Public Finance

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EAE 313- Public Finance
Corporate Finance (Kenyatta University)
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KENYATTA UNIVERSITY
INSTITUTE OF OPEN, DISTANCE & e-LEARNING
IN COLLABORATION WITH
SCHOOL: ECONOMICS
DEPARTMENT: APPLIED ECONOMICS
UNIT CODE & NAME:

EAE 313 - PUBLIC FINANCE
WRITTEN BY:
Dr. James N. Maingi & Dr. Nelson H.W.
Wawire

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Copyright © Kenyatta University, 2009

All Rights Reserved
Published By:
KENYATTA UNIVERSITY PRESS

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INTRODUCTION
The module introduces learners to the fiscal policy and operations of government.
The module then goes further to present theories, processes and practical issues on
how governments raise and allocate resources.
OBJECTIVES
OBJECTIVES
The objective of the module is to acquaint the students with the principles of public
revenue, expenditure, debt, economic stabilization and growth and to equip the
student with the conditions for efficient allocation of public goods.

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TABLE OF CONTENTS
LECTURE TITLE
page
Lecture One: The introduction and the nature of public finance 6 - 16
Definition of public finance; the scope of government activities; the
needs for public sector; reasons why government should participate in
economic activities; models of efficient allocation; the size of the
public sector; the principles of maximum social benefits; measuring the
size of public sector; summary, activities and further reading
Lecture Two: Public policy objectives 17 -

25
Introduction; objective, the allocation function; public provision of
social goods; the distribution function; fiscal instruments of
distribution policy; the stabilization function; instruments of
stabilization policy; coordination; conflict of interest.
Lecture Three: Public goods 26 -

33
Properties of public goods; difference between public goods and
private goods; comparison between efficient provision of public and
private goods
Lecture Four: Market failure and the rationale for government intervention 34 -
50
Imperfect markets as source of market failure; costly information;
externality as a cause of market failure; implications of externalities for
allocation efficiency; solutions to externality.
Lecture Five: Public expenditure 51 -

91
Definition of public expenditure; canons public expenditure; the growth
of public expenditure; reasons for the growth of public expenditure;
restraints to the growth of public expenditure; consequences of the
growth of public expenditure; effect of public expenditure; public
expenditure and economic stability in advanced economies; public
expenditure and economic growth in a developing country; theoretical
aspects to public expenditure evaluation; types of public projects; types
of benefits and costs; shadow pricing and market item; decisions
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involving long-term projects; choice of discount rate; capital budgeting

techniques
Lecture Six: Budget 92 -

96
Canons of budgeting; types of budget; incremental budgeting; zero
base budgeting; performance and programming budgeting system
Lecture Seven: Taxation as a source of revenue 97 -

120
Canons of good tax system; approaches to equity; benefit principle;
ability to pay as basis for taxation; categories of taxes; shifting and
incidence of tax; magnitude of tax burden; types of tax incidences;
effects of tax incidence on market for goods; other factors that affect
effective incidence of tax.
Lecture Eight: Alternative sources of public revenue 121 -

143
Theory of Public debts; classification of public debt; why is public debt
incurred; sources of public borrowing; economic effect of public
borrowing; effects of public debt; burden of internal and external debt;
redemption of public debt; public borrowing requirement; government
induced inflation; donations; user charges.
Lecture Nine: Privatization 144 -

149
Mechanism of privatization; case for privatization; case against
privatization.
REFERENCES 150

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NATURE OF PUBLIC FINANCE

LECTURE ONE
1.1 INTRODUCTION
The chapter introduces to the student the scope of government activity, measures of
public sector and the needs for public sector. Governments provide many goods and
services to public. In Kenya the government provides subsidized education in
primary, secondary and in university. Also provided are health cares and
environmental protection. The government is involved in projects that directly
increase the production of goods and services. It provides water for industrial use,
domestic use. Such projects involve expenditures of large amount of money
provided through taxing, licensing and borrowing.
1.2 LECTURE OBJECTIVE
At the end of this lecture you should be able to:

(i) Define public finance
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(ii) Discuss the scope of government activities
(iii) Explain the measures of public sector
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Definition of public finance

Public finance (government finance) is the field of economics that deals with
budgeting, the revenues and expenditure of a public sector entity, usually
government.
1.3 THE SCOPE OF GOVERNMENT ACTIVITIES
1. Provision of pure public goods. These are goods to which the principle of
exclusion does not apply because they are indivisible and their benefit cannot be
priced. The suppliers are faced with the free riders problem since the users
cannot be forced to reveal their demand preferences. The government must
provide for such.
2. Correction of externalities – suppose a particular public good has external
economies which can not be measured and therefore can not be priced. The
spills over gains are there in the society, but the supplier cannot charge for it.
Hence the price much is lower than the social margin of benefit that determines
his supply on the basis of the price he gets. Hence he produces less than what
could be the optimum quantity from the society’s point of view. The government
must provide for such.
3. Quasi – public goods/mixed goods/impure public goods. They posses both
element of public and private e.g. education, polio vaccination.
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4. Merit goods – They are goods whose provision the society wishes to encourage.
Provision of such goods helps the economy to attain a high level of efficiency
and contribute to achieving basic objectives of the society. E.g. health, education.
They have an overriding importance e.g. precious lives may be lost, if health
services are left to the forces of the market only. The state must supplement
their availability.
5. Demerit goods: these are goods that are viewed as being socially harmful e.g.
cigarette, addictive drugs. For such goods government takes measure to
discourage consumption especially through levy of taxes or legislation to
discourage consumption.
6. Market failure. Market tends to operate inefficiently on account of the existence
of public goods, monopolies and in the absent of law of constant returns. The
condition necessary to achieve the market efficient solution fail to exist. The
government must intervene.
1.4 THE NEED FOR A PUBLIC SECTOR
It was felt that in a capitalistic society government participation in the market should
be very minimal. Those who supported this emphasized the need to leave the
allocation of resources to market forces of demand and supply so that if demand is
greater than supply the prices would rise and vice versa. This process would clear
the market as they argued. But over the years many changes took place, political
ideology evolved hence leading to establishment of socialistic states whose size of
the public sector was larger than private sector.
However, despite the different ideologies the need for government participation in
economic activity in the country is important for various reasons.

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1.5 REASONS WHY GOVERNMENT SHOULD PARTICIPATE IN ECONOMIC

ACTIVITIES
1) The public sector is required to provide goods and services that cannot be
provided through the market owing to problem of “externalities” which lead to
market failure.” For example, the provision of national security. You cannot
bar anybody from enjoying it.
2) The government must formulate and implement economic policies that are
needed to guide, correct and supplement the course that the economy will
take on its’ growth and development over time.
3) Even where market forces are used to allocated resource, there must be a
significantly large public sector to provide regulations and laws that will
provide the required protection, otherwise there will be no property rights, and
there cannot be markets without exclusive ownership rights.
4) Laws and regulations are also needed to ensure free competition in market,
free entry to the market, free exit from the market and for consumer
protection, so that in general, the contractual obligations that arise from free
market transactions cannot be executed unless there is protection and
enforcement of a government provide legal structure.
5) Social values may require adjustments in the distribution of income and
wealth which results from the market systems and from the transmission of
property rights through inheritance. [We are talking of reducing gap between
rich and poor which is as a result of market mechanism. In capitalistic state,
the rich will continue becoming richer and poor, poorer. So something needs
to be done to tax more from rich and provide services which the poor cannot
afford at a subsidized rate].
6) Private sectors invest where returns are high while public sectors look at
overall benefits of a project to the community even if returns are low. e.g.

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Government provide immigration schemes, schools, hospitals etc. Such

projects have no high rate of return on investment but have greater benefits to
the community. Owing to low rate of return on such projects, the private
sector would not invest in them.
1.6 MODELS OF EFFICIENT ALLOCATION
Analysis of the benefits and costs of making additional amounts of a good available
is required to determine whether the existing allocation of resources to its
production is efficient. Any given quantity of an economic good available, say per
month, will provide a certain amount of satisfaction to those who consume it. This
is the total social benefit, of the monthly quantity. The marginal social benefit of a
good is the extra benefits obtained by making one more unit of that good available
per month. The marginal social benefits can be measured as the maximum amount
of money that would be given up by persons to obtain the extra unit of the good. e.g.
if the marginal social benefit of bread is $2 per loaf, some consumers would give up
$2 worth of expenditure on other goods to obtain that loaf and be neither worse off
nor better off by doing so. The marginal social benefit of a good is assumed to
decline as more of that good is made available each month.
The total social cost of a good is the value of all resources necessary to make a
given amount of the good available per month. The marginal social cost of a good is
the minimum sum of money that is required to compensate the owners of inputs
used in producing the good for making an extra unit of the good available. In
computing marginal social costs, it is assumed that output is produced at minimum
possible cost, given available technology. If the marginal social cost of bread is $1
per loaf, they would be made better off.
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Figure (1.0) graphs the marginal social benefit (MSB) and Marginal Social Cost (MSC)
of making various quantities of bread available per month in a nation. Figure (1.1 )
shows the total social benefit (TSB) and the total social costs (TSC) of producing the
bread. The marginal social benefit is given by TBS/Q. Similarly MSC = TSC/ Q
The efficient output of bread can be determined by comparing its marginal social
benefit and marginal social cost at various levels of monthly output.
B
C
A
D
TSC
TSB
TSB - TSC
Q1 Q* Q2
Figure 1.1 The model of efficient allocation

In A, the efficient level of output Q* occurs, at point E. At that output MSB = MSC.
The ‘output Q* maximizes the difference between TSB and TSC as shown in B.
Extension of output to the level corresponding to equality of TSB and TSC would
involve losses in net benefits. Similarly, output level Q1 and Q2 are inefficient.
The marginal net benefit of a good is the difference between its MSB and its MSC.
When MNB (Marginal Net Benefits) are positive, additional gains from allocating
more resources to additional production of the good continue just up to the point at
which the MSB = MSC. If additional resources were allocated to produce more of the
good beyond that point MSC would exceed MSB. The marginal net benefit seen
would be negative.
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The marginal conditions for efficient resource allocation therefore require that
resources be allocated to the production of each good over each period so that MSB
= MSC.
1.7 THE SIZE OF THE PUBLIC SECTOR
Since the government plays an important role in a mixed economy, the question we
must ask is what size of public sector will maximize social welfare. This question
concern both economic efficiency and equity. The approach of identifying the most
efficient and equitable size of the public sector is the principle of maximum social
advantage
1.8 THE PRINCIPLES OF MAXIMUM SOCIAL ADVANTAGE
The principle is concerned with the level at which the government should operate
which in turn is determined by its activities.
The purpose is to design the policy and operations of the government so as to

achieve maximum welfare for the economy.
Simplifying assumptions
i). All taxes drain away the economy’s resources.
ii). All public expenditures restore these resources of the economy
iii). Government revenue consists of only taxes and the government has no surplus
or deficit budgets.
iv). Public expenditure is subject to diminishing marginal social benefit and the
taxes are subject to increasing marginal social disability (cost).
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This implies that the government expenditure will be first directed towards those
uses which are the most beneficial to the society and the taxes will drain away
resources from those lines where they are least useful.
As the government increases taxation and expenditure activities, the social benefit
from each additional shilling spent falls while the dissatisfaction from each
additional shilling taxed increases.
A state is reached at which the rising marginal dissatisfaction of taxation becomes
equal to the falling marginal social benefit of expenditure.
At this stage, the government should stop expanding its activities. It is no longer
beneficial to further expand the state activities because the social benefit of the
marginal unit of public revenue operations is no longer larger than the corresponding
social dissatisfaction.
B
Smb of B
N
Expenditure B1
0
M Amount of taxation
D
N 1 and public
Smc of taxes C expenditure
D1
Figure 1.2 Maximum social advantage
Determination of optimum tax and expenditure activity of the state

Public expenditure and taxation are measured along the X – axis, and social benefit
and cost is measured along the Y – Axis.
The quantities measured along Y – Axis will be positive if measured above the X –
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Axis and negative if measured below the X – Axis.
As a result, the curve showing the marginal social benefit from public expenditure
will lie above X- Axis and the curve showing Marginal disutility from taxation will lie
below X – Axis.
The curve BB1 show the marginal social benefit occurring to the society from
different amount of the public expenditure.
The curve DD1 shows the marginal social cost to the society from the taxation levied
by the state.
The difference between BB1 and DD1 indicates the net social benefit i.e. the excess
of the benefit over the cost to the society. This is depicted by the curve NN1
For example, when taxation is OM which is spend by the government, the marginal
social benefit and the marginal social cost (disutility) are equated i.e. MB = MC.
It is here that the state should stop expanding it activities. The net gained or
maximum possible social advantage to the society is equal to the area ONM. If the
government stopped its operation at less than OM, the society will be foregoing a
possible gain.
If operations are expanded beyond OM, the total net benefit will again start falling.
LIMITATIONS
1) It is necessary for the government to perform certain basic functions like
protection and security. The benefit from the very existence of the government
activities will exceed the cost of maintaining its activities. In fact without the
basic functions of the government, the very existences of the society cannot be
guaranteed. Protection also adds to the productive efficiency of the society.
2) No basis for a generalization that every tax is a burden upon the society and that
every government expenditure is a benefit for it. Example, a tax on consumption
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from harmful drugs is not a burden upon the society. But a tax on health services
will be.
Example II,
If the government undertakes the provision of social overheads and other
public utilities, it leads to the emergence of external economics. Through
them, the cost of production falls, efficiency in production increases and the
economy benefits. The benefits to the economy are actually more than it get.
3) Effects of the budget may spill over to the following periods. Hence appropriate
time tags and effect – spread should be considered.
4) If all taxes are harmful and all government expenditures are beneficial, then the
best course for the government is not to levy any taxes at all. Financing of its
activities could be through deficit financing only. However taxes or expenditures
cannot create or destroy resources. Only transfer of resources between private
and public sectors takes place.
5) Non-tax revenues like fees, fines, profits from parastatals, printing press, and
market borrowing e.t.c. cannot be dismissed as unimportant.
6) Every state is committed to certain compulsory expenses. According to Adam
Smith (1776), these activities include maintenance of state itself, defense,
maintenance of law and order, imparting justice, servicing existing debts e.t.c.
7) It is not easy to identify and quantify the effect of state operations. For example;
indirect taxation changes the relative prices of the commodities been taxed. This
changes demand, consumption, production and investment pattern. Hence the
welfare and growth effect of government activities cannot be linked with the
amount of taxation and expenditure only.
8) It is unrealistic to assume a balanced budget. In developing countries, deliberate
deficit budgeting may be needed to stimulate saving and capital accumulation.
9) The optimum level of government activities determination is done aggregative.
Other factors such as income inequalities, regional imbalances are not
considered yet they are very important.
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1.9 MEASURING THE SIZE OF PUBLIC SECTORS
1. Share of government expenditure in Gross Domestic Product. This is given by the

ratio of total government expenditure in G.D.P
Thus SPS = Total Government Expenditure
Gross Domestic Product
= G
GDP
The ratio shows the share of total output which is purchased by the
government. However the government expenditure should not include transfer
payments.
2. The share of total tax revenue in GDP. This is given by the ratio of tax revenue to
GDP. It measures the countries tax effort or the share of gross income which is
diverted from the private income stream into the public budget.
SPS = Tax Revenue = TR
GDP GDP
This ratio is below the government expenditure ratio if there was a budget
deficit (T<G). However incase of budget surplus (T>G) the ratio is above the
government expenditure ratio. Thus if
i). T < G, TR < G
GDP GDP
ii). T > G, TR > G
GDP GDP
iii). T = G, TR = G
GDP GDP
This ratio is most convenient for global consumption of public sectors
3. The share of government contribution in National Income. National income
measures the sum total of factor incomes (W,r,R,II), earned during a given period.
Hence to measure the size of the public sector we get the proportion of factor
incomes that originated from the government economic activities
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SPS = Total Factor Earning in Government

National Income
4. The share of government contribution in personal income. Personal income
include incomes received by household and contains three government
components;
i). transfer payments (RF)
ii). Wages and salaries earnings from public employment (w)
iii). Interest receipt (r)
This represents the government contribution to the personal income

SPS = Total Government Contribution to Personal Income
Personal Income
= W + RF + R
PI
1.10 SUMMARY
This lecture has given the various measurements of public sector. It has also
explained the principle of maximum social benefit. It pointed out the various needs
of the public sector. The lecture also discussed in details the model of efficient
allocation of resources
1.10 ACTIVITIES
1. Explain the rationale of public sector in the economy.

2. Distinguse between merit and demerit goods..
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1.12 FURTHER READING
A. Asimakopulos, Economic Theory, Welfare and the State (London:Macmillan,

1990).
C.V. Brown and P.M. Jacson, Public Sector Economics (Oxford:Basil Blackwell,
PUBLIC POLICY OBJECTIVES (BUDGETARY OBJECTIVES)

LECTURE TWO
2.1 INTRODUCTION
Lecture two will look at the public policy and fiscal policy instruments that are used
to achieve the budgetary objectives.
At the end of the lecture you should be able to:

a) Explain the four budgetary policies of the government
b) Discuss the coordination and conflict of the objectives
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There are 3 major functions of budgetary policy:

2.3THE ALLOCATION FUNCTION
1) Allocation function: It is a process whereby social goods are provided, or the

process by which total resource use is divided between private and social
goods. The government provided such social goods as security, healthcare,
education, recreational services (parks), road etc.
To understand this clearly we classify goods into 2 categories;
Social goods Private goods
1. The need for social goods is felt 1. The need for private goods is felt
collectively individual.
2. The benefits derived from social 2. The benefits derived from private
goods are not limited to one goods are limited to one particular
particular consumer who purchases consumer who purchases the goods
the good, but becomes available to (e.g. humbugger, shoes)
others as well. (Reduction of air
pollution benefits all). [No.
ownership right]
3. Social goods cannot be provided 3. Provide goods are efficiently
through price mechanism provided through market
mechanism. The market furnishes
a signaling system whereby
producers are guided by consumer
demands.
4. For social good it would be 4. Nothing is lost and much is gained
inefficient to exclude any one when consumers are excluded
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consumer particularly in the unless they pay. Application of the

benefits, when such participation exclusion principle tends to be an
would not reduce consumption by efficient solution.
anyone else. Application of
exclusion principle is impossible
and prohibitively expensive.
5. Social goods do not carry a high rate 5. Private goods carry high rates of
of return on investment. return on investment.
In conclusion: It can be noted that no price could be put on a social good because of
the non-rival ness in consumption. As a result of this, to venture into production of
social good it is highly unprofitable and may not attract private investors. Because of
non-rival ness in consumption, there is market failure. Since the benefits of such
goods are not limited to individuals, beneficiaries may not voluntarily offer payments
to the supplier of such goods. It is as a result of this that the government normally
taxes all citizens irrespectively so that it could provide for such goods.
2.4 Public provision of social goods
Just like in the provision of private goods and services there must be consumer
preference before social goods and services are provided. But because so far social
goods and service is collective from the society as a whole, it is very hard to know
the nature of the society preference map. It would be very difficult to seek individual
opinion from every citizen on type and quantity of a social good that should be
provided. It would also be difficult to decide how much each individual should pay
for the product. One may argue that consumers pay based on benefit principle, as in
the case of private goods, but then the problem would be, how such benefits would
be determined. Just as consumers are unwilling to voluntarily pay for social goods it
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would be difficult to make them reveal accurately how much benefits they are
deriving from such goods.
The question then remains how best public goods could be provided. A different
technique other than market mechanism is needed by which the supply of social
goods and the cost allocation thereof can be determined.
This is where the political process enters the picture and must substitute market
mechanism. Voting by ballot must be resorted to in place of shillings voting. Since
voters know that they will be subject to the voting decision (be it simple majority or
some other voting rule e.g. through their elected MPs, councilors representatives),
they will find it in their interest to vote so as to let the outcome fall closer to their
own preferences. Thus decision making by voting becomes a substitute for
preference revelation through the market. The result will not please everyone but
they will approximately more or less perfectly, depending on the efficiency of the
voting process.
The different set of provision for and production for social goods
2) When the government either directly or through government owned
palastatals e.g. post office, sugar factory, water supply plants etc. or by
assigning private producers to produce goods through tenders, we say that
the government has provided the goods.
If we say that social goods are provided publicly, we mean that they are financed
publicly, we mean that they are financed through the budget and made available free
of direct charge. How they are produced does not matter.
The distribution function

This is a process through which the government redistributes income and wealth
among citizens. In the absence of government intervention in the distribution of
income and wealth, the distribution depends first of all on the distribution of factor
endowments. It is important to note that people’s earning ability differ, ownership of
properties also differ. The distribution of income, based on this distribution of factor
endowments, is then determined by the process of factor pricing, which, in a
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competitive market, sets factor returns equal to the value of the marginal product.
The distribution of income among individuals thus depends on their factor supplies
and the prices which they fetch in the market. In most countries where free market
policies are followed there tends to a rise a class of society where few become
richer and majority poorer. Because this does not fall in line with what is considered
to be just and fair, the government must employ mechanisms and policies to
redistribute wealth and income.
Fiscal instruments of distribution policy

Redistribution is implemented most directly by taking the following action:
a) Employ a tax transfer scheme. Here a vertically progressive tax system is

used to collect more taxes on income of high income households and using
the money to subsidize low income households.
b) Employ a progressive tax system to finance public services such as medical,
education, water etc.
c) Employ a sales tax: Taxes are collected on goods and services used by high
income classes and funds raised are used to subsidize goods used by low
income classes.
The stabilization function

Here macro-economic policies are employed to maintain and achieve the goals of
high employment, acceptable price stability, favourable balance of payment position,
acceptable rate of economic growth and development.
Economic policies are necessary because high rates of employment and low rate of
inflation do not come up automatically in a free market economy. In fact changes in
inflation rate are inversely related to rate of unemployment as can be shown in the
following diagram.
Phillip Curve shows the trade-off

Inflation between unemployment and
22 inflation. To achieve low
unemployment level, we have to
be ready to suffer high inflation
rate.
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Figure 2.1 Relationship between inflation and unemployment

From the diagram it is clear that countries cannot attain zero level of inflation and
unemployment at anytime. There will always be a combination of the two that would
be favourable at one time. When inflation rate is high, rate of unemployment is low
and vice-versa.
 This calls for well planned policy actions to achieve an acceptable level at
inflation and unemployment.
 At times there may be high level of inflation and employment meaning that
Phillip’s has shifted to the right.
Reasons:-
(i) Increased size of labour force due to population growth.
(ii) Low rate of manpower utilization high level of unemployment.
(iii) Low rate of economic growth. Low economic growth implies that when
supply is less than the demand the prices go up hence unemployment.
(iv) Lack of technological know-how – low output.
Therefore economic policy is essential for strong economic growth and development.
The level of employment and prices in an economic depends on level of aggregated
demand and level of output valued at prevailing prices. i.e. Employment = f (Output,
expenditure).
 Aggregate demand is also a function of the spending decisions of many

consumers, corporate managers, many financial investors etc.
 The decision of this people in turn depends on:-
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a) Past and present levels of income and expected level of future

incomes.
b) Level of wealth in a country and its distribution.
c) Credit availability.
d) Future expectations.
2.5Instruments of stabilization policy
a) Recession period
For any given period the level of expenditure or aggregate demand may not be
sufficient to secure full employment of labour and other factors of production. When
this happens expansionary economic policies must be made to stimulate the
economy e.g. increase government expenditure and reduce taxes. The supply of
more money for use in demand increases production (output) hence rise in
employment.
b) Boom period
When aggregate demand is greater than aggregate supply (level of output)
employment level is high in boom period and inflationary pressure is also high.
When this happens, restrictive economic policies must be employed. Reduce in

government expenditure & increase in taxation leads to a decrease in purchasing
power resulting in fall in effective aggregate demand.
2.6 CO-ORDINATION OR CONFLICT OF FUNCTIONS
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In order to provide a good co-ordination of the functions there must be a good

management of the economy. When they are not properly co-ordinate there will be
conflicts among them. Proper co-ordination calls for good policy targeting during
the planning and implementation process.
For example, those who are concerned with planning distribution will design a tax
transfer plan to secure the desired distribution. Similarly, those who are in charge of
allocation in terms of public expenditure must ensure that the funds allocated from
the taxes are used to finance projects with consumer evaluations thereof.
Those who are in charge of policy formulation to stabilize and to stimulate the
economy must ensure that they achieve full employment and economic growth.
When all functions are in balance we say that the budget is balanced.
However, this balance may not be sufficient to provide for or sustain the required
economic growth and development. So the government will result to other sources
of funds other than taxation e.g. externally or internally. In real world situation such a
perfect co-ordination may not be realizable. The achievement of one objective (e.g.
provision of social goods) is achievable at the expense of the other e.g. (price
stability).
1.3.1 Conflict of interest

i) Conflict between allocation and distribution
Taxes are normally imposed so as to redistribute income and wealth and raise
funds for government to provide social good. In order to affect this, a vertical
progressive tax to collect more from the rich and less from the poor is
imposed.
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But if you looks at less developed countries budget is low and majority of
earners are in lower and middle income classes, hence causing conflicts
between allocation and distribution function.
ii) Conflict between distribution and stabilization function:-

Stabilization functions are used to stabilize the economy. When there is need
to stimulate the economy (time of recession) taxes on lower income groups
should be reduced, since their marginal propensity to consume is higher than
that of the rich. This would lead to increased disposable income, demand,
output produced and thus employment.
The opposite course has been made in times of inflation, namely that taxes
on low-income groups should be raised, since they are more potent in
reducing demand than taxes on higher income. Another reason would be, by
taxing the rich a lower rate; they would be motivated to save more because
their MPS are high. Conflicts arises in such as approach because the
distribution function of budgetary policy does not achieve the aims of
deducting more from the rich and less from the poor.
iii) Conflict between distribution and growth and economy

Objective of the budget is to attain high growth rate in economy. This would
only be achieved if capital formation, savings and investments are increased.
This would mean withdrawing more from poor and less from rich. This is
because people with higher propensity to save are high income people.
Conflict arises between distribution and growth. The aim of distribution
function is to deduct more from the rich and less from the poor, which is the
opposite of the goal of high growth rate.
2.7SUMMARY
3
4
5
6
26
The lecture has discussed in details the four policy objectives of the government .It
has also exposed the co-ordination and Katali
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(mwongelikatali@gmail.com)
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2.8 ACTIVITIES
1. What are the budgetary policy objectives of the government?

2. What is a balanced budget
3. What policy instruments that are used during stabilization.
2.9 FURTHER READING
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).
PUBLIC GOODS
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LECTURE THREE
3.1 INTRODUCTION
The lecture will introduce the concept of public goods. It will also show clearly the
distinction between public and private goods. It will also discuss the properties of
public goods
At the end of this lecture you should be able to:

a) Explain the two properties of public goods
b) Distinguish the private and public goods
c) Explain the various categories of goods and explain their
We now need to consider how the characteristic of pure public goods relate to the
concept of market failure. There are some goods that either will not be supplied by
the market or if supplied would be supplied in insufficient quality e.g. defense, street
lighting etc. These are called public goods. If a pure public good is to be available
for consumption then it must be provided collectively either through private voluntary
arrangements or public via the budget.
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3.3 PROPERTIES OF PURE PUBLIC GOODS
Pure public goods have two properties

(1) Non-excludability
(2) Non-rival in consumption.
Non-excludability characteristics of public goods
In the case of pure private good a set of property rights define the ownership of the
good. The individual who possess the property right has the sole claim to enjoy the
benefits of the good and can therefore exclude others from doing so. In the case of a
pure public good technical feature of excludability begin to breakdown. First, it is
generally difficult to exclude individuals from enjoyment of public good. If for
example a geographical area is provided with defense services which diverts and
attack from abroad it becomes extremely difficult to exclude anyone who lives in the
country from being defended. Similar example is found in street lighting.
For pure public good the degree of exclusion depends upon the technical
characteristics of the good and the resources available to the producer to enforce
the exclusion. In general, however, there is no perfect exclusion. So an optimal
amount of exclusion is a decision to be made by a producer.
Second reason why the exclusion principle breakdowns is that, while it may be
technically feasible to exclude, the application of exclusion device may be very
expensive. That is, the cost of exclusion can outweigh any advantages to be
obtained from its application. A pure public good is the one for which exclusion is
either technically not feasible and if feasible, the cost of enforcing the exclusive
device is too prohibitive to apply.
With non-excludability, there is no incentive for a profit maximizing producer to
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supply the public good because once he produces it he cannot exclude individuals
from consuming it and hence he is unable to charge a price. Individuals wishing to
consume the benefits of a pure public good could, however, form a private co-
operative. They could agree to contribute to the cost of supplying the public good.
Such an arrangement might be feasible for a small group of individuals, but as the
group grows in size the possibility of individuals becoming free riders increases and
the private voluntarily arrangement fails.
Non-rivalness in consumption
Definition of a pure public good implies that it is non-rival in consumption. It means
that it does not cost anything for an additional individual to enjoy the benefit of
public goods.
Non-rivalness arises from the indivisibility of public goods. That is, adding one or
more persons (up to a capacity constraint) does not add to the marginal cost.
Formally there is zero marginal cost for an additional individual to enjoy a good. Non-
rivalness thus implies, one individual access to the commodity does not reduce
another individual’s benefit because these benefits are available to all without
interference.
A perfect solution in this case would require a zero price because marginal cost
equals zero.
This will mean that revenues will not cover losses and so a private profit maximizing
producer will not supply such a commodity.
The market, in other words, will not allocate such goods efficiently thus the market
failure.
Therefore goods can be classified into four cases according to their consumption
and excludability characteristic.
Exclusion
Consumption Feasible Not Feasible
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Rival 1 2
Non-Rival 3 4
Characteristic
Case 1
This is a private good that is rival in consumption and excludable e.g. a loaf of bread,
clothing. You only consume the goods after paying for it. Whoever does not pay is
excluded. Benefits are internalized.
Case 2
This represents a good that is rival in consumption but non-excludable. In this case
there is market failure due to non-excludability or high cost of exclusion. Example,
travel on a crowded street, traffic jam due rush hours.
Case 3
This is a good that is non-rival in consumption but excludable. Examples are clubs,
watching a movie, swimming, education, crossing a bridge that is not crowded.
Case 4
This is a good that is non-rival in consumption and non-excludable. This is a pure
public good. Examples are, air purification, national defense, street lights e.t.c.
Comparison between efficient provision of public goods and private goods

In chapter 2 we noted that one goal of the public sector or government was to
ensure the efficient allocation of both public and private goods. It was pointed out
that some goods and services had to be supplied by the public sector, since it would
be difficult, if not impossible, to have them supplied by the private sector in a market
economy.
In this section we shall derived the conditions for efficient provision of a public good,
and then compare them with those of private good. To achieve this objective the
approach of Bowen model shall be used.
Price of PRIVATE GOODS

Private DB Price
31of DB DA + B SOCIAL GOODS
goods
Social
goods DA
E Downloaded by Mwongeli Katali (mwongelikatali@gmail.com)
P2 MC = S
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Figure 3.1 Efficient allocations of private and public goods

In order to explain the foundations of this model, we assume that there are two
individuals, A and B each having a conventional downward sloping demand curve for
some public goods. That is, if the public goods could be sold in units at a price, each
individual would demand more as the price is reduced. These two demand curves
are shown as DA and DB in the right side of figure 3.1. Drawing such demand curves
is based on the unrealistic assumption that consumers volunteer their preferences,
and such curves have therefore been referred to as “Pseudo-demand curves”.
In the earlier discussion we defined public good as one which once produced, is
consumed equally by all. Thus no one person can vary the quantity to be taken. This
being the case, to derive the total demand for public good, the demand curves are
added vertically, not horizontally, as would be the case for a private good.
Suppose a quantity OZ of the public good is made available to A. It is also made

available in the same quantity to B. What we want to know is how much would A and
B, together, be willing to pay for OZ of the public good. To get this add Zs (what
individual A is willing to pay for Oz) and ZH (what individual B is willing to pay for OZ)
to obtain ZE. This is done for each and every amount of the public good, giving us
the total demand curve DA + DB. This tells us how much A and B, together, would be
willing to pay for various amounts of the pure public good.
It should be noted that for each amount of public good supplied, individual B is
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willing to pay more than individual A for that amount.
Since it takes resources to produce the public good, we introduce for convenience a
constant marginal cost (supply schedule) in our diagram, and from its intersection
with the total demand curve, obtain the equilibrium quantity and price, in this case
OP1 and OZ. NB:
MBA +MBB =P ∑MBi = p where MBA is the marginal benefit of person A, MBB is
the marginal, benefit of person B and P is the price.
Thus we see that the sum of the marginal evaluation by each person for the public
good equals the prices, which equals marginal cost, thereby meeting the conditions
of optimal pricing, that is, that price equal marginal cost.
In the case of private goods as can be depicted in the left side of figure 3.1, in a
perfectly competitive market situation, prices are fixed (market determined) and the
consumers would only vary amount they consume. So the total demand curve for
private good (DA + DB) is obtained by horizontal addition of DA and DB. That is,
adding the quantities which A and B purchase at any given price. Given the supply
schedule, the equilibrium is determined at E, the intersection of market demand and
supply.
Prices equals OP2 and output OH, with OF purchased by A and OG by, B, where OF +
OG = OH.
In a perfectly competitive market, equilibrium requires that the price of a good be

equal to each consumer’s marginal evaluation, which in turn is equal to marginal
cost.
The consumer theoretically adjusts his purchase to achieve this, since he faces a
fixed price. In the public goods, case, the price does not equal each consumer’s
marginal evaluation and the consumer cannot vary his purchase to achieve this.
For a non-excludable public good, however, there may be incentives for people to
hide their true preferences. Individual A may falsely claim that the public good
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means nothing to him. If he can get individual B to foot the entire bill, he can still
enjoy the benefits from the public goods and yet have more money to spend on
private goods. In the figure presented above, at output OZ1, individual B meets the
entire Price (Z, V). This incentive to let other people pay while you enjoy the benefits
is known as the free rider problem. Hence, there is a good chance that the market
will fall short of providing the efficient amount of the public goods. No automatic
tendency exists for markets to reach the efficient allocation.
Even if consumption is excludable, market provision of a public good is likely to be

inefficient. Recall the fact that efficiency requires that price equal marginal cost.
Because a public good is non rival in consumption by definition, the marginal cost of
providing it to another person is zero. Hence efficiency requires a price of zero. But
if the entrepreneur charges everyone a price of zero, then we cannot stay in business.
Is there a way out? Suppose that the following two conditions hold:-
(i) The entrepreneur knows each person’s demand curve for the public good and
(ii) It is difficult or impossible to transfer the good from one person to another.
Under these two conditions, the entrepreneur could charge each person an individual
price based on willingness to pay a procedure known as perfect price discrimination.
From our example, because individual B values the public good most, he would pay a
higher price and thus the entrepreneur would still be able to stay in business.
Perfect price discrimination may seem to be the solution until we recall that the first
condition requires knowledge of everybody’s preference. But of course, if individuals’
demand curves were known, there would be no problem in determining the optimum
provision of public good as was earlier demonstrated.
3.4 SUMMARY
34
The lecture has discussed the properties of public goods. It has also shown clearly
the distinction between public and private goods. It
has also shown
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3.5 ACTIVITIES
3.5 ACTIVITY
1. What is a free-rider problem?

2. Explain in details the characteristics of pure public good.
3. Explain the terms excludability and non rival consumption.
3.6 FURTHER READING
1992)
McGraw-Hill,1989).
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MARKET FAILURES AND THE RATIONALE FOR GOVERNMENT INTERVENTION

LECTURE FOUR
4.1 INTRODUCTION
The lecture introduces the rationale of government in the goods market. It discusses
the causes of market failure and their correction. More emphasis are given to the
externalities as a source of market failure.
36able to:
At the end of the lecture you should be
a) Explain the justification of government intervention in the goods market
b) Explain the various
Downloaded sources
by Mwongeli of(mwongelikatali@gmail.com)
Katali market failure
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Where the market is efficient, consumers have freedom to choose what they want to
consume freely, and they reveal their preferences to producers. Producers, in trying
to maximize their profits will produce what consumers want to buy and will do so at
least cost. Competition will not only ensure that the mix of goods and services
produced corresponds to consumers preferences, but would ensure that resources
are allocated efficiently. The main assumption here is markets are efficient and
competitive.
Under normal circumstances, however, this may not be the case. Market may fail to
achieve an efficient allocation of resources, leaving open the possibilities that
government provision of certain commodities might enhance efficiency. Therefore
market failure refers to those situations in which the conditions necessary to achieve
the market efficient solution fail to exist or are contravened in one way or another.
The proposition is therefore that the market system of economy is unlikely to
operate efficiently. In fact there is a tendency for it to produce too much of some
goods and an insufficient amount of others. In extreme cases, certain goods will not
be produced at all.
Given the presence of market failure, one possible role for government would be to
intervene in allocation function of the market to correct the market failure or
introduce policies that would compensate its effect. This gives rise to the allocation
function of the government.
Market failure will also bring about the question of equity of social justice in the
distribution of income and welfare where market failure produces a socially unjust
distribution of welfare. Government intervenes to bring about a distribution that is
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considered to be socially just and fair. This is referred to as distributional role of

government.
Market failures could also produce macro-economic instability such as inflation,

unemployment, BOP disequilibrium, etc. In these circumstances, a stabilization role
exist for government to intervene in the economy using monetary and fiscal policies
to bring about desired level of inflation and unemployment, thereby improving the
welfare of society.
Further, there is a regulative function which government performs. As part of its

allocation role government enact and enforce laws of contracts. It also administers
the more general system of laws, order and justice which regulates individuals or
firms behaviors and ensures that market activities and private exchanges take place
smoothly.
Thus market failure permit four functions of the government.

Certain conditions exist under which the market will fail to be efficient. The
conditions include:-
(i) Imperfect competition
(ii) Costly information
(iii) Public goods
(iv) Externalities.
4.3 IMPERFECT COMPETITION AS A CAUSE OF MARKET FAILURE
When some agents have the ability to affect price, the allocation of resources
generally is inefficient. An extreme form of such market power is monopoly, which
comprises of one seller in the market for a given commodity. Conditions that bring
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about monopoly includes:-
 Where transportation costs are large the relevant market may be limited
geographically if there is only one firm in such a locality. There may be no or very
limited competition.
 In case where cost of production per unit of output declines (decreasing cost of
production or increasing returns to scale) entry into industry becomes very
difficult, thereby permitting the firms already established to exercise natural
monopoly.
 Some monopolies are created by the government or run by the government. The
Kenyan government, for example, has given the Kenya Power and Lighting
Company the exclusive right to generate and distribute electricity in the country.
Patent rights given to some investors grant them monopoly over their invention
over specified period of time.
In some instances it is more efficient to have one or a few firms’ producing rather
than many. This applies where the initial cost of production is high and where the
production of the commodity cannot be subdivided into small units, e.g. the
production of electricity. Such subdivision would be inefficient and uneconomical.
If monopoly has some possible aspects then why is it generally viewed as bad? The
reason is that, if not regulated and if allowed to trade freely, they would restrict
output to attain higher prices.
Mechanism of how they would restrict output to raise prices:

Price
PANEL A
-
Demand
B 39
C Marginal
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Price
PANEL B
-
Demand
B
A F
Average
G C cost
Marginal
cost
Qx Q1 Q2 Out put
MR
Figure 4.1 Monopoly market structure
In panel A of figure 4.1, assume that the marginal cost (MC) of production is
constant at all levels of output. Because the monopolistic seek to maximize profit,
he will produce output OQ*, where price equal marginal cost. Clearly O Q* <OQ, and
also notice that at OQ*, price which measures how much individuals value an extra
unit of the goods exceed the marginal cost implying a welfare loss from restriction
of output by the monopolist. This establishes a case for government intervention to
ensure an efficient allocation of resources.
In panel B of figure 4.1, we assume that marginal cost of production falls as output
is expanded. That is, there is an increasing return to scale (a decreasing average
cost curve). Since AC>MC at any level of output, a price set to equal MC at Q2 would
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cause the monopolist to incur a loss. Q1 is the highest output at which the firm
breaks even since at that output AC=P. A perfect competitive firm would produce at
Q2 since P=MC at that output level. A monopolist on the other hand will restrict
output to C Q*. Again there is a welfare loss arising from this restriction.
The problem of increasing returns to scale establishes a case for government

intervention to ensure an efficient allocation of resources. In situation, as depicted
in the figure, the government could instruct the monopoly firm to charge a price
which equals the marginal cost, subsidizing the loss out of tax revenue. This is a
classic example of regulation of increasing return to scale industries.
Alternatively the government could take over the entire production operation i.e.
through nationalization, produce output Q2 and charge a marginal cost price again
subsidizing the loss from a general taxation.
At this point we should recognize the importance of the way losses made by
decreasing cost industry using marginal cost pricing are financed. They are financed
from taxation but most taxes influence relative price. They introduce a distortion and
thus create additional inefficiencies. Ideal lump-sum taxes, which leave relative
prices unchanged should be used. However, lump sum taxes are generally not
available and so other taxes must be used in practice.
The design of optimal government policy is therefore one of the weighing out the
distortions and inefficiencies introduced by interventions, compared with the
inefficiencies that the policies are designed to reduce.
4.4 COSTLY INFORMATION
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The competitive model assumes that information on existing prices is somehow

spread around at no cost, so that everyone can find the best price. In reality, this is
not the case. Shopping around to find the lowest price requires time which is a
valuable commodity.
Moreover, once information is obtained, it may be imperfect. Thus, it is possible that

because individuals do not have the necessary information to make the right
economic decision, inefficient patterns of resource allocation emerge.
4.5 EXTERNALITIES AS A CAUSE OF MARKET FAILURE
Musgrove and Musgrave define externality as, ‘a situation where the benefit of
consumption of a given good or service cannot be paid by producer who causes
them to result into external costs to others.
For example, a particular technology used in the production of a private good
produces smoke as a by-product (i.e. the externality of spill-over) which is
involuntarily consumed by people living near the factory, thus lowering their utility.
Despite the producer causing pollution, he does not include such external costs as
eradicating air pollution in his production costs. So that, his private costs (costs of
living inputs) is less than the overall social cost (private costs and external costs).
This external diseconomy will result in the overall production of the good associated
with the diseconomy, and the allocations would differ from those that would have
been produced by perfectly competitive markets. The existence of externalities
results in outcomes that are not efficient.
An Externality is something that, while it does not monetarily affect the producer of a
good, it does influence the standard of living of society as a whole. They can also be
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referred to as those conditions where the forces of the market cannot secure,
optimal results," and to public goods as a condition "where the market mechanism
fails altogether."
In the presence of externalities and public goods competitive market equilibrium

cannot be expected to yield socially efficient resource allocations. This is due to
"special" characteristics of externalities and public goods called "non-excludability"
and/market thinness," or what is more commonly called the "free rider problem."
The tree rider problem exits when people enjoy the benefits of government provided
goods i.e. public goods, independent of whether they pay for them. Free riders are
actors who take more than their fair share of the benefits or do not shoulder their fair
share of the costs of their use of resource. The actual "Free rider problem" can
therefore be defined as the question of how to prevent free riding from taking place
or at least limit its effect. Since the notion of "fairness" is highly subjective, free
riding is only considered/to be an economic problem when it leads to under or non-
production of a public good thus Pareto inefficiency. An example of a public good
subject to this is national defense-one is protected whether or not he pays for the
services rendered.
Forms of Externalities:
There are two forms of externalities:
(i) Positive Externalities
(ii) Negative Externalities
(iii) Fiscal Externalities
(i) Positive Externalities:

A positive externality is something that benefits society, but in such a way that the
producer cannot fully profit from the gains made. A few examples of positive
externalities are environmental clean-up and research. A cleaner environment
certainly benefits society, but does not increase profits for the company responsible
for it. Likewise, research and new technological developments create gains on which
the company responsible for them cannot fully capitalize.
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(ii) Negative Externalities:

A negative externality is something that costs the producer nothing, but is costly to
society in general. Unfortunately these externalities are much more common. Let's
take an example of pollution. This is a very common negative externality. A company
that pollutes loses no money in doing so, but society must pay heavily to take care of
the problem pollution caused. The problem this creates is that companies do not
fully measure the economic costs of their actions. They do not have to subtract
these costs from their revenues; hence profits inaccurately portray the company's
actions as positive. This can lead to inefficiency in the allocation of resources.
(iii) Fiscal Externalities:
This is whereby the behavior of people affects the cost of some subsidy or alters the
revenues from some tax as externalities. Fiscal externalities do not necessarily imply
any inefficiency, and when there is inefficiency, it is the result of the pre-existing
policy. An example is smoking; this imposes costs on taxpayers due to the existence
of subsidized medical care. In this case the medical care subsidy creates the fiscal
externality.
However, when there is inefficiency, the nature and magnitude of the fiscal
externality is not a reliable guide to the appropriate corrective policy. Like in the
above example, it will usually be best to modify the pre-existing policy (the medical
care subsidy) rather than tax smoking.
Implications of Externalities for allocation efficiency:

The prevalence of externalities in the market based economy suggests that the
optimality rules normally assumed to lead to allocation efficiency may not in fact
lead to the most socially efficient outcome. The presence, of externalities thus
represents an example of market failure to achieve allocation efficiency. This is
because in the presence of externalities the market price of a good may not reflect
the true societal cost or benefit and hence may be under or over produced. Figure 4.2
illustrate the implication of negative externalities for allocation efficiency.
Dollars SMC = (PMC + d)

per
year
S (PMC)
P*
44
Pm D
d
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Figure 4.2: Effects of Negative Externality on allocative efficiency

In a free market where the optimality rules have been followed the quantity produced
will occur at quantity Xp and price Pm, the point where demand (D) equals the private
marginal cost (PMC). However where a negative externality exists the market fails to
produce the socially optimal level of production. This is because the marginal
damage (d), generated by the negative externality, is a cost not taken in to account in
the market. When a social marginal cost (SMC) curve is generated it is possible to
see that socially optimal level of production is in fat X* and that the product should
be sold at a higher price P* to reflect the fact that the true social cost of the product
is higher than the private cost.
Positive externalities also have their own special implications for the achievement of
allocation efficiency. Figure 4.3 illustrates the implications for the optimality rules of
a positive externality. The market equilibrium in this situation occurs at quantity' Q*
and price Pm where the private marginal benefit (PMB) of the item equals its
marginal cost. However this item produces an external benefit (b) which is not taken
in to account by the market. The socially optimal quantity of this item actually occurs
where the social marginal benefit (SMB) curve derived by summing the private
marginal benefit and the external benefit, equals the marginal cost of producing the
item. This analysis suggests that the allocativion efficient situation occurs at
quantity Q* and price p*.
Dollars
Per year MC
P*
Pm b
45 SMB (PMB + b)
PMB

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Figure 4.3: Effect of positive externality
The conclusion which can be drawn from this is that true allocation efficiency will
not be achieved unless the external benefits and costs associated with externalities
are taken in to account when making economic analysis.
4.6 SOLUTIONS TO EXTERNALITIES:
PUBLIC RESPONSES TO EXTERNALITIES: TAXES AND SUBSIDIES
(1) TAXES
A natural solution suggested by the British economist A.C. Pigeon is to levy a tax
on each unit of a polluter’s output in an amount just equal to the marginal
damage it inflicts at the efficient level of output. This tax is called Pigouvian tax.
Price MSC = MPC + MD

and
Costs (Mpc + cd)
()
d MPC
PS
46 MD
J C

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Figure 4.4. Use of Tax in correcting External Diseconomy

In this case the marginal damage done at the efficient output Qs is distance cd. This
is the Pigouvian tax. Remember that the vertical distance between MSC and MPC is
MD (i.e. cd). The tax raises the firms marginal cost. For each unit the firm produces
it has to make payments both to the suppliers of his inputs (measured by MPC) and
to the tax collector (measured by cd). Geometrically the firm’s new marginal cost
schedule is found by adding cd to MPC at each level of output. This is done by
shifting up MPC by a vertical distance equal to cd.
Profit maximization requires that the firm produce up to the output at which marginal
benefit equals marginal cost. This now occurs at the intersection of MB and MPC+cd
which is at the efficient output Qs. In effect the tax forces the firm to take into
account the costs of the externality that it generates and hence induces him to
produce efficiently.
Note that the tax generates revenue cd dollars for each of the unit which is produced
(psd = OQs). Hence tax revenue is cdxpsd, which is equal to the area of rectangle
psjcd.
WEAKNESS OF PIGOUVIAS TAX

(i) There are practical problems in implementing a pigouvias tax scheme. In light of
the difficulties in estimating the marginal damage function, it is found to be hard
to find the correct tax rate.
(ii) Still sensible compromises can be made. Suppose that a certain type of
automobile produces poisonous fumes. In theory a tax based on the number of
miles driven enhances efficiency. But a tax based on mileage might be so
cumbersome to administer as to be infeasible.
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(iii)The government might instead consider levying a special sales tax on the car
even though it is not ownership of the car per se that determines the size of the
externality but the amount it is driven. The sales tax would not lead to the most
efficient possible result, but it still might lead to a substantial improvement over
the status quo.
(iv)Another weakness is that the tax approach assumes that it is known who is doing
the polluting and in what quantities. In many case these questions are very hard
to answer.
(2) AUCTION POLLUTION PERMITS

Another method of achieving Qs is to sell producers permits to pollute. The
government announces that it will sell permits to dumps into the river the amount of
garbage associated with output Qs. Firms bid for the right to own these permissions
to pollute and the permissions go to the firms with the highest bids. The fee charged
is that which “clears the market” because the amount of [pollution equals the level
set by the government.
In the simple model the pollution permits and the pigouvial tax are identical. Both
achieve the efficient level of pollution. Implementing both requires knowledge of who
is polluting and in what quantities. Baumal and Oates [1979, p.251] argue that
pollution permits have some advantages over the tax scheme from a practical point
of view. One of the most important is that the permit schemes reduce uncertainty
about the ultimate level of pollution. If the government is certain about the shapes of
the marginal private cost and marginal benefit schedules of figure 4.4 it can safely
predict how a Pigouvian tax will affect behaviour. But if there is poor information
about these schedules it is hard to know for sure how much a particular tax will
reduce pollution. If lack of information forces policy makers to choose the pollution
standard arbitrarily with a system of permits, there is more certainty that this level
will be obtained. In addition under the assumption that firms are profit-minimizes,
they will find the cost minimizing technology to attain the standard.
Moreover when the economy is experiencing inflation the market price of pollution
rights would be expected to keep pace automatically, while charging the tax rate
could require a lengthy administrative procedure.
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One possible problem with the auctioning scheme is that large firms might be able to
buy up pollution licenses in excess of the firms cost minimizing requirements to
deter other firms from entering the market.
(3) REGULATION
Under regulation each polluter is told to reduce pollution by a contain amount or else
face legal sanctions.
In case of pollution 2 classes of regulation (control) can be distinguished.

(a) Direct regulation
(b) Input regulation
The direct regulations involve the setting up of critical level of pollution and
monitoring the level of pollution of the firms and prosecute firms that exceed critical
level. Input regulation on the other hand, involves regulating the production process.
When it is feasible to control level of pollution it seems preferable to apply input

regulation. The reason is that the firm is likely to know better than the government in
terms of best way of reducing the pollution. Most government relies heavily on input
regulation since in most cases it is easier to monitor inputs than to measure level of
pollution.
4.7 PRIVATE SOLUTION
i) Internalize Externalities:
Economists recognize that negative externalities are a major problem. To combat
this problem, the government might try to force companies to internalize externality'
costs. In any type of production and economy, some negative externalities of
production are inevitable. The real problem created by negative externalities in the
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free-market economy is that because they are not a cost to the company, the
company will see only what is profitable to itself, not to society as a whole; this will
create inefficiency in the economy. The famous economist Milton Friedman says
that the government should require companies to pay for the costs of cleaning up
the problems they create.
This can be accomplished through taxes and fees, making companies pay for the
amount of harm they do to society as a whole. This solves the inefficiency problem.
If companies have to pay the costs of pollution, they can accurately compare the
total costs and revenues of production and determine if it is profitable to produce.
However the government still has to struggle with the question of placing a monetary
value on such things as death, extinction, the destruction of forests, and many other
social costs and it is not always easy to put this policy into practice. Regulations are
not always enforced, and governments may simply choose to relax their standards in
order to avoid hurting businesses.
ii) Social Conventions;

This deals with negative externalities through social conventions and tradition. The
argument here is that "certain social conventions can be viewed as attempts to force
people to take in to account the externalities that they generate. The example
associated with this is impressing on people from a young age that even though one
bears a cost by holding on to litter until a bin is found that one should do so because
of the externality which litter creates. However its overall usefulness may be limited
to low cost externalities generated by individuals.
iii) Property Rights:

The establishment and enforcement of private property rights provide an alternate
framework for the solving of externalities. "A private property right is a legally
established title to the sole ownership of a scarce resource that is enforceable in the
courts." Private property rights offer a number of solutions to the problems posed by
externalities. Firstly, the establishment and enforcement of greater private property
rights by the legal system would allow victims of negative externalities to sue the
offending party for compensation for the damage caused. For example, if property
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rights to a section of river are assigned to a particular fishing club, then that club will
be able to sue the chemical firm/upstream which pollutes the river and kills the fish
stock in the fishing clubs section of the river.
iv) Coase Theorem & Bargaining:

The other way in which property rights can assist in achieving allocation efficiency is
by providing a framework in which bargaining may take place. Consider the situation
illustrated in Figure 4.5 below which builds on the fishing club example.
Dollars per SMC = (PMC + d)

Years
PMC
MR
X* XP Tons of chemical per year
Figure 4.5: Coase Theorem & Bargaining:

The Coase Theorem suggests that " the efficient solution will-'be achieved
independently of who is assigned the ownership rights , so long as someone is
assigned those rights". The reasoning for this is that if the chemical firm is assigned
the property rights , the fishing club will be prepared to pay the chemical firm an
amount up to the value of the damage being caused, to have the chemical firm
reduce its output and that at any point past X* the damage being caused exceeds
the firms profits from doing so. Hence the firm is willing to accept the payment to
reduce its output to X*. Similarly if the fishing club has the rights, it will not allow the
firm to produce past X* as the damage caused to the fishing club is greater than any
payment the firm would be willing to make. The establishment of property rights
thus creates a framework which allows bargaining and the achievement of the
socially optimal outcome.
WEAKNESSES OF COASE THEOREM
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(i) The Coase theorem assumes zero translation cost. If translation costs are
high then the outcome of bargaining over weights won’t be pareto efficient.
Also the outcome will be affected if there is assignment of translation costs
between the two parties in the bargain.
Pigon (1932) points correctly to the cost in terms of time and efforts required
for bargaining. In the presence of very large lump sum translation costs which
exceeds the benefits from negotiation a discrete decision either allowing or
barring the activity maybe the solution.
(ii) Another problem is that voluntary bargaining may not proceed if large number
of people is involved. For example if pollution problem is experienced by large
numbers of individual then each individual may prefer to sit quietly and hope
that others will offer enough compensation to induce a less polluted
atmosphere. In this way each victim would seek to free ride. Clearly if all
affected people behave in this way the process of negotiation will not
materialize.
Coase solution will only be applicable in those situations in which properly
rights and hence contracts can be well specified at reasonable cost and
where problems of free riding do not arise.
(iii) It is not necessarily the case that negotiation will produce a pareto
improvement if both parties do not have access to all available information’s.
As David and Kamien (1971) has pointed out one side may have more or
superior information than the other and this may lead to cheating or black
mailing.
(iv) The Coase solution has distributional consequences. The individual

consuming the external effects compensate the polluter to reduce level of
pollution whilst solutions to externality problems might not be desirable in
distribution terms. For example consumer of those goods that carry a
pollution tax will end up paying higher prices and some employees who work
in those firms may be made redundant as output levels reduce.
v) Mergers:
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Another possible solution to the problem of externalities may be for the parties
involved to merge. For example if a fishing companies profits are being harmed by
the pollution produced by a steel mill then the problem of this externality can be
solved by merging the parties involved and internalizing the effects. "For instance, if
the steel manufacturer purchased the fishery, he would willingly produce less steel
than before, because at the margin doing so would increase the profits of the fishing
subsidiary more than it decreased the profits from his steel industry.” This
suggestion too however may be seen as having a number of problems in its practical
implantation.
4.8 MARKET SOLUTION
Tradable Pollution Permits:

Tradable pollution (or emission) permits are a free-market solution to the problems
caused by negative externalities. Tradable emission permits allow the government to
give companies licenses to pollute at a certain level. Companies can buy, sell, and
trade these permits on the market. Therefore it is in the interests of companies to
pollute as little, as possible. If they pollute at a level higher than their permit allows,
they have to buy permits from another company. If they pollute less than they are
allowed to, they can sell their permit. The difficulty is that companies that pollute
create a cost to society but not a cost to themselves. Because the company does
not have an accurate view of its costs of production, it cannot set its production at
the level that maximizes efficiency in the economy.
Conclusion:
In conclusion then it can thus be said that the existence of externalities and the
failing of the market to adequately deal with them has serious implications for the
achievement of true allocation efficiency within the economy. Whilst there are a
number of possible approaches to correcting the problems caused by externalities,
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each of the suggested solutions entails its own problems which must be overcome
before society will have an effective means of dealings with the problems caused by
externalities.
4.9 SUMMARY
This lecture has discussed in details the various reasons why the government
should intervene in the goods market. It has also discussed the various sources of
market failure together with their correction.
4.10 ACTIVITIES
1. With the help of diagram show how positive and negative externality lead
to market failure.
2. Explain the various private and market mechanism for solving externality
4.11 problems.
FURTHER READING
A.T. Peacock and J. Wiseman, The growth of public expenditure in the United
Kingdom (London:George Allen Unwin, 1967)
1992)
54
McGraw-Hill,1989).
lOMoARcPSD|13555361
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.

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
5.3 DEFINITION OF PUBLIC EXPENDITURE
Public expenditure can be defined in different ways as:

a) The expenditure of central and local government;
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b) The combined government expendi¬ture 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.
The size of the public expenditure will depend on the definition adopted and will
differ accordingly. This can give rise to confusion when compar¬isons 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.
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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.
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 pre¬ferred 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 ten¬dency 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
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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 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 gov¬ernmental
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
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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 gov¬ernment 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 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 unemploy¬ment 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 govern¬ments in subsequent
periods to retain and to expand their activities.
f) Post-war reconstruction of countries' economies involved govern¬ments in
planning, allocation of resources and in financing some of the projects.
g) Economic development, according to some economists, has consid¬erable
impact on the level of public expenditure. Before a develop¬ing country can
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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 imperfec¬tions 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 expecta¬tion of an improved standard
of living, and hence public expendi¬ture. Governments are likely to-be under
pressure to increase provision of public goods and 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 develop¬ments in
such fields as atomic energy, aerospace and computers are so costly that in
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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 pro¬grammes 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.
q) Inflation. A general increase in prices has been an international phe¬nomenon
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 expen¬diture. But other demographic
trends such as changes in the struc¬ture 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 popu¬lation has
led to growth of public expenditure depends on the specific conditions in
different countries.
5.7 RESTRAINTS TO THE GROWTH OF PUBLIC EXPENDITURE
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Some of the factors in the growth of public expenditure that we have dis¬cussed 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.
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
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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 bor¬rowed 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.
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.
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o) A more egalitarian society can be achieved by narrowing the differ¬ence 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 employ¬ment 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,
a) Ability of the people to work, save and invest.
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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 expen¬diture 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 expen¬diture 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 expen¬diture 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
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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 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 favour¬able 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 develop¬ment 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
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entire planning and expenditure of projects is in the hands of the government.
5.10 PUBLIC EXPENDITURE AND ECONOMIC STABILITY IN ADVANCED

ECONOMIES,
During the 1920s and 1930s, most free economies were working under cyclical
depressions and booms. It was during these period, fiscal theorists showed the
effect of public expenditure in controlling de¬pressions and booms.
During a period of business recession and depression, the anti¬cipations of both

producers and consumers are falling. The producers anticipate a decline in prices
due to a decline in private demand and decline in profit margins. On the other hand,
consumers anticipate a decline in prices and hence tend to postpone their
consumption till the prices fall to still lower levels. Private consumption as well as
investment expenditures decline and the propensity to save and hoard increases. As
a result, the free enterprise market economy suffers from inadequate aggregate
demand and consequent decline in production and increase in unemployment. Once,
the process of business recession starts, there is a cumulative decline.
Since the free economy is not able to reverse the trend itself, the government has an
important role to play. During a business recession the government should pump
funds to offset the decline in demand and income caused by the contraction of
private expenditure. The greater the decline in private expenditure and the greater the
propensity to hoard the larger should be the volume of government expenditure as a
com¬pensatory mechanism. This kind of spending by government to compensate
for shortage in private spending is generally known as compen¬satory spending. It is
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not simply to offset private deficiencies in national' income but also to provide the
initial impetus for the economy to recover.
Compensatory Spending during Depression

Compensatory spending may be undertaken on a modest scale at a time when
national income is declining and unemployment is rising with the hope that at least
further decline may be checked. It may be undertaken on a larger scale with the hope
of
a) Checking the decline in demand, production and employment, and
b) To provide an initial impetus to the forces of business recovery which may be
taken up by the private sector. Compensatory spending of the second variety is
commonly known as 'pump priming'. Essentially, compensatory public spending
implies the use of public expenditure to make up for the decline of private
spending so as to maintain a full employment level of income. Such a policy will
mean different things in different periods. For instance:
i). During a period of depression compensatory spending will involve heavy
government expenditure on public works programmes.
ii). During a period of recovery when private investment has started picking up,
public expenditure will be reduced gradually in the same ratio as the rise of
private expenditure.
iii). During periods of business prosperity and boom, when private demand for
goods and services is rising rapidly, government expenditure should be
reduced considerably so that there would be a surplus (i.e., excess of
taxation over public expenditure.
Public Expenditure in the upward phase of a business cycle

What should be the role of government expenditure during an upward phase of a
business cycle? We assume that pessimism has given place to optimism and that
there is general rising anticipations all round. Consumption and investment
spending are increasing. The economy is expanding and national product and
employment are increasing. During this period, compensatory public expenditure
should be so controlled and managed that the level of full employment is achieved in
an orderly manner.
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During business recovery; when the economy turns from the low level of depression
and starts recovering gradually, the compensatory spending of the previous period,
which would be at a fairly high level, would continue, in other words the expansion in
business activity which will occur during recovery will not necessitate the immediate
withdrawal of government expenditures. For one thing, some government
expen¬diture would be such (e.g. the construction of a road or a dam) that sudden
stoppage in the middle would be impossible. For another, sudden withdrawal of
government spending would upset the economy and may cause a recession. In other
words, nothing should be done to offset optimism of the gradual expansion of
business. Thus, in the initial stages of business recovery, public expenditure would
continue to be large and the government budget would continue to show a deficit.
5.11 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 expen¬diture on
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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. Admi¬nistrative 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 expen¬diture has been
foisted on some less developed countries. In some countries, internal
disturbances and political instability lead to vast expenditures 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? Expen¬diture 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.
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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. 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 ex¬perience 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
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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 deter¬mination 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 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-
pro¬grammes, 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.
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5.12 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:
- 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
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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.
5.13 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:
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
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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 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.
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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 BENEFITS BENEFIT RATIO C
of 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 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
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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.
5.14 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.
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
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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.
Rural health project can be designed to reduce death rates among children. It may
also provide for family planning programme.
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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).
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
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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

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)
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(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.
(7) Peculiarly benefit – relate increase in teachers’ income.
5.15 PROBLEMS OF MEASUREMENT OF BENEFITS AND COSTS
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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 good aspect must be faced head on. Since evaluation through
toll pricing would require the inefficient device of exclusion some other approach is
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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
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monopolist price > 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
0 market structure Q
QM QN
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.
5.16 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.
5.17 DISCOUNTING TECHNIQUES
Method to be used to discount future expected streams of B and C would depend on;
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(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)
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%
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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.
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
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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
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
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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
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/=
5.18 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.
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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 2,397 1000 736
(Kshs.)
(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)
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.
5.19 CHOICE OF DISCOUNT RATE
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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 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
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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 rate of interest argue that when people purchase
government bonds this reflects society’s desire to forego present for future
consumption.
5.20 CAPITAL BUDGETING TECHNIQUES
Involves the entire of planning the expenditure of firms whose returns are expected
to extend beyond one year.
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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.
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
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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
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
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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.
(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.
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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
Expenses include here all expenses and taxes.
5.21 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 used to measure non market costs and benefits of
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5.22 ACTIVITIES
1. How
5.23 can the public
FURTHER READINGexpenditure leads to inflationary pressure in the economy.
2. What is shadow pricing?
3. Distinguse between flexible and lump sum projects.
1992)
THE BUDGET
McGraw-Hill,1989).
LECTURE
C.T. Sandford, The Economics of Public SIX (Oxford: Pergamon Press, 1992).
Finance
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.
98
At the end of the lecture you

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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 govern¬ment 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.
3 Executive responsibility. Chief executive should ensure that the departmental
programmes planned is capable of fulfilling the desire and intention of legislature
4 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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5 Flexibility. Budget should be flexible enough to meet the government’s financial

policies according to the changing social- economic conditions in the society.
6 Adequate tools. The chief executive should be armed with sufficient and
adequate administrative tools to fulfill its budgetary responsibilities
7 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 consump¬tion 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.
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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 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
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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 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.
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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
1992)
McGraw-Hill,1989).
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TAXATION AS A SOURCE OF REVENUE

TAXATION
LECTURE SEVEN
7.1 INTRODUCTION
The lecture will discuss the other side of the coin of the public finance by looking at
the taxation which is the major source of government finance. It will discuss the
canons, the principles and the incidences of taxation

a) Explain the canons of a good tax system
b) Distinguish between benefit and ability to pay principles of taxation
c) Explain how elasticity of demand and supply affect the tax burden of sellers
The primary motivation for taxation in developing COUNTRIES like Kenya is to
and buyers
finance
d) public
Explainadministration
the various taxand the public provision of economic and social goods
classification
and services. The secondary motivation is the redistribution of income and wealth,
the correction of market imperfection and stabilization of the economy.
Taxes are withdrawn from private sector without any obligation to government to
repay. They are imposed to tax payers and are compulsory. Taxes however are not
the only source of funds for government expenditures financing. Other sources
include: internal harrowing through selling of government securities; external
borrowing earnings from state owned enterprises; sales of public assets (e.g. sale of
government owned land and condemned houses) or privatization; through rent (e.g.
housing) and through money creation (printing of money)
7.3 CANONS OF A GOOD TAX SYSTEM
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The following are the requirements for a “good” tax structure: -

(i) Equity – a good tax system must ensure that tax burden is equally distributed.
That is everyone should be made to pay his fair share.
(ii) Economical – a god tax system must ensure that both the costs of collecting
taxes to the government and the costs to tax payers of meeting their tax
obligation are minimized.
(iii) Avoidance of excess Burden – taxes should be chosen so as to minimize

interference with economic decisions in otherwise efficient markets.
If a tax diverts resources into the public sector such that it clearly imposes
a burden on the economy that can be equated only to the revenue raised
we say that the tax is free of excess burden.
But where the imposition of a tax e.g. excise tax levied on a particular
commodity provides an incentives to a consumer to reduce his purchases
of taxed as opposed to untaxed goods to minimize his tax liability. This
reallocation of resources induced by the tax is the nature of the excess
burden over and above the revenue raised.
A desirable goal of a tax system is that it should minimize this excess
burden caused by diverting a given amount of resources into the public
sector. This can be accomplished by choosing those taxes that do the
least to distort economic behavior. Thus a system of selective excise
taxes that raise the price of some of goods but not others will do move to
distort relative prices and hence consumer purchaser than will a general
sales tax that raises the price of all goods on which it is imposed uniformly.
(iv) Awareness – a good tax system should be understandable by the taxpayer.

The move he is aware of the tax burden, the better he is able to judge the
amount of public goods and redistribution he waits against their tax costs and
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the better equipped he is to vote for the size of the public sector he wants.
(v) Elasticity – by elasticity is meant that a tax’s revenue yield should be sensitive
to changes in economic conditions without deliberate changes in rates. It is
important that the principle of elasticity be fulfilled for at least two reasons.
First elasticity enables government to finance the rising demand for public
expenditures without the disturbance of frequent rate changes. It is worth
noting that if a tax is highly elastic with respect to real income, the ratio of
government revenue to GNP will raise as real GNP rises. Second elastic tax
yields function as an automatic stabilizer for fiscal policy purposes.
(vi) Certainty – there are several different interpretations that can be given to the
principle of certainty. One interpretation, which is perhaps the most
fundamental, concerns the ease with which the individual taxpayer can
compute his own tax liability. The law with respect to the payment of taxes
should be made specific as to how much the tax payer should pay, on what he
is paying and when he is to make payments.
Adam Smith regarded a small degree of uncertainty as a much greater evil than
“a very considerable degree of inequality” in that it give the taxing authorities
discretionary power in assessing taxes against individuals. An alternative
interpretation of the certainty principle applies not to the taxpayer but to the
taxing authorities. According to these criteria a desirable feature of a tax is that
its yield should be relatively certain so that the taxing authorities can estimate
their budget requirements more accurately in the light of proposed expenditures.
(vii) Convenience – a further principle of taxation is that tax payment should be

convenient, that is the time and manner of payment should be made as
desired as possible for the taxpayer. It was in accordance with this principle
that he system of withholding in payment of income taxes was adopted by
government. Prior to that time, taxpayers were required to pay one lump sum
on income earned throughout the year. The Long between the earning of
income and the payment of taxes proved to be a burden to most taxpayer.
Thus the system of withholding by assuming that taxes were paid as income
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was earned eliminated the need to accumulate tax liability and hence reduced
evasion in the payment of taxes.
7.4 APPROACHES TO EQUITY
Tax equity refers to fairness of tax system. It is borne out of a feeling that each
citizen of a country should contribute fairly to the cost of government. The difficulty,
however is to know precisely what constitutes fairness in taxation. The discussion of
tax equity has produced two opposing approaches to this problem. These are the
benefit principle and the principle of ability to pay.
THE BENEFIT PRINCIPLE

The benefit principle argues that equity in taxation requires that taxes to be paid in
accordance with the benefits received from government expenditures. If tax burdens
are allocated on any other basis such as ability to pay, then tax payers who have little
or no ability to pay will continue to enjoy the consumption of public goods even
through they have contributed little or nothing to their financing. People should pay
for what they get, disregarding whether what they buy is produced in the public or the
private sector. This approach dates back to the days of Adam Smith, Locke,
Bentham and Hobbe. Most of them belonged to utilitarian school of thought, which
emphasized the need to tax people according to benefits they derive from
consumption of Public goods.
WEAKNESSES OF BENEFIT PRINCIPLE

The benefit approaches requires that the expenditure benefits of each taxpayer be
known. As was seen earlier, much of government spending consists of public goods,
the benefits of which are indivisible. Such goods cannot be parceled out among
individuals and sold at a price that reflects the marginal satisfaction obtained by the
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taxpayer – consumer.
(v) It is generally difficult to establish the degree of benefit that a person derives
from the use of public goods and services, since the consumer would not
voluntarily reveal how highly they value the public services.
(vi)Given that most public goods consumption is non-rival and that one-person
benefit doesn’t restrict consumption of another the benefit tax becomes very
difficult to collect.
However, although there are many problems associated with collection of benefit
taxes they are still used in many countries. This varies from tolls paid by motorists
on highways to finance the construction and maintenance of roads to fees charged
for the collection of waste materials (service charge). Levy can also be placed on the
use of sports grounds in order to finance for more recreational facilities or to help
pay off loans used in constructing such facilities. The question is under what
conditions can such direct charges on the beneficiaries be made?
Benefit taxes works well where goods and services to be taxed have many properties
of private good (rival in consumption, carry a price and benefits are internalized) the
consumer is then taxed according to amount used like in licensing vehicle, in
charging hospital fees, in charging rent for municipal houses etc. where product is
completely rival and there is a significant amount of competition among consumer,
the benefit taxes can be charged in same way private firms charge price.
In other instances where imposition of direct charges is desirable but too costly a
tax on a complementary product may be used in Lieu of Charges. For example taxes
to finance highway construction are often fixed on petroleum products used by road
users. They may also be fixed on the cars used or being bought.
Another area where taxes are paid in lieu of use is on property ownership and use. In
this case tax is collected in form of stamp duty on purchase of houses, on certain
documents of titles during certain financial translation or in general, property tax
may be fixed to finance certain public services that are associated with certain or
specified properties (e.g. Security, street lights, schools etc)
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In conclusion benefit taxes are considered to be suitable because the tax burden is
placed on the shoulder of the persons who benefit from the use of a specified good
or services.
7.5 THE USE OF ABILITY TO PAY AS A BASIS FOR TAXATION
The second or alternative approach holds that equity in taxation is attained when
taxes are paid on the basis of ability to pay, the rich being required to pay more in
taxes than the poor. They argue that the government cannot raise enough funds to
finance public expenditures if each and everyone was required to pay same amount
of tax.
Equity involves two aspects, the treatment of people in like and unlike circumstances.
The first part deals with the tax treatment of people who are similarly situated. This
is the principle of Horizontal Tax equity.
This principle states that those who are in the same position (i.e. have the same
amount of income) should pay the same amount in taxes.
The second part deals with the tax treatment of people who are differently situated
(that is who have different amounts of income). This is the principle of Vertical Tax
Equity. The interpretation given to this principle is that the rich should be required to
pay not only more in taxes than the poor but also a progressively larger amount.
The index of ability to pay include property, income, size of family, and consumption
7.6 CATEGORIES OF TAXES
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Figure given below presents a simplified picture of the circular flow of income and
expenditures, together with the major points of which such taxes are inserted.
Points of Tax Impact in Circular Flow

Househol
1 Consumptio
Dividends Household
Wages Retained n saving
8 1 earnings
9 Business
saving
CAPITAL
MARKET
2
6 7 Investment
Profit
Payroll
MARKET FOR MARKET
5
CONSUMER FOR
Depreciation GOODS CAPITAL
GOODS
Gross 3
Factor receipt
payments 4
FIRMS
Figure 7.1: Points of tax in circular flow

 We may think of the monetary flow of income and expenditures shown in the
figure as proceeding in a clockwise direction, while the real flow of factor inputs
and products outputs (not shown) moves in an anticlockwise direction.
 Starting from factor market households sell their skills earning incomes inform of
wages, dividends, interest, rent and so on. The households save some of the
income with the capital market and consume the other part of their income by
purchasing goods from market for the consumer goods.
Consumer expenditures into the market for consumer goods become receipts of
firms selling such goods. Savings are channeled into investments, becoming
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expenditures in the market for capital goods, and turn into receipts of firms
producing such goods.
Part of business receipts (corporate income) is set aside to cover depreciation and
the remainder goes to purchase the services of labour, capital and other inputs in the
factor market, representing the factor shares in the national income. These shares
are paid out to suppliers of factors – in the form of wages, dividends, interest, rent
and so on – and become income of household.
Some profits, however, are withheld as retained earnings rather than paid out as
dividends. Retained earnings, together with depreciation allowances, comprise
business savings and combine with household savings to finance investment or the
purchase of capital goods. Thus the circular flow of income and expenditure is
closed.
7.7 Locating Impact Points of various Taxes in the diagram
At point 1: Personal income tax is imposed on household income.
At point 2: Following expenditures by consumers on final goods, expenditure tax or

value added tax is collected
At point 3: Can also collect sale tax from retail sales receipts of the firms.
At point 4: Can collect corporate income tax from income of the firms originating
from market for consumer and capital goods.
Note: Depreciation is operating expense and is tax free.
At point 5: Can collect income tax from business receipt net of depreciation.
At point 6: The employer contribution to the payroll tax
At point 7: Can collect corporate profit tax.
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At point 8: The employee contribution to the payroll tax

At point 9: - can collect from retained earning withholding tax.
(vii) Retained earning is part of profit not distributed to dividend holders but are
aimed for expansion purpose.
At point 10: collect income tax.
In Conclusion
From figure above, it can be noted that any particular transaction may be taxed at
either the household (buyer) or the firm (seller) side of the market. We also note that
any particular household or firm may be taxed at either the sources or the uses side
of its account. Since the account balances (total uses equal total sources), a general
tax on the uses side is equivalent to a general tax on the sources side. A tax on total
household income would thus be equivalent to one on total consumption plus
savings. Similarly, a tax on total gross receipts of firms would be equivalent to a tax
on the total uses of its proceeds or cost payments plus profits.
Combining the buyer – seller and sources – uses distinctions, our major taxes may
thus be arranged as follows:
Uses Sources
Households Expenditure tax (2) -Income tax(1)
-Employee payroll tax (8)
Firms Profit tax (7) Retail sales tax(3)
Employee payroll tax (6)
Note: numbers in the parenthesis refer to impact points shown in figure
7.8 FURTHER DISTINCTIONS
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PERSONAL VERSUS IN REM TAXES

Personal taxes are taxes paid according to taxpayer’s personal ability to pay. In Rem
taxes (taxes on “all things”), on the other hand, are taxes imposed on activities or
objects as such, i.e., on purchases, sales, or the holding of property, independently of
the characteristics of the transactor or owner.
In Rem taxes may be imposed on either the household or the firm side. But personal
taxes, by their very nature, must be imposed on the household side of the transaction.
Thus, if proceeds from the sale of factors of production are to be taxed in a personal
fashion, the tax must be imposed on households as a personal income tax. Similarly,
if consumption is to be taxed in a personal fashion, the tax must be placed on the
household in the form of a personal expenditure tax. A sales tax imposed on firms is
not responsive to the particular consumer, but gives the same treatment to all
households which undertake the taxed transaction.
In Rem taxes do not consider the ability to pay or equity. They are based on the
benefits as measured by the amount consumed. Irrespective of whether or not the
consumer ability to pay is low, if his consumption is high he will pay more. They are
in this sense considered to be regressive. As such, personal taxes tend to be
generally superior in equity since they are assessed on the household side.
DIRECT VERSUS INDIRECT TAXES
 Direct taxes are taxes which are imposed initially on the individual or household
that is meant to bear the burden. (e.g. income tax)
 Indirect taxes are the taxes which are imposed at some other point in the system
but are meant to be shifted to whomever is supposed to be the final bearer of the
burden.(sales taxes)
Personal taxes, such as the individual income tax, are thus “direct” and most In Rem
taxes, such as the sales tax are “indirect.” At the same time, the distinction between
direct and indirect taxes does not always coincide with that between personal and In
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Rem taxes. Thus the employee contribution to the payroll tax may be considered
direct, yet it is not a personal tax since no allowance is made for the owner’s ability
to pay. Similarly, the property tax on owner – occupied residences is direct, but it is
an In Rem tax rather than a personal tax.
7.9 SHIFTING AND INCIDENCE OF TAX
The study of tax incidence attempts to determine, who bears the burden of taxation
in an economy. It analyses the process by which taxation removes resources from
the market sector. It compares how the burden is borne using one tax as opposed to
another to raise revenues. Tax incidence refers to micro and macro effects of
taxation. Question normally asked include;
 Does a given tax pattern distribute income and output fairly? If not, where could it
be adjusted so as to reduce tax burden from less privileged society?
Note: Tax incidence refers to the way in which tax burden is shared among individual
households.
For example, if two billion pounds is collected in taxes in order to build a hospital,
then this is the opportunity cost of providing this health service to society. Society
will benefit from improved health services, but incidence of this tax will depend on
who pays how much of total tax liability required to build the hospital. We can also
say that the two billion pounds tax collected represent tax burden to society.
The effects of withdrawing these amounts from tax payers would include reduced
consumption increased employment or reduced output. These are the distributional
incidence of tax. This tax burden is in turn accompanied by the benefit of improved
health services which must be allowed for to derive the net gain or burden of the
entire transaction. In general, taxes have micro effects and macro effects on level of
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output, employment, prices and growth in the economy.
When budget operations do not involve resource transfers to the public, the
government simply collects taxes form the private sector and returns\transfers to
that sector. There is no shift of resources to public use and no opportunity cost in
reduced private resource availability. Some may gain while others will lose, but taxes
being equal to transfers, there will be no net change in income available for private
use.
7.10 MAGNITUDE OF TAX BURDEN
When we talk of tax burden we simplify mean how much it squeezes you. Tax liability
on the other hand refers to actual sum of money a taxpayer is required to pay as a
fraction of his income. We have so far assumed that tax burden equal total tax
liability to an individual. However, this may not always be the case. There are cases
where tax burden can be more than tax liabilities. Where tax burden exceeds tax
liability there is excess burden.
Example: tax is imposed on radio sets (value added taxes) in order to raise one
million pounds. The sum total of tax collections from various consumers still equals
one million pounds, but the burden imposed on the private sector will be larger. This
is so because the tax interferes with consumer choice. Some people who had
planned to buy the radios may avoid buying them because of the tax payable.
Therefore, they pay no taxes but the budget choice is less satisfactory than it was
before. These taxpayers therefore suffer burdens which are not reflected in total
revenue. Others may reduce their purchases and pay a tax on the reduced amount. In
both cases the consumer’s expenditure pattern has been distorted by the tax and
each suffers a burden which is greater than that which would have applied if they
had paid the same amount as a flat charge. Because of this, the overall burden
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suffered by the private sector tends to exceed the amount of revenue obtained. This
is what economists call “excess burden.”
Another reason why tax revenue and total burden may differ is when the imposition
of tax leads to a change in factor inputs and hence in total output. For example,
when same revenue as in the previous example is collected under a progressive
income tax. As a result, workers may work more or less because the tax is imposed.
If we suppose that they work less, their earnings fall. If this decline in earnings is
counted as part of the burden, the total burden once more exceeds tax revenue.
Excess burden can also be considered from the employment point of view. Changes
in output may result, not because of adjustments in factor inputs in response to
changes in after – tax factor rewards, but because of resulting changes in the level
of aggregate demand and unemployment. Introduction of a tax may reduce the level
of employment, or an increase in expenditures may raise it.
7.11 TYPES OF TAX INCIDENCES
Taxes are paid in line with prevailing tax statute that has been legislated. Taxes in
this sense are mandatory imposition and failure to pay them is punishable by law.
When we consider who holds the legal liability to pay tax, we are considering the
statutory incidence of tax. Like in all other cases of incidence, individuals will try to
avoid tax by passing their tax burden to others. While considering the nature of
statutory tax burden we must remember that the final tax burden must be borne by
all citizens. The taxes are usually finally paid by the households in their capacities as
owners of business which pay the taxes, or as consumers of the products of the
taxes, or as consumers of the products of these businesses, or as employees of
these institutions.
When we examine tax from an individual point of view, we encounter certain
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implications. When an individual is taxed a lump - sum tax of say Kshs.200

independent of his ability to pay, he cannot escape it. However, he may adjust
himself to the incidence of this tax by cutting down his consumption or his savings
or his aid to those who are dependent on him. In effect when he does this he passes
his tax burden to others with whom he transacts and thus will have further
repercussions. Moreover, taxes are rarely imposed in lump – sum form. The tax law
typically expresses tax liabilities as a function of some aspect of economic behavior,
such as earnings income, making sales, or making a purchase. Since such taxes are
imposed on economic transactions and since transactions involve more than one
party, the transactors on whom the statutory liability rests may avoid tax payments
by cutting back on their taxable activity; or they may attempt to pass on the burden
to others by changing the terms under which they are willing to trade. Their ability
to do so will depend upon the structure of the markets in which they deal and the
way in which prices are determined.
Thus, imposition of an income tax may lead to reduced hours of work, thereby
driving up the gross wage rate. Increased wages in turn would lead to increased
product prices, which burden the consumer. Nevertheless, the resulting chain of
adjustments may lead to a final distribution of the burden or economic incidence,
which differs greatly from the initial distribution of liabilities or statutory incidence.
In all this cases when one party tries to avoid taxes by passing his burden to other
people, we say that he is shifting his tax burden.
Absolute Tax Incidence

Taxes will reduce the level of disposable income both at macro and micro level. At
macro level, an increase in taxes leads to a decrease in aggregate demand. If the
public policy is to stabilize the economy by increasing taxes without changing
government expenditures, the course that the economy will take will depend on
distributional effect of the tax itself.
An increase in tax depending on state of the economy can lead to unemployment, a

reduction in prices or can lead in a shift in resources from one use to another use, so
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that each tax action has its own effect and distribution implication. Where tax is
increased or reduced without a relative change in government expenditure or an
offsetting change in other taxes the effect that such a tax will have either in
aggregate or to each individual household is called absolute tax incidence.
Differential Tax Incidence

In some cases one tax may be replaced by another tax without changing the amount
of tax revenue and government expenditure. The effects that result from such
changes in taxes are referred to as differential tax incidences.
This form of policy change does not involve any transfer of funds from private hands
to public hands and no net burden on the private sector. It merely involves
redistribution among households. Consider a case where Kshs one billion of income
tax revenue is replaced with a cigarette excise yielding an equivalent amount.
Households whose income tax is reduced will gain, while others with high cigarette
purchases will lose. Going beyond this, tobacco growers and cigarette workers will
lose, while others producing the output purchased by former income taxpayers stand
to gain. This resulting total change in the state of distribution is what is referred to
as differential incidence.
Budget Incidence
Budget incidence may originate from changes in government expenditure and
changes in taxes. Government expenditure may be on transfer payment, salaries to
civil servants, capital expenditures for development, purchases of goods and
services, and debt repayment and servicing. Incidence of government expenditure
can be explained in various ways;
I. Increase in government expenditure leads to increase in disposable real income
and further increase in employment in the country. This is under normal
circumstances. But, if unplanned well,
II. Increase in government expenditure may lead to increased aggregate demand over
aggregate supply, hence leading to inflation.
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On the other hand, increase in taxes has the opposite effect. Its immediate effect is
a reduction in real disposable income, increased unemployment, or reduced inflation.
Note: Taxation and government spending take place simultaneously. Those taxes
reduce earnings of the private sector and in particular they reduce disposable
income. As a result of this, benefits from public goods will increase while benefits
from private sectors will decline. These effects constitute budgeting incidence of a
tax.
7.12 EFFECTS OF TAX INCIDENCE ON MARKET FOR GOODS
 Where tax is collected on each unit of output produced or sold it is called a unit
tax.
 Where it is quoted as a percentage of selling price it is called an advalorem tax.
So, unit tax is quoted as specified amounts per unit sold, for example, 20 Shs per
Kilograms. When it comes to advalorem tax, it may be quoted as 5% of
manufacturers price or 10% of wholesale price, depending on where it is collected.
Taxes, irrespective of their kind, will disrupt the equilibrium existing between demand
and supply in the market. An increase in tax of a given commodity increases the
price and reduces the demand for the product depending on price elasticity of
demand of the product.
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S1
P
S
a
G
F
H
B A
S1 D
S E
O Qe Q
Figure 7.2: Effect of unit tax
When a unit tax is imposed, its effect is to shift the supply curve upwards from SS to
S1S1. Unit tax is viewed here as additional to cost. SS is the supply schedule prior to
tax and S1S1 is the supply schedule as it confronts the consumer after imposition of
a unit tax “a.” The demand schedule is given by DD.
Observation:-
I. Quantity demanded declines from OQe to OE.
OB – Price before tax.
OF – Price after tax.
II. Total tax rate is KF.
III. BF is tax rate payable by consumer per unit sold.
IV. KB is tax rate paid by seller of the product
V. Total amount of tax revenue collected from both seller and consumer
is represented by area KFGL.
 Consumer pays the amounts of tax represented by over BFGH.
 Producer pays the amount of tax represented by area KBHL.
This is the case where we have unit tax charged on every unit sold or bought.
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When it comes to advalorem tax, the case is different. T = F (price per unit sold),
since tax is expressed as % of selling price.
Unlike in unit tax where the supply curve shifts when tax is introduced, in the case of
advalorem tax it is the demand curve which shifts downwards. Tax amount collected
is still represented by the difference between the price paid by consumer and net
price received by seller. Also note that when advalorem tax is imposed, although the
demand curve shifts downwards, the shift is not uniform because the amount of tax
per unit falls as the quality sold increases. (note advalorem tax is quoted as , e.g. 5%
of selling price)
Price D
S
G
F
D1
H A
B
K J
L
S D1 D
Quality
O E Qe
Figure 7.3: Effect of advarolem tax
DD is the market demand schedule and SS is the supply schedule. Equilibrium output
before tax equals OQe, and price equals OB. Now if advalorem tax at rate
T = AJ is imposed. The net demand schedule shifts to D1 D1. Output falls to OE, the
AQe
Gross price rises to OF, and the net price falls to OK.
 Total tax revenue is represented by area KFGL.
 Consumer pays the amount of tax represented by area BFGH. Producer pays
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the amount of tax represented by area KBHL.
 There are two ways of quoting advalorem tax from the diagram;
1. When advalorem tax is quoted as GL it is called net advalorem tax rate.

EL
2. when advalorem tax is quoted as a ratio of tax to the gross price (GL)
EG
It is referred to as the gross advalorem tax rate.
Note that burden to consumer reflect the additional amount which they must pay in
order to get new quantity OE, compared with what they would pay in order to get
whole larger quality OC. To consumer, tax effect is increased prices from OB to OF
and reduced demand from OC to OE.
In general, burden to supplier is reflected in reduced supply and reduced net price.
Supply falls from OC to OE. Net price falls from OB to OK. This has led to less net
revenue from the sale of product.
This explanation doesn’t consider the problem of excess burden but it suggests a
very important rule that the burden of tax is divided between the buyer and the seller
as ratio of elasticity of supply to elasticity of demand in the relevant range of
demand and supply schedule.
It can be shown that Bb = Es = BF/BK ratios or elasticity.
Bs Ed
Bb and Bs represent the consumer and Seller’s shares in the tax burden
Bb – buyers share.
Bs – sellers share.
Es – price elasticity of supply.
Ed – price elasticity of demand.
This can be proved as follows:

From above figure, Ed over the relevant price range OF = Ed = ∂Q PO;
∂P QO
∂P = OF-OB=BF
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Ed = ∂Q PO;
BF QO
Similarly it can also be proved that;
ES = P0. ∂Q
Q0. ∂P
∂P = OB – OK = BK
ES = P0. ∂Q
Q0. BK
(P0. ∂Q)
ES = (Q0 . BK) = BF /BK
ED (∂Q. P0)
(BF. Q0)
When demand curve and supply curve are rotated around point A, then it is clear that
the buyer’s share in the tax burden increases as the demand curves becomes less
elastic and supply curve becomes more elastic. Or, in other words, the consumers
share in the tax burden increases as demand schedule steepens or becomes more
inelastic and the supply schedule flattens or becomes more elastic.
CASES:
1) Where demand is perfectly inelastic while supply is elastic the whole tax burden
is transferred (shifted) to consumer as follows;
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P DD
S2
Tax SO
P2
P1
Q
O Qe
From the diagram, DP does not lead to corresponding D in Q.

Consumer Pay all tax burden as shown by shaded region.
2) Where the supply schedule is perfectly inelastic and demand curve is downwards
slopping, an increase in tax results to an increase in prices and the whole tax
burden is borne by the supplier.
P S
P1
PO Tax Do
D1
O Q
Qe
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3) Perfectly elastic demand and an elastic supply.
P
S2
Tax S1
P1
D
Pnet
O Q1 QE
Effect of an increase in tax when demand is perfectly elastic is to reduce net price
from P1 to Pnet and the net revenue to supplier also declines.
4) Perfectly elastic supply schedule.
P1 S1
t
Pe S2
D
O Q
Q1 Qe
Price rises by the tax amount. Effect of an increase in tax when supply is perfectly
elastic while demand is downward sloping is to increase the Selling price from OPe
to OP1 and reduce quality demanded form OQe to OQ1.
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7.13 OTHER FACTORS THAT AFFECT EFFECTIVE INCIDENCE OF TAX
1) Types of tax. Type of tax e.g. in the case of a sales tax, the sellers quite often
adopt the practice of quoting the sale price as seen and once the bargain has
been settled, add the sales tax in the bill. Such a practice tends to break the
resistance of the buyers and it becomes easier to shift the incidence of the tax on
to them.
2) The price of good. It sometime happens that with a large usage or advertising
and publicity, some prices comes to be fixed and acceptable as normal, tax or no
tax. It is not easy to shift the tax here by means of a price vice. However a
possibility may exist to shift the tax by deteriorating the quality or reducing the
size of the taxed object. Restaurant quite often adopt the policy of reducing the
sizes of various eatables as a substitute for raising prices. Sometimes, the
market may be controlled by a small group of sellers and by a convention. it may
be difficult to change the price unless everyone does so. e.g. newspapers having
the same price in a city. In this case, it will be easier for all of them to raise the
price and if any one of them wants to do so, it would be better to reduce the
number of pages or reduce the quantity.
3) The tax rate. The shifting of tax depends to a great extent upon the tax rate. If the
tax is quite small and the market is competitive, the sellers may choose to absorb
the tax in order to maintain the good will of the buyers.
4) Availability of substitute. It will be more difficult to shift the tax to the buyer in
the case f a commodity tax which has close and effective substitute. The
consumers will then have an easy mean of shifting their demand if the price of
their taxed goods is raised. It means that the elasticity of demand for these
goods will be high and so the tax will have to be borne by the sellers. However, if
the substitutes are also taxed, then the shifting of the tax incidence will depend
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upon the general pattern of the demand elasticity for this group of commodities
as a whole vis-à-vis the pattern of their supply elasticity.
5) Tax area. In the case of goods taxation the geographical coverage of a tax has a
great influence in determining the incidence of the tax in the taxed area. Since the
untaxed goods will be available in the neighboring area, there will be great
resistance of the buyers to bear the tax incidence. The price of the good will
therefore rise to an extent much smaller than would be the case if geographical
area of the coverage was complete. In order to discourage buying of the taxed
commodity in the neighboring untaxed areas and bringing them in, the authorities
often impose a use tax on the taxed goods if it is brought in from the untaxed
area.
6) Time period. Time factor influence the shiftability of a tax. In the short period
supply is inelastic. Hence, during this period greater part of tax burden will be
borne by the seller. In the long-run, supply is more elastic. Hence, there is a better
scope for shifting tax burden upon the buyer. Therefore in short period, shifting of
a tax is difficult, whereas in the long-run it is easy to do.
7) Nature of demand for commodities. By this we mean whether the taxed
commodity is falling under the category of necessity, comfort or luxury. In the
case of necessary goods, demand is inelastic. Hence the burden of tax is higher
upon the buyer, than on seller. In the case of comfort, demand is more elastic,
hence burden of tax will be divided between buyer and seller. In the case of luxury
demand is elastic, hence the burden of tax is more on the seller. It cannot be
easily shifted to the consumers.
8) Business conditions. During periods of rising prices and economic prosperity,
taxes can be shifted more easily. However, during periods of depression, forward
shifting of tax liability is very difficult.
9) The policy of the government. Tax laws clearly indicate the price to be charged
and to be printed on the product cover. Likewise the government fixes maximum
retail price. Those who charge higher prices are legally punished. On the other
hand, if prices are increased due to the attempt to shift some taxes to be paid by
the seller, awareness of tax laws helps the consumer to resist it.
7.14. SUMARY
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7.14 SUMMARY
The lecture has explained clearly the canons of taxation. It has also been discussed
in details the principles of taxation together with their advantages and
disadvantages. The lecture has also shown the effect of ad-varorem and specific on
the goods
7.15 market. It has ended by looking at factors that affect tax shifting in an
ACTIVITIES
economy.
1. Using the circular flow of income diagram explain the various point where tax
can be imposed and specify which tax.
2. Explain the various types of taxes.
3. Explain the factors that determines the shifting of taxes
1992)
McGraw-Hill,1989).
J.Batas, Managing Value for Money in the public Sector (London: Chapman & Hall,
1993)
ALTERNATIVES TO TAXATIONS
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LECTURE EIGHT
8.1 INTRODUCTION
The next chapter introduces you to the other sources of government finances. Apart
from taxation which constitutes over 90 % of government funds there are other
sources which need to be explained.

a) Explain the various sources of public debts
b) Discuss the ways that can be adopted to redeem public debts
c) Discuss the effects of public debt in an economy
d) Compute the public sector borrowing requirement
e)
PUBLIC DEBT
The government of a country gets its income from two sources:
i). Public Revenue and
ii). Public Borrowing or Public Debt.
Public revenue consists of money that the state is under no obligation to return to
the very individuals from whom it has obtained. Public debt, on the contrary, carries
with it the obligation on the part of the state to pay the money back to the persons
from whom it has been received.
8.3 THEORY OF PUBLIC DEBT
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Public debt is of recent growth and was not heard of prior to the 18th century. The
classical economists were generally against the public debt. They assumed that
individual consumer and business firms make use of the resources more efficiently.
Thus, under a fully employed economy, the state can acquire resources by public
debt only at the cost of private sector where they are more efficiently used.
It was Keynes who effected a truly significant revision in the theory of public debt. He
rejected the classical view of a free enterprise economy which is self-equilibrating at
full employment level. He developed and advanced the concept of under-
employment equilibrium. Resources in the private hands may remain unemployed for
relatively long periods if corrective or compensating action is not taken by the
government.
During World War II and in the post-war years, the size of public debt increased
enormously. In modern times borrowing by the state 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 promises the principal sum along with interest at the agreed rate.
8.4 CLASSIFICATION OF PUBLIC DEBT
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Public debt has been classified in many ways, though all the classifications are not
equally useful.
i). Internal and External Debt. Internal debt refers to the public loans floated within
the country, while external debt refers to the obligations of a country to foreign
governments, foreign nationals or international institutions. Internally the
government borrows from private individuals, institutions, commercial banks
etc. External loans may help the government in difficult times, when internal
resources are not sufficient to meet the financial requirements.
ii). Productive and Unproductive Debt. Public debt is said to be productive if the
investment yields an income which will not only meet the yearly interest
payments of the debt but also help repay the principal over the long run. They
help in the creation of remunerative capital assets that yield revenue to the
government. For example, loans raised for the development of railways,
irrigation projects etc are productive loans. On the other hand, public debt
incurred to cover budgetary deficits on revenue account is classified as
unproductive debt. It is also called dead-weight debt. They have no existing
assets. They do not create assets nor any income to the government. The
government may undertake certain projects through loans which may not be
productive in the sense given above but which may be really useful to the
community, as for example, a railway line connecting a backward region, an
irrigation work to prevent famine conditions in an area and so on. In this sense,
most public debt is productive. But public debt may be contracted to finance a
war. Such debt is unproductive because it does not create an asset, it is a dead
weight debt or a useless burden on the community
iii). Redeemable and Irredeemable Debt. The redeemable debts are those which
the government promises to pay off in future at a specified date: they are
terminable loans. Irredeemable debt refers to a debt which may not be
redeemed at all but on which the government promises to pay the interest
regularly. These loans may be known as perpetual debt. The redeemable loans
may be further classified into short period and long period loans depending
upon the period of redemption.
iv). Funded and Unfunded Debt. Public debt is also classified into funded and
unfunded or floating debt. Broadly speaking, funded debt is a long-term debt,
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undertaken for creating a permanent asset and the government normally makes
arrangements about the mode and time of repayment. Unfunded or floating
debt is a relatively short period debt, meant to meet current need. The
government undertakes to pay off the unfunded debt in a very short period, say
within six months.
v). Compulsory and Voluntary Debt. Generally, government debt is of a voluntary
type, that is individuals and institutions are invited to take up government bonds
freely. On the other hand, a compulsory loan implying force is not common in
modern times. However, pressure may be applied by the government at certain
times in selling its bonds.
vi). Marketed and non marketed debt. A marketed debt is one in which the debt
instruments are negotiable. That is it can be freely bought and sold in the
market. Non-marketable debts are those debts such as savings bonds which
cannot be bought and sold in stock-exchange markets.
vii). Callable and non callable. Callable debts are those debts which the government
can repay even before the period of maturity, whenever it is found convenient
for the government to do so. The government can pay back these types of
debts, whenever it enjoys surplus funds, or when the prevailing interest rates
are low. Non- callable debts cannot be repaid in this manner. It can be repaid
only at the time of maturity.
viii). Short term, medium term and long term debt. Short term debts are those debts
which mature within a period of three to six months. These loans are drawn
from the central bank by using the credit instrument of treasury bills. Medium
term loans are those loans which mature within a period of one to ten years.
Long-term loans mature for over ten years. They are usually raised for financing
development projects and carry a high rate of interest.
ix). Gross debt and net debt. Gross debt refers to the total debt obligation of a
government outstanding at a particular time, whereas net debt is gross debt
minus sinking fund or other assets crated for the repayment of loans.
8.5 WHY IS PUBLIC DEBT INCURRED?
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Public loans in modern times are necessary to meet important situations. They can
be explained as below:
i). To meet budget deficits. Modern governments do not have large accumulated
balances or treasure to meet any budget deficit. Normally, the annual
expenditure of the government should be and is met by annual income. But
because of many circumstances the yield from taxation and other sources may
not be equal to the actual expenditure. Similarly, there may be unplanned and
unexpected emergency situations like major fires, floods and famines. Short-
term borrowing is ordinarily used to meet these emergencies.
ii). To meet war expenditure. Modern warfare is so costly that the normal income
through taxation falls short of the actual war expenditure. Besides, taxation
beyond certain limits has disastrous consequences for production, and thus
interferes with the most important objective during a war, viz., the winning of
the war. Moreover, a public loan is better and easier method of collecting
revenue than taxation. Governments, therefore, have to borrow extensively from
individuals and institutions towards war financing. In fact, the enormous
increase in public debt in most countries is due mainly to the First and Second
World Wars.
iii). To remedy a depression. Public borrowing is considered very useful to remedy
a depression; in fact, the strongest case for public borrowing is as a remedy for
depression. During a period of depression, the level of economic activity is low,
resulting in low production and unemployment. The depression and
unemployment are generally due to deficiency of demand for goods and
services. Many economists like Keynes have advocated increased public
expenditure financed through borrowing and not through taxation, for while
taxation will reduce incomes and 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. Thus, there is a strong justification in favour of
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public borrowing to cure unemployment.

iv). To develop the economy. Public loans are resorted to for development
purposes. Even advanced countries have to undertake the construction of
public works like roads, railways, irrigation works, power¬houses, etc., for
accelerating their economic progress. 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.
v). To finance social overheads. Public debt is used to finance the creation and
development of social overheads capital like education and health care
facilities. These basic facilities require huge investments, which cannot be met
by ordinary source like taxation. Hence modern governments utilize borrowed
money to finance these projects.
The first factor, mentioned above, is only to meet temporary difficulties and is soon
repaid out of tax receipts in the subsequent period. The second cause of public
borrowing—the prosecution of a war—has been probably the most important factor
for increasing public debt in all major countries in recent years. But this and the first
factor are of an unplanned type. But the third and fourth cases may be called
planned borrowings, for the Government deliberately plans to use the proceeds of
public debt to finance certain specific projects. In this case, the Government may
borrow resources and would otherwise have been used by the private sector and
also resources that may remain unemployed.
8.6 SOURCES OF PUBLIC BORROWING
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 borrows from
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individuals and banks, international institutions and foreign governments.
Borrowing from Individuals

When individuals purchase government bonds, they are diverting funds from private
use to government use. Individuals may be able to subscribe to government bonds
either through curtailment of current consumption needs (this may be very rare) or
through diversion of funds from their own business or diverting funds into
government bonds from corporate securities. Normally, the sale of government
bonds to indi¬viduals should not curtail either consumption or business expansion.
To a large measure, the bonds will be absorbed out of funds that would have been
lying idle or would have been used to buy other securities.
Borrowing from Non-banking Financial Institutions

More important than individual subscribers to government bonds are the financial
institutions such as insurance companies, 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. But the
rate of interest is low and hence in many cases financial institutions may prefer high-
risk high-return securities particularly equities. When non-banking financial
institutions fake up government bonds, they do so to reduce their cash holdings.
Borrowing from Commercial Banks

While individuals and non-banking financial institutions take up government bonds
out of their own funds, commercial banks can do so by creating additional
purchasing power known as credit creation. The banking system as a whole can
make additional loans up to an amount several times as great as the excess cash
reserves. This is possible because the loans the bankers make are typically book
entries in the names of borrowers who pay in the form of cheques to others who
have also bank accounts. The result is that so long as cash is not withdrawn from
the banks, it serves as the basis for the expansion of loans.
Commercial banks can subscribe to government loans through creation of credit.

They need not contract their other loans and advances. Whenever the banking
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system has excess cash reserves, it can absorb an amount of government bonds
considerably greater than the excess cash reserves. It is important to note that the
power to buy bonds is essentially created rather than merely transferred. So if
commercial banks create additional purchasing power and place it at the disposal of
the govern¬ment to finance the latter's expenditures, inflationary pressures will be
generated (if previously, the economy has been working at full employment).
Borrowing from the Central Bank

The central Bank of the country also subscribes to government loans. The action is
exactly similar to the system of creation of additional purchasing power by the
commercial banking system. By purchasing government bonds, the central bank
credits the account of the govern¬ment. The latter pays to its creditors out of its
account with the central Bank. Those who have received cheques from the
government on the central bank deposit the amount with their banks. These banks
find themselves with large cash reserves which become the basis for additional
loans and advances. It will be seen that 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.
While the borrowings from individuals and financial institutions are simply transfer of
funds from private to government use and, therefore, will not be expansionary in their
effect on the economy (unless the funds were previously lying idle and are being
activised through government borrowing), borrowing from the commercial banking
system and the central bank will have expansionary effect.
Borrowing from External Sources

Government may borrow from other countries too. These borrowings can be used to
finance war expenditure, or to produce defence equipment, or to pay for
development projects, or to pay off adverse balance of payments. Formerly, the
floating of loans for any specific development projects, like railway construction, was
taken up by indi¬viduals and banking and other financial institutions. However, in
recent years, apart from this source, two important sources have become prominent.
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They are:
a) International financial institutions, viz., I.M.F., the I.B.R.D., the I.D.A. and the I.F.C.,
which give loans for short-term for overcoming temporary balance of payments
difficulties and for the long-term for development purposes; and
b) Government assistance generally for development projects. For developing
countries like Kenya, external sources of borrowing are becoming considerably
important in recent years.
8.7 ECONOMIC EFFECTS OF PUBLIC BORROWING
Traditional economists argue that the government should use taxation to finance
current expenditure and borrowing from the public to finance capital expenditure. In
recent years, there has been considerable change in economic thinking on this
question. It is commonly accepted now-a-days that taxation and borrowing can be
used for either type of expenditure depending upon the circumstances. At least, in
the case of developing nations both borrowing and taxation are used to finance
development projects. Basically, the economic effects of government expenditure
financed by public borrowing are different from the effects of similar expenditure
financed by taxation in the following three important respects:
a) The transfer of funds from the public to the government is compulsory under
taxation and voluntary under borrowing ;
b) While taxation reduces the wealth of the taxpayers, loans do-not reduce the
wealth of the lenders but merely change its form ; and
c) Financing through taxation is more contractionary while financing through
borrowing has more expansionary effect. Taxation has contractionary effect
on the economy because it reduces consumption. On the other hand, lending to
the government is voluntary and, hence, will be paid out of saving and not through
curtailment of consumption. More¬over, lending does not involve reduction of
wealth and, therefore, will not have adverse effect on incentives and enterprise as
would be the case with taxation.
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Leaving these general aspects of borrowing, we shall discuss the economic effects
of public borrowing under specific headings.
Effects of Public Borrowing upon Consumption

As has been shown in a previous paragraph, government borrowing should not
normally result in curtailment of consumption. This is so because lending to the
government being voluntary will be met out of saving and not through reduction of
consumption expenditure. But in time of war or in periods of emergency, substantial
pressure may be applied to induce individuals to curtail consumption and to
subscribe to government loans. The only other possibility is when government bonds
may offer special advantages and higher interest rates. Some of the individuals and
financial institutions may then be tempted to save more and invest in government-
bonds. But generally speaking, restriction of consumer spending does not take place.
Effects of Borrowing on Investment

Government borrowing can influence investment adversely, though it can have
neutral effect also. For instance, government borrowing from commercial banks and
the central bank of the country will be of the nature of creation of additional
purchasing power and, therefore, will not result in curtailment of funds available for
investment. But if individuals and financial institutions and even commercial banks
subscribe to govern¬ment loans out of funds meant for investment or for the
accumulation of stocks then investment expenditure is curtailed. But if the interest
rate is not affected and the new government bonds do not carry any special
advantages over existing securities, private investment may not be affected
appreciably.
If interest rates are higher and the advantages attached to govern¬ment bonds are
greater, the demand for company shares will decline and consequently the prices of
stocks and shares will come down. This may restrict private investment in equity
shares. However, governments, in their own interest, will like to follow a cheap
money policy of lower interest rates (for this will mean lower interest burden on
public debt). Even if interest rates are high, investment borrowing by individuals and
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companies will not be affected significantly. For one thing, investment borrowing will
depend upon business prospects and profitability (marginal efficiency of capital) of
investment rather than the rate of interest. This was shown by Keynes and has later
been proved conclu¬sively by many empirical studies. For another, the very large
volume of investment undertaken with funds obtained from past earnings is
particularly insensitive to the interest rate.
On the whole, however, government borrowing need not affect private investment
expenditure adversely except under special circumstances. For instance, the interest
rates should be high and the volume of investment should be dependent upon the
interest rate; or the bonds should be sold to the persons and institutions who curtail
their loans for business expansion in order to buy government bonds. But these
special circumstances need not take place ordinarily. But there can be one indirect
way by which government borrowings may have an adverse effect on investment.
The growth of public debt may be alarmingly rapid and the investing public may fear
a national bankruptcy or anticipate heavy taxation in the near future. The result will
be a decline in investment.
On the other hand, government expenditure financed out of borrowing will normally
be expansionary. When borrowing is restricted to the commercial banks and the
central bank, additional purchasing power will be created which will become the
basis for additional loans and advances to the private investors. Moreover,
government expenditure financed out of borrowing will result in additional demand
for goods and services, the supply being assumed to be the same. This will result in
a rise in prices and rise in profit margins. If the economy has been working below full
employment level, it will stimulate greater investment (in order to secure higher
profits). Thus, while taxation results in contraction, borrowing generally leads to
expansion of the economy.
Effects of Borrowing upon Distribution of Income

Loan finance implies that all those benefiting from government expenditure will have
higher real income. At the same time, loan finance will not reduce the real incomes
of those who have subscribed to government bonds. If government expenditure is
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meant to provide more economic welfare to the lower income groups, then the result
will be a narrowing down of inequalities and a more equal distribution of income
between people. But to the extent that loan finance becomes inflationary, some of
the good effects upon the distribution of income which we have explained above
may be neutralized.
Another point to consider here is the interest payment. Interest payment will
represent a transfer of real income from the taxpayers to the bond-holders, for the
government will have to tax the people so as to pay the bond-holders the interest
charges and later the principal as well. If the bond-holders and the taxpayers are
identical, then there will be no net redistribution of income, but this need not be the
case. Accordingly, some redistribution of income will take place so long as the
taxpayers and the bond-holders belong to different groups.
Effects of Foreign Loans

Foreign loans can influence both consumption and investment favorably. Foreign
loans are meant to finance the imports of goods without paying for them
immediately through exports. If foreign imports consist of consumer goods they
tend to reduce any inflationary pressure which may exist due to shortage of goods.
On the other hand, imports of machinery, industrial raw materials and technical know
-how will have the favourable effect of speeding up industrialization within the
country. If foreign loans are meant to finance a war or to modernize an army, then
obviously they cannot have any effect on investment in the country.
The demand for foreign currencies will be reduced through foreign loans, when they
were floated. But interest payments as well as the repayment later will involve
increasing exports. This may mean a possible lowering of tie real standard of living.
EFFECTS OF PUBLIC DEBT

We should clearly distinguish between economic effects of public borrowing from
economic effects of public debt. Borrowing refers to the method of securing funds
and is one of the alternatives available to the government – the other sources being
taxation, profits from state enterprises and money creation. The effects of borrowing,
therefore, refer to that programme of government expenditure financed by borrowing
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as contrasted with the effect of a similar programme financed by taxation. On the

other hand, the effects of public debt refer to the effects on the economy which are
caused by the existence of public debt, after it has been incurred.
Public Debt and Consumption

The existence of public debt has an important effect upon consum¬ption. Those
who hold government bonds representing the latter's obligation to pay consider
these bonds as personal wealth. This wealth would not have arisen if the
government had chosen to finance its expenditure through taxation. Moreover, the
bond-holders would forget that the bonds represent claims on them as taxpayers in
the form of additional taxation. The net result is that the possession of government
bonds will induce them to spend not only a larger percentage of their incomes but
also spend in excess of their incomes since they can dispose of the bonds to pay for
the excess expenditure. Consequently, the net effect of public debt is to increase the
percentage of total income spent on consumption and thus exert an expansionary
effect on the economy.
Monetization of Public Debt

Public debt of a country has the direct effect of increasing the total money supply in
the country. For instance, deficit financing by the Government actually means
Government borrowing from the Central bank of the country which directly increases
the money supply in the country. Likewise, when the commercial banking system
subscribes to the issue of new Government bonds, they may do so without reducing
their other investments or advances to the industrial and commercial sections but
through a simple creation of credit. This is what is commonly known as
monetization of public debt, that is, the public debt is subscribed to by the banking
system in such a manner that it results in an increase in the money supply of the
country.
Public Debt and Liquidity

Public debt is represented by bonds which are highly negotiable. Those who have
bonds have highly negotiable and highly liquid form of assets. Whenever individuals
require more funds for any purpose – transactions, precautionary or speculative
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motive – they can easily convert the bonds into cash. Public debt is thus responsible
for the existence of highly liquid form of assets.
Another important effect of the highly liquid government bonds is to be found in the
case of commercial banks. The latter hold large amounts of government bonds
which can be converted into cash whenever cash is required. In times of inflation the
central bank of a country may attempt to use bank rate, open market operation and
other weapons to reduce the cash reserves with commercial banks and thus reduce
their credit expansion. But commercial banks can increase their cash reserves
through disposing of their government bonds.
Public Debt and Investment

The effect of public debt on investment is not very clear. Two apparently
contradictory effects can be visualized. On the one hand, the existence of huge
public debt and the consequent high rates of taxation to service the debts will
generate fear and uncertainty in the minds of investors. Besides, the existence of
huge debts involving huge interest payment may suggest the possibility of the
government introducing capital levy or even the extreme method of repudiation of
debt. All this will affect adversely long-term-investments. On the other hand, the
existence of large public debts will force the government to maintain a low rate of
interest in order to keep its interest obligations at the lowest amount possible.
Accordingly, borrowing and investment will be encouraged. It is, thus, difficult to
state clearly whether existence of public debt will encourage or discourage
investment.
As regards the desire to work and save, public debt will generally tend to reduce it.
Public debt, by providing safe and steady channel of investment in government
bonds, may encourage savings. But taxation necessary to pay the principal and
interest charge will discourage savings. Moreover, the receipt of interest by the
holders of government bonds may reduce the latter's desire to work and save to a
certain extent.
Finally, as regards division of resources, public debt involves the use of funds on
those expenditures which are considered essential and more useful than those on
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which the funds would have been used otherwise. If idle funds are channeled into the
development of railways, irrigation and power projects e.t.c., the diversion will be
really justified. The same may be said if borrowing from the banking system is used
to create permanent and productive assets. The only wrong diversion will take place
when funds which otherwise would have been spent on productive under¬takings are
spent on defence purposes. But this will have to be judged according to
circumstances.
8.8 BURDEN OF INTERNAL AND EXTERNAL DEBT
Generally, internal loans have been very important, but in recent decades developing
countries have been borrowing extensively from external sources. The loans have
been from the World Bank and other agencies and governments. Sometimes, the
external loans may be to overcome temporary balance of payments difficulties but in
most cases they are for economic development. External loans are particularly
important for developing nations because the latter have great demand for foreign
machinery and raw materials and do not have adequate exports to pay for them.
These nations are, therefore, plagued by continuous adverse balance of payments
and exchange rate difficulties. There has been considerable confusion and prejudice
in dealing with external loans and hence a comparison between internal and external
loans is being made here.
Burden of Internal Debt

In the case of an internal debt, there is no direct money burden on the community as
a whole, since the payment of interest and taxation to meet the same involve simply
a transfer of purchasing power from one group of persons to another. To the extent,
that the bond-holders and taxpayers are the same, there may not be any net burden
at all on the community. But to the extent that the bond-holders and the taxpayers
belong to different income groups, there are changes in the distribution of income
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between different sections of people in the community.
Internal debt is a burden, and it would be too illogical to argue that internal public
debt does not involve any burden at all. In the first instance, the purpose of the
government loan should be considered. A loan meant to finance a productive
enterprise on investment can be paid out of the profits of the investment. On the
other hand, a loan to finance a war will have to be a dead weight and have to be paid
out of taxation. There is, obviously no burden involved in the first case, but there is
obvious burden in the second case. It is, however, stated that there is no burden in
the second case too because the burden imposed by taxation will be cancelled by
the benefit received through interest payments of the government.
Secondly, as already indicated, the real burden of public debt will depend upon the
type of people who own the bonds and who receive interest payments and the type
of people who pay the taxes. Since in a majority of cases the holders of government
bonds are the higher income groups while the taxpayers are both the rich and the
poor, there is a net increase in the real burden of the community.
Thirdly, the real burden of the debt repayment will be definitely much more than is
thought of at first sight. For instance, the government will be taxing enterprise,
patriotism, activeness and youth (i.e., those who pay) for the benefit of the passive,
old and leisurely class (i.e., those who receive).
Fourthly, during war when the debt is contracted, the value of money is low (because
of high price). Soon alter the war and later, prices generally decline and hence those
who get interest income through ownership of government bonds gain in terms of
real income.
Finally, the payment of interest charges and the repayment of debt will involve tax
measures which, consequent affect the power as well as the willingness to work and
save. The sooner the debt is cleared off through a capital levy or through some
highly progressive taxes the better it will be for the community. It is, however,
necessary that debt repayment is managed in such a manner and in such a period
that there will be no adverse effect on production.
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It will, thus, be clear that even domestic debt imposes both money and real burdens.
To contend that internal debt does not mean any burden on a country's economy is
theoretically unsound and practically unrealistic.
Burden of External Debt

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
they are available to foreigners in the case of foreign debt: 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 develop favorably.
In other words, a regular payment of interest and principal to foreign countries will be
possible only if the exports exceed the imports by at least the obligations arising
from the loan.
It is said that domestic debt does rot normally result in any net burden to the
economy but only a redistribution of national income. But externally held debt can
mean a certain impoverishment of the economy. The paying of interest and debt
redemption to foreign countries means a corresponding reduction 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. After the lapse of a certain t
me, the debtor country manages to secure excess of exports over imports to pay for
the external loan. In this, there is no actual impoverishment of the economy involved
but goods are paid for goods.
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On the other hand, if the external debt was originally incurred to meet war
expenditure, it would have been a dead weight debt. The repayment of debt through
export surplus would not be canceling out the import of goods and services in the
past which had any effect on the productive capacity of the country. In tins case the
export surplus to pay off a war-debt would really deprive the citizens of a debtor
country of a certain amount of goods and services. This would be a net direct real
burden of an external loan.
However, there is one sense in which an external loan can be a source of trouble to a
debtor country. The transfer problem necessitating the creation of an export surplus
means "an exhaustion of the country's future capacity to import"; this is of vital
importance for development. But if the foreign loans are floated only when it is
absolutely essential and when internal resources are utilized as far as possible, and
\\ the foreign loans are used to increase the total national product including goods
specially meant for export, there is no reason why the debtor country should suffer in
the future.
A developing country which borrows from abroad for the development of social and
economic overheads and basic industries will find that the benefits outweigh the
burden of repayment of the loan. An external loan for development purposes is not a
burden but a profitable venture. This is exactly like an internal loan meant for
development purposes.
Can a Country become Bankrupt through Public Debt

Sometimes, people assert that with mounting public debt, the nation would become
bankrupt. This is partly true and partly not true. If bankruptcy means inability to
return the amount borrowed, a country can never become bankrupt, however much
of its domestic debt may have gone up. The government can always honour its
obligations either through higher taxation or through printing of money. It has the
option to impose a heavy capital levy and pay off the debt at one stroke. Even
repudiation of public debt, though morally indefensible, will be right, since, after all
those who receive interest payment from the government will have to pay the taxes
to enable the government to pay the interest. Will it not be better to cancel the debt
altogether or at least scale it down considerably, so that interest payments as well as
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tax payments will be proportionately cut down ? In any case, a government does not
become bankrupt because of its internal debt.
However, there may be circumstances when a government may not be able to

honour its obligations to foreign countries. When interest on foreign loans and
repayment of debt amount to a considerable figure and when adequate export
surplus has not been built up for various reasons, the government of a debtor
country may be unable to honour its 'external obligations. Either it can ask for
postponement or it can float new loans to repay the old ones. Only in extreme cases
it may repudiate external loans. Repudiation is an extreme measure, since through it,
the country loses its creditworthiness in the international capital markets and will
never again be able to borrow from foreign sources.
To conclude, public borrowing has advantages. But it imposes burdens upon the
community, both in real and monetary terms and directly and indirectly. Since there
is additional burden in the case of external loans, extra care should be exercised in
procuring such loans. All public debts impose burdens on the community and to
assert that internal loans do not impose real burdens is highly illogical.
8.9 REDEMPTION OF PUBLIC DEBT
Just as the private individual or organization has to return the loan he or it borrowed,
so also the government has to pay not only interest on the public debt but also repay
the principal. Experience shows clearly that mounting public debt has a demoralizing
effect on the people from the fact that the public is subjected to higher rates of
taxation. The sooner, therefore, the debt is cleared, the better for the government. It
may also be observed here that if the public debt has been contracted for productive
purposes, it may not be strictly necessary to redeem it since the government is
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getting a source of income to pay off the interest of the debt. But if public debt
consists mostly of unproductive or dead weight debt— war debt is a good example
of such debt—the sooner it is paid off the better, both for the government as well as
for the public.
Different methods are used by a government to redeem its debt. Some of these
methods are extreme ones, such as repudiation of debt, while others may not be
redemption at all, but payment of one debt with the help of another debt. We shall
describe the various methods available to the government to pay off its debt.
Repudiation of Debt
Repudiation of debt means simply that the government does not recognize its
obligations and refuses to pay the interest as well as the principal. Repudiation is not
paying off a loan but destroying it. Normally, a government does not repudiate its
debt, for this will shake the confidence of the general public in the government.
However, in extreme circums¬tances, a government may be forced to repudiate its
internal or external debt obligations. For instance, internally, the country may be
facing financial ruin, bankruptcy and externally it may be faced with shortage of
foreign exchange. Generally, a government may not repudiate its internal debt lest it
should lead to internal rebellion—those who have lent to the government would
obviously rise against the government. However, the temptation of a government to
repudiate its external debt obligations may be strong at certain times. Of ail the
methods of redeeming .debt, repudiation is the most extreme, but it is actually not
redemption of debt at ail.
Conversion of Loans
Another method of redemption of public debt is known as conversion of loans, that
is, an old loan is converted into a new loan. Conversion may be resorted to :
(a) When at the time of redemption of a loan, the government has not the necessary
funds, and
(b) When the current rate is lower than the rate which the government is paying for
existing debt, so that the government can reduce its interest payments. Conversion
of a loan is always done through the floating of a new loan. Hence, the volume of
public debt is not reduced. Really speaking, therefore, conversion of debt is not
redemption of debt.
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Sometimes, distinction is made between refunding and conversion of debt, though

sometimes both of them are used to mean the same thing. Strictly speaking,
refunding refers to the method of paying off an o/d loan carrying a higher interest
through a new loan carrying a lower interest rate; refunding, therefore, is the
repayment of debt through fresh loans. On the other hand, conversion involves a
change in the rate of interest or other details. For instance, at the time of maturity of
a loan, the government may give an option to the existing bond-holders either to
receive money in cash or to convert their old bonds for new bonds. Broadly,
refunding and conversion are similar.
Serial Bond Redemption

The government may decide to pay every year a certain portion of the bonds issued
previously. Therefore, a provision may be made so that a certain portion of the public
debt may mature every year and decision may also be made in the beginning about
the serial numbers of bonds which are to mature in the year. This system enables a
portion of the debt to be paid off every year. A variant of this type of bond
redemption is to determine the serial number of bonds to mature every year through
lottery. While under the first variant, the bond-holders know when the different sets
of bonds would mature and could take up the bonds according to their convenience,
under the second variant, the bond¬holders are uncertain about the time of
repayment and they may get back their money at the most inconvenient time. Buying
up Loans
The government may redeem its debt through buying up loans from the market.
Whenever the government has surplus income, it may spend the amount to buy off
government bonds from the market where they are bought and sold. Strictly
speaking, this is not redemption of debt but buying up of debt. It is a good system
provided the government can secure budget surplus. The only defect of this method
of cancelling debt is that it is not systematic.
Sinking Fund
Sinking fund is probably the most systematic method of redeeming public debt. It
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refers to the creation and the fund which will be sufficient to pay off public debt.
There are many varieties of sinking fund. The most common method is as follows:
Suppose, the government floats a loan of Rs. 10 redeemable in, say, 10 years for the
purpose of road construction. At the time the government is floating the loan, it may
levy a tax on petrol, the proceeds of which would be credited to a fund known as the
sinking fund. Year after year, the tax proceeds as well as interest: on investments will
make the fund grow till after 10 years it becomes equivalent to the original amount
borrowed, and at that time, the debt will be paid off. One danger of the sinking fund
method is that a government, in need of money, may not have the patience to wait till
the end of the period of maturity but may utilize the fund for purposes other than the
one for which originally the sinking fund was instituted.
In modern times, sinking funds are not accumulated and continued from year to year
as we have described above. Instead, some-funds are earmarked each year for
repayment of some part of the debt in the same year. The amount earmarked is not
put in a fund and allowed to accumulate but is used every year either to pay off the
bonds which are maturing every year or to buy off bonds from the market.
Capital Levy
Public debt may be redeemed through a capital levy which, as we have seen earlier,
may be levied once in away with the special objective of redeeming public debt. It is
a levy on capital or assets of individuals. The purpose of this levy is to wipe out the
entire war debt, by imposing a once for all tax on capital assets. It is generally
advocated immediately after a war for the following reasons:
(a) Heavy public debt has been incurred during the war to prosecute the war and
hence is quite heavy immediately after the war.
(b) War debt is unproductive and is a dead weight on the community

necessitating heavy taxation year after year. It will be better to wipe it out
once for all by a special levy.
(c) Due to war time inflation businessmen, producers and speculators would
have amassed large fortunes and hence it is easier for them to contribute to.
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a capital levy and, in a sense, it is just that they bear a part of the war burden,
(d) Redemption of public debt through capital levy will leave the higher income
groups almost in the same old position, since they will be receiving back from
the government what they will have paid by way of the special levy.
Redemption, through a special levy, is said to be super or to the method of the

sinking fund, as it is levied only once, while for purposes of the sinking fund, taxes
have to be imposed year after year. The greatest merit of capital levy is that it will
reduce the heavy tax burden which will otherwise be necessary to redeem public
debt. But the danger of a capital levy is that the government may be tempted to
resort to it too often.
Redemption of External Debt
The redemption of external debt can be made only through accumu¬lating the
necessary foreign exchanges to pay for it. This can be done by creating export
surpluses. Towards this end, foreign loans 'should be carefully invested in those
industries which have high productive potentialities and which will promote exports
directly and indirectly. At the same time, the exportable surplus should consist of
goods which are readily taken by foreigners. Temporarily, of course, redemption of
an old debt can be made through the floating of new loans.
To conclude, there is not much to choose between the various methods (except, of
course, repudiation which must not be resorted to) for every method has its own
advantages as well as disadvantages. But the most common and sensible method is
to redeem part of the public debt, every year, so that the debt may not go on
mounting.
8.10 PUBLIC SECTOR BORROWING REQUIREMENT (PSBR)
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Public sector indebtedness is largely, but not wholly, represented by the national debt.
Local authorities can and do borrow directly on their own account at home and
abroad. Public corporations are also permitted to raise loans in foreign capital
markets. To arrive at the public sector bor¬rowing requirement the government has
to take into account its own bor¬rowing, as well as that of local authorities and
public corporations (Figure 14.3 shows the determinants and financing of the PSBR).
The term Public Sector Borrowing Requirement came into use in the mid-1960s, data
on it had been compiled since then (see Table 14.2). The PSBR is an important
economic indicator which shows how much the public sector taken as a whole has
to borrow to finance its expenditure programme. It is a key statistic that has to be
taken into account in the formulation of a government's economic policy and in the
assessment of the effects of fiscal and monetary measures on the economy. PSBR
is expressed by reference to the total resources available in the country and is
calculated as a percentage of the gross domestic product. The higher the
percentage the greater the share of the national resources that are absorbed by the
public sector.
8.11 GOVERNMENT INDUCED INFLATION
This is a sustained annual increase in prices caused by expansion of the money

supply to pay government supplied goods and services. The money is printed to pay
for the cost of the government provided goods and services. Increases in the market
prices of goods and services caused by expansion of money supply force citizens to
reduce their consumption and saving which in turn finances the reallocation of
resources to public use over the long-run.
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DONATIONS
They are voluntary contribution to government from individuals or organization that
are used to finance particular programmes.
USER CHARGES
They are prices determined through the political process rather than market
intervention. They can finance public goods and services only when it is possible to
exclude individual from enjoying their benefit unless they pay a fee.
FORMS
1) Direct prices associated with the consumption of a particular goods and services
2) Fees for the option to use certain facilities or services provided for by the
government
3) Special assignment on privately held property
4) Licenses or franchises
5) Fares or tolls
8.12 SUMMARY
The lecture has explained the alternative sources of government funds such as
public debts, inflationary financing, user charges and so on. It has also show how
debt can be repaid and debt affect the economy.
8.13 ACTIVITIES
153
1. Explain how balance of payment position may influence the external debt
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Alexander and S. Toland, Measuring the Public Sector Borrowing Requirement,

Economic Trends (London: HMSO, 1980).
C.V. Brown and P.M. Jackson, Public Sector Economics (Oxford: Basil Blackwell,
1992)
McGraw-Hill,1989). PRIVATISATION
LECTURE NINE
9.1 INTRODUCTION
The last lecture discusses one way of solving government financial problem. If the
government is having many corporations that are not contributing to the exchequer
then the government may be incurring high debt to support them. One way to reduce
government burden on exchequer is to privatize the inefficient corporations.
154
a) Explain what privatization
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Privatization means transfer of ownership of state assets from the public bodies to
private enterprise or provision of services from public to private enterprise. The aims
of the privatization programmes are political and economic. The relative importance
of the reasons for privatization differs from country to country but basically they are;
a) Failure of nationalized industries in general to meet consumers needs

effectively
b) The wish to reduce the power of the state and its role in the economy.
c) Belief that an enterprise based economy would allow for greater flexibility and
a better response to consumers demand.
d) Determination to create capital – owning democracies.
Thus government privatize to;

a) Reduce the size of public sectors of industry.
b) Increase competition in the market.
c) Improve efficiency among suppliers of goods and services.
d) Extend share ownership in companies by investors with small amounts of
savings.
e) Ease the pressure on central governments’ budget.
The expectation is that as state monopolies are broken up and a competitive

environment established, privatized firms will have to improve their efficiency, cut
costs and reduce prices or keep them below the level up to which they would have
otherwise risen. Firms that are not competitive will unlike state enterprises go out of
business. Privatized companies that are profitable or have profit potential will attract
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investors and enable shareholders with small amounts of capital and employees to
acquire shareholdings. Private funding of industry reduces claims on public finance.
The help to the government comes on both sides of the budget. On the expenditure
sides, the state no longer has to support loss – making nationalized industries and
provide them with capital, thereby increasing the public sector borrowing
requirement on the revenue side, proceeds from the sale of state assets increase
governments resources enabling them to increase public spending or cut taxation or
both.
Opponents of privatization argue that; privatization of natural monopolies merely

substitutes private for state monopoly; that the social service elements in provision
of services by profit – driven companies will disappear and measures to cut costs
will lead to unemployment.
9.3 MECHANISM OF PRIVATISATION
How state – owned enterprises are privatized depends on a variety of factors such
as whether, the country is developed, developing or emerging from a centrally –
planned economic system; the relative size of public sector of industry, the
sophistication of the national capital market and the financial framework. The state
of international capital market is also important. It may reach a saturation level if a
large number of privatization share offers are made concurrently and national
governments restrict the extent of foreign investment that may be allowed. Timing
and local legislation are therefore important factors. Also important to a decision on
the choice of privatization method is the native and size of privatization.
On offer may be;
a) A minority share – holding in a country.
b) A controlling stake in a company.
c) A state – owned company already operating in competitive international
markets.
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d) A whole nationalized industry.

e) Potentially the whole of the economy.
Depending on the circumstances the transfer from state to private ownership may
be by Way of;
1. Public Offering
Shares are offered to the general public and can be traded subsequently on
the stock exchange. This method is only appropriate for privatization of large
enterprises.
2. Placing
Brokers acting on behalf of a government arrange for the purchase of shares
by placing them with a group of investors or one large investor who may wish
to hold or gradually a sell off the stock.
3. Trade sale.
A state enterprise is sold to a private sector company or consortium. A trade
sale is likely to be on the basis of a tender and financial markets are bypassed.
4. Management/worker’s buy – out
A state owned undertaking may be sold to employees because it is loss –
making or faces closure and companies in the private sectors are not
interested in buying it. There may however be a possibility of turning it around
to round to run on a profitable basis. Management/worker buys – out can
save jobs. It may be attractive proposition to government for reasons other
than financial.
5. Auction.
In cases of smaller properties owned by the state, sales by auction may be a
relatively simple way to privatize but the practicality of this depends on there
being a sufficient number of bidders with adequate funds to purchase.
6. Grant of statutory right of purchase.
People may be granted by law the right to purchase specified state property,
provided they meet certain requirements.
9.4 THE CASE OF PRIVATISATION
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1. Privatization which involves the sales of state – owned assets provide the
government with a short – term source of revenue which can be used to finance
development expenditure such as infrastructure development.
2. It helps to reduce public spending and the public sector borrowing requirement.
This is especially so if the state can sell – loss – making enterprises and public
spending on subsidies fall. The public sector borrowing (PSBR) may also fall if
private ownership returns industries to profitability since corporation tax revenue
will increase and the state may earn higher dividend income from any share it still
possesses in the privatized company.
3. Privatization increases competition thereby increasing a locative efficiency where
the organization has ran with prices higher than marginal cost. Competition could
force an organization to be more cost – conscious, making it easier for changes
in work practices to be introduced and enforced both at an operational level and
in the management of the organization.
4. Where privatization results in the breaking of state monopoly, so that a number of
competing firms are able to operate, consumer choice may be enhanced.
Competing firms are more likely to respond to consumer demand and quality of
service should be improved and innovation encouraged in both products and the
means of their production and distribution.
5. Privatization can change the organization culture in that the often – borrow vision
of directorate and management and supply orientation of the organization can be
replaced by a mean more commercially aware enterprise. Restraints can be
removed in financing and market of products diversification. Links with other
companies through joint ventures can be developed. It makes it more difficult for
political interference since politicians who used parastatals for their own ends
cannot easily do so with private enterprises.
6. It has a role in promoting an enterprise culture through extending share
ownership to individual and employees who did not own shares previously. It is
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therefore conducive to hand work and accepting responsibility.
9.5 THE CASE AGAINST PRIVATISATION
1. It may increase monopoly abuse, by transferring socially owned and

accountancies public monopolies into regulated and less accountancies private
monopoly. This monopoly may arise because utilities tend to be natural
monopolies and there have been economic and technological arguments for
keeping them as single suppliers. The monopolies may exploit consumers by
charging excessively high prices and producing poor quality commodities.
2. In the absence of a market for the shares of nationalized industry it may be
difficult to determine the appropriate issue price for shares. This may lead to over
subscription or under subscription. It has been argued that state owned asset
have often been sold off too cheaply.
3. Increased privatization of public sectors enterprises can lead to greater difficulty
in planning the whole economy because unanticipated actions by the private
sector can undermine the targets of a development plan such as delocalization of
industries.
4. Privatization of certain sectors like health and education may lead to those very
goods being provided in inadequate qualities and at prices that are too high for
lower income consumers.
5. The private sector may lack entrepreneurship skills and capital to develop certain
establishments which require heavy capital investments like airways, ports and
harbors.
6. It would imply greater control by multinational corporations with their related
problems of transfer pricing and repatriation of process.
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9.6 SUMMARY
The lecturer has explained in details the reasons for privatization, mechanism and
case for and against the privatization on the economy.
That is the end of public finance lectures and I welcome to the next level of public
finance
9.7 ACTIVITIES
1. Giving examples in Kenya discuss the privatization process.

2. Explain the reasons why privatization is necessary.
9.8 FURTHER READING
C.V. Brown and P.M. Jackson, Public Sector Economics (Oxford: Basil Blackwell,
1992)
McGraw-Hill, 1989).
A.F.Ott and K. Hartley, Privatization and Economic Efficiency (Chelteham: Edward
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REFERENCES
1. Stiglitz Joseph E. (1988) Economics of the Public Sector. Second edition. New
York:
W.W; Norton & Company
2. Hyman N. David (1996) Public Finance: A Contemporary Application of Theory

to
Policy. Fifth edition. New York: The Dryden press; Harcourt Brace Colleague
Publishers.
3. Brown C.V. Jackson, P.M. 1996, Public Sector Economics, Oxford:

Blackwell Publishers
4. Atkinson A. B. and J. E. Sfiglitz (1980) Lectures on Public Finance. New York:

McGraw-Hill
5. Musgrave, R. A. (latest edition) Public Finance. New York McGraw-Hill.
6. Musgrave R, A. and P. B, Musgrave (1989) Public Finance in Theory and

Practice.
New York.
7. Prest A.R. (1972) Public Finance in Developing Countries.

Weidenfteld &
Nicholson.
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8. Prest, A. R. (1974) Public Finance in Theory and Practice. Weideniield &

Nicholson 5th Ed.
9. Wawire N. H. W (2003). ''Trends in Kenya's Tax Ratios and Tax Effort Indices,
and
Their Implications for Future Tax Reforms". In illieva E. V. (Ed.) Egerton
Journal. Volume IV. Numbers 2 & 3, July. Pp.256 - 279
10. Toye, J.F.J (1978) (Ed) Taxation and Economic Development. London: Frank
class
N/B In addition to the above references, students are strongly advised to read the
following: The Journal of public Economics; The Journal of financial economics; The
Journal of Development Economics; Economic surveys; Budget speeches and
National Development Plans,
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EAE 313- Public Finance

Corporate Finance (Kenyatta University)

StuDocu is not sponsored or endorsed by any college or university

UNIT CODE & NAME:

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Copyright © Kenyatta University, 2009

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Lecture Two: Public policy objectives 17 -

Lecture Three: Public goods 26 -

Lecture Five: Public expenditure 51 -

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involving long-term projects; choice of discount rate; capital budgeting

Lecture Six: Budget 92 -

Lecture Seven: Taxation as a source of revenue 97 -

Lecture Eight: Alternative sources of public revenue 121 -

Lecture Nine: Privatization 144 -

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NATURE OF PUBLIC FINANCE

1.2 LECTURE OBJECTIVE

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

Definition of public finance

1.3 THE SCOPE OF GOVERNMENT ACTIVITIES

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1.4 THE NEED FOR A PUBLIC SECTOR

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1.5 REASONS WHY GOVERNMENT SHOULD PARTICIPATE IN ECONOMIC

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Government provide immigration schemes, schools, hospitals etc. Such

1.6 MODELS OF EFFICIENT ALLOCATION

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Figure 1.1 The model of efficient allocation

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1.7 THE SIZE OF THE PUBLIC SECTOR

1.8 THE PRINCIPLES OF MAXIMUM SOCIAL ADVANTAGE

The purpose is to design the policy and operations of the government so as to

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Figure 1.2 Maximum social advantage

Determination of optimum tax and expenditure activity of the state

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Axis and negative if measured below the X – Axis.

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1.9 MEASURING THE SIZE OF PUBLIC SECTORS

1. Share of government expenditure in Gross Domestic Product. This is given by the

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SPS = Total Factor Earning in Government

This represents the government contribution to the personal income

1. Explain the rationale of public sector in the economy.

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1.12 FURTHER READING

A. Asimakopulos, Economic Theory, Welfare and the State (London:Macmillan,

PUBLIC POLICY OBJECTIVES (BUDGETARY OBJECTIVES)

2.2 LECTURE OBJECTIVE

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

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There are 3 major functions of budgetary policy:

1) Allocation function: It is a process whereby social goods are provided, or the

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consumer particularly in the unless they pay. Application of the

2.4 Public provision of social goods

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The distribution function