BAF3202 Public Finance NOTES KAMOYO

SCHOOL OF BUSINESS AND ECONOMICS
DEPARTMENT OF FINANCE &

ACCOUNTING
Course Code: BAF3202
Course Title: Public Finance

Instructional materials for distance learning students
1
1.0 MEANING AND NATURE OF PUBLIC FINANCE.
1.1 Introduction
1.2 Nature of public finance
1.3 Distinction between public and private finance
1.4 Function of public finance
1.5 Sources of public Finance
1.6 Resources allocation in different types of economic systems
1.7 Efficient output of public goods/ optimum level of production of public goods
2.0 PUBLIC GOODS AND PUBLIC UTILITY
2.1 Introduction
2.2 Theory of Private and Social /Public Goods
2.3 The Free Rider Problem
2.4 Market Failure
2.5 Efficient Output of Public Goods/ Optimum Level of Production of Public Goods
3.0 EXTERNALITIES/ EXTERNAL EFFECTS

3.1 Introduction
3.2 Negative externalities
3.3 Positive externalities
3.4 Types of externalities
3.5 Possible solutions to the externality problem
3.6 Implications of Externality
3.7 Graphical Illustration of Supply and Demand Diagrams Showing the External Costs
and Benefits
4.0 EQUITY AND INCOME DISTRIBUTION
4.1 Equitable distribution of income

4.2 Perspectives on equity
4.3 The beneficiary principle and ability to pay
4.4 Horizontal and vertical equity
4.5 Economic and Income Inequality
4.6 Causes of inequality
4.7 Mitigating factors of inequality
4.8 Redistribution of wealth
4.9 Types of redistribution
4.10 Difference between Equity and Equality In Taxation
2
5.0 PUBLIC CHOICE THEORY
5.1 Introduction
5.2 Origins and formation
5.3 Perspective
5.4 Claims of the Public choice theory
5.5 Remedies for the public choice problem
5.6 Areas related to public choice theory
6.0 BEHAVIOURAL RESPONSES TO TAXATION

6.1 Introduction
6.2 Effects of Taxation on Production
6.2.1 Ability to work and save.
6.2.2 Desire to work and save.
6.2.3 The composition and pattern of production.
6.3 Effects of taxation on distribution
CAT
7.0 TAX INCIDENCE
7.1 Introduction
7.2 llustration of tax incidence
7.2.1 Inelastic supply, elastic demand
7.2.2 Elastic supply and demand
7.2.3 Inelastic demand, elastic supply
7.2.4 Graphical illustration of tax incidence
7.3 Macroeconomic perspective of tax incidence
8.0 TAXATION AND EFFICIENCY
8.1 Introduction
8.2 The efficiency principals of taxation
9.0 OPTIMAL TAXATION
9.1 Optimal tax Theory

9.2 Optimal taxation theory
9.3 Excess burden of taxation
9.4 Measures of the excess burden
9.5 Distortion and redistribution
9.6 Factors Determining Taxable Capacity
9.7 Measurements or Limit of Taxable Capacity
10.0 COST BENEFIT ANALYSIS AND INVESTMENT RULES

10.1 Types of benefit and cost
3
10.2 Measurement of benefits and costs
10.2.1 Valuation of intangible items/Non market items.
10.2.2 Shadow pricing of market items
10.2.3 Discounted cost of capital
10.3 Public Expenditure Evaluation Principals
10.4 Concept of Consumer Surplus
11.0 PUBLIC EXPENDITURE PROGRAMS

11.1 Meaning of Public Expenditure
11.2 Objectives of Public Expenditure
11.3 Size and Growth of Public Expenditure
11.4 Theories of Increase in Public Expenditure
11.5 Theories of Public Expenditure
11.6 Effects of Public Expenditure
11.7 Growth of Public Expenditure
11.8 Development Expenditure of Developing Economies
11.9 Role of Development Expenditure in a developing economy.
12.0 PUBLIC DEBT

12.1 Introduction
12.2 Sources
12.3 Classification/ Types of public debt
12.4 Need for public debt
12.5 Burden of public debt
12.6 Debt burden and future generation
12.7 Management of Public Debt
12.8 Techniques/methods of debt management
12.9 Redemption of public debt
12.10 Effects of Public Debt
12.11 Role of public debt on economic development
1.0 MEANING AND NATURE OF PUBLIC FINANCE.
General objective
4
By the end of the lesson the learner should be able to explain the meaning and nature of public
finance
Specific objectives
• By the end of the lesson the learner should be able to explain the meaning of public finance
• By the end of the lesson the learner should be able to the nature of public finance
• By the end of the lesson the learner should be able to explain the similarities and differences
between public finance and private finance
• By the end of the lesson the learner should be able to explain the functions of public finance in
both developing and developed nations.
• By the end of the lesson the learner should be able to explain the sources of public revenue
• By the end of the lesson the learner should be able to explain the resource allocation in different
types of economic systems
1.1 Introduction
Public finance can be defined as the collection of revenue by the central government and local
government and all the expenditure of revenue in the provision of public utilities.
According to Findlay Shirras (year) public finance is the study of the principals underlying the
spending and raising of fund by public authorities.
1.2 Nature of public finance

Prof. Dalton divides the scope of public finance into four categories namely:-
Public income/ revenue
Public expenditure
Public debt
Financial administration
a) Public income/revenue
This refers to government income collected from various sources. The main sources of public revenue
include taxes, fees, fines and penalties, income from properties, interest from loans repayment, sale of
real assets and royalties.
5
b) Public expenditure
This refers to spending by the government. Public expenditure covers the canons or the principals
which govern it and its effects on production, employment, income distribution, stability and growth.
It also includes reasons for increase in public expenditure and changes in the pattern.
c) Public debt
When public revenue falls short of public expenditure, the government borrows to meet the gap. This
is the public debt. Therefore public debt includes reasons, methods and sources of public debts, its
effects on production, consumption, income distribution and economy, the burden of public debt and
methods of debt redemption.
d)Financial administration
The aim of financial administration is to control processes and operations of public revenue, public
expenditure and public debt. The scope of financial administration includes the collection, custody
and disbursement of public money, the coordination of expenditure according to a well formulated
plan, the management of public debt and the general control of the financial operations of the state. It
also includes the preparation of the budget, its execution and auditing of the state.
1.3 Distinction between public and private finance
Public finance is the study of income, expenditure, borrowing and financial administration of the
government .On the other hand, private finance is the study of income, expenditure, borrowing and
financial administration of individual or private companies.
Similarities and differences between public and private finances.

Similarities:
• Objective- Both public and private finances aim at the satisfaction of human wants. The objective
of public finance is to satisfy social wants and that of private finance to satisfy individual wants.
• Principals – both governments and individuals follow similar principals. The government follows
the principal of maximum social benefit while spending its income. Similarly an individual
follows the principal of maximum satisfaction when spending out of his income.
6
• Income expenditure and borrowing- Both government and individuals have similar but limited
sources of income. Both can spend in anticipation of receiving income. If their incomes are
insufficient to meet their expenditure both borrow. Both also have to repay the borrowed money.
• Policies – Governments, individuals and private companies follow sound or unsound (rational or
irrational) financial policies. If the government follows sound financial policies it maximizes
social welfare. Similarly an individual maximizes his welfare. If both follow unsound financial
policies they are unable to maximize welfare.
• Administration- Both government and private companies require efficient administration and if a
private company is corrupt and inefficient, it leads to misuse and wastage of finances.
Differences
Adjustment between income and expenditure- an individual determines his expenditure on he
basis of his income. He prepares his family budget on his expected income during the month. On the
other hand the government first estimates its expenditure and then finds out means to raise the
necessary income.
Elasticity- there is a greater elasticity in public finance than in private finance. The government has
more sources of income whereas the sources of the individual are limited only to his current income,
past savings and borrowings
Motives - an individual or a firm has the private motive whereas the government has a welfare
motive. An individual always tries to save and a firm to earn a profit. However, there are no such
considerations on the part of the government.
Expenditure- an individual expenditure is governed by his habit, customs, and fashion e.t.c.,while
government expenditure depends on its economic and social policies like reducing unemployment
and poverty, reducing income inequalities, providing infrastructure facilities e.t.c.
Compulsion -There compulsion in public finance. People must pay taxes. If they do not pay, they are
punished through fines and imprisonment. But an individual or firm cannot force anybody to pay him
money.
Present-vs-future- an individual is more concerned with his present needs and tries to satisfy them.
On the other hand the government is concerned not only with the welfare of the present generation,
but also with future generation. It therefore undertakes and spends on those activities which also
benefit future generations.
7
Budgeting – an individual may have a weekly or monthly budget. A public budget on the other hand
is for one fiscal year. Also government budget is passed by parliament while the budget of an
individual or firm is a private affair without any controlling authority.
Secrecy-vs-openness- there is secrecy in private finance. No individual wants to reveal his income
and savings. On the contrary, the government budget is an open public document which is
commented on, debated and published at various forums.
Bankruptcy- an individual or firm can be bankrupt. However a government cannot go bankrupt
because it can borrow from international agencies. It can only face a financial crisis.
1.4 Fnctions of public finance

Public finance plays an important role in the economy of a country, whether it is a developed or a
developing country.
In a developed country :
The importance of public finance in an advanced country is to stabilize its growth rates. To achieve
this, the government changes its expenditure and taxation policies to produce good effects and avoid
bad effects on national income, production, employment and prices. When prices are falling in a
recession, private investments fall. To compensate for the lack in investments and to raise effective
demand, output, employment and income, the government increases its expenditure on public works
and social security programmes through budget deficits, debt repayment and reduction in taxes. On
the other hand, when there are inflation tendencies and a boom starts, the government reduces its
expenditure on public works. This reduces effective demand through a budget surplus, public
borrowing and raising taxes. Thus the government controls deflationary (recessions) and inflationary
(booms) pressures by an appropriate combination of expenditure, borrowing and taxation policies.
In a developing economy:
Public finance plays a dynamic role in a developing country. It is very crucial for its economic
development. The per capita income and savings are extremely low for developing countries.
According to Jhingan, (2006), the few rich spend large portions of their savings on property,
jewellery, gold, speculation e.t.c. and in conspicuous consumption.
Fiscal policy diverts them into productive channels through taxation, borrowing and expenditure,
fiscal policy promotes economic development by increasing the rate of investments, encouraging
investment in social and economic infrastructure, increasing employment opportunities, reducing
8
balance of payments disequilibrium, counteracting inflation, reducing inequalities of income and
wealth and increasing national income.
By an appropriate policy of taxation, the government reduces private consumption and transfers
resources to the government for investment, increases the incentives to save and reduce economic
inequalities.
Public borrowing is an anti-inflationary measure. It is used for mobilizing surplus money in the hands
of the people in a developing country. It is a useful tool of economic development by diverting
resources from unproductive uses to productive uses. Public borrowing is resorted to for specific
development projects like power generation, irrigation work, roads e.t.c.
The role of public expenditure in economic development lies in increasing the growth rate of the
economy, providing more employment opportunities, raising incomes and standards of living,
reducing inequalities of income and wealth, encouraging private initiatives and enterprise and
bringing about regional balance in the economy. This is achieved by government spending on public
works, agriculture, industry, transport and communication, power, social services e.t.c.The the
government is able to increase public expenditure though a budget deficit.
1.5 Sources of public Finance
There are two main sources of public finance namely:-
a) Public revenue
b) Public debt
a) Public Revenue
This refers to the income that the government gets from its citizens. The government can raise its
revenues through taxation or non tax activities. This gives rise to tax revenue and non tax revenue.
Taxation
Taxation is considered the most important source of public revenue. A tax is a compulsory payment
made to the government without any direct benefit to the individual or firm. Revenue raised through
taxation is used for the benefit of everyone in the society. Taxes can be classified as either direct or
indirect taxes. Examples of direct tax are income tax, corporation tax, capital gains tax, estate
duty/inheritance tax. Examples of indirect tax are custom duties, exercise duties, sales tax and value
added tax. In the year 2005/2006 88% of the government revenue was from taxes while only 12 %
was from other sources. Income tax contributes the highest percent, followed by customs and excise,
and then VAT.
Non Tax Revenues
9
These include,
(i) Surpluses from public corporations
A public corporation is an organization in which the government has a stake in its ownership. Public
corporation normally provides essential services at a fee to the members of the society. E.g. Kenya
Pipeline Company, KBC, KB Standards, etc. When the revenue earned from the supply of these
services is more than the expense incurred, the surplus is paid to the government.
(ii) Fines and penalties.
The judicial system in the country is made of courts and tribunals which impose fines and penalties
on individuals, firms and corporations that break the laws of the land. The money raised from the
fines and penalties becomes public revenue.
(iii) Fees
The government renders some direct services to its citizens such as licensing of marriages, issuing
birth certificates, permits, issuing and renewal of driving licenses. For such services a small fee is
usually charged. Such fees are a source of public revenue.
(iv) Income from properties.
The government owns many properties. These include homes for which rent is charged, land for
which rates are charged and game parks where entry fees are charged. This also is a source of public
revenue.
(v) Interest from loan repayments
The government charges interest on loans borrowed by the public through its corporations e.g.
Agricultural Finance Corporation, Kenya Industrial Estate (K.I.E) etc. This interest collected
constitutes part of the public revenue.
(vi) Sale of real assets
The government may sell assets that belong to its parastatals and other state corporations as well as
local authority assets. This may take the form of privatization of state corporations, sale of
council assets and direct sale of government properties (e.g. vehicles, Grand Regency etc
(vii) Royalties
These are payments to the government arising from the use of natural resources by companies and
individuals e.g. in the use of mines and forests.
b) Public debt covered later in detail
1.6 Resources allocation in different types of economic systems
10
Resources allocation in any country is generally influenced by its economic system. Broadly
speaking there are three types of economic systems namely:-
i. Market/ capitalistic economy/ free enterprise
ii. Command/ socialist/state enterprise/communism
iii. Mixed economic system
a) Market/ capitalistic economy
This is an economic system whereby there is an absence of government intervention and
where the forces of demand and supply are allowed to operate freely. In this case resources
are allocated through the price mechanism.
b) Command/ planned economy
A planned economy is one where the critical economic system decisions are determined by
the state. In this case the market forces of demand and supply (price mechanism) are given no
role in resources allocation as it is the government that makes decisions on the resources
allocation.
c) Mixed economic system
In a mixed economy, both private and public sector exist and function side by side. Here, the
allocation of resources between alternative uses is determined largely by individual action
through the price mechanism but the government plays some role in determining aggregate
level of output through the use of fiscal and monetary policies.
11
Therefore resource allocation can be examined by assessing:-
a) The role of price mechanism in resource allocation
b) The role of government in resource allocation
Price mechanism and resources allocation

Price mechanism involves the determination of price of commodities through the interaction of
demand and supply of those commodities. In the course of exchange, the price mechanism determines
the allocation of resources in the market economy and indeed under competitive condition, it is
claimed to produce an ‘ideal’ allocation of resources.
How does it work? Each time a consumer spends money on a particular good, he is like ‘casting a
vote’ for its production rather than another by providing an incentive to the producers of that
particular good to supply it.
Suppose consumer are spending their income on a wide range of products and the producers of each
product are earning just sufficient to cover their costs and no more. Suppose consumer taste change
i.e. they buy more of commodity A and less of commodity B, the revenue of the producers of
commodity B falls. Assuming their costs are unchanged, revenue will no longer cover costs for
producers of B and some of these will go out of business. This will leave resources i.e. capital, labour
and raw materials unemployed in industry B. However, demand and profits in industry A will have
increased, new producers are attracted there and the resources released in industry B will thus be
switched to the production of A..The composition of output has therefore been remolded to suit the
tastes of consumers through profit incentives to producers. Thus without need for any overall
planning, the allocation of resources is automatically determined by the price mechanism through
appeals to the self interest of consumers and producers. Adam Smith called this the ‘invisible hand’
of the market.
Role of the government in resource allocation

Issue has been raised on the fact that the price mechanism alone cannot perform all economic
functions in an economy. The government influences resources allocation through production that is
undertaken by the government through nationalized industries and also through the use of regulation,
fiscal and monetary policies which have a direct effect on aggregate demand. The need of the role of
the government in resource allocation is brought about by the defects of price mechanism. The
government’s role in the resource allocation therefore involves:
12
1. Securing condition that ensures price mechanism work:
The claim that the market mechanism leads to efficient resources use (i.e. produces what consumers
want most and does so in the cheapest way) is based on the condition of competitive factor and
product market. Thus there must be no obstacle to free entry in the market and consumers and
producers must have full market knowledge. Government regulation or other measures may be
needed to secure these conditions.
2. Providing a legal structure
The contractual arrangements and exchanges needed for market operation cannot exist without the
protection and enforcement of a governmentally provided legal structure.
3. Provision of public goods
The production or consumption characteristics of certain goods are such that they cannot be provided
for through the market. Problem of ‘externalities’ arise which leads to ‘market failure’ and require
correction by the government either by way of budgetary provision, subsidy or tax penalty.
Externalities refer to social costs and benefits that are not fully accounted for in the market system
e.g. provision of defense, reduction of air pollution, street lights, law and order e.t.c.
Public goods are also characterized by non-excludability and non-rivalry in consumption.
Non excludability means that it’s not possible to exclude individuals who have not paid from
consuming the commodity.
Non rivalry consumption implies that one person’s consumption doesn’t reduce the consumption of
another individual. The problem of provision of public goods by the private sector arises because of
the free rider problem. Free rider problem leads to potential consumer understating their preferences
or willingness to pay and still gain since they receive goods without necessarily paying for it. The
government must step in and allocate resources for the provision of public goods.
4. Adjustments in the reduction of income
Social values may require adjustments in the distribution of incomes and wealth which results from
the market systems and from the transmission of property through inheritance.
5. Objectives of high employment, price level, stability and desired rate of economic growth.
The market system especially in a highly developed financial economy does not necessarily bring
about the above important objective. The government must develop a policy to secure these
objectives. This is especially the case in an open economy subject to international repercussion.
6. Determining proportions of national resources to be devoted to producing consumer goods
and investment goods.
13
This involves making a choice between more income now and more income in future. This can be
done through the budgetary allocation and also through fiscal and monetary policies.
What constitutes optimum resources allocation in case of public goods? In the case of public goods a
certain quantity is consumed by everyone. Therefore the demand for any quantity of that public good
is the sum of prices that each individual consumer is willing to pay for that quantity. In this way, the
community’s demand curve for a public good is the summation of demand curves of the individual
consumers which represent the sum of all marginal benefits received by all consumers.
Each demand curve implies the marginal benefit that the consumer gets from consuming every level
of production. The optimum level of production of a public good is determined by equating the sum
of the marginal benefits to the marginal cost of production i.e. the optimum quantity is that quantity
for which the marginal cost of the last unit is equal to the sum of prices that all consumers are willing
to pay for that unit.
Summary Of The Topic

Nature of public finance
Distinction between public and private finance
Function of public finance
Sources of public Finance
Resources allocation in different types of economic systems
Efficient output of public goods/ optimum level of production of public goods
Revision Questions
Explain the meaning and nature of public finance
Explain the differences and similarities between public finance and private finance
Explain the functions of public finance in both developing and developed nations.
Describe the sources of public revenue
Describe the resource allocation in different types of economic systems
14
Further References
M. L Jighan ( 2006), Public Finance And International Trade, Vrinda Publications P Limited, Delhi
India Pages 1-6
H.L Bhatia (2004) Public Finance.Vikas Publishing House spvt Limited, New Delhi India Pages 16-
25
Musgrave (2005) Public Finance In Theory And Practice, Tata Mcgraw-Hill New Delhi Pages 3-10
David N Hyman (2005) Public Finance, A Contemporary Application Of Theory To Policy Thomson
Learning,Ohio Usa Pages 1-30
15
2.0 PUBLIC GOODS AND PUBLIC UTILITY
General objective
By the end of the lesson the learner should be able to explain the issues pertaining to public goods
and public utility
Specific objectives
a) By the end of the lesson the learner should be able to describe a public good
b) By the end of the lesson the learner should be able to explain the characteristics of public goods
and private goods
c) By the end of the lesson the learner should be able to explain free rider problem and its solutions
d) By the end of the lesson the learner should be able to explain the causes of market failure and the
solutions
2.1 Introduction
A public good is a good that is non rival and non-excludable. Non-rivalry means that consumption of
the good by one individual does not reduce availability of the good for consumption by others; and
non-excludability that no one can be effectively excluded from using the good.
In the real world, there may be no such thing as an absolutely non-rivaled and non-excludable good;
but economists think that some goods approximate the concept closely enough for the analysis to be
economically useful.
For example, if one individual visits a doctor there is one fewer doctor's visit for everyone else, and it
is possible to exclude others from visiting the doctor. This makes doctor visits a rivaled and
excludable private good. Conversely, breathing air does not significantly reduce the amount of air
available to others, and people cannot be effectively excluded from using the air. This makes air a
public good, albeit one that is economically trivial, since air is a free good.
Non-rivalness and non-excludability may cause problems for the production of such goods.
Specifically, some economists have argued that they may lead to instances of market failure, where
uncoordinated markets driven by parties working in their own self interest are unable to provide these
goods in desired quantities. These issues are known as public goods problems, and there is a good
deal of debate and literature on how to measure their significance to an economy, and to identify the
best remedies. These debates can become important to political arguments about the role of markets
16
in the economy. More technically, public goods problems are related to the broader issue of
externalities.
2.2 Theory Of Private And Social /Public Goods

Private goods
This refers to those goods and services that satisfy individual wants and have the characters tics of
rivalry and exclusiveness. These goods can be produced by the free market policy mechanism. Private
goods are rival in consumption i.e. their consumption by a person reduces the amount available to
others. Also all those who want to pay the market price for them will consume them and those who
do not want to pay will be excluded from their use. In this case private goods are subject to the
principal of exclusion. Example of private goods relate to food, clothing, shelter, transportation,
communication etc.
Characteristics of private goods
1. They are rivalrous in consumption.
2. They are subject to exclusion principal
3. They satisfy individual wants.
4. The can be produced through free market pricing mechanism.
5. They are divisible in so far as their use is concerned
6. Marginal cost of providing a private good to an extra consumer is always positive
Public goods
They refer to those goods and services which are jointly and equally consumed by many people at the
same time and their consumption by one person does not alter availability for another person .eg
defence
These goods may not be produced by the free market pricing mechanism because those persons who
do not want to pay for the price can not be prevented from the consumption of those goods and
services i.e. public goods and services have a feature of non-rivalry in consumption and non-
excludability and as a result would not be provided in the free market.
Characteristics of public goods
They are non rivalrous- i.e. the quantity that a person consumes does not affect the quantity that other
can consume. No one has exclusive right over the consumption of good.
17
They are non-excludable i.e. if one person consumes the goods it is not possible to prevent others
from consuming it.
The goods are of collective consumption.
These goods may not be produced through the free market mechanism
They are indivisible
The consumption of a public good is always joint and equal, thus public goods are always produced
and supplied by the society to meet its collective wants for increasing social welfare.
Public goods create externalities or divergences between social and private benefits.
Differences between private and public goods
Public goods satisfy social wants while private goods satisfy individual wants.
Public goods are non-rival in consumption while private goods are rivalrous.
Public goods are non-exclusive whereas private goods permit exclusion.
Public goods cannot be provided by the free market pricing mechanism while, private goods are
priced in the market
The marginal cost of providing a private good to an extra consumer is positive, while in the public
good it is zero.
The efficient level of production of a private good is achieved when the marginal benefit and the
marginal cost are equal. However with a public good, we must ask how much each person values an
additional unit of output and how to add them to the marginal cost of production
18
Further considerations on the types of goods
Excludable Non-excludable
Common goods
Private goods (Common-pool
Rivalrous food, clothing, cars, resources)
personal electronics fish stocks, timber, coal,
national health service
Club goods Public goods

Non-rivalrous cinemas, private parks, free-to-air television, air,
satellite television national defense
A good which is rivalrous but non-excludable is sometimes called a common pool resource. Such
goods raise similar issues to public goods: the mirror to the public goods problem for this case is
sometimes called the tragedy of the commons. For example, it is so difficult to enforce restrictions on
deep sea fishing that the world's fish stocks can be seen as a non-excludable resource, but one which
is finite and diminishing.
The definition of non-excludability states that it is impossible to exclude individuals from

consumption. Technology now allows radio or TV broadcasts to be encrypted such that persons
without a special decoder are excluded from the broadcast. Many forms of information goods have
characteristics of public goods.
For example, a poem can be read by many people without reducing the consumption of that good by
others; in this sense, it is non-rivalrous. Similarly, the information in most patents can be used by any
party without reducing consumption of that good by others. Creative works may be excludable in
some circumstances, however: the individual who wrote the poem may decline to share it with others
by not publishing it.
Copyrights and patents both encourage and inhibit the creation of such non-rival goods by providing
temporary monopolies, or, in the terminology of public goods, providing a legal mechanism to
enforce excludability for a limited period of time. For public goods, the "lost revenue" of the producer
19
of the good is not part of the definition: a public good is a good whose consumption does not reduce
any other's consumption of that good.The economic concept of public goods should not be confused
with the expression "the public good", which is usually an application of a collective ethical notion of
"the good" in political decision-making.
Another common confusion is that public goods are goods provided by the public sector. Although it
is often the case that Government is involved in producing public goods, this is not necessarily the
case. Public goods may be naturally available. They may be produced by private individuals and
firms, by non-state collective action, or they may not be produced at all.
Collective goods
Collective goods (or social goods) are defined public goods that could be delivered as private goods,
but are usually delivered by the government for various reasons, including social policy, and finances
from public funds like taxes.
Examples
Common examples of public goods include: defense and law enforcement (including the system of
property rights), public fireworks, lighthouses, clean air and other environmental goods, and
information goods, such as software development, authorship, and invention.
2.3 The Free Rider Problem
Public goods provide a very important example of market failure, in which market-like behavior of
individual gain-seeking does not produce efficient results. The production of public goods results in
positive externalities which are not remunerated. If private organizations don't reap all the benefits of
a public good which they have produced, their incentives to produce it voluntarily might be
insufficient. Consumers can take advantage of public goods without contributing sufficiently to their
creation. This is called the free rider problem, or occasionally, the "easy rider problem" (because
consumer's contributions will be small but non-zero).
The free rider problem depends on a conception of the human being as homo economicus: purely
rational and also purely selfish -extremely individualistic, considering only those benefits and costs
that directly affect him or her. Public goods give such a person an incentive to be a free rider.
20
For example, consider national defense, a standard example of a pure public good. Suppose homo
economicus thinks about exerting some extra effort to defend the nation. The benefits to the
individual of this effort would be very low, since the benefits would be distributed among all of the
millions of other people in the country. There is also a very high possibility that he or she could get
injured or killed during the course of his or her military service.
On the other hand, the free rider knows that he or she cannot be excluded from the benefits of
national defense, regardless of whether he or she contributes to it. There is also no way that these
benefits can be split up and distributed as individual parcels to people. The free rider would not
voluntarily exert any extra effort, unless there is some inherent pleasure or material reward for doing
so (for example, money paid by the government, as with an all-volunteer army or mercenaries).
In the case of information goods, an inventor of a new product may benefit all of society, but hardly
anyone is willing to pay for the invention if they can benefit from it for free.
Possible solutions to the free rider problem
a) Assurance contracts
An assurance contract is a contract in which participants make a binding pledge to contribute to

building a public good, contingent on a quorum of a predetermined size being reached. Otherwise the
good is not provided and any monetary contributions are refunded.
A dominant assurance contract is a variation in which an entrepreneur creates the contract and
refunds the initial pledge plus an additional sum of money if the quorum is not reached. (The
entrepreneur profits by collecting a fee if the quorum is reached and the good is provided.) In game-
theoretic terms this makes pledging to build the public good a dominant strategy: the best move is to
pledge to the contract regardless of the actions of others.
b) Coasian solution
The coasian solution, named for the economist Ronald Coase and unrelated to the Coase theorem,
proposes a mechanism by which potential beneficiaries of a public good band together and pool their
resources based on their willingness to pay to create the public good. Coase (1960) argued that if the
transaction costs between potential beneficiaries of a public good are sufficiently low, and it is
21
therefore easy for beneficiaries to find each other and pool their money based on the public good's
value to them, then an adequate level of public goods production can occur even under competitive
free market conditions. However, Coase (1988) famously wrote:
"The world of zero transaction costs has often been described as a Coasian world. Nothing could be
further from the truth. It is the world of modern economic theory, one which I was hoping to persuade
economists to leave."
In some ways, the formation of governments and government-like communities, such as homeowners
associations can be thought of as applied instances of practicing the coasian solution by creating
institutions to reduce the transaction costs.
A similar alternative for arranging funders of public goods production, which is especially applicable
to information goods, is to produce the good but refuse to release it to the public until some form of
payment to cover costs is met.
Author Stephen King, for instance, authored chapters of a new novel downloadable for free on his
website while stating that he would not release subsequent chapters unless a certain amount of money
was raised. Sometimes dubbed holding for ransom, this method of public goods production is a
modern application of the street performer protocol for public goods production. Unlike assurance
contracts, this relies on social norms to ensure (to some extent) that the threshold is reached and
partial contributions are not wasted.
c) Government provision
If voluntary provision of public goods will not work, then the obvious solution is making their
provision involuntary. This saves each of us from our own tendency to be a free rider, while also
assuring us that no one else will be allowed to free ride. One frequently proposed solution to the
problem is for governments or states to impose taxation to fund the production of public goods. This
does not actually solve the theoretical problem because good government is itself a public good. Thus
it is difficult to ensure the government has an incentive to provide the optimum amount even if it
were possible for the government to determine precisely what amount would be optimum. These
issues are studied by public choice theory and public finance.
22
Sometimes the government provides public goods using "unfunded mandates". An example is the
requirement that every car be fit with a catalytic converter. This may be executed in the private
sector, but the end result is predetermined by the state: the individually involuntary provision of the
public good clean air. Unfunded mandates have also been imposed by the U.S. federal government on
the state and local governments, as with the Americans with Disabilities Act, for example.
d) Subsidies and joint products
A government may subsidize production of a public good in the private sector. Unlike government
provision, subsidies may result in some form of a competitive market. The potential for cronyism (for
example, an alliance between political insiders and the businesses receiving subsidies) can be limited
with secret bidding for the subsidies or application of the subsidies following clear general principles.
Depending on the nature of a public good and a related subsidy, principal agent problems can arise
between the citizens and the government or between the government and the subsidized producers;
this effect and counter-measures taken to address it can diminish the benefits of the subsidy.
Subsidies can also be used in areas with a potential for non-individualism: For instance, a state may
subsidize devices to reduce air pollution and appeal to citizens to cover the remaining costs.
Similarly, a joint-product model analyzes the collaborative effect of joining a private good to a public
good. For example, a tax deduction (private good) can be tied to a donation to a charity (public good).
It can be shown that the provision of the public good increases when tied to the private good, as long
as the private good is provided by a monopoly (otherwise the private good would be provided by
competitors without the link to the public good).
e) Privileged group
The study of collective action shows that public goods are still produced when one individual benefits
more from the public good than it costs him to produce it; examples include benefits from individual
use, intrinsic motivation to produce, and business models based on selling complement goods. A
group that contains such individuals is called a privileged group. A historical example could be a
downtown entrepreneur who erects a street light in front of his shop to attract customers; even though
there are positive external benefits to neighboring nonpaying businesses, the added customers to the
paying shop provide enough revenue to cover the costs of the street light.
23
The existence of privileged groups may not be a complete solution to the free rider problem,
however, as underproduction of the public good may still result. The street light builder, for instance,
would not consider the added benefit to neighboring businesses when determining whether to erect
his street light, making it possible that the street light isn't built when the cost of building is too high
for the single entrepreneur even when the total benefit to all the businesses combined exceeds the
cost.
An example of the privileged group solution could be the Linux community, assuming that users
derive more benefit from contributing than it costs them to do it. For more discussion on this topic see
also Coase's Penguin.
Another example is those musicians and writers who create music and writings for their own personal
enjoyment, and publish because they enjoy having an audience. Financial incentives are not necessary
to ensure the creation of these public goods. Whether this creates the correct production level of
writings and music is an open question.
f) Merging free riders
Another method of overcoming the free rider problem is to simply eliminate the profit incentive for
free riding by buying out all the potential free riders. A property developer that owned an entire city
street, for instance, would not need to worry about free riders when erecting street lights since he
owns every business that could benefit from the street light without paying. Implicitly, then, the
property developer would erect street lights until the marginal social benefit met the marginal social
cost. In this case, they are equivalent to the private marginal benefits and costs.
While the purchase of all potential free riders may solve the problem of underproduction due to free
riders in smaller markets, it may simultaneously introduce the problem of underproduction due to
monopoly. Additionally, some markets are simply too large to make a buyout of all beneficiaries
feasible - this is particularly visible with public goods that affect everyone in a country.
g) Introducing an exclusion mechanism (club goods)
Another solution, which has evolved for information goods, is to introduce exclusion mechanisms
which turn public goods into club goods. One well-known example is copyright and patent laws.
24
These laws, which in the 20th century came to be called intellectual property laws, attempt to remove
the natural non-excludability by prohibiting reproduction of the good. Although they can address the
free rider problem, the downside of these laws is that they imply private monopoly power and thus
are not Pareto-optimal.
h) Social norms
If enough people do not think like free-riders, the private and voluntary provision of public goods
may be successful. A free rider might litter in a public park, but a more public-spirited individual
would not do so, getting an inherent pleasure from helping the community. In fact, one might
voluntarily pick up some of the existing litter. If enough people do so, the role of the state in using
taxes to hire professional maintenance crews is reduced. This might imply that even someone
typically inclined to free-riding would not litter, since their action would have such a cost.
Public mindedness may be encouraged by non-market solutions to the economic problem, such as
tradition and social norms. For example, concepts such as nationalism and patriotism have been part
of most successful war efforts, complementing the roles of taxation and conscription. To some extent,
public spiritedness of a more limited type is the basis for voluntary contributions that support public
radio and television. Contributions to online collaborative media like Wikipedia and many other
projects utilising wiki technology can also be seen to represent an example of such public
spiritedness, since they provide a public good (information) freely to all readers.
Groups relying on such social norms often have a federated structure, since collaboration emerges
more readily in smaller social groups than in large ones. This explains why labor unions or charities
are often organized this way.
2.4 Market failure
This refers to the circumstances under which the market fails to allocate resources efficiently i.e. it
exists where the production or use of the goods and services by the market is not efficient. The
market failures can be viewed in scenarios where individual pursuit of pure self interest leads to
results that are not efficient i.e. that can be improved from societal point of view.
Causes of market failures
25
There are four main causes:
Market power: Agents in the market can gain market power, allowing them to block other
mutually beneficial gains from trades from occurring. This can lead to inefficiency due to
imperfect competition, which can take many different forms such as monopolies, cartels or
monopolistic competition. In a monopoly, for example, the monopolist will use his/her market
power to restrict output below the quantity at which the marginal social benefit is equal to the
marginal social cost of the last unit produced so as to keep the prices and the profits high.
Externalities: the actions of the agents can have externalities which are innate to the methods of
production or other conditions important to the market eg when a firm is producing papers, it
absorbs labour, capital and other inputs. It must pay for these in the appropriate markets and these
will be reflected in the market price for paper products. If the firm also pollutes the environment
and atmosphere while producing paper products and it is not forced to pay for this resource, then
this cost will not be borne by the firm but by the society. Hence the market price for paper
products will fail to incorporate the full opportunity cost to the society of producing paper
products. In this case the market equilibrium in the paper industry will not be optimal. Therefore
the marginal social cost of the last unit produced will exceed its marginal social benefit.
Public goods: some markets can fail due to the nature of certain goods e.g. existence of public
goods. A public good is one whose consumption or use by one individual does not reduce the
amount available to others e.g. city park, defense, law and order, ocean or lake fishing e.t.c.
Public goods have two characteristics i.e. they are non-excludable and non-rivalrous. A good is
non-excludable if it can be consumed by anyone. It is non-rivalrous, if no one has an exclusive
right over its consumption. Its benefit can be provided to an addition consumer at zero marginal
cost. Thus public goods, being both non-excludable and non-rivalrous are not sold in a free
market like private goods.
Equity: the issue here is that the distribution of goods and services generated by the market may
not be fair. This is due to inequitable distribution of income.
Market failure, the rationale for government intervention / measures to correct market failure
1. Externalities
If pollution costs are external, firms will produce too much of a polluting good.
26
The goal of the goverment should be to discourage production and consumption activities that impose
high external costs on society. This can be accomplished by:
Regulation- passing legislation that address the problem
Altering markets incentives- this can be altered via emission changes. An emission charge is a fee
that is imposed on polluters based on the quantity of pollution.
2. Market power
This is the ability to alter the market price of a good or service. The goal of government policy should
be to prevent or dismantle concentration of market power. This can be done trough the relevant
legislation.
3. Public goods
These goods should be provided by some public authority. As the benefits of public goods are
indivisible, the state should make people share the cost of public goods so that everyone is made
better off. Due to the free rider problems some services such as defense should be provided free to
every user and can be provided by government through taxes.
4. Equity
Government intervention may be needed to redistribute income if the market fails to reflect our
notions of fairness. This can be done through transfer of payments such as social security, welfare
and unemployment benefits.
What constitutes optimum resources allocation in case of public goods? In the case of public goods a
certain quantity is consumed by everyone. Therefore the demand for any quantity of that public good
is the sum of prices that each individual consumer is willing to pay for that quantity. In this way, the
community’s demand curve for a public good is the summation of demand curves of the individual
consumers which represent the sum of all marginal benefits received by all consumers.
Each demand curve implies the marginal benefit that the consumer gets from consuming every level
of production. The optimum level of production of a public good is determined by equating the sum
of the marginal benefits to the marginal cost of production i.e. the optimum quantity is that quantity
27
for which the marginal cost of the last unit is equal to the sum of prices that all consumers are willing
to pay for that unit.

• Theory Of Private And Social /Public Goods
• The Free Rider Problem
• Market Failure
• Efficient Output Of Public Goods/ Optimum Level Of Production Of Public Goods
Revision Questions
• Describe a public good
• Explain the characteristics of public goods and private goods
• Explain free rider problem and its solutions
• Explain the causes of market failure and the solutions
• Explain the optimum output of social goods
Further References
M. L Jighan (2006), Public Finance And International Trade, Vrinda Publications P Limited, Delhi
India Pages 7-10
Harvey S Rosen (1999) Public Finance Irvin/Mcgraw Hill New York Usa Pages 61-83
John Quigley, E. Smolensky (1994) President And Fellows Of Havard University Usa Pages 93-120
28
3.0 EXTERNALITIES/ EXTERNAL EFFECT
General objective
By the end of the lesson the learner should be able to explain the meaning and implications of
externality
Specific objectives
a) By the end of the lesson the learner should be able to explain the meaning of externality
b) By the end of the lesson the learner should be able to describe negative externalities and
give examples
c) By the end of the lesson the learner should be able to describe positive externalities and
give examples
d) By the end of the lesson the learner should be able to graphically illustrate external costs
and benefits
e) By the end of the lesson the learner should be able to explain the types of externalities
f) By the end of the lesson the learner should be able to explain the solutions to externality
problem
g) By the end of the lesson the learner should be able to explain the implications of
externality
3.1 Introduction
This refers to the favourable and unfavourable effects which are associated with the production or
consumption of goods. Such economic effects are also referred to as spill-over effect, neighborhood
effects or third party effects.
These externalities may either be economic gain or economic loss to other parties e.g. the setting up
of a factory in a backward region will help to develop it. This is an example of economic gain
associated with externalities. On the other hand, environmental pollution resulting from the
establishment of a paper mill in an area may be an example of economic loss associated with
externalities. This economic gain or loss cannot be priced in the market and apportioned to particular
parties i.e. it is not possible to find out how much is the benefit of a factory set up in a backward
region or exact economic loss due to air or water pollution of a paper mill.
Market price is fixed in terms of the internal cost of goods and services whereas social cost of some
goods and services must be borne by the society in the form of physical inconvenience and disease.
29
External costs and benefits
Examples of externalities.
3.2 Negative externalities;
A negative externality is an action of a product on consumers that imposes a negative side effect on a
third party; it is "social cost". Many negative externalities (also called "external costs" or "external
diseconomies") are related to the environmental consequences of production and use.
Air pollution from burning fossil fuels causes damages to crops, (historic) buildings and public
health. The most extensive and integrated effort to quantify and monetise these impacts was in the
European ExternE project series. Anthropogenic climate change is attributed to greenhouse gas
emissions from burning oil, gas, and coal. The Stern Review on the Economics Of Climate Change
says "Climate change presents a unique challenge for economics: it is the greatest example of market
failure we have ever seen."
Water pollution by industries that adds poisons to the water, which harm plants, animals, and humans.
Systemic risk describes the risks to the overall economy arising from the risks which the banking
system takes. A condition of moral hazard can occur in the absence of well-designed banking
regulation, or in the presence of badly designed regulation.
Industrial farm animal production, on the rise in the 20th century, resulted in farms that were easier to
run, with fewer and often less-skilled employees, and a greater output of uniform animal products.
However, the externalities with these farms include "contributing to the increase in the pool of
30
antibiotic-resistant bacteria because of the overuse of antibiotics; air quality problems; the
contamination of rivers, streams, and coastal waters with concentrated animal waste; animal welfare
problems, mainly as a result of the extremely close quarters in which the animals are housed."
The harvesting by one fishing company in the ocean depletes the stock of available fish for the other
companies and overfishing may be the result. This is an example of a common property resource,
sometimes referred to as the Tragedy of the commons.
When car owners use roads, they impose congestion costs and higher accidents risks on all other
users.
A business may purposely underfund one part of their business, such as their pension funds, in order
to push the costs onto someone else, creating an externality. Here, the "cost" is that of providing
minimum social welfare or retirement income; economists more frequently attribute this problem to
the category of moral hazards.
Consumption by one consumer causes prices to rise and therefore makes other consumers worse off,
perhaps by reducing their consumption. These effects are sometimes called "pecuniary externalities"
and are distinguished from "real externalities" or "technological externalities". Pecuniary externalities
appear to be externalities, but occur within the market mechanism and are not a source of market
failure or inefficiency.
The consumption of alcohol by bar-goers in some cases leads to drinking and driving accidents which
injure or kill pedestrians and other drivers.
Shared costs of declining health and vitality caused by smoking and/or alcohol abuse. Here, the "cost"
is that of providing minimum social welfare. Economists more frequently attribute this problem to the
category of moral hazards, the prospect that a party insulated from risk may behave differently from
the way they would if they were fully exposed to the risk. For example, an individual with insurance
against automobile theft may be less vigilant about locking his car, because the negative
consequences of automobile theft are (partially) borne by the insurance company.
The cost of storing nuclear waste from nuclear plants for more than 1,000 years (over 100,000 for
some types of nuclear waste) is included in the cost of the electricity the plant produces, in the form
31
of a fee paid to the government and held in the Nuclear Waste Fund. Conversely, the costs of
managing the long term risks of disposal of chemicals, which may remain permanently hazardous, is
not commonly internalized in prices. The USEPA regulates chemicals for periods ranging from 100
years to a maximum of 10,000 years, without respect to potential long-term hazard.
3.3 Positive externalities –
Examples of positive externalities (beneficial externality, external benefit, external economy, or

Merit goods) include:
A beekeeper keeps the bees for their honey. A side effect or externality associated with his activity is
the pollination of surrounding crops by the bees. The value generated by the pollination may be more
important than the value of the harvested honey.
An individual planting an attractive garden in front of his or her house may provide benefits to others
living in the area, and even financial benefits in the form of increased property values for all property
owners.
A public organization that coordinates the control of an infectious disease preventing others in society
from getting sick.
An individual buying a product that is interconnected in a network (e.g., a video cellphone) will
increase the usefulness of such phones to other people who have a video cellphone. When each new
user of a product increases the value of the same product owned by others, the phenomenon is called
a network externality or a network effect. Network externalities often have "tipping points" where,
suddenly, the product reaches general acceptance and near-universal usage.
Knowledge spillover of inventions and information - once an invention (or most other forms of
practical information) is discovered or made more easily accessible, others benefit by exploiting the
invention or information. Copyright and intellectual property law are mechanisms to allow the
inventor or creator to benefit from a temporary, state-protected monopoly in return for "sharing" the
information through publication or other means.
Sometimes the better part of a benefit from a good comes from having the option to buy something
rather than actually having to buy it. A private fire department that only charged people that had a
fire, would arguably provide a positive externality at the expense of an unlucky few. Some form of
insurance could be a solution in such cases, as long as people can accurately evaluate the benefit they
have from the option.
Some studies find that home ownership creates a positive externality in that homeowners are more
likely than renters to become actively involved in the local community. A controlled study on the
32
topic, however, disputes that this effect is causal. Still this is often a justification given for why, in the
US, interest paid on a home mortgage is an available deduction from the income tax.
Education creates a positive externality because more educated people are less likely to engage in
violent crime, which makes everyone in the community, even people who are not well educated,
better off.
3.4 Types of externalities
There are two types namely:
Market externalities
Non-market externalities
Market externalities
This refers to those effects which can be valued in money and expressed in terms of price in the
market as determined by the forces of demand and supply.
Non- market externalities
This refers to those effects which cannot be expressed in terms of price in the market and cannot be
made part of the cost of production
3.5 Possible solutions to the externality problem
There are at least four general types of solutions to the problem of externalities:
• Criminalization: As with prostitution in some countries, addictive drugs, commercial fraud,

and many types of environmental and public health laws.
• Civil Tort law: For example, class action by smokers, various product liability suits.
• Government provision: As with lighthouses, education, and national defense.
• Pigovian taxes or subsidies intended to redress economic injustices or imbalances.
A Pigovian tax is a tax imposed that is equal in value to the negative externality. The result is that the
market outcome would be reduced to the efficient amount. A side effect is that revenue is raised for
the government, reducing the amount of distortionary taxes that the government must impose
elsewhere. Economists prefer Pigovian taxes and subsidies as being the least intrusive and most
efficient method to resolve externalities.
33
Other solutions
However, the most common type of solution is tacit agreement through the political process.
Governments are elected to represent citizens and to strike political compromises between various
interests. Normally governments pass laws and regulations to address pollution and other types of
environmental harm. These laws and regulations can take the form of "command and control"
regulation (such as setting standards, targets, or process requirements), or environmental pricing
reform (such as ecotaxes or other pigovian taxes, tradable pollution permits or the creation of markets
for ecological services). The second type of resolution is a purely private agreement between the
parties involved.
Government intervention may not always be needed. Traditional ways of life may have evolved as
ways to deal with external costs and benefits. Alternatively, democratically-run communities can
agree to deal with these costs and benefits in an amicable way. Externalities can sometimes be
resolved by agreement between the parties involved. This resolution may even come about because of
the threat of government action.
Ronald Coase argued that if all parties involved can easily organize payments so as to pay each other
for their actions, then an efficient outcome can be reached without government intervention. Some
take this argument further, and make the political claim that government should restrict its role to
facilitating bargaining among the affected groups or individuals and to enforcing any contracts that
result. This result, often known as the Coase Theorem, requires that
• Property rights be well defined

• People act rationally
• Transaction costs be minimal
If all of these conditions apply, the private parties can bargain to solve the problem of externalities.
3.6 Implications Of Externality
Standard economic theory states that any voluntary exchange is mutually beneficial to both parties
involved in the trade. This is because either the buyer or the seller would refuse the trade, if it won't
benefit both. However, an exchange can cause additional effects on third parties. From the
34
perspective of those affected, these effects may be negative (pollution from a factory), or positive
(honey bees that pollinate the garden). Welfare economics has shown that the existence of
externalities results in outcomes that are not socially optimal. Those who suffer from external costs
do so involuntarily, while those who enjoy external benefits do so at no cost.
A voluntary exchange may reduce societal welfare if external costs exist. The person who is affected
by the negative externalities in the case of air pollution will see it as lowered utility: either subjective
displeasure or potentially explicit costs, such as higher medical expenses. The externality may even
be seen as a trespass on their lungs, violating their property rights. Thus, an external cost may pose an
ethical or political problem. Alternatively, it might be seen as a case of poorly defined property rights,
as with, for example, pollution of bodies of water that may belong to no-one (either figuratively, in
the case of publicly-owned, or literally, in some countries and/or legal traditions).
On the other hand, a positive externality would increase the utility of third parties at no cost to them.
Since collective societal welfare is improved, but the providers have no way of monetizing the
benefit, less of the good will be produced than would be optimal for society as a whole. Goods with
positive externalities include education (believed to increase societal productivity and well-being; but
controversial, as these benefits may be internalized), public health initiatives (which may reduce the
health risks and costs for third parties for such things as transmittable diseases) and law enforcement.
Positive externalities are often associated with the free rider problem. For example, individuals who
are vaccinated reduce the risk of contracting the relevant disease for all others around them, and at
high levels of vaccination, society may receive large health and welfare benefits; but any one
individual can refuse vaccination, still avoiding the disease by "free riding" on the costs borne by
others.
There are a number of potential means of improving overall social utility when externalities are
involved. The market-driven approach to correcting externalities is to "internalize" third party costs
and benefits, for example, by requiring a polluter to repair any damage caused. But, in many cases
internalizing costs or benefits is not feasible, especially if the true monetary values cannot be
determined.
The monetary values of externalities are difficult to quantify, as they may reflect the ethical views
and preferences of the entire population. It may not be clear whose preferences are most important,
interests may conflict, the value of externalities may be difficult to determine, and all parties involved
35
may try to influence the policy responses to their own benefit. An example is the externalities of the
smoking of tobacco, which can cost or benefit society depending on the situation. Because it may not
be feasible to monetize the costs and benefits, another method is needed to either impose solutions or
aggregate the choices of society, when externalities are significant. This may be through some form
of representative democracy or other means. Political economy is, in broad terms, the study of the
means and results of aggregating those choices and benefits that are not limited to purely private
transactions.
Laissez-faire economists such as Friedrich Hayek and Milton Friedman sometimes refer to
externalities as "neighborhood effects" or "spillovers", although externalities are not necessarily
minor or localized.
Private and social costs: Social costs are the spillover costs to society (society pays off the costs),
while private costs are the costs given to the individual firms or producer.
3.7 Graphical Illustration Of Supply And Demand Diagrams Showing The External Costs And
Benefits
The usual economic analysis of externalities can be illustrated using a standard supply and demand
diagram if the externality can be monetized and valued in terms of money. An extra supply or
demand curve is added, as in the diagrams below. One of the curves is the private cost that consumers
pay as individuals for additional quantities of the good, which in competitive markets, is the marginal
private cost. The other curve is the true cost that society as a whole pays for production and
consumption of increased production the good, or the marginal social cost.
Similarly there might be two curves for the demand or benefit of the good. The social demand curve
would reflect the benefit to society as a whole, while the normal demand curve reflects the benefit to
consumers as individuals and is reflected as effective demand in the market.
External costs
The graph below shows the effects of a negative externality. For example, the steel industry is
assumed to be selling in a competitive market – before pollution-control laws were imposed and
36
enforced (e.g. under laissez-faire). The marginal private cost is less than the marginal social or public
cost by the amount of the external cost, i.e., the cost of air pollution and water pollution. This is
represented by the vertical distance between the two supply curves. It is assumed that there are no
external benefits, so that social benefit equals individual benefit.
Demand curve with external costs; if social costs are not accounted for price is too low to cover all
costs and hence quantity produced is unnecessarily high (because the producers of the good and their
customers are essentially underpaying the total, real factors of production.)
If the consumers only take into account their own private cost, they will end up at price Pp and
quantity Qp, instead of the more efficient price Ps and quantity Qs. These latter reflect the idea that
the marginal social benefit should equal the marginal social cost, that is that production should be
increased only as long as the marginal social benefit exceeds the marginal social cost. The result is
that a free market is inefficient since at the quantity Qp, the social benefit is less than the social cost,
so society as a whole would be better off if the goods between Qp and Qs had not been produced. The
problem is that people are buying and consuming too much steel.
This discussion implies that negative externalities (such as pollution) is more than merely an ethical
problem. The problem is one of the disjuncture between marginal private and social costs that is not
solved by the free market. It is a problem of societal communication and coordination to balance
costs and benefits. This also implies that pollution is not something solved by competitive markets.
Some collective solution is needed, such as a court system to allow parties affected by the pollution to
37
be compensated, government intervention banning or discouraging pollution, or economic incentives
such as green taxes.
External benefits
The graph below shows the effects of a positive or beneficial externality. For example, the industry
supplying smallpox vaccinations is assumed to be selling in a competitive market. The marginal
private benefit of getting the vaccination is less than the marginal social or public benefit by the
amount of the external benefit (for example, society as a whole is increasingly protected from
smallpox by each vaccination, including those who refuse to participate). This marginal external
benefit of getting a smallpox shot is represented by the vertical distance between the two demand
curves. Assume there are no external costs, so that social cost equals individual cost.
Supply curve with external benefits; when the market does not account for additional social benefits
of a good both the price for the good and the quantity produced are lower than the market could bear.
If consumers only take into account their own private benefits from getting vaccinations, the market
will end up at price Pp and quantity Qp as before, instead of the more efficient price Ps and quantity
Qs. These latter again reflect the idea that the marginal social benefit should equal the marginal social
cost, i.e., that production should be increased as long as the marginal social benefit exceeds the
marginal social cost. The result in an unfettered market is inefficient since at the quantity Qp, the
social benefit is greater than the societal cost, so society as a whole would be better off if more goods
had been produced. The problem is that people are buying too few vaccinations.
38
The issue of external benefits is related to that of public goods, which are goods where it is difficult if
not impossible to exclude people from benefits. The production of a public good has beneficial
externalities for all, or almost all, of the public. As with external costs, there is a problem here of
societal communication and coordination to balance benefits and costs. This also implies that
vaccination is not something solved by competitive markets. The government may have to step in
with a collective solution, such as subsidizing or legally requiring vaccine use. If the government
does this, the good is called a merit good.

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

Describe negative externalities and give examples
Describe positive externalities and give examples
Graphically illustrate external costs and benefits
Explain the types of externalities
Explain the solutions to externality problem
Explain the implications of externality
Further References
India Pages 10-15
39
40
4.0 EQUITY AND INCOME DISTRIBUTION
General objective
By the end of the lesson the learner should be able to explain the meaning and implications of
equity in income distribution
Specific objectives
By the end of the lesson the learner should be able to explain the meaning of equity in income
distribution
a) By the end of the lesson the learner should be able to explain the perspectives on equity
b) By the end of the lesson the learner should be able to explain the differences between
vertical and horizontal equity
c) By the end of the lesson the learner should be able to explain income inequality
d) By the end of the lesson the learner should be able to explain the causes and mitigating
factors of inequality
e) By the end of the lesson the learner should be able to explain the concept of and types of
redistribution of wealth
f) By the end of the lesson the learner should be able to distinguish between equity and
equality in taxation
4.1 Equitable distribution of income
There is no commonly accepted benchmark for what constitutes an equitable distribution of

opportunity in an economy. Whether elements of the tax-transfer system improve equity or not
depends on a range of judgements. People put different degrees of emphasis on different priorities of
a tax-transfer system and these priorities can sometimes conflict. For example, some people believe
that high marginal tax rates on capital improve equity since they may help to redistribute income
from rich to poor. Others believe that high rates harm equity because they may reduce the level of
investment and capital income formation, and through that channel result in lower growth in wages,
as well as imposing a higher tax rate on the people who decide to save rather than consume.
41
4.2 Perspectives on equity
There are a number of perspectives on equity that people use to inform their assessments of the
tax-transfer system, including:
Inter-temporal equity, which looks at how the tax-transfer system impacts on longer term decisions of
individuals, such as work, saving, family structure and education. Equity therefore requires some
consideration of dynamic or future lifetime resources;
Intergenerational equity, which looks at how the decisions of today's individuals affect future
generations. In general, this includes the objective of ensuring that the wellbeing of future generations
is at least no lower than the current generation;
Spatial equity, which focuses on the degree to which the tax-transfer system should deliver
individuals in different geographic areas similar consumption opportunities, at least for certain types
of goods and services;
The opportunity and freedom of individuals to participate in society and to achieve the things they
value. Considered here is the role of the tax-transfer system in providing individuals with capabilities
and opportunities rather than specific outcomes
'Rights based' frameworks, which emphasise that the tax-transfer system should not violate
fundamental rights and the procedural fairness necessary to sustain a liberal democracy. For example,
the tax-transfer system needs to treat issues of privacy carefully and certain forms of inequality such
as direct discrimination on the basis of race, gender or sexual preference — should be ruled out
altogether.
While equity can mean different things to different people, there are some common concepts often
used to discuss whether the tax-transfer system contributes to equity, or not, according to different
equity perspectives; in particular, the beneficiary principle and the ability to pay principle.
4.3 The beneficiary principle and ability to pay
The beneficiary principle states that people should pay tax according to the benefits they receive from
spending funded by tax revenue, regardless of their income. The principle could be appropriate for
42
funding the public provision of services where it is possible for a user charge to apply (such as public
transport, electricity and water). There are, however, a range of government-provided services where
access to the service for one person has no impact on access for others: the services are 'non-rival in
consumption'. Examples include national defence, law and order, public health services and fire
protection. The marginal cost of providing such services is usually close to zero, so excluding some
people from consuming them can be inefficient. The beneficiary principle can, nevertheless, be used
to justify higher tax burdens on groups that benefit disproportionately from public goods. For
example, the principle may support progressive income taxation if higher income earners use
relatively more public goods. It may also support taxing foreigners through company tax, as they
benefit from government funded infrastructure, legal institutions, and a skilled workforce.
The ability to pay principle states that those who are more capable of bearing the burden of taxes
should pay more taxes than those with less ability to pay. For transfers, this principle suggests
assistance should increase with the level of disadvantage. This principle requires a measure of ability
to pay, such as overall wealth, income, or consumption. Ability to pay may vary considerably
depending on the measure chosen. For example, a taxpayer's ability to pay, measured by property and
financial wealth, may differ significantly from his or her ability to pay measured by income. A
taxpayer who works for many years and then retires may accumulate a significant amount of wealth
relative to others, typically in the form of owner-occupied housing, but have a relatively low income.
4.4 Horizontal and vertical equity
The concepts of horizontal and vertical equity are refinements of the ability to pay principle.
Horizontal equity requires individuals in the same economic position to be treated the same by the
tax-transfer system. Vertical equity is generally considered to mean that individuals in different
economic positions should be treated differently, usually with those having greater economic capacity
paying more.
Different perspectives on the 'same economic position' can lead to different judgements about
whether a policy is horizontally equitable. Consider two individuals who earn the same amount of
income but do so from different sources, such as wages and dividends. Taxing these two individuals
in an equivalent manner may be considered horizontally equitable by some but others may consider it
appropriate to tax wages less as this income is derived from an individual's work effort while
dividend income may be derived from inherited wealth.The basis for determining 'capacity to pay'
43
differs fundamentally between the tax system focus on the individual and the transfer system focus on
the family.
Vertical equity deals with differences in ability to pay. Subjective judgments about vertical equity are
reflected in debates about the overall fairness of the following three types of personal tax rate
structure:
Progressive tax rates — where the tax liability as a percentage of a taxpayer's income increases as
their income increases;
Proportional tax rates — where the tax liability as a percentage of income stays the same, regardless
of the taxpayer's income; and
Regressive tax rates — where the tax liability as a percentage of a taxpayer's income declines as their
income increases.
4.5 Economic And Income Inequality
Economic inequality (or "wealth and income differences") comprises all disparities in the
distribution of economic assets and income. The term typically refers to inequality among individuals
and groups within a society, but can also refer to inequality among countries.
The issue of economic inequality is related to the ideas of equality of outcome, equality of
opportunity and ideal wealth distribution. The main instrument which diminishes economic
inequality, progressive taxation, has been demonstrated to be effective in international comparisons
of income compression and wealth distribution.
Economic inequality has existed in a wide range of societies and historical periods; its nature, cause
and importance are open to broad debate. A country's economic structure or system (for example,
capitalism or socialism), ongoing or past wars, and differences in individuals' abilities to create
wealth are all involved in the creation of economic inequality.
There are various numerical indices for measuring economic inequality. eg the Gini coefficient,
44
Income inequality describes the extent to which income is distributed unevenly among residents
of an area. High levels of inequality indicate that a small number of people receive most of the
total income, and that most people receive only a small share of the total.
4.6 Causes of inequality
There are many reasons for economic inequality within societies. These causes are often inter-related.
Acknowledged factors that impact economic inequality include:
• The labour market

• Innate ability
• Education
• Computerization/growing technology
• Globalization
• Culture
• Wealth condensation
• Diversity of preferences
• Development patterns
• Inflation
a ) The labour market
A major cause of economic inequality within modern market economies is the determination of
wages by the market. Inequality is caused by the differences in the supply and demand for different
types of work. In a purely capitalist mode of production (i.e. where professional and labor
organizations cannot limit the number of workers) the workers wages will not be controlled by these
organizations, nor by the employer, but rather by the market. Wages work in the same way as prices
for any other good. Thus, wages can be considered as a function of market price of skill. And
therefore, inequality is driven by this price. Under the law of supply and demand, the price of skill is
determined by a race between the demand for the skilled worker and the supply of the skilled worker.
We would expect the price to rise when demand exceeds supply, and vice versa. Employers who offer
a below market wage will find that their business is chronically understaffed. Their competitors will
take advantage of the situation by offering a higher wage to snatch up the best of their labor.
45
A job where there are many willing workers (high supply) competing for a job that few require (low
demand) will result in a low wage for that job. This is because competition between workers drives
down the wage.
A job where there are few able or willing workers (low supply), but a large need for the positions
(high demand), will result in high wages for that job. This is because competition between employers
for employees will drive up the wage. Examples of this would include jobs that require highly
developed skills, rare abilities, or a high level of risk. Competition amongst employers tends to drive
up wages due to the nature of the job, since there is a relative shortage of workers for the particular
position.
The final results amongst these supply and demand interactions is a gradation of different wages
representing income inequality within society.
b) Innate ability
Many people believe that there is a correlation between differences in innate ability, such as
intelligence, motivation, strength, or charisma, and an individual's wealth. Relating these innate
abilities back to the labor market suggests that such abilities are in high demand relative to their
supply and hence play a large role in increasing the wage of those who have them. Otherwise, such
innate abilities might also affect an individual's ability to operate within society in general, regardless
of the labor market.
c) Computerization/Innovative Technology
Another factor that contributed to the already growing inequality in the 20th century was
computerization and growth in technology with electricity replacing manpower. With this growing
change in technology, the countries experienced increasing demand for skilled workers to use
computers and operate the electrical inventions. This resulted in a rightward shift in the Demand for
Skilled Labor Supply, and this created an increase in the relative wages of the skilled compared to the
wages of the unskilled workers. Such a change in wages added to the inequality that was already
present.
d) Education
46
One important factor in the creation of inequality is variation in individuals' access to education.
Education, especially in an area where there is a high demand for workers, creates high wages for
those with this education. As a result, those who are unable to afford an education, or choose not to
pursue education, generally receive much lower wages.
e) Globalization
Trade liberalization may shift economic inequality from a global to a domestic scale. When rich
countries trade with poor countries, the low-skilled workers in the rich countries may see reduced
wages as a result of the competition, while low-skilled workers in the poor countries may see
increased wages.
f) Culture and religion
The existence of different cultures and religions within a society is also thought to contribute to
economic inequality. Culture and religion are thought to play a role in creating inequality by either
encouraging or discouraging wealth-acquiring behavior, and by providing a basis for discrimination.
In many countries individuals belonging to certain racial and ethnic minorities are more likely to be
poor. Proposed causes include cultural differences amongst different races, an educational
achievement gap, and racism.
g) Diversity of preferences
Related to cultural issues, diversity of preferences within a society often contributes to economic
inequality. When faced with the choice between working harder to earn more money or enjoying
more leisure time, equally capable individuals with identical earning potential often choose different
strategies. This leads to economic inequality even in societies with perfect equality in abilities and
circumstances. The trade-off between work and leisure is particularly important in the supply side of
the labor market in labour economics.
Likewise, individuals in a society often have different levels of risk aversion. When equally-able
individuals undertake risky activities with the potential of large payoffs, such as starting new
businesses, some ventures succeed and some fail. The presence of both successful and unsuccessful
ventures in a society results in economic inequality even when all individuals are identical.
47
h) Development patterns
Simon Kuznets argued that levels of economic inequality are in large part the result of stages of
development. Kuznets saw a curve-like relationship between level of income and inequality, now
known as Kuznets curve. According to Kuznets, countries with low levels of development have
relatively equal distributions of wealth. As a country develops, it acquires more capital, which leads
to the owners of this capital having more wealth and income and introducing inequality. Eventually,
through various possible redistribution mechanisms such as social welfare programs, more developed
countries move back to lower levels of inequality
i) Wealth condensation
Wealth condensation is a theoretical process by which, under certain conditions, newly-created

wealth concentrates in the possession of already-wealthy individuals or entities. According to this
theory, those who already hold wealth have the means to invest in new sources of creating wealth or
to otherwise leverage the accumulation of wealth, thus are the beneficiaries of the new wealth. Over
time, wealth condensation can significantly contribute to the persistence of inequality within society.
Related to wealth condensation are the effects of intergenerational inequality. The rich tend to
provide their offspring with a better education, increasing their chances of achieving a high income.
Furthermore, the wealthy often leave their offspring with a hefty inheritance, jump-starting the
process of wealth condensation for the next generation
j) Inflation
Some economists have theorized that high inflation, caused by a country's monetary policy, can
contribute to economic inequality. This theory argues that inflation of the money supply is a coercive
measure that favors those who already have an earning capacity, disfavoring those on fixed income or
with savings, thus aggravating inequality. They cite examples of correlation between inflation and
inequality and note that inflation can be caused independently by "printing money", suggesting
causation of inequality by inflation.
4.7 Mitigating factors of inequality
Many factors constrain economic inequality. They may be divided into two classes namely:
48
Government sponsored
Market driven.
a) Government sponsored
Typical government initiatives to reduce economic inequality include:
Public education: increasing the supply of skilled labor and reducing income inequality due to
education differentials.
Progressive taxation: the rich are taxed proportionally more than the poor, reducing the amount of
income inequality in society.
Minimum wage legislation: raising the income of the poorest workers (though probably increasing
unemployment).
Nationalization or subsidization of products: providing goods and services that everyone needs
cheaply or freely (such as food, healthcare, and housing), governments can effectively raise the
purchasing power of the poorer members of society.
These provisions may lower inequality, but have sometimes resulted in increased economic inequality
(as in the Soviet Union, where the distribution of these government benefits was controlled by a
privileged class).
b) Market driven
Market forces outside of government intervention that can reduce economic inequality include:
a) Propensity to spend: with rising wealth and income, a person must spend more. In an extreme
example, if one person owned everything, they would immediately need to hire people to
maintain their properties, thus reducing the wealth concentration.
b) Unionization: although not a market force, per se, labor organizations may reduce inequality
by negotiating standard pay rates (though probably increasing unemployment). As union
power has declined, and performance related pay has become more widespread, economic
inequality has mirrored productive inequality.
49
4.8 Redistribution of wealth
Redistribution of wealth is the transfer of income, wealth or property from some individuals to
others caused by a social mechanism such as taxation, monetary policies, welfare, nationalization,
charity or tort law. Most often it refers to progressive redistribution, from the rich to the poor,
although it may also refer to regressive redistribution, from the poor to the rich. The desirability and
effects of redistribution are actively debated on ethical and economic grounds.
4.9 Types of redistribution
Income redistribution occurs in some form in most democratic countries. Progressive income
redistribution diminishes the amount of income one individual or corporation receives, while at the
same time benefitting others. In a progressive income tax system, a high income earner will pay a
higher tax rate than a low income earner. A steeper progressive income tax results in more equal
distribution of income and wealth across the board.
Property redistribution is a term applied to various policies involving taxation or nationalization of

property, or of regulations ordering owners to make their property available to others. Public
programs and policy measures involving redistribution of property include eminent domain, land
reform and inheritance tax.
Arguments in favour of redistribution
The arguments include;
a) An ethical basis for redistribution is the concept of distributive justice and wealth.
b) One premise of redistribution is that money should be distributed to benefit the poorer
members of society, and that the rich have an obligation to assist the poor, thus creating a
more financially egalitarian society
c) Another argument is that the rich exploit the poor or otherwise gain unfair benefits, and
thus should return some of those benefits.
d) Another argument is that a larger middle class benefits an economy by enabling more
people to be consumers, while providing equal opportunities for individuals to reach a
better standard of living.
50
e) Some proponents of redistribution argue that capitalism results in an unequal wealth
distribution.
f) They also argue that economic inequality contributes to crime.
g) There is also the issue of equal opportunity to access services such as education and health
care. Studies show that a lower rate of redistribution in a given society increases the
inequality found among future incomes, due to restraints on wealth investments in both
human and physical capital
4.10 Difference Between Equity And Equality In Taxation
Equity means justice or fairness. It is useful to distinguish between

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

• Equitable distribution of income
• Perspectives on equity
• The beneficiary principle and ability to pay
• Horizontal and vertical equity
• Economic And Income Inequality
• Causes of inequality
• Mitigating factors of inequality
• Redistribution of wealth
• Types of redistribution
• Difference Between Equity And Equality In Taxation
Revision Questions
1. Explain the meaning of equity in income distribution
2. Describe the perspectives on equity
3. Explain the differences between vertical and horizontal equity
4. Explain income inequality
51
5. Explain the causes and mitigating factors of inequality
6. Explain the concept of and types of redistribution of wealth
7. Distinguish between equity and equality in taxation
Further References
52
5.0 PUBLIC CHOICE THEORY
General objective
By the end of the lesson the learner should be able to explain the meaning and implications of public
choice theory
Specific objectives
a) By the end of the lesson the learner should be able to describe the public choice theory
b) By the end of the lesson the learner should be able to explain the perspectives of the public
choice theory
c) By the end of the lesson the learner should be able to explain the remedies of the public
choice theory
d) By the end of the lesson the learner should be able to explain rent seeking and bureaucracy
as they relate to the public choice theory
5.1 Introduction
In economics, public choice theory is the use of modern economic tools to study problems that are
traditionally in the area of political science.
In particular, it studies the behavior of politicians and government officials as mostly self-interested
agents and their interactions in the social system either as such or under alternative constitutional
rules. These can be represented a number of ways, including standard constrained utility
maximization, game theory, or decision theory. Public choice analysis has roots in positive analysis
("what is") but is often used for normative purposes ("what ought to be"), to identify a problem or
suggest how a system could be improved by changes in constitutional rules.
5.2 Origins and formation
The modern literature in Public Choice began with Duncan Black, who in 1948 identified the
underlying concepts of what would become median voter theory. He also wrote The Theory of
Committees and Elections in 1958. Gordon Tullock refers to him as the "father of public choice
theory".
53
James M. Buchanan and Gordon Tullock coauthored The Calculus of Consent: Logical Foundations
of Constitutional Democracy (1962), considered one of the landmark works that founded the
discipline of public choice theory.
5.3 Perspective
Public choice theory attempts to look at governments from the perspective of the bureaucrats and
politicians who compose them, and makes the assumption that they act based on Budget-maximizing
model in a self-interested way for the purpose of maximizing their own economic benefits (e.g. their
personal wealth). The theory aims to apply economic analysis (usually decision theory and game
theory) to the political decision-making process in order to reveal certain systematic trends towards
inefficient government policies.
5.4 Claims of the Public choice theory
One of the basic claims that results from public choice theory is that good government policies in a
democracy are an underprovided public good, because of the rational ignorance of the voters. Each
voter is faced with a tiny probability that his vote will change the result of the elections, while
gathering the relevant information necessary for a well-informed voting decision requires substantial
time and effort. Therefore, the rational decision for each voter is to be generally ignorant of politics
and perhaps even abstain from voting. Rational choice theorists claim that this explains the gross
ignorance of most citizens in modern democracies as well as low voter turnout. Rational abstention
does, however, create the "Paradox of voting" whereby strict costs benefit analysis implies that
nobody should vote.
Special interests groups
While good government tends to be a pure public good for the mass of voters, there may be many
advocacy groups that have strong incentives for lobbying the government to implement specific
policies that would benefit them, potentially at the expense of the general public. For example,
lobbying by the sugar manufacturers might result in an inefficient subsidy for the production of sugar,
either direct or by protectionist measures. The costs of such inefficient policies are dispersed over all
citizens, and therefore unnoticeable to each individual. On the other hand, the benefits are shared by a
small special-interest group with a strong incentive to perpetuate the policy by further lobbying. Due
54
to rational ignorance, the vast majority of voters will be unaware of the effort; in fact, although voters
may be aware of special-interest lobbying efforts, this may merely select for policies which are even
harder to evaluate by the general public, rather than improving their overall efficiency. Even if the
public were able to evaluate policy proposals effectively, they would find it infeasible to engage in
collective action in order to defend their diffuse interest. Therefore, theorists expect that numerous
special interests will be able to successfully lobby for various inefficient policies. In public choice
theory, such scenarios of inefficient government policies are referred to as government failure , a term
akin to market failure from earlier theoretical welfare economics.
5.5 Remedies for the public choice problem
Many proposals have been advanced for reducing what is often seen as excessive or improper
influence on public choices by those who invest most to influence them. From game theory we have
the insight that a winning strategy in competitive games should have a random component so that the
opponent can't anticipate one's moves. This is confirmed by the historical resort to having decisions
made by officials selected at random, perhaps with a complex process of intermediate qualifying
steps, called sortition. That is what is done in countries using a trial jury selected at random.
5.6 Areas related to public choice theory
Bureaucracy
Rent-seeking
a) Bureaucracy
Another major sub-field is the study of bureaucracy. The usual model depicts the top bureaucrats as
being chosen by the chief executive and legislature, depending on whether the democratic system is
presidential and parliamentary. The typical image of a bureau chief is a person on a fixed salary who
is concerned with pleasing those who appointed him. The latter have the power to hire and fire him
more or less at will. The bulk of the bureaucrats, however, are civil servants whose jobs and pay are
protected by a civil service system against major changes by their appointed bureau chiefs. This
image is often compared with that of a business owner whose profit varies with the success of
production and sales, who aims to maximize profit, and who can hire and fire employees at will.
55
b) Rent-seeking
A field that is closely related to public choice is "rent-seeking". This field combines the study of a
market economy with that of government. Thus, one might regard it as a "new political economy." Its
basic thesis is that when both a market economy and government are present, government agents are
a source of numerous special market privileges. Both the government agents and self-interested
market participants seek these privileges in order to partake in the monopoly rent that they provide.
When such privileges are granted, they reduce the efficiency of the economic system. In addition, the
rent-seekers use resources that could otherwise be used to produce goods that are valued by
consumers.
Rent-seeking is broader than Public Choice in that it applies to autocracies as well as democracies
and, therefore, is not directly concerned with collective decision-making. However, the obvious
pressures it exerts on legislators, executives, bureaucrats, and even judges are factors that public
choice theory must account for in its analysis of collective decision-making rules and institutions.
Moreover, the members of a collective who are planning a government would be wise to take
prospective rent-seeking into account

Origins and formation of public choice theory
Perspective of public choice theory
Claims of the Public choice theory
Remedies for the public choice problem
Areas related to public choice theory
Questions
1. Describe the public choice theory

2. Describe the perspectives of the public choice theory
3. Explain the remedies of the public choice theory
4. Distinguish between rent seeking and bureaucracy as they relate to the public choice theory
56
Further References
57
6.0 BEHAVIOURAL RESPONSES TO TAXATION
General objective
By the end of the lesson the learner should be able to explain the behavioral responses of taxation on
the economy
Specific objectives
a) By the end of the lesson the learner should be able to explain the effects of taxation on the
ability to work and save
b) By the end of the lesson the learner should be able to explain the effects of taxation on the
desire to work and save
c) By the end of the lesson the learner should be able to explain the effects of taxation on the
composition and pattern of production
d) By the end of the lesson the learner should be able to explain the effects of taxation on the
distribution of income
6.1 Introduction
Every tax system produces various types of consequences on production, distribution, consumption
and the level of economic activity. The effects may be food or bad, but "the best system of taxation
from the economic point is that which has the best, or the least bad, economic effects," according to
Dr Dalton. The behavioural responses to taxation can be examined by analyzing the various effects
to taxation as discussed below.
6.2 Effects Of Taxation On Production
Dalton has studied the effects of taxation on production under three categories
On the ability to work and save
On the desire to work and save.
On the composition and pattern of production.
58
6.2.1 Ability to work and save.
Taxes which lower the efficiency of the taxpayers adversely affect their ability to work and hence
production. When taxes are levied, they reduce the purchasing power of the people who are forced to
cut down expenditures on necessaries, comforts and luxuries, this effect is more pronounced in the
case of the lower and middle income groups that on the upper income groups. People in the lower
and middle income groups reduce expenditure on necessaries of efficiency (such as milk) when taxes
are imposed on necessaries of life. Similarly, taxes on conventional necessaries like cigarettes also
force people to reduce expenditure on necessaries of efficiency, and even on medical facilities and
education of children. This effect is not peculiar in the case of commodity taxation alone. It is also
to be found in the case of progressive income tax which directly reduces the income of the taxpayers
and thus adversely affect their ability to work, and consequently production. But the ability to work
or the rich is not affected by taxation because they can afford to buy whatever they want to.
Taxes also adversely affect the ability to save. If a taxpayer maintains the same standard of living
after the imposition of taxes, and does not reduce his consumption expenditure on goods accordingly,
he will save less or may not save at all. Since saving depends upon income, all taxes reduce the
ability to save of the higher income groups more than that of the lower income groups because the
saving-margins of the former are larger and that of the latter smaller.
6.2.2 Desire to work and save.

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

Moderate commodity taxes do not adversely affect the incentive to work and save and even the
production of taxed commodities. But if heavy commodity taxes are imposed, they will raise the
prices of commodities, reduce their demand, and bring a fall in their production.
On the other hand, some direct taxes do not have any effect on the desire to work and save, and on
expenditure. Windfalls or unexpected gains from war profits, inflation, increase in land values, or
59
from inheritances are unearned incomes. Taxes on them are not felt by the recipients of such gains.
Hence they do not adversely affect the desire to work and save similarly, a tax on monopoly profit
does not reduce the willingness to work, save, and produce on the part of the monopolist. His interest
lies in maximizing his profit. So he will continue to work, save, invest, and produce so long as he
earns some profit. Further, an expenditure tax discourages expenditure rather than the desire to work,
save, and produce. In fact, the latter is encouraged.
But highly progressive income tax, corporation tax, and wealth tax will discourage the willingness to
work, save and invest. These adversely affect business and production. It the inputs are also taxed
heavily, the cost of production and prices of commodities will increase, thereby adversely affecting
their demand and production. on the other hand, moderate rates of taxes on income, corporate profit,
wealth, and on factors of production (which can be easily passed on to the consumers by the
producers) have little adverse effect on the incentives to work and save and hence on production.
The nature of individual reaction

The immediate reaction of a taxpayer to the announcement of tax proposals in a budget is to
adversely affect his willingness to work and save. This is what Pigou called the announcement effect
to taxation. But this effect is not uniform on all tax payers. "Any person's reaction to taxation is
governed by the elasticity of his demand for income," according to Dr Dalton.
The elasticity of demand for income refers to the intensity of desire for obtaining a particular income
on the part of a person. A person's demand for income is elastic when he is not anxious to maintain a
certain minimum level of that level. Suppose a person's salary is sh 15000 per month and he is
required to pay sh 150 per month in the form of income tax. His demand for income is said to be
elastic if he is not prepared to do some extra work in order t compensate for the reduction in his
income to the tune of sh 150 paid as the tax. The demand for his income is said to be inelastic if he
works to earn at least this much so as to maintain his income at sh 15000per month.
Thus the imposition of a tax will retard the desire to work and save if a person's demand for income is
elastic. On the other hand, if the demand for income is inelastic, the desire to work and save will be
encouraged. In the former case, production will be adversely affected and in the latter case it will be
favourably affected.
60
The elasticity of demand for income differs with individuals depending upon their circumstances.
But generally the elasticity of demand for income is inelastic. This is because people like to maintain
a minimum standard of living, have strong desire to save for the future, or for running a business of
their own, or for acquiring power. Prestige and distinction, or for deriving satisfaction from having
more income and wealth than others. In the case of such persons, whenever the rates of taxation are
raised there is greater effort on their part to increase their incomes.
6.2.3 The composition and pattern of production.

Taxation affects the composition and pattern of production through the diversion of resources
between different industries and places. Such diversions may be beneficial or harmful.
Taxes on luxury goods and intoxicants raise their prices, reduce their demand and hence their
production. As a result, factors, factors of production engaged in manufacturing such socially
undesirable commodities shift to the production of other socially useful commodities.
In regions where tax concessions and exemptions are granted to industries, resources flow into them
from those regions where the rates of taxation are high. Such diversions take place in the form of
establishment of new industries. This leads to the opening up and development of new regions which
provide large employment opportunities to the people, and increase production and income.
Similarly, when protection is granted to certain domestic industries in the form of grants, bounties,
import duties, tax concessions and exemptions, etc., there is diversion of resources from non-priority
industries to the protected industries. This will lead to increased production within the country.
These may be called the beneficial effects of diversion of resources if heavy taxes are imposed on
necessaries. Prices of such articles will rise, their demands will re reduced and production will be
adversely affected. This will lead to the diversion of resources to other non-essential articles having
low rates to taxation.
Again, heavy taxation in the county which leaves little for the investors will lead to the flight of
capital to foreign countries. Prices of such articles will rise, their demand will be reduced and
production will be adversely affected. This will lead to the diversion of resources to other non-
essential articles having low rates of taxation.
61
Again, heavy taxation in the country which leaves little for the investors will lead to the flight of
capital to foreign countries. This will adversely affect local industries whose production will all due
to the lack of capital.
So taxation affects the composition and pattern of production in a country through the diversion of
resources.
6.3 Effects of taxation on distribution

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

Taxes which are regressive or proportional in character increase inequalities of income and wealth, a
regressive tax is one which falls more heavily on smaller incomes, such as poll tax, sales tax, tax on
necessaries, etc. A proportional tax is one which is imposed on all incomes at a flat rate. Such taxes
adversely affect the lower income groups and favour the high income groups. Thus from the point of
view of distribution, the best taxes are those which are progressive in nature. The rates of progressive
taxes increase with the increase in the income and wealth of the people. Accordingly, the rich are
required to pay more and the lower income groups less, while people below the minimum taxable
limit are totally exempted form taxation.
Types of Taxes.
Types of taxes – direct and indirect – also affect the distribution of income and wealth.
Indirect taxes on necessaries, such as sales tax and excise duties, are regressive in nature because the
lower incomes groups spend a larger percentage of their incomes on such articles while the higher
income groups spend a smaller percentage on them. Thus taxes on necessaries raise the prices of
such commodities and reduce their consumption on the part of the masses and thus increase
inequalities.
On the other hand, taxation of luxuries with differentiation in rates affects the rich most. This means
that higher-priced goods may be taxed at higher rates so that there is a broad element of progression.
62
Thus high rate on luxuries and low rate on articles for common consumption have beneficial
redistributive effects. Similar is the case with heavy import duties on luxury article.
Highly progressive direct taxation of income and wealth has the effect of reducing the accumulation
of income and wealth by the rich. Progressive taxation of income, gifts, inheritances, Property or
wealth will reduce the concentration of income and wealth in the hands of the few rich. But such
taxes should be so levied as not to adversely affect productive investment.

Effects Of Taxation On Production
Ability to work and save.
Desire to work and save.
The composition and pattern of production.
Effects of taxation on distribution
REVISION QUESTIONS
Explain the effects of taxation on the ability to work and save
Explain the effects of taxation on the desire to work and save
Explain the effects of taxation on the composition and pattern of production
Describe the effects of taxation on the distribution of income
FURTHER REFERENCES
H.L Bhatia (2004) Public Finance.Vikas Publishing Housepvt Limited, New Delhi India Pages 159-
192
Musgrave (2005) Public Finance In Theory And Practice, Tata Mcgraw-Hill New Delhi Pages 297-
313
63
SAMPLE CAT
Instructions
Answer three questions
Question One
Explain the scope of public finance 2 mks

Explain the differences between public finance and private finance 5mks
Explain the functions of public finance in developing nations. 5mks
Explain the characteristics of public goods 3mks
Question Two
Explain the causes of market failure and the solutions 5mks
Explain the optimum output of social goods 5mks
Explain the meaning of equity in income distribution 5mks
Question Three
Explain the meaning of externality 2mks

Describe negative externalities and give 2 examples 3mks
Describe positive externalities and give 2 examples 3mks
Graphically illustrate external costs and benefits 5mks
Explain the solutions to externality problem 2mks
Question Four
Describe the public choice theory 2mks

Explain the remedies of the public choice theory 3mks
Distinguish between rent seeking and bureaucracy as they relate to the public choice theory
5mks
Explain free rider problem and its solutions 5mks
64
Question Five
Distinguish between progressive and proportional taxes. Which one would you prefer and why?
5mks
Explain a progressive tax. Give its merits 3mks
Distinguish between direct and indirect taxes. How do they deliver in their equity effects.
5mks
Explain the differences between vertical and horizontal equity 2mks
65
7.0 TAX INCIDENCE
General objective
By the end of the lesson the learner should be able to explain the meaning and implications of tax
incidence
Specific objectives
a) By the end of the lesson the learner should be able to explain the meaning tax incidence
b) By the end of the lesson the learner should be able to explain tax incidence in the case of
inelastic supply and elastic demand
c) By the end of the lesson the learner should be able to explain tax incidence in the case of
elastic supply and elastic demand
d) By the end of the lesson the learner should be able to explain tax incidence in the case of
inelastic demand and elastic supply
e) By the end of the lesson the learner should be able to graphically illustrate tax incidence
f) By the end of the lesson the learner should be able to explain the macroeconomic perspective
on tax incidence
7.1 Introduction
In economics, tax incidence is the analysis of the effect of a particular tax on the distribution of
economic welfare. Tax incidence is said to "fall" upon the group that, at the end of the day, bears the
burden of the tax. The key concept is that the tax incidence or tax burden does not depend on where
the revenue is collected, but on the price elasticity of demand and price elasticity of supply.
Initially, the incidence of all labour related taxes such as income tax contributions falls on employers.
This must be so at the margin since the employee must receive more net of tax ie take-home than they
can receive from the alternative, such as welfare benefit payments. The tax surcharge may be as high
as 80%.
66
In that all business taxes reduce profitability, and in accordance with the principles set out by the
Physiocrats, they reduce the amount of rent that the business can pay and thus the incidence falls on
the landowner. The land owner may be the business itself but the effect is to cut into that part of the
revenue stream that consists of land rental value. A secondary effect is that locations, where, in the
absence of tax land values would be low, become sub-marginal when the taxes are imposed ie viable
economic activity cannot take place at those locations.
7.2 Illustration of tax incidence
Imagine a sh1 tax on every barrel of apples an apple farmer produces. If the product (apples) is price
inelastic to the consumer (whereby if price rose, a small demand loss would be accounted for by the
extra revenue), the farmer is able to pass the entire tax on to consumers of apples by raising the price
by sh 1. In this example, consumers bear the entire burden of the tax; the tax incidence falls on
consumers. On the other hand, if the apple farmer is unable to raise prices because the product is price
elastic (if prices rose, more demand would be lost than extra revenue gained), the farmer has to bear
the burden of the tax or face decreased revenues: the tax incidence falls on the farmer. If the apple
farmer can raise prices by an amount less than sh 1, then consumers and the farmer are sharing the tax
burden. When the tax incidence falls on the farmer, this burden will typically flow back to owners of
the relevant factors of production, including agricultural land and employee wages.
Where the tax incidence falls depends (in the short run) on the price elasticity of demand and price
elasticity of supply. Tax incidence falls mostly upon the group that responds least to price (the group
that has the most inelastic price-quantity curve). If the demand curve is inelastic relative to the supply
curve the tax will be disproportionately borne by the buyer rather than the seller. If the demand curve
is elastic relative to the supply curve the tax will be born disproportionately by the seller. If PED =
PES the tax burden is split equally between buyer and seller.
7.2.1 Inelastic supply, elastic demand
Because the producer is inelastic, he will produce the same quantity no matter what the price.
Because the consumer is elastic, the consumer is very sensitive to price. A small increase in price
leads to a large drop in the quantity demanded. The imposition of the tax causes the market price to
increase from P without tax to P with tax and the quantity demanded to fall from Q without tax to Q
with tax. Because the consumer is elastic, the quantity change is significant. Because the producer is
67
inelastic, the price doesn't change much. The producer is unable to pass the tax onto the consumer and
the tax incidence falls on the producer. In this example, the tax is collected from the producer and the
producer bears the tax burden. This is known as back shifting.
7.2.2 Elastic supply and demand
Most markets fall between these two extremes, and ultimately the incidence of tax is shared between
producers and consumers in varying proportions. In this example, the consumers pay more than the
producers, but not all of the tax. The area paid by consumers is obvious as the change in equilibrium
price (between P without tax to P with tax); the remainder, being the difference between the new
price and the cost of production at that quantity, is paid by the producers.
7.2.3 Inelastic demand, elastic supply
Because the consumer is inelastic, he will demand the same quantity no matter what the price.
Because the producer is elastic, the producer is very sensitive to price. A small drop in price leads to a
large drop in the quantity produced. The imposition of the tax causes the market price to increase
from P without tax to P with tax and the quantity demanded to fall from Q without tax to Q with tax.
Because the consumer is inelastic, the quantity doesn't change much. Because the consumer is
inelastic and the producer is elastic, the price changes dramatically. The change in price is very large.
The producer is able to pass (in the short run) almost the entire value of the tax onto the consumer.
Even though the tax is being collected from the producer the consumer is bearing the tax burden. The
tax incidence is falling on the consumer, known as forward shifting.
8.2.4 Graphical illustration of tax incidence
Inelastic supply, elastic demand: the burden is on producers
68
Inelastic supply, elastic demand: the burden is on producers
Similar elasticities: burden shared
Inelastic demand, elastic supply: the burden is on consumers

69
7.3 Macroeconomic perspective of tax incidence
The supply and demand for a good is deeply intertwined with the markets for the factors of
production and for alternate goods and services that might be produced or consumed. Although
legislators might be seeking to tax the apple industry, in reality it could turn out to be truck drivers
who are hardest hit, if apple companies shift toward shipping by rail in response to their new cost. Or
perhaps orange manufacturers will be the group most affected, if consumers decide to forgo oranges
to maintain their previous level of apples at the now higher price. Ultimately, the burden of the tax
falls on people—the owners, customers, or workers.
However, the true burden of the tax cannot be properly assessed without knowing the use of the tax
revenues. If the tax proceeds are employed in a manner that benefits owners more than producers and
consumers then the burden of the tax will fall on producers and consumers. If the proceeds of the tax
are used in a way that benefits producers and consumers, then owners suffer the tax burden. These are
class distinctions concerning the distribution of costs and are not addressed in current tax incidence
models. The US military offers major benefit to owners who produce offshore. Yet the tax levy to
support this effort falls primarily on American producers and consumers. Corporations simply move
out of the tax jurisdiction but still receive the property rights enforcement that is the mainstay of their
income.

• llustration of tax incidence
• Inelastic supply, elastic demand
• Elastic supply and demand
• Inelastic demand, elastic supply
• Graphical illustration of tax incidence
• Macroeconomic perspective of tax incidence
70
Revision Questions
1. Explain the meaning tax incidence
2. Explain tax incidence in the case of inelastic supply and elastic demand
3. Explain tax incidence in the case of elastic supply and elastic demand
4. Explain tax incidence in the case of inelastic demand and elastic supply
5. Graphically illustrate tax incidence
6. Explain the macroeconomic perspective on tax incidence
Further References
India Pages 45-56
121
270
71
8.0 TAXATION AND EFFICIENCY
General objective
By the end of the lesson the learner should be able to explain efficiency in taxation
Specific objectives
By the end of the lesson the learner should be able to explain efficiency and taxation
8.1 Introduction
Adam Smith was the first economist who laid down four important canons of taxation which are the
efficiency principals/canons of taxation to which were added few more by subsequent economists.
8.2 The efficiency principals of taxation
1. The canon of equality

2. The canon of certainty
3. The canon of convenience
4. The canon of economy
5. The canon of productivity
6. The canon of elasticity
7. The canon of flexibility
8. The canon of simplicity
9. The canon of diversity
1. The canon of equality
The canon of equality, equity or justice is the most important canon of taxation. Smith explained it
thus: "The subjects of every state ought to contribute towards the support of the government, as
nearly as possible, in proportion to their respective abilities, that is, in proportion to the revenue
which the respectively enjoy under the protection of the State." It means that every person should
pay the tax according to his ability and not he same amount. It also means that everybody should not
pay at the same rate. Rather, every taxpayer should pay the tax in proportion to his income. The rich
72
should pay more and at a higher rate than the other person whose income is less. Thus this canon
implies equality of sacrifice or ability to pay the tax n proportion to the income of the taxpayer.
2. The canon of certainty

According to smith, there should be certainty in taxation because uncertainty breeds corruption. By
the canon of certainty he mans that "the tax which each individual is bound to pay ought to be certain,
and quantity to be paid ought all to be clear and plain to he contributor and to every other person."
Thus this canon requires that there should be no element of arbitrariness in a tax. It should be clear to
every taxpayer as to what, when, and where the tax is to be paid. Nothing should be left to the
direction of the income tax department. Certainly also means that the state should also be certain
about the amount of tax revenue and the time when it is expected to flow in the exchequer.
3. The canon of convenience
This canon lays down that both the time an manner of payment should be convenient to the taxpayer.
In the words of smith, "Every tax ought to be levied at the time or in the manner in which it is most
likely to be convenient for the contributor to pay." In India, the payment of land revenue is in
keeping with this canon because it is to be paid after harvesting. Similarly, the payment of sales tax
and excise duty by the consumer is also convenient because he pays these taxes when he buys
commodities and at a time when he has the means to buy. The manner of payment is very convenient
to him because these taxes are included in the prices of commodities.
4. The canon of economy
Every tax should satisfy the canon of economy in two ways. First, it should be economical for the
state to collect it. if the cost of collection in the form of salaries of tax officials is more that what the
tax brings as revenue, such a tax is uneconomical, and hence it should not be levied. Second, it
should be economical to the taxpayer. It means that he should have sufficient money left with him
after paying the tax. A very heavy tax on incomes will discourage saving and investment, and thus
adversely affect the productive capacity of the community. Smith states this canon in these words:
"Every tax ought to be so contrived as both to take out and to keep out of the pockets of the people as
little as possible, over and above what it brings into the public treasury of the state."
73
5. The canon of productivity
According to this canon, a tax should be productive in the sense that it should bring large revenue
which should be adequate for the government. But it does not mean that in its efforts to raise more
revenue, the government should tax the people heavily. Such an effort would adversely affect the
productive capacity of the economy. Further, this canon implies that one tax which brings large
revenue is better than a number of taxes which bring small revenue. Many taxes may not be
productive. They may also be uneconomical
6. The canon of elasticity

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

Flexibility in taxation is different from elasticity. Flexibility means that there should be no rigidity in
taxation. The tax system can be changed to meet the revenue requirements of the state. On the other
hand, elasticity in taxation means that the revenues can be increased under the prevailing ax system.
But there cannot be any elasticity in taxation without flexibility because some change is required in
the rates and structure of taxes if the state wants to increase revenue.
8. The canon of simplicity
The tax system should be simple, plain and intelligible to the common taxpayer. The tax system
should not be complicated. It should be simple to understand as to how is it to be calculated and how
much is it to be paid. The form/forms to be filled up for calculation and payment of a tax should be
simple and intelligible to the taxpayer. This canon is essential in order to avoid corruption and
oppression on the part of the tax department.
74
9. The canon of diversity
There should be diversity or variety in taxation. A single or a few taxes would neither meet the
revenue requirements of the state nor satisfy the canon of equity. There should, therefore, be a
variety of taxes so that all citizens should contribute towards the state revenues according to their
ability to pay. There should be a variety of direct and indirect taxes. But a large multiplicity of taxes
will be difficult to administer and hence uneconomical.

The efficiency principals of taxation
Revision Question
1. Explain taxation and efficiency
2. Explain the efficiency principals of taxation
Further Refernces
India Pages 32-35
75
9.0 OPTIMAL TAXATION
General objective
By the end of the lesson the learner should be able to explain the various aspects of optimal taxation
Specific objectives
a) By the end of the lesson the learner should be able to explain the meaning of optimal
taxation
b) By the end of the lesson the learner should be able to the meaning of optimal taxation
theory
c) By the end of the lesson the learner should be able to explain excess burden of taxation
d) By the end of the lesson the learner should be able to explain factors determining the
taxable capacity
e) By the end of the lesson the learner should be able to explain the measurement of taxable
capacity
10.1 Optimal tax Theory
Optimal tax theory is the study of how best to design a tax to minimize distortion and inefficiency
subject to raising set revenues through distortionary taxation. A neutral tax is a theoretical tax which
avoids distortion and inefficiency completely. Other things being equal, if a tax-payer must choose
between two mutually exclusive economic projects (say investments) that face the same pre-tax risk
and returns, the one with the lower tax or with a tax break would be chosen by the rational actor.
With that insight, economists argue that generally taxes distort behavior.
For example, since only economic actors who engage in market activity of "entering the labor
market" get an income tax liability on their wages, people who are able to consume leisure or engage
in household production outside the market by say providing housewife services in lieu of hiring a
maid are taxed more lightly. With the "married filing jointly" tax unit in U.S. income tax law, the
second earner's income is placed on top of the first wage earner's taxable income and thus gets the
highest marginal rate. This type of tax creates a large distortion disfavoring women from the labor
force during years when the couple have great child care needs.
76
The incidence of sales taxes on commodities also leads to distortion if say food prepared in
restaurants are taxed but supermarket bought food prepared at home are not taxed at purchase. If the
taxpayer needs to buy food at fast food restaurants because he/she is not wealthy enough to purchase
extra leisure time (by working less) he/she pays the tax although a more prosperous person who say
enjoys playing at being a home chef is more lightly taxed. This differential taxation of commodities
may cause inefficiency (by discouraging work in the market in favor of work in the household).
9.2 Optimal taxation theory
Most governments take revenue which exceeds that which can be provided by non-distortionary taxes
or through taxes which give a double dividend. Optimal taxation theory is the branch of economics
that considers how taxes can be structured to give the least deadweight costs, or to give the best
outcomes in terms of social welfare.
The Ramsey problem deals with minimizing deadweight costs. Because deadweight costs are related
to the elasticity of supply and demand for a good, it follows that putting the highest tax rates on the
goods for which there is most inelastic supply and demand will result in the least overall deadweight
costs.
Some economists sought to integrate optimal tax theory with the social welfare function, which is the
economic expression of the idea that equality is valuable to a greater or lesser extent. If individuals
experience diminishing returns from income, then the optimum distribution of income for society
involves a progressive income tax.
9.3 Excess burden of taxation
In economics, the excess burden of taxation, also known as the distortionary cost or deadweight
loss of taxation, is the economic loss that society suffers as the result of a tax, over and above the
revenue it collects. It is assumed that distortions occur because people or firms change their
behaviour in order to reduce the amount of tax they must pay. Excess burdens can be measured using
the average cost of funds or the marginal cost of funds (MCF). Excess burdens were first discussed
by Adam Smith.
77
An equivalent kind of inefficiency can also be caused by subsidies (that are actually taxes with
negative rates).
9.4 Measures of the excess burden
The cost of a distortion is usually measured as the amount that would have to be paid to the people
affected by its supply, the greater the excess burden. The second is the tax rate: as a general rule, the
excess burden of a tax increases with the square of the tax rate.
The average cost of funds is the total cost of distortions divided by the total revenue collected by a
government. In contrast, the marginal cost of funds (MCF) is the size of the distortion that
accompanied the last unit of revenue raised (ie, the rate of change of distortion with respect to
revenue). In most cases, the MCF increases as the amount of tax collected increases.
The standard position in economics is that the costs in a cost-benefit analysis for any tax-funded
project should be increased according to the marginal cost of funds, because that is close to the
deadweight loss that will be experienced if the project is added to the budget, or to the deadweight
loss removed if the project is removed from the budget.
9.5 Distortion and redistribution
In the case of progressive taxes, the distortionary effects of a tax may be accompanied by other
benefits: the redistribution of dollars from wealthier people to poorer people who could possibly
obtain more benefit from them.
In fact almost any tax measure will distort the economy from the path or process that would have
prevailed in its absence (land value taxes are a notable exception). For example a sales tax applied to
all goods will tend to discourage consumption of all the taxed items, and an income tax will tend to
discourage people from earning money in the category of income that is taxed (unless they can
manage to avoid being taxed). Some people may move out of the work force (to avoid income tax);
some may move into the cash or black economies (where incomes are not revealed to the tax
authorities).
For example, in Western nations the incomes of the relatively affluent are taxed partly to provide the
money used to assist the relatively poor. As a result of the taxes (and associated subsidies to the
78
poor), incentives are changed for both groups. The relatively rich are discouraged from declaring
income and from earning marginal (extra) income, because they know that any additional money that
they earn and declare will be taxed at their highest marginal tax rates. At the same time the poor have
an incentive to conceal their own taxable income (and usually their assets) so as to increase the
likelihood of their receiving state assistance. It can be argued that the distortion of incentives (the
move away from a fiscally neutral stance that does not affect incentives) does more harm than good.
Deliberate distortion
Here, the fiscal distortion is deliberate, so as to compensate for externalities. "Sin taxes" on alcohol,
tobacco, pornography, etc. may be levied so as to discourage their consumption. Such an approach is
often preferable to outright prohibition, since prohibition incites trafficking, often resulting in crime
and other social costs, but no revenue. Similarly, taxes such as a carbon tax, may be levied on
emission of pollutants, in order to encourage corporations to adopt cleaner methods of production.
Fiscal Illusion
Fiscal Illusion is a public choice theory of government expenditure first developed by the Italian
economist Amilcare Puviani. Fiscal Illusion suggests that when government revenues are unobserved
or not fully observed by taxpayers then the cost of government is perceived to be less expensive than
it actually is. Since some or all taxpayers benefit from government expenditures from these
unobserved or hidden revenues the public's demand for government expenditures increases, thus
providing politicians incentive to expand the size of government.
Fiscal Illusion has been used to explain the flypaper effect often seen when a higher level of
government provides a grant to a lower level of government. Here, instead of reducing taxes in order
to pass on the benefits of the grant to local taxpayers, the grant-receiving body increases expenditures
in order to expand local services in some way. Fiscal Illusion is invoked as an explanation because
the local taxpayers are under the mistaken perception that the grant is to local government and not, in
fact, to them.
Another example of fiscal illusion can be seen in local property tax politics. Here renters, who pay
local property taxes indirectly, may vote for an expansion of local government services. Fiscal
79
illusion theory suggests they support this policy because its cost is masked by its roundabout nature
(through an increase in their rent payments
9.6 Factors Determining Taxable Capacity
The taxable capacity of a country depends on the following factors.
Size of national income. Taxable capacity depends on the size of national income or wealth or
natural resources of a country and the extent to which they are developed. The higher the national
income, the higher the taxable capacity of a country, and vice versa.
Distribution of national income. In a country where there is inequality of income, taxable capacity
is high because the few rich can be taxed heavily. On the other hand, if there is equality of income,
the taxable capacity is relatively low because the government expenditure to uplift the poor will be
less.
Stability of income. In developed countries, the incomes of individuals are stable, the taxable
capacity is high. But where incomes are subject to fluctuations and are unstable, as in
underdeveloped countries, the taxable capacity is low.
Size and growth of population. If the size and growth rate of population are high, the per capita
income will be low. So the taxable capacity will also be low, and vice versa.
Standard of living. If the standard of living of the people is high, it means that people are spending
more on comforts and luxuries. So their capacity to pay taxes is also high, and vice versa.
Tax system. The type of tax system affects the taxable capacity. A progressive tax system has a
higher taxable capacity because it falls on higher income groups, as in the case of direct taxes on
incomes. On the other hand, regressive indirect taxes which fall heavily on low income groups have
low taxable capacity.
80
Sources of Revenue. Taxable capacity depends on the number of sources of revenue available to
the government. The greater the number of revenue sources that are productive, the higher the
taxable capacity, and vice versa.
Public expenditure. If public expenditure is meant to increase the welfare of the people, people
do not mind paying taxes. If the government spends money on unnecessary and unproductive
projects, people will not be willing to pay taxes. Thus taxable capacity is high for productive
public expenditure which increases national income, and vice versa.
Taxing and spending income. Taxable capacity depends on the manner and timing of both
taxing and spending income by the government. This involves compensatory spending and
compensatory taxation. Compensatory spending compensates for the fall in private investment
and increases output, employment and income. Compensatory taxation compensates for the fall
in private expenditure, compensates for the fall in private expenditure, saving or investment by
taxing the people. Both tend to increase economic activity and national income thereby raising
the taxable capacity.
Price situation. Taxable capacity is determined by the price situation in the country. If prices
are rising, the real income of the people falls and their taxable capacity declines. The converse is
the case when prices are falling.
Organisation of the economy. If the economy s primarily agricultural, the taxable capacity will
be low because the income from agricultural operations is uncertain. On the other hand, an
industrial economy has high taxable capacity because the industrial sector generates larger income
than the agricultural sector.
Psychology of the people. Taxable capacity also depends upon the psychology of the people.
People are prepared to more pay taxes honestly and willingly during a war and natural calamities
like floods, earthquakes, etc. As pointed out by Findlay Shirras, "the psychology of the people
has much to do with the extent of taxable capacity. People are often willing to bear heavier
taxation on patriotic or sentimental grounds. On the other hand, adverse psychology of the people
has much to do with the extent of taxable capacity. People are often willing to bear heavier
81
taxation patriotic or sentimental grounds. On the other hand, adverse psychology of the people
towards the payment of the taxes lowers down the taxable capacity.
Political conditions. What should be the level of taxation is a political factor these days. A country
with has political stability, its taxable capacity will be high if there is political instability or the
government is unsympathetic and repressive, the taxable capacity will be low.
Conclusion. Thus the taxable capacity of a country depends upon a number of factors. These factors
change from time to time and so does the taxable capacity.
9.7 Measurement Or Limit Of Taxable Capacity
Colin Clark gives a limit of taxable capacity of a country. According to him, "The safe upper limit of
taxation is 25 per cent of national production. "Thus he takes 25 per cent of national income. If the
level of taxation exceeds this limit, it will adversely affect production and incentive to work, save and
invest. Further, a high level of taxation will lead to increase in wages and to a rise in prices. All
these factors will reduce national income. Colin Clark places this limit for advanced counties.
Taxable capacity
But Kaldor does not agree with Colin Clark. He suggests a different limit for different types of taxes.
According to him, a particular tax up to 10 per cent of national income may be a heavy burden on
people and another tax of 25 per cent may not be a burden. For instance, and income tax up to 10 per
cent of national income may adversely affect incentive to work, save and invest. On the other hand,
an expenditure tax of 10 per cent or more will increase production rather than retard it. People will
not spend extravagantly. They will reduce wasteful expenditures. They will save and invest and
productions will not e adversely affected.
However, most governments have accepted Clark's 25 per cent limit of taxable capacity. But the
followers of Kaldor persist that 25 per cent should not be the limit for taxes on incomes.
82
Optimal tax Theory
Optimal taxation theory
Excess burden of taxation
Measures of the excess burden
Distortion and redistribution
Factors Determining Taxable Capacity
Measurements Or Limit Of Taxable Capacity
Revision Questions
1. Explain the meaning of optimal taxation
2. Explain the meaning of optimal taxation theory
3. Explain excess burden of taxation
4. Explain factors determining the taxable capacity
5. Explain the measurement of taxable capacity
Further References
295
83
11.0 COST BENEFIT ANALYSIS AND INVESTMENT RULES
General objective
By the end of the lesson the learner should be able to explain the cost benefit analysis in initiating
public projects
Specific objectives
a) By the end of the lesson the learner should be able to explain the various types benefits and
costs involved in public projects
b) By the end of the lesson the learner should be able to explain the measurement of benefits and
costs in public projects
c) By the end of the lesson the learner should be able to explain the concept of consumer surplus
10.1 Types of benefit and cost

Benefits and costs may be real or pecuniary.
Real vs pecuniary benefits and cost
Real benefits
They are the benefits derived by the final consumer of the public project. They reflect an addition to
the community welfare.
Real costs; Refers to the real/actual cost of resource withdrawal from other uses.
Pecuniary benefits and costs ;Come about because of changes in relative prices which occur as the
economy adjusts itself to the provision of the public services and the pattern of demand changes.
As a result gains and losses accrue to some individual but are offset by losses or gains which are
experienced by others. They do not reflect net gains or costs to the society as a whole.
Real benefits and costs may be;

a) Direct or indirect
b) Tangible or intangible
c) Final or intermediate
d) Inside or outside
84
Types of real benefits
a) Direct vs Indirect: direct cost and benefits are those related closely to the main project
objective while indirect are those in the nature of byproducts. E,g a river development
program may have flood control as its immediate objective but may also have important
bearing on supply of power, on irrigation on soil erosion in adjacent areas.
b) Tangible vs Intangible: tangible refers to benefits and cost which can be valued in the
market while others which can not be valued are referred to as intangible e,g. The
beautification of an area which may result from an irrigation project is an intangible
benefit while the increased farm output is tangible.
c) Intermediate vs Final: final products are those who furnish benefits to the consumer
directly (i,e. Since they involve provision of final goods) , while intermediate are those
which enter into the production of other goods, some project may in fact provide for both
types of goods e,g weather forecasts may be considered as a consumer goods for those
who plan an outing as well as an intermediate good in servicing aviation.
d) Inside vs outside: the distinction here is between benefits and costs which accrue inside
the jurisdiction in which the project is undertaken and other which accrue outside. E.g.
The flood control activity undertaken in a given district may not only be helpful in that
district, but may also help to control floods down stream in other districts if the river
passes through other districts.
Note: All types of real benefits should be allowed the cost benefit analysis.
10.2 Measurement of benefits and costs

The issue of measurement would be simple if all values could be observed in terms of market prices.
However such is not the case. Cost and benefits are frequently in intangible forms and even where
market prices are observable, there may be need of adjustment because markets are not perfect and
distortion must be allowed for.
10.2.1 Valuation of intangible items/Non market items.
1) Social benefits and costs
Project benefits maybe essentially intangible, as with the case of natural defence or both tangible and
intangible benefits may result e,g. education has the tangible benefit of increased earning power and
intangible benefits of cultural enrichment and improved functioning of democratic process.
85
Whenever intangible benefits and costs are involved, then, value can not be derived readily from the
market price and a political process is needed to determine them. Voters must determine how much
they value clean air or water etc. After the value of the benefit has been determined, then cost benefit
analysis is done.
2) Intangible private benefits and costs.
Related problems arise in connection with the benefits and costs which are private in nature, but
which do not lend themselves to markets evaluation. E,g. if the government undertakes a cancer
research project with resulting reduction in suffering, how can the benefit be valued?, how should
one evaluate the cost and injury which result from highway accident? What of benefit of crime
prevention?
Indirect valuation methods of a more or less satisfactory nature may be applied to these intangible
items and economists have shown considerable ingenuity in developing such procedures e.g.
• A school program aimed at reducing absenteeism will be reflected in reduced delinquency
and thus save cost of law enforcement. other gains may be measured in terms of increased
earnings due to improved training
• The value of a park may be measured by the number of travel related and other costs which
visitors are willing to undergo .e.t.c
Note: Having established the cost of those projects, then cost benefit analysis is done.
Other Methods Of Evaluation

10.2.2 Shadow pricing of market items
Projects whose tangible benefits and cost are recorded directly in the market via sales and purchases
have no such difficulties as long as the market is competitive. In this case the tangible benefit is
measured by the price which the public service fetches in the market, or the price at which a similar
service is purchased by consumer from private suppliers
Shadow pricing refers to the arbitrary assignment of money values to non-marketed goods .It may
also involve adjustment of prices of goods.
This is normally done when performing cost benefit analysis in the following circumstances.
1. Incase of monopoly
2. Due to taxes
3. Due to unemployed resources
• Monopoly; In monopoly, market prices of output do not reflect the true resource cost and
86
adjustments are needed. Such adjusted values are referred to as shadows prices. Thus
monopoly prices are not counted e,g. suppose that the market price of a given product is Ksh
1,000,000 but at a competitive market it would cost Ksh 900,000 equal to the marginal
resource cost of its production. The cost to be counted here is kshs 900,000 not one million
even though the government pays a higher price.
• Taxes; There is a need for adjustment in connection with taxes. If the government purchases
input needed in the construction of a project, the market price may include sales taxes. This
tax component of the price does not reflect a social cost, being merely a transfer from
purchasers to the government and therefore should be disallowed in computing the cost of the
project.
• Unemployment resources ; This involves costing of otherwise unemployed resources. The
cost to be accounted for in public resource use is the lost opportunity for putting these
resources to alternative uses, whether they are other public projects or private projects.
10.2.3 Discounted cost of capital

There some investments which yield benefits over many years in the future. To evaluate such benefit
streams, future proceeds must be translated in to present values. The process of doing this is called
discounting. Future costs should be discounted also. This enables cost benefit analysis to be
performed on such projects. However the choice of the discount rate is very important in this case.
There are different discount rates which can be used which includes;
• Private rate
• Social rate.
1. Private rate. This is the rate equal to the time preference of private consumer i, e. the
discount rate in the market. The rationale for using the private rate of discount is that is it
reflects consumer choice between present and the future consumption. The argument here is
that, just as public policy accepts the valuation of oranges and apples by the price which they
fetch in the market, so it should honor the individual valuation of future relative to present
consumption. Given the condition of perfectly competitive capital market and absence of risk,
all consumers will borrow and lend at the same rate. Also with perfect markets, this rate is
equal to the marginal efficiency of investment. Thus there exist an equality between the
marginal rate of substitution of present for future consumption and their marginal rate of
transformations in production. The rate of interest, like in the other competitive price is at its
87
efficient level. However, in practice, this is complicated by various factor that includes ;
• Imperfect markets.
• Uncertainty
• Risk
• Income tax
• Macro policy
2. social rate
There are reasons for not using the time preference rate of private consumers but for
substituting a social rate in it's place .They include;
⚫ Individual are said to suffer from myopia so that in arranging their private affairs, they
underestimate the importance of saving and overestimate that of present consumption
⚫ Also, there are several arguments related to the welfare of future generations. One argument
is that people are too greedy and do not care sufficiently about the welfare of those who
follow them. If they did, they would save more in order to leave the future generation with a
larger capital level and higher level of income. The government as a guardian of the future
generation can offset this by using a lower rate of discount and investing more.
Note: the suggestion here is that the social rate should be set below the private rate so that the
use of social rate calls for a higher rate of investment. Using the social rate rather than the
private rate in product selection will the give a higher present value of benefit stream passing
projects which might be excluded by the use of the private rate.
Opportunity cost of capital

There is the social cost involved in withdrawing resources from private use to public use. The social
opportunity cost of capital, equal the loss of consumption current or future, which results as these
resources are withdrawn.
88
10.3 Public Expenditure Evaluation Principals
Sound expenditure decision requires detailed information regarding the merits of alternative projects.
Fundamentals of project evaluation
Decision rules
Project evaluation, like all issues in allocation economics, involves determination of the ways in
which the most efficient use can be made of scarce resources. The issue is how to determine the
composition of the budget of a given size or how to allocate a total of given funds among alternative
projects. There is also the issue of determining the appropriate size of the budget. In making decision
rules it is also important to consider whether.
The project are divisible or lumpy
the budget is fixed or variable
Divisible Projects
Suppose the projects are finely, divisible i.e. May be increased or decreased by small amount. How
should the project be evaluated? This in influenced by whether the budget is size is fixed or is
variable.
Fixed Budget size
Suppose the budget director is asked to explain how best to allocate a given sum say Kshs. 1 billion,
between two expenditure projects, X and Y. First the director must determine the cost (C) involved in
providing each service and the benefit (B) to be derived from each of them. Then the outlay ,Kshs 1
billion must be allocated between X and Y so as to derive the greatest total benefit from the budget.
i.e. To maximize the sum of the net benefits or the excess of the total benefit over cost. With the total
cost given by the size of the budget, the task is simply to maximize total benefits.
Variable Budget Size

A more global view of budgeting indicates that the problem is not simply one of dividing up a budget
of a given size but also one of determining the budget itself. The government must thereby decide
how resources are to be divided between private and public use.
In this case, the assumption of a fixed budget is dropped and one has to reconsider project choice
along with determination of total budget outlays.
89
Within the fixed budget, the opportunity cost of pursuing the public project consists of the benefit lost
by not pursuing another public project. However in the open budget ,the opportunity cost of public
projects must be redefined as the lost benefits from private projects which are foregone because
resources are transferred to public use. In this case, the task is to maximize B-C, including benefits
and costs of both public and private projects. This condition is met by equating marginal benefits for
the last dollar spent on the alternative public and private project. Public projects are expanded and
private projects are restricted until the benefit of the last dollar spent in either is the same.
Lumpy Projects
When dealing with the allocation of funds between broad expenditure categories, the marginal
approach is applicable, the assumption being that the expenditure can be divided finely between the
projects X and Y so that benefits may be equated for the marginal dollar spent on each. However
when it comes to specific allocation within departments, the choice must be made among particular
projects which are indivisible (lumpy). I,e. Involving lump sum amounts ,e,g if the choice have to be
made between a road connecting cities X and Y and another connecting X and Z where the X to Y
distance is twice the X to Z distance, no marginal adjustment is possible. Again in this case the
decision rule is influenced by whether the budget size in fixed or variable.
Variable budget size

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

Divisible projects
Fixed budget-distribute funds among projects so that marginal benefits are equal.
Variable budget-extend all project until the marginal benefits are equal.
Lumpsy projects
⚫ Fixed budget-choose the project mix that maximizes net benefits
90
⚫ Variable budget-choose all project with positive net benefits.
NB: In practice the combination of lumpy projects and limited project budgets is the most typical
setting. To establish the proper rank order, this means that all possible projects should be considered
and compared.
10.4 Concept Of Consumer Surplus
The table below shows the law of diminishing marginal utility for Mr. X on loaves of bread
Diminishing marginal utility

price no. of loaves
(kshs) purchased
30 1
20 2
15 3
12 4
10 5
8 6
6 7
4 8
2 9
If Mr.X estimates the marginal utility of bread at kshs 30 i,e the price she is prepared to pay for it, she
is prepared to pay thirty shillings for the first , the marginal utility of the second is kshs 20 etc.
If the price of a loaf is set at kshs12 ,and assuming that he has no bread in stock, he will buy the bread
at kshs 12 because he reaches his marginal utility at kshs 30, he will also buy the second loaf at kshs
12 because he assess its value to be worth kshs 20 etc. Therefore Mr.X was willing to pay Kshs 30 for
a loaf while he only paid kshs 12, again for the third he paid kshs 12 although he was willing to pay
kshs 30 Therefore his actual expenditure of the four loaves was actually kshs 48 though he was
willing to pay kshs30, kshs20, kshs15, kshs12 responsively, a total of kshs 77 . Therefore he obtains
Kenya kshs 77 worth of satisfaction for kshs 48.This is a surplus of kshs 29.This is known as
consumer surplus. Mr. X may not buy his 5th unit at a price of kshs 12 because it is higher than his
marginal utility of kshs 10.
91
NOTE: Consumers will extend purchases to the point where the marginal value of the last unit equals
the marginal cost of the price which they must pay.
Summary Of The Topic Types

of benefit and cost Measurement
of benefits and costs
Valuation of intangible items/Non market items.
Shadow pricing of market items
Discounted cost of capital
Public Expenditure Evaluation Principals
Concept Of Consumer Surplus
Revision Questions
1. Explain the various types benefits and costs involved in public projects
2. Explain the measurement of benefits and costs in public projects
3. Explain the concept of consumer surplus
4. Explain how the following methods can be used to do the costing of a project
i. Shadow pricing of market items
ii. Discounted cost of capital
Further References
161
92
11.0 PUBLIC EXPENDITURE PROGRAM
General objective
By the end of the lesson the learner should be able to explain the meaning and nature of public
expenditure
Specific objectives
a) By the end of the lesson the learner should be able to explain the meaning and objectives of
public expenditure
b) By the end of the lesson the learner should be able to account for the size and growth of public
expenditure
c) By the end of the lesson the learner should be able to explain the theories that explain increase
of public expenditure
d) By the end of the lesson the learner should be able to explain the effects of public expenditure
e) By the end of the lesson the learner should be able to account for the growth of public
expenditure
f) By the end of the lesson the learner should be able to explain the role of development
expenditure of developing countries
11.1 Meaning of public expenditure

This refers to the expenses which the government incurs for its own maintenance, for the society, as
well as for the economy as a whole
12.2 Objectives of public expenditure

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

Public expenditure increases over the years due to the following reasons:
a) Expansion of state activities
According to Adolph Wagner (1883) public expenditure increases in response to the law of
increasing expansion of public activities. He maintained that there is a persistent tendency both
towards an intensive and expensive increase of state function and activities.
b) Internal security
93
Wagner also referred to the maintenance of international security as an important factor for the
increase in government expenditure. Enforcement of law and order for maintaining peace and
security has led to the expansion of legal and administrative systems and police force. There have
led to an increase in public expenditure.
c) Defense
Every country pays greater attention to its defense preparedness against foreign attacks. As a
result public expenditure on equipping its armed forces with the latest armaments has increased.
d) Welfare activities
Modern states are welfare states which provide free education, medical facilities, social security
measures, maintain historical monuments, museums and pubic libraries, encourage sports,
cultural and heath programmes. Consequently, public expenditure has tended to increase.
e) Population increase
The increase in population has resulted in increase public expenditure on the people. The state has
to spend more on roads, railways, schools, colleges, houses etc
f) Urbanization
With the growth of population, there is migration of population from rural to urban areas in search
of employment. Exiting cities expand and new cities come up. These require huge public
expenditure in providing amenities such as water, street lighting, sewerage, road, transport,
schools, houses, etc
11.4 Theories of increase in public expenditure

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

Adolph Wagner (1835-1917) was a German economist who based his law on historical facts
prevailing in Germany.
According to him, there has been an inherent tendency for the activities of different layers of
government to increase both intensively and extensively.
Increase in public expenditure is at higher rate than economic growth. He attributed increase in public
expenditure to the following-:
94
(1) Expansion of the traditional function of the state e.g defense, maintenance of law and order,
provision of social overheads, maintenance of the state. e.t.c
(2) Increased awareness of government responsibility to the society rather than in traditional role
eg giving pension to it retiring workers, provision of public goods, social welfare activities,
culture enrichment etc.
(3) The need to provide and expand the sphere of public goods was being increasingly
recognized.
NB However there are other factors that tend to increase public expenditure that he left out.
2) Wiseman and Peacock Hypothesis

Wiseman and peacock did their study of public expenditure behavior in UK for the period 1890-1955.
The main thesis for the two is that public expenditure doesn’t increase in a smooth and continuous
manner but in fort of step like fashion.
According to the 2, at times, some social or other disturbances takes place creating a need for
increased public expenditure which the existing public revenue cannot meet.
Due to the deficit budget as a result of the increased expenditure, the government and its people
review the position and the need to find a solution of the important problem that has come up and
agree to undertake adjustment to finance the increased expenditure. E.g. they can agree to increase
taxes or public borrowing.
The time when the government and the people are deliberating on what to do to finance the
expenditure, is known as the ‘inspection effect.’
The movement from the older level of expenditure and taxation to a new and a higher level is referred
to as the displacement effect.
At a new tax tolerance level, (i.e. new expenditure level) ,people are now ready to tolerate a greater
burden of taxation and as a result, the general level of expenditure and revenue goes up. This way, the
public expenditure and revenue get stabilized at a new level until another disturbance occurs to cause
a displacement effect.
11.5 Theories Of Public Expenditure

There are various theories of public expenditure which includes:
1) The doctrine of Laissez faire
95
2) Individual choice theory
3) The authoritarian conception/ the organic theory
4) Optimum level of public expenditure theory
5) The ballot box theory
6) The positive theory of government expenditure
1) The doctrine of Laissez faire

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

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

The organic theory avoided this difficulty, since it was based on the assumption that the decisions
were made by ruling group
4) Optimum level of expenditure theory

Having accepted the need for some public expenditure, economists turned their attention to the
question of what was its desired level. This theory is associated with W. Stanley Jevons (1835-1882),
an English Economist. The theory postulates that, as a person’s consumption increases, each
additional (marginal unit) of a good consumed gives lower satisfaction (utility) than the one before.
Thus the consumer experiences diminishing utility.
96
The theory is based on the relationship between the satisfaction derived from the consumption of
goods and services provided by that state and the sacrifice involved in paying taxes to finance public
expenditure.
The marginal theory sheds some light on how people behave. We may not go round calculating our
diminishing marginal utility of each good we consume. Nevertheless, all of us are aware that there is
some point at which the burden of taxation appears greater than the various state benefits are worth to
us. We may not be able to put a figure on that point and it may not be the same for all people ,but we
may prefer to go without some public goods and services rather than pay more in taxation to finance
the increase of public expenditure.
The optimum level of public expenditure can be defined as the point at which the benefit to all
individuals from additional expenditure is equal to the additional sacrifice by those involved in
paying more tax.
5) The ballot box theory

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

This theory has been advanced by present day writers such as A. Down, J. Buchaman and G. Tullock.
It could perhaps be described as the ‘clinging to power theory, since it is based on the assumption
that, in a democratic society, governments seek to maximize their lifespan while voters seek to
maximize the benefits they receive from the government. An increase in public expenditure is popular
with voters if they do not pay taxes to finance it.
97
11.6 Effects Of Public Expenditure
Public expenditure has far reaching effects on production, employment and distribution in the
country. We discuss these effects as under:
11.6.1 Effects of Public Expenditure on Production
According to Dalton, production and employment in a country depend on three factors:

(a)Ability of the people to work, save, and invest;
(b)Willingness to work, save and invest’
(c)Diversion of economic resources as between different uses and localities.
Public expenditure influences these factors in a number of ways and thus helps in increasing
production and employment within the country. The ability and Willingness to work, save and
invest depend on the nature of expenditure. The former increase with the increase in the efficiency
of workers which, in turn, raises production and employment.
On Social Insurance. Public expenditure on social insurance benefits such as unemployment,

sickness, maternity, old age pensions, etc. tends to increase the purchasing power of workers
indirectly. When these facilities are provided by the state, the workers indirectly. When these
facilities are provided by the state, the workers are not required to spend on them, thereby increase
their real purchasing power. The money so saved is spent by them on other articles. It means an
increase in their standard of living which raises their efficiency and production.
If, on the other hand, the workers spend the money so saved on gambling, drinking, etc. their ability
and willingness to save fall which adversely affect their ability and willingness to save fall which
adversely affect their ability to work, thereby reducing production.
On Basic Facilities. Public expenditure on basic facilities also tens to raise efficiency and ability to
work. When the state provides such basic facilities as cheap ration, low-rent houses, mid-day meals to
children, cheap milk, etc. the ability to save increases. This, in turn, tends to raise their ability to
work, thereby increasing production.
98
On Education and Public Health. Public expenditure on education and public health has direct
welfare effects on society. Expenditure on education is regarded as investment in human capital
because it helps in skill formation and thus raises the ability to work and produce core. Similarly,
public health is also another form of investment in human capital. Healthy workers, who are free
from diseases, work more and raise production.
On Economic Overheads, Basic Industries, etc. Public expenditure on economic overheads, basic
industries, etc also helps in increasing the productive capacity of the economy. Public expenditure on
power, transport, communications, irrigation, soil erosion. Land reclamation, etc tends to increase the
supply of resources for production over a long period. Moreover, expenditure on roads, railways, and
other means of transport also affects the mobility of men and materials, which, in turn help in
increasing the productive capacity. Further, the development of basic industries like iron and steel,
engineering, heavy chemicals, fertilizers, etc. is very helpful in the development of other industries.
Again, public expenditure on river valley projects helps in providing larger employment
opportunities. It provides protection against floods ad drought, thereby avoiding loss of resources.
On Credit and Banking Facilities. Public expenditure in providing credit and baking facilities also
helps in increasing the productive capacity of the economy. It is through bank nationalistion and/or
through state and cooperative banks and opening of a network of branches throughout the country
that the state can provide cheap and better credit and banking facilities to agriculture, industry and
trade, and thus help in increasing their productivity.
On Backward Regions and Areas. Public expenditure on the development of backward regions and
depressed areas helps in providing employment through basic facilities. The private enterprise is shy
to invest in these areas. It is only the state which by providing all types of basic facilities like roads,
railways, power, industries, etc develops such areas whereby the people get jobs and the production
power of the area increases.
In the Form of Grants and Subsidies. Public expenditure in the form of grants and subsidies to
farmers, firms and industries is highly productive. When there is a bumper crop, the prices of farm
products fall considerably. The state can save them from disaster through price support. It can
purchase their surplus stocks at fixed minimum prices. In order to encourage higher production, the
99
state can provide such inputs as fertilizers, seeds, pump sets, etc at subsidised prices. Similarly, the
state can help develop industries by providing them subsidies. Some of the industries have high costs
in the initial stage of production. As a result. The prices of their products are high and they are not in
a position to compete in the market, and thus they meet an early death. To save such industries, public
expenditure in the form of subsidies may enable them to develop without charging high process from
its customers.
On Information. Public expenditure on providing information in the form of such publicity media as
TV, commercial broadcast, etc helps private and public enterprises in getting their products
publicised. As a result, their sales and production increase. Similarly, public expenditure on
employment news, bureaux and exchanges helps in placing the right man at the right job and in this
way provides larger employment opportunities and tends to increase productivity.
11.6.2 Effects of Public Expenditure on Diversion of Resources
Public expenditure affects the pattern of production through the diversion of resources from
existing uses to more productive uses. In fact, government expenditure in itself is a diversion of
resources from private to public uses. Public expenditure induces people to divert their resources
to more productive uses in the following ways:
1. On Infrastructure. Public expenditure on the development of roads and railways helps in

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

brings diversion of resources from more developed to less developed areas. Such diversion
takes place when the government incurs more expenditure in the form of transport, power, and
100
on the establishment of public enterprises in a backward region. Grants made by the
government for the development o such areas helps in diverting natural and human resources
from the developed to backward areas.
3. To private enterprise. Public expenditure in the form of loans and subsidies to private
enterprise helps in the diversion of resources into productive channels. Sometimes loans and
subsidies are made conditional. They are dependent on the quality of the product. In such
cases, diversion of resources leads to the production of better quality product. In such cases,
diversion of resources leads to the production of better quality products as against inferior
goods.
4. On defence. Public expenditure on defence or war leads to the greatest diversion of resource.
Such expenditure diverts resources from peaceful uses to war uses. It is normally regarded as
the wastage of human and material resources which can otherwise be used for social benefits.
But to defend a country s the foremost duty of government. It provides security to life and
property and saves the nation from foreign domination. All expenditure on defence is not
wasteful rather it is productive indirectly. Defence expenditure on the construction of roads,
bridges, aerodromes, shipyards, and on other means of transport and communications help in
building infrastructure in the country which are ultimately used by the civilian population. It
also provides employment to people engaged in their construction. Moreover. Public
expenditure incurred in maintaining the armed forces in the form of supplies of food, clothing
and other materials increases their demand and production and helps in increasing
employment opportunities manifold. No doubt, when resources are diverted from their
private uses to war, their supplies to the masses are reduced which adversely affect their
standard of living. But this is only a temporary phase so long as the war continues.
11.6.3. Effects of public expenditure on income distribution.

Public expenditure by increasing social welfare helps in reducing inequalities of income and wealth.
According to Dalton, it is only progressive expenditure that tends to reduce inequalities. A
progressive expenditure is one when a person with lower income receives larger benefits as compared
to a person with higher income. Public expenditure for purposes of income distribution is of two
types: transfer expenditure and exhaustive expenditure. In the case of transfer expenditure, low
101
income groups are given cash benefits in the form of unemployment, sickness, disablement,
dependents, and maternity benefits, and old age pensions. All such expenditures by the state help the
poor and middle income groups in raising their incomes indirectly. Exhaustive public expenditure
also tends to reduce income in equalities and it is in the form of free and cheap services of
commodities, such as free education, free medical facilities, free milk or meals to school children,
free transport for school children and for workers subsidized rations, subsidized lunch to workers,
rent – free quarters, etc.
There are also intangible benefits such as providing rent and recreation centres, public parks reading
rooms and libraries etc. Which tend to raise the efficiency of workers indirectly. Such non-monetary
benefits increase the real income and standard of living of the workers and masses. Public
expenditure of both transfer and exhaustive types helps in the redistribution of income. On the other
hand, if such benefits reduce the desire to work and save, they will tend to reduce the incomes of the
beneficiaries. Consequently, the inequalities are not reduced. To conclude with Dalton, "that system
of public expenditure is best which has the strongest tendency to reduce the inequalities of incomes.
11.6.4 Effects of public expenditure on economic stability

Increase in public expenditure tends to raise national income, employment output, and prices. An
increase in public expenditure during deflation increases the aggregate demand for goods and services
and leads to a large increase in income via the multiplier process. It has the effect of raising
disposable income thereby increasing consumption and investment expenditure of the people. The
public expenditure includes expenditure on such public works as roads, canals, dams, parks, schools,
hospitals and other buildings, etc. And on such relief measures as unemployment insurance,
pensions, etc. Expenditure on public works creates demand for the products of private construction
industries and helps in reviving them, while expenditure on relief measures stimulates the demand for
consumer goods industries. But the effectiveness of public expenditure primarily depends upon the
public work programme, its importance in the economic system, the volume and nature of public
works and their planning and timing.
102
11.6.5 Effects of public expenditure on economic development
The effects of public expenditure on economic development lie in increasing the growth rate of the
economy. But investment in the capital goods sector may increase production in the long run.
Therefore, public expenditure should also be directed towards meeting the immediate needs of the
economy, so as to raise agricultural and industrial production, and to increase the production of
essential consumer goods.
Rise in growth rate of the economy. Public expenditure on the establishment of heavy and basic
goods industries in the initial periods increases the growth rate of the economy. But investment in the
capital goods sector may increase production in the long run. Therefore, public expenditure should
also be directed towards meeting the immediate needs of the economy, so as to raise agricultural and
industrial production, and to increase the production of essential consumer goods.
Increase in employment, income and production. Public expenditure on economic and social
overheads provides larger employment opportunities, raises incomes and, above all, the productive
capacity of the economy.
Increase in revenue and profit. To increase the production of certain essentials commodities, to end
private monopoly in various spheres, and to control the "commanding heights" of the economy, the
state starts public enterprises. These bring revenue to the government and profits.
Reduction in inequalities. Public expenditure tends to lessen inequalities of income and wealth by
raising the earning capacity of the people. This is done by providing educational facilities and
through skill formation
Help to private enterprise. Public expenditure helps in encouraging private enterprise by
establishing state-owned financial and banking institutions to provide cheap credit.
Regional balance. Public expenditure helps in bringing about regional balance in the economy by
diversifying industries in backward and less developed areas of the country. Thus public expenditure
is one of the important instruments for economic development.
12.7 Growth Of Public Expenditure

There has been a phenomenal increase in public (centres, state and civic bodies) expenditure over the
years. The following reasons are given for this.
103
Expansion of state activities. Adolph Wagner, a German economist, writing in 1883
propounded the law of Ever-increasing state activity. According to Wagner, public expenditure
increases in response to the law of increasing expansion of public activities. He maintained that
there is a persistent tendency both toward an intensive and expensive increase of state functions
and activities. New duties are being continuously undertaken and old ones are being performed
on a large scale. As a result, public expenditure is increasing steadily.
Internal security. Wagner also referred to the maintenance of internal security as an important
factor for the increase in government expenditure. Enforcement of law and order for maintaining
peace and security has led to the expansion of legal and administrative systems and police force.
These have led to the increase in public expenditure.
Defence. Every country pays greater attention to its defence preparedness against foreign attacks.
As a result, public expenditure on equipping its armed forces with the latest armaments has
increased. As Adam Smith said long ago, Defence is better than opulence." So public
expenditure on defence is essential.
Welfare activities. Wagner wrote about the increase is public expenditure due to the expansion
of cultural and welfare activities of the state. Modern states are welfare sates which provide free
education, medical facilities, and social security measures, maintain historical monuments,
museums and public libraries, and encourage cultural, sports and health programmes.
Consequently, public expenditure has tended to increase.
Population increase. The increase in population on account of better health and medical
facilities leading to reduction in death rates has resulted in increasing public expenditure on the
people. The state has to spend more on roads, railways, schools, colleges, houses, etc.
Urbanisation. With the growth of population, there is migration of population form rural to
urban areas in search of employment. Existing cities expand and new cities come up. These
require huge public expenditure in schools, parks, zoos, houses, etc. Simultaneously, the
expenditure on civic administration also increases.
104
Price Rise. In modern times. Prices have a tendency to rise continuously with the increase in the
growth rte of the economy. As a result, the government expenditure on goods and services
increase. The rise in the cost of living further increases government expenditure by way of higher
salaries and enhanced D.A. to its employees in various civil and military departments.
Economic Development. Modern governments are engaged in the development of their

economies. They spend large sums on infrastructural facilities, on research and development in
various fields, on the development agriculture and industry, on the development of public sector,
etc. This has led to the increase in public expenditure.
Public Debt. The state borrows both internally and externally to meet its eve increasing public
expenditure. This further raises public expenditure in the form of repayment of loans and interest
charges.
Burden of democracy. Modern governments are democratic in nature. Countries are run on a
multi-party system with elections after four or five years.
Often governments fail due to lack of majority in the parliament. This necessitates frequent
elections. This tends to increase public expenditure. Further, there are "pressure groups'" and
"interest groups" within the parliament which want allocation of government funds for providing
public services in their constituencies. Moreover, according to the World Bank, wide spread
corruption in democratic countries has increased public expenditure manifold.
12.8 Development Expenditure Of Developing Economies
Development expenditure refers to public (government) expenditure of developing the economy.

The development expenditure of modern developing economies consists of expenditure on:
• Social services. Like education, health, social security and others;
• Economic services like agriculture, industries, minerals fuel and power, transport
and communication and others
• Community services such as roads and bridges, sanitation and others.
On the other hand, the non-development expenditure of modern developing economies includes.
105
• Expenditure on general services such as defence, justice, police and general
administration;
• Expenditure on unallocable and other purposes such as interest on public debt.
But in these countries, these two types of expenditure cannot be placed in water-tight compartments.
This is because without expenditure on defence, police etc., it is not possible to keep up the pace of
development if there is aggression from outside an unrest from within the country. Unless there is
peace on the boarders and protection of life and property within the country, economic development
is not possible. Similarly, interest on public debt may also be regarded as development expenditure.
This is because governments of developing counties borrow both internally and eternally mainly for
development purpose.
11.9 Role of Development Expenditure in a developing economy.
The role of development expenditure in a country lies in increasing the growth rate of the economy,
providing more employment opportunities, raising incomes and standard of living, reducing
inequalities of income and wealth, encouraging private initiative and enterprise, and bringing about
regional balance in the economy.
a) Heavy and basic goods industries.
Development expenditure on the establishment of heavy and basic goods industries in the initial
period increases the growth rate of the economy. But investment in the capital goods sector
increases production in the long run.
b) Consumer goods and raw materials.
To meet the immediate needs of the economy, development expenditure should be directed
towards increasing agricultural productivity to meet the growing demand for goods and raw
materials, and increasing the supply of consumer goods by encouraging establishment and
expansion of the small industries sector which may also provide sufficient employment
opportunities. The growth rate of the economy can be increased only when public expenditure
fulfills the short-term and long-term objectives of the development plan. Moreover, to prevent
106
inflationary tendencies within the economy, the public expenditure should secure a balance
between demand and supply of goods.
c) Economic overheads.
Economic overheads are such public works as roads, railways, canals, power project, etc. When
the government spends on such project, it provides employment to millions of an employment
people in underdeveloped countries. The provision for such services helps to increase production,
trade an commerce. As a results, employment and incomes increase.
d) Social overheads.
Development expenditure on social overheads like education, public health, cheap housing, etc,
makes the people healthier and efficient. It is the state which can create the "critical skills"
needed for rapid development by investing in human capital.
e) Allocation of resources.
Development expenditure helps in improving the allocation of resources towards desired

channels. In order to remove scarcities of food product, the state opens fair price shops and may
even subsidise food for the working classes to maintain their health and efficiency. It may fix
minimum prices for food grins, and through state trading and creation of buffer stocks encourage
farmers to produce more.
f) Public enterprises.
To increase the production of certain essential commodities to and private monopoly in various
spheres of production, and to supplement private enterprise, the sate may start public enterprises.
the services, to developed and conserve natural resources, to establish basic and key industries
like heavy electrical, chemicals, fertilizers, machine tools, defence production, etc, to undertake
state trading, etc.
g) To stimulate private enterprise.
Development expenditure helps in stimulating private enterprise through the establishment of

state-owned financial and banking institutions t provide chap credit of farmers, small and large
107
industries, traders, etc, development expenditure also encourages the agricultural and industrial
sectors of the economy by means of grants, subsidies, tax exemptions, etc. Moreover, when the
state spends on the creation of economic and social overheads like power, transport, education,
etc., they pave the ay for the establishment and expansion of the private sector. The creation of
the infrastructure leads to external economies that are reaped by the private sector.
h) To remove inequalities.
Developing counties are characterized by extreme inequalities of income and wealth.

Development expenditure tends to lessen them. Expenditure on education, public health and
medical facilities helps n human capital formation. As a result, the earning power of he working
populating is enhanced. As economic development proceeds rapidly through rising public
expenditure, the barriers to upward mobility are removed. Occupations expand and spread,
providing more jobs to the people. With acquisition of skills, the level of wages tends to rise
within the economy. Moreover, industrialization increases the share of wages and decreases the
share of profits in national income in the long run, and the gap between higher and lower incomes
is narrowed.
i) To remove regional imbalance.
Development expenditure helps to remove regional imbalance in the economy. if things were left
to market forces, commerce, banking, industries and almost all the main activities would be
localized in a few selected regions, and the rest of the economy may be in a state of perpetual
backwardness, as was the case developed areas and backward regions can be developed by staring
a certain projects like building a dam, digging a canal, starting new industries, etc. Such project
will not only promote but also secure larger employment opportunities, thereby increasing per
capita output and income of such areas in developing countries.
108
Meaning Of Public Expenditure
Objectives Of Public Expenditure
Size And Growth Of Public Expenditure
Theories Of Increase In Public Expenditure
Theories Of Public Expenditure
Effects Of Public Expenditure
Growth Of Public Expenditure
Development Expenditure Of Developing Economies
Role of Development Expenditure in a developing economy.
Revision Questions
1. Explain the meaning and objectives of public expenditure

2. Account for the size and growth of public expenditure
3. Explain the theories that explain increase of public expenditure
4. By the end of the lesson the learner should be able to explain the effects of public expenditure
5. Account for the growth of public expenditure
6. Explain the role of development expenditure of developing countries
Further References
M. L Jighan (2006), Public Finance And International Trade, Vrinda Publications P Limited, Delhi
India Pages 100-108
284
109
13.0 PUBLIC DEBT
General objectives
By the end of the lesson the learner should be able to explain the economics of public finance
Specific objectives
a) By The End Of The Lesson The Learner Should Be Able To Explain The Meaning Of Public
Debt
b) By The End Of The Lesson The Learner Should Be Able To Explain The Sources Of Public
Borrowings
c) By The End Of The Lesson The Learner Should Be Able To Classify Public Debt
d) By The End Of The Lesson The Learner Should Be Able To Explain The Burden Of Public Debt
e) By The End Of The Lesson The Learner Should Be Able To Explain The Effect Of Public Debt
Burden On Future Generations
f) By The End Of The Lesson The Learner Should Be Able To Explain The Techniques Of Debt
Management
g) By The End Of The Lesson The Learner Should Be Able To Explain The Role Of Public Debt On
Economic development
12.1 Introduction
National debts are debts which a state owes to its own subjects or to the nationals of other countries.
Public debt is a source of government revenue. In the case of public debt the government has to pay
interests and repay the principal to the public.
NB>: Nothing is required to be paid by the government in respect to all other sources of revenue.
12.2 Sources
There are two major sources of public borrowings namely internal and external.
Internal sources:
Internally the government borrows from individuals, corporations, non-banking financial institutions,
commercial banks or from the central bank.
These lend to the government through buying of treasury bills or government bonds. The treasury
bills and bonds sold by the government are relatively safe.
110
External sources:
Externally, the government borrows in the form of foreign capital which can enter a country as
private capital and/or public capital.
Private foreign capital may take the form of direct or indirect investments in the borrowing country.
Public foreign capital may consist of bilateral hard loans e.g. giving of loans by the British
government in Sterling Pounds to Kenyan government, bilateral soft loans and multilateral loans (e.g
loans from IMF, World Bank, UNDP) and Intergovernmental grants.
12.3 Classification/ Types of public debt

Public debts are of various kinds and include:
a) Voluntary debt and compulsory debt.
Voluntary Debt is that debt which is taken by the government without any force or coercion. People
lend it to the government voluntarily. Actually all public debts are voluntarily.
However, sometimes the government compels the people to buy governments bonds. e.g. incase of a
war or a national emergency. These are the compulsory debts.
b) Funded debts and unfunded debts
Funded debt is a long term debt for a definite period. The interest rate to be paid, with terms and
conditions of repayment are clearly stated in the debt instrument (certificate). In order to repay the
debt, a debt fund is created in which some money is deposited every year by the government. The
debt is repaid out of this fund on maturity.
Unfunded debt is for a short period of less than a year. The government does not create any separate
fund to repay the debt. Such a debt is repaid out of its current receipts often by floating additional
bonds in the market. Thus it is also called a floating debt.
c) Productive debt and unproductive debt.

Productive/ reproductive loans are debts/ which are fully covered by assets of equal or greater value
and the source of the interest is the income from the ownership of these, such as railways, oil pipeline
e.t.c. Thus a debt is productive when its amount is spent to finance a project which in long run brings
111
revenue to the government, out of which interest is paid on the debt. Unproductive debt does not
increase the productive capacity of the economy because it is not backed by any existing assets e.g.
loans taken by the government for covering the budget deficit or to help during war, famine,
earthquake and flood victims e.t.c. These do not bring any revenue to the government and are
therefore called dead weight debts.
d) Redeemable debt and irredeemable debt
Redeemable debt is that which is repayable by the government after a fixed period of time. The
interest on this loan is paid by the government regularly, half yearly or annually. When the debt
matures, the government pays back the principal amount to the lenders.
For the repayment of the principal either the government creates a fund in which a fixed amount is
deposited every year or it raises the amount through taxation
Irredeemable debt is that whose principal amount is not refunded by the government. However,
interest is paid regularly on such a debt for the period of its duration.
Debt incurred during a war may be non-redeemable by the government.
e) Internal debt and external debt
Internal debt is that debt which is raised by the government from individuals, institutions e.t.c.
within the country while external debt is a debt that is raised by the government from person or
institution outside the country such as IMF, World Bank e.t.c.
12.4 Need for public debt

The reason for government borrowing includes:
Deficit budget
The government borrows when it has a deficit budget. The deficit budget can be met by raising the
tax rates or levying new taxes. However tax collection takes a long time. By giving a particular date
for the subscription of a loan, the government can meet its requirements immediately. That is why
government prefers debt to other sources of revenue.
112
War
The government borrows from the public when it is involved in a war. During a war, the
government’s expenditure increases many times on armaments and forces. This can be met by
raising public loans on a large scale rather than through taxation.
Natural calamities
Natural calamities like earthquakes, floods, famine e.t.c. tend to increase government expenditure
in order to provide relief to the victims. This necessitates large public borrowing by the
government.
Economic development
Both developed and developing countries borrow for their economic development. Developing
countries do not have sufficient resources to finance their development plans because they are
poor. Developing countries borrow for the development of agriculture, industry, power, transport,
communication e.t.c. Developed countries also borrow to modernize their infrastructure like
roads, railways, powers, e.t.c.
Public enterprise and utilities

Every country whether a socialist, capitalist or mixed economy runs certain public enterprises and
utilities such as railways, power works, postal services e.t.c. which requires large funds. The
government can meet them through public borrowing rather than taxation.
Economic stability
The government also borrows to stabilize the economy. To control inflationary conditions, the
government borrows to take away excess money supply from the public.
Since public borrowing is voluntarily, this is a better method than raising taxes because loans
from the public do not increase the costs of production. Public borrowing also helps to lift the
economy from a depression. During a depression, idle funds are lying with the banks which the
government borrows in order to spend on public work programmes.
113
12.5 Burden of public debt
Public debt is required to be paid back along with interest from whom the government borrows. This
is done by levying taxes on people. This involves hardship on tax payers which is the burden of the
public debt .The debt may be internal or external The burden of debt may be:
1. Direct money burden
2. Indirect money burden
3. Direct real burden
4. Indirect real burden
The burden of public debt can be examined from the point of view of internal debt or external
debt
Burden of internal debt
The external debt imposes burdens on the society in the following ways
1. Direct money burden
The direct money burden of an external debt is the amount which a debtor country pays to the foreign
creditor country in the form of interest and principal. The repayment of loan and payment of the
interest to the foreign country is made in foreign currency. This imposes a direct money burden to the
borrower country.
2. Direct real burden
This is the loss of economic welfare of the people of the debtor country when they make payments to
foreign creditor. In order to pay the interest and the loan, the debtor
Country exports more to earn foreign exchange or pays the debt to the external creditor in the form of
exports of goods and services. This is the real burden of external debt.
3. Indirect money burden
If the external burden is utilized for productive purpose such as building roads, channels, power
projects e.t.c. and establishing industries, this will increase employment, income and production. Its
monetary burden will not be heavy because the payment of the principal and interest will be more
than compensated by the benefits flowing from productive projects.
4. Indirect real burden

The imposition of more direct taxes on commodities in order to pay interest and principal on external
loans puts heavy burden on the people. This is because their capacity to work and save declines. This
114
leads to a fall in production. If interest on external debt consumes a large part of national income, the
government is forced to reduce social and development expenditure. The burden of debt will be more.
The indirect real burden is also very heavy if the external loans are used in unproductive channel like
a war since it will be a dead weight debt on the people.
12.6 Debt burden and future generation
Some economists argue that when the government incurs long term debt it burdens future generation
with the cost of its present policies. Cost here means the sacrifice undergone by the people. They
argue that when the government finances development projects by public borrowing, the present
generation escapes the cost. The burden of debt is shifted to the future generations which pay the
principal and also benefit from projects.
Other economists argue that the real burden is borne in the period in which the government
expenditure is incurred. Therefore, when the government borrows, it diverts private savings into
public use. The payment of interest on bonds is made through taxation and therefore they argue there
is no burden to the future generations.
However, the situation is different when the debt is incurred to finance a war. People who live during
the war bear the heaviest burden by sacrificing consumption of goods. Therefore, the burden is on the
current generation. During war, the nation may be starved of capital goods and this will be an indirect
burden to future generation.
12.7 Management Of Public Debt

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

The main ones are:-
To minimize the interest cost of servicing the debt to the tax payer.
To employ it contracyclically as stabilization weapon to supplement monetary and fiscal policy.
115
12.8 Techniques/methods of debt management
They include:
1) Lowering the interest cost.
2 Changing the maturity structure.
3 Advance refunding.
4 Co-ordination with monetary and fiscal policies.
12.9 Redemption of public debt

This means the payment of interest and repayment of principal by the government.
The method of debt redemption includes:
1. Out of revenues – generally, the government pays the debts out of its revenue though a
surplus budget. It makes a provision in the budget as the amount to be paid during the year.
2. Sinking fund – under this method, the government creates a fund for the repayment of the
debts known as sinking fund and deposits a fixed sum of money out of its revenue each year
for the period of the loan.
3. Serial bond redemption – according to this method, whenever debt is floated, the, date of
maturity of certain bonds is fixed beforehand on the basis of their serial numbers. When the
time for maturity comes, bonds bearing the serial numbers are paid back.
4. Lottery method – according to this method, bonds which are to mature in a particular period
time are drawn on the basis of the lottery system. Only the bond holders whose bond numbers
have come out are paid back while the payments of others are deferred to the other lottery
dates. Such a method creates uncertainty among the bond holders.
5. Debt conversion – in this method, the debt with the highest interest rate is converted into a
new debt when the market rate of interest falls. The government borrows at low rate of
interest and repays the past debt even before it matures. The lender is free to take his money
back or get his loan converted into a fresh one.
6. Capital Levy – this is a once for all tax to redeem a public debt. It is levied on capital assets
on a progressive scale just after a war or an emergency when the burden of the debt is very
heavy.
116
7) Date repudiation – this means canceling of all debt all together. The government refuses to repay
the debt. This method of debt redemption is not practicable because the government’s reputation may
be at stake. Its very existence may be endangered. However, Russia did it in 1917
12.10 Effects Of Public Debt
When government borrows, it transfers money from one type of people to another. Money flows from
the people to the government and further to those on whom government spends the borrowed money.
This leads to expenditure effects of public debt.
When the government pays the interest and repays the loan, money is again transferred from those
who are taxed (by the government in order to pay the interest and principal), to those who hold
government’s bonds. This leads to revenue effects of public debt. These transfers of money from one
set of people to another through public debt affects consumption, production, distribution and the
business activity in general. Therefore public debt has the following effects:
a) Effects of public debts on consumption
b) Effects of public debt on production
c) Effects of public debt on distribution
d) Effects of public debts on prices or economic activity
e) Effects of public debt on private sector
12.11 Role of public debt on economic development
Economic development may be defined as the increase in the standards of living of a nation’s
population with sustained growth from a simple low income economy to a modern high income
economy. Its scope includes the process and policies by which a nation improves the economic, social
well-being of its people.
Public debt plays an important role in economic development of a country in the following ways:
a) Capital formation
b) Anti inflationary measure
c) Compulsory savings
117
1. Capital formation
Borrowing from the public can be another source of capital formation in undeveloped countries. This
device is better that taxation. Taxation means forced saving, borrowing in voluntarily. The tax payer
is never happy in paying tax for he doesn’t expect to get his money back. A lender, on the other hand,
gives his money on loan of his own accord to receive it back along with interest after a stipulated
period. Unlike taxation, borrowing does not adversely affect incentives to save and invest. The lure of
interest is always there to increase the incentives instead.
2. Anti- inflationary.
Public borrowing acts as an anti-inflationary measure by mobilizing surplus money in the hands of
the people in a developing country. A successful public borrowing programme can be a useful tool of
economic development by diverting resources from unproductive channels. Public borrowing is
resorted to for specific development projects like power generation, irrigation works, road, railway,
e.t.c. Thus it is a useful way of financing development projects.
3. Compulsory savings
If sufficient funds are not forthcoming in the form of voluntary loans, the government may have to
resort to compulsory borrowing for the mobilization of resources for capital formation. Compulsory
public borrowing is therefore justified in those undeveloped countries where taxation and voluntary
borrowing fail to bring adequate funds for development to the exchequer. Certain sectors of the
society who waste a large portion of their income in unproductive channels or derive special benefits
from particular development projects may be forced to subscribe to government bond.
However, it is not advisable for any underdeveloped country to rely on this method of forced savings
except for specific development projects and for a short period. Ultimately, governments will have to
depend on voluntary borrowings.

• Classification/ Types of public debt
• Need for public debt
• Burden of public debt
• Debt burden and future generation
• Management Of Public Debt
• Techniques/methods of debt management
118
• Effects Of Public Debt
• Role of public debt on economic development
Revision Questions
1. Explain the meaning of public debt
2. Explain the sources of public borrowings
3. Classify public debt
4. Explain the burden of public debt
5. Explain the effect of public debt burden on future generations
6. Explain the techniques of debt management
7. Describe the role of public debt on economic development
Further References
India Pages 82-99
217
563
Learning 472-500
119
Sample examination paper 1
UNIT NAME: PUBLIC FINANCE

UNIT CODE: BAF3202
TIME: 2 HRS
Instructions:
Attempt question ONE and any other TWO questions
Question One
Explain the functions of public finance in developed nations 3mks

Describe the free rider problem and its solutions 4mks
Highlight the differences between vertical and horizontal equity 3mks
Explain the solutions to externality problem 4mks
Distinguish between rent seeking and bureaucracy as they relate to the public choice theory
4mks
Explain factors determining the taxable capacity 4mks
Account for the growth of public expenditure 4mks
Explain the burden of public debt 4mks
Question Two
a) Explain how to determine the optimum output of social goods 8mks
b) Explain the meaning of externality 2mks
c) Describe negative externalities and give two examples 3mks
d) Explain the measurement of taxable capacity 7mks
Question Three
a) Explain tax incidence in the case of inelastic supply and elastic demand 3mks
b) Describe the efficiency principals of taxation 8mks
c) Explain the measurement of benefits and costs in public projects 7mks
d) Explain the concept of excess burden of taxation 2mks
120
Question Four
Explain how to measure the taxable capacity of people 6mks
Explain the various types benefits and costs involved in public projects 8mks
Explain the theories that explain increase of public expenditure 6mks
Question Five
Explain the various types benefits and costs involved in public projects 6mks
Explain the effect of public debt burden on future generations 6mks
Explain the techniques of debt management 8mks
121
Sample examination paper 2
MOUNT KENYA UNIVERSITY
UNIT NAME: PUBLIC FINANCE

UNIT CODE: BAF3202
TIME: 2 HRS
Instructions:
Attempt question ONE and any other TWO questions
QUESTION ONE
Explain the scope of public finance 4mks

Explain the characteristics of public goods 4mks
Distinguish between equity and equality in taxation 4mks
Describe the public choice theory 5mks
Explain the remedies of the public choice theory 5mks
Explain tax incidence in the case of inelastic demand and elastic supply 4mks
Describe the optimal taxation theory 4mks
QUESTION TWO
Describe a public good 2mks
Explain the differences public finance and private finance 7mks

Explain the sources of public borrowings 5mks
Explain the causes of market failure and the solutions 6mks
122
QUESTION THREE
Explain free rider problem and its solutions 4mks
Explain the objectives of public expenditure 3mks
Explain the effects of public expenditure on the economy 4mks

Explain how the following methods can be used to do the costing of a project
Shadow pricing of market items 5mks
Discounted cost of capital 4mks
QUESTION FOUR
Classify public debt 2mks
Describe the role of public debt on economic development 8mks
Account for the growth of public expenditure 6mks
Describe positive externalities and give three examples 4mks
QUESTION FIVE
Explain the types of externalities 4mks

Graphically illustrate external costs and benefits 4mks
Explain the implications of externality 4mks
Describe the resource allocation in a mixed economic system 8mks
123

BAF3202 Public Finance NOTES KAMOYO

Uploaded by

Document Information

Original Title

Copyright

Available Formats

Share this document

Share or Embed Document

Sharing Options

Did you find this document useful?

Is this content inappropriate?

Copyright:

Available Formats

BAF3202 Public Finance NOTES KAMOYO

Uploaded by

Copyright:

Available Formats

SCHOOL OF BUSINESS AND ECONOMICS

DEPARTMENT OF FINANCE &

Course Code: BAF3202

Course Title: Public Finance

2.0 PUBLIC GOODS AND PUBLIC UTILITY

3.0 EXTERNALITIES/ EXTERNAL EFFECTS

4.0 EQUITY AND INCOME DISTRIBUTION

4.1 Equitable distribution of income

6.0 BEHAVIOURAL RESPONSES TO TAXATION

7.0 TAX INCIDENCE

8.0 TAXATION AND EFFICIENCY

9.0 OPTIMAL TAXATION

9.1 Optimal tax Theory

10.0 COST BENEFIT ANALYSIS AND INVESTMENT RULES

11.0 PUBLIC EXPENDITURE PROGRAMS

12.0 PUBLIC DEBT

1.0 MEANING AND NATURE OF PUBLIC FINANCE.

1.2 Nature of public finance

Similarities and differences between public and private finances.

1.4 Fnctions of public finance

1.6 Resources allocation in different types of economic systems

Price mechanism and resources allocation

Role of the government in resource allocation

Summary Of The Topic

2.2 Theory Of Private And Social /Public Goods

2. They are subject to exclusion principal

3. They satisfy individual wants.

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

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

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

The goods are of collective consumption.

They are indivisible

Differences between private and public goods

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

Club goods Public goods

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

2.3 The Free Rider Problem

Possible solutions to the free rider problem

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

d) Subsidies and joint products

f) Merging free riders

g) Introducing an exclusion mechanism (club goods)

2.4 Market failure

Causes of market failures

Regulation- passing legislation that address the problem

Summary Of The Topic

• Explain the characteristics of public goods and private goods

• Explain free rider problem and its solutions

• Explain the causes of market failure and the solutions

• Explain the optimum output of social goods

3.2 Negative externalities;

3.3 Positive externalities –

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

3.4 Types of externalities

There are two types namely:

Non- market externalities

3.5 Possible solutions to the externality problem

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

• Property rights be well defined

3.6 Implications Of Externality

Summary Of The Topic

Explain the meaning of externality

4.1 Equitable distribution of income