LECTURE 2

TAXATION AND PUBLIC SPENDING

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 Introduction
• The ability of every government to perform its
role of providing public goods and other goods of
merit; and redistributing income and welfare
depends, to a large extent, on a sound fiscal
policy.
• Fiscal Policy refers to any government policy that
is consciously designed to affect government
spending and taxation.
• Government needs revenue or financial resources
to undertake certain functions.
• These revenues are generated locally or abroad.
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 Introduction

• Generally, government revenues are earned from

the collection of taxes or from other sources
called non-tax sources.
• Thus the main sources of government revenues
are: tax revenues and non-tax revenues.
• The non-tax sources include:
– Rents and royalties; licences and fees; lotteries;
– Court fines, penalties and forfeitures
– Sale of confiscated goods
– Borrowing from both internal and external sources
– Surpluses/profits from state-owned enterprises
– Aids, grants and gifts. AD 2015 3
 Tax Revenue

• The most important source of funds for most

governments is through taxes.
• A tax is a compulsory levy charged by a
government or public authority to pay for
expenditure.
• Thus, a levy imposed on an economic agent (an
individual or business) by the government to meet
its expenditure.
• Government demands this compulsory payment,
called tax, from its citizens or any other economic
unit that it can force to make the payment.
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 Tax Revenue
• Payment of tax is compulsory and an attempt to
evade or resist paying the tax is punishable by law.
• Tax evasion: occurs when an economic agent
refuses to comply with tax obligations.
• Per the law, if you earn income above a certain
threshold, you should pay tax.
• Anyone who earns above that level and refuses to
pay has evaded tax. This constitutes an illegality.
The same applies to a business entity.
• Tax avoidance: also occurs when an economic
agent does not engage in any activity that would
make them eligible to pay tax (i.e. not working).5
 Reasons, importance, uses of tax
• Tax is a source of revenue to the government
especially developing countries.
– Taxes help them to undertake recurrent and capital
expenditures.
• It may also be used to create economic stability
– In times of inflation, direct taxes could be increased to
take more money from the people. This will reduce
effective demand and help solve the problem.
• Taxes may be used to support the balance of
payments (BoP).
– A country experiencing continued BoP problems can
employ indirect taxes such as import duties, customs
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duties to help solve the problem.
 Reasons, importance, uses of tax
• The tax system may be employed to redistribute
income towards equity.
– This can be done through the progressive tax system
where the state take more from the rich to provide
basic amenities such as water, electricity and schools.
• Taxes may also be used to support and protect
infant industries.
– Here import duties and tariffs may be increased which
in turn will raise the prices of imported goods hence
switching demand to locally produced goods.
• Taxes may also be employed to prevent the
consumption of goods considered harmful to
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human health i.e. cigarettes.
 Reasons, importance, uses of tax
• Taxes can also be used to correct market failure.
– The activities of sachet water producers for instance
create a negative externalities in the form of waste.
The waste generated is neither taken care of by the
producers nor the consumers.
– This way the market can be made responsible for this
by the government imposing a tax such as
environmental tax in order to deal with it.
• Finally, taxes can also be used to create
employment opportunities.
– Some advocate for reduction in taxes for businesses in
order to attract them to invest and to create more
employment opportunities. 8
 Reasons, importance, uses of tax
• Exhibition of administrative power of the
government.
– A government might wish to extend its administrative
power to isolated regions or over a given population.
– It can use taxes as a means of showing its presence
and exercising its authority.

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 Types of Taxation

• Taxes can be classified in a number of ways.

• According to who levies the tax: Most taxes are
levied by central government, but the local rate is an
example of a local government tax.
• A few taxes, such as the water rate and airport taxes,
are levied by non-governmental public authorities.
• According to what is taxed: The major categories
here are taxes on income, expenditure and capital,
though other categories include pay-roll and poll
taxes.

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 Types of Taxation
• Direct and Indirect Taxation: These concepts are
often used interchangeably with taxes on income
and expenditure, though it is not strictly true that
a tax on spending must be an indirect tax.
Direct taxes:
• Taxes paid directly to the government by the
economic agent on whom the tax is imposed.
• They are usually levied on incomes, property and
wealth of individuals and businesses.
• Examples include income tax, profit tax, property
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 Types of Taxation

• Tax, personal property tax or taxes on assets,

capital gains tax. Such taxes are usually borne by
the one on whom the tax is imposed.
Indirect taxes:
• Taxes that are levied on goods and services,
transactions and privileges.
• Examples include sales tax, purchases tax, VAT,
import duties and export duties, excise duties,
users tax.
• One feature of this type of tax is that the one on
whom the tax is imposed is usually not the
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 Types of Taxation

• same entity that actually pay the tax or carries the

burden of the tax. They are able to shift it to
others.
• Specific tax: An indirect tax of a fixed sum per unit
sold.
• Ad valorem tax: An indirect tax of a certain
percentage of the price of the good.

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 Types of Taxation: Classification
Progressive, Regressive and Proportionate
Taxation:
• All of the taxes mentioned above can fit into
one of three types of taxation system -
proportional, pro­gressive, or regressive.
Progressive Tax System:
• In a progressive tax system a progressively
larger proportion of income is paid in tax as
income rises.
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 Types of Taxation
• Thus, the effective average tax rate (% of
income paid as tax) increases with income.
i.e. 8% => GH¢1,000 but 15% => GH¢1,500.
Regressive Tax System:
• In a regressive system, a progressively
smaller proportion is paid as income rises.
• Thus, a system in which effective average tax
rates or percentage of tax fall with income.
i.e. 8% => GH¢1,500 but 15% => GH¢1,000.
• Mr. A earns 1,500 and pays 150 = 10%.
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 Types of Taxation
Proportional Tax System:
• A tax is proportionate if exactly the same
proportion of income is paid in tax at all
levels of income.
• Thus, the effective tax rate does not change
with income.
• For instance individuals pay say 10% of their
income in taxes, irrespective of whether
they earn GH¢1,000 or GH¢1,500.
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 The Principles of Taxation

• These are norms that guide the design and

implementation of tax system to ensure that its
objectives are achieved. They include:
• Economy: Collection of a tax should be easily and
cheaply administered so that the yield is
maximised relative to the cost of collection.
• Convenience: The method of payment should be
convenient to the taxpayer.
• Certainty: The taxpayer should know what,
when, where and how to pay, in such a manner
that tax evasion is difficult.
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 The Principles of Taxation
• Efficiency: A tax should achieve its intended aim
without side-effects.
 If for example the raising of the top rate of
income tax, in order to raise revenue, results in
increased disincentives to work, then the tax is
inefficient.
• Flexibility: If the tax system is used as a means of
economic management then, in order to meet
new circumstances, certain taxes may need to be
easily altered.
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 The Principles of Taxation
Equity Principle: The principle of equity, when applied
to tax design ensures that there is fairness.
Vertical equity: Under this principle, the amount of
taxes that the government levies depends on the
relative abilities to pay them by the various groups
within the population. The more wealthy people pay
more, while poorer people pay less.
Horizontal equity: Requires that taxpayers in the
same economic circumstances should receive
equivalent treatment and therefore be made to pay
equivalent or same taxes.
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 The Principles of Taxation
 This means that individuals or firms that benefit
from similar types, classes and volumes of income,
privilege or access to any specified resources or live
under similar circumstances must be taxed equally.
 There should not be arbitrary exemptions, favours
or privileges granted to some and denied to others.
• Benefit Principle: Requires that those who benefit
more from the uses of the tax should be made to
pay more in taxes. E.g. Road construction, pipe
borne water, hospital etc.

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 Effects of taxes
• Taxation and Incentives: Progressive tax often
leads to disincentive to work i.e. working fewer
hours or even stop working at all.
• Expenditure taxes are preferable to income taxes
as it has no effect on choice between work and
leisure.
• Expenditure taxes increase the consumption of
untaxed goods and services.
• Fiscal Drag and Fiscal Boost: Fiscal drag is where
government fails to raise tax thresholds at the
same rate as inflation i.e. prices and incomes
double. In real incomes remains same w/o tax.
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 Effects of taxes
• But real disposable income falls in those who
hitherto were not paying tax are dragged into the
tax net.
• Also higher paid workers may be dragged deeper
into the tax net.
• Fiscal boost will reduce the real value of specific
expenditure taxes i.e. ad valorem taxes like VAT.
• Ad valorem tax is an indirect tax levied as a
percentage of the value of a transaction. E.gs. are
sales taxes, excise duties and value-added.
• Unless government adjusts the tax rate to keep
the pace of inflation, the real value will be eroded.
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 Incidence of Taxation
• The point where a tax or part of it is finally paid
and cannot be transferred to others for payment
is known as the incidence of taxation.
• The incidence of taxation is influenced by the
conditions of demand and supply of the affected
goods and not by any individual or government.
• Apart from the new equilibrium price and
quantity, and amount of tax revenue generated as
a result of the tax, there will also be the
deadweight loss.
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 Incidence of Taxation
• A deadweight loss can be defined as revenue that is lost to
the market after the imposition of tax.
• One can also explain it as a reduction in total market surplus
that result from a market distortion such as a tax.
s+t
A
s Explanation
PB Pwt = Price without tax
PB = Price buyer pays
B C
Pwt D E
PS = Price seller receives
B, D = Total tax to gov’t
Ps F B = Buyer’s share of tax
D = Seller’s share of tax
C, E = Deadweight loss
D A, B, C = Consumer surplus
D, E, F = Producer surplus
0 Q2 Q1 A = Consumer surplus left
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F = Producer surplus left
 Incidence of Taxation: Trial Question 1

• Assume an indirect tax is imposed on imported

rice to protect local rice producers and also
create employment.
• Using demand and supply analysis and with the
aid of a suitably labeled diagram,
a) Show how the burden is shared between consumers and
importers if the price elasticity of demand for rice is fairly
inelastic.
b) Indicate the deadweight loss and the total market surplus.
c) Show parts of consumer and producer surpluses that
have been taken from the consumer and the seller.
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 Incidence of Taxation: Trial Question 2
• Assume further that the government wants to deter people
from taking alcohol and so has imposed a tax of GH¢2.00 on
every crate of alcoholic beverages that come into the country.
• The effect of the tax is represented in the diagram below.
s+t
s
¢2.00
¢1.50
¢1.35
D
0 10 20
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 Incidence of Taxation: Trial Question 2
Required:
a) Calculate the revenue the government generates
from the tax?
b) How much is the deadweight loss?
c) Calculate the parts of consumer and producer
surpluses that,
i. Go to the government;
ii. Does not go to the government.
iii. The parts of the consumer and producer surpluses
that is lost due to the tax but does not go to the
government is also referred to as……….
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 Types of Public Spending
• Real expenditure: Real expenditure occurs
when the government directly provides
goods and services which add to national
output.
• All capital spending is real expenditure, as is
the current expenditure on the wages and
salaries of civil servants, local government
officers, teachers, police, the armed forces
and workers in the National Health Service.
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 Types of Public Spending
• Transfer expenditure; Conversely, transfer
expenditure merely redistributes income
between different members of the
community.
• Tax revenues are used to provide income via
pensions, welfare benefits, grants and
subsidies both to households in the personal
sector and to firms within the corporate
sector.
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 Types of Public Spending
• Loan servicing: This type of expenditure is
common is countries like Ghana that mostly
incur budget deficits.
• These deficits are normally financed through
loans which must be paid some time in the
future.
• Like transfer payments, loan servicing are
expenditures without the provision of goods
and services when they are incurred.
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 Objectives of Gov’t Exp.
• These include:
 Enforcement of law and order: Enactment of laws by
parliament and their enforcement by government
agencies like the police.
 Maintenance of security: The state ensures this in
various fields – air, land and navy.
 Provision of Economic Assets: Assets such as roads,
schools and hospitals
 Creation of employment: Teachers, nurses etc.

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 The Control of Public Expenditure

• Theory sometimes portray the level and

pattern of public spending as a controllable
policy instrument capable of being 'fine-
tuned’,
• or easily adjusted in the macro-economic
implementation of fiscal policy and the
management of the economy.
• In practice, however, the control of public
expenditure presents a number of formidable
difficulties:
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The Control of Public Expenditure
• Much expenditure is on necessary
services such as education, the police
and health care which are difficult to cut.
• Control of public expenditure is made
more difficult in a democracy by the
popularity of state spending and the
unpopularity of cuts.

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The Control of Public Expenditure
• Many types of expenditure change
autonomously for reasons outside
the government's direct control, and
sometimes these changes occur
automatically in the upswings and
downswings of the business cycle.
• Central government may have little
direct control over local government.
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