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Fridays Academy: Fiscal policy: Public Expenditure and Finance

Ignacio Hernandez's picture

From Raj Nallari and Breda Griffith's lecture notes.


Public expenditure

Public expenditure is a measure of the value of goods and services bought by the State. Public expenditure is capable of playing four main roles: it contributes to current effective demand; it can be used for stabilization purposes; it increases the public endowment of goods and can be used for redistributive purposes; and it can give rise to positive externalities to the economy and society, especially through its capital component.


Public expenditure can be classified in terms of the kind of goods and services bought, (capital goods; consumption goods; and personnel expenditure), in terms of the official body from which budget it is financed (the central state and its ministries; and regional and local authorities), and according to the macro-function at which it is directed (justice and public order; education; and health).


There is no single desirable level of government spending.  However, the aggregate level of spending must be consistent with the macroeconomic framework.  If not, high or rising budget deficits, depending upon how they are financed, will result in various forms of macroeconomic imbalances. For instance, as we discuss later, excessive budgets can give rise to inflation and crowding out of private investment.



The government finances its expenditures through taxation, borrowing, grants and the creation of new money. In developed countries, the bulk of government revenues are raised through taxation. In some developing countries however, the taxation system is not well developed, therefore non-tax revenue may be the primary source of government finance. Non-tax revenue comprises fees levied by government (e.g., customs and excise duties) as well as profits and dividends from state owned enterprises.

Taxes are commonly divided into:

  • Income tax which are levied on income of households and businesses.

  • Corporate income tax may be levied on a corporation’s profits.

  • Sales and excise taxes are levied on commodities; they are considered pernicious since they do not differentiate between different income levels in application.

It is important to maintain a balance between different types of taxes. Direct taxes are generally a better tool to improve income distribution: those who earn more, pay more. By contrast, although indirect taxes, such as sales taxes or VAT tend to generate revenues more easily and are conducive to macroeconomic stability they are not necessarily progressive since all population groups pay the same (unless basic goods are zero rated). The same is also true for other indirect taxes, such as international trade duties, which tend to be easier to collect but at the same time regressive.


Government revenue may also come in the form of foreign grants. Grants may be either transfers of cash, or the provision of goods or services from bilateral or multilateral donors without any corresponding exchange of payment. Grants have obvious benefits: they do not detract from private sector incomes in the recipient country, nor do they generally impact interest rates and inflation. However, the costs can sometimes be high: grants tend to create a dependency on international aid which may undermine development efforts thereby hurting the domestic market. In addition, they often have conditionalities attached, which compromise the autonomy of a government.


The desired features of an effective tax system are least cost for administration, simplicity in structure for compliance, broad based in application, and tax neutrality to avoid production, consumption or trade distortions. The tax system should provide for a stable and assured source of revenue, understood by both taxpayer and administrator, should be easy to administer and flexible, and should distribute the tax burden in a manner that is perceived to be fair and equitable. 


The Five Desirable Characteristics of any Tax System

1. Economic efficiency: the tax system should not interfere with the efficient allocation of resources.

2. Administrative simplicity: the tax system ought to be easy and relatively inexpensive to administer.

3. Flexibility: the tax system ought to be able to respond easily (in some cases automatically) to changed economic circumstances.

4. Political responsibility: the tax system should be designed so that individuals can ascertain what they are paying for so that the political system can more accurately reflect the preferences of individuals.

5. Fairness: the tax system ought to be fair in its relative treatment of different individuals.

Source: Stiglitz (1988)


In line with these desirable features, raising revenues from a few taxes with simple rate structures would help contain administrative and compliance costs and avoid the perception of excessive taxation.  Broadening the tax base with limited exemptions also enables revenues to be raised with lower rates and makes the revenue stream more predictable.  For example, a value added tax or a single-stage sales tax when levied at a low and uniform rate on a broad base is efficient and avoids “cascading” or cumulative taxation of goods as they move along successive stages of production. By contrast, fiscal incentives for investment in the form of preferential tax rates and so on have usually been found to be ineffective in most developing countries.


Efficient tax collection not only depends on an efficient tax system, it also relies on an efficient tax administration, something that is often missing in developing economies. Perhaps for this reason, recent studies have shown that tax revenue, measured as a percentage of GDP, correlates positively to per capita income.


 Tax revenue as a percentage of GDP

tax revenue

  Source: Bird and Gupta, 2004


Next week: deficits