Public Finance Essentials: Taxation, Borrowing, Budgeting
Principles of an Effective Tax System
Equality and Justice in Taxation
A good tax system should follow the canon of equality. Equality does not mean an equal amount of tax for all taxpayers; rather, it emphasizes equity and justice. The heaviest burden should be placed on the broader shoulders. This indicates two principles: equality of sacrifice and ability to pay.
Tax Certainty and Transparency
A good tax system should be clear and certain regarding the amount, time, and method of tax payment. Taxpayers should know exactly when and how much they have to pay in terms of tax.
Convenience of Tax Payment
In a good tax system, tax should be levied at a time or in a manner that is most convenient to pay. The method of taxation and the time of payment should be suitable for the taxpayer.
Economic Efficiency of Tax Collection
A good tax system should aim to collect the maximum amount of tax revenue at the minimum cost from taxpayers. If the cost of tax revenue collection is large, a greater amount is collected from taxpayers, but a smaller portion reaches the government’s treasury.
Productivity and Economic Impact
A good tax system should be productive. No tax system should negatively impact the production of goods and services in the economy. There should be the least burden on the production of basic goods.
Elasticity and Revenue Generation
A tax system is good if it is elastic. It should help to increase government income when needed. According to this principle, when the tax rate is increased, it should yield more revenue.
Simplicity and Clarity in Taxation
The tax system should be simple and easy for the taxpayer to understand. If taxpayers are confused about taxation, there is a greater chance of corruption.
Diversity in Tax Sources
The tax system of a country should be diversified, covering a wide range of the economy. Reliance on a few taxes will be risky. Therefore, taxes should be imposed on various commodities and persons.
Government Borrowing: Sources and Types
Internal Borrowing
A loan borrowed by the government from internal sources like individuals, public or private organizations, central banks, commercial banks, and other financial institutions within the country is called internal borrowing. In other words, internal borrowing is raised within the country. The internal loan is received in national currency and may be raised voluntarily or compulsorily. There are two sources of internal borrowing:
Market Borrowing
Market borrowing refers to loans raised by selling transferable securities like treasury bills and development bonds. These credit instruments are issued, floated in the market, and sold to individuals, firms, or financial institutions.
Non-Market Borrowing
Loans received by means of non-transferable credit instruments are called non-market borrowing. The credit instruments are issued in the name of different sources, and the loan is received from these sources. The sources are of two types:
Public Sector Sources
Government can receive loans from public financial institutions, insurance companies, postal savings banks, provident funds, etc. The idle funds remaining with these public institutions can be transferred to the government as loans.
Private Sector Sources
Private institutions like commercial banks, finance companies, or other firms can provide loans to the government. The government can draw non-transferable credit instruments in the name of such private institutions and receive loans from them.
External Borrowing
A loan received by the government of a country from foreign individuals, foreign governments, and foreign or international institutions is called external borrowing. This source is used when borrowing from internal sources is insufficient. The sources of external borrowing can be divided into two types:
Bilateral Borrowing
If the government of a country borrows a loan by making an agreement with the government of another country, it is called bilateral borrowing. For example, loans taken by the Government of Nepal from the Governments of the USA, UK, Japan, etc., are bilateral borrowing.
Multilateral Borrowing
If the government of a country borrows a loan from international organizations like UNDP, the World Bank, the Asian Development Bank, the European Union (EU), the International Monetary Fund (IMF), etc., then it is called multilateral borrowing.
Government Budget Formulation Process
Budget formulation is the act of forecasting the income and expenditure of the government for the coming fiscal year. The Ministry of Finance formulates the budget, a process that begins several months before the start of the fiscal year. The common process of budget formulation is given below:
Estimating Overall Expenditure and Income
In the first stage, the planning authority decides on the primary targets for government expenditure and possible income or revenue. Based on these primary targets, the overall expenditure is determined. The National Development Council, including representatives from all government agencies, makes the final decision on the budget limit.
Establishing Sectoral Priorities
In the second stage, the planning authority assigns weightage to different sectors and decides their development priorities. Based on these priorities, it directs all departments to prepare and submit their proposals within the allocated budget limit.
Project Preparation by Departments
The relevant departments prepare their projects and submit the proposals to the planning authority.
Project Selection and Submission
The planning authority reviews and selects the projects submitted by the relevant departments and informs them about the selection. Moreover, it reviews the financial cost of these projects and tries to adjust them to the budget limit. The selected projects are then submitted to the budget office.
Final Budget Preparation and Approval
The budget office gives the final shape to the budget after a thorough review based on different principles and conditions. The final budget is approved by the cabinet and presented to the legislature for discussion.
Sources of Public Revenue
Tax Revenue
Taxes are compulsory payments made by people to the government and are primary sources of public revenue. Various kinds of taxes are imposed on the people, which are described as follows:
Customs Duties
Taxes imposed on exports and imports at customs offices are called customs duties. These taxes are levied on goods according to their quantity and value. Customs duties are indirect taxes.
Consumption and Production Taxes
Government imposes taxes on the production and consumption of goods and services. This category includes excise duty, sales tax, entertainment tax, contract tax, road and bridge tax, value-added tax, etc. These taxes are indirect taxes.
Land Revenue and Registration Fees
Land tax is imposed on landlords for the ownership of land. Registration charges are payments made for the registration of land and houses. These taxes are direct taxes.
Property, Profit, and Income Taxes
Public corporations, private companies, and individuals must pay profit and income taxes according to their income and profit. Taxes on houses in urban areas and vehicle taxes are also imposed on the ownership of such property. These taxes are direct taxes.
Non-Tax Revenue
Non-tax revenue includes the following:
Gifts and Grants
Voluntary payments made by people for relief work during natural calamities and disasters are called gifts. Some institutions or persons also make donations to the government.
Fees for Government Services
Government collects fees from different sources, such as fees charged for education and health services, firm registration, licenses for vehicles and guns, permission for mountaineering, and sales of goods, etc.
Fines and Penalties
Fines and penalties are charged to persons who violate the rules and regulations of the country. The objective of fines and penalties is to prevent crime and undesirable acts, thereby also raising government income.
Direct Taxes: Definition, Merits, and Demerits
What is a Direct Tax?
When the impact and incidence of the tax fall on the same person on whom it is legally imposed, it is called a direct tax.
Merits of Direct Taxes
Promotes Equity and Equality
The burden of direct tax falls more heavily on the richer section of society than on the poorer section because this tax is imposed based on the level of income. The higher the level of income, the higher will be the tax rate. Effective implementation of direct tax helps to achieve the goal of equal distribution of income and wealth in society.
Administrative Efficiency
The cost of collecting direct taxes is low. Direct taxes are mostly collected ‘at the source.’ For instance, income tax is deducted from an officer’s pay every month. Hence, it saves time and the cost of tax collection for the government.
Predictability and Transparency
In the case of direct tax, payers know the amount of direct tax to be paid, the time of payment, and the place of payment. Authorities also know the amount of revenue they can expect. There is certainty on both sides, which minimizes corruption on the part of collecting officials.
Elasticity in Revenue
The government may change the rate of direct tax according to budget requirements to meet development and regular expenses. In addition, government revenue increases along with an increase in the income and property of taxpayers, and vice versa.
High Revenue Yield
Another virtue of direct taxes is that they are very productive. As the community grows in number, the return from direct taxes expands automatically. Direct taxes yield large revenue to the government.
Demerits of Direct Taxes
Inconvenience for Taxpayers
Direct tax is inconvenient for the taxpayer in the sense that they have to maintain records of tax payment and visit the tax office frequently. They may feel a significant burden when a lump sum is taken out of their pocket as tax.
Risk of Evasion
Taxpayers can submit false income returns and thus evade the tax. That is why a direct tax is often called “a tax on honesty.” There is a lot of evasion, with many who should be paying taxes going scot-free by concealing their incomes.
Disincentive to Saving and Investment
If taxes are too heavy, they discourage saving and investment. In that case, the country will suffer economically. A high level of taxation discourages investment and enterprises, inflicting damage on business and industry.
Arbitrary Rate Setting
If taxes are progressive, the rate of progression has to be fixed arbitrarily; if proportional, they fall more heavily on the poor. Thus, both approaches can be problematic. The rate of taxes can depend upon the whim of the Finance Minister, making it arbitrary.
Limited Scope and Base
Direct tax holds a narrow base because it is collected primarily from wealthier individuals. The government may be unable to collect a substantial amount of tax in developing countries where the majority of people are poor.
Indirect Taxes: Definition, Merits, and Demerits
What is an Indirect Tax?
When the impact of the tax falls on one person and the incidence of tax is shifted to another, it is called an indirect tax.
Merits of Indirect Taxes
Convenience for Taxpayers
Indirect taxes are convenient for both the taxpayer and the government. Taxpayers do not feel a significant burden as indirect tax is paid in small amounts, often unknowingly, as part of the price of goods and services.
Broad Tax Base
Since indirect tax is included in the price of goods and services, it is collected from all types of people, whether rich or poor. Therefore, it has a wider scope for collecting government revenue.
Difficulty of Evasion
Indirect taxes cannot be easily evaded as they are part of the price; a consumer is compelled to pay this tax unknowingly during the purchase of goods and services.
Elasticity for Necessities
Indirect taxes can also be very elastic in yield if imposed on necessities of life that have inelastic demand. Indirect taxes on necessities yield large revenue because people must buy these things regardless of price changes.
Potential for Income Redistribution
Indirect taxes can help in the equal distribution of income and wealth if structured progressively. Government can impose a high rate of taxes on goods consumed by wealthy people and a low rate of taxes on goods consumed by poorer people.
Demerits of Indirect Taxes
Regressive Nature
Indirect taxes are often not equitable. The rich and the poor typically pay the same tax rate when purchasing the same goods. Its burden often falls more heavily on the poor than on the rich, which is unfair.
Uncertainty of Revenue
Unless indirect taxes are imposed on necessities, the revenue yield can be uncertain. In the case of goods with elastic demand, the tax might not bring in much revenue. The tax will raise the price and contract demand. When the item is not purchased, the question of tax payment does not arise.
High Collection Costs
The cost of collection for indirect taxes can be quite heavy. Every source of production has to be guarded, and a large administrative staff is required to administer such taxes, which turns out to be a costly affair.
Negative Impact on Saving
Indirect taxes increase the prices of goods and services, which can limit the scope of saving and capital formation in the country.
Harmful to Domestic Industries
Indirect taxes can discourage industries if raw materials are taxed. This will raise the cost of production and impair their competitive capacity, especially against foreign goods.