JIMMA UNIVERSITY

CONTINUING AND DISTANCE EDUCATION DIVISION

FINANCIAL MANAGEMENT IN GOVERNMENT (GaDs 432)

Course Writers: Bisrat Gebru and Fikadu T. Ayanie

Editor: Aliyou Wudu

Jimma, Ethiopia

2011
 Hints to Icons or Symbols Presented in this Module

Dear student, to make presentation of the course simple but attractive so that your learning would
be faster and easier, the following different icons or symbols have been used throughout the
module.

This is to mean there is an introduction of a unit or an overview of a section and

what either of them is all about
It represents pre-test questions at the beginning of each chapter that helps you to

think over some questions in the form of brain storming on important issues
before you start any lesson from the chapter
This informs you that you need to think on some questions raised in the text
before starting discussing.
?
It tells you there is an activity under each lesson or a self-test exercise under each
 chapter that you need to do in accordance with the instructions given.
It tells you the checklist at the end of each chapter where you are expected to try
 some questions from lessons of the chapter just to remind you how much you are
clear with important issues dealt therein.

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 Table of contents
Contents Page
COURSE INTRODUCTION ..................................................................................................................................................................... V
UNIT ONE: INTRODUCTION ............................................................................................................................... 1
SECTION ONE: THE ROLE OF THE MODERN STATE IN THE CONTEXT OF STRUCTURAL ADJUSTMENT PROGRAMS .................................. 2
1.1. THE ROLES OF THE MODERN STATE IN THE CONTEXT OF STRUCTURAL ADJUSTMENT PROGRAMS ............................................... 2
1.1.1. Macroeconomic Management ...................................................................................................................... 3
1.1.2. Provision of Regulatory and Promotional Framework ................................................................................ 3
1.1.3. Human Capital and Infrastructure Development ......................................................................................... 4
1.1.4. Protection of the Poor and Vulnerable Sections of the Society ................................................................... 4
SECTION TWO: THE ECONOMIC RATIONALE AND FUNCTIONS OF THE MODERN STATE/GOVERNMENT ................................................. 4
2.1. MARKET FAILURE AND THE ECONOMIC FUNCTIONS OF GOVERNMENT ........................................................................................ 5
2.1.1. Allocative Function of the State .................................................................................................................. 5
2.1.2. Distributive Role/Function of Government ................................................................................................. 7
2.1.3. Regulatory Role/Function of Government ................................................................................................... 7
2.1.4. Stabilization Role/Function of the Government .......................................................................................... 7
SECTION THREE: THE CONCEPT AND CONCERNS OF PUBLIC FINANCE ................................................................................................. 8
3.1. PUBLIC FINANCE DEFINED.......................................................................................................................................................... 8
SECTION FOUR: THE GROWTH OF FINANCIAL SYSTEMS FROM FINANCIAL REPRESSION TO FINANCIAL LIBERALIZATION ...................... 9
4.1. THE GROWTH OF FINANCIAL SYSTEMS ..................................................................................................................................... 10
UNIT SUMMARY ............................................................................................................................................................................... 12
UNIT TWO: BUDGETING ....................................................................................................................................15
SECTION ONE: THE CONCEPT OF BUDGETING ................................................................................................................................... 16
1.1. DEFINITION OF BUDGET............................................................................................................................................................ 16
1.2. ADVANTAGES AND FUNCTIONS OF PUBLIC BUDGETING ............................................................................................................ 17
1.3. QUALITIES OF A GOOD BUDGET ................................................................................................................................................ 18
SECTION TWO: BUDGETARY CYCLE AND THE BUDGETING PROCESS ................................................................................................. 19
2.1. BUDGETING AND PROGRAMMING.............................................................................................................................................. 19
2.2. PHASES OF THE BUDGET CYCLE ............................................................................................................................................... 20
SECTION THREE: STRUCTURE AND COMPONENTS OF A BUDGET RECEIPT .......................................................................................... 22
3.1. GOVERNMENT ACCOUNTS ........................................................................................................................................................ 23
SECTION FOUR: SYSTEMS OF BUDGETING ......................................................................................................................................... 28
4.1. TYPES OF BUDGETING SYSTEMS ............................................................................................................................................... 28
4.1.1. Incrementalism .......................................................................................................................................... 28
4.1.2. Program Budgeting Vs Line-item Budgeting ............................................................................................ 30
4.1.3. The Planning-Programming-Budgeting System ........................................................................................ 31
4.2. COST-BENEFIT ANALYSIS......................................................................................................................................................... 32
SECTION FIVE: BUDGETING IN ETHIOPIA........................................................................................................................................... 33
5.1. THE BUDGET STRUCTURE IN ETHIOPIA ..................................................................................................................................... 34
5.2. THE BUDGETING PROCESS AT THE FEDERAL LEVEL .................................................................................................................. 36
UNIT SUMMARY ............................................................................................................................................................................... 39
UNIT THREE: MONETARY AND FISCAL POLICIES ...........................................................................................42
SECTION ONE: MONETARY POLICIES AND ISSUES ............................................................................................................................. 42
1.1. UNDERSTANDING MONETARY POLICY AND IMPORTANT CONCEPTS .......................................................................................... 43
1.1.1. Definition of Monetary Policies................................................................................................................. 43
1.1.2. Basic Concepts in Monetary Policy ........................................................................................................... 44
1.2. INSTRUMENTS OF MONETARY POLICY ...................................................................................................................................... 46
SECTION TWO: FISCAL POLICIES....................................................................................................................................................... 48
2.1. FISCAL POLICY ......................................................................................................................................................................... 48
2.1.1. Definition and Elements of Fiscal Policy .................................................................................................. 48
2.1.2. Determinants of Fiscal Policy .................................................................................................................... 50
2.2. CLASSIFICATIONS OF FISCAL POLICIES...................................................................................................................................... 51
2.3. ROLE OF FISCAL POLICY IN ECONOMIC DEVELOPMENT ............................................................................................................. 51
2.4. FISCAL DECENTRALIZATION ..................................................................................................................................................... 53
2.4.1. Understanding the Concept of Fiscal Decentralization and Its Rationales ................................................ 53
2.4.2. Fiscal Decentralization in the Ethiopian Case ........................................................................................... 56
UNIT SUMMARY ......................................................................................................................................................................... 58

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UNIT FOUR: TAXATION......................................................................................................................................60
SECTION ONE: TAXATION AND TAX POLICIES ................................................................................................................................... 60
1.1. TAXATION DEFINED ................................................................................................................................................................. 61
1.2. CHARACTERISTIC FEATURES OF TAXATION............................................................................................................................... 62
1.3. CLASSIFICATION OF TAXES ....................................................................................................................................................... 63
1.3.1. Income Taxes ............................................................................................................................................. 63
1.3.2. Consumption Taxes ................................................................................................................................... 65
1.3.3. Property Taxes ........................................................................................................................................... 66
1.4. CANONS (PRINCIPLES) AND FUNCTIONS OF TAXATION .............................................................................................................. 67
1.4.1. Canons (Principles) of Taxation ................................................................................................................ 67
1.4.2. Functions of Tax ........................................................................................................................................ 68
1.5. INCIDENCE AND IMPACTS OF TAXATION.................................................................................................................................... 69
SECTION TWO: EQUITY AND EFFICIENCY OF TAXATION .................................................................................................................... 71
2.1. APPROACHES TO TAX EQUITY (FAIRNESS) ................................................................................................................................ 72
2.1.1. Ability-to-Pay Principle ............................................................................................................................. 72
2.1.2. Benefits Principle....................................................................................................................................... 73
2.2. EFFICIENCY OF TAXATION ........................................................................................................................................................ 73
UNIT SUMMARY ......................................................................................................................................................................... 74
UNIT FIVE: PUBLIC DEBT ...................................................................................................................................76
SECTION ONE: THE CONCEPT OF PUBLIC DEBT ................................................................................................................................. 76
1.1. DEFINITION OF PUBLIC DEBT AND REASONS FOR GOVERNMENT BORROWING ........................................................................... 77
1.2. TYPES OF PUBLIC DEBT ............................................................................................................................................................ 80
1.3. THE BURDEN OF PUBLIC DEBT ................................................................................................................................................. 81
SECTION TWO: PUBLIC DEBT MANAGEMENT AND REDEMPTION OF PUBLIC DEBT ............................................................................. 82
2.1. PUBLIC DEBT MANAGEMENT.................................................................................................................................................... 82
2.2. REDEMPTION OF PUBLIC DEBT ................................................................................................................................................. 83
UNIT SUMMARY ............................................................................................................................................................................... 85
UNIT SIX: DEVELOPING SECURITIES/STOCK MARKET .....................................................................................87
SECTION ONE: SECURITIES MARKETS ............................................................................................................................................... 87
1.1. UNDERSTANDING SECURITIES MARKETS .................................................................................................................................. 88
1.1.1. Stock Markets ............................................................................................................................................ 88
1.1.2. Non-stock Security Markets ...................................................................................................................... 89
SECTION TWO: RATIONALES, CHALLENGES AND PROSPECTS OF DEVELOPING SECURITIES/ STOCK MARKET WITH EMPHASIS IN
ETHIOPIA ......................................................................................................................................................................................... 91
2.1. RATIONALE AND ENABLING ENVIRONMENT FOR DEVELOPING SECURITIES/STOCK MARKET ..................................................... 92
2.2. LIMITATIONS/ COSTS IN ESTABLISHING STOCK MARKETS ......................................................................................................... 93
2.3. PROSPECTS AND CHALLENGES OF DEVELOPING SECURITIES MARKET IN ETHIOPIA.................................................................... 94
UNIT SUMMARY ......................................................................................................................................................................... 95
REFERENCES .................................................................................................................................................................................... 97

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 Course Introduction

Despite recent trend towards avoiding state control of the economy, the state/government still
has critical role in economies of respective countries all over the world. The state has some
economic functions which are basic for smooth functioning of a society. These recognized roles
emanate from market failure, i.e. these functions cannot be performed by the private sector
through free market system. Like activities of other actors these activities of the government
require financing. In addition, the government has fiscal and monetary policies that regulate the
entire financial system in a country.

Financial management of government activities requires systematic and rational ways of

mobilization, use and control of financial resources. In general, this includes budgeting, taxation,
expenditure, etc. Concerning the duty of the government in financial system of a country, there
are several ways of action for a government towards tackling a financial policy problem,
depending on considerations. So, this course deals with financial management of government
activities as well as the role of the government in the entire financial system of a country.

To this effect, the course is organized around six units. The first unit will introduce you the
overall essence of public finance, the role of government in development finance and some of the
economic rationales of modern states/governments. This will be followed by a discussion in the
second unit on the concept, components and types of budgeting and systems of budgeting with
a brief emphasis on the Ethiopian context. The third unit consists of the discussion about the two
core matters in public finance, i.e. monetary and fiscal issues. The fourth, fifth and sixth units
will be focusing on taxation, public debt management and financial securities respectively.

Course Objectives

Dear distance learner, at the end of this course you should be able to:

∗ discuss the role of the modern state/government in the economy and the growth of public
finance;
∗ explain the rationale of budgeting in financial management and the budget system in
Ethiopia;
∗ analyze monetary and fiscal policies together with their instruments, and fiscal
decentralization;

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∗ describe different features of taxation and discuss classifications, cantons and principles of
taxation;
∗ mention the reasons and classifications of public debt, and be familiar with objectives and
principles of public debt management as well as repayment of public debt; and
∗ discuss the prospects and challenges of developing securities market with special
emphasis on the Ethiopian case.

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 UNIT ONE

INTRODUCTION

Unit Introduction
Dear distance learner, welcome to the first unit of this module! This unit discusses some basic
issues in public finance. The unit is divided in to four sections. The first section describes the
roles of the state/government in the context of structural adjustment programs. The second
section explains the economic rationale and functions of the state and the justification for state
intervention in the economy. The third section deals with the understanding of public finance and
the basic questions in public finance. In this section the understanding of public finance as a
government practice and as an area of academic study is discussed and then the basic concerns of
public finance as a study area is also discussed. Finally, the fourth section discusses the growth
of financial systems from a system called ‘financial repression’ to the context of ‘financial
liberalization’. We hope you will try to understand the discussions in this unit, as they are basic
for your understanding of the discussions in the other units.

Unit Objectives
After successful completion of this unit, you will be able to:
• identify the different roles of the modern state in the context of structural adjustment
programs;
• describe the economic rationales of the modern state/governments;
• explain the concept of public finance and its basic questions, and
• differentiate between financial repression and financial liberalization.

Pre-test Questions

• What are the economic roles of the modern state?

• What do we mean by public finance?

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 Section One: The Role of the Modern State in the Context of Structural
Adjustment Programs

Section Overview
Dear distance learner, welcome to the first section of this module and this unit! In this section
you will learn about the role of the modern state/government under the context of structural
adjustment program. We hope that you will fully understand the different expected roles of the
state in such a context.

Section Objectives
Up on a successful completion of this section, you will be able to:
• describe the changes in developing countries which followed structural adjustment
programs, and
• identify the different role of the state in the context of structural adjustment programs.

1.1. The Roles of the Modern State in the Context of Structural

Adjustment Programs

? Dear student, what do you know about structural adjustment programs, and the roles
of the state under its context?

In the post-1970s period many developing countries faced two major problems in their
economies. The first problem was internal imbalance which was manifested in the form of
inflation and low capacity utilization. The other problem was external imbalance characterized
by lack of foreign exchange resources. To tackle these problems the governments follow two
methods of stabilization programs. These methods are:

i) Expenditure switching: involve exchange rate devaluation and other methods like price
liberalization.
ii) Expenditure reducing: reducing the public sector deficit.

Such reforms were thematically prescribed by IMF and the World Bank in their well-known
Structural Adjustment Program (SAP). Under the context of SAP, the governments of these
developing countries were forced to have limited role. The major roles of the government in the
context of SAP are discussed below.

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 1.1.1. Macroeconomic Management

There are two important areas on which the government has critical roles in macroeconomic
management. These areas include the budgetary position of the government and exchange rate.
Regarding the budgetary position of the government, a government can follow a deficit, balanced
or surplus budgetary policies. Most government budgets are deficit budgets, where anticipated
expenditure is greater than anticipated revenue because government will be spending more for
development. There is no rule for optimal size of budget deficit, but it has to be within certain
limit. Otherwise, it will result in inflation. Budget deficit can be financed through different ways
like:
i) Direct money creation – the central bank will increase money supply. N.B. this may result
in domestic inflation.
ii) Borrowing – from domestic private sector or abroad.

Domestic (internal) borrowing can sometimes be forced. E.g. The commercial banks can be
forced to hold government securities. The government can also borrow from the central bank
reserves and will not pay the debt. The borrowing can also be voluntary, where government
stocks and bonds are sold to the private sector. N.B. the government has to keep the public sector
deficit within a manageable limit.

The other role of the government in macroeconomic management concerns exchange rate
adjustment. In this regard it must be noticed that exchange rate is the most important price in an
economy because it affects imports and exports. Exchange rate is used to adjust external price
competitiveness. In addition, it can also be used as an anti-inflation instrument, for achieving
price stability.

1.1.2. Provision of Regulatory and Promotional Framework

The government has to provide a regulatory and promotional framework. This role has two
major objectives concerning the private sector and the public sector. Regarding the private
sector, the government policy should allow the private sector to expand that the regulatory and
promotional framework should result in market friendly environment; so that there would be
competition and competition in turn would improve the quality. In dealing with the private sector
the government has to remove restrictions like price control, liberalize the investment licensing
and liberalize foreign trade.

With regard to the public sector, the public sector should operate with more efficiency and there
should be more autonomy in the public sector and public enterprises. The government should not
directly control the decisions in the public sector and public enterprises, rather the decisions

3
should be taken on the basis of commercial criteria and the public sector should run at a profit.
However, the commercial criteria can be modified on social consideration grounds.

1.1.3. Human Capital and Infrastructure Development

Human capital and infrastructure sectors/programs have two most important features, i.e. they
have high externalities and the investment is also lumpy (large scale). Private investors may not
be interested to invest in these two sectors because of such characteristics. But if the private
sector invests in these sectors, it may result in socially undesirable consequences or inadequate
level of output. However, there can be involvement by private sector because the government
may have financial stringency. So, private sector participation should be encouraged; the
government having a very important role.

1.1.4. Protection of the Poor and Vulnerable Sections of the Society

The government has to make interventions to protect the welfare of vulnerable sections of the
society and the poor, especially the poorest of the poor. But in doing so, it must be able to hit the
balance between welfare and efficiency.

 Activity-1
1. What are the financial problems that forced governments of developing countries to
accept the reform measures prescribed by structural adjustment program?
___________________________________________________________________
___________________________________________________________________
__________________________________________________________________.

2. What are the roles of the state in the context of structural adjustment program?
___________________________________________________________________
___________________________________________________________________
___________________________________________________________________
___________________________________________________.

Section Two: The Economic Rationale and Functions of the Modern

State/Government

Section Overview
Dear distance learner, in the previous section you have learned about the role of the state in the
context of structural adjustment programs. In this section you will learn about the economic

4
rationale of the state/government. The different economic functions of the government and the
justification for government intervention in the economy are discussed.

Section Objectives
At the end of this section, you will be able to:
 define and describe the concept of “market failure”,
 explain the justification for government intervention in the economy, and
 discuss the different functions of the government in the economy

2.1. Market Failure and the Economic Functions of Government

? Dear learner, do you know what market failure means? What economic functions do
the government has?
The government, as a concrete manifestation of the state, has to play some important economic
roles representing the state. Government intervention in the economy is justified by market
failure. Market failure can be understood in moderate and extreme cases. The moderate case of
market failure is when there is insufficient production of goods and services or surplus
production of goods and services. In other words, when there is no balance between demand and
supply. The extreme case of market failure is when the market fails to exist, so that certain types
of goods and services are not produced at all because the private sector may fail to produce some
socially desirable goods (public goods). E.g. Public park, national defense, etc. So, the
government has the following very important roles because of market failure.

2.1.1. Allocative Function of the State

The allocative function of the state concerns government actions in the ownership and use of
property. There are different types of property, each type having distinguishing features. These
different types of property, their features and the expectations from the government concerning
these property types are discussed below.

a) Property rights: right of private property ownership, excluding others from using it. E.g.
Erecting fences, branding cattle, ‘no trespassing’ signs, etc. Definition and enforcement of
property rights is too costly. If property rights are not clearly defined regarding a commodity,
the marketability and the price of the commodity would be reduced. The government has to
clearly define the terms of ownership of private property and it is also the legal machinery to
enforce contracts concerning property ownership.

5
b) Common property resources: common property resources are resources which everybody has
the right to use, but nobody has the right to sell them. Common property resources have a
rival nature because if one uses more of the resources, other users use less. Often, there is
unregulated use of such resources which result in the deterioration of the resource. There are
some associated problems with common property resources. First, these resources are
indivisible in nature. Second, there is large group size that consumes such properties. Third,
there is the issue of ‘free riders’. Some people (free riders) enjoy the benefits but they do not
pay for the resources. From individual point of view, this may be preferable, but from group
point of view this is not desirable.

The role of the government in common property resources is to regulate individual behavior,
reducing ‘the tragedy of the commons’. The government has to allocate the use of such
resources thereby maximizing the common interest of the group.

c) Positional goods: are goods which are in short supply and cannot be easily increased, for
instance the post of the prime minister, islands in Greece, etc. If everyone gets access to
positional goods, it would result in congestion and the value of the good would be reduced,
and no one is better off. So, the government has to regulate the use of positional goods.

d) Public goods: are goods where each individual’s consumption leads to no subtraction from
any other individual’s consumption of that good. Eg. Road, national defense, etc. However, in
case of some public goods, when some individuals are added, it may result in deterioration of
quality. The defining features of public goods are:

i. Non-excludability: it is not possible to exclude others from enjoying the benefits of the
commodity. The rule of excludability breaks in case of pure public goods. Eg. National
defense. However, certain public goods can be excludable, but it is very expensive to do
so. E.g. If somebody wants to have public goods in its own.

ii. Non-rivalness: the marginal cost of adding another person to consume public goods is
almost zero. Eg. Non-crowded bridge, non-crowded railway compartment.

iii. Non-rejectable: individuals can not reject their use of public goods. Eg. an individual
cannot say ‘I don’t want national defense!’

iv. Public goods cannot be sold

So, pure public goods should be provided by the government through public budget, because
profit maximizing private entrepreneurs are not interested in providing pure public goods for
the above mentioned characteristics of such goods.

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2.1.2. Distributive Role/Function of Government

The distribution of wealth depends on so many factors like inherited wealth and accumulated
wealth over an individual’s lifetime. In addition, inequality of earnings (income) may arise
because of the difference in the skills (training) that members of a society have and the price of
these skills: e.g. between a surgeon and a shoe polisher. Generally, as a result of the above
mentioned factors, there is inequality of wealth in almost all societies. Such inequality can affect
the welfare of the society because it may not be socially justifiable (acceptable).

Equal distribution of wealth (income) is not possible that such end is not expected to result from
government actions. Rather, the role of the government is to bring preferred distribution of
income (wealth). Some of the tools that a government can use to redistribute income are:

a) Progressive taxation
b) Subsidies to the poor section of the society
c) Provision of public goods such as education, health and housing services which are
usually termed as ‘merit goods’.

2.1.3. Regulatory Role/Function of Government

The government has to regulate the decisions of producers and consumers thereby reducing
monopoly elements and externalities. E.g. Fair trading and monopolies commission, anti-
pollution regulation, etc. In this regard the important institutions to be regulated are
macroeconomic management, money supply, stock exchanges and commodity exchanges. The
private sector cannot perform regulatory function because it do not have proper (full)
information about the quality, safety, etc. of the things to be regulated; so that it may make
decisions based on partial information. In addition, the private sector may not have the necessary
resources in sufficient amount.

There are three major problems regarding the regulatory functions of the government. The first
problem is associated with the question ‘who regulates the regulator?’ regulatory functions of the
government tend to favor big businessmen. Often, big companies gain control over the
regulatory agencies and small and disorganized firms are ignored. The second problem is,
through time, regulatory activities become regular and routine. So that they are predictable and it
is easy to evade regulations.

2.1.4. Stabilization Role/Function of the Government

Instability in the economy arises mainly due to imbalance among saving, investment and
consumption. Another reason for instability is discrepancy between demand and supply.

7
Monetary, fiscal, public expenditure and exchange rate policies are the major areas where the
government has stabilizing role. Another major area of stabilizing role of the government is
insurance as far as the issue of social security is concerned. In this regard, the government has to
provide insurances like unemployment fee, health insurance and pensions.

 Activity-2
1. How does market failure happen?
______________________________________________________________________
______________________________________________________________________
______________________________________________________________________

2. How is government intervention in the economy justified?

______________________________________________________________________
______________________________________________________________________
_____________________________________________________________________.

3. What are the different the functions of the government in the economy?
______________________________________________________________________
______________________________________________________________________
______________________________________________________________________
______________________________________________________________________
________________.

Section Three: The Concept and Concerns of Public Finance

Section Overview
Dear distance learner, in the previous section you have learned about the role of the state in the
context of structural adjustment programs. In this section you will learn about the economic
rationale of the state/government. The different economic functions of the government and the
justification for government intervention in the economy are discussed.

Section Objectives
Up on successful completion of this section, you will be able to:
 describe the concept of public finance, and
 identify and explain the basic questions in public finance.

3.1. Public Finance Defined

? Dear learner, can define ‘public finance’? What are major areas of its concern?
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Public finance can be understood as a practice and as an area of study. As a practice it is a
planned action of the government in financing public sector activities. In this sense it involves
identifying the public activities of the government, identifying and mobilizing the necessary
resources to perform these public activities, spending the resources in a planned manner, and
evaluating and investigating the legality and appropriateness of such public spending. As an area
of study, public finance systematically studies financial matters of government activities such as
government revenue and expenditure.

Some important questions addressed by public finance are:

• What type and how many goods and services are to be provided by the public sector?
• For whom are these goods and services to be made available?
• By whom these goods and services are to be produced? By the public sector employees
or private sector contractors?
• How are the resources necessary to pay for these goods and services to be mobilized?
• How many governmental organizations have to be involved in the provision and
financing of public services?

 Activity-3
1. Describe public finance as a government practice and as an area of study.
____________________________________________________________________
____________________________________________________________________
____________________________________________________________________
____________________________________________________________________

2. What are the basic questions raised in the study of public finance?
____________________________________________________________________
____________________________________________________________________
____________________________________________________________________
____________________________________________________________________
_________________________________________________________.

Section Four: The Growth of Financial Systems from Financial Repression to

Financial Liberalization

Section Overview
Dear distance learner, in the previous section you have learned about the concept of public
finance and the basic issues in public finance. In this fourth section of this unit, you will learn
about the growth of public finance. Such growth emphasizes the move from a financial system

9
called ‘financial repression’ to a system known as ‘financial liberalization’. The characteristics
of these types of financial systems are also discussed. In doing so, we will give focus to the
contexts of developing countries.

Section Objectives
Up on successful completion of this section, you will be able to:
 describe the growth of the system of public finance from financial repression to financial
liberalization
 mention the features of financial repression to financial liberalization

4.1. The Growth of Financial Systems

? Dear learner, what do you know about financial repression to financial liberalization?
The financial system approach before the 1970s was financial repression. The financial sector
was considered as being very small and was not developed. Such system of financial repression
was characterized by the following problems in the financial sector. These are:
• Low interest rate which was artificial
• Barrier to entry in the banking and financial sector
• Lack of competition in the banking and the insurance sectors – controls that inhibited the
growth of the financial sector
• High reserves requirement – commercial banks are required to deposit certain level of
reserve in central banks. During the financial repression there was high reserves ratio
because it was the source of funding government budget. The problem was that such
funding government budget was done at the expense of potential borrowers.
• Financial institutions were not running from a business perspective and this resulted in
lack of innovation in the institutions.
• The insurance sector was generally neglected. There was lack of inter-bank markets and
the related absence of actively traded benchmark instruments such as securities.
• Fragmentation of the credit market. The credit market was not organized – there were lots
of intermediaries with limited power.
• In the credit programs lending was not based on market criteria that credit programs were
provided to borrowers who are preferred by government.
• Under financial repression it was difficult to issue small loans such as loan to farmers and
microcredit, and this excludes a large number of potential borrowers.
• Loans were directed to projects and technologies which were inappropriate.

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Financial repression had the following negative consequences on the financial sector and the
whole economies of the countries that followed this system:

a. The rate of growth in the sector was very low

b. Most of the countries which followed financial repression had balance of payment
problem. E.g. The heavily indebted poor countries (HIPCs), most of which are in Africa.

After the 1970s, for most African countries financial liberalization which is also called financial
deepening, was imposed by the World Bank and the International Monetary Fund (IMF) under
their two programs i.e. Structural Adjustment Lending (SAL) and Structural Adjustment
Program (SAP). Under financial liberalization the financial sector is considered proportionally
large sector and it grows faster than other sectors. Financial liberalization lays the way to smooth
functioning of the financial sector. The basic features of financial liberalization are:

 abolishing interest rate control

 lowering restrictions to entry in to the banking sector
 discontinuing government control of the allocation of credit
 stimulating the development of securities market
 liberalization of the foreign exchange, and
 attention is given to small loans – microcredit

 Activity-4
1. Shortly describe the basic characteristics of financial repression?
___________________________________________________________________
___________________________________________________________________
___________________________________________________________________
______________________________________.

2. Shortly describe the basic characteristics of financial liberalization?

___________________________________________________________________
___________________________________________________________________
___________________________________________________________________
____________________________________________________________.

3. What negative consequences were faced by governments of developing countries that

followed the system of financial repression?
___________________________________________________________________
___________________________________________________________________
___________________________________________________________________.

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 Unit Summary
In this unit some basic issues in public finance are discussed. In the post-1970s period most
developing countries faced two major types of imbalances, i.e. internal imbalance and external
imbalance. To deal with these problems the governments followed two methods of stabilization
programs known as expenditure switching and expenditure reducing which were prescribed by
IMF and the World Bank in their Structural Adjustment Programs (SAP). Under the context of
SAP, the role of these governments has come to be limited. However limited, the government
still has some basic roles which are critical for smooth functioning of an economy and a society.
The major roles of the government in the context of SAP are macroeconomic management,
provision of regulatory and promotional framework, protection of the poor and vulnerable
sections of the society, and human capital and infrastructure development. There are different
economic functions to be performed by the state/government, as far as the economic roles are
specifically concerned. These recognized economic functions are justified by market failure. i.e.
these functions can not be performed by the private sector through free market system. These
economic functions of the state are broadly classified as allocative functions, distributive
functions, regulatory functions, and stabilization functions.

Like activities of the private sector, these activities of the government require financing. Public
finance is concerned with such financing. Public finance can be understood as a practice and as
an area of study. As a practice it is a planned action of the government in financing public sector
activities. In this sense it involves identifying the essential public activities, mobilizing resources
to perform these activities, spending the resources, and evaluating the legality and
appropriateness of such public spending. As an area of study, public finance systematically
studies such financial matters of the government.

In addition, the growth of financial systems from a system called ‘financial repression’ to the
context of ‘financial liberalization’ has been discussed in this unit. Financial repression was
financial system approach followed before the 1970s. In such a system the financial sector was
considered as being very small and was not developed. Such system of financial repression has
resulted in the underdevelopment of the financial sector and the problem balance of payment in
the entire economy. In the period after the 1970s, financial liberalization came to replace
financial repression as an approach. However, for most developing countries such shift was the
result of imposition by the World Bank and the International Monetary Fund (IMF). Under
financial liberalization the financial sector is considered proportionally large sector and it grows
faster than other sectors. Financial liberalization also lays the way to smooth functioning of the
financial sector.

12
We hope that you have grasped the discussions in this unit. If so, well done! Such full
understanding of these discussions would help you to understand the discussions in the other
units.

 Check List
Direction: Dear students this is the section in which you self-assess your understanding of the

discussions in this unit. Put a tick mark () in the yes column for activities that you have clear
understanding and in the no column for activities that you doubt that you have good understanding.

I Can: Yes No

• Describe the role of the modern state

• Define market failure

• Discuss economic functions of the government

• Discuss concept of public finance

• Discuss the characteristics of financial repression
and financial liberalization

N.B: If you have any doubt about your understanding of any of the above checklists, don’t hesitate to
go back and refer the discussions in the sections!

 Self-Test Exercise
Part I: Choose the best answer from among the given alternatives

1. Which one of the following characterizes internal imbalance?

A. Low capacity utilization

B. Lack of foreign exchange
C. Inflation
D. A and C
2. Which of the following roles is most associated with the budgetary position of the government and
exchange rate?

13
 A. Provision of regulatory and promotional framework
B. Macroeconomic management
C. Protection of the poor and vulnerable sections of the society
D. Human capital and infrastructure development
3. __________________ is good where an individual’s consumption leads to no subtraction from any
other individual’s consumption of that good.

A. Private good
B. Common property resource
C. Positional good
D. Public good
4. Which of the following questions is/are addressed by public finance?

A. What type and how many goods and services are to be provided by the public sector?
B. For whom are public goods and services to be made available?
C. By whom public goods and services are to be produced?
D. How are the resources necessary to pay for these goods and services to be mobilized?
E. All of the above

5. Which of the following features does not characterize financial liberalization?

A. Interest rate control

B. Lowering restrictions to entry in to the banking sector
C. Stimulating the development of securities market
D. Liberalization of the foreign exchange
Part II: Say true for the correct statement and false for the wrong statement

1. Direct money creation as a method of financing budget deficit has no negative effect.
2. The government should directly control the decisions in the public sector and public enterprises.
3. The regulatory framework of government has to be market friendly.
4. The extreme case of market failure is when there is insufficient or surplus production of goods and
services.
5. Financial repression fosters growth of the financial sector.
Part III: Match items in column A with the items in column B

Column A Column B

1. Expenditure switching A. Reducing the public sector deficit

2. Expenditure reducing B. Exchange rate devaluation
3. Distributive function of the government C. Insurance
4. Stabilization function of the government D. Associated with wealth inequality

14
 UNIT TWO

BUDGETING

Unit Introduction
Dear distance learner, welcome to the second unit of this module! This unit discusses issues of
budgeting in public finance. The unit is divided in to five sections. The first section
conceptualizes government budget. This section provides the definition of budget, and describes
the advantages/functions of budgeting, and then points out the qualities of a good budget. The
second section discusses the budgeting process and budgetary cycle. This second section deals
with the relationship between government programs and government budgeting. The different
phases of the budgeting process or the budget cycle are also discussed in this section. The third
section deals with budget structure and components of a government budget receipt. This section
discusses the different types of funds/accounts kept by the government and the structure and the
components of a government budget. The fourth section discusses the different types of
budgeting systems. The section deals with a way of determining government budget known as
incrementalism and then ways of budgeting known as program budgeting and line item
budgeting are discussed in comparison in this fourth section. Finally, the fifth section describes
budgeting in Ethiopia. This last section is necessitated to acquaint you with practical budgetary
system of our own country, as it affects our day to day work and life. We hope you will try to
understand the discussions in this unit. Have a good reading!

Unit Objectives
After successful completion of this unit, you will be able to:
• understand the concept and functions of government budget,
• describe budgeting process and budgetary cycle,
• explain budget structure and components of a budget receipt,
• identify the types of budgeting systems, and
• understand the budgeting process in Ethiopia.

Pre-test Questions
• What is the concept of budgeting all about?
• What are the main functions of budgeting?
• What are the qualities of a good budget?

15
 Section One: The Concept of Budgeting

Section Overview
Dear learner, welcome to the first section of the second unit! In this section you will learn about
the concept of budgeting. This section is further divided in to three sub-sections. The first sub-
section defines government budget. The second sub-section discusses the advantages and
functions of budgeting. The third sub-section deals with the qualities of a good budget. We hope
that you will fully understand the discussions in this section.

Section Objectives
Up on successful completion of this section, you will be able to:
• define government budget
• describe functions of budgeting
• identify the qualities of a good budget

1.1. Definition of Budget

? Dear learner, do you know what does budget mean?

The word Budget originally meant the moneybag or the public purse. The government budget
reflects what the government intends to do. The budget has become the powerful instrument for
fulfilling the basic objectives of government. The budget covers all the transactions of the
government. Budget is a time bound financial program systematically worked out and ready for
execution in the ensuing fiscal year. It is a comprehensive plan of action, which brings together
in one consolidated statement all financial requirements of the government.

Budget is a guideline for decision making and center of government revenue and expenditure for
a specific period of time, usually a year. Budgeting is an important tool in public finance and it
reveals the basic characteristics of fiscal policy of the government. A rational decision regarding
allocation of resources to satisfy different social wants requires considerable thinking and
planning. Thus budget is an annual statement of receipts and payments of a government.

Another type of financial plan which is slightly different from a budget is vote on account. Vote
on account pertains only to the expenditure side of government budget and does not show the
revenue side of the budget. Vote on account occurs only in care taker governments which are not
expected to present the budget in full manner.

16
There are two types of budget as far as the relative amount of revenue and expenditure is
concerned. These are:

a) Balanced budget: is a type of budget where anticipated revenue is equal to anticipated

expenditure.
b) Unbalance budget: is when there is imbalance between anticipated revenue and
anticipated expenditure. There are two types of unbalanced budget known as surplus
budget and deficit budget. Surplus budget is a type of budget where anticipated revenue
is greater than anticipated expenditure. On the other hand deficit budget is a type of
budget when anticipated revenue is less than the anticipated expenditure.

Most classical economists preferred balanced budget or surplus budget because the basic
objective in classical economic thinking is achieving high saving, and they assumed that as
saving is higher growth will be higher. However, now a days, that is not the case as we find
deficit budget in most cases and this is because governments expend more for development
activities. The governments finance the deficit in budget using different methods such as
borrowing and money printing.

1.2. Advantages and Functions of Public Budgeting

? Dear learner, do you know what the functions of budgeting in government activities
are?
The advantages and functions of government budgeting can be discussed in terms of four
aspects. The first is that government budget can be used as an instrument of planned
implementation. To implement its economic functions government raises revenues through
taxation. Fees and charges, and spend them on different programs and activities. This process of
rising revenues and spending by government is performed through budgeting. Budget thus stands
for the yearly plans/forecasts of government revenues and expenditures. Budgeting helps to
ensure efficiency and effectiveness in the implementation of government programs, and it is also
helpful to relate all major decisions to the state of the national economy.

Secondly, budgeting helps proper allocation of resources between competing needs and to relate
expenditure decisions to specified policy objectives and to existing and future resources. From a
normative standpoint, the role of the budgeting process is to allocate scarce resources to their
most highly valued uses. To accomplish this, the government must first assess the relative worth
of various programs to decide whether they should be produced in the public sector. Then the
government must decide whether the resources are available for the programs and to what extent.
Some programs that appear worthwhile in isolation may not be feasible within the context of, the

17
overall budget if the revenue cannot be generated at a reasonable cost. It is important to note that
as government spending increases, the excess burden involved in raising additional revenue
increases more than proportionally with the growth in government spending. As in private
finance, possible areas of public spending must be weighed against one another in light of the
opportunity cost of raising resources to pay for the program.

Thirdly, budgeting can be used as instrument for regulating the economy. It implies that the
objective of budget policy is to take corrective measures or to adopt regulatory policies to
remove imperfection or inefficiencies of market mechanism. In this regard budget policy is an
important instrument to maintain a high level of employment, reasonable degree of price stability
and an appropriate rate of economic growth. Besides, the budget policy is instrumental in the
provision of public goods and services. It means that the objective of budget policy is to ensure
equitable distribution of income and wealth.

Fourth, budgeting can be used as an instrument for strengthening public accountability in the use
of resources. In relation to this, budgeting is an instrument for democratic control over the
executive – legislative control over the executive. The power of spending the money (the purse)
resides with the legislative. The executive cannot arbitrarily impose taxes on the people without
the sanction of the legislative – budget is expression of ultimate legislative authority. The
executive is accountable to the legislative and it must control the administrative agencies. Budget
shows the development of two way ladders of responsibility:

i. Executive – administrative agencies

ii. Executive – legislative

1.3. Qualities of a Good Budget

A good budget has the following qualities. However, in practice, governments with excellent
budgetary systems may violate some of these principles.

1. Comprehensive: the budget should clearly show the financial position of the government
in all aspects.
2. Clarity and publicity: the budget must be clear and it should get publicity – it should not
be kept secret.
3. Reliable: the budget should be reliable as much as possible.
4. Exclusive: the budget should deal only with financial matters, not other legislations.
5. Unity: the budget mechanisms should be in unity. It should be presented in gross terms,
in terms of total revenue and total expenditure not in terms of net revenue and net
expenditure.

18
 6. Annual: it should cover one fiscal year.
7. Accurate: the revenues and expenditures should be accurately estimated.

 Activity-1
1. Define what a government budget is?
_________________________________________________________________________
_________________________________________________________________________
_______________________________________________________.

2. What are the major functions of budgeting?

_________________________________________________________________________
_________________________________________________________________________
_________________________________________________________________________
_________________________________________________________________________
___________________________________________.

3. Mention some of the qualities of a good budget.

_________________________________________________________________________
_________________________________________________________________________
_________________________________________________________________________
_________________________________________________________________________
___________________________________________.

Section Two: Budgetary Cycle and the Budgeting Process

Section Overview
Dear distance learner, welcome to the second section of this unit! In this section you are going to
learn about budgetary cycle and the budgeting process. This section discusses the relationship
between government programs and government budgeting. The different phases of the budgeting
process or the budget cycle are also discussed in this section.

Section Objectives

At the end of this section, you will be able to:

• discuss the relationship between government programming and government budget
• identify the various phases of the budget cycle

2.1. Budgeting and Programming

? Dear learner, how is a government budget related with its various programs?

19
Budget is not just an annual affair; it affects the day-to-day actions and decisions of the
management at all levels. There is a strong relationship between government budget and
government programs. Government has different programs and these programs must be related
with the budget. In other words the budgeting and programming must go hand in hand. The
previous year’s budget determines the programs which are being conducted currently and the
current year’s budget shapes the programs which are to be recommended in the budget under
preparation. This is because; most of the time, the lifetime of programs is more than one year and
require subsequent funding in subsequent years.

In a static world/situation we can assume there is no change in population, technology, etc. in

such a situation the relationship between programming and budgeting is very simple. But it is
unrealistic to assume to be in a static situation because we live in a world of dynamic situations
where different variables change. These changes affect the smooth implementation of
government programs. So, there should be thorough consideration and flexibility in the
budgeting process. That is why in many countries the budgeting and programming processes take
many months.

2.2. Phases of the Budget Cycle

? How is a government budget prepared?

The budget cycle has four phases which are discussed below.

Phase 1: Budget preparation

It is a two way flow. Decisions are made at operating levels and move-up to higher level, and
then policies and decisions are made at higher level and move-down to operating levels. At the
beginning of the budget cycle the budget office makes a budget call. The budget call shows the
necessary information to be provided by the units such as technical information, reports to be
provided by the units and forms to be filled by the units. Together with the budget call, a specific
letter is sent. This letter shows the economic assumptions on which the budget is going to be
prepared – for instance, whether national income is going to increase or decrease and the amount
of increase or decrease, the price level increase, etc. This forms the basis for the estimation of the
costs of the materials and supplies.

The budget preparation starts at operating levels. The budget office conducts a discussion with
departments and agencies regarding their requirements for the coming year, and the acquired
information forms the framework for the budget for the next year. In addition, there are budget
hearing meetings, which are internal to the budget office. These meetings are not given publicity
because there are Senior Budget Examiners attending the meetings. Budget hearing meetings can
20
also be conducted informally. The budget officers of each operating units attend the meetings
and defend their estimates which they have submitted. The budget examiners ask so many
questions regarding the estimates and in responding to these questions the budget officers of the
operating units can take assistance of their technical staffs. On the basis of the budget hearing
meetings, the examiners propose recommendations and it will be transmitted to the concerned
body for approval.

Phase 2: Budget approval

The proposed budget needs to be approved by the parliament. This bill to be presented to the
parliament is called appropriation bill. The parliament discusses on this bill and parliamentary
members can express their ideas and suggest changes. This bill has to be voted and endorsed by
the parliament.

Phase 3: Budget apportionment

It is a procedure for release of budget authorizations. After the budget is endorsed by the
parliament, there comes the issue of budget authorization. There is some difference in budget
authorization. Budget authorization is related with the authority to spend the endorsed budget.
Some budget authorizations are directly given to the spending agencies and departments, while
budgetary items such as military expenses are given to the President or the Prime Minister (the
Head of the State or the Head of Government). Budget apportionments are cumulative in nature
that an amount which is not used in one period is available for spending in latter periods of the
same fiscal year. But the agencies must report the current status of cumulative apportionments,
expenditures, etc.

Phase 4: Auditing – the resource control

In most countries, there is an office called General Audit Office (GAO). The function and
responsibility of this office is settlement of the accounts of public funds. There are different
types of auditing conducted by this office.

a) General auditing: is examination of accounts of administrative offices which have been

entrusted with public funds. The General Auditing Office examines the legality of all the
transactions of administrative offices.

b) Commercial auditing: is mainly used in case of government enterprises and corporations.

These enterprises maintain their accounts on commercial basis in forms such as balance
sheets and profit and loss accounts. The General Auditing Office examines the legality of
such accounts.

21
 c) Comprehensive auditing: this type of auditing is used for agencies and departments which
have established their systems of accounting. The General Auditing Office examines the
legality of the transactions of such agencies and departments based on the criteria set by
their system of accounting.

After auditing the General Auditing Office sends a report to the parliament and the parliament
can conduct investigations about the financial matters.

 Activity-2
1. Why does government budgeting has to go hand in hand with government
programming?
___________________________________________________________________
___________________________________________________________________
_____________________________________________________.

2. Discuss the major tasks of the four phases of the budgeting process.
___________________________________________________________________
___________________________________________________________________
___________________________________________________________________
___________________________________.

Section Three: Structure and Components of a Budget Receipt

Section Overview
Dear distance learner, welcome to the third section of this unit! In this section you are going to
learn about budget structure and components of a budget receipt. This section first discusses the
different types of funds and accounts kept by the government and then proceeds to the discussion
of the structure and the components of a government budget. The structure of government budget
is discussed in terms of the classification between recurrent and capital budgets and between
revenue and expenditure budgets. At the end of this section the different components of a
government budget bill are summarized in a box.

Section Objectives
Up on successful completion of this section, you will be able to:
• identify different kinds of funds and accounts kept by the government, and
• describe the structure and the different components of a government budget.

22
3.1. Government Accounts

? What are the accounts kept by a government to reserve its revenues and from which it
spends?

Before discussing the components of government budget it is important to see some types of
funds/accounts of the government. The three most important kinds of government accounts are
consolidated fund, contingency fund and public account. These three types of accounts are
discussed below.

Consolidated fund: all the revenues of the government go to the consolidated fund. Spending
from the consolidated fund requires the permission of the legislative.

Contingency fund: along with consolidated fund there is another type of fund called contingency
fund, which is used to meet unforeseen expenses and urgencies. This fund is kept in the form of
imprested money and it is at the disposal of to the President or the Prime Minister (the Head of
the State or the Head of Government). Emergency fund can be withdrawn without approval of
the parliament and latter it will be replenished that an equivalent amount will be withdrawn from
the consolidated fund with the approval of the parliament and deposited with the consolidated
fund.

Public account: another type of account kept by the government is public account. In this case
the government acts like a banker as this account is established from small savings and
collections from the public such as provident fund and pensions. Such funds are retained by the
government, but it is to be repaid to the public latter. The government can cover some of its
expenditures from public account and latter reserve it back from its revenue. Parliamentary
authorization is not necessary for expenditures from public accounts.

? How can a government budget be structured, and what are the components of a
government budget bill?
Budget structures are the formats that organize budget data. The structure of the government
budget can be discussed in terms of two ways of classification. The first classification is between
revenue budget and expenditure budget, and the other way is in terms of the classification
between recurrent and capital budget. These classifications are discussed below.

I. Revenue Budget Vs Expenditure Budget

a) Revenue Budget

23
Revenue budget represents the annual forecast of revenues to be raised by government through
taxation and other discretionary measures, the amount of revenues raised this way differ from
country to country both in magnitude and structure, mainly due to the level of economic
development and the type of the economy.

Ordinary revenues include both tax and not-tax revenues. The tax revenues being direct taxes
(personal income tax, rental income tax, business income tax, agricultural income tax, tax on
dividend and chance wining, land use fee and lease); indirect taxes (excise tax on locally
manufactured goods, sales tax o locally manufactured goods, service sales tax, stamps and duty);
and taxes on foreign trade (customs duty on imported goods, duty and tax on coffee export).
Non-tax revenues include charges and fees; investment revenue; miscellaneous revenue (e.g.
gins); and pension contribution. The second major item in revenue budget is external
assistance. It includes cash grants; these are grants from multilateral and bilateral donors for
different structural adjustment programs; and technical assistance in cash and material form. The
third item is capital revenue. This could be from domestic (sales of movable properties and
collection of loans), external loan from multilateral and bilateral creditors mostly for capital
projects, and grants in the form of counterpart fund.

b) Expenditures Budget

Government expenditures for administration and developmental activities are handled through
the expenditures budget. Expenditure budget can be categorized in two ways. The first
categorizes expenditure in to plan and non-plan expenditure and the other way categorizes
expenditure into recurrent and capital expenditures. When we see the first categorization,
government expenditure can be plan expenditure and non-plan expenditure. Plan expenditure
shows provision of fixed amount of expenditure for various ministries and regional governments
for their plans and schemes. It includes both revenue expenditure and capital expenditure. Non-
plan expenditure is expenditures which are not included in the plans. It includes both
developmental and non-developmental expenditures. Non-plan expenditure includes interest
payment, pension payments, defense expenditure, internal security, etc.

The categorization of expenditure into recurrent and capital expenditures gained acceptance
since the Great Depression of the 1930s. The recurrent budget which covers the current
expenditures is financed in principle by taxation (more broadly by domestic revenue from tax
and non-tax sources), and the capital budget which covers the acquisition of newly produced
assets in the economy is financed through external borrowing and grants.

The acceptance to this categorization of expenditures is related to the general change in the
perception of deficit. Prior to the 1930s, budget deficits were considered to be reprehensible and
24
indicate bad financial management. Over the years, however, the cardinal rule of balanced
budget was changed in favor of cyclical budget, and functional finance.

This change in the rule of budgeting, in turn, resulted in several approaches to measuring and
understanding the deficit some of the concepts that were developed include:

a) The public debt concept of deficit

b) The net worth concept of deficit
c) The overall deficit, and
d) The concept of domestic deficit

To illustrate these four approaches of measuring deficit, we can employ a simplified budget
balance given in the table below.
Revenues Expenditures
A. Tax and Non Tax Revenues C. Recurrent Expenditure
B. Net Borrowing D. Capital Expenditure
A+B C+D
Table: A Simplified Budget Balance

The public debt concept of deficit defines budget deficit as the difference between revenue (A)
and recurrent expenditures (C) and capital expenditures (D) this measure A-(C+D) is equal to net
borrowing (B), and the budget is considered to be balanced if net borrowing remains unchanged
from previous years or is equal to zero. This approach illustrates, the understanding prior to
1930s, which emphasized balanced budget as a prudent fiscal policy.

The emergence of active fiscal policy (i.e. government could borrow as long as that liability is
matched by an increase in assets) right after the depression led to the development of the net
worth concept of deficit. Referring to the table above, the net worth is defined as the difference
between recurrent expenditures and tax and non-tax revenues (C-A), which is equal to the excess
of net borrowing over capital expenditures (B-D) this measure of deficit requires the division of
expenditures into current and capital budgets, with the latter being financed by borrowing.

The concept of the overall deficit or balance has several connotations and methods of
construction. The common practice is to put revenues, expenditures, and borrowing as distinct
groups. Each budget category may then be related economic activity being computed as a ratio of
GDP, which then becomes a first approximation and an important single measure of the impact
of government fiscal operations.

25
The domestic balance concept is a family of the overall budget deficit and it became prominent
after the oil price increases in 1973/74. The basic argument being, in countries that had large
revenues, expanded incomes from government expenditures placed strains on the domestic
economy and spurred inflationary pressures. In such cases, budget surpluses will have an
expansionary effect. Under such circumstances the overall budget deficit or surplus measure
would be misleading to guide government policy. In fulfilling the requirements of oil producing
countries and others in similar circumstances, the technique of splitting the domestic balance is
the component of the overall balance from which external budget transactions have been
excluded.

II. Recurrent Vs Capital Budget

The definition of recurrent and capital budgets has been a common problem in most countries.
The problem relates to delineating, which specific expenditures need to be included in the
recurrent budget and which ones in the capital budget. In practice three criteria have been in use
to define budget into capital and recurrent. These are sources of finance, object of expenditure,
and nature of activity. Capital budgets were originally defined by western governments by the
source of finance, i.e., capital expenditures are financed from loan not current revenue. The
object of expenditure refers to the particular activities to be performed with that budget like,
formation of fixed assets, study and design, salaries of civil servants, etc. The third criteria, the
nature of activity, refers to whether the activity is short term (i.e. project) or ongoing (that may
not terminate in a specific period), and objective specific. The basic characteristics of recurrent
budget and capital budget are discussed below.

a) Recurrent Budget

Recurrent budget consists of recurrent receipts and recurrent expenditure. Recurrent receipts
include tax revenues and non-tax revenues. Recurrent expenditure, on the other hand, can be plan
or non-plan expenditure. Recurrent expenditure is supposed to be met from recurrent receipts.
Recurrent expenditure is used for the normal running of government departments and it does not
lead the creation of any kind of asset.

b) Capital Budget

Capital budget consists of capital receipts and capital expenditure. Capital receipts can take
different forms like borrowing from the central bank, loans raised by the government from the
public which is called market loan, and loans received from abroad including external assistance.
Capital expenditure includes government expenditure on items like land, buildings, machineries,
equipments, etc. This is why capital expenditure is sometimes called development expenditure.
26
In relation with the above budget components, there are two important types of deficits called
recurrent deficit and budget deficit. These types of deficits can be given by the formula below.

Recurrent Deficit = Recurrent Receipts – Recurrent Expenditure

Budget Deficit = Total Receipts – Total Expenditure (on both revenue and capital accounts).

In most of the third world countries there is always deficit in the recurrent account and the
governments have to borrow to cover such deficits. In principle, there should always be surplus
in the recurrent budget and this surplus has to be used to finance the capital expenditure. But this
is an ideal situation. In practice, most countries have recurrent deficit as a result of problems in
recurrent receipts, especially tax revenue because of corruption and inappropriate tax collection
practices that allow tax-evasion and tax-avoidance.

Components of the Budget Bill

1) Revenue
2) Tax revenue
3) Non-tax revenue
4) Capital Receipts
5) Recovery of loans
6) Borrowing and other liabilities
7) Other receipts
8) Total Receipts (1+4)
9) Non-plan Expenditure
10) On revenue account
11) On capital account
12) Interest paying and debt servicing
13) Plan Expenditure
14) On revenue account
15) On capital account
16) Total Expenditure (9+13)
17) Revenue expenditure (10+14)
18) Capital expenditure (11+15)
19) Revenue Deficit (17-1)
20) Fiscal Deficit (16 – [1+5+7])
21) Primary Deficit (20-12)

Figure 2.1: summary of components of the budget bill

27
  Activity-3
1. What are the different kinds of funds and accounts kept by the government?
___________________________________________________________________
___________________________________________________________________
__________________________________________________.
2. Discuss the two ways of classification of components of the government budget.
___________________________________________________________________
___________________________________________________________________
___________________________________________________________________
_______________________________________________________.

Section Four: Systems of Budgeting

Section Overview
Dear distance learner, welcome to the fourth section of the second unit of this module! In this
section you are going to learn about types budgeting systems. This section is further divided in to
two sub-sections. The first sub-section deals with a way of determining government budget
known as ‘incrementalism’ and the second sub-section discusses program budgeting and line
item budgeting in comparison.

Section Objectives
Up on successful completion of this section, you will be able to:
• describe the concept of incrementalism as a system of determining government budget
• differentiate between program budgeting and line item budgeting

4.1. Types of Budgeting Systems

4.1.1. Incrementalism

? Dear learner, what do you think is incrementalism in budgeting?

One way of budget determination, called incrementalism, suggests that an agency’s budget in
one year will tend to be its last year's budget plus some additional increment. Taken at face
value, the theory of incrementalism suggests that legislature and executive do not exert very
much control over the budgetary process. The government budget is complex and with so many
agencies demanding and receiving appropriations, it is difficult to fully review each agency's
requests. This is especially true when the agencies produce nothing relating to profits and losses
28
by which spending can be evaluated. As a result, incrementalism suggests that the budgets of
government agencies will tend to be incrementally larger than they were the previous year. This
incremental growth of government agencies tends to be descriptive of their budgets over time,
but the idea of incrementalism deserves a closer look if it is to be taken as a way of government
budgeting.

In addition to the difficulty of determining how effective various budgetary appropriations are,
the influences of special interests, including the agencies themselves, are an important element in
the budgetary process. Each program has constituents that benefit from the program and,
therefore, will be very knowledgeable about it. To eliminate, or even reduce, the program will
harm these special interests while perhaps benefiting the general public, but recall that the
general public tends to be rationally ignorant of most of what the government does. This means
that individuals probably will be unaware of the benefits of reducing the expenditure. As a result,
political pressure ends to work toward expansion rather than reduction of existing programs. If
budgetary increases are spread among the interest groups favoring various programs, incremental
growth would result.

Incrementalism can easily be understood from two different perspectives. It makes sense within
the framework of the special interest theory of government. Whereas special interests want to see
appropriations to the programs that benefit them increased, the general public has little incentive
to lobby for a cut in a program because the benefits from a cut will be dispersed throughout the
nation and would not benefit anyone very much. Thus, concentrated interests have more
influence than the diluted interest of the general public. Furthermore, the government must
decide which interests to favor with budget increases. For political reasons, the way to maximize
political support is to spread the budget increases around so that everyone gets something.

Incrementalism also makes sense when the complexity of government spending is considered,
keeping in mind that there is no profit and loss indicator to suggest where federal expenditures
are being best spent. In the absence of a clear-cut indicator of the success of a government
program, a legislature may be able to do no better than to increase program budgets by about the
same amount. Programs that appear to be more successful might be increased a little more, while
those that appear unsuccessful might be increased a little less, but on programs for which there is
no clear consensus, increases might take place at roughly the same rate. In this light,
incrementalism becomes a reasonable rule of thumb for making budgetary decisions in the
absence of perfect information.

In actual fact, the increments by which budgets increase for different programs vary
substantially, both for different agencies and for the same agency over time. This suggests that

29
incrementalism cannot be a complete theory of the government budget process. Reflecting on the
difficulty of determining the effectiveness of government expenditures, incrementalism may
make some sense. Programs that are popular or that show increasing demands will be increased
by larger increments, while those that are less in demand will receive smaller budgetary
increments.

This view of incrementalism shows it to be a rational economic policy, given the limited
knowledge about the efficacy of particular government programs. If a program does not appear
to be cost-effective at the margin, the solution is to reduce the budget (or increase it by a smaller
increment than the budget as a whole) until the program provides a satisfactory rate of return.
Likewise, a program that appears to be a good value for the money should rationally be increased
by a larger increment until the additional increments no longer appear worthwhile. And although
it is often difficult to evaluate the costs and benefits of government programs, this should not
deter us from trying.

4.1.2. Program Budgeting Vs Line-item Budgeting

? Dear learner, can you guess the difference between program budgeting and line item
budgeting?
There are some principles of budgeting that make the budgeting process more rational and that
can help to better evaluate which expenditures would be most cost-effective. One way is to
organize budgetary expenditures into programs rather than by line item. A program budget
groups expenditures by the program goals they are intended to achieve, whereas a line item
budget groups expenditures by the types of items that are purchased. For example, a university’s
budget might be organized according to line item, including expenditures for faculty salaries,
utilities, office supplies, building maintenance, and so on. Alternatively, the budget could be
composed of expenditures on business education, arts and sciences, engineering, and so on. In
this case, the budget is composed of programs, so it is a program budget. Each of these budgets
could be broken down further, of course. In the line item budget, office supplies would include
paper, pencils, and photocopier toner. In the program budget, business education could be broken
down into economics, accounting, finance, and so on. The principle is that line item budgets
enumerate the items purchased, whereas program budgets enumerate the objectives sought.

Line item budgets can be useful at times, but they do not give much insight into whether the
budgeted expenditures are being effectively spent. How would one evaluate, for example,
whether Birr 2,000 is too much to spend on pencils? The answer lies in the value of the output
that the pencils produce. Combined with other resources, the pencils are intended to produce a
certain output, and the effectiveness of expenditures can best be measured by comparing the

30
level of expenditures on a program with the benefits that the program produces. Thus, to evaluate
the effectiveness of government expenditures, they should be grouped by program wherever
possible, so that the costs of attaining certain objectives can be compared with the benefits.

4.1.3. The Planning-Programming-Budgeting System

This type of budgeting system has its origin in the American government. When President
Kennedy took office in 1961, he instituted a reform in the procedure by which the Bureau of the
Budget evaluated projects. He instituted a system called Planning- Programming-Budgeting
System (PPBS), in which government expenditures were grouped by objective to facilitate the
undertaking of cost-benefit analyses of the programs. Under PPBS, the government first defined
the objectives sought by the government activity, then considered alternatives for achieving the
objectives, and finally undertook cost-benefit analyses that would compare the costs and benefits
of each alternative. President Johnson was so impressed with the system that in 1965 he required
all executive agencies in the federal government to participate in PPBS. The requirement was
dropped under President Nixon in 1971, but, by then, cost-benefit became a standard part
analysis was firmly established as a tool for evaluating the merits of federal programs.

In some instances, such a system may work well, but, in other cases, it is not well budgeting in
the 1960s suited to the types of decisions that the government must make. If a program requires
major overhaul, a cost-benefit analysis would be likely to give some indication, but the analysis
itself does not give an indication of how the program should be changed. Typically, a cost-
benefit analysis of a current program will show that it is cost-effective as it is. Partly, this may be
because of the biases of those who are doing the analysis. This type of analysis is likely to be
most useful when considering whether a new program should be implemented. The PPBS system
originally implemented by President Kennedy has not been maintained into the present, but one
concept that has survived is the use of program budgets to help evaluate the cost-effectiveness of
government spending.

Budgets should be organized along program lines rather than as line item budgets to facilitate an
evaluation of the effectiveness of government spending in particular areas. Although such an
analysis is not done for every program every year, it is an important part of the process by which
new programs are considered for adoption. The principle of cost-benefit analysis is fairly
straightforward. One simply compares the costs and benefits of a program to see that it generates
net benefits. But a number of difficult problems arise in actually carrying out such an analysis.

31
 4.2. Cost-Benefit Analysis

Cost-benefit analysis is intended to compare the costs and benefits of a program and typically
will be carried out when a program is in its planning stages to see whether the program should be
enacted. This requires that both the costs and the benefits of a project be weighed, which means
that they first must be estimated. The various steps involved in undertaking a cost-benefit
analysis are outlined here to show the potential problems involved.

Step one: Enumerating the options

The first step is to enumerate the options available. Sometimes the only option will be to
undertake or not to undertake the project, but often other options will present themselves. For
example, if a bridge is being considered, a number of potential sites may exist, several types of
bridges might be built, and even the number of lanes can vary. Perhaps a ferry would be better
than a bridge in some locations.

Step two: Enumerating the costs and benefits

The next step is to enumerate the costs and benefits of each option, thus allowing the analyst to
see what costs have to be compared with what benefits. Enumeration of the costs and benefits is
not always easy. Not only might some benefits or costs be over-looked, but some might also be
counted twice if the analyst is not careful. In addition, there may be secondary effects that should
be included in the analysis.

Step three: Converting the costs and benefits to monetary terms

Once the costs and benefits are enumerated, they must be converted to monetary terms so that
they can be compared. The costs are usually easier to estimate than are the benefits because they
tend to be expressed in the form of money. By contrast, the benefits of government programs
usually do not accrue as money. For example, if a dam is to be built, the cost of purchasing the
land to be flooded, in addition to the construction costs of the dam, must be evaluated. Other
costs are relevant as well. For example, some roads may be diverted, increasing the travel time of
some individuals. Also, the land to be used typically will be condemned, forcing some
individuals to sell when they would rather stay. And possible environmental damage must be
factored into the analysis, even though it is often difficult to place a monetary figure on
environmental damage. All in all, the costs may not be as easy to total as it first appears.

The benefit side of the equation is even more difficult to convert into monetary terms. A dam
may produce some hydroelectric power, which then can be evaluated at the market rate for

32
electricity, but even this is speculative because energy prices may change before the dam is
completed. The lake that results from the dam may have recreational benefits such as fishing and
boating, but these types of benefits are not easily measured in monetary terms. Nevertheless, a
successful cost-benefit analysis must attempt not only to enumerate but also to attach monetary
figures to the costs and benefits of a project so that they can be compared on the same terms.

 Activity-4
1. What are the justifications for the application of incrementalism in government
budgeting?
___________________________________________________________________
_________________________________________________________.
2. Discuss the difference between program budgeting and line item budgeting.
___________________________________________________________________
___________________________________________________________________
______________________________________________________.
3. What are the steps in conducing cost-benefit analysis of programs?
___________________________________________________________________
___________________________________________________________________
____________________________________________________.

Section Five: Budgeting in Ethiopia

Section Overview
Dear distance learner, welcome to the fifth section of this unit! In this section you are going to
learn about budgeting in the Ethiopian context. This section is further divided in to two sub-
sections. The first sub-section deals with budget structure in Ethiopia and the second sub-section
discusses the different steps that are followed to prepare the budget of the Federal Government in
Ethiopia. As the discussions in this section are practical to our own context, we hope that you
will read these discussions with much interest.

Section Objectives

Up on successful completion of this section, you will be able to:

• describe the structure of the budget in Ethiopia, and

• identify the steps followed to prepare the budget of the Federal Government in Ethiopia.

33
Commonly government budget is prepared for a year, known as a financial year or fiscal year. In
Ethiopia the fiscal year is from July 7 of this year to July 6 of the coming year (Hamle 1-Sene 30
in Ethiopian calendar). Budgeting involves different tasks on the expenditures and revenues sides
of government finance.

5.1. The Budget Structure in Ethiopia

? What do you know about the budget structure of the Ethiopian government?
In Ethiopia the definition of recurrent and capital budgets follow a combination of some criteria.
These are:
1. Recurrent budget is to be covered by domestic revenue from tax and non-tax sources. But
the economy could borrow to meet its capital budget.

2. The financial proclamation 57/1996 and financial regulations 17/1997 defined capital
budget based on the object of expenditure. Accordingly capital budget equals capital
expenditure which equals fixed assets and consultancy services.

3. Short-term activities that are project in nature are included in capital budget while those
activities that are recurring and continuous in nature are put in the recurrent budget. In
some instances activities with a very long life period have been entertained in the capital
budget. Since fiscal year 1994/95, efforts have been exerted to identify many such projects
that have been categorized under recurrent budget (projects in Education, Health and
Agriculture sectors). The exercise does not seem complete, as there are projects with
recurring nature (e.g. Agricultural Research) though attempts have been made to isolate the
investment components.

The expenditure budget includes the following two types of budgets: Recurrent Budget and
Capital Budget.

i. Recurrent Budget

Financial proclamation 57/1996 and financial regulation 17/1997 defined only the capital budget,
implicitly defining the recurrent one as a residual. To common practice, however, is to include in
the recurrent budget expenditures of recurrent nature (like salaries of civil servants) and fixed
assets with a multi-year life. The recurrent budget is structured by implementing agencies (public
bodies) under four functional categories: administrative and general services, economic services,
social services, and other expenditures. All public bodies then fall under one of these functional
categories. The budget hierarchy will then be down to sub-agencies.

34
ii. Capital Budget

Capital budget is budget for capital expenditures. Financial proclamation 57/1996 defined capital
expenditure as ‘an outlay for the acquisition of improvements to fixed assets, and includes
expenditures made for consultancy services’. Financial regulations 17/1997 further provided a
detailed definition of capital expenditures to include the following:

a) The acquisition, reclamation, enhancement as laying out of land exclusive of roads,

buildings or other structures

b) The acquisition, construction, preparation enhancement or replacement of roads,

buildings and other structures

c) The acquisition, installation or replacement of movable plant, machinery and

apparatus, vehicles and vessels

d) The making of advances, grants or other financial assistance to any person towards
him/her on the matters mentioned in (a) to (c) above or in the acquisition of
investments

e) The acquisition of share of capital or loan capital in anybody corporate

f) Any associated consultancy costs of the above.

Capital budget could thus broadly be described as an outlay on projects that result in the
acquisition of fixed assets and the provision of development services (Ministry of planning and
Economic Development, 1993:4). Therefore, capital budget has a wider coverage than simple
outlays in fixed investments, since it includes expenditure on development services like
agricultural research and transfer payments related to a project.

The capital budget is presented under three functional groups. These are economic
development, social development, and general development. Economic development includes
production activities (agriculture, industry, etc.), economic infrastructure facilities (mining,
energy, road etc.), commerce, communication, and so on. Social development includes
education, health, urban development, welfare and, so on. General development include
services like cartography, statistics, public and administrative buildings, etc.

In Ethiopia, both recurrent and capital budgets are presented by line items (or code of
expenditures). Thus, the budget for the sub agency or department in the case of recurrent will
be prepared by such line items as salaries, office supplies, etc. Similarly, the capital budget for
projects will be prepared by such line items as surveys and designs, equipment and machinery,

35
 operating cost, and so on. In Ethiopia, recurrent and capital budgets are prepared by line items.
Budget request and disbursement are then performed by line items.

5.2. The Budgeting Process at the Federal Level

? How is the budget of the federal government of Ethiopia prepared?

The budget processes at the Federal level follows sequential and iterative steps. Let us briefly
explain these steps one by one here under.

Step one: Preparation of macro-economic and fiscal framework

The preparation of the macro-economic and fiscal framework is basically a component of the
Public Investment Program (PIP). It is a planning practice that determines the overall level of
government expenditures based on policies related to the role of government in the economy,
government deficits, and priorities for resource allocation between regions and sectors. For the
Federal government the framework is a three years forecast and will be updated each year.

The framework is composed of macro-economic forecast and fiscal forecast. The macro-
economic forecast gives the forecast of Gross Domestic Product based on past performance and
estimates for future years, and provides base line information in preparing the fiscal forecast.
Financial Regulation 17/1997 gave the responsibility of preparing this framework to the Ministry
of Finance and Economic Development (MoFED). The fiscal forecast establishes the level of
total resources available for expenditure and it provides a more detailed forecast of revenue (both
Federal and Regional), end projection of expenditure. Given the policy of no borrowing from
domestic banks to finance budget deficit the level of expenditure mainly depend on the amount
of resources to be raised in the form of domestic revenues and external fund that include
counterpart funds. Once prepared by the concerned coordinating ministry, MoFED, it will be
reviewed and approved by the Prime Minister’s Office (PMO).

Step two: Determination of federal government expenditure and subsidy to regional governments

After the revenue and expenditure of the government are estimated through the fiscal framework,
the PMO will decide on the shares of Federal Government expenditures and subsidies Regional
Governments. It is known that, following the decentralization policy, Regional Governments
took grants from the Federal Government in the form of subsidy.

Once the amount of subsidy is known, the allocation among regions is determined on the basis of
a formula. Initially the formula was composed of five parameters (population, level of
development, revenue generating capacity, utilization capacity, and land area). At present,

36
however, the formula takes account of three parameters: population, the level of development,
and revenue generating capacity of each region which are given a relative weight of 60%, 25%
and 15%, respectively. This allocation is first prepared by MoFED, and then reviewed by the
PMO and finally approved by the House of peoples’ Representatives.

Step three: Allocation of federal expenditure between recurrent and capital budget

The practice in the allocation of recurrent and capital budget is to consider the latter as a residual.
That is, first the amount of budget necessary to cover such recurrent expenditures like pensions,
debt servicing, wages and non-wage operating costs are determined. The balance will then be
allotted to capital expenditures. This is performed by the PMO in consultation with MoFED.

Step four: Budget call and ceiling notification

This includes two items. These are recurrent budget and capital budget. With regard to recurrent
budget, MoFED releases the budget ceiling to the line ministries in a budget call. The budget call
provides each ministry such information as the macro-economic environment, an aggregate
recurrent budget ceiling, and priorities to budget. With regard to capital budget, MoFED issues
detailed capital budget preparation guidelines to spending public bodies along with the ceilings
provided to each line institution. MoFED sets the ceiling for each sector.

Step five: Budget review by MoFED

This includes two items. These are Recurrent Budget and capital budget. Regarding recurrent
budget, prior to a formal budget hearing, spending public bodies submit their budget proposals to
the MoFED-Budget Department. In consultation with spending public bodies, MoFED prepares
an issue paper on major issues at each head level in the proposed budget. Here, spending public
bodies can submit above the ceiling but need to have a compelling justification. Concerning the
capital budget, the sector departments of MoFED review the capital budget requests from
different public bodies. At this stage projects are screened. If there exists a discrepancy between
the respective sector department and the public body, a series of discussions are held to reach
agreement. After such a process the various sector departments of MoFED submit their first
round recommendation to the Development Finance and Budget Department of MoFED. Then it
is consolidated and prepared for the capital budget hearing and defense.

Step six: Budget hearing and defense

This step also has different procedures for recurrent budget and capital budget. For recurrent
budget, spending public bodies defend their budget submission in a formal hearing with the
MoFED. The issue paper is the basis of the hearing. The hearing focuses on policies, programs

37
and cost issues, when necessary it might involve discussion down to line item. Spending public
bodies could also challenge the ceiling. The hearing is presented by ministers and/or vice
ministers, heads of public bodies and the MoFED.

For capital budget, spending public bodies are called to defend their projects to a budget hearing
convened by the PMO which is chaired by the Prime Minister or the Deputy Prime Minister or
the their economic advisers. The hearing customarily includes a review of status of the projects,
implementation capacity of the institutions, compatibility with the country’s development
strategy and policy, cost structures, and regional distribution. A project description is presented
which includes objectives of the project, main activities of the project, status of the project, total
cost, past performance of the project, source of finance, and whether the project is accepted or
rejected by MoFED. On the basis of the discussion the respective sector departments of MoFED
in consultations with the spending public body will further refine the capital projects.

Step seven: Review and recommendation

Different procedures are also followed for recurrent budget and capital budget in this step. For
recurrent budget, the budget committee of the MoFED reviews the hearing discussion and makes
recommendations. If there is an increase (over ceiling), it goes to the PMO for approval. With
regard to capital budget, sector departments of MoFED give a final recommendation to the
Development Finance and Budget Department of MoFED. This is then be compiled and put in
appropriate formats for submission to the Council of Ministers.

Step eight: Submission to the Council of Ministers

At this stage the two budgets (recurrent and capital) are be consolidated, and MoFED prepares a
brief analysis of the total budget. For recurrent budget, the recommended budget will be
submitted to the deputy Prime Minister for Economic Affairs. This will first be reviewed by
ministers and vise ministers in economic affairs, and then presented to the Prime Minister along
with a brief. The Prime Minister may or may not make amendments and then the budget will be
sent to the Council of Ministers for discussion. For capital budget, a brief analysis of the capital
budget will be prepared by MoFED on the final recommended budget and, along with the
consolidated capital budget, will be submitted to the Council of Ministers. MoFED will defend
the budget in the council. The council of ministers may make some adjustment and the draft
capital budget will pass the first stage of approval.

Step nine: Submission to the House of Peoples’ Representatives

38
Once approved by the council of ministers, the Prime Minister will present both the recurrent and
capital budget to the House of Peoples’ Representatives. The budget will then be debated based
on the recommendation of the budget of the committee.

Step ten: Notification and publication

The approved budget then gets legal status through the publication in the ‘Negarit Gazeta’.
Spending public bodies will then formally be notified of their approved budget by line items
from MoFED for recurrent and capital budgets. The final stage of the budgetary process is to
request spending public bodies to prepare adjusted work plan and cash flow for the approved
budget. The adjusted work plan and cash flow will be verified by MoFED.

 Activity-5
1. What are the criteria followed to distinguish between recurrent and capital budgets in
Ethiopia?
_____________________________________________________________________
_____________________________________________________________________
_____________________________________________.

2. Discuss the steps followed to prepare the budget of the federal government in Ethiopia.
_____________________________________________________________________
_____________________________________________________________________
_____________________________________________________________________
______________________________________________.

Unit Summary
The government budget reflects the financial plan of the government to perform its activities.
Budget is a comprehensive plan of action, which brings together in one consolidated statement
all financial requirements of the government. Budget is a guideline for decision making and
center of government revenue and expenditure for a specific period of time, usually a year.
Budgeting has several advantages/functions. First, budget can be used as an instrument of
planned implementation. Second, budgeting helps proper allocation resources between
competing. Third, budge is an instrument for regulation of the economy. In addition, budge is an
instrument for strengthening public accountability in the use of resources. It is also an instrument
for democratic control over the executive, i.e. legislative control over the executive. The budget
cycle, a process by which government budget is prepared, implemented and evaluated has four

39
phases. These four phases are budget preparation, budget approval, budget apportionment and
auditing.

Budget structures are the formats that organize budget data. The budget data can be organized in
terms of the classification between recurrent and capital budgets or in terms of the classification
between revenue and expenditure budgets. There are different types of budgeting systems, as far
as how government budget can be prepared is concerned. One way of determining government
budget is known as incrementalism. Incrementalism is a principle that an agency’s budget in one
year tends to be its last year's budget plus some additional increment. The other principles of
budgeting that make the budgeting process more rational and that can help to better evaluate
which expenditures would be most cost-effective are known as program budgeting and line item
budgeting. A program budget groups expenditures by the program goals they are intended to
achieve, whereas a line item budget groups expenditures by the types of items that are purchased.

In Ethiopian context, the budget is structured in terms of recurrent and capital budgets and also in
terms of revenue and expenditure budgets. The budgeting process at the federal level involves
various actors which have critical roles including the operating agencies/ministries, the Prime
Minister’s Office, the Ministry of Finance and Economic Development (MoFED), the House of
People’s Representatives, and the Council of Ministers. Different steps which involve interaction
among these actors are followed in the preparation of the budget of the federal government. We
hope that you have grasped the discussions in this unit.

 Check List
Direction: Dear distance learner, this is the section in which you self-assess your understanding of
the discussions in this unit. Put a tick mark () in the yes column for activities that you have clear
understanding and in the no column for activities that you doubt that you have good understanding.

I Can: Yes No

• Explain the concept and functions of government budget

• Describe budgeting process and budgetary cycle
• Explain budget structure and components of a budget receipt
• Identify the types of budgeting systems
• Discuss the budgeting process in Ethiopia

N.B: If you have any doubt about your understanding of any of the above checklists, don’t hesitate to
go back and refer the discussions in the sections!

40
  Self-Test Exercise
Shortly and briefly discuss the following questions.

1. What is a government budget?

2. What are the advantages of budgeting?
3. Discuss the relationship between government budgeting and government programming.
4. Discuss the four phases of budgeting.
5. Explain the difference between capital budget and recurrent budgets, and between revenue budget
and expenditure budgets.
6. What is the difference between program budgeting and line item budgeting?
7. Describe the different steps followed in the preparation of the Federal Government budget in
Ethiopia.

41
 UNIT THREE

MONETARY AND FISCAL POLICIES

Unit Introduction
It has already been discussed that any function of a government requires financing. It is also
imperative to regulate and handle them in view of some national parameters. Economic policies
do more harm than good if it is based on a mistaken diagnosis of the economic forces at work, or
if those who seek to improve upon market forces lack the necessary understanding and skill.
Employment policy, for example, must adequately understand the causes of unemployment.
Similarly, a policy to control inflation must be based on a view of its causes such as fast growth
of money supply. These are elements of macroeconomic policy that revolve around what is
known as demand management, i.e. regulating spending and thereby, regulating demand. To that
end, this unit is dedicated to the analyses of how governments use two policy instruments
(monetary and fiscal) to regulate national wide financial flows.

Unit Objectives
Dear learner, by the end of this unit you should be able to:

• understand what is meant by fiscal and monetary policies;

• identify and describe the differences between monetary and fiscal policies together with their
instruments, and fiscal decentralization
• discuss how regulatory instruments governments impact the financial matters and the economy
as a whole.

Pre-test Questions

• What do you think is the difference between monetary and fiscal policies together with their
instruments?
• What is fiscal decentralization?

Section One: Monetary Policies and Issues

Section Overview
Money is the backbone of the modern economy. It does not only serve as a medium of exchange
in a way of payment for goods and services, settlement of credit and debts is solely possible with
money. Bank deposits are commonly included in the monetary structure of a country by

42
monetary policies of a nation that has a more direct and immediate impact on the economy. The
prices of goods and services are determined largely or entirely by the volume of money in the
economy. And, this section looks at some of main issues relating to monetary policies.

Section Objectives
Dear learner, by the end of this section you should be able to:

• define monetary policies;

• understand important concepts relating to monetary matters; and
• identify and describe basic instruments of monetary policy used by governments.

1.1. Understanding Monetary Policy and Important Concepts

1.1.1. Definition of Monetary Policies

? Dear student, what do you think is monetary policy? Can you guess how it affects the
circulation of money and nationwide economy?

Monetary policy is a set of economic principles and programmes adopted by a government to

manage the growth of its money supply, the availability of credit, and interest rates. By ‘money’,
we are referring to any medium of exchange that is widely accepted in payment for goods and
services and in settlement of debts. It serves as a standard of value for measuring the relative
worth of different goods and services. The number of units of money required to buy a
commodity is the price of the commodity.

The functions of money as a medium of exchange and a measure of value greatly facilitate the
exchange of goods and services and the specialization of production. Without the use of money,
trade would be reduced to “barter”, i.e. the direct exchange of one commodity for another. In a
money economy, the owner of a commodity may sell it for money, which is acceptable in
payment for goods, thus avoiding the time and effort that would be required to find someone who
could make an acceptable trade. Money may thus be regarded as a keystone of modern economic
life. The amount of money circulating in the economy really matters in determining how better
the system is functioning. Thus, government measures should be devised in such a way to
influence the growth of money and credit as well as the levels of interest rates in the economy.
These are what we often call monetary policies.

Governments use monetary policy, along with fiscal policy (which is concerned with taxation
and spending), to maintain economic growth, high employment, and low inflation. The main
goals for monetary policy are to maintain price and exchange rate stability and safeguard the

43
soundness of the financial system. In most countries, the monetary policy is largely, but not fully,
determined by the central banks (e.g. USA- Federal Reserve, in Ethiopia- the National Bank of
Ethiopia).

1.1.2. Basic Concepts in Monetary Policy

Talking about monetary matters, there are some technical terminologies and concepts that require
elaboration. These include: monetary base, money supply, exogenous and endogenous money,
currency ratio, money multiplier, etc all of which are discussed below.

A. Monetary Base and Money Supply

The monetary base is often termed as high power money. It refers to the currency in circulation
and the commercial banks’ reserve held with the central bank. Commercial banks keep only a
fraction of their deposits as reserves, and money is created when loans are spent by borrowers
and all or part this expenditure is converted into new bank deposits.

Money supply, on the other hand, is amount of money freely circulating in an economy. Money
supply is made up of currency (paper bills and coins) and bank deposits. Money supply is an
important aspect of government monetary policy.

The relationship between monetary base and money supply is conventionally dependent on the
whether the money is exogenous or endogenous.

B. Exogenous versus Endogenous money

The issue of whether money is exogenous or endogenous is a critical interpretation of the

monetary policy. Money is said to be endogenous when it responds passively to expenditure
decisions. In this case, money will have no independent influence on economic activity.

On the other hand, with exogenous money supply, an increase in monetary base (say for
example, due to an increase budget deficit or a rise in foreign exchange reserves, or both) leads to
an increase in currency in circulation. It implies a rise in money supply, which is greater than the
initial increase in the monetary base by the money multiplier (mm).

Money multiplier is the effect of reserves on money supply. It is a measure of changes in the
money supply resulting from changes in bank reserves. The money multiplier can be influenced
by policy. For example, banking rules set a legal reserve ratio (r), and both the currency ratio (c)
and the excess reserve ratio (x) will be affected by the rate of interests and the general climate of

44
confidence. The key point, however, is that with the exogenous money, causation runs from a
change in Mb to a change in Ms in the following manner.

Where, c stands for the currency ratio; r is the reserve ratio; and x is the excess reserve ratio.

A currency ratio is the proportion of deposits of held as cash in central bank. Reserve ratio is the
proportion deposits legally required to be held as reserves with the central bank and the excess
reserve ratio is the proportion of reserves which are above the legally required limit.

Since the factors of monetary base (Mb), i.e. (1+c)/ (c+r+x) is equal to what we call money
multiplier [mm], it can be simplified into the following formula.

Alternatively, if the money is endogenous, the causation is reversed with changes in money
supply resulting from commercial bank operations leading to a change in monetary base. Here,
the effect of money multiplier is the reverse.

Mb= (1/mm) Ms

The mechanism to effect in this change is that in response to investment or consumption demand,
banks see profitable lending opportunities and thus increases their supply of loans (and thus, Ms).
However, some of these loans will be held as cash (due to positive currency ratio c) and to meet
their legal obligations (imposed by the reserve ratio r) banks must increase their reserves with the
central bank when their deposits increase. Both of these effects will increase Mb in response to a
rise in Ms.

For this mechanism to operate, it is necessary for the central bank to undertake lending activities
to commercial banks to allow them replenish their reserves. When central banks operate in this
way, they will not be able to control the money supply as it responds to expenditure decisions.
Yet, they can impose interest rates.

However, it is unlikely for money to be either totally endogenous or totally exogenous. If money
is required to be wholly exogenous, the objective should be to ensure that supply of money (or
credit) grow at a rate that matches the growth of money demand, which is determined primarily

45
by trend in the real output and prices. A rate of money supply growth above necessary will have
an inflationary effect, and the growth of money supply that is below its demand will be
deflationary.

On the contrary, if money is completely endogenous, it remains essentially passive and the key
objective will be determining an interest rate that is appropriate for macroeconomic stability.

Economists disagree on the ultimate effects of changes in the money supply. Two important
schools of economic thought are Keynesianism and monetarism. Scholars who adhere to
Keynesianism believe that an increased money supply can lead to increased employment and
output. On the other hand, monetarists argue that an increased money supply ultimately only
affects prices, leading to inflation, and that output is not increased.

Notwithstanding this quite practical orientation, the literature of targets and instruments of
monetary policy also bears fundamental connections to a variety of broader economic and
political questions. Most obvious among these are the issues of rules versus discretion, and of an
active versus a passive orientation, in economic policy more generally.

1.2. Instruments of Monetary Policy

In most economies, the basic instruments of monetary policy are those mentioned below.

1. Market based approach, which includes two policy instruments: open-market operations
and commercial bank reserve requirement
2. Interest rate intervention
3. Credit control
The market based policies are the most flexible and most frequently used instrument of
controlling the money supply. Open market instruments operate under a situation, for instance,
whereby the government bonds are either sold to or brought from the public by the central bank
to influence the deposit with the commercial banks. A “tight” monetary policy based on such
sales of government bonds will automatically see a shrinking of the monetary base, thus, a
contraction of bank credit leading to rise of interest rates. Although the open-market operation is
the most flexible and the most frequently used instrument of monetary policy, similar results can
be achieved by changing the required reserve ratio, i.e. the percentage of deposits that banks must
maintain on reserve as cash deposits at the central banks.

Usually, other banks may also be required to hold some proportion of their deposit with the
central bank. The increase of the reserve ratio, under ceteris paribus, will reduce the money
supply and vice versa, as the fall of reserve requirements tend to increase deposit and thereby the

46
expansion of credits. When the required reserve ratio is raised up, banks are unable to create as
much money as they previously were able to because a larger portion of their assets must be held
in reserve. The converse is true when the reserve ratio is reduced.

Similarly, the determination and change of interest rate have a direct bearing on the money
supply in the economy. Interest is a payment made for the use of the principal, i.e. the sum of
money loaned, for a given time, usually a year. Putting a direct ceiling of charges on borrowers
will not only curtail the growth of credit from banks but also the demand of borrowers for credit.
Central banks use two types of interest rates known as repo rate and reverse-repo-rate. Repo rate
is rates at which the central bank reserve deposits from the commercial banks. The commercial
banks are supposed to pay a portion of their deposits to the central bank. Reverse-repo-rate is the
rate of interest that commercial banks pay for the credit they obtain from the central bank.

Finally, governments can regulate monetary supply via credit control mechanisms and regulating
operations of the stock (share business) market. It is used as a means of controlling various types
of consumer credit in a way of directly putting limits or ceiling on total credit or patterns of credit
allocation to specific borrowers within the limited framework. The central banks may selectively
lower or raise the margin of the requirement, which is the percentage of a stock price that must
be provided in cash by someone who buys the stock on credit. The margin requirement often
aims to curb market speculation.

 Activity – 1
1. What is monetary policy? ______________________________________________
___________________________________________________________________
________.
2. What do we mean by ‘monetary base’ and ‘money supply’?
___________________
___________________________________________________________________
__________________.
3. What is the difference between exogenous and endogenous money? ______
___________________________________________________________________
_______________________________________.
4. What are the four main instruments of monetary policy? ____________________
___________________________________________________________________
_________________________________________________.

47
 Section Two: Fiscal Policies

Section Overview
Fiscal policy, along with monetary policy, is another macroeconomic policy framework that
characterizes the stabilization branch. When an economy is expanding too quickly or contracting
too rapidly, the government must intervene in order to stabilize it. The stabilization role of
government, as the name suggests, is to intervene in order to rebalance the economy. This can be
done by stimulating aggregate demand in the economy when there is a recession. By reducing
taxes and/or increasing public expenditure a government can increase personally disposable
incomes to boost the economy. The reverse can be done if aggregate demand needs to be
dampened. This section deals in depth about these issues and other related matters.

Section Objectives
Dear learner, after a successful completion of this section you should be able to:

• define fiscal policies;

• describe important components fiscal policies and their roles in economic development of a
country; and
• mention basic instruments of fiscal policy used by governments and their impacts thereof on
the macroeconomic stability.

2.1. Fiscal Policy

2.1.1. Definition and Elements of Fiscal Policy

? Dear student, do you know anything about what is called “fiscal policy” and how
different is it from “monetary policy”?

Fiscal matters apply to the whole of public finance, which includes expenditure, taxes and
borrowing that help to further national economic objectives. From this definition, it can be
inferred that a fiscal policy, also called budgetary policy, is government policy that directs the
whole body of public finance. This implies that fiscal policy is related to those activities of the
state that are concerned with raising financial resources and spending them.

Fiscal policies generally differ from monetary policies in that they are concerned with aggregate
impacts taxation, expenditure and public debt as designed by appropriate organ of a government.
However, monetary policies are simply measures designed to affect the cost and supply of funds
for the conduct of an economic activities. In most cases, monetary policies can meet required
objectives in a relatively shorter period of time than fiscal policies do.
48
Fiscal policy, to be particular, is concerned with the determination of the type, time and the
procedure to be followed in making government expenditure and in obtaining government
revenues. It is that segment of national economic policy, which is primarily concerned with the
receipts, and expenditures of these receipts and expenditures.

Functions of modern governments are broadening due to socio-political reasons. Therefore, to

discharge these increasing functions, the government has to increase its expenditure. To cope
with an ever rising amount of expenditure, it has to mobilize funds with the help of fiscal policy.
Resources are obtained through taxation and borrowing both within the country and from abroad.
Financial accounts of the income and expenditure position are shown in budgetary statement,
which is an important tool of economic policy. The state by its policy of taxation and regulated
expenditure can influence the economic activities and development. Fiscal policy is concerned
with the use and impact of government tax expenditure and debt policy on the levels of
production, income and prices. The precise means of financing fiscal policy (i.e. by taxation or
bonds) will influence its effects on the economy.

Fiscal policy can also be regarded as an element of the government’s approach to ‘demand
management’. The term “demand management” emerged after the Second World War and has its
origins in the classic work of J.M. Keynes, The General Theory of Employment, Interest and
Money (1936). A simplified version of Keynes argument is that capitalist economies have a
tendency to end up in under-employment equilibrium. The aggregate demand for goods and
services has a tendency to fall short of the economy’s capacity to produce thereby resulting in
unemployment. If the government could through its policies increase aggregate demand, then
unemployment would fall. It could do this by reducing taxes thereby giving individuals more
income in their pockets to spend. The government could also increase its own spending and
expand demand. An increase in government spending and reductions in taxation will result in
budget deficits which have to be financed and managed.

Demand management is also referred to as stabilization policy. After all, fiscal policy is an
instrument through which government undertakes its stabilization role by manipulating the
aggregate demand in the economy towards a path of economic growth and full employment.
Fiscal policy could be used to reduce the excess demand which results in inflation. It could
increase taxes and reduce public expenditure. Therefore, it can influence income, output and
employment in the economy. However, it has to be noted that fiscal policy is primarily concerned
with the aggregate effects of public expenditure and taxation on income, output and employment
not the micro consequences.

49
From the above discussions, it becomes apparent that a fiscal policy consists of the following
three conventional components. These are governments’ decision making with respect to: (i)
taxation policy and tax related issues, (ii) public expenditure and other issues pertaining to
government spending and (iii) public debt issues (both the manner and amount of government
borrowing and its management). It is these decisions of government that influence the degree and
manner in which funds are withdrawn from private economy. Basically, fiscal policy in these
different facets deal with the flow and transfer of funds out of the private spending and saving
stream into the hands of government and the recycle funds from government into the private
economy.

Fiscal policy through its different measures such as taxation policy, budgetary policy and public
debt policy, in coordination with monetary policy, can direct the economic destiny of a nation.
Fiscal policy can be used to mitigate the effects of trade cycles such as inflation and depression.
Hence, fiscal policy and monetary policy (which is concerned with money supply) are the two
most important components of a government’s overall economic policy, and governments use
them in an attempt to maintain economic growth, high employment, and low inflation.

2.1.2. Determinants of Fiscal Policy

? What are the factors that really affect fiscal policy?

To determine its fiscal policy, a government must make judgments about a number of factors,
including the level of economic growth or unemployment in the future. These factors will affect
the amount of revenue raised through taxes and the amount of money required for government
programs. Once these parameters are determined, the government can decide on how to raise
revenue and how to allocate it. Revenue is generated through a combination of different taxes,
which are allocated for public utilities such as building new roads, fund government programs, or
to pay expenses for civil servants in a way of salaries.

Another important decision a government must make regarding fiscal policy is whether or not to
run a budget deficit by spending more money than the government obtains.

Dear learner, we guess that you remember the ways in which deficit budget could be financed.
Deficits can be financed in two ways: borrowing or printing more money. If the government
borrows money, it will decrease the supply of money available in the economy for lending; while
the cost of borrowing money and the interest rate may rise. If the government prints more money,
it will increase the supply of money in the economy; without a corresponding increase in
available goods, prices are likely to rise leading to inflation.

50
Thirdly, decisions on fiscal policy are inevitably influenced by political considerations, such as
beliefs about the size of the role that governments should play in the economy, or the likely
public reaction to a particular course of action. Few governments will find it easy to rise taxes or
to decrease funding for programs that have strong support from the public, such as social security
or defense.

Fiscal policy decisions can be influenced by factors outside the national boundary as well. In
today’s global economy, a government also needs to consider the fiscal policies of other
countries, which may tempt companies to relocate by offering them generous tax programs or
other government controlled benefits. Many of the developing countries find their fiscal policy
decisions constrained by the requirements of the International Monetary Fund (IMF), which often
grants aid packages subject to conditions relating to fiscal policy, often known as austerity
measures.

2.2. Classifications of Fiscal Policies

Fiscal policy can be either expansionary or contractionary. A fiscal policy is said to be
expansionary or loose when taxation is reduced or public spending is increased with the aim of
stimulating total spending in the economy, known as aggregate demand.

Expansionary policy is often used when a government feels its economy is not growing fast
enough or unemployment is too high. By increasing spending or cutting taxes, the government
leaves individuals and businesses with more money to purchase goods or invest in new
equipment. When individuals or firms increase their purchases, they raise demand, which
requires additional production, creating jobs and generating more spending. The result is higher
employment and a growing economy.

On the other hand, fiscal policy is contractionary or tight when taxation is increased or public
spending is reduced in order to restrict demand and slow down the economy. A tight fiscal policy
is more likely at work when inflation is high. A contractionary fiscal policy reduces the amount
of money in the economy available for purchasing goods, thus decreasing spending, demand,
and, ultimately, pressure on prices.

2.3. Role of Fiscal Policy in Economic Development

While it is true that fiscal policies have a direct bearing virtually on all governments’ activities
and functions (i.e. allocative, regulative, distributive and stabilization) in every country, the
following are some of the specific roles. The role of fiscal policy in an economy may vary across
countries of the globe. In developed countries, its role is to expand both production capacity as
well as the level of aggregate monetary demand in relation to their economic growth. In under

51
developed countries, the better approach is to transfer resources to capital formation without
inflation.

In developed economies the propensity to consume leads to stability. Excess saving by the
community leads to lowering of demand for goods and services resulting in sub-optimal
employment level. Fiscal policy should balance the economy by sustaining the consumption in
the economy.

In third world countries main objectives are rapid economic development and an equitable
distribution of the income. Fiscal policy can be an important instrument for attaining these
objectives. Fiscal policy influences the economy by the amount of public income that is received
and on the other by the amount and direction of public expenditure. The important fiscal means
by which resources can be raised for the public exchequer are taxation, borrowing from public
and credit creation. These means must be used in harmonious combination so as to produce the
best overall effects on the economic life of the people in terms of economic progress and social
welfare.

Below are some of the common roles that a fiscal policy plays, particularly in the developing
countries.

• Resource allocation: Today, development is the main concern nations throughout the
world, especially in the developing countries. The primary task of fiscal policy in under-
developed countries is, therefore, to allocate more resources for investment and to restrain
consumption. Private section is not interested in investing in social and economic
overheads. Investments in social and economic overheads like education, medical
facilities, infrastructure, dams etc. are very essential to generate more employment and to
accelerate the rate of economic growth. Returns on these investments are long-term and
private sector cannot provide above investments.

• Reducing inequality: Fiscal policy should reduce the economic inequalities of income and
wealth. This can be achieved by taxation and public distribution measures. Inequality
means a lot of politics even than economics when it comes to multi-ethnic societies,
which makes the issue more complex when added together. Poverty and unity can hardly
coexist. Therefore, fiscal policy should attempt economic development of the socially
unfortunate to bring about national unity. Moreover, fiscal policy should aim at reducing
regional social imbalances by directing investments to less developed regions.
• Resource mobilization: In order to attain growth with stability, the goal of fiscal policy
should be promotion of highest possible rate of capital formation and should reduce the

52
 actual and potential consumption. Furthermore, fiscal policy should encourage private
investment and attract foreign funds for development projects. In developing countries,
especially, fiscal policy has to be used as an instrument of resource mobilization where
the requirement of growth demands that fiscal policy has to be used progressively for
rising the level of investments and savings rather than keeping the consumption level.
• Rising the levels of investment: The existing pattern of investment may differ from the
optimum pattern of investment. In underdeveloped economies, the marginal propensity to
consume is very high. Therefore, a small increment in investment can bring manifold
employment due to multiplier effect. Thus, it becomes a responsibility of government to
undertake investments in such a way that it is most beneficial for the people of the
country.
• Controlling inflation: Fiscal policy should aim at controlling inflation within tolerable
levels since inflation mostly affects the poor segment of the society particularly in
underdeveloped economies. Desirable changes in the state of the economy can be gained
via using fiscal policy by adjusting public expenditures and taxes if the government hopes
to reduce unemployment through an increase in GDP without causing inflationary
pressures to increase. Fiscal policy could reduce the effects of inflation in two ways:
either by indexing depreciation allowances and (or) by reducing the number of years over
which the asset could be depreciated. It would, however, be a complex and costly process
to index depreciation allowances. Reducing the number of years is much simpler.
However, if inflation was to decline then the depreciation allowances would be over-
generous if the second method was used.
Fiscal policy should direct available resources for providing basic physical, infrastructural needs
like irrigation, roads, basic industries, railways, ports, telecommunications etc. This would enable
government of a country to alter the rate and patterns of investment of investment, thereby to
expand productive capacity by raising the level of real capital including skills as well as plants
and equipment and to check the demand generating effect of expanding investment.

2.4. Fiscal Decentralization

2.4.1. Understanding the Concept of Fiscal Decentralization and Its Rationales

? What is fiscal decentralization?

Virtually all countries have one or more levels of sub-national governments, which only exercise
jurisdiction over a particular region, district or locality. These different levels of government
have their own ways fiscal relations. Intergovernmental fiscal relations and fiscal decentralization

53
deal with how public expenditure is organized between different tiers of government and how it
is financed. Fiscal decentralization, thus, constitutes the public finance dimension of
decentralization in general, as it defines how and in what way expenditures and revenues are
organized between and across different levels of government in the national polity.

Fiscal decentralization is defined usually in relation to the extent of expenditure responsibilities

and fiscal autonomy entrusted to lower, i.e. regional/local, levels of governments. It refers to the
devolution of governance to the people by way of giving sub-national governments some revenue
and expenditure responsibility. It is an aspect decentralization more oriented towards the
dispersion of economic resources to the provinces or sub-national entities.

Fiscal decentralization may be defined, more specifically, as a delegation, distribution, or shifting

of the planning, decision-making and/or administrative financial authorities from the central
government to its field organizations, local political units, semi-autonomous and parastatal
organizations, local government or nongovernmental organizations in various forms, the major
ones being devolution, deconcentration and even privatization.

According to UNDP (2005), fiscal decentralization, however, that is not only a question of
transferring resources to the different levels of local government. It is also about the extent to
which local governments are empowered, about how much authority and control they exercise
over the use and management of devolved financial resources, measured in terms of their control
over (i) the provision of the basket of local services for which they are responsible; (ii) the level
of local taxes and revenues (base, rates and collection); and (iii) the grant resources with which
they finance the delivery of local public services.

The philosophical underpinning of fiscal decentralization is founded on the concept of

intergovernmental transfer fiscal systems, which are usually explained in the answers to the
following four important questions: who do(es) levy what taxes? (Revenue assignment); who
do(es) spend the money? (Expenditure assignment); how is the imbalance between revenue and
expenditure of the sub-national governments resolved? (Fiscal imbalance which is usually
resolved through intergovernmental transfer); and how do fiscal institutions equilibrate for the
differences in needs and capabilities among government units at the same level of governments?
(Horizontal fiscal imbalance that is usually settled through transfers). These four elements are
reiterated by the UNDP (2005) as the “basic building blocks” or “pillars”, in the following
manner:
(i) The assignment of expenditure responsibilities to different government levels: what are
the functions and expenditure responsibilities of each level of government?

54
 (ii) The assignment of tax and revenue sources to different government levels: once sub-
national governments are assigned certain expenditure responsibilities, which tax or non-
tax revenue sources will be made available to sub-national governments in order to meet
those responsibilities?
(iii)Intergovernmental fiscal transfers: in addition to assigning revenue sources, central
governments may provide regional and local governments with additional resources
through a system of intergovernmental fiscal transfers or grants.
(iv) Sub-national borrowing: local governments can borrow (in a variety of ways) to finance
revenue shortfalls.
It is in recent years, perhaps with the end of the Cold War that the devolving the decision-making
authority to the local and regional political entities, or what we often call “fiscal
decentralization”, has become an important subject matter of governance.

? What are the main justifications for fiscal decentralization?

Today, fiscal decentralization is a reality for most countries of the world including the
developing world. Whatever its justifications vary across countries according to their actual and
contextual needs, fiscal decentralization has commonly strengthened the rationale for promoting
regional policy strategies in so far as it is directed towards the achievement of endogenous,
people-centered, community-oriented and sustainable development.

Many also contend the need for fiscal decentralization by asserting that decentralization
framework must link local financing and fiscal authority to the service provision responsibilities
and functions of the sub-national governments so that they bear the costs of their decisions and
deliver services on their promises.

The principle of fiscal decentralization describes which level of government in the state structure
should be assigned with what types of expenditure discretions and revenue raising powers. In
such a situation, there is a need for transfers of various kinds from the central government to
compensate for vertical fiscal imbalance and /or to offset horizontal imbalance. Indeed, different
countries use transfers to achieve a variety of political, economic and socio-historical objectives.

Most scholars in the field agree that intergovernmental transfer is one of the policy instruments in
a federal setting that can be used to achieve the objectives of, among others, closing fiscal gap
and ensuring equalization or averting fiscal imbalances. Even if the assignment of functions
among different levels of government is done efficiently, there will be fiscal imbalance of a
vertical nature. This is because of the fact that highly income elastic tax and debt instruments are
assigned for the central government on redistributive and stabilization considerations while sub-
55
national governments are believed to be in a better position to provide public services that are
tailored to the particular tastes and circumstances of their respective jurisdictions on efficiency
considerations. As a result, expenditure needs at the sub-national levels tend to outstrip the
revenues generated from relatively income-inelastic revenue nature. Hence, there arises a
mismatch between revenues and expenditure levels, where the former usually fall short of the
latter.

The underlying implication is that the inadequacy of the revenue means sets a limit for sub
national governments to provide the public good in accordance with their expenditure
assignments. Grants, therefore, will have to play a role in resolving this problem.

The other justification for intergovernmental transfers relates to the redistribution of incomes
among the different layers of government on equity grounds. Regions in a country may be
characterized by a varying degree of fiscal conditions due to discrepancies in resource
endowments, historical factors, variations in the level of income, demographic factors. The
implication is that richer regions have a relatively higher fiscal capacity to provide the desired
level and mix of public service to their residents than their poorer counterparts. Thus,
equalization transfers are called to ensure horizontal equity across jurisdictions.

2.4.2. Fiscal Decentralization in the Ethiopian Case

In the Ethiopian case, the experience of fiscal decentralization has its roots in the period of
transition (1991-94) that devolved resources and finance to lower levels of government.
Proclamation No. 33/1992 is the most important legal instrument in the fiscal decentralization in
Ethiopia. The proclamation defined the sharing of revenue between the federal and regional
governments. The proclamation has also specified the basis of revenue sharing, expenditure and
revenue assignment, grants and borrowing. These laid the basis for federal arrangement via new
constitution that came into effect on the 21st August, 1995.

The constitution, inter alia, declared the creation of constituent states/regions of the federal
arrangement, which would be “delimited on the basis of the settlement patterns, language,
identify and consent of the people concerned” (Art. 46, 47). The constitution has allocated a
substantial power and authority to the nations, nationalities and peoples of Ethiopia, and their
respective states. Their “unconditional right to self-determination, including the right to
secession” (Art. 39), has been accompanied by wide range of political, social, economic and
cultural rights (Art. 41).

The economic authority of the states included their power to manage their resources; harness
their development; levy and collect tax concurrently with the federal government; and budget

56
preparation, administration and control. Under the current system of revenue the assignment, for
instance, regional states have the authority over:
• personal income tax collected from employees of the regional states and employees
other than the federal civil servants;
• rural land use fees;
• agricultural income tax collected from farmers not incorporated in an organization;
• profit and sales tax collected from individual traders;
• tax on income from inland water and transportation;
• taxes collected from rent of houses and properties owned by regional states;
• income tax royalty and rent of land collected from mining activities; and
• charges and fees on licenses and services issued or ordered by the regional states.

While the federal government has the authority over:

• duties, taxes and other charges levied on the importation and exportation of goods;
• personal income tax collected from employees of the central government and
international organizations;
• profit tax, personal income tax and sales tax collected from the enterprises owned by
the central government;
• taxes collected from national lotteries and other chance winning prizes;
• taxes collected from rent of houses and properties owned by the central government;
• charges and fees on licenses and services issued or rendered by the central
government.

However, the federal and regional states have also some joint authority in the areas relating to:
profit tax, personal tax and sales tax collected from enterprises jointly owned by the central Profit
tax, dividend tax and collected from organizations; and profit tax, royalty and rent of land
collected from large scale mining, and any petroleum and gas operations. Moreover, in order to
close fiscal gap and ensuring equalization or averting fiscal imbalances, the federal government
has always been providing budget grants. Although the central government has been using
different formula for intergovernmental transfer of finance, the following are the most common
variables that were made use of in the budget disbursement. These are: size of population,
revenue collection effort, level of development, regional revenue collection effort and sectoral
performances in relation to budget, geographical area and extent of poverty.

57
  Activity –2

1. What are the major components of fiscal policy? ______________________________

______________________________________________________________________
____________________________________________________________________ .
2. What is the difference between contractionary and expansionary fiscal policies? _____
______________________________________________________________________
_____________________________________________________________________ .
3. What roles can a fiscal policy play in the economic development of a country? ______
______________________________________________________________________
_____________________________________________________________________ .
4. What are the four major issues in fiscal decentralization? _______________________
______________________________________________________________________
_____________________________________________________________________.

UNIT SUMMARY
Fiscal and monetary policies are the two most important macro-economic policy elements whose
importance prevails in their roles to expand both production capacity as well as the level of
aggregate monetary demand in relation to their economic growth. In underdeveloped countries
these two policies are often designed to constitute a better approach for the transfer of resources
to capital formation without inflation. Fiscal policy through its different measures such as
taxation policy, budgetary policy, public debt policy and a co-ordination with monetary policy
can direct the economic destiny of a nation. Fiscal policy can be used to mitigate the effects of
trade cycles such as inflation, depression and many other economic ills.

 Self-test Exercises
Write short answers for the following questions.
1. What are monetary and fiscal policies?
2. What are the four main instruments of monetary policy?
3. How does interest rate affect money circulation in an economy?
4. What are the two types of fiscal policy?
5. What are the main elements of fiscal policy?
6. What roles can a fiscal policy play in the economic development of a country?

 Unit Checklist
Put an (X) mark in the boxes in front of the ideas you performed well.
I can:
• define fiscal and monetary policies
• appreciate the four main instruments of monetary policy affect the money supply in
an economy and thereby maintain macro-economic stability

58
• identify and describe the components of fiscal policy
• define and describe the various issues involved in fiscal decentralization

If you have any doubt about your understanding of any of the above checklists don’t hesitate to go
back and refer the discussions in the different sections.

59
 UNIT FOUR

TAXATION

Unit Introduction
It has already been discussed that as long as governments have existed, they need to come up
with the means to finance their activities, for any function of a government requires financing. It
is also imperative to regulate and handle them in view of some national parameters. Since the
time of ancient civilizations methods of government revenue generation had changed enormously
over time. Under empire systems, the conquered peoples might be required to make payment
known as “tribute” to the conqueror in acknowledgment of their submission to his power.
The Roman Catholic Church was a major tax collector during the Middle Ages through the
church revenue called “tithe”, a compulsory payment of one-tenth of a person’s harvest and
livestock. Different rulers also taxed their people requiring that they turn over some proportion of
their wealth in kind to the state, even in societies that operated without money.

Although tax systems did not generate as much revenue as the governing classes wanted,
economists and political leaders began realizing that it is of very important political and
economic tool. Today taxes play major roles in all modern economic systems. Let us examine the
whole detail presented in the coming two sections.

Unit Objectives
Dear learner, by the end of this unit you should be able to:

• define taxation and tax policies under various circumstances;

• make a proper linkage between tax and income distribution among citizens; and
• identify different principles of tax equity.

Pre-test Questions
• What do you think are the sources of government revenue which are supposed to cover
the government expenditure?
• What relationship do you see between taxation and equity of income?

Section One: Taxation and Tax Policies

Section Overview

Governments must have funds, or revenue, to pay for their activities. Governments generate
some revenue by charging fees for the services they provide, such as entrance fees at national

60
parks or tolls for using a highway. However, most government revenue comes from taxes. We
have already mentioned that the way the government spends and taxes is determined by a
government’s fiscal policy that bears a direct influence on the performance of the economy.

Hence, taxation directly affects the overall performance of the economy. For example, if the
government increases spending to build a new highway, construction of the highway will create
jobs. Jobs create income that people spend on purchases, and the economy tends to grow. The
opposite happens when the government increases taxes. Households and businesses have less of
their income to spend, they purchase fewer goods, and the economy tends to shrink. Before we
talk a lot, however, it would be imperative to define what a tax is, and describe the features and
principles of taxation.

Section Objectives
Dear learner, by the end of this section you will be able to:

• define taxation and tax systems;

• identify and describe major principles and characteristics features of taxation; and
• describe classifications of tax and their impacts?

1.1. Taxation Defined

? Dear student, what do you think is taxation?

Taxation is a system of raising money to finance government with the objectives to reduce
inequalities of income and wealth; to provide incentives for capital formation in the private
sector, and to restrain consumption so as to keep in check domestic inflationary pressures. All
governments require payments of money, i.e. taxes, from their people. Governments use tax
revenues to render different public services like public school systems, welfare programs, police
and fire protection, maintenance of roads and highways, and public hospitals.

Without taxes to fund its activities, government could hardly exist. That is why it is usually said
that tax is the life source of governments. Hence, taxation constitutes the most important source
of state revenues. It is argued that for modern governments, different types of taxes account for
90 percent or more of their income. The remainder of government revenue comes from
borrowing and from charging fees for services, which shall be elaborated in the coming sections.

Countries differ, however, considerably in the amount of taxes they collect. For instance, in the
United States about 30, in Canada about 35 percent, in France about 45 percent, and in Sweden
about 50 percent of the gross domestic product (GDP), a measure of economic output, are

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derived from tax payments. In Ethiopia, however, the percentage of tax revenue as part of the
GDP is so miniscule. For instance, it was 9.7 percent in 1999/2000 fiscal year, and, after a
decade, it just grew marginally to constitute 11.7 percentages, of GDP in the year 2009/10.

1.2. Characteristic Features of Taxation

? Dear student, what are the major features of taxation?

Taxation has the following common features though it varies across different systems.

• Tax is a compulsory contribution: Tax is an obligatory contribution of the tax-payers

to the government. The people upon whom the tax is levied cannot refuse to pay tax.
After all paying tax is not a matter of ‘right’, it is duty of citizens the refusal of which
unfortunately leads to punishments. Hence, tax imposes a personal obligation on tax-
payers making them liable to pay it, in no way it is escapable.

• Benefit is not the basic condition: There is no direct return to tax payers for the fact
that they have paid tax, i.e. people cannot expect any direct benefit for the amount of
tax paid, because there no relation between the amount of tax paid by the people and
the services rendered by the government to the tax-payers.

• Common interest: The amount of tax received from the people is used for the general
and common benefits of the people as a whole. Now, the government has to render
enormous range of social activities, which incur heavy expenditure. A part of the
expense is sought to be raised through taxation of various types. Thus, tax are said to
be the sharing of common burdens by the people.

• Legal collection: Tax is a legal collection it can be levied only by the government,
both the central and states/local.

• Element of sacrifice: Since tax is paid without any direct return in benefit it can be
said that there is the prevalence of sacrifice in the payment of tax.

• Regularity and periodicity: The payment of tax is regular and periodic in nature. It is
levied for a fixed period, usually a year. Thus, almost all taxes are annual taxes. The
payment is usually conducted on a regular basis.

• Pervasive and wider in scope: Tax is levied on all citizens without any discrimination
of caste, creed, status, etc. In terms of scope, taxes are levied not only on income but
also on properties and commodities.
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To enhance the revenue and to bring all the people under the tax net, the government imposes
various kinds of taxes. This augments the scope of taxes.

1.3. Classification of Taxes

We have already defined taxation as a method through which resources are transferred from the
private to the public sector. Depending on where they may be imposed, taxes are classified as
follows:
1. Taxes which are imposed on the product or factor market
2. Taxes which are imposed on the seller’s and buyer’s side of the market
3. Taxes which are imposed on the household or firms; and
4. Taxes which are imposed on the sources or use side of the tax-payers account.

Cutting across the above categories, the conventional types of taxes imposed by governments are
mentioned below: income taxes; consumption taxes when they spend it, property taxes
(sometimes called “in-rem”), i.e. the tax on “things”, when they own a home or land, and in some
cases estate taxes when they die.

1.3.1. Income Taxes

In most countries, individuals pay the income taxes when they earn. Taxes on people’s incomes
play critical roles in the revenue systems of all developed and underdeveloped countries.

A. Individual Income Tax

An individual income tax, also called a personal income tax, is a tax on a person’s income.
Income includes wages, salaries, and other earnings from one’s occupation; interest earned by
savings accounts and certain types of bonds; rents (earnings from rented properties); royalties
earned on sales of patented or copyrighted items, such as inventions and books; and dividends
from stock. Income also includes capital gains, which are profits from the sale of stock, real
estate, or other investments whose value has increased over time.

The national governments of many other countries require citizens to file an individual income
tax return each year. Each taxpayer must compute his or her tax liability—the amount of money
he or she owes the government. This computation involves four major steps. (1) The taxpayer
computes adjusted gross income—one’s income from all taxable sources minus certain expenses
incurred in earning that income. (2) The taxpayer converts adjusted gross income to taxable
income—the amount of income subject to tax—by subtracting various amounts called
exemptions and deductions. Some deductions exist to enhance the fairness of the tax system. For

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example, the some states permit a deduction for extraordinarily high medical expenses. Other
deductions are allowed to encourage certain kinds of behavior. For example, some governments
permit deductions of charitable contributions as an incentive for individuals to give money to
worthy causes. (3) The taxpayer calculates the amount of tax due by consulting a tax table, which
shows the exact amount of tax due for most levels of taxable income. People with very high
incomes consult a rate schedule, a list of tax rates for different ranges of taxable income, to
compute the amount of tax due. (4) The taxpayer subtracts taxes paid during the year and any
allowable tax credits to arrive at final tax liability.

Income taxation enjoys widespread support because income is considered a good indicator of an
individual’s ability to pay. However, income taxes are hard to administer because measuring
income is often difficult. For example, some people receive part of their income “in-kind”—in
the form of goods and services rather than in cash. Farmers provide field hands with food, and
corporations may give the employees an access to company cars and free parking spaces. If
governments tax cash income but not in-kind compensation, then people can avoid taxation by
taking a higher proportion of their income as in-kind compensation.

B. Corporate Income Tax

Corporations must also pay tax on their net income (profits).The corporate income tax is one of
the most controversial types of taxes. Although the corporations have an independent ability to
pay a tax, many economists note that only real people—such as the shareholders who own
corporations—can bear a tax burden. In addition, the corporate income tax leads to double
taxation of corporate income. Income is taxed once when it is earned by the corporation, and a
second time when it is paid out to shareholders in the form of dividends. Thus, corporate income
faces a higher tax burden than income earned by individuals or by other types of businesses.

C. Payroll Tax

Whereas an income tax is levied on all sources of income, a payroll tax applies only to wages and
salaries. Employers automatically withhold payroll taxes from employees’ wages and forward
them to the government. Payroll taxes are the main sources of funding for various social
insurance programs, such as those that provide benefits to the poor, elderly, unemployed, and
disabled. In countries like the United States and the Canada the role payroll taxes is significant,
and the second-largest tax the citizens pay each year.

Usually, there is a limit rate to the average wage to be taxed. Governments impose no payroll tax
on earnings above the limit. Employers pay some rate of their wages accordingly.

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Although the legislators who set up payroll taxes intended to divide the tax burden equally
between employers and employees, this may not occur in practice. Some economists believe that
the tax causes employers to offer lower pre-tax wages to employees than they would otherwise,
in effect shifting the tax burden entirely to employees.

1.3.2. Consumption Taxes

A consumption tax is a tax levied on sales of goods or services. The most important kinds of
consumption taxes are sales taxes, excise taxes, value-added taxes, and tariffs.

A. Sales Taxes
Sales tax imposes the same tax rate on a wide variety of goods and, in some cases, services.
Although sellers are legally responsible for paying sales taxes, and sellers collect sales taxes from
consumers, the burden of any given sales tax is often divided between sellers and consumers. In
some countries, sales taxes are often exempted certain necessities such as basic groceries and
prescription drugs. Both individuals and businesses pay sales tax.

B. Excise Taxes
Excise taxes are also called selective sales taxes. Goods subject to excise taxes include tobacco
products, alcoholic beverages, gasoline, and some luxury items. Excise taxes are applied either
on a per unit basis, such as per package, or as a fixed percentage of the sales price.
Governments sometimes levy excise taxes to pay for specific projects. For example, voters in a
city might approve a tax on hotel rooms to help pay for a new convention center. Some national
governments impose an excise tax on airline tickets to help pay for airport improvements or
airline security. Revenues from gasoline taxes typically pay for highway construction and
improvements.
Excise taxes designed to limit consumption of a commodity, such as taxes on cigarettes and
alcoholic beverages, are commonly known as “sin taxes.” Another type of excise tax is the
license tax. Most states require people to buy licenses to engage in certain activities, such as
hunting and fishing, operating a motor vehicle, owning a business, and selling alcoholic
beverages.

C. Value-Added Tax
In a value-added tax (VAT) system, the seller pays the government a percentage of the value
added to goods or services at each stage of production. The value added at each stage of
production is the difference between the seller’s costs for materials and the selling price. In
essence, a VAT is just a general sales tax that is collected at multiple stages.
In the production of apple pies, for example, the farmer grows apples and sells them to a baker,
who turns them into a pie. The baker sells the pie to a restaurant owner, who sells it to a

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consumer. At each stage, the producer adds value to the commodity by processing it with capital
(machines) and labor. The farmer, the baker, and the restaurant owner each charge their customer
a VAT. However, they can each claim a credit to recover the tax they paid on purchases relating
to their commercial activities.
In some nations, governments exempt certain goods and services from such tax as food items,
medical services and child-care services.
D. Tariffs
Tariffs, also called duties or customs duties, are taxes levied on imported or exported goods.
Import duties are considered consumption taxes because they are levied on goods to be
consumed. Import duties also protect domestic industries from foreign competition by making
imported goods more expensive than their domestic counterparts.

1.3.3. Property Taxes

In principle, a property tax is a tax on an individual’s wealth—the value of all of the person’s
assets, both financial (such as stocks and bonds) and real (such as houses, cars, and artwork). In
practice, property taxes are usually more limited. Especially, in countries with federal state
structures, there is no federal property tax. By-and-large, the property tax is by far the largest
source of revenue for local governments.
The property tax is often unpopular with homeowners. One reason is that, because homes are not
sold very often, governments must levy the tax on the estimated value of the dwelling. Some
citizens believe that the government overvalues their homes, leading to unfairly high property tax
burdens.
When a person dies, the property that he or she leaves for others may be subject to tax. An estate
tax is a tax on the deceased person’s estate, which includes everything the person owned at the
time of death—money, real estate, stock, bonds, proceeds from insurance policies, and material
possessions. Most governments levy estate taxes before the deceased person’s property passes to
heirs, although many governments do not impose an estate tax on property inherited by a spouse.
An inheritance tax also taxes the value of the deceased person’s estate, but after the estate passes
to heirs. The inheritors pay the tax. Estate and inheritance taxes are sometimes collectively called
death taxes. A gift tax is a tax on the transfer of property between living people.
Estate and gift taxes are controversial. Proponents argue that they are useful tools for distributing
wealth more equally in society and preventing the rise of powerful oligarchies. Opponents argue
that it is a person’s right to pass on property to his or her heirs, and the government has no right
to interfere. If an individual has paid tax on his or her income while in the process of
accumulating wealth, critics ask, why should it be taxed again when the wealth is transferred?
Others argue that estate and gift taxes discourage individuals from working and saving to
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accumulate wealth to leave to their children. On the other hand, the presence of an estate tax
might encourage people to accumulate greater wealth in order to reach a given after-tax goal.
The above mentioned types of taxes are by no means exhaustive. Based on the manner of impact
and incident of their burden, taxes could be said direct (the burden of tax is on the immediate tax
payer) and indirect (the burden of tax is shifted to elsewhere). The other categories include taxes
like poll and pollution taxes. A poll tax, also called a lump-sum tax or head tax, collects the same
amount of money from each individual regardless of income or circumstances. Poll taxes are not
widely used because their burden falls hardest on the poor. A pollution tax is a tax levied on a
company that produces air, water, or soil pollution over a certain level established by the
government.
The tax provides an incentive for companies to pollute less and thus reduce damage to the
environment. Countries like US, France, Germany, and The Netherlands levy taxes on some
types of pollution. However, these taxes account for just a tiny amount of total tax revenue.

1.4. Canons (Principles) and Functions of Taxation

1.4.1. Canons (Principles) of Taxation

? Dear student, what are the main principles of taxation?

In addition to the aforementioned features of taxes, there are basic principles applicable to
taxation. These principles are often called cannons of taxation. The Seventeenth-century French
statesman Jean-Baptiste Colbert called them the qualities of the “art of taxation”. Scottish
economist Adam Smith laid out these principles in his landmark treatise The Wealth of Nations
(1776). Nonetheless, in the contemporary world, the following principles of taxation are the
major ones.
• Cannon of equality: according to this principle, as set forth by Adam Smith, the
“subject of every state ought to contribute towards the support of government, as
nearly as possible, in proportion to their abilities to pay”. That is, a “good” tax
system. Tax system should be based on ability to pay of the people, i.e. all people
should bear the expenditure in proportion to their respective abilities and that too in an
equitable manner.
• Cannon of certainty: The other important cannon of taxation advocated by A. Smith is
‘certainty’. According to him, 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 pay, should be clear and plain to the contributor and every other person.

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 • Cannon of convenience: according to this principle every tax ought to be levied in
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 tax-payers. For example, it could be done like in installments, or say, land revenue
may be collected at the time of harvest, etc.
• Cannon of economy: The next important cannon of taxation is the economy.
According to A. Smith, “every tax ought to be so contrived as both to take out and
keep out of pockets of the people as little as possible over and above what it brings in
to the public treasury of the state.”
• Cannon of productivity: the tax system should be productive enough. That means, it
should ensure sufficient revenue to the government and it should encourage
productive activity by encouraging the people to work, save and invest.
• Cannon of elasticity: the tax should be flexible. It should be levied in such a way to
increase or decrease the tax revenue depending upon the need of the public. For
example, during certain unforeseen situations of calamities like floods, famine, war,
drought, etc.
• Cannon of diversity: According to this principle, there should be diversity in the tax
system of a country. The burden of tax should be distributed widely on the entire
people of the country.
• Cannon 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
tax-payer cannot estimate his/her tax liability and it will cause irregularities in the
payment and leads to corruption.
• Cannon of expediency: According to this principle, a tax should be levied after
considering all favourable and unfavourable factors from different angles such as
economic, political and social.
• Cannon of coordination: in a federal states, like Ethiopia, the federal and states
governments levy taxes. So, there should be a proper coordination between different
taxes imposed by various levels of authorities.
• Cannon 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.

1.4.2. Functions of Tax

All the above cannons are important for any tax system to effectively function. Tax is a major
instrument of social and economic policy. It is a method to distribute the cost of the government

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fairly among different income groups (vertical equity) and among people approximately in the
same economic circumstances (horizontal equity) and to promote economic growth with stability
and efficiency.

Throughout history, people have debated the amount and kinds of taxes that a government should
impose, as well as how it should distribute the burden of those taxes across society. Taxation can
redistribute a society’s wealth by imposing a heavier tax burden on one group in order to fund
services for another. Taxation is also considered as an important tool for maintaining the stability
of a country’s economy. Besides, taxation can play crucial role of accelerating economic growth
in under-developed countries, if their tax system is well laid and tax policies are well conceived
and executed. In addition to using taxation to raise money, governments may raise or lower taxes
to achieve social and economic objectives, or to achieve political popularity with certain groups.
Taxes also have political ramifications. Unpopular taxes have caused public protests, riots, and
even revolutions. In political campaigns, candidates’ views on taxation may partly determine
their popularity with voters.

In underdeveloped countries, more particularly, taxes have four basic functions. These are
curtailment of consumption of above subsistence level families; curtailment of use of resources
for capital formation which are of little value to economic development; provision of funds to the
government; and the provision of incentives to alter economic activities in a fashion favourable
to economic growth. The tax system must be designed in such a way as to fulfill these functions
with a minimum of adverse effects.

1.5. Incidence and Impacts of Taxation

Scholars have devoted considerable effort to studying the effects of taxes. In particular, they
study how taxes affect people’s behavior, including their choices in working, saving, and
investing. To understand the effect of any tax, one must first determine who bears the burden of
the tax, which is not always an easy task.

Points where tax may be imposed is known as impact points, while the way a tax affects people
is called the tax incidence. The statutory incidence of a tax refers to the individuals or groups
who must legally pay the tax. However, the statutory incidence reveals essentially nothing about
a tax’s real burden. In contrast, the economic incidence of a tax refers to its actual effects on
people’s incomes. The economic incidence of a tax depends on how buyers and sellers of the
commodity react when the tax is imposed. The more sensitive consumers are to changes in price,
the easier it is for them to turn to other products when the price goes up, in which case producers
bear more of the tax burden. On the other hand, if consumers purchase the same amount

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regardless of price, they bear the whole burden. Nevertheless, taxes can affect the following
economic variables.

A. Labor Supply

An economy’s labor supply is the number of hours that people work. Taxes can affect the labor
supply by influencing people's decisions about whether to work and how much to work. Suppose
that an individual earns 10 Birr per hour, and the government imposes a 40 percent tax on
earnings. After tax, the individual receives only 6 Birr per hour (10B - 4B = 6B in taxes). The
impact of such a tax is hard to predict. On the one hand, the tax lowers the cost to the individual
of not working. On the other hand, with a lower wage, the individual must work more hours to
maintain the standard of living he or she had before the tax. Thus, the tax simultaneously leads to
two effects that work in opposite directions.

B. Saving

Saving is the portion of income that is not spent. The question remains: might taxes levied on
returns to saving (such as interest and dividends) influence the amount people save? When a tax
is levied on interest or dividends, it reduces the reward for saving. For example, if an individual
earns 10 percent interest on a savings account and faces a 20 percent income tax rate, then he or
she makes only an 8 percent return—the other 2 percent goes to the government. This effect
tends to reduce the amount of saving that an individual does.

On the other hand, when interest is taxed, an individual must save more to achieve any particular
savings goal. For example, if parents regularly save money to accumulate enough for their child’s
college tuition payments, and taxes on interest increase, they must save more in order to reach
their saving target. This effect tends to increase the amount of saving. Because the two effects
work in opposite directions, in theory an increase in the tax on interest can increase or decrease
saving.

C. Physical Investment

? How do taxes affect physical investment?

Physical investment refers to the purchase by businesses of manufactured aids to production.
Physical investment includes such items as machines, factories, computers, trucks, and office
furniture. The return on a physical investment is the amount, which the investment increases the
business’s revenues. In effect, a tax on business income is a tax on the physical investment’s

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return—the tax reduces the firm’s income and thus the benefit from making the investment. It is
usually believed that business taxes decrease the amount of physical investment by businesses.
Taxes also influence the types of physical investments that businesses make. This is because the
government taxes returns on some types of investments at higher rates than others. These
differences cause businesses to make investment decisions based on tax consequences, rather
than whether they are sound from a business point of view. By distorting physical investment
decisions, the tax system may lead to an inefficient pattern of investment.

 Activity – 1
1. What is taxation? ____________________________________________________
__________________________________________________________________
_________.
2. What are the major principles that govern tax systems? ____________________
__________________________________________________________________
___________________.
3. What main functions do taxes have? ___________________________________
__________________________________________________________________
___________________.
4. What do we mean by ‘tax incidence’? ___________________________________
__________________________________________________________________
__________________________________________________.

Section Two: Equity and Efficiency of Taxation

Section Overview
Equity is a very important concept in taxation. Throughout history, people have debated the
amount and kinds of taxes that a government should impose, as well as how it should distribute
the burden of those taxes across society. Unpopular taxes have caused public protests, riots, and
even revolutions. In political campaigns, candidates’ views on taxation may partly determine
their popularity with voters. There is, thus, a continued controversy over what constitutes an
equitable taxation both in method and consequences. Below is a discussion of the two main
approaches to tax equity.

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Section Objectives
Dear learner, by the end of this section you should be able to:

• Define and describe the concept of equity in view of taxation policies;

• Identify different tax systems that are practiced under various circumstances; and
• Mention some administrative costs in relation efficiency of taxes.

2.1. Approaches to Tax Equity (Fairness)

There is a consensus that any taxation should be fair and should aim at bringing an equitable
socio-economic condition for the society. But there are arguments and perspectives on how to
bring the required “fairness”. These are the ability-to-pay and benefit principles.

2.1.1. Ability-to-Pay Principle

The ability-to-pay principle holds that people’s taxes should be based upon their ability to pay,
usually as measured by income or wealth. One implication of this principle is horizontal equity,
which states that people in equal positions should pay the same amount of tax. If two people both
have incomes of, say Birr 5000, then horizontal equity requires that they pay the same amount of
tax.

A second requirement of the ability-to-pay principle is vertical equity, the idea that a tax system
should distribute the burden fairly across people with different abilities to pay. This idea implies
that a person with higher income should pay more in taxes than one with less income. But the
question is: how much more? Should citizens with different incomes be taxed at the same rate or
at different rates?

To answer these questions three tax systems are often advocated and applied. Taxes may be
proportional, progressive, or regressive. A proportional tax takes the same percentage of income
from all people. A progressive tax takes a higher percentage of income as income rises—rich
people not only pay a larger amount of money than poor people, but a larger fraction of their
incomes. A regressive tax takes a smaller percentage of income as income rises—poor people
pay a larger fraction of their incomes in taxes than rich people.

? Dear student, which tax system (proportional, progressive, or regressive) do you think is
fairest system?

There is no scientific way to resolve this question. The answer depends on ethical and
philosophical judgments, such as whether a society has the right to take income from one group
of people and give it to another. A progressive, proportional, or even slightly regressive system

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all can achieve vertical equity’s requirement that a richer person should pay more in taxes than a
poorer person.

Some scholars consider regressive taxes as important because of two reasons. The first is that
individuals with higher incomes spend a smaller proportion of their incomes on taxes such as
sales taxes than those with lower incomes. For example, a poor person and a rich person who
spend the same amount on consumption always will pay the same amount in sales taxes, even
though the rich person earns more money. However, rich people consume more than poor people,
and studies of people’s spending patterns reveal that, over the course of a lifetime, the rich person
will pay roughly the same proportion of his or her income in sales taxes as the poor person.
Secondly, it is believed that such taxes initiate poor individuals to work hard and eventually
become richer.

2.1.2. Benefits Principle

The benefits principle of taxation states that only the beneficiaries of a particular government
program should have to pay for it. The benefits principle regards public services as similar to
private goods and regards taxes as the price people must pay for these services. The practical
application of the benefits principle is extremely limited, because most government services are
consumed by the community as a whole. For example, one cannot estimate the benefit received
by a particular individual for general public services such as national defense and local police
protection. Despite its intuitive appeal, the benefits principle is not important in practice, and it
plays little role in the design of tax systems.

2.2. Efficiency of Taxation

Collection of taxes costs authority money. The following are some of the costs that are incurred.

Administration Costs: The government must hire tax collectors to gather revenue, data entry
clerks to process tax returns, auditors to inspect questionable returns, lawyers to handle disputes,
and accountants to track the flow of money. No tax system is perfectly efficient, but government
should strive to minimize the costs of administration.

Compliance Costs: Complying with the system of paying taxes costs taxpayers money above
and beyond the actual tax bill. These costs include the money that people spend on accountants,
tax lawyers, and tax preparers, as well as the value of taxpayers’ time spent filling out tax returns
and keeping records.

Excess Burden: A third measure of a tax system’s efficiency takes into account the fact that
when the government levies a tax on a good, it distorts consumer behavior—people buy less of

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the taxed good and more of other goods. Instead of choosing what goods to buy solely on the
basis of their intrinsic merits, consumers are influenced by taxes. This tax-induced change in
behavior is called an excess burden. The larger the excess burden of a tax, the worse it is for
efficiency. In fact, taxes on labor can also lead to excess burdens. When the government taxes
people’s labor (through an income tax), people may decide to change the number of hours that
they work. The tax distorts their choice between working and leisure.

 Activity –2
1. What are the two main approaches to equity of taxation? _____________________________
___________________________________________________________________________
_______________________________________________________________ .
2. What are the three tax systems built to ensure equity in relation to the ability of tax payers?
___________________________________________________________________________
__________________________________________________________________.
3. What administrative costs do tax collectors incur? ______________________________
__________________________________________________________________________.

UNIT SUMMARY
In this unit, we have seen that taxation is the most common system of raising money to finance
government. As all governments require fund for public activities, without taxes governments
virtually could not exist.

In addition to using taxation to raise money, governments may raise or lower taxes to achieve
social and economic objectives, or to achieve political popularity with certain groups. Taxation
can redistribute a society’s wealth by imposing a heavier tax burden on one group in order to
fund services for another. Many also consider taxation an important tool for maintaining the
stability of a country’s economy.

Governments impose many types of taxes. Throughout history, people have debated the amount
and kinds of taxes that a government should impose, as well as how it should distribute the
burden of those taxes across society. However, the two approaches to of fairness to determine
whether the burden of a tax is distributed fairly: the ability-to-pay principle and the benefits
principle. The ability-to-pay principle holds that people’s taxes should be based upon their ability
to pay, usually as measured by income or wealth. The benefits principle of taxation states that
only the beneficiaries of a particular government program should have to pay for it.

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In addition to being fair, a good tax system should be efficient, wasting as little money and
resources as possible. Three measures of efficiency are administration costs, compliance costs,
and excess burden.

 Self-test Exercises
Write short answers for the following questions.
1. What is taxation?
2. What are the major principles that govern tax systems?
3. Why governments levy taxes?
4. What is the difference between the “ability-to-pay” and “benefits” approaches to tax
equity?
5. What is the difference among the progressive, proportional and regressive tax systems?

 Unit Checklist
Put an (X) mark in the boxes in front of the ideas you performed well.
I can:
• define taxation and describe tax principles
• identify characteristic features of taxation
• mention different kinds of taxes
• approaches to tax equity
• identify taxation policies that are practiced under various circumstances
• mention some administrative costs that hamper efficiency of taxes
If you have any doubt about your understanding of any of the above checklists don’t hesitate to go
back and refer the discussions in the different sections.

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 UNIT FIVE

PUBLIC DEBT

Unit Introduction
Dear distance learner, welcome to the fifth unit of this course. This unit is concerned with public
debt. This unit has two sections. The first section is concerned with the understanding of public
debt. In the first section the definition of public debt and the reasons for government borrowing
are discussed. The section also discusses the types of public debt and the burden of public debt.
The second section deals with public debt management and the redemption of public debt. We
hope you will have full understanding of public debt after reading the discussions in this unit.

Unit Objectives

After successful completion of this unit, you will be able to:

• define public debt and identify the reasons for government borrowing;
• describe the different types of public debt;
• explain the burden of public debt;
• describe public debt management, and
• discuss the redemption of public debt.

Section One: The Concept of Public Debt

Section Overview
Dear distance learner, welcome to the first section of the fifth unit. This section is concerned
with the understanding of public debt. This section is further divided in to three sub-sections.
The first sub-section defines public debt and discusses the reasons for government borrowing.
The second sub-section deals with the types of public debt. The third sub-section discusses the
burden of public debt.

Section Objectives

Up on successful completion of this section students will be able to:

• define public debt,
• describe the reasons for government borrowing,
• identify the different types of public debt, and
• explain the burden of public debt.

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1.1. Definition of Public Debt and Reasons for Government Borrowing

? Dear student, what do you understand by ‘public debt’, and why does government has
to borrow?
Public debt is the debt which the state/government owes to its subjects, other countries, and the
nationals and institutions of other countries. Public debt can be internal – internal borrowings in
the form of bonds and treasury bills or external – state borrowing from multilateral institutions,
directly from other countries, and even from the private sector in other countries.

A government has to mobilize resources to finance its activities. There are different alternatives
to mobilize resources by the government like taxation, expenditure reduction, and printing of
currency. However, there is a limit for these alternatives. Imposing high taxes negatively affects
the tax payers and can lead to lack of motivation to work and save on the side of the people.
Reducing government expenditure beyond a certain limit is not feasible given the increasing
demand for government activities. Printing of currency also has limits, otherwise it results in
hyperinflation. So, because of the limits to these alternatives, the government should borrow.
There are two major reasons that justify government borrowing are increasing government
expenditure and budget deficit. These reasons are discussed below.

A. The public expenditure has been increasing continuously

A German economist named Adolf Wagner (1880), argues that there is continuous expansion of
the public sector and the share of the public sector has been increasing continuously.
Quantitative indicators in the experience of the American government system show such trend.
The public expenditure/GNP ratio in USA has been continuously increasing. In 1890 the
government expenditure was only 6.5% of the GNP, while this figure has increased to 35% in
1987. The defense expenditure increased from 1.5% in 1890 to 6.7% in 1987, while civilian
expenditure increased from 5% to 28.3% during the same period. These figures show that there
has been continuous increase in public expenditure.

Moreover, the government transfers and purchases have also been increasing. Government
transfers include social security schemes, pension transfers, health care schemes, etc. Another
study has been conducted as per the structure of government expenditure of USA. The result
shows that the lion’s share of government expenditure goes to civilian expenditure (81.5%) than
defense expenditure (18.5%). The important components of the civilian expenditure are social
welfare, education, economic development, transportation, etc. However, there has been
continuous increase in government expenditure.

Why there has been continuous increase in government expenditure?

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 1. There has been growth in per capita income. So, as income increases, there is increase in
the demand for social goods. For example the demand for parks and highways increases
as people secure higher income and then demand more recreation and cars.

2. Technical and technological changes have led to increase in government expenditure. For
instance changes in weapon technology and space technology have led to increase in
government expenditure.

3. Population growth: when there is population growth, there should be increase in

expenditure for the supply of more housing facilities, education and health facilities, care
for old people, etc.

4. The relative cost of public services has been increasing.

5. Urbanization: there has been increase in the demand for infrastructure and public services
because of urbanization.

B. Budget Deficit

Deficit in government budget is highly associated with increase in government expenditure.

Most of developing countries have two types of imbalances, i.e. internal imbalance and external
imbalance. These imbalances are discussed below together with the concepts of internal balance
and external balance.

Internal balance: is a situation where the domestic economy is sufficient to utilize its productive
potential, for instance the maximum feasible use of labor. In this instance, however, it is
important to note that 100% employment is not possible. If the economy is performing well and
secure internal balance, it still will have 8-10% unemployment.

So, internal imbalance is a situation where there is unutilized capacity and unutilized labor. The
laborers are prepared to work but they have no job and there is excess supply of labor. In a
situation of internal imbalance there can be rising prices of the factors of production which the
economy has short supply.

External balance: refers to the trading and financial relations with the rest of the world. So,
external balance is defined as a situation where the current account of the balance of payments
can be financed by long run sustainable capital growth, i.e. there will not be deficit in the current
account. The current account can be completely financed. External imbalance is a situation
where there is an excess supply in the foreign exchange or a deficit (excess demand) in the
foreign exchange.

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If an economy has to perform effectively there should be both internal balance and external
balance.

There are two methods of achieving internal and external balance. These are:

i. Through monetary and fiscal policies. This is known as expenditure reducing policy.
ii. Through exchange rate policy. This is known as expenditure switching policy

The reduction of government budget deficit is an important part of macroeconomic reform

programs. When there is deficit in government budget, there would not be internal and external
balance. If there is imbalance in the government or private sector, it leads to a trade imbalance.
The imbalance in the government sector occurs through deficit in the budget. There are different
ways of covering deficit in the government budget. These include the methods described below.

1. Money Creation

In this method the government prints money and uses this printed money to cover its budget
deficit. The problem with this method is that there is a limit to use it and if it is not within the
limit it results in inflation.

2. Utilizing the Foreign Exchange Reserves

This involves running down the foreign exchange reserves. In addition this is not a permanent
solution because most developing countries have a limited amount of foreign exchange reserves.

3. Foreign Borrowing

A country should be credit worthy in order to borrow from other countries. Foreign borrowing
results in foreign debt and foreign debt creates obligation of repayment. Repayment of foreign
debt is difficult, especially for developing countries, and creates some problems.

4. Domestic Borrowing

In this method the government borrows from domestic private sector. The problem with this
method is that it leads to the crowding out of the private sector capital and, as a result, the private
sector may not be able to invest.

The government borrows (from both domestic and foreign sources) under different situations and
this involves issuing of public debt. The different situations under which the government issues
public debt are the following:

i. In times of substantial full employment because at that time the government wants to
command its real resources.

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 ii. In periods of less than full employment because the government wants to raise the
economy to full employment.

iii. In times of inflation because the government wants to reduce the amount of money supply
in the market.

iv. In times of war in order to finance the war.

v. For investment in long term capital projects which yield social income (not monetary
income).

vi. For investment in self-liquidating public projects which produce monetary (not social)
income.

1.2. Types of Public Debt

? Do you know the different forms that public debt can take?
The types of public debt can be classified based on consideration of different factors. These
classifications are discussed below.
i) Internal Vs External Debts

Internal debt is public debt which is floated within the country. External debt is borrowing from
and the consequent obligation to foreign governments, the nationals of foreign countries,
multilateral institutions or international organizations.

ii) Productive Loans Vs Unproductive Loans

Productive loans are loans which are incurred for productive purposes, which include projects
that result in the creation of assets and yield returns. Examples of such projects include railway
projects, power projects and irrigation projects. On the other hand, unproductive loans are loans
incurred to finance purposes that do not yield returns and which do not lead to the creation of any
asset such as financing wars and relief operations. However, unproductive loans create burden on
the government.

iii) Redeemable Vs Irredeemable Debts

Redeemable debts are debts which the government promises to repay the principal and the
interest at some future date which is clear cut. Irredeemable debts which the government does
not promise to pay the principal at a clear future date but it regularly pays the interest.

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 iv) Funded Vs Unfunded Debts

Funded debts are long term debts so that the repayment is to be made at lease year. Unfunded
debts are debts are debts which are to be repaid within a year such as treasury bills and bonds.

v) Voluntary Vs Compulsory Debts

Voluntary debts are debts which are incurred following voluntary lending. In this case the
government issues and publicizes public debt, and then the lenders voluntarily lend the money to
the government. On the other hand, involuntary debts are debts result from borrowing from
domestic sources in which the lenders are forced by the government to lend some amount of
money. Most of the time debts are voluntary. In modern times compulsory debts are not
common. However, compulsory debts are observed in emergency situations such as in times of
war, inflation, etc.

1.3. The Burden of Public Debt

? Where the burden of repaying public debt does ultimately rests?

When government borrows it is also obligated to repay the debt. This repayment has burden
which is known as burden of public debt. Repayment of public debt involves raising taxes by the
government. A debt can be incurred at some time but most of the time the repayment takes many
years beyond a generation that the burden of public debt also affect future generations. In
general, the burden of public debt ultimately rests on the general public – current or future
generations.

The burden of public debt can be classified in to two:

a) Primary or financial burden: when a debt is incurred there would be increase in taxes.
This increase in taxes results in the transfer of income from the people to the government.
So, there is loss of income on the side of the people and it is this loss of income which is
called primary or financial burden of public debt.

b) Secondary or real burden: in addition to reducing the income of the people, the rise in
taxation negatively affects the capacity and willingness to work and save on the side of
the people. Such effects of rising taxation are called secondary or real burden of public
debt. Secondary burden of public debt affects the entire economy more than what it
seems at first glance.

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  Activity-1
1. Define what public debt is.
___________________________________________________________________
___________________________________________________________________
______________________________________________________________.

2. What are the reasons for government borrowing?

___________________________________________________________________
___________________________________________________________________
_____________________________________________________________.

3. What are the different classifications of public debt?

___________________________________________________________________
___________________________________________________________________
___________________________________________________________.

4. What is the difference between primary and secondary burdens of public debt?
___________________________________________________________________
___________________________________________________________________
______________________________________________________________.

Section Two: Public Debt Management and Redemption of Public Debt

Section Overview
Dear distance learner, welcome to the second section of this unit. This section is further divided
in to two sub-sections. The first sub-section is concerned with public debt management. And the
second sub-section deals with the redemption of public debt.

Section Objectives

At the end of this section, you will be able to:

• define the concept of public debt management,
• discuss the broad principles of public debt management, and
• identify the advantages of public debt redemption.

2.1. Public Debt Management

? What is public debt management?

Public debt management is a systematic management of the methods of borrowing and
repayment of loans. Public debt management is concerned the determination of the structural
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characteristics of public debt. In other words Public debt management is concerned with
decisions regarding:
• The forms of issuing public debt
• The proportion in which different forms of public debt should be issued
• The terms on which new bonds are sold
• The patterns of maturities of debts
• The terms of maturing debts are reduced or refunded, etc.

The objective is that public debt has to be handled in such a way that it helps to maintain
economic stability. Borrowing and its repayment should not have inflationary or deflationary
effects on the economy.

In times of inflation (demandful inflation), the government increases public debt because there is
excess money supply in the market chasing few goods. So, the government borrows to take
certain amount of the money from the market and this, in turn increases the public debt. In times
of deflation, the government repays the debt and this increases the amount of money supply in
the market.

? Dear student, do you know the principles of public debt management?

Public debt management has some basic principles which are discussed below.

1. The interest cost of servicing public debt should be minimized. The government should
be in a position to incur and redeem public debt at a minimum interest cost. In case when
the debt is domestic the interest rate can be minimized through central bank operation by
keeping interest rate low.

2. Public debt should be managed in such a way that satisfies investors. The government
should offer attractive terms to investors.

3. Public debt policy should be coordinated with monetary and fiscal policies of the country
so that the three policies contribute to economic growth and economic stability of the
country.

2.2. Redemption of Public Debt

? Why do governments have to repay public debt?

There are many advantages/reasons for redemption of public debt. These include:

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 1. Redemption of public debt saves the government from expenditure extravagancy. Unless
public debt is reduced there would be extravagant expenditure on the side of the
government while shifting the debt burden to future governments and generations.

2. Redemption of public debt also builds the confidence of the lenders. So that it would be
easier for the government to float loans in the future.

3. Redemption of public debt leads to increase in private investment.

4. It can be used as stabilization instrument when the economy is in deflationary situation.

5. Redemption of public debt reduces the cost of debt management.

? How can the issue of repayment of public debt be handled?

A government can follow different approaches as far as the repayment of public debt is
concerned. These methods of handling debt are:

a) Repudiation: it is refusing to pay the debt. This is an immoral and dishonest way of
approaching the repayment of public debt. The problem with this method is that it will shake
the confidence of the lenders and the general public on the government. In addition, the
government would not be able raise new loans, at least in the near future.

b) Refunding the loans: refunding is a process by which maturing bonds are replaced by new
bonds. The drawback of this method is the government is tempted to postpone its obligation
to repay that the total burden of the debt would continue in the future.

c) Actual repayment of the debt: in this approach the government actually repays the dept. The
government can use different methods for actual debt repayment. Some of these methods are
shown below.
i. Sinking fund – in this method the government deposits certain amount of revenue every
year for the repayment of the outstanding debt. The sinking fund is earmarked for clearing
the debt. However, in practice, the government can use the fund for other purposes in times
of financial difficulty.

ii. The surplus revenue – the government can follow a surplus budget policy so that the
surplus budget can be used to repay the public debt. In recent years, however, due to
rapidly increasing public expenditure, surplus budget is a very rare phenomenon.

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 iii. Capital levy – refers to a heavy tax on property or wealth. It is imposed on very rich
people who have capital assets above a certain value. Usually this capital levy is imposed
for financing or immediately after the war to clear unproductive debts.

 Activity-2
1. What are the basic principles of public debt management?
___________________________________________________________________
___________________________________________________________________
_______________________________________________.

2. What are the different approaches to handle the repayment of public debt?
___________________________________________________________________
___________________________________________________________________
___________________________________________________________________
___________________________________________________________________
_______________________________________________.

Unit Summary
Public debt is the debt which the state/government owes to its subjects, other countries, and the
nationals and institutions of other countries. A government has to mobilize resources to finance
its activities. There are different alternatives to mobilize resources by the government like
taxation, expenditure reduction, and printing of currency. However, there is a limit for these
alternatives. The government has to borrow from different sources. There are two major reasons
for government borrowing. The first reason is a continuous increase in government expenditure.
The other reason is the incidence of budget deficit which in turn results in internal and external
imbalances. So the government has to borrow to finance its increased expenditure and budget
deficit. The types of public debt are classified based on consideration of different factors. These
classifications include: internal Vs external debts, productive loans Vs unproductive loans,
redeemable Vs irredeemable debts, funded Vs unfunded debts, and voluntary Vs compulsory
debts. The government is obligated to repay public debt. This repayment burden is known as
burden of public debt. A debt can be incurred at some time but most of the time the repayment
takes many years beyond a generation that the burden of public debt also affect future
generations. There are two forms of the burden of public debt, i.e. primary or financial burden
and secondary or real burden.

Public debt management is a systematic management of the methods of borrowing and

repayment of loans. Public debt management is concerned the determination of the structural
characteristics of public debt. Public debt has to be handled in such a way that it helps to

85
maintain economic stability. Borrowing and its repayment should not have inflationary or
deflationary effects on the economy. There are many advantages/reasons for redemption of
public debt. Redemption of public debt saves the government from expenditure extravagancy,
builds the confidence of the lenders, leads to increase in private investment, can be used as
stabilization instrument of the economy, and reduces the cost of debt management. Different
approaches can be followed as far as the repayment of public debt is concerned. These methods
of handling debt are repudiation, refunding the loans, and actual repayment of the debt. The
methods for actual repayment of public debt include sinking fund, surplus revenue, and capital
levy. We hope that you have grasped the discussions in this unit. If so, well done!

 Check List
Direction: Dear students this is the section in which you self-assess your understanding of the
discussions in this unit. Put a tick mark () in the yes column for activities that you have clear
understanding and in the no column for activities that you doubt that you have good understanding.

I Can: Yes No

• Explain what public debt is and the reasons for

government borrowing

• Describe the different types of public debt

• Explain the burden of public debt

• Understand public debt management

• Discuss the redemption of public debt

N.B: If you have any doubt about your understanding of any of the above checklists, don’t hesitate to
go back and refer the discussions in the sections!

 Self-Test Exercise
Give short and brief answers for the following questions.
1. What is public debt?
2. Explain the two major reasons for government borrowing.
3. List down the different classifications of the types of public debt.
4. Discuss the concepts of primary and secondary burdens of public debt.
5. What are the major concerns of public debt management?
6. What are the advantages of redemption of public debt?
7. Discuss the different approaches of handling repayment of public debt and the different methods of
actual repayment of public debt.

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 UNIT SIX

DEVELOPING SECURITIES/STOCK MARKET

Unit Introduction
This unit deals with financial securities/ stock markets which operate in organized market for
buying and selling financial instruments known as securities that include stocks, bonds and
others. These stock exchanges perform important roles in national economies. Most importantly,
they encourage investment by providing places for buyers and sellers to trade securities. This
investment, in turn, enables corporations to obtain funds to expand their businesses. In the
modern era, stock exchange arrangements make it easier for corporations to raise the funds that
they need to build and expand their businesses. We will see what are they and how they function
in fair detail.

Unit Objectives
Dear learner, by the end of this unit you should be able to:

• define securities market;

• describe the rationales for developing securities market;
• identify problems (costs) associated with stock market and factors that provide a
conducive environment for securities market;
• describe the state of stock market in Ethiopia; and
• identify the prospects and challenges of developing securities market in Ethiopia.

Pre-test Questions

• What do you know about what we call securities (stocks, bonds, etc.) in financial operations?
• What do you think is the condition of stock market in the Ethiopian context?

Section One: Securities Markets

Section Overview

Dear student, we have already said that securities are capital resource(s) that can be used for
investment to generate further economic wealth. These involve institutions of investment and
lending with a longer lifetime, usually more than a year. They are important in the process of
capital formation, i.e. the transfer of savings from individuals and governments to businesses for
investment. Risk capital is, in fact, another name for the money that investors use to buy stocks,

87
bonds and other securities. It draws from the fact that an investment in stock market is potentially
risky, and we will look at the reasons in the coming sections. But before that, we shall to see how
stock markets operate and the needs to develop them.

Section Objectives
Dear learner, by the end of this section you should be able to:
• define security markets;
• identify some the rationales to develop stock markets
• describe factors that hinder the development and effective functioning of stock
markets.

1.1. Understanding Securities Markets

? Dear learner, do you know anything about financial ‘securities’ and some of the forms
it may take?

Securities are elements of capital that takes the form of financial instruments. Capital refers to a
body of goods and monies from which future income can be derived. It could take productive
capital (such as machines, raw materials, and other physical goods) or financial capital (like such
as corporate securities and accounts receivable) forms. Unlike productive capital, the liquidation
of financial capital does not reduce productive capacity, but it merely changes the distribution of
income. To discuss about securities is nothing but to discuss about the financial capital that
includes stocks, bonds, options, and futures.

1.1.1. Stock Markets

Stocks are shares of ownership in companies. People who buy a company’s stock receive
dividends, i.e. a portion of profits. Stockholders are entitled to any capital gains that arise through
their trading activity, i.e. to any gain obtained when the price at which the stock is sold is greater
than the purchase price. Shares in a corporation can be bought and sold, usually on a public stock
exchange. Consequently, the owner of shares can realize a profit or capital gain if the stock is
sold at a price above what the owner originally paid for it.

Stock markets are organized markets for buying and selling the aforementioned financial
securities. Stock exchange or transactions involve the activities of brokers and dealers. These
individuals facilitate the buying and selling of financial assets. Brokers execute trades on behalf
of clients and receive commissions and fees in exchange for matching buyers and sellers.
Dealers, on the other hand, buy and sell from their own portfolios or inventories of securities.
Inventories are records of business current assets, merchandise on hand, and other resources

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including the value of work in progress and work completed but not sold. Dealers, thus, earn
income by selling a financial instrument at a price that is greater than the price the dealer paid for
the instrument. Some exchange participants perform both roles. These dealer-brokers sometimes
act purely as a client’s agent and at other times buy and sell from their own inventory of financial
assets.

Most stock exchanges have specific locations where the trades are completed. For the stock of a
company to be traded at these exchanges, it must be listed, and to be listed, the company must
satisfy certain requirements. Some of the world’s best known stock exchanges are: the European
Association of Securities Dealers Automated Quotation system (EASDAQ), which is the major
over-the-counter market for the European Union (EU), and those in the USA: the New York
Stock Exchange (NYSE) and the American Stock Exchange (AMEX), both in New York City.

But not all stocks are bought and sold at a specific site. Such stocks are referred to as unlisted.
Many of these stocks are traded “over the counter”, i.e. by telephone or by computer. Since the
late 1980s stock exchanges achieved new levels of market efficiency through an increased use of
fast and inexpensive computers. Computer networks allowed exchanges to connect to each other,
both within countries and internationally. Electronic exchanges fostered the growth of an open,
global securities market.

Sometimes pessimistic economic forecasts rush traders to sell their stocks, which in turn brings a
financial crush, like the one happened in USA in October 1987. The US government then
established new rules for higher margin requirements across markets, including futures trading.
This crash also led to the institution of so-called “circuit breakers” on the NYSE. A circuit
breaker is a temporary suspension of trading when prices fall by a particular amount.

1.1.2. Non-stock Security Markets

? Dear learner, do you know other security trades other than stock markets?

Although the general operations of exchanges apply to all securities trading, there are some
differences. Trades in non-stock securities, such as bonds and options in particular, are often
managed by financial intermediaries other than brokers.

Bond is an interest-bearing certificate sold by corporations and governments to raise money for
expansion or capital. An investor who purchases a bond is essentially loaning money to the bond
issuer in return for interest. The investor can hold the bond and collect interest payments or sell
the bond to a third party. Therefore, bonds provide a way for companies to borrow money. And,
the company begins to obtain funds when it initially issue bonds. Bond issuers can sell bonds

89
directly through an auction process or use investment banking services. The investment banker
buys the bonds from the issuer and then sells them to the public.

In Ethiopia, the culture of corporations to issue bond virtually nonexistent. It was the 1963 (E.C.)
proclamation on bond that gave the first legal ground for the government to issue its own bond
when need arises. The first bond was issued and began operation two years later. Since then,
government bonds have been issued at different times to finance government spending. Recent
examples include the bond issued to cover part of the finance required to build the Millennium
Dam (5250 project) on Abbay river.

A bond’s ‘principal’, or face value, represents the amount of the original loan that is to be repaid
on the bond’s maturity date. The interest that the issuer agrees to pay each year is known as the
“coupon”. The interest rate, or coupon rate, multiplied by the principal of the bond provides the
money amount of the coupon. For example, a bond with an 8 percent coupon rate and a principal
of Birr 1000 will pay annual interest of Birr 80.

Most companies try to establish a financial structure based on a combination of stocks,

representing distributed ownership, and bonds, representing debt obligations. These bonds are
often known as corporate bonds. Corporate bonds are issued by private utilities, transportation
companies, industrial enterprises, or banks and finance companies. These corporate bonds can be
divided into two additional categories: “mortgage bonds”, and “debentures”. The former refers to
bonds which are secured by the issuer’s assets, while the latter are backed only by the issuer’s
credit.

A company that raises funds by issuing these bonds is said to be leveraged. Because bondholders
are paid at a set rate regardless of profits, this approach increases the potential for profit to
stockholders but also increases the level of financial risk.

From an investment point of view, stocks offer a higher potential return if profits rise, but bonds
are generally safer for investment. Stock dividends are paid out of company profits, while bond
interest payments are made even if the company is losing money. If a corporation goes bankrupt,
bondholders must be paid before stockholders. Nonetheless, risks are associated with investing in
bonds. Because most bonds offer a fixed rate of return, a bond with a low coupon rate will be less
valuable if interest rates rise to the point that the investor's money could be more profitably
invested elsewhere. If the inflation rate rises in relation to the coupon rate, the value of the
investor’s return will be reduced. The value of bonds also will vary due to changes in the default
risk, or credit rating, of bond issuers. If the issuer of the bond is unable to make timely principal
and interest payments, the issuer is said to be in default.

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Other kinds of securities are the so-called option and futures. Options refer to rights of a person
or organization that sells a financial instrument giving the right but not the obligation to buy or
sell an asset at a stated price at a future date. Options are traded on many stock exchanges of the
world. Options writers offer investors the rights to buy or sell, at fixed prices and over fixed time
periods, specified numbers of shares or amounts of financial or real assets. Writers give call
options to people who want options to buy. Futures are agreements to deliver a commodity at a
future date at a specific price. A commodity, here, is used to mean any item that can be bought or
sold and delivered. Futures and options traders often judge market trends by monitoring compiled
indexes and averages of stocks, usually organized by industry or market ranking.

 Activity – 1

1. What are the financial instruments we regard as securities? _______________

_____________________________________________________________________
____________________________________________________________.
2. What are the differences between stocks and bonds? ________________________
_____________________________________________________________________
________________.

Section Two: Rationales, Challenges and Prospects of Developing Securities/

Stock Market with Emphasis in Ethiopia

Section Overview
Dear student, this section is also a continuation of the previous section. To this end, it deals with
the rationales, challenges and prospects of developing securities/ stock market with urging you to
pay much more attention to the Ethiopia context.

Section Objectives
Dear learner, by the end of this section you should be able to:

• describe the major rationales to develop security/stock markets;

• mention limitations/problems of security/stock markets; and
• identify the prospects and challenges of developing securities market in the Ethiopian
context.

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 2.1. Rationale and Enabling Environment for Developing Securities/Stock
Market
Stock exchanges perform important roles in national economies. While there are so many reasons
to develop stock markets, the following rationales only suffice few of them.

A. Resource allocation: Stock markets can create new opportunities for emerging
companies. Most importantly, they encourage investment by providing places for buyers
and sellers to trade securities. This arrangement makes it easier for corporations to raise
the funds that they need to build and expand their investment, which in turn enables
corporations to expand their businesses.

B. Improving efficiency of financial operations: Stock markets ensure better and efficient
financial system. If the stock market functions effectively, the financial prices depend on
security values, i.e. they are determined by market forces, rather than administrative
authorities.

C. Enhancing capital structure: Stock markets will improve the capital structure or debt
equity ratio. Capital structure is the company’s assets and liabilities: the relative
proportions of a company’s total capital made up by debt (debt equity ratio), common
stock, and preferred stock. In the absences of security markets the debt equity ratio will
be very high.

D. Improving business management: Stock markets allow deconcentration of the

ownership management by divorcing managerial roles from ownership (shareholders). In
developing countries, there is this usual fear that few individuals affiliated to the ruling
class will dominate the private business men in the financial sector. But if there are stock
markets, individuals who are not affiliated to the ruling class can also have access to
capital ownership and its management.

E. Eases auditing and accounting: Stock markets also improve the auditing and accounting
standards of a country. This would result from the fact that all companies are required to
provide financial reports which would be checked by external auditors. The information
provided by companies enables government authorities to collect tax in an efficient
manner.

F. Instrument for monetary and fiscal policies: Stock markets provide effective tools for
monetary and fiscal policy. In the absence of stock markets, governments can only

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 borrow from the central bank or sales its reserves to the commercial banks, which may
bear a money pressure, i.e. inflationary tendency in the economy.

In addition, since stock markets mark engagement of the private individuals in the financial
sectors, they may enhance privatization efforts. Better economic results could be attained from
stock markets if there are enabling environment. These include:
• Political environment: since political uncertainty highly affects the willingness to invest,
the political framework should be an enabling one.
• Economic and financial: policies that govern economic and financial operation must
consider various factors such as the persistence of sufficient demand and supply of
securities.
• Incentives: incentives must be provided by government in different ways like exemption,
tax holidays, etc.
• Institutional environment: financial intermediaries should be skillful. Auditing and
accounting standards should be systematic and sophisticated.

2.2. Limitations/ Costs in Establishing Stock Markets

So far, we discussed how securities/stocks operate in an economy and the basic rationales to have
them. However, there are also some risks associated with stocks and stock exchange that
stockholders face. One risk is that the firm may experience losses and not be able to continue the
payment of dividends. Another risk involves capital losses when the stockholder sells shares at a
price below the purchase price. Besides, developing stock markets have the following limits.
These are:

Lack of supply: During their early or formative years, stock markets usually face lack of
supply of securities such as stocks and bonds. This would obviously hamper an effective
functioning of the sock markets.

Investment rate fluctuations: An extreme variability of investment rates may put limit
to the operation of stock markets. It, among others, makes business planning very difficult
especially for borrowers and for those who intend to save. As businessmen are profit
motivated, they do not want to incur risk by engaging themselves in unpredictable
economic environment.

Initial capital: Financial transactions are not cost free. There are several costs to be
covered by business men. For example, there are costs to be paid for specialized services
of the financial intermediaries like brokers. Since, the intermediaries themselves
potentially show profiteering behavior. So, it appears to be difficult for investors to cover

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 these costs especially at the earlier stages. Such costs are very much likely to influence
business decisions with the possibility of reversing investment decisions.

Widening income gap: It is general argued that stock markets exacerbate income gap in
the society particularly in the short run. In their early stages, security/stock markets are
limited in their supply and they tend to benefit only a limited section of the people
affected by the economy.

2.3. Prospects and Challenges of Developing Securities Market in Ethiopia

In Ethiopia stock markets have a very recent history. It is a new area of economic engagement.
However, there also prospects to develop securities/stock markets in the country. Ethiopia is
endowed with unexploited potential resources and population that constitutes one of the largest
markets in Africa.

Ethiopia’s transition to market oriented economy another prospect for development of

securities/stock market. There are already profiting companies in the security markets. Financial
institutions are far more developing and the development of financial institutions is important for
the development security markets. For example, development of insurances can boost the
operation of security markets. There is also a gradual improvement in the incentive packages for
investment in the sector.

Equally, there are so many challenges. Potential investors in the security markets always
complain about the bureaucratic red-tapism in the administrative sectors. The bureaucratic
procedures are very cumbersome.

The working financial relationships between the central and states governments are not genuinely
defined in such a way favourable to the development for securities market. However, subsequent
investment proclamations are gradually addressing some of the problems.

The banks in Ethiopia normally require expensive collateral, which should have double value of
the credit on average, as a value to pay back the loans. Investors who do not have collateral,
therefore, will face difficulties to get loans at the initial stage. Credit card services are not yet
widespread and where they are available, the interest charged is so prohibitive. This should be
solved quickly to attract international investors. The restriction on the possession of domestic
credit cards for foreigners and corporate bodies is also an impediment for the business men
business because payment by credit card through internet is often required nowadays.

There is also lack of infrastructure, and the country needs a huge investment infrastructure such
as road networks, supply of energy and telecommunication services. Lack of educated manpower

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in the country is another problem that requires more development in the education sector both
qualitatively and quantitatively to meet the country’s need of skilled man power.

 Activity –2
1. What are the main challenges of developing securities markets? _____________________
________________________________________________________________________
_______________________________________________________________________ .
2. Why do we need to have stock markets? __________________________________
________________________________________________________________________
_____________.
3. What challenges and prospects are available for the development of securities/stock
market in Ethiopia? ________________________________________________________
________________________________________________________________________
________________________________________________________________________.

UNIT SUMMARY

There could be so many reasons to invest in securities particularly in stocks. The general
behavior of the broader stock markets moves-up on a daily basis when stock prices generally
increased. On a long-term basis, variations in a stock’s price reflect profit performance: the
increase in profitability will move a company’s stock price upward, while declining profitability
will move a company’s stock price downward. Thus, prices of stocks and bonds influence
investment decisions. In the Ethiopian context, although there is a very good potential, security
market are yet underdeveloped due to administrative, regulatory and infrastructural
environments.

 Self-test Exercises
Write short answers for the following questions.
1. What are securities markets in general and stock markets in particular?
2. What are the main differences between stock markets and trades in non-stock securities such
as bonds and options?
3. What are the rationales to develop securities/stock market?
4. What limitations and problems do stock markets have?
5. What are the conditions that may provide conducive environment for securities/stock
markets?
6. What are the challenges of developing securities market in Ethiopia?
7.

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 Unit Checklist
Put an (X) mark in the boxes in front of the ideas you performed well.
I can:
• define financial securities
• describe the rationales for developing securities market
• identify problems (costs) associated with stock market
• describe factors that provide a conducive environment for securities market, and
• identify the prospects and challenges of developing securities market in Ethiopia

If you have any doubt about your understanding of any of the above checklists, do not hesitate to go
back and refer the discussions provided under different sections.

96
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