Chapter One

Public Finance

1.1 Introduction

Public finance is the study of income and the expenditure of the government.
Rising of necessary funds for incurring expenditure constitutes the subject
matter of public finance. The methods of public finance have certain effects
on economic life and can, therefore, be used as an instrument for bringing
about desired social and economic changes. Public finance also deals with
the problems of adjustments of income and expenditure of the government.
It is also known as fiscal operations of the treasury. Thus, fiscal operations
and fiscal policies are integral part of public finance.

Public Finance deals with the income and expenditure of the public
authorities. Here the term Public means the Government that is Central,
state and local authorities. The term Finance means Resources.

Public finance: Resources of the masses, how they are collected and utilized.
The discipline of public finance describes and analyses government services,
subsidies, welfare payments and the methods by which the expenditures to
these ends are covered through taxation, borrowing, foreign aid and the
creation of money.

So, Public finance is one of those subjects, which lie on the borderline
between Economics and Politics. It is concerned with the income and
expenditure of public authorities, and with the adjustment of one to another.

Public finance is composed of the following constituent’s public:

 expenditure
 revenue
 debt
 financial administration
 Economic stabilization.
The public finance is not only study the composition of public revenue and
public expenditure. It covers a full discussion of the influence of government
fiscal operations on the level of overall activity, employment, prices and
growth process of the economic system.

Private finance is the study of the income, debt and expenditure of the
individual or a private company or business venture or an association. It

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includes the study of their own view regarding earning expenditure and
borrowing.

1.2 Similarities and Differences between Public Finance and

Private Finance
Despite the differences in scope and nature of the public finance and private
finance, following are similarities.
A. Similarities

1. Based on Similar Theories- The basis of public as well as private

finance is the same. Both seek the help of various principles of
economics in determining various interrelated problems. For example,
a person wants to secure maximum utility on count of minimum
expenditure and government too wants to secure public utility by
spending the least possible amount of public money.
2. Both Face the Problem of Scarcity - Limitation of the resources is
the problem of private as well as public finance. Individuals‟ resources
are limited up to these earnings; past savings and ancestral property
similar governments‟ resources also depend on taxable capacity of the
individual’s earnings of the various corporations etc. None of the two
can extend its expenditure beyond a certain limit; hence non-can
affords to go to the infinity in the use of finance.
3. Both Require Efficient Administration - Private as well as public
finance requires efficient administration to look after the various acts
of extravagance. In the event of the failure of an efficient
administration both might be compelled to face „dire-consequence‟ in
their financial field, individual never wants any kind of wastage or
misuse of his income, so the government if it is alive to the sense of
duty.
4. Both Borrow and Must Repay - To run the administration of finance
sometimes money in hand fails to fulfill the requirements especially in
the times of emergency, governments borrow money from individuals
and borrow from different sources like relatives, banks, and at the
same it is obligatory for both the public finance as well as the private
finance to repay the debt. The point here is that none can live without
repaying the amount.
5. Both are Based on Rationality of Thought - When an individual
spends some money, he makes it certain in his mind that money is
spent in the best way. He applies his rational faculties. In the same
way, any irrational step taken by the government may bring wastage

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 and misuse of finance. This irrationality leads them to damages while
rationality to prosperity and achievement of goals. Differences
between Public Finance and Private Finance
B. Differences
The following are the main points of differences or dissimilarities between
public and private finance:
1. Adjustment between Income and Expenditure – An
individual determines his expenditure based on his income but
government determines its income on the basis of its expenditure. An
individual prepares his family budget on his expected income during
the month. On the other hand, the government first estimates about
his expenditure and then finds out means to raise the necessary
income. Government has the power to increase its income be internal
borrowings but this is not possible for an individual.
2. Elasticity of Finance – Public Finance is more elastic than
private finance. There is not much scope for changes in private finance
while drastic changes can be made in government finance. For
example, a private individual cannot affect any special increase in his
income. As against this the government can increase its income by
imposing fresh taxes on the people Moreover, government can take
the help of the foreign government and this is not possible for a person
to secure such supports. The last resort available to the government is
the printing of new currency notes to increase its income.
3. Differences in Objectives – There are a fundamental
difference in the objective of private and public finance. The motive of
private expenditure is personal benefit whereas the objective of public
expenditure is social benefit. An individual always tries to save and a
firm to earn profit. But there are no such considerations on the part of
the government, except the public welfare. However, there are some
public enterprises which are run on profits that are utilized for public
welfare.
4. Compulsion – There is compulsion in public finance. People
must pay taxes. If they do not pay, they are punished by fine and
imprisonment. An individual or firm cannot force anybody to pay him
money. He can file a suit in the court. But even then, he may not
receive his money back. The same is the case with loans. The
government can force the people to lend it during war or emergency.
But an individual cannot compel any person to lend him money.

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5. Law of Equ-marginal Utility – The private individual spends
his money on various items in such a manner as to secure equal
marginal utilities from them. It is only by equalizing the various
marginal utilities that he can secure maximum utility out of his
expenditure. The government on the contrary, does not give as much
importance to this law as a private individual does. Modern
governments sometimes incur certain types of expenditure from which
they do not derive any advantage, but they o incur this expenditure to
satisfy certain sections of the community.
6. Present Vs Future – An individual is more concerned with his
present needs and tries to satisfy them. Life being uncertain and short,
he has his immediate gain or profit in view. On the other hand,
government is a permanent organization. Only the ruling party
changes it is concerned not only with the welfare of present generation
but also, It with future generations. Therefore, it undertakes and
spends on those activities which also benefit future generations
7. Budgeting process - The budget of the government is subject
to the approval of the parliament of the concerned country. It is now a
well-established principal no taxation without representation and no
tax shall be without the due/process of law. Unless the demand gets
approval of the parliament of the executive cannot spend even a single
penny. But individual is his own master and he need not ask for
parliamentary approval for spending his bricks.
8. Nature of the Budget – A surplus budget is always good for a
private individual. Bin a surplus budget may not be good for the
government. It implies two things: (i) The government is levying more
taxes on the people than its necessity; (ii) The government is not
spending as much on the welfare of the public as it should. Some
theories supported a deficit budget to meet the situation created by
depression. Further, the government budget is passed by the
parliament. But the budget of an individual or firm is a private affair
without any controlling authority.
9. Nature of Borrowing – In the case of an individual, there can
no internal borrowing". An individual cannot borrow from himself. He
can borrow only from an external agency. The State, however, can
borrow both from internal as well as external sources. It borrows not
only from its own citizens, but also from foreigners.
10. Bankruptcy - A private individual can face the crises of being
bankrupt but no government can be bankrupt. An individual may ‘run-
riot’ his money and thus may become an insolvent, but the question of

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 the government being bankrupt is impracticable. It is funny to talk of
the bankruptcy of the government; since all the currencies are printed
and circulated by it.

1.3 Scope of Public Finance

Public finance deals with the income and expenditure pattern of the
Government. Hence the substances concerned with these activities become
its subject matter. The subject matter of the public finance is classified under
five broad categories. They are,

1. Public revenue
2. Public Expenditure
3. Public debt
4. Financial administration
5. Economic stabilization

1.3.1 Public Revenue

Public revenue is the means for public expenditure. Various sources of public
revenue are:

a. Tax revenue:

Taxes are compulsory payments to government without expectation of direct

return or benefit to tax payers. It imposes a personal obligation on the
taxpayer. Taxes received from the taxpayers, may not be incurred for their
benefit alone. Tax revenue is one of the most important sources of revenue.

b. Non-tax revenue:

This includes the revenue from government or public undertakings, revenue

from social services like education and hospitals, and revenue from loans or
debt service. To sum up, non-tax revenue consists of:
i) Interest receipts
ii) Dividends and profits
iii) Fiscal services and others.

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1.3.2 Public Expenditure:

The term “Public Expenditure” is used to designate the expenditure of

government-central, state and local bodies. It differs from private
expenditure in that governments need not to pay for themselves or yield a
pecuniary profit. Public expenditure plays the dual role of administration and
economic achievement of a nation. Wise spending is essential for stability of
government and proper earnings are a prerequisite for wise spending. Hence
planned expenditure and accurate foresight of earnings are the important
aspects of sound government finance.

Expenditure can be categorized into recurrent and capital expenditure.

Recurrent expenditure relates to those, which do not create any addition to
assets, and covers activities of government departments’ services,
subsidiaries and interest charges. Capital expenditure involves that
expenditure, which results in creation of assets. Finance ministry is
responsible for plan expenditure. This includes grants to the state.

1.3.3 Public debt

When public revenue falls short of public expenditure, the government

borrows from the public to meet the gap. This is public debt. Public debt
deals with methods and sources of public debt, its effects on production,
consumption, income distribution and economy, the burden of public debt
and the methods of debt redemption. it includes both internal debt and
external debt.

a. Internal debt:

Increasing need of government for funds cannot be fully met by taxation

alone in under developed and developing countries due to limited scope of
taxation. Government therefore has to resort to alternate sources. Rising of
debt is one such source. Debt, though involves withdrawal of resources by
curtailing private consumption, has certain advantages. Transfer of funds
from public to government is voluntary. Loans do not reduce the wealth of
the lenders. Debt raised for productive purpose will not be a burden on the
economy.

There are many objectives of creation of public debt. Debt may be raised to
meet the normal current expenditure, exigencies like war, finance productive
government enterprise, finance public social welfare and economic
development.

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 b. External Debt:

In under developed and developing countries, internal sources are limited.

Under developed and developing countries, therefore go for external debt.
The transfer of capital at international level may take the form of:

i) Financial aid through grants and loans

ii) Commodity aid
iii) Technical assistance

1.3.4 Financial Administration

This category includes the preparation of financial budget, the control and
administrations of the budget. The term budget includes ‘Annual Financial
Statements’ which incorporates all the annual statements of receipts and
expenditures of the government.

1.3.5 Economic Stabilization

This category analyses the use of public finance to bring the economic
stability in the country. It studies the use of financial policies of the
Government from the view of economic development. It includes
controlling of inflationary and deflationary situations, instability of the
price level, promotion of full employment, growth of economy, welfare of
the people, etc.

1.4 The Role of Government in the Economy

The invisible hand of the government in the economy is manifested when it

intervenes to correct identified flaws in the market mechanism.

Government displaces private business by owning and operating certain

enterprises (like the military); it regulates business (like telephone
companies); spends money on space exploration and scientific research;
imposes tax on citizens and redistributes the proceeds to the people; and
expedite the use of fiscal and monetary power to promote economic growth
and development and tame business cycle if necessary.

a) Resource Allocation Function

Resource allocation means the economic management of natural resource. If

there are certain limited resources that need to be divided among individuals
or projects, this is where resource allocation comes to play. It is usually one

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of project management. The allocation function is that part of government
tax and expenditure policy which is concerned with influencing the provision
of goods and services in the economy.

b) Regulatory function

This means creating conditions to promote competition among producers, as

well as the welfare of customers. Regulation is the form of intervention on
the part of the government when the market is likely to fail.

c) Government intervention on the market failure

Experience has shown that a competitive market economy can achieve most
of its objectives. However, the market is not able to achieve all its objectives.
Therefore, the government intervention in the process of production and
distribution is sometimes necessary to correct certain inadequacies of the
market system. This provides another market based justification for
government activity.

d) Externalities

One of the areas of market “failure” that government seeks to correct is

known as externalities, unintended consequence of actions or policies. There
are two types of externalities: Spill over cost and spill over benefits.

Spill-over costs occur when individuals involuntary bear economic costs

without compensation. They are sometimes called negative externalities.

Spill-over benefits occur when individuals receive economic benefit for

which they have not paid. They are sometimes called positive externalities.

e) Government as moral guardian

Most government action is justified either to maintain competition or to

correct market failure. Governments, however, has yet another role in the
economy. It preserves or guards the ethical values and beliefs of the society.

Functions of modern governments are broadening due to socio-political

reasons. Therefore, to discharge these increasing functions, the government
has to increase its expenditure. To meet out the enormous amount of

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expenditure it has to mobilize funds with the help of public finance policy.
Hence public finance has developed into an important branch of economics.

1.5 Fiscal Federalism

Decentralization is a broad term employed to signify distribution or allocation

of power compared to centralization. It is not only the phenomenon of
federal states but also unitary states. If power and functions are
decentralized to several tiers of governments, in federal arrangements or to
sub regions in unitary states (which do not qualify the principle of
federalism), there is a need for fiscal decentralization in order to carry out
their responsibilities.

Therefore, fiscal decentralization is a general concept that encompasses

decentralization of financial resources and power of spending in both unitary
and federal form of states. On the other hand, the fiscal decentralization of
federal states assigned by federal constitution is termed as „fiscal
federalism‟. Accordingly, fiscal federalism encompasses principles of fiscal
relations between federal and state governments, which are the command
over resources by various level of governments and the direction and size of
intergovernmental fiscal flows. This includes the division of tax power and
the means through which resources are adjusted to match expenditure
responsibilities for the federal and state governments.

The major issues of fiscal federalism are summarized as:

Allocation of expenditure responsibilities, which deals with the issue of

which item of power of spending should be carried by which level of
government;
Allocation of revenue raising power; which deals with the issue of
which types of taxes should be levied and non-tax revenues should be
assumed in which jurisdiction by which level of governments;
The fiscal imbalance between the tires of government and disparities
between them in executing their respective responsibilities; vertical
and horizontal imbalances; and
The intergovernmental financial transfer; which deals with the issue of
financial flows between the federal and the states and among the
states; vertical transfer and horizontal transfer in order to adjust the
imbalance and keep a viable federal system.

1.5.1. Fiscal Federalism: merits and demerits

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A) Merits of Fiscal Decentralization

The merit of fiscal decentralization is the extension of social, economic and

political advantages of federalism. Some of the peculiar advantages of fiscal
federalism will be dealt as follows:

i) Optimum utilization of resources and development growth: - the

federal constitution assigns the federal and the state governments to
determine their revenue sources and area of expenditures. And the fiscal
decentralization of the same permits the local state and federal
administrative agencies to collect revenues and spend them. In doing so, it
makes an effective and proper system to design and implement the methods
of financial operations. Therefore, it also enables to curb the peoples‟
developmental encumbers expeditiously in a manner that satisfy the
beneficiaries. This, in turn, results in the over whole development of the
country.

ii) Job opportunity to professionals and workers: - the decentralization

of fiscal power to different tiers of administration and the need to keep the
financial machineries consistence with the dynamics of the area through
time and technology quests numerous professionals and skillful workers. To
cope up with local needs, the diversities of peoples such as working
languages of the federal and the states where ethnic federalism is
implemented based on language demands of specific professionals. This
urges the governments to train professionals and workers and acquaint them
with the required skills accordingly. Ultimately, fiscal decentralization
generates large public employment because of the need to have more labor
in lower level administration than central financial administration and
because of the more limited ability to exploit economies of scale, and
thereby contributes its part to development.

iii) Decrease central bureaucracy and corruption: - the power division in

federalism enhances the local decisions in their financial matters in a
manner that satisfy the need of the locality and prevents decision making
from becoming overloaded in the central government. Thus, it avoids
inefficiency and bureaucracy and bureaucratic chaos.

The other benefit of decentralization of finance is the fact that it helps to

avoid financial mismanagement, corruption and lack of accountability.
Budget auditing and reporting at different level and inter different level are
some of the mechanisms to achieve these effects

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B) Demerit of Fiscal Federalism

There are inherent problems and demerits of fiscal decentralization which

resulted from the devolution of revenue raising and expenditures
responsibilities among different levels of governments and institutions. The
followings are some to be mentioned.

i) Imbalance and competition: - the very nature of federalism is

devolution of power and functions among different levels of governments.
Hence, the devolution mainly concerns financial power. The federating units
by no means exist identical in population size, natural resources,
development, etc. Thus, these natural diversities and the difficulty to frame
universally applicable decentralization formula creates financial gap among
the member of the federation. For instance, in highly decentralized
federations such as Nigeria, Indonesia, and Russia, problems often arise
because of the regions attempt to claim for their own exclusive use of
revenue from the natural resources found in their territory. This leads to
political unrest and creates problems for the income redistribution role of the
government. Attributed to the above reasons, there exists vertical imbalance
between the federal and states governments and horizontal imbalance
among different states in the federation. The science of fiscal federalism
intrinsically has the room called financial transfer through grant-in-aid and
revenue sharing to curb the imbalances but federalism yet cannot avoid
imbalances.

The other chronic disease of fiscal federalism is competition among states.

Because of devolution of power and function and autonomy to exercise
thereof, states are free to specialize in production of any public services and
goods. In most federation, states try to produce the same services and goods
which the other state is specialized without due consideration given to the
comparative advantages of producing in the state or importing from the
other states. Such phenomenon is conspicuously aggravated by ethnocentric
administration of the states in ethnic-based federalism. Competition results
in duplication of service and goods which is surplus to the whole country and
costs to the non-specialized states. Competition among the states in this
case ultimately results in the phenomenon known as “race to bottom”

ii) Mobility and Migration of workers and professionals: - the other

disadvantage of fiscal federalism is mobility and migration of professional
and skillful persons due to disparity of payment for the same professions in
different states and in between the federal or states governments. The richer

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governments tend to pay better salary and provide wage increment
according to the pace of their development whereas the poor strive to satisfy
public services than individual payment in their financial performance and
development strategies. Hence, disparity of salary payment for the same
professionals is inevitable and therefore it may result in migration and
accumulation of the same professionals and experts to a state or the federal
governments which pays better relative to other states. However, having the
required expertise or skill or profession does not suffice to work in one state
or in the federal government where the working languages of the federal and
each state is not the same like Ethiopia. Thus, language requirement in
addition to profession minimize the migration of the same professionals to
the region of better payment. Ethno-linguistic based federalism like Ethiopia
solves the problem to some extent.

iii) Spillover effects: - in expenditure and revenue assessment after budget

allocation of a fiscal year spillover effects may be shown. Spillover effect is
meant to indicate services which are provided by one federating units either
of the federal or a state or even a local administration in the region/state but
used by people of other regions which are not perceived as the target of the
budget. Township administrations which are surrounded by less developed
rural areas owing to center of service providing institution and faster rate of
urbanization are prone to these effects. More developed part of regions
adjacent to less developed part of other regions also face the same problem.
The spillover effects which are caused by the “flow” from one region to
another would be in one direction, while in other places it would be in
opposite directions and such phenomenon is termed as offsetting effects.

The State of Harari people and Dire Dawa Administration Council are the best
instances of spillover effects in Ethiopia. They are exceptional to this effect
for several reasons

1. They are wholly surrounded by other regions and therefore are particularly
exposed to this effect;

2. They are large centers, with a commensurately extensive range of public

services, relative to rural and smaller centers in the neighboring regions; and

3. For their small size in terms of population, the spillover effect can happen
relatively more than other regions.

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According to the FDRE New Federal Budget Formula, it is assumed that 15
per cent of the expenditures of the two regions on health and education are
with respect to non-residents.

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