PUBLIC FINANCE INTRODUCTION Lecture One: The introduction and the nature of public finance . The scope of government activities .The needs for public sector .Models of efficient allocation .The size of the public sector .Measuring the size of public sector .The principles of maximum social benefits Lecture Two: Public policy objectives .Allocation .Distribution .Stabilization .Growth .Coordination/conflict Lecture Three: Public goods .Properties .Difference between public goods and private goods .Comparison between efficient provision of public and private goods Lecture Four: Market failure and the rationale for government intervention .Sources of market failure; externality, imperfect market, public goods and incomplete information Lecture Five: Public expenditure .Definition .Canons .Growth of public expenditure .Effect of public expenditure Lecture Six: Budget .Types of budget .Zero base budgeting Lecture Seven: Taxation as a source of revenue .Canons of taxation .Principles of taxation .Tax incidences .Effects of tax incidence on market for goods Lecture Eight: Alternative sources of public revenue .Public debts -Types of public debts -Reasons for public debt -Economic effect of public debts -Redemption of public debts .Government induced inflation .Donations .User charges .Public sector borrowing requirements Lecture Nine: Privatization .Mechanism of privatization .Case for and against privatization Lecture ONE NATURE OF PUBLIC FINANCE Governments provide many goods and services to public. In Kenya the government provides subsidized education in primary, secondary and in university. Also provided are health cares and environmental protection. The government is involved in projects that directly increase the production of goods and services. It provides water for industrial use, domestic use. Such projects involve expenditures of large amount of money provided through taxing, licensing and borrowing. The study of public funding enables us to know how the government through its budgetary, monetary and fiscal policy allocates and distributes scarce resources in the country. Definition of public finance Public finance (government finance) is the field of economics that deals with budgeting, the revenues and expenditure of a public sector entity, usually government. THE SCOPE OF GOVERNMENT ACTIVITIES Provision of pure public goods. These are goods to which the principle of exclusion does not apply because they are indivisible and their benefit cannot be priced. The suppliers are faced with the free riders problem since the users cannot be forced to reveal their demand preferences. The government must provide for such. Correction of externalities – suppose a particular public good has external economies which cannot be measured and therefore cannot be priced. The spills over gains are there in the society, but the supplier cannot charge for it. Hence the price much is lower than the social margin of benefit that determines his supply on the basis of the price he gets. Hence he produces less than what could be the optimum quantity from the society’s point of view. The government must provide for such. Quasi – public goods/mixed goods/impure public goods. They possess both element of public and private e.g. education, polio vaccination. Merit goods – They are goods whose provision the society wishes to encourage. Provision of such goods helps the economy to attain a high level of efficiency and contribute to achieving basic objectives of the society. E.g. health, education. They have an overriding importance e.g. precious lives may be lost, if health services are left to the forces of the market only. The state must supplement their availability. Demerit goods: these are goods that are viewed as being socially harmful e.g. cigarette, addictive drugs. For such goods government takes measure to discourage consumption especially through levy of taxes or legislation to discourage consumption. Market failure. Market tends to operate inefficiently on account of the existence of public goods, monopolies and in the absent of law of constant returns. The condition necessary to achieve the market efficient solution fail to exist. The government must intervene. THE NEED FOR A PUBLIC SECTOR. It was felt that in a capitalistic society government participation in the market should be very minimal. Those who supported this emphasized the need to leave the allocation of resources to market forces of demand and supply so that if demand is greater than supply the prices would rise and vice versa. This process would clear the market as they argued. But over the years many changes took place, political ideology evolved hence leading to establishment of socialistic states whose size of the public sector was larger than private sector. However, despite the different ideologies the need for government participation in economic activity in the country is important for various reasons. Reasons why government should participate in Economic Activities The public sector is required to provide goods and services that cannot be provided through the market owing to problem of “externalities” which lead to market failure.” For example, the provision of national security. You cannot bar anybody from enjoying it. The government must formulate and implement economic policies that are needed to guide, correct and supplement the course that the economy will take on its’ growth and development over time. Even where market forces are used to allocated resource, there must be a significantly large public sector to provide regulations and laws that will provide the required protection, otherwise there will be no property rights, and there cannot be markets without exclusive ownership rights. Laws and regulations are also needed to ensure free competition in market, free entry to the market, free exit from the market and for consumer protection, so that in general, the contractual obligations that arise from free market transactions cannot be executed unless there is protection and enforcement of a government provide legal structure. Social values may require adjustments in the distribution of income and wealth which results from the market systems and from the transmission of property rights through inheritance. [We are talking of reducing gap between rich and poor which is as a result of market mechanism. In capitalistic state, the rich will continue becoming richer and poor, poorer. So something needs to be done to tax more from rich and provide services which the poor cannot afford at a subsidized rate]. Private sectors invest where returns are high while public sectors look at overall benefits of a project to the community even if returns are low. e.g. Government provide immigration schemes, schools, hospitals etc. Such projects have no high rate of return on investment but have greater benefits to the community. Owing to low rate of return on such projects, the private sector would not invest in them. Models of Efficient allocation Analysis of the benefits and costs of making additional amounts of a good available is required to determine whether the existing allocation of resources to its production is efficient. Any given quantity of an economic good available, say per month, will provide a certain amount of satisfaction to those who consume it. This is the total social benefit, of the monthly quantity. The marginal social benefit of a good is the extra benefits obtained by making one more unit of that good available per month. The marginal social benefits can be measured as the maximum amount of money that would be given up by persons to obtain the extra unit of the good. e.g. if the marginal social benefit of bread is $2 per loaf, some consumers would give up $2 worth of expenditure on other goods to obtain that loaf and be neither worse off nor better off by doing so. The marginal social benefit of a good is assumed to decline as more of that good is made available each month. The total social cost of a good is the value of all resources necessary to make a given amount of the good available per month. The marginal social cost of a good is the minimum sum of money that is required to compensate the owners of inputs used in producing the good for making an extra unit of the good available. In computing marginal social costs, it is assumed that output is produced at minimum possible cost, given available technology. If the marginal social cost of bread is $1 per loaf, they would be made better off. Figure (1.0) graphs the marginal social benefit (MSB) and Marginal Social Cost (MSC) of making various quantities of bread available per month in a nation. Figure (1.1 ) shows the total social benefit (TSB) and the total social costs (TSC) of producing the bread. The marginal social benefit is given by TBS/Q. Similarly MSC = TSC/ Q The efficient output of bread can be determined by comparing its marginal social benefit and marginal social cost at various levels of monthly output. Figure 1.1 The model of efficient allocation In A, the efficient level of output Q* occurs, at point E. At that output MSB = MSC. The ‘output Q* maximizes the difference between TSB and TSC as shown in B. Extension of output to the level corresponding to equality of TSB and TSC would involve losses in net benefits. Similarly, output level Q1 and Q2 are inefficient. The marginal net benefit of a good is the difference between its MSB and its MSC. When MNB (Marginal Net Benefits) are positive, additional gains from allocating more resources to additional production of the good continue just up to the point at which the MSB = MSC. If additional resources were allocated to produce more of the good beyond that point MSC would exceed MSB. The marginal net benefit seen would be negative. The marginal conditions for efficient resource allocation therefore require that resources be allocated to the production of each good over each period so that MSB = MSC. The size of the public sector Since the government plays an important role in a mixed economy, the question we must ask is what size of public sector will maximize social welfare. This question concern both economic efficiency and equity. The approach of identifying the most efficient and equitable size of the public sector is the principle of maximum social advantage THE PRIN n.jCIPLES OF MAXIMUM SOCIAL ADVANTAGE The principle is concerned with the level at which the government should operate which in turn is determined by its activities. The purpose is to design the policy and operations of the government so as to achieve maximum welfare for the economy. Simplifying assumptions All taxes drain away the economy’s resources. All public expenditures restore these resources of the economy Government revenue consists of only taxes and the government has no surplus or deficit budgets. Public expenditure is subject to diminishing marginal social benefit and the taxes are subject to increasing marginal social disability (cost). This implies that the government expenditure will be first directed towards those uses which are the most beneficial to the society and the taxes will drain away resources from those lines where they are least useful. As the government increases taxation and expenditure activities, the social benefit from each additional shilling spent falls while the dissatisfaction from each additional shilling taxed increases. A state is reached at which the rising marginal dissatisfaction of taxation becomes equal to the falling marginal social benefit of expenditure. At this stage, the government should stop expanding its activities. It is no longer beneficial to further expand the state activities because the social benefit of the marginal unit of public revenue operations is no longer larger than the corresponding social dissatisfaction. Smb of expenditure Smc of taxes Figure 1.2 Maximum social advantage Determination of optimum tax and expenditure activity of the state Public expenditure and taxation are measured along the X – axis, and social benefit and cost is measured along the Y – Axis. The quantities measured along Y – Axis will be positive if measured above the X – Axis and negative if measured below the X – Axis. As a result, the curve showing the marginal social benefit from public expenditure will lie above X- Axis and the curve showing Marginal disutility from taxation will lie below X – Axis. The curve BB1 show the marginal social benefit occurring to the society from different amount of the public expenditure. The curve DD1 shows the marginal social cost to the society from the taxation levied by the state. The difference between BB1 and DD1 indicates the net social benefit i.e. the excess of the benefit over the cost to the society. This is depicted by the curve NN1 For example, when taxation is OM which is spend by the government, the marginal social benefit and the marginal social cost (disutility) are equated i.e. MB = MC. It is here that the state should stop expanding it activities. The net gained or maximum possible social advantage to the society is equal to the area ONM. If the government stopped its operation at less than OM, the society will be foregoing a possible gain. If operations are expanded beyond OM, the total net benefit will again start falling. LIMITATIONS It is necessary for the government to perform certain basic functions like protection and security. The benefit from the very existence of the government activities will exceed the cost of maintaining its activities. In fact without the basic functions of the government, the very existences of the society cannot be guaranteed. Protection also adds to the productive efficiency of the society. No basis for a generalization that every tax is a burden upon the society and that every government expenditure is a benefit for it. Example, a tax on consumption from harmful drugs is not a burden upon the society. But a tax on health services will be. Example II, If the government undertakes the provision of social overheads and other public utilities, it leads to the emergence of external economics. Through them, the cost of production falls, efficiency in production increases and the economy benefits. The benefits to the economy are actually more than it get. Effects of the budget may spill over to the following periods. Hence appropriate time tags and effect – spread should be considered. If all taxes are harmful and all government expenditures are beneficial, then the best course for the government is not to levy any taxes at all. Financing of its activities could be through deficit financing only. However taxes or expenditures cannot create or destroy resources. Only transfer of resources between private and public sectors takes place. Non-tax revenues like fees, fines, profits from parastatals, printing press, and market borrowing e.t.c. cannot be dismissed as unimportant. Every state is committed to certain compulsory expenses. According to Adam Smith (1776), these activities include maintenance of state itself, defense, maintenance of law and order, imparting justice, servicing existing debts e.t.c. It is not easy to identify and quantify the effect of state operations. For example; indirect taxation changes the relative prices of the commodities been taxed. This changes demand, consumption, production and investment pattern. Hence the welfare and growth effect of government activities cannot be linked with the amount of taxation and expenditure only. It is unrealistic to assume a balanced budget. In developing countries, deliberate deficit budgeting may be needed to stimulate saving and capital accumulation. The optimum level of government activities determination is done aggregative. Other factors such as income inequalities, regional imbalances are not considered yet they are very important. MEASURING THE SIZE OF PUBLIC SECTORS Share of government expenditure in Gross Domestic Product. This is given by the ratio of total government expenditure in G.D.P Thus SPS = Total Government Expenditure Gross Domestic Product = G GDP The ratio shows the share of total output which is purchased by the government. However the government expenditure should not include transfer payments. The share of total tax revenue in GDP. This is given by the ratio of tax revenue to GDP. It measures the countries tax effort or the share of gross income which is diverted from the private income stream into the public budget. SPS = Tax Revenue = TR GDP GDP This ratio is below the government expenditure ratio if there was a budget deficit (T<G). However incase of budget surplus (T>G) the ratio is above the government expenditure ratio. Thus if T < G, TR < G GDP GDP T > G, TR > G GDP GDP T = G, TR = G GDP GDP This ratio is most convenient for global consumption of public sectors The share of government contribution in National Income. National income measures the sum total of factor incomes (W,r,R,II), earned during a given period. Hence to measure the size of the public sector we get the proportion of factor incomes that originated from the government economic activities SPS = Total Factor Earning in Government National Income The share of government contribution in personal income. Personal income include incomes received by household and contains three government components; transfer payments (RF) Wages and salaries earnings from public employment (w) Interest receipt (r) This represents the government contribution to the personal income SPS = Total Government Contribution to Personal Income Personal Income = W + RF + R PI ACTIVITY Explain the rationale of public sector in the economy Lecture Two PUBLIC POLICY OBJECTIVES (BUDGETARY OBJECTIVES) There are 3 major functions of budgetary policy: The allocation function Allocation function: It is a process whereby social goods are provided, or the process by which total resource use is divided between private and social goods. The government provided such social goods as security, healthcare, education, recreational services (parks), road etc. To understand this clearly we classify goods into 2 categories; Social goods Private goods The need for social goods is felt collectively The need for private goods is felt individual. The benefits derived from social goods are not limited to one particular consumer who purchases the good, but becomes available to others as well. (Reduction of air pollution benefits all). [No. ownership right] The benefits derived from private goods are limited to one particular consumer who purchases the goods (e.g. humbugger, shoes) Social goods cannot be provided through price mechanism Provide goods are efficiently provided through market mechanism. The market furnishes a signaling system whereby producers are guided by consumer demands. For social good it would be inefficient to exclude any one consumer particularly in the benefits, when such participation would not reduce consumption by anyone else. Application of exclusion principle is impossible and prohibitively expensive. Nothing is lost and much is gained when consumers are excluded unless they pay. Application of the exclusion principle tends to be an efficient solution. Social goods do not carry a high rate of return on investment. Private goods carry high rates of return on investment. In conclusion: It can be noted that no price could be put on a social good because of the non-rival ness in consumption. As a result of this, to venture into production of social good it is highly unprofitable and may not attract private investors. Because of non-rival ness in consumption, there is market failure. Since the benefits of such goods are not limited to individuals, beneficiaries may not voluntarily offer payments to the supplier of such goods. It is as a result of this that the government normally taxes all citizens irrespectively so that it could provide for such goods. Public provision of social goods Just like in the provision of private goods and services there must be consumer preference before social goods and services are provided. But because so far social goods and service is collective from the society as a whole, it is very hard to know the nature of the society preference map. It would be very difficult to seek individual opinion from every citizen on type and quantity of a social good that should be provided. It would also be difficult to decide how much each individual should pay for the product. One may argue that consumers pay based on benefit principle, as in the case of private goods, but then the problem would be, how such benefits would be determined. Just as consumers are unwilling to voluntarily pay for social goods it would be difficult to make them reveal accurately how much benefits they are deriving from such goods. The question then remains how best public goods could be provided. A different technique other than market mechanism is needed by which the supply of social goods and the cost allocation thereof can be determined. This is where the political process enters the picture and must substitute market mechanism. Voting by ballot must be resorted to in place of shillings voting. Since voters know that they will be subject to the voting decision (be it simple majority or some other voting rule e.g. through their elected MPs, councilors representatives), they will find it in their interest to vote so as to let the outcome fall closer to their own preferences. Thus decision making by voting becomes a substitute for preference revelation through the market. The result will not please everyone but they will approximately more or less perfectly, depending on the efficiency of the voting process. The different set of provision for and production for social goods When the government either directly or through government owned palastatals e.g. post office, sugar factory, water supply plants etc. or by assigning private producers to produce goods through tenders, we say that the government has provided the goods. If we say that social goods are provided publicly, we mean that they are financed publicly, we mean that they are financed through the budget and made available free of direct charge. How they are produced does not matter. The distribution function This is a process through which the government redistributes income and wealth among citizens. In the absence of government intervention in the distribution of income and wealth, the distribution depends first of all on the distribution of factor endowments. It is important to note that people’s earning ability differ, ownership of properties also differ. The distribution of income, based on this distribution of factor endowments, is then determined by the process of factor pricing, which, in a competitive market, sets factor returns equal to the value of the marginal product. The distribution of income among individuals thus depends on their factor supplies and the prices which they fetch in the market. In most countries where free market policies are followed there tends to a rise a class of society where few become richer and majority poorer. Because this does not fall in line with what is considered to be just and fair, the government must employ mechanisms and policies to redistribute wealth and income. Fiscal instruments of distribution policy Redistribution is implemented most directly by taking the following action: Employ a tax transfer scheme. Here a vertically progressive tax system is used to collect more taxes on income of high income households and using the money to subsidize low income households. Employ a progressive tax system to finance public services such as medical, education, water etc. Employ a sales tax: Taxes are collected on goods and services used by high income classes and funds raised are used to subsidize goods used by low income classes. The stabilization function Here macro-economic policies are employed to maintain and achieve the goals of high employment, acceptable price stability, favourable balance of payment position, acceptable rate of economic growth and development. Economic policies are necessary because high rates of employment and low rate of inflation do not come up automatically in a free market economy. In fact changes in inflation rate are inversely related to rate of unemployment as can be shown in the following diagram. Figure 2.1 Relationship between inflation and unemployment From the diagram it is clear that countries cannot attain zero level of inflation and unemployment at anytime. There will always be a combination of the two that would be favourable at one time. When inflation rate is high, rate of unemployment is low and vice-versa. This calls for well planned policy actions to achieve an acceptable level at inflation and unemployment. At times there may be high level of inflation and employment meaning that Phillip’s has shifted to the right. Reasons:- Increased size of labour force due to population growth. Low rate of manpower utilization high level of unemployment. Low rate of economic growth. Low economic growth implies that when supply is less than the demand the prices go up hence unemployment. Lack of technological know-how – low output. Therefore economic policy is essential for strong economic growth and development. The level of employment and prices in an economic depends on level of aggregated demand and level of output valued at prevailing prices. i.e. Employment = f (Output, expenditure). Aggregate demand is also a function of the spending decisions of many consumers, corporate managers, many financial investors etc. The decision of this people in turn depends on:- Past and present levels of income and expected level of future incomes. Level of wealth in a country and its distribution. Credit availability. Future expectations. Instruments of stabilization policy Recession period For any given period the level of expenditure or aggregate demand may not be sufficient to secure full employment of labour and other factors of production. When this happens expansionary economic policies must be made to stimulate the economy e.g. increase government expenditure and reduce taxes. The supply of more money for use in demand increases production (output) hence rise in employment. Boom period When aggregate demand is greater than aggregate supply (level of output) employment level is high in boom period and inflationary pressure is also high. When this happens, restrictive economic policies must be employed. Reduce in government expenditure & increase in taxation leads to a decrease in purchasing power resulting in fall in effective aggregate demand. The government can also use monetary policies as stabilization instruments. In doing so, the Central Bank of Kenya and the government has various options: Controlling the reserve ratios Reserve Ratio is that function of total deposits in commercial banks that the Central Bank requires commercial banks to retain to pay its customers. When the ratio is increased, less money remains for lending out and vice versa. Reserve ratio is normally increased if there is inflation and too much money in the economy. b) Bank rates It is the rates of interest that central bank charges commercial banks when they go for short term loans. Increase in bank rates discourages commercial banks from borrowing from Central Bank. This in turn reduces the resources available for commercial banks to loan to public, thus reducing amount of money in the economy. c) Open market operations The government goes in the market and buys or sells government securities in order to influence the direction of the economy. Such securities include treasury bonds. When bonds are sold to the public through Central bank the public buys bonds certificates which pay interest. The result of this is a withdrawal of money from the economy and thus lowering aggregate demand. But when the government redeems them (buy back the bonds) it pays back the public their money and interest earned hence more money in the economy, high aggregate demand, more output and hence increase in employment level. CO-ORDINATION OR CONFLICT OF FUNCTIONS In order to provide a good co-ordination of the functions there must be a good management of the economy. When they are not properly co-ordinate there will be conflicts among them. Proper co-ordination calls for good policy targeting during the planning and implementation process. For example, those who are concerned with planning distribution will design a tax transfer plan to secure the desired distribution. Similarly, those who are in charge of allocation in terms of public expenditure must ensure that the funds allocated from the taxes are used to finance projects with consumer evaluations thereof. Those who are in charge of policy formulation to stabilize and to stimulate the economy must ensure that they achieve full employment and economic growth. When all functions are in balance we say that the budget is balanced. However, this balance may not be sufficient to provide for or sustain the required economic growth and development. So the government will result to other sources of funds other than taxation e.g. externally or internally. In real world situation such a perfect co-ordination may not be realizable. The achievement of one objective (e.g. provision of social goods) is achievable at the expense of the other e.g. (price stability). Conflict of interest Conflict between allocation and distribution Taxes are normally imposed so as to redistribute income and wealth and raise funds for government to provide social good. In order to affect this, a vertical progressive tax to collect more from the rich and less from the poor is imposed. But if you looks at less developed countries budget is low and majority of earners are in lower and middle income classes, hence causing conflicts between allocation and distribution function. Conflict between distribution and stabilization function:- Stabilization functions are used to stabilize the economy. When there is need to stimulate the economy (time of recession) taxes on lower income groups should be reduced, since their marginal propensity to consume is higher than that of the rich. This would lead to increased disposable income, demand, output produced and thus employment. The opposite course has been made in times of inflation, namely that taxes on low-income groups should be raised, since they are more potent in reducing demand than taxes on higher income. Another reason would be, by taxing the rich a lower rate; they would be motivated to save more because their MPS are high. Conflicts arises in such as approach because the distribution function of budgetary policy does not achieve the aims of deducting more from the rich and less from the poor. Conflict between distribution and growth and economy Objective of the budget is to attain high growth rate in economy. This would only be achieved if capital formation, savings and investments are increased. This would mean withdrawing more from poor and less from rich. This is because people with higher propensity to save are high income people. Conflict arises between distribution and growth. The aim of distribution function is to deduct more from the rich and less from the poor, which is the opposite of the goal of high growth rate. ACTIVITY What are the budgetary policy objectives of the government? MARKET FAILURES AND THE RATIONALE FOR GOVERNMENT INTERVENTION Where the market is efficient, consumers have freedom to choose what they want to consume freely, and they reveal their preferences to producers. Producers, in trying to maximize their profits will produce what consumers want to buy and will do so at least cost. Competition will not only ensure that the mix of goods and services produced corresponds to consumers preferences, but would ensure that resources are allocated efficiently. The main assumption here is markets are efficient and competitive. Under normal circumstances, however, this may not be the case. Market may fail to achieve an efficient allocation of resources, leaving open the possibilities that government provision of certain commodities might enhance efficiency. Therefore market failure refers to those situations in which the conditions necessary to achieve the market efficient solution fail to exist or are contravened in one way or another. The proposition is therefore that the market system of economy is unlikely to operate efficiently. In fact there is a tendency for it to produce too much of some goods and an insufficient amount of others. In extreme cases, certain goods will not be produced at all. Given the presence of market failure, one possible role for government would be to intervene in allocation function of the market to correct the market failure or introduce policies that would compensate its effect. This gives rise to the allocation function of the government. Market failure will also bring about the question of equity of social justice in the distribution of income and welfare where market failure produces a socially unjust distribution of welfare. Government intervenes to bring about a distribution that is considered to be socially just and fair. This is referred to as distributional role of government. Market failures could also produce macro-economic instability such as inflation, unemployment, BOP disequilibrium, etc. In these circumstances, a stabilization role exist for government to intervene in the economy using monetary and fiscal policies to bring about desired level of inflation and unemployment, thereby improving the welfare of society. Further, there is a regulative function which government performs. As part of its allocation role government enact and enforce laws of contracts. It also administers the more general system of laws, order and justice which regulates individuals or firms behaviors and ensures that market activities and private exchanges take place smoothly. Thus market failure permit four functions of the government. Certain conditions exist under which the market will fail to be efficient. The conditions include:- Public goods Imperfect competition Costly information Externalities. CHAPTER THREE PUBLIC GOODS We now need to consider how the characteristic of pure public goods relate to the concept of market failure. There are some goods that either will not be supplied by the market or if supplied would be supplied in insufficient quality e.g. defense, street lighting etc. These are called public goods. If a pure public good is to be available for consumption then it must be provided collectively either through private voluntary arrangements or public via the budget. Properties of pure public goods Pure public goods have two properties Non-excludability Non-rival in consumption. Non-excludability characteristics of public goods In the case of pure private good a set of property rights define the ownership of the good. The individual who possess the property right has the sole claim to enjoy the benefits of the good and can therefore exclude others from doing so. In the case of a pure public good technical feature of excludability begin to breakdown. First, it is generally difficult to exclude individuals from enjoyment of public good. If for example a geographical area is provided with defense services which diverts and attack from abroad it becomes extremely difficult to exclude anyone who lives in the country from being defended. Similar example is found in street lighting. For pure public good the degree of exclusion depends upon the technical characteristics of the good and the resources available to the producer to enforce the exclusion. In general, however, there is no perfect exclusion. So an optimal amount of exclusion is a decision to be made by a producer. Second reason why the exclusion principle breakdowns is that, while it may be technically feasible to exclude, the application of exclusion device may be very expensive. That is, the cost of exclusion can outweigh any advantages to be obtained from its application. A pure public good is the one for which exclusion is either technically not feasible and if feasible, the cost of enforcing the exclusive device is too prohibitive to apply. With non-excludability, there is no incentive for a profit maximizing producer to supply the public good because once he produces it he cannot exclude individuals from consuming it and hence he is unable to charge a price. Individuals wishing to consume the benefits of a pure public good could, however, form a private co-operative. They could agree to contribute to the cost of supplying the public good. Such an arrangement might be feasible for a small group of individuals, but as the group grows in size the possibility of individuals becoming free riders increases and the private voluntarily arrangement fails. Non-rivalness in consumption Definition of a pure public good implies that it is non-rival in consumption. It means that it does not cost anything for an additional individual to enjoy the benefit of public goods. Non-rivalness arises from the indivisibility of public goods. That is, adding one or more persons (up to a capacity constraint) does not add to the marginal cost. Formally there is zero marginal cost for an additional individual to enjoy a good. Non-rivalness thus implies, one individual access to the commodity does not reduce another individual’s benefit because these benefits are available to all without interference. A perfect solution in this case would require a zero price because marginal cost equals zero. This will mean that revenues will not cover losses and so a private profit maximizing producer will not supply such a commodity. The market, in other words, will not allocate such goods efficiently thus the market failure. Therefore goods can be classified into four cases according to their consumption and excludability characteristic. Exclusion Consumption Feasible Not Feasible Rival 1 2 Non-Rival 3 4 Characteristic Case 1 This is a private goods that is rival in consumption and excludable e.g. a loaf of bread, clothing. You only consume the goods after paying for it. Whoever does not pay is excluded. Benefits are internenalized. Case 2 This represents a good that is rival in consumption but non-excludable. In this case there is market failure due to non-excludability or high cost of exclusion. Example, travel on a crowded street, traffic jam due rush hours. Case 3 This is a good that is non-rival in consumption but excludable. Examples are clubs, watching a movie, swimming, education, crossing a bridge that is not crowded. Case 4 This is a good that is non-rival in consumption and non-excludable. This is a pure public good. Examples are, air purification, national defense, street lights e.t.c. Comparison between efficient provision of public goods and private goods In chapter 2 we noted that one goal of the public sector or government was to ensure the efficient allocation of both public and private goods. It was pointed out that some goods and services had to be supplied by the public sector, since it would be difficult, if not impossible, to have them supplied by the private sector in a market economy. In this section we shall derived the conditions for efficient provision of a public good, and then compare them with those of private good. To achieve this objective the approach of Bowen model shall be used. Figure 3.1 Efficient allocations of private and public goods In order to explain the foundations of this model, we assume that there are two individuals, A and B each having a conventional downward sloping demand curve for some public goods. That is, if the public goods could be sold in units at a price, each individual would demand more as the price is reduced. These two demand curves are shown as DA and DB in the right side of figure 3.1. Drawing such demand curves is based on the unrealistic assumption that consumers volunteer their preferences, and such curves have therefore been referred to as “Pseudo-demand curves”. In the earlier discussion we defined public good as one which once produced, is consumed equally by all. Thus no one person can vary the quantity to be taken. This being the case, to derive the total demand for public good, the demand curves are added vertically, not horizontally, as would be the case for a private good. Suppose a quantity OZ of the public good is made available to A. It is also made available in the same quantity to B. What we want to know is how much would A and B, together, be willing to pay for OZ of the public good. To get this add Zs (what individual A is willing to pay for Oz) and ZH (what individual B is willing to pay for OZ) to obtain ZE. This is done for each and every amount of the public good, giving us the total demand curve DA + DB. This tells us how much A and B, together, would be willing to pay for various amounts of the pure public good. It should be noted that for each amount of public good supplied, individual B is willing to pay more than individual A for that amount. Since it takes resources to produce the public good, we introduce for convenience a constant marginal cost (supply schedule) in our diagram, and from its intersection with the total demand curve, obtain the equilibrium quantity and price, in this case OP1 and OZ. NB: MBA +MBB =P ∑MBi = p Thus we see that the sum of the marginal evaluation by each person for the public good equals the prices, which equals marginal cost, thereby meeting the conditions of optimal pricing, that is, that price equal marginal cost. In the case of private goods as can be depicted in the left side of figure 3.1, in a perfectly competitive market situation, prices are fixed (market determined) and the consumers would only vary amount they consume. So the total demand curve for private good (DA + DB) is obtained by horizontal addition of DA and DB. That is, adding the quantities which A and B purchase at any given price. Given the supply schedule, the equilibrium is determined at E, the intersection of market demand and supply. Prices equals OP2 and output OH, with OF purchased by A and OG by, B, where OF + OG = OH. In a perfectly competitive market, equilibrium requires that the price of a good be equal to each consumer’s marginal evaluation, which in turn is equal to marginal cost. The consumer theoretically adjusts his purchase to achieve this, since he faces a fixed price. In the public goods, case, the price does not equal each consumer’s marginal evaluation and the consumer cannot vary his purchase to achieve this. For a non-excludable public good, however, there may be incentives for people to hide their true preferences. Individual A may falsely claim that the public good means nothing to him. If he can get individual B to foot the entire bill, he can still enjoy the benefits from the public goods and yet have more money to spend on private goods. In the figure presented above, at output OZ1, individual B meets the entire Price (Z, V). This incentive to let other people pay while you enjoy the benefits is known as the free rider problem. Hence, there is a good chance that the market will fall short of providing the efficient amount of the public goods. No automatic tendency exists for markets to reach the efficient allocation. Even if consumption is excludable, market provision of a public good is likely to be inefficient. Recall the fact that efficiency requires that price equal marginal cost. Because a public good is non-rival in consumption by definition, the marginal cost of providing it to another person is zero. Hence efficiency requires a price of zero. But if the entrepreneur charges everyone a price of zero, then we cannot stay in business. Is there a way out? Suppose that the following two conditions hold:- The entrepreneur knows each person’s demand curve for the public good and It is difficult or impossible to transfer the good from one person to another. Under these two conditions, the entrepreneur could charge each person an individual price based on willingness to pay a procedure known as perfect price discrimination. From our example, because individual B values the public good most, he would pay a higher price and thus the entrepreneur would still be able to stay in business. Perfect price discrimination may seem to be the solution until we recall that the first condition requires knowledge of everybody’s preference. But of course, if individuals’ demand curves were known, there would be no problem in determining the optimum provision of public good as was earlier demonstrated. ACTIVITY What is a free-rider problem? CHAPTER FOUR Imperfect competition as a cause of market failure When some agents have the ability to affect price, the allocation of resources generally is inefficient. An extreme form of such market power is monopoly, which comprises of one seller in the market for a given commodity. Conditions that bring about monopoly includes:- Where transportation costs are large the relevant market may be limited geographically if there is only one firm in such a locality. There may be no or very limited competition. In case where cost of production per unit of output declines (decreasing cost of production or increasing returns to scale) entry into industry becomes very difficult, thereby permitting the firms already established to exercise natural monopoly. Some monopolies are created by the government or run by the government. The Kenyan government, for example, has given the Kenya Power and Lighting Company the exclusive right to generate and distribute electricity in the country. Patent rights given to some investors grant them monopoly over their invention over specified period of time. In some instances it is more efficient to have one or a few firms’ producing rather than many. This applies where the initial cost of production is high and where the production of the commodity cannot be subdivided into small units, e.g. the production of electricity. Such subdivision would be inefficient and uneconomical. If monopoly has some possible aspects then why is it generally viewed as bad? The reason is that, if not regulated and if allowed to trade freely, they would restrict output to attain higher prices. Mechanism of how they would restrict output to raise prices: Figure 4.1 Monopoly market structure Panel A of figure 4.1, assume that the marginal cost (MC) of production is constant at all levels of output. Because the monopolistic seek to maximize profit, he will produce output OQ*, where price equal marginal cost. Clearly O Q* <OQ, and also notice that at OQ*, price which measures how much individuals value an extra unit of the goods exceed the marginal cost implying a welfare loss from restriction of output by the monopolist. This establishes a case for government intervention to ensure an efficient allocation of resources. In panel B of figure 4.1, we assume that marginal cost of production falls as output is expanded. That is, there is an increasing return to scale (a decreasing average cost curve). Since AC>MC at any level of output, a price set to equal MC at Q2 would cause the monopolist to incur a loss. Q1 is the highest output at which the firm breaks even since at that output AC=P. A perfect competitive firm would produce at Q2 since P=MC at that output level. A monopolist on the other hand will restrict output to C Q*. Again there is a welfare loss arising from this restriction. The problem of increasing returns to scale establishes a case for government intervention to ensure an efficient allocation of resources. In situation, as depicted in the figure, the government could instruct the monopoly firm to charge a price which equals the marginal cost, subsidizing the loss out of tax revenue. This is a classic example of regulation of increasing return to scale industries. Alternatively the government could take over the entire production operation i.e. through nationalization, produce output Q2 and charge a marginal cost price again subsidizing the loss from a general taxation. At this point we should recognize the importance of the way losses made by decreasing cost industry using marginal cost pricing are financed. They are financed from taxation but most taxes influence relative price. They introduce a distortion and thus create additional inefficiencies. Ideal lump-sum taxes, which leave relative prices unchanged should be used. However, lump sum taxes are generally not available and so other taxes must be used in practice. The design of optimal government policy is therefore one of the weighing out the distortions and inefficiencies introduced by interventions, compared with the inefficiencies that the policies are designed to reduce. Costly information The competitive model assumes that information on existing prices is somehow spread around at no cost, so that everyone can find the best price. In reality, this is not the case. Shopping around to find the lowest price requires time which is a valuable commodity. Moreover, once information is obtained, it may be imperfect. Thus, it is possible that because individuals do not have the necessary information to make the right economic decision, inefficient patterns of resource allocation emerge. CHAPTER FIVE EXTERNALITIES AS A CAUSE OF MARKET FAILURE Musgrove and Musgrave define externality as, ‘a situation where the benefit of consumption of a given good or service cannot be paid by producer who causes them to result into external costs to others. For example, a particular technology used in the production of a private good produces smoke as a by-product (i.e. the externality of spill-over) which is involuntarily consumed by people living near the factory, thus lowering their utility. Despite the producer causing pollution, he does not include such external costs as eradicating air pollution in his production costs. So that, his private costs (costs of living inputs) is less than the overall social cost (private costs and external costs). This external diseconomy will result in the overall production of the good associated with the diseconomy, and the allocations would differ from those that would have been produced by perfectly competitive markets. The existence of externalities results in outcomes that are not efficient. An Externality is something that, while it does not monetarily affect the producer of a good, it does influence the standard of living of society as a whole. They can also be referred to as those conditions where the forces of the market cannot secure, optimal results," and to public goods as a condition "where the market mechanism fails altogether." In the presence of externalities and public goods competitive market equilibrium cannot be expected to yield socially efficient resource allocations. This is due to "special" characteristics of externalities and public goods called "non-excludability" and/market thinness," or what is more commonly called the "free rider problem." The free rider problem exits when people enjoy the benefits of government provided goods i.e. public goods, independent of whether they pay for them. Free riders are actors who take more than their fair share of the benefits or do not shoulder their fair share of the costs of their use of resource. The actual "Free rider problem" can therefore be defined as the question of how to prevent free riding from taking place or at least limit its effect. Since the notion of "fairness" is highly subjective, free riding is only considered/to be an economic problem when it leads to under or non-production of a public good thus Pareto inefficiency. An example of a public good subject to this is national defense-one is protected whether or not he pays for the services rendered. Forms of Externalities: There are two forms of externalities: Positive Externalities Negative Externalities Fiscal Externalities Positive Externalities: A positive externality is something that benefits society, but in such a way that the producer cannot fully profit from the gains made. A few examples of positive externalities are environmental clean-up and research. A cleaner environment certainly benefits society, but does not increase profits for the company responsible for it. Likewise, research and new technological developments create gains on which the company responsible for them cannot fully capitalize. Negative Externalities: A negative externality is something that costs the producer nothing, but is costly to society in general. Unfortunately these externalities are much more common. Let's take an example of pollution. This is a very common negative externality. A company that pollutes loses no money in doing so, but society must pay heavily to take care of the problem pollution caused. The problem this creates is that companies do not fully measure the economic costs of their actions. They do not have to subtract these costs from their revenues; hence profits inaccurately portray the company's actions as positive. This can lead to inefficiency in the allocation of resources. iii) Fiscal Externalities: This is whereby the behavior of people affects the cost of some subsidy or alters the revenues from some tax as externalities. Fiscal externalities do not necessarily imply any inefficiency, and when there is inefficiency, it is the result of the pre-existing policy. An example is smoking; this imposes costs on taxpayers due to the existence of subsidized medical care. In this case the medical care subsidy creates the fiscal externality. However, when there is inefficiency, the nature and magnitude of the fiscal externality is not a reliable guide to the appropriate corrective policy. Like in the above example, it will usually be best to modify the pre-existing policy (the medical care subsidy) rather than tax smoking. Implications of Externalities for allocation efficiency: The prevalence of externalities in the market based economy suggests that the optimality rules normally assumed to lead to allocation efficiency may not in fact lead to the most socially efficient outcome. The presence, of externalities thus represents an example of market failure to achieve allocation efficiency. This is because in the presence of externalities the market price of a good may not reflect the true societal cost or benefit and hence may be under or over produced. Figure 4.2 illustrate the implication of negative externalities for allocation efficiency. Figure 4.2: Effects of Negative Externality on allocative efficiency In a free market where the optimality rules have been followed the quantity produced will occur at quantity Xp and price Pm, the point where demand (D) equals the private marginal cost (PMC). However where a negative externality exists the market fails to produce the socially optimal level of production. This is because the marginal damage (d), generated by the negative externality, is a cost not taken in to account in the market. When a social marginal cost (SMC) curve is generated it is possible to see that socially optimal level of production is in fat X* and that the product should be sold at a higher price P* to reflect the fact that the true social cost of the product is higher than the private cost. Positive externalities also have their own special implications for the achievement of allocation efficiency. Figure 4.3 illustrates the implications for the optimality rules of a positive externality. The market equilibrium in this situation occurs at quantity' Q* and price Pm where the private marginal benefit (PMB) of the item equals its marginal cost. However this item produces an external benefit (b) which is not taken in to account by the market. The socially optimal quantity of this item actually occurs where the social marginal benefit (SMB) curve derived by summing the private marginal benefit and the external benefit, equals the marginal cost of producing the item. This analysis suggests that the allocativion efficient situation occurs at quantity Q* and price p*. Figure 4.3: Effect of positive externality The conclusion which can be drawn from this is that true allocation efficiency will not be achieved unless the external benefits and costs associated with externalities are taken in to account when making economic analysis. Solutions to Externalities: PUBLIC RESPOSES TO EXTERNALITIES: TAXES AND SUBSIDIES TAXES A natural solution suggested by the British economist A.C. Pigeon is to levy a tax on each unit of a polluter’s output in an amount just equal to the marginal damage it inflicts at the efficient level of output. This tax is called Pigouvian tax. Figure 4.4. Use of Tax in correcting External Diseconomy In this case the marginal damage done at the efficient output Qs is distance cd. This is the Pigouvian tax. Remember that the vertical distance between MSC and MPC is MD (i.e. cd). The tax raises the firms marginal cost. For each unit the firm produces it has to make payments both to the suppliers of his inputs (measured by MPC) and to the tax collector (measured by cd). Geometrically the firm’s new marginal cost schedule is found by adding cd to MPC at each level of output. This is done by shifting up MPC by a vertical distance equal to cd. Profit maximization requires that the firm produce up to the output at which marginal benefit equals marginal cost. This now occurs at the intersection of MB and MPC+cd which is at the efficient output Qs. In effect the tax forces the firm to take into account the costs of the externality that it generates and hence induces him to produce efficiently. Note that the tax generates revenue cd dollars for each of the unit which is produced (psd = OQs). Hence tax revenue is cdxpsd, which is equal to the area of rectangle psjcd. WEAKNESS OF PIGOUVIAS TAX There are practical problems in implementing a pigouvias tax scheme. In light of the difficulties in estimating the marginal damage function, it is found to be hard to find the correct tax rate. Still sensible compromises can be made. Suppose that a certain type of automobile produces poisonous fumes. In theory a tax based on the number of miles driven enhances efficiency. But a tax based on mileage might be so cumbersome to administer as to be infeasible. The government might instead consider levying a special sales tax on the car even though it is not ownership of the car per se that determines the size of the externality but the amount it is driven. The sales tax would not lead to the most efficient possible result, but it still might lead to a substantial improvement over the status quo. Another weakness is that the tax approach assumes that it is known who is doing the polluting and in what quantities. In many case these questions are very hard to answer. Auction Pollution Permits Another method of achieving Qs is to sell producers permits to pollute. The government announces that it will sell permits to dumps into the river the amount of garbage associated with output Qs. Firms bid for the right to own these permissions to pollute and the permissions go to the firms with the highest bids. The fee charged is that which “clears the market” because the amount of [pollution equals the level set by the government. In the simple model the pollution permits and the pigouvial tax are identical. Both achieve the efficient level of pollution. Implementing both requires knowledge of who is polluting and in what quantities. Baumal and Oates [1979, p.251] argue that pollution permits have some advantages over the tax scheme from a practical point of view. One of the most important is that the permit schemes reduce uncertainty about the ultimate level of pollution. If the government is certain about the shapes of the marginal private cost and marginal benefit schedules of figure 4.4 it can safely predict how a Pigouvian tax will affect behaviour. But if there is poor information about these schedules it is hard to know for sure how much a particular tax will reduce pollution. If lack of information forces policy makers to choose the pollution standard arbitrarily with a system of permits, there is more certainty that this level will be obtained. In addition under the assumption that firms are profit-minimizes, they will find the cost minimizing technology to attain the standard. Moreover when the economy is experiencing inflation the market price of pollution rights would be expected to keep pace automatically, while charging the tax rate could require a lengthy administrative procedure. One possible problem with the auctioning scheme is that large firms might be able to buy up pollution licenses in excess of the firms cost minimizing requirements to deter other firms from entering the market. Regulation Under regulation each polluter is told to reduce pollution by a contain amount or else face legal sanctions. In case of pollution 2 classes of regulation (control) can be distinguished. Direct regulation Input regulation The direct regulations involve the setting up of critical level of pollution and monitoring the level of pollution of the firms and prosecute firms that exceed critical level. Input regulation on the other hand, involves regulating the production process. When it is feasible to control level of pollution it seems preferable to apply input regulation. The reason is that the firm is likely to know better than the government in terms of best way of reducing the pollution. Most government relies heavily on input regulation since in most cases it is easier to monitor inputs than to measure level of pollution. PRIVATE SOLUTION i) Internalize Externalities: Economists recognize that negative externalities are a major problem. To combat this problem, the government might try to force companies to internalize externality' costs. In any type of production and economy, some negative externalities of production are inevitable. The real problem created by negative externalities in the free-market economy is that because they are not a cost to the company, the company will see only what is profitable to itself, not to society as a whole; this will create inefficiency in the economy. The famous economist Milton Friedman says that the government should require companies to pay for the costs of cleaning up the problems they create. This can be accomplished through taxes and fees, making companies pay for the amount of harm they do to society as a whole. This solves the inefficiency problem. If companies have to pay the costs of pollution, they can accurately compare the total costs and revenues of production and determine if it is profitable to produce. However the government still has to struggle with the question of placing a monetary value on such things as death, extinction, the destruction of forests, and many other social costs and it is not always easy to put this policy into practice. Regulations are not always enforced, and governments may simply choose to relax their standards in order to avoid hurting businesses. ii) Social Conventions; This deals with negative externalities through social conventions and tradition. The argument here is that "certain social conventions can be viewed as attempts to force people to take in to account the externalities that they generate. The example associated with this is impressing on people from a young age that even though one bears a cost by holding on to litter until a bin is found that one should do so because of the externality which litter creates. However its overall usefulness may be limited to low cost externalities generated by individuals. iii) Property Rights: The establishment and enforcement of private property rights provide an alternate framework for the solving of externalities. "A private property right is a legally established title to the sole ownership of a scarce resource that is enforceable in the courts." Private property rights offer a number of solutions to the problems posed by externalities. Firstly, the establishment and enforcement of greater private property rights by the legal system would allow victims of negative externalities to sue the offending party for compensation for the damage caused. For example, if property rights to a section of river are assigned to a particular fishing club, then that club will be able to sue the chemical firm/upstream which pollutes the river and kills the fish stock in the fishing clubs section of the river. iv) Coase Theorem & Bargaining: The other way in which property rights can assist in achieving allocation efficiency is by providing a framework in which bargaining may take place. Consider the situation illustrated in Figure ES3 below which builds on the fishing club example. Figure E S3: Property rights and. bargaining Figure 4.5: Coase Theorem & Bargaining: The Coase Theorem suggests that " the efficient solution will-'be achieved independently of who is assigned the ownership rights , so long as someone is assigned those rights". The reasoning for this is that if the chemical firm is assigned the property rights , the fishing club will be prepared to pay the chemical firm an amount up to the value of the damage being caused, to have the chemical firm reduce its output and that at any point past X* the damage being caused exceeds the firms profits from doing so. Hence the firm is willing to accept the payment to reduce its output to X*. Similarly if the fishing club has the rights, it will not allow the firm to produce past X* as the damage caused to the fishing club is greater than any payment the firm would be willing to make. The establishment of property rights thus creates a framework which allows bargaining and the achievement of the socially optimal outcome. WEAKNESSES OF COASE THEOREM The Coase theorem assumes zero translation cost. If translation costs are high then the outcome of bargaining over weights won’t be pareto efficient. Also the outcome will be affected if there is assignment of translation costs between the two parties in the bargain. Pigon (1932) points correctly to the cost in terms of time and efforts required for bargaining. In the presence of very large lump sum translation costs which exceeds the benefits from negotiation a discrete decision either allowing or barring the activity maybe the solution. Another problem is that voluntary bargaining may not proceed if large number of people is involved. For example if pollution problem is experienced by large numbers of individual then each individual may prefer to sit quietly and hope that others will offer enough compensation to induce a less polluted atmosphere. In this way each victim would seek to free ride. Clearly if all affected people behave in this way the process of negotiation will not materialize. Coase solution will only be applicable in those situations in which properly rights and hence contracts can be well specified at reasonable cost and where problems of free riding do not arise. It is not necessarily the case that negotiation will produce a pareto improvement if both parties do not have access to all available information’s. As David and Kamien (1971) has pointed out one side may have more or superior information than the other and this may lead to cheating or black mailing. The Coase solution has distributional consequences. The individual consuming the external effects compensate the polluter to reduce level of pollution whilst solutions to externality problems might not be desirable in distribution terms. For example consumer of those goods that carry a pollution tax will end up paying higher prices and some employees who work in those firms may be made redundant as output levels reduce. v) Mergers: Another possible solution to the problem of externalities may be for the parties involved to merge. For example if a fishing companies profits are being harmed by the pollution produced by a steel mill then the problem of this externality can be solved by merging the parties involved and internalizing the effects. "For instance, if the steel manufacturer purchased the fishery, he would willingly produce less steel than before, because at the margin doing so would increase the profits of the fishing subsidiary more than it decreased the profits from his steel industry.” This suggestion too however may be seen as having a number of problems in its practical implantation. MARKET SOLUTION Tradable Pollution Permits: Tradable pollution (or emission) permits are a free-market solution to the problems caused by negative externalities. Tradable emission permits allow the government to give companies licenses to pollute at a certain level. Companies can buy, sell, and trade these permits on the market. Therefore it is in the interests of companies to pollute as little, as possible. If they pollute at a level higher than their permit allows, they have to buy permits from another company. If they pollute less than they are allowed to, they can sell their permit. The difficulty is that companies that pollute create a cost to society but not a cost to themselves. Because the company does not have an accurate view of its costs of production, it cannot set its production at the level that maximizes efficiency in the economy. Conclusion: In conclusion then it can thus be said that the existence of externalities and the failing of the market to adequately deal with them has serious implications for the achievement of true allocation efficiency within the economy. Whilst there are a number of possible approaches to correcting the problems caused by externalities, each of the suggested solutions entails its own problems which must be overcome before society will have an effective means of dealings with the problems caused by externalities. ACTIVITY With the help of diagram show how positive and negative externality lead to market failure Lecture Six PUBLIC EXPENDITURE DEFINITION OF PUBLIC EXPENDITURE Public expenditure can be defined in different ways as: The expenditure of central and local government; The combined government expenditure plus disbursements out of the National Insurance (social security) Fund; or The total government expenditure as in (ii) plus expenditure of the public corporations. The size of the public expenditure will depend on the definition adopted and will differ accordingly. This can give rise to confusion when comparisons are made over a period of time or internationally. Thus, if public-expenditure is defined in terms of what the central government and local authorities spend; it will appear smaller than when expenditure by public corporations is also included. The basis on which public expenditure once defined is analyzed, does not, however, affect the total figure which represents the absorption of resources by the public sector. The analysis can be undertaken-on the following basis: Spending authority: Central government, local authorities, public corporations, Economic category: Current expenditure account (expenditure on goods, services, transfer payments), capital account (investment), Programme: defence, agriculture, housing. The total figure for public expenditure, whichever basis is used, should be the same and represents the absorption of resources by the public sector. Canons of Public Expenditure These are principles proposed to govern the public expenditure decisions. They include; Canon of economy – utmost care must be taken to avoid wasteful usage of public funds. Canon of sanction – no public funds should be used without proper authorization and funds should be used only for the purpose for which they were sanctioned. Canon of benefit – public expenditure should be incurred only if it is beneficial to the society as a whole. The benefits can be through income distribution or production. Canon of surplus – the government should avoid deficit budgeting. It should be prudent and aim at meeting its current expenditure needs out of its current revenue. It should not overspend and run into debts. THE GROWTH OF PUBLIC EXPENDITURE REASONS FOR THE GROWTH OF PUBLIC EXPENDITURE Various factors – political, social and economic – have contributed to the growth of public expenditure and the growth of the public sector. The following are some of the major factors: The abandonment of the laissez-faire doctrine. As the climate of public opinion changed new theories began to emerge and old ones were abandoned; among the latter was the doctrine of laissez-faire. The self-correcting mechanism of an economic system that the classical economists believed in appeared to have failed. Unemployment, which to them was a theoretical impossibility, not only proved possible, but became a major international problem. During the Great Depression of the 1930s over 20 per cent of the insured population of the UK was unemployed. The theory of governmental non-intervention could no longer command support. There was a pressure of public opinion on governments to provide, relief for the unemployed and to create jobs. In order to do so, public expenditure was increased. The advent of Keynesian economics. One book, The General Theory of Employment, Interest and Money (1936), by John Maynard (later Lord) Keynes, had a profound and pervasive influence on economists and on governments for many generations. His arguments that the government not only could but should use public expenditure as a tool of economic policy to manage a national economy so as to counteract unemployment, found ready acceptance in a world that had not yet recovered from the Great Depression. The Keynesian prescription was to inject money into the economic system. If the people were not spending, then it was up to a government to do so. This required an expansive fiscal policy, in which a government would deliberately aim at a Budget deficit by spending more money than it raised in taxation. To cover the difference (deficit) the government would borrow. The 'Multiplier' effect of public expenditure would counteract unemployment. Such fiscal policy was attractive to the governments and popular with the public. By increasing public expenditure, a government was seen to be doing something about unemployment whilst the public were getting something (additional state benefits) for nothing, as it appeared, since there was no increase in taxation. Government therefore had an incentive to increase public expenditure and they did. What is more the policy appeared to work, unemployment began to fall. But to what extent the increase in economic activity can be attributed to governments' conversion to Keynesian economics, and to what extent it was the result of rearmament on which major countries embarked at the time when the General Theory was published, is debatable. Increased expenditure on defence was a response to the threat of war. As such it was a political measure but it did inject money into the economy and therefore had economic consequences. Wars and social crises, such as severe and prolonged unemployment had resulted in the growth of public expenditure. Increase in the range of economic activities by the state. Emergence of political philosophies, social attitudes and economic theories that advocated extension of the activities of the states prepared the way for governments to expand public expenditure. Psychological conditioning of the general public, during a period of war and social crisis, to a greater government intervention and higher levels of expenditure and taxation made it easier for governments in subsequent periods to retain and to expand their activities. Post-war reconstruction of countries' economies involved governments in planning, allocation of resources and in financing some of the projects. Economic development, according to some economists, has considerable impact on the level of public expenditure. Before a developing country can industrialize, it has to invest in transport, water and power supplies, sanitation, education and other basic social projects to reach a 'take-off point. In this early stage of development a high proportion of total investment will have to be made by the government, since the projects do not offer any, or foreseeable, return to investors. Once the country has reached a more advanced stage of economic and social development, private investment expands alongside public investment but, because of the imperfections of the market, government intervention grows and with it public expenditure. Growth of national income is related to the level of government economic activity. Some economists, Wagner among them, had argued that an increase in national income results in an increase in public expenditure on economic welfare. The richer a country the more resources, in theory, are available to the government. Increased public expectation. It can, however, be argued that, although it cannot be statistically proved, an indirect relationship exists between the growth uf national income and public expectation of an improved standard of living, and hence public expenditure. Governments are likely to-be under pressure to increase provision of public goods and services so as to increase the standard of living in general and of the poorest members of society in particular. The establishment of the welfare state. This has created a base for the long term growth of public expenditure. Socialism. Socialist parties, committed by their ideology to the extension of the public sector, won general elections and formed governments after the Second World War in a number of countries, including the UK. Implementation of the policies set out in the election manifestos furthered the development of mixed economies and contributed to the growth of public expenditure. Nationalization. The state takeover of private enterprises has increased public expenditure in two ways, firstly by a government paying compensation to former owners and secondly by subsidizing loss-making nationalized industries. New technology and science. Some new technological developments in such fields as atomic energy, aerospace and computers are so costly that in some countries they can only be financed by the state or with substantial aid from government funds. Scientific advances have enabled doctors to prolong life and reduce suffering, but in some cases at an enormous cost to governments' health programmes by creating ever-increasing demands. Creation of super national organizations. The United Nations, NATO, European Community and other multinational organizations that are responsible for the provision of public goods and services on an international basis, have to be financed out of funds subscribed by member states, thereby adding to their public expenditure. Foreign aid. Acceptance by the richer industrialized countries of their responsibility to help the poorer developing countries has channeled some of the increased public expenditure of the donors into foreign aid programmes. Increased complexity of national economies. As economies develop they become more complex and the interests of various groups within a society come into conflict. This has led to the proliferation of public bodies whose costs, arising out of their coordinating, regulatory, administrative or judiciary functions are borne by governments. Inflation. A general increase in prices has been an international phenomenon during the 1970s-1980s. Inflation increased the cost of all the activities of the public sector and was thus a major factor in growth in money terms of public expenditure in many countries. Demographic changes. Since public expenditure is intended to benefit the people of a country, it could therefore be expected that an increase in total population would result in higher public expenditure. But other demographic trends such as changes in the structure of the population (age and sex) and its geographical distribution also have to be taken into account. The overall effect of the various trends on public expenditure may be such that they cancel each other out, thus the extent to which the growth of population has led to growth of public expenditure depends on the specific conditions in different countries. RESTRAINTS TO THE GROWTH OF PUBLIC EXPENDITURE Some of the factors in the growth of public expenditure that we have discussed are of a temporary nature, others contribute to structural changes that result in an increasing financial commitment by governments on a permanent basis, but the ability to spend is not unlimited. The following are the four main restraints: Resources. In the long run, public expenditure cannot exceed the resources of a country. Taxable capacity. This imposes a ceiling on the government's revenue from taxation and thereby on an increase in public expenditure that is financed out of it. Limit to borrowing. For a time public expenditure can outstrip revenue either as a matter of necessity or of fiscal policy and the deficit can be financed out of loans. But there is a limit to how much money lenders at home and abroad will be prepared lo make available to any government. Public opinion. The final major restraint is the growth of public opinion. The level of public expenditure in a democratic society will depend on the size of the public sector that people want and are willing to pay for through taxation. CONSEQUENCES OF THE GROWTH OF PUBLIC EXPENDITURE Political, social and economic consequences are interrelated. They cannot therefore be easily isolated and compartmentalized. Some are, however, more identifiable than others and are listed below: A political consequence of the growth of public expenditure is the increased size of the public sector and hence of the power of the state. A social consequence of the extension of the welfare system is to allay the fear of deprivation that is consequent to unemployment, sickness and old age. The need for people to provide for themselves is reduced. Development of a welfare mentality is likely to increase people's dependence on government support and to lead to the creation of what politicians and social commentators call the 'underclass' in a society. Its members caught in the poverty trap may lack the means, ability, resourcefulness and incentive to break out. An economic consequence is an increase in taxation or borrowing or both, to finance rising expenditure. A disincentive effect on work and enterprise may result from an increase in taxation required to finance provision of public goods and services but economists disagree on this. National debt will increase as a result of borrowing and this will affect the rates of interest and supply of capital to industry. The rate of economic growth may be adversely affected by the; transfer of resources from use in manufacturing in the private sector to the public sector for provision of social services. The productive capacity and export potential of an economy may be reduced. Public goods and services, such as social security benefits, are not exportable and do not earn foreign currency. The balance of payments, will suffer if exports are reduced and when interest payments on the money that the government had borrowed abroad, or repayment of capital, become due. The prosperity of a country may, however, be increased if public expenditure is on projects that further economic development. If this happens then the balance of payments may improve. The standard of living of the people in general and of some groups in particular can be increased by the provision of public goods and services. Inflation resulting from the injection of public spending into the income flow of a country adversely affects not only the standard of living but the whole economy Stabilization of the economy may result from the use of public expenditure to counteract inflation and deflation. The level of employment may rise, but if the effect of increased public spending is inflationary, employment will be likely to fall. A more egalitarian society can be achieved by narrowing the difference in the level of consumption among its members by means of state benefits financed out of progressive taxation. Increased efficiency in provision of public goods and services as governments put greater emphasis on value for money in an attempt to curb growing public expenditure. This list of favourable and adverse effects that may follow an increase in public expenditure is by no means conclusive. Whether its consequences will be beneficial or not will depend on the existing level of expenditure, the purpose for which the additional money is used, the way that the expenditure is financed and the specific circumstances of a particular country. EFFECT OF PUBLIC EXPENDITURE Government expenditure or outlay has important effects on the entire economy of a country. It is important to consider the impact of public expenditure on such aspects as the level of employment, production and income, stability of prices, the creation and maintenance of full employment and a better distribution of income and wealth in the country. The influence of public expenditure on levels of economic activity and on distribution will depend upon the nature of the government and the period during which public outlay is made. For instance, in a free economy and during peacetime, government expenditure is generally quite low but in a socialist economy and also during war period, the contribution of government expenditure is more significant as regards the level of economic activity and employment. 1. EFFECTS ON PRODUCTION AND EMPLOYMENT Dalton shows how the level of production and employment in any country depends upon three factors, Ability of 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 three factors through public expenditure either for the better or for the worse. Government expenditure may help to improve the efficiency to work and thus raise the income of the people in the country. Accordingly, people may be able to save and invest a considerable part of their incomes. In this way, the productive potential of the country will increase. Such an effect of public expenditure may be explained as follows: Public Expenditure on Ability to work and save. If public expenditure can increase the efficiency of a person to work, it will promote production and national income. Public expenditure on education, medical services, cheap housing facilities and recreational facilities to the working class people will increase the efficiency of persons to work. At the same time, public expenditure can promote saving on the part of the lower income groups by providing additional income to them, for a person who has larger income can be normally expected to save a larger amount. Finally, that part of public expenditure which consists of payment of interest and repayment of public debt will place additional funds at the disposal of those who can save and invest. Thus, it will be seen that public expenditure can promote ability to work, save and invest and thus promote production and employment in the country. Public Expenditure on the willingness to work and save. Public expenditure may not have such a favourable influence on willingness to work and save. For instance, such items of government expenditure as pensions, interest on loans, provident fund and other government payments provide a security to a person and, therefore, reduce the willingness of persons to work and save, after all, why should a person work hard and save when he knows fully well that he will be looked after by the government when he is not in a position to earn an income. Public Expenditure and Diversion of Resources. Public expenditure has far-reaching effects on the utilization of resources as between alternative uses. There are some diversions of resources from private to public use about which there is some doubt. Dalton talks about the government expenditure on armaments and armed forces. To meet such expenditure, which is often called economic waste, the government diverts economic resources from the general public to the government; it is thought by many that these economic resources could have contributed to economic welfare if they had been allowed to remain with the people themselves. But a sensible argument can be given in favour of military expenditure. War expenditure reduces the danger of foreign invasion and thus diminishes the economic loss which would have resulted in the event of a war. It is, thus, true that public expenditure on armaments reduces economic resources from other uses in which they could have made a direct contribution to economic welfare. Millitary expenditure is essential for safety and security of the nation without which no country can flourish economically or otherwise. Thus, we can leave out the diversion of economic resources for purposes of defense. Public expenditure can bring about a better allocation of economic resources as between the present and the future. In a free capitalist society very little provision is made for the future. This is because people prefer the present rather than the future and, therefore, they do not make adequate provision for the future. The state, on the other hand, is the custodian of the interests of the future generations also and, therefore, has to see that adequate provision is made for the future. Some good examples are public expenditures on transport, irrigation and other projects which do not yield immediate returns but yield social and economic benefits for generations to come. In this connection, the government also spends money in the conservation of economic resources which are very essential for the future. Government expenditure for the protection of the environment will also have a favourable effect. The government spends money for the encouragement of research and invention, promotes education and training, looks after public health and sanitation and also takes the responsibility of social security measures. Some fiscal theorists, however, argue that the government" should actually curtail expenditure on many of these measures. Most fiscal theorists agree with Dalton that "increased public expenditure in many of these directions is desirable in order to bring about that distribution of the community's resources between different uses, which will give the best results, balancing without bias between the present and the future. In other words, the diversion of economic resources here will greatly increase production. Diversion of economic resources will be justified in those instances when the volume of new investment may not coincide with the volume of new savings. The lack of this coincidence, as Keynes pointed out is the direct cause of instability in the economy, of inflations and deflations and unemployment. To create a condition of stability and to bring about the equality of saving and investment in the private sector, government expenditure in the form of public works such as construction of roads, railway lines, irrigation works, power, etc., will be necessary. Government expenditure on the public works programmes has favourable effects on production and employment also. Sometimes, public expenditure may result in diversion of economic resources as between localities, in Kenya; this is brought about by the use of central government grants to some local governments to provide certain services more efficiently. This can also be done by careful regional planning, in such a way that a backward region may be economically developed. The government has to select the particular region or area and industry and incur public expenditure so that the maximum national production and following it the maximum community welfare can be attained. For instance, through improvement and development of transport and communication in the North Eastern area and the provision of water facilities in these areas and also through starting a few important industries by the State, the private sector also has been encouraged to open many industries in North Eastern. Thus, if public expenditure is prudently planned it can certainly bring about diversion of resources as between regions which will definitely improve the economic position of backward areas and thus bring about increase in production and employment. Finally, Dalton refers to a country where the government has complete power over the economy. This happens when the government has nationalized means of production as in a communist or socialist economy. In such an economy, there is no question of diversion of resources from the private to the public sector but the entire planning and expenditure of projects is in the hands of the government. PUBLIC EXPENDITURE AND ECONOMIC GROWTH IN A DEVELOPING COUNTRY In the previous section, we explained the role of public expenditure in stabilizing an economy and helping to maintain it at the level of full employment. But all this is relevant to a fully developed economy, which can work by itself but requires the help and support of the Government only at certain times. But this analysis does not hold well in the case of a developing country like Kenya which has: rate of saving and investment is low; the level of production and employment is low ; and there is chronic unemployment According to John Adler, a rising proportion of additional output should be devoted to capital formation, so that the economic growth of an underdeveloped country may be speeded up. For this purpose, two-fold changes in the government budget are required. First, the government budget should be raised so that a rising proportion of additional outlay may be available for development purposes, and second, a rising proportion of government revenues should be used to finance expenditure on development. Thus, public expenditure has a significant role to play in the process of economic growth. Changes in Expenditure If increased public expenditure on development is essential, then the rate of increase in other expenditures should be severally curtailed: Attempts should be made to tighten the administration which in most developing countries is unwieldy, inefficient and sluggish. It is possible to speed up the administration, improve its efficiency and weed out the useless elements and thus increase its productivity. Administrative expenditures can be stabilized if not curtailed, and still step up productivity. Many less developed countries, like Kenya, spend a considerable portion of their tax receipts on defense, which ought to have been spent on economic development. In some cases exorbitant defense expenditure has been foisted on some less developed countries. In some countries, internal disturbances and political instability lead to vast expenditures on the army and the police. It is true that political peace is an essential condition of economic progress but then cost of maintaining it should not be high. The social and cultural expenditure – particularly both general and technical education – are of utmost importance for economic growth. Some may assert that opening up of new schools does not constitute economic growth but without proper change in social and cultural values, it will be impossible to bring about economic progress. What is the use of imported machinery, unless there are technicians to handle it? Expenditure on education, on promotion of health, etc., is of great importance in a developing country. Development expenditure has increased considerably in all less developed countries since the end of the Second World War. Whether the increase in development expenditure in a particular country is adequate and whether it is possible to restrict other types of expenditure so as to increase development expenditure are questions which will have to be answered for every country, separately taking into consideration the special political and social problems involved. Content of Development Expenditure Taking the specific case of Kenya, development expenditure of the government aims at stimulating and supplementing private initiative and enterprise. It is possible, and some governments of less developed countries have attempted to do so, to eliminate the private sector altogether and plan for the entire economy as a whole. Direct stimulation is done by helping the private sector through loans, subsidies, tax concessions and exemptions, providing market and other information and providing research facilities. The government sets up special banking and financial institutions whose main aim is to provide finance for medium and long-term periods at low rates to help the private sector industries with adequate finance. In many less developed countries, the government attempts to set up a strong commercial banking system with the central bank at the top. These are all direct methods of helping the private sector to expand and develop rapidly. Indirect stimulation of the private sector is done by the government through the provision of social and economic overheads. Education and public health will come under the first head, and the provision of power, transportation, communications, etc. will come under the second head. The private sector industries reap economies of production from these facilities provided by the government. Social and economic overheads are a necessity and an essential prerequisite for economic growth. In fact, there are many competent observers who would like governments of less developed countries to provide only these facilities and leave the rest to the private sector. There is, however, a serious danger in the Government taking the responsibility to provide economic overheads. Kenyan experience shows clearly that much of the failure of Kenyan planning is due to the failure of such sectors as power and transportation which have been Government monopolies. However, there are certain enterprises which the private sector in a developing country may be unwilling to undertake, either because profit margins in these industries are low or almost nothing or because they require huge capital investment and a long time to yield returns. In other words, these enterprises may not be appealing to the private sector from the commercial point of view but may be of great significance from the point of view of economic welfare of the community as well as that of economic progress. In this group come all the key and the basic industries, transport and communication, development of irrigation resources, atomic power, etc. In fact, any industry which is necessary for the country and which helps in the growth of the economy can be taken up by the government. But the objective is not to compete with the private sector but really to supplement and complement it. This type of argument was used by – Jawahar Lai Nehru to get monopoly control over the key and basic industries. Priorities in Development Expenditure The basic objective of a less developed economy is to bring about some type of steady balanced growth for this purpose, priority determination of priority between the various development projects is essential for one thing; priority-determination will depend upon the basic objectives. Other things being given priority-determination should guarantee a maximum rate of balanced growth for another, priority will depend upon the available resources which indicate the type of projects that can or cannot be undertaken within a given period of time. Thirdly, priority-determination should also take into account the degree to which a given project will diminish a country's dependence on foreign countries. But ultimately, the solution to the problem of priority determination is an assessment rather than a calculation. This is so because it will be difficult to calculate the net yields of the various projects. A related question is on what sector of the economy, priority in a development programme should be given. While some have emphasized the development of the agrarian sector and exports, others have argued in favour of the development of secondary and tertiary sectors. There is a third view too, according to which, there should be equal emphasis on all sectors so that balanced growth will be achieved. W.A. Lewis has admirably stated the case of balanced growth in development-programmes, all sectors of the economy should grow simultaneously, so as to keep a proper balance between industry and agriculture, and between production for home consumption and production for export. The actual selection of projects from among the various alternatives on which to spend taxpayers money is based on the cost-benefit analysis. Cost-benefit analysis purports to describe and qualify the social advantages and disadvantages of a policy. THEORETICAL ASPECTS TO PUBLIC EXENDITURE EVALUATION Governments at all levels allocate a considerable portion of their revenue for expenditure on such public capital projects as transportation systems, airports and power generating plants. Other expenditures would involve, improving public health programs and education projects. The benefits from this expenditure accrue to society or a portion of the society for a long period of time. Project evaluation like all issues in allocation economics involves determination of the ways in which the most efficient use can be made of scarce resources. In its simplest form, the issue is how to determine the composition of the budget of a given size and how to allocate a total of given funds among alternative projects. To determine allocation between two alternative projects, expenditure evaluation involves evaluation of all costs involved and evaluation of all benefits to be derived from public funds. It is worth noting that where a project is purely private, consideration before investing includes: The expected rate of return on the project that would reflect the net results of private costs (money spent on all resources) Private revenues (sale of the goods and services produced by the capital assets). Degree of risk involved in the project. However, tabulating the private costs and revenues or benefits does not necessarily exhaust all the costs and benefits associated with the proposal. For example wherever a private investor decides to start a manufacturing plant, he only considers such items as the initial costs of construction, annual maintenance and service cost and the money value of the plan output. What his analysis would not consider, unless forced by the regulations, is the noise and air pollution imposed upon nearby area residents. Even social benefits accruing from such a plant (e.g. increased employment opportunities to residents of that area) would not be considered. However in the benefit-cost analysis in a public sector, social benefits and costs are captured in the analysis. Please note that, despite the differences that exist in cost-benefit analysis, both approaches (private and public) are analytically the same. It involves the comparison of the stream of benefits expected from a project measured against the stream of expected cost to obtain the expected net worth of the project. The major problems confronting Benefit Cost Analysis (BCA) from the public or social point of views are: The identification of all costs and benefits associated with a given project and Quantifying these costs and benefits in terms of the common unit, shillings. TYPES OF PUBLIC PROJECTS Public projects can be divisible or lump sum. In divisible groups all projects can be reduced or increased. If budget is fixed, i.e. given specific amount of money to spend, the planner must determine Cost (C) and Benefits (B) involved or derived from each project. After costs and benefits are known for each project the remaining problem is to allocate the cash outlays between the projects so as to maximize benefits and minimize costs. If we let costs be (C) and benefits (B) for any two projects e.g. X and Y the total net benefits can be given as follows: NB = B – C Note, C is the budget amount and in most cases it is fixed. The taste is simply to maximize B in the case of divisible projects and in a situation of a fixed budget, the opportunity cost of spending one more shilling on X is the benefit forgone by not spending it on Y, and vise versa. To maximize total benefits the policy maker should allocate outlays so that total benefits minus total costs are at a maximum. Such is the case if MBx / MBy = MCx / MCy, where MB is marginal benefit and MC is marginal cost. Given MC = sh 1, the policy maker will equate MBx and MBy (MBx = MBy) This is shown by Figure presented below. Figure 5.1: Expenditure Allocation with Fixed Budget Schedule MX and MY show the value of the marginal benefit (additions to total benefits) derived from spending successive shillings on X and Y. Total expenditures E are distributed between X and Y so that the marginal benefit of expenditures on X or Ac equals that Y or BD. Thus OA is spent on X and OB on Y such that OA + OB = E the assigned budgets. If this is done, total benefits from X as measured by the area OACF, plus those from Y as measured by OBDG are maximized. Putting the matter in cost benefit terms we see that the two projects are pushed to the point where the ratios of marginal benefits to marginal costs are equal. Since marginal cost in both cases equal Kshs. 1 we again have AC = BD. In the case of lumpy projects, and in a situation of a fixed budget use of marginal benefit analysis may not work where projects are indivisible or involve lump-sum amounts for example in road, dam, and bridge construction. For example if choice was to be made between road construction and airport construction marginal adjustments so as to equate benefits is not feasible. For such kinds of indivisible projects ranking scale is required where budget is fixed, to rate projects before a choice can be made. Example of Ranking Scale NAME OF PROJECT TOTAL COST (In thousands of Kshs) C TOTAL BENEFITS (In thousands of Kshs) B NET BENEFIT (In thousands of Kshs) B – C B/C RATIO (B - C) C RATIO RANKING K1 2000 4000 2000 2 1 2 K2 1450 1750 300 1.2 0.21 5 K3 800 1040 240 1.3 0.3 4 K4 500 1250 750 2.5 1.5 1 K5 3000 4200 1200 1.4 0.4 3 K6 1250 1250 0 1.0 0 6 K7 3000 2700 -300 0.9 -0.1 7 Table 5.1: Ranking of the projects In cost benefit analysis 1st to calculate net benefit NB = B - C. If you are to base decision on net benefits you will choose all projects that have positive net benefit. However caution need to be taken when ranking projects based on net benefit, since different amounts are involved. By absolute benefit cost differentials, project K1 would lead. Another measure which is considered safest to use is ranking projects is the benefit to cost ration (b/c). The ratio of benefit to cost for each investment is calculated and projects are then ranked in order of their B/C ratio. The project with the highest ratio should be the one to be financed first. Decision as to how many projects to be financed depends on amount of budget. If budget is Kshs. 7 million, the best combination of projects would be K4, K1, K5 and K3. The rest of the projects K2, K6 and K7 won’t quality because the budget is exhausted after the fourth project (K3) if funded. This combination will give me a total cost and benefits of:- COST BENEFITS K4 500,000 1,250,000 K1 2,000,000 4,000,000 K5 3,000,000 4,200,000 K3 800,000 1,040,000 TOTAL 6,300,000 10,490,000 Net Benefits (B-C) = NB = B – C = 10,490,000 – 6,300,000 = Kshs. 4,190,000 Any other alternative combination would have a lower total benefits, a higher total cost and a lower net benefit. Where budget is not fixed, there isn’t need of ranking the projects. The rule would be then to fund development projects so long as Total Benefits > Total Costs i.e. where net benefits are positive. The rule applies especially where a social good has very low rate of return but carries more social benefits to society as a whole. In such a case government will provide funds for such a program. 5.13 TYPES OF BENEFITS AND COSTS:- Benefits and cost may be real or pecuniary. Real benefits and costs may be; Direct or indirect; Tangible or intangible; Inside or outside; Intermediate or final REAL VERSUS PECUNIARY Real benefits are the benefits derived by the final consumer of the public project. They reflect an addition to the community welfare and they are weighted against the real cost of withdrawing resources from alternative uses. Pecuniary benefits and cost – occur as a result of changes in relative prices which occur as the economy adjusts itself to the provision of public goods and services. As a result of changing economic situation resulting from provision of public goods, some members of society may gain while others may lose. But this doesn’t reflect net gain or loss to society as a whole. The reason why society is left the same (no net gain or loss) is because one group’s loss is another group’s gain but since all groups belong to society there is a trade off. Consider the following case study to illustrate pecuniary benefits and costs: Consider a case where a road is constructed through a given district. The demand for construction workers in that district will increase leading to increased wages for construction workers in the area, while those to whom higher taxes have been imposed in order to construct the road will lose. Where the road opens new markets for certain products or raw materials or labour etc. Producers of these products will experience a higher demand leading to increase in price and earnings while those who paid the taxes will suffer reduced incomes. Note in both cases, society considered as a whole will remain indifferent because gain of construction of road will be offset by loses incurred. Welfare of society as a whole will remain uncharged but some individuals will benefits while others lose. DIRECT VERSUS INDIRECT BENEFITS AND COSTS Direct benefits and costs are those which are closely associated with projects objectives while indirect benefits and costs are in the nature of by products. The objectives of any development project are given under or by the intent of the legislative body which proposes it. For example: - An irrigation scheme has the provision of water for farming as its main objective. Rural health project can be designed to reduce death rates among children. It may also provide for family planning programme. While there are many direct benefits and costs there may also be certain silent features in the projects that can provide indirect benefits e.g. an irrigation scheme can also be used or modified to generate electricity and provide clean water for drinking. If provision for water for farming was the main objective of the legislator the eventual provision of electricity and clean water for drinking are indirect benefit. Direct costs to the project would involve costs incurred in purchasing and installing pipes. Indirect costs would be destruction of wildlife and diversion of water. A good education system will train and provide skills which will be used to improve the earning of participants. But, in addition to those direct benefits there may be other indirect benefits e.g. reduction in crime rate and the provision of expert’s services such as doctor’s services lawyer’s services etc. TANGIBLE VERSUS INTANGIBLE BENEFITS AND COSTS Tangible benefits and costs are those that can be valued in the market whereas others, which cannot are referred to as “intangible”. The distinction is thus synonymous with that between benefits from private and social goods or between costs, which are internalized, and costs, which are external. INTERMEDIATE VERSUS FINAL Development projects may be intermediate or final. Final projects are those, which provide services directly to consumer, and they involve also the provision of a final product. Intermediate projects are developed for the purpose of using them in further generation of other benefits. For example provision of road itself may be a social good and it enters as an intermediate good into the production of a final output which is a private good (the transported product ready for sale). INSIDE VERSUS OUTSIDE Another distinction is between benefits and costs which accrue inside the jurisdiction in which the project is undertaken and others which accrue outside. For example where a river basin is developed or drained so as to control flooding in a given district the benefits are derived within that district. However where these benefits are extended to other districts through which the river flows, the benefits can be said to be externalized. Case studies illustrating different types of benefit and costs CASE STUDY (A) IRRIGATION SCHEMES To see how C and B differ consider an irrigation projects which has to be carried out in a given area. The costs and benefits of the irrigation scheme can be classified as:- REAL (1) Direct Tangible Benefit Which include increased output resulting from the use of scheme, Provision of water for drinking, Increased livestock products and increased agricultural earning. (2) Direct Intangible Benefit Improved vegetation leading to a better environment. Intention of starting an irrigation scheme may have been also to improve the surrounding environment (e.g. May be the area is a semi-arid area). (3) Indirect tangible benefit Reduced soil erosion. (4) Indirect intangible benefit Where because of the presence of the scheme the rural society is preserved due to reduced rural-urban migration or general migration to other areas. (5) Direct tangible costs. Include such costs as cost of pipes, cost of labour, cost of hardware, cost of plant and equipment and salaries of experts. (Cannot yet inputs without paying a price) (6) Direct Intangible costs Include loss of natural or original features of the area; the possible loss of aesthetic healthy of the area. (7) Indirect tangible cost Include the effect of the diversion of water from its customary flowing direction. Diversion of water may affect the ecosystem in the area so that the wildlife that depended on it is destroyed. (8) Pecuniary benefits Would include the relative increase in the value of land around the scheme. It would also include relative improvement in the position of farm equipment industry. CASE STUDY B (B) EDUCATION PROJECT REAL Direct tangible benefit – increased future earnings Direct tangible cost – loss of students earning, teachers’ salaries, cost of building and books. Direct Intangible Benefit – Enriched life Direct Intangible cost – forgone leisure time Indirect tangible benefit – reduced costs of crime prevention. Indirect Intangible benefit – more intelligent electorate. Peculiarly benefit – relate increase in teachers’ income. PROBLEMS OF MEASUREMENT OF BENEFITS AND COSTS In the absence of a dictatorial form of government the benefits of a purposed public projects should reflect the preferences within the society. In a market economy preferences for goods and services are expressed in terms of what people are willing to pay for a product with a given cost structure. For product the interaction of demand and supply plays a major role in the determination of market price. However in the case of most public projects there exist many benefit and costs which are intangible (e.g. national defense) and do not have an observable market price. Even where price exist contain adjustments may need to be made since thy may not reflect true social values and costs owing to existence of market imperfections and externalities. Whenever intangible benefits and costs are involved measurements takes us back to the central problem of social good evaluation. This as was discussed in chapter 1, must be accomplished by budget determination through the political process. Imperfect as it may be it would seem rational to proceed with a project if people have expressed a consensus in favour of the project. The major drawback is that every project would have to be submitted to the electorate for approval while assuming that all the information about the project has been made available to the community. It would have to be further assumed that everyone understand the issues involved in the proposal. The impractical nature of this approach is obvious. It is worthy noting that cost benefit analysis is only a method of choosing among alternative projects after their values have been determined by the legislator. It is not substitute to political process. Thus cost-benefit analysis is most easily applied in those areas where benefits are tangible and there is least need for public provision to begin with. The task of benefit evaluation is facilitated where the public facilities are in the nature of intermediate goods rather than final goods. In the case of final goods such as parks, the social good aspect must be faced head on. Since evaluation through toll pricing would require the inefficient device of exclusion some other approach is needed. In case of a road which may be a social good; it enters as an intermediate good into the production of a final output which is a private good (the transported product ready for sale) the value of which can be assessed in market terms. [By provision of the road, the producer is able to reach the customers and the benefits may be valued in terms of extra profit earned as a result of accessibility to the market]. Evaluation can be based also on amount saved when the public project is provided (the cost saving approach). For instance supposing a project is initiated with an intention of reducing school dropouts. The benefits of such a project can be evaluated in term of amount of funds saved by correction institutions such as courts and prisons (Estimate benefit from saving of costs other wise you would have incurred). But even though the evaluation of benefits and costs may be difficult, economic analysis may be useful in identifying the actual benefits and costs expected from a particular project (e.g. gains in literacy from education programmes, better and longer life expectations from health, reduced crime from police protection etc). They can also estimate the costs involved. SHADOW PRICING AND MARKET ITEM Where benefits and costs accrue from a project, evaluation would be easy if markets are perfectly competitive. In this case the social value of tangible benefits is measured by the price which the service would fetch in the market, just as the social cost is measured by the price that must be paid for the inputs needed to render the service. A private market price or cost will reflect social benefits or costs at the margin if: There is no monopoly power There are no externalities Controls on output do not exist. However, these “Ideal” conditions are not met in many instances. Where monopolist exists, market price cannot be used to reflect consumer value of a product because monopolist price > normal price. Also the costs do not reflect true social cost. In such a situation adjustments need to be made to reflect the true market situation. Figure 5.2 Monopoly market structure In a situation where we have monopoly market we would produce OQm (Where MC=MR) so that he charges OPm. The cost per unit (marginal cost) he will be incurring is OMCM. However, this is not what people would be willing to pay for the output if the output could be sold in a competitive market. From diagram above people would be willing to pay a price OPN (which equals the marginal cost). Therefore some adjustments would need to be made to bring down the prices from OPM to OPN the true market situation. The technique of doing this adjustment is known as “shadow pricing”. In a sense then shadow pricing is an attempt to stimulate what people would be willing to pay for an output if the output could be sold in a competitive market. The use of “shadow prices” may be called for also, where relative prices are distorted by indirect taxes, or where externalities have to be taken into account. Other important instances of shadow pricing arise in developing economies with large labour supplies but extensive social legislation, including minimum wages. It may then be desirable to account for labour costs at a lower rate than applies in market. Or, over valued exchange rates may set too low a price on imported capital and induce wasteful investment unless higher shadow prices for such capital are applied. Shadow pricing can also be used to value benefits and costs where activities have no direct market analogue. The construction of a dam for flood control may, for example, reduce the population of certain species of birds in the area where the dam is to be located. How does the analyst evaluate this loss to local bird watchers? The dam will likely increase the population of other birds in the area, such as waterfalls but it would be extremely difficult to place a monetary benefit on this activity. The same project may generate recreational benefits, for example, fishing, swimming, and boating. Shadow pricing may take the form of observing what people in similar situations pay for these as private consumer goods. DECISION INVOLVING LONG-TERM PROJECTS Much public expenditures bestow benefits on society well into the future and there are costs that will be incurred in the future as well. For instance, such expenditures as investments in river basin development will yield benefits over many years. Such costs as machinery maintenance would be incurred in the future. The question is, are the benefits and costs of today to be valued in the same way as those in the future? The generally accepted view is no. Society prefers present net benefits to those in the future owing to uncertainties related with the future. Thus, to evaluate such benefit streams and costs would require their translation into their present values. This requires the future expected streams of B and C to be discounted so as to determine their present value. lDISCOUNTING TECHNIQUES Method to be used to discount future expected streams of B and C would depend on; Whether the streams of benefits and costs are expected after a time period of t years. Whether the streams of benefits and costs are expected annually. CHOICE OF DISCOUNT RATE In choosing the discount rate, government may proceed on the premise that it is desirable to use a rate equal to the time preference of private consumer; or it may substitute social discount rate of its own. The rationale for using the private or markets rate of return is that this rate reflects consumer choice between present and future consumption. Assuming an economy with wholly flexible prices and perfectly competitive capital markets only one rate of interest will prevail in the market determined by DD and SS conditions in the capital market. All households would yield the same rate of return. The prevailing interest rate would reflect the consumers’ marginal rate of substitution (MRS) of future for present consumption i.e. their rate of time preference. By accepting this rate for purpose of project evaluation, the government thus respects consumer’s preference. Where the market is competitive the market rate also reflects the marginal rate of transformation in production (MRT) i.e. the marginal efficiency of investment. As saving and investment are pushed to the point where the two rates are equated, an efficient allocation between present and future consumption is achieved. When r = MEI, financial market is said to be efficient and the rate of discount (r) prevailing in the market is at equilibrium. MEI is also called the internal rate of return (IRR). It is a rate of interest that equates present value of future cash flows of projects over the projects useful life to initial cost of capital. NPV = n Rt - C = O t=1 (1+r) t Where Rt annual cash flows over time t r is the internal rate of return C is the initial cost The government in determining the present values of the benefits stream from public investments will discount this stream at r. Since the market is perfect no “shadow prices” are needed. Public investments would qualify if the present value of the benefit or income stream B exceeds cost C, the benefit – cost ratio B/C must be at least 1 or alternatively, B/C must be positive. However the simple assumption that there exist efficiency in the capital market is unrealistic in the real would. In the presence of risk, some investments are more risky than others. Thus the gross rates of return on investments on these projects would differ by the amount of the risk premiums. Risk may also apply regarding the return on public investment so that it should be allowed for by adding an appropriate risk premium to the discount rate used in determining the present value of the benefit stream for a public investment. There may also exist market imperfection owing to monopolistic elements of various kinds. As a result various consumers may be confronted with different borrowing returns. As a result it is no longer obvious just which rate should be used in discounting the public investment stream or how the opportunity cost of resource withdrawal from the private sector should be measured. The difficulties of identifying the markets rate are avoided if a social rate is used instead. Social rate is the rate at which individuals will loan money to the government. Proponents of the social rate of interest argue that when people purchase government bonds this reflects society’s desire to forego present for future consumption. ACTIVITY 1 How can the public expenditure leads to inflationary pressure in the economy. 2. What is shadow pricing? Lecture Six THE BUDGET Types of Budget There are three types of budget; Balanced budget (where expenditure equals revenue). Deficit budget (where expenditure exceeds revenue). Government borrows. Surplus budget (where expenditure is below revenue). Government saves. A balanced budget can be regarded as neutral. It has been called an 'orthodox' budget, reflecting the Treasury view of sound finance. A deficit budget is expansionary as more money is pumped into the economy than is withdrawn in taxation. The borrowing that this policy requires is likely to have an inflationary effect in some circumstances. During the Great Depression of the 1930s, governments sought to stimulate economic activity by means of deficit budgets. A surplus budget is deflationary insofar as the government takes out more than it puts into the money flow. Which type of budget a Minister of Finance will present will depend on the government's assessment of the economic situation and the overall economic, social and political policy, it seeks to pursue. However, within the three types of budgets there is scope to vary taxes and expenditure to achieve the desired effect. ZERO BASE BUDGETING It involves examination of the very rational of an expenditure item under consideration. The aim is to guard against wastage in public expenditure. It involves a detailed investigation of excess item of expenditure to see whether it is really needed or it should be revised or done away with. If a sector is not able to justify its existence, it should be closed down. If its existence is justified, the optimum level of its operation and the corresponding budget provision must be defended. In zero base budgeting no section is essential. It must proof its worthiness. The budget can be approached from two angles. First, the Minister decides on expenditure both on current account (government's consumption of goods and services, transfer payments, grants, subsidies, interest payment) and on capital expenditure (investment in physical assets, grants). He then adjusts taxes to cover expenditure entirely or partially and then borrows the rest. The second approach is on the basis of the principle of 'living within one's means'. The Minister assesses the total resources available to him, He then works out how much he can 'afford' to spend on different programmes to keep his total expenditure within the limits of the available resources. Performance and programme budgeting system (ppbs) This is when a budget cpvers both performance and programme. Programme budgeting involves laying down the sequence of steps for executing the project along with expenditure of resources involved at each stage. Performance budgeting is a devised tests for comparing actual with the expected results and thereby assessing the performance efficiency of the project. ACTIVITY What is the role of parliament in the budgetary process in Kenya? Lecture Seven TAXATION AS A SOURCE OF REVENUE INTRODUCTION The primary motivation for taxation in developing COUNTRIES like Kenya is to finance public administration and the public provision of economic and social goods and services. The secondary motivation is the redistribution of income and wealth, the correction of market imperfection and stabilization of the economy. Taxes are withdrawn from private sector without any obligation to government to repay. They are imposed to tax payers and are compulsory. Taxes however are not the only source of funds for government expenditures financing. Other sources include: internal harrowing through selling of government securities; external borrowing earnings from state owned enterprises; sales of public assets (e.g. sale of government owned land and condemned houses) or privatization; through rent (e.g. housing) and through money creation (printing of money) It is worth noting that the excessive use of some of the methods of financing would result to certain macro economic imbalances. For instances excessive borrowing and money creation would be inflationary. This is not to suggest of course that taxation should be the sole means of finance. There are times when borrowing or money creation are preferable alternatives to taxation, particularly during periods of unemployment when the goal of stabilization policy is to stimulate and not to reduce private spending. Ignoring cyclical fluctuation however it remains inconceivable that any modern economy would seek to finance its expenditure without taxation being the dominant means of affecting the required resource transfer. CANONS OF A GOOD TAX SYSTEM The following are the requirements for a “good” tax structure: - Equity – a good tax system must ensure that tax burden is equally distributed. That is everyone should be made to pay his fair share. Economical – a god tax system must ensure that both the costs of collecting taxes to the government and the costs to tax payers of meeting their tax obligation are minimized. Avoidance of excess Burden – taxes should be chosen so as to minimize interference with economic decisions in otherwise efficient markets. If a tax diverts resources into the public sector such that it clearly imposes a burden on the economy that can be equated only to the revenue raised we say that the tax is free of excess burden. But where the imposition of a tax e.g. excise tax levied on a particular commodity provides an incentives to a consumer to reduce his purchases of taxed as opposed to untaxed goods to minimize his tax liability. This reallocation of resources induced by the tax is the nature of the excess burden over and above the revenue raised. A desirable goal of a tax system is that it should minimize this excess burden caused by diverting a given amount of resources into the public sector. This can be accomplished by choosing those taxes that do the least to distort economic behavior. Thus a system of selective excise taxes that raise the price of some of goods but not others will do more to distort relative prices and hence consumer purchases than will a general sales tax that raises the price of all goods on which it is imposed uniformly. Awareness – a good tax system should be understandable by the taxpayer. The more he is aware of the tax burden, the better he is able to judge the amount of public goods and redistribution he waits against their tax costs and the better equipped he is to vote for the size of the public sector he wants. Elasticity – by elasticity is meant that a tax’s revenue yield should be sensitive to changes in economic conditions without deliberate changes in rates. It is important that the principle of elasticity be fulfilled for at least two reasons. First elasticity enables government to finance the rising demand for public expenditures without the disturbance of frequent rate changes. It is worth noting that if a tax is highly elastic with respect to real income, the ratio of government revenue to GNP will raise as real GNP rises. Second elastic tax yields function as an automatic stabilizer for fiscal policy purposes. Certainty – there are several different interpretations that can be given to the principle of certainty. One interpretation, which is perhaps the most fundamental, concerns the ease with which the individual taxpayer can compute his own tax liability. The law with respect to the payment of taxes should be made specific as to how much the tax payer should pay, on what he is paying and when he is to make payments. Adam Smith regarded a small degree of uncertainty as a much greater evil than “a very considerable degree of inequality” in that it give the taxing authorities discretionary power in assessing taxes against individuals. An alternative interpretation of the certainty principle applies not to the taxpayer but to the taxing authorities. According to these criteria a desirable feature of a tax is that its yield should be relatively certain so that the taxing authorities can estimate their budget requirements more accurately in the light of proposed expenditures. Convenience – a further principle of taxation is that tax payment should be convenient, that is the time and manner of payment should be made as desired as possible for the taxpayer. It was in accordance with this principle that he system of withholding in payment of income taxes was adopted by government. Prior to that time, taxpayers were required to pay one lump sum on income earned throughout the year. The Long between the earning of income and the payment of taxes proved to be a burden to most taxpayer. Thus the system of withholding by assuming that taxes were paid as income was earned eliminated the need to accumulate tax liability and hence reduced evasion in the payment of taxes. APPROACHES TO EQUITY Tax equity refers to fairness of tax system. It is borne out of a feeling that each citizen of a country should contribute fairly to the cost of government. The difficulty, however is to know precisely what constitutes fairness in taxation. The discussion of tax equity has produced two opposing approaches to this problem. These are the benefit principle and the principle of ability to pay. THE BENEFIT PRINCIPLE The benefit principle argues that equity in taxation requires that taxes to be paid in accordance with the benefits received from government expenditures. If tax burdens are allocated on any other basis such as ability to pay, then tax payers who have little or no ability to pay will continue to enjoy the consumption of public goods even though they have contributed little or nothing to their financing. People should pay for what they get, disregarding whether what they buy is produced in the public or the private sector. This approach dates back to the days of Adam Smith, Locke, Bentham and Hobbe. Most of them belonged to utilitarian school of thought, which emphasized the need to tax people according to benefits they derive from consumption of Public goods. The appropriate tax formula thus depends upon the preference patterns. More specifically it depends upon the income and price elasticity of demand for social goods. If income elasticity is high the appropriate tax prices will rise rapidly with income but if price elasticity is high the increase will be dampened. More specifically the required rate structure will be proportional, progressive or regressive, depending on whether income elasticity equals exceeds or falls short of price elasticity. This can be stated as follows: - Let P be the appropriate unit price of public services to a taxpayer with income Y. Income Elasticity (Ey) = ( Q/Q) / ( y/y)……………. (1) Price Elasticity (Ep) = ( Q/Q) / ( P/P) ……………. (2) Ey = ( Q/Q) / ( y/y) = p – y ……………….. (3) Ep ( Q/Q) / ( p/p) p y If EY = 1 The required tax rate will be proportional Ep If Ey > 1 The required tax rate will be progressive. Ep If Ey < 1 The required tax rate will be regressive. Ep This finding is interesting but it doesn’t permit easy implementation. The relevant price income elasticity’s are not known or readily derived from market observation as in the case of private goods (due to markets failure that is associated with social goods). WEAKNESSES OF BENEFIT PRINCIPLE The benefit approaches requires that the expenditure benefits of each taxpayer be known. As was seen earlier, much of government spending consists of public goods, the benefits of which are indivisible. Such goods cannot be parceled out among individuals and sold at a price that reflects the marginal satisfaction obtained by the taxpayer – consumer. -It is generally difficult to establish the degree of benefit that a person derives from the use of public goods and services, since the consumer would not voluntarily reveal how highly they value the public services. -Given that most public goods consumption is non-rival and that one-person benefit doesn’t restrict consumption of another the benefit tax becomes very difficult to collect. However, although there are many problems associated with collection of benefit taxes they are still used in many countries. This varies from tolls paid by motorists on highways to finance the construction and maintenance of roads to fees charged for the collection of waste materials (service charge). Levy can also be placed on the use of sports grounds in order to finance for more recreational facilities or to help pay off loans used in constructing such facilities. The question is under what conditions can such direct charges on the beneficiaries be made? Benefit taxes works well where goods and services to be taxed have many properties of private good (rival in consumption, carry a price and benefits are internalized) the consumer is then taxed according to amount used like in licensing vehicle, in charging hospital fees, in charging rent for municipal houses etc. where product is completely rival and there is a significant amount of competition among consumer, the benefit taxes can be charged in same way private firms charge price. In other instances where imposition of direct charges is desirable but too costly a tax on a complementary product may be used in Lieu of Charges. For example taxes to finance highway construction are often fixed on petroleum products used by road users. They may also be fixed on the cars used or being bought. Another area where taxes are paid in lieu of use is on property ownership and use. In this case tax is collected in form of stamp duty on purchase of houses, on certain documents of titles during certain financial translation or in general, property tax may be fixed to finance certain public services that are associated with certain or specified properties (e.g. Security, street lights, schools etc) In conclusion benefit taxes are considered to be suitable because the tax burden is placed on the shoulder of the persons who benefit from the use of a specified good or services. The second or alternative approach holds that equity in taxation is attained when taxes are paid on the basis of ability to pay, the rich being required to pay more in taxes than the poor. They argue that the government cannot raise enough funds to finance public expenditures if each and every one was required to pay same amount of tax. Each of these approaches has its own drawback. THE USE OF ABILITY TO PAY AS A BASIS FOR TAXATION The requirement that each citizen should contribute to the cost of government in line with his ability to pay is considered to be more equitable way of distributing income in the country. Actually there are two separate parts of the principle of ability to pay. The first part deals with the tax treatment of people who are similarly situated. This is the principle of Horizontal Tax equity. This principle states that those who are in the same position (i.e. have the same amount of income) should pay the same amount in taxes. The second part deals with the tax treatment of people who are differently situated (that is who have different amounts of income). This is the principle of Vertical Tax Equity. The interpretation given to this principle is that the rich should be required to pay not only more in taxes than the poor but also a progressively larger amount. CATEGORIES OF TAXES The figure given below presents a simplified picture of the circular flow of income and Expenditures, together with the major points of which such taxes are inserted. Points of Tax Impact in Circular Flow We may think of the monetary flow of income and expenditures shown in the figure as proceeding in a clockwise direction, while the real flow of factor inputs and products outputs (not shown) moves in an anticlockwise direction. Starting from factor market households sell their skills earning incomes inform of wages, dividends, interest, rent and so on. The households save some of the income with the capital market and consume the other part of their income by purchasing goods from market for the consumer goods. Consumer expenditures into the market for consumer goods become receipts of firms selling such goods. Savings are channeled into investments, becoming expenditures in the market for capital goods, and turn into receipts of firms producing such goods. Part of business receipts (corporate income) is set aside to cover depreciation and the remainder goes to purchase the services of labour, capital and other inputs in the factor market, representing the factor shares in the national income. These shares are paid out to suppliers of factors – in the form of wages, dividends, interest, rent and so on – and become income of household. Some profits, however, are withheld as retained earnings rather than paid out as dividends. Retained earnings, together with depreciation allowances, comprise business savings and combine with household savings to finance investment or the purchase of capital goods. Thus the circular flow of income and expenditure is closed. Locating Impact Points of various Taxes in the diagram At point 1: Personal income tax is imposed on household income. At point 2: Following expenditures by consumers on final goods, expenditure tax or value added tax is collected At point 3: Can also collect sale tax from retail sales receipts of the firms. At point 4: Can collect corporate income tax from income of the firms originating from market for consumer and capital goods. Note: Depreciation is operating expense and is tax free. At point 5: Can collect income tax from business receipt net of depreciation. At point 6: The employer contribution to the payroll tax At point 7: Can collect corporate profit tax. At point 8: The employee contribution to the payroll tax At point 9: - can collect from retained earning withholding tax. Retained earning is part of profit not distributed to dividend holders but are aimed for expansion purpose. At point 10: collect income tax. In Conclusion From figure above, It can be noted that any particular transaction may be taxed at either the household (buyer) or the firm (seller) side of the market. We also note that any particular household or firm may be taxed at either the sources or the uses side of its account. Since the account balances (total uses equal total sources), a general tax on the uses side is equivalent to a general tax on the sources side. A tax on total household income would thus be equivalent to one on total consumption plus savings. Similarly, a tax on total gross receipts of firms would be equivalent to a tax on the total uses of its proceeds or cost payments plus profits. Combining the buyer – seller and sources – uses distinctions, our major taxes may thus be arranged as follows: Uses Sources Households Expenditure tax (2) -Income tax(1) -Employee payroll tax (8) Firms Profit tax (7) Employee payroll tax (6) Retail sales tax(3) Note: numbers in the parenthesis refer to impact points shown in figure FURTHER DISTINCTIONS Personal Versus In Rem Taxes Personal taxes are taxes paid according to taxpayer’s personal ability to pay. In Rem taxes (taxes on “all things”), on the other hand, are taxes imposed on activities or objects as such, i.e., on purchases, sales, or the holding of property, independently of the characteristics of the transactor or owner. In Rem taxes may be imposed on either the household or the firm side. But personal taxes, by their very nature, must be imposed on the household side of the transaction. Thus, if proceeds from the sale of factors of production are to be taxed in a personal fashion, the tax must be imposed on households as a personal income tax. Similarly, if consumption is to be taxed in a personal fashion, the tax must be placed on the household in the form of a personal expenditure tax. A sales tax imposed on firms is not responsive to the particular consumer, but gives the same treatment to all households which undertake the taxed transaction. In Rem taxes do not consider the ability to pay or equity. They are based on the benefits as measured by the amount consumed. Irrespective of whether or not the consumer ability to pay is low, if his consumption is high he will pay more. They are in this sense considered to be regressive. As such, personal taxes tend to be generally superior in equity since they are assessed on the household side. DIRECT VERSUS INDIRECT TAXES Direct taxes are taxes which are imposed initially on the individual or household that is meant to bear the burden. (e.g. income tax) Indirect taxes are the taxes which are imposed at some other point in the system but are meant to be shifted to whomever is supposed to be the final bearer of the burden.(sales taxes) Personal taxes, such as the individual income tax, are thus “direct” and most In Rem taxes, such as the sales tax are “indirect.” At the same time, the distinction between direct and indirect taxes does not always coincide with that between personal and In Rem taxes. Thus the employee contribution to the payroll tax may be considered direct, yet it is not a personal tax since no allowance is made for the owner’s ability to pay. Similarly, the property tax on owner – occupied residences is direct, but it is an In Rem tax rather than a personal tax. THE TAX AND EXPENDITURE INCIDENCE Tax incidence refers to micro and macro effects of taxation. Question normally asked include; Does a given tax pattern distribute income and output fairly? If not, where could it be adjusted so as to reduce tax burden from less privileged society? Note: Tax incidence refers to the way in which tax burden is shared among individual households. For example, if two billion pounds is collected in taxes in order to build a hospital, then this is the opportunity cost of providing this health service to society. Society will benefit from improved health services, but incidence of this tax will depend on who pays how much of total tax liability required to build the hospital. We can also say that the two billion pounds tax collected represent tax burden to society. The effects of withdrawing these amounts from tax payers would include reduced consumption increased employment or reduced output. These are the distributional incidence of tax. This tax burden is in turn accompanied by the benefit of improved health services which must be allowed for to derive the net gain or burden of the entire transaction. In general, taxes have micro effects and macro effects on level of output, employment, prices and growth in the economy. When budget operations do not involve resource transfers to the public, the government simply collects taxes form the private sector and returns\transfers to that sector. There is no shift of resources to public use and no opportunity cost in reduced private resource availability. Some may gain while others will lose, but taxes being equal to transfers, there will be no net change in income available for private use. MAGNITUDE OF TAX BURDEN When we talk of tax burden we simplify mean how much it squeezes you. Tax liability on the other hand refers to actual sum of money a taxpayer is required to pay as a fraction of his income. We have so far assumed that tax burden equal total tax liability to an individual. However, this may not always be the case. There are cases where tax burden can be more than tax liabilities. Where tax burden exceeds tax liability there is excess burden. Example: tax is imposed on radio sets (value added taxes) in order to raise one million pounds. The sum total of tax collections from various consumers still equals one million pounds, but the burden imposed on the private sector will be larger. This is so because the tax interferes with consumer choice. Some people who had planned to buy the radios may avoid buying them because of the tax payable. Therefore, they pay no taxes but the budget choice is less satisfactory than it was before. These taxpayers therefore suffer burdens which are not reflected in total revenue. Others may reduce their purchases and pay a tax on the reduced amount. In both cases the consumer’s expenditure pattern has been distorted by the tax and each suffers a burden which is greater than that which would have applied if they had paid the same amount as a flat charge. Because of this, the overall burden suffered by the private sector tends to exceed the amount of revenue obtained. This is what economists call “excess burden.” Another reason why tax revenue and total burden may differ is when the imposition of tax leads to a change in factor inputs and hence in total output. For example, when same revenue as in the previous example is collected under a progressive income tax. As a result, workers may work more or less because the tax is imposed. If we suppose that they work less, their earnings fall. If this decline in earnings is counted as part of the burden, the total burden once more exceeds tax revenue. Excess burden can also be considered from the employment point of view. Changes in output may result, not because of adjustments in factor inputs in response to changes in after – tax factor rewards, but because of resulting changes in the level of aggregate demand and unemployment. Introduction of a tax may reduce the level of employment, or an increase in expenditures may raise it. TAX INCIDENCE AND TAX SHIFTING Taxes are paid in line with prevailing tax statute that has been legislated. Taxes in this sense are mandatory imposition and failure to pay them is punishable by law. When we consider who holds the legal liability to pay tax, we are considering the statutory incidence of tax. Like in all other cases of incidence, individuals will try to avoid tax by passing their tax burden to others. While considering the nature of statutory tax burden we must remember that the final tax burden must be borne by all citizens. The taxes are usually finally paid by the households in their capacities as owners of business which pay the taxes, or as consumers of the products of the taxes, or as consumers of the products of these businesses, or as employees of these institutions. When we examine tax from an individual point of view, we encounter certain implications. When an individual is taxed a lump - sum tax of say Kshs.200 independent of his ability to pay, he cannot escape it. However, he may adjust himself to the incidence of this tax by cutting down his consumption or his savings or his aid to those who are dependent on him. In effect when he does this he passes his tax burden to others with whom he transacts and thus will have further repercussions. Moreover, taxes are rarely imposed in lump – sum form. The tax law typically expresses tax liabilities as a function of some aspect of economic behavior, such as earnings income, making sales, or making a purchase. Since such taxes are imposed on economic transactions and since transactions involve more than one party, the transactors on whom the statutory liability rests may avoid tax payments by cutting back on their taxable activity; or they may attempt to pass on the burden to others by changing the terms under which they are willing to trade. Their ability to do so will depend upon the structure of the markets in which they deal and the way in which prices are determined. Thus, imposition of an income tax may lead to reduced hours of work, thereby driving up the gross wage rate. Increased wages in turn would lead to increased product prices, which burden the consumer. Nevertheless, the resulting chain of adjustments may lead to a final distribution of the burden or economic incidence, which differs greatly from the initial distribution of liabilities or statutory incidence. In all this cases when one party tries to avoid taxes by passing his burden to other people, we say that he is shifting his tax burden. TYPES OF TAX INCIDENCES Absolute Tax Incidence Taxes will reduce the level of disposable income both at macro and micro level. At macro level, an increase in taxes leads to a decrease in aggregate demand. If the public policy is to stabilize the economy by increasing taxes without changing government expenditures, the course that the economy will take will depend on distributional effect of the tax itself. An increase in tax depending on state of the economy can lead to unemployment, a reduction in prices or can lead in a shift in resources from one use to another use, so that each tax action has its own effect and distribution implication. Where tax is increased or reduced without a relative change in government expenditure or an offsetting change in other taxes the effect that such a tax will have either in aggregate or to each individual household is called absolute tax incidence. Differential Tax Incidence In some cases one tax may be replaced by another tax without changing the amount of tax revenue and government expenditure. The effects that result from such changes in taxes are referred to as differential tax incidences. This form of policy change does not involve any transfer of funds from private hands to public hands and no net burden on the private sector. It merely involves redistribution among households. Consider a case where Kshs one billion of income tax revenue is replaced with a cigarette excise yielding an equivalent amount. Households whose income tax is reduced will gain, while others with high cigarette purchases will lose. Going beyond this, tobacco growers and cigarette workers will lose, while others producing the output purchased by former income taxpayers stand to gain. This resulting total change in the state of distribution is what is referred to as differential incidence. Budget Incidence Budget incidence may originate from changes in government expenditure and changes in taxes. Government expenditure may be on transfer payment, salaries to civil servants, capital expenditures for development, purchases of goods and services, and debt repayment and servicing. Incidence of government expenditure can be explained in various ways; Increase in government expenditure leads to increase in disposable real income and further increase in employment in the country. This is under normal circumstances. But, if unplanned well, Increase in government expenditure may lead to increased aggregate demand over aggregate supply, hence leading to inflation. On the other hand, increase in taxes has the opposite effect. Its immediate effect is a reduction in real disposable income, increased unemployment, or reduced inflation. Note: Taxation and government spending take place simultaneously. Those taxes reduce earnings of the private sector and in particular they reduce disposable income. As a result of this, benefits from public goods will increase while benefits from private sectors will decline. These effects constitute budgeting incidence of a tax. EFFECTS OF TAX INCIDENCE ON MARKET FOR GOODS Where tax is collected on each unit of output produced or sold it is called a unit tax. Where it is quoted as a percentage of selling price it is called an advalorem tax. So, unit tax is quoted as specified amounts per unit sold, for example, 20 Shs per Kilograms. When it comes to advalorem tax, it may be quoted as 5% of manufacturers price or 10% of wholesale price, depending on where it is collected. Taxes, irrespective of their kind, will disrupt the equilibrium existing between demand and supply in the market. An increase in tax of a given commodity increases the price and reduces the demand for the product depending on price elasticity of demand of the product. When a unit tax is imposed, its effect is to shift the supply curve upwards from SS to S1S1. Unit tax is viewed here as additional to cost. SS is the supply schedule prior to tax and S1S1 is the supply schedule as it confronts the consumer after imposition of a unit tax “a.” The demand schedule is given by DD. Observation:- Quantity demanded declines from OQe to OE. OB – Price before tax. OF – Price after tax. Total tax rate is KF. BF is tax rate payable by consumer per unit sold. KB is tax rate paid by seller of the product Total amount of tax revenue collected from both seller and consumer is represented by area KFGL. Consumer pays the amounts of tax represented by over BFGH. Producer pays the amount of tax represented by area KBHL. This is the case where we have unit tax charged on every unit sold or bought. When it comes to advalorem tax, the case is different. T = F (price per unit sold), since tax is expressed as % of selling price. Unlike in unit tax where the supply curve shifts when tax is introduced, in the case of advalorem tax it is the demand curve which shifts downwards. Tax amount collected is still represented by the difference between the price paid by consumer and net price received by seller. Also note that when advalorem tax is imposed, although the demand curve shifts downwards, the shift is not uniform because the amount of tax per unit falls as the quality sold increases. (note advalorem tax is quoted as , e.g. 5% of selling price) DD is the market demand schedule and SS is the supply schedule. Equilibrium output before tax equals OQe, and price equals OB. Now if advalorem tax at rate T = AJ is imposed. The net demand schedule shifts to D1 D1. Output falls to OE, the AQe gross price rises to OF, and the net price falls to OK. Total tax revenue is represented by area KFGL. Consumer pays the amount of tax represented by area BFGH. Producer pays the amount of tax represented by area KBHL. There are two ways of quoting advalorem tax from the diagram; When advalorem tax is quoted as GL it is called net advalorem tax rate. EL when advalorem tax is quoted as a ratio of tax to the gross price (GL) EG It is referred to as the gross advalorem tax rate. INFLUENCE OF PRICE ELASTICITY OF DEMAND AND SUPPLY Immediate effect of imposing tax on commodity is to raise its price. But the resulting changes in price magnitude by which the price will rise or fall will depend on elasticity of demand and supply. When both demand and supply schedule are elastic, an increase in tax leads to a less than proportionate increase in price. There are few things to note; Total tax liability equals total tax collected from both producer and consumer and is represented by area KLGF. Tax burden to consumer = area BHGF. Tax rate burden = BF. Suppliers tax burden = area KLHB. Tax rate to supplier = BK. Note also that burden to consumer reflect the additional amount which they must pay in order to get new quantity OE, compared with what they would pay in order to get whole larger quality OC. To consumer, tax effect is increased prices from OB to OF and reduced demand from OC to OE. In general, burden to supplier is reflected in reduced supply and reduced net price. Supply falls from OC to OE. Net price falls from OB to OK. This has led to less net revenue from the sale of product. This explanation doesn’t consider the problem of acess burden but it suggests a very important rule that the burden of tax is divided between the buyer and the seller as ratio of elasticity of supply to elasticity of demand in the relevant range of demand and supply schedule. To show how this is true:- This can be proved using the above diagram as follows; In statement No. 1:- When demand curve and supply curve are rotated around point A, then it is clear that the buyer’s share in the tax burden increases as the demand curves becomes less elastic and supply curve becomes more elastic. Or, in other words, the consumers share in the tax burden increases as demand schedule steepens or becomes more inelastic and the supply schedule flattens or becomes more elastic. No.2 It can be shown that Bb = Es, ratios or elasticity. Bb and Bs represent the consumer and Bs Ed Seller’s shares in the tax burden Bb – buyers share. Bs – sellers share. Es – price elasticity of supply. Ed – price elasticity of demand. No.3 From above figure, Ed over the relevant price range OF = Ed = PO; DQ DP QO Original price = OB (Po initial price) DP = OF – OB = BF Initial demand QO = OC DQ = OC – OE = EC Ed = (OB). (EC) (BF). (OC) No.4 Similarly it can also be proved that; ES = PO. DQ DP. QO DP = OB – OK = BK PO = OB DQ = OC – OE = EC Q = OC ES = OB . EC BK OC So that ES is based on net price (OK) to the seller after the tax (FK) as compared to original price (OB) before tax. From equation 3 and 4 above, the ratio of elasticity of SS to DD (EC. OB) = BF proving ES = (OC . BK) = BK ED (OB. EC) (BF. OC) Statement 2 is correct. Note: BF is tax rate payable by consumer. BK is tax rate payable by supplier. We can also interpret BF and BK as follows; BF is buyer’s share in tax burden. BK is seller’s share in tax burden. CASES: Where demand is perfectly inelastic while supply is elastic the whole tax burden is transferred (shifted) to consumer as follows; From the diagram, DP does not lead to corresponding D in Q. Consumer Pay all tax burden as shown by shaded region. Where the supply schedule is perfectly inelastic and demand curve is downwards slopping, an increase in tax results to an increase in prices and the whole tax burden is borne by the supplier. Perfectly elastic demand and an elastic supply. Effect of an increase in tax when demand is perfectly elastic is to reduce net price from P1 to Pnet and the net revenue to supplier also declines. Perfectly elastic supply schedule. Price rises by the tax amount. Effect of an increase in tax when supply is perfectly elastic while demand is downward sloping is to increase the Selling price from OPe to OP1 and reduce quality demanded form OQe to OQ1. 7.12 OTHER FACTORS THAT AFFECT EFFECTIVE INCIDENCE OF TAX Type of tax e.g. in the case of a sales tax, the sellers quite often adopt the practice of quoting the sale price as seen and once the bargain has been settled, add the sales tax in the bill. Such a practice tends to break the resistance of the buyers and it becomes easier to shift the incidence of the tax on to them. It sometime happens that with a large usage or advertising and publicity, some prices comes to be fixed and acceptable as normal, tax or no tax. It is not easy to shift the tax hereby means of a price vice. However a possibility may exist to shift the tax by deteriorating the quality or reducing the size of the taxed object. Restaurant quite often adopt the policy of reducing the sizes of various eatables as a substitute for raising prices. Sometimes, the market may be controlled by a small group of sellers and by a convention. it may be difficult to change the price unless everyone does so. e.g. newspapers having the same price in a city. In this case, it will be easier for all of them to raise the price and if any one of them wants to do so, it would be better to reduce the number of pages or reduce the quantity. The shifting of tax depends to a great extent upon the tax rate. If the tax is quite small and the market is competitive, the sellers may choose to absorb the tax in order to maintain the good will of the buyers. It will be more difficult to shift the tax to the buyer in the case f a commodity tax which has close and effective substitute. The consumers will then have an easy mean of shifting their demand if the price of their taxed goods is raised. It means that the elasticity of demand for these goods will be high and so the tax will have to be borne by the sellers. However, if the substitutes are also taxed, then the shifting of the tax incidence will depend upon the general pattern of the demand elasticity for this group of commodities as a whole vis-à-vis the pattern of their supply elasticity. In the case of goods taxation the geographical coverage of a tax has a great influence in determining the incidence of the tax in the taxed area. Since the untaxed goods will be available in the neighboring area, there will be great resistance of the buyers to bear the tax incidence. The price of the good will therefore rice to an extent much smaller than would be the case if geographical area of the coverage was complete. In order to discourage buying of the taxed commodity in the neighboring untaxed areas and bringing them in, the authorities often impose a use tax on the taxed goods if it is brought in from the untaxed area. 7.14 Activity Using the circular flow of income diagram explain the various point where tax ca be imposed and specify which tax Lecture Eight ALTERNATIVES TO TAXATIONS PUBLIC DEBT The government of a country gets its income from two sources: Public Revenue and Public Borrowing or Public Debt. Public revenue consists of money that the state is under no obligation to return to the very individuals from whom it has obtained. Public debt, on the contrary, carries with it the obligation on the part of the state to pay the money back to the persons from whom it has been received. Theory of Public Debt Public debt is of recent growth and was not heard of prior to the 18th century. The classical economists were generally against the public debt. They assumed that individual consumer and business firms make use of the resources more efficiently. Thus, under a fully employed economy, the state can acquire resources by public debt only at the cost of private sector where they are more efficiently used. It was Keynes who effected a truly significant revision in the theory of public debt. He rejected the classical view of a free enterprise economy which is self-equilibrating at full employment level. He developed and advanced the concept of under-employment equilibrium. Resources in the private hands may remain unemployed for relatively long periods if corrective or compensating action is not taken by the government. During World War II and in the post-war years, the size of public debt increased enormously. In modern times borrowing by the state has become a normal method of government finance along with other sources such as taxes, fees, etc. The government may borrow from banks, business-houses, other organizations and individuals. Besides, it can borrow within the country or from outside. The government loan is generally in the form of bonds (or treasury bills if the loan is required for short periods) which are promises of the government to pay to the holders of these promises the principal sum along with interest at the agreed rate. CLASSIFICATION OF PUBLIC DEBT Public debt has been classified in many ways, though all the classifications are not equally useful. Internal and External Debt. Internal debt refers to the public loans floated within the country, while external debt refers to the obligations of a country to foreign governments, foreign nationals or international institutions. Though external debt is becoming very common these days, there has been general prejudice against foreign debt, based on ignorance and faulty economics Productive and Unproductive Debt. Another classification of public debt which was once, very common was between productive or reproductive debt and dead weight debt, Public debt is said to be productive if the investment yields an income which will not only meet the yearly interest payments of the debt but also help repay the principal over the long run. Public debt can be said to be productive in another sense too. The government may undertake certain projects through loans which ;' may not be productive in the sense given above but which may be really useful to the community, as for example, a railway line connecting a backward region, an irrigation work to prevent famine conditions in an area and so on. In this sense, most public debt is productive. But public debt may be contracted to finance a war. Such debt is unproductive because it does not create an asset, it is a dead weight debt or a useless burden on the community Redeemable and Irredeemable Debt. The redeemable debts are those which the government promises to pay off in future at a specified date: they are terminable loans. Irredeemable debt refers to a debt which may not be redeemed at all but on which the government promises to pay the interest regularly. These loans may be known as perpetual debt. The redeemable loans may be further classified into short period and long period loans depending upon the period of redemption. Funded and Unfunded Debt. Public debt is also classified into funded and unfunded or floating debt. Broadly speaking, funded debt is a long-term debt, undertaken for creating a permanent asset and the government normally makes arrangements about the mode and time of repayment. Unfunded or floating debt is a relatively short period debt, meant to meet current need. The government undertakes to pay off the unfunded debt in a very short period, say within six months. Compulsory and Voluntary Debt. Sometimes, a distinction is made between a compulsory loan and a voluntary loan. Generally, government debt is of a voluntary type, that is individuals and institutions are invited to take up government bonds. On the other hand, a compulsory loan implying force is not common in modern times. However, pressure may be applied by the government at certain times in selling its bonds. WHY IS PUBLIC DEBT INCURRED? Public loans in modern times are necessary to meet important situations. They can be explained as below: To meet budget deficits. Modern governments do not have large accumulated balances or treasure to meet any budget deficit. Normally, the annual expenditure of the government should be and is met by annual income. But because of many circumstances the yield from taxation and other sources may not be equal to the actual expenditure. Similarly, there may be unplanned and unexpected emergency situations like major fires, floods and famines. Short-term borrowing is ordinarily used to meet these emergencies. To meet war expenditure. Modern warfare is so costly that the normal income through taxation falls short of the actual war expenditure. Besides, taxation beyond certain limits has disastrous consequences for production, and thus interferes with the most important objective during a war, viz., the winning of the war. Moreover, a public loan is better and easier method of collecting revenue than taxation. Governments, therefore, have to borrow extensively from individuals and institutions towards war financing. In fact, the enormous increase in public debt in most countries is due mainly to the First and Second World Wars. To remedy a depression. Public borrowing is considered very useful to remedy a depression; in fact, the strongest case for public borrowing is as a remedy for depression. During a period of depression, the level of economic activity is low, resulting in low production and unemployment. The depression and unemployment are generally due to deficiency of demand for goods and services. Many economists like Keynes have advocated increased public expenditure financed through borrowing and not through taxation, for while taxation will reduce incomes and demand still further, borrowing will have no such effect. Besides, loans enable the government to make use of idle and unutilized funds of the public. Thus, there is a strong justification in favour of public borrowing to cure unemployment. To develop the economy. Public loans are resorted to for development purposes. Even advanced countries have to undertake the construction of public works like roads, railways, irrigation works, powerhouses, etc., for accelerating their economic progress. Underdeveloped countries interested in the development of their natural resources to the optimum level find public borrowing a very useful device to finance the various development projects. The first factor, mentioned above, is only to meet temporary difficulties and is soon repaid out of tax receipts in the subsequent period. The second cause of public borrowing—the prosecution of a war—has been probably the most important factor for increasing public debt in all major countries in recent years. But this and the first factor are of an unplanned type. But the third and fourth cases may be called planned borrowings, for the Government deliberately plans to use the proceeds of public debt to finance certain specific projects. In this case, the Government may borrow resources and would otherwise have been used by the private sector and also resources that may remain unemployed. SOURCES OF PUBLIC BORROWING Every government has two major sources of borrowing – internal and external. Internally, the government can borrow from individuals, financial institutions, commercial banks and the central bank. Externally, the government borrows from individuals and banks, international institutions and foreign governments. Borrowing from Individuals When individuals purchase government bonds, they are diverting funds from private use to government use. Individuals may be able to subscribe to government bonds either through curtailment of current consumption needs (this may be very rare) or through diversion of funds from their own business or diverting funds into government bonds from corporate securities. Normally, the sale of government bonds to individuals should not curtail either consumption or business expansion. To a large measure, the bonds will be absorbed out of funds that would have been lying idle or would have been used to buy other securities. Borrowing from Non-banking Financial Institutions More important than individual subscribers to government bonds are the financial institutions such as insurance companies, trusts, mutual savings banks, etc. These non-banking financial institutions prefer government bonds because of the security provided by the latter and also due to their high negotiability and liquidity. But the rate of interest is low and hence in many cases financial institutions may prefer high-risk high-return securities particularly equities. When non-banking financial institutions fake up government bonds, they do so to reduce their cash holdings. Borrowing from Commercial Banks While individuals and non-banking financial institutions take up government bonds out of their own funds, commercial banks can do so by creating additional purchasing power known as credit creation. The banking system as a whole can make additional loans up to an amount several times as great as the excess cash reserves. This is possible because the loans the bankers make are typically book entries in the names of borrowers who pay in the form of cheques to others who have also bank accounts. The result is that so long as cash is not withdrawn from the banks, it serves as the basis for the expansion of loans. Commercial banks can subscribe to government loans through creation of credit. They need not contract their other loans and advances. Whenever the banking system has excess cash reserves, it can absorb an amount of government bonds considerably greater than the excess cash reserves. It is important to note that the power to buy bonds is essentially created rather than merely transferred. So if commercial banks create additional purchasing power and place it at the disposal of the government to finance the latter's expenditures, inflationary pressures will be generated (if previously, the economy has been working at full employment). Borrowing from the Central Bank The central Bank of the country also subscribes to government loans. The action is exactly similar to the system of creation of additional purchasing power by the commercial banking system. By purchasing government bonds, the central bank credits the account of the government. The latter pays to its creditors out of its account with the central Bank. Those who have received cheques from the government on the central bank deposit the amount with their banks. These banks find themselves with large cash reserves which become the basis for additional loans and advances. It will be seen that borrowing from the central bank is the most expansionary of all the sources for not only the government secures funds for its expenditure but the commercial banking system gets additional cash which can be used as the basis for further credit expansion. While the borrowings from individuals and financial institutions are simply transfer of funds from private to government use and, therefore, will not be expansionary in their effect on the economy (unless the funds were previously lying idle and are being activised through government borrowing), borrowing from the commercial banking system and the central bank will have expansionary effect. Borrowing from External Sources Government may borrow from other countries too. These borrowings can be used to finance war expenditure, or to produce defence equipment, or to pay for development projects, or to pay off adverse balance of payments. Formerly, the floating of loans for any specific development projects, like railway construction, was taken up by individuals and banking and other financial institutions. However, in recent years, apart from this source, two important sources have become prominent. They are: International financial institutions, viz., I.M.F., the I.B.R.D., the I.D.A. and the I.F.C., which give loans for short-term for overcoming temporary balance of payments difficulties and for the long-term for development purposes; and Government assistance generally for development projects. For developing countries like Kenya, external sources of borrowing are becoming considerably important in recent years. ECONOMIC EFFECTS OF PUBLIC BORROWING Following Wagner, economists used to argue that the government should use taxation to finance current expenditure and borrowing from the public to finance capital expenditure. In recent years, there has been considerable change in economic thinking on this question. It is commonly accepted now-a-days that taxation and borrowing can be used for either type of expenditure depending upon the circumstances. At least, in the case of developing nations both borrowing and taxation are used to finance development projects. Basically, the economic effects of government expenditure financed by public borrowing are different from the effects of similar expenditure financed by taxation in the following three important respects: The transfer of funds from the public to the government is compulsory under taxation and voluntary under borrowing ; While taxation reduces the wealth of the taxpayers, loans do-not reduce the wealth of the lenders but merely change its form ; and Financing through taxation is more contractionary while financing through borrowing has more expansionary effect. Taxation has contractionary effect on the economy because it reduces consumption. On the other hand, lending to the government is voluntary and, hence, will be paid out of saving and not through curtailment of consumption. Moreover, lending does not involve reduction of wealth and, therefore, will not have adverse effect on incentives and enterprise as would be the case with taxation. Leaving these general aspects of borrowing, we shall discuss the economic effects of public borrowing under specific headings. Effects of Public Borrowing upon Consumption As has been shown in a previous paragraph, government borrowing should not normally result in curtailment of consumption. This is so because lending to the government being voluntary will be met out of saving and not through reduction of consumption expenditure. But in time of war or in periods of emergency, substantial pressure may be applied to induce individuals to curtail consumption and to subscribe to government loans. The only other possibility is when government bonds may offer special advantages and higher interest rates. Some of the individuals and financial institutions may then be tempted to save more and invest in government-bonds. But generally speaking, restriction of consumer spending does not take place. Effects of Borrowing on Investment Government borrowing can influence investment adversely, though it can have neutral effect also. For instance, government borrowing from commercial banks and the central bank of the country will be of the nature of creation of additional purchasing power and, therefore, will not result in curtailment of funds available for investment. But if individuals and financial institutions and even commercial banks subscribe to government loans out of funds meant for investment or for the accumulation of stocks then investment expenditure is curtailed. But if the interest rate is not affected and the new government bonds do not carry any special advantages over existing securities, private investment may not be affected appreciably. If interest rates are higher and the advantages attached to government bonds are greater, the demand for company shares will decline and consequently the prices of stocks and shares will come down. This may restrict private investment in equity shares. However, governments, in their own interest, will like to follow a cheap money policy of lower interest rates (for this will mean lower interest burden on public debt). Even if interest rates are high, investment borrowing by individuals and companies will not be affected significantly. For one thing, investment borrowing will depend upon business prospects and profitability (marginal efficiency of capital) of investment rather than the rate of interest. This was shown by Keynes and has later been proved conclusively by many empirical studies. For another, the very large volume of investment undertaken with funds obtained from past earnings is particularly insensitive to the interest rate. On the whole, however, government borrowing need not affect private investment expenditure adversely except under special circumstances. For instance, the interest rates should be high and the volume of investment should be dependent upon the interest rate ; or the bonds should be sold to the persons and institutions who curtail their loans for business expansion in order to buy government bonds. But these special circumstances need not take place ordinarily. But there can be one indirect way by which government borrowings may have an adverse effect on investment. The growth of public debt may be alarmingly rapid and the investing public may fear a national bankruptcy or anticipate heavy taxation in the near future. The result will be a decline in investment. On the other hand, government expenditure financed out of borrowing will normally be expansionary. When borrowing is restricted to the commercial banks and the central bank, additional purchasing power will be created which will become the basis for additional loans and advances to the private investors. Moreover, government expenditure financed out of borrowing will result in additional demand for goods and services, the supply being assumed to be the same. This will result in a rise in prices and rise in profit margins. If the economy has been working below full employment level, it will stimulate greater investment (in order to secure higher profits). Thus, while taxation results in contraction, borrowing generally leads to expansion of the economy. Effects of Borrowing upon Distribution of Income Loan finance implies that all those benefiting from government expenditure will have higher real income. At the same time, loan finance will not reduce the real incomes of those who have subscribed to government bonds. If government expenditure is meant to provide more economic welfare to the lower income groups, then the result will be a narrowing down of inequalities and a more equal distribution of income between people. But to the extent that loan finance becomes inflationary, some of the good effects upon the distribution of income which we have explained above may be neutralized. Another point to consider here is the interest payment. Interest payment will represent a transfer of real income from the taxpayers to the bond-holders, for the government will have to tax the people so as to pay the bond-holders the interest charges and later the principal as well. If the bond-holders and the taxpayers are identical, then there will be no net redistribution of income, but this need not be the case. Accordingly, some redistribution of income will take place so long as the taxpayers and the bond-holders belong to different groups. Effects of Foreign Loans Foreign loans can influence both consumption and investment favorably. Foreign loans are meant to finance the imports of goods without paying for them immediately through exports. If foreign imports consist of consumer goods they tend to reduce any inflationary pressure which may exist due to shortage of goods. On the other hand, imports of machinery, industrial raw materials and technical know-how will have the favourable effect of speeding up industrialization within the country. If foreign loans are meant to finance a war or to modernize an army, then obviously they cannot have any effect on investment in the country. The demand for foreign currencies will be reduced through foreign loans, when they were floated. But interest payments as well as the repayment later will involve increasing exports. This may mean a possible lowering of tie real standard of living. EFFECTS OF PUBLIC DEBT We should clearly distinguish between economic effects of public borrowing from economic effects of public debt. Borrowing refers to the method of securing funds and is one of the favour alternatives available to the government – the other sources being taxation, profits from state enterprises and money creation. The effects of borrowing, therefore, refer to that programme of government expenditure financed by borrowing as contrasted with the effect of a similar programme financed by taxation. On the other hand, the effects of public debt refer to the effects on the economy which are caused by the existence of public debt, after it has been incurred. Public Debt and Consumption The existence of public debt has an important effect upon consumption. Those who hold government bonds representing the latter's obligation to pay consider these bonds as personal wealth. This wealth would not have arisen if the government had chosen to finance its expenditure through taxation. Moreover, the bond-holders would forget that the bonds represent claims on them as taxpayers in the form of additional taxation. The net result is that the possession of government bonds will induce them to spend not only a larger percentage of their incomes but also spend in excess of their incomes since they can dispose of the bonds to pay for the excess expenditure. Consequently, the net effect of public debt is to increase the percentage of total income spent on consumption and thus exert an expansionary effect on the economy. Monetization of Public Debt Public debt of a country has the direct effect of increasing the total money supply in the country. For instance, deficit financing by the Government actually means Government borrowing from the Central bank of the country which directly increases the money supply in the country. Likewise, when the commercial banking system subscribes to the issue of new Government bonds, they may do so without reducing their other investments or advances to the industrial and commercial sections but through a simple creation of credit. This is what is commonly known as monetization of public debt, that is, the public debt is subscribed to by the banking system in such a manner that it results in an increase in the money supply of the country. Public Debt and Liquidity Public debt is represented by bonds which are highly negotiable. Those who have bonds have highly negotiable and highly liquid form of assets. Whenever individuals require more funds for any purpose – transactions, precautionary or speculative motive – they can easily convert the bonds into cash. Public debt is thus responsible for the existence of highly liquid form of assets. Another important effect of the highly liquid government bonds is to be found in the case of commercial banks. The latter hold large amounts of government bonds which can be converted into cash whenever cash is required. In times of inflation the central bank of a country may attempt to use bank rate, open market operation and other weapons to reduce the cash reserves with commercial banks and thus reduce their credit expansion. But commercial banks can increase their cash reserves through disposing of their government bonds. Public Debt and Investment The effect of public debt on investment is not very clear. Two apparently contradictory effects can be visualized. On the one hand, the existence of huge public debt and the consequent high rates of taxation to service the debts will generate fear and uncertainty in the minds of investors. Besides, the existence of huge debts involving huge interest payment may suggest the possibility of the government introducing capital levy or even the extreme method of repudiation of debt. All this will affect adversely long-term-investments. On the other hand, the existence of large public debts will force the government to maintain a low rate of interest in order to keep its interest obligations at the lowest amount possible. Accordingly, borrowing and investment will be encouraged. It is, thus, difficult to state clearly whether existence of public debt will encourage or discourage investment. As regards the desire to work and save, public debt will generally tend to reduce it. Public debt, by providing safe and steady channel of investment in government bonds, may encourage savings. But taxation necessary to pay the principal and interest charge will discourage savings. Moreover, the receipt of interest by the holders of government bonds may reduce the latter's desire to work and save to a certain extent. Finally, as regards division of resources, public debt involves the use of funds on those expenditures which are considered essential and more useful than those on which the funds would have been used otherwise. If idle funds are channeled into the development of railways, irrigation and power projects e.t.c., the diversion will be really justified. The same may be said if borrowing from the banking system is used to create permanent and productive assets. The only wrong diversion will take place when funds which otherwise would have been spent on productive undertakings are spent on defence purposes. But this will have to be judged according to circumstances. BURDEN OF INTERNAL AND EXTERNAL DEBT Generally, internal loans have been very important, but in recent decades developing countries have been borrowing extensively from external sources. The loans have been from the World Bank and other agencies and governments. Sometimes, the external loans may be to overcome temporary balance of payments difficulties but in most cases they are for economic development. External loans are particularly important for developing nations because the latter have great demand for foreign machinery and raw materials and do not have adequate exports to pay for them. These nations are, therefore, plagued by continuous adverse balance of payments and exchange rate difficulties. There has been considerable confusion and prejudice in dealing with external loans and hence a comparison between internal and external loans is being made here. Burden of Internal Debt In the case of an internal debt, there is no direct money burden on the community as a whole, since the payment of interest and taxation to meet the same involve simply a transfer of purchasing power from one group of persons to another. To the extent, that the bond-holders and taxpayers are the same, there may not be any net burden at all on the community. But to the extent that the bond-holders and the taxpayers belong to different income groups, there are changes in the distribution of income between different sections of people in the community. Internal debt is a burden, and it would be too illogical to argue that internal public debt does not involve any burden at all. In the first instance, the purpose of the government loan should be considered. A loan meant to finance a productive enterprise on investment can be paid out of the profits of the investment. On the other hand, a loan to finance a war will have to be a dead weight and have to be paid out of taxation. There is, obviously no burden involved in the first case, but there is obvious burden in the second case. It is, however, stated that there is no burden in the second case too because the burden imposed by taxation will be cancelled by the benefit received through interest payments of the government. Secondly, as already indicated, the real burden of public debt will depend upon the type of people who own the bonds and who receive interest payments and the type of people who pay the taxes. Since in a majority of cases the holders of government bonds are the higher income groups while the taxpayers are both the rich and the poor, there is a net increase in the real burden of the community. Thirdly, the real burden of the debt repayment will be definitely much more than is thought of at first sight. For instance, the government will be taxing enterprise, patriotism, activeness and youth (i.e., those who pay) for the benefit of the passive, old and leisurely class (i.e., those who receive). Fourthly, during war when the debt is contracted, the value of money is low (because of high price). Soon alter the war and later, prices generally decline and hence those who get interest income through ownership of government bonds gain in terms of real income. Finally, the payment of interest charges and the repayment of debt will involve tax measures which, consequent affect the power as well as the willingness to work and save. The sooner the debt is cleared off through a capital levy or through some highly progressive taxes the better it will be for the community. It is, however, necessary that debt repayment is managed in such a manner and in such a period that there will be no adverse effect on production. It will, thus, be clear that even domestic debt imposes both money and real burdens. To contend that internal debt does not mean any burden on a country's economy is theoretically unsound and practically unrealistic. Burden of External Debt In one sense, the burden of a foreign debt is similar to that of domestic debt. That is, the government will have to pay it through additional taxation. But, while in domestic debt, interest payments and the repayment of loans are available to local nationals they are available to foreigners in the case of foreign debt: In another sense, the total money burden of an external debt is more because there is the additional transfer problem. That is, the government will have to find necessary monetary resources to pay off the external debt and besides will have to secure foreign currencies too (after all, foreigners will have to be paid in their currencies). The transfer problem, therefore, requires that during the term of the loan, the balance of trade must develop favorably. In other words, a regular payment of interest and principal to foreign countries will be possible only if the exports exceed the imports by at least the obligations arising from the loan. It is said that domestic debt does rot normally result in any net burden to the economy but only a redistribution of national income. But externally held debt can mean a certain impoverishment of the economy. The paying of interest and debt redemption to foreign countries means a corresponding reduction of national income and makes greater demand on the gold and foreign exchange resources of the country. This is what has been referred to as the transfer problem in the previous paragraph. But, properly speaking, there is no impoverishment involved. What actually, happens is this: Originally, when foreign loans were made, they entered the debtor country in the form of machinery, raw materials and other essential goods, for which no corresponding exports were made at that time. After the lapse of a certain t me, the debtor country manages to secure excess of exports over imports to pay for the external loan. In this, there is no actual impoverishment of the economy involved but goods are paid for goods. On the other hand, if the external debt was originally incurred to meet war expenditure, it would have been a dead weight debt. The repayment of debt through export surplus would not be canceling out the import of goods and services in the past which had any effect on the productive capacity of the country. In tins case the export surplus to pay off a war-debt would really deprive the citizens of a debtor country of a certain amount of goods and services. This would be a net direct real burden of an external loan. However, there is one sense in which an external loan can be a source of trouble to a debtor country. The transfer problem necessitating the creation of an export surplus means "an exhaustion of the country's future capacity to import"; this is of vital importance for development. But if the foreign loans are floated only when it is absolutely essential and when internal resources are utilized as far as possible, and \\ the foreign loans are used to increase the total national product including goods specially meant for export, there is no reason why the debtor country should suffer in the future. A developing country which borrows from abroad for the development of social and economic overheads and basic industries will find that the benefits outweigh the burden of repayment of the loan. An external loan for development purposes is not a burden but a profitable venture. This is exactly like an internal loan meant for development purposes. Can a Country become Bankrupt through Public Debt Sometimes, people assert that with mounting public debt, the nation would become bankrupt. This is partly true and partly not true. If bankruptcy means inability to return the amount borrowed, a country can never become bankrupt, however much of its domestic debt may have gone up. The government can always honour its obligations either through higher taxation or through printing of money. It has the option to impose a heavy capital levy and pay off the debt at one stroke. Even repudiation of public debt, though morally indefensible, will be right, since, after all those who receive interest payment from the government will have to pay the taxes to enable the government to pay the interest. Will it not be better to cancel the debt altogether or at least scale it down considerably, so that interest payments as well as tax payments will be proportionately cut down ? In any case, a government does not become bankrupt because of its internal debt. However, there may be circumstances when a government may not be able to honour its obligations to foreign countries. When interest on foreign loans and repayment of debt amount to a considerable figure and when adequate export surplus has not been built up for various reasons, the government of a debtor country may be unable to honour its 'external obligations. Either it can ask for postponement or it can float new loans to repay thep|d ones. Only in extreme cases it may repudiate external loans. Repudiation is an extreme measure, since through it, the country loses its ..creditworthiness in the international capital markets and will never again be able to borrow from foreign sources. To conclude, public borrowing has advantages. But it imposes burdens upon the community, both in real and monetary terms and directly and indirectly. Since there is additional burden in the case of external loans, extra care should be exercised in procuring such loans. All public debts impose burdens on the community and to assert that Internal loans do not impose real burdens is highly illogical. REDEMPTION OF PUBLIC DEBT Just as the private individual or organization has to return the loan he or it borrowed, so also the government has to pay not only interest on the public debt but also repay the principal. Experience shows clearly that mounting public debt has a demoralizing effect on the people from the fact that the public is subjected to higher rates of taxation. The sooner, therefore, the debt is cleared, the better for the government. It may also be observed here that if the public debt has been contracted for productive purposes, it may not be strictly necessary to redeem it since the government is getting a source of income to pay off the interest of the debt. But if public debt consists mostly of unproductive or dead weight debt— war debt is a good example of such debt—the sooner it is paid off the better, both for the government as well as for the public. Different methods are used by a government to redeem its debt. Some of these methods are extreme ones, such as repudiation of debt, while others may not be redemption at all, but payment of one debt with the help of another debt. We shall describe the various methods available to the government to pay off its debt. Repudiation of Debt Repudiation of debt means simply that the government does not recognize its obligations and refuses to pay the interest as well as the principal. Repudiation is not paying off a loan but destroying it. Normally, a government does not repudiate its debt, for this will shake the confidence of the general public in the government. However, in extreme circumstances, a government may be forced to repudiate its internal or external debt obligations. For instance, internally, the country may be facing financial ruin, bankruptcy and externally it may be faced with shortage of foreign exchange. Generally, a government may not repudiate its internal debt lest it should lead to internal rebellion—those who have lent to the government would obviously rise against the government. However, the temptation of a government to repudiate its external debt obligations may be strong at certain times. Of ail the methods of redeeming .debt, repudiation is the most extreme, but it is actually not redemption of debt at ail. Conversion of Loans Another method of redemption of public debt is known as conversion, ofioans, that is, an old loan is converted into a new loan. Conversion may be resorted to : (a) when at the time of redemption of a loan, the government has not the necessary funds, and (b) when the current rate is lower than the rate which the government is paying for existing debt, so that the government can reduce its interest payments. Conversion of a loan is always done through the floating of a new loan. Hence, the volume of public debt is not reduced. Really speakng, therefore, conversion of debt is not redemption of debt. Sometimes, distinction is made between refunding and conversion of debt, though sometimes both of them are used to mean the same thing. Strictly speaking, refunding refers to the method of paying off an o/d loan carrying a higher interest through a new loan carrying a lower interest rate; refunding, therefore, is the repayment of debt through fresh loans. On the other hand, conversion involves a change in the rate of interest or other details. For instance, at the time of maturity of a loan, the government may give an option to the existing bond-holders either to receive money in cash or to convert their old bonds for new bonds. Broadly, refunding and conversion are similar. Serial Bond Redemption The government may decide to pay every year a certain portion of the bonds issued previously. Therefore, a provision may be made so that a certain portion of the public debt may mature every year and decision may also be made in the beginning about the serial numbers of bonds which are to mature in the year. This system enables a portion of the debt to be paid off every year. A variant of this type of bond redemption is to determine the serial number of bonds to mature every year through lottery. While under the first variant, the bond-holders know when the different sets of bonds would mature and could take up the bonds according to their convenience, under the second variant, the bondholders are uncertain about the time of repayment and they may get back their money at the most inconvenient time. Buying up Loans The government may redeem its debt through buying up loans from the market. Whenever the government has surplus income, it may spend the amount to buy off government bonds from the market where they are bought and sold. Strictly speaking, this is not redemption of debt but buying up of debt. It is a good system provided the government can secure budget surplus. The only defect of this method of cancelling debt is that it is not systematic. Sinking Fund Sinking fund is probably the most systematic method of redeeming public debt. !t refers to the creation and the fund which will be sufficient to pay off public debt. There are many varieties of sinking fund. The most common method is as follows: Suppose, the government floats a loan of Rs. 10 redeemable in, say, 10 years for the purpose of road construction. At the time the government is floating the loan, it may levy a tax on petrol, the proceeds of which would be credited to a fund known as the sinking fund. Year after year, the tax proceeds as well as interest: on investments will make the fund grow till after 10 years it becomes equivalent to the original amount borrowed, and at that time, the debt will be paid off. One danger of the sinking fund method is that a government, in need of money, may not have the patience to wait till the end of the period of maturity but may utilize the fund for purposes other than the one for which originally the sinking fund was instituted. In modern times, sinking funds are not accumulated and continued from year to year as we have described above. Instead, some-funds are earmarked each year for repayment of some part of the debt ir the same year. The amount earmarked is not put in a fund and allowed to accumulate but is used every year either to pay off the bonds which are maturing every year or to buy off bonds from the market. Capital Levy Public debt may be redeemed through a capital levy which, as we have seen earlier, may be levied once in away with the special objective of redeeming public debt. It is generally advocated immediately after a war for the following reasons: (a) Heavy public debt has been incurred during the war to prosecute the war and hence is quite heavy immediately after the war. (b) War debt is unproductive and is a dead weight on the community necessitating heavy taxation year after year. It will be better to wipe it out once for all by a special levy. (c) Due to war time inflation businessmen, producers and speculators would have amassed large fortunes and hence it is easier for them to contribute to. a capital levy and, in a sense, it is just that they bear a part of the war burden, (d) Redemption of public debt through capital levy will leave the higher income groups almost in the same old position, since they will be receiving back from the government what they will have paid by way of the special levy. Redemption, through a special levy, is said to be super or to the method of the sinking fund, as it is levied only once, while for purposes of the sinking fund, taxes have to be imposed year after year. The greatest merit of capital levy is that it will reduce the heavy tax burden which will otherwise be necessary to redeem public debt. But the danger of a capital levy is that the government may be tempted to resort to it too often. Redemption of External Debt The redemption of external debt can be made only through accumulating the necessary foreign exchanges to pay for it. This can be done by creating export surpluses. Towards this end, foreign loans 'should be carefully invested in those industries which have high productive potentialities and which will promote exports directly and indirectly. At the same time, the exportable surplus should consist of goods which are readily taken by foreigners. Temporarily, of course, redemption of an old debt can be made through the floating of new loans. To conclude, there is not much to choose between the various methods (except, of course, repudiation which must not be resorted to) for every method has its own advantages as well as disadvantages. But the most common and sensible method is to redeem part of the public debt, every year, so that the debt may not go on mounting. PUBLIC SECTOR BORROWING REQUIREMENT (PSBR) Public sector indebtedness is largely, but not wholly, represented by the national debt. Local authorities can and do borrow directly on their own account at home and abroad. Public corporations are also permitted to raise loans in foreign capital markets. To arrive at the public sector borrowing requirement the government has to take into account its own borrowing, as well as that of local authorities and public corporations (Figure 14.3 shows the determinants and financing of the PSBR). The term Public Sector Borrowing Requirement came into use in the mid-1960s, data on it had been compiled since then (see Table 14.2). The PSBR is an important economic indicator which shows how much the public sector taken as a whole has to borrow to finance its expenditure programme. It is a key statistic that has to be taken into account in the formulation of a government's economic policy and in the assessment of the effects of fiscal and monetary measures on the economy. PSBR is expressed by reference to the total resources available in the country and is calculated as a percentage of the gross domestic product. The higher the percentage the greater the share of the national resources that are absorbed by the public sector. GOVERNMENT INDUCED INFLATION This is a sustained annual increase in prices caused by expansion of the money supply to pay government supplied goods and services. The money is printed to pay for the cost of the government provided goods and services. Increases in the market prices of goods and services caused by expansion of money supply force citizens to reduce their consumption and saving which in turn finances the reallocation of resources to public use over the long-run. DONATIONS They are voluntary contribution to government from individuals or organization that are used to finance particular programmes. USER CHARGES They are prices determined through the political process rather than market intervention. They can finance public goods and services only when it is possible to exclude individual from enjoying their benefit unless they pay a fee. FORMS Direct prices associated with the consumption of a particular goods and services Fees for the option to use certain facilities or services provided for by the government Special assignment on privately held property Licenses or franchises Fares or tolls Activity Explain how balance of payment position may influence the external debt repayment Lecture: Nine PRIVATISATION Privatization means transfer of ownership of state assets from the public bodies to private enterprise or provision of services from public to private enterprise. The aims of the privatization programmes are political and economic. The relative importance of the reasons for privatization differs from country to country but basically they are; Failure of nationalized industries in general to meet consumers’ needs effectively The wish to reduce the power of the state and its role in the economy. Belief that an enterprise based economy would allow for greater flexibility and a better response to consumers demand. Determination to create capital – owning democracies. Thus government privatize to; Reduce the size of public sectors of industry. Increase competition in the market. Improve efficiency among suppliers of goods and services. Extend share ownership in companies by investors with small amounts of savings. Ease the pressure on central governments’ budget. The expectation is that as state monopolies are broken up and a competitive environment established, privatized firms will have to improve their efficiency, cut costs and reduce prices or keep them below the level up to which they would have otherwise risen. Firms that are not competitive will unlike state enterprises go out of business. Privatized companies that are profitable or have profit potential will attract investors and enable shareholders with small amounts of capital and employees to acquire shareholdings. Private funding of industry reduces claims on public finance. The help to the government comes on both sides of the budget. On the expenditure sides, the state no longer has to support loss – making nationalized industries and provide them with capital, thereby increasing the public sector borrowing requirement on the revenue side, proceeds from the sale of state assets increase governments resources enabling them to increase public spending or cut taxation or both. Opponents of privatization argue that; privatization of natural monopolies merely substitutes private for state monopoly; that the social service elements in provision of services by profit – driven companies will disappear and measures to cut costs will lead to unemployment. MECHANISM OF PRIVATISATION How state – owned enterprises are privatized depends on a variety of factors such as whether, the country is developed, developing or emerging from a centrally – planned economic system; the relative size of public sector of industry, the sophistication of the national capital market and the financial framework. The state of international capital market is also important. It may reach a saturation level if a large number of privatization share offers are made concurrently and national governments restrict the extent of foreign investment that may be allowed. Timing and local legislation are therefore important factors. Also important to a decision on the choice of privatization method is the native and size of privatization. On offer may be; A minority share – holding in a country. A controlling stake in a company. A state – owned company already operating in competitive international markets. A whole nationalized industry. Potentially the whole of the economy. Depending on the circumstances the transfer from state to private ownership may be by wears of; Public Offering Shares are offered to the general public and can be traded subsequently on the stock exchange. This method is only appropriate for privatization of large enterprises. Placing Brokers acting on behalf of a government arrange for the purchase of shares by placing them with a group of investors or one large investor who may wish to hold or gradually a sell off the stock. Trade sale. A state enterprise is sold to a private sector company or consortium. A trade sale is likely to be on the basis of a tender and financial markets are bypassed. Management/worker’s buy – out A state owned undertaking may be sold to employees because it is loss – making or faces closure and companies in the private sectors are not interested in buying it. There may however be a possibility of turning it around to round to run on a profitable basis. Management/worker buys – out can save jobs. It may be attractive proposition to government for reasons other than financial. Auction. In cases of smaller properties owned by the state, sales by auction may be a relatively simple way to privatize but the practicality of this depends on there being a sufficient number of bidders with adequate funds to purchase. Grant of statutory right of purchase. People may be granted by law the right to purchase specified state property, provided they meet certain requirements. THE CASE OF PRIVATISATION Privatization which involves the sales of state – owned assets provide the government with a short – term source of revenue which can be used to finance development expenditure such as infrastructure development. It helps to reduce public spending and the public sector borrowing requirement. This is especially so if the state can sell – loss – making enterprises and public spending on subsidies fall. The public sector borrowing (PSBR) may also fall if private ownership returns industries to profitability since corporation tax revenue will increase and the state may earn higher dividend income from any share it still possesses in the privatized company. Privatisation increases competition thereby increasing a locative efficiency where the organization has ran with prices higher than marginal cost. Competition could force an organization to be more cost – conscious, making it easier for changes in work practices to be introduced and enforced both at an operational level and in the management of the organization. Where privatization results in the breaking of state monopoly, so that a number of competing firms are able to operate, consumer choice may be enhanced. Competing firms are more likely to respond to consumer demand and quality of service should be improved and innovation encouraged in both products and the means of their production and distribution. Privatization can change the organization culture in that the often – borrow vision of directorate and management and supply orientation of the organization can be replaced by a mean more commercially aware enterprise. Restraints can be removed in financing and market of products diversification. Links with other companies through joint ventures can be developed. It makes it more difficult for political interference since politicians who used parastatals for their own ends cannot easily do so with private enterprises. It has a role in promoting an enterprise culture through extending share ownership to individual and employees who did not own shares previously. It is therefore conducive to hand work and accepting responsibility. THE CASE AGAINST PRIVATISATION It may increase monopoly abuse, by transferring socially owned and accountancies public monopolies into regulated and less accountancies private monopoly. This monopoly may arise because utilities tend to be natural monopolies and there have been economic and technological arguments for keeping them as single suppliers. The monopolies may exploit consumers by charging excessively high prices and producing poor quality commodities. In the absence of a market for the shares of nationalized industry it may be difficult to determine the appropriate issue price for shares. This may lead to over subscription or under subscription. It has been argued that state owned asset have often been sold off too cheaply. Increased privatization of public sectors enterprises can lead to greater difficulty in planning the whole economy because unanticipated actions by the private sector can undermine the targets of a development plan such as delocalization of industries. Privatization of certain sectors like health and education may lead to those very goods being provided in inadequate qualities and at prices that are too high for lower income consumers. The private sector may lack entrepreneurship skills and capital to develop certain establishments which require heavy capital investments like airways, ports and harbors. It would imply greater control by multinational corporations with their related problems of transfer pricing and repatriation of process. Activity Giving examples in Kenya discuss the privatization process. Recommended Text Books 1. Stiglitz Joseph E. (1988) Economics of the Public Sector. Second edition. New York: W.W; Norton & Company 2. Hyman N. David (1996) Public Finance: A Contemporary Application of Theory to Policy. Fifth edition. New York: The Dryden press; Harcourt Brace Colleague Publishers. 3. Brown C.V. Jackson, P.M. 1996, Public Sector Economics, Oxford: Blackwell Publishers 4. Atkinson A. B. and J. E. Sfiglitz (1980) Lectures on Public Finance. New York: McGraw-Hill 5. Musgrave, R. A. (latest edition) Public Finance. New York McGraw-Hill. 6. Musgrave R, A. and P. B, Musgrave (1989) Public Finance in Theory and Practice. New York. 7. Prest A.R. (1972) Public Finance in Developing Countries. Weidenfteld & Nicholson. 8. Prest, A. R. (1974) Public Finance in Theory and Practice. Weideniield & Nicholson 5th Ed. 9. Wawire N. H. W (2003). ''Trends in Kenya's Tax Ratios and Tax Effort Indices, and Their Implications for Future Tax Reforms". In illieva E. V. (Ed.) Egerton Journal. Volume IV. Numbers 2 & 3, July. Pp.256 - 279 10. Toye, J.F.J (1978) (Ed) Taxation and Economic Development. London: Frank class N/B In addition to the above references, students are strongly advised to read the following: The Journal of public Economics; The Journal of financial economics; The Journal of Development Economics; Economic surveys; Budget speeches and National Development Plans,