PUBLIC EXPENDITURE

LECTURE FIVE

5.1 INTRODUCTION

Lecture five discusses the major areas of public expenditure. It explains the various
definitions that can be adopted in public expenditure. It explains the canon of public
expenditure. The lecture ends by discussing in details how the public expenditure can be used
to solve macroeconomic problems such as inflation and unemployment.

5.2 LECTURE OBJECTIVE

At the end of the lecture you should be able to:

a) Explain the theories of the growth of public expenditure
b) Discuss how public expenditure is used to solve macroeconomic
problems
c) Conduct project evaluation
d) Explain the growth of public expenditure

5.3 DEFINITION OF PUBLIC EXPENDITURE

Public expenditure can be defined in different ways as:
a) The expenditure of central and local government;
b) The combined government expenditure plus disbursements out of the National Insurance
(social security) Fund; or
c) The total government expenditure as in (ii) plus expenditure of the public corporations.

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The size of the public expenditure will depend on the definition adopted and will differ
accordingly. This can give rise to confusion when comparisons are made over a period of time or
internationally. Thus, if public-expenditure is defined in terms of what the central government
and local authorities spend; it will appear smaller than when expenditure by public corporations
is also included.

The basis on which public expenditure once defined is analyzed, does not, however, affect the
total figure which represents the absorption of resources by the public sector. The analysis can be
undertaken-on the following basis:
i). Spending authority: Central government, local authorities, public corporations,
ii). Economic category: Current expenditure account (expenditure on goods, services, transfer
payments), capital account (investment),
iii). Programme: defence, agriculture, housing.

The total figure for public expenditure, whichever basis is used, should be the same and
represents the absorption of resources by the public sector.

5.4 Canons of Public Expenditure

These are principles proposed to govern the public expenditure decisions. They include;
1) Canon of economy – utmost care must be taken to avoid wasteful usage of public funds.
2) Canon of sanction – no public funds should be used without proper authorization and funds
should be used only for the purpose for which they were sanctioned.
3) Canon of benefit – public expenditure should be incurred only if it is beneficial to the society
as a whole. The benefits can be through income distribution or production.
4) Canon of surplus – the government should avoid deficit budgeting. It should be prudent and
aim at meeting its current expenditure needs out of its current revenue. It should not
overspend and run into debts.

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5.5 THE GROWTH OF PUBLIC EXPENDITURE
WAGNER'S LAW
Adolf Wagner (a German economist in the nineteenth century) analyzed trends in the growth of
public expenditure and in the size of the public sector in major countries of the world. His
observations led to what is now called Wagner's Law or the Law of Rising Public Expenditure,
(He preferred to call it an observation).
It postulates that;
a) The extension of the functions of the state leads to an increase in public expenditure on
administration, and regulation of the economy;
b) An increase in national income of a Country will bring about a growth in public expenditure
on such programmes as education, health and welfare; and
c) The rise in public expenditure will be more than proportional to the increase in the national
income and will thus result in a relative expansion of the public sector. The cause and effect
can therefore be stated as follows; social progress leads to increased state activity, this is turn
gives rise to greater public expenditure which results in a bigger public sector. Wagner's Law
demonstrated a tendency but not the inevitability of continuous growth of public expenditure.

Displacement Effect
Growth of public expenditure during a war is, however, inevitable. Analysis of the time pattern
of public expenditure by Professor A.T. Peacock and J. Wiseman has established the
Displacement Effect. They found that public expenditure increases during a war or a period of
social crisis. When the war ends or the crisis is resolved, public expenditure falls, but not to the
original level at the start of the emergency, with the result that growth in public expenditure
occurs in stages.

5.6 REASONS FOR THE GROWTH OF PUBLIC EXPENDITURE

Various factors – political, social and economic – have contributed to the growth of public
expenditure and the growth of the public sector. The following are some of the major factors:
a) The abandonment of the laissez-faire doctrine. As the climate of public opinion changed
new theories began to emerge and old ones were abandoned; among the latter was the

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 doctrine of laissez-faire. The self-correcting mechanism of an economic system that the
classical economists believed in appeared to have failed. Unemployment, which to them
was a theoretical impossibility, not only proved possible, but became a major
international problem. During the Great Depression of the 1930s over 20 per cent of the
insured population of the UK was unemployed. The theory of governmental non-
intervention could no longer command support. There was a pressure of public opinion
on governments to provide, relief for the unemployed and to create jobs. In order to do
so, public expenditure was increased.
b) The advent of Keynesian economics. One book, The General Theory of Employment,
Interest and Money (1936), by John Maynard (later Lord) Keynes, had a profound and
pervasive influence on economists and on governments for many generations. His
arguments that the government not only could but should use public expenditure as a tool
of economic policy to manage a national economy so as to counteract unemployment,
found ready acceptance in a world that had not yet recovered from the Great Depression.
The Keynesian prescription was to inject money into the economic system. If the people
were not spending, then it was up to a government to do so.

This required an expansive fiscal policy, in which a government would deliberately aim
at a Budget deficit by spending more money than it raised in taxation. To cover the
difference (deficit) the government would borrow. The 'Multiplier' effect of public
expenditure would counteract unemployment. Such fiscal policy was attractive to the
governments and popular with the public. By increasing public expenditure, a
government was seen to be doing something about unemployment whilst the public were
getting something (additional state benefits) for nothing, as it appeared, since there was
no increase in taxation. Government therefore had an incentive to increase public
expenditure and they did. What is more the policy appeared to work, unemployment
began to fall. But to what extent the increase in economic activity can be attributed to
governments' conversion to Keynesian economics, and to what extent it was the result of
rearmament on which major countries embarked at the time when the General Theory
was published, is debatable. Increased expenditure on defence was a response to the

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 threat of war. As such it was a political measure but it did inject money into the economy
and therefore had economic consequences.
c) Wars and social crises, such as severe and prolonged unemployment had resulted in the
growth of public expenditure.
d) Increase in the range of economic activities by the state. Emergence of political
philosophies, social attitudes and economic theories that advocated extension of the
activities of the states prepared the way for governments to expand public expenditure.
e) Psychological conditioning of the general public, during a period of war and social
crisis, to a greater government intervention and higher levels of expenditure and taxation
made it easier for governments in subsequent periods to retain and to expand their
activities.
f) Post-war reconstruction of countries' economies involved governments in planning,
allocation of resources and in financing some of the projects.
g) Economic development, according to some economists, has considerable impact on the
level of public expenditure. Before a developing country can industrialize, it has to invest
in transport, water and power supplies, sanitation, education and other basic social
projects to reach a 'take-off point. In this early stage of development a high proportion of
total investment will have to be made by the government, since the projects do not offer
any, or foreseeable, return to investors. Once the country has reached a more advanced
stage of economic and social development, private investment expands alongside public
investment but, because of the imperfections of the market, government intervention
grows and with it public expenditure.
h) Growth of national income is related to the level of government economic activity. Some
economists, Wagner among them, had argued that an increase in national income results
in an increase in public expenditure on economic welfare. The richer a country the more
resources, in theory, are available to the government.
i) Increased public expectation. It can, however, be argued that, although it cannot be
statistically proved, an indirect relationship exists between the growth uf national income
and public expectation of an improved standard of living, and hence public expenditure.
Governments are likely to-be under pressure to increase provision of public goods and

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 services so as to increase the standard of living in general and of the poorest members of
society in particular.
j) The establishment of the welfare state. This has created a base for the long term growth
of public expenditure.
k) Socialism. Socialist parties, committed by their ideology to the extension of the public
sector, won general elections and formed governments after the Second World War in a
number of countries, including the UK. Implementation of the policies set out in the elec-
tion manifestos furthered the development of mixed economies and contributed to the
growth of public expenditure.
l) Nationalization. The state takeover of private enterprises has increased public
expenditure in two ways, firstly by a government paying compensation to former owners
and secondly by subsidizing loss-making nationalized industries.
m) New technology and science. Some new technological developments in such fields as
atomic energy, aerospace and computers are so costly that in some countries they can
only be financed by the state or with substantial aid from government funds. Scientific
advances have enabled doctors to prolong life and reduce suffering, but in some cases at
an enormous cost to governments' health programmes by creating ever-increasing
demands.
n) Creation of super national organizations. The United Nations, NATO, European
Community and other multinational organizations that are responsible for the provision
of public goods and services on an international basis, have to be financed out of funds
subscribed by member states, thereby adding to their public expenditure.
o) Foreign aid. Acceptance by the richer industrialized countries of their responsibility to
help the poorer developing countries has channeled some of the increased public
expenditure of the donors into foreign aid programmes.
p) Increased complexity of national economies. As economies develop they become more
complex and the interests of various groups within a society come into conflict. This has
led to the proliferation of public bodies whose costs, arising out of their coordinating,
regulatory, administrative or judiciary functions are borne by governments.

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 q) Inflation. A general increase in prices has been an international phenomenon during the
1970s-1980s. Inflation increased the cost of all the activities of the public sector and was
thus a major factor in growth in money terms of public expenditure in many countries.
r) Demographic changes. Since public expenditure is intended to benefit the people of a
country, it could therefore be expected that an increase in total population would result in
higher public expenditure. But other demographic trends such as changes in the structure
of the population (age and sex) and its geographical distribution also have to be taken
into account. The overall effect of the various trends on public expenditure may be such
that they cancel each other out, thus the extent to which the growth of population has led
to growth of public expenditure depends on the specific conditions in different countries.
5.7 RESTRAINTS TO THE GROWTH OF PUBLIC EXPENDITURE
Some of the factors in the growth of public expenditure that we have discussed are of a
temporary nature, others contribute to structural changes that result in an increasing financial
commitment by governments on a permanent basis, but the ability to spend is not unlimited.
The following are the four main restraints:
a) Resources. In the long run, public expenditure cannot exceed the resources of a country.
b) Taxable capacity. This imposes a ceiling on the government's revenue from taxation and
thereby on an increase in public expenditure that is financed out of it.
c) Limit to borrowing. For a time public expenditure can outstrip revenue either as a matter of
necessity or of fiscal policy and the deficit can be financed out of loans. But there is a limit to
how much money lenders at home and abroad will be prepared lo make available to any
government.
d) Public opinion. The final major restraint is the growth of public opinion. The level of public
expenditure in a democratic society will depend on the size of the public sector that people
want and are willing to pay for through taxation.

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5.8 CONSEQUENCES OF THE GROWTH OF PUBLIC EXPENDITURE
Political, social and economic consequences are interrelated. They cannot therefore be easily
isolated and compartmentalized. Some are, however, more identifiable than others and are listed
below:
a) A political consequence of the growth of public expenditure is the increased size of the
public sector and hence of the power of the state.
b) A social consequence of the extension of the welfare system is to allay the fear of
deprivation that is consequent to unemployment, sickness and old age. The need for people to
provide for themselves is reduced.
c) Development of a welfare mentality is likely to increase people's dependence on
government support and to lead to the creation of what politicians and social commentators
call the 'underclass' in a society. Its members caught in the poverty trap may lack the means,
ability, resourcefulness and incentive to break out.
d) An economic consequence is an increase in taxation or borrowing or both, to finance rising
expenditure.
e) A disincentive effect on work and enterprise may result from an increase in taxation required
to finance provision of public goods and services but economists disagree on this.
f) National debt will increase as a result of borrowing and this will affect the rates of interest
and supply of capital to industry.
g) The rate of economic growth may be adversely affected by the; transfer of resources from
use in manufacturing in the private sector to the public sector for provision of social services.
h) The productive capacity and export potential of an economy may be reduced. Public
goods and services, such as social security benefits, are not exportable and do not earn
foreign currency.
i) The balance of payments, will suffer if exports are reduced and when interest payments on
the money that the government had borrowed abroad, or repayment of capital, become due.
j) The prosperity of a country may, however, be increased if public expenditure is on projects
that further economic development. If this happens then the balance of payments may
improve.
k) The standard of living of the people in general and of some groups in particular can be
increased by the provision of public goods and services.

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l) Inflation resulting from the injection of public spending into the income flow of a country
adversely affects not only the standard of living but the whole economy
m) Stabilization of the economy may result from the use of public expenditure to counteract
inflation and deflation.
n) The level of employment may rise, but if the effect of increased public spending is
inflationary, employment will be likely to fall.
o) A more egalitarian society can be achieved by narrowing the difference in the level of
consumption among its members by means of state benefits financed out of progressive
taxation.
p) Increased efficiency in provision of public goods and services as governments put greater
emphasis on value for money in an attempt to curb growing public expenditure.

This list of favourable and adverse effects that may follow an increase in public expenditure is by
no means conclusive. Whether its consequences will be beneficial or not will depend on the
existing level of expenditure, the purpose for which the additional money is used, the way that
the expenditure is financed and the specific circumstances of a particular country.

5.9 EFFECT OF PUBLIC EXPENDITURE

Government expenditure or outlay has important effects on the entire economy of a country. It is
important to consider the impact of public expenditure on such aspects as the level of
employment, production and income, stability of prices, the creation and maintenance of
full employment and a better distribution of income and wealth in the country. The
influence of public expenditure on levels of economic activity and on distribution will depend
upon the nature of the government and the period during which public outlay is made. For
instance, in a free economy and during peacetime, government expenditure is generally quite low
but in a socialist economy and also during war period, the contribution of government
expenditure is more significant as regards the level of economic activity and employment.

1. EFFECTS ON PRODUCTION AND EMPLOYMENT

Dalton shows how the level of production and employment in any country depends upon three
factors,

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 a) Ability of the people to work, save and invest.
b) Willingness to work, save and invest, and
c) Diversion of economic resources as between different uses and localities.

It is possible to influence all these three factors through public expenditure either for the better or
for the worse. Government expenditure may help to improve the efficiency to work and thus
raise the income of the people in the country. Accordingly, people may be able to save and invest
a considerable part of their incomes. In this way, the productive potential of the country will
increase. Such an effect of public expenditure may be explained as follows:

a) Public Expenditure on Ability to work and save. If public expenditure can increase the
efficiency of a person to work, it will promote production and national income. Public
expenditure on education, medical services, cheap housing facilities and recreational
facilities to the working class people will increase the efficiency of persons to work. At the
same time, public expenditure can promote saving on the part of the lower income groups by
providing additional income to them, for a person who has larger income can be normally
expected to save a larger amount.

Finally, that part of public expenditure which consists of payment of interest and repayment
of public debt will place additional funds at the disposal of those who can save and invest.
Thus, it will be seen that public expenditure can promote ability to work, save and invest and
thus promote production and employment in the country.

b) Public Expenditure on the willingness to work and save. Public expenditure may not have
such a favourable influence on willingness to work and save. For instance, such items of
government expenditure as pensions, interest on loans, provident fund and other government
payments provide a security to a person and, therefore, reduce the willingness of persons to
work and save, after all, why should a person work hard and save when he knows fully well
that he will be looked after by the government when he is not in a position to earn an income.

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 c) Public Expenditure and Diversion of Resources. Public expenditure has far-reaching effects
on the utilization of resources as between alternative uses.
i). There are some diversions of resources from private to public use about which there is some
doubt. Dalton talks about the government expenditure on armaments and armed forces. To
meet such expenditure, which is often called economic waste, the government diverts
economic resources from the general public to the government; it is thought by many that these
economic resources could have contributed to economic welfare if they had been allowed to
remain with the people themselves. But a sensible argument can be given in favour of military
expenditure. War expenditure reduces the danger of foreign invasion and thus diminishes the
economic loss which would have resulted in the event of a war. It is, thus, true that public
expenditure on armaments reduces economic resources from other uses in which they could
have made a direct contribution to economic welfare. Millitary expenditure is essential for
safety and security of the nation without which no country can flourish economically or
otherwise. Thus, we can leave out the diversion of economic resources for purposes of defense.
ii). Public expenditure can bring about a better allocation of economic resources as between the
present and the future. In a free capitalist society very little provision is made for the future.
This is because people prefer the present rather than the future and, therefore, they do not make
adequate provision for the future. The state, on the other hand, is the custodian of the interests
of the future generations also and, therefore, has to see that adequate provision is made for the
future. Some good examples are public expenditures on transport, irrigation and other projects
which do not yield immediate returns but yield social and economic benefits for generations to
come. In this connection, the government also spends money in the conservation of economic
resources which are very essential for the future. Government expenditure for the protection of
the environment will also have a favourable effect.
iii). The government spends money for the encouragement of research and invention, promotes
education and training, looks after public health and sanitation and also takes the responsibility
of social security measures. Some fiscal theorists, however, argue that the government" should
actually curtail expenditure on many of these measures. Most fiscal theorists agree with Dalton
that "increased public expenditure in many of these directions is desirable in order to bring
about that distribution of the community's resources between different uses, which will give the

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 best results, balancing without bias between the present and the future. In other words, the
diversion of economic resources here will greatly increase production.
iv). Diversion of economic resources will be justified in those instances when the volume of new
investment may not coincide with the volume of new savings. The lack of this coincidence, as
Keynes pointed out is the direct cause of instability in the economy, of inflations and deflations
and unemployment. To create a condition of stability and to bring about the equality of saving
and investment in the private sector, government expenditure in the form of public works such
as construction of roads, railway lines, irrigation works, power, etc., will be necessary.
Government expenditure on the public works programmes has favourable effects on production
and employment also.
v). Sometimes, public expenditure may result in diversion of economic resources as between
localities, in Kenya; this is brought about by the use of central government grants to some local
governments to provide certain services more efficiently. This can also be done by careful
regional planning, in such a way that a backward region may be economically developed. The
government has to select the particular region or area and industry and incur public expenditure
so that the maximum national production and following it the maximum community welfare
can be attained. For instance, through improvement and development of transport and
communication in the North Eastern area and the provision of water facilities in these areas and
also through starting a few important industries by the State, the private sector also has been
encouraged to open many industries in North Eastern. Thus, if public expenditure is prudently
planned it can certainly bring about diversion of resources as between regions which will
definitely improve the economic position of backward areas and thus bring about increase in
production and employment.
vi). Finally, Dalton refers to a country where the government has complete power over the
economy. This happens when the government has nationalized means of production as in a
communist or socialist economy. In such an economy, there is no question of diversion of
resources from the private to the public sector but the entire planning and expenditure of
projects is in the hands of the government.

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5.10 PUBLIC EXPENDITURE AND ECONOMIC GROWTH IN A DEVELOPING
COUNTRY
In the previous section, we explained the role of public expenditure in stabilizing an economy
and helping to maintain it at the level of full employment. But all this is relevant to a fully
developed economy, which can work by itself but requires the help and support of the
Government only at certain times. But this analysis does not hold well in the case of a
developing country like Kenya in which:
i). rate of saving and investment is low;
ii). the level of production and employment is low ; and
iii). there is chronic unemployment

According to John Adler, a rising proportion of additional output should be devoted to capital
formation, so that the economic growth of an underdeveloped country may be speeded up. For
this purpose, two-fold changes in the government budget are required. First, the government
budget should be raised so that a rising proportion of additional outlay may be available for
development purposes, and second, a rising proportion of government revenues should be used
to finance expenditure on development. Thus, public expenditure has a significant role to play in
the process of economic growth.

Changes in Expenditure
If increased public expenditure on development is essential, then the rate of increase in other
expenditures should be severally curtailed:
a) Attempts should be made to tighten the administration which in most developing
countries is unwieldy, inefficient and sluggish. It is possible to speed up the
administration, improve its efficiency and weed out the useless elements and thus
increase its productivity. Administrative expenditures can be stabilized if not curtailed,
and still step up productivity.
b) Many less developed countries, like Kenya, spend a considerable portion of their tax
receipts on defense, which ought to have been spent on economic development. In some
cases exorbitant defense expenditure has been foisted on some less developed countries.
In some countries, internal disturbances and political instability lead to vast expenditures

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 on the army and the police. It is true that political peace is an essential condition of
economic progress but then cost of maintaining it should not be high.
c) The social and cultural expenditure – particularly both general and technical education –
are of utmost importance for economic growth. Some may assert that opening up of new
schools does not constitute economic growth but without proper change in social and
cultural values, it will be impossible to bring about economic progress. What is the use of
imported machinery, unless there are technicians to handle it? Expenditure on education,
on promotion of health, etc., is of great importance in a developing country.

Development expenditure has increased considerably in all less developed countries since the
end of the Second World War. Whether the increase in development expenditure in a particular
country is adequate and whether it is possible to restrict other types of expenditure so as to
increase development expenditure are questions which will have to be answered for every
country, separately taking into consideration the special political and social problems involved.

Content of Development Expenditure

Taking the specific case of Kenya, development expenditure of the government aims at
stimulating and supplementing private initiative and enterprise. It is possible, and some
governments of less developed countries have attempted to do so, to eliminate the private sector
altogether and plan for the entire economy as a whole.
Direct stimulation is done by helping the private sector through loans, subsidies, tax concessions
and exemptions, providing market and other information and providing research facilities. The
government sets up special banking and financial institutions whose main aim is to provide
finance for medium and long-term periods at low rates to help the private sector industries with
adequate finance. In many less developed countries, the government attempts to set up a strong
commercial banking system with the central bank at the top. These are all direct methods of
helping the private sector to expand and develop rapidly.

Indirect stimulation of the private sector is done by the government through the provision of
social and economic overheads. Education and public health will come under the first head, and
the provision of power, transportation, communications, etc. will come under the second head.

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The private sector industries reap economies of production from these facilities provided by the
government. Social and economic overheads are a necessity and an essential prerequisite for
economic growth. In fact, there are many competent observers who would like governments of
less developed countries to provide only these facilities and leave the rest to the private sector.
There is, however, a serious danger in the Government taking the responsibility to provide
economic overheads. Kenyan experience shows clearly that much of the failure of Kenyan
planning is due to the failure of such sectors as power and transportation which have been
Government monopolies.

However, there are certain enterprises which the private sector in a developing country may be
unwilling to undertake, either because profit margins in these industries are low or almost
nothing or because they require huge capital investment and a long time to yield returns. In other
words, these enterprises may not be appealing to the private sector from the commercial point of
view but may be of great significance from the point of view of economic welfare of the
community as well as that of economic progress. In this group come all the key and the basic
industries, transport and communication, development of irrigation resources, atomic power, etc.
In fact, any industry which is necessary for the country and which helps in the growth of the
economy can be taken up by the government. But the objective is not to compete with the private
sector but really to supplement and complement it. This type of argument was used by – Jawahar
Lai Nehru to get monopoly control over the key and basic industries.

Priorities in Development Expenditure

The basic objective of a less developed economy is to bring about some type of steady balanced
growth for this purpose, priority determination of priority between the various development
projects is essential for one thing; priority-determination will depend upon the basic objectives.
Other things being given priority-determination should guarantee a maximum rate of balanced
growth for another, priority will depend upon the available resources which indicate the type of
projects that can or cannot be undertaken within a given period of time. Thirdly, priority-
determination should also take into account the degree to which a given project will diminish a
country's dependence on foreign countries. But ultimately, the solution to the problem of

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priority determination is an assessment rather than a calculation. This is so because it will be
difficult to calculate the net yields of the various projects.
A related question is on what sector of the economy, priority in a development programme
should be given. While some have emphasized the development of the agrarian sector and
exports, others have argued in favour of the development of secondary and tertiary sectors. There
is a third view too, according to which, there should be equal emphasis on all sectors so that
balanced growth will be achieved. W.A. Lewis has admirably stated the case of balanced growth
in development-programmes, all sectors of the economy should grow simultaneously, so as to
keep a proper balance between industry and agriculture, and between production for home
consumption and production for export. The actual selection of projects from among the various
alternatives on which to spend taxpayers money is based on the cost-benefit analysis. Cost-
benefit analysis purports to describe and qualify the social advantages and disadvantages of a
policy.

5.11 THEORETICAL ASPECTS TO PUBLIC EXENDITURE EVALUATION

Governments at all levels allocate a considerable portion of their revenue for expenditure on such
public capital projects as transportation systems, airports and power generating plants. Other
expenditures would involve, improving public health programs and education projects. The
benefits from this expenditure accrue to society or a portion of the society for a long period of
time.

Project evaluation like all issues in allocation economics involves determination of the ways in
which the most efficient use can be made of scarce resources. In its simplest form, the issue is
how to determine the composition of the budget of a given size and how to allocate a total of
given funds among alternative projects. To determine allocation between two alternative
projects, expenditure evaluation involves evaluation of all costs involved and evaluation of all
benefits to be derived from public funds.

It is worth noting that where a project is purely private, consideration before investing includes:

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 - The expected rate of return on the project that would reflect the net results of private
costs (money spent on all resources)
- Private revenues (sale of the goods and services produced by the capital assets).
- Degree of risk involved in the project.

However, tabulating the private costs and revenues or benefits does not necessarily exhaust all
the costs and benefits associated with the proposal. For example wherever a private investor
decides to start a manufacturing plant, he only considers such items as the initial costs of
construction, annual maintenance and service cost and the money value of the plan output. What
his analysis would not consider, unless forced by the regulations, is the noise and air pollution
imposed upon nearby area residents. Even social benefits accruing from such a plant (e.g.
increased employment opportunities to residents of that area) would not be considered.
However in the benefit-cost analysis in a public sector, social benefits and costs are captured in
the analysis. Please note that, despite the differences that exist in cost-benefit analysis, both
approaches (private and public) are analytically the same. It involves the comparison of the
stream of benefits expected from a project measured against the stream of expected cost to obtain
the expected net worth of the project.

The major problems confronting Benefit Cost Analysis (BCA) from the public or social point of
views are:
a) The identification of all costs and benefits associated with a given project and
b) Quantifying these costs and benefits in terms of the common unit, shillings.

5.12 TYPES OF PUBLIC PROJECTS

Public projects can be divisible or lump sum. In divisible groups all projects can be reduced or
increased. If budget is fixed, i.e. given specific amount of money to spend, the planner must
determine Cost (C) and Benefits (B) involved or derived from each project. After costs and
benefits are known for each project the remaining problem is to allocate the cash outlays
between the projects so as to maximize benefits and minimize costs. If we let costs be (C) and
benefits (B) for any two projects e.g. X and Y the total net benefits can be given as follows:

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 NB = B– C

Note, C is the budget amount and in most cases it is fixed. The taste is simply to maximize
B in the case of divisible projects and in a situation of a fixed budget, the opportunity cost
of spending one more shilling on X is the benefit forgone by not spending it on Y, and vise
versa. To maximize total benefits the policy maker should allocate outlays so that total benefits
minus total costs are at a maximum. Such is the case if MBx / MBy = MCx / MCy, where MB is
marginal benefit and MC is marginal cost. Given MC = sh 1, the policy maker will equate MBx
and MBy
(MBx = MBy)
This is shown by Figure presented below.

MB of X
MB of Y

F G

C
H J D
MY

MX

0 A Expenditure on X 0 B Expenditure on Y

Figure 5.1: Expenditure Allocation with Fixed Budget

Schedule MX and MY show the value of the marginal benefit (additions to total benefits)
derived from spending successive shillings on X and Y. Total expenditures E are distributed
between X and Y so that the marginal benefit of expenditures on X or Ac equals that Y or
BD. Thus OA is spent on X and OB on Y such that OA + OB = E the assigned budgets. If
this is done, total benefits from X as measured by the area OACF, plus those from Y as
measured by OBDG are maximized. Putting the matter in cost benefit terms we see that the

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 two projects are pushed to the point where the ratios of marginal benefits to marginal costs
are equal. Since marginal cost in both cases equal Kshs. 1 we again have AC = BD.
In the case of lumpy projects, and in a situation of a fixed budget use of marginal benefit
analysis may not work where projects are indivisible or involve lump-sum amounts for
example in road, dam, and bridge construction. For example if choice was to be made
between road construction and airport construction marginal adjustments so as to equate
benefits is not feasible.

For such kinds of indivisible projects ranking scale is required where budget is fixed, to rate
projects before a choice can be made.
Example of Ranking Scale
Table 5.1: Ranking of the projects

NAME OF TOTAL COST TOTAL NET B/C (B - C) RANKING

PROJECT (In thousands of BENEFITS BENEFIT RATIO C
Kshs) C (In thousands of (In thousands RATIO
Kshs) B of Kshs) B – C
K1 2000 4000 2000 2 1 2
K2 1450 1750 300 1.2 0.21 5
K3 800 1040 240 1.3 0.3 4
K4 500 1250 750 2.5 1.5 1
K5 3000 4200 1200 1.4 0.4 3
K6 1250 1250 0 1.0 0 6
K7 3000 2700 -300 0.9 -0.1 7

In cost benefit analysis 1st to calculate net benefit NB = B- C. If you are to base
decision on net benefits you will choose all projects that have positive net benefit.
However caution need to be taken when ranking projects based on net benefit, since different
amounts are involved. By absolute benefit cost differentials, project K1 would lead.

Another measure which is considered safest to use is ranking projects is the benefit to cost ration
(b/c). The ratio of benefit to cost for each investment is calculated and projects are then ranked in

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order of their B/C ratio. The project with the highest ratio should be the one to be financed first.
Decision as to how many projects to be financed depends on amount of budget. If budget is
Kshs. 7 million, the best combination of projects would be K4, K1, K5 and K3. The rest of the
projects K2, K6 and K7 won’t quality because the budget is exhausted after the fourth project
(K3) if funded. This combination will give me a total cost and benefits of:-
COST BENEFITS
K4 500,000 1,250,000
K1 2,000,000 4,000,000
K5 3,000,000 4,200,000
K3 800,000 1,040,000
TOTAL 6,300,000 10,490,000

Net Benefits (B-C) = NB = B– C

= 10,490,000 – 6,300,000
= Kshs. 4,190,000

Any other alternative combination would have a lower total benefits, a higher total cost and a
lower net benefit. Where budget is not fixed, there isn’t need of ranking the projects. The rule
would be then to fund development projects so long as Total Benefits > Total Costs i.e. where
net benefits are positive. The rule applies especially where a social good has very low rate of
return but carries more social benefits to society as a whole. In such a case government will
provide funds for such a program.

5.13 TYPES OF BENEFITS AND COSTS:-

Benefits and cost may be real or pecuniary. Real benefits and costs may be; Direct or indirect;
Tangible or intangible; Inside or outside; Intermediate or final

REAL VERSUS PECUNIARY

Real benefits are the benefits derived by the final consumer of the public project. They reflect an
addition to the community welfare and they are weighted against the real cost of withdrawing
resources from alternative uses.

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Pecuniary benefits and cost – occur as a result of changes in relative prices which occur as the
economy adjusts itself to the provision of public goods and services. As a result of changing
economic situation resulting from provision of public goods, some members of society may gain
while others may lose.

But this doesn’t reflect net gain or loss to society as a whole. The reason why society is left the
same (no net gain or loss) is because one group’s loss is another group’s gain but since all groups
belong to society there is a trade off.

Consider the following case study to illustrate pecuniary benefits and costs:
Consider a case where a road is constructed through a given district. The demand for
construction workers in that district will increase leading to increased wages for construction
workers in the area, while those to whom higher taxes have been imposed in order to construct
the road will lose.

Where the road opens new markets for certain products or raw materials or labour etc, producers
of these products will experience a higher demand leading to increase in price and earnings while
those who paid the taxes will suffer reduced incomes.

Note in both cases, society considered as a whole will remain indifferent because gain of
construction of road will be offset by loses incurred.

Welfare of society as a whole will remain uncharged but some individuals will benefits while
others lose.

DIRECT VERSUS INDIRECT BENEFITS AND COSTS

Direct benefits and costs are those which are closely associated with projects objectives while
indirect benefits and costs are in the nature of by products.
The objectives of any development project are given under or by the intent of the legislative
body which proposes it. For example: - An irrigation scheme has the provision of water for
farming as its main objective.

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Rural health project can be designed to reduce death rates among children. It may also provide
for family planning programme.

While there are many direct benefits and costs there may also be certain silent features in the
projects that can provide indirect benefits e.g. an irrigation scheme can also be used or modified
to generate electricity and provide clean water for drinking. If provision for water for farming
was the main objective of the legislator the eventual provision of electricity and clean water for
drinking are indirect benefit.

Direct costs to the project would involve costs incurred in purchasing and installing pipes.
Indirect costs would be destruction of wildlife and diversion of water.

A good education system will train and provide skills which will be used to improve the earning
of participants. But, in addition to those direct benefits there may be other indirect benefits e.g.
reduction in crime rate and the provision of expert’s services such as doctor’s services lawyer’s
services etc.

TANGIBLE VERSUS INTANGIBLE BENEFITS AND COSTS

Tangible benefits and costs are those that can be valued in the market whereas others, which
cannot are referred to as “intangible”. The distinction is thus synonymous with that between
benefits from private and social goods or between costs, which are internalized, and costs, which
are external.

INTERMEDIATE VERSUS FINAL

Development projects may be intermediate or final. Final projects are those, which provide
services directly to consumer, and they involve also the provision of a final product.
Intermediate projects are developed for the purpose of using them in further generation of other
benefits. For example provision of road itself may be a social good and it enters as an
intermediate good into the production of a final output which is a private good (the transported
product ready for sale).

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INSIDE VERSUS OUTSIDE
Another distinction is between benefits and costs which accrue inside the jurisdiction in which
the project is undertaken and others which accrue outside. For example where a river basin is
developed or drained so as to control flooding in a given district the benefits are derived within
that district.

However where these benefits are extended to other districts through which the river flows, the
benefits can be said to be externalized.

Case studies illustrating different types of benefit and costs

CASE STUDY (A)

IRRIGATION SCHEMES
To see how C and B differ consider an irrigation projects which has to be carried out in a given
area. The costs and benefits of the irrigation scheme can be classified as:-

REAL
(1) Direct Tangible Benefit
Which include increased output resulting from the use of scheme, Provision of water for
drinking, Increased livestock products and increased agricultural earning.

(2) Direct Intangible Benefit

Improved vegetation leading to a better environment. Intention of starting an irrigation scheme
may have been also to improve the surrounding environment (e.g. May be the area is a semi-arid
area).

(3) Indirect tangible benefit Reduced soil erosion.

(4) Indirect intangible benefit

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Where because of the presence of the scheme the rural society is preserved due to reduced rural-
urban migration or general migration to other areas.

(5) Direct tangible costs.

Include such costs as cost of pipes, cost of labour, cost of hardware, cost of plant and equipment
and salaries of experts. (Cannot yet inputs without paying a price)

(6) Direct Intangible costs

Include loss of natural or original features of the area; the possible loss of aesthetic healthy of the
area.
(7) Indirect tangible cost
Include the effect of the diversion of water from its customary flowing direction. Diversion of
water may affect the ecosystem in the area so that the wildlife that depended on it is destroyed.

(8) Pecuniary benefits

Would include the relative increase in the value of land around the scheme. It would also include
relative improvement in the position of farm equipment industry.

CASE STUDY B

(B) EDUCATION PROJECT

REAL
(1) Direct tangible benefit – increased future earnings
(2) Direct tangible cost – loss of students earning, teachers’ salaries, cost of building and
books.
(3) Direct Intangible Benefit – Enriched life
(4) Direct Intangible cost – forgone leisure time
(5) Indirect tangible benefit – reduced costs of crime prevention.
(6) Indirect Intangible benefit – more intelligent electorate.

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 (7) Peculiarly benefit – relate increase in teachers’ income.

5.14 PROBLEMS OF MEASUREMENT OF BENEFITS AND COSTS

In the absence of a dictatorial form of government the benefits of a purposed public projects
should reflect the preferences within the society. In a market economy preferences for goods and
services are expressed in terms of what people are willing to pay for a product with a given cost
structure. For product the interaction of demand and supply plays a major role in the
determination of market price. However in the case of most public projects there exist many
benefit and costs which are intangible (e.g. national defense) and do not have an observable
market price.

Even where price exist contain adjustments may need to be made since thy may not reflect true
social values and costs owing to existence of market imperfections and externalities.

Whenever intangible benefits and costs are involved measurements takes us back to the central
problem of social good evaluation. This as was discussed in chapter 1, must be accomplished by
budget determination through the political process. Imperfect as it may be it would seem rational
to proceed with a project if people have expressed a consensus in favour of the project. The
major drawback is that every project would have to be submitted to the electorate for approval
while assuming that all the information about the project has been made available to the
community. It would have to be further assumed that everyone understand the issues involved in
the proposal. The impractical nature of this approach is obvious.

It is worthy noting that cost benefit analysis is only a method of choosing among alternative
projects after their values have been determined by the legislator. It is not substitute to political
process. Thus cost-benefit analysis is most easily applied in those areas where benefits are
tangible and there is least need for public provision to begin with.

The task of benefit evaluation is facilitated where the public facilities are in the nature of
intermediate goods rather than final goods. In the case of final goods such as parks, the social

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good aspect must be faced head on. Since evaluation through toll pricing would require the
inefficient device of exclusion some other approach is needed.

In case of a road which may be a social good; it enters as an intermediate good into the
production of a final output which is a private good (the transported product ready for sale) the
value of which can be assessed in market terms. [By provision of the road, the producer is able to
reach the customers and the benefits may be valued in terms of extra profit earned as a result of
accessibility to the market].

Evaluation can be based also on amount saved when the public project is provided (the cost
saving approach). For instance supposing a project is initiated with an intention of reducing
school dropouts. The benefits of such a project can be evaluated in term of amount of funds
saved by correction institutions such as courts and prisons (Estimate benefit from saving of costs
other wise you would have incurred).

But even though the evaluation of benefits and costs may be difficult, economic analysis may be
useful in identifying the actual benefits and costs expected from a particular project (e.g. gains in
literacy from education programmes, better and longer life expectations from health, reduced
crime from police protection etc). They can also estimate the costs involved.

SHADOW PRICING AND MARKET ITEM

Where benefits and costs accrue from a project, evaluation would be easy if markets are perfectly
competitive. In this case the social value of tangible benefits is measured by the price which the
service would fetch in the market, just as the social cost is measured by the price that must be
paid for the inputs needed to render the service. A private market price or cost will reflect social
benefits or costs at the margin if:
(1) There is no monopoly power
(2) There are no externalities
(3) Controls on output do not exist.
However, these “Ideal” conditions are not met in many instances. Where monopolist exists,
market price cannot be used to reflect consumer value of a product because monopolist price >

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normal price. Also the costs do not reflect true social cost. In such a situation adjustments need
to be made to reflect the true market situation.

Cost 8
Rev MC = S
AC
PM a

PN b

AR
MCM

MR
Figure 5.2 Monopoly market structure
0 QM QN Q
In a situation where we have monopoly market we would produce OQm (Where MC=MR) so
that he charges OPm. The cost per unit (marginal cost) he will be incurring is OMCM. However,
this is not what people would be willing to pay for the output if the output could be sold in a
competitive market. From diagram above people would be willing to pay a price OPN (which
equals the marginal cost).

Therefore some adjustments would need to be made to bring down the prices from OPM to OPN
the true market situation. The technique of doing this adjustment is known as “shadow pricing”.
In a sense then shadow pricing is an attempt to stimulate what people would be willing to pay for
an output if the output could be sold in a competitive market.

The use of “shadow prices” may be called for also, where relative prices are distorted by indirect
taxes, or where externalities have to be taken into account. Other important instances of shadow
pricing arise in developing economies with large labour supplies but extensive social legislation,
including minimum wages. It may then be desirable to account for labour costs at a lower rate
than applies in market. Or, over valued exchange rates may set too low a price on imported
capital and induce wasteful investment unless higher shadow prices for such capital are applied.

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Shadow pricing can also be used to value benefits and costs where activities have no direct
market analogue. The construction of a dam for flood control may, for example, reduce the
population of certain species of birds in the area where the dam is to be located. How does the
analyst evaluate this loss to local bird watchers? The dam will likely increase the population of
other birds in the area, such as waterfalls but it would be extremely difficult to place a monetary
benefit on this activity. The same project may generate recreational benefits, for example,
fishing, swimming, and boating. Shadow pricing may take the form of observing what people in
similar situations pay for these as private consumer goods.

5.15 DECISION INVOLVING LONG-TERM PROJECTS

Much public expenditures bestow benefits on society well into the future and there are costs that
will be incurred in the future as well. For instance, such expenditures as investments in river
basin development will yield benefits over many years. Such costs as machinery maintenance
would be incurred in the future. The question is, are the benefits and costs of today to be valued
in the same way as those in the future?

The generally accepted view is no. Society prefers present net benefits to those in the future
owing to uncertainties related with the future. Thus, to evaluate such benefit streams and costs
would require their translation into their present values. This requires the future expected streams
of B and C to be discounted so as to determine their present value.

5.16 DISCOUNTING TECHNIQUES

Method to be used to discount future expected streams of B and C would depend on;
(i) Whether the streams of benefits and costs are expected after a time period of t years.
(ii) Whether the streams of benefits and costs are expected annually.

CASE 1: TO DETERMINE COMPOUND VALUE OF ASSET DUE IN t YEARS

& AT THE RATE OF INTEREST r

Cvt = Po (I + r) t …………….. (i)

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Where CVt = Compound (future) value of asset
T = time in years
Po = Initial principle value
r = rate of interest
CASE 1B: DETERMINATION OF PRESENT VALUE
The present value (PV) of a future earning CVt, due in t years and discounted at the rate of
interest r is ;)
Pv = Po = CVt ……………… (2)
(1 + r) t
= CVt 1
(1+ r) t

= CVt.PVIF

Where PVIF is the present value interest factor and is the reciprocal of CVIF.
Equation 2 is used to calculate the current equivalence of earnings to be made in future after t
years.
Numerical example
CVt (future of asset of time t) = 1,217
T = 5years r(discount rate) = 4%

PV = CVt, PVIF = 1,217 X 0.8222 = 1,000/=

CASE 2: COMPUND VALUE OF ANNULTIES

Annuity is a series of payment or receipts of money in most cases on an annual basis and for a
specified numbers of years. Annuity is used for planning pension funds and for calculating
insurance premiums.

The establishment of a planned saving account e.g. into which 5000/= is paid each year for 5
years is a five year annuity. Each payment is made at the end of the year.

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 1yr 2 yr 3yr 4yr 5yr
End of
t=0 5000 5000 5000 5000 5000

If this payments are intended to make a savings plan from which funds will be used to pay a
pension (e.g. in social security or in national health insurance funds), and given that the rate of
interest at which they could be invested is 4% per year, then the amount to which the annuity
will accumulate after 5 years can be calculated in 2 different ways.

(i) By calculating accumulated principle and interest and adding them over the period
specified to determine the sum for period shown.

Formula CVa = P1(1 + r)1 + P2(1 + r)2 +…. + Pn(1 + )n

= n
Pt(1 + r)t
t=1
Where Pt is saved every year.

(ii) By calculating using the compound value interest factor of annuity (CVIFa) which
could be found in CVIFa table. Note that this method is applicable where annual
incomes are equal over the years.
n

Cva = nEPo (1 + r)t Po(1 + r)t

t=1
= Po.CVIFa

= 5000 x CVIFa
Numerical Example

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Po = 5000/= r=4% t=5 yrs
CVIFa = 5.416
t=s
r=4%
CVa= 5000X 5.416
= 27,080

CASE 2B: PRESENT VALUE OF ANNUITY

The present value of an annual income stream R for n years equals.

Pv = R1 + R2 +……….+ Rn
(1+r)1 (1+r)2 (1+r)n
= nE Rt

t=1 (1+r)t

NB. If R1 = R2 = --Rn

n
Then Pr = R t
(1+r)t
T=1
Pv = R.PVIFa

Numerical example
If a machine is expected to produce a net revenue to a company of Ksh.1000 for the next 3
years, the net present value or discounted earning given r (discount rate) = 4%
Is calculated as follows:-

Method 1
Present Value

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 1st year if discounted 1000 at 4% = 1000 = 962.00
(1+0.04)

2nd year if discount 1000 at 4% = 1000 = 925.00

(1.04)2

3rd year if discount 1000 at 4% = 1000 = 889.00

(1.04)3

Total Net Present value is 2,776.00

Method 2
If we use present value interest factor of annuity (PVIFa)
NPV = 1000xPVIFa = 1000 x 2.775 = 2775/=

5.17 IMPORTANCE OF DISCOUNTING

The education of projects and their ranking is highly sensitive to the discount rate which is used.
This is illustrated in table below, where the present values of benefits and benefit cost ratios for
various investments are compared.
Table 1 . Present Value and Discount Rates
PROJECTS X Y Z
Initial cost (Kshs.) 10,380 10,380 10,380
Useful Life 5 Yrs 15 Yrs 25 yrs
Annual Benefits (Kshs.) 2,397 1000 736

(1) Present value of benefits stream using various discounting rates.

X Y Z
3% 10,978 11,938 12,816
5% 10,380 10,380 10,380
8% 9,571 8,559 7,857
(2) Present value of net benefits (current benefit – initial C)

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 X Y Z
3% 598 1558 2436
5% 0 0 0
8% -809 -1821 -2523

(3) Benefit – cost ratio (B/C)

X Y Z
3% 1.0576 1.15009 1.23468
5% 1.000 1.000 1.000
8% 0.92206 0.82456 0.75694

We consider three investment projects X, Y and Z with equal initial cost and income flow
extending over their useful life 5, 15 and 25 years respectively.

5.18 CHOICE OF DISCOUNT RATE

In choosing the discount rate, government may proceed on the premise that it is desirable to use a
rate equal to the time preference of private consumer; or it may substitute social discount rate of
its own.

The rationale for using the private or markets rate of return is that this rate reflects consumer
choice between present and future consumption.
Assuming an economy with wholly flexible prices and perfectly competitive capital markets only
one rate of interest will prevail in the market determined by DD and SS conditions in the capital
market. All households would yield the same rate of return. The prevailing interest rate would
reflect the consumers’ marginal rate of substitution (MRS) of future for present consumption i.e.
their rate of time preference. By accepting this rate for purpose of project evaluation, the
government thus respects consumer’s preference.

Where the market is competitive the market rate also reflects the marginal rate of transformation
in production (MRT) i.e. the marginal efficiency of investment. As saving and investment are

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pushed to the point where the two rates are equated, an efficient allocation between present and
future consumption is achieved.

When r = MEI, financial market is said to be efficient and the rate of discount (r) prevailing in
the market is at equilibrium.

MEI is also called the internal rate of return (IRR). It is a rate of interest that equates present
value of future cash flows of projects over the projects useful life to initial cost of capital.
NPV = n Rt - C = O
t=1 (1+r) t
Where Rt annual cash flows over time t
r is the internal rate of return
C is the initial cost
The government in determining the present values of the benefits stream from public investments
will discount this stream at r. Since the market is perfect no “shadow prices” are needed. Public
investments would qualify if the present value of the benefit or income stream B exceeds cost C,
the benefit – cost ratio B/C must be at least 1 or alternatively, B/C must be positive.

However the simple assumption that there exist efficiency in the capital market is unrealistic in
the real would. In the presence of risk, some investments are more risky than others. Thus the
gross rates of return on investments on these projects would differ by the amount of the risk
premiums. Risk may also apply regarding the return on public investment so that it should be
allowed for by adding an appropriate risk premium to the discount rate used in determining the
present value of the benefit stream for a public investment.
There may also exist market imperfection owing to monopolistic elements of various kinds. As a
result various consumers may be confronted with different borrowing returns. As a result it is no
longer obvious just which rate should be used in discounting the public investment stream or
how the opportunity cost of resource withdrawal from the private sector should be measured.

The difficulties of identifying the markets rate are avoided if a social rate is used instead. Social
rate is the rate at which individuals will loan money to the government. Proponents of the social

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rate of interest argue that when people purchase government bonds this reflects society’s desire
to forego present for future consumption.
5.19 CAPITAL BUDGETING TECHNIQUES
Involves the entire of planning the expenditure of firms whose returns are expected to extend
beyond one year.
Examples of capital outlays are:
- Expenditure on plant and equipment
- Expenditure on acquisition and improvement of land.

The optimal capital budgeting is the level of investment that maximizes the present value of the
project. Factors that affect capital budgeting include: Availability of funds, Rate of return on
investment, Rate of interest at which funds are borrowed, Degree of risk involved in venture,
Useful life of the assets and Degree of competitive in the market.

The following are the methods of capital budgeting:-

(i) Net present value of the project (NPV)
(ii) Internal rate of return method (IRR)
(iii) Payback period method
(iv) Return on investment method
(v) Expected rate of return method.

NET PRESENT VALUE AS A METHOD OF CAPITAL BUDGETING

Most investor would consider the NPV of a project before investing. This method takes into
consideration the time value of money and profitability of a project.

Formula NPV = n Rt - C
t= 1 (1+r) t

Where - Rt is the annual income stream for n years

− C is the initial cost
− R is the discounting rate.

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Decision to invest or not:-
Where NPV>O accept the project. If you are required to choose one project from many projects
using this method, choose the project with highest NPV.
Where NPV=0 for private projects reject the project. But if the project is a government one the
project maybe invested into depending on its usefulness to the society.

Where NPV<0 public project selection decision should consider public interest and how essential
the project is. If the project is an essential (e.g. eradicating polio), the government would
subsidize the difference in cost.
Numerical Example 1
Table 3

PROJECT A
Year Cash Flows PVIF PV
At 10%
1 500 0.91 455
2 400 0.83 332
3 300 0.75 225
4 100 0.68 68
5 10 0.62 6
6 10 0.56 6
Total Present Value 1092.00
Assuming initial cost = 1000
NPV = n Rt - C = 1092 – 1000 = 92
t=1 (1 +r) t
PROJECT B
Year Cash flows PVIF PV
At 10%
1 100 0.91 91
2 200 0.83 166

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 3 300 0.75 225
4 400 0.68 272
5 500 0.62 310
6 600 0.56 336
Total Present Value 1400
Less initial cost 1000
NPV 400

Based on NPV method we should select project B because it has the highest NPV.

INTERNAL RATE OF RETURN (IRR) AS A METHOD OF CAPITAL BUDGETING.

Internal rate of return is the rate of interest which equates present value of the expected future
cash flows or receipts from a project with the costs.
Formula
NPV = n Rt -C =0
t=1 (1 +r) t
or
NPV = n Rt - n Rt - C = 0
t=1 (1 +r)t t=1 (1 +r)t

Formula 2 applies where we have streams of costs. The internal rate of return corresponds to
the r in the formula. Based on the method, we accept a project when
(i) IRR > K (K here would represent the rate at which the investor borrowed loan. It may
also represent the rate of return that the investor has forgone by not investing his
funds in other assets.) e.g. on treasury bonds; on savings.
So in this case we could say that the resources that are invested in the project will
give the investor a better return that he would have received by investing them else
where (for equal risks). Or another conclusion would be; he should invest since the
rate of return on investment exceeds the rate at which he’s paying a loan.

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 (ii) When IRR=K the decision maker is indifferent as to whether he invests in the project
or not. In the case of a public project, the nature of investment would be considered.
If the project has public support accepts it.
(iii) If IRR>K, then by the same argument the opportunity cost of investing in the project
elsewhere, which in this case are greater than the net benefits received from the
project. In that case it would not be worth while investing resources in the public
sector project.
According to the method, when there are many mutually exclusive projects to choose from,
the projects are ranked in terms of their internal rates of return and that project with the
highest IRR is chosen, provided that its IRR>K.

Pay-back period
It measures how long it takes to recover original invested amount from cashflows of an earning
asset.
Where annual incomes are uniform over the year, pay-back period is calculated as;
PBP = C where C = Initial Cost
R R = Annual Income which is uniform
Where annual incomes are not uniform over the years, pay-back period is calculated as follows;

PBP = Complete Period + Balance after complete periods

Cashflow of the next period
Return on investment (ROI)
Rate of return on investments is calculated as;

ROI = Net Income = Gross Income – Expenses

Total Assets Total Assets
Expense include here all expenses and taxes.

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5.20 SUMMARY

The lecture looked at the issues of public expenditure definition; canons, growth and how it
can be use to correct macroeconomic problems in the economy. It also discussed in details
the public project evaluation and selection. Finally the lecture explained how shadow pricing
is
.22used to measure non market costs and benefits of a project.
ACTIVITIES

5.21 ACTIVITY

1. How can the public expenditure leads to inflationary pressure in the economy.
2. What is shadow pricing?
3. Distinguse between flexible and lump sum projects.

5.22 FURTHER READING

A.T. Peacock and J. Wiseman, The growth of public expenditure in the United Kingdom
(London:George Allen Unwin, 1967)
C.V. Brown and P.M. Jacson, Public Sector Economics (Oxford:Basil Blackwell, 1992)
R.A. Musgrave and P.B. Musgrave, Public Finance in Theory and Practice (Ney York:
McGraw-Hill,1989).
C.T. Sandford, The Economics of Public Finance (Oxford: Pergamon Press, 1992).
J.Batas, Managing Value for Money in the public Sector (London: Chapman & Hall, 1993)

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 TOPIC SIX
THE BUDGET
6.1 INTRODUCTION

The lecture introduces you to the planning purpose of the government. Types of budgets are
explained. The budget is the master financial plan of the government. It brings together
estimates of anticipated revenues and proposed expenditures for budgets the activities to be
undertaken and means of their financing can be inferred.

6.2 LECTURE OBJECTIVE

At the end of the lecture you should be able to:

a) Explain the various types of budget.
b) Explain the role of each participant in the budgetary process
c) Explain the Zero base budgetary procedure

The nature and purpose of governments' budgets has changed "over time, and differs from
country to country. Powers, policies and obligations of federal, state and national central
governments, vary and so do their financial requirements.
The budget is an account of the State, showing how much the government spends and on what
and how it finances the expenditure. It is the master financial plan of the government.
Purpose of government budgeting:
In general budget is considered as an instrument of achieving economic policy such as full
employment high level of investment and a better distribution.

6.3 CANNONS/PRINCIPLES OF BUDGETING

1 Executive programming. Being the programme of the executive, the budget should reflect all
government responsibilities and activities. The social, economic and political programmes of the
government should be clearly unveiled in the budget programme.
2 Executive responsibility. Chief executive should ensure that the departmental programmes
planned is capable of fulfilling the desire and intention of legislature
3 Reporting. Information regarding the progress of the work, programmes executed, revenue
mobilized and expenditures made should be furnished to the executive periodically.

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4 Flexibility. Budget should be flexible enough to meet the government’s financial policies
according to the changing social- economic conditions in the society.
5 Adequate tools. The chief executive should be armed with sufficient and adequate
administrative tools to fulfill its budgetary responsibilities
6 Active co-operation. Efficient budgeting depends upon the active co-operation of all
departments and their sub-division mobilized and executions

6.4 Types of Budget

The budget can be approached from two angles. First, the Minister decides on expenditure both
on current account (government's consumption of goods and services, transfer payments, grants,
subsidies, interest payment) and on capital expenditure (investment in physical assets, grants).
He then adjusts taxes to cover expenditure entirely or partially and then borrows the rest. The
second approach is on the basis of the principle of 'living within one's means'. The Minister
assesses the total resources available to him, He then works out how much he can 'afford' to
spend on different programmes to keep his total expenditure within the limits of the available
resources.
A balanced budget can be regarded as neutral. It has been called an 'orthodox' budget, reflecting
the Treasury view of sound finance.
A deficit budget is expansionary as more money is pumped into the economy than is withdrawn
in taxation. The borrowing that this policy requires is likely to have an inflationary effect in
some circumstances. During the Great Depression of the 1930s, governments sought to stimulate
economic activity by means of deficit budgets.
A surplus budget is deflationary insofar as the government takes out more than it puts into the
money flow. Which type of budget a Minister of Finance will present will depend on the
government's assessment of the economic situation and the overall economic, social and political
policy, it seeks to pursue. However, within the three types of budgets there is scope to vary taxes
and expenditure to achieve the desired effect.
INCREMENTAL BUDGETING
It a process in which past level of expenditure are taken as given and only new additions to or
reduction from the past outlay are examined. In incremental budgeting existing and old

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programmes are unexamined, since no substantial changes are called for in the budget. Only
additions and reductions in outlay is subject to scrutiny and examination.
ZERO BASE BUDGETING
The organization should not take earlier years expenditure for granted, but should state
everything afresh. It means that while framing its budget for the coming year an organization
should start from zero point, instead of treating the current budget as the srating point or base for
next years budgetary exercise. It involves a complete reexamination of ongoing programmes to
assess their continued utility instead of following the method of incremental approach to
budgeting. It involves fresh evaluation of every item of expenditure as if were a new item. Each
department ministry is required to justify its budget request from the bottom up, evaluating
alternative programme proposal and prioritizing them so as to select the best alternative on need
base. It focus the budget process on a comprehensive analysis of priorities objectives and needs.
It helps to eliminate those programmes which have outlived their utility. It also help to stimulate
and redirect the resources from less productive to more productive activities.
It involves examination of the very rational of an expenditure item under consideration. The aim
is to guard against wastage in public expenditure. It involves a detailed investigation of excess
item of expenditure to see whether it is really needed or it should be revised or done away with.
If a sector is not able to justify its existence, it should be closed down. If its existence is justified,
the optimum level of its operation and the corresponding budget provision must be defended. In
zero base budgeting no section is essential. It must proof its worthiness.

Performance and programme budgeting system (ppbs)

This is when a budget covers both performance and programme. Programme budgeting involves
laying down the sequence of steps for executing the project along with expenditure of resources
involved at each stage. Performance budgeting is a devised tests for comparing actual with the
expected results and thereby assessing the performance efficiency of the project. It involves the
development of scientific management tools, such as work measurement, performance standards
unit, costs etc. In each classifications government activities are identified in physical and
financial terms. The actual performance results are estimated and compared with target results,
so as to measure the efficiency of a particular project. The government budget decisions are
divided into major functions based on the objective of the government, and then sub-divided into

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major specific programmes activities and projects. The funds are allocated according to the
achievements expected from a department/ministry over a specific period, from the proposed
expenditure. Therefore in performance budgeting, emphasis is placed on the size of the project,
the cost involved and the expected return from the project. Thus the budgeting procedure is
focused towards the efficient and economic use of scarce public resources.
The implementation of performance budgeting involves the following steps:
1. Establishing a meaningful functional programme and activity and classification of government
operations (for example education is a classification, and elementary education is a programme,
training of elementary teachers is an activity and the construction of a school to impart
educational management service is a project.)
2. Bringing the system of accounting and financial management in accordance with the
classification made.
3. Estimating the quality of physical resources like personnel materials, services etc.
4. Developing standard norms for work units of performance.
6.5 SUMMARY

The lecture discussed in details the types of budget

6.6 ACTIVITIES

1. What is the role of parliament in the budgetary process in Kenya?

2. Explain in details the zero base and performance budgeting procedure.

6.7 FURTHER READING

A.T. Peacock and J. Wiseman, The growth of public expenditure in the United Kingdom
(London:George Allen Unwin, 1967)
C.V. Brown and P.M. Jacson, Public Sector Economics (Oxford:Basil Blackwell, 1992)
R.A. Musgrave and P.B. Musgrave, Public Finance in Theory and Practice (Ney York:
McGraw-Hill,1989).
C.T. Sandford, The Economics of Public Finance (Oxford: Pergamon Press, 1992).
J.Batas, Managing Value for Money in the public Sector (London: Chapman & Hall, 1993)

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