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PUBLIC FINANCE
ECON 422

B.A. DEGREE IN ECONOMICS DISTANCE EDUCATION

PROGRAM

JANUARY 2007

BAHIR DAR

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Copyright is reserved to Bahir Dar University. Duplication of this material with out the consent of the
university is legally prohibited.

By
SEID HUSSIEN &

TADDELE MEKONEN (Ph.D)

REVISED BY

MIHRET JEMBER

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CONTENTS

PAGES

Unit 1 Meaning and Scope of public finance............................... 7

Introduction...................................................................... 7

1.1. Public Finance, Definition, Scope and overage............. 7

1.2. Public Finance and private 8

finance..................................

1.3. Need for public

10
Finance...................................................
13
1.4. The theory of Public
Finance..........................................

1.5. Functions of Fiscal 14

Operation.........................................
17
Exercise 1
17
Key points

Checklist
17

Unit 2 Public Expenditure........................................................... 18

Introduction....................................................................... 18

2.1. Meaning and Nature of Public Finance..................... 18

2.2. Scope of Public Expenditure........................................

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 2.3. Classification of Public expenditure.............................. 19

2.4Theories of Increasing Public expenditure....................

2.5. Canons of Public 19

expenditure..........................................
21
2.6. Effects of Public
expenditure...........................................
23
Exercise 2

Key points
25
Checklist
29

29

29

Unit 3 Public Revenue................................................................. 30

Introduction....................................................................... 30

3.1. Meaning and Source of Public revenue........................ 30

3.1.1Tax Revenue...........................................................

3.1.2 Objectives of Taxation............................................. 33

3.1.3 Canons of Taxation.................................................... 34

35

3.1.4 Features of a good tax system.................................

36

3.2. Theories of Taxation.....................................................

37

3.3. Taxable Capacities.....................................................

39

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 3.3.1. Factors Determining Taxable Capacity....................
43

3.4. Classification Of taxation and Types of Taxes............

45

3.4.1 Classification of taxation...........................................

45

3.4.2 Types of Taxes.........................................................

51

3.5 Impact, Shifting and incidence of tax............................

53

3.6. Effects of Taxation........................................................

55

Exercise 3
58

Key points
59

Checklist
60

Unit 4 Public Debt....................................................................

61

Introduction.......................................................................
61

4.1. Meaning and Nature of Public Debt...........................

62.

4.2. Necessity of Public Borrowing...................................

63

4.3. Classification of Public Debt......................................

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4.4 Effect of Public Debt.................................................

66

4.5. Burden of Public debt and debt trap.........................

68

4.6. Debt redemption......................................................

71

4.7. Public Debt Management...........................................

73

Exercise 4
74

Key points
75

Checklist
75

Unit 5 Macroeconomic Analysis of Fiscal policy 76

Introduction....................................................................... 76

5.1. Meaning and objective of Fiscal policy........................

77

5.1.1 Fiscal policy in inflation............................................

79

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 5.1.2 Fiscal policy in depression.........................................
79

5.2 fiscal policy and economic Growth.............................

80

Exercise 5
82

Key points
82

Checklist
82

Unit 6 Public Budget

83

Introduction.......................................................................
83

6.1. Meaning of Public Budget...........................................

83

6.2 Importance of Public Budget........................................

84

6.3 Principle of Budgeting.................................................

84

6.4 Objective of budgeting...............................................

85

6.5 Types of Budgeting................................................

85

6.6 Procedure of Budgeting..........................................

86

Exercise 6

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 88

Key points
89

Checklist
89

Model Examination
90

Assignments
93

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Module Introduction

Public sector plays an important role in accelerating the development of the

country.

Especially in developing countries the private sector is engaged mostly in the

production of consumer goods. Private investments on those sectors, which
require large investments, have long gestation period and where the return on
capital is uncertain is very low. There fore exclusive dependency on the private
sector cannot accelerate the pace of development. It is the public sector, which is
capable of making huge investment on these types of investments and in
establishing public sector enterprises. The public sector participation is not only in
financing but it is extended to a wide range of economic activities, which helps to
accelerate

development. The public sector is required to provide public utilities, to develop

basic and key industries, to develop natural resources, allocate resources, the
distribution of income. The government there fore collects an income from taxes
and other various sources and expends it to finance the various economic and
social works. There fore, in modern times the subject of public finance has of a
growing importance from the point of view of economic theory and policy .The
study of public finance is of vast concern and importance for the administrators
and economic policy makers because of the growing importance of government
interference for accelerated economic growth. The science of public finance
studies systematically and scientifically the income and expenditure of the
government and its control as well as administration. In a nut shell it is concerned
with how and through what different sources does government gets income, how

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it spends it for the public welfare and fulfillment of its requirements and how it
controls and administers this income and expenditure.

UNIT ONE

MEANING AND SCOPE OF PUBLIC FINANCE

Introduction

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During recent times with the emergence of the concept of welfare state, public
finance as a subject matter, has gained much popularity. In olden days when
monarchy was in fashion, the crown used to collect land revenue in order to feed
the armed forces. It was more or less a police state. But as time passes, the
function of the state increased. Now a police state has been changed in to welfare
state. The state has not only to maintain law and order in the country but it has to
fulfill a number of welfare functions for the society .the increasing role of the state
in the economic life of the nation would involve more spending by the state for the
economic betterment of the masses. In the modern era the various governments
all over the world have entered and are entering in to a number of public projects
for the economic and social betterment of their citizens such as rail ways, post,
telegraphs dams and heavy electrical projects etc. More over with the adoption of
planning in almost al the countries the scope of state activity has considerably
expanded

It is obvious that the state has to collect more revenue to meet out its
responsibilities towards the people of the country. With this background now
a day’s public finance has to be studied as a separate department of
economics.

Learning Objectives

Dear student! Up on completion of this unit you should be able to

 Know the reasons for public finance

 Identify the difference between private and public finance

 Identify the nature and purpose of fiscal functions

 Identify the different types of Fiscal Functions

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  Explain the allocation Function

 Explain the Distribution function

 Explain the stabilization function

1.1 Public finance Definition, Scope and Coverage

Public finance is one of those subjects, who lie on the borderline between
economics and politics .It, is concerned with the income or revenue raising
and expenditure incurring or spending activities of public authorities and with
the adjustment of the one with the other. Thus the science of public finance
studies systematically and scientifically the income and expenditure of the
government and its control as well as administration. In a nut shell it is
concerned with how and through what different sources does government
gets income, how it spends it for the public welfare and fulfillment of its
requirements and how it controls and administers this income and
expenditure. Though numerous individuals defined it differently, there is no
significant difference between them and all of them show it as a subject
which studies the income and expenditure of the government as it is defined
above. Thus most of the time contents of public finance are divisible in two
broad categories public income and public expenditure. And this implies
the fact that the science of public finance deals with the finances of the state.
But the scope of public finance is not only confined to public income and
public expenditure, it also studies the financial implication and other aspects
of such activities. More over it examines the mechanisms by which the above
processes are carried on

It was widely accepted that the principles of maximum social advantage is

the guiding principle in all the activities of the state in raising income and in
spending it. And the state ensures maximum social welfare by providing
housing facilities, medical facilities education and remove poverty setting up
relief funds and other security measures. Now a days every state under takes

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various measures to raise the productive power by providing the facilities of
infrastructure i.e railways, roads, power irrigation etc. It also helps in
controlling prices of essential commodities. It further takes measures against
inflation and depression.

In well-advanced countries, the governments are responsible for

maintaining the stability and expanding the level of employment to achieve
the goal of full employment. Developing countries, which are confronted with
various problems, the government is committed to achieve high economic
growth, to reduce high unemployment rate, to reduce inequality with in
individuals or regional disparities, to avoid the negative balance of payment
problem etc. The planners are trying to use scarce human and physical
resource in the most prioritized areas to achieve the desired goals.

The rise of modern states has been accompanied by an increase in the

number of functions and consequently the scope and importance of public
finance. However in general the government in a modern state provides the
following services.

 Security both in internal and external

 To control and regularize the economy

 Justice or the settlement of disputes

 The social and cultural welfare of the people through education, social
welfare schemes

 To make proper utilization of natural resources

 The regulation of moral standards

 The administration of the financial system, expenditure, revenues and

fiscal control

 Proper and efficient administration

Thus public finance has a close effect on investment and consumption which
easily be used for controlling aggregate demand and stabilizing economy, for

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attaining full employment through the use of proper combination of its
various instruments such as taxation, borrowing, expenditure.

In the light of the above discussion the scope of public finance may be
categorized as follows which are to be seen in detail in the coming chapters.

1. Public revenue 4. Financial administration

2. Public expenditure 5.economic stabilization

3. Public debt

1.2 Public Finance and Private Finance

Finance in general means public as well as private finance. Since we study

public finance as something distinct from the private finance, the question,
which we are faced, is what are the differences between private and public
finance that leads to the separate treatment of public finance

Dear student! Can you mention the difference between public finance and
private finance?

______________________________________________________________________________
______________________________________________________________________________
______________________________________________________________________________

Have you answered? Ok try to relate it with the coming discussions.

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Similarities

i. Rationality: both kinds of finance are based on rationality i.e

maximization of benefits. If some times the individual is tempted by
circumstances to act in an irrational and wrong way the government is
also subject to such circumstances in regard to expenditures. Of
course there may be unwise use by the government to its income.

ii. Borrow Funds: just as an individual can not have enough income to
cover his expenses and fills it by borrowing from others, the
government also unable to meet all its targets due to budget
constraint and borrow funds from others

iii. Common interest: both public and private funds may be go in to the
hands of selfish interest

iv. Both the private and the public sectors are engaged in satisfying the
wants of the society. The over all economic activities are divided
between the sectors and in some aspects their problems and decisions
are similar.

v. Both the private and public sectors have limited resources at their
disposal and both the sectors always endeavor to make optimum use
of their resources.

vi. Both engaged in production, exchange, saving, capital accumulation

investment etc

Differences

In spite of the above similarities there are however, there are glaring
differences between them. The differences between the two kinds of finances
are more remarkable than similarities in them and are discussed as follows

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 i. Public revenue is determined by public expenditure: In the words of
Dalton “while an individual income determines his expenditure, public
authority expenditure determines its income. An individual makes his
budget on the basis of the income he expects to receive. The
determination of what and how much he will buy depends mainly on
his income. But the state does not do so. It first sets out the plan of
expenditure it wishes to incur and then investigates in to the resources
from where it can raise funds to meet this expenditure. There may be
exceptions to this. To some extent an individual adjusts his income to
expenditure due to family burden or due to ambition of his own to buy
a certain thing, and try to work hard to earn more income so as to
meet his proposed expenditure. Similarly to some extent a public
authority also adjusts his expenditure to income.

ii. Welfare aspect: the existence of the state is for the welfare the society
as a whole and not for the god of any individual or group. The
individuals or corporations think of earning profits for themselves,
where as the aim of public enterprises, which run on profits or not is to
provide maximum benefit to the society. An individual wishes to save
after consumption, but a government has no such aim. On the contrary
a deficit budget shows that the government collects less from the
public and gives them more in the form of services.

iii. Long tem vision: since the state is a permanent body, its life is much
longer than that of an individual, and tends to see more towards
future. The government spends its funds in to the projects, which will
have fruit full benefits after a considerable time lag. But an individual
cannot wait so long. He is generally concerned with the immediate
enjoyment and seldom bothers for the future.

iv. Sources of income: on the income side, the sources of income of an

individual are relatively very much limited while those of the state are
relatively wide. The government unlike the individual can use its power
and authority. It has the power to levy taxes, to print notes, but an
individual can use none of these resources. In case of loans also, the

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 credit of an individual and the scope with in which an individual can
borrow is also limited. But the state can have internal as well as
external sources of loan.

1.3 Need for Public Finance

Dear student! As it is seen in the previous sections the functions of the state
in the economy has increased what ever the economic system is. The
government has performed a number of activities in the economy. But it is
generally accepted that, the composition of out put should be in line with the
preferences of individual consumers and that the market can adjust the out
put level to be produced and the price that these products will be sold sing
the interplay of demand and supply.

Dear student! Why not the entire economy be left to the private
sector? Are there economic criteria that can help us to decide whether an
activity should properly be in the public or in the private sector? Why that is
in a supposedly private enterprise economy, a substantial part of the
economy is subject to some form of government direction rather than left to
the invisible hand of market forces?

______________________________________________________________________________
______________________________________________________________________________
____________________________________-_________________________________________

Have you tried? Good

The basic nature of every economy lies in the scarcity of its productive
resources in relation to its wants. Our wants are unlimited while resources
available to any society are limited in their ability to produce economic goods
by both quantitative constraints. Land, which may be defined generally as
natural resource, is limited in quantity by the geographical area of the nation

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and by the magnitude of raw material deposits with in this land area. Labor
faces quantitative constraints as productive resources through the numerical
size and age distribution of the nation’s population, and qualitative limitations
through such determinants as the prevailing ethical, health and educational
standards of the society. Capital is limited in quantity by the societies past
capital formation behavior and in quality by the relation ship of its capital
stock to the prevailing state of technology. There fore every economy is
engaged in the solution of this problem of scarcity .It is this basic problem
and existence of unlimited wants which provide the logical ground for the
study of public finance.

Both public as well as private sectors of an economy may take different roles
in this total set up of economic activities .Of course the presence of
government role may reflect the presence of political and social ideologies
which depart from the premises of consumer choice. But there are some facts
that the market mechanism alone cannot perform all economic functions.
Public policy is needed to guide, correct and supplement the private one in
certain respects and the role of government is indispensable in every
economic system.

The forces of supply and demand and the price mechanism, as determined by
consumer sovereignty and producers profit motives, characterize private
sector resource allocation. Public sector allocation on the other hand is
accomplished through the revenue and expenditure activities of government
budgeting. In reality of course no economic society allocates all of its
resources though a single allocation institution. Instead each economy in the
world is mixed to one degree or an other, between market determined and
government determined resource allocation. if the market dominates ,the
system is usually referred to as capitalist and if the government
dominates ,it is a socialist economic system. There fore in the following
section we try to see the need for public finance in these economies.

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A. Capitalist economic system: Dear student! if you notice your discussion
in the course of history of economic thought, many thinkers since ancient
times has concerned on the issue of the role of the government in the nations
economic activity. On this Adam smith the founder of classical economics had
strongly argued on the efficiency of free market economy and strongly
opposes government interference in the economic activities of the economy.
Further he confined government interference to defense, the administration
of justice and provision of certain pubic goods and he gives no economic
rationality for the interference of government in other activities.

Dear student! Are you in favor of the above argument or not? If not
what other economic rationale can you give for the interference of the
government in the economy?

______________________________________________________________________________
______________________________________________________________________________
______________________________________________________________________________

Have you tried? Good

As it is indicated above capitalism does not exist in pure form anywhere.

Private enterprise operating in a market economy, will meet most desires of
consumers, especially in advanced countries like USA. There are however
some limited situations in which the market cannot function properly, and
then government takes some action. These situations have certain economic
characteristics that cause the market mechanism to fail. In such countries
where the private sector is rated high, the need for the public sector and the
importance of government activities have increased due to the following
reasons

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 Inequality in income and wealth: the market-oriented economy did not
satisfy the wants of the poor consumers nor did it improve their
economic conditions. Because production in the market is influenced
by demand conditions, poor people could not influence the type of
product to be produced .The producers will engaged in producing
goods that go with the needs of a few who could influence the market
by their conspicuous consumption, while millions of people remain with
out the basic necessities of life. In other words in this type of system
production is based on demand, not on the basis of necessity.

In addition in market system owners of scarce factors of production

enjoyed a high income while those of plentiful resources secured a low
income. This necessitates the government to intervene and promote
equitable distribution of income by means of taxes, expenditure and
social security laws.

 The private sector under the market economy also failed to produce
certain public goods like public health, defense, parks roads, bridges
etc that can be made available equally to all and which may not be
sold on a profit-making basis.

 Negative or positive welfare effect: In a market economy, producers

will maximize their benefit by producing that level of out put where
marginal revenue equals marginal cost at the market price. But in
some situations a private decision maker may not have to pay for all
the costs he causes the economy. The prices he will be using in his
decision will not fully measure the true values to the economy as a
whole. For example, a brewery that pollutes a river imposes a cost on
the society for which the factory is not charged. It reduces the value of
the river to the economy, since they will not consider this cost in its
profit maximizing calculation conversely the factory may benefit the
people around that locality.Thus private decisions based on only actual
costs or market price will not produce an optimal result. That means
there is divergence between private and social costs and benefits.

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 These divergences are called external economies or diseconomies. The
government can correct this divergence by taxing those who get the
benefit and subsidizing those who incur losses for maintaining
economic welfare under a private economy. And this rationale for
existence of public sector.

 Inefficiency of market system in some sectors: The supply of

electricity, gas telephone services etc which require a huge capital
usually is carried out most effectively if a single organization provides
the service in a community. Average costs fall with size, and if two or
more companies compete, they may to provide waste full duplicate
facilities. Thus a monopoly is typically the most efficient supplier. And
to combat inefficiencies due to competition in most countries, the state
operates such enterprises directly. Even in developed nations like USA
public agencies regulate price and service standards but leave
ownership to private sector.

 The sole motive of a private firm is profit maximization. Therefore

entrepreneurs under take only those industries, which have bright
chances of profit. Thus government has to engage in those activities
where profit is less but have a great economic importance.

B. Socialist economic System

In this system economic activities and decisions of the state are not guided
by commercial profitability but the totality of objectives market mechanism
assigned only a marginal role. With industry state owned, the government
must determine the economies price and production policies. Production
decisions are made through a central plan that sets the production targets for
industries. Price policies become an important instrument of public finance.
On the whole, socialist countries have not used their taxes systems to
promote income equality. They defend themselves on the grounds that with

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 all sectors publicly owned, the income distribution produced by the economic
system is satisfactory.

C. Mixed economic system

Dear student! What is the economic system that exists in Ethiopia

currently? From your observation what role does the government plays in the
economy. Is there any economic rationality for the interference of the
government in these economic activities? What role should the government play
and what economic activities should be left to the private sector, so that the
nation would achieve fast economic growth?
_________________________________________________________________________________
_________________________________________________________________________________
______________________________________________________________________________---

Have you tried? Good. Now try to relate your argument with the following

Most of the developing counties including Ethiopia are categorized under

mixed system. The concept of mixed economic system refers to that system
in which decision making process is shared by public and private sectors. Of
course all these countries do not follow any uniform pattern of economic
development. But in most of them, the state plays an important part in
directing resources for economic development. These countries have low
levels of income and capital formation, higher levels of unemployment, a low
order of resource utilization due to lack of monetization, price fluctuation and
several bottle necks including the administrative one, which hinder the
smooth operation of the economy.

In view of these common characteristics, the government in these countries

assumes direct responsibility in many cases for economic changes. The roles
of public sector in these countries are summarized as follows.

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 Private enterprises in most of the under developed countries focused
more for private gain rather than by public benefit, so that resources may
be used in areas with less economic importance. Direct intervention by
the government, therefore becomes indispensable.

 These countries also face also large fluctuations in income and prices from
to time. There fore it needs government intervention through different
instruments of fiscal policy as well as direct involvement to combat these
problems.

 Since these countries are characterized by low level of income, the private
sector most of the time are incapable to invest on some sectors, which
needs huge capital, but have lower return like electricity,
telecommunication, roads, education health and other infrastructure.
There fore direct government involvement is a must to brought rapid
development.

 Income disparities are high in developing countries where there is a wide

difference of income and wealth between the rich and the poor between
regions. Thus government involvement through its budgetary program
and other fiscal instruments of taxation, subsidy etc

1.4 The Theory of Public Finance

The theory of public goods provides a rationale for the allocation function of
public finance. As we have already discussed in the previous section, the
private market economy could not allocate all goods either efficiently or
equitably. Though the government does not take over the production and
distribution of goods in most cases, even in capitalist economies government
involves the provision of some goods and services. And involves in the
determination of proper tax shares to finance them and the private and social
valuations to coincide and the desired income distribution is achieved. In
view of this we have private goods and public goods. Public goods are goods,

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which made available, free of direct charge to the user and are provided
through budgetary mechanism to satisfy public wants. While private goods
are goods which go to satisfy private wants and are financed and supplied by
the market on price payments.

Dear student! The main focus of this section is on the economic principles of
efficient resource use to the public sector. But before that lets see the
conditions that make a good private or pubic.

A. Private goods

As it is defined above these are goods supplied by the market mechanism.

But for the market economy to secure an efficient use of resources in
providing for private goods the following conditions has to be met.

First, the market can function only in a situation where the exclusion
principle applies i.e those who do not pay the market price are excluded
from their consumption. Thus consumer A consumes a good because he pays
the price f or it and B is excluded from its consumption since he does not pay
the price. Exchange cannot occur with out property rights, and property
rights require exclusion.

Second, consumers must bid for what they wish to buy and thus must reveal
their preference to producer’s i.e. the existence of revealed preference.
Producers in trying to maximize their profits, will produce what consumers
want to buy and will do so at least cost. Competition ensures that the mix of
goods produced corresponds to consumer's preferences.

This process can function in a market for private goods such as food,
clothing, housing, automobiles and millions of other marketable private
goods. Because the benefit derived there from flow to the particular
consumer who pays for them. Thus benefits are internalized and consumption

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is rival. A bread eaten by individual A can not eaten by B. In reality various
difficulties arise. Markets may be imperfectly competitive; consumers as well
as producers may lack sufficient information about prices, product or input
qualities or be misled by advertising and so forth. For these reasons, the
market mechanism may not brought the expected efficient out come. But
even so, it does a good job and a better one than can be done otherwise.

Given the assumption of perfect competition, and exclusion principle and

revealed preference the economy will achieve efficient in production and
consumption. There will be no need for government intervention. But the real
world does not have these conditions and the government has there fore to
intervene to improve the allocation of resources. This leads to the case of
public goods.

B. Public Goods

The very nature of some goods and resources and services makes it difficult,
if not impossible, for markets to function efficiently. The problem is due to
either consumers being unable to exclude others from consuming precisely
the same good as they do, or producers being unable to exclude others from
consuming precisely the same good as they do, or producers being unable to
exclude consumers from enjoying the benefits of a product once it is
produced. One such case is the provision of public goods like defense,
education, health, public roads, and bridges etc which cannot be divisible in
consumption and if provided are equally available to all. This implies that
pubic gods are jointly consumed in equal amounts by more than one person
and further, when they are jointly consumed, consumption by one person
does not alter availability of the products to another person. Public goods are
there fore different from private goods in three respects.

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First, private goods permit exclusion principles while exclusion is not possible
for public goods. That is person as consumption is not affected by person Bs
or others consuming the same product.

Second for private goods benefits flow to a particular consumer implying

there by that benefits are internalized and consumption is rival. There fore
exclusion may be applied with out efficiency loss. But for public goods
consumption is non rival, As consumption does not reduce Bs consumption.
That is, benefits of these goods accrue collectively to the society. There fore
free market cannot efficiently allocate them. If these goods have to produce,
they must be produced b the government.

Third, the marginal cost of providing a private to an extra consumer is

positive, whereas in case of public goods it is zero. Take the case of a street
light; the services are used equally by all the people walking in that street.
The service cannot be parceled out to any specific group and the cost of an
extra person using the service of the light is zero. There fore it would be
inefficient to apply exclusion even if this could readily be done. Because the
derived benefit by individual A from the consumption of the service does not
hurt B and the additional cost is zero. The market, which works on the
principle of price, will be inefficient for such goods.

1.5 Functions of Fiscal Operation

Dear student! As we have seen in the previous section, the market system
may fail to allocate goods either efficiently or equitably. Thus the interference
of government in the economy is indispensable .The question there fore will
be what the proper scope of government is. According to prof. Musgrave,
although particular and tax measures affect the economy in many ways and

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may be designed to serve a variety of purposes, several more or less distinct
policy objectives may be set fourth. It means that fiscal operations of the
government, which consists of public expenditure and taxation, significantly
affect the economy in many ways and it may be used to achieve the following
objectives.

A. Allocation Function

Dear student! How the government allocates resources to the production of

different goods and services and why?
______________________________________________________________________________
______________________________________________________________________________
_____________________________________________________________________________

Have you answered the above question? Good. Now try to relate it with the
following discussion.

As you have learned in your microeconomics course, resources available to a

society are very limited but demand for goods and services, which can be
produced by these resources, are unlimited. Thus the unlimited scope of
aggregate human wants, along with the limited resources which produce the
economic goods capable of satisfying these wants, makes it necessary to

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allocate the scarce resources among alternative uses. An infinite or unlimited
quantity of economic goods cannot be produced. When certain goods are
produced with the scarce resources, the opportunities to produce other goods
are fore gone, assuming there is full employment of resources. Thus an
economic system must exist to determine the pattern of production, that is to
answer questions of which economic goods should be produced, and in what
quantities they ought to be produced. But the market system is not efficient
in allocating all resources. In some cases the market fails entirely, while in
others it can function only in an efficient way. And it requires government
involvement. The most important one is the case of public goods. Thus the
public sector is used to make provision of social wants or collective wants.
The needs of the community are called collective wants i.e defense, justice,
regulation and control of public enterprises, social and cultural welfare,
railways and roads etc. Besides the expenditure and revenue process of the
government is used to divide the total resources of the community between
private and social goods. It is also used to determine the proportion in which
different social goods are produced. . The provision is termed as allocation
function of the budgetary policy.

B. Distribution function

The revenue and expenditure process of the government may be used to

reduce disparities in the distribution of income and wealth. Prof. Musgrave
pointed out that among the various fiscal devices, redistribution might be
implemented most directly through the following measures:

 A tax transfer scheme, combining progressive income taxation of high-

income house holds with a subsidy to low income households.

 Progressive income taxes may be used to finance public services,

especially those such as public housing which particularly benefit low
income house holds

30
  A combination of taxes on goods purchased largely by high income
consumers and subsidies to other goods which are used chiefly by low
income consumers

C. Stabilization function

An uncontrolled free economy is characterized by fluctuations in prices and

employment. Apart from relatively short-term swings, secular
maladjustments may create problems of unemployment and inflation.

The revenue and expenditure process of the government may be used to

secure economic stability or to remove economic fluctuations and distortions
in the economy i.e plays stabilizing functions in order to limit the deviations
from higher unemployment and price instability. The over all level of
employment and prices in the economy depends up on the level of aggregate
demand, relative to out put valued at prevailing prices.

 If involuntary unemployment prevails, increase the level of demand i.e

increase the level of public expenditure and reduce the level of
taxation.

 If inflation prevails, reduce the level of demand I,e reduce level of

public expenditure and increase the level of taxation .

 If full employment and price stability prevail, maintain the aggregate

level of money expenditure i.e maintain the present level of public
expenditure and taxation, to prevent unemployment and inflation.

D. To accelerate economic development

31
In under development countries the per capital real income is low because of
insufficient productive resource and due to insufficient and ineffective use of
such resource. Certain market imperfection such as factor immobility, price
rigidity, ignorance of market conditions, rigid social structure and lack of
specialization have acted as frictions and impediment in the way of economic
progress, preventing the achievements of an optimum allocation of
resources.

More important, there exists vicious circle of poverty and under

development, which forces these countries to remain in a state of poverty.
Total out put in these countries is very low, and after consumption
requirements are satisfied little remains as surplus for capital accumulation.
Because of the low level of real income and high propensity to consume, the
flow of saving is small. Investment in capital goods is low on account of low
saving; and due to in adequate capital stock the level of real income is low
again. That means a poor country is poor because it is poor. Thus vicious
circle of poverty can be broken through heavy capital investment in the
economy.

Thus, the fiscal instruments in under developed countries are concerned with
allocating more resources for investment and restraining consumption. To put
it differently, fiscal instruments i.e taxation, borrowing, deficit financing and
public expenditure, are used for mobilization of resources to achieve
accelerated rate of growth with reasonable stability and to remove
inequalities in the distribution income and wealth, when fiscal instruments
are used to achieve such objectives it is known “ activating finance “

32
EXERCISE 1

1. What do you understand by public finance? In what way does public

finance differ from private finance?

33
 2. What is the role of public finance in the economic development of a
country?

3. What are the scopes of public finance in an economy?

4. The study of public finance has assumed increasing significance in the

field of economic analysis in recent years. Explain the statement?

5. Why public sector is needed in an economy?

6. What are public goods? What is its relation ship with efficiency and
market failure?

Important terms

Public finance

Public goods

Private goods

Exclusion principle

Revealed preference

Check List

Dear Distance learner, now it is time to check your understanding of

the meaning and essence of the following terms. Read the following
questions and answer them by checking in one of the boxes under
alternatives" yes" or " No "

34
 Yes No

Can you define public good?

Can you give examples of Public good?

Can you define positive or negative externality (spillover?)

Can you define Coase theorem?

What is public finance?

What are the scopes of public finance?

What are the different between public and private finance?

What is the need for public finance?

Is there any box that you marked "NO" under it? If there is please go back to
your teaching material and read about it before you go to the following
exercise.

Unit Two

Public Expenditure

Introduction

35
The concept of public expenditure plays a very prominent role in public
finance. In the 19th century economists especially Adam Smith advocates
minimal government activity and paid a very little attention to public
expenditure. Basically the functions of the government were restricted to
justice, police and arms. They were believed that government’s expenditures
are totally waste full and money can best utilized by the private persons
rather than government. With the passage of time the situation has changed
and economic activities have become complex which has forced the
economists to pay a great attention to public expenditure. Thus in modern
times the subject of public expenditure has earned great significance

Objective

Dear student! Up on the completion of this unit you should be able to:

 Identify different reasons that cause increased public expenditure

 Examine the impact that increased expenditure will cause in the

economy.

 Describe the different theories of increasing public expenditure

 Explain Wagner's law of increasing state activities

 Explain Wiseman peacock Hypothesis

 Explain the importance and kinds of public Expenditure

 Explain public Expenditure and Economic stabilization

 Explain public Expenditure and production.

2.1 Meaning and Nature of Public Expenditure

36
Public expenditure is the expenditure incurred by public authorities’ i.e
central, state and local for the satisfaction of collective needs of the citizens
or for promotion of economic and social welfare. Government plays a large
role in the economy, as regulator of the private sector, as supplier of public
service and many other ways so that it incurs expense.

Dear student! Similar to private expenditure public expenditure is made in

expectation of returns, which may be expressed in many forms. But there are
some unique features that it different to private expenditure. First; public
expenditure determines the amount of income where as private expenditure
is determined by the individual’s income i.e private finance (firms or
individuals) starts with the given income plan with in which expenditure must
be planned, public finance on the contrary starts with a given expenditure
plan and the authorities adjust their income by means of taxes and others.
Second, public expenditure is not profit motive where as private expenditure
is strictly based on the objective of maximum profit. Third, the target for
public expenditure is maximum return for the state as a whole, while private
expenditure is limited to personnel level. Finally public expenditure is
influenced by various politically motivated and social aspects while there is
no such consideration or influence on private expenditure.

2.2 Scope of Public Expenditure

37
As it is mentioned earlier the government has made expenditure to maximize
social welfare or with the objective of maximum return to the nation as a
whole. In doing so how ever, involvement in every aspect of the economy
could not bring the desired maximum return. Depending on the nature of the
commodity the private sector is efficient in the case of some goods but not in
others. Thus public expenditure is undertaken to satisfy those wants which
the people in their individual capacity are unable to satisfy efficiently. A
person in his individual capacity has no control over so many resources,
which may be required to start the school, to open a hospital or to construct a
high way. Even if the individual has the resource to finance all these, supply
using the market principle may be more efficient quick and economical. It is
reasonable there fore for the state to delimit its scope and incurs that
expenditure which the people in their private capacity either would not or
cannot incur. Of course, these scopes differ from one economic system to
other.

In socialist country, the public sector directly produces most of the goods and
services and thus increases production and employment as it is indicated in
planned programs of the country. But in mixed economies, where the private
sector plays an important part, the public sector influences production and
employment mostly by indirect methods. This is particularly so in some
countries where the private sector is sufficiently strong to maintain economic
efficiency .In under developed countries like Ethiopia, how ever, direct
intervention by the government becomes inevitable to transfer the economy,
though the private sector is allowed to play an important role in the process
of production. The scope of public expenditure in such under developed
countries of mixed economies can be stated as follows.

 The public sector produces some important public goods, which the
private sector cannot produce since the benefit of these goods, accrue
collectively to the society.

38
  The government may subsidize the private production of certain partial
social goods for increasing their out put. In such cases the external
benefits are recognizable and appropriable and the market can
allocate these goods efficiently if certain subsidies are given by the
government so that their prices reflect marginal social cost.

 In underdeveloped countries, the public sector may have to produce

certain private goods which are considered important from the point of
economic development and which the private sector is unable to
produce due to lack of adequate resource, lack of enterprise or
technical know how or lack of experience. The public sector may also
produce these goods to have strategic control over the economy.

 Public expenditure may be used as a balancing factor or contra cyclical

measure to attain full employment and maintain stability.

 Public expenditure may bring about equitable distribution of income

between different sections of the community.

2.3 Classification of Public Expenditure

Classification of public expenditure refers to the systematic arrangement of

different items of states expenditure on some scientific and economic basis
from which one is enabled to distinguish between the nature and effects of
different types of public expenditure. The government has in any nation
performed many functions, which involve expenditure of different type
according to the classified activities of the government. These expenditures
will have different economic, social and political effect on the state. Thus this
classification is necessary for a clear understanding of the nature and effects
of various branches of public expenditure.

Different economists like C.C Plehm, Nicolson, Adam Smith, J.S Mill, and
Rosher Dalton have given their own style of classification of public

39
 expenditure. But these classification do not investigate the changed nature of
the state activities, instead they represent the same thing in different ways.
C.C Plehn, for instance classifies on the basis of benefit as: public
expenditure, which specially benefit certain people, public expenditure, which
benefits equally to all. Adam Smith has classified public expenditure
according to the functions of the government as: Protective, commercial and
development expenditure. Nicholson on the other hand categorizes on the
basis of revenue in that public expenditure with out direct return of revenue
(example poor relief on some cases), expenditure with out direct returns but
with indirect benefits to revenue (example education expenditure with the
assumption that educated people are better tax payers), expenditure with full
return or even profit like that of post office, gas service and generally public
enterprises etc.

However, this way or that way the reason for public expenditure is to
maximize the social welfare and to enhance fast economic growth. Thus here
in this section we can take up to most important classifications of public
expenditure, each of them indicating an area of possible effects on the
economy.

i. Productive and un productive

ii. Transferable and non transferable expenditures

Dear student! Let us discus each of them one by one

i. Productive and un productive

Dear student! What payment made by the government have you

observed? Can you classify which payments are productive and which are
unproductive?
______________________________________________________________________________

40
______________________________________________________________________________
______________________________________________________________________________

Have you tried? Good

This classification emphasizes that while some expenditure is in the nature of

consumption; others are in the nature of investment and help the economy in
improving its productive capacity.

Accordingly those expenditures, which enables the economy to produce more

in the future directly or indirectly such as expenditures on social over heads
(construction of roads, schools, hospitals, telephone, electric power etc). The
productive power of the society can increase in the form of human wealth. If
through education, training, health, better living conditions etc, the working
population of the country can add to its productive power and the
expenditure on such items should certainly be termed productive (though
they are productive).

There are also certain expenditures with out which the economy can not live
and can not maintain its productivity. Such expenditures indirectly help the
economy in attaining higher levels of productivity. Fore instance expenditure
on research and expenditure on made to build efficient administration,
communication and other infrastructural facilities indirectly add to the health
and efficiency of the economy.

On the other hand some times the government has made expenditure for
waging wars, for ceremonial purpose etc. Such waste full and avoidable
expenditures are termed as unproductive.

41
 ii. Transfer and non transfer expenditure

This classification was favored by Pigou Transfer expenditure is a payment

with out corresponding receipt of goods and services by the state .For
example old age pensions and unemployment benefits. In this case the
government has transferred the right to use goods and services to certain
sections of the society to enhance the social welfare. In contrast non-
transferable expenditure is that by which the state pays directly for the use
of goods and services. Such a use of resources by the state may be for
consumption or for investment purposes. These include expenditure on
defense, education etc and are all non-transferable or real expenditure. The
difference is that in the case of transferable expenditure the beneficiaries
have the right to decide about the use of real resources, but in the case of
non transferable, it is the state which uses directly.

2.4 Theories of Increasing Public Expenditure

The earlier economists have almost ignored the importance of which the
public expenditure has in the study of public finance. Because the notion,
which the economists of that period has in their mind is that of laissez-faire.
They advise expenditure by the government in the matters of defense and
protection. But after the world depression of the1930s J.M Keynes
revolutionaries the economic thoughts. Keynes and onward economists have
expressed that the public expenditure plays an important role to achieve
definite objectives.

In the modern era, a democratic government has to perform many functions

with in its territory for the betterment of its citizens, which might not other
wise, is provided by the private sector. As a result there exists an increasing

42
trend in public expenditure from time to time. Many individuals have
examined many reasons responsible for the tendency of increasing volume of
expenditure.

Dear student! Here in this section we will see three important and
well-known theories of increasing public expenditure: Wagner’s law
and Wise –Man peacock hypothesis.

Let you try some of the general causes for the increasing trend of public
expenditure examining the real situations in Ethiopia and in the world.

______________________________________________________________________________
______________________________________________________________________________
______________________________________________________________________________

Have you tried? Good. Now try to relate your answer with the following
discussion.

i. Wagner’s law of increasing state activities

Adolph Wagner (1835-1917) was a German economist who based his

law increasing state activities, on the experience of Germany. According
to Wagner, there are enactment tendencies for the activities of the state
to increase both intensively and extensively. Accordingly, a functional
cause and effect relationship existed between the growth of an economy

43
 and the government's activities. The following are reasons for the
increase in public expenditure.

1. The traditional functions of the state expand. The traditional

functions of the state include: defense, administration, and
maintenance of law and order. These functions become
more expensive and cumbersome as society progresses and
these results in an increase in public expenditure.

2. State activities increase in coverage. In addition to the

traditional, activities of the state modern governments
undertake various welfare measures such as outracing the
cultural life of the society, provision of social security,
subsidies and direct provision of merit goods and public
goods. The state also undertakes necessary measures to
create a better condition of distribution of income. All of
these push up the total public expenditure.

3. The growing need for public goods which results in the shift
of the composition of national product in favor of public
goods forces the government to expand its investment there
by expounding its expenditure

4. Population growth and urbanization also cause public

expenditure to expand over time.

5. Social progress: the social progress leads a growth in the

government functions which in turn leads to the absolute and
relative growth governmental economic activity.

Wagner's Law was based on historical facts and emphasized the long term
trend rather than the short term changes in public expenditure

44
It can be argued that in the initial stages of economic growth the state might
expand its expenditure at a faster rate than the rate of the economy. But at
a later stage the state activities can be considered to grow at a slower rate
than the overall growth in the economy.

Additional factors, which contribute to in public expenditure, are:

1. A continuous increase in prices

2. The growth in the quantity and quality of the goods and

services purchased by the government for its own
maintenance

3. The increasing state activity in regulation economic

fluctuations

4. The increasing public debt which results in heavy debt

services

5. The growth in the public sector as a result of increasing

acceptance of economic planning and the growing
efforts on the part of the government to promote saving
and accumulation of capital.

ii. Wiseman- Peacock Hypothesis

Allan T. Peacock and jack Wiseman based their study on public expenditure in

Britain for the period 1890-1955. According to the hypothesis the public
expenditure does not increase in a smooth and continues manner, but in a
step- like fashion. The general approach of the hypothesis is inclusive of the
following three separate, though related concepts.

i. Displacement effect

45
 ii. Inspection effect

iii. Concentration effect

Major social and other disturbance takes place at limes and this result in the
need for increased public expenditure and revenue. In this way public
expenditure moves from the pervious lower level to a new and higher level of
expenditure and taxation. This is referred to as the displacement effect.
After the removal of the cause of the displacement effect (e.g. removal of
war) a new level of tax tolerance is reached and this supports a new level of
public expenditure.

Moreover some of the increased government outlays (such as debt interest)

are direct result of a social disturbance other expenditure frequently involve
the expansion of the government activity in to new areas of economic
activity. War or other social disturbances force people and governments to
seek solutions to important problems previously neglected. This regard to the
inspection effect. Wiseman and Peacock also refer to the concentration
effect. This concept refers to the fact that the government assumes a larger
proportion of the total national economic activity. The concentration effect
also refers to the apparent tendency of central government economic activity
to grow faster than that of the state and local governments. This means that
the economic activity of the central governments becomes an increasing
proportion of the total public sector as a society experience economic growth.

Wiseman-Peacock hypothesis emphasizes the recurrence of abnormal

situations, which cause a sizable increase in public expenditure and revenue.
This refers to the apparent tendency for the central government economic
activity to become an increasing proportion of the total public sector
economic activity when the society is experiencing economic growth. The
hypothesis was based on the particular tendency and cannot identify all the
forces at work.

46
In addition to such factors like population growth urbanization, defense and
administration expenditure, price, etc. an important force that has had to an
increase in public expenditure is the failure in the market mechanism to
enable the economy achieve it objectives efficiently. The deficiency in the
market mechanism is responsible for economic instability such deficiencies of
the market like income and wealth inequalities defective patterns, of
consumption unemployment, etc. call for the expansion of the activities of
the state into these spheres and thereby lead to a corresponding in public
expenditure.

III Colin Clark (critical Limit) Hypothesis

This hypothesis was developed immediately after the Second World War. It is
concerned with the tolerance level of taxation. The critical limit hypothesis
concludes from the empirical data drawn from several western countries for
the interwar period that inflation in the economic necessarily occurs when the
share of the government sector, as measured in terms of taxes and other
receipts, exceeds 25% of the aggregate economic activity in the economy.

The hypothesis is based on the following institutional factors:

1. When taxes collected by the government reach the critical limit of 25%
ratio of the aggregate economic activity reflected in the gross national
product, the community behavior patterns change and people become
less productive since incentives are harmed by the fact that increasing
proportions of additional income must be paid in taxes under a
progressive tax system.

2. People become less resistant to various inflationary means of financing

the government expenditure. Thus, the loss of incentive tends to
reduce the aggregate supply while the increased purchasing power
resulting from inflationary financing techniques tends to expand
governments aggregate effective demand. Inflation tends to result

47
 form this new aggregate supply -aggregate demand equilibrium under
conditions of higher employment resources

2.5 Canons of Public Expenditure

Though the volume of public expenditure is not less important but the
method and direction in which the public expenditure is executed has of
paramount importance. It is the principle of public expenditure, in fact, which
determines the efficiency and property of the expenditure itself. The canons
or principle of public expenditure are concerned with finding out those
fundamental rules which should govern the public expenditure policy of the
government. There are various canons suggested by various economists,
which the fiscal authorities must take in to account while formulating their
expenditure policies.

The allocation of the public fund cannot be done in arbitrary and haphazard
way. More over, the public cannot tolerate this in this democratic age and
there will be too much hue and cry if allocation of the public fund is done in
an arbitrary and haphazard way. It should promote the social welfare, Prof.
Findley Shirras has the unique contribution in this regard .He has described
four most important canons of public expenditure. These are canons of
benefit, canon of economy, canon of sanction and canon of surplus. These
canons are discussed below.

i. Canons of benefit: According to Prof. Shirras “other things being equal,

public expenditure should bring with it important t social advantages
such as increased production, the preservation of the social whole
against external attack and internal disorder, and as far as possible a

48
 reduction in the in equality of incomes. In short public funds must be
spent in those directions most conducive to public interest i.e
maximum utility is to be attained in public expenditure”

ii.

Public expenditure should be so planned that it would result maximum social

advantage and social welfare. Public wealth should not be utilized for the
benefit of a particular group or society but it should confer benefits on the
entire society in an equitable manner. This principle of social benefit in the
theory of public finance is similar to the equi- marginal utility in the theory of
consumer behavior. Thus public authorities should distribute its resource in
such a way that marginal utility from all uses should be equal.

iii. Canon of economy: This canon implies the state should be economical
in spending money. The waste full and extravagant expenditure must
be avoided and expenditure must be productive and efficient

iv. Canon of sanction: This canon asserts that no public funds should be
used with out proper authorization and further that funds must be used
only for the purpose for which they have been sanctioned. In a
democratic set up, it is the legislative, which sanctions the expenditure
on demand by the executive authorities. The idea is that such a
restriction would avoid unwanted expenditure and will also be a check
against misappropriation of funds.

v. Canon of surplus: This canon should actually be interpreted to mean

that the government should avoid deficit budgeting at least a
persistent one. In the modern times, the balanced budget is not always
considered good. It depends up on the condition of the economy.
Balanced budget is desirable when there is full employment and price
stability. In the inflationary condition, a surplus budget is desirable,
because it will reduce the excessive purchasing power purchasing
power in the hands of public. On the other hand, deficit budget is

49
 desirable in times of depression, because it will increase the
purchasing power of the people and will increase the effective
aggregate demand and brings equilibrium between demand and the
current out put. Thus the canon of surplus has lost the importance in
present times.

Dear student! In addition to these four important canons of public

expenditure, there other few canons of public expenditure suggested by
other economists. These are:

 Canon of elasticity: the canon of elasticity means the

expenditure policy of government should be flexible i.e it would be
possible to change the size and direction of public expenditure according
to the requirements of the country. There fore expenditure policy of the
government must be elastic rather than rigid. It should be formulated in
such a way that it may not fail in times of emergency like war or in
financing usually large development programs.

 Canon of productivity: the canon of productivity implies the

expenditure policy should be such that would encourage the production
of the country. This means that the major part of the public expenditure
should be allocated towards productive and developmental purposes.

 Canon of Equitable distribution: One of the for most aims of

public expenditure is also to ensure the equitable distribution of income
by conferring more benefits on the poorer section of the community.
Hence the canon of equitable distribution is more significant for the
countries w here the gap between the highest income group and the
lowest income group is very wide.

Dear student! You have to remind that all the above mentioned canons of
public expenditure do not have the same importance all the times for all
countries .It depends on economic, social and other objective of the country.

50
 1.6 Effects of Public Expenditure

Dear student! So far we have seen causes for public expenditure,

characters tics of public expenditure, the nature of public expenditure. In this
section we will see the effect of public expenditure in the economy. What
positive as well as negative effects do you think these expenditures made by
the government will have in the economy? Let you try
________________________________________________________________________________
________________________________________________________________________________
________________________________________________________________________________

Have you tried? Good. Now try to relate your answer with the following points

It is always expected that expenditure, which is incurred by the government

according, exert its important healthy effects on the entire economy of a
country. The final effects of public expenditure in the form of great
production and more equitable distribution of income and wealth in the
community are always expected to be present if it is incurred with utmost
rationality. Thus it is important to consider the impact of public expenditure
on the levels of employment, production and income, on achieving the
optimal allocation of resources, stability of prices, creation and maintenance
of full employment and amore equitable distribution incomes in the country.
The influence of public expenditure on the level of economic activity and on
the distribution of income will depend on the nature of the government and
the period during which public outlay is made. Although the effects of public
expenditure have wide ramifications, we shall consider only the important
effects of public expenditure.

The following are possible effects of public expenditure.

1. Public Expenditure and Economic Stabilization

51
With the further development of the economy, the market economies
experience stronger trade cycles. This means, there are fluctuations in
income, employment, and prices. The Great Depression of the 1930s was an
example of trade cycle. According to Keynes, the basic cause of the failure of
the market economy and economic fluctuation is the deficiency of effective
demand. The causes behind low effective demand are a low propensity to
consume and low marginal efficiency of investment. Therefore, a continuous
injection of additional purchasing power is necessary in the form of direct
government investment in order to stimulate consumption. The direct
government investment is part of public expenditure. The public expenditure
adds to the demand and through a multiplier effect which results in an all-
round increased in demand, the state of depression is cured.

In general during depression the state is expected to increase total spending

in the economy to stimulate effective demand. It need be, this can be done
through deficit financing.

During unlimited economic expansion or a boom, the need is to lower the

excess demand. This can be done through reducing public expenditure while
maintaining the same amount of taxation and/ or borrowing in this way a cut-
back on government expenditure can ease inflationary pressures.

It must be remembered that the use of public expenditure as an anti-cyclical

weapon presupposes the existence of a well-developed free market economy.
In the developing countries were there are technical and other rigidities
public expenditure may not be easy tool. Developing countries suffer from
shortages of particular materials, machinery, skilled labor and means of
transportation and communication. Certain industries and therefore,
adequate productive capacity are lacking. Moreover, developing economies
have inelastic demand for imports, while the demand for there exports are

52
weak. This condition complicates the problem of economic fluctuations in the
developing countries by distressing sales when export prices fall and
increasing import costs when prices of imports rise.

In summary in developing countries, public expenditure has a limited use in

stabilizing the economy. In order to achieve effective results, public
expenditure has to be used in combination with other measures such as
import and export subsidies, etc.

2. Public Expenditure and Production

The level of production and employment in any country up on the following

factors.

a) Willingness of people to work save and invest

b) Ability of people to work, save and invest

It is possible to influence all these three important factors through effecting

the size and direction of public expenditure. If the public expenditure so
affects the efficiency or income of the people in the country that they are
able to invest a considerable part of their income after saving it, it is obvious
that the productive potential of the country will increase. More over, certain
sectors of the economy can be made more efficient and productive by
conferring on them direct assistance or subsidies. Public expenditure incurred
on providing the generalized social services like education, public health,
justice etc tends to raise the efficiency of the nation as a whole. In this
manner the expenditure of the state in the interest of the whole society
promotes peoples efficiency to work save and invest, which necessarily
boosts up the production. On the other hand, if the state provides certain
sectors with special public investments through direct financial assistance

53
and subsidies, it will certainly add to the total investment and there by
contribute to wards increasing economy's productive potential.

Public expenditure also affects people's willingness to work in future. The

expenditure policy of the government influences the decision of the people in
future as to which part of their income may be available for saving and
investment. If the people do not expect any rise in their income in future,
their willingness to work in present is most certainly likely to be adversely
affected. Like wise, if they consider that their present savings and
investments will not earn for them any income in future, their willingness to
save and invest is also substantially reduced and vice versa.

In the developed economies (where there is deficiency of effective demand)

public expenditure can add to the effective demand and create conditions,
which favor higher level of production. But it should not necessarily be in the
form of productive investment; if not, it will result in inflationary situation.

In developing economies public expenditure can result in higher production

by expedient direct public investment and by stimulating private investment.
The growth in investment creates social over-heads skilled labor, and can add
to capital equipment and machinery. These can result in higher productivity.
In this way, capital accumulation can grow there by leading to accelerate
economic growth.

In summary, in a developing economy, public expenditure can help the

growth of production in the following ways.

a. It can narrow the gap between private savings and investment

needs, thereby adding to the accumulation of capital and growth of
production.

54
 b. It can be used to create demand for various domestic products and
thus stimulate private production.

c. it can help private investment and production through measures

which reduce the cost of production, or push up demand or remove
particular shortages and obstacles. Creation of social overheads
would lead to an all-round reduction in cost of production and
improvement in efficiency. This leads to growth in profitability and
production

d. By promoting integration of the economy through the creation of

social overhead, public expenditure can help narrow the gap
between regional economic growth

e. Public expenditure can be used to create basic and key industries,

power, irrigation mines etc, thereby creating the necessary
infrastructures a firm basis for economic growth

f. Public expenditure can be used in creating and promoting

educational and research facilities.

However, in using public expenditure to accelerate economic growth in a

developing country, the following points should be considered.

I. The various projects have a long gestation period, i.e., it

will take a long time before the projects can start yielding
output, and in the short-run an inflationary situation might
arise.

II. On account of erroneous planning and execution a lot of

wastage can take place in public expenditure. This must
be avoided.

III. Care must be taken to choose the most appropriate and

most useful projects. A proper cost-benefit study is to be

55
 undertaken for each project and those projects, which
satisfy the cost- benefit criteria, should be given priority.

IV. Financing of public expenditure has to review constantly

for its inflationary effects. For instance, finance
expenditure through printing money and borrowing can
contribute to price rises.

2. Public Expenditure and Distribution

One of the undesirable outcomes of the market mechanism is the inequality

of income and wealth. Such inequalities result in a social and economic
injustice and also distort production and employment patterns.

Public expenditure can be used as an instrument by which income

inequalities can be reduced. Different forms of public expenditure, especially
those that can help the poorer sections of the society, can result in a shift
towards equality of income. The following measure can help the poorer
sections of the society.

a. Free education, free health service, supply of water, etc,

b. Social security measure, such as old-age pensions unemployment

benefits, sickness allowances, etc

c. Subsidies for the production of a citoles of common consumption

like food

d. Production of goods which are in short supply

e. Ensuring the supply of merit goods' through purchases subsidies

and production

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 The effects of public expenditure on distribution of income depend upon the
nature of spending made by the government. Certain types of spending
benefit only a few sections of the society, for instance unemployment
benefits, etc help the poorer sections, while expenditure on roads, railways,
electrification, water supply defense, police and courts benefit the whole
society. These do not have appreciable effect on redistribution.

The distributions of public expenditure are subject to two considerations.

a) The classes, which are taxed heavily, may work less and save less

b) The classes, which benefits may reduce their efforts to work harder.

Roll of public Expenditure in Developing countries

Most of the people in developing countries are engaged in agriculture to get their
ends meet. There is a shortage of capital. Public expenditure in such economies
plays an important role in increasing the rate of capital formation. The basic
objectives of developing countries are to attain a rapid economic growth in public
and private sections. Achievement of more employment opportunities and
bringing about an equal distribution of income and reconstruction of the
agricultural sector is the main objective of these countries. In order to achieve all
these, the public expenditure must be incurred in such a way that they may be
achieved, which requires balanced growth of different regions of the economy.

In the initial stages of economic development the government must give top
priority to agricultural and allied sectors, which provide a basis for industrial
development by providing raw material and food supplies. There for considerable
amount will have to be spent on dams, irrigation projects, soil conservation etc. It
should also spent large amount on mineral development for increasing raw

57
materials for modern industries. The government must also concentrate on social
and economic overheads. . By increasing its expenditure on the social overheads,
a government can contribute to economic growth. . The increased expenditure on
economic overheads such as railways, roads, shipping, natural resources, social
conservation etc contribute considerably to development because they are
considered to be the basic foundations of economic growth. When public
expenditures are made on such social overheads, the external economies in the
form of availability of skilled and efficient labor force and efficient means of
transport and communication are automatically created. This would provide
greater incentives to private entrepreneurs so that it is likely to raise the volume
and rate of investment in the private sector. Thus the incentives to investment to
modern industries would tend to rise.

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Exercise 2

1. Public expenditure has a tendency to grow very fast in modern times.

Briefly discuss the factors responsible for the rapid growth of public
expenditure

2. Describe the different canons of public expenditure. Which canons are

a must to be followed by developing countries like Ethiopia for the
achievement of different prior objectives settled by the planning
authorities or other concerned bodies?

3. Explain the effects of public expenditure on production and

distribution

Check List

Dear Distance learner, now it is time to check your understanding of

the meaning and essence of the following terms. Read the following

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 questions and answer them by checking in one of the boxes under
alternatives" yes" or " No "

Yes No

What are the difference & similarities between public and private finance?

What is the scope of public expenditure?

Wagner's law of state expenditure

Wiseman's law of state expenditure

The canons of public expenditure

Effects of public expenditure

Role of public expenditure in developing expenditure

Is there any box that you marked "NO" under it? If there is please go back to
your teaching material and read about it before you go to the following
exercise.

UNIT THREE
PUBLIC REVENUE

INTRODUCTION

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Government is an economic unit, which has legal and political power to exert
control over individuals, business firms, and markets. The necessity of public
revenue is due to the necessity of public expenditure. As the government has
to perform certain functions for the welfare of the public and these functions
are not performed free of cost, they involve expenditure It provides social
goods and services such as defense, health services, education, streetlight,
highways and other infrastructures. To finance them it needs income. Thus
the amount of public revenue to be raised is a function of necessity of public
expenditure. The government there fore has to think of how and from where
and how much revenue should be raised from the public. The government
can collect revenue from different sources .The income of government
through all these sources is called public revenue. Of these various sources of
government revenue taxation is the most important one. Therefore, this unit
will be emphasized more on taxation and it's effects.

Learning Objectives
Dear Student! After completing this unit, you will be expected to:

 Define concepts like public receipt, revenue receipt, tax

 Describe the different sources of public revenue

 Explain the concept of tax revenue.

 Analyze the objectives of taxation

 Describe the different canons (principles) of taxation

 Analyze the theories of taxation and their relevance under developing

countries context

 Explain the classification of taxation and the different types of taxes.

 Show the effects of taxation

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  Identify what taxable capacity is and the difference between absolute
taxable capacity and relative taxable capacity

 factors determining taxable capacity

3.1 Meaning and Source of Public Revenue

Dear distance learner! Have you ever paid taxes imposed by

government, fees for services rendered, and special payment for benefits
that you have got from improvement of infrastructure made by government,
fines and penalties? Or have you observed people while paying either of
them? Why do you think government collects them?
_____________________________________________________________________________

______________________________________________________________________________
______________________________________________________________________________

Have you answered all questions? Ok, good. Now relate your answers with
the following explanation.

It is clear that government collects income from different sources to cover its
expenditure. The term public income, according to Dalton, has two senses:
wider and narrow.

In it's wider sense, it incorporates all receipts and incomes that a public
authority may get during any period of time irrespective of their sources and
nature and is called public receipt But in it's narrow sense it includes those
sources of income of the public usually known as public revenue, which
excludes public borrowing and income from the sale of public assets. The
distinction is that in its narrow sense it includes only those sources of
government income which are not subject to repayment while in the broad

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sense of the term, it includes all the receipts of a government irrespective of
the fact whether these are subject to repayment or not.

Dear learner! What are the important sources that federal or local
governments used to collect revenue? OK. Try to relate it with the coming
analysis.
______________________________________________________________________________
______________________________________________________________________________
______________________________________________________________________________

Generally government sources of revenue are generally divided as tax revenue and non-tax
revenue

Tax revenue - In every country, the largest part of the public revenue is
raised through taxation and mainly it incorporates the following three
sections.

i) Taxes on income and expenditure- it deals with taxes that are

imposed on receipts and expenditures such as corporation tax,
income tax, expenditure tax, interest tax and other similar taxes.

ii) Taxes on property and capital transaction- this part includes taxes
imposed on specific form of wealth and its transfer.

Example, estate duty, wealth tax, gift tax, house tax, etc

iii) A tax on commodities and services -it is concerned on taxes levied

on production, sale, purchase, transport, storage and
consumption of goods and services.

Non-tax revenue

Public revenues received through administration, commercial enterprise, gifts

and grants are non- tax revenue of the government.

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i) Administrative revenue- under administration public authorities can get
income in the form of fees, fines and penalties, and special assessments.

- Fees - are charged by the government for providing services to

the beneficiaries. For instance, court fees; passport fees, license
fees etc are grouped under this category. They are to be paid
by those who receive some special advantages. More or less
there is free choice on the part of the payer. Fees are different
from prices because prices are always voluntary payments but
fees are compulsory contributions even though both are
expended for special services. According to Lutz a license fee is
paid in those instances in which the government authority is
invoked simply to confer permission or a privilege rather than to
perform a service of a more tangible and definite short. Thus
when the government realizes a license fee, no direct service is
rendered but permission is granted for doing certain things or
activities.

- Fines and penalties- are imposed and collected from offenders

of law as punishment. The main purpose of these impositions is
not to obtain as much income but to prevent the offense and
violation of laws of the country. Therefore, collections from
these impositions are negligible as a source of revenue.

- Special Assessments- as Seligman pointed out that “Special

assessment is a compulsory contribution imposed in proportion
to the social benefits derived to defray the cost of a specific
improvement to property undertaken in the public interest."
This means when government carries out certain public
improvements such as construction of road, street lighting etc it
may provide special benefit for those who has properties near
by. Consequently, values, i.e. rents, of these properties may
rise. Therefore, some special levy may be imposed on them to
recover a part of the costs so incurred. Fore instance the rent or

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 prices of houses in a certain locality may increase due to the
fact that the government has made it accessible for trains,
airplanes .The government may charge special assessment from
the house owners of that locality in the proportion of the
increase in the price of the houses. Special assessment,
however, is imposed incommensurate with the increase in the
value of the properties under consideration. On this reason, it
differs from tax.

ii) Profits of state enterprise- these are important sources of revenue

these days, owing to the expansion to the public sector. These revenues are
received in the form of prices paid for the government produced goods and
services. For example, a central government runs telecommunication.
Surplus from telecommunication earnings can be normally contributed to the
revenue budget of the government. Similarly profits from other public
undertakings are important sources of revenue for the budgets of the state.
There is, however, an element of quid pro quo in between the prices charged
and the services rendered. This means, prices are charged directly in
proportion to the services provided.

iii) Grants and Gifts- they cover very small part of public revenue. Usually
patriotic people or institutions may provide gifts to the state. They are
voluntary contributions that are beneficial particularly during wartime and
emergency. In addition, one government provides grant, which have greater
importance for another. Local governments obtain grants from state
government and state government from the center. It is said to be grants -
in - aid. When one country’s government makes grants to another country's
government, it is referred to as foreign aid. In modern times, poor counties
usually receive foreign aid from advanced countries which can be in the form
of military aid, economic aid, food aid, technological aid and so on. But this
is not a certain and fixed sources of revenue and is also out of the control of
the state.

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Iv) Borrowings- It has many forms. But the most important are fresh
borrowings that can be categorized according to their origin and maturity.
Interims of their origin, public borrowing may be external or internal. Interims
of their maturity, they may be long term, medium term and short term with
specific demarcation of boundaries for each. You will learn in detail about it
in the unit of public debt.

Note. Income and profit from the creation of currency by government that is
greater than its face value of currency over its cost of creation are also
incorporated into the category of non-tax revenue.

3.1.1 Tax Revenue

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 What is tax revenue, what are their characteristics differences, what are
the bases of a tax?
______________________________________________________________________________
______________________________________________________________________________
__________________________________-___________________________________________

_ Have you tried? Good

Taxes are the primary sources of government revenue even though the
proportion of tax revenue to the total public revenue varies considerably
among levels and units of government. Fund raised through the various
taxes is referred to as tax revenue. Taxes may be imposed on person's
income or wealth, they may be direct or indirect and they may be different
rates and nature.

Taxes are compulsory payments imposed by the government on it's citizens

to finance it's general expense incurred for common good, without any
corresponding benefits to the tax payer.

Most taxes flow into the general treasury fund of a unit of the government.
However, some taxes are earmarked for a specific purpose, and thus go in to
a separate budget or trust fund. For instance, Federal excise tax on gasoline
goes in to the special High way Trust Fund in USA.

The main characters tics of a tax are as follows:

a) A tax is compulsory payment to be paid by the citizens who are

supposed to be liable to pay it. Therefore, any one who wants to
refuse to pay a tax will be punished.

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 b) There is no direct quid pro quo between the taxpayer and public
authority. This means a taxpayer may not receive a benefit
proportional to the tax that he has paid. (Quid pro quo means
something given or taken as equivalent to another.)

c) A tax is imposed to meet public spending incurred by the

government in the general interest of the nation. It is a
payment for the indirect service to be provided by the
government to community as a whole.

d) A tax is not a price paid by the taxpayer for any definite service
rendered or a commodity offered by the government.

e) A tax is payable regularly and periodically as determined by the

tax authority. For instance, income taxes are usually paid
annually.

The Base of a Tax

The tax collecting authority has legally described the object on which the tax
is imposed. It is termed as the base of a tax. For instance, the base of
excise duty is production, packaging or processing of a specific good, the
base of an income tax is the income defined and estimated with certain rules
formulated for this purpose. The base of each tax has to be defined legally
and quantified for the purpose of determining the tax liability for an individual
taxpayer.

Each taxpayer is considered as a legal entity for this purpose. According to

the different tax base, an individual taxpayer may be subjected to more than
one tax. After determining the tax base, the authorities are expected to
emphasize on several questions such as cost of collection, administration and
effects of tax.

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The optimum combination of these concepts determines the exact coverage
of a tax base. A tax base, however, under consideration may grow or shrink
through time. For instance, as income increases the base of income tax
increases.

Buoyancy of a Tax

The growth of tax base increases the tax revenue. This rise in tax revenue is
termed as buoyancy of tax. A buoyant tax has an inherent tendency to
yield more tax revenue with the growth of its base. For example, with a given
rate of income tax and definition of taxable income, the yield from income
tax increases as national income increases. Similarly, excise duties are
imposed on production of specified goods. Hence, with a given rate of excise
duties, the revenue from excise duty increases with an increase in excisable
items. The concept of buoyancy may be applied to an individual tax or to a
whole set of taxes.

Buoyancy of = Proportionate increase in tax revenue

a tax Proportionate change in tax coverage

3.1.2 Objectives of taxation

Dear learner! What do you think the objectives of taxation in developed

and underdeveloped nations will be?
______________________________________________________________________________
______________________________________________________________________________
______________________________________________________________________________

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Have you answered it? OK. Try and relate your answer with the following
analysis.

Objectives of a tax system in an economy are mainly connected with

- The over all economic and non- economic policies of the

government

- The non-tax components of it's fiscal policy

- Institutional and other situations faced by the economy.

Objectives of a tax system differ significantly in between

- Developed countries

- Underdeveloped countries

Developed countries do not have to worry about facilitating their rate of

economic growth. Rather they have adequate capacity to save and invest.
The incidence of absolute poverty is very low in advanced countries. The
main problem affecting them is instability of income and employment.
Therefore, they design their tax system to solve this problem.

Unlike advanced nations the primary objective of taxation in underdeveloped

countries is not related to instability of

 Income and

 Employment

Rather these countries, like Ethiopia, have been affected by several problems
that are related with

 Economic growth

 Poverty

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  Inequality

 Health

 Chronic unemployment

 Regional disparities etc.

In general, there is vicious circle of poverty in developing nations.

Therefore, the tax system in least developed countries should be designed in
such a manner that it can raise adequate resources for the government’s
developmental as well as non-developmental activities with out having
adverse effects on investment activity in the private sector. The government
can set up saving and investment through its taxation policy. For instance
levying tax people with low incomes will have adverse effects on capacity to
work and save. Taxation of luxury good is just; it diverts resources from non-
essential consumer goods industries to essential developmental industries.
Import duties imposed on luxury goods check imports to create favorable
balance of trade, which developing countries may use for importing capital
equipment and essential raw materials required for the development of the
economy.

3.1.3 Canons of Taxation

Dear colleague! Have you ever read about the four canons of taxation
developed by Adam smith? Have you answered this question? Ok. Try to
relate it with the following analysis.

Taxation must be levied with great care and rationality. In order to practice
this rationality and care, the taxing agency must follow certain code of
conduct in the form of principle of taxation. By cannon of taxation we mean
those characteristics, which a good tax should, posses. The canons of

71
taxation are concerned with the rate, amount and method of levy and
collection of a tax.

The first set of principles developed by Adam smith is referred to as canons

of taxation. These are:

 Canon of equality

 Canon of certainty

 Canon of convenience

 Canon of economy

Let us discuss each of these as follow.

Canon of Equality: It explains that taxation must be distributed equally in

relation to the ability of the taxpayer. It requires that the rich should pay
more taxes and the poor should bear a lesser burden. However, if we
interpret this principle with regard to disutility which taxpayers sacrifice by
paying taxes, the tax should impose equal marginal disutility up on every
taxpayer. This situation results in two possibilities of imposing a tax.

On the one hand, if the marginal utility of income is constant, the rich as well
as the poor people should pay a given percentage of their income in the form
of tax. On the other hand, if we agree that the marginal utility of income
decreases, equality can be approved when the rich pay larger proportion of
his income as taxes and the poor pay smaller proportion of his income in the
form of taxes (i.e. tax should be progressive).However it is obvious that the
marginal utility of money goes on diminishing with the increase in its stock
and hence the rich person feels less disutility or sacrifice in paying taxes than
the poor person paying at the same rate There fore ,if the canon of equity to
be properly observed ,the progressive taxes must be advocated.

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Canon of certainty- it indicates that taxation has to include the element of
certainty to prevent the taxpayer from unnecessary harassment by tax-
officials. Adam smith said that the tax that is paid by each individual should
be certain and not arbitrary. This means

 the time of payment

 the manner of payment and the person to whom the tax

is to be paid

 the amount to be paid should be clear to the contributor

and every person

Government must also be certain of the amount, which it derives from the
particular tax. This facilitates proper planning of public expenditure in
anticipation of estimated revenue. If there is no certainty about the rate of
tax and the tax payer does not know what amount of tax he has to pay, the
taxing authority gets the opportunity of practicing dishonesty and even if it
collects the specified amount of tax, the tax payer may feel cheated because
he is not aware of the rate of tax before hand.

Canon of Convenience- According to this canon tax should be collected in

away that are convenient for the taxpayer as far as possible. For instance, it
is convenient to collect a tax from salaried employees at the time of paying
salaries. In addition to this, as it is applied in Ethiopia, farmers have paid
their tax as soon as they harvest their crops.

In general, these cannon recommend that unnecessary trouble to the

taxpayer should be eliminated. Otherwise, several bad effects may be
created.

Canon of Economy: It is clear that government has incurred costs to collect

taxes. Consequently, this principle suggests that the cost of collecting taxes
should be as minimum as possible. It is not useful to impose taxes that are
too widespread and difficult to administer because these taxes create

73
unnecessary burden up on the society in the form of administrative expense
that affects the productive efforts of the people.

Dear distance learner! Have you noted the difference between the four
canons of taxation developed by Adam smith? If so write a paragraph about
them in your own words. Otherwise, re-read them again.

In the previous part of this section we have learnt about the principles of
taxation formulated by Adam south. However, in view of developments in
economic philosophy, economists have added a few more canons. These are

 Canon of elasticity

 Canon of productivity

 Canon of Simplicity

 Canon of diversity

We shall briefly discuss them as follows.

Canon of elasticity- it states that taxation should be elastic in nature for

the purpose of collecting more tax when income of the people increases.
This means, it should be possible for the authorities to revise the tax
structure both with respect to coverage and rates to fit it the changing
requirement of the economy and the Treasury.

Canon of productivity- it indicates that the tax system should be able to

generate enough revenue for the treasury. And the government should have
no need to resort to deficit financing and taxes should be levied that they do
not obstruct and discourage production.

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Canon of simplicity- it suggests that the tax system should not be too
complex and beyond the understanding of the layman. Rather, it should be as
simple as possible. So that the tax payer should not be confronted with
accounting, administrative and other difficulties.

Canon of diversity- it implies that taxes should be imposed on diverse

sources because having a single tax system may be risky and inequitable.

However, too much multiplicity of taxes should be avoided because it leads

to unnecessary cost of collection and violates the canon of economy.

3.1.4 Features of a Good Tax System.

Dear student! The above-mentioned canons of taxation are considered

to be the essential requirements of a good taxation policy. Is there any
taxation system, which can fulfill practically all these, and can we say a tax
system be perfect?

______________________________________________________________________________
______________________________________________________________________________
____________________________________ _________________________________________

A good tax system does not mean a perfect tax system that contains all the
taxes, which fulfill:

 All the canons of taxation

 Fetching adequate revenue for the public service.

 Causing no hurt to the taxpayer.

Rather, a good tax system is one which

75
  has predominately good taxes

 fulfils most of the canons of taxation

 yield sufficient revenue

 causes minimum aggregate sacrifice to the people

 Least obstructs the incentives for production.

Thus for such a good tax system to exist, the following principles must be
observed:

 It should ensure maximum social advantage –the effect that the tax
produce must be considered i.e the effect on production and
distribution of wealth in a society.

 It ought to cause minimum aggregate sacrifice, i.e., the tax burden

should be imposed according to the ability to pay the tax.

 It should satisfy most of the canons of taxation

 A good tax system should have built in flexibility, so that changes

are possible according to the changing condition of the dynamic
economy.

 It ought to be a balanced one. This means it should not contain just,

progressive, regressive or proportional tax only but a combination of
all taxes. Because all type of taxes has its own merits and demerits

 The good tax system should be multiple, but greater multiplicity is

not necessary.

 In addition, in a good tax system there should be simplicity,

 Furthermore, a good tax system should not hamper the

development of trade and industry otherwise it ought to buttress the
economic development of the country.

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3.2 Theories of Taxation

Dear colleague! Have you ever observed that individuals who are
on the same foot of income pay equal tax and those who have different
income pay different tax? If yes, why do you think so?

______________________________________________________________________________
______________________________________________________________________________
____________________________________ ______________________________________
Have you answered this question? OK, please try to relate it with the
following explanation.

The payment of public services is a painful but essential process, which

affects directly or indirectly the well being of every individual and profit
position of every business organization. Economists usually speak of the
money burden and real burden of taxation. They also discuss the direct and
indirect burdens of taxes.

The total amount of money burden of taxation is the amount of money

income transferred from the people to the government by way of various
taxes. On the other hand, the total amount of direct real burden of taxation
refers to the volume of goods and services transferred from the payers to the
government or the value of money raised by the government. The total direct
real burden of taxation also refers to the amount of sacrifice imposed on the
community due to the transfer of money income from the taxpayers on
account of the imposition of tax by the government

Equity on taxation refers to fairness or justice in the distribution of tax

burden. Therefore, modern economists put great consideration on justice in
taxation and state that taxation should be based on the principle of equity.
The concept of equity has two notions such as horizontal equity and
vertical equity.

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Horizontal equity implies that people in equal economic circumstance should
pay equal amount of taxes. However if one individual is single while the other
is trying to support a family on the same income, then it might be argued
that the individual supporting the family does not have the same ability to
pay. There fore it would be inequitable to tax the individual with family as
much as the single individual, because even though they have the same
income, they do not have the same ability to pay. Vertical equity indicates
that people who are in different economic situation should be treated
unequally. Thus economically bettered placed people should pay more taxes
than others.

Different economists, on equitable distribution of tax burden, have

formulated different theories. Some of them are

 the expediency theory

 the socio-political theory

 the cost of service theory

 the benefit received theory

 the ability to pay theory

Let us discuss each of them in turn.

1The Expediency Theory

This theory suggests that every tax proposal has to consider its practicability.
According to this theory, economic as well as social consideration of the state
should be treated as irrelevant. Since it is useless to have a tax that cannot
be imposed and collected efficiently, this principle has validity in it.

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Therefore, countries that follow it design a tax system that incorporates
easily payable taxes.

However, designing an entire tax system only on consideration of expediency

is full of difficulty. Hence, given a set of practical taxes and different
practicable rates, a choice has to be made with reference to their possible
effects on the working of the economy.

2 The Socio- Political Theory

The German economist Adolph Wagner suggested that a tax system should
be designed based on political and social objectives.

He said that each economic problem should be looked at in its social and
political context. Hence, anyone ought to formulate a tax system not to
serve an individual member of the society but to solve the problem of the
society as a whole. In other words, Wagner was advocating a modern welfare
approach in adopting a tax system. He was, specifically in favor of using
taxation for reducing income disparities. As stated earlier, the main objective
of taxation is realizing socio-economic stabilization such as reducing

 income inequality

 unemployment

 cyclical fluctuation

Therefore, this principle has emphasized that

 the poor

 religious organization

 educational organization

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  Charity organization should be free from tax
because imposing a tax on them may lead to social instability.

Dear distance learner! Have you noted the difference between

expediency and sociopolitical theory? If yes, go to the next principle if no re-
read them.

3 Cost of Service Theory

This theory recommends that the cost incurred by the government in

providing public goods and services would be regarded as the basis of
taxation. Thus, citizens should pay a tax as per the cost of public goods
enjoyed by them. In other words, government is just like a producer of social
goods and services, and taxes are the price of these goods.

However, this principle has the following weakness.

 Estimating the cost of social goods and services offered to each

individual is difficult

 It violates the definition of tax. Tax is not price.

 It does not consider the essence of welfare. If cost is the base of

taxation, government cannot provide free education and
medical care to the poor.

4 Benefit- Received Theory

This principle suggests that they should divide the burden of taxes among
taxpayers in relation to the benefits enjoyed from the government. This

80
means those who get more benefit from public goods should pay more taxes
than others. However, this theory has the following shortcomings.

 Measuring benefits received by an individual from public goods

is difficult. Benefit is ultimately subjective.

 It violates the definition of tax because tax is not price.

 It results in injustice. This principle recommends imposing more

tax on the poor because they get more benefit from social goods
and services.

 It does not address the main objective of taxation, i.e. reducing

income disparity.

Dear distance learner! Have you understood the difference and

similarities between cost of service and benefit received theory of imposing a
tax on a taxpayer? If yes, write a paragraph with you own words. If no, re-
read them.

The cost of service is the supply side and the benefit principle the demand
side.

5. The ability to pay principle Theory

The most important aspect of this theory is that the burden of taxation
should be distributed among members of the society according to the
principle of justice and equity. This means that the tax is imposed on the
taxpayer based on their relative ability to pay. There are two indices of
measuring ability to pay. These are

 objective indices

 subjective indices

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Let's discuss each of them in turn

A) Objective Indices of Measuring Ability to pay- it considers the money

value of the taxable capacity of each taxpayer rather than his psychology of
sacrifice and feelings. The indices used to measure the ability to pay are

 Property (houses, farms, factories, equipments etc)

 Consumption expenditure

 Income etc.

Property- according to this method a tax is based on the property such as

 residential houses ( owner occupied or rented)

 farms

 Business equipments etc..

It is clear that some properties yield more income than others and some do
not yield income at all. Therefore, it is incomplete to be choosing as index of
ability to pay.

Consumption expenditure- according to this method people with greater

consumption expenditure get smaller marginal utility from their expenditure.
Therefore, they can pay more tax without losing more utility than those who
are spending less. But it is not a satisfactory index because there are several
problems in estimating consumption expenditure during a given period of
time.

Income -according to this method people who receive more income should
pay more tax and who get smaller income ought to pay less tax. By income
we mean the net income not gross income.

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Net income = (gross income- expenses)

B) Subjective Indices of Measuring Ability to pay

This approach has emphasized on the assumption that a taxpayer suffers a

sacrifice by paying the tax. It supposes that taxation does not make the
taxpayer feel better by the idea that he is contributing to the welfare of the
society. It is also assumed that the sacrifice of the taxpayer depends on his
own tax liability, not affected by the tax paid by others.

Therefore the question of determining the tax liability of the taxpayer is

related to equal sacrifice principle that can be interpreted in three alternative
ways namely:

 equal absolute sacrifice

 equal proportional sacrifice

 equal marginal sacrifice

Let us discuss each of them in turn.

Equal absolute sacrifice- it would require that a tax imposed on a higher

income individual should cause him to loss an amount of satisfaction (utility)
equal to that scarified by a lower income tax payer. In other words, higher
income people should pay more tax then the other.

Equal proportional sacrifice- it implies that the loss of utility

(satisfaction) in tax payment should be proportional to the total income of
each taxpayer. For example suppose individual X S higher income would

83
provide him 400 units of utility and Y' S lower income yield him 200 units of
utility. If taxpayer X decreases a utility of 10 units, 'Y' should loss a utility of
5 units.

Equal marginal sacrifice or least aggregate sacrifice - suggests that

the marginal utility of income scarified by all taxpayers should be the same.
The marginal utility of income for a higher income people is low and the
marginal utility of income for lower income people is high. Therefore, the rich
should pay more tax than the poor.

Out of these three versions, equal marginal sacrifice is considered as the best
and generally accepted principle of taxation by modern economists.

3.3 Taxable Capacities

Dear colleague! Have you ever opposed over taxation or have you
ever observed people while opposing over taxation? What is your
reason for performing this act?

_____________________________________________.________________________________
______________________________________________________________________________
______________________________________________________________________________
_ Have you answered these questions? OK. Try to relate it with the following
analysis.

The concept of taxable capacity is essentially related with the notion of ability
to pay. However economists widely differ in their opinions about the concept
of taxable capacity. According to Josiah Stamp,” taxable capacity is the total
production minus the amount required to maintain the population at
subsistence level. According to Findlay Shirras, " taxable capacity is the limit
of squeezability It is the total surplus of production over the minimum

84
consumption required to produce that level of production ,the standard of
living remain unchanged “. But this is also not clear. Because population
continuous to rise, people want to raise their living standard over time and
production of new good is required to meet their growing needs. The capital
for this new production as Hugh Dalton says should be included in this
minimum.

High taxation reduces the purchasing power of the people and adversely
affects their ability and willingness to work, save and invest. There fore most
economists have defined taxable capacity as the ability of people to pay
taxes with out adversely affecting or worsening their standard of living and
the efficiency i.e it is the maximum capacity of the community to bear tax
without much hardship. Therefore; taxation beyond the taxable capacity is
over-taxation. It results in economic as well as political instability.

Dear distance learner! Do you know the difference between absolute

and relative taxable capacity?

______________________________________________________________________________
______________________________________________________________________________
______________________________________________________________________________
Have you answered this question? Ok. Try to relate with the following
analysis.

The concept of taxable capacity has been distinguished between

 Absolute taxable capacity

 Relative taxable capacity

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Absolute taxable capacity-Absolute taxable capacity indicates the amount
of money or the proportion of income that can be taken away by the
government from people in the form of taxes without producing unfavorable
effects. In other words, it represents the maximum number of taxes that can
be collected from the individuals of a particular country. If we make reference
to time, then absolute taxable capacity of a country for a given period of time
is measured by the maximum amount of money that can be obtained during
that period from taxation. It will be seen that in this definition, there is no
consideration of what the consequences would be during the period that
follows the given one .And the maximum fro any given year takes no account
of the consequence in the years that follow. The term absolute taxable
capacity has been interpreted by economists in different ways. Sir Josiah
Stamp has defined absolute taxable capacity as the total production minus
the amount required maintaining the population at subsistence level. There
are, however, two drawbacks in this definition

Firstly, it is not possible to measure the subsistence level of a community.

Differences are bound to crop up when an attempt is made to measure the
community’s subsistence level.

Secondly, if the entire amount i.e total production minus subsistence

consumption level is taken away by the state from the citizen in the form of
taxes, then their living standards are bound to be adversely affected. Their
efficiency will decline and the production of goods and services will fall
resulting in serious reduction in the future productive capacity and
consequently, absolute capacity of the society.

Findlay Shirras has also defined absolute taxable capacity as the limit of
suitability. This definition of has also drawbacks because it considers
community’s standard of living as some thing static.

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None of the definitions are perfect and correct. According to Hugh Dalton, all
these definitions of absolute taxable capacity suffer from ambiguity and
vagueness. According to him, every tax has the unpleasant effect of reducing
the income of the tax payers. Consequently, it makes little sense if we say
that absolute taxable capacity is the limit up to which a community can be
taxed without producing unpleasant effects. It is not possible to single out
any particular unpleasant effect as indicating the limit of taxable capacity.

Further, the concept of absolute taxable capacity is not to be assumed as a

constant entity. In the long period, it is bound to change through growth in
savings and investment, economic growth, changes in the production pattern
etc. Therefore, the determination of absolute taxable capacity is almost
impossible.

Relative taxable capacity- The concept of relative taxable capacity is more

definite, concrete and intelligible than the concept of the absolute taxable
capacity. In the relative sense, the reference is to the proportion in which
two or more nations or group of persons or states in a country contribute to
wards the common expenditure through taxation. It is possible to determine
in advance the proportion in which two or more communities should
contribute in order to meet some common expenditure in accordance with
their respective abilities to pay. The richer community shall be called up on to
bear a greater share of such common expenditure. If the common
expenditure increases due to certain reasons then the contribution of the
richer section of community shall rise at a rate faster than that of the poorer
section. In other words the relative taxable capacity is the capacity of the
community to contribute to some expenditure in relation to the capacities of
other communities. It refers to the comparison between the absolute taxable
capacity of different taxpayers or group of taxpayers or the country as a
whole.

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For al practical purposes, the concept of relative taxable capacity is more
useful. Moreover, income of one unit of the economy is the nearest
approximation to the true measure of the relative taxable capacity whereas
there is no unanimity about the basis of measurement of the absolute taxable
capacity. The concept of the relative taxable capacity is more useful in a
federal economy like Ethiopia, where different states are required to
contribute towards a common expenditure.

Comparing these two concepts, Dalton said that absolute taxable capacity is
a myth while relative taxable capacity is a reality because absolute taxable
capacity cannot be precisely defined or quantitatively assessed where as
relative taxable capacity gives us a comparative picture of the capacity of
two or more tax paying entities.

Indeed, it is very difficult to measure absolute taxable capacity. There is no

specific standard to measure it. However, some economists have pointed out
that the maximum taxable capacity for most countries of the world is 25% of
the national income above of which results in unpleasant consequence.
Because

 It will affect the willingness to work and hence reduce the

level of national income.

 It will affect the willingness to work and capital formation

 It will lead to higher pries and hence inflation.

Economists like Dalton said “It is impossible to fix any definite sum which
could be said to represent the limit of the country's taxable capacity at any
particular time." Therefore, it can be concluded that the limit of taxable
capacity is not fixed but varies from time to time and from country to
country.

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 Dear colleague! Have you ever understood the factors that determine
taxable capacity? What are they?

______________________________________________________________________________
______________________________________________________________________________
______________________________________________________________________________
Have you answered these questions? OK. Please, try to relate it with the
following analysis

3.3.1Factors Determining Taxable Capacity

1. The size of National Income The taxable capacity of a country depends

on several factors. Following are the important factors, which determine the
taxable capacity of people

The higher the national income the greater the taxable capacity is.

2. The distribution of income

The greater the inequality of income, the higher shall be the taxable capacity
of the country. The reason is that the government under such circumstance
can get an adequate income by imposing taxation on the richer section of the
community.

3. Size and rate of population growth

89
With a given amount of national income, there is an inverse relationship
between the size of population and taxable capacity. In addition to this,
when population increases at faster rate than national income, taxable
capacity will be low. The reason is that the expenditure on consumption
increases as a result of increase in population. However, if the productive
capacity of the country increases in the same proportion in which the
population increases, the taxable capacity will remain unaffected.

4. Pattern of Taxation

Taxable capacity depends on the system of taxation. If the tax system is not
diversified, taxable capacity will be less. If the tax system satisfies the canon
of economy and convenience, the taxable capacity would be high. If the tax
system produces adverse effects on the productive capacity of the people,
then the taxable capacity will be low.

5. The Stability of income

If income is stable, taxable capacity is high. Other wise it is low. In

underdeveloped country like Ethiopia, there is instability in the national
income. A large proportion of country’s population gets its livelihood from
agriculture, which is totally dependent on rain. If unfortunately, the rain fails
and the country is confronted with drought, the national income of the
country suffers a serious decline. Consequently, it becomes difficult to devise
the taxation system on any scientific basis on account of this instability in

90
national income. But national income in developed countries is generally
stable and their taxable capacity is sufficiently higher than developing
nations.

6. Nature of public expenditure

If the tax revenue is used for productive activities, income and production of
the country will increase leading to an increase in taxable capacity. But if it
is used for unproductive activities, taxable capacity will be less.

7. Psychology of the taxpayers

People may be willing to pay high tax due to patriotism. Some people may
also prefer to pay indirect taxes as it is distributed over a number of
commodities and over a period of time. The sense of democracy, citizenship
and responsibility towards the working of the government are those factors
which, if present in tax payers, increase the taxable capacity of the people
and vice versa.

8. Standard of living of the people

When the standard of living of people in the country is low, greater surplus is
available for taxation purposes

9. Administrative efficiency

Taxable capacity will be high only if tax-collecting machinery is efficient.

Otherwise, tax evasion will be high.

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10. Economic Situations.

During boom conditions, taxable capacity will be high, as people will be

making maximum profit. On the contrary, during depression,
taxable capacity will below because of low income.

11. Political conditions

Stable political condition and successful planned economic development

create confidence in the mind of the people. Under such conditions taxable
capacity will be high.

3.4 Classification of Taxation and Types of Taxes

In this section you will learn about

 the difference between Single and multiple tax

system

 the difference between progressive, regressive,

digressive, and proportional taxation

 the difference between direct and indirect taxation

 the various types of taxes, such as income tax, value

added tax, etc.

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 Dear colleague! Have you ever understood that there are different types of
taxation? What are they?

______________________________________________________________________________
______________________________________________________________________________
_____________________________________________________________________________

Have you responded these questions? OK. Try to relate with the following
analysis.

3.4.1 Classification of Taxation

The system of taxation can be classified in various ways on different bases.

The most important classifications are

i). Progressive, proportional, regressive and digressive

ii). Single and multiple

iii). direct and in direct

Let us discuss each of them in turn.

1. Progressive, proportional, regressive and digressive

This classification is based on the degree of progression of a tax, or

distribution of their burden on the tax payers.

Progressive taxes-is one for which the percentage of tax increases with
income (base). In other words, the tax liability increases not only in absolute
terms but also as proportion of income.

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 Example: Table 1. Schedule of progressive tax rate

Tax Base Tax Rate (%) Amount of tax

(Birr) (Birr)

300 5 15

500 10 50

700 15 105

1000 20 200

Advantages of progressive Taxation

 it fully compiles with the principle of ability to pay

 it is more economical ie more income through increase in the

rate of tax with out increase in cost

 it has greater revenue productivity

 it leads to better distribution of income on full.

 It fits with canon of elasticity. It is elastic in the sense that with

minor changes in the tax rates substantial changes can be
brought about in the income of the government.

Disadvantages of Progressive Taxation

 Non measurability of utility to decide the degree of progression.

Marginal utility of net incomes of different persons cannot be
measured in such a way as to permit precise comparisons
between individuals. Consequently, it is impossible to discover
any faultless objective standard of progression of tax rates on the
basis of subjective utility.

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  It reduces capital formation –it is the rich who can save ,thus if
they are taxed more heavily the process of capital formation is
adversely affected as a result of progressive taxation

In spite of these defects, the system of progressive taxation is now widely

recognized as desirable. The main reason fro this is that under progressive
taxation it becomes possible to eliminate or reduce the glaring economic
inequalities in the society.

Proportional Tax-- is one for which the percentage of income paid in taxes
is the same regardless of the taxpayers income. Here, the tax base may be
income, money value of property, wealth or goods etc.

Example: Table 2. Schedule of proportional tax rate

Tax Base Tax Rate Amount of tax

( Birr) (%) (Birr)

300 5 15

500 5 25

700 5 35

1000 5 50

It imposes the same amount of tax liability. However, the propensity to

consume for the rich is less than the poor. The poor easily feel the burden of
taxation more than the rich and thus equal rate of tax affects the rich and the
poor unequally. Consequently it is unfair and unjust.

Advantages of proportional taxation

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  It is easy for every individual to evaluate the total amount of tax he
has to pay. The tax payers can easily and quickly calculate the amount
of tax they have to pay to the government.

 There is no change in the existing distribution of income and wealth in

the society as a result of proportional taxation because all the tax
payers pay the tax at a single uniform rate. It is neutral with respect to
income and wealth distribution and consequently it involves no
structural change in the socio economic set up of the country.

Disadvantages of proportional taxation

 The burden of taxation falls more heavily on the poorer section of the
society. The reason is that, the marginal utility of money fro the rich is
lower than the marginal utility of money for the poor. If the rich and
the poor are taxed at the same rate, the poor section of the society will
be making greater sacrifice than the richer section.

 Proportional taxation does not reduce the inequalities of income and

wealth rather it enhances these inequalities and increase the gap
between the rich and the poor.

 It contributes less to public revenue

Regressive tax- is one for which the tax rate decreases as income
increases. This has been indicated in the following table.

Table 3.Schedule of regressive Tax Rate

Tax Base Tax Rate Amount of tax

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 ( Birr) (%) (Birr)

300 10 30

500 7 35

700 5 35

1000 4 40

Regressive taxation imposes higher burden on the poor. Therefore it is unjust

and unfair than proportional taxation.

Graph

Digressive tax - is one for which the tax rate increases up to a certain limit,
after that it is constant while the income is increasing. Thus, the digressive
tax is a blend of progressive and proportional taxation.

Example: Table 4.Schedule of Digressive Tax Rate

Tax Base Tax Rate Amount of tax

( Birr) (%) (Birr)

300 5 15

500 10 50

700 15 105

1000 20 200

1000 20 240

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 Dear distance learner! Which one do you think is the best for developing
countries like Ethiopia from the above stated categories of rate structure?
Why? Write a paragraph about this with your words.

2. Single and Multiple tax system

This classification is based on the diversification of the tax base.

Single tax system- is one in which only one tax has been advocated. An
example for this is a tax on agricultural rent. In the 17 th to 18th century, the
physiocrates school of thought believed that agriculture is the only
productive sector that results in economic surplus. According to them, all
taxes would finally be born by this agricultural surplus. Therefore, they
argued that the state should impose a tax on only agricultural sector and
nowhere else. However the tax burden lies on a specific segment of the
society. Thus, it is unfair and unjust. A millionaire owning no land would
completely escape the burden of taxation while a poor person who invested
all his savings in the purchases of land would pay a proportionately high
taxation. I addition single tax system would not produce adequate revenue to
the public.

Multiple tax system- is a tax system that comprises a number of taxes.

Practicing a multiple tax system is very important because a single tax
system is not expected to improve economic situation in all aspects. Different
taxes contribute for the fulfillment of different objectives. For instance, some
tax would help to redistribute income and wealth more equitably. Some
taxes would assist the economy to approve regional balance. Others may be
required for providing enough revenue for the government treasury.

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Therefore, a multiple tax system becomes essential in a modern economy
where the objectives of the government are diverse. It would be highly unjust
to tax income originating from only one source and ignore out of others.
Hence, justice and equity could be achieved when government would tax all-
important sources of income in an equitable manner.

Generally multiple tax system if advantageous in that:

 It is efficient in checking the tendencies of frequent tax evasion

 It does not discriminate so that inequality of income and wealth can be

reduced

 It increases the income of the public

 It is more flexible than the single tax system

However, too great multiplicity of taxes is undesirable and should be avoided.

Because a large number of taxes would involve a high cost of collection. It is
there fore best to rely on a few substantial taxes.

3. Direct and Indirect taxes.

Dear colleague! Have you ever observed that the seller of a product
transfers a tax imposed on him to the consumer of his product? Which taxes
do you think he can transfer? Why do you think so?

______________________________________________________________________________
______________________________________________________________________________
______________________________________________________________________________

Have you answered these questions? OK. Please, try to relate it with the
following analysis.

99
Taxes are direct or indirect depending upon the fact whether or not they are
actually paid by the people on whom their immediate burden of payment
falls.

A) Direct tax- is a tax that is paid by the person on whom it is legally

imposed. The burden of direct tax cannot be shifted to any other person.
Thus, impact, i.e., the initial burden as well as the incidence, the ultimate
burden of a direct tax lies on the same person. Examples for direct tax are
personal income tax, expenditure tax, property tax etc.

Advantages of Direct tax

Equity- direct taxes such as income tax, wealth tax etc are based on the
principle of ability to pay i.e. the rich pay more and the poor less. Vertical
equity as well as horizontal equity is maintained. It is progressive in effect.

Certainty- in direct taxes the tax payer knows the

 amount of tax

 the time of payment

 the manner of payment of tax

The governments also estimate the amount of such tax which it will receive
from the public and accordingly it can prepare its development plans.

Economy- in direct taxation the expenditure incurred for collection is almost

nil. Example, payroll is prepared for salary payment and at this time the
cashier collects the tax without additional payment. Therefore, direct tax
fulfils the cannon of economy.

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Elasticity- revenue from direct taxes can be increased or decreased with
change in national income or wealth of the nation.

Civic Consciousness -the burden of direct tax is heavier than indirect taxes
thus people feel that they are paying a sum of money and they want to see
where the money is spent i.e they try to see whether the collected tax is used
for productive purpose or not

Anti- inflationary -At the time of inflation, there is more money in the hand
of the people but the purchasing power is less. Therefore, direct taxes collect
the excess money and then minimize inflation.

Disadvantages of Direct Tax

Pinching- the money paid in direct taxes is large (lump sum) and thus they
pinch the taxpayers more. They feel that something is deducted from their
incomes, and their saving and consumption pattern is affected.

Inconvenient -Tax is collected from the

 Payroll for individuals

 income statement for enterprises

However, in the case of enterprises, government should check whether the

income statement is real and correct in order to avoid tax evasion. It results
in inconvenience.

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Tax evasion and corruption
In direct taxation assessment is based on the willingness of the taxpayer
about his income statement. Enterprises may prepare two documents one for
taxation that is false statement and the other is real for internal purpose.
There is greater scope for tax evasion that leads to corruption.

Uneconomical

In private enterprises direct taxes are uneconomic because tax collectors

should check the statement of the enterprises, which take long time and
costs a lot. But in government enterprises there is no such problem.

Narrow based

There is small number of employees eligible for direct taxation. Larger

section of the society remains untouched and hence, it fails to achieve its
objective of promoting civic sense among citizens.

Arbitrary

There is no scientific way of levying the tax rates.

Disincentive to work and save

Direct taxation system discourages people not to work and they might prefer
to leisure than work.

B) Indirect tax- is taxes a burden of which can be shifted to others. Thus,

the impact and the incidence of indirect taxes lie on different persons. In
indirect taxes, the taxpayer is the tax bearer. For example, sales taxes are
indirect taxes because they are imposed on producers or sellers but their
incidence is shifted to consumers.

Advantage of Indirect Taxes

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Convenient

It is convenient for transferring tax to taxpayer through the price of goods

and services. The taxpayer does not feel the burden of the tax.

Elastic

Indirect taxation can easily increase the rate of taxes.

Progressive

Indirect taxes are progressive in nature because tax rates on necessity

products are less and on luxurious products are high. As a result the rich will
pay higher tax and the poor lower amount of tax that approves equity.

No evasion

Since the tax is included in the price of good or services, there is lower
chance for tax evasion.

Wide Coverage

The indirect taxes are included in the price of goods and services and thus
every body that is buying goods and services is paying taxes. This means,
the whole population, even the beggar pays indirect tax.

Less pinching

Indirect taxes are not that much known by the taxpayer. As a result they are
less pinching

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Social value

Indirect taxes discourage the consumption of harmful products such as

tobacco and there by they improve social value.

Saving and Capital formation

When government imposes higher tax on commodities, consumption will

decrease and saving will increases, which in effect raises investment and
capital formation.

Balanced Regional Development.

Tax exemption for commodities produced in backward region and relatively

higher taxes for commodities produced in advanced region brings a balance
among regions.

Disadvantages of Indirect taxation

Inequitable-

When the poor and the rich purchase the same product they have to pay the
same amount of tax. This means indirect taxes are imposed more on the
poor than on the rich and violates the principle of ability –to- pay.

Uncertainty

Government cannot be certain about how much tax revenue is collected in

the form of indirect taxes. In indirect taxation the taxpayer does not know
the

104
  amount of tax

 time of payment

 the manner of payment of the tax

No Civic Consciousness

Many people are not aware of that they are paying taxes because the tax is
born by the price of the product. Therefore, they do not feel much pain and
will not be interested to know where the tax is spent.

Discourage Saving

As indirect tax increases, the price of goods will increase which increases
consumption expenditure. Thus, the level of saving will be decreased.

Inflationary potential

When in direct taxes are excessive the price of a product increases which
leads to inflation.

In summary, all modern writers have recommended that direct and indirect
taxes are completely with each other. Because of increasing requirement of
public expenditure, government of one nation cannot collect enough revenue
through either indirect or direct tax only. Therefore a country must apply
both direct and indirect taxation. However, one cannot suggest a perfect
balance between them in a fiscal system of a nation.

105
3.4.2 Types of Taxes

There are various types of taxes but the most important one are discussed
as follows.

Personal income tax- is tax paid on all types of income including wages,
salaries, dividends, interest, rents and capital gains. Employers collect a
salary from employee’s payroll.

Corporations’ income taxes- is imposed directly on the accounting profit

of a corporation. It is a type of direct tax.

Personal expenditure tax- is a tax that is levied on the income used for
consumption. This means it would not tax income used for saving and
investment purpose. This tax encourages activities leading to increased
capital formation and economic growth.

Property taxes- is tax that is imposed on different taxable properties such

as

 residential houses ( both owner occupied and rented)

 farms

 factories

 business equipments etc.

It is the only important tax that is based on wealth. In order to pay income
tax, one must generate income (i.e., sell labor, capital services or whatever).

106
In order to pay sales tax, one has to buy or sell something. But to owe
property tax, one must own property.

Sales tax- is type of indirect tax, which is imposed on market transaction.

The imposition of these taxes may be placed at different stages of economic
activities such as

 extraction of natural resources

 manufacturing

 wholesale

 retail level of production

If a tax is levied on one of these transaction points, it is said to be single-

stage sales tax. Where as a tax imposed on two or more stages of
production is referred to as multiple stage tax

Excise taxes

Dear colleague! Have you ever observed that the government

imposes taxes on selective commodities? What are these commodities?
Why do you think it imposes them on these accommodations?

______________________________________________________________________________
______________________________________________________________________________
______________________________________________________________________________

Have you answered these questions? OK. Try to relate them with the
following analysis.

Excise taxes are type of sales taxes, which are levied on selective
commodities. Such taxes may be imposed either externally or internally. An

107
external excise tax is levied on the movement of economic goods and
resources across an international boundary. They are usually known as
Custom duties or tariffs.

Thus, an external excise can be

 export duty

 import duty

On the other hand, an internal excise tax may be applied to one or certain
number of items involving market transactions with in the political
boundaries of a nation. The most important one are those imposed on
tobacco, alcohol, gasoline, luxurious goods etc. Government imposes them
for various reasons other than the primary objective of collecting revenue.
For instance, some excise taxes are intended to discourage the consumption
of undesirable commodities.

Turnover Taxes- is a primary type of multistage sales tax. It is imposed on

the gross monetary value of a product at each stage of the production
process. As a result turnover tax intends to increase the final sales value to
the consumer. For example, if a 10% sales tax is imposed on a commodity
that has a value of 5000 Birr, the seller should pay a tax of 500 Birr. As a
result he will sell this commodity to the retailer at a price of 5500 Birr.
Similarly, the retailer is expected to pay a tax of 550 Birr. Therefore the
retailer will sell this product to the consumer at a price of 6050 Birr.

Value added tax (VAT)-

Dear colleague! In the current period the value added tax has been applied in
Ethiopia. Do you know about the concept of value added tax? Please, go to
the near by library or to the office of inland revenue and read the news paper

108
prepared at that time and take as note for this. After that, relate it with the
following analysis of about VAT.

Value added tax (VAT) is a group of sales tax. VAT is applied on a multiple
stages of business activity, but it differs from turnover tax in that it defines
the tax base at each level only in the net sense of the value added at that
particular stage of production. In other words, the seller is not obligated to
pay a tax on its gross value but on a net value that is gross value minus the
value of inputs. i.e it is the tax not on the total value of the commodity being
sold ,it is a tax levied only on the value added to it by the trader or
manufacturer. Vale added is the difference between a firm’s receipts from the
sale of a product and the payment made for the various inputs or raw
materials used in producing it. Therefore, at the same tax rate, the turnover
tax would generate more tax revenue than that of the value added tax as
indicated in the following table.

Table 5. Comparison of Turnover Tax and Value Added Tax .

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Stage of Value of Tax base under Rate and amount of tax
production economic revenue
good (Br)
Turnover VAT Turnover tax VAT (12%)
tax (12%)

. Manufacturing 100 100 100 12 12

. Wholesale 200 200 100 24 12

. Retail 300 300 100 36 12

Cumulative base 600 300 72 36

are tax revenue

3.5 Impact, Shifting and Incidence of Tax

In this section you will learn about

 What incidence of a tax is?

 the difference between impact and incidence

 How a tax can be shifted?

 the difference between backward and forward

shifting

Dear colleague! Have you ever observed that producers or sellers transfer
taxes to consumers when government imposes on them? Which taxes do
you think are transferable? Write the answers for these questions on a rough
paper and try to relate it with the following analysis.

110
 The incidence of a tax does not always fall on the same person who is
directed to pay the tax but it is transferred to some other person, group of
persons or community. As far as direct tax is concerned, a tax on income can
not be shifted to others, but tax shifting is very much expected in the case of
indirect taxation.

Let us see the terms one by one

Incidence of Tax- this term refers to the location of the ultimate money
burden of a tax. Incidence emerges when the tax finally rests on the person
who bears it. The person who bears the ultimate tax burden cannot shift the
tax to another person.

Impact of Tax - this term is used to explain the initial imposition of a tax.
This means the impact of a tax falls on the person it is imposed first.
Therefore, an individual who is obligated to pay a tax to the government
bears the impact. In short, the term impact refers to the immediate money
burden of a tax. However ,it does not mean that the person who pays the tax
in the first instance will also bear the ultimate or final burden of the tax
When government imposes a tax on one individual, he may transfer it on to
another person or not. In other words, the impact and the incidence of a tax
may not fall on the same person. Fore instance when the government levies
excise on Mugar cement factory, it is paid in the first instance by Mugar .
Thus the impact of the cement duty is on the factory owner. But it does not
mean that the incidence of this duty will also fall on the factory’s owner. The
owner of the factory will pass the burden of the excise duty on the consumer
in the form of higher prices of cement i.e the owner will include the amount
of tax or duty in the price of cement and transfer to the consumer. Thus in
this case the incidence of excise tax will be borne by the consumer and the
impact is on the producer. The process of transferring this money burden of
the tax is said to be shifting.

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Therefore the process of shifting a tax starts from its impact and ends at the
point of incidence.

One can easily understand the difference between impact and incidence of
taxation as follows.

i) Impact indicates the initial burden of tax where as incidence

refers to the ultimate burden of a tax.

ii) Impact lies on the point of imposition where as incidence lies

on the point of settlement.

iii) Impact lies on the person from whom the tax is collected
where as incidence rests on an individual who pays the tax
finally.

iv) Impact may be shifted but incidence cannot be shifted. For

example, in direct taxation, the impact as well as the
incidence lies on the same person. This means, the impact
cannot be shifted. However, in indirect taxation system, the
impact lies on the producer or the seller where as the
incidence lies on the consumer. This means, the impact can
be shifted.

Tax shifting- is process of transferring the burden of the tax from one
person to another and is the intermediate process between the impact and
incidence of taxation. By means of shifting, the taxpayer can easily be free
from tax burden. Shifting can happen only in relation with the price
transaction. Therefore, shifting is usual in sales tax.

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The shifting process can be either

 Forward or

 Backward.

Let us discuss each of them separately

Forward shifting - a tax is said to be shifted forward when the price of the
product, which constitutes the medium for shifting the money burden of a
tax, is increased. Under complete shifting; the price of a commodity will be
increased by the full amount of the tax. The producer may, however also shift
the burden of the tax through reducing the quality or quantity of the taxed
commodity .In forward shifting, the price so raised or the quality and quantity
of the commodity are so reduced that the entire amount of tax is shifted from
the original tax payer ( i.e producer) finally to the consumers.

For example, when a 10% tax is imposed on the seller who has a commodity
with a value of 5000 Birr, he will sell this commodity at a price of 5500 Br for
the buyer. Thus, the price is increased by the full amount of the tax.

Backward shifting- a tax on the commodity is shifted backward to the

agents of production or to the producer. A consumer can transfer a tax to
the producer in the form of lower prices by restricting his demand when the
tax is firstly imposed on income of the buyer. Similarly a tax on a producer
may induce him to force his workers to accept lower wages or force other
factors of production to accept lower remunerations. Thus back ward shifting
of a tax takes place when the price of the commodity taxed remains the
same and the burden of tax (incidence) is borne by the seller or producers of
raw materials and other inputs or the factors of production and not by the
final consumers.

It is also possible that a combination of forward and back ward shifting may
take place when a tax is imposed on a producer and the demand conditions
are such that he is able to pass on part of the money burden of a tax to

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consumers through a partial rise in price of his product and the other part of
the tax burden to the factors of production by compelling them to accept
lower remunerations.

More generally, if a tax is levied on the seller it will be shifted forward where
as if it is imposed on the consumer, it will be transferred backward to the
producer.

3.6 Effects of Taxation

In this section you will learn about

- how does taxation affect production

- the effect of taxation on allocation of

resources

- the way how taxation affects income

distribution

- how taxation realizes economic stabilization

Dear colleague! Have you ever paid tax to a government? If so, what
are the effects you have observed?

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______________________________________________________________________________
______________________________________________________________________________
______________________________________________________________________________

Do you answer these questions? Ok. List them on a rough paper and try to
relate with the following analysis.

According to the classical economists the purpose or objective of taxation

was to raise the required revenue fro the state. Today however with the
change in circumstances and ideologies the motives of taxation have also
changed and the objectives of a tax is not only to earn income fro the
government. According to the modern view, a tax is also imposed to affect
the pattern of consumption, production and distribution in the economy.

Effects of taxation include all changes in an economy originating from the

imposition of tax. It is clear that a market economy may attain certain.

 Production

 Consumption

 Investment or other situations.

But the existence of taxation changes these situations for bad or good.
Such changes can collectively be referred to as effects of taxation. Dalton
said" the best system of taxation from the economic point of view is that
which has the best, or the least bad, economic effects." Thus while framing
its tax policy the government has to keep in mind the effects which the
taxes would exert on the nature of the functioning of the economy.

Effects of taxation can be analyzed

 on production

 on allocation of resources

 on distribution

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  on economic stabilization

Let us discuss each of them separately

i) Effects of taxation on Production

According to Dalton, affects of taxation on production may be observed with

reference to:

 the ability to work, save and invest

 The willingness to work, save and invest.

Effects on ability to work, save and invest

Taxes decrease disposable income that in turn reduces purchasing power and
consumption expenditure. As a result standard of living will be eroded and
ability to work is negatively affected.

In addition to this saving is a function disposable income. Therefore,

imposition of tax would reduce the ability to save proportionally to the
amount of a tax.

Moreover, investment depends on saving. Hence, reduction of saving on

account of tax imposition results in deterioration of the ability to invest which
decreases production.

Effects on willingness to work, save and invest

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 It is realized that taxes result in disutility because the imposition of tax
immediately declines the disposable income of the taxpayer. His desire to get
income at this moment as well as in the future will be eroded when he knows
that the tax levied will continue. It indicates that people may react to taxation
by changing their preferences from work to leisure. If people prefer leisure to
work, their income decreases which affects saving and investment adversely.
Therefore, it can be concluded that tax has a disincentive effect on the
willingness to work, save and invest.

ii) Effects of Taxation on Allocation of Resources

In an economy the process of production depends on the allocation of

resources. The government may use its tax policy to divert the scarce
resources of the country in the desired productive activities. Tax re-allocates
factors of production from one industry or region to another in such away
that the imposition of high tax on some industries will shift resources from
them to the low taxed industries. Similarly, it re-allocates economic resources
from developed regions to less developed regions which results in regional
balance.

In addition to this, imposition of higher taxes on luxurious product will re-

allocate factors of production to the production of necessity goods. High
Taxation on harmful drugs and commodities will raise the price of such
products so much that the demand fro these products will be curtailed
considerably. Consequently, production of such products will be discouraged
and resources engaged in their production will be gradually shifted to other
industries, which are useful for economic growth of the country.

iii. Effects of Taxation on Distribution

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Taxation may increase or decrease income disparity in an economy and in
modern times it is used as an effective instrument for reducing the
inequalities of income and wealth in the country.

Usually taxation may be progressive, proportional or regressive out of which

progressive taxation can minimize income disparity because larger proportion
of a tax will be collected from the higher income group. However,
proportional taxation results in no change in the relative income distribution
of the society. On the other hand, regressive taxation increases income
disparity as larger amount of tax is collected from the lower income group.
Therefore making some direct taxes more progressive in nature reduce
income disparity among people in an economy.

Different taxes affect the distribution of income and wealth differently in the
country. Wealth and income tax is helpful in reducing the inequalities of
income as its rates can be made substantially progressive. On the contrary
taxes imposed on necessities and commodities of wide use are regressive in
that such taxes would not reduce the inequalities of income and wealth in the
country. Although commodity taxes, such as excise duties and sales taxes,
are generally regressive in nature and fall equally on the rich and the poor,
yet, it is possible to select those goods, which are generally consumed by the
rich section of the community for special taxation. Fore instance high duties
and sales tax levied on luxury goods.

Iv.Effects of Taxation on Economic Stabilization

There are fluctuations in the level of economic activity. This means there
may be inflation or deflation. Therefore, taxes can be used as an economic
stabilizer where either of these situations occurs. At the time of deflation,
government implements expansionary fiscal policy through reducing taxes
and there by it can stabilize the economy. On the other hand, during

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inflation, government undertakes contraction fiscal policy through increasing
taxes because it can easily collect the excessive amount of money in the
market through it and then achieve economic stabilization.

Now you have completed the last section of this unit. Therefore, do the
following self-test question to see how well you have understood about the
effects of taxation.

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 Exercise 3

1. Discuss the difference between the following

A. tax and price

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 B. price and fee

C. tax and fees

D. tax and special assessment

2. Discuss the relative advantages and disadvantages of direct and indirect

taxes

3. Ddiscuss the arguments for and against the progressive taxation

4. Based on the information, which has been discussed in this section match
each of the following.

____ i. Grant- in –aid A. Profit from the creation of currency

____ ii. Foreign aid B. Grants received by state government from

____ iii. Tax-revenue central government

____iv .Non- tax revenue C. Exiles duty

____ v. Fine and penalty D. Special assessment

____vi.Capital receipt E. Public borrowing

. F. The core objectives imposing them is to

protect

he infringement of law of country.

G. Grants that one country’s governments

receive

from another.

5. Based on the information discussed in section three fill in the blank.

A. The principle that suggests that the cost of collection should be as

121
 Minimum as possible
__________

B. the Canon that implies a tax system must yield sufficient revenue is

C. the Canon that states that tax should be collected in a manner suitable
for the taxpayer

D. The principle that suggests taxation must have built in flexibility is______

E. The principle that recommends that the time of payment for tax should
be clearly determined.

F. The canon which implies that a tax system should not be too
complex.________ .

6. Write true when the statement is correct and false when the statement is
incorrect

i. Cost of Service theory implies that people in equal economic

Condition should pay equal amount of tax.

ii. Vertical equity implies that people who are in different economic

Condition should be treated equally._______, why? _________

iii. According to the expediency theory those who get more benefit from
government should pay more tax. _____ Why? ________

iv. The German economist Adolph Wagner recommended that a tax system
should be designed based on political and social conditions._________ why?

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v. The socio political theory has emphasized that Charity organization should
be free from taxes why?

VI .Property is one of the indices of measuring ability to pay________ why?

Choose the best answer for the following questions

_______1. The effect of taxation on distribution depends on

A. Nature of taxes B. Kind of taxes

C. Rate of taxes D. All E. None

2. Which of the following taxes ensure equitable distribution of

income?

A. Income tax B. Wealth tax C. Commodity tax D. A

and B E. A and C

3. Increases in income tax

A. Increases consumption C. increases investment

B. decreases saving D. B and C

4. When there is inflation

A. Purchasing power of money increases.

B. government undertakes expansionary fiscal policy.

C. government increases taxation.

D. government increases it's expenditure E. None

5. Which of the following statement is false?

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 A. Taxes, such as tariff, may protect infant industries of a nation
from

Foreign competition.

B. Taxes encourage the willingness to work.

C. Taxation may influence distribution as well as production in a

Nation.

D. Taxes can serve as an economic stabilizer.

Important Terms
Public revenue Equality Value added
tax

Excise tax Turn over tax Taxable capacity

Custom duties Tariff
Buoyancy of Tax

Elasticity of tax Earmarked tax Tax evasion

Incidence Shifting Impact

Equity

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 Checklist

Put tick against each of the following tasks that you can perform.

1. Write the definition of the term public revenue

2 Explain the different sources of public revenue

3. Describe the concept of tax revenue

4 Analyze the difference between tax revenue and non tax

revenue

5. Describe the objectives of taxation

6 Explain the principles of taxation

7 Give the definition of taxation

8 Analyze the classification of taxation

9 Assess the effects of taxation on production

10 What does the impact of tax mean?

11 Describe the process of tax shifting

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12 Explain the concept of taxable capacity

Is there any box that you do not tick in it? If yes, please go back once to
this unit and read about it before going to the next unit.

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 UNIT FOUR

PUBLIC DEBT

INTRODUCTION

Government is an economic unit that provides public goods and services such
as defense, health services, education, streetlight, highways and other
infrastructure facilities. To finance its expenditure, government collects its
income in the form of tax and non-tax revenue. When government revenue
is greater than its expenditure, there is budget surplus. If government
revenue is equal to its expenditure, there exists budget balance. When
public expenditure exceeds its revenue, budget deficit exists. This budget
deficit leads to the problem of public debt. In modern times, borrowing by the
government has become a normal method of government finance along with
other sources of public finance like taxes, fees etc. In all countries of the
world, public debt has shown the tendency of increasing. In fact, the debt
burden, particularly the external debt burden of developing countries like
Ethiopia has grown at a faster rate and is beyond their debt servicing
capacity. More over, we find significant difference in the composition of debt
of the developed and developing countries. The total public borrowings of the
less developed countries generally comprises in a very large part of the
borrowings made from abroad while in a developed country these may
mainly consist of the borrowings raised internally from the local authorities,

127
institutions and individuals. However both internal debts as well as external
debt are the essential and important constituents of public debt.

Objectives of the Unit

After completing this unit, a student should be expected to:

 Explain why public debt is created.

 Explain the classification of public debt.

 Describe why debt burden is existed in most of

developing countries.

 Analyze the effects that public debt results in.

 Explain what redemption of debt means.

 Explain the different methods of debt redemption.

 Describe the way that government manages its debt.

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4.1 Meaning and Nature of Public Debt
In this section you will learn about

 What public debt is?

 Features of public debt

Dear colleague! Have you ever heard that the Ethiopian government
borrows money from abroad? Why do you think that Ethiopia does so?

______________________________________________________________________________
______________________________________________________________________________
______________________________________________________________________________
Have you answered these questions? OK. Try to relate your answer with the
following analysis.

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It is clear that the expenditure of most governments in developing countries
exceeds their revenue that results in budget deficit. If there happens budget
deficit, then the extra expenditure must be financed. And this will usually
happen through borrowing.

Public debt is a means of meeting a particular budgetary situation namely

deficit budget caused by the excess of government spending
over receipt.

In general public debt has the following features.

 Public debt arises in the form of borrowing by the treasury or state

exchequer.

 Government borrows a certain amount now but promises to pay in

the future not only the principal amount but also the interest.

 Government borrows when there is budget deficit.

Sources of Public Borrowings

There are two important sources of public borrowings, internal and external
sources. Internally the government may borrow funds from:

- Individuals

- commercial banks

- other financial institutions in money market

- central bank

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Externally it may borrow from:

- individuals

- bank of foreign countries

- foreign governments and

- international institutions like IMF , World Bank etc.

4.2 Necessity of Public Borrowing

Dear colleague! Do you know the reasons that force government to borrow
money?

______________________________________________________________________________
______________________________________________________________________________
_____________________________________________________________________________-
List them on a rough paper and try to relate them with the following analysis.

Classical economists argued that there is no need of government

interference. Government should provide only

 law and order

 defense and

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  Administration services by collecting small amount of taxes because if
there is high taxation, there will be public unrest. Classicalists
considered taxation as evil.

But after 1930's economists have argued that governments should

interfere in the economic activity and being considered as welfare state.
As a result their expenditure increases and exceeding their revenue. For
financing the ever-increasing public expenditures, governments float huge
loans from time to time .On account of this a huge national debt has
become the main characteristics of modern public finance. In modern
economies, public borrowing is created due to the following reasons.

1. To Finance War
Modern war is so costly and one cannot easily finance it with the revenue
collected through taxation. If governments use only taxes to finance war,
production activity will be negatively affected under direct taxes. In addition
enhancing indirect taxes affects fixed income groups. Therefore,
governments borrow money inside as well as outside the country to finance
war and there by they can minimize the above problem.

2. to Fight Depression

Depression is one of the phases in the business cycle in which there is

 Shrinkage in the volume of output, trade and transaction

 Rise in the level unemployment

 Price deflation

 Fall in aggregate income of the community ( wage & salary)

132
  Decline in investment

Consequently, increase in taxation during depression will have an adverse

effect on incentive to work and invest. Therefore, public borrowing is
supposed to be a very critical means of avoiding depression by raising the
level of aggregate effective demand.

3. To Meet Unexpected Emergency

Famine, war, flood, epidemics etc are causes of huge losses especially in
developing nations. Internal sources of revenue are unlikely to cover the
emergency expenses because the people affected are unable to pay taxes.
Therefore, government may have to borrow to finance a sudden rise in its
expenditure required to meet the emergency.

4. To check Inflation

Inflation is a sustainable increase in average price level of goods and

services. When there is inflation, the purchasing power of money declines
because there is a huge amount of money in the market. Therefore, public
borrowing may be considered as a means to relieve the pressure of
inflationary spiral in an economy, as by raising public loan, the government
can absorb the excessive amount of money in a market. But according to
modern economists, taxation would be a good anti- inflationary measure as
compared to public borrowing since the liability of the government rises in
public borrowing.

5. To Finance Economic Development

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Now a day it is mainly believed that the government of developing nations
should play an active role in the development of the economy. In this view,
budgetary policy is an important and effective means to facilitate the growth
of an economy. However, in most of the underdeveloped nations
government revenue is less than government expenditure. Therefore, the
problem of economic growth can be minimized through public borrowing and
investing these funds in various development projects.

By now you have finalized the second section of this unit. So try to do the
following self-test to observe how you have understood about why
governments undertake borrowing.

4. 3 Classification of public Debt

Dear colleague! Do you have an idea about the different forms of public
debt? Do you know the various features on which public debt can be
classified?

______________________________________________________________________________
______________________________________________________________________________
______________________________________________________________________________
Ok. Try to write them on a rough paper and relate them with the following
analysis.

Public debt differs from one another in many aspects. These differences are
due to either the markets in which the loans are floated, the rate of interest
offered on the government bonds, the conditions of repayment or the
purpose for which they are used. Generally public debt is categorized based
on the

 Source of borrowing

 Purpose of loan

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  Time duration of loan

 Nature of contribution of loan

Let us discuss each of them separately.

1. Source of Borrowing

The source of borrowing may be internal or external. Public loans floated

with in the country are called internal debt where as public borrowings from a
broad are termed as external debts. Internal debt is distinguished from
external debt as follows.

 An internal borrowing may be voluntary or compulsory where as

external debt is voluntary in nature.

 An internal loan can be estimated before hand with certainty but

external debt cannot be estimated confidently. The realization of
external borrowing is so much conditioned by the international politics'
and foreign policies of the lending government

 Internal debt is in the form of domestic currency while external debts

are in the form of foreign currency.

When the external borrowing is in terms of foreign currency, the foreign

exchange resources of the borrowing nation increases. But this foreign
exchange reserve is diminished to that extent when there is repayment of
such loan.

Under internal debt, borrowing is undertaken inside the country. As a result,

the availability of total resources is not increased. In this case, the fund is
simply transferred from individuals or institutions to the government or vice
versa when the debt is repaid,

135
On the other hand, external borrowing results in a transfer of wealth from the
lender to the borrower nation. Through external debt the resources available
to the borrowing nation increases. But, the payment of interest and
repayment of principal of such debt would result in the transfer of resources
from the borrower to the lender that led to a decrease in the total output of
the borrower country.

2. Purpose of Borrowing

According to its purpose public debt can be classified as

 Productive debt and

 Unproductive debt

Let us discuss each of them.

Productive debts- is debts that are invested on productive assets like

railways, irrigation, dams, roads, multipurpose projects etc. Investing a debt
on these ventures enables the government to produce more output and there
by to pay out the annual interest on the debt as well as to repay the principal
in the long run. Therefore, productive debt is self- liquidating in nature.

Unproductive debts- is those debts that don’t add to the productive asset
of the economy. Public debts for unproductive purpose like:

 financing war

 public administration

136
  relief expenditure etc are unproductive debts.

Unproductive debts are not self- liquidating. Therefore they impose a burden
on the community.

Dear distance learner! Do you know the difference among short –term,
medium- term and long-term loan? Write a paragraph about this.

3. Time/ Duration of loan

According to their duration, public debts are classified as

 short-term

 medium -term

 long- term debts

Let us discusses them separately.

Short - term debts- are those debts, which mature with in a short period of
time say from 3 months to 1 year. Government usually borrows such debts
when there is a shortage of money for recurrent expenditure, urgent
expenditure etc., sale of Treasure Bill for 90 days is an example of short-term
debt. The interest rate for short -term debts is relatively low.

Medium-term debts- are those debts which mature in between one and ten
years. Government borrows such loans

 To finance war

 To meet expenditure on

137
 o education

o health

o relief work etc

Long -term debts- are those debts that are repayable after a long period of
time usually ten years or more. Long-term loans bear higher interest.
Government raises these debts for financing developmental activities.

4. Nature of Contribution

According to their nature of contribution, public debts are classified as

funded and unfunded debt.

Funded debt – is that public debt for the payment of which the government
establishes a separate fund. Every year the government credits a certain
amount of money to this fund. On maturity, the debt is repaid out of this
particular fund and these debts are usually long-term debt used for
productive purpose.

Unfunded debt –is that debt for the repayment of which the government
sets up no separate fund. These are usually short-term debts used for
meeting current needs. Unfunded debts are incurred with the expectation of
public revenue. The interest on this debt is paid by the government out of its
ordinary income and is usually paid off with in a year. Treasury bills are
unfunded debts because these are generally for a period of three or six
months and are never for a longer period than a year.

138
Now you have completed the third section of this unit. Therefore, do the
following s

4.4 Effects of Public Debt

Dear colleague! Have you ever heard that most of developing nations
borrow money from a broad as well as inside them? What effects have you
observed from this?

______________________________________________________________________________
______________________________________________________________________________
______________________________________________________________________________
Have you answered these questions? Ok. Please, write your answer on a
rough paper and try to relate it with the following analysis.

The effect of public debt can be analyzed under the following headings:

 Effects of public debt on economic growth

 Effects of public debt on inflation

 Effects of public debt on political freedom

 Effects of public debt on distribution of income

Let us discuss each of them separately

1. Effects of Public Debt on Economic Growth

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 An underdeveloped nation is characterized by a shortage of capital
resources. Therefore, governments of these nations must implement
appropriate measures to increase the rate of saving and investment in their
economy, Restoring public borrowing and investing it on productive activities
is among the various means that can be adopted for this purpose. However,
the net effect of public debt also depends on the resources from which they
come. For instance, when the people of a nation reduce their consumption
and lend their saving to the government, the result will be a net increase in
the rates of saving. On the other hand, the provision of loan to the
government by diverting the savings from private investment does not lead
to a net increase in saving and investment activity.

The effect of external public debt depends on the purpose for which
governments borrow. When government borrows it for productive purpose
such as constructing rail way, dam, irrigation etc, economic growth can be
enhanced because these activities can yield more output which enable the
government for reinvesting or to repay the debt to the creditor. But public
borrowing for unproductive purpose such as financing war, celebration etc
does not enhance economic growth because they do not add to the
productive capacity of the economy, so that government will have to impose
higher taxes on the people to repay the debt. This situation affects people's
willingness and ability to work, and save which will in turn affect economic
growth inversely.

2. Effect of Public Debt on Inflation

It has been said that most government market borrowings transfer funds
from the market into the hands of the government. Consequently, there is no
net addition to aggregate demand and hence inflationary pressure. But this
reasoning is misleading because it hides the following basic facts.

140
Firstly public debt is bound to be inflationary although it does not add to
aggregate demand because the economy’s productive resources are diverted
from the production of consumption goods to that of capital goods. By their
nature investment goods industries have longer gestation periods and
therefore, the demand of consumption goods will tend to be greater than
their supply.

In addition to this, public borrowing used for financing war activities, for
meeting natural calamities such as drought and for other relief measures are
most likely result in inflation because they are basically consumption
oriented.

Moreover, government borrowing from central bank increases money supply

that in turn adds to aggregate demand. This situation pushes the price up.

However, when public borrowing is used for increasing productivity of the

economy, the supply of demanded goods will be increased and inflationary
forces would be checked to that extent. In addition, governments may take
different measures to control price such as rationing.

3. Effects of Public Debt on Political Freedom

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 Dear distance learner! Have you ever heard that most of the advanced
nations set preconditions for providing money to the borrower countries?
Why do you think so? What effect do you expect out of this?

______________________________________________________________________________
______________________________________________________________________________
___________________________________

Now a days almost all developing nations have borrowed money from abroad
.To get this money, they should accept the preconditions that the lending
countries put. But this situation affects the political freedom of the borrowing
nation negatively because it will be dependent up on the creditor. The
monetary, fiscal and even political policies of other borrowing nation should
be inline with that of the lending country.

4. Effects on distribution of income

A programme of government expenditure financed by borrowings increase

the real income of those persons who benefit from the expenditure. If the
government expenditure provides more economic welfare to the lower
income groups, the result will be a reduction in the inequalities and a more
equal distribution of income between people.

On the other hand the interest payment usually has a reverse effect. Interest
payment represents a transfer of real income from the taxpayers to the bond
holders because the government will have to tax the people so as to pay to
the bond holders the interest charges. If the bondholders and the taxpayers
are identical persons, there will be no net redistribution income. How ever
this happens in a very rare case and the bondholders and the tax payer

142
belongs to different income groups in the community. As a result some
redistribution of income will take place.

4. 5 Burden of public Debt and Debt trap

Dear distance learner! I hope that you have heard the idea that
debt burden has suffered many underdeveloped nations in the world. What is
debt burden? Why do you think it has been existed?

______________________________________________________________________________
______________________________________________________________________________
______________________________________________________________________________
Have you answered these questions? OK. Please write your answer on a
rough paper and try to relate it with the following analysis.

Government may borrow money from abroad or internally to finance budget

deficit. Initially these debts are so beneficial, but their repayment and
servicing certainly creates a burden on the borrowing nation.

According to its source, there may be

 External debt burden or

 Internal debt burden

Let us see each of them separately.

External debt burden

External debt represents a debt that a nation borrows from abroad and
has to repay at the time of maturity those results in a burden on it.
The sum of money that a borrowing country repays in the form of
principal and interest to the creditor measures the direct money

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burden of external debt where as the direct real burden is measured
by the loss of economic welfare interims of consumption of goods and
services foregone. Keeping the direct money burden, the direct real
burden depends on the payment that various sections of the society
contribute for servicing the debt. When government repays the
external debt through taxation and the relative burden of taxation is
imposed heavily up on the rich, the direct real burden to the
community as a whole will be lesser.

In addition to this, the extent of the burden depends on the purpose for which the debt is incurred.
External debt rose for war expenditure or other unproductive activities will increase the real
burden to the society because there will be a real transfer of resources to abroad at the time of
payment. This would decline consumption and economic welfare by reducing the total amount of
domestic resources available for developmental activities. On the other hand when external loans
are incurred for productive activities such as investment on social and economic overheads, the
borrowing country would get various benefits and earning through which it could repay the debt.

Therefore, an external debt incurred by the community for development purpose will not be a
burden but a profitable undertaking. However, it is recommended that there should be a limit for
external public debt, so that repayment does not impose heavy burden on the borrowing
community.

Generally the incidence of external public debt can be discussed on the following headings:
1. Direct Money Burden. In the external public
borrowing, the debtor country has to pay to the
creditor country every year large sums of money by
way of payment of interest on loan. After the
maturity of debt, the principal amount of loan has to
be paid to the foreign country in terms of foreign
exchange. In order to earn this foreign exchange, the
country has to make exports. Such exports for which

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 the country receives no payment from the foreign
country are known as unrequited exports and
represent the direct money burden of an external
debt.

2. Indirect money burden. Sometimes, the debtor

country has to pay interest in terms of the goods and
services to the creditor country. In other words, the
debtor country has to export goods and services on a
large scale to the creditor country. This inevitably
results in a rise in the prices of these goods and
services in the country. As a consequence there will
exist a fall in the economic welfare of the society.
This fall in community’s welfare shows the indirect
money burden of the external public borrowing’s

3. Direct real burden. The government most of the time

imposes new taxes on the people to pay the debt.
Thus, the burden of these taxes falls more heavily on
the poor rather than on the rich section of the
society.

4. Indirect real burden. As a result of imposition of new

taxes to pay the debt, the capacity of the people to
work, save and invest declines which will have
unfavorable effects on production.

Measurement of External Debt Burden

The extent of external debt burden can be measured by the following ratio:

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 i) Debt Service Ratio =

This measure indicates the extent to which the burden of debt service has
raised or declined over a given period of time.

ii) Debt service- saving ratio=

It has indicated the effect that external debt service imposes on saving
and in turn on capital formation of the country.

iii) Debt service -Export Earning Ratio=

It indicates how much of the export earning is used for repaying the
interest on external loan.

iv) Debt service- Tax Revenue Ratio=

It indicates the proportion of tax revenue that is directed for repaying

external debt.

Internal Debt Burden

1. Direct money burden. Internal debt is borrowed from individuals
and institutions inside the country .As a result; it will re-distribute
resources without resulting any change in the total resource of the
community. Therefore, internal debt does not impose direct money
burden on the country because the tax collected for repaying the
debt redistributes resources from one section of the society to
another.

2. Indirect money burden. However, internal debt may result in a

direct real burden. When the government spends the loan on

146
 development projects, it results in the creation of demand for
several commodities and services. As a consequence, the prices of
these goods and services rise, imposing additional burden on the
society.

3. Direct real burden. Internal debt may result in a direct real burden
according to the sources tax is collected to finance the debt. When
the tax collected from the rich people is smaller, there will be a
direct real burden where as the extent of direct real burden will be
lesser if the rich section of the society pays higher taxes.

4. Indirect real burden. In addition to this, transfer of income for

serving an internal debt transfers from the active to the inactive
enterprise. Government has imposed taxes on enterprises and
earnings from productive efforts for the benefit of idle, old and
inactive bond- holders which penalize work and productive-risk
taking efforts, It adds to the net real burden of the debt.

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Measurement of Internal Debt Burden

Internal public debt indicates a financial burden on the government. The size
of internal debt burden can be measured or estimated through the following
methods.

i) Debt- Service Ratio =

It indicates the extent to which government must tax national income

so as to raise enough revenue to pay the interest on debt

ii) Interest Cost- Revenue Ratio=

It indicates the effect of public borrowing on the budget of the country.

i) Interest cost- Public Expenditure Ratio=

It shows the proportion of revenue expenditure that is used for

paying the debt service (interest of debt),

ii) Interest Cost- profit Ratio =

It indicates the extent of public debt that is used for achieving production
activities. This measure is applicable when the borrowed fund is invested
on measurable productive industrial projects. But it is difficult to apply it
in most of developing countries like Ethiopia where government allocates
these funds on social overheads, power generation, infrastructure
development etc.

Debt Trap

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 We have discussed that public debt invested on unproductive activities
may put the country into debt trap. Debt trap refers the situation of
vicious circle of borrowing when the government must borrow so as to pay
the interest charges on the previous loans and to repay the principal
borrowed. This means, the fresh loans raised are not used for investment
or capital formation rather for repaying the earlier debt incurred.

Have you understood the difference between internal and external

debt burden? Write a paragraph about it.

4. 6 Debt Redemption

Dear colleague! Do you know the various means that a borrowing

nation has used for repaying its debt? What are they?

___________________________________________________________________________
___________________________________________________________________________
___________________________________________________________________________

Have you answered the above questions? OK. Write your answer on a
rough paper and try to relate with the following analysis.

Debt redemption is a means of repaying a loan. Different means are

used by the government to redeem its debt. The major means adopted for
redemption of public loans are:-

 Refunding

 Conversion/surplus budget

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  Sinking fund

 Additional taxation

 Capital levy

 Surplus Balance of payment

Let us each of them separately

1. Refunding - government issues new bonds and securities so as to repay

the matured debts. This process is said to be refunding. In this process long-
term securities replace short-term securities. So the money burden, under
this process, is accumulated rather than reduced because government has
postponed the date of payment.

2. Conversion- refers to situation of converting the existing debt into a new

debt prior to maturity with benefit of servicing charges. For instance, a
government might have borrowed when the rate of interest was high. But at
the time when interest rate declines, it can change the existed one into a
new debt at lower interest and there by it can reduce the burden. Therefore,
the benefit that it provides to the debtor country is minimizing the burden of
interest on the taxpayer. However, conversion can be realized based on

 the creditworthiness of the government

 the maintenance of adequate stock of securities

 the efficiency in managing the public debt.

3.Surplus budgets- refers to the method that government repays it's debt
by keeping public expenditure lower than the public revenue obtained.
However, surplus budget is a method that is used rarely because of ever-
increasing public expenditure.

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4. Sinking fund- is a method that government regularly keeps some money
in such a manner that it would be enough to retire the debt at the time of
maturity. For this method of debt retirement, government budget must have
overall surplus. Perhaps it is the most systematic and best method of
redemption.

This approach is applied by a number of countries. But this method can

succeed in repaying the debt only if there is substantial budget saving
every year and no additional borrowing

5. Additional Taxation - The simplest method that enables the government

for debt redemption is imposing new taxes and gets the required revenue to
repay the principal as well as the interest. This method redistributes income
from the taxpayer to the bond- holder. However, it may impose a burden on
future generation when the new tax imposed is used for repaying the debt.

6. Capital levy - refers to a very heavy tax on property and wealth. Dalton
recommended that government could repay its debt with the least real
burden on the community.

7. Surplus Balance of Payment- An economy can repay its external debt

only through the accumulation of foreign exchange reserve. This requires the
creation of surplus balance of payments by the debtor nation. A nation can
realize this by increasing it's export and reducing it’s import. Therefore, the
debtor country must put great attention to expand the export sector
industries.

151
Now you have completed the six section of this unit. Therefore, do the
following self-test questions to see how you have understood about the
concept of debt burden and the different method of debt redemption?

4. 7 Public Debt Management

Dear distance learner! Do you know what debt management mean? Write
your answer on rough paper and try to relate with the following analyses.

Public debt has different effects. So one should consider them carefully when
procuring loan. The term debt management refers to the formulation and
implementation of debt policy designed to achieve certain objectives such as

 Economic stabilization

 Economic growth

 Employment

 Overall soundness of financial system

According to the traditional state debt management is emphasized on

keeping its interest rate to the minimum possible and repaying it as soon as
possible. Where as modern welfare state has considered debt management
as a means of gaining various socio-economic developments. It is clear that
every nation is in need of keeping the rate of interest smaller as far as
possible; however, it may sacrifice this objective when it contradicts with
other objectives. Debt management and monetary policy affect stabilization
and economic growth. Therefore, debt management policy should be
formulated harmoniously with monetary policy.

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In addition to this, the debt management policy should not have any adverse
effect on the economy especially on willingness and ability to work, save and
invest. Moreover, during inflation it should be designed to curtail aggregate
demand. Public borrowing may be regarded as a means to relieve the
pressure of inflationary spiral. Furthermore, at the time of depression
government should design its debt management policy to raise aggregate
demand and there by it can increase output and improve employment in an
economy.

Exercise 4

II Based on the information given above choose the best answer for each of
the following question and write the answer in capital letter on the space
provided.

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_______1. When government revenue override it's expenditure, there exists

A. Budget deficit C. Budget balance

B. Budget surpass D. None

2. Most developing countries have experienced

A. Budget deficit C. budget balance

B. Budget surplus D. None

3. Which of the following are /is a means of financing budget deficit

A. Borrowing from foreign countries.

B. Borrowing from commercial banks.

C. Printing of paper money.

D. Issuance of Treasury bill. E. All F. A and B

4. Which of the following statement is /are true?

A. Governments need to borrow when current revenue falls short of

Public expenditure.

B. Budget surplus is the phenomena of most third world nations.

C. Foreign government is the only source of public borrowing.

D.A and B E.A and C

III Write true if the statement is true and false if the statement is incorrect
and gives reasons for each of them

1. Classical economists argued in favor of government intervention in

economic

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 activity. ___F_______________________________________Why?

_______________________________________________________

2. Classical economists assumed that taxation is the key to achieve economic

development. ______________________________________Why

________________________________________________________________

3.During depression there is a decline in the level of unemployment. ______

FALSE __________Why? Explain
__________________________________.

4. Governments borrow money through different means in the market when

there is inflation. _____TRUE___________________________ Why.

______________________________________________________________

5.The portion of debt that a nation owes to citizens of other nations is its

external debt. _____ TRUE____

6. An external debt can be easily controllable and estimated prior to getting

it. false Why?
____

7. In the case of internal loan resources are transferred from individuals and
institutions to government. ______ TRUE ______ Why? __________________.

8. Productive debts are considered to be self- liquidating _____ TRUE

_________Why _____________________________________________________________.

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Important Terms

Public Debt Sinking fund Debt burden Debt management

Capital levy Debt redemption Debt Trap Internal debt

External debt Conversion

By now you have completed the fourth unit of this module. Complete the
following checklist about the unit.

Checklist

Put tick against each of the following task that you can perform.

1. Describe the concept of public debt

2 Explain why government debt is created

3. What does debt burden mean?

4 Describe why debt burden is existed in most of developing

countries

5. Explain the effects of public debt

6 Analyze debt redemption

7 Describe public debt Management

8 Assess the situation of debt trap in developing nations

Is there any box that you do not tick in it? If yes, please go back once to this
unit and read about it before going to the next unit.

156
 CHAPTER FIVE

MACRO ECONOMIC ANALYSIS OF FISCAL POLICY

Introduction

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Public budgets are not neutral moreover; they can be used as a potent
tool in different spheres of economic policy. Budgetary of fiscal policy
obviously consist of the steps and measures which the government
might take both on the revenue and expenditure, the government's
debt and its proper management. This amounts to budgetary policy.
There is no clear demarcation between fiscal policy, monetary and
debt management. The main reason is that these policy instruments
deal with over lapping aspects of the economy. Sometimes, fiscal
policy is seen as that policy which concerns itself with the aggregate
effects of government expenditures and taxation on income production
and employment. This view suggests that the micro level effects of
taxation and expenditures should not be included in the field of fiscal
policy. A good and effective fiscal policy requires that all the necessary
components line expenditures, loans transfers tax revenues, income
from property, debt management, etc, are kept in proper balanced so
as to achieve the best possible results in terms of the desired
economic objectives.

The classical economists have a strong belief in the policy of lasses-

faire. The say’s law of market was the corner stone of all economic
policies, which says that supply creates its own demand and as a
result, there is no question of general over production or involuntary
unemployment. Thus they thought that the free operation of market
forces would achieve full employment and ensure an optimum
allocation of resources in a country. And they consider it more
desirable that the government should perform only minimum essential
functions and not interfere in the working of the economic system. In
other words it implies that fiscal policy should be neutral in its impact
on economic system. Further they advocate a balanced budget and
surplus and deficit budget is undesirable.

158
The use fullness of fiscal policy as an appropriate instrument to
regulate the economy was recognized after the publication of
Keynes’s well known book “The General Theory of Employment,
Interest and Money” in 1936. The post Keynesian revolutionary
popularity of fiscal policy has been largely due to the following three
factors.

 Ineffectiveness of the monetary policy as a means of removing

mass unemployment in

the great depression of 1930s.

 The development of ‘ new economics “ by Keynes with its stress

on the roll of aggregate effective demand

 The growing importance of government spending and taxation in

relation to national income and output.

Today as an instrument of macroeconomic policy, fiscal policy has

been very popular with modern governments to influence the size and
components of national product, employment, to prevent inflation, to
promote rapid economic growth and encouraging long run economic
stability. Therefore in this chapter we will see meaning of fiscal policy,
instrument of fiscal policy, importance of fiscal policy and effects of
fiscal instruments.

159
 Learning Objectives

Dear student! Up on the completion of this chapter you should be able

to:

 Understand the term expansionary and contraction fiscal policy

 Understand the different effects of fiscal policy on different

aspects of the economy.

 identify the different objectives by which fiscal policy is used

5.1 Meaning and Objective of Fiscal Policy

Ordinarily by fiscal policy is meant a policy which affects the

macroeconomic variables such as output, employment, saving, investment
etc through the budgetary manipulations. In other words it refers with the
aggregate effect of government expenditure, public debt or public
borrowings on macro economic variables of income, production,
employment price level etc. But the concept of fiscal policy has been
defined differently by different individuals.

According to Arthur Smithies, the term fiscal policy refers to “a policy

under which government uses its expenditure and revenue
programmes to produce desirable effects and undesirable effects on
the national income, production and employment”

160
 According to Mrs.Ursula K.Hicks ,” fiscal policy is concerned with
the manner in which all the different elements of public finance ,while
still primarily concerned with carrying out their own duties ( as the
first duty of a tax is to raise revenue ),may collectively be geared to
forward the aims of economic policy”. In the view of American
Economic association “fiscal policy should mean the policy which
concerns itself with aggregate effects of government expenditure and
taxation on income, production and employment”.

 All these and other definitions generally involve government

expenditure, and tax which is an important source of government
revenue, as instruments of fiscal policy.

Government expenditure and revenue can be combined in several ways in

order to stimulate or depress the aggregate demand and economic activity
in the economy.

Dear student! As you have seen in the previous chapters a given amount of
revenue can be realized by the government in several ways –by levying
taxes, profits from commercial activities and by borrowing. However,
although the revenues raised through several methods may be the same,
each method of raising revenue will affect the economy differently. The
same is true for different types of public expenditures. For instance, the
same amount of revenue may be raised either through taxing the people or
through floating bonds in the market but the effect each one of these two
methods of raising government income will be different in the economy.
Thus the mix of these different of fiscal instruments used in an economy
depends on the general objectives that the government would like to
achieve in the period. As an instrument of macroeconomic policy, the goals
of fiscal are likely to be different in different countries and in the same
country in different situations.

161
In the developed countries, fiscal policy aims at encouraging long run
economic stability. In the developing economies however fiscal policy is
directed towards promoting the growth of savings, investment and
reducing inequalities in incomes and wealth, besides stabilizing the
economy.

 Moreover, one of the objectives of fiscal policy is to break the

vicious circle of poverty and enable to a tap growth of agriculture
and Industry in the developing countries. Since the objectives are
vast in these countries different objectives might come in to
conflict & it needs identification of priorities. Thus the most
important thing is designing appropriate fiscal instruments that in
order to achieve the different objectives in a proper balance
according to the settled targets.

 Generally fiscal policy as a means of promoting economic development

aims at achieving the following objectives.

1. To increase the rate of investment

Fiscal policy aims at the promotion and acceleration of the rate of

investment in the private and public sectors of the economy. This can be
achieved by checking actual and potential consumption and by raising the
incremental saving ratio. Fiscal policy should also be used to encourage
some and discourage other forms of investment. In order to raise the rate
of investment government should, in the first instance, undertake a policy
of planned investment in the public sector. This will have the effect of
increasing the volume of investment in the private sector. But the main
problem in an underdeveloped country is to find out adequate financial
resources for investment purposes in the absence of sufficient voluntary
savings. Measures aimed at curtailing conspicuous consumption and

162
investment in unproductive channels can make available some resources
by encouraging savings or through taxation. (ie either increasing the rates
of existing taxes or imposition of new taxes) . Measures which curtails
consumption includes progressive income taxes, luxury import restrictions,
high duty on luxury imports.

2. To increase employment opportunities

Fiscal policy should aim at increasing employment opportunities and

reducing unemployment and underemployment by directing the state
investment to wards providing social and economic overheads such as
transport, communication power development, education public health etc.
Such expenditure creates more employment and increases the productive
efficiency of the economy in the long run. In underdeveloped countries with
a larger base of rural population, the state would under take local public
works of community development involving more labor and less capital per
head

3. To promote economic stability

Developing countries are prone to the effects of international cyclical

fluctuations due to the very nature of their economy. They mainly exports
primary products and imports manufactured goods and capital goods. In
the event of a fall in the prices of agricultural and mineral products in the
world market, the terms of trade become adverse, foreign exchange
earnings decline and national income falls. Further due to the inelastic
nature of the supply of agricultural products an under developed country

163
cannot take of advantage of increasing its exports when their prices fall.
Fiscal policy plays a crucial role in maintaining economic stability in the
face of external and internal forces through its various instruments.

4. To increase and redistribute national income

Fiscal policy is should also aim at increasing national income and

redistribute it in such a manner that the extreme inequalities of income and
wealth are reduced in the economy. Extreme inequalities of income and
wealth lead to economic and political instability. The redistribute role off
fiscal policy consists in increasing the real income of the masses and
reducing higher income levels. In order to do so fiscal policy uses highly
progressive and broad based tax structure.

5. To counter act inflation or deflations

Dear student! In the following sections we will try to see the appropriate
fiscal policy on major macroeconomic situations.

Fiscal Policy in Inflation

164
 Dear student! What fiscal measure do you think is appropriate when the
general price level in the country has risen?

____________________________________________________________________________
____________________________________________________________________________
____________________________________________________________________________
_____________________

Have you answered the question? Good

When resources are fully employed and the economy is plagued with
inflation the appropriate fiscal remedy is to create a budget surplus in order
to reduce aggregate spending. In other words, fiscal authorities should not
retain the existing tax structure; they must design new taxes to wipe off
the excessive purchasing power and consumer demand. The burden of
taxation may be raised to the extent which may not retard new investment.
A steeply progressive personal income taxation and tax on windfall is highly
effective to curb the abnormal inflationary pressure. Export should be
restricted and imports of essential commodities should be liberated through
tariffs. In addition public spending policy must aim at reducing the
government spending. Because during the period of inflation, the basic
reason of inflationary pressure is the excessive aggregate spending i.e both
private consumption and investment spending are abnormally high.
However it should be carefully noted that government spending which is of
productive nature, should not be restricted, since it may aggravate the
inflationary dangers further by decreasing the supply of commodities.

Fiscal Policy in Depression

165
 Dear student! In depression, the economy suffers from raising
unemployment, falling income and shrinking economic activity. In general
private investment is very low. There is a massive idle plant capacity.
Resources are there in the economy but there is no demand for them. What
are the appropriate fiscal measures for a country faced with this situation?

____________________________________________________________________________
____________________________________________________________________________
____________________________________________________________________________
_____________________

Have you answered? Good

In depression, when the existing aggregate private and government

spending is to low to achieve full employment, the government must
increase public spending directly by undertaking public work programmes
on massive scale and indirectly by inducing people to spend more.
Aggregate spending in the economy can be increased also by reducing
taxes. The effects of tax cuts would be to increase the amount of
disposable income of individuals and business firms.

Dear student! If there is a persistent occurrence of depression and

inflationary pressure it creates instability in the economy. In other words
there will exist recurring phase of upward and downward cumulative
movement in income, employment, output, prices etc

These recurrent changes in the economy i.e depression and boom are
caused by the fluctuations in the effective demand of the society.
Depression is caused by a deficiency in effective demand i.e when the
purchasing power of the population is lower than the supply of goods and
services on the other hand excess demand results in a boom. A boom is
characterized by higher prices and unlimited action towards economic
expansion.

166
Thus if the government has to stabilize the economy, it has to regulate
effective demand primarily through taxes and expenditure programmes as
we have seen in the above discussion.

Generally there are two methods that can be employed to achieve the
goals of stability .The two sets of stabilizers are as follows.

i. Built in Stabilizers: These are also known as automatic stability of

the economy. The built in stabilizers consists of taxes and
expenditures, which automatically respond to changes in business
conditions. A recession can be corrected in two ways by raising
expenditures and by lowering tax receipts (expansionary fiscal
policy). Similarly, a boom can be controlled by a budgetary surplus,
which can be derived by a reduction in government expenditure and
an increase in tax receipts (contraction fiscal policy). They are
automatic in the sense that it involves a change in government
revenue or expenditure quickly and in the right direction so that it
may produce stabilizing effect on aggregate demand.

When there is a fall in GNP, the yield from some taxes like income tax
and corporate tax automatically falls. Some categories of public
expenditure like unemployment & welfare benefits automatically
increase in response to a decline in the GNP. Because of falling tax and
rising expenditure, a decline in the GNP pushes the budget towards
deficit. Thus the taxes and expenditure that exhibits this response and
vice versa are called automatic stabilizers. They change in response to
the change in the economic activity. The income tax and corporation
tax have become important sources of revenue and they are also
progressive in character. As such their yields tend to rise in inflationary
times and fall in times of depression. Thus, they automatically
moderate the business cycles. Similarly unemployment compensation

167
 has been built-in in industrial countries. if due to recession employs are
laid of ,they begin to receive payments from the unemployment
compensation fund ,when they go back to work ,the payment ceases.

ii. Discretionary fiscal policy: Unlike the automatic stabilizers, the

government can change tax rates or expenditure programmes as
necessary from time to time to control the instability in the economy.
This is called discretionary fiscal policy and they are deliberate
changes. There are three principal discretionary fiscal measures

 Varying public works and other public expenditure programmes

 Varying transfer expenditure programmes

 Varying tax rates cyclically

If the economy is in recession ,the government can take up a number

of public works like road building ,urban rehabilitation etc in order to
provide employment to the unemployed and increase effective
demand. Even plans for a number of public works can be prepared in
advance and released at the time of recession so as to offset income
and employment instability. A reverse process can be initiated at the
time of inflation, reducing the number of public works so as to
decrease effective demand. Similarly, welfare expenditure and tax
rates can be varied deliberately by the government to counter a
recession or control an inflationary trend.

Fiscal Policy and Economic Growth:

168
As it has already been mentioned, government expenditures can have
an important role in directing the working of the economy. All
countries, including the developed, face the problem of stagnation and
even decay. Developed countries are confronted with the problem of
maintaining a steady rate of economic growth. Which can help the
economy to attain higher level of income and employment? Economic
investment decisions can be influenced by stability. However, stability
of income and employment might not necessarily concise with
maximum growth rate. This is because of the fact that the long run
growth capital accumulation and the development of capital goods
sector. For example, a high increasing unproductive investment and
expenditure on the part of the government, But this would be helpful
for short-run stability and it need not be the best from the long-run
point of view.

In the developing countries, the need to accelerate capital formation is

very pressing. This demands that priority be given for the
development of the capital goods sector and social overheads.
However, since capital goods are capital intensive their development
might go against the policy of higher employment. The development
of labor-intensive industries might create higher employment level but
retards the process of capital formation.

The market mechanism in the developing countries cannot generate

sufficient among of savings and investment needed for rapid economic
growth. For the risen government budget has to play an important role
in effecting savings. Of course foreign capital can have some
contributions in closing the saving gap. However, foreign capital can
help only to a certain extent. Government budgets have more direct
rote to play in capital formation and economic growth in developing

169
countries than in developed countries. The saving potential in a
developing economy is very limited because of the following reasons.

a) Shortage of particular resources.

b) lack or adequate demand, especially for capital good

c) High cost of production.

This problem can overcome by a savings:-

 Oriented government budget. Therefore the authorities

to raise surplus that can be invested in building social
overheads and basic and key industries can use fiscal
policy.

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 Exercise 5

1. Discus the role which fiscal policy can play in promoting economic
stability

2. How and what fiscal instruments are used during inflation and
depression in an economy

3. Discuss and reason out on the objectives that fiscal policy should
focus in developing and developed nations

Key Terms

Expansionary fiscal policy

Contractionary fiscal policy

Built in stabilizer

Check Lists

Yes No

171
Can you define Fiscal Policy?

Can you define discretionary fiscal policy?

Can you define expansionary fiscal policy?

Can you define contraction fiscal policy?

Can you define built-in stabilizers?

Is there any box that you marked "NO" under it? If there is please go back to
your teaching material and read about it before you go to the following
exercise.

172
 CHAPTER SIX

PUBLIC BUDGET

Introduction

Every nation needs to perform various economic as well as non-economic

activities to fulfill the needs of the society. For achieving such objectives,
government should administer its finance properly. To this end, it describes its
intentions and policies that it would want to perform in the coming period
(usually a year) and prepare financial plan corresponding to its activities. This
financial plan is referred to as government budget.

Learning Objectives

After completing this unit, a student is expected to:

 describe the meaning of government budget

173
  explain the features and importance of budget

 analyze the principles of budgeting

 explain the types of budget

 describe the procedure of budgeting

 describe performance of budgeting

6.1 Meaning of Public Budget

Dear colleague! Have you ever heard the term government budget? What do
you think about it? Write your answer on a rough paper and try to relate it with
the following analysis.

___________________________________________________________________________________
___________________________________________________________________________________
___________________________________________________________________________________

Have you answered? Good

Many scholars have defined budget in different ways. According to Prof. Rene
Stourn” it is a document containing a preliminary approved plan of public revenue
and expenditure”. According to Gaston Gaze “The budget in a modern state is a
forecast and an estimate of all public receipt and expenses, and for certain
expenses and receipts, an authorization to incur them and collect them.” There
are many others, which can be cited, but they all express the same things. They
all put forth the elements that are present in a budget. These main elements that
present in budget are:

 It is a statement of expected revenue and proposed expenditures of the

authorities concerned

 It requires some authority to sanction. For example after it is prepared, the

parliament has to approve public budget in Ethiopia

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  It has a periodicity which generally in one current year. For example : The
1999 Ethiopian budget year extends from Hamle 1, 1998 E.C up to Sene 30,
1999 E.C

 It sets procedure in which the collection of revenue and administration of

expenditure is to be executed.

Thus with these characteristics we can define budget as:

The main tool to administer finance, and is an annual statement of

government fiscal policies, revenue and expenditure.

6.2 Importance of Public Budget

Dear student! What importance does public budget has for the economy
especially for developing countries?

___________________________________________________________________________________
___________________________________________________________________________________
___________________________________________________________________________________

As you know every nation needs to achieve many goals (to achieve rapid
development, to rise per capital income, remove poverty, to achieve higher
employment etc), but due to the existence of scarcity of resources it is impossible
to achieve all this goals at a time. A proper plan of action is there fore necessary.
A budget is a short term plan which explicitly mentions the programmes that are
to be taken up in the course of the fiscal year, it specifies what part of different
programmes to be completed with in the year, it clearly draws up schemes of
revenue sources for these programmes and how this programmes to be
implemented by the responsible bodies. There for, public budget enables
countries to:

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 To use their resources efficiently by setting the physical targets for
different actions considering different factors, It may be formulating the
programmes on the basis of past experience

 To avoid arbitrary use of resources

 Avoid corruption. Because at the end of the budget year ,the government
and its various departments know that they are responsible to the
legislature for their action and budgetary performances

 To achieve regional balance by reallocating funds

6.3 Principles of Budgeting

Dear distance learner! Do you know the principles that government budget should include? What
are they? Write your answer on a rough paper and try to relate it with the following analysis.

______________________________________________________________________________
______________________________________________________________________________
______________________________________________________________________________

A principle of sound budget consists of wise spending and collection of revenue and involves the
following principles.

Canon of Comprehensiveness: according to this principle a yearly financial plan of a nation

should include complete revenue and expenditure lists. It ought to be accompanied by an account
of the performance of fiscal policies and programmers of the government during the previous
year.

 Canon of Exclusiveness: this canon suggests that public

budget should exclude matters out of finance.

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  Canon of Unity -according to this principle revenue should be
recorded in a revenue account and expenditure ought to be
recorded in the expenditure account.

 Canon of Specification -this principle suggests that every item

of revenue should be specific, this means the type, and amount
and time of collection ought to be determined. The same should
be done for expenditure.

 Canon of Periodicity -this rule implies that government should

prepare a yearly plan of revenue and expenditure.

6.4 Objective of Budgeting

As an instrument of economic policy, the objectives of budget are likely to be

different in different countries and in the same country in different situations.
It depends on the economic and social policy of the government. In
developing economies the objectives may be economic growth, reduction of
unemployment and reduction in economic inequalities; but for developed
nations which are operating at full and near full employment level the is
maintaining full employment. Budget as an annual financial plan for a specific
period of time containing estimates of revenue-expenditure of various
departments of the government; it high lights the decision and policies of the
government required for achieving the desired objectives. Thus budget as a
crucial and imperative instrument of economic policy would involve the
following objectives.

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  Building of economic overheads: In less developed countries, there
is scarcity of economic overheads. Thus budgetary provisions help to
build infrastructures, which in turn make important influence on
industrial and agricultural development.

 Balanced development: developing countries suffer from regional

imbalance in economic development. There fore, government budget
can correct these geographical back ward regions

 Poverty reduction: poverty removal programme is a part and parcel of

the budget in less developed countries. All expenditure measures are
designed so that they directly or indirectly influence reduction of poverty
in the country.

 Full employment and price stability: A significant function of the

budget is to secure the objective of full employment and price stability

 Check on misuse of public goods: No doubt budget is a financial plan

relating to public revenues and expenditures. Thus it is a check whether
the collected revenues are used for the proposed objectives in an
efficient way or not

 Development of human capital: Skilled human labor is most

important for any countries development more than any thing. Thus
budget provisions can go a long way to serve the purpose

6.5 Types of Budgeting

Dear distance learner! Do you know the different types of budget? What are
they? Write your answer on a rough paper and try to relate it the following
analysis.

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Multiple and unified budgets
In some countries of the world, for instance U.S.A, there was traditional way
of preparing budgets in parts and presents each part separately in order to
evaluate specialize function of the government This types of budgets are said
to be Multiple budgets.

However, in now a day a type of budget that has got favor is a united budget. In this case a
budget is prepared in a united way; important sub portions are classified and presented separately
under it.

Revenue (current) and capital Budgets

In various countries of the world, the budget is categorized in to

 Revenue

 Capital account.

Revenue budget- includes those items that have recurring nature. This
means it incorporates tax as well as non-tax revenue and the expenditures
financed with revenue receipts. Current expenditures, which are financed out
of these revenue receipts, are all sorts of administrative as well as defence
expenditures and debt services. They are also known as non-developmental
expenditures.

Capital budget- includes these items that have a nature of acquiring and
disposing capital assets. This means it consists capital account receipts such
as market loans, borrowing from National Bank of a nation, through the sell of
Treasury Bills, and others in order to finance capital expenditures that are
intended for the creation of capital assets in the economy. They contribute
to increase the productive capacity of the nation and hence, are said to be
developmental expenditures. Expenditure of on construction of dam, building,

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and irrigation agricultural and industrial activities are examples capital
budget.

Functional Budget-

It is classified based on the purpose of the expenditure. This classification

covers only the expenditure. The UN Bureau of Economic Affairs, in it's "
Manual for Economic and Functional classification of Government Transaction
1959" groups expenditure under five headings namely general services,
community services, social services, economic service and un allocable
(quoted in Bahtia, 2002).

However, the National Council of Applied Economic Research in its Economic

functional Classification of Central and State Government Budget 1957-58 did
not include the group of community service. It distributed these services in
to social or economic services accordingly. (Bhatia, 2002, p. 263). Therefore,
the functional classification of spending has bee divided in to four groups as
shown below.

General services: this group incorporates expenditures on civil and defense activities such
as general administration, tax collection, police defense, mint and currency, external affairs,
provision for against natural disasters etc.

Social Services: this group involves expenditures on services like

education, health, family planning, housing, library (public),
broadcasting, employment program, and nutrition program for
children, relief expenditure for disabled persons and etc.

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Economic Services: this category involves all spending which
facilitate economic activity directly or indirectly. They are divided into
agriculture, industry, transport and communication, and other
economic activities.

Un allocable: this group involves those items that cannot be

categorized under the above groups. These are interest payment,
pension, food subsidies, special loan, aid to foreign nations etc.

Now you have completed the fourth section of this unit. So, do the
following self-test questions to see how you have understood the types
of budget?

6.6 Procedure of Budgeting

Dear distance learner! Do you know the procedure of preparing a

budget? Go to the near by planning office and ask about it. Write what
you get from there and try to relate with following analysis.

One of the most important factors which affect economic growth is

inefficient utilization of limited economic resources. Therefore,
any country has to control it's expenditure in such away to buttress its
growth. There are different stages of controlling public expenditure.
These are:

Budget preparation- it is the first stage of controlling annual

financial Plan. The Ministry of Finance prepares the National
budget. The main target of budget preparation is to

 Make the plan to send and raise revenue systematically.

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  Show economic, social and other government policies.

 Provide consistence means for auditing and careful

implementation of financial plans.

 get approval and power from the legislature to raise the

said revenues and spend them etc.

Approval of Budget- it is the second stage that implies the

presentation of budget to the parliament and getting approval. The
Minister of Finance presents the budget. The initial speech that it
makes is emphasized on overall economic and related conditions of the
nation and the main budgetary. Finally, the budget is approved by the
parliament and assumes the power of law.

Execution of Budget- is the third stage of control over of public

expenditure. The implementation of the budget will be started after it
is approved but with great commitment to avoid wastage.

Auditing of Budget- is the fourth stage of control over of government

spending. In this stage the auditor audits government account and
prepare the audit report. This enables government to see the area
where wastage exists and to correct it.

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 EXERCISE 6

By now you have completed the sixth chapter. Hence, try to do the following
self-test to see how you have understood the chapter.

Part I. Write true if the statement is correct and false if it is incorrect and write reasons for each

1. In order to fulfill the needs of the society with limited resources,

government should administer its finance efficiently. True Why?

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 2. Various governments have made taxation, borrowing, expenditure and
other financial decisions randomly False Why?

3. Government budget is always prepared on the assumption that the

existing taxes and their rate would continue. _______Why?
___________________

4. Government budget involves the details of estimated revenue and

proposed expenditures. True Why.

Part II. Answer the following questions briefly.

1. List at least three features of public budget

a. Periodicity

b. Sanction

c. Specification

2. The beginning and ending of the 1998 budget year in Ethiopia are

______________________ and _____________________________

3. Write at least two importance of government budget.

a. _____________________________________

b. _____________________________________

4. Government budget is statement of

a. gen

b. _____________________________________

c. _____________________________________

5. What does periodicity of public budget mean? ______________

________________________________________________________

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6 .The Ethiopian annual budgets has prescribed that revenue is collected by
_____________________

7. Explain the canon of unity

_______________________________________________

8. What does the principle of comprehensiveness refer? _________________

9. Analyze the difference between canon of unity and Periodicity.

10. Describe the rule of specification shortly _____________________

______________________________________________________

Key Terms
Government budget Capital budget

Multiple budgets Unified budget

Functional budget Approval of budget

Revenue budget Budget execution

Budget preparation Budget auditing

Supplementary budget

Checklist- Put tick against each of the following task you can perform.

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1. Describe government budget

2 Explain the features of public budget?

3. What is the importance of public budget?

4 Analyze the different canons of budgeting

5. Explain what revenue budget is

6 Describe the concept of capital budget

7 Assess the procedure of budgeting

8 Analyze the performance of budget

9 Explain how budget is approved

Is there any box that you do not tick in it? If yes, please go back once to this
unit and read about it before going to the following unit.

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BAHIR DAR UNIVERSUTY

FACULTY OF BUSINESS AND ECONOMICS

ECONOMICS DEPARTEMENT

Model Examination

187
Dear student! Your final exam will have the type here under. So get
prepared expecting such kinds of questions in your exam

Part I. Match the following.

A tax that flows to a separate budget

___ 1.A tax for specific purpose.

___ 2.Developed nation. B. The responsiveness of change in tax

___ 3.Earmarked tax revenue to a change in its

coverage ____4.Quid Pro quo
and rate

___ 5.Elasticity of a tax C. A compulsory payment to be

paid

___ 6.Buoyancy of a tax by the citizen who is assumed to

be liable to pay it.

D. The rise in tax revenue due to the

Growth of tax base.

E. Something taken or given as

equivalent to another.

F. A tax system is designed to curb

the

Problem of instability in income

and employment.

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Part II Write true if the statement is correct and false if the
statement is incorrect.

1. A good tax system means a perfect tax system.____ why?

.

2. A rigid tax structure is one of the features of a good tax system____

Why? _____________________

3. Rise in standard of living of the people declines taxable capacity.

____________why_________________________________________________

4,.If the tax revenue is used for repaying external debt, taxation will be
declined. Why?
.

5. Knowing taxable capacity enables the government to mobilize resources

for economic development. __________

6. In the case of indirect taxes, impact and incidence coincide on the same
person ________. Why
_______________________________________________________________

7. Incidence refers to the initial money burden of tax. _________________

Why __________________________________________________________

8. In backward shifting of commodity taxation, the money burden of a tax is

transferred from the seller to the buyer when the tax is initially imposed on
the producer. _____. Why

9. When an external debt is received in the form of domestic currency, the

foreign exchange reserve of the borrower country increase, ________________
why __________________________________________

10. Government borrows long-term loans for covering temporary deficit in

budget. __________________Why __________________________________

________________________________________________________________.

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Part III. Choose the best answer for each question.

1. Taxes in which the rate of tax remains constant although the tax
base changes, are called

A. Progressive C. Regressive

B. Proportional D. Digressive

2. A tax levied at 10% on the first Br. 650 of income, 15% on the next
1200 Br and 20%on the next 2000 Br would be

A. Proportional B. digressive C. progressive D. regressive

3. Which of the following is the merit of direct tax?

A. Equity C. Certainty

B. Economy D. Pinching E. All except D.

4. Which of the following is an example of indirect tax?

A. Export duty C. corporation tax

B. Income tax D. Property tax

5. Property tax is not imposed on one of the following property.

A. Farms C. Ranted house

B. Factories D. None

6. Sales tax includes all except

A. Turnover tax C. Value added tax

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 B. Excise tax D. Personal consumption tax

7. When government imposes higher tax on commodities,

A. Consumption will be increased

B. Consumption will be decreased

C. Saving will be raised

D. Capital formation will be increased

E. All except A

8. Which of the following is the disadvantage of indirect tax?

A. It is less pinching. C. There is no certainty.

B. There is no tax evasion. D. It is elastic.

9. In direct taxation system

A. The taxpayer knows the amount of tax he should pay.

B. There may be tax evasion.

C. The taxpayer wants to see where the money is spent.

D. The burden of a tax cannot be shifted to other person E. All

_______10. Which of the following statement is /are true?

A. Shifting refers to the final money burden of the tax.

B. Impact is the point of settlement.

C. Tax evasion is one of the methods of shifting.

D. Tax shifting is illegal E. None

11. In indirect taxation incidence of sales tax lies on the

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 A. Producer C. seller

B. Consumer D. None

12. One of the following is a sort of tax evasion?

A. Shifting C. Contraband

B. Smuggling D. A and B E. B and C

13. Shifting is common in

A. Income tax C. Commodity tax

B. Property tax D. All

14. Impact as well as incidence lies on the same point in the case of

A. Income tax C. Turnover tax

B. Value added tax D. Excise tax

_____. 15. One of the following is the danger of public debt.

A. Decrease in people’s willingness to work

B. Increases in taxation

C. It increases fund for investment

D. All except C.

_____16. Which of the following statement is true?

A. Public debt may lead to full employment

B. Classical economists opposed any form of public

loan.

C Public borrowing may check economic development

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 D. Public loan for celebration does not increase output.

E.All F. All except B

_____17. Public loan may lead to except

A. Inflation C. Loss of political freedom

B. Economic growth D.A and B E. None

_____18. The effect of government borrowing from Central Bank is

A. Increase in money supply C. Inflation

B. Increase in aggregate demand D. A and B E. All

_________19. The direct money burden of external debt is measured by

A. The money payment in the form of interest to creditors

B. The money payment in the form of principal to creditors

C. The loss of economic welfare in terms of consumption of goods and services

foregone

D.A and B E. None

_________20. Which of the following statement is true?

A. Increase in debt service- saving ratio indicates a decline in

availability of saving for domestic capital formation.

B. External public debt invested on war decreases real burden.

C. In the payment of internal debt there is real transfer of

resources.

D. A and C E. None

_________21. In the case of internal debt

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 A. There is a direct money burden on the society

B. There is a direct real burden on the society

C. There is a loss of political freedom

D. A and B E. B and C

_________22. Which is not the method of debt redemption?

A. Refunding C. sinking fund B. Repudiations D. Capital

levy

_________23. The success of conversion of debt depends on

A. The creditworthiness of the government.

B. The maintenance of adequate stock of securities.

C. The efficiency in managing the debt

D. All E. None

Part IV. Discus each of the following questions in detail

1. Explain the difference between unified budget and multiple budgets.

______________________________________________________________________________
_____________________________________________________________________________

2. List the items involved in current budget. _____________________________

________________________________________________________________

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3. Current expenditures are referred to as non-developmental. Why?
_____________________________________________________

4. Write at least two activities on which capital expenditure is made.

_________________________________________________________

___________________________________________________________

Assignments

Here under are assignment questions to be submitted to the program

coordinator under the branch you are following your education.

1.Please go to the near by finance bureau and take data's for different years
and prepare a term paper stating the goals, the instruments designed, the
achievements, drawbacks including your recommendations in no less than 15
pages and not more than 20 pages on your woreda.s tax performance
comparing the actual and the planned one

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