MWALIMU NYERERE MEMORIAL

ACADEMY (MNMA – KARUME

CUMPASS)

MODULE TWO

MODULE code: ESU

07316
PUBLIC FINANCE THEORY
Instructor : Mr. Fungwa Elias
Joseph

Email: josephfungwa88@gmail.com Phone:0765-808876

PUBLIC FINANCE
THEORY

ESU 07316
 Fiscal Policy
At the end of the session students
should be able to understand the:
Explain the meaning and
objectives of fiscal policy
Describe tools/mechanisms of
Fiscal policy
Describe Forms of Fiscal policy
Functions of Fiscal policy
Describe problems in using Fiscal
policy
 Meaning of fiscal policy
When speaking of fiscal policy, the
government generally is referring to
two major governmental economic
activities;
Taxation, and
Spending.

Definition:
Fiscal policy: Is the government
using its tools(T and G ) to influence
the welfare of the economy. It does this
by either government spending (G)or
taxation (T). It is used when trying to
manipulate the macroeconomic
welfare of the economy.
 Cont…..
• Fiscal policy: Is any change in government
spending and taxation that is designed to change
overall spending in an economy. The use of
government spending and taxation to influence
economic growth/Any action taken by the
government which influences the timing,
magnitude and structure of current revenue and
expenditure
 Cont….
Fiscal policy: is the use of the government’s
budget to influence the total level of economic
activity in the country by influencing the total
demand for goods and services or
Use of government spending and tax policies
to influence total desired expenditure in order
to influence the level of national income (i.e
trying to avoid unsustainable booms and
recessions)
Objectives of fiscal policies
 To achieve full employment: Fiscal policy aim to
reduce unemployment
 Price stability: However lowering expenditure is not
advisable in less developed countries to fight
inflation. So also an increase in taxation may not be
possible as taxable capacity is low. Hence in time of
inflation, fiscal policy should be supplemented by
monetary policy to control inflation.
 Cont…..
• To accelerate the rate of economic
growth: Taxation, government expenditure
and public borrowings should be used to
encourage consumption, production and
distribution
 Tools/Mechanisms Of
Fiscal Policy
The followings are the tools of fiscal policy.

1. Government expenditures.

2. Taxation.

3. Borrowings.
 Mechanisms/types of
Fiscal Policy
• Expansionary Fiscal Policy
• In this policy the government increases its
expenditures and reduces the amount of tax in an
attempt to increase aggregate demand.
Expansionary fiscal policy is designed to influence
aggregate demand since when expenditures are
increased on things such as education, health,
road construction, salary to civil servants it
results to an increase in incomes to the people
which act as a stimulant to aggregate demand.
 Cont…..
• When the economy is in a contraction or
recession, the government will enact an
EXPANSIONARY FISCAL POLICY to "expand" the
economy

• There is an increasing GDP, disposable income

and lowering unemployment. A result of this
policy is an increase in the price level.
 Cont…..
This will increase the aggregate demand by doing the
following:

i. Decreasing Taxes (more money in people's pockets)

ii. Increasing Transfer Payments (more money in

people's pockets)

iii. Increase Government Spending on social programs

(more money in people's pockets)
 Cont…..
• Contractionary Fiscal Policy
• This is a policy in which the government attempts
to reduce aggregate demand by increasing tax
and reducing expenditures. The aim is to control
inflation. When the economy is in an expansion
which results in high prices, the government will
enact a contractionary fiscal policy to "contract"
the economy.
 Cont…..
• There by decreasing GDP and increasing
unemployment a result of this policy is a
decrease in the price level. Remember that fiscal
policy is a tool to help stabilize prices and control
unemployment. Since unemployment is linked to
GDP, it is possible that when the government
enacts a contractionary policy to decrease
aggregate demand, that unemployment is going
to increase. However, mild unemployment is
better than hyperinflation.
 Cont…..
This will decrease the aggregate demand by doing
the follow
I. Increasing taxes (less money in people's
pockets)
II. Decreasing transfer payments (less money in
people's pockets)
III. Decrease government spending (less money in
people's pockets)
 Forms Of Fiscal Policy
Discretionary Fiscal Policy
• Discretionary fiscal policy involves changes in the
government which is designed to change level of
real gross domestic product (GDP),
unemployment, income or price level.
• Specific actions are needed in a discretionary
fiscal policy that involves changes in government
spending (increasing/decreasing) and taxation
(increasing/decreasing tax rate)
 Cont…..
Automatic or Built-In Stab/ Non-discretionary fiscal
policy
• Automatic or Built-In Stab: Changes in government
spending and taxation that occur automatically
without deliberate action of government Non-
discretionary fiscal policy occurs automatically
through built in stabilizers such as progressive tax
rates.
• As Gross Domestic Product (GDP) increases, the
average tax rate will increase in progressive tax
system. The increases average tax will reduce
people’s incomes and hence demand for goods and
services
Functions or purposes of fiscal
policy
The development of a fiscal policy
generally has four primary purposes
or functions (Musgrave Richard and
Musgrave Peggy (1989) which are
Allocation
Distribution
Stabilization and
Development
 Cont…..
Allocation
The first major function of fiscal policy is
to determine exactly how funds will be
allocated. This is closely related to the
issues of taxation and spending, because
the allocation of funds depends upon the
collection of taxes and the government
using that revenue for specific purposes.
The national budget determines how
funds are allocated.
 Cont…..
Distribution
The distribution function of fiscal policy is to determine more
specifically how those funds will be distributed throughout each
segment of the economy.
For instance, the government might allocate $1 billion toward
social welfare programs, but $100 million could be distributed
to food stamp programs, while another $250 million is
distributed among low-cost housing authority agencies.
Distribution provides the specific explanation of what allocation
was intended for
 Cont…..
Stabilization
Stabilization is another important function
of fiscal policy in that the purpose of
budgeting is to provide stable economic
growth. Without some restraints on
spending, the economic growth of the
nation could become unstable, resulting in
periods of unrestrained growth and
contraction. While many might frown
upon governmental restraint of growth
 Cont…..
Development
The fourth major function of fiscal policy is that of
development. Development seems to indicate economic
growth, and that is, in fact, its overall purpose
True economic growth occurs when various projects are
financed and carried out using borrowed funds. This stems
from the the belief that the private sector cannot grow the
economy by itself. Instead, some government input and
influence are needed.
Borrowing funds for this economic growth is one way in which
the government brings about development.
 Problems in using Fiscal policy
Crowding Out Effect

• When the government increases spending by

borrowing money (like with Treasury bonds), that
leaves fewer funds available for firms to borrow for
investment and for consumers to borrow to
purchase goods and services. In others words, the
government "crowds out" private investment
 Cont…..
Time Lags
• If the government plans to increase spending
this can take a long time period to filter into the
economy and it may be too late spending plans
are only set once a year. It takes time for the
government to recognize the need for
intervention, to agree on a policy, to implement
the policy, and for the policy to start affecting
the behavior of consumers and firms
 Cont…..

Side effects on public spending

• Reduced government spending to decrease

inflationary pressure could adversely affect
public services such as public transport and
education caused by market failure.
 Cont…..

Disincentive of tax cuts

• Increasing taxes reduces AD may cause

disincentive to work , if this occurs there will be
a fall in productivity and AS could fall. However
higher taxes do not necessary reduce incentives
to work if the income effect dominates
 Cont…..
Inflexibility of government finance
• Much government expenditures go to
wages and salaries and it is not possible
to play around with these to suit the short
run needs of the government
 Test yourself
1. Despite the significant increase in
government expenditures, a sizeable
proportion of population is living below the
poverty line. Many people fail to obtain
even necessaries for human survival. They
hardly derive any benefit from the public
expenditure. Discus the reasons for
increasing Government Expenditure
2. Discus why Monetarists and Keynessian do
not seem to agree on the efficiency of fiscal
policy.
THANK YOU
 Government Debt
• Public Debt is defined as how much a
country owes to lenders outside of itself.
These can include individuals, businesses,
and even other governments.
• Debts can be categorized into the following
groups
 Classifications of
Public Debt
• Internal or external debts
1. Internal Debts This refers to money owed by the
government to
institutions/individuals/commercial bank within
the country.
2. External Debts This refers to money owed by the
government to institutions outside the country
and donor countries.
 Cont…
• Long term and short term debts

1. Long Term Public Debts: These are debts which

are repaid after a long period of time, e.g
between 5 and 20 years.

2. Short Term Debts: These are debts which are

repaid after a short period of time
 Cont…
• Reproductive and non-reproductive debts:
1. Reproductive Debts These are debts which a
government use the money borrowed for
productive expenditures such as construction of
roads or provision of social services.
2. Non-Reproductive Debts These are the debts
which the government use the money borrowed
for non-productive expenditures such as buying
of arms.
 Causes and justification of
public debt
• Inadequate tax revenue. Poor countries incur debts
because the revenue collected from taxes is insufficient to
finance government programmes. At times, the expected
revenue tends to fluctuate.
• To reduce the burden of taxation. Borrowing is often
resorted to, as a means of reducing the tax burden from the
people.
• Overcome natural calamities. Debts are also incurred to
meet the unexpected occurrences such as floods, drought,
etc.
• Debt servicing. It is a common practice y some developing
national to incur fresh debt in order to repay the old ones.
• Political instability. The prevailing political turmoil in
developing countries (especially in Africa), has greatly
necessitated government borrowing thereby incurring public
debts.
 Positive Consequences of a
Public Debt
• The debt incurred can lead to an increase in GDP,
if it is used appropriately to exploit and mobilize
the domestic production for increased output.
• More employment prospects can be generated,
when the debt is a self-liquidating one (i.e. aimed
at stimulating production activities).
• To reduce political resistance to high taxation
which is likely among the citizens of developing
countries.
• A public debt can reduce political instability e.g.
through borrowing to finance wars. A stable
political atmosphere, there is no doubt, can
encourage production for development.
Negative Consequences of a Public Debt
1. The burden falls on the citizens who are taxed
to cover an internal debt, so that the size of the
debt may influence the level of taxation.
2. The effect is great on the level of consumption
as high taxes on individuals deprive them of
consumption.
3. The future generation is affected as a result of
the debt incurred sometime back, to finance
services that it never enjoyed.
 Cont….
• Debt repayment reduces expenditure on capital
goods for investment and thus limited capital
formation.
• A public debt encourages over dependence on
external sources, and yet this cannot promote the
spirit of self-reliance
• The debt incurred (in form of tied aid) is always
accompanied with strings (conditions) attached
which often conflict with the development
programmes of the recipient country.
Repayment of public debts
Refunding
• Refunding of debt implies the issue of new bonds
and securities by the government in order to
repay the matured loans.
Conversion
• Conversion of public debt implies changing the
existing loans, before maturity, into new loans at
an advantage in servicing charges
 Cont….
Surplus budgets
• Quite often, surplus budgets (i.e. by spending less
than the public revenue obtained) may be utilized
for clearing off public debts.
Negotiation for Debt cancellation
• Similarly public debt can be settled through round
table negotiation between countries in exchange
for future services or as way of providing grant
especially in developing countries
 Cont….
• Sinking fund: A sinking fund is a fund created by
the government and gradually accumulated every
year by setting aside a part of current public
revenue in such a way that it would be sufficient to
pay off the funded debt at the time of maturity.
 QUIZ
1. Explain sources of external borrowing
2. Reasons for borrowing from external