Part One: Principles of Public Finance

Lectures on:
Principles of public finance
Part One
By:
Dr. Mohamed Abdel-Gany

Associate Professor of economics
Vice Dean of Faculty of Politics and Economics,
Beni Suef University
(M.sc & ph. D: Vienna University
of Economics and Business Austria)
Contents
1 Introduction to Public finance __________________________________ 3
1.1 Meaning and Concept of Public Finance ___________________________ 3
1.2 Objectives of Public Finance ____________________________________ 4
1.3 Nature and Scope of public finance_______________________________ 5
1.4 Importance of Public Finance ___________________________________ 7
2 background for studying public finance __________________________ 9
2.1 Allocation of Resources ________________________________________ 9
2.2 The Mixed Economy __________________________________________ 10
2.3 Circular Flow ________________________________________________ 11
2.4 Indifference Curves Analysis ___________________________________ 12
2.5 Budget Constraint Line________________________________________ 14
2.6 Consumer Equilibrium ________________________________________ 15
2.7 Changes in Income and Prices __________________________________ 18
2.8 Income and Substitution Effects ________________________________ 19
2.9 The Law of Demand __________________________________________ 21
2.10 Production and Cost _________________________________________ 24
2.11 Principles of Public Finance ___________________________________ 31
2.12 The Relationship between Public and Private Finance: _____________ 32
2.13 The Public Project in the Capital System: ________________________ 34
2.14 The Public Project in the Socialist System: _______________________ 34
2.15 public budget ______________________________________________ 35
2.16 Terminology _______________________________________________ 38
3 Revenues and Taxation ______________________________________ 42
3.1 Tax Definition: ______________________________________________ 42
3.2 Classification of Taxes: ________________________________________ 43
3.3 Direct and indirect taxation: ___________________________________ 45
3.4 Specific taxes _______________________________________________ 47
3.5 Laffer curve _________________________________________________ 49
3.6 Tax evasion & Double taxation _________________________________ 51
3.7 Revenues of financial fees _____________________________________ 54
3.8 Public loans revenues_________________________________________ 55
3.9 Income Redistribution ________________________________________ 57
4 The Theory of Taxation ______________________________________ 59
4.1 Tax Incidence _______________________________________________ 59
4.2 Excess Burden _______________________________________________ 62
4.3 Optimal Taxation ____________________________________________ 64
4.5 Income Tax _________________________________________________ 68
4.6 Corporation Income Tax_______________________________________ 71
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Public Finance Dr Mohamed Abdelgany
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4.7 Consumption Taxes __________________________________________ 75
4.8 Wealth Taxes _______________________________________________ 78
4.9 Deficit Finance ______________________________________________ 81
5 Taxation: Functions, Objective and Characteristics ________________ 85
5.1 Role of Taxes _______________________________________________ 85
5.2 Characteristics for evaluating taxes _____________________________ 86
5.3 Fair and Simple Taxation ______________________________________ 99
6 Equity, income distribution, and the social safety net _____________ 101
6.1 Concepts of equity __________________________________________ 101
6.2 Horizontal equity ___________________________________________ 108
6.3 Vertical equity _____________________________________________ 109
6.4 The compensation principle __________________________________ 111
6.5 Measuring inequality ________________________________________ 114
6.6 Measuring poverty __________________________________________ 117
6.7 Policy issues in poverty and inequality __________________________ 118
6.8 Is poverty a form of market failure? ____________________________ 122
6.9 Redistribution and free-riding behaviour ________________________ 124
6.10 Administrative cost and fraud ________________________________ 126
6.11 Efficiency and work incentives _______________________________ 129
6.12 Equality of opportunity or equality of results? ___________________ 132
6.13 Behavioural economics: in-kind or in-cash? _____________________ 134
6.14 Which level of government? _________________________________ 136
7 Tax Incidence _____________________________________________ 141
7.1 The Three Rules of Tax Incidence ______________________________ 143
7.2 The second rule of tax incidence is that the side of the market on which
the tax is imposed is irrelevant to the distribution of the tax burdens: ___ 152
7.3 Parties with Inelastic Supply or Demand Bear Taxes; Parties with Elastic
Supply or Demand Avoid Them ___________________________________ 156
8 Tax Incidence in Factor Markets ______________________________ 166
8.1 Incidence Analysis Is the Same in Factor Markets _________________ 166
8.2 Impediments to Wage Adjustment _____________________________ 170
8.3 Tax Incidence in Imperfectly Competitive Markets ________________ 172
8.4 Taxation in Monopoly Markets ________________________________ 176
Tax Incidence in Oligopolies _____________________________________ 177
8.4 General Equilibrium Tax Incidence _____________________________ 180
References_________________________________________________ 186
1 Introduction to Public finance
1.1 Meaning and Concept of Public Finance

In public finance we study the finances of the
Government.
Public finance examines how the Government raises
its resources to meet its ever-rising expenditure.
Public finance is “concerned with the income and
expenditure of public authorities and with the
adjustment of one to the other.”
Public Finance definite as a study of the public

authorities’ income, expenditures and their balance.
• Public finance, as defined by R/G
– “The field of economics that analyzes government

taxation and spending policies”
• Public finance, as described by Former
– “Public finance is nothing else than a sophisticated

discussion of the relationship between the
individual and the state”
• Public finance is about the taxing and spending activities

of the government.
Also known as “public sector economics” or “public

economics.”
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Public finance is both science and art. It positive
science as well as normative science
1) Public Finance is a science – Science is the

systematic study of any subject which studies causal
relationship between facts. Public finance is a
systematic study relating to revenue and expenditure
of the govt. It also studies the causal relationship
between facts relating to revenue expenditure of the
government.
2) Public Finance is an art – Art is the application
knowledge for achieving definite objective. Fiscal
Policy which is an important instrument of public
finance makes use of the knowledge of govt. revenue
and expenditure.
Public finance is an art. It is concerned with real
problems.
1.2 Objectives of Public Finance

We can summarize the Objectives of Public Finance in:
• Increase of efficient use of available economic resources.
• Efficiency of resources allocation.
• Income distribution equality.
• Maintenance of full employment.
• Achievement of economic growth.
• Realization of economic welfare.

1.3 Nature and Scope of public finance
The study of public finance relates to financial
activities of the government including the financial
activities central govt., state govt. and local govt.
Public and Private Finance
Public finance is concerned with the economic
activities of the govt.
Private finance is related to finance of a person
Focus is on microeconomic functions of government –
polices that affect overall unemployment or price
levels are left for macroeconomics.
Scope of public finance unclear – government has role
in many activities, but focus will be on taxes and
spending.
The subject matter of public finance can be divided

into following parts:
• 1) Theory of public Revenue – This branch of
publics finance is related to the study of all those
sources through which a govt. earns revenue. In
it, various sources of govt. income, such as
taxes, public debt and deficit financing are
studied.
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• 2) Theory of Public Expenditure – Problems
related to the govt. expenditure are studied in this
branch of public finance.
• 3) Financial Administration – This branch of
public finance studies the income and
expenditure of the financial administration of the
govt.
• 4) Stability and Growth - In the present times ,
public finance is mainly concerned with the
economic stability and other related problems
of a country.
• 5)Federal Finance – Distribution of the sources of
income and expenditure between the central and
the state govt. in the in the federal system of the
govt. is also studied as the subject matter of
public finance
Further it also deals with fiscal policies which ought to

be adopted to achieve certain objectives such as price
stability, economic growth, more equal distribution of
income. Economic thinking about the role that public
finance is expected to play has changed from time to
time according to the changes in economic situation.
1.4 Importance of Public Finance
Increase in the Activities of government
Government responsibility today is not merely to
maintain Peace and order rather the modern welfare
government also work for the economic development,
full employment, price stability, eradication of poverty,
etc. So owing to an increase in economic development
and social welfare activities, there has also been an
increase in the importance of public finance.
Effect on Economic life
The activities of public finance like public expenditure,
taxation system, etc have a great effect on economic
life. As a result of the govt. policy regarding taxation or
expenditure, production can be increase, saving can
be increased.
Significance of public finance to modern economy is

evident from the following
• 1) To Achieve Adjustment in allocation of

resource – study of public finance tells how
coordination among the allocation of resources
should be effected. Income and expenditure
process of the govt. serves to allocate the
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resources of the country between private goods
and social goods . It also determine the quantum
of production of different social goods.
• 2)To Achieve Adjustment in the Distribution of
Income and Wealth – Study of Public finance give
us knowledge of those methods which help us to
inequalities of wealth and income
• To Achieve Economic Stability –1) In order to
remove involuntary unemployment, effective
demand be stimulated by reducing the taxes.
2)To check inflation, public expenditure be
curtailed and the 3)If there is full employment and
price stability in the economy , then existing level
of taxes be maintained.
• 4) To Achieve Economic Development – T o
increase the rate economic growth , it is essential
to accelerate the rate of capital formation. Hence,
fiscal policy should be so framed as to increase
the rate of saving and investment and reduce
consumption.
It is clear from the above that study of public finance is
of utmost importance in the modern times.
2 background for studying public finance
2.1 Allocation of Resources
Resources are allocated between government and private use:
• For Government Use

– Roads
– Schooling
– Fire Protection
• For Private Use
– Food
– Clothing
• Units of private goods and services are forgone by
individuals so that government can provide goods and
services.
The production-possibility curve
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The production-possibility curve shows alternative
combinations of government goods and services and
private goods and services that can be produced in an
economy. The curve assumes that productive
resources and technology are given. An increase in
government goods from 0G1 to 0G2 requires a
sacrifice of X1X2 units of private goods per year.
2.2 The Mixed Economy

Characteristics of a mixed economy:
1. Government supplies many goods and

services
2. Government regulates private economic
activity
3. Government expenditures equal ¼ to ½ of GDP
4. Government participates in markets as a buyer
of goods and services
2.3 Circular Flow
The upper and lower loops represent transactions

between households and business firms in markets.
Households use the income they earn from the sale of
productive services to purchase the outputs of
business firms. The inner loop represents transactions
between households and government and between
business firms and government. Governments
purchase productive services from households and
outputs of business firms. These purchases are
financed with taxes, fees, and charges levied on
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persons and firms, and the inputs acquired are used to
provide government services and transfers.
2.4 Indifference Curves Analysis
• Tool for understanding choices people make

regarding purchase and use of goods and
services
• Understanding choices to give up leisure time to
obtain income through work
• Understanding choices to give up consumption
today for more consumption in the future
• Uses concept of the market basket – a
combination of various goods and services
available for consumption over a certain period
Assumptions Underlying Indifference Curve Analysis
1. People can rank market baskets from most to

least desired.
2. If basket A is preferred to basket B and basket B
is preferred to basket C, then basket A must be
preferred to basket C.
3. People always prefer more of a good to less of it,
all other things being equal.
4. The amount of money people will give up to
obtain additional units of a given good will
decrease as more of the good is acquired.
Indifference Curve – a graph of all combinations of
market baskets among which a person is indifferent
Indifference curves are downward sloping. Curves

farther out from the origin correspond to higher levels
of satisfaction for a person.
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2.5 Budget Constraint Line
The budget constraint indicates the monthly market
baskets that the person can afford, given monthly
income and the prices of good X and all other goods.
The Figure shows a person’s monthly budget
constraint between gasoline and expenditures on other
goods.
Assume that the price of gasoline is $1 per gallon and
that the person’s monthly income is $100. A market
basket corresponding to 100 gallons of gasoline per
month would exhaust the person’s monthly income,
allowing no expenditures on other goods. This
corresponds to point B in the Figure.
Similarly, if the person spent all available monthly
income on goods other than gasoline, there would be
no gasoline in the monthly market basket. This
corresponds to point A on the graph.
The budget constraint is a straight line connecting
these two points. Market baskets corresponding to
points on or below the line are affordable. Those above
the line, such as C, cannot be purchased with available
monthly income.
The consumer can afford only those market baskets of
gasoline and other goods per month on or below the
budget constraint line AB.
2.6 Consumer Equilibrium

The consumer is assumed to behave so as to obtain
the most satisfaction (or utility) possible, given the
budget constraint.
The consumer substitutes expenditures on goods
other than X for purchases of good X, up to the point at
which the highest possible satisfaction is obtained.
Because indifference curves are convex, this occurs at
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a point of tangency between the budget line and an
indifference curve. In Figure, the consumer equilibrium
is represented by point E.
The market basket corresponding to point E is the one

that gives the consumer the highest possible level of
satisfaction, given the budget constraint.
The corresponding monthly consumption of gasoline
is 60 gallons. The person therefore spends $40 on
goods other than X each month when the price of
gasoline is $1 per gallon. The equilibrium condition is
a tangency between the indifference curve and the
budget line, implying that the slopes of these two
curves are equal. The slope of the budget line is the
extra dollars that must be surrendered to obtain each
extra gallon of gasoline, which is the price of gasoline
multiplied by 1. The slope of the indifference curve is
the marginal rate of substitution of gasoline for
expenditures on goods other than gasoline per month
multiplied by 1. The marginal rate of substitution can
be thought of as the marginal benefit of good X. The
equilibrium condition can be written as
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An increase in income shifts the budget constraint line
out of parallel to itself. A decrease in income shifts it
inward.
2.7 Changes in Income and Prices

A change in income shifts the budget constraint line in or out
parallel to itself without changing its slope. This is illustrated in
Figure.
Changes in the price of good X rotate the budget constraint line

to a new intercept on the X axis.
An increase in income shifts the budget line outward, expanding

the number of affordable market baskets. Similarly, a decrease
in income diminishes the number of affordable market baskets.
A change in the price of good X changes the slope of the budget
line. As illustrated in Figure, a decrease in the price of X swivels
the budget line outward to a new intercept, B , on the X axis. The
budget line becomes flatter, reflecting the lower price of X.
Similarly, an increase in the price of good X makes the budget
line steeper as it rotates to point B.
2.8 Income and Substitution Effects

The Figure shows how the substitution effect can be
isolated from the income effect. The person whose
indifference curves are shown is initially in equilibrium
at E1. Consuming 60 gallons of gasoline per month
and spending $40 per month on other goods, this
person’s monthly income is $100. If the price of
gasoline goes up to $2 per gallon as a result of a tax,
the budget line would swivel inward.
The consumer is now worse off, in a shift from point
E1 to point E2. AtE2, monthly gasoline consumption
falls to 40 gallons per month. The consumer spends
$80 per month on gasoline at the higher price and uses
$20 of the remaining income to buy other goods.
Suppose the consumer were offered a monthly
subsidy (say, by helpful parents) to help buy gasoline
after the price increase. If this monthly increase in
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income were sufficient enough to return the consumer
to indifference curve U2, where the level of satisfaction
is the same as before the price increase, the
substitution effect could be isolated
The substitution effect could be observed if the

consumer were given an increase in income to offset
the decline in satisfaction caused by the price increase
of gasoline.
2.9 The Law of Demand
For most goods, both the income effects and the
substitution effects of price increases tend to decrease
the consumption of a good. The opposite is true for
price decreases. Goods for which the income effect of
a price increase acts to decrease consumption (and for
which price decreases have the opposite effect) are
called normal goods.
Throughout this text, the assumption is that all goods
and services discussed are normal goods. The inverse
relationship between price and the quantity of a good
purchased per time period is the law of demand, which
holds that demand curves slope downward, other
things being equal. The Figure shows a demand curve
for a good. Movements along that curve in response to
price changes are called changes in quantity
demanded. A shifting in or out of the curve is called a
change in demand, which can be caused by changes in
income, tastes, or the prices of substitutes or
complements for the good. The demand curve also
gives information on the maximum price that a
consumer will pay for a good. This maximum price
represents the marginal benefit of the good to a
consumer.
Accordingly, the demand curve in Figure is also
labeled MB. Points on demand curves throughout this
text are interpreted as the marginal benefit (MB) of the
corresponding quantity. Market demand curves are
derived from individual demand curves simply by
adding the quantities consumed by all purchasers at
each possible price
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The demand curve depicts the inverse relationship
between price and quantity demanded implied by the
law of demand. Points on a demand curve also can be
interpreted as the marginal benefit of the various
amounts of the good available by month.
Price Elasticity of Demand
Measures the percentage change in quantity
demanded due to a given percentage change in price:
Consumer Surplus
The area PAB is a measure of the consumer surplus

(net benefit) that consumers receive from consuming
Q1 gallons of gasoline per month.
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The Work-Leisure Choice
Point E represents the combination of leisure and

income from work each day that gives the worker the
greatest possible level of daily well-being. In
equilibrium, the person whose indifference curves are
drawn chooses 16 hours of leisure per day. The person
therefore works 8 hours per day.
2.10 Production and Cost

• Production function – the maximum output obtainable
from any given combination of inputs (land, labor,
materials, capital), given technology
• Two periods to production
– Short run (inputs cannot be varied)

– Long run (all inputs are variable)
Isoquant Analysis
Isoquants - curves that show alternative combinations

of variable inputs that can be used to produce a given
amount of output
The monthly input combination corresponding to point

E represents the minimum cost method of producing a
monthly output of Q1 units.
Costs
• Total cost (TC) – the value of all inputs used to

produce a given output
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• Variable cost (VC) – the cost of variable inputs
such labor, machines, and materials
• Fixed cost (FC) – cost of inputs that do not vary
with output
• Average cost (AC) – equal to total cost of
production divided by the number of units
produced
• Average variable cost (AVC) – variable cost
divided by the number of units produced
• Average fixed cost (AFC) – difference between
average cost and average variable cost
Short-Run Cost Curves

The competitive firm maximizes profits in the short run
by adjusting output to Q*, which corresponds to the
point at which P MC The portion of the marginal cost
curve for which MC exceeds minimum possible
average variable costs is the short-run supply curve
under perfect competition.
Competition
1. Perfect competition exists when a firm is one of

many producing a small market share of a
standardized product with no difference in
quality.
2. A competitive firm sells its output in a perfectly
competitive market and is a price taker, because
it takes the price of its product as given.
3. Profits are maximized by producing that output
for which price is equal to marginal cost:
P = MC
Supply
• Short-run supply curve – price exceeds minimum

possible average variable costs of production
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• Long-run competitive equilibrium – economic
profits are zero so that no incentive exists for
firms to either enter or leave
• Long-run industry supply curve – a relationship
between price and quantity supplied for points at
which the industry is in equilibrium:
P = LRMC = LRACmin
Long-Run Competitive Equilibrium
In the long-run competitive equilibrium, P = LRMC =

LRAC. Points on the long-run supply curve correspond
to outputs at which firms in the industry earn zero
economic profits.
Long-Run Supply
If input prices are independent of the size of an

industry, the long-run supply curve is indefinitely
elastic at a price corresponding to LRACmin, which
remains constant as the industry increases or
decreases in size in the long run. The supply curve is
infinitely elastic at P = LRACmin in the long run.
Price Elasticity of Supply
The percentage change in quantity supplied in response to any

given change in price:
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Long-Run Supply
If annual output is fixed and does not vary with market

price, supply is perfectly inelastic.
2.11 Principles of Public Finance
• Stabilization
• Allocation
• Distribution
Stabilization
Govt. Decisions on:
• Revenues – Spending – Surplus- Deficit-
Lending- Borrowing.
• Income – Prices- Savings – Investment- Balance
of payments- Rate of Monetary Growth.
Principles of Stabilization
1) non-inflationary financing.
2) sustainability of expenditure & revenue decisions
and debt financing.
3) credibility and predictability.
Allocation
Production- Consumption- Tax –Subsidies- Prohibit or
require certain production.
Allocation Principles
 Tax policies that reflect the taxable capacity of
the economy (% of GDP) as little as possible.
 Expenditure decisions that contribute most to the
provision of public goods and services.
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 Decentralizing budget decision-making as much
as possible consistent with good financial
control.
Distribution
Government Policy:
 Tax- Expenditure.
 Distribution of Wealth and Poverty.
Distribution Principle:
a preference in tax and expenditure policy change for
policies that relatively benefit poor people.
• The individuals can seek loans, in accordance to

their resources, to meet their expanding
expenditures.
• The state can seek external loans to cover
unordinary expenditures such as the
expenditures of wars and crises.
2.12 The Relationship between Public and

Private Finance:
The public finance differs from private finance in terms

of objectives, methods and regulations.
As to Objectives:
• The public finance aims to achieve the public
interest.
• The private finance aims to achieve the private
interest.
• Profitability is one of the private finance’s
objectives.
• The state establishes projects and provides
services regardless of profitability.
As to Methods:
• The state has several authorities and mandates in
managing its affairs such imposing taxes and
fees.
• The individuals or the private corporations enjoy
limited not broad authorities and mandates.
As to Regulations:
• Individuals estimate revenues and then spend in
accordance to those revenues.
• The state estimates the expenditures and then
starts to work out the necessary resources that
can cover such expenditures.
• The individuals can seek loans, in accordance to
their resources, to meet their expanding
expenditures.
• The state can seek external loans to cover
unordinary expenditures such as the
expenditures of wars and crises.
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2.13 The Public Project in the Capital System:
• The project make its decisions according to prior
calculations, production expectations and the
expected revenue of its activity.
• Realization of maximum productivity or
profitability.
• Use of optimal combination of production
elements.
• Revenues depend on prices.
Advantages of the Capital System:
• Economic Freedom.
• Promotion of invention and innovation motives.
Disadvantages of the Capital System:
• Monopoly.
• Squander of Economic Resources.
• Ill-distribution of income and property.
• Economic Fluctuations.
2.14 The Public Project in the Socialist System:

Features of the Socialist System:
• Collective property of mass production.
• Satisfaction of social needs.
• Centralized Planning.
• Provision of necessary goods and services for
individuals at reasonable prices.
• Reform of income distribution defect.
Disadvantages of the Socialist System:
• Imbalance between individual and collective
tendencies.
• Individual do not participate in production
decision making.
• Absence of discretion and democracy.
• Non-realization of social justice.
• Absence of flexibility in the method of socialist
performance.
• Imposing certain types of consumption goods at
specific prices and low quality.
2.15 public budget

Meaning of public budget:
It means the financial authorities’ initial assessment

for each fiscal year, in turn for, the state’s detailed
public revenues and expenditures. Thus, the list
includes two columns:
• First column: it includes expenditures.
• Second column: it includes revenues statement
Main basis of public budget
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• Relative assessment:
the budget does not contain real figures but expected

estimation of government’s revenues and expenditures
for the next fiscal year.
• Annual assessment:
if expected estimations prepared for a year, they are

often named after it.
• Detailed assessment:
it includes a detailed statement of the state’s all

revenues and expenditures where each item of the
agreement is entered and distributed at different
sectors. All revenues and their sources are registered
and distributed according to each source of revenues.
• Authorized:
in this case the projected public budget is referred to

the legislative council for discussion and amendments.
• Non-allocation base:
this basis is related to the non-allocation of a particular

revenue to cover a particular expenditure. However, all
public expenditures are met through all public
revenues
• Balance base:
it necessitates the necessary equality of public

revenues to public expenditures. Whenever the public
expenditures exceed the public revenues, there is a
budget deficit appears. On the contrary, whenever
public revenues exceed public expenditures there is a
budget surplus.
Deficit of public budget

The public budget may face deficit when the public
expenditures exceed the public revenues.
• Total deficit:
is the difference between the public expenditures and

its own public revenues during the fiscal year.
• Net deficit:
It means the remained value of the total deficit after

including all domestic savings and loans. This deficit
is often met by the banking system.
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• Cyclical deficit: the part of the budget deficit that
is a result of a downturn in economic activity.
• Structural deficit: the part of the budget deficit

that would exist even if the economy were
operating at full employment.
• Total Budget Deficit = Cyclical Deficit +

Structural Deficit
2.16 Terminology
• Debt Service - the sum of loan repayments,
interest payments, commitment fees and other
charges on foreign and domestic borrowings.
• Free rider:
An actor such as an individual or a firm that enjoys

the benefits of a public good without paying for it.
• Global public good:
A public good with benefits or costs that are strongly

universal across countries, people, and generations.
• Regional public good:

A public good whose benefits or costs span some or
all countries within a geographic region.
Transnational public goods: An umbrella term

covering both regional and global public goods.
• Pareto efficient:
A resource allocation is said to be Pareto efficient (or

optimal) if there is no rearrangement that can make
anyone better off without making someone else worse
off.
Static efficiency:
The efficiency of the economy with given technology.
Fiscal Policy
• We studies how governments can use fiscal

policy—changes in taxes and spending that
affect the level of GDP—to stabilize the economy
(to achieve particular economic goals, such as
low unemployment, price stability, and economic
growth.)
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• Expansionary Fiscal Policy: Increases in
government expenditures and/or decreases in
taxes to achieve particular economic goals.
• contractionary Fiscal Policy: Decreases in

government expenditures and/or increases in
taxes to achieve macroeconomic goals.
Crowding Out
Refers to a decrease in private expenditures that
occurs as a consequence of increased government
spending or the financing needs of a budget deficit.
• Complete Crowding Out: a decrease in one or

more components of private spending completely
offsets the increase in government spending.
• Incomplete Crowding Out: the decrease in one or

more components of private spending only
partially offsets the increase in government
spending.
Market Failure
• When the market does not efficiently allocate

resources.
• Either too much or too little is produced
– Monopoly
– Externalities
– Public goods
Externalities
• Occur when decision makers do not consider all

costs (or benefits) of their actions.
Pigouvian Approach
Social Cost = Private Cost + External Cost
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3 Revenues and Taxation
The public revenues can be classified into:

• Revenues which the state collects from its
properties (Domain yield)
• Revenues which the state collects from running
the public utilities.
• Revenues which the state collects from financial
aids, grants, military compensations and
international assistances.
• Revenues which the state collects from the taxes.
3.1 Tax Definition:

• Tax is considered as the most important sources
of the state public revenues and comes first in
the capitalist and socialist systems due to its
economic, political and social effects.
• Tax is defined as the sums of money which the
state forcibly deducts, and for no return, to
finance its needs. It is imposed on the taxpayers
that have normal and moral personality according
to their financial and payment abilities.
Tax includes the following elements:
1- Tax is paid in cash

Tax is distinguished as it is paid in cash and not in
kind.
2- Element of obligation:
Tax is distinguished by the element of obligation and
forcing.
3- It does not generate a return:
Tax is based on the state’s right of imposing tax
regardless of the returned benefit that each individual
can gain separately.
4- Generalization of tax:
Tax is generally imposed on all personalities in the
society, individuals, companies, corporations, banks,
etc.
5- Financing the state’s needs:
The state collects taxes to obtain revenues necessary
for covering its public expenditures.
6- Payment ability:
Tax is imposed on taxpayers according to their ability
to bear its burdens.
3.2 Classification of Taxes:

Taxes can be divided into four categories, namely:
• Taxes imposed on individuals and taxes imposed
on funds.
• Distributive taxes and measuring taxes.
• In kind taxes and personal taxes.
• Direct taxes and indirect taxes.
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Distributive Taxes and Measuring Taxes:
• Distributive taxes mean the state determines in
prior the tax amount that it intends to collect.
Then, it distributes the burdens of collecting the
tax amount on individual taxpayers according to
their payment ability.
• The distributive tax is distinguished by the state’s
prior knowledge of that tax amount. Since this tax
is unfair, all states have abandoned and tended to
the measuring tax.
Measuring taxes
• In the measuring tax, the state determines the tax
price without determining the tax amount.
Personal Taxes:
• They do not include the income or wealth as a
whole they give room for the minimum standard
of living.
• They take income source into consideration.
• They take into account the taxpayer’s personal
circumstances.
• They are imposed on the net income or the
capital.
• They increase progressively according to the
income increase, that is, they are progressive
taxes.
In kind Taxes:
• They include the whole income or wealth.
• They do not take income source into
consideration.
• They do not take into account the taxpayer’s
personal circumstances.
• They are imposed on the total income or the
capital.
• They are imposed with a unified price, that is,
they are proportional taxes.
3.3 Direct and indirect taxation:
• Direct taxation are the taxes imposed on the

income and the capitals. In such a case it is
impossible to transfer the tax burden.
• Indirect taxation are the taxes imposed on the
consumption and customs taxes and it is
possible to transfer the tax burden.
Meaning of tax burden transfer:
means another person- rather than entitled tax-paying
person- can bear by end the tax.
Types of tax burden transfer:

• Cash or payment burden:
It means the person who bears the direct cash burden
of tax.
• Real burden or effect:
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It occurs when a person manage to transfer the tax
burden to another person or other persons.
• Forward burden transfer:
It occurs when the good producer manages to transfer
the tax toward the final consumer.
• Backward burden transfer:
It occurs when a producer lowers the elements of
production cost.
• Total transfer of tax burden:
Transfer can be total when the tax payer manages to
totally transfer the tax paid sum to another one.
• Partial transfer of tax burden:
Transfer could be partial when a tax payer can only
transfer part of it.
• Deviated Tax burden transfer:
It occurs when the tax is transferred to another good
instead of the one on which tax was imposed.
• The legislator intended transfer of tax burden:
It occurs when the legislator determines the legal
taxpayer who is required to pay the tax to the public
treasury.
• Unintended transfer of tax burden:
It is the opposite of the legislator’s intended transfer of
tax burden.
Disadvantage of direct taxation

• There are many opportunities for tax evasion.
• The delay of collecting a large portion of the tax
due to the complication and extended procedures
of the collection process.
• The amount of collected tax cannot be controlled.
• The reduction of the amount’s actual value in
times of inflation and rising prices.
3.4 Specific taxes
Specific taxes are these taxes imposed on each type of

income according to income source whether work,
capital, or work and capital together.
 There are more than three types of specific

taxes:
Such as the income work tax which is imposed on
salaries, wages and tax of no-commercial professions
which is imposed on private professions’ revenues
and finally the public revenue income.
Unified taxes
Unified taxes mean that the taxpayer’s income,

regardless of its varied sources, subjects to a tax paid
at once.
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Definition of tax capacity:
It means “the maximum amount of funds which the

taxes can collect according to the national income
limits and its structure, and under the prevailed
political and social system.”
The difference between tax capacity and tax pressure
• Tax capacity expresses the society’s potential

ability of bearing taxes.
• Tax pressure expresses the society’s actual
ability of bearing taxes.
• Tax pressure could be less than or equal to tax
capacity but never exceeds tax capacity.
Factors affecting tax capacity:

• Individual’s average income:
The higher the individual’s average income, the more
the tax capacity is.
• Economic surplus:
Economic surplus is the difference between dwelt
production and necessary consumption. The higher
the economic surplus, the more the society’s tax
capacity is.
• Pattern of national income distribution:
Tax capacity is affected by the pattern of national
income distribution among the individuals.
• Condition of economic activity:
When inflation dominates the economic activity, the
taxes’ cash amount increases.
3.5 Laffer curve

• High tax rates decrease revenues
– Reduce incentives to work
– Encourage consumption of leisure activities
– Encourage participation in shadow (hidden)

economy
Encourage out-migration
The Laffer Curve: Tax Rates and Tax Returns
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• If income tax rates were lowered, would it
increase or decrease tax revenue?
• There are two tax rates at which zero tax

revenues will be collected ( 0% and 100% )
• An increase in tax rates could cause tax revenues

to increase.
• A decrease in tax rates could cause tax revenues

to increase.
Tax exemption meaning
However, taxes laws in all states stipulated granting

certain exemptions for different aims mostly:
exemptions due to the increased family burdens,
exemption on costs for getting an income, exemptions
for achieving economic purposes and tax justice.
3.6 Tax evasion & Double taxation
Tax evasion meaning:
• Tax evasion is a phenomenon by which a

taxpayer tries to evade paying part or whole of a
tax that he should pay, by using different means.
• International tax evasion:
It occurs when a taxpayer hides from his state the

profits which he had obtained by investing his funds in
another state.
3.6.1 Types of tax evasion

• Full evasion: it occurs when a taxpayer manages
in evading the whole tax.
• Partial evasion: when a tax payer evades paying

part of the tax, it is called partial evasion.
Means of fighting against tax evasion
First: precautionary procedures which includes:
• Collecting taxes from the main source.
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• Reporting about the tax evaders in turn of a
financial reward.
• The right of scrutinizing the taxpayers’ records.
• Submission of an oath-supported report. In such

a case, the false oath should be punished
according to the law.
• Second: Punitive procedures:
• The application of a certain punition on an

evader of who evades paying taxes stipulated in
law could be either confiscation, fine or
imprisonment for all types of evasion.
Third: international means for fighting against •
evasion:
These means are conducted through the •
inclusion of agreements among states to fight

against tax evasion and exchange information
about taxpayers who are staying in other
countries.
3.6.2 Meaning of double taxation
It means imposing the tax more than once on the same

person and on the same fund during the same
duration. For example, when Egypt and Austria impose
a tax on a resident in Austria on his 2008 return from
Egyptian shares and bonds, then, the double taxation
occurs twice in this case.
There are four conditions for the occurrence of double

taxation, namely:
• The taxpayer should be the same person.
• The taxable material should be the same.
• The two taxes or taxes should be of the same

type or at least similar.
• The duration in which taxes are paid should be

the same.
Types of double taxation:
Double taxation could be either internal or external and

could be in both cases intended or unintended.
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• internal double taxation:
It occurs when the central government, public

domestic authorities impose the same tax on the same
fund.
Means of double taxation avoidance
– First: double taxation avoidance could be

done through domestic legislation by
restricting the stare’s financial authority
from extending out of its territories.
– Second: double taxation could be avoided

through international agreements by
concluding bilateral agreements to prevent
certain double taxation according to what
the international agreements stipulate in the
international law.
3.7 Revenues of financial fees

Revenues of financial fees have a great importance as
a source of revenues.
• Fee is a cash sum of money.
• Fees are considered as dominant revenues.

• Some fees could be transferred into taxes such
as registration fees.
• The revenues fees are little.
• It is difficult to predict the revenues fees in prior.
• Fees are not characterized by flexibility.
• A fee is paid for a return.
• A fee price does not differ according to the

individual’s financial position.
Examples of financial fees
Postal fees, education fees, judicial fees,

documentation of an agreement or a date verification,
immigration fees for passport issuance, hunting
license, license of public road occupation, weapon
license, private driving license.
3.8 Public loans revenues

Public loans are one of the most important unordinary
sources of revenues. Whenever a state is unable to
settle expenditures from its ordinary source, it often
makes use of public loans such as when a state sells
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part of its properties. A state could also make use of
its reserved funds, impose unordinary taxes or
conclude a loan.
Types of public loans:
Loans are either internal or external.
– Internal loan:
it is a loan which the state concludes within its

territories. The state determines loans conditions such
as duration, ways of payment and privileges granted to
lenders.
– External loan:
it is a loan which the state concludes in the foreign

markets. The state obtains the loan amount from a
foreign country or a normal or moral person resides
abroad.
Permanent and contemporary loans:
• Permanent loans:
They are loans which the state concludes without
determining a payment deadline and called long or
medium term debts.
• Contemporary loans:
they consumable loans in the sense that the state

determines in prior their payment deadline.
Public loan denial
It means that the state announces its refusal of paying

the loan’s interests or its asset.
3.9 Income Redistribution

Measuring Income Inequality
 Lorenz curve:
a curve showing the percentage of total income

received by a given percentage of households whose
income are arrayed from smallest to largest.
Gini Coefficient
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 Gini coefficient:
a measure of inequality of the income distribution,

defined as the ratio of area between the Lorenz curve
of the distribution and, to the area under the uniform
distribution.
A number between 0 and 1, where 0 corresponds to

perfect equality (i.e. everyone has the same income)
and 1 corresponds to perfect inequality (i.e. one
person has all the income, while everyone else has
zero income).
4 The Theory of Taxation
Taxes are the most important source of revenue for
modern economies. The theory of taxation explores
how taxes should be levied to enhance economic
efficiency and to promote a “fair” distribution of
income.
Various aspects of the Taxation theory are examined in
the following pages.
4.1 Tax Incidence

To discuss this normative issue requires some
understanding how taxes affect the distribution of
income.
A simple way to determine how taxes change the
income distribution would be to conduct a survey in
which each person is asked how many pound he or
she pays to the tax collector each year.
Although such an approach is convenient, it is
quite likely to produce misleading answers.
To see why, suppose that the government levies a tax
of one pound on the sellers of a certain commodity.
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Suppose that prior to the tax, the price of the
commodity is 20 pound, and that after the tax is levied,
the price increases to 21 pound. Clearly, the sellers
receive as much per unit sold as he did before.
The tax has not made them worse off.
Consumers pay the entire tax in the form of higher
prices. Suppose that instead, the price increases to
20.25 pound. In this case, sellers are worse off by 75
cents per unit sold; whereas consumers are worse off
by 0.25 pound per unit sold.
The burden of the tax is shared between the two
groups.
Yet another possibility is that after the tax is imposed,
the price stays at 20 pound. If so, the consumer is no
worse off, while the seller bears the full burden of the
tax.
All three cases above have exactly the same
statutory incidence. But the situations differ
drastically with respect to who really bears the
burden.
The economic incidence of a tax is the change in the
distribution of private real income induced by the tax.
The example above suggests that the economic
incidence problem is fundamentally one of determining
how taxes change prices.
In the conventional supply and demand model of price
determination, the economic incidence of a tax
depends on how responsive supply and demand are to
prices.
In general, the more responsive supply is to price
relative to demand, the greater the share of the tax that
will be shifted to consumers. Intuitively, the more
responsive demand is to price, the easier it is for
consumers to turn to other products when the price
goes up, and therefore more of the tax must be borne
by suppliers. Conversely, if consumers purchase the
same amount regardless of price, the whole burden
can be shifted to them.
In cases where the responses of supply and demand to
price are well understood, then fairly reliable estimates
of the economic incidence of a tax can be obtained. In
some areas, the behavioural responses are not well
understood, and incidence analysis is on less firm
ground.
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For example, there is still great controversy over the
burden of taxes on corporations--to what extent are
they borne by owners of capital, and to what extent by
laborers? This is an important topic for research.
4.2 Excess Burden

Taxes impose a cost on the taxpayer. It is tempting to
view the cost as simply the amount of money that he
or she pays to the government.
However, A tax distorts economic behaviour--in
general, consumers buy fewer taxed goods and more
untaxed goods than otherwise would have been the
case. Their decisions are not based entirely on the
merits of the commodities themselves. In the same
way, business owners make investments based in part
on tax considerations, as opposed to economic
fundamentals. Because a tax distorts economic
activity, it creates a loss in welfare that actually
exceeds the revenues collected.
In general, the more responsive behavior is to the tax,
the greater the excess burden, other things being the
same. Intuitively, because excess burdens arise
because of distortions in behavior, the more that
behavior is capable of being distorted, the greater the
excess burden.
Another important result is that the excess burden of a
tax increases with the square of the tax rate--doubling
a tax quadruples its excess burden, other things being
the same.
This means that, in general, it makes sense to spread
taxes over as large a group of commodities as
possible--a small tax on a number of commodities has
a smaller excess burden than a very large tax on one
commodity.
This discussion suggests that, just like the incidence
problem discussed above, the excess burden of a tax
depends on the behavioural response to the tax.
Estimating such behavioural responses and
computing excess burdens is an important role for
public finance economists.
The fact that a tax generates an excess burden does
not mean that the tax is bad.
One hopes, after all, that it will be used to obtain
something beneficial for society either in terms of
enhanced efficiency or fairness.
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But to determine whether or not the supposed benefits
are large enough to justify the costs, sensible policy
requires that excess burden be included in the
calculation as a cost to society.
4.3 Optimal Taxation

Public finance economists have devoted a great deal
of attention to the problem of the design of optimal
taxes.
Of course, this is a normative issue, and it cannot be
answered without a statement of ethical goals.
To begin, suppose that the goal is to raise a given
amount of money with the smallest amount of excess
burden possible. There are a variety of ways to
characterize the result. One of the most elegant is the
rule that as long as goods are unrelated in
consumption (that is, are neither substitutes nor
complements), then the more responsive demand is to
price, the lower should be the tax rate on that
commodity.
The intuition behind this rule is straightforward.
Efficient taxes should distort decisions as little as
possible. The potential for distortion is greater the
more responsive the demand for the commodity is to
its price. Therefore, efficient taxation requires that
relatively high rates of taxation be levied on goods
whose demands are relatively unresponsive to their
price.
This result strikes many people as ethically
unappealing. For example, the demand for food is
relatively unresponsive to changes in its price. Is it
really desirable to tax food at relatively high rates?
Most people would argue that it is not desirable,
because their ethical views indicate that a tax system
should have vertical equity: It should distribute
burdens fairly across people with different abilities to
pay.
Public finance economists have shown how to modify
the efficiency rule to account for the distributional
consequences of taxation. Suppose, for example, that
the poor spend a greater proportion of their income on
commodity X than do the rich, and vice versa for
commodity Y. Then even if the demand for X is less
responsive to price than the demand for Y, optimal
taxation may require a higher rate of tax on Y than X.
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True, a high tax rate on Y creates a relatively large
excess burden, but it also tends to redistribute income
toward the poor. As in other areas of public finance,
the optimal policy depends on the extent to which
society is willing to trade-off efficiency for fairness
The theory of optimal taxation falls directly within the
framework of conventional welfare economics. There
are other criteria for tax design that are not reconciled
so easily with welfare economics. The main one is
horizontal equity, the notion that people in equal
positions should pay equal amounts of taxes. One
problem with implementing this principle is defining
equal positions. The most common criterion is
income, but wealth and consumption are also possible.
A problem with all three measures, however, is that
they are the outcomes of people’s decisions.
Two individuals may have exactly the same wage rate,
but one chooses to work 40 hours per week while
another chooses to work 80 hours per week.
Despite the fact that they have different incomes, in a
meaningful sense they are in “equal positions”
because their potential to earn income is the same.
Things are complicated further by the fact that
adjustments in market prices may render some
horizontal inequities more apparent than real.
Suppose, for example, that in one type of job a large
part of compensation consists of amenities that are
not taxable-pleasant offices, access to a swimming
pool, and so forth. In another occupation,
compensation is exclusively monetary, all of which is
subject to income taxation.
This would appear to be a violation of horizontal
equity, because the person in the job with a lot of
amenities has too small a tax burden. But, if both
arrangements coexist and individuals are free to
chose, then the net after-tax rewards (including
amenities) must be the same in both jobs. Otherwise,
people would leave the job with the lower net after-tax
rewards. In short, the fact that amenities are not taxed
is not unfair, because the before- tax monetary
compensation falls by just enough to offset this
advantage. Put another way, introducing taxation for
such amenities would create horizontal inequities
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4.5 Income Tax
Taxes on income play a major role in the fiscal
systems of all western countries. A starting point for
the analysis and evaluation of income tax systems is a
definition of income.
public finance economists use the so-called Haig
Simons definition: Income is the money value of the
net increase in an individual’s power to consumer
during a period.
This is equal to the amount actually during the period
plus net additions to wealth. Net additions to wealth--
saving--must be included in income because they
represent an increase in potential consumption.
Importantly, the Haig-Simons criterion requires the
inclusion of all sources of potential increases in
consumption, regardless of whether the actual
consumption takes place, and regardless of the form in
which the consumption occurs.
The Haig-Simons definition encompasses those items
ordinarily thought of an income: wages and salaries,
business profits, rents, royalties, dividends, and
interest.
These forms of income are relatively easy to measure
and to tax. However, in other contexts, implementing
the Haig-Simons criterion can lead to major problems.
for examples:
• Only income net of business expenses increases
potential consumption power.
But distinguishing between consumption and costs of
obtaining income can be difficult. To what extent is a
desk bought for an office at home just furniture, and to
what extent is it a business expense?
• A capital gain is the increase in the value of an asset--
say, a share of stock-- during a period of time. From a
Haig-Simons point of view, a capital gain is income
whether or not the stock is actually sold, because the
capital gain represents an increase in potential to
consume. However, capital gains and losses may be
very difficult o measure, particularly when the assets
are not sold. Indeed, in general, no attempts are made
to tax capital gains of assets that have not actually
been sold.
• In-kind services are not easy to value. One important
example is the income produced by people who do
housework rather than participate in the market. Such
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difficulties in implementing a Haig-Simons concept of
income are of great practical significance.
To the extent that income that comes in certain forms

cannot be taxed, individuals’ decisions are biased in
the direction of taking their income in those forms.
Thus, for example, there is a bias in favor of capital
gains (which are taxed only when the asset is sold) as
opposed to dividend income (which is taxed as it is
earned).
Such biases create efficiency losses to the economy.
Further, complicated rules are often needed to
determine whether a certain type of income falls in a
category that is favored by the tax system. Capital
gains again provides a good example; it is not always
obvious whether the return that an individual receives
from a company is a dividend or a capital gain. Such
complexity leads to substantial compliance costs.
In additions, several forms of income that would be
administratively relatively easy to tax are partially or
altogether excluded from the income tax bases of most
countries.
An important example is the return on saving that is
deposited in retirement accounts. Indeed, given the
extent to which income that is saved in various forms
is excluded from taxation, it is a misnomer to
characterize these systems as income taxes.
4.6 Corporation Income Tax

Corporations are independent legal entities and as
such are subject to taxes on their incomes. Most
public finance economists believes that it makes little
sense to levy a special tax on corporations. Only real
people can pay a tax; hence, it would make more sense
to tax the incomes of corporation owners via the
personal income tax. Again, this distinction is of more
than academic importance. Treating the corporation
as a freestanding entity for tax purposes leads to
important distortions in economic activity.
To see why, note that when a corporation earns
income it is taxed once at the corporate level, and then
again when it is paid out to shareholders in the form of
dividends.
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In effect, then, corporate income that is paid out in the
form of dividends is double taxed.
This biases businesses against organizing in
corporate form. Moreover, double taxation
of corporate income effectively increases the tax rate
on the return to corporate investments. This reduces
the volume of investment undertaken by corporations,
although there is substantial disagreement about the
magnitude of this effect.
The incidence of the corporation tax is highly
controversial.
In one highly influential model due to Harberger
(1962), the tax on corporate capital leads to a migration
of capital from the corporate sector until after-tax rates
of return are equal throughout the economy.
In the process, the rate of return to capital in the
noncorporate sector is depressed so that ultimately all
owners of capital, not just those in the corporate
sector, are affected.
The reallocation of capital between the two sectors
also affects the return to labor.
Most public finance economists believe that the
burden of the corporation tax is split between labor
and capital, although there is significant disagreement
about the exact division.
If corporate income were untaxed, individuals
could avoid personal income taxes by
accumulating income with corporations.
Evidently, this would lead to serious equity and
efficiency problems.
The question is whether there is a way to
integrate personal and corporate income taxes
into a single system so as to avoid the
distortions associated with double taxation.
The most radical solution to this problem is
called full integration.
Under this approach, all earnings of the
corporation during a given year, whether they
are distributed or not, are attributed to
stockholders just as if the corporation were a
partnership.
The corporation tax as a separate entity is
eliminated.
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This approach has not been implemented in any
country, in part because of administrative
problems.
The dividend relief approach is less extreme.
With it, the corporation can deduct dividends paid to
stockholders. Although this approach eliminates the
double taxation of dividends, it still maintains the
corporation tax as a separate entity. Variants on this
approach are used in a number of European nations.
4.7 Consumption Taxes
The base of a consumption tax is the value (or
quantity) of commodities sold to a person for actual
consumption, as opposed to an income tax, whose
base is the change in potential consumption.
Consumption taxes tax a variety of forms. A retail
sales tax is levied on the purchase of a commodity. In
the United States, retail sales taxes are not a
significant component of revenue at the national level,
but they are at the state level.
Even there, though, the rates generally do not exceed 7
percent or so. In Europe, the most important type of
consumption tax is a value-added tax (VAT).
The value-added at each stage of production of a
commodity is the difference between the firm’s sales
and the purchased material inputs used in production.
If a firm pays 100 Pound for its material inputs and
sells its output for 150 Pound, then its value added is
50 Pound.
A VAT is a percentage tax on value added at each
stage of production. For example, if the VAT rate were
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10 percent, then the firm’s tax liability would be 5
Pound.
Note that the total value of a commodity when it is
finally sold is equal to the sum of the value-added at
each stage of production. thus, a VAT of 10 percent
applied to each stage is equivalent to a 10 percent tax
on the final product.
In Europe, VAT rates are as high as 25 percent. With
rates of such levels, evasion is likely to be a problem
for retail sales taxes; VATs are easier to administer,
which accounts for their popularity.
A special feature of both VATs and retail sales taxes is
that the tax liability does not depend on the
characteristics of the buyer. Whether one is rich or
poor, the rate is the same. This prompts concerns over
equity, which have been dealt with by applying lower
rates to commodities such as food and medicine.
But this may not be an effective way to deal with equity
concerns. For example, even if it is true that food
expenditures on average play an especially important
role in the budgets of the poor, there are still many
upper-income families whose food consumption is
proportionately very high.
In recent years, public finance economists have given
a great deal of attention to the problem of designing
personal consumption taxes. Such taxes require
individuals to file tax returns and write checks to the
government, allowing tax liabilities to depend on
personal circumstances.
One example is a cash-flow tax. Each household files
a return reporting its annual consumption
expenditures during the year. Just as under the
personal income tax, various exemptions and
deductions can be taken to allow for special
circumstances, and a progressive marginal rate
schedule applied to taxable consumption. From an
administrative viewpoint, the major question is how to
compute annual consumption.
Taxpayers would report their incomes, and then
subtract all saving.
To keep track of saving, qualified accounts would be
established at various financial institutions. Whether a
cash-flow tax is administratively feasible is very
controversial.
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4.8 Wealth Taxes
Wealth is the value of the assets an individual has
accumulated as of a given time.
Wealth taxes do not play a major role in the fiscal
systems of any western countries. One justification of
taxing wealth is that it is a good measure of an
individual’s ability to pay taxes.
This is a debatable issue. Suppose that a miser has
accumulated a huge hoard of gold that yields no
income. Should she or he be taxed on the value of the
hoard?
Some believe that as long as the miser was subject to
the income tax while the hoard was accumulating, it
should not be taxed again.
Others would argue that the gold per se generates
satisfaction and power for the individual, and should
therefore be subject to tax.
Perhaps the major problem with this argument is that
many rich people have a substantial component of
their wealth in human capital--their stock of education,
skills, and so on.
However, there is no way to value human capital
except by reference to the income it yields.
This logic points back to income as the appropriate
base.
Some nations levy taxes on wealth only when it is
transferred at the time of the death of the owner.
These are referred to as estate taxes. Estate tax
proponents argue
That it is a valuable tool for creating a more equal
distribution of income. Further, many believe that
ultimately, all property belongs to society as a whole.
During an individual’s life, society permits her to
dispose of the property she has managed to
accumulate as she wishes. But at death, the property
reverts to society, which can dispose of it at will.
A debatable issue is the incentives created by an
estate tax. Suppose that an individual is motivated to
work hard during his lifetime to leave a large estate for
his children. The presence of an estate tax might
discourage his work effort.
On the other hand, with an estate tax, a greater amount
of wealth has to be accumulated to leave a given after-
tax bequest, so the tax might induce the individual to
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work harder to maintain the net value of his estate.
Consequently, the effect of an estate tax on a donor’s
work effort is logically indeterminate.
Similarly, one cannot predict how the tax will affect the
amount of saving.
There is currently very little in the way of empirical
evidence on these incentive issues.
To the extent that an estate tax reduces saving, it may
actually increase inequality.
If there is less saving, then there is less capital
investment. With less capital with which to work, the
real wages of workers decrease and under certain
circumstances, the share of income going to labor
falls.
To the extent that capital income is more unequally
distributed than labour income, the effect is to
increase inequality. This scenario is hypothetical. It
simply emphasizes a point made above in a variety of
different contexts-to understand the impact of a tax,
one must take into account how taxpayers respond to
it.
4.9 Deficit Finance
The government’s other major source of revenue is
borrowing.
The deficit during a time period is the excess of
spending over revenues. The national debt at a given
time is the sum of all past budget deficits.
The debt is the cumulative excess of past spending
over past receipts. Future generations either have to
retire the debt or else refinance it.
Then, that future generations must bear the burden of
the debt. But the theory of incidence tells us that this
line of reasoning is questionable. Merely because the
legal burden in on future generations does not mean
that they bear a real burden.
Just as in the case of tax incidence, the answer
depends on economic behaviour.
Assume that the government borrows from its own
citizens. One view is that such an internal debt creates
no burden for the future generation. Members of the
future generation simply owe it to each other. There is
a transfer of income from those who do not hold bonds
to the bondholders, but the generation as a whole is no
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worse off in the sense that its consumption level is the
same as it would have been.
That ignores the fact that economic decisions can be
affected by government debt policy. According to the
neoclassical model of the debt, when the government
borrows, it competes for funds with individuals and
firms who want the money for their own investment
projects. thus, debt finance leaves the future
generation with a smaller capital stock, other things
being the same.
Its members therefore are less productive and have
smaller real incomes than otherwise would have been
the case.
Thus, the debt imposes a burden on future
generations, through its impact on capital formation.
The key assumption in this argument is that public
spending crowds out private investment Whether
crowding out actually occurs is a controversial issue;
the empirical evidence is mixed.
A further complication is introduced when we
consider individuals’ transfers across generations.
Suppose that when the government borrows, people
realize that their heirs will be made worse off.
Suppose further that people care about the welfare of
their descendants and do not want their descendants’
consumption levels reduced. What can they do about
this? They can save more to increase their bequests
by an amount sufficient to pay the extra taxes that will
be due in the future.
The result is that nothing really changes. Each
generation consumes exactly the same amount as
before the government borrowed.
The conclusion is that private individuals undo the
intergenerational effects of government debt policy so
that tax and debt finance are essentially equivalent.
This view is sometimes referred to as the Ricardian
model because its antecedents appeared in the work of
the 19th century economist David Ricardo.
Some public finance economists have challenged the
plausibility of the Ricardian model. They believe that
information on the implications of current deficits for
future tax burdens is not easy to obtain. Another
criticism is that people are not as farsighted and not as
altruistic as supposed in the model. A number of
statistical studies have examined the relationship
between budget deficits and private saving. The
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evidence is rather mixed, and the Ricardian model has
both critics and adherents among professional
economists.
5 Taxation: Functions, Objective and
Characteristics
We evaluate to create a means of comparison a
standard, a benchmark, or a desired outcome.
5.1 Role of Taxes

Generally, taxes serve three functions:
1. Generating revenue is the overwhelming reason
state and local governments collect taxes.
2. Implementing fiscal policy (i.e., using taxes and
spending to influence the economy) is best
accomplished by the Federal government. Fiscal
policy efforts by state and local governments can
only be modest and may prove counterproductive
by causing individuals or firms to “vote with their
feet,” moving into or out of the state.
3. Redistributing income in the interest of societal
equity (i.e., the “fair” distribution of wealth within
a society) is best accomplished by the Federal
government. Redistributing income within state
and federal jurisdictions for the purpose of
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improved societal equity will be countered by
movement into or out of the jurisdiction.
5.2 Characteristics for evaluating taxes

The major difficulty with evaluating tax issues, or many
issues related to taxes, is that there are no universal
yardsticks, benchmarks, or desired outcomes. Some
say the only “fair” tax is one that somebody else pays!
There are also local vs. State wide vs. national vs. societal
and present vs. future perspectives. Which is appropriate?
They all are—what may be “right” at the local level, may

be just as “wrong” at the state level, or vice versa.
Should we benchmark our overall tax burden, its
distribution, and the individual tax bites against some
point in the past, against our neigh boring states, or
against some universal measure of fairness and
balance?
Unfortunately there are no single, universal measures
of fairness or balance.
In the end, most tax policy decisions are based on the
politics of balancing multiple objectives in a dynamic
environment.
There are several, more-or-less objective,
characteristics that can be used to evaluate tax policy.
However, the importance, or weighting, of each
characteristic in achieving a desired “balance” in a tax
system remains a subjective, political choice.
Most changes in tax policies will have unintended side
effects, such as perverse incentives, excess
burden/deadweight loss, or inadvertent shifting, that
need to be considered.
The following 13 characteristics for evaluating taxes
are meant to be exhaustive, but not necessarily
mutually exclusive. Others may present four, six, or
ten characteristics; but the intent is to expose all
readers to the methods of evaluation presented in
public finance literature
Some of the characteristics are more important to
taxpayers (e.g., low compliance costs, equitable), while
others are more important to lawmakers (e.g., revenue
adequacy and reliability, low administrative costs).
Unfortunately, there is not a simple, objective
procedure for answering most of the important
questions about taxes. Often, if not always,
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adjustments to “fix” one perceived flaw, create other
problems.
5.2.1 Equitable
Equity, or fairness, is perhaps the most cited and least

agreed upon concern relating to taxes.
Public finance literature describes two tax equity
principles:
• Ability To Pay, and
• Benefits Received
Equity is not a function of residence, occupation, age,
business organization, or any other characteristic
other than ability to pay and benefits received. These
other characteristics (i.e., occupation, age,) influence
ability to pay and benefits received. Nor is “balance”
related to equity other than to argue that there could
be a balance between reliance upon ability to pay and
benefits received in the aggregate; or that there should
be a balance among all the characteristics, which
include equity.
The Ability To Pay principle simply states that those who

have more ability should pay more (vertical equity), and
those with equal ability should pay equal taxes (horizontal
equity), ceteris paribus. The federal income tax is a good
example of a tax based on ability to pay.
However, there are many definitional, measurement,

and philosophical issues involved with implementing
the ability to pay principle, including:
1. How is ability measured? Is the base measured
by income, wealth, consumption, or by
something else?
2. How progressive should tax rates be relative to
ability to pay?
Progressive taxes tax those with greater ability to pay
a greater percentage of their incomes and reduce the
gap between rich and poor. Regressive taxes tax
those with a greater ability to pay a smaller percentage
of their incomes and increase the gap between rich
and poor.
Proportional taxes tax the same percentage across all
ability to pay categories and do not change the gap
between rich and poor.
The Benefits Received principle holds that those who
receive benefits should pay the costs. In principle,
there is no distinction as to whether or not there needs
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to be a direct correspondence between a specific tax
revenue (e.g., gambling tax) and a specific public
program (e.g., compulsive gambling programs).
However, in practice it is easier to assess the
implementation of benefits received on a tax-by-tax
basis. A classic example of a tax based on benefits
received is highway fuel taxes: the more someone
drives, the more tax they pay, and the heavier the
vehicle (causing road wear and tear), the more tax is
paid.
5.2.2 Efficient
Estimating its excess burden assesses the efficiency

of a tax instrument.
Excess burden is the tax’s social cost, above and
beyond the actual tax revenue along with the costs of
administering and complying with the tax. It is also
referred to as “deadweight loss.” Excess burden is a
real loss of social welfare that is not subsequently
gained back elsewhere in the economy. It results from
losses of consumers’ and producers’ surpluses
brought about by government-induced distortions in
the market. In other words, the range of choices
available to consumers and the net gains of producers
are both reduced. Estimating excess burden is
difficult without good economic and market data.
There are, however, some anecdotal and benchmark
data available collected.
Trade-offs between efficiency and equity are common
(but usually not explicit) in tax policy. For example, a
less efficient economy may be accepted for a more
equitable distribution of income; or, more efficiency
may be worth some loss in equity.
Economists can measure the effects of tax policy
changes and the subsequent effect on efficiency and
equity (and all of the other characteristics), but the
trade-offs are made by policy makers.
5.2.3 Minimal shifting
It is crucial that tax system evaluation takes into

consideration the ultimate incidence of each tax levy—
who actually pays the tax. Who or what legal entity is
responsible for the tax according to law/regulation
designates the statutory incidence of a tax.
For example, the consumer is usually legally
responsible to pay sales taxes, but in most cases
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consumers do not pay the full amount of the sales tax.
Some of the tax is shifted to other players in the
economy.
The economic incidence of a tax identifies, after all
shifts of burden have occurred, whose pocket(s) the
tax ultimately comes from. For example, a large share
of the burden of sales taxes on goods with priceelastic
demands, such as soft drinks, is borne by merchants
and input suppliers.
On the other hand, the consumer pays nearly the full
amount of sales taxes on goods with price-inelastic
demands (such as tobacco). Tax incidence is
especially important when addressing fairness issues.
Tax on rental property is an example of tax burden
shifting.
The statutory incidence of real estate tax is on the
property owner. However, depending on conditions in
the local/regional real estate market, all or none of the
real estate tax may be shifted to renters.
The important point is that the market determines the
ultimate economic incidence of real estate tax (of all
taxes, for that matter), it cannot be determined a priori
or mandated by regulation.
The textbook example of tax shifting is corporate
income taxes, which may be shifted by more than 100
percent. In other words, the income tax burden levied
against corporations is ultimately borne by other
economic units, such as its shareholders, employees,
holders of non-corporate debt, or customers. Again,
identifying specifically who bears the burden is not a
simple matter, but it greatly influences the equity of a
tax.
Tax shifting is a function of
1. demand elasticities (i.e., how responsive demand
is to changes in price),
2. supply elasticities (i.e., how responsive supply is
to changes in price),
3. geographic location, and
4. the type of tax.
5.2.4 Neutral
Unless meant to do otherwise, taxes should not affect

individual or business decisions–they should not
distort decision-making. Assuming the market is
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working efficiently, a tax that affects decisions
introduces distortions for goods and services into the
markets. Market distortions cause inefficiencies
resulting in reduced social satisfaction than without
the inefficiencies. Cases where taxes are not meant to
be neutral include the family of sin, or sumptuary,
taxes; where one of the tax policy objectives is to
reduce consumption of something society has deemed
undesirable. Tax neutrality may be easy to assess (as
in the case of cigarette tax) or difficult to assess (e.g.,
property taxes).
5.2.5 Adequate
If the principal purpose of a tax is to generate revenue,

then it is obvious that, in the aggregate, the tax system
should generate adequate revenue that will provide the
levels of public goods and services typically supplied
by a government unit.
Simply put, the tax rates and bases need to be
designed to achieve the desired revenue effect.
5.2.6 Reliable
State and local governments need aggregate tax (and
nontax) revenues that can be relied on through
dynamic economic, social, and environmental
conditions.
Thus, the government unit’s tax (and nontax) portfolio
could include tax instruments that generate more when
the economy is doing well (e.g., progressive income
taxes) as well as those instruments that will continue
to generate revenue when the economy is not doing
so well (e.g., real estate taxes). Revenue elasticity
measures a tax’s reliability with respect to economic
indicators such as annual personal income. In other
words, what is the percent change in tax revenue when
the state’s personal income increases (or decreases)
by a certain percentage?
5.2.7 Understandable
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When taxpayers understand a particular tax, they are
more likely to support it and less likely to find ways to
evade it.
Tax evasion is defined as illegally avoiding tax
payments that are legally due. Tax avoidance,
however, is finding ways to legally minimize tax
obligations.
5.2.8 Low compliance costs
Taxpayers are burdened with the actual tax

obligations, the deadweight loss, and the costs of
complying with tax codes (i.e., record keeping and
reporting requirements). Keeping compliance costs
low is clearly a worthwhile goal.
5.2.9 Low administrative costs
Cost to administer tax programs should be kept to a

minimum.
Administrators may have considerable discretion
regarding the amount of money spent on enforcement
or compliance.
The rule of thumb would be to spend until the expected
gains just offset the expected costs. Spending
anything less would leave money on the table, and
spending anything more would be clearly inefficient.
If the primary purpose of the tax is something other
than to generate revenue, then administrative costs
become a lesser issue.
5.2.10 Stable
Taxpayers appreciate a tax code that is predictable—

one that allows them to plan for the future, personally
or in business. While occasional tax code changes
may be necessary to satisfy some of the above nine
characteristics, the negative impact of frequent or
dramatic changes need to be considered.
NOTE: The following three characteristics for
evaluating taxes will not normally be found in public
finance textbooks, but they are common in economic
development literature and campaign rhetoric.
5.2.11 Exportable
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Clearly, getting non-residents to finance local
government services is preferred over paying for them
internally, at least from the local taxpayers’
perspective. There is a benefits received argument for
exporting some of the local costs. After the first ten
characteristics are considered, the only remaining
issue regarding exportability is whether more (or less)
than a “fair” share should be shifted to non-residents.
5.2.12 Competitive
No taxing jurisdiction wants to price itself out of the

market so that dissatisfied individuals and businesses
vote with their feet and leave for a better “tax climate.”
Thus, being competitive means keeping an eye on the
neighbors’ tax structures and reacting accordingly.
5.2.13 Balanced
“Balance” is something that taxpayers and politicians

frequently call for in tax system assessment.
A “balanced” tax system is one that appropriately
weights each of the first ten characteristics, given the
objectives and biases of the evaluator. If the first ten
characteristics are given appropriate attention,
balance, from a public finance theory perspective, is
achieved by default.
It should be clear that the objective evaluation of a tax
system can only result in identification of some
bounds within which fairness and equity measures
should fall.
It is, ultimately, politics that is necessary to make the
trade-offs regarding the details within those bounds to
develop specific tax regulations.
5.3 Fair and Simple Taxation

Achieving universal fairness in taxation may not be
simple (in fact, it may be impossible!) and if a system
is simple it may not be fair. Generally, fairness in
taxation is based on either the ability to pay or the
benefits received principle, as discussed previously.
Revenue Neutral
The Committee agreed we were to look for
opportunities to improve the overall system while
remaining revenue neutral. This was neither an
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opportunity to increase nor to decrease North Dakota’s
overall tax collections.
6 Equity, income distribution, and the social
safety net
Redistribution through government does not simply
consist of taking money in the form of taxes from the
rich and giving it either in cash or in services to the
poor. Everything the government does is
redistributive, and much of that redistribution does not
benefit the poor and needy. Corporate handouts, farm
subsidies, special tax breaks for some of the rich, and
tax structures that favour the voting majority in the
middle class are among those other kinds of
redistribution
6.1 Concepts of equity

Equity is rooted in the ethical concept of justice.
Justice comes in three forms: distributive justice,
retributive justice, and restorative justice.
Distributive justice refers to access to the necessities
of life, however defined. Distributive justice may
involve a minimum income or access to certain
services regardless of ability to pay. Retributive justice
requires an appropriate penalty for engaging in actions
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considered harmful to others or to society. Restorative
justice means making a person whole for harm or
injury inflicted on them. Our focus in this chapter is
primarily on distributive justice.
Economists find it difficult to formulate an acceptable
definition of distributional equity because it would
require interpersonal comparisons of utility. Ideally, a
tax system would require equal sacrifice, not of
dollars, but of utility from each citizen in order to
support shared public services. If A is very poor and B
is very rich, it seems reasonable that a smaller
contribution from A and a larger contribution from B
would meet this standard of equal sacrifice. To
simplify the equity question, suppose that, instead of
taking $1 from A and $2 from B to finance a public
service that A and B can share equally, the
government simply takes a dollar from B and gives it
to A. Is equity (and social welfare) increased,
decreased, or unchanged by this action? If A is poor
and B is rich, the initial response is to say that equity
has increased, and that in the opposite case equity
would have decreased. But to arrive at that judgment
implies some comparison of the marginal utility of
income (or wealth) between persons A and B. In order
to make such comparisons, some assumptions have to
be made about whether income or wealth as a whole
(as distinct from a particular kind of consumption) is
subject to diminishing marginal utility, and whether the
marginal utility declines at similar or different rates for
different people. If the marginal utility of income
declines as income rises, and does so at about the
same rate for everyone, then a transfer from A to B
would indeed increase utility, because the gain to B
would be greater than the loss to A. But what if income
or wealth is not subject to diminishing marginal utility?
O r suppose that A, while wealthier, also has a greater
capacity to enjoy income due to her cultured tastes,
while B is an ascetic with limited needs and wants. A’s
greater capacity for enjoying income could mean that
the utility she sacrifices is greater than the utility B
gains. In either case, there is nothing that can be said
about net gains and losses in utility to society as a
whole. Yet another way to approach the question of
equity is through the idea of entitlement. An
entitlement is something for which we qualify or
become eligible by meeting certain criteria. In the US
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Declaration of Independence, the entitlements (or
inalienable rights) that Jefferson specified were “life,
liberty, and the pursuit of happiness.” Since that time,
the concept of entitlement in the United States has
included adequate food, shelter, education, and more
or less health care. In other developed countries,
entitlements are often both broader in scope and more
generous in content.
Equity is a central issue in public sector economics
and in public policy. It is at the heart of almost all
economics policy debates. Is there a way out of this
impasse that might make it possible to define equity?
This question has engaged some of the best minds in
economics in the past two centuries, resulting in some
creative if not always definitive answers.
6.1.1 Rawls’ theory of justice
Equity, fairness, and justice are all closely intertwined.

Justice may be thought of as more structural in nature,
the rules of society that determine the rights,
privileges and obligations as well as the opportunities,
income, and wealth that each of us is entitled to as a
member of society. In his landmark 1971 book A
Theory of Justice, John Rawls set forth a theoretical
model for how those rules might be developed for a
particular society.
In his more recent work, Political Liberalism, Rawls
answers some of his critics and extends his model.
The rules that Rawls developed in both of these works
that are of particular concern to public sector
economics are those that pertain to distribution of
resources, including income and wealth.
Suppose that you were given the charge to design a

system to distribute opportunities, resources, and
rewards among workers and non-workers, old and
young, productive and unproductive, skilled and
unskilled, without any prior knowledge of where you
will find yourself in the system you have designed?
Rawls described this decision framework in his earlier
work as the “ veil of ignorance. ” The reader is asked
to think about how to design a system of incentives
and rewards without knowing where he or she will be
located in the system once it is in place.
As you might expect, the outcome of such a thought

experiment is usually a system of rules and practices
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that provide more protection for those who find
themselves most disadvantaged in a market system—
those with few skills, little education, or other
handicaps that affect their productivity. In particular,
Rawls suggests that the rules of society that result
from such an experiment are likely to reflect the
“maximin principle” from game theory. The maximin
principle is short for maximizing the value of the worst
(minimum) outcome in the system.
In his later work, Rawls attempted to extend his theory

to address the specific challenge of a pluralistic
society. Markets are particularly efficient in addressing
the diverse material needs of a pluralistic society, but
the challenge Rawls attempted to address is that
different values among different groups make it
difficult to develop an agreed-on set of rules by which
society should operate. Those different values among
different groups are described by Rawls as
“reasonable comprehensive doctrines”.
Rawls suggested that it would be necessary to identify

the areas of agreement or overlapping consensus
among those competing comprehensive doctrines (of
the goals of society, or the nature of the good), and to
base the rules for distribution of society’s income,
wealth, and opportunities on those areas of agreement.
Among the areas of agreement that Rawls thought
might emerge from such a process are some basic
personal liberties guaranteed to all, and a set of rules
that guaranteed equality of opportunity in competing
for offices and positions with different rewards. In
addition, Rawls believed (as in his earlier work) that
any rules that allowed inequality in income and wealth
must be designed so as to be of the greatest benefit to
the least advantaged members of society.
While Rawls’ philosophical system is more general

than the specific distributional issues of concern to a
modified market economy, it does raise some
important questions about the existing distribution of
income and wealth as well as the distribution of the
increases in income and wealth that result from
innovation, risk-taking, skill improvements, and other
factors. These actions result in increased output per
worker in a firm (micro) or economic growth (macro).
How much of the additional income and wealth should
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go to those responsible for creating it as an efficiency
incentive and how much should be shared with fellow
workers and owners (micro) or with others in the
economy (macro)? Rawls’ notion of the veil of
ignorance is also a useful way of thinking about
proposals to modify reward and incentive systems for
groups such as those retired on Social Security or
welfare recipients being encouraged (or pressured) to
find paid employment.
6.2 Horizontal equity

One partial answer to the dilemma of defining and
measuring equity is the concept of horizontal equity,
which means treating people alike if they are in the
same or similar economic situations—making them
pay the same taxes and/or providing them with the
same public services. Implicit in the notion of
horizontal equity is an assumption that people’s
capacity to enjoy income is similar, at least within a
given range of incomes.
Economic situation does not simply mean income. It
could include the concept of permanent or lifetime
income rather than simply current annual income. It
might take into account wealth, family size, age, or
special circumstances such as disability or chronic
health problems. As a result, a generally accepted
measure of horizontal equity can be difficult to find.
Instead, it is defined differently in specific contexts;
charges for admission to national parks are by the
carload, all income up to a certain level is taxed at the
same rate, all children are entitled to 12 years of free
public schooling. Much of the complexity in the federal
income tax arises from attempts to define equal
economic situations for purposes of horizontal equity.
6.3 Vertical equity

A second and even more challenging concept of equity
is vertical equity. Vertical equity means treating people
differently according to the differences in their income,
wealth, or other measure of need or ability to pay.
Vertical equity appears in many different contexts.
Progressive income taxes are often justified on the
basis of some concept of vertical equity.
Vertical equity is also reflected in the use of means
testing for many public programs, including free or
reduced price school lunches, subsidized housing,
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and Medicaid. Property tax relief at the state and local
level is also means-tested in many cases.
Means testing refers to determining eligibility for a
public program or service on the basis of having an
income that is less than some threshold level.
Sometimes means-tested programs involve a
threshold or a cut off point. Subsidized child care, for
example, might be available to households with
incomes up to 150 percent of the poverty level. Once
the family reaches that level, they are no longer
eligible. Other programs gradually reduce the benefits
as family income gets higher, and at the threshold
level the benefit finally reaches zero.
One difficulty with using vertical equity as a guide to
public policy is in measurement. How unequal should
the treatment of people be in relation to their unequal
ability to pay? In a famous work on the progressive
income tax, a nineteenth-century economist argued
that once we depart from the notion of proportionality
in taxation “we are at sea without rudder or compass”
(McCullough 1845). Does having twice as much income
mean twice as much ability to pay taxes, or three times
as much? Does a family of four with an income of less
than $15,000 deserve food stamps, but the same family
should no longer be entitled when their income
reaches $15,001? Using cut off income levels as a tool
for vertical equity create notches in eligibility for
benefits or services that create new inequities between
those just under the notch and those just over the
notch. Attempting to determine vertical equity also
raises the serious problems discussed earlier that are
associated with interpersonal comparisons of utility
6.4 The compensation principle

Finally, a third route out of the thicket of interpersonal
comparisons of utility lies in the theory of the second
best and the compensation principle.
Economists define Pareto optimality as a state in
which no change can be made that makes some
people better off without making at least one person
worse off. Strictly interpreted, the concept of Pareto
optimality is heavily loaded in favor of the status quo.
Most policy proposals—tax cuts, highway programs,
sentencing guidelines, or almost anything you can
imagine—will involve both winners and losers. A
criterion of Pareto optimality would rule out such
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changes. The inability to make interpersonal
comparisons of utility makes it very difficult to justify
any policy change for which there are losers as well as
gainers. Pareto optimality becomes a strong
endorsement of the status quo, whatever that status
quo happens to be.
Recognizing this problem, economists have searched
for some criteria for policy decisions where Pareto
optimality is not attainable. These criteria provide a
guide to making “second-best” decisions. One of the
most useful criteria is the compensation principle,
which offers a rough guide to choosing between
alternative policies on the basis of which one does
more to increase social welfare.
The principle goes something like this: If, in moving
from state A to state B, the gainers from the move can
compensate the losers for their losses and still be
better off, then the move is desirable from the
standpoint of total social welfare. Conversely, if those
who lose by moving from state A to state B can bribe
the gainers not to make the change and still have some
welfare gain remaining, then the change should not be
made. Note that the compensation does not actually
have to be paid. Actual compensation is a political
rather than a theoretical question, whether the “bribe”
is actually either required to get legislation passed (or
other change approved) or desirable from the
standpoint of income distribution (e.g., gainers are
rich, losers are poor). And even if there is
compensation, it doesn’t necessarily have to be in
cash. When the nuclear plant at Barnwell, South
Carolina, was built to process nuclear weapons
materials in the 1970s, the federal government helped
to build a new town and relocate the people in the town
of Ellington to that new site, now known as New
Ellington. That kind of compensation comes closer to
restorative than distributive justice. T he compensation
principle has been particularly visible in trade policy.
The gradual reduction of barriers to international trade
throughout the mid- to late twentieth century benefited
consumers and exporters at the expense of workers
and owners in import-competing industries. Losers
were compensated with trade adjustment assistance
as well as gradual implementation of policy changes.
(Gradual implementation of new policies, giving time to
adjust, is one form of compensation.) But almost any
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proposal for spending or changing tax rules or
choosing a site for a new prison or building a new
highway creates both winners and losers. There is
always an opportunity to negotiate compensation for
at least some of the losers as a condition for
persuading politicians to vote for such legislation
6.5 Measuring inequality

While alleviating poverty has been a primary focus of
government policy in redistribution, there are also
concerns about the shape of the overall distribution of
income. The most widely used measure of income
distribution is the Lorenz curve, which shows the
cumulative percentages of income accruing to various
percentages of population. Usually the population is
sorted into quintiles, or fifths, so the graph shows the
percentage of income received by the lowest fifth (20
percent), the lowest two-fifths (40 percent), and so
forth.
If income were distributed with complete equality, the
Lorenz curve would be the straight line from the origin
to the northeast corner of the box. The greater the
deviation of the actual curve from the diagonal line, the
greater the degree of inequality.
The next Figure shows the US income distribution in

2008. The lowest 20 percent of the population received
only 3.4 percent of the income; the lowest 40 percent,
12.0 percent of income; and the lowest 60 percent, 28.6
percent, leaving 71.4 percent for the top 40 percent and
48.5 percent for the top 20 percent. Inequality has
increased in the United States over the past three
decades.
To provide a numerical comparison, the area between

the diagonal line and the curve is divided by the total
area of the lower half of the diagram (below the
diagonal). This number is called a Gini coefficient.
The higher the Gini coefficient, the greater the degree
of inequality.
The Lorenz curve is used as a comparative tool in
measuring changes in income distribution over time
and differences in income distribution between
different countries. However, the Gini coefficient is
often a more convenient way to compare across
multiple countries. In the mid-2000s, the United States
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had a relatively high degree of inequality, with a Gini
coefficient of .38. Other developed countries ranged
from .23 (Denmark, Switzerland, Sweden) to .35 (Italy),
as indicated in Table
6.6 Measuring poverty
In the United States, measures of poverty were
developed in the 1960s as part of President Johnson’s
War on Poverty. The original measure was based on
the cost of food for a family of four for a year, which
was estimated at $1,000 in 1965. Since food typically
took about one-third of a low-income household’s
budget, the poverty level for a family of four was set at
$3,000.
Since that time the figure has been regularly adjusted

for inflation, and adjusted for family size, rural–urban
cost of living differences, and other considerations. In
2009, the poverty level of income was $22,025 a year
for an urban family of four. Information on income is
then used to compute the percentage of the population
in poverty or near poverty (e.g., 150 percent of poverty
is the ceiling income for eligibility for certain
programs). In 2008, the official poverty rate in the
United States was 13.2 percent, an increase over the
11.7 percent in 1999. 2008 was a year of high and rising
unemployment and recession, which always drives up
the poverty rate. About 40 million people were classed
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as below the poverty threshold (or other thresholds for
single persons or families of varying size).
The highest poverty rate was for children: 19 percent
of those under 18 years of age were poor in 2008, while
the poverty rate for those over age 65 was only 9.7
percent (US Bureau of the Census 2008.
6.7 Policy issues in poverty and inequality

In a market system, household are expected to earn
their income by making productive resources available
in the marketplace. That assumption is valid for most
but not all households in a market economy. There are
always people who are unable to earn at all because of
age, disability, lack of skills, lack of opportunities, or
other barriers. Others are able to work but cannot earn
enough to sustain a decent standard of living.
Sometimes the problem is temporary and can be
addressed by improving the efficiency of labour
markets and/or by
unemployment insurance and other programs for

periods of high unemployment. But even in robust
economic times, there will be households in need of
support.
The challenge of a market economy is to ensure that
those who cannot earn or cannot earn enough are
adequately provided for while at the same time
retaining strong work incentives and limiting the
amount spent on supporting low-income households.
A system that is too restrictive will leave many people
undernourished, badly housed, and without access to
essential services such as health care, transportation,
and education. A system that is too lavish will have to
impose high tax burdens on those who do work in
order to support those who do not, creating poor work
incentives and inadequate work effort at both ends of
the spectrum. A well-designed social safety net must
be broad enough to catch those who fall in, but not so
attractive as to invite people to jump in.
Some economists regard poverty as a form of market

failure, or at least some kinds of poverty. When
poverty results from intentional choices—to be a
starving artist, to drop out of the labor force and do
nothing—then there is no particular need or
justification for providing assistance. To do so would
weaken the incentives to work and contribute that lie at
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the heart of a market-driven economy. The concern
about poverty deals, rather, with two groups of people
who do not fare well under a pure market economy.
Some people are unable to work because they are too

old, or disabled in some way. A second group suffers
from lack of access to jobs because of their location,
lack of skills, or lack of access to transportation or
child care. This group includes the underemployed,
who may be working part-time but would prefer full-
time, or who work full-time but earn too little to lift
them out of poverty. Social Security is intended to
protect the elderly and those with disabilities. Reforms
in the welfare system in the 1990s addressed some of
the problems represented by the second category, but
not all. The problem of those who are young and
physically able to work but cannot fi nd enough work
or work that pays adequately accounts for a great deal
of poverty among children.
For the most part, poor children live in poor families

with adults who fall into one of the following
categories:
Those who work but who lack the skills, training, or
experience to earn a wage that will pull them and their
families above the poverty level. The responsibility for
addressing this source of poverty falls heavily on the
states in such programs as school-to-work, technical
and community colleges, job training programs for
industries, and other activities that link economic
development with getting people ready to fully
participate in the labour force.
Those with special circumstances such as poor health,

large family size, or special responsibilities to care for
dependents (e.g., aging parents, family members with
disabilities) that make it impossible either to work or to
maintain an above-poverty standard of living on their
earnings, even though such earnings might be
adequate under more normal circumstances. For those
who work at all, the primary policy response to this
source of poverty is the Earned Income Tax Credit.
Other responses include Temporary Assistance to
Needy Families (TANF), food stamps, and direct
provision of services such as health care (Medicaid
and State Children’s Health Insurance Program
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(SCHIP), both of which are funded jointly by federal
and state governments
6.8 Is poverty a form of market failure?

In what sense does this kind of poverty constitute
market failure?
One argument that these cases represent market

failure is that the existence of poverty among some
individuals reduces the well-being of others (because
of empathy with the suffering of others) and therefore
has the same kinds of spillover effects as water
pollution, noise, litter, or other familiar negative
externalities.
second argument is also based on negative

externalities. Poverty can diminish the quality of life of
the community. Poverty may breed drug addiction,
blight, crime, and other social ills that impact on more
prosperous households. Children who lack homes
where their brains are stimulated early are likely to
have difficulties in school, requiring more resources
and holding back the rest of the students. Poor
children who lack basic health care and skills may
grow up to be unproductive workers and/or dependent
on society. A little prevention or correction of these
social ills will benefit others besides the target
population. This different type of externality argument
still treats the consequences of poverty as a form of
market failure.
Yet a third argument is that social safety nets are a
form of insurance that catch those who suffer from
economic reversals outside their control. Even the
non-poor may think that this could happen to them as
well, and they would like to ensure the existence of a
social safety net in case they should ever happen to
need one. Some kinds of insurance lend themselves
better to private provision than others. Disasters that
strike unexpectedly at identifiable target groups, such
as foods, hurricanes, or earthquakes are least suited to
purely private (unsubsidized, non-mandatory)
insurance. Unemployment, prolonged illness, or
disability have some of the same characteristics as
natural disaster.
Those most at risk may be willing to buy insurance,
but the premiums are prohibitively high because of the
high probability of loss. Those least at risk see no
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need for the insurance and opt out of the pool, leaving
only the high-risk applicants.
If those who are at risk of unemployment, prolonged
illness or disability are not only high risk but also low
income, as they often are, the private market will not
be able to resolve their need for a social safety net with
affordable private insurance. For this reason, social
insurance has been one of the fastest growing
categories of government activity in the United States
and other nations in the last century. Since the market
fails to provide insurance against these types of
hazards, it could be argued that the absence of such a
market constitutes a form of market failure, and the
provision of this service has some attributes of a
public good
6.9 Redistribution and free-riding behaviour

Few people will argue that there should be no
redistribution, but it is often argued that redistribution
should be voluntary rather than through government.
There is some voluntary redistribution through
churches, non-profit agencies, and individual charity
that alters the distribution of income and wealth
determined solely by the market. If voluntary
redistribution could do the job, there would be no need
for government intervention. But can society rely on
individual decisions to ensure that the total amount of
redistribution is socially optimal? Probably not. It is
too easy to free-ride on the charity of others, even
more so in larger communities than in smaller ones
where your failure to contribute is more likely to be
noticed.
If Mrs. Jones is a widow with six children and unable to

work because of lack of child care, lack of opportunity,
and health problems, most people would feel
charitably disposed toward her and the six children.
But because each of their contributions would likely be
a very small part of the total needed, they are likely to
free-ride, feeling that the amount of aid going to Mrs.
Jones will not be significantly altered by their small
share of the total required. If everyone reasons this
way, Mrs. Jones is out of luck. In very small
communities, shirking one’s due share of the
obligation is too visible and has too much impact on
the outcome to allow free-riding to dominate. But in a
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highly mobile society, and a society in which most
people live in large urban areas where the poor and
needy are often less directly visible, free-riding is likely
to predominate. With free-riding, the amount of private
voluntary redistribution will fall short of the socially
optimum level
6.10 Administrative cost and fraud

while some economists and policy-makers are
opposed to any intentional redistribution of income
through government, there appears to be some degree
of social consensus that at least some aid to
designated groups (such as the elderly or disabled, or
abandoned children) is a desirable activity for
government to undertake. Once it is agreed that it is
appropriate for the government to undertake some
direct redistribution, the challenge becomes one of
finding a way to do so with maximum efficiency.
However, there is another kind of efficiency in
redistribution: targeting aid to those who “deserve” it,
with minimal expenditures for administration and
minimal diversion of revenues to those who are
perceived as “undeserving” (including those who
obtain assistance via fraud or misrepresentation). If
the goal is to minimize administrative costs, then the
limited resources for oversight may make it difficult to
exclude the undeserving. If an extensive cross-
checking system is created to root out fraud and
abuse, then administrative costs will be much higher. T
he two most successful programs of redistribution in
terms of minimizing fraud while operating with very
low overhead expense are the Social Security
retirement program and the Earned Income Tax Credit
(EITC) on the federal income tax. The success of
Social Security rests on two important features: near-
universal participation, and no means-testing
Near universal participation means that Social Security
enrollment is simple and automatic.
Much of the burden of getting revenue into the system

with the accompanying documentation falls on
employers and the self-employed.
For the pension part of Social Security, the only test is

a simple one of age and years of participation in the
system, both of which are easy to verify.
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In the case of the Earned Income Tax Credit, which
provides refundable credits for working individuals
and families, the tests are again fairly simple and
straightforward because they rely on information
provided for income tax purposes. Other forms of
income transfers, such as Temporary Assistance to
Needy Families, housing vouchers, and food stamps,
require a complex verification process to determine
eligibility and are much more costly to administer.
Most of that higher cost is a result of efforts to prevent
fraud.
It is quite possible that, for some kinds of

redistribution, the cost of monitoring to prevent fraud
would be greater than the savings from preventing or
detecting fraud. That is, it could very well be cheaper
to operate a system that is 90 percent fraud proof and
allow 10 percent to get away with cheating, because
the benefits paid to that 10 percent would cost less
than the additional monitoring effort required to screen
cheaters out. T hat argument may be valid in the short
run, but in the long run the negative effects on the
system as a whole may outweigh the short-run cost
savings from tolerating a certain amount of fraud and
abuse. It does not take long for rational, calculating
people to figure out how to “game” the system for their
own benefit if the risk is perceived as low (because of
lack of monitoring) and the payoff high. In the long run,
a system that is vulnerable to fraud and abuse because
of inadequate safeguards will attract cheaters. This
long-run effect will not only increase costs but also
decrease faith in and support for the system of
redistribution.
6.11 Efficiency and work incentives

Another important efficiency issue in redistribution is
the effect of these programs on incentives to work,
invest, and take entrepreneurial risks. These negative
incentive effects impact both those who “contribute”
the tax monies and those who receive the aid. The tax
wedge between the gross earnings of the worker,
investor, and entrepreneur and the after-tax earnings
can result in a diminution of effort below the optimal
level. The combined effect of state and federal income
taxes and Social Security taxes can push the marginal
tax rate on a highly productive worker above 40
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percent, discouraging overtime, freelancing,
moonlighting, or other forms of extra effort.
When redistribution of one’s earnings to others

reduces the return to work or investment effort, many
rational, calculating members of society will respond
by making less effort than they would otherwise have
done. Workers will substitute leisure, which is not
taxed, for income from working, which is taxed.
Next Figure shows a representative citizen balancing

the choices between work and leisure. With no taxes
on earnings (line A1 B), this individual would choose
OX1 of earnings and OY1 of leisure. If a tax is placed on
earnings while leisure is untaxed, the budget line
rotates to A2 B . The worker is forced to accept less of
both earnings and leisure, but the drop in earnings (to
OX2 ) is greater than the drop in leisure (to OY2 ).
If the tax became severe enough (A3 B), the worker

might respond by increasing leisure to OY3 at the
expense of earnings (now only OX3 ).
The availability of public assistance, and the likelihood

of losing that assistance when moving into paid
employment, can also create disincentives to work. In
the past, prior to welfare reform, recipients of aid who
compared the returns to working 40 hours a week at
the minimum wage or slightly above, after adjusting for
the costs of working (child care,
transportation, etc.) and the loss of benefits, might well

have concluded that there would be little or no
increase in economic well-being as a result of entering
the workforce. A major goal of US welfare reform in the
1990s was to provide support services and delay the
cut off of benefits to those who do enter the labor
force, while at the same time imposing time limits on
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benefits and other penalties on those who do not
respond to work opportunities.
6.12 Equality of opportunity or equality of

results?
Beyond the earlier debates over whether there should
be any governmental redistribution at all, there is a
secondary debate among both economists and policy-
makers over whether the goal of any intentional
redistribution should focus on equality of opportunity
or equality of results. Equality of opportunity —
providing education, health care and other services
that allow people to develop into and remain
productive, contributing adults—is a philosophy more
in accord with a market system. F or a large share of
the population, equality of opportunity represents the
primary form of redistribution, especially in the form of
free, compulsory public education and low-cost, state
sponsored post-secondary education and training
programs. These services are available to all, more or
less irrespective of ability to pay. Even access to post-
secondary education is heavily subsidized with grants,
low-cost student loans, and work-study opportunities.
In other countries, including Canada and Western
Europe, the extent of such services is much greater,
including universal health care and day care for
preschool children regardless of ability to pay.
Equality of results emphasizes reducing disparities in

income and immediate alleviation of poverty, rather
than on “investing” in poor people. The difference in
strategy is captured in the old proverb, “Give a man a
fish, he can eat for a day; teach a man to fish, he can
eat for a lifetime.” Often the need is too immediate and
direct to be addressed by longer-term strategies of
education and training. Ideally, both strategies would
be pursued simultaneously, but usually budget
limitations push legislators toward responding to the
immediate problem rather than the long run. One
component of equality of results in the United States
and elsewhere is the progressive income tax, which
takes a larger share of income in taxes from higher-
income households than from lower-income ones.
Since World War II, when the top bracket on the
income tax rose to 98 percent during the war, there has
been a series of reductions in federal income tax rates
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across the board. Bigger reductions in top bracket
rates have made the system less progressive.
Although the EITC and larger personal exemptions
have also favored lower income households, a variety
of specialized tax breaks have also reduced tax
burdens on middle- and upper-income taxpayers.
Other programs that aim at equality of results are
payments, direct or indirect, to low income households
in the form of cash, food stamps, housing subsidies,
and other forms of income support. Social Security,
another results-oriented program, has been
particularly successful in reducing poverty among the
elderly.
6.13 Behavioural economics: in-kind or in-cash?

Another issue that is often viewed differently by
donors and recipients is the form that redistribution
takes. Recipients prefer cash, which gives them more
flexibility in how they use the funds. Donors, however,
are often looking for specific outcomes and want to
impose their preferences rather than those of
recipients on the use of funds. Donors may want to see
the money earmarked for food, or housing, or child
care, or health services. Implicit in the donor
preferences is the expectation that recipients are not
rational, responsible, thoughtful people who will use
those resources effectively.
Donors think of themselves as Homo economicus , but
they are not so sure about the motivations and the
cognitive abilities of those who receive assistance.
Both groups vote, lobby, and exercise political
influence in various ways. In general, donors are more
interested in creating equality of opportunity and in
making sure that funds are spent in particular ways.
Recipients are more interested in equality of results
and in having some flexibility in how to use the
resources that come their way. While in-kind payments
may satisfy donor (or taxpayer or legislator)
preferences about how funds are spent, they usually
cost more to administer than cash payments.
The easiest way to earmark funds is to provide the
services directly rather than cash payments. Health
clinics and education programs are examples of direct
service provision.
A second substitute for cash, increasingly popular in
recent years, is a voucher.
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Vouchers are written claims, issued by government,
that can be exchanged for housing, education, food
(food stamps), or other designated uses. The voucher
is presented to the seller as the equivalent of cash, but
only for the designated use. Vouchers are not
supposed to be convertible into cash, which can then
be spent on other purposes.
6.14 Which level of government?

Should redistribution be the responsibility of the
central government, state (or provincial) government
or local government? Or should it be shared between
them? Until the 1930s,
addressing poverty in the United States was primarily
the responsibility of local governments, with
workhouses for families with employable members and
“outdoor relief” (outside of poorhouses or
workhouses) for widows and orphans. Private charity
took care of some problems.
With the advent of the Great Depression, First local
and later state governments were overwhelmed with
the magnitude of the problem of poverty resulting from
widespread unemployment. In the 1930s, the
combination of a worldwide depression and the
aftermath of a major conversion from small town,
agricultural economies to an industrial age with
population concentrated in large urban centers, the
capacity of local governments to take care of the poor,
the elderly, the sick, and others who were unable to
earn a living in a market system was overwhelmed.
Central (and in the United States and Canada, state or
provincial) governments became increasingly involved
in providing a social safety net.
In the United States, a major part of the New Deal was
a series of programs designed to relieve poverty
among the aged, the disabled, widows with small
children, and the unemployed. The two primary
underpinnings of that social safety net were created
simultaneously in 1935. One was the Social Security
system for those who worked, and the other was the
welfare system (Aid to Dependent Children, Aid to the
Aged, Aid to the Blind, etc.) for those who were unable
to work because of age or other disabilities. With many
modifications in the intervening years, these two
pillars of the social safety net remained intact in the
United States until the 1990s.
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The enlarged federal role relative to state and local
governments may have been a pragmatic response to
necessity, but there is some economic justification as
well for locating some of that responsibility at the
central level in a federal system. Poorer states tend to
have larger concentrations of low-income people with
a greater need for assistance and fewer tax resources
with which to provide that assistance. If they raise
benefits, they have to raise taxes, making them less
competitive to attract or retain industry and higher-
income residents. Wealthier states that can afford to
offer more generous benefits are hesitant to do so for
fear of attracting welfare recipients from other states.
This kind of competitive environment is less likely to
encourage support for the poor than a system where
welfare benefits are more uniform across states. If the
benefits of antipoverty programs spill over state
boundaries to affect nearby states and even the nation
as a whole, then the cost should be shared in a similar
manner. All of these reasons offer support and
economic justification for the ultimately practical
decisions of politicians during the Great Depression
who designed and implemented both the welfare
system and the social insurance system that are still
with us in modified form today. Even in the 1930s,
however, there continued to be a state and local role in
poverty relief. Federal aid consisted primarily of cash
payments to the poor with some state-matching funds.
The required match varied from state to state
depending on income and poverty levels in each state.
These programs continued to exist, expand and evolve
until 1996 when welfare reform significantly reduced
this kind of federal aid to individuals mediated through
state social service agencies. T he case for centralizing
redistribution rests on competition among states. If
one state offers more attractive benefits to persons in
need than another, it risks becoming a haven for
migration of those persons. Faced with the threat of
attracting the needy and overburdening the welfare
system, states will reduce their benefit levels below
what they would offer in the absence of migration.
Uniform national standards (adjusted for differences in
the cost of living) remove that incentive to migrate
between states in search of better benefits.
The case for localizing redistribution rests on the
arguments offered above for regarding poverty as a
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form of market failure. Both the empathy and the social
blight arguments for poverty relief suggest that the
benefits from relieving poverty are very local in nature.
In addition, there is the need to monitor eligibility and
control fraud, which is much easier to do effectively at
the local community level. Despite repeated efforts to
sort out responsibilities and assign responsibilities for
poverty relief to a particular level of government, it is
as it has been since the Great Depression a shared
function of federal, state, and local governments
7 Tax Incidence
Assessing which party (consumers or producers)
bears the true burden of a tax
The fundamental disagreement between the governor
and the business community concerned who would
ultimately pay this new tax.
The business community claimed workers would bear
the burden, while the governor claimed the burden
would be shouldered by wealthy companies and their
executives.
This debate focuses on the central question of tax
incidence: Who bears the burden of a tax? A simple
answer to this question would be that whoever sends
the check to the government bears the tax. Yet such an
answer ignores
Tax incidence is assessing which party (consumers or

producers) bear the true burden of a tax.
The fact that markets respond to taxes and that these

responses must be taken into account to assess the
ultimate burden, or incidence, of taxation.
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Figure 7.1
The Sources of Federal Government Revenue (% of Total Receipts) The

federal government depends much less on corporate and excise taxes and
much more on payroll taxes than it did in 1960. Its biggest source of
revenue, then as now, is the individual income tax. Source: Bureau of
Economic Analysis (2009).
To see the importance of this question, let’s return to

the facts on the distribution of federal taxation over
time from Chapter 1. Figure 19-1 shows these facts
again. In 1960, 22.8% of federal taxes was collected
from corporations, and 61.5% was collected from
individuals through income and payroll taxes. Today,
11.3% of taxes is collected from corporations, and
81.5% is collected from individuals. Is this an equitable
shift in the burden of taxation? Your first reaction
might be “No, it’s not at all equitable! Corporations are
rich, and individuals aren’t, so this imbalance is not
fair.” Your indignant reaction, however noble, is
misplaced because corporations don’t pay taxes;
corporate taxes are paid by the individuals who own,
work for, and buy from the corporations. When we
study tax incidence, then, we are always comparing
taxes collected from one set of people to taxes
collected from another set. This comparison makes the
issue of figuring out who bears the burden of a tax less
clear than if we view it simply as a matter of pitting rich
corporations against poor individuals. This chapter
examines the equity implications of taxation. We begin
with the three rules of tax incidence that guide our
modeling of the distributional implications of taxation.
We then turn to the study of general equilibrium tax
incidence, the effect of taxes on one sector in a multi
sector world. Finally, we present empirical evidence on
the burden of taxation in the United States over time.
7.1 The Three Rules of Tax Incidence

The goal of determining a tax’s incidence is to assess
who ultimately bears the burden of paying a tax.
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Economic tax incidence can be described by three
basic rules.
We describe these rules with reference to the
incidence of a tax of a fixed amount on a specific
commodity, or a specific excise tax.
An alternative form of taxation of commodities is ad
valorem taxes, a fixed percentage of the sales price
(such as with state sales taxes).
All of the lessons drawn here apply equally to both
types of taxes; the major difference with ad valorem
incidence analysis is that taxes shift the demand or
supply curve proportionally (e.g., quantity rises by
10%) rather than by fixed amounts (e.g., quantity rises
by 5 units).
The Statutory Burden of a Tax Does Not Describe Who
Really Bears the Tax
The first and most important rule of tax incidence is
that tax laws do not accurately identify who actually
bears the burden of the tax. The statutory incidence of
a tax is determined by who pays the tax to the
government. For example, the statutory incidence of a
tax paid by producers of gasoline is on those very
producers. Statutory incidence, however, ignores the
fact that markets react to taxation.
This market reaction determines the economic
incidence of a tax, the change in the resources
available to any economic agent as a result of taxation.
The economic incidence of any tax is the difference
between the individual’s available resources before
and after the tax has been imposed. When a tax is
imposed on producers in a competitive market,
producers will raise prices to some extent to offset this
tax burden, and the producers’ income will not fall by
the full amount of the tax.
When a tax is imposed on consumers in a competitive
market, the consumers will not be willing to pay as
much for the taxed good, so prices will fall, offsetting
to some extent the statutory tax burden on consumers.
Technically, we can define the tax burden for
consumers as
Consumer tax burden =

(post-tax price - pre-tax price) + per-unit tax
payments by consumers.
For producers the tax burden is
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Producer tax burden =
(pre-tax price - post-tax price) +
per-unit tax payments by producers.
For example, suppose that tomorrow the federal

government levied a 50¢ per gallon tax on gasoline, to
be paid by the producers. Will gas producers receive
50¢ less on each gallon they produce as a result of this
tax?
To answer this question, we need to consider the

impact of the gas tax on the market for gas, as shown
in panel (a) of the next Figure.
The vertical axis in this graph shows the price per

gallon of gas, and the horizontal axis shows billions of
gallons of gas. Recall from Chapter 2 that the supply
curve shows the quantity that suppliers are willing to
sell at any given price. In a competitive market, the
supply curve is determined by the firm’s marginal cost:
the producer will sell any units for which the market
price is at or above its marginal cost of producing that
unit. In Figure 19-2, the market is initially in equilibrium
at point A: at the market price of $1.50 (P1), producers
will supply 100 billion gallons (Q1) of gasoline.
Producers are willing to supply 100 billion gallons at
$1.50 per gallon because $1.50 is the producers’
marginal cost of producing that quantity of gas. Panel
(b) of Figure 19-2 shows the effects of imposing a tax
of 50¢ per gallon of gas sold on the producers of gas.
For these producers, this is equivalent to a 50¢ per
gallon increase in marginal cost. Because firms must
pay both their original marginal cost and the 50¢ tax,
they now require a price that is 50¢ higher to produce
each quantity.
To supply the initial equilibrium quantity of 100 billion
gallons after the tax is imposed, for example, firms
would now require a price of P2 $2.00 (50¢ higher than
the initial $1.50 equilibrium price, at point B). Because
the tax acts like an increase in marginal cost, the entire
supply curve shifts upward by 50¢ from S1 to S2 and
the supply of gas falls.
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Figure 7.2
Statutory Burdens Are Not Real Burdens • Panel (a) shows the equilibrium
in the gas market before taxation (point A ). A 50¢ tax levied on gas
producers (the statutory burden) in panel (b) leads to a decrease in supply
from S 1 to S 2 and to a 30¢ rise in the price of gas from P 1 to P 3 (point D
). The real burden of the tax is borne primarily by consumers, who pay 30¢
of the tax through higher prices, leaving producers to bear only 20¢ of the
tax.
At the initial equilibrium price of $1.50, there is now

excess demand for gasoline.
Consumers want the old amount of gasoline (100
billion gallons) at $1.50, but with the new tax in place
producers are willing to supply only 80 billion gallons
(point C). At $1.50, there is a shortage of Q1 (point A)
minus Q2 (point C), or 20 billion gallons. Consumers
therefore bid up the price as they compete for the
smaller quantities of gas that are now available from
producers. Prices continue to rise until the market
arrives at a new equilibrium (point D) with a market
price of $1.80 (P3) and a quantity of 90 billion gallons
(Q3). The market price is now 30¢ higher than it was
before the tax was imposed.
Burden of the Tax on Consumers and Producers The

tax has two effects on the participants in the gas
market. First, it has changed the market price that
consumers pay and producers receive for a gallon of
gas; this price has risen by 30¢ from $1.50 to $1.80.
Second, producers must now send a check to the
government for 50¢ for each gallon sold
From the producers’ perspective, the pain of the 50¢
tax is offset by the fact that the price the producers
receive is 30¢ more than the initial equilibrium price.
Thus, the producers have to pay only 20¢ of the tax,
the portion that is not offset by the price increase.
From the consumers’ perspective, they feel some of
the pain of the tax since they pay 30¢ more per gallon.
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Even though consumers send no check to the
government and producers send a 50¢ check to the
government, consumers actually bear more of the tax
(30¢ to the producers’ 20¢). The price increase has
transferred most of the tax burden from producers to
consumers. These burdens are illustrated in Figure 19-
2 by the segments labeled “Consumer burden” and
“Producer burden.” Using the formulas on p. 559, we
can compute the burdens on consumers and
producers. The consumers’ burden is
consumer tax burden = (post-tax price- pre-tax

price) + per-unit tax payments by consumers
= P3 - P1 + 0 1.80 - 1.50 = 0.30
The producers’ burden is
producer tax burden = (pre-tax price - post-tax

price) + per-unit tax payments by producers
= P1 - P3 + 0.50 1.50 = 1.80 - 0.50 = 0.20
The key insight is that the burden on producers is not

the 50¢ tax payment they make on each gallon but
some lower number, because some of the tax burden
is borne by consumers in the form of a higher price.
The sum of these burdens is $0.50, the total tax wedge
created by this tax, which is the difference between
what consumers pay ($1.80) and what producers
receive net of tax ($1.30, at point E) from a transaction.
The Side of the Market on Which the Tax Is Imposed Is

Irrelevant to the Distribution of the Tax Burdens
Figure 7.3
The Side of the Market Is Irrelevant A 50¢ tax levied on gas consumers
(the statutory burden) leads to a decrease in demand from D 1 to D 2 and
to a 20¢ fall in the price of gas from P 1 to P 3 (with the market moving from
the pre-tax equilibrium at point A to the post-tax equilibrium at point D ).
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The real burden of the tax is borne primarily by consumers, who pay the
50¢ tax to the government but receive an offsetting price reduction of only
20¢; producers bear that 20¢ of the tax.
7.2 The second rule of tax incidence is that the

side of the market on which the tax is imposed is
irrelevant to the distribution of the tax burdens:
tax incidence is identical whether the tax is levied on
producers or consumers.2 In terms of the previous
rule and previous Figure , this rule means that whether
the 50¢ tax is imposed on producers or consumers,
consumers will always end up bearing 30¢ of the tax
and the producers will end up bearing 20¢. Previous
Figure considers the impact of a 50¢ per gallon tax on
consumers of gas. In this case, the tax is collected
from consumers at the pump when they pay for their
gas rather than from producers, as in Figure 7.2. Recall
that the demand curve represents consumers’
willingness to pay for any quantity of a good. Each
point on the demand curve shows the quantity
demanded for any market price encountered by
consumers. With consumers having to pay a 50¢ tax in
addition to the market price at every quantity, they are
now willing to pay 50¢ less for each quantity. Thus,
because the tax causes a reduction in consumers’
willingness to pay (before adding in their tax
payments), the entire demand curve shifts downward
by 50¢, from D1 to D2. Before the tax, consumers were
willing to pay a price of P1 = $1.50 for the 100 billionth
gallon of gas at point A. Now they are willing to pay
only a price of P2 $1.00 for the 100 billionth gallon
(point B), since they also have to pay the 50¢ tax on
each gallon purchased. At the old market price of
$1.50, there is now an excess supply of gasoline:
producers are willing to sell the old amount of gasoline
(100 billion gallons, at point A), but consumers are
willing to buy only 80 billion gallons at that price, at
point C.
There is an excess supply of gasoline of Q1 Q2 20
billion gallons at the initial equilibrium price of $1.50
after the demand curve shifts. Producers therefore
lower their price to sell their excess supply until the
price falls to $1.30 (P3) at point D, with an equilibrium
quantity of 90 billion gallons (Q3). The market price is
now 20¢ lower than it was before the tax was imposed.
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As in the previous example, this tax has two effects on
the participants in the gas market. First, it has changed
the market price that consumers pay and producers
receive for a gallon of gas; this price has fallen by 20¢
from $1.50 to $1.30. Second, the consumer must now
pay the government 50¢ for each gallon purchased. At
the equilibrium price of $1.30, adding the 50¢ tax yields
a cost to consumers (price plus tax) of $1.80 at point E.
From the consumers’ perspective, the pain of the 50¢
check is offset by the 20¢ per gallon decline in the
market price. From the producers’ perspective, they
are feeling some of the pain of this tax since they are
receiving 20¢ less per gallon. Even though producers
send no check to the government, and consumers
send a 50¢ check to the government, both parties bear
some of the ultimate burden of the tax, since the price
decrease has transferred some of the tax burden from
consumers to producers.
These burdens are illustrated in Figure 7-3 by the
segments labeled “Consumer burden” and “Producer
burden.” Using our formulas, we can compute the
burdens on consumers and producers:
Consumer: P3 P1 + 0.50= 1.30 - 1.50 + 0.50= 0.30
Producer: P1 P3+ 0 = 1.50 - 1.30 = 0.20
Once again, the sum of the burdens on consumers and

producers, the difference between what consumers
pay ($1.80) and what producers receive ($1.30), is the
tax wedge of 50¢. Note that these tax burdens are
identical to the burdens in the previous example.
Consumers now have to pay the 50¢ at the pump, but
they are facing a lower price ($1.30) to which they have
to add that tax. Adding the two together, the consumer
pays exactly the same amount ($1.80, price plus tax) as
in the previous case. Producers now don’t have to pay
a tax, but they receive a lower price for their gas ($1.30
instead of $1.50), so they end up receiving the same
amount ($1.30) as well.
Gross Versus After -Tax Prices

While there is only one market price when a tax is
imposed, there are two different prices that
economists often track in these types of tax incidence
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models. The first is the gross price, the price paid by
or received by the party not paying the tax to the
government; it is the same as the price in the market.
The second is the after-tax price, the price paid by or
received by the party that is paying the tax to the
government; it is either lower by the amount of the tax
(if producers pay the tax) or higher by the amount of
the tax (if consumers pay the tax). When the gas tax is
levied on producers, as shown in Figure 7-2, the gross
price paid by consumers is $1.80, and the after -tax
price received by producers is $1.80 - $0.50 = $1.30.
When the gas tax is levied on consumers, as in Figure
7-3, the gross price received by producers is $1.30,
and the after -tax price paid by consumers is 1.30 +
0.50 = 1.80.
The after -tax price is equal to the gross price plus

the tax wedge if the tax is on consumers, but is equal
to the gross price minus the tax wedge if the tax is on
producers.
7.3 Parties with Inelastic Supply or Demand Bear

Taxes; Parties with Elastic Supply or Demand
Avoid Them
In the previous example, we described a particular
case in which consumers bear more of the burden of a
tax than do producers.
This is, however, only one of many possible outcomes.
The incidence of taxation on producers and
consumers is ultimately determined by the elasticity of
supply and demand on how responsive the quantity
supplied or demanded is to price changes.
Perfectly Inelastic Demand Consider again the case in
which the 50¢ per gallon tax is levied on gasoline
producers, but let’s assume this time that consumers
have a perfectly inelastic demand for gas, as shown in
Figure 7-4. At initial equilibrium, the price for 100
billion gallons is P1 ($1.50).
When the tax is levied on producers, they once again
treat this as equivalent to a 50¢ rise in marginal cost,
raising the price that they require to supply any
quantity; supply falls and the supply curve shifts from
S1 to S2. The new equilibrium market price is $2.00
(P2), a full 50¢ higher than the original price P1. When
demand is perfectly inelastic, the tax burdens are
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Consumer burden = (post-tax price - pre-tax price) +
tax payments by consumers P2 - P1 = 2.00 - 1.50 =
0.50
Figure 7.4
Inelastic Factors Bear Taxes • A tax on producers of an inelastically

demanded good is fully reflected in increased prices, so consumers bear
the full tax
When demand is perfectly inelastic, producers bear

none of the tax and consumers bear all of the tax. This
is called the full shifting of the tax onto consumers.
Perfectly Elastic Demand Contrast that outcome with
the case in which consumers’ demand for gas is
perfectly elastic, as shown in Figure 19-5. Initially, the
market is in equilibrium at P1 = $1.50 and Q1 = 100
billion gallons.
In this case, when a 50¢ tax causes the supply curve to
shift from S1 to S2, the equilibrium price remains at P1,
$1.50, but the quantity falls to Q2, 80 billion gallons.
When demand is perfectly elastic, the tax burdens are
therefore
Consumer = P1 - P1 = 1.50 - 1.50 = 0
Producer = P1 - P1 + 0.50 = 1.50 - 1.50 + 0.50 = 0.50
In this case, producers bear all of the tax and

consumers bear none of the tax.
General Case, These extreme cases illustrate a general

point about tax incidence: parties with inelastic
demand (or supply, as we show below) bear taxes;
parties with elastic demand (or supply) avoid them.
Demand for goods is more elastic (the price elasticity
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of demand is higher in absolute value) for goods with
many substitutes. For example, the demand for fast
food is fairly elastic because higher-quality restaurant
meals or home cooking can be substituted for fast
food fairly easily. Thus, if the government levied a tax
on fast food, fast -food restaurants would find it
difficult to raise prices in order to pass all of the tax
onto fast- food consumers; if they did, individuals
would substitute one of these alternatives for their fast
food. Thus, because the demand for fast food is
elastic, the producers (the restaurants) bear most of
the burden of the tax. For products with an inelastic
demand, the burden of the tax is borne almost entirely
by the consumer. For example, the demand for insulin
is highly inelastic because it is essential to the health
of diabetics.
If the government taxes the producers of insulin, they
can easily raise their price and completely shift most
of the tax burden onto consumers because there are
no substitutes available that allow consumers to leave
this market because of a higher price.
Figure 7.5
Elastic Factors Avoid Taxes • A tax on producers of a perfectly elastically

demanded good cannot be passed along to consumers through an
increase in prices, so producers bear the full burden of the tax.
Supply Elasticity
Supply elasticity also affects how the tax burden is
distributed. Supply curves are more elastic when
suppliers have more alternative uses to which their
resources can be put. In the short run, a steel
manufacturer has fairly inelastic supply; having
invested in the steel plant and expensive machinery to
produce steel, there are few alternative choices for
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production. The plant cannot easily convert from
making steel to making plastic pipes or wood furniture.
So the supply curve for steel will be fairly inelastic
(vertical).
The supply of sales from sidewalk vendors (of items
such as watches, purses, scarves, and so on) in New
York City, in contrast, is very elastic. Since the
individuals selling these goods have a very low
investment in that particular business, if it is taxed.
Compare the incidence of a tax on steel (levied on
steel producers) to the incidence of a tax on sidewalk
vendors (levied on the vendors) for any given demand
curve (assuming that the demand curve is neither
perfectly elastic nor inelastic).
Panel (a) of Figure 7-6 shows the impact of a tax on
steel producers. The steel market is initially in
equilibrium at point A.
The steel company can reduce the amount of steel it
produces only slightly because it is committed to a
level of production by its fixed capital investment. As a
result, even when the steel company is paying 50¢ to
the government for each unit of steel produced, it still
wants to produce almost the same amount. Overall, the
steel company’s supply curve shifts upward from S1 to
S2. Price rises only slightly from P1 to P2, and quantity
of steel sold falls only from Q1 to Q2; the new
equilibrium is at point B.
Since the price rise is very small, it does not much
offset the tax that the steel company must pay. The
steel company therefore bears most of the tax, and
consumers of steel bear very little (since they don’t
pay a much higher price).
Figure 7.6
Elasticity of Supply Also Matters • A tax on producers of an inelastically

supplied good, as in panel (a), leads to a very small rise in prices, so
producers bear most of the burden of the tax. An equal -sized tax on
producers of an elastically supplied good, as in panel (b), leads to a large
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rise in prices, so producers bear little of the burden of the tax (and
consumers bear most of the burden).
Panel (b) of Figure 7-6 shows the impact of an equal-

sized tax on sidewalk vendors. These vendors are very
sensitive to the costs of production in their production
decisions, leading to the very elastic supply curve.
They are initially willing to provide a quantity Q1 of
goods at a price of P1. If the government makes them
pay 50¢ per good they sell, then many vendors will
move out of the sidewalk vending business into some
more lucrative line of work.
The supply curve therefore shifts from S1 to S2, with
prices rising from P1 to P2, and the quantity of goods
sold falling from Q1 to Q2 (at point B). The large
increase in price in the sidewalk vendors’ market
greatly offsets the taxes the vendors have to pay, so
they bear little of the burden of the tax. Consumers of
goods sold by sidewalk vendors will see much higher
prices for these goods, however, so they will bear
most of the tax.
Thus, the same principles hold for supply as for
demand elasticity’s; elastic factors avoid taxes, while
inelastic factors bear them. In the appendix to this
chapter, we develop the mathematical tax incidence
formulas that formalize this intuition.
Reminder: Tax Incidence Is About Prices, Not
Quantities When the demand for gas is perfectly
elastic, as in Figure 7-5, we claimed that consumers
bore none of the burden of taxation, and yet the
quantity of gas consumed fell dramatically. Doesn’t
this decrease in consumption make consumers worse
off? And if so, shouldn’t that be taken into account
when determining tax incidence?
The answer to both questions is “no” because, at both the old
and new equilibrium, consumers in this case are indifferent
between buying the gas and spending their money elsewhere.
Each point on a demand curve represents consumers’
willingness to pay for a good. That willingness to pay reflects
the value of the next best alternative use of their budget. If the
demand curve for gas is perfectly elastic, consumers are truly
indifferent, at the market price, between consuming gas and
consuming some other good. So if they have to shift to buying
more of another good and less gas, they are no worse off. More
generally, when we analyze tax incidence we ignore changes in
quantities and only focus on the changes in prices paid by
consumers and suppliers.
This assumption makes tax incidence analysis simpler
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8 Tax Incidence in Factor Markets
Our discussion thus far has focused on taxes that are
levied in the goods markets, such as the markets for
gas or fast food. Many taxes, however, are levied in
factor markets, such as the market for labor.
The analysis of tax incidence in factor markets is
identical to that in goods markets; the only difference
is that consumers of the factors are the firms (they
demand factors such as labor) and producers of
factors are individuals (who provide factors such as
labor).
8.1 Incidence Analysis Is the Same in Factor

Markets
Consider, for example, the market for labor shown in
panel (a) of Figure 8-1. Hours of labor supplied in the
market are shown on the x-axis; the market wage is on
the y-axis. There is a downward -sloping demand for
labor from firms (D1) and an upward -sloping supply of
labor from individuals (S1). The market is initially in
equilibrium, before taxes, with a wage W1 of $7.25 per
hour at point A.
Suppose that the government levies a payroll tax of $1
per hour on all workers. This tax lowers the return to
work by $1 at every amount of labor.As a result,
individuals require a $1 rise in wages to supply any
amount of labor and the supply shifts up from S1 to S2
in panel (a) of Figure 19-7. With demand remaining at
its original level, this shift results in a higher market
equilibrium wage of $7.75 (W2) at point B. The
incidence of the tax is shared by workers (suppliers)
and firms (demanders) according to the elasticity of
demand and supply.
Figure 8.1
Incidence Analysis Is the Same in Factor Markets • These figures show the
market for labor where firms are the consumers and workers are the
producers of hours worked at a wage rate W. A $1.00 tax per hour worked
that is levied on workers, shown in panel (a), leads the supply curve to rise
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from S 1 to S 2 and the wage to rise from its initial equilibrium value of
$7.25 (point A ) to a higher value of $7.75 (point B ). A tax of $1.00 per hour
worked that is levied on firms, shown in panel (b), leads the demand curve
to fall from D 1 to D 2 and the wage to fall from $7.25 to $6.75 at point C .
Thus, regardless who pays the tax, workers and firms each have a burden
of 50¢ per hour.
If these elasticity are equal, the burden is shared

equally: the wage will rise to $7.75 per hour, and
workers will take home $6.75 per hour after paying
their $1 per hour tax. The firms and the workers each
bear 50¢ of the $1.00 tax, split as indicated on the
vertical axis. The firms pay a 50¢ higher wage ($7.75)
and the workers receive a 50¢ higher wage ($7.75), but
because they must pay $1 an hour in tax, they receive
50¢ less in after -tax wage ($6.75). The gross wage in
the market has risen to $7.75, but the after tax wage of
workers has fallen to $6.75.
According to the second rule of tax incidence, what
matters for the burdens on workers and employers
from this tax is the total tax wedge and the elasticities
of supply and demand, not who sends the check to the
government. Panel (b) of Figure 19-7 shows the effect
on the labor market if the payroll tax in our example
were instead paid only by firms and not by workers. In
that case, the supply curve would remain at S1, and,
because the tax on consumers (the firms) acts like an
increase in the price of labor, the demand for labor
would fall and the demand curve would shift inward to
D2. Market wages would fall by $1.00 from $7.75 to
$6.75, the new equilibrium (point C), and the burdens
of taxation would be unchanged. Firms bear the same
50¢ burden as before; rather than paying a 50¢ higher
wage, however, they now pay a wage ($6.75) that is 50¢
lower than the initial equilibrium wage of $7.25. In
addition, firms now must send a $1 check to the
government, so in effect they are paying a wage of
$7.75.
Workers see the same 50¢ burden; rather than
receiving a 50¢ higher wage and sending a $1 check to
the government, however, they now receive a 50¢
lower wage ($6.75). The gross wage in the market has
fallen to $6.75, but the after-tax wage paid by firms is
$7.75.
The tax incidence analysis of a payroll tax shows that
it makes no difference that the Social Security payroll
tax is levied half on workers and half on firms, rather
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than being levied 100% on workers or on firms. The
second rule of tax incidence tells us that what matters
for determining the burden of the Social Security tax is
the total size of the tax (the total tax wedge), not how
the tax is distributed across demanders and
producers.
8.2 Impediments to Wage Adjustment

These conclusions from comparing panels (a) and (b)
in Figure 19-7 will not be correct, however, if anything
impedes the free adjustment of wages in the labor
market. One such impediment is a minimum wage, a
mandated minimum amount that virtually all workers
must be paid for each hour of work. The current U.S.
minimum wage is $7.25 per hour. Panels (a) and (b) of
Figure 19-8 show how the analysis of Figure 19-7
changes when a minimum wage, WM, is introduced at
the initial equilibrium wage of $7.25.
Panel (a) shows the case where the payroll tax is levied
on workers. In that case, the minimum wage has no
effect on incidence analysis: when the tax is
implemented, wages rise to $7.75 at point B (firms pay
50¢ in higher wages), workers send $1 to the
government in taxes, and they earn an after -tax wage
of $6.75.
Figure 8.2
Incidence Analysis in Factor Markets Differs with a Minimum Wage • The

analysis here is the same as in Figure 19-7, with the addition of the
constraint that the wage cannot fall below $7.25 per hour. If the payroll tax
is levied on workers, as shown in panel (a), this constraint has no effect:
the wage rises to $7.75, as in Figure 19-7, and workers and firms equally
share the burden of the tax. If the payroll tax is levied on firms, as shown in
(panel (b), however, the firms cannot lower the wage to the desired $6.75
per hour, so the firms bear the full amount of the tax.
Panel (b) shows the case where the payroll tax is

levied on firms. In that case, the supply curve remains
at S1 and the demand curve shifts to D2. However, the
firms cannot lower the wage to the desired level of
$6.75 (point C), because this is an illegally low wage.
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The wage must stay at $7.25, and the firm must bear all
of the burden. The workers’ wage doesn’t fall from
$7.25, and the firm sends the check to the government,
so the firm bears the full incidence of the payroll tax
and pays an after -tax wage of $8.25. The quantity of
labor in the market falls to H3, where the new demand
curve D2 intersects the minimum wage line (point C´).
When there are barriers to reaching the competitive
market equilibrium (as in this minimum wage example),
the side of the market on which the tax is levied can
matter.
There are a number of potential barriers, ranging from
the minimum wage to workplace norms, that do not
allow employers to explicitly cut workers’ wages. Such
rigidities are often not present in output markets.
For this reason, the party on whom the tax is levied
may matter more in input than in output markets.
8.3 Tax Incidence in Imperfectly Competitive

Markets
Our analysis thus far has focused on perfectly
competitive markets in which there are a large number
of demanders and suppliers consuming very similar
goods. Very few markets are perfectly competitive in
practice. Unfortunately, modeling imperfectly
competitive markets is an imperfect science. In this
section, we discuss the one case that we can model
clearly, a monopoly market, a market in which there is
only one supplier of a good.
Background: Equilibrium in Monopoly Markets

Monopolists maximize profits just as competitive firms
do: they produce a good or service until the marginal
cost of the next unit produced equals the marginal
revenues earned on that unit. For competitive firms,
the marginal revenue earned on the next unit is the
market price, so they set marginal cost equal to price.
Because monopolists are price makers, not price
takers, however, marginal revenue is not a price
determined in the market but a price chosen by the
monopolist. (In our analysis of tax incidence in
monopoly markets, we assume that monopolists
charge one price to all consumers; we do not consider
the case of price discriminating monopolists.)
Panel (a) of Figure 8-3 shows the determination of
equilibrium in monopoly markets. The monopoly seller
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has an upward -sloping marginal cost curve and faces
a downward -sloping demand curve. For a monopolist,
there are two aspects to the decision about whether to
produce and sell the next unit. The first is the price
that the monopolist will earn on the next unit. The
second is that in order to sell the next unit, the (non–
price discriminating) monopolist must lower the price
because he or she faces a downward -sloping demand
curve. Consumers will buy another unit only if the
market price is less than it was at the previous
quantity. However, because the monopolist charges
only one price to all customers, he or she must lower
the price on all previous units for sale as well. Thus
monopolists face a trade -off as price makers:
additional sales at a given price will increase revenue,
but they will also force the monopolist to lower prices
on all existing units to achieve equilibrium at the new
higher quantity produced, lowering revenue.
The result of this pricing decision is that the
monopolist’s marginal revenue curve is the line MR1 in
panel (a) of Figure 8-3, which lies everywhere below
the demand curve D1.
The marginal revenue that the monopolist gets from
additional sales is below the consumers’ willingness to
pay for the given unit (the demand curve) because it
incorporates the negative effect of lowering prices on
all other units. In our example, the monopolist chooses
to produce the quantity Q1, the quantity at which
marginal revenue equals marginal cost at point A. As
measured on the demand curve D1, consumers are
willing to pay price P1 for quantity Q1.
Figure 8.3
Tax Incidence in Monopoly Markets • Panel (a) shows the equilibrium in a

monopoly market. The monopolist sets quantity produced where the
marginal revenue curve intersects the supply curve (at Q 1) and then sets
the price using the demand curve for that quantity (at P 1). When a tax is
imposed on consumers in this market, as in panel (b), the demand curve
shifts downward from D 1 to D 2, leading the marginal revenue curve to
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also shift downward from MR 1 to MR 2. The new equilibrium quantity is
Q2, with a new price of P 2.
Thus, the monopolist produces Q1 and charges price

P1. Note that even though the monopolist sets the
price, the demand curve still must be respected. The
monopolist cannot, for example, produce quantity Q1
and charge price P2 because at that price consumers
would demand Q2 far more than Q1 (where the
monopolist’s marginal revenue equals marginal costs).
The mathematics of the monopolist’s profit
maximization, and its implications for tax incidence,
are developed in the appendix.
8.4 Taxation in Monopoly Markets

Suppose that the government imposes a tax on
consumers in a monopoly market, as shown in panel
(b) of Figure 8.3.
This tax causes consumers to be less willing to pay a
given market price for the monopolist’s good, shifting
the demand curve to D2. This reduction in willingness
to pay leads to an associated shift in the marginal
revenue curve to MR2.The new equilibrium (at the
intersection of MR2 and the marginal cost curve) is at a
lower quantity Q2, and the new lower price is P2. The
monopolist bears some of the tax, just as the
competitive firm does: even though consumers are
paying the tax to the government, the monopolist
receives a lower price (P2) in the market, so he or she
shares the tax burden.
The three rules of tax incidence therefore apply in
monopoly markets as well. In this case, as we show in
the appendix to this chapter, the side of the market on
which the tax is imposed remains irrelevant: even
though the monopolist has market power, a tax on
either side of the market results in the same sharing of
the tax burden. So monopolists cannot “exploit their
market power” to avoid the rules of tax incidence.
Tax Incidence in Oligopolies

Very few markets are perfectly competitive or
monopolistic. Most markets operate somewhere in
between, with some degree of imperfect competition.
Oligopoly markets are markets in which firms have
some market power in setting prices but not as much
as a monopolist. While there are widely accepted
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models of how competitive and monopolistic markets
work, there is much less consensus on models for
oligopolistic markets. As a result, economists tend to
assume that the same rules of tax incidence apply in
these markets as well, but there is more work to do to
understand the burden of taxes in oligopoly markets.
Balanced Budget Tax Incidence

The model we have used thus far to examine the
burden of taxation in perfectly competitive markets
and monopolies has focused on the incidence of the
tax alone. Taxes also raise revenues, however, and
these revenues will ultimately be spent. Thus, a
complete picture of tax incidence would consider not
only who bears the tax but also who receives the
benefit of the spending that is financed out of the tax
revenues. Consider, for example, the federal gas
excise tax, a tax levied by the federal government on
the sale of gasoline. Suppose that demand for gasoline
is very inelastic (or supply is very elastic), so that the
price of gas to consumers rises by the full amount of
this tax . At the same, however, 80% of the revenues
collected by this 18.4¢ gas tax are spent on highway
improvements and repairs through the highway trust
fund.5 In this case, it would be wrong to say that
drivers fully bear the tax: they do pay the tax, but they
also reap some of the rewards in terms of better roads
on which to drive. Tax incidence that takes into
account the incidence of both the tax and the benefit is
called balanced budget incidence. It is often difficult,
however, to trace the spending associated with a given
tax increase. Thus, we typically ignore the spending
side when we do tax incidence analysis. It is important
to remember, however, that in reality the full burden of
a tax policy will depend on the distribution of the both
the tax payments and the spending of the associated
revenues.
Page
179
8.4 General Equilibrium Tax Incidence
To study the effects on related markets of a tax
imposed on one market, economists use the model of
general equilibrium tax incidence.
Effects of a Restaurant Tax:
A General Equilibrium Example
I live in the town of Lexington, Massachusetts, which is
nestled among a number of neighboring similar towns.
Suppose that Lexington were to announce tomorrow
that it was levying a tax of $1 on all restaurant meals in
that town. The demand for restaurant meals in
Lexington is fairly elastic because there are many
substitutes, such as cooking at home or going to a
restaurant in a nearby town. For ease, let’s suppose
that the demand for Lexington restaurant meals is
perfectly elastic
The effect of the restaurant meal tax under this
assumption is illustrated in Figure 8.4.
The restaurant meal market in Lexington is initially in
equilibrium at point A: at a price of $20 per restaurant
meal (P1), 1,000 restaurant meals are sold per day in
the town (Q1). The meal tax acts like an increase in the
restaurants’ marginal costs and shifts the supply curve
inward from S1 to S2,
Figure 8.4
The Incidence of a Tax on Lexington Restaurants • The demand for

restaurants in Lexington is perfectly elastic, so prices cannot increase when
they are taxed; as a result of a $1.00 tax on restaurant meals, the supply of
meals falls from S 1 to S 2, and the quantity of meals demanded and
supplied falls to Q 2 (950). The price of a restaurant meal remains at $20,
so the restaurant, which is paying the tax, bears its full burden.
With quantity falling to 950 meals sold per day (Q2).

Note that this tax has no effect on the price charged by
restaurants: because demand is perfectly elastic, any
Page
181
increase in price to consumers would drive all
business away. Thus, the restaurant bears the entire
burden of the tax, and consumers bear none of it. The
story can’t end there, however, for the simple reason
that restaurants cannot bear taxes. As Nobel Prize–
winning economist Milton Friedman once said in
discussing energy taxes, “How do you ‘burden’
industry or ‘tax’ a factory? Do you squeeze it until it
screams? Send it to jail? Only people can bear a
‘burden’ or pay a tax. An industry, a factory, or a utility
can do neither.”
In the standard microeconomics model, firms are not
self -functioning entities but are a technology for
combining capital and labor to produce an output. In
the context of our restaurant example, capital is best
thought of as financial capital, the money that buys
physical capital inputs, such as the building, the
ovens, tables, and so on. By labor, we mean the hours
of labor workers supply to the restaurant. When we say
that the $1 Lexington meals tax is borne by
restaurants, we mean that it is borne by the factors
(labor and capital) that restaurants have organized to
produce meals. To accurately identify who bears the
burden of the meals tax, we need to move the analysis
back one step and ask: In what proportions do these
factors of production bear the restaurant tax?
General Equilibrium Tax Incidence
Consider first the market for labor employed by
restaurants in Lexington, shown in panel (a) of Figure
8.5. In this market, supply is likely to be very elastic,
because workers can always choose another job in
Lexington or go to work in a restaurant in a nearby
town. Once again, for ease, let’s assume that the labor
supply available to restaurants in Lexington is
perfectly elastic. At the initial market equilibrium (point
A), the wage is $8/hour (W1) and the quantity of labor
is 1,000 hours per year (H1). When the new tax goes
into effect, and restaurants bear its full burden (since
the demand for restaurant meals is perfectly elastic),
they will reduce their demand for workers. Each worker
is worth less because the restaurant’s willingness to
pay for an hour of labor falls when it is taxed on the
fruits of that labor (the meals).
The demand curve in the Lexington restaurant labor
market shifts downward from D1 to D2, but because
labor supply is perfectly elastic, wages do not fall and
Page
183
workers bear none of this tax. If restaurant owners try
to pay their workers a wage lower than W1, the
workers will simply go work someplace else.
Now consider the market for capital in Lexington
restaurants, shown in panel (b) of Figure 8.5. In the
short run, having invested in a Lexington restaurant,
the capital owner is stuck, unable to pull out money
that has already been spent on stoves, tables, and a
building. In principle, the capital owner could resell
goods, such as chairs, tables, and buildings, but in
reality the owner would receive only a fraction of the
purchase price. Thus, while the supply of capital isn’t
perfectly inelastic in reality, we assume for
convenience in panel (b) of Figure 8.5 that capital
supply is perfectly inelastic.
The initial equilibrium in this capital market is at point A: the
rate of return to capital is 10% (r1) and the investment in
restaurants is $50 million. Since the tax is borne fully by the
restaurants, it reduces their demand for capital just as it
reduced their demand for labor. Capital is also worth less when
the restaurant is taxed on the fruits of that capital (meals), so
the restaurant will demand capital only from those who are
willing to charge a lower rate of return. The lower demand is
reflected in the fall in the demand curve from D1 to D2; the new
equilibrium is at point B, with a lower rate of return of 8% (r2).
Because the supply of capital is inelastic in the short run,
capital owners will bear the meals tax in the form of a lower
return on their investment in the restaurant. Thus, when
Lexington levies a tax on restaurant meals, its incidence
ultimately rests on the investors in Lexington restaurants. This
spillover of incidence to other markets is an example of general
equilibrium tax incidence.
Figure 8.5
The Incidence of a Lexington Restaurant Tax on Labor versus Capital • If

the burden of a tax on restaurants is borne by the restaurants, it must be
borne by the factors of production used by the restaurants. In panel (a), the
supply of labor to restaurants in Lexington is perfectly elastic, so when
demand for labor falls to D 2, it cannot be reflected in lower wages; the
wage is unchanged and workers do not bear any of this tax. In panel (b),
the supply of capital to restaurants in Lexington is perfectly inelastic, so
when demand for capital falls to D 2, the rate of return to capital falls by the
full amount of this tax to r 2.
Page
185
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the 57th Legislative Assembly, Final
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2001.
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PUBLIC FINANCE
PART TWO
DR. Mosaad EL-Gayish
VICE DEAN OF
FACULTY OF POLITICS & ECONOMICS
-1-
PUBLIC FINANCE
PART TWO
-2-
Contents
Elements page
Introduction 4
Chapter One Public budget 10
Chapter Two Public goods 28
Chapter Three Public expenditure 45
Chapter Four Public debts 89
Appendix Public Egyptian budget 129
-3-
Introduction
-4-
Introduction
Some may wonder about the importance of the

state role in the field of the economic activities next
to individuals and private enterprises, as well as
some may wonder about how the performance of
the state of these activities, how they were funded
and the proportionality of revenue collected for the
expenses of public utilities that lead state role in
meeting the public needs through them, do enough
of these revenues.
The most important of these revenues, the various

types, why are constantly changing public
expenditures of the state, and whether taxes and
fees collected by the state are the only sources of
revenue, all of these questions shows how
important the study of public finances and the
study of financial phenomenon aware of the subject
of public finance science which studies the
-5-
necessary financial resources to finance the
necessary expenses of the State.
Not necessarily to carry out the functions assigned

to it, the most important defense and security,
justice and the satisfaction of the public and social
needs, so public finances, knowing which one of
the areas of economics, exposed public
expenditures and their impact on the national
economy , the impact of taxes , public loans and
the government's role in economic activity.
The aim of the public budget in this to estimate the

necessary public expenditure to satisfy the public
needs within the limits of the possible revenue
needed to cover these expenses to a future period
(usually a year), and in this sense the budget is
different from the final calculation, The budget
contains estimates for the period to come.
These estimates are realized and may not

materialize while the final account of the budget is
-6-
a statement of expenditures actually spent and
revenue that actually took place, as the budget is
also different from the balance of a statement of
assets and liabilities of the state at a given moment,
and vary the state budget finally on the national
budget.
Indeed, the expenses and revenues of the State

Planning time to come in the framework of the
budget made the latter the first planning tool in all
economic systems, has been linked to the
prosperity of financial planning in the socialist
systems demise of the primitive ideas about the
possibility of organizing economic life. the kind the
amount of grounds only, while in capitalist systems
have this layout offers after that increased state
intervention in economic life.
-7-
The way it did after World War II evolution of the
role of the budget in these systems are linked to the
development of public finance science.
Studies of the budget is a study in Applied

Economics and the merits of the allocation of
resources between the various public needs and the
modern trend which aims to integrate the budget of
any economic activity for the public business sector
in national economic activity, the time factor plays
an important role in the field of the general budget,
as is the case for other economic phenomena,
economic euphoria ongoing activity in which the
past related to the present.
Also enable us to balance the study of economic

relations that are connected between the activities
belong to the successive intervals in the financial
year to take a number of financial decisions.
Each particular implementation of the budget of the

current fiscal year and some special ratify the final
-8-
account of the previous fiscal year and some
private estimates next year's budget.
-9-
Chapter one
Public budget
- 10 -
Chapter one
Public budget
Budget definition
Budget is a financial document includes all government
revenues and expenditures during the fiscal year,
reflecting the main goals of the general policy of the
government.
As known to the general budget 53 of 1973 Act as

amended by Law 87 of 2005, it is the annual financial
program to plan for economic and social development
set by the state in order to achieve the multiple
economic and social objectives.
And the budget in general, also known as an estimate

of future revenues and expenses during the coming
period is usually a year. Financial year may start at the
beginning of the calendar year and ends its end or begin
on the first of July and ends on the thirtieth of June, or
start from the first of March and ends at the end of
- 11 -
February or beginning in September and ending the end
of August.
In other words, there is no general rule to determine

the beginning and end of the fiscal year, but the timing
will depend financially beginning and end of the state's
ability to determine the timing of revenues and
expenditures and business results of special economic
operations, according to the Financial settled custom in
the state.
Public Finance
Public Finance has a lot of definitions depend on the

view of its goal and ideology of government Such as:
- Public finance is the plan for government expenses

and revenues to steer aggregate demand in the same
desired direction.
- 12 -
- Public finance refers to the government budget which
measures goals primarily at changing income and
employment in the short run
- Public finance is the tool to control the government:

Economic Activity by controlling the public revenue
and public debt to rich the government goals.
What are the Public finance goals?
Really the goals of Public finance are vary depend on

the ideology of the government and what role it will
accept. But the most popular fiscal policy goals are:
1- Price level stability
2- Full employments for the economic production

factors
3- Justice in income distributions
4- High level from economic development
5- Economic resource efficiency
- 13 -
Public finance instruments to achieve its goals?
1- Public revenue
In Egypt the main source of revenue is taxes, it is very
important o determine not only the quantity of income
but also the timing to have this income, the natural of
this income and why the governments choose increase
the income from one source or another.
2- Public expenditure
Salaries and wages in Egypt represent the main
expenditure, and it is very important to determine not
only the changing in quantity of the expenditure but
also the natural of expenditure timing of expenditure
and how it will affect development process.
3-Public debt
It could be divided into internal and external debts, the
way the government will choose to get this borrowing it
is from national market or from international market.
- 14 -
Schools of public finance
The classical school
Classical school opinion of public finance intended to

reduce the size of the public sector and to reduce the
role of governments to its minimum role. Because they
think market mechanism could operate unhindered by
institutional restraints.
Classical believed in the virtues of (advantage) a neutral
fiscal policy. Also the classical view of public finance
regarded the role of governments in the economy as a
necessary evil. Their view in taxes were regarded as
unproductive and the operation of the market
mechanism.
The classical theory of a sound fiscal policy

corresponded to the maxim of a neutral fiscal policy
and their view called for three important things:
- 15 -
1- Reduction of public expenses to the most possible
limit.
2-they believe that tax structure disturbed the pricing

system. So it is very important to reduce taxes and
make it as little as possible. Also from the point of view
of classical school in developing countries, it is being
consciously used to influence the flow of resources in
the interest of planned development and to direct the
resources from unproductive investment and
consumption into productive investment.
3- Government failure
Government failure is a situation in which government

actions lead to inefficiency. Government failure can
lead to overprovision or under provision. Classical
questioned the equilibrating tendencies of the market
forces; also they believe that, the market forces tend to
lead an economy to a stable level of underemployment
equilibrium.
- 16 -
Keynesian view of fiscal policy
The Keynesian view of fiscal policy come from the

believe of market failure. From the point of view of
Keynesian analysis, the aggregate demand function of
employment AD does not automatically adjust itself to
the aggregate supply function of employment AS.
Keynesian considers fiscal policy as a balancing factor,

which would bring about an adjustment between MPC
(propensity to consume) and the inducement to invest.
It will be showed mathematically after that.
Keynesian believes in Market failure, they think that

there are two reasons for market to be inefficient
(failure),
The first reason is Market Power:
All consumers and firms are price takers. But if some

individuals or firms are price makers, they have the
power to affect prices, and then the allocation of
resources is generally inefficient, why? A firm with
- 17 -
market power may be able to raise price above marginal
cost by supplying less output than a competitor would.
There are three types of market power:
1-Monopoly
Monopoly market characteristic
1- There is only one firm in the market.
2-The market price is higher than the marginal cost.
3-The supply is less than that in perfect

competition.
4- Fewer resources are allocated for the good.
Oligopoly market characteristic
1-There are few sellers
2-The firms may be able to raise price above

marginal cost.
- 18 -
Monopolistic competition characteristics
1-There are many firms in the industry.
2-Each firm has the some market power because

firms produce
3- Differentiated products.
The second reason is Nonexistence of Markets
If a market for a commodity does not exist, and then

we can hardly expect the market to allocate it
efficiently. In reality, markets for certain commodities
may fail to emerge, for example, market for insurance
against the possibility of becoming poor.
Why Governments intervention?
Governments exist for three reasons.
1- They Establish and maintain property rights.
2- Provide nonmarket mechanisms for allocating

scarce resources.
- 19 -
3-Implement arrangements that redistribute income
and wealth
Stages of preparing the state budget
The budget cycle means the process through which

the preparation, adoption and implementation of
the general budget until it ends in the stage of
reviewing the actual implementation of the public
budget as a last stage. Budgeting stages include
three basic phases:-
First: Preparing the general budget of the State
Here, the Ministry of Finance or the State Treasury

begins to estimate the requests of the various
parties, by sending a statement to each party.
Budget authorities then send their budget projects
to the responsible for preparing the budget.
The executive branch then, plays the main role in

shaping the final form, which the budget then
submits to the legislative authority to request
accreditation, as it executes the implementation and
- 20 -
is therefore better able to estimate future
expenditures and revenues.
Second: The stage of approving the budget
Then, the budget is presented to the parliament in

preparation for approval. Therefore, the budget
must be presented to the parliament in a
sufficiently time to be properly evaluated so that
the term is no less than three months before the
beginning of the fiscal year, but in certain countries
that take the budget discussions for about 6 months.
The adoption, rejection or amendments to the
budget are the jurisdiction of the legislative
authorities as provided for in the constitutional
articles of each state's constitution and the budget
law.
If the Parliament does not issue the General Budget

Law before the start of the fiscal year, the expenses
would be within the limits of the budget
- 21 -
appropriation of the previous fiscal year until the
adoption of the new budget
Third: stage of implementation of the state

budget
At this stage, beginning with the beginning of the

new fiscal year, each budget authority will start
implementing the various expenditure programs in
light of the allocations allocated to it in accordance
with the budget law. During the implementation of
the executive bodies, the supervisory bodies,
whether the parliament or the presidency or what is
usually known as the Central Audit Bureau or
follow-up and evaluation of the results of the
implementation of budgets of various parties and
the preparation of financial reports thereon at the
end of age.
- 22 -
Phase IV review of implementation
At this stage of the budget cycle or called the

stages of budget preparation. The mere adoption of
the budget from the Parliament passed a law by
linking it and is called the Budget Linkage Law.
However, there is the possibility of increasing the

linkage of some budget items if circumstances
require, and in the case of the increase of some
items shows the so-called link to the budget
adjusted.
Steps to adopt the general budget of the state
First: Adoption of the legislative authority
After the executive is in the preparation and

preparation stage, the legislative authority adopts
the budget as the competent authority to review the
government in all its work, In addition to being
representative of the people as the source of all
authorities in the democratic systems.
- 23 -
And the right of the legislature to adopt the budget
of the main rights acquired by the legislative
authority through historical development, and
therefore the adoption of the legislative authority
for the budget must precede implementation, in the
sense that the executive authority cannot begin to
implement the budget only after the adoption of the
legislative authority.
Second: Budget approval procedures
The executive authority prepares the draft budget

and then submits it to Parliament where the
Minister of Finance sends it to Parliament because
it represents the people who bear the financial
burden necessary to cover the public expenditure.
The adoption of the budget is subject to
constitutional procedures aimed at finalizing its
research in a timely manner, where the draft budget
must be submitted to the legislative authority
before the beginning of the fiscal year.
- 24 -
There are specialized committees to discuss the
draft budget, and most of the debate is the
expenditure side, especially the proposed changes
in the draft budget after amendments by the
relevant committees. The committees conclude
three possibilities either
- Adoption of the draft budget and then called the

budget law.
- The rejection of the draft budget and this

procedure in democratic societies lead to a political
change such as the resignation of the government
dissolved the parliament.
- Adoption of the draft budget after the

introduction of some amendments to it, this phase
ends with the issuance of the budget law or the
issuance of public funds as a legal document can be
implemented.
- 25 -
Third: Implement the budget
The executive branch, through the ministries,

public bodies and institutions, shall implement the
general budget of the state, which has been adopted
by the parliament, where at this stage the collection
of revenues and disbursement of expenditures
according to the allocation allocated to each side.
Expenditure is made through administrative units
as permitted by law. Implementation is carried out
through the following stages
1- The drainage phase
The Ministry of Finance is responsible for

disbursement operations to all the organs and
government departments affiliated to it through its
representative, and the process of exchange in four
consecutive stages can be summarized as follows:
- Linkage to alimony: This association is obtained

when the executive authority takes a decision that
- 26 -
results in debt owed by the state and must be
repaid.
- Determination of maintenance: a decision issued

by the executive authority to estimate the amount
owed to the creditor and deducted from the
budgeted appropriations.
- Authorization of the disbursement, which is

directed to the treasurer in the concerned
departments pay a sum of money to the creditor.
- Disbursement of alimony: the disbursement of

the amount of maintenance previously specified for
the person concerned, and the process of payment
in cash may be imminent.
2- Collecting public revenues phase
The competent governmental bodies collect the

budget in the general revenue items, in accordance
with the applicable laws and regulations, while not
allocating public revenues.
- 27 -
All revenues received by the Treasury shall be
deposited in the account of the State in a single
group, so that all public expenditures of the State
shall be financed without distinction between
income and others
Step 4: Control the implementation of the

general budget
The goal for revenue is to ensure that all types of

revenues provided for in the general budget are
collected and all obstacles to collection are
removed. The expenditure control is intended to
ensure that the expenditure is in the form approved
by Parliament. And the tax paid is part of the entry
of the people, as the budget aims to achieve
economic objectives, social and political, so it can
be said that monitoring the implementation of the
budget is the real guarantee to achieve these goals.
- 28 -
Control Forms
First: - In terms of quality control
Quality control is divided into
1 - Formal or accounting control includes control

of accounting books in addition to all documents
related to disbursement and collection, and this
control aims to ensure the validity of the
application of financial laws and regulations, such
as verification of matching the disbursement of
credits for each of the budget items.
2- Substantive control or evaluation control, and to

assess the activity of the government to identify the
extent to achieve the objectives of the budget and
then the extent to achieve the objectives of
economic policy in general and fiscal policy in
particular.
- 29 -
Second: - In terms of timing - Administrative
control is divided into
1. Pre-supervision of disbursement or
preventive control
The aim is to prevent the financial error, and to

deal with it before it occurs, and represents the
most important part of administrative control, and
its mission is not to spend any amount unless it is
in accordance with the rules of finance in force,
whether, the rules of the budget or rules prescribed
in the various administrative regulations. It is
carried out by the Ministry of Finance as
responsible for public funds and by financial
observers.
2- Subsequent supervision of exchange:
This supervision shall commence after the end of

the financial year and the closure of the accounts
and the preparation of the final accounts of the
- 30 -
State, This control is based on the discovery of
deviations, errors and problems and take corrective
action to address them and avoid future access and
not aggravated when discovered, then it is a means
of accounting and prevention, and this is known as
therapeutic control. This oversight is carried out by
a fully independent organ, ie not under executive
authority.
Thirdly: - In terms of supervision
They are divided into internal control and external

control
1. Internal control
It is carried out within the ministries and

government departments themselves, where some
government officials control other government
officials. Where it is entrusted to a specialized unit
linked to the higher administrative bodies and is
known as supervisory supervision. One of the most
- 31 -
important types of internal control is personal and
personal control because it stems from the
individual, his personality and his beliefs.
2. External control
It is carried out independently and is not subject to

executive authority and is divided into special
monitoring and legislative oversight.
- Special control
It is the most effective type of control and is
supervised by an independent technical authority.
Its task is to supervise the execution of the budget
and to ensure that the expenditure and revenue
operations have been approved by the legislative
authority. Through the audit of government
accounts and documents collection and
disbursement and the attempt to detect the
violations contained in the detailed report on it.
- 32 -
Legislative control
It is also called political control, which is a

parliamentary oversight of the executive branch of
the government. The request of the parliaments to
the government includes providing clarifications
and information that contribute to ensuring the
conduct of operations related to expenditures and
public revenues
Principles of preparing the general budget
The first principle: - Annual budget
Where the state budget is issued for a future

financial year and is dependent on its resources and
expenditures. Some countries are setting a medium-
term time frame for a period of three to five years
to implement their various programs.
It is known that the shorter the period of time, the

more accurate the estimates of the financial
amounts will be in the general budget. A one year
- 33 -
period is a relatively appropriate period for
determining different estimates of revenues and
general expenditures and is also appropriate for the
movement of economic transactions of different
sectors.
The second principle: - The integrity of the

budget
The intention here is to include the budget for all

public revenues and expenditures of the State
during the fiscal year in full transparency, Which
allows the various regulatory bodies to control the
various executive organs that are based on public
expenditure operations and their revenue
collection.
Principle 3: Non-allocation
In other words, no sample revenue is allocated to a

particular tunnel, since the budget contains all the
public resources to face a various public
expenditure. For example, according to this
- 34 -
principle, tourism revenues cannot be allocated to
finance the expenditure of the health sector, for
example.
Principle 4: Budget Unit
Budget unit means that, all revenues and

expenditures are included in a single document.
And it does not allow for the application of some
revenue or expenditure outside the budget.
Principle 5: Balance of the budget
The public expenditures should be within the limits

of their revenues, provided that the deficit in
revenues is financed by finding suitable economic
financing alternatives to cover this deficit. In the
sense that borrowing is within the limits of the
State's ability to pay, that is, borrowing is a
temporary means of financing the imbalance that is
supposed to be temporary.
- 35 -
Chapter two
Public goods
- 36 -
Chapter two
Public goods
Classification of goods
Private Goods
A private good is both rival and excludable. A private

car and a watch are examples of private goods.
Public goods
Public goods are commodities that are non-rival and

Non-excludable in consumption. Non-rival means that
the fact that one person consumes it does not prevent
anyone else from doing so as well.
Non-excludable good means that, it is either very

expensive or impossible to prevent anyone from
consuming it. The classic example of a public good is a
lighthouse.
- 37 -
Excludable
A good is excludable if only the people who pay for it

are able to enjoy its benefits. East Point Seafood‘s fish
and a Coldplay concert are examples.
A good is non-excludable if it is impossible (or
extremely costly) to prevent anyone from benefiting
from it. The services of the LAPD, fish in the Pacific
Ocean, and a concert on network television are
examples.
Rival
A good is a rival if one person‘s use of it decreases the
quantity available for someone else. A fish can be
consumed only once. A good is non-rival if one
person‘s use of it does not decrease the quantity
available for someone else. The services of a concert on
network television are non-rival.
Conclusion: a public good is both non-rival and non-

excludable. A public good can be consumed
- 38 -
simultaneously by everyone, and no one can be
excluded from its benefits. National defense is the best
example of a public good.
Common Resources
A common resource is rival and non-excludable. A unit
of a common resource can be used only once, but no
one can be prevented from using what is available.
Ocean fish are a common resource. They are rival
because a fish taken by one person isn‘t available for
anyone else. They are non-excludable because it is
difficult to prevent people from catching them.
Natural Monopoly Goods

A natural monopoly good is non-rival and excludable.
A special case of natural monopoly arises when the
good or service can be produced at zero marginal cost.
Such a good is non-rival.
- 39 -
If it is also excludable, it is produced by a natural
monopoly. The Internet and cable television are
examples
Merit goods
Musgrave developed the concept of merit goods to
describe commodities that ought to be provided even if
the members of society do not demand them. Gov-
ernment support of the fine arts is often justified on this
basis. Operas and concerts should be provided publicly
if individuals are unwilling to pay enough to meet their
costs.
Externalities
Externality An activity of one entity affects the welfare
of another entity in a way that is outside the market.
Externalities Characteristics
1. Externalities can be produced by firms as well as

producers.
2. Externalities are reciprocal in nature.
3. Externalities can be positive as well as negative
- 40 -
4. Public goods can be viewed as a special kind of
externality.
Private response to externalities
1. by Bargaining (negotiating)
2. by making Mergers (union)
3. by Social Conventions
Public response to externalities
1. by taxes
2. by subsidies
3. by creating a market
4. by regulation
Mixed Goods and Externalities
A mixed good is a private good the production or

consumption of which creates an externality.
An externality
An externality is a cost (external cost) or a benefit
(external benefit) that arises from the production or
consumption of a private good and that falls on
- 41 -
someone other than its producer or consumer. A
negative externality imposes a cost; a positive
externality provides a benefit.
Mixed Goods with External Benefits
Mixed goods with external benefits include for

example health care and education. Mixed Goods
with External Costs, include for example electricity
and road, rail, and air transportation produced by
burning hydrocarbon fuels (coal, oil, and natural
gas).
Inefficiencies that Require Public Choices
Public choices must be made to
1-Provide public goods and mixed goods
2-Conserve common resources
3-Regulate natural monopoly
- 42 -
The Free-Rider Problem
A free rider enjoys the benefits of a good or

service without paying for it. Because no one can
be excluded from the benefits of a public good,
everyone has an incentive to free ride.
Public goods create a free-rider problem—the
absence of an incentive for people to pay for what
they consume. The value of a private good is the
maximum amount that a person is willing to pay
for one more unit of it.
The value of a public good is the maximum amount
that all the people are willing to pay for one more
unit of it. To calculate the value placed on a public
good, we use the concepts of total benefit and
marginal benefit.
- 43 -
Chapter Three
Public expenditure
- 44 -
Chapter three
Public expenditure
Definition of public expenditure
Public expenditure is a sum of money spent by a

general legal person for the purpose of achieving
public benefit.
The previous definition includes three basic

elements of the definition
1- First public expenditure cash amount

2- The second is the issuance of public
maintenance by the state or a public person
3- The third is that public expenditure is intended
to achieve public benefit
The first element: - Public expenditure cash

amount
Where the State spends only cash in exchange for

the goods and services necessary to carry out its
- 45 -
activity, that is, all the State spent on obtaining
goods and services must be in cash form to be
included under the name of public expenditure.
Therefore, the non-monetary means adopted by the
State to obtain its requirements, both in terms of
forced labor and forfeiture and for payment in
exchange for a limited amount, as well as for
certain benefits in kind, are not included in public
expenditure.
The second element: - Issuance of maintenance

from the state
The requirement for the issuance of maintenance

by a public entity is a prerequisite for its adoption
as a public expense. Public expenditures include
those incurred by the public, state and public
institutions, as well as public enterprise
expenditures. However, if the expenditure is paid
by private individuals or institutions (for example,
charity), it is not considered a public expense
- 46 -
because it has not come out of the treasury of the
State.
The third element: - The applicant must be a

general legal person.
The legal nature of the spending order is an

essential element in determining whether this
expenditure is public or private, and that the
general public person is the same person who
regulates his relations with other natural and legal
persons. There are two criteria for identifying a
moral person:
Legal standard
According to this criterion, the nature of the

expenses is determined on the basis of the party
that is making the expenditures. Accordingly, the
expenditures are considered on the basis of the
party making the expenditure. Accordingly, the
expenses are considered to be general if issued by a
general legal person. The nature of the activity of
- 47 -
public law persons is different from the nature of
the activity of private law persons, in addition to
the fact that public law activity is aimed at
achieving the public interest and depends on jus
cogent, while the activity of private law persons
aims to achieve the private interest, relying on
contracting.
Career Standard
According to this criterion, the tunnel is considered

to be general if it is carried out by the State under
its sovereignty. Expenditures by private persons are
considered to be special expenses. The
expenditures of private persons authorized by the
State to use its jus cogent may be considered public
expenses provided that such public expenditures
Sovereign.
The third element: - Achieving the public good
The general purpose of the tunnel must be to satisfy

the public needs and thus to achieve the benefit or
- 48 -
the public interest. Therefore, such expenditure is
not considered as a public expenditure, which aims
at satisfying a special need, i.e. a special benefit
State expenditure sections
The expense sections can be displayed in three

sections
First: - Functional division
Here expenses can be divided according to their

purpose. Public expenditure is divided according to
the functions of the government, such as education,
health, security, defense, etc. And highlights the
importance of this division ... and helps when the
government allocates resources available to them to
carry out specific activities and achieve various
objectives. Such as defense and national security,
environmental protection, public order and public
security affairs, economic affairs, housing and
public utilities, health, religious affairs, education.
- 49 -
Second: Administrative division
This division is based on determining which

spending or receiving revenue is. Public
expenditure is therefore distributed to the
administrative bodies of the State.1
Third: Economic division
Division based on the economic nature of the

transaction. In other words, whether transactions
are paid or unpaid, and whether they are carried out
for current or capital purposes. This division is
usually used to identify the nature of government
processes and their economic effects.
1
The central government and its affiliated bodies, local governments, public sector units and other
state agencies.
- 50 -
Real expenses and transfer expenses
Real expenses
When the state uses part of the purchasing power to

buy goods and services for the establishment of
projects that meet public needs, real expenditures
lead to a direct increase in gross domestic product
such as the disbursement of public funds on wages
and salaries of workers, as well as the purchase of
goods and services necessary for the functioning of
administrations and state agencies.
Transfer expenses
Transfer expenses occur when cash is transferred

from one category to another in the community.
These expenditures have no direct cost and do not
lead to an increase in domestic production. But lead
to its redistribution. Which means that this type of
expenditure is working to change the way the
distribution of national income.
- 51 -
Transformational divisions
The expenditure is divided into: - economic

expenditures such as subsidies in order to reduce
the prices of necessary and necessary goods. Social
transfer costs: such as social insurance and
unemployment insurance. Financial transfer
expenses The best example of this is the interest
payments on public debt.
Criteria for calculating the type of maintenance

(ordinary or extraordinary)
- Regularity and periodicity
When the expenditure is cyclical and regular, it is

considered as ordinary, such as wages, and if not, it
is unusual, such as financing disasters such as
floods, wars, earthquakes, etc.
- Length of spending
The criteria here is that the maintenance of the

maintenance for the period of the year is unusual,
- 52 -
and if the maintenance during the year is
considered a regular expense.
- Productivity standard
The expenditure is normal, as long as it is

consumption and non-productive, and does not lead
to an increase in GDP. If it is a product that leads to
increased local production, it is an extraordinary
expense such as expenses for establishing schools,
hospitals, bridges and other investment projects.
- The criterion of contribution to the formation

of capital in kind
The maintenance shall be ordinary in accordance

with this standard if it does not contribute to the
formation of capital, such as that which
necessitates the running of public utilities and is
called ongoing or also known as administrative
expenses. However, if they contribute to the
formation of capital in kind, such as capital and
investment, it is an extraordinary expense.
- 53 -
Functional division of public expenditure
On this basis, public expenditure is divided

according to the functions performed by the State.
The basic functions of the State are: administrative
function, social function and economic function,
and thus there are three types of expenditure falling
under functional division
- State administrative expenses
These expenses include the salaries of employees,

workers' wages and pensions, as well as
expenditures for public administration, defense,
security, justice and diplomatic representation.
- Social expenditure of the state
These are expenditures for the social purposes of

the State, ie expenditures for the achievement of
the social goals of individuals. The most important
items of these expenditures are expenditures for
education, health and social and cultural insurance.
- 54 -
- Economic expenditure of the State
These are expenditures related to the establishment

of certain activities by the State with a view to
achieving economic objectives such as public
investments aimed at providing basic services such
as transport, communications, irrigation, electricity
and other economic activities. In order to facilitate
the division, public expenditure can be traced back
to two main types: public expenditure on services
and overhead expenditures.
The size of government intervention
There are two measures:
1- It could be measured by calculating the

numbers of the workers in the public sector,
but it is a misleading measurement; why?
Because of in the case of a small public sector
operate by a high technology and guides
economic decisions with few workers, this way
- 55 -
of measurement underestimate the importance
of the government. That is we may have a
large employers ineffective public sector, at the
time we may have a few employers and high
tech effective public sector.
2- Also it could be Measured by the level of

public expenditure, it could consider better
than the number of workers measurement, but
it may be inaccurate (inexact) because of:
- If the Inflation is continues decrease in the

purchasing power of money over time.
- If the population growth, thus a decrease in the
per capita government expenditure.
- It is very important to estimate the government
expenditure to the GDP.
- 56 -
Note that, to overcome the inflation problem
the real government expenditure could be
calculated by the following equations:
total government exp enditure

Real government expenditure = consumer price index
The consumer price index (CPI) in any year
The price of a chosen bundle in that year

  100
The price of a chosen bundle in base year
Government Expenditure
Government expenditure such as (defense, health

insurance, Social security, public welfare activities,
Payments of interest and others, while government
revenue such as Individual income taxes, Social
security's, corporate income taxes, Sales taxes,
Property taxes.
- 57 -
Government expenditure contains three elements
- Wages & Salaries

- Purchase of goods and services by central and
local government &Transfer payment to people,
businesses and other governments.
- The interest payment to the public debt.
The relative importance of government expenditure

and revenue could be calculated as follow:
- The relative importance of government

exp enditure on the item
expenditure = total exp enditure
- The relative importance of government revenue

revenue from the item
= total revenue
- 58 -
Government expenditure (spending)
Government spending (G) is a component of

aggregate expenditure (AE) and aggregate demand
AD (While AE = AD). And if it supposed that
there are no exports nor imports (closed economy).
Also the changes in planned aggregate expenditure
do not affect the interest rate.
Now let us consider that the government expenses

are independent of the level of income then the
change in income will not affect the of government
spending. (This is an assumption to simplify the
explanation)
The aggregate expenditure equation
AE = C + I + G
Where
AE aggregate expenditure
C consumption
I investment
- 59 -
G government expenditure
Y income (output)
The effects of government expenditure on

income
The equilibrium equation in closed economy could

be writing as following
Y=C+I+G
If the aggregate expenditures AE is more than

aggregate output AO Then There will be either a
line of unsatisfied customers or an unplanned
reduction of the inventories of goods, previously
produced either situation will signal firms to
increase production and increased production will
lead to increase in income.
But On the other side, if we want to make

aggregate expenditure AE is less than aggregate
output AO then the inventories of firms will
accumulate over their planned levels. And it leads
- 60 -
to a reduction in total production and in turn
reduction in income.
The equilibrium level of income will be that level

at which desired
AE (C+I+G) = AO
At this level of income will be no changes in

production level because the spending plan of
household firms and government will be equal to
the firm's production plans.
AE = AO
No change in production level then No change in

income
AE > AO
Unplanned reduction of the inventories  increase

production
 Increase income
AE < AO
- 61 -
Accumulated inventories  Reduction in total
production  Reduction in income.
Example 1
Suppose that, the net income, consumption,

investment, and government expenditure as
following:
Y= C + I + G = AE
Net Desired Desired Governme Desire

domest consumpti Investme nt d
ic on nt Spending AE
Income
48 53 8 18 79
58 58 8 18 84
68 63 8 18 89
78 70 8 18 96
88 73 8 18 99
98 78 8 18 104
108 83 8 18 109
118 92 8 18 118
128 93 8 18 119
138 98 8 18 124
From the table
1- Without government spending the equilibrium

will be at the
- 62 -
Level of 78 m where:
AO = 78 AE = C + I = 78
But with government spending G = 18 m the

desired
AE = C + I + G = 118
. In this case AE > AO then they will increase

production to reach
Level 118 m where
AE =AO
Types of fiscal policy
Contractionary fiscal policy

Reduction of government spending has negative
effects on aggregate expenditure, and in turn on has
negative effects on aggregate demand and finally
negative effects on income. When the government
spends less on goods and services the population
which provides those goods and services receives
less money.
- 63 -
In terms of the economy as a whole this is again
represented by Y= C(Y-T) +I+G+NX, where a
decrease in G leads to a decrease in Y. when the
government uses fiscal policy to decrease the
amount of money available to the populace.
Examples of this include increasing taxes and
lowering government spending, this policy of fiscal
policy called contractionary fiscal policy. This
policy uses when the government try to treat
inflation problem.
Expansionary fiscal policy
While increasing of government spending has

positive effects on aggregate expenditure, and in
turn on has positive effects on aggregate demand
and finally positive effects on income. When the
government spends more on goods and services the
population which provides those goods and
services receives more money.
- 64 -
In terms of the economy as a whole this is again
represented by Y= C(Y-T) +I+G+NX, where an
increase in G leads to an increase in Y. when the
government uses fiscal policy to increase the
amount of money available to the populace.
Examples of this include decreasing taxes and

increasing government spending, this policy of
fiscal policy called expansionary fiscal policy. This
policy uses when the government try to treat
unemployment problem or budget deficit problem.
Fiscal policy multipliers
Types of multipliers: There are two Types of

multipliers
1- Government spending multipliers

2- Tax multipliers
- 65 -
Government spending multipliers
Government spending multiplier is derived in a

different way. When the government increases
purchases it directly increases output or national
income. But there is a greater effect than just the
actual amount of increase in government
purchases. When the government spends more the
populace receives more that is because the
population is the target of increased government
spending personal incomes and thus consumption
increases.
Recalling that; the size of this increase is based on

the MPC the total change in output as a result of a
change in government purchases this number is
called the government spending multiplier.
Government spending multiplier = (Change in

government purchases) / (1-MPC).
- 66 -
Marginal propensity to consume: (MPC)
Marginal propensity to consume is an amount of an

additional pound of income that a consumer will
spend on goods and services the MPC can have a
value between 0 and 1.
A small MPC represents large amount of savings

and a small amount of consumption. A large MPC
represents a large amount of savings and a small
amount of savings and a large amount of
consumption.
When a tax decrease occurs consumers will spar of

the money and save part of it, therefore the actual
change in national income as a result of a change in
tax policy is equal to [(+ or -) change in taxes (-
MPC) / (1-mpc) the resulting number is called the
tax multiplier.
- 67 -
We showed the effect of government spending on
NDI and tax on NDI separately and we reach
conclusion that:
Government spending with increases the NDI by

two ways, Directs way and indirect way. Tax will
reduce the NDI by reducing the disposable income
available to consume .Now we will show
How will the equilibrium level of net domestic

income be affected by government spending and
tax? (The effect of government spending and tax on
NDI together)
Disposable Income = NDI – T
S = Disposable income - C
NDI = C + I + G
- 68 -
Example 2
NDI Tax Disposable C S I G AE
Income
50 10 40 45 -5 10 20 75
60 10 50 50 0 10 20 80
70 10 60 55 5 10 20 85
80 10 70 60 10 10 20 90
90 10 80 65 15 10 20 95
100 10 90 70 20 10 20 100
110 10 100 75 25 10 20 105
120 10 110 80 30 10 20 110
130 10 120 85 35 10 20 115
130 10 120 90 30 10 20 120
- 69 -
The effect of government spending multiplier
Y = C+I+G
C = a + by
Y = by + I + G + a
Y – by = G + I + a
Y (1-b) = G + I + a
Y = G + I + a + (1/1-b)
In case we increase the G or I or a by one pound

the NDI will Increase by (1/1-b)
Tax multipliers
Tax multipliers are based on the populations'

willingness to consume the marginal propensity to
consume or MPC is a measure of that willingness.
- 70 -
The effect of Tax multiplier
Y = (C – t) + I + G
Y = a + b (y – t) + I + G
Y = a + by – b t + I + G
Y –by = a – b t + I + G
Y (1 – b) = a – b t +I + G
Y = a – b t (1/1-b) + I + G
Y = a (-b / 1-b) + I + G
So, in case we increase the tax by one pound the
NDI will decrease by (- b / 1- b).
- 71 -
Example 3
If a country has consumption function
= 100 + 0.8 YD and have fixed investment 20
million fixed government spending 40 million and
lump – sum tax 10 million calculate the NDI and
saving?
Solution
Y=C+I+G
Y = 100 +. 8 Yd. + 20 + 40
Y = 160 + .8 (Y – 10)
Y = 160 + .8Y – 8
Y- 0.8Y = 152
0.2Y = 152
Y = 152 / 0.2 = 760
- 72 -
Injections – withdrawals Approach:
I+G=S+T
20 + 40 = S + 10
S = 60 – 10 = 50
Or
S = Yd – C
S = Yd – (100 + 0.8Yd)
S = Yd –100 – 0.8 Yd
S = -100 + .2Yd
S = -100 + .2 (750)
S = -100 + 150 = 50
- 73 -
Example 4 (expansionary public policy)
Suppose that the government want to increase the

net domestic income NDI by 100 Million which
methods will be more effective?
Then, we could calculate the Government spending

Multiplier and the tax multiplier
Where marginal propensity to consume MPC
Multiplier of government MG
Multiplier of Tax MT
MG = 1 / 1 – MPC
MG = 1 / 1 - .8 = 1 / .2 = 5
MT = (-b / 1-b)
MT = -.8 / 1-8 = -4
If we want to make Y = 100
MG = Y / G
- 74 -
5 = 100 / G
G = 100 / 5 = 20
So government could spend 20 Million more to

Increase the NDI (Y) by 100 Million.
Or
Mt = Y / T
- 4 = 100 / T
T = 100 / -4 = -25
Then government can decrease tax by 25 Million to
Increase the NDI by 100 Million.
- 75 -
Example 5 (The equilibrium level of income)
If you have the following data:
Planned investment I = 100 billion pounds
Government expenditure G = 180 billions
The tax function is T = 10 + 0.25Y
The consumption function C = 100 + 0.8Yd
What is the equilibrium level of income tax?
I  investment
G  government spending
T  tax
C  consumption
Y  Income
MPC  Marginal rate of consumption
MPS  Marginal rate of saving
- 76 -
The equilibrium occurs when
Y=C+G+I
By substituting the values of C, G and I in the
Equilibrium condition we will find that:
Y = 100 + 0.8 Yd + 180 + 100
But Yd = Y- (10 + 0.25 Y)
So; Y = 380 + 0.8 (Y – 10 -0.25Y)
Y = 380 + 0.8 (0.75 Y – 10)
Y = 380 + 0.6Y – 8
Y – 0.6Y = 372
0.4Y = 372
Y = 372 / 0.4 = 930 billion pounds
This is the equilibrium level of income to
- 77 -
- Calculate the equilibrium level of taxes
T = 10 + 0.25Y
= 10 + 0.25 * 930
= 10 + 232.5 = 242.5 millions
By the same method:
Yd = Y – T = 930 -242.5 = 687.5 billions
Equilibrium level of consumption will be:
C = 100 + 0.8 Yd
= 100 + 0.8 * 687.5
= 100 + 550 = 650 millions
Note that
MPC + MPS = 1
S = Yd - C
S = -100 + 0.2 Yd
So that equilibrium value of savings will be

- 78 -
S = -100 + 0.2 * 687.5
S = 37.5 billions
-We can prove the equilibrium using the in
- injections with drawls approach as follows :
S + T = I+ G
S + T = 37.5 + 242.5 = 280 billions
I + G = 180 + 100 = 280 billions
- The budget position may be concluded by
- subtracting government spending from
- taxations as follows :
T - G = 242.5 – 180 = 62.5 billions
So there is a surplus in the government budget
= 62.5 billion pounds.
- 79 -
Example 6
Use different ways to achieve the goal of the
Government if it wants to increase the equilibrium
by 20 billion?
Solution
Government may use one of the following
1- government may change its expenditure
2- government may change its lump sum tax
Government may change its expenditure
KG = 1/ 1-mpc (1-t)
= 1/1-0.8 (1-0.25)
1/0.4 = 2.5
KG = Y / G
G = Y / KG = 20 /2.5 = 8 billion
- 80 -
The new equilibrium level will be
G1 = G + 8 = 180 +8 = 188
Y=C+G+T
Y = 100 + 0.8Yd + 188 +100
Y = 100 + 0.8 (Y – T) + 288
Y = 388 + 0.8 (Y – (10 + 0.25 Y))
Y = 388 + 0.8 (Y – 10 - 0.25Y)
Y = 388 + 0.8 Y -8 -0.2Y
Y = 380+0.6Y
Y – 0.6 Y = 380
0.4 Y = 380
Y = 380 / 0.4 = 950 billion
- 81 -
T = 10 + 0.25 Y = 10 + 0.25 (950)
= 247.5
Yd = Y – T = 950 – 247.5 = 702.3 billion
C = 100 + 0.8 Yd
C = 100 + 0.8 * 702.3 = 661.8 billion
S = -100 + 0.2 Yd
S = -100 + 0.2 * 702.3
S = -100 + 140.5 = 40.5 billion
I + G = 100 + 188 = 288
T + S = 247 .5 + 40.5 = 288
Budget position
T - G = 247.5 – 188 = 59.5 billions
T – G = 247.5 – 180 = 67.5 billion
So the surplus in budget reduces by
67.5 – 59.5 = 8 billion

- 82 -
A budget surplus
Exist when the government spends less than it
collects in taxes. The size of the surplus is the
difference between taxes and government
spending.
Budget Surplus = T–G
A budget deficit
Exist when the government spends more than it

collects in taxes the size of the deficit is the
difference between government spending (G) and
taxes (T)
Budget Deficit = G – T
Balanced Budget
Exist when the government currently spends

exactly as much as it collects in taxes there is no
surplus and there is no deficit.
- 83 -
G&T
X Surplus
X G
Deficit
X
From the Fig.
- Budget Balanced at a level of income of Y,

G=T
- Budget deficit at any income level below Y,
G>T
- Budget surplus at any income level above Y,
G<T
- Classical economists firmly believed that
sound government finance consisted of
balancing the budget.
- Keynesian economics, functional finance
(that is, intentional budget deficits and
- 84 -
surpluses) can be used as an effective weapon
against recessionary and inflationary
situations.
- 85 -
Chapter Four
Egyptian Public
Debts
- 86 -
Chapter Four
Egyptian Public debts
Introduction
Public debt problem has become one of the major

problems that plague much of the world,
particularly developing countries. Also it was
transformed from a problem for the poor countries
to the problem for rich countries.
Public debt has increased for many of the

developed countries to levels that exceeded the
safety limit as a result of increase accelerated in
public spending and that was invited to the
importance of controlling the budget deficit,
Putting public spending under control, when unable
local resources of the state to cover public spending
needs to fill the local gap (the budget deficit).
- 87 -
Or to fill the gap international (balance of
payments deficit), and then forced the state to the
loan contract (whether internal or external).
In any case, the public debt should not exceed

growth rate of gross domestic product growth rate
of the state. As has been the financial crisis
triggered in Greece in 2009. a lot of the concerns
there are many countries - especially countries
where public debt is increasing -hat skip economic
growth rate of domestic debt growth rate Greek
economy. (Public debt has increased until it
reached about 105% of GDP).
The Egyptian public debt has recently increased

significantly; the ratio of public debt in Egypt
amounted to about 90.3% of GDP in 2009, which is
close to the percentage of the percentage reached
by public debt in Greece.
- 88 -
As noted by the researcher to increase the Egyptian
public debt in the years 2013-2014 where skip
external debt of $ 45 billion as local to the debt
reached more than one billion and 400 million
pounds.
The neoclassical school concluded that to financing

the state budget deficit through public debt has an
impact on consumption, investment and interest
rate and net exports also noted (Diamond 1965)
that the economic effects of public debt in the
analysis neoclassical are loans earmarked to cover
a permanent deficit in the budget.
But it would be the impact economic in the short

term those loans on a very small savings if the debt
to cover a temporary shortfall for short periods.
While Ricardian School said that the impact of any
government spending is independent fully about
the way funding independent.
- 89 -
Barro has confirmed (Barro 1974) Health
Ricardo's theory if we assume the existence of
altruistic motivation among the different
generations.
At Crystal and Thorton study (Chrystal and

Thorton 1988) proved that the budget deficit
financed public debt will not affect the equilibrium
income and the volume of employment in the long
term.
Ferdman (Fredman1988) point to the magnitude of

the public debt of the United States of America
appeared impact of the decline in living individual
level and at lower America's role in international
affairs.
As Tobin (Tobin 1986) point to that if the taxes are

not enough to finance the benefits of public loans
outstanding, the state will have to issue bonds to
cover the deficit.
- 90 -
And this will lead to economic problems resulting
in a decrease in output, consumption.
Keynesians believe that the positive effects of the

expected deficit financed public debt can occur if
the deficit was nominally (Nominal), but if it was a
real deficit, the effects are harmful to the economy.
As (Yellen 1989), Point to an increase in effective

demand due to increased state spending financed
through public debt will lead to increased
profitability anticipated for the investor, and this
leads to increased investment at any level of
interest rates.
The deficit financed public debt may have led to

increased savings and investment and higher
interest rates. In the study (Watchmaker 1996)
concluded that there was a negative relationship
between government loans and GNP.
- 91 -
Analysis of the Egyptian public debt situation
The concept of public debt
The public debt is total loans obtained by the state

from internal and external loans and benefits until a
certain date. The domestic debt in its broadest
sense in loans obtained by the government's
economic and public bodies, and the National
Investment Bank, excluding debt nib we get the
internal debt, the narrow sense.
The external debts include loans obtained by the

state from the States and international bodies. This
includes bilateral soft loans and non-concessional,
loans from international institutions, regional, and
net non-resident deposits in the banking system.
- 92 -
First, the domestic public debt
Domestic debt rose from 114 billion pounds in

1993 to 172 billion pounds in 1997, then came to
330 billion pounds in 2002 and 537 in 2008 and
finally reached 1650 billion in 2013, and as a
percentage of GDP stood at domestic debt ratio to
GDP in 1994 about 55%, while in 2005 amounted
to 65%.
Also arrived in 2009 about 761 billion pounds, a

growth rate far exceeds the GDP growth rate in
Egypt, which was in the same year only about 7.4%
(2009). While such total domestic public debt of
61.8% in 2009, it has this ratio to 63.8% in 2010 it
rose, and then continued to rise to 68% in 2011.
While the safety limit where should this ratio not

only exceed 60% of GDP, but that this percentage
has continued to rise in 2012 and 2013, reaching
71.7% and 80.5%, respectively.
- 93 -
Domestic public debt structure in Egypt
Government debt: represented by the Public

Treasury, Ministry of Finance is responsible for the
required debt to finance the state budget deficit
(entities within the scope of the state budget are the
state administration (central government) and
includes ministries and departments thereto and the
sector of presidential services - public bodies
service.
Government debts has reached total government

public debt in 2009 almost 700 billion pounds,
while this amount exceeded by about 33 billion in
2010 and amounted to about 889 billion in 2011
has exceeded the government's debt trillion pounds
in 2012 and reached the trillion and 410 billion in
2013.
- 94 -
General economic institutions: the institutions
that provide public service in economic activities,
in the sense that financed expenditures from
revenues earned from the sale of these services, has
almost reached the religion of economic public
bodies.
In 2009 more than about 91 billion pounds, and

then increased to about 100 billion in 2010 and
then continued rise to more than 109 billion in
2011 and then dropped in 2012 to 105 billion, but
came back in 2013 to rise to more than 110 billion
pounds
Investment National Bank: Investment National

Bank was created under Act 119 of 1980 to
necessary national investments carried out by the
government or the private sector or the public
sector, to deposit the national savings from
insurance, pension funds, proceeds of investment
certificates and provide along Fund.
- 95 -
It can be mobilized from domestic, foreign
savings, and the national investment Bank to lend
economic bodies of more than 50 billion pounds in
2009 contributed, and in 2010 lent about 51 billion
and 469 million pounds, while the lending ratio
increased in 2011 and 2012, reaching 52 billion and
670 then 52 million and 655 million, respectively,
and in 2013 gave loans to 51 billion and 382
million pounds.
Burden of servicing the public debt
It includes the burden which should pay by debtors

calculated and paid periodically to creditors
represented by:
1-Debt repayment premiums, which amounts to

be paid periodically out of debt to creditors by the
due date according to the terms of borrowing and
appear in the budget of capital transfers.
- 96 -
2-burden: a percentage of the value of religion
paid by the debtors to the point of creditors, and
these benefits appear in the current state budget
annually and represent a current expenditure items.
In 1993 the benefits of domestic debt has

amounted to about 9.32 billion pounds, while in
1997 increased to about 13 billion almost increased
to more than 14 billion in 2002 and then jumped to
more than 46 billion pounds in 2008, and recorded
more than 143 billion pounds in 2013.
The evolution of the domestic public debt has

become a real problem, because the public debt
problem in Egypt has taken a general trend upward
increments unity in general after 2000 and a growth
rate far exceeds the GDP growth rate in Egypt.
As well as the possibility of a financial crisis

similar to the financial crisis Greek, which took
place in Greece in 2009, and made Greece
- 97 -
threatened by publicizing its bankruptcy, was the
primary cause of borrowing, both from the local
market or the world beyond the capabilities of the
Greek economy, which led to rising public debt
until it reached about 105% of gross domestic
product.
Note that the ratio of debt year in Egypt amounted

to about (90.3%) of GDP, which is close to the
percentage of the percentage reached by public
debt in Greece), which does not help to achieve the
economic goals of the Egyptian public budget.
Second: Egyptian external debt
At the beginning of the nineties of the twentieth

century arrived about $ 55 billion.
a large part of these debts was adjusted by the Paris

Club rescheduling and reducing 50% of the net
worth of the settlement, it has been dropped 50% of
the external debt of Egypt (under the Paris Club) by
three phases.
- 98 -
The first cut in 15% of the value in 1/71991, and
the second in whom the total reduction came to
35% of the value in 1/11993, and the third in which
the total reduction reached 50% of the value in the
01/06/1994.
In 1993 the total Egyptian external debt stood at

about $ 30.9 billion, then dropped in 1997 to $ 28.8
billion and then to 28.7 in 2002, and although it is
at a time when total external debt declined from
31.1 billion in 1994 to $ 29 billion in 2006.
For example, the total external debt has increased

from $ 1.9 million in 1994 to $ 3.5 million in 2006,
due to the debt that has been dropped under the
Paris Club burdens persisted and payable, but rose
to 33.89 billion dollars in 2008 and in 2013 rose up
to $ 45 billion.
- 99 -
Overall, the Egyptian public debt described as the
second worst debt on the world level after Cyprus
and worse than Greece.
The Gulf aid after the revolution of 30 June 2013

saved Egypt from great difficulties, and this debt
represents a burden on the state budget in favor of
banks, the banks have achieved huge gains despite
the difficult economic situation in Egypt in while
giving up lending to small and medium enterprises
for fear of stumbling, and banks' share of the
domestic debt 82 amounted to 0.6% worth trillion
and 533.6 billion pounds, the end of June 2013.
- 100 -
The effect of increasing the debt targets and
economic budget
A review of some of the indicators over the past

two decades, from the Egyptian public debt and
budget deficit, inflation and the rate of economic
growth may reach a conclusion shows to what
extent can affect increased debt to achieve the most
important state budget targets.
For example, the unemployment rates in the years

selected comparison ranged between 11.1% and
then to 8.9 to 10.2% and then to 9% and finally to
13.3% in the year 1993.1997, 2002.2008 0.2013
respectively. The inflation rates ranged from 11%
in 1993 to 18.3% in 2008 and then to 11% in 2013,
as economic growth rates were 2.5% in 1993 and
then rose markedly in 1997 to 5.3%.
And then dropped to 3.2 in 2002 and then rise

significantly in 2008 to 7.3% and then followed by
a sequential decline in economic growth rates.
- 101 -
Especially after 2010, when the economic growth
rate scored only 2%, which is roughly the
population growth rate, which means that there is
no real growth mentioned in the Egyptian
economy.
Application on the economic objectives of the

budget 2013- 2014
The top of the page of the ministry of finance on

the Internet site, ministry goals represented by the
balance between financial stability, economic
growth and social justice, as well as drawing up
financial policy in order to ensure the achievement
of the objectives of the economic development plan
and social, as it is competent to develop plans and
related financial aspects that ensure the
achievement of the programs national goals.
- 102 -
The top priorities of the economic goals of the
Egyptian public budget are reducing the
unemployment rate, the achievement of social
justice, to reduce the budget deficit to relieve
inflationary pressures and the burden of debt
service.
General Budget 2013-2014 goals
And include the 2013 plan \ 2014 goals tremendous

requires achieved considerable effort has been a
barrier to implementation or without the
implementation of a large part of which the debt,
which includes the plan, participatory planning
rather than indicative planning, accelerate growth
in GDP to reach 3.8% out of recession, which
dominates Egypt, targeted investment plan in 2013
\ 2014 about 291 billion pounds.
An increase of 12% for investments in 2012 \ 2013,

and it is still a modest investment rate (14%),
- 103 -
which prevents the achievement of the highest rates
of economic growth.
so the plan focuses on raise the efficiencies of

existing investments to re-run facilities completely
stalled and partly for work and increased
exploitation of the current production capacity rate
in addition to the development of small enterprises
and micro small, confirmation of institutional
reform, based on the corporate governance and
good fight administrative corruption as input key to
starting economic growth and establish the rules of
social justice.
- 104 -
Targeted economic development plan for 2013 \ 2014
statement Actual Expected Targeted
2011-2012 2012-2013 2013-2014
The growth rate of the real economy% 2.6 3.8
2.2
%Real per capita income growth rate 0.2 0.6 2.1
Total investment 258 265 291
LE billion
Thousands of new jobs 500 700 800
Unemployment rate% 12.6 13 12.4
%Poverty rate 25.2 - 24
General budget deficit \ GDP 10.8 10.7 9.6
The current account deficit \ GDP 10.4 7.3 5.2
Overall deficit 11.3 6.5 0.6
Billion dollar
International foreign exchange reserves !5.5 19 22.5
US $ Billions
Source Arab Republic of Egypt and the Ministry of Planning, documents the economic and
social development plans 30 \ 6 \ 2013, economic and social development plan for 2013 \
2014, www.mop.gov.eg
- 105 -
First, the impact on the state budget deficit
The Egyptian government has adopted in the last

two decades local debt to repay the state budget
deficit. About 4.3 billion Egyptian pounds in 1996
to repay part of the budget deficit, while used 34.6
billion 2006, which led to increased domestic debt
increased significantly domestic debt has increased
from 96 billion pounds in 1994 to 349 billion
pounds in 2005. And then to 129 billion pounds in
June 2012 in addition to the $ 35 billion foreign
debt for the same year.
In 2013 the internal debt reached1650 billion

pounds and an external debt reached $ 45 billion,
and the evolution of the domestic public debt.
This situation has become a real problem and

ordered the calls of specialists stand it and warn of
danger.
- 106 -
The budget data indicated that during the fiscal
year 2013/2014 to the burden of domestic debt
amounted to 174.6 billion pounds, 32% growth rate
compared to 132.5 billion pounds budget prior to
the year 2012/2013, amounting foreign debt
interest rate of 4% benefits of the total public debt
of up to 7.5 billion pounds, a growth rate of 22%
compared to about 6 billion pounds the previous
budget for the year 2012/2013.
The burden of treasury bonds was the largest share

of the total benefits of the public debt by 37%, it
amounted to 67.7 billion pounds, compared to 52.6
billion pounds, a growth rate of 29%, followed by
the burden of Egyptian treasury bonds by 44.3
billion pounds compared to 33.2 billion pounds, a
growth rate of 33%, followed by the benefits of
central bank bonds by 16 percent to 29.9 billion
pounds, compared to about 14 billion pounds at a
rate of 113%.
- 107 -
There is no doubt that the interest rate rise on the
religion of the state bonds can lead to the so-called
impact '' snowball Snow ball effect '', as the high
rate of interest on state bonds leads to a high cost of
debt service, which requires a growth in public
revenues state at least similar proportions.
otherwise the government would have to borrow

for debt service, and pay Egypt's interest rate up to
about 16% on its bonds in Egyptian pounds, which
is high, where significantly exceeds the growth rate
in the gross as well as in the general revenues of
the state, and such the high rate of interest confirms
the necessity of a financial reform to control the
budget deficit, if Egypt were previously adapted
proposals and International Monetary Fund policies
and World Bank, particularly with regard to the
balance of the general budget and to accelerate
trade liberalization and privatization of the public
sector.
- 108 -
But it was done without to create the climate for
the presence of a strong private sector, and without
that the fund contributes and the World Bank have
in encouraging more foreign investment.
Conclusion, If acquires the debt burden of

premiums and benefits of nearly one-third of the
state budget and therefore the debt adverse impact
on the balance of the state budget.
Standard model (path analysis) showed that 59% of

the budget deficit rate caused by the increase in
domestic public debt.
(Results summarized the standard model in the

graph shown in the next page).
- 109 -
Second, the impact on inflation
The rate of inflation expresses for monetary policy

performance and can be considered the most
important economic stability indicators, the
continuous rise in inflation leads to the corruption
of the investment climate through a loss of
confidence in the national currency.
The low inflation rates - less than 10% per annual -

incentive to invest only there is inversely correlated
between high inflation rates and direct investment,
especially foreign because the high rate of inflation
is considered a sign of weakness for the economy
in the host country and represents a risk for the
investor in the form of predicted undesirable
policies.
- 110 -
The persistence of inflation leads to a rise in the
deficit in the balance of payments because it is
hampering exports and encourages imports; it also
helps the phenomenon of capital to escape outside.
It is also at times when inflation was high
dollarization rate was too high, for example, in
1990 the dollarization rate reached 46.1% of total
deposits, where the inflation rate was 22.2%.
When the inflation rate dropped in 1994 to 7%

dollarization rate fell to 27.5%. And also
dollarization rate in 1999 reached 20.8%, where
inflation was 3.7%, while the inflation rate and the
rate rose to 13.1% in 2005 dollarization rate rose to
29.8%. Then arrived to approximately 19% in
2008.kma that the removal of subsidies on some
commodities to reduce the public budget.
- 111 -
Previously mentioned deficit may cause to raise
prices again, and that the increase in public debt
and the consequent burden of payment of the
Ministry of Finance and the Central Bank to
version the new cash or the issuance of government
bonds, which involves the successive increases in
the prices.
Because of government depends on counting the

finance of central bank to the budget through new
cash release. (Which is what always happens), so
counterproductive to the rate of inflation which
pushes prices to the continued increase, was offset
by cash source in June 2013 from 6.5% gold and
64.4% government bonds and foreign exchange
and foreign instruments 29.1 %, at the end of 2013
it became 6.5% gold, 58.5% government bonds,
35% foreign exchange and foreign instruments.
- 112 -
The total cash issues by the central Bank in the years
from 2010 to 2013
Million pounds
At the end June 2010 June 2011 June 2012 June 2013
Total cash 145.914 179.794 207.473 264.128

issues
Central bank of Egypt
Monetary Source 2012- 2013 has increased during

the fiscal year by 56 billion pounds to 264.1 billion
pounds at the end of June 2013 and attributed the
cause of this increase in the cash release
government spending during the fiscal year 2012-
2013 increased by 117.2 billion pounds to 588 0.2
billion pounds, which caused the state budget
deficit of 239.7 billion pounds, up 13.7% of the
GDP.
- 113 -
The standard model (path analysis) point that 42%
of the inflation rate due to the increase in domestic
public debt. And therefore, the result is (the greater
the public debt and increased burdens whenever the
inflation rate) has increased.
While it if directed contracted loans into practical

productivity, it will result in a net increase in
savings and speed of capital accumulation if the
warheads money unused in the process production,
occurs the opposite (do not lead to increase the
contractual loan by a net increase in savings and
investment) in the case of whether the warheads
untapped money from the foundation in the
production process.
- 114 -
Third, the impact on employment, or (the
unemployment rate)
Increase domestic public debt and external and the

consequent burdens acquires more than 200 billion
pounds from the state budget there is no doubt that
this negatively on employment affects instead of
these amounts went to invest and open new
projects to accommodate labor and work to reduce
the unemployment rate.
Trend towards repayment of the debt burden, and

unemployment of more serious underlying
problems facing most countries in the world, has
reached attributed by the Egyptian Central Agency
for public mobilization and Statistics data in 2000
about 9% of the labor force. Negative relationship
between the domestic public debt, the standard
model and the unemployment rate among
explained that 94% of the unemployment rate due
to increased public debt.
- 115 -
Human Development Report for Egypt in 2005
pointed that unemployment is one of the most
serious problems facing the Egyptian economy, and
has reached the unemployment rate 11 0.2% of the
total labor force in 2006, so unemployment remains
more social challenges facing the Egyptian
economy.
But international institutions estimates raise this

ratio to between 20-30% of the total workforce in
Egypt, and this percentage rises among girls In
rural areas.
Some sources specify more than 5.3 million

unemployed graduates from universities and higher
institutes and medium. The unemployment rate
reached in 2008 to 9% and then to 13.3 in 2013.
No doubt that, this is reflected in the form of high

rates of poverty in Egypt in recent years, if we look
at poverty rates in Egypt in recent years will find
- 116 -
that the poverty rate reached 19.7% in 2008 and
grew rapidly to 25% in 2011.
year 2008 2009 2010 2011
Poverty rate 19.7% 19.6% 21.6% 25%
Source: Ministry of Planning
Fourthly impact on economic growth rate
The effect of increasing the public debt may be the

rate of economic growth positive, provided the debt
is directed to invest directly, in order to achieve a
surplus to meet the principal and interest and the
rest is in addition to national output in this case is
the debt is desirable.
- 117 -
But as long as the increase of public debt is not in
the interest of increasing employment rates and
increase investment, leading ultimately to increase
production and reflect positively on increasing the
rate of economic growth.
the effect of increasing the public debt to be

inversely related to economic growth, and the
continuing rise in prices as a result of the new cash
release is not in favor of increasing production and
hence the opposite effect also on the economic
growth rate.
It is known that the security achieved when r = g or

increasing GDP growth rate of the public debt
growth rate, (r> g, r = g), but is noticeable in the
Egyptian case that public debt is growing at an
annual rate greater than the GDP growth rate, ( r
<g) in Egypt.
- 118 -
we find that the GDP growth rate has fallen from
4.5% in the period from 1990 to 2001 and then to
3.6 per period 2001 to 2004, and this decline has
been associated with a sharp fall in gross domestic
investment rate of 19% in the period 1997 2002 -
and then to 18% in the period 2003-2006.
The high rate of economic growth in the year (2005

- 2006) from 4.9% to 6.8%, is the highest growth
rate achieved by the Egyptian economy in 15 years,
due to the development of various sectors
performing major economic activities including oil
and gas, tourism and the Suez Canal, industry and
construction and construction, telecommunications,
information technology and the growing role as an
engine driving the growth of the national economy.
And more recently in the last five years, if it has to

compare the rates of economic growth, we find it
ranged from 4.7 in 2009 and then reached to 2.1 in
2013, and this is especially a normal situation.
- 119 -
If we know that the net foreign investment to Egypt
flows in the last five years dropped from 8 billion
dollars in 2009 to be reached to 1.1 billion dollars
in 2013. As it can be seen from the following table
The evolution of net foreign direct investment flows to

ancient Egypt Billion dollars
year 2009 2010 2011 2012 2013
follows 8.1 6.8 2.2 2.1 1.1
http://ar.tradingeconomics.com/egypt/indicators
The Standard Model (path analysis) has proved an

inverse relationship between the domestic public
debt and the rate of economic growth has been
attributed model 41% percent of the reduced rate of
economic growth due to increased domestic public
debt, and that the relationship between the increase
in domestic debt and standard of living overall
inverse relationship, because the level of Price
increases.
- 120 -
Variable Summary (Group number 1)
Your model contains the following variables (Group number 1)
Observed, endogenous variables
Growth rate
Unemployment rate
Inflation Rate
Internal dept.
Deficit of public budget
Unobserved, exogenous variables
e1
e3
e5
e2
e4
Variable counts (Group number 1)
Number of variables in your model: 10

Number of observed variables: 5
Number of unobserved variables: 5
Number of exogenous variables: 5
Number of endogenous variables: 5
Parameter Summary (Group number 1)
Weights Covariances Variances Means Intercepts Total

Fixed 4 0 0 0 0 4
Labeled 0 0 0 0 0 0
Unlabeled 17 0 5 0 0 22
Total 21 0 5 0 0 26
Models
Default model (Default model)
Notes for Model (Default model)
Computation of degrees of freedom (Default model)
Number of distinct sample moments: 15

Number of distinct parameters to be estimated: 22
Degrees of freedom (15 - 22): -7
Group number 1 (Group number 1 - Default model)
Estimates (Group number 1 - Default model)
Scalar Estimates (Group number 1 - Default model)
Maximum Likelihood Estimates
- 121 -
Regression Weights: (Group number 1 - Default model)
Estimate S.E. C.R. P Label

Growth rate <--- Internal dept. -.002
Growth rate <--- e2 .588
Public budget deficit <--- Internal dept. .005
Inflation rate <--- Internal dept. .005
Unemployment rate <--- Internal dept. .005
Growth rate <--- Unemployment rate -.165
Growth rate <--- Inflation rate .166
Inflation rate <--- Growth rate .130
Unemployment rate <--- Growth rate -.034
Unemployment rate <--- Public budget deficit -.273
Public budget deficit <--- Unemployment rate .328
Inflation rate <--- Unemployment rate .883
Public budget deficit <--- Inflation rate .050
Inflation rate <--- Public budget deficit -.118
Public budget deficit <--- Growth rate -.063
Growth rate <--- Public budget deficit -.099
Unemployment rate <--- Inflation rate -.011
Standardized Regression Weights: (Group number 1 - Default model)
Estimate
Growth rate <--- Internal dept. -.410
Growth rate <--- e2 .786
Public budget deficit <--- Internal dept. .594
Inflation rate <--- Internal dept. .421
Unemployment rate <--- Internal dept. .943
Growth rate <--- Unemployment rate -.217
Growth rate <--- Inflation rate .476
Inflation rate <--- Growth rate .045
Unemployment rate <--- Growth rate -.026
Unemployment rate <--- Public budget deficit -.462
Public budget deficit <--- Unemployment rate .194
Inflation rate <--- Unemployment rate .406
Public budget deficit <--- Inflation rate .064
Inflation rate <--- Public budget deficit -.092
Public budget deficit <--- Growth rate -.028
Growth rate <--- Public budget deficit -.220
Unemployment rate <--- Inflation rate -.023
- 122 -
Variances: (Group number 1 - Default model)
Estimate S.E. C.R. P Label

e2 3.776
e1 134219.410 43546.527 3.082 .002
e3 2.568
e5 5.026
e4 9.743
Squared Multiple Correlations: (Group number 1 - Default model)
Estimate
Internal dept. .000
Public budget deficit .521
Inflation rate .439
Unemployment rate .300
Growth rate .383
Matrices (Group number 1 - Default model)
Total Effects (Group number 1 - Default model)
Internal Public budget Inflation Unemployment Growth

dept. deficit rate rate rate
Public budget
.007 -.089 .031 .336 -.065
deficit
Inflation rate .007 -.335 -.004 .750 .126
Unemployment
.003 -.242 -.025 -.098 -.019
rate
Growth rate -.002 -.106 .166 -.057 .030
Standardized Total Effects (Group number 1 - Default model)

Public budget
.757 -.089 .040 .199 -.029
deficit
Inflation rate .572 -.260 -.004 .344 .044
Unemployment
.591 -.409 -.054 -.098 -.014
rate
Growth rate -.432 -.235 .477 -.076 .030
Direct Effects (Group number 1 - Default model)

Public budget
.005 .000 .050 .328 -.063
deficit
Inflation rate .005 -.118 .000 .883 .130
Unemployment
.005 -.273 -.011 .000 -.034
rate
- 123 -
Growth rate -.002 -.099 .166 -.165 .000
Standardized Direct Effects (Group number 1 - Default model)

Public budget
.594 .000 .064 .194 -.028
deficit
Inflation rate .421 -.092 .000 .406 .045
Unemployment
.943 -.462 -.023 .000 -.026
rate
Growth rate -.410 -.220 .476 -.217 .000
Indirect Effects (Group number 1 - Default model)
Internal Public budget Inflation Unemployment

Growth rate
dept. deficit rate rate
Public budget deficit .001 -.089 -.019 .009 -.002
Inflation rate .002 -.217 -.004 -.134 -.005
Unemployment rate -.002 .032 -.014 -.098 .015
Growth rate .000 -.007 .000 .107 .030
Standardized Indirect Effects (Group number 1 - Default model)
Public
Internal Inflation Unemployment
budget Growth rate
dept. rate rate
deficit
Public budget deficit .163 -.089 -.024 .005 -.001
Inflation rate .151 -.168 -.004 -.061 -.002
Unemployment rate -.352 .053 -.031 -.098 .012
Growth rate -.022 -.015 .001 .142 .030
Notes for Group/Model (Group number 1 - Default model)
Stability index for the following variables is .125

Y4
Y3
Y2
Y1
- 124 -
Minimization History (Default model)
Negative Smallest
Iterati Diamet NTri
eigenvalu Condition # eigenval F Ratio
on er es
es ue
9999.0 2447.6 9999.0
0 e 4 -.571 0
00 33 00
1021.9
1 e 4 -.468 .506 11 1.121
88
473.63
2 e 2 -.100 1.127 15 1.263
7
216.28
3 e 1 -.006 .371 2 1.291
2
4 e 1 .000 .361 92.788 2 1.288
5 e 0 117223332.059 .385 35.635 2 1.276
6 e 0 1299.155 1.597 27.713 2 .000
7 e 0 950.314 .829 5.823 1 1.192
8 e 0 2721.527 .456 .788 1 1.195
9 e 0 44618.436 .256 .034 1 1.122
10 e 0 10771199.000 .069 .000 1 1.036
11 e 0 31967602247.923 .004 .000 1 1.002
8930626004725870
12 e 0 .000 .000 1 1.000
.000
Model Fit Summary
CMIN
Model NPAR CMIN DF P CMIN/DF

Default model 22 .000 0
Saturated model 15 .000 0
Independence model 5 43.976 10 .000 4.398
RMR, GFI
Model RMR GFI AGFI PGFI

Default model .000 1.000
Saturated model .000 1.000
Independence model 345.866 .515 .272 .343
Baseline Comparisons
NFI RFI IFI TLI

Model CFI
Delta1 rho1 Delta2 rho2
Default model 1.000 1.000 1.000
Saturated model 1.000 1.000 1.000
Independence model .000 .000 .000 .000 .000
Parsimony-Adjusted Measures
Model PRATIO PNFI PCFI

Default model .000 .000 .000
Saturated model .000 .000 .000
- 125 -
Model PRATIO PNFI PCFI
Independence model 1.000 .000 .000
NCP
Model NCP LO 90 HI 90
Default model .000 .000 .000
Saturated model .000 .000 .000
Independence model 33.976 17.086 58.408
FMIN
Model FMIN F0 LO 90 HI 90
Default model .000 .000 .000 .000
Saturated model .000 .000 .000 .000
Independence model 2.315 1.788 .899 3.074
RMSEA
Model RMSEA LO 90 HI 90 PCLOSE

Independence model .423 .300 .554 .000
AIC
Model AIC BCC BIC CAIC

Default model 44.000 64.308 65.906 87.906
Saturated model 30.000 43.846 44.936 59.936
Independence model 53.976 58.591 58.955 63.955
ECVI
Model ECVI LO 90 HI 90 MECVI

Default model 2.316 2.316 2.316 3.385
Saturated model 1.579 1.579 1.579 2.308
Independence model 2.841 1.952 4.127 3.084
HOELTER
HOELTER HOELTER
Model
.05 .01
Default model
Independence model 8 11
- 126 -
References
1- Abdullah Shehata Khattab, .saleh Abdul Rahman Ahmad, the general budget
and the budget to participate ,With the application on the Egyptian budget,
Cairo University, 2008
2- Abdul Majeed Rashid, the dilemmas of the Egyptian economy, a study in the
reservoirs of internal imbalances and to resort to economic reform policy
policy, in February 2007 of an article published on the Internet, p 1,
www.grenc.com
3- Abdul Rahim Abdul Hamid Watchmaker, public debt and public ticks and
their impact on the welfare, King Abdulaziz University Magazine, King
Abdulaziz University – Jeddah
4- Arab Republic of Egypt and the Ministry of Planning, documents the

economic and social development plans 30 \ 6 \ 2013, Economic Development
and Social Plan 2013 \ 2014, www.mop.gov.eg
5- Arab Republic of Egypt and the Ministry of Planning, documents the

economic and social development plans 30 \ 6 \ 2013, Economic Development
and Social Plan 2013 \ 2014, www.mop.gov.eg
6- Barro, Robert J. (1974) ―Are Government Bonds Net Wealth?‖ Journal of

Political Economy, Nov./Dec. pp. 1095-1117.
7- Chrystal K. Alec, and Thorton Daniel L. ―The Macroeconomic Effects of

Deficit Spending: A Review‖, Fedral Reserve Bank of St. Louis Review, vol.
70, No. 6, November/December 1988. Pp.48-60.
8- Diamond, P. (1965) ‗Economic Growth‘,American Economic Review, 55, pp.

1125-1150.
9- Fredman, Benjamin (1988) Day of Reckoning, N. Y. Random House
10- Nassar Ibrahim Salman, fiscal policy and its role in economic development in
developing countries (with special reference to Egypt) survey, Faculty of
Commerce, Ain Shams University, August
11- Mustafa Al-Said, the Egyptian economy and the challenges of the situation
Alrahenh- appearances Aldaf- causes and treatment op. Cit., P. 42
12- Mohamed Abdel Halim Omar, public debt concepts - indicators - effects,
application to the case of Egypt, Al-Azhar University
- 127 -
13- Manal Affan, evaluate the use of economic policy tools to achieve economic
balance, a study on the Egyptian economy with reference to the experiences of
newly industrialized countries, PhD Thesis, 2009, p. 351, Faculty of
Commerce Library, University of Tanta
14- Ministry of Finance, the Central Directorate for Financial Research and
Administrative Development, the monthly financial report, December 2013
15- Ministry of finance, analytical statement of the state's general budget for 2013-
2014, Cairo, Egypt.
16- Egyptian Ministry of Finance, the minister's office sector, the Central
Directorate for Financial Research and Management Development, the
development of the budget deficit of the state (the reasons -alathar - solutions),
2007, p. 11
17- The Egyptian Cabinet, IDSC, Poll business owners about the needs of the
labor market, December 2006, p. 3
18- Al-Watan number 1927, 8/1/2006, http://www.alwatan.com.sa/daily/2006-01-
19- World Bank. Official Web Site. http://www.albankaldawli.org
20- The Egyptian Cabinet, IDSC, human skills and the labor market in Egypt,
Mahratmgarnh, March 2002, p. 6
21- The Central Bank of Egypt, time series data, www.be.org.eg
22- The Central Bank of Egypt, time series data, www.be.org.eg
.
23- Center for Political and Strategic Studies in Al-Ahram, seminars and
conferences, a final report on the workshop Almojtamaalssayas work and
economic transformation issues in Egypt, Saturday, June 2006, p. 5,
www.ahram.org.eg
24- Ministry of Foreign Affairs, Arab Republic of Egypt, Bulletin of the Egyptian
economy, the evolution of the performance of the Egyptian economy,
9/1/2007, p. 1 http://www.mfa.gov.eg
25- Michael Parkin , Economics , eleventh edition , University of Western Ontario, Canada
- 128 -
PART THREE
Test Bank
Dr: Ali Mohamed Ali
- 129 -
Answer the following questions:
Question no. (1):
Define the following expressions:
1. Public finance.
2. The budget.
3. Externalities.
4. Public goods.
5. Congestible public goods.
6. Public choice.
7. Political externalities.
8. Tax shares (or tax prices).
9. Tax evasion.
Question no. (2):
Using graphs if it is possible, Compare between Pure public
good and pure private good.
Question no. (3):
- 130 -
Using graphs if it is possible, Compare between Horizontal
equity and vertical equity.
Question no. (4):
Using graphs if it is possible, Compare between the marginal
cost of consuming a pure public good and a congestible public
good.
Question no. (5):
Compare between positive and normative economics.
Question no. (6):
Compare between public finance and private finance.
Question no. (7):
Compare between fees and fines.
Question no. (8):
- 131 -
Compare between the advantages and disadvantages of the
direct taxes.
Question no. (9):
Compare between progressive and digressive taxation.
Question no. (10):
Compare between a budget surplus and a budget deficit.
Question no. (11):
Compare between tax capacity and tax pressure.
Question no. (12):
Compare between Union budget and state budget.
Question no. (13):
Compare between plan budget and performance budget.
Question no. (14):
Compare between supplementary budget and Zero-based
budget.
- 132 -
Question no. (15):
What is the difference between supplementary budget and plan
budget?
Question no. (16):
Compare between internal loan and external loan.
Question no. (17):
Using graphs; illustrate the circular flow in the mixed
economy.
Question no. (18):
Using graphs; illustrate marginal conditions of efficiency
according to Pareto optimality.
Question no. (19):
Using graphs; illustrate the three cases in which the market
interactions fail to achieve efficiency.
Question no. (20):
- 133 -
Using graphs; illustrate the allocation between private and
government resources.
Question no. (21):
Using graphs; illustrate the balanced budget.
Question no. (22):
Using graphs; illustrate the idea of Laffer curve.
Question no. (23):
Using graphs; illustrate income redistribution using Lorenz
curve.
Question no. (24):
Using graphs; illustrate the corrective subsidies as means of
adjusting positive externalities.
Question no. (25):
Using graphs; illustrate the corrective taxes as means of
adjusting negative externalities.
- 134 -
Question no. (26):
Explain why most taxes impose an excess burden, but lump-sum
taxes do not. What is the main disadvantage of lump-sum taxes?
Question no. (27):
Using graphs; illustrate negative externalities and efficiency.
Question no. (28):
Using graphs; illustrate the difference between demand for
pure public good and pure private good.
Question no. (29):
Illustrate the stages of preparing state budget.
Question no. (30):
Illustrate the main characteristics of the public goods.
Question no. (31):
Explain briefly the determinants of political equilibrium.
- 135 -
Question no. (32):
Illustrate the objectives of public finance.
Question no. (33):
Explain briefly the three principles of public finance.
Question no. (34):
Illustrate the relationship between public and private finance.
Question no. (35):
Illustrate the factors affecting the tax capacity.
Question no. (36):
Explain the differences between direct and indirect taxation.
Question no. (37):
Illustrate the different types of tax burden transfer.
Question no. (38):
Illustrate the disadvantages of direct taxation.
- 136 -
Question no. (39):
Define a negative production externality.
Question no. (40):
Why do markets not always manage to solve the problem of
externalities on their own?
Question no. (41):
Explain the intuition behind the shape of the Laffer curve.
Question no. (42):
Explain why higher tax rates could decrease the government
revenue.
Question no. (43):
Illustrate the types of tax evasion.
Question no. (44):
Explain the means of fighting tax evasion.
- 137 -
Question no. (45):
What is the meaning of double taxation?
Question no. (46):
What are the features of public goods?
Question no. (47):
What are the Types of budgets?
Question no. (48):
Explain the budget preparation stages (the budget cycle).
Question no. (49):
Explain the general principles of the budget preparation.
Question no. (50):
Explain briefly the meaning of double taxation.
Question no. (51):
If the answer is correct, please mark (), otherwise mark
(), and justify your answer:

- 138 -
1. Prices and willingness to pay those prices are applicable to
goods such as national defense.
2. Price excludable public goods are rivalry but not
excludability goods.
3. When government gets bigger, it comes at the expense of
less public consumption.
4. Maximum Net Benefit occurs where MSB = TSB.
5. A stable market is a reason in which government
intervention may be warranted.
6. The marginal cost of allowing another person to benefit
from a pure public good is positive while the marginal cost
of a greater level of public good is zero.
7. Freeriding occurs when people are honest in stating their
Marginal Benefit.
8. Freeriding is easier with the large numbers of people.
9. There is no difference between price excludable public
goods and congestible public goods.
10. Budget is a financial document that includes only
government revenue during the fiscal year.
- 139 -
11. Fines are an important source of non-tax revenue.
12. Fees are commercial non-tax revenues to the
Government.
13. Indirect taxes are imposed on goods and services.
14. Direct taxes are imposed on goods and services.
15. The burden of direct taxes cannot be shifted.
16. The burden of indirect taxes cannot be shifted.
17. Taxes on expenditure are regarded as direct taxes.
18. Service tax is an example of direct tax.
19. If the price of a commodity did not rise by the full
amount of the tax, the consumer would pay only a part of
the tax.
20. In the case of commodities having inelastic supply,
the tax imposed on them can be easily shifted to the
buyers.
21. In the case of commodities having elastic supply, the
tax shifting is relatively easier.
22. The taxation of necessary goods will have regressive
effects.
- 140 -
23. In the case of luxuries, the burden of tax will be more
on the producers.
24. Indirect taxes may be inflationary.
25. Indirect taxes guide resource allocation in the
economy.
26. In the case of indirect taxes, evasion is relatively
easy.
27. The tax will be economical if the cost of collection is
very small.
28. Income tax is a form of tax which is levied on
individual's total earnings.
29. The burden of a direct tax can be shifted to anyone
else.
30. Direct taxes refer to the type of tax which is
indirectly imposed on a person.
31. In direct tax, the burden can be shifted.
32. In indirect tax, the burden can be shifted to another
person.
33. Direct taxes are regressive in nature.
- 141 -
34. The government borrows money when it issues
treasury bills.
35. Direct taxes are progressive in nature.
36. If the economy have been operating at full
employment, it would be probably better to finance
government purchases by taxes.
37. Indirect taxes are regressive in nature.
38. Increased government spending financed by
government borrowing creates greater expansion of the
economy than if the increased government spending is
financed by increased taxes.
39. Indirect taxes are progressive in nature.
40. Direct taxes help to reduce inequalities.
41. Expenditure on defense, law and order maintenance
and public administration expenses are unproductive
expenditure.
42. Expenditure on economic services like agriculture is
a part of non-development expenditure.
- 142 -
43. A balanced budget is one in which public revenue
equals public expenditure.
44. The government borrows fund from domestic market
and foreign governments to meet expenditure on its
various activities.
45. Government borrowing within the country is known
as external debt.
46. Internal debt creates more burden than external debt.
47. The knowledge that a Beni-Suef student won a
scholarship this year is a public good.
48. A progressive tax is one that takes a larger
percentage of income from low-income people than from
high-income people.
49. The total amount of money that the government has
borrowed and not yet repaid is the national debt.
borrowed and not yet repaid is the budget deficit.
Question no. (52):
- 143 -
Suppose that the net domestic income, the consumption, the
investment, and the government expenditure as follow:
net
Desired Desired Government
domestic
consumption Investment Spending
income
90 92 20 50
100 95 20 50
110 98 20 50
120 100 20 50
130 103 20 50
140 105 20 50
150 107 20 50
160 110 20 50
170 112 20 50
180 115 20 50
190 120 20 50
200 125 20 50
Calculate:
a) The equilibrium without government spending.
b) The equilibrium with government spending.
Question no. (53):
- 144 -
net
domestic
income
90 92 15 100
110 95 15 100
115 98 15 100
120 100 15 100
130 103 15 100
140 105 15 100
150 107 15 100
160 110 15 100
170 112 15 100
180 115 15 100
200 120 15 100
240 125 15 100
Calculate:
Question no. (54):
- 145 -
net
domestic
income
50 80 55 200
90 90 55 200
115 95 55 200
155 100 55 200
220 103 55 200
250 105 55 200
305 107 55 200
365 110 55 200
390 115 55 200
400 150 55 200
420 170 55 200
450 190 55 200
Calculate:
Question no. (55):
- 146 -
If a country has consumption function as follow:
and has fixed investment 40 million, fixed government spending
60 million, and lump-sum tax 20 million. Calculate the NDI and
saving.
Suppose that the government want to increase the net domestic
income NDI by 200 million, which methods will be more
effective?
Question no. (56):
and has fixed investment 200 billion, fixed government
spending 250 billion, and lump-sum tax 80 billion.
a) Calculate the NDI and saving.
b) Suppose that the government want to increase the net
domestic income NDI by 1000 billion, which methods will
be more effective?
- 147 -
Question no. (57):
be more effective?
Question no. (58):
- 148 -
be more effective?
Question no. (59):
be more effective?
Question no. (60):
If you had the following data:
Planned investment 200 million, government expenditure 300
million, the tax function represented as follows:
- 149 -
and the consumption function is represented as follows:
a) What is the equilibrium level of income and tax?
b) Use different ways to achieve the goal of the government
if it wanted to increase the equilibrium by 40 million.
c) Determine the budget position.
Question no. (61):
- 150 -
Question no. (62):
Planned investment 200 billion, government expenditure 110
billion, the tax function represented as follows:
if it wanted to increase the equilibrium by 15 billion.
Question no. (63):
- 151 -
Question no. (64):
- 152 -
Question no. (65):
Suppose we have three people who are discussing the issue of
hiring security guards; the following table shows the marginal
benefits of them and its corresponding number of security
guards could be hired:
Number of Security Guards per Week
1 2 3 4
MBA
$300 $250 $200 $150
MBB
$250 $200 $150 $100
MBC
$200 $150 $100 $50
Determine the optimal number of security guards must be hired,
assuming that the cost of security guards is $450 per week.
Question no. (66):
hiring teachers; the following table shows the marginal benefits
of them and its corresponding number of teachers could be
hired:
- 153 -
Number of teachers per Week
1 2 3 4
MBA
$500 $300 $100 $150
MBB
$300 $150 $200 $100
MBC
$300 $400 $200 $100
Determine the optimal number of teachers must be hired,
assuming that the cost of teachers is $500 per week.
Question no. (67):
hiring new waiters; the following table shows the marginal
benefits of them and its corresponding number of waiters could
be hired:
Number of waiters per Week
1 2 3 4
MBA
$1200 $900 $1100 $800
MBB
$1000 $950 $900 $950
MBC
$1050 $1000 $1000 $850
- 154 -
Determine the optimal number of waiters must be hired,
assuming that the cost of waiters is $1000 per week.
Question no. (68):
1. Let's assume we are to receive $100 at the end of two
years. How do we calculate the present value of the
amount, assuming the interest rate is 8% per year
compounded annually?
2. Calculate the present value of receiving a single amount of
$1,000 in 20 years. The interest rate for discounting the
future amount is estimated at 10% per year compounded
annually.
3. What is the present value of receiving a single amount of
$5,000 at the end of three years, if the time value of
money is 8% per year, compounded quarterly?
Hint:
- 155 -
[ ( ) ]
Question no. (69):
Choose the right answer from the following:
(1) The tax on net income of companies is
a. Personal income tax
b. Indirect tax
c. Wealth tax
d. Corporation tax
(2) Fiscal Policy is related to
a. Money supply
b. Regulation of the banking system
c. Planning for economic development
d. Government's Revenue and Expenditure
(3) Monetary Policy is related to
a. Money supply
b. Managing foreign trade
- 156 -
c. Planning for economic development
d. Government's Revenue and Expenditure
(4) The objective of taxation by the Government are
a. Raising revenue for the state
b. To maintain economic stability
c. To remove disparities in the distribution of income
d. All of the above
(5) Which of the following is not a direct tax?
a. Personal Income Tax
b. Service tax
c. Wealth Tax
d. Corporate Income Tax
(6) On what broad aspect of commodities are indirect taxes
imposed?
a. Production
- 157 -
b. Sales
c. Movement
d. All of the above
(7) Which factor has no role in the shifting of a tax?
a. Change in prices
b. Elasticity of demand and supply
c. Nature of Demand
d. Income of the consumer
(8) Pick out the incorrect statement.
a. In the short period, shifting of a tax is easy.
b. In the long period shifting of a tax is easy.
c. When supply is elastic, shifting is easy.
d. None of the above.
(9) Pick out the factor which is not a feature of indirect taxes.
a. Convenience
- 158 -
b. Tax evasion is difficult
c. Fair to the poor
d. Powerful tool of economic policy
(10) Which of the following is not a direct tax?
a. Income tax
b. wealth tax
c. gift tax
d. service tax
(11) The main objective of taxation is to
a. Raise revenue to the Government
b. to promote exports
c. increase inequalities of income
d. promote employment)
(12) The main objective of taxation is to
- 159 -
a. Obtain revenue to the Government
b. check harmful consumption
c. promote investment
d. check savings
(13) Which of the following is not an indirect tax?
a. Sales tax
b. custom duty
c. excise duty
d. gift tax
(14) An example of direct tax is
a. Sales tax
b. Central excise duty
c. Custom duty
d. Wealth tax
(15) Generally, the nature of indirect tax is
- 160 -
a. Progressive
b. Regressive
c. Proportional
d. None of the above
(16) Generally, the nature of direct tax is
a. Progressive
b. Regressive
c. Proportional
(17) An increase in the direct tax means it is
a. Inflationary
b. Anti-inflationary
c. Having no impact on price
- 161 -
(18) The shared burden of taxation on consumer and producer
implies
a. Inelastic Supply and Elastic Demand
b. Elastic Supply and Demand
c. Inelastic Supply and Demand
d. Elastic Supply and Inelastic Demand
(19) Which of the following is not true of public budget?
a. A budget contains only proposals of taxation.
b. It refers to the policies of the government.
c. It contains the estimated receipts and proposed expenditure.
d. It reflects the programs of the government.
(20) Public Expenditure refers to
a. Government Expenditure
b. Private Expenditure
c. Private Expenditure
- 162 -
(21) The major objectives of public expenditure are
a. Economic Growth
b. Maintenance of infrastructure
c. Social Welfare
d. All of the above
(22) Consider replacing the current Egyptian tax system with a
proportional tax in which everyone would pay a constant
fraction of their wages, and there would be no other taxes.
Compared to the current personal tax system:
(a) The proportional tax would increase the amount of personal
saving.
(b) The proportional tax would make the tax system less
progressive than it is now.
(c) The proportional tax would increase the number of hours
people work.
(d) All of the above
- 163 -
(e) None of the above
(23) The incidence of a tax relies on
(a) The elasticity of demand in the market
(b) The market structure (competition, monopoly)
(c) The production function for the good
(d) All of the above
(e) None of the above
(24) Government securities consist of
a. the reserve system.
b. government bonds and treasury bills.
c. corporate bonds and stocks.
d. All of the above.
(25) A tax base is
a. always expressed as a percentage.
b. always expressed as some form of income.
c. an item that has a tax credit applied to it.
d. an item that has a tax rate applied to it.

- 164 -
(26) A decrease in personal income taxes will raise
a. disposable income.
b. consumption spending.
c. aggregate demand.
d. all of the above
(27) Which of the following is a regressive tax
a. sales tax
b. property tax
c. social security tax
d. all of the above
(28) A regressive tax:
a. takes a larger amount of tax dollars from low income
people than high income people
b. takes a larger percentage of income from low income
people than from high income people.
- 165 -
c. takes a larger percentage of income from high income
people than from low income people.
d. takes the same percentage of income from high income
(28) A progressive tax:
a. takes a larger amount of tax dollars from low income
people than high income people
b. takes a larger percentage of income from low income
people than from high income people.
c. takes a larger percentage of income from high income
d. takes the same percentage of income from high income
(29) Which causes greater expansion of the economy?
a. an increase in taxes only
b. an increase in government spending financed by an
increase in taxes
- 166 -
c. an increase in government spending financed by
government borrowing
d. a and b are equal
(30) Increased government spending financed by government
borrowing will generally cause:
a. an increase in interest rates.
b. an expansion of the economy.
c. Inflationary effect.
d. all of the above
(31) Government tax revenue of $200 billion and government
spending of $180 billion in any given year results in:
a. a budget deficit of $20 billion.
b. a budget surplus of $20 billion.
c. a national debt of $20 billion.
d. a national surplus of $20 billion.
- 167 -
(33) The difference between government spending and
government revenue in a specific year is:
a. the budget deficit/surplus
b. the national debt
c. Inflationary effect
d. the trade deficit/surplus
Question no. (70):
Using the following graphs show the effects of the following
on GDP:
- 168 -
a. Increased government spending on infrastructure
financed by government borrowing.
b. Increased government spending on infrastructure
financed by increased taxes.
P D S
- 169 -
c. Using corrective tax as a mean to adjust negative
externalities.
P D S
d. Using corrective subsidies as a mean to adjust positive
externalities.
P D S
Question no. (71):
Given the following Table:
- 170 -
Tax rate Value
0 0
50 20
150 40
250 60
350 80
450 100
550 80
650 60
750 40
850 20
950 0
What do you conclude from this Table? Use graphs to illustrate
your answer.
Question no. (72):
Use the following Table to prove the idea of Laffer curve.
Tax rate Value
- 171 -
0 0
100 50
200 100
300 150
400 200
500 250
600 200
700 150
800 100
900 50
1000 0
Question no. (73):
Discuss the various sources of public revenue.
Question no. (74):
Discuss the advantages and disadvantages of direct taxes.
Question no. (75):
- 172 -
Discuss the advantages and disadvantages of indirect taxes.
Question no. (76):
Explain the term shifting of a tax with the help of an example.
Question no. (77):
What are the factors which affect the shifting of a tax?
Question no. (78):
Explain the various objectives of taxation.
Question no. (79):
Explain the various classification of tax revenue.
Question no. (80):
Distinguish between the direct and indirect tax based on its
advantages and disadvantages.
Question no. (81):
Distinguish between the forward and backward shifting of tax.
- 173 -
Question no. (82):
Write explanatory note on cash or payment burden and real
burden.
Question no. (83):
From your point of view, explain the role of direct and indirect
taxes in a developing economy.
Question no. (84):
Explain the various types of public expenditure.
Question no. (85):
Explain the various causes of increasing public expenditure.
Question no. (86):
What is public debt? What are its different types?
Question no. (87):
Discuss briefly the public debt management in Egypt.
Question no. (88):

- 174 -
Discuss the burden of public debts in Egypt.
Question no. (89):
Discuss the internal and external burden of debt. From your
point of view, does debt burden create an impact on future
generations?
Question no. (90):
Explain the concept of public debt and its various types.
Question no. (91):
Discuss in details the differences between regressive,
proportional, and progressive taxes?
Question no. (92):
What is the difference between internal and external debt?
Question no. (93):
How does a regressive income tax differ from a proportional tax
and a progressive tax? Which type of tax is the fairest? Why?
- 175 -
Question no. (94):
State whether the following statements are true (T) or false
(F). Justify your answer.
1. Permanent loans are loans in which the state determines in
prior their payment deadline.
2. Laffer curve is called a perfect unequal distribution line.
3. Unified budget is one in which public revenue is greater
than public expenditure.
4. According to Laffer curve the tax revenue decreases with
increasing tax rate.
5. According to Lorenz curve the tax revenue increases with
increasing tax rate, then decreases after reaching the
maximum point.
6. Price excludable public goods are both non-rivalry and
excludability goods.
7. There is no reason for government intervention in the
market.
- 176 -
8. The marginal cost of allowing another person to benefit
from a pure public good is zero while the marginal cost of
a greater level of public good is negative.
9. There is no difference between price non-excludable
public goods and congestible public goods.
10. Budget is a financial document that includes
government revenue and government expenditure during
the fiscal year.
11. Fees are an important source of tax revenue.
12. Fines are commercial non-tax revenues to the
Government.
13. The burden of sales taxes cannot be shifted.
14. The burden of income taxes can be shifted.
15. Taxes on property are regarded as direct taxes.
16. Sales tax is an example of indirect tax.
17. If the price of a commodity did not rise by the full
amount of the tax, the producer would pay the tax.
18. In the case of commodities having elastic supply, the
tax imposed on them cannot be shifted to the buyers.
- 177 -
19. In the case of commodities having inelastic demand,
the tax shifting is relatively easier.
20. The taxation of luxuries will have regressive effects.
21. In the case of necessary goods, the burden of tax will
be more on the producers.
22. Direct taxes may have an inflationary effect.
23. In the case of direct taxes, evasion is relatively easy.
24. The tax would not be economical if the cost of
collection is very small.
25. Tax on property is a form of tax which is levied on
individual's total assets.
26. Indirect taxes refer to the type of tax which is
directly imposed on a person but collected indirectly.
27. The government lends money when it issues
government securities.
28. If the economy have been operating at full
employment, it would be probably better to finance
government purchases by borrowing.
- 178 -
29. Increased government spending financed by
increased taxes creates inflationary effect in the economy
than if the increased government spending is financed by
government borrowing.
30. Indirect taxes help to reduce inequalities.
31. Expenditure on law and order are productive
expenditure.
borrowed and not yet repaid is the budget surplus.
33. Expenditure on establishing infrastructure is a part of
non-development expenditure.
34. Contemporary loans are loans in which the state
concludes without determining a payment deadline.
35. The government cannot borrow money from foreign
governments and international organizations to meet its
own domestic expenditure.
36. Government borrowing within the country is known
as internal debt.
- 179 -
37. Internal debt creates fewer burdens than external
debt.
38. A regressive tax is one that takes a smaller
percentage of income from low-income people than from
high-income people.
39. Prices and willingness to pay those prices are
applicable to any kind of goods.
40. Maximum Net Benefit occurs where MSB > TSB.
41. Preparation and passing of the budget may have to be
done more than once in a year.
42. A supplementary budget is considered during periods
of war or natural crisis.
43. Expenditure on justice and police is a part of
developmental expenditure.
44. Treasury bills constitute major source of long term
fund.
45. Public debt policy has no connection to economic
stability and growth.
- 180 -
46. Growth of towns, cities, and villages are another
cause of concern to the huge amount of public expenditure.
47. During recent years, public debt in Egypt has been
growing at an alarming rate.
48. Tax capacity and tax pressure are the same.
49. Tax pressure expresses the society's potential ability
of bearing taxes.
50. Tax pressure could be less than or equal to tax
capacity but never exceeds tax capacity.
51. External debt is private debt and internal debt is
public debt.
52. If the government raises interest rates on the
securities that it sells, government debt may crowd out
private investment.
53. The size of government intervention could be
measured by only one measure which is the number of the
workers in the public sector.
Question no. (95):
- 181 -
Re-write the statement after choosing the appropriate
answer:
(1) Which of the following is not true about public budget?
a. A budget contains only proposals of taxation.
b. It refers to the policies of the government.
c. It contains the estimated receipts and proposed expenditure.
d. It reflects the programs of the government.
(2) The defense expenditure minimizes the possibility of
a. External threats
b. Internal threats
c. Terrorism
d. All of the above
(3) External debts can be raised from
a. Individuals
b. The central bank
- 182 -
c. Commercial Banks
d. World Bank
(4) The treasury bills are issued by the central bank of Egypt on
behalf of the government
a. Short-term public debt
b. Medium-term public debt
c. Long-term public
(5) The tax levied by the Egyptian government on income of
individuals is known as
b. Interest tax
c. Wealth tax
d. Corporation tax
(6) The tax levied by the Egyptian government on net income of
companies is
- 183 -
b. Interest tax
c. Wealth tax
d. Corporation tax
(7) The difference between total expenditure and total revenue is
a. Fiscal deficit
b. Budget deficit
c. Expenditure deficit
d. Revenue deficit
(8) A pure private good is subject to
a. Exclusion
b. Non exclusion
c. High satisfaction
(9) A pure public good is subject to
- 184 -
a. Exclusion
b. Non exclusion
c. High satisfaction
(10) Which of the following is not a fiscal policy instrument?
a. Taxation
b. Public expenditure
c. Money supply.
d. None of the above.
(11) A decrease in tax rate when tax base expands is considered
A. Regressive taxation
b. Progressive taxation
c. Proportional taxation
(12) Consider the following taxes:
- 185 -
1) Personal income tax 2) Import duty
3) Service tax
Which of the taxes given above are Indirect Taxes?
a. 1 and 2
b. 2 and 3
c. 2 and 3
d. Only 3
(13) A regressive income tax is one where the poor people
a. have a lower percentage of their income taxed than the rich
b. pay a larger amount in taxes than the rich
c. pay a tax that varies directly with their income
d. have a higher percentage of their income taxed than the rich
(14) The level of external debt rises when the government of
Egypt
a. prints more money
b. sells securities to the people of Egypt
c. sells securities to foreigners

- 186 -
(16) All of the following are examples of regressive taxes except
a. Sales taxes
b. The proportional income tax
c. Customs duties
(17) The national debt is a burden to future generations to the
extent that a portion of the debt is held by
a. Government institutions
b. Foreigners
- 187 -
c. National banks
d. All of the above
(18) A progressive income tax is one in which
a. Everyone pays the same rate
b. Everyone pays a fixed amount
c. The poor people pay a larger percentage of their income than
do the rich
d. The rich people pay a larger percentage of their income than
do the poor
(19) Deficit financing is most likely to be inflationary when the
debt is purchased by
a. The public
b. Foreigners
c. State governments
d. Private banks
(20) The primary source of revenue for general spending by the
government of Egypt is
a. Property taxes
- 188 -
b. Income taxes
c. Custom duties
d. Tariff revenues
Question no. (96):
(1) Match the terms on the left with the definitions in
the column on the right.
 Tax  The taxpayer's income,
Capacity regardless of its varied
sources.
 Tax  The sums of money which
pressure the state forcibly deducts to
finance its needs.
 Direct  Expresses the society's actual
taxation ability of bearing taxes
 Indirect  The taxes imposed on the
taxation consumption and customs
taxes
- 189 -
 Unified  The taxes imposed on the
taxes income and capitals
 Tax  Expresses the society's
potential ability of bearing
taxes.
 Public  Inability to prevent the
expenditure goods from consuming by
others.
 Tax burden  The sums of money spent
transfer by a general legal person
for the purpose of
achieving public benefit.
 External  The difference between
debt dwelt production and
necessary consumption.
 Internal loan  Another person rather
- 190 -
than entitled tax paying
person can bear the tax.
 Non-  A loan which the state
exclusion concludes in the foreign
markets.
 Economic  A loan which the state
surplus concludes within its
territories.
 Direct Tax  Expresses the society's
actual ability of bearing
taxes.
 Tax  The sums of money spent
Capacity by a general legal person
for the purpose of
achieving public benefit.
 External  A loan which the state
- 191 -
debt concludes within its
territories.
 Internal loan  A loan which the state
concludes in the foreign
markets.
 Tax pressure  The taxes imposed on the
income and capitals.
 Public  Expresses the society's
expenditure potential ability of bearing
taxes.
 Tax burden  Inability to prevent the
transfer goods from consuming by
others.
 Public debt  Financial document
includes all government
revenues and
- 192 -
expenditures.
 Public  The difference between
finance dwelt production and
necessary consumption.
 Public  Another person rather
budget than entitled tax paying
person can bear the tax.
 Non-  The total loans obtained
exclusion by the state from internal
and external loans.
 Economic  Study of the public
surplus authorities' income,
expenditures and their
balance.
Question no. (97):
Read the following statement carefully and write a suitable
comment:
- 193 -
(1) "The higher the individual's average income, the more the
tax capacity is."
(2) "Tax capacity is affected by the pattern of national
income distribution among the individuals."
(3) "Tax pressure could be less than or equal to tax capacity
but never exceeds tax capacity."
(4) "Tax is imposed on all personalities in the society,
individuals, companies, corporations, banks, etc."
(5) "Taxes can be divided into four categories."
(6) "Tax evasion is a phenomenon by which a taxpayer tries
to evade paying part or whole of tax that he has to pay by
using different means."
(7) "Double taxation could be either internal or external."
(8) "Revenue of financial fees has a great importance as a
source of revenue."
(9) "Public loans are one of the most important unordinary
sources of revenue."
(10) "Public goods are goods for which exclusion is
impossible."
- 194 -
(11) "The marginal cost of allowing another person to benefit
from a pure public good equals zero while the marginal
cost of a greater level of public good is positive."
(12) "There are public goods where, after a point, the
enjoyment received by the consumer is reduced by
crowding or congestion."
(13) "The socially optimal level of the public good requires
that the marginal social benefit of that good equals to its
marginal social cost."
(14) "The efficiency condition for a pure public good is
∑ "
(15) "Externalities can be negative or positive."
(16) "When a positive externality occurs, marginal private
benefit will fall short of marginal social benefit at each
level of annual production."
(17) "Corrective tax is considered to adjust the marginal
private cost of good or service in such a way as to
overcome the externality."
- 195 -
(18) "A corrective subsidy is a payment made by government
to either buyers or sellers of a good so that the price paid
by consumers is reduced."
(19) "One of the most important basic principles of the public
budget is to issue a fiscal year with its resources and
expenditures."
(20) "The general principles of the budget preparation are
annual budget, inclusion budget, prevalence of the
budget, unity of the budget, and balancing the budget."
(21) "The budget divisions mean the different ways in which
the expenses and revenue are presented to the parliament
in order to identify its structure."
(22) "According to the legal standard, the nature of the
expenses is determined on the basis of the party that is
making the expenditures."
(23) "According to career standard, the tunnel is considered to
be general if it is carried out by the state under its
sovereignty."
- 196 -
(24) "Transfer expenses occur when cash is transferred from
one category to another in the community."
(25) "There are two different measures for the size of
government intervention."
Question no. (98):
Suppose we have five people who are discussing the issue of
hiring new servants; the following table shows the marginal
benefits of them and its corresponding number of servants could
be hired:
Number of servants per Week
1 2 3 4
MBA
$1200 $900 $1100 $800
MBB
$1000 $950 $900 $950
MBC
$1050 $1000 $1000 $850
MBD
$950 $1000 $1050 $1000
MBE
$1100 $800 $1000 $1000
Determine the optimal number of servants must be hired,
assuming that the cost of servants is $1000 per week.
Question no. (99):
- 197 -
Suppose we have four people who are discussing the issue of
hiring new servants; the following table shows the marginal
benefits of them and its corresponding number of servants could
be hired:
Number of servants per Week
1 2 3 4
MBA
$2000 $3000 $3500 $5500
MBB
$1500 $2500 $2000 $2400
MBC
$3050 $3200 $2900 $3000
MBD
$2500 $2500 $2800 $2900
Determine the optimal number of servants must be hired,
assuming that the cost of servants is $2000 per week.
Question no. (100):
- 198 -
Question no. (101):
Question no. (102):
- 199 -
and has fixed investment 10000 million, fixed government
spending 5500 million, and lump-sum tax 3000 million.
domestic income NDI by 3000 million, which methods
will be more effective?
Question no. (103):
and has fixed investment 15 billion, fixed government spending
10 billion, and lump-sum tax 2 billion.
domestic income NDI by 5 billion, which methods will be
more effective?
- 200 -
Question no. (104):
net
domestic
income
1500 1000 1200 1000
1900 1100 1200 1000
2300 1200 1200 1000
2500 1300 1200 1000
2700 1400 1200 1000
3000 1500 1200 1000
3200 1600 1200 1000
3500 1700 1200 1000
3700 1800 1200 1000
4000 1900 1200 1000
4200 2000 1200 1000
4500 2100 1200 1000
Calculate:
Question no. (105):
- 201 -
net
domestic
income
140 100 120 100
200 110 120 100
230 120 120 100
250 130 120 100
280 140 120 100
300 150 120 100
320 160 120 100
350 170 120 100
370 180 120 100
400 190 120 100
420 200 120 100
450 210 120 100
Calculate:
Question no. (106):
- 202 -
- 203 -

Part One: Principles of Public Finance

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Part One: Principles of Public Finance

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Lectures on:

Principles of public finance

Dr. Mohamed Abdel-Gany

1.1 Meaning and Concept of Public Finance

Public Finance definite as a study of the public

– “The field of economics that analyzes government

• Public finance, as described by Former

– “Public finance is nothing else than a sophisticated

• Public finance is about the taxing and spending activities

Also known as “public sector economics” or “public

1) Public Finance is a science – Science is the

1.2 Objectives of Public Finance

• Efficiency of resources allocation.

• Income distribution equality.

• Maintenance of full employment.

• Achievement of economic growth.

• Realization of economic welfare.

The subject matter of public finance can be divided

Further it also deals with fiscal policies which ought to

Significance of public finance to modern economy is

• 1) To Achieve Adjustment in allocation of

• For Government Use

The production-possibility curve

2.2 The Mixed Economy

1. Government supplies many goods and

The upper and lower loops represent transactions

2.4 Indifference Curves Analysis

• Tool for understanding choices people make

Assumptions Underlying Indifference Curve Analysis

1. People can rank market baskets from most to

Indifference curves are downward sloping. Curves

2.6 Consumer Equilibrium

The market basket corresponding to point E is the one

2.7 Changes in Income and Prices

Changes in the price of good X rotate the budget constraint line

An increase in income shifts the budget line outward, expanding

2.8 Income and Substitution Effects

The substitution effect could be observed if the

The area PAB is a measure of the consumer surplus

Point E represents the combination of leisure and

2.10 Production and Cost

• Two periods to production

– Short run (inputs cannot be varied)

Isoquants - curves that show alternative combinations

The monthly input combination corresponding to point

• Total cost (TC) – the value of all inputs used to

Short-Run Cost Curves

1. Perfect competition exists when a firm is one of

• Short-run supply curve – price exceeds minimum

Long-Run Competitive Equilibrium

In the long-run competitive equilibrium, P = LRMC =

If input prices are independent of the size of an

Price Elasticity of Supply

The percentage change in quantity supplied in response to any

If annual output is fixed and does not vary with market

• The individuals can seek loans, in accordance to

2.12 The Relationship between Public and

The public finance differs from private finance in terms

2.14 The Public Project in the Socialist System:

2.15 public budget

It means the financial authorities’ initial assessment

• First column: it includes expenditures.

• Second column: it includes revenues statement