FINANCING THE PUBLIC SECTOR

TAXATION : DIRECT AND INDIRECT

 Lesson Objectives
• Identify the main sources of public sector revenue
• Define the term ‘tax’ and explain the canons
(Principles) of taxation
• Explain the reasons for taxation
• Identify and explain the merits and demerits of
direct and indirect taxes
• Distinguish between proportional, progressive and
regressive systems of taxation
• Distinguish between the impact and incidence of an
indirect tax
• Explain deficit, balanced and surplus budgets
 Sources of Government Revenue
• Government revenue includes:
– Taxes
– Proceeds from privatised industries
– Rent from government buildings and land
– Profits from nationalised industries
– Dividend income from any government shares in private
enterprises
– Grants received from other countries or international
financial institutions
– The most significant source of government revenue is
usually income tax, VAT and social security contributions.
 Taxation
• Taxes are compulsory transfer of money from
individuals, groups or institutions to the
government for which nothing is directly is
given by government in return.
• The tax payer only receives indirect benefits
from the payment of taxes in the form of good
roads, healthcare etc.
 Canons /Principles of a Good Tax System
• Equity: The tax system should be fair in its treatment of different
individuals. Horizontal Equity: Individuals who are the same in
all relevant aspects should be treated equally; Vertical Equity:
treating people in different economic circumstances differently
in order to reduce inequalities. Individuals who are better able
to pay higher taxes should bear a higher share of total taxes.
• Economical (Administrative Efficiency) : it should be cost less to
collect taxes. Cost of collection should be low relative to the
proceeds obtained
• Convenient: the method and frequency of the payment should
be convenient to the taxpayer.
• Certainty: taxpayers must know how much they have to pay
and when to pay
• Simplicity- the tax system should be easy to
understand
• Non Distortionary – the tax rate should not be
so high as to reduce work incentives or
dampen entrepreneurial motivations
 Why Collect Taxes?
• Redistribution of income and wealth through progressive taxes
• To correct market failure: indirect taxes make demerit goods
( alcohol and cigarettes) more expensive contracting demand and
discouraging consumption
• Environmental Protection – taxing activities that generate negative
externalities (pollution) to reduce their occurrence by setting an
indirect tax equal to the amount of negative externality generated.
• As a tool for managing the economy in order to achieve
government’s macroeconomic objectives. Taxes can be cut to boost
total spending and increase GDP growth during a recession
• To raise revenue to finance government expenditure e.g. building
roads, schools and hospitals
• To discourage imports (tariffs) and correct deficits on the current
account of the balance of payments. Tariffs make imports more
expensive compared to local substitutes
 Types of Taxes
• Taxes are usually classified as direct and indirect.
– Direct taxes are taxes, which are levied on the income and
wealth of an individual or organisation. Examples of direct
taxes include:
– Personal Income Tax, which are levied on incomes of
individuals.
– Corporate Tax: this is a tax, which is levied on the profits of
companies.
– Capital Gains Tax: this is tax levied on gains accruing from the
sale of assets. The tax is payable when assets are disposed off
and not when the gains actually accrue.
– Inheritance Tax: this is levied at a progressive rate on capital
values of property bequeathed to others.
– Gift Tax
– Property Tax: levied on the value of buildings and offices
 Advantages of Direct Taxes
• It is equitable because it is based on the ability to
pay.
• Progressive income taxes are used to reduce
income inequalities
• There is certainty as to how much he is expected
to pay, as the tax rates are decided in advance.
• The Government can also estimate the tax
revenue from direct taxes with a fair accuracy.
• They yield a high amount of revenue
• Direct taxes are relatively elastic. With an
increase in income and wealth of individuals and
companies, the yield from direct taxes will also
increase.
• Tax payers feel directly the burden of taxes and
hence take keen interest in how public funds are
spent.
• The direct taxes can help to control inflation.
During inflationary periods, the government may
increase the tax rate. With an increase in tax rate,
the consumption demand may decline, which in
turn may reduce inflation.
 Demerits of Direct Taxes
• Tax payers are required file annual tax returns
unlike indirect taxes
• High direct tax rates encourage high tax evasion
• High income can reduce work incentives
• High corporate taxes can be a disincentive for
investment and job creation. This can have a
negative effect on GDP growth
 Indirect Taxes
• These are taxes imposed on goods and services. They
The impact of the tax falls on one person and the
incidence on another, the tax is called indirect tax
• Examples of indirect taxes include:
– Value Added Tax: this is the most important indirect tax. It
may be described as a tax levied on businesses at every
stage of production and distribution on the value they
add to their purchases of raw materials
– Customs and Excise Duties: customs duties (tariffs) are
imposed on certain imported goods.
– Excise duties are generally imposed on goods, which are
not subject to value added tax: in particular, goods such
as tobacco, beer, wine and spirits.
 Advantages of Indirect Taxes

• It is very easy to pay because they are included in

prices. The consumer often does not know that he
is paying the tax.
• Very cheap and easy to collect
• Any one who will purchase the taxed commodity,
will pay the tax. So it is not possible to evade
indirect tax.
• It can be used to discourage the consumption of
harmful drugs, by increasing the taxes on them.
• Unlike direct taxes, the indirect taxes have a wide
coverage. Majority of the products or services are
subject to indirect taxes.
• By imposing taxes on certain commodities or
sectors, the government can achieve better
allocation of resources. For e.g. By Imposing
taxes on luxury goods and making them more
expensive, government can divert resources
from these sectors to sector producing
necessary goods.
 Demerits of Indirect Taxes
• Lower cost of collection.
• Generally, the indirect taxes are regressive in
nature and worsens income inequalities
• An increase in indirect tax causes cost push
inflation
• Indirect taxes are inflationary in nature. The tax
charged on goods and services increase their
prices.
• Revenue from indirect taxes cannot be predicted
because government cannot determine how
much consumers will spend
 Impact and Incidence of an Indirect Tax

• Impact of an Indirect Tax

– The impact of an indirect tax falls on the person or
organisation who initially bears the obligation to pay
the tax.
– The Impact of an indirect tax is always on the firm
– An importer pays the tariff initially
• Incidence of an indirect Tax
– This is borne by the individual or organisation that
ultimately bears the burden on the tax
– If a good is perfectly inelastic, the impact falls on the
firm but incidence is entirely on the producer
 Differences
Direct Tax
• Imposed on income and
wealth
• The impact and incidence of
the tax falls on the same
taxpayer
Indirect Tax
• Imposed on goods and
services
• Impact fall on the firm but
the incidence may fall on
the consumer or the
producer or be split
between them depending
on the PED of the good
 Tax Structures: Progressive, Proportional and Regressive Taxes

• Taxes are also classified as progressive,

proportional or regressive. These designations
focus on the relationship between tax rates and
income.
• Progressive Tax
– A tax is progressive if the proportion of income paid as
tax increases as income increases.
– The tax rate rises as income rises
– It is used to reduce income inequalities
– Personal income taxes are progressive
• Regressive Tax
– A tax is regressive if the tax rate or the percentage of
income paid as tax decreases as income increases.
– All indirect taxes are regressive
– A rise in indirect taxes worsen income inequalities
• Proportional Tax
– Tax rate remains constant for all levels of income
– Corporate tax and capital gains tax are proportional
PUBLIC EXPENDITUE
 The Public Sector
• The public sector refers to that part of the
national economy for which the government
has direct control over the allocation of
resources; it includes both central and local
government, public corporations and other
public enterprise activities.
 Purpose of Government Spending
• To supply goods and services that the private sector would fail to
do, such as public goods, including defence, roads and bridges;
merit goods, such as hospitals and schools; and welfare payments
and benefits, including unemployment and disability benefit.
• To achieve supply-side improvements in the macro-economy,
such as spending on education and training to improve labour
productivity.
• To subsidise industries which may need financial support, and
which is not available from the private sector.
• To help redistribute income and achieve more equity. By paying
unemployment benefits
• To inject extra spending into the macro-economy, to help achieve
increases in aggregate demand and economic activity. Such a
stimulus is part of discretionary fiscal policy.
 Budget

• A budget is a detailed statement of government’s

expected expenditure and revenue for a future
period
• The act of budgeting involves ways and means of
financing expected public expenditure.
• The annual budget is detailed expression of the
government’s fiscal policy for the year.
• Fiscal policy is the control of government
spending and taxation to achieve specific
macroeconomic goals.
 Types of Budgets
• The government may run a:
• Balanced budget – planned government expenditure
equals government revenue
• Deficit Budget – planned government expenditure
exceeds government revenue( expansionary fiscal policy)
– For economic growth and job creation
– Applied in during economic recessions
• Surplus budget - planned government expenditure is
less than government revenue (contractionary fiscal
policy)
– For reducing inflation (price stability)
– Applied during a period of rapid growth in total spending
 Financing Deficit Budgets
• If government plans to spending more than the
revenue available, it has to borrow to meet the
shortfall in revenue
• Public Sector Net Cash Requirement (PSNCR) is
the amount that the government sector needs to
borrow, to finance planned excess government
spending in a given year.
• External or Foreign Sources for Financing Deficit:
– Multilateral sources of finance i.e. IMF, World Bank, African
Development Bank and the International Finance Corporation.
– Bilateral Sources i.e. borrowing from other rich countries e.g UK,
USA, China, Japan, etc.
– Foreign Capital Markets- this usually involves the sale of
government bonds in foreign financial markets.
• Domestic or Internal Sources for Financing Deficits
– Sale of short term government debt i.e. treasury bills ( they are
short term because they mature in one year)
– Sale of long term government debt i.e. bonds (they are long term
debt which mature in 5 years plus)
– Borrowing from the central bank but it may increase the money
supply
– Printing of new money – this is the least preferred option because
printing more money without a corresponding increase in total
output will trigger uncontrollable price inflation.
 National Debt
• This is the total amount owed by the
government. It is the sum of all PSNCRs ever
borrowed.
• The degree of a country’s indebtedness is
measured by expressing the national debt as a
percentage of GDP.
• Increased government borrowing adds to the
debt stock.