Public Finance Teaching - Material

MEKELLE UNIVERSITY
COLLEGE OF BUSINESS & ECONOMICS

1 DEPARTMENT OF ECONOMICS
COURSE MATERIAL FOR: PUBLIC FINANCE

Course code: Econ 3122
 Credit hours: 3 hrs /5 ECTS/, Semester II
 Compiled by: KELEM TADEGE
April, 2020
Mekelle
Course Outline
2
 Course Description
 Public finance deals with the financial aspects of the government
and the possible role of the state in a market economy through
the use of lecture, directed reading and term paper (seminar)
preparation and presentation.
 The general objective of the course is to acquaint students with
various concepts, theories and realities of public finance such as
the rationale for state in the economy, the sources and types of
revenue for the public, taxing system and types of taxes,
characteristics of an efficient taxing system, criteria for
evaluating public expenditure, theories of public expenditure
and its impact on the economy, significance , objective and types
of public budget, deficit financing and its various means, and
some relevant public finance issues in the Ethiopian context.
Course Content
3
 1. Nature and Scope of Public Finance

 1.1. Definition of Public Finance
 1.2. Scope of Public Finance
 1.3. Public Finance and Private Finance
 1.4. Significance of Public Finance
 1.4.1. Economic Significance
 1.4.2. Social Significance
 1.5. Theory of public finance
Course Content
4
 Chapter Two
 2. Fundamentals of Welfare Economics (5Hrs)
 2.1. Brief Review of Welfare Economics
 2.2 The Efficiency of Competitive Markets
 2.3. Perfect Competition and Pareto Optimality
 2.4. Perfect Competition and General Economic Efficiency
 2.5 Optimum welfare of society
 2.5. Fundamental theorem of welfare economics
 2.5.1 First fundamental theorem
 2.5.2 Second fundamental theorem
Course Content
5
 Chapter Three
 3. Public Expenditure (6Hrs)
 3.1. Meaning and nature of public expenditure
 3.2. Public expenditure: Canons, Theories and Accountability
 3.2.1. Canon of public expenditure
 3.2.2. Theories of public expenditure
 3.2.3. Control and Accountability of Public Expenditure
 3.3. Effects of Public Expenditure of Production and Distribution
 3.3.1. Effects on production and employment
 3.3.2. Effects on distribution and income
 3.4. Public Expenditure and Control of Inflation
 3.5. Content of Development Expenditure
Course content
6
 Chapter Four
 4. Public Revenue (9Hrs)
 4.1. Meaning and Sources of Public revenue
 4.2. The Ratio, Bouncy and Elasticity of Taxation
 4.2.1. Tax ratio
 4.2.2. The base of a tax
 4.2.3. Bouncy and elasticity of a tax
 4.3. Adam Smith’s Canon of Taxation
 4.4. Features of Sound Taxation
 4.4.1. Equity in the distribution of tax burden
 4.4.2. Productivity
 4.4.3. Rights of taxpayers
 4.4.4. The tax system and the economy
 4.5. The theory of Taxation
Course content
7
 4.6. Theories of equitable distribution of tax burden of Taxation

 4.6.1. Socio-political theory
 4.6.2. Cost of service theory
 4.6.3. Benefit received theory
 4.6.4. The ability to pay principle theory
 4.7. Taxable capacity
 4.7.1 Absolute taxable capacity
 4.7.2 Relative taxable capacity
 4.8. Direct and Indirect Taxes
 4.8.1. Direct and indirect taxes: a comparison
 4.8.2. The case of direct taxes
 4.8.3. The case of indirect taxes
Course content
8
 Chapter Five
 5. Public Debt (5Hrs)
 5.1 Nature and Kinds of Public Debt
 5.2 Source of public borrowing
 5.3 Classification of Public Debt
 5.4 Effects of Public Debt
 5.5 Burden of Public Debt and debit trap
 5.6 Measurement of public debt burden
 5. 6.1 Internal measurement
 5.6.2 External measurement
 5.7 public debit management
Course content
9
Chapter six
 6. Analysis of fiscal policy and principles of federal finance
 6.1 Meaning of Fiscal Policy
 6.2 Objectives of Fiscal Policy
 6.3. Built in stabilization Fiscal Policy
 6.4 Discretionary Fiscal Policy
Chapter Seven
 7. Federal finance
 7.1 principles allocation of resource between federal and

state government
 7.2 principle of federal finance
Module Delivery Methods
10
 The delivery method shall be student-centered.

Students are highly expected to participate in class
works at the middle and end of each session and in
group discussions inside and outside of the class.
Specifically the course will be delivered through the
following methods:
 Lecture Method
 In-class problem solving
 Group Work
 Assignment
Assessment Methods
11
 Student evaluation in this module consist both formative

and summative assessments including quizzes, test and
final exam. Marks will be allocated according to the
following grading schedule.
Assessment method Weight
Assignment (Indiv/group) 20%
Quizzes/Tests 30%
Final Exam 50 %
Total 100%
References
12
 Atkinson, Anthony B. and Joseph E.Stiglitz.1980.Lecture on public

economics McGraw-Hill books Co-.;
 Bailey, Stephen J. 1995. Public sector Economics: Theory, policy and
practice
 Macmillan Press Ltd.’London.
 Baker,Samuel& Catherine Elliot (eds.) 1990. Readings in public sector
Economics .
 D.C.Health and Co: Lexington.
 Boadway.Robin W. 1979.Public sector Economics. Wintrop Publisher:
Cambridge.
 Brown .C.V. and P.M. Jackson, 1990.Pulic sector Economics, 4th edition.
Blackwell:
 Oxford.
 Browning ,E.K. and J.M. Browning ,1987 Public finance and the price
system 3red Edition . Macmillan publishing Co.: New York.
References
13
 Cullis John ,& Philip Jones 1998. Public finance and public
choice .2nd edition.
 Oxford University Press;Oxford.
 Easterly ,William , et al (eds.),1994. Public sector Deficits and
macroeconomic
 performance, Oxford University Press : Oxford. Jha
Raghbendra ,1998 Modern Public economics Rout ledge :
London
 Musgrave ,R.A and Peggy Musgrave ,1982. Public Finance in
theory and practice, 3rd edition McGraw-Hill: London.
 Stiglitz,J.E. 2000.Economics of the public sector ,3rd edition
.W.W. Norton & co.: New York
14
UNIT ONE
NATURE AND SCOPE OF PUBLIC
FINANCE ECONOMICS
Introduction
15
 Public finance: is the field of economics concerned

with how governments raise money, how that money
is spent and the effects of these activities on the
economy and the society.
 Public finance studies how governments at all levels
national, states, and local- provides the public with
desired services and how they secure the financial
resources to pay for these services.
Contd……………….
16
 Public finance is one of those subjects that lie on the

borderline between economics and politics.
 In olden days when monarchy was in fashion, the
crown used to collect land revenue in order to feed
the armed forces.
 But as time passes, the function of the state has
increased.
 Police state has been changed into welfare state.
17
 The increasing role of the state in the economic life

of the nation would involve more spending by the
state for the economic betterment of the masses.
 such as railways, postal service, dams, highways,
electrical projects, etc.
 Hence, in modern states the major objective of
public finance is maximization of social welfare.
18
 Maximizing social advantage is the guiding

principle in all the activities of the modern states in
raising income and in spending it (public finance).
 The state ensures maximum social welfare by
providing housing, medical facilities, education and
remove poverty by setting up relief funds and other
security measures.
19
 Now a days every state undertakes various

measures to raise the productivity of the nation by
providing the facilities of infrastructure such as
railways, roads, power, irrigation, etc.
 It also helps in controlling prices of essential
commodities by taking measures against inflation and
depression.
Contd………………….
20
 In a well-advanced countries, the governments are

responsible for maintaining the stability and
expanding the level of employment to achieve the
goal of full employment, while in
 Developing countries, which are confronted with
various problems, the government is committed to
achieve high economic growth, reduce high
unemployment rate, reduce inequality, avoid the
negative balance of payment problem, etc.
Scope and coverage of P.F.
21
 Most of the time, contents of public finance are

divisible in two broad categories
 public income and
 public expenditure
 But the scope of public finance is not only confined

to public income and public expenditure.
Contd…………………
22
 The scope of public finance may include the

following economic activities
 Public revenue Stabilization
 Public expenditure Economic growth
 Public debt
 Financial administration
 Resource Allocation
 Resource distribution
Public Finance and Private Finance
23
 Finance in general can be public or private finance.

 Similarities & differences between private and public
finance
 Similarities
 Rationality: both kinds of finance are based on
rationality i.e maximization of benefits. (private-profit
& public-social welfare)
 Borrow Funds: individually they cannot have enough
income to cover all their expenses and fills the short fall
by borrowing from others
Contd………………..
24
 Common interest: both public and private funds may

go into the hands of selfish interest
 Both the private and public sectors have limited
resources at their disposal
 Both are engaged in production, exchange, saving,
capital accumulation, investment, etc
 Differences
 Public revenue is determined by public expenditure:
while an individual income determines its expenditure,
public authority’s expenditure determines its income.
Contd………………..
25
 Welfare aspect: the existence of the state is for the

welfare of the society as a whole and not for the good
of any individual or group. The private individuals or
corporations think of earning profits for themselves.
 Long term vision: since the state is a permanent body,
its life is much longer than that of an individual, and
tends to see more towards the future.
 Sources of income: the sources of income of an
individual are relatively very much limited while those
of the state are relatively wide. It has the power to
levy taxes
Need for Public Finance
26
 Our wants are unlimited while resources available

to any society are limited in their ability to produce
economic goods both due to qualitative and
quantitative constraints.
 Scarcity of productive resources and existence of
unlimited wants with in states provide the logical
ground for the study of public finance.
Contd………………..
27
 Both public as well as private sectors of an

economy may take different roles in the total set up
of the country’s economic activities.
 Thus, the market mechanism alone cannot perform
all economic functions efficiently.
 Therefore, public policy is needed to guide, correct
and supplement the private sector in certain
aspects.
 This means that, the role of the government is
indispensable in every economic system.
28
 The forces of supply and demand and the price

mechanism characterize private sector resource
allocation.
 Public sector allocation on the other hand is
accomplished through the revenue and expenditure
activities of government budgeting.
 In reality, no economic society allocates all of its
resources through a single allocation institution.
Contd………………..
29
 Instead, each economy in the world is mixed to one

degree or another, between market determined
and government determined resource allocation…
 if the market dominates, the system is usually
referred to as capitalist and
 if the government dominates, it is a socialist
economic system.
 Therefore, in the following section we will try to see
the need for public finance in these economies.
30
A. Capitalist (market ) economic system: production is

based on demand, not on the necessity.
 This necessitates the government to intervene and
promote equitable distribution of income by means
of taxes, expenditure and social security laws.
 Because, the private sector under the market
economy failed to produce certain public goods like
public health, defense, parks, roads, bridges, etc
that can be made available equally to all and
which may not be sold on a profit-making basis.
Contd………………..
31
 Negative or positive welfare effect (Externalities):

 Inefficiency of the market system in some sectors:
The supply of electricity, telephone services, roads,
etc which require a huge capital usually is carried
out most effectively if government provides the
service to the community.
 The sole motive of a private firm is profit
maximization: Thus government has to engage in
those activities where profit is less but have a great
economic importance to the society.
32
 B. Socialist economic System: Production decisions

are made through a central plan that sets the
production targets for industries.
 Price policies become an important instrument of
public finance.
 C. Mixed economic system: Most of the
developing countries, including Ethiopia are
categorized under mixed economic system.
Contd………………..
33
 The concept of a mixed economic system refers to

that system in which decision making process is
shared between the public and the private sectors.
 All countries do not follow any uniform pattern of
economic development.
 But in most of them, the state plays an important part
in directing resources for economic development.
The Theory of Public Finance
34
 The theory of public finance economics provides a

rationale for the allocation function of public finance.
 The private market economy could not allocate all
goods either efficiently or equitably.
 Moreover, the government does not take over the
production and distribution of goods in most cases.
 Therefore, there is a distinction between privately and
publicly allocated goods & services.
35
 Conditions that makes a good private or public

 Private goods : are goods supplied by the market
mechanism
 Characteristics of private goods
 the exclusion principle applies i.e those who do not
pay the market price are excluded from their
consumption.
 The exchange cannot occur without property rights,
and property rights require exclusion.
Conted………………
36
 the existence of revealed preference: Producers in trying

to maximize their profits, will produce what consumers
want to buy and will try to do so at a least cost.
 Competition ensures that the mix of goods produced
corresponds to the consumer's preferences.
 consumption is rival: benefits are internalized and
diminished by the particular consumer who pays for
them. A bread eaten by individual A diminishes it and
the benefit is internalized by A cannot do the same to B.
 the marginal cost of providing a private good to an
extra consumer is positive.
Contd………………..
37
 Public Goods: Goods that are provided by the

public sector. The very nature of those goods and
services creates difficulty, if not impossible, for
markets to function efficiently.
 Characteristics of public goods
 consumers are unable to exclude others from
consuming precisely the same good; or producers
being unable to exclude others from consuming
precisely the same good.
38
 Example of such public goods are defense, public

roads, and bridges, street lights, etc which cannot
be divisible in consumption and if provided are
equally available to all.
 In public goods consumption is non rival, A’s
consumption does not reduce B’s consumption. there
for there are free riders- who consumes without
paying.
 The marginal cost of providing a public good to an
extra consumer is zero.
Functions of Fiscal Operation
39
 Fiscal operations consists of

 publicexpenditure (G)and
 Taxation (T)
 Functions of Fiscal Operation

 Allocation Function
 Distribution function
 Stabilization function
 Acceleration of economic growth & development

Questions
40
1. What is public finance?

2, What is the difference and similarities between
private finance and public finance?
3, what is the objective of public finance?
4, clearly justify the need of public finance in the
three economic systems.
5, what are the characteristics of public and private
goods?
CHAPTER 2:
FUNDAMENTALS OF WELFARE
ECONOMICS
Introduction
42
Welfare Economics – the branch of economic theory

concerned with the study of all feasible allocations
of resources for a society and the establishment of
criteria for selecting among these allocations.
welfare economics includes the study of society’s
value of commodities under alternative resource
allocations
Theory: Pure Exchange Economy
43
 We start with a simple model:

2 people
 2 goods, each of fixed quantity
 Determine good allocation
 The important results of this simple, 2-person model

hold in more real-world cases of many people and
many commodities
Pure Exchange Economy Example
44
 Two people: Mosses and Susan

 Two goods: Food (f) & Video Games (V)
 We put Mosses on the origin, with the y-axis
representing food and the x axis representing video
games
 If we connect a “flipped” graph of Susan’s goods, we
get an EDGEWORTH BOX, where y is all the food
available and x is all the video games:
Mosses’s Goods Graph
45
Ou is Mosses’s food, and Ox

is Mosses’s Video Games
Food
O x
Mosses Video Games
Edgeworth Box
46 Susan
r
y O’ O’w is Susan’s food,
and O’y is Susan’s
Video Games
Total food in the

Food
u w market is Or(=O’s)
and total Video
Games is Os (=O’r)
Each point in the
Edgeworth Box
O represents one
x s
possible good
Mosses Video Games allocation
Edge-Worth and Utility
47
 We can then add INDIFFERENCE curves to

Mosse’s graph (each curve indicating all
combinations of goods with the same utility)
 Curves farther from O have a greater utility
 (For a review of indifference curves, refer
Microeconomics)
 We can then superimpose Susan’s utility curves
 Curves farther from O’ have a greater utility
Mosses’s Utility Curves
48
Mosses’s utility is greatest at M3

Food
M3
M2
M1
O
Mosses Video Games
Edgeworth Box and Utility
49 Susan
r O’ Susan has the
S1 highest utility at S3
S2 A
S3 At point A, Mosses
Food
has utility of M3 and

Susan has Utility of
M3 S2
M2
M1
O s
Mosses Video Games
Edgeworth Box and Utility
50 Susan
r O’ If consumption is at
A, Mosses has utility
M1 while Susan has
A utility S3
S3 B
Food
C By moving to point
B and then point C,
M3 Mosses’s utility
M2 increases while
M1
Susan’s remains
constant
O s
Mosses Video Games
Perfect competition and Pareto
Efficiency Susan
51
r O’ Point C, where the

indifference curves
barely touch is
called PARETO
S3 EFFICIENT, as one
Food
C person can’t be
made better off
M3
without harming the
M2
M1 other.
O s
Mosses Video Games
Pareto Efficiency
52
 When an allocation is NOT pareto efficient, it

is wasteful (at least one person could be made
better off)
 Pareto efficiency evaluates the desirability of an allocation
 A PARETO IMPROVEMENT makes one person better
off without making anyone else worth off (like the
move from A to C)
 However, there may be more than one pareto
improvement:
Pareto Efficiency
53 Susan
r O’ If we start at point A:
-C is a pareto
improvement that
A makes Mosses better
S3 off
Food
S4 C
-D is a pareto
S5 E improvement that
M3
makes Susan better
D M2
M1 off
-E is a pareto
improvement that
O s makes both better off
Mosses Video Games
Optimum Welfare
54
 Welfare of a society is optimized if the following

conditions are fulfilled
1. Efficiency in consumption is achieved
2. Efficiency in production is achieved
3. Efficiency in product-mix is achieved
 That is when a general equilibrium is attained in
all markets.
Efficiency in Consumption
55
 Efficiency in consumption requires that MRS is

identical for all individuals.
Marginal Rate of Substitution (MRS)
The rate at which one commodity can be substituted for
another without changing a person’s utility
NB: equals the slope of the indifference curve
Pareto Efficiency Condition- Consumption efficiency

Efficiency In Production
56
 Efficiency in production requires that the combination

of goods actually produced must be on the
production possibility frontier (PPF).
 Efficiency in production Condition: requires that the
MRTS (Marginal Rate of Technical Substitution) must
be identical for all firms.
Efficiency in production
57
Marginal rate of technical substitution (MRTS):

The rate at which one production factor can be
substituted for another without changing the output of the
commodity
NB: equals the slope of the iso-quant

Efficiency in the Product Mix
58
 This condition concerns the interface between

production and consumption.
 The absolute value of the slope of the PPF is known
as the marginal rate of transformation (MRT).
 The MRT measures the opportunity cost of the
economy as a whole for a small increase in the
amount of good x relative to good y.
Efficiency in product mix
59
Marginal rate of transformation (MRT)

The rate at which the output of one commodity can be
transformed into output of another commodity by a shift
of a production factor from one production process to
another
NB: Equals the slope of the production possibility
frontier
Theory - First Fundamental Theorem Of
Welfare Economics
60
IF
1) All consumers and producers act as perfect competitors (no
one has market power)
and
2) A market exists for each and every commodity
Then
Resource allocation is Pareto Efficient
Contd……………..
61
 If Pareto Efficiency was the only concern, competitive markets

automatically achieve it and there would be very little need for
government:
 Government would exist to protect property rights
 Laws, Courts, and National Defense
 But Pareto Efficiency doesn’t consider distribution. One person
could get all society’s resources while everyone else starves.
 This isn’t typically socially optimal.
Second Fundamental Theorem of Welfare
62
Economics
 The SECOND FUNDAMENTAL THEOREM OF WELFARE ECONOMICS
states that society can attain any Pareto efficient allocation of
resources by making a suitable assignments of original endowments,
and then letting people trade
 Roughly, by redistributing income, society can pick the starting point in

the Edgeworth box, therefore obtaining a desired point on the Utility
Possibility Frontier:
Efficient Allocation of resources
63
 Each of the three efficiency conditions is necessary

for an efficient allocation of resources:
1. Efficiency in consumption requires that MRS is
identical for all individuals.
2. Efficiency in production requires that the MRTS be
identical for all firms.
3. Efficiency in the product mix requires that each
consumer’s MRS be identical to the economy’s MRT.
 This framework considers all markets in the economy
simultaneously and in equilibrium. Hence, it is known
as a general equilibrium analysis.
Why Income Redistribution?
64
 Why achieve equity through income redistribution instead of

taxes/penalties and subsidies/incentives?
 Taxes and penalties punish income-enhancing behavior,
encouraging people to work less.
 Subsidies and incentives give an incentive to stay in a negative
state to keep receiving subsidies and incentives.
 Lump sum transfers have the least distortion.
Welfare Economics Evaluation
65
 Welfare Economics asks 3 questions of every

government action:
1) Will it have desirable distributional consequences?

2) Will it enhance efficiency?
3) Is the cost reasonable?
 Although these questions may be difficult to answer, they provide

direction, and if they are all “no”, the government shouldn’t
interfere
Questions
66
1, what is the difference between pareto

Improvement and pareto efficiency?
2, what are indifference curves and what is their
characteristics?
3, list and discuss the three conditions that we can say
welfare of a society is optimized.
4. Discuss the difference among MRS, MRTS and MRT.
5, Discuss the theorem of welfare economics.
67
UNIT THREE
PUBLIC EXPENDITURE
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Meaning and Nature of Public
68
Expenditure
 Public expenditure is the expenditure incurred by
public authorities’ i.e central, state and local for the
satisfaction of collective needs of the citizens or for
promotion of economic and social welfare.
 Government plays a large role in the economy, as
regulator of the private sector, as supplier of public
service and many other ways. Hence, it incurs
expense.
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Contd………………
69
 There are some unique features of public

expenditure
1. public expenditure determines the amount of income
where as private expenditure is determined by the
individual’s income
2. public expenditure is not for profit motive
3. the target for public expenditure is a maximum return
for the state as a whole,
4. public expenditure is influenced by various political
motive and social aspects
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Scope of Public Expenditure in LDCs
70
 The scope of public expenditure in under developed

countries of mixed economies, like Ethiopia, can be
stated as follows.
 The public sector produces some important public goods,
which the private sector cannot produce
 The government may subsidize the private production of
certain partial social goods for increasing their output
 In underdeveloped countries, the public sector may have to
produce certain private goods which are considered
important from the point of economic development and
which the private sector is unable to afford
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71
 lack of enterprise or technical knowhow or lack of

experience, these goods to have strategic control over
the economy.
 Public expenditure may be used as a balancing factor
or contra cyclical measure to attain full employment
and maintain stability.
 Public expenditure may used to bring about equitable
distribution of income between different sections of
the community
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Classification of Public Expenditure
72
 Different economists have given their own style of

classification of public expenditure how ever they
are not mutually exclusive
 C.C. Plehn, Classify P. E. on the basis of benefits
 Public expenditure, which specially benefit certain
people,
 Public expenditure, which benefits equally to all.
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73
 Adam Smith has classified public expenditure

according to the functions of the government as:
 Protective,
 commercialand
 Development expenditure
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74
 Nicholson on the other hand categorizes on the

basis of revenue in that:
 public expenditure without direct return to revenue
(example poor relief on some cases),
 Expenditure without direct returns but with indirect
benefits to revenue (example education expenditure
with the assumption that educated people are better
tax payers),
 Expenditure with full return or even profit like that of
post office, gas service and generally public enterprises
etc
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 Other important classifications includes

 Productive: expenditures on social over heads
(construction of roads, schools, hospitals, telephone,
electric power, etc). education, training, health, better
living conditions etc, expenditure on research and
expenditure made to build efficient administration,
communication and other infrastructural facilities
indirectly add to the health and efficiency &
productivity of the economy.
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76
 un productive: expenditure for waging wars, for

ceremonial purpose etc are termed as unproductive.
 Pigou’s classification of P.E.
 Transferable: is a payment without corresponding receipt
of goods and services by the state. For example, old age
pensions and unemployment benefits.
 non transferable expenditures: is that by which the state
pays directly for the use of goods and services. Such a
use of resources by the state may be for consumption or
for investment purposes. These include expenditure on
defense, education, etc
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 The difference is that in the case of transferable

expenditure the beneficiaries have the right to decide
about the use of real resources, but in the case of non
transferable, it is the state which uses directly
 Generally; this way or that way the reason for
public expenditure is to maximize the social
welfare and to enhance fast economic growth
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Public expenditure: Canons, Theories
78
and Accountability
 Canons of public expenditure
 Some of these canons may be regarded as
principles, while others are no more than general
guidelines for the public authorities to help them in
their task of planning and execution of public
expenditure properly.
 The following will be the canons of public
expenditure:
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 Canon of Benefit. Public expenditure should be so

planned and implemented as to bring about the
greatest possible benefit to society. Thus, all non-
essential expenditures should be cut to the minimum.
 Canon of economy. Public expenditure should be
incurred carefully so that there is no wastage of
funds. Since resources are limited in the society, they
have to be most properly utilized.
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 Canon of surplus. This canon requires that

expenditure of public authorities should be kept
within the limits of current revenues. If possible, the
expenditure should be less than the earnings of
government so that the surplus so generated can be
used when there is unavoidable deficit.
 Canon of sanction. This canon requires that the
public authorities should not be allowed to spend
funds without having a previous sanction from
appropriate authority for the purpose.
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 Canon of elasticity. Canon of elasticity requires

that the rules of public expenditure should not be
too rigid to achieve the real purpose and that it
should be allowed to vary according to the needs
and circumstances.
 Canon of certainty. This canon requires that public
authorities should clearly know the purpose and
extent of public expenditure. The spending unit
should be certain as to the amount and objective of
public expenditure.
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Theories of Public Expenditure
82
 Economists have offered a number of theories on

public expenditure. The following theories of public
expenditure need special attention.
 1. Classical theory of Minimum expenditure.
 2. Principle of Maximum Social Advantage.
 3. Principle of Maximum Aggregate Benefit.
 4. Bowen's Benefit Theory of Public Expenditure.
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1. Classical Theory of Minimum
83
Expenditure
 Classical economists did not favor large public
expenditure.
 The 'laissez-faire' philosophy of Adam Smith implies
that individual is the best judge of himself and that
he will be the best productive agent if he is left free
to take his own decisions.
 They advocated the principle of sound finance,
according to which budget should always be
balanced, i.e. public expenditure should not rise
above or fall below revenue earnings.
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 The classical theory of minimum expenditure is

based on the assumption of full employment on the
one hand and laissez-faire doctrine on the other.
 Since the economy operates at full employment
level, it functions with maximum efficiency.
 Moreover, with the philosophy of ‘laissez-faire’
follows, that most of the economic activities are
performed by the private sector.
 hence, the size of public expenditure is always small
and the budget should always be balanced.
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2. Principle of Maximum Social
85
Advantage
 Public expenditure is made from the resources
mobilized through taxation or borrowing to balance
any further increase in the advantage to the community
 The principle of maximum social advantage lays down
on that public expenditure should be so planned and,
 hence, revenue resources so raised so as to bring about
benefit larger than sacrifice and that the surplus of
aggregate satisfaction in the society is maximum.
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 To judge whether the principle of maximum social

advantage is secured or not, the following points
have to be considered.
 The character and composition of public expenditure is
the most important consideration.
 Large expenditure on investment means large
sacrifice of tax payers. However, the ultimate
benefit may be much larger than the communities’
sacrifice.
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 Secondly, the method of taxation has to be judicious.

 The method should be employed which will result in
least sacrifice.
 Thirdly, tax-expenditure programme should be so
structured to increase the productive capacity of the
community and, hence, enhanced national income.
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 The principle of maximum social advantage is

derived from the principle of equi-marginal returns
as applied to an individual.
 Thus, if it is found that marginal utility from public
expenditure on medical and public health measures
is greater than the marginal utility derived from the
same amount spent on provision of public parks,
then the government should transfer the public funds
from the park to medical account.
 This will maximize social advantage.
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3. Principle of Maximum Aggregate
89
Benefit
 “expenditure should be pushed in all directions up
to the point, at which satisfactions obtained from the
last money expended is equal to the satisfaction lost
in respect of the last money called upon government
service.”
 Thus, Pigou brings in both taxation and expenditure
sides of the budget determination. His theory
determines the size of the budget.
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 Pigou's theory requires the application of two rules,

viz.,
 (a) the principle of equi-marginal returns in such a
way that marginal utility from each type of
expenditure is equal and
 (b) the principle of equality between marginal
social sacrifice and marginal social benefit.
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4. Bowen's Model of Public Expenditure
91
 Since social goods, by definition, are those goods

and services which are consumed equally by all.
 Hence, the cost of supplying them have to be
contributed by all beneficiaries.
 However, every user cannot be asked to contribute
equal amount in meeting the cost of social goods
because different individuals will derive different
amounts of satisfaction.
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Conted……………..
92
 Since social goods benefit everyone, the amounts of

benefit derived by different individuals are like
joint products.
 Hence, it is the joint contribution of all individuals
that has to meet the cost of supplying social goods.
 Suppose a public park is provided in a locality of
100 individuals.
 The benefit of public Park is consumed equally by
everyone.
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Contd………………..
93
 Hence, the cost of supplying must be raised from the

aggregate contribution of 100 individuals.
 It must, however, be noted that each individual will pay
an amount equal to the marginal valuation he attaches
to the social good, i.e. the public park services.
 This follows from rules of economic efficiency.
 Since the capacity to enjoy benefit of the public park,
as in case of anything else, is different for different
persons, they will attach different marginal valuation to
the benefit and will contribute different amounts for the
consumption of the same public good.
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 How much amount of social goods is to be supplied by

the public authority will be determined at that level
where marginal cost of supplying the social goods
becomes equal to the sum of marginal utilities received
by the beneficiaries.
 Assuming that there are only two individuals in society,
viz., A and B and only one type of public goods, called
X, the following condition will hold for the determination
of public expenditure or, what it means the same thing,
the amount of social goods to be supplied by the
government.
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 MUA + MUB= MCx, Or

 Px-A + Px-B = MCx, Hence, TCx = QPx-A + QPx-B,
 where MU stands for marginal utility derived from
social goods, MC stands for marginal cost of
supplying social goods, A and B are consumers, X
stands for the social good supplied, P stands for
price to be paid by the consumer, Q indicates
quantity of social goods and TC stands for total cost
of supplying the quantity.
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 where MU stands for marginal utility derived from

social goods, MC stands for marginal cost of
supplying social goods, A and B are consumers, X
stands for the social good supplied, P stands for
price to be paid by the consumer, Q indicates
quantity of social goods and TC stands for total cost
of supplying the quantity.
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Control and Accountability of Public
97
Expenditure
 The necessity to control public expenditure in order to
check misuse of public funds and ensure their efficient
utilization is obvious.
 Control of public expenditure is sought to be ensured
multi-dimensionally at a number of stages. The most
important means of control are
 (a) budgetary control
 (b) legislative control
 (c) executive control
 (d) audit control, and
 (e) parliamentary control.
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 Budgetary Control. Budget preparation is the most

primary stage of expenditure control. Budget is a
well thought-out plan of governmental activities
during the coming year and speaks of much more
than a mere statement of income and expenditure
of public authorities.
 It specifies the functions and objects of public
expenditure.
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 Legislative Control. After the budget plan is

prepared, it has to be presented in the legislature
for its approval. There occurs debate in the
legislature where the members seek clarification
and justification of expenditure programmes.
 During the legislative scrutiny of the budget, the
details of expenditure, department-wise and
ministry-wise are discussed. Thus, it is a very
important stage of expenditure control.
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 Administrative Control. The rules and regulations ensure

that no amount is spent without proper sanction or
diverted to some other purpose for which it is not
sanctioned.
 Audit Control. The next stage is scrutiny of accounts and
audit control. There is the system of both internal and
external audit. Every department has its accounts
section which scrutinizes all accounts of expenditure and
ensures that public funds are spent according to rules of
propriety, economy and efficient utilization.
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 Parliamentary Control. The last of these stages of

expenditure control is the parliamentary right to
enquire into any particular item of expenditure deal.
 There are two committees constituted by the parliament
to go into such scrutiny.
 They are
 (i) Public Accounts Committee is entrusted with the
responsibility of examining audit reports and
appropriation accounts. They also examine profit and
loss accounts of government undertakings and
autonomous bodies.
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 They follow up cases of impropriety, unauthorized and

illegal expenditure, misuse and misappropriation and
go into further investigation if necessary.
 (ii) the Estimates Committee. locks into the financial
operation of the executive and suggests measures to
achieve maximum economy of expenditure consistent
with maximum efficiency.
 The parliamentary committees pinpoint the erring
officials, examine them and suggest follow-up measures
for suitable punishment to them.
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Effects of public expenditure on
103
production and distribution
 Effects on Production and Employment
 Expenditure on agriculture and allied services, industries
and minerals, water and power development, transport
and communication and other expenditures on
community and social development by the State
Governments help directly to raise the level of
production and employment in the country.
 the enormous expansion in expenditure by the State
Governments is to boost demand for goods and
services and thus to boost production.
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Contd……………...
104
 The level of production and the level of employment

in any country depends upon three factors, viz.,
 Abilityof the people to work, save and invest,
 Willingness to work, save and invest, and
 Diversion of economic resources as between different

uses and localities.
 It is possible to influence all these factors through
public expenditure either for the better or for the
worse.
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Effect of public expenditure on
105
distribution of income
 While taxes, particularly progressive direct taxes,
have the effect of reducing the incomes and wealth
of the higher income groups, public expenditure has
the effect of raising the incomes of the lower income
groups.
 Government's expenditure on education, public
health and medicine, housing, etc., is directed to
help the poor and the lower income classes
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Public expenditure and control of
106
inflation
 Inflationary pressures may be considerably
lessened if government expenditure is reduced.
 This may be taken as a simple and direct solution,
but for the fact that, in the majority of cases, the
most serious type of inflation has always been due
to enormous government expenditure.
 However, the government can suitably change and
adjust its expenditure during an inflationary period
so that the inflationary pressure may be reduced.
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Content of Development Expenditure
107
 Stimulating private initiative Development

expenditure of the government will take the form of
stimulating private initiatives and enterprises.
 Direct stimulation is done by the Government
helping the private sector through loans, subsidies,
tax concessions and exemptions and providing
market and other information and research
facilities.
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 Provision of social and economic overheads. Indirect

stimulation of the private sector may be done by
the government through the provisions of social and
economic overheads -education and public health
will come under the first head, and provision of
power, transportation, communication, etc., will come
under the second head.
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 Public enterprises. The government will have to start

and run such undertakings which the private sector
may be unwilling to undertake, either because
profit margins are low or almost nothing, or because
they require huge capital investment and a long
time to yield returns.
 all the key and basic industries, development of
irrigation resour-ces, electric power, etc. are some
of them.
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Questions
110
1, what is the importance of public expenditure?

2, what is canons of public expenditure?
3, how does public expenditure affect the economy?
4, what are the causes for increasing public
expenditure?
5, how the government can control inflation by using
public expenditure?
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UNIT FOUR
PUBLIC REVENUE
INTRODUCTION
112
 The necessity of public revenue is due to the

necessity of public expenditure.
 As the government has to perform certain functions
for the welfare of the public and these functions
are not performed free of cost, they involve
expenditure.
 the state provides social goods and services such
as defense, health services, education, streetlight,
highways and other infrastructures.
 To finance them it needs income.
Contd…………….
113
 Thus the amount of public revenue to be raised is a

function of necessity of public expenditure.
 The government can collect revenue from different
sources .
 The income of government through all these sources
is called public revenue.
 Of these various sources of government revenue
taxation is the most important one.
Meaning and Source of Public Revenue
114
 In its wider sense, P.R. incorporates all receipts and

incomes that a public authority may get during any
period of time irrespective of their sources and
nature and is called public receipt.
 Generally government sources of revenue are
generally divided as tax revenue and non-tax
revenue
 Tax revenue - In every country, the largest part of
the public revenue is raised through taxation and
mainly it incorporates the following three sections.
115
 Taxes on income and expenditure- it deals with taxes

that are imposed on receipts and expenditures such as
corporation tax, income tax, expenditure tax, interest
tax and other similar taxes.
 Taxes on property and capital transaction- this part
includes taxes imposed on specific form of wealth and
its transfer.
Example, estate duty, wealth tax, gift tax, house tax, etc
 A tax on commodities and services -it is concerned on
taxes levied on production, sale, purchase, transport,
storage and consumption of goods and services.
116
 Non-tax revenue: Public revenues received through

administration, commercial enterprise, gifts and grants
are non- tax revenue of the government.
 Administrative revenue- under administration public
authorities can get income in the form of
 fees,
 fines and penalties, and
 special assessments.
 Profits of state enterprise- these are important sources

of revenue these days, owing to the expansion to the
public sector. These revenues are received in the form
of prices paid for the government produced goods and
services.
117
 Grants and Gifts- they cover very small part of

public revenue. Usually patriotic people or
institutions may provide gifts to the state.
 They are voluntary contributions that are beneficial
particularly during wartime and emergency.
 Local governments obtain grants from state government
and state government from the center. It is said to be
grants - in - aid.
 When one country’s government makes grants to
another country's government, it is referred to as foreign
aid.
118
 Borrowings- It has many forms. But the most important

are fresh borrowings that can be categorized
according to their origin and maturity.
 Interims of their origin: public borrowing may be
 external or internal.
 Interims of their maturity: public borrowing may be
 long term, medium term and short term
 Note. Income and profit from the creation of currency
by government that is greater than its face value of
currency over its cost of creation are also incorporated
into the category of non-tax revenue.
Tax Revenue
119
 Fund raised through the various taxes is referred to

as tax revenue.
 Taxes may be imposed on person's income or
wealth, they may be direct or indirect and they may
be different rates and nature.
The main characteristics of a tax are
120
as follows
 A tax is compulsory payment to be paid by the
citizens who are supposed to be liable to pay it.
Therefore, anyone who wants to refuse to pay a
tax will be punished.
 There is no direct quid pro quo between the
taxpayer and public authority. This means a
taxpayer may not receive a benefit
proportional to the tax that he has paid. (Quid
pro quo means something given or taken as
equivalent to another.)
121
 A tax is imposed to meet public spending incurred by

the government in the general interest of the nation.
It is a payment for the indirect service to be
provided by the government to community as a
whole.
 A tax is not a price paid by the taxpayer for any
definite service rendered or a commodity offered
by the government.
 A tax is payable regularly and periodically as determined
by the tax authority. For instance, income taxes are
usually paid annually.
The Base of a Tax
122
 The tax collecting authority has legally described

the object on which the tax is imposed.
 The base of each tax has to be defined legally and
quantified for the purpose of determining the tax
liability for an individual taxpayer.
 Each taxpayer is considered as a legal entity for
this purpose. According to the different tax base, an
individual taxpayer may be subjected to more than
one tax.
Buoyancy of a Tax
123
 The growth of tax base increases the tax revenue.

 This rise in tax revenue is termed as buoyancy of
tax.
 A buoyant tax has an inherent tendency to yield
more tax revenue with the growth of its base.
Objectives of taxation
124
 Objectives of a tax system in an economy are

mainly connected with
 The overall economic and non- economic policies of the
government
 The non-tax components of its fiscal policy
 Institutional and other situations faced by the economy.
 Objectives of a tax system differ significantly in

between
 Developed countries
 Underdeveloped countries
125
 The main problem affecting the developed

countries is instability of income and
employment. Therefore, they design their tax
system to solve this problem.
 Unlike advanced nations the primary objective
of taxation in underdeveloped countries is not

related to instability of
 Incomeand
 Employment
126
 Rather these countries, like Ethiopia, have been

affected by several problems that are related
with
 Economic growth
 Poverty
 Inequality
 Health
 Chronicunemployment
 Regional disparities etc.
Canons of Taxation
127
 By cannon of taxation we mean those characteristics,

which a good tax should, posses. The canons of
taxation are concerned with the rate, amount and
method of levy and collection of a tax.
 The first set of principles developed by Adam smith is
referred to as canons of taxation. These are:
 Canon of equality
 Canon of certainty
 Canon of convenience
 Canon of economy
 Let us discuss each of these as follow.
128
 Canon of Equality: It explains that taxation must be

distributed equally in relation to the ability of the
taxpayer.
 It requires that the rich should pay more taxes and the
poor should bear a lesser burden.
 However, if we interpret this principle with regard to
disutility which taxpayers sacrifice by paying taxes, the
tax should impose equal marginal disutility up on every
taxpayer.
 This situation results in two possibilities of imposing a
tax.
129
 On the one hand, if the marginal utility of income is

constant, the rich as well as the poor people should
pay a given percentage of their income in the form
of tax.
 On the other hand, if we agree that the marginal
utility of income decreases, equality can be
approved when the rich pay larger proportion of
his income as taxes and the poor pay smaller
proportion of his income in the form of taxes (i.e.
tax should be progressive).
130
 However, it is obvious that the marginal utility of

income goes on diminishing with the increase in its
stock and hence the rich person feels less disutility
or sacrifice in paying taxes than the poor person
paying at the same rate.
 Therefore, if the canon of equity to be properly
observed ,the progressive taxes must be
advocated.
131
 Canon of certainty- it indicates that taxation has to

include the element of certainty to prevent the
taxpayer from unnecessary harassment by tax-officials.
Adam smith said that the tax that is paid by each
individual should be certain and not arbitrary. This
means
 the time of payment
 the manner of payment and the person to whom the tax is
to be paid
 the amount to be paid should be clear to the contributor
and every person
132
 Canon of Convenience- According to this canon

tax should be collected in away that are convenient
for the taxpayer as far as possible.
 For instance, it is convenient to collect a tax from
salaried employees at the time of paying salaries.
 Canon of Economy: It is clear that government has
incurred costs to collect taxes.
 Consequently, this principle suggests that the cost of
collecting taxes should be as minimum as possible.
Contd………………..
133
 However, in view of developments in economic

philosophy, economists have added a few more
canons. These are
 Canon of elasticity
 Canon of productivity
 Canon of Simplicity
 Canon of diversity
 We shall briefly discuss them as follows

134
 Canon of elasticity- it states that taxation should

be elastic in nature for the purpose of collecting
more tax when income of the people increases.
 This means, it should be possible for the authorities
to revise the tax structure both with respect to
coverage and rates to fit it the changing
requirement of the economy and the Treasury
135
 Canon of productivity- it indicates that the tax

system should be able to generate enough revenue
for the treasury.
 And the government should have no need to resort
to deficit financing and taxes should be levied that
they do not obstruct and discourage production.
136
 Canon of simplicity- it suggests that the tax system

should not be too complex and beyond the
understanding of the layman.
 Rather, it should be as simple as possible. So that
the tax payer should not be confronted with
accounting, administrative and other difficulties
137
 Canon of diversity- it implies that taxes should be

imposed on diverse sources because having a single
tax system may be risky and inequitable.
 However, too much multiplicity of taxes should be
avoided because it leads to unnecessary cost of
collection and violates the canon of economy.
Features of a Good Tax System
138
 A good tax system does not mean a perfect tax

system that contains all the taxes, which fulfill:
 Allthe canons of taxation
 Fetching adequate revenue for the public service.
 Causing no hurt to the taxpayer.

Contd………………..
139
 Rather, a good tax system is one which

 has predominately good taxes
 fulfils most of the canons of taxation
 yield sufficient revenue
 causes minimum aggregate sacrifice to the people
 Least obstructs the incentives for production.

Contd………………..
140
 Thus for such a good tax system to exist, the

following principles must be observed:
 It should ensure maximum social advantage –the effect
that the tax produce must be considered i.e the effect
on production and distribution of wealth in a society.
 It ought to cause minimum aggregate sacrifice, i.e., the
tax burden should be imposed according to the ability
to pay the tax.
 It should satisfy most of the canons of taxation
141
A good tax system should have built in flexibility, so

that changes are possible according to the changing
condition of the dynamic economy.
 It ought to be a balanced one. This means it should not
contain just, progressive, regressive or proportional tax
only but a combination of all taxes. Because all type of
taxes has its own merits and demerits
Contd………………..
142
 The good tax system should be multiple, but greater

multiplicity is not necessary.
 In addition, in a good tax system there should be
simplicity,
 Furthermore, a good tax system should not hamper the
development of trade and industry otherwise it ought
to buttress the economic development of the country.
Theories of Taxation
143
 Economists focus on the issue of tax burden and

justice for equity in its distribution.
 Accordingly tax burden can be classified as
1. Money burden of taxation: is the amount of money
income transferred from the people to the
government by way of various taxes.
2. Real burden of taxation: refers to the volume of goods
and services transferred from the payers to the
government or the value of money raised by the
government.
144
 Equity on taxation refers to fairness or justice in the

distribution of tax burden.
 There are two classes of equity
1. Horizontal equity: implies that people in equal
economic circumstance should pay equal amount of
taxes.
2. Vertical equity: people who are in different economic
situation should be treated differently
The rich people should pay more taxes than others.
Theories of equitable distribution of
145
tax burden
1. The Socio- Political Theory
 Every economic problem should be looked at its
social and political context

 The main objective of taxation is the realizing socio-
economic stabilization through reducing
 income inequality
 unemployment
 cyclical fluctuation
146
 Therefore, this principle emphasizes on that

 thepoor, religious, educational, and Charity
organization should be free from tax
 because imposing tax on them may lead to social
instability
147
2. Cost of Service Theory (supply side)

 The cost incurred by the government in providing
public goods and services would be regarded as

the basis of taxation.
 Thus, citizens should pay a tax as per the cost of
public goods enjoyed.

 In other words, government is just like a producer of
social goods and services, and taxes are the price
for those goods
Contd………………….
148
 Weakness
 Estimating the cost of social goods and services offered
to each individual is difficult
 It violates the property of tax. Tax is not price.
 It does not consider the essence of welfare. If cost is

the base of taxation, government cannot provide free
education and medical care to the poor.
149
3. Benefit- Received Theory (demand side)

 The burden of taxes should be divided among
taxpayers in relation to the benefits enjoyed from

the government.
 This means those who get more benefit from public
goods should pay more taxes than others

150
 Weakness
 Measuring benefits received by an individual from
public goods is difficult. Benefit is ultimately subjective
 It results in injustice. This principle recommends imposing
more tax on the poor because they get more benefit
from social goods and services.
 It does not address the main objective of taxation, i.e.
reducing income disparity.
Contd………………..
151
4. The ability to pay principle Theory

 The burden of taxation should be distributed
among members of the society according to the

principle of justice and equity.
 This means that the tax should be imposed on the
taxpayer based on their relative ability to pay.

 There are two indices for measuring ability to pay.
152
 A. Objective Index of Measuring Ability to pay- it

considers the money value of the taxable capacity
of each taxpayer rather than their psychology of
sacrifice and feelings
 The indices used to measure the ability to pay are
 Property (houses, farms, factories, equipments etc)
 Consumption expenditure
 Income etc.
Contd………………..
153
B. Subjective Index of Measuring Ability to pay:

 Taxpayers suffers a sacrifice by paying the tax.
 It supposes that taxation does not make the
taxpayer feel better by the idea that he is

contributing to the welfare of the society.
 Tax liability of the taxpayer s should be related to
equal sacrifice principle

154
 There are three alternative ways of interpreting

equal sacrifice
i. Equal absolute sacrifice- tax imposed on a higher
income individual should cause him to lose an
amount of satisfaction (utility) equal to that
scarified by a lower income tax payer. In other
words, higher income people should pay more tax
then the other.
Contd………………...
155
i. Equal proportional sacrifice- the loss of utility

(satisfaction) in tax payment should be
proportional to the total income of each taxpayer.
ii. Equal marginal sacrifice or least aggregate sacrifice
- the marginal utility of income sacrificed by all
taxpayers should be the same
Contd………………..
156
 The marginal utility of income for a higher income

people is low and the marginal utility of income for
lower income people is high.
 Therefore, the rich should pay more tax than the
poor.
 Out of these three versions, equal marginal sacrifice
is considered as the best and generally accepted
principle of taxation by modern economists.
Taxable Capacities
157
 Economists have defined taxable capacity as the

ability of the people to pay tax without adversely
affecting or worsening their standard of living and
efficiency
 i.e it is the maximum capacity of the community to bear
tax without much hardship.
 Taxation beyond the taxable capacity is over-
taxation. It results in economic as well as political
instability.
 Taxable capacity can be seen in two ways
Contd………………..
158
1. Absolute taxable capacity- the amount of money or

the proportion of income that can be taken away
by the government from people in the form of
taxes without producing unfavorable effects.
 It represents the maximum amount of tax that can
be collected from the individuals of a particular

country.
Contd………………..
159
 In the long period, it is bound to change through

growth in savings, investment, economic growth,
changes in the production pattern etc.
 Therefore, the determination of absolute taxable
capacity is almost impossible.
160
2. Relative taxable capacity- In the relative sense, the

reference is to the proportion in which two or more
nations or group of persons or states in a country
contribute towards the common expenditure through
taxation.
 It is possible to determine in advance the proportion
in which two or more communities should contribute

in order to meet some common expenditure in
accordance with their respective abilities to pay.
161
 The richer community shall be called up on to bear

a greater share of such common expenditure
 The concept of the relative taxable capacity is
more useful in a federal economy like Ethiopia,
where different states are required to contribute
towards a common expenditure.
 In other words the relative taxable capacity is the
capacity of the community to contribute to some
expenditure in relation to the capacities of other
communities.
Factors Determining Taxable
162
Capacity
 The size of National Income
 The distribution of income
 Size and rate of population growth
 Pattern of Taxation
 The Stability of income
 Nature of public expenditure
 Psychology of the taxpayers
 Standard of living of the people
 Administrative efficiency
 Economic Situations
 Political conditions
Classification of Taxation and Types
163
of Taxes
 Reading Assignment!
Questions
164
1, What are the major source o f revenue of the

government?
2, What are the qualities of good tax system?
3, Explain the canons of taxation.
4, what are the main principles of taxation?
5, distinguish between direct and indirect taxation.
6, explain the concept of equity in taxation.
165
UNIT FIVE
PUBLIC DEBT
INTRODUCTION
166
 To finance its expenditure, government collects its

income from
 tax and
 non-tax revenues
 When government revenue is greater than its

expenditure, there is budget surplus
 If government revenue is equal to its expenditure,
there is budget balance.
 When public expenditure exceeds its revenue there
is budget deficit
167
 This budget deficit leads to the problem of public

debt
 In modern times, borrowing by the government has
become a normal method
 However the composition of loan is significantly
different in developed and underdeveloped
countries
 Publicborrowings of the less developed countries
generally comprises in a very large part of the
borrowings made from abroad while
168
 in a developed country these may mainly consist of the

borrowings raised internally from the local authorities,
institutions and individuals.
 However both internal debts as well as external
debt are the essential and important constituents of
public debt.
Sources of Public Borrowings
169
 There are two important sources of public

borrowings,
 internaland
 external sources.
 Necessity of Public Borrowing

 To Finance War
 To Fight Depression
 To Meet Unexpected Emergency
 To check Inflation
 To Finance Economic Development
Classification of public Debt
170
 Generally public debt is categorized based on the

 Source of borrowing
 Purpose of loan
 Time duration of loan
 Nature of contribution of loan
1. Source of Borrowing
A. Internal borrowing: may be voluntary or compulsory
where as external debt is voluntary in nature
Can be estimated before hand with certainty
Contd………………..
171
 the availability of total resources is not increased.

2. external debt: is voluntary in nature.
 The realization of external borrowing is so much
conditioned by the international politics' and foreign
policies of the lending government
 the foreign exchange resources of the borrowing nation
increases; but this foreign exchange reserve is
diminished to that extent when there is repayment of
such loan.
 external borrowing results in a transfer of wealth from
the borrower to the lender nation that led to a
decrease in the total output of the borrower country.
Contd………………..
172
2. Purpose of Borrowing:
 Productive debts- debts that are invested on productive
assets like railways, irrigation, dams, roads,
multipurpose projects etc
 Unproductive debts- those debts that don’t add to the
productive asset of the economy. Those are debts used
to
 financing war
 public administration
 relief expenditure etc are examples of unproductive debts.
 Unproductive debts are not self- liquidating. Therefore
they impose a burden on the community.
Contd………………..
173
3. Time/ Duration of loan

 short-term: which mature within a short period of
time say from 3 months to 1 year.

 medium –term: debts which mature in between one
and ten years.
 long- term debts: debts which mature after a long
period of time usually ten years or more.

174
4. Nature of Contribution
 Funded debt – is that public debt for the repayment of
which the government establishes a separate fund.
these debts are usually long-term debt used for
productive purpose.
 Used for the construction of permanent asset
 Unfunded debt –is that debt for the repayment of which

the government sets up no separate fund. These are
usually short-term debts used for meeting current needs.
 They are repaid from other source of income
 They have no specification of time

Effects of Public Debt
175
 Effects of public debt on

 economic growth
 inflation
 political freedom
 distribution of income
Burden of public Debt and Debt trap
176
 Debt burden The amount of money that a

borrowing country repays in the form of principal
and interest to the creditor.
 According to its source, there may be
 External debt burden: The sum of money that a
borrowing country repays in the form of principal and
interest to the creditor measures direct money burden
of external debt where as the direct real burden is
measured by the loss of economic welfare in terms of
consumption of goods and services foregone for the
repayment .
Contd………………..
177
 The extent of the burden depends on the purpose

for which the debt is incurred. External debt rose
for war expenditure or other unproductive activities
will increase the real burden to the society
 External debt incurred for development purpose will
not be a burden but a profitable undertaking
 However, it is recommended that there should be a
limit for external public debt, so that repayment does
not impose heavy burden on the borrowing
community.
178
 Generally the incidence of external public debt can

be discussed on the following headings
 Direct Money Burden: the debtor country has to
pay to the creditor country every year large sums
of money by way of payment of interest on loan
and the principal amount up on maturity in terms of
foreign exchange.
 In order to earn this foreign exchange, the country
has to make exports
179
 Indirect money burden: Sometimes, the debtor

country has to pay interest in terms of the goods
and services to the creditor country.
 In other words, the debtor country has to export
goods and services on a large scale to the creditor
country.
180
 This inevitably results in a rise in the prices of these

goods and services in the country
 As a consequence there will exist a fall in the economic
welfare of the society. This fall in community’s welfare
shows the indirect money burden of the external public
borrowing’s
 Direct real burden: The government most of the time
imposes new taxes on the people to pay the debt.
Thus, the burden of these taxes falls more heavily on
the poor rather than on the rich section of the society.
Contd………………..
181
 Indirect real burden: As a result of imposition of new

taxes to pay the debt, the capacity of the people to
work, save and invest declines which will have
unfavorable effects on production.
Measurement of External Debt
182
Burden
 The extent of external debt burden can be measured by the following
ratios
I. Debt Service Ratio = external debt service
 National income (at current price)
 This measure indicates the extent to which the burden of debt
service has raised or declined over a given period of time.
II. Debt Service- Saving Ratio = external debt service

Saving (at current price)

 It has indicated the effect that external debt service imposes on

saving and in turn on capital formation of the country.
183
III. Debt Service- Export Earnings Ratio

= external debt service
Export Earnings

 It indicates how much of the export earning is used for

repaying the interest on external loan.
IV. Debt service- Tax Revenue Ratio = external debt service
total tax revenue
 It indicates the proportion of tax revenue that is directed

for repaying external debt
Contd………………..
184
 Internal Debt Burden

 Direct money burden: Internal debt is borrowed
from individuals and institutions inside the country.
 As a result; it will redistribute resources without
resulting any change in the total resource of the
community.
 Therefore, internal debt does not impose direct
money burden on the country because the tax
collected for repaying the debt redistributes
resources from one section of the society to another.
Contd………………..
185
 Indirect money burden: However, internal debt

may result indirect money burden. When the
government spends the loan on development
projects, it results in the creation of demand for
several commodities and services.
 As a consequence, the prices of these goods and
services rise, imposing additional burden on the
society.
Contd………………..
186
 Direct real burden: Internal debt may result in a

direct real burden according to the sources tax is
collected to finance the debt.
 When the tax collected from the rich people is
smaller, there will be a direct real burden where as
if the extent of direct real burden will be lesser if
the rich section of the society pays higher taxes.
187
 Indirect real burden: In addition to this, transfer of

income for serving an internal debt transfers from
the active to the inactive enterprise.
 Government has imposed taxes on enterprises and
earnings from productive efforts for the benefit of
idle, old and inactive bond holders which penalize
work and productive risk taking efforts, It adds to
the net real burden of the debt.
Measurement of Internal Debt Burden
188
 Internal public debt indicates a financial burden on

the government.
 The size of internal debt burden can be measured
or estimated through the following methods.
I. Debt Service Ratio = annual interest payment on public debt

 National income (at current price)
 It indicates the extent to which government must tax
national income so as to raise enough revenue to pay
the interest on debt
Contd………………..
189
II. Interest Cost- Revenue Ratio= debt service change

 total tax revenue
 It indicates the effect of public borrowing on the budget of the
country
A. Interest Cost- P. E Ratio= annual interest payment
 total expenditure
 It shows the proportion of revenue expenditure that is used for
paying the debt service (interest of debt),
B. Interest Cost- Profit Ratio= interest payment on public debt
 profit of public enterprise
Contd………………..
190
 It indicates the extent of public debt that is used for

achieving production activities.
 This measure is applicable when the borrowed fund
is invested on measurable productive industrial
projects. But it is difficult to apply it in most of
developing countries like Ethiopia where
government allocates these funds on social
overheads, power generation, infrastructure
development etc.
191
 Debt Trap
 Debt trap refers the situation of vicious circle of
borrowing when the government must borrow so as
to pay the interest charges on the previous loans
and to repay the principal borrowed.
 This means, the fresh loans raised are not used for
investment or capital formation rather for repaying
the earlier debt incurred.
192
 Conversion- refers to situation of converting the

existing debt into a new debt prior to maturity with
benefit of servicing charges.
 Debt Redemption
 Debt redemption is a means of repaying a loan.
 Different means are used by the government to
redeem its debt. The major means adopted for
redemption of public loans are
Contd………………..
193
 Refunding - government issues new bonds and

securities so as to repay the matured debts. This
process is said to be refunding.
 In this process long-term securities replace short-
term securities. So the money burden, under this
process, is accumulated rather than reduced
because government has postponed the date of
payment.
Contd………………..
194
 Surplus budgets- refer to the method that

government repays its debt by keeping public
expenditure lower than the public revenue
obtained.
 However, surplus budget is a method that is used
rarely because of ever- increasing public
expenditure.
195
 Sinking fund- is a method that government

regularly keeps some money in such a manner that
it would be enough to retire the debt at the time of
maturity. For this method of debt retirement,
government budget must have overall surplus.
 Perhaps it is the most systematic and best method of
redemption
Contd………………..
196
 This approach is applied by a number of countries.

But this method can succeed in repaying the debt
only if there is substantial budget saving every year
and no additional borrowing
 Additional Taxation - The simplest method that
enables the government for debt redemption is
imposing new taxes and gets the required revenue
to repay the principal as well as the interest.
197
 Capital levy - refers to a very heavy tax on

property and wealth. Dalton recommended that
government could repay its debt with the least real
burden on the community
 Surplus Balance of Payment- An economy can
repay its external debt only through the
accumulation of foreign exchange reserve.
 This requires the creation of surplus balance of
payments by the debtor nation. A nation can realize
this by increasing its export and reducing its import.
Public Debt Management
198
 The term debt management refers to the

formulation and implementation of debt policy
designed to achieve certain objectives such as,
Economic stabilization, Economic growth,
Employment, Overall soundness of financial system
 According to the traditional state debt management
is emphasized on keeping its interest rate to the
minimum possible and repaying it as soon as
possible.

Contd………………...
199
 Whereas modern welfare state; has considered

debt management as a means of gaining various
socio-economic developments.
 Debt management and monetary policy affect
stabilization and economic growth.
 Therefore, debt management policy should be
formulated harmoniously with monetary policy.
200
 the debt management policy should not have any

adverse effect on the economy especially on
willingness and ability to work, save and invest.
Moreover, during inflation it should be designed to
curtail aggregate demand
 Furthermore, at the time of depression government
should design its debt management policy to raise
aggregate demand and thereby it can increase
output and improve employment in an economy
Principles of public debt management
201
 Minimum interest cost. If the interest is low, it will

impose less burden of taxation at the time of
redemption
 Satisfaction of investor’s needs. The terms of loan
should attract the public to invest in government
securities.
Contd………………..
202
 Funding of short-term debt into long-term debt

Public debt management should enable the
Government to convert short-term loans into long-
term loans.
 Co-ordination of public debt policy with
monetary and fiscal policy. Public debt
management should not clash with monetary or
fiscal policy.
Contd………………..
203
 Composition of public debt and maturity. If the

public debt program results in a large proportion of
short-term debt held by commercial banks, there
will be a high degree of liquidity in the market.
 This can generate inflation.
 If the holders of such liquid assets try to monetize
their debt obligations before maturity, controlling
inflation will be difficult.
Questions
204
1, what is public debt? What are the reasons for

incurring public debt?
2,what are the types of public debt?
3, what are the methods of redemption of public
debt?
4, list and discuss the measurements of internal debt
burden
5, what do we mean by budget? Explain the
objective of budget.
205
CHAPTER SIX
ANALYSIS OF FISCAL POLICY
AND PRINCIPLE OF FEDERAL
FINANCE
Introduction
206
 The use fullness of fiscal policy as an appropriate

instrument to regulate the economy was recognized
after the publication of Keynes’s well known book
“The General Theory of Employment, Interest and
Money” in 1936.
207
 The post Keynesian revolutionary popularity of

fiscal policy has been largely due to the following
three factors.
 Ineffectiveness of the monetary policy as a means of
removing mass unemployment in the great depression
of 1930s.
 The development of ‘ new economics “ by Keynes with
its stress on the role of aggregate effective demand
 The growing importance of government spending and
taxation in relation to national income and output.
208
 Today as an instrument of macroeconomic policy,

fiscal policy has been very popular with modern
governments to influence the size and components
of national product, employment, preventing
inflation, promoting rapid economic growth and
encouraging long run economic stability.
Meaning and Objective of Fiscal
209
Policy
 In the view of American Economic association “fiscal
policy means the policy which concerns itself with
aggregate effects of government expenditure and
taxation on income, production and employment”.
 A given amount of revenue can be realized by the
government in several ways by levying taxes,
profits from commercial activities and by borrowing.

210
 However, each method of raising revenue will affect

the economy differently.
 The same is true for different types of public
expenditures.
 Thus, the mix of these different fiscal instruments
used in an economy depends on the general
objectives that the government would like to achieve
in the period.
Contd………………..
211
 As an instrument of macroeconomic policy, the goals

of fiscal policy are likely to be different in different
countries and in the same country in different
situations.
 In the developed countries, fiscal policy aims at
encouraging long run economic stability.
 In the developing economies however fiscal policy is
directed towards promoting the growth of savings,
investment and reducing inequalities in incomes and
wealth, be sides stabilizing the economy.
212
 Since the objectives are vast in these countries

different objectives might come in to conflict & it
needs identification of priorities.
 Thus the most important thing is designing
appropriate fiscal policy instruments in order to
achieve the different objectives in a proper balance
according to the stetted targets.
Contd………………..
213
 Generally fiscal policy as a means of promoting

economic development aims at achieving the
following objectives:
 To increase the rate of investment
 To increase employment opportunities
 To promote economic stability
 To increase and redistribute national income
 To counter act inflation or deflations

To counter act inflation or deflations
214
 Recurrent changes in the economy are caused by

the fluctuations in the effective demand of the
society.
 Depression is caused by a deficiency in effective
demand i.e when the purchasing power of the
population is lower than the supply of goods and
services on the other hand excess demand results in a
boom.
215
 A boom is characterized by higher prices and

unlimited action towards economic expansion.
 Thus if the government has to stabilize the economy,
it has to regulate effective demand primarily through
taxes and expenditure programs
216
 Generally there are two methods to achieve stability
1. Built in Stabilizers: These are also known as

automatic stabilizers of the economy. The built in
stabilizers consists of taxes and expenditures, which
automatically respond to changes in business
conditions. A recession can be corrected in two ways
by raising expenditures and by lowering tax receipts
(expansionary fiscal policy).
Contd………………….
217
 Similarly, a boom can be controlled by a budgetary

surplus, which can be derived by a reduction in
government expenditure and an increase in tax
receipts (contraction fiscal policy).
 They are automatic in the sense that it involves a
change in government revenue or expenditure
quickly and in the right direction so that it may
produce stabilizing effect on aggregate demand.
Contd………………..
218
 When there is a fall in GNP, the yield from some

taxes like income tax and corporate tax
automatically falls.
 Some categories of public expenditure like
unemployment & welfare benefits automatically
increase in response to a decline in the GNP.
 Because of falling tax and rising expenditure, a
decline in the GNP pushes the budget towards deficit.
219
 Thus the taxes and expenditure, that exhibits this

response and vice versa are called automatic
stabilizers. They change in response to the change in
the economic activity.
 The income tax and corporation tax have become
important sources of revenue and they are also
progressive in character
220
2. Discretionary fiscal policy: Unlike the automatic

stabilizers, the government can change tax rates or
expenditure programs as necessary from time to time
to control the instability in the economy. This is called
discretionary fiscal policy and they are deliberate
changes.
Contd………………..
221
There are three principal discretionary fiscal

measures
 Varying public works and other public expenditure
programs
 Varying transfer expenditure programs
 Varying tax rates cyclically

Fiscal Policy and Economic Growth
222
 All countries, including the developed, face the

problem of stagnation and even decay.
 Developed countries are confronted with the
problem of maintaining a steady rate of economic
growth which can help the economy to attain higher
level of income and employment.
Contd………………..
223
 In the developing countries, the need to accelerate

capital formation is very pressing.
 This demands that priority be given for the
development of the capital goods sector and social
overheads.
 However, since capital goods are capital intensive
their development might go against the policy of
higher employment.
224
 The development of labor-intensive industries might

create higher employment level but retards the
process of capital formation.
 The market mechanism in the developing countries
cannot generate sufficient amount of savings and
investment needed for rapid economic growth.
 For this reason government budget has to play an
important role in affecting savings.
225
 Government budgets have more direct role to play in

capital formation and economic growth in developing
countries than in developed countries.
 The saving potential in a developing economy is very
limited because of the following reasons.
 Shortage of particular resources.
 lack of adequate demand, especially for capital

good
 High cost of production.
Contd………………...
226
 This problem can overcome by a savings oriented

government budget.
 Therefore the authorities to raise surplus that can be
invested in building social overheads and basic and
key industries can use fiscal policy.
Principles of allocation of resources
between Federal and State governments
227
 In a federal set up, the federal-State financial relations are

based on the principle of federal finance.
 Federation may be defined as a “form of political association
in which two or more states constitute a political unity with a
common government, but in which these member states retain a
measure of internal autonomy.”
 Thus, in a federation, there is constitutional divides of powers,
functions and resource between the federal and the state
governments.
 The two sets of governments are independent so far as their
own functions and resources are concerned.
PRINCIPLES OF FEDERAL FINANCE
228
 Prof. B.P. Adakar, in his celebrated book on principles and

problems of federal finance lays down three principles
which should govern the working of federal finance, system.
 These principles are:
1. Independence and responsibility: central and state

governments should be financially independent within their
own sphere. Besides, each government should take the
responsibilities of taxing, borrowing, and raising resources
in their spheres for performing their functions.
The authority which has a pleasing job of spending money
should also do the unpleasant job of raising it. Thus,
“taxing autonomy and spending autonomy should go hand
in hand.”
229
 However, there are some who believe that, if every level of

government is to raise the money that it was going to spend,
then there would be great disparity in quality and quantity of
public expenditure from state to state.
 State with wealthier population and richer tax resources will
be able to fulfill their social obligation much better than the
poor ones.
 This view intends that taxing autonomy should lie with federal
government while spending autonomy with the states.
230
2. Principle of Adequacy and Elasticity: the principle

of adequacy means that
 the resources of the federal government and local
governments should be adequate so that each layer
of government can discharge its obligations laid upon
it.
 Principle of elasticity means that there must be
feasibility to expand its resources in response to its
requirements especially during the period of internal
and external crisis.
231
3. Administrative Economy and Efficiency: the administrative

cost of finances should be at minimum and there should be no tax
evasion.
 Administrative efficiency can be achieved, if the resources are
allocated properly between the centre and the state

governments.
Questions
232
1, What do you mean by fiscal policy? Explain the

major fiscal tools used to check depression and boom
2, what is the objective of fiscal policy?
3, explain the concept of federal finance.
4, what is the importance of federal finance?
5, explain and discuss the two macro economic
instruments that uses for correcting the economy

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MEKELLE UNIVERSITY

COLLEGE OF BUSINESS & ECONOMICS

COURSE MATERIAL FOR: PUBLIC FINANCE

 Compiled by: KELEM TADEGE

 1. Nature and Scope of Public Finance

 4.6. Theories of equitable distribution of tax burden of Taxation

 6.1 Meaning of Fiscal Policy

 6.2 Objectives of Fiscal Policy

 6.3. Built in stabilization Fiscal Policy

 6.4 Discretionary Fiscal Policy

 7.1 principles allocation of resource between federal and

 The delivery method shall be student-centered.

 Student evaluation in this module consist both formative

 Atkinson, Anthony B. and Joseph E.Stiglitz.1980.Lecture on public

 Public finance: is the field of economics concerned

 Public finance is one of those subjects that lie on the

 The increasing role of the state in the economic life

 Maximizing social advantage is the guiding

 Now a days every state undertakes various

 In a well-advanced countries, the governments are

 Most of the time, contents of public finance are

 But the scope of public finance is not only confined

 The scope of public finance may include the

 Finance in general can be public or private finance.

 Common interest: both public and private funds may

 Welfare aspect: the existence of the state is for the

 Our wants are unlimited while resources available

 Both public as well as private sectors of an

 The forces of supply and demand and the price

 Instead, each economy in the world is mixed to one

A. Capitalist (market ) economic system: production is

 Negative or positive welfare effect (Externalities):

 B. Socialist economic System: Production decisions

 The concept of a mixed economic system refers to

 The theory of public finance economics provides a

 Conditions that makes a good private or public

 the existence of revealed preference: Producers in trying

 Public Goods: Goods that are provided by the

 Example of such public goods are defense, public

 Fiscal operations consists of

 Functions of Fiscal Operation

 Acceleration of economic growth & development

1. What is public finance?

Welfare Economics – the branch of economic theory

 We start with a simple model:

 Determine good allocation

 The important results of this simple, 2-person model

 Two people: Mosses and Susan

Ou is Mosses’s food, and Ox

Total food in the

 We can then add INDIFFERENCE curves to

Mosses’s utility is greatest at M3

has utility of M3 and

r O’ Point C, where the

 When an allocation is NOT pareto efficient, it

 Welfare of a society is optimized if the following

 Efficiency in consumption requires that MRS is

Pareto Efficiency Condition- Consumption efficiency

 Efficiency in production requires that the combination