PUBLIC EXPENDITURES AND PUBLIC DEBT DISCUSSION

Introduction
The economic functions of government often times do require expenses to be made
by government. These expenses are analyzed within the framework of public
expenditures.
Public expenditures refer to the outlay, expenses or costs that government usually
incurs for maintenance of itself as an institution, the economy and the society.

Classification of public expenditures

Generally, public expenditures can be classified based on what one wishes to
achieve by such classification. As a result, there are several classifications (hence
making the issue of classification of public expenditure more subjective) but we will
look at a few of such classifications. Note that classification of public expenditures
here refers to the systematic arrangement of different items on which the
government incurs expenditure from various points of view.

Objective Classification
This looks at public expenditures as Personnel compensation Expenditures (eg.
Compensation for full time permanent jobs, emoluments for consults of projects, etc)
and Personal benefit Expenditures ( eg. T&T expenses, grants and subsidies etc).

Functional classification
This classification is based on the services that public or govt expenditures provide.
Two categories here include General Public Service Expenditures (eg. Spending on
defence, education, social security and welfare, housing and community amenities),
and Economic Service Expenditures (eg. Spending on agriculture, mining,
manufacturing, electricity, roads, railways and communications)

Economic classification
This classification is often referred to in many analyses. Three categories are
normally identified:
Recurrent Expenditures (generally spendings on day-to-day administration of the
public sector activities or govt machinery and to maintain the existing facilities in the
economy including wages and salaries, maintenance of social services and security,
interest payments, subsidies and transfer payments);
Capital Expenditures (spending on all investment in infrastructural projects;
physical assets that are for long term purpose or generally productive investments
like housing, road construction, agriculture and water resource).
Expenditure on Memorandum items (eg. Expenditure abroad, domestic lending,
lending abroad, expenditure on activities of international organizations, or in aid of
support for international organization activities)

Other classifications include: Productive expenditures vs Unproductive expenditures;

Development vs Non-development expenditures, etc.
Classification of public expenditure in Ghana
In Ghana, government expenditure is mainly categorized into two: Discretionary
expenditures and statutory expenditures.
Discretionary expenditure consists of that expenditure for which the government
can exercise some judgment with respect to the quantum of resources it provides.
Statutory expenditure, on the other hand, is obligatory for government to undertake
since it is usually defined by legislative instruments or backed by some legal
authority.

Discretionary expenditure is further classified into four major categories:

• Personnel emoluments,
• Administration,
• Services,
• Investment
Statutory expenditure includes:
• Transfer to statutory funds such as the district assembly common fund
(DACF),
• Transfers to households through the social security system and gratuities,
• Ghana Education Trust Fund (GETFUND),
• The Road Fund
• Public expenditure refers to the cost of carrying out government provision of
goods and services.

Measurement of public expenditures

Absolute measurement: eg. €7.8m
Percentage measures: eg 44% of GDP.

Canons (principles) of Public expenditures

Good attributes of public expenditures:
1). Canon of Economy: Public expenditures (PE) should not be wasteful; it should
be productive and efficient. To ensure this in Ghana, we have Public Accounts
Committee, PFM Act, Fiscal responsibility Act, Auditor General’s surcharges and
disallowance.
2). Canon of sanction/approval: No expenditure should be incurred without the
prior approval of the appropriate authority. This is to avoid misuse of public funds or
reckless spending. In Ghana, government first seeks approval from Parliament for
spending plans (appropriation) of Ministries, MMDAs, etc.
3). Canon of surplus: Refers to avoidance of deficits in government finance. Govt
should live within its means. Public bodies should aim at budget surpluses. Routine
public expenditures should be met from current revenues and not from borrowings.
Hardly met in Ghana so Fiscal Responsibility Act specifies 5% budget deficits as a
rule. Because deficit budgets sometimes support capital formation or increases
overhead economic and social capital.
4). Canon of benefit: PE should bring maximum social advantage. PE should be
planned to yield maximum social advantage and social welfare to the entire
community and not just a segment. Examples: increased production, security,
narrow income inequalities, serve public interest.
5). Canon of Elasticity: PE should contain an element of flexibility so that it is
amenable to changing circumstances: can be expanded or contracted in emergency
situations like floods, war, external shocks, or difficult periods. Example: Recent cuts
in expenditures due reasons offered.
6). Canon of productivity: PE should aim at improving the productive capacity of
the economy: development purposes, raise output, employment, and income,
provide social amenities, etc.
7). Canon of Equity: PE should aim at equitable distribution of income especially
more benefits for the poorer in society to reduce inequalities e.g. health, education,
and housing facilities.

Principles/impact/effects of public expenditures

The principles of public expenditures refer to the application of economic theory to
examine the consequences of public expenditures programmes. In doing this, we
distinguish:

Allocation effects
This refers to the way an expenditure program affects pattern of goods and
services produced in the economy. For instance, does a given government
subsidy raise output in the economy or does it raise consumption in the targeted
area of the economy.

Redistributive effects
This also looks at how government expenditure redistributes income within the
economy in order to achieve some equity. That is to say that, who benefits from
the expenditure process and who loses?
Stabilization effects
This refers to role of government expenditure in achieving specified targets of
levels of output and employment as well as stabilization of prices. Expenditure
methods can be used to check inflationary pressures or raise a modest inflation
rate.

Other perspectives on the effects of public expenditures

1. Effects on Production
The effect of public expenditure on production can be examined with reference to its
effects on ability & willingness to work, save & invest and on diversion of resources.
(a) Ability to work, save and invest: Socially desirable public expenditure
increases community's productive capacity. Expenditure on education, health,
 communication, increases people's productivity at work and therefore their
incomes. With rise in income savings also increase and this in turn has a
beneficial effect on investment and capital formation.
(b) Willingness to work, save and invest: Public expenditure, sometimes,
brings adverse effects on people's willingness to work and save. Government
expenditure on social security facilities may bring such unfavourable effects.
For e.g. Government spends a considerable portion of its income towards
provision of social security benefits such as unemployment allowances old
age pension, insurance benefits, sickness benefit, medical benefit, etc. Such
benefits reduce the desire to work. In other words they act as disincentive to
work.
(c) Effect on allocation of resources among different industries & trade:
Many a times the government expenditure proves to be an effective
instrument to encourage investment on a particular industry. For e.g. If
government decides to promote exports, it provides benefits like subsidies,
tax benefits to attract investment towards such industry. Similarly government
can also promote a particular region by providing various incentives for those
who make investment in that region.
2. Effects on Distribution
The primary aim of the government is to maximise social benefit through public
expenditure. The objective of maximum social welfare can be achieved only when
the inequality of income is removed or minimised. Government expenditure is very
useful to fulfill this goal. Government collects excess income of the rich through
income tax and sales tax on luxuries. The funds thus mobilised are directed towards
welfare programmes to promote the standard of poor and weaker section. Thus
public expenditure helps to achieve the objective of equal distribution of income
through spending towards welfare programmes that promote the standard of living of
the poor and weaker section of the society.
Expenditure on social security & subsidies to poor are aimed at increasing their real
income & purchasing power. Public expenditure on education, communication,
health has a positive impact on productivity of the weaker section of society, thereby
increasing their income earning capacity.
3. Effects on Consumption
Public expenditure enables redistribution of income in favour of poor. It improves the
capacity of the poor to consume. Thus public expenditure promotes consumption
and thereby other economic activities. The government expenditure on welfare
programmes like free education, health care and housing certainly improves the
standard of the poor people. It also promotes their capacity to consume and save.
4. Effects on Economic Stability
Economic instability takes the form of depression, recession and inflation. Public
expenditure is used as a mechanism to control instability. The modern economist
Keynes advocated public expenditure as a better device to raise effective demand &
to get out of depression. Public expenditure is also useful in controlling inflation &
deflation. Expansion of Public expenditure during deflation & reduction of public
expenditure during inflation control money supply & bring price stability.
5. Effects on Economic Growth
The goals of planning are effectively realized only through government expenditure.
The government allocates funds for the growth of various sectors like agriculture,
industry, transport, communications, education, energy, health, exports, imports, with
a view to achieve impressive growth.
Government expenditure has been very helpful in maintaining balanced economic
growth. Government takes keen interest to allocate more resources for development
of backward regions. Such efforts reduce regional inequality and promote balanced
economic growth.

PUBLIC EXPENDITURE GROWTH MODELS

Critical observations have been made about the quantum and trend of government
or public expenditures and various attempts made to explain the phenomenon of
government expenditures and management strategies. It is generally observed that
government or public expenditures tend to increase with time. Various arguments
have therefore been advanced by research to explain the phenomenon in what is
termed as models of public expenditure growth. These models attempt to answer the
question: What accounts for the growth in government expenditure? These
include Musgrave-Rostow Development Model, Wagner’s model (The Law of
Increasing State Activity), the peacock-Wiseman model (Displacement Effect Model).

Musgrave-Rostow Development Model

This model suggested that the growth of public expenditure might be related to the
pattern of economic growth and development in societies. Three stages in the
development process could be distinguished:

(a) The early development stage where considerable expenditure is required on

education, health and the infrastructure of the economy (also known as social
overhead capital). Under normal circumstance, these necessary expenditures should
have come from private savings. But at the early stage of development, private saving
is inadequate to finance these necessary expenditures. According to Rostow and
Musgrave, at the early stages of economic development, the rate of growth of public
expenditure will be very high. This is the case because at the early stages of economic
development, the government provides the basic infrastructural facilities (social
overhead capital) and most of these projects require huge capital, therefore the
spending of the government will increase steadily.
The investments in water education, health, water, roads, electricity, and water supply
(Social Overhead Capital (SOC)) are necessities that can launch the economy from
the traditional stage to the take-off stage of economic development, making
government to make increasing expenditures. At this stage, government expenditures
as a proportion of total output or GDP is really high.
(b) This stage or phase is characterised by rapid growth (given that SOC is adequately
provided) in which there are large increases in private saving and public investment
falls proportionately because private savings are high enough to finance expenditure
on education, health and infrastructure. Hence in the second stage of development,
public expenditures fall proportionately with an increase in private savings.

(c) The third stage identified in high income societies with increased demand for
private goods which need complementary public investment expenditures (e.g. motor
car, urbanisation and good roads). Besides, high population movements could also
lead to development of slums in this stage hence need high government expenditures
to address such problems together with redistributive welfare expenses such as
unemployment benefits, transfer payments, etc.

Summary of this model: Public expenditures vary with the stage of development.
It is high in the early stages of development, falls in the second stage of development
and the rise again in the last stage of development. The arguments advanced by this
model are interesting in relation to theories of growth and development but are rather
too general to provide much of a guide to recent experience in developed industrial
countries.

Wagner’s Model: The Law of Increasing State/Government Activity

Based on Adolf Wagner’s study on public expenditures, he propounded a law called
"The Law of Increasing State Activity" which states that "as the economy develops
over time, the activities and functions of the government increase". In other words,
Wagner’s law states that as per capita income of an economy grows, the relative size
of public expenditure grows along with it. This observation was made because there
was a direct relationship between growth of output or GDP and government
expenditures in absolute and specific terms, and the share of public sector activities
in GDP was increasing over time.

Can this law be justified? On what basis?

1. Economic growth results in an increase in complexity of society requiring
continued introduction of new laws and development of the legal structure. As
the economy grows, there will be an increase in the number of urban centers
with the associated social vices such as crime which require the intervention of
the government (new laws, legal structure etc) to reduce such activities to the
barest minimum. Such interventions will come with increasing costs.
2. Economic growth and development comes with urbanization. Urbanisation
increases situations of externalities and market failure which necessitate
intervention (regulation and legislation) to address such externalities and
market failure.
3. To sustain economic growth and development, there is need for increased
government or public expenditures to serve as a permissive force for directly
productive activities (DAP). These expenditures are needed to provide social
 overhead capital to create enabling environment for enterprises and put
business activities on expansion path.
4. Over time, as the economic grows, luxury goods gradually become necessities
and government has to provide complementary public goods for such luxuries.
For example, ownership of a car in Accra is no more viewed as a luxury but like
a necessity. Thus, as per capita income grows there will high preference for
certain private goods which need more social goods to complement their usage
or consumption.
5. Often times, economic growth also elicits quest for increased civil, social and
political rights and democratization. Embarking on these activities to advance
citizens’ civil and political rights call for increasing government expenditures.
Eg. Government or public expenditures over-run their targets in almost every
election year in Ghana. The budget for the Electoral Commission in Ghana is
huge every election year and has to be paid for by the government. Expenditure
shocks have therefore become a common phenomenon after many elections
in Ghana.
6. For purposes of equity, as the economy grows need for redistribution policies
become very much pronounced. Governments therefore have to maintain a
certain standard of living eg. 2 dollars per day etc, this makes governments
draw up huge expenditures for transfer payments for such purposes:
unemployment benefits, LEAP, school feeding, free school uniform among
others.
7. Government failure issues (rent-seeking directly unproductive activities,
corruption, small power broker controls etc) can also account for increasing
public expenditures especially in developing economies where mechanisms for
accountability, transparency and fiscal discipline are lacking. Though this point
does not fall in line with the basic Wagner’s law, it is a strong reason for high
public expenditures in Ghana.

Can we always justify rising public expenditures? To what extent can they be
justified? What are your proposals on how to strategically manage public
expenditures? Discuss this among yourselves!

Hint: Quality spending (capital expenditures)-spending which yields returns in the

future or prioritization of expenditures, cutting waste in expenditures- pay roll
clean-up exercise, halt of initiation of new projects and concentration on
ongoing projects, Need for workable cost-benefit analysis (CBA), financing
and time value.

Peacock-Wiseman model (Displacement Effect Model)

This model explains that government expenditures are often times shifted upwards
because in times of crisis (eg war, famine, drought, upheaval etc), the citizen are
willing to pay some more tax to enable government solve such problems but
thereafter government will keep its expenditures at that high level after the crisis as if
that is the usual trend. This temporary rise in expenditures, which later turn out to be
permanent provide another reason while there is rising public expenditures. The
displacement effect comes handy when the private expenditure is displaced
downwards (as a result of increased taxation) while government expenditures are
displaced upwards during such periods of crises and thereafter.

COST BENEFIT ANALYSIS (CBA)

It is a technique normally used in assessing, in monetary terms, whether or not the
costs of an activity (or public expenditures earmarked or proposed) can be justified
by the outcomes and impacts. Taking government expenditures as an activity for
instance, CBA will elicit whether or not government expenditure is worth embarking
upon in order to ensure efficiency in public spending.

What can we use CBA for?

■ Informing decisions about the most efficient allocation of resources
■ Identifying projects that offer the highest rate of return on investment

ADVANTAGES:
■ Good quality approach for estimating the efficiency of programs, projects and
expenditures
■ Makes explicit the economic assumptions that might otherwise remain implicit or
overlooked at the design stage.
■ Useful for convincing policy-makers and funders that the benefits justify the activity

DISADVANTAGES:
■ Fairly technical, requiring adequate financial and human resources available.
■ Requisite data for cost-benefit calculations may not be available, and projected
results may be highly dependent on assumptions made.
■ Results must be interpreted with care, particularly in projects where benefits are
difficult to quantify.

FINANCING OF GOVERNMENT ACTIVITIES

Government often times rely on tax and non-tax sources of revenue to finance its
expenditures. While the tax sources are more domestic in nature, the non-tax
sources could be both domestic and external.

Tax revenue
Revenue from various taxes eg income taxes, property taxes, domestic taxes, taxes
on international trade (import and export duties) etc.

Non-tax revenue
Grants (aids), loans (borrowing domestically and abroad), Sale of assets, goods and
services by government- revenue from divestiture or privatization, User charges
(road toll, talk time tax), and Monetization.
In most countries especially the developing countries like Ghana, tax is the major
source of government revenue. In fact in Ghana, tax revenue forms the largest
proportion of government revenue. As a consequence, taxes can also be described
as the basic source of government revenue. Therefore, government revenue could be
divided into tax revenue and non-tax revenue.

PUBLIC DEBT ANALYSIS

Public debt (also known as government debt, national debt) is money (or credit) owed
by any level of government; either central government, regional government, municipal
government or local government.
Public debt accrues over time when the government spends more money than it
collects in taxation. As government engages in more deficit spending, the amount of
public debt also increases.

Why Governments Borrow

Countries borrow because of their inability to generate enough savings which
could be used for investment and hence growth. This is because the incomes of
developing countries such as Ghana is so low that it is hardly adequate for personal
consumption and therefore individuals are not able to save enough.
Countries borrow to promote economic development, ensuring that there exists
enabling environment for people to invest their money in other sectors of the
economy.
Borrowing is necessary to meet the financing requirement of the government. Where
government has a budget deficit, then the best alternative is to borrow or increase
taxes.
Governments borrow in order to close the resource gap between savings and
investment.

Nature of public debt

• Public Debt can be either internal (where citizens and groups within the country
lend the government money to continue operating through issuance of
government securities) or external (money owned to foreign lenders like
international organizations, other govts, or foreign groups). It can also be
classified as long term (designed to last more than ten years) or short term debt
(foreseen to last only one or two years).

Sources of public debt

Domestic (internal) and External sources
Ghana’s domestic debt sources:
(1) development stocks (floated mainly to raise long term finance for
development projects by the government. Its maturity ranges from five to
twenty five years),
 (2) treasury certificates (Treasury certificates are short term debt instruments
where governments borrow. Their maturity is of two denominations; one
year and two year periods. Treasury certificate is also affected by the
practice of rolling over the issues),
(3) treasury bonds (were introduced with the objective of minimizing debt
service payments rather than providing deficit financing to meet budgetary
gap. Treasury bills and certificates outstanding can be converted into fixed
interest bonds; carrying a fixed rate of interest of five percent and are wholly
held by the BOG).
(4) Treasury Bills are short term debt instruments that mature within 91 days.

External sources of debts

Loans from international organizations and interests, international debt markets

Consequences of domestic borrowing and external borrowing

Borrowing in the domestic economy through the money and capital market has the
advantage of arresting foreign exchange leakages or outflows of investment funds.
Also, it has the advantage of developing the financial market in a bid to mobilize
domestic savings for both public and private sector investment.
However, borrowing by government must be guided because excess borrowing will
shrink investible funds in the money market ‘crowding out’ investors (crowding out
effects).
On the other hand, most external debts tend to have concessionary rates and long
maturity. These debts thus tend to be cheaper than domestic borrowing. Given its long
term nature, concessional external debts are also likely to be safer than domestic debt
which often has short maturity and is subject to roll-over risk.
However, the supply of external funds tends to be volatile and pro-cyclical. Moreover,
large industrial countries can borrow abroad in their own currency, but most
international borrowing by emerging and developing countries is in foreign currency.
These might lead to foreign currency debt explosions.
Summary:
• There are two main sources of Ghana’s public debt; domestic sources and
external sources.
• Domestic debts are sourced from the domestic economy through the Bank of
Ghana and other financial institutions
• External debts are obtained from bilateral and multilateral sources.
• Borrowing from domestic and external sources has their consequences and
various governments ought to consider these before deciding on which source
to borrow from and the structure of their debt.

Causes of public debt

Unviable projects, Rise in interest rates, International Economic Recession,
Availability of cheap credit, Ownership of public corporations debts, etc
Public Debt Sustainability
Debt sustainability is the ability of government to service its borrowings, both internal
and external, without resorting to rescheduling or accumulation of arrears.
The IMF and the World Bank define the external debt sustainability of a country as its
ability and willingness to “meet the current and future external debt service obligations
in full, without recourse to debt rescheduling or accumulation of arrears and without
compromising growth”.
This concept of sustainability focuses on the behaviour of the borrower (the
borrower’s willingness and ability to repay its debt “in full”) rather than on the behaviour
of the lender (based on the lender’s liquidity and investment alternatives).
According to this view, the signal of an unsustainable debt is clear: a country receiving
external debt relief (in form of debt rescheduling or debt forgiveness) is in a situation
of “excess” of debt. That is, the current debt level is higher that the sustainable one.

Indicators of debt sustainability

Debt stock: The quantum of the total debt. However, the debt stock does not indicate
the capacity of the economy to service such debt obligations.
Debt burden indicators include the debt to GDP ratio, foreign debt to exports ratio,
and government debt to current fiscal revenue ratio. This set of indicators also
covers the structure of the outstanding debt including the share of foreign debt, short-
term debt, and concessional debt in the total debt stock.
Another set of indicators focuses on the short-term liquidity requirements of the
country with respect to its debt service obligations. These indicators are useful early-
warning signs of debt service problems, but also highlight the impact of the inter-
temporal trade-offs arising from past borrowing decisions.
Examples of liquidity monitoring indicators include the debt service to GDP ratio,
foreign debt service to exports ratio, and government debt service to current
fiscal revenue ratio.
Incurring high public debt is not necessarily bad. It is really bad if the ratios show that
the economy will be unable to service such debts.

Analysis of public debt burden

It is possible to explain the burden of public debt. Three schools of thought (The
Learner’s model,The overlapping generation model, and The Neoclassical model)
attempted this and their conclusion are summarized below:
• According to Learner’s model, the future generation will not bear debt
financing burden if the borrowed funds are invested into productive activities
(capital investments) which will yield benefits greater than the debt.
• According to the overlapping generational model, the old age at the time of
borrowing enjoy at the expense of the young generation at the time of payment.
 • According to the neoclassical model, borrowing imposes a burden on the
future generation through its impact on capital formation.
• It is quite clear from these models that the future generations do bear much
burden of public debt than the current generation. This is largely because the
future generation will have to pay higher taxes to pay off the debt.

The debt burden and intergenerational equity

Intergenerational equity is the equity between one generation (present) and another
(future) generation.
Arguments on the prospect of passing on the debt burden to succeeding
generations:

Fiscal solvency argument

A loan finance is a mere postponement of tax payment. The postponement makes
the burden fall on future generation causing future welfare loss to posterity.
Contracting a loan to finance development projects amounts to postponing tax
payments in which case the burden is shifted forward to the future generation.
If the government has to tax the people in the future to pay the loan (interest
payment & amortization), the burden then falls on the future generation.
This burden will not be acceptable (offers no equity) if the loan was spent on current
consumption e.g. on wages and salaries, etc.
Counter-argument: When the loan is invested into long-lasting projects the future
generation will benefit, even as they bear the burden so there is equity (benefit
principle). E,g.: Building of a sports stadium.

Debt-capital formation argument

Government can take loan or tax to finance its activities.
Tax financing falls on private consumption because it reduces disposable income.
Loan financing tends to fall on investment because a loan can crowd out private
sector, i.e. a reduction in private capital formation.
Tax financing reduces consumption, so the current generation bears the burden.
Loan financing will affect future generations because it reduces private investment
and loan payment by future generations.
To ensure intergenerational equity, loan financing should go into capital investments
by the state so that future generations can benefit.
We can have a situation of overlapping in inter-generational equity where investment
goods are concerned. In this case, the first generation bears part of the burden, and
the second generation bears the rest.
For instance, if investment projects are financed with borrowed money, the effect can
be inter-generational where the current bears some of the burden (in terms of short-
term interest payment) and the future generation bears the rest (in terms of
amortization). This often ensures intergenerational equity.

External debt and burden transfer

Loan financing through external sources has grave effect on the second generation.
But of the loan is used well to increase SOC to create enabling environment for
directly productive, future generation will benefit as well. Thus, it is possible the
benefits that future generations will get may even outweigh the tax burden they
shoulder in paying the loan. Eg. Hospital, School, robust economy.

Policy implications:
Policymakers should try to be minded about generational equity in public debt
issues.