PUBLIC FINANCE

DEFINITION OF PUBLIC FINANCE

Public finance is a branch of economics that studies the financing of public activities and
the impact of various ways of raising government revenue and expenditure in country
economy, various sector and on an individual. It deals with the public expenditure,
public revenue and public borrowing.

Due to the failure of market mechanism to provide public and merit goods, all
government worldwide participate in the economic in terms of provision of goods and
services and in regulation of the economic.

SOURCES OF PUBLIC FINANCE

The source of public finance are:

• Taxation
• Fees
• Services offered by the government i.e. transportation
• Fines charged to the people who violate law
• Gifts and grants that the government may receive from other foreign friendly
countries.
• Sale of government property e.g. houses vehicles, etc
• Sale of government share equity in public corporations.

QUESTION – KASNEB (DEC 2002 8(a))

Identify and explain options available for raising funds to finance government activities.

TAXATION

Principles of Taxation

Principles of Taxation are also referred to as cannons of taxation. They are the following;

1. Simple: taxation must be single so that citizen can understand system of their
economy.
2. Cannon of Equity: Cannon of equity refers to the burden of paying taxation,
which must be equal; that is, rich should pay more compared with the poor.
3. Cannon of Economics: This means that the cost of collection of tax must be
minimum.

1
 4. Cannon of Convenience: Tax system must be convenient for all citizens.
This is quite applicable to income tax where people pay at the end of the
month.
5. Cannon of Elasticity: This refers to degree of changes in taxation with
reference to macro-economic problems in a country, i.e. if the economy is
facing unemployment the government can decide to reduce VAT and income
tax in stimulate economic growth.
6. The Cannon of Variety: This is in order to solving the problem of tax evasion.
Thus, the government must introduce different type of taxes to increase public
revenue.
7. Cannon of Productivity: The main objective of taxation is to raise
government revenue. The government must therefore introduce tax system to
enable it to increase revenue e.g. VAT on addictive goods like cigarettes,
alcohol, etc.
8. Cannon of Certainty: Means that the amount of tax, time and method of
payment should be certain. There must be no confusion in this regard.

TYPES OF TAXATION

KASNEB – DEC. 2006 Q7(a)

Distinguish between the following
i) Regressive tax and progressive tax. (2mks)

Proportionate Tax: It is a tax system introduced by the government whereby the tax
impact/burden is borne by everybody equally. In other words, it is a uniform tax system
irrespective of income status.

Merits
(a) Sacrifice is borne equally;
(b) Easier to estimate how much you pay;
(c) Simple to understand; and
(d) Increase incentive to work.

Demerits
(a) Higher burden especially he poor; and
(b) Causes uneven distribution of national income.

2. Progressive Tax: Applicable to income tax whereby the more you earn the more
you are taxed, that is, Pay as You Earn (PAYE).

Merits
a) Solve the problem of uneven distribution of national income
b) Ability to pay is the basis
c) Less expensive in terms of tax collection, and

2
 d) Effective especially in developed countries where many people are receiving
higher wages.

Demerits
a) Discourages investment
b) Discourages savings
c) Increases tax evasion

In regressive tax system, the poor tend to be taxed more.

KASNEB – NOV 2004 – Question 4 (b)

Argue the case for indirect taxes as a fiscal policy tool. (4mks)

Direct Tax: The tax burden is borne by the payer only through the incidence of taxation.
It can be borne by many people, e.g. income tax.

Merits
a) Based on ability to pay
b) Helps to control uneven distribution of national income
c) It is easier to collect
d) Simple to understand
e) Used as one of the methods of controlling inflation; and
f) Makes taxpayer conscious of government expenditure.

Demerits
a) Discourage investment and savings
b) Increases incidences of tax evasion:
c) Act as a disincentive as may people aren’t willing to work hard due to high
income tax they pay

4. Indirect Tax: A tax system where the burden can be borne by the payer and
seller (i.e. consumer and producer) but this will depend on the nature of elasticity of
demand. For example, under unitary elasticity, the tax burden will be borne equally
between producer and consumer, while on relatively inelastic demand; the tax burden
will be borne greatly by the consumer. Finally, where elasticity of a commodity is
demand elastic, the tax burden will be borne greatly by the producer. On the other
hand if elasticity of a commodity is perfectly inelastic, the tax burden will be borne
by the consumer 100%, while in a perfectly elastic good, tax burden is borne 100%
by the producer.

Merits
a) It is not easy to evade e.g. VAT
b) It is used as a method to reduce inflation
c) It is productive as government generates a lot of revenue through indirect
taxation such as VAT.

3
 d) Can also be used to control uneven distribution of national income especially
if VAT is imposed on goods consumed by the rich.
e) Used to solve social welfare problems such as use of cigarettes by the
imposing much VAT tax.

Demerits

a) Can bring inequality if VAT is charged on basic goods

b) Un-economical in terms of collection
c) Discourages savings.

PUBLIC EXPENDITURE

Public expenditure may be defined as expenses incurred by the government for direct
purposes.

Objectives of Public Expenditure

1) To increase the standard of living by providing public services

2) To maintain law and order
3) Reduce uneven distribution of national income by expanding employment
levels and bring stability in the country whereby the country will be self
sufficient.
4) Increase productivity within the country.

Types of Public Expenditure

Government expenditure includes spending money on:

• Defense
• Maintenance of law and order
• General administration
• Education
• Health
• Labour
• Environment
• Road maintenance and repair
• Community development
• Economic services e.g. agriculture, veterinary, forestry, games and fisheries,
tourism, mining, commerce, industry, transport, etc
• Management of public debt and many others.

4
In broad terms, public expenditure can be distinguished into two categories; namely:

• Recurrent expenditure, and

• Development expenditure

CAUSES OF INCREASE IN PUBLIC EXPENDITURE

1) Increase in population will force the government to increase its expenditure in

terms of education, health etc.
2) Inflation will cause the government to increase expenditure to meet demand.
3) Democracy- where the aim of the government is to satisfy citizens in order to be
elected back to power.
4) Expenditure on war due to political instability
5) Increase in urbanization will force the government to spend more on reoad
construction, housing, electrification, water supply, sanitation, etc.
6) Increase in government administrative functions due to bloated civil servants such
as police, clerks, Dos, DCs, ministries, etc.

PUBLIC DEBT

Definition of a Public Debt

Public debt refers to public borrowing whereby the government is forced to borrow either
internally or externally in order to solve macro-economic problems such as
unemployment, inflation, balance of payment deficits, budgetary deficits, etc

Purposes of Public Debt

• Equate distribution on national income

• Control inflation especially cost push
• Finance public projects/works
• Provision of public goods
• Control economic recession and depression
• War expenditure
• Emergency, e.g., droughts, El Nino weather phenomena, etc

Types of Public Borrowing

1. Internal Debts: It is referred to as domestic debt in internal debt, the government

borrows money from the public by selling securities and bonds. Internal debt can
increase the interest rates as commercial banks will not be in a position to create
credit as much of the money will be borrowed by the government. It can also be
used to control supply of money in the economy hence brining down the inflation
rate.
2. External Debts: Occurs when the government borrows money outside the
country from World Bank, International Monetary Funds (IMF) and other foreign

5
 friendly countries. Most developing countries development plans and
programmes are affected adversely because the government will be forced to
increase its taxation level in order to redeem these debts. If a country fails to
redeem these debts, the interest rate that is charged on them will keep on swelling
and this worsens its budgetary deficits and balance of payments. Moreover,
external debt worsens the foreign exchange reserves, as it must be paid back in
foreign currency.

Public debt can also be classified as:

a) Productive Debts: Occurs when government borrows money for development

purposes. This is regarded as better for economic development because the
project can redeem the debt.
b) Unproductive Debts: Refers to money borrowed by the government to
sponsor war or finance a general election or any other social welfare such
debts don’t generate output.
c) Voluntary Debts: Refers to a situation there the government draws/floats
security bonds in the country only for those willing to buy them.
d) Compulsory Debts: Occurs in a situation when the government wants to
redeem external debts and thus it decides to deduct a certain percentage for
debts relieve.
e) Short-term Debts: This is normally facilitated by treasury bills which mature
after 90 days. Thus, this enables the government to borrow money from the
public within a short period of time.

f) Long-term debts: These can take 5 – 10 years and above.

KASNEB – DEC 2003 – Question 7 (a)

“Taxation does not offer sufficient revenue for the government expenditure, hence the
government resort to public debts”.
In light of the above statements name the causes of public debts. (3mks)

Causes of increase in Public Debt.

• Increase in population
• War expenditure
• Higher increase in tax evasion
• Natural calamities which interfere with the production of goods and services e.g.
drought.
• Expansion of public and merit goods
• Ineffective planning
• Increase in government administrative system forces e.g. policy, provincial
administration, etc
• Budget deficit in order to stimulate economic growth
• Increase in social welfare
• Unfavorable balance of payment.

6
 NATIONAL BUDGET

Definition of a Budget

A budget is defined as a master plan of estimated government revenue and proposed

expenditures in a specific period usually one year and is a key policy instruments used to
directly or indirectly to influence activities in a given country or economy. Usually a
budget is a statement presented by the Minister for Finance to Parliament for approval,
which contains an estimate of government revenue and expenditure during the next
Financial (Fiscal) Year. In Kenya, for example, Financial Year begins on July 1st and
ends on June 30th the following year. Budget may be on three types of relations to
revenue and expenditure:

• If government expenditure is greater than revenue then such a budget is known as

deficit budget.
• If government revenue is greater than government expenditure, it is known as
surplus budget; and
• If the government expenditure and revenue are equal, it is known as balanced
budget.

A budget deficit is a macro-economic problem and therefore a concern to any economy

especially in developing countries. (For the causes of budget deficit, see notes on causes
of increase of public expenditure and public debt.)

KASNEB PAST PAPER QUESTIONS

1. June, 2003 (Question 7)

a) What is meant by the term “balanced budget”? (4mks)
b) Explain the causes of budget deficit in developing countries. (8mks)
c) Suggest policy measures that developing countries should take in order to reduce budget deficit. (8mks)

2. Dec. 2000 (Question 7)

a) What are the main causes of budget deficits?
b) Explain why reduction of government deficits has increasingly become an important issue in fiscal policy framework
of developing countries.
c) Outline how each of following may contribute to economic growth and development in developing countries.
i. Domestic economic governance and transparency
ii. Activities of commercial banks and non-bank financial industry.

3. July, 2000 Question 6

a) What is a government deficit. (2mks)
b) Explain the main causes of the huge budget deficit being experienced in the most sub-Saharan African countries
including Kenya. (7mks)
c) What are the major methods of financing budget deficits used by these countries? (4mks)
d) The impact of budget deficit on the economy of a country depends on the sources of financing the deficit. Explain
the impact of each of the methods of financing deficit discussed above in © on the economy and the business sector
in general. (7mks)

7
DEFICIT FINANCING

Deficit Financing means issuing of new notes or borrowing from central bank and is
mostly used by most countries for development purposes, that is, if there is shortage of
funds, then the government can borrow money from central bank to complete new
development projects such as road construction. Deficit financing method should be used
when other sources of internal and external finance are not sufficient. Otherwise if it is
abused, it can lead to inflation resulting from increase in supply of paper money.

The Functions of a Budget

The budget fulfils the following functions:

1. To Raise Revenue in order to meet Government Expenditure: The government of

a country provides certain services such a s administration, defense and
maintenance of law and order, environmental services, social services and
economic services, also it must meet charges on public debt. Sufficient revenue
must be raised to meet the necessary expenditure. The budget provides ways and
means of raining such revenue.
2. It is a Means of Redistributing Wealth: In many developing countries, a situation
has arisen where a small proportion of the population owns a more than
proportionate share of the nation’s wealth, while the majority of the population
owns a small proportion of it. One method of redressing such inequalities of
wealthy people are not only paying more tax raised through this method can be
used to provide free services such as health services, primary, secondary and
higher education to the low-income group of the population.
3. To control the level of Economic Activity: This is achieved either by monetary or
fiscal policy. The government implements fiscal policy through the budget to
counter macro-economic problems such as inflation, unemployment, balance of
payments deficits, etc.
4. Budget as an instrument of Planning: Budget is an important instrument for
achieving objectives of fiscal policy and it must be consistent with the national
economic development plans. National budget should therefore be prepared
within the framework of four- or five-year’s development plans, sessional policy
documents, national long-term development plans, etc.

Budgetary Policy

Budgetary policies are measurers designed to achieve clearly defined budgetary

objectives. Budgets are annual plans designed by the government to achieve specific
economic objectives such as:

8
 • Price stability (i.e. control inflation)
• Encourage investment
• Promote economic growth
• Achieve equitable distribution of income
• Raising government revenue for provision of government services.

Therefore, a national budget is a means through which the government regulates the
economy. Budgetary policies are closely related to both monetary and fiscal policies in
order to achieve budgetary objectives.

TYPES OF BUDGETS

Budget may be of two types:

1) Revenue Budget: Relates to normal income and expenditure items.

The main sources of revenue budget are:

• Custom and exercise duty

• Income and Corporation Tax
• Value Added Tax (VAT)
• Income from the sale of state property and fines
• Dividends and profits from government investments.

Recurrent budget contains expenditure on day-today running of government functions

such as provision of:

• Defense services;
• Administrative services (e.g. civil servant salaries);
• Educational
• Health services, etc.

2) Capital Budget: Capital budget relates to development projects. Its main source
of income includes loans and grants obtained by the government.

FISCAL POLICY

Definition Keynes Defines fiscal policy that policy which uses public finance as a
balancing factor in the development of the economy.

However, a more broad definition of fiscal policy is that it is the action by the
government to spend or collect money in form of taxes with the aim of influencing the
level of economic activities. Fiscal policy therefore involves a component of public debt
management.

Objective of Fiscal Policy

9
The main objectives of fiscal policy are to:

• Achieve a desirable price level (price stability)

• Achieve desirable consumption level
• Raise employment level
• Achieve fair distribution of National Income
• Increase the level of economic growth

Tools or Instruments of Fiscal Policy

The government may use fiscal policy to intervene in the economy in the following ways:

• By spending more money and financing those expenditures through borrowing

(public borrowing).
• By collecting more taxes without increasing public expenditure (public revenue).
• By collecting more taxes with the aim of increasing spending (public
expenditure).

Therefore, from the above, tools or instruments of fiscal policy are:

• Public borrowing (public debt).

• Public revenue (taxation).
• Public expenditure (public spending).

The government can therefore achieve the objectives of fiscal policy by changing public
expenditure, taxation policy, and public borrowing. For example, during inflation, public
expenditure is decreased, more taxes are imposed and internal (domestic) borrowing is
increased. On the other hand, during economic depression and recession, the government
advances loans to individuals while public expenditure is increased and taxes are
reduced.

Changes in the level of government expenditure and taxation could be used to eliminate
inflationary and deflationary gaps. When aggregate expenditure is more than or exceeds
national income output leading a tendency of price increase phenomena referred to as
inflation. On the other hand, deflation is where the aggregate expenditure is less than the
national income leading to decrease in general price levels.

Additional government spending could create a multiplier effect on national income

although such public sector spending may have the effect of “crowding out” private
sector investments owing the increase in interest rates. What is crowding out?
“crowding out” refers to the process by which a rise in government borrowing displaces
the private investment spending.

10
KASNEB PAST PAPER QUESTION
1. December, 2002 question 8(b)
With regard to fiscal policies, discuss short-run measures a government of a developing country may adopt to
ensure sustainable economic growth. (10mks)

2. May 2005 question 1 (b)

a) Briefly explain how changes in the tax policy can be used to spur growth in the agricultural sector.
(6mks)

FISCAL POLICY AND BUDGET

The effects of budgetary deficits

1) Keynesian View of Point: According to Keynesian perspective, a budget deficit
may not in itself be a problem. During the times of unemployment and recession,
the government may deliberately create or allow budget deficit to develop with
the intention of stimulating economic growth. This increase in government
expenditure may be illustrated with the help of the following diagram:

W = S+T+M

J=I+G+X

J4+G+X

45o
0 12 yc yf National Income

From the above diagram, the nation income is in equilibrium at level Yc where
withdrawals are equal to injections (W = J). This level of income fails short of full
employment levels Yf. According to Keynesian view point,, if the government increases
it’s spending to (G*) to exceed its income (taxation) then through the multiplier effect,
National Income will be increased towards Yf. A new equilibrium at Yf is achieved
with, withdrawals being equal to injections by which government expenditure or
spending exceeds taxation. In this context there is a budget deficit since government

11
expenditure exceeds its tax revenue. Therefore according to Keynes this is viewed as a
positive measure for taking the economy out of recession and contributing to greater
employment.

2) Monetarists Assessment of the Effects of a Budget Deficit

The monetarists assessment of the effects of a budgetary deficit differs with those
expressed by Keynes. They argue that:

a) Excess spending by the government may increase inflationary pressures when an

economy attain full employment, national income can increase only in monetary
terms implying that prices will increase.

b) Budget deficits have to be financed and this will usually done through the flow of
government borrowing. Government borrowing is usually done through the flow
of government securities such as treasury bills and treasury bonds. This will
have the following effects:

i. In situation where capital market is depressed then the price of

government securities will have to fall to encourage buyers.
Falling government securities prices implies rising interest rates.
An increase in interest rate may deter (affects negatively)
investments and also contributes to a strength of the exchange rate
which may negatively impact in a country’s export.
ii. The possible interest rates increase may crowd out private sector
investment, which would have contributed to capital stock, or
investment to facilitate future increase in output or national
income.
iii. An increase in government borrowing implies that the national
debt also rises. Internal or domestic debt imposes a problem
because of the interest payment burden. The payment of interest
may have to be funded by tax increases, which raises the
controversial issue of disincentives.

As per above arguments, if price stability is to be maintained, budget deficits are

thus a concern especially in developing countries.

EFFECTIVENESS OF FISCAL POLICY IN DEVELOPING COUNTRIES.

The effectiveness of fiscal policy in developing countries is influenced by the following

factors:

1) The Nature of Economy

• A fiscal policy is more effective where the economy is monetarized and
since most developing economies are non-monetarized, fiscal policy is
likely to be ineffective, as most of the goods do not reach the market where
subsistence sector is said to be predominant.

12
 • Size of public sector vis-à-vis (in relation to) the public sector. Influences
the effectiveness of the fiscal policy. The more important the public sector,
the more effective the directive measures such as government expenditure
will be.
• The dominance of the agricultural sector in relation to industrial sector also
influences the effectiveness of the fiscal policy. The more dominant the
agricultural sector the less efficient the fiscal policies because agricultural
activities in developing countries are generally more difficult to tax due to
poor record keeping. Taxation is more efficient where industries sector is
dominant.

2) How Fiscal Policies are implemented

• It is difficult to implement projects which are not properly appraised (to
determine their financial and economy viability) and this is very common in
donor sponsored projects in developing countries. It therefore becomes
difficult to apply a tool or instruments such as public expenditure where
donor sponsored projects constitute a large proportion.
• It is difficult to implement fiscal policy in developing countries due to extent
of tax evasion. Tax systems have loopholes and some tax collectors are
incompetent and corrupt.

3) The Nature and Objective to be Achieved

Fiscal policy measures are more appropriate to problems such as unemployment
and inflation but not in addressing problems such as balance of payment deficit.
The choice and quality of policy mix chosen is also vital. The fiscal and
monetary policy mix should be well chosen to address the macro-economic
problem that is being dealt with.

KASNEB PAST PAPER QUESTION

1. June, 200 Question 8
a) What monetary and fiscal policies can a government adopt to reduce inflation? (12mks)
b) Explain the factors that may affect the effectiveness of the policies mentioned in (a) above. (8mks)

2. Dec. 2002 Question 8 (b)

With regard to fiscal policies discuss short-run measures a government of a developing country may adopt to
ensure sustainable economic growth. (10mks)

3. Dec 2001 Question 8.

a) Explain how both fiscal and monetary policies are used to influence the performance of an economy. (8mks)
b) Discuss the factors which limit the effectiveness of monetary and fiscal policies in developing countries.
(6mks)

4. 13