
itself (impact) and they could also follow from the process of
shifting its incidence.

61
 Shifting of Tax Incidence

Shifting of tax incidence refers to the process by which the money

burden of a tax is transferred from one person to another. Shifting of
tax incidence is done through the means of a price variation and it
may be of the following types:
• Forward shifting
• Backward shifting
If a tax incidence is shifted through a sales transaction, it is called forward shifting.
For example, an excise duty imposed on a producer may be shifted to a
consumer, or a value added tax (VAT) imposed on a seller may be shifted to a
buyer. In case of multi-stage forward shifting of tax incidence, a tax incidence
shifted from a seller to an intermediate purchaser who will also shift it to another
buyer and so on until the tax finally settles on the ultimate purchaser or consumer,
it62may be called that the tax is being shifted onward.
 Shifting of Tax Incidence

Backward shifting: If a tax incidence is shifted through a purchase

transaction, it is called backward shifting. If a VAT imposed on a
consumer and he can shift it to the producer, or a VAT imposed on a
buyer and he can shift it to the seller, then it will be backward shifting.
Backward shifting may be through tax capitalization, when a tax affects
the capital value of assets. If a tax changes the expected yield of an
asset, then it will also change its market price. In other words, the tax
has been capitalized. Say, a durable good is subject to a periodic tax
(e.g., equivalent to previous annual licence fee on TV) and an
equivalent of the future tax payments is found in terms of the present
value (PV) of the periodic tax discounted on the basis of interest rate. If
the purchase price of the durable item is reduced by a part or full
amount of this PV by the purchaser, then it is called tax capitalization.
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