Oromia State University

Course ---Introduction to Public Finance

Instructor name –Yonas Gurmessa
Email –[email protected]
Introduction
• The intervention of government 6+ is
essential to accomplish the goals of any
welfare state
• The economists Keynes demonstrated that it
was possible through fiscal activities of the
state to increase employment and to
maintain it at high level
• Roles of govt in the economy is differ from
country to country
• However, in all cases the aim is to attain full
employment and economic development
through the development of agriculture,
industry and service sector.
Private & public good
• Good & service we use are produced by the
private and public sectors
• The Private finance deals with the wants and
the satisfaction of households and firms.
• Public finance deals with the collective
wants and their satisfaction. The objective
of both private and public finance is similar.
• Private finance aims at maximizing social
welfare or social benefit by efficient use of
public goods.
Definition of Public Finance
Public Finance”.
• Public finance is the study of income and the
expenditure of the govt.
• It is discipline that deals how govt operate its
function with respect to income and
expenditure of the gov’t.
Cont.
• According to Prof. Dalton, public finance is
one of those subjects, which lie on the
borderline between Economics and Politics
and it is concerned with income and
expenditure of govt authority
• It is concerned with the income and
expenditure of govt and the impact of the
household and economy of the country .
Scope of Public Finance:

• Public revenue
• Public Expenditure
• Public debt
• Financial administration
• Economic stabilization
 Functions of modern government
Modern govt has the following function
It expand infrastructure like road , hospital etc
It regulate rule and regulation
Provide security
Maximize warfare citizen
• Protect the poor
• Stabilization the market
Public Finance Vs Private Finance

Similarities b/n Public Finance and Private

Finance
Satisfaction of Human Wants
Balancing of Income and Expenditure
Maximum Satisfaction
Borrowing a Common Feature
Economic Choice a Common Problem
 Difference b/n Public Finance and Private Finance

Adjustment of Income and Expenditure:

• In private finance, first determine income and then
decides about his expenditure. But public finance, the
govt first estimates expenditure and then tries to find
out the methods of raising the necessary income
• That is the private finance tries to adjust its income to
expenditure, whereas the public finance tries to meet
the expenditure by raising income.
Nature of Benefit:
• The private finance work for satisfying individual need
but the public finance satisfy collective need i.e benefit
of the nation as a whole
 Cont.
Allocation of Resources
Private finance get maximum satisfaction from resource
allocation but not possible in Govt cannot aim at
maximum satisfaction on the expenditures’
Motives
Private finance ----profit motives but public – maximizing
social welfare
Nature of resources:
Private finance the individuals have limited resources.
They cannot raise the income, as they like. But, in the
case of public finance the Government has enormous
kinds of resources
 Cont
An Individual Cannot Borrow From Himself.
Issue of currency
Unit of Time.
The public finance usually one year but for private not
limited
 Fiscal policy
• It is also called budgetary policy.
• Refers to the segment of national economic
policy which is primarily concerned with the
receipts and expenditures
 Chapter two
Public Revenue
 Classification of govt revenue

Public revenue
• It is all income collected from different sources
within specific period of time.
• It is classified into two broad classes. These
are
1. Tax revenue
2. Non tax revenue
 Tax revenue
A tax is a compulsory payment levied by the
government without any expectation of direct
return or benefit for the amount paid to the gov’t
as a tax ,
The definition of taxation covers the following
major concepts:
Levied/imposed by Government
No proportionate return or benefit
It is not a price paid by the tax-payer
Financing public expenditures
Compulsory payment
 Objectives of Taxation
 Raising Revenue
 Stability and Promoting economic growth
 Encourage of Exports
 Reduction in Regional Imbalances
 Preventing Harmful Consumption
 Changing people's behavior
 Prevent harmful consumption
 Regulation of Consumption & Production
 Encouraging Domestic Industries
 Ensuring Economic Stability

08/05/2024 YONAS G.
 General Characteristics of Tax
1. Tax is a Compulsory Contribution:
2. It is not a price paid by the tax-payer for any
definite service rendered
3. Benefit is not the Basic Condition:
4. No proportionate benefit
5. Used for common Interest:
6. Legal Collection:
7. Element of Sacrifice:
8. Regular and Periodical Payment:
9. No Discrimination:
10.Wide Scope:

08/05/2024 YONAS G.
 Cont.
Government collect Tax from
A. Income :
it is income generated /earned by individuals.
Tax imposed on income is called income tax.
It includes
1. Personal /individual Income tax
Tax levied on the income of individuals,
Also called individual income tax.
2. The Corporate Tax
 Tax on income of corporation
3.Employment income tax / payroll tax
Tax on salary and wage of employee
4.Business income tax :
Tax on profit of the business
Cont.
5. Estate, Inheritance and Gift Taxes
 Estate tax is a tax on the dead person’s
assets
 An inheritance tax --- taxes levied on the
value of the deceased/dead person’s
estate after the estate passed to its heirs
 A gift tax : is a tax on the value of asset
transferred between living person
6. Withholding Tax :- retained /reserved tax
 it is income tax

08/05/2024 YONAS G.
Cont.
7. Interest income tax : tax on interest on
saving account
8. Dividend income tax ; tax on dividend
9. Rental income tax :- profit of rent
10.Tax on winning chance
11.Agricultural income tax
B. Tax on property :-
tax is levied on the value of property like
Building ,
Machinery
Cont.
C. Taxes On Consumption
 Also called transaction tax because it is
Collected when transaction is occurred
 It is levied on the value of sale (transaction) .
 It includes
Value Added Tax
Turn Over Tax
Customs Duty,
Excise Duty… also called selective tax

08/05/2024 YONAS G.
 Non-Tax Revenues
Non-Tax Revenue
It is all income other than tax revenue
It includes
Fees:- it is cash charged by the Govt on
citizen for services rendered
Licenses:- permission or a privilege to those
who want to do a special or specified work. It
is charged to control of certain activities.
Fines and Penalties:-imposed as a form of
punishment for the mistakes committed such
as violation of the provisions of law, etc.
Cont.

Forfeitures:-
Penalty imposed by the courts on the
persons who have not complied with the
notice served by it
Escheats:
Resource heired by govt of a person having
no legal heirs
Special Assessment
Gifts and Grants
Printing paper money
 Principles of taxation
• Guide line that should be adhere while
designing tax system
A. Canons Advocated by Adam Smith
1. Canon of equality
State that Every citizen ought to contribute
toward the support of the government in
proportion to their abilities.
• The word equality here does not mean that
everyone should pay the exact, equal amount
of tax.
• What equality really means here is that the
rich people should pay more taxes and the
poor pay less .i.e. every citizen should
participate on paying tax based on their
ability to pay
2. Canon of certainty
the tax each individual bound to pay should be
certain and not arbitrary. That is
The time of payment,
The manner of payment,
The quantity to be paid should be clear.
3. 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 that levied on the tax payer
should be convenient to taxpayer.
4. Canon of economy
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 i.e.
Benefit govt get from system should be
grater than cost spent to collect tax
Canons Advocated by Others
5.Canon of productivity
6.Canon of elasticity
7.Canon of diversity
8.Canon of simplicity
9.Canon of expediency
 tax should be levied after considering all
favorable and unfavorable
10.Canon of coordination
11.Canon of Neutrality
Tax Classifications
• Tax are classified based on the burden or
incidence
 Chapter Three

Public Expenditure and

Public Debt
 Public Expenditure

What is Public Expenditure? Meaning Definition

• Public expenditure can be defined as, "The
expenditure incurred by public authorities like
central, state and local governments to satisfy
the collective social wants of the people
• Government expenditure refers Govt spending.
• It includes all govt consumption, investment and
transfer payments made by a state
 Principles of Public Expenditure

Principles of public expenditure : it is guide line used by

govt to incur public resource
It includes
1. The Principle of Maximum Social Advantage
This principle says that the public expenditure should be
incurred only if it is beneficial to the society.
Benefit can be measured in terms of various effects on
income and wealth distribution, effects on production,
and so on.
2. The Principle of Economy
This principles dedicated that public expenditure should
be incurred without wasteful , extravagance and
duplication
3. The Principle of Sanction:
According to the principle, all public expenditure should
get prior approval of concerned body before it is
incurred .
This principle helps in avoiding waste, extravagance, and
overlapping of public money
4. The Principle of balanced Budgets:
Every government must try to keep its budgets well
balanced.
There should not be surpluses or deficits in the budgets
5. The Principle of Elasticity:
This principle dedicated that public expenditure should
not be fixed for all times.
It should be fairly elastic.
The public authorities should be in a position to vary the
expenditure as the situation demands
6. No unhealthy effect on Production and Distribution:
The public expenditure should be neutral
Should not create adverse effect on production or
distribution of wealth in the country.
stimulate production and reducing inequalities of wealth
distribution.
 Causes of Growth of Public Expenditure
• Public expenditure has increased from time to time due
to the intensive and extensive expansion of state
activities. The main factors/causes for increasing of
govt expenditures are
Expansion of Government Functions
Increase in Population
Higher Price Level
Increase in Public Revenue
Duplication of Expenses
Accelerating Economic Growth
Increase in Defense Expenditure
 Classification of Public Expenditure
Classification of Public expenditure
• it refers to the systematic arrangement of
public spending
• Used
for controlling expenditure
to determine volume of resource allocated
various activities and its contribution in the
economic
 Cont.
Classification of expenditure is as follow
1. Functional Classification
Classification based on the functions for which
expenditures are incurred. E.g. defense, agriculture,
economic ,social ,administrative
2. Recurrent & capital expenditure
Recurrent expenditure : expenditure incurred for
recurring activity of the govt like salary ,operational etc
Capital expenditure : expenditure incurred for one tie
activities like road
3. Transfer and Non-Transfer Expenditure
Transfer expenditure
It refers those expenditure transferred & used by other
than govt like citizen
The govt does not directly uses & get anything in return,
but it adds value to the welfare of the people,
It includes :-
1. National Old Age Pension Schemes,
2. Interest payments,
3. Subsidies,
4. Unemployment allowances,
5. Benefits to weaker sections, etc
Non-Transfer Expenditure
It refers all expenditures consumes by govt for
performing its mandate .
By incurring such expenditure, the government creates
a healthy conditions or environment for economic
activities.
it includes expenditure for
Building economic infrastructure such as power,
transport, irrigation, etc.
Building social infrastructure such as education, health
and family welfare.
Maintaining internal law and order and defense.
Public administration, etc.
4. Productive and Unproductive Expenditure
Productive Expenditure
Expenditure on infrastructure , public enterprises or
development of agriculture , electric power ,road etc.
Such expenditure increase productivity of the citizen
and income collecting capacity of the govt

Unproductive Expenditure
Expenditures on defense, interest payments,
expenditure on law and order, public administration,
Do not create any productive asset which can bring
income or returns to the government.
 5. Devt and Non-Devt Expenditure
Development Expenditure
All expenditures that promote economic growth and
development
Non-Development Expenditure
All expenditures that does not directly serving the
economic growth and development
 Public Finance Management
Public Finance Management (PFM)
Deals with all aspects of resource mobilization and
expenditure management in government.
It is essential part of the governance process.
Public finance management includes:
Resource mobilization,
Prioritization of programmes
The budgetary process,
Efficient management of resources and
Exercising controls.
 Public Debt
• Public Debt is any money or credit owed by any
level of government result of past economic
activities and settled in the future .
• This category deals with the causes, methods
and problems of public borrowings and their
management.
• it is an obligation of the government & which
has financial nature.
 Why governments operate public debt
The following are reason for raising loan by govt
When the expenditure exceed the revenue the deficit is
occurred
If the state faces any catastrophe such as flood,
earthquake, draught, etc., it cannot meet these
emergencies out of the normal receipts. So the state
has to borrow funds.
to accelerated, investment expenditure has to be met by
borrowing money
To mobilize the ideal resource the country …specially
accumulated in the financial institution
To control the inventory of currency in the economy
 Sources of Public Debt
The Govt can get debt fro two sources .
These are the
 Internal and
 External source of debt .
Internal Sources of debt
Such loan is obtained within the country
It includes
Borrowings from Individuals
By selling treasury bond
Borrowings from Commercial Banks
Borrowings from Non-Banking Financial Institutions like
insurance
Borrowings from Central Bank
External source of debt
Such debt obtained out side of the country
from partner country , bank like
International Monetary Fund, World Bank,
Agricultural Development Bank and African
Development Bank
 Classification of debt
Based on period of payment debt is classified
into two
These are short term & long term debt
Short term debt …
Debt repaid within one year
Long term debt …
Debt repaid more than one year
 Disadvantages of Short Term Loans:

• It is the safest and profitable form of investment,

they divert their resources from trade and
industry and invest their funds in treasury bills.
The economic progress of the country is thus
badly affected.
• When a government is in debt, it becomes very
difficult to get out of it
 Long Term Loans: advantage
• Provides an opportunity to under-take large
projects like constructions of hydro-electric
projects, buildings, highways, hospitals, etc.
• Easily obtained . It is good opportunity for
financial institution to invest their surplus funds.
Because the rate of interest in long term loan is
higher and earn large profits./if it is obtained
from domestic
• it can be repaid by the government by the time
which is favorable or convenient to it.
• It can also convert long term loan into lower
interest rate
 Disadvantages of Long Term Loans:

• Because of higher rate of interest the burden of

the public debt is too much increased.
• If the government has no real assets exists to pay
off such debts, then it uses excessive taxation.
Heavy taxation reduces the profits of the
businessmen and discourages the new
industrialists to take up new’ enterprises.
 Methods of Paying Public Debt:

• The main methods which are adopted to pay/reduce

or wipe off the public debt are as follows:
(I) Sinking Funds:
 It is a fund which is created out of the general
revenue for paying off the loans every year.
(II) Terminable Annuities:
 If a debtor country wishes to repay a permanent
debt, it may do so by fixing installments over a
period of years. These installment repayments
are known as annuities
(III) Utilization of Surplus Budget:
 Cont.
(iv) Redemption by the Purchase of Government
Stock
(v) Conversion
It is convert a loan bearing a high rate of interest
into another with a lower rate of interest.
Conversion as stated by Dalton is not repayment;
it is only the exchange of new debt for old.
(vi) Capital Levy
The state should levy a special tax on a
accumulated wealth or capital of the people at a
progressive rate
 Cont.
(vii) Surplus Balance of Payments
Process of repaying the debt by increasing exports and
reducing imports.
(viii) Writing off loans
The government can also request the credited
countries to write off loans.
 Fiscal Policy:

Definition :
Fiscal policy under which the government uses its
expenditure and revenue programmes to produce
desirable effects and to avoid undesirable effects
on the national income, production and
employment
It is also called budgetary policy
It is a powerful instrument in the hands of the
government to interfere in the economy.
It is essential method for achieving, the objectives
of the nation
Cont.
It is classified, as:
(a) Taxation,
(b) Public expenditure and
(c) Public borrowing.
 Role of Fiscal Policy:

The role of fiscal policy is differ from country to country

Objectives of Fiscal Policy:
A. To mobilize resources for financing development.
B. To promote economic growth in the private sector.
C. To control inflationary pressure in the economy.
D. To promote economic stability with employment
opportunities.
E. To ensure equitable distribution of income and
wealth.
 Chapter Four
Federal Finance
Federal Finance
Federal finance refers to the system of
assigning the source of revenue to the
Central as well as State Governments for the
efficient discharge of their respective
functions
 Principles of Federal Finance

In the case of federal • Principle of Fiscal Access.

system of finance, the • Principle of Integration
following main principles and Co-ordination.
must be applied: • Principle of Efficiency.
• Principle of • Principle of Administrative
Independence. Economy.
• Principle of Equity. • Principle of
• Principle of Uniformity. Accountability.
• Principle of Adequacy.
 Federal Finance
1. Principle of Independence:
Govt should be autonomous and free about the
internal financial matters concerned.
It means each Govt should have separate
sources of revenue, authority to levy taxes, to
borrow money and to meet the expenditure.
2. Principle of Equity:
The resources should be distributed among the
different states so that each state receives a
fair share of revenue.
3. Principle of Adequacy of Resources:
The principle dedicated that the resources of
each Government i.e. Central and State should
be adequate to carry out its functions
effectively.
4. Principle of Fiscal Access:
There should be opportunity for the Central
and State Govt to develop new source of
revenue within their prescribed fields to meet
the growing financial needs.
The resources should grow with the increase
in the responsibilities of the Government.
5. Principle of Integration and Co-ordination:
The whole financial system of a federation should be
well integrated. There should be a perfect co-
ordination among different layers of the financial
system of the country. Then only the federal system
will prosper. This should be done in such a way to
promote the overall economic development of the
country.
6. Principle of Efficiency:
The financial system should be well organized and
efficiently administered. There should be no scope for
evasion and fraud. No one should be taxed more than
once in a year.
7. Principle of Administrative Economy:
That is, the cost of collection should be at the
minimum level and the major portion of revenue
should be made available for the other
expenditure outlays of the Governments.
8. Principle of Accountability:
Each Government should be accountable to its
own legislature for its financial decisions i.e.
the Central to the Parliament and the State to
the Assembly.
Modes of Allocation of Revenue Resources
Two method are used to allocate revenue . These
are
1. Independent method
Under this system, the units in a federation
are deriving their revenue from absolutely
different sources.
There would be no concurrence or contact
between the center and the units
 2. Mixed System
Under this system, there would be concurrence and
contact between the center and the units.
This system is divided into two viz., concurrent mixed
system and the contact mixed system.
• Concurrent mixed system, both center and the states
have concurrent powers of taxation regarding certain
sources. There would be no transfer of resources from
the center to the states.
• Contact mixed system, contact between the centre and
the states is created.
• There would be assignments, subsidies, subventions or
contributions.
 Balancing Factors of Allocation :

1. Assignments:
Usually the Federal Government levies and
collects certain taxes. But it is shared on an
agreed basis with the states.
The federal govt distributes the share between
the states by using their agreement e.g.
population ,actual collections from different
states etc.
2. Subsidies:
They are granted certain revenue by the center
to transfer certain sources of revenue like
customs to the center.
3. Subvention:
Subventions are grants-in-aid to redress
certain inequalities between states.
They are made for specific purposes.
They should be spent for the purpose for which
they are made.
The spending of the amount would be under
the supervision of the granting authority .
 Federal Finance in Ethiopia
• Ethiopia is a federal state and the Central-
Regional financial relations are based on the
principle of federal finance.
• There is constitutional division of powers,
functions and resources between central and the
state govt i.e sharing responsibilities and
resources.
• The areas of the government’s budgetary
operation (i.e. receipts and expenditures) between
the centre and the states are demarcated.
• The two sets of governments are independent
with respect to their own functions and resources
• The federal system in Ethiopia comprises a central
government and Regional Governments.
 Disbursing and Transfer of Public Funds
• The structure of federal finance comprises
two essential components.
One is the division of powers between the
Union and the states in respect of rising
and disbursing of public funds
The second relates to the transfer of
funds from the center to the states.
Cont.

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 interregional activities should be
placed under the control of the central
government and that all matters which
are primarily of regional interest should
remain in the hands of the Regional
Government”.
Pattern of Revenue Sharing
• Distribution of Revenues between Central
and States based on the Constitution of
Ethiopia
• The Articles 96, 97, 98, 99 and 100 contains
a detailed list of the functions and financial
resources of the Center and States.
 Objectives of Revenue sharing
• The sharing of revenue b/n central govt and the
National/Regional Govt have the following
objectives:
• Enable them to carry out their respective duties
and responsibilities efficiently.
• Assist development of their regions on their own
initiatives;
• Narrow the existing gap in development and
economic growth between regions;
• Encourage activities that have common interest
to regions.
 Basis for Revenue Sharing
The sharing of revenue consider the following
Principles:
Ownership of source of revenue;
The National or Regional character of the sources
of revenue;
Convenience of levying and collection of the tax or
duty;
Population, distribution of wealth and standard of
development of each region;
Other factors that are basis for integrated and
balanced economy
Categorization of Revenue

According to "Constitution of Ethiopia”

revenues shall be categorized as
Central List,
Regional List, and
Joint/Concurrent List.
 Central List
The sources of revenue for Federal/Central List,
are as follows:
A. Duties, tax and other charges levied on the
importation and exportation of goods;
B. Personal income tax collected from the
employees of the central Government and the
International Organizations;
C. Profit tax, Personal income tax and sales tax
collected from enterprises owned by the
Central Government. (Now sales tax is replaced
with VAT and Turnover taxes).
Cont.
D. Taxes collected from National Lotteries and
other chance winning prizes;
E. Taxes collected on income from air, train
and marine transport activities;
F. Taxes collected from rent of houses and
properties owned by the central
Government;
G.Charges and fees on licenses and services
issued or rented by the central
Government;
Regional List
The following shall be Revenues for the Regions:
A. Personal income tax collected from the employees of
the Regional Government and employees other than
those covered under the sources of central
government.
B. Rural land use fee.
C. Agricultural income tax collected from farmers not
incorporated in an organization.
D. Profit and sales tax collected individual traders.
 Cont.
E. Tax on income from inland water transportation.
F. Taxes collected from rent of houses and properties
owned by the Regional Governments;
G. Profit tax, personal income tax and sales tax collected
from enterprises owned by the Regional Government:
H. With prejudice to joint revenue sources, income tax,
royalty and rent of land collected from mining
activities.
I. Charges and fees on licenses and services issued or
rented by the Regional Government;
Joint/Concurrent List:

The following shall be Joint revenues of the Central and

Regional Governments:
• Profit tax, personal income tax and sales tax collected
from enterprises jointly owned by the central
Government and Regional Governments;
• Profit tax, dividend tax and sales tax collected from
Organizations;
• Profit tax, royalty and rent of land collected from large
scale mining, any petroleum and gas operations;
• Forest royalty.
 Relations of Tax Systems
Proclamation stressed that in order to avoid
cascading incidence effect of the tax the tax
system shall have unified policy base.
The tax rates levied on types of taxes jointly
owned by the central Government and the
Regional Governments shall be fixed by the
Central Government
Collection of Revenue
• Jointly owned revenue shall be collected by
the Central Government revenue collection
organs.
• However, it can be delegated to regional
Governments . when it is difficult for the
central govt and inconvenient for tax payer
 Sharing of revenue between federal government and regional st ates

Revenue Sharing Formula

S. Types of Joint Federal Regional
Revenue Government States
No.

Jointly Established Companies

1.1. Profit Tax As per Capital As per
1. As per Capital Capital As
Share per Capital
Share
1.2. Employee 50% 50%
 Federal Regional
2. Govt States
Private Companies
Profit Tax 50% 50%
Indirect Taxes 70% 30%
Dividends 50% 50%

Minerals & Petroleum

3. Profit Tax 50% 50%
Royalty 60% 40%