Ambo University Woliso Campus SoBE Department of Economics

CHAPTER FOUR
4. GOVERNMENT REVENUE
4.1. Sources of Public Revenue
A government gets revenue from three different sources. In the first place, it gets
income from taxes and from other sources in which there is an element of compulsion.
Secondly, the government gets income for services rendered to the public. These may
be fees or prices of services rendered or profits of enterprises, and so on. Thirdly, there
are certain sources of income which may not come under any of the above two types;
they are not compulsory nor are they voluntary payments.
The process of socio-economic development requiring huge expenditure cannot be
carried out unless the government has the perennial source of income. Every
government has two important sources of revenue. These are:
(a) Tax sources, and
(b) Non-tax sources. .
A tax is a compulsory charge imposed by the government, without any reference to the
service rendered to a taxpayer. In other words, a tax is a compulsory contribution for
which there is no direct return or quid pro quo.
It is compulsory in the sense that once it is levied, the person concerned has to pay it and
cannot escape it (though he may try to avoid or evade the tax). Most of the sources of
income of the government these days come from taxes. Fines or penalties imposed by
courts of justice resemble each other since there is compulsion in both. The distinction
between them, however, is one of motive. While taxes are generally imposed to obtain
revenue, fines are imposed as a form of punishment for mistakes committed or to prevent
people from making mistakes in the future.
E.g. Taxes sources: taxes on income (Tax on personal income and Tax on corporation
profits), tax on properties (rental income tax, land use tax, etc.), tax on commodities
(Customs Duty, Excise Duty, Value Added Tax, Turnover Tax, etc.). And non-tax revenues:
Fees, Licenses, Fines and Penalties, Forfeitures, Escheats, Special Assessment, Gifts and
Grants, etc.
Every Government imposes two kinds of taxes:
(1) Direct taxes, and
(2) Indirect taxes
The meaning of these terms can vary in different contexts, which can sometimes lead to
confusion. In economics, direct taxes refer to those taxes that are paid by the person who
earns the income. By contrast, the cost of indirect taxes is borne by someone other than
the person responsible for paying them. For example, taxes on goods are often included
in the price of the items, so even though the seller sends the payments to the
government, the buyer is the real payer. Indirect taxes are sometimes described as
hidden taxes because the purchaser of goods or services may not be aware that a
proportion of the price is going to the government.
1. Direct taxes
A direct tax is paid by a person on whom it is levied. In direct taxes, the impact and
incidence fall on the same person. If the impact and incident of a tax fall on the same
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person, it is called as direct tax. It is borne by the person on whom it is levied and cannot
be passed on to others. For example, when a person is assessed to income tax or wealth
tax, he has to pay it and he cannot shift the tax burden to anybody else. In Ethiopia,
Government levies the direct taxes such as income tax, tax on agricultural income,
professional tax, land revenues, taxes on stamps and registrations etc i.e. taxes levied on
income and property.
Merits of Direct Taxes:
a) Ensures the Principle of Ability to Pay: Direct taxes are based on the principle of ability
to pay. They fall more heavily on the rich than on the poor. The tax burden is
distributed on different sections of the society in a just and equitable manner.
b) Reduces the Social and Economical Inequalities: Direct taxes reduce a disparity in the
distribution of income and wealth. By adopting the progressive tax system, rich people
pay on higher rates of taxation, while the poor pay on lower rates or given exemptions.
This reduces the gap between the poor and rich to a considerable extent.
c) Certainty: Direct taxes satisfy the canon of certainty. In direct taxes, the time of
payment, mode of payment, the amount to be paid etc are made clear. Both the
taxpayers and the Government know the amounts to be paid and the Government
can estimate the revenue from these taxes.
d) Economy: The cost of collection of these taxes is low because the government adopts
the different methods of collections like tax deduction at source, advance payment of
tax etc. Besides, the taxpayers pay the amount of tax directly to government. Thus, the
principle of economy is achieved in the case of direct taxes.
e) Elasticity: Direct taxes are elastic in nature. For example, when the income of the
people increases, the tax revenue also increases. Moreover, during the unforeseen
situation like flood, war etc. the government can raise its revenue by increasing the tax
rates without affecting the poor.
f) Educative Effect: Direct taxes create civic consciousness among taxpayers. Since the
taxpayers feel the burden of tax directly, they are interested in seeing that the
Government properly spends the money. They are conscious of their rights and
responsibilities as a citizen of the State.
g) Control the Effects of Trade Cycles: Direct taxes control the effects of trade cycles.
They can be used as a tool to mitigate the effects of inflationary and deflationary
trends by raising or reducing the tax rates.
Limitations of Direct Taxes:
a) Arbitrary in Nature: Direct taxes tend to be arbitrary because of the difficulty in
measuring the ability to pay tax. Paying capacity of the people cannot be measured
precisely. The levy is highly influenced by the policies of the Government.
b) Difficulties in the Formulation of Progressive Tax Rates: Direct taxes take the form of
progressive taxation i.e. the tax rates increases with the rise in income. It is very difficult

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to formulate the ideal progressive rate schedules in this regard, since there is no
scientific base.
c) Inconvenience: Under direct taxes, the taxpayer has to adhere to many legal
formalities such as submission of the income returns, disclosing the sources of income
etc. Moreover, he has to follow numerous accounting procedures which are difficult to
comply with. Further, direct taxes have to be paid in lump sum and at times, advance
payment of tax has to be made. This causes much inconvenience to the taxpayers.
d) Possibility of Tax Evasion: The high rates of direct taxes create the tendency to evade
more. There is possibility for tax evasion by fraudulent activities. Thus, it is said that the
direct taxes are the taxes on honesty.
e) Limited Scope: The scope of the direct tax is very limited. In Ethiopia, most of the
people come under or below the middle-income category. If only direct tax is
followed, these people cannot be brought into the tax net because of the basic
exemption given. Thus, the Government cannot depend upon direct tax alone.
f) Disincentive to Work, Save, and Invest: When the taxpayer earns certain level, they
have to pay more, because of the higher rate of taxes attributed to the higher slabs.
This will in turn discourages them to work further, save and invest.
g) Expensive to Collect: Under direct taxes, each and every taxpayer is separately
assessed. Thus, the large number of taxpayers to be contacted and assessed and the
prevention of tax evasion make the cost of collection more expensive.
2. Indirect Taxes
Under indirect taxes, the impact and incidence fall on different persons. It is not borne by
the person on whom it is levied and can be passed on to others. For example, when the
excise duty is levied on the manufacturer of cement, he shifts the burden of tax to the
consumers by raising the selling price. Here the impact of excise duty falls on the
manufacturer and the incidence on the ultimate consumers. The person who is required
to pay the tax does not bear its burden. Thus, indirect taxes can be shifted.
Merits of Indirect Taxes:
a. Convenience: Indirect taxes are more convenient to the taxpayers. Since the tax is
included in the selling price of the commodities, the consumer pays the tax when he
purchases them. He pays the tax in small amounts (installments) and does not feel its
burden. Thus, indirect taxes are quite convenient and less burdensome.
b. Wide Scope: While the people with income and wealth above a certain limit are
brought under the levy of direct taxes, indirect taxes are paid by all both poor and
rich. Under indirect taxes, everybody pays according to their ability. The tax burden is
not imposed on to the small section but it is widely spread. Thus, the indirect tax has
wider scope.
c. Elastic: The revenue from the indirect taxes can be increased. Whenever the
Government wants to raise its revenue, or lower it, it can be achieved by increasing
and decreasing the rates of taxes on the commodities whose demand is inelastic.
d. Tax Evasion is Not Possible: Indirect taxes are included in the selling price of the
commodities. So, evading of such tax becomes very difficult. If the person wants to

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evade the tax, it can be done only by refraining the consumption of the particular
commodity.
e. Substantial Revenue: Indirect taxes yield substantial revenue to both Central and State
Governments. The developing countries like Ethiopia are heavily dependent on
indirect taxes. Direct taxes have a limited scope in these countries because of low per
capita income.
f. Progressive: Indirect taxes can be made progressive by imposing lower rates of taxes
or giving exemption to the necessary articles and heavy taxes on luxurious articles.
Thus, indirect taxes also confirm the principle of equity.
g. Effective Allocation of Resources: Indirect taxes have great influence in the allocation
of resources among different sectors of the economy. Resources allocation can be
made effective by imposing heavy excise duties on low priority goods and by granting
relief to industries producing high priority goods. This results into mobilization of
resources from one sector to another positively.
h. Discourages the Consumption of Articles Injurious to Health: Indirect taxes discourage
the consumption of certain commodities, which are harmful to health. By imposing
very high rates of taxes on commodities like liquors, drugs, cigarettes etc., which are
harmful to health, their consumption can be reduced.
Limitations of Indirect Taxes:
a. Ability to Pay Principle is violated: Indirect taxes are not directly connected to the
taxpayers' ability to pay. Therefore, both the rich and poor equally pay the tax. Thus,
the principle of ability to pay is violated. Indirect taxes are regressive in nature.
b. Uncertainty: If indirect taxes are not levied on the commodities of common
consumption and levied only on luxurious articles, they tend to be inelastic. The
quantity demanded will be affected by the imposition of the taxes. Thus, the revenue
generated from them is uncertain.
c. Discourages Saving: Indirect taxes are included in the selling price of the commodities.
Hence, the people have to spend more on the purchase of the goods. This, in turn
affects the savings of the people.
d. High Cost of Collection: Indirect taxes are uneconomical as they involve high cost of
collection.
e. Civic Consciousness is Not Created: Under indirect taxes, taxpayers don‟t feel the
burden of the tax. They are not aware of their contribution to the State. Thus, indirect
taxes do not create the civic consciousness in the minds of the people.
f. Inflationary: The indirect taxes cause an increase in the price all around. The increase
in the prices of raw materials, finished goods and other factors of production creates
inflationary trends in the economy.
Differences between Direct and Indirect Taxes:
Direct and Indirect taxes differ among themselves on the following grounds:
i. Shift ability of the Burden of Tax: In the direct taxes, the impact and incidence fall on the
same person. It is borne by the person on whom it is levied and is not passed on to
others. For example, when a person is assessed to income tax, he cannot shift the tax
burden to anybody else, and he himself has to bear it. On the other hand, in the case of

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indirect taxes, the impact and incidence fall on different persons. It is not borne by the
person on whom it is levied. The burden of the tax can be shifted. For example, when
the manufacturer of cement pays excise duty, he can shift the tax burden to the buyers
by including the tax in the price of the cement.
ii. Principle of Ability to Pay: Direct taxes conform to the principle of ability to pay. For
example, now people having income above Birr.150 pm, only is liable to pay income
tax. But, indirect taxes are borne and paid by the weaker sections of the society also. As
such, these taxes do not conform to the principle of ability to pay.
iii. Measurement of Taxable Capacity: In the case of direct taxes, tax-paying capacity is
directly measured. For example, the taxable capacity for income tax is measured on
basis of the income of the individual. On the other hand, in the case of indirect taxes,
taxable capacity is measured indirectly. The luxurious articles are levied at the higher
rate of taxes on the assumption that they are purchased by the rich people. However,
low rate is charged on the articles of common consumption.
iv. Principle of Certainty: Direct taxes ensure the principle of certainty. Both the
Government and the taxpayer know what amount is to be paid and the procedures
to be followed. But in the case of indirect taxes, it is not possible. The taxpayer does not
know the amount of tax to be paid and the Government cannot predict the quantum
of revenue generated from the indirect taxes.
4.2 Objectives of Taxation
1. Raising Revenue: The basic purpose of taxation is raising revenue which used to render
various economic and social activities.
2. Removal of Inequalities in Income and Wealth: By framing suitable tax policy, this end
can be achieved. It is stressed in the Canon of Equality. In Ethiopia, the progressive
taxation on income is the suitable examples in this regard.
3. Ensuring Economic Stability: Taxation affects the general level of consumption and
production. Hence, it can be used as an effective tool for achieving economic
stability.
4. Reduction in Regional Imbalances: It is normal that certain parts of the country are
well developed, whereas some other parts or states are in backward conditions. To
remove these regional imbalances, the Government can use tax measures. By way of
announcing various tax exemptions and concessions to that particular backward
regions or states, the economic activities in those areas can be induced and
accelerated.
5. Capital Accumulation: Tax concessions or rebates given for savings or investment in
provident funds, life insurance, unit trusts, housing banks, post offices banks, investment
in shares and debentures of certain companies etc. lead to large amount of capital
accumulation which is essential for the promotion of industrial development.
6. Creation of Employment Opportunities: More employment opportunities can be
created by giving tax concessions or exemptions to small entrepreneurs and to the
industries adopting labour-intensive techniques. In this way, unemployment problem
can be solved to certain extent.

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7. Preventing Harmful Consumption: Taxation can be used to prevent harmful
consumption. By way of imposing heavy excise duties on the commodities like liquors,
cigars etc
8. Beneficial Diversion of Resources: The imposition of heavy duties on nonessential and
luxury goods discourages the producers of such goods. The resources utilized for the
production of these goods may be diverted into the production of other essential
goods for which various tax concessions are given. This is called as beneficial diversion.
9. Encouragement of Exports: Now-a-days export oriented industries are encouraged by
way of providing various exemptions like 100% relief from income tax, free trade zones
etc.
10. Enhancement of Standard of Living: By way of giving various tax concessions to certain
essential goods, the Government enhances the standard of living of people.
4.3. Characteristics of a Good Tax System
i. Tax is a Compulsory Contribution
A tax is a compulsory payment from the person to the Government without
expectation of any direct return. Every person has to pay direct as well as indirect
taxes. As it is a compulsory contribution, no one can refuse to pay a tax on
the ground that he or she does not get any benefit from certain public services
the government provides.
ii. The Assessee will be required to pay Tax if it is due from him
No one can be forced by any authority to pay tax, if it is not due from him.
Suppose, if there is a tax on liquor, the state can force an individual to pay the tax
only when he drinks liquor. But, if he does not drink liquor, he cannot be forced
to pay the tax on liquor. Similarly, if an individual‟s income is below the
exemption limit, he cannot be forced to pay tax on income. For example
individuals earning monthly salary below birr 150 cannot be forced to pay tax on
income.
iii. Taxes are levied by the Government
No one has the right to impose taxes. Only the government has the right to impose
taxes and to collect tax proceeds from the people.
iv. Common Benefits to All
The tax, so collected by the Government, is spent for the common benefit of
all the people. e.g. The Government incurs expenditure on the defense of the
country, on maintenance of law and order, provision of social services such as
education, health etc. Such benefits are given to all the people- whether they are
tax-payers or non-tax payers. These benefits satisfy social wants. But the Government
also spends on subsidies to satisfy merit wants of poor people.
v. No Direct Benefit
In the modern times, there is no direct relationship between the payment of tax
and direct benefits. In other words, there is absence of any benefit for taxes paid
to the governmental authorities. The government compulsorily collects all types of
taxes and doesn‟t give any direct benefit to tax-payers for taxes paid.
vi. Certain Taxes Levied for Specific Objectives

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Though taxes are imposed for collecting revenue for the government to meet
expenditure on social wants and merit wants, certain taxes are imposed to achieve
specific objectives. For example, heavy taxes are imposed on luxury goods to
reduce their consumption so that resources are directed to the production of
essential goods, such as cheaper variety of cloth, less costly goods of mass
consumption, etc. Thus, taxes are levied not only to earn revenue but also for
diversion of resources or saving foreign exchange. Certain taxes are imposed to
reduce inequalities of income and wealth.
vii. Attitude of the Tax-Payers
The attitude of the tax-payers is an important variable determining the contents of a
good tax system. It may be assumed that each tax -payer would like to be
exempted from tax paying, while he would not mind if other bears that burden. In any
case, he would want his share to be within the general level of tax burden
being borne by others. In other words, it is essential that a good tax system should
appear equitable to the tax-payers. Similarly, overall burden of the tax system is of
equal importance. The attitudes of the tax-payers in this regard are influenced by a
host of other factors like the political situation such as war or peace, natural
calamities like floods and droughts, economic situations like prosperity or
depression and so on.
viii. Good tax system should be in harmony with national objectives
A good tax system should run in harmony with important national objectives and if
possible should assist the society in achieving them. It should try to
accommodate the attitude and problems of tax-payers and should also take
into consideration the goals of social and economic justice. It should also yield
adequate revenue for the treasury and should be flexible enough to move with
the changing requirements of the State and the economy.
ix. Tax-system recognizes basic rights of tax-payers
A good tax system recognizes the basic rights of the tax-payers. The tax-payer is
expected to pay his taxes but not undergo harassment. In other words, the tax law
should be simple in language and the tax liability should be determined with
certainty. The mode and timing of payment should be convenient to the tax-
payer. At the same time, a tax system should be equitable between tax -payers.
It should be progressive and burden of taxation should be equitable on all the
tax-payers.
It is commonly believed that there are five properties of a good tax system, these are:
Economic efficiency, Administrative simplicity, Fairness, Political responsibility and
Flexibility.
1. Economic efficiency: A good tax system should not interfere with the efficient
allocation of resources. A good tax policy has to question whether the tax system
discourages savings and work and whether it has distorted economic behavior in other
ways.
2. Administrative Simplicity: There are significant costs associated with administering a tax
system. There are direct costs-the cost of running the authority responsible to collect

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and administer taxes and indirect costs, which taxpayers must bear. These indirect costs
take on a variety of forms: the costs of time spent filling out the tax forms, costs o f
record keeping, and the costs of accountants, if any.
3. Flexibility: Changes in economic circumstances require changes in tax rates. For some
tax structures these adjustments are easy; for some they require extensive political
debate; for still others they are done automatically. For instance it is said that there
is usually a difficulty in adjusting the rate of income tax. What must be
emphasized is that timing is very crucial element of flexibility. The speed with
which changes in the tax legislation (one enacted) can be implemented and the
lags in the collection of funds may limit the efficiency of the tax. An important
aspect of the “flexibility” of a tax system for purposes of stabilizing the economy is
timing: the speed with which changes in the tax laws can b e implemented and
the lags in the collection of funds. If fluctuations in the economy are rapid, the
lags may limit the efficacy of, say, the income tax, in stabilizing the economy.
4. Political Responsibility: The government is the competent authority to administer taxes.
A good tax system requires that the government is not to abuse its power of tax
administration. A politically responsible government has to address the feeling of the
tax payers. The government should not take advantage of its tax payers. According
to this view it is said that taxes where it is clear who pays are better than taxes where
the burden is not so apparent. Thus the individual income tax is a good tax compared
to the corporation tax. A politically responsible tax structure is also one in which
changes in taxes come about as a result of legislated changes, and where the
government must repeatedly come back to the tax payers for an appraisal of
whether the government is spending too much or too little.
5. Fairness: Most criticisms of tax systems begin with their unfairness. It is, however, difficult
to define precisely what is or is not fair. There are two distinct concepts of fairness:
horizontal equity and vertical equity.
I) Horizontal Equity
A tax system is said to b e horizontally equitable if individuals who are the same in all
relevant respects are treated equally. The principle of horizontal equity is so important.
Thus a tax system that discriminates on the basis of race or color would generally
be viewed to be horizontally inequitable. A condition of perfect horizontal equity can
be said to exist when a tax or tax structure can be described as achieving an
“equal tax treatment of equals.” That is, horizontal equity requires that people who
are deemed to be in an equal economic position should pay the same amount in
taxes. James Buchanan has given a broader view to the concept of horizontal
equity. For him it is fiscal residuum (the difference between benefits received and taxes
paid) that should be equal for people in an equal economic position.
The significance of this rather straightforward criterion of horizontal equity should not
be underestimated. Adherence to it provides a basic protection against discriminatory
activity of government. By focusing on people‟s economic characteristics, the chance of
grouping them by their geographic region or by their race is reduced. Horizontal equity
represents an application of an ethical value judgment that is pleasing to those who
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accept democratic as opposed to authoritarian principles of government. If the
ethical guideline stopped here, however, designing a tax system would be easy.
Everyone or perhaps every citizen would pay the same tax.
II) Vertical Equity
Fairness in taxation must also cope with the idea that we do not all fit in one
economic group. Vertical equity, therefore, requires an acceptable pattern of tax
payments among people deemed to be unequal. While the principle of horizontal
equity says that individuals who are essentially identical should be treated the same,
the principle of vertical equity says that some individuals are in a position to pay
higher taxes than others, and that these individuals should do so.
There are three problems in relation to vertical equity: determining who, in principle,
should pay at the higher rate; implementing this principle-that is, writing tax rules
corresponding to this principle; and deciding, if someone is in a position to pay the
higher rate, how much more he should pay than others.
Three criteria are commonly proposed for judging whether one individual should pay
more than another. Some individuals may be judged to have a greater ability to pay;
some may be judged to have a higher level of economic well being; and some
may receive more benefits from general government spending. Even if agreement
were to be reached on which of these criteria should be employed, there would
be controversies concerning how to measure ability to pay, economic wellbeing, or
benefits received. In some cases the same measures- such as income or consumption-
might are used to judge ability to pay and economic well-being. Generally the principle of
vertical equity says that those who are better off or have a greater ability to pay ought to
contribute more to support the government. The principle of horizontal equity says that
those who are equally well off (who have equal ability to pay) should all contribute the
same amount. In both cases, there is a difficulty of determining whether an individual is
better off than another, or of determining whether an individual has a greater ability
to pay than another. This implies that the difficult questions namely-how do we tell
which of two individuals is better off or which has a greater ability to pay and what do we
mean by equality of treatment are very difficult to answer. Furthermore the principle of
vertical equality does not tell us how much more someone who is better off should
contribute to the support of the government; all that it tells us is that he should pay
more.
Because of these difficulties economists have looked for other principles on which to
base a fair tax. One such principle is the pareto-efficient taxation. The pareto-efficient
tax structures are those that maximize the welfare of one (group of) individuals (s),
subject to the government attaining given revenue. No one can be made better off
without someone else being made worse off.
4.4. The Base, Buoyancy and Elasticity of Taxation
4.4.1. The Base of a Tax
The base of a tax is the legal description of the object with reference to which the tax
applies. For example, the base of an excise duty is the production or packing or
processing of a specific good; the base of an income-tax is the income of the assessee

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defined and estimated in terms of certain rules laid down for the purpose; a gift may
be defined and made a base for levying a gift-tax. Note that the base of each tax has
to be defined legally and it is to be quantified for the purpose of determining the tax
liability of an individual tax-payer. Each tax-payer is considered a legal entity for this
purpose. Accordingly, an individual legal entity may be subjected to more than one
tax. It should be noted that a tax base may have a time dimension also. For example,
income-tax is usually on an annual basis and the law has to decide whether income
would be taxed on the basis of accrual or receipt. The authorities, while determining a
tax base, are expected to give due consideration to various questions like those of cost
of collection, administration and effects of that tax. The exact coverage of a tax base
is sought to be determined by an optimum combination of these considerations. With
the passage of time, a tax base under consideration may grow or may shrink.
4.4.2. Buoyancy and Elasticity of a Tax
Buoyancy of a tax indicates the factors responsible for an increase in the yield of a tax-
over time. If a tax revenue increase with the growth of its base, but without an upward
revision of the tax rates (without an increase in the rate of tax), then the tax is said
to be buoyant. It has an inherent tendency to yield more tax revenue with the growth of
the base. Tax revenue changes when there is change in tax rate, tax coverage and tax
base. Numerically, the buoyancy of a tax is measured as a ratio of the proportionate
increase in tax

Elasticity of tax is related to the rate of tax and yield of a tax. If the yield of a tax
increases or decreases owing to reduction or increase in tax rates, we call it elasticity
of a tax. The yield of a tax may also go up on account of extension of its coverage or a
revision of its rates. Such a characteristic of a tax is ref erred to as its elasticity. In other
words, the elasticity of a tax refers to the steps taken by authorities in increasing its
yield through an extension of its coverage or revision of its rates. Numerically, the
elasticity of a tax is measured by the ratio of proportionate change in its yield to the
proportionate change in its coverage or rates.

4.4.3. Canons of taxation

Taxation is an important instrument for the development of economy of the country. A
good tax system ensures maximum social advantage without any hardship on taxpayers.
While framing the tax policy, the government should consider not only its financial needs
but also taxable capacity of the community. Besides the above, government has to
consider some other principles like equality, simplicity, convenience etc. These principles
are called as "Canons of Taxation". The following are the important canons of taxation.
1. Canon of Equality: canon of equality implies that when ability to pay is taken into
consideration, a good tax should distribute the burden of supporting government more
or less equally among all those who benefit from government.
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2. Canon of Certainty: "the tax which each individual is bound to pay ought to be certain
and not arbitrary. The time of payment, the manner of payment, the quantity to be
paid, should be clear and plain to the contributor and every other person". It means
the time; amount and method of payment should all be clear and certain so that the
taxpayer can adjust his income and expenditures accordingly. This principle removes
all uncertainties in the payment of tax and ensures smooth functioning of the tax
department.
3. Canon of Convenience: In the canon of convenience, "every tax ought to be levied at
the time or in the manner in which it is most likely to be convenient for the contributor
to pay it”. That is, the tax should be levied and collected in such a way that is
convenient to taxpayer.
4. Canon of Economy: "every tax ought to be so contrived as both to take out and keep
out of the pockets of the people as the little as possible over and above what it brings
into the public treasury of the state". This principle states that the minimum possible
amount should be spent on tax collection and the maximum part of the collection
should be brought to the Government treasury. Taxation should be economical i.e. this
should be much more than mere saving in the cost of collection.
5. Canon of Productivity: tax system should be productive enough i.e. it should ensure
sufficient revenue to the Government and it should encourage productive activity by
encouraging the people to work, save and invest.
6. Canon of Elasticity: The taxes should be flexible. It should be levied in such a way to
increase or decrease the tax revenue depending upon the need. For example, during
certain unforeseen situations like floods, war, famine, and drought etc. the
Government needs more amount of revenue. If the tax system is elastic in nature, then
the Government can raise adequate funds without any extra cost of collection.
7. Canon of Diversity: According to this principle, there should be diversity in the tax
system of the country. The burden of the tax should be distributed widely on the entire
people of the country. The burden of the tax should be decentralized so that every
one should pay according to his ability. To achieve this, the Government should
impose both direct and indirect taxes of various types. It should not depend upon one
or two types of taxes alone.
8. Canon of Simplicity: This principle states that the tax system should be simple, easy and
understandable to the common man. If the tax system is complex and vague, the
taxpayer cannot estimate his tax liability and it will cause irregularities in the payments
and leads to corruption.
9. Canon of Expediency: According to this principle, a tax should be levied after
considering all favorable and unfavorable factors from different angles such as
economical, political and social.
10. Canon of Co-ordination: In a federal set up like Ethiopia, Federal and State
Governments levy taxes. So, there should be a proper co-ordination between different
taxes imposed by various authorities. Otherwise, it will affect the people adversely.

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11. Canon of Neutrality: This principle stresses that the tax system should not have any
adverse effect. That is, it shouldn‟t create any deflationary or inflationary effects in the
economy.
4.5. Approaches to Taxation
How does the government impose tax? There are a number of theories on the basis of
which the government distributes tax burdens. In this regard there are five approaches
that have found a wide coverage. These are the expediency approach, cost-of-service
approach, socio-political approach, benefit received approach, and ability to pay
approach. But our discussion is limited to benefit received approach and ability to pay
approach only.
1. Benefit received approach
According to this principle, the burden of taxation should be divided among the
people in proportion to the benefits received from the state. The persons receiving
equal benefits from the state should pay equal amount as taxes and those who
receive greater benefits should pay more as taxes than those getting less benefits.
The benefit theory, therefore, demands that on the ground of equity, the people
should be taxed according to benefits (protection, hospitals, education, roads,
irrigation etc) they receive from the government and that the division
apportionment of taxes be in proportion to the benefits received by each individual
or group of individuals. Larger the benefits received, larger should be the amount of tax
on the beneficiary concerned.
Limitations of Benefit Principle Approach:
i. It is very difficult to estimate the benefit that an individual receives from the expenditure
of the government, e.g., how much benefit an individual receives from the army, police
and educational institutions cannot be exactly estimated. And therefore, the burden of
taxation may not be equitable.
ii. If the basis of taxation is benefit, then the poor will have to pay higher taxes than rich
because the poor derives greater benefits than rich from the expenditure of the
government, e.g., the poor may be more benefited by the provision of free medical
service and free education. And, therefore, on this ground also, this theory cannot be
accepted as the basis of taxation.
iii. Rich people have more capacity to pay taxes than poor; but according to this principle
the per capita tax burden upon the rich and the poor is the same. This means regressive
taxation. It is, therefore, clear that the benefit principle cannot ensure just distribution of
burden of taxation among different sections of society.
iv. The principle is also not conducive to general welfare which requires redistribution of
income in favour of the poorer sections through public welfare programmes and
services for their benefit.
v. The general tax formula depends on the price elasticity of demand and income
elasticity public goods and services.
And this implies that = , then we can get the

following conclusion.

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 If
 If
 If
But could not be calculated from market price because it is difficult to express
the demand for public good and the price of public good and service
E.g. taxation of gasoline and automobile products to finance highway construction i.e.
the owners of these product should responsible to finance the construction of the
projected way. This type of financing /budgeting is known as earmarking i.e. selective
taxation on the beneficiary body only.
2. Ability to Pay Approach:
This approach considers the tax liability in its true form-a compulsory payment to the state
without quid pro quo. It doesn‟t assume any commercial or semi-commercial relationship
between the State and the citizens. According to this approach, a citizen has to pay
taxes because he can, and his relative share in the total tax burden is to be
determined by his relative paying capacity. The basic tenet of the ability-to-pay doctrine
is that the burden of taxation should be shared amongst the members of the society
so as to conform to the principles of justice and equity, and that this equity criterion will
be satisfied if the tax burden is apportioned according to their relative ability to pay.
The supporters of the ability theory have justified it on three grounds:
Firstly, it has been justified on psychological effects of tax payments upon individual
tax-payer. Psychologically every tax -payer should feel that he has made equal sacrifice
in the payment of tax. Equality of sacrifice means that all the tax-payers should feel the
same pinch by paying the last Birr as tax.
Secondly, it has been justified in terms of diminishing marginal utility of income. As
income increases, marginal utility of additional unit of income decreases and vice-
versa. The tax-burden should be more on rich than on poor.
Thirdly, ability is known as the faculty interpretation. The faculty is represented by the
income, property and wealth on an individual.
The real burden of taxation should be equal for all and that “similar and similarly situated
persons ought to be treated equally”. But the term “equal” in equal sacrifice has been
interpreted differently. There are three concepts of equal sacrifice-equal absolute
sacrifice, equal proportional sacrifice and equal marginal sacrifice.
Equal Absolute Sacrifice. Equal absolute sacrifice implies that the total loss of utility as a
result of tax should be equal for all tax-payers. If there are two tax-payers with different
incomes, the one who has more will pay more tax and the one who has less will pay less,
but the sacrifice to both as a result of the tax should be equal. This principle received the
greatest support at one time because of its apparent fairness.
Equal Proportional Sacrifice. Equal proportional sacrifice implies that the loss of utility as
the result of a tax should be proportional to the total income of tax-payers. Here, too,
those with a higher income will pay more but the ratio of sacrifice to the income will be
the same for all. This can be expressed as:
Sacrifice to taxpayer A = Sacrifice to taxpayer B = etc.
Income of A Income of B
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This proportional sacrifice principle attempts to relate the sacrifice of tax payment to the
capacity of enjoyment or satisfaction resulting from income. Every taxpayer‟s loss in
proportion to his income should be the same as everyone else's. The difficulty with this
principle is to give a practical shape; besides, the concept is somewhat difficult to grasp.
Equal Marginal Sacrifice. Equal marginal sacrifice implies that the marginal sacrifice for
the different taxpayers should be the same. Since marginal utility of a higher income will
be very much low as compared to a low income, equal margined sacrifice will imply that
the person with a higher income will be expected to bear the heavier burden. In fact, it is
under the minimum sacrifice principle that the total or collective sacrifice of all taxpayers
will be the lowest. Hence, this principle is also known as the least aggregate sacrifice
principle of taxation.
4.6. Effects of Taxation

An important objective of taxation in most of the welfare states is to reduce the

inequalities of income and wealth and to bring about an equal society. The effects of
taxation on the distribution of income and wealth among the different sections of the
society depend upon two important factors. They are;
1. Nature of Taxation, and
2. Kinds of Taxes.
1. Nature of Taxation
The nature of taxation influences the distribution of tax among the different sections of the
society. It includes proportional, regressive and progressive nature of taxation.
(a) Effects of Regressive Taxation on Distribution: Under regressive taxation, the burden of
taxation falls more heavily upon the poor than on the rich. Regressive taxation may
increase the inequalities on the distribution of income and wealth. Hence, the burden of
taxation is higher on the poor than on the rich. In effect, this system widens the gap
between the rich and the poor.
(b) Effects of Proportional Taxation on Distribution: Under the proportional taxation, taxes
are levied uniformly upon the rich and the poor. When the tax rate remains the same, it
creates inequalities between them. However, if there is any increase in the income of
these sections, the inequalities in distribution of income will also increase. The burden of
taxation falls more heavily upon the poor than on the rich.
(c) Effects of Progressive Taxation on Distribution: Under the system of progressive taxation,
the tax rates go up with the increase in the income. Thus, in this system, the inequalities in
the income and wealth will be reduced. The major portion of the income and the wealth
of the rich is taken away by way of higher tax rates. Hence, the progressive tax system
tends to reduce the inequalities in the distribution of income and wealth.
2. Effects of Taxation on the basis of Kinds of Taxes:
The effects of taxation depend upon the kinds of taxes i.e. direct or indirect taxes.
(a) Effects of Direct Taxes on Distribution: Direct taxes take the form of taxation on the
income and property. It attempts to reduce the income of the richer sections and
transfers the income to the Government. The Government may use these resources to
raise the standard of living of the poor. Therefore, all those taxes, which fall heavily upon
the higher income groups, can have favourable distributional effects.
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(b) Effects of Indirect Taxes on Distribution: Indirect taxes are levied on commodities. They
fall heavily on the lower and middle-income groups who spend a large portion of their
income on commodities. In such a situation, indirect taxes have adverse distributional
effects. However, indirect taxes may be made progressive if the necessity goods are
exempted from taxation or levied on low tax rates, and luxuries are subjected to higher
rates of taxes.
(c) Effects of Taxation on Consumption:
Taxes increases the price of the taxed goods relative to the prices of untaxed or lower
taxed goods. The increase in the relative price affects the taxpayer in two ways.
1. Income Effect: The tax reduces the taxpayer's purchasing power or real income.
It takes resources away from the taxpayer and transfers them to the government. This is
often referred to as the direct burden of the tax.
2. Substitution (or Price) Effect : The tax creates an incentive for the taxpayer to substitute
less preferred but untaxed or lower-taxed goods for the more-preferred taxed good. The
loss in consumer utility from this substitution is the excess burden (or welfare cost) of the
tax.
Taxation influences the consumption as well. Such influence can be studied on the
following grounds:
1. Influence the Allocation of Resource of Individuals: Every individual has limited money
income and allocate it to different uses. Taxation affects their allocation directly or
indirectly. For example, the income tax reduces the money income of a consumer and
forces him to buy a smaller volume of goods and it reduces the standard of living of the
consumers. Likewise, a levy of indirect taxes on the goods of common consumption will
affect the allocation of individual resources. Thus, taxes influence the allocation of
resources of individuals.
2. Effects of Taxation on Consumption and Employment:
Taxation reduces the purchasing power of the people and it reduces their consumption.
The decline in consumption leads to decrease in effective demand for the goods and
services, which in turn affects the production of these commodities. Ultimately, the
reduction in consumption leads to a reduction in employment opportunities. For example,
due to rise in price, instead of getting two different commodities, the individual may buy
more quantity of any one commodity to maximize the utility and his satisfaction.
3. Effects of Taxation on Consumption during Inflation and Depression:
Taxation has different effects in times of inflation and depression. During the time of
inflation, the purchasing power of the people is reduced by a raise in the rates of existing
taxes or imposition of new taxes. This would control the consumption and therefore, help
in bringing up stability in prices. During the period of depression, taxation may be
reduced. As the result of the reduction on direct tax rates, the people will have more
disposable income and higher purchasing power and a decrease in indirect taxes leads
to the reduction of selling prices. Both of them encourage the total consumption of the
people and thereby the economic activities are induced in the country.
4. Regulatory Effect of Taxation on Consumption:

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Taxation may be used to regulate the production and consumption. Consumption can
be regulated by taxing the production and use of certain commodities. For example, the
object of some taxes may be to reduce the consumption of certain harmful commodities
such as liquors, cigars etc. In short taxation has the following roles: Distributive role,
Allocative role and stabilization role in the economy.
4.7. Impact, Shifting and Incidence of Tax
The traditional concept of shifting and incidence of tax is more popularly associated with
the classical theorist, E.R.A. Seligman. According to him, answer to the following three
questions relating to a tax will give us the meaning of the terms impact, shifting and
incidence.
(a) Who bears the money burden of tax in the first instance?
(b) Is it possible to transfer this money burden of tax to some one else?
(c) Who ultimately bears the money burden of tax?
It is clear from the above that the person who bears the burden of tax in the first instance
need not be the person to ultimately bear it. He may transfer the burden. He may not
however, be able to transfer the money burden of tax completely to some one else and
he may have to bear a part of the burden. Thus, there are three distinct situations in the
process of taxation. Impact (statutory incidence) of the tax refers to the point of original
assessment. Hence, impact is on that person who pays the tax in the first instance. It is the
immediate money burden of tax. Thus, when a tax is imposed, its impact is on that person
who bears the immediate money burden of it.
The person need not, however, continue to bear this money burden. He will try to transfer
this burden to some one else, i.e., he will try to shift the tax. If he is able to transfer the
burden to some one else, shifting of tax has taken place. Thus, shifting is the process of
transferring money burden of tax. Shifting ends in incidence of tax (economic incidence
of tax). Incidence is the ultimate money burden of tax. Hence, incidence of tax lies on
that person who is the ultimate bearer of the tax burden. Thus, if the original tax payer is
unable to shift the burden of the tax at all, then the impact as well as incidence will be on
him. If, on the other hand, he is able to transfer the money burden of tax, i.e., if he has
succeeded in shifting the tax to some one else, say, Mr. X, then the incidence of tax will
be said to have moved from him to Mr. X who becomes the ultimate bearer of the tax
burden.
Suppose, for example, an excise tax is levied on cloth and the tax authority collects it from
the manufacturer of cloth. Hence the impact of tax is on the manufacturer. If he is now
able to transfer the money burden to the whole-seller by raising the price to the extent of
tax, tax shifting has taken place. The whole-seller may again be able to shift this money
burden to the retailor and the retailor may pass on the burden to the consumer through a
continued process of shifting. If the consumer has no more possibility of shifting the tax, he
becomes the ultimate bearer of the money burden of tax and, hence, incidence will lie
on him. If at the retail level, on the other hand, the retailor succeeds in shifting only half
the tax burden to ultimate consumers and has to bear the rest half by himself, then fifty
percent of the tax incidence will be on consumers and fifty percent on the retailor, i. e.,
the incidence will be equally shared between the buyers and the seller.

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CHAPTER FIVE

5. GOVERNMENT BUDGETING
5.1. Meaning and purpose of government budget
Today, the government budget is much more than a statement of income and
expenditure of public authorities. It is a reflection of not only taxation and public
expenditure policy, but also of a plan for future course of action. As Gladstone remarks,
“Budgets are not merely maters of arithmetic, but in thousand ways go to the root of
prosperity of individuals and relation of classes, and the strength of kingdom.”
According to Bastable, budget has come to mean the financial arrangements of a given
period, with the usual implication that they have been submitted to the legislature for
approval. Though budget is a program for future action and is generally framed for a
year, it presents a picture of the details of expenditure, taxation and borrowings for three
consecutive years, i.e., the actual receipts and disbursements of the previous year, the
budget and revised estimates of the current year and the estimated receipts and
expenditures of the coming fiscal year. The fiscal year in our country, Ethiopia, comprises
the period from July 1st to June 31st. Though budget estimates for the coming fiscal year
contain proposals of taxation, borrowing and public expenditure, the government in
course of implementation of the budget programs might face shortage of funds due to
some important additions of activity and, hence, might be in the necessity of fresh
proposal of revenue receipts and expenditure which are made in what is called a
“Supplementary Budget”. In this way, the action plan of the original budget gets revised.
A good budget should be one that will enable the legislature and the people to
appreciate the proposals of receipts and disbursements in the context of prevailing state
of economy of the country.
The budget undergoes through different stages of action. Firstly, the budget frame is
structured. The government asks different departments to submit their proposed programs
of action for the coming year. After all such proposals are received, they are
consolidated into an overall budget plan. In the second stage, the budget is presented in
legislature for its approval. At this stage, the legislature carefully considers the proposals.
There may be additions or alternations in budgetary provisions as considered necessary
by the legislature. After the budget is approved, the government is authorized to take

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action on the budget. Thirdly, the implementation of the budgetary programs is the next
stage. Revenues are raised and expenditures relating to the budget plan are made.
In the forth and the last expenditures relating to the budget plan are made. In the fourth
and the last stage, a scrutiny and Parliamentary Committees look after how best financial
abuse can be prevented.
Purpose.
The purpose of government budget is varied. There are a number of objectives which the
budget seeks to attain simultaneously. The overall purpose is to use the budget as
instrument of government economic policy. The following are the chief purpose of the
budget. To achieve any purpose, a planning is necessary. The government needs to
achieve many goals all of which cannot be attained at a time. A proper plan of action is,
therefore, necessary. A budget is such a plan which explicitly mentions the programs that
are to be taken up in the course of the fiscal year. Secondly, implementation of a
program requires availability of necessary funds. The extent of availability depends upon
the budgetary sources of revenue. Hence, that program-structure has to be built which
can be supported by the funds. This is the most important purpose of the government
budget. Thirdly, to achieve efficiency in public expenditure, physical targets of
achievement are specified in the budget. In fixing the physical targets, careful
considerations is given to the factors of efficiency in course of implementation of the
programmes so that nearer the actual achievement at the close of fiscal year, the higher
is the efficiency of level of expenditure agencies. Fourthly, most of the countries,
particularly in developing world, today have taken up their task of their economic
development in the phased manner of five year plans and long-drawn perspective plans.
In order that the planned targets are achieved at the end of the plan period, resources
have to be found. The annual government budgets are framed with an eye to the
provision of necessary funds for the purpose. Lastly, the government budget serves the
purpose of public accountability of funds to a considerable extent. The first control is
imposed at the budgeting framing level itself when the government asks different
departments to submit their own budgets. Because the departments know that their
programmes of expenditure will be scrutinized by the government level, they become
careful to observe economy in the budget. The next stage of control is imposed by the
legislature which is the ultimate authority to decide the size and extent of the budget. At
the end of the financial year, again, the government and its various departments are

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 Ambo University Woliso Campus SoBE Department of Economics
responsible to the legislature for their action and budgetary performance. Hence, budget
serves as a powerful weapon of financial control in respect of both collection of revenues
and disbursement of them.

5.2. Theories of government budgeting

There are two theories of government budgeting, viz., (1) the classical theory of balanced
budget and (2) the modern theory of „Managed Budget‟.
I. Classical Theory.
The classical theory of balanced budget is based on the assumption of full employment
on one hand and the „laissez-faire‟ doctrine on the other. Since the economy operates at
full employment level, the problem of economy in the classical system is not attainment of
growth. The economy functions with maximum efficiency. Moreover, with the philosophy
of „laissez-faire‟ followed, the functions of government are limited to the minimum and,
hence, most of the economic activities are performed by the private sector. Under such a
situation, the size of the budget is always small and the budget should always be
balanced. If there is budget deficit and it is financed by public borrowing, it will withdraw
funds from private sector where they are more productively employed. Such diversion of
resources will bring down overall economic efficiency.
Another justification of the balanced budget is that since deficit financing through
borrowing is easy, the practice of unbalanced budget will encourage expansion of
government activities as against the classical notion of small budgets. This will reduce the
capacity of government to spend for more important purposes because interest charges
on borrowed funds have to be paid in addition to repayment of the principal amount.
Thus, public borrowings are expensive; they require double payment in the form of debt
charges as well as repayment.
There are two views regarding the balanced budget theory. According to one view, the
balancing of budget is brought about by equating current revenues with current
expenditure. There is no role of borrowing in the budget. Since total revenues are equal
total expenditures, the budget is balanced. In the other view of balanced budget,
governmental receipts include public debt also. The budget has, however, two parts –
current budget and capital budget, both of which are balanced. Thus, current
expenditures are financed by current revenues while capital expenditures are financed
by public borrowing. Thus, the overall budget is balanced.
II. Modern Theory.

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As against the above, the modern theory of Managed Budget does not agree with the
classical assumption of full employment. The celebrated Keynesian theory of
underemployment equilibrium shows that full employment is only a limiting case and is not
automatically attained. It follows that the normal situation is one of less than full
employment in an economy. Hence, in order to ensure employment of unutilized and idle
resources, a flexible budgetary policy is needed. Thus, when widespread unemployment
exists, the classical system of balanced budget becomes helpless. The modern
economists like Keynes, Hansen, Dalton and others advocate that the objective of
budget policy should be to attain and maintain full employment. The modern approach
to flexible budget policy is essentially a counter measure against economic fluctuations of
business cycle to which advanced countries are subjected. When depression and
unemployment occurs in the economy due to deficiency of effective demand, the need
is to inject additional purchasing power into the economy that effective demand, hence
employment of production factors are enhanced. This objective can be realized through
a deficit budget policy; because such a budget will put additional purchasing power into
circulation and the aggregate consumption expenditure will increase. This will raise prices
and profit prospects of the business community which will employ available unutilized
production factors to increase production and meet the increased demand. When the
economy, on the other hand, suffers from inflation due to excess purchasing power over
and above the amount necessary to deal with the transaction of available goods and
services at prevailing prices, the necessity is to pump out the excess amount from the
economy. This can be done by surplus budget which will raise more revenues like taxes
and borrowings and lower down government expenditures.
The process will cure the ills of inflation and bring about economic stabilization. When
there is neither inflation nor unemployment, the budget should be balanced. Thus, there
should be flexibility in the budget policy according to the modern economists. Whether
the budget should be balanced or a deficit or a surplus should be decided by the
prevailing economic circumstances. Hence, the modern theory is called the principle of
managed budget.
The main difference between classicists and modem economists in so far as the principle
of government budgeting is concerned lies with their views on savings and investment.
To the classical economists, saving is always equal to investment because the former is
automatically converted into the latter. In such a system, there is no unemployment. To

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 Ambo University Woliso Campus SoBE Department of Economics
the modem economists, however, savings and investment need not be equal. They are
determined by different factors and, more normally, they are different. When savings
become more than investment, deficiency of effective demand develops and
unemployment occurs due to fall in production. The economy is then faced with
depression. On the other hand, when investment becomes more than saving, the
aggregate purchasing power in the economy increases and the available output cannot
absorb it at the prevailing price level. Thus, there becomes inflation. It is only when savings
are equal to investment, the stabilization function of the economy remains undisturbed
and the society suffers neither form unemployment nor from inflation.
Under such circumstances, the modem theory argues, the budget policy of government
should be flexible, allowing for balanced budget when there is neither inflation nor
unemployment i.e., when savings and investment are equal and for unbalanced budget
when the economy suffers from either inflation or unemployment, i.e., when savings and
investment are unequal.

5.3. Budget Framing

A government budget is framed in the shape of a financial plan which is a statement of
income and expenditure relating to various economic and other activities that the
government intends to perform in the coming period. The structure of budget frame may
be different in different countries.
i) Revenue and Capital budget. Many countries, particularly the less developed ones,
prepare budget in two parts, viz., the revenue and capital budgets mainly because the
government has to spend enough resources on economic infrastructure without which
development process cannot start. Capital budget in these countries separates the
revenue expenditure items of capital account from those of current or revenue account.
The main sources of government revenue are taxes and borrowings from internal sources
on one hand and loans and grants from other governments and international agencies
on the other. In the revenue budget, the current expenditure is met out of domestic
taxation, while the expenditure on capital account is made out of domestic and foreign
borrowings. Government obligations for some extra-ordinary expenditure particularly in
the initial stages of development arise on account of economic overheads like roads and
railways, electricity generation, schools and hospital buildings and facilities and other
investment projects which require special revenues and are generally financed by
borrowing. Such expenditures and receipts are shown in the capital budget.

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Revenue Budget Capital Budget
Items of receipts items of Items of receipts items of
Expenditure Expenditure
1. Taxes on income Administrative 1. Loans and Public works
and general recoveries
services
2. Taxes on Social services 2. Market loans Construction of power
property generation plant
3. Custom duties economic services 3. Small savings construction of
roads and railways
4. Union excise Community services 4. External loans Flood control works
duties
5. Non-tax revenue Maintenance of 5. Other receipts Irrigation canals etc.
road and railways.
6. Total revenue Total revenue 6. Total capital Total capital
receipts expenditure receipts expenditure

Since capital projects are very important as they will form the sources of regular flow of
productive services in future, the long drawn financial plan and its consequence on the
economy over years ahead can be read from the capital budget. Such a separation of
the budgets secures expenditure discipline and, hence, the lenders can form a clear idea
about the solvency or otherwise of the country. It is, therefore, very important for
developing countries to frame such a type of budget. The above table will give an idea
of the structure of revenue and capital budgets.
ii) Incremental and Zero-base Budgets. The budget, in order to be meaningful, should be
appraised occasionally and requests for grant of fund should be properly reviewed. The
review is necessary at both administrative and legislative levels. But, there is a proper
allocation of economic resources. „Such a focus on increases and reductions can well
lead to hardening of the bureaucratic arteries, maintain old programmes that go
unexamined simply because no substantial changes are called for in the budget‟. This
deficiency of incremental budgeting is done away with by what is called „Zero-base
budgeting‟.
Since every outlay in the budget has some attainment objective, either short-run or long-
run, it is necessary to regularly examine the expenditure components in the light of
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 Ambo University Woliso Campus SoBE Department of Economics
anticipated results. In the case of budgeted expenditure having been associated with
long term objective, the time-bound expected result-component should be examined
occasionally. This is what is done by Zero-base budgeting. It is not necessary, however,
that each and every programme be reviewed afresh or restructured anew every year
under the zero-base budgeting, though such necessity might arise in case of some of the
programmes. But it does require that programmes should not go unscruitnished in any
case for a long period. Such budgeting is a new technique of bringing the spending
agencies under a regular scrutiny and accountability. Zero-Base-Budget, therefore, acts
as a constant reminder of the necessity of utmost efficiency in public expenditure and in
resource allocation programmes.
iii) Plan and non plan budgets. Most of the underdeveloped and developing countries
pursue planned economic development through periodic plans. The basic aim of
economic planning is to achieve repaid development in different sectors like agriculture,
industry, power, transport, etc. and to raise per capita income, remove poverty,
unemployment and regional disparity so that social justice can be achieved. Ethiopia
practices five-year plans. A part of the budgetary receipts and expenditures is devoted to
the administration and implementation of the plans. The part of budgetary receipts which
goes to finance the plan expenditure and the outlays on planned developmental heads
constitute the plan budget, while the remaining part of the budgetary resources and
expenditures is referred to as the „Normal‟ or „Non-plan budget.‟ general tendency to
confine the exercise of scrutiny within the area of changes proposed for particular
budget items rather than to extend over every aspect of the whole programme structure.
Past levels of expenditure are taken as given and only new additions to or reductions from
the past outlay are examined. This is what is known as 'incremental budgeting' which
should not be allowed to be in vogue since it cannot ensure.
iv) Balanced and Unbalanced Budget. Government budget may be balanced or
unbalanced. Unbalanced Budget may be either a surplus budget or a deficit budget.
When the government revenues are equal to government expenditures, the budget is
balanced and when they are not equal, the budget is unbalanced. P. E. Taylor explains
the nature of budget balance in the following terms. (a) A budget is balanced if during
the budget period revenue receipts are exactly equal to cost payments. (b) If revenue
receipts for the budget period are greater than cost payments, the difference is budget

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 Ambo University Woliso Campus SoBE Department of Economics
surplus and (c) if revenue receipts for the budget period are less than cost payments, the
difference is budget deficit.
In the advanced countries, a balanced budget is pursued at a time when the economy
suffers neither from inflation nor from unemployment or depression so that the objective of
maintaining full employment with price stability is achieved. When the economy suffers
from inflation, a surplus budget is operated while a deficit budget is pursued when the
economy suffers from unemployment. The developing and underdeveloped countries
suffer normally from idle resources and, to make their proper use, additional expenditures
are incurred and, hence, they mostly pursue deficit budgets.

5.4. Modern Classification of Budget

There are many governmental functions on which expenditure is planned in the budget.
To get a fuller picture of the various implications of budget frame, a proper analysis is
necessary. Modem budgeting recognizes this need and attempts to classify the budget
from different analytical angles. The Economic Commission for Asia and Far East explains
this necessity in the following words. The systems of classification provide information on
the working of budgetary process. Since such a process has a multitude of functions and
objectives, different types of classification are needed, either singly or in combination, to
serve the purpose of appropriation, programme management and review, evaluation of
plan implementation, and financial and economic analysis. The various ways in which the
public sector transactions can be classified are (a) by organization, (b) by object, (c) by
function, (d) by their economic character, (e) by programme and (f) by origin of the
purchases affected by the government. Accordingly, from different analytical view
points, we may classify the budget in the following ways.
i. Functional Classification. A better idea of government expenditure is obtained from
functional classification since it goes by purpose of expenditure rather than by
departments of government. As the United Nations says, “It classifies public expenditure
by specific governmental function such as defense, health, education, promotion of
agriculture, etc”. Since the resources of government are limited and since the functions of
government are many, the latter are essentially competing objectives. Therefore, it is
important to determine the extent of budgetary resources that can be earmarked for
each of these purposes of public expenditure. This is what the functional classification
does.

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 Ambo University Woliso Campus SoBE Department of Economics
ii. Economic Classification. Economic classification seeks to categorize the government
receipts and expenditures into different classes of economic significance so that the
pattern of resource allocation and its impact on the rest of the economy can be readily
grasped. This classification shows how expenditure for a particular purpose, say, health, is
divided between such classes of economic significance as current expenditure on goods
and services, capital formation, current transfers, capital transfers and loans. It also shows
how expenditure belonging to a particular category, capital formation, is designed to
serve different purposes. Such classification provides important macroeconomic
information that is essential for construction of national accounting data.
Economic classification broadly categorizes public expenditure into two classes, viz.,
current expenditure and capital expenditure
1. Current Expenditure 1. Capital Expenditure
a. Consumption expenditure a. Gross capital formation
b. transfer payment b. Capital transfers
c. Total current expenditure =(a + b) c. Investment in shares
d. Loans and advances
a. Consumption Expenditure e. Repayment of public debt
i. Salaries and wages f. Total capital expenditure = (a + b + c + d + e)
ii. Goods and services a. Gross capital formation
iii. Less outside sales i. Buildings and other construction
iv. Net consumption expenditure = (i) + (ii) – (iii) ii. Machinery and equipments
b. Transfer payment iii. net increase in stock
i. Interest payment Total G.C.F = (i) + (ii) + (iii)
ii. Grants to local bodies b. Capital transfers
iii. Subsidies i. Grants for capital formation to total bodies
iv. Income account of household ii. Other capital transfers
Total transfer payment = (i + ii + iii +v)
Total cap. Transfers = (i) + (ii)
c. Loans and advances
i. Capital formation
ii. Current consumption
Total = (i) + (ii)

v. Programme Budgeting Classification. Under this classification, the budget would frame
a programme structure to attain a particular objective and specify spending to attain it.
We may think of all those expenditures allocated to the set of programmes under a
particular objective as belonging to a total spending agency which is responsible for
attainment of the objective. If, for example, the objective is poverty removal, these
expenditures would constitute the poverty removal programme. It is important to note
that since these expenditure agencies are inter-related, some programmes expenditure

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 Ambo University Woliso Campus SoBE Department of Economics
would draw support from a number of agencies. To explain the anatomy of programme
budgeting, let us take the following example.
1. Current Expenditure 1. Capital Expenditure
Specific objective No.1 Increase of earning capacity
programs a. Elementary and secondary education
program
b. Enrollment incentive program
c. Teachers training program
d. Adult literacy program
e. Vocational education program
f. Labour mobility program
g. Skill formation program
h. Job placement program

Specific objective No. 2 Income maintenance

Programs i. Employment insurance program
j. Social security programs like retirement and
disablement benefits
k. Consumption subsidy program
l. Public distribution program
m. Price support program etc.

Specific objective No. 3 Community Improvement program

Programs a. Low income housing program
b. Area development program
c. flood control program
d. consumers‟ co-operative program
e. market improvement program

Specific objective No. 4 Agriculture Improvement Program

Programs  Input supply program
 Irrigation improvement program
 Flood control program
 Land reforms program
 Agriculture wage restructuring program, etc

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 Ambo University Woliso Campus SoBE Department of Economics
In this way, there may be as many specific objectives as would be helpful in securing the
general objective of purpose. A more detailed programme budgeting will break down
each of these programmes into what are known as programme elements.
VI.Performance Budgeting Classification. The scientific treatment to budget making is well
demonstrated in the programme and performance budgeting. The approach is
essentially managerial in outlook. Burk head defines performance budget as one
which presents the purposes and objectives for which funds are requested, the costs
for programmes proposed for achieving these objectives and quantitative data
measuring the accomplishments and work performance under each programme.
The difficulty of functional budget to detect whether the anticipated benefits from
expenditure is really materialized is overcome by the performance budget. Its main
purpose is to measure the benefits and to relate them to costs incurred. The targets to be
achieved during the budget period are set as objectives. Thus, a determination of
attaining a specific amount of benefit from a particular outlay inevitably takes into
consideration some sort of cost-benefit analysis on the basis of either past performance or
comparative study of the relevant market situation.
In the mixed economy of developing countries where a part of the budget is concerned
with planned development programmes and a time bound achievement of objectives is
all the more necessary, the role of performance budgeting is paramount. This
classification also helps to detect the pockets of inefficiency in administration as well as
resource allocation so that corrective steps may be designed to improve the efficiency
level of administering and executing the development programmes.
5.5. Budget as an Instrument of Economic Policy
Government budget is an important instrument of economic policy in both developed
and developing countries. In the developed countries, the economy operates at full
employment level and, hence, there does not exist unemployed resources. But the
economy is subjected to trade cycle and, therefore, occasionally faces the problems of
depression or unemployment and inflation or pressure of excess purchasing power. In the
underdeveloped countries, the economy operates at less than full employment level
and, hence, the main problem is how to attain economic growth. In these poor
countries, growth process is faced with a number of problems. They are allocational,
distributional and stabilisational. Budget serves as an important device to achieve
economic development in these countries also. The following are the important ways in

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 Ambo University Woliso Campus SoBE Department of Economics
which the government budget can influence the economy of a country.
(1) Revenue Raising Device. The government requires enough revenue to discharge its
fiscal responsibility. Modern countries have increasingly become welfare states with larger
and larger state activities coming under the fold of public sector. Hence, resources have
to be found in sufficient quantity. Budget secures this purpose through a financial plan.
The receipts side of the budget clearly mentions the sources and the extent of funds for
the purpose of financing state activities.
(2) Building of Economic Overheads. The main reason of underdevelopment, of the poor
countries is absence of proper economic infrastructure. Without proper transport and
communication system, large scale generation of electric power, establishment of basic
and key industries and proper training facilities for workers and entrepreneurs, industrial
development is not possible. Similarly, agricultural production and productivity cannot
improve in the absence of proper irrigation facilities, flood control measures,
technological improvement with research and development activities, etc. These facilities
must be provided by the government. The cost of supplying these services is heavy and
cannot be raised directly from the beneficiaries. Therefore, these facilities are supplied
free of direct charges through the budgetary provisions. Thus, budget has a tremendous
influence on the industrial and agricultural development.
(3) Diversion of Resources to More Useful Production. Free market mechanism leads to
production of those goods which give maximum profit to private enterprises. Hence
private investment is generally concentrated on the production of luxury commodities. It
is, therefore, necessary to divert resources to the production of more useful goods and
services, particularly of the kind of mass consumption ones. This can be done by
government interference through the budget. Imposition of heavy tax on harmful and less
essential goods and tax exemption or tax concessions granted to more essential goods
and services can divert resources to the production of right kind of goods and services.
Grant of facilities through budgetary expenditure can also do the same job.
(4) Proper Allocation of Resources. Most efficient allocation of resources is given by the
equality between marginal cost and price which is possible only under perfect market
conditions. Underdeveloped countries seriously suffer from malallocation of resources.
The general market conditions in private sectors are set by existence of monopoly,
monopolistic competition and oligopoly. To correct this misallocation, the government
has to interfere either in the form of production subsidy or supply of goods and services

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 Ambo University Woliso Campus SoBE Department of Economics
by public authorities so that the gap between average revenue (i.e. price) and the
marginal cost is reduced as far as possible. This is the reason why the heavy investment
public welfare industries which are subjected to decreasing cost conditions are
increasingly coming under the fold of public sector.
(5) Balanced Development. Underdeveloped countries suffer from regional imbalance in
economic development. Left to the private sector which is motivated by profit
maximization, the industries will be located in the urban and already-developed areas.
The government can correct this geographical imbalance by setting up public sector
industries in backward areas. Moreover, the development of agriculture and small scale
and village industries can be secured through government patronage in the form of
supply of infrastructure facilities and various incentive or subsidy measures. This will
develop the economy of rural areas.
(6) Income and Employment. Since underdeveloped countries are low income
economics, people live in poverty and, hence, saving and investment is very low. Income
of the people can be increased only through increased productivity and production.
Budgetary provisions can go a long way to achieve this. When agricultural technology is
improved through budgetary programmes, the income of the people engaged in
agriculture rises. People get gainful employment in the sector. Improvement in small scale
industries in the rural areas and setting up of public sector industries in the backward
regions will increase employment opportunities in these industries. The budgetary
provisions of employment-related tax concessions can influence creation of employment
opportunity in the private sector also.
(7) Saving and Investment. In underdeveloped countries, the level of saving and
investment is very low. Moreover, without increased saving and investment, economic
growth cannot be achieved. Due to low level of income, marginal propensity to consume
is very high and, hence, the mass people cannot save. Public saving is, therefore,
necessary. Taxation of various types serves this purpose. The saving and investment of
private individuals are also influenced by the savings-investment-related tax concessions
and other budgetary subsidy programmes. Capacity and willingness to work, save and
invest of the people is increased through various human capital formation measures and
creation of employment opportunities. These are all done through budgetary
expenditures.
(8) Poverty Removal. Poverty removal programme is a part and parcel of the budget in

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 Ambo University Woliso Campus SoBE Department of Economics
underdeveloped countries. All expenditure measures are designed in such a way that
they directly or indirectly influence reduction of poverty in the economy. Thus, when
budgetary resources are spent on account of education, whether general or technical
and vocational or on health measures, land reforms, flood control and irrigation, etc, an
important objective is to remove poverty of people. Direct budgetary programmes for
poverty removal are those of increasing employment opportunities and creation of
community assets like employment insurance, social security, consumption subsidy,
public distribution system and price support programmes, low-income housing, area
development, input supply, agricultural wage restructuring, etc.
(9) Full Employment and Price Stability. An important function of the budget is to secure
the objective of full employment and price level stability. We have seen how this should
be done in the case of depression and inflation. When the economy, on the other hand,
suffers from neither inflation nor deflation, the budget is to maintain full employment and
prevailing prices through judicious programmes of public expenditure and taxation. In this
case, a balanced budget is helpful in developed countries. In the underdeveloped
economies where resources are not fully employed public expenditure programmes and
tax incentive measures are put into operation to secure full employment.
(10) A Check to Misuse of Public Funds. Since budget is a financial plan relating to public
revenues and public expenditures for the budgeted period, it imposes definite restraints
on the tax gatherer and public funds spender. The legislature and the people know from
the study of budget how the revenues will be raised and how will they be spent. Revenue
mobilization and public expenditure activities will be put to scrutiny of the legislature and
also of the members of public. In case of inefficiency or misuse in the task of budgetary
performance, the executive agencies will be accountable. This will definitely put a check
on the improper use and mishandling of public funds.

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