CANONS OF TAXATION

CANONS OF TAXATION

                   To begin with, we shall elaborate on Adam smith’s canons which are still used as the foundation of discussion on the principles of taxation. His canons are four altogether and the remaining five have been developed with the passage of time.

1.      CANON OF EQUALITY:  The word equality here does not mean that everyone should pay the equal amount of tax. That would be unjust generally it would benefit the economy if all the inhabitants could pay taxes i.e. apart from the indirect taxes. However, this is not possible as everybody does not fall within the tax-payers category. What equality reality means is that sacrifice of energy body has got to be equal so that the rich pay more and the poor pay less. The amount of tax paid has to be in proportion to the abilities of the tax payers.

2.      CANON OF CERTAINTY: Tax-payers ought to be aware of the purpose, amount and manner of payment. They should not be misled by tax-collectors as this would lead to aggravation and arbitrariness. Everything should be made clear and simple for the benefit of the tax payer. Uncertainty leads to corruption. Hence, publicity is usually given to budget proposals for discussion as well as criticism. Certainly the government wants to be accurate so that estimates of taxes to be levied and expected return is properly calculated.

3.      CANON OF CONVENIENCE: In the canon of certainty we maintained that there ought to be certainty in the time and manner of payment. However in this canon we say that both-element i.e. time and manner of payment must be convenient for the tax-payer so that he is able to pay his taxes in the time e.g. if farmers were to pay taxes on their crops before they were harvested, naturally they would not be able to do so. Consumers find it convenient in paying their taxes as such taxes are already included in the prices of the commodity and unless they are purchased they would not have to pay the tax.

4.      CANON OF ECONOMY:  What this canon means is that tax would be economical if the cost of collecting it is very small. The whole amount taken out of people pockets should go directly to the Treasury. There should not be any leakage in the way i.e. to say any form of corruption. This canon also means to say that the expenditure on tax collecting should be kept as low as possible and maximize the tax return. In another sense a tax would be economical if it does not hamper the economic progress.

          The following canons of taxation have come into existence with the passage of time through modern economists.

5.      CANON OF PRODUCTIVITY:  This canon means that production should be encouraged rather than otherwise. The productive capacity of the community should not be crippled or impaired. The government should avoid running into a deficit whenever possible. However, as we mentioned in an earlier chapter, deficit budgeting is not a bad phenomenon, it merely reflects that the government is in debt. Through canon of productivity it is better to have fewer taxes with large revenue rather than more taxes with less revenue.

6.      CANAN OF ELASTICITY:  This would depend upon the state of affairs prevailing in a country. “As a country’s needs arise, likewise revenue should also be increased otherwise it (i.e. revenue) will be inadequate, e.g. during the phase of war. Government expenditure must be-increased and likewise its revenue. That is why during war periods countries tend to suffer. A classic example of classic tax is income tax. Raising the rate up to small extent yields greater revenue.

7.      CANON OF SIMLICITY: This canon emphasizes that method of taxation should be made a simple procedure for the laymen to understand. It should be plain, non-technical and straightforward’. This will allow the layman to understand why he is paying tax. More important is that simplicity will avoid corruption which would take place if procedures were complicated. The amount and the purpose of taxation should be made clear.

8.      CANON OF DIVERSITY: According to this canon, taxation should be broad based i.e. to say there should be taxes of all kinds so that the whole community shares the burden. There should be variety of direct and indirect rates (for at least all those who are able to pay).

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ITEMS OF GOVERNMENT EXPENITURE

ITEMS OF GOVERNMENT EXPENITURE

       We shall now briefly elaborate on the items of expenditure which the government initiates after accumulating the necessary revenue. These expenditures may be in the form of development expenditure or even non-development expenditure.

1.                            DEFENCE AND INTERNAL SECURITY:  Expenditure on defence for a country is usually determined by surrounding circumstances. For countries in the war-zone Government expenditure on defence would be quite high. Internal security or police and other uniform services is a must in every country, for it is in their hands to ensure that peace and law and one order is maintained. Thus expenditure on recruitment of personal, uniforms, equipments etc. is provided by the government.

2.                            CIVIL ADMINISTRATION AND THE COURTS: Civil servants and other Government staff salaries are paid by the government. In other words, we could also say that the people generally pay the salaries of government servants. The courts, on the other particularly the judiciary are also paid a handsome allowance. This is to safeguard the judiciary and maintain its impartiality so that no bribery may take place. However, in certain countries like England the judiciary is paid out of a special fund to avoid scrutiny in parliament.

3.                            EDUCATION AND SOCIAL WELFARE: The Government sets up schools and higher mediums of education with the revenue obtained partly and allocate a certain part of its budget for that purpose as well. Likewise health centers, orphanage homes etc, are set up by the government in the interest of the people in general. Doctors, nurses and other staff are thus paid by the government as well.

4.                            COMMUNICATION/ TRANSPORTATION AND IRRIGATION PROJECTS:  Roads, railways, ships and aero planes are provided by the government for purposes of communication on and transportation. Likewise irrigation projects such as dams, hydroelectric generators etc, are built for the community.

5.                            FOREIGN RELATIONS AND FOREIGN LOANS:  For diplomatic purposes a government would have to build or at least provide money for the payment of rent on an embassy in the host country. Similarly the government has to pay back its debt i.e. loans obtained from foreign bodies.

                We shall now proceed on the next phase i.e. to explain the canons of taxation or in other words, the characteristics of good taxation.

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USE OF FINANCIAL RESOURCES

USE OF FINANCIAL RESOURCES

              Generally the government utilizes its resources for social benefits. However, individuals generally allocate their resources under the law of equi-marginal utility.

SOURCES OF GOVERNMENT REVENUE:

       Government revenue is obtained by such as (i) Tax revenue (ii) Non tax revenue. Tax revenue is obtained from the taxes itself i.e. direct and indirect taxes. Non-tax revenues are those sources of revenue such as free, special assessment, royalty etc., as we shall briefly discuss following this introduction.

1.      TAXES: This is the most important source of government revenue. An economist has defined taxes as “taxes are general compulsory contributions of wealth levied upon persons, natural or corporate, to defray the expenses incurred in conferring common benefit upon the residents of the state”. Generally speaking taxes are being paid for the social welfare of the people. The governments use the tax revenue to create facilities and other necessary environment for the people.

2.      FEE; A fee is a form of compulsory payment made by a person for a return of service. A classic example would be education fees. Generally the fee is part of the cost of service. It is charged for a specific service rendered primarily in public interest. There is a distinction between fee and price. The former is paid in public interest whereas a price is a compulsory form of payment for a service of business character.

3.      PRICE: This is a compulsory payment for goods provided by the government. For example, the government lunches public enterprises when the private sector is unable or is unwilling to do so for some reason or the other. Such enterprises are e.g. multipurpose projects, water works etc. the government in turn charges a certain price for the goods and services used by people in general.

4.      SPECIAL ASSESSMENT: This kind of payment is said to be a special form of tax as it only affects a particular locality or area. e.g. the government builds a bridge connecting mainland and the island. Generally the bridge is for the benefit of the island occupants. Thus, these inhabitants will be paying a toll.

5.      ROYALITY: Let us take a hypothetical example. Supposing (A) gets a piece of land from the government and makes a profit of say 100 billion. Assuming that 20% of this profit is to be paid to the government. This 20% constitutes the royalty of the land and becomes a source of revenue for the government.

6.      INCOME FROM GOVERNMENT PROPERTY: Sometime it sells its property to obtain revenue e.g. the government property may be in the forestry sector or any other wide piece of land.

7.      INCOME FROM GOVERNMENT ENTERPRISES: Government bodies or government enterprises such as the national airlines, insurance agencies’ commercial banks etc. earn a substantial amount of profit annually. These bodies surplus income or profit becomes part of the government revenue.

8.      INTEREST INCOME: This form of revenue is obtained by the government through the loans being given by it to the respective persons. Such loans may be for business transactions on behalf of commercial banks.

 

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PUBLIC FINANCE

PUBLIC FINANCE

          Public finance can be classified into three categories i.e. Government Expenditure, Government Revenue and Government Debt and its management.

          Government expenditures are the expenditure, incurred by the government for development of the country and also on non-development objectives in view. Government revenue comes from taxation i.e. direct taxation and indirect taxation. Government debt is obtained from internal and external sources. Loans from internal sources are obtained by selling Government securities to the people whereas external sources are those such as the World Bank, IMF etc.

        Public finance is for the benefit of the people in general unlike private financing which is confined to particular purpose i.e. family matters only. We shall now take up the difference between the two.

DIFFERENCE BETWEEN PUBLIC FINANCE & PRIVATE FINANCE:

1.      BALANCING INCOME AND EXPENDITURE: The basic difference between public and private financing is that an individual adjusts his expenditure in accordance with the given income. On the other hand, the Government relatively speaking, adjusts its income in accordance with its expenditure.

       Thus, the individual is only able to spend so much but the government may spend as much as it likes and then takes care of the income. Relatively speaking the Government prepares its expenditure first or rather it estimates expenditure, and only then devises ways and means to obtain the amount required. However, sometimes the individual also does the same thing as the Government and vice versa i.e. when the Government realizes a surplus budget it would increase expenditure in specific areas and when the public revenue is declining the Government brings about a corresponding reduction in its expenditure through a policy of retrenchment.

2.      TIME-SPAN: In the case of public finance the government declares its expenditure for a certain period usually one year and meets the required limit within the stipulated time. However, the individual is not bound to such a requirement. He may plan his expenditure for a day, week or even for a month. Short private finance is flexible and, depends entirely upon the individual.

3.      ACQUISTION OF LOANS: Methods for obtaining financial resources differ between the two parties particularly when both parties are facing a tight situation.

         When such a situation arises the government may obtain resources internally and externally i.e. from foreign bodies e.g. World Bank, IMF etc, and internally by selling Government securities to the people. However, the individual will not be as fortunate, rather the only visual possibility of him obtaining resources in such a period is from state welfare department and this also is only possible in developed countries, otherwise they would have to turn to the streets!

4.      EXTRAORDINARY CHANGES: Public finance to a great extent depends upon the type of government. A socialist government would presumably increase expenditure for welfare purpose to a great extent, but a Capital Government is less spend thrift and tends to reduce expenditure in various sectors. An individual has no choice, whether he is a socialist or capitalist, he can still only spend within this limit.

5.      FUTURE PLANNING: Generally speaking, a government as the representative of the people in general will do this its utmost best to ensure that the future to come will be a prosperous one for those to live. In government planning such as the five year plan for commercial or agricultural products or even planning for future industrial changes in the society, the return is not the concern of the government as it may take some time until profits are realized. On the other hand individual are more optimistic and would only invest when immediate returns are likely.

6.      SURPLUS BUDGET: A Government surplus budget reflects a bad image on itself to the people in general. It creates the impression that the government is purposely increasing taxes and thus if there were to be such a surplus budget the government devises ways to increase expenditure in certain areas. However, a surplus budget for the individual is better in the sense that surplus money income can be used for purposes e.g. holidays etc.

7.      ISSUE OF CURRENCY: As a result of deficit financing the government can print more money. Usually the government prints more money when it feels that the nation has been over burdened with tax and that they (the nation) are starting to be pessimistic about the government of the day. An individual cannot do so as it is crime and would result in him going serving a sentence.

8.      PUBLIC OF FINANCE: The annual budget or rather public finance is made known, to all. It is declared by the minister of finance through the media. Such a mean strengthens rather than weakens the public credit. On the other hand, individuals are generally more secretive about their budget. The situation is generally that they either want to create an impression that they are not so fortune or may be even otherwise, but the answer lies between God and himself?

9.      RECORD OF FINANCE: The government usually keeps records of its budgets i.e. of previous years. This would provide the incoming government to ensure that the money spent is put to good use and that these records will serve as a guidance to prevent misgivings. However, the individual is less likely to do so and would spend at his own with regardless to what has happened or what may even happen.

10.  GRANTS AND FOREIGN AID: As mentioned earlier, the government may obtain external loans from the World Bank, IMF etc. the individual on the other hand is not as fortunate as such. Generally, developed countries lend a helping hand through grants and foreign aid e.g. for countries like Bangladesh, etc.

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CRITICISM ON THE CLASSICAL THEORY OF FULL EMPLOYMENT

CRITICISM ON THE CLASSICAL THEORY OF FULL EMPLOYMENT

1.                 According to the classical economists the method of overcoming the problem of unemployment is the cutting down of competitive wage rate as explained in the Marginal Productivity theory. However, such a solution is not applicable in practice particularly in the third world countries where the supply of labour exceeds the demand for it but labourers are already living at low subsistence level. Thus as a result of cutting down the wage rate they would eventually be led to starvation. This would lead to the creation of a new problem instead of solving the problem of unemployment moreover in this age of democracy labourers cannot really tolerate such a low wage rate and would express their grievance through trade unions, strikes, etc.

2.             This theory represents the working of a laissez faire economy which fluctuates through changes in the forces of demand and supply. This means that it is rather impossible to achieve a stable equilibrium at full employment level in such an economy. Therefore the problem of unemployment will surely exist to a certain extent in a laissez faire economy. It appears that this theory is more applicable in a socialist economy where the government attains full control of the whole economic system and can therefore cut the wage rate so as to maintain full employment.

3.               The classical theory of full employment only takes into account the demand for labour as indicated by the MRP curve and it totally ignores its supply whereas in reality wage rate is determined through the interaction of forces of demand and supply.

4.                According to Keynes the policy of cutting down wage rate would aggravate the problem of unemployment rather than achieving full employment. Keynes arguments are that the wage rate aggregate demand for goods and services would fall. Production would also fall and eventually firms would close down as a result of a fall in the level of investment. This according to Keynes more unemployment will take place as a result of cutting down of the wage rate.

5.                Furthermore Keynes says that unemployment in a laissez faire economy is not something to worry about but it is in fact an inevitable phenomenon simply because the level of employment depend upon the effective demand which in turn relies upon the level of investment. Similarly the level of investment mainly depend upon future business expectations and if at any time these expectations indicate a bleak future, the level of investment would naturally fall and this unemployment takes place.

6.                Keynes challenged the assumption of interest elasticity of aggregate saving and investment functions. He says that it is the national income and not the rate of interest which bring equilibrium between saving and investment. According to him when investment goes up the level of income goes up and consequently. Saving goes up to become equal to higher level of investment.

7.              Classical economists assume that there is perfect competition in the product and factor markets. This is not realistic because in the modern capitalist economies there is strong tendency towards the establishment of monopolies. This hinders the working of free forces of demand and supply in the product and markets.

8.             Keynes points out that laissez faire economy has a natural tendency to fall into a slump and this situation can be remedied only through state intervention in the form of public investment and other fiscal measures. This Keynes justifies state intervention in clear contraction to the concept of free enterprise economy presented by the classical economists.

9.                 Evidently we gather from the theory that classical economists were against labour laws, minimum wage legislation, the concept of collective bargaining, unemployment allowances, etc. However nowadays the negation of such practices would be considered unjust and against morality. Moreover cutting down the wage rate would retard growth rate of the economy because a reasonable wage rate always act as an incentive to stimulate production.

10.         Last but not the least practical experience shows that there has massive unemployment in the past in advanced countries. Following are the evidence which establish the existence of unemployment in these countries.

a)              During the Second World War the United Kingdom had suffered greatly by unemployment as the rate of unemployment in the country at that time varied from 10% to 22%.

b)            During the year 1932-37 the level of unemployment in the United States of America was 15 million. In spite of the application of economics policies the level of unemployment could not be reduced to less than 7.5 million in 1937. Thus this clearly point out that the theory of full employment was just imaginary.

c)              Finally during the period of the great depression, i. e in the early 1930’s. There was massive unemployment throughout the world and the reality of this phenomenon establishes a notion against the concept of full employment. 

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Classical Theory of Income and Employment

Classical Theory of Income and Employment

                   Most of classical theories were involved during the 18^th and 19^th centuries. Their main emphasis was on the laissez faire economy (free enterprise). However, by the year1936 a British economist, Mr. Keynes, wrote a book titled, “General Theory of Employment, Interest and Money”. in which he challenged the theories of the classical economists. Keynes justified the government intervention into the economic affairs as opposed to the classical economists. Keynes theory proved to be successful in bringing the world out of the great depression of 1930s. However now a day certain countries, particularly the United States of America, have decided to confine themselves to the classical theories and sought to revive them. They criticize Keynes theory by stating that the classical theories are more applicable under normal economic situations and that Keynes theory was only suitable for depression periods.

            The classical economists believe that there is always full employment of resources in the economy of a country, and hence there does not exist the problem of unemployment. The classical theory of full employment is based on says Law of Markets. We shall discuss this law before going into classical theory of income and employment.

SAY’S LAW OF MARKETS

            The simple statement of Says law is supply creates its own demand. According to this law whatever is produced in a free enterprise economy is automatically demand and over a long period of time when a supply of goods and services increases, the demand for them also increases automatically and vice versa. Hence there is no question of over production or under production and the economy remains at full employment all the time.

             With assumption of full employment J. B says notes down the market mechanism in the following ways: “When the producer has put the finishing hand to his product he is most anxious to sell it immediately test the value should vanish in his hands. Nor is he anxious to dispose off the money he may get for it, for the value of money is also perishable. But the only way of getting rid of money is the purchase of some product or other. Thus the mere circumstance of the creation of one product immediately opens a vent for other product”. Hence aggregate demand would be equal to aggregate supply which means that there cannot be general over-production and unemployment.

       Say’s law of markets has been interpreted by various economists as follows.

            According to Marshall “A man is devoted to the production of wealth from which he expects to drive the means of enjoyment in the future.” The above quotation simply means that a typical man produces for the sake of future consumption and that everybody’s consumption is commensurate with his own level of production. Hence this quotation shows that there is not going to be any over-production or unemployment.

            According to Mill, “All sellers are inevitably, and by the meaning of the word buyers. Could we suddenly double the production powers of the country we should double the supply of commodities in every market: but we should by the same stroke double the purchasing power, everybody would bring a double demand as well as double supply,”

              This quotation is a crystal clean explanation of “Supply creates its own demand” According to it if the productive resources of a country. i.e. land, labour, capital and organization are double production of goods and services and their supply would also be doubled. Consequently the aggregate demand of the people would be doubled because in the aggregate sense of the word the people of a country are themselves the producers as well as consumers. Thus from the above explanation, we finds the Say’s law of Markets can be explained both in a barber economy as well as in a monetary.

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ROLE OF SAVING INVESTMENT AND RATE OF INTEREST IN THE CLASSICAL THEORY OF FULL EMPLOYMENT

ROLE OF SAVING

 INVESTMENT AND RATE OF INTEREST IN THE CLASSICAL THEORY OF FULL EMPLOYMENT

        As the saving goes money Burns holes in people pockets, money is spent on consumer goods and the rest of it saved and invested. Whichever way it goes it is expenditure. Saving is converted into investment in three ways:

(i)  By purchasing capital goods.

(ii) By buying bonds.

(iii) By money in the saving accounts of banks.

        Classical economists believe that is always full employment in the country for which sufficient amount of saving and investment is automatically generated. The natural rate of interest is the mechanism which brings about the equilibrium between full employment saving and investment. (We know that the saving function is always positively correlated with the rate of interest).

          According to the classical economists, if at a certain time investment falls short of savings, it results in the rate of interest to fall. This induces investment to increase and thus the equilibrium is required again. The classical theory of interest can be further explained with the following diagram.

                                            

          In this diagram the SS curve represents saving function and I I curve represents the investment function. As we already know that the classical economists strongly uphold the concept of full emlpoyment and in the diagram this is achieved at point E where the equilibrium amount of saving and investment is OZ; OR is the rate of interest which bring about this equilibrium. A change in the rate of interest only occurs due to the change in investment. When the investment falls short of savings as shown by the i i curve above, it results in the interest falling to Or. This encourages investment to rise and hence the full employment equilibrium is restored again at point E.

CRITICISM ON THE CLASSICAL THEORY OF INTEREST:

1.                               Accourding to the classical economists, when investment falls short of full employment saving demand for consumer goods also due to excess savings. Thus,  entrepreneurs shift their resources to capital goods industries to avoid losses due to which investment increases to be equal to the full employment savings. However, this theory may not prove to be true because a fall in demand for consumer good swill lead to a fall of aggregate demand in the economy. Hence investment will fall instead of rising.

2.                                     Keynes believes that as a result of a higher rate of interest, investment squeezes and consequently National Income falls. Out of lower level of national income less savings would be generated to equate with the lower level of investment. Hence it is not necessary that saving would increases at a higher rate of interest as indicated by classical economists.

3.                                       With reference to the preceding diagram, Keynes believes that not only the investment function but also the savings function at full employment equilibrium can rise or fall. Thus, when investment curve I I falls to become i i, in the diagram saving curve SS must also fall to the left due to fall of national income. This means that a new equilibrium of saving and investment can take place at less than full employment level where the equilibrium rate of interest could be between OR and Or. This is in clear contradiction with the classical theory of full employment and rate of interest.

1.                  Involuntary unemployment: This is real form of unemployment. Individuals who fall in this category are those possess high qualification but do not find any jobs commensurate with the qualification which they possess.

2.                  Structural unemployment: Structural unemployment is the result of a change in the structure of the economy of the country. For Example, with a rapid pace of industrial advancement in the country people shift from agriculture sector to industries but do not find any jobs there. This type of unemployment is called structural unemployment.

3.                  Frictional unemployment: This from the unemployment takes place as a result of imperfections in the labour markets. These imperfections occur due to seasonal nature of jobs, natural calamities, imperfect mobility of labour shortage in the supply of raw materials, accidental breakdown of machinery, etc.

4.                  Technological unemployment: This occurs as a result of change in the production technology, e.g. replacement of workers by machines. Hence modern techniques of production used in reduce the cost of production are creating the problems of technological unemployment.

5.                  Cyclical unemployment: In this case unemployment takes place in the depression phase of the business cycle. Unemployment during the depression phase occur due to the fall in the level of investment and consequently that of national income.

                          Keeping in view the above kinds of unemployment classical economists believe that voluntary unemployment is not infect unemployment as it can be avoided and hence should not be considered. Involuntary unemployment is the real form of unemployment and the solution for this has been given by them the marginal productivity theory of distribution discussed an earlier. The solution is that the competitive wage rate should be allowed to fall to a point at which even the last man unemployed is gainfully employed. This means that if there is to be any unemployment it can be overcome by reducing the wage rate with the ever declining MRP so that they both are in equilibrium. Thus according to classical economists, there cannot be any problem of unemployment. Since this can happen in a laissez-faire economy, it is evident that classical economists are against strikes, collective bargaining and pressure tactics labourers. As far as the other forms of unemployment are concerned, these are said to be of only a temporary nature and are eliminated with the passage of time. Hence, the classical economists state that even in the presence of these forms of unemployment there is always a tendency towards full employment. Thus, on the basis of above arguments, classical economists strongly uphold the theory that there is always full employment in a laissez-faire economy and any divergence from it is only temporary in nature.

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BALANCE OF TRADE and BALANCE OF PAYMENT

BALANCE OF TRADE and BALANCE OF PAYMENT

 

               Here, we would like to make a sharp distinction between balance of international trade and balance of international payments as they are often confused by the readers. By balance of international trade we mean, statement that takes into account the total value of exports and imports of visible commodities of a country during a year. By visible commodities is meant the commodities which when exported or imported are recorded to the trade accounts at the ports. Balance of imported are recorded to the trade accounts at the ports. Balance of payments, on the other hand, is a statistical statement of income and expenditure both of the visible and invisible items of trade on international account during a calendar year. Invisible items are those items which are not shown in the trade accounts at the time of their imports. Under this heading comes all the receipts and payment made for the international services such as banking, shipping, educational, insurance, travel, etc. when the total value of visible exports is in excess to total value to visible imports during a year, the country is said to have favourable or positive balance of trade. Conversely, when the total value of goo imported exceeds the total value of goods exported, the country is said to have unfavourable balance of trade. The mercantilists believed that a favourable balance of trade indicates that country is heading towards prosperity while unfavourable balance of trade is a sign of approaching national disaster. When exports are greater than imports, they say gold is brought into country and national wealth in increased. When imports exceed exports, gold is taken out of the country and this leads to reduction in national wealth. The importance of service transactions and other invisible item was under estimated by them.

       The modern economists, however, differ with this view. They are of the opinion that a country’s prosperity or adversity in not judged by its favourable or unfavourable balance of trade but by its favourable or unfavourable balance of payment in England, for instance with the exception of 1958 had an adverse balance of trade since 1890 but its national wealth during these long years was increasing at a very last rate. It was because of this fact that its debt balance visible trade was offset by its credit balance on invisible trade. We conclude therefore, that favourable balance of trade is not an index of the economic prosperity or poverty of the country. It is the balance of payment which serves as a better guide to its economic position. If a country has persistently unfavourable balance of payments, it can be safely taken as a sing of apporoaching national disaster. Temporarily, a country may have favourable or unfavourable balance payments but on the long run, it must balance its payment, otherwise, it will be inviting troubles.

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MULTIPLIER AND ACCELERATOR

MULTIPLIER AND ACCELERATOR

CONCEPT OF MULTIPLIER

                 We have studied the determination of income and employment in a country. There we saw that the volume of employment depends on aggregate demand. The aggregate demand is composed of

(a) Consumption demand

(b) Investment demand. Consumption demands on the consumer’s income and his propensity to consume and investment demand on

(a) The marginal efficiency of capital

(b) The rate of interest

            Higher the propensity to consume the higher will be the level of income and employment in a country. Hence, if there is unemployment in a country, steps should be taken to raise the propensity to consume, when investment is increased then also the level of income and employment rises. As income increases, consumption expenditure too increase, but proportionately less than the increase in income. This is due to the fact that the marginal propensity to consume is less than unity.

            In this topic we discuss, propose to study how much or how many times income increases as investment is done. This can be known from the concept of the multiplier. We shall see that as investment is increases proportionately much more. How many times it increases depends on the marginal propensity to consume. As we have said already, the higher the marginal propensity to consume, the greater will be the increase in income as a result of investment. The higher the marginal propensity to consume the bigger will be the multiplier. We shall explain this fully presently.

        Since the national income increase many items more as a result of a given investment, Keynes multiplier theory attaches great importance to increase in public investment and government expenditure for raising the level of income and employment. The multiplier theory emphasizes that public investment is highly useful, nay necessary, for increasing income and employment in the country.

         It may be borne in mind that both consumption and investment create employment. If there is unemployment or less than full employment, increase both in consumption and investment will increase employment. In this respect they stand in complementary relationship with one another. When investment increases, consumption increases too and help in creating employment. It is only when the level of full employment has been reached that investment and consumption become competitive instead of being complementary; then increase in one will reduce other; one will be at the expense of the other.

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BARTER ECONOMY

BARTER ECONOMY

                  Every producer produces goods and services more than this own personal requirements with the intention that the excess amount of goods and services would be brought into the markets for change with the goods and services produced by the other producers excess of their needs. This method of production and the system of exchange is carried out in the economy throughout the year and hence aggregate supply become equal to the aggregate demand. Therefore, there exists no question of over production or unemployment.

               Keeping in view the barter economy, Ricardo expresses Says law of markets in the following words: “No man produces but a view to consume or sell and he never sells but with an intention to purchase some other commodity which may be useful to him or which contributes to future production. By producing them he necessarily become either the consumer of this owns goods or the purchaser and consumer of the goods of some other persons. Productions are always bought by productions: money is only the medium by which the exchange is affected.

MONETARY ECONOMY

              In a monetary economy, goods and services produced throughout the year by the combination of the four factors of production. They are given rewards in form of rent, interest, wages and profits respectively for the services rendered. These rewards are simply used for purchasing the goods and services, so the consumers pay back these rewards in the form of prices to the firms for the goods and services purchased. Hence, aggregate supply = aggregate demand. Therefore there is no over-production as in the aggregate sense. People living in a country are by themselves the producers as well as the consumers. With the same token no question of unemployment arises (note that this is an explanation with reference to the circular flow of national income).

CRITICISM ON SAY’S LAW OF MARKETS

(1) NOT APPLICABLE TO THE WHOLE ECONOMY

                The critics who oppose Say, mention that Say’s Law of markets can only be applied in one industry or firm and is not applicable on the whole economy as desired. For example, as it result of over-production in the industry there will be unemployment and hence rewards to factors of production will be cut down, under free consumption. Cost of production will fall and as a result prices of the products will also fall. Hence, there will be excess demand for goods and services and over production will be eliminated. But this is possible only in case of an industry. However, Say’s theory is not applicable on the economy as a whole because as a result of the low prices of the product the aggregate demand cannot be increased and hence over-production will continue and unemployment will persist.

(2) INAPPLICABLE WHEN PRICES ARE STABLE

            According to Says prices of goods are highly flexible at the full employment level due to which the aggregate supply of the goods adjusts with the aggregate demand for it and therefore, eliminates any possible signs of over-production and unemployment. However, in the real world today, prices of goods and services are generally stable. Hence, in case of stable prices, over-production cannot be eliminated and consequently unemployment takes place.

(3) IGNORES THE TIME LAG IN INVESTMENT

              Say’s theory is explained with reference to the circular flow of national income, according to which people living in a country are in the aggregate sense, the producers as well as the ultimate consumers. Consequently, over-production does not take place. For example, we already know that the people get their rewards in the form of rent, interest, wages and profits respectively by which they create demand for the aggregate supply of the goods and services. Now in reality, demand for consumer goods takes place immediately but the demand for the capital goods takes some time to be initiated as the people would generally think fast about their investment project. As a result of this time lag, over production and unemployment takes place.

(4) THE CLLASICAL THEORY OF FULL EMPLOYMENT

              Following Say’s Law of Markets, the classical economist believed that there would always be full employment of resources (I, e, the land, labour and organization) in a laissez faire economy and this was said to be normal situation. Another strong belief of the classical economists was that there would be lapses from full employment at certain time due to the establishment of monopolies and by government intervention in the economic life of the people. However they added that despite this handicap, tendency to restore full employment will always exist. Hence, according to the classical economist such a thing as unemployment and over production does not exist in a free economy. And if by some reason any such thing appears it will automatically disappear with the interaction of natural forces of demand and supply. Thus according to this theory, if the employment level goes up in one firm or industry under the situation of full employment, it would result in the employment level of another firm and industry going down. Similarly, if the production level in one industry rises, it falls in the other due to the given level of resources in the economy. Hence, there exists no question of unemployment and no question of over-production. This simply means that the classical economists believe that the laissez faire economy is always static at full employment level, instead of being dynamics

              This proposition of the classical economists rests on the plea that national income is spent automatically at a rate which will always keep the resources fully employed. Savings, according to classical are just another form of spending. National income they believe is in a large part spent on consumption and the rest on investment. Therefore there is no ground to fear about any obstruction in the flow of income stream in the economy. Hence there cannot be any general over-production or general unemployment.

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