Public Finance and

Taxation
2020/21 AY

Wollela Abehodie
Office: Eshetu Chole Bld #718
Email: wollela.abehodie@aau.edu.et
1. Basics of Public Finance

• Public Finance- Defn.

• Public finance – finances of the government;

• Finances of the government include: raising and disbursement of

government funds;

• Public finance is viewed as a study of funds raised by government

to meet its costs (government costs);

• Public finance is concerned with the income and expenditure of

public authorities and with the adjustment of one to the other.
Basics of Public Finance (Cont’d)

• Public finance is concerned with the process of raising and

spending funds for the functioning of the government.

• Thus, the study of public revenue, public expenditure, and

public borrowings (public debts), public financial
administration constitutes the main divisions in the study of
public finance.
Basics of Public Finance (Cont’d)
• Public finance seeks answers to the following
questions:
• When should the government intervene in the
economy;

• How might the government intervene in the economy;

• What are the effects of government interventions on

economic outcomes
Basics of Public Finance (Cont’d)

• When should the government intervene?

• There are at least two reasons:
• Redistribution: shifting resources from some groups in society to
other groups (usually from rich to poor people);

• Market failure: a problem that causes the market economy to

deliver an outcome that does not maximize efficiency
Basics of Public Finance (Cont’d)
• Market failure may happen, among others:
• Public goods: non-rival and non-excludable
goods are underprovided through the market
system;
• Externalities: spill over effects of individuals or
firms’ decisions on others;
• Externalities could be positive – bringing benefits to
others (eg. vaccination) and negative (eg. pollution);
• Imperfect competition: a single seller for
example can exert a significant influence on
prices (monopoly);
Basics of Public Finance (Cont’d)

• How might government intervene?

• Price mechanism
• Tax “bad” (tax harmful activities like polluting activities etc.)
• Subsidize/support “good” (e.g. encourage recycling of plastic
products through subsidy)
• Regulations: Restrict/ban
purchase/production of “bad”
(e.g. pollution causing activities;
• In Ethiopia, plastic shopping bags with thickness of
0.03mm and less are prohibited to be produced and
imported.
• Provision:
Public provision of goods and services;
Finance the provision of goods and services;
Basics of Public Finance (Cont’d)
• What are the effects of government
interventions on economic outcomes?
• Direct and indirect effects:
• Direct : effects on the economy with no
changes on individuals behavior;

• eg. the costs of providing a new public health

insurance plan to those who are currently
uninsured;
Basics of Public Finance (Cont’d)
• Indirect: effects due to changes in behavior

• The effects that arise because individuals change

their behavior in response to government
interventions;

• eg. The additional cost of providing insurance

coverage to those who drop private insurance;

• Effects of taxation, government expenditure,

public borrowing on the economy constitute the
subject matter of public finance.
Basics of Public Finance (Cont’d)

• Public goods and Private goods

• Public goods: one for which the investment of one individual

benefits everyone in a larger group

• Public goods have two criteria:

• Nonexclusion: cannot exclude people from enjoying the

benefits (even if they do not pay)

• Shared consumption (nonrivalry): one person’s consumption

of a good does not reduce the benefits to the others;
Basics of Public Finance (Cont’d)
• Private goods are rival: one person’s consumption of a
good reduces the benefits to the others;

• Private goods are excludable: one person’s

consumption of a goods excludes others from enjoying
the benefits (example, a kilo of banana)

• The market mechanism is well suited for the provision of

private goods;
Basics of public finance (Cont’d)

• Private goods may be produced and sold to

private buyers either by private firms, as is
normally done, or by public enterprises, such as
public power and transportation authorities;

• Social goods are provided publicly; they are

financed through government budget;
Basics of public finance (Cont’d)
• Merit goods
• are goods which are deemed to be socially desirable,
and which are likely to be under-produced and under-
consumed through the market mechanism.
• Examples of merit goods include education, health
care, welfare services, housing, fire protection,

• In contrast to pure public goods, merit goods could be

provided through the market, but not necessarily in
sufficient quantities to maximize social welfare.

• Thus goods such as education and health care are

provided by the state, but there is also a parallel,
private sector provision
Basics of public finance (Cont’d)
Main features Public goods Merit goods Private goods

Diminishabilit Non-diminishable Diminishable Diminishable

y (non- (non-rivalry) (rivalry) (rivalry)
rivalry)
Excludability Non-excludable Excludable (but Excludable
full benefits are
not felt by those
who are included)
Benefits Communal Individual and Individual
communal (strong (mainly
positive internalities)
externalities)
Provider Usually Government Usually private
government and/or private enterprise
enterprise)
Financed by Usually taxation Taxes and/or Usually through
prices the price system
Examples National defense, Health, education, Cereal, clothes,
law and order, housing computers, TV
street lights, sets etc.
lighthouses
 Basics of Public Finance (Cont’d)
• Public Sector Activities;
• Government’s intend to correct market failure and
accomplish redistribution, among others;

• Public sector activities include the provision of goods

and services, which are known as public goods;
correction of issues of externalities, imperfect
competition etc.
Basics of Public Finance (Cont’d)
• Some public sector activities include:
• maintenance of law and order (including the preparation
of laws and controlling whether they are put in practice or
not),
• defense,
• formulating policies and looking into their implementation,
• maintaining equality among citizens,
• operating public enterprises,
• Construction of roads, bridges, railways, generating
electricity, providing irrigation through dams, health,
education etc. are a few examples of public sector
activities (Involve huge investment)
Basics of Public Finance (Cont’d)
• Public Finance covers:
• Public Expenditure;
• Public Revenues;
• Public Debt (public borrowings);
• Financial administration and control;
Basics of Public Finance (Cont’d)
• Public Expenditures:
• The expenditure incurred by government/public authorities to
provide for goods and services collectively consumed by the
society.
• Expenses incurred by the public authorities—central (federal),
state (regional) and local governments—are called public
expenditures.
• Why Public Expenditure?
• The rationale for the public sector spending lies in the quest to
respond to market failure and the concern on equity
(accomplish redistribution);

• Public spending enables governments to produce and purchase

goods and services, in order to fulfill their objectives – such as
the provision of public goods (correcting market failure) or the
redistribution of resources.
Basics of Public Finance (Cont’d)

• Classification of public expenditures:

• Revenue (recurrent) and capital expenditures;

• Developmental and non-developmental
expenditures
Basics of Public Finance (Cont’d)
• Revenue expenditure: is a current or consumption
expenditure incurred on civil administration (i.e., police, jails
and judiciary), defense forces, public health and education.

• This is recurrent type which is incurred every year;

• Capital expenditure: is incurred on building/buying durable
assets.

• It is a non-recurring type of expenditure.

• Expenditure incurred on building multipurpose river projects,
highways etc., and buying machinery and equipment is
regarded as capital expenditure.
Basics of Public Finance (Cont’d)
• Developmental and non-developmental
expenditures:
• Developmental are those expenditures of Government
which promote economic growth;
• Expenditures on:
• irrigation projects,
• flood control measures,
• transport and communication,
• capital formation in agricultural and industrial sectors are de­
scribed as developmental.
• Expenditures on education, research and health are
generally regarded as developmental;
Basics of Public Finance (Cont’d)

• Non-developmental Expenditures
• Expenditure on defense, civil administration (i.e., police,
jails and judiciary), interest on public debt etc., are put
under the category of non-development expenditure.
Basics of Public Finance (Cont’d)
• Means of financing government expenditures:

• Tax and non-tax money (Public Revenues)

• Borrowed money (Public Debt): (this may impose

burden on future generation for the debt has to be paid
back);

• Printing money: (this increases money supply in the

economy and causes inflation);

• Nationalization of private property- would be unfair

and under our constitution this needs fair
compensation;
Basics of Public Finance (Cont’d)
• Public Revenue:
• Income of the government through all sources is called
public income or public revenue.
• A wider view of public revenues refers to all the
incomes or receipts which a public authority may obtain
during any period of time. Under this we may include
public debt;
• In a narrower view, however, it includes only those
sources of income of the public authority which are
ordinarily known as “revenue resources”; public debt is
not revenue

• To avoid ambiguity, the former is termed “public

receipts” and the latter “public revenue.”
Basics of Public Finance (Cont’d)
• Public revenues:
• Tax revenues;
• Non-tax revenues
• Tax revenues are funds raised through various tax
instruments;

• Taxes are compulsory contributions imposed by the

government on payers without any direct benefit accruing
to the payer;

• Main tax bases: income, consumption, wealth

• The different tax instruments may include- income tax,

various consumption taxes – value added tax, excise tax,
turnover tax, property tax, gift tax etc.
Basics of Public Finance (Cont’d)

• Non-Tax Revenues: Public income received through

the administration, commercial (activities) enterprises,
gifts and grants are the source of non-tax revenues of
the government.
Basics of Public Finance (Cont’d)
• Non­tax revenues originate from, among others:
• Administrative revenue sources: public authorities may raise
some funds in the form of fees, fines and penalties, and any
other nontax levy;
• eg. Fees are charged by public authorities or the government for
rendering services to beneficiaries; -
-fees to get passport renewed (issued);
-fees to get some service from document
authentication authority
• Fees are different from taxes (cost recovery basis)

• Public investment income (Profit from state owned

enterprises (dividends to government)); dividends from CBE,
Ethio-telecom in Ethiopia for example

• Gifts and grants (domestic and foreign sources);