Economics

Key unit competence:

Learners will be able to analyse the role of public finance in economic development.

My goals 

By the end of this unit, I will be able to: 

• Identify the branches and sources of government revenue. 
• Explain the objectives, types of budgets and the problems of budgeting in Least Developed Countries(LDCs). 
• Explain why governments incur debt. 
• Explain the different types and purpose of government expenditure. 
• Analyse the sources of government revenue. 
• Describe the role of budgeting in an economy.
• Examine the effects of public debt on an economy.
• Assess the impact of government expenditure on economic development. 
• Appreciate the role of budgeting and public expenditure in an economy.
• Appreciate the need for a government to spend.

9.1 Public finance

9.1.1 Meaning 

Public finance is macroeconomic discipline that concerns the collection of government revenue and how it is allocated for public expenditure so as to achieve targeted objectives. 

Fiscal policy on the other hand refers to the deliberate use of taxation, government borrowing and government expenditure to regulate the level of economic activities. 

Activity 1

Visit the school library or internet, do research on the following and respond to these questions: 

1. What is the difference between public finance and fiscal policy? 

2. Explain the different branches of public finance.

9.1.2 Branches of public finance 

Public finance is made up of the following five branches:

1. Public Revenue. Deals with methods or collecting public revenue through taxation plus the principles governing taxation. 

2. Public Expenditure. This deals with the total amount of money the government spends on social services  and the effects of such expenditure. 

3. Public Debt. Handles the causes and effects of the debt which the state and local authorities borrow for various reasons. 

4. Financial Administration. This handles the preparation and sanctioning of the budget and auditing of all other organs of the state. 

5. Fiscal policy. Studies the use of public finance operations especially taxation through the budget so as to bring about economic stability.

Government and the economy 

 Activity 2

Describe the role of government in the economy.

Facts 

The major aim of government in economic activities and intervention is to improve the welfare of the people and to ensure economic stability. Government intervention in economic activities differs from country to another depending on the type of economic system. 

Government intervenes in economic activities and regulates the activities of the private sector in any of the following ways: 

9.2 Sources of public revenue  

 Activity 3

Facts

• Taxes: A tax is a compulsory contribution imposed by a public authority, irrespective of the exact amount of service rendered to the tax-payer in return. This is the most important source. 

• Licenses: This is a payment made to the government to secure permission to carry out any gainful activity. 

• Fees: Payment made by an individual for personal services rendered to them by the government. Examples of fees are postal services, medical fees charged in private wards of government hospitals, weighing vehicles, surveying land for a person etc. 

• Fines: Penalties imposed on citizens who break laws e.g. traffic offenders. 

• Loans: Governments can borrow either internally or externally. 

• Compulsory savings: Like insurance payments, social security funds.

• Rent of government property. 

• Gifts and grants: These are contributions made by individuals and societies to the government for meeting the cost of specific projects or schemes in public interest; for relief work in the event of an earthquake, flood, famine, or war; for reconstruction or for development. However, this is an uncertain source of revenue to the government. 

• Privatisation: I.e. sale of public enterprises. 

• Deficit financing. This means the issuing of new notes or borrowing from the central bank. 

• Earning a surplus from gambling: This is common especially in a more developed country. e.g. the national lottery. 

• Earning profit from its commercial ventures. Governments at times set up commercial enterprises from which they earn some revenue. 

• Special assessments: A special assessment is a compulsory contribution, levied in proportion to the special benefits, derived to meet  the cost of a specific improvement to property undertaken in the public interest.

9.3 Methods of expanding sources of government revenue 

• Ensuring political stability and security in all parts of the country to encourage smooth production and business. 

• Attracting more investors both local and foreign so as to expand the tax base. 

• Monetising the economy so as to increase income earners who contribute to the revenues of the economy in different ways. 

• Train and retrain manpower to properly assess taxpayers and collect tax revenue. 

• Diversification  of the economy so as to widen the tax base and increase tax revenue as the major source of government revenue. 

• Introducing new forms of taxes both direct and indirect. 

• Tax education to the public through radios, televisions, posters and seminars to reduce tax defaulters.

• Strengthening anti-smuggling measures. 

• Fighting corruption in all revenue collection offices. 

• Seeking aid and grants. 

• Privatisation of government enterprises which don’t bring in much revenue to the government in form of profits.

9.4 National budget

 Activity 4

Visit the school library or the internet; do research on the following: 

Facts

A budget is a statement, which consists of the revenue and expenditure estimates of the government for one particular financial year. It is prepared on an annual basis and presented by the Minister of Finance before Parliament i.e MINECOFIN. It deals with policy techniques, both monetary and fiscal that are aimed at directing the economy of the country for the coming fiscal year.

Objectives of government budget 

The original purpose of the budget was to raise revenue to meet government expenditures. Nowadays, the budget is the major instrument for regulating the economy. In effect, a budget process is a key instrument in national policy-making. With the use of a budget, a country states which actions to be taken. The main objectives of the budget are to: 

Types of budgets 

               Figure 3 indicates the types of budget and their classifications

There are basically two types of budgets, namely: 

1. Balanced budget

This is the type of government budget where the estimated government revenue is equal to expected expenditure in a financial year. For example, if government plans to spend FRW 200 million and expects to collect FRW 200 million then that is a balanced budget. This type of budget is not common within the developing countries even the developed world.

2. Unbalanced budget 

Figure 4‘a’ shows estimated expenditures greater than estimated revenues while ‘b’ shows estimated expenditures are less than estimated revenues.

This is the type of budget where the estimated revenue is either greater or less than the expected expenditure in a financial year. It has two categories namely:

a) Deficit budget 

This is the type of budget where the expected expenditure is greater than the estimated revenue. This type of budget is common in developing countries because of different reasons and it can be financed in the following ways: 

• External borrowing from developed countries or international  organisations.

• Internal borrowing by selling securities to the people. 

• Increasing taxation by widening the base or the tax rate. 

• Privatisation to generate more income. 

• Borrowing from the central bank through financial accommodation. 

• Use of the sinking fund and drawing from the reserves held by other countries.

b) Surplus budget 

This is the type of budget where the estimated revenue is greater than the expected expenditure in a financial year

Why government may plan for an unbalanced budget 

Surplus budget 

Government may deliberately plan for a surplus budget due to the following reasons: 

• To reduce money in circulation and reduce aggregate demand thus controlling inflationary tendencies. 

• To accumulate reserves for future investment needs. 

•  To reduce government expenditure. 

• To achieve economic stability in case of a boom which may lead to an economic crisis . 

• For redeeming national debts. 

• To improve on the BOP position by reducing expenditure on imports. 

• To set aside funds so as to give grants and loans to others countries. 

Deficit budget 

Government may deliberately plan for a deficit budget because of the following reasons; 

• Need to raise aggregate demand and stimulate the economy out of a recession. 

•  Fear of social and political consequences of high taxes i.e. to reduce political resentment.

• To increase peoples incomes through the government multiplier process. 

• To stimulate economic activities. 

• Borrowing or soliciting aid may be  easier, quicker and cheaper in raising funds for government. 

• When the taxable capacity is low. 

• To  improve standards of living by raising their disposable income. 

• To avoid negative effects of taxation such as political uprising or industrial unrest. 

• To increase the debt servicing capacity so as to reduce public debt burden on the future generation. 

• To collect BOP disequilibrium by increasing expenditure on and subsidisation of exports. 

• To expand employment opportunities by increasing expenditure on employment generating project. 

• To rally political support of masses. 

• To encourage investment both private and public hence increasing capital accumulation.

Causes of budget deficit in LDCs

Activity 5

1. Analyse the reasons as to why there are budget deficits in your country. 

2. Suggest possible solutions to Rwanda’s budget deficit.

Facts

Rwanda recorded a Government Budget deficit equal to 4.30 per cent of the country’s Gross Domestic Product in 2014. Government Budget in Rwanda averaged -1.94 per cent of GDP from 2006 until 2014, reaching an all-time high of -0.10 per cent of GDP in 2010 and a record low of -5.20 per cent of GDP in 2013. A budget deficit occurs  when a government spends more money than it takes in and this is usually due to: 

• Low taxable capacity due to wide poverty and low levels of income. 

• Deteriorating terms of trade for most LDCs’ products which generate little foreign exchange earning. 

• Price fluctuations of LDCs primary products which lead to fluctuations in government revenue. 

• Existence of a large subsistence sector which doesn’t produce for the market and export hence loss of domestic revenues and foreign exchange. 

• High population growth rates which calls for higher government expenditure in excess of government receipts. 

• High levels of tax evasion  tax avoidance  resulting into low tax revenue. 

• Rising costs of imported inputs and manufactured goods due to frequent depreciation of local currencies. 

• Heavy tax concessions and exemptions or holidays on infant firms with an aim of attracting private investment. 

• Low levels of industrialisation and business profitability hence low revenues from corporate and profit taxes. 

• Financial indiscipline/ corruption and embezzlement of public funds by tax collectors and tax administrators which reduces government revenue. 

• High inflationary rates which erode away the value of tax revenue hence requiring supplementary budget. 

• Breakdown of major economic infrastructure like roads and directly productive activities. 

• Increased political instability and insecurity and other calamities 

• High level of unemployment and under employment hence low tax revenue. 

• Persistent debt servicing. 

• Over ambitious programs and projects as a result of poor planning.

• Improving the value of domestic market by processing their products so as to increase foreign exchange value. 

• Restoration of peace security, law and order in all parts of the country so as to reduce military expenditure. 

• Reducing the levels of corruption  and fraud in tax assessment and administration through proper accountability and transparency. 

• Civil service reforms so as to reduce expenditure on a large public sector through retrenchment. 

• Population control programs through family planning campaigns and education for females. 

• Modernisation of agriculture so as to increase  the value of agriculture products that respond to market demand. 

• Increasing capital development expenditure rather than expenditure on unproductive projects. 

• Reducing the subsistence sector by monetising the economy. 

• Diversification of economic activities so as to increase the tax base and eventually increasing the export base. 

• Privatisation of public companies so as to reduce government expenditure through financial accommodation and generating more revenues from taxing private companies. 

• Adopting export promotion industrialisation so as to increase foreign exchange earnings.

Development budget and recurrent budgets

Activity 6

Visit the nearby sector offices and inquire from the sector executive secretary about the following: 

1. The difference between a development budget and a recurrent budget. 

2. The different activities that require a development budget and or recurrent budget.

Facts

A development budget also known as a capital development budget is where government out lines its estimated expenditure to be allocated for long-term projects which lead to increase in production directly or indirectly. Such expenditures include financing of industries, road and railway construction, construction of energy facilities, mining etc. 

A recurrent budget is  where estimated government revenue and expenditures are devoted to maintaining  the existing capacities or day to day programs e.g. payment of wages of public servants, day to day office expenses, cost of wear and tear capital assets etc.

Importance of budgeting 

Activity 7

1. Examine the importance of budgeting in your country. 

2. Identify the problems of budgeting in Rwanda/LDCs.

Facts

• It is useful in raising revenue through taxation or forced and voluntary savings. 

• It is used as a correcting tool during both inflationary periods and periods of economic depression so as to achieve economic stability. 

• It is used in correcting BOP disequilibrium by discouraging imports and subsidising exports. 

• It is instrumental in creating a conducive climate for creating and maintaining employment opportunities. 

• It is used in redistribution of income and wealth among citizens/ regions through taxation and subsidisation.

• It is used to attract private investments both domestic and foreign hence increasing capital accumulation. 

• It is used in protecting infant industries by reducing expenditure on imports and subsidising domestic industries. 

• It is used in mobilisation of foreign capital through aid, grants or loans. 

• It is used in discouraging of harmful or demerit commodities by increasing taxes on them. 

• It is used to encourage production of essential commodities by increasing expenditure on them. 

• It is used in soliciting or rallying political support of citizens because it is a statement of accountability for use of national revenue. 

• It is a background for future economic planning because it is used to review economic progress of a nation. 

• It is used to correlate and coordinate financial administration of various government departments.

Problems of budgeting in LDCs 

Making a national budget is not a simple process, since different sectors, regions, departments of the national economy that have to be involved have different problems and needs. The problems facing the budgeting process especially in LDCs include among others the following: 

• Unpredictable sources of revenue due  to low tax base hence making it hard for government to achieve objectives in the budget. 

• Inadequate skilled manpower / personnel to collect data and draw the national budget in proper consideration of all the needs of all the sectors and regions of the country. 

• Poor accountability/ corruption which causes misappropriation of revenues in some departments in favour of some groups and regions leaving out those that are in most need. 

• High rates of inflation which reduces the real value of estimated revenue thus causing short falls in budget estimates. 

• Political instability and insecurity which reduce the capacity of revenue collection and call for supplementary budgets.

• Donor pressure and dependency i.e. donors tend to dictate the direction budgeting should take and at times it is not where LDCs feel there is need but where donors wish. 

• LDCs have a large public sector and find it difficult to ration the little available resources to several government projects.

• There is no logical consistency in budgeting i.e. allocation of funds to build up on projects year after year is lacking which leads to wastage of resources. 

• Change in exchange rates i.e. depreciation of LDCs currencies makes it difficult to plan since money collected may not adequately finance the budgeted expenditure. 

• Natural hazards and emergencies which divert resources from one sector to another  and this distorts the functioning of the entire system. 

• LDCs normally make over ambitious development budgets which cannot be financed from the available revenue sources. 

• High capital outflow which drains LDCs revenue.

9.5 Public debt/borrowing

 Activity 8

Visit the school library or internet and research on the following 

Facts

This involves the principle of borrowing as well as public debt management. 

A public debt  is a debt incurred by the central government, local government, and public corporations as a result of borrowing from within the country or external sources. 

A national debt on the other hand is the debt owed by the government to its people and institutions within the borders or to foreigners, excluding the debts of local authorities and public corporations. 

9.5.1 Classification/types of debts 

1. According to the source of borrowing. Under this we have; 

2. According to how a debt is going to be used. 

3. According to the methods of debt repayment. 

4. According to the maturity period; 

9.5.2 Causes of public debt 

The following are some of the causes of public debt in LDCs:

• To fill the foreign exchange gap because it brings in foreign exchange in case it is a public debt. 

• Most governments resort to borrowing in order to reduce the tax burden on citizens of the country that  would reduce savings, discourage work and consumption and even make the government unpopular. • To win government more support from the people than taxation. 

• To fight and reduce economic depression in the economy by increasing money supply in the economy which increases aggregate demand and production. 

• To finance the balance of payment deficit when the country’s earning from the exports are lower than the expenditures on imports. 

• To fill the saving- investments gap especially where the domestic savings are low. 

• To pay any mature debts which may have been acquired long time ago. 

• To accumulate government reserves which can be used to facilitate the implementation of the monetary policy. 

• To reduce inflation in the country through with drawing excess money from the hands of the public by selling to them securities. 

• To finance the budget deficit through borrowing so as to meet actual expenditure. 

• To finance emergencies like wars, natural disasters etc. which do not coincide with budget plans.

9.5.3 Consequences of a public debt 

Public debt/ borrowing has got the following consequences: 

• It increases aggregate demand/ market by reducing taxes on household incomes and providing credit facilities or subsidies to consumers. 

• It fills the manpower gap by importing expatriates or increasing expenditure on education. 

• Borrowing leads to foreign exchange outflow when paying  the debts and this leads to  balance of payment deficits. 

• Loans are a public burden because the people repay through increased taxation and reduced standard of living. 

• Borrowing encourages laziness and dependence. People are reluctant to work because of the expected funds. 

• Debt servicing leads to reduced  savings, investments, capital accumulation and lowers the rate of economic growth. 

• Borrowing leads to extravagance because the public looks at it as free money yet it has to be paid back. 

• Unproductive long-term loans shifts the burden to the future generation who have to  pay without seeing any benefits. 

• Debt servicing leads to foregoing of current consumption especially social services and infrastructure development. 

• Some external debts need to be paid back in terms of goods and services and this reduces the variety that would serve the local population. 

• Internal borrowing worsens income inequality because the poor are over taxed to pay off the rich who lend the government so resources flow from the “have-nots to the haves”.

9.5.4 Public debt management

 Activity 9

Invite a resourceful person from the sector/ district/ national level, in charge of economic planning and social welfare, inquire about the following and present in class after; 

Facts 

Public debt management refers to the ways and means of how the public debts are administered.

Objectives/ aims of public debt management 

9.5.5 Methods of clearing public debt 

Government usually clears off their debts whether internal or external through either debt servicing or debt redemption. 

Ways of clearing internal debts 

• Using a sinking fund: This refers to that fixed amount of money set aside annually for the purposes of paying debts. 

• Taxation: Government can widen the tax base, increase the tax rate so as to raise money to pay the debts. 

• Debt conversion: This refers to the government act of borrowing new loans from a cheaper source so as to pay the old debts. 

• Borrowing  from the central bank through financial accommodation. 

• Using promissory notes: These are documents issued by monetary authorities promising to pay creditors at a future date. 

• Reduction in government expenditure to save money and clear off the debts. 

• Through acquiring gifts and grants. 

• Privatisation to raise money etc. 

Ways of clearing an external debt 

• Debt conversion: This involves borrowing from new low interest rate source to pay off old debts. 

• Using sinking funds: Here government sets aside some money in every financial year and the accumulated funds are used to service or repay the debt. 

• Dis-investment: The government may sell its foreign investments through privatisation and uses the proceeds to raise foreign exchange to service or pay back the debt. 

• Printing more money for payment of internal debts. However this causes inflation. 

• Adoption of export promotion to raise money for servicing the debts. 

• Adoption of import substitution to save foreign exchange. 

• Using foreign reserves that may be held in other countries. 

• Debt cancellation/ debt relief: Here a country negotiates for relief from the lender. Most LDCs are being forgiven debts they owe the rich countries and multilateral financial institutions like World Bank and IMF. 

• Debt rescheduling: This is the act of extending the debt repayment date in case the recipient country is unable to pay immediately. 

• Repudiation: This is the complete refusal of the debtor country to pay debts. A country decides not to acknowledge debt obligations especially of the previous regimes. This normally attracts serious penalties from other countries or lenders. 

• Local currency servicing strategy: This is when the donor country allows the recipient country to service the debt in local currency and this helps to reduce the demand for foreign exchange. 

• Unrequited exports: This involves exporting goods to the lender without expecting any payment and using the value of the goods to offset the debt. 

• International liquidity (SDRs): A country may use its Special Drawing Rights at the IMF to pay off debts.

9.5.6 Burden of the public debt

 Activity 10

Visit the school library or the internet and research on: 

Facts 

The burden of public debt refers to the cost of borrowing (effects) on the present and future generation.

Burden of an internal public debt 

The burden of the internal public debt is indirect and comes about in form of the cost of taxation to finance the debt. These include; 

• Taxation reduces the rate of private capital formation. 

• Repayment of the debt by taxation reduces the work effort of the people.

• Government may resort to financial accommodation (printing money)\ and this results to inflation. 

• Favours the rich who use services like roads, electricity among others yet the poor are also taxed to pay. 

• Internal debts worsen income inequality because it is the rich who can afford to buy the government securities and are the ones to be paid. 

Burden of an external debt 

• Deprives the country of foreign exchange which is used to pay the debt with an interest. 

• The government has to cut its expenditure on social services so as to pay the debt. 

• Sometimes the external aid is tied with strings meaning that it cannot be used by the government on any other activity. 

• For a dead weight debt, the future generation has to suffer to pay the debt whose benefits they do not see. 

• External borrowing leads to dependence and hinders self-sustenance. 

• External debts lead to balance of payment problems and worsen poverty since there is a lot of capital outflow.

9.6 Government/public expenditure

 Activity 11

Visit the school library or internet, basing on photos a, b, c, and d in figure 5 on page 320: 

1. Define the term public expenditure. 

2. Identify different activities in your area on which Rwandan government can spend her resources. 

3. Explain the types of public expenditure.

4. Why is there much public expenditure in Rwanda? 

5. Suggest the measures that Rwanda should employ to reduce on her public expenditure. 

...... 3 ......

Facts 

Public expenditure refers to the spending made by the central government and local or regional governments which includes development and recurrent expenditure. It is any money that goes out of government coffers for various purposes.

9.6.1 Types of public expenditure 

There are basically two ways / types of government expenditure and these include: 

1. Recurrent expenditure: This refers to expenditure by the government on day to day activities like payment for wages, rent, interest, debts, transfer payments, payment for public consumption (drugs) etc. 

2. Development expenditure: Sometimes referred to as capital expenditure and it’s the expenditure made  to finance development projects in the country e.g.  Infrastructure development like roads, electricity, communication lines, industries, schools among others. 

9.6.2 Reasons for/purpose of public expenditure in LDCs 

• Presence of political instabilities making high public expenditure on defence. 

• High levels of corruption and embezzlement by public officials leading to high expenditure of government money. 

• High population rates leading to several dependants and increasing government expenditure in form of social service provision. 

• Operation of inefficient enterprises that don’t make profits but survive on government subsidies. 

• Poor planning by the government ministries and departments leading to spending of more revenue on projects which in the end fail to work. 

• Foreign missions abroad by the government officials and even within the country increase government expenditure. 

• Quite often but not expected occurrences like famine, floods, drought etc. increase state spending. 

• Servicing the debts which were acquired unfortunately some debts are unproductive. 

• Expenditures on ever increasing civil servants, cabinets among others.

9.6.3 Ways of reducing government expenditure

• Privatisation. Transferring government assets to the hands of the private individuals. 

• Acquiring concessional loans i.e. those with a low interest rate and long period of payment. 

• Reduction in the privileges given to government allowances like unnecessary allowances. 

• Controlling population growth rate and this will reduce expenditure on social services. 

• Ensuring peace and stability in the country to reduce expenditure on defence. 

• Merging of some ministries so as to reduce expenditure on a single ministry. 

• Introduction of cost sharing for public services like education, health etc. 

• Demobilisation of soldiers and retrenchment of civil servants to reduce government expenditures on salaries and allowances. 

• Encourage investment to increase production levels and increase production levels.

Unit assessment

9.7 Glossary 

• Balanced budget: The type of government budget where the estimated government revenue is equal to expected expenditure in a financial year.

• Burden of the Debt: The true cost to society of the national debt. Interest charges on debt which arises as a result of borrowing by individuals, firms and governments. 
  

• Dead weight debt: A debt used to finance unproductive ventures like wars. 
  

• Debt burden: The cost/ effects of borrowing on the future and present generation.

• Debt financing: The government act of fulfilling its expenditure requirements through public borrowing either from internal or external sources or both. 

• Debt Redemption: The government act of paying back maturing debts with their interests. It is sometimes called debt retirement. 

• Debt Servicing: The government act of paying interest on borrowed money with or without the principle.  

• Deficit budget: The type of budget where the expected expenditure is greater than the estimated revenue. 

• Development expenditure: The expenditure made to finance development projects in the country e.g. Infrastructure development like roads, electricity, communication lines, industries, schools among others. It is sometimes called capital expenditure. 

• External debt: A debt raised by developing countries from abroad to raise money for development. Normally got from individual countries or organisations like IMF and World Bank. 

• Funded debt: This is where the specific date of paying back the debt (redemption) is not known.

• Fiscal policy: This refers to the deliberate use of taxation, government borrowing and government expenditure to regulate the level of economic activities. 

• Government budget: This is an estimate of the revenue the government intends/ expects to raise and how it plans to spend that revenue in a financial  year. 

• Internal debt: A debt raised from the public within the country especially in developed countries where there are rich people and companies which can afford to lend to the government. 

• National debt: The debt owed by the government to its people and institutions within the boarders or to foreigners, excluding the debts of local authorities and public corporations.
•   
• Public debt: A debt incurred by the central government, local government, and public corporations as a result of borrowing from within the country or external sources. 

• Public debt management: The ways and means of how the public debts are administered. 

• Public finance: This is macroeconomic discipline that concerns the collection of government revenue and how it is allocated for public expenditure so as to achieve targeted objectives. 

• Recurrent expenditure: This refers to expenditure by the government on day to day activities like payment for wages, rent, interest, debts, transfer payments etc. 

• Reproductive debt: This is a debt which is used to finance projects that bring returns. It is sometimes called self -liquidating debt. 

• Surplus budget: This is the type of budget where the estimated revenue is greater than the expected expenditure in a financial year. 

• Taxation financing: This refers to the government act of meeting its expenditure requirements through raising revenue from taxation.

•  Unfunded debt: This is where the specific period and date of paying back is known. It consists of short-term debts like treasury bills. It is sometimes called floating debt. 

• Unbalanced budget: This is the type of budget where the estimated revenue is either greater or less than the expected expenditure in a financial year. 

Unit summary 

• Public finance 

• National Budget 

• Public debt/ borrowing 

• Public expenditure