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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 1|Page 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 2|Page 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, 3|Page 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 4|Page 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. 5|Page 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. 6|Page 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. 7|Page 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. 8|Page 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 9|Page 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. 10 | P a g e 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 11 | P a g e 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 12 | P a g e 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. 13 | P a g e 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. 14 | P a g e 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 15 | P a g e 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 17 | P a g e PX E 18 | P a g e 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.” 21 | P a g e 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 22 | P a g e 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. 23 | P a g e 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. 24 | P a g e 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. 25 | P a g e 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. 26 | P a g e 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. 27 | P a g e 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. 31 | P a g e 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. 36 | P a g e 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. 37 | P a g e 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 39 | P a g e 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. 40 | P a g e 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. 41 | P a g e 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 46 | P a g e 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 48 | P a g e 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. 51 | P a g e 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 52 | P a g e 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. 53 | P a g e 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. 54 | P a g e 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. 55 | P a g e 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 56 | P a g e 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 57 | P a g e 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 58 | P a g e 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 59 | P a g e 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 60 | P a g e 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 61 | P a g e 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 62 | P a g e 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 63 | P a g e 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. 64 | P a g e 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. 65 | P a g e 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 66 | P a g e 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 67 | P a g e 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 68 | P a g e 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 69 | P a g e 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 70 | P a g e 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. 71 | P a g e 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 72 | P a g e 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. 73 | P a g e 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 74 | P a g e 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. 75 | P a g e 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 76 | P a g e 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 77 | P a g e 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 ; 78 | P a g e 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 79 | P a g e 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 80 | P a g e 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 81 | P a g e 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 82 | P a g e 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 83 | P a g e 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. 84 | P a g e 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 85 | P a g e 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. 86 | P a g e 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 87 | P a g e 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 88 | P a g e 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 89 | P a g e 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 90 | P a g e 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 91 | P a g e 92 | P a g e