Ambo University Woliso Campus SoBE Department of Economics

CHAPTER ONE
1.1. Overview of Public Finance
Public finance is a study of the financial aspects of government. The term has been variously defined.
According to Dalton, “public finance is one of those subjects which lie on the borderline between economics
and politics. It is concerned with the income and expenditure authorities and with the adjustment of the
one to the other.” Harold Groves, an authority on the subject, defines public finance as: “A field of inquiry
that treats of the income and outgo of governments (federal, state and local). In modern times this includes
four major divisions: public revenue, public expenditure, public debt, and certain problems of the fiscal
system as a whole, such as fiscal administration and fiscal policy. Therefore, the subject matter of public
finance deals with public revenue, public expenditure, and public debt.
1.2. Definition and Scope of Public Finance
Public finance is a very old science and different economists have defined it in their own ways. Some of
the important definitions of public finance are given as follow.
a. “Public finance is concerned with the income and expenditure of public authorities and with the
adjustment of one to the other.” Huge Dalton
b. “Public finance deals with the provision custody and disbursement of resources needed for conduct of
public or government functions.” Lutz
c. “Public finance is a science which deals with the activity of the statement in obtaining and
applying the material means necessary for fulfilling the proper functions of the state.” Carl Plehn
d. “Public finance is the study of the principles underlying the spending and raising of funds of public
authorities.” Findley Shirras
e. “The government, considered as a unit, may be defined as the subject of study of public finance. More
specifically, public finance studies the economic activity of government as a unit.” Buchanan
f. “Public finance deals with expenditure and income of public authorities of the state and their mutual
relations as also with the financial administration and control.” Bastable
All of them say that it is a study of income and expenditure of the central, state, and local
governments. Government performs many functions which the individual can not or do not perform.
Therefore, rising of funds for the expenditure and their disbursement constitutes the subject of Public finance
(Gupta, 2001)
The contents (scope) of the science of public finance are divided into five categories of financial
activities of the government:
i. Public Revenue,
ii. Public Expenditure,
iii. Public Debt,
iv. Financial Administration and Control, and
v. Economic Stability and Growth.

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 Ambo University Woliso Campus SoBE Department of Economics
i. Public Revenue: - this part includes the study of raising public revenues and the principles of taxation.
ii. Public Expenditure: - this consists of the study of the principles and the effects of public expenditure.
iii. Public Debt. A public authority can obtain income through loans and public borrowings. The loans
raised in a particular year constitute receipts for that year. It is an income of a capital nature, while
the provision for repayment of the capital sum for the year constitutes expenditure of a capital
nature. The study public debt also includes:
(i) Methods and objectives of public borrowings;
(ii) Management of public debt; and
(iii) Burden of public-internal and external.
Methods of public debt are an important instruments of not only raising funds but also for meeting
increasing government expenditure, for securing economic stability, increasing public borrowings
during the periods of inflation and liquidation of public debt during the period of depression,
borrowings from the people during inflation and borrowings from banks during depression and so on.
iv. Financial Administration and Control:- The scope of public finance is not confined only to
public revenue, public expenditure and public debt. We have to examine the mechanism by
which the above processes are carried on. With out a study of relevant dimensions of financial
administration the subject of public finance remains incomplete. Thus financial administration and
control include the following:
(i) Study of budgets and their procedure.
(ii) Budget as an instrument of securing certain objectives, such as promotion of employment, economic
growth with stability, welfare of the weaker sections, infrastructural development for promoting private
investments, etc.
(iii) Financial and physical controls through different fiscal tools for controlling private expenditure in the
economy to avoid the effects inflation deflation, recession etc.
v. Economic Stability and Growth:- The study o f public finance includes fiscal policy of the
government in dealing with inflationary and deflationary situations, instability of the price level,
promotion of full employment, growth of economy, welfare of the people, etc. Economic stabilization is
of recent origin. It has a wide scope to play especially in the less developed countries. The main task of
this section is to frame and look after the implementation of various policies required for
economic stabilization and growth.
1.3. Public finance and private finance
Finance in general means public as well as private finance. Public finance relates
to the money-raising and income-expenditure functions of the government. Private finance refers to the
income-expenditure phenomenon of an individual or private business firm. By private finance we mean the
financial problems and policies of an individual economic unit. It is a convention to look into similarities

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 Ambo University Woliso Campus SoBE Department of Economics
and dissimilarities between the two so as to provide an analytical foundation for the decision making
aspects of public finance
Similarities
(1) Satisfaction of Human Wants.
Both the public and private finance have the same objective, i.e., the satisfaction of human wants.
Public finance is concerned with the satisfaction of social or collective wants, whereas private
finance is concerned with the satisfaction of personal or individual wants.
(2) Maximum Advantage
Both the public finance and private finance try to secure maximum advantage or maximum
benefit. An individual or a corporation or a private business firm tries to obtain maximum
advantage from his expenditure. Similarly, the government also tries to obtain maximum good of
the people by incurring expenditure on the society.
(3) Borrowings
Another similarity between the public and private finance is that many times both have to be
obtained from the market in the form of borrowings whenever the expenditure of either the
government or any individual or firm exceeds their income/revenue.
(4) Engagement in Similar Activities
Both the private and public sectors are engaged in activities that involve lots of purchases, sales
and other transactions. Similarly, they are engaged in production, exchange, saving capital
accumulation, investment, and so on. In order to finance these operations, the government, creates
money, raises loans and makes payments etc. Similarly, a private economic unit lends, borrows,
receives payments, and makes payments and so on. In these respects, therefore, both the public and
private finance are quite similar to each other.
(5) Scarcity of Resources
The scarcity of resources is also an important factor which is common to both. They have
unlimited objectives, whereas the resources are limited.
(6) Problem of Adjustment of Income and Expenditure
Another similarity between public and private finance is that both the public as well as private
sectors face the problem of adjustment of income and expenditure.
Dissimilarities
(1) Adjustment Approach of Income and Expenditure
Another dissimilarity between the individual’s private finance and the government’s public finance is
that every individual tries as far as possible to adjust his expenditure to his income because his
expenditure depends on his income. Conversely, the government first prepares its budget. In other
words, the government first determines its expenditure and then devises ways and means to raise
the requisite revenue to meet its expenses.

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 Ambo University Woliso Campus SoBE Department of Economics
(2) Nature of Resources
The resources (private finance) of an individual are more or less limited, whereas the resources of the
government (public finance) are enormous. Government can raise resources from tax sources as well as
non-tax sources. The government can borrow from internal as well as external sources.
(3) Coercive Methods
An individual (private finance) cannot use coercive methods to raise his income, whereas the
government (public finance) can use forceful methods to collect revenue. In other words, to
collect revenue, the government imposes taxes at a high rate on the people irrespective of their
capacity to pay. Private individuals or bodies have no such powers.
(4) Secrecy of Budget
Public finance is an open affair as the government gives utmost publicity to its budget by
publishing it in newspapers and by showing it on television. For example, the Ethiopian
government tells to the public the yearly approved budget by parliament, whereas private finance is
a secret affair. An individual tries to keep his accounts secret as he does not want his
competitors to know his real financial position.
(5) Long/Short-term Consideration
Another point of difference between private and public finance is that the private individuals incur
expenditure in those areas of business which give quick returns. They, as individuals keep in view short-
term considerations. On the contrary, government incurs expenditure keeping in view the long-
term considerations, such as construction of dams, multi purpose hydro-electric projects, etc.
(6) Elasticity of Finance
Public finance is elastic in nature-as compared to private finance. Public finance can be increased by
imposing various taxes as public finance is open to drastic changes. Private finance on the other
hand, cannot be increased as there is not much scope for changes in private finance.
(7) Motive of Expenditure: In the case of an individual, the main consideration in expenditure is whether
it will be profitable and beneficial to him. On the other hand, the motives of profit and surplus do not
influence government departments except such commercial departments as the railways, posts,
telegraphs, etc. The government has to finance improvements of a general nature and activities for
which financial return is uncertain or long delayed.
(8) Expenditure and Welfare: Every individual attempts to maximize his satisfaction by distributing his
limited income on different goods and services in such a way that marginal utilities of money spent on
all goods would be more or less the same. On the other hand, the government should spend its income
in such a way that the welfare of the community should be maximized.
(9) Provision Made for the Future: The individual hopes to live only for a short period and he feels the
present needs far more urgently; therefore, he goes about satisfying his present needs and allots only a
very small portion of his income for the future since generally he underestimates the future. The state,

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 Ambo University Woliso Campus SoBE Department of Economics
on the other hand, is a permanent organization and is the custodian of not only the present but also the
future generations and, therefore, allots a large portion of its resources for the conservation as well as
the promotion of future interests.
Thus, on important points, private and public finance differ from each other. It is not; therefore, correct to
assume that the principles and rules which govern private finance are equally applicable to public finance.
1.4. Economic and Social Significance of Public Finance
i. Economic Significance
Economic Stability and maintenance of full employment are the two main goals of public finance in
advanced countries like the U.K. and the U.S.A. In developing countries economists were of the view that
the fiscal policies should be formulated for the rapid economic development. Public Finance occupies great
significance in an under developed or developing country. According to R.J. Chelliah, “Public Finance has
a positive and significant role in the context of economic development.” The importance of public finance
in an under developed/developing country discussed as follows:
(1) Capital Formation
Since the economic development of the country depends on the rate of capital formulation, the first
and the foremost aim of public finance is to promote capital formation. In a developing country, the
government’s economic policy should concentrate on production and fiscal policy should act as a
tool of capital formation. For rapid capital formation, the government should incur expenditure on the
establishment of basic and heavy industries, infrastructural development, such as power projects,
transport sector, means of communications etc.
(2) Economic Stabilization
Economic stabilization is yet another economically significant responsibility of the government. The
problem arises whenever there is economic instability such as inflation, deflation and recession. Public
finance (revenue and expenditure process of the government) may be, therefore, used to secure
economic stability or to remove economic fluctuations in the economy.
(3) Full Employment
Public finance also plays an important role in increasing employment. In an underdeveloped/
developing country, major problem faced by the people is the problem of unemployment. This problem
leads to low standard of living, poverty, backwardness, ignorance and above all starvation. It is the
function of public finance to provide employment opportunities. Therefore, expenditure should be
incurred by the government for increasing employment and for achieving full employment. To
generate employment, public expenditure should be incurred on setting up new industries,
encouraging small-scale and cottage industries through financial subsidies, expenditure on training
schemes etc.

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(4) Balanced Regional Development
For the economic development of a country, balanced regional development is very essential.
Balanced regional development is possible by setting up private industries in backward areas instead of
in urban areas. To encourage this diversion, the government should provide fiscal or tax concessions in
the form of 5 year tax holiday, communication facilities should also be provided. If the private
industries fail to divert to backward regions, should be taxed heavily.
(5) Reduction in Economic Inequalities
One of the major problems of underdeveloped countries is the unequal distribution of income
and wealth. There is a gap between the rich and the poor. Public finance has an important role to play
in this context. To bring about equitable distribution of income and wealth, the government
should follow the system of progressive taxation. In other words, the government should impose
heavy taxes on the richer section of society, and the amount realized from the rich should then be
spent on the poor by way of providing them social amenities such as free education, medical facilities,
public utilities like road, water facility, recreation facilities etc.
(6) Mobilization of Resources
Mobilization of resources is another important role of public finance. The government can mobilize or
raise resources by imposing taxes on the people and industries, by encouraging savings through
various saving schemes, surplus of public enterprises and borrowings and making them available
for investment for the rapid economic development of the underdeveloped country.
(7) Optimum Utilization of Resources
Optimum utilization of scarce resources is very essential for the economic development of the
underdeveloped countries. In a developing country it is not uncommon to find non-utilization or
destruction of scarce resources. The solution of this problem lies in the optimum utilization of
available resources by means of adopting planned monetary and public finance policies. The state
can direct the flow of consumption, production and distribution in the right direction by adopting
balanced budgetary policy.
ii. Social Significance
Social justice or equitable distribution of income and wealth is another responsibility of the government
in its public finance operations. As already been discussed there is unequal distribution of income and wealth
in developing countries. There is a wide gap between the rich and the poor. For example according to
Fikreyesus (2006), the top 20 percent of the population have control about 50 percent of the Ethiopian
economy. This gap can be bridged by adopting a rational fiscal policy, such as taxation and public
expenditure. In other words luxury items purchased mainly by the rich should be subjected to higher
rates of taxation, and necessary items should be exempted from taxation. Social justice also requires
investment expenditure on the establishment of enterprises in the public sector. By doing so, the

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government would be able to produce goods of mass consumption to make available cheap goods to the
people.
iii. Satisfaction of Social Wants
Another significant point of public finance is the satisfaction of social or collective wants and merit
wants. Wants are divided under three heads:
(a) Private Wants:
(b) Social Wants or Collective Wants and
(c) Merit Wants
a) Private Wants
Private wants are those wants which are satisfied by individuals according to their personal incomes. Degree of
satisfaction depends upon their respective incomes. Wants for houses, food, clothes, entertainment or
recreation etc, are satisfied according to individual preferences.
b) Social Wants or Collective Wants
Social or collective wants require public goods which are demanded by all members of society equally
whether the people have the capacity to pay or not. Wants like defense, education, public health, flood
control provisions, weather forecasting bureaus, research centers, police protection, social overhead capital
like roads, bridges, etc. are collective wants which must be available to all the people, irrespective of
whether they are rich or poor, whether they can afford to have them or not. In other words, consumer is
supreme. Public expenditure on these heads is necessary to satisfy y social or collective wants. Since
nobody is ready to pay for them, therefore, taxes are imposed on the people to meet expenditure for the
satisfaction of these wants.
c) Merit Wants
Merit wants are essential private such as food, clothing, housing etc, which are
satisfied by the government at low prices for the poor due to their low level of income. Merit wants are,
thus, provided by the government for the benefit of the poor. These wants are satisfied by the government for the
upliftment and progress of the poor. Such wants are food, clothing, low cost housing (e.g. condominium), free
nutritious means to school children, free education to the children of the poor, low priced milk to the poor,
old age pensions and social security measures, maternity benefits etc. Satisfaction of these wants for the
poor increases their productivity efficiency and there by their income.

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Chapter Two
2. The theory of public Economy
i. Welfare Economics
In this section we sketch the fundamentals of welfare economics. The theory is used to
distinguish the circumstances under which markets can be expected to perform well from
those under which markets fail to produce desirable results.
We begin by considering a very simple economy: only two people who consume two
commodities with fixed supplies. The only economic problem here is to allocate amounts
of the two goods between the two people.
2.2. An economy with consumption
The framework used by most public finance specialist is welfare economics, the branch of
economic theory concerned with the social desirability of alternative economic states.
The fundamentals of welfare economics is used to distinguish the circumstances under
which markets can be expected to perform well from those under which markets fail to
produce desirable results.
We begin by considering a very simple economy: only two people who consume two
commodities with fixed supplies. The only economic problem here is to allocate amounts
of the two goods between the two people.
As simple as this model is, all the important results from the two good two person case
hold in economies with many people and commodities. The two-by-two case is analyzed
because of its simplicity. The two people are Adam and Eve, and the two commodities
are apples (food) and fig leaves (clothing). An analytical device known as the
Edgeworth Box depicts the distribution of apples and fig leaves between Adam and Eve.
In Figure 2.1, the length of the Edgeworth Box, Os, represents the total number of apples
available in the economy; the height, Or, is the total number of fig leaves. The amounts
of the goods consumed by Adam are measured by distances from point O; the quantities
consumed by Eve are measured by distances from O’. For example, at point v, Adam
consumes Ou fig leaves and Ox apples, while Eve consumes O’y apples and O’w fig
leaves. Thus, any point within the Edgeworth Box represents some allocation of apples
and fig leaves between Adam and Eve.

Figure 1.1: Edgeworth Box

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Now assume Adam and Eve each have a set of conventionally shaped indifference
curves that represent their preferences for apples and fig leaves. In Figure 1.2, both sets
of indifference curves are superimposed onto the Edgeworth Box. Adam‟s ICs are labeled
with A’s; Eve‟s ICs are labeled with E’s. Indifference curves with greater numbers represent
higher levels of happiness (utility). Adam is happier on indifference curve A3 than on A2 or
A1, and Eve is happier on indifference curve E3 than on E2 or E1. In general, Eve‟s utility
increases as her position moves toward the northeast.

Figure 1.2: Indifference curves in an Edgeworth Box

Suppose some arbitrary distribution of apples and fig leaves is selected – say point g in
Figure 1.3. AgAg is Adam‟s indifference curve that runs through point g, and EgEg is Eve‟s.
Now pose the following question: Is it possible to reallocate apples and fig leaves
between Adam and Eve in such a way that Adam is made better off, while Eve is made
no worse off? A moment‟s thought suggests such an allocation, at point h. Adam is
better off at this point because indifference curve AhAh represents a higher utility level for
him than AgAg. On the other hand, Eve is no worse off at h because she is on her original
indifference curve, EgEg.
Can Adam‟s welfare be further increased without doing any harm to Eve? As long as
Adam can be moved to indifference curves further to the northeast while still remaining
on EgEg, it is possible. This process can be continued until Adam‟s indifference curve is just
touching EgEg, which occurs at point p in Figure 1.3. The only way to put Adam on a
higher indifference curve than ApAp would be to put Eve on a lower one. An allocation
such as point p, at which the only way to make one person better off is to make another
person worse off, is called Pareto efficient. Pareto efficiency is often used as the standard
for evaluating the desirability of an allocation of resources. If the allocation is not Pareto
efficient, it is “wasteful” in the sense that it is possible to make someone better off without
hurting anybody else. When economists use the word efficient, they usually have the
notion of Pareto efficiency in mind.

Figure 1.3: Making Adam better off without Eve becoming worse off

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 Ambo University Woliso Campus SoBE Department of Economics
A related notion is that of a Pareto improvement – a reallocation of resources that makes
one person better off without making anyone else worse off. In Figure 1.3, the move from
g to h is a Pareto improvement, as is the move from h to p. Point p is not the only Pareto
efficient allocation that could have been reached by starting at point g.
Figure 1.4 examines whether we can make Eve better off without lowering the utility of
Adam. Logic similar to that surrounding Figure 1.3 suggests moving Eve to indifference
curves further to the southwest, provided that the allocation remains on AgAg. In doing so,
a point like p1 is isolated. At p1, the only way to improve Eve‟s welfare is to move Adam to
a lower indifference curve. Then, by definition, p1 is a Pareto efficient allocation. So far,
we have been looking at moves that make one person better off and leave the other at
the same level of utility. In Figure 1.5 we consider reallocations from point g that make
both Adam and Eve better off. At p2, for example, Adam is better off than at point g
(Ap2Ap2 is further to the northeast than AgAg) and so is Eve (Ep2Ep2 is further to the
southwest than EgEg). Point p2 is Pareto efficient, because at that point it is impossible to
make either individual better off without making the other worse off. It should now be
clear that starting at point g, a whole set of Pareto efficient points can be found. They
differ with respect to how much each of the parties gains from the reallocation of
resources.

Figure 1.4: Making Eve better off without Adam becoming worse off
Recall that the initial point g was selected arbitrarily. We can repeat the procedure for
finding Pareto efficient allocations with any starting point. Had point k in Figure 1.6 been
the original allocation, Pareto efficient allocations like p3 and p4 could have been
isolated. This exercise reveals a whole set of Pareto efficient points in the Edgeworth Box.
The locus of all the Pareto efficient points is called the contract curve, and is denoted mm
in Figure 1.7. Note that for an allocation to be Pareto efficient (to be on mm), it must be a
point at which the indifference curves of Adam and Eve are barely touching., In
mathematical terms, the indifference curves are tangent – the slopes of the indifference
curves are equal.

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Figure 1.5: Making both Adam and Eve better off

Figure 1.6: Starting from a different initial point

Figure 1.7: The contract curve

In economic terms, the absolute value of the slope of the indifference curve indicates the
rate at which the individual is willing to trade one god for an additional amount of
another, called the marginal rate of substitution (MRS). Hence, Pareto efficiency requires
that marginal rates of substation be equal for all consumers:

MRS afAdam  MRS afEve (1.1)

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 Ambo University Woliso Campus SoBE Department of Economics
Where MRS afAdam is Adam‟s marginal rate of substitution of apples for fig leaves, and
MRS afEve is Eve‟s.
2.2.i.1. An Economy with Production
The production possibilities curve. So far we have assumed that supplies of all the
commodities are fixed. Consider what happens when productive inputs can shift
between the production of apples and fig leaves, so the quantities of the two goods are
alterable. Provided the inputs are efficiently used, if more apples are produced, then fig
leaf production must necessarily fall and vice versa. The production possibilities curve
shows the maximum quantity of fig leaves that can be produced along with any given
quantity of apples. A typical production possibilities curve is depicted as CC in Figure 1.8.
As shown in Figure 1.8, one option available to the economy is to produce Ow fig leaves
and Ox apples. The economy can increase apple production from Ox to Oz, distance xz.
To do this, inputs have to be removed from the production of fig leaves and devoted to
apples. Fig leaf production must fall by distance wy if apple production is to increase by
xz. The ratio of distance wy to distance xz is called the marginal rate of transformation of
apples for fig leaves (MRTaf) because it shows the rate at which the economy can
transform apples into fig leaves. Just as MRSaf measures the absolute value of the slope of
an indifference curve, MRTaf measures the absolute value of the slope of the PPC.
It is useful to express the marginal rate of transformation in terms of marginal cost (MC) –
the incremental production cost of one more unit of output. To do so, recall that society
can increase apple production by xz only by giving up wy fig leaves. In effect, then, the
distance wy represents the incremental cost of producing apples, which we denote MC a.
Similarly, the distance xz is the incremental cost of producing fig leaves, MCf.
By definition, the absolute value of the slope of the production possibilities curve is
distance wy divided by xz, or MCa/MCf. But also by definition, the slope of the production
possibilities curve is the marginal rate of transformation. Hence, we have shown that:
MCa
MRTaf  . (1.2)
MC f
Efficiency conditions with variable production. When the supplies of apples and fig leaves
are variable, the condition for Pareto efficiency in Equation (2.1) must be extended. The
condition becomes:
MRTaf  MRS afAdam  MRS afEve (1.3)

Figure 1.8: Production possibilities curve

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A simple arithmetic example demonstrates why the first equality in Equation (1.3) must
hold. Suppose that at a given allocation Adam‟s MRSaf is 1 , and the MRTaf is 2 . By the
3 3
definition of MRTaf, at this allocation two additional fig leaves could be produced by
giving up three apples. By the definition of MRSaf, if Adam lost three extra apples, he
would require only one fig leaf to maintain his original utility level. Therefore, Adam could
be made better off by giving up three apples and transforming them into two fig leaves,
and no one else would be made worse off in the process. Such a trade is always possible
as long as the marginal rate of substitution does not equal the marginal rate of
transformation. Only when the slopes of the curves for each are equal is it impossible to
make a Pareto improvement. Hence, MRTaf=MRSaf is a necessary condition for Pareto
efficiency. The rate at which apples can be transformed into fig leaves (MRTaf) must
equal the rate at which consumers are willing to trade apples for fig leaves (MRSaf).
Using Equation (1.2), the conditions for Pareto efficiency can be reinterpreted in terms of
marginal cost. Just substitute (1.2) into (1.3), which gives us
MCa
 MRS afAdam  MRS afEve (1.4). As a necessary condition for Pareto efficiency.
MC f
ii. The Fundamental Theorem of Welfare Economics
Now that we have described the necessary conditions for Pareto efficiency, we may ask
whether a real-world economy will achieve this apparently desirable state. The
Fundamental Theorem of Welfare Economics provides an answer:
As long as producers and consumers act as perfect competitors, that is, take prices as
given, the under certain conditions a Pareto efficient allocation of resources emerges.
Thus, a competitive economy “automatically” allocates resource efficiency, without any
need for centralized direction (shades of Adam Smith‟s “invisible hand”). In a way, the
fundamental theorem merely formalizes an insight that has long been recognized: When
it comes to providing goods and services, free enterprise systems are amazingly
productive.
A rigorous proof of the fundamental theorem requires fairly sophisticated mathematics,
but we can provide an intuitive justification. The essence of competition is that all people
face the same price – each consumer and producer is so small relative to the market that
his or her action alone cannot affect prices. In our example, this means Adam and Eve
both pay the same prices for fig leaves (Pf) and apples (Pa). A basic result from the theory
of rational choice is that a necessary condition for Adam to maximize utility is
P
MRS afAdam  a (1.5)
Pf
Similarly, Eve‟s utility-maximizing bundle is characterized by:
P
MRS afEve  a (1.6)
Pf
Equations (2.5) and (2.6) together imply that
MRS afAdam  MRS afEve
This condition, though, is identical to Equation (1.1) one of the necessary conditions for
Pareto efficiency. However, as emphasized in the preceding section, we must consider

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the production side as well. A basic result from economic theory is that a profit-
maximizing competitive firm produces output up to the point at which marginal cost and
price are equal. In our example, this means Pa=MCa and Pf=MCf, or
MC a Pa
 (1.7)
MC f Pf
But recall from Equation (2.2) that MCa/MCf is just the marginal rate of transformation.
Thus, we can rewrite (2.7) as
P
MRTaf  a (1.8)
Pf
Now, consider Equations (1.5), (1.6), and (1.8), and notice that Pa/Pf appears on the right-
hand side of each. Hence, these three equations together imply
that MRS afAdam  MRS afEve  MRTaf , which is the necessary condition for Pareto efficiency.
Competition, along with maximizing behavior on the part of all individuals, leads to an
efficient outcome.
Finally, we can take advantage of Equation (1.4) to write the conditions for Pareto
efficiency in terms of marginal cost. Simply substitute (1.6) or (1.5) into (1.4) to find:
Pa MC a
 (1.9)
Pf MC f
Pareto efficiency requires that prices be in the same ratios as marginal costs, and
competition guarantees this condition is met. The marginal cost of a commodity is the
additional cost to society of providing it. According to Equation (1.9), efficiency requires
that the additional cost of each commodity be reflected in its price.
iii. The Role of Fairness
If properly functioning competitive markets allocate resources efficiently, what role does
the government have to play in the economy? Only a very small government would
appear to be appropriate. Its main function would be to establish a setting in which
property rights are protected so that competition can work. Government provides law
and order, a court system and national defense. Anything more is superfluous. However,
such reasoning is based on a superficial understanding of the fundamental theorem.
Things are really much more complicated. For one thing, it has implicitly been assumed
that efficiency is the only criterion for deciding if a given allocation of resource is good. It
is not obvious; however, that Pareto efficiency by itself is desirable.
To see why, let us return to the simple model in which the total quantity of each good is
fixed. Consider Figure 1.9, which reproduces the contract curve mm derived in Figure 1.7.
Compare the two allocations p5 (at the lower left-hand corner of the box) and q (located
near the center). Because p5 lies on the contract curve, by definition it is Pareto efficient.
On the other hand, q is inefficient. Is allocation p5 therefore better? That depends on
what is meant by better. To the extent that society prefers a relatively equal distribution of
real income, q might be preferred to p5, even though q is not Pareto efficient. On the
other hand, society might not care about distribution at all, or perhaps care more about
Eve than Adam. In this case, p5 would be preferred to q.
The key point is that the criterion of Pareto efficiency by itself is not enough to rank
alternative allocations of resources. Rather, explicit value judgments are required on the
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fairness of the distribution of utility. To formalize this concept, note that the contract curve
implicitly defines a relationship between the maximum amounts of utility that Adam can
attain for each level of Eve‟s utility. In Figure 1.10, Eve‟s utility plotted on the horizontal
axis, and Adam‟s utility is recorded on the vertical axis. Curve UU is the utility possibilities
curve derived from the contract curve. It shows the maximum amount of one person‟s
utility given the other individual‟s utility level.

Figure 1.9: Efficiency versus equity

Point ~p5 corresponds to point p5 on the contract curve in Figure 1.9. Here, Eve‟s utility is
relatively high compared to Adam‟s. Point ~p in Figure 1.10, which corresponds to p3 in
3

Figure 1.9, is just the opposite. Point q~ corresponds to point q in Figure 1.9. Because q is
off the contract cure, q~ must be inside the utility possibilities curve, reflecting the fact that
it is possible to increase one person‟s utility without decreasing the other‟s.

Figure 1.10: Utility Possibilities Curve

All points on or below the utility possibilities curve are attainable by society; all points
above it are not attainable. By definition, all points on UU are Pareto efficient, but they
represent very different distributions of real income between Adam and Eve. Which point
is best? The conventional way to answer this question is to postulate a social welfare
function, which embodies society‟s views on the relative deservedness of Adam and Eve.
Imagine that just as an individual’s welfare depends on the quantities of commodities she
consumes, society’s welfare depends on the utilities of each of its members.
Algebraically, social welfare (W) is some function of each individual‟s utility:
W = F (UAdam,UEve) (1.10)

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We assume the value of social welfare increases as either U Adam or UEve increases – society
is better off when any of its members becomes better off. Note that we have said
nothing about how society manifests these preferences. Under some conditions,
members of society may not be able to agree on how to rank each other‟s utilities, and
the social welfare function does not even exist. For the moment, we simply assume it
does exist.
Just as an individual‟s utility function for commodities leads to a set of indifference curves
for those commodities, so does a social welfare function lead to a set of indifference
curves between people‟s utilities.
Figure 1.11 depicts a typical set of social indifference curves. Their downward slope
indicates that if Eve‟s utility decreases, the only way to maintain a given level of social
welfare is to increase Adam‟s utility, and vice versa. The level of social welfare increases
as we move toward the northeast, reflecting the fact that an increase in any individual‟s
utility increases social welfare, other things being the same.

Figure 1.11: Social indifference curves

In Figure 1.12, the social indifference curves are superimposed on the utility possibilities
curve from Figure 1.10. Point i is not as desirable as point ii (point ii is on a higher social
indifference curve than point i) even though point i is Pareto efficient and point ii is not.
Here, society‟s value judgments, embodied in the social welfare function, favor a more
equal distribution of real income, inefficient though it may be. Of course, point iii is
preferred to either of these. It is both efficient and “fair.”
Now, the Fundamental Theorem of Welfare Economics indicates that a properly working
competitive system leads to some allocation on the utility possibilities curve. There is no
reason, however, that it is the particular point that maximizes social welfare. We conclude
that, even if the economy generates a Pareto efficient allocation of resources,
government intervention may be necessary to achieve a “fair” distribution of utility.
A second reason the fundamental theorem need not imply a minimal government has to
do with the fact that the certain conditions required for its validity may not be satisfied by
real-world markets. As we now show, an absence of these conditions may lead free
markets to allocate resources inefficiently.

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Figure 1.12: Maximizing social welfare

2.3. Market Failure
Whenever markets appear to be failing to allocate resources efficiently, economists
round up the same group of possible causes for the supposed failure. An economy may
fail to generate an efficient allocation of resources for two general reasons – market
power and non-existence of markets.
i. Market Power
The Fundamental Theorem holds only if all consumers and firms are price takers. If some
individuals or firms are price makers (they have the power to affect prices), then the
allocation of resources will generally be inefficient. Why? A firm with market power may
be able to raise price above marginal cost by supplying less output than a competitor
would. Thus, Equation (1.9), one of the necessary conditions for Pareto efficiency, is
violated. An insufficient quantity of resources is devoted to the commodity.
Situations in which firms are price makers can arise in several different ways. An extreme
case is monopoly, where there is only one firm in the market, and entry is blocked. Even in
the less extreme case of oligopoly (a few sellers), the firms in an industry may be able to
increase price above marginal cost. Finally, some industries have many firms, but each
firm has some market power because the firms produce differentiated products. For
example, a lot of firms produce running shoes, yet Reeboks, Nikes, and Etonics are
regarded by many consumers as distinct commodities.
ii. Non-existence of Markets
The proof behind the Fundamental Theorem assumes a market exists for every
commodity. After all, if a market for a commodity does not exist, then we can hardly
expect the market to allocate it efficiently. In reality, markets for certain commodities
may fail to emerge. Consider, for instance, insurance, a very important commodity in a
world of uncertainty. But, there are certain events for which insurance simply cannot be
purchased on the private market. For example, suppose you wanted to purchase
insurance against the possibility of becoming poor. Would a firm in a competitive market
ever find it profitable to supply “poverty insurance”? The answer is no, because if you
purchased such insurance, you might decide not to work very hard. To discourage such
behaviour, the insurance firm would have to monitor your behavior to determine whether
your low income was due to bad luck or to goofing off. However, to perform such
monitoring would be very difficult or impossible. Hence, there is no market for poverty
insurance – it simply cannot be purchased.
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Basically, the problem here is one of asymmetric information – one party in a transaction
has information that is not available to another. One rationalization for governmental
income support programs is that they provide poverty insurance that is unavailable
privately. The premium on this “insurance policy” is the taxes you pay when you are able
to earn income. In the event of poverty, your benefit comes in the form of welfare
payments.
Another type of inefficiency that may arise due to the nonexistence of a market is an
externality, a situation in which one person‟s behaviour affects the welfare of another in a
way that is outside existing markets. For example, suppose your roommate begins
smoking large cigars, polluting the air and making you worse off. Why is this efficiency
problem? Your roommate uses up a scarce resource, clean air, when he smokes cigars.
However, there is no market for clean air that forces him to pay for it. In effect, he pays a
price of zero for the clean air and therefore “overuses” it. The price system is failing to
provide correct signals about the opportunity cost of a commodity.
Externalities have a simple interpretation in the analysis of welfare economics. In the
derivation of Equation (1.9), it was implicitly assumed that marginal cost meant social
marginal cost – it embodied the incremental value of all of society‟s resource used in
production. In the example above, however, your roommate‟s private marginal cost of
smoking is less than the social marginal cost because he does not have to pay for the
clan air he uses. The price of a cigar, which reflects its private marginal cost, is not
correctly reflecting its social marginal cost. Hence, Equation (1.9) is not satisfied, and the
allocation of resources is inefficient. Incidentally, an externality can be positive – confer a
benefit – as well as negative. Think of a molecular biologist who publishes a paper about
a novel gene-splicing technique that can be used by a pharmaceutical firm. In the case
of a positive externality, the amount of the beneficial activity generated by the market is
inefficiently small.
Closely related to an externality is the case of a public good, a commodity that is nonrival
in consumption – the fact that one person consumes it does not prevent anyone else from
doing well. The classic example of a public good is lighthouse. When the lighthouse turns
on its beacon, all the ships in the vicinity benefit. The fact that one person takes
advantage of the lighthouse‟s services does not keep anyone else from doing so
simultaneously.
In using the lighthouse, people may have an incentive to hide their true preferences.
Suppose it would be worthwhile to me to have the lighthouse operate. I know, however,
that once the beacon is lit, I can enjoy its services, whether I pay for them or not.
Therefore, I may claim the lighthouse means nothing to me, hoping that I can get a “free
ride” after other people pay for it. Unfortunately, everyone has the same incentive, so the
lighthouse may not get built, even though its construction could be very beneficial. The
market mechanism may fail to force people to reveal their preferences for public goods,
and possibly result in insufficient resources being devoted to them. Private markets often
under provide nonexcludable public goods because individuals have the incentive to
“free ride” -- not pay for the benefits they receive from consuming the public good.
Public Goods have two distinct characteristics:

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 Non-rivalry: several individuals can consume the same good without diminishing its
value and individual demand curves are summed vertically to get the aggregate
demand curve for the public good. Where as for Private goods => individual demands
are summed horizontally.
 Non-excludability: an individual cannot be prevented from consuming the good.
Deriving Aggregate Demand for Private Good

Why Private Goods Are Summed Horizontally?

 Exclusive: once you buy it, you own it and can consume it as you want.
 Rival: A good taken off the shelf isn‟t there for other people to consume.
Deriving Aggregate Demand for Public Good
(Recreational Demand for Water Quality at Wanci Lake)

Heterogeneity, Non-Rivalry and Market Failure

Consider Two Goods with Identical Aggregate Demand:
The first good is a private good, (Chicken Sandwiches) and the second good is a public
good, (Water Quality at Wanci Lake)

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Private good public good
Price price

Dt
D1 D2 Dt
P* P=MC D2 MC
D1
P1

Q1 Q2 Q1+Q2 Quantity Q2 Q* Quantity

Private Good: market price is an efficient mechanism.
 Equilibrium price of a chicken sandwich is P=MC when consumer1 eats Q1 sandwiches;
consumer2 eats Q2 (total revenue paid by each is shown by the shaded regions.)
Public Good: market price is not efficient mechanism
 Equilibrium price cannot be P=MC. consumer1 would not pay for any water quality
improvements and consumer2 would pay for only Q2 where as Q2 < Q*, the efficient
level of water quality would not be met. If Q* is provided and each consumer pays his
marginal value. (total revenue paid by each is shown by the shaded regions)

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Optimal Provision of a Nonexcludable Public Good, the Free-Rider Problem, and Market Failure

D1 = Demand of one individual for public good X.

D2 = Total Demand of two individuals for public good X.
D3 = Total Demand of three individuals for public good X.
D4 = Total Demand of four individuals for public good X.
MC= Marginal cost of providing the public good X.
 Socially-optimal level of public good X with four consumers is X4. if individual1
decides to purchase (and the others free ride), the private market will provide a
level of the public good equal to X1(where MB1 equals MC of provision)
The Socially-Optimal Provision of a Public Good
X = level of provision of a public good and n = number of homogeneous individuals
in a society, then (Inverse) demand of one individual: Di(X) = a - bX.
(Inverse) demand of n individuals ("aggregate demand"):
Dn(X) = n (a - bX) = na – nbX.
(Inverse) Supply): MC(X) = c + d X
The socially-optimal level of provision of X occurs where MRn(X) = MC(X) or the difference between
TBn(X) and TC (X) is maximized:

The FOC for this problem is:

Solving the FOC for X:

Private Market Outcome for Non-excludable Public Goods

Private providers will provide public goods where the marginal benefit of one individual (the other
individuals‟ free ride) equals the marginal cost of providing the public good

The FOC for this problem is:

=
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Solving for the level of the public good provided by the private market:
Note that (the private market under-provides the public good)

Mechanisms for Providing the Socially-Optimal Level of Public Goods:

 Civic responsibility, volunteerism, and donations. E.g. volunteer fire departments, donations to the arts
 Private provision of excludable public goods. E.g. movies, music concerts
 Public provision of excludable public goods through the use of entrance fees. E.g. entrance fees for a
National Park.
 Public provision of nonexcludable public goods through the use of general government tax revenues.
E.g. taxes earmarked for National Defense.
 Religious Beliefs. e.g. collection basket is passed around for donations
Gov't Provision of Non-Excludable Public Goods through Taxes
Public financing of public goods may be the only option in cases where the public good is non-excludable
and, therefore, entry fees cannot be charged.
 National Defense
 Public Education
 Social Welfare Programs.
The Governments‟ problem
 There is only one public good
 Gov‟t seeks to provide the public good in a budget balancing, or revenue-neutral manner.
If there are „n‟ individuals in the society, then:
Total Tax = TC(X*) = , so that the tax per individual = TC(X*)/n.
Congestion Costs in Public Goods Models
 congestion costs: an increasing number of users can reduce the benefits to each individual
Negative congestion externalities
The benefits to each viewer of a scenic vista may be reduced if the overlook site becomes crowded
Positive congestion externalities
“Information highway”: When the first individual subscribes to email, the value of the service is equal to
zero, since there is no one out there to send messages to. As subscription to the service increases, however,
the value of email increases due to the positive congestion externality.
X is the level of provision of a public good, N is the number of people consuming the public good and Bi(X,
N) is the benefit to individual i from the public good at a level of X when N individuals are using the public
good the existence of congestion costs implies that: dBi/dN < 0 benefit to an individual of consuming the
public good decreases as the number of individuals consuming the public good increases. Consider the
following functional form:
Bi(X, N) = a+ bX- cX2, where the parameters a, b, c > 0.
N
When we maximize Benefits with respect to N, we find that:
dBi = - (a+ bX- cX2), the expression is negative => a negative congestion externality
dN N2

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CHAPTER – THREE
PUBLIC EXPENDITURE
3.1. Meaning and importance of public expenditure
Public expenditure refers to the expenses which the government incurs for its own maintenance
and/or for the society and the economy as a whole. In reality, Public expenditure is incurred by
public authorities: Central, State and local governments either for the satisfaction of
collective needs of the citizens or for promoting their economic and social welfare since the
problems of labor exploitation, economic and social injustice etc, assumed serious proportions
and would not be ignored.
It is incurred by the government for the attainment of public good. Every government has
to maintain law and order, armed forces for providing protection, public parks, schools,
health of the people. Government has to perform certain other welfare measures like maternity
protection, arranging for cheap food, cloth and low-cost housing for the poor and so on.
All these multifarious activities which are increasing every year require huge funds. Therefore
public expenditure, deals with the expenditure which a government incur for its own
maintenance, the society and the economy and helping other countries.
Objectives of public expenditure
 Security of life against the external aggression, internal disorder and injustice.
 Development or up gradation of social life in the community.
3.2. Kinds of public expenditure
Technically, most governments classify public expenditure into two:
 Recurrent expenditure and capital expenditure
All sorts of administrative and defense expenditure and debt services are called current
expenditure. They are also referred to as non-developmental expenditure. They are intended
for continuing the existing flow of goods and services and maintaining the capital of the
country intact. On the other hand, capital expenditures contribute to increased productive
capacity of the nation and therefore, are known as development expenditure. Expenditures
on construction of dams, public works, state enterprises, agricultural and industrial
development etc., are instances o f capital expenditure.
 Productive and Unproductive Expenditures
This distinction emphasizes that while some expenditure is in the nature of consumption; others are
in the nature of investment and help the economy in improving its productive capacity. Under the
laissez-faire philosophy, the only productive public expenditures are those which are incurred to
create and maintain social overheads. Expenditures on administration, defense, justice, law and
order, and maintenance of the State are unproductive.
 Transfer and Non-transfer Expenditures,
This classification was favoured by Pigou. Transfer expenditure is a payment without corresponding
receipt of goods and services by the State. Examples are interest payments, old-age pensions and
unemployment benefits. In these cases, the government is simply transferring the right or claim to
use the goods and services to certain sections of the society. In contrast, non-transfer expenditure
is that by which the State pays for its purchases or use of goods and services. While in the case of
transfer expenditure, the beneficiaries are to decide about the use of real resources, in the case
of non-transfer expenditure, it is the State which uses the resources straightaway. Such a use of
resources by the State, of course, may be for consumption purposes or for investment purposes.
Expenditure on defense, education and such and such things are of non-transfer or real
expenditure type as are the investment expenditures.

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Though public expenditure is a means of maintaining the capital of the country intact, it is
not merely a financial mechanism, it is rather a means of securing social objectives.
Socialism can be realized only through progressive taxation and their distribution afterwards.
Therefore, public expenditure is that expenditure incurred by the public authorities i.e.
Central, State and Local Governments, to satisfy those common wants which the people in
their individual capacity are unable to satisfy efficiency wants.
3.3. Reasons for growing of the expenditure
Q. Why government made expenditure for the acquisitions of some goods and services
irrespective of who produce and supply them to the market?
Some of the basic causes of ever-increasing public expenditure have been mentioned in the
theories associated with the issue. Among some of them are:
i. Population growth. The growth in the number of population has been a major cause of the
continuous rise in public expenditure since the responsibility of government relating to public
services has been multiplied.
ii. Increasing urbanization. As the rural areas cannot subsist the growing population, there is a
continuous rush to the urban areas. The size of cities is becoming larger and larger, government
responsible by increasing expenditure on water supply, electricity, construction and
maintenance of hospitals, schools and other public services.
iii. Provision of economic overheads. Without the creation and maintenance of economic
overhead facilities, no country can develop. These facilities like provision of a good system of
transport and communication, generation of electric power, etc. require heavy investment of
capital which does not flow from private sector sources.
iv. Maintenance of law and order. Along with the growth of population, urbanization and
complexities of modern economic and sociopolitical life, law and order problems have also
multiplied. The government responsibilities of internal protection of people from breach of
peace by antisocial elements have gradually become multi-sided requiring government
expenditure of more and more funds.
v. Welfare activities. Previously, public expenditure was limited by only a few functions of
government, viz, the defense, maintenance of law and order and administration. But,
presently, the countries have emerged as modern welfare states where the greatest good of
the greatest number is the main objective of statehood. The government now has to assume
such responsibilities as family and child welfare, social security like old age pension,
unemployment benefit, sickness benefit, etc. housing for the poor, welfare of handicapped
and backward classes, rehabilitation of displaced persons, subsidy on food and production
inputs, etc. Public expenditure on welfare programmes has, therefore, become tremendous
with the passage of time.
vi. Provision of public goods and utility services. Public goods are those that are consumed
equally by all such as Defense and police services, justice, roads, irrigation and flood control
projects, public parks, etc. They involve huge investment and have to be provided by the
government. Moreover, there has been a growing trend of public utility services like railways
and other transport services, postal, telegraph and telephone services, electricity services, etc.
coming under the government sector. They all involve heavy expenditure on installation and
maintenance.
vii. Servicing of public debt. A substantial part of the huge expenditure program of government is
met from public borrowings. This is because resources cannot be mobilized from taxation
beyond a limit. Hence, modern states incur considerable internal and external public debt.
The repayment of debt and obligation to pay service charges become huge.

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viii. International obligation. Finally, the modern states have to maintain many international socio-
political and economic links. They have to maintain diplomatic relations, economic links with
international institutions like IBRD (the International Bank for Reconstruction and Development),
IMF, etc. Socio-cultural and academic exchange relations, linkage with development programs
of the type of economic co-operation, gifts and donations, regional economic integration and
membership of other international organization like UNO, UNDP, UNICEF, etc – all these involve a
considerable amount of public expenditure.
ix. Growth of Democracy: Growth of democracy has been responsible for the increasing
tendency of public expenditure to a great extent to achieve the goodwill o f the public,
when the ruling party has to incur heavy expenditure on providing variety of services and
facilities to the public. Expenditure on elections and by elections is increasing every year.
Number of ministries and executive offices has also been increased. As a result of this the
public expenditure increases rapidly.
3.4. Public Expenditure: Canons, Theories and Accountability
3.4.1. Canons of Public Expenditure
Findlay Shirras suggests that public expenditure should be beneficial to society while incurred
economically and should not be wasteful. Other economists have added a few more guidelines.
Taking all of them into consideration, the following will be the canons of public expenditure.
i. Canon of Benefit. Public expenditure should be planned and implemented as to bring about
the greatest possible benefit to society. This means that all the expenditures which do not bring
benefit to society should be avoided. This canon also points to the need of undertaking a cost-
benefit analysis of the competing schemes of public expenditure before the final selection of
investment project is made.
ii. Canon of economy. Public expenditure should be incurred carefully so that there is no wastage
of funds. Most important reasons of wasteful expenditure are faulty planning, faulty execution,
corrupt practice and delay due to time lag between plan and execution and, hence,
escalation of prices. These types of wastage have to be avoided at any cost. It must be noted
here that benefit to society cannot come without proper pursuit of the canon of economy.
iii. Canon of surplus. This canon requires that expenditure of public authorities should be kept
within the limits of current revenues. If possible, the expenditure should be less than the earnings
of government so that the surplus so generated can be used when there is unavoidable deficit.
This canon is important reminder of the fact that the government should not overspend and run
into debts and that a deficit spending should be avoided as far as possible.
iv. Canon of sanction. This canon requires that the public authorities should not be allowed to
spend funds without having a previous approval from appropriate authority for the purpose. It
also requires that funds sanctioned for a particular expenditure should not be diverted to a
different purpose and spent thereon.
v. Canon of elasticity. Canon of elasticity requires that the rules of public expenditure should not
be too rigid to achieve the real purpose and that it should be allowed to vary according to the
needs and circumstances.
vi. Canon of certainty. This canon requires that public authorities should clearly know the purpose
and extent of public expenditure. The spending unit should be certain as to the amount and
objective of public expenditure. This requires a proper expenditure plan well thought-out
beforehand.
vii. Canon of Productivity: This principle implies that the expenditure policy of the
Governments should encourage production in a country. That means a large part of public
expenditure must be allocated for development purpose.

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viii. Canon of Equity: One of the foremost aims of public expenditure is to ensure the just and
equitable distribution of income for the countries where the gap between the highest
income and the lowest income groups is very wide.
3.4.2. Theories of Public Expenditure
There are two important and well-known theories of increasing public expenditure: Wagner Law
of Increasing State Activities and the other Wiseman and Peacock hypothesis. To discuss about
theories of Public expenditure, let‟s try to differentiate the two important terms; viz, public
expenditure and private expenditure
With regard to similarities both private units and public authorities try to maximize returns per unit
of expenditure (the returns being the objectives to be achieved), both private economic units
and public authorities take a collective view of the income, expenditure and the possibilities of
adjustments in each. Any shortfall on this front will be on account of inefficiency, uncertainty,
lack of foresight and similar other causes
Though private and public expenditures are similar in their overall and complex ramifications,
the dissimilarities between them are also quite glaring. The first dissimilarity is the objective with
which the expenditure is incurred. . In the case of an individual economic unit, generally an
exchange relationship determines the mode, pattern and volume of expenditure. As a
consumer, an individual equates the marginal utility of the good (or service) purchased with the
disutility of expenditure. A commercial economic unit compares private marginal returns from
expenditure with the amount spent. Public authorities, however, cannot and do not always
adopt a commercial attitude towards their expenditure plans. They have to consider social
benefits generated in the process of their expenditure activities. And, in quite a few cases these
benefits are vague and immeasurable. The State has to impute social valuation to these benefits
and decide whether it is worthwhile undertaking these expenditures or not. Also, certain State
expenditures are directed at bringing about social and economic justice. The benefits of such
State expenditures cannot be evaluated directly.
1. Wagner's Law of Increasing State Activities
Adolph Wagner (1835-1917) was a German economist who set his Law of Increasing State
Activities based on historical facts, primarily of Germany. According to Wagner, there are inherent
tendencies for the activities of different layers of a government (such as central and state
governments) to increase both intensively and extensively. There is a functional relationship
between the growth of an economy and government activities with the result that the
governmental sector grows faster than the economy. From the original version of this theory it is
not clear whether Wagner was referring to an increase in (a) absolute level of public expenditure,
(b) the ratio of government expenditure to GNP, or (c) proportion of public sector in the total
economy. All kinds of governments, irrespective of their levels (say, the central or state
governments), intentions (peaceful or warlike), and size, etc., had exhibited the same tendency of
increasing public expenditure.
A number of reasons can be enumerated for this inherent long-term tendency recorded in
history.
Firstly, we can mention an expansion in the traditional functions of the State. Defense became
increasingly more expensive over time. Within the country, administrative set kept increasing both
in coverage and intensity. The government machinery had to be manned by experts in their fields.
With the progress of society, administration of the government and its services had to become
increasingly more extensive, bulky and expensive so as to' retain efficiency.
Secondly, the State activities were increasing in their coverage. Traditionally, they were limited to
only defense, justice, law and order maintenance of the State and social overheads. But with

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growing awareness of its responsibilities to the society, the government started expanding its
activities in till now unexplored field of socio-economic' welfare. These measures included efforts
to enrich cultural life of the society and provision of social security to the people (such as old age
pensions and so on). Subsidies for and direct provision of various merit goods also registered an
increase. Most governments also took active steps to ensure distributive justice by reducing
income and wealth inequalities.
Thirdly, the need to provide and expand the sphere of public goods received an increasing
attention. The state tried to shift the composition of national produce in favour of public goods
and this in turn necessitated an expansion of investment activity of the government.
Wagner's Law was based upon historical facts. It did not reveal the inner compulsions under
which a government has to increase its activities and public expenditure as time passes. It was
applicable only to modern progressive governments which were interested in expanding public
sector of the economy for its overall benefit. This general tendency of expanding State activities
had a definite long-term trend, though in the short-run, financial difficulties could come in its
way. "But in the long-run the desire for development of a progressive people will always
overcome these financial difficulties.”
Thus, Wagner was emphasizing long-term trend rather than short-term changes in public
expenditure. Moreover, he was not concerned with the mechanism of increase in public
expenditure. Since his study is based on the historical experience, the precise quantitative
relationship between the extent of increase in public expenditure and time taken by it was not
fixed in any logical or functional manner. His argument that public expenditure had been
increasing over time could not be used to predict its rate 0f increase in future. Actually, it is
consistent with Wagner's law to state that in future the State expenditure would increase at a
rate slower than the national income. Thus, in the initial stages of economic growth, the State
finds that it has to expand its activities quite fast in several fields like education, health, civic
amenities, transport, communications, and so on. But when the initial deficiency is removed, then
the increase in State activities may be slowed down.
Additional factors which contribute to the tendency of increasing public expenditure relate to a
growing role of the State in ever-increasing socio-economic complexities of modern society.
(i) Many societies are experiencing a growing population which becomes a major
contributory factor in the growth of public expenditure. The sheer scale of state' services
has to' increase to keep pace with population growth, including, for example, more
schools, hospitals, and police, etc ..
(ii) Most countries have registered increasing urbanization. Existing cities grow and new ones
come up. Urbanisation implies a much larger per capita expenditure on civic amenities. It
necessitates a much larger supply of incidental services like those connected with traffic,
roads, and so.
(iii) Prices have a secular tendency to go up. This also adds to public expenditure even if the
scale of state services remains unchanged.
(iv) The size and nature of public services necessitates an ever increasing specialization. The
quality of the services improves, both as a historical fact as also due to circumstantial
compulsions. Better quality services and higher qualified administrators, technicians etc.,
imply a higher cost of providing public services. Also, the government has to purchase a
number of goods and services for its own maintenance. With rising prices, expenditure on
them also goes up.
(v) A modern government considers it a part of its duty to protect the economy from the
"failures" of market mechanism. Accordingly, anti-cyclical and other regulatory measures

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 Ambo University Woliso Campus SoBE Department of Economics
are adopted. Efforts are made to reduce the income and wealth inequalities and bring
about social and economic justice which in turn adds to public expenditure.
(vi) Modern governments have shown a tendency to run into debt and this leads to a
subsequent increase in public expenditure in the form of increasing cost of debt servicing
and repayment of the loans.
(vii) Popularity of the philosophy of planning and economic growth as also increasing
government activities in the areas of capital accumulation and economic growth have
also contributed to the growth of public sector.
(viii) Musgrave emphasize growing complementarities between public and private consumer
and capital goods so that with an increase in per capita income, demand for public
services also increases with a corresponding growth in public expenditure.
(ix) There is an inherent tendency of vested interests to develop which demand an increase
in public expenditure for their own benefit. For this reason, a variety of subsidies and other
avoidable expenditures inflate the public budget.
(x) It is claimed that government bureaucracy has an inherent tendency to expand
irrespective of the size and nature of public services provided by it
(xi) Recent investigations have brought into focus productivity and efficiency dimensions of
government organs and public undertakings as also the manner in which these dimensions
push up public expenditure. Specific mention may be made of the concepts of
"productivity lag" advanced by Allan Peacocks and Baumol’s Disease. According to these
concepts, public sector is less efficient and productive than the private one, and tends to
be more labour-intensive (or over-staffed). Similarly, an element of avoidable inefficiency
and therefore cost (termed X-inefficiency) creeps in due to poor supervision, non-fixation of
responsibility, non-check on output of individual employees and non-quantification of
government services.
(xii) At the same time, there is a myth that the individuals can voluntarily get together to resolve
market deficiencies without government intervention which is known as Coase Fallacy. The
myth is explained by: Fundamental Non-Decentralizability Theorem expounded by B.
Greenland and J. Stiglitz.
Wagner's model has an important analytical limitation which can be removed in an expanded
version. A government is not a monolithic entity. It comprises a number of organs and associated
institutions. Households and business units in the private sector also don‟t observe government
activities passively. Instead, they respond to them more actively. Thus, the government decision-
making has become a complex phenomenon and has multifarious tendencies to increase public
expenditure.
Buchanan and Tullock, in context of US experience, have viewed Wagner's theory in terms of
increasing discrepancy between growth of government expenditure and output and termed the
phenomenon as "Wagner Squared" hypothesis. They base their argument on two facts.
Firstly, in contrast with the situation prevailing in the private sector, expenditure on civil servants
grows faster than the corresponding increase in their output.
Secondly, with increasing social security and other measures, the proportion of population
receiving transfer payments from authorities keeps increasing. This way public expenditure
increases both in absolute terms and as a proportion of national income. It may be noted that
even if the expenditure on civil services as a proportion of expenditure on employees in the
private sector does not increase, and even if the proportion of population receiving transfer
payments remains stable, the Wagner Squared hypothesis would hold. The major limitation of this
hypothesis is that output of public servants cannot be measured with any degree of accuracy.

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Alan Tait Peacock does not agree with this explanation of Buchanan and Tullock. He says that a
typical .individual does not relate his tax payments with the receipt of government services .He
considers his tax liabilities as they are and strives for additional public services; that is, he fights for
additional opportunities for milking government services and not for reducing taxes. The
politicians, to win their votes try to expand government services and, therefore, impose more
taxes. The government expenditure keeps on increasing without any reference to
productivity/cost ratio of government services.
We may add that modern governments have found new weapons whereby to increase their
expenditure even without collecting more taxes. They now own public undertakings which can
be a source of revenue to them. But, more important than that is their capacity and willingness to
resort to deficit financing. Even in advanced countries deficit financing has become a common
occurrence. The public opinion is not strong enough to check this sort of policy even though it has
disastrous inflationary effects.
2. Wiseman-Peacock Hypothesis
The second thesis dealing with the growth of public expenditure was put forth by Wiseman and
Peacock in their study of public expenditure in UK for the period 1890-1955. The main thesis of the
authors is that public expenditure does not increase in a smooth and continuous manner, but in
jerks or step like fashion. At times, some social or other disturbance takes place, creating a need
for increased public expenditure which the existing public revenue cannot meet. While earlier,
due to an insufficient pressure for public expenditure, the revenue constraint was dominating and
restraining an expansion in public expenditure, now under changed requirements such a restraint
gives way.
The public expenditure increases and makes the inadequacy of the present revenue quite clear
to every one. The movement from the older level of expenditure and taxation to a new and
higher level is the displacement effect. The inadequacy of the revenue as compared with the
required public expenditure creates an inspection effect. The government and the people review
the revenue position and the need to find a solution of the important problems that have come
up and agree to the required adjustments to finance the increased expenditure. They attain a
new level of tax tolerance. They are now ready to tolerate a greater burden of taxation and as a
result the general level of expenditure and revenue goes up. In this way, the public expenditure
and revenue get stabilized at a new level till another disturbance occurs to cause a displacement
effect. Thus, each major disturbance leads to the government assuming a larger proportion of the
total national economic activity. In other words, there is a concentration effect. The
concentration effect also refers to the apparent tendency for central government economic
activity to grow faster than that of the state and local level governments. Moreover, this aspect of
concentration effect is also closely connected with the political set up of the country.
On the face of it, Wiseman Peacock hypothesis looks quite convincing. But, we must remember
that they are emphasizing the recurrence of abnormal situations which cause sizeable jumps in
public expenditure and revenue. In all fairness to the historical facts, we must not forget that on
account of advancement of the economy and the structural changes therein, there are constant
and regular increments in public expenditure and revenue. Public expenditure has a tendency to
grow on account of a systematic expansion of the public activities as also an increase in their
intensity and quality. Increasing population urbanization and an ever-increasing awareness of the
civic rights on the part of the public, coupled with an increasing awareness of its duties on the
part of the State, leads to an upward movement of public expenditure. To an extent public
expenditure gets financed by ever-increasing revenue which is made possible through the
expansion and structural changes in the economy.

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 Ambo University Woliso Campus SoBE Department of Economics
These days, in underdeveloped countries like Ethiopia, the State is deliberately trying to increase its
activities and makes an effort to finance those activities through various tax efforts. Even in
developed countries, the State finds that it has to perform an increasing regulatory duty to protect
the economy against instability and excessive inequalities of income and wealth. Thus, Wiseman
Peacock hypothesis is still a description of a particular tendency and does not isolate all the
relevant causes at work.
It must be emphasized that apart from various factors like population growth, defense
expenditure, urbanization, rising prices etc., which by themselves pushup public expenditure, an
important additional contributory force is the failure of market mechanism in achieving various
socioeconomic objectives of the country. Inherent deficiencies of market mechanism make the
economy a prey of economic instability, income and wealth inequalities, defective patterns of
consumption, employment and investment and so on. In a number of cases, the market
mechanism is not able to pull the economy out of its vicious circle of poverty and launch it on a
path of secular and rapid economic growth. Therefore: the government is forced to increase its
field of activities with a corresponding increase in public expenditure.
3. Bowen's Model of Public Expenditure
Since social goods, by definition, are those goods and services which are consumed equally by
all, the cost of supplying them have to be contributed by all beneficiaries. However, every user
cannot be asked to contribute equal amount in meeting the cost of social goods because
different individuals will derive different amounts of satisfaction. Since social goods benefit
everyone, the amounts of benefit derived by different individuals are like joint products. Hence, it
is the joint contribution of all individuals that has to meet the cost of supplying social goods.
It must be noted that each individual will pay an amount equal to the marginal valuation he
attaches to the social good, i.e. the public park services. This follows from rules of economic
efficiency. Since the capacity to enjoy benefit of the public park, as in case of anything else, is
different for different persons, they will attach different marginal valuation to the benefit and will
contribute different amounts for the consumption of the same public good. How much amount of
social goods is to be supplied by the public authority will be determined at that level where
marginal cost of supplying the social goods becomes equal to the sum of marginal utilities
received by the beneficiaries. Assuming that there are only two individuals in society, viz., A and B
and only one type of public goods, called X, the following condition will hold for the
determination of public expenditure or, what it means the same thing, the amount of social
goods to be supplied by the government.
MUA + MUB= MCx Or PxA + PxB = MCx, Hence, TCx = QPxA + QPxB,
where MU stands for marginal utility derived from social goods, MC stands for marginal cost of
supplying social goods, A and B are consumers, X stands for the social good supplied, P stands for
price to be paid by the consumer, Q indicates quantity of social goods and TC stands for total
cost of supplying the quantity.
Bowen's model of determining public expenditure may be explained by the below figure where
units of social goods are measured along horizontal axis and the combined unit price including
the contributions of both A and B is measured in the vertical axis.
The demand schedules for social goods of A and B are shown by the lines aa and bb respectively.
The line tt shows the aggregate demand schedule of both A and B. Let SS be the supply schedule
of social goods which are assumed to be produced under conditions of increasing cost. Since the
same amount of social good will be consumed by both A and B, the aggregate demand
schedule, tt is made up of vertical addition of aa and bb.

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 Ambo University Woliso Campus SoBE Department of Economics

Figure 4.4: Bowen Model

The equilibrium output will be determined at OQ because it is at this level of production that
the aggregate demand schedule and aggregate supply schedule intersect at point P, where
the equilibrium price will be PQ. This is the combined unit price which will be contributed by
both A and B. Of the unit price PQ, A contributes QR and B contributes QN, their respective
demand prices. If the output is less than this, say, OC, the demand price or the combined
contribution will be much larger (CG) than the supply price (CE). Since the combined offer
price exceeds the unit cost, this will lead to increase in supply of social goods. If, on the other
hand, supply is more than OQ, say, OD, the unit cost (DK) exceeds the combined offer price
(DL). This will lead to reduction in supply of social goods. In this way, equilibrium output is
established at OQ.
At OQ level of output, the marginal cost of supplying social goods is PQ which is equal to the
sum of QN and QR, the marginal utility to B and A respectively. The total cost of supplying OQ
amount of social good equals OQPU which is covered by A's contribution OQRV plus B's
contribution OQNW since OQRV + OQNW = OQPU.
4. Samuelson's Benefit theory of Public Expenditure
The most recent benefit theory of Public expenditure comes from Samuelson as a critique of the
voluntary exchange model of Erik Lindahl. The voluntary exchange principle has a partial
equilibrium approach in which satisfaction of social wants is considered independently of private
wants. Samuelson considers it an inadequate explanation and thinks that the problem must be
restated in terms of general equilibrium. This is what he has done in his theory of public
expenditure. In his general equilibrium approach to optimal allocation of public and private
goods, Samuelson takes unto account both the allocation and distribution aspects to build up a
unified system.
Application of market principle to the pricing of social goods to determine optimum allocation of
resources becomes the starting point of Samuelson's theory. In the case of a private good,
marginal utility and marginal cost are equal for all consumers. Since utility schedules of individuals
are different, such equality and hence efficient level of output will be attained with different
consumers consuming different amounts of output at the same price. It follows that the
aggregate demand schedule will be the horizontal summation of individual demand schedules.
However, in the case of public goods which are consumed equally by all, different individuals will
pay different prices for the same quantity of output. Here the sum of marginal utilities to
consumers will be equal to the marginal cost. It follows that the individual demand schedules will
be vertically added in this case. Thus under such circumstances, “even if all preferences are
revealed, there is no single best solution analogous to the pareto optimum in the satisfaction of
purely private wants. Instead, we are confronted with large number of solutions, all of which are
optimal in the Pareto sense.”
5. Musgrave's Optimum Budget Theory
The Optimum Budget theory of Musgrave seeking to determine the optimum amount of public
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expenditure is a normative approach to budget policy. Musgrave built up an ideal theory
according to which a budget should realize three objectives, viz, proper allocation of resources,
proper distribution of income, and price level stability with full employment. For each of three
objectives, Musgrave would consider a sub-budget. When these three sub-budgets are prepared
according to their objectives, they will be consolidated into a single whole budget plan.
The optimum budget theory seeks to achieve the purpose of allocation branch of the budget.
Musgrave's theory of determination of optimum public expenditure in the allocation branch of the
budget is based on benefit approach. The people have a choice pattern or preference schedule
between public goods, private goods and leisure. Leisure is a component of welfare because
leisure can be transformed into production of goods and services of earnings of income.
Optimum budget theory seeks to allocate public expenditure or provide for public goods in such
a manner and, to that extent, whereby the community, as a whole, is able to derive the greatest
attainable satisfaction. This is possible when allocation of public expenditure in different lines of
state activity is so determined in the budget that the community is able to reach the highest
possible indifference surface as between public goods, private goods and leisure.
Practical difficulty, however, lies in the fact that the people cannot be made to reveal their
preference pattern and that it is difficult, if not impossible, to construct community indifference
surface from individual indifference patterns.
3.4.3. Control and Accountability of Public Expenditure
The necessity to control public expenditure in order to check misuse of public funds and ensure
their efficient utilization is only obvious. Control does not necessarily mean reduction. “It means
that expenditures are justified in terms of the whole welfare of society and in terms of the financial
means at the disposal of government. Control implies that expenditures are economic by which
we mean that resources not unlimited in quantity are devoted to their most productive uses.”
Control of public expenditure is sought to be ensured multi-dimensionally at a number of stages.
The most important means of control are (a) budgetary control (b) legislative control, (c)
executive control, (d) audit control, and (e) parliamentary control.
(a) Budgetary Control. Budget preparation is the most primary stage of expenditure control.
Budget is a well thought-out plan of governmental activities during the coming year and speaks
of much more than a mere statement of income and expenditure of public authorities. It specifies
the functions and objects of public expenditure. How much of the public funds is to be spent for
which particular purpose, and which particular department, what should be attainment of
physical targets against the specific expenditure amount and what should be the allocation of
funds for the use of a particular department are all specified in the budget frame. The budget
also presents a comparable picture of the revenue earnings and expenditure of the outgoing
year along with the estimates of such financial operation for the coming year. The difference
between the two, if any, has to be convincingly explained. Hence, a budgetary exercise of this
kind serves as a control of public expenditure in many ways. In recent years, the practice of
breaking up of public expenditure in terms of major heads, minor heads and sub-heads has
provided added means of controlling expenditure.
(b) Legislative Control. After the budget plan is prepared, it has to be presented in the legislature
for its approval. There occurs debate in the legislature where the members seek clarification and
justification of expenditure programmes. After critical study of the budget plan, expenditures
estimated originally may be curtailed or enhanced or kept unchanged according to the merit of
the case. When the legislature is satisfied, it gives approval to the budget plan. During the
legislative scrutiny of the budget, the details of expenditure, department-wise and ministry-wise
are discussed. Thus, it is a very important stage of expenditure control.

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(c) Administrative Control. The rules and regulations ensure that no amount is spent without
proper sanction or diverted to some other purpose for which it is not sanctioned. There is
elaborate body of rules to fix responsibility on specific executive personnel for the funds spent. The
rules ensure that there is no fraud or misuse or misappropriation or any other kind of leakage
during the execution of public expenditure programmes. It is not only that the government official
through whom is the public fund directly spent in the project work is responsible to his head of the
department but also that the latter is responsible to higher authority.
(d) Audit Control. The next stage is examination of accounts and audit control. There is the system
of both internal and external audit. Every department has its accounts section which scrutinizes all
accounts of expenditure and ensures that public funds are spent according to rules of propriety,
economy and efficient utilization.
However, audit reports are less than vocal relating to efficiency of public expenditure. This
shortcoming is sought to be removed through economic and functional classification of public
expenditure and practice of performance and program budgeting which have an in-built
mechanism to ensure efficient use of public funds.
(e) Parliamentary Control. The last of these stages of expenditure control is the parliamentary right
to enquire into any particular item of expenditure deal. There are two committees constituted by
the parliament to go into such scrutiny. They are (i) Public Accounts Committee and (ii) the
Estimates Committee. Public accounts committee is entrusted with the responsibility of examining
audit reports and appropriation accounts. They also examine profit and loss accounts of
government undertakings and autonomous bodies. They follow up cases of impropriety,
unauthorized and illegal expenditure, misuse and misappropriation and go into further
investigation if necessary. Estimates committee locks into the financial operation of the executive
and suggests measures to achieve maximum economy of expenditure consistent with maximum
efficiency. The parliamentary committees pinpoint the erring officials, examine them and suggest
follow-up measures for suitable punishment to them.
3.5. Effects of Public Expenditure
Public expenditure, in modern government finance, is regarded as a means of securing
social ends rather than just being a mere financial mechanism. Public expenditure is
significant in a modern economy because it produces many direct and indirect socio-
economic effects. A brief account of these effects may be given as under:
i. Effects of public expenditure on production and Employment
The expenditure of the central Government on development is meant to promote production
and employment in the country. Expenditure on agriculture and allied activities, industries and
minerals, water and power development, transport and communication and other expenditures
on community and social development by the central and State Governments help directly to
raise the level of production and employment in the country. Further, the enormous expansion in
expenditure by the central and State Governments is to boost demand for goods and services
and thus to boost production. The level of production and the level of employment in any country
depend upon three factors, viz,
(a) Ability to Work, Save and Invest. If public expenditure can increase the efficiency of a person
to work, it will promote production and national income. Public expenditure on education,
medical services, cheap housing facilities and recreational facilities will increase the efficiency
of persons to work. At the same time, public expenditure can promote income of the people.
Finally, public expenditure, particularly repayment of public debt, will place additional funds at
the disposal of those who can invest. Thus, it will be seen that public expenditure can promote
ability to work, save and invest and thus promote production and employment.

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 Ambo University Woliso Campus SoBE Department of Economics
(b) Willingness to Work, Save and Invest. The effects of public expenditure on the willingness-as
different from ability to work and save and invest on production are not clear enough.
Pensions, interest on loans, provident fund and other government payments provide security
and safety to a person, and therefore, reduce the willingness of persons to work and save; why
should a person work hard and save when he knows well that he will be looked after by the
government when he is not in a position to earn an income?
(c) Diversion of Economic Resources. Public expenditure has far-reaching effects on the utilization
of economic resources as between alternative uses. Public expenditure can bring about a
better allocation of economic resources as between the present and the future. In a free
capitalist society very little provision is made for the future. This is because people prefer the
present rather than the future and, therefore, they do not make adequate provision for the
future. The State on the other hand, is the custodian of the interests of the future generations
also and, therefore, has to see that adequate provision is made for the future. Public
expenditure on transport, irrigation and other projects which yield both immediate return as
well as social and economic benefits for generations to come, are some examples. Secondly,
the government spends money in the conservation of economic resources which are very
essential for the future. Thirdly, the government spends money for encouragement of research
and invention, promotes education and training, looks after public health and sanitation and
also takes the responsibility of social security measures. It is necessary to emphasize that the
diversion of economic resources in all these ways will greatly increase production.
Generally, the effects of public expenditure on production and employment are favorable.
Taxation, taken alone, may check production; but public expenditure, taken alone, should almost
certainly increase it. The development expenditures of the Central and State Governments aim at
raising the level of production and employment in the country. It is possible that production will be
adversely affected if public expenditure is carelessly planned, but it will positively stimulate
production if carefully planned.
ii. Effects of public expenditure on Distribution of income
These days, every government aims at reducing inequalities of income. Public expenditure (as
part of fiscal policy) can be used by the government to achieve this aim. While taxes, particularly
progressive direct taxes, have the effect of reducing the incomes and wealth of the higher
income groups, public expenditure has the effect of raising the incomes of the lower income
groups. Government's expenditure on education, public health and medicine, housing, etc., is
directed to help the poor and the lower income classes (who make use of government schools
and hospitals). At the same time, social security schemes are run by the government for the
benefit of the working classes so that they may be protected from unemployment, accidents,
sickness and old age. Thus, public expenditure, if carefully planned and executed, will help in
redistribution of income in favor of the poor provided, of course, taxation is used to reduce the
incomes and wealth of the higher income groups.
iii. Effects of public expenditure on control of inflation
Inflationary pressures may be considerably narrowed if government expenditure is reduced. This
may be taken as a simple and direct solution, but for the fact that, in the majority of cases, the
most serious type of inflation has always been due to enormous government expenditure. This
type of situation may be due to war when large sums are spent for military purposes or due to
preparations for war during peace time. However, the government can suitably change and
adjust its expenditure during an inflationary period so that the inflationary pressure may be
reduced. For instance, all those schemes which may be justified during a period of depression and
low level of employment may be omitted during inflation. At the same time, the government can

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 Ambo University Woliso Campus SoBE Department of Economics
postpone the construction of social capital such as post offices, schools, etc., which will increase
the size of income of people but will not contribute to the increase of goods. Secondly, the
government can give subsidies to those industries which are producing inflation-sensitive goods so
as to accelerate their production or to enable producers to sell them at lower prices
iv. Effects of public expenditure on the content of development expenditure
Development expenditure of the government should aim at stimulating and supplementing
private initiative and enterprise. In a democratic setup, with parliamentary institutions, emphasis
will have to be on the setting up of a mixed system in which private enterprise will be given active
encouragement and, at the same time, the government will become an interested and active
participant in development activities.
a. Stimulating private initiative. Development expenditure of the government will take the form of
stimulating private initiative and enterprise. Direct stimulation is done by the Government helping
the private sector through loans, subsidies, tax concessions and exemptions and providing market
and other information and research facilities. The government can set up special banking and
financial institutions whose main aim will be to provide finance for medium and long-term periods
at low rates to help the private sector industries with adequate finance. In many underdeveloped
countries, the government will have to set up a strong commercial banking system with a central
bank at the top. These are direct methods of helping the private sector to expand and develop.
b. Provision of social and economic overheads. Indirect stimulation of the private sector may be
done by the government through the provisions of social and economic overheads -education
and public health will come under the first head, and provision of power, transportation,
communication, etc., will come under the second head. The private sector industries would reap
enormous benefits of economies of production from these facilities provided by the government.
Social and economic overheads are necessary and essential prerequisites for economic growth.
In fact, there are many competent authorities who would like governments of underdeveloped
countries to provide only these facilities and leave the rest to the private sector.
c. Public enterprises. The government will have to start and run such undertakings which the
private sector may be unwilling to undertake, either because profit margins are low or almost
nothing, or because they require huge capital investment and a long time to yield returns.
These enterprises may not be appealing to the private sector from the commercial point of
view but may be of great significance from the point of view of economic welfare of the
community as well as that of economic progress. In this group will come all the key and
basic industries, development of irrigation resources, electric power, etc. In fact, any industry
which is necessary for the country and which will help in the growth of the economy can be
taken up by the government. The idea, however, is not to compete with the private sector
but really to supplement and complement it.
3.6. Principle of Maximum Social Advantage
Dalton states this principle: “Public expenditure in every direction must be carried so far that the
advantage to the community of a further small increase in any direction is just balanced by the
advantage of a corresponding small increase in taxation and receipts from any other source of
public income.
Pubic expenditure is made from the sources mobilized through taxation or borrowing. Thus, there is
a continuous transfer of resources from one section of people to another. The funds paid by tax
payers come to the public treasury. These funds go back to the people through public
expenditure programmes. The principle lays down that public expenditure should be so planned
and, hence, revenue resources so raised so as to bring about benefit larger than sacrifice and
that the surplus of aggregate satisfaction in the society is maximum.

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 Ambo University Woliso Campus SoBE Department of Economics
To judge whether the principle of maximum social advantage is secured or not, the following
points have to be considered. The character and composition of public expenditure is the most
important consideration. Large investment of expenditure means large sacrifice of tax payers.
Even then if it is a capital investment, the ultimate benefit may be much larger than the
communities‟ sacrifice. On the contrary, unremunerative public expenditure, even when amount
is small, will not achieve the principle. Secondly, the method of taxing to raise resources for
expenditure has to be judicious. The same amount may be raised from a number of alternative
taxes. This method should be employed which will result in least sacrifice. Thirdly, tax-expenditure
programme should be so structured as to result in increased productive capacity of community
and, hence, enhanced national income.
It is, therefore, important to see that public funds are not spent for the benefit of a particular
group only. In order that public expenditure contributes welfare to the whole community, they
should be made on protection of the country from foreign attack and result in increased
production and productivity, reduction of inter-personal and inter-regional inequality,
maintenance of economic stability and provision of future development.
The principle of maximum social advantage is derived from the principle of equi-marginal returns
as applied to an individual. Thus, if it is found that marginal utility from public expenditure on
medical and public health measures is greater than the marginal utility derived from the same
amount spent on provision of public parks, then the government should transfer the public funds
from the latter to the former account. This will maximize social advantage. As shown in figures 4.1
and 4.2, the limited amount of public expenditure totals OA and the amount O 1B spent
respectively on public parks and medical and public health. Expenditure is measured along
horizontal axis and marginal utility along vertical axis. As clear from the figures, the allocation of
expenditure at OA results in lower marginal utility than at O 1B. Hence, transfer of expenditure of
the amount AK (=BL) from public parks to the provision of medical and public health will raise
aggregate utility because the increase of utility area BLMD is larger than reduction of utility area
KACN. This is how equality in marginal utility from public expenditure in all directions will maximize
social advantage.

Figure 4.1 Public expenditure on Figure4.2 Public expenditure on

public parks medical and public health
The main defect of the theory is that it is not possible to measure precisely the difference in
benefits from different directions of public expenditure. However, a rough guidance is obtained
and this is what is important. Secondly, the requirement of the principle that expenditure should
not be specially made for a particular section of society is not followed in many underdeveloped
countries where special attention is paid to the benefits of backward sections of society in
preference to other communities.

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CHAPTER FOUR
4. GOVERNMENT REVENUE
4.1. Sources of Public Revenue
A government gets revenue from three different sources. In the first place, it gets
income from taxes and from other sources in which there is an element of compulsion.
Secondly, the government gets income for services rendered to the public. These may
be fees or prices of services rendered or profits of enterprises, and so on. Thirdly, there
are certain sources of income which may not come under any of the above two types;
they are not compulsory nor are they voluntary payments.
The process of socio-economic development requiring huge expenditure cannot be
carried out unless the government has the perennial source of income. Every
government has two important sources of revenue. These are:
(a) Tax sources, and
(b) Non-tax sources. .
A tax is a compulsory charge imposed by the government, without any reference to the
service rendered to a taxpayer. In other words, a tax is a compulsory contribution for
which there is no direct return or quid pro quo.
It is compulsory in the sense that once it is levied, the person concerned has to pay it and
cannot escape it (though he may try to avoid or evade the tax). Most of the sources of
income of the government these days come from taxes. Fines or penalties imposed by
courts of justice resemble each other since there is compulsion in both. The distinction
between them, however, is one of motive. While taxes are generally imposed to obtain
revenue, fines are imposed as a form of punishment for mistakes committed or to prevent
people from making mistakes in the future.
E.g. Taxes sources: taxes on income (Tax on personal income and Tax on corporation
profits), tax on properties (rental income tax, land use tax, etc.), tax on commodities
(Customs Duty, Excise Duty, Value Added Tax, Turnover Tax, etc.). And non-tax revenues:
Fees, Licenses, Fines and Penalties, Forfeitures, Escheats, Special Assessment, Gifts and
Grants, etc.
Every Government imposes two kinds of taxes:
(1) Direct taxes, and
(2) Indirect taxes
The meaning of these terms can vary in different contexts, which can sometimes lead to
confusion. In economics, direct taxes refer to those taxes that are paid by the person who
earns the income. By contrast, the cost of indirect taxes is borne by someone other than
the person responsible for paying them. For example, taxes on goods are often included
in the price of the items, so even though the seller sends the payments to the
government, the buyer is the real payer. Indirect taxes are sometimes described as
hidden taxes because the purchaser of goods or services may not be aware that a
proportion of the price is going to the government.
1. Direct taxes
A direct tax is paid by a person on whom it is levied. In direct taxes, the impact and
incidence fall on the same person. If the impact and incident of a tax fall on the same
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person, it is called as direct tax. It is borne by the person on whom it is levied and cannot
be passed on to others. For example, when a person is assessed to income tax or wealth
tax, he has to pay it and he cannot shift the tax burden to anybody else. In Ethiopia,
Government levies the direct taxes such as income tax, tax on agricultural income,
professional tax, land revenues, taxes on stamps and registrations etc i.e. taxes levied on
income and property.
Merits of Direct Taxes:
a) Ensures the Principle of Ability to Pay: Direct taxes are based on the principle of ability
to pay. They fall more heavily on the rich than on the poor. The tax burden is
distributed on different sections of the society in a just and equitable manner.
b) Reduces the Social and Economical Inequalities: Direct taxes reduce a disparity in the
distribution of income and wealth. By adopting the progressive tax system, rich people
pay on higher rates of taxation, while the poor pay on lower rates or given exemptions.
This reduces the gap between the poor and rich to a considerable extent.
c) Certainty: Direct taxes satisfy the canon of certainty. In direct taxes, the time of
payment, mode of payment, the amount to be paid etc are made clear. Both the
taxpayers and the Government know the amounts to be paid and the Government
can estimate the revenue from these taxes.
d) Economy: The cost of collection of these taxes is low because the government adopts
the different methods of collections like tax deduction at source, advance payment of
tax etc. Besides, the taxpayers pay the amount of tax directly to government. Thus, the
principle of economy is achieved in the case of direct taxes.
e) Elasticity: Direct taxes are elastic in nature. For example, when the income of the
people increases, the tax revenue also increases. Moreover, during the unforeseen
situation like flood, war etc. the government can raise its revenue by increasing the tax
rates without affecting the poor.
f) Educative Effect: Direct taxes create civic consciousness among taxpayers. Since the
taxpayers feel the burden of tax directly, they are interested in seeing that the
Government properly spends the money. They are conscious of their rights and
responsibilities as a citizen of the State.
g) Control the Effects of Trade Cycles: Direct taxes control the effects of trade cycles.
They can be used as a tool to mitigate the effects of inflationary and deflationary
trends by raising or reducing the tax rates.
Limitations of Direct Taxes:
a) Arbitrary in Nature: Direct taxes tend to be arbitrary because of the difficulty in
measuring the ability to pay tax. Paying capacity of the people cannot be measured
precisely. The levy is highly influenced by the policies of the Government.
b) Difficulties in the Formulation of Progressive Tax Rates: Direct taxes take the form of
progressive taxation i.e. the tax rates increases with the rise in income. It is very difficult

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to formulate the ideal progressive rate schedules in this regard, since there is no
scientific base.
c) Inconvenience: Under direct taxes, the taxpayer has to adhere to many legal
formalities such as submission of the income returns, disclosing the sources of income
etc. Moreover, he has to follow numerous accounting procedures which are difficult to
comply with. Further, direct taxes have to be paid in lump sum and at times, advance
payment of tax has to be made. This causes much inconvenience to the taxpayers.
d) Possibility of Tax Evasion: The high rates of direct taxes create the tendency to evade
more. There is possibility for tax evasion by fraudulent activities. Thus, it is said that the
direct taxes are the taxes on honesty.
e) Limited Scope: The scope of the direct tax is very limited. In Ethiopia, most of the
people come under or below the middle-income category. If only direct tax is
followed, these people cannot be brought into the tax net because of the basic
exemption given. Thus, the Government cannot depend upon direct tax alone.
f) Disincentive to Work, Save, and Invest: When the taxpayer earns certain level, they
have to pay more, because of the higher rate of taxes attributed to the higher slabs.
This will in turn discourages them to work further, save and invest.
g) Expensive to Collect: Under direct taxes, each and every taxpayer is separately
assessed. Thus, the large number of taxpayers to be contacted and assessed and the
prevention of tax evasion make the cost of collection more expensive.
2. Indirect Taxes
Under indirect taxes, the impact and incidence fall on different persons. It is not borne by
the person on whom it is levied and can be passed on to others. For example, when the
excise duty is levied on the manufacturer of cement, he shifts the burden of tax to the
consumers by raising the selling price. Here the impact of excise duty falls on the
manufacturer and the incidence on the ultimate consumers. The person who is required
to pay the tax does not bear its burden. Thus, indirect taxes can be shifted.
Merits of Indirect Taxes:
a. Convenience: Indirect taxes are more convenient to the taxpayers. Since the tax is
included in the selling price of the commodities, the consumer pays the tax when he
purchases them. He pays the tax in small amounts (installments) and does not feel its
burden. Thus, indirect taxes are quite convenient and less burdensome.
b. Wide Scope: While the people with income and wealth above a certain limit are
brought under the levy of direct taxes, indirect taxes are paid by all both poor and
rich. Under indirect taxes, everybody pays according to their ability. The tax burden is
not imposed on to the small section but it is widely spread. Thus, the indirect tax has
wider scope.
c. Elastic: The revenue from the indirect taxes can be increased. Whenever the
Government wants to raise its revenue, or lower it, it can be achieved by increasing
and decreasing the rates of taxes on the commodities whose demand is inelastic.
d. Tax Evasion is Not Possible: Indirect taxes are included in the selling price of the
commodities. So, evading of such tax becomes very difficult. If the person wants to

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 Ambo University Woliso Campus SoBE Department of Economics
evade the tax, it can be done only by refraining the consumption of the particular
commodity.
e. Substantial Revenue: Indirect taxes yield substantial revenue to both Central and State
Governments. The developing countries like Ethiopia are heavily dependent on
indirect taxes. Direct taxes have a limited scope in these countries because of low per
capita income.
f. Progressive: Indirect taxes can be made progressive by imposing lower rates of taxes
or giving exemption to the necessary articles and heavy taxes on luxurious articles.
Thus, indirect taxes also confirm the principle of equity.
g. Effective Allocation of Resources: Indirect taxes have great influence in the allocation
of resources among different sectors of the economy. Resources allocation can be
made effective by imposing heavy excise duties on low priority goods and by granting
relief to industries producing high priority goods. This results into mobilization of
resources from one sector to another positively.
h. Discourages the Consumption of Articles Injurious to Health: Indirect taxes discourage
the consumption of certain commodities, which are harmful to health. By imposing
very high rates of taxes on commodities like liquors, drugs, cigarettes etc., which are
harmful to health, their consumption can be reduced.
Limitations of Indirect Taxes:
a. Ability to Pay Principle is violated: Indirect taxes are not directly connected to the
taxpayers' ability to pay. Therefore, both the rich and poor equally pay the tax. Thus,
the principle of ability to pay is violated. Indirect taxes are regressive in nature.
b. Uncertainty: If indirect taxes are not levied on the commodities of common
consumption and levied only on luxurious articles, they tend to be inelastic. The
quantity demanded will be affected by the imposition of the taxes. Thus, the revenue
generated from them is uncertain.
c. Discourages Saving: Indirect taxes are included in the selling price of the commodities.
Hence, the people have to spend more on the purchase of the goods. This, in turn
affects the savings of the people.
d. High Cost of Collection: Indirect taxes are uneconomical as they involve high cost of
collection.
e. Civic Consciousness is Not Created: Under indirect taxes, taxpayers don‟t feel the
burden of the tax. They are not aware of their contribution to the State. Thus, indirect
taxes do not create the civic consciousness in the minds of the people.
f. Inflationary: The indirect taxes cause an increase in the price all around. The increase
in the prices of raw materials, finished goods and other factors of production creates
inflationary trends in the economy.
Differences between Direct and Indirect Taxes:
Direct and Indirect taxes differ among themselves on the following grounds:
i. Shift ability of the Burden of Tax: In the direct taxes, the impact and incidence fall on the
same person. It is borne by the person on whom it is levied and is not passed on to
others. For example, when a person is assessed to income tax, he cannot shift the tax
burden to anybody else, and he himself has to bear it. On the other hand, in the case of

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 Ambo University Woliso Campus SoBE Department of Economics
indirect taxes, the impact and incidence fall on different persons. It is not borne by the
person on whom it is levied. The burden of the tax can be shifted. For example, when
the manufacturer of cement pays excise duty, he can shift the tax burden to the buyers
by including the tax in the price of the cement.
ii. Principle of Ability to Pay: Direct taxes conform to the principle of ability to pay. For
example, now people having income above Birr.150 pm, only is liable to pay income
tax. But, indirect taxes are borne and paid by the weaker sections of the society also. As
such, these taxes do not conform to the principle of ability to pay.
iii. Measurement of Taxable Capacity: In the case of direct taxes, tax-paying capacity is
directly measured. For example, the taxable capacity for income tax is measured on
basis of the income of the individual. On the other hand, in the case of indirect taxes,
taxable capacity is measured indirectly. The luxurious articles are levied at the higher
rate of taxes on the assumption that they are purchased by the rich people. However,
low rate is charged on the articles of common consumption.
iv. Principle of Certainty: Direct taxes ensure the principle of certainty. Both the
Government and the taxpayer know what amount is to be paid and the procedures
to be followed. But in the case of indirect taxes, it is not possible. The taxpayer does not
know the amount of tax to be paid and the Government cannot predict the quantum
of revenue generated from the indirect taxes.
4.2 Objectives of Taxation
1. Raising Revenue: The basic purpose of taxation is raising revenue which used to render
various economic and social activities.
2. Removal of Inequalities in Income and Wealth: By framing suitable tax policy, this end
can be achieved. It is stressed in the Canon of Equality. In Ethiopia, the progressive
taxation on income is the suitable examples in this regard.
3. Ensuring Economic Stability: Taxation affects the general level of consumption and
production. Hence, it can be used as an effective tool for achieving economic
stability.
4. Reduction in Regional Imbalances: It is normal that certain parts of the country are
well developed, whereas some other parts or states are in backward conditions. To
remove these regional imbalances, the Government can use tax measures. By way of
announcing various tax exemptions and concessions to that particular backward
regions or states, the economic activities in those areas can be induced and
accelerated.
5. Capital Accumulation: Tax concessions or rebates given for savings or investment in
provident funds, life insurance, unit trusts, housing banks, post offices banks, investment
in shares and debentures of certain companies etc. lead to large amount of capital
accumulation which is essential for the promotion of industrial development.
6. Creation of Employment Opportunities: More employment opportunities can be
created by giving tax concessions or exemptions to small entrepreneurs and to the
industries adopting labour-intensive techniques. In this way, unemployment problem
can be solved to certain extent.

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 Ambo University Woliso Campus SoBE Department of Economics
7. Preventing Harmful Consumption: Taxation can be used to prevent harmful
consumption. By way of imposing heavy excise duties on the commodities like liquors,
cigars etc
8. Beneficial Diversion of Resources: The imposition of heavy duties on nonessential and
luxury goods discourages the producers of such goods. The resources utilized for the
production of these goods may be diverted into the production of other essential
goods for which various tax concessions are given. This is called as beneficial diversion.
9. Encouragement of Exports: Now-a-days export oriented industries are encouraged by
way of providing various exemptions like 100% relief from income tax, free trade zones
etc.
10. Enhancement of Standard of Living: By way of giving various tax concessions to certain
essential goods, the Government enhances the standard of living of people.
4.3. Characteristics of a Good Tax System
i. Tax is a Compulsory Contribution
A tax is a compulsory payment from the person to the Government without
expectation of any direct return. Every person has to pay direct as well as indirect
taxes. As it is a compulsory contribution, no one can refuse to pay a tax on
the ground that he or she does not get any benefit from certain public services
the government provides.
ii. The Assessee will be required to pay Tax if it is due from him
No one can be forced by any authority to pay tax, if it is not due from him.
Suppose, if there is a tax on liquor, the state can force an individual to pay the tax
only when he drinks liquor. But, if he does not drink liquor, he cannot be forced
to pay the tax on liquor. Similarly, if an individual‟s income is below the
exemption limit, he cannot be forced to pay tax on income. For example
individuals earning monthly salary below birr 150 cannot be forced to pay tax on
income.
iii. Taxes are levied by the Government
No one has the right to impose taxes. Only the government has the right to impose
taxes and to collect tax proceeds from the people.
iv. Common Benefits to All
The tax, so collected by the Government, is spent for the common benefit of
all the people. e.g. The Government incurs expenditure on the defense of the
country, on maintenance of law and order, provision of social services such as
education, health etc. Such benefits are given to all the people- whether they are
tax-payers or non-tax payers. These benefits satisfy social wants. But the Government
also spends on subsidies to satisfy merit wants of poor people.
v. No Direct Benefit
In the modern times, there is no direct relationship between the payment of tax
and direct benefits. In other words, there is absence of any benefit for taxes paid
to the governmental authorities. The government compulsorily collects all types of
taxes and doesn‟t give any direct benefit to tax-payers for taxes paid.
vi. Certain Taxes Levied for Specific Objectives

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 Ambo University Woliso Campus SoBE Department of Economics
Though taxes are imposed for collecting revenue for the government to meet
expenditure on social wants and merit wants, certain taxes are imposed to achieve
specific objectives. For example, heavy taxes are imposed on luxury goods to
reduce their consumption so that resources are directed to the production of
essential goods, such as cheaper variety of cloth, less costly goods of mass
consumption, etc. Thus, taxes are levied not only to earn revenue but also for
diversion of resources or saving foreign exchange. Certain taxes are imposed to
reduce inequalities of income and wealth.
vii. Attitude of the Tax-Payers
The attitude of the tax-payers is an important variable determining the contents of a
good tax system. It may be assumed that each tax -payer would like to be
exempted from tax paying, while he would not mind if other bears that burden. In any
case, he would want his share to be within the general level of tax burden
being borne by others. In other words, it is essential that a good tax system should
appear equitable to the tax-payers. Similarly, overall burden of the tax system is of
equal importance. The attitudes of the tax-payers in this regard are influenced by a
host of other factors like the political situation such as war or peace, natural
calamities like floods and droughts, economic situations like prosperity or
depression and so on.
viii. Good tax system should be in harmony with national objectives
A good tax system should run in harmony with important national objectives and if
possible should assist the society in achieving them. It should try to
accommodate the attitude and problems of tax-payers and should also take
into consideration the goals of social and economic justice. It should also yield
adequate revenue for the treasury and should be flexible enough to move with
the changing requirements of the State and the economy.
ix. Tax-system recognizes basic rights of tax-payers
A good tax system recognizes the basic rights of the tax-payers. The tax-payer is
expected to pay his taxes but not undergo harassment. In other words, the tax law
should be simple in language and the tax liability should be determined with
certainty. The mode and timing of payment should be convenient to the tax-
payer. At the same time, a tax system should be equitable between tax -payers.
It should be progressive and burden of taxation should be equitable on all the
tax-payers.
It is commonly believed that there are five properties of a good tax system, these are:
Economic efficiency, Administrative simplicity, Fairness, Political responsibility and
Flexibility.
1. Economic efficiency: A good tax system should not interfere with the efficient
allocation of resources. A good tax policy has to question whether the tax system
discourages savings and work and whether it has distorted economic behavior in other
ways.
2. Administrative Simplicity: There are significant costs associated with administering a tax
system. There are direct costs-the cost of running the authority responsible to collect

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 Ambo University Woliso Campus SoBE Department of Economics
and administer taxes and indirect costs, which taxpayers must bear. These indirect costs
take on a variety of forms: the costs of time spent filling out the tax forms, costs o f
record keeping, and the costs of accountants, if any.
3. Flexibility: Changes in economic circumstances require changes in tax rates. For some
tax structures these adjustments are easy; for some they require extensive political
debate; for still others they are done automatically. For instance it is said that there
is usually a difficulty in adjusting the rate of income tax. What must be
emphasized is that timing is very crucial element of flexibility. The speed with
which changes in the tax legislation (one enacted) can be implemented and the
lags in the collection of funds may limit the efficiency of the tax. An important
aspect of the “flexibility” of a tax system for purposes of stabilizing the economy is
timing: the speed with which changes in the tax laws can b e implemented and
the lags in the collection of funds. If fluctuations in the economy are rapid, the
lags may limit the efficacy of, say, the income tax, in stabilizing the economy.
4. Political Responsibility: The government is the competent authority to administer taxes.
A good tax system requires that the government is not to abuse its power of tax
administration. A politically responsible government has to address the feeling of the
tax payers. The government should not take advantage of its tax payers. According
to this view it is said that taxes where it is clear who pays are better than taxes where
the burden is not so apparent. Thus the individual income tax is a good tax compared
to the corporation tax. A politically responsible tax structure is also one in which
changes in taxes come about as a result of legislated changes, and where the
government must repeatedly come back to the tax payers for an appraisal of
whether the government is spending too much or too little.
5. Fairness: Most criticisms of tax systems begin with their unfairness. It is, however, difficult
to define precisely what is or is not fair. There are two distinct concepts of fairness:
horizontal equity and vertical equity.
I) Horizontal Equity
A tax system is said to b e horizontally equitable if individuals who are the same in all
relevant respects are treated equally. The principle of horizontal equity is so important.
Thus a tax system that discriminates on the basis of race or color would generally
be viewed to be horizontally inequitable. A condition of perfect horizontal equity can
be said to exist when a tax or tax structure can be described as achieving an
“equal tax treatment of equals.” That is, horizontal equity requires that people who
are deemed to be in an equal economic position should pay the same amount in
taxes. James Buchanan has given a broader view to the concept of horizontal
equity. For him it is fiscal residuum (the difference between benefits received and taxes
paid) that should be equal for people in an equal economic position.
The significance of this rather straightforward criterion of horizontal equity should not
be underestimated. Adherence to it provides a basic protection against discriminatory
activity of government. By focusing on people‟s economic characteristics, the chance of
grouping them by their geographic region or by their race is reduced. Horizontal equity
represents an application of an ethical value judgment that is pleasing to those who
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accept democratic as opposed to authoritarian principles of government. If the
ethical guideline stopped here, however, designing a tax system would be easy.
Everyone or perhaps every citizen would pay the same tax.
II) Vertical Equity
Fairness in taxation must also cope with the idea that we do not all fit in one
economic group. Vertical equity, therefore, requires an acceptable pattern of tax
payments among people deemed to be unequal. While the principle of horizontal
equity says that individuals who are essentially identical should be treated the same,
the principle of vertical equity says that some individuals are in a position to pay
higher taxes than others, and that these individuals should do so.
There are three problems in relation to vertical equity: determining who, in principle,
should pay at the higher rate; implementing this principle-that is, writing tax rules
corresponding to this principle; and deciding, if someone is in a position to pay the
higher rate, how much more he should pay than others.
Three criteria are commonly proposed for judging whether one individual should pay
more than another. Some individuals may be judged to have a greater ability to pay;
some may be judged to have a higher level of economic well being; and some
may receive more benefits from general government spending. Even if agreement
were to be reached on which of these criteria should be employed, there would
be controversies concerning how to measure ability to pay, economic wellbeing, or
benefits received. In some cases the same measures- such as income or consumption-
might are used to judge ability to pay and economic well-being. Generally the principle of
vertical equity says that those who are better off or have a greater ability to pay ought to
contribute more to support the government. The principle of horizontal equity says that
those who are equally well off (who have equal ability to pay) should all contribute the
same amount. In both cases, there is a difficulty of determining whether an individual is
better off than another, or of determining whether an individual has a greater ability
to pay than another. This implies that the difficult questions namely-how do we tell
which of two individuals is better off or which has a greater ability to pay and what do we
mean by equality of treatment are very difficult to answer. Furthermore the principle of
vertical equality does not tell us how much more someone who is better off should
contribute to the support of the government; all that it tells us is that he should pay
more.
Because of these difficulties economists have looked for other principles on which to
base a fair tax. One such principle is the pareto-efficient taxation. The pareto-efficient
tax structures are those that maximize the welfare of one (group of) individuals (s),
subject to the government attaining given revenue. No one can be made better off
without someone else being made worse off.
4.4. The Base, Buoyancy and Elasticity of Taxation
4.4.1. The Base of a Tax
The base of a tax is the legal description of the object with reference to which the tax
applies. For example, the base of an excise duty is the production or packing or
processing of a specific good; the base of an income-tax is the income of the assessee

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 Ambo University Woliso Campus SoBE Department of Economics
defined and estimated in terms of certain rules laid down for the purpose; a gift may
be defined and made a base for levying a gift-tax. Note that the base of each tax has
to be defined legally and it is to be quantified for the purpose of determining the tax
liability of an individual tax-payer. Each tax-payer is considered a legal entity for this
purpose. Accordingly, an individual legal entity may be subjected to more than one
tax. It should be noted that a tax base may have a time dimension also. For example,
income-tax is usually on an annual basis and the law has to decide whether income
would be taxed on the basis of accrual or receipt. The authorities, while determining a
tax base, are expected to give due consideration to various questions like those of cost
of collection, administration and effects of that tax. The exact coverage of a tax base
is sought to be determined by an optimum combination of these considerations. With
the passage of time, a tax base under consideration may grow or may shrink.
4.4.2. Buoyancy and Elasticity of a Tax
Buoyancy of a tax indicates the factors responsible for an increase in the yield of a tax-
over time. If a tax revenue increase with the growth of its base, but without an upward
revision of the tax rates (without an increase in the rate of tax), then the tax is said
to be buoyant. It has an inherent tendency to yield more tax revenue with the growth of
the base. Tax revenue changes when there is change in tax rate, tax coverage and tax
base. Numerically, the buoyancy of a tax is measured as a ratio of the proportionate
increase in tax

Elasticity of tax is related to the rate of tax and yield of a tax. If the yield of a tax
increases or decreases owing to reduction or increase in tax rates, we call it elasticity
of a tax. The yield of a tax may also go up on account of extension of its coverage or a
revision of its rates. Such a characteristic of a tax is ref erred to as its elasticity. In other
words, the elasticity of a tax refers to the steps taken by authorities in increasing its
yield through an extension of its coverage or revision of its rates. Numerically, the
elasticity of a tax is measured by the ratio of proportionate change in its yield to the
proportionate change in its coverage or rates.

4.4.3. Canons of taxation

Taxation is an important instrument for the development of economy of the country. A
good tax system ensures maximum social advantage without any hardship on taxpayers.
While framing the tax policy, the government should consider not only its financial needs
but also taxable capacity of the community. Besides the above, government has to
consider some other principles like equality, simplicity, convenience etc. These principles
are called as "Canons of Taxation". The following are the important canons of taxation.
1. Canon of Equality: canon of equality implies that when ability to pay is taken into
consideration, a good tax should distribute the burden of supporting government more
or less equally among all those who benefit from government.
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 Ambo University Woliso Campus SoBE Department of Economics
2. Canon of Certainty: "the tax which each individual is bound to pay ought to be certain
and not arbitrary. The time of payment, the manner of payment, the quantity to be
paid, should be clear and plain to the contributor and every other person". It means
the time; amount and method of payment should all be clear and certain so that the
taxpayer can adjust his income and expenditures accordingly. This principle removes
all uncertainties in the payment of tax and ensures smooth functioning of the tax
department.
3. Canon of Convenience: In the canon of convenience, "every tax ought to be levied at
the time or in the manner in which it is most likely to be convenient for the contributor
to pay it”. That is, the tax should be levied and collected in such a way that is
convenient to taxpayer.
4. Canon of Economy: "every tax ought to be so contrived as both to take out and keep
out of the pockets of the people as the little as possible over and above what it brings
into the public treasury of the state". This principle states that the minimum possible
amount should be spent on tax collection and the maximum part of the collection
should be brought to the Government treasury. Taxation should be economical i.e. this
should be much more than mere saving in the cost of collection.
5. Canon of Productivity: tax system should be productive enough i.e. it should ensure
sufficient revenue to the Government and it should encourage productive activity by
encouraging the people to work, save and invest.
6. Canon of Elasticity: The taxes should be flexible. It should be levied in such a way to
increase or decrease the tax revenue depending upon the need. For example, during
certain unforeseen situations like floods, war, famine, and drought etc. the
Government needs more amount of revenue. If the tax system is elastic in nature, then
the Government can raise adequate funds without any extra cost of collection.
7. Canon of Diversity: According to this principle, there should be diversity in the tax
system of the country. The burden of the tax should be distributed widely on the entire
people of the country. The burden of the tax should be decentralized so that every
one should pay according to his ability. To achieve this, the Government should
impose both direct and indirect taxes of various types. It should not depend upon one
or two types of taxes alone.
8. Canon of Simplicity: This principle states that the tax system should be simple, easy and
understandable to the common man. If the tax system is complex and vague, the
taxpayer cannot estimate his tax liability and it will cause irregularities in the payments
and leads to corruption.
9. Canon of Expediency: According to this principle, a tax should be levied after
considering all favorable and unfavorable factors from different angles such as
economical, political and social.
10. Canon of Co-ordination: In a federal set up like Ethiopia, Federal and State
Governments levy taxes. So, there should be a proper co-ordination between different
taxes imposed by various authorities. Otherwise, it will affect the people adversely.

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11. Canon of Neutrality: This principle stresses that the tax system should not have any
adverse effect. That is, it shouldn‟t create any deflationary or inflationary effects in the
economy.
4.5. Approaches to Taxation
How does the government impose tax? There are a number of theories on the basis of
which the government distributes tax burdens. In this regard there are five approaches
that have found a wide coverage. These are the expediency approach, cost-of-service
approach, socio-political approach, benefit received approach, and ability to pay
approach. But our discussion is limited to benefit received approach and ability to pay
approach only.
1. Benefit received approach
According to this principle, the burden of taxation should be divided among the
people in proportion to the benefits received from the state. The persons receiving
equal benefits from the state should pay equal amount as taxes and those who
receive greater benefits should pay more as taxes than those getting less benefits.
The benefit theory, therefore, demands that on the ground of equity, the people
should be taxed according to benefits (protection, hospitals, education, roads,
irrigation etc) they receive from the government and that the division
apportionment of taxes be in proportion to the benefits received by each individual
or group of individuals. Larger the benefits received, larger should be the amount of tax
on the beneficiary concerned.
Limitations of Benefit Principle Approach:
i. It is very difficult to estimate the benefit that an individual receives from the expenditure
of the government, e.g., how much benefit an individual receives from the army, police
and educational institutions cannot be exactly estimated. And therefore, the burden of
taxation may not be equitable.
ii. If the basis of taxation is benefit, then the poor will have to pay higher taxes than rich
because the poor derives greater benefits than rich from the expenditure of the
government, e.g., the poor may be more benefited by the provision of free medical
service and free education. And, therefore, on this ground also, this theory cannot be
accepted as the basis of taxation.
iii. Rich people have more capacity to pay taxes than poor; but according to this principle
the per capita tax burden upon the rich and the poor is the same. This means regressive
taxation. It is, therefore, clear that the benefit principle cannot ensure just distribution of
burden of taxation among different sections of society.
iv. The principle is also not conducive to general welfare which requires redistribution of
income in favour of the poorer sections through public welfare programmes and
services for their benefit.
v. The general tax formula depends on the price elasticity of demand and income
elasticity public goods and services.
And this implies that = , then we can get the

following conclusion.

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 If
 If
 If
But could not be calculated from market price because it is difficult to express
the demand for public good and the price of public good and service
E.g. taxation of gasoline and automobile products to finance highway construction i.e.
the owners of these product should responsible to finance the construction of the
projected way. This type of financing /budgeting is known as earmarking i.e. selective
taxation on the beneficiary body only.
2. Ability to Pay Approach:
This approach considers the tax liability in its true form-a compulsory payment to the state
without quid pro quo. It doesn‟t assume any commercial or semi-commercial relationship
between the State and the citizens. According to this approach, a citizen has to pay
taxes because he can, and his relative share in the total tax burden is to be
determined by his relative paying capacity. The basic tenet of the ability-to-pay doctrine
is that the burden of taxation should be shared amongst the members of the society
so as to conform to the principles of justice and equity, and that this equity criterion will
be satisfied if the tax burden is apportioned according to their relative ability to pay.
The supporters of the ability theory have justified it on three grounds:
Firstly, it has been justified on psychological effects of tax payments upon individual
tax-payer. Psychologically every tax -payer should feel that he has made equal sacrifice
in the payment of tax. Equality of sacrifice means that all the tax-payers should feel the
same pinch by paying the last Birr as tax.
Secondly, it has been justified in terms of diminishing marginal utility of income. As
income increases, marginal utility of additional unit of income decreases and vice-
versa. The tax-burden should be more on rich than on poor.
Thirdly, ability is known as the faculty interpretation. The faculty is represented by the
income, property and wealth on an individual.
The real burden of taxation should be equal for all and that “similar and similarly situated
persons ought to be treated equally”. But the term “equal” in equal sacrifice has been
interpreted differently. There are three concepts of equal sacrifice-equal absolute
sacrifice, equal proportional sacrifice and equal marginal sacrifice.
Equal Absolute Sacrifice. Equal absolute sacrifice implies that the total loss of utility as a
result of tax should be equal for all tax-payers. If there are two tax-payers with different
incomes, the one who has more will pay more tax and the one who has less will pay less,
but the sacrifice to both as a result of the tax should be equal. This principle received the
greatest support at one time because of its apparent fairness.
Equal Proportional Sacrifice. Equal proportional sacrifice implies that the loss of utility as
the result of a tax should be proportional to the total income of tax-payers. Here, too,
those with a higher income will pay more but the ratio of sacrifice to the income will be
the same for all. This can be expressed as:
Sacrifice to taxpayer A = Sacrifice to taxpayer B = etc.
Income of A Income of B
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This proportional sacrifice principle attempts to relate the sacrifice of tax payment to the
capacity of enjoyment or satisfaction resulting from income. Every taxpayer‟s loss in
proportion to his income should be the same as everyone else's. The difficulty with this
principle is to give a practical shape; besides, the concept is somewhat difficult to grasp.
Equal Marginal Sacrifice. Equal marginal sacrifice implies that the marginal sacrifice for
the different taxpayers should be the same. Since marginal utility of a higher income will
be very much low as compared to a low income, equal margined sacrifice will imply that
the person with a higher income will be expected to bear the heavier burden. In fact, it is
under the minimum sacrifice principle that the total or collective sacrifice of all taxpayers
will be the lowest. Hence, this principle is also known as the least aggregate sacrifice
principle of taxation.
4.6. Effects of Taxation

An important objective of taxation in most of the welfare states is to reduce the

inequalities of income and wealth and to bring about an equal society. The effects of
taxation on the distribution of income and wealth among the different sections of the
society depend upon two important factors. They are;
1. Nature of Taxation, and
2. Kinds of Taxes.
1. Nature of Taxation
The nature of taxation influences the distribution of tax among the different sections of the
society. It includes proportional, regressive and progressive nature of taxation.
(a) Effects of Regressive Taxation on Distribution: Under regressive taxation, the burden of
taxation falls more heavily upon the poor than on the rich. Regressive taxation may
increase the inequalities on the distribution of income and wealth. Hence, the burden of
taxation is higher on the poor than on the rich. In effect, this system widens the gap
between the rich and the poor.
(b) Effects of Proportional Taxation on Distribution: Under the proportional taxation, taxes
are levied uniformly upon the rich and the poor. When the tax rate remains the same, it
creates inequalities between them. However, if there is any increase in the income of
these sections, the inequalities in distribution of income will also increase. The burden of
taxation falls more heavily upon the poor than on the rich.
(c) Effects of Progressive Taxation on Distribution: Under the system of progressive taxation,
the tax rates go up with the increase in the income. Thus, in this system, the inequalities in
the income and wealth will be reduced. The major portion of the income and the wealth
of the rich is taken away by way of higher tax rates. Hence, the progressive tax system
tends to reduce the inequalities in the distribution of income and wealth.
2. Effects of Taxation on the basis of Kinds of Taxes:
The effects of taxation depend upon the kinds of taxes i.e. direct or indirect taxes.
(a) Effects of Direct Taxes on Distribution: Direct taxes take the form of taxation on the
income and property. It attempts to reduce the income of the richer sections and
transfers the income to the Government. The Government may use these resources to
raise the standard of living of the poor. Therefore, all those taxes, which fall heavily upon
the higher income groups, can have favourable distributional effects.
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(b) Effects of Indirect Taxes on Distribution: Indirect taxes are levied on commodities. They
fall heavily on the lower and middle-income groups who spend a large portion of their
income on commodities. In such a situation, indirect taxes have adverse distributional
effects. However, indirect taxes may be made progressive if the necessity goods are
exempted from taxation or levied on low tax rates, and luxuries are subjected to higher
rates of taxes.
(c) Effects of Taxation on Consumption:
Taxes increases the price of the taxed goods relative to the prices of untaxed or lower
taxed goods. The increase in the relative price affects the taxpayer in two ways.
1. Income Effect: The tax reduces the taxpayer's purchasing power or real income.
It takes resources away from the taxpayer and transfers them to the government. This is
often referred to as the direct burden of the tax.
2. Substitution (or Price) Effect : The tax creates an incentive for the taxpayer to substitute
less preferred but untaxed or lower-taxed goods for the more-preferred taxed good. The
loss in consumer utility from this substitution is the excess burden (or welfare cost) of the
tax.
Taxation influences the consumption as well. Such influence can be studied on the
following grounds:
1. Influence the Allocation of Resource of Individuals: Every individual has limited money
income and allocate it to different uses. Taxation affects their allocation directly or
indirectly. For example, the income tax reduces the money income of a consumer and
forces him to buy a smaller volume of goods and it reduces the standard of living of the
consumers. Likewise, a levy of indirect taxes on the goods of common consumption will
affect the allocation of individual resources. Thus, taxes influence the allocation of
resources of individuals.
2. Effects of Taxation on Consumption and Employment:
Taxation reduces the purchasing power of the people and it reduces their consumption.
The decline in consumption leads to decrease in effective demand for the goods and
services, which in turn affects the production of these commodities. Ultimately, the
reduction in consumption leads to a reduction in employment opportunities. For example,
due to rise in price, instead of getting two different commodities, the individual may buy
more quantity of any one commodity to maximize the utility and his satisfaction.
3. Effects of Taxation on Consumption during Inflation and Depression:
Taxation has different effects in times of inflation and depression. During the time of
inflation, the purchasing power of the people is reduced by a raise in the rates of existing
taxes or imposition of new taxes. This would control the consumption and therefore, help
in bringing up stability in prices. During the period of depression, taxation may be
reduced. As the result of the reduction on direct tax rates, the people will have more
disposable income and higher purchasing power and a decrease in indirect taxes leads
to the reduction of selling prices. Both of them encourage the total consumption of the
people and thereby the economic activities are induced in the country.
4. Regulatory Effect of Taxation on Consumption:

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Taxation may be used to regulate the production and consumption. Consumption can
be regulated by taxing the production and use of certain commodities. For example, the
object of some taxes may be to reduce the consumption of certain harmful commodities
such as liquors, cigars etc. In short taxation has the following roles: Distributive role,
Allocative role and stabilization role in the economy.
4.7. Impact, Shifting and Incidence of Tax
The traditional concept of shifting and incidence of tax is more popularly associated with
the classical theorist, E.R.A. Seligman. According to him, answer to the following three
questions relating to a tax will give us the meaning of the terms impact, shifting and
incidence.
(a) Who bears the money burden of tax in the first instance?
(b) Is it possible to transfer this money burden of tax to some one else?
(c) Who ultimately bears the money burden of tax?
It is clear from the above that the person who bears the burden of tax in the first instance
need not be the person to ultimately bear it. He may transfer the burden. He may not
however, be able to transfer the money burden of tax completely to some one else and
he may have to bear a part of the burden. Thus, there are three distinct situations in the
process of taxation. Impact (statutory incidence) of the tax refers to the point of original
assessment. Hence, impact is on that person who pays the tax in the first instance. It is the
immediate money burden of tax. Thus, when a tax is imposed, its impact is on that person
who bears the immediate money burden of it.
The person need not, however, continue to bear this money burden. He will try to transfer
this burden to some one else, i.e., he will try to shift the tax. If he is able to transfer the
burden to some one else, shifting of tax has taken place. Thus, shifting is the process of
transferring money burden of tax. Shifting ends in incidence of tax (economic incidence
of tax). Incidence is the ultimate money burden of tax. Hence, incidence of tax lies on
that person who is the ultimate bearer of the tax burden. Thus, if the original tax payer is
unable to shift the burden of the tax at all, then the impact as well as incidence will be on
him. If, on the other hand, he is able to transfer the money burden of tax, i.e., if he has
succeeded in shifting the tax to some one else, say, Mr. X, then the incidence of tax will
be said to have moved from him to Mr. X who becomes the ultimate bearer of the tax
burden.
Suppose, for example, an excise tax is levied on cloth and the tax authority collects it from
the manufacturer of cloth. Hence the impact of tax is on the manufacturer. If he is now
able to transfer the money burden to the whole-seller by raising the price to the extent of
tax, tax shifting has taken place. The whole-seller may again be able to shift this money
burden to the retailor and the retailor may pass on the burden to the consumer through a
continued process of shifting. If the consumer has no more possibility of shifting the tax, he
becomes the ultimate bearer of the money burden of tax and, hence, incidence will lie
on him. If at the retail level, on the other hand, the retailor succeeds in shifting only half
the tax burden to ultimate consumers and has to bear the rest half by himself, then fifty
percent of the tax incidence will be on consumers and fifty percent on the retailor, i. e.,
the incidence will be equally shared between the buyers and the seller.

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CHAPTER FIVE

5. GOVERNMENT BUDGETING
5.1. Meaning and purpose of government budget
Today, the government budget is much more than a statement of income and
expenditure of public authorities. It is a reflection of not only taxation and public
expenditure policy, but also of a plan for future course of action. As Gladstone remarks,
“Budgets are not merely maters of arithmetic, but in thousand ways go to the root of
prosperity of individuals and relation of classes, and the strength of kingdom.”
According to Bastable, budget has come to mean the financial arrangements of a given
period, with the usual implication that they have been submitted to the legislature for
approval. Though budget is a program for future action and is generally framed for a
year, it presents a picture of the details of expenditure, taxation and borrowings for three
consecutive years, i.e., the actual receipts and disbursements of the previous year, the
budget and revised estimates of the current year and the estimated receipts and
expenditures of the coming fiscal year. The fiscal year in our country, Ethiopia, comprises
the period from July 1st to June 31st. Though budget estimates for the coming fiscal year
contain proposals of taxation, borrowing and public expenditure, the government in
course of implementation of the budget programs might face shortage of funds due to
some important additions of activity and, hence, might be in the necessity of fresh
proposal of revenue receipts and expenditure which are made in what is called a
“Supplementary Budget”. In this way, the action plan of the original budget gets revised.
A good budget should be one that will enable the legislature and the people to
appreciate the proposals of receipts and disbursements in the context of prevailing state
of economy of the country.
The budget undergoes through different stages of action. Firstly, the budget frame is
structured. The government asks different departments to submit their proposed programs
of action for the coming year. After all such proposals are received, they are
consolidated into an overall budget plan. In the second stage, the budget is presented in
legislature for its approval. At this stage, the legislature carefully considers the proposals.
There may be additions or alternations in budgetary provisions as considered necessary
by the legislature. After the budget is approved, the government is authorized to take

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action on the budget. Thirdly, the implementation of the budgetary programs is the next
stage. Revenues are raised and expenditures relating to the budget plan are made.
In the forth and the last expenditures relating to the budget plan are made. In the fourth
and the last stage, a scrutiny and Parliamentary Committees look after how best financial
abuse can be prevented.
Purpose.
The purpose of government budget is varied. There are a number of objectives which the
budget seeks to attain simultaneously. The overall purpose is to use the budget as
instrument of government economic policy. The following are the chief purpose of the
budget. To achieve any purpose, a planning is necessary. The government needs to
achieve many goals all of which cannot be attained at a time. A proper plan of action is,
therefore, necessary. A budget is such a plan which explicitly mentions the programs that
are to be taken up in the course of the fiscal year. Secondly, implementation of a
program requires availability of necessary funds. The extent of availability depends upon
the budgetary sources of revenue. Hence, that program-structure has to be built which
can be supported by the funds. This is the most important purpose of the government
budget. Thirdly, to achieve efficiency in public expenditure, physical targets of
achievement are specified in the budget. In fixing the physical targets, careful
considerations is given to the factors of efficiency in course of implementation of the
programmes so that nearer the actual achievement at the close of fiscal year, the higher
is the efficiency of level of expenditure agencies. Fourthly, most of the countries,
particularly in developing world, today have taken up their task of their economic
development in the phased manner of five year plans and long-drawn perspective plans.
In order that the planned targets are achieved at the end of the plan period, resources
have to be found. The annual government budgets are framed with an eye to the
provision of necessary funds for the purpose. Lastly, the government budget serves the
purpose of public accountability of funds to a considerable extent. The first control is
imposed at the budgeting framing level itself when the government asks different
departments to submit their own budgets. Because the departments know that their
programmes of expenditure will be scrutinized by the government level, they become
careful to observe economy in the budget. The next stage of control is imposed by the
legislature which is the ultimate authority to decide the size and extent of the budget. At
the end of the financial year, again, the government and its various departments are

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 Ambo University Woliso Campus SoBE Department of Economics
responsible to the legislature for their action and budgetary performance. Hence, budget
serves as a powerful weapon of financial control in respect of both collection of revenues
and disbursement of them.

5.2. Theories of government budgeting

There are two theories of government budgeting, viz., (1) the classical theory of balanced
budget and (2) the modern theory of „Managed Budget‟.
I. Classical Theory.
The classical theory of balanced budget is based on the assumption of full employment
on one hand and the „laissez-faire‟ doctrine on the other. Since the economy operates at
full employment level, the problem of economy in the classical system is not attainment of
growth. The economy functions with maximum efficiency. Moreover, with the philosophy
of „laissez-faire‟ followed, the functions of government are limited to the minimum and,
hence, most of the economic activities are performed by the private sector. Under such a
situation, the size of the budget is always small and the budget should always be
balanced. If there is budget deficit and it is financed by public borrowing, it will withdraw
funds from private sector where they are more productively employed. Such diversion of
resources will bring down overall economic efficiency.
Another justification of the balanced budget is that since deficit financing through
borrowing is easy, the practice of unbalanced budget will encourage expansion of
government activities as against the classical notion of small budgets. This will reduce the
capacity of government to spend for more important purposes because interest charges
on borrowed funds have to be paid in addition to repayment of the principal amount.
Thus, public borrowings are expensive; they require double payment in the form of debt
charges as well as repayment.
There are two views regarding the balanced budget theory. According to one view, the
balancing of budget is brought about by equating current revenues with current
expenditure. There is no role of borrowing in the budget. Since total revenues are equal
total expenditures, the budget is balanced. In the other view of balanced budget,
governmental receipts include public debt also. The budget has, however, two parts –
current budget and capital budget, both of which are balanced. Thus, current
expenditures are financed by current revenues while capital expenditures are financed
by public borrowing. Thus, the overall budget is balanced.
II. Modern Theory.

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As against the above, the modern theory of Managed Budget does not agree with the
classical assumption of full employment. The celebrated Keynesian theory of
underemployment equilibrium shows that full employment is only a limiting case and is not
automatically attained. It follows that the normal situation is one of less than full
employment in an economy. Hence, in order to ensure employment of unutilized and idle
resources, a flexible budgetary policy is needed. Thus, when widespread unemployment
exists, the classical system of balanced budget becomes helpless. The modern
economists like Keynes, Hansen, Dalton and others advocate that the objective of
budget policy should be to attain and maintain full employment. The modern approach
to flexible budget policy is essentially a counter measure against economic fluctuations of
business cycle to which advanced countries are subjected. When depression and
unemployment occurs in the economy due to deficiency of effective demand, the need
is to inject additional purchasing power into the economy that effective demand, hence
employment of production factors are enhanced. This objective can be realized through
a deficit budget policy; because such a budget will put additional purchasing power into
circulation and the aggregate consumption expenditure will increase. This will raise prices
and profit prospects of the business community which will employ available unutilized
production factors to increase production and meet the increased demand. When the
economy, on the other hand, suffers from inflation due to excess purchasing power over
and above the amount necessary to deal with the transaction of available goods and
services at prevailing prices, the necessity is to pump out the excess amount from the
economy. This can be done by surplus budget which will raise more revenues like taxes
and borrowings and lower down government expenditures.
The process will cure the ills of inflation and bring about economic stabilization. When
there is neither inflation nor unemployment, the budget should be balanced. Thus, there
should be flexibility in the budget policy according to the modern economists. Whether
the budget should be balanced or a deficit or a surplus should be decided by the
prevailing economic circumstances. Hence, the modern theory is called the principle of
managed budget.
The main difference between classicists and modem economists in so far as the principle
of government budgeting is concerned lies with their views on savings and investment.
To the classical economists, saving is always equal to investment because the former is
automatically converted into the latter. In such a system, there is no unemployment. To

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 Ambo University Woliso Campus SoBE Department of Economics
the modem economists, however, savings and investment need not be equal. They are
determined by different factors and, more normally, they are different. When savings
become more than investment, deficiency of effective demand develops and
unemployment occurs due to fall in production. The economy is then faced with
depression. On the other hand, when investment becomes more than saving, the
aggregate purchasing power in the economy increases and the available output cannot
absorb it at the prevailing price level. Thus, there becomes inflation. It is only when savings
are equal to investment, the stabilization function of the economy remains undisturbed
and the society suffers neither form unemployment nor from inflation.
Under such circumstances, the modem theory argues, the budget policy of government
should be flexible, allowing for balanced budget when there is neither inflation nor
unemployment i.e., when savings and investment are equal and for unbalanced budget
when the economy suffers from either inflation or unemployment, i.e., when savings and
investment are unequal.

5.3. Budget Framing

A government budget is framed in the shape of a financial plan which is a statement of
income and expenditure relating to various economic and other activities that the
government intends to perform in the coming period. The structure of budget frame may
be different in different countries.
i) Revenue and Capital budget. Many countries, particularly the less developed ones,
prepare budget in two parts, viz., the revenue and capital budgets mainly because the
government has to spend enough resources on economic infrastructure without which
development process cannot start. Capital budget in these countries separates the
revenue expenditure items of capital account from those of current or revenue account.
The main sources of government revenue are taxes and borrowings from internal sources
on one hand and loans and grants from other governments and international agencies
on the other. In the revenue budget, the current expenditure is met out of domestic
taxation, while the expenditure on capital account is made out of domestic and foreign
borrowings. Government obligations for some extra-ordinary expenditure particularly in
the initial stages of development arise on account of economic overheads like roads and
railways, electricity generation, schools and hospital buildings and facilities and other
investment projects which require special revenues and are generally financed by
borrowing. Such expenditures and receipts are shown in the capital budget.

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Revenue Budget Capital Budget
Items of receipts items of Items of receipts items of
Expenditure Expenditure
1. Taxes on income Administrative 1. Loans and Public works
and general recoveries
services
2. Taxes on Social services 2. Market loans Construction of power
property generation plant
3. Custom duties economic services 3. Small savings construction of
roads and railways
4. Union excise Community services 4. External loans Flood control works
duties
5. Non-tax revenue Maintenance of 5. Other receipts Irrigation canals etc.
road and railways.
6. Total revenue Total revenue 6. Total capital Total capital
receipts expenditure receipts expenditure

Since capital projects are very important as they will form the sources of regular flow of
productive services in future, the long drawn financial plan and its consequence on the
economy over years ahead can be read from the capital budget. Such a separation of
the budgets secures expenditure discipline and, hence, the lenders can form a clear idea
about the solvency or otherwise of the country. It is, therefore, very important for
developing countries to frame such a type of budget. The above table will give an idea
of the structure of revenue and capital budgets.
ii) Incremental and Zero-base Budgets. The budget, in order to be meaningful, should be
appraised occasionally and requests for grant of fund should be properly reviewed. The
review is necessary at both administrative and legislative levels. But, there is a proper
allocation of economic resources. „Such a focus on increases and reductions can well
lead to hardening of the bureaucratic arteries, maintain old programmes that go
unexamined simply because no substantial changes are called for in the budget‟. This
deficiency of incremental budgeting is done away with by what is called „Zero-base
budgeting‟.
Since every outlay in the budget has some attainment objective, either short-run or long-
run, it is necessary to regularly examine the expenditure components in the light of
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 Ambo University Woliso Campus SoBE Department of Economics
anticipated results. In the case of budgeted expenditure having been associated with
long term objective, the time-bound expected result-component should be examined
occasionally. This is what is done by Zero-base budgeting. It is not necessary, however,
that each and every programme be reviewed afresh or restructured anew every year
under the zero-base budgeting, though such necessity might arise in case of some of the
programmes. But it does require that programmes should not go unscruitnished in any
case for a long period. Such budgeting is a new technique of bringing the spending
agencies under a regular scrutiny and accountability. Zero-Base-Budget, therefore, acts
as a constant reminder of the necessity of utmost efficiency in public expenditure and in
resource allocation programmes.
iii) Plan and non plan budgets. Most of the underdeveloped and developing countries
pursue planned economic development through periodic plans. The basic aim of
economic planning is to achieve repaid development in different sectors like agriculture,
industry, power, transport, etc. and to raise per capita income, remove poverty,
unemployment and regional disparity so that social justice can be achieved. Ethiopia
practices five-year plans. A part of the budgetary receipts and expenditures is devoted to
the administration and implementation of the plans. The part of budgetary receipts which
goes to finance the plan expenditure and the outlays on planned developmental heads
constitute the plan budget, while the remaining part of the budgetary resources and
expenditures is referred to as the „Normal‟ or „Non-plan budget.‟ general tendency to
confine the exercise of scrutiny within the area of changes proposed for particular
budget items rather than to extend over every aspect of the whole programme structure.
Past levels of expenditure are taken as given and only new additions to or reductions from
the past outlay are examined. This is what is known as 'incremental budgeting' which
should not be allowed to be in vogue since it cannot ensure.
iv) Balanced and Unbalanced Budget. Government budget may be balanced or
unbalanced. Unbalanced Budget may be either a surplus budget or a deficit budget.
When the government revenues are equal to government expenditures, the budget is
balanced and when they are not equal, the budget is unbalanced. P. E. Taylor explains
the nature of budget balance in the following terms. (a) A budget is balanced if during
the budget period revenue receipts are exactly equal to cost payments. (b) If revenue
receipts for the budget period are greater than cost payments, the difference is budget

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 Ambo University Woliso Campus SoBE Department of Economics
surplus and (c) if revenue receipts for the budget period are less than cost payments, the
difference is budget deficit.
In the advanced countries, a balanced budget is pursued at a time when the economy
suffers neither from inflation nor from unemployment or depression so that the objective of
maintaining full employment with price stability is achieved. When the economy suffers
from inflation, a surplus budget is operated while a deficit budget is pursued when the
economy suffers from unemployment. The developing and underdeveloped countries
suffer normally from idle resources and, to make their proper use, additional expenditures
are incurred and, hence, they mostly pursue deficit budgets.

5.4. Modern Classification of Budget

There are many governmental functions on which expenditure is planned in the budget.
To get a fuller picture of the various implications of budget frame, a proper analysis is
necessary. Modem budgeting recognizes this need and attempts to classify the budget
from different analytical angles. The Economic Commission for Asia and Far East explains
this necessity in the following words. The systems of classification provide information on
the working of budgetary process. Since such a process has a multitude of functions and
objectives, different types of classification are needed, either singly or in combination, to
serve the purpose of appropriation, programme management and review, evaluation of
plan implementation, and financial and economic analysis. The various ways in which the
public sector transactions can be classified are (a) by organization, (b) by object, (c) by
function, (d) by their economic character, (e) by programme and (f) by origin of the
purchases affected by the government. Accordingly, from different analytical view
points, we may classify the budget in the following ways.
i. Functional Classification. A better idea of government expenditure is obtained from
functional classification since it goes by purpose of expenditure rather than by
departments of government. As the United Nations says, “It classifies public expenditure
by specific governmental function such as defense, health, education, promotion of
agriculture, etc”. Since the resources of government are limited and since the functions of
government are many, the latter are essentially competing objectives. Therefore, it is
important to determine the extent of budgetary resources that can be earmarked for
each of these purposes of public expenditure. This is what the functional classification
does.

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 Ambo University Woliso Campus SoBE Department of Economics
ii. Economic Classification. Economic classification seeks to categorize the government
receipts and expenditures into different classes of economic significance so that the
pattern of resource allocation and its impact on the rest of the economy can be readily
grasped. This classification shows how expenditure for a particular purpose, say, health, is
divided between such classes of economic significance as current expenditure on goods
and services, capital formation, current transfers, capital transfers and loans. It also shows
how expenditure belonging to a particular category, capital formation, is designed to
serve different purposes. Such classification provides important macroeconomic
information that is essential for construction of national accounting data.
Economic classification broadly categorizes public expenditure into two classes, viz.,
current expenditure and capital expenditure
1. Current Expenditure 1. Capital Expenditure
a. Consumption expenditure a. Gross capital formation
b. transfer payment b. Capital transfers
c. Total current expenditure =(a + b) c. Investment in shares
d. Loans and advances
a. Consumption Expenditure e. Repayment of public debt
i. Salaries and wages f. Total capital expenditure = (a + b + c + d + e)
ii. Goods and services a. Gross capital formation
iii. Less outside sales i. Buildings and other construction
iv. Net consumption expenditure = (i) + (ii) – (iii) ii. Machinery and equipments
b. Transfer payment iii. net increase in stock
i. Interest payment Total G.C.F = (i) + (ii) + (iii)
ii. Grants to local bodies b. Capital transfers
iii. Subsidies i. Grants for capital formation to total bodies
iv. Income account of household ii. Other capital transfers
Total transfer payment = (i + ii + iii +v)
Total cap. Transfers = (i) + (ii)
c. Loans and advances
i. Capital formation
ii. Current consumption
Total = (i) + (ii)

v. Programme Budgeting Classification. Under this classification, the budget would frame
a programme structure to attain a particular objective and specify spending to attain it.
We may think of all those expenditures allocated to the set of programmes under a
particular objective as belonging to a total spending agency which is responsible for
attainment of the objective. If, for example, the objective is poverty removal, these
expenditures would constitute the poverty removal programme. It is important to note
that since these expenditure agencies are inter-related, some programmes expenditure

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 Ambo University Woliso Campus SoBE Department of Economics
would draw support from a number of agencies. To explain the anatomy of programme
budgeting, let us take the following example.
1. Current Expenditure 1. Capital Expenditure
Specific objective No.1 Increase of earning capacity
programs a. Elementary and secondary education
program
b. Enrollment incentive program
c. Teachers training program
d. Adult literacy program
e. Vocational education program
f. Labour mobility program
g. Skill formation program
h. Job placement program

Specific objective No. 2 Income maintenance

Programs i. Employment insurance program
j. Social security programs like retirement and
disablement benefits
k. Consumption subsidy program
l. Public distribution program
m. Price support program etc.

Specific objective No. 3 Community Improvement program

Programs a. Low income housing program
b. Area development program
c. flood control program
d. consumers‟ co-operative program
e. market improvement program

Specific objective No. 4 Agriculture Improvement Program

Programs  Input supply program
 Irrigation improvement program
 Flood control program
 Land reforms program
 Agriculture wage restructuring program, etc

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 Ambo University Woliso Campus SoBE Department of Economics
In this way, there may be as many specific objectives as would be helpful in securing the
general objective of purpose. A more detailed programme budgeting will break down
each of these programmes into what are known as programme elements.
VI.Performance Budgeting Classification. The scientific treatment to budget making is well
demonstrated in the programme and performance budgeting. The approach is
essentially managerial in outlook. Burk head defines performance budget as one
which presents the purposes and objectives for which funds are requested, the costs
for programmes proposed for achieving these objectives and quantitative data
measuring the accomplishments and work performance under each programme.
The difficulty of functional budget to detect whether the anticipated benefits from
expenditure is really materialized is overcome by the performance budget. Its main
purpose is to measure the benefits and to relate them to costs incurred. The targets to be
achieved during the budget period are set as objectives. Thus, a determination of
attaining a specific amount of benefit from a particular outlay inevitably takes into
consideration some sort of cost-benefit analysis on the basis of either past performance or
comparative study of the relevant market situation.
In the mixed economy of developing countries where a part of the budget is concerned
with planned development programmes and a time bound achievement of objectives is
all the more necessary, the role of performance budgeting is paramount. This
classification also helps to detect the pockets of inefficiency in administration as well as
resource allocation so that corrective steps may be designed to improve the efficiency
level of administering and executing the development programmes.
5.5. Budget as an Instrument of Economic Policy
Government budget is an important instrument of economic policy in both developed
and developing countries. In the developed countries, the economy operates at full
employment level and, hence, there does not exist unemployed resources. But the
economy is subjected to trade cycle and, therefore, occasionally faces the problems of
depression or unemployment and inflation or pressure of excess purchasing power. In the
underdeveloped countries, the economy operates at less than full employment level
and, hence, the main problem is how to attain economic growth. In these poor
countries, growth process is faced with a number of problems. They are allocational,
distributional and stabilisational. Budget serves as an important device to achieve
economic development in these countries also. The following are the important ways in

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 Ambo University Woliso Campus SoBE Department of Economics
which the government budget can influence the economy of a country.
(1) Revenue Raising Device. The government requires enough revenue to discharge its
fiscal responsibility. Modern countries have increasingly become welfare states with larger
and larger state activities coming under the fold of public sector. Hence, resources have
to be found in sufficient quantity. Budget secures this purpose through a financial plan.
The receipts side of the budget clearly mentions the sources and the extent of funds for
the purpose of financing state activities.
(2) Building of Economic Overheads. The main reason of underdevelopment, of the poor
countries is absence of proper economic infrastructure. Without proper transport and
communication system, large scale generation of electric power, establishment of basic
and key industries and proper training facilities for workers and entrepreneurs, industrial
development is not possible. Similarly, agricultural production and productivity cannot
improve in the absence of proper irrigation facilities, flood control measures,
technological improvement with research and development activities, etc. These facilities
must be provided by the government. The cost of supplying these services is heavy and
cannot be raised directly from the beneficiaries. Therefore, these facilities are supplied
free of direct charges through the budgetary provisions. Thus, budget has a tremendous
influence on the industrial and agricultural development.
(3) Diversion of Resources to More Useful Production. Free market mechanism leads to
production of those goods which give maximum profit to private enterprises. Hence
private investment is generally concentrated on the production of luxury commodities. It
is, therefore, necessary to divert resources to the production of more useful goods and
services, particularly of the kind of mass consumption ones. This can be done by
government interference through the budget. Imposition of heavy tax on harmful and less
essential goods and tax exemption or tax concessions granted to more essential goods
and services can divert resources to the production of right kind of goods and services.
Grant of facilities through budgetary expenditure can also do the same job.
(4) Proper Allocation of Resources. Most efficient allocation of resources is given by the
equality between marginal cost and price which is possible only under perfect market
conditions. Underdeveloped countries seriously suffer from malallocation of resources.
The general market conditions in private sectors are set by existence of monopoly,
monopolistic competition and oligopoly. To correct this misallocation, the government
has to interfere either in the form of production subsidy or supply of goods and services

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 Ambo University Woliso Campus SoBE Department of Economics
by public authorities so that the gap between average revenue (i.e. price) and the
marginal cost is reduced as far as possible. This is the reason why the heavy investment
public welfare industries which are subjected to decreasing cost conditions are
increasingly coming under the fold of public sector.
(5) Balanced Development. Underdeveloped countries suffer from regional imbalance in
economic development. Left to the private sector which is motivated by profit
maximization, the industries will be located in the urban and already-developed areas.
The government can correct this geographical imbalance by setting up public sector
industries in backward areas. Moreover, the development of agriculture and small scale
and village industries can be secured through government patronage in the form of
supply of infrastructure facilities and various incentive or subsidy measures. This will
develop the economy of rural areas.
(6) Income and Employment. Since underdeveloped countries are low income
economics, people live in poverty and, hence, saving and investment is very low. Income
of the people can be increased only through increased productivity and production.
Budgetary provisions can go a long way to achieve this. When agricultural technology is
improved through budgetary programmes, the income of the people engaged in
agriculture rises. People get gainful employment in the sector. Improvement in small scale
industries in the rural areas and setting up of public sector industries in the backward
regions will increase employment opportunities in these industries. The budgetary
provisions of employment-related tax concessions can influence creation of employment
opportunity in the private sector also.
(7) Saving and Investment. In underdeveloped countries, the level of saving and
investment is very low. Moreover, without increased saving and investment, economic
growth cannot be achieved. Due to low level of income, marginal propensity to consume
is very high and, hence, the mass people cannot save. Public saving is, therefore,
necessary. Taxation of various types serves this purpose. The saving and investment of
private individuals are also influenced by the savings-investment-related tax concessions
and other budgetary subsidy programmes. Capacity and willingness to work, save and
invest of the people is increased through various human capital formation measures and
creation of employment opportunities. These are all done through budgetary
expenditures.
(8) Poverty Removal. Poverty removal programme is a part and parcel of the budget in

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 Ambo University Woliso Campus SoBE Department of Economics
underdeveloped countries. All expenditure measures are designed in such a way that
they directly or indirectly influence reduction of poverty in the economy. Thus, when
budgetary resources are spent on account of education, whether general or technical
and vocational or on health measures, land reforms, flood control and irrigation, etc, an
important objective is to remove poverty of people. Direct budgetary programmes for
poverty removal are those of increasing employment opportunities and creation of
community assets like employment insurance, social security, consumption subsidy,
public distribution system and price support programmes, low-income housing, area
development, input supply, agricultural wage restructuring, etc.
(9) Full Employment and Price Stability. An important function of the budget is to secure
the objective of full employment and price level stability. We have seen how this should
be done in the case of depression and inflation. When the economy, on the other hand,
suffers from neither inflation nor deflation, the budget is to maintain full employment and
prevailing prices through judicious programmes of public expenditure and taxation. In this
case, a balanced budget is helpful in developed countries. In the underdeveloped
economies where resources are not fully employed public expenditure programmes and
tax incentive measures are put into operation to secure full employment.
(10) A Check to Misuse of Public Funds. Since budget is a financial plan relating to public
revenues and public expenditures for the budgeted period, it imposes definite restraints
on the tax gatherer and public funds spender. The legislature and the people know from
the study of budget how the revenues will be raised and how will they be spent. Revenue
mobilization and public expenditure activities will be put to scrutiny of the legislature and
also of the members of public. In case of inefficiency or misuse in the task of budgetary
performance, the executive agencies will be accountable. This will definitely put a check
on the improper use and mishandling of public funds.

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 CHAPTER SIX
PUBLIC DEBT
In this chapter we will cover five sections: 1) Nature and kinds of public debt. 2)
Effects of public debt. 3) Burden of public debt. 4) Redemption of public debt. 5)
Public debt in a developing economy.
6.1. NATURE AND DEFINITION OF PUBLIC DEBT
Public debt is of recent growth and was unheard of prior to the 18 th century. In
modern times, however, borrowing by the States has become a normal method of
government finance along with other sources such as taxes, fees, etc. The
government may borrow from banks, business houses, other organizations and
individuals. Besides, it can borrow within the country or from outside. The
government loan is generally in the form of bonds (or treasury bills if the loan is
required for short periods) which are promises of the government to pay to the
holders of these bills the principal sum along with interest at the stated rate.
Borrowing is resorted to in order to provide funds for financing a current deficit. This
definition very clearly explains the three features of public debt.
1. Public debt arises in the form of borrowings by the treasury or by the state
2. The government borrows a certain amount now but promises to pay in the
future not only the principal amount but the interest also.
3. The government borrows when there is a budget deficit i.e. public expenditure
is more than revenue.
6.2. CLASSIFICATION OF PUBLIC DEBT
Public debt can be classified in different ways according to various factors like
sources of borrowing, purpose of loan, the term duration of loan provision for
repayment, nature of contribution, marketability.
1.Source of Borrowing (internal debt and external debt).
There are two sources of public debt, internal and external. Internal debt refers to
public loans floated within the country, while external debt refers to the obligations
of a country to foreign governments, or foreign nationals or international institutions.
Internally, the government can borrow from individuals, financial institutions,
commercial banks and the central bank. Externally, the government generally

1
borrows from individuals and banks, international institutions and other
governments.

When individuals purchase government bonds, they are diverting fund from private
use to government use. More important than individual subscribers to government
bonds are the financial institutions such as insurance companies, investment trusts,
mutual savings banks, etc. These non-banking financial institutions prefer
government bonds because of the security provided by the latter and also due to
their high negotiability and liquidity. While individuals and non-banking financial
institutions take up government bonds out of their own funds, the commercial
banks can do so by creating additional purchasing power-known as credit
creation. The central bank of the country can subscribe to government loans. By
purchasing government bonds, the central bank irradiates the account of the
government. Borrowing from the central bank is the most expansionary of all the
sources, for not only the government secures funds for its expenditure but the
commercial banking system gets additional cash which can be used as the basis
for further credit expansion.
Government may borrow from other countries too to finance war expenditure or to
pay for development projects or to payoff adverse balance of payments. Two
important sources have become prominent. They are: (a) international financial
institutions, viz., the IMF and World Bank, which give loans for short term to payoff
temporary balance of payments difficulties and for long term for development
purposes; and (b) government assistance generally to assist in development
projects. For developing countries like Ethiopia, external sources of borrowing are
becoming considerably important in recent years.
Though external debt is becoming very common these days, there has been
general prejudice against foreign debt, based on ignorance and faulty economics.
2. Purpose of the loan (Productive and unproductive debt)
Public debt is said to be productive if the investment yields an income which will not
only meet the yearly interest payments of the debt but also help repay the principal
over the long run. All public debt can be said to be productive in another sense
too. The government may undertake certain projects through loans which may not

2
be productive in the sense given above but which may be really useful to the
community – for example, a railway line connecting a backward region, an
irrigation work to prevent famine conditions in an area, and so on. In this sense all
public debt is productive. But in many cases, public debt may be contracted
during war-time to finance war. Such debt is unproductive because it does not
create an asset; it is a dead-weight debt or a useless burden on the community.
3.Funded debt and unfunded or floating debt.
Broadly speaking, funded debt is a long-term debt, undertaken for creating a
permanent asset and the government normally makes arrangements about the
mode and the time of repayment. Unfunded and floating debt is a relatively short-
period debt meant to meet current needs. The government undertakes to pay off
the unfunded debt in a very short period, say, within six months. Treasury bills are
examples of unfunded debt. The rate of interest on unfunded debt is lower.
4.Time Duration of loan (short, medium, and long term loan).
According to time duration of the loan, public debt can be classified into short
term, medium term, and long term loans. Short term loan is usually incurred for a
period varying from three months to one year. Usually government gets such loans
from the central (national) banks by using treasury bills. These loans are also called
„ways and means advances‟. Such loans are obtained to overcome temporary
deficits in payment to be made by the government in the course of one year to
pay salaries etc.
Medium term loans are those which are obtained for more than one year but less
than ten years. Usually the governments borrow only long term loans for more than
ten years. The maturity period is long so that the rate of interest tends to be higher
on the long term loan than short term loan. Long term loans are incurred to finance
development schemes.
6.3. CAUSES OF PUBLIC DEBT: WHY PUBLIC DEBT IS INCURRED?
Public loans in modern times are necessary to meet difficult situations. In the first
place, modern governments do not have any large accumulated balance or
treasure to meet a budget deficit. Normally, the annual expenditure of the
government should be and is met by annual income. But because of many

3
circumstances the yield from taxation and other sources may not be equal to the
actual expenditure. Similarly, there may be unplanned and unexpected
emergency situations like major fires, floods and famines. It may not be possible to
secure funds through taxation. Short-term borrowing in anticipation of tax
collections in subsequent years is ordinarily used in the above two circumstances.
Secondly, a factor which necessitates public loans is war. Modern warfare is so
costly that the normal income through taxation falls short of the actual war
expenditure. A public loan is a better and easier method of collecting revenue
than taxation. Governments, therefore, have to borrow extensively from individuals
and institutions towards war financing. In fact, the enormous increase in public debt
in most countries is due mainly to the First and Second World Wars.
Thirdly, public borrowing is considered very useful to remedy a depression. Business
depression and unemployment are generally due to deficiency of demand for
goods and services. Keynes advocated increased public expenditure financed
through borrowing and not through taxation. For, while taxation will reduce the
incomes of the public and their demand still further, borrowing will have no such
effect. Besides, loans enable the government to make use of idle and unutilized
funds of the public.
Finally, public loans are resorted to for development purposes. Underdeveloped
countries interested in the development of their natural resources to the optimum
level find public borrowing a very useful device to finance the various development
projects. In countries like Ethiopia, public debt has been increasing in recent years
because of this factor.
6.2. EFFECTS OF PUBLIC DEBT
We should clearly distinguish economic effects of public borrowing from non
economic effects of public debt. Borrowing refers to the method of securing funds,
and it is one of the four alternatives available to the government-the other sources
being taxation, profits from State enterprises and money creation. The effects of
borrowing, therefore, relate to government expenditure financed through
borrowing are different from the effects of a similar programme financed by
taxation. On the other hand, the effects of public debt refer to the effects on the

4
economy which are caused by the existence of public debt, after it had been
incurred.
Public borrowing from individuals and firms has effects on all aspects of economic
life. They may be considered as follows:
1. Effects on consumption. The effect of public debt on consumption depends
upon how it is financed by individuals. If they lend to the government out of their
idle savings, consumption is not affected. If they buy out of past savings it has only a
limited impact on present expenditure. But if they lend by cutting present savings, it
may make them feel less secure and so they may reduce consumption. But if the
people feel that they have invested in government securities which are considered
safe investment, they may actually increase their consumption.
2. Effects on Production and Investment. The effect of public debt on production
depends upon whether it affects private investment or not. If people buy
government bonds by selling their shares or debentures in private individual firms,
there is an adverse effect on private investment. But if the money borrowed by the
government is for productive purpose, over all production is not affected. But if it is
used for wasteful or non-productive purpose, total investment is affected
negatively.

If people buy government bonds by taking away their bank deposits, bank‟s
lending capacity is reduced and this again affects private investment. Private
investment is not affected only when it is financed by people out of their idle
funds.

If the government uses the funds for productive purpose, it can repay it out of
income generated by these projects. But if pubic debt is used for unproductive
purposes, it can be repaid only by through additional taxation in future which
affects future consumption as well as production by reducing future disposable
incomes. However, if public debt is used for welfare schemes, it may increase
people‟s efficiency to work and thus improve productive capacity.
3. Effects on Distribution. Public debt is bound to have effects on distribution of
income because it involves transfer of purchasing power from one sector to

5
another. Usually government bonds are purchased by the richer section. But the
burden of tax to repay the debt falls on all sections including the poor. To that
extent the inequality of income will increase. If the bondholder and taxpayers is the
same people, theoretically there will be no effect on redistribution of income.
Hence redistribution of income effects of public debt depends upon whether the
taxpayers and the bond holders are the same people or not.
However if the public debt is used for public welfare programmes especially the
poor, inequalities of income decreases. But if public borrowing creates inflation, the
beneficial effects of redistribution will be neutralized as prices rise.
4.Effects on National Income. Public debt has an adverse effect on national
income only if private investment is adversely affected. However if government
expenditure is incurred on capital goods, it gives incentive to greater production
and this again increases the income. Government investment financed by public
debt will have a multiple effect on national income. If public debt is financed by
commercial banks and national banks, the credit creation and the public
expenditure from that will have a very large expansionary effect on national
income.
5. Effects on Resource Allocation. Unlike tax finance, public debt has little effect on
resource allocation. Public borrowing curtails business investment activities but the
decline of business investment varies from one industry to another. Allocation of
resources is not affected much.
6. Effects on Liquidity. Effect of public debt on liquidity is favorable if the
governments bonds are liquid assets which can be sold in the market whenever the
bondholders need money. So public debt increases the volume of liquid assets in
the country. Secondly the larger quantity of such liquid government bonds can
result the failure of monetary policy. For example, when national bank tries to
control inflation through monetary policy tools like bank rate, the commercial banks
can increase their cash reserves by selling government bonds.
7.Effects on Money Market. The government has to compete with the private sector
for fund. Usually if the rate of interest paid by private sector on borrowing is high, the
government also will have to rise its interest rate to attract public funds. On the

6
other hand if the state tries to borrow from commercial banks and national banks,
more than what is available at current rate of interest it results in currency
expansion.
6.3. BURDEN OF PUBLIC DEBT
There has been considerable confusion as regards the burden of public debt. Two
extreme views have been held, the traditional view and its counterarguments. The
traditional view is that public debt, as in the case of private debt, imposes a real
burden on the community. This opinion is based on the following assumptions:
(a) Public debt necessitates a transfer of funds from the private sector (individuals
and companies) to the Government in the form of additional taxation;
(b) Public debt is a more costly method of financing public expenditure than
taxation because of the additional cost of interest payments;
(e) Public debt tends to transfer the burden of a particular outlay to future
taxpayers; and
(d) Excessive borrowing by and huge public debt of the Government, may
undermine the creditworthiness of the Government.
The traditionalists, therefore, conclude that public debt should be kept to the
minimum and should be redeemed as early as Possible. The other extreme view-
held by some modern writers – is that internal public debt is not burdensome, since
payment of interest and the use of taxes to meet the same involve simply a transfer
of funds between people within the country. People will be receiving interest from
the Government for the bonds they hold but will be paying taxes to meet interest
obligations of the Government. In other words, it is almost like transfer of funds from
one pocket to another, or from one individual to another. The result is that the
internal public debt does not impose a real burden on the community. Both these
apparently conflicting views on the burden of public debt can be easily shown to
be wrong. For this Purpose, it would be convenient and useful to adopt Dalton's
distinction between direct and indirect burden of public debt and between money
burden and real burden of public debt. We can, therefore, speak about four types
of burdens of public debt, viz.,

7
 (a) Direct money burden,
(b) Direct real burden,
(c) Indirect money burden, and
(d) Indirect real burden.
(a) Direct Money Burden. Public debt involves payment of interest and repayment
of the principal by the government, who will have to raise the necessary amount by
way of taxes. The direct money burden of public debt consists of the tax burden
imposed on the public and it is equal to the sum of money payments for interest
and repayment of principal. Actually, in the case of an internal debt, there can be
no direct money burden because all the money payments (taxes) and receipts
(interest) cancel out. Suppose the government of Ethiopia collects taxes to the
extent of Birr 1000 million a year from the general public towards its debt services.
This amount is transferred from the public to the government. But the latter
distributes this amount to the general public by way of interest on its loans. Thus
servicing of internally held public debt is reduced to a series of transfers of wealth
between parties – total receipts will necessarily be equal to total payment. There
would, therefore, be not net direct money burden in internal debt. On the other
hand in the case of an external debt, money payments by the debtor nation (say
Ethiopia) are to external creditors (say, Americans); these constitute clear direct
money burden of public debt on the debtor nation.
(b) Direct Real Burden. When we refer to monetary transfers between taxpayers
and creditors we are speaking about the direct money burden. But when we refer
to the distribution of taxes and public securities among the public, we are referring
to the real burden of public debt. We know that people hold public securities (and
get interest from the Government) but they also pay taxes towards the cost of the
debt service. If the proportion of taxation paid by the rich towards the cost of the
debt service is smaller than the proportion of public securities held by them, while
on the other, if the proportion of taxation paid by the poor and middle income
groups towards the cost of the debt service is greater than the proportion of public
securities held by them, there is a direct real burden from public debt. In this case,
public debt has been responsible for worsening inequality of incomes. Suppose, on

8
the other hand, government bonds and securities are held by the working classes
and the middle income group (and, therefore, they receive the interest) while the
taxation towards the cost of debt service is paid by the rich (by way of income tax
and the other highly progressive direct taxes) then public debt actually tends to
decrease the inequality of incomes in the country. In this case there is actually no
direct real burden but there is a direct real burden to the community. Thus whether
internally held public debt imposes a direct real burden or provides a, direct real
benefit will depend upon the distribution of taxation on the one hand and
ownership of public securities on the other, among different sections of the
community. Dalton argues that in most modern capitalist or mixed economies, with
large inequality of incomes, internally held public debt will generally result in transfer
of money from poorer to richer sections of the community and hence will impose a
direct real burden because:
(i) the bulk of the government bonds and public securities will generally be
held by the richer sections of the community, directly or indirectly, (through their
ownership of banks and insurance companies which hold public securities among
their assets); and
(ii) even the most progressive of taxation cannot fall so heavily on the rich as to
counterbalance, among the richer classes, the income derived from public
securities.
We may now refer to the direct real burden of external debt. In the case of external
debt, there is a transfer of payment from the debtor country to the creditor country.
The direct real burden refers to the loss of economic welfare which these money
transfers involve. In case the money payments for servicing external debt are made
by the richer classes, the direct real burden will be less; if, on the other hand, they
are contributed by the poorer sections of the country, the direct real burden will be
much more.
(c) Indirect money and real burdens. Heavier taxation to meet debt charges may
reduce taxpayers‟ ability and desire to work and save and thus check production.
Heavy debt charges may also force the government to economies on public
expenditure as might promote production. In case these adverse effects of

9
taxation could be neutralized by some favourable effects of public expenditure,
the indirect burden of public debt can be cancelled out. In practice, however, this
may not be possible. In the case of external debt, indirect money and real burden
arise from checks to production because of additional taxation (to pay for debt
charges) and to possible economies which government may effect in desirable
social expenditure.
Burden of External Debt
In one sense, the burden of a foreign debt is similar to that of domestic debt. That is,
the government will have to pay it through additional taxation. But, while in
domestic debt, interest payments and the repayment of loans are available to
local nationals; in the case of foreign debt they are available to foreigners. In
another sense, the total money burden of an external debt is more because there is
the additional transfer problem. That is, the government will have to find necessary
monetary resources to pay off the external debt and besides will have to secure
foreign currencies too (after all, foreigners will have to be paid in their currencies).
The transfer problem, therefore, requires that during the term of the loan, the
balance of trade must become favourable. In other words, a regular payment of
interest and principal to foreign countries will be possible only if the export value
exceeds the import value by at least the obligations arising from the loan.
But external debt can mean a certain impoverishment of the economy. The
payment of interest and debt redemption to foreign Countries means a
corresponding exhaustion of national income and makes greater demand on the
gold and foreign exchange resources of the country. This is what has been referred
to as the transfer problem in the previous paragraph. But properly speaking, there is
no impoverishment involved. What actually happens is this: originally, when foreign
loans were made, they entered the debtor country in the form of machinery, raw
materials and other essential goods, for which no corresponding exports were
made at that time. After the lapse of a certain time, the debtor country manages
to secure excess of exports over imports to pay for the external loan. In this case,
there is no actual impoverishment of the economy involved but goods are paid for
goods. But if the external debt would really deprive the citizens of a debtor country

10
of a certain amount of, goods and services, this would be a net direct real burden
of an external loan.
However, there is one sense in which an external loan can be a source of trouble to
a debtor country. The transfer problem necessitating the creation of an export
surplus means “an exhaustion of the country‟s future capacity to import,” which is
of vital importance for development. But if the foreign loans are floated only when
it is absolutely essential and when internal resources are utilized as far as possible,
and if the foreign loans are used to increase the total national product, including
goods specially meant for export, there is no reason why the debtor country should
suffer in the future.
An underdeveloped country which borrows abroad for the development of social
and economic overheads and basic industries will find that the benefits outweigh
the burden of repayment of the loan. Thus, an external loan for development
purposes is not a burden but a profitable venture. This is exactly like an internal loan
meant for development purposes.
Measurements of debt burden.
There are various ways of estimating the burden of public debt. Three simple
methods are suggested.
1. The first method is to consider the ratio of aggregate public debt to national
income i.e., P/Y , where P is the quantum of public debt and Y is the national
income. If changes in the quantum of public debt are greater than the change
in the national income, the net relative burden can be said to have increased.
This is the simple, yet commonly adopted method.
2. The second method considered the interest paid every year on public debt
as proportion of national income i,e., I/Y where „I‟ is the interest payment or
debt service charges and „Y‟ is the national income. This method gives an idea
of the extent of burden from the point of view of debt service charges.
3. The third method considers the ratio of debt service charge (I) to total public
expenditure in a year I/E where „I‟ is interest payment on debt and „E‟ is public
expenditure. This method has the advantage of comparing the cost side i.e.
interest charges in relation to benefit side i.e. public expenditure.

11
Can the Future Generation be made to bear the burden of Public Debt?
It is often contended that the burden of public debt can be shifted “to make
posterity pay” the debt of the present generation. The argument assumes that
taxation imposes a direct burden on the present generation while government
borrowing does not impose such a burden. Suppose public expenditure is financed
out of taxes, the benefit of public expenditure as well as the burden of taxation will
fall upon the present generation. On the other hand, in the case of debt financing
of public expenditure, the benefit of public expenditure will accrue to the present
generation but the burden of taxation to pay for the interest and repayment of
principal will fall upon the future generations. Financing of investment projects such
as construction of irrigation works, rail and road construction, etc., through
borrowing is sought to be justified on the ground that (a) the benefit of public debt
accrues to future generations, and (b) the burden of servicing and repaying public
debt would, therefore, be borne by the future generations. This line of thinking is
obviously wrong and cannot be maintained.
In the first place, real resources required by the government for war, economic
development or any other purpose have to be obtained now and at the
immediate cost of the present generation, whether they are derived from taxation
or borrowing. Borrowing is only an alternative to taxation for diverting real resources
from private sector to the government. The present generation will have to transfer
these resources to the government either through taxes or through loans and will,
therefore, have to suffer a loss of resources. In other words, the present generation
will have to bear the burden of public debt and the question of shifting it to the
future generations does not arise.
Secondly, there is no direct money burden of public debts on the future
generations. As we have seen earlier, the burden of taxation to pay for public debt
is cancelled out by the receipt of interest from the government. While some groups
in the future pay taxes some others will receive interest. The question of shifting the
burden to the future generations is actually confusing.
It is, however, possible to argue that under tax financing, the present generation will
have to curtail its consumption, but in the case of debt financing there will be no

12
such reduction of consumption. The assumption here is that those who are paying
taxes do so out of their current income and, therefore, reduce their consumption
expenditure but those who are subscribing to public debt do so out of their savings.
Debt financing leaves in the hands of public debt owners bonds and other
securities which they consider as part of their wealth. While tax financing makes the
general public poorer and, accordingly, reduce their consumption, debt financing
does not have such a result since the owners of public debt do not feel that they
are poorer. In fact, they have bonds and securities on behalf of funds transferred to
the government. Under debt financing, therefore, consumption is not likely to fall.
In this sense, tax financing imposes a real burden on the present generation, while
debt financing does not impose such a burden on the future.
Suppose, the present generation reduces its savings to subscribe to public debt,
and suppose further that as a result of reducing saving and capital formation, the
capital stock of future generation is reduced. In such a case debt financing can
impose a heavy indirect burden on the future generation. On the other hand, if the
present generation reduced its consumption, to subscribe to public debt, saving
and capital formation would not be affected and the future generation would not
be burdened through inheritance of reduced capital stock. The above analysis is
defective since the expenditure side of the government is ignored. If the
government resorts to debt financing for planned economic growth and
accumulation of capital stock, the benefits will be available to the future
generations and there will be no real burden from such debt – for the loss of welfare
through taxation will be more than made good by benefits from government
investment.
Only in the case of external debt, the burden of public debt can be passed on to
the future generations. When a country raises resources in foreign countries for war,
the present generation receives additional resources and, therefore, need not
curtail its consumption or saving. The future generations will have to pay the
interest and also repay the principal, and hence the burden of external debt is on
them. But in case the country has borrowed in a foreign country for development
purposes (as in the case of India), the future generations may not feel the burden

13
on account of increased productivity which external borrowing has made possible.
Generally, therefore, the burden of public debt cannot be shifted from one
generation to another. We cannot “make posterity pay”. Nor is it normally correct
to make the future pay for policies taken now for which the future has no control or
influence.
Can a Country Become Bankrupt?
Sometimes people assert that with mounting public debt, the nation would
become bankrupt. This is partly true and partly untrue. If bankruptcy means
inability to return the amount borrowed, a country can never become bankrupt,
however much its domestic debt may have gone up. The government can always
honor its obligations either through higher taxation or through printing of money. It
has the option to impose a heavy capital levy and pay off the debt at one stroke.
Even repudiation of public debt – though morally indefensible – will be justified,
since, after all those who receive interest payments from the government will have
to pay taxes to enable the government to pay the interest. Will it not be better to
cancel the debts altogether or at least scale down considerably so that interest
receipts as well as tax payment will be proportionately cut down? In any case, a
government does not become bankrupt because of its internal debt.
Debt Trap: However, there may be circumstances when a government may not be
able to honour its obligations to foreign countries. When interest on foreign loans
and repayment of debt amount to a considerable figure and when adequate
export surplus has not been built up for various reasons a debtor country may be
unable to honour its obligations. Either it can ask for postponement or raise new
foreign loans to repay the old ones. This has come to be known as the “debt trap.”
Many South American countries are caught in this trap. Only in extreme cases, it
may repudiate external loans. Repudiation is an extreme measure, since the
country loses its creditworthiness in the international capital markets and will never
again be able to borrow from foreign sources.
6.4 REDEMPTION OF PUBLIC DEBT
Experience shows clearly that mounting public debt has a demoralizing effects of
the people apart from the fact that the public is subjected to higher rates of

14
taxation. Besides, public debt consists mostly of unproductive or dead-weight debt
– war debt is a good example of such debt – the sooner it is paid off, the better
both for the government as well as for the public. The various methods available to
the government to pay off its debt are:
i.Repudiation of Debt. Repudiation of debt means simply that the government
refuses to pay the interest as well as the principal. Repudiation is not paying off a
loan but destroying it. Normally, a government does not repudiate its debt, for this
will shake the confidence of the general public in the government. However, in
extreme circumstances, a government may be forced to repudiate its internal or
external debt obligations. For instance, internally the country may be facing
financial ruin and bankruptcy and externally, it may be faced with shortage of
foreign exchange. Generally, a government may not repudiate its internal debt
lest it should lead to internal rebellion: those who have lent to the government
would obviously rise against the government. However, the temptation of a
government to repudiate its external debt obligation may be strong at certain
times. Of all the methods of redeeming debt, repudiation is the most extreme.
ii.Conversion of Loans. Another method of redemption of public debt is known as
conversion of loans, that is, an old loan is converted in to a new loan (in a broad
way, conversion is the same as refunding debt; i.e., repayment of a debt through a
new loan). Conversion may be resorted to:

(a) When at the time of redemption of a loan, the government has not the
necessary funds, and/or

(b) When the current rate of interest is lower than the rate which the
government is paying for its existing debt, so that the government can
reduce its interest obligations. Conversion of a loan is, always done through
the floating of a new loan. Hence, the volume of public debt is not
reduced. Really speaking, therefore, conversion of debt is not redemption
of debt.

iii.Serial Bond Redemption. The government may decide to repay every year a
certain portion of the bonds issued previously. Therefore, a provision may be
made so that a certain portion of public debt may mature every year and

15
 decision may also be made in the beginning about the serial number of bonds
which are to mature each year. This system enables a portion of the debt being
paid off every year. A variant of this type of bond redemption is to determine
the serial number of bonds to mature every year through lottery. While under-the
first variant, the bond-holders know when the different sets of bonds would
mature and could take up the bonds according to their convenience, under the
second variant, the bond-holders are uncertain about the time of repayment
and they may get back their money at the most inconvenient time.
iv.Buying up Loans. The government may redeem its debt through buying up loans
from the market. Whenever the government has surplus income, it may spend the
amount to pay off government loan bonds from the market where they are bought
and sold. It is a good system, provided the government can secure budget
surpluses. The only defect of this method of canceling debts is that it is not
systematic.
v.Sinking Fund. Sinking fund is probably the most systematic and, therefore, the
best method of redeeming public debt. It refers to the creation and the gradual
accumulation of a fund which will be sufficient to pay off public debt. Suppose the
government floats a loan of Birr10 billions, redeemable in say, 10 years, for the
purpose of road construction. At the time the government is floating the loan, it
may levy a tax on petrol, the proceeds of which would be credited to a fund
known as the sinking fund. Year after year, the tax proceeds as well as interest on
investments will make the fund grow till after 10 years it becomes equivalent to the
original amount borrowed; at that time, that debt will be paid off. One danger of
the sinking fund methods is that a government, in need of money, may not have
the patience to wait till the end of the period of maturity but may utilize the fund for
purposes other than the one for which originally the sinking fund was instituted.
vi.Capital Levy. Public debt may be redeemed through a capital levy which, as we
have seen earlier, may be levied once in a way with the special objective of
redeeming public debt. It is generally advocated immediately after a war for the
following reasons:

(a) Heavy public debt is incurred during a war to prosecute it and hence is
quite heavy immediately after war.
(b) War debt is unproductive and is a dead weight on the community
necessitating heavy taxation year after year. It will be better to wipe it out once

16
 and for all by a special levy.
(c) Due to war-time inflation, businessmen, producers and speculators would
have amassed large fortunes and hence it is easier for them to contribute to a
capital levy and, in a sense, it is just they bear a part of the war burden.
(d) Redemption of public debt through capital levy will leave the higher
income groups almost in the same old position, since they will be receiving
back from the government what they had paid by way of a special levy.

Redemption through a special levy is said to be superior to the method of the

sinking fund, as it is levied only once, while for purposes of the sinking fund, taxes
have to be imposed year after year. The greatest merit of capital levy is that it will
reduce heavy tax burden which will otherwise be necessary to redeem public
debt. But the danger of a capital levy is that the government may be tempted to
resort to it too often.
vii.Redemption of External Debt. The redemption of external debt can be made
only through accumulating the necessary foreign exchange to pay for it. This can
be done by creating export surpluses. Towards this end, foreign loans should be
carefully invested in those industries which have high productive potentialities and
which will promote exports directly. At the same time, the exportable surplus should
consist of goods which can be really taken by foreigners. Temporarily, of course,
redemption of an old debt can be made through the floating of new loans.
Of the various methods available to a government to payoff its debt, the most
common and- sensible method is to redeem part of the public debt every year, so
that the debt may not go on mounting.

6.5 PUBLIC DEBT IN A DEVELOPING ECONOMY

Public borrowings may be for short and long periods but we are interested only in
long-term borrowings for purposes of investment. Since voluntary loans come from
voluntary savings, the scope for domestic borrowings will be limited. The reasons for
this are not far to seek: low income levels of the masses, very low savings of the
peasants and the middle classes, the perpetual attempt towards higher
consumption, etc. The small minority of the rich does save a considerable portion of

17
their incomes, but these savings are not generally available to the government. The
only good source for the government is the banking system and the financial
institutions. But the banking system is still undeveloped and the financial institutions
are too few to be significant.
Even though domestic borrowings may not be of much importance during the
initial years of economic development, its importance would grow as time passes.
With increased tempo of economic development incomes rise and savings also
rise. The government tries to stimulate savings through educative propaganda, tax
concessions and exemption, etc. Besides, the government promotes the setting up
of a sound banking system and a well-organized money and capital market and a
whole set of financial institutions/financial intermediaries. These institutions help in
the mobilization of savings and make them available for investment.
Public Borrowings from Foreign Sources
A developing country borrows from three foreign sources: Foreign capital markets,
foreign governments and international institutions. In the past, governments
generally floated loans in foreign capital markets and expected the foreign
nationals to subscribe to them. But nowadays the demand for funds is so large and
political and other difficulties are so numerous against private foreign investment
that prospects of investment of funds by foreign nationals and institutional investors
in government securities seem to be not attractive. The government of a
developing country can lessen political and social unrest and economic instability
by appropriate measures but it would be difficult to convince foreign nationals and
make them accept government bonds as riskless. After all, the repayment of
interest and principal over the long period implies a high degree of risk and what
guarantee can there be in the promises of a government which may be
overthrown by another in no time.

In recent years, advanced countries are taking great interest in the economic
development of underdeveloped and developing countries. Intergovernmental
loans are becoming very significant these days. Besides, international institutions,
such as the World Bank and the I.D.A, Asian Development Bank (ADB) etc., are
important sources from which developing countries draw for purposes of
18
development. But these institutions insist upon certain minimum conditions before
granting loans and many developing countries may not be able to fulfill them.
Conditions Necessary for Foreign Loans
Foreign loans enable a developing country to secure capital and technology
which it cannot get internally and which are so essential for economic
development. But the total burden of a foreign loan is higher than that of an
internal loan of equal extent, because the former involves also a transfer problem.
Besides, debt redemption to foreign countries means a corresponding exhaustion
of national income and moreover makes greater demand on the gold and foreign
exchange treasures of the country. It is essential therefore, that great care is taken
in the matter of securing foreign loans. It is but natural that certain internal
conditions are fulfilled so as to justify foreign loans.
(a) The foreign loan should be used to stimulate economic growth directly. This
will facilitate repayment later.
(b) The foreign loans should be invested in such a way that the country secures
a favourable balance of trade in the future. This is necessary, as we have
pointed out earlier, because foreign loan involves a transfer problem, viz., the
necessity to transfer from the debtor country to the creditor country. This would
further necessitate the excess of exports over imports.
c) Foreign loans will be justified only if the productive resources of the country
are insufficient to bring about a planned pace of growth. This is so because the
gross burden of foreign borrowing is higher than that of domestic borrowing.

A backward country is not justified in borrowing from abroad unless internal sources
are inadequate and there could be proper use of loan proceeds. The existence of
an adverse balance of payments alone cannot be a sufficient reason for
borrowing. It is not really necessary that foreign loan should be used on projects
which will increase exports and check imports and thus help in remedying adverse
balance of payments. What is required basically is the development of the total
national product and not be development of exports only. However, there may be
circumstances under which even a temporary adverse balance of payments may

19
have serious adverse effects on economic development. Foreign borrowing will be
justified here, again, not to remedy adverse balance of payment but to prevent
internal disturbances.

Public Debt management

Public debt management refers to important policy decisions to be made with
regard to public debt. This is an important aspect of modern public finance as it is
now accepted that public debt is an active fiscal tool just like taxation and public
expenditure, all of which have varied effects on the economy. Hence the floating
and repayment of debt should be carefully planned. The forms of public debt, the
terms of loan with regard to interest and duration, the ownership pattern are all
crucial issues in management of public debt. In short public debt management is
concerned with the policy decisions on the structural characteristics of public debt.
Objective of public debt management
Public debt management can help the Government to achieve several goals.
Important objectives of public debt management in this respect are:
1. It should not have any adverse effect on the economy, especially on
willingness and ability to work and save
2. During inflation public debt management should aim at curtailing aggregate
demand
3. During depression it should help to raise aggregate demand in order to
improve employment.
4. Public debt management can help to secure funds during War.
5. It should go hand in hand with monetary policy to strengthen the money
market.
Principles of public debt management
Phillip E. Taylor points out that a general principle of public debt management
should be to get loans from the public without undue coercion or force. The raising
of loans by the government as well as its redemption should not interfere with the
smooth functioning of the economy. The government should not enter the loan

20
market when it is not convenient to do so. Accordingly following principles of Public
Debt management can be stated.
1. Minimum interest cost. The first principle of public debt management is that the
government should keep the interest cost of the loan at the minimum. If the interest
is low, it will impose less burden of taxation at the time of redemption
2. Satisfaction of investor’s needs. Public debt should be managed in such a way
that the needs of different types of investors should be satisfied with regard to the
type of securities as well as general terms. The terms of loan should attract the
public to invest in government securities.
3.Funding of short-term debt into long-term debt. Public debt management should
enable the Government to convert short-term loans into long-term loans. But such
funding operations should not harm economic stability because the conversion of
short-term loans into long-term loans will necessarily result in a rise in the interest
rates. This rise in interest rate on Government securities will affect the volume of
private investment. The low demand for short term securities will reduce their
interest rate and may even make such funds go out of the country.
4. Co-ordination of public debt policy with monetary and fiscal policy. Public debt
management should not clash with monetary or fiscal policy. The Government
may want to keep interest rates low. So it might advise the central bank to follow a
cheap money policy of low interest rates. This will encourage inflationary trends.
Such a problem can be avoided if there is a proper co-ordination of public debt
policy with monetary and fiscal policy.
5. Composition of public debt and maturity. If the public debt programme results in
a large proportion of short-term debt held by commercial banks, there will be a
high degree of liquidity in the market. This can generate inflation. If the holders of
such liquid assets try to monetize their debt obligations before maturity, controlling
inflation will be difficult.
An analysis of the objectives and principles of debt management makes it clear
that debt management is a subtle art. The basic requirement of an efficient public
debt management is that from the time of floating the debt to its redemption, the
strains and friction are kept to the minimum. Public debt has become an important

21
instrument of fiscal policy and public debt management should be coordinated
with general economic policy to realize maximum social advantage.

22
 CHAPTER SEVEN
DEFICIT FINANCING
7.1. INRODUTCION
In this chapter we will discuss four sections: 1) the meaning of deficit financing. 2)
Objectives of deficit financing. 3) Effects of deficit financing. 4) Limits of deficit
financing.
7.2. MEANING OF DEFICIT FINANCING
Deficit financing has become an important tool of financing government
expenditure. In simple terms it means the way the gap between excess of
government expenditure over its receipts is financed. However the concept of
deficit financing is interpreted in different ways in the western countries.
In the western countries whenever the public expenditure is greater than its
revenue receipts, it is financed through public borrowing or creation of new
money. Whenever there is deficit in the current account, its financing becomes
deficit financing. Even public borrowing is a way of deficit financing.
In the modern sense public borrowings to finance excess of public expenditure
over revenue is included in the capital account of the budget. After including
these borrowings in the capital account, there may still be a deficit in the budget.
The method adopted by the government to finance this overall budget deficit in
the current and capital account together is known as deficit financing.
Thus budget deficit and deficit financing are two different concepts. Budget
deficit is a narrower concept, referring to excess of public expenditure over
current revenues. Most countries adopt a wider concept of deficit financing
whereby any method adopted to bridge the budget deficit even after
borrowings, becomes deficit financing. Further in the narrower concept, the
budget deficit is managed through market borrowing out of public saving. So it is
non-inflationary. But in the broader sense of deficit financing, it refers to borrowing
from the banking system. Hence it is inflationary in character.
Different Methods of Deficit Financing
Governments can adopt three methods of deficit financing and the impact is
different in each case. Firstly governments can borrow from non-bank investors or

1
commercial banks. This is considered non-inflationary as it tends to replace
private expenditure. For example when government borrows from commercial
banks, their liquidity is reduced so that it reduces loans to the private sector. Thus
the government borrowing from commercial banks replaces private expenditure
and hence it is non-inflationary. If the non bank investors get loans from the
commercial banks against their fixed deposits and use it to lend to government it
would be inflationary.
In the second case when the government draws from its cash balances with the
central (National) bank it is not inflationary. But in the third method when the
government borrows from the central bank against its securities, the central bank
creates new money by resorting to the printing press. This would again result in a
secondary reaction of expansion of bank credit. This type of deficit financing by
loans from central bank tends to be highly inflationary.
7.3. OBJECTIVES OF DEFICIT FINANCING
Deficit financing has been ascribed an important role in fiscal policy on account of
increases in public expenditure on various accounts. The different objectives of
deficit financing make it clear.
1.To finance wars. Deficit financing has been found to be the simplest and quickest
method to finance huge War expenditures. War time emergency makes it difficult
for government to raise urgent resources through its usual methods of taxation and
public borrowing. The funds obtained through deficit financing are used by the
government to purchase goods and services to fight war. This raises the aggregate
demand. Resources are mobilized by the government not for productive purpose
but for war efforts which is unproductive. Thus the rise in aggregate demand and
non-availability of sufficient goods result in an inflationary price rise. The experience
of Germany during the two world wars is a classic example of the harmful effects of
Wartime inflation. During First World War, the German paper Mark depreciated so
much in value that one gold Mark could not be purchased by even one billion
papers Mark. Similarly during Second World War, the ratio of gold to paper currency
became as low as 0.01 per cent on account of deficit financing. However, wartime
emergency requires a quick mode of financing. Hence deficit financing cannot be

2
avoided. Precautions should be taken to control private demand.
2.To fight unemployment during depression. Keynes advocated deficit financing as
an important tool of solving the problem of involuntary unemployment during
depression. This unemployment during depression occurs due to lack of effective
demand since private spending is low. Therefore the only way to combat
unemployment would be for the government to invest in public works programmed
to create employment. Further during depression welfare payments to be made by
the government would also increase. Government cannot get finance for this
expenditure out of taxation or public borrowing as taxable capacity and ability to
contribute to government loans is very low during depression. Hence the
government has to borrow from the banking system. Thus deficit financing
becomes the best mode of financing anti-deflationary expenditure.
Keynes suggested that the investment undertaken by the government will result in a
multiple increase in incomes via the multiplier effect. However the operation of the
multiplier may not be that successful in underdeveloped countries as there is
unutilized or idle capacity in both agricultural and industrial sectors. Supply of
working capital is also very low. On the other hand marginal propensity to consume
is very high. Thus Keynes' multiplier may actually raise the aggregate demand
instead of raising the aggregate supply. Hence deficit financing to combat
unemployment in underdeveloped countries requires great caution in handling so
that inflationary pressures are not generated.
3. To promote economic development. Deficit financing can go a long way in
promoting economic development in underdeveloped countries. There are two
issues to be discussed here. First refers to the way in which deficit financing can be
used to finance development projects. Second whether deficit financing for
development results in inflationary potential. The major obstacle to development in
these countries is low rate of capital formation which is not enough for sufficient
investment to provide jobs for the large number of unemployed. With increasing
population the level of unemployment also increases necessitating greater capital
formation. Low incomes of people reduce the taxable capacity as well as ability to
save. For the same reason, government cannot raise resources through public

3
borrowing too. Hence deficit financing becomes the only way of mobilizing
required resources, in developing countries.
Deficit financing can help to stimulate the rate of investment indirectly. Deficit
financing for development first of all increases incomes and thus savings too. It
results indirectly in forced saving too because when the government purchases
goods and services for its projects, people do not get them. So the reduced private
spending results in larger saving.
If the government uses deficit financing to undertake productive projects then
output would increase and it may not be inflationary. But there are certain rigidities
in the developing countries which do not result in complementary factors for
investment. Firstly there is a lack of entrepreneurship and technical know-how.
Secondly there is no adequate infrastructure such as organizations, market
communications etc. These market imperfections fail to increase effective supply
along with increasing demand and these causes rising prices.
Further elasticity of supply is not the same in different sectors of the economy. For
example elasticity of supply tends to be low in agriculture than in industry. In the
initial stages of development if the government expenditure is directed towards
these sectors whose elasticity of supply is low, it is certain to increase incomes and
demand in these sectors but lack of supply response would raise prices. In all these
cases, if deficit financing used for development schemes results in inflationary price
rise, the government should carefully raise taxation to siphon off the excess
purchasing power in the hands of the people.
Another way in which deficit financing can promote development is when it
increases the incomes of the entrepreneurs whose propensity to save is high. In
fact this may result in greater inequality of income. But in the initial stages, higher
propensity to save of the entrepreurial class is a welcome feature in the interest of
general economic development. This fits into the theory of imbalanced growth
given by A.O. Hirshman.
In general it is accepted now that so long as care is taken to avoid inflationary
potential, deficit financing is a very useful instrument of development in developing
countries. Deficit financing should preferably be used for quick yielding projects in

4
the initial stages so that the increase in production will control inflationary pressure.
If development projects have long gestation period, deficit financing for such
projects would bring in inflationary price rise. Hence in developing countries deficit
financing should be carefully used in the initial stages to lay a good foundation for
necessary infrastructure for development.
4. To mobilize surplus, idle and unutilized resources. Keynes had advocated deficit
financing for the mobilization of surplus labour and other resources during
depression. This argument may be applicable to underdeveloped countries only
with limitations. If deficit financing is used to employ such labour in the agricultural
sector in these countries, it may create inflationary price rise.
On the other hand deficit financing is recommended for its ability to create new
resources in these countries. When deficit financing raises prices in these countries, it
reduces consumption and savings become forced. Thus deficit financing is
recommended in developing countries for the mobilization of forced savings or for
the creation of new resources, which again can be used for next stage of
development. That is why W. A. Lewis said that "Inflation for the purpose of capital
formation is in due course self-destructive".
5. To finance the Plans. In developing countries like Ethiopia which have adopted
planned economic development huge resources are required for implementation
of government investment. The government takes greater interest to create
infrastructure, industrial development in vital sector besides transport and
communication. Deficit financing is a. useful tool to finance the Plans.
6. To serve as an alternative tool. Underdeveloped countries suffer from low taxable
capacity and low savings. Hence government's ability to raise resources gets
constrained. Therefore there is no harm in resorting to deficit financing as an
alternative source of mobilizing resources besides taxation and public borrowing.
7.3 EFFECTS OF DEFICIT FINANCING
Deficit financing can make or mar progress if it is not carefully planned. It has
diverse effects depending upon how it is handled. The major effects pertain to
inflation and distribution of income.
1.Deficit financing and inflation. There are two views regarding the impact of

5
deficit, financing on prices. The first view is that deficit financing is pro inflationary.
This view holds that the first impact of deficit financing is on the creation of new
money. Deficit financing is recommended for the creation of capital goods whose
gestation period is long. There is increase in money incomes in this sector. But
consumer goods producing sector does not respond quickly to bring more
production. This results in rise in prices of consumer goods which may prove to be
spiraling. The price rise will be greater if market imperfections exist as bottlenecks to
increased production.

Further, a part of the increased incomes, in the absence of sufficient goods to

spend, may be channelized into commercial banks who may use it for further credit
creation. In fact in developing countries the inflationary pressures are due to
monetary expansion after deficit financing. Inflation then tends to be demand-pull
type while deficit financing in developed countries causes cost-push type of
inflation on account of long-term gestation projects.
The poor developing countries are not well equipped in terms of monetary and
fiscal policy to control inflation. Hence there is a possibility that unabated inflation
on account of deficit financing may hinder economic development of these
countries.
The second view holds that deficit financing is not necessarily inflationary because
public sector has emerged as a dominant sector in these economies. If this
additional finance is utilized for productive purposes, it need not be inflationary.
Deficit financing is required to provide finance for increasing output at stable
prices. If deficit financing is not resorted to there may be a decline in prices which
will have an adverse effect on output and employment.
W. A. Lewis points out that there are three stages in the impact of deficit financing.
Inthe first stage, only capital goods industries are created through deficit financing
and as they have long gestation, prices rise steeply. In the second stage, the rise" in
prices makes people reduce consumption which results in forced savings which
increases investment. In the third stage, the capital formation of the first stage
begins to bring consumer goods to the market which helps to lower prices.

6
Therefore deficit financing is 'dangerous and painful' only in the first stage. In Lewis'
view inflationary potential of deficit financing is therefore self-destructive. Others
however point out that if the consumer goods are not increased in the second and
third stages due to some constraints, inflation becomes rampant.
2. Effect on distribution of income. Deficit financing has certain undesirable effects
on the distribution of income. Deficit financing provides incentives to entrepreneurs
through larger profits on account of rising prices. But the same rising prices reduce
real incomes of the wage earning class. This leads to a distribution of income in
favour of the profit earning classes. Hence inequality of incomes widens. This is very
much against the social objectives of equitable distribution of income and wealth.
Thus an analysis of the objectives and effects of deficit financing proves that it is a
double-edged sword. Its effects can be good so far as it promotes capital
formation and does not allow for a steep increase in prices. Its effects can be
harmful if the inflationary potential goes uncontrolled, bringing about adverse
effects on distribution of incomes and wealth, thus increasing inequality. The exact
impact of deficit financing depends upon the mode of deficit, governments'
attitudes and policies, reaction of the private sector and growth of the public
sector.
Deficit financing can be a very useful and effective fiscal tool for development in
under developed countries if it is used only for capital formation to channelise
resources into productive areas. The mild price rise on account of deficit financing
in the early stages acts as an incentive to entrepreneurs to increase productive
activity. Such a functional rise in prices is harmless.
7.4 LIMITS TO DEFICIT FINANCING
It is now recognized that deficit financing is a bad master but can be a good
servant i.e., it should be handled carefully without using it excessively. This raises the
question as to what is the safe limit for deficit financing. Several factors are to be
considered in determining the safe limit.
1.Growth rate of the economy and money supply. The money supply should
expand to facilitate the growth rate of the economy. Suppose the total money
supply in the economy is 4,000 million Birr and the growth rate of the economy is 5

7
per cent, it requires an additional money supply Birr. 200 billions per annum to
sustain the growth rate. Hence deficit financing can be used to create Birr 200
billions per annum. But since it is used for productive assets creation, deficit
financing can be even more than 5 per cent of the money supply. Thus even 7 or 8
per cent expansion in money supply on account of deficit financing need not be
inflationary in developing countries.

2. The efforts made by the government to mobilize its resources. Deficit financing
should be used only as a last resort after all alternative source of finances are
exhausted. The public will not mind the effects of deficit financing when they know
that the government has undertaken all efforts to mobilize other resources and only
when they are exhausted, deficit financing is adopted.
3. Control of incomes and prices. Deficit financing to finance government projects
enters the income stream in the form of wages and salaries. It is this increasing
incomes and wages which exert an inflationary pressure. Hence a proper control
over income and prices acts as a control over the inflationary potential of deficit
financing.
4. The growth of monetized sector. It is the existence of a large nonmonetised sector
which aggravates the inflationary potential of deficit financing. The extent to which
the non-monetized sector is brought into the ambit of monetized sector, acts as a
safe limit to deficit financing.
5. Increase in the production of public sector. Deficit financing is incurred to finance
public sector projects. If their production increases, this increase in production will
cushion the inflationary potential of deficit financing. It is for the same reason deficit
financing should not be incurred for unproductive purposes.
6. Promotion of imports. Deficit financing is bound to increase incomes in the initial
stages which causes and increase in demand for goods and services. Since
production does not increase immediately in the early stages, the inflationary
pressures can be kept within safe limits by permitting import of goods. This of course
depends upon the foreign exchange reserves to the country.
7. Restriction on credit A large portion of new money created through deficit

8
financing may reach the banking sector in which case it gives them an opportunity
to create credit further. Restriction on credit can limit inflationary pressures.
8. Direct and indirect control. Government should adopt various measures to
control prices directly and indirectly. Direct control refers to the control of prices
beyond the stipulated levels. It is a type of administered prices. Indirect controls
result in government's improving the public distribution system to supply goods to
the people at reasonable prices.
9. Public spirit of cooperation and toleration. Some economists point out that "The
role of public understanding and public cooperation is a factor in tending to
diminish the price effect of deficit financing". Unless the government enjoys the
public cooperation, it will have to face open, popular and political opposition to
further use of deficit financing when the prices rise excessively. The spirit of
tolerance on the part of public acts a limit on government's use of deficit financing.
In the final analysis the state of the economy, the purpose for which deficit
financing is incurred, the control over money expansion, prices and incomes, the
magnitude of the deficit financing, are all factors /which, limit the government's
powers to resort to deficit financing excessively.

9
 CHAPTER EIGHT
PRINCIPLES OF FEDERAL FINANCE
(Principles of allocation of resources between Federal and State governments)

8.1. Introduction
In this chapter we will discuss three sections, namely 1) Principles of Federal finance,
2) Problems of Federal finance, 3) Different forms of inter-governmental financial
transfers
In a federal set up, the federal-State financial relations are based on the principle
of federal finance. The world federation connotes the union of two or more states.
In a federation we have on the one hand, the Federal Government and on the
other the Constituent States. Federation may be defined as a “form of political
association in which two or more states constitute a political unity with a common
government, but in which these member states retain a measure of internal
autonomy.”
According to the Encyclopedia Britannica, “federation is a form of Government in
which the essential principle is that there is union of two or more states under the
central body for certain permanent objectives.”
Sir Robert Farn defined, “a federation as a form of government in which sovereignty
of political powers is divided between the central and local governments, so that
each of them within its own sphere is independent of the other.”
Thus, in a federation, there is constitutional division on powers, functions and
resource between the federal and the state governments. The two sets of
governments are independent so far as their own functions and resources are
concerned.
8.2. PRINCIPLES OF FEDERAL FINANCE
Prof. B.P .Adakar, in his celebrated book on principles and problems of federal
finance lays down three principles which should govern the working of federal
finance, system. These principles have been discussed as follows:
1. Independence and responsibility – In the first place Prof. B.P. Adarkar said that
“full freedom of financial operations must be extended to both federal as well as
state governments in order that they may not suffer from a feeling of cramp in the

1
discharge of their normal activities and in the achievement of their legitimate
aspirations for the promotion of social and economic advancement.” It means
that central and state governments must each have under it, its own independent
central financial resources sufficient to carry out its exclusive functions. In other
words, central and state governments should be financially independent within
their own sphere. Besides, each government should take the responsibilities of
taxing, borrowing, and raising resources in their spheres for performing their
functions. The authority which has a pleasing job of spending money should also
do the unpleasant job of raising it. Thus, “taxing autonomy and spending
autonomy should go hand in hand.”
However, there are some who believe that, if every level of government is to raise
the money that it was going to spend, then there would be great disparity in quality
and quantity of public expenditure from state to state. State with wealthier
population and richer tax resources will be able to fulfill their social obligation much
better than the poor ones.” In an under-developed country certain practical
considerations such as uniformity in tax rates throughout the federation, promotion
of economic growth and maintenance of internal and external stability, balancing
economic and social development in all regions, etc., cannot be ignored. In other
words, the advocate of this view intends that taxing autonomy should lie with
federal government while spending autonomy with the states.
Theoretically speaking the case of centralization of revenues in the hands of the
federal governments appears to be very sound in the case of under developed
countries on the ground of economy and efficiency and balanced economic
growth.
However, the practical point of view should not be totally ignored. If too much
dependence of State government on central government for finance is accepted
then the former may be reduced to the status of spending agencies of the federal
government and may not feel as partners in progress. It is, therefore, concluded
that central government and state governments both should be autonomous in the
sphere of raising resources and performing their functions effectively, but periodical

2
adjustment in these aspects is necessary for the successful working of both
governments.
2. Adequacy and elasticity – The principles of adequacy means that the resources
of central and the state governments should be adequate so that each layer of
government can discharge its obligations laid upon it. It stands for sufficiency of
resources for the discharge its obligations laid upon it. It stands for sufficiency of
resources for the discharge of functions and duties assigned. Thus, Sir Johan
Latham, former Chief Justice of Australian High Court said “If a federal system with
real independence in the state is to continue, the state must have financial
resources under their own control reasonably adequate to meet their
responsibilities.”
Besides to adequacy, there should be elasticity in the financial resources. It means
that resources should be capable of expansion in response to rapidly growing
needs and responsibilities of the government concerned. Otherwise, the Federal
Finance Scheme will become an obstacle in time s of economic and defense crisis.
For this, each layer should have considerable initiative and freedom to raise
finance.
3. Administrative economy and efficiency – For the success of central-state
financial relations, it is very much required that the administrative cost should be
minimum and there should be no frauds and evasion in matter of finances. It
should also be taken into account that at the time of allocating resources as to
whether a certain source can be better administered by federal or state
government. Corruption and inter-regional smuggling are to be avoided and the
resources of revenue are to be fully exploited.
Some other principles: Besides these principles, some scholars on the subject of
central-state financial relations have added a few more principles in view of the
needs and present conditions, especially of under-developed countries.
4. Principle of equity – Equity is an important canon of taxation laid down by Adam
Smith. The applicability of this principle in federal system is important, because in
the assignment and allocation of functions, there is an opportunity for inequity to
creep in and may spoil the entire structure basically. Different state of a federation

3
may have disparity in the level of economic development and, therefore,
according to this principle, the burden of taxation will be in equally distributed as
the marginal sacrifice will be different in different states. The marginal sacrifice of
the tax-payers of richer states will be less as compared to those of the poor states.
Therefore, a need may arise to adjust the federal and states taxes in such a way
that the marginal sacrifice of the federal and state taxation taken together is equal
or nearly equal to every person, no matter in which state he resides. Therefore,
there should be proper adjustment between federal and state taxation so as to
make the tax burden on all citizens equitable as far as possible.
5. Principle of integration and coordination – The whole financial system of
federation should be well integrated and each layer of financial system of
federation should not be taken as completely isolated from the other layers of
financial system. Integration of financial systems of federal and state governments
is essential in contemporary federations. This should be done in a way that
promotes working of federal financial system. The coordination of federal state
should not be in taxation alone but in every aspect of finance. “The coordination
of federal state and local finance should, however, be concerned not only within
taxation. It should also embrace the current budgets, capital outlay programs and
credit operations of various authorities and should be accompanied with a
coordination of administrative activities as well.”
6. Principles of accountability – freedom and democracy are sister institutions in a
federal system. Therefore, in federal system such government should be
accountable to its own legislative for its having and spending decisions and should
make these decisions with due regard for their effect on other government.
7. Principle of uniformity – The financial system in a federation should be such as to
enable each regional government to provide an adequate level of public service
without resort to higher rates of taxation substantially than those of other regions.
8. Principle of fiscal access –This canon implies that the resources should grow with
the increase in functions and responsibilities. The state governments should have
access to develop new sources of revenue to meet their financial needs. There
should be no bar on central and state governments in developing new sources of

4
revenue within their own prescribed fields to meet the growing financial needs. It
implies that resources should grow with the increase in responsibilities.
The problem of federal finance should not be over shadowed by dogmas or rigid
principles but should be solved by an approach of reality and pragmatism, so that
healthy financial relations may develop. The conditions differ from time to time and,
therefore, a fixed division of financial resources cannot be applied. Thus, division of
resources should be subjected to flexibility and adaptability. There can be no final
solution to the allocation of financial resources in a federal system. There can be
only adjustments and re-allocation in the light of changing condition. Thus, rigidity
should be replaced by dynamism and changes be made according to the needs
of different layers of the government. “The importance of flexibility or adaptability
in the distribution has been widely recognized.” Flexibility seems to be sine-qua-non
of a rational system of federal finance. According to Dr.Gyan Chand, the system of
federal finance should be designed to meet the needs of changes that may have
to be introduced in the interest of harmony and efficiency. It should be based on a
large measure of general consent. It can, however, be concluded that central and
state governments should collaborate in such a way that ensure maximum
utilization of national resources, accelerated economic development, reduction in
disparity and augmentation in production and productivity.

8.3. PROBLEMS OF FEDERAL FINANCE

In a unitary government there is centralized public finance; but in a federation two
constitutionally independent fiscal systems operate upon the fiscal resources of the
individual citizens.
There is multiplicity of taxing and spending authorities in a federation. Thus, in a
federation, fiscal structure is decentralized, and wheels with it‟s the wheels operate
in the financial machinery. Hence, it may be called multi-unit public finance. Thus,
the federal finance faces the problem of “financial arrangement between the
federal government and states. This is of crucial importance for them, for they

5
govern the effective powers of the center and regions in the field of economic
affairs and the nature of their future development.
Thus, in federal system, the functions and duties of the state are divided between
the central government and several state governments and they are generally
defined in the constitution. The allocation of function and resources between the
central and state governments, however, differ from country to country. The
general principle on which the allocation of functions and duties are based is
“whatever concerns the nation as a whole, principally external relations and inter-
regional activities should be placed under the control of the central government
and that all maters which are primarily of regional rather than common interest
should remain in the hands of the regional government.” It should however, be
noted that functions and duties should be allocated in such a way that each layer
of the government gets those functions and duties which it is able to perform. In
other words, the main criterion in the allocation of functions is whether a particular
function can best be discharged by the centre or by the states and the allocation
should be made accordingly. Thus, following this principle, generally external
affairs, foreign and inter-regional trade, shipping, inter-regional communications,
defense, post and telegraph, etc, are assigned to the central government.
Subjects of local interests such as education, health services, public works, social
services, internal law and order, etc, are assigned to the state government. Broadly
speaking, the functions which are of national importance have generally been
assigned to the central government and those which are of local or regional
importance have been assigned to the state governments.
It should, however, be kept in mind that these functions cannot be strictly
separated in present times. There is no function in which both central and state
governments are not interested. For instance, the central government is equally
interested in the developmental functions like education, public health, etc.
Similarly, state governments cannot ignore defense, communication, etc. Thus,
there should be a close coordination between the policies of central government
and state governments. In any case, the interests of central government should not
come in conflict with state governments. Thus, James A. Marxwell rightly said that

6
“the practice of cooperative federalism does not correspond to the theory of
separation of functions.” Here, he also quotes, Morton Gordzins saying that “colors
are mixed in marble cake, so functions are in the federal system.”
Allocation of functions may create problem in the allocation of resources between
central and state governments corresponding to their requirements. Therefore,
“the fundamental problem of federal finance is that ensuring that the division of
revenue between central and regional governments corresponds with the
distribution of function in order that teach government may have the functional
capacity to carry out its responsibilities as far as possible.” This is a difficult problem
which generally arises, in a federal set up. It is not easy to allocate functions
between federal and state governments and when they are allocated, it is still
harder to allocate resources between them, because both functions and the
responsibilities for financing them over-lap. Besides, functions and responsibilities
are dynamic in character. For instance, the responsibilities of the state government
may be comparatively fewer fifty years back than what they are at present.
Accordingly, the financial requirements of the state may be less at that time than
what they are at present. And the same may be true for the central government.
Thus, the success of federal finance depends upon the efficient solution of these
problems and adjusting it with changing circumstances.
Problem of Imbalance in Financial Resources
Causes of imbalance:
It has been observed that the problem of imbalance in the allocation of financial
resources and functions between center and all state governments generally arise
because almost all important and elastic sources of revenue like customs, income
tax, corporation tax, etc., are allocated to the federal government on the
consideration of administrative efficiency. On the consideration of autonomy, state
governments are assigned expenditures on social and developmental items. Thus,
in practical life, it has been found that federal revenue grow more quickly than
state revenues and state expenditures grow more quickly than the federal, while
resources have increased in the account of Federal Government, need for
spending has increased in the account of regional government. As a result, the

7
federal government has the resources and the state have responsibilities. Hence
there is imbalance in the federal financial system.
This imbalance has led to a general strain. Even in a well established federation this
problem exists. This has been due to the fact that federal and state governments
had limited functions and utilize resources of revenue which were fairly separate.
The scope of government now has expanded everywhere and the original division
of functions and resources has been characterized as belonging to the „Horse and
Buggy Period‟. With the expansion of functions, central government began to
encroach upon the tax revenues of the regional government and the regional
governments in turn have been faced with growing maladjustments between
resources and functions.
There is one other aspect of this problem; there are differences in the levels of the
economic development leading to marked disparities in income and wealth of the
constituent units. In this context Mr.K.V.S. Sastri said that “the question of financial
imbalances is made worse by the fact of inter-regional inequalities in economic
development and fiscal capacity.” Thus, for bringing nation-wide uniformity in
economic and social development, there will be greater than average financial
strain for the poorer states in a federation, and, therefore, the ideal of “welfare
state” may suffer. Thus, financial resources are in paucity, where they are needed
most.
With the growth of activities of the modern state on the one hand and the lop sided
allocation of financial resources on the other, it becomes inevitable to make
adjustments into the financial system of federation. However, there cannot be any
final solution to the problem. There can, however, be adjustments, reallocations or
transfer of resources in the light of changing circumstances.
How to Remove Imbalances
The financial imbalance between federal and state governments may be
corrected either by transferring some functions from states to central government
or by transferring some resources from federal governments to state governments.
However, no developing society can afford a rigid division of powers and functions.
If there are great inequalities in the economic and social development to different

8
constituent units, and it is desired in the national interest to mitigate them, the
federal government may undertake the functions which lie in the sphere of regional
governments; Switzerland provides an example of such adjustment. Functions, such
as social security, can easily be transferred to federal government. This was also to
bring uniformity in the standard of social service. But this step may generally be
opposed by state government on the ground of interference with autonomy.
The problem of imbalance between federal and state governments can be solved
by transferring certain federal taxes to the state governments. But, this is opposed
on ground of uniformity of rates and administrative efficiency. However, if it is
thought highly important to maintain the rights of the states vis-à-vis those of federal
government, one should favor as much financial autonomy for the states as
possible. States should not starve for funds or be always looking at center for help.
Thus, the financial imbalance between federal and state governments should be
removed.
This imbalance of financial resources between the central and state governments
can be solved by transferring funds from the center to state governments. The
practice is very common in almost all the federations. The common wealth grant
commission of Australia observes that “we have an accepted practice of
transferring large and increasing sums from commonwealth to state governments
primarily because the commonwealth can raise the money more easily.” Thus, by
transfer of funds from the federal to states government, the financial balance is
achieved. Therefore, inter-governmental financial transfer constitutes an integral
part of the system of federal finance in maintaining financial equilibrium. It may
assume various forms, which have been discussed as follows.
8.4. FORMS OF INTER-GOVERNMENTAL FINANCIAL TRANSFER
1. Distributive Pool Method, or Distribution of Tax Proceeds, or Tax Sharing:
According to this method, pre-determined proportions of the proceeds of certain
central taxes are combined into a single pool, and the contents of this pool are
then allocated percent wise to different states on a pre-determined basis. Three
problems are involved in putting this method into practice, which taxes should be

9
shared, what proportion of these taxes should be assigned to the regional
government, and how the share of each state should be determined.
The taxes to be shared are mentioned in the constitution of the federation
concerned. As regards the proportion of the shared taxes to be assigned to the
states, it may also be provided for in the constitution itself. In India and certain
African Federations a commission, set up in terms of the constitution, decides the
share of taxes to be assigned to the states. In Canada, it is a matter of five-yearly
agreements between federal and provincial governments. In this respect, Indian
provisions have flexibility. The finance commission fixes the proportion according to
the needs of the state and it has been increased by the succeeding finance
commissions.
It should, however, be noted that, if the proportion of shared taxes to be assigned
to the states is laid down in the constitution, it will make the system rigid, as changes
in the constitution cannot easily be made.
The other problem is concerned with the determination of each state share in the
distributive pool. However, this is a tough problem. In Ethiopia the House of
Federation determines the share of each state and in India and certain African
Federation, this is determined by an Independent Finance Commission on the basis
of such factors as the size of population, economic and social backwardness and
contribution of each unit in the divisible pool. Thus, allocation to the states from the
distributive pool should be done according to the principle of need, keeping in
view with the size of population, economic and social backwardness,
responsibilities which the government has to perform.
In Ethiopia, a combination of both the principles (i.e., population and contribution)
is followed. For instance, the proceeds of income tax from the divisible pool may
be allocated to each state, 80 percent on the basis of population and 20 percent
on the basis of collection. It is done, because population is not only considered as
the criterion of needs of the state but per-capita income and contribution has also
been given due consideration.
Advantages and Disadvantages:

10
 1. Distributive pool method has certain advantages. In the first place, the
superior position of the central government is maintained without destroying
autonomy of the regional governments.
2. Secondly, the method has the merit of simplicity
3. Thirdly, the method is helpful in distributing the proceeds in equitable and
efficient manner. In this context the requirements of the centre as well as
those of the component states can be met in the most equitable and
efficient manner, by distributing the proceeds after these have been
collected by the central government, rather than by dividing power of tax
collection between centre and states which would not only means high costs
of decentralized collection and large scope for evasion but also varying
rates of taxation in different areas and rigidity of distribution in the face of
changing requirements.
4. Regional governments would be encouraged to undertake those activities
for which Federal Government would be interested in those activities of
individual states which will bring them on equal footing.
5. Fifthly, the share of regional government will expand with the expansion of
tax revenue of the central government.
6. Lastly, it involves some measures of redistribution of national wealth.
But, this device also suffers from certain defects. For instance, there will be
fluctuations in their share, upward as well as downward and the regional
government may not have the capacity to react to these changes. In this context,
Harold M.Grove said that “this technique is attractive for those who attach supreme
importance to logical and simple mechanism, but encounters impressive
objections. It involves a high degree of centralization as to both levies and
administration. The fiscal independence of the regional units under sharing is about
the same as that of minor son placed upon a revocable allowance by a generous
father.”

2. Loans:
Loans play a special role in federal set up. Loans can be given by the center to the
states or by states to the center. However in almost all the countries, the common

11
practice has been-loan given by center to the states. At the same time the state
governments should follow principle of economy while spending the loans.
3. Supplementary Levies
According to this method the principal tax is levied by the federal government and
supplementary tax is levied by the regional governments or vice versa. Generally,
regional governments levy supplementary tax over the principal tax levied by the
federal government. States add a percentage to the national levy for their own
use. “It secures an integrated tax and is administratively efficient, since assessment
and collection will be the responsibility of the federal government.” It should,
however, be noted that a ceiling has to be put over the state‟s supplementary levy,
so that the tax burden may not become heavy or may not exceed 100 percent.
4. Grants:
If taxation devices are insufficient to correct the imbalance between revenues and
expenditure of the regional governments the other obvious solution is grant from
the federal to the regional governments. The system of grants is an effective
instrument for bridging the gap between revenues and expenditure of the regional
governments. It is a device for making the constitution more flexible and is a means
of modifying the distribution of tax burden. The grants may be on a number of
bases, there may be general grants or grants-in-aid and special grants. A new
technique of giving grants is a matching grants system or specific purpose or
conditional grants system or shared cost programs. In almost all the federations,
there is provision for federal grants to the regional government.
Grants-in-aid are given to fill up the gap between the revenues and the
expenditures of the regional governments. Generally, budgetary needs of the
regional governments are the criterion for giving such grants. Different states may
be given different amounts of grant in aid. Such grants leave the state budgeting
unfettered, as their amounts may be utilized by the recipient units as they desire.

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