Q1.

Welfare economics is a branch of economics that focuses on the study of how the allocation of
resources and the distribution of income and wealth affect the well-being of individuals and society as a
whole. It aims to provide a framework for evaluating the efficiency and equity of economic policies and
outcomes.

The fundamental theorem of welfare economics states that under certain conditions, a competitive
market equilibrium will be Pareto optimal. This means that in a perfectly competitive market, the
allocation of resources will be such that it is impossible to make one person better off without making
someone else worse off.

Regarding the efficiency of a competitive economy, the first fundamental theorem of welfare economics
states that any competitive equilibrium is Pareto optimal, meaning that the allocation of resources
cannot be improved upon without making someone worse off. This is because in a perfectly competitive
market, prices reflect the true scarcity of resources, and individuals and firms make decisions that
maximize their own welfare, leading to an efficient allocation of resources.

However, the market economy may not always achieve Pareto optimality due to various market failures.
These include:

 Externalities: When the actions of individuals or firms have unintended consequences on others
who are not directly involved in the transaction, leading to a divergence between private and
social costs or benefits. Examples include pollution, public health issues, and the provision of
public goods.
 Public Goods: Goods that are non-rival (one person’s consumption does not reduce the amount
available to others) and non-excludable (it is difficult to prevent people from using the good).
The private market may underprovide public goods, as individuals have an incentive to free-ride
on the provision of the good by others.
 Information Asymmetries: When one party in a transaction has more information than the
other, leading to inefficient outcomes, such as adverse selection and moral hazard.

In these cases, government intervention, such as taxes, subsidies, regulations, or the direct provision of
public goods, may be necessary to achieve a more efficient and equitable allocation of resources.

Q2. An overview of public finance in Ethiopia:

Fiscal Policy and Budgeting:

 Ethiopia has a federal system of government, with the federal government and regional states
having their own budgets and fiscal policies.
 The federal government’s fiscal policy is formulated by the Ministry of Finance and Economic
Cooperation (MoFEC).

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  The federal budget is prepared annually and approved by the House of People’s Representatives
(parliament).
 Budgeting follows a medium-term expenditure framework to ensure fiscal sustainability.

Revenue Sources:

The main sources of government revenue in Ethiopia are:

 Tax revenue (income tax, value-added tax, excise tax, customs duties, etc.)
 Non-tax revenue (fees, charges, profits from state-owned enterprises, etc.)
 Grants and loans from development partners

Expenditure Patterns:

 The federal government’s expenditure is focused on key sectors like education, health,
infrastructure, agriculture, and defense.
 There is an emphasis on capital expenditure to support economic development.
 Spending on social services and poverty reduction programs has been increasing in recent years.

Income Tax Exemptions, Brackets, and Marginal Rates in Ethiopia:

Types of Taxes in Ethiopia:  Rental Income Tax

Direct Taxes: Indirect Taxes:

 Personal Income Tax  Value-Added Tax (VAT)

 Corporate Income Tax  Excise Tax
 Capital Gains Tax  Customs Duties

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  Turnover Tax  Administrative Fees and Charges
 Rental Income from Government
Other Taxes:
Properties
 Stamp Duty  Miscellaneous Revenues
 Tax on Interest Income
External Sources of Revenue:
 Tax on Dividends
 Tax on Royalties Grants:

Domestic versus External Sources of Revenue  Bilateral Grants

for the Government of Ethiopia:  Multilateral Grants (from organizations
like the World Bank, IMF, etc.)
Domestic Sources of Revenue:
Loans:
Tax Revenue:
 Concessional Loans (from development
 Personal Income Tax
partners)
 Corporate Income Tax
 Non-Concessional Loans (from
 Value-Added Tax (VAT)
commercial sources)
 Excise Tax
 Customs Duties Breakdown of Revenue Sources:

 Domestic Revenue (Tax and Non-Tax):

Approximately 70-80% of total
government revenue
Non-Tax Revenue:  External Revenue (Grants and Loans):
Approximately 20-30% of total
 Revenue from State-Owned Enterprises government revenue

Federal versus State Power of Taxation in Ethiopia:

Federal Government:

 The federal government has the power to levy and collect major taxes, including personal
income tax, corporate income tax, VAT, and customs duties.
 The federal government sets the tax policies, rates, and regulations for these taxes.

State Governments (Regional States):

 The regional states have the authority to levy and collect their own taxes, such as land use fees,
agricultural income tax, and taxes on small businesses.

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  The regional states can also set their own tax rates and policies for the taxes under their
jurisdiction, within the framework of federal tax laws.
 There is coordination between the federal and state governments on tax administration and
revenue sharing.

Trends of Public Revenue in Ethiopia:

 Total government revenue has been increasing over the years, both in absolute terms and as a
percentage of GDP.
 Tax revenue has been the dominant source, accounting for around 60-70% of total government
revenue.
 The share of non-tax revenue, such as from state-owned enterprises and administrative fees,
has been relatively stable.
 External sources of revenue, including grants and loans, have fluctuated over time, depending
on the availability of development assistance.

Macroeconomic Effects of Public Revenue (Tax) in Ethiopia:

 Economic Growth:

Efficient tax collection and utilization of public revenue can support public investment in infrastructure,
education, and other productive sectors, thereby promoting economic growth.

 Fiscal Stability:

Maintaining a stable and sustainable tax revenue base can help the government manage its fiscal
position and reduce reliance on borrowing.

 Income Distribution:

Progressive taxation, such as personal income tax, can contribute to more equitable income distribution
and support social welfare programs.

 Inflation Control:

Prudent management of public revenue and expenditure can help mitigate inflationary pressures in the
economy.

 Private Sector Development:

A well-designed tax system that is transparent and predictable can create a favorable environment for
private investment and business growth.

The key macroeconomic effects of public revenue (tax) in Ethiopia

 Effect on Inflation:

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Prudent management of public revenue and expenditure can help mitigate inflationary pressures in the
economy.

Excessive government spending financed by tax revenue can lead to demand-pull inflation, which the
government can address through fiscal policy measures.

Efficient tax collection and effective utilization of public revenue for productive investments can help
control cost-push inflation by improving productivity and supply-side factors.

 Effect on Unemployment:

Public revenue, when invested in infrastructure, education, and social welfare programs, can create
employment opportunities and support job creation in the economy.Tax incentives and policies that
encourage private investment and business growth can also lead to increased employment.

However, high tax rates or inefficient tax administration can discourage private sector investment and
hiring, potentially leading to higher unemployment.

 Effect on Private Investment:

A well-designed and transparent tax system can create a favorable environment for private investment
by providing predictability and stability.

Tax incentives, such as tax holidays, reduced corporate tax rates, or investment tax credits, can attract
private investment, especially in priority sectors.

Excessive or complex taxation, as well as frequent changes in tax policies, can discourage private
investment and reduce the overall competitiveness of the economy.

 Effect on Economic Growth:

Efficient tax collection and effective utilization of public revenue for productive investments in
infrastructure, education, and other growth-enhancing sectors can support long-term economic growth.

Maintaining a stable and sustainable tax revenue base can help the government manage its fiscal
position and reduce reliance on borrowing, which can crowd out private investment and slow down
economic growth.

Progressive taxation, such as personal income tax, can contribute to more equitable income distribution
and support social welfare programs, which can have positive spillover effects on economic growth.

Trends of Public Expenditure in Ethiopia:

Total government expenditure has been increasing over the years, both in absolute terms and as a
percentage of GDP.

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The share of recurrent expenditure (e.g., salaries, operations, and maintenance) has been relatively
higher than capital expenditure (e.g., investment in infrastructure, development projects).

The government has been gradually increasing its capital expenditure to support economic development
and infrastructure projects.

Expenditure on social sectors, such as education and health, has also been rising over time.

Macroeconomic Effects of Public Expenditure in Ethiopia:

 Economic Growth:

Productive public investments in infrastructure, education, and other sectors can enhance the
economy’s productive capacity and support long-term economic growth.

 Employment and Income Generation:

Government spending can create employment opportunities, both directly through public sector jobs
and indirectly through the multiplier effect on the private sector.

 Inflation Control:

Prudent management of public expenditure, especially recurrent expenditure, can help mitigate
inflationary pressures in the economy.

 Private Sector Development:

Investments in public infrastructure and services can improve the business environment and support
private sector growth.

 Income Distribution:

Increased spending on social welfare programs and targeted subsidies can contribute to more equitable
income distribution.

 Fiscal Sustainability:

Maintaining a balance between capital and recurrent expenditure, as well as efficient utilization of
public funds, can ensure the long-term fiscal sustainability of the government.

Review of the government budget and its trends in Ethiopia:

Government Budget in Ethiopia:

Budget Structure:

The government budget in Ethiopia is composed of both recurrent and capital expenditures.

Recurrent expenditures include salaries, operations, and maintenance of government services.

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Capital expenditures are for investments in infrastructure, development projects, and acquisition of
assets.

The budget also includes revenue sources, such as tax revenue, non-tax revenue, and external financing
(grants and loans).

Budget Preparation and Approval:

 The Ministry of Finance is responsible for preparing the annual government budget.
 The budget is then submitted to the House of People’s Representatives (the parliament) for
review and approval.
 Once approved, the budget is implemented by the various government ministries, agencies, and
regional administrations.

Trends of Government Budget in Ethiopia:

Total Budget Size:

The total government budget in Ethiopia has been increasing over the years, both in absolute terms and
as a percentage of GDP.

This reflects the government’s efforts to expand public services and investments to support economic
and social development.

Composition of the Budget:

 The share of recurrent expenditure has been relatively higher than capital expenditure, though
the government has been gradually increasing its capital investments.
 The share of social sector spending (e.g., education, health) has been rising, reflecting the
government’s focus on human capital development.
 The share of economic sector spending (e.g., agriculture, industry, infrastructure) has also been
increasing to support productive investments.

Revenue Sources:

 Tax revenue has been the dominant source of government revenue, accounting for around 60-
70% of the total.
 Non-tax revenue, such as from state-owned enterprises and administrative fees, has been
relatively stable.
 External financing, including grants and loans, has fluctuated over time, depending on the
availability of development assistance.

Fiscal Deficit and Financing:

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Ethiopia has generally maintained a fiscal deficit, which has been financed through a combination of
domestic and external borrowing.

The government has been working to maintain a sustainable fiscal position and reduce its reliance on
borrowing.

Means of Deficit Financing in Ethiopia:

 Domestic Borrowing:

The government borrows from the domestic financial market, including the central bank, commercial
banks, and the public through the issuance of government securities (e.g., treasury bills, bonds).

 External Borrowing:

The government secures loans from international financial institutions, such as the World Bank, the
International Monetary Fund (IMF), and other bilateral and multilateral lenders.

The government also issues sovereign bonds in the international capital markets.

 Grants and Aid:

The government receives grants and development assistance from bilateral and multilateral donors,
which help finance a portion of the fiscal deficit.

 Privatization Proceeds:

The government generates revenue from the sale of state-owned enterprises or assets, which can be
used to finance the fiscal deficit.

Impacts of Deficit Financing on Key Macroeconomic Variables in Ethiopia:

Inflation:

 Excessive deficit financing, particularly through monetary financing (borrowing from the central
bank), can lead to inflationary pressures in the economy.
 This can occur due to the expansion of the money supply, which can increase aggregate demand
and drive up prices.

Unemployment:

 Deficit financing, when used for productive investments in infrastructure, education, and other
sectors, can create employment opportunities and support economic growth.
 However, if the deficit financing is used for unproductive expenditures, it may not have a
significant impact on employment.

Private Investment:

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  Deficit financing can have a mixed impact on private investment, depending on how the funds
are utilized.
 If the deficit financing is used for productive investments that improve the business
environment, it can crowd in private investment.
 However, if the deficit financing leads to high interest rates or macroeconomic instability, it can
crowd out private investment.

Economic Growth:

 Deficit financing, when used for productive investments in infrastructure, human capital, and
other growth-enhancing sectors, can support long-term economic growth.
 However, if the deficit financing is used for unproductive expenditures or leads to
macroeconomic imbalances, it can have a negative impact on economic growth.

Trends and Structure of Public Debt in Ethiopia:

Debt Levels:

 Ethiopia’s public debt has been increasing over the years, both in absolute terms and as a
percentage of GDP.
 The country’s total public debt has risen from around 30% of GDP in the early 2000s to over 50%
of GDP in recent years.

Debt Composition:

Ethiopia’s public debt is composed of both domestic and external debt.

 Domestic debt, which includes government securities and borrowing from the domestic financial
market, has been growing in recent years.
 External debt, which includes loans from multilateral and bilateral lenders, as well as the
issuance of sovereign bonds, has also been increasing.

Debt Servicing:

 The government’s debt servicing costs, including interest payments and principal repayments,
have been rising, putting pressure on the government’s fiscal resources.
 The government has been working to manage its debt servicing obligations and maintain debt
sustainability.

Effects of Public Debt on the Economy:

Inflation:

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  Excessive public debt, particularly if financed through monetary expansion, can lead to
inflationary pressures in the economy.
 This can occur due to the increased money supply and the potential crowding out of private
investment.

Unemployment:

 The impact of public debt on unemployment can be mixed, depending on how the borrowed
funds are utilized.
 If the debt is used for productive investments in infrastructure, education, and other growth-
enhancing sectors, it can create employment opportunities.
 However, if the debt is used for unproductive expenditures or leads to macroeconomic
instability, it may have a negative impact on employment.

Private Investment:

 High levels of public debt can crowd out private investment, as the government’s borrowing
needs can lead to higher interest rates and reduced access to credit for the private sector.
 This can have a negative impact on private sector growth and investment.

Economic Growth:

 The impact of public debt on economic growth can be complex and depends on the efficiency
and productivity of the investments financed by the debt.
 Productive investments in infrastructure, human capital, and other growth-enhancing sectors
can support long-term economic growth.
 However, if the debt is used for unproductive expenditures or leads to macroeconomic
instability, it can have a negative impact on economic growth.

Q3. Fiscal Federalism: Concepts, Types, and Rationale

Fiscal Federalism refers to the financial arrangements and relationships between different levels of
government (central, state/regional, and local) in a federal system. It encompasses the division of public
sector responsibilities, revenue sources, and fiscal transfers between the various levels of government.

Types of Fiscal Federalism:

I. Centralized Fiscal Federalism: The central government has a dominant role in revenue
collection and expenditure decisions.
II. Decentralized Fiscal Federalism: Subnational governments (state/regional and local) have a
greater degree of fiscal autonomy and responsibility.
III. Cooperative Fiscal Federalism: A balance between central and subnational fiscal powers, with
shared responsibilities and coordinated policies.

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Rationale for Fiscal Federalism:

 Allocative Efficiency: Decentralization can better match public services with local preferences
and needs.
 Macroeconomic Stability: Central government can use fiscal policy tools to stabilize the
economy, while subnational governments focus on local development.
 Accountability and Responsiveness: Decentralization can make governments more accountable
and responsive to citizens.
 Experimentation and Innovation: Subnational governments can experiment with different
policies and serve as “laboratories of democracy.”
 Preserving Diversity: Fiscal federalism can accommodate the diverse needs and preferences of
different regions within a country.

Arguments for Fiscal Federalism:

 Improved Allocative Efficiency: Decentralization allows for better matching of public services
with local preferences.
 Enhanced Accountability: Subnational governments are closer to the people and more
responsive to local needs.
 Fostering Innovation: Decentralization encourages experimentation and the sharing of best
practices among subnational governments.
 Preserving Diversity: Fiscal federalism can accommodate the diverse needs and preferences of
different regions.
 Promoting Competition: Fiscal decentralization can create competition among subnational
governments, leading to improved public service delivery.

Arguments against Fiscal Federalism:

o Macroeconomic Instability: Decentralization can make it more challenging for the central
government to manage the economy.
o Unequal Fiscal Capacity: Subnational governments may have varying fiscal capacities, leading to
disparities in public service provision.
o Coordination Challenges: Decentralization can create coordination problems between different
levels of government.
o Race to the Bottom: Subnational governments may engage in a “race to the bottom” by
competing for mobile factors of production, such as capital and skilled labor.
o Increased Administrative Costs: Fiscal federalism may result in higher administrative costs due
to the need for multiple layers of government.

Fiscal Policy and its Implementation in Ethiopia

Fiscal policy in Ethiopia refers to the government’s approach to managing public revenues,
expenditures, and the overall budget to achieve macroeconomic objectives that we have discussed
above.

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The effectiveness of fiscal policy implementation in Ethiopia depends on factors such as the
government’s revenue mobilization capacity, the efficiency of public expenditure management, the
management of fiscal deficits and public debt, and the coordination between fiscal and monetary
policies. Ongoing reforms and capacity-building efforts in these areas are crucial for enhancing the
impact of fiscal policy on Ethiopia’s economic development.

Intergovernmental Transfers in Ethiopia

Intergovernmental transfers refer to the financial resources that flow from the federal government to
regional and local governments in a fiscal federalism system.

Rationales for Intergovernmental Grants:

 Fiscal Equalization: Grants help to address the fiscal disparities among regions and localities,
ensuring a more equitable distribution of resources and public services.
 Spillover Effects: Grants can be used to finance public goods and services that have positive
spillover effects across jurisdictions, such as infrastructure development.
 Macroeconomic Stabilization: Grants can be used as a tool for the federal government to
stabilize the economy and support subnational governments during economic downturns.

Incentives for Policy Alignment: Conditional grants can be used to incentivize regional and local
governments to align their policies and priorities with national development objectives.

Intergovernmental Transfer System in Ethiopia:

 Block Grants (Unconditional Grants):

The federal government provides block grants to regional governments based on a formula that
considers factors such as population, development needs, and fiscal capacity.

These grants account for a significant portion of regional government budgets and are used to finance
the provision of basic public services.

 Conditional Grants:

The federal government provides conditional grants to regional and local governments for specific
purposes, such as the implementation of federal programs in areas like education, health, and
infrastructure development.

These grants come with specific guidelines and reporting requirements to ensure the funds are used for
the intended purposes.

 Equalization Grants:

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The federal government provides equalization grants to regional governments to address fiscal
disparities and ensure a minimum level of public service provision across different regions.

The equalization grants are calculated based on factors such as population, development needs, and
fiscal capacity of the regions.

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