Download BFI 306: PUBLIC FINANCE HERMAN MWANGI St.Paul`s University

BFI 306: PUBLIC FINANCE
HERMAN MWANGI
St.Paul’s University
CHAPTER ONE
NATURE OF PUBLIC FINANCE
Governments provide many goods and services to public. In Kenya the government provides
subsidized education in primary, secondary and in university. Also provided are health cares
and environmental protection. The government is involved in projects that directly increase
the production of goods and services. It provides water for industrial use, domestic use. Such
projects involve expenditures of large amount of money provided through taxing, licensing
and borrowing.
The study of public funding enables us to know how the government through its budgetary,
monetary and fiscal policy allocates and distributes scarce resources in the country.
THE SCOPE OF GOVERNMENT ACTIVITIES
1. Provision of pure public goods. These are goods to which the principle of exclusion does
not apply because they are indivisible and their benefit can not be priced.
2. Correction of externalities – suppose a particular public good has external economies
which can not be measured and therefore can not be priced. The spills over gains are there
in the society, but the supplier cannot charge for it. Hence the price will be much lower
than the social margin of benefit that determines his supply on the basis of the price he
gets. Hence he produces less than what could be the optimum quantity from the society’s
point of view. The government must provide for such.
3. The suppliers are faced with the free riders problem since the users cannot be forced to
reveal their demand preferences. The government must provide for such.
4. Quasi – public goods/mixed goods/impure public goods. They posses both element of
publicness and privateness e.g. education, polio vaccination.
5. Merit goods – goods whose provision the society wishes to encourage. Provision of such
goods helps the economy to attain a high level of efficiency and contribute to achieving
basic objectives of the society. E.g. health, education. They have an overriding
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importance e.g. precious lives may be lost, if health services are left to the forces of the
market only. The state must supplement their availability.
6. Demerit goods: these are goods that are viewed as being socially harmful e.g. cigarette,
addictive drugs. For such goods government takes measure to discourage consumption
especially through levy of taxes or legislation to discourage consumption.
7. Market failure. Market tends to operate inefficiently on account of the existence of public
goods, monopolies and in the absent of law of constant returns. The condition necessary
to achieve the market efficient solution fail to exist. The government must intervene.
1.1
THE NEED FOR A PUBLIC SECTOR
It was felt that in a capitalistic society government participation in the market should be very
small. Those who supported this emphasized the need to leave the allocation of resources to
market forces of demand and supply so that if demand is greater than supply the prices would
rise and vice versa. This process would clear the market as they argued. But over the years
many changes took place, political ideology evolved hence leading to establishment of
socialistic states whose size of the public sector was larger than private sector.
However, despite the different ideologies the need for government participation in economic
activity in the country is important for various reasons.
Reasons why the government should participate in Economic Activities
1)
The public sector is required to provide goods and services that cannot be provided
through the market owing to problem of “externalities” which lead to market failure.”
For example, the provision of national security. You cannot bar anybody from
enjoying it.
2)
The government must formulate and implement economic policies that are needed to
guide, correct and supplement the course that the economy will take on its’ growth
and development over time.
3)
Even where market forces are used to allocated resource, there must be a significantly
large public sector to provide regulations and laws that will provide the required
protection, otherwise there will be no property rights, and there cannot be markets
without exclusive ownership rights.
4)
Laws and regulations are also needed to ensure free competition in market, free entry
to the market, free exit from the market and for consumer protection, so that in
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general, the contractual obligations that arise from free market transactions cannot be
executed unless there is protection and enforcement of a government provide legal
structure.
5)
Social values may require adjustments in the distribution of income and wealth which
results from the market systems and from the transmission of property rights through
inheritance. [We are talking of reducing the gap between the rich and the poor which
is as a result of market mechanism. In a capitalistic state, the rich will continue
becoming rich and poor, poorer. So something needs to be done - tax the rich and
provide services which the poor cannot afford at a subsidized rate].
6)
Private sectors invest where returns are high while public sectors look at overall
benefits of a project to the community even if returns are low. e.g. Governments
provide irrigation schemes, schools, hospitals etc. Such projects have no high rate of
return on investment but have greater benefits to the community. Owing to low rate
of return on such projects, the private sector would not invest in them.
Examination question
Why is it that in a supposedly private enterprise economy, a substantiate part of the economy
is subject to some form of government direction, rather than left to the “invisible hand” of
market forces?
1.2
PUBLIC POLICY OBJECTIVES (BUDGET OBJECTIVES)
There are 3 major functions of budgetary policy:1)
Allocation formulation: this is a process whereby social goods are provided, or the
process by which total resource use is divided between private and social goods. The
government provides such social goods as security, healthcare, education, recreational
services (parts), road etc. The government may participate directly in production of
goods and services where it employs parastatals e.g. post office, sugar factory, water
supply plants etc.
2)
Distribution function: Adjustment of the distribution of income and wealth to ensure
conformance with what society considers a “fair” or “just” state of distribution is
referred to as the distribution function.
3)
Stabilization function:
The government uses budgetary policy as a means of
maintaining high level of employment, reasonable degree of price level stability,
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appropriate rate of economic growth & development a stable balance payment in
international trade.
1.2.1 The allocation function
To understand this clearly we classify goods into 2 categories;
Exam Question: How do social goals differ from private goods?
Social goods
Private goods
1. The need for social goods is felt 1. The need for private goods is felt
collectively
individually.
2. The benefits derived from social goods 2. The benefits derived from private goods
are not limited to one particular
are limited to one particular consumer
consumer who purchases the good, but
who
becomes available to others as well.
humbugger, shoes)
purchases
the
goods
(e.g.
(Reduction of air pollution benefits all).
[No. ownership right]
3. Social
goods
cannot
be
provided 3. Private goods are efficiently provided
through free market mechanism
through market mechanism. The market
furnishes a signaling system whereby
producers are guided by consumer
demands.
4. For social good it would be inefficient 4. Nothing is lost and much is gained
to
exclude
consumer
when consumers are excluded unless
particularly in the benefits, when such
they pay. Application of the exclusion
participation
principle tends to be an efficient
consumption
any
would
by
one
not
anyone
reduce
else.
solution.
Application of exclusion principle is
impossible and prohibitively expensive.
5. Social goods do not carry a high rate of 5. Private goods carry high rates of return
return on investment.
on investment.
In conclusion: It can be noted that no price could be put on a social good because of the
non-rival ness in consumption. As a result of this, to venture into production of social goods
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is highly unprofitable and may not attract private investors. Because of non-rival ness in
consumption, there is market failure. Since the benefits of such goods are not limited to
individuals, beneficiaries may not voluntarily offer payments to the supplier of such goods. It
is as a result of this that the government normally taxes all citizens irrespectively so that it
could provide for such goods.
Public provision of social goods
Just like in the provision of private goods and services, there must be consumer preference
before social goods and services are provided. But because so far social goods and service is
collective from the society as a whole, it is very hard to know the nature of the society
preference map. It would be very difficult to seek individual opinion from every citizen on
type and quantity of a social good that should be provided. It would also be difficult to
decide how much each individual should pay for the product on pay for the product. One
may argue that consumers pay based on benefit principle, as in the case of private goods, but
then the problem would be, how such benefits would be determined. Just as consumers are
unwilling to voluntarily pay for social goods it would be difficult to make them reveal
accurately how much benefits they are deriving from such goods.
The question then remains how best public goods could be provided. A different technique
other than market mechanism is needed by which the supply of social goods and the cost
allocation thereof can be determined.
This is where the political process enters the picture and must substitute market mechanism.
Voting by ballot must be resorted to in place of shillings voting. Since voters know that they
will be subject to the voting decision (be it simple majority or some other voting rule e.g.
through their elected MPs, councilors representatives), they will find it in their interest to vote
so as to let the outcome fall closer to their own preferences. Thus decision making by voting
becomes a substitute for preference revelation through the market. The result will not please
everyone but they will approximately move or less perfectly, depending on the efficiency of
the voting process.
This difference set provision for and production of social goods
When the government either directly or through government owned parastatals or by
assigning private producers to produce goods through tenders, we say that the government
has provided the goods.
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If we say that social goods are provided publicly, we mean that they are financed publicly, we
mean that they are financed through the budget and made available free of direct charge.
How they are produced does not matter.
The distribution function
This is a process through which the government redistributes income and wealth among
citizens. In the absence of government intervention in the distribution of income and wealth,
the distribution depends first of all on the distribution of factor endowments. It is important
to note that people’s earning ability differ, ownership of properties also differ.
The
distribution of income, based on this distribution of factor endowments, is then determined by
the process of factor pricing, which, in a competitive market, sets factor returns equal to the
value of the marginal product. The distribution of income among individuals thus depends on
their factor supplies and the prices which they fetch in the market. In most countries where
free market policies are followed there tends to arise a class of society where few become
richer, majority poorer because this does not fall in line with what is considered to be just and
fair, the government must employ mechanisms and policies to redistribute wealth and
income.
Various prepositions have been made in this respect.
(i)
States as follows: - Efficient factor use required factor inputs to be valued with
compatible factor prices.
(ii)
The preposition that the distribution of income among families should be fixed by the
market process (Perfect competitive market, oligopolistic or monopolistic market).
Principle a is an economic rule that must be observed if there is to be efficient use of
resources but preposition 2 is speaks a different language. Second preposition has largely
failed because of the inequalities that have resulted from imperfect markets.
However, even if all factor prices were determined competitively, the resulting pattern of
distribution might not be acceptable. Therefore if redistribution of income and wealth is to be
improved.
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Fiscal instruments of distribution policy
Redistribution is implemented most directly by taking the following action; most widely used
schemes will be;
a)
Employ a tax transfer scheme. Here a vertically progressive tax system is used to
collect more taxes on income of high income households and using the money to
subsidize low income households.
b)
Employ a progressive tax system to finance public services. Such as medical,
education, water etc.
c)
Employ a sales tax: Taxes are collected on goods and services used by high income
classes and funds raised are used to subsidize goods used by low income classes.
The stabilization function
Here macro-economic policies are employed to maintain and achieve the goals of high
employment, acceptable price stability, favourable balance of payment position and are
acceptable rate of economic growth and development.
Economic policies are necessary because high rates of employment and low rate of inflation
do not come up automatically in a free market economy. In fact changes in inflation rate are
inversely related to rate of unemployment as can be shown in the following diagram.
P.C. shows the trade off between
unemployment and inflation. To achieve
low unemployment level, we have to be
ready to suffer high inflation rate.
Inflation
10%
6%
0
Phillip’s curve
4%
12%
Unemployment
From the diagram it is clear that countries cannot attain zero level of inflation and
unemployment at anytime. There will always be a combination of the 2 that would be
favourable at one time. When ….. rate is high, rate of unemployment is low and vice-versa.
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
This calls for well planned policy actions to achieve an acceptable level at inflation
and unemployment.

At times there may be high level of inflation and employment meaning that Phillip’s
has shifted to the right.
Reasons:(i)
Increased size of labour force due to population growth.
(ii)
Low rate of manpower utilization high level of unemployment.
(iii)
Low rate of economic growth. Low economic growth implies that when supply is
less than the demand the prices go up hence unemployment.
Lack of technological know-how – low output.
(iv)
Therefore economic policy is essential for strong economic growth and development level of
employment and prices in an economic depends on level of aggregated demand and level of
output valued at prevailing prices. i.e. Employment = f (Output, expenditure).

Aggregate demand is also a function of the spending decisions of many consumers,
corporate managers, many financial investors etc.

The decision of this people in turn depends on:a)
Past and present levels of income and expected level of future incomes.
b)
Level of wealth in a country and its distribution.
c)
Credit availability.
d)
Future expectations.
1.2.1.1 Instruments of stabilization policy
a) Recession period
For any given period the level of expenditure or aggregate and may not be sufficient to secure
full employment of labour and other factors of production. When this happens expansionary
economic policies must be made to stimulate the economy e.g. government expenditure and
taxation = More money
Supply for use in demand increases production (output) hence rise in employment.
b) Boom period
When aggregate demand is greater than aggregate supply (level of output) employment level
high in boom period, inflationary pressure high, hence operating costs become high. There is
a drop in quantity.
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When this happens, restrictive economic policies must be employed. G.E & increase in
taxation leads to a decrease in purchasing power resulting in full ineffective aggregate
demand and policies.
Note case 1 and 2 constitute fiscal policy measures.
The government can also use monetary policies as stabilization instruments. In doing so, the
Central Bank of Kenya, the government has various options
a) Controlling the reserve ratios

Reserve Ratio is that function of total deposits in commercial banks that the Central
Bank requires commercial banks to retain to pay its customers

When the ratio is increased, less money remains for lending out and vice versa.
Reserve ratio is normally increased if there is (inflation and too much money in the
economy).
b)
Bank rates
Rates of interest that control bank charges commercial banks when they go for short term
loans. Increase in bank rates discourages commercial banks from borrowing from Central
Bank. This in turn reduces the resources available for commercial banks to loan to public,
thus reducing amount of money in the economy.
c)
Open market operations
The government goes in the market and buys or sells government securities in order to
influence the direction of the economy. Such securities include treasury bonds, when bonds
are sold to the public through Central bank the public buys bonds certificates which pay
interest. The result of this is a withdrawal of money from the economy and thus lowering
aggregate demand. But when the government redeems them (buy back the bonds) it pays
back the public their money and interest earned hence more money in the economy, high
aggregate demand, more output and hence increase in employment level.
CO-ORDINATION OR CONFLICT OF FUNCTIONS
In order to provide a good co-ordination of the functions there must be a good management
of the economy when they are not properly co-ordinated there will be conflicts among them.
Proper co-ordination calls for good policy targeting during the planning and implementation
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process.
For example, those who are concerned with planning distribution will design a tax transfer
plan to secure the desired distribution. Similarly, those who are in charge of allocation in
terms of public expenditure must ensure that the funds allocated from the taxes are used to
finance projects with consumer evaluations thereof.
Those who are in charge of policy formulation to stabilize and to stimulate the economy must
ensure that they achieve full employment growth when all functions are in balance we say
that the budget is balanced.
However, this balance may not be sufficient to provide for or sustain the required economic
growth and development. So the government will result to other sources of funds other than
taxation e.g. externally or internally. In real world situation such a perfect co-ordination may
not be realizable. The achievement of one objective (e.g. provision of social goods) is
achievable at the expense of the other e.g. (price stability).
1.3.1 Conflict of interest
i)
Conflict between allocation and distribution
Taxes are normally imposes so as to redistribute income and wealth and raise funds
for government to provide. Social good in order to affect this, a vertical progressive
tax to collect more from the rich and less from the poor is imposed.
But if looks at less developed countries budget is low and majority of earners are in
lower and majority of earners are in lower and middle income classes, hence causing
conflicts between allocation and distribution function.
ii)
Conflict between distribution and stabilization function:-
Stabilization functions are used to stabilize the economy. When there is need to
stimulate the economy (time of recession) taxes on lower income groups should be
reduced, since their marginal propensity to consume is higher than that of the rich.
This would lead to increased disposable income, demand, output produced and thus
employment.
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The opposite cause has been made in times of inflation, namely that taxes on lowincome groups should be raised, since they are more potent in reducing demand than
taxes on higher income. Another reason would be, by taxing the rich a lower rate;
they would be motivated to save more because their MPs are high. Conflicts arises in
such as approach because the distribution function of budgetary policy does not
achieve the aims of deducting more from the rich and less from the poor.
iii)
Conflict between distribution and growth and economy
Objective of the budget is to attain high growth rate in economy. This would only be
achieved if capital formation, savings and investments are revealed. This would mean
from poor and less from rich. Why? Because people with higher propensity to save
are high income people. Conflict arises between distribution and growth. The aim of
distribution function is to deduct more from the rich and less from the poor, which is
the opposite of the goal of high growth rate.
THE PRINCIPLES OF MAXIMUM SOCIAL ADVANTAGE
The principle is concerned with the level at which the government should operate which in
turn is determined by its activities.
The purpose is to design the policy and operations of the government so as to achieve
maximum welfare for the economy.
Simplifying assumptions
i). All taxes drain away the economy’s resources.
ii). All public expenditures restore these resources of the economy
iii). Government revenue consists of only taxes and the government has no surplus or deficit
budgets.
iv). Public expenditure is subject to diminishing marginal social benefit and the taxes are
subject to increasing marginal social disability (cost).
This implies that the government expenditure will be first directed towards those uses which
are the most beneficial to the society and the taxes will drain away resources from those lines
where they are least useful.
As the government increases taxation and expenditure activities, the social benefit from each
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additional shilling spent falls while the dissatisfaction from each additional shilling taxed
increases.
A state is reduced at which the rising marginal dissatisfaction of taxation becomes equal to
the falling marginal social benefit of expenditure.
At this stage, the government should stop expanding its activities. It is no longer beneficial to
further expand the state activities because the social benefit of the marginal unit of public
revenue operations is no longer larger than the corresponding social dissatisfaction.
B
B
N
B1
0
D
M
1
N
C
Amount of taxation
and public expenditure
D1
Determination of optimum tax and expenditure activity of the state
Public expenditure and taxation are measured along the X – axis, and social benefit and cost
is measured along the Y – Axis.
The quantities measured along Y – Axis will be positive if measured above the X – Axis and
negative if measured below the X – Axis.
As a result, the curve showing the marginal social benefit from public expenditure will lie
above X- Axis and the curve showing Marginal disutility from taxation will lie below X –
Axis.
The curve BB1 show the marginal social benefit occurring to the society from different
amount of the public expenditure.
The curve DD1 shows the marginal social cost to the society from the taxation levied by the
state.
The difference between BB1 and DD1 indicates the net social benefit i.e. the excess of the
benefit over the cost to the society. This is depicted by the curve NN1
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For example, when taxation is OM which is spend by the government, the marginal social
benefit and the marginal social cost (disutility) are equated i.e. MB = MC.
It is here that the state should stop expanding it activities. The net gained or maximum
possible social advantage to the society is equal to the area ONM. If the government stopped
its operation at less than OM, the society will be foregoing a possible gain.
If operations are expanded beyond OM, the total net benefit will again start falling.
LIMITATIONS
1) It is necessary for the government to perform certain basic functions like protection and
security. The benefit from the very existence of the government activities will exceed the
cost of maintaining its activities. In fact without the basic functions of the government,
the very existences of the society cannot be guaranteed. Protection also adds to the
productive efficiency of the society.
2) No basis for a generalization that every tax is a burden upon the society and that every
government expenditure is a benefit for it. Example, a tax on consumption from harmful
drugs is not a burden upon the society. But a tax on health services will be.
Example II,
If the government undertakes the provision of social overheads and other public
utilities, it leads to the emergence of external economics. Through them, the cost of
production falls, efficiency in production increases and the economy benefits. The
benefits to the economy are actually more than it get.
3) Effects of the budget may spill over to the following periods. Hence appropriate time tags
and effect – spread should be considered.
4) If all taxes are harmful and all government expenditures are beneficial, then the best
course for the government is not to levy any taxes at all. Financing of its activities could
be through deficit financing only. However taxes or expenditures cannot create or destroy
resources. Only transfer of resources between private and public sectors takes place.
5) Non-tax revenues like fees, fines, profits from parastatals, printing press, market
borrowing e.t.c. cannot be dismissed as unimportant.
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6) Every state is committed to certain compulsory expenses. According to Adam Smith
(1776), these activities include maintenance of state itself, defence, maintenance of law
and order, imparting justice, servicing existing debts e.t.c.
7) It is not easy to identify and quantify the effect of state operations. For example; indirect
taxation changes the relative prices of the commodities been taxed. This changes demand,
consumption, production and investment pattern. Hence the welfare and growth effect of
government activities cannot be linked with the amount of taxation and expenditure only.
8) It is unrealistic to assume a balanced budget. In developing countries, deliberate deficit
budgeting may be needed to stimulate saving and capital accumulation.
9) The optimum level of government activities determination is done aggregative. Other
factors such as income inequalities, regional imbalances are not considered yet they are
very important.
Models of Efficient allocation
Marginal conditions required for the efficient output of a particular good over a period of
time can be derived easily. Analysis of the benefits and costs of making additional amounts
of a good available is required to determine whether the existing allocation of resources to its
production is efficient. Any given quantity of an economic good available, say per month,
will provide a certain amount of satisfaction to those who consume it. This is the total social
benefit, of the monthly quantity. The marginal social benefit of a good is the extra benefits
obtained by making one more unit of that good available per month. The marginal social
benefits can be measured as the maximum amount of money that would be given up by
persons to obtain the extra unit of the good. e.g. if the marginal social benefit of bread is $2
per loaf, some consumers would give up $2 worth of expenditure on other goods to obtain
that loaf and be neither worse off nor better off by doing so. The marginal social benefit of a
good is assumed to decline as more of that good is made available each month.
The total social cost of a good is the value of all resources necessary to make a given amount
of the good available per month. The marginal social cost of a good is the minimum sum of
money that is required to compensate the owners of inputs used in producing the good for
making an extra unit of the good available. In computing marginal social costs, it is assumed
that output is produced at minimum possible cost, given available technology. If the marginal
social cost of bread is $1 per loaf, they would be made better off.
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Figure (
) graphs the marginal social benefit (MSB) and Marginal Social Cost (MSC) of
making various quantities of bread available per month in a nation. Figure ( ) shows the total
social benefit (TBS) and the total social costs (TSC) of producing the bread. The marginal
social benefit TBS/Q. Similarly MSC = TSC/ Q
The efficient output of bread can be determined by comparing its marginal social benefit and
marginal social cost at various levels of monthly output.
B
C
Figure A
A
D
TSC
TSB
Figure B
TSB -
Q1
Q*
TSC
Q2
In A, the efficient level of output Qk occurs, at point E. At that output MSB = MSC. The
‘output Qk maximizes the difference between TSB and TSC as shown in B. Extension of
output to the level corresponding to equality of TSB and TSC would involve losses in net
benefits. Similarly, output level Q1 and Q2 are inefficient.
The marginal net benefit of a good is the difference between its MSB and its MSC. When
MNB (Marginal Net Benefits) are positive, additional gains from allocating more resources
to additional production of the good continue just up to the point at which the MSB = MSC.
If additional resources were allocated to produce more of the good beyond that point MSC
would exceed MSB. The marginal net benefit seen additional resource we therefore would
be negative.
The marginal conditions for efficient resource allocation therefore require that resources be
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allocated to the production of each good over each period so that MSB = MSC.
Market failure
How taxes can cause losses in efficiency in competitive market.
Competitive markets
When a product or a service is taxed, the amount that is traded is influenced by the tax paid
per unit as well as the MSB and MSC of the item. The tax distorts the decision’s of market
participants e.g. income taxes influence the decision workers make about the allocation of
their time between work leisure. Workers consider not only the amount of extra income they
can get from more work but also he extra taxes they must pay on that income when deciding
how may hours per week or year to devote to work. In deciding whether to work more when
you have the opportunity to do so, people the extra income after taxes against the value of the
leisure time they give up. Taxes influence individual decision to work by reducing the net
gain from working.
Figure (
) shows the demand and supply curves for long-distance telephone service.
Assume that point on the demand curve reflect the MSB of any given number of message
units and polnes on the supply curve reflect the MSC of the service.
The equilibrium output in the market is given by E. The market output is efficient because it
corresponds to the point at which the MSC = MSB.
S1 = MPS + T> MSC
S = MSC = MPC
E1
P1
E
P0
P2
16 | P a g e
B
Q1
Q0
Now suppose that the government levels a 2 percent per message. Unit tax on sellers of longdistance services. Sellers must now consider the fact that each time they supply a message
unit, they must not cover the MSC of that unit but also the 2 cent tax. The effect of a tax is to
decrease the supply of the service as the price required by producers to expand service by one
unit must be equal to the sum of Marginal Private Cost (MPC) of the service and tax per tax
included decrease in supply the point of the service and tax per unit of service, T. As a result
of the tax included decrease in supply the point of equilibrium now corresponds to E’. At the
point the price has increased to P1 and equilibrium output has fallen to Q1.
The tax has prevented the market from achieving efficiency and resulted in a loss in net
benefits from telephone services. At an output level Q1 MSB = P1. However the MSC of
that output is only P2. As a result of the change in behaviour caused by the tax, the MSB >
MSC. The loss in net benefits from telephone service is equal to the shaded area E1EB.
How Government Subsidies can cause losses in efficiency
Government often subsidize private enterprise or operate their own enterprises at a loss, using
operate their own enterprises at a loss, using tax payer funds to make up the difference, taxes
can impair market efficiency and so can subsidies. Let’s examine the effects of agricultural
subsidies and the operating of agricultural markets. Suppose that the government guarantees
farmers a certain price for their crops. When the market price fall below the target price
guaranteed by the government, the government will pay eligible farmers a subsidy equal to
the difference between the market price of the product and the target price.
The figure (
) shows how the target price program works and how it results in more than
the efficient output of the subsidized grains when the target price is above the market
equilibrium price.
The figure shows the supply and demand curves
SS=MSCfor wheat in a
competitive market for that product.
Price
PY
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PX
E
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In the absence of any government subsidize the equilibrium is given by point E giving of Q*
quantity and Ph price. This is an efficient point because MSB = MSC.
With subsidy, farmers know that they will receive a minimum of P1 from wheat, in deciding
how much to plant, they will base their decision on the target price rather than the market
price when they believe that the target price will exceed the market price when they believe
that the target price will exceed the market price. They will produce Q1. The output Q1 is
greater than the efficient amount because MSC>MSB at point A. As a result of the target
price program, more than the efficient amount of resources are devoted to the production of
wheat. Therefore the loss in net benefits from resolve use is equal to the area EAC in the
graph.
CHAPTER TWO
PUBLIC GOODS
We now need to consider how the characteristic of pure public goods relate to the concept of
market failure. There are some goods that either will not be supplied by the market or if
supplied would be supplied in insufficient quality e.g. defence, street lighting etc. These are
called public goods. If a pure public good is to be available for consumption then it must be
provided collectively either through private voluntary arrangements or public via the budget.
Pure public goods have 2 properties
Non-excludability
Non-rival in consumption.
Non-excludability characteristics of public goods
In the case of pure private good a set of property rights define the ownership of the good.
The individual who possess the property right has the sole claim to enjoy the benefits of the
good and can therefore exclude others from doing so. In the case of a pure public good
technical feature of excludability begin to breakdown. First, it is generally difficult to exclude
individuals from enjoyment of public good. If for example a geographical area is provided
with defence services which diverts and attack from abroad it becomes extremely difficult to
exclude anyone who lives in the country from being defended. Similar example is found in
street lighting.
19 | P a g e
For pure public good the degree of exclusion depends upon the technical characteristics of the
good and the resources available to the producer to enforce the exclusion. In general,
however, there is no perfect exclusion. So an optimal amount of exclusion is a decision to be
made by a producer.
Second reason why the exclusion principle breakdowns is that, while it may be technically
feasible to exclude, the application of exclusion device may be very expensive. That is, the
cost of exclusion can outweigh any advantages to be obtained from its application. A pure
public good is the one for which exclusion is either technically not feasible and if feasible,
the cost of enforcing the exclusive device is too prohibitive to apply.
With non-excludability, there is no incentive for a profit maximizing producer to supply the
public good because once he produces it he cannot exclude individuals from consuming it
and hence he is unable to charge a price. Individuals wishing to consume the benefits of a
pure public good could, however, form a private co-operative. They could agree to contribute
to the cost of supplying the public good. Such an arrangement might be feasible for a small
group of individuals, but as the group grows in size the possibility of individuals becoming
free riders increases and the private voluntarily arrangement fails.
Non-rivalness in consumption
Definition of a pure public good implies that it is non-rival in consumption. It means that it
does not cost anything for an additional individual to enjoy the benefit of public goods.
Non-rivalness arises from the indivisibility of public goods. That is, adding one or more
persons (up to a capacity constraint) does not add to the marginal cost. Formally there is zero
marginal cost for an additional individual to enjoy a good. Non-rivalness thus implies, one
individual access to the commodity does not reduce another individual’s benefit because
these benefits are available to all without interference.
A perfect solution in this case would require a zero price because marginal cost equals zero.
This will mean that revenues will not cover losses and so a private profit maximizing
producer will not supply such a commodity.
The market, in other words, will not allocate such goods efficiently thus the market failure.
20 | P a g e
PUBLIC GOODS
Therefore goods can be classified into four cases according to their consumption and
excludability characteristic.
Exclusion
Consumption
Rival
Non-Rival
Feasible
1
3
Not Feasible
2
4
Characteristic
Case 1
This is a private goods that is rival in consumption and excludable e.g. a loaf of bread,
clothing. You only consume the goods after paying for it. Whoever does not pay is excluded.
Benefits are internenalized.
Case 2
This represents a good that is rival in consumption but non-excludable. In this case there is
market failure due to non-excludability or high cost of exclusion. Example, travel on a
crowded street, traffic jam due rush hours.
Case 3
This is a good that is non-rival in consumption but excludable. Examples are clubs, watching
a movie, swimming, education, crossing a bridge that is not crowded.
Case 4
This is a good that is non-rival in consumption and non-excludable. This is a pure public
good. Examples are, air purification, national defence, street lights e.t.c.
Externality as a cause of market failure
Where provision of certain products result to “externalities”, market cannot function
effectively.
In this basic competitive model, people interact solely by trading with each other in the
market. There are situations, however, in which economic agents affect each other in ways
outside the market. According to Harvey S. Roser, “the activity of one person affecting the
welfare of another in a way that is outside the market is termed and externality.”
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Musgrove and Musgrave define externality as, ‘a situation where the benefit of consumption
of a given good or service cannot be paid by producer who causes them to result into external
costs to others.
For example, a particular technology used in the production of a private good producers
smoke as a by-product (i.e. the externality of spill-over) which is involuntarily consumed by
people living near the factory, thus lowering their utility. Despite the producer causing
pollution, he does not include such external costs as eradicating air pollution in his
production costs. So that, his private costs (costs of living inputs) is less than the overall
social cost (private costs and external costs). This external diseconomy will result in the
overall production of the good associated with the diseconomy, and the allocations would
differ from those that would have been produced by perfectly competitive markets. The
existence of externalities results in outcomes that are not pave to efficient.
A further follow-up on the issue of externality will made at a later stage.
Comparison between efficient provision of public goods and private goods
In chapter 1 we noted that one goal of the public sector or government was to ensure the
efficient allocation of both public and private goods. It was pointed out that some goods and
services had to be supplied by the public sector, since it would be difficult, if not impossible,
to have them supplied by the private sector in a market economy.
There are several approaches to the pure theory of public goods, but all are based on a fairly
common set of assumption and facts.
The most fundamental fact that can be identified is the existence of certain goods that, when
“consumed” or enjoyed by one person, do not reduce the enjoyment (technically) of someone
else who wishes to e.g. national defence). This is in contract to most other goods (private
goods), where, for example, if there is one apple between two people, A and B means that is
not available to B for consumption.
Formal definitions of pure public goods are manifold. Paul Samuelson has referred to the as
goods that have property that “each individual’s consumption of such a good leads to no
subtraction from any other individual’s consumption of that good.” Richard Musgrave has
stated that such goods “Must be consumed in equal amount by all.” John Head has put it
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slightly differently by saying that “once produced, any given unit of the good can be made
equally available to all.”
The non-rival nature of social good consumption makes it virtually impossible to optimally
price such goods even if provided by government.
In the next section we shall derived the conditions for efficient provision of a public good,
and then compare them with those of private good. To achieve this objective two approaches
shall be used.
The Bower Model Approach
The General Equilibrium Approach
In order to explain the foundations of this model, we assume that there are two individuals, A
and B each having a conventional downward sloping demand curve for some public goods.
That is, if the public goods could be sold in units at a price, each individual would demand
move as the price is reduced. These two demand curves are shown as DA and DB in the right
side of figure 2.1. Drawing such demand curves is based on the unrealistic assumption that
consumers volunteer their preferences, and such curves have therefore been referred to as
“Pseudo-demand curves”.
In the earlier discussion we defined public good as one which once produced, is consumed
equally by all. Thus no one person can vary the quantity to be taken. This being the case, to
derive the total demand for public good, the demand curves are added vertically, not
horizontally, as would be the case for a private good.
Suppose a quality OZ of the public good is made available to A. It is also made available in
the same quantity to B. What we want to know is how much would A and B, together, be
willing to pay for OZ of the public good. To get this add Zs (what individual A is willing to
pay for Oz) and ZH (what individual B is willing to pay for OZ) to obtain ZE. This is done
for each and every amount of the public good, giving us the total demand curve DA + B.
This tells us how much A and B, together, would be willing to pay for various amounts of the
pure public good.
It should be noted that for each amount of public good supplied, individual B is willing to
pay more than individual A for that amount.
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Since it takes resources to produce the public good, we introduce for convenience a constant
marginal cost (supply schedule) in our diagram, and from its intersection with the total
demand curve, obtain the equilibrium quantity and price, in this case OP1 and OZ.
Thus we see that the sum of the marginal evaluation by each person for the public good
equals the prices, which equals marginal cost, thereby meeting the conditions of optimal
pricing, that is, that price equal marginal cost.
This approach is usually termed as the Bowen Model.
In the case of private goods as can be depicted in the left side of figure 2.1, in a perfectly
competitive market situation, prices are fixed (market determined) and the consumers would
only vary amount they consume. So the total demand curve for private good (DA + B) is
obtained by horizontal addition of DA and DB. That is, adding the quantities which A and B
purchase at any given price. Given the supply schedule, the equilibrium is determined at E,
the intersection of market demand and supply.
Prices equals OP2 and output OH, with OF purchased by A and OG by, B, where OF + OG =
OH.
In a perfectly competitive market, equilibrium requires that the price of a good be equal to
each consumer’s marginal evaluation, which in turn is equal to marginal cost.
The consumer theoretically adjusts his purchase to achieve this, since he faces a fixed price.
In the public goods, case, the price does not equal each consumer’s marginal evaluation and
the consumer cannot vary his purchase to achieve this.
For a non-excludable public good, however, there may be incentives for people to hide their
two preferences. Individual A may falsely claim that the public good means nothing to him.
If he can get individual B to foot the entire bill, we can still enjoy the benefits from the public
goods and yet have more money to spend on private goods. In the figure presented above, at
output OZ1, individual B meets the entire Price (Z, V). This incentive to let other people pay
while you enjoy the benefits is known as the free wider problem. Hence, there is a good
chance that the market will fall short of providing the efficient amount of the public goods.
No automatic tendency exists for markets to reach the efficient allocation.
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Even if consumption is excludable, market provision of a public good is likely to be
inefficient. Recall the fact that pare to efficiency requires that price equal marginal cost.
Because a public good is non rival in consumption by definition, the marginal cost of
providing it to another person is zero. Hence efficiency requires a price of zero. But if the
entrepreneur charges everyone a price of zero, then we cannot stay in business.
Is there a way out? Suppose that the following two conditions hold:The entrepreneur knows each person’s demand curve for the public good and
It is difficult or impossible to transfer the good from one person to another.
Under these two conditions, the entrepreneur could charge each person an individual price
based on willingness to pay a procedure known as perfect price discrimination. From our
example, because individual B values the public good most, we would pay a higher price and
thus the entrepreneur would still be able to stay in business.
Perfect price discrimination may seem to be the solution until we recall that the first
condition requires knowledge of everybody’s preference. But of course, if individuals’
demand curves were known, there would be no problem in determining the optimum
provision of public good as was earlier demonstrated.
CHAPTER THREE
MARKET
FAILURES
AND
THE
RATIONALE
FOR
GOVERNMENT
INTERVENTION
Where the market is efficient, consumers have freedom to choose what they want to consume
freely, and they reveal their preferences to producers. Producers, in trying to maximize their
profits will produce what consumers want to buy and will do so at least cost. Competition
will not only ensure that the mix of goods and services produced corresponds to consumers
preferences, but would ensure that resources are allocated efficiently. The main assumption
here is markets are efficient and competition.
Under normal circumstances, however, this may not be the case. Market may fail to achieve
an efficient allocation of resources, leaving open the possibilities that government provision
of certain commodities might enhance efficiency.
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Given the presence of market failure, one possible role for government would be to intervene
in allocation function of the market to correctly the market failure or introduce policies that
would compensate its effect. This gives rise to the allocation function of the government.
Market failure will also bring about the question of equity of social justice in the distribution
of income and welfare where market failure produces a socially unjust distribution of welfare,
government intervene to bring about a distribution that is considered to be socially just and
fair. This is referred to as distributional role of government.
Market failures could also produce macro-economic instability such instability as inflation,
unemployment, BOP disequilibrium, etc. In these circumstances, a stabilization role exist for
government to intervene in the economy using monetary and fiscal policies to bring about
desired level of inflation and unemployment, thereby improving the welfare of society.
Further, there is a regulative function which government performs. As part of its allocative
role government enact and enforce laws of contracts. It also administers the more general
system of laws, order and justice which regulates individuals or firms behaviours and ensures
that market activities and private exchanges take place smoothly.
Thus market failure permit four functions of the government.
Certain conditions exist under which the market will fail to be pare to efficient. The
conditions include:i)
Imperfect competition
ii)
Costly information
iii)
Public goods
iv)
Externalities.
Imperfect competition as a cause of market failure
When some agents have the ability to affect price, the allocation of resources generally is
inefficient. An extreme form of such market power is monopoly, which comprises of one
seller in the market for a given commodity. Conditions that bring about monopoly includes:
Where transportation costs are large the relevant market may be limited a geographically
if there is only one firm in such a locality, there may be no or very limited competition.
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
In case where cost of production per unit of output declines (decreasing cost of
production or increasing returns to scale) entry into industry becomes very difficult,
thereby permitting the firms already established to exercise natural monopoly.

Some monopolies are created by the government or run by the government. The Kenyan
government, for example, has given the Kenya Power and Lighting Company the
exclusive right to generate and distribute electricity in the country. Patent rights given to
some investors grant them monopoly over their invention over specified period of time.
In some instances it is more efficient to have one or a few firms’ producing rather than many.
This applies where the initial cost of production is high and where the production of the
commodity cannot be subdivided into small units, e.g. the production of electricity. Such
subdivision would be inefficient and uneconomical.
If monopoly has some possible aspects then why is it generally viewed as bad? The reason is
that, if not regulated and if allowed to trade freely, they would restrict output to attain higher
prices.
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Mechanism of how they would restrict output to raise prices:
Price
PANEL A
- Demand
B
C
P
A
Marginal cost
(average cost)
AR
Qx
0
Q1
Output
MR
Price
PANEL B
- Demand
B
F
A
Average cost
G
Qx
MR
C
Q1
Q2
Marginal cost
Out put
In panel A of figure 2.0, 23 assume that the marginal cost (MC) of production is constant at
all levels of output. Because the monopolistic seek to maximize profit, he will produce output
OQ*, where price equal marginal cost. Clearly O Q* <OQ, and also notice that at OQ*, price
which measures how much individuals value an extra unit of the goods exceed the marginal
cost implying a welfare less from restriction of output by the monopolist. This establishes a
case for government intervention to ensure an efficient allocation of resources.
In panel B of figure 2.0., we assume that marginal cost of production falls as output is
28 | P a g e
expanded. That is, there is an increasing return to scale (a decreasing average cost curve).
Since AC>MC at any level of output, a price set to equal MC at Q2 would cause the
monopolist to incur a loss. Q1 is the highest output at which the firm breaks even since at that
output AC=P. A perfect competitive firm would produce at Q2 since P=MC at that output
level. A monopolist on the other hand will restrict output to C Q*. Again there is a welfare
loss arising from this restriction.
The problem of increasing returns to scale establishes a case for government intervention to
ensure an efficient allocation of resources.
In situation, as depicted in the figure, the
government could instruct the monopoly firm to charge a price which equals the marginal
cost, subsidizing the loss out of tax revenue. This is a classic example of regulation of
increasing return to scale industries.
Alternatively the government could take over the entire production operation i.e. through
nationalization, produce output Q2 and charge a marginal cost price again subsidizing the
loss from a general taxation.
At this point we should recognize the importance of the way losses made by decreasing cost
industrial using marginal cost pricing are financed. They are financed from taxation but most
taxes influence relative price. They introduce a distortion and thus create additional
inefficiencies. Ideal lumpsum taxes, which leave relative prices unchanged should be used.
However, lump sum taxes are generally not available and so other taxes must be used in
practice.
The design of optimal government policy is therefore one of the weighing out the distortions
and inefficiencies introduced by interventions, compared with the inefficiencies that the
policies are designed to reduce.
Costly information
The competitive model assumes that information on existing prices is somehow spread
around at no cost, so that everyone can find the best price. In reality, this is not the case.
Shopping around to find the lowest price requires time which is a valuable commodity.
Moreover, once information is obtained, it may be imperfect. Thus, it is possible that because
individuals do not have the necessary information to make the right economic decision,
29 | P a g e
inefficient patterns of resource allocation emerge.
CHAPTER FOUR
EXTERNALITIES
An Externality is something that, while it does not monetarily affect the producer of a good, it
does influence the standard of living of society as a whole. They can also be referred to as
those conditions where the forces of the market cannot secure, optimal results," and to public
goods as a condition "where the market mechanism fails altogether."
In the presence of externalities and public goods competitive market equilibria cannot be
expected to yield socially efficient resource allocations. This is due to "special"
characteristics of externalities and public goods called "non-excludability" and/market
thinness," or what is more commonly called the "free rider problem."
Free-rider problem
The free rider problem exits when people enjoy the benefits of government provided goods
i.e. public goods, independent of whether they pay for them. Free riders are actors who take
more than their fair share of the benefits or do not shoulder their fair share of the costs of
their use of resource. The actual "Free rider problem" can therefore be defined as the question
of how to prevent free riding from taking place or at least limit its effect. Since the notion of
"fairness" is highly subjective, free riding is only considered/to be an economic problem
when it leads under or non-production of a public good thus Pareto inefficiency.
Examples of free riding:
(i)
National defense-one is protected whether or not he pays for the
services rendered.
(ii)
An employee who pays no union dues but benefits from union
representation as dues-payers since the union owe a duty fo fair
presentation to all employees.
(iii)
25 peope living in a street each prepared to pay $100 for
installation of a CCTV costing $2500. Since if the system is
installed everyone will benefit from it, its very possible that some
people will refuse to pay, and instead hope that others will pay
for the system anyway, and receive benefits for no personal
30 | P a g e
expense. This will result in no system installed, an example of
market failure. This is despite the fact that allocative efficiency
would be improved.
Forms of Externalities:
There are two forms of externalities:
(i)
Positive Externalities
(ii)
Negative Externalities
(iii)
Fiscal Externalities
(i)
Positive Externalities:
A positive externality is something that benefits society, but in such a way that the producer
cannot fully profit from the gains made. A few examples of positive externalities are
environmental clean-up and research. A cleaner environment certainly benefits society, but
does not increase profits for the company responsible for it. Likewise, research and new
technological developments create gains on which the company responsible for them cannot
fully capitalize.
(ii)
Negative Externalities:
A negative externality is something that costs the producer nothing, but is costly to society in
general. Unfortunately these externalities are much more common. Let's take an example of
pollution. This is a very common negative externality. A company that pollutes loses no
money in doing so, but society must pay heavily to take care of the problem pollution caused.
The problem this creates is that companies do not fully measure the economic costs of their
actions.
They do not have to subtract these costs from their revenues; hence profits
inaccurately portray the company's actions as positive. This can lead to inefficiency in the
allocation of resources.
iii) Fiscal Externalities:
This is whereby the behavior of people affects the cost of some subsidy or alters the revenues
from some tax as externalities. Fiscal externalities do not necessarily imply any inefficiency,
and when there is inefficiency, it is the result of the pre-existing policy. An example is
smoking; this imposes costs on taxpayers due to the existence of subsidized medical care. In
this case the medical care subsidy creates the fiscal externality.
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However, when there is inefficiency, the nature and magnitude of the fiscal externality is not
a reliable guide to the appropriate corrective policy. Like in the above example, it will usually
be best to modify the pre-existing policy (the medical care subsidy) rather than tax smoking.
Implications of Externalities for allocative efficiency:
The prevalence of externalities in the market based economy suggests that the optimality
rules normally assumed to lead to allocative efficiency may not in fact lead to the most
socially efficient outcome. The presence, of externalities thus represents an example of
market failure to achieve allocative efficiency. This is because in the presence of externalities
the market price of a good may not reflect the true societal cost or benefit and hence may be
under or over produced. Figure EE1 illustrate the implication of negative externalities for
allocative efficiency.
Figure EE1: Effects of Negative Externality on allocative efficiency
Dollars
per year
SMC = (PMC + d)
S (PMC)
P*
D
Pm
d
X*
Xp
Tons of output per year
In a free market where the optimality rules have been followed the quantity produced will
occur at quantity Xp and price Pm, the point where demand (D) equals the private marginal
cost (PMC). However where a negative externality exists the market fails to produce the
socially optimal level of production. This is because the marginal damage (d), generated by
the negative externality, is a cost not taken in to account in the market. When a social
marginal cost (SMC) curve is generated it is possible to see that socially optimal level of
production is in fat X* and that the product should be sold at a higher price P* to reflect the
fact that the true social cost of the product is higher than the private cost.
32 | P a g e
Positive externalities also have their own special implications for the achievement of
allocative efficiency. Figure EE2 illustrates the implications for the optimality rules of a
positive externality. The market equilibrium in this situation occurs at quantity' Q* and price
Pm where the private marginal benefit (PMB) of the item equals its marginal cost. However
this item produces an external benefit (b) which is not taken in to account by the market. The
socially optimal quantity of this item actually occurs where the social marginal benefit
(SMB) curve derived by summing the private marginal benefit and the external benefit,
equals the marginal cost of producing the item. This analysis suggests that the allocatively
efficient situation occurs at quantity Q* and price p*.
Figure EE2: Effect of positive externality
Dollars Per
year
MC
P*
Pm
b
SMB (PMB + b)
PMB
QP
Q*
Units of outputs per year
The conclusion which can be drawn from this is that true allocative efficiency will not be
achieved unless the external benefits and costs associated with externalities are taken in to
account when making economic analysis.
Solutions to Externalities:
i) Internalize Externalities:
Economists recognize that negative externalities are a major problem. To combat this
33 | P a g e
problem, the government might try to force companies to internalize externality' costs. In any
type of production and economy, some negative externalities of production are inevitable.
The real problem created by negative externalities in the free-market economy is that because
they are not a cost to the company, the company will see only what is profitable to itself, not
to society as a whole; this will create inefficiency in the economy. The famous economist
Milton Friedman says that the government should require companies to pay for the costs of
cleaning up the problems they create.
This can be accomplished through taxes and fees, making companies pay for the amount of
harm they do to society as a whole. This solves the inefficiency problem. If companies have
to pay the costs of pollution, they can accurately compare the total costs and revenues of
production and determine if it is profitable to produce. However the government still has to
struggle with the question of placing a monetary value on such things as death, extinction, the
destruction of forests, and many other social costs and it is not always easy to put this policy
into practice. Regulations are not always enforced, and governments may simply choose to
relax their standards in order to avoid hurting businesses.
ii) Social Conventions;
This deals with negative externalities through social conventions and tradition. The argument
here is that "certain social conventions can be viewed as attempts to force people to take in to
account the externalities that they generate." and through tradition "recognition of signals and
appropriate responses are instilled as part of the culture." The example associated with this is
impressing on people from a young age that even though one bears a cost by holding on to
litter until a bin is found that one should do so because of the externality which litter creates.
However its overall usefulness may be limited to low cost externalities generated by
individuals.
iii) Property Rights:
The establishment and enforcement of private property rights provide an alternate framework
for the solving of externalities. "A private property right is a legally established title to the
sole ownership of a scarce resource that is enforceable in the courts." Private property rights
offer a number of solutions to the problems posed by externalities. Firstly, the establishment
and enforcement of greater private property rights by the legal system would allow victims of
negative externalities to sue the offending party for compensation for the damage caused. For
34 | P a g e
example, if property rights to a section of river are assigned to a particular fishing club, then
that club will be able to sue the chemical firm/upstream which pollutes the river and kills the
fish stock in the fishing clubs section of the river.
iv) Coase Theorem & Bargaining:
The other way in which property rights can assist in achieving allocative efficiency is by
providing a framework in which bargaining may take place. Consider the situation illustrated
in Figure ES3 below which builds on the fishing club example.
Figure E S3: Property rights and. bargaining
SMC = (PMC + d)
Dollars per
Years
PMC
MR
X*
XP
Tons of chemical per year
The Coase Theorem suggests that " the efficient solution will-'be achieved independently of
who is assigned the ownership rights , so long as someone is assigned those rights" The
reasoning for this is that if the chemical firm is assigned the property rights , the fishing club
will be prepared to pay the chemical firm an amount up to the value of the damage being
caused, to have the chemical firm reduce its output and that at any point past X* the damage
being caused exceeds the firms profits from doing so. Hence the firm is willing to accept the
payment to reduce its output to X*. Similarly if the fishing club has the rights, it will not
allow the firm to produce past X* as the damage caused to the fishing club is greater than any
payment the firm would be willing to make. The establishment of property rights thus creates
a framework which allows bargaining and the achievement of the socially optimal outcome.
35 | P a g e
v) Mergers:
Another possible solution to the problem of externalities may be for the parties involved to
merge. For example if a fishing companies profits are being harmed by the pollution
produced by a steel mill then the problem of this externality can be solved by merging the
parties involved and internalizing the effects. "For instance, if the steel manufacturer
purchased the fishery, he would willingly produce less steel than before, because at the
margin doing so would increase the profits of the fishing subsidiary more than it decreased
the profits from his steel industry.” This suggestion too however may be seen as having a
number of problems in its practical implantation.
vi) Tradable Pollution Permits:
Tradable pollution (or emission) permits are a free-market solution to the problems caused by
negative externalities. The difficulty is that companies that pollute create a cost to society but
not a cost to themselves. Because the company does not have an accurate view of its costs of
production, it cannot set its production at the level that maximizes efficiency in the economy.
One method of stopping this economic problem is to impose emission (or pollution) taxes.
This would mean that companies have to pay a certain amount for the pollution they produce.
While this system would solve the externalities problem, it would make it difficult for the
government to set absolute pollution limits if it felt the need to do so.
Tradable emission permits allow the government to give companies licenses to pollute at a
certain level. Companies can buy, sell, and trade these permits on the market. Therefore it is
in the interests of companies to pollute as little, as possible. If they pollute at a level higher
than their permit allows, they have to buy permits from another company. If they pollute less
than they are allowed to, they can sell their permit.
Conclusion:
In conclusion then it can thus be said that the existence of externalities and the failing of the
market to adequately deal with them has serious implications for the achievement of true
allocative efficiency within the economy. Whilst there are a number of possible approaches to
correcting the problems caused by externalities, each of the suggested solutions entails its
own problems which must be overcome before society will have an effective means of
dealings with the problems caused by externalities.
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ECONOMIC EFFETS OF EXTERNALITIES
Where there are externalities resource allocations will not be pareto efficient. The levels of
production and consumption will differ from those that would have been obtained under
perfectly competitive markets. The level of production of negative externality generating
commodities would be excessive while an external economy would result in under production
or consumption. Reason is that externality generates costs and benefits that are not included
in the prices that rule in the market. The market price signals are therefore distorted and
decision made on the basis of these prices will not fully reflect real values of the resources
employed.
In the next section we shall analyze these inefficiencies that are caused by externality and
possible remedies for them.
A number of alternative solutions for achieving the efficient level of output Oqs have been
proposed as follows:-
(1) TAXES
Fig 2.5. Use of Tax in correcting External Diseconomy
MSC = MPC + MD
Price and
Costs
(Mpc + cd)
()
d
MPC
PS
J
MD
C
V
MB
0
QS
Marketable Output
A natural solution suggested by the British economist A.C. Pigeon is to levy a tax on each
unit of a polluter’s output in an amount just equal to the marginal damage it inflicts at the
efficient level of output. This tax is called Pigouvian tax.
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In this case the marginal damage done at the efficient output Qs is distance cd. This is the
Pigouvian tax. Remember that the vertical distance between MSC and MPC is MD (i.e.
cd=VQs). The tax raises the firms marginal cost. For ach unit the firm produces it has to
make payments both to the suppliers of his inputs (measured by MPC) and to the tax collector
(measured by cd). Geometrically the firm’s new marginal cost schedule is found by adding cd
to MPC at each level of output. This is done by shifting up MPC by a vertical distance equal
to cd.
Profit maximization requires that the firm produce up to the output at which marginal benefit
equals marginal cost. This now occurs at the intersection of MB and MPC+cd which is at the
efficient output Qs. In effect the tax forces the firm to take into account the costs of the
externality that it generates and hence induces him to produce efficiently.
Note that the tax generates revenue cd dollars for each of the psd units which produced (psd =
OQs). Hence tax revenue is cdxpsd, which is equal to the area of rectangle psjcd.
WEAKNESS OF PIGOUVIAN TAX
-
There are practical problems in implementing a pigouvian tax scheme. In light of the
difficulties in estimating the marginal damage function, it is found to be hard to find the
correct tax rate.
-
Still sensible compromises can be made. Suppose that a certain type of automobile
produces noxious fumes. In theory a tax based on the number of miles driven enhances
efficiency. But a tax based on mileage might be so cumbersome to administer as to be
infeasible.
-
The government might instead consider levying a special sales tax on the car even though
it is not ownership of the car per se that determines the size of the externality but the
amount it is driven. The sales tax would not lead to the most efficient possible result, but
it still might lead to a substantial improvement over the status quo.
-
Another weakness is that the tax approach assumes that it is known who is doing the
polluting and in what quantities. In many case these questions are very hard to answer.
(2) Auction Pollution Permits
Another method of achieving Qs is to sell producers permits to pollute. The government
38 | P a g e
announces that it will sell permits to dumps into the river the amount of garbage associated
with output Qs. Firms bid for the right to own these permissions to pollute and the
permissions go to the firms with the highest bids. The fee charged is that which “clears the
market” because the amount of [pollution equals the level set by the government.
In the simple model the pollution permits and the pigouvial tax are identical. Both achieve the
efficient level of pollution. Implementing both requires knowledge of who is polluting and in
what quantities. Baumal and Oates [1979, p.251] argue that pollution permits have some
advantages over the tax scheme from a practical point of view. One of the most important is
that the permit schemes reduce uncertainty about the ultimate level of pollution. If the
government is certain about the shapes of the marginal private cost and marginal benefit
schedules of figure 2.5 it can safely predict how a Pigouvian tax will affect behaviour. But if
there is poor information about these schedules it is hard to know for sure how much a
particular tax will reduce pollution. If lack of information forces policy makers to choose the
pollution standard arbitrarily with a system of permits, there is more certainty that this level
will be obtained. In addition under the assumption that firms are profit-minimizers, they will
find the cost minimizing technology to attain the standard.
Moreover when the economy is experiencing inflation the market price of pollution rights
would be expected to keep pace automatically, while charging the tax rate could require a
lengthy administrative procedure.
One possible problem with the auctioning scheme is that large firms might be able to buy up
pollution licenses in excess of the firms cost minimizing requirements to deter other firms
from entering the market.
(3) Regulation
Under regulation each polluter is told to reduce pollution by a contain amount or else face
legal sanctions.
In case of pollution 2 classes of regulation (control) can be distinguished.
(a) Direct regulation
(b) Input regulation
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The direct regulations involve the setting up of critical level of pollution and monitoring the
level of pollution of the firms and prosecute firms that exceed critical level. Input regulation
on the other hand, involves regulating the production process.
When it is feasible to control level of pollution it seems preferable to apply input regulation.
The reason is that the firm is likely to know better than the government in terms of best way
of reducing the pollution. Most government relies heavily on input regulation since in most
cases it is easier to monitor inputs than to measure level of pollution.
(4) Private Solution to Externalities
Do all externalizing situations require government intervention to correct them? When the
number of individuals involved is small then it is possible that they could bargain with one
another. Both translations and bargaining costs rise; this calls for political action to enforce a
solution and to eliminate the possibility of some individuals acting strategically as free riders.
This leads us to the Coase Theorem. The Coase theorem demonstrates the falsity that all
forms of market failure require government intervention to correct them.
If translations costs are zero (or low) then a private voluntary bargaining solution will
produce an efficient outcome. According to Coase theorem, whenever there are externalities
the parties involved can get together and make some set of arrangement by which the
externality can be internalized and efficiency ensured. Most externalities are dealt by the
assignments of property rights.
These rights confer on a particular agent the right to control some assets and to receive fees
for the use of that properly. For example a firm may possess a right to the environment and
hence parties concerned about the environment could arrange to purchase back these rights
from the firm thereby reducing the firm’s stock of rights and hence the level of pollution.
Hence the price that the parties (consumers) are willing to pay reflects their valuation of the
environment. On the other hand consumer could hold back the rights to the environment and
firms would purchase these environmental rights and hence the right to pollute.
According to Coase theorem it does not matter who is assigned the right. The outcome in
terms of the level of pollution is the same and will be non-zero. So long as the translation
costs are zero or low, a private voluntary arrangement can produce an efficient solution.
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Another example is when there are smokers and non-smokers in the same room. If the loss to
non-smokers exceed the gain to the smokers then the non-smokers can come together to
compensate smokers not to smoke. On the other hand, if the smokers are in a non-smokers
room and restriction on smoking which can be viewed as externality imposed by nonsmokers to smokers takes away more of their welfare than the non-smokers gain the smokers
can get together and compensate non-smokers in order to allow them to smoke. Either way it
will appear that the parties involved can verify the problem. As far as an efficient allocation
of resources is concerned, it does not matter who compensate who.
Coase solution has income distribution consequences i.e. the individual consuming the
external effect
pays (bribes) the polluter to reduce the level of pollution. Where there are
external diseconomies output of producer will be excessive and those affected will attempt to
offer compensation to secure reduction of activity in question. On the other hand where there
is an external economies, output of the good will be too small and compensation will have to
be offered to induce an increase in the activity. Clearly, if all parties perceive gains from
trade, such translation will takes place in voluntary basis.
WEAKNESSES OF COASE THEOREM
(i)
The Coase theorem assumes zero translation cost. If translation costs are high then the
outcome of bargaining over weights won’t be pareto efficient. Also the outcome will
be affected if there is assignment of translation costs between the two parties in the
bargain.
Pigon (1932) points correctly to the cost in terms of time and efforts required for
bargaining. In the presence of very large lump sum translation costs which exceeds
the benefits from negotiation a discrete decision either allowing or barring the activity
maybe the solution.
(ii)
Another problem is that voluntary bargaining may not proceed if large number of
people is involved. For example if pollution problem is experienced by large numbers
of individual then each individual may prefer to sit quietly and hope that others will
offer enough compensation to induce a less polluted atmosphere. In this way each
victim would seek to free ride. Clearly if all affected people behave in this way the
process of negotiation will not materialize.
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Coase solution will only be applicable in those situations in which properly rights and
hence contracts can be well specified at reasonable cost and where problems of free
riding do not arise.
(iii)
It is not necessarily the case that negotiation will produce a pareto improvement if
both parties do not have access to all available information’s. As David and Kamien
(1971) has pointed out one side may have more or superior information than the other
and this may lead to cheating or black mailing.
(iv)
The Coase solution has distributional consequences. The individual consuming the
external effects compensate the polluter to reduce level of pollution whilst solutions to
externality problems might not be desirable in distribution terms. For example
consumer of those goods that carry a pollution tax will end up paying higher prices
and some employees who work in those firms may be made redundant as output
levels reduce.
PUBLIC EXPENDITURE
DEFINITION OF PUBLIC EXPENDITURE
Public expenditure can be defined in different ways as:
a) The expenditure of central and local government;
b) The combined government expenditure plus disbursements out of the National
Insurance (social security) Fund; or
c) The total government expenditure as in (ii) plus expenditure of the public
corporations.
The size of the public expenditure will depend on the definition adopted and will differ
accordingly. This can give rise to confusion when comparisons are made over a period of
time or internationally. Thus, if public-expenditure is defined in terms of what the central
government and local authorities spend; it will appear smaller than when expenditure by
public corporations is also included.
The basis on which public expenditure once defined is analyzed, does not, however, affect
the total figure which represents the absorption of resources by the public sector. The analysis
can be undertaken-on the following basis:
42 | P a g e
i). Spending authority: Central government, local authorities, public corporations,
ii). Economic category: Current expenditure account (expenditure on goods, services,
transfer payments), capital account (investment),
iii). Programme: defence, agriculture, housing.
The total figure for public expenditure, whichever basis is used, should be the same and
represents the absorption of resources by the public sector.
THEORIES OF PUBLIC EXPENDITURE - THE DOCTRINE OF LAISSEZ-FAIRE
Some of the philosophers and classical economists of the eighteenth century subscribed to the
doctrine of laissez-faire which was based on the principle of minimum state intervention in
the workings of the economy. ‘Governments are always and without exception the greatest
spendthrifts of society' because, argued Adam Smith, 'they spend other people's money'.
Adam Smith believed that individual people acting in self-interest will promote public good
under the guidance of the 'invisible hand'. The supporters of laissez-faire therefore
maintained that people should be left unhindered to pursue their best interests and in the
process they would benefit the society. The implication of this was a low level of public
expenditure and taxation but the need for some increase in public expenditure was conceded.
Social injustice which was intensified by the Industrial Revolution undermined the belief in
the doctrine of state non-intervention.
Individual Choice Theory
Emphasis in theoretical discussion of public finance shifted to the consideration of the basis
on which collective decisions in the public sector should be made. Writers, such as Ferrara
(1850), advocated individual choice as the basis of social choice and of collective decision
making. The problem of this approach to government intervention and public expenditure
was the aggregation of individual preferences and of relating them to policies.
The Authoritarian Conception or the Organic Theory
The organic theory avoided this difficulty, since it was based on the assumption that the
decisions were made by a ruling group.
Optimum Level of Public Expenditure Theory
Having accepted the need for some public expenditure, economists turned their attention to
43 | P a g e
the question of what was its desirable level. As far back as the turn of the nineteenth century
Emil Sax attempted to provide an answer by the application of the marginal utility theory to
public finance. The theory is chiefly associated with W. Stanley Jevons (1835-82), who was
an English economist, and with Karl Menger, an Austrian. However, Leon Walras in France
and Herman Gossen in Germany also formulated it independently. The theory postulates that,
as a person's consumption increases, each additional (marginal) unit of a good consumed
gives lower satisfaction (utility) than the one before. Thus the consumer experiences
diminishing marginal utility.
The concept can also be applied to money. The more money a person has, the less importance
he or she will attach to each additional £1. Thus to somebody who has only £10 per week £1
may make all the difference between being able to buy such necessities as food or going
hungry. To a person with £100 a week £1 will make little difference. With an income of
£1,000 a week having £1 more or less will hardly be noticeable. Nevertheless, a person's
economic welfare will be higher, the greater the number of £1 coins they have - even if the
marginal increase is less and less.
The theory is based on the relationship between the satisfaction derived from the
consumption of goods and services provided by that state, and the sacrifice involved in
paying taxes to finance public expenditure. To calculate this way would have to be found of
measuring all individual satisfactions and sacrifices and also of aggregating them.
No objective and precise way of doing this has been found and the theory is more of
academic interest than of practical value to any Chancellor of the Exchequer in the
formulation of fiscal policy. As Professor A.T. Peacock (b. 1922), a leading contemporary
authority on public finance, has pointed out, economists are becoming increasingly skeptical
of the value of welfare economics for the study of actual economies and of the associated
theories of public expenditure.
The marginal utility theory does, however, shed some light on how people behave. We may
not go around calculating our diminishing marginal utility of each public good we consume.
Nevertheless, all of us are aware that there is some point at which the burden of taxation
appears greater than the various state benefits are worth to us. We may not he able to put a
figure on that point and it may not be the same for all the people, but we may prefer to go
44 | P a g e
without some public goods and services rather than pay more in taxation to finance the
increase in public expenditure.
The optimum level of public expenditure can be defined as the point at which the benefit to
all individuals from additional expenditure is equal to the additional sacrifice by them
involved in paying more tax. There is no agreement, in theory or practice, on the optimum
size of public expenditure. What will be regarded as a desirable level, will be influenced by
political, social and economic considerations. It will vary from society to society, and change
over time.
A discussion of the optimum level of public expenditure does, however, have more relevance
to a government's decision when it has a choice whether to spend or not. At a time of war or
economic crisis it may have no option but to increase public expenditure.
The ability of a government to spend in a democratic society depends in the long run on the
following factors:
i). National resources (national Income),
ii). The level of taxation required to finance spending,
iii). The acceptability of the public expenditure programmes to the electorate.
The Ballot Box Theory
In a democratic society people have the opportunity to decide how much they wish to provide
for themselves and how much they want the state to provide for them. Their individual
preferences can be expressed by putting a vote in the ballot box at the next election for a
political party whose manifesto most closely reflects their views. It is the majority vote,
which is the aggregate of individual preferences that gives the government the mandate to
carry out its policies. The problem however is that at a general election people vote on a
number of issues and for a manifesto 'package' containing various proposals. Consequently,
the electors have no opportunity' to express their view on a particular issue or measure. Not
all of the proposals in a manifesto may be equally acceptable to them. Examples of instances
where a choice was possible are few. The following is a case in point.
A referendum in California gave the state's residents an opportunity to vote on one specific
point - the level of taxation to finance local public expenditure. Proposition 13 proposing to
cut taxes and halt the growth of public expenditure was put before them, and they
45 | P a g e
overwhelmingly voted for it in 1978. This was followed in 1979 by a proposition to put a
ceiling on public expenditure. The result of the second referendum was three to one in favour
of the proposal. But, in 1980, a third attempt to cut income tax was rejected. Californians had
decided this would have required a reduction in public expenditure to below an acceptable
level.
In the UK, resort to referenda is rare. In between elections, various pressure groups such as
the Confederation of British Industry can seek to influence government's expenditure
programmes by persuasion, protest or the use of the power to strike by the trade unions.
The Positive Theory of Government Expenditure
This theory has been advanced by present-day writers such as A. Downs, J.M. Buchanan
(winner of the Nobel Prize for Economics in 1986) and G. Tullock. It could perhaps be
described as the 'clinging to power' theory; since it is based on the assumption that in a
democratic society governments seek to maximize their life span, while voters seek to
maximize the benefits they receive from the government. An increase in public expenditure is
popular with voters - if they do not have to pay the taxes to finance it.
WAYS OF MEASURING THE SIZE OF PUBLIC SECTORS
1. Share of government expenditure in Gross Domestic Product. This is given by the ratio of
total government expenditure in G.D.P
Thus SPS = Total Government Expenditure
Gross Domestic Product
=
G
GDP
The ratio shows the share of total output which is purchased by the government.
However the government expenditure should not include transfer payments.
2. The share of total tax revenue in GDP. This is given by the ratio of tax revenue to GDP. It
measures the countries tax effort or the share of gross income which is diverted from the
private income stream into the public budget.
SPS = Tax Revenue = TR
GDP
GDP
This ratio is below the government expenditure ratio if there was a budget deficit
(T<G). However incase of budget surplus (T>G) the ratio is above the government
expenditure ratio. Thus if
i). T < G, TR
< G
GDP
GDP
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ii). T > G,
TR
> G
GDP
GDP
iii). T = G, TR
= G
GDP
GDP
This ratio is most convenient for global consumption of public sectors
3. The share of government contribution in National Income. National income measures the
sum total of factor incomes (W,r,R,II), earned during a given period. Hence to measure
the size of the public sector we get the proportion of factor incomes that originated from
the government economic activities
SPS = Total Factor Earning in Government
National Income
4. The share of government contribution in personal income. Personal income include
incomes received by household and contains three government components;
i). transfer payments (RF)
ii). Wages and salaries earnings from public employment (w)
iii). Interest receipt (r)
This represents the government contribution to the personal income
SPS = Total Government Contribution to Personal Income
Personal Income
= W + RF + R
PI
Canons of Public Expenditure
These are principles proposed to govern the public expenditure decisions. They include;
1) Canon of economy – utmost care must be taken to avoid wasteful usage of public funds.
2) Canon of sanction – no public funds should be used without proper authorization and
funds should be used only for the purpose for which they were sanctioned.
3) Canon of benefit – public expenditure should be incurred only if it is beneficial to the
society as a whole. The benefits can be through income distribution or production.
4) Canon of surplus – the government should avoid deficit budgeting. It should be prudent
and aim at meeting its current expenditure needs out of its current revenue. It should not
overspend and run into debts.
OBSERVATIONS ON THE GROWTH OF PUBLIC EXPENDITURE
WAGNER'S LAW
Adolf Wagner (a German economist in the nineteenth century) analyzed trends in the growth
of public expenditure and in the size of the public sector in major countries of the world. His
47 | P a g e
observations led to what is now called Wagner's Law or the Law of Rising Public
Expenditure, (He preferred to call it an observation).
It postulates that;
a) The extension of the functions of the state leads to an increase in public expenditure on
administration, and regulation of the economy;
b) An increase in national income of a Country will bring about a growth in public
expenditure on such programmes as education, health and welfare; and
c) The rise in public expenditure will be more than proportional to the increase in the
national income and will thus result in a relative expansion of the public sector. The cause
and effect can therefore be stated as follows; social progress leads to increased state
activity, this is turn gives rise to greater public expenditure which results in a bigger
public sector. Wagner's Law demonstrated a tendency but not the inevitability of
continuous growth of public expenditure.
Displacement Effect
Growth of public expenditure during a war is, however, inevitable. Analysis of the time
pattern of public expenditure by Professor A.T. Peacock and J. Wiseman has established the
Displacement Effect. They found that public expenditure increases during a war or a period
of social crisis. When the war ends or the crisis is resolved, public expenditure falls, but not
to the original level at the start of the emergency, with the result that growth in public
expenditure occurs in stages.
TRENDS IN PUBLIC EXPENDITURE: CURRENT AND CONSTANT PRICES
The trends in public expenditure can appear very different depending on the definition of
public expenditure used and the prices at which it is expressed. Prices can be as follows:
i). Current prices. They are those that prevail at the time under consideration and
represent the actual amount that has to be paid for goods and services.
ii). Constant prices. They are the .prices that were current at a specified period (e.g. a
certain, year, a day or the date of a price survey) which is then used as the base for
comparison with other periods. In this way changes in consumption in volume terms
(actual quantities of goods and services) can be shown and changes in the figures
indicate real improvement or deterioration. The effect of changes in the value of money
is removed so that the expenditure figures are not calculated in terms of inflationary
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prices. Expenditure at constant prices (or. survey prices) does not, however, show what
will have to be paid or had been paid in years other than the base year. What is shown is
what public expenditure on the goods and services would have been if the purchasing
power of money had remained constant.
Choice of the base year for comparison can also make a great deal of difference to the
appearance of a trend. The need is to select a year that is as normal as possible, that is one in
which nothing very exceptional has happened. War years or years of .economic crisis such as:
1914-1918 (the First World War); 1939-45 (the Second World War); 1932 (the worst year of
the Great Depression) or 1973 (the Oil Crisis), should be avoided as they distort the trend by
selecting one of the more abnormal years for comparison. It is possible to give a distorted
impression when using the same figures. In the study of a trend of public expenditure it is
therefore prefect-able to look at data for as many years as possible.
Problems in using 'constant prices' and in choosing a base year can make governments'
control of expenditure more difficult.
REASONS FOR THE GROWTH OF PUBLIC EXPENDITURE
Various factors – political, social and economic – have contributed to the growth of public
expenditure and the growth of the public sector. The following are some of the major factors:
a) The abandonment of the laissez-faire doctrine. As the climate of public opinion
changed new theories began to emerge and old ones were abandoned; among the
latter was the doctrine of laissez-faire. The self-correcting mechanism of an economic
system that the classical economists believed in appeared to have failed.
Unemployment, which to them was a theoretical impossibility, not only proved
possible, but became a major international problem. During the Great Depression of
the 1930s over 20 per cent of the insured population of the UK was unemployed. The
theory of governmental non-intervention could no longer command support. There
was a pressure of public opinion on governments to provide, relief for the
unemployed and to create jobs. In order to do so, public expenditure was increased.
b) The advent of Keynesian economics. One book, The General Theory of Employment,
Interest and Money (1936), by John Maynard (later Lord) Keynes, had a profound and
pervasive influence on economists and on governments for many generations. His
arguments that the government not only could but should use public expenditure as a
tool of economic policy to manage a national economy so as to counteract
49 | P a g e
unemployment, found ready acceptance in a world that had not yet recovered from the
Great Depression. The Keynesian prescription was to inject money into the economic
system. If the people were not spending, then it was up to a government to do so.
This required an expansive fiscal policy, in which a government would deliberately
aim at a Budget deficit by spending more money than it raised in taxation. To cover
the difference (deficit) the government would borrow. The 'Multiplier' effect of public
expenditure would counteract unemployment. Such fiscal policy was attractive to the
governments and popular with the public. By increasing public expenditure, a
government was seen to be doing something about unemployment whilst the public
were getting something (additional state benefits) for nothing, as it appeared, since
there was no increase in taxation. Government therefore had an incentive to increase
public expenditure and they did. What is more the policy appeared to work,
unemployment began to fall. But to what extent the increase in economic activity can
be attributed to governments' conversion to Keynesian economics, and to what extent
it was the result of rearmament on which major countries embarked at the time when
the General Theory was published, is debatable. Increased expenditure on defence
was a response to the threat of war. As such it was a political measure but it did inject
money into the economy and therefore had economic consequences.
c) Wars and social crises, such as severe and prolonged unemployment had resulted in
the growth of public expenditure.
d) Increase in the range of economic activities by the state. Emergence of political
philosophies, social attitudes and economic theories that advocated extension of the
activities of the states prepared the way for governments to expand public
expenditure.
e) Psychological conditioning of the general public, during a period of war and social
crisis, to a greater government intervention and higher levels of expenditure and
taxation made it easier for governments in subsequent periods to retain and to expand
their activities.
f) Post-war reconstruction of countries' economies involved governments in planning,
allocation of resources and in financing some of the projects.
g) Economic development, according to some economists, has considerable impact on
the level of public expenditure. Before a developing country can industrialize, it has
to invest in transport, water and power supplies, sanitation, education and other basic
50 | P a g e
social projects to reach a 'take-off point. In this early stage of development a high
proportion of total investment will have to be made by the government, since the
projects do not offer any, or foreseeable, return to investors. Once the country has
reached a more advanced stage of economic and social development, private
investment expands alongside public investment but, because of the imperfections of
the market, government intervention grows and with it public expenditure.
h) Growth of national income is related to the level of government economic activity.
Some economists, Wagner among them, had argued that an increase in national
income results in an increase in public expenditure on economic welfare. The richer a
country the more resources, in theory, are available to the government.
i) Increased public expectation. It can, however, be argued that, although it cannot be
statistically proved, an indirect relationship exists between the growth uf national
income and public expectation of an improved standard of living, and hence public
expenditure. Governments are likely to-be under pressure to increase provision of
public goods and services so as to increase the standard of living in general and of the
poorest members of society in particular.
j) Extension of the franchise. The increased expectation of a higher standard of living
has manifested itself through the 'Ballot Box' in a vote for higher public expenditure.
The extension of the franchise had given the right to vote at elections to people who
had previously been excluded from a choice of a political party to govern them and
from influencing the policies that they wished the government to pursue.
Under a progressive system of taxation it is those in the lower income groups who
stand most to gain from the extension of provision of goods and services by the public
sector. They have least to lose from increases in taxation required to finance higher
expenditure since they may not be liable to any direct taxes. The gradual extension of
the franchise has put pressure on governments to respond to the electorate's demands.
The extension of the franchise in Europe did not follow a uniform pattern and come
simultaneously. For example, women in Liechtenstein only voted for the first time in
1986. It can be argued that votes for women have resulted in votes for higher public
expenditure. It has been suggested that as women are more directly involved in their
children's education and safeguarding the health of the family, they are likely to
demand improvements in state provision of social services, through the ballot box.
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k) The establishment of the welfare state. This has created a base for the long term
growth of public expenditure.
l) Socialism. Socialist parties, committed by their ideology to the extension of the
public sector, won general elections and formed governments after the Second World
War in a number of countries, including the UK. Implementation of the policies set
out in the election manifestos furthered the development of mixed economies and
contributed to the growth of public expenditure.
m) Nationalization. The state takeover of private enterprises has increased public
expenditure in two ways, firstly by a government paying compensation to former
owners and secondly by subsidizing loss-making nationalized industries.
n) New technology and science. Some new technological developments in such fields as
atomic energy, aerospace and computers are so costly that in some countries they can
only be financed by the state or with substantial aid from government funds. Scientific
advances have enabled doctors to prolong life and reduce suffering, but in some cases
at an enormous cost to governments' health programmes by creating ever-increasing
demands.
o) Creation of super national organizations. The United Nations, NATO, European
Community and other multinational organizations that are responsible for the
provision of public goods and services on an international basis, have to be financed
out of funds subscribed by member states, thereby adding to their public expenditure.
p) Foreign aid. Acceptance by the richer industrialized countries of their responsibility
to help the poorer developing countries has channeled some of the increased public
expenditure of the donors into foreign aid programmes.
q) Increased complexity of national economies. As economies develop they become
more complex and the interests of various groups within a society come into conflict.
This has led to the proliferation of public bodies whose costs, arising out of their
coordinating, regulatory, administrative or judiciary functions are borne by
governments.
r) Inflation. A general increase in prices has been an international phenomenon during
the 1970s-1980s. Inflation increased the cost of all the activities of the public sector
and was thus a major factor in growth in money terms of public expenditure in many
countries.
s) Demographic changes. Since public expenditure is intended to benefit the people of a
country, it could therefore be expected that an increase in total population would
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result in higher public expenditure. But other demographic trends such as changes in
the structure of the population (age and sex) and its geographical distribution also
have to be taken into account. The overall effect of the various trends on public
expenditure may be such that they cancel each other out, thus the extent to which the
growth of population has led to growth of public expenditure depends on the specific
conditions in different countries.
RESTRAINTS TO THE GROWTH OF PUBLIC EXPENDITURE
Some of the factors in the growth of public expenditure that we have discussed are of a
temporary nature, others contribute to structural changes that result in an increasing financial
commitment by governments on a permanent basis, but the ability to spend is not unlimited.
The following are the four main restraints:
a) Resources. In the long run, public expenditure cannot exceed the resources of a country.
b) Taxable capacity. This imposes a ceiling on the government's revenue from taxation and
thereby on an increase in public expenditure that is financed out of it.
c) Limit to borrowing. For a time public expenditure can outstrip revenue either as a matter
of necessity or of fiscal policy and the deficit can be financed out of loans. But there is a
limit to how much money lenders at home and abroad will be prepared lo make available
to any government.
d) Public opinion. The final major restraint is the growth of public opinion. The level of
public expenditure in a democratic society will depend on the size of the public sector
that people want and are willing to pay for through taxation.
CONSEQUENCES OF THE GROWTH OF PUBLIC EXPENDITURE
Political, social and economic consequences are interrelated. They cannot therefore be easily
isolated and compartmentalized. Some are, however, more identifiable than others and are
listed below:
a) A political consequence of the growth of public expenditure is the increased size of the
public sector and hence of the power of the state.
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b) A social consequence of the extension of the welfare system is to allay the fear of
deprivation that is consequent to unemployment, sickness and old age. The need for
people to provide for themselves is reduced.
c) Development of a welfare mentality is likely to increase people's dependence on
government support and to lead to the creation of what politicians and social
commentators call the 'underclass' in a society. Its members caught in the poverty trap
may lack the means, ability, resourcefulness and incentive to break out.
d) An economic consequence is an increase in taxation or borrowing or both, to finance
rising expenditure.
e) A disincentive effect on work and enterprise may result from an increase in taxation
required to finance provision of public goods and services but economists disagree on
this.
f) National debt will increase as a result of borrowing and this will affect the rates of interest
and supply of capital to industry.
g) The rate of economic growth may be adversely affected by the; transfer of resources from
use in manufacturing in the private sector to the public sector for provision of social
services.
h) The productive capacity and export potential of an economy may be reduced. Public
goods and services, such as social security benefits, are not exportable and do not earn
foreign currency.
i) The balance of payments, will suffer if exports are reduced and when interest payments
on the money that the government had borrowed abroad, or repayment of capital, become
due.
j) The prosperity of a country may, however, be increased if public expenditure is on
projects that further economic development. If this happens then the balance of payments
may improve.
k) The standard of living of the people in general and of some groups in particular can be
increased by the provision of public goods and services.
l) Inflation resulting from the injection of public spending into the income flow of a country
adversely affects not only the standard of living but the whole economy
m) Stabilization of the economy may result from the use of public expenditure to counteract
inflation and deflation.
n) The level of employment may rise, but if the effect of increased public spending is
inflationary, employment will be likely to fall.
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o) A more egalitarian society can be achieved by narrowing the difference in the level of
consumption among its members by means of state benefits financed out of progressive
taxation.
p) Increased efficiency in provision of public goods and services as governments put greater
emphasis on value for money in an attempt to curb growing public expenditure.
This list of favourable and adverse effects that may follow an increase in public expenditure
is by no means conclusive. Whether its consequences will be beneficial or not will depend on
the existing level of expenditure, the purpose for which the additional money is used, the way
that the expenditure is financed and the specific circumstances of a particular country.
THE TREASURY
Treasury functions which reflect its importance within the administrative machinery are to:
i). Operate a central system for planning and control of expenditure,
ii). Prepare proposals for allocation of resources to government departments to finance their
expenditure programmes,
iii). Advise departments on improvements in their management strategies and on obtaining
value for money,
iv). Organize spending plans and estimates for publication,
v). Co-ordinate strategy on taxation,
vi). Administer economic and monetary policy and borrowing,
vii). Liaise with the European Community, International Monetary Fund, the World Bank
and other organizations,
viii). Analyze financial developments worldwide,
ix). Forecast changes in the economy and finance.
x). Make the Treasury Forecasting Model for the economy available to the public,
xi). Publish information and statistical data for the benefit of interested parties and to assist
the government and Parliament.
ROLE OF PARLIAMENT
It is the function of Parliament to impose taxes, to grant appropriate supplies, i.e. money to
finance public expenditure, and to exercise control over both.
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Provision of Finance
The Consolidated Fund is a government account at the Central Bank into which are paid all
the proceeds of taxation and other revenues and out of which money is paid to finance public
expenditure. These are classified as follows:
i). Charges under permanent legislator. These are charged on the Consolidated Fund (e.g.
interest on national debt) and are not debated in Parliament.
ii). Supplies for the current year. These are subject to debate.
Parliament can reduce supplies but cannot increase them, since it is the responsibility of the
government to initiate expenditure. The government may present supplementary estimates
during the course of the year, if the authorized supplies prove inadequate to meet the
expenditure for some reason - such as acceleration in the rate of inflation. A number of funds
have been set up for specific purposes, such as:
a) The Contingency Fund. This has been set up to provide for emergencies in anticipation
of subsequent provision by Parliament. Such funds have to be repaid.
b) Specific Funds. They have been set up under permanent legislation and can dispense
money without having to obtain annual authorization from Parliament.
c) The National insurance Fund.
National insurance legislation governs the rate of
contributions and benefits. Parliament does not have to authorize total disbursements but
the government actuary does, however, bring to its notice estimated effects of changes in
the rates on the Fund.
d) The National Loan Fund. An Act of Parliament specifies who can get loans and with
what limit. The authorization to provide the money does not run out at the end of the
financial year. Nationalized industries and local authorities (through the Public Works
Loan Board) borrow from this particular fund.
EFFECT OF PUBLIC EXPENDITURE
Government expenditure or outlay has important effects on the entire economy of a country.
It is important to consider the impact of public expenditure on such aspects as the level of
employment, production and income, stability of prices, the creation and maintenance of full
employment and a better distribution of income and wealth in the country. The influence of
public expenditure on levels of economic activity and on distribution will depend upon the
nature of the government and the period during which public outlay is made. For instance, in
a free economy and during peacetime, government expenditure is generally quite low but in a
socialist economy and also during war period, the contribution of government expenditure is
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more significant as regards the level of economic activity and employment.
1. EFFECTS ON PRODUCTION AND EMPLOYMENT
Dalton shows how the level of production and employment in any country depends upon
three factors,
a) Ability of the people to work, save and invest.
b) Willingness to work, save and invest, and
c) Diversion of economic resources as between different uses and localities.
It is possible to influence all these three factors through public expenditure either for the
better or for the worse. Government expenditure may help to improve the efficiency to work
and thus raise the income of the people in the country. Accordingly, people may be able to
save and invest a considerable part of their incomes. In this way, the productive potential of
the country will increase. Such an effect of public expenditure may be explained as follows:
a) Public Expenditure on Ability to work and save. If public expenditure can increase the
efficiency of a person to work, it will promote production and national income. Public
expenditure on education, medical services, cheap housing facilities and recreational
facilities to the working class people will increase the efficiency of persons to work. At
the same time, public expenditure can promote saving on the part of the lower income
groups by providing additional income to them, for a person who has larger income can
be normally expected to save a larger amount.
Finally, that part of public expenditure which consists of payment of interest and
repayment of public debt will place additional funds at the disposal of those who can save
and invest. Thus, it will be seen that public expenditure can promote ability to work, save
and invest and thus promote production and employment in the country.
b) Public Expenditure on the willingness to work and save. Public expenditure may not
have such a favourable influence on willingness to work and save. For instance, such
items of government expenditure as pensions, interest on loans, provident fund and other
government payments provide a security to a person and, therefore, reduce the
willingness of persons to work and save, after all, why should a person work hard and
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save when he knows fully well that he will be looked after by the government when he is
not in a position to earn an income.
c) Public Expenditure and Diversion of Resources. Public expenditure has far-reaching
effects on the utilization of resources as between alternative uses.
i). There are some diversions of resources from private to public use about which there is
some doubt. Dalton talks about the government expenditure on armaments and armed
forces. To meet such expenditure, which is often called economic waste, the government
diverts economic resources from the general public to the government; it is thought by
many that these economic resources could have contributed to economic welfare if they had
been allowed to remain with the people themselves. But a sensible argument can be given
in favour of military expenditure. War expenditure reduces the danger of foreign invasion
and thus diminishes the economic loss which would have resulted in the event of a war. It
is, thus, true that public expenditure on armaments reduces economic resources from other
uses in which they could have made a direct contribution to economic welfare (as, for
instance, able-bodied men, iron, coal, oil and other raw materials which are used in defence
instead of promoting economic welfare). But it is also true that defence expenditure is
essential for safety and security of the nation without which no country can flourish
economically or otherwise. Thus, we can leave out the diversion of economic resources for
purposes of defence.
ii). Public expenditure can bring about a better allocation of economic resources as between the
present and the future. In a free capitalist society very little provision is made for the future.
This is because people prefer the present rather than the future and, therefore, they do not
make adequate provision for the future. The state, on the other hand, is the custodian of the
interests of the future generations also and, therefore, has to see that adequate provision is
made for the future. Some good examples are public expenditures on transport, irrigation
and other projects which do not yield immediate returns but yield social and economic
benefits for generations to come. In this connection, the government also spends money in
the conservation of economic resources which are very essential for the future. Government
expenditure for the protection of the environment will also have a favourable effect.
iii). The government spends money for the encouragement of research and invention, promotes
education and training, looks after public health and sanitation and also takes the
responsibility of social security measures. Some fiscal theorists, however, argue that the
government" should actually curtail expenditure on many of these measures. Most fiscal
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theorists agree with Dalton that "increased public expenditure in many of these directions is
desirable in order to bring about that distribution of the community's resources between
different uses, which will give the best results, balancing without bias the present and the
future. In other words, the diversion of economic resources here will greatly increase
production.
iv). Diversion of economic resources will be justified in those instances when the volume of
new investment may not coincide with the volume of new savings. The lack of this
coincidence, as Keynes pointed out is the direct cause of instability in the economy, of
inflations and deflations and unemployment. To create a condition of stability and to bring
about the equality of saving and investment in the private sector, government expenditure
in the form of public works such as construction of roads, railway lines, irrigation works,
power, etc., will be necessary. Government expenditure on the public works programmes
has favourable effects on production and employment also.
v). Sometimes, public expenditure may result in diversion of economic resources as between
localities, in India; this is brought about by the use of central government grants to some
state governments to provide certain services more efficiently. This can also be done by
careful regional planning, in such a way that a backward region may be economically
developed. The government has to select the particular region or area and industry and
incur public expenditure so that the maximum national production and following it the
maximum community welfare can be attained. For instance, through improvement and
development of transport and communication in the North Eastern area and the provision of
water facilities in these areas and also through starting a few important industries by the
State, the private sector has been encouraged to open many industries in North Eastern.
Thus, if public expenditure is prudently planned it can certainly bring about diversion of
resources as between regions which will definitely improve the economic position of
backward areas and thus bring about increase in production and employment.
vi). Finally, Dalton refers to a country where the government has complete power over the
economy. This happens when the government has nationalized means of production as in a
communist or socialist economy. In such an economy, there is no question of diversion of
resources from the private to the public sector but the entire planning and expenditure of
projects is in the hands of the government. Dalton's conclusions on the question of the
effect of public expenditure on production and employment is that; "whereas taxation taken
alone, may check production, public expenditure, taken alone should almost certainly
increase it." The development expenditures of the Central and State Governments in Kenya
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aim at raising 'the level of production and of employment in the country. It is possible that
production will definitely be checked if public expenditure is carelessly planned, but it will
stimulate production if carefully planned.
PUBLIC
EXPENDITURE
AND
ECONOMIC
STABILITY
IN
ADVANCED
ECONOMIES,
During the 1920s and 1930s, most free economies were working under cyclical depressions
and booms. It was during these period, fiscal theorists showed the effect of public
expenditure in controlling depressions and booms.
During a period of business recession and depression, the anticipations of both producers and
consumers are falling. The producers anticipate a decline in prices due to a decline in private
demand and decline in profit margins. On the other hand, consumers anticipate a decline in
prices and hence tend to postpone their consumption till the prices fall to still lower levels.
Private consumption as well as investment expenditures decline and the propensity to save
and hoard increases. As a result, the free enterprise market economy suffers from inadequate
aggregate demand and consequent decline in production and increase in unemployment.
Once, the process of business recession starts, there is a cumulative decline.
Since the free economy is not able to reverse the trend itself, the government has an
important role to play. During a business recession the government should pump funds to
offset the decline in demand and income caused by the contraction of private expenditure.
The greater the decline in private expenditure and the greater the propensity to hoard the
larger should be the volume of government expenditure as a compensatory mechanism. This
kind of spending by government to compensate for shortage in private spending is generally
known as compensatory spending. It is not simply to offset private deficiencies in national'
income but also to provide the initial impetus for the economy to recover.
Compensatory Spending during Depression
Compensatory spending may be undertaken on a modest scale at a time when national
income is declining and unemployment is rising with the hope that at least further decline
may be checked. It may be undertaken on a larger scale with the hope of
a) Checking the decline in demand, production and employment, and
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b) To provide an initial impetus to the forces of business recovery which may be taken up by
the private sector. Compensatory spending of the second variety is commonly known as
'pump priming'. Essentially, compensatory public spending implies the use of public
expenditure to make up for the decline of private spending so as to maintain a full
employment level of income. Such a policy will mean different things in different
periods. For instance:
i). During a period of depression compensatory spending will involve heavy
government expenditure on public works programmes.
ii). During a period of recovery when private investment has started picking up, public
expenditure will be reduced gradually in the same ratio as the rise of private
expenditure.
iii). During periods of business prosperity and boom, when private demand for goods
and services is rising rapidly, government expenditure should be reduced
considerably so that there would be a surplus (i.e., excess of taxation over public
expenditure.
Let us describe, in greater detail, how public expenditure can be used to influence the level of
economic activity during the upward and downward phases of the business cycle.
Compensatory spending implies deficit budgeting. In a period of depression, current
expenditure should be in excess of current revenues resulting in a deficit. On the one hand,
government expenditure will have to increase to finance relief works to help the unemployed.
On the other hand, tax revenues will naturally decline because of the general decline in
national income and employment, increased taxation is not advisable.
During business depression, since it will further aggravate the depression by reducing the
volume of private demand for goods and services. Thus, compensatory spending will
necessarily mean deficit budgeting.
Borrowing from the public and borrowing from the Central Bank
Another aspect of compensatory public expenditure during a depression refers to the method
of financing the deficits. There are three possible ways of financing the deficit due to
compensatory expenditure, higher taxation; borrowing and creation of new money. The first
method – High taxation – is not possible in a period when unemployment is high and the
level of incomes is very low. Borrowing from the public, so long as it does not reduce private
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expenditure, will be all right, but it may happen that government borrowing may reduce the
funds available for private consumption and investment. Finally, funds may be made
available to the government through borrowing from the Central Bank of the country or
through borrowing from commercial banks. Such borrowing is in the nature of creation of
new money which will not restrict the amounts of funds needed by the private investors.
Compensatory spending by the Government will involve both borrowing from the general
public and also of new money created by the banking system.
Increase in national income and employment without reducing the private sector.
A third characteristic of compensatory public spending during depression is that it should
raise national income and employment without, at the same time, reducing the working of the
private sector industries. To reduce unemployment and to provide relief to the unemployed,
the government should emphasize the relief works schemes in the first stage. Apart from
providing employment and relief to the unemployed such expenditure provides funds into the
hands of those who, because of their low standard of living, can be expected to consume their
income almost in full. The marginal propensity to consume (mpc) of these people is equal to
one and the multiplier effect will be infinites-Then it should undertake all those schemes such
as construction of railways, roadways and communications system, irrigation and power
projects, etc., which raise national income both directly and indirectly through
encouragement of further private investment. Such compensatory expenditure has the
advantage of raising national income and economic welfare but has the additional merit of
pushing up private investment still further.
It is, however, important to emphasize that compensatory spending by the government should
create confidence among the investors and the general public. If the programmes of the
government are of a 'leaf-taking variety' and if those who have subscribed to government
bonds and other loans become different about the ability of the government to repay the
public debt, compensatory spending programmes will not lead to business confidence but, on
the other hand, will reduce it.
Thus, during a period of cyclical depression, private expenditure declines due to a decline in
a private demand and thus leads to a contraction of production, employment and income. The
theory of compensatory spending implies that the decline in private expenditure should be
made good by a proportionate increase in public expenditure. This theory is based on the
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assumption that if public funds are injected into the income stream, in sufficient quantities,
they would reverse the trend towards depression and unemployment and generate a
recovery. Further, it is assumed that Government expenditure has multiplier effects on
production and employment; at the same time, the acceleration principle will operate
positively. In this manner, cyclical unemployment and decline in national income can be
effectively checked and pushed upwards.
Public Expenditure in the upward phase of a business cycle
What should be the role of government expenditure during an upward phase of a business
cycle? We assume that pessimism has given place to optimism and that there is general rising
anticipations all
round. Consumption and investment spending are increasing. The economy
is expanding and national product and employment are increasing. During this period,
compensatory public expenditure should be so controlled and managed that the level of full
employment is achieved in an orderly manner.
During business recovery; when the economy turns from the low level of depression and
starts recovering gradually, the compensatory spending of the previous period, which would
be at a fairly high level, would continue, in other words the expansion in business activity
which will occur during recovery will not necessitate the immediate withdrawal of
government expenditures. For one thing, some government expenditure would be such (e.g.
the construction of a road or a dam) that sudden stoppage in the middle would be impossible.
For another, sudden withdrawal of government spending would upset the economy and may
cause a recession. In other words, nothing should be done to offset optimism of the gradual
expansion of business. Thus, in the initial stages of business recovery, public expenditure
would continue to be large and the government budget would continue to show a deficit.
Business expansion and the stage of full employment; When recovery has gathered
momentum sufficiently, the government should reduce its expenditure progressively. As
expenditure declines gradually, government's revenue will rise (with the rise in income and
employment) and the budget may be balanced. As the economy reaches the level of full
employment, government compensatory expenditure should be completely stopped. The
government budget should be designed to yield a surplus so that a part of public debt may be
retired. If the government fails to curtail its compensatory expenditure as the economy
approaches full employment, it will be contributing to the appearance of the bottlenecks
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during the expansion process. For, as the goal of full employment is approached, there will be
a scarcity in the supply of factors of production and if the government continues to compete
with the private sector for the available human and material resources, it will help in pushing
up prices and bringing about inflationary conditions. At the same time, compensatory
spending should maintain full employment conditions by establishing the economy at the
level of full employment by preventing it from proceedings to a boom or from receding into a
recession. Compensatory policy designed to check the business boom will depend mostly on
taxation to keep public demand in check and that designed to prevent the economy from
plunging into a depression will emphasize both taxation and public expenditure.
It may be emphasized here that compensatory spending by the government during the upward
phase of the business cycle may be divided into two parts:
a) In the initial stages of recovery it is merely deficit spending, though the volume would
be progressively declining; and
b) In the later stages of business recovery and prosperity, it is mainly surplus budgeting
so that the economy may not proceed to a boom and experience excessive rise in
prices.
Experience in the use of public expenditure during the great depression in 1930s has brought
out clearly that compensatory spending would be successful only if the Government is careful
in using it properly:
a) Compensatory spending during a business depression should not be accompanied by
increased taxation. The role of public debt in compensatory finance is explained later.
b) Monetary policy of the Central Bank should be used to supplement the fiscal policy of the
government. That is, the central bank should maintain low interest rates and create excess
reserves for commercial banks from which the government could borrow.
c) Public authorities should lay emphasis on both relief works as well as recovery
programmes.
d) The government should have well thought out schemes which could be implemented as
and when the level of employment was falling.
e) The government should help the private sector in the process of recovery and should not
hamper or retard private economic activity.
f) The government should be clear about the role of compensatory spending which is not
substitute for private spending.
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PUBLIC EXPENDITURE AND ECONOMIC GROWTH IN A DEVELOPING
COUNTRY
In the previous section, we explained the role of public expenditure in stabilizing an economy
and helping to maintain it at the level of full employment. But all this is relevant to a fully
developed economy, which can work by itself but requires the help and support of the
Government only at certain times. But this analysis does not hold well in the case of a
developing country like Kenya which has:
i). rate of saving and investment is low;
ii). the level of production and employment is low ; and
iii). there is chronic unemployment
According to John Adler, a rising proportion of additional output should be devoted to capital
formation, so that the economic growth of an underdeveloped country may be speeded up.
For this purpose, two-fold changes in the government budget are required. First, the
government budget should be raised so that a rising proportion of additional outlay may be
available for development purposes, and second, a rising proportion of government revenues
should be used to finance expenditure on development. Thus, public expenditure has a
significant role to play in the process of economic growth.
Changes in Expenditure
If increased public expenditure on development is essential, then the rate of increase in other
expenditures should be severally curtailed:
a) Attempts should be made to tighten the administration which in most developing
countries is unwieldy, inefficient and sluggish. It is possible to speed up the
administration, improve its efficiency and weed out the useless elements and thus
increase its productivity. Administrative expenditures can be stabilized if not
curtailed, and still step up productivity.
b) Many less developed countries, like Kenya, spend a considerable portion of their tax
receipts on defence, which ought to have been spent on economic development. In
some cases exorbitant defence expenditure has been foisted on some less developed
countries. In some countries, internal disturbances and political instability lead to vast
expenditures on the army and the police. It is true that political peace is an essential
condition of economic progress but then cost of maintaining it should not be high.
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c) The social and cultural expenditure – particularly both general and technical
education – are of utmost importance for economic growth. Some may assert that
opening up of new schools does not constitute economic growth but without proper
change in social and cultural values, it will be impossible to bring about economic
progress. What is the use of imported machinery, unless there are technicians to
handle it? Expenditure on education, on promotion of health, etc., is of great
importance in a developing country.
Development expenditure has increased considerably all less developed countries since the
end of the Second World War. Whether the increase in development expenditure in a
particular country is adequate and whether it is possible to restrict other types of expenditure
so as to increase development expenditure are questions which will have to be answered for
every country, separately taking into consideration the special political and social problems
involved.
Content of Development Expenditure
Taking the specific case of Kenya, development expenditure of the government aims at
stimulating and supplementing private initiative and enterprise. It is possible, and some
governments of less developed countries have attempted to do so, to eliminate the private
sector altogether and plan for the entire economy as a whole. There is some advantage in that.
But most observers do not like a communist pattern of economic development which
appeared rapid initially as in the case of former U.S.S.R., but nevertheless prove ruthless and
inhuman and failed ultimately. In a democratic set up, with parliamentary institutions
emphasis has to be not on the elimination of the private sector but the setting up a mixed
system in which private enterprise is given active encouragement and at the same time the
government is an active participant in development activities.
Development expenditure of the government takes the form of stimulating private initiative
and enterprise. Direct stimulation is done by helping the private sector through loans,
subsidies, tax concessions and exemptions, providing market and other information and
providing research facilities. The government sets up special banking and financial
institutions whose main aim is to provide finance for medium and long-term periods at low
rates to help the private sector industries with adequate finance. In many less developed
countries, the government attempts to set up a strong commercial banking system with the
central bank at the top. These are all direct methods of helping the private sector to expand
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and develop rapidly.
Indirect stimulation of the private sector is done by the government through the provision of
social and economic overheads. Education and public health will come under the first head,
and the provision of power, transportation, communications, etc. will come under the second
head. The private sector industries reap economies of production from these facilities
provided by the government. Social and economic overheads are a necessity and an essential
prerequisite for economic growth. In fact, there are many competent observers who would
like governments of less developed countries to provide only these facilities and leave the rest
to the private sector. There is, however, a serious danger in the Government taking the
responsibility to provide economic overheads. Indian experience shows clearly that much of
the failure of Indian planning is due to the failure of such sectors as power and transportation
which have been Government monopolies.
However, there are certain enterprises which the private sector in a developing country may
be unwilling to undertake, either because profit margins in these industries are low or almost
nothing or because they require huge capital investment and a long time to yield returns. In
other words, these enterprises may not be appealing to the private sector from the commercial
point of view but may be of great significance from the point of view of economic welfare of
the community as well as that of economic progress. In this group come all the key and the
basic industries, transport and communication, development of irrigation resources, atomic
power, etc. In fact, any industry which is necessary for the country and which helps in the
growth of the economy can be taken up by the government. But the objective is not to
compete with the private sector but really to supplement and complement it. This type of
argument was used by – Jawahar Lai Nehru to get monopoly control over the key and basic
industries. This argument is rejected by most Indian economists now.
Public Expenditure and Cyclical Fluctuations
Public expenditure in a developing economy should be carefully planned so that it may serve
as a part of a deliberate anti-cyclical fiscal policy also. Development programmes should be
accelerated in periods of depression and should be reduced during a business boom. As Van
Philips has put it, “the direct impact of this policy is not formed by total effective demand,
but by the volume of capital goods (private as well as public which as a result of government
activity will show on balance a more continuous increase than if it were left to cyclical
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fluctuations. The government, thus, continuously takes part in investment activity, to a larger
extent during a depression, while by restricting itself in the upswing; it leaves room for the
increase in induced private investment”.
But it may be pointed out that if a less developed economy subjects itself to strict planning,
then it can isolate itself to a certain extent from the forces of cyclical fluctuations emanating
from outside. The necessity for correct projection in terms of the various development
programmes will not arise; rather the main purpose will be the achievement of a steady
balanced growth of the economy through public expenditure.
Thus, development expenditure is of great importance in the economic growth of less
developed countries. Not only the magnitude but even the nature of public expenditures is
also of great importance.
Priorities in Development Expenditure
The basic objective of a less developed economy is to bring about some type of steady
balanced growth for this purpose, priority determination of priority between the various
development projects is essential for one thing; priority-determination will depend upon the
basic objectives. Other things being given priority-determination should guarantee a
maximum rate of balanced growth for another, priority will depend upon the available
resources which indicate the type of projects that can or cannot be undertaken within a given
period of time. Thirdly, priority-determination should also take into account the degree to
which a given project will diminish a country's dependence on foreign countries.
But
ultimately, the solution to the problem of priority determination is an assessment rather than a
calculation. This is so because it will be difficult to calculate the net yields of the various
projects.
A related question is on what sector of the economy, priority in a development programme
should be given. While some have emphasized the development of the agrarian sector and
exports, others have argued in favour of the development of secondary and tertiary sectors.
There is a third view too, according to which, there should be equal emphasis on all sectors
so that balanced growth will be achieved. W.A. Lewis has admirably stated the case of
balanced growth in development-programmes, all sectors of the economy should grow
simultaneously, so as to keep a proper balance between industry and agriculture, and between
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production for home consumption and production for export. The actual selection of projects
from among the various alternatives on which to spend taxpayers money is based on the costbenefit analysis. Cost-benefit analysis purports to describe and qualify the social advantages
and disadvantages of a policy.
The theory underlying the cost benefit appraisal can be traced back to the welfare economics
of the 19th century. The first practical case of maximization of net benefit was applied in the
1930s in the USA in the realm of water resources. The cost-benefit analysis is used in almost
all the countries of the world. This analysis is of course relevant particularly for long-term
projects. For such projects, costs are incurred currently as well as in future. Benefits accrue
over a number of years. To evaluate future costs and benefits, they have to be translated into
present values. Such a transaction needs to discount the future benefits since they are less
valuable than present ones. The effectiveness of cost-benefit analysis is subject to many
limitations. This analysis offers no solution to the problem of optional outputs of social
goods. It is not of help in establishing national priorities.
THE BUDGET
The nature and purpose of governments' budgets has changed "over time, and differs from
country to country. Powers, policies and obligations of federal, state and national central
governments, vary and so do their financial requirements.
The budget is an account of the State, showing how much the government spends and on
what and how it finances the expenditure.
Types of Budget
There are three types of budget;
a) Balanced budget (where expenditure equals revenue).
b) Deficit budget (where expenditure exceeds revenue). Government borrows.
c) Surplus budget (where expenditure is below revenue). Government saves.
A balanced budget can be regarded as neutral. It has been called an 'orthodox' budget,
reflecting the Treasury view of sound finance.
A deficit budget is expansionary as more money is pumped into the economy than is
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withdrawn in taxation. The borrowing that this policy requires is likely to have an
inflationary effect in some circumstances. During the Great Depression of the 1930s,
governments sought to stimulate economic activity by means of deficit budgets.
A surplus budget is deflationary insofar as the government takes out more than it puts into
the money flow. Which type of budget a Minister of Finance will present will depend on the
government's assessment of the economic situation and the overall economic, social and
political policy, it seeks to pursue. However, within the three types of budgets there is scope
to vary taxes and expenditure to achieve the desired effect.
ZERO BASE BUDGETING
It involves examination of the very rational of an expenditure item under consideration. The
aim is to guard against wastage in public expenditure. It involves a detailed investigation of
excess item of expenditure to see whether it is really needed or it should be revised or done
away with. If a sector is not able to justify its existence, it should be closed down. If its
existence is justified, the optimum level of its operation and the corresponding budget
provision must be defended. In zero base budgeting no section is essential. It must proof its
worthiness.
The budget can be approached from two angles. First, the Minister decides on expenditure
both on current account (government's consumption of goods and services, transfer payments,
grants, subsidies, interest payment) and on capital expenditure (investment in physical assets,
grants). He then adjusts taxes to cover expenditure entirely or partially and then borrows the
rest. The second approach is on the basis of the principle of 'living within one's means'. The
Minister assesses the total resources available to him, He then works out how much he can
'afford' to spend on different programmes to keep his total expenditure within the limits of the
available resources.
PREPARATION OF THE BUDGET: ADMINISTRATIVE FRAMEWORK
Work on the budget goes on throughout the year. Soon after one budget is out of the way
preparations on the next one begin and government departments start work on estimates of
their expenditure for the forthcoming year. The revenue departments - the Inland Revenue
and the Customs and Excise Board - prepare estimates of revenue on the basis of unchanged
tax rates. Inter-departmental economic forecasts are made and departments continue their
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work on estimates and agree the figures with the Treasury, in case any adjustments are
needed as a result of some changes in the economic, conditions.
The Minister consults with Treasury, Revenue and other departments involved, and with the
Central Bank outside experts. He receives advice from outside experts and representatives
from interested parties, such as the Confederation of employers (representing employers) and
Trade Unions (representing employees). Various pressure groups and individuals send their
views to him. He then makes up his mind on the proposals and presents the budget to
Parliament. Documents published in association with the budget and made available to the
members of Parliament and the public are the White Paper on Public Expenditure, the
Financial Statement and the Budget Report.
PUBLIC DEBT
The government of a country gets its income from two sources:
i). Public Revenue and
ii). Public Borrowing or Public Debt.
Public revenue consists of money that the state is under no obligation to return to the very
individuals from whom it has obtained. Public debt, on the contrary, carries with it the
obligation on the part of the state to pay the money back to the persons from whom it has
been received.
Theory of Public Debt
Public debt is of recent growth and was not heard of prior to the 18th century. The classical
economists were generally against the public debt. They assumed that individual consumer
and business firms make use of the resources more efficiently. Thus, under a fully employed
economy, the state can acquire resources by public debt only at the cost of private sector
where they are more efficiently used.
It was Keynes who effected a truly significant revision in the theory of public debt. He
rejected the classical view of a free enterprise economy which is self-equilibrating at full
employment level. He developed and advanced the concept of under-employment
equilibrium. Resources in the private hands may remain unemployed for relatively long
periods if corrective or compensating action is not taken by the government.
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During World War II and in the post-war years, the size of public debt increased enormously.
In modern times borrowing by the state has become a normal method of government finance
along with other sources such as taxes, fees, etc. The government may borrow from banks,
business-houses, other organizations and individuals. Besides, it can borrow within the
country or from outside. The government loan is generally in the form of bonds (or treasury
bills if the loan is required for short periods) which are promises of the government to pay to
the holders of these promises the principal sum along with interest at the agreed rate.
Government Borrowing and Taxation – A Comparison
Both taxes and government borrowings have some similarities. Both of them come from the
general public. In both cases, the total volume of money in the country will remain the same;
the increase in revenue to the government by way of a tax or a loan will be by the same
amount as decrease of money with the public.
However, while a tax is not paid back to any group directly, the loan amount is paid back to
the lenders, viz., those who hold government bonds. But even when the loan is paid back,
there is no change in the volume of money in the country since what is paid to the people is
also obtained from the people. Again, a tax is paid out of current income and hence will
affect consumption in the first instance and saving later. On the other hand, a loan is made
out of saving or capital; it will not affect consumption but will affect saving.
The classical economists favoured taxation to public debt for the .following reasons:
a) Since public debt is an easy method of getting income, government is likely to be
extravagant and irresponsible. Public debt would become a burden on the economy
b) Payment of interest on public debt and refund of the principal will require additional
taxation. It might prove to be difficult since government's power to tax is not unlimited.
PR1VATE DEBT AND PUBLIC DEBT
There are obvious similarities and dissimilarities between private borrowing and public
borrowing;' Private individuals and business-houses utilize borrowed funds to acquire certain
resources. Private debt, therefore, involves the diversion of funds from one type of use to
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another and, therefore, the sacrifice of one use for another. Similarly, the public authorities
borrow funds and make use of them to acquire certain resources, in effect; public debt means
the sacrifice of those alternatives of productive uses which the private sector might have liked
in favour of those uses which the government may like. Thus, basically, private and public
borrowing implies diversion of funds from one use to another. Again, a private borrower
cannot repay the debt unless he makes profitable use of his borrowing. In a like manner, the
government should invest its borrowings in profitable or productive schemes so as to earn the
means to redeem the public debt later.
When an individual borrows, he spends the amount on himself, but when the government
borrows, it uses the amount on the community as a whole. Again, when an Individual repays
his debt, the burden of repayment is borne by himself. But when a public authority repays its
debt, it will be through taxation, that is, the burden will be borne by the entire community.
But the point of interest here is that the lender who receives payment from the government
will also have contributed by means of taxation towards the repayment.
In private debt, the lender sacrifices money while lending and does not get any benefit out of
the money spent by the borrower. On the other hand, in public debt, since the money will be
spent by the government on the community as a whole, the lenders also will benefit. It is,
therefore, said that when a person lends to the government, he lends to himself.
Thus, it will be noted that a person lending to the government will be both better off as well
as worse off. He will be better off because he will get the benefit of the money spent by the
government; he will be worse off because he himself will have to share in the payment of the
interest charges as well as the repayment of the principal. Thus, there is a basic difference
between private and public debt.
While the government may borrow from the whole world, a private individual or corporation
can generally borrow from within the country. Again, a private individual may borrow both
for productive as well as consumption purposes; the government on the other hand, borrows
normally to finance productive works only. Furthermore, the rate of interest of a private loan
is generally higher than that of a public loan because the government has greater
creditworthiness and greater capacity to repay.
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CLASSIFICATION OF PUBLIC DEBT
Public debt has been classified in many ways, though all the classifications are not equally
useful.
i). Internal and External Debt. Internal debt refers to the public loans floated within the
country, while external debt refers to the obligations of a country to foreign
governments, foreign nationals or international institutions. Though external debt is
becoming very common these days, there has been general prejudice against foreign
debt, based on ignorance and faulty economics
ii). Productive and Unproductive Debt. Another classification of public debt which was
once, very common was between productive
or reproductive debt and dead weight
debt, Public debt is said to be productive if the investment yields an income which will
not only meet the yearly interest payments of the debt but also help repay the principal
over the long run. Public debt can be said to be productive in another sense too. The
government may undertake certain projects through loans which
;
' may not be
productive in the sense given above but which may be really useful to the community,
as for example, a railway line connecting a backward region, an irrigation work to
prevent famine conditions in an area and so on. In this sense, most public debt is
productive. But public debt may be contracted to finance a war. Such debt is
unproductive because it does not create an asset, it is a dead weight debt or a useless
burden on the community
iii). Redeemable and Irredeemable Debt. The redeemable debts are those which the
government promises to pay off in future at a specified date: they are terminable loans.
Irredeemable debt refers to a debt which may not be redeemed at all but on which the
government promises to pay the interest regularly. These loans may be known as
perpetual debt. The redeemable loans may be further classified into short period and
long period loans depending upon the period of redemption.
iv). Funded and Unfunded Debt. Public debt is also classified into funded and unfunded or
floating debt. Broadly speaking, funded debt is a long-term debt, undertaken for
creating a permanent asset and the government normally makes arrangements about the
mode and time of repayment. Unfunded or floating debt is a relatively short period debt,
meant to meet current need. The government undertakes to pay off the unfunded debt in
a very short period, say within six months.
v). Compulsory and Voluntary Debt. Sometimes, a distinction is made between a
compulsory loan and a voluntary loan. Generally, government debt is of a voluntary
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type, that is individuals and institutions are invited to take up government bonds. On the
other hand, a compulsory loan implying force is not common in modern times.
However, pressure may be applied by the government at certain times in selling its
bonds.
WHY IS PUBLIC DEBT INCURRED?
Public loans in modern times are necessary to meet important situations. They can be
explained as below:
i). To meet budget deficits. Modern governments do not have large accumulated balances
or treasure to meet any budget deficit. Normally, the annual expenditure of the
government should be and is met by annual income. But because of many
circumstances the yield from taxation and other sources may not be equal to the actual
expenditure. Similarly, there may be unplanned and unexpected emergency situations
like major fires, floods and famines. Short-term borrowing is ordinarily used to meet
these emergencies.
ii). To meet war expenditure. Modern warfare is so costly that the normal income through
taxation falls short of the actual war expenditure. Besides, taxation beyond certain
limits has disastrous consequences for production, and thus interferes with the most
important objective during a war, viz., the winning of the war. Moreover, a public loan
is better and easier method of collecting revenue than taxation. Governments, therefore,
have to borrow extensively from individuals and institutions towards war financing. In
fact, the enormous increase in public debt in most countries is due mainly to the First
and Second World Wars.
iii). To remedy a depression. Public borrowing is considered very useful to remedy a
depression; in fact, the strongest case for public borrowing is as a remedy for
depression. During a period of depression, the level of economic activity is low,
resulting in low production and unemployment. The depression and unemployment are
generally due to deficiency of demand for goods and services. Many economists like
Keynes have advocated increased public expenditure financed through borrowing and
not through taxation, for while taxation will reduce incomes and demand still further,
borrowing will have no such effect. Besides, loans enable the government to make use
of idle and unutilized funds of the public. Thus, there is a strong justification in favour
of public borrowing to cure unemployment.
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iv). To develop the economy. Public loans are resorted to for development purposes. Even
advanced countries have to undertake the construction of public works like roads,
railways, irrigation works, powerhouses, etc., for accelerating their economic progress.
Underdeveloped countries interested in the development of their natural resources to the
optimum level find public borrowing a very useful device to finance the various
development projects.
The first factor, mentioned above, is only to meet temporary difficulties and is soon repaid
out of tax receipts in the subsequent period. The second cause of public borrowing—the
prosecution of a war—has been probably the most important factor for increasing public debt
in all major countries in recent years. But this and the first factor are of an unplanned type.
But the third and fourth cases may be called planned borrowings, for the Government
deliberately plans to use the proceeds of public debt to finance certain specific projects. In
this case, the Government may borrow resources and would otherwise have been used by the
private sector and also resources that may remain unemployed.
SOURCES OF PUBLIC BORROWING
Every government has two major sources of borrowing – internal and external. Internally, the
government can borrow from individuals, financial institutions, commercial banks and the
central bank. Externally, the government borrows from individuals and banks, international
institutions and foreign governments.
Borrowing from Individuals
When individuals purchase government bonds, they are diverting funds from private use to
government use. Individuals may be able to subscribe to government bonds either through
curtailment of current consumption needs (this may be very rare) or through diversion of
funds from their own business or diverting funds into government bonds from corporate
securities. Normally, the sale of government bonds to individuals should not curtail either
consumption or business expansion. To a large measure, the bonds will be absorbed out of
funds that would have been lying idle or would have been used to buy other securities.
Borrowing from Non-banking Financial Institutions
More important than individual subscribers to government bonds are the financial institutions
such as insurance companies, trusts, mutual savings banks, etc. These non-banking financial
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institutions prefer government bonds because of the security provided by the latter and also
due to their high negotiability and liquidity. But the rate of interest is low and hence in many
cases financial institutions may prefer high-risk high-return securities particularly equities.
When non-banking financial institutions fake up government bonds, they do so to reduce
their cash holdings.
Borrowing from Commercial Banks
While individuals and non-banking financial institutions take up government bonds out of
their own funds, commercial banks can do so by creating additional purchasing power known
as credit creation. The banking system as a whole can make additional loans up to an amount
several times as great as the excess cash reserves. This is possible because the loans the
bankers make are typically book entries in the names of borrowers who pay in the form of
cheques to others who have also bank accounts. The result is that so long as cash is not
withdrawn from the banks, it serves as the basis for the expansion of loans.
Commercial banks can subscribe to government loans through creation of credit. They need
not contract their other loans and advances. Whenever the banking system has excess cash
reserves, it can absorb an amount of government bonds considerably greater than the excess
cash reserves. It is important to note that the power to buy bonds is essentially created rather
than merely transferred. So if commercial banks create additional purchasing power and
place it at the disposal of the government to finance the latter's expenditures, inflationary
pressures will be generated (if previously, the economy has been working at full
employment).
Borrowing from the Central Bank
The central Bank of the country also subscribes to government loans. The action is exactly
similar to the system of creation of additional purchasing power by the commercial banking
system. By purchasing government bonds, the central bank credits the account of the government. The latter pays to its creditors out of its account with the central Bank. Those who have
received cheques from the government on the central bank deposit the amount with their
banks. These banks find themselves with large cash reserves which become the basis for
additional loans and advances. It will be seen that borrowing from the central bank is the
most expansionary of all the sources for not only the government secures funds for its
expenditure but the commercial banking system gets additional cash which can be used as the
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basis for further credit expansion.
While the borrowings from individuals and financial institutions are simply transfer of funds
from private to government use and, therefore, will not be expansionary in their effect on the
economy (unless the funds were previously lying idle and are being activised through
government borrowing), borrowing from the commercial banking system and the central
bank will have expansionary effect.
Borrowing from External Sources
Government may borrow from other countries too. These borrowings can be used to finance
war expenditure, or to produce defence equipment, or to pay for development projects, or to
pay off adverse balance of payments. Formerly, the floating of loans for any specific
development projects, like railway construction, was taken up by individuals and banking and
other financial institutions. However, in recent years, apart from this source, two important
sources have become prominent. They are:
a) International financial institutions, viz., I.M.F., the I.B.R.D., the I.D.A. and the I.F.C.,
which give loans for short-term for overcoming temporary balance of payments
difficulties and for the long-term for development purposes; and
b) Government assistance generally for development projects. For developing countries like
Kenya, external sources of borrowing are becoming considerably important in recent
years.
ECONOMIC EFFECTS OF PUBLIC BORROWING
Following Wagner, economists used to argue that the government should use taxation to
finance current expenditure and borrowing from the public to finance capital expenditure. In
recent years, there has been considerable change in economic thinking on this question. It is
commonly accepted now-a-days that taxation and borrowing can be used for either type of
expenditure depending upon the circumstances. At least, in the case of developing nations
both borrowing and taxation are used to finance development projects. Basically, the
economic effects of government expenditure financed by public borrowing are different from
the effects of similar expenditure financed by taxation in the following three important
respects:
a) The transfer of funds from the public to the government is compulsory under taxation and
voluntary under borrowing ;
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b) While taxation reduces the wealth of the taxpayers, loans do-not reduce the wealth of the
lenders but merely change its form ; and
c) Financing through taxation is more contractionary while financing through borrowing has
more expansionary
effect.
Taxation has contractionary effect on the economy because
it reduces consumption. On the other hand, lending to the government is voluntary and,
hence, will be paid out of saving and not through curtailment of consumption. Moreover,
lending does not involve reduction of wealth and, therefore, will not have adverse effect
on incentives and enterprise as would be the case with taxation.
Leaving these general aspects of borrowing, we shall discuss the economic effects of public
borrowing under specific headings.
Effects of Public Borrowing upon Consumption
As has been shown in a previous paragraph, government borrowing should not normally
result in curtailment of consumption. This is so because lending to the government being
voluntary will be met out of saving and not through reduction of consumption expenditure.
But in time of war or in periods of emergency, substantial pressure may be applied to induce
individuals to curtail consumption and to subscribe to government loans. The only other
possibility is when government bonds may offer special advantages and higher interest rates.
Some of the individuals and financial institutions may then be tempted to save more and
invest in government-bonds. But generally speaking, restriction of consumer spending does
not take place.
Effects of Borrowing on Investment
Government borrowing can influence investment adversely, though it can have neutral effect
also. For instance, government borrowing from commercial banks and the central bank of the
country will be of the nature of creation of additional purchasing power and, therefore, will
not result in curtailment of funds available for investment. But if individuals and financial
institutions and even commercial banks subscribe to government loans out of funds meant for
investment or for the accumulation of stocks then investment expenditure is curtailed. But if
the interest rate is not affected and the new government bonds do not carry any special
advantages over existing securities, private investment may not be affected appreciably.
If interest rates are higher and the advantages attached to government bonds are greater, the
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demand for company shares will decline and consequently the prices of stocks and shares will
come down. This may restrict private investment in equity shares. However, governments, in
their own interest, will like to follow a cheap money policy of lower interest rates (for this
will mean lower interest burden on public debt). Even if interest rates are high, investment
borrowing by individuals and companies will not be affected significantly. For one thing,
investment borrowing will depend upon business prospects and profitability (marginal
efficiency of capital) of investment rather than the rate of interest. This was shown by Keynes
and has later been proved conclusively by many empirical studies. For another, the very large
volume of investment undertaken with funds obtained from past earnings is particularly
insensitive to the interest rate.
On the whole, however, government borrowing need not affect private investment
expenditure adversely except under special circumstances. For instance, the interest rates
should be high and the volume of investment should be dependent upon the interest rate ; or
the bonds should be sold to the persons and institutions who curtail their loans for business
expansion in order to buy government bonds. But these special circumstances need not take
place ordinarily. But there can be one indirect way by which government borrowings may
have an adverse effect on investment. The growth of public debt may be alarmingly rapid and
the investing public may fear a national bankruptcy or anticipate heavy taxation in the near
future. The result will be a decline in investment.
On the other hand, government expenditure financed out of borrowing will normally be
expansionary. When borrowing is restricted to the commercial banks and the central bank,
additional purchasing power will be created which will become the basis for additional loans
and advances to the private investors. Moreover, government expenditure financed out of
borrowing will result in additional demand for goods and services, the supply being assumed
to be the same. This will result in a rise in prices and rise in profit margins. If the economy
has been working below full employment level, it will stimulate greater investment (in order
to secure higher profits). Thus, while taxation results in contraction, borrowing generally
leads to expansion of the economy.
Effects of Borrowing upon Distribution of Income
Loan finance implies that all those benefiting from government expenditure will have higher
real income. At the same time, loan finance will not reduce the real incomes of those who
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have subscribed to government bonds. If government expenditure is meant to provide more
economic welfare to the lower income groups, then the result will be a narrowing down of
inequalities and a more equal distribution of income between people. But to the extent that
loan finance becomes inflationary, some of the good effects upon the distribution of income
which we have explained above may be neutralized.
Another point to consider here is the interest payment. Interest payment will represent a
transfer of real income from the taxpayers to the bond-holders, for the government will have
to tax the people so as to pay the bond-holders the interest charges and later the principal as
well. If the bond-holders and the taxpayers are identical, then there will be no net
redistribution of income, but this need not be the case. Accordingly, some redistribution of
income will take place so long as the taxpayers and the bond-holders belong to different
groups.
Effects of Foreign Loans
Foreign loans can influence both consumption and investment favorably. Foreign loans are
meant to finance the imports of goods without paying for them immediately through exports.
If foreign imports consist of consumer goods they tend to reduce any inflationary pressure
which may exist due to shortage of goods. On the other hand, imports of machinery,
industrial raw materials and technical know-how will have the favourable effect of speeding
up industrialization within the country. If foreign loans are meant to finance a war or to
modernize an army, then obviously they cannot have any effect on investment in the country.
The demand for foreign currencies will be reduced through foreign loans, when they were
floated. But interest payments as well as the repayment later will involve increasing exports.
This may mean a possible lowering of tie real standard of living.
EFFECTS OF PUBLIC DEBT
We should clearly distinguish between economic effects of public borrowing from economic
effects of public debt. Borrowing refers to the method of securing funds and is one of the
favour alternatives available to the government – the other sources being taxation, profits
from state enterprises and money creation. The effects of borrowing, therefore, refer to that
programme of government expenditure financed by borrowing as contrasted with the effect of
a similar programme financed by taxation. On the other hand, the effects of public debt refer
to the effects on the economy which are caused by the existence of public debt, after it has
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been incurred.
Public Debt and Consumption
The existence of public debt has an important effect upon consumption. Those who hold
government bonds representing the latter's obligation to pay consider these bonds as personal
wealth. This wealth would not have arisen if the government had chosen to finance its
expenditure through taxation. Moreover, the bond-holders would forget that the bonds
represent claims on them as taxpayers in the form of additional taxation. The net result is that
the possession of government bonds will induce them to spend not only a larger percentage of
their incomes but also spend in excess of their incomes since they can dispose of the bonds to
pay for the excess expenditure. Consequently, the net effect of public debt is to increase the
percentage of total income spent on consumption and thus exert an expansionary effect on the
economy.
Monetization of Public Debt
Public debt of a country has the direct effect of increasing the total money supply in the
country. For instance, deficit financing by the Government actually means Government
borrowing from the Central bank of the country which directly increases the money supply in
the country. Likewise, when the commercial banking system subscribes to the issue of new
Government bonds, they may do so without reducing their other investments or advances to
the industrial and commercial sections but through a simple creation of credit. This is what is
commonly known as monetization of public debt, that is, the public debt is subscribed to by
the banking system in such a manner that it results in an increase in the money supply of the
country.
Public Debt and Liquidity
Public debt is represented by bonds which are highly negotiable. Those who have bonds have
highly negotiable and highly liquid form of assets. Whenever individuals require more funds
for any purpose – transactions, precautionary or speculative motive – they can easily convert
the bonds into cash. Public debt is thus responsible for the existence of highly liquid form of
assets.
Another important effect of the highly liquid government bonds is to be found in the case of
commercial banks. The latter hold large amounts of government bonds which can be
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converted into cash whenever cash is required. In times of inflation the central bank of a
country may attempt to use bank rate, open market operation and other weapons to reduce the
cash reserves with commercial banks and thus reduce their credit expansion. But commercial
banks can increase their cash reserves through disposing of their government bonds.
Public Debt and Investment
The effect of public debt on investment is not very clear. Two apparently contradictory
effects can be visualized. On the one hand, the existence of huge public debt and the
consequent high rates of taxation to service the debts will generate fear and uncertainty in the
minds of investors. Besides, the existence of huge debts involving huge interest payment may
suggest the possibility of the government introducing capital levy or even the extreme
method of repudiation of debt. All this will affect adversely long-term-investments. On the
other hand, the existence of large public debts will force the government to maintain a low
rate of interest in order to keep its interest obligations at the lowest amount possible.
Accordingly, borrowing and investment will be encouraged. It is, thus, difficult to state
clearly whether existence of public debt will encourage or discourage investment.
As regards the desire to work and save, public debt will generally tend to reduce it. Public
debt, by providing safe and steady channel of investment in government bonds, may
encourage savings. But taxation necessary to pay the principal and interest charge will
discourage savings. Moreover, the receipt of interest by the holders of government bonds
may reduce the latter's desire to work and save to a certain extent.
Finally, as regards division of resources, public debt involves the use of funds on those
expenditures which are considered essential and more useful than those on which the funds
would have been used otherwise. If idle funds are channeled into the development of
railways, irrigation and power projects e.t.c., the diversion will be really justified. The same
may be said if borrowing from the banking system is used to create permanent and productive
assets. The only wrong diversion will take place when funds which otherwise would have
been spent on productive undertakings are spent on defence purposes. But this will have to be
judged according to circumstances.
BURDEN OF INTERNAL AND EXTERNAL DEBT
Generally, internal loans have been very important, but in recent decades developing
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countries have been borrowing extensively from external sources. The loans have been from
the World Bank and other agencies and governments. Sometimes, the external loans may be
to overcome temporary balance of payments difficulties but in most cases they are for
economic development. External loans are particularly important for developing nations
because the latter have great demand for foreign machinery and raw materials and do not
have adequate exports to pay for them. These nations are, therefore, plagued by continuous
adverse balance of payments and exchange rate difficulties. There has been considerable
confusion and prejudice in dealing with external loans and hence a comparison between
internal and external loans is being made here.
Burden of Internal Debt
In the case of an internal debt, there is no direct money burden on the community as a whole,
since the payment of interest and taxation to meet the same involve simply a transfer of
purchasing power from one group of persons to another. To the extent, that the bond-holders
and taxpayers are the same, there may not be any net burden at all on the community. But to
the extent that the bond-holders and the taxpayers belong to different income groups, there
are changes in the distribution of income between different sections of people in the
community.
Internal debt is a burden, and it would be too illogical to argue that internal public debt does
not involve any burden at all. In the first instance, the purpose of the government loan should
be considered. A loan meant to finance a productive enterprise on investment can be paid out
of the profits of the investment. On the other hand, a loan to finance a war will have to be a
dead weight and have to be paid out of taxation. There is, obviously no burden involved in
the first case, but there is obvious burden in the second case. It is, however, stated that there
is no burden in the second case too because the burden imposed by taxation will be cancelled
by the benefit received through interest payments of the government.
Secondly, as already indicated, the real burden of public debt will depend upon the type of
people who own the bonds and who receive interest payments and the type of people who pay
the taxes. Since in a majority of cases the holders of government bonds are the higher income
groups while the taxpayers are both the rich and the poor, there is a net increase in the real
burden of the community.
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Thirdly, the real burden of the debt repayment will be definitely much more than is thought
of at first sight. For instance, the government will be taxing enterprise, patriotism, activeness
and youth (i.e., those who pay) for the benefit of the passive, old and leisurely class (i.e.,
those who receive).
Fourthly, during war when the debt is contracted, the value of money is low (because of high
price). Soon alter the war and later, prices generally decline and hence those who get interest
income through ownership of government bonds gain in terms of real income.
Finally, the payment of interest charges and the repayment of debt will involve tax measures
which, consequent affect the power as well as the willingness to work and save. The sooner
the debt is cleared off through a capital levy or through some highly progressive taxes the
better it will be for the community. It is, however, necessary that debt repayment is managed
in such a manner and in such a period that there will be no adverse effect on production.
It will, thus, be clear that even domestic debt imposes both money and real burdens. To
contend that internal debt does not mean any burden on a country's economy is theoretically
unsound and practically unrealistic.
Burden of External Debt
In one sense, the burden of a foreign debt is similar to that of domestic debt. That is, the
government will have to pay it through additional taxation. But, while in domestic debt,
interest payments and the repayment of loans are available to local nationals they are
available to foreigners in the case of foreign debt: In another sense, the total money burden of
an external debt is more because there is the additional transfer problem. That is, the
government will have to find necessary monetary resources to pay off the external debt and
besides will have to secure foreign currencies too (after all, foreigners will have to be paid in
their currencies). The transfer problem, therefore, requires that during the term of the loan,
the balance of trade must develop favorably. In other words, a regular payment of interest and
principal to foreign countries will be possible only if the exports exceed the imports by at
least the obligations arising from the loan.
It is said that domestic debt does rot normally result in any net burden to the economy but
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only a redistribution of national income. But externally held debt can mean a certain
impoverishment of the economy. The paying of interest and debt redemption to foreign
countries means a corresponding reduction of national income and makes greater demand on
the gold and foreign exchange resources of the country. This is what has been referred to as
the transfer problem in the previous paragraph. But, properly speaking, there is no
impoverishment involved. What actually, happens is this: Originally, when foreign loans
were made, they entered the debtor country in the form of machinery, raw materials and other
essential goods, for which no corresponding exports were made at that time. After the lapse
of a certain t me, the debtor country manages to secure excess of exports over imports to pay
for the external loan. In this, there is no actual impoverishment of the economy involved but
goods are paid for goods.
On the other hand, if the external debt was originally incurred to meet war expenditure, it
would have been a dead weight debt. The repayment of debt through export surplus would
not be canceling out the import of goods and services in the past which had any effect on the
productive capacity of the country. In tins case the export surplus to pay off a war-debt would
really deprive the citizens of a debtor country of a certain amount of goods and services. This
would be a net direct real burden of an external loan.
However, there is one sense in which an external loan can be a source of trouble to a debtor
country. The transfer problem necessitating the creation of an export surplus means "an
exhaustion of the country's future capacity to import"; this is of vital importance for
development. But if the foreign loans are floated only when it is absolutely essential and
when internal resources are utilized as far as possible, and \\ the foreign loans are used to
increase the total national product including goods specially meant for export, there is no
reason why the debtor country should suffer in the future.
A developing country which borrows from abroad for the development of social and
economic overheads and basic industries will find that the benefits outweigh the burden of
repayment of the loan. An external loan for development purposes is not a burden but a
profitable venture. This is exactly like an internal loan meant for development purposes.
Can a Country become Bankrupt through Public Debt
Sometimes, people assert that with mounting public debt, the nation would become bankrupt.
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This is partly true and partly not true. If bankruptcy means inability to return the amount
borrowed, a country can never become bankrupt, however much of its domestic debt may
have gone up. The government can always honour its obligations either through higher
taxation or through printing of money. It has the option to impose a heavy capital levy and
pay off the debt at one stroke. Even repudiation of public debt, though morally indefensible,
will be right, since, after all those who receive interest payment from the government will
have to pay the taxes to enable the government to pay the interest. Will it not be better to
cancel the debt altogether or at least scale it down considerably, so that interest payments as
well as tax payments will be proportionately cut down ? In any case, a government does not
become bankrupt because of its internal debt.
However, there may be circumstances when a government may not be able to honour its
obligations to foreign countries. When interest on foreign loans and repayment of debt
amount to a considerable figure and when adequate export surplus has not been built up for
various reasons, the government of a debtor country may be unable to honour its 'external
obligations. Either it can ask for postponement or it can float new loans to repay thep|d ones.
Only in extreme cases it may repudiate external loans. Repudiation is an extreme measure,
since through it, the country loses its ..creditworthiness in the international capital markets
and will never again be able to borrow from foreign sources.
To conclude, public borrowing, domestic orforeign, has advantages. But it imposes burdens
upon the community, both in real and monetary terms,,and directly and indirectly. Since there
is additional burden in the case of external loans, extra care should be exercised in procuring
such loans. All public debts impose burdens on the community and to assert tnat Internal
loans do not impose rea! burdens is highly illogical.
REDEMPTION OF PUBLIC DEBT
Just as the private individual or organization has to return the loan he or it borrowed, so also
the government has to pay not only interest on the public debt but also repay the principal.
Experience shows clearly that mounting public debt has a demoralising effect on the people
from the fact that the public is subjected to higher rates of taxation. The sooner, therefore, the
debt is cleared, the better for the government. It may also be observed here that if the public
debt has been contracted for productive purposes, it may not be strictly necessary to redeem it
since the government is getting a source of income to pay off the interest of the debt. But if
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public debt consists mostly of unproductive or dead weight debt— war debt is a cfoo'd
example of such debt—the sooner it is paid off the better, both for the government as well as
for the public.
Different methods are used by a government to redeem its debt. Some of these methods are
extreme ones, such as repudiation of debt, while others may not be redemption at all, but
payment of one debt with the help of another debt. We shall describe the various
methods'available to the •government to pay off its debt.
Repudiation of Debt
Repudiation of debt means simply that the government does not recognize its obligations and
refuses to pay the interest as well as the principal. Repudiation is not paying off a loan but
destroying it. Normally, a government does not repudiate its debt, for this will shake the
confidence of the general public in the government. However, in extreme circumstances, a
government may be forced to repudiate its internal or external debt obligations. For instance,
internally, the country may be facing financial ruin, bankruptcy and externally it may be
faced with shortage of foreign exchange. Generally, a government may not repudiate its
internal debt lest it should lead to internal rebellion—those who have lent to the government
would obviously rise against the government. However, the temptation of a government to
repudiate its external debt obligations may be strong at certain times. Of ail the methods of
redeeming .debt, repudiation is the most extreme, but it is actually not redemption of debt at
ail.
Conversion of Loans
Another method of redemption of public debt is known as conversion, ofioans, that is, an old
loan is converted into a new loan. Conversion may be resorted to :
(a) when at the time of redemption of a loan, the government has not the necessary funds,
and
(b) when the current rate is lower than the rate which the government is paying for existing
debt, so that the government can reduce its interest payments. Conversion of a loan is always
done through the floating of a new loan. Hence, the volume of public debt is not reduced.
Really speakng, therefore, conversion of debt is not redemption of debt.
Sometimes, distinction is made between refunding and conversion of debt, though sometimes
both of them are used to mean the same thing. Strictly speaking, refunding refers to the
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method of paying off an o/d loan carrying a higher interest through a new loan carrying a
lower interest rate; refunding, therefore, is the repayment of debt through fresh loans. On the
other hand, conversion involves a change in the rate of interest or other details. For instance,
at the time of maturity of a loan, the government may give an option to the existing bondholders either to receive money in cash or to convert their old bonds for new bonds. Broadly,
refunding and conversion are similar.
Serial Bond Redemption
The government may decide to pay every year a certain portion of the bonds issued
previously. Therefore, a provision may be made so that a certain portion of the public debt
may mature every year and decision may also be made in the beginning about the serial
numbers of bonds which are to mature in the year. This system enables a portion of the debt
to be paid off every year. A variant of this type of bond redemption is to determine the serial
number of bonds to mature every year through lottery. While under the first variant, the
bond-holders know when the different sets of bonds would mature and could take up the
bonds according to their convenience, under the second variant, the bondholders are uncertain
about the time of repayment and they may get back their money at the most inconvenient
time. Buying up Loans
The government may redeem its debt through buying up loans from the market. Whenever
the government has surplus income, it may spend the amount to buy off government bonds
from the market where they are bought and sold. Strictly speaking, this is not redemption of
debt but buying up of debt. It is a good system provided the government can secure budget
surplus. The only defect of this method of cancelling debt is that it is not systematic. Sinking
Fund
Sinking fund is probably the most systematic method of redeeming public debt. !t refers to
the creation and the fund which will be sufficient to pay off public debt. There are many
varieties of sinking fund. The most common method is as follows:
Suppose, the government floats a loan of Rs. 10 crores 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 interes: on investments will make the fund grow
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till after 10 years it becomes equivalent to the original amount borrowed, and at that time, the
debt wiil be paid off. One darger of the sinking fund method is that a government, in need of
money, may not have the patience to wait till the end of the period of maturity but may utilise
the fund for purposes other than the one for which originally the sinking fund was instituted.
In modern times, sinking funds are not accumulated and continued from year to year as we
have described above. Instead, some-funds are earmarked each year for repayment of some
part of the debt ir the same year. The amount earmarked is not put in a fund and allowed to
accumulate but is used every year either to pay off the bonds which are maturing every year
or to buy off bonds from the market.
Capital Levy
Public debt may be redeemed through a capital levy which, as we have seen earlier, may be
levied once in away with the specia objective of redeeming public debt. It is generally
advocated immediately after a war for the following reasons :
(a) Heavy public debt has been incurred during the war to prosecute the war and hence is
quite heavy immediately after the war.
(b) War debt is unproductive and is a dead weight on the community necessitating heavy
taxation year after year. It will be better to wipe it out once for all by a special levy.
(c) Due to war time inflation businessmen, producers and speculators would have amassed
large fortunes and hence it is easier for them to contribute to. a capital levy and, in a sense, it
is just that they bear a part of
the war burden,
(d) Redemption of public debt through capital levy will leave ;he higher income groups
almost in the same old position, since they will be receiving back from the government what
they will have paid by way of the special levy.
Redemption, through a special levy, is said to be super or to the method of the sinking fund,
as it is levied only once, while for purposes of the sinking fund, taxes have to be imposed
year after year. The greatest merit of capita! levy is that it will reduce the heavy tax burden
which will otherwise be necessary to redeem public debt. But the danger of a capital levy is
that the government may be tempted to resort to it too often.
Redemption of External Debt
The redemption of external debt can be made only through accumulating the necessary
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foreign exchanges to pay for it. This can be done by creating export surpluses. Towards this
end, foreign loans 'should be carefully invested in those industries which have high
productive potentialities and which will promote exports directly and indirectly. At the same
time, the exportable surplus should consist of goods which are readily taken by foreigners.
Temporarily, of course, redemption of an old debt can be made through the floating of new
loans.
To conclude, there is not much to choose between the various methods (except, of course,
repudiation which must not be resorted to) foi every method has its own advantages as well
as disadvantages. But tlv most common and sensible method is to redeem part of the public
deb, every year, so that the debt may not go on mounting.
GOVERNMENT INDUCED INFLATION
This is a sustained annual increase in prices caused by expansion of the money supply to pay
government supplied goods and services. The money is printed to pay for the cost of the
government provided goods and services. Increases in the market prices of goods and
services caused by expansion of money supply force citizens to reduce their consumption and
saving which in turn finances the reallocation of resources to public use over the long-run.
DONATIONS
They are voluntary contribution to government from individuals or organization that are used
to finance particular programmes.
USER CHARGES
They are prices determined through the political process rather than market intervention.
They can finance public goods and services only when it is possible to exclude individual
from enjoying their benefit unless they pay a fee.
FORMS
1) Direct prices associated with the consumption of a particular goods and services
2) Fees for the option to use certain facilities or services provided for by the government
3) Special assignment on privately held property
4) Licenses or franchises
5) Fares or tolls
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