The Kisumu National Polytechnic

Topic: Public Finance

Abridged Class Study Notes For Revision

Compiled by Anthony Omwange Maangi

6-25-2023
 PUBLIC FINANCE
Table of Contents
1. Public Finance Explained.................................................................................................................................................................. 2
2. Objectives of Government ................................................................................................................................................................ 2
2.1. The Microeconomic objectives of government.............................................................................................................. 2
2.2. Macro-economic policy objectives ...................................................................................................................................... 3
3. Purpose of public finance ................................................................................................................................................................. 4
4. Difference between Private Finance and Public Finance .................................................................................................... 4
5. Themes/Subdivisions/Components of Public Finance ........................................................................................................ 5
5.1. Public Revenue ............................................................................................................................................................................ 5
5.1.1. Sources of Public Revenue ............................................................................................................................................ 5
5.1.2. Taxation ................................................................................................................................................................................ 5
5.2. Public Expenditure ..................................................................................................................................................................10
5.2.1. Principles and Role of Public Expenditure in the development of a welfare state .............................11
5.2.2. Importance of Public Expenditure ..........................................................................................................................11
5.3. Public/Government/National Debt ..................................................................................................................................12
5.3.1. Objectives of Public Debt.............................................................................................................................................12
5.3.2. Role of National Debt for Economic Stability......................................................................................................12
5.3.3. Types of Public Debt......................................................................................................................................................13
5.3.4. Bilateral Lenders ............................................................................................................................................................13
5.3.5. Multi-lateral Lenders ....................................................................................................................................................13
5.3.6. Burden of the national debt .......................................................................................................................................13
5.3.7. The Budget ........................................................................................................................................................................14
5.4. Fiscal Policy ................................................................................................................................................................................15
5.4.1. Objectives and Role of Fiscal Policy ........................................................................................................................16
5.4.2. Difficulties in using fiscal policy ...............................................................................................................................16
5.5. Financial administration .......................................................................................................................................................17

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1. Public Finance Explained
Public finance refers to the activities carried out by the government associated with raising of finances and
the spending of the finances raised (it is the study of how government collects revenue and how it spends
it)
The components of public finance are;
1. Public revenue
2. Public expenditure
3. Public debt
4. Fiscal Policy
5. Financial Administration
 Public revenue - refers to the revenues (income) and resources received by the government from
different sources.
 Public expenditure - refers to the resources spent by the government.
 Public debt - refers to the money and resources borrowed (both internally and externally) by the
government.
 Fiscal Policy - refers to the use of government revenue collection (mainly taxes) and expenditure
(spending) to influence the economy.
 Financial Administration - refers to that set of activities which are related to making available
money to the various branches of an office, or an organization to enable it to carrying out its
objectives.

2. Objectives of Government
Government policies are required in market economies to achieve certain goals. There are broadly two
types of government policies viz;
a) Microeconomic policy objectives, and
b) Macroeconomic policy objectives.

2.1. The Microeconomic objectives of government

These are the policies which are concerned with the allocation and distribution of resources to maximize
social welfare.
(i) Allocation policies
The major objective of government is to achieve pareto efficiency in resource allocation. An economy
is said to be Pareto efficient when it must be impossible to increase the production of another, or to
increase the consumption of one household without reducing the consumption of another. Such
situation results when the following three conditions are satisfied:
a) The given stock of resources must be allocated in the production of goods and services in such a
way that no re-location can increase the output of one good without decreasing the output of any
other.
b) The combination of goods and the proportions in which they are produced must be in response to
tastes and preferences of the community – i.e. the goods produced must be the ones that the
community wants.
c) The distribution of goods and services must be in conformity with consumers’ preferences, given
their tastes and incomes.
(ii) The distribution function /policy
The overriding aim of the strategy is to promote equity – that is to achieve a “fair” distribution of
income and wealth. For this purpose, budgets are usually designed to impose higher rates of taxation
on higher incomes and to try and secure a fair distribution of tax burdens in the community.
On the expenditure side of the budget, spending can be channeled into areas (such as health,
education, and social security benefits), which directly benefit the lower income groups.

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2.2. Macro-economic policy objectives
The major macro-economic policy objectives which the governments strive to achieve are:
(i) Full employment /Low rates of unemployment/Control of unemployment
• Economists are not agreed on what constitutes full employment.
• However and generally, full employment refers to the degree to which all willing and able workers can
find jobs (generally measured through the unemployment rate).
• A lower rate of unemployment means that productivity in the economy is higher. This objective simply
means that as many people who want to be employed are employed, so the economy is running at or
near full productivity.
• An unemployment rate of 4–5% is generally considered full employment.
• Note; full employment does not mean 100 percent of the working labor force. There are always some
people who are voluntarily unemployed as a result of being dissatisfied with their current jobs and
resigning to find another job.
(ii) The control of inflation (Low levels of inflation) / Price Stability
• Since most monetarists believe that inflation has a negative effect upon economic growth as it increases
uncertainty and discourages savings, maintaining stable prices usually is a major objectives of most
governments. This is generally measured with a price index.
• A low rate of inflation around 2% helps spenders and investors plan their spending appropriately. The
2% target helps keep countries away from deflation (negative inflation where prices fall) and and away
from high levels of inflation where uncertainty leads to economic downfall.
• Note; Inflation can reduce the purchasing power of consumers.
These two foregoing objectives can be regarded as “good housekeeping”. They may be called the key
indicators of health of an economy. In other words, modern governments aim at reducing both
unemployment and inflation rates
(iii) Stable and Sustainable (High) Growth rates
• This refers to a nation’s ability to produce more goods and services over time (and is generally
measured through GDP or GNP). Another way of measuring economic growth in an economy is
through an outward shift in its Production Possibility Curve (PPC).
• The objective of the central bank and government would be an increase in economic growth without a
rise in the rate of inflation.
• It allows everyone to enjoy a better standard of living.
• Note, to achieve economic growth, the economy must be operating at maximum capacity. Economic
growth refer to an increase in the full production output level of a nation over time
(iv) Balance of payments equilibrium
• Most governments like to have an equilibrium position in the BOP accounts as there are problems
associated with both sides of disequilibrium.
• A government aims to import around the same value of the goods it exports. This helps the country earn
foreign currency, as well as provide a more diversified product choice for the citizens of the country.
• A country aims to neither be in a surplus (exports more than imports) nor in a deficit (imports more
than exports).
(v) Equitable distribution of income
• A government aims for as equal a distribution of income as possible, as that gives signs of a well-to-do
economy where everyone is well off, and no sections of the economy are better off than the other.
• A fair or equitable distribution of income means that the gap between the rich and the poor is not too
large. Fair or equitable doesn’t mean equal, but fair is a relative concept. What could be fair to one
person, may not be fair to another. The government doesn’t want all the wealth concentrated with a
small group of people.
• Note; most nations try to narrow the gap between the higher income and the lower income groups.
This is to ensure that all people are equal in terms of the standard of living. One of the method of
achieving an equitable distribution of income is taxation. When taxes are imposed, the higher income
groups pay a higher tax to the government.
• Other aspects of equal income distribution include aspects relating to social justice and welfare.

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3. Purpose of public finance
1. Provision of essential goods and services. The government has a responsibility of providing its
citizens with essential goods and services such as security, health, schools, drought control, law etc. such
facilities and services may not be adequately covered by the private sector because of the high costs
involved and risks.
2. Encouraging consumption of certain commodities-The government may encourage consumption of
certain commodities e.g. maize by subsidizing on their productions or lowering their taxes.
3. Controlling consumption of certain commodities-The government may also encourage consumption
of some commodities e.g. cigarettes and alcohol by imposing heavy taxes on them.
4. Promotion of Balanced regional development-This may be done by initiating economic projects in
areas that are under developed/lagging behind.
5. Wealth Redistribution-This is done by heavily taxing the rich and using the money raised to provide
goods and services that benefit the poor
6. To promote economic stability-Economic instability may be caused by factors such as unemployment.
Such problems can be solved through public expenditure in projects that generate employment such as
‘kazi kwa vijana’
7. Creation of a conducive Business Environment-Through public expenditure, the government may
develop infrastructure such as roads, electricity, and security etc. thereby creating a conducive
environment for businesses to thrive in.
8. To raise government revenue-Through public finance, the government raises revenue which it uses in
provision of essential goods and services to the public.
9. Improving balance of payment-This may be done by improving heavy taxes such as customs duty to
discourage importation.

4. Difference between Private Finance and Public Finance

There is a great difference in private and public finance when we talk about its revenue and expenditure.
On other hand the management of personal and private income to make certain expenditure is called
private finance. We can distinguish between two (Private Finance and Public Finance) by the following
facts:
1. Private Expenditure :-
Private authority/persons spend the money according to his income. He lives within his own
resources. So he first of all looks to his pocket and then spends accordingly.
2. Public Expenditure Adjustment:-
While public authority adjusts its income according the expenditure. It looks forward to expenditure
and then increases or decreases the income accordingly.
3. State can issue the Currency:-
A private person cannot issue the currency while a state has authority to issue the currency to meet its
expenditure.
4. Record Keeping:-
The state keeps the proper record of income and expenditure every year; while a private person
continue earning and spending without keeping any record.
5. Budget Period:-
Government balances its budget during a one year while individuals do not have any specific period.
6. Deficit Financing Facility:-
Through the process of deficit financing Govt. can increase the supply of money to meet its
expenditure while an individual can not avail this facility.
7. Difference in Objectives:-
The main objective of the public finance is increase the welfare of the people; while the individual have
the objective of personal satisfaction.
8. Borrowing:-
The state can borrow the money from inside and outside the country while an individual can borrow
from other persons.
9. Publishing of Budget:-
Budget is not secret document; it is published by the government. Individual on the other hand keeps
secrecy about his income and expenditure.

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 10. Surplus Budget:-
If government prepares surplus budget, it is considered inefficient. On other hand if a man saves the
money he is appreciated.
11. Changes in Public Finance:-
The government can bring big changes in the income and expenditure of the state according the
prevailing situation. But an individual cannot bring a big change at the time of crises.

5. Themes/Subdivisions/Components of Public Finance

5.1. Public Revenue
5.1.1. Sources of Public Revenue
The major sources of Public Revenue are categorized as under;
(1) Taxation
This is a compulsory payment levied by the government on individuals and firms without any direct
benefit to the payer. Tax is further categorized as:
 Direct taxes: paid directly to the government by the individual taxpayer – usually through “pay as
you earn”. The tax liability cannot be passed onto someone else
 Indirect taxes: include VAT and excise duties. The supplier can pass on the burden of an indirect
tax to the final consumer – depending on the price elasticity of demand and supply for the product.
(2) Government Borrowing (Public Debt/National Debt)
 This is the money that the government borrows when tax is insufficient to meet all its financial
obligations. Government borrowing is also referred to as national debt. It includes all outstanding
borrowing by the central government, local authorities and government corporations.

(3) Other Sources

 Fines and penalties - These are the charges imposed on individuals, firms and corporations who
break the laws of the country.(offenders)
 Fees - These are the payments charged by the government for the direct services it renders to its
people e.g. road license fee, marriage certificate fee and import licence fee.
 Rent and rates - Charged on use of government properties e.g. game parks, forests etc.
 Escheat - Income obtained from properties of persons who die without legal heirs or proper wills.
Such people’s properties are taken over by the state. (The reversion of property to the state on the
owner's dying without legal heirs.)
 Dividends and profits - These are the income received from the government direct investments
e.g. income/surplus from public corporations.
 Interest from loans - This is the interest on loans advanced by the government to firms and
individuals through its agencies such as ICDC, AFC etc.
 Proceeds from scale of government property.

5.1.2. Taxation
Taxation is the process of imposing compulsory contribution on the private sector to meet the expenses
which are incurred for a common good.
Functions or Purposes of Taxation
The functions of taxation can be discussed from the activities of the government it is meant to achieve.
These are:
(a) Raise revenue
This is the main reason for Taxation. The revenue is required to pay for the goods and services which
the government provides. These goods are of two types – public and merit goods. Public goods, such
as defence and police are consumed collectively and no one can be prevented from enjoying them if he
wishes to do so. These goods have to be provided by governments. Merit goods, such as education
and medical care, could be, and often are, provided privately but not necessarily in the amounts
considered socially desirable and hence governments may subsidize the production of certain goods.
This may be done for a variety of reasons but mainly because the market may not reflect the real costs
and benefits of the production of a good. Thus, the public may be subsidized because the market does
not take account of all the costs and benefits of the public transport system.
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 (b) Economic stability
These are imposed to maintain economic stability in the country. During inflation, the government
imposes more taxes in order to discourage the unnecessary expenditure of the individuals. During
deflation, taxes are reduced in order to enable the individuals to spend more money. In this way, the
increase or decrease helps to check the big fluctuations in the prices and maintain economic stability.
(c) Fair redistribution of income
A major function of taxation is to bring about some redistribution of income. First, tax revenue
provides the lower income groups with benefits in cash and kind. Second, the higher income groups,
through a system of progressive taxation, pay a higher proportion of their income in tax than the less
well-off members of the society.
(d) Pay interest on National debt
Taxes are also levied by the government to pay interest on national debt.
(e) Optimum allocation of resources
Taxes are also imposed to allocate resources of the country for optimum use of these resources. The
amounts collected by the Government from taxes are spent on more productive projects. It means the
resources are allocated to achieve the maximum possible output in the given circumstances.
(f) Protection policy
Taxes are also imposed to give protection to those commodities which are produced in the country. The
government thus imposes heavy taxes on the import of such commodities from the other countries. In
the view of these taxes, the individuals are induced to buy local products.
(g) Social welfare
The government imposes taxes on the production of those commodities which are harmful to human
health e.g. excise duty on wines, cigarettes, etc.

Principles of an Optimal Tax System

When taxes are imposed certain conditions must be fulfilled. These conditions are known as Principles or
canons of taxation. According to Adam Smith who first studied the principles of taxation, these are equity,
certainty, economy and convenience. Other Principles were later added by other economists. These
principles are highlighted below.

1. Equitable/principle of equity - Every subject of the state should pay tax in proportion to their
income. A tax system should therefore have horizontal and vertical equity. Horizontal equity means
that those at the same level of income and circumstances should pay the same amount of tax. Vertical
equity means that those earning higher incomes should pay proportionately higher amounts of tax than
those earning less.
2. Certain/principle of certainty - The tax that an individual should pay should be clear in terms of the
amount, time and manner in which it should be paid. The government should also be fairly certain of
the amount of tax expected so that planning can be easier.
3. Economical/principle of economy - The cost of collecting and administering the tax should be lower
than the tax so collected.
4. Convenient/principle of convenience - Tax levied ought to be convenient to both the contributor and
collector, it should be levied at a time when the payer has money and mode of payment should be
convenient to both the payer and the payee.
5. Flexible/principle of flexibility - It should be readily adaptable to changing economic times i.e. when
the economic conditions of the people improve it should give raised revenue e.g. VAT
6. Ability to pay/non-oppressive - A tax system should be designed in a way that the amount charged is
not too high to the extent that the contributors are unable to pay or is discouraged from working hard.
7. Diversified/principle of diversity - There should be different types of taxes so that the tax burden is
on different groups in the society - This also ensures that the government has money at all times.
8. Simplicity-A good tax system should be simple enough to be understood by each tax payer. This will
motivate them to pay tax.
9. Elastic/principle of elasticity-The tax system should be able to generate more revenue for the
government by targeting items of mass consumption.

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 Factors that determine the amount of money raised through taxation
1. Distribution of incomes
2. Social and political factors
3. Honesty and efficiency of tax authorities
4. Citizens level of real income
5. Economic structure of the country i.e. relative size of the country’s commercial and subsistence
sectors.

Classification of Taxes
Taxes can be classified on the basis of:
1. Impact of the taxes (Direct Taxes and Indirect Taxes)
It means on whom the tax is imposed. On the other hand, incidence of the tax refers to who had to
bear the burden of the tax. In this case the taxes may be:
(i) Direct Taxes or
(ii) Indirect Taxes

2. Rates of tax
The rate of tax is the percentage of the tax base to be taken in each situation. In this case the taxes may
be:
(i) progressive or
(ii) proportional or
(iii) regressive or
(iv) digressive

Direct Taxes
A direct tax is one where the impact and incidence of the Tax is on the same person e.g. Income Tax, death
or estate duty, corporation taxes and capital gains taxes. It can also be defined as the tax paid by the
person on whom it is legally imposed.
Note:
 Impact of tax refers to ‘on whom the tax is imposed’
 Incidence of tax refers to ‘who has to bear the burden of the tax, i.e. who finally pays the tax’
Merits of direct taxes
(i) They satisfy the principle of equity as they are easily matched to the tax payers capacity to pay once
assessed.
(ii) They satisfy the principles of certainty and convenience to tax payers as they know the time and manner
of payment, and the amount to be paid in the case of these taxes. Similarly, the government is also
certain as to the amount of money it shall receive from these taxes.
(iii) They satisfy the Canon Simplicity as they are easy to understand.
(iv) Because most of them are progressive, they tend to reduce income inequalities as the rich are taxed
heavily through income tax, wealth tax, expenditure tax, excess profit, gift tax, etc. so long as they are
alive; and through inheritance taxes or death duties when they die. The poor and the income groups
which are below the minimum tax limit are exempted form these taxes. These taxes thus reduce income
and wealth inequalities because of their progressive nature.
(v) Because the public are paying taxes to the government, they take an interest in the activities of the state
as to whether the public expenditure is incurred on public welfare or not. Such civic consciousness puts
a check on the wastage of the public expenditure in a democratic country.
Demerits of direct taxes
(i) Heavy direct taxation, especially when closely linked to current earnings, can act as a serious check to
productivity by encouraging absenteeism and making men disinclined to work.
(ii) Heavy direct taxation will clearly reduce people’s ability to save since it leaves them with less money to
spend. Taxation may, therefore, act as a deterrent to saving. Heavy taxation of profits makes it more
difficult for business to build up reserves to cover replacement of obsolete or worn-out capital and thus
investment.
(iii) Direct taxes possess an element of arbitrariness in them. They leave much to the discretion of the
taxation authorities in fixing the rates and in interpreting them.
(iv) They are not imposed on all as incomes earned on subsistence and non legal activities are left out.
(v) Cost of collection is generally high.
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 (vi) These taxes are easily evaded either by understating the source of income or by any other means. Such
taxes thus cultivate dishonesty and there is loss of revenue to the state.

Indirect Taxes
These are imposed on an individual mostly producers or traders but they can be passed on to be borne by
others usually the final consumers. They can also be defined as taxes where he incidence is not on the
person on whom it’s legally imposed. They include excise duties, sales tax, Value Added Tax and others.
Merits of Indirect Taxes
(i) They are less costly to administer because the producers and sellers themselves deposit them with the
government.
(ii) If levied on goods with inelastic demand with respect to price rises, it will result in high revenue
collection.
(iii) Indirect taxes reach the pockets of all income groups. Thus, they have a wide coverage, and every
consumer pays to the state exchequer according to his ability to pay.
(iv) They can check on the consumption of harmful goods like wine, cigarettes and other toxicants.
(v) Can be used as a powerful tool for implementing economic policies by the government. If the
government wants to protect domestic industries from foreign competition, it can levy heavy import
duties. This will help to develop domestic industries. If the government wants to encourage one
industry on a priority basis, it may not levy any taxes on its products but continue the taxes imposed on
other industries. The government may do so in order to encourage, a particular technology or
employment in a particular industry.

Demerits of Indirect Taxes

(i) Most indirect taxes are regressive as they are based are not based on ability to pay.
(ii) The rich and the poor are required to pay the same amount of tax on such commodities as matches,
kerosene, toilet soap, washing soap, toothpaste, blades, shoes, etc.
(iii) They may lead to inflation as their imposition tends to raise the prices of commodities, thereby leading
to higher costs, to higher wages, and again to higher prices. Thus a price-wage cost spiral sets in the
economy
(iv) They sometimes have adverse effects on production of commodities, and even employment. When the
price of a commodity increases with the levy of a tax, its demand falls. As a result, its production falls,
and so employment.
(v) The revenue from indirect taxes is uncertain because it is not possible to accurately estimate the effect
of such taxes on the demand for products.

Arguments For Using Indirect Taxation Arguments Against Using Indirect Taxation
1. Changes in indirect taxes can change the pattern of 1. Many indirect taxes make the distribution of
demand by varying relative prices income more unequal because of their regressive
(e.g. an increase in the real duty on petrol) effects
2. Indirect taxes can be used as a means of making the 2. Higher indirect taxes can cause cost-push
polluter pay and “internalizing the external costs” of inflation which can lead to a rise in inflation
production and consumption expectations
3. Indirect taxes are less likely to distort choices 3. If indirect taxes are too high – this creates an
between work and leisure and have less of a negative incentive to avoid taxes through “boot-legging”
effect on work incentives.
4. Indirect taxes can be changed more easily than 4. Revenue from indirect taxes can be uncertain
direct taxes – this gives policy-makers more particularly when inflation is low or there is a
flexibility. recession causing a fall in consumer spending
5. Indirect taxes are less easy to avoid 5. There is a loss of welfare from duties e.g. loss of
producer & consumer surplus
6. Indirect taxes provide an incentive to save that help 6. Higher indirect taxes affect households on lower
to provide finance for investment incomes who are least able to save

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 Progressive Tax
A progressive income tax system is one where the higher the income, the greater the proportion paid in
taxes. This is effected by dividing the taxpayers’ incomes into bands (brackets) upon which different rates of
tax are paid – the rates being higher and the band of income.
Examples of Progressive taxes in Kenya are Income Tax, Estate Duty, Wealth Tax and Gift Tax.
Merits of Progressive Tax
(i) It is more equitable. The broader shoulders are asked to carry the heavier burden.
(ii) It satisfies the canon of productivity as it yields much more than it would under proportional taxation.
(iii) It satisfies the canon of equity as it brings about an equality of sacrifice among the taxpayers.
(iv) To some extent it reduces inequalities of wealth distribution.

Demerits of Progressive Tax

(i) The effect on incentives: High progressive tax makes work and extra effort become less valuable.
(ii) The effect on the willingness to accept risk: High marginal rates of tax are likely to make
entrepreneurs less willing to undertake risks.
(iii) Effects on mobility
 Some financial inducement is usually required if people are to be asked to change their location, or
undergo training, or accept promotion. Progressive taxation by reducing differentials is likely to
have some effect on a person’s willingness to any of the above.
 Encourages tax avoidance and evasion.
 Outflow of high achievers to other countries with lower Marginal tax rates.
 It can lead to fiscal-drag where wage and price inflation cause people to pay higher proportion of
income as tax.

Proportional Tax
Is where whatever the size of income, the same rate or same percentage is charged. Examples are
commodity taxes like customs, excise duties and sales tax.
Its advantage is that it’s much simpler than progressive taxation.

Regressive Tax
A tax is said to be regressive when its burden falls more heavily on the poor than on the rich. No civilized
government imposes a tax like this.

Digressive Tax
A tax is called digressive when the higher incomes do not make a due contribution or when the burden
imposed on them is relatively less.
Another way in which digressive tax may occur is when the highest percentage is set for that given type of
income one which it is intended to exert most pressure; and from this point onwards, the rate is applied
proportionally on higher incomes and decreasing on lower incomes, falling to zero on the lowest incomes.

Economic Effects of Taxation

(i) A deterrent to work
Heavy direct taxation, especially when closely linked to current earnings, can act as a serious check to
production by encouraging absenteeism, and making men disinclined to work. However, indirect
taxation may actually increase the incentive to work, since the more money is then required to satisfy
the same wants, indirect taxes having made goods dearer than they were before.
(ii) A deterrent to saving
Taxation will clearly reduce people’s ability to save since it leaves them with less money to spend.
Taxation may, therefore, act as a deterrent to saving. However, this will not always be the case, as it
will depend on the purpose for which people are saving.
(iii) A deterrent to enterprise
It is argued that entrepreneurs will embark upon risky undertakings only when there is a possibility of
earning large profits if they are successful. Heavy taxation of profits, it is said, robs them of their
possible reward without providing any compensation in the case of failure. As a result, production is
checked and economic progress hindered. It may be, too, that full employment provides conditions

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 under which even the less efficient firms cannot fail to make profits, and so there may be greater
justification for taxation of profits, and so there may be greater justification for taxation of profits
under such conditions.

(iv) Taxation may encourage inflation

Under full employment increased indirect taxation will lead to demand for higher wages, thereby
encouraging inflation. A general increase in purchase taxes pushes up the Index of Retail Prices, and
so brings in its train demands for wage increase.
(v) Diversion of economic resources
Only if there are no hindrances to the free play of economic forces will resources be distributed among
occupations in such a way as to yield that assortment of goods and services desired by consumers.
Taxation of commodities is similar in effect to an increase in their cost of production. Thus, the
influence of a change of supply has to be considered, effect depending on their elasticity of demand. In
consequence of taxation, resources will more from heavily taxed to more lightly taxed forms of
production. This result may, of course, be desired on Non-economic grounds.

5.2. Public Expenditure

The accounts of the central government are centered on two funds, the Consolidated Fund, which handles
the revenues form taxation and other miscellaneous receipts such as broadcasting license fees, interest
and dividends, and the National Loans Fund which conducts the bulk of the governments domestic
borrowing and lending.

In Kenya Each government ministry works out how much money it wants to spend in the coming
Financial Year which starts on 1st July in each year and ends on 30th June on the following year. This is
known as preparing estimates.
The types of estimates include;
(i) Capital Expenditure estimates, and;
(ii) Recurrent Expenditure estimates
(iii) Transfer Payments

 Recurrent expenditure
This refers to government spending that takes place regularly e.g. payments of salaries to civil , fuelling
of government vehicles e.g. Every financial year, the government must allocate funds to meet such
expenditure. Recurrent expenditure is also known as consumption expenditure.
 Development / Capital Expenditure
This is also referred to as capital expenditure. It is government spending on projects that facilitate
economic development. Such projects include construction of railway lines, roads, bridges, health
facilities, educational institutions, airports, rural electrification and other infrastructure
facilities. Once completed expenditure on such projects ceases and may only require maintenance.
 Transfer Payments
These are any payments made to households by the government that are not made in return for the
services of factors of production i.e. there is no Quid pro Quo. Such payments do not lead directly to
any increase in output. Transfer Payments include gifts, unemployment or relief benefits, lottery,
pensions, grants for students famine and disaster relief, pension, bursaries etc. These are payments
from the taxpayer to the recipient.

Government departments also have to prepare estimates for the next financial year for presentation to
parliament. Any department which earns revenue for sales of goods or services to the public shows this as
an Appropriations-in-Aid, which is deducted from its estimated gross expenditure to show net
expenditure, that is, the actual amount required of the Exchequer.

The estimates also include Grants-in aid i.e. grants made by the central government to local authorities to
supplement their revenue from their levying of rates.

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5.2.1. Principles and Role of Public Expenditure in the development of a welfare state
Public expenditure is the expenditure incurred by the public authorities to satisfy those common wants
which the people in their individual capacity are unable to satisfy efficiently.
The range of state economics activities has been increased in the modern age. Some of the causes for
increase in public expenditure include: (1) Developmental work; (2) Rise in price level; (3) Increase in
population; (4) Rise in democracy; (5) Greater expenditure on internal and external security; (6) Expenditure
on war; (7) Welfare state; (8) Urbanization; (9) Growth of public sector; and (10) Economic aid to private
sector.
The following are the main important principles of public expenditure:
1. Canon of Growth:-The public expenditure should stimulate the production and reduce the poverty. It
should not have an adverse effect on the economy.
2. Canon of Social Welfare/Maximum social benefit: - It is very important principal of public
expenditure. The government should spend the money in such a way that it should give maximum
benefit to the whole society. The expenditure cannot be justified, if one particular class enjoys all the
benefits at the expenses of the whole society.
3. Canon of Prior Permission / Sanction: - All the public expenditure should be incurred by getting
prior sanction from the competent authority. It will stop the wastage of money and help the auditors to
audit the expenditure properly. Every public expenditure must be approved by the relevant authority
like parliament.
4. Canon of Economy: - The government money should be spent in such a manner that there should be
no wastage of expenditure. The money collected through takes from the people should not be spent
lavishly. Public expenditure should be planned carefully and prudently to avoid any possible waste.
5. Canon of Elasticity: - Public expenditure should be fairly elastic. It can be increased or decreased
according the requirement of the situation. In case of inflation it may be decreased and in case of
deflation it may be increased, without disturbance.
The policy on public expenditure should be flexible enough to meet prevailing economic situations i.e. it
should be possible to increase or decrease the expenditure on projects depending on the prevailing
circumstances e.g. during drought, it should be possible to spend on famine relief.
6. Canon of Proper Distribution: - Public spending should not concentrate in any particular class. It
should reduce the inequalities of wealth in the country.
7. Canon of Balanced Budget:-Surplus and deficit both budgets are not appreciative. Surplus budget
indicates that heavy taxes are imposed on the people, while deficit budget shows that revenue is less
than the expenditure. So all the governments should prepare the balanced budget.
8. Proper financial management (Accountability)-public funds should be well managed. This should
be facilitated by maintenance of proper records which should be audited as required.
9. Productivity-The biggest proportion of public expenditure should be spent on development projects
and less on non-development projects.
10. Equity-Government expenditure should be distributed equitably to all sectors of the economy in order
to reduce income and wealth inequalities.
11. Surplus-Surplus revenue collected should be saved for emergencies or for when collection of revenue
is below projections.

5.2.2. Importance of Public Expenditure

The following are the main important factors which are responsible for increasing the government
expenditure:
1. Welfare of the People: Every government is spending a huge amount of money to provide the various
facilities to the public. Every government is spending money on medical aid, education, and transport
and housing facilities to the people. So it has extended the expenditure of the government.
2. Population Pressure: - In the developing countries birth rate is very high. To provide the basic
necessities of life to the population, government has to spend the huge amount of money.
3. Development of Back-Ward Areas: - Every government is developing its neglected areas, so public
expenditure has increased. Every government allocates particular amount every year in the budget to
develop these areas.
4. To Increase the Output: - Every government is spending money to cultivate the Barron lands and to
increase the output of the country. Because without increasing the growth rate we cannot improve the
economics condition of the people.

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 5. Inflation: - In the developing countries rate of inflation is very high so their expenditure on goods and
services is also increasing day by day.
6. Increase in Administrative Expenditure: - To maintain peace, security and democracy every
government is spending money. Now Terrorism has also increased the growth of public expenditure.
7. Tax Collection: - As the tax capacity of the people is increasing, government is also spending a huge
amount of money on the revenue department. It has also increased the expenditure of the government.
8. Defense Expenditure: - The defense is main factor which has increased the public expenditure that is
defense. Now armament race among the nations is increasing day by day. This expenditure has
contributed to the increase in expenditure.

5.3. Public/Government/National Debt

Taxation does not often raise sufficient revenue for the Government Expenditure. So, governments resort
to borrowing. This government borrowing is called Public debt or National debt. It thus refers to the
government total outstanding debt. This debt increases whenever the government runs a deficit for then
it has to borrow to pay for the excess of expenditure over taxes and other receipts.

Public Debt is undertaken basically for two reasons:

(a) Given the scarcity of our resources, it is necessary for the government to borrow funds in order to
speed up the process of economic development.
(b) Export earnings of foreign exchange usually fall short of the needed outlays for imports. In order to
cover this foreign exchange deficit on transactions, it is necessary for the government to borrow from
abroad. In the short-run therefore, the external debt is incurred to finance balance of payment deficits.
These deficits are incurred in the course of importing vital consumers and producer goods and
services.
5.3.1. Objectives of Public Debt
1. Deficit in Budget:-
Sometimes government expenditure increases than the revenue, so government fills the gap by
borrowing the money.
2. Development Plans:-
Today less developed countries are making plans to improve their economic condition. A huge amount
of capital is needed for the new projects. So government borrows the money to meet the requirements.
3. Emergency Needs:-
Sometimes a country has to wage a war, so money has to be borrowed on a large scale in order meet
the requirements.
4. Repayment of Debt:-
Sometimes government borrows the money to repay the previous debt.
5. To Control Deflation:-
Sometimes there is a deficiency in aggregate demand, income, output and in employment. The state
borrows the money to fill the gap between saving and expenditure. By increasing investment it
removes the gap.
5.3.2. Role of National Debt for Economic Stability
Sometimes it has been stated that public debt is a curse for the nation. But nothing is good or bad with
the debts. It depends upon the various factors like use of debt and rate of interest. In order to examine
the economic effects of public debt, we will have to examine the following matters:
1. The Quantity of Loan:-
If the economy is functioning at the level of full employment then a small amount of loan will also
create inflationary pressure in the country. If the quantity of loan is greater than rate of inflation will
also be higher.
2. Purpose of Debt:-
If the loan is used for the productive purpose in the period of depression it will increase the income,
employment, and production in the country. On the other hand if loan is used for unproductive
purpose like war, it will lead to instability in the country.
3. Nature of Internal and External Debt:-
Debt whether internal or external is a burden on the nation. However, the natures of both types of
debts differ from each other. In case of foreign loan, interest is also paid with the loan. If it is used for

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 economic development it will have a healthy effect on the country. If internal loan is used for the
consumption purposes, it leads to inflation (due to increased supply of money circulating in an
economy). On the other hand if it is used for the productive purpose then it can increase the income
and employment.
4. Rate of Interest:-
If the debt is borrowed at a higher rate of interest, it will take away a major portion of income for its
repayment and economic stability of the country will be affected adversely.

5.3.3. Types of Public Debt

As mentioned elsewhere, the sum of money which a government borrows from inside or outside the
country to utilize the natural resources of the country or to meet emergency requirements is called
national debt or public debt. If differs from the private debt. Government borrows the money for the
welfare of the citizens while an individual uses it for personal profit.
Public debts can be classified according to the purpose for which the money was borrowed into;
(a) Reproductive Debt: where a loan has been obtained to enable a government to purchase some
real assets, or Deadweight Debt where the debt is not covered by any real assets.
(b) Public/ National Debt: can also be classified into marketable and non-marketable debt.
 Marketable debt can be bought and sold on the money market or stock exchange. It can be
divided into two types;
o short term debt; consisting of Treasury Bills
o long-term debt; consisting of Treasury Bonds (Stocks) (also called government bonds)
 Non-marketable debt cannot be sold on the money market or stock exchange and includes such
items as National Savings certificates, various types of Bonds, and deposits at the National Savings
Bank.
Finally, Public/National debt can also be classified into Domestic and external debt.
 Domestic public debt is owed by the state mainly to its citizens or to domestic institutions such
as commercial companies, etc. The public and financial institutions provide loan to the
government. It includes interest payments on domestic institutions such as commercial
companies, etc. Interest payments on domestic debt are raised from the taxation of the
community. Such interest payments are transfer payments since the total wealth is not affected,
irrespective of the size of the debt.
 External public debt is owed to foreign institutions and governments. These loans are provided
from other states and international agencies like International Monetary Fund. External loans
also depend upon the sound economic condition of the borrowing country. Foreign countries
advance loan if taxable capacity of the national and rate of production is high. Kenya’s external
debt is incurred with two types of lenders:

5.3.4. Bilateral Lenders

This is official lending between two governments. Chief among the lenders of Kenya in this category
are the U.S.A., Britain and Japan.

5.3.5. Multi-lateral Lenders

This is lending from organizations comprising of many governments. By for the leading lender is the
World Bank (IBRD) – with two main lending affiliate bodies - the International Development
Association (IDA) – the international Finance Corporation (IFC); and the International Monetary Fund,
and since 1983, the African Development Bank (ABD).

5.3.6. Burden of the national debt

The extent of the burden on a nation of public debt, depends in the first place on whether it is an
external or an internal debt. The burden of the national debt to the community can be approximated
by the cost of serving it. The cost of servicing the public debt can be calculated:
(i) Per head of the population, or
(ii) As a percentage of government revenue, or
(iii) As a percentage of the national income.

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 Whichever method used, the National debt shall have the following burden on society:
 If higher taxation is required to service a debt which might have disincentive effects resulting in a
lower level of output, then this is a burden.
 If the debt is held by foreigners, goods will need to be exported to pay the interest and possible
repayment of capital. This part of the debt will involve a great burden.
5.3.7. The Budget
The budget is a summary statement indicating the estimated amount of revenue that the government
requires and hopes to raise. It also indicates the various sources from which the revenue will be
raised and the projects on which the government intends to spend the revenue in a particular financial
year. The budget in Kenya is presented to parliament by the Minister of Finance around mid June. In
the budget the Minister reviews government revenue and expenditure in the previous financial year.
The minister presents tax proposals i.e. how he intends to raise the proposed revenue from taxation
for parliament to approve.

Functions of the Budget

The budget fulfils three main functions:
 To raise revenue to meet government expenditure
The government of a country provides certain services such as administration, defence, law and order,
environmental services and economic services. Also it must meet the public debt. Sufficient revenue
must be raised to pay for this.
 It is a means of redistributing wealth
In many countries, a situation has arisen where a small proportion of the population own a more than
proportionate share of the nations wealth, while the majority of the population own only a small
proportion of it. One method of redressing such inequalities of wealth is through a progressive system
of taxation on income and capital. A progressive system is one whereby the wealthy people do not only
pay more tax than the poor, but also pay a greater proportion of their income or wealth.
 To control the level of economic activity
The government uses the budget to implement fiscal policy, i.e. the regulation of the economy through
governments expenditure and taxes.
Types of Budgets
1. Deficit budget
If the proposed expenditure is greater than the planned revenue from taxation and miscellaneous
receipts, this is a budget deficit. The excess of expenditure over revenue will be met through borrowing
both internally through the sale of Treasury Bills and externally from other organisations.
2. Balanced budget
If the proposed expenditure is equal to the planned revenue from taxation and other miscellaneous
receipts, this is a balanced budget. Usually, balanced budgets are not presented, unless the expenditure
is very limited. It would mean the government would have to over-tax the population which can create
disincentives. It is to avoid this that the tax revenue is supplemented by borrowing.
3. Surplus budgets
If the proposed expenditure is less than the planned revenue from taxation and other miscellaneous
receipts, this is a surplus budget. Usually, surplus budgets are not presented for they are deflationary
and can create unemployment as the government takes out of the economy more than it puts back.

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 Public Sector Borrowing Requirement (PSBR)
Public Sector Borrowing Requirement (PSBR) is the amount which the government needs to borrow in
any one year to finance an excess expenditure over income.

Effects of Government Borrowing on the Economy

 If the government borrows from the general public, this may divert funds from more productive uses.
 Firms also require finance and it may be that individuals and financial institutions prefer to lend to
the government where the risk is less and possibly the returns are greater. Thus the public sector
may “crowd out” the private sector. This is known as the “crowding out” effect.
 A further harmful effect may occur. Government borrowing will tend to raise the rate of interest.
This increase in interest rates will make certain capital investments less profitable resulting in a fall
in investment, slower economic growth and a reduction in the competitiveness of the
industries.
 The increase in interest rates will also raise the cost of borrowing money for the purchase of
houses and other goods hence an increase in the cost of living leading to inflationary wage
pressure.
 To avoid the above adverse effects, the government would borrow from the banking system the use
of Treasury Bills; But this would raise eligible reserve assets in the banking system and thereby the
money supply and the resultant inflation: This puts the government in a dilemma.
 The above pattern could be alleviated if the size of the PSBR was reduced. This could be done by:
o Reducing government expenditures and/or increasing taxation: The first option is the trend in
recent years but increased taxation is said to have the effect of reducing initiative and incentives.
o Of late, employment has been put in the control of PSBR and ensuring that the growth of money did
not exceed the growth of output.

5.4. Fiscal Policy

Fiscal policy is defined as the process of shaping government taxation and expenditure to achieve desired
economic and social objectives. It involves the process of shaping the public finance with a view to reduce
fluctuations in the business.
It refers to the manipulation of government revenue and expenditure to achieve policy objectives
associated with:
 Moderating resources allocation and adjusting price mechanisms in favour of the satisfaction of public
wants by encouraging socially optimal investments as well as increasing rate of investments;
 Redistributing wealth income;
 Guiding the national economy in terms of growth and stability;
 Increasing employment opportunities;
 Counteracting inflation; and
 Improving the balance of payments.
The usefulness of fiscal policies if often limited by:
 Structural constraints in the economies; and
 Observed conflicts of objectives between long term growth and short term stability; social welfare and
economic growth; income distribution and growth and personal freedom and social control.
Basically, fiscal policy can be applied in many ways to influence the economy. For example the government
can increase its own expenditure which it can influence by raising taxes, by borrowing from non bank
members of the public and/or borrowing from the Central and Commercial bank. Borrowing from non - bank
members of the public often raises interest rates and reduces availability of credit to the private sector
forcing a reduction in the sectors of consumption and investment expenditures. Borrowing from the Central
Bank increases money supply and may give rise to inflation and balance of payments problems.
Taxes can be used to change the consumption of demand in the economy and to affect consumption of certain
commodities.

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5.4.1. Objectives and Role of Fiscal Policy
1. Increase in Savings :-
This policy is also used to increase the rate of savings in the country. In the developing countries rich
class spends a lot of money on luxuries. The government can impose taxes on them and can provide
the basic necessities of life to the poor class on low rate. In this way by providing incentives, savings
can be increased.
2. To Encourage Investment :-
The government can encourage the investment by providing various incentives like the tax holiday
in the various sectors of the economy. The capital can be shifted from less productive sectors to
more productive sectors. So the resources of the country can be utilized maximum.
3. To Achieve Equal Distribution of Wealth :-
Fiscal policy is very useful for the achievement of equal distribution of wealth. When the wealth is
equally distributed among the various classes, then their purchasing power increases which ensures
the high level of employment and production.
4. To Control Inflation :-
Fiscal policy is very useful weapon for controlling the rate of inflation. When the expenditure on non
productive projects is reduced or the rate of taxes is increased then the purchasing power of the
people reduces.
5. To Reduce the Regional Disparity :-
In the less developing countries the regional disparity is found. Some areas are more developed
while the others are less developed. Government provides the infrastructure facilities in less
developed areas. The tax holiday incentive is also provided in these areas which is very useful in
increasing the per capita income.
6. Stabilization of Price Level :-
Fiscal policy is also used to achieve desirable level of prices in the country. It means the cost and
price should be at such level that production and employment may increase.
7. Increase in Agriculture and Industrial output :-
Fiscal policy is also used that the output of various sectors of the economy must increase. The
demand inside and out side the country should be satisfied.
8. To Attain Maximum Welfare of the People :-
Fiscal policy main objective is to achieve maximum welfare of the people. The quality of life must
improve in the country.
9. To Check Rapid Increase in Consumption :-
Fiscal policy is also used to check the rapid increase in the consumption will be high then the rate of
saving will be low and consequently rate of investment will be low. So, one country cannot improve
its economic condition without increasing the investment.
10. To Achieve Economic Stability :-
The aim of fiscal policy is to increase the rate of production and employment without inflation. So all
in all, a country’s fiscal policy major objective is to ensure the economic stability in the country.

5.4.2. Difficulties in using fiscal policy

There are several problems involved in implementing fiscal policy. They include:
(i) Theoretical problems
Monetarists and the Keynesians do not seem to agree on the efficacy of fiscal policy. Monetarists claim
that budget deficits (or surpluses) will have little or no effect upon real national income while having
adverse effect upon real national income while having adverse effects upon the interest rates and upon
prices.
(ii) The net effects of the budget
Unlike the simple Keynesian view that various types of budgets have different effects, the empirical
evidence is that the net effects of taxes and government expenditure are influenced by the marginal
propensities to consume of those being taxed and governments expenditure.

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 (iii) The Inflexibility of government finances
Much of the government’s finances are inflexible. One of the reasons for this is that the major portion of
almost any departments budget is wages and salaries, and it is not possible to play around with these to
suit the short-run needs of the government.
(iv) Discretionary and automatic changes
Discretionary changes are those which come about as a result of some conscious decision taken by the
government, e.g. changes in tax rates or a change in the pattern of expenditure.
Automatic changes come about as a result of some changes in the economy, e.g. an increase in
unemployment automatically increases government expenditure on unemployment benefits.

In fact it is the case that deficits tend to increase automatically in times of recession and decrease in
times of recovery. (These fiscal weapons which automatically increase in times of recession and
decrease in times of recovery are referred to as brick stabilizers). It is possible for a government to
compound the effects of a recession by raising taxes in order to recover lost revenues. This, according to
Keynesians, would cause a multiplier effect downwards on the level of economic activity.

 A fiscal policy which is meant to control unemployment may cause inflation if it achieves full
employment or policies to combat inflation might call for a cut in public expenditure which in the
short-run may lead to a higher rate of unemployment and a less equitable distribution of income and
wealth.
 Also the policy of maintaining low council houses rents on equity grounds results in long waiting list;
this may be undesirable on efficiency grounds as it acts as a barrier to labour mobility and this in
turn may increase unemployment.
 A fiscal policy meant to cure balance of payments may not just reduce demand for imports but also
reduces demand for domestically produced goods. This in turn can have a knock on effect in the
form of lower output and higher unemployment.

5.5. Financial administration

Financial administration is concerned with the organization and functioning of the government
machinery that is responsible for performing various financial activities of the state.
 Preparing the budget for the particular financial year is the master financial plan of the government.
 The various works, starting with the objectives of designing a budget, the methods of preparing it,
presentation of the budget before the Parliament and State Assembly, passing or sanctioning by the
Parliament, execution, auditing, implementation etc., constitute the subject matter of financial
administration.

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