Capital Levy 

This is a direct tax upon the capital rather than income of the tax payers.The government may retire its public debt by levying a heavy additional tax only once, or at the most twice. This special heavy tax to repay public debt is generally called a capital levy as it is assessed on the value of capital held by the rich people. Sometimes, when the heavy tax is levied on an index of ability other than capital, it is also known as special levy. It is also a capital levy over the sinking fund method it is that in the case of the latter method the government has to impose the burden of taxation to repay public debt over a period of years, whereas in the former case the burden of taxation is imposed once for all and, therefore gives some psychological relief to people that there will be no more taxation for the purpose of repaying debt. In times of war or emergencies, the money necessary for the redemption of the public debt is raised by imposing a special tax on capital. During and after the First World War, capital levies were frequently proposed and sometimes enacted either as a means of securing additional tax revenues or as a method of repaying government debts. 

Dalton recommended this method very strongly. It was advocated as a method of liquidating the unproductive war debts. Debt redemption by imposing a very high taxation on property has been advocated. They are usually advocated as a means of disposing of onerous debts. 

In the recent capital levies, certain property was often exempted, especially the property of less wealthy. The rates of the taxes were commonly progressive. It has sometimes been proposed that the capital levy should be laid only on wealth arising for war enterprise, but it would probably be impracticable to separate such wealth from all other property for taxation.

If such a capital levy were practicable, it might be utilised to provide enough funds to finance a war or some other emergency expenditure. But European experience with the capital levy shows that it could probably be employed only as a minor source of revenue, as suggested by Prof. A Comstyck.One of the best known capital levies was imposed by Germany in 1916 in the form of an emergency tax at rates that progressed from 10 to 65 percent on taxable capital. This had provided about 18 per cent of the total tax receipts in 1921, and then declined its importance. If a highly productive capital levy were used at the beginning of a war, it would lessen the need for borrowing and would tend to discourage the continuance of war, because the owners of the taxed property at least would immediately feel the effects of the war expenditures. In fact, it might have a demoralizing effect upon middle and upper income classes, as Keynes intimated.

The idea behind this is that increased levels of public debt are accompanied by mounting private wealth,which is increasingly concentrated on the wealthy elite. There is no burden on future generations because only existing wealth is subject to the capital levy.

Advantages of Capital Levy :

A capital levy, according to its advocates, would have several advantages.It would raise a large sum by a special property tax that might be assessed only once, although the tax might be paid in convenient instalments. A capital levy would fall heavily on the wealthy classes who generally have most of the resources to pay taxes. These classes usually buy large amount of government loans and a tax on their capital would compel them to bear the burden of the levy. A capital levy imposed in lieu of borrowing would tend to reduce debt and keep the budget in better balance. This tax should also, if collected at steeply progressive rates from property owners, tend to reduce inequalities in the distribution of wealth.

A capital levy could be employed to equalise the distribution of wealth on ethical grounds as weapon of economic warfare to combat over-saving and under-consumption, thus striking at what are popularly regarded as causes of economic instability. The proposal raises the issues of the capital levy primarily as a regulatory measure and of the validity of theory of business cycles that would call for its application.

As a result of the imposition of a capital levy, as R. N. Bhargava observes,it may be possible to reduce the level of taxation and this may give relief to earned income and may thus encourage work and enterprise. A very large national debt may also weaken the financial position of the government and may at some times make it difficult for the government to raise loans in an emergency situation when its financial needs may be very great. When a nation is engaged in a war, soldiers take lives for the sake of the nation and it may, therefore be necessary for political reasons to resort to a capital levy so that the sacrifice of soldiers and others during the war may be matched by the sacrifice of the capitalists who are asked to part with some of their capital to pay the public debt. It may, however, be noted that the payment of interest on internal debt is not a loss to the community. It is largely a problem of distribution. The government taxes one group of people in order to pay interest to another group, some of whom may belong to the former group itself. Since taxation is imposed in accordance with the principles of taxation and public expenditure is incurred in accordance with the principles of expenditure there is no inequity involved from the distributional view point in the payment of interest and the imposition of taxes to pay it. Further the advantage of reduction in public expenditure that used to be incurred in paying interest on the debt, would to a great extent, be balanced by a reduction in the future yield of taxes on income and wealth.

Disadvantages of Capital Levy :

However, as H.M. Groves mentioned, like the excess profit and the income tax the capital levy is weaker on its administrative side. Although the tax might be equitable, it is very difficult to apply. Probably, the most difficult part of a tax on capital is that of finding a fair value of property involved.

There are certain disadvantages of a capital levy or special levy which may produce extremely adverse effects on the economy. They force a relatively small section of the population to meet an expenditure that is theoretically undertaken for the general welfare. A general capital levy might also be so heavy as to exert a deadening effect upon initiative and enterprise and seriously penalize saving.

Another important disadvantage of capital levy is that it produces a concentrated burden on the community whereas in the sinking fund method the burden is spread over number of years. Thus, the capital levy is discriminatory because it imposes burden on those who own capital on that particular date and relieves those who are likely to acquire or build up capital in the future.

Besides as R.N. Bhargava observes, the capital levy may also hit industries by reducing the amount of capital that may be available for their use. So far as joint stock companies are concerned they will have to be exempted fromthe capital levy otherwise great inequity will result. If, however, the capital levy is imposed on joint stock companies it would adversely affect the operations of many of them as they would not be able to liquidate capital assets to pay the levy. This, in turn will produce adverse effect on national output and income. In the case of private business, the extent of hardship will depend upon whether the owners have any liquidating assets to meet the liability of their capital levy. Otherwise they will be forced to sell their businesses to people who are relatively less competent to manage them. It is sure that capital equipment will remain intact even after the imposition of a capital levy,but the existing owners may find it difficult to borrow in a dislocated money market and may be forced to sell their business at distress price to those who possess liquid cash but not business brains as the two do not always go together. The imposition of a capital levy may also dislocate the securities market as many owners of capital may be forced to sell their securities hurriedly to meet the tax liability. However, this difficulty could be overcome to a considerable extent if the government agreed to realize the capital levy in the form of securities or other assets. These could be passed on to a special institution to be created to hold such assets on behalf of the government and to liquidate them gradually so as to prevent the dislocation of the securities market.

Fiscal Policy and Redistribution of Income and Wealth :

In developed countries inequalities of income and wealth, while still substantial have narrowed down. This has been possible by a combination of increases in productivity and redistributive government.

The case do developing countries is quite different. There is worsening poverty with increasing GNP. Traditionally, fiscal policy has been considered to take care of income redistribution. For this purpose it is considered as "the most effective and least disruptive instrument of the state for bringing about distribution." The fiscal redistribution is brought about in two ways. The first instrument is progressive income taxes which take relatively larger shares from the rich than from the poor.The other is the expenditure programmes which transfer income to the poor through various measures.

Now, increasing doubt is expressed about the efficacy of the fiscal system as a weapon of social justice. It is now being realized that fiscal systems of developing countries have failed to redistribute income in favour of the poor. On the contrary, it has accentuated the inequality and the short term effect of economic growth on income distribution may cause greater inequality.

 Anti-Inflationary Fiscal Policy

Inflationary phase of trade cycle is the reverse order of unemployment and deflationary situation. Under inflationary situation, private expenditure go on increasing even after full employment is reached. Since there do not remain unutilised capacity and idle resources or manpower, the increase in aggregate expenditure cannot add to production but only raises the price level. However, due to increased incomes in society, government revenues would rise and would lead to budget surplus. But this surplus is often not sufficient to counter the inflationary pressure of over-investment. The normal budget surplus that could be created due to automatic rise in revenues and fall in deflation - oriented public expenditure is no

likely to be anywhere near the excessive rise in private expenditure. Therefore a deliberate budget policy and fiscal action must be evolved to meet the situation. The alternative fiscal remedies are :

(i) reduce effective demand to a level where aggregate expenditures become equal to the value of output at stable prices.

(ii) reduce private consumption by imposing new taxes or raising rates of taxes.

(iii) curtail all non-development expenditure of government.

(iv) combine tax-expenditure measures. If economy suffers from acute inflation, decrease in government expenditure should be combined with increase in tax rates and imposition of new taxes. Thus Budget surplus is the main instrument to check inflation. But the creation of budget surplus is not always feasible, when inflation arises due to war expenditures or compulsions of public expenditure for economic development in under-developed countries. Hence in such cases the revenue side has to provide the main fiscal measures. Taxation as an anti-inflationary fiscal device has also serious limitations.The fiscal policies must be supplemented by monetary and debt policy.

 Fiscal Policy Vs Monetary Policy

The divergent views on the relationship of money supply and level of economic activity resulted in the formulations of different sets of policies for the control of economic oscillations. The doubts have been frequently raised about the monetary policy from the angles of its effectiveness, the desirability of the ways in which the policy works and the value of the actual compatibility of its aims. 

A very significant factor which affects the effectiveness of monetary policy is the duration of the lags of monetary policy. In addition, there are certain institutional difficulties in the effective operation of the monetary policy. The effectiveness of the monetary policy is also limited by the decisions of the individuals and business units about the income, spending and assets. Still another factor to account for the limited efficacy of the monetary policy is inflation and particularly the cost push inflation. 

The fiscal policy too has its weaknesses. It is often considered to be quite rigid, insensitive and cumbersome.Anderson and Jordan laid down, tests to know the relative effectiveness of monetary policy and fiscal policy. On the basis of strength, predictability and promptness they found that monetary policy has a relatively greater effectiveness than the fiscal policy. 

Now the attitudes of the two divergent groups of economists have been considerably softened. An appropriate monetary - fiscal policy must be evolved for the achievement of different macroeconomic goals. 

During the period of boom or inflation, the fiscal restraints are likely to generate greater unemployment.

Therefore, the monetary action is likely to tackle the situation much more effectively. The expansion of income and output and the maintenance of price stability can be ensured through a proper mix of monetary and fiscal action. When the economy is in a state of recession or depression, the easy money supply should be supplemented by a policy of tax reduction and expansion in government expenditure. When the system is close to a boom, the greater reliance upon monetary rather than fiscal action can yield desired results. For achieving other goals fiscal policy is more powerful than monetary policy.

 INTRODUCTION

It is now widely recognized that the state has a sine qua non in the regulation of economic activity along the desired lines. Fiscal policy is traditionally concerned with the determination of state income and expenditure policy. However, in recent times, public borrowing and deficit budgeting have also become a part of fiscal policy.Thus all the budgetary instruments like taxes, public spending, borrowing and debt management constitute the fiscal policy. Fiscal policy tries to achieve its objectives by regulating the working of the market mechanism while retaining the mechanism itself.

Meaning and objectives of Fiscal Policy

In simple words, fiscal policy refers to the instruments by which a government tries to regulate or modify the economic affairs of the economy keeping in view certain objectives.The concept of fiscal policy has been defined by different economists as follows:

Harvey and Johnson define fiscal policy as "changes in government expenditure and taxation designed to influence the pattern and level of activity."

According to G.K. Shaw, "We define fiscal policy to include any design to change the price level, composition or timing of government expenditure or to vary the burden, structure or frequency of the tax payment."

Must see- Fiscal-policy-and-crowding-out-effect

Objectives of  Fiscal Policy

Fiscal policy in under-developed countries has a different objective to that in advanced countries.The objective of fiscal policy in developed economies is to maintain the condition of full employment, economic stability and stabilise the rate of growth.For an under-developed economy, the main purpose of fiscal policy is to accelerate the rate of capital formation and investment.

To achieve economic stability in developed countries, functional finance by regulating the volume of public expenditure go a long way but this device is not relevant to solve the problem of under-developed countries at length because lack of resource mobilisation is the major hindrance in such economies. Thus the technique of "Activating Finance" i.e. mobilisation of resources through taxation, borrowing and deficit financing is advocated to achieve the economic growth and stability.

Following are the main objectives of a fiscal policy in a developing economy :

1. Full employment.

2. Price stability

3. Accelerating the rate of economic development

4. Optimum allocation of resources

5. Equitable distribution of income and wealth.

6. Economic stability

7. Capital formation and growth

8. Encouraging investment.

The nature of economic fluctuations in under-developed countries is different from those in the developed economies.

It follows that in under-developed countries stability cannot be separated from economic growth. Growth and stability present more challenging problem than a merely compensatory fiscal policy. Thus, Government has to follow a policy of 'Activating Finance' and try to increase resources for economic development. The objectives of fiscal policy in under-developed countries are :

(i) To maximise the rate of capital formation and to lead the economy on the path of rapid economic progress.

(ii) To make available the maximum flow of human and material resources consistent with current consumption requirements.

(iii) To guide the allocation of existing resources into socially necessary lines of development.

(iv) To reduce the extreme inequalities in wealth, income and consumption standards which undermine productive efficiency, offend justice and endanger political stability.

(v) To mop up the excess purchasing power so as to mobilise savings for investment.

(vi) To eliminate as far as possible sectorial imbalances in the economy.

Instruments of Fiscal Policy

Contra-cyclical fiscal policy occupies the centre place for maintaining full employment without inflationary and deflationary forces. Thus, the various instruments or measures which influence the economic stability of an economy are :

(i) Budget :- The budget of a nation is a useful instrument to assess the fluctuations in an economy. Different budgetary principles like annual budget,cyclical budget and fully managed compensatory budget have been formulated by the economists.

(ii) Taxation :- Taxation is a powerful instrument of fiscal policy in the hands of public authorities which greatly affect the changes in disposable income,consumption and investment.

(iii) Public Expenditure :- The active participation of the government in economic activity has brought public spending to the front line among the fiscal tools. The appropriate variation in public expenditure as compared to taxes have more direct effect upon the level of economic activity. The increased public spending will have a multiple effect upon income, output and employment exactly in the same way as of increased investment has its effect on them. Similarly, a reduction in public spending, can reduce the level of economic activity through the reverse operation of the government expenditure multiplier.

(iv) Public Works :- Keynes has highlighted public works programme as the most significant anti-depression device because:

(i) they absorb hitherto to unemployed workers.

(ii) they help to create economically and socially useful capital assets as roads, canals, power.

(iii) they increase the purchasing power of the community and thereby stimulate the demand for consumption goods.

(v) Public Debt :- Public debt is a sound weapon to fight against inflation and deflation. It brings about economic stability and full employment in an economy. The government borrowing may assume any of the following forms:

(a) Borrowing from Non-Bank Public

(b) Borrowing from banking system

(c) Drawing from treasury

(d) Printing of currency notes (i.e. Deficit Financing).

Fiscal Policy and Full Employment

When the economy suffers from involuntary unemployment, i.e.unemployment of idle resources and manpower, three alternative fiscal policies measures may be used to attain full employment which are -

(i) Deficit Spending i.e. increased government expenditure without increase in taxation.

(ii) Deficit without spending i.e. decreased taxation without increase in government expenditure and

(iii) Balanced Budget Multiplier i.e. spending without deficit.

Deficit Spending :

When the sum of private consumption, private investment, government consumption and government investment is less than full employment income and as such there is a deflationary gap in the economy causing unemployment, the government may increase its expenditure either on consumption or on investment without an increase in taxation and thereby incur a deficit in the budget, the deficit being covered either by the creation of new money or by government borrowing. For example, marginal propensity to spend is 3/4 in the society and, hence, multiplier is 4, a deficit government expenditure of Rs. 1000 which is invested and spent in total will generate a national income of Rs. 4000 i.e., by multiplier times the initial injection of money into economy. This point has been shown with the help of diagram 1.

Deficit without Spending :

The second device by which the government can remedy the problem of unemployment is by the reduction of taxation without any increase in government expenditure and thereby creating a budget deficit. When taxation is decreased, the

disposable income of the people is increased. This will result in an ultimate increase in national income through successive doses of private expenditure. This is shown in Diagram 2, where a tax reduction of amount AB raises the consumption - investment function, and income, as a result, rises by BC which will generate additional employment.

Balanced Budget Multiplier

The third alternative expansionary fiscal policy measures is the balanced budget multiplier. Here an increase in government expenditure is matched by an equal increase in taxes but still there is net increase in the national income, if we assume that the marginal propensity to spend is same for both the tax payers and the people who receive the money spent by government. An increase in government expenditure financed by an equal increase in taxes leads to a net increase in the national income and hence in employment and output.

Fiscal Policy and Economic Development

Economic growth implies a long-period expansion of the gross national product in real terms. Economic growth does not end with achievement of full employment.Level of full employment varies in different countries. Production capacity can be increased in many ways and, thus, every economy aims at higher rates of growth.Thus deficit financing becomes an essential fiscal instrument in raising the level of full-capacity output as a long-run policy. Long-run growth depends on many factors like volume of employment, technical skill, physical capacity etc., all these will be fully exploited. The physical capacity is higher in developed countries than in under-developed ones. In the former, labour is generally fully utilised with production capacity left unutilised while in the under-developed countries, labour can not be fully employed because of shortage of capital formation. Thus fiscal policy in developed countries is more concerned with increase of labour employment, but in backward economies, it is basically devoted to development of infrastructure which helps to generate capital formation.

Fiscal Policy and Inflation

To meet the chronical situation of inflation and deflation, compensatory fiscal policy is adopted. Compensatory fiscal policy refers to those fiscal actions that are directed to compensate for this undesireable development in the private economy so that a high level of employment can be maintained without inflation or deflation.When there are inflationary tendencies, the government should take steps to reduce its expenditure by having a surplus budget and raising taxes in order to stabilise the economy. In deflationary situation the government should adopt methods to raise expenditure through reducing taxes, public borrowings and deficit budgets.Since the stabilisation function of government budget is to maintain full employment with price level stability, compensatory fiscal policy becomes the main instrument of achieving this objective.

Musgrave describes the basic logic of compensatory fiscal policy in three rules, 

(a) If involuntary unemployment prevails, increase the level of demand so as to adjust aggregate expenditures upward to the value of output produced at full employment.

(b) If inflation prevails, reduce the level of demand so as to adjust aggregate expenditures upward to the value of output measured in current, rather than rising prices. 

(c) If full employment and price-level stability prevail, maintain the aggregate level of money expenditures to prevent unemployment and inflation.The effect of compensatory fiscal policy in relation to inflation and deflation on the economy is created by three principal means, viz., (i) changes in the amount of government expenditure, (ii) changes in the amounts of taxes and transfer payments and (iii) changes in the amount of budget deficit and budget surplus. To cure the economy of inflation and deflation, a combination of these fiscal instruments is generally used.

Anti-Inflationary Fiscal Policy

Inflationary phase of trade cycle is the reverse order of unemployment and deflationary situation. Under inflationary situation, private expenditure go on increasing even after full employment is reached. Since there do not remain unutilised capacity and idle resources or manpower, the increase in aggregate expenditure cannot add to production but only raises the price level. However, due to increased incomes in society, government revenues would rise and would lead to budget surplus. But this surplus is often not sufficient to counter the inflationary pressure of over-investment. The normal budget surplus that could be created due to automatic rise in revenues and fall in deflation - oriented public expenditure is no likely to be anywhere near the excessive rise in private expenditure. Therefore a deliberate budget policy and fiscal action must be evolved to meet the situation. The alternative fiscal remedies are :

(i) reduce effective demand to a level where aggregate expenditures become equal to the value of output at stable prices.

(ii) reduce private consumption by imposing new taxes or raising rates of taxes.

(iii) curtail all non-development expenditure of government.

(iv) combine tax-expenditure measures. If economy suffers from acute inflation, decrease in government expenditure should be combined with increase in tax rates and imposition of new taxes.Thus Budget surplus is the main instrument to check inflation. But the creation of budget surplus is not always feasible, when inflation arises due to war expenditures or compulsions of public expenditure for economic development in under-developed countries. Hence in such cases the revenue side has to provide the main fiscal measures. Taxation as an anti-inflationary fiscal device has also serious limitations.The fiscal policies must be supplemented by monetary and debt policy.

 Introduction

Most of the economists believe that debt redemption that is the repaymentof pubic debt is desirable for the government.The need to repay public debt exercises a sort of check on the recklessnessof the government. A weak government may borrow large amounts to finance its expenditure because public debt does not impose a burden on the subscriber to increase his income. However, the government will have to tax the people to pay interest on the debt even if it postpones repayment of the principal. A government that continuously borrows to finance its expenditure will be faced with a rising interest bill, it will not be able to postpone imposing the burden of taxation indefinitely. The need for debt redemption exercises beneficiary effect on the fiscal policy of the government, as it is then forced to increasea taxation to finance its regular current expenditure. 

Meaning and Need for Debt Redemption

Debt redemption implies repayment of public debt which the government borrows to finance its expenditure. Debt redemption is advantageous because it cancels outstanding claims against the government and places it in a stronger position to secure new loans at moderate rates of interest. The repayment of debt reduces the tax burden by eliminating debt charges and keeps the treasury in a strong position, provided that the redemption of debt is conducted in a manner that will not excessively burden the economy. If the governments knowin advance they must redeem their debts according to the terms of their loan contracts, imprudent spending is less likely to occur and public financing can be kept under more rational control.

Debt redemption enhances the credit worthiness of the government. When the government borrows, it promises to repay the loan at a stated time in the future. It has to redeem the debt to honour its pledged word. Debt redemption also produces a salutary effect on the people who think that, if the government is borrowing, it is simultaneously making efforts to repay the loans.

An advantage of debt repayment is that the problem of debt management becomes less difficult to handle as the amount of debt decreases. Government may also have more freedom of choice as to interest rates and can give more weight to consideration of monetary policy. As the banks find it less necessary to furnish credit to governments, they should be able to give more thought to the credit needs of private borrowers and to serve them more effectively.

Debt redemption saves the cost of debt administration and cost of collecting taxes to service the debt. This is desirable when there is full employment in the economy and the resources needed in debt administration and tax collection can be diverted to produce useful commodities and services that will increase the welfare of the people.

Must see public-debt-its-classifications-and-classical views

Methods of Redemption of Public Debt

The government can adopt several methods to redeem its debt.

1. Conversion or Refunding/Fresh Borrowing : 

The government may redeem its public debt by converting it into a new debt or it may issue conversion loan to the holders of existing debt. Alternatively, it may borrow in the open market and use the funds to repay the old debt. Generally, the government adopts this method when at the retirement of the debt the government has not the capacity to repay or when the current interest rate is lower than the rate which the government is paying for the existing debt and in this way government may reduce its interest expenditure. Strictly speaking, this is actually no retirement because the government incurs fresh obligations to repay old ones and there is thus no decrease in the total amount of public debt. Sometimes a distinction is made between refunding and conversion of debt, though some times both of them are used to mean the same thing. 

In the strict sense, refunding refers to the repayment of debt through fresh loans i.e., the method of paying off an old loan carrying a higher interest rate through a new loan carrying a lower interest rate whereas conversion involves a change in the rate of interest or other details of the lenders the government may pass an ordinance to reduce the rate of interest payable on its debt.

2) Additional Taxation : 

The government imposes new taxes to get revenue to repay the principal and interest of the loan. This is the simplest method of debt redemption.

3. Sinking Fund Method : 

The most commonly used device for the actual retirement of a debt is that of the sinking fund. The government sets aside a small amount every year from the revenue budget and this accumulates at compound interest so that it may equal the amount of the public debt by the time of its maturity. Thus, the burden of taxing the people to repay the debt is spread out evenly over the period of the accumulation of the fund. The government has, therefore, not to impose a concentrated burden, if it were to repay the debt by raising funds through taxation in one year only.

4)Inflation or Currency Expansion : 

This method amounts to confiscation. It implies a fall in the value of the monetary standard due to currency expansion or inflation in the economy. Therefore, the real value of public debt depreciates. If there is hyper-inflation in the economy then the value of the country's currency and also its public debt will become almost negligible. Under this method the debt holders are taxed in proportion to the debt held by them in order to repay the debt. This is very tax for the tax- payers but is related to the extent of their debt holding. Those who supported the government in the past by lending their savings are penalised, whereas those who chose other forms of investment escape the burden of taxationnecessary to redeem public debt. Accordingly, this method is exceedingly inequitable and for that reason, undesirable from the fiscal view point. When the government resorts to this method of liquidating its public debt, it loses confidence of the public and it may be difficult for the government to borrow funds again.

5. Repudiation : 

The most extreme solution to the problem of government debt is repudiation. In this case the government refuses to repay the public debt and in this way liability for public debt is extinguished. In the federal system the states being sovereign so far as debt is concerned, can repudiate their debts if they wish. The bond holders will be having no redress. This is actually no retirement but confiscation of the bond holders to the extent of their holding. A particular group of wealth owner is penalised. Other groups even benefit through reduction in taxation, as thereafter the government will not have to pay interest on the public debt. This procedure is exceedingly inequitable as those who supported the government by investing their savings in public debt suffer irrespective of their ability as compared with the owners of other forms of wealth. When the government repudiates its public debt, it loses the confidence of the public and it will find it extremely difficult to raise further loans in future. 

6. Serial Bonds :

The serial bonds are financial bonds that mature in installments over a period of times. It provides for establishing a scheme for annually retiring a state amount of the issues. The annual payments are usually uniform as they facilitate budgetary provision. The serial bond has become a popular method of retiring local government debt. Many states actually require its use by their local sub divisions.The disadvantage with the method is that it does not permit government to cease retirement of debt during periods of depression. The payments need not be made when the national income falls below a given level.

7.Capital Levy : 

This is a direct tax upon the capital rather than income of the tax payers.The government may retire its public debt by levying a heavy additional tax only once, or at the most twice. This special heavy tax to repay public debt is generally called a capital levy as it is assessed on the value of capital held by the rich people. Sometimes, when the heavy tax is levied on an index of ability other than capital, it is also known as special levy. It is also a capital levy over the sinking fund method it is that in the case of the latter method the government has to impose the burden of taxation to repay public debt over a period of years, whereas in the former case the burden of taxation is imposed once for all and, therefore gives some psychological relief to people that there will be no more taxation for the purpose of repaying debt. In times of war or emergencies, the money necessary for the redemption of the public debt is raised by imposing a special tax on capital.

A Disadvantages of Capital Levy :

A capital levy, according to its advocates, would have several advantages.It would raise a large sum by a special property tax that might be assessed only once, although the tax might be paid in convenient instalments. A capital levy would fall heavily on the wealthy classes who generally have most of the resources to pay taxes. These classes usually buy large amount of government loans and a tax on their capital would compel them to bear the burden of the levy. A capital levy imposed in lieu of borrowing would tend to reduce debt and keep the budget in better balance. This tax should also, if collected at steeply progressive rates from property owners, tend to reduce inequalities in the distribution of wealth.

A capital levy could be employed to equalise the distribution of wealth on ethical grounds as weapon of economic warfare to combat over-saving and under-consumption, thus striking at what are popularly regarded as causes of economic instability. The proposal raises the issues of the capital levy primarily as a regulatory measure and of the validity of theory of business cycles that would call for its application.

Disadvantages of Capital Levy :

However, as H.M. Groves mentioned, like the excess profit and the income tax the capital levy is weaker on its administrative side. Although the tax might be equitable, it is very difficult to apply. Probably, the most difficult part of a tax on capital is that of finding a fair value of property involved.There are certain disadvantages of a capital levy or special levy which may produce extremely adverse effects on the economy. They force a relatively small section of the population to meet an expenditure that is theoretically undertaken for the general welfare. A general capital levy might also be so heavy as to exert a deadening effect upon initiative and enterprise and seriously penalize saving.

Another important disadvantage of capital levy is that it produces a concentrated burden on the community whereas in the sinking fund method the burden is spread over number of years. Thus, the capital levy is discriminatory because it imposes burden on those who own capital on that particular date and relieves those who are likely to acquire or build up capital in the future.

Introduction 

In an open economy, domestic spending no longer determines domestic output. Instead, spending on domestic goods determines output. A currency depreciation (increases in R) has two distinct effects on this measure: (i) value effects, and (ii) volume effects. A currency depreciation is equivalent to an increase in the relative price of imports to domestic goods. Even if the volume of trade does not change, the measured value of imports unambiguously increases. The volume effects run in the opposite direction. Exports should rise and imports should fall due to the reason imports are now relatively more expensive. 

The domestic income is now dependent on both foreign income and the real exchange rate. The IS curve is steeper in an open economy setting due to the marginal propensity to import. The fact that some of our income is spent on imports decreases the amount of induced spending in our economy. For a given reduction in the interest rate, a smaller increase in output and income is required to restore goods market equilibrium.

Capital Mobility 

Lets consider a very simplified version of the international economy. Let us assume the following: 

(i) exchange rates are fixed forever at a given level, 

(ii) taxes are the same everywhere, and 

(iii) foreign asset holders face no political risk.

In this setting, capital would chase the highest return. As such, interest rates would have to equate across economies. These assumptions do not hold in reality. Although a very slightly unrealistic assumption, we will assume perfect mobility of capital, in which investors can purchase assets in any country they choose, quickly, in unlimited amounts, and with little transaction cost. With this assumption, differences in interest rates will induce capital flows between economies. These flows put pressure on interest rates until they are once again equated between nations. 

Mundell-Fleming Model with a Floating Exchange Rate 

In an open economy with external trade and financial transactions, how are the key macrovariables (GDP, inflation, balance of payments, exchange rates, interest rates, etc) determined and interact with each other? What are the effects of fiscal and monetary policies? The Mundell-Fleming model is the standard open macroeconomic model that tries to answer these questions. Theoretically, it is the most popular model. But its applicability to actual policy making is not as high as we would hope (especially for developing and transition countries). In 1963 when he was young, Prof. Robert Mundell was working with Marcus Fleming at the IMF and wrote a paper which gave birth to this model. He has been at Columbia University (New York) for the last 25 years. He has been a strong advocate of stabilization of major currencies and establishment of euro. In 1999, he won the Nobel Prize in economics, partly because of the Mundell-Fleming model. 

The Mundell-Fleming model is an open macro application of the standard IS-LM analysis. More precisely, it is an IS-LM analysis with trade and international capital mobility. Consider the following three aspects of the macroeconomy: 

(1) Aggregate demand (IS and LM curves, representing goods and money markets) 

(2) Aggregate supply (production function and labor market) 

(3) Balance of payments (current account and capital account) 

The usual textbook exposition (with no trade or capital mobility) combines (1) and (2), with a downward sloping AD (aggregate demand) curve and an upward-sloping AS (aggregate supply) curve. The Mundell-Fleming model combines (1) and (3), namely AD and B (balance of payments) curves. This means that the Mundell-Fleming model (in its simplest version) has no supply side constraint. As in the most elementary Keynesian model, it implicitly assumes that capital and labour are generally underemployed so that any demand stimulus will expand real GDP (rather than cause inflation).

Aggregate Demand - IS curve 

Aggregate demand is composed of two parts: absorption (A, namely, domestic demand) and trade balance (T, namely, foreign demand). We ignore service trade, factor income and transfers, so the current account is the same as the trade balance. 

Y = A + T (GDP by expenditure decomposition) 

where 

 A=C + I + G (definition of absorption) 

   = A (Y, i; G) A1 >0, A2 <0, A3 >0; G is an exogenous spending (shift parameter) [A1 means partial derivative of A with respect to first variable, etc.] 

and 

T = M*- qM (definition of trade balance, measured in domestic currency) 

 = T (q, Y*, Y) T1 >0, T2 >0, T3 <0; foreign 

income Y* is assumed fixed (Y: income C: private consumption I: private investment G: government spending M: imports M*: foreign imports (=our exports), i: interest rate) Note that A and T are defined as real variables (deflated by domestic price P). The real exchange rate q is defined thus: 

q = EP*/P (a rise in q means real depreciation of home currency) Please note that T1 >0, namely, partial derivative of trade balance with respect to q is positive. This means that the Marshall-Lerner condition is satisfied, so real depreciation will improve the trade balance (when other variables remain unchanged). From above, we have 

Y= A (Y, i; G) + T (q, Y*, Y) 

= F (Y, i, q; G) Note: 0 < F1 < 1 

Collecting Y to the left-hand side, 

Y = f (i, q; G) f1 <0, f2 >0, f3 >0 

This is our IS curve. It is downward-sloping in the (i, Y) plane. Moreover, a rise in q (real depreciation) or a rise in G (government spending) shifts the IS curve up and to the right.

Aggregate Demand - LM curve 

The LM curve is the same as in the domestic macro version. It shows the condition for money market equilibrium. In particular, we ignore the possibility of "currency substitution," a phenomenon where domestic citizens hold foreign currency (typically US dollar) as well as domestic currency, and change their relative shares as circumstances change. No currency substitution is a reasonable assumption in developed countries, where people hold only domestic currency. But in many developing countries, currency substitution may be a big factor that influences the money demand. Currency substitution is also called "dollarization." But dollarization has two meanings: (1) the situation where people use dollars in addition to domestic currency because they do not trust the latter (in this case, the monetary authority usually tries to prevent the use of dollar); (2) the situation where the government declares that the national currency is the US dollar, abolishes the central bank, and gives up independent monetary policy. Currency substitution is equivalent to the first (traditional) meaning of dollarization. 

The LM curve is simply: 

Ms/P = LD(i, Y) LD1 <0, LD2 >0 

(Ms: money supply P: price level) 

As in the domestic version, it is upward-sloping in the (i, Y) plane. A rise in money supply Msshifts the LM curve down and to the right. In this formulation, the price level P is assumed fixed. This may be unrealistic in a small open economy where exchange rate pass-through (E -> P) is significant.

 Balance of payments

The balance of payments (B) is the sum of current account (T) and capital account (K). Remember, for simplicity we have assumed away the flows of service, factor income and transfers so that the current account is identical with the trade balance. 

B= T + K

   = T (q, Y) + K (i - i*)          T1 >0, T2 <0; K1 >0 

   = 0 

Assumptions: 

The exchange rate is floating (the real exchange rate q is also flexible). 

1) The monetary authority does not intervene in the foreign exchange market. This means that there is no change in international reserves, the monetary account is zero, and, therefore, the current account and the capital account must always add up to zero (T + K = 0). 

2)  Additionally, we assume perfect capital mobility. This means that i = i*, K1 = +∞, and K is indeterminate. In other words, if i > i* there will be a massive capital inflow into the home country and if i < i* there will be a massive outflow, so the only way K can remain finite is when i = i*. When that happens, K can take any value (positive or negative) to offset T, so that T + K = 0 holds. 

3) The exchange rate expectation is static. That is to say, people expect that the future exchange rate will be the same as today's (even though the exchange rate is floating). This is a simplifying assumption. If we depict this situation in the (i, Y) plane, we have a horizontal line at i*. The domestic interest rate must be equal to the worldinterest rate. There will be a massive capital inflow above that line and a massive capital outflow below that line. 

Equilibrium 

Under a freely floating exchange rate and perfect capital mobility, the following 

three equations derived above determine the equilibrium position. 

Y = f (i, q; G)   f1 <0, f2 >0, f3 >0          <IS> 

Ms/P = LD(i, Y)    LD1 <0, LD2 >0       <LM> 

i = i*                                                <BOP> 

Recall that foreign income, foreign interest rate and domestic price are all fixed (Y*, i*, P). 

The equilibrium can be pictured as follows:

Comparative Statics 

Comparative statics means checking how the equilibrium changes if one input variable is changed. More technically, it is a matrix of signs (+ or -) indicating the changes in endogenous variables in response to a change in each exogenous variable.

In this model, we ask two specific questions: 

(1) Can we increase Y by an expansionary fiscal policy (an increase in G)? 

(2) Can we increase Y by an expansionary monetary policy (an increase in Ms)? G and Ms are the input variables and Y is the output variable in question. (We may add that these questions themselves reflect the rather old-fashioned mentality of macroeconomic fine-tuning. More recently, fiscal and monetary policies are not considered as tools for adjusting real GDP.)

First, consider fiscal expansion, 

1. An increase in G shifts the IS curve upward and to the right. 

2. This puts an upward pressure on the domestic interest rate (i > i*). 

3. But this immediately invites a massive capital inflow. 

4. This appreciates the nominal exchange rate E as well as the real exchange rate q. 

5. This worsens the trade balance T. 

As the model is constructed, no gradual adjustment is allowed; these events are supposed to take place instantaneously. The exchange rate appreciates and the trade balance worsens until the initial increase in G is completely offset. The IS curve is pushed back to the original position and Y cannot increase at all.What happened is that, in Y = A + T, as A is increased by fiscal spending, T is reduced by exactly the same amount. Y is unchanged, and only the relative composition of Y is changed. The conclusion is that under a floating exchange rate and perfect capital mobility, fiscal policy is ineffective. Here, "ineffective" means unable to increase Y.

These conclusions are significantly different from those of the domestic version of the IS-LM model. In the domestic version, fiscal and monetary policies are both effective, and their relative effectiveness depends on various elasticities and slopes. But in this case, one policy is utterly impotent and the other policy is doubly potent. By now, you should clearly see why (by what mechanism and assumptions) these conclusions are generated.

Equilibrium with no Capital Mobility 

With a fixed exchange rate and no capital mobility, how does the equilibrium look? Our three equations are as follows: 

Y = f (i, q; G).   f1 <0, f2 >0, f3 >0         <IS> 

Ms/P = LD(i, Y)  LD1 <0, LD2 >0.     <LM> 

T(q, Y) = 0 T1 >0, T2 <0            <BOP> 

But since the real exchange rate q is given and unchanged by assumption, we can ignore it for now. q will matter only when the government devalues or revalues the exchange rate. 

Since the trade balance must be zero, output Y and the interest rate i are determined by IS and LM as if in a purely domestic macro model. IS is downward sloping and LM is upward sloping in the (i, Y) plane. The economy goes to the intersection of IS and LM. This is the short-run equilibrium. 

But this is not the final outcome. This short-run equilibrium may be off the BOP line (T=0). If it is to the right of T=0, there is a trade deficit because Y is too large. To keep the exchange rate fixed, the central bank is obliged to sell dollars, lose IR and reduce H. Gradually, money supply Ms falls and the LM curve shifts up and to the left until the three lines (IS, LM, T=0) intersect at the same point. After that, there is no more movement; we have reached the long-run equilibrium.

As we said before, the government can resist the shift of LM by sterilization. But eventually, it will run out of international reserves. Then the process above must continue. 

Equilibrium under Perfect Capital Mobility 

With a fixed exchange rate and perfect capital mobility, what is the equilibrium situation? Consider the following set of equations 

Y= f (i, q; G).     f1 <0, f2 >0, f3 >0.     <IS> 

Ms/P = LD(i, Y).   LD1 <0, LD2 >0.    <LM> 

i = i*.                     <BOP> 

The only difference from the case of no capital mobility is the BOP condition. Instead of trade balance, we have interest rate equalization. 

Let us do comparative statics with this model. Are monetary and fiscal policies effective (can they change Y)? We already said that money is endogenous under a fixed exchange rate and any attempt for sterilization is futile when capital is perfectly mobile. So we know monetary policy can do nothing. To be more precise, consider an attempt at monetary expansion by increasing DC (open market purchase of domestic government bonds). The LM curve wants to shift down and to the right, but this movement is immediately countered by a massive capital outflow and a loss of IR, at the slightest fall of the domestic interest rate. So the total high-powered money H (=DC+IR) remains constant. LM cannot shift. The conclusion is that under a fixed exchange rate and perfect capital mobility, monetary policy is ineffective. 

In the previous section with a floating exchange rate, a massive capital outflow prompted currency depreciation and an export boom. Here with a fixed exchange rate, it simply leads to the loss of international reserves.

If government spending G is increased, the IS curve is pushed up and to the right. But this tends to raise i and generate a massive capital inflow. To prevent an appreciation of the domestic currency, the central bank must buy up dollars, which will increase IR and H. Money supply Ms jumps up and the LM curve shifts out as a consequence. Note that this occurs instantaneously. Unlike the case of no capital mobility, there is no distinction between short-run and long-run. Everything takes place at once. 

Since both IS and LM shifts to the right, Y is doubly increased. The conclusion is that under a fixed exchange rate and perfect capital mobility, fiscal policy is very effective.

Conclusion 

In the previous sections we have seen that with a floating exchange rate, a massive capital outflow prompted currency depreciation and an export boom and with a fixed exchange rate, it simply leads to the loss of international reserves. The conclusion is that under a floating exchange rate and perfect capital mobility, monetary policy is very effective and under a fixed exchange rate and perfect capital mobility, fiscal policy is very effective.