IQRA STUDY CENTRE - History and Evolution of Privatization in Pak.

IQRA STUDY CENTRE - History and Evolution of Privatization in Pak.

IQRA STUDY CENTRE - Elasticity and Its Application

IQRA STUDY CENTRE - Elasticity and Its Application

COACHING CLASSES ICAP STUDENTS

WHY PRIVATIZATION IS NECESSARY FOR ECONOMIC GROWTH IN PAKISATAN?

WHY PRIVATIZATION IS NECESSARY FOR ECONOMIC GROWTH IN
PAKISTAN?

The decade of 1970s in Pakistan witnessed a massive redistribution of national
assets from the private owners to the state. The reason underlying the then Government’s
thinking for this extremely radical action was that the national wealth was being
concentrated in the hands of few families and the rich were getting richer and the poor
getting poorer. It was asserted by the proponents of this strategy that the state control
over allocation of the resources would promote the best interests of the poor. The
intellectual support for this strategy was drawn from the success of the Soviet Union and
the socialist economic model practised in that part of the world.
Two decades later it turned out that these assertions and assumptions that drove
this particular line of action i.e. nationalization was not only unrealistic and flawed but
the consequences were exactly opposite to what the intentions were. The collapse of the
Soviet Union and the bankruptcy of the socialist model eroded the ideological
underpinning of this strategy and the actual results on the ground in Pakistan and almost
all the developing countries shattered the ideal and utopian dreams of the proponents of
this philosophy. Pakistan’s public enterprises including banks became a drain on the
country’s finances through continuous hemorrhaging and leakages and a drag on the
economic growth impulses. The poor instead of benefiting from the state’s control over
these assets were actually worse off as almost Rs. 100 billion a year were spent out of the
budget annually on plugging the losses of these corporations, banks and other enterprises.
These public enterprises became the conduit for employing thousands of supporters of
political parties that assumed power in the country in rapid succession and a source of
patronage, perks and privileges for the ministers and the favoured bureaucrats appointed
to manage these enterprises. These employees and managers had neither the managerial
expertise nor technical competence to carry out the job. Instead of providing goods &
services to the common citizens at competitive prices efficiently, the public enterprises

turned into avenues for loot and plunder, inefficient provision of services and production
of shoddy goods. It was a common knowledge that getting a telephone connection in
Pakistan required years not months and that too with the help of sifarish and exchange of
bribes. No wonder the country was able to install less than 3 million telephones in the
entire 50 years of its history while under a deregulated and private sector driven
environment an additional 6 to 7 million mobile phone connections were given to
Pakistanis from all walks of life without any favour or discrimination in one year alone
i.e. 2004.
The hangover of the past in general and the lingering fascination for the socialist
model among some of our intellectuals in particular continue to have a dominant
influence on our thinking. Some of the resentment against private profit making is also
quite legitimate and understandable. In the past, private entrepreneurs in Pakistan did not
make ‘profits’ in the real economic sense of the word by earning a return on their
investment in a competitive world. On the contrary, they earned ‘rents’ through the maze
of permits, licences, preferred credit by the banks, subsidies, privileges, concessions and
specific SROs granted to the favoured few. Naturally when one sees people becoming
rich not through the dint of their hard work and enterprise but by manipulation, back door
entry, connections, reciprocity, paying bribes, adopting extra legal means, bypassing the
established rules and laws, getting scarce foreign exchange quotas, evading taxes,
defaulting on bank loans and rigging the markets etc., we should not be surprised to see
the venom against the so called ‘private profits’.
The policy reforms introduced in Pakistan by the Nawaz Sharif Government in
1991 and more importantly followed by that strong citadel of socialist raj – India – were a
watershed reflecting the new realities of economic life. These reforms, though quite
extensive and diverse, could be summed up for the sake of simplification in three words –
Liberalization, Deregulation and Privatization. The results of Indian reforms are quite
evident before us. During the first 45 years of its independence until 1991, India was
hardly able to achieve per capita income growth of 1 percent per year and the incidence
of poverty remained persistently high. In the 12-year period since 1991, India’s average
per capita income growth has been 4 percent per year, poverty has been declining ever
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since and has fallen below 25 percent. Pakistan, unfortunately, could not follow through
these reforms in a continuous and consistent manner despite the fact that both Benazir
and Nawaz Sharif governments were fully committed to these reforms. For example, 12
percent shares of PTCL were first sold to the general public in 1993-94 and it has been on
the privatization agenda of every successive government since then. The short term
political expediency may dictate a different behaviour at present, but I am quite sanguine
that the PPP and PML(N) would have pursued the same path were they at the helm of the
affairs. Thus, there is a broad political consensus in the country that privatization is in
the larger national interest of the country.
Privatization has to be seen in the overall context of the respective roles of the
state and markets. The State has to be strong to combat the excesses of the market and
cope with market failures. It is not that the state should play a lesser or reduced role but a
different role in so far as it provides an enabling environment for equitable development
and creates necessary conditions for growth through investment in human development
and infrastructure. The government’s effective role in regulating and monitoring the
market has to be strengthened to promote healthy competition and avoid the rigging of
the market by a few. Markets are the best known vehicle for efficient allocation and
utilization of resources and thus the decisions as what goods and services to produce,
how much to produce, distribute and trade can be done well only by the private sector
and not by the bureaucrats. This division and redefinition is also essential to reduce
corruption and generate sustained and equitable growth in the country. Market-based
competition, privatization of public banks and a strong regulator have successfully
reformed the banking sector in Pakistan during the last several years and this model
should be replicated elsewhere in the economy. It is not ideology but pragmatism and
learning from the past mistakes that should drive our economic policies and strategies.
Growth takes place only when productivity from the existing resources keeps on rising.
The global experience shows that by and large, productivity actually declines or remains
stagnant when the businesses are managed and operated by the government thus slowing
down or hurting the pace of growth.
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I will now turn to the economic rationale of privatization that is not fully
understood by many. In particular, there is a popular view that it is okay to sell the loss
making enterprises but retain the profit making entities such as PTCL and PSO in the
public sector. It is true that the budgetary stress and commercial bank borrowing factors
are not valid in such cases but there is a larger economic case for the divestiture of even
such profit making enterprises. The main logic behind this divestiture is that it will
promote efficient allocation of scarce resources, optimal utilization of resources, making
sound, timely and market responsive investment choices, winning and retaining
customer’s loyalty through better service standards and lower product prices or user
charges and contributing to the expansion of the economy through taxes, dividends etc. I
would take the most debated example – that of the PTCL – as an illustration of the
general point I am making about the economic rationale for privatizing profit making
public sector enterprises.
The most oft pronounced arguments against privatization of profit making
enterprises are (a) why fix it when it ain’t broke? (b) Protection of workers (c) a better
and more professional management can bring about the same results as under
privatization. The basic reason for privatizing these enterprises is that the government
should not be in the business of running businesses but regulating businesses. The role of
the government should be that of a neutral umpire, who lays down the ground rules for
businesses to operate and compete, to monitor and enforce these rules, to penalize those
found guilty of contraventions and to adjudicate disputes between the competing business
firms. If the government owned firm itself is one of the players in the market, there is a
strong conflict of interest and the other market players lose confidence in the neutrality of
the umpire. Under these circumstances, the market becomes chaotic, disorderly and
unruly as there is no neutral ‘person’ to monitor and enforce the rules. The economy thus
pays a heavy price for this loss of the market mechanism in the production, sale and
distribution of goods and services. The present controversy between the PIA and private
airlines is a manifestation of this tendency. If the ‘umpire’ favours its owned enterprise
i.e. PIA and discriminates against the rival private airlines, the ultimate result would be
the winding up of these airlines. The growth of aviation industry would suffer as the
present competition is cutting down the prices and stimulating demand for air travel in
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the country. In absence of such competition, the PIA would have the sole monopoly and
the planes would fly with empty seats as the ticket prices would not be market based but
arbitrarily high. The consumers of airline industry – existing and potential – will be the
loser in this bargain.
The same argument can be applied in case of PTCL. If the Government had
continued to own and manage PTCL, the private sector competing firms would have felt
that they would always remain at a disadvantage in relation to the PTCL. The constant
fear that the government’s coercive powers and full force of policy making ability would
always be used to safeguard and enhance the interests of PTCL. This would have kept
the private firms away from investment in the fixed telephone or wireless loop segments.
If this may not be true under one particular set of rulers, the apprehension that such an
eventuality may happen at some time in the future keeps prospective investors away from
that field of business. The growth of a dynamic private sector in the economy is thus
stifled. The PTCL would under that scenario preserve its monopoly, pass on its
inefficiencies to the customers, charge exorbitant prices and resort to seeking concessions
of various kinds from the government. The result would be stagnation in the growth of
fixed telephony in the country and poor service to the customer. So while the PTCL is
not broke and is indeed profitable it needs to be privatized to provide a level playing field
for fostering competition, stimulating demand, expanding telecom customer base,
improving service delivery and contribute to rapid economic growth. None of this will
happen if the PTCL remains a public owned and managed firm.
A lot is being made of the fact that the PTCL was making huge profits for the
exchequer and these profits will now be diverted to the private owner. The facts are quite
contrary to this assertion. The Government of Pakistan will still retain 62 percent of the
shares while the private operator will have only 26 percent. Thus out of each billion
rupees of profits earned by PTCL, the GoP will receive Rs. 620 million while the private
operator only Rs. 260 million. In addition, the PTCL will continue to pay the corporate
tax on its income. The burning desire to transfer the management to a private investor
was that the profits earned by the PTCL were largely derived not from its own efficient
operations but from its monopoly status as the sole provider of fixed telephony in the
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country. In the coming years, the PTCL will have to compete for its market share as it
has lost its monopoly and it was quite likely that the public sector ownership will act as a
serious constraint and the level of profits will be eroded over time.
Since the private sector competitors of PTCL will have more flexibility, agility
and capacity to respond and seize the opportunities for expansion and improved customer
service, they will give a hard time to rule bound, inflexible and slow moving public
sector owned PTCL. However, competent and able top managers and the Board of
Directors may be, they have to follow set procedures, prior clearances and approvals by
multiple ministerial bodies before they can make any operational decisions of
significance. U-Fone lost 18 months’ valuable time facing various inquiries into its
procurement while its competitors were enhancing their market share at its cost. Such a
scenario is likely to recur once a government owned PTCL is pitted against several
private competitors.
The fears about employment losses in the industry as a result of privatization are
also, by and large, unfounded. The example of the banking industry privatization
controverts those who claim that privatization means jobs are lost. In 1997 when the
restructuring, down-sizing and privatization of the nationalized commercial banks picked
up speed there were 105,000 employees working in the financial sector. After
privatization was completed, the banking industry has expanded and the work force has
expanded to 114,000. It is true that the pattern of employment has changed and more
productive and skilled workers have been taken in at the expense of low skilled or
unskilled. There is no doubt that the PTCL will also expand under its new owners and
employ more people but in the skilled category. This upgradation of skills will raise
productivity of the firm as well as of the industry.
The skill mix of the staff employed by the PTCL and its numbers at present are
inappropriate to meet the new challenges of providing high standards of value added
services and new product development. One of the difficulties faced by the public sector
businesses is that they cannot pay market based remunerations to their executives or
highly technical manpower. If the PTCL is not allowed to pay more than MP1 scale to its
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Chief Executive i.e. Rs. 200,000 per month which is a fraction of what senior executives
in the rival private firms get, should we expect the PTCL to attract, retain or motivate
high performing manpower. The field gets tilted against a public sector company as it
has skill gaps and redundancies and is unable to provide value added services of the same
quality as provided by the private sector rivals.
The process of hiring and firing of employees in a public sector company such a
PTCL is highly convoluted, complex and cumbersome. Those found guilty of infractions
or negligence of duties or even corruption can only be dispensed with after a protracted
process of disciplinary proceedings that sometimes take several years to complete. In the
meanwhile, the employee continues to stay put in service and receives all the emoluments
and perks. In a rare case, a departmental inquiry comes up with a guilty verdict, the
employee can appeal to the Federal Services Tribunal and if he is unsuccessful, then all
the way to the Supreme Court. Why will any right minded boss choose to go through
such an ordeal?
The alarm of employment losses after privatization is also unjustified for another
reason. Telecom sector has already generated, after deregulation, hundreds of thousands
of new jobs through public call offices, calling cards and pre-paid card companies,
Internet Service Providers, mobile phone companies, broad band services, and other
value added services under the private sector. As the penetration ratios in Pakistan are
still quite low, there is going to be a large expansion in the telecom sector.
The losses of redundant jobs in PTCL, if any, will be more than offset by new
productive jobs in the Local Loop, Wireless Loop and LDI companies being set up in the
private sector. Industry estimates that 100,000 new jobs will be added during next 3 – 5
years. The substitution of unskilled jobs in the PTCL by the skilled jobs in the telecom
industry as a whole will raise the productivity of the sector as well as that of the user
companies and institutions. Those among the unskilled who can be retrained or
redeployed could be retained minimizing the overall loss of jobs within the PTCL itself.
If the PTCL itself is able to expand its services and operations, the manpower that is
surplus to its present requirements can be productively employed. Thus the fears of
8
workers losing protection under a privatized entity appear to be misplaced. After all, the
PTCL is the only telecom company that has been in the business for the last 58 years.
The oversight, monitoring and guidance capabilities of public enterprises are
ridden with the aggravated problems of principal – agent relationship. As the Board
Members, however able and honest they may be, have no direct personal stakes in the
well-functioning of a public enterprise, they cannot be expected to devote as much time
or energy to the Board’s affairs as the private strategic investors would. Thus, the
PTCL’s governance structure would always remain second best to its private sector
competitors and put it at a comparative disadvantage. If a more callous Minister is
unfortunately appointed to chair the Board, the appointments, award of contracts and
transfers and postings will do further damage to the performance of the PTCL.
The temptation by the elected political leaders or other rulers to interfere in the
affairs of the public sector companies is not only high but natural. They are constantly
accosted by their constituents for jobs, contracts, postings and transfers and it is not
possible for them to keep on saying no to everyone all the time. In some cases, they have
to yield to pressures. It is, therefore, necessary to sever the connection between the
government and the business.
How can a public sector company then be expected to show same results as its
private sector competitors whose compensation structure is driven by performance,
whose managers enjoy full powers of hiring and firing without any restraint, their Boards
have direct stakes in ensuring good governance and the political interference is almost
non existent?
The legacy of PTCL inherited from the culture of the Post and Telegraph
Department cannot therefore be washed away if it operates under these constraints. This
culture can only be replaced by a dynamic competition-oriented culture under the
leadership of a private sector operator.
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As a government entity, PTCL is considered a rich cash cow to meet the fiscal
needs rather than a business enterprise that requires funds for its own maintenance and
operations and more important for its investment needs. The compulsions of extracting
as much profits and cash for meeting fiscal deficit will always predominate and the
imperatives of expanding the network, infrastructure and services through retained
earnings will be neglected. Even assuming that a perceptive government does allow
PTCL the funds to make investment, it is not obvious if these will be used in an efficient
and cost-effective manner. The World Bank has recently blacklisted 200 firms for
padding contracts and bribing officials in public sector procurement awards in a number
of developing countries.
It must once again be stressed that private sector ownership and efficient
functioning of market mechanism require certain legal and regulatory institutions. In
absence of these institutions, private monopolies or oligopolies can surface, market
distortions can accentuate and markets can be rigged for the benefit of few. Strong legal
and regulatory institutions would be able to counter these evils forcefully and provide a
level playing field for all market participants. We have to strengthen these legal and
regulatory institutions in the country.
Public policy should also be geared at removing preferential treatment or granting
of concessions or privileges to a particular segment of the population. During the last
five years, the Government has endeavoured to move in this direction and act in an even
handed manner. No firm specific SROs have been issued to favour a particular enterprise
at the expense of others. Under these circumstances, private sector will earn true ‘profits’
through competition and not ‘rents’ and the justified grudge against the private sector will
be minimized.
CONCLUSION:
Privatization contributes to economic growth through productivity gains,
efficient utilization of resources, better governance and expansion in output and
employment. Profit making enterprises under the public sector may be making profits
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due to the unique market structure such as monopoly or other privileges or concessions
conferred upon them by the government but it does so at the expense of the consumer
who has to pay higher than market price for the product or the services. The ordinary
consumer gets a benefit only through competition among private sector firms in form of
lower prices and better services as has been demonstrated in the cases of banking,
telecommunications and, more recently, air travel.
In a deregulated market environment, public ownership becomes a serious
constraint as the rule – bound procedures and the rigidity in the structure do not allow
public sector companies the flexibility to respond promptly to dynamic market
conditions. Furthermore, the government’s role as a regulator and neutral umpire
becomes questionable once it is itself a participant in the game through its own company.
This stifles competition and subverts expansion and growth by the private sector
companies.

Measures of Variation

Measures of Variation




From our raw data, we were able to calculate a measure of central location. Although we found five measures of central location, we shall, for the remainder of this course, concentrate only on the arithmetic mean

Having found the mean of our data set, we can now proceed to calculate a statistic that measures how much are observed data varies around its mean.

Suppose that we had two sections of students (X & Y) taking an exam graded out of ten.

Observation X Y

1 7 6
2 9 10
3 6 6
4 9 4
5 4 2
6 7 8
7 5 10
8 8 6
9 8 9
10 7 9

Σ 70 Σ 70

= ΣX/n = 7 = ΣY/n = 7

The mean of both data sets is 7, yet closer inspection reveals that there is greater variation in data set Y than in data set X. For starters, the top score in X is 9, and the low score is 4. By contrast the high and low scores in Y are 10 and 2 respectively.

But this is hardly rigorous, what we need is a statistic that is calculated from as much of our data as possible, not merely the high and low scores.

The statistics of choice will be the Variance, the Standard Deviation and the Coefficient of Determination.

But. before I start throwing equations around the shop, I need to sell you on the idea of why we should be interested in a measure of variation – what does it tell us?

Consider first meteorology. The average July temperature in Buffalo NY is 69°F the average July temperature in Seattle WA is also 69°F. However, the average January temperature in Buffalo is 25°F, while Seattle it’s a balmy 41°F.

In finance, the riskyness of an asset is measured by the standard deviation (variation) of it’s price over a period of time (say, 250 days). Indeed, there is a relationship between an asset’s return and its riskyness, assets with low risk (such as US T-Bills) also have low returns, while assets with higher risk, have high returns (for example, the stock of Google). Even in the universe of stocks, some are considered stable (General Electric, IBM, to name but two), while others are considered to be volatile, such as the stocks in the bio-technology sector. For those of you who might be interested the translation of the word risk into Mandarin Chinese is 風險, It means risk but opportunity, not just plain risk

In sports, the idea of variation is pegged to consistency. For example in baseball, the closer might not necessarily be the best pitcher on a team, but he’s probably the most consistent. In golf, major tournaments are decided over four rounds. The winner is rarely the golfer who scored the lowest round in the tournament, but is definitely the most consistent.

Anyhow, the variation found in a data set is measured as following way.

Variance =

We subtract the mean from each observation and sum the squares. We then divide by the number of observation minus 1. The reason why we have to square the deviation from the mean is because the simple sum of the mean deviations will be zero. The reason we divide by ‘n-1’ rather than ‘n’, is a bit tricky but I’ll deal with that later. Let’s have look at the X data from the previous page, where we found the mean to be 7.

Observation X

1 7 0 0
2 9 2 4
3 6 -1 1
4 9 2 4
5 4 -3 9
6 7 0 0
7 5 -2 4
8 8 1 1
9 8 1 1
10 7 0 0
Σ = 70 Σ = 0 Σ = 24

Therefore our variance = 24 ÷ 9 = 2⅔ or 2.6667

We can repeat the process for our Y data and will find that its variance is 7.1111, or seven and one ninth.

So, the variance of the Y data is larger than the variance of the X data, which is what we expected when we first looked at the data. However, what we now want is a way to interpret 2.6667 and 7.1111 – what do those numbers mean? The answer is not immediately obvious, we had to square the deviations from the mean in order to ensure that they did not sum to zero, but in doing so we inflated each deviation.

The obvious thing to do would be to somehow undo the squaring, by taking the square root of the variance. This statistic is called the Standard Deviation.


Standard Deviation =


So the standard deviation of X = ( 2.6667)1/2 = 1.6330

And the standard deviation of Y = (7.1111)1/2 = 2.6667


Note: The fact that the standard deviation of Y happened to be the variance of X was purely accidental. The data sets are independent of each other.

Now we can interpret the standard deviation.

Standard Deviation: The standard deviation is the average deviation, of the individual observations, from their mean.

For practical purpose, we are only really interested in the standard deviation, the fact that we have to calculate the variance first, is neither here or there.

Notation

The variance of a sample is denoted S2

The Standard deviation of a sample is denoted S


S2 The sample variance is a statistic, it is our best estimate of the population variance, which denoted by σ2 (sigma squared). σ2 is a parameter.

S The sample standard deviation is a statistic, it is our best estimate of the population standard deviation, which denoted by σ (sigma). σ is a parameter.

Recall that we referred to the mean of a data set as its first moment. The standard deviation is called the second moment.


Degrees of Freedom

We can now return to the thorny issue of why we divided by (n-1) rather than simply (n).

The short answer is that we lost one degree of freedom, but I would venture to guess that this fact alone is not particularly helpful.

Formally,

Degrees of freedom are the number of independent pieces of information (our observations) that are available to estimate another piece of information. More concretely, the number of degrees of freedom is the number of independent observations in a sample of data that are available to estimate a parameter of the population from which that sample is drawn.

Example 1) If we have two observations, when calculating the mean we have two independent observations; however, when calculating the variance, we have only one independent observation, since the two observations are equally distant from the mean.

Example 2) Suppose we have three observation (n = 3), if I tell you that the arithmetic mean of this data set is five (5), I have lost a degree of freedom. Otherwise stated, only two of the original three variables can actually vary, the third has to be fixed – it can no long vary.

I have three volunteers: Tom, Dick and Harry who are free to chose any number they wish, but I tell them that the mean of their choices must be 5.

Tom scratches his head and comes up with three (3).

Dick choose nine (9)

Now Harry, unlike Tom & Dick, cannot choose any number he wants; he is constrained by the fact that the mean is five (5). Therefore he must say four (4) because only for can give us a mean of five (3 + 9 + 4)/3 = 5.
Thus, having calculate the mean, we no longer have (n) variables that can vary, we now only have (n-1), the last has to be fixed.

Alternative Way to Calculate the Standard Deviation/Variance

The formula given earlier on in this note has the advantage of being intuitive, we can immediately see that we are summing squares of deviations from the mean. Pedagogically this is a desirable quality. Unfortunately, it is not computationally efficient, in the sense that we can compute the standard deviation using fewer steps.

Rather that simply give you the alternative formula, I will derive it for you. I do this not to aggravate you, or to show off, but I want to give you a sense of what Mathematical Statistics looks like. Since this is a course in Business Statistics, you are not required to learn this, but I believe you will benefit from the exercise.

We will start with the variance

(1)

Since I am not going to play with the denominator, I will omit it for clarity and bring it back later. Again for clarity, I’ll also lose the super & subscripts from the Sigma.


(2)


I expand the term in the bracket


(3)

Now, I will run the sigma operator through the equation. We treat Σ in exactly the same way as we wood a constant (like a fixed number).


(4)

Now before this gets too unmanageable, why don’t we concoct a little data set to help us unravel the three above terms.



Suppose X = {4, 8, 6} So ΣX = 18 n = 3 and, = 6

X X X2

4 36 24 16

8 36 48 64

6 36 36 36

ΣX = 18 Σ 2 =108 ΣX = 108 ΣX2 = 116


So, we notice that a) Σ 2 = ΣX Think about why this has to be so.

b) Σ 2 = n. 2

Returning to equation (4)


(4)

From a) above we get

(5)


(6)

From b) above we get

(7)

Replacing the denominator we get the variance

Variance =

And, taking the square root we recover the standard deviation

Standard Deviation = (8)
We can now double check if this new equation is actually correct, with our original X
Data.


Observation X X2

1 7 49 2 9 81
3 6 36
4 9 81
5 4 16
6 7 49
7 5 25
8 8 64
9 8 64
10 7 49
Σ(X) = 70 ΣX2 = 514

n = 10

= 7


Standard Deviation = = = 1.6330 Yes!!! 


I don’t care which method you use as long as the answer is correct. Computers use the above method because it is computationally more efficient than the mean deviation method.


The coefficient of Variation


Suppose we have a random variable X

The coefficient of Variation is given by:

This quantity, which gives the standard deviation as a proportion of the mean, is sometimes informative. For example, the value S = 10 has little meaning unless we can compare it to something else.. If S is observed to be 10 and is observe to be 1,000, the amount of variation is small relative to the size of the mean. However, if S is observed to be 10 and is observed to be 5, the variation is quite large relative to the size of the mean.

Example: In statistics, the term precision has a special meaning.

Precision means variation in repeated measurement

If we were interested in testing a measuring instrument, such as those stupid plastic things nurses shove into ones ear to take your temperature.

A Coefficient of variation of 10/1,000 = 0.01 might be acceptable. However, a coefficient of variation of 10/5 = 2 might be unacceptable.

Example: We have two stocks: ABC Corp. and XYZ Corp. Which has the most risk.
ABC has a standard deviation of $12 and an average price of $50

XYZ has a standard deviation of $6 and an average price $24 .

Coefficient of Variation for ABC Corp. is $12/$50 = 0.24

Coefficient of Variation for XYZ Corp. is $6/$24 = 0.25

Remember, in finance less risky is good, more risky is bad

Thus, ABC Corp. is slightly less risk (but not by much).



Summary

1) Our main measure of variability is the sample Standard Deviation denotes S

2) S is given by either or,

3) S2 is the sample variance given by or,


4) The Coefficient of Variation given by allows us to compare the relative variability of two data sets.

5) Degrees of freedom is the number of independent observations in a sample of data that are available to estimate a parameter of the population from which that sample is drawn. For the purposes of this course, whenever a mean is calculated we lose one degree of freedom. Later on in the course we will be dealing with two two random variables and how they vary together (Covariance). Not surprisingly,
if we calculate the mean of both variables for the sake of calculating their covariance – we lose two degrees of freedom.

6) S and S2 are sample statistics, they are our best estimate of the population standard deviation and variance, σ and σ2 – these are population parameters

7) The coefficient of variation for a random variable X, is given by is also a sample statistic. It is our best estimate of the population coefficient of variation, which is a parameter given by , where is the population mean of X (parameter), and is the population standard deviation of X (also a

parameter). There is no ancient Greek letter for the Coefficient of variation.


Incidentally, these ancient Greek letter were not chosen at random.

μ Is pronounced “mu”, chosen to represent the mean

Σ Is the ancient Greek capital letter “sigma,” chosen to represent the sum

σ Is the ancient Greek lower case letter “sigma”, chosen to represent the Standard deviation.

Π Is the ancient Greek capital letter “pi” , chosen to represent the product.

π Is the ancient Greek lower case letter ‘pi”, which you know from grade school to represent the mathematical constants, approximately equal to 3.14159. It represents the ratio of any circle's circumference to its diameter in Euclidean geometry.

Never be afraid of notation, it’s like manners, it’s there to put you at ease, not to frighten you.


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IQRA STUDY CENTRE - Introduction to macroeconomics and national income accounting

IQRA STUDY CENTRE - Introduction to macroeconomics and national income accounting

IQRA STUDY CENTRE - MA-ECONOMICS KARACHI UNIVERSITY SYLLABUS

IQRA STUDY CENTRE - MA-ECONOMICS KARACHI UNIVERSITY SYLLABUS

Public Revenue

The public revenue can be broadly classified into two:
(a) Tax Revenue: It is the most important and major source of public revenue. Government may require the members of the community to contribute to the support of governmental functions through the payment of taxes. An individual has no right to directly demand social services in return to his payment of tax nor has he any other choice except to pay the tax when it is levied on him.
Taxes, in general, serve both functions of a revenue system:
(i) they provide funds, and
(ii) they reduce private consumption and investment.
(b) Non-Tax Revenue: Non-tax revenue is derived from public undertakings called ‘Prices’ and other miscellaneous receipts. It also raises loans, short-term and long-term, to augment its revenues. Other minor revenue sources are fees, special assessment, fines, forfeitures and escheats, tributes and indemnities, gifts and grants.
Adam Smith’s Canon of Taxation
Adam Smith’s contribution to this part of economic theory is still regarded as classic. His presented theory on taxation is still considered as the foundation of all discussions on the principles of taxation. There are four essentials of his theory of taxation, i.e., equality, certainty, convenience and economy. The first canon is ethical and other three are administrative in character:
1. Canon of Equality: means the principle of justice, i.e., in accordance to ‘ability to pay’. This is the most important canon of taxation. It lays the moral foundation of the tax system. The cannon of equality does not mean that every taxpayer should pay at the same sum. That would be manifestly unjust. Nor does it means that they should pay at the same rate, which means proportional taxation, for a proportional tax is also not a very just tax. What this canon really means is the equality of sacrifice. The amount of the tax paid is to be in proportion to the respective abilities of the taxpayers. This clearly points to progressive taxation, i.e., taxing higher incomes at higher rates.
2. Canon of Certainty: means the tax which each individual is bound to pay ought to be certain, and not arbitrary. The time of payment, the manner of payment, the quantity to be paid, ought to be clear and simple to the taxpayer. According to Adam Smith, uncertainty in taxation encourages insolence or corruption.
3. Canon of Convenience: Every tax, according to Adam Smith, ought to be levied at the time or in the manner in which it is most convenient for the taxpayers to pay their dues. The canon of certainty says that the time and the manner of payment should be certain. But the canon of convenience states that the time of payment and the manner of payment should be convenient. For example, if a tax on land or house is collected at a time when rent is expected to be received, it satisfies the canon of convenience. If the tax can be paid through cheque, or credit card, or internet, the manner is convenient, but not so if it is to be paid personally to the taxing authority. In the latter case there will be a lot of inconvenience and harassment.
4. Canon of Economy: The tax will be economical if the cost of collection is very small. If, on the other hand, the salaries of the officers engaged in collecting the tax eat up a big portion of the tax revenue, the tax is certainly uneconomical. Similarly, such other huge and unnecessary administrative costs will make the tax collection an extravagant task. If there is corruption or oppression involved in the frequent visits to the income tax office and the odious examination by the taxing officer the canon of economy is not satisfied.
In broader sense, the canon of economy means a tax must not obstruct in any manner the ultimate prosperity of the country. It would infringe the canon of economy if it retards the development of trade and industry in any manner. If incomes are subjected to a very heavy tax, saving may be discouraged, capital will not accumulate and the productive capacity of the community will be seriously impaired.
Other Canons of Taxation
1. Fiscal Adequacy or Productivity: The State should be able to function with the revenue raised from the people by means of taxes. The government should be free from financial embarrassments. It will be necessary, therefore, that the tax proceeds should adequately cover the government expenditure and the government does not run into a deficit. But at the same time, the government should also not err on the side of excess. In their zeal to raise more revenue, they should not cripple, in any manner, the productive capacity of the community.
2. Canon of Elasticity: The canon of elasticity is closely connected with that of ‘fiscal adequacy’. As the needs of the State increase, the revenue should also increase otherwise they will cease to be adequate. To meet an emergency or a period of stress and strain, the government should be in a position to augment its financial resources. Income tax is considered to be an elastic tax, as it can be considerably increased when needed.
3. Canon of Flexibility: There is a difference between flexibility and elasticity. Flexibility means that there should be no rigidity in the tax system so that it can be quickly adjusted to new conditions; and elasticity means that the revenues can be increased. The presence of flexibility is a condition of elasticity. A tax system cannot be altered without bringing about a revolution or without much flexibility in the tax system.
4. Canon of Simplicity: According to Armitage Smith, a system of taxation should be simple, plain and intelligible to the common understanding. This canon is essential if corruption or oppression is to be avoided.
5. Canon of Diversity: Another important principle of taxation – diversity. A single tax or only a few taxes will not do. There should be a variety of taxes so that all the citizens, who can afford to contribute to the State revenue, should be made to do so. They should be approached in a variety of ways. There should be a wise admixture of direct and indirect taxes. But too great multiplicity will be bad and uneconomical.
6. Social and Economic Objectives: In modern times, economists emphasised that the tax system should be based on the principle that the effects of taxation should be compatible with the economic and social objectives and preferences of the community. The social and economic objectives of a standard tax system are:
(i) Reduction of inequalities in the distribution of income and wealth: For this purpose, progressive taxes must be levied instead of proportional taxes.
(ii) Accelerating economic growth: For this purpose, the tax system must be so designed as to raise the rates of saving and investment. This is a very important objective for less developed countries (LDCs), where there is a deficiency of savings and investments.
(iii) Price stability: to ensure stable economic growth. When LDCs launch economic development programme they have to face inflation or soaring prices. An integrated tax policy would solve this problem.
Objectives of Taxation in Developing Economies
(a) Ability to contribute to economic development: Each person should be made to contribute to economic development, according to his ability to do so. All his unused capacity must be utilised, through appropriate tax measures, for purposes of economic development. Suppose a person is making a large saving but he lets it lie idle. Such saving must be mobilised and channelised into investment.
(b) Mobilisation of economic surplus: In all backward countries, a significant portion of national output goes to the big landlords and other idle rich people. A large portion of their income is spent on conspicuous consumption, e.g., building of palaces, etc. This is unproductive expenditure and a waste from the point of national development. Economic growth can be accelerated if an appreciable portion of this ‘surplus’ income is mobilised and made available for productive investment.
(c) Increasing the incremental saving ratio: As economic development proceeds apace, incomes rise. But there is a danger that propensity to consume may also increase so that extra incomes generated in the economy are utilised in consumption rather then invested in production. This has to be prevented. In other words, the consumption is not allowed to increase in proportion to increase in income. For this purpose commodity taxes are quite effective.
(d) Income elasticity of taxation: In backward economies, the share of taxation out of the national income is less than 10%. This share must be progressively raised as national income increases as a result of economic development. This needs built-in flexibility in the tax system. Progressive taxation of income provides this flexibility. Taxation of goods having a high income-elasticity of demand also imparts to the tax system much needed flexibility.
(e) Equity: The canon of equity demands that the burden of economic development must be distributed among the different sections of the community equitably. That is why the richer classes are prevented from increasing their consumption in proportion to the rise in their incomes. This is how they make a sacrifice for the economic development of their country. The poor people also make a sacrifice because rising prices curtail their consumption. In this manner, sacrifices in consumption are shared by all sections of the society. Thus, the burden of economic development is equitably distributed among all. This is also known as ‘horizontal equity’.
Characteristics of A Good Tax System
(a) Simple, financially adequate and elastic: The tax system should be simple, financially adequate and elastic. In other words, the system should be easily intelligible; it should be sufficiently productive of revenue; and the tax structure should be adaptable to meet the changing requirements of the economy.
(b) Broad based: The tax system should be as much broad-based as possible. It should be multiple tax system. There should be diversity in the system. But too great multiplicity in tax system should be avoided.
(c) Administratively efficient: The tax system should be efficient from the administrative point of view. It should be simple to administer. There should be little scope for evasion or accumulation of arrears. It should be foolproof and knave-proof. Chances of corruption should be minimised.
(d) Balanced and harmonious: Another important characteristic of a good tax system is that it should be a harmonious whole. It should have a balanced structure. It should be truly a system and not a mere collection of isolated taxes. Every tax should fit in properly in the system as a whole so that it is a part of a connected system. Each tax should occupy a definite and due place in the financial structure.
(e) Ensuring the reduction of economic inequalities: A good tax is that it should be an instrument for the reduction of economic inequalities. The purpose of public finance is not merely to raise revenues for the State but to raise the revenue in such a manner as to reduce the economic inequalities. In this manner, the State may also be able to divert idle resources in bank balances or lockers to more productive areas.
(f) Ensuring economic stability: From the point of view of ensuring economic stability, it is necessary that the tax system must be progressive in relation to changes in the national income. This means that when national income rises, an increasing part of rise in income should automatically accrue to the tax authorities and when national income falls, as in a depression, the tax revenue should fall faster than the fall in national income.
(g) Ensuring that national income is increasing: The tax system should ensure that the national income is increasing during boom periods. Similarly, in depression, tax revenues should fall faster than income so that the purchasing power of people does not fall as fast as their pre-tax income. Thus, an overall progressive tax system is an important factor in ensuring stability.
(h) An instrument of economic growth: For developing economies, the tax system has to serve as an instrument of economic growth. Economic development rather than economic stability is the objective of under-developed countries. Their tax system must be so shaped as to accelerate economic development. For this purpose, it must mobilise the required resources and channelise them into investment. It must, in short step up savings and investment and raise the level of income and employment in the economy.
(i) Socially advantageous: The tax system should be socially advantageous and promote general economic welfare. From this point of view, taxes on goods of mass consumption should be avoided. The burden of tax on basic items should not be excessive.
(j) Optimum allocation of resources: The tax system should be so framed as to ensure that the productive resources of the economy are optimally allocated and utilised. For this purpose, it is essential that the tax system should be economically neutral. In other words, it should interfere as little as possible with the consumers’ choices for consumption goods and the producers’ choices regarding the use of factors.
Classification of Tax
Some classifications of taxes are as follows:
1. Proportional & Progressive Tax: A proportional tax is one in which, whatever the size of income, same rate or percentage is charged.
On the contrary, progressive tax refers to the tax system in which the rate of tax increases with the increase in table income. It is based on the principle ‘higher the income, higher the tax’.
2. Regressive & Digressive Tax: A tax is said to be regressive when its burden falls more heavily on low-income earners / poor than the high-income earners / rich. It is opposite of progressive tax.
A tax is called digressive when the higher income does not make a due sacrifice, or when the burden imposed on them is relatively less. This tax may be progressive up to a certain limit beyond which a uniform rate is charged.
3. Specific & Advolarem Tax: A specific tax is according to the weight of the commodity. An advolarem tax is according to the value of a commodity.
4. Direct & Indirect Tax: Direct tax is one which is paid by the person on which it is charged. The examples of direct taxes are income tax, wealth tax, etc.
On the contrary, the indirect tax’s is paid by one person and its burden is fall on other, generally the consumer. The examples of indirect taxes are sales tax, central excise duty, custom duty, recreational tax, etc.
Sources of Tax Revenue / Major Types of Tax
1. Income Tax: It is a form of direct tax which is levied on individual’s total earnings. It is the most effective tax vehicle for attaining equity, particularly if it is progressive tax. Following are the requirements for an optimal income tax system:
(a) All incomes should be treated uniformly and all rupees of income should be accorded equal tax treatment regardless of the source.
(b) Just as ‘equals’ should be treated ‘equally’, ‘unequals’ should be treated ‘unequally’.
(c) The tax structure should be sensitive to changes in economic activity in order to dampen the changes
(d) The tax structure should be designed in such a fashion as to facilitate compliance and in enforcement, consistent with the attainment of the other objectives.
2. Corporate Tax: The following are the primary tax consequences of the existence of the corporation:
(a) The corporation’s earnings are accumulated as reserves giving rise to capital gains.
(b) The division between initial earning of the income and subsequent payment of dividends encourages government to tax both the corporation and the dividend earners.
(c) The division between ownership and top management in a large corporation may cause the reactions to the tax to be different from the personal income tax.
Under perfectly competitive markets the corporate tax shifted to reduce the real income of stockholders. Under imperfectly competitive markets the firms use mark-up price for shifting the tax burden on consumers.
3. Wealth Tax: A wealth tax is a levy upon individuals not corporations, on the basis of their net wealth. Corporate property is reached via securities outstanding in the hands of the owners and creditors. The wealth tax can take form of either progressive or proportional tax. Wealth tax is not a major source of revenue and in most countries they form 1 to 2% of the total tax revenue.
4. Sales Tax: Sales tax is applied to all or a wide range of commodities and services. It is collected from vendors rather than individual consumers. The sales tax is finally borne by consumers. The sales tax is often refer to regressive tax relative to income.
5. Excise Duty: It is actually imposed on the manufacturers but the consumers have to pay it. It is a form of indirect tax imposed on widely used commodities often regarded as non-essential such as cigarettes, liquor, tobacco, etc.
6. Custom Duty: Custom duties are of two types:
(i) specific, and
(ii) advolarem.
Specific custom duty is fixed per physical units of goods, e.g., television, CD players, computers, etc. The advolarem custom duty is according to the value of a good and charged at a certain rate.
As industrial and commercial development continues the increased use of custom duties lessens the revenue potential.
7. State Duties: There are several other duties imposed by the government broadly classified as ‘state duty’. These include the tax on the earnings of commercial deposits and on sales and purchase of properties. These are some what different types of tax as:
(a) the taxes imposed by the federal government and used by itself,
(b) the taxes imposed by the federal government and distributed among provinces, and
(c) the taxes imposed by the provincial governments and used by themselves.
8. Other Sources:
(i) Fee: It is also a compulsory payment but made only by those who obtain a definite service in return from the government. The fee covers the part of the cost of service provided to the consumer / client. The licence fee, however, is much more than the cost of service and there is not much of a positive service in return.
(ii) Price: A price is the payment of a service of business character, for example, charges for travelling on railway. The price is different from fee. The fee is for public interest. You can escape a price by not purchasing the said service / commodity.
(iii) Special Assessment: According to Professor Seligman, special assessment is a compulsory contribution, levied in proportion to the special benefit derived, to defray the cost of a specific improvement to property undertaken in the public interest. Suppose the government build a road or bridge or provide mass transport system or makes suitable sewerage and water supply arrangements, all the property will appreciate in value. The State has the right to levy a special tax on the owners of land or property known as ‘special assessment’.
(iv) Rates: Rates are levied by the local bodies, municipalities and district boards for local purposes. They are generally levied on immovable property of the residents, but not necessarily for any special improvements effected or special benefits conferred.
Sources from Non-Tax Revenues
In Pakistan, following are the sources of non-tax revenue available for Federal Government:
1. Income from Property & Enterprise: The Government receives income from the owned lands, forests, mines, canal water and various public enterprises.
2. Profit from Post Office and TNT: The Government also receives income from its Post and Telegraph departments
3. Trading Profits: The Government of Pakistan earns trading profits from exports of rice, cotton and edible oil
4. Interest Receipts: It is the most important head in the NTR source. The interest and the return from investment received from various autonomous bodies, and central bank and state-owned banks come under this head
5. Surcharges: The difference between the sales price and the production cost / import price of petroleum products, gas and fertilisers represents the surplus profit or the surcharge, which is used to iron out the fluctuations in the prices of these essential commodities.
6. Other Sources of Non-Tax Revenue: The other minor heads of non-tax revenue are:
(i) Dividends and returns
(ii) Receipts from civil administration and other functions
(iii) Miscellaneous sources, which includes passport, CNIC (Computerised National Identity Card), copyright fees and other receipts.

Equity in Taxation Principles of Equity in Taxation

1. Cost of Service Principle: This principle states that it would be just if people are charged the cost of the service rendered to them. This principle has no practical application. The cost of service of armed forces, police, etc. – the services which are rendered out of tax proceeds – cannot be exactly determined. Only in those cases, where the services are rendered out of prices, e.g., supply of electricity, railway or postal service, a near approach can be made to charging according to the cost of service.

2. Benefit or Quid Pro Quo Theory: This theory suggests that the taxes should be levied according to the benefit conferred on the tax-payers. But its practical application is also difficult. Most of the public expenditure is incurred for common or indivisible benefits. It is impossible to calculate how much benefit accrues to a particular individual. There are a few cases only where the benefit to one individual is ascertainable, e.g., old-age pensions. The benefit theory violates the basic principle of tax. A tax is paid for the general purposes of the State and not in return for a specific service. Moreover, it is commonly believed that the poor benefit more from the State activities than the rich. If that is so, then the poor has to contribute more than the rich. This would be absurd. However, the idea of benefit stands out prominently in the case of fees, licences, special assessment and local rating.

3. Ability to Pay or Faculty Theory: This is the most popular and the plausible theory of justice in taxation is that every tax-payer should be made to contribute according to his ability or faculty to pay. The difficult task is to determine a person’s ability to pay tax. There are two approaches for this theory – subjective and objective:

(i) Subjective Approach: In the subjective aspect, the inconvenience, the pinch or the sacrifice bear by tax-payer is considered. There are three distinct views in this regard:

(a) (a) The Principle of Equal Sacrifice: According to J.S. Mill, equality of taxation, as a maxim of politics, means equality of sacrifice. According to this principle, the money burden of taxation is to be so distributed as to impose equal real burden on the individual tax-payers. This would mean proportional taxation.

(b) (b) The Principle of Proportional Sacrifice: According to the principle of proportional sacrifice, the real burden on the individual tax payer is to be not equal but proportional either to their income or the economic welfare they derive. This would mean progressive taxation.

(c) (c) The Principle of Minimum Sacrifice: The minimum sacrifice principle considers the body of tax-payers in the aggregate and not individually. According to this principle, the total real burden on the community should be as small as possible.

(ii) Objective Approach: Under objective approach, a man’s faculty to pay may be measured according to:

(a) (a) Consumption: Consumption, as a criterion of ability to pay, is not a sound criterion, because consumption or utilisation of the services of the State by the poor is considered to be out of all proportion to their means, and, as such, it cannot be taken as a practical principle of taxation.

(b) (b) Property: Property also cannot be a fair basis of taxation, for properties of the same size and description may not yield the same amount of income; and some persons having no property to show may have large incomes, whereas men of large property may be getting small incomes. Thus, to tax according to property will not be taxation according to ability.

(c) (c) Income: Income, however, remains the single best test of a man’s ability to pay. But even in the case of income, the tax will be in proportion to faculty. The principle of progression is satisfied under this criterion.

Proportional vs. Progressive Taxation
Proportional Taxation:
Case for:
1. 1. Equitable rate for taxation, i.e., equal contribution
2. 2. Simpler taxation system
3. 3. Tax is charged in proportion to the tax payers’ income
4. 4. It encourages saving and drives in capital
5. 5. Investment is encouraged and in the long run increases the level of income and employment
6. 6. The tax-payer has the motivation to pay tax as it is simple and has less burden on high-income earners



Case against:
1. 1. The burden of tax under proportional tax system is heavily fall on low-income earners, i.e., it is regressive
2. 2. It does not entail equal sacrifice. All the tax payers have to pay tax at the same rate or equal proportion. The sacrifice should be in proportion to the tax payers’ capacity
3. 3. The government cannot raise substantial tax revenue which is used for public welfare
4. 4. Increased use of luxuries
5. 5. Less productive
6. 6. Economic instability as a result of weakening purchasing power of the people
7. 7. Economic inequalities cannot be reduced

Progressive Taxation:
Case for:
1. 1. As income increases, the utility of each addition to the income decreases. Hence, the payment of the tax by the rich entails much less sacrifice than by the poor. The rich people should be, therefore, taxed at higher rates
2. 2. By taxing affluent class more, its expenditure on luxurious goods is curtailed.
3. 3. Progressive taxation yields much greater revenue and hence it is more productive.
4. 4. Progressive taxation is more economical and equitable. The cost of collection of the taxes does not increase when the rate of tax increases. It calls forth a proportional sacrifice from the tax payers. It places the heaviest burden on the broader shoulders.
5. 5. The principle of progression gives to the tax system much-needed elasticity or flexibility. When there is an emergency, only a little raising of the rates may be sufficient to meet the situation.
6. 6. Progressive taxation promotes economic stability and checks cyclical fluctuations. The government can easily control the inflationary and deflationary pressures by checking the purchasing power of the people through progressive taxation.
7. 7. Progressive taxes are badly needed for reducing economic inequalities and for bring about more equitable distribution of wealth in the community.
8. 8. Progressive taxes may increase the desire to work, save and invest.





Case against:
1. 1. The degree of progression is settled by the finance minister on no definite and scientific basis. It is purely his personal opinion.
2. 2. It is pointed out that the principle of progression cannot be advocated on the ground of promoting welfare, because welfare is subjective and cannot be measured.
3. 3. Heavy progressive taxation will discourage saving, drive out capital and thus hamper trade and industry.
4. 4. Risky investments which yield high returns are discouraged because the proportion of tax increases as income increases. Reduction of investment will reduce the level of income and employment in the country.
5. 5. Progressive taxes put premium on idleness and leisure since they penalise those who work hard and make more money. It amounts almost the graduated confiscation of rich man’s income.
6. 6. Progressive taxes are more vulnerable to tax-evasion. But the possibility of evasion in proportional taxation is not less. It all depends on the social conscience.

Taxable Capacity
The taxable capacity can be used in two senses:

(a) (a) In the absolute sense, and
(b) (b) In the relative sense.

(a) Absolute Taxable Capacity: It means how much a particular community can pay in the form of taxes without producing unpleasant effects. There are two extreme views about absolute taxable capacity:

(i) (i) The capacity to pay without suffering, and
(ii) (ii) The capacity to pay regardless of suffering

Sir Josiah Stamp defines taxable capacity as the margin of total production over total consumption or the amount required to maintain the population at subsistence level. It is the maximum amount of taxation that can be raised and spent to produce the maximum economic welfare in that community.

(b) Relative Taxable Capacity: On the other hand, relative taxable capacity means the respective contribution which the communities should make towards a common expenditure, for example, provincial contribution to control expenditure. Dalton says the absolute capacity is a myth and relative taxable capacity is a truth. A relative limit may be reached without reaching the absolute limit.

Factors Governing Taxable Capacity: Following are the factors governing taxable capacity:

(a) (a) Number of inhabitants: It is quite obvious that the larger the population the greater is the taxable capacity of the community to contribute towards the expenses of the government.

(b) (b) Distribution of wealth: If wealth is more equally distributed, the taxable capacity will be correspondingly reduced. But if there are large accumulations of wealth in a few hands, the government can raise more money by taxing the rich.

(c) (c) Method of taxation: A scientifically constructed tax system with a wise admixture of the various types of taxes, direct and indirect, is sure to bring a larger yield.

(d) (d) Purpose of taxation: If the purpose of taxation is to promote welfare of the people, they will be more willing to tax themselves. But if the bulk of the public funds is to be spent on the maintenance of foreign armed forces and for the upkeep of a costly civil service, in which foreign element is predominant, as was the case in Pakistan, the taxable capacity must correspondingly shrink.

(e) (e) Psychology of tax-payers: The taxable capacity much depends on the people’s attitude towards a government. A popular government can galvanise the spirit of the people and prepare them for greater sacrifice. Psychology of the people is an important factor, and unless they are properly approached, they may be unwilling to tax themselves.

(f) (f) Stability of income: If the income of the citizens is precarious, there will be not much scope for further taxation.

(g) (g) Inflation: High inflation rate lowers the purchasing power of people and it cripples many; it has an adverse effect on taxable capacity.

(h) (h) Level of economic development: The level of economic development attained by a country is an important determinant of its taxable capacity. Undoubtedly, all highly developed countries of the world have greater taxable capacity than the under-developed countries.

Incidence of Taxation

Taxes are not always borne by the people who pay them in the first instance. They are often shifted to other people. Tax incidence means the final placing of a tax. Incidence is on the person who ultimately bears the money burden of tax. According to the modern theory, incidence means the changes brought about in income distribution by changes in the budgetary policy.
Impact and Incidence: The impact of a tax is on the person who pays it in the first instance and the incidence is on the one who finally bears it. Therefore, the incidence is on the final consumers.
Incidence and Effects: The effect of a tax refers incidental results of the tax. There are several consequences of imposition of tax, for example, decreased demand.
Money Burden and the Real Burden: The money burden of a tax is represented by the total amount of money received by the treasury. For example, the consumer has to spend Rs. 50 more on sugar monthly, it is the money burden that he has to bear. But if he has to reduce his consumption of sugar it means there is a reduction in economic welfare. This inconvenience, pinching, sacrifice or in short the loss of economic welfare is the real burden of tax.
Theories of Tax Shifting and Incidence
1. Earlier Theories: The earlier theories may be classified into:
(a) Concentration or Surplus theory: According to concentration theory, each tax tends to concentrate on a particular class of people who happen to enjoy surplus from their products.
(b) Diversion or Diffusion theory: The diffusion theory states that the tax eventually got diffused in the entire society. That is, the final placing of tax is not one but multiple. The process of diffusion took place through shifting or through process of exchange.
2. Modern Theory: According to modern theory, the concentration and diffusion theories are partially true. Actually there are both concentration and diffusion of taxes according to the conditions present. The modern theory seeks to analyse the conditions which bring about concentration or diffusion.

Factors determining Tax Incidence
(a) Elasticity: While considering incidence we consider both elasticity of demand and elasticity of supply. If the demand for the commodity taxed is elastic, the tax will tend to be shifted to the producer but in case of inelastic demand, it will be largely borne by the consumer. In case of elastic supply, the burden will tend to be on the purchaser and in the case of inelastic supply on the producer.
(b) Price: Since shifting of the tax burden can only take place through a change in price, price is a very important factor. If the tax leaves the price unchanged, the tax does not shift.
(c) Time: In short run, the producer cannot make any adjustment in plant and equipment. If, therefore, demand falls on account of price rise resulting from the tax, he may not be able to reduce supply and may have to bear the tax to some extent. In the long run, however, full adjustment can be made and tax shifted to the consumer.
(d) Cost: Tax raises the price; rise in price reduces demand and reduced demand results in the reduction of output. A change in the scale of production affects cost and the effect will vary according as the industry is decreasing, increasing or constant costs industry. For instance, if the industry is subject to decreasing cost, a reduction in the scale of production will raise the cost and hence price, shifting the burden of the tax to the consumer.
(e) Nature of tax: The incidence of taxation will definitely depend on the nature of tax. For example, an indirect tax’s burden is fall on the consumer.
(f) Market form: Another factor determining the incidence of taxation is the market form. Under perfect competition, no single producer or single purchaser can affect the price; hence shifting of tax in either direction is out of the question. But under monopoly, a producer is in a position to influence price and hence shift the tax.
Distinction between Direct and Indirect Taxes
A direct tax is not intended to be shifted, whereas an indirect tax is so intended.
Taxes on commodities are generally called indirect taxes as they completely or partially shifted consumers. But it should be remembered that all the commodity taxes are not indirect taxes. A tax is said to be indirect if its burden is shifted finally to the consumer.
Direct tax is the tax in which the commodity is taxed by the government, yet its price remains unaffected or changed. In this case the tax is not shifted to consumer and the tax will be called direct tax. If the tax is shifted, the tax is indirect, otherwise indirect.


Merits and Demerits of Direct and Indirect Taxes
Merits of Direct Tax:
1. Equitable, i.e., the principle of progression is applied
2. Economical, i.e., the cost of collection is small
3. Certain, i.e., the direct tax can be calculated with a fair degree of precision
4. High degree of elasticity, i.e., the direct tax can be raised much easily
5. Civic consciousness, direct tax creates civic consciousness among tax-payers
6. Reduction of inequalities, i.e., the objective of direct tax is to reduce economic inequalities by taxing higher income earners at progressive tax rates.
Demerits of Direct Tax:
1. Inconvenient: for the tax payer to pay and file the income tax return
2. Unpopular tax system
3. Tax evasion is common
4. Unarbitrary tax rates
Merits of Indirect Tax:
1. Convenient: for the tax payer to pay and it requires no filing of returns
2. No tax evasion
3. Unified tax rate
4. Beneficial social effects (in case of harmful drugs and intoxicants)
5. Capital formation
6. Re-allocation of resources
7. Wide coverage
Demerits of Indirect Tax:
1. Uncertain
2. Regressive
3. No civic consciousness
4. Inflationary
5. Loss of economic welfare


Incidence of Some Taxes
Taxes on Personal Income:
1. Income tax, super tax and excess profit tax are all direct taxes and generally cannot be shifted.
2. However, the business is in a strong position and can shift a part of his tax burden to his customers. But this situation is rarely present and the income tax payer must bear the burden of tax.
3. If the income tax is extremely heavy, it may discourage saving and investment. However, it will mainly depend on whether the tax falls on average income or marginal income, the effects would be adverse. If the increase in tax is fall on marginal income, it will mean a positive discouragement to the earning of that income.
Corporate Tax:
1. Corporate tax discourages investment, level of national income and employment.
2. A corporation tax, by reducing the earnings of the existing firms, discourages the entry of new firms into the industry which may result in a monopoly or a semi-monopoly for the existing firms with all the attendant evils.
3. A part of corporate tax may be shifted to the buyers through a price rise.
Tax on Profits:
1. Some economists are not of the view that the tax on profit should be shifted to buyers. It should be borne by the seller who pays it.
2. The second view does not subscribe with the above approach. It is argued that normal profit is a part of the cost and when the entrepreneur is able to influence the price, the tax is generally shifted to the consumer.
3. However, the tax on profit in the form of a licence duty will be borne by the producer.


Wealth Tax:
1. Wealth tax is imposed on value of a person’s stock of wealth
2. By enabling the government not to raise the income tax rates too high, the wealth tax encourages investment in modern industries
3. Another obvious effect of wealth tax is the reduction of economic inequalities by reducing the size of inherited wealth
Property Tax:
1. The wealth tax is imposed on the net worth of the individual. Whereas, the property tax is levied on the gross amount of assets’ value
2. There is no shifting of tax and the incidence is on the person on whom the tax is levied. However, the tax on productive property may be shifted to consumers.
Land Taxation:
1. The value of land depends on two sets of factors:
(a) Natural factors like the fertility of the soil, the situation of the land, some other natural conditions, and
(b) Investment of capital in drainage schemes, anti-erosion measures, irrigation facilities and other measures necessary to increase and sustain productivity
2. The tax on the first set is a tax on economic rent and has a tendency to fall on the owners
3. But when the owner can vary his investment when the tax increases, he can shift the tax burden to the consumer.
Tax on Buildings:
1. If the tax is imposed on the owner, he will try to raise the house rent and thus shift the tax to the occupier or tenant. But he cannot do this during the currency of the lease.
2. A heavy tax will check building activity and the remuneration of the builder and of other people engaged in the trade may fall
3. The tax may fall partly on the owner, partly on the builder and partly on the occupier
Death Duty:
1. Death duty may take two forms, i.e., Estate Duty and Succession Duty
2. The Estate Duty is levied on the total value of the estate (i.e., movable and immovable property) left by the deceased irrespective of the relationship of the successor
3. The succession duty varies with the relationship of the beneficiary to the deceased. It takes into consideration individual share of the successor and not the total value as in the estate duty.
Tax on Monopoly:
1. The monopoly tax may be:
(a) Independent of the output of the monopolised product, or
(b) It may vary with the output, i.e., increase or decrease with the output
2. When the tax is independent of the quantity produced, it may either be lump sum tax on the monopolist or a percentage of the monopoly net revenue (profits). In both cases it will be borne by the monopolist and he cannot shift the same to the consumer, because the monopolist is already on a price with maximum beyond which his profit will decline
3. In the second case, the price of the commodity or incidence of taxation will depend on the elasticities of supply and demand, and the influence of laws of returns.
4. Taxing of the commodity, therefore raises the price which will tend to reduce the demand
5. If, however, the demand is inelastic, it cannot be appreciably reduced and the tax will be borne by the consumer.
6. If the demand is elastic, the consumers may buy less when the tax has raised the price. Instead of facing a decline in demand the monopolist may reduce the price and decide to bear the tax himself.


Commodity Tax:
1. Taxes on commodities may take several forms:
(a) Tax on manufacture or production of a commodity called excise duties,
(b) Tax on sale of a particular commodity known as sales tax, and
(c) Import or export of commodities known as custom duties.
2. The commodity tax is tended to be shifted to the consumer and from consumer to the producer
3. Tax on production tends to raise the prise and will therefore be normally borne by the consumer
4. But the consumption tax is likely to check consumption and tends to be shifted backward to the producer.
5. Therefore, the tax on commodity will be partly borne by the producer and partly borne by the consumer
6. The portions of commodity tax to be borne by the producer and consumer depends on the degree of elasticity of demand and supply:
Elasticity Incidence
Elastic demand More tax burden on the supplier / producer
Inelastic demand More tax burden on the buyer / consumer
Elastic supply More tax burden on the buyer / consumer
Inelastic supply More tax burden on the supplier / producer

7. As a rule, the consumer bears a smaller part of the tax when the demand is more elastic than the supply
8. This may happen that the price may not rise at all. This is because the consumers have been able to discover an untaxed supply of the commodity or substitute. In this case, the tax burden will fall on the producer.



9. DD and SS intersect at point P and MP is the price determined. Now suppose a sales tax per unit is levied. As a result the supply curve of the commodity will rise upward equal to the tax per unit. The new supply curve will be S’S’. The distance between the two supply curves represents the tax per unit of the commodity. S’S’ cuts the demand curve DD at Q and, therefore, now TQ is the price determined which is higher than the old price PM by RQ. Hence RQ is the burden of tax borne by the consumer even though the tax per unit is LQ. Therefore, RL (LQ – QR) is the burden of the tax borne by the seller or he has RL price less than before (PM being the first price).
10. Therefore the commodity tax is distributed between the buyers and sellers according to the ratio of elasticities of demand and supply:
RL = Burden of the tax on the seller (producer) .
RQ Burden of the tax on the buyer (consumer)
Ed = Proportionate decrease in quantity demanded
Proportionate increase in price

---------------------------------- (i)


Es = Proportionate decrease in quantity supplied
Proportionate decrease in price

------------------------------------- (ii)
= Elasticity of Demand (Ed)
Elasticity of Supply (Es)



11. In the above equation, RL is the burden of the tax on the seller and RQ is the burden of tax on the buyers. Hence:

RL = Burden of tax on the seller
RQ = Burden of tax on the buyer
= Elasticity of demand (Ed)
Elasticity of supply (Es)
Sales Tax:
1. The sales tax is levied on the turnover, profits or no profits. It covers a wide variety of commodities.
2. The sales tax may make heavy inroads into profits which may lead to retrenchment in the staff and management, restrict enterprise and employment and hamper utilisation of resources.

3. Thus, its incidence may fall upon employees, management and landlords.
Import Duties and Export Duties:
1. Import Duties are generally borne by the home consumer
2. If the demand for the imported product is elastic and the supply is inelastic and the foreign producer has no alternative market, then in such a case the burden of tax may be shifted to foreign seller. This situation is rarely present.
3. Export duty is borne by the exporter. The price in the world market is fixed and no individual exporter is in a position to influence the world price.
4. There are certain exceptional situations in which the purchaser may bear the burden of export duty. For example, the supplier or the producer has the monopoly of the supply of a commodity.
Effects of Taxation on Production, Consumption and Distribution
Effects on Production:
1. Production is affected by taxes in two ways:
(a) By affecting the ability to work, save and invest
(b) By affecting the desire to work, save and invest
2. A tax on necessaries of life, will obviously affect the workers’ productivity and hence reduce production. A heavy tax on income tends to reduce the ability to save and invest on part of individuals. A decrease in investment is bound to affect adversely the level of output in the country
3. Normally taxation induces people to work harder, earn more, save more and invest more to increase their income and enjoy the same income after tax
4. Some taxes has no adverse effects, for e.g., import duties, tax on monopolists, etc.
5. High marginal rates of income tax are likely to affect adversely the tax payers’ desire to work, save and invest
6. The reaction varies from individual to individual. It depends on the individual’s elasticity of demand for income. When it is fairly elastic, the tax will lessen his desire to work and save
7. Entrepreneurs may avoid the production of goods which are taxed. There is likely to be a diversion of resources from some sectors of economy to others
Effects on Income Distribution:
1. The effects of taxes on income distribution depends on the type of taxes and rates of taxes
2. Taxation of goods of mass consumption is regressive and redistributes incomes in favour of rich.
3. But if such commodities are exempted and luxuries are taxed, and the taxation is made progressive, then the income will be redistributed in favour of poor.
Effects on Consumption:
1. By imposing tax on a consumable good which is injurious to health, its consumption can be checked.
2. Similarly the tax on luxury goods can decrease their consumption and resources diverted to the production of mass consumption

Public Debt

Public debt refers to borrowing by a government from within the country or from abroad, from private individuals or association of individuals or from banking and NBFIs.
Classification of Public Debt
(a) Internal and External: When a state finds that it is not possible to obtain further money by taxation, it resorts to borrowing from citizens and financial institutions within the country. This is ‘internal borrowing’. The state may accumulate funds by raising short-term loans or long-term loans or by both. If the state is passing through a very critical period, then it can borrow all the money which the nation saves. In that case trade and industry will suffer a lot because no money is left to finance them. In the normal period, however, the state can borrow only surplus funds which are left with the businessmen after meeting all the needs of the business.
External loan is that which is raised from international money markets, foreign governments, and from international agencies like International Monetary Fund. When a state is in need of money, it tries to get as much loan as it can from other states. The foreign governments do not advance loans without a limit. They minutely study the budgetary position of the borrowing country, the tax-bearing capacity of the nation, the per-capita income of the people and the purpose for which the loan is desired. If the position of the budget is sound and the taxable capacity of the nation is high, then a foreign government may advance sizable loan to the borrowing country.
(b) Productive and Unproductive: The debt that is expected to create assets which will yield income sufficient to pay the principal amount and the interest on it, is known as ‘productive debt’. In other words, they are expected pay their way; they are self-liquidating. J.L. Hanson has referred such a debt as ‘reproductive debt’.
On the other hand, unproductive debt is the debt that is raised for financing unproductive assets or heavy unproductive expenditures. Such a debt is a deadweight debt. Debt invested on wars or prevention of war is a deadweight debt.
(c) Short-term and Long-term: The loans that are repayable within a period of one year, they are termed as ‘short-term loans’ and if they are taken for more than one year, they are referred to as ‘long-term loans’. Following are the reasons for raising short-term loans:
1. If, at any time, the expenditure of the government exceeds the revenue, then she takes recourse to short-term borrowing.
2. If, at any time, the rate of interest in the market is very high and the government is in need of large fund to finance her various projects, then it raises loan for a short-period of time only and waits till the prevailing high rate of interest comes down.
3. The commercial banks find a very safe and profitable opportunity to invest their surplus funds in the government short-term loans.
If the government is in need of large funds and the short-term loans are not enough, then she takes recourse to long-term borrowing. Long-term loans entail following advantages:
1. Long-term loan provides an opportunity to the state in undertaking large projects like construction of canals, hydroelectric projects, buildings, highways, etc. As these loans are not to be repaid at a short notice, so the government safely spends them on productive projects.
2. Long-term loans are also unavoidable for strengthening country’s defence.
3. Long-term loans provide good opportunity for commercial banks and insurance companies to invest their surplus funds. As the rate of interest on long-term loans is higher than on the short-term loans.
4. Long-term loans can be repaid by the government by the time which is favourable or convenient to her. She can also convert these loans at a lower rate of interest later on.
5. If at any time, the rate of interest is low, the government can contract a long-term loan and with the amount thus raised some public work programmes at lower cost.
Causes of Increase in Public Debt
1. War or war-preparedness, including nuclear programmes
2. To cover the budget deficits on current account
3. To undertake public welfare schemes
4. Urge for economic growth
5. Inefficiencies of public organisations and corruption
Purposes of Public Debt
1. Bringing gap between revenue and expenditure through temporary loans from central bank. In Pakistan, the Government issues what are called ‘Treasury Bills’ which are repayable within one year.
2. To reduce depression in the economy and financing public works programme.
3. To curb inflation by withdrawing the purchasing power from the public.
4. Financing economic development esp. in under-developed countries.
5. Financing the public sector for expanding and strengthening the public enterprises.
6. War, arms and ammunition financing.
Methods of Debt Redemption
1. Utilisation of surplus revenue: This is an old method and badly out of tune with the modern conditions. Budget surplus is not a common phenomenon. Even when there is a surplus, it cannot be used for making any substantial reduction in the public debt.
2. Purchase of government bonds: The government may buy her own stocks in the market, thus wiping off its obligation to that extent. This may be done by the application of surplus revenues or by borrowing at low rates, if the conditions are favourable.
3. Terminable annuities: When it is intended completely to wipe off a permanent debt, it may be arranged to pay the creditors a certain fixed amount for a number of years. These annual payments are called ‘annuities’. It will appear that, during the time these annuities are being paid, there will be much greater strain on the government finances than when only interest has to be paid.
4. Conversion of high-interest-rated loans to low-interest-rated loans: A government may have borrowed when the rate of interest was high. Now, if the rate of interest falls, it can convert a high-rated loan into a low-rated one.
5. Sinking fund: This is the most important method. A fund is created for the repayment of every loan by setting aside a certain amount every year out of the current revenue. The sum to be set aside is so calculated that over a certain period, the total sum accumulated, together with the interest thereon, is enough to pay off the loan.
Burden of Public Debt
If the debt is taken for productive purposes, for e.g., for irrigation, transportation, railway, roads, information technology, human skill development, etc., it will not mean any burden. Infact, they will confer a benefit. But if the debt is unproductive it will impose both money burden and real burden on the economy.
(a) Burden of internal debt: Internal debt involves a series of transfers of wealth within the country, i.e., from lender to government and then later on at the time of redemption from government to lender. Money is thus transferred from one section of the community to other sections. In this case the money burden on the economy is zero.
But there may be real burden on the community. In order to repay the interest and the principal amount of the debt, the government has to levy taxes. What the taxpayers pay the lenders receive. The lenders are generally rich people and tax burden is fall on poor especially in the case of indirect taxes. The net result may be that the wealth is transferred from poor to rich. This is the loss of economic welfare.
(b) Burden of external debt: External debt also involves a series of transfer of wealth from the foreign lender to the borrowing country, and when it is repaid the transfer is in the opposite direction. As the borrowing country paid interest to the foreign lenders, a direct money burden is fall on the whole community.
The community is also suffered from real burden of external debts. Government has to cover the amount of interest to be paid to the foreign lender by heavily taxing the income of the community. As a result the production, consumption and distribution of income is badly affected. Moreover, the foreign lender has direct involvement in the economic activities of the country.
Role of Public Borrowing in a Developing Economy
1. Taxation should cover at least current expenditure on normal government services and borrowing should resort to finance government expenditure which results in creation of capital assets.
2. Public borrowing for financing productive investment generates additional productive capacity in the economy
3. It is used as an instrument to mobilise resources which would otherwise hoarded in real estate or jewellery
4. It provides the people opportunities to hold their wealth in the form of safe and stable income-yielding assets, i.e., government bonds
5. The management of public debt is used as a method to influence the structure of interest rates.
6. Public has become a powerful tool of developmental monetary policy
7. There are two ways in which the governments of under-developed countries raise resources through public loans:
a. Market borrowing, i.e., sales to the public of government bonds (long-term) and treasury bills (short-term) in the capital market
b. Non-market borrowing, i.e., issue to the public of debt which is not negotiable and is not exchange in the capital market, for e.g., National Saving Certificates
8. There are two forms of loans, i.e., voluntary and forced loans. Forced loans or compulsory borrowing is a compromise between taxation and borrowing. Like a tax it is a compulsory contribution to the government but like a loan, it is to be repaid with interest.
Difficulties of Public Borrowings in UDCs
1. In UDCs there are no or very small organised capital and money markets. The resources are too inadequate to fulfil the capital needs of the economy.
2. Resources are hoarded in non-productive sections of the economy, for e.g., real estate jewellery.
3. The savings in rural areas cannot be mobilised effectively because rural incomes do not move through monetary channels
4. The response to government securities is also poor because of rising prices.
Effects of Public Debt on Production, Consumption, Distribution and Level of Income and Employment
1. Effects on Production: Public debts are raised to finance productive enterprises of various kinds, e.g., steel works, cement, multipurpose projects, construction of ships, railway lines and highways, heavy electrical and engineering works, mining, oil refining, etc.
2. Effects on Consumption: When people subscribe to government loans, they generally have to curtail consumption. Since investment of funds raised by borrowing raises the level of employment and as a result raises the level of consumption.
3. Effects on Distribution: Public loans transfer money from rich to government. The fiscal operations of the government are to benefit the poor primarily. The incomes of the poor increase directly through increased employment or it benefits them in directly through the enlargement of social services.
4. Effects on the Level of Income and Employment: In modern times, public borrowing is resorted to in order to raise funds for financing agriculture, industry, mining, transportation, communication, etc. It increases employment opportunities, the level of income and standard of living.
Hicks’ Classification of Public Debts
1. Deadweight Debt: Deadweight debt is one which is not covered by any real assets. In the words of Hicks: “Deadweight is that which is incurred in consequences of expenditures which in no way increase the productive power of the community, yielding neither money revenue nor a future flow or utilities.” The loan raised during war period is a deadweight debt because for such debts no real assets exist to balance them.
2. Passive Debt: Sometimes government raises loans for spending on such projects which neither yield money income nor help in raising the productivity of the country. They simply provide enjoyments to the citizens such as public parks, museums, public buildings, etc.
3. Active Debt: Active debt is one which is spent on those projects that directly help in yielding money income and increasing the productive power of the community.
Hanson’s Classification of Public Debt
J.L. Hanson has classified public debt into four main classes:
1. Reproductive Debt: When a debt has assets to balance it, it is called reproductive debt. For instance, if a state borrows money for spending it on the construction of canals, railways, factories, etc, it is then able to repay the loan from these self-liquidating projects.
2. Deadweight Debt: A debt which is not covered by any real assets is called deadweight debt. Debt invested on wars or prevention of war is a deadweight debt.
3. Funded Debt: Funded debts are long-term debts. The government continues paying the annual interest on such loans but makes no promise to pay the principal sum to the lender on any specified date. The examples of funded debts are long-term government stocks, war loans and console.
4. Floating or Unfunded Debt: Floating or unfunded debt comprises of short-term loans. It is payable to the lender with interest on or before a fixed date.