CHAPTER FOUR: PUBLIC EXPENDITURE
4.1 Meaning and Nature of Public Expenditure
Public expenditure refers to the expense which the government incurs for:
its own maintenance,
the society,
the economy as a whole, and
to help other countries.
But, it is difficult to determine what portion of expenditure is used for each
activity.
Types of public expenditure:
Most governments classify public expenditure in to two basic types.
1)Recurrent expenditure:
•They are intended for continuing the existing flow of goods and services, and
maintaining the capital flow of the country intact.
•It refers to expenditure for non-development investments like:
law and order, civil administration,
defense which are indirectly involved in production (social overhead
expenditure).
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2) Capital expenditure: Expense for development investment activities like research
and development activity, expenditure on infrastructure, public work, agriculture,
industrial development, etc.
Figure 4.1Trend of government expenditure of Ethiopia by its components (in millions of
birr)
Source : NBE annual report 2017/18.
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Causes of Growth in Public Expenditure
•During the 20th century, the dogma of welfare state has got great
attention, where the functions of the state have been enlarged and the
significance of public expenditure has limelight.
•During the last two decades public expenditure has been increased
due to the following factors (reasons).
1. Population growth: The major cause in LDCs for the continuous
rise in public expenditure;
• Public service (for solving problems of food, housing,
unemployment, sanitation, etc…).
• Check for the growth of population (spend more for family
planning every year).
2. Increasing urbanization:
The rural cannot subsist the growing population hence, there is a
continuous rush to urban areas.
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• To this end the size of cities is becoming larger and larger, while
newer urban habitations are springing up and the maintenance of
complexity of life is costlier .
• Urbanization is responsible for the increase in expenditure on
water supply, electricity, maintenance of hospital, park, library,
play station, road, street light, etc.
3. Provision of economic overheads (transportation and
communication): public expenditure on account of economic
infrastructure is of huge size in developing countries. (Example: in
Ethiopia in 2016, public expenditure as part of GDP was 18.20%).
4. Maintenance of law and order: The growth of population,
urbanization and complexities of modern economic and
sociopolitical life, law and order problems have also multiplied
which results in uncertainty and insecurity, and there by rise public
expenditure.
5. Rising trend of price: Increase in salary and allowance for
government employees.
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6. Welfare activities: presently, countries have emerged as modern
welfare states where the greatest good of the greatest number is the
main objective of statehood, social insurance, unemployment relief,
free medical aid, free education, housing for the poor, welfare of
handicapped and backward classes, rehabilitation of displaced people,
subsidy on food and production inputs, etc.
7. Provision of public goods and utility services: Defense and
police services, justice, roads, irrigation and flood control projects,
public parks, and railways and other transport services, postal,
telegraph and telephone services, electricity services, etc.
8. Servicing of public debt: The repayment of debt and obligation to
pay service charges become huge resulted from limited tax sources in
LDCs,
9. International obligations: Modern states have to maintain many
international socio-political and economic links.
10. Rural development effect: In LDCs, governments have to spend
more for rural development. 6
4.2 Planning and Budgeting of Public Expenditure
Public budgeting is a field of public administration and a discipline in the
academic study of public administration.
Budgeting is characterized by its approaches, functions, types and formation.
Public budgeting is described through four perspectives:
incrementalism, comprehensive planning, decision making and
managerial.
A "budget" is a plan for the accomplishment of programs related to
objectives and goals within a definite time period, including an estimate
of resources required, together with an estimate of resource availability,
usually compared with one or more past periods and showing future
requirements.
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4.2 Planning and Budgeting of Public Expenditure …
In general public budgeting refers to the process of allocating and
managing public funds, typically by a government or other public
organizations.
• It involves setting priorities, estimating revenue, determining spending levels
and monitoring the use of funds.
Guidelines for public expenditure management include five basic
components
Introduction,
The expenditure approach and data sources,
Budget preparation and execution, and
Cash planning and management.
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4.3 Techniques Used for Evaluating Public Expenditures
Techniques include: construction of cash flows, alternative investment rules, inflation
adjustments, optimal timing and duration of projects, private and social pricing. Adjustments
for economic distortions, foreign exchange adjustments, risk and income distribution
examined in the context of present value rules.
4.3.1 Cost benefit analysis and cost effectiveness
Cost-effectiveness analysis is a technique that relates the costs of a program to
its key outcomes or benefits.
Cost benefit analysis takes that process one step further, attempting to
compare costs with the dollar value of all (or most) of the program's many
benefits.
The development of cost-benefit analysis is basic from alternative points of
view.
For example it will be based on: equity, debt and economy as a whole.
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4.4 Public Expenditure: Canons, Theories and Accountability
4.4.1 Canons of public expenditure
1) Canon of Benefit: Government expenditure should be so planned
and implemented as to bring about the greatest possible benefit to the
society (maximum social advantage; i.e cause of social benefit or
general well-being of the common people).
2) Canon of economy: Public expenditure should be incurred
carefully and economically (there should not be wastage of funds and
extravagancy of public expenditure or most proper utilization).
•The most important reasons of wasteful expenditure are; faulty
planning, faulty execution and corrupt practices.
•Delay due to time lag between plan and execution and, hence,
escalation of prices. These types of wastage have to be avoided at any
cost.
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3) Canon of surplus: Means expenditure of public authorities should
be kept within the limits of current revenues.
•Every government should have to attempt to balance its income and
expenditure.
•Surplus can be generated either by controlling expenditure or by
increasing current revenues.
•An important reminder of the fact that the government should not
over spend and run into debts, and that deficit spending should be
avoided as far as possible.
4) Canon of sanction: It requires that public authorities should not be
allowed to spend funds without having the previous sanction from
appropriate authority for the purpose.
•No public spending should be made without approval by the proper
authority.
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5) Canon of elasticity: It requires that the rules of public
expenditure should not be too rigid to achieve the real purpose and
that it should be allowed to vary according to the needs and
circumstances.
•There should be a scope for changes in public expenditure according
to the requirements of the country.
6. Canon of certainty: It requires that public authorities should
clearly know the purpose and extent of public expenditure.
7. Canon of productivity: The expenditure policy of the
government should be in such a way that it should encourage
production in the country.
8. Canon of equity (fairness): Expenditure should benefit the poor
section of the community.
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4.4.2 Theories of public expenditure
•Economists have offered a number of theories on public
expenditure. The following theories of public expenditure need
special mention.
1. Classical Theory of Minimum Expenditure (Adam Smith).
•According to classical theory, public expenditure must be limited
to the bare minimum and must not exceed public revenues.
2 Principle of Maximum Social Advantage (Dalton).
•It lays down that public expenditure should be so planned and,
hence, revenue resources raised so as to bring about benefit
larger than sacrifice and that the surplus of aggregate
satisfaction in the society is the maximum.
•The principle of maximum social advantage is derived from the
principle of equi-marginal returns as applied to an individual.
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• Thus, if it is found that marginal utility from public expenditure
on medical and public health measures is greater than marginal
utility derived from the same amount spent on provision of
public parks, then the government should transfer public funds
from the latter to the former account.
• This will maximize social advantage.
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To analyze;
Let OA is total public expenditure on public park.
O1B is total public expenditure on medical and public
health.
OY represents marginally utility of the individual for
public goods.
OX represents total expenditure on public goods.
The allocation of expenditure at OA results in lower
marginal utility than at O1B.
Transferring expenditure of the amount AK (=BL) from
public parks to the provision of medical and public health:
Will raise aggregate utility, because the increase of utility area
BLMD is larger than reduction of utility area KACN.
12/20/24This is how equality in marginal utility from public expenditure
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3) The Principle of Maximum Social Advantage Given by Musgrave
Or Maximum Benefit to the Society
•The principle of Maximum Social Advantage has been interpreted by the
economist Richard Musgrave who termed it as Maximum Welfare
Principle of Budget Determination.
•According to Musgrave, the principle explains that taxation and public
expenditure should be carried out up to that level where the satisfaction
obtained from the last unit of money spent is equal to the sacrifice from
the last unit of money taken in terms of taxes.
•In other words, it should be carried out up to the point where marginal
social benefit is equal to marginal social sacrifice (MSB = MSS).
Musgrave used the following figure to analyze this concept clearly.
•Let the X axis shows the level of taxation and public expenditure.
•On the Y-axis (+ve Y-axis ) marginal social benefit and (-ve Y-axis )
shows the marginal social sacrifice.
•The curve EE in the first quadrant shows the marginal social benefit
(MSB) of successive units of money spent as public expenditure, allocated
optimally
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• It falls from left to right because as public expenditure increases,
MSB declines.
• The curve TT, in the fourth quadrant, represents the marginal
social sacrifice (MSS). As additional units of taxation are raised
from the people, MSS increases.
• Accordingly, the curve TT slopes downwards from left to right in
the fourth quadrant showing rising MSS.
Figure 4.2 Gain and loss from budget operation
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• The curve NN measures Net Marginal Benefit (NMB) which is derived from
successive addition to public budget (public expenditure).
NMB = MSB-MSS
• The vertical distance between EE curve and TT curve measures NMB at
different sizes (levels) of the budget.
• The optimum size of the budget is determined at OM, where NMB is zero. At
this size of the budget, the marginal social benefit: MP is equal to the marginal
social sacrifice: MQ (i.e. MSB = MSS).
• Since MSB and MSS are measured in opposite directions, net marginal benefit
is zero at M (NMB = MSB-MSS = 0).
• At the optimal point, the NMB curve NN cuts the X-axis.
• Any point to the left of M like M1, results in positive NMB (i.e. MSB>MSS),
hence it is beneficial to increase the size of the budget as long as NMB is
positive. So, there will be a tendency to move from M1 towards M.
• Any point to the right of M like M2, results in negative NMB (i.e MSB<MSS),
hence it is beneficial to the government to cut the size of the budget and move
back from M2 to M.
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• According to Musgrave, the optimum size of the budget is given by the
point where the marginal net benefit is zero. This point corresponds to
the point of maximum social advantage, that is at the point where,
MSB=MSS.
Limitations of maximum social benefit theory:
The principle of maximum social advantage has been criticized on various
grounds.
1) Difficulties in Measuring Social Benefits:
• The marginal benefits of public expenditure and the marginal disutility
on sacrifice of public revenue are concepts, the objective measurement
of which is extremely difficult.
2) Unrealistic Assumptions:
• It is unrealistic to assume that government expenditure is always
beneficial and that every tax is a burden to the society (e.g Hazardous
consumption tax).
3) Neglect of Non-Tax Revenue:
• It ignores public borrowing, profits from public sector enterprises,
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imposition of fees, penalties, etc.
4) Lack of divisibility:
•It is impossible to divide tax and public expenditure in to small units.
5) Large Budget Size:
•Public authorities are not in a position to estimate marginal benefits and
marginal sacrifices.
6) Misuse of Government Funds:
•Quite often, a large share of government funds is misused for unproductive
purposes which do not provide any social benefit.
7) Contra-Cyclical Measures:
•The government has to undertake contra-cyclical measures to control
inflation, overcome recession, reduce increasing level of unemployment,
etc.
7) Conceptual differences:
•Taxes are paid by individuals and the sacrifice involved is felt at an
individual or micro level. Whereas, public expenditure gives rise to public
goods that are jointly consumed by all in a community.
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4) Critical Limit Hypothesis (Colin Clark )
•This hypothesis was developed immediately after the Second World War. It is
concerned with the tolerance level of taxation.
•The critical limit hypothesis is concluded from the empirical data drawn from several
western countries for the interwar period that inflation in the economy necessarily occurs
when the share of the government sector, as measured in terms of taxes and other
receipts, exceeds 25% of the aggregate economic activity in the economy.
The hypothesis is based on the following institutional factors;
[Link] taxes are collected by the government, it reach the critical limit of 25% ratio of
the aggregate economic activity reflected in the GNP, the community behavior patterns
change and people become less productive since incentives are harmed by the fact that
increasing proportions of additional income must be paid in taxes under progressive tax
system.
2. People become less resistant to various inflationary means of financing government
expenditure.
•Thus, the loss of incentive tends to reduce the aggregate supply while the increased
purchasing power resulting from inflationary financing techniques tends to expand
government’s aggregate effective demand.
• Inflation tends to result from this new aggregate supply-aggregate demand equilibrium
under conditions of higher employment resources.
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Source : NBE,2018 annual
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report
4.4.3 Control and Accountability of Public Expenditure
•It means that expenditures are justified in terms of the whole welfare
of the society and in terms of the financial means at the disposal of
the government.
•Control implies that expenditures are economic by which we mean
that resources not unlimited in quantity are devoted to their most
productive uses.
•Control of public expenditure is sought to be ensured multi-
dimensionally at a number of stages.
•The most important means of control are:
1. Budgetary Control;
2. Legislative Control;
3. Administrative Control;
4. Audit Control; and
5. Parliamentary Control.
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4.5 Macroeconomic Effects of Public Expenditure
1) Effects of Public Expenditure on Production:
Output raises, if we spend more expenditure on agriculture and allied services,
industries and minerals, water and power development, transport and
communication, and other expenditures on community and social development by
the Federal and State governments.
According to Dalton, the levels of production and employment in any country
depends upon three factors:
[Link] of people to work, save and invest: Which depends upon the healthy and
efficiency possessed by the person. Health and efficiency depend on consumption,
which in turn depends upon the public expenditure incurred by the government.
[Link] of people to work, save and invest: Pension contribution, provident
fund, interest free loans, free medical, and unemployment allowance provide
security for a person but reduce the willingness to work, save and invest. In
contrast, expectation of large amenities and higher standards of living will stimulate
people to work hard.
[Link] of economic resources: Government provides financial assistance for
productive sectors and in the same way to attract production to particular region, it
will start giving various incentives like tax holidays and tax concession to the
industrialists.
2) Effects of Public Expenditure on Employment:
•Public expenditure also affects employment and employment
opportunity.
•Therefore, public expenditure should be incurred in such a way that
creates additional job on public and private sectors.
The following expenditures increase employment opportunity in any
economy:
[Link] expenditure in the public sector: (iron, engineering and
coal).
[Link] on public utility: (supply of water, electricity, and
telephone service) which create large employment opportunity.
[Link] expenditure to encourage small scale industries.
[Link] expenditure at the time of depression.
[Link] expenditure to create employment opportunity in backward
areas.
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3) Effects of public expenditure on distribution of income:
•Public expenditure helps the government in bringing about equitable
distribution of income and wealth.
•By collecting revenue with high direct tax on the rich section of the society,
and then spending on the poor section of the society i.e. government's
expenditure on education, public health and medicine, housing, etc… are
directed to help the poor.
•Public expenditure by nature may be progressive, regressive and
proportional.
1)Progressive expenditure: (large public expenditure is made for smaller the
recipients income) will reduce income inequality like old age pension, free
education to economically poor section of the society and subsidizing the mass
consumption goods.
2)Proportional public expenditure: It is the case when public expenditure is
made for every body in equal proportion.
3)Regressive public expenditure: If the smaller is the income receipts, the
small public expenditure is incurred. It confers large benefit to the rich section
of the society.
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4) Effects of public expenditure on inflation:
• Government expenditure must be reduced in non productive and
long-gustation period productive projects to reduce inflationary
pressure, i.e reduce public expenditure on civil service, defense
and interest payment.
•The most serious type of inflation is due to enormous government
expenditure on war, and preparation for war in peace time.
•The government can postpone construction of social capital; such
as post offices, schools, etc... which will increase the size of income
of people but will not contribute to the increase of goods and
services.
•The government can give subsidies to those industries which are
producing inflation-sensitive goods, so as to accelerate their
production or to enable producers to sell them at lower price.
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Contents of Development Expenditure
There are three contents through which development expenditure can
be implemented.
1. Stimulating private initiative and enterprises: Development
expenditure of the government should aim at stimulating and
supplementing private initiatives and enterprises; through loans,
subsidies, tax concessions and exemptions, and providing market and
other information and research facilities.
2. Provision of social and economic overheads: Indirect stimulation
through:
I. First head; education and public health.
II. Second head; power, transportations and communication.
3. Public enterprise: The private sector is unable to undertake
certain economic activities either due to low profit margin or require
huge capital investment like basic industries, development of
irrigation resources, electric power, etc.
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4.6 Patterns of the Ethiopia’s Public Expenditure
(Reading Assignment!!!!)
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Unemployment and job searching in Ethiopia
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