Most Important Canons of Taxation as given by “Adam Smith”

Tax system in order to be effective must observe certain principles; some of the important canons as given by Adam Smith are as follows:

Canon of Equality or Canon of Ability:

“The subjects of every state ought to contribute towards the support of the govt, as nearly as possible in proportion to their respective abilities, i.e., in proportion to the revenue which they respectively enjoy under the protection of the state”. If every person pays according to his ability there is equality of sacrifice and it is this canon of equality or equity or ability which justifies progressive taxation.

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Canon of Certainty:

“The tax which every individual is bound to pay ought to be certain and not arbitrary. The time of payment, the quantity to be paid ought all to be clear and plain to the contributor and to every other person.” For Adam Smith, uncertainty in taxation will lead corruption. He considers canon of certainty more important than canon of equality.

Canon of Convenience:

“Every tax ought to be levied at the time or in the manner in which it is most likely to be convenient for the contributor to pay it.” It means that the time of payment and manner of payment should cause the least inconvenience to the tax-payer for example, a tax payable by a school teacher should be collected after he gets his salary and not before it.

Canon of Economy:

“Every tax ought to be so contrived as both to take out and to keep out of the pockets of the people as little as possible over and above what it brings into the public treasury of the state. The canon means that the cost of collection should be minimum. To the above four canons of Adam Smith, modern writers have added few more canons.

Canons of Productivity or Fiscal Adequacy:

The tax system should be so organised as to yield an adequate amount of revenue and the government does not run into a deficit.

Canon of Elasticity or Flexibility:

This canon wants the tax structure to be elastic or flexible to meet the requirements of the situation. The revenue collected should increase or decrease fairly quickly with an increase or decrease in national income or output.

Canon of simplicity:

According to Adam Smith, “A system of taxation should be simple, plain and intelligible to the common understanding.” It means that the tax system should not be complex and should be intelligible to common man.

Canon of Diversity:

Diversity or variety in Tax system is essential to cover all categories of income earner and to make the tax structure wide base. The variety of taxes (like direct tax and indirect taxes, progressive taxes, and regressive taxes etc.) should be properly coordinated to form an integrated consistent whole.

Added to these canons, several other considerations have also been put forward. It is recommended, for instance, that a tax should fall on revenue and not a capital. It should cut down the minimum subsistence of the tax-payer, and so on.

Non-Tax Revenue:

Non Tax Revenue includes profit from various financial institutions, government commercial undertakings, interest from loans given to other Govts. Local bodies and other institutions.

Deficit Financing:

When the government cannot raise enough financial resources through taxation and sources of income, it makes use of DEFICIT FINANCING (DF) for acquiring funds to bridge the revenue gap finance economic development.

Deficit financing is the financing of deliberately created gap between public revenue and public expenditure or a budgetary deficit.

There is a difference between the definition of deficit financing adopted by Western Countries and that adopted by the G.O.I. In the Western Countries the govt, borrowing from the banks to cover the budgetary gap is defined as deficit financing, while in India DF is defined in a narrow way and it only implies borrowings from the RBI against the issue of treasury bills or a running down of accumulated cash balances.

DF helps a govt, in mobilising additional resources and in pumping up additional purchasing power during a depression on one hand and on the other it may even lead to inflationary situation or rise in prices in the economy.

Revenue Deficit:

Revenue Deficit = Revenue Expenditure – Revenue Receipts

= (Plan Expenditure + Non-Plan Expenditure) – (Tax receipts + Non Tax receipts)

Till the mid 1970’s revenue receipts of Central Govt, exceeded its revenue expenditure, accordingly, the govt, enjoyed revenue surplus. This was in keeping with the recommendations of V.T. Krishnamachari Commission. But from 1975 the objective of revenue surplus was gradually eroded because of continuous expansion of current expenditure. Accordingly, revenue deficit has become a special feature of Central Govt, budgeting from the middle of the 1970’s.

As percentage of GDP, Revenue Deficit for

2001- 02 – was – 4%

2002- 03 – was – 3.8%

Such huge revenue deficit indicates that govt, has been living beyond its means and that it has to cut its expenditure especially its non plan expenditure-instead of looking for sources of additional taxation.

Budgetary Deficit:

Deficit financing is the difference between Total Expenditure and Total Receipts

Budgetary Deficit = Total Exp. – Total Receipts

It occurs when Total expenditure exceed Total Receipts. On the other hand, there is a budget surplus when Total receipts exceed Total Expenditure.

Budgetary Deficit = (Revenue Exp. + Capital Exp.)

– (Revenue Receipts + Capital Receipts)

Budgetary deficit only shows the extent to which cash balances kept with RBI have been depleted and the net addition to the treasury till issued by the central govt.

Since 1977, RBI lending to govt, through adhoc. Treasury Bills was given up. The concept of budget deficit lost its relevance.

Fiscal Deficit:

Fiscal deficit was introduced on the recommendation of CHAKRAVARTY COMMITTEE (1985) Fiscal deficit is budgetary deficit plus market borrowings and other liabilities of the govt, of India

Fiscal deficit = Total Exp. – Revenue receipts + recovery of loans and other receipts

= Budget Deficit + market borrowing + liabilities

It is the internationally used concept and indicates the indebtedness of the govt. IMF and IBRD are interested in Fiscal Deficit of the country only. As percentage of GDP fiscal deficit for the year

2000-01 – was – 5.7%

2001-02 – was – 5.3%

Such a high rate of fiscal deficit is not conducive to the overall growth.

Primary Deficit:

In addition to the different concepts of deficits like revenue deficit, budgetary deficit, fiscal deficit, in recent years the Finance Ministry has introduced one more concept of deficit known as Primary Deficit.

Primary Deficit is the difference between the Fiscal Deficit and interest payments

Primary Deficit = Fiscal Deficit – Interest Payment

Primary deficit is of significance and interest because it reveals the balance of revenue and expendi­ture that are in principle under the control of the present govt, submitting the budget.