P.O.

Box 342-01000
Thika
Email: info@mku.ac.ke
Web: www.mku.ac.ke

DEPARTMENT OF MANAGEMENT

COURSE CODE: BFM 321

COURSE TITLE: PUBLIC FINANCE

Instructional Material for BBM- Distance Learning

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 COURSE OUTLINE

Contact hours: 42

Pre-requisites: BBM 225

Purpose: Learners should understand the rationale behind common public programs, the
considerations for designing taxation policies, and potential problems in the public decision-making
process.

Expected Learning Outcomes of the Course

By the end of the course unit the learners should be able to:-
i) Describe concepts and methods in Public Finance
ii) Explain good public and public utility
iii) Explain public choice and political behaviour
iv) Explain the cost and benefits analysis on public expenditure

Course Content
Basic concepts and methods in Public Finance; Public good and public utility; Externality; Equity
and income distribution; Public choice and political behaviour; Behavioral responses to taxation; Tax
incidence; Taxation and efficiency; Optimal taxation; Cost and benefit analysis; Public expenditure
program; Public debt

Teaching / Learning Methodologies: Lectures and tutorials; group discussion; demonstration;

Individual assignment; Case studies

Instructional Materials and Equipment: Projector; test books; design catalogues; computer
laboratory; design software; simulators

Course Assessment
Examination - 70%; Continuous Assessment Test (CATS) - 20%; Assignments - 10%; Total - 100%

Recommended Text Books:

i) Musgrave R.A and P.B Musgrave (2005), Public Finance in Theory and Practice, New York
McGraw Hill
ii) Hyman (2007), Public Finance, Cengage Learning ( Thompson )
iii) S.n. Chand (2008), Public Finance, Atlantic Publishers & Distributors

Text Books for further Reading:

i) Jonathan Gruber, (2004), Public Finance and Public Policy, Worth Publishers
ii) Arye L. Hillman, (2003), Public finance and public policy, Cambridge University Press
th
iii) Rosen, Harvey S., (2005) Public Finance, 7 Ed, McGraw-Hill

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 TABLE OF CONTENT

COURSE OUTLINE .................................................................................................................................... 2

1.0 MEANING AND NATURE OF PUBLIC FINANCE. .......................................................................... 6
1.1 INTRODUCTION .............................................................................................................................. 6
1.2 NATURE OF PUBLIC FINANCE .................................................................................................... 6
1.3 DISTINCTION BETWEEN PUBLIC AND PRIVATE FINANCE .................................................. 8
1.4 FUNCTIONS OF PUBLIC FINANCE ............................................................................................ 10
1.5 SOURCES OF PUBLIC FINANCE ................................................................................................. 11
1.6 RESOURCES ALLOCATION IN DIFFERENT TYPES OF ECONOMIC SYSTEMS ................ 13
1.7 EFFICIENT OUTPUT OF PUBLIC GOODS/ OPTIMUM LEVEL OF PRODUCTION OF
PUBLIC GOODS ................................................................................................................................... 16

2.0 PUBLIC GOODS AND PUBLIC UTILITY ............................................................................... 19

2.1 INTRODUCTION ............................................................................................................................ 19
2.2 THEORY OF PRIVATE AND SOCIAL /PUBLIC GOODS .......................................................... 20
2.3 THE FREE RIDER PROBLEM ....................................................................................................... 23
2.4 MARKET FAILURE ....................................................................................................................... 29
3.0 EXTERNALITIES/ EXTERNAL EFFECT ......................................................................................... 33
3.1 INTRODUCTION ............................................................................................................................ 33
3.2 NEGATIVE EXTERNALITIES; ..................................................................................................... 34
3.3 POSITIVE EXTERNALITIES – ...................................................................................................... 36
3.4 TYPES OF EXTERNALITIES ........................................................................................................ 37
3.5 POSSIBLE SOLUTIONS TO THE EXTERNALITY PROBLEM ................................................. 38
3.6 IMPLICATIONS OF EXTERNALITY ........................................................................................... 39
3.7 GRAPHICAL ILLUSTRATION OF SUPPLY AND DEMAND DIAGRAMS SHOWING THE
EXTERNAL COSTS AND BENEFITS ................................................................................................ 41
4.0 EQUITY AND INCOME DISTRIBUTION ........................................................................................ 46
4.1 EQUITABLE DISTRIBUTION OF INCOME ................................................................................ 46
4.2 PERSPECTIVES ON EQUITY ....................................................................................................... 47
4.3 THE BENEFICIARY PRINCIPLE AND ABILITY TO PAY ........................................................ 48
4.4 HORIZONTAL AND VERTICAL EQUITY .................................................................................. 48
4.5 ECONOMIC AND INCOME INEQUALITY ................................................................................. 49
4.6 CAUSES OF INEQUALITY ........................................................................................................... 50
4.7 MITIGATING FACTORS OF INEQUALITY ................................................................................ 54
4.8 REDISTRIBUTION OF WEALTH ................................................................................................. 55
4.9 TYPES OF REDISTRIBUTION ...................................................................................................... 55
4.10 DIFFERENCE BETWEEN EQUITY AND EQUALITY IN TAXATION................................... 56
5.0 PUBLIC CHOICE THEORY ............................................................................................................... 59
5.1 INTRODUCTION ............................................................................................................................ 59
5.2 ORIGINS AND FORMATION ........................................................................................................ 59
5.3 PERSPECTIVE ................................................................................................................................ 60
5.4 CLAIMS OF THE PUBLIC CHOICE THEORY ............................................................................ 60
5.5 REMEDIES FOR THE PUBLIC CHOICE PROBLEM .................................................................. 61

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 5.6 AREAS RELATED TO PUBLIC CHOICE THEORY ................................................................... 61
6.0 BEHAVIOURAL RESPONSES TO TAXATION ............................................................................... 64
6.1 INTRODUCTION ............................................................................................................................ 64
6.2 EFFECTS OF TAXATION ON PRODUCTION ............................................................................ 64
6.3 EFFECTS OF TAXATION ON DISTRIBUTION .......................................................................... 68
SAMPLE CAT ............................................................................................................................................ 71
7.0 TAX INCIDENCE ................................................................................................................................ 72
7.1 INTRODUCTION ............................................................................................................................ 72
7.2 ILLUSTRATION OF TAX INCIDENCE........................................................................................ 73
7.2.1 INELASTIC SUPPLY, ELASTIC DEMAND ......................................................................... 73
7.2.2 ELASTIC SUPPLY AND DEMAND ...................................................................................... 74
7.2.3 INELASTIC DEMAND, ELASTIC SUPPLY ......................................................................... 74
7.3 MACROECONOMIC PERSPECTIVE OF TAX INCIDENCE...................................................... 76
8.0 TAXATION AND EFFICIENCY ........................................................................................................ 78
8.1 INTRODUCTION ............................................................................................................................ 78
8.2 THE EFFICIENCY PRINCIPALS OF TAXATION ....................................................................... 78
9.0 OPTIMAL TAXATION ....................................................................................................................... 82
10.1 OPTIMAL TAX THEORY ............................................................................................................ 82
9.2 OPTIMAL TAXATION THEORY .................................................................................................. 83
9.3 EXCESS BURDEN OF TAXATION .............................................................................................. 83
9.4 MEASURES OF THE EXCESS BURDEN ..................................................................................... 84
9.5 DISTORTION AND REDISTRIBUTION....................................................................................... 84
DELIBERATE DISTORTION............................................................................................................... 85
FISCAL ILLUSION ................................................................................................................................... 85
9.6 FACTORS DETERMINING TAXABLE CAPACITY ................................................................... 86
9.7 MEASUREMENT OR LIMIT OF TAXABLE CAPACITY.......................................................... 88
11.0 COST BENEFIT ANALYSIS AND INVESTMENT RULES .......................................................... 91
10.1 TYPES OF BENEFIT AND COST ................................................................................................ 91
10.2 MEASUREMENT OF BENEFITS AND COSTS ......................................................................... 93
10.3 PUBLIC EXPENDITURE EVALUATION PRINCIPALS ........................................................... 96
10.4 CONCEPT OF CONSUMER SURPLUS ...................................................................................... 98
11.0 PUBLIC EXPENDITURE PROGRAM ........................................................................................... 101
11.1 MEANING OF PUBLIC EXPENDITURE.................................................................................. 101
11.2 OBJECTIVES OF PUBLIC EXPENDITURE ............................................................................. 101
11.3 SIZE AND GROWTH OF PUBLIC EXPENDITURE ................................................................ 101
11.4 THEORIES OF INCREASE IN PUBLIC EXPENDITURE ....................................................... 103
11.5 THEORIES OF PUBLIC EXPENDITURE ................................................................................. 104
11.6 EFFECTS OF PUBLIC EXPENDITURE .................................................................................... 106
11.7 GROWTH OF PUBLIC EXPENDITURE ................................................................................... 113
11.8 DEVELOPMENT EXPENDITURE OF DEVELOPING ECONOMIES .................................... 114
11.9 ROLE OF DEVELOPMENT EXPENDITURE IN A DEVELOPING ECONOMY. ................. 115
13.0 PUBLIC DEBT ................................................................................................................................. 120
12.1 INTRODUCTION ........................................................................................................................ 120
12.2 SOURCES .................................................................................................................................... 120

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 12.3 CLASSIFICATION/ TYPES OF PUBLIC DEBT ....................................................................... 121
12.4 NEED FOR PUBLIC DEBT ........................................................................................................ 122
12.5 BURDEN OF PUBLIC DEBT ..................................................................................................... 124
12.6 DEBT BURDEN AND FUTURE GENERATION...................................................................... 125
12.7 MANAGEMENT OF PUBLIC DEBT ......................................................................................... 126
12.8 TECHNIQUES/METHODS OF DEBT MANAGEMENT ......................................................... 126
12.9 REDEMPTION OF PUBLIC DEBT ............................................................................................ 126
12.10 EFFECTS OF PUBLIC DEBT ................................................................................................... 127
12.11 ROLE OF PUBLIC DEBT ON ECONOMIC DEVELOPMENT.............................................. 128
SAMPLE EXAMINATIONS ................................................................................................................... 131

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 1.0 MEANING AND NATURE OF PUBLIC FINANCE.

General objective

By the end of the lesson the learner should be able to explain the meaning and nature of
public finance

Specific objectives

By the end of the lesson the learner should be able to

a) explain the meaning of public finance

b) explain to the nature of public finance

c) explain the similarities and differences between public finance and private
finance

d) Explain the functions of public finance in both developing and developed

nations.

e) Explain the sources of public revenue

f) explain the resource allocation in different types of economic systems

1.1 Introduction

Public finance can be defined as the collection of revenue by the central government and local
government and all the expenditure of revenue in the provision of public utilities.
According to Findlay Shirras (year) public finance is the study of the principals underlying the
spending and raising of fund by public authorities.

1.2 Nature of public finance

Prof. Dalton divides the scope of public finance into four categories namely:-
Public income/ revenue

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 Public expenditure
Public debt
Financial administration

a) Public income/revenue
This refers to government income collected from various sources. The main sources of public
revenue include taxes, fees, fines and penalties, income from properties, interest from loans
repayment, sale of real assets and royalties.

b) Public expenditure
This refers to spending by the government. Public expenditure covers the canons or the
principals which govern it and its effects on production, employment, income distribution,
stability and growth. It also includes reasons for increase in public expenditure and changes in
the pattern.

c) Public debt
When public revenue falls short of public expenditure, the government borrows to meet the gap.
This is the public debt. Therefore public debt includes reasons, methods and sources of public
debts, its effects on production, consumption, income distribution and economy, the burden of
public debt and methods of debt redemption.

d)Financial administration
The aim of financial administration is to control processes and operations of public revenue,
public expenditure and public debt. The scope of financial administration includes the collection,
custody and disbursement of public money, the coordination of expenditure according to a well
formulated plan, the management of public debt and the general control of the financial
operations of the state. It also includes the preparation of the budget, its execution and auditing
of the state.

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1.3 Distinction between public and private finance

Public finance is the study of income, expenditure, borrowing and financial administration of the
government .On the other hand, private finance is the study of income, expenditure, borrowing
and financial administration of individual or private companies.

Similarities and differences between public and private finances.

Similarities:
Objective- Both public and private finances aim at the satisfaction of human wants. The
objective of public finance is to satisfy social wants and that of private finance to satisfy
individual wants.

Principals – both governments and individuals follow similar principals. The government
follows the principal of maximum social benefit while spending its income. Similarly an
individual follows the principal of maximum satisfaction when spending out of his income.

Income expenditure and borrowing- Both government and individuals have similar but limited
sources of income. Both can spend in anticipation of receiving income. If their incomes are
insufficient to meet their expenditure both borrow. Both also have to repay the borrowed money.

Policies – Governments, individuals and private companies follow sound or unsound (rational or
irrational) financial policies. If the government follows sound financial policies it maximizes
social welfare. Similarly an individual maximizes his welfare. If both follow unsound financial
policies they are unable to maximize welfare.

Administration- Both government and private companies require efficient administration and if
a private company is corrupt and inefficient, it leads to misuse and wastage of finances.

Differences
Adjustment between income and expenditure- an individual determines his expenditure on he
basis of his income. He prepares his family budget on his expected income during the month. On

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the other hand the government first estimates its expenditure and then finds out means to raise
the necessary income.

Elasticity- there is a greater elasticity in public finance than in private finance. The government
has more sources of income whereas the sources of the individual are limited only to his current
income, past savings and borrowings

Motives - an individual or a firm has the private motive whereas the government has a welfare
motive. An individual always tries to save and a firm to earn a profit. However, there are no such
considerations on the part of the government.

Expenditure- an individual expenditure is governed by his habit, customs, and fashion e.t.c.,
while government expenditure depends on its economic and social policies like reducing
unemployment and poverty, reducing income inequalities, providing infrastructure facilities e.t.c.

Compulsion -There compulsion in public finance. People must pay taxes. If they do not pay,
they are punished through fines and imprisonment. But an individual or firm cannot force
anybody to pay him money.

Present-vs-future- an individual is more concerned with his present needs and tries to satisfy
them. On the other hand the government is concerned not only with the welfare of the present
generation, but also with future generation. It therefore undertakes and spends on those activities
which also benefit future generations.

Budgeting – an individual may have a weekly or monthly budget. A public budget on the other
hand is for one fiscal year. Also government budget is passed by parliament while the budget of
an individual or firm is a private affair without any controlling authority.

Secrecy-vs-openness- there is secrecy in private finance. No individual wants to reveal his

income and savings. On the contrary, the government budget is an open public document which
is commented on, debated and published at various forums.

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Bankruptcy- an individual or firm can be bankrupt. However a government cannot go bankrupt
because it can borrow from international agencies. It can only face a financial crisis.

1.4 Functions of public finance

Public finance plays an important role in the economy of a country, whether it is a developed or
a developing country.

In a developed country:
The importance of public finance in an advanced country is to stabilize its growth rates. To
achieve this, the government changes its expenditure and taxation policies to produce good
effects and avoid bad effects on national income, production, employment and prices. When
prices are falling in a recession, private investments fall. To compensate for the lack in
investments and to raise effective demand, output, employment and income, the government
increases its expenditure on public works and social security programmes through budget
deficits, debt repayment and reduction in taxes. On the other hand, when there are inflation
tendencies and a boom starts, the government reduces its expenditure on public works. This
reduces effective demand through a budget surplus, public borrowing and raising taxes. Thus the
government controls deflationary (recessions) and inflationary (booms) pressures by an
appropriate combination of expenditure, borrowing and taxation policies.

In a developing economy:
Public finance plays a dynamic role in a developing country. It is very crucial for its economic
development. The per capita income and savings are extremely low for developing countries.
According to Jhingan, (2006), the few rich spend large portions of their savings on property,
jewellery, gold, speculation e.t.c. and in conspicuous consumption.
Fiscal policy diverts them into productive channels through taxation, borrowing and expenditure,
fiscal policy promotes economic development by increasing the rate of investments, encouraging
investment in social and economic infrastructure, increasing employment opportunities, reducing
balance of payments disequilibrium, counteracting inflation, reducing inequalities of income and
wealth and increasing national income.

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By an appropriate policy of taxation, the government reduces private consumption and transfers
resources to the government for investment, increases the incentives to save and reduce
economic inequalities.
Public borrowing is an anti-inflationary measure. It is used for mobilizing surplus money in the
hands of the people in a developing country. It is a useful tool of economic development by
diverting resources from unproductive uses to productive uses. Public borrowing is resorted to
for specific development projects like power generation, irrigation work, roads e.t.c.
The role of public expenditure in economic development lies in increasing the growth rate of the
economy, providing more employment opportunities, raising incomes and standards of living,
reducing inequalities of income and wealth, encouraging private initiatives and enterprise and
bringing about regional balance in the economy. This is achieved by government spending on
public works, agriculture, industry, transport and communication, power, social services e.t.c.
The government is able to increase public expenditure though a budget deficit.

1.5 Sources of public Finance

There are two main sources of public finance namely:-

a) Public revenue
b) Public debt

a) Public Revenue
This refers to the income that the government gets from its citizens. The government can raise its
revenues through taxation or non tax activities. This gives rise to tax revenue and non tax
revenue.

Taxation
Taxation is considered the most important source of public revenue. A tax is a compulsory
payment made to the government without any direct benefit to the individual or firm. Revenue
raised through taxation is used for the benefit of everyone in the society. Taxes can be classified
as either direct or indirect taxes. Examples of direct tax are income tax, corporation tax, capital
gains tax, estate duty/inheritance tax. Examples of indirect tax are custom duties, exercise duties,

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sales tax and value added tax. In the year 2005/2006 88% of the government revenue was from
taxes while only 12 % was from other sources. Income tax contributes the highest percent,
followed by customs and excise, and then VAT.

Non Tax Revenues

These include,

(i) Surpluses from public corporations

A public corporation is an organization in which the government has a stake in its ownership.
Public corporation normally provides essential services at a fee to the members of the society.
E.g. Kenya Pipeline Company, KBC, KB Standards, etc. When the revenue earned from the
supply of these services is more than the expense incurred, the surplus is paid to the government.

(ii) Fines and penalties.

The judicial system in the country is made of courts and tribunals which impose fines and
penalties on individuals, firms and corporations that break the laws of the land. The money
raised from the fines and penalties becomes public revenue.

(iii) Fees
The government renders some direct services to its citizens such as licensing of marriages,
issuing birth certificates, permits, issuing and renewal of driving licenses. For such services a
small fee is usually charged. Such fees are a source of public revenue.

(iv) Income from properties.

The government owns many properties. These include homes for which rent is charged, land for
which rates are charged and game parks where entry fees are charged. This also is a source of
public revenue.

(v) Interest from loan repayments

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The government charges interest on loans borrowed by the public through its corporations e.g.
Agricultural Finance Corporation, Kenya Industrial Estate (K.I.E) etc. This interest collected
constitutes part of the public revenue.

(vi) Sale of real assets

The government may sell assets that belong to its parastatals and other state corporations as well
as local authority assets. This may take the form of privatization of state corporations, sale
of council assets and direct sale of government properties (e.g. vehicles, Grand Regency etc

(vii) Royalties
These are payments to the government arising from the use of natural resources by companies
and individuals e.g. in the use of mines and forests.

b) Public debt covered later in detail

1.6 Resources allocation in different types of economic systems

Resources allocation in any country is generally influenced by its economic system. Broadly
speaking there are three types of economic systems namely:-
a) Market/ capitalistic economy/ free enterprise
b) Command/ socialist/state enterprise/communism
c) Mixed economic system

a) Market/ capitalistic economy

This is an economic system whereby there is an absence of government intervention and
where the forces of demand and supply are allowed to operate freely. In this case resources
are allocated through the price mechanism.

b) Command/ planned economy

A planned economy is one where the critical economic system decisions are determined by
the state. In this case the market forces of demand and supply (price mechanism) are given

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 no role in resources allocation as it is the government that makes decisions on the resources
allocation.

c) Mixed economic system

In a mixed economy, both private and public sector exist and function side by side. Here,
the allocation of resources between alternative uses is determined largely by individual
action through the price mechanism but the government plays some role in determining
aggregate level of output through the use of fiscal and monetary policies.
Therefore resource allocation can be examined by assessing:-
a) The role of price mechanism in resource allocation
b) The role of government in resource allocation

Price mechanism and resources allocation

Price mechanism involves the determination of price of commodities through the interaction of
demand and supply of those commodities. In the course of exchange, the price mechanism
determines the allocation of resources in the market economy and indeed under competitive
condition, it is claimed to produce an ‘ideal’ allocation of resources.

How does it work? Each time a consumer spends money on a particular good, he is like ‘casting
a vote’ for its production rather than another by providing an incentive to the producers of that
particular good to supply it.
Suppose consumer are spending their income on a wide range of products and the producers of
each product are earning just sufficient to cover their costs and no more. Suppose consumer taste
change i.e. they buy more of commodity A and less of commodity B, the revenue of the
producers of commodity B falls. Assuming their costs are unchanged, revenue will no longer
cover costs for producers of B and some of these will go out of business. This will leave
resources i.e. capital, labour and raw materials unemployed in industry B. However, demand and
profits in industry A will have increased, new producers are attracted there and the resources
released in industry B will thus be switched to the production of A..The composition of output
has therefore been remolded to suit the tastes of consumers through profit incentives to
producers. Thus without need for any overall planning, the allocation of resources is

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automatically determined by the price mechanism through appeals to the self interest of
consumers and producers. Adam Smith called this the ‘invisible hand’ of the market.

Role of the government in resource allocation

Issue has been raised on the fact that the price mechanism alone cannot perform all economic
functions in an economy. The government influences resources allocation through production
that is undertaken by the government through nationalized industries and also through the use of
regulation, fiscal and monetary policies which have a direct effect on aggregate demand. The
need of the role of the government in resource allocation is brought about by the defects of price
mechanism. The government’s role in the resource allocation therefore involves:

1. Securing condition that ensures price mechanism work:

The claim that the market mechanism leads to efficient resources use (i.e. produces what
consumers want most and does so in the cheapest way) is based on the condition of competitive
factor and product market. Thus there must be no obstacle to free entry in the market and
consumers and producers must have full market knowledge. Government regulation or other
measures may be needed to secure these conditions.

2. Providing a legal structure

The contractual arrangements and exchanges needed for market operation cannot exist without
the protection and enforcement of a governmentally provided legal structure.

3. Provision of public goods

The production or consumption characteristics of certain goods are such that they cannot be
provided for through the market. Problem of ‘externalities’ arise which leads to ‘market failure’
and require correction by the government either by way of budgetary provision, subsidy or tax
penalty. Externalities refer to social costs and benefits that are not fully accounted for in the
market system e.g. provision of defense, reduction of air pollution, street lights, law and order
e.t.c.

Public goods are also characterized by non-excludability and non-rivalry in consumption.

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Non excludability means that it’s not possible to exclude individuals who have not paid from
consuming the commodity.
Non rivalry consumption implies that one person’s consumption doesn’t reduce the
consumption of another individual. The problem of provision of public goods by the private
sector arises because of the free rider problem. Free rider problem leads to potential consumer
understating their preferences or willingness to pay and still gain since they receive goods
without necessarily paying for it. The government must step in and allocate resources for the
provision of public goods.

4. Adjustments in the reduction of income

Social values may require adjustments in the distribution of incomes and wealth which results
from the market systems and from the transmission of property through inheritance.

5. Objectives of high employment, price level, stability and desired rate of economic
growth.
The market system especially in a highly developed financial economy does not necessarily
bring about the above important objective. The government must develop a policy to secure
these objectives. This is especially the case in an open economy subject to international
repercussion.

6. Determining proportions of national resources to be devoted to producing consumer

goods and investment goods.
This involves making a choice between more income now and more income in future. This can
be done through the budgetary allocation and also through fiscal and monetary policies.

1.7 Efficient output of public goods/ optimum level of production of public goods

What constitutes optimum resources allocation in case of public goods? In the case of public
goods a certain quantity is consumed by everyone. Therefore the demand for any quantity of that
public good is the sum of prices that each individual consumer is willing to pay for that quantity.
In this way, the community’s demand curve for a public good is the summation of demand

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curves of the individual consumers which represent the sum of all marginal benefits received by
all consumers.

Each demand curve implies the marginal benefit that the consumer gets from consuming every
level of production. The optimum level of production of a public good is determined by equating
the sum of the marginal benefits to the marginal cost of production i.e. the optimum quantity is
that quantity for which the marginal cost of the last unit is equal to the sum of prices that all
consumers are willing to pay for that unit.

Summary Of The Topic

 Nature of public finance
 Distinction between public and private finance
 Function of public finance
 Sources of public Finance
 Resources allocation in different types of economic systems
 Efficient output of public goods/ optimum level of production of public goods

Revision Questions
i. Explain the meaning and nature of public finance
ii. Explain the differences and similarities between public finance and private
finance
iii. Explain the functions of public finance in both developing and developed
nations.
iv. Describe the sources of public revenue
v. Describe the resource allocation in different types of economic systems

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Further References
i. M. L Jighan ( 2006), Public Finance And International Trade, Vrinda Publications P
Limited, Delhi India Pages 1-6
ii. H.L Bhatia (2004) Public Finance.Vikas Publishing House spvt Limited, New Delhi
India Pages 16-25
iii. Musgrave (2005) Public Finance In Theory And Practice, Tata Mcgraw-Hill New Delhi
Pages 3-10
iv. David N Hyman (2005) Public Finance, A Contemporary Application Of Theory To
Policy Thomson Learning,Ohio Usa Pages 1-30

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 2.0 PUBLIC GOODS AND PUBLIC UTILITY

General objective

By the end of the lesson the learner should be able to explain the issues pertaining to public
goods and public utility
Specific objectives:
By the end of the lesson the learner should be able to
a) describe a public good
b) explain the characteristics of public goods and private goods
c) explain free rider problem and its solutions
d) explain the causes of market failure and the solutions

2.1 Introduction

A public good is a good that is non rival and non-excludable. Non-rivalry means that
consumption of the good by one individual does not reduce availability of the good for
consumption by others; and non-excludability that no one can be effectively excluded from using
the good.

In the real world, there may be no such thing as an absolutely non-rivaled and non-excludable
good; but economists think that some goods approximate the concept closely enough for the
analysis to be economically useful.

For example, if one individual visits a doctor there is one fewer doctor's visit for everyone else,
and it is possible to exclude others from visiting the doctor. This makes doctor visits a rivaled
and excludable private good. Conversely, breathing air does not significantly reduce the amount
of air available to others, and people cannot be effectively excluded from using the air. This
makes air a public good, albeit one that is economically trivial, since air is a free good.

Non-rivalness and non-excludability may cause problems for the production of such goods.
Specifically, some economists have argued that they may lead to instances of market failure,

19
where uncoordinated markets driven by parties working in their own self interest are unable to
provide these goods in desired quantities. These issues are known as public goods problems, and
there is a good deal of debate and literature on how to measure their significance to an economy,
and to identify the best remedies. These debates can become important to political arguments
about the role of markets in the economy. More technically, public goods problems are related to
the broader issue of externalities.

2.2 Theory of Private and Social /Public Goods

Private goods
This refers to those goods and services that satisfy individual wants and have the characters tics
of rivalry and exclusiveness. These goods can be produced by the free market policy mechanism.
Private goods are rival in consumption i.e. their consumption by a person reduces the amount
available to others. Also all those who want to pay the market price for them will consume them
and those who do not want to pay will be excluded from their use. In this case private goods are
subject to the principal of exclusion. Example of private goods relate to food, clothing, shelter,
transportation, communication etc.

Characteristics of private goods

1. They are rivalrous in consumption.

2. They are subject to exclusion principal

3. They satisfy individual wants.

4. The can be produced through free market pricing mechanism.

5. They are divisible in so far as their use is concerned

6. Marginal cost of providing a private good to an extra consumer is always positive

Public goods
They refer to those goods and services which are jointly and equally consumed by many people
at the same time and their consumption by one person does not alter availability for another
person .e.g. defence

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These goods may not be produced by the free market pricing mechanism because those persons
who do not want to pay for the price can not be prevented from the consumption of those goods
and services i.e. public goods and services have a feature of non-rivalry in consumption and non-
excludability and as a result would not be provided in the free market.

Characteristics of public goods

i. They are non rivalrous- i.e. the quantity that a person consumes does not affect the
quantity that other can consume. No one has exclusive right over the consumption of
good.

ii. They are non-excludable i.e. if one person consumes the goods it is not possible to
prevent others from consuming it.

iii. The goods are of collective consumption.

iv. These goods may not be produced through the free market mechanism

v. They are indivisible

vi. The consumption of a public good is always joint and equal, thus public goods are
always produced and supplied by the society to meet its collective wants for increasing
social welfare.

vii. Public goods create externalities or divergences between social and private benefits.

Differences between private and public goods

i. Public goods satisfy social wants while private goods satisfy individual wants.

ii. Public goods are non-rival in consumption while private goods are rivalrous.

iii. Public goods are non-exclusive whereas private goods permit exclusion.

iv. Public goods cannot be provided by the free market pricing mechanism while, private
goods are priced in the market

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 v. The marginal cost of providing a private good to an extra consumer is positive, while
in the public good it is zero.

The efficient level of production of a private good is achieved when the marginal benefit and the
marginal cost are equal. However with a public good, we must ask how much each person values
an additional unit of output and how to add them to the marginal cost of production

Further considerations on the types of goods

Excludable Non-excludable

Common goods
Private goods (Common-pool
Rivalrous food, clothing, cars, resources)
personal electronics fish stocks, timber, coal,
national health service

Club goods Public goods

Non-rivalrous cinemas, private parks, free-to-air television, air,
satellite television national defense

A good which is rivalrous but non-excludable is sometimes called a common pool resource.
Such goods raise similar issues to public goods: the mirror to the public goods problem for this
case is sometimes called the tragedy of the commons. For example, it is so difficult to enforce
restrictions on deep sea fishing that the world's fish stocks can be seen as a non-excludable
resource, but one which is finite and diminishing.

The definition of non-excludability states that it is impossible to exclude individuals from

consumption. Technology now allows radio or TV broadcasts to be encrypted such that persons
without a special decoder are excluded from the broadcast. Many forms of information goods
have characteristics of public goods.

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For example, a poem can be read by many people without reducing the consumption of that good
by others; in this sense, it is non-rivalrous. Similarly, the information in most patents can be used
by any party without reducing consumption of that good by others. Creative works may be
excludable in some circumstances, however: the individual who wrote the poem may decline to
share it with others by not publishing it.

Copyrights and patents both encourage and inhibit the creation of such non-rival goods by
providing temporary monopolies, or, in the terminology of public goods, providing a legal
mechanism to enforce excludability for a limited period of time. For public goods, the "lost
revenue" of the producer of the good is not part of the definition: a public good is a good whose
consumption does not reduce any other's consumption of that good.The economic concept of
public goods should not be confused with the expression "the public good", which is usually an
application of a collective ethical notion of "the good" in political decision-making.

Another common confusion is that public goods are goods provided by the public sector.
Although it is often the case that Government is involved in producing public goods, this is not
necessarily the case. Public goods may be naturally available. They may be produced by private
individuals and firms, by non-state collective action, or they may not be produced at all.

Collective goods

Collective goods (or social goods) are defined public goods that could be delivered as private
goods, but are usually delivered by the government for various reasons, including social policy,
and finances from public funds like taxes.

Examples

Common examples of public goods include: defense and law enforcement (including the system
of property rights), public fireworks, lighthouses, clean air and other environmental goods, and
information goods, such as software development, authorship, and invention.

2.3 The Free Rider Problem

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Public goods provide a very important example of market failure, in which market-like behavior
of individual gain-seeking does not produce efficient results. The production of public goods
results in positive externalities which are not remunerated. If private organizations don't reap all
the benefits of a public good which they have produced, their incentives to produce it voluntarily
might be insufficient. Consumers can take advantage of public goods without contributing
sufficiently to their creation. This is called the free rider problem, or occasionally, the "easy rider
problem" (because consumer's contributions will be small but non-zero).

The free rider problem depends on a conception of the human being as homo economicus: purely
rational and also purely selfish -extremely individualistic, considering only those benefits and
costs that directly affect him or her. Public goods give such a person an incentive to be a free
rider.

For example, consider national defense, a standard example of a pure public good. Suppose
homo economicus thinks about exerting some extra effort to defend the nation. The benefits to
the individual of this effort would be very low, since the benefits would be distributed among all
of the millions of other people in the country. There is also a very high possibility that he or she
could get injured or killed during the course of his or her military service.

On the other hand, the free rider knows that he or she cannot be excluded from the benefits of
national defense, regardless of whether he or she contributes to it. There is also no way that these
benefits can be split up and distributed as individual parcels to people. The free rider would not
voluntarily exert any extra effort, unless there is some inherent pleasure or material reward for
doing so (for example, money paid by the government, as with an all-volunteer army or
mercenaries).

In the case of information goods, an inventor of a new product may benefit all of society, but
hardly anyone is willing to pay for the invention if they can benefit from it for free.

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Possible solutions to the free rider problem

a) Assurance contracts

An assurance contract is a contract in which participants make a binding pledge to contribute to

building a public good, contingent on a quorum of a predetermined size being reached.
Otherwise the good is not provided and any monetary contributions are refunded.

A dominant assurance contract is a variation in which an entrepreneur creates the contract and
refunds the initial pledge plus an additional sum of money if the quorum is not reached. (The
entrepreneur profits by collecting a fee if the quorum is reached and the good is provided.) In
game-theoretic terms this makes pledging to build the public good a dominant strategy: the best
move is to pledge to the contract regardless of the actions of others.

b) Coasian solution

The coasian solution, named for the economist Ronald Coase and unrelated to the Coase
theorem, proposes a mechanism by which potential beneficiaries of a public good band together
and pool their resources based on their willingness to pay to create the public good. Coase (1960)
argued that if the transaction costs between potential beneficiaries of a public good are
sufficiently low, and it is therefore easy for beneficiaries to find each other and pool their money
based on the public good's value to them, then an adequate level of public goods production can
occur even under competitive free market conditions. However, Coase (1988) famously wrote:

"The world of zero transaction costs has often been described as a Coasian world. Nothing could
be further from the truth. It is the world of modern economic theory, one which I was hoping to
persuade economists to leave."

In some ways, the formation of governments and government-like communities, such as

homeowners associations can be thought of as applied instances of practicing the coasian
solution by creating institutions to reduce the transaction costs.

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A similar alternative for arranging funders of public goods production, which is especially
applicable to information goods, is to produce the good but refuse to release it to the public until
some form of payment to cover costs is met.

Author Stephen King, for instance, authored chapters of a new novel downloadable for free on
his website while stating that he would not release subsequent chapters unless a certain amount
of money was raised. Sometimes dubbed holding for ransom, this method of public goods
production is a modern application of the street performer protocol for public goods production.
Unlike assurance contracts, this relies on social norms to ensure (to some extent) that the
threshold is reached and partial contributions are not wasted.

c) Government provision

If voluntary provision of public goods will not work, then the obvious solution is making their
provision involuntary. This saves each of us from our own tendency to be a free rider, while also
assuring us that no one else will be allowed to free ride. One frequently proposed solution to the
problem is for governments or states to impose taxation to fund the production of public goods.
This does not actually solve the theoretical problem because good government is itself a public
good. Thus it is difficult to ensure the government has an incentive to provide the optimum
amount even if it were possible for the government to determine precisely what amount would be
optimum. These issues are studied by public choice theory and public finance.

Sometimes the government provides public goods using "unfunded mandates". An example is
the requirement that every car be fit with a catalytic converter. This may be executed in the
private sector, but the end result is predetermined by the state: the individually involuntary
provision of the public good clean air. Unfunded mandates have also been imposed by the U.S.
federal government on the state and local governments, as with the Americans with Disabilities
Act, for example.

d) Subsidies and joint products

A government may subsidize production of a public good in the private sector. Unlike
government provision, subsidies may result in some form of a competitive market. The potential

26
for cronyism (for example, an alliance between political insiders and the businesses receiving
subsidies) can be limited with secret bidding for the subsidies or application of the subsidies
following clear general principles. Depending on the nature of a public good and a related
subsidy, principal agent problems can arise between the citizens and the government or between
the government and the subsidized producers; this effect and counter-measures taken to address
it can diminish the benefits of the subsidy.

Subsidies can also be used in areas with a potential for non-individualism: For instance, a state
may subsidize devices to reduce air pollution and appeal to citizens to cover the remaining costs.

Similarly, a joint-product model analyzes the collaborative effect of joining a private good to a
public good. For example, a tax deduction (private good) can be tied to a donation to a charity
(public good). It can be shown that the provision of the public good increases when tied to the
private good, as long as the private good is provided by a monopoly (otherwise the private good
would be provided by competitors without the link to the public good).

e) Privileged group

The study of collective action shows that public goods are still produced when one individual
benefits more from the public good than it costs him to produce it; examples include benefits
from individual use, intrinsic motivation to produce, and business models based on selling
complement goods. A group that contains such individuals is called a privileged group. A
historical example could be a downtown entrepreneur who erects a street light in front of his
shop to attract customers; even though there are positive external benefits to neighboring
nonpaying businesses, the added customers to the paying shop provide enough revenue to cover
the costs of the street light.

The existence of privileged groups may not be a complete solution to the free rider problem,
however, as underproduction of the public good may still result. The street light builder, for
instance, would not consider the added benefit to neighboring businesses when determining
whether to erect his street light, making it possible that the street light isn't built when the cost of
building is too high for the single entrepreneur even when the total benefit to all the businesses
combined exceeds the cost.

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An example of the privileged group solution could be the Linux community, assuming that users
derive more benefit from contributing than it costs them to do it. For more discussion on this
topic see also Coase's Penguin.

Another example is those musicians and writers who create music and writings for their own
personal enjoyment, and publish because they enjoy having an audience. Financial incentives are
not necessary to ensure the creation of these public goods. Whether this creates the correct
production level of writings and music is an open question.

f) Merging free riders

Another method of overcoming the free rider problem is to simply eliminate the profit incentive
for free riding by buying out all the potential free riders. A property developer that owned an
entire city street, for instance, would not need to worry about free riders when erecting street
lights since he owns every business that could benefit from the street light without paying.
Implicitly, then, the property developer would erect street lights until the marginal social benefit
met the marginal social cost. In this case, they are equivalent to the private marginal benefits and
costs.

While the purchase of all potential free riders may solve the problem of underproduction due to
free riders in smaller markets, it may simultaneously introduce the problem of underproduction
due to monopoly. Additionally, some markets are simply too large to make a buyout of all
beneficiaries feasible - this is particularly visible with public goods that affect everyone in a
country.

g) Introducing an exclusion mechanism (club goods)

Another solution, which has evolved for information goods, is to introduce exclusion
mechanisms which turn public goods into club goods. One well-known example is copyright and
patent laws. These laws, which in the 20th century came to be called intellectual property laws,
attempt to remove the natural non-excludability by prohibiting reproduction of the good.
Although they can address the free rider problem, the downside of these laws is that they imply
private monopoly power and thus are not Pareto-optimal.

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h) Social norms

If enough people do not think like free-riders, the private and voluntary provision of public
goods may be successful. A free rider might litter in a public park, but a more public-spirited
individual would not do so, getting an inherent pleasure from helping the community. In fact,
one might voluntarily pick up some of the existing litter. If enough people do so, the role of the
state in using taxes to hire professional maintenance crews is reduced. This might imply that
even someone typically inclined to free-riding would not litter, since their action would have
such a cost.

Public mindedness may be encouraged by non-market solutions to the economic problem, such
as tradition and social norms. For example, concepts such as nationalism and patriotism have
been part of most successful war efforts, complementing the roles of taxation and conscription.
To some extent, public spiritedness of a more limited type is the basis for voluntary contributions
that support public radio and television. Contributions to online collaborative media like
Wikipedia and many other projects utilising wiki technology can also be seen to represent an
example of such public spiritedness, since they provide a public good (information) freely to all
readers.

Groups relying on such social norms often have a federated structure, since collaboration
emerges more readily in smaller social groups than in large ones. This explains why labor unions
or charities are often organized this way.

2.4 Market failure

This refers to the circumstances under which the market fails to allocate resources efficiently i.e.
it exists where the production or use of the goods and services by the market is not efficient. The
market failures can be viewed in scenarios where individual pursuit of pure self interest leads to
results that are not efficient i.e. that can be improved from societal point of view.

Causes of market failures

There are four main causes:

29
Market power: Agents in the market can gain market power, allowing them to block other
mutually beneficial gains from trades from occurring. This can lead to inefficiency due to
imperfect competition, which can take many different forms such as monopolies, cartels or
monopolistic competition. In a monopoly, for example, the monopolist will use his/her market
power to restrict output below the quantity at which the marginal social benefit is equal to the
marginal social cost of the last unit produced so as to keep the prices and the profits high.

Externalities: the actions of the agents can have externalities which are innate to the methods of
production or other conditions important to the market eg when a firm is producing papers, it
absorbs labour, capital and other inputs. It must pay for these in the appropriate markets and
these will be reflected in the market price for paper products. If the firm also pollutes the
environment and atmosphere while producing paper products and it is not forced to pay for this
resource, then this cost will not be borne by the firm but by the society. Hence the market price
for paper products will fail to incorporate the full opportunity cost to the society of producing
paper products. In this case the market equilibrium in the paper industry will not be optimal.
Therefore the marginal social cost of the last unit produced will exceed its marginal social
benefit.

Public goods: some markets can fail due to the nature of certain goods e.g. existence of public
goods. A public good is one whose consumption or use by one individual does not reduce the
amount available to others e.g. city park, defense, law and order, ocean or lake fishing e.t.c.
Public goods have two characteristics i.e. they are non-excludable and non-rivalrous. A good is
non-excludable if it can be consumed by anyone. It is non-rivalrous, if no one has an exclusive
right over its consumption. Its benefit can be provided to an addition consumer at zero marginal
cost. Thus public goods, being both non-excludable and non-rivalrous are not sold in a free
market like private goods.

Equity: the issue here is that the distribution of goods and services generated by the market may
not be fair. This is due to inequitable distribution of income.

Market failure, the rationale for government intervention / measures to correct market
failure

1. Externalities

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If pollution costs are external, firms will produce too much of a polluting good.

The goal of the goverment should be to discourage production and consumption activities that
impose high external costs on society. This can be accomplished by:

Regulation- passing legislation that address the problem

Altering markets incentives- this can be altered via emission changes. An emission charge is a
fee that is imposed on polluters based on the quantity of pollution.

2. Market power

This is the ability to alter the market price of a good or service. The goal of government policy
should be to prevent or dismantle concentration of market power. This can be done trough the
relevant legislation.

3. Public goods

These goods should be provided by some public authority. As the benefits of public goods are
indivisible, the state should make people share the cost of public goods so that everyone is made
better off. Due to the free rider problems some services such as defense should be provided free
to every user and can be provided by government through taxes.

4. Equity

Government intervention may be needed to redistribute income if the market fails to reflect our
notions of fairness. This can be done through transfer of payments such as social security,
welfare and unemployment benefits.

2.5 Efficient output of public goods/ optimum level of production of public goods

What constitutes optimum resources allocation in case of public goods? In the case of public
goods a certain quantity is consumed by everyone. Therefore the demand for any quantity of that
public good is the sum of prices that each individual consumer is willing to pay for that quantity.
In this way, the community’s demand curve for a public good is the summation of demand
curves of the individual consumers which represent the sum of all marginal benefits received by
all consumers.

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Each demand curve implies the marginal benefit that the consumer gets from consuming every
level of production. The optimum level of production of a public good is determined by equating
the sum of the marginal benefits to the marginal cost of production i.e. the optimum quantity is
that quantity for which the marginal cost of the last unit is equal to the sum of prices that all
consumers are willing to pay for that unit.

Summary Of The Topic

 Theory Of Private And Social /Public Goods
 The Free Rider Problem
 Market Failure
 Efficient Output Of Public Goods/ Optimum Level Of Production Of Public Goods

Revision Questions
i. Describe a public good

ii. Explain the characteristics of public goods and private goods

iii. Explain free rider problem and its solutions

iv. Explain the causes of market failure and the solutions

v. Explain the optimum output of social goods

Further References
i. M. L Jighan (2006), Public Finance And International Trade, Vrinda Publications P
Limited, Delhi India Pages 7-10
ii. Harvey S Rosen (1999) Public Finance Irvin/Mcgraw Hill New York Usa Pages 61-83
iii. John Quigley, E. Smolensky (1994) President And Fellows Of Havard University Usa
Pages 93-120

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 3.0 EXTERNALITIES/ EXTERNAL EFFECT

General objective

By the end of the lesson the learner should be able to explain the meaning and implications
of externality
Specific objectives
By the end of the lesson the learner should be able to:
a) explain the meaning of externality
b) describe negative externalities and give examples
c) describe positive externalities and give examples
d) graphically illustrate external costs and benefits
e) explain the types of externalities
f) explain the solutions to externality problem
g) explain the implications of externality

3.1 Introduction

This refers to the favourable and unfavourable effects which are associated with the production
or consumption of goods. Such economic effects are also referred to as spill-over effect,
neighborhood effects or third party effects.

These externalities may either be economic gain or economic loss to other parties e.g. the setting
up of a factory in a backward region will help to develop it. This is an example of economic gain
associated with externalities. On the other hand, environmental pollution resulting from the
establishment of a paper mill in an area may be an example of economic loss associated with
externalities. This economic gain or loss cannot be priced in the market and apportioned to
particular parties i.e. it is not possible to find out how much is the benefit of a factory set up in a
backward region or exact economic loss due to air or water pollution of a paper mill.

33
Market price is fixed in terms of the internal cost of goods and services whereas social cost of
some goods and services must be borne by the society in the form of physical inconvenience and
disease.

External costs and benefits

Examples of externalities.

3.2 Negative externalities;

A negative externality is an action of a product on consumers that imposes a negative side effect
on a third party; it is "social cost". Many negative externalities (also called "external costs" or
"external diseconomies") are related to the environmental consequences of production and use.

Air pollution from burning fossil fuels causes damages to crops, (historic) buildings and public
health. The most extensive and integrated effort to quantify and monetise these impacts was in
the European ExternE project series. Anthropogenic climate change is attributed to greenhouse
gas emissions from burning oil, gas, and coal. The Stern Review on the Economics Of Climate
Change says "Climate change presents a unique challenge for economics: it is the greatest
example of market failure we have ever seen."

Water pollution by industries that adds poisons to the water, which harm plants, animals, and
humans.

34
Systemic risk describes the risks to the overall economy arising from the risks which the banking
system takes. A condition of moral hazard can occur in the absence of well-designed banking
regulation, or in the presence of badly designed regulation.

Industrial farm animal production, on the rise in the 20th century, resulted in farms that were
easier to run, with fewer and often less-skilled employees, and a greater output of uniform
animal products. However, the externalities with these farms include "contributing to the
increase in the pool of antibiotic-resistant bacteria because of the overuse of antibiotics; air
quality problems; the contamination of rivers, streams, and coastal waters with concentrated
animal waste; animal welfare problems, mainly as a result of the extremely close quarters in
which the animals are housed."

The harvesting by one fishing company in the ocean depletes the stock of available fish for the
other companies and overfishing may be the result. This is an example of a common property
resource, sometimes referred to as the Tragedy of the commons.

When car owners use roads, they impose congestion costs and higher accidents risks on all other
users.

A business may purposely underfund one part of their business, such as their pension funds, in
order to push the costs onto someone else, creating an externality. Here, the "cost" is that of
providing minimum social welfare or retirement income; economists more frequently attribute
this problem to the category of moral hazards.

Consumption by one consumer causes prices to rise and therefore makes other consumers worse
off, perhaps by reducing their consumption. These effects are sometimes called "pecuniary
externalities" and are distinguished from "real externalities" or "technological externalities".
Pecuniary externalities appear to be externalities, but occur within the market mechanism and are
not a source of market failure or inefficiency.

The consumption of alcohol by bar-goers in some cases leads to drinking and driving accidents
which injure or kill pedestrians and other drivers.

35
Shared costs of declining health and vitality caused by smoking and/or alcohol abuse. Here, the
"cost" is that of providing minimum social welfare. Economists more frequently attribute this
problem to the category of moral hazards, the prospect that a party insulated from risk may
behave differently from the way they would if they were fully exposed to the risk. For example,
an individual with insurance against automobile theft may be less vigilant about locking his car,
because the negative consequences of automobile theft are (partially) borne by the insurance
company.

The cost of storing nuclear waste from nuclear plants for more than 1,000 years (over 100,000
for some types of nuclear waste) is included in the cost of the electricity the plant produces, in
the form of a fee paid to the government and held in the Nuclear Waste Fund. Conversely, the
costs of managing the long term risks of disposal of chemicals, which may remain permanently
hazardous, is not commonly internalized in prices. The USEPA regulates chemicals for periods
ranging from 100 years to a maximum of 10,000 years, without respect to potential long-term
hazard.

3.3 Positive externalities –

Examples of positive externalities (beneficial externality, external benefit, external economy, or

Merit goods) include:

A beekeeper keeps the bees for their honey. A side effect or externality associated with his
activity is the pollination of surrounding crops by the bees. The value generated by the
pollination may be more important than the value of the harvested honey.

An individual planting an attractive garden in front of his or her house may provide benefits to
others living in the area, and even financial benefits in the form of increased property values for
all property owners.

A public organization that coordinates the control of an infectious disease preventing others in
society from getting sick.

An individual buying a product that is interconnected in a network (e.g., a video cellphone) will
increase the usefulness of such phones to other people who have a video cellphone. When each
new user of a product increases the value of the same product owned by others, the phenomenon
36
is called a network externality or a network effect. Network externalities often have "tipping
points" where, suddenly, the product reaches general acceptance and near-universal usage.

Knowledge spillover of inventions and information - once an invention (or most other forms of
practical information) is discovered or made more easily accessible, others benefit by exploiting
the invention or information. Copyright and intellectual property law are mechanisms to allow
the inventor or creator to benefit from a temporary, state-protected monopoly in return for
"sharing" the information through publication or other means.

Sometimes the better part of a benefit from a good comes from having the option to buy
something rather than actually having to buy it. A private fire department that only charged
people that had a fire, would arguably provide a positive externality at the expense of an unlucky
few. Some form of insurance could be a solution in such cases, as long as people can accurately
evaluate the benefit they have from the option.

Some studies find that home ownership creates a positive externality in that homeowners are
more likely than renters to become actively involved in the local community. A controlled study
on the topic, however, disputes that this effect is causal. Still this is often a justification given for
why, in the US, interest paid on a home mortgage is an available deduction from the income tax.

Education creates a positive externality because more educated people are less likely to engage
in violent crime, which makes everyone in the community, even people who are not well
educated, better off.

3.4 Types of externalities

There are two types namely:

Market externalities

Non-market externalities

Market externalities

This refers to those effects which can be valued in money and expressed in terms of price in the
market as determined by the forces of demand and supply.

37
Non- market externalities

This refers to those effects which cannot be expressed in terms of price in the market and cannot
be made part of the cost of production

3.5 Possible solutions to the externality problem

There are at least four general types of solutions to the problem of externalities:

 Criminalization: As with prostitution in some countries, addictive drugs, commercial

fraud, and many types of environmental and public health laws.
 Civil Tort law: For example, class action by smokers, various product liability suits.
 Government provision: As with lighthouses, education, and national defense.
 Pigovian taxes or subsidies intended to redress economic injustices or imbalances.

A Pigovian tax is a tax imposed that is equal in value to the negative externality. The result is
that the market outcome would be reduced to the efficient amount. A side effect is that revenue is
raised for the government, reducing the amount of distortionary taxes that the government must
impose elsewhere. Economists prefer Pigovian taxes and subsidies as being the least intrusive
and most efficient method to resolve externalities.

Other solutions

However, the most common type of solution is tacit agreement through the political process.
Governments are elected to represent citizens and to strike political compromises between
various interests. Normally governments pass laws and regulations to address pollution and other
types of environmental harm. These laws and regulations can take the form of "command and
control" regulation (such as setting standards, targets, or process requirements), or environmental
pricing reform (such as ecotaxes or other pigovian taxes, tradable pollution permits or the
creation of markets for ecological services). The second type of resolution is a purely private
agreement between the parties involved.

Government intervention may not always be needed. Traditional ways of life may have evolved
as ways to deal with external costs and benefits. Alternatively, democratically-run communities

38
can agree to deal with these costs and benefits in an amicable way. Externalities can sometimes
be resolved by agreement between the parties involved. This resolution may even come about
because of the threat of government action.

Ronald Coase argued that if all parties involved can easily organize payments so as to pay each
other for their actions, then an efficient outcome can be reached without government
intervention. Some take this argument further, and make the political claim that government
should restrict its role to facilitating bargaining among the affected groups or individuals and to
enforcing any contracts that result. This result, often known as the Coase Theorem, requires that

Property rights be well defined

People act rationally

Transaction costs be minimal

If all of these conditions apply, the private parties can bargain to solve the problem of
externalities.

3.6 Implications of Externality

Standard economic theory states that any voluntary exchange is mutually beneficial to both
parties involved in the trade. This is because either the buyer or the seller would refuse the trade,
if it won't benefit both. However, an exchange can cause additional effects on third parties. From
the perspective of those affected, these effects may be negative (pollution from a factory), or
positive (honey bees that pollinate the garden). Welfare economics has shown that the existence
of externalities results in outcomes that are not socially optimal. Those who suffer from external
costs do so involuntarily, while those who enjoy external benefits do so at no cost.

A voluntary exchange may reduce societal welfare if external costs exist. The person who is
affected by the negative externalities in the case of air pollution will see it as lowered utility:
either subjective displeasure or potentially explicit costs, such as higher medical expenses. The
externality may even be seen as a trespass on their lungs, violating their property rights. Thus, an
external cost may pose an ethical or political problem. Alternatively, it might be seen as a case of

39
poorly defined property rights, as with, for example, pollution of bodies of water that may belong
to no-one (either figuratively, in the case of publicly-owned, or literally, in some countries and/or
legal traditions).

On the other hand, a positive externality would increase the utility of third parties at no cost to
them. Since collective societal welfare is improved, but the providers have no way of monetizing
the benefit, less of the good will be produced than would be optimal for society as a whole.
Goods with positive externalities include education (believed to increase societal productivity
and well-being; but controversial, as these benefits may be internalized), public health initiatives
(which may reduce the health risks and costs for third parties for such things as transmittable
diseases) and law enforcement. Positive externalities are often associated with the free rider
problem. For example, individuals who are vaccinated reduce the risk of contracting the relevant
disease for all others around them, and at high levels of vaccination, society may receive large
health and welfare benefits; but any one individual can refuse vaccination, still avoiding the
disease by "free riding" on the costs borne by others.

There are a number of potential means of improving overall social utility when externalities are
involved. The market-driven approach to correcting externalities is to "internalize" third party
costs and benefits, for example, by requiring a polluter to repair any damage caused. But, in
many cases internalizing costs or benefits is not feasible, especially if the true monetary values
cannot be determined.

The monetary values of externalities are difficult to quantify, as they may reflect the ethical
views and preferences of the entire population. It may not be clear whose preferences are most
important, interests may conflict, the value of externalities may be difficult to determine, and all
parties involved may try to influence the policy responses to their own benefit. An example is the
externalities of the smoking of tobacco, which can cost or benefit society depending on the
situation. Because it may not be feasible to monetize the costs and benefits, another method is
needed to either impose solutions or aggregate the choices of society, when externalities are
significant. This may be through some form of representative democracy or other means.
Political economy is, in broad terms, the study of the means and results of aggregating those
choices and benefits that are not limited to purely private transactions.

40
Laissez-faire economists such as Friedrich Hayek and Milton Friedman sometimes refer to
externalities as "neighborhood effects" or "spillovers", although externalities are not necessarily
minor or localized.

Private and social costs: Social costs are the spillover costs to society (society pays off the costs),
while private costs are the costs given to the individual firms or producer.

3.7 Graphical Illustration Of Supply And Demand Diagrams Showing The External Costs
And Benefits

The usual economic analysis of externalities can be illustrated using a standard supply and
demand diagram if the externality can be monetized and valued in terms of money. An extra
supply or demand curve is added, as in the diagrams below. One of the curves is the private cost
that consumers pay as individuals for additional quantities of the good, which in competitive
markets, is the marginal private cost. The other curve is the true cost that society as a whole pays
for production and consumption of increased production the good, or the marginal social cost.

Similarly there might be two curves for the demand or benefit of the good. The social demand
curve would reflect the benefit to society as a whole, while the normal demand curve reflects the
benefit to consumers as individuals and is reflected as effective demand in the market.

External costs

The graph below shows the effects of a negative externality. For example, the steel industry is
assumed to be selling in a competitive market – before pollution-control laws were imposed and
enforced (e.g. under laissez-faire). The marginal private cost is less than the marginal social or
public cost by the amount of the external cost, i.e., the cost of air pollution and water pollution.
This is represented by the vertical distance between the two supply curves. It is assumed that
there are no external benefits, so that social benefit equals individual benefit.

41
Demand curve with external costs; if social costs are not accounted for price is too low to cover
all costs and hence quantity produced is unnecessarily high (because the producers of the good
and their customers are essentially underpaying the total, real factors of production.)

If the consumers only take into account their own private cost, they will end up at price Pp and
quantity Qp, instead of the more efficient price Ps and quantity Qs. These latter reflect the idea
that the marginal social benefit should equal the marginal social cost, that is that production
should be increased only as long as the marginal social benefit exceeds the marginal social cost.
The result is that a free market is inefficient since at the quantity Qp, the social benefit is less
than the social cost, so society as a whole would be better off if the goods between Qp and Qs
had not been produced. The problem is that people are buying and consuming too much steel.

This discussion implies that negative externalities (such as pollution) is more than merely an
ethical problem. The problem is one of the disjuncture between marginal private and social costs
that is not solved by the free market. It is a problem of societal communication and coordination
to balance costs and benefits. This also implies that pollution is not something solved by
competitive markets. Some collective solution is needed, such as a court system to allow parties
affected by the pollution to be compensated, government intervention banning or discouraging
pollution, or economic incentives such as green taxes.

42
External benefits

The graph below shows the effects of a positive or beneficial externality. For example, the
industry supplying smallpox vaccinations is assumed to be selling in a competitive market. The
marginal private benefit of getting the vaccination is less than the marginal social or public
benefit by the amount of the external benefit (for example, society as a whole is increasingly
protected from smallpox by each vaccination, including those who refuse to participate). This
marginal external benefit of getting a smallpox shot is represented by the vertical distance
between the two demand curves. Assume there are no external costs, so that social cost equals
individual cost.

Supply curve with external benefits; when the market does not account for additional social
benefits of a good both the price for the good and the quantity produced are lower than the
market could bear.

If consumers only take into account their own private benefits from getting vaccinations, the
market will end up at price Pp and quantity Qp as before, instead of the more efficient price Ps
and quantity Qs. These latter again reflect the idea that the marginal social benefit should equal
the marginal social cost, i.e., that production should be increased as long as the marginal social
benefit exceeds the marginal social cost. The result in an unfettered market is inefficient since at
the quantity Qp, the social benefit is greater than the societal cost, so society as a whole would be

43
better off if more goods had been produced. The problem is that people are buying too few
vaccinations.

The issue of external benefits is related to that of public goods, which are goods where it is
difficult if not impossible to exclude people from benefits. The production of a public good has
beneficial externalities for all, or almost all, of the public. As with external costs, there is a
problem here of societal communication and coordination to balance benefits and costs. This also
implies that vaccination is not something solved by competitive markets. The government may
have to step in with a collective solution, such as subsidizing or legally requiring vaccine use. If
the government does this, the good is called a merit good.

Summary Of The Topic

 Negative externalities
 Positive externalities
 Types of externalities
 Possible solutions to the externality problem
 Implications Of Externality
 Graphical Illustration Of Supply And Demand Diagrams Showing The External Costs
and benefits

Revision Questions
i. Explain the meaning of externality
ii. Describe negative externalities and give examples
iii. Describe positive externalities and give examples
iv. Graphically illustrate external costs and benefits
v. Explain the types of externalities
vi. Explain the solutions to externality problem
vii. Explain the implications of externality

44
Further References
i. M. L Jighan ( 2006), Public Finance And International Trade, Vrinda Publications P
Limited, Delhi India Pages 10-15
ii. Musgrave (2005) Public Finance In Theory And Practice, Tata Mcgraw-Hill New Delhi
Pages 42-58
iii. David N Hyman (2005) Public Finance, A Contemporary Application Of Theory To
Policy Thomson Learning,Ohio Usa Pages 96-138
iv. Harvey S Rosen (1999) Public Finance Irvin/Mcgraw Hill New York Usa Pages 85-110

45
 4.0 EQUITY AND INCOME DISTRIBUTION

General objective

By the end of the lesson the learner should be able to explain the meaning and
implications of equity in income distribution

Specific objectives

By the end of the lesson the learner should be able to

i. explain the meaning of equity in income distribution

ii. explain the perspectives on equity

iii. explain the differences between vertical and horizontal equity

iv. explain income inequality

v. explain the causes and mitigating factors of inequality

vi. explain the concept of and types of redistribution of wealth

vii. distinguish between equity and equality in taxation

4.1 Equitable distribution of income

There is no commonly accepted benchmark for what constitutes an equitable distribution of

opportunity in an economy. Whether elements of the tax-transfer system improve equity or not
depends on a range of judgements. People put different degrees of emphasis on different
priorities of a tax-transfer system and these priorities can sometimes conflict. For example, some
people believe that high marginal tax rates on capital improve equity since they may help to
redistribute income from rich to poor. Others believe that high rates harm equity because they
may reduce the level of investment and capital income formation, and through that channel result
in lower growth in wages, as well as imposing a higher tax rate on the people who decide to save
rather than consume.

46
4.2 Perspectives on equity

There are a number of perspectives on equity that people use to inform their assessments of the
tax-transfer system, including:

Inter-temporal equity, which looks at how the tax-transfer system impacts on longer term
decisions of individuals, such as work, saving, family structure and education. Equity therefore
requires some consideration of dynamic or future lifetime resources;

Intergenerational equity, which looks at how the decisions of today's individuals affect future
generations. In general, this includes the objective of ensuring that the wellbeing of future
generations is at least no lower than the current generation;

Spatial equity, which focuses on the degree to which the tax-transfer system should deliver
individuals in different geographic areas similar consumption opportunities, at least for certain
types of goods and services;

The opportunity and freedom of individuals to participate in society and to achieve the things
they value. Considered here is the role of the tax-transfer system in providing individuals with
capabilities and opportunities rather than specific outcomes

'Rights based' frameworks, which emphasise that the tax-transfer system should not violate
fundamental rights and the procedural fairness necessary to sustain a liberal democracy. For
example, the tax-transfer system needs to treat issues of privacy carefully and certain forms of
inequality such as direct discrimination on the basis of race, gender or sexual preference —
should be ruled out altogether.

While equity can mean different things to different people, there are some common concepts
often used to discuss whether the tax-transfer system contributes to equity, or not, according to
different equity perspectives; in particular, the beneficiary principle and the ability to pay
principle.

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4.3 The beneficiary principle and ability to pay

The beneficiary principle states that people should pay tax according to the benefits they receive
from spending funded by tax revenue, regardless of their income. The principle could be
appropriate for funding the public provision of services where it is possible for a user charge to
apply (such as public transport, electricity and water). There are, however, a range of
government-provided services where access to the service for one person has no impact on
access for others: the services are 'non-rival in consumption'. Examples include national defence,
law and order, public health services and fire protection. The marginal cost of providing such
services is usually close to zero, so excluding some people from consuming them can be
inefficient. The beneficiary principle can, nevertheless, be used to justify higher tax burdens on
groups that benefit disproportionately from public goods. For example, the principle may support
progressive income taxation if higher income earners use relatively more public goods. It may
also support taxing foreigners through company tax, as they benefit from government funded
infrastructure, legal institutions, and a skilled workforce.

The ability to pay principle states that those who are more capable of bearing the burden of taxes
should pay more taxes than those with less ability to pay. For transfers, this principle suggests
assistance should increase with the level of disadvantage. This principle requires a measure of
ability to pay, such as overall wealth, income, or consumption. Ability to pay may vary
considerably depending on the measure chosen. For example, a taxpayer's ability to pay,
measured by property and financial wealth, may differ significantly from his or her ability to pay
measured by income. A taxpayer who works for many years and then retires may accumulate a
significant amount of wealth relative to others, typically in the form of owner-occupied housing,
but have a relatively low income.

4.4 Horizontal and vertical equity

The concepts of horizontal and vertical equity are refinements of the ability to pay principle.
Horizontal equity requires individuals in the same economic position to be treated the same by
the tax-transfer system. Vertical equity is generally considered to mean that individuals in
different economic positions should be treated differently, usually with those having greater
economic capacity paying more.

48
Different perspectives on the 'same economic position' can lead to different judgements about
whether a policy is horizontally equitable. Consider two individuals who earn the same amount
of income but do so from different sources, such as wages and dividends. Taxing these two
individuals in an equivalent manner may be considered horizontally equitable by some but others
may consider it appropriate to tax wages less as this income is derived from an individual's work
effort while dividend income may be derived from inherited wealth.The basis for determining
'capacity to pay' differs fundamentally between the tax system focus on the individual and the
transfer system focus on the family.

Vertical equity deals with differences in ability to pay. Subjective judgments about vertical
equity are reflected in debates about the overall fairness of the following three types of personal
tax rate structure:

Progressive tax rates — where the tax liability as a percentage of a taxpayer's income
increases as their income increases;

Proportional tax rates — where the tax liability as a percentage of income stays the
same, regardless of the taxpayer's income; and

Regressive tax rates — where the tax liability as a percentage of a taxpayer's income
declines as their income increases.

4.5 Economic and Income Inequality

Economic inequality (or "wealth and income differences") comprises all disparities in the
distribution of economic assets and income. The term typically refers to inequality among
individuals and groups within a society, but can also refer to inequality among countries.

The issue of economic inequality is related to the ideas of equality of outcome, equality of
opportunity and ideal wealth distribution. The main instrument which diminishes economic
inequality, progressive taxation, has been demonstrated to be effective in international
comparisons of income compression and wealth distribution.

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Economic inequality has existed in a wide range of societies and historical periods; its nature,
cause and importance are open to broad debate. A country's economic structure or system (for
example, capitalism or socialism), ongoing or past wars, and differences in individuals' abilities
to create wealth are all involved in the creation of economic inequality.

There are various numerical indices for measuring economic inequality. eg the Gini coefficient,

Income inequality describes the extent to which income is distributed unevenly among residents
of an area. High levels of inequality indicate that a small number of people receive most of the
total income, and that most people receive only a small share of the total.

4.6 Causes of inequality

There are many reasons for economic inequality within societies. These causes are often inter-
related. Acknowledged factors that impact economic inequality include:

 The labour market

 Innate ability
 Education
 Computerization/growing technology
 Globalization
 Culture
 Wealth condensation
 Diversity of preferences
 Development patterns
 Inflation

a ) The labour market

A major cause of economic inequality within modern market economies is the determination of
wages by the market. Inequality is caused by the differences in the supply and demand for
different types of work. In a purely capitalist mode of production (i.e. where professional and
labor organizations cannot limit the number of workers) the workers wages will not be controlled

50
by these organizations, nor by the employer, but rather by the market. Wages work in the same
way as prices for any other good. Thus, wages can be considered as a function of market price of
skill. And therefore, inequality is driven by this price. Under the law of supply and demand, the
price of skill is determined by a race between the demand for the skilled worker and the supply
of the skilled worker. We would expect the price to rise when demand exceeds supply, and vice
versa. Employers who offer a below market wage will find that their business is chronically
understaffed. Their competitors will take advantage of the situation by offering a higher wage to
snatch up the best of their labor.

A job where there are many willing workers (high supply) competing for a job that few require
(low demand) will result in a low wage for that job. This is because competition between
workers drives down the wage.

A job where there are few able or willing workers (low supply), but a large need for the positions
(high demand), will result in high wages for that job. This is because competition between
employers for employees will drive up the wage. Examples of this would include jobs that
require highly developed skills, rare abilities, or a high level of risk. Competition amongst
employers tends to drive up wages due to the nature of the job, since there is a relative shortage
of workers for the particular position.

The final results amongst these supply and demand interactions is a gradation of different wages
representing income inequality within society.

b) Innate ability

Many people believe that there is a correlation between differences in innate ability, such as
intelligence, motivation, strength, or charisma, and an individual's wealth. Relating these innate
abilities back to the labor market suggests that such abilities are in high demand relative to their
supply and hence play a large role in increasing the wage of those who have them. Otherwise,
such innate abilities might also affect an individual's ability to operate within society in general,
regardless of the labor market.

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c) Computerization/Innovative Technology

Another factor that contributed to the already growing inequality in the 20th century was
computerization and growth in technology with electricity replacing manpower. With this
growing change in technology, the countries experienced increasing demand for skilled workers
to use computers and operate the electrical inventions. This resulted in a rightward shift in the
Demand for Skilled Labor Supply, and this created an increase in the relative wages of the
skilled compared to the wages of the unskilled workers. Such a change in wages added to the
inequality that was already present.

d) Education

One important factor in the creation of inequality is variation in individuals' access to education.
Education, especially in an area where there is a high demand for workers, creates high wages
for those with this education. As a result, those who are unable to afford an education, or choose
not to pursue education, generally receive much lower wages.

e) Globalization

Trade liberalization may shift economic inequality from a global to a domestic scale. When rich
countries trade with poor countries, the low-skilled workers in the rich countries may see
reduced wages as a result of the competition, while low-skilled workers in the poor countries
may see increased wages.

f) Culture and religion

The existence of different cultures and religions within a society is also thought to contribute to
economic inequality. Culture and religion are thought to play a role in creating inequality by
either encouraging or discouraging wealth-acquiring behavior, and by providing a basis for
discrimination. In many countries individuals belonging to certain racial and ethnic minorities
are more likely to be poor. Proposed causes include cultural differences amongst different races,
an educational achievement gap, and racism.

52
g) Diversity of preferences

Related to cultural issues, diversity of preferences within a society often contributes to economic
inequality. When faced with the choice between working harder to earn more money or enjoying
more leisure time, equally capable individuals with identical earning potential often choose
different strategies. This leads to economic inequality even in societies with perfect equality in
abilities and circumstances. The trade-off between work and leisure is particularly important in
the supply side of the labor market in labour economics.

Likewise, individuals in a society often have different levels of risk aversion. When equally-able
individuals undertake risky activities with the potential of large payoffs, such as starting new
businesses, some ventures succeed and some fail. The presence of both successful and
unsuccessful ventures in a society results in economic inequality even when all individuals are
identical.

h) Development patterns

Simon Kuznets argued that levels of economic inequality are in large part the result of stages of
development. Kuznets saw a curve-like relationship between level of income and inequality, now
known as Kuznets curve. According to Kuznets, countries with low levels of development have
relatively equal distributions of wealth. As a country develops, it acquires more capital, which
leads to the owners of this capital having more wealth and income and introducing inequality.
Eventually, through various possible redistribution mechanisms such as social welfare programs,
more developed countries move back to lower levels of inequality

i) Wealth condensation

Wealth condensation is a theoretical process by which, under certain conditions, newly-created

wealth concentrates in the possession of already-wealthy individuals or entities. According to
this theory, those who already hold wealth have the means to invest in new sources of creating
wealth or to otherwise leverage the accumulation of wealth, thus are the beneficiaries of the new
wealth. Over time, wealth condensation can significantly contribute to the persistence of
inequality within society.

53
Related to wealth condensation are the effects of intergenerational inequality. The rich tend to
provide their offspring with a better education, increasing their chances of achieving a high
income. Furthermore, the wealthy often leave their offspring with a hefty inheritance, jump-
starting the process of wealth condensation for the next generation

j) Inflation

Some economists have theorized that high inflation, caused by a country's monetary policy, can
contribute to economic inequality. This theory argues that inflation of the money supply is a
coercive measure that favors those who already have an earning capacity, disfavoring those on
fixed income or with savings, thus aggravating inequality. They cite examples of correlation
between inflation and inequality and note that inflation can be caused independently by "printing
money", suggesting causation of inequality by inflation.

4.7 Mitigating factors of inequality

Many factors constrain economic inequality. They may be divided into two classes namely:

Government sponsored

Market driven.

a) Government sponsored

Typical government initiatives to reduce economic inequality include:

Public education: increasing the supply of skilled labor and reducing income inequality
due to education differentials.

Progressive taxation: the rich are taxed proportionally more than the poor, reducing the
amount of income inequality in society.

Minimum wage legislation: raising the income of the poorest workers (though probably
increasing unemployment).

54
 Nationalization or subsidization of products: providing goods and services that everyone
needs cheaply or freely (such as food, healthcare, and housing), governments can
effectively raise the purchasing power of the poorer members of society.

These provisions may lower inequality, but have sometimes resulted in increased economic
inequality (as in the Soviet Union, where the distribution of these government benefits was
controlled by a privileged class).

b) Market driven

Market forces outside of government intervention that can reduce economic inequality include:

a) Propensity to spend: with rising wealth and income, a person must spend more. In an
extreme example, if one person owned everything, they would immediately need to hire
people to maintain their properties, thus reducing the wealth concentration.
b) Unionization: although not a market force, per se, labor organizations may reduce
inequality by negotiating standard pay rates (though probably increasing unemployment).
As union power has declined, and performance related pay has become more widespread,
economic inequality has mirrored productive inequality.

4.8 Redistribution of wealth

Redistribution of wealth is the transfer of income, wealth or property from some individuals to
others caused by a social mechanism such as taxation, monetary policies, welfare,
nationalization, charity or tort law. Most often it refers to progressive redistribution, from the
rich to the poor, although it may also refer to regressive redistribution, from the poor to the rich.
The desirability and effects of redistribution are actively debated on ethical and economic
grounds.

4.9 Types of redistribution

Income redistribution occurs in some form in most democratic countries. Progressive income
redistribution diminishes the amount of income one individual or corporation receives, while at
the same time benefitting others. In a progressive income tax system, a high income earner will

55
pay a higher tax rate than a low income earner. A steeper progressive income tax results in more
equal distribution of income and wealth across the board.

Property redistribution is a term applied to various policies involving taxation or nationalization

of property, or of regulations ordering owners to make their property available to others. Public
programs and policy measures involving redistribution of property include eminent domain, land
reform and inheritance tax.

Arguments in favour of redistribution

The arguments include;

a) An ethical basis for redistribution is the concept of distributive justice and wealth.
b) One premise of redistribution is that money should be distributed to benefit the poorer
members of society, and that the rich have an obligation to assist the poor, thus creating a
more financially egalitarian society
c) Another argument is that the rich exploit the poor or otherwise gain unfair benefits, and thus
should return some of those benefits.
d) Another argument is that a larger middle class benefits an economy by enabling more people
to be consumers, while providing equal opportunities for individuals to reach a better
standard of living.
e) Some proponents of redistribution argue that capitalism results in an unequal wealth
distribution.
f) They also argue that economic inequality contributes to crime.
g) There is also the issue of equal opportunity to access services such as education and health
care. Studies show that a lower rate of redistribution in a given society increases the
inequality found among future incomes, due to restraints on wealth investments in both
human and physical capital

4.10 Difference between Equity And Equality In Taxation

Equity means justice or fairness. It is useful to distinguish between

56
Horizontal equity requires equals are treated equally e.g. people in the same income group
should be taxed at the same rate. (Equality)
Vertical equity requires unequal treatment of unequals to promote greater fairness eg higher
income groups taxed at higher rates. (Equity)

Summary of The Topic

 Equitable distribution of income
 Perspectives on equity
 The beneficiary principle and ability to pay
 Horizontal and vertical equity
 Economic And Income Inequality
 Causes of inequality
 Mitigating factors of inequality
 Redistribution of wealth
 Types of redistribution
 Difference Between Equity And Equality In Taxation

Revision Questions
i. Explain the meaning of equity in income distribution
ii. Describe the perspectives on equity
iii. Explain the differences between vertical and horizontal equity
iv. Explain income inequality
v. Explain the causes and mitigating factors of inequality
vi. Explain the concept of and types of redistribution of wealth
vii. Distinguish between equity and equality in taxation

57
Further References

i. Musgrave (2005) Public Finance In Theory And Practice, Tata Mcgraw-Hill New Delhi
Pages 73-85
ii. David N Hyman (2005) Public Finance, A Contemporary Application Of Theory To
Policy Thomson Learning,Ohio Usa Pages 70-75
iii. Harvey S Rosen (1999) Public Finance Irvin/Mcgraw Hill New York Usa Pages 142-161

58
 5.0 PUBLIC CHOICE THEORY

General objective

By the end of the lesson the learner should be able to explain the meaning and implications
of public choice theory
Specific objectives
By the end of the lesson the learner should be able to
a) describe the public choice theory
b) explain the perspectives of the public choice theory
c) explain the remedies of the public choice theory
d) explain rent seeking and bureaucracy as they relate to the public choice theory

5.1 Introduction

In economics, public choice theory is the use of modern economic tools to study problems that
are traditionally in the area of political science.

In particular, it studies the behavior of politicians and government officials as mostly self-
interested agents and their interactions in the social system either as such or under alternative
constitutional rules. These can be represented a number of ways, including standard constrained
utility maximization, game theory, or decision theory. Public choice analysis has roots in positive
analysis ("what is") but is often used for normative purposes ("what ought to be"), to identify a
problem or suggest how a system could be improved by changes in constitutional rules.

5.2 Origins and formation

The modern literature in Public Choice began with Duncan Black, who in 1948 identified the
underlying concepts of what would become median voter theory. He also wrote The Theory of
Committees and Elections in 1958. Gordon Tullock refers to him as the "father of public choice
theory".

59
James M. Buchanan and Gordon Tullock coauthored The Calculus of Consent: Logical
Foundations of Constitutional Democracy (1962), considered one of the landmark works that
founded the discipline of public choice theory.

5.3 Perspective

Public choice theory attempts to look at governments from the perspective of the bureaucrats and
politicians who compose them, and makes the assumption that they act based on Budget-
maximizing model in a self-interested way for the purpose of maximizing their own economic
benefits (e.g. their personal wealth). The theory aims to apply economic analysis (usually
decision theory and game theory) to the political decision-making process in order to reveal
certain systematic trends towards inefficient government policies.

5.4 Claims of the Public choice theory

One of the basic claims that results from public choice theory is that good government policies in
a democracy are an underprovided public good, because of the rational ignorance of the voters.
Each voter is faced with a tiny probability that his vote will change the result of the elections,
while gathering the relevant information necessary for a well-informed voting decision requires
substantial time and effort. Therefore, the rational decision for each voter is to be generally
ignorant of politics and perhaps even abstain from voting. Rational choice theorists claim that
this explains the gross ignorance of most citizens in modern democracies as well as low voter
turnout. Rational abstention does, however, create the "Paradox of voting" whereby strict costs
benefit analysis implies that nobody should vote.

Special interests groups

While good government tends to be a pure public good for the mass of voters, there may be
many advocacy groups that have strong incentives for lobbying the government to implement
specific policies that would benefit them, potentially at the expense of the general public. For
example, lobbying by the sugar manufacturers might result in an inefficient subsidy for the
production of sugar, either direct or by protectionist measures. The costs of such inefficient
policies are dispersed over all citizens, and therefore unnoticeable to each individual. On the
other hand, the benefits are shared by a small special-interest group with a strong incentive to

60
perpetuate the policy by further lobbying. Due to rational ignorance, the vast majority of voters
will be unaware of the effort; in fact, although voters may be aware of special-interest lobbying
efforts, this may merely select for policies which are even harder to evaluate by the general
public, rather than improving their overall efficiency. Even if the public were able to evaluate
policy proposals effectively, they would find it infeasible to engage in collective action in order
to defend their diffuse interest. Therefore, theorists expect that numerous special interests will be
able to successfully lobby for various inefficient policies. In public choice theory, such scenarios
of inefficient government policies are referred to as government failure , a term akin to market
failure from earlier theoretical welfare economics.

5.5 Remedies for the public choice problem

Many proposals have been advanced for reducing what is often seen as excessive or improper
influence on public choices by those who invest most to influence them. From game theory we
have the insight that a winning strategy in competitive games should have a random component
so that the opponent can't anticipate one's moves. This is confirmed by the historical resort to
having decisions made by officials selected at random, perhaps with a complex process of
intermediate qualifying steps, called sortition. That is what is done in countries using a trial jury
selected at random.

5.6 Areas related to public choice theory

Bureaucracy

Rent-seeking

a) Bureaucracy

Another major sub-field is the study of bureaucracy. The usual model depicts the top bureaucrats
as being chosen by the chief executive and legislature, depending on whether the democratic
system is presidential and parliamentary. The typical image of a bureau chief is a person on a
fixed salary who is concerned with pleasing those who appointed him. The latter have the power
to hire and fire him more or less at will. The bulk of the bureaucrats, however, are civil servants
whose jobs and pay are protected by a civil service system against major changes by their

61
appointed bureau chiefs. This image is often compared with that of a business owner whose
profit varies with the success of production and sales, who aims to maximize profit, and who can
hire and fire employees at will.

b) Rent-seeking

A field that is closely related to public choice is "rent-seeking". This field combines the study of
a market economy with that of government. Thus, one might regard it as a "new political
economy." Its basic thesis is that when both a market economy and government are present,
government agents are a source of numerous special market privileges. Both the government
agents and self-interested market participants seek these privileges in order to partake in the
monopoly rent that they provide. When such privileges are granted, they reduce the efficiency of
the economic system. In addition, the rent-seekers use resources that could otherwise be used to
produce goods that are valued by consumers.

Rent-seeking is broader than Public Choice in that it applies to autocracies as well as

democracies and, therefore, is not directly concerned with collective decision-making. However,
the obvious pressures it exerts on legislators, executives, bureaucrats, and even judges are factors
that public choice theory must account for in its analysis of collective decision-making rules and
institutions. Moreover, the members of a collective who are planning a government would be
wise to take prospective rent-seeking into account

Summary of the Topic

 Origins and formation of public choice theory

 Perspective of public choice theory

 Claims of the Public choice theory

 Remedies for the public choice problem

 Areas related to public choice theory

62
 Review Questions

i. Describe the public choice theory

ii. Describe the perspectives of the public choice theory
iii. Explain the remedies of the public choice theory
iv. Distinguish between rent seeking and bureaucracy as they relate to the public
choice theory

Further References

i. David N Hyman (2005) Public Finance, A Contemporary Application Of Theory To

Policy Thomson Learning,Ohio Usa Pages 170-216
ii. Harvey S Rosen (1999) Public Finance Irvin/Mcgraw Hill New York Usa Pages 112-140
iii. John Quigley, E. Smolensky (1994) President And Fellows Of Havard University Usa
Pages 126-164

63
 6.0 BEHAVIOURAL RESPONSES TO TAXATION

General objective

By the end of the lesson the learner should be able to explain the behavioral responses of
taxation on the economy

Specific objectives

By the end of the lesson the learner should be able to

a) explain the effects of taxation on the ability to work and save

b) explain the effects of taxation on the desire to work and save

c) explain the effects of taxation on the composition and pattern of production

d) explain the effects of taxation on the distribution of income

6.1 Introduction

Every tax system produces various types of consequences on production, distribution,

consumption and the level of economic activity. The effects may be food or bad, but "the best
system of taxation from the economic point is that which has the best, or the least bad, economic
effects," according to Dr Dalton. The behavioural responses to taxation can be examined by
analyzing the various effects to taxation as discussed below.

6.2 Effects Of Taxation On Production

Dalton has studied the effects of taxation on production under three categories
On the ability to work and save
On the desire to work and save.
On the composition and pattern of production.

Let us analyze how taxation affects production through these factors.

64
6.2.1 Ability to work and save.
Taxes which lower the efficiency of the taxpayers adversely affect their ability to work and
hence production. When taxes are levied, they reduce the purchasing power of the people who
are forced to cut down expenditures on necessaries, comforts and luxuries, this effect is more
pronounced in the case of the lower and middle income groups that on the upper income groups.
People in the lower and middle income groups reduce expenditure on necessaries of efficiency
(such as milk) when taxes are imposed on necessaries of life. Similarly, taxes on conventional
necessaries like cigarettes also force people to reduce expenditure on necessaries of efficiency,
and even on medical facilities and education of children. This effect is not peculiar in the case of
commodity taxation alone. It is also to be found in the case of progressive income tax which
directly reduces the income of the taxpayers and thus adversely affect their ability to work, and
consequently production. But the ability to work or the rich is not affected by taxation because
they can afford to buy whatever they want to.

Taxes also adversely affect the ability to save. If a taxpayer maintains the same standard of
living after the imposition of taxes, and does not reduce his consumption expenditure on goods
accordingly, he will save less or may not save at all. Since saving depends upon income, all
taxes reduce the ability to save of the higher income groups more than that of the lower income
groups because the saving-margins of the former are larger and that of the latter smaller.

6.2.2 Desire to work and save.

Taxes also affect production through the desire to work and save of the taxpayers. According
to Dalton, "The effects of any particular tax upon desire to work and save depend partly on the
nature of tax and partly on the nature of individual reaction to taxation." We analyse the effects
of taxation on the desire to work and save in terms of these two factors.

The nature of taxes

Moderate commodity taxes do not adversely affect the incentive to work and save and even the
production of taxed commodities. But if heavy commodity taxes are imposed, they will raise the
prices of commodities, reduce their demand, and bring a fall in their production.

65
On the other hand, some direct taxes do not have any effect on the desire to work and save, and
on expenditure. Windfalls or unexpected gains from war profits, inflation, increase in land
values, or from inheritances are unearned incomes. Taxes on them are not felt by the recipients
of such gains. Hence they do not adversely affect the desire to work and save similarly, a tax on
monopoly profit does not reduce the willingness to work, save, and produce on the part of the
monopolist. His interest lies in maximizing his profit. So he will continue to work, save, invest,
and produce so long as he earns some profit. Further, an expenditure tax discourages
expenditure rather than the desire to work, save, and produce. In fact, the latter is encouraged.

But highly progressive income tax, corporation tax, and wealth tax will discourage the
willingness to work, save and invest. These adversely affect business and production. It the
inputs are also taxed heavily, the cost of production and prices of commodities will increase,
thereby adversely affecting their demand and production. on the other hand, moderate rates of
taxes on income, corporate profit, wealth, and on factors of production (which can be easily
passed on to the consumers by the producers) have little adverse effect on the incentives to work
and save and hence on production.

The nature of individual reaction

The immediate reaction of a taxpayer to the announcement of tax proposals in a budget is to
adversely affect his willingness to work and save. This is what Pigou called the announcement
effect to taxation. But this effect is not uniform on all tax payers. "Any person's reaction to
taxation is governed by the elasticity of his demand for income," according to Dr Dalton.

The elasticity of demand for income refers to the intensity of desire for obtaining a particular
income on the part of a person. A person's demand for income is elastic when he is not anxious
to maintain a certain minimum level of that level. Suppose a person's salary is sh 15000 per
month and he is required to pay sh 150 per month in the form of income tax. His demand for
income is said to be elastic if he is not prepared to do some extra work in order t compensate for
the reduction in his income to the tune of sh 150 paid as the tax. The demand for his income is
said to be inelastic if he works to earn at least this much so as to maintain his income at sh
15000per month.

66
Thus the imposition of a tax will retard the desire to work and save if a person's demand for
income is elastic. On the other hand, if the demand for income is inelastic, the desire to work
and save will be encouraged. In the former case, production will be adversely affected and in the
latter case it will be favourably affected.

The elasticity of demand for income differs with individuals depending upon their
circumstances. But generally the elasticity of demand for income is inelastic. This is because
people like to maintain a minimum standard of living, have strong desire to save for the future,
or for running a business of their own, or for acquiring power. Prestige and distinction, or for
deriving satisfaction from having more income and wealth than others. In the case of such
persons, whenever the rates of taxation are raised there is greater effort on their part to increase
their incomes.

6.2.3 The composition and pattern of production.

Taxation affects the composition and pattern of production through the diversion of resources
between different industries and places. Such diversions may be beneficial or harmful.

Taxes on luxury goods and intoxicants raise their prices, reduce their demand and hence their
production. As a result, factors, factors of production engaged in manufacturing such socially
undesirable commodities shift to the production of other socially useful commodities.

In regions where tax concessions and exemptions are granted to industries, resources flow into
them from those regions where the rates of taxation are high. Such diversions take place in the
form of establishment of new industries. This leads to the opening up and development of new
regions which provide large employment opportunities to the people, and increase production
and income.

Similarly, when protection is granted to certain domestic industries in the form of grants,
bounties, import duties, tax concessions and exemptions, etc., there is diversion of resources

67
from non-priority industries to the protected industries. This will lead to increased production
within the country.

These may be called the beneficial effects of diversion of resources if heavy taxes are imposed
on necessaries. Prices of such articles will rise, their demands will re reduced and production
will be adversely affected. This will lead to the diversion of resources to other non-essential
articles having low rates to taxation.

Again, heavy taxation in the county which leaves little for the investors will lead to the flight of
capital to foreign countries. Prices of such articles will rise, their demand will be reduced and
production will be adversely affected. This will lead to the diversion of resources to other non-
essential articles having low rates of taxation.

Again, heavy taxation in the country which leaves little for the investors will lead to the flight of
capital to foreign countries. This will adversely affect local industries whose production will all
due to the lack of capital.

So taxation affects the composition and pattern of production in a country through the diversion
of resources.

6.3 Effects of taxation on distribution

One of the important objectives of taxation is to reduce the gap between the rich and the poor.
Taxes levies with this motive are known as redistributive taxes. The effects of taxation on
distribution depend upon the nature of taxation and the types of taxes.

The nature of taxation.

Taxes which are regressive or proportional in character increase inequalities of income and
wealth, a regressive tax is one which falls more heavily on smaller incomes, such as poll tax,
sales tax, tax on necessaries, etc. A proportional tax is one which is imposed on all incomes at a
flat rate. Such taxes adversely affect the lower income groups and favour the high income

68
groups. Thus from the point of view of distribution, the best taxes are those which are
progressive in nature. The rates of progressive taxes increase with the increase in the income
and wealth of the people. Accordingly, the rich are required to pay more and the lower income
groups less, while people below the minimum taxable limit are totally exempted form taxation.

Types of Taxes.
Types of taxes – direct and indirect – also affect the distribution of income and wealth.

Indirect taxes on necessaries, such as sales tax and excise duties, are regressive in nature because
the lower incomes groups spend a larger percentage of their incomes on such articles while the
higher income groups spend a smaller percentage on them. Thus taxes on necessaries raise the
prices of such commodities and reduce their consumption on the part of the masses and thus
increase inequalities.

On the other hand, taxation of luxuries with differentiation in rates affects the rich most. This
means that higher-priced goods may be taxed at higher rates so that there is a broad element of
progression. Thus high rate on luxuries and low rate on articles for common consumption have
beneficial redistributive effects. Similar is the case with heavy import duties on luxury article.

Highly progressive direct taxation of income and wealth has the effect of reducing the
accumulation of income and wealth by the rich. Progressive taxation of income, gifts,
inheritances, Property or wealth will reduce the concentration of income and wealth in the hands
of the few rich. But such taxes should be so levied as not to adversely affect productive
investment.

Summary Of The Topic

 Effects Of Taxation On Production
 Ability to work and save.
 Desire to work and save.
 The composition and pattern of production.
 Effects of taxation on distribution

69
 Revision Questions
i. Explain the effects of taxation on the ability to work and save

ii. Explain the effects of taxation on the desire to work and save

iii. Explain the effects of taxation on the composition and pattern of production

iv. Describe the effects of taxation on the distribution of income

FURTHER REFERENCES

i. H.L Bhatia (2004) Public Finance.Vikas Publishing Housepvt Limited, New Delhi India
Pages 159-192
ii. Musgrave (2005) Public Finance In Theory And Practice, Tata Mcgraw-Hill New Delhi
Pages 297-313
iii. David N Hyman (2005) Public Finance, A Contemporary Application Of Theory To
Policy Thomson Learning,Ohio Usa Pages 503-580

70
 SAMPLE CAT

Instructions

Answer three questions

Question One
i. Explain the scope of public finance 2mks
ii. Explain the differences between public finance and private finance 5mks
iii. Explain the functions of public finance in developing nations. 5mks
iv. Explain the characteristics of public goods 3mks
Question Two
i. Explain the causes of market failure and the solutions 5mks
ii. Explain the optimum output of social goods 5mks
iii. Explain the meaning of equity in income distribution 5mks
Question Three
i. Explain the meaning of externality 2mks
ii. Describe negative externalities and give 2 examples 3mks
iii. Describe positive externalities and give 2 examples 3mks
iv. Graphically illustrate external costs and benefits 5mks
v. Explain the solutions to externality problem 2mks
Question Four
i. Describe the public choice theory 2mks
ii. Explain the remedies of the public choice theory 3mks
iii. Distinguish between rent seeking and bureaucracy as they relate to the public choice
theory 5mks
iv. Explain free rider problem and its solutions 5mks
Question Five
i. Distinguish between progressive and proportional taxes. Which one would you prefer
and why? 5mks
ii. Explain a progressive tax. Give its merits 3mks
iii. Distinguish between direct and indirect taxes. How do they deliver in their equity effects.
5mks
iv. Explain the differences between vertical and horizontal equity 2mks

71
 7.0 TAX INCIDENCE

General objective

By the end of the lesson the learner should be able to explain the meaning and implications
of tax incidence

Specific objectives

By the end of the lesson the learner should be able to

a) explain the meaning tax incidence

b) explain tax incidence in the case of inelastic supply and elastic demand

c) explain tax incidence in the case of elastic supply and elastic demand

d) explain tax incidence in the case of inelastic demand and elastic supply

e) graphically illustrate tax incidence

f) explain the macroeconomic perspective on tax incidence

7.1 Introduction

In economics, tax incidence is the analysis of the effect of a particular tax on the distribution of
economic welfare. Tax incidence is said to "fall" upon the group that, at the end of the day, bears
the burden of the tax. The key concept is that the tax incidence or tax burden does not depend on
where the revenue is collected, but on the price elasticity of demand and price elasticity of
supply.

Initially, the incidence of all labour related taxes such as income tax contributions falls on
employers. This must be so at the margin since the employee must receive more net of tax ie
take-home than they can receive from the alternative, such as welfare benefit payments. The tax
surcharge may be as high as 80%.

72
In that all business taxes reduce profitability, and in accordance with the principles set out by the
Physiocrats, they reduce the amount of rent that the business can pay and thus the incidence falls
on the landowner. The land owner may be the business itself but the effect is to cut into that part
of the revenue stream that consists of land rental value. A secondary effect is that locations,
where, in the absence of tax land values would be low, become sub-marginal when the taxes are
imposed ie viable economic activity cannot take place at those locations.

7.2 Illustration of tax incidence

Imagine a sh1 tax on every barrel of apples an apple farmer produces. If the product (apples) is
price inelastic to the consumer (whereby if price rose, a small demand loss would be accounted
for by the extra revenue), the farmer is able to pass the entire tax on to consumers of apples by
raising the price by sh 1. In this example, consumers bear the entire burden of the tax; the tax
incidence falls on consumers. On the other hand, if the apple farmer is unable to raise prices
because the product is price elastic (if prices rose, more demand would be lost than extra revenue
gained), the farmer has to bear the burden of the tax or face decreased revenues: the tax
incidence falls on the farmer. If the apple farmer can raise prices by an amount less than sh 1,
then consumers and the farmer are sharing the tax burden. When the tax incidence falls on the
farmer, this burden will typically flow back to owners of the relevant factors of production,
including agricultural land and employee wages.

Where the tax incidence falls depends (in the short run) on the price elasticity of demand and
price elasticity of supply. Tax incidence falls mostly upon the group that responds least to price
(the group that has the most inelastic price-quantity curve). If the demand curve is inelastic
relative to the supply curve the tax will be disproportionately borne by the buyer rather than the
seller. If the demand curve is elastic relative to the supply curve the tax will be born
disproportionately by the seller. If PED = PES the tax burden is split equally between buyer and
seller.

7.2.1 Inelastic supply, elastic demand

Because the producer is inelastic, he will produce the same quantity no matter what the price.
Because the consumer is elastic, the consumer is very sensitive to price. A small increase in price

73
leads to a large drop in the quantity demanded. The imposition of the tax causes the market price
to increase from P without tax to P with tax and the quantity demanded to fall from Q without
tax to Q with tax. Because the consumer is elastic, the quantity change is significant. Because the
producer is inelastic, the price doesn't change much. The producer is unable to pass the tax onto
the consumer and the tax incidence falls on the producer. In this example, the tax is collected
from the producer and the producer bears the tax burden. This is known as back shifting.

7.2.2 Elastic supply and demand

Most markets fall between these two extremes, and ultimately the incidence of tax is shared
between producers and consumers in varying proportions. In this example, the consumers pay
more than the producers, but not all of the tax. The area paid by consumers is obvious as the
change in equilibrium price (between P without tax to P with tax); the remainder, being the
difference between the new price and the cost of production at that quantity, is paid by the
producers.

7.2.3 Inelastic demand, elastic supply

Because the consumer is inelastic, he will demand the same quantity no matter what the price.
Because the producer is elastic, the producer is very sensitive to price. A small drop in price
leads to a large drop in the quantity produced. The imposition of the tax causes the market price
to increase from P without tax to P with tax and the quantity demanded to fall from Q without
tax to Q with tax. Because the consumer is inelastic, the quantity doesn't change much. Because
the consumer is inelastic and the producer is elastic, the price changes dramatically. The change
in price is very large. The producer is able to pass (in the short run) almost the entire value of the
tax onto the consumer. Even though the tax is being collected from the producer the consumer is
bearing the tax burden. The tax incidence is falling on the consumer, known as forward shifting.

7.2.4 Graphical illustration of tax incidence

Inelastic supply, elastic demand: the burden is on producers

74
Inelastic supply, elastic demand: the burden is on producers

Similar elasticities: burden shared

Inelastic demand, elastic supply: the burden is on consumers

75
7.3 Macroeconomic perspective of tax incidence

The supply and demand for a good is deeply intertwined with the markets for the factors of
production and for alternate goods and services that might be produced or consumed. Although
legislators might be seeking to tax the apple industry, in reality it could turn out to be truck
drivers who are hardest hit, if apple companies shift toward shipping by rail in response to their
new cost. Or perhaps orange manufacturers will be the group most affected, if consumers decide
to forgo oranges to maintain their previous level of apples at the now higher price. Ultimately,
the burden of the tax falls on people—the owners, customers, or workers.

However, the true burden of the tax cannot be properly assessed without knowing the use of the
tax revenues. If the tax proceeds are employed in a manner that benefits owners more than
producers and consumers then the burden of the tax will fall on producers and consumers. If the
proceeds of the tax are used in a way that benefits producers and consumers, then owners suffer
the tax burden. These are class distinctions concerning the distribution of costs and are not
addressed in current tax incidence models. The US military offers major benefit to owners who
produce offshore. Yet the tax levy to support this effort falls primarily on American producers
and consumers. Corporations simply move out of the tax jurisdiction but still receive the
property rights enforcement that is the mainstay of their income.

Summary of The Topic

 Illustration of tax incidence
 Inelastic supply, elastic demand
 Elastic supply and demand
 Inelastic demand, elastic supply
 Graphical illustration of tax incidence
 Macroeconomic perspective of tax incidence

76
 Revision Questions
i. Explain the meaning tax incidence
ii. Explain tax incidence in the case of inelastic supply and elastic demand
iii. Explain tax incidence in the case of elastic supply and elastic demand
iv. Explain tax incidence in the case of inelastic demand and elastic supply
v. Graphically illustrate tax incidence
vi. Explain the macroeconomic perspective on tax incidence

Further References
i. M. L Jighan ( 2006), Public Finance And International Trade, Vrinda Publications P
Limited, Delhi India Pages 45-56
ii. H.L Bhatia (2004) Public Finance. Vikas Publishing Housepvt Limited, New Delhi India
Pages 90-121
iii. Musgrave (2005) Public Finance In Theory And Practice, Tata McGraw-Hill New Delhi
Pages 249-270

77
 8.0 TAXATION AND EFFICIENCY

General objective

By the end of the lesson the learner should be able to explain efficiency in taxation

8.1 Introduction

Adam Smith was the first economist who laid down four important canons of taxation which are
the efficiency principals/canons of taxation to which were added few more by subsequent
economists.

8.2 The efficiency principals of taxation

1. The canon of equality

2. The canon of certainty
3. The canon of convenience
4. The canon of economy
5. The canon of productivity
6. The canon of elasticity
7. The canon of flexibility
8. The canon of simplicity
9. The canon of diversity

1. The canon of equality

The canon of equality, equity or justice is the most important canon of taxation. Smith explained
it thus: "The subjects of every state ought to contribute towards the support of the government, as
nearly as possible, in proportion to their respective abilities, that is, in proportion to the revenue
which the respectively enjoy under the protection of the State." It means that every person
should pay the tax according to his ability and not he same amount. It also means that everybody

78
should not pay at the same rate. Rather, every taxpayer should pay the tax in proportion to his
income. The rich should pay more and at a higher rate than the other person whose income is
less. Thus this canon implies equality of sacrifice or ability to pay the tax n proportion to the
income of the taxpayer.

2. The canon of certainty

According to smith, there should be certainty in taxation because uncertainty breeds corruption.
By the canon of certainty he mans that "the tax which each individual is bound to pay ought to be
certain, and quantity to be paid ought all to be clear and plain to he contributor and to every other
person." Thus this canon requires that there should be no element of arbitrariness in a tax. It
should be clear to every taxpayer as to what, when, and where the tax is to be paid. Nothing
should be left to the direction of the income tax department. Certainly also means that the state
should also be certain about the amount of tax revenue and the time when it is expected to flow
in the exchequer.

3. The canon of convenience

This canon lays down that both the time an manner of payment should be convenient to the
taxpayer. In the words of smith, "Every tax ought to be levied at the time or in the manner in
which it is most likely to be convenient for the contributor to pay." In India, the payment of land
revenue is in keeping with this canon because it is to be paid after harvesting. Similarly, the
payment of sales tax and excise duty by the consumer is also convenient because he pays these
taxes when he buys commodities and at a time when he has the means to buy. The manner of
payment is very convenient to him because these taxes are included in the prices of commodities.

4. The canon of economy

Every tax should satisfy the canon of economy in two ways. First, it should be economical for
the state to collect it. if the cost of collection in the form of salaries of tax officials is more that
what the tax brings as revenue, such a tax is uneconomical, and hence it should not be levied.
Second, it should be economical to the taxpayer. It means that he should have sufficient money
left with him after paying the tax. A very heavy tax on incomes will discourage saving and
investment, and thus adversely affect the productive capacity of the community. Smith states

79
this canon in these words: "Every tax ought to be so contrived as both to take out and to keep
out of the pockets of the people as little as possible, over and above what it brings into the public
treasury of the state."

5. The canon of productivity

According to this canon, a tax should be productive in the sense that it should bring large
revenue which should be adequate for the government. But it does not mean that in its efforts to
raise more revenue, the government should tax the people heavily. Such an effort would
adversely affect the productive capacity of the economy. Further, this canon implies that one tax
which brings large revenue is better than a number of taxes which bring small revenue. Many
taxes may not be productive. They may also be uneconomical

6. The canon of elasticity

This canon is closely related to that of productivity. The canon of elasticity requires that the
government should be able to raise the rates of axes when it is in need of more revenue. In other
words, taxes should be elastic. The best example is excise duties. They can be levied on any
number of commodities and their rates can be increased every year in order to raise more
revenue. But care has to be taken that the rates of excise duties should not be so raised that they
may encourage inflationary pressures in the economy.

7. The canon of flexibility

Flexibility in taxation is different from elasticity. Flexibility means that there should be no
rigidity in taxation. The tax system can be changed to meet the revenue requirements of the
state. On the other hand, elasticity in taxation means that the revenues can be increased under
the prevailing ax system. But there cannot be any elasticity in taxation without flexibility
because some change is required in the rates and structure of taxes if the state wants to increase
revenue.

8. The canon of simplicity

The tax system should be simple, plain and intelligible to the common taxpayer. The tax system
should not be complicated. It should be simple to understand as to how is it to be calculated and

80
how much is it to be paid. The form/forms to be filled up for calculation and payment of a tax
should be simple and intelligible to the taxpayer. This canon is essential in order to avoid
corruption and oppression on the part of the tax department.

9. The canon of diversity

There should be diversity or variety in taxation. A single or a few taxes would neither meet the
revenue requirements of the state nor satisfy the canon of equity. There should, therefore, be a
variety of taxes so that all citizens should contribute towards the state revenues according to their
ability to pay. There should be a variety of direct and indirect taxes. But a large multiplicity of
taxes will be difficult to administer and hence uneconomical.

Summary Of The Topic

 The efficiency principals of taxation

Revision Question
i. Explain taxation and efficiency
ii. Explain the efficiency principals of taxation

Further Refernces

i. M. L Jighan ( 2006), Public Finance And International Trade, Vrinda Publications P

Limited, Delhi India Pages 32-35

81
 9.0 OPTIMAL TAXATION

General objective

By the end of the lesson the learner should be able to explain the various aspects of optimal
taxation

Specific objectives

By the end of the lesson the learner should be able to

a) explain the meaning of optimal taxation

b) Define optimal taxation theory

c) explain excess burden of taxation

d) explain factors determining the taxable capacity

e) explain the measurement of taxable capacity

10.1 Optimal tax Theory

Optimal tax theory is the study of how best to design a tax to minimize distortion and
inefficiency subject to raising set revenues through distortionary taxation. A neutral tax is a
theoretical tax which avoids distortion and inefficiency completely. Other things being equal, if a
tax-payer must choose between two mutually exclusive economic projects (say investments) that
face the same pre-tax risk and returns, the one with the lower tax or with a tax break would be
chosen by the rational actor. With that insight, economists argue that generally taxes distort
behavior.

For example, since only economic actors who engage in market activity of "entering the labor
market" get an income tax liability on their wages, people who are able to consume leisure or
engage in household production outside the market by say providing housewife services in lieu
of hiring a maid are taxed more lightly. With the "married filing jointly" tax unit in U.S. income
tax law, the second earner's income is placed on top of the first wage earner's taxable income and

82
thus gets the highest marginal rate. This type of tax creates a large distortion disfavoring women
from the labor force during years when the couple have great child care needs.

The incidence of sales taxes on commodities also leads to distortion if say food prepared in
restaurants are taxed but supermarket bought food prepared at home are not taxed at purchase. If
the taxpayer needs to buy food at fast food restaurants because he/she is not wealthy enough to
purchase extra leisure time (by working less) he/she pays the tax although a more prosperous
person who say enjoys playing at being a home chef is more lightly taxed. This differential
taxation of commodities may cause inefficiency (by discouraging work in the market in favor of
work in the household).

9.2 Optimal taxation theory

Most governments take revenue which exceeds that which can be provided by non-distortionary
taxes or through taxes which give a double dividend. Optimal taxation theory is the branch of
economics that considers how taxes can be structured to give the least deadweight costs, or to
give the best outcomes in terms of social welfare.

The Ramsey problem deals with minimizing deadweight costs. Because deadweight costs are
related to the elasticity of supply and demand for a good, it follows that putting the highest tax
rates on the goods for which there is most inelastic supply and demand will result in the least
overall deadweight costs.

Some economists sought to integrate optimal tax theory with the social welfare function, which
is the economic expression of the idea that equality is valuable to a greater or lesser extent. If
individuals experience diminishing returns from income, then the optimum distribution of
income for society involves a progressive income tax.

9.3 Excess burden of taxation

In economics, the excess burden of taxation, also known as the distortionary cost or
deadweight loss of taxation, is the economic loss that society suffers as the result of a tax, over
and above the revenue it collects. It is assumed that distortions occur because people or firms
change their behaviour in order to reduce the amount of tax they must pay. Excess burdens can

83
be measured using the average cost of funds or the marginal cost of funds (MCF). Excess
burdens were first discussed by Adam Smith.

An equivalent kind of inefficiency can also be caused by subsidies (that are actually taxes with
negative rates).

9.4 Measures of the excess burden

The cost of a distortion is usually measured as the amount that would have to be paid to the
people affected by its supply, the greater the excess burden. The second is the tax rate: as a
general rule, the excess burden of a tax increases with the square of the tax rate.

The average cost of funds is the total cost of distortions divided by the total revenue collected by
a government. In contrast, the marginal cost of funds (MCF) is the size of the distortion that
accompanied the last unit of revenue raised (ie, the rate of change of distortion with respect to
revenue). In most cases, the MCF increases as the amount of tax collected increases.

The standard position in economics is that the costs in a cost-benefit analysis for any tax-funded
project should be increased according to the marginal cost of funds, because that is close to the
deadweight loss that will be experienced if the project is added to the budget, or to the
deadweight loss removed if the project is removed from the budget.

9.5 Distortion and redistribution

In the case of progressive taxes, the distortionary effects of a tax may be accompanied by other
benefits: the redistribution of dollars from wealthier people to poorer people who could possibly
obtain more benefit from them.

In fact almost any tax measure will distort the economy from the path or process that would have
prevailed in its absence (land value taxes are a notable exception). For example a sales tax
applied to all goods will tend to discourage consumption of all the taxed items, and an income
tax will tend to discourage people from earning money in the category of income that is taxed
(unless they can manage to avoid being taxed). Some people may move out of the work force (to

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avoid income tax); some may move into the cash or black economies (where incomes are not
revealed to the tax authorities).

For example, in Western nations the incomes of the relatively affluent are taxed partly to provide
the money used to assist the relatively poor. As a result of the taxes (and associated subsidies to
the poor), incentives are changed for both groups. The relatively rich are discouraged from
declaring income and from earning marginal (extra) income, because they know that any
additional money that they earn and declare will be taxed at their highest marginal tax rates. At
the same time the poor have an incentive to conceal their own taxable income (and usually their
assets) so as to increase the likelihood of their receiving state assistance. It can be argued that the
distortion of incentives (the move away from a fiscally neutral stance that does not affect
incentives) does more harm than good.

Deliberate distortion

Here, the fiscal distortion is deliberate, so as to compensate for externalities. "Sin taxes" on
alcohol, tobacco, pornography, etc. may be levied so as to discourage their consumption. Such an
approach is often preferable to outright prohibition, since prohibition incites trafficking, often
resulting in crime and other social costs, but no revenue. Similarly, taxes such as a carbon tax,
may be levied on emission of pollutants, in order to encourage corporations to adopt cleaner
methods of production.

Fiscal Illusion

Fiscal Illusion is a public choice theory of government expenditure first developed by the Italian
economist Amilcare Puviani. Fiscal Illusion suggests that when government revenues are
unobserved or not fully observed by taxpayers then the cost of government is perceived to be less
expensive than it actually is. Since some or all taxpayers benefit from government expenditures
from these unobserved or hidden revenues the public's demand for government expenditures
increases, thus providing politicians incentive to expand the size of government.

Fiscal Illusion has been used to explain the flypaper effect often seen when a higher level of
government provides a grant to a lower level of government. Here, instead of reducing taxes in

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order to pass on the benefits of the grant to local taxpayers, the grant-receiving body increases
expenditures in order to expand local services in some way. Fiscal Illusion is invoked as an
explanation because the local taxpayers are under the mistaken perception that the grant is to
local government and not, in fact, to them.

Another example of fiscal illusion can be seen in local property tax politics. Here renters, who
pay local property taxes indirectly, may vote for an expansion of local government services.
Fiscal illusion theory suggests they support this policy because its cost is masked by its
roundabout nature (through an increase in their rent payments

9.6 Factors Determining Taxable Capacity

The taxable capacity of a country depends on the following factors.

Size of national income. Taxable capacity depends on the size of national income or wealth or
natural resources of a country and the extent to which they are developed. The higher the
national income, the higher the taxable capacity of a country, and vice versa.

Distribution of national income. In a country where there is inequality of income, taxable

capacity is high because the few rich can be taxed heavily. On the other hand, if there is equality
of income, the taxable capacity is relatively low because the government expenditure to uplift the
poor will be less.

Stability of income. In developed countries, the incomes of individuals are stable, the taxable
capacity is high. But where incomes are subject to fluctuations and are unstable, as in
underdeveloped countries, the taxable capacity is low.

Size and growth of population. If the size and growth rate of population are high, the per
capita income will be low. So the taxable capacity will also be low, and vice versa.

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Standard of living. If the standard of living of the people is high, it means that people are
spending more on comforts and luxuries. So their capacity to pay taxes is also high, and vice
versa.

Tax system. The type of tax system affects the taxable capacity. A progressive tax system has a
higher taxable capacity because it falls on higher income groups, as in the case of direct taxes on
incomes. On the other hand, regressive indirect taxes which fall heavily on low income groups
have low taxable capacity.

Sources of Revenue. Taxable capacity depends on the number of sources of revenue available
to the government. The greater the number of revenue sources that are productive, the higher the
taxable capacity, and vice versa.

Public expenditure. If public expenditure is meant to increase the welfare of the people, people
do not mind paying taxes. If the government spends money on unnecessary and unproductive
projects, people will not be willing to pay taxes. Thus taxable capacity is high for productive
public expenditure which increases national income, and vice versa.

Taxing and spending income. Taxable capacity depends on the manner and timing of both
taxing and spending income by the government. This involves compensatory spending and
compensatory taxation. Compensatory spending compensates for the fall in private investment
and increases output, employment and income. Compensatory taxation compensates for the fall
in private expenditure, compensates for the fall in private expenditure, saving or investment by
taxing the people. Both tend to increase economic activity and national income thereby raising
the taxable capacity.

Price situation. Taxable capacity is determined by the price situation in the country. If prices
are rising, the real income of the people falls and their taxable capacity declines. The converse is
the case when prices are falling.

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Organization of the economy. If the economy s primarily agricultural, the taxable capacity will
be low because the income from agricultural operations is uncertain. On the other hand, an
industrial economy has high taxable capacity because the industrial sector generates larger
income than the agricultural sector.

Psychology of the people. Taxable capacity also depends upon the psychology of the people.
People are prepared to more pay taxes honestly and willingly during a war and natural calamities
like floods, earthquakes, etc. As pointed out by Findlay Shirras, "the psychology of the people
has much to do with the extent of taxable capacity. People are often willing to bear heavier
taxation on patriotic or sentimental grounds. On the other hand, adverse psychology of the
people has much to do with the extent of taxable capacity. People are often willing to bear
heavier taxation patriotic or sentimental grounds. On the other hand, adverse psychology of the
people towards the payment of the taxes lowers down the taxable capacity.

Political conditions. What should be the level of taxation is a political factor these days. A
country with has political stability, its taxable capacity will be high if there is political instability
or the government is unsympathetic and repressive, the taxable capacity will be low.

Conclusion. Thus the taxable capacity of a country depends upon a number of factors. These
factors change from time to time and so does the taxable capacity.

9.7 Measurement Or Limit Of Taxable Capacity

Colin Clark gives a limit of taxable capacity of a country. According to him, "The safe upper
limit of taxation is 25 per cent of national production. "Thus he takes 25 per cent of national
income. If the level of taxation exceeds this limit, it will adversely affect production and
incentive to work, save and invest. Further, a high level of taxation will lead to increase in
wages and to a rise in prices. All these factors will reduce national income. Colin Clark places
this limit for advanced counties.

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Taxable capacity
But Kaldor does not agree with Colin Clark. He suggests a different limit for different types of
taxes. According to him, a particular tax up to 10 per cent of national income may be a heavy
burden on people and another tax of 25 per cent may not be a burden. For instance, and income
tax up to 10 per cent of national income may adversely affect incentive to work, save and invest.
On the other hand, an expenditure tax of 10 per cent or more will increase production rather than
retard it. People will not spend extravagantly. They will reduce wasteful expenditures. They
will save and invest and productions will not e adversely affected.

However, most governments have accepted Clark's 25 per cent limit of taxable capacity. But the
followers of Kaldor persist that 25 per cent should not be the limit for taxes on incomes.

Summary of The Topic

 Optimal tax Theory
 Optimal taxation theory
 Excess burden of taxation
 Measures of the excess burden
 Distortion and redistribution
 Factors Determining Taxable Capacity
 Measurements Or Limit Of Taxable Capacity

Revision Questions
i. Explain the meaning of optimal taxation
ii. Explain the meaning of optimal taxation theory
iii. Explain excess burden of taxation
iv. Explain factors determining the taxable capacity
v. Explain the measurement of taxable capacity

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Further References
i. Musgrave (2005) Public Finance In Theory And Practice, Tata Mcgraw-Hill New Delhi
Pages 277-295
ii. David N Hyman (2005) Public Finance, A Contemporary Application Of Theory To
Policy Thomson Learning,Ohio Usa Pages 427-460
iii. John Quigley, E. Smolensky (1994) President And Fellows Of Havard University Usa
Pages 247-280

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 11.0 COST BENEFIT ANALYSIS AND INVESTMENT RULES

General objective

By the end of the lesson the learner should be able to explain the cost benefit analysis in
initiating public projects

Specific objectives

By the end of the lesson the learner should be able to

a) explain the various types benefits and costs involved in public projects

b) explain the measurement of benefits and costs in public projects

c) explain the concept of consumer surplus

10.1 Types of benefit and cost

Benefits and costs may be real or pecuniary.

Real vs pecuniary benefits and cost

Real benefits
They are the benefits derived by the final consumer of the public project. They reflect an
addition to the community welfare.

Real costs; Refers to the real/actual cost of resource withdrawal from other uses.

Pecuniary benefits and costs ;Come about because of changes in relative prices which occur
as the economy adjusts itself to the provision of the public services and the pattern of demand
changes.
As a result gains and losses accrue to some individual but are offset by losses or gains which are
experienced by others. They do not reflect net gains or costs to the society as a whole.

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Real benefits and costs may be;
a) Direct or indirect
b) Tangible or intangible
c) Final or intermediate
d) Inside or outside

Types of real benefits

a) Direct vs Indirect: direct cost and benefits are those related closely to the main project
objective while indirect are those in the nature of byproducts. E,g a river development
program may have flood control as its immediate objective but may also have important
bearing on supply of power, on irrigation on soil erosion in adjacent areas.

b) Tangible vs Intangible: tangible refers to benefits and cost which can be valued in the
market while others which can not be valued are referred to as intangible e,g. The
beautification of an area which may result from an irrigation project is an intangible benefit
while the increased farm output is tangible.

c) Intermediate vs Final: final products are those who furnish benefits to the consumer
directly (i,e. Since they involve provision of final goods) , while intermediate are those which
enter into the production of other goods, some project may in fact provide for both types of
goods e,g weather forecasts may be considered as a consumer goods for those who plan an
outing as well as an intermediate good in servicing aviation.

d) Inside vs outside: the distinction here is between benefits and costs which accrue inside the
jurisdiction in which the project is undertaken and other which accrue outside. E.g. The flood
control activity undertaken in a given district may not only be helpful in that district, but may
also help to control floods down stream in other districts if the river passes through other
districts.
Note: All types of real benefits should be allowed the cost benefit analysis.

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10.2 Measurement of benefits and costs

The issue of measurement would be simple if all values could be observed in terms of market
prices. However such is not the case. Cost and benefits are frequently in intangible forms and
even where market prices are observable, there may be need of adjustment because markets are
not perfect and distortion must be allowed for.

10.2.1 Valuation of intangible items/Non market items.

1) Social benefits and costs
Project benefits maybe essentially intangible, as with the case of natural defence or both tangible
and intangible benefits may result e,g. education has the tangible benefit of increased earning
power and intangible benefits of cultural enrichment and improved functioning of democratic
process.
Whenever intangible benefits and costs are involved, then, value can not be derived readily from
the market price and a political process is needed to determine them. Voters must determine how
much they value clean air or water etc. After the value of the benefit has been determined, then
cost benefit analysis is done.

2) Intangible private benefits and costs.

Related problems arise in connection with the benefits and costs which are private in nature, but
which do not lend themselves to markets evaluation. E,g. if the government undertakes a cancer
research project with resulting reduction in suffering, how can the benefit be valued?, how
should one evaluate the cost and injury which result from highway accident? What of benefit of
crime prevention?
Indirect valuation methods of a more or less satisfactory nature may be applied to these
intangible items and economists have shown considerable ingenuity in developing such
procedures e.g.
 A school program aimed at reducing absenteeism will be reflected in reduced
delinquency and thus save cost of law enforcement. other gains may be measured in
terms of increased earnings due to improved training
 The value of a park may be measured by the number of travel related and other costs
which visitors are willing to undergo .e.t.c

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Note: Having established the cost of those projects, then cost benefit analysis is done.

Other Methods Of Evaluation

10.2.2 Shadow pricing of market items

Projects whose tangible benefits and cost are recorded directly in the market via sales and
purchases have no such difficulties as long as the market is competitive. In this case the tangible
benefit is measured by the price which the public service fetches in the market, or the price at
which a similar service is purchased by consumer from private suppliers
Shadow pricing refers to the arbitrary assignment of money values to non-marketed goods .It
may also involve adjustment of prices of goods.
This is normally done when performing cost benefit analysis in the following circumstances.
1. Incase of monopoly
2. Due to taxes
3. Due to unemployed resources
 Monopoly; In monopoly, market prices of output do not reflect the true resource cost and
adjustments are needed. Such adjusted values are referred to as shadows prices. Thus
monopoly prices are not counted e,g. suppose that the market price of a given product is Ksh
1,000,000 but at a competitive market it would cost Ksh 900,000 equal to the marginal
resource cost of its production. The cost to be counted here is kshs 900,000 not one million
even though the government pays a higher price.

 Taxes; There is a need for adjustment in connection with taxes. If the government
purchases input needed in the construction of a project, the market price may include sales
taxes. This tax component of the price does not reflect a social cost, being merely a transfer
from purchasers to the government and therefore should be disallowed in computing the cost
of the project.

 Unemployment resources ; This involves costing of otherwise unemployed resources.

The cost to be accounted for in public resource use is the lost opportunity for putting these
resources to alternative uses, whether they are other public projects or private projects.

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10.2.3 Discounted cost of capital
There some investments which yield benefits over many years in the future. To evaluate such
benefit streams, future proceeds must be translated in to present values. The process of doing this
is called discounting. Future costs should be discounted also. This enables cost benefit analysis
to be performed on such projects. However the choice of the discount rate is very important in
this case. There are different discount rates which can be used which includes;
 Private rate
 Social rate.

1. Private rate. This is the rate equal to the time preference of private consumer i, e. the
discount rate in the market. The rationale for using the private rate of discount is that is it
reflects consumer choice between present and the future consumption. The argument here
is that, just as public policy accepts the valuation of oranges and apples by the price
which they fetch in the market, so it should honor the individual valuation of future
relative to present consumption. Given the condition of perfectly competitive capital
market and absence of risk, all consumers will borrow and lend at the same rate. Also
with perfect markets, this rate is equal to the marginal efficiency of investment. Thus
there exist an equality between the marginal rate of substitution of present for future
consumption and their marginal rate of transformations in production. The rate of
interest, like in the other competitive price is at its efficient level. However, in practice,
this is complicated by various factor that includes ;
 Imperfect markets.
 Uncertainty
 Risk
 Income tax
 Macro policy

2. Social rate
There are reasons for not using the time preference rate of private consumers but for
substituting a social rate in it's place .They include;
 Individual are said to suffer from myopia so that in arranging their private affairs, they

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 underestimate the importance of saving and overestimate that of present consumption
 Also, there are several arguments related to the welfare of future generations. One
argument is that people are too greedy and do not care sufficiently about the welfare of
those who follow them. If they did, they would save more in order to leave the future
generation with a larger capital level and higher level of income. The government as a
guardian of the future generation can offset this by using a lower rate of discount and
investing more.
Note: the suggestion here is that the social rate should be set below the private rate so
that the use of social rate calls for a higher rate of investment. Using the social rate rather
than the private rate in product selection will the give a higher present value of benefit
stream passing projects which might be excluded by the use of the private rate.

Opportunity cost of capital

There is the social cost involved in withdrawing resources from private use to public use. The
social opportunity cost of capital, equal the loss of consumption current or future, which results
as these resources are withdrawn.

10.3 Public Expenditure Evaluation Principals

Sound expenditure decision requires detailed information regarding the merits of alternative
projects.

Fundamentals of project evaluation

Decision rules
Project evaluation, like all issues in allocation economics, involves determination of the ways in
which the most efficient use can be made of scarce resources. The issue is how to determine the
composition of the budget of a given size or how to allocate a total of given funds among
alternative projects. There is also the issue of determining the appropriate size of the budget. In
making decision rules it is also important to consider whether.
The project are divisible or lumpy
The budget is fixed or variable

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Divisible Projects
Suppose the projects are finely, divisible i.e. May be increased or decreased by small amount.
How should the project be evaluated? This in influenced by whether the budget is size is fixed or
is variable.

Fixed Budget size

Suppose the budget director is asked to explain how best to allocate a given sum say Kshs. 1
billion, between two expenditure projects, X and Y. First the director must determine the cost (C)
involved in providing each service and the benefit (B) to be derived from each of them. Then the
outlay, Kshs 1 billion must be allocated between X and Y so as to derive the greatest total benefit
from the budget. i.e. To maximize the sum of the net benefits or the excess of the total benefit
over cost. With the total cost given by the size of the budget, the task is simply to maximize
total benefits.

Variable Budget Size

A more global view of budgeting indicates that the problem is not simply one of dividing up a
budget of a given size but also one of determining the budget itself. The government must
thereby decide how resources are to be divided between private and public use.
In this case, the assumption of a fixed budget is dropped and one has to reconsider project choice
along with determination of total budget outlays.
Within the fixed budget, the opportunity cost of pursuing the public project consists of the
benefit lost by not pursuing another public project. However in the open budget ,the opportunity
cost of public projects must be redefined as the lost benefits from private projects which are
foregone because resources are transferred to public use. In this case, the task is to maximize B-
C, including benefits and costs of both public and private projects. This condition is met by
equating marginal benefits for the last dollar spent on the alternative public and private project.
Public projects are expanded and private projects are restricted until the benefit of the last dollar
spent in either is the same.

Lumpy Projects

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When dealing with the allocation of funds between broad expenditure categories, the marginal
approach is applicable, the assumption being that the expenditure can be divided finely between
the projects X and Y so that benefits may be equated for the marginal dollar spent on each.
However when it comes to specific allocation within departments, the choice must be made
among particular projects which are indivisible (lumpy). I,e. Involving lump sum amounts ,e,g if
the choice have to be made between a road connecting cities X and Y and another connecting X
and Z where the X to Y distance is twice the X to Z distance, no marginal adjustment is possible.
Again in this case the decision rule is influenced by whether the budget size in fixed or variable.

Variable budget size

If there is no fixed limit to the budget size, the problem is once more one of weighing public
against private uses of resources. Since we are now dealing with lumpy projects, this can no
longer be done by balancing the benefits derived from marginal outlays on both uses. We now
proceed by the rule that public project is worth undertaking so long as the benefits derived there-
from exceeds its cost. The justification for the rule is that the cost of spending n dollar is the loss
of n dollars of benefit, a loss which results from not spending n dollars in the private sector.

Summary of decision rules

Divisible projects
Fixed budget-distribute funds among projects so that marginal benefits are equal.
Variable budget-extend all project until the marginal benefits are equal.

Lumpsy projects
 Fixed budget-choose the project mix that maximizes net benefits
 Variable budget-choose all project with positive net benefits.
NB: In practice the combination of lumpy projects and limited project budgets is the most typical
setting. To establish the proper rank order, this means that all possible projects should be
considered and compared.

10.4 Concept of Consumer Surplus

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The table below shows the law of diminishing marginal utility for Mr. X on loaves of bread

Diminishing marginal utility

price no. of loaves
(kshs) purchased
30 1
20 2
15 3
12 4
10 5
8 6
6 7
4 8
2 9

If Mr. X estimates the marginal utility of bread at kshs 30 i,e the price she is prepared to pay for
it, she is prepared to pay thirty shillings for the first , the marginal utility of the second is kshs 20
etc.
If the price of a loaf is set at kshs12 ,and assuming that he has no bread in stock, he will buy the
bread at kshs 12 because he reaches his marginal utility at kshs 30, he will also buy the second
loaf at kshs 12 because he assess its value to be worth kshs 20 etc. Therefore Mr.X was willing
to pay Kshs 30 for a loaf while he only paid kshs 12, again for the third he paid kshs 12 although
he was willing to pay kshs 30 Therefore his actual expenditure of the four loaves was actually
kshs 48 though he was willing to pay kshs30, kshs20, kshs15, kshs12 responsively, a total of
kshs 77. Therefore he obtains Kenya kshs 77 worth of satisfaction for kshs 48.This is a surplus of
Kshs 29. This is known as consumer surplus. Mr. X may not buy his 5th unit at a price of kshs 12
because it is higher than his marginal utility of kshs 10.
NOTE: Consumers will extend purchases to the point where the marginal value of the last unit
equals the marginal cost of the price which they must pay.

Summary Of The Topic

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  Types of benefit and cost
 Measurement of benefits and costs
 Valuation of intangible items/Non market items.
 Shadow pricing of market items
 Discounted cost of capital
 Public Expenditure Evaluation Principals
 Concept Of Consumer Surplus

Revision Questions
i. Explain the various types benefits and costs involved in public projects
ii. Explain the measurement of benefits and costs in public projects
iii. Explain the concept of consumer surplus
iv. Explain how the following methods can be used to do the costing of a project
a) Shadow pricing of market items
b) Discounted cost of capital

Further References
i. Musgrave (2005) Public Finance In Theory And Practice, Tata Mcgraw-Hill New Delhi
Pages 130-161
ii. David N Hyman (2005) Public Finance, A Contemporary Application Of Theory To
Policy Thomson Learning,Ohio Usa Pages 219-250
iii. Harvey S Rosen (1999) Public Finance Irvin/Mcgraw Hill New York Usa Pages 223-249

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 11.0 PUBLIC EXPENDITURE PROGRAM

General objective

By the end of the lesson the learner should be able to explain the meaning and nature of
public expenditure
Specific objectives
By the end of the lesson the learner should be able to
a) explain the meaning and objectives of public expenditure
b) to account for the size and growth of public expenditure
c) explain the theories that explain increase of public expenditure
d) explain the effects of public expenditure
e) account for the growth of public expenditure
f) explain the role of development expenditure of developing countries

11.1 Meaning of public expenditure

This refers to the expenses which the government incurs for its own maintenance, for the society,
as well as for the economy as a whole

11.2 Objectives of public expenditure

Public expenditure's objective is supposed to provide security for the country or state and to
promote the well being of the citizens. Major government spending can be classified as national
defense, education, social welfare, interest on the national debt and pensions.

11.3 Size and growth of public expenditure

Public expenditure increases over the years due to the following reasons:
a) Expansion of state activities

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According to Adolph Wagner (1883) public expenditure increases in response to the law of
increasing expansion of public activities. He maintained that there is a persistent tendency
both towards an intensive and expensive increase of state function and activities.

b) Internal security
Wagner also referred to the maintenance of international security as an important factor for
the increase in government expenditure. Enforcement of law and order for maintaining peace
and security has led to the expansion of legal and administrative systems and police force.
There have led to an increase in public expenditure.

c) Defense
Every country pays greater attention to its defense preparedness against foreign attacks. As a
result public expenditure on equipping its armed forces with the latest armaments has
increased.

d) Welfare activities
Modern states are welfare states which provide free education, medical facilities, social
security measures, maintain historical monuments, museums and pubic libraries, encourage
sports, cultural and heath programmes. Consequently, public expenditure has tended to
increase.

e) Population increase
The increase in population has resulted in increase public expenditure on the people. The
state has to spend more on roads, railways, schools, colleges, houses etc

f) Urbanization
With the growth of population, there is migration of population from rural to urban areas in
search of employment. Exiting cities expand and new cities come up. These require huge
public expenditure in providing amenities such as water, street lighting, sewerage, road,
transport, schools, houses, etc

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11.4 Theories of increase in public expenditure

There are two theories that explain increase in public expenditure namely:-
a. Wagner’s law of increased public expenditure
b. Wiseman and Peacock Hypothesis.

1) Wagner’s law of increased public expenditure

Adolph Wagner (1835-1917) was a German economist who based his law on historical facts
prevailing in Germany.
According to him, there has been an inherent tendency for the activities of different layers of
government to increase both intensively and extensively.
Increase in public expenditure is at higher rate than economic growth. He attributed increase in
public expenditure to the following-:
(1) Expansion of the traditional function of the state e.g defense, maintenance of law and
order, provision of social overheads, maintenance of the state. e.t.c
(2) Increased awareness of government responsibility to the society rather than in traditional
role eg giving pension to it retiring workers, provision of public goods, social welfare
activities, culture enrichment etc.
(3) The need to provide and expand the sphere of public goods was being increasingly
recognized.
NB However there are other factors that tend to increase public expenditure that he left out.

2) Wiseman and Peacock Hypothesis

Wiseman and peacock did their study of public expenditure behavior in UK for the period 1890-
1955.
The main thesis for the two is that public expenditure doesn’t increase in a smooth and
continuous manner but in fort of step like fashion.
According to the 2, at times, some social or other disturbances takes place creating a need for
increased public expenditure which the existing public revenue cannot meet.
Due to the deficit budget as a result of the increased expenditure, the government and its people
review the position and the need to find a solution of the important problem that has come up and

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agree to undertake adjustment to finance the increased expenditure. E.g. they can agree to
increase taxes or public borrowing.
The time when the government and the people are deliberating on what to do to finance the
expenditure, is known as the ‘inspection effect.’
The movement from the older level of expenditure and taxation to a new and a higher level is
referred to as the displacement effect.
At a new tax tolerance level, (i.e. new expenditure level) ,people are now ready to tolerate a
greater burden of taxation and as a result, the general level of expenditure and revenue goes up.
This way, the public expenditure and revenue get stabilized at a new level until another
disturbance occurs to cause a displacement effect.

11.5 Theories of Public Expenditure

There are various theories of public expenditure which includes:

i. The doctrine of Laissez faire
ii. Individual choice theory
iii. The authoritarian conception/ the organic theory
iv. Optimum level of public expenditure theory
v. The ballot box theory
vi. The positive theory of government expenditure

1) The doctrine of Laissez faire

This one is based on the principle of minimum state intervention in the working of the economy.
‘Governments are always and without exemption the greatest spendthrifts of society,’ according
to Adam Smith, because, they spend other people’s money. Adam Smith believed that individual
people acting in self interest will promote public good under the guidance of the ‘invisible hand’.
The implication of this theory was a low level of public expenditure and taxation but the need for
some increase in public expenditure was conceded.

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2) Individual choice theory
Emphasis in theoretical discussion of public finance shifted to the consideration of the basis on
which collective decision in the public sector should be made. Writers such as Ferra (1850)
advocated individual choice as the basis of social choice and of collective decision making. The
problem of this approach was the aggregation of individual preferences and of relating them to
policies.

3) The authoritarian conception/organic theory

The organic theory avoided this difficulty, since it was based on the assumption that the
decisions were made by ruling group

4) Optimum level of expenditure theory

Having accepted the need for some public expenditure, economists turned their attention to the
question of what was its desired level. This theory is associated with W. Stanley Jevons (1835-
1882), an English Economist. The theory postulates that, as a person’s consumption increases,
each additional (marginal unit) of a good consumed gives lower satisfaction (utility) than the one
before. Thus the consumer experiences diminishing utility.
The theory is based on the relationship between the satisfaction derived from the consumption of
goods and services provided by that state and the sacrifice involved in paying taxes to finance
public expenditure.
The marginal theory sheds some light on how people behave. We may not go round calculating
our diminishing marginal utility of each good we consume. Nevertheless, all of us are aware that
there is some point at which the burden of taxation appears greater than the various state benefits
are worth to us. We may not be able to put a figure on that point and it may not be the same for
all people ,but we may prefer to go without some public goods and services rather than pay more
in taxation to finance the increase of public expenditure.
The optimum level of public expenditure can be defined as the point at which the benefit to all
individuals from additional expenditure is equal to the additional sacrifice by those involved in
paying more tax.

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5) The ballot box theory
In a democratic society, people have the opportunity to decide how much they wish to provide
for themselves and how much they want the state to provide for them. Their individual
preferences can be expressed by putting on vote in the ballot box at the next election for a
political party whose manifesto most closely reflects their views. It is the majority vote, which is
the aggregate of individual preferences that gives the government the mandate to carry out its
policies.
The problem however is that at a general election, people vote on a number of issues and for a
‘manifesto package’ containing various proposals.
Consequently elections have no opportunity to express the views on a particular issue or
measure. Also not all of the proposals in a manifesto may be equally acceptable to them.

6) The positive theory of public expenditure

This theory has been advanced by present day writers such as A. Down, J. Buchaman and G.
Tullock. It could perhaps be described as the ‘clinging to power theory, since it is based on the
assumption that, in a democratic society, governments seek to maximize their lifespan while
voters seek to maximize the benefits they receive from the government. An increase in public
expenditure is popular with voters if they do not pay taxes to finance it.

11.6 Effects of Public Expenditure

Public expenditure has far reaching effects on production, employment and distribution in the
country. We discuss these effects as under:

11.6.1 Effects of Public Expenditure on Production

According to Dalton, production and employment in a country depend on three factors:
(a)Ability of the people to work, save, and invest;
(b)Willingness to work, save and invest’
(c)Diversion of economic resources as between different uses and localities.

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Public expenditure influences these factors in a number of ways and thus helps in increasing
production and employment within the country. The ability and Willingness to work, save and
invest depend on the nature of expenditure. The former increase with the increase in the
efficiency of workers which, in turn, raises production and employment.

On Social Insurance. Public expenditure on social insurance benefits such as unemployment,

sickness, maternity, old age pensions, etc. tends to increase the purchasing power of workers
indirectly. When these facilities are provided by the state, the workers indirectly. When these
facilities are provided by the state, the workers are not required to spend on them, thereby
increase their real purchasing power. The money so saved is spent by them on other articles. It
means an increase in their standard of living which raises their efficiency and production.

If, on the other hand, the workers spend the money so saved on gambling, drinking, etc. their
ability and willingness to save fall which adversely affect their ability and willingness to save
fall which adversely affect their ability to work, thereby reducing production.

On Basic Facilities. Public expenditure on basic facilities also tens to raise efficiency and ability
to work. When the state provides such basic facilities as cheap ration, low-rent houses, mid-day
meals to children, cheap milk, etc. the ability to save increases. This, in turn, tends to raise their
ability to work, thereby increasing production.

On Education and Public Health. Public expenditure on education and public health has direct
welfare effects on society. Expenditure on education is regarded as investment in human capital
because it helps in skill formation and thus raises the ability to work and produce core. Similarly,
public health is also another form of investment in human capital. Healthy workers, who are free
from diseases, work more and raise production.

On Economic Overheads, Basic Industries, etc. Public expenditure on economic overheads,

basic industries, etc also helps in increasing the productive capacity of the economy. Public
expenditure on power, transport, communications, irrigation, soil erosion. Land reclamation, etc
tends to increase the supply of resources for production over a long period. Moreover,

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expenditure on roads, railways, and other means of transport also affects the mobility of men and
materials, which, in turn help in increasing the productive capacity. Further, the development of
basic industries like iron and steel, engineering, heavy chemicals, fertilizers, etc. is very helpful
in the development of other industries. Again, public expenditure on river valley projects helps in
providing larger employment opportunities. It provides protection against floods ad drought,
thereby avoiding loss of resources.

On Credit and Banking Facilities. Public expenditure in providing credit and baking facilities
also helps in increasing the productive capacity of the economy. It is through bank nationalistion
and/or through state and cooperative banks and opening of a network of branches throughout the
country that the state can provide cheap and better credit and banking facilities to agriculture,
industry and trade, and thus help in increasing their productivity.

On Backward Regions and Areas. Public expenditure on the development of backward regions
and depressed areas helps in providing employment through basic facilities. The private
enterprise is shy to invest in these areas. It is only the state which by providing all types of basic
facilities like roads, railways, power, industries, etc develops such areas whereby the people get
jobs and the production power of the area increases.

In the Form of Grants and Subsidies. Public expenditure in the form of grants and subsidies to
farmers, firms and industries is highly productive. When there is a bumper crop, the prices of
farm products fall considerably. The state can save them from disaster through price support. It
can purchase their surplus stocks at fixed minimum prices. In order to encourage higher
production, the state can provide such inputs as fertilizers, seeds, pump sets, etc at subsidised
prices. Similarly, the state can help develop industries by providing them subsidies. Some of the
industries have high costs in the initial stage of production. As a result. The prices of their
products are high and they are not in a position to compete in the market, and thus they meet an
early death. To save such industries, public expenditure in the form of subsidies may enable
them to develop without charging high process from its customers.

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On Information. Public expenditure on providing information in the form of such publicity
media as TV, commercial broadcast, etc helps private and public enterprises in getting their
products publicized. As a result, their sales and production increase. Similarly, public
expenditure on employment news, bureaux and exchanges helps in placing the right man at the
right job and in this way provides larger employment opportunities and tends to increase
productivity.

11.6.2 Effects of Public Expenditure on Diversion of Resources

Public expenditure affects the pattern of production through the diversion of resources from
existing uses to more productive uses. In fact, government expenditure in itself is a diversion of
resources from private to public uses. Public expenditure induces people to divert their resources
to more productive uses in the following ways:

1. On Infrastructure. Public expenditure on the development of roads and railways helps in

diverting resources to more productive uses when the market for products becomes large.
Again, public expenditure on generation of power supply and irrigation facilities helps in the
diversion of resources to large industries and agriculture. Further, public expenditure on
providing research technical education, etc tends to divert economic resources in order to
create conditions of economic stability. Further, when public expenditure is made on such
long-run infrastructural facilities as roads, railways, power, irrigation, etc it is trying to divert
resources from their present to future uses which are more productive.

2. On Backward Areas. Public expenditure on the development of backward regions or areas

brings diversion of resources from more developed to less developed areas. Such diversion
takes place when the government incurs more expenditure in the form of transport, power,
and on the establishment of public enterprises in a backward region. Grants made by the
government for the development o such areas helps in diverting natural and human resources
from the developed to backward areas.

3. To private enterprise. Public expenditure in the form of loans and subsidies to private
enterprise helps in the diversion of resources into productive channels. Sometimes loans and

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 subsidies are made conditional. They are dependent on the quality of the product. In such
cases, diversion of resources leads to the production of better quality product. In such cases,
diversion of resources leads to the production of better quality products as against inferior
goods.

4. On defence. Public expenditure on defence or war leads to the greatest diversion of

resource. Such expenditure diverts resources from peaceful uses to war uses. It is normally
regarded as the wastage of human and material resources which can otherwise be used for
social benefits. But to defend a country s the foremost duty of government. It provides
security to life and property and saves the nation from foreign domination. All expenditure
on defence is not wasteful rather it is productive indirectly. Defence expenditure on the
construction of roads, bridges, aerodromes, shipyards, and on other means of transport and
communications help in building infrastructure in the country which are ultimately used by
the civilian population. It also provides employment to people engaged in their construction.
Moreover. Public expenditure incurred in maintaining the armed forces in the form of
supplies of food, clothing and other materials increases their demand and production and
helps in increasing employment opportunities manifold. No doubt, when resources are
diverted from their private uses to war, their supplies to the masses are reduced which
adversely affect their standard of living. But this is only a temporary phase so long as the
war continues.

11.6.3. Effects of public expenditure on income distribution.

Public expenditure by increasing social welfare helps in reducing inequalities of income and
wealth. According to Dalton, it is only progressive expenditure that tends to reduce inequalities.
A progressive expenditure is one when a person with lower income receives larger benefits as
compared to a person with higher income. Public expenditure for purposes of income
distribution is of two types: transfer expenditure and exhaustive expenditure. In the case of
transfer expenditure, low income groups are given cash benefits in the form of unemployment,
sickness, disablement, dependents, and maternity benefits, and old age pensions. All such
expenditures by the state help the poor and middle income groups in raising their incomes
indirectly. Exhaustive public expenditure also tends to reduce income in equalities and it is in

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the form of free and cheap services of commodities, such as free education, free medical
facilities, free milk or meals to school children, free transport for school children and for workers
subsidized rations, subsidized lunch to workers, rent – free quarters, etc.

There are also intangible benefits such as providing rent and recreation centres, public parks
reading rooms and libraries etc. Which tend to raise the efficiency of workers indirectly. Such
non-monetary benefits increase the real income and standard of living of the workers and
masses. Public expenditure of both transfer and exhaustive types helps in the redistribution of
income. On the other hand, if such benefits reduce the desire to work and save, they will tend to
reduce the incomes of the beneficiaries. Consequently, the inequalities are not reduced. To
conclude with Dalton, "that system of public expenditure is best which has the strongest
tendency to reduce the inequalities of incomes.

11.6.4 Effects of public expenditure on economic stability

Increase in public expenditure tends to raise national income, employment output, and prices.
An increase in public expenditure during deflation increases the aggregate demand for goods and
services and leads to a large increase in income via the multiplier process. It has the effect of
raising disposable income thereby increasing consumption and investment expenditure of the
people. The public expenditure includes expenditure on such public works as roads, canals,
dams, parks, schools, hospitals and other buildings, etc. And on such relief measures as
unemployment insurance, pensions, etc. Expenditure on public works creates demand for the
products of private construction industries and helps in reviving them, while expenditure on
relief measures stimulates the demand for consumer goods industries. But the effectiveness of
public expenditure primarily depends upon the public work programme, its importance in the
economic system, the volume and nature of public works and their planning and timing.

11.6.5 Effects of public expenditure on economic development

The effects of public expenditure on economic development lie in increasing the growth rate of
the economy. But investment in the capital goods sector may increase production in the long
run. Therefore, public expenditure should also be directed towards meeting the immediate needs

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of the economy, so as to raise agricultural and industrial production, and to increase the
production of essential consumer goods.

Rise in growth rate of the economy. Public expenditure on the establishment of heavy and
basic goods industries in the initial periods increases the growth rate of the economy. But
investment in the capital goods sector may increase production in the long run. Therefore, public
expenditure should also be directed towards meeting the immediate needs of the economy, so as
to raise agricultural and industrial production, and to increase the production of essential
consumer goods.

Increase in employment, income and production. Public expenditure on economic and social
overheads provides larger employment opportunities, raises incomes and, above all, the
productive capacity of the economy.

Increase in revenue and profit. To increase the production of certain essentials commodities,
to end private monopoly in various spheres, and to control the "commanding heights" of the
economy, the state starts public enterprises. These bring revenue to the government and profits.

Reduction in inequalities. Public expenditure tends to lessen inequalities of income and wealth
by raising the earning capacity of the people. This is done by providing educational facilities
and through skill formation

Help to private enterprise. Public expenditure helps in encouraging private enterprise by

establishing state-owned financial and banking institutions to provide cheap credit.

Regional balance. Public expenditure helps in bringing about regional balance in the economy
by diversifying industries in backward and less developed areas of the country. Thus public
expenditure is one of the important instruments for economic development.

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11.7 Growth of Public Expenditure

There has been a phenomenal increase in public (centres, state and civic bodies) expenditure
over the years. The following reasons are given for this.

Expansion of state activities. Adolph Wagner, a German economist, writing in 1883

propounded the law of Ever-increasing state activity. According to Wagner, public expenditure
increases in response to the law of increasing expansion of public activities. He maintained that
there is a persistent tendency both toward an intensive and expensive increase of state functions
and activities. New duties are being continuously undertaken and old ones are being performed
on a large scale. As a result, public expenditure is increasing steadily.

Internal security. Wagner also referred to the maintenance of internal security as an important
factor for the increase in government expenditure. Enforcement of law and order for maintaining
peace and security has led to the expansion of legal and administrative systems and police force.
These have led to the increase in public expenditure.

Defence. Every country pays greater attention to its defence preparedness against foreign
attacks. As a result, public expenditure on equipping its armed forces with the latest armaments
has increased. As Adam Smith said long ago, Defence is better than opulence." So public
expenditure on defence is essential.

Welfare activities. Wagner wrote about the increase is public expenditure due to the expansion
of cultural and welfare activities of the state. Modern states are welfare sates which provide free
education, medical facilities, and social security measures, maintain historical monuments,
museums and public libraries, and encourage cultural, sports and health programmes.
Consequently, public expenditure has tended to increase.

Population increase. The increase in population on account of better health and medical
facilities leading to reduction in death rates has resulted in increasing public expenditure on the
people. The state has to spend more on roads, railways, schools, colleges, houses, etc.

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Urbanization. With the growth of population, there is migration of population form rural to
urban areas in search of employment. Existing cities expand and new cities come up. These
require huge public expenditure in schools, parks, zoos, houses, etc. Simultaneously, the
expenditure on civic administration also increases.

Price Rise. In modern times, prices have a tendency to rise continuously with the increase in the
growth rte of the economy. As a result, the government expenditure on goods and services
increase. The rise in the cost of living further increases government expenditure by way of
higher salaries and enhanced D.A. to its employees in various civil and military departments.

Economic Development. Modern governments are engaged in the development of their

economies. They spend large sums on infrastructural facilities, on research and development in
various fields, on the development agriculture and industry, on the development of public sector,
etc. This has led to the increase in public expenditure.

Public Debt. The state borrows both internally and externally to meet its eve increasing public
expenditure. This further raises public expenditure in the form of repayment of loans and
interest charges.

Burden of democracy. Modern governments are democratic in nature. Countries are run on a
multi-party system with elections after four or five years.

Often governments fail due to lack of majority in the parliament. This necessitates frequent
elections. This tends to increase public expenditure. Further, there are "pressure groups'" and
"interest groups" within the parliament which want allocation of government funds for providing
public services in their constituencies. Moreover, according to the World Bank, wide spread
corruption in democratic countries has increased public expenditure manifold.

11.8 Development Expenditure Of Developing Economies

Development expenditure refers to public (government) expenditure of developing the economy.

The development expenditure of modern developing economies consists of expenditure on:

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  Social services. Like education, health, social security and others;
 Economic services like agriculture, industries, minerals fuel and power, transport
and communication and others
 Community services such as roads and bridges, sanitation and others.

On the other hand, the non-development expenditure of modern developing economies includes.

 Expenditure on general services such as defence, justice, police and general

administration;

 Expenditure on unallocable and other purposes such as interest on public debt.

But in these countries, these two types of expenditure cannot be placed in water-tight
compartments. This is because without expenditure on defence, police etc., it is not possible to
keep up the pace of development if there is aggression from outside an unrest from within the
country. Unless there is peace on the boarders and protection of life and property within the
country, economic development is not possible. Similarly, interest on public debt may also be
regarded as development expenditure. This is because governments of developing counties
borrow both internally and eternally mainly for development purpose.

11.9 Role of Development Expenditure in a developing economy.

The role of development expenditure in a country lies in increasing the growth rate of the
economy, providing more employment opportunities, raising incomes and standard of living,
reducing inequalities of income and wealth, encouraging private initiative and enterprise, and
bringing about regional balance in the economy.

a) Heavy and basic goods industries.

Development expenditure on the establishment of heavy and basic goods industries in the initial
period increases the growth rate of the economy. But investment in the capital goods sector
increases production in the long run.

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b) Consumer goods and raw materials.

To meet the immediate needs of the economy, development expenditure should be directed
towards increasing agricultural productivity to meet the growing demand for goods and raw
materials, and increasing the supply of consumer goods by encouraging establishment and
expansion of the small industries sector which may also provide sufficient employment
opportunities. The growth rate of the economy can be increased only when public expenditure
fulfills the short-term and long-term objectives of the development plan. Moreover, to prevent
inflationary tendencies within the economy, the public expenditure should secure a balance
between demand and supply of goods.

c) Economic overheads.

Economic overheads are such public works as roads, railways, canals, power project, etc. When
the government spends on such project, it provides employment to millions of an employment
people in underdeveloped countries. The provision for such services helps to increase
production, trade an commerce. As a results, employment and incomes increase.

d) Social overheads.

Development expenditure on social overheads like education, public health, cheap housing, etc,
makes the people healthier and efficient. It is the state which can create the "critical skills"
needed for rapid development by investing in human capital.

e) Allocation of resources.

Development expenditure helps in improving the allocation of resources towards desired

channels. In order to remove scarcities of food product, the state opens fair price shops and may
even subsidise food for the working classes to maintain their health and efficiency. It may fix
minimum prices for food grins, and through state trading and creation of buffer stocks encourage
farmers to produce more.

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f) Public enterprises.

To increase the production of certain essential commodities to and private monopoly in various
spheres of production, and to supplement private enterprise, the sate may start public enterprises.
the services, to developed and conserve natural resources, to establish basic and key industries
like heavy electrical, chemicals, fertilizers, machine tools, defence production, etc, to undertake
state trading, etc.

g) To stimulate private enterprise.

Development expenditure helps in stimulating private enterprise through the establishment of

state-owned financial and banking institutions t provide chap credit of farmers, small and large
industries, traders, etc, development expenditure also encourages the agricultural and industrial
sectors of the economy by means of grants, subsidies, tax exemptions, etc. Moreover, when the
state spends on the creation of economic and social overheads like power, transport, education,
etc., they pave the ay for the establishment and expansion of the private sector. The creation of
the infrastructure leads to external economies that are reaped by the private sector.

h) To remove inequalities.

Developing counties are characterized by extreme inequalities of income and wealth.

Development expenditure tends to lessen them. Expenditure on education, public health and
medical facilities helps n human capital formation. As a result, the earning power of he working
populating is enhanced. As economic development proceeds rapidly through rising public
expenditure, the barriers to upward mobility are removed. Occupations expand and spread,
providing more jobs to the people. With acquisition of skills, the level of wages tends to rise
within the economy. Moreover, industrialization increases the share of wages and decreases the
share of profits in national income in the long run, and the gap between higher and lower
incomes is narrowed.

i) To remove regional imbalance.

Development expenditure helps to remove regional imbalance in the economy. if things were
left to market forces, commerce, banking, industries and almost all the main activities would be

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localized in a few selected regions, and the rest of the economy may be in a state of perpetual
backwardness, as was the case developed areas and backward regions can be developed by
staring a certain projects like building a dam, digging a canal, starting new industries, etc. Such
project will not only promote but also secure larger employment opportunities, thereby
increasing per capita output and income of such areas in developing countries.

Summary of The Topic

 Meaning Of Public Expenditure
 Objectives Of Public Expenditure
 Size And Growth Of Public Expenditure
 Theories Of Increase In Public Expenditure
 Theories Of Public Expenditure
 Effects Of Public Expenditure
 Growth Of Public Expenditure
 Development Expenditure Of Developing Economies
 Role of Development Expenditure in a developing economy.

Revision Questions
i. Explain the meaning and objectives of public expenditure
ii. Account for the size and growth of public expenditure
iii. Explain the theories that explain increase of public expenditure
iv. By the end of the lesson the learner should be able to explain the effects of public
expenditure
v. Account for the growth of public expenditure
vi. Explain the role of development expenditure of developing countries

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Further References
i. M. L Jighan (2006), Public Finance And International Trade, Vrinda Publications P
Limited, Delhi India Pages 100-108
ii. H.L Bhatia (2004) Public Finance.Vikas Publishing Housepvt Limited, New Delhi India
Pages 247-284
iii. David N Hyman (2005) Public Finance, A Contemporary Application Of Theory To
Policy Thomson Learning,Ohio Usa Pages 444-499

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 13.0 PUBLIC DEBT

General objectives

By the end of the lesson the learner should be able to explain the economics of public
finance

Specific objectives

By The End Of The Lesson The Learner Should Be Able To

a) Explain The Meaning Of Public Debt

b) Explain The Sources Of Public Borrowings

c) Classify Public Debt

d) Explain The Burden Of Public Debt

e) Explain The Effect Of Public Debt Burden On Future Generations

f) Explain The Techniques Of Debt Management

g) Explain The Role Of Public Debt On Economic development

12.1 Introduction

National debts are debts which a state owes to its own subjects or to the nationals of other
countries. Public debt is a source of government revenue. In the case of public debt the
government has to pay interests and repay the principal to the public.
NB
Nothing is required to be paid by the government in respect to all other sources of revenue.

12.2 Sources

There are two major sources of public borrowings namely internal and external.
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Internal sources:
Internally the government borrows from individuals, corporations, non-banking financial
institutions, commercial banks or from the central bank.
These lend to the government through buying of treasury bills or government bonds. The
treasury bills and bonds sold by the government are relatively safe.

External sources:
Externally, the government borrows in the form of foreign capital which can enter a country as
private capital and/or public capital.
Private foreign capital may take the form of direct or indirect investments in the borrowing
country. Public foreign capital may consist of bilateral hard loans e.g. giving of loans by the
British government in Sterling Pounds to Kenyan government, bilateral soft loans and
multilateral loans (e.g loans from IMF, World Bank, UNDP) and Intergovernmental grants.

12.3 Classification/ Types of public debt

Public debts are of various kinds and include:

a) Voluntary debt and compulsory debt.

Voluntary Debt is that debt which is taken by the government without any force or coercion.
People lend it to the government voluntarily. Actually all public debts are voluntarily.
However, sometimes the government compels the people to buy governments bonds. e.g. incase
of a war or a national emergency. These are the compulsory debts.

b) Funded debts and unfunded debts

Funded debt is a long term debt for a definite period. The interest rate to be paid, with terms and
conditions of repayment are clearly stated in the debt instrument (certificate). In order to repay
the debt, a debt fund is created in which some money is deposited every year by the government.
The debt is repaid out of this fund on maturity.

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Unfunded debt is for a short period of less than a year. The government does not create any
separate fund to repay the debt. Such a debt is repaid out of its current receipts often by floating
additional bonds in the market. Thus it is also called a floating debt.

c) Productive debt and unproductive debt.

Productive/ reproductive loans are debts/ which are fully covered by assets of equal or greater
value and the source of the interest is the income from the ownership of these, such as railways,
oil pipeline e.t.c. Thus a debt is productive when its amount is spent to finance a project which in
long run brings revenue to the government, out of which interest is paid on the debt.
Unproductive debt does not increase the productive capacity of the economy because it is not
backed by any existing assets e.g. loans taken by the government for covering the budget deficit
or to help during war, famine, earthquake and flood victims e.t.c. These do not bring any revenue
to the government and are therefore called dead weight debts.

d) Redeemable debt and irredeemable debt

Redeemable debt is that which is repayable by the government after a fixed period of time. The
interest on this loan is paid by the government regularly, half yearly or annually. When the debt
matures, the government pays back the principal amount to the lenders.
For the repayment of the principal either the government creates a fund in which a fixed amount
is deposited every year or it raises the amount through taxation
Irredeemable debt is that whose principal amount is not refunded by the government. However,
interest is paid regularly on such a debt for the period of its duration.
Debt incurred during a war may be non-redeemable by the government.

e) Internal debt and external debt

Internal debt is that debt which is raised by the government from individuals, institutions e.t.c.
within the country while external debt is a debt that is raised by the government from person or
institution outside the country such as IMF, World Bank e.t.c.

12.4 Need for public debt

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The reason for government borrowing includes:
Deficit budget
The government borrows when it has a deficit budget. The deficit budget can be met by raising
the tax rates or levying new taxes. However tax collection takes a long time. By giving a
particular date for the subscription of a loan, the government can meet its requirements
immediately. That is why government prefers debt to other sources of revenue.

War
The government borrows from the public when it is involved in a war. During a war, the
government’s expenditure increases many times on armaments and forces. This can be met by
raising public loans on a large scale rather than through taxation.

Natural calamities
Natural calamities like earthquakes, floods, famine e.t.c. tend to increase government
expenditure in order to provide relief to the victims. This necessitates large public borrowing by
the government.

Economic development
Both developed and developing countries borrow for their economic development. Developing
countries do not have sufficient resources to finance their development plans because they are
poor. Developing countries borrow for the development of agriculture, industry, power,
transport, communication e.t.c. Developed countries also borrow to modernize their
infrastructure like roads, railways, powers, e.t.c.

Public enterprise and utilities

Every country whether a socialist, capitalist or mixed economy runs certain public enterprises
and utilities such as railways, power works, postal services e.t.c. which requires large funds. The
government can meet them through public borrowing rather than taxation.

Economic stability

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The government also borrows to stabilize the economy. To control inflationary conditions, the
government borrows to take away excess money supply from the public.
Since public borrowing is voluntarily, this is a better method than raising taxes because loans
from the public do not increase the costs of production. Public borrowing also helps to lift the
economy from a depression. During a depression, idle funds are lying with the banks which the
government borrows in order to spend on public work programmes.

12.5 Burden of public debt

Public debt is required to be paid back along with interest from whom the government borrows.
This is done by levying taxes on people. This involves hardship on tax payers which is the
burden of the public debt .The debt may be internal or external The burden of debt may be:
1. Direct money burden
2. Indirect money burden
3. Direct real burden
4. Indirect real burden
The burden of public debt can be examined from the point of view of internal debt or
external debt
Burden of internal debt

The external debt imposes burdens on the society in the following ways
1. Direct money burden
The direct money burden of an external debt is the amount which a debtor country pays to the
foreign creditor country in the form of interest and principal. The repayment of loan and payment
of the interest to the foreign country is made in foreign currency. This imposes a direct money
burden to the borrower country.

2. Direct real burden

This is the loss of economic welfare of the people of the debtor country when they make
payments to foreign creditor. In order to pay the interest and the loan, the debtor

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Country exports more to earn foreign exchange or pays the debt to the external creditor in the
form of exports of goods and services. This is the real burden of external debt.

3. Indirect money burden

If the external burden is utilized for productive purpose such as building roads, channels, power
projects e.t.c. and establishing industries, this will increase employment, income and production.
Its monetary burden will not be heavy because the payment of the principal and interest will be
more than compensated by the benefits flowing from productive projects.

4. Indirect real burden

The imposition of more direct taxes on commodities in order to pay interest and principal on
external loans puts heavy burden on the people. This is because their capacity to work and save
declines. This leads to a fall in production. If interest on external debt consumes a large part of
national income, the government is forced to reduce social and development expenditure. The
burden of debt will be more. The indirect real burden is also very heavy if the external loans are
used in unproductive channel like a war since it will be a dead weight debt on the people.

12.6 Debt burden and future generation

Some economists argue that when the government incurs long term debt it burdens future
generation with the cost of its present policies. Cost here means the sacrifice undergone by the
people. They argue that when the government finances development projects by public
borrowing, the present generation escapes the cost. The burden of debt is shifted to the future
generations which pay the principal and also benefit from projects.
Other economists argue that the real burden is borne in the period in which the government
expenditure is incurred. Therefore, when the government borrows, it diverts private savings into
public use. The payment of interest on bonds is made through taxation and therefore they argue
there is no burden to the future generations.
However, the situation is different when the debt is incurred to finance a war. People who live
during the war bear the heaviest burden by sacrificing consumption of goods. Therefore, the

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burden is on the current generation. During war, the nation may be starved of capital goods and
this will be an indirect burden to future generation.

12.7 Management Of Public Debt

Debt management refers to all actions of the government, including both the treasury and the
central bank which affect the composition and retirement of the debt held by the public.

Objectives of debt management

The main ones are:-
To minimize the interest cost of servicing the debt to the tax payer.
To employ it contra cyclically as stabilization weapon to supplement monetary and fiscal policy.

12.8 Techniques/methods of debt management

They include:
1) Lowering the interest cost.
2 Changing the maturity structure.
3 Advance refunding.
4 Co-ordination with monetary and fiscal policies.

12.9 Redemption of public debt

This means the payment of interest and repayment of principal by the government.
The method of debt redemption includes:

1 Out of revenues – generally, the government pays the debts out of its revenue though a
surplus budget. It makes a provision in the budget as the amount to be paid during the year.

2) Sinking fund – under this method, the government creates a fund for the repayment of
the debts known as sinking fund and deposits a fixed sum of money out of its revenue each year
for the period of the loan.

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3) Serial bond redemption – according to this method, whenever debt is floated, the, date
of maturity of certain bonds is fixed beforehand on the basis of their serial numbers. When the
time for maturity comes, bonds bearing the serial numbers are paid back.

4) Lottery method – according to this method, bonds which are to mature in a particular
period time are drawn on the basis of the lottery system. Only the bond holders whose bond
numbers have come out are paid back while the payments of others are deferred to the other
lottery dates. Such a method creates uncertainty among the bond holders.

5) Debt conversion – in this method, the debt with the highest interest rate is converted into
a new debt when the market rate of interest falls. The government borrows at low rate of interest
and repays the past debt even before it matures. The lender is free to take his money back or get
his loan converted into a fresh one.

6) Capital Levy – this is a once for all tax to redeem a public debt. It is levied on capital
assets on a progressive scale just after a war or an emergency when the burden of the debt is very
heavy.

7) Date repudiation – this means canceling of all debt all together. The government refuses to
repay the debt. This method of debt redemption is not practicable because the government’s
reputation may be at stake. Its very existence may be endangered. However, Russia did it in 1917

12.10 Effects of Public Debt

When government borrows, it transfers money from one type of people to another. Money flows
from the people to the government and further to those on whom government spends the
borrowed money. This leads to expenditure effects of public debt.
When the government pays the interest and repays the loan, money is again transferred from
those who are taxed (by the government in order to pay the interest and principal), to those who
hold government’s bonds. This leads to revenue effects of public debt. These transfers of money
from one set of people to another through public debt affects consumption, production,
distribution and the business activity in general. Therefore public debt has the following effects:

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 a) Effects of public debts on consumption

b) Effects of public debt on production

c) Effects of public debt on distribution

d) Effects of public debts on prices or economic activity

e) Effects of public debt on private sector

12.11 Role of public debt on economic development

Economic development may be defined as the increase in the standards of living of a nation’s
population with sustained growth from a simple low income economy to a modern high income
economy. Its scope includes the process and policies by which a nation improves the economic,
social well-being of its people.
Public debt plays an important role in economic development of a country in the following ways:
a) Capital formation

b) Anti inflationary measure

c) Compulsory savings

1. Capital formation
Borrowing from the public can be another source of capital formation in undeveloped countries.
This device is better that taxation. Taxation means forced saving, borrowing in voluntarily. The
tax payer is never happy in paying tax for he doesn’t expect to get his money back. A lender, on
the other hand, gives his money on loan of his own accord to receive it back along with interest
after a stipulated period. Unlike taxation, borrowing does not adversely affect incentives to save
and invest. The lure of interest is always there to increase the incentives instead.

2. Anti- inflationary.
Public borrowing acts as an anti-inflationary measure by mobilizing surplus money in the hands
of the people in a developing country. A successful public borrowing programme can be a useful
tool of economic development by diverting resources from unproductive channels. Public

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borrowing is resorted to for specific development projects like power generation, irrigation
works, road, railway, e.t.c. Thus it is a useful way of financing development projects.

3. Compulsory savings
If sufficient funds are not forthcoming in the form of voluntary loans, the government may have
to resort to compulsory borrowing for the mobilization of resources for capital formation.
Compulsory public borrowing is therefore justified in those undeveloped countries where
taxation and voluntary borrowing fail to bring adequate funds for development to the exchequer.
Certain sectors of the society who waste a large portion of their income in unproductive channels
or derive special benefits from particular development projects may be forced to subscribe to
government bond. However, it is not advisable for any underdeveloped country to rely on this
method of forced savings except for specific development projects and for a short period.
Ultimately, governments will have to depend on voluntary borrowings.

Summary of the Topic

 Classification/ Types of public debt
 Need for public debt
 Burden of public debt
 Debt burden and future generation
 Management Of Public Debt
 Techniques/methods of debt management
 Effects Of Public Debt
 Role of public debt on economic development

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 Revision Questions
i. Explain the meaning of public debt

ii. Explain the sources of public borrowings

iii. Classify public debt

iv. Explain the burden of public debt

v. Explain the effect of public debt burden on future generations

vi. Explain the techniques of debt management

vii. Describe the role of public debt on economic development

Further References

i. M. L Jighan ( 2006), Public Finance And International Trade, Vrinda Publications P

Limited, Delhi India Pages 82-99
ii. H.L Bhatia (2004) Public Finance.Vikas Publishing Housepvt Limited, New Delhi India
Pages 198-217
iii. Musgrave (2005) Public Finance In Theory And Practice, Tata Mcgraw-Hill New Delhi
Pages 544-563
iv. David N Hyman (2005) Public Finance, A Contemporary Application Of Theory To
Policy Thomson Learning 472-500

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 SAMPLE EXAMINATIONS

UNIT NAME: PUBLIC FINANCE

UNIT CODE: BFM 321
TIME: 2 HRS
Instructions:

Attempt question ONE and any other TWO questions

Question One
i. Explain the functions of public finance in developed nations 3mks
ii. Describe the free rider problem and its solutions 4mks

iii. Highlight the differences between vertical and horizontal equity 3mks

iv. Explain the solutions to externality problem 4mks

v. Distinguish between rent seeking and bureaucracy as they relate to the public choice
theory 4mks

vi. Explain factors determining the taxable capacity 4mks

vii. Account for the growth of public expenditure 4mks

viii. Explain the burden of public debt 4mks

Question Two
i. Explain how to determine the optimum output of social goods 8mks
ii. Explain the meaning of externality 2mks
iii. Describe negative externalities and give two examples 3mks
iv. Explain the measurement of taxable capacity 7mks

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Question Three
i. Explain tax incidence in the case of inelastic supply and elastic demand 3mks
ii. Describe the efficiency principals of taxation 8mks
iii. Explain the measurement of benefits and costs in public projects 7mks
iv. Explain the concept of excess burden of taxation 2mks

Question Four
i. Explain how to measure the taxable capacity of people 6mks
ii. Explain the various types benefits and costs involved in public projects 8mks
iii. Explain the theories that explain increase of public expenditure 6mks

Question Five
i. Explain the various types benefits and costs involved in public projects 6mks

ii. Explain the effect of public debt burden on future generations 6mks

iii. Explain the techniques of debt management 8mks

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UNIT NAME: PUBLIC FINANCE
UNIT CODE: BFM 321
TIME: 2 HRS
Instructions:
Attempt question ONE and any other TWO questions

QUESTION ONE

i. Explain the scope of public finance 4mks

ii. Explain the characteristics of public goods 4mks

iii. Distinguish between equity and equality in taxation 4mks

iv. Describe the public choice theory 5mks

v. Explain the remedies of the public choice theory 5mks

vi. Explain tax incidence in the case of inelastic demand and elastic supply 4mks

vii. Describe the optimal taxation theory 4mks

QUESTION TWO
i. Describe a public good 2mks

ii. Explain the differences public finance and private finance 7mks
iii. Explain the sources of public borrowings 5mks

iv. Explain the causes of market failure and the solutions 6mks

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QUESTION THREE

i. Explain free rider problem and its solutions 4mks

ii. Explain the objectives of public expenditure 3mks

iii. Explain the effects of public expenditure on the economy 4mks

iv. Explain how the following methods can be used to do the costing of a project
a. Shadow pricing of market items 5mks
b. Discounted cost of capital 4mks

QUESTION FOUR
i. Classify public debt 2mks
ii. Describe the role of public debt on economic development 8mks
iii. Account for the growth of public expenditure 6mks
iv. Describe positive externalities and give three examples 4mks

QUESTION FIVE
i. Explain the types of externalities 4mks
ii. Graphically illustrate external costs and benefits 4mks
iii. Explain the implications of externality 4mks
iv. Describe the resource allocation in a mixed economic system 8mks

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