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P.F Chapter Three
P.F Chapter Three
Different sources of public revenue have different relative significances, which can be known
only when we suitably classify the public revenue. Similarly, the effects and incidence of various
kinds of public revenue differ from each other. Thus, in order to know these differences and
significances we need to classify public revenue. Economists have given various classifications
of the public revenue. Looking from different angles, they have grouped public revenue in one
or another manner. The differences of opinion in this regard are not important, as they are only
the different faces of the same coin viewed from different angles. Different classifications do not
change the nature of public revenue. The following are the main classifications given by
different economists.
A. Bastable's Classification
Like Adam Smith, Charles F. Bastable has also divided public revenue into: (i) those incomes
which the government receives from performing its various functions just like a private
individual or corporation, and (ii) those incomes which the state derives in its capacity as ‘state’.
The first category of revenue includes all the incomes which the government derives in the form
of fees and prices, while the second category of revenue includes taxes and levies. Like Adam
Smith's classification of public revenue, Bastable's approach is also narrow and limited.
B) Seligman's Classification
Seligman has divided pubic revenue into:
(i) Gratuitous revenue: It is that public revenue which is derived by the government free
of cost. It includes gifts received from the public and others including foreign
governments and does not constitute an import ant source of public revenue for the
government.
(ii) Contractual revenue: this part of pubic revenue is derived by the government as a
result of the contracts made between the public and the government. Royalty incomes
from land and mines and income from public enterprises are included under this
category.
(iii) Compulsory revenue: it includes those incomes which are derived by the government
from administration, justice and taxation. Thus, taxes, fees, fines etc. are the main
sources of this category or revenues.
C) Taylor's Classification
Taylor has classified public revenue into the following four parts.
(i) Grants-in-aid: these are the means by which one government provided financial assistance
to another, usually in the performance of a specified manner. Education and health grants
flowing from the center to the states in the federal form of government are examples of
grants - in - aid . Grants are sometimes, although very seldom, also made for general and
unspecified purposes. Grants-in-aid are cost payment for the grantor government and
revenue receipts for the grantee government since no obligation to repay such grants is
established. Gifts are voluntary contributions made by donors generally for specified
purposes. As a category of public revenue, grants and gifts are characterized by their
voluntary nature and by the absence of any expectation of direct benefit for the donor.
(ii) Administrative revenue: these revenues include fees, licenses, fines and special
assessment etc. They are characterize by more or less free choice on the part of the payer
as to whether or not he will pay and more or less direct benefit (or penalty) conferred
upon him . The amount of the assessment does not necessarily bear close relationship
either to the value of the benefit conferred or the cost incurred in administrating the
benefit. They generally arise as a by -product of the administration of a control function
of the government. It is simply due to this last peculiar characteristic to these public
revenues that Taylor gives them the name of Administrative Revenues.
(iii) Commercial revenues: These revenues are received in the form of prices paid for the
government produced goods and services . These include payments for postage , interest
on funds borrowed from the government , tuition fees of public educational institutions,
prices paid for liquor in government stores , surplus war materials , electricity distributed
by public owned utilities and the like . The salient characteristic which distinguishes
commercial revenues from those in other categories is the direct receipt of a good or
service in return for payment and adjustment of the amount of payment approximately to
the cost of production.
(iv) Taxes: Taxes are compulsory payments made to government without expectation of any
direct return or benefit of the tax -payer. Taxes are in the nature of compulsory
contribution made by the tax - payers to the general funds of the government and these do
not confer any specific benefits on the tax -payers, although there has been some
tendency toward allocation of the benefits roughly on the basis of tax revenue.
Taylor's classification of pubic revenue is based on sound economic and scientific principles and
it seems to be the most logical and useful classification among the above-discussed
classifications of public revenue.
Public debt is of recent growth and was unheard of prior to the 18 th century. In modern times,
however, borrowing by the States has become a normal method of government finance along
with other sources such as taxes, fees, etc. The government may borrow from banks, business
houses, other organizations and individuals. Besides, it can borrow within the country or from
outside. The government loan is generally in the form of bonds (or treasury bills if the loan is
required for short periods) which are promises of the government to pay to the holders of these
bills the principal sum along with interest at the stated rate. Borrowing is resorted to provide
funds for financing a current deficit. This definition very clearly explains the three features of
public debt.
1. Public debt arises in the form of borrowings by the treasury or by the state exchequer.
2. The government borrows a certain amount now but promises to pay in the future not only
the principal amount but also the interest.
3. The government borrows when there is a budget deficit i.e. public expenditure is more than
revenue.
3.2.2 Classification of Public Debt
Public debt can be classified in different ways according to various factors like sources of
borrowing, purpose of loan, the term duration of loan provision for repayment, nature of
contribution, marketability.
Thirdly, public borrowing is considered very useful to remedy a depression. Business depression
and unemployment are generally due to deficiency of demand for goods and services. Keynes
advocated increased public expenditure financed through borrowing and not through taxation.
For, while taxation will reduce the incomes of the public and their demand still further,
borrowing will have no such effect. Besides, loans enable the government to make use of idle
and unutilized funds of the public.
Finally, public loans are resorted to for development purposes. Underdeveloped countries
interested in the development of their natural resources to the optimum level find public
borrowing a very useful device to finance the various development projects. In countries like
Ethiopia, public debt has been increasing in recent years because of this factor.
Every government has two major sources of borrowing-internal and external. Internally, the
government can borrow from individuals, financial institutions, commercial banks and the
central bank. Externally, the government generally borrows from individuals and banks,
international institutions and other governments. When individuals purchase government bonds,
they are diverting fund from private use to government use. More important than individual
subscribers to government bonds are the financial institutions such as insurance companies,
investment trusts, mutual savings banks, etc. These non-banking financial institutions prefer
government bonds because of the security provided by the latter and also due to their high
negotiability and liquidity. While individuals and non-banking financial institutions take up
government bonds out of their own funds, the commercial banks can do so by creating additional
purchasing power-known as credit creation. The central bank of the country can subscribe to
government loans. By purchasing government bonds, the central bank irradiates the account of
the government. Borrowing from the central bank is the most expansionary of all the sources, for
not only the government secures funds for its expenditure but the commercial banking system
gets additional cash which can be used as the basis for further credit expansion.
Government may borrow from other countries to finance war expenditure or to pay for
development projects or to payoff adverse balance of payments. Two important sources have
become prominent. They are: (a) international financial institutions, viz., the IMF and World
Bank, which give loans for short term to payoff temporary balance of payments difficulties and
for long term for development purposes; and (b) government assistance generally to assist in
development projects. For developing countries like Ethiopia, external sources of borrowing are
becoming considerably important in recent years.
a) Public debt necessitates a transfer of funds from the private sector (individuals and
companies) to the Government in the form of additional taxation;
b) Public debt is a more costly method of financing public expenditure than taxation
because of the additional cost of interest payments;
c) Public debt tends to transfer the burden of a particular outlay to future taxpayers; and
d) Excessive borrowing by and huge public debt of the Government, may undermine the
credit worthiness of the Government.
It is convenient and useful to adopt Dalton's distinction between direct and indirect burden of
public debt and between money burden and real burden of public debt. We can, therefore, speak
about four types of burdens of public debt, viz.,
(a) Direct money burden,
(b) Direct real burden,
(c) Indirect money burden, and
(d) Indirect real burden.
(a) Direct Money Burden: Public debt involves payment of interest and repayment of the
principal by the government, who will have to raise the necessary amount by way of taxes. The
direct money burden of public debt consists of the tax burden imposed on the public and it is
equal to the sum of money payments for interest and repayment of principal.
(b) Direct Real Burden: when we refer to the distribution of taxes and public securities among
the public, we are referring to the real burden of public debt. We know that people hold public
securities (and get interest from the Government) but they also pay taxes towards the cost of the
debt service. If the proportion of taxation paid by the rich towards the cost of the debt service is
smaller than the proportion of public securities held by them, while on the other, if the proportion
of taxation paid by the poor and middle income groups towards the cost of the debt service is
greater than the proportion of public securities held by them, there is a direct real burden from
public debt. In this case, public debt has been responsible for worsening inequality of incomes.
(c) Indirect money and real burdens. Heavier taxation to meet debt charges may reduce
taxpayers’ ability and desire to work and save and thus check production. Heavy debt charges
may also force the government to economies on public expenditure as might promote production.
In case these adverse effects of taxation could be neutralized by some favorable effects of public
expenditure, the indirect burden of public debt can be cancelled out. In practice, however, this
may not be possible. In the case of external debt, indirect money and real burden arise from
checks to production because of additional taxation (to pay for debt charges) and to possible
economies which government may effect in desirable social expenditure.
In one sense, the burden of a foreign debt is similar to that of domestic debt. That is, the
government will have to pay it through additional taxation. But, while in domestic debt, interest
payments and the repayment of loans are available to local nationals; in the case of foreign debt
they are available to foreigners. In another sense, the total money burden of an external debt is
more because there is the additional transfer problem. That is, the government will have to find
necessary monetary resources to pay off the external debt and besides will have to secure foreign
currencies too (after all, foreigners will have to be paid in their currencies). The transfer problem,
therefore, requires that during the term of the loan, the balance of trade must become favorable.
In other words, a regular payment of interest and principal to foreign countries will be possible
only if the export value exceeds the import value by at least the obligations arising from the loan.
But external debt can mean a certain impoverishment of the economy. The payment of interest
and debt redemption to foreign Countries means a corresponding exhaustion of national income
and makes greater demand on the gold and foreign exchange resources of the country. This is
what has been referred to as the transfer problem in the previous paragraph. But properly
speaking, there is no impoverishment involved. What actually happens is this: originally, when
foreign loans were made, they entered the debtor country in the form of machinery, raw
materials and other essential goods, for which no corresponding exports were made at that time.
3.4. THE ROLE OF GOVERNMENT IN THE ECONOMY
Although the market system in developed countries relies on private ownership and decentralized
decision-making by households and privately owned businesses, the government does perform
important economic functions. The government passes and enforces laws that protect the
property rights of individuals and businesses. It restricts economic activities that are considered
unfair or socially unacceptable.
In addition, government programs regulate safety in products and in the workplace, provide
national defense, and provide public assistance to some members of society coping with
economic hardship. There are some products that must be provided to households and firms by
the government because they cannot be produced profitably by private firms. For example, the
government funds the construction of interstate highways, and operates vaccination programs to
maintain public health. Local governments operate public elementary and secondary schools to
ensure that as many children as possible will receive an education, even when their parents are
unable to afford private schools.
Other kinds of goods and services (such as health care and higher education) are produced and
consumed in private markets, but the government attempts to increase the amount of these
products available in the economy. For yet other goods and services, the government acts to
decrease the amount produced and consumed; these include alcohol, tobacco, and products that
create high levels of pollution. These special cases where markets fail to produce the right
amount of certain goods and services mean that the government has a large and important role to
play in adjusting some production patterns in the economy. But economists and other analysts
have also found special reasons why government policies and programs often fail, too.
At the most basic level, the government makes it possible for markets to function more
efficiently by clearly defining and enforcing people’s property or ownership rights to resources
and by providing a stable currency and a central banking system. Even these basic functions
require a wide range of government programs and employees. For example, the government
maintains offices for recording deeds to property, courts to interpret contracts and resolve
disputes over property rights, and police and other law enforcement agencies to prevent or
punish theft and fraud. The Treasury Department issues currency and coins and handles the
government’s revenues and expenditures. And as we have seen, the National Bank controls the
nation’s supply of money and availability of credit. To perform these basic functions, the
government must be able to shift resources from private to public uses. It does this mainly
through taxes, but also with user fees for some services (such as admission fees to national
1.4.1 Correcting Market Failures
The government attempts to adjust the production and consumption of particular goods and
services where private markets fail to produce efficient levels of output for those products. The
two major examples of these market failures are what economists call public goods and external
benefits or costs.
1.4.1.1 Providing Public Goods
Public goods are a category of goods and services that benefit members of society in general.
National defense is one of the public goods that government provides in the country’s Economy.
Private markets do not provide some essential goods and services, such as national defense.
Because national defense is so important to the nation’s existence, the government steps in and
entirely funds and administers this product.
Public goods differ from private goods in two key respects. First, a public good can be used by
one person without reducing the amount available for others to use. This is known as shared
consumption. An example of a public good that has this characteristic is a spraying or fogging
program to kill mosquitoes. The spraying reduces the number of mosquitoes for all of the people
who live in an area, not just for one person or family. The opposite occurs in the consumption of
private goods. When one person consumes a private good, other people cannot use the product.
This is known as rival consumption. A good example of rival consumption is a hamburger. If
someone else eats the sandwich, you cannot.
The second key characteristic of public goods is called the non-exclusion principle: It is not
possible to prevent people from using a public good, regardless of whether they have paid for it.
For example, a visitor to a town who does not pay taxes in that community will still benefit from
the town’s mosquito-spraying program. With private goods, like a hamburger, when you pay for
the hamburger, you get to eat it or decide who does. Someone who does not pay does not get the
hamburger.
1.4.1.2 Adjusting for Negative or Positive Externalities (Social Costs or Benefits)
The idea that competitive market automatically brings about efficient resource use rests on the
assumption that all benefits and costs of production and consumption’s of each product are fully
reflected in the market demand and supply curve respectively.
There are some private markets in which goods and services are produced, but too much or too
little is produced. Whether too much or too little is produced depends on whether the problem is
one of external costs or external benefits. In either case, the government can try to correct these
market failures, to get the right amount of the good or service produced.
Negative externalities occur when not all of the costs involved in the production or consumption
of a product are paid by the producers and consumers of that product. Instead, some of the costs
shift to others. One example is drunk driving. The consumption of too much alcohol can result in
traffic accidents that hurt or kill people who are neither producers nor consumers of alcoholic
products. Another example is pollution. If a factory dumps some of its wastes in a river, then
people and businesses downstream will have to pay to clean up the water or they may become ill
from using the water.
When people other than producers and consumers pay some of the costs of producing or
consuming a product, those external costs have no effect on the product’s market price or
production level. As a result, too much of the product is produced considering the overall social
costs. To correct this situation, the government may tax or fine the producers or consumers of
such products to force them to cover these external costs. If that can be done correctly, less of the
product will be produced and consumed.
Positive externalities occur when people other than producers and consumers enjoy some of the
benefits of the production and consumption of the product. One example of this situation is
vaccinations against contagious diseases. The company that sells the vaccine and the individuals
who receive the vaccine are better off, but so are other people who are less likely to be infected
by those who have received the vaccine. Many people also argue that education provides
external benefits to the nation as a whole, in the form of lower unemployment, poverty, and
crime rates, and by providing more equality of opportunity to all families.
The governments do allow what economists call natural monopolies. However, the governments
then regulate those businesses to protect consumers from high prices and poor service, and often
limit the profits these firms can earn. The classic examples of natural monopolies are local
services provided by public utilities. Economies of scale make it inefficient to have even two
companies distributing electricity, gas, water, or local telephone service to consumers. It would
be very expensive to have even two sets of electric and telephone wires, and two sets of water,
gas, and sewer pipes going to every house. That is why firms that provide these services are
called natural monopolies.
Some government policies intentionally reduce competition, at least for some period of time.