TOPIC 13: PUBLIC FINANCE ~ ECONOMICS FORM 6
– Is the study of how the government or public sector pays for or finance expenditures through taxes and borrowing .Public finance adapts and applies the fundamental microeconomic theory of markets to the public sectors and government sectors.In particular,this area of study analyses the efficiency of taxes and the market failure of public goods.Public finance is also a key to the study of government stabilization polices that address the inflation and unemployment problems of business cycle.
THE FOLLOWING ARE THE FUNCTIONS OF THE GOVERNMENT.
The government is responsible for the day to day running of activities in the economy, i.e. the government sets different departments and sectors to enable it administer their activities in its economy.
The government provides social needs such as education, health, housing etc.
The government provides funds for projects like roads construction, rural electrification, irrigation etc.
DIVISION OF PUBLIC FINANCE.
Public finance is divided into four areas including
Refers to the amount of money which received by the government from different sources.
The following are source of government revenue;
i) Tax: is a compulsory payment levied by the government on individuals or companies to meet the expenditure which is required for public welfare.
ii) Fees: Are all payment made to the government on any direct services rendered/provided. E.g. payment of road licenses, stamp duty.
iii) Fines: Are penalties imposed by the government to the low breakers.
iv) State property:(Also known as public property)is a property that is owned by all, but is is accessed and use is controlled by the state.An example is a National Park or National Stadium.
v) Selling of public good: Like government shares,Through privatization of public companies like Tanesco in 2005,National Micro-finance Bank (NMB) in Tanzania hence the amount of money earned is revenue.
vi) Profit obtains from government properties like bus stations and public buses like UDA,uses of roads and airports etc.
vii) Special assessment: It is amount of money charged to people living in an area for specific purpose.
viii) Internal loan from central Bank for different uses like government projects.
ix) External loan from International financial Institution WORLD BANK, IMF and Development bank.
x) Grant and gifts inform of cash.
xi) Foreign Investment
is the imposition or infliction of taxes.The process whereby charges are imposed on individuals/property by legislative branch of the state or federal government to raise funds for public purposes.
The following principles or cannons are important for good tax system when tax is imposed it must fulfill the following conditions.
CANONS OF TAXATION (PRINCIPLE)
According to Adam smith there are four important canons of taxation which are( canons of equity,certainty,convenience and economy)and other additions like canon of productivity,elasticity,flexibility,simplicity and diversity as discussed below.
1. Canon of Equity.
he principle aims at providing economic and social justice to the people. According to this principle, every person should pay to the government depending upon his ability to pay. The rich class people should pay higher taxes to the government, because without the protection of the government authorities (Police, Defence, etc.) they could not have earned and enjoyed their income. Adam Smith argued that the taxes should be proportional to income, i.e., citizens should pay the taxes in proportion to the revenue which they respectively enjoy under the protection of the state.
2. Canon of Certainty
According to Adam Smith, the tax which an individual has to pay should be certain, not arbitrary. The tax payer should know in advance how much tax he has to pay, at what time he has to pay the tax, and in what form the tax is to be paid to the government. In other words, every tax should satisfy the canon of certainty. At the same time a good tax system also ensures that the government is also certain about the amount that will be collected by way of tax.
3. Canon of Convenience
The mode and timing of tax payment should be as far as possible, convenient to the tax payers. For example, land revenue is collected at time of harvest income tax is deducted at source. Convenient tax system will encourage people to pay tax and will increase tax revenue.
4. Canon of Economy
This principle states that there should be economy in tax administration. The cost of tax collection should be lower than the amount of tax collected. It may not serve any purpose, if the taxes imposed are widespread but are difficult to administer. Therefore, it would make no sense to impose certain taxes, if it is difficult to administer.
Additional Canons of Taxation
Activities and functions of the government have increased significantly since Adam Smith’s time. Government are expected to maintain economic stability, full employment, reduce income inequality & promote growth and development. Tax system should be such that it meets the requirements of growing state activities.
Accordingly, modern economists gave following additional canons of taxation.
5. Canon of Productivity
It is also known as the canon of fiscal adequacy. According to this principle, the tax system should be able to yield enough revenue for the treasury and the government should have no need to resort to deficit financing. This is a good principle to follow in a developing economy.
6. Canon of Elasticity
According to this canon, every tax imposed by the government should be elastic in nature. In other words, the income from tax should be capable of increasing or decreasing according to the requirement of the country. For example, if the government needs more income at time of crisis, the tax should be capable of yielding more income through increase in its rate.
7. Canon of Flexibility
It should be easily possible for the authorities to revise the tax structure both with respect to its coverage and rates, to suit the changing requirements of the economy. With changing time and conditions the tax system needs to be changed without much difficulty. The tax system must be flexible and not rigid.
8. Canon of Simplicity
The tax system should not be complicated. That makes it difficult to understand and administer and results in problems of interpretation and disputes. In India, the efforts of the government in recent years have been to make the system simple.
9. Canon of Diversity
This principle states that the government should collect taxes from different sources rather than concentrating on a single source of tax. It is not advisable for the government to depend upon a single source of tax, it may result in inequity to the certain section of the society; uncertainty for the government to raise funds. If the tax revenue comes from diversified source, then any reduction in tax revenue on account of any one cause is bound to be small.
There are mainly three tax systems.
This is a tax system in which the tax rate increase with increase in income. It is aimed at reducing the gap between the rich and the poor (income gap) or income inequality.
Example of progressive tax is direct tax from income which is PAYE (Pay As You Earn).
It can be illustrated as follows.
This is a tax system in which the tax rate is constant or fixed regardless of the changes in income. Aim to collect more money.Proportional taxes maintain equal tax incidence regardless of the ability-to-pay and do not shift the incidence disproportionately to those with a higher or low economic well-being
A tax system where the tax rate decreases with increase in income (The higher the income,the low the proportional of the income is payed as tax and the low the income, the higher the proportional of the income is payed as tax. It is mainly used to encourage investments.Example Social security tax ,for 2007 in USA,you pay 6.2% tax on wages up to a maximumu wage of$97,500.Therefore
(i) A person who makes $30,000 a year pays $1,860 (30,000 x 0.062) in tax or 6.2% of wages
(ii)A person who makes $200,000 a year pays $6,045 (97,500 x 0.062) in tax or 3% of wages.
(iii) A person who makes $500,000 a year pays $6,045 (97,500 x 0.062) in tax or 1.2% of wages.
Since the richest people pay the smallest percentage of their in tax,it is a regressive tax.
Requirement of a Good Tax Structure / System
The tax structure is a part of economic organization of a society and therefore fit in its overall economic environment. No tax system that does not satisfy these basic condition can be termed a good one.
However, the state should pursue mainly following principles in structuring its tax system :-
1.The primary aim of the tax should be to raise revenue for public services.
2.People should be asked to pay taxes according to their ability to pay and assessment of their taxable capacity should be made primarily on the basis of income and property.
3.Tax should not be discriminatory in any aspect between individuals and also between various groups.
4.Tax system should be flexible and tax law should be clear and simple.
5.They should be comprehensive,it covers a wide tax base
6.They should be economical,should reduce the cost of tax administration
7.It should avoid double taxation.
TYPES OF TAX
1: DIRECT TAX.
Taxes which are imposed on incomes and personal property and whose burden is not shifted to another.
The direct tax includes (a) Pay as you earn(PAYE) (b) corporation tax (c) Capital gain tax (d) Agriculture revenue tax (e) Death/estate duty. (f) Property tax (g) Inheritance duty (h) Surtax. is the tax imposed on very rich person who earn much money.
ADVANTAGES OF DIRECT TAX.
DISADVANTAGES OF DIRECT TAX.
2. INDIRECT TAX.
Are taxes usually imposed on commodities. This tax can be passed from one person to another in terms of high prices.
ADVANTAGES OF INDIRECT TAX.
DISADVANTAGES OF INDIRECT TAX.
Qn : Why do most LDCs depend on indirect tax more than direct tax. Disadvantages of direct and advantages of indirect tax.
VALUE ADDED TAX (VAT)
VAT is a tax on expenditure, it is a tax goods and services at each of production.
ADVANTAGES OF VAT.
DISADVANTAGES OF VAT.
IMPORTANT TERMS IN TAXATION.
Is a situation where tax payer refuses to pay the tax assessed to her/him by tax officers. It is illegal.
Is a situation where a tax payer falls to pay tax using the loophole in the tax law. It is not illegal.
This is a tax of a fixed amount per unit purchased.
This refers to a tax which is based on the value of the goods it is percentage tax for example, sales tax, property tax etc.
Refers to the feeling of tax payer as he/she pays the tax.
It state that ‘the amount of tax paid by tax payer should be related directly to the benefit the tax pay will get after the government has spent its revenue.
It state that, ‘the tax imposed on tax payers should be according to their taxable capacity i.e. high income earners higher taxes and lower income earns lower taxes.
INCIDENCE OF TAXATION.
Refers to the burden to pay tax, the final payer of the tax i.e. when a tax is paid who actually pays the tax.
The incidence of tax can either be formal incidence (among burden) or effective incidence (final resulting of the tax)
The incidence of tax can be seen in the following cases case of direct.
In case of direct tax the incidence rest on the person who pays the tax first. It can be shifted to someone else.
In indirect tax the incidence can be shifted into two ways
The incidence of a tax under indirect tax can be shifted either to the supplier or buyer (consumer). This shifting will depend on elasticity of demand for the commodities concerned, this can be good shown as follows:-
Elastic demand refers to the elasticity where a small change in price (increase or decrease) leads to big change in quantity (increase or decrease.)
When commodities have elastic demand the burden of tax is born by the seller and cannot be shifted to the buyer. An increase in tax means an increase in price leading to a big increase in quantity demanded.
Perfectly inelastic demand refers to the elasticity in which price changes do not change the quantity demanded. This is the demand of necessary goods which do not have substitute. In case of such goods an introduction of tax would lead t an increase in price and the burden of the tax is shifted to the buyer.
Perfectly elastic refers to elasticity in which the price remains constant with changes in quantity. The whole burden of the tax is paid by the supplier.
The elasticity of demand of commodity is said to be inelastic when a big change in price leads to a small change in quantity demand. In this case the burden of tax falls to the buyer (consumer)
THERE ARE FACTORS THAT MAY DETERMINE THE SHIFTING OF THE INCIDENCE.
For a case of monopoly the whole burden is shifted to the buyer through price discrimination while under perfect competition it taken by supplier.
If the tax base is narrow its difficult to shift the tax burden i.e. if few commodities are taxed and a tax is introduced on other commodities the tax payer would substitute those tax commodities with untaxed commodities and vice versa.
WHY PAYING TAX. (Positive effect of tax)
NEGATIVE EFFECTS OF TAXATION.
THE FOLLOWING ARE FACTORS AFFECTING TAXABLE CAPACITY.
Qn. Discuss why the taxable capacity is low in less developed country
Qn. Discuss the measure of the country can adopt to widen tax base and increase taxable capacity.
II. PUBLIC EXPENDITURE.
Refers to the spending by the government .it is categorized into two groups.
Refers to government expenditure on public consumption like in education, salaries, health etc
Is the expenditure by government on development projects like roads, in communication etc.
Roles of government expenditure (why should spend?)
III. NATIONAL BUDGET
TYPES OF NATIONAL BUDGET.
There two main types of government budget (Balanced and unbalanced budget which includes (Deficit surplus budget)).
This refers to budget in which the anticipated revenue is great than anticipated expenditure. This surplus budget implies that
This kind of budget is not found in LDCs.
Qn, Why do countries plan for surplus budget, what are the objectives of surplus budget.
Surplus budget may lead to the following problems;
Refers to the budget in which the anticipated revenue is less than anticipated expenditure. It occurs when government estimated expenditure is greater than estimated revenue.This is mainly occur in developing countries like Tanzania.
Balanced budget is when the anticipated budget is equal to anticipated expenditure.Government estimated revenue Government proposed expenditure.Most of the classical economist advocated balanced budget,which was based on the policy of ‘line within means’.According to them,government revenue should not fall short of expenditure.
This implies that;
Qn. Why having a deficit budget in LDC’S.
Qn. What are the causes of budgetary deficit in Tanzania
Qn. Discuss the functions of the budget
Is the total borrowing by the government. This includes internal and external borrowing.
CLASSIFICATION OF DEBTS
1. INTERNAL DEBTS.
Is the total money which the government borrows from individual and institutions within the country.
2. EXTERNAL DEBTS
Is the borrowing of a money outside the country e.g. from WB, IMF, ADB (African development bank)
3. REPRODUCTIVE DEBTS.
These are debts which the government uses for productive activities that will generate revenue to repay back the debts.
4. NON REPRODUCTIVE DEBTS (dead weight)
This are debts used to finance activities that do not give the return e.g. weapons.
5. SHORT TERM DEBTS.
This is debts paid within short time.
6. LONG TERM DEBTS
These are debts paid after a long period of time for example 10year – 50year.
7. A FUNDED DEBTS
These are debts in which a specific time of repaying debts is not fixed to get the loan.
8. UN-FUNDED DEBTS
These are debts in which date of redemption is stated while receiving the loan.
9. VOLUNTARY AND COMPOLSORY DEBT
REDEMPTION OF PUBLIC DEBTS
Redemption of public debt refers to the payment of public debts
WAYS USED IN REDEMPTION OF PUBLIC DEPT.
Repudiation is form of debt redemption where the government refuse to pay debts.
2. BY CONVERSION.
Is the form of debts redemption where the government takes new loan with low interest and paying the previous loan with higher interest.
3. NEGOTIATIONS ON DEBTS.
This refers to cancellation of a debt
4. USE OF SURPLUS BUDGET
Where the expenditure is less than revenue and extra amount of money is left for paying debt.
5. CAPITAL LEVY.
Is where the government imposes taxation on asset like building and the revenue is used to pay the debts.
6. SINK FUND
Is the situation where the government invest a given amount of money in the bank to get compound interest and hence use the amount obtained to pay a debts.
7. PRIVATIZATION OF PUBLIC GOODS.
The money obtained from privatization is used for debts repayment.
8. USE OF GRANTS AND GIFTS RECEIVED
9. SELLING SECURITY TO THE GOVERNMENT
10. USE OF ACCUMULATED FOREIGN RESERVES.
CAUSES AND JUSTIFICATION OF PUBLIC DEBTS.
Qn. Why do LDC’s government depend on borrowings?
-To increase revenue since tax revenue is not enough to finance government activities in LDCS.
-To reduce the tax burden from tax payers
-To correct balance of payment deficit,
-To reduce printing of more money by the government to avoid inflation.
-In order to overcome natural calamities such as drought etc.
-To help the government attain economic growth through the finding of more economic activities hence economic growth
-Enable the government persuade its development plan
-To balance the budget and cover budgetary deficits.
-To enable the government repay loan conversion
-To control economic depression through increase in aggregate demand result from increase in unemployment opportunities.
Qn. Discuss the roles played by public borrowing in LDC.
-It leads to over dependency
-It reduces money available for consumption and investment.
-Debts worsen the country balance of payment position.
-If the dept is not used reproductively it becomes a burden to the government and its people.
-Most of the debts are always in the form of a tied aid i.e. debt with conditions (strings attached)
-When the debt is long-term its burden is shifted to another generation
-There is a burden of paying interest and other cost in debts administration.
Qn. Discuss the measure your country is using to reduce debt burden?
Qn. Discuss why external debts have been increasing instead decreasing in LDCS
-This is the use of taxation, government expenditure and public borrowing to influence the economic activity of a given country.
How fiscal policy work (mechanism of fiscal policy)
It works in two ways i.e. expand economic and to contract economy.
EXPANSION FISCAL POLICY
This is a situation where there is increase of government expenditure and decrease in tax. It is aimed at increasing aggregate demand.
II. CONTRACTION FISCAL POLICY.
It aimed at reducing aggregate demand where there is increase in tax and decrease in expenditure.
Qn. Discuss how fiscal policy can be used to bring economic development hint (use roles of tools of fiscal policy)