Directions : Each of the next four (04) items consists of two statements, one labelled as the 'Statement (I)' and the other as 'Statement (II)'. Examine these two statements carefully and select the answers to these items using the codes given below : Statement (I) : The effects of an income tax on consumption, saving and investment are micro effects. Statement (II) : Income tax is an example of direct tax.

Correct — B, (b) Both Statement (I) and Statement (II) are individually true but Statement (II) is not the correct explanation of Statement (I).

HOW THIS FORMAT MUST BE WORKED, because the discipline matters more here than the economics. The four codes ask two questions, and they must be answered in order:

FIRST, is each statement true ON ITS OWN, judged without reference to the other ? SECOND, and only if both are true, does Statement (II) EXPLAIN Statement (I) ?

A candidate who runs the two questions together — deciding that the statements 'go together' and choosing (a) — loses the item even with both facts secure. Codes (c) and (d) are reached only when a statement is actually false, so they are settled at the first stage and never at the second.

STATEMENT (I) IS TRUE. Public finance classifies the effects of a tax by the LEVEL at which they operate. MICRO EFFECTS are effects on the behaviour of the individual economic unit — a household or a firm. The standard list is the effect on the ABILITY to work, save and invest, which falls because a tax reduces disposable income; the effect on the WILLINGNESS to work, save and invest, which depends on the rate and structure of the tax and pulls in two directions through the income and substitution effects; and the effect on the PATTERN of consumption and on the allocation of resources between uses. MACRO EFFECTS are effects on the economy in aggregate — the level of national income and output, employment, the general price level, the distribution of income between classes, and economic stability and growth. Consumption, saving and investment as they are listed in Statement (I) are the decisions of the taxpayer whose income is taxed, so the effects named are effects on individual economic behaviour. On the standard classification these are micro effects, and the statement stands.

STATEMENT (II) IS TRUE, and is the simpler of the two. Income tax is the textbook example of a DIRECT TAX: it is levied on the person who is intended to bear it, its impact and its incidence fall on the same taxpayer, and it cannot ordinarily be shifted to anyone else. In India it is charged under the Income-tax Act, 1961 and administered by the Central Board of Direct Taxes; the Union's power to levy it comes from Entry 82 of the Union List, which covers taxes on income other than agricultural income.

WHY (II) IS NOT THE EXPLANATION OF (I) — the point on which the item turns. The two statements classify the same tax on TWO INDEPENDENT AXES, and neither axis determines the other.

DIRECT versus INDIRECT is a classification by SHIFTABILITY: can the burden be passed to someone other than the person on whom the tax is levied ? A direct tax cannot, an indirect tax can. MICRO versus MACRO is a classification by the LEVEL OF ANALYSIS at which an effect is observed: the individual unit, or the economy as a whole.

Nothing about being unshiftable makes an effect individual rather than aggregate. The independence can be shown in both directions. An INDIRECT tax also has micro effects — an excise duty on a commodity changes a household's pattern of consumption, which is a micro effect by the same definition. And a DIRECT tax also has macro effects — an income tax reduces aggregate demand, alters the level of national income and redistributes income between groups. So the two classifications cut across each other, and 'income tax is a direct tax' is a true fact that leaves Statement (I) exactly as unexplained as it found it. That is precisely what code (b) is for.

THE VOCABULARY THAT MAKES THE DISTINCTION CLEAN, and it is worth carrying because it is examined in its own right. The IMPACT of a tax is the point at which it is first levied. SHIFTING is the process of passing the burden on. INCIDENCE is where the final burden comes to rest. EFFECTS are the further consequences on production, consumption and distribution. Direct and indirect describe impact and incidence; micro and macro describe effects. Different stage, different question.

In the printed booklet the Directions block and the four codes appear once, at the head of the column, and govern this item together with the three that follow it. The word 'not' inside code (b) is set in bold italic, both statement labels are in italics, and each carries a space before its colon, as this booklet sets them.

Why the others are wrong

• (a)Both Statement (I) and Statement (II) are individually true and Statement (II) is the correct explanation of Statement (I) — This is the trap the item is built around, and it catches the candidate who knows both facts perfectly. Both statements ARE true, so the first half of this code is satisfied; the failure is in the second half. Being a direct tax is a statement about whether the burden can be shifted to another person. Being a micro effect is a statement about whether an effect is observed at the level of the individual unit or of the whole economy. Neither implies the other, and the independence can be demonstrated both ways: an indirect tax such as an excise duty also alters a household's consumption pattern, which is a micro effect, so directness is not necessary for micro effects; and an income tax also alters aggregate demand, national income and the distribution of income, which are macro effects, so directness does not confine a tax's effects to the micro level. A correct explanation must supply the REASON the first statement holds. Here the second statement supplies a different classification of the same tax, which is a related fact and not a reason. The habit that prevents this error is to state the reason for Statement (I) in one's own words first, and only then to check whether Statement (II) is that reason.
• (c)Statement (I) is true but Statement (II) is false — This code requires Statement (II) to be false, and it is not. That income tax is a direct tax is among the most secure propositions in public finance and is the illustration every textbook uses. The defining test of a direct tax is that its impact and its incidence fall on the same person — the taxpayer on whom it is levied is the taxpayer who bears it, and the burden cannot ordinarily be shifted to anyone else. Income tax satisfies that test: the individual assessed pays out of the income assessed. The category also contains corporation tax and capital gains tax, while customs duty, excise and the goods and services tax are the standard indirect taxes, levied on one person and passed on in the price to another. In India income tax is charged under the Income-tax Act, 1961 and administered by the Central Board of Direct Taxes, whose very name records the classification. Selecting this code means rejecting a definition rather than a debatable claim.
• (d)Statement (I) is false but Statement (II) is true — This code requires Statement (I) to be false, and on the classification public finance actually uses it is true. The temptation is understandable: consumption, saving and investment are the headline aggregates of macroeconomics, so a candidate who meets those three words expects 'macro' and rejects the statement. But the statement is about the effects of a tax on the economic unit that pays it, and the standard treatment sorts the effects of taxation into micro effects — on the ability and the willingness of individuals to work, save and invest, and on their pattern of consumption and the allocation of resources — and macro effects — on the level of national income, output, employment, the price level, the distribution of income and economic stability. The three items named in Statement (I) belong to the first list. Note also what accepting this code would commit a candidate to: if Statement (I) were false there would be no explanatory question left to answer, and the item's entire point, which is the distinction between a related fact and a reason, would disappear.

TWO SUBJECTS MEET IN THIS ITEM: the assertion-reason format, and the classification of taxes and of their effects.

THE FORMAT. Four items on this paper — this one and the three that follow — present two statements and ask the candidate to judge them against four codes. The codes are exhaustive over the cases that matter: (a) both true, and the second explains the first; (b) both true, but the second does not explain the first; (c) the first true, the second false; (d) the first false, the second true. The correct procedure is fixed: establish the truth of each statement independently, and only when both survive does the question of explanation arise. Most candidates lose these items not on facts but by allowing the plausibility of the pairing to substitute for the explanatory test.

WHAT COUNTS AS AN EXPLANATION. Statement (II) explains Statement (I) only if it gives the REASON that Statement (I) holds — if, knowing Statement (II), one could derive or at least account for Statement (I). Two true statements about the same subject, or two classifications of the same object, are not an explanation of one another. That is the whole content of the distinction between codes (a) and (b).

THE CLASSIFICATION OF TAXES. A DIRECT TAX is one whose impact and incidence fall on the same person and which cannot be shifted: income tax, corporation tax, capital gains tax. It is generally progressive and is assessed on ability to pay. An INDIRECT TAX is levied on one person but its burden is passed on to another through the price: customs duty, central excise, and the goods and services tax which subsumed most of India's indirect taxes from July 2017, after this paper was set. Indirect taxes tend to be regressive in effect, since they take the same amount from rich and poor buyers alike.

THE VOCABULARY OF TAX BURDEN, examined in its own right. IMPACT — the point at which the tax is levied, the person legally liable to pay it. SHIFTING — the process by which the burden is transferred to another. INCIDENCE — the point at which the burden finally rests. EFFECTS — the further consequences for production, consumption, allocation and distribution. Direct and indirect are defined at the impact-and-incidence stage; micro and macro classify the effects.

THE EFFECTS OF TAXATION, sorted by level. MICRO EFFECTS, on the individual household or firm: the ABILITY to work, save and invest, which a tax reduces by reducing disposable income; the WILLINGNESS to work, save and invest, in which a substitution effect discourages effort as the marginal rate rises while an income effect may increase it as the taxpayer works to restore a target income; and the pattern of consumption and the allocation of resources between uses, which taxes on particular goods alter. MACRO EFFECTS, on the economy in aggregate: the level of national income and output, employment, the general price level, the distribution of income between classes, and stability and growth. Taxation used deliberately to influence these aggregates is FISCAL POLICY.

INCOME TAX IN INDIA, for the factual anchor. Charged under the Income-tax Act, 1961. Levied by the Union under Entry 82 of the Union List, which covers taxes on income other than agricultural income; tax on agricultural income belongs to the States under the State List. Administered by the Central Board of Direct Taxes in the Department of Revenue, Ministry of Finance. Article 265 of the Constitution provides that no tax shall be levied or collected except by authority of law.

Key facts

• In an assertion-reason item, the truth of each statement is judged independently first; the question of explanation arises only if both are true.
• Code (b) applies when both statements are true but the second does not give the reason for the first.
• A direct tax is one whose impact and incidence fall on the same person and which cannot be shifted; income tax is the standard example.
• An indirect tax is levied on one person and its burden passed to another through the price; customs duty, excise and the goods and services tax are examples.
• Impact is where a tax is levied, shifting is the process of passing it on, incidence is where the burden finally rests, and effects are the further consequences.
• Micro effects of taxation are effects on the individual household or firm: the ability and willingness to work, save and invest, and the pattern of consumption and allocation of resources.
• Macro effects of taxation are effects on aggregates: national income, output, employment, the price level, income distribution and economic stability.
• Direct versus indirect classifies by shiftability, while micro versus macro classifies by level of analysis, and the two axes are independent of each other.
• Income tax in India is charged under the Income-tax Act, 1961 and administered by the Central Board of Direct Taxes.
• The Union's power to tax income other than agricultural income comes from Entry 82 of the Union List; agricultural income is taxable by the States.
• Article 265 of the Constitution provides that no tax shall be levied or collected except by authority of law.

Common traps

• Choosing code (a) because the two statements are both true and clearly related. Relatedness is not explanation.
• Deciding the explanation question before establishing that both statements are true.
• Reading 'consumption, saving and investment' as necessarily macroeconomic. In the classification of tax effects these are the decisions of the individual taxpayer.
• Supposing that a direct tax has only micro effects. Income tax affects aggregate demand and the distribution of income as well.
• Supposing that an indirect tax has no micro effects. An excise duty changes a household's pattern of consumption.
• Confusing impact with incidence. Impact is where the tax is levied; incidence is where its burden ends up.
• Forgetting that codes (c) and (d) are settled purely on the truth of a statement and never on the explanation test.

• practice — not a real PYQ

  Which one of the following is the defining characteristic of a direct tax ?

  • (a)It is collected by the Central Government rather than by a State
  • (b)Its impact and its incidence fall on the same person
  • (c)It is levied at a flat rate on all taxpayers
  • (d)It is collected at the point of sale of a commodity

  Answer(b) Its impact and its incidence fall on the same person — the taxpayer on whom the tax is levied is the taxpayer who bears the burden, and it cannot ordinarily be shifted to another. Which government collects a tax is a separate question, direct taxes are usually progressive rather than flat, and collection at the point of sale describes an indirect tax.

• practice — not a real PYQ

  In the classification of the effects of taxation, which one of the following would be described as a macro effect ?

  • (a)A taxpayer's reduced willingness to work longer hours
  • (b)A household shifting its purchases from one commodity to another
  • (c)A change in the level of national income and employment
  • (d)A firm's decision to postpone the replacement of a machine

  Answer(c) A change in the level of national income and employment — macro effects are those observed on economy-wide aggregates such as output, employment, the price level and the distribution of income. The other three describe the responses of an individual taxpayer, household or firm, which are micro effects.