67

UNIT THREE

PUBLIC EXPENDITURE

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 Meaning and Nature of Public
68
Expenditure
 Public expenditure is the expenditure incurred by
public authorities’ i.e central, state and local for the
satisfaction of collective needs of the citizens or for
promotion of economic and social welfare.
 Government plays a large role in the economy, as
regulator of the private sector, as supplier of public
service and many other ways. Hence, it incurs
expense.

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 Contd………………
69

 There are some unique features of public

expenditure
1. public expenditure determines the amount of income
where as private expenditure is determined by the
individual’s income
2. public expenditure is not for profit motive
3. the target for public expenditure is a maximum return
for the state as a whole,
4. public expenditure is influenced by various political
motive and social aspects
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 Scope of Public Expenditure in LDCs
70

 The scope of public expenditure in under developed

countries of mixed economies, like Ethiopia, can be
stated as follows.
 The public sector produces some important public goods,
which the private sector cannot produce
 The government may subsidize the private production of
certain partial social goods for increasing their output
 In underdeveloped countries, the public sector may have to
produce certain private goods which are considered
important from the point of economic development and
which the private sector is unable to afford
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 Contd………………
71

 lack of enterprise or technical knowhow or lack of

experience, these goods to have strategic control over
the economy.
 Public expenditure may be used as a balancing factor
or contra cyclical measure to attain full employment
and maintain stability.
 Public expenditure may used to bring about equitable
distribution of income between different sections of
the community

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 Classification of Public Expenditure
72

 Different economists have given their own style of

classification of public expenditure how ever they
are not mutually exclusive
 C.C. Plehn, Classify P. E. on the basis of benefits
 Public expenditure, which specially benefit certain
people,
 Public expenditure, which benefits equally to all.

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 Contd………………
73

 Adam Smith has classified public expenditure

according to the functions of the government as:
 Protective,
 commercial and

 Development expenditure

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 Contd………………
74

 Nicholson on the other hand categorizes on the

basis of revenue in that:
 public expenditure without direct return to revenue
(example poor relief on some cases),
 Expenditure without direct returns but with indirect
benefits to revenue (example education expenditure
with the assumption that educated people are better
tax payers),
 Expenditure with full return or even profit like that of
post office, gas service and generally public enterprises
etc

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 Contd……………….
75

 Other important classifications includes

 Productive: expenditures on social over heads
(construction of roads, schools, hospitals, telephone,
electric power, etc). education, training, health, better
living conditions etc, expenditure on research and
expenditure made to build efficient administration,
communication and other infrastructural facilities
indirectly add to the health and efficiency &
productivity of the economy.

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 Contd………………
76

 un productive: expenditure for waging wars, for

ceremonial purpose etc are termed as unproductive.
 Pigou’s classification of P.E.
 Transferable: is a payment without corresponding receipt
of goods and services by the state. For example, old age
pensions and unemployment benefits.
 non transferable expenditures: is that by which the state
pays directly for the use of goods and services. Such a
use of resources by the state may be for consumption or
for investment purposes. These include expenditure on
defense, education, etc

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 Contd……………….
77

 The difference is that in the case of transferable

expenditure the beneficiaries have the right to decide
about the use of real resources, but in the case of non
transferable, it is the state which uses directly
 Generally; this way or that way the reason for
public expenditure is to maximize the social
welfare and to enhance fast economic growth

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 Public expenditure: Canons, Theories
78
and Accountability
 Canons of public expenditure
 Some of these canons may be regarded as
principles, while others are no more than general
guidelines for the public authorities to help them in
their task of planning and execution of public
expenditure properly.
 The following will be the canons of public
expenditure:

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 Contd………………
79

 Canon of Benefit. Public expenditure should be so

planned and implemented as to bring about the
greatest possible benefit to society. Thus, all non-
essential expenditures should be cut to the minimum.
 Canon of economy. Public expenditure should be
incurred carefully so that there is no wastage of
funds. Since resources are limited in the society, they
have to be most properly utilized.

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 Contd………………
80

 Canon of surplus. This canon requires that

expenditure of public authorities should be kept
within the limits of current revenues. 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.
 Canon of sanction. 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.

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 Contd………………
81

 Canon of elasticity. Canon of elasticity requires

that the rules of public expenditure should not be
too rigid to achieve the real purpose and that it
should be allowed to vary according to the needs
and circumstances.
 Canon of certainty. This canon requires that public
authorities should clearly know the purpose and
extent of public expenditure. The spending unit
should be certain as to the amount and objective of
public expenditure.

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 Theories of Public Expenditure
82

 Economists have offered a number of theories on

public expenditure. The following theories of public
expenditure need special attention.
 1. Classical theory of Minimum expenditure.
 2. Principle of Maximum Social Advantage.

 3. Principle of Maximum Aggregate Benefit.

 4. Bowen's Benefit Theory of Public Expenditure.

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 1. Classical Theory of Minimum
83
Expenditure
 Classical economists did not favor large public
expenditure.
 The 'laissez-faire' philosophy of Adam Smith implies
that individual is the best judge of himself and that
he will be the best productive agent if he is left free
to take his own decisions.
 They advocated the principle of sound finance,
according to which budget should always be
balanced, i.e. public expenditure should not rise
above or fall below revenue earnings.

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 Contd………………
84

 The classical theory of minimum expenditure is

based on the assumption of full employment on the
one hand and laissez-faire doctrine on the other.
 Since the economy operates at full employment
level, it functions with maximum efficiency.
 Moreover, with the philosophy of ‘laissez-faire’
follows, that most of the economic activities are
performed by the private sector.
 hence, the size of public expenditure is always small
and the budget should always be balanced.
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 2. Principle of Maximum Social
85
Advantage
 Public expenditure is made from the resources
mobilized through taxation or borrowing to balance
any further increase in the advantage to the community
 The principle of maximum social advantage lays down
on that public expenditure should be so planned and,
 hence, revenue resources so raised so as to bring about
benefit larger than sacrifice and that the surplus of
aggregate satisfaction in the society is maximum.

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 Contd………………
86

 To judge whether the principle of maximum social

advantage is secured or not, the following points
have to be considered.
 The character and composition of public expenditure is
the most important consideration.
 Large expenditure on investment means large
sacrifice of tax payers. However, the ultimate
benefit may be much larger than the communities’
sacrifice.

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 Contd………………
87

 Secondly, the method of taxation has to be judicious.

 The method should be employed which will result in
least sacrifice.
 Thirdly, tax-expenditure programme should be so
structured to increase the productive capacity of the
community and, hence, enhanced national income.

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 Contd………………
88

 The principle of maximum social advantage is

derived from the principle of equi-marginal returns
as applied to an individual.
 Thus, if it is found that marginal utility from public
expenditure on medical and public health measures
is greater than the marginal utility derived from the
same amount spent on provision of public parks,
then the government should transfer the public funds
from the park to medical account.
 This will maximize social advantage.

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 3. Principle of Maximum Aggregate
89
Benefit
 “expenditure should be pushed in all directions up
to the point, at which satisfactions obtained from the
last money expended is equal to the satisfaction lost
in respect of the last money called upon government
service.”
 Thus, Pigou brings in both taxation and expenditure
sides of the budget determination. His theory
determines the size of the budget.

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 Contd………………
90

 Pigou's theory requires the application of two rules,

viz.,
 (a) the principle of equi-marginal returns in such a
way that marginal utility from each type of
expenditure is equal and
 (b) the principle of equality between marginal
social sacrifice and marginal social benefit.

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 4. Bowen's Model of Public Expenditure
91

 Since social goods, by definition, are those goods

and services which are consumed equally by all.
 Hence, the cost of supplying them have to be
contributed by all beneficiaries.
 However, every user cannot be asked to contribute
equal amount in meeting the cost of social goods
because different individuals will derive different
amounts of satisfaction.

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 Conted……………..
92

 Since social goods benefit everyone, the amounts of

benefit derived by different individuals are like
joint products.
 Hence, it is the joint contribution of all individuals
that has to meet the cost of supplying social goods.
 Suppose a public park is provided in a locality of
100 individuals.
 The benefit of public Park is consumed equally by
everyone.
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 Contd………………..
93

 Hence, the cost of supplying must be raised from the

aggregate contribution of 100 individuals.
 It must, however, be noted that each individual will pay
an amount equal to the marginal valuation he attaches
to the social good, i.e. the public park services.
 This follows from rules of economic efficiency.
 Since the capacity to enjoy benefit of the public park,
as in case of anything else, is different for different
persons, they will attach different marginal valuation to
the benefit and will contribute different amounts for the
consumption of the same public good.
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 Contd………………
94

 How much amount of social goods is to be supplied by

the public authority will be determined at that level
where marginal cost of supplying the social goods
becomes equal to the sum of marginal utilities received
by the beneficiaries.
 Assuming that there are only two individuals in society,
viz., A and B and only one type of public goods, called
X, the following condition will hold for the determination
of public expenditure or, what it means the same thing,
the amount of social goods to be supplied by the
government.

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 Contd………………
95

 MUA + MUB= MCx, Or

 Px-A + Px-B = MCx, Hence, TCx = QPx-A + QPx-B,
 where MU stands for marginal utility derived from
social goods, MC stands for marginal cost of
supplying social goods, A and B are consumers, X
stands for the social good supplied, P stands for
price to be paid by the consumer, Q indicates
quantity of social goods and TC stands for total cost
of supplying the quantity.

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 Contd………………
96

 where MU stands for marginal utility derived from

social goods, MC stands for marginal cost of
supplying social goods, A and B are consumers, X
stands for the social good supplied, P stands for
price to be paid by the consumer, Q indicates
quantity of social goods and TC stands for total cost
of supplying the quantity.

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 Control and Accountability of Public
97
Expenditure
 The necessity to control public expenditure in order to
check misuse of public funds and ensure their efficient
utilization is obvious.
 Control of public expenditure is sought to be ensured
multi-dimensionally at a number of stages. The most
important means of control are
 (a) budgetary control
 (b) legislative control
 (c) executive control
 (d) audit control, and
 (e) parliamentary control.

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 Contd………………
98

 Budgetary Control. Budget preparation is the most

primary stage of expenditure control. Budget is a
well thought-out plan of governmental activities
during the coming year and speaks of much more
than a mere statement of income and expenditure
of public authorities.
 It specifies the functions and objects of public
expenditure.

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 Contd………………
99

 Legislative Control. After the budget plan is

prepared, it has to be presented in the legislature
for its approval. There occurs debate in the
legislature where the members seek clarification
and justification of expenditure programmes.
 During the legislative scrutiny of the budget, the
details of expenditure, department-wise and
ministry-wise are discussed. Thus, it is a very
important stage of expenditure control.

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 Contd………………
100

 Administrative Control. The rules and regulations ensure

that no amount is spent without proper sanction or
diverted to some other purpose for which it is not
sanctioned.
 Audit Control. The next stage is scrutiny of accounts and
audit control. There is the system of both internal and
external audit. Every department has its accounts
section which scrutinizes all accounts of expenditure and
ensures that public funds are spent according to rules of
propriety, economy and efficient utilization.

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 Contd………………
101

 Parliamentary Control. The last of these stages of

expenditure control is the parliamentary right to
enquire into any particular item of expenditure deal.
 There are two committees constituted by the parliament
to go into such scrutiny.
 They are
 (i) Public Accounts Committee is entrusted with the
responsibility of examining audit reports and
appropriation accounts. They also examine profit and
loss accounts of government undertakings and
autonomous bodies.
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 Contd………………
102

 They follow up cases of impropriety, unauthorized and

illegal expenditure, misuse and misappropriation and
go into further investigation if necessary.
 (ii) the Estimates Committee. locks into the financial
operation of the executive and suggests measures to
achieve maximum economy of expenditure consistent
with maximum efficiency.
 The parliamentary committees pinpoint the erring
officials, examine them and suggest follow-up measures
for suitable punishment to them.
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 Effects of public expenditure on
103
production and distribution
 Effects on Production and Employment
 Expenditure on agriculture and allied services, industries
and minerals, water and power development, transport
and communication and other expenditures on
community and social development by the State
Governments help directly to raise the level of
production and employment in the country.
 the enormous expansion in expenditure by the State
Governments is to boost demand for goods and
services and thus to boost production.
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 Contd……………...
104

 The level of production and the level of employment

in any country depends upon three factors, viz.,
 Abilityof the people to work, save and invest,
 Willingness to work, save and invest, and

 Diversion of economic resources as between different

uses and localities.
 It is possible to influence all these factors through
public expenditure either for the better or for the
worse.

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 Effect of public expenditure on
105
distribution of income
 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.
 Government's expenditure on education, public
health and medicine, housing, etc., is directed to
help the poor and the lower income classes

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 Public expenditure and control of
106
inflation
 Inflationary pressures may be considerably
lessened if government expenditure is reduced.
 This may be taken as a simple and direct solution,
but for the fact that, in the majority of cases, the
most serious type of inflation has always been due
to enormous government expenditure.
 However, the government can suitably change and
adjust its expenditure during an inflationary period
so that the inflationary pressure may be reduced.

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 Content of Development Expenditure
107

 Stimulating private initiative Development

expenditure of the government will take the form of
stimulating private initiatives and enterprises.
 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.

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 Contd……………….
108

 Provision of social and economic overheads. Indirect

stimulation of the private sector may be done by
the government through the provisions of social and
economic overheads -education and public health
will come under the first head, and provision of
power, transportation, communication, etc., will come
under the second head.

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 Contd………………
109

 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.
 all the key and basic industries, development of
irrigation resour-ces, electric power, etc. are some
of them.

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 Questions
110

1, what is the importance of public expenditure?

2, what is canons of public expenditure?
3, how does public expenditure affect the economy?
4, what are the causes for increasing public
expenditure?
5, how the government can control inflation by using
public expenditure?

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 111

UNIT FOUR
PUBLIC REVENUE
 INTRODUCTION
112

 The necessity of public revenue is due to the

necessity of public expenditure.
 As the government has to perform certain functions
for the welfare of the public and these functions
are not performed free of cost, they involve
expenditure.
 the state provides social goods and services such
as defense, health services, education, streetlight,
highways and other infrastructures.
 To finance them it needs income.
 Contd…………….
113

 Thus the amount of public revenue to be raised is a

function of necessity of public expenditure.
 The government can collect revenue from different
sources .
 The income of government through all these sources
is called public revenue.
 Of these various sources of government revenue
taxation is the most important one.
 Meaning and Source of Public Revenue
114

 In its wider sense, P.R. incorporates all receipts and

incomes that a public authority may get during any
period of time irrespective of their sources and
nature and is called public receipt.
 Generally government sources of revenue are
generally divided as tax revenue and non-tax
revenue
 Tax revenue - In every country, the largest part of
the public revenue is raised through taxation and
mainly it incorporates the following three sections.
 Contd…………….
115

 Taxes on income and expenditure- it deals with taxes

that are imposed on receipts and expenditures such as
corporation tax, income tax, expenditure tax, interest
tax and other similar taxes.
 Taxes on property and capital transaction- this part
includes taxes imposed on specific form of wealth and
its transfer.
Example, estate duty, wealth tax, gift tax, house tax, etc
 A tax on commodities and services -it is concerned on
taxes levied on production, sale, purchase, transport,
storage and consumption of goods and services.
 Contd…………………
116

 Non-tax revenue: Public revenues received through

administration, commercial enterprise, gifts and grants
are non- tax revenue of the government.
 Administrative revenue- under administration public
authorities can get income in the form of
◼ fees,
◼ fines and penalties, and
◼ special assessments.
 Profits of state enterprise- these are important sources
of revenue these days, owing to the expansion to the
public sector. These revenues are received in the form
of prices paid for the government produced goods and
services.
 Contd………………
117

 Grants and Gifts- they cover very small part of

public revenue. Usually patriotic people or
institutions may provide gifts to the state.
 They are voluntary contributions that are beneficial
particularly during wartime and emergency.
 Local governments obtain grants from state government
and state government from the center. It is said to be
grants - in - aid.
 When one country’s government makes grants to
another country's government, it is referred to as foreign
aid.
 Contd…………….
118

 Borrowings- It has many forms. But the most important

are fresh borrowings that can be categorized
according to their origin and maturity.
 Interims of their origin: public borrowing may be
◼ external or internal.
 Interims of their maturity: public borrowing may be
◼ long term, medium term and short term
 Note. Income and profit from the creation of currency
by government that is greater than its face value of
currency over its cost of creation are also incorporated
into the category of non-tax revenue.
 Tax Revenue
119

 Fund raised through the various taxes is referred to

as tax revenue.
 Taxes may be imposed on person's income or
wealth, they may be direct or indirect and they may
be different rates and nature.
 The main characteristics of a tax are
120
as follows
 A tax is compulsory payment to be paid by the
citizens who are supposed to be liable to pay it.
Therefore, anyone who wants to refuse to pay a
tax will be punished.
 There is no direct quid pro quo between the
taxpayer and public authority. This means a
taxpayer may not receive a benefit
proportional to the tax that he has paid. (Quid
pro quo means something given or taken as
equivalent to another.)
 Contd………………
121

 A tax is imposed to meet public spending incurred by

the government in the general interest of the nation.
It is a payment for the indirect service to be
provided by the government to community as a
whole.
 A tax is not a price paid by the taxpayer for any
definite service rendered or a commodity offered
by the government.
 A tax is payable regularly and periodically as determined
by the tax authority. For instance, income taxes are
usually paid annually.
 The Base of a Tax
122

 The tax collecting authority has legally described

the object on which the tax is imposed.
 The base of each tax has to be defined legally and
quantified for the purpose of determining the tax
liability for an individual taxpayer.
 Each taxpayer is considered as a legal entity for
this purpose. According to the different tax base, an
individual taxpayer may be subjected to more than
one tax.
 Buoyancy of a Tax
123

 The growth of tax base increases the tax revenue.

 This rise in tax revenue is termed as buoyancy of
tax.
 A buoyant tax has an inherent tendency to yield
more tax revenue with the growth of its base.
 Objectives of taxation
124

 Objectives of a tax system in an economy are

mainly connected with
 The overall economic and non- economic policies of the
government
 The non-tax components of its fiscal policy
 Institutional and other situations faced by the economy.

 Objectives of a tax system differ significantly in

between
 Developed countries
 Underdeveloped countries
 Contd……………….
125

 The main problem affecting the developed

countries is instability of income and
employment. Therefore, they design their tax
system to solve this problem.
 Unlike advanced nations the primary objective

of taxation in underdeveloped countries is not

related to instability of
◼ Income and
◼ Employment
 Contd……………….
126

 Rather these countries, like Ethiopia, have been

affected by several problems that are related
with
◼ Economic growth
◼ Poverty
◼ Inequality
◼ Health
◼ Chronic unemployment
◼ Regional disparities etc.
 Canons of Taxation
127

 By cannon of taxation we mean those characteristics,

which a good tax should, posses. The canons of
taxation are concerned with the rate, amount and
method of levy and collection of a tax.
 The first set of principles developed by Adam smith is
referred to as canons of taxation. These are:
 Canon of equality
 Canon of certainty
 Canon of convenience
 Canon of economy
 Let us discuss each of these as follow.
 Contd……………….
128

 Canon of Equality: It explains that taxation must be

distributed equally in relation to the ability of the
taxpayer.
 It requires that the rich should pay more taxes and the
poor should bear a lesser burden.
 However, if we interpret this principle with regard to
disutility which taxpayers sacrifice by paying taxes, the
tax should impose equal marginal disutility up on every
taxpayer.
 This situation results in two possibilities of imposing a
tax.
 Contd……………….
129

 On the one hand, if the marginal utility of income is

constant, the rich as well as the poor people should
pay a given percentage of their income in the form
of tax.
 On the other hand, if we agree that the marginal
utility of income decreases, equality can be
approved when the rich pay larger proportion of
his income as taxes and the poor pay smaller
proportion of his income in the form of taxes (i.e.
tax should be progressive).
 Contd……………….
130

 However, it is obvious that the marginal utility of

income goes on diminishing with the increase in its
stock and hence the rich person feels less disutility
or sacrifice in paying taxes than the poor person
paying at the same rate.
 Therefore, if the canon of equity to be properly
observed ,the progressive taxes must be
advocated.
 Contd…………………
131

 Canon of certainty- it indicates that taxation has to

include the element of certainty to prevent the
taxpayer from unnecessary harassment by tax-officials.
Adam smith said that the tax that is paid by each
individual should be certain and not arbitrary. This
means
 the time of payment
 the manner of payment and the person to whom the tax is
to be paid
 the amount to be paid should be clear to the contributor
and every person
 Contd………………
132

 Canon of Convenience- According to this canon

tax should be collected in away that are convenient
for the taxpayer as far as possible.
 For instance, it is convenient to collect a tax from
salaried employees at the time of paying salaries.
 Canon of Economy: It is clear that government has
incurred costs to collect taxes.
 Consequently, this principle suggests that the cost of
collecting taxes should be as minimum as possible.
 Contd………………..
133

 However, in view of developments in economic

philosophy, economists have added a few more
canons. These are
 Canon of elasticity
 Canon of productivity

 Canon of Simplicity

 Canon of diversity

 We shall briefly discuss them as follows

 Contd…………………
134

 Canon of elasticity- it states that taxation should

be elastic in nature for the purpose of collecting
more tax when income of the people increases.
 This means, it should be possible for the authorities
to revise the tax structure both with respect to
coverage and rates to fit it the changing
requirement of the economy and the Treasury
 Contd………………
135

 Canon of productivity- it indicates that the tax

system should be able to generate enough revenue
for the treasury.
 And the government should have no need to resort
to deficit financing and taxes should be levied that
they do not obstruct and discourage production.
 Contd……………….
136

 Canon of simplicity- it suggests that the tax system

should not be too complex and beyond the
understanding of the layman.
 Rather, it should be as simple as possible. So that
the tax payer should not be confronted with
accounting, administrative and other difficulties
 Contd……………….
137

 Canon of diversity- it implies that taxes should be

imposed on diverse sources because having a single
tax system may be risky and inequitable.
 However, too much multiplicity of taxes should be
avoided because it leads to unnecessary cost of
collection and violates the canon of economy.
 Features of a Good Tax System
138

 A good tax system does not mean a perfect tax

system that contains all the taxes, which fulfill:
 Allthe canons of taxation
 Fetching adequate revenue for the public service.

 Causing no hurt to the taxpayer.

 Contd………………..
139

 Rather, a good tax system is one which

 has predominately good taxes
 fulfils most of the canons of taxation

 yield sufficient revenue

 causes minimum aggregate sacrifice to the people

 Least obstructs the incentives for production.

 Contd………………..
140

 Thus for such a good tax system to exist, the

following principles must be observed:
 It should ensure maximum social advantage –the effect
that the tax produce must be considered i.e the effect
on production and distribution of wealth in a society.
 It ought to cause minimum aggregate sacrifice, i.e., the
tax burden should be imposed according to the ability
to pay the tax.
 It should satisfy most of the canons of taxation
 Contd………………
141

A good tax system should have built in flexibility, so

that changes are possible according to the changing
condition of the dynamic economy.
 It ought to be a balanced one. This means it should not
contain just, progressive, regressive or proportional tax
only but a combination of all taxes. Because all type of
taxes has its own merits and demerits
 Contd………………..
142

 The good tax system should be multiple, but greater

multiplicity is not necessary.
 In addition, in a good tax system there should be
simplicity,
 Furthermore, a good tax system should not hamper the
development of trade and industry otherwise it ought
to buttress the economic development of the country.
 Theories of Taxation
143

 Economists focus on the issue of tax burden and

justice for equity in its distribution.
 Accordingly tax burden can be classified as
1. Money burden of taxation: is the amount of money
income transferred from the people to the
government by way of various taxes.
2. Real burden of taxation: refers to the volume of goods
and services transferred from the payers to the
government or the value of money raised by the
government.
 Contd………………
144

 Equity on taxation refers to fairness or justice in the

distribution of tax burden.
 There are two classes of equity
1. Horizontal equity: implies that people in equal
economic circumstance should pay equal amount of
taxes.
2. Vertical equity: people who are in different economic
situation should be treated differently
The rich people should pay more taxes than others.
 Theories of equitable distribution of
145
tax burden
1. The Socio- Political Theory
 Every economic problem should be looked at its
social and political context
 The main objective of taxation is the realizing socio-
economic stabilization through reducing
 income inequality
 unemployment

 cyclical fluctuation
 Contd………………
146

 Therefore, this principle emphasizes on that

 thepoor, religious, educational, and Charity
organization should be free from tax
 because imposing tax on them may lead to social
instability
 Contd……………….
147

2. Cost of Service Theory (supply side)

 The cost incurred by the government in providing
public goods and services would be regarded as
the basis of taxation.
 Thus, citizens should pay a tax as per the cost of
public goods enjoyed.
 In other words, government is just like a producer of
social goods and services, and taxes are the price
for those goods
 Contd………………….
148

 Weakness
 Estimating the cost of social goods and services offered
to each individual is difficult
 It violates the property of tax. Tax is not price.

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

the base of taxation, government cannot provide free
education and medical care to the poor.
 Contd……………….
149

3. Benefit- Received Theory (demand side)

 The burden of taxes should be divided among
taxpayers in relation to the benefits enjoyed from
the government.
 This means those who get more benefit from public
goods should pay more taxes than others
 Contd……………….
150

 Weakness
 Measuring benefits received by an individual from
public goods is difficult. Benefit is ultimately subjective
 It results in injustice. This principle recommends imposing
more tax on the poor because they get more benefit
from social goods and services.
 It does not address the main objective of taxation, i.e.
reducing income disparity.
 Contd………………..
151

4. The ability to pay principle Theory

 The burden of taxation should be distributed
among members of the society according to the
principle of justice and equity.
 This means that the tax should be imposed on the
taxpayer based on their relative ability to pay.
 There are two indices for measuring ability to pay.
 Contd…………………
152

 A. Objective Index of Measuring Ability to pay- it

considers the money value of the taxable capacity
of each taxpayer rather than their psychology of
sacrifice and feelings
 The indices used to measure the ability to pay are
 Property (houses, farms, factories, equipments etc)
 Consumption expenditure

 Income etc.
 Contd………………..
153

B. Subjective Index of Measuring Ability to pay:

 Taxpayers suffers a sacrifice by paying the tax.

 It supposes that taxation does not make the

taxpayer feel better by the idea that he is
contributing to the welfare of the society.
 Tax liability of the taxpayer s should be related to
equal sacrifice principle
 Contd……………….
154

 There are three alternative ways of interpreting

equal sacrifice
i. Equal absolute sacrifice- tax imposed on a higher
income individual should cause him to lose an
amount of satisfaction (utility) equal to that
scarified by a lower income tax payer. In other
words, higher income people should pay more tax
then the other.
 Contd………………...
155

i. Equal proportional sacrifice- the loss of utility

(satisfaction) in tax payment should be
proportional to the total income of each taxpayer.
ii. Equal marginal sacrifice or least aggregate sacrifice
- the marginal utility of income sacrificed by all
taxpayers should be the same
 Contd………………..
156

 The marginal utility of income for a higher income

people is low and the marginal utility of income for
lower income people is high.
 Therefore, the rich should pay more tax than the
poor.
 Out of these three versions, equal marginal sacrifice
is considered as the best and generally accepted
principle of taxation by modern economists.
 Taxable Capacities
157

 Economists have defined taxable capacity as the

ability of the people to pay tax without adversely
affecting or worsening their standard of living and
efficiency
 i.e it is the maximum capacity of the community to bear
tax without much hardship.
 Taxation beyond the taxable capacity is over-
taxation. It results in economic as well as political
instability.
 Taxable capacity can be seen in two ways
 Contd………………..
158

1. Absolute taxable capacity- the amount of money or

the proportion of income that can be taken away
by the government from people in the form of
taxes without producing unfavorable effects.
 It represents the maximum amount of tax that can
be collected from the individuals of a particular
country.
 Contd………………..
159

 In the long period, it is bound to change through

growth in savings, investment, economic growth,
changes in the production pattern etc.
 Therefore, the determination of absolute taxable
capacity is almost impossible.
 Contd……………….
160

2. Relative taxable capacity- In the relative sense, the

reference is to the proportion in which two or more
nations or group of persons or states in a country
contribute towards the common expenditure through
taxation.
 It is possible to determine in advance the proportion
in which two or more communities should contribute
in order to meet some common expenditure in
accordance with their respective abilities to pay.
 Contd………………
161

 The richer community shall be called up on to bear

a greater share of such common expenditure
 The concept of the relative taxable capacity is
more useful in a federal economy like Ethiopia,
where different states are required to contribute
towards a common expenditure.
 In other words the relative taxable capacity is the
capacity of the community to contribute to some
expenditure in relation to the capacities of other
communities.
 Factors Determining Taxable
162
Capacity
 The size of National Income
 The distribution of income
 Size and rate of population growth
 Pattern of Taxation
 The Stability of income
 Nature of public expenditure
 Psychology of the taxpayers
 Standard of living of the people
 Administrative efficiency
 Economic Situations
 Political conditions
 Classification of Taxation and Types
163
of Taxes

 Reading Assignment!
 Questions
164

1, What are the major source o f revenue of the

government?
2, What are the qualities of good tax system?
3, Explain the canons of taxation.
4, what are the main principles of taxation?
5, distinguish between direct and indirect taxation.
6, explain the concept of equity in taxation.
 165

UNIT FIVE
PUBLIC DEBT
 INTRODUCTION
166

 To finance its expenditure, government collects its

income from
 tax and
 non-tax revenues

 When government revenue is greater than its

expenditure, there is budget surplus
 If government revenue is equal to its expenditure,
there is budget balance.
 When public expenditure exceeds its revenue there
is budget deficit
 Contd……………..
167

 This budget deficit leads to the problem of public

debt
 In modern times, borrowing by the government has
become a normal method
 However the composition of loan is significantly
different in developed and underdeveloped
countries
 Publicborrowings of the less developed countries
generally comprises in a very large part of the
borrowings made from abroad while
 Contd……………..
168

 in a developed country these may mainly consist of the

borrowings raised internally from the local authorities,
institutions and individuals.
 However both internal debts as well as external
debt are the essential and important constituents of
public debt.
 Sources of Public Borrowings
169

 There are two important sources of public

borrowings,
 internaland
 external sources.

 Necessity of Public Borrowing

 To Finance War
 To Fight Depression
 To Meet Unexpected Emergency
 To check Inflation
 To Finance Economic Development
 Classification of public Debt
170

 Generally public debt is categorized based on the

 Source of borrowing
 Purpose of loan

 Time duration of loan

 Nature of contribution of loan

1. Source of Borrowing
A. Internal borrowing: may be voluntary or compulsory
where as external debt is voluntary in nature
Can be estimated before hand with certainty
 Contd………………..
171

 the availability of total resources is not increased.

2. external debt: is voluntary in nature.
 The realization of external borrowing is so much
conditioned by the international politics' and foreign
policies of the lending government
 the foreign exchange resources of the borrowing nation
increases; but this foreign exchange reserve is
diminished to that extent when there is repayment of
such loan.
 external borrowing results in a transfer of wealth from
the borrower to the lender nation that led to a
decrease in the total output of the borrower country.
 Contd………………..
172

2. Purpose of Borrowing:
 Productive debts- debts that are invested on productive
assets like railways, irrigation, dams, roads,
multipurpose projects etc
 Unproductive debts- those debts that don’t add to the
productive asset of the economy. Those are debts used
to
 financing war
 public administration
 relief expenditure etc are examples of unproductive debts.
 Unproductive debts are not self- liquidating. Therefore
they impose a burden on the community.
 Contd………………..
173

3. Time/ Duration of loan

 short-term: which mature within a short period of
time say from 3 months to 1 year.
 medium –term: debts which mature in between one
and ten years.
 long- term debts: debts which mature after a long
period of time usually ten years or more.
 Contd……………….
174

4. Nature of Contribution
 Funded debt – is that public debt for the repayment of
which the government establishes a separate fund.
these debts are usually long-term debt used for
productive purpose.
 Used for the construction of permanent asset

 Unfunded debt –is that debt for the repayment of which

the government sets up no separate fund. These are
usually short-term debts used for meeting current needs.
 They are repaid from other source of income

 They have no specification of time

 Effects of Public Debt
175

 Effects of public debt on

 economic growth
 inflation
 political freedom

 distribution of income
 Burden of public Debt and Debt trap
176

 Debt burden The amount of money that a

borrowing country repays in the form of principal
and interest to the creditor.
 According to its source, there may be
 External debt burden: The sum of money that a
borrowing country repays in the form of principal and
interest to the creditor measures direct money burden
of external debt where as the direct real burden is
measured by the loss of economic welfare in terms of
consumption of goods and services foregone for the
repayment .
 Contd………………..
177

 The extent of the burden depends on the purpose

for which the debt is incurred. External debt rose
for war expenditure or other unproductive activities
will increase the real burden to the society
 External debt incurred for development purpose will
not be a burden but a profitable undertaking
 However, it is recommended that there should be a
limit for external public debt, so that repayment does
not impose heavy burden on the borrowing
community.
 Contd……………….
178

 Generally the incidence of external public debt can

be discussed on the following headings
 Direct Money Burden: the debtor country has to
pay to the creditor country every year large sums
of money by way of payment of interest on loan
and the principal amount up on maturity in terms of
foreign exchange.
 In order to earn this foreign exchange, the country
has to make exports
 Contd…………………
179

 Indirect money burden: Sometimes, the debtor

country has to pay interest in terms of the goods
and services to the creditor country.
 In other words, the debtor country has to export
goods and services on a large scale to the creditor
country.
 Contd…………………
180

 This inevitably results in a rise in the prices of these

goods and services in the country
 As a consequence there will exist a fall in the economic
welfare of the society. This fall in community’s welfare
shows the indirect money burden of the external public
borrowing’s
 Direct real burden: The government most of the time
imposes new taxes on the people to pay the debt.
Thus, the burden of these taxes falls more heavily on
the poor rather than on the rich section of the society.
 Contd………………..
181

 Indirect real burden: As a result of imposition of new

taxes to pay the debt, the capacity of the people to
work, save and invest declines which will have
unfavorable effects on production.
 Measurement of External Debt
182
Burden
 The extent of external debt burden can be measured by the following
ratios
I. Debt Service Ratio = external debt service
 National income (at current price)
 This measure indicates the extent to which the burden of debt
service has raised or declined over a given period of time.

II. Debt Service- Saving Ratio = external debt service

Saving (at current price)


 It has indicated the effect that external debt service imposes on

saving and in turn on capital formation of the country.
 Contd………………
183

III. Debt Service- Export Earnings Ratio

= external debt service
Export Earnings


 It indicates how much of the export earning is used for

repaying the interest on external loan.
IV. Debt service- Tax Revenue Ratio = external debt service
total tax revenue

 It indicates the proportion of tax revenue that is directed

for repaying external debt
 Contd………………..
184

 Internal Debt Burden

 Direct money burden: Internal debt is borrowed
from individuals and institutions inside the country.
 As a result; it will redistribute resources without
resulting any change in the total resource of the
community.
 Therefore, internal debt does not impose direct
money burden on the country because the tax
collected for repaying the debt redistributes
resources from one section of the society to another.
 Contd………………..
185

 Indirect money burden: However, internal debt

may result indirect money burden. When the
government spends the loan on development
projects, it results in the creation of demand for
several commodities and services.
 As a consequence, the prices of these goods and
services rise, imposing additional burden on the
society.
 Contd………………..
186

 Direct real burden: Internal debt may result in a

direct real burden according to the sources tax is
collected to finance the debt.
 When the tax collected from the rich people is
smaller, there will be a direct real burden where as
if the extent of direct real burden will be lesser if
the rich section of the society pays higher taxes.
 Contd……………….
187

 Indirect real burden: In addition to this, transfer of

income for serving an internal debt transfers from
the active to the inactive enterprise.
 Government has imposed taxes on enterprises and
earnings from productive efforts for the benefit of
idle, old and inactive bond holders which penalize
work and productive risk taking efforts, It adds to
the net real burden of the debt.
 Measurement of Internal Debt Burden
188

 Internal public debt indicates a financial burden on

the government.
 The size of internal debt burden can be measured
or estimated through the following methods.

I. Debt Service Ratio = annual interest payment on public debt

 National income (at current price)
 It indicates the extent to which government must tax
national income so as to raise enough revenue to pay
the interest on debt
 Contd………………..
189

II. Interest Cost- Revenue Ratio= debt service change

 total tax revenue
 It indicates the effect of public borrowing on the budget of the
country
A. Interest Cost- P. E Ratio= annual interest payment
 total expenditure
 It shows the proportion of revenue expenditure that is used for
paying the debt service (interest of debt),
B. Interest Cost- Profit Ratio= interest payment on public debt
 profit of public enterprise
 Contd………………..
190

 It indicates the extent of public debt that is used for

achieving production activities.
 This measure is applicable when the borrowed fund
is invested on measurable productive industrial
projects. But it is difficult to apply it in most of
developing countries like Ethiopia where
government allocates these funds on social
overheads, power generation, infrastructure
development etc.
 Contd…………………
191

 Debt Trap
 Debt trap refers the situation of vicious circle of
borrowing when the government must borrow so as
to pay the interest charges on the previous loans
and to repay the principal borrowed.
 This means, the fresh loans raised are not used for
investment or capital formation rather for repaying
the earlier debt incurred.
 Contd……………….
192

 Conversion- refers to situation of converting the

existing debt into a new debt prior to maturity with
benefit of servicing charges.
 Debt Redemption
 Debt redemption is a means of repaying a loan.
 Different means are used by the government to
redeem its debt. The major means adopted for
redemption of public loans are
 Contd………………..
193

 Refunding - government issues new bonds and

securities so as to repay the matured debts. This
process is said to be refunding.
 In this process long-term securities replace short-
term securities. So the money burden, under this
process, is accumulated rather than reduced
because government has postponed the date of
payment.
 Contd………………..
194

 Surplus budgets- refer to the method that

government repays its debt by keeping public
expenditure lower than the public revenue
obtained.
 However, surplus budget is a method that is used
rarely because of ever- increasing public
expenditure.
 Contd……………….
195

 Sinking fund- is a method that government

regularly keeps some money in such a manner that
it would be enough to retire the debt at the time of
maturity. For this method of debt retirement,
government budget must have overall surplus.
 Perhaps it is the most systematic and best method of
redemption
 Contd………………..
196

 This approach is applied by a number of countries.

But this method can succeed in repaying the debt
only if there is substantial budget saving every year
and no additional borrowing
 Additional Taxation - The simplest method that
enables the government for debt redemption is
imposing new taxes and gets the required revenue
to repay the principal as well as the interest.
 Contd……………….
197

 Capital levy - refers to a very heavy tax on

property and wealth. Dalton recommended that
government could repay its debt with the least real
burden on the community
 Surplus Balance of Payment- An economy can
repay its external debt only through the
accumulation of foreign exchange reserve.
 This requires the creation of surplus balance of
payments by the debtor nation. A nation can realize
this by increasing its export and reducing its import.
 Public Debt Management
198

 The term debt management refers to the

formulation and implementation of debt policy
designed to achieve certain objectives such as,
Economic stabilization, Economic growth,
Employment, Overall soundness of financial system
 According to the traditional state debt management
is emphasized on keeping its interest rate to the
minimum possible and repaying it as soon as
possible.

 Contd………………...
199

 Whereas modern welfare state; has considered

debt management as a means of gaining various
socio-economic developments.
 Debt management and monetary policy affect
stabilization and economic growth.
 Therefore, debt management policy should be
formulated harmoniously with monetary policy.
 Contd……………….
200

 the debt management policy should not have any

adverse effect on the economy especially on
willingness and ability to work, save and invest.
Moreover, during inflation it should be designed to
curtail aggregate demand
 Furthermore, at the time of depression government
should design its debt management policy to raise
aggregate demand and thereby it can increase
output and improve employment in an economy
 Principles of public debt management
201

 Minimum interest cost. If the interest is low, it will

impose less burden of taxation at the time of
redemption
 Satisfaction of investor’s needs. The terms of loan
should attract the public to invest in government
securities.
 Contd………………..
202

 Funding of short-term debt into long-term debt

Public debt management should enable the
Government to convert short-term loans into long-
term loans.
 Co-ordination of public debt policy with
monetary and fiscal policy. Public debt
management should not clash with monetary or
fiscal policy.
 Contd………………..
203

 Composition of public debt and maturity. If the

public debt program results in a large proportion of
short-term debt held by commercial banks, there
will be a high degree of liquidity in the market.
 This can generate inflation.
 If the holders of such liquid assets try to monetize
their debt obligations before maturity, controlling
inflation will be difficult.
 Questions
204

1, what is public debt? What are the reasons for

incurring public debt?
2,what are the types of public debt?
3, what are the methods of redemption of public
debt?
4, list and discuss the measurements of internal debt
burden
5, what do we mean by budget? Explain the
objective of budget.