ADDIS ABABA UNIVERSITY

Public Finance & Tax Accounting(AcFn-3171)

Alem H.(PhD)
Session Two
 Contents of Chapter One
Basics of Public Finance
❑ Definition of public finance

❑Scope of public finance

❑The role of government in the economy

❑Public expenditure

❑Public revenue

❑Public debt

❑Public administration

❑Fiscal federalism
 What is Public Finance?
• The study of how governments collect and spend money and real resources

• How do governments collect/spend money? Positive analysis( describes and

explains various economic phenomena)

• How should governments collect/spend money? Normative analysis(focuses on

the value of economic fairness, or what the economy "should be" or "ought to be.)

• We are studying public finance in a market economy

 What is the Role of Government?
• To maintain and improve the welfare of the people
• To protect the people from harm
• To provide the institutions that allow market to function (e.g. protection of
property rights)
• To provide the essential goods and services that markets fail to adequately
provide
 What is the Role of Government?
➢ The Government’s roles include:

✓Providing a stable set of institutions, laws and rules.

✓Promoting effective and workable competition.(fiscal vs Monetary)

✓Adjusting for undesirable market results.

✓Correcting for externalities.(see next page in detail)

✓Creating an environment that fosters economic stability and growth.

✓Providing public goods.

Alem H.(Ph.D.)
 Taxation :Ways to Correct Negative Externalities
There are two types of negative externalities:
1) Negative Production Externality
✓ Reduces the well-being of others who are not compensated by the firm.
✓ The production of smoke from factories may create clean-up costs to reduce air
pollution by nearby residents.

✓ The building of a dam that prevents the fish from swimming upstream, thus
destroying the fishing industry in towns upstream.
2) Negative consumption externality:
✓ when an individual's consumption reduces the well-being of others who are not
compensated by the individual.

✓The consumption of cigarettes in a restaurant that allows smoking decreases the

enjoyment of a non-smoker who is consuming his/her meal at the same restaurant.
Alem H.(Ph.D.)
 SCOPE OF PUBLIC FINANCE
Four areas which includes public income, Public expenditure public debt and financial
administration.
(a) Public revenue
The study of various sources of government’s income, the principles guiding the raising of income
(e.g. canons of taxation), their relatives merits and demerits and their effects on the economy (e.g.
impact and incidence of taxation).
(b) Public expenditure
The study of the manner in which public expenditure is classified, the principles guiding public
expenditure (canons of public expenditure), causes of growth and effects of public expenditure.
(c) Public debts
The study of public debt forms a very important part of public finance in modern times as
governments are increasingly resorting to debt to meet the growing needs of the people. Public
finance studies the sources, burden and impact of public debt.
(d) Financial administration
This includes the study of the preparation, passing and implementation Of the budget, budgetary
policies and their socio-economic impact, inter-governmental financial relations, fiscal
management and fiscal responsibility
 FUNCTIONS OF PUBLIC FINANCE.
The functions of public finance all activities with regard to collection of revenue and
expenditure on various activities .
1) Economic activities of the state
The scope of public finance was confined to the traditional functions of the state, that is,
provision of defense, law and order, justice and civic amenities. But with the emergence of
welfare states the scope of public finance was broadened public finance now includes the
use of the budget as a tool to correct distortion in the economy, to mobilise resources, to
maintain price stability create employment prevent market failure, achieve growth equity and
maximize social welfare.
2) Functional Finance(seeks to eliminate economic insecurity through government intervention-inflation and
unemployment)
The government should maintain a reasonable level of aggregate demand at all times by
using the budget. Most developed economies followed functional finance policies in order to
control trade cycles. Developing countries followed such policies to promote economic
growth.
 FUNCTIONS OF PUBLIC FINANCE.
3) Fiscal Operations
• The scope of public finance includes fiscal operations and their objectives.
• Fiscal operations refer to raising public revenue, spending to achieve certain goals and financial administration. For such
operations, the government uses fiscal tools like taxation, public expenditure and public debt. The following are the objectives
of fiscal operations;
(a) Allocation of resources
• The most important objectives of fiscal operations is to determine how the Country’s resources will be allocated to different
sectors of the economy in order to achieve predetermined goals.
• The national budget determines how funds are allocated to different heads of expenses.
• The policy of public expenditure is used by the government to directly undertake resource allocation for different sectors. On
the other hand, the government can use taxation and subsidies to indirectly influence resource allocation.
(b) Distribution
• Fiscal operations can be effectively used affect the distribution of national income and resource
• Taxation and public expenditure policies are used by the government to reduce inequalities.
• Progressive direct taxation impose heavier burden on the rich than the poor.
• Public expenditure on social infrastructure and subsidies on food housing, health and education help reduce income inequality.
 FUNCTIONS OF PUBLIC FINANCE.
(c) Stabilization
• Economic stability implies absence of sharp cyclical movements in the form of booms
and depressions.
• To bring about such stability, countercyclical fiscal operations are adopted.
• To counter depression and recession, government expenditure is increased to generate
employment and taxes are reduced to encourage consumption and investment.
• During inflation, public expenditure is reduced and taxes are raised.
(d) Economic growth
• The objectives of fiscal operations are more promotional in nature.
• The basic focus of fiscal operations in such economies is the use of budgetary
operations to achieve growth and development.
• This is done by encouraging capital formation and investments through public
expenditure and tax incentives to private sectors.
The simil.and dissimilar. b/n public finance and private finance.
Distinguish between public finance and private finance.
• Public finance deals with study of income, Expenditure, borrowing and financial
administration of the government.
• Private finance is the study of income, expenditure, borrowing and financial
administration of individual or private companies.
• Both public and private finance are fundamentally similar in nature but different
from each other on various operational aspects .
• The similarities and differences between public and private finance have been
explained below
 The Similarities and Dissimilarities Between Public Finance and
Private Finance.
SIMILARITIES:
1. Objective
Satisfaction of human wants is the main objective of both public and private finance. The
main aim of public finance is to satisfy social wants and that of private finance to satisfy
individual wants.
2. Principles
The principle of maximum social benefits is the guiding principle followed by the
government while spending its income. Individuals also follow the principle of maximum
satisfaction when spending out his given income.
3. Income, Expenditure and borrowing
The resources or the income for both government and the individuals are limited .In case of
shortage, borrowing can be done for both and both are under obligation to repay the borrowed
money.
 The Similarities and Dissimilarities Between Public Finance and
Private Finance.
SIMILARITIES:
4. Policies
Both the private and public finances adopt policies for maximizing welfare. In Private finances
as well as in public finance only sound policies will enable maximization of welfare and
benefits.
5. Administration
• The effectiveness and success of measures adopted by private and public sector depends on
the administrative machinery.
• If the administrative machinery is inefficient and corrupt it will lead to losses and wastages
 The Similarities and Dissimilarities Between Public Finance and
Private Finance.
Dissimilarities: (Distinction between public and private finance)
1. Magnitude :
The most significant difference between the two types of finances is in terms of size and
magnitude. Households and businesses have relatively smaller amount of resources available
to them and hence their budgets are smaller in size as compared to those of governments.
2. Public Scrutiny:(critical observation)
• Personal budgets of households are a private affair and not made public.
• In case of business finance, the budget is made known to the stakeholders and General public for information
and scrutiny.
• In case of public finance, every budgetary decision has to be made known to the people of the nation.
 The Similarities and Dissimilarities Between Public Finance and
Private Finance.
Dissimilarities: (Distinction between public and private finance)
3. Source of revenue:
• Private economic units earn their income by using assets owned by them.
• Their sources of income are salaries, wages,interest, rent and profits which arise out of transactions.
• In case of governments, the source of income are taxes and non tax revenues.
• In case of taxes, fees, fines, fines there in an element of compulsion/force
4. Sources of borrowing:
• Private economic units may borrow from informal sources like friends, Relatives ,moneylenders as well as from
formal sources like banks and financial institution.
• Public bodies can borrow almost on a continuous basis from internal and external sources. They can borrow
from the people, the central bank, Commercial banks and other financial institutions as well from external
sources.
 The Similarities and Dissimilarities Between Public Finance and
Private Finance.
5. Motive:
• Incase of public finance, the decisions are reached through political and administrative procedure and based
on common social objectives.
• Private finances is governed by profit motive for businesses or satisfaction of wants of individuals and
households.
6. Time dimension:
Both private and public financial activities try to balance between the immediate objectives and future goals. But
private economic units, especially households, are primarily focused on fulfillment of present and immediate
wants. In case of public authorities, the focus is on both present and future
 The Similarities and Dissimilarities ………
7. Income Expenditure adjustment:
• Generally, while a private economic unit adjust its expenditure to income, public bodies adjust income to
expenditure.
• Private finance will try and adjust expenditure according to income and in order to do so may even forego
fulfillment of certain wants. On the other hand, Government are guided by welfare and growth consideration for
which expenditure have to be predetermined. Since they have the power to raise fund through taxation,
borrowing, deficit financing, they try to adjust their revenues to the predetermined expenditure requirements.
8. Assessment of outcomes:
• It is much easier to measure and evaluate the outcome of private financial activities than the outcome of public
financial activities.
• In case of private economic units, the outcome may be measured by profits of business, fulfillments of wants of
households.
• In case of public finance, the outcome has to measured and evaluated in terms of multiple parameters. These are
social welfare, economic growth, security, Productivity and efficiency.
 The Similarities and Dissimilarities ………
9. Nature of the budget:
• Private economic units aim at surplus budget.
• Having a surplus is considered economically prudent. This is not the case with government budgets. In countries
that need to grow and develop rapidly, deficit budgets need to be followed. A long term surplus budget indicates
that the government may not be fulfilling some of its obligation.
 SESSION THREE

Public expenditure
Public revenue
Public debt
Public administration
Fiscal federalism
 Public Expenditure

• The term public expenditure refers to the expenses of public authorities like the
Central, state and local governments.

• Public expenditure occupies a very important place in the study of public finance.

• It is the end of all financial activities of the government.

• Public expenditure is incurred basically to maximize social welfare.

• Classification of public expenditure
❑Revenue(development and non-development expenditure) and
❑Capital Expenditure(Productive versus non-productive):
 Public Expenditure
A)Revenue Expenditures are recurrent or consumption expenditures
incurred on public administration, defence forces, public health and
education, maintenance of government machinery, subsidies and interest
payments.
• These expenditures are recurrent in nature and they do not create any
capital assets.
• Revenue expenditure is classified into development and non-
development expenditure
i) Development Expenditure:
oThe part of revenue expenditure that directly or indirectly contributes
to the development of the country is known as development revenue
expenditure.
oIt includes expenditures on the maintenance and functioning of social
and community services and physical infrastructure. For example,
maintenance of education and public health infrastructure like schools,
hospitals, irrigation facilities, electricity boards etc.
 Public Expenditure
ii) Non-Development Expenditure:
• The part of revenue expenditure that may not directly contribute to economic
development is known as non-development revenue expenditure. They include
expenditures on the maintenance of defence establishments, administrative expenditure, interest
payments, payment of old age pension etc.
(B) Capital Expenditures are incurred on building durable assets, like highways,
multipurpose dams, irrigation projects, buying machinery and equipment. They are a
non-recurring type of expenditure in the form of capital investments. Such
expenditures are expected to improve the productive capacity of the economy.
i) Not all capital expenditures are productive. Non-development capital expenditure
on defence establishment which does not have any direct impact on economic
development but is necessary for the security of the nation.
ii) Capital expenditures on social infrastructure like government schools, hospitals,
primary health centers may not generate revenue and therefore cannot be termed
productive in that sense, but they indirectly contribute to improving productivity.
 Public Expenditure
C. Non-Transfer and Transfer Expenditure:
(a) Non-transfer Expenditures:
✓Are incurred for buying or using goods and services. These include expenditure on defence,
education, public health etc.
✓Investment expenditures on capital assets are also non-transfer expenditures as the
government gets capital goods and assets in return for them.
(b) Transfer Expenditures:
• Refer to those expenditures against which there is no corresponding transfer of
real resources i.e. goods or services.
• These include expenditures incurred on old age pension, unemployment
allowance, sickness benefits, interest payments on public debt and subsidies.
 Public Expenditure
D. Plan and Non-Plan Expenditure:
(a) Plan Expenditures:
• Refer to the spending of the annual funds allocated by the Central government
for development schemes outlined in the ongoing Five Year Plan. For example:
Industrial Development, Agricultural
• Development, Infrastructure, Education & Health etc.
(b) Non-Plan Expenditures:
• Include all those expenditures of the government that are not included in the
ongoing Five-Year Plan.
• They include both development and non-development expenditure. Part of the
expenditure is obligatory in nature e.g. interest payments, pensions etc. and a
part is essential obligation e.g. defence and internal security.
 Public Expenditure
5. Dalton’s Classification:
• Economist Hugh Dalton has provided the following comprehensive
classification of public expenditure:
i) Expenditures on political executives i.e. maintenance of ceremonial heads of
state, like the President.
ii) Administrative expenditure to maintain the general administration of the
country, like government departments and offices.
iii) Security expenditures to maintain armed forces and the police forces.
iv) Expenditures on administration of justice include maintenance of courts,
judges, public prosecutors.
v) Developmental expenditures to promote growth and development of the
economy, like expenditure on infrastructure, irrigation etc.
vi) Social expenditures on public health, community welfare, social security etc.
vii) Public debt charges include payment of interest and repayment of principal
amount.
 Public Revenue
• Public Revenue is an important concept of Public Finance.
• It refers to the income of the Government from different sources.
• Dalton in his “Principle s of Public Finance” mentioned two kinds of public revenue.
• Public revenue includes income from taxes and goods and services of public enterprises, revenue
from administrative activities such as fees, fines etc. and gifts and grants. On the other hand public
receipts include all the incomes of the government received from formal sources.
The sources of public revenue have been broadly divided into:
(A) Tax Revenue
(B) (B) Non-Tax Revenue.
(
Taxes are the first and foremost sources of public revenue. Taxes are compulsory payments to
government without expecting direct benefit or return by the tax-payer. Taxes collected by
Government are used to provide common benefits to all. Taxes do not guarantee any direct benefit
for person who pays the tax. It is not based on “quid pro quo principle.”
The Tax has been divided into two types such as Direct Taxes and Indirect Taxes.
 Public Revenue
• Public Revenue is an important concept of Public Finance.
• It refers to the income of the Government from different sources.
• Dalton in his “Principle s of Public Finance” mentioned two kinds of
public revenue.
• Public revenue includes income from taxes and goods and services of
public enterprises, revenue from administrative activities such as fees,
fines etc. and gifts and grants.
• On the other hand public receipts include all the incomes of the
government received from formal sources.
 Public Revenue
• Taxes are the first and foremost sources of public revenue. Taxes are
compulsory payments to government without expecting direct benefit
or return by the tax-payer.
• Taxes collected by Government are used to provide common benefits
to all.
• Taxes do not guarantee any direct benefit for person who pays the tax.
• It is not based on “quid pro quo principle.”
• The Tax has been divided into two types such as Direct Taxes and
Indirect Taxes.
(A) Direct Taxes:
Direct taxes are those taxes which are paid by the same person on whom
it has been imposed. The impact and incidence of tax fall on the same
person, because the tax burden cannot be shifted to others.
 Public Revenue
• Direct taxes include the following taxes.
i) Personal Income tax is a tax imposed on the excess income earned by an individual over and
above the limit decided by the finance ministry form time to time.
• It is progressive in nature.
ii) Corporate Tax is a tax levied on the profits earned by registered companies.
iii) Capital Gains Tax is a tax imposed on the net profits earned through capital
investment in stock market ,Rreal estate, Gold and Jewelry etc.
iv) Wealth Tax (or) Property
• Tax is a tax levied upon the property owned by individuals.
• The property includes Land, Building, shares, Bonds, Fixed Deposits, Gold and Jewelry etc.
v) Other taxes :
• These taxes include taxes like Gift tax and Estate duty.
 Public Revenue
(B) Indirect Taxes:
• Indirect taxes are those taxes which are imposed on one group of people, but the ultimate burden will fall on another group of people.
• The impact of tax and incidence of tax are on different people.
• In case of Indirect taxes tax burden can be shifted. There are middlemen between the Government and the tax payer.
• The important Indirect Taxes are as follows:
i) Excise tax is a tax imposed on the manufacturers as per the value of goods produced but the ultimate burden will
fall on the final consumers.
ii) Customs Duty is a tax imposed on import and export of Goods.
• Customs duty may be specific or advalorem.
• Advalorem duty is a tax imposed on the basis the value of goods imported while specific duty is imposed as per the number of units
imported.
iii) Value Added Tax (VAT) is a part of a sales tax imposed by the state government.
iv) Sales Tax revenue goes to the state government when sale or purchase takes place within the state. Sales tax
revenue on interstate transactions goes to the central government.
v) Service Tax is tax imposed on services provided.
The impact is on the service provider and the incidence of tax false on the customers.
 Public Revenue
(B) Non-Tax Revenue:
These sources of revenue are classified as administrative revenues, commercial revenues and
grants and gifts.
1) Grants: Grants :
• are made by a higher public authority to a lower one, for example, from the Central to the State government or
from the State to the local government.
• Grants are given so that a public authority is able to perform certain activities at the local level.
• There is no repayment obligation in case of grants.
2) Gifts:
• Gifts and donations are voluntarily made by individuals, organizations, foreign governments to the funds of the government.
• Such gifts are usually made at the time of crisis like war or floods. Gifts cannot be considered a regular source of revenue.
3) Fees:
• Fees are an important source of administrative non-tax revenue to the government.
• The government provides certain services and charges, certain fees for them. For example, fees are charged
for issuing of passports, granting licenses to telecom companies, driving licenses etc.
 Public Revenue
4) Fines and Penalties:
• Another source of administrative non-tax revenue includes fines and penalties.
• They are imposed as a form of punishment for breaking law or non-fulfillment of certain conditions or for
failure to observe some regulations.
• They are not expected to be a major source of revenue to the government.
5) Special Assessment:
• It is a kind of special charge levied on certain members of the community who are beneficiaries of certain
government activities or public projects. For example, due to public park in a locality or due to the construction
of a road, people in the locality may experience an appreciation in the value of their property or land.
6) Surpluses of Public Enterprises:
• Most countries have government departments and public sector enterprises involved in commercial activities.
• The surpluses of these departments and enterprises are an important source of non-tax revenue.
• These revenues are in the form of profits and interests and are termed as commercial revenues.
7) Borrowings:
• When government revenue is not sufficient to meet the public expenditure government borrows either from internal or external sources.
• Borrowing is income of the government which creates liability because the government has to repay the borrowings with interest.
 Public Debt
• Public debt or public borrowing is considered to be an important source of
income to the government.
• If revenue collected through taxes and other sources is not adequate to cover
government expenditure, government may resort to borrowing.
• Public debt may be raised internally or externally.
• Internal debt refers to public loans floated within the country, while external
debt refers loans floated outside the country.
• Loans taken by the government may be from individuals, banks, financial
institutions like the International Monetary Fund, World Bank etc.
• The instruments of public debt take the form of government bonds or
securities of various kinds.
 Public Debt
Types of public Debt:
Government loans are of different kinds. They may differ in respect of time of repayment, the purpose,
conditions of repayment, place of their floating and the method of covering the liability.
Thus public debt may be classified into following types.
1. Internal and External Debt:
▪ The internal loans are raised within the country and subscribed mainly by its own citizens and/or
institutions.
✓It is repayable only in domestic currency.
✓An internal debt may be either voluntary or compulsory.
✓Internal debt imply a redistribution of income and wealth within the country and therefore it has no direct money burden.
▪ External loans are raised from foreign countries or international institutions.
✓These loans are repayable in foreign currencies.
✓External loans help to take up various development programme in developing and underdeveloped
countries.
✓These loans are usually voluntary.
✓An external loan involves, initially a transfer of resources from foreign countries to the domestic
country but when interest and principal amount are being repaid a transfer of resources takes place in
the reverse direction.
 Public Debt
2. Voluntary and Compulsory debt:
• Public debts may be incurred through voluntary or compulsory loans.
• Generally, public loans are voluntary in nature.
• In this case the government makes an announcement regarding the floating of loans.
• This announcement may be accompanied by some kind of publicity.
• The government floats a loan by issuing certificates, bond, etc.
• Individuals, banks and other financial institutions lend to the government willingly by purchasing
these securities.
• On the other hand, compulsory loans are those which are raised by using coercive
methods.
• A compulsory loan is a rare phenomenon in modern public finance unless there are
some special circumstances like war or crisis.
• The rate of interest on such loans may be low.
• Considering the compulsion aspect, these loans resemble a tax, the only difference is
that loans are repaid but tax is not.
 Public Debt
3. Productive and unproductive debts:
▪ Public debt is said to be productive when it is raised for productive purposes and is
used to add to the productive capacity of the economy.
✓If the borrowed money is invested in the construction of railways, irrigation projects, power
generations, etc.
✓It adds to the productive capacity of the economy and also provides a continuous
flow of income to the government.
✓The interest and principal amount is generally paid out of income earned by the government from
these projects.
▪ Unproductive are those which do not add to the productive capacity of the economy.
✓Such debts are not necessarily self-liquidating.
✓The interest and the principal amount may have to be paid from other sources of
revenue, generally from taxation, and therefore, such debts are a burden on the
community.
✓Public debt used for war, famine relief, social services,etc. is considered as
unproductive debt.
 Public Debt
4. Short Term, Medium Term and Long-Term Debt:
Here the basis of classification is duration of loans.
▪ Short-term debt matures within a duration of 3 to 9 months. Generally, rate of
interest is low. For instance, Treasury Bills of 91 days and 182 days are examples
of short term debts incurred to cover temporary shortages of funds.
✓The treasury bills of government of Ethiopian govt, which usually have a maturity period
of 90 days, are the best examples of short-term loans.
✓Interest rates are generally low on such loans.
▪ Long-term debt has a maturity period of ten years or more. Generally the rate of interest is high.
✓Such loans are raised for development programmes and to meet other long-term needs of public authorities.
▪ Medium-term debt has a maturity period in between short-term and long-term
loans.
✓The rate of interest is intermediate.
✓They are generally raised for welfare programmes.
 Public Debt
5. Redeemable and Irredeemable Debt:
▪ Redeemable debt is repaid at some specific future date and therefore,
government has to make arrangement for repayment of interest and principle
amount within a specific time period.
✓These loans are terminable.
✓The debts which the government promises to pay off at some future date are called
redeemable debts.
▪ In case of irredeemable debt,
✓no definite date for final repayment is promised for the rate of interest is paid regularly.
Therefore, the government makes arrangements for interest payment only.
✓Such debts are likely to become perpetual and therefore, they are considered as
undesirable on the grounds of sound finance.
✓The maturity period is not fixed. Such loans create a burden as taxes would be raised to
pay the debt in the future.
 Public administration

Administration’ is
• “Administration is determined action taken in pursuit of a conscious purpose.
• It is the systematic ordering of affairs and the calculated use of resources aimed at
making those happen which one wants to happen.”
• Organizing and maintaining human and fiscal resources to attain a group’s goals.”
 What is Public Administration?

‘Public
Administration’
is like any other
administration
which is carried
out in public
interest.
 Fiscal federalism
• The field of fiscal federalism studies how to divide responsibilities (including
finances) among federal, state, and local governments to improve economic
efficiency and achieve various public policy objectives.
• Determining the optimal division of responsibilities is difficult because of
varying subjective views about what the role of government should be.
• As a result, fiscal federalism research generally renders no judgment on the
proper level of total government intervention or what types of services
governments should provide.
• The research focuses instead on how responsibilities are assigned across
multiple layers of government once policymakers have decided to implement a
given policy, and what trade-offs may be involved in administering it.
Fiscal federalism