Development Finance For GaDS

3rd Year
Prepared Derara Daba
 Chapter One: Introduction to Development Finance
1.1. Definition of development finance
• Development finance can be understood as a practice
and as an area of study.
• As a practice it is a planned action of financing
development activities.
• In this sense it involves identifying the development
activities, identifying and mobilizing the necessary
resources to perform these activities, and follow up
the appropriateness of such spending.
• As an area of study, development finance
systematically studies about financial matters of
development activities such as government revenue
and expenditure.
 1.2. Finance and Development: Relationships

• An efficient and effective financial system is a key driver of economic growth.

• Not only political, legal and administrative framework; a country’s financial
infrastructure and institutions have associated with long term growth.
• For example, Arthur Lewis argued that economic growth and financial
development run in both directions.
• Levine goes further and identified five key functions of financial institutions
for development:
• Mobilization of saving
• Facilitating the management of risk
• Obtaining and filtering information on investment opportunities
• Monitoring the use of funds
• Facilitating the exchange of goods and services

• Considerable empirical research has shown a strong correlation between

financial sector development and economic growth.
• If the national economy is an engine, the finance and financial system is a
fuel that enables the machine to function.
 1.3. The Role of the Government in the Economy
• The government has to play some important economic roles
representing the state.
• Government intervention in the economy is acceptable by
market failure.
• Market failure happens when there is insufficient production of
goods and services or surplus production of goods and services.
In other words, when there is no balance between demand and
supply.
• It also exists when certain types of goods and services are not
produced at all because the private sector may fail to produce
some socially desirable.
• In other way government has to provide promotional framework both for
the private and public sector in balancing market.
• The government has to make interventions to protect the interests of
vulnerable sections of the society and the poor, especially the poorest of
the poor. But in doing so, it must be able to hit the balance between
interests and efficiency.
• There are two important areas on which the government
has critical roles in macroeconomic management.
• 1. Budgetary position of the government- a government can
follow a deficit, balanced or surplus budgetary policies.
• Most government budgets are deficit budgets, where
anticipated expenditure is greater than anticipated revenue
because government will be spending more for
development.
• 2. The other role of the government in macroeconomic
management is exchange rate adjustment. In this regard it
must be noticed that exchange rate is the most important
price in an economy because it affects imports and exports.
• Exchange rate is used to adjust external price
competitiveness. In addition, it can also be used as an anti-
inflation instrument, for achieving price stability.
 1.4.Public Finance and Private Finance

 Similarities and difference

 Both with Welfare Objective
 Both with Scarcity of Resources:
 Both With rationality
• Private finance is concerned with the maximization of individual
welfare while public finance is concerned with the maximization
of a community’s welfare from given resources.
• A rational individual tries to maximize his personal gain by
allocating his given income. Likewise, the government also
behaves rationally in the sense that it seeks to maximize society’s
welfare from the expenditures made in different activities.
• Government is not guided by the profit motive; where as profit is
central point for Private finance
• An individual adjusts his expenditure to income while
government adjusts income to expenditure.
• An individual highly tries to maintain a balanced budget and
maintenance of a surplus budget is a good quality than
government. The government prefers a deficit budget.
• Resources of the state are large compared to individuals
• Private finance relating to sources of revenue and spending is a
secret affair, Public Finance is transparent
 Chapter Two:
Sources and Purposes of Development Finance
2.1. Introduction
• Financing is the process of providing funds for
business activities, making purchases, or investing.
• Financing can come in the form of private commercial
funding that seeks a market-rate return, or as
noncommercial funding from governments.
• Private commercial finance can support investments in
private assets, such as factories and machinery.
• Private investors respond to private returns, not to social
returns.
• The poor very often need public financing to meet their
basic needs and to build the capital necessary to escape
poverty.
 2.2. Major Sources of Development Finance
2.2.1. Domestic Sources of Finance
2.2.1.1. Saving
• The primary responsibility for achieving growth and
equitable development lies with the developing
countries themselves.
• The third world has relatively low income per capita
level and this circumstance requires paying special
attention to creation of the favorable conditions for
saving by economic agents (households, businesses and
governments).
• It’s necessary to point out that microfinance activities in
the third world give additional opportunities for saving
and therefore additional opportunities for mobilization
of domestic financial resources.
 2.2.1.2. Taxation

• Since the time of ancient civilizations methods of government revenue

generation had changed over time.
• Under empire systems, the peoples might be required to make payment
known as “tribute” to the king in acknowledgment of their submission to his
power.
• Today taxes play major roles in all modern economic systems.
• Governments must have revenue, to pay for their activities.
• Governments generate some revenue by charging fees for the services they
provide, such as entrance fees at national parks or tolls for using a highway.
• However, most government revenue comes from taxes. The way the
government spends and taxes is determined by a government’s fiscal policy
that bears a direct influence on the performance of the economy.
• Hence, taxation directly affects the overall performance of the economy. For
example, if the government increases spending to build a new highway,
construction of the highway will create jobs. Jobs create income that people
spend on purchases, and the economy tends to grow. The opposite happens
when the government increases taxes. Households and businesses have less of
their income to spend, they purchase fewer goods, and the economy tends to
shrink.
Taxation: What?
• Taxation is a system of raising money to finance government with the
objectives to reduce inequalities of income and wealth; to provide
incentives for capital formation in the private sector, and to keep in
check domestic inflationary pressures.
• All governments require payments of money, i.e. taxes, from their
people.
• Governments use tax revenues to render different public services like
public school systems, welfare programs, police and fire protection,
maintenance of roads and highways, and public hospitals.
• Without taxes to fund its activities, government could hardly exist.
That is why it is usually said that tax is the life source of
governments.
• Hence, taxation constitutes the most important source
of state revenues. It is argued that for modern governments, different
types of taxes account for 90% or more of their income.
• Countries differ, however, considerably in the amount of taxes they
collect.
 Characteristic Features of Taxation

Taxation has the following common features though it varies across

different systems.
1. Tax is a compulsory contribution: Tax is an obligatory contribution
of the tax-payers to the government. The people cannot refuse to
pay tax.
• After all, paying tax is not a matter of ‘right’, it is duty of citizens;
the refusal of which unfortunately leads to punishments. In no
way it is escapable.
2. Benefit is not the basic condition: There is no direct return to tax
payers for the fact that they have paid tax, i.e. people cannot
expect any direct benefit for the amount of tax paid, because
there no relation between the amount of tax paid by the people
and the services rendered by the government to the tax-payers.
3. Common interest: The amount of tax received from the people is
used for the general and common benefits of the people as a
whole.
 Continued
4. Legal collection: Tax is a legal collection it can be charged
only by the government, both the central and states/local.
5. Element of sacrifice: Since tax is paid without any direct
return in benefit it can be said that there is the prevalence
of sacrifice in the payment of tax.
6. Regularity and periodicity: The payment of tax is regular
and periodic in nature. It is levied for a fixed period, usually
a year. Thus, almost all taxes are annual taxes. The
payment is usually conducted on a regular basis.
7. All encompassing and Wider in scope: Tax is levied on all
citizens without any discrimination of class, dogma, status,
etc. In terms of scope, taxes are levied not only on income
but also on properties and commodities.
 1.3. Classification of Taxes
• Depending on where they may be imposed,
taxes are classified as follows:
1. Taxes which are imposed on the product
2. Taxes which are imposed on the seller’s and
buyer’s side of the market
3. Taxes which are imposed on the household or
firms; and
4. Taxes which are imposed on the sources of the
tax-payers account.
 Classification of Taxes

• Cutting across the above categories, the conventional

types of taxes imposed by governments are mentioned
below: income taxes; consumption taxes when they
spend it, property taxes i.e. the tax on “things”, when
they own a home or land, and in some cases estate taxes
when they die.
1. Income Taxes
1.1. Personal Income Tax
• A personal income tax, also called an individual income
tax. It includes Income includes salaries, and other
earnings from one’s occupation; interest earned by
savings accounts; rents (earnings from rented
properties); royalty earned on sales of patented or
copyrighted items, such as inventions and books.
1.2. Corporate Income Tax
• Corporations must also pay tax on their net
income (profits).The corporate income tax is one
of the most controversial types of taxes.
• The corporate income tax leads to double
taxation of corporate income. Income is taxed
once when it is earned by the corporation, and a
second time when it is paid out to shareholders in
the form of shares. Thus, corporate income
faces a higher tax burden than income earned by
individuals.
2. Consumption Taxes
• A consumption tax is a tax levied on sales of goods or services.
The most important kinds of consumption taxes are sales taxes,
excise taxes, value-added taxes, and tariffs.
2. 1. Sales Taxes: Sales tax imposes the same tax rate on a wide
variety of goods and, in some cases, services. Although sellers
are legally responsible for paying sales taxes, and sellers
collect sales taxes from consumers. Both individuals and
businesses pay sales tax.
2.2. Excise Taxes: Excise taxes are also called selective sales taxes.
Goods subject to excise taxes include tobacco products,
alcoholic beverages, gasoline, and some luxury items. Excise
taxes designed to limit consumption of a commodity, such as
taxes on cigarettes and alcoholic beverages, are commonly
known as “sin taxes.”.
2.3. Value-Added Tax: In a value-added tax (VAT) system, the
seller pays the government a percentage of the value added
to goods or services at each stage of production.
• VAT is just a general sales tax that is collected at multiple
stages.
• In the production of apple pies, for example, the farmer grows
apples and sells them to a baker, who turns them into a pie.
The baker sells the pie to a restaurant owner, who sells it to a
consumer. At each stage, the producer adds value to the
commodity by processing it with capital (machines) and labor.
2.4. Tariffs: Tariffs, also called duties or customs duties, are taxes
levied on imported or exported goods. Import duties are
considered consumption taxes because they are levied on
goods to be consumed. Import duties also protect domestic
industries from foreign competition by making imported goods
more expensive than their domestic counterparts.
3. Property Taxes
• In principle, a property tax is a tax on an individual’s wealth
—the value of all of the person’s assets, both financial (such
as stocks and bonds) and real (such as houses, cars, and
artwork By-and-large, the property tax is by far the largest
source of revenue for local governments.
4. Estates Tax: When a person dies, the property that he or
she leaves for others may be subject to tax. An estate tax is
a tax on the deceased person’s estate, which includes
everything the person owned at the time of death—money,
real estate, stock, bonds, proceeds from insurance policies,
and material possessions.
• Most governments levy estate taxes before the deceased
person’s property passes to heirs, although many
governments do not impose an estate tax on property
inherited by a spouse.
 Canons (Principles) and Functions of Taxation
Canons (Principles) of Taxation

In addition to the aforementioned features of taxes, there are basic

principles applicable to taxation. These principles are often called
cannons of taxation.
1. Cannon of equality: according to this principle, as set forth by
Adam Smith, the “subject of every society ought to contribute
towards the support of government, as
nearly as possible, in proportion to their abilities to pay”.
2. Cannon of certainty: each individual is bound to pay ought to be
certain and not arbitrary. The time of payment, the manner of
payment, the quantity to pay, should be clear.
3. Cannon of convenience: according to this principle every tax
ought to be levied in time or in the manner in which it is most
likely to be convenient for the contributor to
pay it. For example, land revenue may be collected at the time of
harvest, etc.
4. Cannon of economy: This principle argue the cost of tax
collection should not outweigh the benefits from tax collection.
5. Cannon of productivity: the tax system should be productive
enough. It should encourage productive activity by encouraging
the people to work, save and invest.
6. Cannon of elasticity: the tax should be flexible. It should be
levied in such a way to increase or decrease the tax revenue
depending upon the need of the public.
7. Cannon of diversity: The burden of tax should be distributed
widely on the entire people of the country good to have
diversified sources of tax.
8. Cannon of simplicity: this principle states that the tax system
should be simple, easy and understandable to the common man.
9. Cannon of expediency: According to this principle, a tax should
be levied after considering all favorable and unfavorable factors
from different angles such as economic, political and social.
10. Cannon of coordination: in a federal states, like Ethiopia, the
federal and states governments levy taxes.
11. Cannon of neutrality: it shouldn’t create any deflationary or
inflationary effects in the economy.
11. Ability-to-Pay Principle: The ability-to-pay principle holds that
people’s taxes should be based upon their ability to pay, usually
as measured by income or wealth.
 2.2.2.External Sources of Finance
1. Capital Flows or Foreign Direct Investment (FDI)
• the desired increase in investment (development) has to be
achieved through an increase in FDI flows, at least in the short-
run. Foreign direct investment (FDI) is one of the most
important components of private financial flows.
• More specifically FDI can play the following important potential
roles in development efforts.
A. Employment generation and growth: By providing additional
capital to a host country, FDI can create new employment
opportunities resulting in higher growth. It can also increase
employment indirectly through increased linkages with
domestic firms.
B. Supplementing domestic savings: FDI can fill this resource gap
between domestic savings and investment requirements.
C. Integration into the global economy: Openness to FDI
enhances international trade thereby contributing to the
integration of the host-country into the world economy.
D. Raising skills of local manpower: Through training of workers
and learning by doing, FDI raises the skills of local manpower
thereby increasing their productivity level.
E. Transfer of modern technologies: Foreign firms typically make
significant investments in research and development. FDI
gives developing countries cheap access to new technologies
and skills thereby enhancing local technological capabilities
and their ability to compete on world markets.
F. Enhanced efficiency: Opening up an economy to foreign firms
increases the degree of competition in product markets
thereby forcing domestic firms to allocate and use resources
more efficiently.
2. Remittance
• Private transfers from migrant workers and diaspora
communities to families and villages back home which we call it
remittance marks an increasingly prominent feature of
globalization.
• Still, the volume of global remittances is substantial and rising.
• The World Bank estimates that developing countries received
$404 billion in remittances in 2013, and forecasts this figure to
grow at an average annual rate of 8.4% to $516 billion in 2016.
• Remittances to the developing and transition countries became
an important part of available financing in the recent decades.
• Moreover, remittances exhibit marked stability or even
increase during periods of recession or financial crisis in home
countries.
3. Official Development Assistance (ODA) or Aid
• It is generally believed that foreign capital inflows in form of
international aid play a strategic role in promoting progress toward
self-sustained growth in developing countries. ODA accounts for
more than two thirds of international resource flows, and about
one third of government revenues.
• It plays a vital role in some of the poorest countries, particularly
for financing essential public services
• ODA is aid grants and concessional loans made by donor
governments and multilateral agencies for the purpose of
promoting economic development and welfare.” World Bank
(2005: 22).
• The purpose of an international program of aid to
underdeveloped countries is to accelerate their economic
development up to a point where a satisfactory rate of growth
can be achieved on a self-sustaining basis.
4. Debt Financing and Debt Relief
• The external official lending provided by international
institutions (primarily IMF, World Bank and the regional
development banks) and foreign governments on the
standard conditions are also of great importance to the
developing world and transition countries.
• It helps to overcome the narrow domestic debt market
• The clear disadvantage relates to necessity to service the
debt (to pay off the principal and the interest) and the
wide spread inefficiency of public spending in the third
world countries.
• The debt relief may potentially create moral hazard
problems and increase irresponsibility on both sides –
lenders and borrowers.