Public Finance
Chapter one: Introduction to Public finance
1.1 Concept of Public Finance
Public finance is defined as a branch of economics focused on the "management and allocation of resources by the
government at various levels to achieve economic and social objectives.
It deal with:
Debt management
Expenditure Allocation
Revenue Generation
The key areas encompassed by public finance include:
Public Revenue Debt Management Fiscal Policy
Public Expenditure Taxation
Budgeting Public Goods
1.2. Sources of Government Revenue and Expenditure
1.2.1. Sources of Government Revenue:
Primary source of government revenue Other significant revenue sources
Income Tax: Levied on individuals and corporations Customs and Import Duties: Fees collected on
based on their income or profits. imported goods, serving to protect domestic
Sales Tax: Imposed on the sale of goods and services. industries and generate revenue.
Property Tax: Levied on the value of real estate and Excise Taxes: Levied on specific goods, often
property. considered harmful (e.g., alcohol, tobacco, gasoline).
Corporate Tax: Applied to the profits of businesses User Fees and Charges: Fees charged for specific
and corporations. government services (e.g., licenses, permits,
Value-Added Tax (VAT): A consumption tax added at passports).
each stage of production. Fines and Penalties: Revenue generated from
enforcing laws and regulations.
1.2.2. Sources of Government Expenditure:
Government expenditure covers a wide range of areas, including:
Social Services: Spending on education, healthcare, and social welfare programs.
Infrastructure: Investment in roads, bridges, airports, and public transit.
Defense and Security: Allocation of funds for national defense, military forces, and law enforcement.
Public Administration: Funding for the operation of government agencies and civil servant salaries.
Subsidies:
Foreign Aid:
Environmental Protection:
1.3. Government Expenditure: Operating and Development Expenditure
Operating Expenditure: This covers spending aimed at Development Expenditure: This focuses on long-term
maintaining day-to-day operations development and growth
Salaries and Wages Infrastructure Projects
Pensions Education and Healthcare Facilities
Interest Payments Research and Innovation
Maintenance and Repairs Social Welfare Programs
Administrative Costs Public Housing
Economic Development Initiatives
1.4. Types of Tax Structure
Tax systems can be structured in different ways:
Progressive Taxation: The tax rate increases as the taxable income or wealth increases.
It is based on the principle of diminishing marginal utility of income. Hence to equalize sacrifice on account of
taxation, the rich should be made to pay higher rate of tax than the poor.
Regressive Taxation: The tax rate decreases as the taxable income or wealth increases.
Proportional (Flat) Taxation: A constant tax rate is applied to all individuals or entities, regardless of income or
wealth.
1.5. Types of Government Budget
Government budgets reflect the relationship between revenue and expenditure:
Deficit Budget: Government expenditures exceed government revenue.
Surplus Budget: Government revenue exceeds government expenditures.
Balanced Budget: Government revenue equals government expenditures.
1.6. Types and Roles of Fiscal Policy
Fiscal policy is a crucial tool used by governments to influence the economy through the use of "government's revenue
collection and expenditure." It is employed to achieve economic stability, promote growth, and address economic
challenges.
There are two main types of fiscal policy:
Expansionary Fiscal Policy: involves increasing government Contractionary Fiscal Policy: involves decreasing government
spending and/or reducing taxes to boost economic activity spending and/or increasing taxes to cool down an
and stimulate demand, particularly during economic overheating economy and control inflation.
downturns.
Stimulate Aggregate Demand Control Inflation
Counter Cyclical Effect Counter Overheating
Reduce Unemployment Reduce Budget Deficits
Boost Consumer and Business Confidence
Chapter two: PUBLIC FINANCE vs PRIVATE FINANCE?
2.1 Concepts of Public finance
Public finance is a study of the financial aspects of government. The term has been variously defined. According to
Dalton, “public finance is one of those subjects which lie on the borderline between economics and politics”
Harold Groves: “A field of inquiry that treats of the income and outgo of governments”.
In modern times this includes four major divisions:
Public revenue Public debt
Public expenditure Certain problems of the fiscal system as a whole, such as fiscal administration & fiscal policy
The subject matter (scope) of public finance consists of the following parts:
Public income: the study of raising public revenues and the principles of taxation.
Public expenditure: study of the principles and the effects of public expenditure.
Public debt: studies the causes and the methods of public borrowing as well as public debt management.
Financial Administration: studies the use of fiscal policy to bring about economic stability in the country.
Economic Stability and Growth.
2.2 Public finance and private finance – A comparison
Similarities Dissimilarities
Both individuals and governments borrow as and Adjustment of Income and Expenditure: the
when current incomes are insufficient individual ordinarily knows the size of his income
Both private finance and public finance have broadly while the Gov’t does not know it.
the same objective, the satisfaction of human wants. Nature of Resources: The individual has only limited
Income is not fixed for private business, so also it is resources at his disposal, while Gov’t can draw upon
not fixed for a government the entire wealth of the community, by using force, if
necessary.
Motive of Expenditure: For an individual, spending
hinges on personal profit and benefit. In contrast,
Gov’t departments, excluding commercial ones,
aren't driven by profit or surplus.
Expenditure and Welfare: Every individual attempts
to maximize his satisfaction, while Gov’t attempts to
maximize the welfare of the community.
Provision made for the Future: An individual, focused
on short-trim needs due, saves little. While, the state,
a permanent entity responsible for present and
future generations, allocates significant resources for
long-term programs.
Secrecy and Publicity: Personal finances are typically
private. Conversely, governments widely publicize
their budget plans.
2.3 Role of Public Finance
2.3.1 Public Finance in Advanced Economies
In advanced economies, public finance, particularly through "Fiscal policy," is considered a critical tool for achieving
"stability in business conditions and – maintaining full employment."
2.3.2 Public Finance in Developing Economies
While facing challenges due to less developed institutions, fiscal policy is argued to have a "positive and significant
role to play in an underdeveloped economy." It is seen as a "most powerful and least undesirable weapon of
control" to promote economic development, primarily through "capital accumulation," which "can be done through
taxation." Fiscal policy is also essential for implementing financial plans within democratic planning frameworks.
Chapter three: SOURCES OF PUBLIC REVENUE – PROMINENT TAXES
3.1 Sources of Public Income
A government gets revenue from three different sources:
Taxes and other sources in which there is an element of compulsion.
Income for services rendered to the public.
Sources of income which are partly compulsory and partly voluntary
Income based on Compulsion Income by way of Voluntary Payment Sources of Income, Partly Compulsory and
Partly Voluntary (According to Dr. Dalton)
Taxes of various types(It is Income from public property. Income from public enterprises using
compulsory in the sense that once it Receipts from government monopoly power to raise their prices
is levied, the person concerned has enterprises (don’t have monopoly above the competitive level;
to pay it and cannot escape it) power or they don’t exercises) Betterment levy and other special
Fines or penalties imposed by courts Fees for services rendered by the assessment:
of justice resemble each other since government. Income from the use of the printing
there is compulsion in both. Receipts from voluntary public press or through the issue of new
Compulsory loans loans. paper money to cover the deficit in
Tributes and indemnities arising out public expenditure;
of war or from other reasons. Voluntary gifts
In the case of customs duties, the concepts of compulsion and penalty gradually merge with each other.
To raise revenue and, if a higher rate of customs duty is followed by increased revenue, the duty is a tax
If the purpose of raising the rate of a particular duty is to restrict imports, then a rise in the rate of a particular
duty should be followed by a reduction in imports and in revenue. In this case, the duty is of the nature of a
penalty for imports.
3.2 Features of Sound Taxation
According to Mrs. Hicks, emphasized three characteristics of a good tax system,
First, taxation should be used to finance public services.
Secondly, the general public should be taxed according to their ability to pay
Thirdly, taxes should be universal in the sense that persons in the same financial position should be treated in the
same way without any discrimination whatsoever.
In a broad sense, there are four general characteristics for a sound tax system:
Equity in the distribution of tax burden.
Productivity of the tax system.
Appreciation of the rights and problems of the taxpayers.
Adaptability of the tax structure to meet the changing needs of an economy.
3.2.1The Benefit Principle of Taxation
In the benefit principle of taxation ‘quid-pro-quo terms’, relationship between tax payer and the government is seen
as one of exchange in which tax is considered as a price to be paid for the benefit received.
Thus, the benefit principle of taxation follows that larger the benefit, larger should be the contribution of tax payer.
This fact, raises a controversial question as to whether tax should be proportional, progressive or regressive in
character.
The benefit theory of taxation may be interpreted in two ways,
The ‘cost of service principle’ and
The ‘value of service principle’.
According to the former, the contribution of tax payer should be equal to the cost of supplying public services that
benefit him.
The principle can be applied to certain areas of public services like Posts and telegraphs, Electricity, etc. Where the
payment is directly linked to benefits received.
But it cannot be applied to those services where the expenses of production are met from the tax revenues of
government. Such public services include those like police, public parks, etc. where the cost of rendering services to
the tax payers cannot be determined.
Merits of Benefit Principle Demerits of Benefit Principle
It is based on the assumption that the benefits conferred It is assumes that varied and complex activities of Gov’t can
(Transferred) by public services justify the imposition of and should be calculated and assessed against each person
taxes to pay for them. on the basis of the individual benefit derived, which is
It combines both the income and expenditure sides of the highly unrealistic
budget processes and thus determines simultaneously It was developed in early days where gov’t was said to
both the public service as well as tax shares. provide certain services and the individual was expected to
Benefit taxation is applicable to those cases where the pay for them. But now, the gov’t provides certain services
benefit received by the individuals can be measured. for the general welfare & not for individual welfare.
Benefit approach, if applied blindly, will lead to great
injustice rather than bring about justice in taxation.
It have only a limited application and for special or direct
services made available to individuals on a voluntary basis.
3.2.2 Ability Principle of Taxation
The ability approach is based on the broad assumption that those who have should pay and those who have not
need not.
Supporters of the ability approach have sought to justify it on three grounds:
First is the sacrifice interpretation of ability.
Secondly, the ability principle is justified through the principle of diminishing marginal utility of income.
Finally, ability principle is justified on the basis of faculty.
Faculty is the capacity of an individual to produce and consume and this is represented by the income and
the accumulated wealth of the individual.
Weaknesses of the ability approach:
Sacrifice is subjective and each writer would interpret it in his own way.
Marginal utility of income interpretation of ability has considerable merit but it is also on a subjective plane.
Besides, it ignores the use of income for saving and investment which are important both individually and socially
3.2.3: Index of Ability to Pay
At one time, property or accumulated wealth was considered as the best index of ability to pay.
It is now rightly held that property is unsatisfactory as a primary test of ability, because property as a source of
income is subject to a number of weaknesses:
Property is not the main source of income
Property may or may not yield an income in any particular year.
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.
Income as the basis is regarding as the best indicator of a person’s ability to pay.
For purposes of taxation, gross income is considered unsuitable, but net income is regarded as the best measure
of taxpaying ability because it reflects the sum of net receipts over costs.
Expenditure as the basis of index of ability to pay
Consumption has been suggested as an index of calculating taxpaying capacity on the assumption that such
expenditure measures the true utility or satisfaction derived from income.
It is true that income is earned to satisfy consumption but income is not utilized for investment is a very
important aspect of spending, both significant and urgent.
Thus, the main index of ability, it seems to be agreed generally, is income while supplementary indices can both be
property and expenditure.
3.3: Ability to Pay and Equality of Sacrifice
According to Mill, that the real burden of taxation should be equal for all and that “similar and similarly situated
persons ought to be treated equally”.
But there are three concepts of equal sacrifice-equal:
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.
If there are two tax-payers with different incomes, the one who has more will pay more tax and the one
who has less will pay less, but the sacrifice to both as a result of the tax should be equal.
Equal Proportional Sacrifice.
Equal proportional sacrifice implies that the loss of utility as the result of a tax should be proportional to the
total income of tax-payers.
Means those with a higher income will pay more but the ratio of sacrifice to the income will be the same
for all. For example: Sacrifice of Taxpayer A/ Income of A = Sacrifice of Taxpayer B/ income of B and etc.
Equal Marginal Sacrifice.
Equal marginal sacrifice implies that the marginal sacrifice for the different taxpayers should be the same.
Since marginal utility of a higher income will be very much low as compared to a low income, equal margined
sacrifice will imply that the person with a higher income will be expected to bear the heavier burden.
Chapter four: Direct and Indirect Taxes
4.1 Introduction
According to Mill, taxes were direct or indirect depending upon the fact whether they were actually paid by the
people on whom the burden fell or not.
In modern times, taxes are classified into direct and indirect on the basis of assessment (fixed percent), rather than
on the point of assessment (current situation on fixed percent).
A direct tax is tax demanded from the person who it is intended or desired should pay it.
Indirect taxes are those which are demanded from one person in the expectation and intention that he shall
indemnify himself at the expenses to another.
Therefore, those which are imposed on the receipt of income are called direct such as income tax, while those which
are imposed on expenditure are regarded as indirect such as Excise tax.
4.2 Direct and Indirect Taxes: A Comparison
Direct and indirect taxes may be compared from three different angles:
Allocation of resources:
Economists have maintained that the allocative effects of indirect taxes are inferior to those of direct taxes.
That is, if a certain amount of money is collected from the community by way of indirect taxes (say, an excise
duty) the burden will be greater than if the same amount were to be collected by way of a direct tax (say,
personal income-tax).
In other words, a direct tax has less harmful effects on the allocation of resources than an indirect tax.
Administrative Aspect:
From the administrative point of view, indirect taxes were considered superior to direct taxes. They are easy
to collect; they are convenient and are difficult to evade.
However, such a comparison between direct and indirect taxes does not hold well because of many factor:
a) The modem administrative machinery for tax assessment and tax collection has been revolutionized so
much that income taxes and other direct taxes can be levied even on the lowest income groups.
b) Those income groups which are exempted from the operation of direct taxes on the ground of equity and
justice are not exempted from payment of indirect taxes.
Distributional Aspect:
Distributional effects Direct and indirect taxes are compared based on their distributional effects, with direct
taxes being considered progressive and indirect taxes generally regressive.
Both types of taxes can achieve desired income redistribution, but the process of achieving it differs. Direct
taxes adjust through the factor market, while indirect taxes adjust through the commodity market.
We may conclude our comparison of direct and indirect taxes by pointing out that:
Direct taxes are superior to indirect taxes on allocative and distribution grounds.
Indirect taxes are superior to direct taxes on the ground of administrative cost and efficiency.
4.2.1 The Case of Direct Taxes
Merits of Direct Taxation Demerits of Direct Taxation
They are based on the principle of ability to pay. Direct taxes tend to be arbitrary because it is indeed
Direct taxes satisfy the canon of certainty. difficult to have an objectively just basis of ability.
They are elastic in the sense that with the increase in They are taxes on honesty and they tempt people to evade
income and wealth of the people. them by hiding their income and wealth partly or fully.
Direct taxes are inconvenient.
Direct taxes are often regarded as expensive to collect
The advantages of direct taxes are, therefore, equity, certainty, elasticity and civic consciousness.
4.2.2 The Case of Indirect Taxes
Merits of Indirect Taxation Demerits of Indirect Taxation
Indirect taxes are regarded as convenient, They are regarded as unjust and inequitable.
Indirect taxes are difficult to evade Indirect taxes are extremely uncertain.
Some of the Indirect taxes can be elastic, Indirect taxes do not create any social consciousness.
Indirect taxes enable everyone.
4.3 Superiority of Indirect Taxes over Direct Taxes
In spite of their demerits, indirect taxes are regarded as better from the point of allocation of resources:
Indirect taxes which are confined to goods with zero elasticity of demand low elasticity are regarded the best.
Indirect taxes are useful where external diseconomies exist on the production side or on the consumption side.
Indirect taxes have been found to be superior to direct taxes,
They are also suitable for purposes of income correction.
Due to the difficulty in levying direct taxes on low income groups, the poor can only be asked to pay for
government expenditure through commodity taxes.
Chapter five: Somaliland Taxation
Rental income tax is an annual tax payable by individuals on their rental income. (deduction only allowed for net
capital losses, if any, arising from the disposal of rental assets)
Corporate taxpayers are NOT required to pay rental income tax. Instead, they are required to include their rental
income along with their other income in their annual income tax returns.
Who is obliged to pay rental income tax?
o Any individual taxpayer or business other than corporate business, who derives income from the lease of
immovable properties in Somaliland in respect of each year before 30th of April of the following year.
Goods and services tax (GST) replaces sales tax and is payable on a limited range of supplies of goods and services. It
is payable only in respect of: Goods supplied by a manufacturer, imported goods, Taxable services, and so on.
Employment Income Tax: (Payroll Tax) are taxes imposed on employees, and are usually calculated as a percentage
of the total income that employers pay their staff which is 6%, paid in monthly basis.
Business Income Tax: The corporate income tax is an assessment levied by a government on the profits of a
company on a yearly basis. The rate of this tax is 12.3% (inclusive of the stamp and administration taxes).
Who are “non-residents” to which withholding taxes apply?
o Withholding taxes are only required to be deducted from certain payments to persons or organizations that are
defined as “non-residents” for tax purposes and who are not exempt from income tax.
Chapter six: PUBLIC EXPENDITURE
6.1 Introduction
Public expenditure refers to the expenses which the government incurs for its own maintenance as also for the
society and the economy as a whole. (in some cases some gov’t may incurring expenditure to help other countries)
Causes of Growth in Public Expenditure:
o Population: To check the growth of population, again, the government has to incur a huge expenditure.
o Increasing urbanization: As the rural areas cannot subsist the growing population, there is a continuous rush to the
urban areas.
o Provision of economic overheads: Without the creation and maintenance of economic overhead facilities, no
country can develop.
o Maintenance of law and order.
o Welfare activities: The government now has to assume such responsibilities as:
Family and child welfare,
Social security like old age pension, unemployment benefit, sickness benefit, etc.
Housing for the poor,
Welfare of handicapped
o Provision of public goods and utility services: Public goods are those that are consumed equally by all. They cannot
be sold in the private market.
o Servicing of public debt:
o International obligation: A considerable amount of public expenditure involve:
Socio-cultural and academic exchange relations,
Linkage with development programs of the type of economic cooperation,
Gifts and donations,
Regional economic integration and membership of other international organization like UNO (United Nations
Organization).
6.2 Public expenditure: Canons and Accountability
Canon of Benefit:
o Public authorities that whatever they spend they should do it according to the principle of maximum social
advantage.
o Benefit from public expenditure may be identified with achievement of proper allocation of economic resources,
proper distribution of income and wealth in society and stability of price level and growth of economy.
Canon of economy:
o Economical use means most proper utilization. Most important reasons of wasteful expenditure are:
faulty planning,
faulty execution,
corrupt practice and delay due to time lag
Canon of surplus:
o This canon requires that expenditure of public authorities should be kept within the limits of current revenues.
o If possible, the expenditure should be less than the earnings of government so that the surplus so generated can
be used when there is unavoidable deficit. Surplus can be generated either by controlling expenditure or by
increasing current revenues
Canon of sanction:
o This canon requires that the public authorities should not be allowed to spend funds without having a previous
sanction from appropriate authority for the purpose.
Canon of elasticity:
o This requires that the rules of public expenditure should not be too rigid to achieve the real purpose.
Canon of certainty:
o This canon requires that public authorities should clearly know the purpose and extent of public expenditure.
6.3 Effects of public expenditure on production, employment, distribution of income and controlling inflation
The expenditure of the Government on development is meant to promote production and employment in the
country. The level of production and the level of employment in any country depends upon three factors:
o Ability to Work, Save and Invest: If public expenditure can increase the efficiency of a person to work, it will
promote production and national income.
o Willingness to Work, Save and Invest:
The effects of public expenditure on the willingness-as different from ability to work and save and invest on
production are not clear enough, as public welfare provision reduce the willingness of persons to work & save
o Diversion of Economic Resources:
In a free capitalist society very little provision is made for the future, because people prefer the present rather
than the future.
On the other hand, Gov’t is the custodian of the interests of the future generations; therefore, has to see that
adequate provision is made for the future, and spent money on in the conservation of economic resources.
Public expenditure can be used by the government to achieve the distribution of income:
o While taxes, particularly progressive direct taxes, have the effect of reducing the incomes and wealth of the higher
income groups, public expenditure has the effect of raising the incomes of the lower income groups.
o Government's expenditure on: education, public health and medicine, housing, etc., is directed to help the poor
and the lower income classes.
In the majority of cases, the most serious type of inflation has always been due to enormous government
expenditure.
o However, the government can suitably change and adjust its expenditure during an inflationary period so that the
inflationary pressure may be reduced.
o Another way is the government can give subsidies to those industries which are producing inflation-sensitive
goods
6.4 Content of Development Expenditure
Development expenditure of the government should aim at stimulating and supplementing private initiative and
enterprise:
o Stimulating private initiative:
Direct stimulation is done by the Government helping the private sector through loans, subsidies, tax
concessions and exemptions and providing market and other information and research facilities.
o Provision of social and economic overheads:
Indirect stimulation through the provisions of social and economic overheads. Social and economic overheads
are necessary and essential prerequisites for economic growth.
o Public enterprises
The government will have to start and run such undertakings which the private sector may be unwilling to
undertake, either because profit margins are low or almost nothing, or because they require huge capital
investment and a long time to yield returns.
