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UNIVERSITY OF NAIROBI

COLLEGE OF HUMANITIES AND SOCIAL SCIENCES

SCHOOL OF BUSINESS

In Collaboration with

CENTRE FOR OPEN AND DISTANCE LEARNING

FINANCING AND ACCOUNTING

DFI 306: PUBLIC FINANCE

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LECTURE ONE
INTRODUCTION TO PUBLIC FINANCE

Lecture Outline
1.1 Introduction
1.2 Objectives
1.3 Meaning of Public Finance
1.4 The Character of the Public Finance
1.4.1 Differences Public Sector and Private Sector Decision Making
1.5 The Relation between Public Finance and Private Finance
1.5.1 Similarities between Public Finance and Private Finance
1.5.2 Differences between Public Finance and Private Finance

1.6 The Scope of Public Finance

1.6.1 Public Income
1.6.2 Public Expenditure
1.6.3 Economic Stabilization
1.6.4 Distributive Justice
1.7 The Economic and Social Responsibility of the Government
1.7.1 The Need for the Public Sector in a Market Economy
1.7.2 The Allocation Function
1.7.3 The Distribution Function
1.8 Summary
1.9 References

1.1 Introduction
In this first lecture we will examine the allocation of scarce economic resources through
the government or the public sector in a mixed economy. Since the allocation function
can be achieved through the market or the government, we shall also study the difference
between these two institutional frameworks through which allocation decisions are made.

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Lastly, we shall discuss how the government exerts a significant influence on the
performance of the economy through its allocation, distribution and stabilization
functions. Therefore, as you study public finance you will learn more about the
economic basis for public sector activities.

1.2 Objectives
At the end of this lecture you should be able to:
1. Define Public Finance.
2. State and explain the character of Public Finance.
3. Describe the difference between Public Finance and Private
Finance.
4. Explain the scope of Public Finance.
5. Discuss the economic and social responsibility of the
government.

1.3 Definition of Public Finance

Public finance is can be defined as a branch of economics that deals with revenue raising
and expenditure activities of the government and how they affect real economic
activities. It lies on the continuum between economics and politics. However, the focus of
public finance is on the budget policy of the government, which is made through the
political process. Therefore, the study of public finance assumes the existence of
democratic states.

1.4 The Character of Public Finance

Public finance lies very close to practical politics. This makes it the liveliest branch of
economics. Its principles and its mechanics may change, at the wave of a politician’s
wand, into the clause of an Act of Parliament. It is also easy to find theory and practice
play into each other’s hands or remain at cross-purposes.

1.4.1 Differences Public Sector and Private Sector Decision Making

Individual decision making for public sector output differs in several significant ways
from decision making for private output.

1. Inability to Control the Amount Purchased

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The output of a public good and the tax price of this output are decided by
government on the basis of overall preferences. Therefore, an individual cannot
influence the quantity of the public good produced and the level of taxation required
to finance it.

2. Nature and Knowledge of Benefits

Pure public goods are consumed collectively; the benefits, indivisible in nature,
accrue to persons constituting the community as a whole. Thus, though the
individual may not realize any benefit at all, yet if the activity were not carried on,
might be worse-off or better off. For example, a person may be unaware of public
health measures designed to reduce HIV/AIDS prevalence yet if the activity were
not undertaken, might become ill with the disease.

3. Uncertainty
There is an unusually high degree of uncertainty associated with public goods.
Individuals may be highly uncertain about their benefits, for instance, the gain from
additional spending on national defense. They are also uncertain about the
consequences of their own actions for the actual determination of the level of
government activity and about the actual tax price they will pay i.e. their share of
various taxes, particularly with the corporate income tax and progressive income
taxes.

Lastly, persons are uncertain about their ability to escape the tax by altering their
activities (earning less or altering consumption patterns, for example) and the extent
to which the tax price will be affected by the changes in activity by other persons.

4. Community Interest Motivation

The self-interest assumption does not preclude consideration of the interests of
others either in the purchase of private goods or in decision making for public goods.
Persons do frequently act as a group (e.g. labor union, political party, civic club) on
matters of pubic goods; they consider the interests of the group and abide by its
decisions rather than act on the basis of narrow personal self interests.

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5. Mixture of Allocation and Distributional Activities

The provision of most government services of a locational nature has distributional
implications as well, especially those that increase outputs of certain goods relative
to others. Since different types of goods are taxed differently, a net redistribution of
real incomes results. Some public goods characteristics convey private benefits as
well. Education, for example, conveys particular benefits to lower income families
but may be financed primarily by higher-income groups. Thus individual preference
schedules for government services are influenced by attitudes toward the
redistribution consequences.

1.5 The Relation between Public Finance and Private Finance

While private finance is concerned with the financial problems and policies of an
individual economic unit public finance is concerned with financial problems and
policies of public authorities. In broader terms, an individual’s expenditure is limited by
the individual’s income whereas a public authority’s expenditure determines its income.
But there are qualifications to this statement.

Similarities between Public Finance and Private Finance

Public Finance is similar to Private Finance in the following ways:
1. Both private and public sectors are engaged in activities that involve purchases, sales
and other transactions.
2. Similarly, they are engaged in production, exchange, saving, capital accumulation,
investment and so on.
3. To finance its activities, the government creates money, raises loans, and makes
payments etc. In the same manner, a private economic unit lends, borrows, receive
payments, makes payments and so on.
4. The problems and decisions of the public and private sectors are similar.

Differences between Public Finance and Private Finance

Public Finance differs from Private Finance in the following ways:

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1. A private economic unit has to live within its means. This constraint hardly applies to
the state.
2. Public and private borrowings also differ in their amounts, forms, rates and interest
and other terms and conditions.
3. The government has the ability to create money that is readily acceptable. A private
economic unit cannot do so.
4. Private finance follows the “market principle”, or the principal of economic
rationality; but public finance follows the budget principle. This means that private
economic units are guided by market signals and the market mechanisms and their
own economic interests. In contrast, the budget principle is governed by the political
and administrative procedures based on common social objectives. The state does not
go by principle of quid pro quo.
5. The discount rate in private finance is higher than in public finance projects since
communities outlive individuals.
6. While a private economic unit proceeds by first ascertaining its income and then its
expenditure, the government does the converse though there are constraints on
government expenditure.

Note
Some principles of private finance will not apply in public finance. The
public sector is part and parcel of the whole economy. Activities of these
two sectors are interrelated and interdependent and involve a good deal
of mutual transfer of resources.

1.6 The Scope of Public Finance

There are four major divisions of public finance: Public Income, Public Expenditure,
Economic Stabilization and Distributive Justice. These divisions are discussed below.

1.6.1 Public Income

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Public income is concerned with revenue raising activities of the government. The
principle source of government income is tax. However, there are other sources of public
revenue like user charges, fees and fines.
1.6.2 Public Expenditure
Public expenditure refers to the allocation of public revenue through the budget policy.
The major forms of public expenditure include education, health, national defense and
law and order.

1.6.3 Economic Stabilization

Economic stabilization is concerned with maintaining stable prices in the economy. The
key financial prices are wages, interest rates, exchange rates, and the inflation rate. The
government plays a big role in ensuring low volatility and variability of macroeconomic
prices thereby reducing risk and uncertainty in the economy. Therefore, price stability is
fundamental to achieving economic growth and development.

1.6.4 Distributive Justice

The objective of distributive justice is to ensure a “fair”, “just” and equitable distribution
of wealth and income in the state. This is arguably the most difficult function for the
government. Even Welfare Economics does not provide guidance on how the
government can achieve fairness, justice and equity in the distribution of the national
cake.

Thus, distribution of income and wealth involves important philosophical issues and
value judgments that are not quantifiable. Hence, there are no objective measures for
criteria like fairness, justice and even equity. It is no wonder then that distributional
issues present a lot of problems for politicians and public policy makers.

Activity 1.1
1. Define Public Finance. Explain its importance in modern
democratic states.
2. Distinguish between Private Finance and Public Finance.
3. State and explain the major divisions of Public Finance.

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1.7 The Economic and Social Responsibility of the Government

Governments have played a key role in all economies, consuming colossal amounts of
money in their activities. The activities are mainly financed with taxes raised from the
citizenry. Taxes, direct and indirect, constitute at least 30% of total income of the
government of Kenya.

1.7.1 The Need for the Public Sector in a Market Economy

The government plays the following important roles in the economy:
1. It provides most education.
2. It pays a large proportion of the medical bills of its citizens.
3. It provides national defense, police and fire protection.
4. It provides housing, recreational facilities, and parklands.
5. It sets health standards and other forms of regulation.
6. It ensures adequate water supplies, transportation and other public facilities.
7. It ensures equitable distribution of income and wealth.
8. It stabilizes the economy from periods of excessive inflation or unemployment.
9. It ensures an adequate rate of economic growth

Governments influence individual decision making through taxation to finance the

activities above. Although particular tax or expenditure measures affect the economy in
many ways and may be designed to serve a variety of purposes, several more or less
distinct policy objectives may be set forth. They include:
1. The provision of social goods, or the process by which the total resource use is
divided between private and social goods and by which the mix of social goods is
chosen. This is the allocation function of budget policy.
2. Adjustment of the distribution of income and wealth to ensure conformance with
what society considers a “fair” or “just” state of distribution. This is the distribution
function.
3. The use of budget policy as a means of maintaining high employment, a reasonable
degree of price level stability, and an appropriate rate of economic growth, with

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allowances for effects on trade and on the balance of payments. This is the
stabilization function.

Though these policy objectives are distinct, any one tax or expenditure measure is likely
to affect more than one objective. Thus, the problem therefore is how to design budget
policy so that the pursuit of one goal does not void that of another.

1.7.2 The Allocation Function

The basic argument here is that certain goods referred to as social or public, as distinct
from private goods – cannot be provided through the market system i.e. by transactions
between individual consumers and producers. In some cases the market fails entirely,
while in other it can function only in an inefficient way.

Public Provision of Social Goods

A major obstacle in the provision of public goods is the elimination of the free-riders
problem. Voluntary payments for services consumed or voluntary payment of taxes is
usually not possible. Also the market mechanism sometimes does not function at all or
functions only inefficiently.

Thus the above problems are solved through the political process. This is where decision-
making by voting replaces preference revelation through the market. The collection of
cost shares is decided upon and must be implemented via a tax system. However, it is
important to note that taxation generates efficiency costs or dead weight losses which do
not arise in a market for private goods and services. Furthermore, the results of the vote
will not please everyone but it can only hope to approximate an efficient solution. It will
do so more or less perfectly, depending on the efficiency of the voting process and the
homogeneity of the community’s preferences in the matter.

1.7.3 The Distribution Function

This function presents major problems for the government. Therefore distribution issues
are a major point of controversy in the budget debate. However, they play a key role in
determining tax and transfer policies.

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(a) Determinants of Distribution

In the absence of policy adjustments, the distribution of income and wealth depends on:-
1. The distribution of factor endowments, including personal earning abilities and the
ownership of accumulated and inherited wealth.
2. The distribution of income, based on this distribution of factors endowments, is then
determined by the process of factor pricing, which in a competitive market sets factor
returns equal to the value of the marginal product.

(b) How Income Should Be Distributed

Modern economic analysis has avoided the question of what constitutes a fair or just state
of distribution. Even welfare economics has defined economic efficiency in a manner
that excludes distributional concerns.

The solution to the problem of fair distribution of income is complex because it involves
issues of social philosophy and value judgment. Philosophers have argued that persons
have a right to the fruits derived from their particular endowments; that distribution
should be arranged so as to maximize total happiness or satisfaction; and that distribution
should meet certain standards of equity. However, choosing among these criteria is no
easy task, nor is it easy to translate any one criterion into the corresponding “correct”
pattern of distribution.

There are two problems involved in the translation of a justice rule into an actual state of
income distribution.
1. It is difficult or impossible to compare the levels of utility which various individuals
derive from their income.
2. Redistribution policies may involve an efficiency cost which must be taken into
account when one is deciding on the extent to which equity objectives should be
pursued.

However, distributional concerns remain an important issue in public policy. Attention is

now shifting from the traditional concern with relative income positions, with the overall
state of equality, and with excessive income at the top of the scale, to the adequacy of

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income at the lower end. Thus the current discussion emphasizes prevention of poverty,
setting what is considered a tolerable cutoff line or floor at the lower end rather than
putting a ceiling at the top, as was once a major concern. This has important bearing on
the design of tax structure.

(c) Fiscal Instruments of Distribution Policy

In democratic states redistribution is implemented most directly by:
1. A tax-transfer scheme, combining progressive taxation of high income with a subsidy
to low-income households.
2. Progressive taxes are used to finance public services, especially those such as pubic
housing, which particularly benefit low-income households.
3. A combination of taxes on goods purchased largely by high-income consumers with
subsidies to other goods, which are used chiefly by low income consumers.

The fact that redistribution inevitably involves efficiency costs does not constitute a good
case against redistribute policies. It simply tells as that:
1. Any given distributional change should be accomplished at the least efficiency cost.
2. A need exist for balancing conflicting equity and efficiency objectives. An optimally
conducted policy must allow for both concerns.

1.7.4 The Stabilization Function

This is concerned with the influence of the budget policy on the macro performance of
the economy, i.e. on targets such as high employment, a reasonable degree of price level
stability, soundness of foreign accounts, and an acceptable rate of economic growth.

(a) The need for Stabilization Policy

The need for stabilization policy arises from the following reasons:
1. Achievement of these targets does not come automatically but requires policy
guidance.
2. Without a stabilization policy, the economy tends to be subject to substantial
fluctuations and may suffer from sustained periods of unemployment or inflation.

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3. With growing international interdependence, forces of instability may be transmitted

form one country to another, which makes the problem complicated.
4. The overall level of prices and employment in the economy depends on the level of
aggregate demand, relative to potential or capacity output valued at prevailing prices.
5. The level of demand is a function of the spending decisions of millions of consumers,
corporate managers, financial investors, and unincorporated operators. These
decisions in turn depend on many factors, such as past and present income, wealth
position, credit availability and expectations.
6. In any one period, the level of expenditures may be insufficient to secure full
employment of labor and other resources. For various reasons, including the fact that
wages and prices tend to be downward rigid there is no ready mechanism by which
such employment will restore itself automatically. Expansionary measures to raise
aggregate demand are then needed.
7. At other times, expenditure may exceed the available output under conditions of high
employment and thus may cause inflation. In such situations, restrictive measures are
needed to reduce demand.
8. Just as deficient demand may generate further deficiency, so may an increase in
prices generate further price rise, leading to renewed inflation. In neither case is there
an automatic adjustment process which ensures that the economy promptly returns to
high employment and stability.
9. Changing expectations introduce a dynamic force which may prove a source of
growth as well as of system instability and decline.

(b) Instruments of Stabilization Policy

Policy instruments available to deal with these problems involve both monetary and fiscal
measurements and their intersection is of great importance.
(i) Monetary Instruments
The central bank controls money supply so that it is adjusted to the needs of the
economy in terms of both short run stability and long run growth. Thus, the
following instruments are used to control money supply (1) Reserve requirement
(ratio) (2) Discount rates, and (3) Open market operations. Expanding money supply

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will tend to increase liquidity, reduce interest rates, and thereby increase the level of
demand, while monetary restrictions work in the opposite direction.

(ii) Fiscal Instruments

Fiscal policy has a direct effect on the level of demand. This can be achieved
through:
1. Raising public expenditures will be expansionary as demand is increased, initially
in the public sector and then transmitted to the private market.
2. Tax reduction, similarly, may be expansionary as taxpayers are left with a higher
level of income and may be expected to spend more.
3. Changes in the level of the deficit and how the deficient is financed are certainly
important. It accompanied by a easy monetary policy, the expansionary effects of
deficit finance will be greater as the deficit can be met by increased credit. If
matched by tight money, placing the additional debt will require an increase in the
rate of interest and thus have a restrictive effect on market transactions. Effects on
the international capital flows are very important.

Activity 1.2
1. State and explain three major functions of the government in a
market economy.
2. Discuss the fiscal instruments for economic stabilization.
3. Explain why the distribution function is difficult to achieve by the
government.

1.8 Summary
This lecture is an introduction to Public Finance where the following
main points should be noted:
 Public Finance is a branch of economics that deals with how
the government raises revenue and spends it. It also examines
the impact of taxation and expenditure activities of the

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government on the economy.

 Public Finance lies on the continuum between economics and
politics.
 Public Finance is concerned with the maximization of social
welfare while Private Finance is concerned with maximization
of private welfare.
 Public Finance has five divisions: Public Income, Public
Expenditure, Financial Administration, Economic Stabilization
and Distributive Justice.
 The government performs three important functions in the
mixed economy: Allocation Function, Distribution Function
and the Stabilization Function.

1.8 References
2 1. Musgrave, R.A. and Musgrave, P.B. Public Finance in Theory and
Practice. 5th Edition, McGraw-Hill Book Company, New
York. 1989. pp. 3 -14, 73 - 85
3
4 2. Bhatia H.L. Public Finance 24th Edition. Vikas Publishing House
Pvt. Ltd. Jangpwa. New Delhi 2003. pp. 16 - 25
5
6 3. Rosen S. Harvey, Public Finance. 7th Edition. McGraw-Hill.,
Homewood. IL, 2005. pp. 3 - 16
7
8 4. Herber, P.B., Modern Public Finance. 5th Edition. Richard D. Irwin
Inc., Homewood. IL, 1990. pp. 23 - 50
9
10 5. Due, J.F. and Friedlaender, A.F., Government Finance: Economics
of the Public Sector. 2002. A.I.T.B.S., Delhi, India. Pp.
108 - 148
11
12 6. Hindriks, J. and Myles, D. G., Intermediate Public Economics. MIT
Press, Cambridge, USA. 2006.
13
14 7. Sundharam, K.P.M. and Andley, K.K., Public Finance: Theory and
Practice, 16th Edition. S. Chand and Company Ltd. New
Delhi. 2003. pp. 1 - 17

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LECTURE TWO
EXTERNALITIES AND THE ROLE OF GOVERNMENT
Lecture Outline
2.1 Introduction
2.2 Objectives
2.3 Definition of Externalities
2.4 Types of Externalities
2.4.1 Positive Externalities
2.4.2 Negative Externalities
2.5 Externalities and Market Failure
2.6 Mechanisms for Correcting Externalities
2.6.1 Property Rights and the Coase Theorem
2.6.2 Tax Incentives and Vouchers
2.6.3 Educational/Informational Programs
2.6.4 Marketable Emission Permits
2.6.5 Regulation, Licensing and Standards
2.7 Summary
2.8 References

2.1 Introduction
In this second lecture we will study how the existence of externalities causes market
failure and hence justify government intervention in the market economy. With
externalities the need for government intervention arises because there is no market
mechanism to ensure that the benefited party compensates the person or firm that is
providing the benefits or that the harmed economic agent receives compensation from the
economic agent that creates the harm. The presence of externalities causes a divergence
between private and social valuations. Thus government intervention of one form or
another is required to equalize private and social valuations. However, government
production is not required because the market is capable of efficiently allocating the
economic resources once the prices are equal to social marginal costs.

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1.2 Objectives
At the end of this lecture you should be able to:
1. Define an externality
2. Explain how positive and negative externalities can cause market
failure.
3. Describe the mechanisms for internalizing externalities.
4. Explain the Coase Theorem and its significance.

2.3 Definition of Externalities

Externalities are costs or benefits imposed on other economic agents arising from
consumption and/or production activities that are not captured by the market
mechanisms. The means that third parties harmed by the activities of a particular
producer or consumer are not compensated. Moreover, third parties benefiting from the
production and consumption activities do not voluntarily pay for the benefits enjoyed.

A distinguishing feature of externalities is that they are reciprocal in nature. For instance,
the more benefits accrue from a particular consumption or production activity the higher
the demand for the same. The converse is also true.

There are two types of externalities: positive and negative. A positive externality confers
benefits to third parties. For example through attending workshops and seminars on
HIV/AIDS may lead to reduced prevalence of HIV/AIDS as a result of people getting
information. Negative externality causes harm to third parties. For example air pollution
arising from heavy chemical industries causes respiratory diseases to those living in the
neighborhood of each chemical plant.

A key question in the analysis of externalities is: Who bears the costs or reaps the
benefits? Thus much of the controversies surrounding externalities boil down to how
costs or benefits are distributed. From an economic perspective, costs benefit should be
allocated in a manner that ensure marginal costs are just equal to marginal benefits.

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2.4 Types of Externalities

Externalities can be either positive or negative.

2.4.1 Positive Externalities

Production or consumption of economic goods and services sometimes confers social
benefits to third parties. The reason is that while most of the costs accrue to the producer
or consumer, not all benefits accrue exclusively to the producer or consumer. The
problem arising from production or consumption of goods with positive externalities is
the divergence between social benefits from private benefit. Some exclusion is difficult
to enforce, third parties free-ride on direct producers or consumers of such goods. Third
parties cannot voluntarily pay for the benefits enjoyed from the production or
consumption activities generating positive externalities. Government must intervene.

Though the existence of positive externalities can cause underproduction or under

consumption of the good generating them, this is not always the case. The level of
production or consumption depends on the size of private benefits relative to social
benefits. When private benefits are large compared to social benefits, production or
consumption activities do not change significantly.

However, where production or consumption activities are seriously affected, government

intervention is required to achieve optimal production and consumption levels. The
various mechanisms available to solve this problem are stetting appropriate prices
(regulation), taxation, subsidies and fees. The objective is to distribute the burden of
payment efficiently and equitably while ensuring efficiency in production or consumption
activities. The above techniques for internalizing externalities will be discussed in detail
in section 2.6 below.

2.4.2 Negative Externalities

Negative externalities are also called external, social costs. Common examples of
negative externalities are pollution, congestion and orders. Since negative externalities
are not a cost of the consumer of producer they cause excess consumption or excess
supply of a given good or service. Consequently, the market fails to efficiently allocate

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resources since the price of goods is below the equilibrium price. Prices do not include
marginal external cost (MEC).

For efficient production or consumption MEC costs must are added to the prices of goods
and services. Thus, the socially efficient price will be P=MC + MEC, where MC is the
marginal cost. Since the prices of goods has increased consumers will consume less, and
consequently, the negative externalities are reduced if not completely eliminated.

Several mechanisms are available for internalizing negative externalities as will be

discussed in section 2.6. These are regulations, fees, fines taxes and user charges.

2.5 Externalities and Market Failure

The principle role played by markets is the allocation of economic resources through
providing price signals. In an efficient and competitive market the forces of demand and
supply determine prices. Therefore the equilibrium price is at the point of intersection of
the demand and supply curves. If the market generates prices either below or above the
equilibrium price, economic activities are distorted. Either too much or too little is
produced or consumed hence market failure.

As already mentioned above, the existence of positive externalities may cause the level of
production or consumption to fall below what is economically optimal. Therefore, the
prevailing prices in the market are not good indicators of how much should be produced
or consumed. Thus, the existence of positive externalities can lead to market failure.

Since negative externalities also distort production or consumption activities, they can
lead to market failure. The tendency to over-produce or over-consume due to under
pricing of goods and services is indeed evidence for a failed market mechanism. The
market is simply inefficient in allocating economic resources on its own. Government
intervention is required to achieve efficiency.

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Note 1.1
Governments like markets also fail. This is pointed out in lecture
three. This eventuality is a double tragedy that can easily degenerate
into anarchy.

2.6 Mechanisms for Correcting Market Failure

The challenge facing policy makers is determining the optimal level of public good
production and allocating costs efficiently among the respective economic agents.
Equally challenging is the measurement of externalities, and the design and
implementation of appropriate intervention to achieve economic efficiencies.

The most common mechanisms for internalizing externalities are: Assignment of

property rights (the Coase Theorem); Tax incentives and vouchers;
Educational/informational programs to encourage or discourage certain types of
production; Development of markets in permits for emissions; Devolution; Regulation;
Mergers; Licensing; Subsidies; Standardization.

2.6.1 Property Rights and the Coase Theorem

The Coase Theorem suggests that some externality problems could be resolved through
assignment of property rights. Specifically this theorem states that, where small numbers
of participants are involved, property rights can be assigned to one of the parties for a
contested resource, and through negotiation efficiency can be achieved in resource
allocation. However, it does not matter who gets the property rights through these could
be a redistribution of income and wealth.

The coarse theorem is only relevant where the size of the consuming or producing group
is small. This makes it most appropriate for resolving local disputes/conflicts if equity
can be achieved. Through bidding for the contested resource, beneficiaries are forced to
reveal their preferences and efficient pricing can be achieved. However, the free-riding
problem emerges as the size of the producing or consuming group increases.

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2.6.2 Tax Incentives and Vouchers

Tax incentives include deductions, exclusions, or credits usually on income tax. The
incentives are used to encourage the production and consumption of goods that generate
positive externalities. The amount of tax foregone to increase production and
consumption is called tax expenditure.

Vouchers are typically given for housing, education or health care services. They allow
individuals to access those goods and services at no cost or at less that the market price.
The vouchers are later redeemed for payment from the issuing public authority. Like tax
incentives, vouchers are used to encourage increased production and consumption of
goods and services conferring positive externalities.

Advantages
Tax incentives and vouchers have the following advantages:
1. The producers and the consumers make the production and consumption decisions.
2. Competition is likely to increase, given the role of the private sector in this scheme.
Disadvantages
Tax incentives and vouchers have the following disadvantages:
1. The two methods are inefficient in terms of the divergence of consumption levels per
dollar given the incentives voucher from the without the incentives or voucher.
2. Tax credit or voucher goes to all consumers who qualify, including a substantial
number of those who would have made the purchase without the incentive.
3. Consumer or produce preferences are completely ignored. Hence utility or
satisfaction or welfare improvement could be sub-optimal.

2.6.3 Educational/Informational Programs

The government can encourage or discourage certain production or consumption
activities through educational and informational methods. Goods with positive
externalities are, for example, education and health care. Goods with negative
externalities include alcohol, cigarettes and tobacco. By using advertising and
educational seminars and workshops, the government can shift the demand curve to the

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left or to the right as the circumstances dictate, moving closers to the optimal level of
production and consumption.

2.6.4 Marketable Emission Permits

Regulation of environmental emissions often stifles innovation. As an alternative, the
market for pollution permits can be developed in which firms buy the permits to pollute
the environment. The forces of demand and supply determine the price of each permit.

Suppose that the government wants to attain a certain level of environmental quality.
There are several ways in which this goal can be attained. Different sources of
environmental emissions have different costs associated for their control. The limited
permits to pollute the environment can be more efficiently allocated through the market
than through regulations.

2.6.5 Regulation, Licensing and Standards

Government can control production and consumption activities through setting rules and
changing fees for these activities. Regulation and standards involves rules that the
government enforce to achieve the optimal level of production and consumption.
Licensing involves setting fees for engaging in consumption and production activities.

One area where regulations and standards have been applied is in the fishing industry.
The government wants to ensure a continuous supply of a cheap source of protein for its
citizens. This is achieved through rules governing fishing seasons. It also enforces
standards for fishing equipment like fishing nets. This ensures that fish population is
maintained at sustainable levels. This is illustrated in the diagram below.

The optimal quantity of fish to be harvested each season, Q *, is set by the government. In
order to achieve this, fishermen are required to use fishing nets of size S*. If fishermen
use nets with small holes, so, the fish population in the take will be significantly reduced
endangering some species, e.g. Nile Perch. The reason is that more fish, Q, will be
harvested than it is optimal, Q *. Conversely, if nets with size S1 are used, less fish is
harvested, Q0, than is optimal 1, Q*, thus under utilizing this resource. Therefore,

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through setting up rules and standards, only the optimal level of fish, Q*, can be
harvested.

Size of
Fishing Net

S1

S*

So

0 Qo Q* Q1
Quantity of Fish Harvested Annually

Activity 2.1
1. Discuss the link between externalities and market failures.
2. What kind of information do you need to internalize an
externality?
3. Does the existence of an externality require government
intervention? Explain.

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2.7 Summary
In this second lecture you have learnt the following key points:
 An externality is a cost or benefit imposed on a third party arising
from the consumption and/or production activities that are not
captured by the prices of goods and services being produced
and/or consumed.
 There are two types of externalities: positive and negative
externalities.
 Positive externalities confer benefits to third parties while
negative externalities cause harm to third parties.
 Externalities can cause market failure. However, not every
externality calls for government intervention.
 Positive externalities cause market failure through under-
allocation, under-production and under-consumption.
 Negative externalities cause market failure due to over-allocation,
over-production and over-consumption.
 The mechanisms for correcting market failure due to positive
externalities include subsidy, tax holidays and tax waivers, and
government production.
 The mechanisms for correcting market failure due to negative
externalities include taxation, standardization, regulation and
licensing.

2.8 Reference
1. Ulbrich, H., Public Finance in Theory and Practice. Thomson –
South-Western, USA. 2003.
2. Rosen S. Harvey, Public Finance. 7th Edition. McGraw-Hill.,
Homewood. IL, 2005. pp. 81 - 110

3. Due, J.F. and Friedlaender, A.F., Government Finance:

Economics of the Public Sector. 2002. A.I.T.B.S., Delhi,
India. Pp. 63 - 84

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LECTURE THREE
PUBLIC CHOICE AND THE POLITICAL PROCESS

Lecture Outline
3.1 Introduction
3.2 Objectives
3.3 Definition of Public Choice and the Political Process
3.4 Public Goods
3.4.1 Characteristics of Public Goods
3.4.2 Individual Preferences for Public Goods
3.4.3 Income Elasticity of Demand for Public Goods
3.4.4 The Relationships of the Tax Payment and Quantity Demanded
3.4.5 Some Consequences of the Nature of Public Goods Decision Making
3.5 Political Equilibrium
3.5.1 Elections and Voting
3.5.2 Determinants of Political Equilibrium
3.5.3 The Function of Elections
3.6 Voters, Politicians, Political Parties and Bureaucrats
3.6.1 Referendum
3.6.2 Representatives
3.6.3 Political Parities
3.6.4 The Decision Making Role of the Executive and Bureaucracy
3.7 Voting Mechanisms.
3.7.1 The Unanimity Rule – Absolute Unanimity or Complete Consensus Rule
3.7.2 The Relative Unanimity or Qualified Majority Voting Rule
3.7.3 The Majority Decision Making – Arrow’s Impossibility Theorem
3.7.4 Point Voting
3.7.5 Revealing Social Preferences under Conditions of Uncertainty
3.8 The Political Interaction Costs of Democratic Voting
3.9 Government Failure
3.9.1 The Median Voter
3.9.2 When Voting Works Well

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3.9.3 When Voting Conflicts with Economic Efficiency

3.9.4 Mechanisms for Alleviating Government Failure
3.10 Summary
3.11 References

3.1 Introduction
In this third lecture we will study the problems encountered in revealing social allocation
preferences through the political process. Both normative issues of public goods
consumption and the positive issues of the institutional decision-making mechanisms will
be discussed. Therefore, in this lecture we shall study the economics of political decision
making. As the previous lecture has illustrated, partial or complete market failure in the
allocation of economic resources justifies government intervention in a market economy.
But as pointed out in Lecture One, since distributional issues involve philosophical,
ethical and value judgments, the political process sometimes will not function as
efficiently as it is expected. Thus just as the market sometime fails to allocate economic
resources efficiently, so do the government.

3.2 Objectives
At the end of this lecture you should be able to:
1. Define public choice and the political process.
2. Define public goods and discuss their characteristics.
3. Define the concept of political equilibrium
4. State and explain the function of elections in democratic societies.
5. State and explain the mechanisms for achieving political
equilibrium.
6. Distinguish between the various voting mechanisms.
7. Discuss the causes of and the mechanisms for alleviating
government failure.

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3.3 Definition of Public Choice and the Political Process

A public choice is a decision made through the interaction of many persons according to
laid down rules. The theory of public choice studies how decisions to allocate resources
and the redistribution of income are made through a nation’s political system. The theory
of public choice examines how the political process is used to determine the quantity of
goods and services supplied by governments.

The political process involves agenda setting, provision of information on costs and
benefits of alternative government programs (campaigns), deciding on voting rules and
counting votes. The outcome of the political process depends on the behavior of citizens
as voters, politicians, bureaucrats, and special interest groups. Political decisions affect
many aspects of our lives, quality of education system, road network, and defense. The
political process also determines the amount of taxes paid, and how the burden of
financing government programs is distributed among citizens. Moreover, political
decisions are also used to dispense favors of the government. The political process is
based on rules embodied in the national constitution. In democratic nations citizen have
an opportunity to vote on issues or for candidates who take position on those issues.

3.4 Public Goods

Public goods are economic goods that are collectively consumed by members of the
society. Therefore, they are indivisible. Examples of public goods are national defense,
law and order, and public administration.

3.4.1 Characteristics of Public Goods

Public goods have the following three unique characteristics:
1. Non-appropriability. This means that once they are available, they are equally
available to all members of the society. Therefore, the consumption of a public
good by one citizen does not reduce the amount available to another.
Consequently, there is no need for a citizen to appropriate a public good in order
to gain benefits from it.

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2. Non-rivalry in consumption. This means that one citizen can increase her
satisfaction from the public good without reducing the utility derived by others
from the same public good.

3. Non-excludability. Once a public good becomes available to one citizen it is

equally available to all. Thus it is not possible to deny other citizens the chance of
enjoying a public good.

3.4.2 Individual Preferences for Public Goods

Individual preferences for public goods are influenced by a number of forces:

1. Tastes
Individual preference schedules for public goods are influenced in part by the same
forces that affect the demand for private goods. Individual preferences vary, to some
defense is important while to others, resource conservation.

2. Information
Information is necessary if individuals are to have meaningful preference schedules. If
persons have no knowledge whatever of the benefits of a particular government service,
they can scarcely have a demand for it; they will therefore take no action on the proposal
or will oppose any change because they know nothing of the situation.

For rational action a person must have information about costs and distribution of
services. For most persons optimal allocation of time and money dictates against
scientific endeavor to obtain information necessary for a rational position on many issues
relating to governmental activities. Those who reach a position usually rely on
information readily available from newspapers, and similar sources, which may be
neither unbiased nor accurate. Three consequences of this information gap can be
distinguished: Individuals frequently do not have opinions on various issues of
governmental activity and thus a small group that does is in a position to dominate
policy-making. Persons in higher income groups are in a better position to gain

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information and are likely to have more influence on governmental policy than those in
lower income groups. Many opinions are formed upon meager and biased information.

3. Degrees of Uncertainty
Preferences are affected by the certainty of the consequences of governmental activities
on both benefit and cost sides. Generally the more certainty there is about achieving
benefits from government, the greater the preference at any particular tax price.
Preferences are also affected by estimates of the relative possibilities of the benefits being
more or less than anticipated. For instance, with national defense, the possibility that the
benefits may be much greater than expected (in the event of attack, which while not
expected, may occur) costs leads persons to favour higher levels of the governmental
service than otherwise.

Uncertainty about taxes has similar effects. If people fear that there is a greater chance
that the tax cost to them will exceed rather than fall short of the anticipated figure, they
will prefer less service than otherwise.

4. Philosophy of Government
Many persons have strong biases in favour of or against governmental activity generally.
There is a correlation between income, wealth, and occupational activity and bias,
conservatism is typically found in higher income businesses and professional groups.
There are exceptions of course, and many persons in these groups strongly favour certain
specific governmental activities.

5. Emotional Reactions
Persons are conscious of the reactions of others to their attitudes on certain types of
governmental activities, and their decision making relative to these activities is
influenced thereby e.g. national defense.

3.4.3 Income Elasticity of Demand for Public Goods

The relationship between persons' incomes and their demand for public goods may be
positive or negative. As incomes rise, many persons will feel that they can afford more

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governmental services and they may wish higher standards of such services – better
schools, varied curricula. For public goods regarded as inferior, the reverse will be true;
for example, as incomes rise, some persons will shift from pubic schools to private.

The interdependence between demand for private and public good is worth noting.
Relationships may be complementary; as more families have cars, their relative
preferences for highways and national parks will increase. Other demands are of a
substitute nature, particularly those for governmental services that convey individual as
well as community benefits. For example, increased availability or lower charges for
swimming pools will lessen preference for public pools.

3.4.4 The Relationships of the Tax Payment and Quantity Demanded

Given peoples preference schedules, incomes, and the prices of other goods, the amount
of a particular service that they wish produced is a function of the tax price that they must
pay for it; the lower the tax price, the greater the quantity they will prefer. The actual tax
price, given the tax structure, is affected by the ability of people to escape the tax, legally
or illegally. For example, if people are unwilling to stop purchasing the article that is
taxed to finance the service or do not use it at all, their demand for the service will be
greater than if they are unable or unwilling to avoid the tax.

Similarly, the convenience of the tax and the peoples attitude toward its desirability, or
towards the tax system as a whole if t he service is not related to a particular tax,
influence their demand. Should the government finance its expenditure from a new tax or
a tax increase, from growing revenue from existing levies, or from curtailment of other
spending? People are much more willing on the average to support additional activities
that can be financed without tax increases than ones that require increases even though,
with the former if the service were not increased, they would benefit from tax reduction
or increases in other services. This is an aspect of the “threshold” or “displacement”
phenomenon in taxation.

People become accustomed to a given level of taxes and will oppose any governmental
services that require passage across the threshold. Only when shocked by some drastic

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event, such as a major war or a severe and prolonged financial crisis, will a country be
able to pass the tax threshold. But once it has done so, a tax plateau is reached, persons
normally become accustomed to higher taxes, and there is little pressure to move back
below the original threshold.

3.4.5 Some Consequences of the Nature of Public Goods Decision Making

The failure of the market mechanism to determine the efficient levels of output of public
goods or to allocate their costs makes it necessary for governments to utilize other means
to determine people’s preferences for public goods and to reconcile the conflict between
preferences of various persons.

Moreover, since public goods are indivisible and since their costs are allocated among
individuals through the political process, people can neither adjust the amount of a public
good made available to them neither nor its tax price. Individuals typically realize that
their participation in the decision making process is not likely to influence the outcome
and that decisions will be made about public goods whether they act or not.

Participation requires time and effort. Many people therefore, take no part in collective
decision making, preferring to delegate the task to others, and many even abstain from
voting to choose the representatives who will make the decisions. Or if they do
participate, they do so perfunctorily, choosing among candidates on the basis of general
ideology, ethnicity or political affiliation rather than on any real understanding of the
issues.

Another consequence is that small interested groups exercise primary influence in

decision-making. Also there is a disproportionate influence of the higher income groups
on public policy. While in theory all persons are equal in a democracy for purposes of
collective decision making, their influence is not equal, with the higher income groups
exercising a disproportionate share. Why?
(i) The wealthy are in a much better position to acquire information about
governmental activities and to participate in government.

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(ii) Because of their knowledge and stake in the protection of property, they are
likely to have stronger desires for certain types of government services, and
their bias toward government activity generally, although often adverse, may
be stronger.
(iii) They are in a position to buy influence, while votes cannot legally be bought
and sold; persons contributing substantial amounts of money to political
groups are in a position to receive favors in return. Members of parliament
are relatively affluent.

Activity 3.1
1. Distinguish between a pure public good and a pure private good.
2. How do public goods cause market failure?
3. State and explain factors that influence the demand for public
goods.

3.5 Political Equilibrium

A political equilibrium is an agreement on the level of production of one or more public
goods, given the specific rule for making collective choice and the distribution of tax
shares among individuals. Tax shares or tax prices are pre-announced levies assigned to
citizens and are equal to a portion of the unit cost of a good proposed to be provided by
government. Tax shares represent the cost per unit of a government supplied good to a
voter.

The cost of supplying and producing a public good influences the amount of taxes that
citizens must pay to finance production of each unit of the good. Public goods which do
not yield benefits at least equal to their cost will not receive support from the citizens.
Nonetheless, it is difficult to provide information on the costs and benefits of public
goods. Political campaigns are aimed at solving this problem. The particular public
goods to be provided will be determined by the voting rules used.

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3.5.1 Elections and Voting

Public choices are made formally through elections in which each individual is usually
allowed one vote. The economic analysis of the political process assumes that persons
evaluate the desirability of goods supplied by government in the same way they consider
market goods and services. They are presumed to vote in favour of a proposal only if
they will be made better off by its passage.

A rational voter’s most preferred outcome is the quantity of the government supplied
good corresponding to the point at which the voter’s tax share is exactly equal to the
marginal benefit of the good. At this level of output the voter receives the maximum
possible benefit from the public good. Any output beyond this point makes the voter
worse-off. For a particular voting rule, the results of an election will depend on the
distribution of tax shares and benefits among voters.

The decision to vote depends on the costs and benefits voting and likelihood to achieve
the anticipated benefits. It also depends on the pleasure derived from exercising one’s
freedom of suffrage. The cost of voting include: time, effort and money to gather relevant
information in order to vote wisely. Rational voters believe that their votes will not make
a difference in the outcome of the election. They reason that the likelihood of the ballot
determining the result of the election is almost nil when the number of voters in large.
Since the costs of voting exceed the benefits it is rational not to vote, for a single voter.
Thus a free-rider problem arises in voting.

Some of the reasons why voters do not vote are:

1. The voting system, for example Mlolongo (Queueing method) and acclamation in
Kenya.
2. The voter’s preferred position might be so far from the alternatives being offered
that the probability of receiving any benefit through voting is diminished.
3. Lack of information on candidates and issues being voted for.
4. The circumstances of the vote may not allow voting.

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3.5.2 Determinants of Political Equilibrium

In summary the following factors influence whether a public choice will result in
approval or disapproval of any proposal regarding the level of production of a public
good:
1. The public choice rule itself.
2. The average and marginal cost of the public good.
3. The information available to voters on the cost and benefits associated with the
public good.
4. The distribution of tax shares among voters and the way in which extra taxes vary
with extra output of the good produced.
5. The distribution of benefits among voters.
6. Legal restrictions on the financing of political campaigns.
If any of these factors changes, the political equilibrium will shift appropriately.

3.5.3 The Function of Elections

Elections serve at least the following functions in democratic societies:
1. Basically, elections offer the mechanism for selecting the individuals who will
occupy seats in representative institutions.
2. Elections “provide for orderly succession in government, by the peaceful transfer
of authority to new rulers when the time comes for the old rulers to go, because of
morality or because of failure” (Mackenzie, 1958).
3. The electoral process helps to legitimate the government of the day.
4. Elections allow citizens to participate in the political process and to express their
support for the system.
5. Elections also serve as agents of political socialization and political integration.
6. Political campaigns help inform the electorate about the costs and benefits of
various government programs.
7. Elections provide a forum for airing views not regularly articulated in day-to-day
political debate.

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Activity 3.2
1. Discuss the determinants of political equilibrium.
2. What is the function of elections in democratic states?

3.6 Voters, Politicians, Political Parties and Bureaucrats

This section answers the following questions: Will individuals reveal their preferences at
all? What techniques may be employed to ascertain preferences? The answer to the first
question is yes so long as they know their tax burden is not dependent upon preferences
they indicate. The answer to the second questions depends on the size of the social group.
For instance, when the size is small individual voting on most issues is feasible.
However, for large jurisdictions it is both very costly and time consuming.

The following techniques are used to ascertain individual preferences for public goods:

3.6.1 The Referendum

A referendum is also known as a plebiscite. The referendum involves individual voting
on all policy issues. Policy questions are directly presented to the electorate rather than
being decided solely by their representatives. A referendum may consist of a single direct
question or statement that requires a simple yes or no vote from the public, or of
alternative policy proposals from which the electorate may choose from.

Referendums may be used in different ways. They can be used as a means of consultation
or as an instrument of ratification. When referendums are consultative, they serve as a
kind of public opinion poll on the issue in order to guide politicians in their own
deliberations. Here the politicians are under no obligation to follow the majority
perspective. As instruments of ratification, referendums act as the final seal of approval
on a course of action taken by the government. A good example is where constitutional
amendments must be ratified by the electorate before they can become the law.

It is important to note that in non-democratic states referendums are liable to abuse by the
ruling elite. Here referendums can be used to give an illusion of popular participation
without offering any meaningful choice. The motivation of the ruling elite is to give an

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aura of legitimacy to decisions agreed upon beforehand. However, where referendums do

allow meaningful choice, they enhance the democratic process.

(a) Advantages of the Referendum

The referendum has the following advantages:
1. It represents a system of direct democracy. Voters are given an opportunity to
participate much more immediate influence on public decisions than is possible
through the representative system.
2. The widespread consultation referendums increase the legitimacy of political
decisions.

(b) Disadvantages of the Referendum

The referendum has the following disadvantages:
(i) It is time consuming and requires a lot of effort.
(ii) Most individuals lack information for reaching a decision about the various
programs
(iii) Individual voters may act irresponsibly – voting to increase expenditures and
disapproving all proposals for financing them.
(iv) Rating by all individuals on proposed measures makes the log rolling
necessary for recognition of the interests of the minorities virtually
impossible.
(v) Referendums detract from the legitimacy of parliament – legislators are
elected to make decisions on behalf of their constituents and bypassing
parliament by appealing directly to voters downgrades the importance of the
sovereign legislative body.
(vi) Referendums are inflexible – they require a yes or no answer to often complex
political decisions therefore making compromises difficult. This can cause
anarchy.
(vii) Referendums pose a threat to the minority when used frequently. They result
into “the tyranny of the majority”.

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(c) Applications of Referendums

Due to the disadvantages of referendums listed above, most countries tend to use
them with extreme caution and only under certain circumstances.
1. Frequently, referendums are associated with the process of constitutional
amendment which requires the referendum to ratify changes.
2. Referendums are also used in deciding questions of national importance like
sovereignty, secession or autonomy.
3. Referendums are used to allow citizens to decide on “moral” issues (like
nuclear energy, divorce, licensing and drinking laws) over which there are
sharp and divergent views among political parties.

3.6.2 Representatives
These are the voters’ representatives who reflect their preferences in collective goods
decision-making. The persons elected are those who most successfully estimate social
preferences. Once elected, they will presumably follow polices that reflect their estimates
of the wishes of the constituents, if they seek re-election.

Disadvantages of the Representative System

The representative system suffers from the following disadvantages:
(i) Candidates may seriously err in their estimates of individual preferences.
(ii) Voters may have little real choice if none of the candidates takes an overall
position that coincides with majority preferences.
(iii) Voters lack information about the positions of candidates and do not trouble
themselves to obtain it.
(iv) Once elected, legislators may make little effort to ascertain preferences of their
constituents and may have great difficult in doing so if they try.

Note 3.1
Though the representative system is an imperfect system, there is no
better alternative in a democratic society.

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3.6.3 Political Parties

At the national and to some extent the local level, political parties play a major role in
decision-making processes. Parties mobilize voters around issues, offer policy
alternatives, and as governing instruments lead and direct the bureaucratic machinery of
the state in transforming philosophical dispositions and policy pronouncements into
concrete programs.

When we study parties collectively and comparatively, and seek patterns of their
interactions, we are studying the party system. The performance of the party system can
be analyzed by asking the following questions: How are parties organized? How do
parties operate? How do parties relate to one another in the nation? Who are the leaders
of these parties and what do they stand for? The answers to these questions provide an
insight into the national party system.

A party may be defined as a group of persons with like interests seeking control of
government. The goal of the party leaders is assumed to be maximization of votes in
order to gain and retain office. Accordingly, politicians seek to frame party platforms that
most closely coincide with preferences of the voters as whole.

There are many ways of classifying political parties. Duverger (1954) developed a simple
and widely used system of dividing political parties into three classes: mass, cadre, or
devotee. Mass parties are those which have open membership and recruit members
across the social strata to obtain as many members as possible. The objective here is to
counter the power of establishment parties whose leaders are mainly from the economic,
political and social elite of the society.

Cadre parties are distinguished by their highly centralized structures and the
membership of elites. They are common in developing nations but are found in developed
countries as well. Devotee parties, on the other hand, are those that are built around a
charismatic leader, for example Kenya African National Union under Daniel Moi.

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There are also many ways of characterizing party systems (Sartori, 1976). One way is to
classify party systems by the number of active parties. In both developed and developing
nations there are one-party, dominant party, two-party and multi-party systems. In the
one-party state, a single – which is the only legal party – controls every level of
government. The one-party states are characteristic of authoritarian regimes like People’s
Republic of China.

A dominant Party system exists when a single party regularly wins almost every
election in a multiparty state. A good example is India, where the Congress Party under
Indira Gandhi dominated Indian politics since 1947.

In a two-party system two major parties dominate others. The United States is a good
example of a two-party system. Great Britain, Canada, Australia, and New Zealand have
two dominant parties with one or more weaker parties. The main advantage of this
system is that it offers the electorate a choice of policies and leaders, and simultaneously
promotes political stability by ensuring that one party wins the majority vote in the
legislature.

The multi-party system is characterized by the division of popular support among

several political parties. Consequently, there is no single dominant political party. Thus,
the party in power must generally form coalitions with other parties to form a
government. The main disadvantage of this system is that it is inherently unstable.
However, there are many examples of multi-party systems with stable governments like
Switzerland, the Netherlands and France after the Fourth Republic. The main advantage
of this system is that it allows wider expression of interests in increasingly complex
democratic states.

Parties in designing their programs attempt to expand each activity to the level at which
the marginal gain from such activities is exactly equal to the marginal adverse response to
the concomitant taxation.

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People will presumably vote for the party that they regard as maximizing their gain.
Thus, these parties act as intermediaries, facilitating the functioning of the representatives
system by providing individual candidates of the party with a more or less common set of
proposals and simplifying voting as particular parties come to stand for certain general
propositions i.e. to represent a particular ideology.

Disadvantages of Political Parties

Political parties have the following disadvantages:
1. If there are several sharply divergent views on a major issue, a multi-party system
develops. Since no one party is likely to gain a majority, the consequences are
instability of power and difficulty of deciding on and carrying through any consistent
set of policies.
2. Parties may not correctly estimate the preference schedules of the majority of voters
on all issues of governmental activities. Consequently, party leaders may substitute
their own judgments for those of the community and seek to obtain popular support
for them. Such a policy may cause parties to mislead their constituents about the
merits of certain policies or the effectiveness of those carried out.

4. The Decision Making Role of the Executive and Bureaucracy

The head of government is the leader of the ruling party and thus has primary
responsibility for interpreting the wishes of the public and developing and executing
policies, subject to legislative approval to meet the wishes of society.

Capable leaders, through their positions can exercise great influence in and thus shape the
nature of individual preference schedules for public goods. This influence is made
possible by the lack of information on the part of voters and their uncertainty about the
outcomes of various policies.

Significant influence is similarly exercised over governmental programs by the

administrative organization – the bureaucracy of government. Bureaucracy also
influences the specific manner in which the program is carried out. However, voters can

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influence only the general nature of an activity while the bureaucracy determines the
details.

Some economists have argued that the supply of public goods is also influenced by the
monopolistic behavior of bureaucrats who are interested in the extension of their power.
Niskanen argues that bureaucrats act in a way analogous to the private monopolist. But
unlike the monopolist who is interested in maximizing profits and therefore produces
until marginal revenue equals marginal cost, the bureaucrat is interested in maximizing
activities and will therefore provide the service until total benefits equal the marginal
costs, the result is that the public good will be in over supply.

Recent variants of the monopolistic view of the provision of pubic goods include the
notion of agenda setting. This is a situation where the government is actually in a
position to determine the agenda or issues on which citizens are permitted to vote. In
agenda setting, it is assumed that the government’s objective is to maximize the level of
services and that the public has little or no control over the proposals on which it must
vote. The public is assumed to react positively to the agenda set by the government,
which not only determines the proposed level of services but also determines the tax
packages on which the public may vote.

The above views are necessarily simplistic. No single motive can appropriately be
assumed, since both purely personal motives as well as those relating to furtherance of
the activity influence behavior. For example, a good reason for personal motivation is the
desire to maintain position and gain promotion. Some people seek to attain this goal
primarily by performing their tasks with as little change as possible, aiming never to
incur the enmity of anyone and to avoid policies that might fail and thus discredit them
and their superiors.

Others emphasize the innovative role, seeking change and improvement to demonstrate
their capacities to their superiors. They are willing to take risks and thus move up very
rapidly, on the one hand, or fail completely on the other. Both motives provide incentives
towards efficiency and towards implementing as effectively as possible policies

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determined at higher levels. Unfortunately, they sometimes lead to empire building.

Bureaucrats attempt to secure as many subordinates as possible in the belief that the
larger the empire the higher the salary and the greater the chances for promotion.

Many persons become zealots for the activity with which they are associated. For
instance, to them preservation of wildlife or forests, improved standards of education etc
become highly important goals. While this phenomenon may further efficient operation
of particular governmental units, it may lead to expansion of activities beyond society’s
preferences.

Also, most persons in higher administrative tasks do become concerned with the interests
of society as a whole and not only with their immediate personal interests. Therefore,
any economic analysis of government that does not take these political behaviors into
account will cause failure in public policies. Thus, with the dual motivation – personal
and societal interests – the bureaucrats not only influence the manner in which activities
are carried out but also exercise influence upon the scope of various government
programs.

The president and the legislators are heavily dependent upon the bureaucrats for advice
concerning benefits from expansion or contraction of each function of government, since
they have first-hand knowledge of benefits and needs. However, bureaucrats favour
continually higher levels of activity, which they seek to justify. They derive benefits from
these both personally and in terms of broader interests, but bear little of the additional
cost.

Concerning bureaucratic recommendations, legislative bodies must exercise independent

judgment as they estimate the preferences of individuals, considering benefits and costs.
The attitudes of those who bear costs as well as benefits must play a part in the decision
process.

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Note 3.2
This analysis presents situation where the government proposes what it
believes will maximize its vote getting ability, and the political leaders
act in such a way that they think will maximize their vote-getting ability.
Moreover, career civil servants or bureaucrats act to maximize their
power and influence through provision of public goods and the setting of
an agenda. The citizens are assumed to play a rather passive role and vote
for the person or party they feel best represents their interests.
Accordingly, different political leaders typically represent different socio
economic groups. The art of politics is reaching a consensus that appeals
to the majority of the leaders or at least that is acceptable to them. While
it is doubtful that the political process attempts to maximize anything, on
the whole it seems to work in that the perceived benefit arising from
government are usually thought to be greater than the perceived costs by
the relevant constituencies or socio economic groups. This is essential for
the maintenance of a viable democracy.

Activity 3.3
1. Compare and contrast the following mechanisms for political
participation: (a) referendums and representatives (b)
Representatives and political parties
2. Discuss the reasons for the rise and growth of multi-party systems
in Africa.
3. What are the motivations and behaviors of the main actors in the
political process?
4. (a) Why are the incentives facing bureaucrats inconsistent with
addressing the desires and preferences of voters? (b) How can they
be aligned?

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3.7 Voting Mechanisms

Different groups in the state have different attitudes towards provision of public goods.
There are also conflicts among the bureaucrats, the political representatives and the
citizen voters. These conflicts are reconciled by the political process through the
mechanisms voting below.

3.7.1 The Unanimity Rule – Absolute and Relative Unanimity Rule of Knut Wicksell
The absolute unanimity rule or the complete consensus rule could be employed to only
those actions relating to output of public goods on which complete agreement can
justifiably be undertaken. This rule is closely related to the Pareto criterion. Given
rational behavior, only change in the output of public goods benefiting one or more
persons and injuring no one will receive unanimous support, whereas changes not
meeting this requirement will not. This rule avoids voter externality costs of change, i.e.
injury to persons who do not wish to change, and provides maximum protection of the
minority interests

3.7.2 The Relative Unanimity or Qualified Majority Voting Rule

This rule suggests that the approval of a budgetary policy should be as close to 100
percent (absolute unanimity) as possible without inducing excessive voting strategy. For
example, a two thirds, three fourths, five sixths might be required for approval of a
budget policy under this rule. The implication here is that in a large group situation an
individual knows that his or her vote, by itself, could not block a budget proposal.
Consequently, a person would not be as strongly motivated to exploit others through a
negative strategy as would be the case under absolute unanimity rule.

Under a relative unanimity rule it is more likely that a sufficient number of individuals in
the society would follow “non strategic” behavior so as to allow an acceptable number of
collective decisions to be made. The rule of relative unanimity tends to reduce voter
externality costs, since the proportion of voters who may be losers is reduced to less than
50 percent minus 1. It could be counter argued, however, that the relative unanimity rule
works against the general well being of the majority, thus creating a “tyranny of the

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minority”, whereby a minority of say 34 voters can bind a majority of 66 voters to a

budgetary decision under the two thirds approval rule.

Wicksell also recognizes the need of making expenditure and tax decisions
simultaneously in the legislature, thereby ensuring a close link between spending and
revenue decisions. However, the common practice in a democratic state is to first
establish the quantity of public goods (the level of public expenditure) and then select the
means finance them. This avoids the making of the benefit-tax cost decision at once.

3.7.3 The Majority Decision Making – Arrow’s Impossibility Theorem

This rule provides additional insight into problems involved in making societal decisions
consistent with individuals/preferences through group voting in a democratic political
process. The majority voting rule is the mainstay of modern democracies.

Arrow argued that the following conditions must be met if a collective decision reached
under majority voting conditions is to accurately reveal the individual economic
preferences which constitute effective social indifference curve (the social welfare
function).
1. Social choice must be transitive (consistent). That is, a unique social ordering
must exist which will yield a clear cut wining alternative regardless of the
ordering sequence in which alternative choices are voted on.
2. The social welfare function must be non-perverse in the sense that an alterative
policy which might otherwise have been chosen by the society must not be
rejected because any one individual has changed the relative ranking of that
alternative.
3. The elimination of any one alternative must not influence the ranking of other
alternatives in the social welfare function.
4. Voters have free choices among all alternative policies.
5. Social choices must not be dictatorial.

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Examples of Majority Voting: Individual Preferences for Alternative Budget

Policies.
a) Results: Intransitive
Policy alternatives
Voter Preference 1 Preference 2 Preference 3
X - A B C
Y - B C A
Z - C A B
Summary: Voters X and Z prefer policy A to policy B; X and Y prefer policy B to C, Y and Z prefer policy C to A; thus a majority (2
of 3 individuals in this case) prefer policy A to B, B to C, and C to A. this result in intransitive (inconsistent) and violates condition 1,
above.
b) Results: Transitive
Policy alternatives
Voter Preference 1 Preference 2 Preference 3
X A B C
Y B C A
Z C B A
Summary: Since voter Z exhibits a C, B, A preference pattern; B is preferred over A by 2 of 3 voters, C is preferred over A by 2 of 3
voters, and B is preferred over C by 2 of 3 voters, thus making the median policy “B” the winner. A=build 3 dispensaries; B=Build 2
dispensaries; C = build 1 dispensary.

a) Results: Intransitive
Figure (a): Twin-peaked function for voter Z

Voter X
Voter Y
B Voter Z
1

2
Ranking

A B C

Policy alternatives

In (a) above, the transivity condition is violated, leading to what is known the
impossibility theorem or voting paradox. There is no winner. In this case, the
“sequence” in which the voting occurs would determine the final outcome - obviously an
illogical result. A close inspection of the above paradox reveals that intransivity occurs

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because one voter, Z, prefers the two extreme policies (C for 1 dispensary and A for 3
dispensaries) over the median or intermediate alternative B, for two dispensaries. This is
an unlikely position for the voter to take. When graphed the result is a twin-peaked
preference function for voter Z in Figure (a) below.

b) Results: Transitive
Figure (b): Single-peaked preference function for voter Z

Voter X
Voter Y
B Voter Z
1

2
Ranking

A B C
If voter C behaves in a more rational manner and prefers two libraries as a second choice,
Policy alternatives
the intransivity problem disappears and the solution becomes determinate, Figure (b)
above.

Arrow’s condition 3 is unduly rigorous. It basically asserts that a consideration of

preference intensity is irrelevant. The Arrow approach thus tends to understate the
intensity of desires among alternative policy choices. It is difficult for a system of social
choice which ignores the basic preference consideration to interpret accurately individual
demands expressed in the political process.

In summary, the arrow theorem seems too pessimistic concerning the efficiency of the
democratic political process, though it does point out some weaknesses. This problem
arises mainly from (1) the irrational voter depicted in the twin peaked preference
function; and (2) the assumption which ignores the ability of the democratic process to
reveal voter’s preference intensities among policy alternatives.

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3.7.4 Point Voting

This method emphasizes the relative intensity of preferences among alternative budgetary
policies.
Examples of Point Voting in the Revelation of Social Preferences (100 Points
Maximum for Each Individual)

a) Results: (1) Transitive (No tie)

b)
Points assigned to policy alternatives
Voter X Y Z
A 22 20 8
B 4 40 6
C 14 12 24
Total 40 72 38
Note: policy Y will be selected

b) Results (1): Transitive (No Tie)

Points assigned to policy alternatives
Voter X Y Z
A 26 15 9
B 6 30 14
C 18 5 27
Total 50 50 50

Though the intransivity problem is avoided under the point voting rule, a tie could occur.
Consumer sovereignty in the market sense appears to be approximated more closely in
point voting than in simple majority voting. The formal structuring of a point voting
system would entail numerous institutional and administrative problems. Moreover,
strategy would come into play more prominently. Though strategy would alleviate the
free rider problem it increases the costs of reaching an agreement in a large group.

3.7.5 Revealing Social Preferences under Conditions of Uncertainty

a) Allowing for Relative Preference Intensities under Uncertainty
The importance of relative preference intensities for various policy alternatives has been
emphasized by James J. Coleman. Coleman questions the third condition for efficient
majority voting provided by Arrow, and demonstrates that the Arrow impossibility

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theorem is relevant only to those social mechanisms in which relative intensities of desire
between alternatives cannot be expressed. Coleman overcomes the above limitation by
using Utility Theory in which the problems of individualistic choice and social welfare
are viewed in terms of utility maximization under conditions of uncertainty.

In the public sector a voter only has partially control a policy outcome. Therefore
uncertainty and risk matter a lot to the public sector allocation of economic resources.
Under uncertainty, each individual voter attaches a subjective probability to each possible
policy outcome. Consequently, the voter will rationally rank the utilities of alternative
budget policies and the expected relative sizes of utility differences between various
possible outcomes, under uncertainty.

Public Choice Using Vote Exchanges under Conditions of Expected Utility and Risk

a) Results: (1) Intransitive

Policy alternatives
Voter Preference 1 Preference 2 Preference 3
X - A B C
Y - B C A
Z - C A B

Table (b) Results (1) intransitive

Policy alternatives
Voter Preference 1 Preference 2 Preference 3
X - A’ B’ C’
Y - B’ C’ A’
Z - C’ A’ B’

Table (c) Results: (1) Transitive (no tie )

Utility expected from budget policy
Voter A B C A’ B’ C’
X 20 10 2 20 18 16
Y 16 20 18 16 20 18
Z 18 16 20 18 12 20

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Table (c) gives the relative intensities of preference of the three voters for the six
alternative budgetary policies, in terms of the relative utility differences among possible
outcomes.

3.8 Political Interaction Costs of Democratic Voting

This analysis is due to James M. Buchanan and Gordon Tullock (1962), in their work,
The Calculus of Consent. The key issues in the analysis are presented diagrammatically
below. Curve DM above represents the nature of decision-making costs. Curve PI reflects
the performance of the overall political interaction costs. The curve is the summation of
its two components, the VE curve and the DM curve. At 70 percent, PI costs are lowest
per voter for a particular fiscal decision.

The expected political interaction costs from collective decision making are two fold (1)
the voter externality cost component and (2) the decision making cost component. A
voter externality cost refers to the cost incurred by a voter who has voted against a fiscal
choice, which nonetheless has been approved by the required proportion of voters
necessary to carry the decision for approval. The nature of voter externality costs are
represented by the VE curve.

PI
Expected costs (present value)

VE

DM

0 50 70 100

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Key
PI = Political Interaction cost curve
VE = Voter Externality cost curve
DM = Decision Making cost curve
A decision cost, in political terms, refers to the bargaining cost required to reach a group
political consensus or agreement. Essentially, these are real resource costs in terms of
direct labor, material, and capital outlay, as well as opportunity cost of the value of time
spent in bargaining. Decision making costs may increase with the size of the rating group
required to approve a decision. The maximum cost will occur at the point of absolute
unanimity because the incentives for strategy will be highest at this point.

Activity 3.4
1. Discuss the five major criteria of fairness in voting mechanisms.
2. What are the limitations of majority voting?
3. Discuss the political interaction costs of voting.

3.9 Government Failure

The government like the market mechanism can also fail in its allocation function. Below
we examine the various causes of government failure in democratic states.

3.9.1 The Median Voter

This is a voter whose most preferred outcome is the median of the most preferred
outcomes of those voting. Voters whose most preferred outcomes deviate from the
median must consume either more or less of the public good than they would choose
independently given their tax shares. The greater the dispersion of most preferred
outcomes from the median, the more likely to be dissatisfaction with public choices under
majority rule. The more voters whose most-preferred outcomes are clustered toward the
median voter’s most preferred outcome, the greater the political equilibrium under
majority rule.

Political externalities are losses in well-being that occur when voters do not obtain
their most preferred outcomes, given their tax shares. Under complete unanimity rule

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political externalities are zero. This is the case since every voter has the power to vote
any public program. Political transaction costs measure the value of time, effort, and
other resources expended to reach and enforce a collective agreement. These are
additional costs of the political process that must be considered in evaluating the
efficiency of government supply compared with market supply.

In choosing political institutions, citizens must weigh the political externalities associated
with these rules against the political transaction costs of the rules. The prevalence of
representative government in all democratic states is best attributed to an effort to
economize on political transaction costs. Other costs of political interaction are those
resulting from bureaucratic inefficiency. If bureaucrats do not produce their output at
minimal cost, or if they succeed in getting more than the efficient amount approved, there
will be losses in net benefits to citizens.

3.9.2 When Voting Works Well

When voters pay tax in proportion to benefits received, all voters will gain if the
government action is productive and all will lose if it is unproductive. When the benefits
and costs of voters are directly related, productive government actions will be favored by
almost all voters, the converse is also true.

In the public sector there is no quid pro quo. The benefits from government action may
be either widespread among the general populace or concentrated among a small
subgroup. Similarly the costs may be either widespread or highly concentrated among
voters. This is illustrated below:

The Distribution of Benefits among Voters

Widespread Concentrated
Widespread Type Type
1 2

Concentrated Type Type

4 3

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The provision of traditional public goods best fits type 1, for example, national defense, a
legal system for the protection of persons and property and enforcement of contracts.
Nearly everyone benefits. The political process will also work pretty well for type 3
measures. Sometimes concentrated groups may pay government to provide services e.g.
user charges for garbage collection or air safety.

3.9.3 When Voting Conflicts with Economic Efficiency

There are four major reasons why unconstrained majority voting rule may conflict with
economic efficiency and prosperity:
1. Special – interest effect
2. Shortsightedness effect
3. Rent seeking behavior or corruption
4. Inefficiency of government operations

1. Special Interest Effect

The special interest effect arises when an issues generates substantial personal benefits
for a small number of constituents while imposing a cost on a large number of other
voters (Type 2). Members of the special interest group and lobbyist representing their
interests have a strong incentive to inform themselves and their allies and let regulators
know how strongly they feel about an issue of special interest.

Interest groups are also a source of campaign resources, including financial contributions.
Others voters will care less about a special interest issue. Politicians are more likely to
rally behind the special interest groups than other voters. The rational ignorance of
voter’s strengthens the power of special interests. The ability of the voter to punish
politicians for supporting special interest legislation is also hindered by the fact that many
issues are bundled together when the voter chooses one candidate or another.

Bureaucratic interests which are often aligned with special interests also favors special
interests. Bureaucrats are usually happy to work to expand their programs to deliver
benefits to special interest groups who, in turn work with politicians to expand their
bureau budgets and programs.

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Another force that strengthens the political doubt of special – interest groups is logrolling
Logrolling is the exchange of political support among politicians one issue for political
support for another issues.

Pork barred legislation is a variant of logrolling this types of legislation bundles together
a set of projects to benefit regional interests at the expenses of general tax payers. As in
the case of logrolling, the bundler of pork – barred projects can often gain approval even
if the items of themselves would be seen as counter productive and would individually be
rejected by the legislative assembly.

In conclusion, public choice analysis demonstrates that majority voting and

representative democracy do not work so well when concentrated interests benefit at the
expense of widely dispersed interests. This special interest of the political process
helps to explain the presence of many programs that reduce the size of the economic
pie.

2. Shortsightedness effect
Voters find it difficult to identify the effects of complex issues over time, so they
tend to rely primarily on he current economic conditions when evaluating the
performance of political incumbents. Unfortunately, policies that look good around
Election Day may have sustained side effect after election. On the other hand, policies
that generate costs before the elections in order to provide long-term gains that
emerge only after the next election reduce the re-election prospects of incumbents. As
a result, the political of short-sighted policies and against the election of sound
long-range policies that involve observable costs prior to the next election. This bias is
called the shortsightedness effect.

Rational ignorance reinforces the shortsightedness of voters. The shortsightedness effect

is also compounded by the lack of tradable property rights the lack of a capital market in
government enterprises.

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3. Rent Seeking
Rent seeking is the term describing actions taken by individuals and groups seeking to
use the political process to plunder the wealth of others. The incentive to engage in
rent seeking behavior/activities is directly proportional to the ease with which the
political process can be used for personal (or interest group) gain at the expense of
others. Weak laws in the state increase rent seeking. Economic regulation also increase
rent seeking activities.

4. Inefficiency of Government Operation

There several reasons for government inefficiency:
1. Lack of incentives for high performance.
2. Profitability is not the goal of government.
3. There is no direct competition in the form of other firms trying to take customers
away.
4. A government cannot become bankrupt
5. No information is available about individual performance in the government.

In summary, what strengthens the case for market sector allocation versus pubic sector
intervention, and vice versa?

These factors strengthen the case for public sector intervention.

1. External costs and benefits
2. Public goods
3. Monopoly
4. Uninformed consumers

These factors weaken the case for public sector intervention

1. The power of special interests
2. The shortsightedness effect
3. Rent-seeking behavior or corruption.
4. Little incentive for operational efficiency.

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3.9.4 Mechanisms for Alleviating Government Failure

1. Privatization
One of the most commonly used method for correcting market failure is privatization.
Both the size and scope of government activity at all levels have expanded significantly.
Since some of the activities undertaken by government lend themselves to private
production or at least private provision, there exist an opportunity to use the beneficial
effects of market prices, competition, and the profit motive to ensure an increase in social
welfare.

2. Devolution
Devolution is the shifting responsibility for providing (and sometimes financing) certain
government activities from the central government to state and/or local governments.
Where no significant externalities are involved with costs or benefits spilling over to
adjacent social groups, real increases in efficiency can be achieved from placing the
provision and financing of services at the lowest possible level of government.

These gains arise at least from two sources. First of all, with smaller social groups, there
is reduced rational ignorance and free-rider problems. It is also easier for citizens to
reveal their preferences.

Second, the availability of small jurisdictions makes it more likely that preferences will
be more homogenous within those localities. The distribution of tastes and preferences
tends to be homogeneous for smaller communities. There also will be fewer citizens
whose individual preferred baskets of public goods and services are far from the most
preferred basket by the social group.

3. Regulation
Regulation involves placing limits to the discretionary authority of both elected officials
(politicians) and appointed civil servants. This is usually achieved through setting of
rules to govern the conduct of government business. Many rules have been passed that tie
the hands of judges, future legislatures and city council, regulatory agencies, and the
executive branch.

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The advantage of rules is that they offer certainty for the citizens, the business firm, and
the politician. Rules make it easier to make difficult or unpopular decisions, pointing to
the rule as limiting one’s ability to make the decision being sought. Rules make it harder
for big interest groups or lobbyists to use the government for their own purposes. Rules
can be effective in checking the size of the public sector.

The disadvantage of rules is that they rigid and therefore stifle innovation. An
economist’s desire is to weigh the costs and benefits for every public good to achieve a
balance at the margin. Also rules eliminate the opportunity for cost-benefit analysis.

4. Participatory Government
Participatory government occurs where citizens are directly involved in making decisions
affecting social welfare like legislation, budgets, and regulations. An example of direct
citizen decision making is the town meeting. Annual (or special) town meetings may
approve the budget, approve ordinances, and take other actions, leaving the local
governing body to run the town’s affairs between meetings. The use of town meetings
has not increased, but it does provide an effective channel of communication between
voters and elected officials in a small town setting.

Other forms of citizen decision making are the initiative and the referendum. Initiatives
bring up issues for voting at the request of a group of citizens, usually with some
minimum number of signatures. Referenda are questions referred to the voters by the
state legislature or local governing body. Referenda frequently deal with such
fundamental questions as a change in the form of government or the state constitution or
with bond issues, although less weighty matters can.

Activity 3.5
1. State the main causes of government failure. How can this problem
be alleviated?
2. Briefly, examine the harmony and conflict between good politics
and sound economics.

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3.10 Summary
In this third lecture you have learnt the following important points:
 A public choice is a decision made through the interaction of many
persons according to laid down rules.
 The political process involves setting the agenda, provision of
information on cost and benefits of government programs, deciding
on voting rules, and vote counting.
 Public goods are goods that are collectively consumed by members
of the society.
 The main actors in the political process are citizens as voters,
politicians, and bureaucrats.
 A political equilibrium is a point of agreement on the quantity of
public goods that should be produced and at what cost. It is achieved
through voting.
 The main forms of political participation in democratic states are the
referendums, representatives and political parties.
 It is impossible for any public choice decision rule to meet all the
criteria of fairness.
 Governments can also fail in the efficient allocation of resources in
the economy.

3.11 References

1. Musgrave, R.A. and Musgrave, P.B. Public Finance in Theory and

Practice. 5th Edition, McGraw-Hill Book Company, New
York. 1989. pp. 87 - 108

2. Herber, P.B., Modern Public Finance. 5th Edition. Richard D. Irwin

Inc., Homewood. IL, 1990. pp. 51 - 71

3. Due, J.F. and Friedlaender, A.F., Government Finance: Economics

of the Public Sector. A.I.T.B.S., Delhi, India. 2002. pp.
25 - 62

4. Hindriks, J. and Myles, D. G., Intermediate Public Economics. MIT

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Press, Cambridge, USA. 2006.

5. Rosen S. Harvey, Public Finance. 7th Edition. McGraw-Hill.,

Homewood. IL, 2005. pp. 111 - 142
6. Jackson, R. L. and Jackson, D., Politics in Canada: Culture,
Institutions and Public Policy. Prentice – Hall,
Scarborough, Ontario, 1990. pp. 433 – 438

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LECTURE FOUR
SOURCES OF PUBLIC INCOME
Lecture Outline
4.1 Introduction
4.2 Objectives
4.3 Definition of Public Income
4.4 Revenue Receipts
4.4.1 Tax Revenue
4.4.2 Non-tax revenue can be divided into three categories.
4.5 Capital Receipts
4.6 Summary
4.7 References

4.1 Introduction
Government, like other economic units, needs funds to finance its activities. There are
various sources of government finance such that an exhaustive list is impossible. The
main sources are taxes, income from the printing press, fees, fines, gifts and donations.
Therefore, the process of raising funds to support government expenditure exerts a
burden to the private sector. This necessitates government to make a set of decisions
concerning its revenue raising activities. Should the government prefer voluntary or
compulsory methods of raising revenue? If the government prefers the compulsory
method of raising revenue through taxes, what criteria should be used to select between
the different taxes available? What price should the government charge for its services?
And, how should this price be determined?

4.2 Objectives
At the end of this lecture you should be able to:
1. Define public income.
2. Discuss the various sources of public income.

4.3 Definition of Public Income

Public income refers to the funds available to the government to finance its activities.
Such funds are sourced from public receipts and public revenue. Public receipts include

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income from all sources. Public revenue excludes public borrowings, income from the
sale of public assets, or receipts from running the printing press. The important sources of
public income include: Taxes, income from currency, market borrowing, sales of public
assets, income from public undertakings, fines, fees, gifts and donations.

4.4 Revenue Receipts

Revenue receipts are divided into tax- revenue and non-tax revenue

4.4.1 Tax Revenue

A tax is a compulsory charge imposed by a public authority, and as Taussig puts it, “the
essence of a tax, as distinguished from other charges by government, is the absence of a
direct quid pro quo between the taxpayer and the public authority.”

There are three types of tax - revenue

1. Taxes on income and expenditure. These including all taxes which are levied on
receipt of income and expenditures such as corporation tax, income tax, expenditure
tax, interest tax, etc.
2. Taxes on property and capital transactions. These covers taxes on specific forms
of wealth and its transfers such as estate duty, wealth tax, gift tax, house tax, and land
revenue and stamps and registration fees, etc.
3. Taxes on commodities and services. These include taxes on production, sale,
purchase, transport, storage, and consumption of goods and services.

4.4.2 Non-tax revenue can be divided into three categories.

1. Currency, carriage and mint. This is revenue from running the printing press.
2. Interest receipts, dividend and profits. This is revenue from public enterprises.
3. Other non-tax revenue. This includes revenue from various government activities
and services such as administrative services, public service commission, police, jails,
etc.

4.5 Capital Receipts

Capital receipts of the government take many forms. The most important ones include:

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1. Public borrowings from both internal and external sources.

2. Long-term, medium-term or short-term loans. These may be marketable or non-
marketable, interest-free or interest bearing.
3. Recovery of loans due from to debtors to the government.
4. Grants and donations, deposits and appropriation funds and so on.

Activity 4.1
1. Discuss the factors that influence the selection of the source of
finance for the government.

2. State and explain the advantages and disadvantages of donations

and grants as sources of government revenue.

3. Compare and contrast taxes on income and wealth and taxes on

commodities as sources of government revenue.

4.6 Summary
In this fourth lecture you have learnt the following:
The main sources of government revenue are taxes, public borrowings,
dividends and profits from public enterprises, proceeds from printing
money, and gifts and donations.

4.7 References
1. Musgrave, R.A. and Musgrave, P.B. Public Finance in Theory and
Practice. 5th Edition, McGraw-Hill Book Company,
New York. 1989. pp. 211 - 217

2. Herber, P.B., Modern Public Finance. 5th Edition. Richard D. Irwin

Inc., Homewood. IL, 1990. pp. 95 - 114

3. Due, J.F. and Friedlaender, A.F., Government Finance: Economics

of the Public Sector. A.I.T.B.S., Delhi, India. 2002.
pp. 213 - 252

4. Bhatia H.L. Public Finance 24th Edition. Vikas Publishing House

Pvt. Ltd. Jangpwa. New Delhi 2003. pp. 35 – 51

5. Sundharam, K.P.M. and Andley, K.K., Public Finance: Theory and

Practice, 16th Edition. S. Chand and Company Ltd.
New Delhi. 2003. pp. 51 - 54

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LECTURE FIVE

DISTRIBUTIONAL EQUITY IN TAXATION

Lecture Outline
5.1 Introduction
5.2 Objectives
5.3 Theory of Taxation
5.3.1 The Expediency Theory
5.3.2 The Social Political Theory
5.3.3 The Benefits Received Theory
5.3.4 The Cost of Service Theory
5.3.5 The Ability to Pay Theory (APT)
5.3.6 Indices of Ability to Pay
5.4 Classification and Choices of Taxes
5.4.1 Direct and Indirect Taxes
5.4.2 Merits and Demerits of Direct Taxes
5.4.3 Merits and Demerits of Indirect Taxes

5.4.4 Types of Tax Systems

5.4.5 Forms of Tax Progression
5.5 Characteristics of Optimal Tax Systems
5.6 Equity and Efficiency in Tax Enforcement
5.6.1 Tax equity in the enforcement sense
5.6.2 Tax Evasion, Tax Avoidance, and Tax Delinquency
5.6.3 Techniques and Agencies of Tax Enforcement
5.6.4 Tax Enforcement Efficiency
5.7 Summary
5.8 References

5.1 Introduction
In this fifth lecture we examine how the burden of taxation should be distributed among
individuals and firms in the economy. This is an important distributional question in a
mixed economy. It is also a very old question having been studied by economists for

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centuries. The result from this scholarly endeavor has been the creation and use of certain
operational norms or rules for equity in taxation. However, such rules or norms are laden
with value-judgments since distributional issues fall outside the realm of economics.
Moreover, these rules are discussed in the context of the ultimate economic incidence of a
tax. This takes into account the possibility that tax burdens may be transferred (tax
shifting) from those who are legally required to pay taxes (statutory incidence) to those
not initially legally intended to pay the tax (economic incidence).

5.2 Objectives
At the end of this lecture you should be able to:
1. State and explain major theories of taxation.
2. Distinguish between different types of taxes.
3. Discuss the criteria for selecting between different types of taxes.
4. State and explain the characteristics of an optimal tax system.
5. Discuss equity and efficiency in tax enforcement.

5.3 Theories of Taxation

There are three bases on which tax theories are generally developed:
1. A taxation theory may be developed from an assumption that there need not be
any relationship between tax paid and benefits received from state activities.
This gives rise to two theories of taxation:
i) The Socio-Political Theory
ii) The Expediency Theory
2. A taxation theory may be based on the link between tax liability and state
activities. This yields two theories of taxation:
i) The Benefits Received Theory
ii) The Cost of Service Theory
3. An extension of the former would be that though there need not be any
relationship between tax liability and provision of state services, tax liability
should be apportioned on the basis of comparative ability to pay of the
taxpayers. This gives rise to The Ability to Pay Theory.

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The theories stated above are discussed below in more detail.

5.3.1 The Expediency Theory

The expediency theory asserts that every tax proposal must pass the test of practicality. It
emphasizes levying and collecting taxes efficiently. The economic and social
responsibilities of the state are considered not important.

This theory suffers from two major limitations:

1. It ignores the redistribution, allocation and stabilization roles of taxes.
2. It cannot help public authorities to select between different practicable taxes.

5.3.2 The Social Political Theory

This theory was developed by a German economist called Adolf Wagner. Wagner
advocated that social and political objectives should be the deciding factors in choosing
taxes. He argued that a tax system should be used to cure the social ills like poverty,
disease and illiteracy. Wagner further contended that the state should control the
ownership of private property and its inheritance in the interest of the whole society.

Wagner’s ideas now form the cornerstone of fiscal policies of modern democratic states.
A modern democratic state believes that a tax policy should be used for allocation,
redistribution and stabilization purposes.

The Socio-Political theory suffers from one major limitation. It ignores the principle of
equity. This leads to unfairness between different members of the society and this can be
a source of social, economic and political unrest.

5.3.3 The Benefits Received Theory

The benefits received theory has its roots in the contract theory of the state which states
that the subjects of a state have a contract with the state for the protection of their lives
and property; and the citizens on their part are to surrender all their rights to the state.

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This theory assumes that there is a basically contractual relationship between taxpayers
and the state. The state provides certain goods and services to members of the society and
members contribute to the cost of these supplies in proportion to the benefits received. In
this quid pro quo set up there is no place for issues like equitable distribution of income
and wealth. Instead, the benefits received are taken to represent the basis for distributing
the tax burden in a specific way.

There are two types of services provided by the state:

1. Non-excludable services where every member pays taxes according to the benefits
received.
2. Excludable services where members of the society pay fees and prices instead of
taxes. Here a market relationship exists between taxpayers and the state. Taxpayers
can accept or reject the state services.

Since the tax burden is to be distributed between taxpayers in proportion to the benefits
received by them from state activities, the authorities must identify the beneficiaries and
measure the benefits derived from the goods and services provided. However, this is a
difficult task.

The benefits received theory has a number of limitations:

1. Benefits received from state services are closely related to the distribution pattern
of income and wealth in the state.
2. The benefit received by an individual is ultimately a subjective thing and is
influenced by so many other factors.
3. It is possible that state services may lead to a net contribution to or reduction in
national income. This theory does not state the appropriate action to take in such
a case.
4. It overlooks the possible use of tax policy for bringing about economic growth or
economic stabilization in the economy.
5. It erroneously argues that the contributions of the society to the state treasury for
provisions of services are in the nature of prices which are voluntarily paid.

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5.3.4 The Cost of Service Theory

The Cost of Service Theory (COST) is similar to the Benefits Received Theory by virtue
of its emphasis on the semi-commercial relationship between the state and the citizens.
The citizens are not entitled to any benefit from the state and if they do receive any, they
must pay for it.

In this theory the state is supposed to abdicate its protective and welfare functions. The
state is also required to fully recover all the costs incurred in providing its services.
Consequently, the government must balance its budget thus its expenditure should be
equal to its income.

The COST has a number of conceptual problems:

1. It is difficult to measure the cost of state services and then assign them to
beneficiaries.
2. The nature of the costs cannot be clearly determined.
3. Some state costs have externalities associated with them that are not amenable
quantitative measurement.

5.3.5 The Ability to Pay Theory (APT)

The APT considers the tax liability in its true form – a compulsory payment to the state
without quid pro quo. This theory does not consider any commercial or contractual
relationship between the state and the citizens. According to this theory, a citizen is to
pay taxes just because s/he can, and the relative share of the total tax burden is to be
determined by the citizen’s ability to pay.

The basic tenet of the ability to pay doctrine is that the burden of taxation should be
shared by members of the society on the principles of equity and justice.

The ability approach is based on the broad assumption that those who posses income or
wealth should contribute to support of public functioning according to their relative
abilities. The idea of a just and equitable taxation – in other words, the distribution of tax
burden should be just – has been associated from the earliest times with the concept of
ability to pay. The most classic statement of ability principle comes from the pen of John

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Stuart Mill. He categorically rejected the benefit doctrine based on contact and
protection. If taxation were to be based on protection, it would definitely lend to
regressive taxation, for the poor need more protection than the rich. Besides, the
protection theory was extremely inadequate to explain all the functions of the state.

Supporters of the ability approach have sought to justify it on three grounds:

(i) Sacrifice interpretation of ability. The sacrifice interpretation of ability looks at

the psychological effects of tax payments upon individual taxpayers or every group of
taxpayers. What could be more equitable than a situation under which each person’s
contribution to the support of the government resulted in equal sacrifice for all?

(ii) Diminishing Marginal utility of income. The concept of diminishing marginal

utility of income is derived from the general principle of diminishing marginal utility.
Increase in income will mean lower utility from the additional income. As one
proceeds from basic necessities to conventional necessities and then on to comforts
and luxuries, the intensity of desire will go on decreasing and therefore, the
successive increments of income necessary to satisfy these categories of wants will
necessarily give less and less utility. From this, it follows that tax burdens should be
imposed on large incomes, in which case the burdens will no be felt much. At the
same time, the lower income groups who spend all their incomes to satisfy their most
urgent and essential wants be exempted from taxation.

(iii)Faculty interpretation. The capacity of an individual to produce and consume is

represented by the income and accumulated wealth of an individual. The ability
principle is justified on the basis of the ability or capacity or faculty of a person to
work and earn income or surplus income.

A little consideration of the above three points, justifying the ability to pay principle of
taxation, will show the weakness of each one of them.
1. Sacrifice is subjective and each writer could interpret it in his own way.

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2. It ignores the use of income for saving and investment which are important for the
individual and for the community.
3. There are several indices for determining the relative ability to pay such as
income, property and wealth, and consumption expenditure.
4. Finally, though faculty interpretation of ability is objective, it bristles with many
difficulties when applied in practice.

5.3.5 Indices of Ability to Pay

There are two types of indices of ability to pay of the taxpayer. These are the objective
indices and the subjective indices of ability to pay.

(a) Objective Indices of Ability to Pay

Economists have used three indices to measure ability of a person to pay tax to the
Government. These indices are property, income and personal consumption expenditure.
A family‘s well-being would depend upon the accumulated wealth possessed by it which
provide security and insurance against risk. It is now correctly held that property is
unsatisfactory as a primary test of ability but that it can provide a possible supplementary
index of ability.

Property as a source of income is subject to a number of weaknesses:

(i) Property is not the main source of income, though it is an important source
(ii) Property may or may not yield an income, though it is an important source
(iii)Income from property may very from zero to a large amount depending upon its
nature, location, use, etc.
(iv) The tax on property will fall upon the capital value of the property, if in, any year,
there is no income or there is actually a deficit.

In spite of these weaknesses, the ownership of property gives its holder the additional
source of taxpaying capacity which is not reflected by net income.

A family’s well – being will depend primarily upon the income received and hence,
income after making due allowances for the number of children in the family, etc. is
generally regarded as the best indicator of a person’s ability to pay. Net income is

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regarded as the better measure of tax paying ability because it reflects the sum of net
receipts over costs. Net income exempts the minimum subsistence needs of the family
group and, therefore, will not restrict the consumption of lower substandard income
groups.

Taxable income should be defined as `clear income or income above subsistence. Many
of the classical writers, therefore, advocated the complete exemption of the low and
middle income groups and the imposition of proportional taxation on higher income
brackets.

Later economists introduced yet another degree of progression between earned and
unearned incomes. Earned income refers to income from services, wages and salaries,
while unearned income refers to income from capital. Taxation on earned income is
supposed to imply double sacrifice, that is, loss of enjoyment from the use of income and
also pain of having suffered in vain the disutility of earning such income. On the other
hand, the tax paying capacity of unearned income is rated high.

Income has thus come to be accepted as the proper index of ability and income – tax on
personal income is regarded as the most equitable of all taxes.

Consumption has been suggested as an index of calculating tax paying capacity on the
assumption that such expenditures measure the true utility or satisfaction derived from
income.

(b) Subjective Indices of Ability to Pay

Mill argued that the real burden of taxation should be equal for all and that “similar and
similarly situated persons are to be treated equal.” But the concept `equal’ in equal
sacrifice has been interpreted differently. There are three interpretations of equal
sacrifice – (i) equal absolute sacrifice (ii) equal proportional sacrifice (iii) equal marginal
sacrifice.

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(i) Equal Absolute Sacrifice

Equal absolute sacrifice implies that the total loss of utility as a result of tax should
be equal for all tax payers. This principle received the greatest support at one time
because of its apparent fairness.

(ii) Equal Proportional Sacrifice

Equal proportional sacrifice implies that loss of utility as a result of tax should be
proportional to the total income of tax payers.

This proportional sacrifice principle attempts to relate the sacrifice of tax payment
to the capacity of enjoyment of satisfaction resulting from income. Every
taxpayer’s loss in proportion to his income should be the same as everyone else’s.

(iii) Equal Marginal Sacrifice

Equal marginal sacrifice implies that the marginal sacrifice for the different tax
payers should be the same. Since marginal utility of higher income will be very
low as compared to that of a low income, equal marginal sacrifice will imply that
the person with a higher income will be expected to bear the heaviest burden. This
principle is also known as the least aggregate sacrifice principle of taxation.

Activity 5.1
1. Discuss the following theories of taxation and their policy
implications: (a) The Expediency Theory (b) The Socio-Political
Theory
2. What are the limitations of the benefit principle of taxation?
3. Distinguish between the following subjective indices of ability to
pay: equal absolute sacrifice, equal proportional sacrifice, and equal
marginal sacrifice.

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5.4 Classification and Choice of Taxes

This section discusses how taxes are classified and chosen for purposes of achieving the
goals of government.

5.4.1 Direct and Indirect Taxes

Taxes are classified into direct and indirect taxes on the basis of assessment rather than
on the point of assessment. Those taxes which are imposed on the receipt of income are
called directed taxes, while those which are imposed on expenditure as regarded as
indirect taxes. On this basis income – tax, profit tax and capital tax or wealth tax will be
examples of direct taxes. Excise duties, customs duties and sales taxes (commodity taxes
as they are generally called) are indirect taxes.

5.4.2 Merits and Demerits of Direct Taxes

Direct taxes claim five important merits:
(1) Direct taxes are equitable: Direct taxes are based on the principle of ability to
pay so that the burden of taxation is distributed on different people and
institutions in a just or equitable manner.

(2) Direct taxes satisfy the canon of certainty: The tax payer is certain as to how
much he is expected to pay and the state can estimate the yield from direct taxes,
fairly, accurately and adjust its income and expenditure.

(3) Direct taxes are elastic: They are elastic in the sense that with the increase in
income and wealth of the peoples, the yield of direct taxes will also increase.
Elasticity also implies that the government’s revenue can be increased simply by
raising the rates of taxation.

(4) Direct taxes create civic consciousness: In the case of direct taxes the taxpayers
are made to feel directly the burden of the taxes and hence take intelligent and
keen interest in the way public income is spent.

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(5) Direct taxes are economical: Direct taxes are generally economical in the sense
that the cost of collecting them is rather low.

Among the disadvantages of direct taxes, three points may be emphasized.

1. Direct taxes tend to be arbitrary. It is indeed difficult to have an objectively just
basis of ability in the case of direct taxes. The rate of income tax, for example, will
depend upon the political complexion of the government. A conservative government
may levy a low rate of income tax while a leftist government may impose a stiff rate
of tax.
2. Direct taxes are taxes on honesty and they tempt people to avoid and evade.
There is always a possibility of tax evasion in the case of direct taxes. In fact, even in
advanced countries tax evasion and avoidance are common.
3. Direct taxes are inconvenient. Direct taxes are inconvenient in the sense that the
tax payer has to prepare and supply income returns showing all the sources of his
income to the tax authorities.

5.4.3 Merits and Demerits of Indirect Taxes

Indirect taxes have the following advantages over direct taxes:
1. Indirect taxes are regarded as convenient.
2. Indirect taxes are difficult to evade.
3. They are elastic.
4. They can be equitable.
5. They are contributed by all sections of the society.

Indirect taxes have been criticized on various grounds:

1. Unjust and inequitable: Indirect taxes are regarded as unjust and inequitable since
they fall on all persons indiscriminately, irrespective of their ability to pay. When
mass consumption goods are taxed the burden will be borne more by the poor than by
the rich.
2. Element of uncertainty: Indirect taxes are extremely uncertain. Taxes on
commodities with elastic demand are particularly uncertain, since quantity demanded
will be affected by the imposition of taxes.

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3. Lack of social consciousness: Indirect taxes do not create any social consciousness
as the taxpayers, in most cases, do not feel the burden of the taxes they pay.

5.4.4 Types of Tax Systems

Two types of tax system can be distinguished – the single tax system and the multiple tax
system.

1. The Single Tax System

Poll tax or head tax is a simple form of a single tax. It is imposed on a person simply
because he is there in the society and not because he has income or wealth or is following
a particular trade or profession. Each adult member of the society is expected to pay poll
tax except for the disabled and the elderly persons.

(a) Merits of Single Tax System

The single tax system has the following merits:
1. Poll tax is almost neutral in terms of allocation effects – the imposition of this tax
does not distort the pattern of economic activity in the country.
2. The rate of the poll tax can be adjusted to the needs of the government
3. In this system every member of the society contributes to the upkeep of the
government.

(b) Demerits of Single Tax System

The single tax system has the following demerits:
1. The unequal distribution on income and wealth might be large or moderate thus
poll tax might not be neutral.
2. The needs of members of society are varied. Therefore, the marginal utility of
income differs from one person to another. Hence an equal absolute sacrifice of
every tax payer would hurt the poor than the rich.
3. It is not likely to generate sufficient tax revenue for the public treasury.

2. The Multiple Tax System

This is a worthwhile tax system in a modern economy for the following reasons:

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1. There exist multiple objectives of the government in the modern economy.

2. Sources of income in a modern economy are varied.
3. Some taxes have a distortionary impact on the economy that requires correction
by imposing other taxes.

5.4.5 Forms of Tax Progression

Tax progression refers to the change in tax liability given a change in the tax base. Three
forms of tax progression can be distinguished – progressive, regressive and proportional
progression.

Proportional taxes are those whose tax liability increases in the same proportion as the
increase in income. A progressive tax is one whose tax liability not only increases in
absolute terms, but also in proportion to income. The base of a tax is the legal description
of the object to which the tax applies such as net income of an individual, the value of a
property etc. The tax rate is the amount per unit of the tax base. A regressive tax is one
whose average and marginal tax rates fall as the tax base increases and accordingly the
marginal tax rate lies below the average tax rate. Degressive taxation is used to
distinguish between certain forms of progressive rates. Degressive progression occurs
when there is a declining degree of progression as the tax base increases.

Note
1. Progressiveness as stated above is with reference to the money
burden of a tax, not the real burden or sacrifice tax payers
undergo.
2. The tax burden should be measured in terms of the sacrifice it
imposes upon the tax payers.
3. We should look at the tax structure in terms of the various
economic and social effects.

1. Proportional Taxation
(a) Arguments for Proportional Taxation
The following arguments have been advanced in favour of proportional taxation:

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1. It is not possible to decide upon a precise and appropriate degree of progression.

2. It is easily decided and enforced
3. It is neutral in terms of allocation of resources of the economy to different users.

(c) Arguments against Proportional Taxation

The following arguments have been advanced against proportional taxation:
1. The inherent faculty to enjoy income does not depend upon the level of income
one is having.
2. A proportional tax is regressive and oppressive, when the sacrifice aspect is
considered.
3. The costs of tax administration are high due to numerous collection points.
4. Proportional taxation has distortionary effects on the economy
5. It can cause social and political unrest.

2. Progressive Taxation
(a) Arguments for Progressive Taxation
The following arguments have been advanced in favour of progressive taxation:
1. It is based on the ability to pay principle and the corresponding tax sacrifice
which taxation involves.
2. It is just at least from a social perspective since progressive tax schedules try to
bring about equal marginal sacrifice on the part of tax payers and through that
approach the whole tax system evolves towards the least aggregate sacrifice.
3. It acts ass a cushion against excessive upward or downward movement in income
and prices (stabilizing effect).
4. It is administratively convenient. The cost of tax administration and collection is
proportionately much lower.
(c) Arguments against Progressive Taxation
The following arguments have been advanced against progressive taxation:
1. It is not possible to measure utility and to compare interpersonal utility functions.
2. It is not possible to achieve equal sacrifice through progressive taxation.

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3. It is difficult to fully implement progressive taxation in developing countries, due

to welfare and growth considerations.

Activity 5.2
1. Using the following three criteria, compare and contrast direct and
indirect taxes: (a) Allocation of resources (b) Administrative aspect
(c) Distributional aspect
2. In what specific ways are indirect taxes superior to direct taxes?
3. Discuss the following: (a) Single and multiple tax system (b)
Progressive, proportional and regressive taxes (c) Specific and ad
valorem taxes.
4. Discuss the advantages and disadvantages of direct taxes in an
optimal tax system.

5.5 Characteristics of an Optimal Tax System

1. Canon of Ability. All citizens should contribute towards the expenses of the
government, in proportion to the revenue, which they respectively enjoy under the
protection of the state. The richer a person, the more is his ability to pay towards the
running of the government. The ability to pay may be judged on the basis of income or
wealth or expenditure.

2. Canon of Certainty. The amount to be paid, the time and the method of payment
should all be clear and certain for the taxpayer to adjust his income and expenditure
accordingly. The state should also be certain for the taxpayer to adjust his income and
expenditure accordingly. The state should also be certain as to how much revenue it
could expect and when it could get it. The canon of certainty was meant to prevent
exploitation of the taxpayer by the tax –collector or the state.

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3. Canon of Convenience. The canon of convenience is quite simple. As a tax imposes a

burden on the taxpayer, it should be imposed at such a time and in such a manner that the
taxpayer feels minimum inconvenience.

4. Canon of Economy. This is the minimization in the cost of collection. The revenue
from a tax should very much more than the cost of its collection.
5. Canon of Simplicity. The tax structure should be simple and easy to understand in the
sense that the tax system should be easily comprehensible to the common man.

6. Canon of Productivity. The tax system as a whole should produce adequate revenue.
It is not worth imposing a tax burden on the community unless its yield is adequate.

7. Canon of Elasticity: The tax system should be elastic, that is, the amount of revenue
to be procured through them can be increased or decreased with the least inconvenience
as the necessity of the state expenditure compels it to be increased or decreased.

8. Canon of Diversity: There should be diversity in the tax system of a country. The
reason is that if the government imposes a large variety of taxes, it will be difficult for the
people to evade or avoid them.

Many modern writers have multiplied the requirements of s sound tax system. A sound
tax system, it is argued, should be based on the principle of progression, i.e. the rate of
taxes should rise with the rise in incomes and in wealth and the tax burdens should be
increasingly borne by the richer classes. Proportional and regressive taxes should be
avoided as far as possible.

It is further argued that between direct and indirect taxes, the former should be preferred
to the latter since it was easy to introduce the principle of progression in direct taxes. The
tax system should be diversified instead of being concentrated in one or two taxes,
though from certain points of view, a single tax on income would be probably the best
type of tax.

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5.6 Equity and Efficiency in Tax Enforcement

5.6.1 Tax equity in the enforcement sense
Tax equity in the enforcement sense requires the consistent and unbiased imposition of
taxes on all those prescribed by the law to the taxpayers. Though a good enforcement
system cannot improve the rationality of an irrational tax structure, a poor system of
enforcement can undo the advantages of a rational tax structure. The importance of
equitable enforcement cannot be overemphasized.

5.6.2 Tax Evasion, Tax Avoidance, and Tax Delinquency

Tax evasion involves a fraudulent or deceitful effort by a taxpayer to escape a legal tax
obligation. This is a direct violation of tax law.

Tax avoidance, in contrast, does not violate the letter of the law. It occurs when a tax
payer arranges his/her economic behaviour in such a manner as to maximize his/her pos
tax economic position, that is, to minimize the amount of a tax owed. This may be
accomplished in the short run by the advantageous use of existing tax law provisions and,
in the long run, by influencing tax legislation through the support of lobbies and pressure
groups which represent the special interests of the tax payer. Tax avoidance is lawful,
while tax evasion is not.

Tax delinquency refers to failure to pay a tax obligation on the date it is due. Ordinarily,
tax delinquency is associated with inability to pay a tax because of inadequate funds, but
it does cover the possibility of non payment even though funds are available. In any
event, tax delinquency may be only a temporary escape from tax payment, since the
government unit to which the tax is owed can place liens on the property and future
earnings of the tax payer in order to secure payment eventually.

5.6.3 Techniques and Agencies of Tax Enforcement

Various techniques (instruments) of tax enforcement are used in the Kenyan public
sector:

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1. Voluntary Taxpayer Compliance

This technique is especially important for the collection of personal income taxes,
though it seems to be eroding somewhat during recent times as the so-called subterranean
(underground) economy, based on cash transactions and the absence of records, grows as
part of an effort to escape income taxation.

Note 5.2
The use of voluntary taxpayer compliance and withholding means that
both consumers and businesses bear a significant part of the explicit
enforcement costs.

2. The Withholding Technique

This is where tax funds are collected from wages and salaries at the income source of the
tax payer. This device was used first by the US Federal government during World War II,
when there was critical need for immediate federal funds to finance the war, and
inflationary pressures were severe.

3. Auditing
Auditing, whether computerized or clerical, is basic to any tax enforcement program.
The government in recent decades has expanded its use of computers to assist tax
administrator’s enforcement efforts. Moreover, tax payers Personal Identification
Numbers (PIN) are required by law as part of the federal income tax enforcement
program.

Tax auditing by government requires adequate information, which may be gathered in a

variety of ways. Among the techniques in use, especially by the central government are:
1. routine checks of tax returns by a tax enforcement agency
2. a check on large or unusual business transactions
3. appraisal of relevant newspaper reports, court proceedings, and legal fillings
4. Routine check of the business activities of gangsters and racketeers.
5. exchange of information with other agencies within the same unit of government
and also among units and levels of government

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6. using information obtained from business, as required by law, to report various

information items such as wages, dividends, and interest paid to taxpayers and
7. Use of tax informers.

In Kenya the primary tax enforcement agency is the Kenya Revenue Authority (KRA). It
employs tax assessors and tax inspectors who ensure compliance with tax legislation in
Kenya. In the recent past KRA has stepped efforts to reign in delinquent tax payers
through offers of tax amnesty if the tax payers declared truthfully their income and paid
the tax due within the stipulated time. KRA has also embarked on taxpayer education to
help taxpayers understand the value and importance of paying taxes to the government.
Various awards have also been introduced to recognize the most outstanding taxpayers in
the country to encourage others to emulate them.

5.6.4 Tax Enforcement Efficiency

There is general consensus that economies of scale exist in centralized tax collection. The
central government is said to be able to collect revenue from most taxes at a lower cost
per unit of revenue that can state and local governments. Though empirical studies in this
regard are somewhat scarce, the argument for economies of scale is centralized tax
collection is probably a valid one. Tax collection operations are considerably
decentralized.

For a rational tax system, the direct monetary costs of enforcement must not comprise an
exceedingly high proportion of the revenues collected from the taxes. This is particularly
true when reasonable tax source alternatives are available to a unit of government. In the
present context, the term enforcement costs should be construed to include both the direct
administrative costs of the public sector and the voluntary compliance costs of the private
sector.

Also, it should be observed that various secondary effects, such as negative allocational
nonneutralities in the form of disincentives of consumption and investment, may result
from irritating or irrational tax enforcement efforts. This is undesirable. On the other

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hand, tax evasion- the target of enforcement efforts – is also undesirable. Thus tax
enforcement efforts, though justified, should avoid unnecessary disincentives.

Another secondary result of tax enforcement activities is that some potential evasion
never occurs, because tax payers know that an adequate tax enforcement system is in
operation and they avoid or limit evasion efforts. Although the additional revenues
collected directly as a result of the detection of tax evasion can be estimated, the
additional revenues which indirectly accrue because potential tax evasion is discouraged
cannot be determined. Yet, this may constitute a considerable amount.

Activity 5.3
1. State and explain the characteristics of an optimal tax
system.
2. Suppose you have been asked to design a tax system for
Kenya. What characteristics would you include? Explain.

5.7 Summary
In this fifth lecture you have learnt the following important points:
 There are five theories of taxation: The Expediency Theory,
the Socio-political Theory, the Benefits Received Theory,
the Cost of Service Theory and the Ability to Pay Theory.
 Equity and efficiency are the two fundamental characteristics
of any system of taxation.
 The objective indices of taxation are income, property and
wealth, and personal consumption expenditure.
 Taxes can be classified as direct or indirect depending on the
basis of assessment.
 There are three forms of tax progression: proportional,
progressive, and regressive taxation.

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5.8 References
1. Musgrave, R.A. and Musgrave, P.B. Public Finance in Theory
and Practice. 5th Edition, McGraw-Hill Book Company,
New York. 1989. pp. 218 – 231, 277 - 295

2. Herber, P.B., Modern Public Finance. 5th Edition. Richard D.

Irwin Inc., Homewood. IL, 1990. pp. 117 - 130

3. Due, J.F. and Friedlaender, A.F., Government Finance:

Economics of the Public Sector. A.I.T.B.S., Delhi, India.
2002. pp. 349 – 403

4. Bhatia H.L. Public Finance 24th Edition. Vikas Publishing House

Pvt. Ltd. Jangpwa. New Delhi 2003. pp. 52 - 89

5. Rosen S. Harvey, Public Finance. 7th Edition. McGraw-Hill.,

Homewood. IL, 2005. pp. 304 – 359

6. Sundharam, K.P.M. and Andley, K.K., Public Finance: Theory

and Practice, 16th Edition. S. Chand and Company Ltd.
New Delhi. 2003. pp. 55 - 72

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LECTURE SIX
INCIDENCE AND SHIFTING OF TAXES
Lecture Outline
6.1 Introduction
6.2 Objectives
6.3 The Impact, Incidence and Effect of Tax
6.4 Shifting of Taxes
6.4.1 The Concentration Theory
6.4.2 The Diffusion Theory
6.4.3 The Demand and Supply Theory
6.5 Theory of Tax Shifting
6.5.1 Formal and Effective Incidence
6.5.2 Forward and Backward Shifting
6.6 Incidence of Taxes on Commodities, Income, Land Values, Buildings.
6.6.1 Elasticity of Demand and the Incidence of Tax
6.6.2 Elasticity of Supply and the Incidence of a Tax
6.6.3 Tax Capitalization
6.6.4 Other Factors Influencing the Incidence of Tax
6.7 Incidence of Particular Taxes
6.7.1 Personal Net Income Taxes
6.7.2 Taxes on Business Profit
6.7.3 Taxes on Production and Sales of Commodities
6.7.4 The Incidence of Customs Duties
6.7 Summary
6.8 References

6.1 Introduction
In this lecture we will review the various factors which influence the incidence and
shifting of the burden of taxation. This will be discussed within the general equilibrium
framework or in the long run. Thus we shall emphasize the importance of relative prices
in the analysis of incidence and shifting of taxes in contrast to absolute prices. Therefore,

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we shall consider the interaction of various markets within the economy. This makes the
analysis of tax incidence necessarily complex. Consequently, incidence analysis is
impossible under such extreme circumstances.

6.2 Objectives
At the end of this lecture the learner should be able to:
1. Define the impact, incidence and effect of a tax.
2. State and explain major theories of incidence and shifting of
taxes.
3. State and explain the factors influencing the incidence and
shifting of taxes.
4. Discuss the various theories of taxation.
5. Discuss the incidence of different types of taxes.

6.3 The Impact, Incidence and Effect of a Tax

It is highly important to understand the economic and social effect of particular taxes.
Some of these effects result directly from the payment of the tax, while others are the
indirect consequences of the imposition of the tax. In order to analyze the effects of taxes,
we will have to determine:
(a) who pays the tax in the first instance; and
(b) who actually bears the burden of the tax

The study of incidence and shifting of tax is one of the most necessary studies in public
finance. The object of the study is to enquire about the class, section or group of
individuals who ultimately bear the burden of taxation. It also includes the enquiry of the
manner of its distribution among the different sections of the society.

Traditionally, incidence of tax has come to mean the final or ultimate resting of the direct
burden of a tax payment. Impact refers to the point of original assessment. If the original
or first taxpayer is able to transfer the burden of someone else, tax shifting has taken
place.

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6.4 Theories of Tax Shifting

There are at least three theories that have been put forward to explain the incidence and
shifting of taxes. They are discussed below.

6.4.1 The Concentration Theory

The hallmark of this theory is its emphasis of the idea that there is an inherent tendency
for the taxes to be absorbed by certain income classes. It was advocated by the
physiocrats and classical economists. According to the physiocrats it was only those who
bear the taxes who could appropriate the surplus from production in the economy. The
physiocrats argued that any tax imposed on any other sector of the economy would
eventually fall on land rent. It was therefore better if taxation was levied on agricultural
land in the first place.

The classical economist extended the analysis by physiocrats by arguing that taxes should
be levied to both rent and profit. Thus, all taxes would be concentrated and absorbed by
those two taxes

6.4.2 The Diffusion Theory

This theory emphasizes the close linkages between the various sectors of the economy.
Accordingly sale/purchase transactions are so inter twined that it becomes difficult to
trace the incidence of any tax in the economy. Thus, taxes get diffused in the complex
web of economic activities.

Some economists have argued that this approach to tax incidence analysis is escapism.
They content that with a proper analytical framework it is possible to derive the incidence
and far reaching impact of the tax irrespective of the complexity of economic activity.

Limitations of the Diffusion Theory

The Diffusion Theory has the following limitations:
1. Both the incidence and effects of a tax are fundamental to tax analysis and policy,
yet they are all ignored in this theory
2. The assumption of perfect market does not hold. In the real world markets are
imperfect and factor mobility limited

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3. Also significant transaction costs exist. This affects the elasticity of demand and
supply which is a key determinant of the shiftability of a tax

6.4.3 The Demand and Supply Theory

This is the most reliable theory of tax shifting. It states that the incidence of taxes can
only be shifted through sale/purchase transactions and only through changes in prices.
Price changes are only feasible through a shift in the demand and/or supply curves while
the sharing of incidence will be determined by the demand and supply elasticity.

The general rule is that the share of the tax borne by the seller will be large if the
elasticity of demand is large and the share borne by the buyers will be large if the
elasticity of supply is large.

6.5 Conventional Analysis of Tax Incidence

There is no consensus on the definition of incidence in conventional analysis of tax
incidence. Dalton defined incidence as the person or persons who ultimately pay the tax.
Any other considerations about the imposition of tax are regarded as the effects of the
tax. Conventional analysis also distinguishes between the real burden and the money
burden of the tax. The real burden of the tax refers to the loss of welfare as a result of
paying tax. The money burden of tax on the other hand refers to the amount of money set
aside to pay the tax. A distinction is also made between formal and effective incidence of
a tax.

6.5.1 Formal and Effective Incidence

Formal incidence refers to the legal definition of incidence. It is normally upon those who
are legally required to pay tax to the government. Formal incidence is the same thing as
the money burden of a tax. Effective incidence on the other hand, refers to the broader
effects of a tax.

6.5.2 Forward and Backward Shifting

Shifting of a tax is generally done through the manipulation of price of the taxed
commodity but the producer may also shift the burden of the tax through reducing the

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quality of quantity of the taxed goods. Economists speak of these directions of tax
shifting forward, backward and a combination of the two.
(a) Forward of Shifting. This is the most common, and said to take place when the
producer of a good is able to shift the money burden of the tax completely on to
someone else, say the wholesaler, who may, in turn, pass it on to the retailer who
ultimately passes it to the final consumer. In forward shifting, the price is so raised
that the entire amount of the tax is shifted from the original taxpayer to someone else.
(b) Backward Shifting. It occurs when a tax on the commodity is shifted back to
producers. If a tax is levied on a commodity, the purchaser may take the initiative of
compelling the seller to accept a lower price. Suppose a tax is imposed on the
wholesale distributor of a commodity. The wholesaler may secure a lower price from
the producers. Similarly, a tax on a producer of a good may induce him to force his
workers to accept lower wages or force other factor owners to accept lower
remuneration. However, backward shifting is not common as forward shifting.

(c) Combination of Forward and Backward Shifting. It may take place when a
producer of a taxed commodity is able to pass on part of the money burden to
consumers through a partial rise in price and the other part of the burden to the factor
owners by compelling them to accept lower wages. It is also possible that the
producer of the taxed, commodity may have to absorb part of the money burden (if he
is not completely successful in shifting the burden forward or backward.)

6.6 Factors Involved in Tax Shifting and Incidence

Whether or not the money burden of a particular tax imposed upon any commodity can
be wholly, partially or not at all shifted to the buyers depends upon numerous factors.
These factors can be conveniently grouped under two broad headings:
1. Factors which affect the determination of price of the taxed commodity i.e. demand
and supply.
2. Factors which relate to the nature of production, its impact and public policy.

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6.6.1 Elasticity of Demand and the Incidence of Tax

The demand of a commodity is said to be elastic when a slight change in price will lead
to a marked change in the quantity purchased by the consumers. If the change in price of
a commodity does not cause a significant change in demand then it is said that there is
inelastic demand for the commodity. The influence of elasticity of demand on incidence
as follows:
(a) If demand is perfectly elastic, the whole incidence will be on the seller.
(b) If demand is absolutely inelastic, the whole incidence will be on the buyer.
(c) The greater the elasticity of demand the greater will be the incidence on
the seller.
(d) The greater the inelasticity of demand the greater will be the incidence on
the consumer.

Shifting and incidence may also depend upon the regularity of demand, the level of
aggregate demand and existence of ‘charm’ prices. If consumer demand for any
commodity is irregular, it will be difficult to shift the tax on the consumer. Again, if
national income and level of aggregate demand are rising, shifting becomes easy. On the
other hand, if national income and aggregate demand are declining, it will be difficult to
shift taxes. Thus, shifting and incidence of certain taxes depend directly on the national
income and the level of aggregate demand.

Finally, many commodities of common consumption come to acquire ‘charm’ prices or

customary prices. Consumer’s demand for these goods has been built up around these
fixed prices. Shifting in such cases becomes difficult except through lowering of the
quality of the product.

6.6.2 Elasticity of Supply and the Incidence of a Tax

The supply of a commodity refers to the different qualities of the taxed commodity which
will be offered for sale in the market at various possible prices. Supply can be elastic or
inelastic. If the supply of a commodity is elastic, the tax burden will fall on the buyer, if
other things remain equal. On the other hand, if tax is levied on a commodity with a fixed
or inelastic supply, the whole incidence will tend to be on the seller.

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It is however, important to emphasize the factors on which elasticity of supply depends.

Elasticity of the supply may be said to depend upon
a) The nature of production and pricing conditions.
b) The character of cost conditions.

Under conditions of perfect or pure competition it will not be possible for the firm to
increase the price in the market in the short period. But in the long run, the rise in costs
will necessitate upward adjustment of the price and consequently, the burden of the tax
will shift to the buyer. But such shifting will necessitate transfer of capital and labor and
other resources from the industry to others since there will be a decline in the sales of the
taxed commodity.

In the case of an absolute monopoly, the firm has the power to manipulate the price
through its control over the supply. Except in the case of lump sum tax, there would be
some shifting under monopoly. By how much the price will rise will depend upon the
elasticity of demand as well as of the cost curves.

Under duopoly and oligopoly, price determination is the work of the price leader. While
there may be many firms in oligopoly situation, only one or two will act as price leader.
A tax which influences the cost of production of the price-leader may be shifted unless
demand happens to be highly elastic. On the other hand, a tax which influences the cost
curves of only small firms may not be easily shifted.

If the tax is a small one and if is taxes away only a part of the super –normal profits of
these firms, the tax will undoubtedly be borne by these firms without much difficulty. But
if the tax removes much of the profits, then the burden will be shifted to the consumers in
the long run through compulsory withdrawal of these firms.

Shifting and incidence will thus depend upon the nature of production and price
conditions of different types of industry. If an industry requires a large amount of fixed
capital – in the form of machinery, plant, buildings, materials, etc., naturally its fixed
costs will forma a large proportion of the total costs. In such a case, two important

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features will be seen. First high ratios of fixed factors to variable factors will result in
decreasing cost per unit as output is expanded. Second, it will be difficult to transfer
capital to possible alternative uses. As a result, if a tax on such an industry is shifted, it
will raise prices, reduce sales and increase costs (when output is decreased, costs will
higher). Therefore, tax shifting by firms producing under diminishing cost will lead to a
rise in price by more than the amount of the tax. Therefore, it will not be easy for the
industry to shift the tax to the buyer or consumer.

If an industry consists of firms using small investment of capital and plant, etc and which
have a large ratio of variable costs to fixed costs, it will generally experience either
constant costs or rising costs. In such a case, if a tax is levied, it will lead to transfer of
labor and capital to other industries rather easily. As a result, it would be easy for the
industry to shift the tax.

6.6.3 Tax Capitalization

Tax capitalization is done in the case of durable goods that are subject to various kinds of
property tax. The buyer of property shifts the tax backward at the time of purchase by
making a deduction, equal to the government tax, but the incidence is on the seller.

6.6.4 Other Factors Influencing the Incidence of Tax

Tax shifting and incidence is influenced by the size of the area in which a tax is applied,
the nature of the tax base, the type of rate employed, the impact of the tax and public
policy.

It is difficult to shift a local tax, especially if it is very heavy. On the other hand, a light
local tax may easily be shifted. However, taxes which are applicable to the entire country
can be more easily shifted than local taxes because they are uniform and cover a wider
region. A tax which has a broad generalized base is more likely to be shifted than the
exclusive type since it covers most competing and alternative products or activities and
creates a wider interest in the shifting attempt.

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Moreover, the nature and level of tax rates affect shifting. Progressive rates, which fall
differently on different persons or organizations, may be difficult to shift easily. Specific
rates on goods may fall heavily on the lower –grade and lower-priced goods and, thus,
may make it difficult to shift the tax. The higher and more excessive the tax rates, the
greater will be the tendency among buyers to escape the tax burden and consequently, tax
shifting will be comparatively difficult.

Finally, reference should be made to public policy and tax shifting. The tax authorities
may provide directly or indirectly, the methods of shifting tax to the consumers and in
many cases they may make shifting compulsory. Sales tax legislation clearly implies that
the tax burden should be borne by the consumers. Sometimes, the government may
impose controls and restrictions on prices and wages (as during a war or an emergency),
and, therefore, make it impossible for shifting of taxes through price adjustments.

Note
Shifting and incidence are governed by many factors. The most
important factors are elasticity of demand and elasticity of supply.
While considering elasticity of demand, factors on which elasticity of
demand depends should be analyzed. On the other hand, in considering
the role of supply, both cost conditions as well as market situations
(whether perfect competition, monopoly and so on) should be
emphasized. Besides these two factors, other conditions such as
geographical coverage, the tax base, the nature of tax rates, public
attitudes towards shifting, etc., should be also be taken into
consideration.

6.7 Incidence of Particular Taxes

The general factors affecting tax shifting have been given rather elaborately. We shall
presently indicate the shifting and incidence of particular taxes in the light of these
general principles.

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6.7.1 Personal Net Income Taxes

The incidence of taxes on income, capital and abnormal profits is difficult to shift. These
are direct taxes and thus are to be paid by the person on whom it has been imposed. A tax
on labor can not be shifted by laborers on to the producers.

Personal income may be received through wages, interest and rents. The conventional
belief is that the incidence of progressive taxes on personal net income will generally be
on the taxpayers themselves unless the income-tax encroaches upon the level of
subsistence itself. There are three reasons for this conventional belief.
(a) Progressive income taxes are limited in their scope and the money burden is
unequal
(b) Their burden falls upon the surplus element of income.
(c) Market forces relating to wage and other personal receipts are usually unfavorable
to attempts at shifting.
Let us consider these points one by one and assess their validity.

6.7.2 Taxes on Business Profit

The question of shifting and incidence of business profit taxes has been one of the
most controversial questions in the theory of public finance. Taxes on company
incomes can be shifted. Taxes on business income may be of three different kinds:
a) Tax on the income of proprietorships and partnerships
b) Corporate income tax
c) Tax on excess profits

On theoretical and empirical grounds it may be possible to argue that taxes on business
incomes cannot be shifted. We can consider the excess profits tax first. Excess profits
tax may be regarded as a tax shifted, that is, profits in excess of all necessary
expenses profits constituting a surplus over and beyond the income required to
secure business activity. Besides, the tax will not discriminate between enterprises
and will fall equally upon all pure profits whatever may be the source. At the same
time, those business units which are getting only normal profits will not be touched by
the tax. Thus, the excess profits tax will fall upon the residual profits resulting from

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the fixing of pricing which yield the maximum profits; consequently, such as a tax will
not change the level of prices and, therefore, cannot be shifted.

In practice, excess profits tax has been levied during was and other emergencies. In many
cases, the excess profits tax absorbed as much as 955 of all profits during the second
World War and in the immediate post-war period. It was widely held that during war
periods and other emergency conditions, the demand for goods is very heavy and is,
therefore, very favorable to the shifting of excess profits tax.

In practice, corporation taxes have been collected from all types of firms which are
earning any income for their shareholders. Since interest on owner’s capital is a necessary
business cost, taxes on companies fall upon an important element of cost. Some
economies have argued that the corporation tax has an adverse effect on private
investment and initiative and that it discourages business expansion and the promotion
of new ventures. They contend that the tax is substantially shifted over long periods.

According to most businessman, corporation taxes are business costs and as such are
added to total costs and therefore to prices. Most businessmen therefore contend that they
can influence prices and consequently shift the taxes to the consumers. On the other
hand, it is highly possible that a corporation may not have so much control over
prices as claimed by many and this is particularly true in the case of small business
enterprises. Besides, the business tax falls upon income after sales have been completed
and the books have been closed rather than before.

Finally, some businessmen and economies are of the opinion that the business taxes
can be shifted only partly to others - partly to consumers through higher prices and
partly to workers through lower wages – but a portion of the taxes will still remain
with the businessmen who have to absorbs them. It is, therefore, argued that the
corporate tax is a bad tax is its incidence is highly uncertain and that it should be
removed. Thus, all sorts of opinions are held about the shifting and incidence of
corporation income taxes.

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There are many reasons for this confusion about shifting of corporation taxes. In the first
place the market forces under which business income is earned are so numerous and so
complex, and both general and specific, that is extremely difficult to study the process
of shifting. Secondly, every industry (or firm) is faced with different types if demand
schedules, varying in elasticity. If a business unit has an elastic demand for its product
and if, at the same time, it has control over its price through its control over the supply,
then tax on its income will be shifted the price, it cannot easily shift the corporate
income tax. However, there are two demand conditions which are favorable to shifting of
corporate income tax. They are:
a) Increase in the demand for particular goods or services at a given price and
b) A rise in aggregate demand.
In both cases, the prices of goods can rise and consequently the money burden of the
corporate income tax can be shifted to the buyers of the products. But such a shifting
will be only temporary. For over a long period, the output will be adjusted to a higher
level of demand.

Thirdly, shifting of business taxes will depend essentially on the supply and, therefore
of the price of the goods or services which produce the corporate incomes. Except in
the two special cases of demand which we have mentioned above, short period
shifting of business income taxes will require a direct control over the supply of the
commodities. In the long run, shifting of corporation income tax will require generally
a curtailment of output through transfer of factors of production employed in the
taxed industry.

To conclude, there is some truth in the traditional theory that a tax on business profits
will not be shifted on the assumption that business profits constitute an economic
surplus (i.e. income above costs) and tax on surplus cannot be shifted. Excess profits
tax may be considered as pure profits or economic surplus cannot be shifted. Excess
profits tax may be considered as pure profits or economic surplus and therefore, such
a tax cannot be shifted. But the regular corporate income taxes generally affect one
of the cost items, viz., the return on the shareholders’ capital. It is therefore, possible
that they become part of the total costs and consequently become part of the total

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costs and consequently become part of the price, and thus are shifted to the buyers of
the products.

6.7.3 Taxes on Production and Sales of Commodities

Taxes on production and sale of goods have become very common in all countries.
While sales, taxes are on the turnover of goods, excise duties are levied on the production
of goods. They can be combined for our analysis of incidence and may be called as
commodity taxation. Commodity taxes may be of different varieties and may differ from
one another in their scope and specific measures employed. But the common thing about
all of them is that they are intended to fall on consumers. For one thing commodity
taxes imply equality or proportionality of treatment and do not contain any exemption
provisions. They are added directly to the cost of the taxed goods or activities. As they
form part of the cost production, it is highly desirable that they are shifted.

Moreover, commodity tax laws, on the whole, contain clear cut shifting provisions
and the taxpayers have come to acknowledge the fact of the commodity taxes being
shifted.

Taxes on sales or production of commodities are shifted forward through a rise in price.
The exact shift in price will depend on the slope of the demand curve for the product. If
the demand curve has a very steep slope, the price rises by a large part of the tax
and a large share of the tax is shifted forward. In the case of a more elastic demand, a
larger share of the tax falls on the seller.

As has already been observed, the shifting of a commodity tax depends also on the nature
of supply. The price of the commodity rises by more than, or equal to or less than the rate
of another.

Another factor which affects the incidence of commodity taxation is its scope and
coverage. General sales taxes fall early on all competing goods. The consumers have
little choice but to pay the tax. A selective sales tax, on the other hand, is on certain
selected good only and therefore , may be only partially shifted to consumers and the

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sellers may have to hear a part of the tax. Sales tax laws often contain provisions which
make shifting both mandatory and easy. The tax may be added as a separate item in the
bill.

Commodity taxes may be selective in respect of geographical areas. The rates of taxes
may differ in different states, and the same commodities may pay different rates of tax
in adjoining states. In such cases, consumers in a high tax state take advantage of the
lower rates in the neighboring states. The existence of a lower price of the commodity
in a neighboring market keeps the price down in the border districts of high tax state,
which indicates that there is consumer resistance of tax shifting in these areas.

6.7.4 The Incidence of Customs Duties

Customs duties or taxes on foreign trade are of two types – import duties and export
duties. Import duties are taxes upon foreign produced goods and are usually collected
from importers, though the intention of the government may be the tax is shifted to
consumers. Export duties are taxes on locally produced goods which are exported,
and though the impact of the taxes falls on the exporters in the first instance, they are
intended to be shifted to the foreign consumers of the exported goods. The general
view of is generally accepted, though many important qualifications have to be
addressed.

Taking import duties first, it may be pointed out that incidence will be on the
consumers of the importing country. So long as the home consumers demand the
commodity and consider it better than the local product, they may be prepared to buy
it despite a higher price due to import duties. Shifting of the import taxes to consumers
is, therefore, generally accepted. At the same time, shifting of the import taxes to
consumers is, therefore, generally accepted. At the same time, shifting of import duties
will depend upon the nature of competition. If import duties are low and do not restrict
imports the importer will shift the tax in the absence of competition , the importer
may not be able to shift the tax burden to the consumers. But under certain special
circumstances, there can be backward shifting- that is, foreigners may be forced to pay
the tax.

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Similar arguments will apply to the question of incidence of export duties. They would
raise the prices of exported goods and, thus, the incidence will be shifted to the
foreigners. However, if the foreign market happens to be a competitive market, the
price of the product there cannot raise because an exporting country has levied duties
on the commodity. In such a case the exporters will have to bear the burden. On the
other had, if the exporting country has a monopoly of the exported product, or if it
the most important exporter, or if the commodity concerned is an important raw
material which the foreign countries require, that is, there is inelastic demand for it,
the export duty can be shifted forward to the foreign consumer. Under all other
circumstances, the exporters will have to absorb the burden or will have to shift it
backward to the producers of the commodity within the country.

Activity 6.1
1. Discuss the concept of tax incidence and its application in Kenya.
2. State and explain the principal mechanisms for shifting taxes.
3. Write brief notes on the following theories of tax shifting and
incidence: (a) The concentration theory (b) The demand and supply
theory
4. Discuss the incidence of tax under (a) Perfect competition (b) Pure
monopoly (c) Oligopoly.

6.7 Summary
In this sixth lecture you have learnt the following important points:
 The incidence of a tax is the final resting place of the burden of
taxation.
 The burden of tax can be shifted forward, backward and either
way principally through changes in the prices of goods and
services.
 There are three theories of tax incidence: the Concentration
Theory, the Diffusion Theory, and the Demand and Supply

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Theory.
 Shifting and incidence are governed by many factors: elasticity of
demand, elasticity of supply, geographical coverage, the tax base,
and the nature of tax rates.

6.8 References
1. Herber, P.B., Modern Public Finance. 5th Edition. Richard D. Irwin
Inc., Homewood. IL, 1990. pp. 95 – 114, 131 - 150

2. Ulbrich, H., Public Finance in Theory and Practice. Thomson –

South-Western,USA. 2003.

3. Sundharam, K.P.M. and Andley, K.K., Public Finance: Theory and

Practice, 16th Edition. S. Chand and Company Ltd. New
Delhi. 2003. pp. 201 – 220

4. Musgrave, R.A. and Musgrave, P.B. Public Finance in Theory and

Practice. 5th Edition, McGraw-Hill Book Company, New
York. 1989. pp. 3 -14, 249 - 276

5. Bhatia H.L. Public Finance 24th Edition. Vikas Publishing House

Pvt. Ltd. Jangpwa. New Delhi 2003. pp. 90 - 121

6. Rosen S. Harvey, Public Finance. 7th Edition. McGraw-Hill.,

Homewood. IL, 2005. pp. 304 - 327

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LECTURE SEVEN
PUBLIC EXPENDITURE
Lecture Outline
7.1 Introduction
7.2 Objectives
7.3 Meaning and Scope of Public Expenditure
7.4 Theories of Public Expenditure
7.4.1 Wagner’s Law of Increasing State Activities
7.4.2 Wiseman – Peacock Hypothesis
7.4.3 Development Models
7.4.4 Baumol’s Law
7.4.5 A Political Model
7.4.6 Ratchet Effect Models
7.5 Demand and Supply of Government Services
7.5.1 Comparison between Private and Public Expenditure
7.5.2 Forms of Public Expenditure
7.6 Canons of Expenditure
7.6.1 The Canon of Economy
7.6.2 The Canon of Sanction
7.6.3 The Canon of Benefit
7.6.4 The Canon of Surplus
7.7 Effects of Public Expenditure on the Economy
7.7.1 Public Expenditure and Production
7.8 Cost Benefit Analysis
7.8.1 The Elements in a Cost-Benefit Study
7.8.2 The Need for Discounting
7.8.3 Merits and Limitations of Cost-Benefit Analysis
7.8.4 The Role of Cost-Benefit Analysis in Budgeting
7.9 Summary
7.10 References

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7.1 Introduction
In this lecture we shall first examine the theory of public expenditure growth. The
objective is to understand the factors that can explain the growth in public expenditure
over the last three centuries in democratic states. We will then discuss effects of public
expenditure on economic stabilization. The focus here will be on how government
expenditure can influence employment, inflation and economic growth in the economy.
Lastly, we study the economic process of evaluating and selecting investment projects in
the public sector. Though the question of what public project should be selected and
where it will be implemented is a political issue, it is often preceded by some economic
analysis albeit to justify the political decision.

7.2 Objectives
At the end of this lecture you should be able to:
1. Define the meaning and scope of public expenditure.
2. State and explain forms of public expenditure.
3. Discuss the theories of public expenditure growth.
4. State and explain the canons of public expenditure.
5. Discuss the effects of public expenditure.
6. Apply cost-benefit analysis to public investment projects.

7.3 Meaning and Scope of Public Expenditure

Public expenditure refers to the expenses which a government incurs for:
i. Its own maintenance;
ii. The society and the economy; and
iii. Helping other countries.

Governments in democratic states perform many and different functions. Therefore, there
are different forms of government expenditure. The most common ones are as follows:
national defense, education, medical and health services, police, transport and
communications, social insurance and administration, poverty alleviation and financial
administration.

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7.4 Theories of Public Expenditure

The increasing role of the government in the mixed economy has led to the rapid growth
in the public sector since the 19th century. There are two aspects of growth that have been
noted: absolute growth and relative growth. Absolute growth arises in the presence of
increasing population, economic output and sophistication in economic activity. In
relative terms the size of the public sector has increased at a faster rate compared to the
rate of economic growth. In this section we discuss some of the theories that have been
put forward to explain the growth of the public sector.

7.4.1 Wagner’s Law of Increasing State Activities

Adolph Wagner was a nineteenth-century economist who analyzed data on public sector
expenditure for several European countries, Japan, and the United States. These data
revealed the fact that the share of the public sector in gross domestic product had been
increasing over time. The content of Wagner’s law was an explanation of this trend and a
prediction that it would continue.

The basis for the theory consists of three distinct components. First, it was observed that
the growth of the economy results in an increase in complexity. Economic growth
requires continual introduction of new laws and the development of the legal structure.
Law and order imply continuing increases in public sector expenditure. Second, there was
the process of urbanization and the increased externalities associated with it.
Third, Wagner argued that the goods supplied by the public sector have a high income
elasticity of demand. This claim appears reasonable, for example, for education,
recreation, and health care. Given this fact, as economic growth raises incomes, there will
be an increase in demand for these products. In fact from a high elasticity it can be
inferred that public sector expenditure does rise as a proportion of income. This
conclusion is the substance of Wagner’s law.

There have been many attempts at testing whether Wagner’s law is valid. The problem
that surfaces in all of these tests is how to distinguish the causality between public
expenditure and the level of income. Wagner’s law proposes that it is income that
explains expenditure. In contrast, there is much macroeconomic theory in favor of the

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argument that government spending explains the level of income—this was the essential
insight of Keynesian economics. Tests to date have not convincingly resolved this issue.

A number of reasons have been put forward to explain this inherent tendency of
increasing public expenditure.
1. Expansion of the traditional functions of the state
2. The state activities are increasing in their coverage
3. The need to provide and expand the sphere of public goods. Wagner’s law was based
upon historical facts. It failed to reveal the inner compulsion under which the
government has to increase its activities and public expenditure as time passes
4. The growth on the national population
5. The increase in urbanization
6. The secular tendency of prices in rise
7. The size and nature of public services
8. Market failure that necessitate government intervention in the economy
9. The popularity of economic planning and economic growth as objectives of
government
10. The growing complementarities between public and private consumer goods
11. Development of rested interests which demand an increase in public expenditure
for their own benefit
12. Growth in government bureaucracy
13. Low productivity and inefficiency in the public sector.

Limitations of the Wagner’s Hypothesis

In many ways Wagner’s law provides a good explanation of public sector growth.
However, Wagner’s law suffers from the following limitations:
1. Wagner’s hypothesis mainly deals with social, cultural, economic and political issues
while its framework is rigidly economic.
2. It is based on a self-determining theory of the state, which does not reflect the true
theory manifest in many democratic states.
3. It avoids the influence of wars, famines and epidemics on government expenditure.

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4. It stresses the long-term trend of government expenditure which tends to overlook the
significant time pattern or process of government expenditure growth.
5. Wagner’s law focuses exclusively on the demand side for public goods and services
and completely ignores the supply side.

7.4.2 Wiseman – Peacock Hypothesis

This theory was put forward of Wiseman and Peacock in their study entitled The
Growth of Public Expenditure in United Kingdom for the period 1890-1955. This
hypothesis states that public expenditure does note increase in a smooth and continuous
manner, but in jerks or step like fashion. Public expenditure increases due to social or
other disturbances. These put pressure on government to spend. Examples are war,
epidemics, and famine. The movement from an older level of expenditure to a new
and higher level of expenditure is called the displacement effect.

The inadequately of the revenue as compared to the required public expenditure creates
in inspection effect. The inspection effect is needed to determine and ascertain the need
for increased public expenditure. It leads to a tax tolerance effect. Tax payers are ready
to tolerate a burden of taxation consequently the general level of government revenue
and expenditure rises. Thus, public relevance and expenditure causes a displacement
effect. The concentration effect is the tendency of the state to assume a larger role in
economic activity. It is clearly connected with the political set up of the country.
One limitation of this hypothesis is its primary focus on abnormal events. There are many
causes of growth in public expenditure as already mentioned above.

7.4.3 Development Models

The basis of the development models of public sector growth is that the economy
experiences changes in its structure and needs as it develops. There are three stages of
economic development: the early stage, the middle stage and the developed stage.

(a) The Early Stage

The early stage of development is viewed as the period of industrialization during which
the population moves from the countryside to the urban areas. To meet the needs that
result from this, there is a requirement for significant infrastructural expenditure in the

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development of cities. The typically rapid growth experienced in this stage of

development results in a significant increase in expenditure and the dominant role of
infrastructure determines the nature of expenditure.

(b) The Middle Stage

In the middle stages of development, the infrastructural expenditure of the public sector
becomes increasingly complementary with expenditure from the private sector.
Developments by the private sector, such as factory construction, are supported by
investments from the public sector, such as the building of connecting roads. As
urbanization proceeds and cities increase in size, so does population density. This
generates a range of externalities such as pollution and crime. An increasing proportion
of public expenditure is then diverted away from spending on infrastructure to the control
of these externalities.

(c) The Developed Stage

In the developed phase of the economy, there is less need for infrastructural expenditure
or for the correction of market failure. Instead, expenditure is driven by the desire to react
to issues of equity. This results in transfer payments, such as social security, health, and
education, becoming the main items of expenditure. Of course, once such forms of
expenditure become established, they are difficult to ever reduce. They also increase with
heightened expectations and through the effect of an aging population.

Limitations of the Development Models

Although this theory of the growth of expenditure concurs broadly with the facts, it has a
number of weaknesses.
1. It is primarily a description rather than an explanation.
2. It does not have any behavioral basis but is essentially mechanistic

7.4.4 Baumol’s Law

Rather than work from the observed data, Baumol’s law starts from an observation about
the nature of the production technology in the public sector. The basic hypothesis is that
the technology of the public sector is labor-intensive relative to that of the private sector.
In addition the type of production undertaken leaves little scope for increases in

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productivity and that makes it difficult to substitute capital for labor. As examples,
hospitals need minimum numbers of nurses and doctors for each patient, and maximum
class sizes place lower limits on teacher numbers in schools.

Competition on the labor market ensures that labor costs in the public sector are linked to
those in the private sector. Although there may be some frictions in transferring between
the two, wage rates cannot be too far out of line. However, in the private sector it is
possible to substitute capital for labor when the relative cost of labor increases.
Furthermore technological advances in the private sector lead to increases in productivity.
These increases in productivity result in the return to labor rising. The latter claim is
simply a consequence of optimal input use in the private sector resulting in the wage rate
being equated to the marginal revenue product.

Since the public sector cannot substitute capital for labor, the wage increases in the
private sector feed through into cost increases in the public sector. Maintaining a constant
level of public sector output must therefore result in public sector expenditure increasing.
If public sector output/private sector output remains in the same proportion, public sector
expenditure rises as a proportion of total expenditure. This is Baumol’s law, which
asserts the increasing proportional size of the public sector.

Limitations of Baumol’s Law

Baumol’s law has the following weaknesses:
1. It is entirely technology- driven and does not consider aspects of supply and demand or
political processes.
2. There are also reasons for believing that substitution can take place in the public
sector. For example, additional equipment can replace nurses, and less qualified staff can
take on more mundane tasks.
3. Major productivity improvements hay also been witnessed in universities and
hospitals.
4. Finally, there is evidence of steady decline in public sector wages relative to those in
the private sector. This reflects lower skilled labor being substituted for more skilled.

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7.4.5 A Political Model

A political model of public sector expenditure needs to capture the conflict in public
preferences between those who wish to have higher expenditure and those who wish to
limit the burden of taxes. It must also incorporate the resolution of this conflict and show
how the size and composition of actual public spending reflects the preferences of the
majority of citizens as expressed through the political process. The political model we
now describe is designed to achieve these aims.

The main point that emerges is that the equilibrium level of public spending can be
related to the income distribution, and more precisely that the growth of government is
closely related to the rise of income inequality.
The quantity of the public good demanded by the consumer depends on their income
relative to the mean since this determines the marginal cost.
The marginal benefit of the public good has been assumed to be a decreasing function of
public spending, so it follows that the preferred public good level is decreasing as income
rises. The reason for this is that with a proportional income tax the rich pay a higher share
of the cost of public good than the poor. Thus public good provision will
disproportionately benefit the poor.

The usual way to resolve the disagreement over the desired level of public good is to
choose by majority voting. If the level of public good is to be determined by majority
voting, which level will be chosen? In the context of this model the answer is clear-cut
because all consumers would prefer the level of public good to be as close as possible to
their preferred level. Given any pair of alternatives, consumers will vote for that which is
closest to their preferred alternative. The alternative that is closest for the largest number
of consumers will receive maximal support. There is in fact only one option that will
satisfy this requirement: the option preferred by the consumer with the median income.
The reason is that exactly one-half of the electorate, above the median income (the rich),
would like less public good and the other half, below the median (the poor) would like
more public good. Any alternative that is better for one group would be opposed by the
other group with opposite preferences.

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Government activities are perceived as redistributive tools. Redistribution can be explicit,

such as social security and poverty alleviation programs, or it can take a more disguised
form like public employment which is probably the main channel of redistribution from
rich to poor in many countries. Because of its nature, and interaction with the tax system,
the demand for redistribution will increase as income inequality increases as
demonstrated by this political model.

7.4.6 Ratchet Effect Models

These models assume that the preference of the government is to spend money.
Explanations of why this should be so can be found in the economics of bureaucracy. In
contrast, it is assumed that the public do not want to pay taxes. Higher spending can only
come from taxes, so by implication the public partially resists this; they do get some
benefit from the expenditure. The two competing objectives are moderated by the fact
that governments desire re-election. This makes it necessary for government to take some
account of the public’s preferences.

The equilibrium level of public sector expenditure is determined by the balance between
these competing forces. In the absence of any exogenous changes or of changes in
preferences, the level of expenditure will remain relatively constant. In the historical data
on government expenditure, the periods prior to 1914, between 1920 and 1940, and post-
1945 can be interpreted as displaying such constancy. Occasionally, though, economies
go through periods of significant upheaval such as occurs during wartime. During these
periods normal economic activity is disrupted. Furthermore the equilibrium between the
government and the taxpayers becomes suspended. Ratchet models argue that wartime
permits the government to raise expenditure with the consent of the taxpayers on the
understanding that this is necessary to meet the exceptional needs that have arisen.
The final aspect of the argument is that the level of expenditure does not fall back to its
original level after the period of upheaval.

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Several reasons can be advanced for this:

1. The taxpayers become accustomed to the higher level of expenditure and perceive
this as the norm.
2. Debts incurred during the period of upheaval have to be paid off later. This
requires the raising of finance.
3. Promises made by the government to the taxpayers during periods of upheaval
then have to be met.
4. Finally, there may occur an inspection effect after an upheaval whereby the
taxpayers and government reconsider their positions and priorities. The discovery
of previously unnoticed needs then provides further justification for higher public
sector spending.

These reasons can jointly be termed ratchet effects that sustain a higher level of spending.
This theory is similar to the Wiseman-Peacock Hypothesis discussed above.

The prediction of the ratchet-effect model is that spending remains relatively constant
unless disturbed by some significant external event. These events can trigger substantial
increases in expenditure. The ratchet and inspection effects work together to ensure that
expenditure remains at the higher level until the next upheaval.

7.5 Demand and Supply of Government Services

The complementarities between private and public consumer goods increase the demand
for government services e.g. Education, public transport, parks. Growth in public
services also creates externalities which encourage private investment. Political forces
including voting rights and preferences contribute to the pattern of public expenditure.

7.5.1 Comparison between Private and Public Expenditure

a) Similarities between Public and Private Expenditure
Public expenditure and private expenditure have the following similarities:
1. Both private and public economic units attempt for maximize returns per unit of
expenditure.
2. Private and public expenditure flexible though it more in the latter in the former.

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3. Both the private and public sector a collective view of income, expenditure and
adjustment in each.

b) Differences between Public and Private Expenditure

Public expenditure and private expenditure have the following differences:
1. There are differences in the objectives of expenditure.
2. There is no of quid pro quo in public expenditure.
3. It is not possible to evaluate the direct benefits of public expenditure.
4. The time horizon of decision-making is different. Societies are infinitely lived.

7.5.2 Forms of Public Expenditure

The expenditure by the public sector takes different forms:
1. Productive and Unproductive Expenditure
This distinction in public expenditure emphasizes the fact that while some
expenditures are in the nature of consumption, others are in the nature of and help the
economy in improving its productive ability.

Under laissez-faire philosophy the only productive expenditures are those on social
overheads. Expenditure on administration, defense, justice, law and order, and
maintenance of the state the unproductive - this is classical view. The public sector is,
however part and parcel of the economy as a whole, and should be considered as such.
Public expenditures can be productive or unproductive.

The precise definition of productive and unproductive expenditure is not easy. Each case
has to be judged on its own merit. In general, any stratified and avoidable expenditure is
unproductive, while all necessary and relevant expenditure is productive.

2. Transfer and Non-Transfer Expenditure

Transfer expenditures are payments without corresponding receipt of goods and services
by the state e.g. pension and unemployment benefits. Non-transfer expenditure is that
expenditure in which the state pays for purchases or use of goods and services e.g.
education, defense.

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7.6 Canons of Expenditure

The theory of public expenditure provides certain principles that any form of public
spending should follow. The most common ones are as follows:

7.6.1 The Canon of Economy

National economic resources are scarce companied to national needs. Thus, no wastage
should be permitted. The process of public expenditure should not involve use of
resources more than what is just necessary. Greater care and a scientific approach is
required toward the assessment of the required expenditure budgeting and zero base
budgeting have been developed to meet this objective.

7.6.2 The Canon of Sanction

This canon asserts that no public funds should be used without proper authorization
and further that funds must be used only for purposes for which they have been
sanctioned. The basic idea is that such a restriction would avoid unscrupulous and
unwanted expenditure and will check against misappropriation of funds. Given the
authority of the legislature, detailed authorization are marked out and at each stage
the spending unit has to have the sanction and approval of the appropriate authorities.

7.6.3 The Canon of Benefit

This canon is related to the canon of economy. Any expenditure is to be viewed against
the benefits that will accrue from it. It also states that public expenditure should be
incurred only if beneficial to society. The beneficial effects of public expenditure can
manifest itself also in the form of various effects on income and wealth distribution,
effects on production and so on. The general implication is that this canon leads public
authorities to observe principle of maximum social advantage. This can be achieved
through reallocation of public expenditure between different items in a way that
increases social benefit.

7.6.4 The Canon of Surplus

This canon can be interpreted to mean that the government should avoid deficit
budgeting, at least a persistent one. It should always try to be prudent and should

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aim at meeting its current expenditure needs out its current revenue. I t should not
overspend and run into debt.

This canon states that since it may not be possible to avoid some deficits, it would
be better if the general effort is directed at achieving a moderate surplus. Such
moderate surplus during some years will take care of reasonable but unavoidable deficits
during other years. This canon no longer finds favor with the fiscal authorities or with
economists in general.

7.7 Effects of Public Expenditure on the Economy

Some scholars have characterized public expenditure as a potent for bringing about
income and employment stability in the economy. Others are skeptical about the very
possibility of using public expenditure usefully. To them public expenditure is a waste,
and therefore a burden to the economy. Still others look at public expenditure as a
major weapon for brining about on egalitarian society - through various welfare
measures and so on.

7.7.1 Public Expenditure and Production

Public expenditure can boost on economy’s capacity to produce in a variety of ways.

1. Public Expenditure and Production in Developed Countries

Public expenditure can increase the effective demand directly. This generates conditions
for market forces to push up production. This techniques, however, becomes ineffective
once the level of full employment is reached. There also exist certain rigidities in the
economy that might hamper effective stimulation of demand like monopolistic
practices, excess capacity and militant trade unions.

2. Public Expenditure and Production in Developing Countries

Generally, developing countries are characterized by low saving and investment activity.
This deficiency can be reminded by stimulating private saving and investment or both.
In developing countries there is also a shortage of social overheads, skilled labor,
capital equipment and machinery.

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Public expenditure can be used to improve production in the following ways:

a. Public expenditure can be directly used to create and maintain social overheads.
b. It can also be used to create human capital through education and training.
c. Public expenditure can be used to provide the necessary economic
infrastructure for the development of selected economic activities and can be
used to provide subsidies for increasing their profitability.
d. Public expenditure can also be used to encourage the market sector of an
underdeveloped economy for contribution growth.
e. Public expenditure can be used to stimulate demand for certain products and
this stimulate demand for certain products and this stimulate private
production. A policy of purchasing indigenous products will help domestic
industries to grew, and it also create employment opportunities.
f. Public sector investments can be directed towards creation of particular
supplies and facilities, which form important and necessary inputs to other
industries education and training facilities that aid in reducing regional
disparities.
g. Research and development activities can also be financed from public coffees.
New method of production can be found where local resources are utilized
thereby saving on imports and foreign exchange

3. Public Expenditure and Economic Growth

Public expenditure can also be used to influence economic growth. This is achieved
through a number of ways:
a. Economic stabilization.
b. Stimulation of investments in the economy.
c. Reduction in regional disparities in education, income and wealth.
d. Developing social overheads, creation of infrastructure in the form of transport
and communication facilities, growth of capital gods industries, basic and key
industries, research and development and so on.
e. Stimulation of saving and capital formation.

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7.8 Cost - Benefit Analysis

Cost-benefit analysis, in the technical sense, involves the ascertainment of the
economic desirability of a government investment project – a project yielding its
return over a period of years – with analysis of costs and benefits over the entire
economic life of the investment. Cost benefit analysis seeks to take all benefits and
costs , direct and indirect, into consideration and to evaluate alternative approaches as
well as the overall project in light of objectives.

7.8.1 The Elements in a Cost-Benefit Study

Cost-benefits studies are typically undertaken within a particular government
department as a preliminary to budget preparations or as a continuing program to
determine efficient expenditure patterns and budget recommendation. A study involves
several major steps:-

1. Statement of Objectives
Obviously, the goals of the particular programs must be defined: what does the activity
seek to attain, in conformity with the overall objective of society of seeking the
highest possible level of welfare? The goal may be very specific, such as that of an
irrigation project, with the immediate objective of bringing 2,000 acres under
cultivation by providing adequate water.

Other projects have multiple goals; dams may have flood control, irrigation, navigation
and recreational objectives. Other projects may have goals much more difficult to define
specifically. In general, goals such as income generation, income redistribution, regional
development and/or regional self-sufficiency typically enter as objectives in the
evaluation process.

2. Statement of Alternatives
With many types of activities, there are various alternative ways of attaining the
goals: different locations for irrigation n facilities, different timing for parts of the
project, different methods of construction. Cost-benefit analysis seeks to determine the
relative costs and benefits of the major alternatives.

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Cost-benefit analysis is costly, and the number of alternative considered must be held
within tolerable limits.

3. Analysis of benefits.
Determination of benefits involves two major questions: which benefits are to be
included and how are the benefits to be valued:

(a) Direct and Indirect Benefits

With many projects there are two types of benefits: those accruing directly to the
users of the service provided and those accruing to others - the indirect benefits or
externalities. For example, a new rapid-transit line offers direct benefits to those who
use it and externalities to others, such as reduced congestion for those who continue
to drive on less-crowded streets.

Obviously the direct benefits to the users must be included, the problems center on the
indirect benefits. Should they be taken into consideration and which indirect benefits are
relevant? The answer to the former question is that evaluation of the undertaking
requires that all appropriate indirect benefits be considered, although in practice the
inclusion must be restricted to major categories. The answer to the second aspect of the
question is more complex. In general, only real or technological benefits (those
increasing the output potential of society other than through direct use of the activity)
are relevant, where as strictly pecuniary benefits are not.

If the building buildings o fan irrigation dam reduces flooding or provides more
pleasant scenery for tourists driving past the lake created by the dam, these are real
externalities and should be included in the measured benefits. The building of a
subway by lessening the traffic on expressways, saves time for persons continuing to
use their cars and reduces accidents, air and noise pollution, and investment in
expressways and parking structures. These benefits alter the physical conditions of
production or consumption for persons other than those directly using the activities.

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Pecuniary benefits in the form of lower input costs or increased volumes of business
and land values arising through the use of the service are not real externalities and
should not be included. Many are distributional in nature; benefit some persons at the
expenses of others.

(b) Valuation of Benefits

The direct benefits to the users of many services can be calculated on the basis of the
amounts the users are willing to pay, or in other words, the revenue that would be
obtained from the sale of the services with perfect discrimination. With electric power
plants and city water systems the amounts can be calculated accurately in advance on
the basis of experience elsewhere. In other words, the revenue that would be obtained
from the sale of the services with perfect discrimination.

With electric power plants and city water systems the amounts can be calculated
accurately in advance on the basis of experience elsewhere. In other instances,
however only a rough estimate is possible. For example, recreational activity: How does
one measure the amount a person is willing to pay for spending a day fishing a lake
or camping in a fore preserve, if similar facilities not actually sold to the users?

Similarly, valuation of human life always involves arbitrary assumptions. Another

valuation problem arises from the lack of perfect competition in the market for the
activity or the products produced as a result of the program. If the government charges
for the service and prices on a monopoly basis, total revenues and thus the measure
of benefit will differ from the competitive market figure.

Apart from valuation difficulties, estimation of benefits is always colored by uncertainties

about future conditions. Benefits from irrigation facilities will depend upon future trends
in population and farm outputs. The uncertainties with some activities are so great that
any precise conclusions are impossible. Valuation of externalities encounters even more
difficult problems.

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With purely public goods the task is particularly difficult, since there is no accurate
way of estimating what the community as a while is willing to pay for the services.

4. Analysis of Costs
Costs of the project may be defined as the present value of resources that will be used
in the project, valued at their opportunity cost, that is, the amount that would be paid
for them for alternative use. Analysis of cost involves the same type of problem as that
of benefits, although costs are more easily calculable. The direct costs include capital
costs and operating and maintenance costs over the years. Indirect costs including those
created for other governmental agencies. And overall costs to society not directly borne
by the government. These are in sense negative benefits.

Without cost-benefits analysis, indirect costs are often not taken to consideration. There
are obviously measurement and valuation difficulties, just a there are with benefits. Air
pollution provides an excellent example.

7.8.2 The Need for Discounting

Cost-benefit analysis is primarily employed for long-range projects. Costs will be
incurred currently and in the future, benefits will be obtained over a number of years.
Because of time preference, benefits in subsequent years are of less importance than
benefits in the incurred year; costs incurred now are more significant than costs
incurred in later years because of the existence of interest. Some method, therefore,
must be used to adjust benefit and cost figures on the basis of the year in which they
occur. This process is referred to as discounting.

(a) Choice of Method of Evaluation

Three types of decisions may be involved in the final evaluation of a project. First, a
particular project warranted or not, under the assumption that funds will be available
for all projects that are economically justifiable under the criteria employed? Second, if
two mutually exclusive projects are being considered , both of which are justified
under the criteria, which of the two is to be selected.

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Third, if several projects of a no mutually exclusive nature are under consideration

and funds are not available for all of them, what criteria should be used in establishing
priorities?

It is generally agreed that the maximization of the net present value of the project
subject to the available capital constraints is the most appropriate procedure to follow
in evaluating public investments, that is, the net excess of benefits over costs (B/C) is
discounted for each year of the project’s life, back of the present year of decision. A
project having a positive value is justified; if funds are available, all such projects other
should be undertaken.

(b) The Discount Rate

In order to evaluate a particular project and to compare alternatives, therefore, a
discount factor must be used to determine the present value of benefits and costs.
There are several possible alternative rates.

1. The marginal productivity of capital in private investments. The opportunity cost may
be defined as the amount the funds would earn in private investment- the typical earnings
rate of money capital in new private investment. This approach is favored by persons
who seek to minimize government investment activity since it produce the highest of
the alternative discount rates and therefore allows justification of a minimum of
governmental activities. It may also provide maximum pressure toward efficiency in the
use of resources in the project.

But there are several objections. First, risk is greater with private enterprise, if the
project is unsuccessful, the owners may lose their entire investment and control of the
firms. It is true that any particular government project does involve some risk of failure,
in the sense of waste of the resources, but this is of a different order of magnitude
than the risk facing the business firm.

Second, capital markets are by no means perfect. Third, the use of this discount rate is
based on the assumption that are resources taken by government are diverted from

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private investment. But this is not necessarily valid, if the project is tax-or user-
charge financed, the resources are in part diverted from consumption, not investment,
and the opportunity cost of use in the investment sector is not relevant.

2. Social rate of time preference. This consideration leads to the second alternative that
the discount rate should be the figures of the rate-of-time preference, the
compensation necessary to induce consumers to refrain from consumption and save.
This figure would be equal to the marginal productivity of capital in private
investment in a riskless world with perfect capital markets, but in fact is substantially
lower than the actual marginal productivity of capital. The only feasible method is to
ascertain the current government bond rate which reflects riskless investment.

But there are several problems. From all indications most saving is made for reasons
unrelated to compensation for time preference, and thus the figure is of no particular
significance; it measures the compensation necessary to induce persons to forego
liquidity and buy bonds rather than to forego present consumption. The actual bond
rate is dependent in large measure upon monetary policy, reflecting the current
objectives of the federal reserve system to expand or contract the supply of money
capital. It may also be higher than the figure allowing full employment. The bond rate is
higher than the figure allowing full employment. The bond rate also involves in part a
compensation for risk that is not relevant for a variant of this objection maintains that
the unadjusted government borrowing rate is unsuitable as a measure of social rate-
of-time preference because it does not take into consideration the neglect by
individuals of the welfare of persons living in the future. Society as a whole should,
therefore, give additional weight to the interest of future generations; accordingly, the
social rate-of-time preferences is less than the borrowing rate.

Since future generations will presumably have higher real incomes than present ones,
there seems little need for formal consideration of their interests relative to those of
present generations. Furthermore, if the government wishes to increase the overall rate
of real saving, it may do so by encouragement private investment as well as public
investment.

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3. Government borrowing rate without reference to the preference. The complexities and
inadequacies of these approaches suggest the use of a simple rule: the rate of interest
at which the particular government can borrow, on a long-tem basis, without any
effort to justify this figure on a time-preference basis. Admittedly, it is an artificial
figure because of the influence of monetary policy the rate, and it is substantially
lower than the figure of marginal productivity of element on an equity basis in
private enterprise. But given the risk element and the fact that government investment
is in large measure competitive with private consumption investment is in large
measure competitive with private consumption, not private investment, use of the
figure is perhaps the most logical. Certainly it is the simplest.

7.8.3 Merits and Limitations of Cost-Benefit Analysis

There are significant problems when it comes to the measurement of benefits. There are
also uncertainties associated with the measurement of the costs and benefits.
Consequently, it is almost impossible to quantify both the costs and benefits. More often
than not, the techniques used tend to overemphasize those benefits and costs that can be
easily quantified, compared to those that cannot.

Furthermore, while CBA may aid in measuring the distributional effects of alternative
programs, it offers no guide for the establishment of the appropriate objective function
or the weights that should be utilized in this function.

Finally, CBA is not useful in evaluating relatively broad-based programs or in

comparing programs with different objectives, for example, highways versus housing,
nor does it solve the problem of the optimal provision of public goods or assist in the
establishment of national priorities, for example defense versus education.

However, these limitations do not present a convincing case for discarding CBA. What
CBA does provide is a framework for evaluating a range of projects of a similar nature
and goal. Not only can it be used to evaluate competing similar investments like rails
versus high ways versus waterways, it also provides a framework to incorporate multiple
objectives and goals. This ensures efficiency in the allocation of available.

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7.8.5 The Role of Cost-Benefit Analysis in Budgeting

CBA is a useful instrument for evaluating the net benefits of public sector projects. The
information obtained form the CBA can be utilized by citizens, politicians and
bureaucrats to make informed choices. The main limitation in the application of CBA is
that some costs and benefits of public goods are not amenable to quantitative
measurement. There are also differences in opinions and attitudes towards what costs and
benefits to include into a CBA and the price to attach to project outputs. The process of
selecting public goods and services is complex thus it cannot be adequately handled
within the simple framework of CBA. This reflects the complex political interests at play
at any given time. Often the projects selected for implementation do no necessarily
maximize social welfare even when CBA seems to suggest so. In this instance, the CBA
only serves to justify an already endorsed public project.

Activity 7
1. State and explain the major divisions of public finance.
2. State and explain the factors responsible for the growth of public
expenditure in developing countries.
3. Write brief notes on the following theories of public sector growth
(a) Wagner’s Law (b) Wiseman-Peacock Hypothesis (c) Baumol’s
Law (d) Development Models
4. Compare and contrast public expenditure and private expenditure.
5. Discuss the four canons of public expenditure.
6. Discuss the impact of public expenditure on economic growth in
Kenya.
7. State and explain the main difficulties involved in implementing a
cost-benefit analysis?
8. Explain how you would estimate the costs and benefits of an
irrigation project.
9. How does the social discount rate affect the number of projects that
can be selected and their priority in the cost-benefit analysis?

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7.9 Summary
In this seventh lecture you have learnt the following important points:
 Public expenditure is influenced by several factors: expansion of
the traditional functions of the state; the need to provide and
expand the sphere of public goods; increase in the national
population; urbanization ; inflation; the size and nature of public
services; market failures; and the need for economic growth.
 Wagner’s Law is the most comprehensive and convincing model of
public expenditure growth.
 Public expenditure takes at least two forms: productive and non-
productive expenditure, and transfer and non-transfer expenditure.
 There are four canons of public expenditure: the Canon of
Economy, the Canon of Sanction, the Canon of Benefit and the
Canon of Surplus.
 Public expenditure can be used for economic stabilization, poverty
alleviation, capital formation and capital accumulation.
 Cost-Benefit Analysis is used in the public investment process to
prioritize competing projects for public funding. However, the
actual selection of a public project is a political decision.

7.10 References
1. Rosen S. Harvey, Public Finance. 3rd Edition. Richard D. Irwin Inc.,
Homewood. IL, 1992. pp. 165 – 190, 191 – 215, 216 – 238,
239 - 273

2. Herber, P.B., Modern Public Finance. 5th Edition. Richard D. Irwin

Inc., Homewood. IL, 1990. pp. 311 - 332

3. Due, J.F. and Friedlaender, A.F., Government Finance: Economics of

the Public Sector. 2002. A.I.T.B.S., Delhi, India. pp. 179 -
212

4. Hindriks, J. and Myles, D. G., Intermediate Public Economics. MIT

Press, Cambridge, USA. 2006.

5. Sundharam, K.P.M. and Andley, K.K., Public Finance: Theory and

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Practice, 16th Edition. S. Chand and Company Ltd. New

Delhi. 2003. pp. 30 – 50

6. Musgrave, R.A. and Musgrave, P.B. Public Finance in Theory and

Practice. 5th Edition, McGraw-Hill Book Company, New
York. 1989. pp. 113 -161

7. Bhatia H.L. Public Finance 24th Edition. Vikas Publishing House Pvt.
Ltd. Jangpwa. New Delhi 2003. pp. 218 - 246

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LECTURE EIGHT
BUDGET DEFICITS AND PUBLIC DEBT
Lecture Outline
8.1 Introduction
8.2 Objectives
8.3 Meaning of Budget Surplus, Budget Deficit, and Public Debt
8.4 Budget Philosophies
8.4.1 The Annually Balanced Budget
8.4.2 The Cyclically Balanced Budget
8.4.3 Functional Finance
8.5 Public Debt and Private Debt
8.5.1 Differences between Public Debt and Private Debt
8.5.2 Why Public Debt?
8.6 Forms of Debts
8.7 Public Debt versus Taxation
8.7.1 Merits of Debt Financing
8.7.2 Demerits of Debt Financing
8.8 Public Debt and Economic Growth
8.8.1 Contribution to the Financial System of the Economy
8.8.3 Contribution to the Saving Effort of the Economy
8.8.4 Public Debt as a Means of Regulating the Economy
8.9 Debt Burden
8.9.1 The Burden of Debt and Future Generations
8.9.2 Debt Redemption
8.9.3 Some Issues in Debt Management
8.10 Summary
8.11 References

8.1 Introduction
Public debt is related to the taxation and expenditure activities of the government. If
government expenditure is more than government tax and other revenues, a budget deficit

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occurs. The existence of the budget deficit is the rationale for the creation of public debt.
However, it is not the same as debt creation, which is just one of the ways of financing
government expenditure. The other methods of financing government expenditure are
taxation, user charges, revenue from public enterprises, running the printing press and
court fines. Once debt has been incurred, interest on debt must be paid to service it. If the
government still requires funds to finance its activities it can roll-over the debt. This is
known as debt refinancing. In this lecture we examine the public debt, budget deficits,
and budget surpluses and the economic effects of public debt.

8.2 Objectives
At the end of this lecture you should be able to:
1. Define the budget deficit, the budget surplus, and public debt.
2. State and explain different types of public budgets.
3. Distinguish between Public Debt and Private Debt.
4. Discuss the various forms of public borrowing.
5. State and explain limits to public borrowing.
6. Compare and contrast public debt and taxation as ways of financing
the public deficit.
7. Discuss the false and true implications of public debt on the
economy.

8.3 Meaning of Budget Deficit, Budget Surplus and Public Debt

A budget deficit is the amount by which government expenditures exceed government
revenues in a given year. On the other hand, a budget surplus is the amount by which
government revenues exceed government expenditures in a given year. A balanced
budget occurs when government expenditure equals government revenue. The public
debt is the accumulation of the deficits minus the surpluses that the central government
has incurred through time. Public debt therefore represents the total amount of money
owed by the central government to the holder of government securities such as Treasury
bills, Treasury notes, Treasury bonds and saving bonds.

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The obligations of the government take different forms:

1. Currency – this is an active or dormant obligation.
2. Short term debt - matures within 1-2 years.
3. Floating debt – this has no specific maturity date.
4. Permanent or funded debt – this matures in 3-30 yrs.
5. External loans – these are obligations owed to outsiders or foreigners.

8.4 Budget Philosophies

This section examines the economic implications of various budget philosophies. There
are at least three budget philosophies – the annually balanced budget, the cyclically
balanced budget, and functional finance.

8.4.1 The Annually Balanced Budget

Under this budget philosophy the government balances its budget over the financial year.
Thus an annually balanced budget is not compatible with the stabilization function of the
government. It also accentuates the business cycle. For example, suppose the economy is
in a recession. In such circumstances, tax revenue falls. Thus, to balance the budget, the
government must (a) Increase taxes, (b) reduce government expenditure, or (c) use a
combination of (a) and (b). However, each of these three policy actions is contractionary,
therefore, reduces aggregate demand.

Further, annually balanced budget will fuel inflationary pressures. During an economic
boom, tax revenues rise. To avoid a budget surplus, government must (a) cut taxes, (b)
increase government expenditure, or (c) use a combination of (a) and (b). However, all
the three policy actions fuel inflationary pressures. There are some arguments that have
been put forward to support an annually balanced budget. An annually balanced budget
is necessary to check the growth of public sector.

8.4.2 The Cyclically Balanced Budget

Some economists argue that a cyclically balanced budget would enable the government to
exert a countercyclical influence and at the same time balance its budget. They are

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convinced that the budget does not need to be balanced annually, but should be balanced
over the business cycle.

The reason is simple, convincing and appealing. To offset a recession, the government
should lower taxes and increase spending, intentionally incurring a deficit. In the
intervening inflationary boom, the government would raise taxes and reduce spending. It
would use the surplus to retire public debt incurred during the recession. Thus
government fiscal policy will exert a countercyclical force, and the government could
still balance its budget over the years.

The main limitation of this budget philosophy arises from asymmetrical business cycles.
This occurs when recessions are longer than booms or when recessions have higher
magnitudes than economic booms.

8.4.3 Functional Finance

The main concern of the central government here is to achieve a non-inflationary full
employment to balance the economy rather than the budget. Whether this will translate
into persistent deficits or persistent surpluses does not matter. The budget is the fiscal
instrument for achieving economic stability. Therefore the government need not worry
about whether it is incurring deficits or surpluses as long as the economy is stable and
growing.

8.5 Public Debt and Private Debt

8.5.1 Differences between Public Debt and Private Debt
1. A private economic unit cannot borrow from itself. However, government usually
borrows internally, i.e., from its own subjects and from within the country.
2. The government can repay debt through money creation while a private economic
unit cannot.
3. Public debt affects various aspects of the economy: distribution, capital accumulation,
economic growth, national income and employment stability. Thus, it is a source of
problems and a tool of economic management.

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8.5.2 Why Public Debt?

There several reasons on the basis of which a government might raise public debt.
(1) A mismatch between expenditure and revenue flows
(2) Spurts in government expenditure due to are famine, epidemics etc
(3) Modern governments do not subscribe to the philosophy of avoiding a surplus or
deficit for its own sake. Rather they are ready to use them as a matter of policy –
functional finance.
(4) The increasing role of government in the economy especially developing countries to
increase economic growth.
When a government adopts a deficit budget, it may finance it through:
1. Running down its cash reserves
2. Sale of its assets like properties and investments
3. Borrowing and spending

8.6 Forms of Public Debt

The obligations of the government take different forms:
1. Internal debt is owned or held by a country’s citizens or subjects
2. External debt is owned or held by foreigners
3. Marketable loans can be sold to another person in the debt market.
4. Non-marketable loans are issued in favour of specified debt holders only and
cannot be sold to others.
5. Interest bearing loans usually carry a fixed coupon or a variable coupon.
6. Non-interest bearing loans do not attract interest payments on outstanding
amount.
7. Zero coupon bonds are normally issued at a discount e.g. treasury bills.
8. Productive loans are used to acquire productive assets.
9. Non productive loans are used for consumption purposes only.

Limits of Raising Public Debt

The fundamental question in this section is this: Are there any definite limits beyond
which the government cannot raise loans and add to its outstanding debt obligations?

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The answer to this question depends on the will and capability of the government to raise
loans both in the constraints on government borrowing include:
(1) The moral compulsion – it is expected that the government would abide by a self-
imposed limitation that all borrowings must be for public purposes or for social good.
(2) Legal restrictions on government borrowings.
(3) The cost of debt i.e. interest rates.

8.7 Public Debt versus Taxation

The advantages and disadvantages of debt and tax finance have been debated for a long
time. However, the choice depends upon specific circumstances and overall long-term
implications for the economy.

A major part of government expenditure is financed through tax revenue. Therefore, the
real issue is to decide how to choose between tax and debt finance for the remaining
expenditure.

8.7.1 Merits of Debt Financing

Debt financing has the following advantages over other sources of financing:
1. It is a necessary feature of a healthy and strong financial structure of an economy.
Thus some secular increase in public debt should be planned by every government.
2. It is necessary under exceptional circumstances like war, famine and epidemics.
3. It is also needed in cases where tax receipts are falling below target, yet expenditure
does not show a corresponding reduction or is rising.
4. It is required to finance particular projects e.g. construction of dams for irrigation
purposes.

8.7.2 Demerits of Debt Financing

Debt financing suffers from the following disadvantages:
1. It increases future budgeting commitments to the government.
2. It is only the rich who can subscribe to it since it causes a redistribution of income in
their favour.

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3. Project funded by debt are subject to inefficiency and corruption thus they may not
generate a surplus to affect their cost.
4. Control of inflation under debt financing is more challenging than under tax financing
of war.

8.8 Public Debt and Economic Growth

Public debt affects economic growth as follows:

8.8.1 Contribution to the Financial System of the Economy

Financial assets can be divided into two categories ‘inside money’, and ‘outside money’.
Outside money refers to financial claims against the government sector i.e. flat money.
Inside money refers to financial claims against the private sector of the economy.
Government obligations act as an acceptable and sound base for the private financial
assets, especially credit. Government debt has the lowest risk of default and a readily
marketable. Thus government debt is a precondition for the existence of a developed
financial system of the economy.

8.8.2 Contribution to the Saving Effort of the Economy

In developing countries private saving and public saving are complimentary. Since
saving capacity of the masses in low, the government is required to take appropriate
measures to stimulate savings and investment in the economy.

The net impact of public debt depends on the sources of financing. If the government
borrows from the market, competition for inventible funds between the government and
the private sector will push up interest rates thus increasing the cost of finance.
Consequently, only the government will be able to borrow at the increased level of
interest rates, effectively crowding out the private sector. This results in a slump in the
economy due to a decrease in investments.

However, public debt can be used to invest in public goods unlike private investment
which concentrates on consumption goods. Thus public investment can stimulate
economic growth. Borrowing from the local market can also encourage savings by
discouraging consumption. When the government borrows from the central bank, it

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increases the aggregate money supply. This causes inflation that negatively affects the
economy.

8.8.3 Public Debt as a Means of Regulating the Economy

The financial system of the economy can be regulated through changes in the volume,
composition and yield rate of public debt. When the maturity composition of public debt
increases its overall liquidity is lowered and vice versa. The government can substitute
long term as a matter of policy. Change in liquidity arising from the composition of
public debt affects the term structure of interest rates for both debt and other financial
assets.

Ownership of public debt confers instant purchasing power or liquidity to the holder.
Thus changes in public debt policy directly influence the sum purchasing power of public
sector. Public debt forms the base for the private credit structure, and, thus it can be used
to influence the private credit structure, as well, through open market operations. By
influencing the yield curve, public debt also influences the market values of various
financial and real assets. Changing values of these assets affect the volume and pattern of
demand and consumption in the economy.

The exact way in which, and the extent to which, changes in the interest rate structure and
the volume and composition of the demand flows, investment and other decisions in the
economy, are an empirical question. However, the following are some general
tendencies:
1. An increase in liquidity or purchasing power will increase demand and (if demand
does not rise fast enough) prices also. The converse is also true.
2. When interest rates go up, investment will fall unless inflationary expectations
have raised the expectations of rising prices too much. High interest rates also
push down the prices of assets – real and financial this dampens consumption and
investment activity.
3. Lower interest rates induce extra expenditure in the economy

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The above tendencies can be used to devise a debt policy which will be anti cyclical in
effect, and will therefore contribute to economic stability. However, such a debt policy
must be aligned with the monetary policy of the government.

8.9 The Burden of Debt

The burden of debt is represented by the interest payment on public debt. This was
emphasized by Evesy Domar in his article, “The Burden of the Debt and National
Income”, in the American Economic Review, 1944. He related interest payments to the
level of national income, and thus pointed out that, as interest on debt as a proposition of
national income rises, a large portion of national income will have to be taxed to pay that
interest.

Factors determining the burden of debt include:

(1) The resource used in administering the tax collection and interest payments.
(2) Loss of flexibility in public budget and related constraints
(3) The distributive effects of such a process.

The burden of debt may lessened by favorable terms of trade to the debtor country. It is
also reduced by yields from productive investments undertaken by the debtor country.

8.9.1 The Burden of Debt and Future Generations

Two fundamental questions naturally arise when considering the burden of public debt:
1. Does debt financing necessarily impose a burden or a sacrifice upon future
generations?
2. Is it possible to make the future generations contribute to the present utilization of
resources through debt financing?

The classical view on this matter is that it is only the present generation that bears the
burden of public debt. Future generations suffer only to the extent that the present
generation reduces its savings to meet debt finance and therefore leaves a small amount
of capital resources for the future. This reduces the predictive capacity of future
generations and they will accordingly lose.

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The burden of debt is perceived in terms of reduced consumption availability. In debt

financing, consumption is not likely to fall thus debt financing can impose a burden upon
future generations. The burden of debt can be passed to future generations in cases where
debts are raised externally. The current generation receives the resources and the future
generations pay back the debt.

In conclusion, public debt will be a burden to the future generations if two conditions are
satisfied:
1. The current generation does not reduce its savings, and
2. The government does not add to the capital stock and productive capacity of the
country.

8.9.2 Debt Redemption

The traditional thinking on this issue is that public should be paid off as quickly as
possible. Current thinking considers debt retirement in the context of overall debt and
fiscal policies of the government and favors repayment of debt under normal conditions.
There several ways of retiring debt:
1. Repudiation of debt. However, it is wrong on the government to do so. It also
negatively affects the government’s ability to borrow in future.
2. Sinking fund. This is where the government creates a fund in which it regularly
deposits money and uses the accumulated fund for periodic and partial retirement of
debt.
3. Regular retirement of a small part of debt every year. This can be affected as follows:
(a) The loans outstanding may have staggered maturity dates (serial bonds). The
advantage of this method is that the repayment obligations are well-spread over
time. However, serialization of bonds may affect the bond market.
(b) Ear-marking part of the budget for debt retirement and then purchasing bonds in
the market and canceling them. The disadvantage here is that the method is
voluntary in character and the government might not commit itself.

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8.9.3 Some Issues in Debt Management

Debt management refers to the formulation and implementation of debt policy designed
to achieve certain objectives. The traditional philosophy was to keep interest cost to a
minimum and paying off debt as early as possible. In the modern welfare state, debt is
used as a policy tool for achieving socio-economic objectives. Keeping interest cost to a
minimum is just one of the objectives and whenever is runs into conflicts with other
important objectives of government, it is always scarified.

Debt management policy must be in harmony with monetary management in the country.
The both influence stabilization and growth – they’re linked. The aggregate volume of
outstanding debt reflects a cumulative effect of the budgeting policy of government. The
volume of debt increases or decreases in line with deficit- or surplus- budgeting.
Budgeting policy can also aim at altering the volume and composition of money and
credit without the above constraint.

Public debt management would mainly consist of changing its maturity composition to
affect it yield structure and liquidity content.

Activity
1. Define the following terms: budget deficit, budget surplus, and the
public debt.
2. Distinguish between public debt and private debt.
3. Public debt is a burden to the future generations. Discuss.
4. Sate and explain the methods for repaying public debt.
5. State and explain the causes of public debt.
6. Compare and contrast taxation and public debt as sources of government
finance.
7. Discuss the effects of public debt on economic growth.

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8.10 Summary
In the eighth lecture you learnt the following important points:
 A budget deficit arises when government expenditure exceeds
government revenue.
 A public debt is the accumulation of the deficits minus the
surpluses of the central government through time.
 There are three budget philosophies that can be adopted by the
government: the annually balanced budget, the cyclically balanced
budget and functional finance.
 Public debt affects the functioning of the real economy as it
influences the interest rates, the development of the financial
system and economic growth.
 Public debt can or cannot be a burden to the future generation. It all
depends on what use the borrowed funds are put.

8.11 References
1. Bhatia H.L. Public Finance 24th Edition. Vikas Publishing House
Pvt. Ltd. Jangpwa. New Delhi 2003. pp. 198 – 217, 247 – 284,
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