UNIVERSITY OF GHANA

DEPARTMENT OF PUBLIC ADMINISTRATION AND HEALTH

SERVICES MANAGEMENT

UNIVERSITY OF GHANA BUSINESS SCHOOL

UNIVERSITY OF GHANA, LEGON

ADMN 053: PUBLIC FINANCE

LECTURE NOTES

Prepared by:

DR. EMMANUEL Y. M. SEIDU & PROF. JUSTICE N. BAWOLE

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 TABLE OF CONTENT

CHAPTER 1: DEFINITION, NATURE AND SCOPE OF PUBLIC FINANCE

• Defining Public Finance

• Public Choice theory and Public finance
• Role of Government in an Economy
• Government and Economic Growth
• Government-Business Interface
• Institutional and Legal Framework of Public Finance in Ghana

CHAPTER 2: GOVERNMENT, MARKETS, AND EFFICIENCY

• Government and Resource Allocation
• Market Structures / Types of markets
• Market and Government Failures
• Public Goods
• Externalities

CHAPTER 3: GOVERNMENT REVENUE AND EXPENDITURE

• Government Revenue
• Receipts excluded from public revenue
• Government Expenditure
• Theories of Public Expenditure Growth
• Understanding Public Expenditure
• The impact of public expenditure on the economy

CHAPTER 4: TAXATION
• What is a tax?
• Characteristics of Good Tax Administration
• Overview of Tax Administration in Ghana
• Types of Taxes
• The Burden of Taxation

CHAPTER 5: BUDGETING
• Definition, Nature and Scope of Budgeting
• Budgeting Cycle
• Medium Term Expenditure Framework (MTEF)
• Budgeting in Ghana

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 CHAPTER 1

DEFINITION, NATURE AND SCOPE OF PUBLIC FINANCE

SECTION 1: Defining Public Finance

Public finance is the study of the financial activities of governments and public authorities. It describes
and analyzes the expenditures of government and the techniques used by governments to finance its
expenditures. As such, its interest lies in studying the institution and decision making processes that help
mold the observed behavior of people acting through government.

Public finance therefore deals with the economic role of government as a response to market failures, its
limitation in responding to such failures, the design and evaluation of expenditure and tax program, and
short & long term consequences of the deficit in the economy.

There are different definitions and interpretations of public finance as a discipline of the social sciences.
Some key definitions include:

• Public finance is the field of economics that studies government activities and the alternative
means of financing government expenditures. A crucial objective is to understand the impact of
government expenditures, regulations, taxes, borrowing, on incentives to work, invest, and spend
income (Hyman, 1999).

• Public finance, also known as public sector economics, focuses on the taxing and spending
activities of government and their influence on the allocation of resources and distribution of
income. The goal is to interweave institutional, theoretical and econometric material to provide
students with a clear and coherent views of government spending and taxing. Public finance is
not a mere academic exercise; its goal is to help us understand and perhaps improve real world
situations (Rosen, 1999).

• It is a field of economics concerned with paying for collective or governmental activities, and
with the design and administration of those activities (Wikipedia, 2008).

• It is concerned with how governments raise money, how that money is spent, and the effects of
these activities on the economy and the society (Encarta, 2002).

Scope of Public Finance

Public Finance is the branch of economics that studies the taxing and spending activities of government.
The term is something of a misnomer, because the fundamental issues are not financial (that is, relating
to money). Rather, the key problems relate to the use of real resources. For this reason, some practitioners
prefer the label public sector economics or simply public economics.

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The scope of Public finance encompasses both positive and normative analysis. Positive analysis deals with
issues of cause and effect, for example, “If the government cuts the tax rate on petrol, what will be the
effect on petrol consumption?” Normative analysis deals with ethical issues, for example, “Is it fairer to
tax income or consumption?”

However, modern public finance focuses on the microeconomic functions of government, how the
government does and should affect the allocation of resources and the distribution of income. For the
most part, the macroeconomic functions of government – the use of taxing, spending, and monetary
policies to affect the overall level of unemployment and the price level - are covered in other fields.

Public finance therefore deals with the provision, custody and disbursement of the resources needed for
the conduct of public or governmental functions. The subject matter falls into four main divisions,
namely:

1. Public expenditures which represent the needs of the state.

2. Public revenues which are the sources of the funds that are expended in the conduct of the
public business.
3. Financial administration and management which deal with the determination of expenditures
and income as well as with the collection disbursing public funds (e.g. the Public Procurement
Act, Financial Administration Act, Audit Act).
4. Public Debt and Social security are also generally featured in the discussion of public finance.

Motivations for studying Public Finance

According to A.C Pigou, in every developed society there is some form of government organization,
which may or may not represent the members of the society collectively, but certainly has coercive
authority over them individually. The “coercive nature of government” or “compulsion power” refers to
the ability of government to force people to do things that they probably will not otherwise do or value.

However because there is no guarantee that the government will act in the best interest of the people,
public finance ensures efficiency and equity in the program and activity of the government. It also
provides information and knowledge on how the government spends the taxes it collects.

In addition to the above benefits, the motivations for studying public finance may generally be
categorized into three, namely:

• Knowing what activities the public sector engages in and how these are organized

The amount of work the government of a country is called upon to perform today has become so
immense and complex that it is difficult to assess what its total expenditures are and what they go
for. The budget of the central government of Ghana alone is a document that is more than 100 pages,
and within the budget, activities are not easily compartmentalized. Some activities are undertaken in
different ministries, departments and agencies. Taxes and expenditures occur at different levels. The
advent of macro and micro-economic planning and the impact of government proposed bill
(revenue/expenditure) on national income management have further complicated the magnitude of
government business.

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• Understanding and anticipating the full consequences of these governmental activities
When a tax is imposed on a corporation, who bears the tax? For example, since the talk tax was
introduced by the government who has borne the tax? Most economists agree that society bears some
of the weight as excess burden. The corporate tax’s non-neutrality distorts resource allocation
between corporate and non-corporate firms and leads to corporations to use resources in ways that
reduce efficiency. Whose pocket does the corporate revenue come from? The legal incidence is on
the corporation, but the economic incidence is more complex than just individual consumers.

• Evaluating Alternative Policies

To do this, not only do we need to know the consequences of alternatives policies, but we need to
develop criteria for evaluation. First we must understand the objectives of government policy, and
then we must ascertain the extent to which the particular proposal meets (or is likely to meet) those
criteria. Many proposals have effects other than intended effects, and one most know how to predict
these other consequences and to bring them into the evaluation.

Government’s economic activities under public finance

Like economics to which it is closely related, public finance also deals with the satisfaction of human
wants. The manner in which economic activities are directed toward satisfying human wants could be
carried out through Private organizations such as sole ownerships, partnerships, cooperatives and trade
organizations engage in different economic activities; or through Public organizations which engage in
economic activities at the national, regional, metropolitan, municipal and district levels.

In this classification, government appears as one form of cooperative economic entity. The reasons for
an extension of the cooperative organization beyond the limits of private groups have been:

i. the emergence of the needs affecting or involving all of the people rather than those of a particular
group or segment.

ii. the greater economy of effort in supplying these universal needs by a general or common
organization.

The quality and usefulness of government, under this view, depends on its capacity to exist and operate
within the same economic facts and principles as those of individuals and private associations. No
government is superior to, or immune from, the economic facts which condition the solvency and well-
being of the individual.

The list of the common or universal needs which are undertaken by public or governmental action has
varied over the years. In Ghana, the central core of these needs, according to the Medium Term
Expenditure Framework (MTEF) has five broad sectors which are: Administration, Economic Services,
Infrastructure, Social Services, and Public Safety.

The increase in urban population, the complexity of social life, specialization of labor and growth of
technology has also hastened the enlargement of governmental activities. Thus, the improvement in street
lighting, the enlargement of the police service to provide adequate protection, fire service, education,
welfare, public health, environment and recreation have all become additional needs of government.

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The cost of providing infrastructure and service needs and providing the resources for government
business has been rising so rapidly that the difficulties of government spending decisions cannot be
dismissed without critical analysis. The student of public finance is therefore concerned with facts of
public activity rather than with the philosophy of the state and the theories of the scope of governmental
functions.

Beginning with the famous maxims of Adam Smith, writers on public finance have attempted to establish
a criterion by which the revenue and expenditure policies of government should be evaluated.
Government must tax and spend the money so raised for the benefit of the citizens. This is the subject
matter of Public Finance focuses on microeconomic functions of government, and deals with the way
the government affects the allocation of existing resources, the distribution of income and the effects
government regulatory policies have on resource allocation. Nowadays, the macroeconomic functions of
government examine the use of taxing, spending, and monetary policies to affect the overall level of
unemployment and the price level.

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SECTION 2: Public Choice theory and Public finance

Public choice theory defined

Public choice theory is a branch of economics that developed from the study of taxation and public
spending. Public choice applies the theories and methods of economics to the analysis of political
behavior, an area that was once the exclusive province of political scientists and sociologists. It emerged
in the fifties and received widespread public attention in 1986, when James Buchanan, one of its two
leading architects (the other was his colleague Gordon Tullock), was awarded the Nobel Prize in
economics. Since then, public choice has revolutionized the study of democratic decision-making
processes.

Public choice takes the same principles that economists use to analyze people's actions in the marketplace
and applies them to people's actions in collective decision making. Economists who study behaviour in
the private marketplace assume that people are motivated mainly by self-interest. Although most people
base some of their actions on their concern for others, the dominant motive in people's actions in the
marketplace—whether they are employers, employees, or consumers—is a concern for themselves.

Public choice economists therefore make the same assumption—that although people acting in the
political marketplace have some concern for others, their main motive, whether they are voters,
politicians, lobbyists, or bureaucrats, is self-interest. In Buchanan's words the theory "replaces... romantic
and illusory... notions about the workings of governments [with]... notions that embody more
skepticism".

Though in economics, public choice theory is the use of modern economic tools to study problems that
are traditionally in the province of political science, from the perspective of political science, it may be
seen as the subset of positive political theory which deals with subjects in which material interests are
assumed to predominate.

In particular, it studies the behaviour of politicians and government officials as mostly self-interested
agents and their interactions in the social system either as such or under alternative constitutional rules.
These can be represented a number of ways, including standard constrained utility maximization, game
theory, or decision theory. Public choice analysis has roots in positive analysis ("what is") but is often
used for normative purposes ("what ought to be"), to identify a problem or suggest how a system could
be improved by changes in constitutional rules.

Foundational Principles of Public choice

As James Buchanan artfully defined it, public choice is “politics without romance.” The wishful thinking
it displaced presumes that participants in the political sphere aspire to promote the common good. In
the conventional “public interest” view, public officials are portrayed as benevolent “public servants”
who faithfully carry out the “will of the people.” In tending to the public’s business, voters, politicians,
and policymakers are supposed somehow to rise above their own parochial concerns.

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In modeling the behavior of individuals as driven by the goal of utility maximization (economics jargon
for a personal sense of well-being), economists do not deny that people care about their families, friends,
and community. But public choice, like the economic model of rational behavior on which it rests,
assumes that people are guided chiefly by their own self-interests and, more important, that the
motivations of people in the political process are no different from those of people in the meat, housing,
or car market. They are the same human beings, after all. As such, voters “vote their pocketbooks,”
supporting candidates and ballot propositions they think will make them personally better off;
bureaucrats strive to advance their own careers; and politicians seek election or re-election to office.
Public choice, in other words, simply transfers the rational actor model of economic theory to the realm
of politics.

Two insights follow immediately from economists’ study of collective choice processes. First, the
individual becomes the fundamental unit of analysis. Public choice rejects the construction of organic
decision-making units, such as “the people,” “the community,” or “society.” Groups do not make
choices; only individuals do. The problem then becomes how to model the ways in which the diverse
and often conflicting preferences of self-interested individuals get expressed and collated when decisions
are made collectively.

Second, public and private choice processes differ, not because the motivations of actors are different,
but because of stark differences in the incentives and constraints that channel the pursuit of self-interest
in the two settings. A prospective home buyer, for example, chooses among the available alternatives in
light of his personal circumstances and fully captures the benefits and bears the costs of his own choice.
The purchase decision is voluntary, and a bargain will be struck only if both buyer and seller are made
better off. If, on the other hand, a politician proposes a project that promises to protect the new
homeowner’s community from flooding, action depends on at least some of his neighbours voting for a
tax on themselves and others. Because the project’s benefits and costs will be shared, there is no guarantee
that everyone’s welfare will be improved. Support for the project will likely be forthcoming from the
owners of houses located on the floodplain, who expect to benefit the most. Their support will be
strengthened if taxes are assessed uniformly on the community as a whole. Homeowners far from the
floodplain, for whom the costs of the project exceed expected benefits, rationally will vote against the
proposal; if they find themselves in the minority, they will be coerced into paying for it. Unless the voting
rule requires unanimous consent, which allows any individual to veto a proposal that would harm him,
or unless those harmed can relocate easily to another political jurisdiction, collective decision-making
processes allow the majority to impose its preferences on the minority.

The Institutions and Mechanisms of Public Choice

It has been recognized at least since the time of the Marquis de Condorcet (1785) that voting among
three or more candidates or alternatives may fail to select the majority’s most preferred outcome or may
be prone to vote “cycles” producing no clear winner. Indeed, Kenneth Arrow’s “impossibility theorem”
shows that there is no mechanism for making collective choices, other than dictatorship, that translates
the preferences of diverse individuals into a well-behaved social utility function. Nor has any electoral
rule been found whose results cannot be manipulated either by individuals voting insincerely - that is,
casting their ballots strategically for less-preferred candidates or issues in order to block even worse
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outcomes – or by an agenda setter who controls the order in which votes are taken. However, some of
the mechanisms and institutions of public choice include.

Elections

Studying collective decision-making by committees, Duncan Black deduced what has since been called
the median-voter theorem. If voters are fully informed, if their preferred outcomes can be arrayed along
one dimension (e.g., left to right), if each voter has a single most-preferred outcome, and if decisions are
made by simple majority rule, then the median voter will be decisive. Any proposal to the left or right of
that point will be defeated by one that is closer to the median voter’s preferred outcome.

Because extreme proposals lose to centrist proposals, candidates and parties in a two-party system will
move to the center, and, as a result, their platforms and campaign promises will differ only slightly.
Reversing 1964 presidential hopeful Barry Goldwater’s catchphrase, majority-rule elections will present
voters with an echo, not a choice. If the foregoing assumptions hold, the median voter’s preferences also
will determine the results of popular referenda. As a matter of fact, anticipating that immoderate
proposals will be defeated, the designers of ballot initiatives will strive to adopt centrist language, in
theory moving policy outcomes closer to the median voter’s ideal point than might be expected if
decisions are instead made by politically self-interested representatives.

Modeling the decision to vote in a rational choice context, Anthony Downs pointed out that the act of
voting itself is irrational. That conclusion follows because the probability of an individual’s vote
determining an election’s outcome is vanishingly small. One person’s vote will tip the scales in favor of
the preferred candidate or issue only if the votes of all other voters are evenly split. As the number of
voters becomes large, the chances of that happening quickly approach zero, and hence the benefits of
voting are likely to be less than the costs. Public choice reasoning thus predicts low rates of voter
participation if voters are rational.

Downs and other public choice scholars also conclude that voters in democratic elections will tend to be
poorly informed about the candidates and issues on the ballot. Voter ignorance is rational because the
cost of gathering information about an upcoming election is high relative to the benefits of voting. Why
should a voter bother to become informed if his vote has a very small chance of being decisive? Geoffrey
Brennan and Loren Lomasky, among others, have suggested that people vote because it is a low-cost
way to express their preferences. In this view, voting is no more irrational than cheering for one’s favorite
sports team.

Legislatures
Ballot initiatives, referenda, and other institutions of direct democracy aside, most political decisions are
made not by the citizenry itself, but by the politicians elected to represent them in legislative assemblies.
Because the constituencies of these representatives typically are geographically based, legislative
officeholders have strong incentives to support programs and policies that provide benefits to the voters
in their home districts or states, no matter how irresponsible those programs and policies may be from a
national perspective. Such “pork barrel” projects are especially likely to gain a representative’s

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endorsement when they are financed by the taxpayers in general, most of whom reside, and vote, in other
districts or states.

Legislative catering to the interests of the minority at the expense of the majority is reinforced by the
logic of collective action. Small, homogeneous groups with strong communities of interest tend to be
more effective suppliers of political pressure and political support (votes, campaign contributions, and
the like) than larger groups whose interests are more diffuse. The logic of collective action explains why
farmers have secured government subsidies at the expense of millions of unorganized consumers, who
pay higher prices for food, and why textile manufacturers have benefited significantly from trade barriers
at the expense of clothing buyers.

The legislative pork barrel is facilitated by rational-voter ignorance about the adverse effects of legislative
decisions on their personal well-being. It also is facilitated by electoral advantages that make it difficult
for challengers to unseat incumbents, who, accordingly, can take positions that work against their
constituents’ interests with little fear of reprisal.

Bureaucracies
Owing to the benefits of specialization and division of labour, legislatures delegate responsibility for
implementing their policy initiatives to various departments and agencies staffed by career bureaucrats,
who secure their positions through civil service appointment rather than by democratic election. The
early public choice literature on bureaucracy, launched by William Niskanen, assumed that these agencies
would use the information and expertise they gained in administering specific legislative programs to
extract the largest budget possible from relatively uninformed, inexpert legislators. Budget maximization
was assumed to be the bureaucracy’s goal because more agency funding translates into broader
administrative discretion, more opportunities for promotion, and greater prestige for the agency’s
bureaucrats.

More recently, public choice scholars have adopted a “congressional dominance” model of bureaucracy.
In that model, government bureaus are not free to pursue their own agendas. On the contrary, agency
policy preferences mirror those of the members of key legislative committees that oversee particular areas
of public policy, such as agriculture, international trade, and the judiciary. These oversight committees
constrain bureaucratic discretion by exercising their powers to confirm political appointees to senior
agency positions, to mark up bureau budget requests, and to hold public hearings. The available evidence
does suggest that bureaucratic policymaking is sensitive to changes in oversight committee membership.

Other Institutions
Public choice scholars, such as Gary Anderson, Mark Crain, William Shughart, and Robert Tollison, have
not neglected the study of the other major institutions of democratic governance: the president or chief
executive officer and the “independent” judiciary. They model the occupants of these positions as self-
interested people who, by exercising the power to veto bills, on the one hand, and by ruling on the
constitutionality of laws, on the other, add stability to democratic decision-making processes and increase
the durability of the favours granted to special-interest groups and, hence, the amounts the groups are
willing to pay for them.

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SECTION 3: Role of Government in an Economy

Introduction

In the narrowest sense, the government's role in the economy is to help correct market failures, or
situations where private markets cannot maximize the value that they could create for society. This
includes providing public goods, internalizing externalities, and enforcing competition. Other
economists, however, have add additional functions of governments in market economies such as the
provision of legal and social framework, redistribute income and stabilize the economy. That said, many
societies have accepted a broader role of government in a capitalist economy. However, citizens, interest
groups, and political leaders disagree about how large a scope of activities the government should
perform within each of these functions. Over time, as our society and economy have changed,
government activities within each of these functions have expanded. For instance, the current free senior
high policy of the NPP government expands the frontiers of the role of the state in education, a key
developmental role of government in many parts of the world.

Theories on the role of government in an economy

The government plays a huge role in the economy. Consumers technically are capable of participating in
a capitalist system in which they own and purchase private property and participate in a free marketplace.
The government plays a large role in the system by affecting the amount of money that can be put into
the system. Taxes, inflation, and interest rates, all controlled by government decisions and actions, play a
substantial role in the public's ability to live an adequate lifestyle.

Cummings (1999) explains that there are four main theories concerning the role of the government in
the economy, including: Laissez-Faire Economics, Keynesian Economics, Supply-Side Economics, and
Monetarism.

The idea of laissez-faire economics is for the government to abstain from involvement in anything that
will affect the economy. The system includes the idea that the government should not regulate the
marketplace, workforce, environment, etc. and allow the economy to move and evolve naturally.

Keynesian economics is the opposite of laissez-faire economics. Based on the ideas of John Maynard
Keynes, the idea stated that if the people didn't consume or invest enough into the marketplace, the
government should step in and regulate the economy using fiscal policy. Fiscal policy involved either tax
cuts or increased spending to combat recession. According to Keynes, if the government had to spend
money to combat recession, the resulting deficit was not bad because it was necessary.

Supply-side economics is an economic theory designed to combat the effects of inflation. It called for
tax and spending cuts, which would in turn give people the incentive to produce and increase the supply
of goods available. The tax reductions would leave more money for the building of new factories and job
growth, allowing, in theory, for the benefits to flow to the public.

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The economic role of government

The economic role of government can best be defined by a classification of its economic policy aims.
Broadly speaking, the political choices made by electorates in Western-type democracies influence
governments to perform four functions.

The first is production of services which private firms are either unwilling to produce or for some
reason are not allowed to produce (or at least not exclusively). This public provision may be to provide
immediate benefits (e.g. defence, law and order) or deferred benefits (e.g. investment in roads).

These ‘production’ activities may be divided into two types.

1. Services which are not sold in the market but are financed out of compulsory levies. It is
considered preferable in economic analysis to treat the government here as a collective consumer in
a position to influence the allocation of resources, rather than as a producer because the ‘output’ is
intangible and is not priced.

For our purposes, what is important is that the government has to purchase in the market the
current output of private firms and the labour services of households in order to fulfil its task. It
can, of course, ‘rig’ the market. For example, the UK government is not only an important
purchaser of vehicles for use in government departments; it also buys almost exclusively only
vehicles produced in the UK.

2. Goods produced and sold in the market by public corporations. Many countries have state-owned
fuel and power industries whose operation is very similar to private industry though the policy
instructions laid down by governments for their operation will usually include objectives other
than the making of profits.

The second function is the alteration of the structure of private production in order to conform to
some conception of the allocation of resources which is considered ‘better’ than that resulting from
private market transactions. In the national accounts, this aim will be reflected in the choice of taxes
levied on goods and services (e.g. taxes on expenditure), in corporation taxes and in current subsidies.

The third function is to intervene in the distribution of income generated by private market
transactions in order to conform to some acceptable criterion of equity, for example a minimum income
guarantee. This will be reflected in the national accounts principally in the choice of taxes and in the
provision of transfer payments to households against which there is no counter-flow of current services.

For example, state pension payments are transfer payments, and though pensioners do not render current
services in order to receive them, they may have contributed to their finance through compulsory levies
on their past incomes. Transfer payments do not form a direct link between government and industry
but major efforts by government to alter income distribution have considerable influence on the structure
of household purchases and therefore on the pattern of demand for industrial products.

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The fourth function is the stabilization of the economy by attempting to reduce fluctuations in income
and employment and to control movements in the general price level. The effects of this action can be
seen in both the volume and the mix of transactions between the government and the rest of the
economy.

Policy models of the economy which place particular emphasis on the control of the money supply and
interest rates will pay close attention to the size of the government budget deficit/surplus. Therefore, no
particular transaction with the private sector is solely identified with this function except perhaps for the
interest paid by government to firms and households as a payment for holding government debt
accumulated in the course of financing past government deficits.

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SECTION 4: Government and Economic Growth

Government growth – why study it and how

The study of the causes of government growth is a hot subject because it tests the skills of economists
in model building and econometricians and statisticians who devise means for empirical testing. Their
results only influence business decisions in an indirect way, notably in the presentation of background
information for the speeches of business executives who wish to make pronouncements about public
policy issues, particularly on the consequences of government growth.

How does one approach the study of growth? Imagine that you are writing a history of your own firm
or organization. You might begin by a description, which shows how the firm has changed both in the
amount and scope of its activities and, using statistical indicators such as the growth in revenue, in the
composition of that revenue as the product mix changes, and in the amount and composition of the
work force.

In examining these changes, you would evaluate the influences on the decisions of the firm's management.
These influences might be classified into changes in demand conditions (and the extent to which these
were altered by the firm itself through marketing) and changes in supply conditions (which again might
be classified into external factors beyond the control of the firm, such as raw material prices, and those
within its control, such as in-house changes in technology). Through time the degree of influence of these
conditions would be likely to vary. This approach is quite a good way of appreciating the similarities and
the differences betwee]n the growth of a firm and the growth of government.

A word of warning is necessary. In a world in which there is rapid change in business environment
resulting from globalization, takeovers and mergers complicate the problem of tracing growth of individual
business through time. Even governments are subject to major influences which produce breaks in the
continuity of change, notably when territorial boundaries are altered.

Causes of government growth - Demand Factors

As the economy grows, there is a complementary demand set up, alongside industrial and manufacturing
expansion, for transport and communication services, energy, and waste disposal. It is commonly claimed
that governments, central and local, have a comparative advantage in provision of such services. This
view was the centre of late nineteenth-century speculation about the growth of government and was
widely supported by industrial pressure groups as the justification for government expansion as the
economy grew.

However, such a hypothesis would not explain the relative expansion, particularly after World War II, in
social services and transfer payments. While demand pressures from industrial firms to expand economic
services, e.g. roads, might command the general support of individual voters, particularly if it were
claimed that their employment in industry and in government would depend on it, the benefits would
seem intangible alongside money payments to individuals or health services which require direct contact
between government and the individual.

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This accounts for the addition to the list of demand factors influencing government growth of the power
of the voter, which accompanied the extension of franchise in many countries in the course of the
twentieth century. This extension took the form of gradual enfranchisement of the relatively poor who
could try to use their voting power to exploit the government as a mechanism for redistributing resources
from the relatively rich towards themselves.

This hypothesis raises the question: what happens when the franchise cannot be extended any further
and increasing redistribution reaches the stage where those who seek more social benefits can only obtain
them by taxing themselves? Presumably this would have an effect similar to a rise in the relative price of
some goods against the consumer/taxpayer. It would place a limit on the growth of government (i.e.
G/GDP would converge to some limit). If this were true, then governments would lose voter support if
they put forward future plans for increasing G/GDP.

This is where the analogy with the activities of a firm finally breaks down. Firms cannot finance their
sales by compulsory levies on purchasers, though they may get close to it, for a while, if there is no rival
producer of their product. Firms can be taken over if shareholders vote the management out of office,
just as voters can vote in alternative governments. But whichever government is in power, it can prevent
competition in the ‘government business’, whereas firms will have to be prepared for new entrants who
may compete alongside them and may lower their market share.

So far as the growth of government is concerned, the government therefore has extra weapons at its
disposal to promote its own expansion. It can incur debt to finance further expansion, with the assurance
that it can tax future generations of voters, if the present generation allows it, in order to pay off its debts.
An interesting case is pension provision. The voting and working population of today can support
improved pensions for themselves in the future without having to make a contract with those who will
have to pay for them – future voters.

Causes of government growth - Supply Factors

In most democracies, it is clearly the case that a necessary condition for expansion of GDP is voter
support, just as a necessary condition for a firm to expand is an increasing demand for its products. But
the existence of that demand is not a sufficient condition.

The fact that governments can prevent competition in the ‘government business’ suggests that supply
factors may play a part in government growth. Monopoly provision of important services, particularly
defence, and compulsory financing blunt the incentive to be efficient, as happens in the case where
private companies have a substantial monopoly, particularly one protected by government regulations or
by tariffs which inhibit foreign competition.

However, to affect the growth in public expenditure, it must be assumed that somehow productivity
gains are less likely to be characteristic of government services than of the private sector. This assertion
is not so easy to justify. It has been claimed that there are technical factors preventing the growth of
productivity in the public sector relative to the private sector because personal attention is an important
part of the service. This would mean that productivity gains resulting from the substitution of machines
for people, or from changes in technology, would be denied to public services.
15
This argument certainly does not apply to defence services, and could not apply to transfer payments
which are not government-produced services. If it applies at all, it must be to such services as education
and health which are certainly government-produced services, but it would be difficult to argue that these
are services where new technologies which are cost-effective could not be introduced. This suggests that
the incentive to introduce such changes in productive techniques could be lacking. Why should public
service unions support changes which would reduce the demand for their members' services? Why should
public sector managers insist on making such changes in the teeth of union opposition, if the government
has the power to raise extra taxation as services expand?

Clearly, the most that a short discussion of the determinants of government growth can convey is some
idea about how to draw up a check-list of relevant influences. If there is one general point to be made, it
is that one must be able to trace these influences to individual or collective decisions and note how these
are translated into demand for and supply of government services at different points in time.
Explanations which regard the ‘government’ as some kind of impersonal referee acting to serve the
interests of the community are divorced from reality.

The relations between government and industry are relations between people. These relations are
markedly affected by the division of function between government and the private sector; a knowledge
of how this division of function has changed, and of the influences which have caused that change,
should leave you better prepared to understand the later analysis.

16
SECTION 5: Government-Business Interface

The reasons for government control of industry can be derived from either (a) a set of value judgements
consistent with a particular philosophical standpoint; or (b) the study of the actual policy objectives which
governments wish to implement. The first approach is called the normative approach, and the second
the positive approach. If we adopt approach (a) we have to justify or evaluate the policy objectives,
whereas under approach (b) we can take the policy objectives as given.

Government Control of Industry: Positive approach

The positive approach requires the identification of the policy objectives of government which are
actually operative. This is more difficult than it sounds. Governments in different countries may promote
different objectives or at least assign them different orders of priority, and likewise successive
governments in the same country may support different policy objectives.

Governments may not wish to reveal their policy objectives and their implications for the choice of policy
instruments, at least in detail, for this may adversely affect voter support – no policy is ‘costless’ in the
sense that it will satisfy all voters all of the time. What can safely be said is that modern day governments
are concerned with a wider range of objectives affecting industry than indicated by welfare economics with
its emphasis on the allocation of resources at a point in time.

At a minimum they are concerned with the growth in industrial output over time and therefore with
productive efficiency of factor inputs. They are concerned, rightly or wrongly, with the distribution of
industry among regions. Unequal opportunities for employment in different regions could be an
important dimension in policies designed to achieve a given distribution of income, and could militate
against policies designed to influence individual incomes, such as social security schemes. It is equally
clear that regional industrial policy is influenced by the need to retain voter support, particularly in
marginal constituencies.

Government Control of Industry - Normative approach

The normative approach frequently employed by economists is associated with welfare economics. An
initial value judgement is made about optimal economic conditions, usually that the economy must be
designed to maximize the satisfaction of consumers. To achieve the optimum requires that marginal
social value must equal marginal social costs in all markets.

The free enterprise economy does not automatically fulfill these conditions because
(i) companies may be able to exploit monopoly positions;
(ii) externalities of consumption and production exist; and
(iii) there are difficulties in supplying goods and services with the characteristics of ‘publicness’; and
(iv) consumers may not choose the amount and composition of goods and services which ‘are in
their best interests’.

17
The government ‘should’ therefore intervene in the free enterprise economy in order to rectify these
‘market failures’ using such instruments as anti-monopoly legislation, taxes to eliminate negative
externalities and subsidies to promote positive externalities, public production of goods which the market
cannot provide, and regulations to prohibit sale of ‘harmful’ products.

There is considerable controversy about whether these optimal conditions properly reflect consumer
interests, particularly in a world of uncertainty about trends in costs and prices and changing consumer
tastes and preferences. Nor can it be assumed that government policies can be precisely designed to
remove the perceived failures of the market.

However, instead of having to prescribe what governments ought do, it is more in keeping with the
acquisition of knowledge necessary for a business career to identify with the actual policies of
government, whatever one may think of them, and to discover how they are likely to affect company
strategies. That is why a positive rather than a normative approach governs subsequent analysis.

Limitations on government actions

Western-type economies are committed to a large degree to the free movement of goods and services
and of the factors of production –capital, labour, ideas – across national borders. Exporters of goods
may find it vitally important to know in detail how legislation in other countries affects their products
and may seek to reduce the costs of its effects on them by lobbying their own governments to supply the
necessary information and advice and even to bargain with foreign governments with a view to removing
or mitigating any detrimental effects.

Multinational firms pay particular attention to the present and prospective industrial policies of individual
countries in planning where to site new plants or whether or not to expand, contract or even close existing
plants. They, too, may expect help and support from the government of their country of origin in
negotiating within the framework of industrial policy of governments having jurisdiction over their
overseas operations.

The second group of ‘actors’ is the most important of all. Most countries across the globe have elected
governments. To remain in power, governments formed by the majority party or a coalition of parties
must ‘sell’ policies for votes just as industrial companies remain in business by selling products and
services that customers want.

A large proportion of the voting population are employees in industrial and commercial concerns and
there is a presumption that their voting preferences will be influenced by what happens at their place of
work. Voters' influence on the details of industrial policy is unlikely to be significant but the broad
direction of policy must rely on voter support. In Ghana, and other countries where the multi-tier system
of governance is practiced, the local governments may have the power to formulate policies of their own
with respect to industry within their jurisdiction. Voters have therefore the opportunity to express
preferences at two levels.

18
SECTION 6: Institutional and Legal Framework of Public Finance in Ghana

Public finance institutions in Ghana

The Bank of Ghana and the Ministry of Finance (MoF) are the primary institutions in Ghana’s public
finance sector. The Bank of Ghana which is also the Central Bank of Ghana and the sole custodian of
state funds was established with the aspiration of playing “a very important and decisive role in the life
of a country. It is essential to our own independence that we have a government-owned bank and that
the central bank follows a policy designed to secure our economic independence and to further the
general development of our country.” The principal objects of the central bank, as enshrined in the 1957
Ordinance, were “to issue and redeem bank notes and coins: to keep and use reserves and to influence
the credit situation with a view to maintaining monetary stability in Ghana and the external value of the
Ghana pound; and to act as banker and financial adviser to the Government.”

Currently, the Bank of Ghana undertakes variety of responsibilities that are meant to improve the health
of the Ghanaian economy. Section 3 of the Bank of Ghana Act 2002 (Act 612), the Bank task to
“maintain stability in the general level of prices, support the general economic policy of the
Government”. It is also responsible for the promotion of economic growth as well as effective and
efficient operation of banking and credit systems in the country, independent of instructions from the
Government or any other authority. Base on this, section 4 (1) of the Act spells out the detail functions
of the Bank of Ghana.

Another significant public finance institution in Ghana is the Ministry of Finance. The Ministry exists
to ensure macro-economics stability for promotion of sustainable economic growth and development of
Ghana and her people through the formulation and implementation of sound financial, fiscal and
monetary policies; efficient mobilisation, allocation and management of financial resources; and
establishing and disseminating performance-oriented guidelines and accurate user- friendly financial
management information systems. The ministry is also responsible for creating an enabling environment
for investment. Other agencies under MOF which play key roles in Ghana’s public finance environment
include the following:

The Ghana Revenue Authority (GRA) was established by an Act of Parliament, Act 2009 (Act 791)
merging the three revenue agencies that is the Customs, Excise and Preventive Service (CEPS), the
Internal Revenue Service (IRS), the Value Added Tax Service (VATS) and the Revenue Agencies
Governing Board (RAGB) Secretariat into a single Authority for the administration of taxes and customs
duties in the country. GRA has been established to: integrate Internal Revenue Service (IRS) and Value
Added Tax Service (VATS) into domestic tax operations on functional lines; integrate the management
of Domestic Tax and Customs; modernize Domestic Tax and Customs operations through the review
of processes and procedures with ICT as the backbone. It is envisaged that the integration of the revenue
agencies will bring the following benefits to taxpayers and the tax administration: reduced administrative
and tax compliance cost; better service delivery; improved departmental information flow; holistic
approach to domestic tax and customs administration and enhanced revenue mobilization.

GRA has three main divisions: Customs Division (CD); Domestic Tax Revenue Division (DTRD) and
Support Services Division (SSD). The three-winged structure merges the management support services
of Finance, Administration, Research of the erstwhile agencies under one Support Services Division. This
leaves the Customs Division and the Domestic Tax Revenue Division free to focus entirely on revenue
collection.

19
The Controller and Accountant - General’s Department is mandated by Financial Administrative
Act, 2003 (Act 654) to: receive all Public and Trust monies payable into the Consolidated Fund (done
through its staff stationed in all government departments including the revenue collecting ones); provide
secure custody of Public and Trust monies (with the support of the Ministry of Finance and Bank of
Ghana): make disbursements on behalf of the Government(includes the payment of monthly salaries to
government employees inactive service; pension gratuity and monthly pension payment to those on
retirement; and releases of funds to prosecute government projects and development throughout the
country); pay all Government Workers’ wages, salaries and allowances; process and pay all Pension
gratuity for the Civil Service; establish, on behalf of government, such accounts with the Bank of Ghana
and its agents for the deposit of Public and Trust monies; be solely responsible for the opening of bank
accounts for any government department; among others.

Other institutions like the Economic and Organized Crime Office (EOCO), the Bureau of National
Investigations (BNI), Office of Accountability etc also play a crucial role in public finance in Ghana.

Legal Framework of Public Finance in Ghana

There are a number of regulatory instruments guiding public finance in Ghana. Amidst these laws, the
1992 Constitution of the Republic of Ghana serves as the mother legal document. It spells out the nature
and limits of public finance activities in the country. Some of the provisions made by the constitution in
relation to public finance are identified under this topic.

Chapter five: government provision of public goods like defense, police protection, and courts through the
protection of the various rights of the citizenry; the rights of citizens to exist as economic entities (right
to own property and do legal business); and the economic rights of citizens.

Chapter six: the role, duties, rights and responsibilities of government, citizens and other incorporate
persons. Also talks about the political, economic, social, educational, cultural, and international relations
objectives of Ghana.

Chapter seven: politics, decision making in public finance, and the public choice theory

Chapter eight: discusses the President, international relations, the Cabinet, National Security Council,
National Development Planning Commission and the Attorney General; and the role they play in public
finance decision-making.

Chapter ten: the role of the legislature in legitimizing public finance policies especially budgeting; the
committees of parliament (the Public accounts Committee, the Finance Committee etc).

Chapter thirteen: taxation; the public funds of Ghana; public revenue; public expenditure; public debt; the
role of the central bank, statistical service, auditor general and the audit service.

Chapter fourteen: the public services – Ghana Revenue Authority (comprising CEPS, IRS, VAT Service),
Statistical Service, Audit service; and Public Corporations

20
Chapter twenty: financial decentralization; the District Assembly Common Fund (DACF) and Grants-in-
Aid; audit at the local level; local government budgeting etc.

Beside the 1992 constitution of Ghana, Public Financial Management Act 2016 (Act 921), Public
Procurement Act 2003 (Act 663), Public Procurement Amendment Act 2016 (914), Income Tax Act,
2015 (Act 896), Capital Gains Tax Act 1965 (Act 289) and monitory policies by Bank of Ghana among
others regulate public finance in Ghana. As part of the reforms under the Public Financial Management
Reform Program, a scoping study for the establishment of internal control audit functions in Ministries,
Departments and Agencies (MDAs) and Metropolitan, Municipal and District Assemblies (MMDAs) was
carried out in 2003. It resulted in proposals for the establishment of a Central Internal Audit Agency to
enhance efficiency, accountability and transparency in the management of resources in the public sector
which eventually resulted in the passage of the Internal Audit Agency Act.

Notwithstanding the robust institutional and legal framework and Ghana and other developing countries,
public financial management is still confronted with a number of behavioral, infrastructural and capacity
challenges. In Ghana for instance, the Ministry of Finance (2017) highlights that excessive borrowing,
financial indiscipline, low internal revenue by parastatal and decentralized agencies as a result of leakages,
loopholes, and tax evasion and exemptions are some stabling blocks to effective public financial
management. Debilitating environment for the private sector characterized by stiff energy sector
challenges and ineffective public expenditure monitoring and control also humper efforts to sanitize the
practice.

21
 CHAPTER 2:
GOVERNMENT, MARKETS, AND EFFICIENCY

SECTION 1: Government and Resource Allocation

Government and economic efficiency

The government of every country has economic efficiency as its allocation goal. Economic efficiency
means using scarce resources so that they yield a stream of benefits that society values above all possible
alternatives. The efficient allocation of resources then, means the use with the highest social value – the
one that society prefers above all others.

You can see the idea of economic efficiency pictured in figure 2.1. It shows a simple world with just 2
goods: bread (a private good) and circuses (a collective good). The production possibility curve shows
all attainable combinations of these two items, given infinite resources and existing technology.

Economic efficiency first requires technical efficiency. An interior combination like A in the figure fails
technical efficiency because resources are being poorly used or wasted. This economy could produce
more of both goods by moving from interior point A to a combination on the PPC boundary, like B, C,
or D. Every combination on the PPC boundary displays technical efficiency because it is impossible to
produce more of one good without giving up some of the other.

Once technical inefficiencies have been eliminated, economic efficiency requires that resources be used
to produce the combination of goods with the highest social value (the combination most preferred by
society).This means that the government should aim for combination B in the figure. Though
combinations B, C, and D are all efficient in the technical sense, only B is most preferred by society;
only B meets the criteria of economic efficiency.

An efficient allocation, like in B in the figure, displays the property of Pareto optimality. According to
the pareto principle, social welfare rises whenever an individual is made better off without making anyone
else worse off. With an inefficient combination like A, resources can be reallocated to make at least some
people better off without hurting others. After the efficient point however, any act that makes one
individual better off must make another worse off. This means that once efficiency is achieved, it is
impossible to further increase social well-being using pareto’s welfare criteria.

FIGURE 2.1: ECONOMIC EFFICIENCY

22
 QUANTITY
OF CIRCUSES

PPC

D (THIRD CHOICE)

B (FIRST CHOICE)

C (SECOND CHOICE)

A
(INEFFICIENT)

QUANTITY
OF BREAD

Marginal Social Value

Economic efficiency is a desirable goal for every government, but how is this end reached? Suppose the
government wants to achieve the efficient production of bread for example, how will it know what the
efficient quantity is and how can it tell when it has produced too little or too much?

Because the efficient output is one that society values highly, it is important to know how society values
bread. Figure 2.2 graphs the assumed knowledge of the government on the value of bread. The
government measures value on the vertical axis of the figure and chooses money as a convenient scale.
The marginal social value of a loaf of bread is the social value of the last loaf produced. Thus, for
example the 50th loaf of bread has a social value of GH₵ 2.00.

23
FIGURE 2.2: MARGINAL SOCIAL VALUE

SOCIAL VALUE
(GH₵)

MARGINAL
SOCIAL
₵2.00 VALUE

₵1.00
₵0.75 MSV

50 100 150 QUANTITY

OF BREAD

MSV curve for bread slopes down ward because the law of diminishing marginal utility holds for
bread and other items. The 1st few loaves of bread satisfy intense needs and are highly valued. However,
as more and more bread is produced, each additional loaf goes to a less valuable use than the one before
it. Finally, at some point, additional output of bread has no value to society at all – zero marginal social
value.

Does efficiency mean producing as much bread as possible (to maximize total social value)? Flooding
the world with bread makes sense only in a land of infinite resources: we live in a word of scarcity. The
choice to produce more bread means a movement along the PPC in figure 2.1 –extra bread is obtained
only by paying an opportunity cost. The opportunity cost is the value of best foregone alternative use
of scarce resources.

Note that the MSC curve maps the marginal social value of each loaf. Also, diminishing returns mean
that additional bread adds less value to society.

Marginal Social Cost

Marginal social cost (MSC) reflects the value of the best alternative goods given up. Figure 2.3 shows
the problem of social cost. What does society give up to produce the 50 th loaf of bread? Producing this
bread means diverting resources from making steel, maintaining parks, moving a circus or some other
use.

According to figure 2.3, the 50 th loaf of bread uses resources that could have produced goods with
marginal social value of 40 pesewas. As bread production rises, resource must be diverted from more
and more valuable alternative uses. The opportunity cost of producing bread rises as the quantity of steel
increases. The 100th loaf of bread, for example, has a marginal social cost of GH₵1.00. Alternative goods
valued at GH₵1.00 must be forgone to make this production possible. The MSC of the 150 th loaf of
24
bread is even higher because it can be produced only if resources are diverted from yet more valuable
uses.

FIGURE 2.3: MARGINAL SOCIAL COST

SOCIAL COST MARGINAL

(GH₵) SOCIAL
COST MSC

₵3.00

₵1.00
₵0.40

50 100 150 QUANTITY

OF BREAD

The MSC curve slopes upwards because, as bread production rises, it first draws resources from lower-
valued alternative uses. As more and more bread is made, however, society gives up more and more
valuable alternative goods. The MSC curve measures the value of these forgone alternatives, so the MSC
rises as the quantity of bread increases.

Note that the social cost is the opportunity cost of producing a given good. Also note that the MSC curve
rises as more and more bread is produced because resources are diverted from production in other areas.
Diminishing returns in production and diminishing MSV of the forgone goods accounts for the upward
slope of the MSC curve.

Conditions for Efficiency

Now we know that the MSV tells how much society values different quantities of bread, while the MSC
measures the opportunity cost of that bread. What then is the efficient production of bread? We know
from the figures that society values the 50 th loaf at GH₵2.00 (MSV= GH₵2.00), but this alone doesn’t
guarantee that it is efficient to produce. What does society give up to make this bread?

Figure 2.3 tells us that the MSC of the 50 th loaf is 40 pesewas. Society can therefore produce a loaf of
bread that it values at GH₵2.00 if it means giving up alternatives valued at just 40 pesewas. Production
of the 50th loaf is efficient and generates a social gain or social net benefit of GH₵2.00 minus 40p =
GH₵1.60 (the vertical difference between the MSV and the MSC curves in figure 2.4).

The government will be wrong to order production of the 150 th loaf because society puts a value of 50
pesewas on the 150th loaf of bread but it must give up alternative goods worth GH₵3.00. Society prefers
25
an alternative use of its resources, so production of the 150 th loaf of bread violates the standard of
efficiency. Economic efficiency requires that goods be produced so long as they have a social value (MSV)
greater than or equal to their social cost (MSC). This means efficiency is achieved when 100 loaves of
bread are produced in figure 2.4, the output where MSV=MSC.

FIGURE 2.4: EFFICIENCY AND NET SOCIAL BENEFITS

NET SOCIAL
BENEFIT
SOCIAL
VALUE
COST (₵) MSC

MSV=MSC
ECONOMIC
Marginal EFFICIENCY Marginal
Social Social
Gain Loss

MSV

50 100 150 QUANTITY

OF BREAD
Producing more than 100 loaves is an efficiency sin of commission because resources are drawn from
more valuable uses to make less valuable bread. Producing fewer than 100 loaves of bread is an efficiency
sin of omission because it means diverting resources from bread production to alternative uses that
society deems less valuable.

In sum, the vertical difference between the MSV and MSC is the gain or social net benefit of production
– this is shown as the shaded area between the 2 curves in figure 2.4. The efficient level of production is
the one that maximizes the net benefits – that maximizes the shaded area. Many net benefits would be
lost if production stopped below the efficient level (at 50 in the figure, for example). A social loss or
negative net benefit results if production goes on past the efficient level to say, the 150th loaf in the figure.
Efficiency occurs and net benefits are maximized when resources sufficient to produce 100 loaves of
bread are allocated to bread production.

26
SECTION 2: Market Structures / Types of markets

Monopoly

In economics, monopoly is a pivotal area to the study of market structures, which directly concerns
normative aspects of economic competition, and sets the foundations for fields such as industrial
organization and economics of regulation.

8Monopoly (from Greek monos / μονος (alone or single) + polein / πωλειν (to sell) exists when a specific
individual or an enterprise has sufficient control over a particular product or service to determine
significantly the terms on which other individuals shall have access to it. (This is in contrast to a
monopsony which relates to a single entity's control over a market to purchase a good or service).

Monopolies are thus characterised by a lack of economic competition for the good or service that they
provide and a lack of viable substitute goods. The verb "monopolise" refers to the process by which a
firm gains persistently greater market share than what is expected under perfect competition. Monopolies
can form naturally or through vertical or horizontal mergers. A monopoly is said to be coercive when
the monopoly firm actively prohibits competitors from entering the field or punishes competitors who
do

In many jurisdictions, competition laws place specific restrictions on monopolies. Holding a dominant
position or a monopoly in the market is not illegal in itself, however certain categories of behavior can,
when a business is dominant, be considered abusive and therefore be met with legal sanctions. A
government-granted monopoly or legal monopoly, by contrast, is sanctioned by the state, often to
provide an incentive to invest in a risky venture or enrich a domestic interest group. Patents, copyright,
and trademarks are all examples of government granted and enforced monopolies. The government may
also reserve the venture for itself, thus forming a government monopoly. If there is a single seller in a
certain industry and there are no close substitutes for the goods being produced, then the market
structure is that of a "pure monopoly". Electricity Company of Ghana (ECG) and Ghana Water Company
Limited are tipical examples of monopolies in Ghana.

The main characteristics of a monopoly are:

• Single seller: In a monopoly there is one seller of the monopolised good who produces all the output.
Therefore, the whole market is being served by a single firm, and for practical purposes, the firm is
the same as the industry.

• Market power: Market power is the ability to affect the terms and conditions of exchange so that the
price of the product is set by the firm (price is not imposed by the market as in perfect competition).
Although a monopoly's market power is high it is still limited by the demand side of the market. A
monopoly faces a negatively sloped demand curve not a perfectly inelastic curve. Consequently, any
price increase will result in the loss of some customers.

27
Sources of Monopoly Power

Monopolies derive their market power from barriers to entry - circumstances that prevent or greatly
impede a potential competitor's entry into the market or ability to compete in the market. There are three
major types of barriers to entry; economic, legal and deliberate.

Economic barriers: These include economies of scale, capital requirements, cost advantages and
technological superiority.

Economies of scale: Monopolies are characterized by declining costs over a relatively large range of
production. Declining costs coupled with large startup costs give monopolies an advantage over would
be competitors. Monopolies are often in a position to cut prices below a new entrant's operating costs
and drive them out of the industry. Further the size of the industry relative to the minimum efficient
scale may limit the number of firms that can effectively compete within the industry.

Capital requirements: Production processes that require large investments of capital, or large research and
development costs or substantial sunk costs limit the number of firms in an industry. Large fixed costs
also make it difficult for small firms to enter an industry and expand.

Technological superiority: A monopoly may be better able to acquire, integrate and use the best possible
technology in producing its goods while entrants do not have the size or fiscal muscle to use the best
available technology. In plain English one large firm can sometimes produce goods cheaper than several
small firms.

No substitute goods: A monopoly sells a good for which there is no close substitute. The absence of
substitutes makes the demand for the good relatively inelastic enabling monopolies to extract positive
profits.

Control of Natural Resources: A prime source of monopoly power is the control of resources that are critical
to the production of a final good.

Legal barriers: Legal rights can provide opportunity to monopolise the market in a good. Intellectual
property rights, including patents and copyrights, give a monopolist exclusive control over the production
and selling of certain goods. Property rights may give a firm the exclusive control over the materials
necessary to produce a good.

Deliberate Actions: A firm wanting to monopolise a market may engage in various types of deliberate action
to exclude competitors or eliminate competition. Such actions include collusion, lobbying governmental
authorities, and force.

In addition to barriers to entry and competition, barriers to exit may be a source of market power. Barriers
to exit are market conditions that make it difficult or expensive for a firm to leave the market. High
liquidation costs are a primary barrier to exit. Market exit and shutdown are separate events. The decision
whether to shut down or operate is not affected by exit barriers. A firm will shut down if price falls below
minimum average variable costs.

28
Perfect Competition

The textbook case of perfect competition is an ideal model of a competitive market. Perfect competition
rarely (if ever) occurs in practice. It is more an ideal than a market reality, and so is not useful as a standard
for analyzing the performance of real world markets.

Perfect competition requires a number of conditions:

• The product concerned must be “homogeneous”. That is, the product must have identical
attributes and quality regardless of who buys or sells it;
• There must be a large number of buyers and sellers for that product;
• Buyers must be homogeneous and perfectly informed;
• No single consumer or firm must buy or sell anything more than an insignificant proportion of
the available market volume of that product;
• All buyers and sellers must enjoy the freedom to enter or exit the market at will and without
incurring additional costs;
• There must be no economies of scale. Economies of scale arise where the average cost of
production falls as the volume of production increases. Where economies of scale exist it is more
efficient for a single firm to produce a given volume than for two or more firms that between
them produce the same total volume, as the larger firm;
• There must be no economies of scope. Economies of scope arise when different products have
significant shared fixed costs, so that a single firm can produce them using a common facility.
Where economies of scope exist it is cheaper (and more efficient) to produce different products
out of a common plant or facility than to produce them separately;
• There must be no externalities. An externality is an unintended side effect (either beneficial or
adverse) of an ordinary economic activity that arises outside the market or price system so that
its impact is not reflected in market prices and costs;
• There must be no regulation of the market or franchise obligations; and
• There must be no restrictions on capital.

Effective Competition

Effective competition occurs in economic markets when four major market conditions are present:

• Buyers have access to alternative sellers for the products they desire (or for reasonable substitutes)
at prices they are willing to pay,
• Sellers have access to buyers for their products without undue hindrance or restraint from other
firms, interest groups, government agencies, or existing laws or regulations,
• The market price of a product is determined by the interaction of consumers and firms. No single
consumer or firm (or group of consumers or firms) can determine, or unduly influence, the level
of the price, and
• Differences in prices charged by different firms (and paid by different consumers) reflect only
differences in cost or product quality/attributes.

29
In effectively competitive markets, consumers are protected to some degree from exploitative prices that
firms, acting unilaterally or as a collusive bloc, could charge. Likewise, firms are protected from
manipulation by large individual consumers (or groups of consumers) and from disruption or
interference from other firms.

Competition occurs on the basis of both price and the quality or features of the product. Products are
often differentiated, that is they are not identical across firms. One form of a product is usually a
reasonable substitute for another form of that product. This is often referred to as “functional
equivalence”. Sellers may also offer product combinations or bundles that appeal to specific consumers
or consumer segments.

Effective competition can occur even in markets with relatively few firms that differ substantially in size,
market share, and tenure. However, for such markets to be competitive, it is important that there are no
barriers to entry and exit.

Oligopoly

In Economics, an oligopoly is a market form in which a market or industry is dominated by a small

number of sellers (oligopolists). The word is derived, by analogy with "monopoly", from the Greek ὀλίγοι
(oligoi) "few" + πωλειν (polein) "to sell". Because there are few sellers, each oligopolist is likely to be
aware of the actions of the others. The decisions of one firm influence, and are influenced by, the
decisions of other firms. Strategic planning by oligopolists needs to take into account the likely responses
of the other market participants.

Oligopoly is a common market form. As a quantitative description of oligopoly, the four-firm

concentration ratio is often utilized. This measure expresses the market share of the four largest firms in
an industry as a percentage. Oligopolistic competition can give rise to a wide range of different outcomes.
In some situations, the firms may employ restrictive trade practices (collusion, market sharing etc.) to
raise prices and restrict production in much the same way as a monopoly. Where there is a formal
agreement for such collusion, this is known as a cartel. A primary example of such a cartel is OPEC
which has a profound influence on the international price of oil.

Firms often collude in an attempt to stabilize unstable markets, so as to reduce the risks inherent in these
markets for investment and product development. There are legal restrictions on such collusion in most
countries. There does not have to be a formal agreement for collusion to take place (although for the act
to be illegal there must be actual communication between companies)–for example, in some industries
there may be an acknowledged market leader which informally sets prices to which other producers
respond, known as price leadership.

In other situations, competition between sellers in an oligopoly can be fierce, with relatively low prices
and high production. This could lead to an efficient outcome approaching perfect competition. The
competition in an oligopoly can be greater than when there are more firms in an industry if, for example,
the firms were only regionally based and did not compete directly with each other.

30
Thus the welfare analysis of oligopolies is sensitive to the parameter values used to define the market's
structure. In particular, the level of dead weight loss is hard to measure. The study of product
differentiation indicates that oligopolies might also create excessive levels of differentiation in order to
stifle competition.

Characteristics of Oligopoly

Oligopolies usually have some or all of the following characteristics;

Interdependence: The distinctive feature of an oligopoly is interdependence. Oligopolies are typically

composed of a few large firms. Each firm is so large that its actions affect market conditions. Therefore
the competing firms will be aware of a firm's market actions and will respond appropriately. This means
that in contemplating a market action, a firm must take into consideration the possible reactions of all
competing firms and the firm's countermoves.

It is very much like a game of chess or pool in which a player must anticipate a whole sequence of moves
and countermoves in determining how to achieve his objectives. For example, an oligopoly considering
a price reduction may wish to estimate the likelihood that competing firms would also lower their prices
and possibly trigger a ruinous price war. Or if the firm is considering a price increase, it may want to
know whether other firms will also increase prices or hold existing prices constant. This high degree of
interdependence and need to be aware of what the other guy is doing or might do is to be contrasted
with lack of interdependence in other market structures.

Profit maximization conditions: An oligopoly maximizes profits by producing where marginal revenue
equals marginal costs.

Ability to set price: Oligopolies are price setters rather than price takers

Entry and Exit: Barriers to entry are high. The most important barriers are economies of scale, patents,
access to expensive and complex technology, and strategic actions by incumbent firms designed to
discourage or destroy nascent firms.

Number of firms: "Few"– a "handful" of sellers. There are so few firms that the actions of one firm can
influence the actions of the other firms.

Long Run Profits: Oligopolies can retain long run abnormal profits. High barriers of entry prevent
sideline firms from entering market to capture excess profits.

Product differentiation: Product may be standardized (steel) or differentiated (automobiles).

Perfect Knowledge: Assumptions about perfect knowledge vary but the knowledge of various economic
actors can be generally described as selective. Oligopolies have perfect knowledge of their own cost and
demand functions but their inter-firm information may be incomplete. Buyers have only imperfect
knowledge as to price, cost and product quality.

31
Monopolistic Competition

Monopolistic competition is a form of imperfect competition where many competing producers sell
products that are differentiated from one another (that is, the products are substitutes, but, with
differences such as branding, are not exactly alike). In monopolistic competition firms can behave like
monopolies in the short-run, including using market power to generate profit. In the long-run, other
firms enter the market and the benefits of differentiation decrease with competition; the market becomes
more like perfect competition where firms cannot gain economic profit.

Unlike perfect competition, the firm maintains spare capacity. Models of monopolistic competition are
often used to model industries. Textbook examples of industries with market structures similar to
monopolistic competition include restaurants, cereal, clothing, shoes, and service industries in large cities.

Monopolistically competitive markets have the following characteristics:

• There are many producers and many consumers in a given market, and no business has total control
over the market price.
• Consumers perceive that there are non-price differences among the competitors' products.
• There are few barriers to entry and exit
• Producers have a degree of control over price.

The long-run characteristics of a monopolistically competitive market are almost the same as in perfect
competition, with the exception of monopolistic competition having heterogeneous products, and that
monopolistic competition involves a great deal of non-price competition (based on subtle product
differentiation).

A firm making profits in the short run will break even in the long run because demand will decrease and
average total cost will increase. This means in the long run, a monopolistically competitive firm will make
zero economic profit. This gives the amount of influence over the market; because of brand loyalty, it
can raise its prices without losing all of its customers. This means that an individual firm's demand curve
is downward sloping, in contrast to perfect competition, which has a perfectly elastic demand schedule.

Major Characteristics of Monopolistic Competition

There are six characteristics of monopolistic competition (MC). These are explained briefly below.

Product differentiation: MC firms sell products that have real or perceived non-price differences.
However, the differences are not so great as to eliminate goods as substitutes. Technically the cross price
elasticity of demand between goods would be positive. In fact the cross price elasticity of demand would
be high. MC goods are best described as close but imperfect substitutes. The goods perform the same
basic functions. The differences are in "qualities" and circumstances such as type, style, quality,
reputation, appearance and location that tend to distinguish goods. For example, the function of motor
vehilces is basically the same - to get from point A to B in reasonable comfort and safety. Yet there are
many different types of motor vehicles, motor scooters, motor cycles, trucks, cars and SUVs.

32
Many firms: There are many firms in each MC product group and many firms on the side lines prepared
to enter the market. A product group is a "collection of similar products" The fact that there are "many
firms" gives each MC firm the freedom to set prices without engaging in strategic decision making. The
requirements assures that each firm's actions have a negligible impact on the market. For example, a firm
could cut prices and increase sales without fear that its actions will prompt retaliatory responses from
competitors.

Free entry and exit: In the long run there is free entry and exit. There are numerous firms awaiting to
enter the market each with its own "unique" product or in pursuit of positive profits and any firm unable
to cover its costs can leave the market without incurring liquidation costs. This assumption implies that
there are low startup costs, no sunk costs and no exit costs.

Independent decision making: Each MC firm independently sets the terms of exchange for its
product. The firm gives no consideration to what effect its decision may have on competitors. The theory
is that any action will have such a negligible effect on the overall market demand that an MC firm can act
without fear of prompting heightened competition. In other words each firm feels free to set prices as if
it were a monopoly rather than an oligopoly.

Market power: MC firms have some degree of market power. Market power means that the firm has
control over the terms and conditions of exchange. An MC firm can raise it prices without losing all its
customers. The firm can also lower prices without triggering a potentially ruinous price war with
competitors. The source of an MC firm's market power is not barriers to entry since there are none. An
MC firm derives its market power from the fact that it has relatively few competitors, competitors do
not engage in strategic decision making and the firms sells differentiated product. Market power also
means that an MC firm faces a downward sloping demand curve. The demand curve is highly elastic
although not "flat".

Perfect information: Buyers know exactly what goods are being offered, where the goods are being
sold, all differentiating characteristics of the goods, the good's price, whether a firm is making a profit
and if so how much.

Section 3. Market and Government Failures

33
Market failure in a simple sense refers to an economic term that encompasses a situation where, in any
given market, the quantity of a product demanded by consumers does not equate to the quantity supplied
by suppliers. This is a direct result of a lack of certain economically ideal factors, which prevents
equilibrium.

In a broad sense, market failure is a concept within economic theory wherein the allocation of goods and
services by a free market is not efficient. That is, there exists another outcome where market participants'
overall gains from the new outcome outweigh their losses (even if some participants lose under the new
arrangement). Market failures can be viewed as scenarios where individuals' pursuit of pure self-interest
leads to results that are not efficient – that can be improved upon from the societal point-of-view.

Traffic congestion is an example of market failure, since driving can impose hidden costs on other drivers
and society. Solutions for this include public transportation, congestion pricing, toll roads and toll
bridges, and other ways of making the driver include the social cost in the decision to drive. Other
common examples of market failure include environmental problems such as pollution or
overexploitation of natural resources.

Market failures have negative effects on the economy because an optimal allocation of resources is not
attained. In other words, the social costs of producing the good or service (all of the opportunity costs
of the input resources used in its creation) are not minimized, and this results in a waste of some
resources.

Take, for example, the common argument against minimum wage laws. Minimum wage laws set wages
above the going market-clearing wage in an attempt to raise market wages. Critics argue that this higher
wage cost will cause employers to hire fewer minimum-wage employees than before the law was
implemented. As a result, more minimum wage workers are left unemployed, creating a social cost and
resulting in market failure.

Causes of Market Failure

According to mainstream economic analysis, a market failure (relative to Pareto efficiency) can occur for
three main reasons.

• First, agents in a market can gain market power, allowing them to block other mutually beneficial gains
from trades from occurring. This can lead to inefficiency due to imperfect competition, which can
take many different forms, such as monopolies, monopsonies, cartels, or monopolistic competition,
if the agent does not implement perfect price discrimination. In a monopoly, the market equilibrium
will no longer be Pareto optimal. The monopoly will use its market power to restrict output below
the quantity at which the Marginal social benefit (MSB) is equal to the Marginal social cost (MSC) of
the last unit produced, so as to keep prices and profits high.

• Second, the actions of agents can have which are innate to the methods of production, or other
conditions important to the market. For example, when a firm is producing steel, it absorbs labor,
capital and other inputs, it must pay for these in the appropriate markets, and these costs will be
reflected in the market price for steel. If the firm also pollutes the atmosphere when it makes steel,
34
 however, and if it is not forced to pay for the use of this resource, then this cost will be borne not by
the firm but by society. Hence, the market price for steel will fail to incorporate the full opportunity
cost to society of producing. In this case, the market equilibrium in the steel industry will not be
optimal. More steel will be produced than would occur were the firm to have to pay for all of its costs
of production. Consequently, the MSC of the last unit produced will exceed its MSB.

• Finally, some markets can fail due to the nature of certain goods, or the nature of their exchange. For instance,
goods can display the attributes of public goods or common-pool resources, while markets may have
significant transaction costs, agency problems, or informational asymmetry. In general, all of these
situations can produce inefficiency, and a resulting market failure. A related issue can be the inability
of a seller to exclude non-buyers from using a product anyway, as in the development of inventions
that may spread freely once revealed. This can cause underinvestment, such as where a researcher
cannot capture enough of the benefits from success to make the research effort worthwhile.

More fundamentally, the underlying cause of market failure is often a problem of property rights. As
Gravelle and Rees put it, ‘a market is an institution in which individuals or firms exchange not just
commodities, but the rights to use them in particular ways for particular amounts of time. [...] Markets are
institutions which organize the exchange of control of commodities, where the nature of the control is
defined by the property rights attached to the commodities.

As a result, agents' control over the uses of their commodities can be imperfect, because the system of
rights which defines that control is incomplete. Typically, this falls into two generalized rights –
excludability and transferability. Excludability deals with the ability of agents to control who uses their
commodity, and for how long – and the related costs associated with doing so. Transferability reflects
the right of agents to transfer the rights of use from one agent to another, for instance by selling or
leasing a commodity, and the costs associated with doing so. If a given system of rights does not fully
guarantee these at minimal (or no) cost, then the resulting distribution can be inefficient.

Government Failure

Government failure (or non-market failure) is the public sector analogy to market failure and occurs
when a government intervention causes a more inefficient allocation of goods and resources than would
occur without that intervention. Likewise, the government's failure to intervene in a market failure that
would result in a socially preferable mix of output is referred to as passive Government failure (Weimer and
Vining, 2004). Just as with market failures, there are many different kinds of government failures that
describe corresponding distortions.

The term, coined by Roland McKean in 1965, became popular with the rise of public choice theory in
the 1970s. The idea of government failure is associated with the policy argument that, even if particular
markets may not meet the standard conditions of perfect competition, required to ensure social
optimality, government intervention may make matters worse rather than better.

Just as a market failure is not a failure to bring a particular or favored solution into existence at desired
prices, but is rather a problem which prevents the market from operating efficiently, a government failure

35
is not a failure of the government to bring about a particular solution, but is rather a systemic problem
which prevents an efficient government solution to a problem. The problem to be solved need not be a
market failure; sometimes, some voters may prefer a governmental solution even when a market solution
is possible.

Government failure can be on both the demand side and the supply side. Demand-side failures include
preference-revelation problems and the illogics of voting and collective behaviour. Supply-side failures
largely result from principle/agent problems

Reasons for government failure may include poor information (politicians may have poor information
about the type of service to provide), political interference (e.g. politicians may take the short term view
rather than considering long term effects), administrative cost of government bureaucracy in running
public services, and the lack of incentives (there is no profit motive working in the public sector this can
lead to inefficiency)

SECTION 4: Public Goods

36
Defining Public Goods – Non-rivalry and non-exclusion

The line between public and private goods is drawn using the principle of rivalry and exclusion.

Goods are either rivalrous or non-rivalrous, and are either excludable or non-excludable. Rivalrous goods
are those which can be consumed by only one person at the same time - for example, a candy bar or a
suit. Non-rivalrous goods on the other hand may be consumed by many at the same time at no additional
cost - for example, national defense or a piece of scientific knowledge. In effect therefore, rivalry is the
principle that goods consumed by one party reduce those available for others; consumers are rivals for
scarce goods such that if consumer A has more, Consumer B necessarily has less.

An alternative definition is that a non-rivalrous good may be provided to more consumers at a very low
marginal cost for each additional consumer. The alternative is correct, since even national defence takes
additional resources for each person covered (it would be cheaper not to extend the area protected to
Ghana’s beyond territorial waters) and disseminating scientific knowledge does take added expense in
printing journals and books. However, the marginal cost is very low compared to the cost of establishing
an army in the first place or of making the scientific discovery. The alternative does leave us with the
question: how low is "low enough" to qualify a good as "public"?

Excludable goods are those for which one can, at a low cost, prevent those who have not paid for the good
from consuming it. You can require people to pay for a stamp before you deliver mail or pay for a ticket
before they board a train; you cannot cheaply or easily prevent people from entering a park or from
listening to a radio station. In effect, exclusion is the principle that the owner of a good can effectively bar
third-party benefits. Exclusion therefore depends on transaction costs. Note that excludable goods are
sometimes provided publicly (mail service) and non-excludable goods (radio and television) sometimes
privately.

Deriving from the above, we can simply define a public good as any good or service that exhibits the
traits of non-rivalry and non-exclusion whereas private good may be defined as any good where both
rivalry and exclusion apply.

Pure and impure public goods

Public goods can be pure or impure. A pure public good provides the same level of benefit for
everybody independently of the number of users. The benefit of any one person is not at the expense of
any other person. Figure 5.2a shows benefits from a pure public good. Individual benefit is constant as
the number of users increases.

A pure public good can also be a local public good. That is, the benefits can be locally available to people
in an area. Non-congested local roads, local police protection or local public health services are pure
public goods that benefit people in a particular area.

Individual
benefit 37
 Constant
benefit

Number of
O users
Figure 5.5a: Pure public goods (individual benefits are independent of the number of users)

Individual benefit from an impure public good declines with the number of users because of congestion
effects. The same public good may at different times be pure or impure (that is, congestible). A highway
at 3A.M. may be a pure public good, whereas at 8A.M., when choked with peak hour traffic, the same
highway becomes an impure public good.

Figure 5.2b shows the benefits from a public good that is pure up to a number n1 of users, after which
congestion begins and the benefit from use declines s negative benefit. We can imagine cars not moving
on a congested highway; reflecting the common negative benefit, after n2 are on the highway. At this
stage, people are, in principle, even willing to pay to leave the highway.

Individual
benefit

38
 Number of
O users
n1 n2
1 1

Figure 5.5b: Impure public goods (a public good that becomes subject to congestion)

Common goods and Public Enterprise goods

In addition to the pure and impure public goods discussed by the preceding topic, the principles of rivalry
and exclusion provide us with two other types of goods. All four types of goods, together with their
relation to rivalry and exclusion are displayed in table 5.3 below.

Table 5.3 Types of goods

Excludable Non-excludable

Rivalrous Private goods (ex candy) Common goods (ex. fishing grounds)

Non-rivalrous Public enterprise goods (ex. TVA, Pure public goods (ex. National defense,
mail, trains) court system)

From table 5.3, it is evident that Common goods are those which are rivalrous in consumption but non-
excludable. Fishing grounds provide a good example - fish caught by one boat reduce the catch available
for others, but it is difficult to exclude fishing boats from going where they please. Often the problem
with common goods is overuse - overfishing, overuse of rivers or the air to discharge waste.

A step towards a solution for problems relating to common goods is often to define property rights
which had been left undefined because of a belief (perhaps justified at an earlier time) that such goods
were non-rivalrous - that the fishing grounds were inexhaustible or the river unpollutable'

Public enterprise goods are those which are excludable and so could be privately provided, but which
have low marginal costs of production and so are likely to be natural monopolies. Private provision runs
the risk of monopoly and hence of under-provision; public provision is accordingly desirable. Note that
private provision is not impossible8YUU76 in these cases, so it is always debatable whether government
should be in the business - and the public choice school of thought would argue that politicians and
bureaucrats will always have an incentive to ensure their own employment by over-providing these goods.

39
It is not clear whether the government should provide mail service (UPS or Federal Express may do so
more efficiently), train service, telecommunications (Ghana Telecom has debatably become much more
efficient since privatization), health or insurance services such as Social Security. Nor is it clear that the
government should NOT provide these services; they are likely to be hotly debated political issues for
the foreseeable future.

Exclusion and free riders

It is often impossible to exclude people from the benefits of public goods. The rule of law, for example,
protects everybody from anarchy. Public health programmes likewise benefit everybody by eradicating
communicative diseases. When exclusion from benefit does not or cannot take place, a person can benefit
from spending of public goods by others. Such attempt to benefit without personally paying is called free-
riding behavior.

To illustrate free riding, suppose that a number of people in Winneba have fishing boats and Sakyi, the
chief fisherman, proposes that a lighthouse be built. Nyigmah, Azunu and some other fishermen might
claim that they feel under no obligation to contribute to the financing of a lighthouse because they are
able to fish adequately without a lighthouse. After the lighthouse has been constructed without their
participation, they nonetheless benefit from the additional safety due to the presence of the lighthouse.

Means could be made available to exclude Nyigmah, Azunu and the other free riders from the benefits
of the lighthouse. Someone could be stationed in the lighthouse to turn off the lights whenever a free
rider is seen in the vicinity. However, this would be inefficient. Exclusion from a pure public good is
Pareto inefficient because allowing additional users to benefit makes no one worse off. Exclusion also
requires resources: the time of the person on watch to exclude free riders could be used productively
rather than used to make some people worse off through exclusion. If everybody attempts to free ride,
there would be off course no public good. The population would consist exclusively of prospective free
riders – prospective because, when all people attempt to free ride, no one pays and no public good is
supplied on which to free ride.

The free rider problem raises the issue of externalities which will be discussed in the next section.

SECTION 5: Externalities

Externalities defined

Externalities are said to exist when an economic agent (producer or consumer) fails to bear the full cost
or gain the full benefit of its choices. They are sometimes called ‘spillovers’ or ‘neighbourhood effects’
because when externalities exist, the costs or benefits of an individual’s choice spills over to others or is
shared with neighbouring producers or consumers. Alternatively, an externality may be seen as a cost or
benefit, not transmitted through prices, incurred by a party who did not agree to the action causing the
cost or benefit.

40
In these cases in a competitive market, prices do not reflect the full costs or benefits of producing or
consuming a product or service, producers and consumers may either not bear all of the costs or not
reap all of the benefits of the economic activity, and too much or too little of the good will be produced
or consumed in terms of overall costs and benefits to society. For example, manufacturing that causes
air pollution imposes costs on the whole society, while fire-proofing a home improves the fire safety of
neighbors.

If there exist external costs such as pollution, the good will be overproduced by a competitive market, as
the producer does not take into account the external costs when producing the good. If there are external
benefits, such as in areas of education or public safety, too little of the good would be produced by private
markets as producers and buyers do not take into account the external benefits to others. Here, overall
cost and benefit to society is defined as the sum of the economic benefits and costs for all parties
involved.

There are a number of potential means of improving overall social utility when externalities are involved.
The market-driven approach to correcting externalities is to "internalize" third party costs and benefits,
for example, by requiring a polluter to repair any damage caused. But, in many cases internalizing costs
or benefits is not feasible, especially if the true monetary values cannot be determined.

The monetary values of externalities are difficult to quantify, as they may reflect the ethical views and
preferences of the entire population. It may not be clear whose preferences are most important, interests
may conflict, the value of externalities may be difficult to determine, and all parties involved may try to
influence the policy responses to their own benefit. An example is the externalities of the smoking of
tobacco, which can cost or benefit society depending on the situation. Because it may not be feasible to
monetize the costs and benefits, another method is needed to either impose solutions or aggregate the
choices of society, when externalities are significant. This may be through some form of representative
democracy or other means. Political economy is, in broad terms, the study of the means and results of
aggregating those choices and benefits that are not limited to purely private transactions.

Negative and Positive externalities

As explained by the previous topic, externalities are costs or benefits imposed by a market transaction
on people who are not parties to that transaction. Externalities may therefore be negative or positive.

Negative externalities are those that impose costs on others. For example, pollution resulting from the
production of a good will impose costs even on those who do not buy the good – in Ghana, floods
resulting from the pollution of water ways by sachet water containers affect even those who do not
patronize sachet water. In this case, the marginal social costs of production -- which take into account
the "costs" in terms of polluted air or water paid by those who do not produce or buy the good -- are
higher than the marginal private costs of production. Graphically, the situation may be presented as
follows:

41
The point at which demand (or marginal private benefit) intersects with marginal social cost is the
optimum from the social viewpoint; since the market will normally consider only private costs and
benefits, the market will overproduce the good.

Positive externalities are those that result in benefits to people who are not parties to the transaction. For
example, scientific research which results in a new product can be used by companies which did not pay
for the research, at least after any patents have expired (and often slight modifications will be enough to
have a sufficiently different product so that patent coverage will not apply). The history of inventions is
littered with inventors who failed to profit very much from their inventions, from James Watt (steam
engine) to John Mauchly and John Prosper Eckert (digital computer).

As a result, the marginal social benefit of research and development activities is greater than the marginal
private benefit of those activities, and the market will tend to under-provide those activities.

Remember that the demand curve shows the marginal private benefit and you will easily see that
graphically, the situation is as follows:

Policies toward externalities

Several policies have been adopted or suggested toward externalities. In evaluating them, keep one typical
negative externality in mind: water pollution -- most of which is caused not by toxic waste discharges by
big industries, but by the runoff of fertilizer from farms.

One such policy toward externalities is the Prohibition of activities which give rise to negative
externalities. The problem is that any production process results in some pollution, and unless the
pollution is so dangerous as to be life threatening, prohibition is impractical. Would you require all
farmers to grow their foods organically? What do you think would happen to the price of tomatoes?

Regulation or limiting the amount of polluting activity to a certain amount or permitting it only with
the adoption of a given production technology (avoid certain types of fertilizer, specific types of the
42
smokestack scrubbers). Let us use our fertilizer example and suggest a regulation that no farmer can use
more than 100 tons of fertilizer. There are three problems with regulation:

 the cost of reducing pollution -- which can be a very real cost in the form of lost jobs or foregone
production -- is not taken into consideration

 there is no incentive for firms which could easily reduce pollution to reduce it by more than the
minimum required amount.

 Monitoring may be difficult, especially when there are a large number of sources of pollution.

Taxation can also raise private costs of production until they coincide with social costs of production.
The use of taxes to bring private and social costs of production into agreement is known as Pigovian
taxation after Arthur Cecil Pigou, the English economist who proposed such taxes in his work on The
Economics of Welfare. The advantage of Pigovian taxation is that detailed monitoring is not necessary:
if the government taxes fertilizer, farmers have a built-in economic incentive not to use any more than
necessary. The problem with Pigovian taxation is the assumption that the government knows exactly
what taxes to levy, that is, exactly what marginal social costs are.

Ronald Coase pointed out that clear assignment of property rights could in principle avoid the need for
Pigovian taxation. The Coase theorem with regard to pollution is that however property rights are
assigned, an economically efficient outcome can in principle result from free market exchange between
polluters and their victims -- if the polluters are assigned the right to pollute, their victims could bribe
them to stop; if the victims are assigned the right to clean air and water, the polluter can bribe them to
permit at least some pollution. The problem with the Coase theorem -- as Coase himself recognized -- is
that high transactions costs may prevent the victims of pollution from organizing, and the free rider
problem will lead some victims to wait for others to make the first contributions to paying off the
polluter.

Tradeable emission permits combine many of the advantages of Pigovian taxation and Coasian
negotiation. The government decides on how much pollution to permit and issues permits to firms for
that amount, but permits the firms to trade the permits among themselves. Firms which can reduce
pollution at a low cost have an incentive to do so and to sell their unneeded pollution permits; firms
which could not reduce pollution except at high cost will buy the permits. Monitoring to see that the
permitted limits are not exceeded remains a problem.

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 CHAPTER 3:
GOVERNMENT REVENUE AND EXPENDITURE

SECTION 1: Government Revenue

Government/Public revenue

Though government revenue includes all amounts of money received from sources outside the
government entity, government revenue simply is revenue received by a government. Its opposite is
government spending and an important part of fiscal policy. Revenue may be from various taxes or non-
tax revenue (such as revenue from government-owned corporations or sovereign wealth funds).

From a broader perspective, revenue includes all amounts of money received by a government from
external sources during its fiscal year (i.e., those originating "outside the government"), net of refunds
and other correcting transactions, other than issuance of debt, sale of investments, and agency or private
trust transactions. Under this definition, revenue excludes amounts transferred from other funds or
agencies of the same government.

Large governments usually have an agency or department responsible for collecting government revenue
from companies and individuals. Revenue, in this sense, comprises amounts received by all agencies,
boards, commissions, or other organizations categorized as dependent on the government concerned.
Stated in terms of the accounting procedures from which these data originate, revenue covers receipts
from all accounting funds of a government, other than intra-governmental service (revolving), agency,
and private trust funds.

Government revenue may also include reserve bank currency which is printed. This is recorded as an
advance to the retail bank together with a corresponding currency in circulation expense entry. The
income derives from the Official Cash rate payable by the retail banks for instruments such as 90 day
bills.

Sources of Government/public Revenue

Public revenue is the income that accrues to the government. The revenue needed by the government to
finance its economic activities may be raised from various sources. Some of these sources include

Taxation: this is compulsory levy on all taxable individuals and corporate institutions within the country.
Taxation is one of the main sources of government revenue and will be explained in detail in Unit 4.

Loans: This is a temporary source of revenue to the government due to its indebtedness clause requiring
future repayment of both principal and interest as a reward for parting with capital. When government
borrowing is not properly managed, it can lead to a huge debt burden, since it carries the clause of the
ability of the borrower to pay back. Sometimes, the interest paid on such loans can be more than the
44
principal amount on a cumulative basis. Loans can be categorized as internal or external, or short term
and long term.

Grants and aid: this represents financial assistance that flows from richer countries and corporate
institutions to the poorer countries without any condition for repayment from the donor country. This
has contributed to the growth of the world economy since it is a way of maintaining international liquidity
worldwide.

Profits: profits represents income that government raises from its investments, public corporations,
stock appreciation, redeemed debentures or interest paid to a government from the loans it has granted
to other countries.

Royalties/ rents: this is the rent paid for the usage of land as a reward or compensation for the land
owner by corporate bodies. In many cases, it is the revenue generated by the government from the use
of land for exploitation of the mineral resources within the country.

Printing and minting of money: government can also raise revenue from the printing of currency.
Government through the central bank can print a specified quantity of money for the financing of its
expenditure.

Confiscation: this is the direct seizure of property or the conversion of any property for government
use without any compensation to the owner and without any promise to return the property to the
original owner. Examples include the confiscation of cars not properly cleared at the ports and other
government agencies, and the seizure of smuggled goods into the country.

Other Sources of Government/Public Revenue

In addition to the sources of revenue discussed above, there are other forms of public revenues – fees,
charges, etc., for providing various forms of services or issuing licenses for this and that. Hidden taxation
is another important source of government revenue and may come in two forms.

One is where government collects revenue by some roundabout fashion, for instance a dual exchange
rate system, rather than in a standard tax form. The second form is where there is no entry into the
government’s accounts at all but nevertheless, the equivalent of a tax is levied. A standard illustration is
the inflation tax arising when government indebtedness falls in real terms as prices rise – or, to put the
same point differently, when real capital gains accrue to government.

Other sources of public revenue include public enterprise receipts (including those of fiscal monopolies),
internal borrowing (Whether from central Bank or more generally), foreign borrowing (from commercial
sources as well as foreign governments and international agencies) and aid of all types from abroad.

The promotion of international arrangements which increase the value of sales of particular exports (for
instance, oil, minerals, foodstuffs), and thus facilitate revenue-raising by export taxes and the like is also
an important source of government revenue in recent times.

45
Classification of Government/Public revenue

Differing classifications of public revenue have been almost as numerous as the writers who have made
them. Without entering into a discussion of the reasons for such differences, we may present at once a
classification which is in general harmony with the usual treatment of the subject.

A. Permanent Revenues

Regular revenues – these are derived directly from government ownership. These revenues include revenues
from public domains, revenues from public industries (industries publicly owned and managed), quasi-
public industries (industries publicly owned, but managed by lessees under a charter), and revenues
derived from the incomes of private persons and corporations (fees, special assessments, and taxes).

Irregular and miscellaneous – these include fines, forfeits, escheats, gifts, etc

B. Temporary Revenues – these are revenues that will be repaid by government. These include public
loans by the sale of bonds, and public loans by the issue of treasury notes.

Miscellaneous Revenues - The class of miscellaneous revenues includes gifts, fines, forfeits, escheats,
"conscience money," etc. Escheat is a legal term used to describe a property that falls to the State in
default of other heirs. Conscience money is money sent without name by persons who have defrauded
the government.

Gifts amount to more than is commonly supposed, although they form a relatively unimportant source
of revenue. Formerly gifts were not infrequently made for the general expenditures of government. Less
than a quarter of a century ago, a citizen of New Jersey left the United States nearly a million dollars to
be applied to the payment of the national debt. But gifts are now more commonly made for special
purposes, as when Mr. Smithson left the United States half a million dollars to be used in the foundation
of the Smithsonian Institution for the Advancement of Science.

SECTION 2: Receipts excluded from public revenue

Revenue of business-type activities of governments (utilities and other commercial or auxiliary

enterprises) is reported on a gross basis. That is, related expenditures are not deducted from their
revenues to derive net revenue amounts. From the accounting perspective, however, the following types
of receipts are excluded from revenue:

46
 • Taxes and other amounts paid under protest and held in suspense accounts subject to possible
refund. Such amounts are not reported as revenue unless and until the protest is decided in the
government's favor (example, Suspense Transactions).

• Proceeds from borrowing, whether short- or long-term, except contingent loans and advances
which are reported as intergovernmental revenues.

• Recoveries or refunds of amounts spent in the same fiscal year, which are deducted from
expenditures.

• Proceeds from the sale of investments and the repayment of loans, except for contingent loans
as mentioned above. Any recorded profit or loss from the sale of investments, however, is
reported as revenue or expenditure, based on the situation.

• Transfers from agencies or funds of the same government

• Agency or private trust transactions, where the government is acting on behalf of others

• Non-cash transactions, such as receipt of technical services, commodities, property, noncash gifts
or bequests, and other "receipts-in-kind."

• that are sensitive to changes in economic conditions

SECTION 3: Government Expenditure

What is government/public expenditure

Public expenditure is the expenses or cost that government usually incurs for maintenance of itself as an
institution, the economy and the society. Government expenditure tends to increase with time as the
economy becomes more developed or as there is an increase in the scope of the activities of the
government.

Since market mechanisms fail to bring about the desired result in the economy, government is forced to
intervene. Though this is one of the contributory factors that led to the increasing state expenditure, in
47
most cases, government intervention has brought about stability in income and employment in the
economy. Public expenditure is therefore an important tool that brings about egalitarian society through
the provision of welfare facilities.

Government sector is part and parcel of the economy and it is a source where certain changes in the
economy are effected, through redirecting the workings of the economy, where there are lapses in the
free market.

Government expenditure is made up of the capital and recurrent expenditure. Capital expenditure
includes all investment in infrastructural projects; physical assets that are for long term purpose, mainly
to improve the living conditions of citizens. Capital expenditure is made on generally productive
investments like housing, road construction, agriculture and water resource.

The recurrent expenditure is generally spendings on service to maintain the existing facilities in the
economy including wages and salaries, maintenance of social services and security.

Characteristics of government expenditure

Any expenditure by the government should be on projects and programmes that will help reduce the
inequality of income, and improve the welfare of the citizens of the country. In order for the expenditure
to make an impact in the life of the citizens some characteristics of such spending must be put into
consideration.

Economy: because economic resources are scarce, there should be no wastage of public funds. Care
must be taken in planning and executing public expenditure on projects to reduce delays since such delays
can lead to increasing cost. For each project to which the government is committing its resources there
should be cost-benefit analysis in which social cost and social benefit of the project is estimated to
determine the worthiness of such expenditure on the project. The long run social benefit should be
greater than or equal to the social cost.

Benefit: government should embark on projects that are beneficial to the social and general public.
Government expenditure should be on programmes that have positive distributional effect of income,
wealth, production and distribution within the economy. This ensures that the citizens’ social welfare is
collectively maximized.

Authorization: there should be adequate legal restriction that will check diversion of funds. Public funds
should be used only for the purpose it was budgeted. In a democratic system of government, decisions
on government expenditure are taken by the legislature where detail authorizations are worked out before
the actual spending will take place.

Balance: government should not be running into debts when financing its projects. There should be
prudent spending where current expenditure will be financed by current revenue. Every project should
be self-liquidating and appropriate measures should be taken to minimize budget deficit.

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Classification of government expenditure

Public expenditure can be classified according to the function that they perform. Among these functions
are:

General administration: Government may spend money on payment of wages and salaries including
other running costs; and expenses for the maintenance of law and order through internal security such
as police and the armed forces that require the necessary equipment to forestall external aggression.

Economic services: Government spends money on this sector so as to increase the pace of economic
development which in turn will improve the welfare of the citizens. Such expenses include investment in
agriculture and water resources, construction, manufacturing industries, mining and quarrying, transport
and communication.

Social and community services: Government spends money in providing social amenities or
infrastructure which reduces the cost of production in the other sectors of the economy. This includes
expenses for establishment of schools, health facilities etc.

Transfers: this is the amount of money spent on debt repayments - both the principal and the interest;
running cost of foreign missions; as well as donations, grants and aid given to other countries.

• Section summary

• Government expenditure tends to increase with time as the economy becomes more developed
or as there is an increase in the scope of the activities of the government.

• Government must spend on projects and programmes that will help reduce the inequality of
income, and improve the welfare of the citizens of the country

• Government expenditure may be classified under General administration, economic services,

social and community services and transfers:

SECTION 4: Theories of Public Expenditure Growth

Wagner’s Law

Wagner was a nineteenth century economist who analysed data on the public sector for a range of
countries. The data at that time demonstrated that the share of the public sector in GDP had increased
over time. Wagner’s law was an explanation of this trend and a prediction that it would continue.

49
The theory states that as per capita income of an economy grows, the relative size of public expenditure
grows along with it. As the economy grows, there will be increase in the number of urban centers with
the associated social vices such as crime which require the intervention of the government to reduce such
activities to the barest minimum. Large urban centers also require internal security to maintain law and
order; these interventions by the government have cost leading to increase in public expenditure in the
economy.

Wagner says there is a positive relationship between per capita income of the citizens in a country with
government spending, that the income elasticity of government expenditure is always greater than one.
However, other researchers have discovered that the relationship is not always certain. This is because
there are periods where government expenditure in relation to the national income will decline when the
elasticity of income to government expenditure is less than one (inelastic).

The basis for the Law consists of three distinct components:

1. Economic growth results in an increase in complexity requiring continued introduction of new laws
and development of the legal structure.
2. Urbanisation increases externalities which necessitate intervention.
3. The goods supplied by the public sector have a high income elasticity of demand.

It is the third point that differentiates Wagner’s law from other explanations and is founded on principles
of economic choice. The claim appears reasonable, for example, for education, recreation and health
care. Its consequence is that as economic growth raises income then demand for these products will rise.
If the elasticity of demand exceeded one, public sector expenditure would consequently rise as a
proportion of income.

Wagner’s law is compelling but by concentrating solely on the demand for public sector services it
overlooks the supply side and the politics of provision. Both of these are essential ingredients.

Rostow-Musgrave Model

The economist, Musgrave, and the economic historian, Rostow, (separately) suggested that the growth
of public expenditure might be related to the pattern of economic growth and development in societies.
Three stages in the development process could be distinguished:

(a) the early development stage where considerable expenditure is required on education and on the
infrastructure of the economy (also known as social overhead capital) and where private saving is
inadequate to finance this necessary expenditure (in this stage, government expenditure must thus be
a high proportion of total output);

(b) the phase of rapid growth in which there are large increases in private saving and public investment
falls proportionately; and

(c) high income societies with increased demand for private goods which need complementary public
investment (e.g. the motor car and urbanisation).

50
According to Rostow and Musgrave, at the early stages of economic development, the rate of growth of
public expenditure will be very high. This is because at the early stages of economic development, the
government provides the basic infrastructural facilities (social overhead) and most of these projects are
capital intensive, therefore the spending of the government will increase steadily.

The investments in water education, health, water, roads, electricity, and water supply are necessities that
can launch the economy from the traditional stage to the take-off stage of economic development,
making government to spend an increasing amount with time in order to develop an egalitarian society.

The model identifies five stages of expenditure growth - traditional society, preconditions for take-off,
the take-off; the drive to maturity and the eye of high mass consumption. What determines the accepted
expenditure growth depends critically on the assumption of the type of economy, i.e. whether it is a free
market economy, a mixed economy or a command economy

The increasing need in high income societies for skilled labour leads education to become increasingly
an investment good for society as a whole. Increased population movements lead to the development of
urban slums. Such factors and others lead once again to an increase in public expenditure in relation to
total output.

Peacock-Wiseman’s model

Peacock-Wiseman’s of public sector expenditure sets the desire of the government to supply expenditure
against the unwillingness of the public to finance the expenditure. It is founded on the existence of a
trade-off between the preferences of the government and those of the public. The model therefore looks
at increasing public expenditure from the socio-political perspective.

The preference of the government is to spend money and invariably, government expenditure will
increase as income increases. However, the citizens of the country are less willing to pay tax. Higher
spending can only come from taxes, but the public partially resists this. The resistance of individuals to
pay tax must be taken care of by government in the form of increased spending to avoid social crisis in
the economy. The resistance to pay tax by people will also make the state to have low revenue hence the
cost of providing more facilities is borne by the government making government expenditure to increase
rapidly.

But because the leaders want re-election into political offices, more infrastructures must be provided in
order to convince the electorate that their interest is being catered for by the people they voted into
power. The desire for reelection also makes it necessary for it to take some account of the public’s
preferences. The equilibrium level of public sector expenditure is, in effect, determined by the balance
between these competing forces (taxation and re-election).

In the absence of any exogenous changes or changes in preferences, the level of expenditure will remain
relatively constant. Occasionally, though, economies go through periods of significant upheaval such as
during wartime. The equilibrium between the government and the taxpayers becomes suspended. This
permits the government to raise expenditure with the consent of the taxpayers on the understanding that
this is necessary to meet the exceptional needs that have arisen.
51
The level of expenditure does not fall back to its original level after the period of upheaval. Firstly,
taxpayers become accustomed to the higher level of expenditure and perceive this as the norm. Secondly,
debts are incurred during the period of upheaval which have to be paid off later. Thirdly, promises are
made by the government to the taxpayers during periods of upheaval. These are termed ratchet effects
that sustain a higher level of spending. There may also be an inspection effect after an upheaval when
taxpayers and government reconsider their positions and priorities.

The prediction of the model is that spending remains relatively constant unless disturbed by some
significant external event. These events lead to substantial increases in expenditure. The ratchet and
inspection effects then ensure that expenditure remains at the higher level until the next upheaval.

Baumol’s model

Baumol’s law provides a supply-side explanation of expenditure growth. It does this by focusing upon
the technology of the public sector. Baumol’s law begins by asserting that the production technology in
the public sector:

i) is labour-intensive relative to that of the private sector;

ii) has little scope for increases in productivity; and
iii) makes it difficult to substitute capital for labour.

For example, hospitals need minimum numbers of nurses and doctors per patient and maximum class
sizes place lower limits on teacher numbers in schools.

Competition on the labour market ensures that wages in the public sector are linked to those in the
private sector. In the private sector, capital can be substituted for labour when the relative cost of labour
increases. Furthermore, technological advances in the private sector lead to increases in productivity and
result in the wage rate rising.

Since the public sector cannot substitute capital for labour, the wage increases in the private sector feed
through into cost increases in the public sector. Maintaining a constant level of public sector output must
therefore result in public sector expenditure increasing. If public sector output/private sector output
remain in the same proportion, public sector expenditure rises as a proportion of total expenditure. This
is Baumol’s law which asserts the increasing proportional size of the public sector.

This law is entirely driven by technology and does not consider aspects of supply and demand or political
processes. Substitution of capital for labour has taken place in the public sector. There is also evidence
of a steady decline in public sector wages relative to those in the private sector as lower-skilled labour is
substituted for higher-skilled.

52
SECTION 5: Understanding Public Expenditure

Principles of public expenditure

Government expenditure is usually funded from taxation. The principle of maximum social gain posits
that, for any project to be of interest to the public, the social value of that project must exceed the cost
or tax paid by the individuals within the environment .So government should not embark on any project
that the cost is greater than the benefit. To effectively do this, government may employ either the
maximum test or the minimum test.

Maximum Test: Maximum test theorists believe that government should search all possible alternatives
and embark on projects that generate the largest or maximum gains to the inhabitants of any given

53
community. Under the maximum test theory, if a community prefers road to water supply, government
should consider the benefit of the road as the best priority and give such a community such an amenity.

Therefore if a government is faced with two alternatives; water supply that cost twenty million Ghana
cedis and the benefit is fifty million Ghana cedis to the community; and the road construction that cost
thirty million Ghana cedis and the benefit is seventy million Ghana cedis to the community, government
should provide the road because the road is more beneficial to the population.

Minimum Test: Public expenditure should be taken only when the prospective benefits exceed
anticipated cost. Government should not approve of any expenditure that does not pass this test, because
if approved, government will be tapping resources from high value private sector to low value public
sector.

Given that government will introduce a new airline service that will cost five hundred billion Ghana cedis
and the total revenue it can generate for its life span would be three hundred billion Ghana cedis, this in
the long term will reduce the economic welfare of the people by two hundred billion Ghana cedis, so
such a project must not be embarked upon. This is because the project will depress the GNP of the
country.

Factors That Determine Public Expenditure

All economies have experienced growth in government expenditure over the years. However, the pace
of the expenditure may vary and this is determined by some or all of the following reasons.

Urbanisation: It is the process of expanding the existing towns or founding new towns due to state or
local government creation or migration. It requires larger per capita expenditure on amenities to increase,
in order to take care of the structural changes taking place.

Population: As the population increases, there is pressure on the existing facilities; this makes it
necessary for government to provide more facilities in order to meet the need of the existing population.
This leads to an increase in government expenditure.

Economic growth: Every government desires to raise the level of productivity which will bring about
increase in the flow of goods and services. This is done through the provision of more social amenities
which entails spending more money by the government.

Technological Change: One of the basic requirements for economic development is improvement in
technology. The change in technology facilitates production efficiency and makes more goods available
in the economy. The change in technology makes it possible for people’s welfare to improve because of
the benefits the citizens will derive from the variety of goods made available for consumption. This has
been the reason why governments in most developing countries incur increasing expenses in technology,
to speed the level of development.

Depreciation: This is the wear and tear of existing facilities which require regular replacements. Such
replacement may be done at a higher cost leading to increase in government spending.

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Reduction in Inequality: Government tries to protect its citizens from exploitation, and reduces the
level of inequality, which exists in the various classes of people by providing increasing welfare services
and social security to its citizens. This has resulted in the increasing level of government expenditure.

Public Expenditure and Production

Developing countries like Ghana are characterized by low savings and investments. This deficiency can
be reduced through higher government expenditure by establishing the basic infrastructures and other
fiscal measures. Ghana and other developing countries are also characterized by high social overhead,
low technological development, and basic industries that lack or need expansion.

Government expenditure therefore can be used to create and maintain social facilities. Public expenditure
can also be used to create human skills through education, training and health facilities. In Ghana, there
are great regional disparities especially between the northern regions and the southern regions. This
disparity can be reduced through government’s improved provision of amenities across the length and
breadth of the country but with particular emphasis on the deprived regions. The state can reduce the
cost of production by providing a more congenial atmosphere for business. This increases the
profitability of companies and can easily lead to diversification of the economy.

The state must also take adequate precautions since development projects have long gestation period and
yield returns only in the long run. This requires adequate planning to avoid inflationary pressure in the
economy. In view of the limited resources available for government, there should be proper cost benefit
analysis to determine the project importance before resources are committed into it. State expenditure
should therefore always pass the minimum and maximum tests to make it worth embarking upon.

Public expenditure can also accelerate the pace of economic growth by narrowing down the difference
between the social and private marginal productivity of certain investments. This is necessary because
such expenditure serve as subsidy to these investments that are not self-liquidating but are useful in
accelerating economic growth.

SECTION 6: The impact of public expenditure on the economy

Consumption and allocation of resources

Public expenditure affects consumption and allocation of resources in the following ways.

Consumption: Public expenditure enhances the quality of life of people by providing recreational,
cultural, educational, and public health facilities, such as public parks, playgrounds, libraries, educational
institutions, hospitals and dispensaries and scientific, cultural and commercial exhibitions.

Consumption, after all, is the end objective of economic activity of individuals. By promoting the level
of economic activity and a more equitable distribution of income, the state can bring about a greater
sense of social and economic security in the lives of individuals. The government, through public
expenditure, therefore enables them to live a fuller and richer life.

55
Allocation of Resources: Public expenditure allocates resources in accordance with national priorities.
The priorities may be defense, agricultural production and self-sufficiency in food, industrial
development, generation of employment opportunities, an equitable distribution of income, balanced
regional development, population control, a better ecological balance etc.

Public expenditure in these areas is bound to raise the community's productive power. According to
Dalton (xxxx) 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 the present and future.

Changes in national priorities, from time to time, will also be reflected in the pattern of public
expenditure.

Again, resource allocation has to take into account the balance between present needs and future
requirements. Apart from imparting a sense of fairness as between generations, projects with long
gestation periods can be undertaken only by the state. Hence allocation has to keep in view the fact that
market economy cannot always take care of social needs. These can be taken care of only by the state.

Production and Distribution

Public expenditure affects production and distribution in the following ways

Production: The roles of private and the public sectors are complementary. The public sector provides
the infrastructure, transport and communications, power, education and public health programmes. In
the absence of goods and services provided by the government sector, private sector can hardly make
any meaningful contribution towards production and development: According to Dalton, other things
being equal, taxation should not adversely affect production and public expenditure should increase it as
much as possible.

Public expenditure can affect

(i) the ability to work, save and invest,
(ii) the desire to work, save and invest, and
(iii) allocation of resources as between different uses.

Public expenditure can influence these factors either favourably or unfavourably.

The economies of developing countries cannot make significant progress unless they concentrate on
development of investment goods sector. This may not result in production in the immediate future, as
in education and health programmes, infrastructural projects and projects with long gestation periods.
This would, however, certainly build up growth potential in the economy, and help take the economy to
a self-generating level.

Distribution: In Dalton's words, "other things being equal, that system of public expenditure is best,
which has the strongest tendency to reduce the inequality of incomes." A system of grants and subsidies
is equitable in the measure in which it is progressive. This leads to maximum social benefit. An

56
approximation to this principle would be provided by a system of grants which would bring all incomes
below a certain level to that level (say, above the poverty line), without adding anything to incomes above
that level.

A public distribution system which makes available essential commodities at subsidized prices to the
poor, will also achieve the same result. Free provision of services to all members of the society e.g., free
health service or free education, "narrows the area of inequality". Social security measures and social
insurance schemes, which are helped partly or wholly from public funds, e.g. old age pensions, sickness
and maternity benefits, unemployment relief, industrial injury compensation, widow’s pension etc.,
improve distribution by reducing inequality of incomes.

Economic Stabilization

Business activity in an economy is usually characterized by fluctuations of a cyclical nature. A boom in

the economy may burst and lead to a depression. While during boom, prices rise beyond the reach of
common person, spelling misery. During depression, employment and production levels fall drastically
causing colossal damage.

During depression, when employment, production and national income start declining, government can
undertake compensatory spending. This may imply heavy public works programmes so that employment
and incomes may pick up leading to economic recovery. During boom, public expenditure should be
strictly curtailed, leading to surplus budgets. During depression, public expenditure policy would lead to
heavy outlays on public works; expenditure would thus be in excess of revenues, leading to deficit
budgets.

Thus public expenditure, if properly planned and conscientiously undertaken, will have the favourable
effect of raising employment, production and national income, after pulling the economy out of
depression and thus bringing about greater economic stability.

On the other hand, some public sector economists posit that government has no role in fighting inflation
or unemployment because price flexibility, competition, free entry and exit, and perfect mobility and
information combine to guarantee both full employment and zero inflation.

57
 CHAPTER 4:
TAXATION

SECTION 1: What is a tax?

A tax may be defined as a compulsory contribution from individuals and or business organizations for
the purposes of financing government expenditure. In the words of Bogunjoko (1999), a tax is “a levy
collected by government for the purpose of generating financial resources needed for meeting
constitutional demands on the government by its citizens. Taxation may also be seen as the imposition
of a compulsory levy on persons, corporate bodies, goods and services. Taxation in this respect is a major
source of revenue to government which is used in the provision of social services.

Taxes can be collected by force or by willingly paid ‘contributions’, advertised or hidden, honestly paid
or surreptitiously ‘fiddled’, but they always come out of someone’s pocket. Even when taxes are avoided
through legal loopholes or illegal activity, their collection and payment divert effort from otherwise more
profitable pursuits. The government uses the revenue generated from tax collection to protect her citizens
from violence and invasion by other states, from injustice, oppression and lawless within society and to
provide certain public goods and institutions which are beyond private interest considerations.

Taxation usefully regulates externalities. For instance, a pollution tax improves efficiency by making
private firms and consumers bear the equivalent of true social costs. Taxes finances public goods and
subsidize external benefits, which improves efficiency, too. Taxes are also a distributive tool as well; they
reroute resource from one group in society to another.

Economists also spend so much time studying taxation because taxes affect allocation, distribution,
public choice and, through effects on inflation and unemployment, macroeconomic stability. Taxes are
also part of all four government functions

Objectives of Taxation

Several objectives exist in support of taxation. However, the objectives of taxation are bound to differ
between countries and even in the same country, among governments with varying ideologies.
Notwithstanding these differences, the primary objectives for taxation remain common and serve as a
driving force for decisions on the nature and form of taxation.

One such primary objective of taxation is the removal of poverty and inequality. In Ghana and other West
African countries, the progressive tax system is used by the government, and the money that is realized
is used to provide social amenities that will benefit both the rich and the poor, which tend to improve
the welfare of the poor through bringing the social amenities closer to them at an affordable price.

Taxes may also be used to curb unnecessary and conspicuous private consumption. Luxury goods are highly taxed
to reduce their consumption, since high tax on such goods will make them expensive and those buying
them will have to spend a large part of their income. Under such a situation, customers are discouraged
from buying such goods. However, essential goods may attract a lower tax rate.
58
Taxation may also be used to promote private savings through the granting of tax holidays or exemptions.
This can lead to more savings which can then be used for investment along the desired sectors of the
economy. Taxation can also be used to alter production technique and profitability of investment.

Taxation can also be used to correct the balance of payment deficit. Depending on the elasticity of demand and
supply, tax on unnecessary imports will discourage such imports, and encourage import substitution
which can lead to the growth and development of the economy. Government can also fine tune the
allocation of resources using tax instead of leaving resource allocation to market forces. Taxes can thus be
used to guide the economy toward the desired line.

Taxation ultimately, is a source of revenue to the government which may be used to monitor economic activities;
reduce aggregate demand so as to reduce inflation; and boost aggregate demand so as to increase purchase
of goods and services.

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SECTION 2: Characteristics of Good Tax Administration

Canons of Taxation

Adam Smith’s ‘canons of taxation’ in ‘Wealth of Nations’ contains a wealth of advice on the sound
administration of government and economy. Smith’s prescription for good government includes his
famous canons of taxation – a list of maxims for the taxman. Smith thought that a good tax would have
four qualities.

i. The first quality propounded by Smith is the test of Equity, that is, taxes must be equitable.
Though equity is important for moral reasons, it also has some practical concerns because voters
to not tolerate governments which are considered to be unfair. Even ‘efficient’ taxes that are
thought to be unfair quickly disappear; they are repealed or simply avoided.

ii. A good tax should also be certain. Taxes should not be arbitrary; they should be imposed according
to some plan or rule, so individuals can order their affairs and know the tax consequences of each
act. The income tax in most countries, per this feature, displays certainty in that tax liabilities are
set by Internal Revenue Codes, not the whim of individual tax collectors. However, yearly
changes in the tax laws reduce tax certainty, by making it harder for individuals to order their
affairs.

iii. Smith also said that a good tax must be convenient in their time and manner of payment. Farmers,
for instance, should be taxed within the periods when they earn their harvest revenues rather than
in the lean seasons. Modern taxes must also be collected in ways that make them easy to pay.
Local government sales taxes in Ghana, for example, are levied a little at a time throughout the
year, as consumers make purchases. This is convenient to pay, compared to annual lump-sum
payment of the same total amount.

iv. Finally, Smith held that a good tax should be economical. Economy has several meanings all
intended by Smith. Taxes could be economical to collect and government should not use many
resources in collecting its due tax. Taxes should be economical in the way they fall on individuals,
too. Additionally, private behaviour should be distorted as little as possible since economical taxes
promote economic efficiency.

Smith’s exposition on the ‘canons of taxation’ has formed the basis of what is now known as the
principles or characteristics of taxation. A detailed discussion of the characteristics of good taxes will be
in order in the next topics in this section.

Principles of Taxation

The first major principle of taxation is the Principle of equality. This focuses on how much each citizen
should pay as tax and what should determine it. Two propositions have been espoused in this regard.
First, that payment should be based on the benefits derived from government expenditures financed
from tax revenue. This underscores the rationale of user charges in pricing public goods. The second
proposition suggests payment according to the ability to pay. The objective of economic justice or
60
equality of sacrifice is the fulcrum of the equality thesis. Two possible scenarios emerge in this case; that
is, if income is subject to diminishing marginal utility, then the rich should pay a larger proportion of
their income as tax; or if income is subject to constant marginal utility then both the rich and the poor
should pay tax proportional to their incomes. Thus, the tax rate in this context is seen to be determined
by marginal utility of income. In practice however, what constitutes the ability to pay remains unclear.

The efficiency principle emphasizes that tax authorities must experience little difficulty in assessing the
liabilities of various parties. One way to make a tax administratively efficient is to choose a tax base that
is easily understood and observable. In Ghana as well as in many other developing countries, the tax
system is administratively inefficient because it is not easy to trace much of the income earned by people.
This is due to the predominance of an informal sector and its concomitant subsistence economy. In
addition, the rate structure is simple, the easier it is for the tax authorities to administer, and the more
efficient is the administration of the tax system. However, it needs to be pointed out that, the simpler the
tax system, the greater the probability of evasion and avoidance.

The principle of certainty accentuates that, how much should be paid as tax, time of payment and manner of
payment should be clear and certain to the taxpayer and the taxman. This is to avoid a situation where
taxpayers are subjected to arbitrariness and unnecessary harassment by the tax collector. On the issue,
Adam Smith submitted that if a scope for arbitrariness exists then under such circumstance even the
most efficient and the honest tax machinery will be unpopular. He further claimed that “a very
considerable degree of inequality is no near so great an evil as a very small degree of uncertainty”. In this
respect, tax laws are to be simple in language, and tax liability certain.

The principle of Convenience also suggests that a good tax system should be such that the method, manner
and time of tax payment should be convenient to the payer. This principle advocates that the taxpayer
should be assisted to meet his tax obligation. The design of monthly income tax deductions from income
of a worker is a typical example of this assumption.

The principle of economy suggests that the cost of administering a tax should be as minimum as possible.
Thus the cost of tax assessment and tax collection should be small in relation to the revenue accruing
from taxation. It is useless and counterproductive to allow the productive efforts of people to waste tax
resources on endless tax activities. Such wastage can encourage and breed widespread tax evasion and
corruption.

The next is the principle of productivity. According this principle, the tax system should be able to yield
enough revenue for government use. The principle emphasizes fiscal adequacy through taxation and
suggests that deficit financing should be discouraged.

The principle of buoyancy and flexibility is also of utmost importance. Tax buoyancy suggests that tax revenue
should have an inherent tendency to increase along with an increase in the tax base (ie. National income).
It should be so even if the rates and coverage of taxes are not revised. This is the basis of an automatic
adjustment of a tax system. On the other hand, tax flexibility suggests that government should, without
undue delay, be able to review the tax structure, in respect of its coverage and rates, to suit contemporary
circumstances. This situation is not very common in most developing countries.

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The principle of diversity suggests the diversification of the source of tax revenue. This is to prevent a lot of
uncertainty for the Treasury and minimize the impact of possible negative revenue shocks. However, as
a side effect, a multiplicity of tax rates can violate, considerably, the principle of certainty, economy and
efficiency.

The final principle which will be discussed is the principle of Neutrality. Except for equity reasons, the
principle of neutrality emphasizes that taxes should not discriminate between taxpayers. Tax
administration can distort people’s choices, reduce the willingness to work, increase business risks, and
may dampen the efficiency objective of a tax.

SECTION 3: Overview of Tax Administration in Ghana

Independence Period (1952 – 1965)

The Income Tax Ordinance after independence in 1957 faced its first amendment after its promulgation
in 1952, and sought to correct most of the inherent carried over from the colonial era.

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The attempt at amending the income Tax ordinance introduced some of the major changes that happened
in the 1961 amendment were the personal relief and the Pay-As-You-Earn (PAYE) collection system for
all groups of employees. Business deductions which until now was allowed, was abolished, and, a further,
the amendment introduced 2% of minimum chargeable income on turnover of partnerships and
companies.

The changes resulted in the Income Tax (Amendment) Act 1961(Act 68). The Act subsequently, was
followed by minor amendments like Act 178 and Act 179 in 1963, and Act 312 in 1965. Again in 1965,
the Capital Gains Tax Act, 1965 (Act 289) was also passed and it was a direct tax.

It is also worthy to note that within this period, there was a reduction of the company tax rate from 45%
to 40% in 1958, and there was a granting of tax relief to new industries; for instance, the exemptions of
customs duties on raw materials and semi-processed materials for manufacturing.

Post-Independence Period (1967 – 1993)

After the overthrow of President Nkrumah, the National Liberation Council (NLC) immediately
introduced a major Income Tax Law, the Income Tax Decree, 1966 (NLCD 78). Although is was a major
income tax law, it was basically a second consolidation of the many amendments of the earlier
amendments to the Income Tax Ordinance by the Convention Peoples’ Party (CPP).

Five significant major Laws were promulgated between 1967 and 1975 that chronologically amended
NLCD 78. These were the Income Tax (Amendment) Decree, 1968 (NLCD 265); Income Tax
(Amendment) Decree 1973 (NRCD 202), Income Tax (Amendment) Decree 1974 (NRCD 271), Income
Tax (Amendment) Decree 1974 (NRCD 281); and Income Tax (Amendment) Decree, 1975 (NRCD
343).

After NRCD 343 was promulgated, the then military government in 1975 published another Income Tax
Law - the Income Tax Decree, 1975 (SMCD 5). SMCD 5 was enforced without any amendments until
1983 when it was amended by the PNDC. This was the Income Tax (Amendment) Law, 1983 (PNDC
Law 61) with significant changes, including changes from the preceding year as the basis for assessment,
and also the increase of the amount of penalties.
Between 1984 and 1986, tow other amendments were made to SMCD 5, and these included: the Income
Tax (Amendment) Law, 1984 (PNDC 96), and Income Tax (Amendment) Law, 1986 (PNDC 116). It
should also be noted that between 1975 and 1986, two other tax laws were promulgated and they were
the Gifts Tax Decree, 1975 (NRCD 348), and the Wealth Tax Law, 1984 (PNDCL 93).

Tax Reform in the 1980s/90s

Ghana is one of the countries that has received applause from the IMF and the World Bank for
successfully implementing the Structural Adjustment Programme (SAP). At a point, tax reform became
an increasingly important element of SAP. The reasons for the reform were rooted in the IMF and the
World Bank assertion that the tax system in Ghana was distortionary, and that it was contributing to
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distributional problems. Restructuring the Tax system was and is thus perceived to be critical for the
success of both the macroeconomic and structural reform policies (Anuradha & Ayee, 2002).

Tax Reform in the 2000s

In order to ensure greater efficiency, in 2002, the automation of the clearing procedures was completed
with the installation of the Ghana Customs Management System (GCMS) and the Ghana Community
Network (GC-Net) computer-based information systems at the country’s International Airport and at
the CEPS headquarters.

In recent years further tax reforms undertaken include the Communication Service Tax (Act, 754, 2008)
and the Vehicle Insurance Tax. The former was introduced to replace charging of import duties, VAT
and (National Health Insurance Levy (NHIL) on the importation and sale of telephone sets. Other
reforms also involve the establishment of the Ghana Revenue Authority (GRA) (2009), the introduction
in 2011 of the e-government project aimed at linking the GRA to the Registrar General’s Department
(RGD) electronically to ensure GRA has access to the database of registered businesses for easy tracking
and collection of tax payments.

Impetus for reform

The World Bank in March 1990 conducted a research review on a number of specific tax policy issues in
a number of developing countries including Ghana and gave the following report about the Tax structure,
that it is
• Complex – difficult to administer and comply with
• Inelastic – unresponsive to growth and the changing structure of economic activity
• Inefficient – introduces serious economic distortions while often raising relatively little revenue
• Inequitable – treats individuals and businesses in similar circumstances differently, and
• Unfair – tax administration and enforcement are selective and favour those with the ability to
defeat the system.

The research also found out that there was heavy reliance on import and export taxes which undermine
long-term competitiveness, while the potential to raise revenue through consumption taxes is not
exploited. Additionally, the existing tax system was widely used to advance wide-ranging and often
conflicting policy objectives such as revenue enhancement, industrial and regional development, saving,
investment, employment and export promotion.
It is in recognition of these factors that the PNDC military government, with intense prodding from the
IMF and the World Bank, initiated Tax reforms. The broad goal of these tax reforms is to secure an
efficient tax system based on taxes that are politically feasible and administratively practicable, and to
produce sufficient revenue with minimum economic distortions. Since then till then till date, Ghana has
undergone s host of tax reforms all aimed at enhancing the efficacy of the administration of taxes.

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SECTION 4: Types of Taxes

Direct taxes

This is the tax imposed directly on the income of individuals, corporate entities and properties. It is direct
because the burden, incidence or impact is felt directly by the taxpayer. Examples of direct taxes collected
in Ghana include the following

Personal Income Tax: this is tax levied on the gross income of all taxable people, but all allowances and
other deductions are effected before the remaining gross income is taxed. In most developing countries,
personal income constitutes only a small portion of government revenue because majority of the citizens

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are farmers, whose income is very difficult to determine. Similarly, businessmen and other rich elite do
not state their true income.

Company Income Tax: This is the tax levied on the profit of companies because most companies keep data
on their finances making it easier for deductions. However, the amount realized from company tax is low
due to low industrial activities and the desire by the government to promote industrialization which
makes it necessary for it to grant tax concession and holidays.

Expenditure Tax: this is the tax levied on conception expenditure be it individual consumption or
consumption by corporate institutions. Government uses this tax method with caution because of its
potential of discouraging savings in the economy.

Capital Tax: it is a kind of tax levied on capital assets, properties and assets whose value appreciate, this
is more common in urban centers where property owners like land, pay tax.

Petroleum profit tax: this is tax paid for the petroleum exploration and exploitation of the mineral resource
on land. This contributes a sizeable proportion of total tax collection in countries with oil reserves.

Advantages and Disadvantages of Direct Taxes

Being a major contributor to public revenue, direct taxes has numerous advantages to the economy
including the fact that the cost of collecting direct taxes is very small, especially income tax. Direct taxes
are also beneficial because it enables government to predict the range of revenue derivable from this
source and enable it to budget for its activities.

Direct taxes also adopt equity as a guiding principle. There is equality in the burden of tax among the
different categories of tax payers. Further, direct taxes serve as a fiscal policy instrument to curb
inflationary pressures in the economy. This is done either to reduce aggregate demand when there is high
inflation or to increase aggregate demand through tax cut to stimulate aggregate demand during economic
slump. Finally, direct taxes create awareness among the citizens in terms of their contribution to the
administration of the national economy.

Despite the advantages aforementioned, direct taxes also pose some constraints in the event when it is
too high. This discourages work since the higher the income, the higher the tax which discourages
additional effort by the worker. Also, tax avoidance is common in these circumstances because workers
and/or companies falsify their income so as to pay only a little amount of tax.

Direct taxes can also discourage industrial activities, since it will reduce the profit margin of companies,
making it impossible to embark on new projects. High direct tax rates can discourage industrial efficiency
and production leading to a fall in investment in the economy.

Indirect Taxes

Indirect taxes are taxes that those who pay do not bear the entire burden of the tax but is partly passed
on to the consumer through higher prices. The degree by which the burden is passed to the consumer

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depends on the elasticity of demand for the commodity being taxed. Some indirect taxes collected in
Ghana are briefly outlined below.

Excise duties: this tax imposed on goods that are manufactured within Ghana. This includes textile
industries, sugar manufacturing companies, and cement manufacturing companies. The total tax
generated through excise tax depends on the level of industrialization of the country.

Value Added Tax: this tax was introduced in Ghana in 1995 and is a tax on goods and services that can
be collected at multiple stages (distribution and consumption levels). Being a consumer tax, it has the
potential of raising the prices of goods and services in the economy.

Import duties: this is a tax levied on goods imported into the country. This is a good source of revenue to
the government of developing countries because the demand for import is inelastic.

Export duties: this is the tax levied on goods exported out of the country. This method is used with caution
because developing countries like Ghana want to promote export of goods to earn more foreign
exchange.

Advantages and Disadvantages of Indirect Taxes

Indirect tax is a good source of revenue to the government which can be used in providing more social
amenities. When properly administered, tax avoidance is remote, since payment of the tax is made at
every point of purchase of the goods. Indirect tax is also selective and therefore flexible. It can therefore
be easily modified.

Also indirect tax is a tool for molding production and investment activities. It is a guide for resource
allocation through encouraging priority industries and discouraging low priority ones. It also helps in
adopting a given type of technology in the economy. Finally, it creates less resistance since consumers do
not clearly see and feel that they are being taxed.

On the other hand, indirect tax tends to create inflationary pressures in the economy through higher
prices. This reduces demand and erodes purchasing power of the consumers. Indirect tax also negates
the principle of the ability to pay and so the poor are worse off by paying more since it is evenly spread
making it regressive in nature.

Section 5: The Burden of Taxation

Incidence of Taxation

The incidence of taxation refers to the impact or burden of the tax being paid and who bears the burden
of such tax. There are instances where the taxpayer bears a larger proportion of the burden of tax or the
burden may be shared equally. In other instances, the taxpayer bears very little amount as the tax and the
greater proportion is passed to consumers in the form of higher prices.

There are also situations where the burden of tax fall on the consumer completely or the producer
entirely. Whichever the category of the tax burden will be determined by the elasticity of demand of the
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commodity. The various scenarios that will manifest through the elasticity of demand are explained in
the following part of this topic and the next topic.

Scenario one: Demand elastic

When the demand for a commodity is elastic and a tax is imposed on it, the tax burden is shared between
the consumer and the producer. But the consumer bears less burden of the tax because the demand
elastic commodity has close substitutes. So the producer absorbs a higher amount of the burden in order
to maintain his customer.

Scenario two: Demand inelastic

When the demand for a commodity is inelastic and a tax is imposed on the commodity, the tax will be
shared by the consumer and the producer. However, the consumer pays a higher amount of the tax and
the producer bears a small tax burden. This is because the demand inelastic commodity does not have
close substitutes. Even though consumers can reduce the quantity consumed, yet, the net effect of the
tax burden remains more on the consumer.

Scenario three: Perfectly inelastic demand

When the demand for a commodity is perfectly inelastic, the consumer bears the entire burden of a tax
because the commodity is a necessity and consumers cannot do without its consumption on a regular
basis. So the producer can pass the entire burden to the consumer

Scenario Four: Perfectly Elastic demand

The producer bears the entire burden of tax when the demand for a commodity is perfectly elastic and
tax is levied on it. This is because price does not adjust to changes in demand. Consumers are willing to
buy any quantity of the commodity only at a specified price, so the introduction of tax does not have any
effect on the consumer.

Progressive, Proportional and Regressive taxes

Taxes, depending on the relationship between the income earned and the quantum of tax paid may be
classified as progressive, proportional or regressive.

Progressive taxation is a tax system that increases as the income of the taxpayer increases. It is based on the
assumption that high income earners are better placed to enjoy the services provided by government and
to stabilize the economy by moderating the spending pattern of the high income earners.

Proportional taxation is a tax system where individuals are levied the same amount irrespective of how much
is earned by individuals. It is argued that it encourages additional effort by workers because even if the
salary increases, there will not be additional tax.

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Regressive taxation is the opposite of the progressive tax. The higher the income of the taxpayer, the lower
the tax paid. It is assumed that it encourages individuals to be hardworking to earn more income.

Tax avoidance and tax evasion

One of the most serious problems of taxation is tax evasion and tax avoidance. The term tax avoidance is
used to distinguish legal methods of not paying taxes from tax evasion, which is illegal. Tax avoidance
takes place by taking advantage of opportunities offered by tax laws to reduce tax payments.

In clearer terms, tax evasion is a deliberate attempt by individuals or corporate bodies not to pay tax,
making the government lose money. Tax avoidance on the other hand is a deliberate attempt by
individuals or corporate bodies who take advantage of the loopholes in the tax law to reduce the amount
to be paid as tax. This fraudulent practice could be in the form of declaring a loss by a company while in
actual sense it is making profit.

For example, it may be beneficial for tax purposes for an individual to form a corporation with family
members and close friends as shareholders, since expenses incurred by the corporation can be the source
of benefit for individuals. Also, depending on the corporate tax rate and personal income tax rates, tax
payments might be reduced.

Trusts and NGOs that save on the payment of taxes may be set up. Income-earning assets might be
transferred to offshore companies in foreign tax havens. Individuals also sometimes define themselves
as farmers, natural resource explorers or a member of other non-tax paying categories in order to gain
special tax deductions or exemptions. Converting income to capital gains is another form of tax
avoidance. Please note that as long as such activities are legal, tax evasion has not taken place.

Tax avoidance usually requires the services of skilled tax accountants or tax lawyers. Only high-income
taxpayers may be able to afford or find or find worthwhile hiring the accountants and lawyers. Therefore
tax avoidance is generally undertaken by high income or wealthier people who can afford to pay for
professional advice (and for whom it is worthwhile). Poorer or low income people may choose tax
evasion, which does not require the professional expenses of tax avoidance, but which is illegal and
subject to penalties if detected.

Causes and Effects of Tax Avoidance and Tax Evasion

Clearly, there are underlying reasons why individuals or corporate entities will choose to avoid or evade
tax. The common causes of tax evasion and avoidance include

High tax rate: when the tax rate is too high, it discourages taxpayers from paying the due amount. Hence
they device ways of escaping or reducing the amount to be paid as tax.

Imperfect tax administration: when there is lack of comprehensive income reporting system, lack of proper
training of the tax officials or the temptation of taking gratification by tax official so that they can reduce
the amount of tax to be collected from taxpayers.

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Complicated tax laws: when tax laws are complicated, it allows for concealment and understatement of
income or profit

Information gap: In an agriculture dependent economy like Ghana, most farmers do not have adequate
accounts of their earnings while others have no account of their income at all.

No matter the cause, tax evasion and avoidance have some negative effects on the economy. It neutralizes
any attempts by the government to regulate the economy through a reduction in aggregate demand. Tax
evasion also has the potential of increasing inflationary problems in the economy because it weakens the
monetary and fiscal policies of the government if it occurs on a wide-scale. Tax evasion and avoidance
can also cause considerable leakage of foreign exchange through shady trade deals.

Tax evasion and avoidance further reduce the tax adequacy and buoyancy which are both important in
taxation. Those who avoid and evade tax shift the burden of the tax more to those who pay and reduce
the total amount that government can generate from taxation.

Policies to Deter Tax Avoidance and Tax Evasion

When the payment of taxes is based on self-assessment and self-reporting by tax payers, tax compliance
requires taxpayer honesty. Governments must however not rely on taxpayer honesty alone. Policies must
therefore be adopted to ensure taxpayer compliance.

Tax authorities could maximize the likelihood that taxes are paid in full by meticulously auditing every
tax return. The cost of such complete systematic audits might exceed the benefits obtained through
additional tax revenue. Tax returns are therefore more usually randomly audited. The random auditing
introduces a probability of detection for taxpayers who understate taxable income.

Random auditing must be encouraged by penalties. The combination of the likelihood of detection and
the penalty is detected is intended to deter tax evasion. Increasing the probability of detection is costly
because of the additional personnel required for auditing tax returns. Increasing the penalty may be less
costly: the costs of increased penalties consist of public spending for additional time in prison and the
output lost because a person has been imprisoned (e.g. imprisonment of a skilled surgeon deprives society
of the surgeon’s skills).

If penalties are fines and not imprisonment, the costs of imprisonment are avoided, and also revenue
increases when a tax evader is detected. No matter the form it taxes, to enforce tax compliance, penalties
could be set extremely high. However, the principle of penalties commensurate with acts committed
deters extreme penalties.

Also, since tax evasion is illegal, people who evade taxes believe they will be successful in underpaying or
not paying taxes. Otherwise, the threat of the penalty for tax evasion would deter them from evading tax
payments.

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The solution to tax evasion and avoidance include restructuring the organizational defects in the
economy. A reduction in the tax rate will also reduce the desire by individuals to evade tax, should there
be an adequate reporting system of all income/capital transactions.

Tax evasion and avoidance has been a difficult problem due to the nature of the economy where most
income earners camouflage their tax paying capacity and where businessmen and farmers do not have
adequate knowledge of their income.

Within the year 2017, Ghana’s Minister for Finance launched a tax stamp policy that seeks to address the
counterfeiting of products on the market and improve revenue generation and ensure that more
businesses pay taxes. This attempt is partly intended to avoid tax evasion (MoF, 2017).

CHAPTER 5
BUDGETING

SECTION 1: Definition, Nature and Scope of Budgeting

What is budgeting?

Aaron Wildavsky has defined a budget as a “document containing words and figures, which proposes
expenditure for certain items and processes”. The works in the budget describes items of expenditure
(such as salaries, equipment, travel) or purposes (prevention of wars, improving mental health, providing
low-income housing); and the figures are attached to each item or purpose.

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If an organization utilized its funds granted in accordance with instructions and achieves desired results,
then the purpose stated in the budget document would be achieved. According to Wildavsky, therefore,
the budget becomes the link between financial resources and human behaviour to achieve policy
objectives.
Budgeting on the other hand is defined by WIldavsky as “a process that is concerned with the translation
of financial resources into human purposes”. Since funds are limited and have to be divided in one way
or the other, the budgeting process becomes a mechanism for making choices among alternative
expenditures.
When choices are coordinated so as to achieve desired goals, a budget may be called a plan. Should the
budget include detailed specifications of how its objectives are to be achieved, it may serve as a plan of
work. Consequently, if emphasis is placed on achieving the most policy returns for a given sum of money
at the lowest cost, then the budget may become an instrument for ensuring efficiency.
However, the intentions of those who make up the budget sometimes never materialize. Although the
language of a budget calls for the achievement of certain goals through planned expenditure,
investigations may reveal that no funds have been spent for those purposes and that the money has been
spent for other purposes.
Budgeting and Planning

In a forward-looking sense, the budget is best understood as a program of government activity over a
designated fiscal period. It includes the various activities upon which the public authorities propose to
spend revenue. It also includes the listing of various tax sources from which revenues are to be secured.
In the backward looking sense, the budget provides a record of expenditure actually made and tax revenue
actually collected.
Naomi Caiden and Wildavsky therefore assert that budgeting involves different but related tasks on
revenue and expenditure. On the revenue side, it entails careful and realistic estimation of the revenue
for the ensuing period, based on relevant economic and financial data and the results achieved in the
preceding period. On the expenditure side, budgeting involves the estimation of expenditure patterns on
the basis of the previous years’ experience and the requirements for ongoing and newly planned programs
during the budget year.
It is therefore clear, from the above that budgeting is strongly dependent on planning. Indeed, planning
is most certainly an essential element in every society. Every rational being, not only countries, make
plans. Planning has come to be accepted as an essential starting point not merely to the implementing
but also the shaping of budgeting and other public policies.

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An individual’s plan of his financial activities is called the personal budget while the government’s plan
of a country’s financial activities is known as the National budget. Government’s financial planning
and budgeting describes the present state of the economy and recent trends. Since no public policy can
be carried out without money, government budgeting is not only a financial plan and a mechanism of
expenditure control but also a plan for regulating the volume of governmental taxation and expenditure
to offset the threats of inflation.

Characteristics of a budget

A typical budget has the following characteristics

a. It is a compass indicating the course the government should take in its financial administration and
the wheel with which it can steer that course (UN, 1961)

b. It shows the estimated revenues from all sources in the year to come compared with the actual
revenues in the current year and during the past year. For the same periods, it should present the
estimated expenditures and an economic and function classifications thereof

c. The budget contains not only records of estimates and numerical projections but also written
descriptions and justifications of the activities of the various departments and functions of
government.

d. The budget is an instrument for evaluating government activities

e. It is a comprehensive statement of the government’s financial programme and work plan for the
fiscal year in question

f. It should list the contributions to or appropriations required from the budget as a result of gains or
losses in the operation of autonomous institutions and public enterprises

g. It should report the financial position of all special funds including the consolidated fund, the social
security fund and the government’s contribution to them

h. It is a projection of government expenditures of a capital and developmental nature into the future
for a period of say 5 years may also be a useful addition in a budget document particularly in any
long-term planning of a national development planning

i. The budget is a representation in monetary terms of governmental activity.

The Budget: Concepts and Process

History of Budgetary Concepts

Bertram Gross and Allen Schick have broken down, in slightly differing ways, the evolvement of
budgetary thinking by public officials. Briefly, the past development of the budget can be categorized

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into five periods. Within each of these periods budgeting was manifested in various means and
orientations. As a result, one type of budgeting with an accompanying orientation can be linked with
each of the five periods.
The various forms of budget within these periods, which will be examined in detail subsequently, are;
1. Traditional or Line Item budgeting with its control orientation

2. Performance or Program Budgeting with its management orientation

3. Planning-Programming Budgeting (PPB) with its economic planning orientation

4. Management-by-Objectives (MBO), with is emphasis on budgetary decentralization

5. Zero-base Budgeting (ZBB), with its stress on ranking program priorities

In each of the above thrusts, the idea of what a budget is, could be, or should be, has assumed a different
cast. Nevertheless, the essential meaning of the word budget has remained unaltered. To borrow Aaron
Wildavsky’s definition, a budget has within all these orientation has remained “ a series of goals with
price tags attached”. Note however that there are, of course, other lengthier definitions reflecting the
various orientations.

Line-item budgeting (1921 – 1939)

The line-item budget represents the popular conception of what a budget looks like. On a typical Line-
Item budget, each line on a piece of paper has an item (for example, pencils, 112) on the left side followed
by a cost (GH¢ 5.00) on the right side. Hence the traditional budget acquired its descriptive title of “line-
item” or “objects of expenditure”.

Fig 6.1 Example of a line-item budget

Item Description Quantity Price (GH¢)

Pencils No. 2 grade 6”×1/4” lead 112 38
Eraser oval-shaped 2” diameter 8 6

From the days of the ancient courts in Egypt, Babylon and China, all governments have always had some
form of line-item budgets to keep track of expenses. The rationale behind the use of the line-item budget
was the ousting of financial corruption in government often associated with lump-sum expenditure and

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revenue by public officials. To prepare and execute the line-item budgetary system, bureaus and
departments were created and laws were enacted in that respect.
Consequently, the line-item budget rapidly became associated with governmental honesty, efficiency, and
less propitiously, inflexibility. Also, the line-item budget emphasized such factors as skilled accountancy,
the objects needed to run an office or program and their costs, incremental policy making throughout
government, dispersed responsibility for management and planning, and a fiduciary role for the budgetary
agencies. The line-item also stresses on the technical definitions of items (for example, pencils, 112, with
2 grade 6”×1/4” lead).

From another perspective, Gross observes that the line-item budget covers input only, meaning that it
deals with only what it takes to make a project continue – typewriter ribbons, erasers, paper, and
secretaries. Therefore under a line-item budget, the only policy-related questions that a public
administrator may ask are how many items will be needed and what they will cost as well as what it will
cost to maintain or replace them.
On the whole, however, the line-item budget represents a way of thinking about, measuring and
evaluating public policy.

Performance budgeting (1939 – 1960)

In the early part of the 20th century, budget officers displayed a recognition that the budget could be used
for more than merely controlling the public’s fiscal accounts such that budgets could be used to classify
costs in as many different ways as there are stories to be told. This marked the advocacy and subsequent
adoption of a budget attuned to governmental performance as well as objects of expenditure.
The transition from the line-item budget to the performance budget was catalysed by the fact that the
performance budget provided the obvious salient tool for systematically coordinating government
management and also seen as a means by which the appropriate managerial delivery systems could be
measured. The Performance budgeting system also marked the move of public budgeting process from
its watchdog role (line-item) in favour of a managerial emphasis. The managerial orientation of the budget
was reified by the pre-eminence of administrative management in public administration and to a large
extent, scientific management in business administration (Operations Management).
Thus this new budgeting system was preoccupied with originating measures of work performance and
performance standards and was named ‘performance budgeting’ by the Hoover Commission in 1949. It
is also known as functional or activity budgeting or program budgeting.

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In sum, performance budgeting covers more administrative activities than the line-item budget because
it considered outputs as well as inputs. The role of budget officers also changed from precise and
controlled accounting to the development of activity classifications, the description of an agency’s
program and its performance, and the exploration of the various kinds of work/cost measurement. Also,
administrative rather than accounting skills were stressed, activities of the agencies were given precedence
over the purchase of items required to run the office, management responsibility became newly
centralized and the role of the budget agency evolved from a fiduciary to an efficiency function.

Planning Programming Budgeting (1960 – 1970)

Though it was significant in some respects, there were several problems with performance budgeting.
Aside being increasingly subjective, the management emphasis of performance budgeting was viewed
increasingly as an impediment to public planning. Just like line-item budgeting, performance budgeting
also tended to increase the purview and costs of an agency’s programmes incrementally.
These concerns eventually led to the displacement of performance budgeting concepts in government
by Planning Programming Budgeting (PPB) which had their origins in industry. Taking its components
one by one, planning is the defining and choice of operational goals of the organization and the choice of
methods and means to be used to achieve those goals over a specified period of time. Programming is the
scheduling and implementation of the particular projects designed to fulfil an organization’s goals in the
most favourable, efficient and effective way possible. Budgeting is the price estimate attached to each goal,
plan, program and project.
Beyond simple definitions, however, PPB represents a systemization of political choice in the format of
budget formulation. It is an effort to render decision making by public administrators as rational as
possible. It therefore represents a rapprochement between budgeting and planning with the major
characteristics being that PPB is an effort to:

1. integrate budgetary formulation with Keynesian economic concepts; that is, it attempts to consider
the effects of government spending on the national economy

2. develop and use new informational sources and technologies to bring more objective and qualitative
analysis to public policy making

3. integrate systems-wide planning with budgeting

PPB is associated with budget officers who have skills in economic analysis, as well as accountancy and
administration. Focus is also put on the purposes of the programs rather than the expenses incurred on
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them while decision making becomes less incremental and more systemic throughout the bureaucracy.
PPB is therefore concerned not only with inputs and outputs, but also with effects and alternatives.

Management-by-Objectives (1970 – 1976)

Management-by-Objectives (MBO) got its start in the private sector with Peter Drucker’s book ‘the practice
of management’ being the first major expression of the MBO concept. Management-by-Objectives may be
defined as “a process whereby organizational goals and objectives are set through the participation of
organizational members in terms of results expected”. With this kind of definition, McGregor’s theory
Y becomes an important component of the budgetary process.
Management-by-Objectives encourages “self-management” and decentralization, advocates an integrated
approach to total management, stresses the concepts of communication and feedback, encourages
organizational development and change, and emphasises policy research and the support of top
management. MBO, in short is an attempt to set objectives, track the progress of the appropriate
program, and evaluate its results. Through this process, an organization decentralizes by operationalizing
its objectives and letting the individual managers most concerned with the appropriate aspects of the
program achieve those objectives in the most effective fashion possible.
MBO is therefore concerned with inputs, outputs, effects but not necessarily alternatives. It deals
primarily with agency performance and the effectiveness of governmental programmes. MBO also has a
managerial orientation that stresses, in terms of personnel skills, something called “common sense”. It is
concerned primarily with program effectiveness, and its policymaking style is decentralized and
participatory. In terms of planning – and very much unlike PPB – MBO is comprehensive in one sense
(that is, it sets operational goals centrally), but it allocates the implementation of that comprehensive
planning responsibility to line managers.
The advantages of the MBO system are obvious. It gives those people closest to the problem some
latitude in dealing with that problem and simultaneously measures their performance according to criteria
developed by policy makers at the highest level. An MBO system that works should permit individual
initiative and innovation, but MBO is no management panacea and, like any quantitative based system,
MBO can be used to obscure efficient and effective management as well as to enhance it.

Zero-Base Budgeting (1976 – present)

Zero-base budgeting (ZBB), in essence, mandates that the entire budget of an agency be re-evaluated and
that all programs be justified periodically. In practice, ZBB employs two steps.

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The first step is the development of ‘decision packages’ for each agency with each package containing
summary analyses of each program within the agency. These packages are then ranked by the agency
head in accordance with his/her perception of overall agency priorities. The second step requires that
each decision package by evaluated by top management to determine whether it is justified for further
funding. Programs that are considered ineffective or to have grown their usefulness are discarded,
modified, or combined in other agencies.
In short, ZBB gets its name from the fact that each year’s budget is computed from a hypothetical ‘zero
base’. It asks, what would we do with this agency’s funds if they were not already committed? To
determine such options, practitioners of ZBB identify each decision unit, analyze each decision unit
within a decision package, evaluate and rank all decision packages to develop the appropriations requests
and finally, prepare a detailed operations budget that reflects those decision packages approved in the
budget appropriations.

Consequently, ZBB means the evaluation of all programs. In other words ZBB considers inputs, outputs,
effects and alternatives. It focuses of the decision-making process; it demands managerial and planning
skills of its personnel; it regards as critical information about the purposes of the program or agency; and
its policy-making style can be characterized as cautiously systematic, utilizing a decentralized planning
concept, and reinstating the budget agency in its role of a policy-making body.

The Nature of budgeting in Ghana

In Ghana, however, the budget approach that was in use for preparation of the National Budget since
1998 was Activity Based Budgeting (ABB). The ABB was introduced under the Public Financial
Management Reform Programme (PUFMARP) as part of wider PFM reforms and was intended to bring
a stronger performance focus to MDA budgets by linking strategic objectives to outputs and activities.
However, recent reviews of the budget process and systems in Ghana have identified limitations with the
ABB procedures and systems. This approach have /proved overly detailed, making the budget
cumbersome to prepare and contributing to excessively centralized control over budget implementation.
The lack of performance indicators of MDA budgets also made it difficult to measure budget
performance and outputs. There has also been an absence of a real strategic focus in MDA budgets with
limited linkage between resource allocations and policy priorities.

Following on from these review findings, the Ministry of Finance and Economic Planning (MoFEP)
considered how to improve the budget preparation. In so doing, it considered the experience of other

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countries that have sought to introduce a stronger policy and performance focus to their budgets and
replaced ABB system with a Programme Based Budgeting (PBB) approach effective 2014.

Programme Based Budgeting Guidelines

This is applied at a more aggregated level that is more closely aligned with the way that MDAs manage
their resources and activities. The new approach simplifies the process of budget preparation and allows
MDAs to be more strategic in their approach to budget management. Performance indicators have been
introduced to ensure performance measurement and assessment.

Difference between the PBB and ABB

The concepts of policy linkage, costing and performance under PBB are similar to those on which
Ghana’s ABB system was based. The major differences are that PBB is more strategic in its focus, more
closely aligned to organizational structures, and emphasizes more clearly defined management
responsibility. The way in which ABB was applied has also resulted in inputs often being classified as
activities resulting in unnecessary and confusing duplication between the activity and economic (input)
classification used in the Budget.

Purpose of Programme Based Budgeting

Programme Based Budgeting is a budgeting approach which directly links the planned expenditures to
clearly determined results and improved service delivery within the mandate of an organisation. Simply
put, programme budgeting is shifting emphasis from input (activities) and outputs to outcomes, service
delivery and results. Programme Based Budgeting exists where the budget is formed around groupings
of related services and activities that are all determined to achieve a single strategic purpose called a
programme. The programme may be broken down for the purposes of management into sub-programme
and activities. The performance of each programme can be measured in terms of its:

• Outcomes (the extent to which its sub-programmes and activities have contributed to the
advancement of the strategic objective);
• Outputs (the goods and services provided under the programme which can be measured in terms of
quantity, quality and timeliness); and Cost.

Each programme therefore can be described in terms of the objective it seeks to achieve, the strategies
it employs to impact on the objective, the outputs to be delivered in pursuing the strategies and the inputs
used in the production of outputs.

PBB provides both a clearer way of describing the purpose of the budget and a framework with which
to measure budget performance in meeting that purpose for which it has been implemented. While an
MTEF can function with any form of budgeting (ie inputs, activities, programmes) better performing
MTEF’s will usually be associated with performance based approaches such as PBB. Through
measurement of performance, the Government will be better informed to make strategic decisions about
the budget resource mix in the strategic phase of the MTEF.

The main purposes of introducing PBB include:

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Policy delivery. PBB specifically links resource allocations to MDA functions and its strategic policy
objectives.

Costing. PBB structures allow for the identification of necessary inputs to produce the core operations
and projects required in order to contribute to strategic objectives. These are then rolled up to produce
sub-programme and programme costs. Budget users can then be aware of the cost of Government
interventions designed to achieve each objective.

Performance. PBB provides a framework against which to measure the performance of MDA
expenditure programmes. As explained in the previous paragraph, the programme structure allows
measurement of: the impact of government in meeting strategic objectives; the effectiveness and
efficiency the services produced under the programme; and the overall cost of addressing the objective

Management Authority and Responsibility . PBB provides a management framework within which
MDAs can effectively manage resources to achieve government objectives. That is, programme managers
can be appointed and assigned human, physical and financial resources in order to meet definable
objectives and milestones which will be measured and for which the manager will be accountable.

Concepts
Budget programmes are a part of a planning and budgeting hierarchy that links national policy goals to
the services that an MDA delivers through its budget operations. The hierarchy runs downward in terms
of its policy logic and upwards in terms of performance logic. Thus the specification of MDA budget
programmes, budget sub-programmes and budget operations/projects is a top-down process, while
programme delivery and performance reporting is essentially a bottom-up process.

The budget programme hierarchy helps to integrate the criteria of effectiveness, efficiency, accountability
and innovation into the budget process:

• Effectiveness can be facilitated through a clear logic that links resource allocations for MDA budget
operations to budget sub-programmes to budget programmes to strategic objectives to policy goals.
This makes it easier to identify budget operations that are not crucial to delivery of programme
outputs and policy outcomes.
• Efficiency can be facilitated by making transparent the linkage between budget programmes which
cover similar functions performed in different MDAs.
• Accountability can be enhanced by assigning clearly defined responsibility to budget programme
managers for achieving defined outputs.
• Innovation in service delivery can be encouraged by providing increased flexibility in managing
resources at budget programme and budget sub-programme level.

The Budget Programme Structure

In PBB the term Budget Programme refers to a programme for which there is a specific definition
and an associated structure. This structure is reflected in both the government’s Budget and in the
classification that is used in accounting for public resources.

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In Ghana it has been decided that the PBB structure should initially comprise the following three
levels:
• A budget programme: is a clearly defined set of services that deliver one or more of the core
functions contained in the MDA’s legislated and assigned mandates.

• A budget sub-programme comprises a distinct grouping of services and activities that fall within
the framework of a budget programme which for management reasons it is desirable to identify
separately within the budget programme.

• Budget operations and projects refer to the activities that are to be undertaken in delivering the
budget programme or budget sub-programme:

• Core Operations refer to the main on-going activities carried out under the budget
programme or budget sub-programme.

• Projects refer to (primarily) capital spending that form part of the government’s investment plan.

SECTION 4: Budgeting Cycle

Budget formulation
The budget is planned by career officials, assembled, coordinated and standardized by a budget agency.
It is then submitted to the political leaders for approval and relayed to the legislature for concurrence
and official execution supervised by the budget agency.
The budget office/ bureau plays a crucial role in the budget formulation stage. The budget office helps
the executive to balance and determine competing policy claims as they are reflected in the budget
submissions. The officers keep the budget within predetermined budget targets. Budget examiners at the
bureau have representatives for specific depths and programme areas such as education, labour, defence,
and health

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We must remember that the formulation of a budget is an extension of the programming phase of
budgeting. Programs become expenditure items and these are expressed in terms of cedis and pesewas
or some other currency. They can then be compared with each other and with their costs in terms of
revenue or borrowing with greater precision than is feasible in the earlier stages of the process.
Furthermore, the question of economy – the attainment of given program results at minimum costs –
can be effectively considered only when all the elements of the program are expressed in terms of cedis
(money). The comparisons and calculations that go into formulation of budget are likely to call for
revision of programs, since more light is thrown on implications of those programs that were previously
available. The budget formulation stage is the first point at which national economic calculations – that
is consideration of how resources can be best allocated for the various alternative uses are made.

Legislative/ Authorization Stage

This is usually known as the appropriation process. The Minister of Finance submits the executive budget
to the legislature. The budget is then reviewed in parts by the subcommittees of appropriations
committees of the legislature. These subcommittees hold hearings on the budget requests of the
departments under their domain. The hearings provide the legislators the opportunities to scrutinize the
activities of the executive agencies. Agency heads use the occasion to lobby for support for their
programs. The Article 21 (3) of the Public Financial Management Act, 2016 (Act 921) for instance states that,
“the Minister shall, on behalf of the President, lay before Parliament not later than the 15th of November
of each financial year, estimates of the revenues and expenditure of the Government, the annual budget,
for the ensuing financial year.” This is intended to give Parliament the room to debate and approve the
budget.
The budget hearing process is very important in the budgeting cycle. As explained by Lee and Johnson
(1978), budget hearing is important because
1. it provides one of the best opportunities for legislative oversights (watchful care)

2. it helps to point out claims that lack credibility

3. it also provides representatives with the opportunity to alter executive priorities. They sometimes
could even restore funds from an agency’s request that may be cut by the budget bureau or the
head of government.

The question that arises is that how do legislators achieve the aim of the budget authorization process.
They mostly achieve the aims of the process through assistance from supporting staff. They sometimes
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also employ what Aaron Wildavsky calls the “aids to calculation”. The “aids to calculation” explains a
series of events and processes that legislators may draw upon to facilitate the authorization stage.
Legislators employ the “aids to calculation” in three main means.
The first use of the “aids to calculation” is when legislators resort to what happened in the past and focus
on deviations from it. They examine particularly new items in the budget and large increases in existing
terms (Incrementalism). Legislators also employ the “aids to calculation” by usually judging the value of
the budget by concentrating on what they know best. They would also, through the “aids to calculation”,
go with the first satisfactory option when making decisions rather than trying to evaluate all conceivable
options before them.

Budget Execution/ Implementation

After going through the authorization stage, the budget is then implemented. The appropriation of funds
by the legislature is followed by the budget execution. This aspect of the budgetary process is the
responsibility of the Executive branch of government. This is done through:
1. Apportionment: that is, amounts of funds that can be spent by an agency within a specified period of
tirne (e.g. monthly, quarterly, half-yearly, yearly). This technique prevents over-spending during the
fiscal year.

2. Allotment: the amount of funds that an institution's head provides for sub-units within the agency.
Allotments are also apportioned to prevent over-spending by the units;

3. Pre-audit: this is the procedure whereby a proposal is checked to ensure that the aim of the expenditure
is approved and that there are enough funds for the expenditure;

4. Transfer of Funds: sometimes funds are moved from one account to another during the execution of
the budget. Transfer controls usually limit the amount that can be transferred. Transfer controls may
also require some type of prior approval from the legislature.

Budget execution is therefore the stage where resources are expended on programs to achieve program
objective within the fiscal year. It is difficult to prescribe what is to be done with complete specificity as
to provide for all contingencies. The objectives of the budget can be more really achieved if there is some
discretion exercised in the execution of the budget than if it is followed rigidly.
During the budget period, external factors will make it necessary to do some minor changes in policy
objectives (for example, change in world prices for export commodity - in cocoa required changes in The
Seven Year Development Plan, 1963-70). The possibilities of the economy become more apparent at this
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stage. Occurrences that could not have been foreseen at the time of budget preparation now come into
the open. Successful execution of the budget therefore requires adherence to its intent but departs from
its details where necessary to give effect to its intent.
In the course of the execution of the budget new methods for achieving economy and efficiency in the
conduct of operations should be tested and explored. The management of the budget is influenced based
on actual by experience and the talents and the techniques required for this task are essentially different
from those required to secure an efficient allocation of the budget among the various programs.

Budget Accountability/ post mortem/ Auditing

The last stage of the budget cycle is known as auditing which occurs after the financial year has ended
since spending from the fiscal year may not be completed until the next year is well underway, auditing
will usually take place sometime after the close of a fiscal year.
Auditing is the examination of records conducted by an independent authority to support an evaluation,
recommendation or opinion concerning –

(a) Adequacy or reliability of information

(b) Efficiency and effectiveness of an agency’s program
(c) Faithfulness of an agency’s adherence to rules and procedures
(d) Accuracy of financial statement or permanent reports that are supposed to say something about
the present condition or past operations of an organisation.

To ensure budget accountability, four types of audit may be conducted. These are -
(a) Financial Auditing: this type of audit is restricted to financial records. The purpose is to
determine at funds were legally and honestly spent and that documentation is reliable.
(b) Compliance Audit: This type of audit examines the adherence to administration rules and
procedures such as requirement for competitive bidding, or enforcement of civil service hiring
rules.
(c) Operational Audit: This audit focuses on the efficiency of an agency’s operation; eg personnel
turnover rate and productivity of employees to determine why an agency is not operating as
efficiently as possible.
(d) Programme Audit: This type of audit tries to determine whether an agency’s programmes have
met the intended objectives.

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The audit agency should have the right to make annual and special reports with its comments on the
soundness of government’s accounting and fiscal procedures. The preservation of the neutrality and
impartiality, integrity and the efficiency of the auditor-general and the audit agency are of special
important. The audit agency reports directly the legislature through a special committee of parliament
called the Public Accounts Committee.
The Auditor-General is usually appointed with fixed term of office and his appointment and removal are
made subject to legislative approval.

The public financial management system of Ghana has, in recent times, witnessed a change in its Financial
Management practices. For instance concerning national budget preparation, the newly introduced Public
Financial Management Act, 2016 (Act 921) makes provision for:
• clear timelines for budget preparation
• minimum content for both the budget guidelines and the budget itself
• expanded coverage for budget
• expanded coverage of reporting of government operations
• stronger oversight of state owned enterprises by the MOF
• alignment of all the statutory funds to policy framework of government and budget
• participatory approach to budgeting formulation into law to improve transparency of budget
processes

SECTION 5: Medium Term Expenditure Framework (MTEF)

Background to the Introduction of MTEF

The Government of Ghana (GoG) implemented an integrated public financial management reform
programme (PUFMARP) in mid-1996 which also included a Budget and Public Expenditure
Management System (BPEMS) component to computerize the whole public expenditure management
cycle. The Medium Term Expenditure Framework (MTEF) is one component of PUFMARP. Various
PUFMARP components aim to improve macroeconomic planning, resources allocation and budgeting,
revenue collection, expenditure control and accounting, cash management, aid and debt management,
audit and procurement.
The initial rationale for PUFMARP was derived from the overall shift in Ghana from a planned control
economy to a liberal market based economy. With respect to the MTEF, weakness in budget preparation
was identified in the 1993 Public Expenditure Review. These weaknesses typically were those to be
associated with an incremental budget. The 1995 Public Expenditure Review expressed the intention of
institutionalising a MTEF as part of the normal budget process. In October 1996, the World Bank agreed
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a Public Financial Management Technical Assistance Project, one of whose components was the MTEF.
Donor financial and technical assistance support to PUFMARP was provided by the World Bank, CIDA,
European Union and DFID who assisted the MTEF in particular with consultancy support. The MTEF
commenced in September 1997 with the arrival of the DFID funded consultants.
The introduction of the MTEF was initially planned on a pilot basis in three Ministries, Departments
Agencies (MDAs) only, but was quickly extended to all MDAs. PUFMARP itself forms one part of a
wider transformation process in the public service, which is being implemented by GoG as part of its
National Institutional Renewal Programme (NIRP). There are parallel and complementary reform efforts
under the NIRP umbrella, with Civil Service Performance Improvement Programme (CSPIP), having
the greatest interdependency with PUFMARP.
The MTEF approach to budgeting was introduced into the 1999 Budget. Since then, support for the
process has been widespread ranging from mention of the wider reform process by subsequent
Presidents to participation in workshops by Ministers and senior government officials, as well as their
counterparts in line ministries.
Rationale for MTEF

The MTEF was introduced in response to common problems facing developing countries in the area of
budget preparation and management. Some of the major weaknesses to be addressed by the MTEF are
as follows:
• Five Year Development Plans and three year Public Sector Investment Programmes, which set out
national and sectoral objectives, policies and specific projects, were not linked to the availability of
resources through a macroeconomic framework. Some projects in the PSIP therefore were not
funded, and the link between policy implementation and the Budget was not established.

• the budget preparation process did not link the achievement of objectives and meeting of targets
with the funds required: there was greater emphasis on control of inputs and less on improving
performance of the sector through meeting its objectives and targets

• the recurrent budget was prepared on an incremental basis (adding a percentage to last year’s
estimates) without reviewing whether the activities being funded should be continued

• activities continued from year to year while resources were declining, therefore some activities which
were critical were under funded

• the classification of the budget did not show activities (e.g. provision of extension services) but only
types of expenditure (e.g. fuel)
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• the investment budget was prepared separately from the recurrent budget, therefore the recurrent
costs arising from the investment programmes were not taken care of

• Controlling Officers did not have much autonomy to utilize funds for better performance, rather
proper accounting was emphasized more

The Medium Term Expenditure Framework (MTEF) approach is seen as a response to the above
problems. It is a process that attempts to improve the decision making process so as to link Government
policies, priorities and requirements with limited resources. These decisions have been identified as
improving resource allocation at three levels: macroeconomic balance, strategic allocation, and
operational efficiency

Objectives of MTEF

The MTEF approach in Ghana started with four primary objectives namely:
1. Improving macroeconomic balance by developing consistent and realistic estimates of available
resources, both domestic and foreign;

2. Restructuring and rationalizing resource allocation so that priority areas receive adequate funding;

3. Improving the basis of the budget by moving away from the incremental approach to estimating the
actual costs of Government activities in delivering goods and services and integrating the
preparation and presentation of the recurrent and development budgets

4. Introducing a forward or medium term perspective in the planning of policies, expenditures and
revenues

These objectives were to be achieved through a fundamental change to the budget preparation process
involving:
• a more strategic approach to the allocation of resources linked to ministries’ objectives

• greater emphasis on the performance and achievement of objectives in sectors

• improvements to the budget classification so that the types of activities being funded could be more
clearly seen in the budget documents

• using the activities to be implemented as the basis for estimating both the Recurrent and
Development Budgets, thus moving to an activity based budget approach

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 • building strong links between all stages in the public financial management cycle: budget preparation,
implementation; monitoring and evaluation.

In Ghana the MTEF process has focused more on all three levels of improving macroeconomic balance;
strategic allocation and operational efficiency. The Ghana approach has also involved providing line
ministries with greater responsibility for allocating resources to priority activities in order to encourage
greater ownership and effectiveness in the use of the scarce resources. Most progress has also been
made in improving the performance basis of the budget through preparing budgets based on agreed
objectives and outputs.

The stages in the MTEF process

The MTEF process is a top down process of determining resource availability and allocating these
resources between sectors, and a bottom up process of estimating the actual requirements of
implementing policies in each sector. The steps involved in developing an MTEF are the means to bring
these processes together, and are described briefly below.

Step One: Macroeconomic framework

This involves projecting resource availability based on the projections of economic growth, domestic
revenues and availability of donor funds;

Step Two: Preliminary ceilings

This involves developing preliminary sectoral ceilings by allocating total resources between sectors on
the basis of government priorities. This step provides Ministries with an indication of the likely resource
available before they start on their detailed costing and should provide some sense of reality. Step two
may not be necessary in the second year of the process as Ministries can use the two forward years’
indicative figures as the starting point.

Step Three: Estimation of requirements

Here, each Ministry estimates requirements for the medium term based on government policies and
priorities. Determining sectoral priorities involves a process of sector reviews through which sector
ministries:
• review sectoral objectives, policies and strategies

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• identify outputs and activities needed to achieve the agreed objectives. This involves consideration
of existing activities, i.e. whether they are line with sectoral policies and priorities and whether new
activities are required
• estimate the actual costs of activities (Recurrent and Development, Government and donor)
• prioritise activities so as to fit within the sectoral resource ceiling and identify which activities that
should continue, those that have to scaled back and those that need to be stopped.
The aim is to indicate trade-offs within sectors by estimating real costs of providing services so that
governments can make decisions about the level of services they can afford to provide.

Step Four: Sectoral ceilings

This stage involves revisiting sectoral ceilings after the sector review exercise the medium term sectoral
ceilings are reviewed and reallocations between sectors considered on the basis of additional information
gathered in the sector reviews. If these exercises reveal that certain objectives cannot be achieved within
the sectoral ceilings, reallocations between sectors may be required. This step is not always necessary and
it is possible to undertake these kinds of analysis during the finalisation of the Budget Estimates in Step
Six.

Step Five: Preparation of estimates

This step involves finalising three year estimates: sector ministries make final adjustment to the three year
estimates at an aggregate level, i.e. at the Programme and Sub-programme level, with first year’s estimate
shown at a detailed level.

Step Six: Review and finalization of the estimates

Once Ministries have completed their Plans and Estimates, these are reviewed by Ministry of Finance, to
assess whether the estimates are consistent with the policies, plan and priorities, and whether the
estimates are within the ceilings. The estimates are then discussed at Budget Hearings and presented to
Cabinet and Parliament for discussion and approval. The first year’s estimates are approved while the
second and third year’s estimates are indicative.

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SECTION 6: Budgeting in Ghana

An overview of budgeting in Ghana

Since gaining independence in 1957, various governments in Ghana both civil and military have
attempted to resolve some of the problems affecting the efficient management of the nation's financial
resources. Some of these initiatives in this respect are:
• The Public Investment Program (PIP) to deal with issues affecting the capital budget;
• The Integrated Personnel and Pay-roll Project (IPPD) to deal with staff costs;
• The Budget Improvement Working Group (BIWG) to help implement the broad based budget
concept, that is, including donor funds in the budget and; .
• The Expenditure Tracking System (EXTRACON) to monitor expenditures in the ministries.

The effects of these initiatives were found to be, disjointed, incoherent and incomprehensive. Thus, there
was the need to develop an all - embracing program, which would link all aspects of public financial
management together. With this in mind, when the Government and the development partners
conducted the first ever Public Expenditure Review meeting in Ghana at Akosombo in 1993, relating to
budget formulation and implementation, it came out with the Public Financial Management Reform
Program (PUFMARP) to address the concerns.
The Medium Term Expenditure Framework (MTEF) approach to budget preparation is a component of
the PUFMARP, which was officially launched by the Minister of Finance in July 1995. The MTEF was
however not implemented till 1999 when it was used to draw the national budget. The MTEF is a
multiyear budgeting system which spans three years including the year in which the budget was presented.

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The Budget Cycle in Ghana

The budget cycle can simply be defined as the time frame within which the budget process (annual or
multiyear) is completed. Before the introduction of the MTEF, the issue of the budget guidelines marked
the beginning of the budget cycle, while the reading of the budget by the minister of finance ended the
preparation process in the cycle. The implementation processes also spanned another period of equal
length. Thus, the implementation processes of the previous fiscal year ran parallel to the preparation
processes of the following year.
With the introduction of the MTEF, the budget cycle now starts in May, before the issue of the guidelines.
The new system has introduced a top-down as well as a bottom-up approach with the determination of
the three-year Macro-economic framework from which the three-year preliminary ceilings will be
determined for the MDAs. These preliminary ceilings are discussed by Cabinet and after approval,
conveyed to the MDAs in the Budget Guidelines by June.
The MTEF process has already assisted all MDAs to prepare strategic plans consisting of the MDAs
mission statement, objectives, outputs and activities. These strategic plans are to be reviewed by the
MDAs after the receipt of the guidelines and the preliminary macro-ceilings approved by Cabinet. All
these reviews are expected to be completed by the end of June to enable the costing of inputs to commence
in July. These inputs are what the MDAs require in order to carry out the prioritized activities in their
strategic plans.
The prioritization continues during costing until the MDA is able to live within the macro-ceiling. During
reviews, the MDAs are expected to consider existing activities to see whether they are in line with sectoral
policies and priorities. The review does not necessarily draw the line between recurrent and capital
expenditures, so long as they contribute to the achievement of the outputs. In order to prioritize activities
to fit into the MDA resource ceilings, the MDAs have to scale down certain activities or even stop them
altogether.
Policy hearings are organized in August for MDAs to enable them re-examine their priorities vis-a-vis
sectoral policies and additional information to be gathered at the sectoral reviews, all aiming at costing
within the sectoral ceilings. It is after these policy hearings that the preparation of the three year estimates
are finalized followed by budget hearings on the estimates in September. The estimates are expected to
be before parliament by the end of November, after the cabinet approval in October.

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Budget Evaluation

Apart from the provisional “budget out turn” read during the presentation of the budget to parliament
in the budget statement, the only formalized budget evaluation system in Ghana until the introduction of
the MTEF has been the Public Expenditure Review (PER). The existing as well as the new rules proposed
under MTEF can be seen on page 64 of the Budget implementation Workshop Handbook.
Under the MTEF, the Monitoring Division of the Ministry of Finance and Economic Planning (MOFEP)
has been strengthened to monitor and evaluate budget performance. In addition, consolidated returns
for the whole MDA are to be submitted quarterly on a monthly basis and broken down to cost centre
level. Reports are to be submitted not more than fifteen (15) days after the end of the month.

Strengths of the Ghanaian Budgeting System

The MTEF process involves matching resources and requirements at two levels (between sectors within
sectors) so as to ensure that government is able to achieve its objectives at both the macro and micro
levels in the most efficient and effective manner. The matching of revenues or resources and MDA
requirements (including statutory obligations) is achieved through an iterative top-down and bottom-up
process which involves developing information on the cost of achieving government objectives in each
sector. This kind of information would not be produced in MDAs use the traditional ‘line-item’ approach
to budgeting.
The current budgeting system therefore has the following strengths:
1. Using a more strategic basis for the budget by defining MDA mission, objective and outputs

2. Defining the activities needed to achieve the outputs and objectives

3. Basing the budget on the costs of the inputs required to carry out these activities, that is, moving
away from incremental approach to the preparation of the recurrent aspect of the budget

4. Identifying and costing both recurrent and capital inputs together, that is, integrating the preparation
of the recurrent and developmental budgets

5. Improving the classification and the presentation of the budget so that the activities to be
implemented by ministries can be seen more clearly (rational basis for resource allocation more
transparent)

6. Identifying and monitoring the outputs or targets as a measure of performance in meeting the agreed
objectives.
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7. By starting the cycle with the determination of the macro-economic framework with both inter-
sectoral, ceilings and revenue forecasting, the budget is linked to the macro-economic targets like
inflation, GDP, growth and others

8. By considering resources from both domestic and external sources, donors can be persuaded to re-
allocate donor funds to priority government activities in the strategic plans.

Despite these benefits, the current Ghanaian budgeting system is not without fault. The process is more
time consuming, cumbersome, bureaucratic and involves greater analysis. It has also led to the
restructuring of the some MDA functions beyond the capacities of the MDAs.

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