Chapter- Three

Public Finance in Ethiopia

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 CHAPTER OUTLINES
 Public Finance in Ethiopia
–Features of Ethiopian Federal Finance
–Expenditure Assignment
–Revenue Assignment
–Intergovernmental Transfer
–Borrowing
• Budget and its process in Ethiopia
• Deficit Financing in Ethiopia
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3.1. Features of Ethiopian Federal Finance
• Ethiopia is a federal state which comprises of a
central government having nine Regional
Governments and two chartered cities.
• One component of federalism is fiscal
federalism which gives local governments
some taxing power and expenditure
responsibility, and allows them to decide on
the level and structure of their expenditure
budgets.
• Fiscal decentralization requires local
governments with some autonomy to make
independent fiscal decisions.
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• Fiscal federalism has four components:
1. Revenue Assignment
2. Expenditure Assignment
3. Intergovernmental Transfer (subsidy)
4. Borrowing
1. Revenue Assignment
• The division of taxation power is a principal
aspect of the Constitution that provides the
legal framework of the Ethiopian federal
system.
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• The Constitution divides the taxation power
into three categories, namely
– The federal power of taxation

– The state power taxation and

– The concurrent power of taxation

• The Constitution of Ethiopia make a clear

demarcation of areas where the Central alone
or State alone have authority to impose taxes.
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Objectives of Revenue sharing:
• The sharing between the central and the
Regional government
• A government has the following objectives:
– To enable the central Government and the
Regional Governments efficiently carry out
their respective duties and responsibilities.
– To assist Regional Governments develop
their regions on their own initiatives;
– To narrow the existing gap in development
and economic growth between regions;
– To encourage activities those have common
interest to regions. 6
Basis for Revenue Sharing:
– Ownership of source of revenue;
– The National or Regional character of the
sources of revenue
– Convenience of levying and collection of
the tax or duty
– Population, distribution of wealth and
standard of development of each region;
– Other factors that are basis for integrated
and balanced economy.

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Categorization of Revenue:
• The following are Federal Taxes:
– Duties, tax & other charges levied on the import & export
– Personal income tax collected from the employees of the
central Government and the international Organizations;
– Profit tax, Personal income tax and sales tax collected from
enterprises owned by the Central Government. (Now sales
tax is replaced with VAT and Turnover taxes).
– Taxes collected from National Lotteries and other chance
winning prizes;
– Taxes collected on income from air, train and marine
transport activities;
– Taxes collected from rent of houses and properties owned
by the central Government;
– Charges and fees on licenses and services issued or rented
by the central Government;
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The following are Taxes of Regional Government:
– Personal income tax collected from the employees of the
Regional Government and employees other than those
covered under the sources of central government.
– Agricultural income tax collected from farmers not
incorporated in an organization.
– Profit and sales tax collected individual traders.
– Tax on income from inland water transportation.
– Taxes collected from rent of houses and properties owned
by the Regional Governments;
– Profit tax, personal income tax and sales tax collected
from enterprises owned by the Regional Governments:
– Income tax, royalty and rent of land collected from small
scale mining activities.
– Rural land use fee.
– Charges and fees on licenses and services issued or rented
by the Regional Government;
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• The following are Joint Taxes:
– Profit tax, personal income tax and sales tax
collected from enterprises jointly owned by the
central Government and Regional Governments;
– Profit tax, dividend tax and sales tax collected
from Organizations;
– Profit tax, royalty and rent of land collected from
large scale mining, any petroleum and gas
operations;
– Forest royalty

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Jointly Established Enterprises Federal Gov’t Regional Gov’t
Profit Tax In proportion to their respective
capital contribution
Employment Income Tax 50% 50%
Value-added Tax 70% 30%
Turnover Tax 70% 30%
Excise Taxes 70% 30%
Companies
Profit Tax 50% 50%
Dividend Income 50% 50%
Value-added Tax 70% 30%
Turnover Tax 70% 30%
Excise Taxes 70% 30%
Mineral & Petroleum Operation
Profit Tax 50% 50%
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Royalty 60% 40%
• Expenditure Assignment
– The federal structure of Ethiopia allocates functions
and responsibilities, and hence expenditure, to
federal government and regional governments.
• Intergovernmental Transfer (subsidy)
– Refer to the transfer of money from central
government to regional governments.
– In Ethiopia the transfer is in the form of subsidy.
• The main objectives of subsidy in Ethiopia are:
– Offsetting fiscal imbalances or closing fiscal gaps;
– Establishing horizontal equity across the federation
– Offsetting inter-jurisdictional benefit spillovers or
for merit good reasons 12
1. Offsetting fiscal Imbalances:
To offset the imbalances/mismatch b/n revenues
and expenditures of different governmental units.
• It can be “vertical” or “horizontal”.
– Vertical fiscal imbalance: refers to the difference
between expenditures and revenues at different
levels of government, and
– Horizontal fiscal imbalance: refers to the
differences between revenue and expenditure
levels within a particular level of government.
2. Fiscal Equity:
– In terms of ensuring inter-regional equity.
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3. Correction of spillovers:
• It is an instance of overflowing into another area.
• Optimal provision of the service is ensured through central
subsidies to offset spillovers.
Borrowing
• Regional governments are not allowed to borrow
from abroad. It is the federal government that has
the power to borrow from abroad.
• They can, however, borrow internally from banks to
meet the cash flow timing problem.
• Borrowing internally from banks requires the
permission of MOFED.
• When regional governments experience budget
shortfall in any fiscal year the federal government
may give them loan in the form of advance to be
charged to their budgetary subsidy of the following
year. 14
Ethiopian Public Finance
• Source of Government Finance
• Domestic Revenue
– Tax Revenue
– Non-Tax Revenue
– Capital Revenue
• External Assistance
– Multilateral Institutions
– Bilateral Assistance
– Counter Part Fund Assistance
• External Loans and Credits
– Multilateral Institutions
– Bilateral Loan
– Counter Part Fund Loan
• Domestic Borrowing 15
1. Public Revenue
• The Ethiopian government revenue is broadly divided into
three: tax revenue, non-tax revenue, and capital revenue.
• The tax revenue includes income taxes, VAT, TOT, excise tax,
custom duty, and stamp duty. The non-tax revenue includes
– Administrative fees and charges:
– Sales of public goods & services:
– Government investment income: such as dividend income from
government assets; national lottery surplus; interests
– Miscellaneous revenue:
• Capital revenue: sales of moveable and immovable properties;
privatization proceeds; collection of principal from on-
lending.
• The government receives grants from foreign governments
and other developmental organizations.
• The grant may be in cash or in-kind.
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2. Public expenditure
• Classifying expenditures is important in policy
formulation and the identification of resources
allocation among sectors.
• The best-known classification systems are
• The functional “classification of the functions of
government” developed by united nations, and
• The Government Financial Statistics (GFS)
classification, developed by the IMF.
I. Classification by Function: A functional
classification organizes government activities
according to their purposes (e.g., education,
defense, health, social security, housing, etc.).
– A functional classification allows analyzing the
allocation of resources among sectors.
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II. Line-item classification:
• For budget management purposes, the budgets
include an object classification (also called “line-
item classification”).
• This line-item classification lists expenditures along
categories used for budgetary control and
monitoring, such as different categories of
personnel expenditures, travel expenses, printing.
III. Administrative classification: Public expenditures
can be classified based on governmental
organization.
• Expenditures are classified into separate sections
for each ministry, department, or agency.
• It is used for clear identification of responsibilities
in public expenditure management and also for
day-to-day administration of the budget. 18
IV. Economic classification: Public expenditures
are classified into recurrent expenditure,
capital expenditure, interest payment, and
repayment of loan.
– Recurrent expenditure covers all items to be
funded during the current fiscal year like salaries,
materials, and services necessary for the ongoing
activities.
– Capital expenditure refer to the cost of acquiring
buildings, roads, dams, equipment and other items
that will have a life-span of more than 1 year.

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• In addition expenditures are also classified based on
functions as shown here below
General Services Economic Services Social Services
Organ of the Agriculture & Natural Education &
State Resource training
Justice Trade & Industry Culture & sports
Defense Mines & Energy Public health
Public order & Labor & social
security Tourism welfare
General services Transport & communicatio Rehabilitation
Urban development &
construction
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3. Public Debt
• It is obvious that when any government's expenditure
exceeds its revenue, then this deficit will be financed
either by internal or external borrowing.
• The external debt of the government is divided into
three: multilateral, bilateral, and private creditors.
– Multilateral creditors are institutions such as the IMF,
the World Bank, African Development Bank, and
Fund for International Development, as well as other
multilateral development banks.
– Bilateral creditors include governments and their
agencies (including Central Bank), autonomous public
bodies or official export credit agencies.
– Private creditors include foreign commercial banks
and suppliers.
• The government borrows internally through issue of
bonds, sale of treasury bills and direct advances from
National Bank of Ethiopia. 21
4. Public Financial Administration
• Proper utilization of public resources calls for a
systematic administration of public financial
resources.
• The public financial administration is about
budgeting, execution of budget, reporting, and
control of performances.
Budgeting Process in Ethiopia
• Budgeting cycle consists of four roles
1. Budget preparation
2. Legislative approval
3. Budget implementation, and
4. Audit and evaluation. 22
A. Executive Preparation
• This includes preparation of the annual budget by
public bodies according to directives of the
MoFED.
• Executive preparation can be divided into some
stages as described below.
Stage 1: Budget Preparation:
• The preparation stage has three tasks. All the
three tasks would be carried out by the public
bodies who prepare their budget request.
• The 1st task is to determine the unit cost of goods
and services of developing cost build-up in the
request stage.
• Unit cost will be determined for each major area
of service by dividing the resource invested by the
output. 23
• The 2nd task in the budget preparation will be
the mid-year program review. The review
involves assessment of the performance of on-
going projects.
• The 3rd task in the budget preparation will be
development of work plans for on-going and
new projects for the upcoming fiscal year.

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Stage 2: Preparation of the Formula for Subsidy to
Regions:
• MoFED will prepare a proposal and present it to
the Federation Council for the formula to be used
in allocating the regional subsidy.
• The federation council will then amend the
formula for the regional subsidy if it is commonly
felt that the formula does not permit allocation of
resources in an equitable manner.
Stage 3: Notification of the Estimate of Subsidy
• MoFED releases to regions and administrative
councils of their estimated subsidies for the
coming fiscal year.
• The notification is issued by the MoFED to
regions and administrative councils between
January 9 and January 16. 25
Stage 4-Budget Call:
• The budget call provides public bodies with
their budget ceiling for recurrent and capital
expenditure for the coming fiscal year and
the deadline for submitting their budget
requests.
• In general, the budget call allows public
bodies to start the task of formulating the
budget by taking into view resource
constraints and specific guidelines of format.

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Stage 5- Budget Request:
• The budget request begins when public bodies
receive the budget call.
• The central task of the public bodies during the
request stage is to fit their request within the
budget ceiling issued in the budget call.
• To “fit” the requests two tasks have to be done by
the public bodies.
• First, they have to adjust their planning and
programming based on resource envelope and
work plans to the budget ceiling.
• Second, they have to prepare a justification of the
cost build-up of the work plans of their projects
and sub-agencies. 27
Stage 6- Preparation of the Recommended Budget:
• This is done for both recurrent and capital
budgets.
• The MoFED prepares a recommended budget,
consolidates it, and forwards it to the Office of
the Prime Minister for approval.
• The recommended budget will have the
following parts:
– An estimate of resources;
– Subsidies to the regions and administrative council;
– A recurrent budget, and;
– A capital budget.
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Stage 7: Approval of the Recommended Budget:
• This is a stage where the budget gets approval from
the office of prime minister and the council of
ministers.
• The approval will be finalized within two weeks
because most of the comments have already been
communicated during review of capital expenditure.
The four tasks involved in this stage are:
– To assess the reasonableness of the resource
estimate;
– To review the total of the subsidies to regions and
administrative councils and the split between
federal expenditures and subsidies
– To ensure that priorities established have been
reflected in the budget &
– To ensure that recurrent budgets are budgeted
according to the government policy. 29
B. Legislative Approval
• The stages stated from stage 1 to stage 7
constitute the first part of budgeting referred as
budget preparation.
Stage 8: Approval of the Recommended Budget:
• Next stage of budgeting deals with legislative
approval and executive implementation.
• The recommended budget is draft approved
budget subject to review, revision, and approval
of the parliament.
• It has been stated draft approved budget because
it has got the approval of council of ministers
but now waiting for final decision.
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Stage 9: Appropriation of the Approved Budget:
• At this stage, the parliament, based on the
approved budget, authorizes funds for
appropriations.
• Approved budget is appropriated by budget
type (capital and recurrent expenditure for
federal government), and by subsidy (by
region and administrative council).
• The approved budget and its annual
appropriation become proclaimed budget and
it is published in Negarit gazeta.
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C. Executive Implementation
Stage 10: Notification of the Proclaimed Budget:
• This is an initial implementation stage of the
budget cycle. Public bodies are notified by
MoFED of their proclaimed budget in detail to
the extent of line items of expenditure.
Stage 11- Implementation of the proclaimed budget:
• In the implementation stage, the proclaimed
budget is managed in terms of requests for
adjustments and monitored through financial and
physical reports.
• The adjustments are commonly made through
transfers, virement, and Supplementary.
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 Transfers:
These are the transfers of funds between public
bodies, which increase one public body’s budget
and decrease another public body’s budget.
The transfer can be done in two different ways.
• The first type is reallocation between the capital
and recurrent budgets within the same public
body.
– Under this type, surplus funds from recurrent
budget can be transferred to the capital budget
with the approval of council of Ministers.
• The second type of reallocation is between public
bodies within the same type of budget (e.g.
capital or recurrent). The second type of
reallocation also requires the approval of Council
of Ministers. 33
Virement: This is the reallocation of funds
within a public body’s budget between items
of expenditures.
– This occurs when the amount of resource allocated
to a particular activity is relatively higher than the
one allocated to another activity.
Allotment: In nearly all governments the
central budget office apportions the funds
periodically (monthly, quarterly, or semi-
annually), or as needed.

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Apportionment: Following the approval of
allotment by the budget office,
apportionments are made within the
department. This process grants expenditure
authority to subunits of operating agencies.
Supplementary: These are additional funds to
a public body, which increase the total
government budget.
– Supplementary appropriations are made after
checking for the possibility of both transfers and
virement.

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 Mid-year Changes: As the year progresses, the
budget office conducts reviews of agency
operations.
• When resources in some agencies are
insufficient to meet the demand for services,
one alternative for the budget office is to
approve supplemental appropriations by
making request to the legislative branch.

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 End-of-Year Spending: As the fiscal year
approaches its end, agencies will attempt to
exhaust their budgets; an agency having
unexpended funds at the end of the fiscal
year may be considered a prime candidate for
cuts in the upcoming budget.
• In addition, unexpended funds often lapse at
the end of the budget year.

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D. Budgetary Control
• Internal control (i.e., the compliance of the rules
and regulations, procedures, etc.) is an essential
function for every public body to ensure effective
and efficient use of budget resources.
• The budgetary control examines records, facilities,
systems, and other evidence to discover or verify
desired information.
• Internal audits/controls are those performed by
professionals employed by the organization being
audited.
• External audits/controls are performed by outside
professionals who are independent from the
organization being audited.
• It can also be classified as financial statement
audit, compliance audit, and performance audit. 38
 Deficit financing in Ethiopia
• Deficit, refers to the excessive public expenditure
over public revenue.
• Deficit is occurred when government expenditure
in a particular period exceeds government at
source of income due to several reasons such as
expansion of government activities in a budgeted
period, decline in source of revenue, inflation,
over and under estimations, etc.
• The gap between the shortfall of public revenue
and excessive public expenditure must be filled.
• The means by which governments fill this gap is
deficit financing. 39
• Deficit is financed through different mechanism. In a
wider context, countries shift their excess of current
account or capital account to finance wherever
deficit exists.
• Macroeconomic alternatives: such as taxation,
printing money and borrowing financing sources are
key factors to make decisions of filling the gap in the
fiscal policy.
• But money financing is proved as inflationary.
• Deficit financing through taxation and borrowing
from the public and commercial banks is considered
as non-inflationary as public expenditure replaces
private expenditure.
• Hence, borrowing and taxing are ranked as best
deficit financing tools.
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 Deficit financing objectives
• There are several reasons why deficit financing
is important including the following ones.
To finance wars
To reduce unemployment
To promote economic development
To finance strategic plans
To serve as an alternative tool: underdeveloped
countries suffer from low taxable capacity and low
savings.

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 Effects of Deficit Financing
• Deficit financing has both positive and negative effects
in the economy as under:
• Inflationary rise in prices: The most serious
disadvantage of deficit finance is the inflationary rise of
prices. Deficit financing increases the total volume of
money supply.
• Effects on distribution of wealth and income: The real
income of wage earners gets reduced and that of
entrepreneurs/ businessmen increased, leading to
distribution of wealth in favor of business class
• Faster growth: Country is able to implement the
developmental plans through deficit financing thereby
attaining faster growth.
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• Change in pattern of Investment
– Deficit financing leads to encouragement for
investment in certain fields like construction,
luxury consumption inventory holding and
speculation.
• Credit creation in banks
– Inflationary forces created by deficit financing are
reinforced by increase credit creation by banks.

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 Deficit financing practice in Ethiopia
• Deficit financing in Ethiopia was mainly resorted
to enable the government of Ethiopia to obtain
necessary resources for the plans.
• The gap in resources is made up partly through
external assistance.
• But when external assistance is not enough to fill
the gap, deficit financing has to be undertaken.
• When targets of production and employment in
the plans cannot be achieved through resources
obtained from taxation and external borrowing,
additional resources have to be found. Deficit
financing is the easier option. 44
 END OF
CHAPTER THREE

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