ECON 422 Notes

ECON 422: PUBLIC FINANCE AND FISCAL POLICY

TOPIC 1: INTRODUCTION

Public Finance

 This refers to the activities carried out by the government associated with raising finances
and then responding of the finances raised.
 Therefore, it is the study of how the government collects revenue and how it spends the
revenue collected.
 It, therefore, deals with the question of how the government rules its revenue to meet its
rising expenditure.
 It also deals with fiscal policies that ought to be adopted and implemented to achieve
certain objectives such as; price stability, economic growth, equal income distribution and
creation of more employment opportunities.
 Public finance is a branch of economics that attempts to identify and evaluate the effects of
various ways of raising government revenue and government expenditure programs and
policies on a countries economy.
 It can also be defined as a collection of revenue by the central government as well as the
local government and all expenses of revenue in the provision of public goods and
services.
 Public finance is not a new discipline and the classical economists touched on its aspects.
For example; Adam Smith in his book ‘wealth of nation’ talked about the four principles of
taxation.
 John Stuart Smith in his book included what he called the principle of taxation and
classification of taxes (direct and indirect taxes)
 Ricardo also discussed about the general effects of taxes on the economy.
 Malthus discussed the effects of population growth and government spending.
 Karl Marx also talked about public finance in terms of inequality and income distribution.
 Public finance is also the study of the principles underlying the spending and raising of
finances by public authorities.
 It is concerned with allocation of scares resources. It also deals with stabilization policies
and programs aimed at maintaining low levels of inflation and minimizing expenditure.
 It also looks at how some fiscal policies that affect the incentives of workers.
 It also looks at how the fiscal policy is used to create an enabling environment for the
private sector. It also looks at the nature of public goods as well as the market failure.
 ECON 422 Notes

The following areas constitute to the subject matter of public finance:

1. Taxation and its effects

2. Government expenditure
3. Public borrowing
4. Deficit financing

Components/Divisions of Public Finance

According to Prof. Dalton, the scope of public finance can be divided into four categories; namely
public revenue, public expenditure, public debts, and budgeting.

1. Public Revenue

It refers to the incomes and the resources received by the government from different sources i.e.;
taxes and borrowing.

2. Public Expenditure

It refers to the incomes and resources spent by the government.

3. Public Debt

Refers to the incomes and resources borrowed by the government.

4. Budgeting

Its aim is to control the process and operations of public revenue. It also includes the collection,
distribution of public money and, coordination of expenditure according to formulated plan.

Distinction between Public Finance and Private Finance

Public finance is the study of income, expenditure, borrowing and budgeting of government
revenues.

On the other hand, private finance is the study of income, expenditure, borrowing and budgeting
of incomes of individuals or company’s revenues.

Similarities between Public Finance and Private Finance

1. Objectives

Both public finances and private finance aim at satisfaction of human wants.
 ECON 422 Notes

2. Principles

Both government and individuals follow similar principles. i.e.; maximum social benefits while
spending its income and maximum utility.

3. Policies

Both public and private finances follow rational and irrational financial policies.

4. Income, Expenditure and Borrowing

Both the government and individuals face limited resources. Therefore, the government and the
individuals borrow finances or incomes.

5. Administration

Both the public finance and private finance require sufficient administration of resources.

Differences between Public Finance and Private Finance

1. Adjustment between Income and Expenditure

An individual determines his expenditure on the basis of his income. On the other hand, the
government estimates the expenditure and then determines the best way of raising the projected
revenues.

2. Elasticity

There is greater elasticity in public finance than in private finance as the government has many
sources of income compared to individuals.

3. Motives

An individual has a private motive (that of maximizing utility). They are rational and selfish.
However, the motive of the government is to improve the welfare of the society. They are
irrational and generous.

4. Expenditure

Individual expenditure is guided by habits and fashion, tastes and preferences while the
government expenditure is guided by the economic and social policy.
 ECON 422 Notes

5. Present vs Future

Individuals are mainly concerned with the present needs while the government is concerned with
both present and future needs and generation welfare. Government is concerned with sustainable
development that will satisfy the needs of the current generation without compromising the needs
of the future generation.

6. Budget

Individual budget is a secret affair while government budget is a public affair.

7. Bankruptcy

Government cannot be bankrupt while individuals can be bankrupt.

Sources of Public Finance

There are two main sources of public finance i.e.

 Public Revenue
 Public Debt

1. Public Revenue

It is the income that the government gets from its citizens

They include the following:

a) Tax: This is a compulsory payment laid by the government on individuals and firms
without any direct benefit to the payment. Examples are direct tax (PAYE) and indirect tax
(VAT).
b) Fines and Penalties: These are charges imposed on individuals, firms and cooperations
who break the laws of a country.
c) Surplus from public corporations (parastatals): Government parastatals provide
essential services to the members of the public. If their revenues exceed costs, they remit
the surplus to the government.
d) Fees: These are payments charged by the government for the direct services it renders to
its people e.g., license fees, marriage certificates fee, import license fee.
e) Rent and rates: These are charges on the use of government properties like game parks,
forests, government conference halls etc.
 ECON 422 Notes

f) Escheats: This is income obtained from the sale of properties of persons who die without
legal inheritance or proper will. Such properties are taken over by the state.
g) Dividends and profits: These are incomes received from government direct investments.
h) Interests from loans: It is advanced by the government to firms and individuals.
i) Profits from sale of public property like buildings and national parks.

2. Public debt / Government Borrowing

This is the money borrowed by the government when the public revenue is insufficient to meet all
government financial obligations. Government borrowing is also referred to as national debt. It
includes all the outstanding borrowing by the central government, local government and
government corporations.

The government can borrow from the local or external sources. Locally, the government can
borrow through the sale of treasury bills or bonds.

Externally, the government can borrow from international institutions such as the IMF and World
Bank.

Purpose of Public Finance

1. Provision of essential goods and services

The government has a responsibility of providing its citizens with essential goods and services
such as health, security, education etc., that may not be adequately provided by the private sector
because of high costs and risks involved.

2. Encouraging consumption of certain commodities

The government may encourage consumption of certain commodities by offering subsidies and
lowering taxes.

3. Controlling or discouraging consumption of certain commodities

The government may discourage consumption of certain goods like cigarettes and alcohol by
imposing heavy taxes on them.
4. Promotion of balanced regional development

This may be done by initiating development projects in areas that are underdeveloped or were
initially marginalized.
 ECON 422 Notes

5. Wealth distribution

This is done by heavily taxing the rich and using the money raised to provide goods and services
to the poor.

6. To promote economic stability

Economic instability may be caused by factors such as high rates of unemployment. Such
problems can be solved through public spending on projects that generate employment
opportunities. Examples of such projects are Kazi Mtaani, Kazi kwa vijana, Affordable Housing
etc.,

7. Creation of a conducive business environment

Through public expenditure, the government may develop and improve infrastructure such as
roads, electricity, water, etc., thereby creating a conducive environment for businesses to thrive.

8. To raise government revenue

Through public finance, the government raises revenue which it uses in provision of essential
goods and services to the public.
9. Improving balance of payments (BOP)

This may be done by imposing heavy taxes such as custom duty to discourage importation.
 ECON 422 Notes

TOPIC 2: THE ROLE OF GOVERNMENT IN DIFFERENT ECONOMIC SYSTEMS

Functions of the State or Government

1. Maintain a legal social framework

The government/state comes up with norms, provide information and services to help the
economy function better, establish a monetary system, define and enforce intellectual property
rights.
2. Maintaining competition
The government/state regulates natural monopolies and comes up with laws aimed at ensuring fair
competition in the market.
3. Provision of public goods and services
The government/state provides public goods and services that the private sector is unable or not
willing to provide.
4. Redistributing income
Higher income tax rates for the rich and provision of social security and providing health
insurance to the poor.
5. Correcting externalities
The government/state imposes taxes to reduce the negative externalities such as environmental
pollution and subsidies to encourage positive externalities such as education. Externalities exist
when some of the costs or benefits associated with the production or consumption of a product
spill over to third parties other than the direct producer or consumer of the product.
6. Stabilizing the economy
The government/state uses budget and monetary policies to promote economic growth, control
inflation and reduce unemployment.

Factors or Reasons that have led to Increased Government Participation (Government

Intervention) in an Economy

The following are some of the factors that have led to increased government intervention in an
economy:

1. Political reasons

The government is usually elected or re-elected into office based on the success of executing tasks
aimed at improving the well-being of the people or citizens.
 ECON 422 Notes

Some of the roles which can make a government to be elected and elected into office include
ensuring economic stability and improved economic well-being for the electorate.

2. Deficiency in market system

Market system is usually characterized by deficiencies that include market failures and
externalities. The government, therefore, has to intervene to correct these deficiencies in a market
system.

3. Scarcity of resources

Since the resources are scarce in both the private and public sectors of the economy, the
government has to intervene by coming up with policies aimed at ensuring efficient or optimal
allocation of resources.

4. The inability of the private sector to supply merit and public goods

Since the private sector is unable to adequately provide merit and public goods to all citizens, the
government has to intervene by providing those goods.

5. Provision of information

The government has to play a vital role of providing information to the private sector. Such kind
of information can relate to GDP, marginal propensity to save (MPS), marginal propensity to
consume (MPC), marginal propensity to invest (MPI), and economic performance of a country.

6. Maximum social benefits

The private sector is mainly driven by the profit motive and the aim of private sector is usually to
maximize profits.

The private sector usually ignores the role of ensuring maximum social benefits for the society.
The government thus intervene in the economy to ensure maximum social benefits for the
citizens.

7. Research and Development (R&D)

The government intervenes in the economy by carrying out research in its research institutions
such as KEMRI, KALRO, KEFRI etc.

This research is aimed at developing or coming up with the most efficient production techniques
hence quality output.
 ECON 422 Notes

The Role of Government in Different Economic Systems

The government usually intervenes in the economy due to shortcomings of the free market
mechanism. Due to market failure, government intervention in the economy became indispensable
for the for the growth of the economy.

Now, the question arises of determining the extent of government in regulating and managing
economic activities. This remains a debatable issue among various economists. This is because of
the reason that the government intervention is also not able to eradicate the economic problems of
a nation completely.

The following are some of the viewpoints given by different economists:

Different economists have given various viewpoints concerning the role of government in an
economy. According to Colin Clark, “the role of government must be held at a ceiling of 25% of
the national income.” According to Samuelson, “There are no rules concerning the proper role of
government that can be established by priori reasoning.”

From the aforementioned viewpoints, it can be concluded that the accurate and exact percent or
amount of government intervention in an economy is hard to decide and calls for an issue of
collective social choice. The extent of role of government differs in different economies. An
economic system is a way through which economic resources are owned and distributed.

Capitalist Economic System

A capitalist economic system refers to an economy that works on the principle of a free market
mechanism. It is also referred to as laissez-faire economic system. In a capitalist economic
system, the role of government is very limited.

Adam Smith points out the main functions of government. They include: maintaining law and
order in a country, make national defense stronger, and regulate money supply. According to
Smith, the market system administers various economic functions. However, over a period of time
the functions of government in an economy have increased significantly.

The Main Roles of Government in a Capitalist Economic System include:

(1) Developing and sustaining the free market mechanism.

(2) Eliminating any kind of restrictions on the working of the free competitive market.
(3) Increasing the effectiveness of the free competitive market system through various
measures.
 ECON 422 Notes

(4) Regulating and controlling various economic situations such as inflation using fiscal and
monetary policies.
(5) Controlling the power of monopolists and large corporations to elude various economic
problems such as unemployment and inequitable distribution of resources.
(6) Maintaining law and order, administering justice, and safeguarding the freedom of
individuals in an economy.
(7) Creating a conducive (favorable) environment for private ventures to thrive.
(8) Handling issues such as environmental degradation, depletion or extinction of natural
resources, and growth of population.
(9) Possessing the ownership of public utilities, such as railways, education, medical care,
water, and electricity, which are required by an economy as a whole.
(10) Prohibiting discrimination among individuals and providing them equal
educational and job opportunities
(11) Limiting restrictive trade practices and power of trade unions.
(12) Supporting private ventures in an economy.
(13) Creating central planning body that helps in the development of an economy on a
larger scale

Therefore, we can conclude that the major role of government in a capitalist economy is to control
and encourage the free market mechanism. In addition, the government should encourage private
ventures for safeguarding the future of an economy.

Socialist Economic System

Socialist economic system is a type of economic system in which property and the means of
production are owned in common, typically controlled or owned by the state or government.
Socialism is based on the idea that common or public ownership of resources and means of
production leads to a more equal society.

In a socialist economy, the function of government is entirely different from the function of
government in a capitalist economy. In a capitalist economy, the government acts as a regulatory
and complementary body. On the other hand, in a socialist economy, the government plays a
comprehensive role in almost all economic activities, such as production, distribution, and
consumption, of a nation. In a socialist economy, not only the ownership of private property is
allowed to a limited amount, but the concept of free market mechanism is also eliminated.
 ECON 422 Notes

The private ownership of resources, in a socialist economy, is changed by state ownership. In

addition, in a socialist economy, the government plans and regulates all the economic activities
centrally at a state level. Moreover, the decisions related to production, allocation of resources,
employment, pricing, and consumption, are completely dependent on the government or its
central planning authority. In a socialist economy, individual’s decisions are totally dependent on
the limit decided by the government.

For example, individuals are given the freedom of choice, but it is subject to the limitations of
policy framework of the socialist economy. The countries in which socialist economy is adopted
are China, Yugoslavia, Czechoslovakia, and Poland. The objective of the government in a socialist
economy is same as in the capitalist economy, such as growth, efficiency, and maintaining justice.
However, the ways adopted by the socialist economy to achieve those objectives are different
from the capitalist economy.

For example, in the capitalist economy, the main force of motivation is the private profit, whereas
in the social economy, the encouraging factor is the social welfare. The socialist way of managing
an economy facilitates the elimination of various evil activities of the capitalist economy, such as
labor exploitation, unemployment, and inequality in the society. This is only the classical view of
the socialist economy.

However, over a passage of time, the scope of socialist economy has also been reduced due to
various reasons, such as prohibition of profits from private ventures, inadequate utilization of
resources, and restrictions on economic development as noted by Union of Soviet Socialist
Republics (USSR).

Mixed Economic System

Mixed economy refers to an economy that comprises the features of both, the socialist economy
and capitalist economy. This implies that working of a mixed economy is based on the principles
of the free-market mechanism and centrally planned economic system.

In a mixed economy, the private sector is encouraged to work on the principle of the free market
mechanism under a political and economic policy outline decided by the government. On the
other hand, the public sector, in a mixed economy, is involved in the growth and development of
public utilities, which is based on the principle of socialist economy.

In a mixed economy the public sector comprises certain industries, businesses, and activities that
are completely owned, managed, and operated by the government. Moreover, in a mixed
 ECON 422 Notes

economy, certain laws have been enacted by the government to restrict the entry of private
entrepreneurs in industries reserved for the public sector.

Apart from this, the government also strives hard for the expansion of the public sector by
nationalizing various private ventures. For example, in India, the government has nationalized
several private banks, which has resulted in the expansion of the public sector. Besides working
for the growth and development of the public sector, the government, in a mixed economy,
controls the activities of the private sector by implementing various monetary and fiscal policies.

It should be noted here that the free-market mechanism is actually a form of a mixed economy.
This is because of the reason that in free market mechanism, both the private and public sectors
exist simultaneously. However, public sector in a free-market mechanism economy is different
from the public sector of the mixed economy.

In free market mechanism economy, the public sector is responsible to maintain law and order in a
country, make national defense stronger, and regulate money supply. On the other hand, the public
sector of a mixed economy is involved almost all economic activities, such as production,
distribution, and consumption. For example, the public sector of an economy, such as India, is
based on the socialist pattern of society.
 ECON 422 Notes

TOPIC 3: PUBLIC EXPENDITURE AND THE BUDGET

Meaning of Public Expenditure

Public expenditure refers to the resources spent by the government. Public expenditure thus, refers
to the expenses incurred by the public authorities that include the central government and local
government. In order to carry on their functions, government must obtain the services of labor and
other factors of production and acquire goods produced by private business firms.

Public expenditure consists of expenditure by central government, local governments (county

governments) and public corporations, with central government accounting for the major portion
of public expenditure.

The main items of government spending include the following:

 Social services such as education, health and social security

 Defence, that is the cost of maintaining the defence forces
 Infrastructural services, that is, spending on public works such as roads, housing, railways,
airways, ports etc.,
 Internal security that is maintenance of law and order
 National debt interest, that is, interest payments on money borrowed by the government.

Classification of Government Expenditure

Public expenditure can be classified into:

(i) Recurrent Expenditure (Consumption Expenditure)

Recurrent expenditure refers to government spending that takes place regularly i.e. every financial
year. They include civil expenditure (payments of salaries to civil servants), expenditure on
administrative services, defence expenditure, social security (pension), debt servicing, subsidies
etc.,

(ii) Development Expenditure (Capital Expenditure)

Development expenditure refers to government spending on projects that facilitate economic

development. Development expenditure comprises expenditures on projects such as construction
of railways, roads (rural and urban roads), airports, stadium, ports, schools, health facilities,
housing, rural electrification etc.,
 ECON 422 Notes

Principles of Public Expenditure

The rules or principles that govern the expenditure policy of the government are also called
canons of public expenditure. Fundamental principles of public spending determine the efficiency
and propriety of the expenditure itself. The considerations that are necessary before any
expenditure can be incurred by the government include the following:

1. Principle of Maximum Social Benefit

It is necessary that all public expenditure should satisfy one fundamental test, that of maximum
social advantage. That is, the government should discover and maintain an optimum level of
public expenditure by balancing social benefits and social costs. Any public expenditure must be
incurred in such a way that majority of the citizens are able to reap maximum benefit from it e.g.
improved living standards and quality of life.

2. Principle of Economy

Public expenditure should be planned carefully and prudently to avoid any possible waste.
Extravagance and waste of public resources should thus be avoided. To satisfy the canon of
economy, it will be necessary to avoid all duplication of expenditure and overlapping of
authorities.

3. Principle of Sanction

Every public expenditure must be approved by the relevant authority like parliament. Every public
spending should thus, be sanctioned by a competent authority. Unauthorized spending is bound to
lead to extravagance and over-spending. It also means that the amount must be spent on the
purpose for which it was sanctioned.

4. Principle of Accountability

This involves proper management of public resources. This should be facilitated by maintenance
of proper records. Public accounts should also be properly audited as required. This is in a bid to
find out if there are any public finances that have been misspent or misappropriated.

5. Principle of Flexibility

Another important principle of public expenditure is that it should be flexible. The policy on
public expenditure should be flexible enough to meet the prevailing economic situations i.e. it
should be possible to increase or decrease the expenditure depending on the prevailing
circumstances e.g., during drought, famine and floods, it should be possible to spend on relief. It
 ECON 422 Notes

should, therefore, be possible for public authority to vary the expenditure according to need or
circumstances. A rigid level of expenditure may prove a source of trouble and embarrassment in
bad times.

6. Principle of Surplus

Expenditure should be kept well within the revenue of the government so that a surplus is left at
the end of the year. In other words, the government should avoid deficit budget. Surplus revenue
should be saved for emergencies.

7. Principle of Equity

Government expenditure should be distributed equitably to all sectors of the economy in order to
reduce income and wealth inequalities.

8. Principle of Productivity

The biggest proportion of public expenditure should be spent on development projects and less on
non-development project.

Importance of Public Expenditure

a) Economic Development

It is through government spending that a country is able to make huge investments that will bring
about a favourable change in the economic landscape of a country. That is why massive
investments are made by the government in the development of basic and key industries,
infrastructure, agriculture, consumable goods, etc.

Public expenditure has the expansionary effect on the growth of national income, employment
opportunities, etc. Economic development also requires development of economic infrastructures.
A developing country like Kenya must undertake various projects, like road, railway, bridge, and
dam construction, power plants, transport and communications, etc.,

These social overhead capital or economic infrastructures are of crucial importance for
accelerating the pace of economic development. It is to be remembered here that private investors
are incapable of making such massive investments on the various infrastructural projects. It is
imperative that the government undertakes such projects. Greater the public expenditure, higher is
the level of economic development.
 ECON 422 Notes

b) Fiscal Policy Instrument

Public expenditure is considered as an important tool of fiscal policy. Public expenditure creates
and increases the scope of employment opportunities during depression. Thus, public expenditure
can prevent periodic cyclical fluctuations. During depression, it is recommended that there should
be more and more governmental expenditures on the ground that it creates jobs and incomes.

On the contrary, a cut-back in government’s expenditure is necessary when the economy faces the
problem of inflation. That is why it is said that by manipulating public expenditure, cyclical
fluctuations can be lessened greatly. In other words, variation of public expenditure is a part of the
anti- cyclical fiscal policy.

It is to be kept in mind that it is not just the amount of public expenditure that is incurred which is
of importance to the economy. What is equally, if not more, important is the purpose of such
expenditure or the quality of expenditure. The quality of expenditure determines the adequacy and
effectiveness of such expenditure. Excessive expenditures may cause inflation.

Moreover, if the government has to impose taxes at high rates there will be loss of incentives. So,
it is necessary to avoid unnecessary expenditure as far as practicable, otherwise benefits of better
economic development may not be reaped. As a fiscal policy instrument, it may be counter-
productive.

c) Redistribution of Income

Public expenditure is used as a powerful fiscal instrument to bring about an equitable distribution
of income and wealth. Public expenditure is likely to benefit the poor or low-income earning
groups. By providing subsidies, free education and health care facilities to the poor people,
government can improve the economic position of these people.

d) Balanced Regional Growth

Public expenditure can help correct regional disparities. By diverting resources to backward
regions, government can bring about all-round development there so as to compete with the
advanced regions of the country.

The Budget

A budget may be defined as a financial plan that serves as the basis for expenditure decision
making and for subsequent control. A budget indicates the planned expenditures of government
programmes and the expected revenues from tax systems for a given financial year.
 ECON 422 Notes

The budget is thus meant to organize government expenditure and collection of revenues. It helps
control the actual spending by government ministries and departments. It also regulates the
economy in the short run.

The budget in Kenya is part of the five-year medium-term plan and it must conform to the
development plan e.g., bottom-up economic transformation agenda (BETA) for continuity of
projects.

Budgetary Issues in Least Developed Countries (LDCs)

As a mechanism to regulate the economy, it faces overriding internal and external pressures which
may inhibit its application and implementation. For instance, the 1974 to 1974 oil price shocks,
serious (severe) drought of 1994 and COVID-19 pandemic in 2020 and 2021.

The Budget stimulates economic growth by development expenditure component. However, in

many LDCs the development expenditure component is very small.

Many LDCs face a declining domestic budgetary funding but a large external funding. This
increases economic dependency of many LDCs and also debt burden increases.

Kenya has an annual budget. However, in many other LDCs this is not the case.

In many LDCs, the estimated expenses are more than the expected revenues. This will result in
increased borrowing from international organizations such as World Bank and IMF to finance
their deficit budgets.

Functions of the Budget

(1) The Allocative Function

(2) The Distributive Function
(3) The Stabilization Function

(1) The Allocative Function of the Budget

The allocative function refers to the process by which total resource use is divided between
private and social goods and by which the appropriate mix of private and social goods is chosen.
This is done by the budgetary policy.

The allocative function or activity arises out of the failure of the market mechanism to adjust the
output of various goods in accordance with the preferences of the society i.e. maximization of the
social welfare of the society.
 ECON 422 Notes

The budget ensures optimum allocation of resources which will result in production of public and
private goods on optimum quantity or level. Also, it will help remove the problems associated
with market mechanism i.e. market failure and negative externalities.

In price mechanism, the motive of profit maximization is so strong such that public and social is
ignored and the production of social goods and services i.e., schools, hospitals, roads, etc., are
avoided. This is because in production of such goods and services, the entrepreneur earns limited
profit. Therefore, in these circumstances the government intervention becomes very necessary.

(2) The Distributive Function of the Budget

The distributive function of the budget arises out of the price mechanism to distribute resources in
the most efficient manner. Under market mechanism, the distribution of resources is determined
by ownership, income and sale of factors of factors of production.

The distributive function is, therefore, concerned with the adjustments of income and wealth or
resource distribution to ensure fair distribution of income and wealth within the economy. One of
the indicators of income or wealth inequalities is that factors have different earnings.

The government, therefore, has to intervene by formulating a budgetary policy that will positively
influence the distribution of income in a country. The government adopts a tax and expenditure
measures to modify the existing distribution of resources with a view of reducing economic
inequalities. In this way optimal distribution of resources is brought about. Budgetary policy,
therefore, becomes an important mechanism through which optimum distribution of resources,
incomes and wealth can be achieved.

Through various budgetary policy measures, the resources can be diverted to the poor and
vulnerable segments of the society. To remove inequalities, the government using appropriate
budgetary policy tools (taxation) will impose heavy taxes on the incomes of the rich and use the
incomes generated to provide subsidies on basic goods and services i.e., food, housing, health care
services, education etc.,

(3) The Stabilization Function of the Budget

The stabilization function entails the macroeconomic aspect of the budgetary policy. The
stabilization function aims at reducing various macroeconomic instabilities or limit their levels.
Some of the examples of macroeconomic instabilities include: inflation, unemployment, balance
of payments (B.o.P) deficit, unfavorable terms of trade etc.
 ECON 422 Notes

There are various reasons which prompts the government to intervene through budgetary policy
hence ensuring stabilization within an economy. Firstly, wages or prices are sticky downwards.
Therefore, the government has to intervene to correct this particular form of market failure.

Secondly, the significant role of future expectations in price levels, exchange rates, and interest
rates. This is likely to influence the speculation rate by individuals and other economic agents.
Therefore, the government has to intervene and stabilize such macroeconomic variables. Thirdly,
the exogenous shocks such as exogenous shocks in the international trade are likely to cause
economic instability. Therefore, the government has to intervene to correct such form of
instabilities.

The stabilization function, therefore, involves the use of budgetary policy as a measure to correct
various macroeconomic instabilities within an economy. In executing its stabilization role, the
budgetary policy will result in maintenance of a high level of employment, a reasonable degree of
price level stability, an appropriate rate of economic growth and favorable balance of payments
(stability in the balance of payments).

Additionally, in this function of the budgetary policy, economic performance is seen by tracing
measures on how the objectives of full employment and price stability (low level of inflation) will
be achieved. This function also ensures that GDP growth rate is higher or at least stable.

Policy Tools used to Achieve the Stabilization within an Economy

The government uses the following policy tools to achieve its stabilization role:

(1) Monetary Policy Tools

(2) Fiscal Policy Tools
(3) Physical or Regulatory Policy Tools

(1) Monetary Policy Tools

Monetary policy is a deliberate action by the government through the Central Bank to influence
macroeconomic variables towards a desired direction.

Monetary policy mainly deals with management of money supply hence control of quantity of
money within an economy.

The main objective of monetary policy is to bring stabilization within an economy. It targets
variables such as interest rate, foreign exchange, money supply etc. The commonly used monetary
policy tools include the following:
 ECON 422 Notes

(i) Open Market Operations (OMO)

The government through the Central Bank usually buys and sells its securities (treasury bills and
bonds) in an open market. When the Central Bank buys securities (treasury bills and bonds) in an
open market, the commercial banks acquire money which it can lend out. This is likely to result in
increased amount of money in circulation within the economy. Thus, purchase of securities by the
Central Bank in an open market puts money into the economy.

However, when the Central Bank sells securities (treasury bills and bonds) in an open market, the
Central Bank acquires money. The result will be decreased amount of money in circulation.

(ii) Discount Rate (Bank Rate)

When the Central Bank makes a loan to Commercial Banks, the loan is called a discount loan. The
interest rate charged on a discount loan is called a discount rate. Discount rate is thus, the rate at
which the Central Bank charges Commercial Banks when they borrow from it. Lowering the
discount rate encourages commercial banks to take out more discount loans while raising the
discount rate discourages commercial banks from borrowing from the Central Bank. Therefore,
lowering the discount rate puts more money into the economy while raising the discount rate
results in decreased amount of money in circulation.

(iii) Reserve Ratio

Central Banks may require commercial banks to keep a certain portion of their deposits which
they are not required to loan out. Reserve ratio is therefore, the percentage of deposits commercial
banks are required to hold as vault cash and not loan out. Lowering the reserve ratio allows
commercial banks to loan out a greater fraction of deposits and the amount of money in
circulation would increase. On the other hand, raising the reserve ratio would cause a decrease in
the amount of money in circulation because a smaller percentage of deposits can be loaned out.

(iv) Selective Credit Controls

Selective credit control is a qualitative tool that restricts credit and expands it for the priority
sector. It ensures that funds are used only for productive and beneficial purposes. In non-
liberalized economies, i.e., Least Developed Countries (LDCs), the government through the
Central Bank may dictate commercial banks on where to direct their credits or loans. For
example, the government may direct commercial banks to give 30% of their loans to agricultural
sector. In order to reinforce factors that help the entire economy remain stable, the rationale for
selective credit control operations has been to distinguish between different uses of credit, various
 ECON 422 Notes

economic sectors or channels through which credit flows from the stream of the banking system.
The goal is to change the flow of funds for specific purposes without affecting the banks’ reserve
positions or the amount of credit that is available in general.

(v) Moral Suasion

Moral suasion is a qualitative method of credit control, being used by the Central Bank. Under
this method, the Central Bank merely uses its moral influence on the commercial banks. It
includes the advice, suggestion request and persuasion with the commercial banks to co-operate
with the Central Bank. For instance, the Central Bank may persuade commercial banks to increase
or relax credit restriction in order to achieve certain economic objectives.

(2) Fiscal Policy Tools

Fiscal policy is a deliberate action by the government to influence the economy towards a certain
direction using fiscal policy tools such as taxation and government expenditure.

Objectives of Fiscal Policy

1. To increase domestic investment both in the public and private sectors.

Through increase in tax on some commodities, the government is able to control consumption of
some goods such as luxuries. This leads to forced savings and the government uses the money
obtained to fund priority development projects.

2. To increase optimum investment in social sectors

The money obtained from taxation is used by the government to supply social services such as
education to the vulnerable groups in the society. Poverty will thus be alleviated in the society.

3. To increase employment opportunities

The government uses tax revenue to create employment opportunities for its citizens e.g., the
affordable housing levy (which is a tax imposed on salaried individuals). The money obtained will
be used in construction of affordable houses which is likely to create more job opportunities for
the people.

4. To promote favourable balance of payments (B.o.P)

Through imposition of import duty and custom duty on import goods, the government aims at
protecting local domestic industries and encouraging production of more export commodities.
This will result in favorable balance of payments due to exports being more than imports.
 ECON 422 Notes

5. To maintain low level of inflation

The government manages aggregate demand in an economy through the use of fiscal policy.

6. To increase and redistribute national income by reducing income inequalities

This involves progressive taxation where the rich are taxed more than the poor in a bid to reduce
income inequalities.

(i) Taxation

Taxation is a powerful instrument of fiscal policy in the hands of public authorities which greatly
influence the changes in disposable income, consumption and investment. Taxation is the most
effective in terms of revenue generation. It accounts about 4.75% of revenues in LDCs.

It is also the most significant fiscal tool used to reduce private consumption and transfer resources
to the government. An anti - recession tax policy increases disposable income of the individual,
promotes consumption and investment. Obviously, there will be more funds with the people for
consumption and investment purposes at the time of tax reduction.

This will ultimately result in the increase in spending activities i.e. it will tend to increase
effective demand and reduce the deflationary gap. In this regard, sometimes, it is suggested to
reduce the rates of commodity taxes like excise duties, sales tax and import duty. As a result of
these tax concessions, consumption is promoted.

Taxation can be used for economic development in the following ways:

 Increases incentive to invest and save.

 Discourages unnecessary consumption and transfers the income to government.
 Transfers resources to the public from the government for investment in public goods in
order to break the vicious cycle of poverty.
 It modifies investment pattern by imposing different taxes on different sectors e.g.,
agriculture and manufacturing are taxed differently.
 Reduces economic inequalities by expanding the taxable brackets through progressive
form of taxation.
 Funds capital and recurrent expenditures for public operations, agencies, authorities, and
research institutions e.g., KEMRI, KALRO etc.

However, some issues associated with taxation include tax evasion and discourages production.
 ECON 422 Notes

(ii) Government Expenditure

The active participation of the government in economic activity has brought government spending
to the front line among the fiscal tools.

The appropriate variation in public expenditure can have more direct effect upon the level of
economic activity than even taxes.

The increased public spending will have a multiple effect upon income, output and employment
exactly in the same way as increased investment has its effect on them.

Similarly, a reduction in public spending, can reduce the level of economic activity through the
reverse operation of the government expenditure multiplier.

(3) Physical or Regulatory Measures

These are quantitative and qualitative measures adopted by the government to bring about
stabilization within an economy.

Some of the quantitative measures include price controls and regulation and banning certain
commodities.

Some of the qualitative measures include regulation of standards by KEBS and product
(commodity) rationing.

Self-Assessment Exercise

a) Explain the main factors affecting the effectiveness of the stabilization function of the
budget
b) What are the main limitations of monetary policy and fiscal policy in promoting
stabilization in a developing economy like Kenya.

How Stabilization is Achieved

Balance of payments deficits, high levels of unemployment, and inflation are some of the
common macroeconomic instabilities experienced in many Least Developed Countries (LDCs)
like Kenya.

To correct these macroeconomic instabilities, three main policies namely:

(1) monetary policy, (2) fiscal policy, and (3) physical or regulatory measures are used.
 ECON 422 Notes

(1) Monetary Policy

The Expansionary Monetary Policy

Expansionary monetary policy leads to an increase in money supply in the economy. The
government through the Central Bank buys government securities (treasury bills and bonds) in an
open market, lowers the discount rate, and lower the reserve ratio.

Expansionary monetary policy is appropriate when there are high levels of unemployment in an
economy. Expansionary monetary policy is thus an appropriate policy used to correct
unemployment which is one of macroeconomic instabilities.

The Contractionary Monetary Policy

Contractionary monetary policy leads to a decrease in money supply in the economy. The
government through the Central Bank sells government securities (treasury bills and bonds) in an
open market, raises the discount rate, and raises the reserve ratio.

Contractionary monetary policy is appropriate when there are high levels of inflation in an
economy. Contractionary monetary policy is thus an appropriate policy used to correct inflation
which is one of macroeconomic instabilities.

(2) Fiscal Policy

Expansionary Fiscal Policy

Expansionary fiscal policy involves increasing government expenditure and decreasing taxes. The
aim of expansionary fiscal policy is to fight recession by increasing aggregate demand (AD) in an
economy. Expansionary fiscal policy is appropriate when there are high levels of unemployment
in an economy. Expansionary fiscal policy is thus an appropriate policy used to correct
unemployment which is one of macroeconomic instabilities.

Contractionary Fiscal Policy

Contractionary fiscal policy involves decreasing government expenditure and increasing taxes.
The aim of contractionary fiscal policy is to deal with inflation (demand-pull inflation) by
reducing aggregate demand (AD) in an economy. Contractionary fiscal policy is thus appropriate
when there are high levels of inflation in an economy.

Contractionary fiscal policy is, therefore, the most appropriate policy which can be used to correct
inflation which is one of macroeconomic instabilities.
 ECON 422 Notes

(3) Physical or Regulatory Measures

To correct inflation, the government can apply measures such as price controls (price ceilings and
price floors) and subsidizing production of some products.

To correct balance of payments deficit, the government can ban import of some commodities and
encourage production of more products locally for export.

To correct unemployment, the government can dictate the type of technology to be used in
production e.g., use of labour-intensive technology.

Devaluation of currency – This is a deliberate action by the government through the Central Bank
to reduce value of a of a country’s currency. The objective is to reduce imports. Imports become
more expensive and exports cheaper in the foreign market.

The Budget Process in Kenya

The following are important steps in the preparation of the budget:

1. Formulation of the Budgetary Policy (Drafting of the Budget Statement) and

Resource Projections

The budget process begins with formulation of the budget policy objectives, priorities, and
resource projections based on macroeconomic performance review. Review of macroeconomic
performance starts with an assessment on performance of the previous budget, objectives, and
targets to determine the level of achievement. Other macroeconomic variables which are reviewed
include economic growth rate, inflation, and available government finances or revenues.

2. Budget Authorization by Parliament

The process of obtaining parliamentary approval starts with discussions by the Budget and
Appropriations Committee of the National Assembly. After the Committee has reviewed the
estimates, the budget proposals are tabled in the National Assembly for debate. After the debate,
the National Assembly can either vote to either reject or approve the proposed budgetary
proposals.

3. Budget Execution or Implementation

It is at this stage that actual revenue collections and service delivery takes place. Execution of the
budget, therefore, entails the collection and accounting for revenue and provision of social
services such as education and health care services through the recurrent budget and
implementation of development projects.
 ECON 422 Notes

Collection and accounting for tax revenue collections is done by the Kenya Revenue Authority
(KRA) and other concerned Ministries, Departments and Agencies (MDAs). These institutions
ensure maintenance of proper book of accounts for control and accountability.

4. Monitoring, Control and Evaluation

The government through the Ministry of Treasury has to put in place mechanisms for monitoring,
control and evaluation of the budget. This involves periodic reporting and follow up. Both internal
and external audits of the budget are done by the Controller of Budget and the Public Accounts
Committee (PAC) of the National Assembly. This phase also involves budget reviews and
adjustments (Supplementary Budget), public expenditure tracking, physical projection inspection,
and evaluation.

5. Reporting

Reports on the performance of the budget are prepared and presented to the stakeholders.
 ECON 422 Notes

TOPIC 4: TAXATION

Tax refers to a compulsory payment by either individuals or organizations to the government

without any direct benefit to the tax payer.

Taxation refers to the process through which the government raises revenue by collecting taxes.
The authority tasked with tax revenue collection in Kenya is the Kenya Revenue Authority
(KRA).

Reasons for Imposition of Tax by the Government

1. To raise revenue for the government.

2. To discourage consumption of some products.
3. To reduce inequality in income distribution by distributing income and wealth from the
rich to the poor people.
4. To discourage importation of some products hence protect domestic industries from
foreign competition.
5. To achieve stability within an economy.
6. To promote social welfare.

Canons or Principles of Taxation

By canons of taxation, we simply mean the characteristics or qualities which a good tax system
should possess. In fact, canons of taxation are related to the administrative part of a tax. Adam
Smith first devised the principles or canons of taxation in 1776. Even in the 21st century, Smithian
canons of taxation are applied by the modern governments while imposing and collecting taxes.

The four canons of taxation that were postulated by classical economists include:

(i) Canon of equality or equity

(ii) Canon of certainty
(iii) Canon of economy
(iv) Canon of convenience

Modern economists have added more in the list of canons of taxation, and they are:

(v) Canon of productivity

(vi) Canon of elasticity

(vii) Canon of simplicity

 ECON 422 Notes

(viii) Canon of diversity

1. Canon of Equality or Equity

Canon of equality states that the burden of taxation must be distributed equally or equitably
among the taxpayers. This means that every citizen should pay tax in proportion to their income.
However, this sort of equality in payment of tax robs of justice because not all taxpayers have the
same ability to pay taxes. Rich people are capable of paying more taxes than poor people. Thus,
justice demands that a person having greater ability to pay must pay large taxes.

If everyone is asked to pay taxes according to his ability, then sacrifices of all taxpayers become
equal. This is the essence of canon of equality (of sacrifice). To establish equality in sacrifice,
taxes are to be imposed in accordance with the principle of ability to pay.

In view of this, canon of equality and canon of ability are the two sides of the same coin. A good
tax system should, therefore, have both horizontal and vertical equity. Horizontal equity means
that those who earn the same levels of income under any circumstance should pay the same
amount of tax. Vertical equity means that those earning higher incomes should pay
proportionately higher amounts of tax than those earning less.

2. Canon of Certainty

The tax which an individual has to pay should be certain and not arbitrary. According to Adam
Smith, the time of payment, the manner of payment, the quantity to be paid, i.e., tax liability,
ought all to be clear and plain to the contributor and to everyone. Thus, canon of certainty
embraces a lot of things. It must be certain to the taxpayer as well as to the tax-levying authority.
The tax that a person is supposed to pay should be clear in terms of the amount, time and manner
in which it should be paid.

Not only taxpayers should know when, where and how much taxes are to be paid. In other words,
the certainty of liability must be known beforehand. Similarly, there must also be certainty of
revenue that the government intends to collect over the given time period. The government
should, therefore, be fairly certain of the amount of tax expected so that planning can be easier.
Any amount of uncertainty in these respects may invite a lot of trouble.

3. Canon of Economy

This canon implies that the cost of collecting a tax should be as minimum as possible. The cost of
collecting and administering the tax should, therefore, be lower than the tax collected. Any tax
that involves high administrative cost and unusual delay in assessment and high collection of
 ECON 422 Notes

taxes should be avoided altogether. According to Adam Smith: “Every tax ought to be contrived as
both to take out and to keep out of the pockets of the people as little as possible, over and above
what it brings into the public treasury of the State.”

4. Canon of Convenience

Taxes should be levied and collected in such a manner that it provides the greatest convenience
not only to the taxpayer but also to the government. The tax levied ought to be convenient to both
the contributor and the collector. It should be levied at a time when the payer has money and the
mode of payment should be convenient to both the payer and the payee. Thus, it should be
painless and trouble-free as far as practicable. “Every tax”, stresses Adam Smith: “ought to be
levied at time or the manner in which it is most likely to be convenient for the contributor to pay
it.” That is why, after the harvest, agricultural income tax is collected. Salaried people are taxed at
source at the time of receiving salaries.

5. Canon of Productivity

According to a well-known classical economist in the field of public finance, Charles F. Bastable,
taxes must be productive or cost-effective. This implies that the revenue yield from any tax must
be a sizable one. Further, this canon states that only those taxes should be imposed that do not
hamper productive effort of the community. A tax is said to be a productive one only when it acts
as an incentive to production.

6. Canon of Elasticity

Modern economists attach great importance to the canon of elasticity. This canon implies that a
tax should be flexible or elastic in yield. It should be levied in such a way that the rate of taxes can
be changed according to urgency (exigency) of the situation. Whenever the government needs
money, it must be able to extract as much income as possible without generating any harmful
consequences through raising tax rates. Income tax satisfies this canon. The tax system should
also be able to generate more revenue for the government by targeting items of mass
consumption.

7. Canon of Simplicity

Every tax must be simple and intelligible to the people so that the taxpayer is able to calculate it
without taking the help of tax consultants. A good tax system should, therefore, be simple enough
to be understood by each tax payer. This will motivate them to pay tax. A complex tax system as
 ECON 422 Notes

well as a complicated tax is bound to yield undesirable side-effects. It may encourage taxpayers to
evade taxes if the tax system is found to be complicated.

A complicated tax system is expensive in the sense that even the most honest educated taxpayers
will have to seek advice of the tax consultants. Ultimately, such a tax system has the potentiality
of breeding corruption in the society.

8. Canon of Diversity

Taxation must be dynamic. This means that a country’s tax structure ought to be dynamic or
diverse in nature rather than having a single or two taxes. A dynamic or a diversified tax structure
will result in the allocation of burden of taxes among the vast population resulting in a low degree
of incidence of a tax in the aggregate. There should be different types of taxes so that the tax
burden is on different groups in the society. This also ensures that the government has money at
all times. Diversification in a tax structure will demand involvement of the majority of the sectors
of the population. If a single tax system is introduced, only a particular sector will be asked to pay
to the national exchequer leaving a large number of population untouched. Obviously, incidence
of such a tax system will be greatest on certain taxpayers.

The above canons of taxation are considered to be essential requirements of a good tax policy.
Unfortunately, such an ideal tax system is rarely observed in the real world. But a tax authority
must go on maintaining relentlessly the above canons of taxation so that a near- ideal tax structure
can be built-up.

Taxation in Least Developed Countries (LDCs)

Economists have long recognized that the tax system in any country is a powerful policy
instrument available to governments in the pursuit of a number of economic and social objectives.
Among these objectives it is perhaps in assisting the acceleration of economic growth that tax
instruments have most often been identified, particularly in the Keynesian tradition, as of crucial
importance. In the early stages of development such prerequisites for rapid growth education,
health care and agriculture sectors must be expanded and these are often provided by
governments. The funding of these services is therefore an important constraint in many LDCs.
Although the size of the government sector in these countries, as measured by various statistical
indicators, is typically smaller than in most developed countries (DCs) - excluding centrally
planned economies – the government's direct impact on production is often more widespread.

Tax systems are used by governments to achieve a variety of objectives, including income
redistribution, stabilization, financing publicly provided goods and services, and fostering
 ECON 422 Notes

economic growth. The weighting of these and other objectives is likely to vary across countries
and over time, depending on such factors as the economic environment and political outlook, and
it is, therefore, not surprising that tax systems vary enormously across countries. Differences in
the ease with which different households, firms or sectors within an economy can be taxed also
give rise to many alternative specifications of particular taxes which may have different associated
economic effects.

Although income taxes are less important in revenue terms in LDCs, they are often more complex
than in developed countries, with greater use of “schedular” income taxes which tax different
sources of income using different schedules, with a variety of thresholds and rates. Similarly,
indirect taxes in LDCs typically use a more complex set of consumption and commodity-specific
taxes (excises) than DCs. Subsidies on basic wage-goods (for example, bread, rice, beans) are
frequently used and implicit taxes and subsidies occur when “marketing boards” - government
agencies which act as intermediaries between producers and consumers in the market, and to
whom producers are usually obliged to sell - fix prices above or below “market” rates. Such
schemes are particularly associated with African countries. In recent years, however, following the
adoption of value added taxes (VAT) in the EEC, a number of LDCs have introduced or
experimented with VAT-type taxes and other general sales taxes. VAT now exists in such countries
as Kenya, Brazil, Argentina, Mexico, Israel, Korea, Ivory Coast and Senegal. Not surprisingly it is
generally in the more developed LDCs - mainly in Latin America- that VAT is most important,
since the tax requires well-developed administrative and accounting systems.

Among the issues of the extensive and complex tax system used in LDCs are:

a) Widespread evasion because the tax system cannot be adequately monitored

b) Unintended economic effects resulting from unforeseen interactions between different
component taxes
c) Problems identifying whether tax policies are achieving government objectives

Finally, evidence from several sources suggests strongly that the ratios of total tax revenue to GDP
are higher on average in developed than in less developed countries, due primarily to higher ratios
of income tax revenue to GDP.

Taxation Issues in Least Developed Countries (LDCs)

Taxation is the only practical means of raising the revenue to finance government spending on the
goods and services that most of us demand. Setting up an efficient and fair tax system is, however,
far from simple, particularly for developing countries that want to become integrated in the
 ECON 422 Notes

international economy. The ideal tax system in LDCs should be the one that raises essential
revenue without excessive government borrowing, and should do so without discouraging
economic activity and without deviating too much from tax systems in other countries.

LDCs face formidable challenges when they attempt to establish efficient tax systems. First, most
workers (labour) in these countries are typically employed in agriculture or in small, informal
enterprises. As they are seldom paid a regular, fixed wage, their earnings fluctuate, and many are
paid in cash, “off the books.” The base for an income tax is therefore hard to calculate. Nor do
workers in these countries typically spend their earnings in large stores that keep accurate records
of sales and inventories. As a result, modern means of raising revenue, such as income taxes and
consumer taxes, play a diminished role in these economies, and the possibility that the
government will achieve high tax levels is virtually excluded.

Second, it is difficult to create an efficient tax administration without a well-educated and well-
trained staff, when money is lacking to pay good wages to tax officials and to computerize the
operation (or even to provide efficient telephone and mail services), and when taxpayers have
limited ability to keep accounts. As a result, governments often take the path of least resistance,
developing tax systems that allow them to exploit whatever options are available rather than
establishing rational, modern, and efficient tax systems.

Third, because of the informal structure of the economy in many developing countries and
because of financial limitations, statistical and tax offices have difficulty in generating reliable
statistics. This lack of data prevents policymakers from assessing the potential impact of major
changes to the tax system. As a result, marginal changes are often preferred over major structural
changes, even when the latter are clearly preferable. This perpetuates inefficient tax structures.

Fourth, income tends to be unevenly distributed within developing countries. Although raising
high tax revenues in this situation ideally calls for the rich to be taxed more heavily than the poor,
the economic and political power of rich taxpayers often allows them to prevent fiscal reforms
that would increase their tax burdens. This explains in part why many developing countries have
not fully exploited personal income and property taxes and why their tax systems rarely achieve
satisfactory progressivity (in other words, where the rich pay proportionately more taxes).

In conclusion, in LDCs, tax policy is often the art of the possible rather than the pursuit of the
optimal. It is therefore not surprising that economic theory and especially optimal taxation
literature have had relatively little impact on the design of tax systems in these countries. In
discussing tax policy issues facing many LDCs today, economists consequently draw on extensive
 ECON 422 Notes

practical, first-hand experience with the IMF’s provision of tax policy advice to LDCs.
Economists consider these issues from both the macroeconomic (the level and composition of tax
revenue) and microeconomic (design aspects of specific taxes) perspective.

Determining Optimal Level of Tax Revenue

What level of public spending is desirable for a developing country at a given level of national
income? Should the government spend one-tenth of national income? A third? Half? Only when
this question has been answered can the next question be addressed of where to set the ideal level
of tax revenue; determining the optimal tax level is conceptually equivalent to determining the
optimal level of government spending. Unfortunately, the vast literature on optimal tax theory
provides little practical guidance on how to integrate the optimal level of tax revenue with the
optimal level of government expenditure.

Nevertheless, an alternative, statistically based approach to assessing whether the overall tax level
in a developing country is appropriate consists of comparing the tax level in a specific country to
the average tax burden of a representative group of both developing and industrial countries,
taking into account some of these countries' similarities and dissimilarities. This comparison
indicates only whether the country's tax level, relative to other countries and taking into account
various characteristics, is above or below the average. This statistical approach has no theoretical
basis and does not indicate the “optimal” tax level for any country. The most recent data show that
the tax level in major industrialized countries (members of the Organization for Economic
Cooperation and Development or OECD) is about double the tax level in a representative sample
of developing countries (38% of GDP compared with 18%).

Economic development will often generate additional needs for tax revenue to finance a rise in
public spending, but at the same time it increases the countries' ability to raise revenue to meet
these needs. More important than the level of taxation per se is how revenue is used. Given the
complexity of the development process, it is doubtful that the concept of an optimal level of
taxation robustly linked to different stages of economic development could ever be meaningfully
derived for any country.

Composition of Tax Revenue

Turning to the composition of tax revenue, economists find themselves in an area of conflicting
theories. The issues involve the taxation of income relative to that of consumption and under
 ECON 422 Notes

consumption, the taxation of imports versus the taxation of domestic consumption. Both
efficiency (whether the tax enhances or diminishes the overall welfare of those who are taxed) and
equity (whether the tax is fair to everybody) are central to the analysis.

The conventional belief that taxing income entails a higher welfare (efficiency) cost than taxing
consumption is based in part on the fact that income tax, which contains elements of both a labor
tax and a capital tax, reduces the taxpayer's ability to save. Doubt has been cast on this belief,
however, by considerations of the crucial role of the length of the taxpayer's planning horizon and
the cost of human and physical capital accumulation. The upshot of these theoretical
considerations renders the relative welfare costs of the two taxes (income and consumption)
uncertain.

Another concern in the choice between taxing income and taxing consumption involves their
relative impact on equity. Taxing consumption has traditionally been thought to be inherently
more regressive (that is, harder on the poor than the rich) than taxing income. Doubt has been cast
on this belief as well. Theoretical and practical considerations suggest that the equity concerns
about the traditional form of taxing consumption are probably overstated and that, for developing
countries, attempts to address these concerns by such initiatives as graduated consumption taxes
would be ineffective and administratively impractical.

With regard to taxes on imports, lowering these taxes will lead to more competition from foreign
enterprises. While reducing protection of domestic industries from this foreign competition is an
inevitable consequence, or even the objective, of a trade liberalization program, reduced
budgetary revenue would be an unwelcome by-product of the program. Feasible compensatory
revenue measures under the circumstances almost always involve increasing domestic
consumption taxes. Rarely would increasing income taxes be considered a viable option on the
grounds of both policy (because of their perceived negative impact on investment) and
administration (because their revenue yield is less certain and less timely than that from
consumption tax changes).

Data from industrial and developing countries show that the ratio of income to consumption taxes
in industrial countries has consistently remained more than double the ratio in developing
countries. (That is, compared with developing countries, industrial countries derive proportionally
twice as much revenue from income tax than from consumption tax.) The data also reveal a
notable difference in the ratio of corporate income tax to personal income tax. Industrial countries
raise about four times as much from personal income tax than from corporate income tax.
 ECON 422 Notes

Differences between the two country groups in wage income, in the sophistication of the tax
administration, and in the political power of the richest segment of the population are the primary
contributors to this disparity. On the other hand, revenue from trade taxes is significantly higher in
developing countries than in industrial countries.

While it is difficult to draw clear-cut normative policy prescriptions from international

comparisons as regards the income-consumption tax mix, a compelling implication revealed by
the comparison is that economic development tends to lead to a relative shift in the composition of
revenue from consumption to personal income taxes. At any given point of time, however, the
important tax policy issue for developing countries is not so much to determine the optimal tax
mix as to spell out clearly the objectives to be achieved by any contemplated shift in the mix, to
assess the economic consequences (for efficiency and equity) of such a shift, and to implement
compensatory measures if the poor are made worse off by the shift.

Selecting the Right Tax System

In LDCs where market forces are increasingly important in allocating resources, the design of the
tax system should be as neutral as possible so as to minimize interference in the allocation
process. The system should also have simple and transparent administrative procedures so that it
is clear if the system is not being enforced as designed.

Personal Income Tax

Any discussion of personal income tax in developing countries must start with the observation
that this tax has yielded relatively little revenue in most of these countries and that the number of
individuals subject to this tax (especially at the highest marginal rate) is small. The rate structure
of the personal income tax is the most visible policy instrument available to most governments in
developing countries to underscore their commitment to social justice and hence to gain political
support for their policies. Countries frequently attach great importance to maintaining some
degree of nominal progressivity in this tax by applying many rate brackets, and they are reluctant
to adopt reforms that will reduce the number of these brackets.

More often than not, however, the effectiveness of rate progressivity is severely undercut by high
personal exemptions and the plethora of other exemptions and deductions that benefit those with
high incomes (for example, the exemption of capital gains from tax, generous deductions for
medical and educational expenses, the low taxation of financial income). Tax relief through
 ECON 422 Notes

deductions is particularly egregious because these deductions typically increase in the higher tax
brackets. Experience compellingly suggests that effective rate progressivity could be improved by
reducing the degree of nominal rate progressivity and the number of brackets and reducing
exemptions and deductions. Indeed, any reasonable equity objective would require no more than a
few nominal rate brackets in the personal income tax structure. If political constraints prevent a
meaningful restructuring of rates, a substantial improvement in equity could still be achieved by
replacing deductions with tax credits, which could deliver the same benefits to taxpayers in all tax
brackets.

The effectiveness of a high marginal tax rate is also much reduced by its often being applied at
such high levels of income (expressed in shares of per capita GDP) that little income is subject to
these rates. In some developing countries, a taxpayer's income must be hundreds of times the per
capita income before it enters the highest rate bracket.

Moreover, in some countries the top marginal personal income tax rate exceeds the corporate
income tax by a significant margin, providing strong incentives for taxpayers to choose the
corporate form of doing business for purely tax reasons. Professionals and small entrepreneurs can
easily siphon off profits through expense deductions over time and escape the highest personal
income tax permanently. A tax delayed is a tax evaded. Good tax policy, therefore, ensures that
the top marginal personal income tax rate does not differ materially from the corporate income tax
rate.

In addition to the problem of exemptions and deductions tending to narrow the tax base and to
negate effective progressivity, the personal income tax structure in many developing countries is
riddled with serious violations of the two basic principles of good tax policy: symmetry and
inclusiveness. (It goes without saying, of course, that tax policy should also be guided by the
general principles of neutrality, equity, and simplicity.) The symmetry principle refers to the
identical treatment for tax purposes of gains and losses of any given source of income. If the gains
are taxable, then the losses should be deductible. The inclusiveness principle relates to capturing
an income stream in the tax net at some point along the path of that stream. For example, if a
payment is exempt from tax for a payee, then it should not be a deductible expense for the payer.
Violating these principles generally leads to distortions and inequities.

The tax treatment of financial income is problematic in all countries. Two issues dealing with the
taxation of interest and dividends in developing countries are relevant:
 ECON 422 Notes

 In many developing countries, interest income, if taxed at all, is taxed as a final

withholding tax at a rate substantially below both the top marginal personal and corporate
income tax rate. For taxpayers with mainly wage income, this is an acceptable
compromise between theoretical correctness and practical feasibility. For those with
business income, however, the low tax rate on interest income coupled with full
deductibility of interest expenditure implies that significant tax savings could be realized
through fairly straightforward arbitrage transactions. Hence it is important to target
carefully the application of final withholding on interest income: final withholding should
not be applied if the taxpayer has business income.
 The tax treatment of dividends raises the well-known double taxation issue. For
administrative simplicity, most developing countries would be well advised either to
exempt dividends from the personal income tax altogether, or to tax them at a relatively
low rate, perhaps through a final withholding tax at the same rate as that imposed on
interest income.

Corporate Income Tax

Tax policy issues relating to corporate income tax are numerous and complex, but particularly
relevant for developing countries are the issues of multiple rates based on sectoral differentiation
and the incoherent design of the depreciation system. Developing countries are more prone to
having multiple rates along sectoral lines (including the complete exemption from tax of certain
sectors, especially the parastatal sector) than industrial countries, possibly as a legacy of past
economic regimes that emphasized the state's role in resource allocation. Such practices, however,
are clearly detrimental to the proper functioning of market forces (that is, the sectoral allocation of
resources is distorted by differences in tax rates). They are indefensible if a government's
commitment to a market economy is real. Unifying multiple corporate income tax rates should
thus be a priority.

Allowable depreciation of physical assets for tax purposes is an important structural element in
determining the cost of capital and the profitability of investment. The most common
shortcomings found in the depreciation systems in developing countries include too many asset
categories and depreciation rates, excessively low depreciation rates, and a structure of
depreciation rates that is not in accordance with the relative obsolescence rates of different asset
categories. Rectifying these shortcomings should also receive a high priority in tax policy
deliberations in these countries.
 ECON 422 Notes

In restructuring their depreciation systems, developing countries could well benefit from certain
guidelines:

 Classifying assets into three or four categories should be more than sufficient—for
example, grouping assets that last a long time, such as buildings, at one end, and fast-
depreciating assets, such as computers, at the other with one or two categories of
machinery and equipment in between.
 Only one depreciation rate should be assigned to each category.
 Depreciation rates should generally be set higher than the actual physical lives of the
underlying assets to compensate for the lack of a comprehensive inflation-compensating
mechanism in most tax systems.
 On administrative grounds, the declining-balance method should be preferred to the
straight-line method. The declining-balance method allows the pooling of all assets in the
same asset category and automatically accounts for capital gains and losses from asset
disposals, thus substantially simplifying bookkeeping requirements.

Value-Added Tax, Excises, and Import Tariffs

While VAT has been adopted in most developing countries, it frequently suffers from being
incomplete in one aspect or another. Many important sectors, most notably services and the
wholesale and retail sector, have been left out of the VAT net, or the credit mechanism is
excessively restrictive (that is, there are denials or delays in providing proper credits for VAT on
inputs), especially when it comes to capital goods. As these features allow a substantial degree of
cascading (increasing the tax burden for the final user), they reduce the benefits from introducing
the VAT in the first place. Rectifying such limitations in the VAT design and administration
should be given priority in developing countries.

Many developing countries (like many OECD countries) have adopted two or more VAT rates.
Multiple rates are politically attractive because they ostensibly — though not necessarily
effectively — serve an equity objective, but the administrative price for addressing equity
concerns through multiple VAT rates may be higher in developing than in industrial countries.
The cost of a multiple-rate system should be carefully scrutinized.

The most notable shortcoming of the excise systems found in many developing countries is their
inappropriately broad coverage of products — often for revenue reasons. As is well known, the
economic rationale for imposing excises is very different from that for imposing a general
 ECON 422 Notes

consumption tax. While the latter should be broadly based to maximize revenue with minimum
distortion, the former should be highly selective, narrowly targeting a few goods mainly on the
grounds that their consumption entails negative externalities on society (in other words, society at
large pays a price for their use by individuals). The goods typically deemed to be excisable
(tobacco, alcohol, petroleum products, and motor vehicles, for example) are few and usually
inelastic in demand. A good excise system is invariably one that generates revenue (as a by-
product) from a narrow base and with relatively low administrative costs.

Reducing import tariffs as part of an overall program of trade liberalization is a major policy
challenge currently facing many developing countries. Two concerns should be carefully
addressed. First, tariff reduction should not lead to unintended changes in the relative rates of
effective protection across sectors. One simple way of ensuring that unintended consequences do
not occur would be to reduce all nominal tariff rates by the same proportion whenever such rates
need to be changed. Second, nominal tariff reductions are likely to entail short-term revenue loss.
This loss can be avoided through a clear-cut strategy in which separate compensatory measures
are considered in sequence: first reducing the scope of tariff exemptions in the existing system,
then compensating for the tariff reductions on excisable imports by a commensurate increase in
their excise rates, and finally adjusting the rate of the general consumption tax (such as the VAT)
to meet remaining revenue needs.

Tax Incentives

While granting tax incentives to promote investment is common in countries around the world,
evidence suggests that their effectiveness in attracting incremental investments—above and
beyond the level that would have been reached had no incentives been granted—is often
questionable. As tax incentives can be abused by existing enterprises disguised as new ones
through nominal reorganization, their revenue costs can be high. Moreover, foreign investors, the
primary target of most tax incentives, base their decision to enter a country on a whole host of
factors (such as natural resources, political stability, transparent regulatory systems, infrastructure,
a skilled workforce), of which tax incentives are frequently far from being the most important
one. Tax incentives could also be of questionable value to a foreign investor because the true
beneficiary of the incentives may not be the investor, but rather the treasury of his home country.
This can come about when any income spared from taxation in the host country is taxed by the
investor's home country.
 ECON 422 Notes

Tax incentives can be justified if they address some form of market failure, most notably those
involving externalities (economic consequences beyond the specific beneficiary of the tax
incentive). For example, incentives targeted to promote high-technology industries that promise to
confer significant positive externalities on the rest of the economy are usually legitimate. By far
the most compelling case for granting targeted incentives is for meeting regional development
needs of these countries. Nevertheless, not all incentives are equally suited for achieving such
objectives and some are less cost-effective than others. Unfortunately, the most prevalent forms of
incentives found in developing countries tend to be the least meritorious.

Tax Holidays

Of all the forms of tax incentives, tax holidays (exemptions from paying tax for a certain period of
time) are the most popular among developing countries. Though simple to administer, they have
numerous shortcomings. First, by exempting profits irrespective of their amount, tax holidays tend
to benefit an investor who expects high profits and would have made the investment even if this
incentive were not offered. Second, tax holidays provide a strong incentive for tax avoidance, as
taxed enterprises can enter into economic relationships with exempt ones to shift their profits
through transfer pricing (for example, overpaying for goods from the other enterprise and
receiving a kickback). Third, the duration of the tax holiday is prone to abuse and extension by
investors through creative redesignation of existing investment as new investment (for example,
closing down and restarting the same project under a different name but with the same
ownership). Fourth, time-bound tax holidays tend to attract short-run projects, which are typically
not so beneficial to the economy as longer-term ones. Fifth, the revenue cost of the tax holiday to
the budget is seldom transparent, unless enterprises enjoying the holiday are required to file tax
forms. In this case, the government must spend resources on tax administration that yields no
revenue and the enterprise loses the advantage of not having to deal with tax authorities.

Tax Credits and Investment Allowances

Compared with tax holidays, tax credits and investment allowances have a number of advantages.
They are much better targeted than tax holidays for promoting particular types of investment and
their revenue cost is much more transparent and easier to control. A simple and effective way of
administering a tax credit system is to determine the amount of the credit to a qualified enterprise
and to “deposit” this amount into a special tax account in the form of a bookkeeping entry.
 ECON 422 Notes

In all other respects the enterprise will be treated like an ordinary taxpayer, subject to all
applicable tax regulations, including the obligation to file tax returns. The only difference would
be that its income tax liabilities would be paid from credits "withdrawn" from its tax account. In
this way information is always available on the budget revenue forgone and on the amount of tax
credits still available to the enterprise. A system of investment allowances could be administered
in much the same way as tax credits, achieving similar results.

There are two notable weaknesses associated with tax credits and investment allowances. First,
these incentives tend to distort choice in favor of short-lived capital assets since further credit or
allowance becomes available each time an asset is replaced. Second, qualified enterprises may
attempt to abuse the system by selling and purchasing the same assets to claim multiple credits or
allowances or by acting as a purchasing agent for enterprises not qualified to receive the incentive.
Safeguards must be built into the system to minimize these dangers.

Accelerated Depreciation

Providing tax incentives in the form of accelerated depreciation has the least of the shortcomings
associated with tax holidays and all of the virtues of tax credits and investment allowances — and
overcomes the latter's weakness to boot.

Since merely accelerating the depreciation of an asset does not increase the depreciation of the
asset beyond its original cost, little distortion in favor of short-term assets is generated.

Moreover, accelerated depreciation has two additional merits. First, it is generally least costly, as
the forgone revenue (relative to no acceleration) in the early years is at least partially recovered in
subsequent years of the asset's life.

Second, if the acceleration is made available only temporarily, it could induce a significant short-
run surge in investment.

Investment Subsidies

While investment subsidies (providing public funds for private investments) have the advantage
of easy targeting, they are generally quite problematic. They involve out-of-pocket expenditure by
the government up front and they benefit nonviable investments as much as profitable ones.
Hence, the use of investment subsidies is seldom advisable.
 ECON 422 Notes

Indirect Tax Incentives

Indirect tax incentives, such as exempting raw materials and capital goods from the VAT, are
prone to abuse and are of doubtful utility. Exempting from import tariffs raw materials and capital
goods used to produce exports is somewhat more justifiable.

The difficulty with this exemption lies, of course, in ensuring that the exempted purchases will in
fact be used as intended by the incentive. Establishing export production zones whose perimeters
are secured by customs controls is a useful, though not entirely foolproof, remedy for this abuse.

Triggering Mechanisms

The mechanism by which tax incentives can be triggered can be either automatic or discretionary.
An automatic triggering mechanism allows the investment to receive the incentives automatically
once it satisfies clearly specified objective qualifying criteria, such as a minimum amount of
investment in certain sectors of the economy. The relevant authorities have merely to ensure that
the qualifying criteria are met.

A discretionary triggering mechanism involves approving or denying an application for incentives

on the basis of subjective value judgment by the incentive-granting authorities, without formally
stated qualifying criteria. A discretionary triggering mechanism may be seen by the authorities as
preferable to an automatic one because it provides them with more flexibility. This advantage is
likely to be outweighed, however, by a variety of problems associated with discretion, most
notably a lack of transparency in the decision-making process, which could in turn encourage
corruption and rent-seeking activities. If the concern about having an automatic triggering
mechanism is the loss of discretion in handling exceptional cases, the preferred safeguard would
be to formulate the qualifying criteria in as narrow and specific a fashion as possible, so that
incentives are granted only to investments meeting the highest objective and quantifiable standard
of merit. On balance, it is advisable to minimize the discretionary element in the incentive-
granting process.

Summing Up

The cost-effectiveness of providing tax incentives to promote investment is generally

questionable. The best strategy for sustained investment promotion is to provide a stable and
transparent legal and regulatory framework and to put in place a tax system in line with
 ECON 422 Notes

international norms. Some objectives, such as those that encourage regional development, are
more justifiable than others as a basis for granting tax incentives.

Not all tax incentives are equally effective. Accelerated depreciation has the most comparative
merits, followed by investment allowances or tax credits. Tax holidays and investment subsidies
are among the least meritorious. As a general rule, indirect tax incentives should be avoided, and
discretion in granting incentives should be minimized.

Tax Policy Challenges Facing Least Developed Countries (LDCs)

Developing countries attempting to become fully integrated in the world economy will probably
need a higher tax level if they are to pursue a government role closer to that of industrial
countries, which, on average, enjoy twice the tax revenue. Developing countries will need to
reduce sharply their reliance on foreign trade taxes, without at the same time creating economic
disincentives, especially in raising more revenue from personal income tax. To meet these
challenges, policymakers in these countries will have to get their policy priorities right and have
the political will to implement the necessary reforms. Tax administrations must be strengthened to
accompany the needed policy changes.

As trade barriers come down and capital becomes more mobile, the formulation of sound tax
policy poses significant challenges for developing countries. The need to replace foreign trade
taxes with domestic taxes will be accompanied by growing concerns about profit diversion by
foreign investors, which weak provisions against tax abuse in the tax laws as well as inadequate
technical training of tax auditors in many developing countries are currently unable to deter. A
concerted effort to eliminate these deficiencies is therefore of the utmost urgency.

Tax competition is another policy challenge in a world of liberalized capital movement. The
effectiveness of tax incentives — in the absence of other necessary fundamentals — is highly
questionable. A tax system that is riddled with such incentives will inevitably provide fertile
grounds for rent-seeking activities. To allow their emerging markets to take proper root,
developing countries would be well advised to refrain from reliance on poorly targeted tax
incentives as the main vehicle for investment promotion.

Finally, personal income taxes have been contributing very little to total tax revenue in many
developing countries. Apart from structural, policy, and administrative considerations, the ease
with which income received by individuals can be invested abroad significantly contributes to this
 ECON 422 Notes

outcome. Taxing this income is therefore a daunting challenge for developing countries. This has
been particularly problematic in several Latin American countries that have largely stopped taxing
financial income to encourage financial capital to remain in the country.

Economic Effects of Taxation

The most important objective of taxation is to raise required revenues to meet expenditures. Apart
from raising revenue, taxes are considered as instruments of control and regulation with the aim of
influencing the pattern of consumption, production and distribution. Taxes thus affect an economy
in various ways, although the effects of taxes may not necessarily be good. There are some bad
effects of taxes too.

Economic effects of taxation include the following:

1. Effects of Taxation on Production

Taxation can influence production and growth. Such effects on production are analyzed
under three areas:

(i) Effects on the ability to work, save and invest.

(ii) Effects on the willingness to work, save and invest.

(iii) Effects on the allocation of resources.

a) Effects on the Ability to Work, Save and Invest

Imposition of taxes results in the reduction of disposable income of the taxpayers. This will
reduce their expenditure on necessaries which are required to be consumed for the sake of
improving efficiency. As efficiency suffers ability to work declines. This ultimately adversely
affects savings and investment. However, this happens in the case of poor persons.

Taxation on rich persons has the least effect on the efficiency and ability to work. Not all taxes,
however, have adverse effects on the ability to work. There are some harmful goods, such as
cigarettes, whose consumption has to be reduced to increase ability to work. That is why high rate
of taxes are often imposed on such harmful goods to curb their consumption.
 ECON 422 Notes

But all taxes adversely affect ability to save. Since rich people save more than the poor,
progressive rate of taxation reduces savings potentiality. This means low level of investment.
Lower rate of investment has a dampening effect on economic growth of a country.

Thus, on the whole, taxes have the disincentive effect on the ability to work, save and invest.

b) Effects on the will to Work, Save and Invest

The effects of taxation on the willingness to work, save and invest are partly the result of money
burden of tax and partly the result of psychological burden of tax.

Taxes which are temporarily imposed to meet any emergency (e.g., Kargil Tax imposed for a year
or so) or taxes imposed on windfall gain (e.g., lottery income) do not produce adverse effects on
the desire to work, save and invest. But if taxes are expected to continue in future, it will reduce
the willingness to work and save of the taxpayers.

Taxpayers have a feeling that every tax is a burden. This psychological state of mind of the
taxpayers has a disincentive effect on the willingness to work. They feel that it is not worth taking
extra responsibility or putting in more hours because so much of their extra income would be
taken away by the government in the form of taxes.

However, if taxpayers are desirous of maintaining their existing standard of living in the midst of
payment of large taxes, they might put in extra efforts to make up for the income lost in tax.

It is suggested that effects of taxes upon the willingness to work, save and invest depends on the
income elasticity of demand. Income elasticity of demand varies from individual to individual.

If the income demand of an individual taxpayer is inelastic, a cut in income consequent upon the
imposition of taxes will induce him to work more and to save more so that the lost income is at
least partially recovered.

On the other hand, the desire to work and save of those people whose demand for income is
elastic will be affected adversely.

Thus, we have conflicting views on the incentives to work. It would seem logical that there must
be a disincentive effect of taxes at some point but it is not clear at what level of taxation that
crucial point would be reached.
 ECON 422 Notes

c) Effects on the Allocation of Resources

By diverting resources to the desired directions, taxation can influence the volume or the size of
production as well as the pattern of production in the economy. It may, in the ultimate analysis,
produce some beneficial effects on production. High taxation on harmful drugs and commodities
will reduce their consumption.

This will discourage production of these commodities and the scarce resources will now be
diverted from their production to the other products which are useful for economic growth.
Similarly, tax concessions on some products are given in a locality which is considered as
backward. Thus, taxation may promote regional balanced development by allocating resources in
the backward regions.

However, not necessarily such beneficial effect will always be reaped. There are some taxes
which may produce some unfavourable effects on production. Taxes imposed on certain useful
products may divert resources from one region to another. Such unhealthy diversion may cause
reduction of consumption and production of these products.

2. Effects of Taxation on Income Distribution

Taxation has both favourable and unfavourable effects on the distribution of income and wealth.
Whether taxes reduce or increase income inequality depends on the nature of taxes. A steeply
progressive taxation system tends to reduce income inequality since the burden of such taxes falls
heavily on the richer persons.

But a regressive tax system increases the inequality of income. Further, taxes imposed heavily on
luxuries and nonessential goods tend to have a favourable impact on income distribution. But
taxes imposed on necessary articles may have regressive effect on income distribution.

However, we often find some conflicting role of taxes on output and distribution. A progressive
system of taxation has favourable effect on income distribution but it has disincentive effects on
output.

A high dose of income tax will reduce inequalities but such will produce some unfavourable
effects on the ability to work, save, investment and, finally, output. Both the goals — the
equitable income distribution and larger output — cannot be attained simultaneously.
 ECON 422 Notes

3. Other Effects of Taxation

If taxes produce favourable effects on the ability and the desire to work, save and invest, there will
be a favourable effect on the employment situation of a country. Further, if resources collected via
taxes are utilized for development projects, it will increase employment in the economy. If taxes
affect the volume of savings and investment badly then recession and unemployment problem will
be aggravated.

Incidence of a Tax

Taxes are not always borne by the people who pay them in the first instance. They are often
shifted to other people.

Incidence of at tax means the final placing of a tax. Incidence is on the person who ultimately
bears the money burden. Incidence, therefore, means the final resting or placing of a tax. The
incidence is on the individual who ultimately bears the money burden of the tax Incidence is
therefore on the person who finally bears the tax. Therefore, incidence is on the final consumers
(the one who finally bears it).

According to the modern theory, incidence means the changes brought about by income
distribution and by changes in the budgetary policy.

Impact of a Tax

The impact of a tax is on the who pays it in the first instance. The term impact is used to express
the immediate result of or original imposition of the tax. The impact of a tax is on the person on
whom it is imposed first.

Distinguishing between Impact and Incidence of Taxes

1. Impact refers to the initial burden of the tax, while incidence refers to the ultimate burden of the
tax.

2. Impact is at the point of imposition; incidence occurs at the point of settlement.

3. The impact of a tax falls upon the person from whom the tax is collected and the incidence rests
on the person who pays it eventually

4. Impact may be shifted but incidence cannot. For, incidence is the end of the shifting process.
Sometimes, however, when no shifting is possible, as in the case of income tax or such other
direct taxes, the impact coincides with incidence on the same person.
 ECON 422 Notes

Factors Determining the Shifting of Incidence of a Tax

1. Elasticity

While considering how elasticity affects shifting of incidence of a tax, we lay emphasis on
elasticity of demand and elasticity of supply. If the demand for the commodity taxed is elastic, the
tax will tend to be shifted to the producer. However, if the demand for the commodity taxed is
inelastic, the tax will be largely borne by the consumer (buyer).

If the supply of the commodity taxed is elastic, the tax burden will tend to be on the consumer
(buyer). However, if the supply of the commodity taxed is inelastic, the tax will be largely borne
by the producer.

2. Price

Since shifting of the tax burden can only take place through a change in price, price is a very
important factor determining the incidence of a tax. If the tax leaves the price unchanged, the tax
does not shift. However, if the tax leaves the price changed (i.e., a rise in price), the tax burden
shifts. Hence price flexibility is the most important factor influencing the shift of tax burden.

3. Time Period

In the short run, the producer cannot make any adjustment in plant and equipment (inputs) and
hence the supply is inelastic. Thus, if aggregate demand falls on account of price resulting from
the tax, he/she may not be able to reduce supply and, therefore, the producer has to bear a greater
part of the tax burden.

However, in the long run, full adjustments can be made in plant and equipment (inputs) and hence
supply is elastic and, therefore, the tax burden will be shifted to the consumer. Therefore, in the
short run period, shifting of a tax burden is difficult, whereas in the long run period it is easy to
shift a tax burden.

4. Cost

Tax raises the price of commodity. A rise in price reduces the demand for a commodity and
reduced demand results in the reduction in output. A change in the scale of production affects cost
and the effect will vary according to whether the industry is a decreasing, increasing or constant
costs industry.

For instance, if the industry is subject to decreasing costs, a reduction in the scale of production
will raise the cost and hence shifting the burden of the tax to the consumer.
 ECON 422 Notes

5. Tax Area

The nature of the area in which the tax is imposed also affects shifting of a tax burden. For
instance, if the tax is imposed on a commodity having a local (domestic market), it will be
difficult to shift the tax by raising its price. In such a case people can avoid the tax by purchasing
a commodity from the neighbourhood market where the commodity is cheap. This also gives rise
to smuggling of commodities from non-tax levying locality to avoid taxes.

6. Coverage of Tax

If the tax is general in nature, falling on wide range of commodities, it is easy to shift the tax
burden. For example, if the tax is levied on tooth paste is general in nature covering all brands and
kinds of tooth paste, it will be easily shifted. However, if a tax is imposed on one brand of tooth
paste, excluding the other brands, it will not be possible to shift the tax burden. So, we can
conclude that shifting of a tax is rendered easier in general tax than in non-general taxes.

7. Availability of Substitutes

Taxes imposed on a commodity having no close substitutes can be easily shifted to the consumer.
Here the buyer cannot find alternative product as substitutes to satisfy his demand. Hence, he/she
will be ready to purchase the taxed commodity. On the other hand, if the taxed product has close
substitutes, shifting the money burden to buyers will be difficult. Any rise in price due to tax will
be opposed by the buyer, and he will go for the non-taxed substitutes. So, the seller will
himself/herself bear the burden of tax instead of attempting to shift.

8. Nature of Demand for Commodities

By this, we mean whether the taxed commodity is falling under the category of necessities,
comforts or luxuries. The nature of demand is different for various commodities. In the case of
necessities, demand is inelastic. Hence the burden of tax is high upon the buyer than on seller. In
the case of comforts, the demand is more elastic hence the burden will be divided between buyer
and seller. For the case of luxuries, the demand is elastic. Hence, the tax burden is more on the
seller. It cannot be easily shifted to the buyers.

9. Business Conditions

Shifting of a tax is influenced by the existing business conditions in the economy. During the
periods of rising prices and economic growth, taxes can be shifted more easily. However, during
periods of depression i.e., falling prices, shifting of a tax burden is very difficult.
 ECON 422 Notes

10. Types of Tax

Shifting of incidence of a tax depends upon the nature or type of tax imposed. If a tax is imposed
on the profits of a firm (corporate tax), the incidence will not be shifted. On the other hand, if the
tax is levied on the output (products) of the firm, a part of incidence can be shifted to the
consumers.

11. Government Policy

Shift of a tax burden is determined by tax laws and public policy in place. In Kenya, a tax law
stipulates that the producers and sellers should clearly indicate the price to be charged by printing
on the product cover. For example, a sales tax legislation stipulates that that the burden of sales is
to be borne by the consumers. The burden of indirect tax will fall on the consumers.

12. Market Structures

Under perfect competition market structure, no single seller or single buyer can affect the price
hence shifting of tax burden is very difficult. However, under monopoly market structure, a
producer is in a position to influence price of a product and hence shift in the tax burden to the
final consumer.

Types of Taxes

1. Income Tax

Income tax is a tax charged for each year of income, upon all the income of a person whether
resident or non-resident, which is accrued in or was derived from Kenya. Income Tax is imposed
on;

 Business income from any trade or profession

 Employment income
 Rent income
 Dividend and Interests
 Pension income
 Income from a Digital Marketplace
 Natural resource income among others

There are different methods of collecting income tax from companies & partnerships, based on
their sources of income. These methods include:
 ECON 422 Notes

a) Corporation Tax

This is a form of Income Tax that is levied on corporate bodies such as Limited companies,
Trusts, and Co-operatives, on their annual income. Companies that are based outside Kenya but
operate in Kenya or have a branch in Kenya pay Corporation Tax on income accrued within
Kenya only.

b) Pay As You Earn (PAYE)

This is a method of collecting tax at source from individuals in gainful employment. Companies
and Partnerships with employees are required to deduct tax according to the prevailing tax rates
from their employees’ salaries or wages on each payday for a month and remit the same to KRA
on or before the 9th of the following month.

c) Withholding Tax (WHT)

This is a tax that is deductible from certain classes of income at the point of making a payment, to
non-employees. WHT is deducted at source from the following sources of income:

 Interest
 Dividends
 Royalties
 Management or professional fees (including consultancy, agency or contractual fees)
 Commissions
 Pensions
 Rent received by non-residents
 Other payments specified

Companies and partnerships making the payment, are responsible for deducting and remitting the
tax to the Commissioner of Domestic Taxes.

d) Advance Tax

This is a tax paid in advance before a public service vehicle or a commercial vehicle goes for the
annual inspection.
 ECON 422 Notes

e) Installment Tax

Installment tax is paid by persons who have tax payable for any year that amounts to KShs 40,000
and above.

2. Rental Income Tax

This is a tax charged on rental income received from renting out property. Taxation of rental
income depends on how the rented property was used for residential or commercial purposes.

All persons (individuals), partnerships and companies that rent out property to other persons for
either residential or commercial use are required to pay income tax on rent received.

To facilitate compliance, KRA appoints agents to withhold and pay, a percentage of the gross rent
as tax.

3. Value Added Tax (VAT)

Value Added Tax is charged on supply of taxable goods or services made or provided in Kenya
and on importation of taxable goods or services into Kenya.

While companies & partnerships can voluntarily register for VAT they MUST register if their
annual revenue exceeds Kshs. 5,000, 000.

To facilitate compliance, KRA appoints agents to withhold and pay, VAT on supplies made.

4. Excise Duty

This is a duty of excise imposed on;

 goods manufactured in Kenya, or;

 imported into Kenya and specified in the 1st schedule to Excise Duty Act, 2015.

Companies and Partnerships dealing in excisable good and services are required to pay excise
duty.
The List and types of Excisable goods and services are listed in the 5th Schedule as read together
with Section 117 (1) (d) of the Customs and Excise Act, CAP 472 Laws of Kenya.

They include:
 ECON 422 Notes

 Mineral water
 Juices, soft drinks
 Cosmetics and Preparations for use on hair
 Other beer made from malt
 Opaque beer
 Mobile cellular phone services
 Fees charged for money transfer among others

5. Capital Gains Tax (CGT)

This is a tax chargeable on the whole of a gain which accrues to a company or an individual upon
transfer of property situated in Kenya, whether or not the property was acquired before 1st
January 2015. It took effect on 1st January 2015.

6. Agency Revenue

This is a type of payment that KRA collects on behalf of various revenue collection agencies in
Kenya. The two types of Agency Revenue include;

 Stamp Duty
 Betting and Pool Tax

a) Stamp Duty

Stamp duty is a tax charged on transfer of properties, shares and stock. It is collected by the
Ministry of Lands, which has seconded the function to Kenya Revenue Authority (KRA).

b) Betting Tax

Betting Tax is chargeable on the gross gaming revenue (GGR) of a bookmaker at the rate of 15%
as provided by Section 29A of the Betting, Lotteries and Gaming Act, 1966.

Betting, gaming and Lottery businesses are required to withold as tax and remit to KRA 20% of
the winnings being paid out to winners.

Excise Duty on Betting is chargeable at the rate of 20% of the amount wagered or staked, and it
commenced on 7th November, 2019.
 ECON 422 Notes

7. Turnover Tax

Turnover Tax (TOT) is a tax charged on gross sales of a business as per Sec. 12(c) of the Income
Tax Act. First introduced vide Finance Act 2006, replaced by Presumptive Income Tax vide
Finance Act 2018 then reintroduced vide Finance Act 2019. The effective date of TOT
is 01/01/2020.

Progressive Tax

A tax that takes a larger percentage of income from high-income groups than from low-income
groups. Tax is a higher percentage of income for those with higher incomes than those with lower
incomes.

Proportional Tax

A tax that takes the same percentage of income from all income groups. Tax is the same
percentage of income for those with higher incomes as those with lower incomes.

Regressive Tax

A tax that takes a larger percentage of income from low-income groups than from high-income
groups. Tax is a lower percentage of income for those with higher incomes than those with lower
incomes.

Direct Tax

Direct taxes are levied on individuals or firms directly by the government. In other words, the
direct tax burden falls directly on the taxpayer. Some of the most common examples of direct
taxes include income tax, corporate tax, capital gains tax and property tax. These taxes are based
on income or assets.

Indirect Tax

Indirect taxes are those collected by an intermediary (e.g. marketplaces, manufacturers, platform
owners, vendors) from the end consumer. In other words, indirect taxes are paid by consumers
indirectly through the goods and services they purchase. The most common examples of indirect
taxes include goods and services tax (GST), value-added tax (VAT), sales tax, excise tax and
customs duty. These taxes are based on the consumption or expenditure of goods and services.
 ECON 422 Notes

The Principle of Maximum Social Advantage

Modern states are welfare states whose main objective is to ensure maximum social welfare for
the people. The fiscal operations of the government have significant effect on the economy as a
whole. Government collects revenue through taxation and public expenditure brings out changes
in consumption, production and distribution of national income.

Public finance plays a key role in the determination of national income, employment, output and
other parameters in the economy. Thus, it is desirable that some criterion or principle must guide
operations of government. This guiding principle has been technically called the principle of
maximum social advantage or principle of public finance. The principle of public finance has
been named differently by different economists. Prof. Dalton has named it as ‘Principle of
Maximum Social Advantage’ while Pigou calls it as ‘Principle of Maximum Aggregate
welfare’.

Prof. Dalton’s View on the Principle of Maximum Social Advantage

Principle of Maximum Social Advantage governs both operations of public finance, i.e. revenue
and expenditure which act simultaneously to maximize the economic welfare of the society as a
whole. The principle says that public authority should collect revenue and spend the money to
maximize the welfare of the people as a whole. Imposition of taxes creates disutility among tax-
payers while public expenditure provides utility. So, the state should adjust the revenue and
expenditure in such a manner that utility is maximized and disutility is minimized. In other words,
income and expenditure of the state should be managed in such a way that there should be greatest
net advantage to the society.

Assumptions of the Principle of Maximum Social Advantage

 Public revenue only consists of taxes and no other sources of income from government.
 All taxes result in sacrifice while public expenditure results in benefits.
 There is no deficit or surplus in the government budget i.e., there is only a balanced
budget.
 Public expenditure is subject to diminishing marginal social benefits (MSB).
 Taxes are subject to increasing marginal social sacrifice (MSS).
 ECON 422 Notes

Prof. Dalton explained the principle of maximum social advantage with reference to marginal
social sacrifice (MSS) and marginal social benefits (MSB).

The marginal social sacrifice (MSS) is the amount of social sacrifice that the public undergoes
due to imposition of additional tax by the government. Additional taxes result in loss of utility
hence marginal sacrifice (additional burden) keeps increasing. The reason for increase in MSS is
because more taxes reduce the stock of money for the public which implies that marginal utility of
money keeps increasing. That is why we have an upwards sloping MSS curve because with each
additional unit of taxation, the level of sacrifice also increases.

The marginal social benefit (MSB) is the amount of social benefits conferred to the public due to
additional public expenditure. Social benefits from additional units of public expenditure
decreases as public expenditure on social services increases. That is why we have a downwards
sloping MSB curve sloping from the left to the right. This implies that social benefits derived out
of public expenditure keeps on reducing at a diminishing rate.

In the table below we can see that as the rate of taxation increases, the marginal sacrifice of the
community also increases while with increasing units of public expenditure marginal benefits
accruing to the society decreases.

A point is achieved where MSS becomes equal to MSB. Therefore, government will not impose
any tax beyond fifth unit because marginal sacrifice due to taxation (marginal disutility) is equal
to marginal benefit or utility due to public expenditure (marginal utility).

Table 1: Marginal Social Sacrifice and Marginal Social

Benefit

Units of Taxation & Marginal Social Marginal Social Benefit

Public Sacrifice (MSB)
Expenditure (MSS)
1 10 90
2 20 75
3 30 65
4 40 55
5 50 50
6 60 35
7 70 25
8 80 15

Maximum Social Advantage is achieved at a point where marginal social benefit of public
expenditure and the marginal social sacrifice of taxation are equal, i.e., where MSB = MSS.
 ECON 422 Notes

This is the optimum limit of the government’s public finance activity. Thus, public expenditure
should be incurred up to the point where marginal utility due to public expenditure is just equal to
the marginal disutility due to taxation.

Figure 1: Prof. Dalton’s View

The above graph represents Prof. Dalton’s view on the Principle of Maximum Social
Advantage.

The curve in first graph (3.1a) represents marginal sacrifice which slopes upwards from left to
right. The curve in second graph (3.1b) shows marginal utility of public expenditure having a
negative slope. The last graph (3.1c) shows the interaction of the above two curves. It determines
the optimum limit of public finance where MSS curve intersects MSB curve at point P showing
OM level as the optimum. Therefore, at point P welfare in terms of net social benefits is
maximized and society achieves maximum social advantage.
 ECON 422 Notes

Musgrave’s View on the Principle of Maximum Social Advantage

Musgrave has built his version on maximum social advantage on the lines of Prof. Pigou. Prof.
Pigou says that public expenditure should be raised to the point where the utility derived from the
last spent Dollar equalizes the utility lost by paying the last dollar as taxes. He also said that
resources should be distributed among different uses so that the marginal return of benefit for
each type of outlay should be equal. The explanation of Musgrave is depicted with the help of
figure below:

Figure 2: Musgrave’s View

In the above figure, marginal utility of successive dollars of public expenditures allocated
optimally between public uses is shown by line aa and marginal disutility of taxes imposed is
shown by curve bb.

Line GG is obtained by deducting bb from aa and it measures the net benefits derived from
successive addition to public budget. The optimum size of budget is determined at OS where
marginal net benefits are zero. In this way minimum sacrifice approach to the allocation of taxes
is matched by maximum benefit approach to the determination of public expenditure, and the two
are combined in the general theory of budget planning.
 ECON 422 Notes

Objective Tests of Maximum Social Advantage

The following are some criteria of maximum social advantage:

1. Preservation of community

The duty of the govt. Should be to preserve the community against internal disorders and external
attacks. It creates confidence and promotes economic life of its citizens.

2. Improvements in Production

Increase in productive power so that large product per worker shall be obtained to achieve
minimum waste of economic resources hence improvement in pattern of production. Improvement
in production is thus a necessary condition which requires increase in productive power in order
to obtain large product with minimum effort and improvement in organization of production.

3. Improvement in Distribution

The inequalities of income, resulting due to unearned income, should not be tolerated while the
skills and efforts may be justified and suitably rewarded.

4. Stability and Full Employment

The social advantage to the community can be increased if economic stability and full
employment level is achieved. Economic stability indicates less fluctuations and a stable
atmosphere for economic agents. Attainment of full employment favours increase in production
and promotes greater equality of income.

5. Provisions for the Future

Individuals give more importance to the present than to the future and, therefore, the
responsibility of the state has double responsibility of looking after the interests of the present as
well as future generations.
 ECON 422 Notes

TOPIC 5: PUBLIC DEBT

Many governments need to borrow from different sources when current revenue falls short of
public expenditures. Thus, public debt refers to loans incurred by the government to finance its
activities when other sources of public income fail to meet the requirements. In this wider sense,
the proceeds of such public borrowing constitute public income.

However, since debt has to be repaid along with interest from whom it is borrowed, it does not
constitute income. Rather, it constitutes public expenditure. Public debt is incurred when the
government floats loans and borrows either internally or externally. The government can borrow
loans from other countries, private individuals, association of individuals, banks or non-bank
financial institutions (NBFIs) or international loan-giving institutions.

Classification of Public Debt

The structure of public debt is not uniform in any country on account of factors such as categories
of markets in which loans are floated, the conditions for repayment, the rate of interest offered on
bonds, purposes of borrowing, etc. In view of these differences in criteria, public debt is classified
into various categories:

(i) Internal and external debt

(ii) Short-term and long-term loans

(iii) Funded and unfunded debt

(iv) Voluntary and compulsory loans

(v) Redeemable and irredeemable debt

(vi) Productive (reproductive) debt and unproductive debt (deadweight) debt

1. Internal and External Debt

Money owed to the citizens and institutions within the country are called internal debt and money
owed to foreigners are called the external debt. Internal debt refers to the government loans
floated in the capital markets within the country. Such debt is subscribed by individuals and
institutions of the country. On the other hand, if a public loan is floated in the foreign capital
markets, i.e., outside the country, by the government from foreign nationals, foreign governments,
international financial institutions, it is called external debt. It is important to note that total
internal debt added to total external debt constitutes the national debt.
 ECON 422 Notes

2. Short-Term and Long-Term Debts

Debts are classified according to the duration it takes to repay. Most government debt is held in
short term interest-bearing securities, such as Treasury Bills and Bonds or Ways and Means
Advances (WMA). Maturity period of Treasury Bill is usually 90 days.

Government borrows money for such period from the central bank of the country to cover
temporary deficits in the budget. Only for long term loans, government comes to the public. For
development purposes, long period loans are raised by the government usually for a period
exceeding five years or more.

3. Funded and Unfunded (Floating) Debt

Funded debt is the loan repayable after a long period of time, usually more than a year. Thus,
funded debt is long term debt. Further, since for the repayment of such debt government maintains
a separate fund, the debt is called funded debt. Floating or unfunded loans are those which are
repayable within a short period, usually less than a year.

It is unfunded because no separate fund is maintained by the government for the debt repayment.
Since repayment of unfunded debt is made out of public revenue, it is referred to as a floating
debt. Thus, unfunded debt is a short-term debt.

4. Voluntary and Compulsory Debt

A government raises loans for the nationals on a voluntary basis. Thus, loans given to the
government by the people on their own will and ability are called voluntary loans. Normally,
public debt, by nature, is voluntary. But during emergencies (e.g., war, natural calamities, etc.,)
government may force the nationals to lend it. Such loans are called forced or compulsory loans.

5. Redeemable and Irredeemable Debt

Redeemable public debt refers to that debt which the government promises to pay off at some
future date. After the maturity or repayment period, the government pays the amount to the
lenders. Thus, redeemable loans are called terminable loans.

In the case of irredeemable debt, government does not make any promise about the payment of
the principal amount, although interest is paid regularly to the lenders.

For the most obvious reasons, redeemable public debt is preferred.

If irredeemable loans are taken by the government, the society will have to face the consequence
of burden of perpetual debt.
 ECON 422 Notes

6. Productive (Reproductive) and Unproductive (Deadweight) Debt

On the criteria of purposes of loans, public debt may be classified as productive (reproductive)
and unproductive (deadweight) debt. Public debt is productive when it is used in income-earning
enterprises. Or productive debt refers to that loan which is raised by the government for increasing
the productive power of the economy.

A productive debt creates sufficient assets by which it is eventually repaid. If loans taken by the
government are spent on the building of railways, development of mines and industries, irrigation
works, education, etc., income of the government will increase ultimately.

Productive loans thus add to the total productive capacity of the country. In the words of Findlay
Shirras: “Productive or reproductive loans which are fully covered by assets of equal or greater
value, the source of the interest is the income from the ownership of these as railways and
irrigation works.”

Public debt is unproductive when it is spent on purposes which do not yield any income to the
government, e.g., refugee rehabilitation or famine relief work. Loans for financing war may be
regarded as unproductive loans. Instead of creating any productive assets in the economy,
unproductive loans do not add to the productive capacity of the economy. That is why
unproductive debts are called dead-weight debts.

Sources of Borrowing

1. Internal Borrowing

This refers to borrowing by government from firms and individuals within the country. This may
be done through open market operations where the government sells its securities (Treasury Bills
and Bonds). This, however, has a disadvantage of causing ‘crowding out effect’ where the
government leaves the private sector investors with little to borrow.

2. External Borrowing

This refers to borrowing by government from external sources. It may either be on a bilateral or
multilateral basis. Bilateral borrowing is where the government borrows directly from another
country. Multilateral borrowing is where the government borrows from international institutions
such as international monetary fund (IMF), World Bank, African Development Bank etc. Such
international bodies get finances from various sources which they lend to their member countries
who are in need of such funds.
 ECON 422 Notes

Purpose of Public Debt

1. To bridge the gap between revenue and expenditure i.e. to cover budget deficit of a
country.
2. To reduce depression in the economy for instance by initiating projects which are likely to
create more employment opportunities for the people.
3. To increase economic growth of a country.
4. To undertake infrastructural projects and public works programs such as roads
construction and public housing construction.
5. To curb inflation by reducing the supply of money in the economy.
6. To achieve economic development especially in least developed countries (LDCs)
7. To undertake the public welfare programs and activities such as construction of public
schools.
8. To finance public corporations (enterprises) or parastatals.
9. To finance defense activities of a country e.g. purchasing of military hardware such as
arms or ammunition.

Advantages of Long-Term Loans

If the government is in need of large amount of funds and the short-term loans are not enough,
then the government can opt for long-term loans. The following are some of the key advantages of
long-term loans:

1. Long-term loans provide an opportunity for the government to undertake large

infrastructural projects like construction of roads, railways, ports, airports, public houses
etc. These critical for infrastructure projects, by nature take many years to complete and
require large amounts of money.
2. Long-term loans help to finance a country’s defense activities such as purchasing of
modern military equipment and ammunition.
3. Long-term loans provide an opportunity for commercial banks and insurance companies to
invest their surplus funds. This is because the rate of interest on long-term loans is higher
than on short-term loans.
4. Long-term loans can be repaid by the government at a time which is favourable or
convenient. Government can also convert long-term loans at a lower rate of interest later
on.
5. Long-term loans might contribute to higher economic growth and lower macroeconomic
volatility (instability).
 ECON 422 Notes

Reasons for Increase in Public Debt Among LDCs

1. Increased spending on military and defense activities

2. Budget deficits
3. Increased government spending
4. Urge for sustained economic growth
5. Inefficiencies of public (government) institutions
6. High rates of corruption

Economic Effects of Public Debt

1. Effect on Consumption

Public debt has a contractionary effect on the economy through reduced consumption expenditure.
The purchasing power of the customers is reduced due to their contribution towards public debt,
making them unable to buy goods and services in the same quantity in which they used to
purchase them earlier. It is on account of this that governments all over the world resort to large-
scale public borrowings to reduce the impact of inflation.

Foreign loans can have a positive impact on domestic consumption. If foreign loans are used for
importing those goods and services that are needed by domestic consumers, the result will be
increased consumption expenditure and reduced inflationary pressure in the economy.

2. Effect on Private Investment

Public debt leads to less availability of funds for private investors for investment opportunities
i.e., ‘crowding out effect.’ Investible funds become limited in the market.

If the funds get blocked in public debts, fewer funds will be available to the private sector.

Public debt; therefore, directly affects the availability of funds to the private sector.

3. Effect on Distribution

Public debts also affect distribution. Loans transfer money from the rich to the government. If the
public loans are subscribed by rich people only and the amount so realized is spent by the
government on the economic welfare of poor people or low-income groups, the benefit will be a
narrowing down (reduction) of the inequalities and more equal distribution of income between
people is achieved.

However, if the poorer classes have to bear the burden of public debt along with interest
payments, the tendency of public debt would increase the inequalities of incomes.
 ECON 422 Notes

4. Effect on Production

If the people buy government securities (Treasury Bills and Bonds) hence withdrawing money
from their economic activities or by selling debentures and shares of industrial concerns or
financial institutions and even commercial banks subscribe to government loans out of funds
meant for investment, then the investment is adversely affected, leading to adverse effects on
production. However, if the government utilizes this money in commercial public enterprises, the
total investments available for production may not be adversely affected. Additionally, the loans
may be used to finance productive sectors of the economy e.g., agriculture and manufacturing.

5. Public Debts and Credit Control

Public debt also produces some impact on the effectiveness of credit control measures by the
Central Bank. It is well known that the main contributors to public loans are the commercial
banks, which are required to invest a pre-determined percentage of their investible funds in
government loans in exchange for bonds. These government bonds are highly liquid assets that are
converted into cash in no time.

6. Effects on Cost of Production

The cost of production of a product depends upon the prices of raw materials and other factors
used in production. The state utilizes the borrowed money in providing raw materials to the
producers at reasonable/concessional rates. The state may also utilize borrowed money in
promoting industrial research as well as in providing subsidies to private enterprises.

7. Effects of Foreign Loans on Economy

External borrowing in the economic development of under-developed and developing countries

has made possible the import of high-priority goods or capital goods or goods to be used to create,
build, and develop capacity for accelerating the rate of growth of the economy.

Methods of Redemption of Public Debt

Redemption of debt refers to the repayment of a public loan. Although public debt should be paid,
debt redemption is desirable too. In order to save the government from bank-ruptcy and to raise
the confidence of lenders, the government has to redeem its debts from time to time.

Sometimes, the government may resort to an extreme step, such as repudiation of debt. This
extreme step is, of course, violation of the contract. Use of repudiation of debt by the government
is economically unsound.
 ECON 422 Notes

Here, instead of concentrating on the repudiation of debt, we discuss below other important
methods for the retirement or redemption of public debt:

1. Refunding

Refunding of debt implies issue of new bonds and securities for raising new loans in order to pay
off the matured loans (i.e., old debts).

When the government uses this method of refunding, there is no liquidation of the money burden
of public debt. Instead, the debt servicing (i.e., repayment of the interest along with the principal)
burden gets accumulated on account of postponement of the debt- repayment to save future debt.

2. Conversion of high-interest loans to low-interest loans

By debt conversion we mean reduction of interest burden by converting old but high interest-
bearing loans into new but low interest-bearing loans. This method tends to reduce the burden of
interest on the taxpayers.

As the government is enabled to reduce the burden of debt which falls, it is not required to raise
huge revenue through taxes to service the debt.

Instead, the government can cut down the tax liability and provide relief to the taxpayers in the
event of a reduction in the rate of interest payable on public debt. It is assumed that since most
taxpayers are poor people while lenders are rich people, such conversion of public debt results in
a less unequal distribution of income.

3. Sinking Fund

One of the best methods of redemption of public debt is sinking fund. It is the fund into which
certain portion of revenue is put every year in such a way that it would be sufficient to pay off the
debt from the fund at the time of maturity. In general, there are, in fact, two ways of crediting a
portion of revenue to this fund.

The usual procedure is to deposit a certain (fixed) percentage of its annual income to the fund.
Another procedure is to raise a new loan and credit the proceeds to the sinking fund. However,
there are some reservations against the second method.

Dalton has opined that it is in the Tightness of things to accumulate sinking fund out of the current
revenue of the government, not out of new loans.

Although convenient, it is one of the slowest methods of redemption of debt. That is why capital
levy as a form of debt repudiation is often recommended by economists.
 ECON 422 Notes

4. Capital Levy

In times of war or emergencies, most governments follow the practice of raising money necessary
for the redemption of the public debt by imposing a special tax on capital.

A capital levy is just like a wealth tax in as much as it is imposed on capital assets. This method
has certain decisive advantages. Firstly, it enables a government to repay its (emergency) debt by
collecting additional tax revenues from the rich people (i.e., people who have huge properties).

This then reduces consumption spending of these people and the severity of inflation is weakened.
Secondly, progressive levy on capital helps to reduce inequalities in income and wealth. But it has
certain clear-cut disadvantages too.

Firstly, it hampers capital formation.

Secondly, during normal time this method is not suggested.

5. Terminal Annuity

It is something similar to sinking fund. Under this method, the government pays off its debt on the
basis of terminal annuity. By using this method, the government pays off the debt in equal annual
instalments.

This method enables government to reduce the burden of debt annually and at the time of maturity
it is fully paid off. It is the method of redeeming debts in instalments since the government is not
required to make one huge lump sum payment.

6. Budget Surplus

By making a surplus budget, the government can pay off its debt to the people. As a general rule,
the government makes use of the budgetary surplus to buy back from the market its own bonds
and securities.

This method is of little use since modern governments resort to deficit budget. A surplus budget is
usually not made.

7. Additional Taxation

Sometimes, the government imposes additional taxes on people to pay interest on public debt. By
levying new taxes — both direct and indirect — the government can collect the necessary revenue
so as to be able to pay off its old debt. Although an easier means of repudiation, this method has
certain advantages since taxes have large distortionary effects.
 ECON 422 Notes

8. Compulsory Reduction in the Rate of Interest

The government may pass an ordinance to reduce the rate of interest payable on its debt. This
happens when the government suffers from financial crisis and when there is a huge deficit in its
budget. There are so many instances of such statutory reductions in the rate of interest. However,
such practice is not followed under normal situations. Instead, the government is forced to adopt
this method of debt repayment when situation so demands.
 ECON 422 Notes

TOPIC 6: MARKET FAILURE AND EXTERNALITIES

Market Failure

Market failure arises when the price mechanism fails to account for all the costs and benefits
necessary to provide and consume a good. Market failure is thus the economic situation defined
by an inefficient distribution of goods and services in a market. Here, the market is said to have
failed by not supplying a socially optimal amount of a good and the price does not reflect the
marginal benefits of consumption.

Causes of Market Failure

(1) Externalities

An externality is an effect on a third party that is caused by the consumption or production of a

good or service. A positive externality is a positive spillover on third parties that results from the
consumption or production of a good or service. For example, although public education may not
only directly affect students and schools, an educated population may provide positive effects on
society as a whole. On the other hand, a negative externality is a negative spillover on third parties
that results from the consumption or production of a good or service. For example, smoking in
public might negatively affect the health of people even if they do not directly engage in smoking.
The collateral damage caused by negative externalities may lead to market failure.

(2) Market Control

When one party has too much control over a market, this can also create imbalanced pricing and
lead to market failure. In the case of a monopoly or oligopoly, a single seller or a small group of
sellers can manipulate pricing of goods and services. Monopolies can abuse their power by setting
prices very high, which can lead to the exploitation of consumers. The market failure is caused by
the uneven allocation of resources and inefficient pricing.

(3) Public Goods

Public goods are goods whose total cost of production does not increase with the number of
consumers. Public goods might cause market failure in that they defy the tenets of demand and
supply that drive the free markets. Public goods are non-excludable for instance when a street
light is installed, it is accessible to everyone, and the producer cannot limit consumption only to
paying customers. Public goods are also non-rival, as use by one individual does not limit
consumption by others. Given these characteristics, the private sector has little incentive to
 ECON 422 Notes

produce public goods, which leads to market failure, and the government usually has to provide
these goods or subsidize their production.

Market failure usually occurs due to the lack of public goods caused by the ‘free-rider problem’
which means that there are too many non-paying people using public goods.

(4) Information Failure

When there is insufficient information available to certain participants in the market, this can also
be the source of market failure. If the buyer or seller in a transaction lacks access to the
information on which the price is based, they may be willing to overpay or undercharge for a good
or service, disrupting the market’s equilibrium.

(5) Underproduction and Underconsumption of Merit Goods

A merit good is a good that society believes is under consumed, often with positive externalities.
Merit goods include education, health care, career advice, etc. and are associated with generating
positive externalities and bringing benefits to individuals and society. However, due to the
imperfect information about their benefits, merit goods are under-consumed, which causes market
failure. To increase consumption of merit goods, the government provides them for free. However,
they are still under-provided if we take into account all the social benefits that they can generate.

(6) Overproduction and Overconsumption of Demerit Goods

A demerit good is a good that society believes is over consumed, often with negative externalities.
Demerit goods are harmful to society and they include alcohol and cigarettes. Market failure
occurs due to information failure as consumers do not understand the level of harm these goods
can cause. Therefore, they are overproduced and overconsumed.

(7) Inequalities in the Distribution of Income and Wealth

Income includes the flow of money going to factors of production, such as wages, interest on
savings, etc. Wealth is the assets that someone or society owns, which include stocks and shares,
savings in a bank account, etc. The unequal allocation of income and wealth can cause market
failure.

(8) Environmental Concerns

The production of goods raises environmental concerns. For example, pollution and
environmental degradation come from the production of certain goods. Pollution damages the
environment and causes health problems to individuals. The production process that generates
 ECON 422 Notes

pollution to the environment means that the market is performing inefficiently, which causes a
market failure.

Reasons for Government Intervention

When a market fails, the government usually intervenes depending on the reason for the failure.
The market economic system operates under price mechanism.

Consumers show their willingness or desire to purchase a commodity at a given price in order to
maximize their utility.

On the other hand, producers aim at maximizing their profits for what they produce. In a market
economy, there is no justification for government/state intervention but there are some reasons
that necessitate the government to intervene in an economy as discussed below:

(1) To Maintain Price Mechanism

There may be possibilities of prevailing of an unjustified price mechanism even in the presence of
perfect competition in the market. The government, therefore, intervenes in order to monitor the
prices fixed by the market and protect the consumers from the burden of unjustified prices of
goods and services.

(2) To Regulate or Control Monopolies

Monopoly is a situation in which there is one producer/seller in the industry. The buyers are
compelled to purchase the commodity at the price fixed by the monopolist. Therefore, the
government intervenes for the benefit of consumers. The government intervenes in fixing prices
of commodities, and/or put measures to encourage new firms to enter into the market/industry.

(3) To Correct Externalities

Externalities represents those activities that affect others for better or worse, without others paying
or being compensated for the activity. Externalities exist when private costs or benefits do not
equal social costs or benefits. In such situation, government intervenes in the market with its
different policies.

(4) To Increase Social Welfare

Another strong reason for government intervention in an economy is the social welfare and
benefits. It is the duty and responsibility of a government to work for the common welfare of a
country by providing social goods and services such as hospitals, education facilities, parks,
museums, water and sewerage facilities, electricity, retirement benefits, scholarships, etc.
 ECON 422 Notes

(5) To Address Macroeconomic Issues

The government intervenes in an economy to ensure that the country is in the right trajectory with
regard to economic growth and development. Government ensures controlled inflation, creation of
more employment opportunities for the people, rapid technological advancement, favourable
business environment, and higher economic growth rate.

Ways of Correcting Market Failure

The government usually attempts to intervene to correct the market failure. The government can
use different methods to correct complete and partial market failures. The key methods that a
government can use are:

(1) Legislation

A government can enact specific laws that decrease consumption of demerit goods or make the
sale of these products illegal to correct market failure. For instance, to reduce the consumption of
cigarettes, the government sets 18 as the legal smoking age and bans smoking in certain public
areas (e.g. inside buildings, train stations, etc.)

(2) Direct provision of merit and public goods

This means that government engages to provide certain essential merit and public goods directly
at no cost to the public. For instance, the government may decide to build street lights in areas that
do not have them, to make neighbourhoods safer.

(3) Taxation

The government can tax demerit goods in order to reduce their consumption and production of
negative externalities. For example, taxing demerit goods such as alcohol and cigarettes increase
their price thereby decreasing their demand.

(4) Subsidies

This means that government pays the production firm to lower the price of goods in order to
encourage their consumption. For example, the government pays higher education institutions to
lower the price of tuition for students to encourage education consumption.

(5) Tradable permits

This is meant to reduce or minimize the production of negative externalities by imposing legal
permits. For instance, the government imposes a predetermined amount of pollution that firms are
 ECON 422 Notes

allowed to produce. If they exceed the limit, they have to buy add-on permits. On the other hand,
if they are under permitted allowance they can sell their permits to other firms and generate more
profit this way. This is the basis behind cap-and-trade, an attempt to reduce pollution.

(6) Extension of property rights

This means that government protects the property owner’s rights. For example, the government
implements copyrights to protect music, ideas, art, films, etc. This helps to stop inefficient
allocation of resources in the market such as stealing music (music piracy), ideas, etc., or
downloading films and music without paying.

(7) Advertising

Government’s advertising can assist in bridging the information gap. For instance, advertisements
increase awareness of health problems that can occur due to smoking, or raise awareness about the
importance of education.

(8) International cooperation among governments

This means that governments from different countries share important information as well as
address various problems, and work towards a common goal. Governments can work together on
issues that affect the future of the environment. This can help to correct market failure brought
about as a result of environmental concerns such as pollution. The government can address issues
such as lack of internal security to keep citizens safe and secure. Once this issue is addressed more
governments can work together to increase the national defence in their countries.

Externalities

Externalities are those activities that affect others (third parties) for better or worse without those
others paying or being compensated for the activity. Externalities exist when private costs or
benefits do not equal costs or benefits. Externalities are of two types, positive externalities and
negative externalities.

(1) Positive Externalities

A positive externality occurs when the actions of a producer or consumer have positive effects on
people who are not involved in the market transaction, and these effects are not reflected in
market prices.

For example, a local restaurant owner decides to invest in cleaning up the town's main park and
installing new playground equipment for children. While the restaurant owner may not directly
 ECON 422 Notes

benefit from the park renovation, the increase in tourism from families with young children who
come to use the new playground will benefit the town’s economy as a whole. This is an example
of a positive externality because the restaurant owner’s investment in the park benefits the
community beyond what they intended or are compensated for.

The main cause of a positive externality is a spillover of benefits. In other words, when a person
makes an economic decision, and the benefit is not limited to the decision-maker, but other people
benefit as well, there has been a positive externality.

When an economic activity is undertaken, it has a private cost and social cost, as well as a
private benefit and social benefit. A private cost is a cost incurred by the party who makes an
economic decision, whereas the social cost also includes the cost incurred by society or
bystanders as a result of the decision made by one party.

Similarly, a private benefit is a benefit gained by the party who makes an economic decision,
whereas a social benefit also includes the benefit to society or bystanders as a result of that
person’s economic decision. A positive externality is essentially a part of social benefits.

The most common examples of positive externalities include:

Education: Consuming education allows an individual to contribute to society in many ways,

such as by creating new inventions, sharing knowledge and ideas, and producing higher-quality
work.

Green spaces: Public parks and green spaces benefit the individuals who use them for
recreational purposes and the surrounding community.

Research and development: Technological advancements that result from research benefit the
companies and individuals that invest in them and positively affect society as a whole.

N/B: Sometimes, when the government realizes that a particular good or service has high positive
externalities, the government intervenes in the market to ensure that more of that good or service
is produced. One of the ways through which the government does this is the use of subsidies. A
subsidy is a benefit, often monetary, given to an individual or business to produce a particular
good.

(2) Negative Externalities

Negative externality occurs when the production or consumption of a good or service imposes
costs on third parties who are uninvolved in the transaction and do not receive compensation for
 ECON 422 Notes

those costs. Negative externalities are responsible for the inefficient allocation of resources in the
economy due to the cost they impose on third parties.

Pollution is one of the most common negative externalities that individuals face. Pollution
worsens when firms decide to increase their earnings while simultaneously decreasing their
expenses by introducing new practices that are worse for the environment.

In the process of this, the firm contributes to a significant increase in the amount of pollution.
Pollution causes disease, which reduces the ability of one to provide labor and increases health
care expenses.

The following are five examples of negative externalities:

Air pollution: When factories emit pollutants into the air, it can harm the health of nearby
residents, causing respiratory problems and other illnesses.

Noise pollution: Loud noises from construction sites, transportation, or entertainment venues can
cause hearing damage and other negative health effects for nearby residents.

Traffic congestion: When too many cars are on the road, it can lead to delays and increased
commute times, as well as increased air pollution and greenhouse gas emissions.

Deforestation: When forests are cut down for agricultural or industrial purposes, it can lead to
soil erosion, loss of biodiversity, and reduced ability to absorb carbon dioxide from the
atmosphere.

Second-hand smoke: Cigarrete consumption in public places, it can harm the health of non-
smokers who are exposed to the smoke, increasing the risk of respiratory illnesses and cancer.

N/B: Correcting a negative externality becomes essential when the production of a good results in
the incurrence of spillover costs. One of the central authorities capable of mitigating the effect of a
negative externality is the government. One way the government can reduce negative externalities
is through taxes.

Policies Used to Correct Externalities/ Methods of Internalizing Externalities

Internalizing externalities means making changes in the market so that individuals are aware of all
the costs and benefits they receive from externalities.

The objective of internalizing externalities is to change the behavior of individuals and businesses
so that negative externalities decrease and positive ones increase. The goal is to make private
costs or benefits equal to the social costs or benefits. We can achieve this by raising the prices of
 ECON 422 Notes

certain products and services to reflect the costs that individuals and unrelated third parties
experience. Alternatively, the prices of products and services that bring benefits to individuals can
be lowered to increase positive externalities.

The following are methods that governments and firms use to internalize externalities:

(1) Taxes

The consumption of demerit goods such as cigarettes and alcohol produce negative externalities.
For example, in addition to harming their own health by smoking, individuals can also negatively
affect third parties because smoke harms those around them. The government can internalize these
externalities by taxing those demerit goods to decrease their consumption. They would also reflect
the external costs that third parties experience in their price. In order to reduce the level of
pollution, an emission tax is levied on firms. With an emission tax, firms responsible for
emissions must pay for the services of the environment just like any other input. Emission taxes
are utilized in many countries as a source of revenue for environmental clean up.

(2) Raising prices of goods that produce negative externalities

To internalize the negative production externality such as pollution, businesses can raise the price
of their products to reduce their consumption. This would reflect the costs that third parties
experience in the products’ prices.

(3) Direct provision

The government could opt for directly providing goods or services that generate positive
externalities, such as public hospitals, public schools, or national parks and stadia.

(4) Subsidies

Subsidies reduce the cost of production or consumption, which in turn encourages more of the
activity. For instance, the government might subsidize vaccinations because of their positive
spillover effects on public health. Government can give subsidies to firms so as to reduce their
levels of pollution. The subsidies will act as an incentive for firms to reduce pollution levels.
Firms will determine the best ways of reducing emissions.

(5) Regulation

Regulation is a mandated level of performance that is enforced in law. Regulatory measures like
laws or mandates can ensure that activities with positive externalities occur. Compulsory
education laws, for example, ensure more children get go to school than might otherwise be the
 ECON 422 Notes

case. Regulatory measures like laws or mandates can ensure that activities with negative
externalities ae minimized or reduced. For instance, regulations can specify the maximum rate of
emission that is legally allowed or the technologies or practices potential polluters must adopt
(e.g. chemical truck drivers must obtain a commercial driver’s license and be drug tested).

(6) Tradable Pollution Permits

Each permit entitles the holder to emit one unit of the pollutant specified during a certain period
of time. Permits can be bought and sold at whatever price the participants agree on. Suppose a
power plant firm emits 8,000 tons of Sulphur per year and the government wants an overall
reduction of Sulphur emissions by 25%. The firm is given a 6,000-ton discharge (pollution)
permit. The options will be:

(a) Reduce emissions to 6,000 tons, buy additional pollution permit and emit at a higher level
Or
(b) Reduce emissions below 6,000 tons and sell excess permits.

The advantage of pollution permits over simple regulations is that we get the same overall level of
environmental quality at a lower cost since the firm that find it inexpensive to reduce emissions
will do so and sell permits to other firms that have high abatement costs.

(7) Assigning Property Rights

Property rights create a set of controls on net positive or negative externalities, because they
provide incentive to impose costs or realize benefits. Without property rights, or when property
rights are unclear, there is no way to efficiently solve the problems posed by externalities.

Assigning property rights exist and if private parties can bargain without cost (or with low enough
costs), they can solve the problem of externalities on their own. It does not matter how the
property rights are initially distributed. This depends upon the transaction costs (the opportunity
costs of conducting a transaction) of bargaining. Take for instance, the fly-fishing farmer. The
farmer use of the water created a negative externality for the fishermen - so they bargained. The
fishermen paid the farmers not to farm.

Also take for example smoking. Smokers might create negative externalities for non-smokers -
but if smokers do not smoke to please the non-smokers, then they have a negative externality put
on them.
 ECON 422 Notes

Precedents (norms) are important in determining respective property rights. Then, of course, once
property rights are assigned - invading another’s property or person can be taken care of under the
criminal legal system. For example, fraud or assault.

Asymmetric Information

Asymmetric information is the situation when one party in a transaction possesses more
information about the product/service involved than the other party.

Types of Asymmetric Information

(1) Adverse Selection

Adverse selection occurs when information is known to one party but not the other. This makes it
difficult for potential trading partners to distinguish between high-risk and low-risk transactions.
This problem is particularly common in insurance markets.

Adverse selection occurs when products of different qualities are sold at the same price due to the
information asymmetry between buyers and sellers.

This causes a problem to determine the true quality of the product while purchasing it. Hence, it
causes a higher quantity of low-quality products and less quantity of high-quality products being
sold in the market.

Adverse selection is also a problem for the insurance market. Let us consider an example in the
health insurance market.

Example

People who purchase insurance are far more informed about their health than the insurance
company. Even if the insurance company runs many screening tests, they may not be able to
identify all of the health problems. In this case, there is an information asymmetry between the
insurance buyers and the insurance company. Knowing that less healthy people are more likely to
get insurance, insurance companies raise the price of their premiums. This forces more relatively
healthy people to drop out, leaving the insurance pool with even less healthy people. You can see
why this can turn into a problematic cycle for the insurance market.

(2) Moral Hazard

The situation when an individual alters his/her behavior knowing that their actions are unobserved
is known as a moral hazard. In insurance markets, moral hazard occurs when insured consumers
are likely to take greater risks knowing that a claim will be paid for by their cover. The consumer
 ECON 422 Notes

(insured) knows more about his/her intended actions than the producer (insurer). If more people
have access to health insurance for example, behavioural changes arising from moral hazard
might lead to a substantial rise in health insurance payouts.

Moral hazard does not only alter the behavior of an individual, it leads to economic inefficiency.
Economic inefficiency arises because, in comparison to actual cost and benefits, the insured
person perceives the cost and benefits differently.

Example

Suppose that Emily gets full insurance on her house against theft. Now, her behavior might alter.
She might not be as careful as before while locking the doors, and she might choose to not get an
alarm system. The change in her behavior as she is insured is an example of a moral hazard.