EAE 313 AEC 307 PUBLIC FINANCE fINAL (2) - 1-1-2

KENYATTA UNIVERSITY
INSTITUTE OF OPEN, DISTANCE & e-LEARNING
IN COLLABORATION WITH
SCHOOL: ECONOMICS
DEPARTMENT: APPLIED ECONOMICS
UNIT CODE & NAME:

EAE 313 - PUBLIC FINANCE
WRITTEN BY:
Dr. James N. Maingi & Dr. Nelson H.W.
Wawire
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Copyright © Kenyatta University, 2009
All Rights Reserved
Published By:
KENYATTA UNIVERSITY PRESS
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INTRODUCTION
The module introduces learners to the fiscal policy and operations of government. The
module then goes further to present theories, processes and practical issues on how
governments raise and allocate resources.
OBJECTIVES
OBJECTIVES
The objective of the module is to acquaint the students with the principles of public revenue,
expenditure, debt, economic stabilization and growth and to equip the student with the
7conditions for efficient allocation of public goods.
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TABLE OF CONTENTS
LECTURE TITLE page
Lecture One: The introduction and the nature of public finance 6 - 16
Definition of public finance; the scope of government activities; the needs for
public sector; reasons why government should participate in economic
activities; models of efficient allocation; the size of the public sector; the
principles of maximum social benefits; measuring the size of public sector;
summary, activities and further reading
Lecture Two: Public policy objectives 17 - 25

Introduction; objective, the allocation function; public provision of social
goods; the distribution function; fiscal instruments of distribution policy; the
stabilization function; instruments of stabilization policy; coordination;
conflict of interest.
Lecture Three: Public goods 26 - 33

Properties of public goods; difference between public goods and private
goods; comparison between efficient provision of public and private goods
Lecture Four: Market failure and the rationale for government intervention 34 - 50
Imperfect markets as source of market failure; costly information; externality
as a cause of market failure; implications of externalities for allocation
efficiency; solutions to externality.
Lecture Five: Public expenditure 51 - 91

Definition of public expenditure; canons public expenditure; the growth of
public expenditure; reasons for the growth of public expenditure; restraints to
the growth of public expenditure; consequences of the growth of public
expenditure; effect of public expenditure; public expenditure and economic
stability in advanced economies; public expenditure and economic growth in a
developing country; theoretical aspects to public expenditure evaluation; types
of public projects; types of benefits and costs; shadow pricing and market
item; decisions involving long-term projects; choice of discount rate; capital
budgeting techniques
Lecture Six: Budget 92 - 96

Canons of budgeting; types of budget; incremental budgeting; zero base
budgeting; performance and programming budgeting system
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Lecture Seven: Taxation as a source of revenue 97 - 120
Canons of good tax system; approaches to equity; benefit principle; ability to
pay as basis for taxation; categories of taxes; shifting and incidence of tax;
magnitude of tax burden; types of tax incidences; effects of tax incidence on
market for goods; other factors that affect effective incidence of tax.
Lecture Eight: Alternative sources of public revenue 121 - 143

Theory of Public debts; classification of public debt; why is public debt
incurred; sources of public borrowing; economic effect of public borrowing;
effects of public debt; burden of internal and external debt; redemption of
public debt; public borrowing requirement; government induced inflation;
donations; user charges.
Lecture Nine: Privatization 144 - 149

Mechanism of privatization; case for privatization; case against privatization.
REFERENCES 150
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NATURE OF PUBLIC FINANCE
LECTURE ONE
1.1 INTRODUCTION
The chapter introduces to the student the scope of government activity, measures of public
sector and the needs for public sector. Governments provide many goods and services to
public. In Kenya the government provides subsidized education in primary, secondary and in
university. Also provided are health cares and environmental protection. The government is
involved in projects that directly increase the production of goods and services. It provides
water for industrial use, domestic use. Such projects involve expenditures of large amount of
money provided through taxing, licensing and borrowing.
The study of public funding enables us to know how the government through its budgetary,
1.2 LECTURE OBJECTIVE
At the end of this lecture you should be able to:

(i) Define public finance
(ii) Discuss the scope of government activities
(iii) Explain the measures of public sector
(iv) Discuss the needs of public sector
Definition of public finance

Public finance (government finance) is the field of economics that deals with budgeting, the
revenues and expenditure of a public sector entity, usually government.
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1.3 THE SCOPE OF GOVERNMENT ACTIVITIES
1. Provision of pure public goods. These are goods to which the principle of exclusion does
not apply because they are indivisible and their benefit cannot be priced. The suppliers
are faced with the free riders problem since the users cannot be forced to reveal their
demand preferences. The government must provide for such.(non-chargeable and non-
excludable)
2. Correction of externalities – suppose a particular public good has external economies
which can not be measured and therefore can not be priced. The spills over gains are there
in the society, but the supplier cannot charge for it. Hence the price much is lower than
the social margin of benefit that determines his supply on the basis of the price he gets.
Hence he produces less than what could be the optimum quantity from the society’s point
of view. The government must provide for such.
3. Quasi – public goods/mixed goods/impure public goods. They posses both element of
public and private goods e.g. education, polio vaccination.
4. Merit goods – They are goods whose provision the society wishes to encourage. Provision
of such goods helps the economy to attain a high level of efficiency and contribute to
achieving basic objectives of the society. E.g. health, education. They have an overriding
importance e.g. precious lives may be lost, if health services are left to the forces of the
market only. The state must supplement their availability.
5. Demerit goods: these are goods that are viewed as being socially harmful e.g. cigarette,
addictive drugs. For such goods government takes measure to discourage consumption
especially through levy of taxes or legislation to discourage consumption.
6. Market failure-This is a situation where the market forces of demand and supply are not
at work. Market tends to operate inefficiently on account of the existence of public goods,
monopolies and in the absent of law of constant returns. The condition necessary to
achieve the market efficient solution fail to exist. The government must intervene.
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1.4 THE NEED FOR A PUBLIC SECTOR
It was felt that in a capitalistic society government participation in the market should be very
minimal. Those who supported this emphasized the need to leave the allocation of resources
to market forces of demand and supply so that if demand is greater than supply the prices
would rise and vice versa. This process would clear the market as they argued. But over the
years many changes took place, political ideology evolved hence leading to establishment of
socialistic states whose size of the public sector was larger than private sector.
However, despite the different ideologies the need for government participation in economic
activity in the country is important for various reasons.
1.5 REASONS WHY GOVERNMENT SHOULD PARTICIPATE IN ECONOMIC

ACTIVITIES
1) The public sector is required to provide goods and services that cannot be provided
through the market owing to problem of “externalities” which lead to market failure.”
For example, the provision of national security. You cannot bar anybody from
enjoying it.-To participate in projects where the returns are low.
2) The government must formulate and implement economic policies that are needed to
guide5, correct and supplement the course that the economy will take on its’ growth
and development over time.
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3) Even where market forces are used to allocated resource, there must be a significantly
large public sector to provide regulations and laws that will provide the required
protection, otherwise there will be no property rights, and there cannot be markets
without exclusive ownership rights.
4) Laws and regulations are also needed to ensure free competition in market, free entry
to the market, free exit from the market and for consumer protection, so that in
general, the contractual obligations that arise from free market transactions cannot be
executed unless there is protection and enforcement of a government provide legal
structure.
5) Social values may require adjustments in the distribution of income and wealth which
results from the market systems and from the transmission of property rights through
inheritance. [We are talking of reducing gap between rich and poor which is as a
result of market mechanism. In capitalistic state, the rich will continue becoming
richer and poor, poorer. So something needs to be done to tax more from rich and
provide services which the poor cannot afford at a subsidized rate].
6) Private sectors invest where returns are high while public sectors look at overall
benefits of a project to the community even if returns are low. e.g. Government
provide immigration schemes, schools, hospitals etc. Such projects have no high rate
of return on investment but have greater benefits to the community. Owing to low
rate of return on such projects, the private sector would not invest in them.
1.6 MODELS OF EFFICIENT ALLOCATION
Analysis of the benefits and costs of making additional amounts of a good available is
required to determine whether the existing allocation of resources to its production is
efficient. Any given quantity of an economic good available, say per month, will provide a
certain amount of satisfaction to those who consume it. This is the total social benefit, of the
monthly quantity. The marginal social benefit of a good is the extra benefits obtained by
making one more unit of that good available per month. The marginal social benefits can be
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measured as the maximum amount of money that would be given up by persons to obtain the
extra unit of the good. e.g. if the marginal social benefit of bread is $2 per loaf, some
consumers would give up $2 worth of expenditure on other goods to obtain that loaf and be
neither worse off nor better off by doing so. The marginal social benefit of a good is
assumed to decline as more of that good is made available each month.
The total social cost of a good is the value of all resources necessary to make a given amount
of the good available per month. The marginal social cost of a good is the minimum sum of
money that is required to compensate the owners of inputs used in producing the good for
making an extra unit of the good available. In computing marginal social costs, it is assumed
that output is produced at minimum possible cost, given available technology. If the marginal
social cost of bread is $1 per loaf, they would be made better off.
Figure (1.0) graphs the marginal social benefit (MSB) and Marginal Social Cost (MSC) of
making various quantities of bread available per month in a nation. Figure (1.1 ) shows the
total social benefit (TSB) and the total social costs (TSC) of producing the bread. The
marginal social benefit is given by TBS/Q. Similarly MSC = TSC/ Q
The efficient output of bread can be determined by comparing its marginal social benefit and
marginal social cost at various levels of monthly output.
B
C
A
D
TSC
TSB
TSB - TSC
Q1 Q* Q2
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Figure 1.1 The model of efficient allocation
In A, the efficient level of output Q* occurs, at point E. -At that output MSB = MSC. The
‘output Q* maximizes the difference between TSB and TSC as shown in B. Extension of
output to the level corresponding to equality of TSB and TSC would involve losses in net
benefits. Similarly, output level Q1 and Q2 are inefficient.
The marginal net benefit of a good is the difference between its MSB and its MSC. When
MNB (Marginal Net Benefits) are positive, additional gains from allocating more resources
to additional production of the good continue just up to the point at which the MSB = MSC.
If additional resources were allocated to produce more of the good beyond that point MSC
would exceed MSB. The marginal net benefit seen would be negative.
The marginal conditions for efficient resource allocation therefore require that resources be
allocated to the production of each good over each period so that MSB = MSC.
1.7 THE SIZE OF THE PUBLIC SECTOR
Since the government plays an important role in a mixed economy, the question we must ask
is what size of public sector will maximize social welfare. This question concern both
economic efficiency and equity. The approach of identifying the most efficient and equitable
size of the public sector is the principle of maximum social advantage
1.8 THE PRINCIPLES OF MAXIMUM SOCIAL ADVANTAGE
The principle is concerned with the level at which the government should operate which in
turn is determined by its activities.
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The purpose is to design the policy and operations of the government so as to achieve
maximum welfare for the economy.
Simplifying assumptions
i). All taxes drain away the economy’s resources.
ii). All public expenditures restore these resources of the economy
iii). Government revenue consists of only taxes and the government has no surplus or deficit
budgets.
iv). Public expenditure is subject to diminishing marginal social benefit and the taxes are
subject to increasing marginal social disability (cost).
This implies that the government expenditure will be first directed towards those uses which
are the most beneficial to the society and the taxes will drain away resources from those lines
where they are least useful.
As the government increases taxation and expenditure activities, the social benefit from each
additional shilling spent falls while the dissatisfaction from each additional shilling taxed
increases.
A state is reached at which the rising marginal dissatisfaction of taxation becomes equal to
the falling marginal social benefit of expenditure.
At this stage, the government should stop expanding its activities. It is no longer beneficial to
further expand the state activities because the social benefit of the marginal unit of public
revenue operations is no longer larger than the corresponding social dissatisfaction.
Smb of
B
Expenditure B
N
B1
0
M Amount of taxation
Smc of taxes D
N 1 and public expenditure
C
D1
Figure 1.2 Maximum social advantage
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Determination of optimum tax and expenditure activity of the state
Public expenditure and taxation are measured along the X – axis, and social benefit and cost
is measured along the Y – Axis.
The quantities measured along Y – Axis will be positive if measured above the X – Axis and
negative if measured below the X – Axis.
As a result, the curve showing the marginal social benefit from public expenditure will lie
above X- Axis and the curve showing Marginal disutility from taxation will lie below X –
Axis.
The curve BB1 show the marginal social benefit occurring to the society from different
amount of the public expenditure.
The curve DD1 shows the marginal social cost to the society from the taxation levied by the
state.
The difference between BB1 and DD1 indicates the net social benefit i.e. the excess of the
benefit over the cost to the society. This is depicted by the curve NN1
For example, when taxation is OM which is spend by the government, the marginal social
benefit and the marginal social cost (disutility) are equated i.e. MB = MC.
It is here that the state should stop expanding it activities. The net gained or maximum
possible social advantage to the society is equal to the area ONM. If the government stopped
its operation at less than OM, the society will be foregoing a possible gain.
If operations are expanded beyond OM, the total net benefit will again start falling.
LIMITATIONS
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1) It is necessary for the government to perform certain basic functions like protection and
security. The benefit from the very existence of the government activities will exceed the
cost of maintaining its activities. In fact without the basic functions of the government,
the very existences of the society cannot be guaranteed. Protection also adds to the
productive efficiency of the society.
2) No basis for a generalization that every tax is a burden upon the society and that every
government expenditure is a benefit for it. Example, a tax on consumption from harmful
drugs is not a burden upon the society. But a tax on health services will be.
Example II,
If the government undertakes the provision of social overheads and other public
utilities, it leads to the emergence of external economics. Through them, the cost of
production falls, efficiency in production increases and the economy benefits. The
benefits to the economy are actually more than it get.
3) Effects of the budget may spill over to the following periods. Hence appropriate time tags
and effect – spread should be considered.
4) If all taxes are harmful and all government expenditures are beneficial, then the best
course for the government is not to levy any taxes at all. Financing of its activities could
be through deficit financing only. However taxes or expenditures cannot create or destroy
resources. Only transfer of resources between private and public sectors takes place.
5) Non-tax revenues like fees, fines, profits from parastatals, printing press, and market
borrowing e.t.c. cannot be dismissed as unimportant.
6) Every state is committed to certain compulsory expenses. According to Adam Smith
(1776), these activities include maintenance of state itself, defense, maintenance of law
and order, imparting justice, servicing existing debts e.t.c.
7) It is not easy to identify and quantify the effect of state operations. For example; indirect
taxation changes the relative prices of the commodities been taxed. This changes demand,
consumption, production and investment pattern. Hence the welfare and growth effect of
government activities cannot be linked with the amount of taxation and expenditure only.
8) It is unrealistic to assume a balanced budget. In developing countries, deliberate deficit
budgeting may be needed to stimulate saving and capital accumulation.
9) The optimum level of government activities determination is done aggregative. Other
factors such as income inequalities, regional imbalances are not considered yet they are
very important.
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1.9 MEASURING THE SIZE OF PUBLIC SECTORS
1. Share of government expenditure in Gross Domestic Product. This is given by the ratio of
total government expenditure in G.D.P
Thus SPS = Total Government Expenditure
Gross Domestic Product
= G
GDP
The ratio shows the share of total output which is purchased by the government.
However the government expenditure should not include transfer payments.
2. The share of total tax revenue in GDP. This is given by the ratio of tax revenue to GDP. It
measures the countries tax effort or the share of gross income which is diverted from the
private income stream into the public budget.
SPS = Tax Revenue = TR
GDP GDP
This ratio is below the government expenditure ratio if there was a budget deficit
(T<G). However incase of budget surplus (T>G) the ratio is above the government
expenditure ratio. Thus if
i). T < G, TR < G
GDP GDP
ii). T > G, TR > G
GDP GDP
iii). T = G, TR = G
GDP GDP
This ratio is most convenient for global consumption of public sectors
3. The share of government contribution in National Income. National income measures the
sum total of factor incomes (W,r,R,II), earned during a given period. Hence to measure
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the size of the public sector we get the proportion of factor incomes that originated from
the government economic activities
SPS = Total Factor Earning in Government
National Income
4. The share of government contribution in personal income. Personal income include
incomes received by household and contains three government components;
i). transfer payments (RF)
ii). Wages and salaries earnings from public employment (w)
iii). Interest receipt (r)
This represents the government contribution to the personal income

SPS = Total Government Contribution to Personal Income
Personal Income
= W + RF + R
PI
1.10 SUMMARY
This lecture has given the various measurements of public sector. It has also explained the
principle of maximum social benefit. It pointed out the various needs of the public sector.
The lecture also discussed in details the model of efficient allocation of resources
1.10 ACTIVITIES
1. Explain the rationale of public sector in the economy.

2. Distinguse between merit and demerit goods..
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1.12 FURTHER READING
A. Asimakopulos, Economic Theory, Welfare and the State (London:Macmillan, 1990).

C.V. Brown and P.M. Jacson, Public Sector Economics (Oxford:Basil Blackwell, 1992).
PUBLIC POLICY OBJECTIVES (BUDGETARY OBJECTIVES)

LECTURE TWO
2.1 INTRODUCTION
Lecture two will look at the public policy and fiscal policy instruments that are used to
achieve the budgetary objectives.
At the end of the lecture you should be able to:

a) Explain the four budgetary policies of the government
b) Discuss the coordination and conflict of the objectives
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There are 3 major functions of budgetary policy:
2.3 THE ALLOCATION FUNCTION
1) Allocation function: It is a process whereby social goods are provided, or the process
by which total resource use is divided between private and social goods. The
government provided such social goods as security, healthcare, education, recreational
services (parks), road etc.
To understand this clearly we classify goods into 2 categories;
Social goods Private goods
1. The need for social goods is felt 1. The need for private goods is felt
collectively individual.
2. The benefits derived from social goods 2. The benefits derived from private goods
are not limited to one particular are limited to one particular consumer
consumer who purchases the good, but who purchases the goods (e.g.
becomes available to others as well. humbugger, shoes)
(Reduction of air pollution benefits all).
[No. ownership right]
3. Social goods cannot be provided 3. Provide goods are efficiently provided
through price mechanism through market mechanism. The
market furnishes a signaling system
whereby producers are guided by
consumer demands.
4. For social good it would be inefficient 4. Nothing is lost and much is gained
to exclude any one consumer when consumers are excluded unless
particularly in the benefits, when such they pay. Application of the exclusion
participation would not reduce principle tends to be an efficient
consumption by anyone else. solution.
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Application of exclusion principle is
impossible and prohibitively expensive.
5. Social goods do not carry a high rate of 5. Private goods carry high rates of return
return on investment. on investment.
In conclusion: It can be noted that no price could be put on a social good because of the
non-rival ness in consumption. As a result of this, to venture into production of social good it
is highly unprofitable and may not attract private investors. Because of non-rival ness in
consumption, there is market failure. Since the benefits of such goods are not limited to
individuals, beneficiaries may not voluntarily offer payments to the supplier of such goods. It
is as a result of this that the government normally taxes all citizens irrespectively so that it
could provide for such goods.
2.4 Public provision of social goods
Just like in the provision of private goods and services there must be consumer preference
before social goods and services are provided. But because so far social goods and service is
collective from the society as a whole, it is very hard to know the nature of the society
preference map. It would be very difficult to seek individual opinion from every citizen on
type and quantity of a social good that should be provided. It would also be difficult to
decide how much each individual should pay for the product. One may argue that consumers
pay based on benefit principle, as in the case of private goods, but then the problem would be,
how such benefits would be determined. Just as consumers are unwilling to voluntarily pay
for social goods it would be difficult to make them reveal accurately how much benefits they
are deriving from such goods.
The question then remains how best public goods could be provided. A different technique
other than market mechanism is needed by which the supply of social goods and the cost
allocation thereof can be determined.
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This is where the political process enters the picture and must substitute market mechanism.
Voting by ballot must be resorted to in place of shillings voting. Since voters know that they
will be subject to the voting decision (be it simple majority or some other voting rule e.g.
through their elected MPs, councilors representatives), they will find it in their interest to vote
so as to let the outcome fall closer to their own preferences. Thus decision making by voting
becomes a substitute for preference revelation through the market. The result will not please
everyone but they will approximately more or less perfectly, depending on the efficiency of
the voting process.
The different set of provision for and production for social goods
2) When the government either directly or through government owned palastatals e.g.
post office, sugar factory, water supply plants etc. or by assigning private producers to
produce goods through tenders, we say that the government has provided the goods.
If we say that social goods are provided publicly, we mean that they are financed publicly, we
mean that they are financed through the budget and made available free of direct charge.
How they are produced does not matter.
The distribution function

This is a process through which the government redistributes income and wealth among
citizens. In the absence of government intervention in the distribution of income and wealth,
the distribution depends first of all on the distribution of factor endowments. It is important
to note that people’s earning ability differ, ownership of properties also differ. The
distribution of income, based on this distribution of factor endowments, is then determined by
the process of factor pricing, which, in a competitive market, sets factor returns equal to the
value of the marginal product. The distribution of income among individuals thus depends on
their factor supplies and the prices which they fetch in the market. In most countries where
free market policies are followed there tends to a rise a class of society where few become
richer and majority poorer. Because this does not fall in line with what is considered to be
just and fair, the government must employ mechanisms and policies to redistribute wealth
and income.
Fiscal instruments of distribution policy

Redistribution is implemented most directly by taking the following action:
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a) Employ a tax transfer scheme. Here a vertically progressive tax system is used to
collect more taxes on income of high income households and using the money to
subsidize low income households.
b) Employ a progressive tax system to finance public services such as medical,
education, water etc.
c) Employ a sales tax: Taxes are collected on goods and services used by high income
classes and funds raised are used to subsidize goods used by low income classes.
The stabilization function

Here macro-economic policies are employed to maintain and achieve the goals of high
employment, acceptable price stability, favourable balance of payment position, acceptable
rate of economic growth and development.
Economic policies are necessary because high rates of employment and low rate of inflation
do not come up automatically in a free market economy. In fact changes in inflation rate are
inversely related to rate of unemployment as can be shown in the following diagram.
Phillip Curve shows the trade-off

Inflation between unemployment and inflation.
To achieve low unemployment level,
we have to be ready to suffer high
inflation rate.
10%
6%
Phillip’s curve
0 4% 12% Unemployment
Figure 2.1 Relationship between inflation and unemployment

From the diagram it is clear that countries cannot attain zero level of inflation and
unemployment at anytime. There will always be a combination of the two that would be
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favourable at one time. When inflation rate is high, rate of unemployment is low and vice-
versa.
 This calls for well planned policy actions to achieve an acceptable level at inflation
and unemployment.
 At times there may be high level of inflation and employment meaning that Phillip’s
has shifted to the right.
Reasons:-
(i) Increased size of labour force due to population growth.
(ii) Low rate of manpower utilization high level of unemployment.
(iii) Low rate of economic growth. Low economic growth implies that when supply is
less than the demand the prices go up hence unemployment.
(iv) Lack of technological know-how – low output.
Therefore economic policy is essential for strong economic growth and development. The
level of employment and prices in an economic depends on level of aggregated demand and
level of output valued at prevailing prices. i.e. Employment = f (Output, expenditure).
 Aggregate demand is also a function of the spending decisions of many consumers,

corporate managers, many financial investors etc.
 The decision of this people in turn depends on:-
a) Past and present levels of income and expected level of future incomes.
b) Level of wealth in a country and its distribution.
c) Credit availability.
d) Future expectations.
2.5 Instruments of stabilization policy
a) Recession period
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For any given period the level of expenditure or aggregate demand may not be sufficient to
secure full employment of labour and other factors of production. When this happens
expansionary economic policies must be made to stimulate the economy e.g. increase
government expenditure and reduce taxes. The supply of more money for use in demand
increases production (output) hence rise in employment.
b) Boom period
When aggregate demand is greater than aggregate supply (level of output) employment level
is high in boom period and inflationary pressure is also high.
When this happens, restrictive economic policies must be employed. Reduce in government
expenditure & increase in taxation leads to a decrease in purchasing power resulting in fall in
effective aggregate demand.
2.6 CO-ORDINATION OR CONFLICT OF FUNCTIONS
In order to provide a good co-ordination of the functions there must be a good management
of the economy. When they are not properly co-ordinate there will be conflicts among them.
Proper co-ordination calls for good policy targeting during the planning and implementation
process.
For example, those who are concerned with planning distribution will design a tax transfer
plan to secure the desired distribution. Similarly, those who are in charge of allocation in
terms of public expenditure must ensure that the funds allocated from the taxes are used to
finance projects with consumer evaluations thereof.
Those who are in charge of policy formulation to stabilize and to stimulate the economy must
ensure that they achieve full employment and economic growth. When all functions are in
balance we say that the budget is balanced.
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However, this balance may not be sufficient to provide for or sustain the required economic
growth and development. So the government will result to other sources of funds other than
taxation e.g. externally or internally. In real world situation such a perfect co-ordination may
not be realizable. The achievement of one objective (e.g. provision of social goods) is
achievable at the expense of the other e.g. (price stability).
1.3.1 Conflict of interest

i) Conflict between allocation and distribution
Taxes are normally imposed so as to redistribute income and wealth and raise funds
for government to provide social good. In order to affect this, a vertical progressive
tax to collect more from the rich and less from the poor is imposed.
But if you looks at less developed countries budget is low and majority of earners are
in lower and middle income classes, hence causing conflicts between allocation and
distribution function.
ii) Conflict between distribution and stabilization function:-

Stabilization functions are used to stabilize the economy. When there is need to
stimulate the economy (time of recession) taxes on lower income groups should be
reduced, since their marginal propensity to consume is higher than that of the rich.
This would lead to increased disposable income, demand, output produced and thus
employment.
The opposite course has been made in times of inflation, namely that taxes on low-
income groups should be raised, since they are more potent in reducing demand than
taxes on higher income. Another reason would be, by taxing the rich a lower rate;
they would be motivated to save more because their MPS are high. Conflicts arises in
such as approach because the distribution function of budgetary policy does not
achieve the aims of deducting more from the rich and less from the poor.
iii) Conflict between distribution and growth and economy

Objective of the budget is to attain high growth rate in economy. This would only be
achieved if capital formation, savings and investments are increased. This would
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mean withdrawing more from poor and less from rich. This is because people with
higher propensity to save are high income people. Conflict arises between
distribution and growth. The aim of distribution function is to deduct more from the
rich and less from the poor, which is the opposite of the goal of high growth rate.
2.7 SUMMARY
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4
5
6
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The lecture has discussed in details the four policy objectives of the government .It has also
exposed the co-ordination and the possible conflict between objectives.
2.8 ACTIVITIES
1. What are the budgetary policy objectives of the government?

2. What is a balanced budget
3. What policy instruments that are used during stabilization.
2.9 FURTHER READING
C.V. Brown and P.M. Jacson, Public Sector Economics (Oxford:Basil Blackwell, 1992)
R.A. Musgrave and P.B. Musgrave, Public Finance in Theory and Practice (Ney York:
McGraw-Hill,1989).
C.T. Sandford, The Economics of Public Finance (Oxford: Pergamon Press, 1992).
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PUBLIC GOODS
LECTURE THREE
3.1 INTRODUCTION
The lecture will introduce the concept of public goods. It will also show clearly the
distinction between public and private goods. It will also discuss the properties of public
goods
At the end of this lecture you should be able to:

a) Explain the two properties of public goods
b) Distinguish the private and public goods
c) Explain the various categories of goods and explain their
characteristics
We now need to consider how the characteristic of pure public goods relate to the concept of
market failure. There are some goods that either will not be supplied by the market or if
supplied would be supplied in insufficient quality e.g. defense, street lighting etc. These are
called public goods. If a pure public good is to be available for consumption then it must be
provided collectively either through private voluntary arrangements or public via the budget.
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3.3 PROPERTIES OF PURE PUBLIC GOODS
Pure public goods have two properties

(1) Non-excludability
(2) Non-rival in consumption.
Non-excludability characteristics of public goods
In the case of pure private good a set of property rights define the ownership of the good.
The individual who possess the property right has the sole claim to enjoy the benefits of the
good and can therefore exclude others from doing so. In the case of a pure public good
technical feature of excludability begin to breakdown. First, it is generally difficult to exclude
individuals from enjoyment of public good. If for example a geographical area is provided
with defense services which diverts and attack from abroad it becomes extremely difficult to
exclude anyone who lives in the country from being defended. Similar example is found in
street lighting.
For pure public good the degree of exclusion depends upon the technical characteristics of the
good and the resources available to the producer to enforce the exclusion. In general,
however, there is no perfect exclusion. So an optimal amount of exclusion is a decision to be
made by a producer.
Second reason why the exclusion principle breakdowns is that, while it may be technically
feasible to exclude, the application of exclusion device may be very expensive. That is, the
cost of exclusion can outweigh any advantages to be obtained from its application. A pure
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public good is the one for which exclusion is either technically not feasible and if feasible,
the cost of enforcing the exclusive device is too prohibitive to apply.
With non-excludability, there is no incentive for a profit maximizing producer to supply the
public good because once he produces it he cannot exclude individuals from consuming it
and hence he is unable to charge a price. Individuals wishing to consume the benefits of a
pure public good could, however, form a private co-operative. They could agree to contribute
to the cost of supplying the public good. Such an arrangement might be feasible for a small
group of individuals, but as the group grows in size the possibility of individuals becoming
free riders increases and the private voluntarily arrangement fails.
Non-rivalness in consumption
Definition of a pure public good implies that it is non-rival in consumption. It means that it
does not cost anything for an additional individual to enjoy the benefit of public goods.
Non-rivalness arises from the indivisibility of public goods. That is, adding one or more
persons (up to a capacity constraint) does not add to the marginal cost. Formally there is zero
marginal cost for an additional individual to enjoy a good. Non-rivalness thus implies, one
individual access to the commodity does not reduce another individual’s benefit because
these benefits are available to all without interference.
A perfect solution in this case would require a zero price because marginal cost equals zero.
This will mean that revenues will not cover losses and so a private profit maximizing
producer will not supply such a commodity.
The market, in other words, will not allocate such goods efficiently thus the market failure.
Therefore goods can be classified into four cases according to their consumption and
excludability characteristic.
Exclusion
Consumption Feasible Not Feasible
Rival 1 2
Non-Rival 3 4
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Characteristic
Case 1
This is a private good that is rival in consumption and excludable e.g. a loaf of bread,
clothing. You only consume the goods after paying for it. Whoever does not pay is excluded.
Benefits are internalized.
Case 2
This represents a good that is rival in consumption but non-excludable. In this case there is
market failure due to non-excludability or high cost of exclusion. Example, travel on a
crowded street, traffic jam due rush hours.
Case 3
This is a good that is non-rival in consumption but excludable. Examples are clubs, watching
a movie, swimming, education, crossing a bridge that is not crowded.
Case 4
This is a good that is non-rival in consumption and non-excludable. This is a pure public
good. Examples are, air purification, national defense, street lights e.t.c.
Comparison between efficient provision of public goods and private goods

In chapter 2 we noted that one goal of the public sector or government was to ensure the
efficient allocation of both public and private goods. It was pointed out that some goods and
services had to be supplied by the public sector, since it would be difficult, if not impossible,
to have them supplied by the private sector in a market economy.
In this section we shall derived the conditions for efficient provision of a public good, and
Price of DA + Bthe approach
SOCIAL
then compare them with those of private good. To achieve DB this objective of GOODS
Price of PRIVATE GOODS Social
Bowen
Private DBmodel shall be used. goods
goods DA
E MC = S
P1
E
P2 MC = S
H
DA + B
V
J
DB 29 DB
DA DA
O F G H Quantity of O Z Z1 Quantity of
Private goods Social goods
Figure 3.1 Efficient allocations of private and public goods
In order to explain the foundations of this model, we assume that there are two individuals, A
and B each having a conventional downward sloping demand curve for some public goods.
That is, if the public goods could be sold in units at a price, each individual would demand
more as the price is reduced. These two demand curves are shown as DA and DB in the right
side of figure 3.1. Drawing such demand curves is based on the unrealistic assumption that
consumers volunteer their preferences, and such curves have therefore been referred to as
“Pseudo-demand curves”.
In the earlier discussion we defined public good as one which once produced, is consumed
equally by all. Thus no one person can vary the quantity to be taken. This being the case, to
derive the total demand for public good, the demand curves are added vertically, not
horizontally, as would be the case for a private good.
Suppose a quantity OZ of the public good is made available to A. It is also made available in
the same quantity to B. What we want to know is how much would A and B, together, be
willing to pay for OZ of the public good. To get this add Zs (what individual A is willing to
pay for Oz) and ZH (what individual B is willing to pay for OZ) to obtain ZE. This is done
for each and every amount of the public good, giving us the total demand curve DA + DB.
This tells us how much A and B, together, would be willing to pay for various amounts of the
pure public good.
It should be noted that for each amount of public good supplied, individual B is willing to pay
more than individual A for that amount.
Since it takes resources to produce the public good, we introduce for convenience a constant
marginal cost (supply schedule) in our diagram, and from its intersection with the total
demand curve, obtain the equilibrium quantity and price, in this case OP1 and OZ. NB:
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MBA +MBB =P ∑MBi = p where MBA is the marginal benefit of person A, MBB is the
marginal, benefit of person B and P is the price.
Thus we see that the sum of the marginal evaluation by each person for the public good
equals the prices, which equals marginal cost, thereby meeting the conditions of optimal
pricing, that is, that price equal marginal cost.
In the case of private goods as can be depicted in the left side of figure 3.1, in a perfectly
competitive market situation, prices are fixed (market determined) and the consumers would
only vary amount they consume. So the total demand curve for private good (DA + DB) is
obtained by horizontal addition of DA and DB. That is, adding the quantities which A and B
purchase at any given price. Given the supply schedule, the equilibrium is determined at E,
the intersection of market demand and supply.
Prices equals OP2 and output OH, with OF purchased by A and OG by, B, where OF + OG =
OH.
In a perfectly competitive market, equilibrium requires that the price of a good be equal to
each consumer’s marginal evaluation, which in turn is equal to marginal cost.
The consumer theoretically adjusts his purchase to achieve this, since he faces a fixed price.
In the public goods, case, the price does not equal each consumer’s marginal evaluation and
the consumer cannot vary his purchase to achieve this.
For a non-excludable public good, however, there may be incentives for people to hide their
true preferences. Individual A may falsely claim that the public good means nothing to him.
If he can get individual B to foot the entire bill, he can still enjoy the benefits from the public
goods and yet have more money to spend on private goods. In the figure presented above, at
output OZ1, individual B meets the entire Price (Z, V). This incentive to let other people pay
while you enjoy the benefits is known as the free rider problem. Hence, there is a good
chance that the market will fall short of providing the efficient amount of the public goods.
No automatic tendency exists for markets to reach the efficient allocation.
Even if consumption is excludable, market provision of a public good is likely to be

inefficient. Recall the fact that efficiency requires that price equal marginal cost. Because a
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public good is non rival in consumption by definition, the marginal cost of providing it to
another person is zero. Hence efficiency requires a price of zero. But if the entrepreneur
charges everyone a price of zero, then we cannot stay in business.
Is there a way out? Suppose that the following two conditions hold:-
(i) The entrepreneur knows each person’s demand curve for the public good and
(ii) It is difficult or impossible to transfer the good from one person to another.
Under these two conditions, the entrepreneur could charge each person an individual price
based on willingness to pay a procedure known as perfect price discrimination. From our
example, because individual B values the public good most, he would pay a higher price and
thus the entrepreneur would still be able to stay in business.
Perfect price discrimination may seem to be the solution until we recall that the first
condition requires knowledge of everybody’s preference. But of course, if individuals’
demand curves were known, there would be no problem in determining the optimum
provision of public good as was earlier demonstrated.
3.4 SUMMARY
The lecture has discussed the properties of public goods. It has also shown clearly the
distinction between public and private goods. It has also shown diagrammatically the
horizontal
3.5 summation of private goods and the vertical summation of the public goods
ACTIVITIES
3.5 ACTIVITY
1. What is a free-rider problem?

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2. Explain in details the characteristics of pure public good.
3. Explain the terms excludability and non rival consumption.
3.6 FURTHER READING
McGraw-Hill,1989).
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MARKET FAILURES AND THE RATIONALE FOR GOVERNMENT
INTERVENTION
LECTURE FOUR
4.1 INTRODUCTION
The lecture introduces the rationale of government in the goods market. It discusses the
causes of market failure and their correction. More emphasis are given to the externalities as
a source of market failure.

a) Explain the justification of government intervention in the goods market
b) Explain the various sources of market failure
c) Explain how externality interferes with efficient allocation of goods
d) Explain the three types of externalities
Where the market is efficient, consumers have freedom to choose what they want to consume
freely, and they reveal their preferences to producers. Producers, in trying to maximize their
profits will produce what consumers want to buy and will do so at least cost. Competition
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will not only ensure that the mix of goods and services produced corresponds to consumers
preferences, but would ensure that resources are allocated efficiently. The main assumption
here is markets are efficient and competitive.
Under normal circumstances, however, this may not be the case. Market may fail to achieve
an efficient allocation of resources, leaving open the possibilities that government provision
of certain commodities might enhance efficiency. Therefore market failure refers to those
situations in which the conditions necessary to achieve the market efficient solution fail to
exist or are contravened in one way or another. The proposition is therefore that the market
system of economy is unlikely to operate efficiently. In fact there is a tendency for it to
produce too much of some goods and an insufficient amount of others. In extreme cases,
certain goods will not be produced at all.
Given the presence of market failure, one possible role for government would be to intervene
in allocation function of the market to correct the market failure or introduce policies that
would compensate its effect. This gives rise to the allocation function of the government.
Market failure will also bring about the question of equity of social justice in the distribution
of income and welfare where market failure produces a socially unjust distribution of welfare.
Government intervenes to bring about a distribution that is considered to be socially just and
fair. This is referred to as distributional role of government.
Market failures could also produce macro-economic instability such as inflation,

unemployment, BOP disequilibrium, etc. In these circumstances, a stabilization role exist for
government to intervene in the economy using monetary and fiscal policies to bring about
desired level of inflation and unemployment, thereby improving the welfare of society.
Further, there is a regulative function which government performs. As part of its allocation
role government enact and enforce laws of contracts. It also administers the more general
system of laws, order and justice which regulates individuals or firms behaviors and ensures
that market activities and private exchanges take place smoothly.
Thus market failure permit four functions of the government.
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Certain conditions exist under which the market will fail to be efficient. The conditions
include:-
(i) Imperfect competition
(ii) Costly information
(iii) Public goods
(iv) Externalities.
4.3 IMPERFECT COMPETITION AS A CAUSE OF MARKET FAILURE
When some agents have the ability to affect price, the allocation of resources generally is
inefficient. An extreme form of such market power is monopoly, which comprises of one
seller in the market for a given commodity. Conditions that bring about monopoly includes:-
 Where transportation costs are large the relevant market may be limited geographically if
there is only one firm in such a locality. There may be no or very limited competition.
 In case where cost of production per unit of output declines (decreasing cost of
production or increasing returns to scale) entry into industry becomes very difficult,
thereby permitting the firms already established to exercise natural monopoly.
 Some monopolies are created by the government or run by the government. The Kenyan
government, for example, has given the Kenya Power and Lighting Company the
exclusive right to generate and distribute electricity in the country. Patent rights given to
some investors grant them monopoly over their invention over specified period of time.
In some instances it is more efficient to have one or a few firms’ producing rather than many.
This applies where the initial cost of production is high and where the production of the
commodity cannot be subdivided into small units, e.g. the production of electricity. Such
subdivision would be inefficient and uneconomical.
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If monopoly has some possible aspects then why is it generally viewed as bad? The reason is
that, if not regulated and if allowed to trade freely, they would restrict output to attain higher
prices.
Mechanism of how they would restrict output to raise prices:

Price
PANEL A
- Demand
C Marginal cost
P (average cost)
A
AR
0 Qx Q1 Output
MR
Price
PANEL B
- Demand
A F
Average cost
G C
Marginal cost
Qx Q1 Q2 Out put
MR
Figure 4.1 Monopoly market structure

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In panel A of figure 4.1, assume that the marginal cost (MC) of production is constant at all
levels of output. Because the monopolistic seek to maximize profit, he will produce output
OQ*, where price equal marginal cost. Clearly O Q* <OQ, and also notice that at OQ*, price
which measures how much individuals value an extra unit of the goods exceed the marginal
cost implying a welfare loss from restriction of output by the monopolist. This establishes a
case for government intervention to ensure an efficient allocation of resources.
In panel B of figure 4.1, we assume that marginal cost of production falls as output is
expanded. That is, there is an increasing return to scale (a decreasing average cost curve).
Since AC>MC at any level of output, a price set to equal MC at Q2 would cause the
monopolist to incur a loss. Q1 is the highest output at which the firm breaks even since at that
output AC=P. A perfect competitive firm would produce at Q2 since P=MC at that output
level. A monopolist on the other hand will restrict output to C Q*. Again there is a welfare
loss arising from this restriction.
The problem of increasing returns to scale establishes a case for government intervention to
ensure an efficient allocation of resources. In situation, as depicted in the figure, the
government could instruct the monopoly firm to charge a price which equals the marginal
cost, subsidizing the loss out of tax revenue. This is a classic example of regulation of
increasing return to scale industries.
Alternatively the government could take over the entire production operation i.e. through
nationalization, produce output Q2 and charge a marginal cost price again subsidizing the
loss from a general taxation.
At this point we should recognize the importance of the way losses made by decreasing cost
industry using marginal cost pricing are financed. They are financed from taxation but most
taxes influence relative price. They introduce a distortion and thus create additional
inefficiencies. Ideal lump-sum taxes, which leave relative prices unchanged should be used.
However, lump sum taxes are generally not available and so other taxes must be used in
practice.
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The design of optimal government policy is therefore one of the weighing out the distortions
and inefficiencies introduced by interventions, compared with the inefficiencies that the
policies are designed to reduce.
4.4 COSTLY INFORMATION
The competitive model assumes that information on existing prices is somehow spread
around at no cost, so that everyone can find the best price. In reality, this is not the case.
Shopping around to find the lowest price requires time which is a valuable commodity.
Moreover, once information is obtained, it may be imperfect. Thus, it is possible that because
individuals do not have the necessary information to make the right economic decision,
inefficient patterns of resource allocation emerge.
4.5 EXTERNALITIES AS A CAUSE OF MARKET FAILURE
Musgrove and Musgrave define externality as, ‘a situation where the benefit of consumption
of a given good or service cannot be paid by producer who causes them to result into external
costs to others.
For example, a particular technology used in the production of a private good produces
smoke as a by-product (i.e. the externality of spill-over) which is involuntarily consumed by
people living near the factory, thus lowering their utility. Despite the producer causing
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pollution, he does not include such external costs as eradicating air pollution in his
production costs. So that, his private costs (costs of living inputs) is less than the overall
social cost (private costs and external costs). This external diseconomy will result in the
overall production of the good associated with the diseconomy, and the allocations would
differ from those that would have been produced by perfectly competitive markets. The
existence of externalities results in outcomes that are not efficient.
An Externality is something that, while it does not monetarily affect the producer of a good, it
does influence the standard of living of society as a whole. They can also be referred to as
those conditions where the forces of the market cannot secure, optimal results," and to public
goods as a condition "where the market mechanism fails altogether."
In the presence of externalities and public goods competitive market equilibrium cannot be
expected to yield socially efficient resource allocations. This is due to "special"
characteristics of externalities and public goods called "non-excludability" and/market
thinness," or what is more commonly called the "free rider problem."
The tree rider problem exits when people enjoy the benefits of government provided goods
i.e. public goods, independent of whether they pay for them. Free riders are actors who take
more than their fair share of the benefits or do not shoulder their fair share of the costs of
their use of resource. The actual "Free rider problem" can therefore be defined as the question
of how to prevent free riding from taking place or at least limit its effect. Since the notion of
"fairness" is highly subjective, free riding is only considered/to be an economic problem
when it leads to under or non-production of a public good thus Pareto inefficiency. An
example of a public good subject to this is national defense-one is protected whether or not he
pays for the services rendered.
Forms of Externalities:
There are two forms of externalities:
(i) Positive Externalities
(ii) Negative Externalities
(iii) Fiscal Externalities
(i) Positive Externalities:

40
A positive externality is something that benefits society, but in such a way that the producer
cannot fully profit from the gains made. A few examples of positive externalities are
environmental clean-up and research. A cleaner environment certainly benefits society, but
does not increase profits for the company responsible for it. Likewise, research and new
technological developments create gains on which the company responsible for them cannot
fully capitalize.
(ii) Negative Externalities:
A negative externality is something that costs the producer nothing, but is costly to society in
general. Unfortunately these externalities are much more common. Let's take an example of
pollution. This is a very common negative externality. A company that pollutes loses no
money in doing so, but society must pay heavily to take care of the problem pollution caused.
The problem this creates is that companies do not fully measure the economic costs of their
actions. They do not have to subtract these costs from their revenues; hence profits
inaccurately portray the company's actions as positive. This can lead to inefficiency in the
allocation of resources.
(iii) Fiscal Externalities:
This is whereby the behavior of people affects the cost of some subsidy or alters the revenues
from some tax as externalities. Fiscal externalities do not necessarily imply any inefficiency,
and when there is inefficiency, it is the result of the pre-existing policy. An example is
smoking; this imposes costs on taxpayers due to the existence of subsidized medical care. In
this case the medical care subsidy creates the fiscal externality.
However, when there is inefficiency, the nature and magnitude of the fiscal externality is not
a reliable guide to the appropriate corrective policy. Like in the above example, it will usually
be best to modify the pre-existing policy (the medical care subsidy) rather than tax smoking.
Implications of Externalities for allocation efficiency:

The prevalence of externalities in the market based economy suggests that the optimality
rules normally assumed to lead to allocation efficiency may not in fact lead to the most
socially efficient outcome. The presence, of externalities thus represents an example of
market failure to achieve allocation efficiency. This is because in the presence of externalities
the market price of a good may not reflect the true societal cost or benefit and hence may be
under or over produced. Figure 4.2 illustrate the implication of negative externalities for
allocation efficiency.
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Dollars SMC = (PMC + d)
per year
S (PMC)
P*
Pm D
d
X* Xp Tons of output per year

Figure 4.2: Effects of Negative Externality on allocative efficiency
In a free market where the optimality rules have been followed the quantity produced will
occur at quantity Xp and price Pm, the point where demand (D) equals the private marginal
cost (PMC). However where a negative externality exists the market fails to produce the
socially optimal level of production. This is because the marginal damage (d), generated by
the negative externality, is a cost not taken in to account in the market. When a social
marginal cost (SMC) curve is generated it is possible to see that socially optimal level of
production is in fat X* and that the product should be sold at a higher price P* to reflect the
fact that the true social cost of the product is higher than the private cost.
Positive externalities also have their own special implications for the achievement of
allocation efficiency. Figure 4.3 illustrates the implications for the optimality rules of a
positive externality. The market equilibrium in this situation occurs at quantity' Q* and price
Pm where the private marginal benefit (PMB) of the item equals its marginal cost. However
this item produces an external benefit (b) which is not taken in to account by the market. The
socially optimal quantity of this item actually occurs where the social marginal benefit
(SMB) curve derived by summing the private marginal benefit and the external benefit,
equals the marginal cost of producing the item. This analysis suggests that the allocativion
efficient situation
Dollarsoccurs
Per at quantity Q* and price p*.
year MC
P*
Pm b
SMB (PMB + b)
PMB
42
QP Q* Units of outputs per year

Figure 4.3: Effect of positive externality
The conclusion which can be drawn from this is that true allocation efficiency will not be
achieved unless the external benefits and costs associated with externalities are taken in to
account when making economic analysis.
4.6 SOLUTIONS TO EXTERNALITIES:
PUBLIC RESPONSES TO EXTERNALITIES: TAXES AND SUBSIDIES
(1) TAXES
A natural solution suggested by the British economist A.C. Pigeon is to levy a tax on each
unit of a polluter’s output in an amount just equal to the marginal damage it inflicts at the
efficient level of output. This tax is called Pigouvian tax.
Price and MSC = MPC + MD
Costs
(Mpc + cd)
d MPC
PS
MD
J C
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V
MB
0 QS Marketable Output
Figure 4.4. Use of Tax in correcting External Diseconomy
In this case the marginal damage done at the efficient output Qs is distance cd. This is the
Pigouvian tax. Remember that the vertical distance between MSC and MPC is MD (i.e. cd).
The tax raises the firms marginal cost. For each unit the firm produces it has to make
payments both to the suppliers of his inputs (measured by MPC) and to the tax collector
(measured by cd). Geometrically the firm’s new marginal cost schedule is found by adding cd
to MPC at each level of output. This is done by shifting up MPC by a vertical distance equal
to cd.
Profit maximization requires that the firm produce up to the output at which marginal benefit
equals marginal cost. This now occurs at the intersection of MB and MPC+cd which is at the
efficient output Qs. In effect the tax forces the firm to take into account the costs of the
externality that it generates and hence induces him to produce efficiently.
Note that the tax generates revenue cd dollars for each of the unit which is produced (psd =
OQs). Hence tax revenue is cdxpsd, which is equal to the area of rectangle psjcd.
WEAKNESS OF PIGOUVIAS TAX

(i) There are practical problems in implementing a pigouvias tax scheme. In light of the
difficulties in estimating the marginal damage function, it is found to be hard to find the
correct tax rate.
(ii) Still sensible compromises can be made. Suppose that a certain type of automobile
produces poisonous fumes. In theory a tax based on the number of miles driven enhances
efficiency. But a tax based on mileage might be so cumbersome to administer as to be
infeasible.
(iii) The government might instead consider levying a special sales tax on the car even
though it is not ownership of the car per se that determines the size of the externality but
the amount it is driven. The sales tax would not lead to the most efficient possible result,
but it still might lead to a substantial improvement over the status quo.
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(iv)Another weakness is that the tax approach assumes that it is known who is doing the
polluting and in what quantities. In many case these questions are very hard to answer.
(2) AUCTION POLLUTION PERMITS

Another method of achieving Qs is to sell producers permits to pollute. The government
announces that it will sell permits to dumps into the river the amount of garbage associated
with output Qs. Firms bid for the right to own these permissions to pollute and the
permissions go to the firms with the highest bids. The fee charged is that which “clears the
market” because the amount of [pollution equals the level set by the government.
In the simple model the pollution permits and the pigouvial tax are identical. Both achieve the
efficient level of pollution. Implementing both requires knowledge of who is polluting and in
what quantities. Baumal and Oates [1979, p.251] argue that pollution permits have some
advantages over the tax scheme from a practical point of view. One of the most important is
that the permit schemes reduce uncertainty about the ultimate level of pollution. If the
government is certain about the shapes of the marginal private cost and marginal benefit
schedules of figure 4.4 it can safely predict how a Pigouvian tax will affect behaviour. But if
there is poor information about these schedules it is hard to know for sure how much a
particular tax will reduce pollution. If lack of information forces policy makers to choose the
pollution standard arbitrarily with a system of permits, there is more certainty that this level
will be obtained. In addition under the assumption that firms are profit-minimizes, they will
find the cost minimizing technology to attain the standard.
Moreover when the economy is experiencing inflation the market price of pollution rights
would be expected to keep pace automatically, while charging the tax rate could require a
lengthy administrative procedure.
One possible problem with the auctioning scheme is that large firms might be able to buy up
pollution licenses in excess of the firms cost minimizing requirements to deter other firms
from entering the market.
(3) REGULATION
Under regulation each polluter is told to reduce pollution by a contain amount or else face
legal sanctions.
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In case of pollution 2 classes of regulation (control) can be distinguished.
(a) Direct regulation
(b) Input regulation
The direct regulations involve the setting up of critical level of pollution and monitoring the
level of pollution of the firms and prosecute firms that exceed critical level. Input regulation
on the other hand, involves regulating the production process.
When it is feasible to control level of pollution it seems preferable to apply input regulation.
The reason is that the firm is likely to know better than the government in terms of best way
of reducing the pollution. Most government relies heavily on input regulation since in most
cases it is easier to monitor inputs than to measure level of pollution.
4.7 PRIVATE SOLUTION
i) Internalize Externalities:
Economists recognize that negative externalities are a major problem. To combat this
problem, the government might try to force companies to internalize externality' costs. In any
type of production and economy, some negative externalities of production are inevitable.
The real problem created by negative externalities in the free-market economy is that because
they are not a cost to the company, the company will see only what is profitable to itself, not
to society as a whole; this will create inefficiency in the economy. The famous economist
Milton Friedman says that the government should require companies to pay for the costs of
cleaning up the problems they create.
This can be accomplished through taxes and fees, making companies pay for the amount of
harm they do to society as a whole. This solves the inefficiency problem. If companies have
to pay the costs of pollution, they can accurately compare the total costs and revenues of
production and determine if it is profitable to produce. However the government still has to
struggle with the question of placing a monetary value on such things as death, extinction, the
destruction of forests, and many other social costs and it is not always easy to put this policy
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into practice. Regulations are not always enforced, and governments may simply choose to
relax their standards in order to avoid hurting businesses.
ii) Social Conventions;

This deals with negative externalities through social conventions and tradition. The argument
here is that "certain social conventions can be viewed as attempts to force people to take in to
account the externalities that they generate. The example associated with this is impressing
on people from a young age that even though one bears a cost by holding on to litter until a
bin is found that one should do so because of the externality which litter creates. However its
overall usefulness may be limited to low cost externalities generated by individuals.
iii) Property Rights:

The establishment and enforcement of private property rights provide an alternate framework
for the solving of externalities. "A private property right is a legally established title to the
sole ownership of a scarce resource that is enforceable in the courts." Private property rights
offer a number of solutions to the problems posed by externalities. Firstly, the establishment
and enforcement of greater private property rights by the legal system would allow victims of
negative externalities to sue the offending party for compensation for the damage caused. For
example, if property rights to a section of river are assigned to a particular fishing club, then
that club will be able to sue the chemical firm/upstream which pollutes the river and kills the
fish stock in the fishing clubs section of the river.
iv) Coase Theorem & Bargaining:

The other way in which property rights can assist in achieving allocation efficiency is by
providing a framework in which bargaining may take place. Consider the situation illustrated
in Figure 4.5 below which builds on the fishing club example.
Dollars per SMC = (PMC + d)

Years
PMC
MR
47
X* XP Tons of chemical per year
Figure 4.5: Coase Theorem & Bargaining:
The Coase Theorem suggests that " the efficient solution will-'be achieved independently of
who is assigned the ownership rights , so long as someone is assigned those rights". The
reasoning for this is that if the chemical firm is assigned the property rights , the fishing club
will be prepared to pay the chemical firm an amount up to the value of the damage being
caused, to have the chemical firm reduce its output and that at any point past X* the damage
being caused exceeds the firms profits from doing so. Hence the firm is willing to accept the
payment to reduce its output to X*. Similarly if the fishing club has the rights, it will not
allow the firm to produce past X* as the damage caused to the fishing club is greater than any
payment the firm would be willing to make. The establishment of property rights thus creates
a framework which allows bargaining and the achievement of the socially optimal outcome.
WEAKNESSES OF COASE THEOREM

(i) The Coase theorem assumes zero translation cost. If translation costs are high then the
outcome of bargaining over weights won’t be pareto efficient. Also the outcome will
be affected if there is assignment of translation costs between the two parties in the
bargain.
Pigon (1932) points correctly to the cost in terms of time and efforts required for
bargaining. In the presence of very large lump sum translation costs which exceeds
the benefits from negotiation a discrete decision either allowing or barring the activity
maybe the solution.
(ii) Another problem is that voluntary bargaining may not proceed if large number of
people is involved. For example if pollution problem is experienced by large numbers
of individual then each individual may prefer to sit quietly and hope that others will
offer enough compensation to induce a less polluted atmosphere. In this way each
victim would seek to free ride. Clearly if all affected people behave in this way the
process of negotiation will not materialize.
Coase solution will only be applicable in those situations in which properly rights and
hence contracts can be well specified at reasonable cost and where problems of free
riding do not arise.
48
(iii) It is not necessarily the case that negotiation will produce a pareto improvement if
both parties do not have access to all available information’s. As David and Kamien
(1971) has pointed out one side may have more or superior information than the other
and this may lead to cheating or black mailing.
(iv) The Coase solution has distributional consequences. The individual consuming the
external effects compensate the polluter to reduce level of pollution whilst solutions to
externality problems might not be desirable in distribution terms. For example
consumer of those goods that carry a pollution tax will end up paying higher prices
and some employees who work in those firms may be made redundant as output
levels reduce.
v) Mergers:
Another possible solution to the problem of externalities may be for the parties involved to
merge. For example if a fishing companies profits are being harmed by the pollution
produced by a steel mill then the problem of this externality can be solved by merging the
parties involved and internalizing the effects. "For instance, if the steel manufacturer
purchased the fishery, he would willingly produce less steel than before, because at the
margin doing so would increase the profits of the fishing subsidiary more than it decreased
the profits from his steel industry.” This suggestion too however may be seen as having a
number of problems in its practical implantation.
4.8 MARKET SOLUTION
Tradable Pollution Permits:

Tradable pollution (or emission) permits are a free-market solution to the problems caused by
negative externalities. Tradable emission permits allow the government to give companies
licenses to pollute at a certain level. Companies can buy, sell, and trade these permits on the
market. Therefore it is in the interests of companies to pollute as little, as possible. If they
pollute at a level higher than their permit allows, they have to buy permits from another
company. If they pollute less than they are allowed to, they can sell their permit. The
49
difficulty is that companies that pollute create a cost to society but not a cost to themselves.
Because the company does not have an accurate view of its costs of production, it cannot set
its production at the level that maximizes efficiency in the economy.
Conclusion:
In conclusion then it can thus be said that the existence of externalities and the failing of the
market to adequately deal with them has serious implications for the achievement of true
allocation efficiency within the economy. Whilst there are a number of possible approaches
to correcting the problems caused by externalities, each of the suggested solutions entails its
own problems which must be overcome before society will have an effective means of
dealings with the problems caused by externalities.
4.9 SUMMARY
This lecture has discussed in details the various reasons why the government should
intervene in the goods market. It has also discussed the various sources of market failure
together with their correction.
4.10 ACTIVITIES
1. With the help of diagram show how positive and negative externality lead to
market failure.
2. Explain the various private and market mechanism for solving externality
problems.
50
A.T. Peacock and J. Wiseman, The growth of public expenditure in the United Kingdom
(London:George Allen Unwin, 1967)
McGraw-Hill,1989). PUBLIC EXPENDITURE
LECTURE
J.Batas, Managing Value for Money FIVE
in the public Sector (London: Chapman & Hall, 1993)
5.1 INTRODUCTION
Lecture five discusses the major areas of public expenditure. It explains the various
definitions that can be adopted in public expenditure. It explains the canon of public
expenditure. The lecture ends by discussing in details how the public expenditure can be used
to solve macroeconomic problems such as inflation and unemployment.

a) Explain the theories of the growth of public expenditure
b) Discuss how public expenditure is used to solve macroeconomic
problems
c) Conduct project evaluation
51
5.3 DEFINITION OF PUBLIC EXPENDITURE
Public expenditure can be defined in different ways as:

a) The expenditure of central and local government;
b) The combined government expenditure plus disbursements out of the National
Insurance (social security) Fund; or
c) The total government expenditure as in (ii) plus expenditure of the public
corporations.
The size of the public expenditure will depend on the definition adopted and will differ
accordingly. This can give rise to confusion when comparisons are made over a period of
time or internationally. Thus, if public-expenditure is defined in terms of what the central
government and local authorities spend; it will appear smaller than when expenditure by
public corporations is also included.
The basis on which public expenditure once defined is analyzed, does not, however, affect
the total figure which represents the absorption of resources by the public sector. The analysis
can be undertaken-on the following basis:
i). Spending authority: Central government, local authorities, public corporations,
ii). Economic category: Current expenditure account (expenditure on goods, services,
transfer payments), capital account (investment),
iii). Programme: defence, agriculture, housing.
The total figure for public expenditure, whichever basis is used, should be the same and
represents the absorption of resources by the public sector.
5.4 Canons of Public Expenditure
52
These are principles proposed to govern the public expenditure decisions. They include;
1) Canon of economy – utmost care must be taken to avoid wasteful usage of public funds.
2) Canon of sanction – no public funds should be used without proper authorization and
funds should be used only for the purpose for which they were sanctioned.
3) Canon of benefit – public expenditure should be incurred only if it is beneficial to the
society as a whole. The benefits can be through income distribution or production.
4) Canon of surplus – the government should avoid deficit budgeting. It should be prudent
and aim at meeting its current expenditure needs out of its current revenue. It should not
overspend and run into debts.
5.5 THE GROWTH OF PUBLIC EXPENDITURE
WAGNER'S LAW
Adolf Wagner (a German economist in the nineteenth century) analyzed trends in the growth
of public expenditure and in the size of the public sector in major countries of the world. His
observations led to what is now called Wagner's Law or the Law of Rising Public
Expenditure, (He preferred to call it an observation).
It postulates that;
a) The extension of the functions of the state leads to an increase in public expenditure on
administration, and regulation of the economy;
b) An increase in national income of a Country will bring about a growth in public
expenditure on such programmes as education, health and welfare; and
c) The rise in public expenditure will be more than proportional to the increase in the
national income and will thus result in a relative expansion of the public sector. The cause
and effect can therefore be stated as follows; social progress leads to increased state
53
activity, this is turn gives rise to greater public expenditure which results in a bigger
public sector. Wagner's Law demonstrated a tendency but not the inevitability of
continuous growth of public expenditure.
Displacement Effect
Growth of public expenditure during a war is, however, inevitable. Analysis of the time
pattern of public expenditure by Professor A.T. Peacock and J. Wiseman has established the
Displacement Effect. They found that public expenditure increases during a war or a period
of social crisis. When the war ends or the crisis is resolved, public expenditure falls, but not
to the original level at the start of the emergency, with the result that growth in public
expenditure occurs in stages.
5.6 REASONS FOR THE GROWTH OF PUBLIC EXPENDITURE
Various factors – political, social and economic – have contributed to the growth of public
expenditure and the growth of the public sector. The following are some of the major factors:
a) The abandonment of the laissez-faire doctrine. As the climate of public opinion
changed new theories began to emerge and old ones were abandoned; among the
latter was the doctrine of laissez-faire. The self-correcting mechanism of an economic
system that the classical economists believed in appeared to have failed.
Unemployment, which to them was a theoretical impossibility, not only proved
possible, but became a major international problem. During the Great Depression of
the 1930s over 20 per cent of the insured population of the UK was unemployed. The
theory of governmental non-intervention could no longer command support. There
was a pressure of public opinion on governments to provide, relief for the
unemployed and to create jobs. In order to do so, public expenditure was increased.
b) The advent of Keynesian economics. One book, The General Theory of Employment,
Interest and Money (1936), by John Maynard (later Lord) Keynes, had a profound and
pervasive influence on economists and on governments for many generations. His
arguments that the government not only could but should use public expenditure as a
54
tool of economic policy to manage a national economy so as to counteract
unemployment, found ready acceptance in a world that had not yet recovered from the
Great Depression. The Keynesian prescription was to inject money into the economic
system. If the people were not spending, then it was up to a government to do so.
This required an expansive fiscal policy, in which a government would deliberately

aim at a Budget deficit by spending more money than it raised in taxation. To cover
the difference (deficit) the government would borrow. The 'Multiplier' effect of public
expenditure would counteract unemployment. Such fiscal policy was attractive to the
governments and popular with the public. By increasing public expenditure, a
government was seen to be doing something about unemployment whilst the public
were getting something (additional state benefits) for nothing, as it appeared, since
there was no increase in taxation. Government therefore had an incentive to increase
public expenditure and they did. What is more the policy appeared to work,
unemployment began to fall. But to what extent the increase in economic activity can
be attributed to governments' conversion to Keynesian economics, and to what extent
it was the result of rearmament on which major countries embarked at the time when
the General Theory was published, is debatable. Increased expenditure on defence
was a response to the threat of war. As such it was a political measure but it did inject
money into the economy and therefore had economic consequences.
c) Wars and social crises, such as severe and prolonged unemployment had resulted in
the growth of public expenditure.
d) Increase in the range of economic activities by the state. Emergence of political
philosophies, social attitudes and economic theories that advocated extension of the
activities of the states prepared the way for governments to expand public
expenditure.
e) Psychological conditioning of the general public, during a period of war and social
crisis, to a greater government intervention and higher levels of expenditure and
taxation made it easier for governments in subsequent periods to retain and to expand
their activities.
f) Post-war reconstruction of countries' economies involved governments in planning,
allocation of resources and in financing some of the projects.
g) Economic development, according to some economists, has considerable impact on
the level of public expenditure. Before a developing country can industrialize, it has
55
to invest in transport, water and power supplies, sanitation, education and other basic
social projects to reach a 'take-off point. In this early stage of development a high
proportion of total investment will have to be made by the government, since the
projects do not offer any, or foreseeable, return to investors. Once the country has
reached a more advanced stage of economic and social development, private
investment expands alongside public investment but, because of the imperfections of
the market, government intervention grows and with it public expenditure.
h) Growth of national income is related to the level of government economic activity.
Some economists, Wagner among them, had argued that an increase in national
income results in an increase in public expenditure on economic welfare. The richer a
country the more resources, in theory, are available to the government.
i) Increased public expectation. It can, however, be argued that, although it cannot be
statistically proved, an indirect relationship exists between the growth uf national
income and public expectation of an improved standard of living, and hence public
expenditure. Governments are likely to-be under pressure to increase provision of
public goods and services so as to increase the standard of living in general and of the
poorest members of society in particular.
j) The establishment of the welfare state. This has created a base for the long term
growth of public expenditure.
k) Socialism. Socialist parties, committed by their ideology to the extension of the public
sector, won general elections and formed governments after the Second World War in
a number of countries, including the UK. Implementation of the policies set out in the
election manifestos furthered the development of mixed economies and contributed to
the growth of public expenditure.
l) Nationalization. The state takeover of private enterprises has increased public
expenditure in two ways, firstly by a government paying compensation to former
owners and secondly by subsidizing loss-making nationalized industries.
m) New technology and science. Some new technological developments in such fields as
atomic energy, aerospace and computers are so costly that in some countries they can
only be financed by the state or with substantial aid from government funds. Scientific
advances have enabled doctors to prolong life and reduce suffering, but in some cases
at an enormous cost to governments' health programmes by creating ever-increasing
demands.
56
n) Creation of super national organizations. The United Nations, NATO, European
Community and other multinational organizations that are responsible for the
provision of public goods and services on an international basis, have to be financed
out of funds subscribed by member states, thereby adding to their public expenditure.
o) Foreign aid. Acceptance by the richer industrialized countries of their responsibility
to help the poorer developing countries has channeled some of the increased public
expenditure of the donors into foreign aid programmes.
p) Increased complexity of national economies. As economies develop they become
more complex and the interests of various groups within a society come into conflict.
This has led to the proliferation of public bodies whose costs, arising out of their
coordinating, regulatory, administrative or judiciary functions are borne by
governments.
q) Inflation. A general increase in prices has been an international phenomenon during
the 1970s-1980s. Inflation increased the cost of all the activities of the public sector
and was thus a major factor in growth in money terms of public expenditure in many
countries.
r) Demographic changes. Since public expenditure is intended to benefit the people of a
country, it could therefore be expected that an increase in total population would
result in higher public expenditure. But other demographic trends such as changes in
the structure of the population (age and sex) and its geographical distribution also
have to be taken into account. The overall effect of the various trends on public
expenditure may be such that they cancel each other out, thus the extent to which the
growth of population has led to growth of public expenditure depends on the specific
conditions in different countries.
5.7 RESTRAINTS TO THE GROWTH OF PUBLIC EXPENDITURE
Some of the factors in the growth of public expenditure that we have discussed are of a
temporary nature, others contribute to structural changes that result in an increasing financial
commitment by governments on a permanent basis, but the ability to spend is not unlimited.
The following are the four main restraints:
57
a) Resources. In the long run, public expenditure cannot exceed the resources of a country.
b) Taxable capacity. This imposes a ceiling on the government's revenue from taxation and
thereby on an increase in public expenditure that is financed out of it.
c) Limit to borrowing. For a time public expenditure can outstrip revenue either as a matter
of necessity or of fiscal policy and the deficit can be financed out of loans. But there is a
limit to how much money lenders at home and abroad will be prepared lo make available
to any government.
d) Public opinion. The final major restraint is the growth of public opinion. The level of
public expenditure in a democratic society will depend on the size of the public sector
that people want and are willing to pay for through taxation.
5.8 CONSEQUENCES OF THE GROWTH OF PUBLIC EXPENDITURE
Political, social and economic consequences are interrelated. They cannot therefore be easily
isolated and compartmentalized. Some are, however, more identifiable than others and are
listed below:
a) A political consequence of the growth of public expenditure is the increased size of the
public sector and hence of the power of the state.
b) A social consequence of the extension of the welfare system is to allay the fear of
deprivation that is consequent to unemployment, sickness and old age. The need for
people to provide for themselves is reduced.
c) Development of a welfare mentality is likely to increase people's dependence on
government support and to lead to the creation of what politicians and social
commentators call the 'underclass' in a society. Its members caught in the poverty trap
may lack the means, ability, resourcefulness and incentive to break out.
d) An economic consequence is an increase in taxation or borrowing or both, to finance
rising expenditure.
e) A disincentive effect on work and enterprise may result from an increase in taxation
required to finance provision of public goods and services but economists disagree on
this.
58
f) National debt will increase as a result of borrowing and this will affect the rates of
interest and supply of capital to industry.
g) The rate of economic growth may be adversely affected by the; transfer of resources
from use in manufacturing in the private sector to the public sector for provision of social
services.
h) The productive capacity and export potential of an economy may be reduced. Public
goods and services, such as social security benefits, are not exportable and do not earn
foreign currency.
i) The balance of payments, will suffer if exports are reduced and when interest payments
on the money that the government had borrowed abroad, or repayment of capital, become
due.
j) The prosperity of a country may, however, be increased if public expenditure is on
projects that further economic development. If this happens then the balance of payments
may improve.
k) The standard of living of the people in general and of some groups in particular can
be increased by the provision of public goods and services.
l) Inflation resulting from the injection of public spending into the income flow of a
country adversely affects not only the standard of living but the whole economy
m) Stabilization of the economy may result from the use of public expenditure to counteract
inflation and deflation.
n) The level of employment may rise, but if the effect of increased public spending is
inflationary, employment will be likely to fall.
o) A more egalitarian society can be achieved by narrowing the difference in the level of
consumption among its members by means of state benefits financed out of progressive
taxation.
p) Increased efficiency in provision of public goods and services as governments put
greater emphasis on value for money in an attempt to curb growing public expenditure.
This list of favourable and adverse effects that may follow an increase in public expenditure
is by no means conclusive. Whether its consequences will be beneficial or not will depend on
the existing level of expenditure, the purpose for which the additional money is used, the way
that the expenditure is financed and the specific circumstances of a particular country.
5.9 EFFECT OF PUBLIC EXPENDITURE

59
Government expenditure or outlay has important effects on the entire economy of a country.
It is important to consider the impact of public expenditure on such aspects as the level of
employment, production and income, stability of prices, the creation and maintenance
of full employment and a better distribution of income and wealth in the country. The
influence of public expenditure on levels of economic activity and on distribution will depend
upon the nature of the government and the period during which public outlay is made. For
instance, in a free economy and during peacetime, government expenditure is generally quite
low but in a socialist economy and also during war period, the contribution of government
expenditure is more significant as regards the level of economic activity and employment.
1. EFFECTS ON PRODUCTION AND EMPLOYMENT

Dalton shows how the level of production and employment in any country depends upon
three factors,
a) Ability of the people to work, save and invest.
b) Willingness to work, save and invest, and
c) Diversion of economic resources as between different uses and localities.
It is possible to influence all these three factors through public expenditure either for the
better or for the worse. Government expenditure may help to improve the efficiency to work
and thus raise the income of the people in the country. Accordingly, people may be able to
save and invest a considerable part of their incomes. In this way, the productive potential of
the country will increase. Such an effect of public expenditure may be explained as follows:
a) Public Expenditure on Ability to work and save. If public expenditure can increase the
efficiency of a person to work, it will promote production and national income. Public
expenditure on education, medical services, cheap housing facilities and recreational
facilities to the working class people will increase the efficiency of persons to work. At
the same time, public expenditure can promote saving on the part of the lower income
groups by providing additional income to them, for a person who has larger income can
be normally expected to save a larger amount.
60
Finally, that part of public expenditure which consists of payment of interest and
repayment of public debt will place additional funds at the disposal of those who can save
and invest. Thus, it will be seen that public expenditure can promote ability to work, save
and invest and thus promote production and employment in the country.
b) Public Expenditure on the willingness to work and save. Public expenditure may not
have such a favourable influence on willingness to work and save. For instance, such
items of government expenditure as pensions, interest on loans, provident fund and other
government payments provide a security to a person and, therefore, reduce the
willingness of persons to work and save, after all, why should a person work hard and
save when he knows fully well that he will be looked after by the government when he is
not in a position to earn an income.
c) Public Expenditure and Diversion of Resources. Public expenditure has far-reaching

effects on the utilization of resources as between alternative uses.
i). There are some diversions of resources from private to public use about which there is
some doubt. Dalton talks about the government expenditure on armaments and armed
forces. To meet such expenditure, which is often called economic waste, the government
diverts economic resources from the general public to the government; it is thought by
many that these economic resources could have contributed to economic welfare if they had
been allowed to remain with the people themselves. But a sensible argument can be given
in favour of military expenditure. War expenditure reduces the danger of foreign invasion
and thus diminishes the economic loss which would have resulted in the event of a war. It
is, thus, true that public expenditure on armaments reduces economic resources from other
uses in which they could have made a direct contribution to economic welfare. Millitary
expenditure is essential for safety and security of the nation without which no country can
flourish economically or otherwise. Thus, we can leave out the diversion of economic
resources for purposes of defense.
ii). Public expenditure can bring about a better allocation of economic resources as between the
present and the future. In a free capitalist society very little provision is made for the future.
This is because people prefer the present rather than the future and, therefore, they do not
make adequate provision for the future. The state, on the other hand, is the custodian of the
interests of the future generations also and, therefore, has to see that adequate provision is
61
made for the future. Some good examples are public expenditures on transport, irrigation
and other projects which do not yield immediate returns but yield social and economic
benefits for generations to come. In this connection, the government also spends money in
the conservation of economic resources which are very essential for the future. Government
expenditure for the protection of the environment will also have a favourable effect.
iii). The government spends money for the encouragement of research and invention, promotes
education and training, looks after public health and sanitation and also takes the
responsibility of social security measures. Some fiscal theorists, however, argue that the
government" should actually curtail expenditure on many of these measures. Most fiscal
theorists agree with Dalton that "increased public expenditure in many of these directions is
desirable in order to bring about that distribution of the community's resources between
different uses, which will give the best results, balancing without bias between the present
and the future. In other words, the diversion of economic resources here will greatly
increase production.
iv). Diversion of economic resources will be justified in those instances when the volume of
new investment may not coincide with the volume of new savings. The lack of this
coincidence, as Keynes pointed out is the direct cause of instability in the economy, of
inflations and deflations and unemployment. To create a condition of stability and to bring
about the equality of saving and investment in the private sector, government expenditure
in the form of public works such as construction of roads, railway lines, irrigation works,
power, etc., will be necessary. Government expenditure on the public works programmes
has favourable effects on production and employment also.
v). Sometimes, public expenditure may result in diversion of economic resources as between
localities, in Kenya; this is brought about by the use of central government grants to some
local governments to provide certain services more efficiently. This can also be done by
careful regional planning, in such a way that a backward region may be economically
developed. The government has to select the particular region or area and industry and
incur public expenditure so that the maximum national production and following it the
maximum community welfare can be attained. For instance, through improvement and
development of transport and communication in the North Eastern area and the provision of
water facilities in these areas and also through starting a few important industries by the
State, the private sector also has been encouraged to open many industries in North Eastern.
Thus, if public expenditure is prudently planned it can certainly bring about diversion of
62
resources as between regions which will definitely improve the economic position of
backward areas and thus bring about increase in production and employment.
vi). Finally, Dalton refers to a country where the government has complete power over the
economy. This happens when the government has nationalized means of production as in a
communist or socialist economy. In such an economy, there is no question of diversion of
resources from the private to the public sector but the entire planning and expenditure of
projects is in the hands of the government.
5.10 PUBLIC EXPENDITURE AND ECONOMIC STABILITY IN ADVANCED

ECONOMIES,
During the 1920s and 1930s, most free economies were working under cyclical depressions
and booms. It was during these period, fiscal theorists showed the effect of public
expenditure in controlling depressions and booms.
During a period of business recession and depression, the anticipations of both producers and
consumers are falling. The producers anticipate a decline in prices due to a decline in private
demand and decline in profit margins. On the other hand, consumers anticipate a decline in
prices and hence tend to postpone their consumption till the prices fall to still lower levels.
Private consumption as well as investment expenditures decline and the propensity to save
and hoard increases. As a result, the free enterprise market economy suffers from inadequate
aggregate demand and consequent decline in production and increase in unemployment.
Once, the process of business recession starts, there is a cumulative decline.
Since the free economy is not able to reverse the trend itself, the government has an
important role to play. During a business recession the government should pump funds to
offset the decline in demand and income caused by the contraction of private expenditure.
63
The greater the decline in private expenditure and the greater the propensity to hoard the
larger should be the volume of government expenditure as a compensatory mechanism. This
kind of spending by government to compensate for shortage in private spending is generally
known as compensatory spending. It is not simply to offset private deficiencies in national'
income but also to provide the initial impetus for the economy to recover.
Compensatory Spending during Depression

Compensatory spending may be undertaken on a modest scale at a time when national
income is declining and unemployment is rising with the hope that at least further decline
may be checked. It may be undertaken on a larger scale with the hope of
a) Checking the decline in demand, production and employment, and
b) To provide an initial impetus to the forces of business recovery which may be taken up by
the private sector. Compensatory spending of the second variety is commonly known as
'pump priming'. Essentially, compensatory public spending implies the use of public
expenditure to make up for the decline of private spending so as to maintain a full
employment level of income. Such a policy will mean different things in different
periods. For instance:
i). During a period of depression compensatory spending will involve heavy
government expenditure on public works programmes.
ii). During a period of recovery when private investment has started picking up, public
expenditure will be reduced gradually in the same ratio as the rise of private
expenditure.
iii). During periods of business prosperity and boom, when private demand for goods
and services is rising rapidly, government expenditure should be reduced
considerably so that there would be a surplus (i.e., excess of taxation over public
expenditure.
Public Expenditure in the upward phase of a business cycle

What should be the role of government expenditure during an upward phase of a business
cycle? We assume that pessimism has given place to optimism and that there is general rising
anticipations all round. Consumption and investment spending are increasing. The economy
is expanding and national product and employment are increasing. During this period,
compensatory public expenditure should be so controlled and managed that the level of full
employment is achieved in an orderly manner.
64
During business recovery; when the economy turns from the low level of depression and
starts recovering gradually, the compensatory spending of the previous period, which would
be at a fairly high level, would continue, in other words the expansion in business activity
which will occur during recovery will not necessitate the immediate withdrawal of
government expenditures. For one thing, some government expenditure would be such (e.g.
the construction of a road or a dam) that sudden stoppage in the middle would be impossible.
For another, sudden withdrawal of government spending would upset the economy and may
cause a recession. In other words, nothing should be done to offset optimism of the gradual
expansion of business. Thus, in the initial stages of business recovery, public expenditure
would continue to be large and the government budget would continue to show a deficit.
5.11 PUBLIC EXPENDITURE AND ECONOMIC GROWTH IN A DEVELOPING
COUNTRY
In the previous section, we explained the role of public expenditure in stabilizing an economy
and helping to maintain it at the level of full employment. But all this is relevant to a fully
developed economy, which can work by itself but requires the help and support of the
Government only at certain times. But this analysis does not hold well in the case of a
developing country like Kenya in which:
i). rate of saving and investment is low;
ii). the level of production and employment is low ; and
iii). there is chronic unemployment
According to John Adler, a rising proportion of additional output should be devoted to capital
formation, so that the economic growth of an underdeveloped country may be speeded up.
For this purpose, two-fold changes in the government budget are required. First, the
government budget should be raised so that a rising proportion of additional outlay may be
available for development purposes, and second, a rising proportion of government revenues
should be used to finance expenditure on development. Thus, public expenditure has a
significant role to play in the process of economic growth.
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Changes in Expenditure
If increased public expenditure on development is essential, then the rate of increase in other
expenditures should be severally curtailed:
a) Attempts should be made to tighten the administration which in most developing
countries is unwieldy, inefficient and sluggish. It is possible to speed up the
administration, improve its efficiency and weed out the useless elements and thus
increase its productivity. Administrative expenditures can be stabilized if not
curtailed, and still step up productivity.
b) Many less developed countries, like Kenya, spend a considerable portion of their tax
receipts on defense, which ought to have been spent on economic development. In
some cases exorbitant defense expenditure has been foisted on some less developed
countries. In some countries, internal disturbances and political instability lead to vast
expenditures on the army and the police. It is true that political peace is an essential
condition of economic progress but then cost of maintaining it should not be high.
c) The social and cultural expenditure – particularly both general and technical
education – are of utmost importance for economic growth. Some may assert that
opening up of new schools does not constitute economic growth but without proper
change in social and cultural values, it will be impossible to bring about economic
progress. What is the use of imported machinery, unless there are technicians to
handle it? Expenditure on education, on promotion of health, etc., is of great
importance in a developing country.
Development expenditure has increased considerably in all less developed countries since the
end of the Second World War. Whether the increase in development expenditure in a
particular country is adequate and whether it is possible to restrict other types of expenditure
so as to increase development expenditure are questions which will have to be answered for
every country, separately taking into consideration the special political and social problems
involved.
Content of Development Expenditure

Taking the specific case of Kenya, development expenditure of the government aims at
stimulating and supplementing private initiative and enterprise. It is possible, and some
governments of less developed countries have attempted to do so, to eliminate the private
sector altogether and plan for the entire economy as a whole.
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Direct stimulation is done by helping the private sector through loans, subsidies, tax
concessions and exemptions, providing market and other information and providing research
facilities. The government sets up special banking and financial institutions whose main aim
is to provide finance for medium and long-term periods at low rates to help the private sector
industries with adequate finance. In many less developed countries, the government attempts
to set up a strong commercial banking system with the central bank at the top. These are all
direct methods of helping the private sector to expand and develop rapidly.
Indirect stimulation of the private sector is done by the government through the provision of
social and economic overheads. Education and public health will come under the first head,
and the provision of power, transportation, communications, etc. will come under the second
head. The private sector industries reap economies of production from these facilities
provided by the government. Social and economic overheads are a necessity and an essential
prerequisite for economic growth. In fact, there are many competent observers who would
like governments of less developed countries to provide only these facilities and leave the rest
to the private sector. There is, however, a serious danger in the Government taking the
responsibility to provide economic overheads. Kenyan experience shows clearly that much of
the failure of Kenyan planning is due to the failure of such sectors as power and
transportation which have been Government monopolies.
However, there are certain enterprises which the private sector in a developing country may
be unwilling to undertake, either because profit margins in these industries are low or almost
nothing or because they require huge capital investment and a long time to yield returns. In
other words, these enterprises may not be appealing to the private sector from the commercial
point of view but may be of great significance from the point of view of economic welfare of
the community as well as that of economic progress. In this group come all the key and the
basic industries, transport and communication, development of irrigation resources, atomic
power, etc. In fact, any industry which is necessary for the country and which helps in the
growth of the economy can be taken up by the government. But the objective is not to
compete with the private sector but really to supplement and complement it. This type of
argument was used by – Jawahar Lai Nehru to get monopoly control over the key and basic
industries.
Priorities in Development Expenditure

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The basic objective of a less developed economy is to bring about some type of steady
balanced growth for this purpose, priority determination of priority between the various
development projects is essential for one thing; priority-determination will depend upon the
basic objectives. Other things being given priority-determination should guarantee a
maximum rate of balanced growth for another, priority will depend upon the available
resources which indicate the type of projects that can or cannot be undertaken within a given
period of time. Thirdly, priority-determination should also take into account the degree to
which a given project will diminish a country's dependence on foreign countries. But
ultimately, the solution to the problem of priority determination is an assessment rather than a
calculation. This is so because it will be difficult to calculate the net yields of the various
projects.
A related question is on what sector of the economy, priority in a development programme
should be given. While some have emphasized the development of the agrarian sector and
exports, others have argued in favour of the development of secondary and tertiary sectors.
There is a third view too, according to which, there should be equal emphasis on all sectors
so that balanced growth will be achieved. W.A. Lewis has admirably stated the case of
balanced growth in development-programmes, all sectors of the economy should grow
simultaneously, so as to keep a proper balance between industry and agriculture, and between
production for home consumption and production for export. The actual selection of projects
from among the various alternatives on which to spend taxpayers money is based on the cost-
benefit analysis. Cost-benefit analysis purports to describe and qualify the social advantages
and disadvantages of a policy.
5.12 THEORETICAL ASPECTS TO PUBLIC EXENDITURE EVALUATION
Governments at all levels allocate a considerable portion of their revenue for expenditure on
such public capital projects as transportation systems, airports and power generating plants.
Other expenditures would involve, improving public health programs and education projects.
The benefits from this expenditure accrue to society or a portion of the society for a long
period of time.
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Project evaluation like all issues in allocation economics involves determination of the ways
in which the most efficient use can be made of scarce resources. In its simplest form, the
issue is how to determine the composition of the budget of a given size and how to allocate a
total of given funds among alternative projects. To determine allocation between two
alternative projects, expenditure evaluation involves evaluation of all costs involved and
evaluation of all benefits to be derived from public funds.
It is worth noting that where a project is purely private, consideration before investing
includes:
- The expected rate of return on the project that would reflect the net results of private
costs (money spent on all resources)
- Private revenues (sale of the goods and services produced by the capital assets).
- Degree of risk involved in the project.
However, tabulating the private costs and revenues or benefits does not necessarily exhaust
all the costs and benefits associated with the proposal. For example wherever a private
investor decides to start a manufacturing plant, he only considers such items as the initial
costs of construction, annual maintenance and service cost and the money value of the plan
output. What his analysis would not consider, unless forced by the regulations, is the noise
and air pollution imposed upon nearby area residents. Even social benefits accruing from
such a plant (e.g. increased employment opportunities to residents of that area) would not be
considered.
However in the benefit-cost analysis in a public sector, social benefits and costs are captured
in the analysis. Please note that, despite the differences that exist in cost-benefit analysis,
both approaches (private and public) are analytically the same. It involves the comparison of
the stream of benefits expected from a project measured against the stream of expected cost
to obtain the expected net worth of the project.
The major problems confronting Benefit Cost Analysis (BCA) from the public or social point
of views are:
a) The identification of all costs and benefits associated with a given project and
b) Quantifying these costs and benefits in terms of the common unit, shillings.
5.13 TYPES OF PUBLIC PROJECTS

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Public projects can be divisible or lump sum. In divisible groups all projects can be reduced
or increased. If budget is fixed, i.e. given specific amount of money to spend, the planner
must determine Cost (C) and Benefits (B) involved or derived from each project. After costs
and benefits are known for each project the remaining problem is to allocate the cash outlays
between the projects so as to maximize benefits and minimize costs. If we let costs be (C) and
benefits (B) for any two projects e.g. X and Y the total net benefits can be given as follows:
NB = B– C
Note, C is the budget amount and in most cases it is fixed. The taste is simply to
maximize B in the case of divisible projects and in a situation of a fixed budget, the
opportunity cost of spending one more shilling on X is the benefit forgone by not spending it
on Y, and vise versa. To maximize total benefits the policy maker should allocate outlays so
that total benefits minus total costs are at a maximum. Such is the case if MBx / MBy =
MCx / MCy, where MB is marginal benefit and MC is marginal cost. Given MC = sh 1, the
policy maker will equate MBx and MBy
(MBx = MBy)
This is shown by Figure presented below.
MB of X
MB of Y
F G
C
H J D
MY
MX
0 A Expenditure on X 0 B Expenditure on Y
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Figure 5.1: Expenditure Allocation with Fixed Budget
Schedule MX and MY show the value of the marginal benefit (additions to total benefits)
derived from spending successive shillings on X and Y. Total expenditures E are
distributed between X and Y so that the marginal benefit of expenditures on X or Ac
equals that Y or BD. Thus OA is spent on X and OB on Y such that OA + OB = E the
assigned budgets. If this is done, total benefits from X as measured by the area OACF,
plus those from Y as measured by OBDG are maximized. Putting the matter in cost
benefit terms we see that the two projects are pushed to the point where the ratios of
marginal benefits to marginal costs are equal. Since marginal cost in both cases equal
Kshs. 1 we again have AC = BD.
In the case of lumpy projects, and in a situation of a fixed budget use of marginal benefit
analysis may not work where projects are indivisible or involve lump-sum amounts for
example in road, dam, and bridge construction. For example if choice was to be made
between road construction and airport construction marginal adjustments so as to equate
benefits is not feasible.
For such kinds of indivisible projects ranking scale is required where budget is fixed, to rate
projects before a choice can be made.
Example of Ranking Scale

NAME OF TOTAL COST TOTAL NET B/C (B - C) RANKING
PROJECT (In thousands of BENEFITS BENEFIT RATIO C
Kshs) C (In thousands of (In thousands RATIO
Kshs) B of Kshs) B – C
K1 2000 4000 2000 2 1 2
K2 1450 1750 300 1.2 0.21 5
K3 800 1040 240 1.3 0.3 4
K4 500 1250 750 2.5 1.5 1
K5 3000 4200 1200 1.4 0.4 3
K6 1250 1250 0 1.0 0 6
K7 3000 2700 -300 0.9 -0.1 7
Table 5.1: Ranking of the projects
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In cost benefit analysis 1st to calculate net benefit NB = B- C. If you are to
base decision on net benefits you will choose all projects that have positive net benefit.
However caution need to be taken when ranking projects based on net benefit, since different
amounts are involved. By absolute benefit cost differentials, project K1 would lead.
Another measure which is considered safest to use is ranking projects is the benefit to cost
ration (b/c). The ratio of benefit to cost for each investment is calculated and projects are then
ranked in order of their B/C ratio. The project with the highest ratio should be the one to be
financed first. Decision as to how many projects to be financed depends on amount of budget.
If budget is Kshs. 7 million, the best combination of projects would be K4, K1, K5 and K3.
The rest of the projects K2, K6 and K7 won’t quality because the budget is exhausted after
the fourth project (K3) if funded. This combination will give me a total cost and benefits of:-
COST BENEFITS
K4 500,000 1,250,000
K1 2,000,000 4,000,000
K5 3,000,000 4,200,000
K3 800,000 1,040,000
TOTAL 6,300,000 10,490,000
Net Benefits (B-C) = NB = B– C

= 10,490,000 – 6,300,000
= Kshs. 4,190,000
Any other alternative combination would have a lower total benefits, a higher total cost and a
lower net benefit. Where budget is not fixed, there isn’t need of ranking the projects. The rule
would be then to fund development projects so long as Total Benefits > Total Costs i.e.
where net benefits are positive. The rule applies especially where a social good has very low
rate of return but carries more social benefits to society as a whole. In such a case
government will provide funds for such a program.
5.14 TYPES OF BENEFITS AND COSTS:-
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Benefits and cost may be real or pecuniary. Real benefits and costs may be; Direct or
indirect; Tangible or intangible; Inside or outside; Intermediate or final
REAL VERSUS PECUNIARY

Real benefits are the benefits derived by the final consumer of the public project. They reflect
an addition to the community welfare and they are weighted against the real cost of
withdrawing resources from alternative uses.
Pecuniary benefits and cost – occur as a result of changes in relative prices which occur as
the economy adjusts itself to the provision of public goods and services. As a result of
changing economic situation resulting from provision of public goods, some members of
society may gain while others may lose.
But this doesn’t reflect net gain or loss to society as a whole. The reason why society is left
the same (no net gain or loss) is because one group’s loss is another group’s gain but since all
groups belong to society there is a trade off.
Consider the following case study to illustrate pecuniary benefits and costs:
Consider a case where a road is constructed through a given district. The demand for
construction workers in that district will increase leading to increased wages for construction
workers in the area, while those to whom higher taxes have been imposed in order to
construct the road will lose.
Where the road opens new markets for certain products or raw materials or labour etc,
producers of these products will experience a higher demand leading to increase in price and
earnings while those who paid the taxes will suffer reduced incomes.
Note in both cases, society considered as a whole will remain indifferent because gain of
construction of road will be offset by loses incurred.
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Welfare of society as a whole will remain uncharged but some individuals will benefits while
others lose.
DIRECT VERSUS INDIRECT BENEFITS AND COSTS

Direct benefits and costs are those which are closely associated with projects objectives while
indirect benefits and costs are in the nature of by products.
The objectives of any development project are given under or by the intent of the legislative
body which proposes it. For example: - An irrigation scheme has the provision of water for
farming as its main objective.
Rural health project can be designed to reduce death rates among children. It may also
provide for family planning programme.
While there are many direct benefits and costs there may also be certain silent features in the
projects that can provide indirect benefits e.g. an irrigation scheme can also be used or
modified to generate electricity and provide clean water for drinking. If provision for water
for farming was the main objective of the legislator the eventual provision of electricity and
clean water for drinking are indirect benefit.
Direct costs to the project would involve costs incurred in purchasing and installing pipes.
Indirect costs would be destruction of wildlife and diversion of water.
A good education system will train and provide skills which will be used to improve the
earning of participants. But, in addition to those direct benefits there may be other indirect
benefits e.g. reduction in crime rate and the provision of expert’s services such as doctor’s
services lawyer’s services etc.
TANGIBLE VERSUS INTANGIBLE BENEFITS AND COSTS

Tangible benefits and costs are those that can be valued in the market whereas others, which
cannot are referred to as “intangible”. The distinction is thus synonymous with that between
benefits from private and social goods or between costs, which are internalized, and costs,
which are external.
INTERMEDIATE VERSUS FINAL

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Development projects may be intermediate or final. Final projects are those, which provide
services directly to consumer, and they involve also the provision of a final product.
Intermediate projects are developed for the purpose of using them in further generation of
other benefits. For example provision of road itself may be a social good and it enters as an
intermediate good into the production of a final output which is a private good (the
transported product ready for sale).
INSIDE VERSUS OUTSIDE

Another distinction is between benefits and costs which accrue inside the jurisdiction in
which the project is undertaken and others which accrue outside. For example where a river
basin is developed or drained so as to control flooding in a given district the benefits are
derived within that district.
However where these benefits are extended to other districts through which the river flows,
the benefits can be said to be externalized.
Case studies illustrating different types of benefit and costs
CASE STUDY (A)

IRRIGATION SCHEMES
To see how C and B differ consider an irrigation projects which has to be carried out in a
given area. The costs and benefits of the irrigation scheme can be classified as:-
REAL
(1) Direct Tangible Benefit
Which include increased output resulting from the use of scheme, Provision of water for
drinking, Increased livestock products and increased agricultural earning.
(2) Direct Intangible Benefit

Improved vegetation leading to a better environment. Intention of starting an irrigation
scheme may have been also to improve the surrounding environment (e.g. May be the area is
a semi-arid area).
(3) Indirect tangible benefit Reduced soil erosion.

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(4) Indirect intangible benefit
Where because of the presence of the scheme the rural society is preserved due to reduced
rural-urban migration or general migration to other areas.
(5) Direct tangible costs.

Include such costs as cost of pipes, cost of labour, cost of hardware, cost of plant and
equipment and salaries of experts. (Cannot yet inputs without paying a price)
(6) Direct Intangible costs

Include loss of natural or original features of the area; the possible loss of aesthetic healthy of
the area.
(7) Indirect tangible cost
Include the effect of the diversion of water from its customary flowing direction. Diversion
of water may affect the ecosystem in the area so that the wildlife that depended on it is
destroyed.
(8) Pecuniary benefits

Would include the relative increase in the value of land around the scheme. It would also
include relative improvement in the position of farm equipment industry.
CASE STUDY B
(B) EDUCATION PROJECT
REAL
(1) Direct tangible benefit – increased future earnings
(2) Direct tangible cost – loss of students earning, teachers’ salaries, cost of building and
books.
(3) Direct Intangible Benefit – Enriched life
(4) Direct Intangible cost – forgone leisure time
(5) Indirect tangible benefit – reduced costs of crime prevention.
(6) Indirect Intangible benefit – more intelligent electorate.
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(7) Peculiarly benefit – relate increase in teachers’ income.
5.15 PROBLEMS OF MEASUREMENT OF BENEFITS AND COSTS
In the absence of a dictatorial form of government the benefits of a purposed public projects
should reflect the preferences within the society. In a market economy preferences for goods
and services are expressed in terms of what people are willing to pay for a product with a
given cost structure. For product the interaction of demand and supply plays a major role in
the determination of market price. However in the case of most public projects there exist
many benefit and costs which are intangible (e.g. national defense) and do not have an
observable market price.
Even where price exist contain adjustments may need to be made since thy may not reflect
true social values and costs owing to existence of market imperfections and externalities.
Whenever intangible benefits and costs are involved measurements takes us back to the
central problem of social good evaluation. This as was discussed in chapter 1, must be
accomplished by budget determination through the political process. Imperfect as it may be it
would seem rational to proceed with a project if people have expressed a consensus in favour
of the project. The major drawback is that every project would have to be submitted to the
electorate for approval while assuming that all the information about the project has been
made available to the community. It would have to be further assumed that everyone
understand the issues involved in the proposal. The impractical nature of this approach is
obvious.
It is worthy noting that cost benefit analysis is only a method of choosing among alternative
projects after their values have been determined by the legislator. It is not substitute to
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political process. Thus cost-benefit analysis is most easily applied in those areas where
benefits are tangible and there is least need for public provision to begin with.
The task of benefit evaluation is facilitated where the public facilities are in the nature of
intermediate goods rather than final goods. In the case of final goods such as parks, the social
good aspect must be faced head on. Since evaluation through toll pricing would require the
inefficient device of exclusion some other approach is needed.
In case of a road which may be a social good; it enters as an intermediate good into the
production of a final output which is a private good (the transported product ready for sale)
the value of which can be assessed in market terms. [By provision of the road, the producer is
able to reach the customers and the benefits may be valued in terms of extra profit earned as a
result of accessibility to the market].
Evaluation can be based also on amount saved when the public project is provided (the cost
saving approach). For instance supposing a project is initiated with an intention of reducing
school dropouts. The benefits of such a project can be evaluated in term of amount of funds
saved by correction institutions such as courts and prisons (Estimate benefit from saving of
costs other wise you would have incurred).
But even though the evaluation of benefits and costs may be difficult, economic analysis may
be useful in identifying the actual benefits and costs expected from a particular project (e.g.
gains in literacy from education programmes, better and longer life expectations from health,
reduced crime from police protection etc). They can also estimate the costs involved.
SHADOW PRICING AND MARKET ITEM

Where benefits and costs accrue from a project, evaluation would be easy if markets are
perfectly competitive. In this case the social value of tangible benefits is measured by the
price which the service would fetch in the market, just as the social cost is measured by the
price that must be paid for the inputs needed to render the service. A private market price or
cost will reflect social benefits or costs at the margin if:
(1) There is no monopoly power
(2) There are no externalities
(3) Controls on output do not exist.
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However, these “Ideal” conditions are not met in many instances. Where monopolist exists,
market price cannot be used to reflect consumer value of a product because monopolist price
> normal price. Also the costs do not reflect true social cost. In such a situation adjustments
need to be made to reflect the true market situation.
Cost 8
Rev MC = S
AC
PM a
b
PN
AR
MCM
MR
Figure 5.2 Monopoly market structure
0 QM QN Q
In a situation where we have monopoly market we would produce OQm (Where MC=MR) so
that he charges OPm. The cost per unit (marginal cost) he will be incurring is OMCM.
However, this is not what people would be willing to pay for the output if the output could be
sold in a competitive market. From diagram above people would be willing to pay a price
OPN (which equals the marginal cost).
Therefore some adjustments would need to be made to bring down the prices from OPM to
OPN the true market situation. The technique of doing this adjustment is known as “shadow
pricing”. In a sense then shadow pricing is an attempt to stimulate what people would be
willing to pay for an output if the output could be sold in a competitive market.
The use of “shadow prices” may be called for also, where relative prices are distorted by
indirect taxes, or where externalities have to be taken into account. Other important instances
of shadow pricing arise in developing economies with large labour supplies but extensive
social legislation, including minimum wages. It may then be desirable to account for labour
costs at a lower rate than applies in market. Or, over valued exchange rates may set too low a
price on imported capital and induce wasteful investment unless higher shadow prices for
such capital are applied.
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Shadow pricing can also be used to value benefits and costs where activities have no direct
market analogue. The construction of a dam for flood control may, for example, reduce the
population of certain species of birds in the area where the dam is to be located. How does
the analyst evaluate this loss to local bird watchers? The dam will likely increase the
population of other birds in the area, such as waterfalls but it would be extremely difficult to
place a monetary benefit on this activity. The same project may generate recreational
benefits, for example, fishing, swimming, and boating. Shadow pricing may take the form of
observing what people in similar situations pay for these as private consumer goods.
5.16 DECISION INVOLVING LONG-TERM PROJECTS
Much public expenditures bestow benefits on society well into the future and there are costs
that will be incurred in the future as well. For instance, such expenditures as investments in
river basin development will yield benefits over many years. Such costs as machinery
maintenance would be incurred in the future. The question is, are the benefits and costs of
today to be valued in the same way as those in the future?
The generally accepted view is no. Society prefers present net benefits to those in the future
owing to uncertainties related with the future. Thus, to evaluate such benefit streams and
costs would require their translation into their present values. This requires the future
expected streams of B and C to be discounted so as to determine their present value.
5.17 DISCOUNTING TECHNIQUES
Method to be used to discount future expected streams of B and C would depend on;
(i) Whether the streams of benefits and costs are expected after a time period of t
years.
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(ii) Whether the streams of benefits and costs are expected annually.
CASE 1: TO DETERMINE COMPOUND VALUE OF ASSET DUE IN t YEARS

& AT THE RATE OF INTEREST r
Cvt = Po (I + r) t …………….. (i)
Where CVt = Compound (future) value of asset

T = time in years
Po = Initial principle value
r = rate of interest
CASE 1B: DETERMINATION OF PRESENT VALUE

The present value (PV) of a future earning CVt, due in t years and discounted at the rate of
interest r is ;)
Pv = Po = CVt ……………… (2)
(1 + r) t
= CVt 1
(1+ r) t
= CVt.PVIF
Where PVIF is the present value interest factor and is the reciprocal of CVIF.
Equation 2 is used to calculate the current equivalence of earnings to be made in future after t
years.
Numerical example
CVt (future of asset of time t) = 1,217
T = 5years r(discount rate) = 4%
PV = CVt, PVIF = 1,217 X 0.8222 = 1,000/=
CASE 2: COMPUND VALUE OF ANNULTIES

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Annuity is a series of payment or receipts of money in most cases on an annual basis and for
a specified numbers of years. Annuity is used for planning pension funds and for calculating
insurance premiums.
The establishment of a planned saving account e.g. into which 5000/= is paid each year for 5
years is a five year annuity. Each payment is made at the end of the year.
1yr 2 yr 3yr 4yr 5yr

End of
t=0 5000 5000 5000 5000 5000
If this payments are intended to make a savings plan from which funds will be used to pay a
pension (e.g. in social security or in national health insurance funds), and given that the rate
of interest at which they could be invested is 4% per year, then the amount to which the
annuity will accumulate after 5 years can be calculated in 2 different ways.
(i) By calculating accumulated principle and interest and adding them over the period
specified to determine the sum for period shown.
Formula CVa = P1(1 + r)1 + P2(1 + r)2 +…. + Pn(1 + )n
= n
Pt(1 + r)t
t=1
Where Pt is saved every year.
(ii) By calculating using the compound value interest factor of annuity (CVIFa) which
could be found in CVIFa table. Note that this method is applicable where annual
incomes are equal over the years.
n
Cva = nEPo (1 + r)t Po(1 + r)t

t=1
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= Po.CVIFa
= 5000 x CVIFa
Numerical Example
Po = 5000/= r=4% t=5 yrs
CVIFa = 5.416
t=s
r=4%
CVa= 5000X 5.416
= 27,080
CASE 2B: PRESENT VALUE OF ANNUITY

The present value of an annual income stream R for n years equals.
Pv = R1 + R2 +……….+ Rn
(1+r)1 (1+r)2 (1+r)n
= nE Rt
t=1 (1+r)t
NB. If R1 = R2 = --Rn
n
Then Pr = R t
(1+r)t
T=1
Pv = R.PVIFa
Numerical example
If a machine is expected to produce a net revenue to a company of Ksh.1000 for the next
3 years, the net present value or discounted earning given r (discount rate) = 4%
Is calculated as follows:-
Method 1
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Present Value
1st year if discounted 1000 at 4% = 1000 = 962.00
(1+0.04)
2nd year if discount 1000 at 4% = 1000 = 925.00

(1.04)2
3rd year if discount 1000 at 4% = 1000 = 889.00

(1.04)3
Total Net Present value is 2,776.00
Method 2
If we use present value interest factor of annuity (PVIFa)
NPV = 1000xPVIFa = 1000 x 2.775 = 2775/=
5.18 IMPORTANCE OF DISCOUNTING
The education of projects and their ranking is highly sensitive to the discount rate which is
used. This is illustrated in table below, where the present values of benefits and benefit cost
ratios for various investments are compared.
Table 1 . Present Value and Discount Rates

PROJECTS X Y Z
Initial cost (Kshs.) 10,380 10,380 10,380
Useful Life 5 Yrs 15 Yrs 25 yrs
Annual Benefits (Kshs.) 2,397 1000 736
(1) Present value of benefits stream using various discounting rates.
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X Y Z
3% 10,978 11,938 12,816
5% 10,380 10,380 10,380
8% 9,571 8,559 7,857
(2) Present value of net benefits (current benefit – initial C)
X Y Z
3% 598 1558 2436
5% 0 0 0
8% -809 -1821 -2523
(3) Benefit – cost ratio (B/C)

X Y Z
3% 1.0576 1.15009 1.23468
5% 1.000 1.000 1.000
8% 0.92206 0.82456 0.75694
We consider three investment projects X, Y and Z with equal initial cost and income flow
extending over their useful life 5, 15 and 25 years respectively.
5.19 CHOICE OF DISCOUNT RATE
In choosing the discount rate, government may proceed on the premise that it is desirable to
use a rate equal to the time preference of private consumer; or it may substitute social
discount rate of its own.
The rationale for using the private or markets rate of return is that this rate reflects consumer
choice between present and future consumption.
Assuming an economy with wholly flexible prices and perfectly competitive capital markets
only one rate of interest will prevail in the market determined by DD and SS conditions in the
capital market. All households would yield the same rate of return. The prevailing interest
85
rate would reflect the consumers’ marginal rate of substitution (MRS) of future for present
consumption i.e. their rate of time preference. By accepting this rate for purpose of project
evaluation, the government thus respects consumer’s preference.
Where the market is competitive the market rate also reflects the marginal rate of
transformation in production (MRT) i.e. the marginal efficiency of investment. As saving and
investment are pushed to the point where the two rates are equated, an efficient allocation
between present and future consumption is achieved.
When r = MEI, financial market is said to be efficient and the rate of discount (r) prevailing
in the market is at equilibrium.
MEI is also called the internal rate of return (IRR). It is a rate of interest that equates present
value of future cash flows of projects over the projects useful life to initial cost of capital.
NPV = n Rt - C = O
t=1 (1+r) t
Where Rt annual cash flows over time t
r is the internal rate of return
C is the initial cost
The government in determining the present values of the benefits stream from public
investments will discount this stream at r. Since the market is perfect no “shadow prices” are
needed. Public investments would qualify if the present value of the benefit or income stream
B exceeds cost C, the benefit – cost ratio B/C must be at least 1 or alternatively, B/C must be
positive.
However the simple assumption that there exist efficiency in the capital market is unrealistic
in the real would. In the presence of risk, some investments are more risky than others. Thus
the gross rates of return on investments on these projects would differ by the amount of the
risk premiums. Risk may also apply regarding the return on public investment so that it
should be allowed for by adding an appropriate risk premium to the discount rate used in
determining the present value of the benefit stream for a public investment.
There may also exist market imperfection owing to monopolistic elements of various kinds.
As a result various consumers may be confronted with different borrowing returns. As a
result it is no longer obvious just which rate should be used in discounting the public
86
investment stream or how the opportunity cost of resource withdrawal from the private sector
should be measured.
The difficulties of identifying the markets rate are avoided if a social rate is used instead.
Social rate is the rate at which individuals will loan money to the government. Proponents of
the social rate of interest argue that when people purchase government bonds this reflects
society’s desire to forego present for future consumption.
5.20 CAPITAL BUDGETING TECHNIQUES
Involves the entire of planning the expenditure of firms whose returns are expected to extend
beyond one year.
Examples of capital outlays are:
- Expenditure on plant and equipment
- Expenditure on acquisition and improvement of land.
The optimal capital budgeting is the level of investment that maximizes the present value of
the project. Factors that affect capital budgeting include: Availability of funds, Rate of return
on investment, Rate of interest at which funds are borrowed, Degree of risk involved in
venture, Useful life of the assets and Degree of competitive in the market.
The following are the methods of capital budgeting:-

(i) Net present value of the project (NPV)
(ii) Internal rate of return method (IRR)
(iii) Payback period method
(iv) Return on investment method
(v) Expected rate of return method.
NET PRESENT VALUE AS A METHOD OF CAPITAL BUDGETING

Most investor would consider the NPV of a project before investing. This method takes into
consideration the time value of money and profitability of a project.
87
Formula NPV = n Rt - C
t= 1 (1+r) t
Where - Rt is the annual income stream for n years

 C is the initial cost
 R is the discounting rate.
Decision to invest or not:-

Where NPV>O accept the project. If you are required to choose one project from many
projects using this method, choose the project with highest NPV.
Where NPV=0 for private projects reject the project. But if the project is a government one
the project maybe invested into depending on its usefulness to the society.
Where NPV<0 public project selection decision should consider public interest and how
essential the project is. If the project is an essential (e.g. eradicating polio), the government
would subsidize the difference in cost.
Numerical Example 1
Table 3
PROJECT A
Year Cash Flows PVIF PV
At 10%
1 500 0.91 455
2 400 0.83 332
3 300 0.75 225
4 100 0.68 68
5 10 0.62 6
6 10 0.56 6
Total Present Value 1092.00
Assuming initial cost = 1000
NPV = n Rt - C= 1092 – 1000 = 92
t=1 (1 +r) t
PROJECT B
88
Year Cash flows PVIF PV
At 10%
1 100 0.91 91
2 200 0.83 166
3 300 0.75 225
4 400 0.68 272
5 500 0.62 310
6 600 0.56 336
Total Present Value 1400
Less initial cost 1000
NPV 400
Based on NPV method we should select project B because it has the highest NPV.
INTERNAL RATE OF RETURN (IRR) AS A METHOD OF CAPITAL BUDGETING.

Internal rate of return is the rate of interest which equates present value of the expected future
cash flows or receipts from a project with the costs.
Formula
NPV = n Rt -C =0
t=1 (1 +r) t
or
NPV = n Rt - n Rt - C = 0
t=1 (1 +r)t t=1 (1 +r)t
Formula 2 applies where we have streams of costs. The internal rate of return corresponds
to the r in the formula. Based on the method, we accept a project when
(i) IRR > K (K here would represent the rate at which the investor borrowed loan. It
may also represent the rate of return that the investor has forgone by not investing
his funds in other assets.) e.g. on treasury bonds; on savings.
So in this case we could say that the resources that are invested in the project will
give the investor a better return that he would have received by investing them
else where (for equal risks). Or another conclusion would be; he should invest
since the rate of return on investment exceeds the rate at which he’s paying a loan.
89
(ii) When IRR=K the decision maker is indifferent as to whether he invests in the
project or not. In the case of a public project, the nature of investment would be
considered. If the project has public support accepts it.
(iii) If IRR>K, then by the same argument the opportunity cost of investing in the
project elsewhere, which in this case are greater than the net benefits received
from the project. In that case it would not be worth while investing resources in
the public sector project.
According to the method, when there are many mutually exclusive projects to choose
from, the projects are ranked in terms of their internal rates of return and that project with
the highest IRR is chosen, provided that its IRR>K.
Pay-back period
It measures how long it takes to recover original invested amount from cashflows of an
earning asset.
Where annual incomes are uniform over the year, pay-back period is calculated as;
PBP = C where C = Initial Cost
R R = Annual Income which is uniform
Where annual incomes are not uniform over the years, pay-back period is calculated as
follows;
PBP = Complete Period + Balance after complete periods

Cashflow of the next period
Return on investment (ROI)

Rate of return on investments is calculated as;
ROI = Net Income = Gross Income – Expenses

Total Assets Total Assets
Expenses include here all expenses and taxes.
5.21 SUMMARY
The lecture looked at the issues of public expenditure definition; canons, growth and how it
90 in the economy. It also discussed in details
can be use to correct macroeconomic problems
the public project evaluation and selection. Finally the lecture explained how shadow pricing
is used to measure non market costs and benefits of a project.
5.22 ACTIVITIES
1. How
5.23 can the public
FURTHER expenditure leads to inflationary pressure in the economy.
READING
2. What is shadow pricing?
3. Distinguse between flexible and lump sum projects.
McGraw-Hill,1989).
THEFinance
BUDGET
C.T. Sandford, The Economics of Public (Oxford: Pergamon Press, 1992).
J.Batas, Managing Value for MoneyLECTURE
in the publicSIX
Sector (London: Chapman & Hall, 1993)
6.1 INTRODUCTION
The lecture introduces you to the planning purpose of the government. Types of budgets are
explained. The budget is the master financial plan of the government. It brings together
91 expenditures for budgets the activities to be
estimates of anticipated revenues and proposed
undertaken and means of their financing can be inferred.

a) Explain the various types of budget.
b) Explain the role of each participant in the budgetary process
c) Explain the Zero base budgetary procedure
The nature and purpose of governments' budgets has changed "over time, and differs from
country to country. Powers, policies and obligations of federal, state and national central
governments, vary and so do their financial requirements.
The budget is an account of the State, showing how much the government spends and on
what and how it finances the expenditure. It is the master financial plan of the government.
Purpose of government budgeting

In general budget is considered as an instrument of achieving economic policy such as full
employment high level of investment and a better distribution.
6.3 CANNONS/PRINCIPLES OF BUDGETING
1 Executive programming. Being the programme of the executive, the budget should reflect
all government responsibilities and activities. The social, economic and political programmes
of the government should be clearly unveiled in the budget programme.
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3 Executive responsibility. Chief executive should ensure that the departmental
programmes planned is capable of fulfilling the desire and intention of legislature
4 Reporting. Information regarding the progress of the work, programmes executed,
revenue mobilized and expenditures made should be furnished to the executive
periodically.
5 Flexibility. Budget should be flexible enough to meet the government’s financial policies
according to the changing social- economic conditions in the society.
6 Adequate tools. The chief executive should be armed with sufficient and adequate
administrative tools to fulfill its budgetary responsibilities
7 Active co-operation. Efficient budgeting depends upon the active co-operation of all
departments and their sub-division mobilized and executions
6.4 Types of Budget
The budget can be approached from two angles. First, the Minister decides on expenditure
both on current account (government's consumption of goods and services, transfer payments,
grants, subsidies, interest payment) and on capital expenditure (investment in physical assets,
grants). He then adjusts taxes to cover expenditure entirely or partially and then borrows the
rest. The second approach is on the basis of the principle of 'living within one's means'. The
Minister assesses the total resources available to him, He then works out how much he can
'afford' to spend on different programmes to keep his total expenditure within the limits of the
available resources.
A balanced budget can be regarded as neutral. It has been called an 'orthodox' budget,
reflecting the Treasury view of sound finance.
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A deficit budget is expansionary as more money is pumped into the economy than is
withdrawn in taxation. The borrowing that this policy requires is likely to have an
inflationary effect in some circumstances. During the Great Depression of the 1930s,
governments sought to stimulate economic activity by means of deficit budgets.
A surplus budget is deflationary insofar as the government takes out more than it puts into
the money flow. Which type of budget a Minister of Finance will present will depend on the
government's assessment of the economic situation and the overall economic, social and
political policy, it seeks to pursue. However, within the three types of budgets there is scope
to vary taxes and expenditure to achieve the desired effect.
INCREMENTAL BUDGETING
It a process in which past level of expenditure are taken as given and only new additions to or
reduction from the past outlay are examined. In incremental budgeting existing and old
programmes are unexamined, since no substantial changes are called for in the budget. Only
additions and reductions in outlay is subject to scrutiny and examination.
ZERO BASE BUDGETING
The organization should not take earlier years expenditure for granted, but should state
everything afresh. It means that while framing its budget for the coming year an organization
should start from zero point, instead of treating the current budget as the srating point or base
for next years budgetary exercise. It involves a complete reexamination of ongoing
programmes to assess their continued utility instead of following the method of incremental
approach to budgeting. It involves fresh evaluation of every item of expenditure as if were a
new item. Each department ministry is required to justify its budget request from the bottom
up, evaluating alternative programme proposal and prioritizing them so as to select the best
alternative on need base. It focus the budget process on a comprehensive analysis of priorities
objectives and needs. It helps to eliminate those programmes which have outlived their
utility. It also help to stimulate and redirect the resources from less productive to more
productive activities.
It involves examination of the very rational of an expenditure item under consideration. The
aim is to guard against wastage in public expenditure. It involves a detailed investigation of
excess item of expenditure to see whether it is really needed or it should be revised or done
away with. If a sector is not able to justify its existence, it should be closed down. If its
94
existence is justified, the optimum level of its operation and the corresponding budget
provision must be defended. In zero base budgeting no section is essential. It must proof its
worthiness.
Performance and programme budgeting system (ppbs)

This is when a budget covers both performance and programme. Programme budgeting
involves laying down the sequence of steps for executing the project along with expenditure
of resources involved at each stage. Performance budgeting is a devised tests for comparing
actual with the expected results and thereby assessing the performance efficiency of the
project. It involves the development of scientific management tools, such as work
measurement, performance standards unit, costs etc. In each classifications government
activities are identified in physical and financial terms. The actual performance results are
estimated and compared with target results, so as to measure the efficiency of a particular
project. The government budget decisions are divided into major functions based on the
objective of the government, and then sub-divided into major specific programmes activities
and projects. The funds are allocated according to the achievements expected from a
department/ministry over a specific period, from the proposed expenditure. Therefore in
performance budgeting, emphasis is placed on the size of the project, the cost involved and
the expected return from the project. Thus the budgeting procedure is focused towards the
efficient and economic use of scarce public resources.
The implementation of performance budgeting involves the following steps

1 Establishing a meaningful functional programme and activity and classification of
government operations (for example education is a classification, and elementary education is
a programme, training of elementary teachers is an activity and the construction of a school to
impart educational management service is a project.)
2. Bringing the system of accounting and financial management in accordance with the
classification made. 3. Estimating the quality of physical resources like personnel materials,
services etc. 4. Developing standard norms for work units of performance.
6.5 SUMMARY
95
The lecture discussed in details the types of budget

6.6 ACTIVITIES
1. What is the role of parliament in the budgetary process in Kenya?

2. Explain in details the zero base and performance budgeting procedure.
6.7 FURTHER READING
McGraw-Hill,1989).
J.Batas, Managing Value for Money in the public Sector (London: Chapman & Hall, 1993)
TAXATION AS A SOURCE OF REVENUE

TAXATION
LECTURE SEVEN
96
7.1 INTRODUCTION
The lecture will discuss the other side of the coin of the public finance by looking at the
taxation which is the major source of government finance. It will discuss the canons, the
principles and the incidences of taxation

a) Explain the canons of a good tax system
b) Distinguish between benefit and ability to pay principles of taxation
c) Explain how elasticity of demand and supply affect the tax burden of sellers and buyers
The primary motivation for taxation in developing COUNTRIES like Kenya is to finance
d) Explain the various tax classification
public administration and the public provision of economic and social goods and services.
The secondary motivation is the redistribution of income and wealth, the correction of market
imperfection and stabilization of the economy.
Taxes are withdrawn from private sector without any obligation to government to repay.
They are imposed to tax payers and are compulsory. Taxes however are not the only source
of funds for government expenditures financing. Other sources include: internal harrowing
through selling of government securities; external borrowing earnings from state owned
enterprises; sales of public assets (e.g. sale of government owned land and condemned
houses) or privatization; through rent (e.g. housing) and through money creation (printing of
money)
7.3 CANONS OF A GOOD TAX SYSTEM
97
The following are the requirements for a “good” tax structure: -
(i) Equity – a good tax system must ensure that tax burden is equally distributed. That is
everyone should be made to pay his fair share.
(ii) Economical – a god tax system must ensure that both the costs of collecting taxes to
the government and the costs to tax payers of meeting their tax obligation are
minimized.
(iii) Avoidance of excess Burden – taxes should be chosen so as to minimize interference

with economic decisions in otherwise efficient markets.
If a tax diverts resources into the public sector such that it clearly imposes a
burden on the economy that can be equated only to the revenue raised we say that
the tax is free of excess burden.
But where the imposition of a tax e.g. excise tax levied on a particular commodity
provides an incentives to a consumer to reduce his purchases of taxed as opposed
to untaxed goods to minimize his tax liability. This reallocation of resources
induced by the tax is the nature of the excess burden over and above the revenue
raised.
A desirable goal of a tax system is that it should minimize this excess burden
caused by diverting a given amount of resources into the public sector. This can
be accomplished by choosing those taxes that do the least to distort economic
behavior. Thus a system of selective excise taxes that raise the price of some of
goods but not others will do move to distort relative prices and hence consumer
purchaser than will a general sales tax that raises the price of all goods on which it
is imposed uniformly.
(iv) Awareness – a good tax system should be understandable by the taxpayer. The move
he is aware of the tax burden, the better he is able to judge the amount of public goods
and redistribution he waits against their tax costs and the better equipped he is to vote
for the size of the public sector he wants.
(v) Elasticity – by elasticity is meant that a tax’s revenue yield should be sensitive to
changes in economic conditions without deliberate changes in rates. It is important
that the principle of elasticity be fulfilled for at least two reasons. First elasticity
98
enables government to finance the rising demand for public expenditures without the
disturbance of frequent rate changes. It is worth noting that if a tax is highly elastic
with respect to real income, the ratio of government revenue to GNP will raise as real
GNP rises. Second elastic tax yields function as an automatic stabilizer for fiscal
policy purposes.
(vi) Certainty – there are several different interpretations that can be given to the
principle of certainty. One interpretation, which is perhaps the most fundamental,
concerns the ease with which the individual taxpayer can compute his own tax
liability. The law with respect to the payment of taxes should be made specific as to
how much the tax payer should pay, on what he is paying and when he is to make
payments.
Adam Smith regarded a small degree of uncertainty as a much greater evil than “a very
considerable degree of inequality” in that it give the taxing authorities discretionary
power in assessing taxes against individuals. An alternative interpretation of the certainty
principle applies not to the taxpayer but to the taxing authorities. According to these
criteria a desirable feature of a tax is that its yield should be relatively certain so that the
taxing authorities can estimate their budget requirements more accurately in the light of
proposed expenditures.
(vii) Convenience – a further principle of taxation is that tax payment should be

convenient, that is the time and manner of payment should be made as desired as
possible for the taxpayer. It was in accordance with this principle that he system of
withholding in payment of income taxes was adopted by government. Prior to that
time, taxpayers were required to pay one lump sum on income earned throughout the
year. The Long between the earning of income and the payment of taxes proved to be
a burden to most taxpayer. Thus the system of withholding by assuming that taxes
were paid as income was earned eliminated the need to accumulate tax liability and
hence reduced evasion in the payment of taxes.
7.4 APPROACHES TO EQUITY
99
Tax equity refers to fairness of tax system. It is borne out of a feeling that each citizen of a
country should contribute fairly to the cost of government. The difficulty, however is to know
precisely what constitutes fairness in taxation. The discussion of tax equity has produced two
opposing approaches to this problem. These are the benefit principle and the principle of
ability to pay.
THE BENEFIT PRINCIPLE

The benefit principle argues that equity in taxation requires that taxes to be paid in
accordance with the benefits received from government expenditures. If tax burdens are
allocated on any other basis such as ability to pay, then tax payers who have little or no
ability to pay will continue to enjoy the consumption of public goods even through they have
contributed little or nothing to their financing. People should pay for what they get,
disregarding whether what they buy is produced in the public or the private sector. This
approach dates back to the days of Adam Smith, Locke, Bentham and Hobbe. Most of them
belonged to utilitarian school of thought, which emphasized the need to tax people according
to benefits they derive from consumption of Public goods.
WEAKNESSES OF BENEFIT PRINCIPLE

The benefit approaches requires that the expenditure benefits of each taxpayer be known. As
was seen earlier, much of government spending consists of public goods, the benefits of
which are indivisible. Such goods cannot be parceled out among individuals and sold at a
price that reflects the marginal satisfaction obtained by the taxpayer – consumer.
(v) It is generally difficult to establish the degree of benefit that a person derives from the use
of public goods and services, since the consumer would not voluntarily reveal how highly
they value the public services.
(vi)Given that most public goods consumption is non-rival and that one-person benefit
doesn’t restrict consumption of another the benefit tax becomes very difficult to collect.
100
However, although there are many problems associated with collection of benefit taxes they
are still used in many countries. This varies from tolls paid by motorists on highways to
finance the construction and maintenance of roads to fees charged for the collection of waste
materials (service charge). Levy can also be placed on the use of sports grounds in order to
finance for more recreational facilities or to help pay off loans used in constructing such
facilities. The question is under what conditions can such direct charges on the beneficiaries
be made?
Benefit taxes works well where goods and services to be taxed have many properties of
private good (rival in consumption, carry a price and benefits are internalized) the consumer
is then taxed according to amount used like in licensing vehicle, in charging hospital fees, in
charging rent for municipal houses etc. where product is completely rival and there is a
significant amount of competition among consumer, the benefit taxes can be charged in same
way private firms charge price.
In other instances where imposition of direct charges is desirable but too costly a tax on a
complementary product may be used in Lieu of Charges. For example taxes to finance
highway construction are often fixed on petroleum products used by road users. They may
also be fixed on the cars used or being bought.
Another area where taxes are paid in lieu of use is on property ownership and use. In this case
tax is collected in form of stamp duty on purchase of houses, on certain documents of titles
during certain financial translation or in general, property tax may be fixed to finance certain
public services that are associated with certain or specified properties (e.g. Security, street
lights, schools etc)
In conclusion benefit taxes are considered to be suitable because the tax burden is placed on
the shoulder of the persons who benefit from the use of a specified good or services.
7.5 THE USE OF ABILITY TO PAY AS A BASIS FOR TAXATION
101
The second or alternative approach holds that equity in taxation is attained when taxes are
paid on the basis of ability to pay, the rich being required to pay more in taxes than the poor.
They argue that the government cannot raise enough funds to finance public expenditures if
each and everyone was required to pay same amount of tax.
Equity involves two aspects, the treatment of people in like and unlike circumstances.
The first part deals with the tax treatment of people who are similarly situated. This is the
principle of Horizontal Tax equity.
This principle states that those who are in the same position (i.e. have the same amount of
income) should pay the same amount in taxes.
The second part deals with the tax treatment of people who are differently situated (that is
who have different amounts of income). This is the principle of Vertical Tax Equity. The
interpretation given to this principle is that the rich should be required to pay not only more
in taxes than the poor but also a progressively larger amount.
The index of ability to pay include property, income, size of family, and consumption
7.6 CATEGORIES OF TAXES
Households
Figure given below presents a simplified picture of the circular flow of income and
expenditures,
1 together with the major points of which such taxes are inserted.
Consumption
Dividends Household
Wages Retained saving
8 of10Tax Impact
Points earnings
9 in Circular Flow Business
saving
CAPITAL
MARKET
2
6 7 Investment
Profit
Payroll
MARKET MARKET
5
FOR FOR
Depreciation CONSUMER CAPITAL
GOODS GOODS
102
Gross 3
Factor payments receipt
FIRMS 4
Figure 7.1: Points of tax in circular flow
 We may think of the monetary flow of income and expenditures shown in the figure as
proceeding in a clockwise direction, while the real flow of factor inputs and products
outputs (not shown) moves in an anticlockwise direction.
 Starting from factor market households sell their skills earning incomes inform of wages,
dividends, interest, rent and so on. The households save some of the income with the
capital market and consume the other part of their income by purchasing goods from
market for the consumer goods.
Consumer expenditures into the market for consumer goods become receipts of firms selling
such goods. Savings are channeled into investments, becoming expenditures in the market for
capital goods, and turn into receipts of firms producing such goods.
Part of business receipts (corporate income) is set aside to cover depreciation and the
remainder goes to purchase the services of labour, capital and other inputs in the factor
market, representing the factor shares in the national income. These shares are paid out to
suppliers of factors – in the form of wages, dividends, interest, rent and so on – and become
income of household.
Some profits, however, are withheld as retained earnings rather than paid out as dividends.
Retained earnings, together with depreciation allowances, comprise business savings and
combine with household savings to finance investment or the purchase of capital goods. Thus
the circular flow of income and expenditure is closed.
7.7 Locating Impact Points of various Taxes in the diagram
103
At point 1: Personal income tax is imposed on household income.
At point 2: Following expenditures by consumers on final goods, expenditure tax or value

added tax is collected
At point 3: Can also collect sale tax from retail sales receipts of the firms.
At point 4: Can collect corporate income tax from income of the firms originating from
market for consumer and capital goods.
Note: Depreciation is operating expense and is tax free.
At point 5: Can collect income tax from business receipt net of depreciation.
At point 6: The employer contribution to the payroll tax
At point 7: Can collect corporate profit tax.
At point 8: The employee contribution to the payroll tax
At point 9: - can collect from retained earning withholding tax.
(vii) Retained earning is part of profit not distributed to dividend holders but are aimed for
expansion purpose.
At point 10: collect income tax.
In Conclusion
From figure above, it can be noted that any particular transaction may be taxed at either the
household (buyer) or the firm (seller) side of the market. We also note that any particular
household or firm may be taxed at either the sources or the uses side of its account. Since the
account balances (total uses equal total sources), a general tax on the uses side is equivalent
to a general tax on the sources side. A tax on total household income would thus be
equivalent to one on total consumption plus savings. Similarly, a tax on total gross receipts of
firms would be equivalent to a tax on the total uses of its proceeds or cost payments plus
profits.
104
Combining the buyer – seller and sources – uses distinctions, our major taxes may thus be
arranged as follows:
Uses Sources
Households Expenditure tax (2) -Income tax(1)
-Employee payroll tax (8)
Firms Profit tax (7) Retail sales tax(3)
Employee payroll tax (6)
Note: numbers in the parenthesis refer to impact points shown in figure
7.8 FURTHER DISTINCTIONS
PERSONAL VERSUS IN REM TAXES

Personal taxes are taxes paid according to taxpayer’s personal ability to pay. In Rem taxes
(taxes on “all things”), on the other hand, are taxes imposed on activities or objects as such,
i.e., on purchases, sales, or the holding of property, independently of the characteristics of the
transactor or owner.
In Rem taxes may be imposed on either the household or the firm side. But personal taxes, by
their very nature, must be imposed on the household side of the transaction. Thus, if proceeds
from the sale of factors of production are to be taxed in a personal fashion, the tax must be
imposed on households as a personal income tax. Similarly, if consumption is to be taxed in a
personal fashion, the tax must be placed on the household in the form of a personal
expenditure tax. A sales tax imposed on firms is not responsive to the particular consumer,
but gives the same treatment to all households which undertake the taxed transaction.
105
In Rem taxes do not consider the ability to pay or equity. They are based on the benefits as
measured by the amount consumed. Irrespective of whether or not the consumer ability to
pay is low, if his consumption is high he will pay more. They are in this sense considered to
be regressive. As such, personal taxes tend to be generally superior in equity since they are
assessed on the household side.
DIRECT VERSUS INDIRECT TAXES
 Direct taxes are taxes which are imposed initially on the individual or household that is
meant to bear the burden. (e.g. income tax)
 Indirect taxes are the taxes which are imposed at some other point in the system but are
meant to be shifted to whomever is supposed to be the final bearer of the burden.(sales
taxes)
Personal taxes, such as the individual income tax, are thus “direct” and most In Rem taxes,
such as the sales tax are “indirect.” At the same time, the distinction between direct and
indirect taxes does not always coincide with that between personal and In Rem taxes. Thus
the employee contribution to the payroll tax may be considered direct, yet it is not a personal
tax since no allowance is made for the owner’s ability to pay. Similarly, the property tax on
owner – occupied residences is direct, but it is an In Rem tax rather than a personal tax.
7.9 SHIFTING AND INCIDENCE OF TAX
The study of tax incidence attempts to determine, who bears the burden of taxation in an
economy. It analyses the process by which taxation removes resources from the market
sector. It compares how the burden is borne using one tax as opposed to another to raise
revenues. Tax incidence refers to micro and macro effects of taxation. Question normally
asked include;
 Does a given tax pattern distribute income and output fairly? If not, where could it be
adjusted so as to reduce tax burden from less privileged society?
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Note: Tax incidence refers to the way in which tax burden is shared among individual
households.
For example, if two billion pounds is collected in taxes in order to build a hospital, then this
is the opportunity cost of providing this health service to society. Society will benefit from
improved health services, but incidence of this tax will depend on who pays how much of
total tax liability required to build the hospital. We can also say that the two billion pounds
tax collected represent tax burden to society.
The effects of withdrawing these amounts from tax payers would include reduced
consumption increased employment or reduced output. These are the distributional incidence
of tax. This tax burden is in turn accompanied by the benefit of improved health services
which must be allowed for to derive the net gain or burden of the entire transaction. In
general, taxes have micro effects and macro effects on level of output, employment, prices
and growth in the economy.
When budget operations do not involve resource transfers to the public, the government
simply collects taxes form the private sector and returns\transfers to that sector. There is no
shift of resources to public use and no opportunity cost in reduced private resource
availability. Some may gain while others will lose, but taxes being equal to transfers, there
will be no net change in income available for private use.
7.10 MAGNITUDE OF TAX BURDEN
When we talk of tax burden we simplify mean how much it squeezes you. Tax liability on the
other hand refers to actual sum of money a taxpayer is required to pay as a fraction of his
income. We have so far assumed that tax burden equal total tax liability to an individual.
However, this may not always be the case. There are cases where tax burden can be more
than tax liabilities. Where tax burden exceeds tax liability there is excess burden.
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Example: tax is imposed on radio sets (value added taxes) in order to raise one million
pounds. The sum total of tax collections from various consumers still equals one million
pounds, but the burden imposed on the private sector will be larger. This is so because the tax
interferes with consumer choice. Some people who had planned to buy the radios may avoid
buying them because of the tax payable. Therefore, they pay no taxes but the budget choice is
less satisfactory than it was before. These taxpayers therefore suffer burdens which are not
reflected in total revenue. Others may reduce their purchases and pay a tax on the reduced
amount. In both cases the consumer’s expenditure pattern has been distorted by the tax and
each suffers a burden which is greater than that which would have applied if they had paid
the same amount as a flat charge. Because of this, the overall burden suffered by the private
sector tends to exceed the amount of revenue obtained. This is what economists call “excess
burden.”
Another reason why tax revenue and total burden may differ is when the imposition of tax
leads to a change in factor inputs and hence in total output. For example, when same revenue
as in the previous example is collected under a progressive income tax. As a result, workers
may work more or less because the tax is imposed. If we suppose that they work less, their
earnings fall. If this decline in earnings is counted as part of the burden, the total burden once
more exceeds tax revenue.
Excess burden can also be considered from the employment point of view. Changes in output
may result, not because of adjustments in factor inputs in response to changes in after – tax
factor rewards, but because of resulting changes in the level of aggregate demand and
unemployment. Introduction of a tax may reduce the level of employment, or an increase in
expenditures may raise it.
7.11 TYPES OF TAX INCIDENCES
Taxes are paid in line with prevailing tax statute that has been legislated. Taxes in this sense
are mandatory imposition and failure to pay them is punishable by law. When we consider
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who holds the legal liability to pay tax, we are considering the statutory incidence of tax. Like
in all other cases of incidence, individuals will try to avoid tax by passing their tax burden to
others. While considering the nature of statutory tax burden we must remember that the final
tax burden must be borne by all citizens. The taxes are usually finally paid by the households
in their capacities as owners of business which pay the taxes, or as consumers of the products
of the taxes, or as consumers of the products of these businesses, or as employees of these
institutions.
When we examine tax from an individual point of view, we encounter certain implications.
When an individual is taxed a lump - sum tax of say Kshs.200 independent of his ability to
pay, he cannot escape it. However, he may adjust himself to the incidence of this tax by
cutting down his consumption or his savings or his aid to those who are dependent on him. In
effect when he does this he passes his tax burden to others with whom he transacts and thus
will have further repercussions. Moreover, taxes are rarely imposed in lump – sum form. The
tax law typically expresses tax liabilities as a function of some aspect of economic behavior,
such as earnings income, making sales, or making a purchase. Since such taxes are imposed
on economic transactions and since transactions involve more than one party, the transactors
on whom the statutory liability rests may avoid tax payments by cutting back on their taxable
activity; or they may attempt to pass on the burden to others by changing the terms under
which they are willing to trade. Their ability to do so will depend upon the structure of the
markets in which they deal and the way in which prices are determined.
Thus, imposition of an income tax may lead to reduced hours of work, thereby driving up the
gross wage rate. Increased wages in turn would lead to increased product prices, which
burden the consumer. Nevertheless, the resulting chain of adjustments may lead to a final
distribution of the burden or economic incidence, which differs greatly from the initial
distribution of liabilities or statutory incidence.
In all this cases when one party tries to avoid taxes by passing his burden to other people, we
say that he is shifting his tax burden.
Absolute Tax Incidence

Taxes will reduce the level of disposable income both at macro and micro level. At macro
level, an increase in taxes leads to a decrease in aggregate demand. If the public policy is to
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stabilize the economy by increasing taxes without changing government expenditures, the
course that the economy will take will depend on distributional effect of the tax itself.
An increase in tax depending on state of the economy can lead to unemployment, a reduction
in prices or can lead in a shift in resources from one use to another use, so that each tax action
has its own effect and distribution implication. Where tax is increased or reduced without a
relative change in government expenditure or an offsetting change in other taxes the effect
that such a tax will have either in aggregate or to each individual household is called absolute
tax incidence.
Differential Tax Incidence

In some cases one tax may be replaced by another tax without changing the amount of tax
revenue and government expenditure. The effects that result from such changes in taxes are
referred to as differential tax incidences.
This form of policy change does not involve any transfer of funds from private hands to
public hands and no net burden on the private sector. It merely involves redistribution among
households. Consider a case where Kshs one billion of income tax revenue is replaced with a
cigarette excise yielding an equivalent amount. Households whose income tax is reduced will
gain, while others with high cigarette purchases will lose. Going beyond this, tobacco
growers and cigarette workers will lose, while others producing the output purchased by
former income taxpayers stand to gain. This resulting total change in the state of distribution
is what is referred to as differential incidence.
Budget Incidence
Budget incidence may originate from changes in government expenditure and changes in
taxes. Government expenditure may be on transfer payment, salaries to civil servants, capital
expenditures for development, purchases of goods and services, and debt repayment and
servicing. Incidence of government expenditure can be explained in various ways;
I. Increase in government expenditure leads to increase in disposable real income and further
increase in employment in the country. This is under normal circumstances. But, if
unplanned well,
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II. Increase in government expenditure may lead to increased aggregate demand over
aggregate supply, hence leading to inflation.
On the other hand, increase in taxes has the opposite effect. Its immediate effect is a
reduction in real disposable income, increased unemployment, or reduced inflation.
Note: Taxation and government spending take place simultaneously. Those taxes reduce
earnings of the private sector and in particular they reduce disposable income. As a result of
this, benefits from public goods will increase while benefits from private sectors will decline.
These effects constitute budgeting incidence of a tax.
7.12 EFFECTS OF TAX INCIDENCE ON MARKET FOR GOODS
S1
P
S
 Where tax is collected on each unit of output produced
a or sold it is called a unit tax.
 Where it is quoted as a percentage of selling price it is called an advalorem tax.

G
So, unit tax is quoted as specified amounts per unit sold, for example, 20 Shs per Kilograms.
F
When it comes to advalorem tax, it may be quoted as 5% of manufacturers price or 10% of
H
B price, depending on where it is collected.
wholesale A
K
Taxes, irrespective of their kind, will disrupt the equilibrium existing between demand and
supply in the market. An increase in tax of a given commodity increases the price and
reduces the demand for the product depending on price elasticity of demand of the product.
S1 D
S E
O Qe Q
Figure 7.2: Effect of unit tax
When a unit tax is imposed, its effect is to shift the supply curve upwards from SS to S 1S1.
Unit tax is viewed here as additional to cost. SS is the supply schedule prior to tax and S 1S1 is
the supply schedule as it confronts the consumer after imposition of a unit tax “a.” The
demand schedule is given by DD.
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Observation:-
I. Quantity demanded declines from OQe to OE.
OB – Price before tax.
OF – Price after tax.
II. Total tax rate is KF.
III. BF is tax rate payable by consumer per unit sold.
IV. KB is tax rate paid by seller of the product
V. Total amount of tax revenue collected from both seller and consumer is
represented by area KFGL.
 Consumer pays the amounts of tax represented by over BFGH.
 Producer pays the amount of tax represented by area KBHL.
This is the case where we have unit tax charged on every unit sold or bought.
When it comes to advalorem tax, the case is different. T = F (price per unit sold), since tax is
expressed as % of selling price.
Unlike in unit tax where the supply curve shifts when tax is introduced, in the case of
advalorem tax it is the demand curve which shifts downwards. Tax amount collected is still
represented by the difference between the price paid by consumer and net price received by
seller. Also note that when advalorem tax is imposed, although the demand curve shifts
downwards, the shift is not uniform because the amount of tax per unit falls as the quality
sold increases. (note advalorem tax is quoted as , e.g. 5% of selling price)
Price D
S
G
F
D1
H A
B
K J
L
S D1 D
112 Quality
O E Qe
Figure 7.3: Effect of advarolem tax
DD is the market demand schedule and SS is the supply schedule. Equilibrium output before
tax equals OQe, and price equals OB. Now if advalorem tax at rate
T = AJ is imposed. The net demand schedule shifts to D1 D1. Output falls to OE, the
AQe
Gross price rises to OF, and the net price falls to OK.
 Total tax revenue is represented by area KFGL.
 Consumer pays the amount of tax represented by area BFGH. Producer pays the
amount of tax represented by area KBHL.
 There are two ways of quoting advalorem tax from the diagram;
1. When advalorem tax is quoted as GL it is called net advalorem tax rate.

EL
2. when advalorem tax is quoted as a ratio of tax to the gross price (GL)
EG
It is referred to as the gross advalorem tax rate.
Note that burden to consumer reflect the additional amount which they must pay in order to
get new quantity OE, compared with what they would pay in order to get whole larger quality
OC. To consumer, tax effect is increased prices from OB to OF and reduced demand from
OC to OE.
In general, burden to supplier is reflected in reduced supply and reduced net price. Supply
falls from OC to OE. Net price falls from OB to OK. This has led to less net revenue from the
sale of product.
This explanation doesn’t consider the problem of excess burden but it suggests a very
important rule that the burden of tax is divided between the buyer and the seller as ratio of
elasticity of supply to elasticity of demand in the relevant range of demand and supply
schedule.
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It can be shown that Bb = Es = BF/BK ratios or elasticity.
Bs Ed
Bb and Bs represent the consumer and Seller’s shares in the tax burden
Bb – buyers share.
Bs – sellers share.
Es – price elasticity of supply.
Ed – price elasticity of demand.
This can be proved as follows:

From above figure, Ed over the relevant price range OF = Ed = ∂Q PO;
∂P QO
∂P = OF-OB=BF
Ed = ∂Q PO;
BF QO
Similarly it can also be proved that;
ES = P0. ∂Q
Q0. ∂P
∂P = OB – OK = BK
ES = P0. ∂Q
Q0. BK
(P0. ∂Q)
ES = (Q0 . BK) = BF /BK
ED (∂Q. P0)
(BF. Q0)
When demand curve and supply curve are rotated around point A, then it is clear that the
buyer’s share in the tax burden increases as the demand curves becomes less elastic and
supply curve becomes more elastic. Or, in other words, the consumers share in the tax burden
increases as demand schedule steepens or becomes more inelastic and the supply schedule
flattens or becomes more elastic.
CASES:
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1) Where demand is perfectly inelastic while supply is elastic the whole tax burden is
transferred (shifted) to consumer as follows;
P DD
From the diagram, DP does not lead to corresponding D in Q.S2
Consumer Pay all tax burden as shown by shaded region.
2) Where the supply schedule is perfectly inelastic Tax SO curve is downwards
and demand
P2
slopping, an increase in tax results to an increase in prices and the whole tax burden is
borne by the supplier.
P1
P S
Q
O Qe
P1
PO Tax Do
D1
O Q
Qe
3) Perfectly elastic demand and an elastic supply.
P
Effect of an increase in tax when demand is perfectlySelastic
2
is to reduce net price from P 1 to
Pnet and the net revenue to supplier also declines. Tax S1
4) PerfectlyPelastic
1
supply schedule.
D
P
Pnet
O Q1 115
QE
P1 S1
t
Pe S2
D
O Q
Q1 Qe
Price rises by the tax amount. Effect of an increase in tax when supply is perfectly elastic
while demand is downward sloping is to increase the Selling price from OPe to OP 1 and
reduce quality demanded form OQe to OQ1.
7.13 OTHER FACTORS THAT AFFECT EFFECTIVE INCIDENCE OF TAX
1) Types of tax. Type of tax e.g. in the case of a sales tax, the sellers quite often adopt the
practice of quoting the sale price as seen and once the bargain has been settled, add the
sales tax in the bill. Such a practice tends to break the resistance of the buyers and it
becomes easier to shift the incidence of the tax on to them.
2) The price of good. It sometime happens that with a large usage or advertising and
publicity, some prices comes to be fixed and acceptable as normal, tax or no tax. It is not
easy to shift the tax here by means of a price vice. However a possibility may exist to
shift the tax by deteriorating the quality or reducing the size of the taxed object.
Restaurant quite often adopt the policy of reducing the sizes of various eatables as a
substitute for raising prices. Sometimes, the market may be controlled by a small group of
sellers and by a convention. it may be difficult to change the price unless everyone does
so. e.g. newspapers having the same price in a city. In this case, it will be easier for all of
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them to raise the price and if any one of them wants to do so, it would be better to reduce
the number of pages or reduce the quantity.
3) The tax rate. The shifting of tax depends to a great extent upon the tax rate. If the tax is
quite small and the market is competitive, the sellers may choose to absorb the tax in
order to maintain the good will of the buyers.
4) Availability of substitute. It will be more difficult to shift the tax to the buyer in the case
f a commodity tax which has close and effective substitute. The consumers will then have
an easy mean of shifting their demand if the price of their taxed goods is raised. It means
that the elasticity of demand for these goods will be high and so the tax will have to be
borne by the sellers. However, if the substitutes are also taxed, then the shifting of the tax
incidence will depend upon the general pattern of the demand elasticity for this group of
commodities as a whole vis-à-vis the pattern of their supply elasticity.
5) Tax area. In the case of goods taxation the geographical coverage of a tax has a great
influence in determining the incidence of the tax in the taxed area. Since the untaxed
goods will be available in the neighboring area, there will be great resistance of the
buyers to bear the tax incidence. The price of the good will therefore rise to an extent
much smaller than would be the case if geographical area of the coverage was complete.
In order to discourage buying of the taxed commodity in the neighboring untaxed areas
and bringing them in, the authorities often impose a use tax on the taxed goods if it is
brought in from the untaxed area.
6) Time period. Time factor influence the shiftability of a tax. In the short period supply is
inelastic. Hence, during this period greater part of tax burden will be borne by the seller.
In the long-run, supply is more elastic. Hence, there is a better scope for shifting tax
burden upon the buyer. Therefore in short period, shifting of a tax is difficult, whereas in
the long-run it is easy to do.
7) Nature of demand for commodities. By this we mean whether the taxed commodity is
falling under the category of necessity, comfort or luxury. In the case of necessary goods,
demand is inelastic. Hence the burden of tax is higher upon the buyer, than on seller. In
the case of comfort, demand is more elastic, hence burden of tax will be divided between
buyer and seller. In the case of luxury demand is elastic, hence the burden of tax is more
on the seller. It cannot be easily shifted to the consumers.
8) Business conditions. During periods of rising prices and economic prosperity, taxes can
be shifted more easily. However, during periods of depression, forward shifting of tax
liability is very difficult.
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9) The policy of the government. Tax laws clearly indicate the price to be charged and to
be printed on the product cover. Likewise the government fixes maximum retail price.
Those who charge higher prices are legally punished. On the other hand, if prices are
increased due to the attempt to shift some taxes to be paid by the seller, awareness of tax
laws helps the consumer to resist it.
7.14. SUMARY
7.14 SUMMARY
The lecture has explained clearly the canons of taxation. It has also been discussed in details
the principles of taxation together with their advantages and disadvantages. The lecture has
also shown the effect of ad-varorem and specific on the goods market. It has ended by
looking
7.15 at factors that affect tax shifting in an economy.
ACTIVITIES
1. Using the circular flow of income diagram explain the various point where tax can be
imposed and specify which tax.
2. Explain the various types of taxes.
3. Explain the factors that determines the shifting of taxes
McGraw-Hill,1989).
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J.Batas, Managing Value for Money in the public Sector (London: Chapman & Hall, 1993)
S.James and C. Nobes, The Economics of Taxation (London:Prentice-Hall,1992).
M. Wilkinson, Taxation (London: Macmillan)
ALTERNATIVES TO TAXATIONS
LECTURE EIGHT
8.1 INTRODUCTION
The next chapter introduces you to the other sources of government finances. Apart from
taxation which constitutes over 90 % of government funds there are other sources which need
to be explained.

a) Explain the various sources of public debts
b) Discuss the ways that can be adopted to redeem public debts
c) Discuss the effects of public debt in an economy
d) Compute the public sector borrowing requirement
e)
PUBLIC DEBT
The government of a country gets its income from two sources:
i). Public Revenue and
ii). Public Borrowing or Public Debt.
Public revenue consists of money that the state is under no obligation to return to the very
individuals from whom it has obtained. Public debt, on the contrary, carries with it the
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obligation on the part of the state to pay the money back to the persons from whom it has
been received.
8.3 THEORY OF PUBLIC DEBT
Public debt is of recent growth and was not heard of prior to the 18th century. The classical
economists were generally against the public debt. They assumed that individual consumer
and business firms make use of the resources more efficiently. Thus, under a fully employed
economy, the state can acquire resources by public debt only at the cost of private sector
where they are more efficiently used.
It was Keynes who effected a truly significant revision in the theory of public debt. He
rejected the classical view of a free enterprise economy which is self-equilibrating at full
employment level. He developed and advanced the concept of under-employment
equilibrium. Resources in the private hands may remain unemployed for relatively long
periods if corrective or compensating action is not taken by the government.
During World War II and in the post-war years, the size of public debt increased enormously.
In modern times borrowing by the state has become a normal method of government finance
along with other sources such as taxes, fees, etc. The government may borrow from banks,
business-houses, other organizations and individuals. Besides, it can borrow within the
country or from outside. The government loan is generally in the form of bonds (or treasury
bills if the loan is required for short periods) which are promises of the government to pay to
the holders of these promises the principal sum along with interest at the agreed rate.
8.4 CLASSIFICATION OF PUBLIC DEBT
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Public debt has been classified in many ways, though all the classifications are not equally
useful.
i). Internal and External Debt. Internal debt refers to the public loans floated within the
country, while external debt refers to the obligations of a country to foreign
governments, foreign nationals or international institutions. Internally the government
borrows from private individuals, institutions, commercial banks etc. External loans
may help the government in difficult times, when internal resources are not sufficient to
meet the financial requirements.
ii). Productive and Unproductive Debt. Public debt is said to be productive if the
investment yields an income which will not only meet the yearly interest payments of
the debt but also help repay the principal over the long run. They help in the creation of
remunerative capital assets that yield revenue to the government. For example, loans
raised for the development of railways, irrigation projects etc are productive loans. On
the other hand, public debt incurred to cover budgetary deficits on revenue account is
classified as unproductive debt. It is also called dead-weight debt. They have no
existing assets. They do not create assets nor any income to the government. The
government may undertake certain projects through loans which may not be productive
in the sense given above but which may be really useful to the community, as for
example, a railway line connecting a backward region, an irrigation work to prevent
famine conditions in an area and so on. In this sense, most public debt is productive.
But public debt may be contracted to finance a war. Such debt is unproductive because
it does not create an asset, it is a dead weight debt or a useless burden on the community
iii). Redeemable and Irredeemable Debt. The redeemable debts are those which the
government promises to pay off in future at a specified date: they are terminable loans.
Irredeemable debt refers to a debt which may not be redeemed at all but on which the
government promises to pay the interest regularly. These loans may be known as
perpetual debt. The redeemable loans may be further classified into short period and
long period loans depending upon the period of redemption.
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iv). Funded and Unfunded Debt. Public debt is also classified into funded and unfunded or
floating debt. Broadly speaking, funded debt is a long-term debt, undertaken for
creating a permanent asset and the government normally makes arrangements about the
mode and time of repayment. Unfunded or floating debt is a relatively short period debt,
meant to meet current need. The government undertakes to pay off the unfunded debt in
a very short period, say within six months.
v). Compulsory and Voluntary Debt. Generally, government debt is of a voluntary type,
that is individuals and institutions are invited to take up government bonds freely. On
the other hand, a compulsory loan implying force is not common in modern times.
However, pressure may be applied by the government at certain times in selling its
bonds.
vi). Marketed and non marketed debt. A marketed debt is one in which the debt
instruments are negotiable. That is it can be freely bought and sold in the market. Non-
marketable debts are those debts such as savings bonds which cannot be bought and
sold in stock-exchange markets.
vii). Callable and non callable. Callable debts are those debts which the government can
repay even before the period of maturity, whenever it is found convenient for the
government to do so. The government can pay back these types of debts, whenever it
enjoys surplus funds, or when the prevailing interest rates are low. Non- callable debts
cannot be repaid in this manner. It can be repaid only at the time of maturity.
viii). Short term, medium term and long term debt. Short term debts are those debts which
mature within a period of three to six months. These loans are drawn from the central
bank by using the credit instrument of treasury bills. Medium term loans are those loans
which mature within a period of one to ten years. Long-term loans mature for over ten
years. They are usually raised for financing development projects and carry a high rate
of interest.
ix). Gross debt and net debt. Gross debt refers to the total debt obligation of a government
outstanding at a particular time, whereas net debt is gross debt minus sinking fund or
other assets crated for the repayment of loans.
8.5 WHY IS PUBLIC DEBT INCURRED?
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Public loans in modern times are necessary to meet important situations. They can be
explained as below:
i). To meet budget deficits. Modern governments do not have large accumulated balances
or treasure to meet any budget deficit. Normally, the annual expenditure of the
government should be and is met by annual income. But because of many
circumstances the yield from taxation and other sources may not be equal to the actual
expenditure. Similarly, there may be unplanned and unexpected emergency situations
like major fires, floods and famines. Short-term borrowing is ordinarily used to meet
these emergencies.
ii). To meet war expenditure. Modern warfare is so costly that the normal income through
taxation falls short of the actual war expenditure. Besides, taxation beyond certain
limits has disastrous consequences for production, and thus interferes with the most
important objective during a war, viz., the winning of the war. Moreover, a public loan
is better and easier method of collecting revenue than taxation. Governments, therefore,
have to borrow extensively from individuals and institutions towards war financing. In
fact, the enormous increase in public debt in most countries is due mainly to the First
and Second World Wars.
iii). To remedy a depression. Public borrowing is considered very useful to remedy a
depression; in fact, the strongest case for public borrowing is as a remedy for
depression. During a period of depression, the level of economic activity is low,
resulting in low production and unemployment. The depression and unemployment are
generally due to deficiency of demand for goods and services. Many economists like
Keynes have advocated increased public expenditure financed through borrowing and
not through taxation, for while taxation will reduce incomes and demand still further,
borrowing will have no such effect. Besides, loans enable the government to make use
of idle and unutilized funds of the public. Thus, there is a strong justification in favour
of public borrowing to cure unemployment.
iv). To develop the economy. Public loans are resorted to for development purposes. Even
advanced countries have to undertake the construction of public works like roads,
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railways, irrigation works, powerhouses, etc., for accelerating their economic progress.
Underdeveloped countries interested in the development of their natural resources to the
optimum level find public borrowing a very useful device to finance the various
development projects.
v). To finance social overheads. Public debt is used to finance the creation and
development of social overheads capital like education and health care facilities. These
basic facilities require huge investments, which cannot be met by ordinary source like
taxation. Hence modern governments utilize borrowed money to finance these projects.
The first factor, mentioned above, is only to meet temporary difficulties and is soon repaid
out of tax receipts in the subsequent period. The second cause of public borrowing—the
prosecution of a war—has been probably the most important factor for increasing public debt
in all major countries in recent years. But this and the first factor are of an unplanned type.
But the third and fourth cases may be called planned borrowings, for the Government
deliberately plans to use the proceeds of public debt to finance certain specific projects. In
this case, the Government may borrow resources and would otherwise have been used by the
private sector and also resources that may remain unemployed.
8.6 SOURCES OF PUBLIC BORROWING
Every government has two major sources of borrowing – internal and external. Internally, the
government can borrow from individuals, financial institutions, commercial banks and the
central bank. Externally, the government borrows from individuals and banks, international
institutions and foreign governments.
Borrowing from Individuals

When individuals purchase government bonds, they are diverting funds from private use to
government use. Individuals may be able to subscribe to government bonds either through
curtailment of current consumption needs (this may be very rare) or through diversion of
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funds from their own business or diverting funds into government bonds from corporate
securities. Normally, the sale of government bonds to individuals should not curtail either
consumption or business expansion. To a large measure, the bonds will be absorbed out of
funds that would have been lying idle or would have been used to buy other securities.
Borrowing from Non-banking Financial Institutions

More important than individual subscribers to government bonds are the financial institutions
such as insurance companies, trusts, mutual savings banks, etc. These non-banking financial
institutions prefer government bonds because of the security provided by the latter and also
due to their high negotiability and liquidity. But the rate of interest is low and hence in many
cases financial institutions may prefer high-risk high-return securities particularly equities.
When non-banking financial institutions fake up government bonds, they do so to reduce
their cash holdings.
Borrowing from Commercial Banks

While individuals and non-banking financial institutions take up government bonds out of
their own funds, commercial banks can do so by creating additional purchasing power known
as credit creation. The banking system as a whole can make additional loans up to an amount
several times as great as the excess cash reserves. This is possible because the loans the
bankers make are typically book entries in the names of borrowers who pay in the form of
cheques to others who have also bank accounts. The result is that so long as cash is not
withdrawn from the banks, it serves as the basis for the expansion of loans.
Commercial banks can subscribe to government loans through creation of credit. They need
not contract their other loans and advances. Whenever the banking system has excess cash
reserves, it can absorb an amount of government bonds considerably greater than the excess
cash reserves. It is important to note that the power to buy bonds is essentially created rather
than merely transferred. So if commercial banks create additional purchasing power and
place it at the disposal of the government to finance the latter's expenditures, inflationary
pressures will be generated (if previously, the economy has been working at full
employment).
Borrowing from the Central Bank
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The central Bank of the country also subscribes to government loans. The action is exactly
similar to the system of creation of additional purchasing power by the commercial banking
system. By purchasing government bonds, the central bank credits the account of the govern-
ment. The latter pays to its creditors out of its account with the central Bank. Those who have
received cheques from the government on the central bank deposit the amount with their
banks. These banks find themselves with large cash reserves which become the basis for
additional loans and advances. It will be seen that borrowing from the central bank is the
most expansionary of all the sources for not only the government secures funds for its
expenditure but the commercial banking system gets additional cash which can be used as the
basis for further credit expansion.
While the borrowings from individuals and financial institutions are simply transfer of funds
from private to government use and, therefore, will not be expansionary in their effect on the
economy (unless the funds were previously lying idle and are being activised through
government borrowing), borrowing from the commercial banking system and the central
bank will have expansionary effect.
Borrowing from External Sources

Government may borrow from other countries too. These borrowings can be used to finance
war expenditure, or to produce defence equipment, or to pay for development projects, or to
pay off adverse balance of payments. Formerly, the floating of loans for any specific
development projects, like railway construction, was taken up by individuals and banking and
other financial institutions. However, in recent years, apart from this source, two important
sources have become prominent. They are:
a) International financial institutions, viz., I.M.F., the I.B.R.D., the I.D.A. and the I.F.C.,
which give loans for short-term for overcoming temporary balance of payments
difficulties and for the long-term for development purposes; and
b) Government assistance generally for development projects. For developing countries like
Kenya, external sources of borrowing are becoming considerably important in recent
years.
8.7 ECONOMIC EFFECTS OF PUBLIC BORROWING
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Traditional economists argue that the government should use taxation to finance current
expenditure and borrowing from the public to finance capital expenditure. In recent years,
there has been considerable change in economic thinking on this question. It is commonly
accepted now-a-days that taxation and borrowing can be used for either type of expenditure
depending upon the circumstances. At least, in the case of developing nations both borrowing
and taxation are used to finance development projects. Basically, the economic effects of
government expenditure financed by public borrowing are different from the effects of
similar expenditure financed by taxation in the following three important respects:
a) The transfer of funds from the public to the government is compulsory under taxation and
voluntary under borrowing ;
b) While taxation reduces the wealth of the taxpayers, loans do-not reduce the wealth of the
lenders but merely change its form ; and
c) Financing through taxation is more contractionary while financing through borrowing has
more expansionary effect. Taxation has contractionary effect on the economy because
it reduces consumption. On the other hand, lending to the government is voluntary and,
hence, will be paid out of saving and not through curtailment of consumption. Moreover,
lending does not involve reduction of wealth and, therefore, will not have adverse effect
on incentives and enterprise as would be the case with taxation.
Leaving these general aspects of borrowing, we shall discuss the economic effects of public
borrowing under specific headings.
Effects of Public Borrowing upon Consumption

As has been shown in a previous paragraph, government borrowing should not normally
result in curtailment of consumption. This is so because lending to the government being
voluntary will be met out of saving and not through reduction of consumption expenditure.
But in time of war or in periods of emergency, substantial pressure may be applied to induce
individuals to curtail consumption and to subscribe to government loans. The only other
possibility is when government bonds may offer special advantages and higher interest rates.
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Some of the individuals and financial institutions may then be tempted to save more and
invest in government-bonds. But generally speaking, restriction of consumer spending does
not take place.
Effects of Borrowing on Investment

Government borrowing can influence investment adversely, though it can have neutral effect
also. For instance, government borrowing from commercial banks and the central bank of the
country will be of the nature of creation of additional purchasing power and, therefore, will
not result in curtailment of funds available for investment. But if individuals and financial
institutions and even commercial banks subscribe to government loans out of funds meant for
investment or for the accumulation of stocks then investment expenditure is curtailed. But if
the interest rate is not affected and the new government bonds do not carry any special
advantages over existing securities, private investment may not be affected appreciably.
If interest rates are higher and the advantages attached to government bonds are greater, the
demand for company shares will decline and consequently the prices of stocks and shares will
come down. This may restrict private investment in equity shares. However, governments, in
their own interest, will like to follow a cheap money policy of lower interest rates (for this
will mean lower interest burden on public debt). Even if interest rates are high, investment
borrowing by individuals and companies will not be affected significantly. For one thing,
investment borrowing will depend upon business prospects and profitability (marginal
efficiency of capital) of investment rather than the rate of interest. This was shown by Keynes
and has later been proved conclusively by many empirical studies. For another, the very large
volume of investment undertaken with funds obtained from past earnings is particularly
insensitive to the interest rate.
On the whole, however, government borrowing need not affect private investment
expenditure adversely except under special circumstances. For instance, the interest rates
should be high and the volume of investment should be dependent upon the interest rate; or
the bonds should be sold to the persons and institutions who curtail their loans for business
expansion in order to buy government bonds. But these special circumstances need not take
place ordinarily. But there can be one indirect way by which government borrowings may
have an adverse effect on investment. The growth of public debt may be alarmingly rapid and
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the investing public may fear a national bankruptcy or anticipate heavy taxation in the near
future. The result will be a decline in investment.
On the other hand, government expenditure financed out of borrowing will normally be
expansionary. When borrowing is restricted to the commercial banks and the central bank,
additional purchasing power will be created which will become the basis for additional loans
and advances to the private investors. Moreover, government expenditure financed out of
borrowing will result in additional demand for goods and services, the supply being assumed
to be the same. This will result in a rise in prices and rise in profit margins. If the economy
has been working below full employment level, it will stimulate greater investment (in order
to secure higher profits). Thus, while taxation results in contraction, borrowing generally
leads to expansion of the economy.
Effects of Borrowing upon Distribution of Income

Loan finance implies that all those benefiting from government expenditure will have higher
real income. At the same time, loan finance will not reduce the real incomes of those who
have subscribed to government bonds. If government expenditure is meant to provide more
economic welfare to the lower income groups, then the result will be a narrowing down of
inequalities and a more equal distribution of income between people. But to the extent that
loan finance becomes inflationary, some of the good effects upon the distribution of income
which we have explained above may be neutralized.
Another point to consider here is the interest payment. Interest payment will represent a
transfer of real income from the taxpayers to the bond-holders, for the government will have
to tax the people so as to pay the bond-holders the interest charges and later the principal as
well. If the bond-holders and the taxpayers are identical, then there will be no net
redistribution of income, but this need not be the case. Accordingly, some redistribution of
income will take place so long as the taxpayers and the bond-holders belong to different
groups.
Effects of Foreign Loans

Foreign loans can influence both consumption and investment favorably. Foreign loans are
meant to finance the imports of goods without paying for them immediately through exports.
If foreign imports consist of consumer goods they tend to reduce any inflationary pressure
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which may exist due to shortage of goods. On the other hand, imports of machinery,
industrial raw materials and technical know-how will have the favourable effect of speeding
up industrialization within the country. If foreign loans are meant to finance a war or to
modernize an army, then obviously they cannot have any effect on investment in the country.
The demand for foreign currencies will be reduced through foreign loans, when they were
floated. But interest payments as well as the repayment later will involve increasing exports.
This may mean a possible lowering of tie real standard of living.
EFFECTS OF PUBLIC DEBT

We should clearly distinguish between economic effects of public borrowing from economic
effects of public debt. Borrowing refers to the method of securing funds and is one of the
alternatives available to the government – the other sources being taxation, profits from state
enterprises and money creation. The effects of borrowing, therefore, refer to that programme
of government expenditure financed by borrowing as contrasted with the effect of a similar
programme financed by taxation. On the other hand, the effects of public debt refer to the
effects on the economy which are caused by the existence of public debt, after it has been
incurred.
Public Debt and Consumption

The existence of public debt has an important effect upon consumption. Those who hold
government bonds representing the latter's obligation to pay consider these bonds as personal
wealth. This wealth would not have arisen if the government had chosen to finance its
expenditure through taxation. Moreover, the bond-holders would forget that the bonds
represent claims on them as taxpayers in the form of additional taxation. The net result is that
the possession of government bonds will induce them to spend not only a larger percentage of
their incomes but also spend in excess of their incomes since they can dispose of the bonds to
pay for the excess expenditure. Consequently, the net effect of public debt is to increase the
percentage of total income spent on consumption and thus exert an expansionary effect on the
economy.
Monetization of Public Debt

Public debt of a country has the direct effect of increasing the total money supply in the
country. For instance, deficit financing by the Government actually means Government
borrowing from the Central bank of the country which directly increases the money supply in
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the country. Likewise, when the commercial banking system subscribes to the issue of new
Government bonds, they may do so without reducing their other investments or advances to
the industrial and commercial sections but through a simple creation of credit. This is what is
commonly known as monetization of public debt, that is, the public debt is subscribed to by
the banking system in such a manner that it results in an increase in the money supply of the
country.
Public Debt and Liquidity

Public debt is represented by bonds which are highly negotiable. Those who have bonds have
highly negotiable and highly liquid form of assets. Whenever individuals require more funds
for any purpose – transactions, precautionary or speculative motive – they can easily convert
the bonds into cash. Public debt is thus responsible for the existence of highly liquid form of
assets.
Another important effect of the highly liquid government bonds is to be found in the case of
commercial banks. The latter hold large amounts of government bonds which can be
converted into cash whenever cash is required. In times of inflation the central bank of a
country may attempt to use bank rate, open market operation and other weapons to reduce the
cash reserves with commercial banks and thus reduce their credit expansion. But commercial
banks can increase their cash reserves through disposing of their government bonds.
Public Debt and Investment

The effect of public debt on investment is not very clear. Two apparently contradictory
effects can be visualized. On the one hand, the existence of huge public debt and the
consequent high rates of taxation to service the debts will generate fear and uncertainty in the
minds of investors. Besides, the existence of huge debts involving huge interest payment may
suggest the possibility of the government introducing capital levy or even the extreme
method of repudiation of debt. All this will affect adversely long-term-investments. On the
other hand, the existence of large public debts will force the government to maintain a low
rate of interest in order to keep its interest obligations at the lowest amount possible.
Accordingly, borrowing and investment will be encouraged. It is, thus, difficult to state
clearly whether existence of public debt will encourage or discourage investment.
As regards the desire to work and save, public debt will generally tend to reduce it. Public
debt, by providing safe and steady channel of investment in government bonds, may
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encourage savings. But taxation necessary to pay the principal and interest charge will
discourage savings. Moreover, the receipt of interest by the holders of government bonds
may reduce the latter's desire to work and save to a certain extent.
Finally, as regards division of resources, public debt involves the use of funds on those
expenditures which are considered essential and more useful than those on which the funds
would have been used otherwise. If idle funds are channeled into the development of
railways, irrigation and power projects e.t.c., the diversion will be really justified. The same
may be said if borrowing from the banking system is used to create permanent and productive
assets. The only wrong diversion will take place when funds which otherwise would have
been spent on productive undertakings are spent on defence purposes. But this will have to be
judged according to circumstances.
8.8 BURDEN OF INTERNAL AND EXTERNAL DEBT
Generally, internal loans have been very important, but in recent decades developing
countries have been borrowing extensively from external sources. The loans have been from
the World Bank and other agencies and governments. Sometimes, the external loans may be
to overcome temporary balance of payments difficulties but in most cases they are for
economic development. External loans are particularly important for developing nations
because the latter have great demand for foreign machinery and raw materials and do not
have adequate exports to pay for them. These nations are, therefore, plagued by continuous
adverse balance of payments and exchange rate difficulties. There has been considerable
confusion and prejudice in dealing with external loans and hence a comparison between
internal and external loans is being made here.
Burden of Internal Debt

In the case of an internal debt, there is no direct money burden on the community as a whole,
since the payment of interest and taxation to meet the same involve simply a transfer of
purchasing power from one group of persons to another. To the extent, that the bond-holders
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and taxpayers are the same, there may not be any net burden at all on the community. But to
the extent that the bond-holders and the taxpayers belong to different income groups, there
are changes in the distribution of income between different sections of people in the
community.
Internal debt is a burden, and it would be too illogical to argue that internal public debt does
not involve any burden at all. In the first instance, the purpose of the government loan should
be considered. A loan meant to finance a productive enterprise on investment can be paid out
of the profits of the investment. On the other hand, a loan to finance a war will have to be a
dead weight and have to be paid out of taxation. There is, obviously no burden involved in
the first case, but there is obvious burden in the second case. It is, however, stated that there
is no burden in the second case too because the burden imposed by taxation will be cancelled
by the benefit received through interest payments of the government.
Secondly, as already indicated, the real burden of public debt will depend upon the type of
people who own the bonds and who receive interest payments and the type of people who pay
the taxes. Since in a majority of cases the holders of government bonds are the higher income
groups while the taxpayers are both the rich and the poor, there is a net increase in the real
burden of the community.
Thirdly, the real burden of the debt repayment will be definitely much more than is thought
of at first sight. For instance, the government will be taxing enterprise, patriotism, activeness
and youth (i.e., those who pay) for the benefit of the passive, old and leisurely class (i.e.,
those who receive).
Fourthly, during war when the debt is contracted, the value of money is low (because of high
price). Soon alter the war and later, prices generally decline and hence those who get interest
income through ownership of government bonds gain in terms of real income.
Finally, the payment of interest charges and the repayment of debt will involve tax measures
which, consequent affect the power as well as the willingness to work and save. The sooner
the debt is cleared off through a capital levy or through some highly progressive taxes the
better it will be for the community. It is, however, necessary that debt repayment is managed
in such a manner and in such a period that there will be no adverse effect on production.
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It will, thus, be clear that even domestic debt imposes both money and real burdens. To
contend that internal debt does not mean any burden on a country's economy is theoretically
unsound and practically unrealistic.
Burden of External Debt

In one sense, the burden of a foreign debt is similar to that of domestic debt. That is, the
government will have to pay it through additional taxation. But, while in domestic debt,
interest payments and the repayment of loans are available to local nationals they are
available to foreigners in the case of foreign debt: In another sense, the total money burden of
an external debt is more because there is the additional transfer problem. That is, the
government will have to find necessary monetary resources to pay off the external debt and
besides will have to secure foreign currencies too (after all, foreigners will have to be paid in
their currencies). The transfer problem, therefore, requires that during the term of the loan,
the balance of trade must develop favorably. In other words, a regular payment of interest and
principal to foreign countries will be possible only if the exports exceed the imports by at
least the obligations arising from the loan.
It is said that domestic debt does rot normally result in any net burden to the economy but
only a redistribution of national income. But externally held debt can mean a certain
impoverishment of the economy. The paying of interest and debt redemption to foreign
countries means a corresponding reduction of national income and makes greater demand on
the gold and foreign exchange resources of the country. This is what has been referred to as
the transfer problem in the previous paragraph. But, properly speaking, there is no
impoverishment involved. What actually, happens is this: Originally, when foreign loans
were made, they entered the debtor country in the form of machinery, raw materials and other
essential goods, for which no corresponding exports were made at that time. After the lapse
of a certain t me, the debtor country manages to secure excess of exports over imports to pay
for the external loan. In this, there is no actual impoverishment of the economy involved but
goods are paid for goods.
On the other hand, if the external debt was originally incurred to meet war expenditure, it
would have been a dead weight debt. The repayment of debt through export surplus would
not be canceling out the import of goods and services in the past which had any effect on the
productive capacity of the country. In tins case the export surplus to pay off a war-debt would
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really deprive the citizens of a debtor country of a certain amount of goods and services. This
would be a net direct real burden of an external loan.
However, there is one sense in which an external loan can be a source of trouble to a debtor
country. The transfer problem necessitating the creation of an export surplus means "an
exhaustion of the country's future capacity to import"; this is of vital importance for
development. But if the foreign loans are floated only when it is absolutely essential and
when internal resources are utilized as far as possible, and \\ the foreign loans are used to
increase the total national product including goods specially meant for export, there is no
reason why the debtor country should suffer in the future.
A developing country which borrows from abroad for the development of social and
economic overheads and basic industries will find that the benefits outweigh the burden of
repayment of the loan. An external loan for development purposes is not a burden but a
profitable venture. This is exactly like an internal loan meant for development purposes.
Can a Country become Bankrupt through Public Debt

Sometimes, people assert that with mounting public debt, the nation would become bankrupt.
This is partly true and partly not true. If bankruptcy means inability to return the amount
borrowed, a country can never become bankrupt, however much of its domestic debt may
have gone up. The government can always honour its obligations either through higher
taxation or through printing of money. It has the option to impose a heavy capital levy and
pay off the debt at one stroke. Even repudiation of public debt, though morally indefensible,
will be right, since, after all those who receive interest payment from the government will
have to pay the taxes to enable the government to pay the interest. Will it not be better to
cancel the debt altogether or at least scale it down considerably, so that interest payments as
well as tax payments will be proportionately cut down ? In any case, a government does not
become bankrupt because of its internal debt.
However, there may be circumstances when a government may not be able to honour its
obligations to foreign countries. When interest on foreign loans and repayment of debt
amount to a considerable figure and when adequate export surplus has not been built up for
various reasons, the government of a debtor country may be unable to honour its 'external
obligations. Either it can ask for postponement or it can float new loans to repay the old ones.
Only in extreme cases it may repudiate external loans. Repudiation is an extreme measure,
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since through it, the country loses its creditworthiness in the international capital markets and
will never again be able to borrow from foreign sources.
To conclude, public borrowing has advantages. But it imposes burdens upon the community,
both in real and monetary terms and directly and indirectly. Since there is additional burden
in the case of external loans, extra care should be exercised in procuring such loans. All
public debts impose burdens on the community and to assert that internal loans do not impose
real burdens is highly illogical.
8.9 REDEMPTION OF PUBLIC DEBT
Just as the private individual or organization has to return the loan he or it borrowed, so also
the government has to pay not only interest on the public debt but also repay the principal.
Experience shows clearly that mounting public debt has a demoralizing effect on the people
from the fact that the public is subjected to higher rates of taxation. The sooner, therefore, the
debt is cleared, the better for the government. It may also be observed here that if the public
debt has been contracted for productive purposes, it may not be strictly necessary to redeem it
since the government is getting a source of income to pay off the interest of the debt. But if
public debt consists mostly of unproductive or dead weight debt— war debt is a good
example of such debt—the sooner it is paid off the better, both for the government as well as
for the public.
Different methods are used by a government to redeem its debt. Some of these methods are
extreme ones, such as repudiation of debt, while others may not be redemption at all, but
payment of one debt with the help of another debt. We shall describe the various methods
available to the government to pay off its debt.
Repudiation of Debt
Repudiation of debt means simply that the government does not recognize its obligations and
refuses to pay the interest as well as the principal. Repudiation is not paying off a loan but
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destroying it. Normally, a government does not repudiate its debt, for this will shake the
confidence of the general public in the government. However, in extreme circumstances, a
government may be forced to repudiate its internal or external debt obligations. For instance,
internally, the country may be facing financial ruin, bankruptcy and externally it may be
faced with shortage of foreign exchange. Generally, a government may not repudiate its
internal debt lest it should lead to internal rebellion—those who have lent to the government
would obviously rise against the government. However, the temptation of a government to
repudiate its external debt obligations may be strong at certain times. Of ail the methods of
redeeming .debt, repudiation is the most extreme, but it is actually not redemption of debt at
ail.
Conversion of Loans
Another method of redemption of public debt is known as conversion of loans, that is, an old
loan is converted into a new loan. Conversion may be resorted to :
(a) When at the time of redemption of a loan, the government has not the necessary funds,
and
(b) When the current rate is lower than the rate which the government is paying for existing
debt, so that the government can reduce its interest payments. Conversion of a loan is always
done through the floating of a new loan. Hence, the volume of public debt is not reduced.
Really speaking, therefore, conversion of debt is not redemption of debt.
Sometimes, distinction is made between refunding and conversion of debt, though sometimes
both of them are used to mean the same thing. Strictly speaking, refunding refers to the
method of paying off an o/d loan carrying a higher interest through a new loan carrying a
lower interest rate; refunding, therefore, is the repayment of debt through fresh loans. On the
other hand, conversion involves a change in the rate of interest or other details. For instance,
at the time of maturity of a loan, the government may give an option to the existing bond-
holders either to receive money in cash or to convert their old bonds for new bonds. Broadly,
refunding and conversion are similar.
Serial Bond Redemption

The government may decide to pay every year a certain portion of the bonds issued
previously. Therefore, a provision may be made so that a certain portion of the public debt
may mature every year and decision may also be made in the beginning about the serial
numbers of bonds which are to mature in the year. This system enables a portion of the debt
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to be paid off every year. A variant of this type of bond redemption is to determine the serial
number of bonds to mature every year through lottery. While under the first variant, the
bond-holders know when the different sets of bonds would mature and could take up the
bonds according to their convenience, under the second variant, the bondholders are uncertain
about the time of repayment and they may get back their money at the most inconvenient
time. Buying up Loans
The government may redeem its debt through buying up loans from the market. Whenever
the government has surplus income, it may spend the amount to buy off government bonds
from the market where they are bought and sold. Strictly speaking, this is not redemption of
debt but buying up of debt. It is a good system provided the government can secure budget
surplus. The only defect of this method of cancelling debt is that it is not systematic.
Sinking Fund
Sinking fund is probably the most systematic method of redeeming public debt. It refers to
the creation and the fund which will be sufficient to pay off public debt. There are many
varieties of sinking fund. The most common method is as follows:
Suppose, the government floats a loan of Rs. 10 redeemable in, say, 10 years for the purpose
of road construction. At the time the government is floating the loan, it may levy a tax on
petrol, the proceeds of which would be credited to a fund known as the sinking fund. Year
after year, the tax proceeds as well as interest: on investments will make the fund grow till
after 10 years it becomes equivalent to the original amount borrowed, and at that time, the
debt will be paid off. One danger of the sinking fund method is that a government, in need of
money, may not have the patience to wait till the end of the period of maturity but may utilize
the fund for purposes other than the one for which originally the sinking fund was instituted.
In modern times, sinking funds are not accumulated and continued from year to year as we
have described above. Instead, some-funds are earmarked each year for repayment of some
part of the debt in the same year. The amount earmarked is not put in a fund and allowed to
accumulate but is used every year either to pay off the bonds which are maturing every year
or to buy off bonds from the market.
Capital Levy
Public debt may be redeemed through a capital levy which, as we have seen earlier, may be
levied once in away with the special objective of redeeming public debt. It is a levy on capital
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or assets of individuals. The purpose of this levy is to wipe out the entire war debt, by
imposing a once for all tax on capital assets. It is generally advocated immediately after a war
for the following reasons:
(a) Heavy public debt has been incurred during the war to prosecute the war and hence is
quite heavy immediately after the war.
(b) War debt is unproductive and is a dead weight on the community necessitating heavy
taxation year after year. It will be better to wipe it out once for all by a special levy.
(c) Due to war time inflation businessmen, producers and speculators would have
amassed large fortunes and hence it is easier for them to contribute to. a capital levy
and, in a sense, it is just that they bear a part of the war burden,
(d) Redemption of public debt through capital levy will leave the higher income groups
almost in the same old position, since they will be receiving back from the
government what they will have paid by way of the special levy.
Redemption, through a special levy, is said to be super or to the method of the sinking fund,
as it is levied only once, while for purposes of the sinking fund, taxes have to be imposed
year after year. The greatest merit of capital levy is that it will reduce the heavy tax burden
which will otherwise be necessary to redeem public debt. But the danger of a capital levy is
that the government may be tempted to resort to it too often.
Redemption of External Debt
The redemption of external debt can be made only through accumulating the necessary
foreign exchanges to pay for it. This can be done by creating export surpluses. Towards this
end, foreign loans 'should be carefully invested in those industries which have high
productive potentialities and which will promote exports directly and indirectly. At the same
time, the exportable surplus should consist of goods which are readily taken by foreigners.
Temporarily, of course, redemption of an old debt can be made through the floating of new
loans.
To conclude, there is not much to choose between the various methods (except, of course,
repudiation which must not be resorted to) for every method has its own advantages as well
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as disadvantages. But the most common and sensible method is to redeem part of the public
debt, every year, so that the debt may not go on mounting.
8.10 PUBLIC SECTOR BORROWING REQUIREMENT (PSBR)
Public sector indebtedness is largely, but not wholly, represented by the national debt. Local
authorities can and do borrow directly on their own account at home and abroad. Public
corporations are also permitted to raise loans in foreign capital markets. To arrive at the
public sector borrowing requirement the government has to take into account its own bor-
rowing, as well as that of local authorities and public corporations (Figure 14.3 shows the
determinants and financing of the PSBR).
The term Public Sector Borrowing Requirement came into use in the mid-1960s, data on it
had been compiled since then (see Table 14.2). The PSBR is an important economic indicator
which shows how much the public sector taken as a whole has to borrow to finance its
expenditure programme. It is a key statistic that has to be taken into account in the
formulation of a government's economic policy and in the assessment of the effects of fiscal
and monetary measures on the economy. PSBR is expressed by reference to the total
resources available in the country and is calculated as a percentage of the gross domestic
product. The higher the percentage the greater the share of the national resources that are
absorbed by the public sector.
8.11 GOVERNMENT INDUCED INFLATION
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This is a sustained annual increase in prices caused by expansion of the money supply to pay
government supplied goods and services. The money is printed to pay for the cost of the
government provided goods and services. Increases in the market prices of goods and
services caused by expansion of money supply force citizens to reduce their consumption and
saving which in turn finances the reallocation of resources to public use over the long-run.
DONATIONS
They are voluntary contribution to government from individuals or organization that are used
to finance particular programmes.
USER CHARGES
They are prices determined through the political process rather than market intervention.
They can finance public goods and services only when it is possible to exclude individual
from enjoying their benefit unless they pay a fee.
FORMS
1) Direct prices associated with the consumption of a particular goods and services
2) Fees for the option to use certain facilities or services provided for by the government
3) Special assignment on privately held property
4) Licenses or franchises
5) Fares or tolls
8.12 SUMMARY
The lecture has explained the alternative sources of government funds such as public debts,
inflationary financing, user charges and so on. It has also show how debt can be repaid and
debt affect the economy.
8.13 ACTIVITIES
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1. Explain how balance of payment position may influence the external debt repayment.
2. Discuss the various methods that can be used to repay debts.
3. What public debt repudiation.
Alexander and S. Toland, Measuring the Public Sector Borrowing Requirement, Economic
Trends (London: HMSO, 1980).
C.V. Brown and P.M. Jackson, Public Sector Economics (Oxford: Basil Blackwell, 1992)
McGraw-Hill,1989).
C.T. Sandford, The Economics ofPRIVATISATION
Public Finance (Oxford: Pergamon Press, 1992).
LECTURE NINE
9.1 INTRODUCTION
The last lecture discusses one way of solving government financial problem. If the
government is having many corporations that are not contributing to the exchequer then the
government may be incurring high debt to support them. One way to reduce government
burden on exchequer is to privatize the inefficient corporations.
142

a) Explain what privatization is and its mechanism.
b) Discuss the case for and against the privatization in the economy.
c) Explain the justification of privatization
Privatization means transfer of ownership of state assets from the public bodies to private
enterprise or provision of services from public to private enterprise. The aims of the
privatization programmes are political and economic. The relative importance of the reasons
for privatization differs from country to country but basically they are;
a) Failure of nationalized industries in general to meet consumers needs effectively

b) The wish to reduce the power of the state and its role in the economy.
c) Belief that an enterprise based economy would allow for greater flexibility and a
better response to consumers demand.
d) Determination to create capital – owning democracies.
Thus government privatize to;

a) Reduce the size of public sectors of industry.
b) Increase competition in the market.
c) Improve efficiency among suppliers of goods and services.
d) Extend share ownership in companies by investors with small amounts of savings.
e) Ease the pressure on central governments’ budget.
The expectation is that as state monopolies are broken up and a competitive environment
established, privatized firms will have to improve their efficiency, cut costs and reduce prices
or keep them below the level up to which they would have otherwise risen. Firms that are not
competitive will unlike state enterprises go out of business. Privatized companies that are
143
profitable or have profit potential will attract investors and enable shareholders with small
amounts of capital and employees to acquire shareholdings. Private funding of industry
reduces claims on public finance. The help to the government comes on both sides of the
budget. On the expenditure sides, the state no longer has to support loss – making
nationalized industries and provide them with capital, thereby increasing the public sector
borrowing requirement on the revenue side, proceeds from the sale of state assets increase
governments resources enabling them to increase public spending or cut taxation or both.
Opponents of privatization argue that; privatization of natural monopolies merely substitutes

private for state monopoly; that the social service elements in provision of services by profit
– driven companies will disappear and measures to cut costs will lead to unemployment.
9.3 MECHANISM OF PRIVATISATION
How state – owned enterprises are privatized depends on a variety of factors such as whether,
the country is developed, developing or emerging from a centrally – planned economic
system; the relative size of public sector of industry, the sophistication of the national capital
market and the financial framework. The state of international capital market is also
important. It may reach a saturation level if a large number of privatization share offers are
made concurrently and national governments restrict the extent of foreign investment that
may be allowed. Timing and local legislation are therefore important factors. Also important
to a decision on the choice of privatization method is the native and size of privatization.
On offer may be;
a) A minority share – holding in a country.
b) A controlling stake in a company.
c) A state – owned company already operating in competitive international markets.
d) A whole nationalized industry.
e) Potentially the whole of the economy.
Depending on the circumstances the transfer from state to private ownership may be by wears
of;
144
1. Public Offering
Shares are offered to the general public and can be traded subsequently on the stock
exchange. This method is only appropriate for privatization of large enterprises.
2. Placing
Brokers acting on behalf of a government arrange for the purchase of shares by
placing them with a group of investors or one large investor who may wish to hold or
gradually a sell off the stock.
3. Trade sale.
A state enterprise is sold to a private sector company or consortium. A trade sale is
likely to be on the basis of a tender and financial markets are bypassed.
4. Management/worker’s buy – out
A state owned undertaking may be sold to employees because it is loss – making or
faces closure and companies in the private sectors are not interested in buying it.
There may however be a possibility of turning it around to round to run on a
profitable basis. Management/worker buys – out can save jobs. It may be attractive
proposition to government for reasons other than financial.
5. Auction.
In cases of smaller properties owned by the state, sales by auction may be a relatively
simple way to privatize but the practicality of this depends on there being a sufficient
number of bidders with adequate funds to purchase.
6. Grant of statutory right of purchase.
People may be granted by law the right to purchase specified state property, provided
they meet certain requirements.
9.4 THE CASE OF PRIVATISATION
145
1. Privatization which involves the sales of state – owned assets provide the government
with a short – term source of revenue which can be used to finance development
expenditure such as infrastructure development.
2. It helps to reduce public spending and the public sector borrowing requirement. This is
especially so if the state can sell – loss – making enterprises and public spending on
subsidies fall. The public sector borrowing (PSBR) may also fall if private ownership
returns industries to profitability since corporation tax revenue will increase and the state
may earn higher dividend income from any share it still possesses in the privatized
company.
3. Privatization increases competition thereby increasing a locative efficiency where the
organization has ran with prices higher than marginal cost. Competition could force an
organization to be more cost – conscious, making it easier for changes in work practices
to be introduced and enforced both at an operational level and in the management of the
organization.
4. Where privatization results in the breaking of state monopoly, so that a number of
competing firms are able to operate, consumer choice may be enhanced. Competing firms
are more likely to respond to consumer demand and quality of service should be
improved and innovation encouraged in both products and the means of their production
and distribution.
5. Privatization can change the organization culture in that the often – borrow vision of
directorate and management and supply orientation of the organization can be replaced by
a mean more commercially aware enterprise. Restraints can be removed in financing and
market of products diversification. Links with other companies through joint ventures can
be developed. It makes it more difficult for political interference since politicians who
used parastatals for their own ends cannot easily do so with private enterprises.
6. It has a role in promoting an enterprise culture through extending share ownership to
individual and employees who did not own shares previously. It is therefore conducive to
hand work and accepting responsibility.
9.5 THE CASE AGAINST PRIVATISATION
146
1. It may increase monopoly abuse, by transferring socially owned and accountancies public
monopolies into regulated and less accountancies private monopoly. This monopoly may
arise because utilities tend to be natural monopolies and there have been economic and
technological arguments for keeping them as single suppliers. The monopolies may
exploit consumers by charging excessively high prices and producing poor quality
commodities.
2. In the absence of a market for the shares of nationalized industry it may be difficult to
determine the appropriate issue price for shares. This may lead to over subscription or
under subscription. It has been argued that state owned asset have often been sold off too
cheaply.
3. Increased privatization of public sectors enterprises can lead to greater difficulty in
planning the whole economy because unanticipated actions by the private sector can
undermine the targets of a development plan such as delocalization of industries.
4. Privatization of certain sectors like health and education may lead to those very goods
being provided in inadequate qualities and at prices that are too high for lower income
consumers.
5. The private sector may lack entrepreneurship skills and capital to develop certain
establishments which require heavy capital investments like airways, ports and harbors.
6. It would imply greater control by multinational corporations with their related problems
of transfer pricing and repatriation of process.
9.6 SUMMARY
The lecturer has explained in details the reasons for privatization, mechanism and case for
and against the privatization on the economy.147
That is the end of public finance lectures and I welcome to the next level of public finance
9.7ACTIVITIES
1. Giving examples in Kenya discuss the privatization process.

2. Explain the reasons why privatization is necessary.
9.8 FURTHER READING
C.V. Brown and P.M. Jackson, Public Sector Economics (Oxford: Basil Blackwell, 1992)
McGraw-Hill, 1989).
A.F.Ott and K. Hartley, Privatization and Economic Efficiency (Chelteham: Edward Elgar,
1991).
REFERENCES
148
1. Stiglitz Joseph E. (1988) Economics of the Public Sector. Second edition. New York:
W.W; Norton & Company
2. Hyman N. David (1996) Public Finance: A Contemporary Application of Theory to

Policy. Fifth edition. New York: The Dryden press; Harcourt Brace Colleague
Publishers.
3. Brown C.V. Jackson, P.M. 1996, Public Sector Economics, Oxford: Blackwell
Publishers
4. Atkinson A. B. and J. E. Sfiglitz (1980) Lectures on Public Finance. New York:

McGraw-Hill
5. Musgrave, R. A. (latest edition) Public Finance. New York McGraw-Hill.
6. Musgrave R, A. and P. B, Musgrave (1989) Public Finance in Theory and Practice.

New York.
7. Prest A.R. (1972) Public Finance in Developing Countries. Weidenfteld &

Nicholson.
8. Prest, A. R. (1974) Public Finance in Theory and Practice. Weideniield &

Nicholson 5th Ed.
9. Wawire N. H. W (2003). ''Trends in Kenya's Tax Ratios and Tax Effort Indices, and
Their Implications for Future Tax Reforms". In illieva E. V. (Ed.) Egerton Journal.
Volume IV. Numbers 2 & 3, July. Pp.256 - 279
10. Toye, J.F.J (1978) (Ed) Taxation and Economic Development. London: Frank class
149
N/B In addition to the above references, students are strongly advised to read the
following: The Journal of public Economics; The Journal of financial economics; The Journal
of Development Economics; Economic surveys; Budget speeches and National Development
Plans,
150

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KENYATTA UNIVERSITY

INSTITUTE OF OPEN, DISTANCE & e-LEARNING

UNIT CODE & NAME:

LECTURE TITLE page

Lecture One: The introduction and the nature of public finance 6 - 16

Lecture Two: Public policy objectives 17 - 25

Lecture Three: Public goods 26 - 33

Lecture Five: Public expenditure 51 - 91

Lecture Six: Budget 92 - 96

Lecture Eight: Alternative sources of public revenue 121 - 143

Lecture Nine: Privatization 144 - 149

1.2 LECTURE OBJECTIVE

At the end of this lecture you should be able to:

Definition of public finance

1.5 REASONS WHY GOVERNMENT SHOULD PARTICIPATE IN ECONOMIC

1.6 MODELS OF EFFICIENT ALLOCATION

1.7 THE SIZE OF THE PUBLIC SECTOR

1.8 THE PRINCIPLES OF MAXIMUM SOCIAL ADVANTAGE

Figure 1.2 Maximum social advantage

This represents the government contribution to the personal income

1. Explain the rationale of public sector in the economy.

A. Asimakopulos, Economic Theory, Welfare and the State (London:Macmillan, 1990).

PUBLIC POLICY OBJECTIVES (BUDGETARY OBJECTIVES)

2.2 LECTURE OBJECTIVE

At the end of the lecture you should be able to:

2.4 Public provision of social goods

The distribution function

Fiscal instruments of distribution policy

The stabilization function

Phillip Curve shows the trade-off

Figure 2.1 Relationship between inflation and unemployment

 Aggregate demand is also a function of the spending decisions of many consumers,

2.5 Instruments of stabilization policy

2.6 CO-ORDINATION OR CONFLICT OF FUNCTIONS

1.3.1 Conflict of interest

ii) Conflict between distribution and stabilization function:-

iii) Conflict between distribution and growth and economy

1. What are the budgetary policy objectives of the government?

2.9 FURTHER READING

3.2 LECTURE OBJECTIVE

At the end of this lecture you should be able to:

Pure public goods have two properties

Comparison between efficient provision of public goods and private goods

Even if consumption is excludable, market provision of a public good is likely to be

1. What is a free-rider problem?

4.2 LECTURE OBJECTIVE

At the end of the lecture you should be able to:

Market failures could also produce macro-economic instability such as inflation,

Thus market failure permit four functions of the government.

4.3 IMPERFECT COMPETITION AS A CAUSE OF MARKET FAILURE

Mechanism of how they would restrict output to raise prices:

Figure 4.1 Monopoly market structure

4.4 COSTLY INFORMATION

4.5 EXTERNALITIES AS A CAUSE OF MARKET FAILURE

(i) Positive Externalities:

Implications of Externalities for allocation efficiency:

X* Xp Tons of output per year

QP Q* Units of outputs per year

4.6 SOLUTIONS TO EXTERNALITIES:

PUBLIC RESPONSES TO EXTERNALITIES: TAXES AND SUBSIDIES

WEAKNESS OF PIGOUVIAS TAX

(2) AUCTION POLLUTION PERMITS

4.7 PRIVATE SOLUTION