Government Revenue and the Role of Public Expenditure
Introduction to public finance
Public Finance is a section of finance which deals with public expenditure and government revenue.
How the government provides public services
- Protective services: The government is responsible for maintaining peace and order in a country and in defending the country against external aggression. For this purpose, the government maintains police and armed forces.
- Administrative services: The government is responsible for administration of the country. Various administrative departments are established by the government for this purpose.
- Social services: The government provides social services like education, health, housing and so on. These services are vital for the welfare of the society and directly improve the standard of living of the people.
- Development services: The development of different sectors of the economy require state help to progress rapidly for the benefit of the entire citizenry. Such sectors include agriculture, transport, health, communications and energy among others.
The main divisions of public finance are:
- Public expenditure
- Public revenue
- Public borrowing (debt)
- The government budget
Public expenditure is the sum of all the money spent by the government in provision of different services and goods to the nation.
Why public expenditure has risen significantly in recent years
(1) Rapid increase of the country’s population.
(2) Increase in price levels of goods and services.
(3) Increase in demand for social services.
(4) Development programmes such as CDF.
Principles of public expenditure
Government expenditure is aimed at satisfying the common needs of all citizens. To achieve this end, the following principles must be applied.
- Maximum social benefit: The government expenditure must be incurred in such a way that people should get maximum possible benefit from this expenditure.
- Economy: Wastage must be discouraged in public expenditure.
- Elasticity: It must be possible to increase or decrease public expenditure according to the circumstances. During peace time, public expenditure should be focused on development programs. If a country is at war, more money should be allocated to defense, security and peace initiatives.
- Sanction (Approval): Public expenditure must be approved (sanctioned) by a determinate authority. In democratic countries, this authority is the parliament.
- Sound financial administration: It means public accounts must be maintained accurately and systematically. They must be regularly audited to prevent fraud and genuine errors.
Role of public expenditure
The roles of public expenditure can be analyzed as follows:
- Production: Public expenditure increases the production of goods and services. By developing public infrastructure, for instance, the government encourages development of the productive capacity of a country.
- Maintaining peace and security: People invest more in a safe and secure environment
- Distribution of income: Public expenditure is helpful in ensuring fair distribution of income. The government taxes the high income earners more and this revenue is spent in provision of free services to the poor.
- Economic stability: When inflation rises, public expenditure is increased to ensure economic equilibrium.
Public revenue (government revenue) refers to the income accrued by the state from different sources. Broadly, the government gets revenue from three main sources: tax revenue, non-tax revenue and grants.
Sources of public revenue
- Taxes: A compulsory contribution imposed by the government to its people.
- Fees: Amounts charged by the government for direct services rendered by the government, for example road license fee, vehicle transfer fees and so on.
- Fines and penalties: Amounts obtained by charging those who break the laws of the land.
- Prices: Amounts received by the government for commercial services rendered, for example railway fare, stamp duty and telephone charges.
- State property: Amounts obtained from charges on use of government property such as forests, mines, national parks, buildings and so on.
The purpose of taxation
- To achieve the government’s economic objectives
- To achieve the government’s social objectives
- Finance government spending
- To service internal and external loans.
- To pay civil servants.
Types of taxes
- Income tax:
- Corporation tax:
- Sales tax:
- Excise tax:
- Customs duty:
- Value added tax:
Principles of taxation
- Equality: A tax must be imposed in such a way that the incidence of tax must be proportionate to the incomes of different individuals. The high income earners must pay higher taxes relative to the low income earners. The equality in sacrifice is important for the welfare of the society.
- Economical: It means the cost of collecting a tax must be as low as possible. The cost of collecting or administering a tax should not exceed the revenue gained.
- Convenience: The tax must be imposed in such a way that the method of tax payment is convenient for the taxpayer. Tax on the income of employees is deducted on monthly basis but tax on business profits is payable on annual basis.
- Certainty: It means the amount of tax and time and method of payment should be certain. There must be no confusion in this regard
- Productivity: Every tax imposed should give greater income to the government. There is no use to impose any tax, if it does not bring significant amounts to the exchequer (government treasury).
- Elasticity: It must be possible to increase or decrease the taxes according to the economic situation of the country. During inflation, taxes must be increased and vice versa.
- Simplicity: It means the tax system must be simple enough for an ordinary person to understand its computation so that they can make prior arrangements.
- Diversity: There must be different type of taxes, so that the burden of these taxes is on different groups of the society.
- Impartial: Two citizens with equal income and size of family, should be pay the same tax.
Proportional and progressive tax system
Proportional tax system is that system under which tax is imposed at the same rate on all incomes. It is simpler to apply. But proportional tax system does not fulfill the requirements of productivity, equality and economy.
Progressive tax system is that system under which the rate of tax increases with the increase in income. It fulfills the requirements of the principles of productivity, economy and equality. But this system discourages investment and savings activities.
Direct and indirect taxation
Direct tax is the tax levied directly on an individual’s income, for example income tax, whereas indirect taxation is levied on consumer’s expenditure for example, excise duty, customs duty and VAT.
Indirect tax is the tax under which the impact of the tax is on one person and incidence is on the other person. By impact of tax, we mean the person or entity on whom tax is imposed. Incidence of tax means the one, who has to bear the burden of the tax or ultimately has to pay the tax.
Merits of direct tax
- Progressive – Direct tax can be imposed at a higher rate on rich persons and at a lower rate on the poor person. It helps achieve equality in sacrifice.
- Productive – direct tax is more productive because it gives greater income to the government.
- Economical – This tax is economical because the cost of collecting it is comparatively low and easy to do.
- Sense of citizenship – When an individual pays taxes to the Government, they expect these taxes to be spent for welfare purposes. If these amounts are not spent for the benefit of the majority of the population then the taxpayers can raise an objection.
Demerits of direct tax
- Inconvenience – These taxes are deducted from an individual’s pay and as a result, the individuals feel greatly inconvenienced while paying these taxes.
- Evasion – Individuals can avoid the payment of a direct tax by showing less income. In other words, this type of taxation encourages tax evasion. To avoid paying tax, certain individuals may use professional accountants to advise them on how to legally avoid paying a high amount of tax.
- No choice – There is no element of choice about paying the tax, it is unavoidable.
- Demoralizing – Direct tax may be a disincentive to hard work.
- Discourages saving – Direct taxation discourages savings because after paying tax, individuals and companies have less income available to save or reinvest.
Demerits of indirect tax
- Convenient to pay an indirect tax. These taxes are charged together with the price of goods sold. The individuals pay these taxes without knowing that they are paying any tax.
- Uncertainty – When these taxes are imposed, the amount to be collected by the Government is not certain from the onset.
- Uneconomical – The cost of collecting an indirect tax is too high comparatively. So it is uneconomical.
- Increases inflation – Indirect tax may contribute to inflation. The imposition of an indirect tax on an item will increase its price which is, in itself, inflationary. This may have an effect on other areas as workers demand higher wages due to high cost of living.
Tax incidence of a commodity
Commodity tax is that tax imposed on any commodity bought. It is also called excise duty. When imposed, this tax is supposed to impact the manufacturer who has to pay the tax to the government. However, manufacturers always pass on the burden of tax to the consumers by raising prices.
If demand for the commodity is inelastic, the total burden of the tax will be borne by the consumers. However, if the demand is elastic, then price increment of the commodity is followed by a decrease in quantity demand and hence the tax burden is shifted to the manufacturer as the market may not accept price increments.
However, if demand and supply are both elastic, the tax incidence of the commodity is borne partly by the manufacturer and partly by the consumer.
Public borrowing (National debt)
Public borrowing means borrowing money from the public to finance government expenditure. It is also known as national debt. The government borrows money to meet its budget deficits.
Types or categories of public debts
- Internal and external – The government can borrow money from the individuals of the country. This is called internal debt. External public debts are those amounts which are borrowed by the government from other countries or external institutions like World Bank.
- Productive and unproductive – Productive national debts are those which are obtained for development projects like irrigation and industrial projects. Unproductive public debts are those which are spent for unproductive purposes like family planning, education and health schemes. These are known as unproductive debts because these schemes do not result in increase in production directly.
- Short term debts and long term debts – Public debt may be for a short period, for example treasury bills or it may be for a long period, for example a loan taken for twenty or thirty years.
Methods of public debt redemption
The following methods can be adopted to repay public debts:-
- Use of surplus budget – If the budget of the government has a surplus during a particular year then this surplus can be used to repay public debts.
- Sinking fund – The government can develop a sinking fund into which a specific amount is deposited every year. After some years, this fund is used to repay public debt.
- Capital levy – Capital levy is a special tax which is imposed by the government on people with high income for purposes of specially repaying public debt.
- Conversion – The government can get a new loan at a low rate of interest. This loan can be used to repay any previous loan carrying a high rate of interest. This method is helpful to reduce the burden of interest.
- Deficit financing – Deficit financing means the issuing of new notes or borrowing from the Central Bank. This method is used by most of the countries for development purposes. If there is shortage of funds, then the government can borrow money from the Central Bank and this money is used for completing new development projects. As a result, production of goods and services increases and this excessive issue of currency notes becomes real increase in output. Deficit financing method can be used when other sources of internal and external finance are not sufficient. It must be adopted within certain limits because the excessive use of this method can create inflation.
- Repudiation – It means to refuse to pay any debt. It lies within the power of the government to repudiate its obligation. Repudiation would make it extremely difficult for the government to borrow in future.
The government budget
Budget is a financial plan or a statement covering revenue receipt and expenditure outlays.
Types of government budgets
- Capital budget which relates to development projects.
- Revenue budget which relates to expenditure items and normal income
The main sources of public revenue are
(1) Custom and excise duty
(2) Income and corporation tax
The main expenditure heads of revenue budget are:
(5) Collection of taxes.
The main expenditure heads of capital budget are:
(1) Development projects
(2) Establishment of new industrial projects.
Weaknesses of budget process
- Macroeconomic framework may not explicitly take care of all constraints during the process.
- Projections of the ensuing years may not be deeply analysed.
- Public expenditure reviews may not be exhaustive.
- Prioritisations of the programs may not be well represented.
- Appropriation in aid may not be well accounted for.
- Poor accounting of the fiscal expenditures and extra budgetary funds may arise.
The role of the budget as an instrument of development planning
- The budget does not confine itself to review of public sector programs only. The budget in the framework of economic planning is an overall regulator of all the determinants of economic growth.
- The government budget plays a fundamental role in increasing the rate of capital accumulation and economic growth.
- With the increased responsibility of government for adequate spending in a planned economy, the theory of sound finance and balanced budget is delegated.
Budgetary policies are measures designed to achieve clearly defined budgetary objectives.
The economic objectives of the government are:
- Price stability
- Capital accumulation
- Economic growth
- Equitable distribution of income
Components of the budgetary policies used by governments
- Fiscal instruments
- Monetary instruments
Although Budgetary Policies are separately designed to answer particular needs, they are closely related to both monetary and fiscal policies and utilize both monetary and fiscal instruments to achieve the budgetary objectives.
A broad definition of fiscal policy is that it is the action by the government to spend or collect money in from of taxes with the aim of influencing the level of economic activities. Fiscal policy therefore involves a component of public debt management.
The main objectives of fiscal policy are:
- Achieve a desirable price level (price stability)
- Achieve desirable consumption level.
- Raise employment level
- Achieve fair distribution of national income.
- Achieve economic stability
- Increase the level of economic growth.
The government may use fiscal policy to intervene in the following ways:
- By spending more money and financing those expenditures through borrowing (public borrowing)
- By collecting more taxes without increasing public expenditure (public revenue).
- By collecting more taxes with the aim of increasing spending (public expenditure).
Tools or instruments of fiscal policy are:
- Public borrowing (public debt)
- Public revenue (taxation) and
- Public expenditure (public spending)