CHAPTER #03

PUBLIC FINANCE IN ETHIOPIA

Federalism

Federalism is a form of state structure by which power of a state is formally

(constitutionally) divided among different level of government, each of which in its
own sphere coordinates with the others and acts directly on the people through its
administrative machinery. Ethiopia follows a federal government structure. The
government is divided into federal government and nine regional governments,
namely, Tigray, Afar, Amhara, Oromiya, Somali, Benishangul, Southern nations and
nationalities, Gambela, and Harare. There are also two special administrations Addis
Ababa and dire dawa. The form of government is parliamentary having both Federal
and state governments with legislative, executive, and judicial powers.

FEDERAL FINANCE:

Federal finance refers to the system of assigning the expenditure and revenue
responsibilities to the federal as well as regional governments for the efficient discharge
of their respective functions i.e. clear-cut division is made regarding the allocation of
expenditure and revenue between the central and regional state authorities. The main
goal of fiscal/economic decentralization is to move governance closer to the people, and
this does require strengthening local government finances. Fiscal decentralization
requires local governments with some autonomy to make independent fiscal decisions.
Fiscal federalism has four components

A. Expenditure Assignment

B. Revenue Assignment

C. Intergovernmental Transfer (subsidy)

D. Borrowing

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PRINCIPLES OF FEDERAL FINANCE:

In a federation there is a division of legislative/governmental, executive/decision

making and financial powers between the Centre and regional state governments. The
duty of the federal government is to fulfill its responsibilities towards the states while
utilizing its own financial powers within its own authority. Therefore, for the smooth
functioning of a federal financing, the following main principles must be applied:

1. Principle of Independence: Under the system of federal finance, each government

should be independent and free from the internal financial matters concerned. It
means each government should have separate sources of revenue, authority to levy
taxes, to borrow money to meet their expenditure. The Government should
normally enjoy autonomy in fiscal/economic matters.

2. Principle of Uniformity and Equity: Principle of Uniformity means that there should
not be any discrimination among different state in a federation, while distributing
resources among various states. But according to equity principle the
contribution/allocation of each state in federal taxes should be based on ability to
pay or economic considerations. Similarly, in order to achieve uniformity and equity
in taxation, there should be a proper adjustment between federal and state taxation
to make the tax burden on all the citizens equitable as far as possible, unless heavy
burden will imposes on backward states.

3. Principle of Adequacy of Resources: The principle of adequacy means that the

resources of each Government i.e. Central and State should be adequate to carry out
its functions effectively. Here adequacy must be decided with reference to both
current as well as future needs.

4. Principle of Fiscal Access: this implies that there should not be bar on federal and
state governments in developing new sources of revenue within their own
prescribed areas to meet the growing financial needs. That is, resources should grow
with the expansion of responsibilities of the government.

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5. Principle of Integration and Co-ordination: according to this principle, the whole
financial system of a federation should be well-integrated and coordinated.
Integration of financial systems of federal government and state governments is
essential in contemporary/modern federations. Similarly, coordination is essential
for smooth and efficient functioning of federal financial system.

6. Principle of Federal Supervision: there should be supervision by the federal

government to ensure whether state governments follow the rules and regulations
with regard to taxation and expenditure laid down by it from time to time.

7. Principle of Efficiency: The financial system should be well organized and efficiently
administered. There should be no scope for tax evasion and fraud.

8. Principle of Administrative Economy: Economy is the important criterion of any

federal financial system. That is, the cost of collection should be at the minimum
level.

9. Principle of Accountability: In a federal set up, the Governments both Central and
States enjoy financial autonomy. Therefore, the governments in a federation should
be accountable to its own legislature for its spending and collecting revenue
decisions.

10. Principle of Elasticity: Principle of elasticity means that there must be flexibility to
expand its resources in response to its requirements especially during the period of
internal and external crisis, like war, floods etc.

11. Principle of Transfer of Resources: this means that there should be provisions for
transferring the resources from central government to regional government and also
from one state to the other.

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Public Expenditure

The expenses incurred by the governments for its own maintenance, preservation and
welfare of the economy as a whole is referred to as public expenditure. In other words,
it refers to the expenses of public authorities - Central, State and Local Governments –
either for the satisfaction of collective needs of the citizens which the people in their
individual capacity are unable to satisfy efficiently or for promoting their economic and
social welfare. It implies government’s identifying and prioritizing areas of spending
and implementing those identified projects in particular fiscal year.

The major reasons for the government expenditures are:

 To protect the society from violence and invasion of other independent

societies, such as armed forces for providing protection,
 To protect against injustice
 Erecting and maintaining certain public works such as public parks,
schools, health care centers and
 To perform certain other welfare measures like maternity protection,
arranging for cheap food, cloth and low-cost housing for the poor and so
on. All these multifarious activities which are increasing every year
require huge fund.

Causes for the Increase in Public Expenditure:

One of the most important features of the present century is the phenomenal growth of
public expenditure. Some of the important reasons for the growth of public expenditure
are the following.
1. Welfare state: Modern states are no more police states. They have to look in to
the welfare of the masses for which the state has to perform a number of
functions. They have to create and undertake employment opportunities, social

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 security measures and other welfare activities. All these require enormous
expenditure.
2. Defence expenditure: Modern warfare is very expensive. Wars and possibilities
of wars have forced the nation to be always equipped with arms. This causes
great amount of public expenditure.
3. Growth of democracy: The form of democratic government is highly expensive.
The conduct of elections, maintenance of democratic institutions like legislatures
etc. cause great expenditure.
4. Growth of population: tremendous growth of population necessitates enormous
spending on the part of the modern governments. For meeting the needs of the
growing population more educational institutions, food materials, hospitals,
roads and other amenities of life are to be provided.
5. Rise in price level: Rises in prices have considerably enhanced public
expenditure in recent years. Higher prices mean higher spending on the part of
the govt. on items like payment of salaries, purchase of goods and services and
so on.
6. Expansion public sector: Counties aiming at socialistic pattern of society have to
give more importance to public sector. Consequent development of public sector
enhances public expenditure.
7. Development expenditure: Modern governments are incurring huge expenditure
for implementing developmental programs like road, telecommunication, pure
water, health care, electricity, irrigation etc.
8. Public debt: Along with debt rises the problem like payment of interest and
repayment of the principal amount. This results in an increase in public
expenditure.
9. Grants and loans to state governments: is one of the methods used to close the
fiscal imbalance of sub-national governments. It is an important feature of public
expenditure of the central government of Ethiopia. The government provides
assistance in the forms of grants-in-aid and loans to the regional states.

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Principles of Public Expenditure

Canons of public expenditure” is used for the fundamental rules or principles

governing the spending policy of the government. The following canons of public
expenditure have been laid down by many scholars on the subject:

(1) Canon of Benefit: - this canon suggests that every public spending must ultimately be
used for the cause of social benefit i.e. for the general well-being of the common people.
In other words, the State spending should confer/give benefits on the entire
community at large than on an individual group or section. It means public
funds should be spending in such directions which pursue common interest and
promote general welfare.

(2) Canon of Economy: - It implies that public expenditure should be incurred

carefully and economically. Economy here means that wasteful and extravagant
expenditure should be avoided at all levels. Public expenditure must be productive
and efficient. Hence, it must be incurred only on very essential items of common
benefit – without duplication in a way that involves minimum cost. An efficient
system of financial administration is therefore, very essential in any country.

(3) Canon of Sanction: this canon suggests that no public spending should be made
without the approval of proper authority. Only obtaining prior sanction is not
sufficient. It must be properly inspected and examined whether the sanctioned
amount of money spent on the purpose for which it is sanctioned by the highest
authority and accounts properly audited.

(4) Canon of Surplus: this canon suggest that saving is a virtue even for the
government, so an ideal budget is one which contains an element of surplus by
keeping public expenditure below public revenue. In other words, public
authorities should aim at surplus of income over expenditure and they should avoid
deficits. Frequent and huge deficits lead to uncontrollable financial situation with
dire consequences of inflation. Therefore every government should attempt to
balance its income and expenditure.

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 (5) Canon of Elasticity: - this canon requires that the expenditure policy of the State
should be such that changes must be possible in the expenses according to the
changes in requirements and circumstances. In other words, there should be
scope for changes in public expenditure according to the requirements of the
country.

(6) Canon of Productivity: - this canon or principle implies that the expenditure
policy of the Government should be such that would encourage production in a
country. That means a large part of public expenditure must be allocated for
development purposes.

(7) Canon of Equality: - one of the primary aims of public expenditure is also to
ensure the just and equitable distribution of income by conferring benefits on the
poorer section of the community. This canon of equitable distribution is more
significant for the countries where the gap between the highest income and the
lowest income groups is very wide. Developing countries like Ethiopia, have
given this aim a significant and particular importance in the economic activities
of the State and in their fiscal policies.

A. EXPENDITURE ASSIGNMENT

The ‘’division’’ of expenditure responsibilities is also called the 'assignment' of

expenditure responsibilities.

In the Ethiopian federal system, the Constitution follows an approach of listing the
exclusive powers and functions of the federal government (Art.51). It also provides a
limited list of exclusive powers for the states (Article 52(2)). It mentions the source and
type of taxes for which the states may exercise exclusive power. In principle, the
Ethiopian Constitution that follows the assignment of expenditure responsibilities is
depicted in Table 1

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 Public service Function Assignment of Expenditure
Responsibilities

Federal Regional
government government
1. Those functions which are considered common for X
all states e.g.
1.1. national defense,
1.2. the federal police force,
1.3. international or foreign relations,
1.4. citizenship, immigration and other powers that
are supplementary to the main powers in this
category
2. commercial activities that are essential for X
facilitating as well as international trade such as
2.1. Interstate commerce;
2.2. postal,
2.3. Telecommunication services;
2.4. Monetary and fiscal policy,
2.5. Domestic currency coinage and foreign currency
usage;
2.6. banking,
2.7. insurance,
2.8. Patents and copyright.
3. Major roads linking two or more states such as X
3.1. rail,
3.2. air and
3.3. water transports
4. various aspects of social and political issues such as X
4.1. Electoral laws and procedures, and
4.2. Enforcement of political rights
5. Civil and criminal laws i.e. penal code X
6. Major policy matters/standards governing X
6.1. Education,
6.2. Health,
6.3. Environment,
6.4. Science and technology, and
6.5. Protection and preservation of cultural and
Historical legacies and
6.6. Development strategies
7. Formulate and implement the country's policies, X
strategies and plans in respect of overall
7.1. Economic,
7.2. Social and

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 7.3. Development matters
8. legislation enacted on matters that are not covered X
by the penal code, and the power over civil laws
 e.g. the law of family
9. All powers not given expressively to the federal X
government alone or concurrently to the federal
government and the states are reserved to the
states.
10. Establishment of regional state X
10.1. police power, the
10.2. maintenance of public peace and order,
10.3. levying and collecting taxes

11. the administration of land and other natural resources x

based on federal laws, and the employment and
working conditions of civil servants.
12. Power over such areas
12.1. Education
12.1.1. Elementary schools X
12.1.2. Secondary schools X
12.1.3. Tertiary (University) X
12.2. Health care X
12.3. Agriculture, forestry, hunting and fishing X

13. Any matters not mentioned in the federal list. X

14. Formulate and execute economic, social and X
development policies, strategies and plans of the
regional state

B. REVENUE ASSIGNMENT

The division of taxation power is a principal aspect of the constitution that provides the
legal frame work of the Ethiopian federal system. The constitution divides the taxation
power into three categories, namely

i. The federal power of taxation-,

ii. The state power taxation- and
iii. The concurrent/jointly power of taxation-.

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The FDRE constitution under Article 96 enumerates the exclusive revenue sources of
the federal government. They include

 Foreign trade tax

 Tax from employees of central government and international organizations
 personal income tax, value added tax, turnover tax, and excise taxes from the
enterprises owned by federal government
 Tax on lottery and other chance winning
 Tax from air, rail and marine transportation
 Tax on rent of houses and properties owned by central government
 Fee for services rendered and licenses issued by federal government
Revenue of Regional government

Employment income tax from employees of regional government and

employees other than those covered under the sources of central government
such as private employees
personal income tax, value added tax, turnover tax, and excise taxes from
enterprises owned by regional government
Agricultural income tax from farmers and rural land use fee
profit, value added tax, turnover tax, and excise taxes of individual traders
Tax on income from inland water transportation.
Taxes collected from rent of houses and properties owned by the Regional
Governments;
Charges and fees on licenses and services issued or rented by the Regional
Government;

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Joint/Concurrent List:
The following shall be Joint revenues of the Central Government and Regional
Governments:
 Profit tax, personal income tax and VAT collected from enterprises jointly owned
by the central Government and Regional Governments;
 Profit tax, dividend tax and VAT collected from Organizations;
 Profit tax, royalty and rent of land collected from large scale mining, any
petroleum and gas operations;
 Forest royalty.

Collection of Revenue:
Regional governments collect their own revenue. The Central Government revenues
collection organs are responsible to collect revenues of the federal and revenues jointly
owned by the Central Government and Regional Governments. However, whenever
deemed necessary the collection of such revenues may be delegated to regional
Governments.

Basis for Revenue Sharing:

The sharing of revenue between the central government and the Regional governments
take the following Principles in to consideration:
1. Ownership of source of revenue;
2. The National or Regional character of the sources of revenue;
3. Convenience of levying and collection of the tax or duty;
4. Population, distribution of wealth and standard of development of each region;
5. Other factors that are basis for integrated and balanced economy.

Let us see the present position of revenue sharing arrangements between Federal
Government and Regional States regarding jointly established companies, Private
companies and Minerals and petroleum.

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SHARING OF REVENUE BETWEEN FEDERAL GOVERNMENT AND REGIONAL
STATES

Types of Joint Revenue Revenue Sharing Ratio

Jointly Established Companies Federal government Regional state
Profit Tax As per Capital Share As per Capital Share
Employee Income Tax 50% 50%
Service, VAT, and Excise Taxes 70% 30%
/indirect taxes
Tax on Dividends 50% 50%
Private Companies
Profit Tax 50% 50%
Indirect Taxes 70% 30%
Dividends 50% 50%
Revenues from Large Scale Mining and All Petroleum and Gas Operations
Profit Tax 50% 50%
Royalty 60% 40%

C. INTERGOVERNMENTAL TRANSFER/OR SUBSIDY

Transfer in simple sense is a mechanism which involves a vertical flow from the center
to lower/regional governments or the vice versa and horizontally from wealthier
regions to poorer regions in order to maintain fiscal stability. This means that the
underlying rationale for a system of intergovernmental transfer is the existence of a
fiscal gap at the sub-national government level emanating from lack of locally
generated own revenue to finance own expenditure assignments. Therefore
intergovernmental transfer or grant system is one of the methods used to close the fiscal
imbalance of sub-national governments. There are three main categories of grants:

1. General Purpose (Unconditional) Grants: - As the name indicates, general

purpose grants are allocated to states to spend the money in any area of public
purposes designated/selected by them. It is characterized by the absence of
significant restrictions on the use of funds, as it is at the region’s
discretion/judgment to spend the money for any preferred purposes. The choice

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 of a general purpose grant not only maximizes the financial capacity, but also
broadens the area of spending which may be considered essential by the states.
General purpose grants aid at addressing vertical imbalances.
2. Conditional grants: - are grants that carry conditions regarding the use of funds.
The conditionality refers to earmarking /assigning by the central government to
finance certain services such as primary education, primary health services,
water supply, agricultural extension, roads, etc. such earmarking of grants will of
course limited the autonomy of the local governments’ jurisdictions and, hence,
partly negating/opposing the arguments decentralization.
3. Equalization grants: - are used to address horizontal imbalance between local
governments. The purpose of these grants is to channel resource from relatively
wealthy sub-national governments to poorer. Therefore, these grants are used to
equalize the capacity of local governments to provide a national standard level of
goods and services. These grants also have the effect of reducing the vertical
fiscal gap.

In Ethiopia, with limited exceptions such as the road fund, the system
intergovernmental transfers have always taken in the form of unconditional
grant (or budgetary subsidies).

The system of intergovernmental transfers (subsidies or grants) begun in the

Ethiopia in 1992/93. However, the formula determined federal transfers to
regions started two years later, in 1994/95, though it has been continual
evolution since then, for example, the 2001, formula is based on a weighted
average of four elements:

 Relative population
 A development index
 Poverty index
 An index of revenue raising effort and sectoral output performance

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D. BORROWING

A public authority can obtain income through public borrowings. The loans raised in a
particular year constitute receipts for that year.

Public borrowing is one means of raising funds for meeting increasing government
expenditure, securing economic stability etc.

Group Assignment (10%)

1. Explain the various effects of public expenditure on total employment, total
income, aggregate investment, output, distribution and general price level etc.

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