MONETARY AND FISCAL POLICY AS

TOOLS FOR
GOOD GOVERNANCE
 OUTLINE
 Monetary Policy
- Definition
- Changes in the international policy setting
- Targets and Instruments of Monetary Policy
- The link between the money supply and policy targets

- CONCLUSION – Monetary Policy

 FISCAL POLICY

- Definition of Fiscal Policy

 OUTLINE
-Key fiscal objectives
 GOVERNMENT REVENUE

- Issues on taxation

- Prerequisites for a Good Tax System

- Tax Compliance
1. Tax Compliance Issues

2. Decision to non- comply

3. Measures to improve Tax Compliance

Part I: MONETARY POLICY AS A TOOL
FOR
GOOD GOVERNANCE
 MONETARY AND FISCAL POLICY AS
TOOLS FOR
GOOD GOVERNANCE
MONETARY POLICY
 Definition

• Monetary policy involves all the deliberate decisions and

actions by the monetary authorities to influence
·       the monetary aggregates,
·       the availability of credit,
·       interest rates and
·       exchange rate,
• with a view to affecting monetary demand, income,
output, prices and the balance of payments.
 Changes in the international policy setting

World War 2 to 1971: Discipline

• fixed exchange rates
• smooth the business cycle
From 1971 to 1980: Instability
• Large deficits on the balance of payments
• Exchange rate depreciation
• inflation accelerated
From 1980 to 1990: Stability regained
• More market related monetary policy.
• Low inflation by following strict macroeconomic policies.
• Stability regained in spite of the monetary supply targets generally not
being very successful.
• Furthermore the Central Banks’ independence in many countries was
strengthened.
 1990 - 2005: transparency and increasing
global integration

• Strict monetary and fiscal policies.

• Increasing world integration raised cross- border
financial flows.
• A reduction in policy freedom in individual
countries.
• Volatile capital flows internationally brought
problems of their own.
 Since 2005: More volatility in economic
variables with more pressure on monetary
policy
• Rising food prices.
• Rising fuel prices.
• Rising inflationary pressures.
• Increased interest rates.
• More volatility in exchange rates.
• Pressure on Fiscal policy - more intervention?
 Targets and Instruments of Monetary Policy

Policy targets
• Price stability
• Economic growth
• Exchange rate stability
Monetary policy instruments
• Open market operations
• The setting of the bank/discount/repo rate
• Reserve requirements
• Selective credit controls
• Public debt management
 The link between the money supply and policy
targets
• Monetary policy can achieve either a price level target or
an output target, but not both.
• With instruments that directly only affects the money
supply, the central bank can only achieve one target.
• The flows between monetary policy instruments and
targets can be illustrated as follows:
The link between the money supply and policy
targets

Policy Operating Intermediate

instruments targets targets
 Open market  Repo rate  Money
PPoperations  Borrowed stock
 Accomodation reserves  Interest
policy - Repo  Non- rates
 Reserve Borrowed  Price level
requirements reserves  Nominal
 Public debt GDP
management

Final Targets
 Inflation rate
 Unemployment
rate
 Real GDP
 CONCLUSION – Monetary Policy
 Good governance through monetary policy could
imply that certain targets are set for variables such as
inflation, the growth in the money supply, or the
exchange rate.
 In South Africa today the policy target is the inflation
rate through the process of inflation targeting.
 Good governance in this country implies that the
inflation rate as measured by CPIX (i.e. consumer
prices minus bond rates), is set between 3% and 6%.
 This has become important in the globalised world
and the difficulty to compete in international markets.
Part II: FISCAL POLICY AS A TOOL FOR

GOOD GOVERNANCE
 Revenue and expenditure policies
 Definition of Fiscal Policy
 Fiscal policy entails the ways in which government intervenes
in the economic activity of a country…
 through its expenditure priorities, and also, the way in which
such expenditures are financed through taxes and borrowing.

Fiscal policy as a tool in good governance has both an active-

and passive element.
 The active element implies that the government takes a
deliberate step to “do something”, for example to decrease
the budget deficit.
 The passive element implies that the government is “not
doing something”, for example, no tax rate changes are
announced in a particular budget.
 Key fiscal objectives

1. Economic growth - synchronize policies

2. Ensure fiscal stability
3. Address the deepening of poverty
4. Progressively raise the ratio of capital formation to GDP
5. Address the saving catastrophe
6. Ensure continuous productivity growth
 Address high costs of power, transport, regulatory
requirements, security and other indirect costs that depress
the productivity of firms
 Upgrade deteriorating infrastructure
7. Promote enterprise development and deregulation – especially
small businesses
8. Eliminate bottlenecks that prevent more effective delivery of
social services
9. Strengthen local and provincial government service delivery
 GOVERNMENT REVENUE

 Why do governments use taxes to intervene in the

economy?

 Raise revenue
 Redistribution of income
 Encourage/discourage certain behaviour
(sumptuary taxes)
 GOVERNMENT REVENUE
 Revenue derived from various sources: taxation, loans and
income from property.
 Some of these taxes are visible (for example income tax);
others are less visible to the consumer because they are
levied on the producers of raw materials and intermediate
goods such as VAT.
 Taxes can be classified as being direct or indirect.
 A direct tax is paid directly by the taxpayer to the
Revenue Service – eg. Income tax.
 Indirect tax is paid on goods and services, and is paid to
the Revenue Service by a third party.
Eg. VAT and customs taxes.
 Issues on taxation
 Progressive tax
Progressive tax indicates that the percentage of the tax paid on
income will increase as income increases.
Eg. Income taxes
 
 Proportional tax
The taxpayer pays a fixed percentage of tax for different levels of
income. This implies that the average tax rate is unchanged for all
the taxpayers (independent of levels if income earned.

 Regressive tax
The percentage tax decreases as income increases.
Eg. VAT
 Prerequisites for a Good Tax System
 Equity (Fairness)
 Efficiency (Neutrality)
 Administrative feasibility (Simplicity)
 Flexibility
 Prerequisites for a Good Tax System
Equity (Fairness)
 An equitable tax system should be in line with the:
 Benefit principle
 Ability-to-pay principle
 The tax burden should be spread fairly across the tax
base.
 If not it will create incentives for people to avoid or even
evade taxes.   
 Prerequisites for a Good Tax System
Equity (Fairness)
 The benefit principle
 People should be taxed if they directly benefit from the
availability of certain goods and services that the government
provides.
 Known as user charges.
 Can be implemented where exclusion is possible.
 Ability to pay principle
 People pay tax according to their economic ability (may be
either income/wealth or both.
 horizontal equity
 vertical equity
 Prerequisites for a Good Tax System
Efficiency (Neutrality)
 Taxes may distort prices and therefore distort the
allocation of resources and cause economic instability.
 Creates “deadweight-losses”.

 Economists always conduct incidence analyses to

determine “true” tax burden.
 High tax percentages may affect the behaviour of
taxpayers in the economy.
 The cost of taxation (i.t.o economy-wide resource
allocation) should be kept as low as possible.
 Prerequisites for a Good Tax System
Efficiency (Neutrality) – Incidence Analysis
 The person who pays the tax to the authorities may not
be same the same person who carries the eventual tax
burden.
 Since taxes impose an additional cost on people, they
will try to shift the burden of tax onto someone else.
 Tax evasion is a deliberate and deceitful effort by the
taxpayers to avoid their tax obligations. This is a
criminal offence - punishable by law.
 Tax avoidance implies that a taxpayer changes his/her
behaviour so that the personal tax liability is minimised.
 Prerequisites for a Good Tax System
Administrative feasibility (Simplicity)
 The tax system has to be simple enough, so that every person
knows exactly how much tax he/she has to pay.
 Taxes create costs for the taxpayers. This cost does not only
include the tax payments, but also the cost of keeping tax
records and the expenditures on financial advisers.
 This type of cost is called compliance cost.
 On the administration’s side there also exists enforcement
costs.
 A good tax system should try to minimise both these costs.
 Tax Evasion Vs Tax Avoidance
 The classic distinction between avoidance and evasion is due to Oliver Wendell Holmes, who
wrote

 "When the law draws a line, a case is on one side of it or the other, and if on the safe side is
none the worse legally that a party has availed himself to the full of what the law permits.
When an act is condemned as evasion, what is meant is that it is on the wrong side of the
line..." (Bullen v. Wisconsin (1916), 240. U.S. 625 at p.630).

 Thus, the distinguishing characteristic of evasion is illegality.

 Tax evasion is the illegal manipulation of one’s affairs with the intention to escape taxes. Tax
evasion is illegal
 Tax avoidance is the rearrangement of a taxpayer’s affairs, within the law, in order to reduce
tax liability. Tax avoidance is legal
 Tax Evasion Vs Tax Avoidance
 Tax avoidance has got to do with substitution effect of taxation. Whenever one
activity is taxed more highly than others, people will switch to the lightly taxed or
untaxed activity e.g increase in tax on labour income results in the following:

 Putting in more hours to compensate

 More leisure (untaxed)

 Home production increases- you keep on working the same hours, but you divide
them between market work and untaxed home-production.

 However, If two neighbours both decide to increase their home production, and at
the same time they exchange goods in kind, they should be taxed if not, they are
said to be operating in the underground economy.
 Reasons for honesty

 People may tend to overestimate both the probability and

magnitude of penalties;

 The fear of social stigma or damage to their reputation if they are

exposed as cheaters.

 People pay tax because it is linked to governance. In the words of

Friedman (2003:1) “we obey the rules when the government does
its job and ensures that the systems are in place to force us to
comply”
 Reasons for Non-compliance
 Negative attitude of citizens toward the government

 Inadequate services from the Government- taxpayers believe that they do not receive
value for money when comparing the services

 Community standards- when the general level of honesty in the community is low the
compliance level is usually very low

 The level of corruption- high levels of corruption by officials lead to dishonest

taxpayers;

 Inadequate interest/penalty regimes, which encourage taxpayers to evade filling

returns and paying tax or ‘borrow’ from the government.
 Reasons for Non-compliance
 Low risk of discovery-the perception that the tax administration is
weak and the chances of being caught are low enough to take the
risk

 Ignorance and confusion

 Poor service by the tax administration

 High compliance costs

 Defective law
 Creating Tax Compliance
Introduce self-assessment

 “Administrative assessment” is not compatible with modern tax

administration

 Self-assessment helps improve effectiveness by focusing resources

on (1) tax services and (2) compliance enforcement (instead of
paperwork)

 Self-assessment helps reduce compliance and administrative costs

 Self-assessment helps reduce corruption

 Creating Tax Compliance

 Adequate services from the Government- taxpayers should receive value for
money when comparing the services provided by Govt.

 Keep the rates low; fight tax base erosion- in most countries tax base erosion
has led to high marginal (effective) tax rates. Following Allingham/Sandmo-
model, the lower the marginal rate, the lower tax evasion.
 Focus on the probability of getting caught (ignoring risk seekers)- more effective
than increasing the penalties- increasing only the penalty without increasing the
probability, is inequitable.

 Make sure penalties are quickly applied (deterrent taxes should deter)
 Creating Tax Compliance
 Educate citizens- Politicians should set the standard.

 Identify main sources of underground activity and incorporate them

into the tax system

 Reduce compliance cost- simple and transparent procedures –i.e

simplified tax regimes.

 Electronise the economy (making cash transaction limited)

 GOVERNMENT EXPENDITURE

 The government participates in the economy by producing

goods and services.
 Government provides the community with collective goods,
such as education, defence, infrastructure and health services.

 The composition of government spending reflects changes in

the economy, social conditions and the priorities i.e.
 consumer preferences

 political and other shocks

 redistribution of income

 government failure

 population growth and urbanisation

 GOVERNMENT EXPENDITURE
 Functional classification of government spending.
 defence and on health services.

 Budget deficit
 expenditures exceed revenues.

 This deficit has to be financed to get the budget to

balance.
 Deficits are usually expressed as a percentage of the GDP.

 Good governance would imply that the ratio stays within limits
that are acceptable for sustainable economic growth.
 A rule of thumb is that the ratio in any particular fiscal year
should not exceed the three per cent (3%) level.
 DEFICIT FINANCING

 Affects levels of national saving, investment and the

current account on the balance of payments.
 Sources of finance:
·       Loans
·       Domestic
·       Foreign
·       Loan levies
·       Treasury bills
 GOVERNMENT DEBT

 Difference between the government debt and the deficit.

 The goals of debt management are:
 Financial certainty
 Debt service minimisation
 Macroeconomic stabilisation and time consistency
 The significance of public debt can be expressed as a
percentage of GDP.
 According to the Maastricht Treaty this ratio should not
exceed the sixty per cent (60%) level.
 CONCLUSION – Fiscal Policy

 Good governance in fiscal policy implies a government

that is committed to increasing the level of welfare of all
the citizens of the particular country.
 Welfare levels could be raised by both government
revenue programmes, or direct or indirect expenditure
programmes.
 Readings
 Harvey S. Rosen/ Ted Gayer: Public Finance (8th Ed)

 Libanior Gilberto (2005): Good Governance in Monetary Policy and

the negative effects of Inflation Targeting; available at
www.policyinnovations.org/ideas/policy_library/data/01191

 Silvani CA (1992): improving tax Compliance’ in Bird R. and

Casanegra de Jantscher M (eds) Improving Tax Administration in
developing Countries (IMF: Washington DC, pp 276-287, 293-297.