Public Finance 2

Principles of Public/government Expenditure

These are the considerations that are necessary before any expenditure can be incurred by the government.

They include:

a) Sanctions:

Every public expenditure must be approved by the relevant authority like parliament.

b) Maximum social benefit:

Any public expenditure must be incurred in such a way that majority of the citizens are able to reap maximum benefit from it e.g. improved living standards and quality of life.

c) Flexibility /elasticity ;

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.

d) Economy

public expenditure should be planned carefully and prudently to avoid any possible waste.

e) 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.

f) Productivity

The biggest proportion of public expenditure should be spent on development projects and less on non-development projects.

g) Equity

Government expenditure should be distributed equitably to all sectors of the economy in order to reduce income and wealth inequalities.

h) Surplus

Surplus revenue collected should be saved for emergencies or for when collection of revenue is below projections.

Taxation

Tax:

Is a compulsory payment by either individuals or organizations to the government without any direct benefit to the payer.

Taxation

Refers to the process through which the government raises revenue by collecting taxes.

Purposes/reasons for taxation

i. Raising revenue for government expenditure. This is the main reason for taxation.

ii. Discouraging /controlling consumption of certain commodities e.g. alcohol and cigarattes which are considered to be harmful.

iii. Discouraging importation of certain commodities in order to protect local industries. This is done by imposing heavy taxes on such commodities.

iv. Controlling inflation. Taxation reduces money supply by reducing peoples ‘disposable’ income thereby controlling inflation.

v. Reducing inequality in income distribution; this is done by taxing the rich heavily and using the finances raised in provision of goods and services that benefit the poor.

vi. Influencing locations of businesses. This is done by taxing businesses located in urban areas heavily and those in rural areas lightly hence businesses moving to rural areas.

vii. Correcting unfavorable balance of payments. High taxes are imposed on imported commodities thereby discouraging their importation leading to an improvement in the balance of payments.

viii. To protect the key selectors of the economy such as the agricultural sector, by stimulating their growth.

Factors that determine the amount of money raised through taxation

i. Distribution of incomes

ii. Social and political factors

iii. Honesty and efficiency of tax authorities

iv. Citizens level of real income

v. Economic structure of the country i.e. relative size of the country’s commercial and subsistence sectors.

Principles of taxation

These are the characteristics that a good tax system should have. They are also referred to as the cannons of taxation.


A good tax system should be;

j. 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.

k. 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.

l. 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.

m.Economical/principle of economy

The cost of collecting and administering
the tax should be lower than the tax so collected.

n. 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

o. 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.

p. 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.

q. Simplicity

A good tax system should be simple enough to be understood by each tax payer. This will motivate them to pay tax.

r. Elastic/principle of elasticity

The tax system should be able to generate more revenue for the government by targeting items of mass consumption.


Impact and Incidence of Tax

Impact of tax: The burden of tax on the initial person Incidence of tax: The final resting place of the tax burden.

The person on whom tax is initially imposed may either bear the whole burden or pass part or the whole burden to someone else. E.g. for manufactured goods, the impact of the tax is on the manufacturer and the manufacturer may pass the incidence of the tax to the consumer.

If the manufacturer only passes part of the burden to the consumer, then the incidence of the tax will be partly on the manufacturer and partly on the consumer.

Classification of Taxes

Taxes are classified according to;

i. Structure of the tax

ii. Impact of the tax on the tax payer.

a. According to the structure

In this case, taxes are classified according to the relationship between the amount paid on tax and the income of the tax payer. These are:

i. Progressive tax

ii. Regressive tax

iii. Proportional tax

b. Progressive tax

This is a type of tax where the rate/amount paid increases proportionately with increase in income.e.g tax may be as follows Income Rate

0-5000 20%

5001-10000 25%

10001-15000 30% e.t.c

-In progressive tax, those with higher income rates remit a higher proportion of their income as tax compared to those in lower income brackets.

This type of tax is based on the belief that one only needs a certain amount in order to have a decent standard of living.

Advantages of progressive tax

• It reduces income inequality as the rich are taxed more

• It encourages people to work harder/more in order to maintain
their standard of living

• The revenue collected is higher

• The unit cost of collecting tax reduces as the tax increases.

Disadvantages of progressive tax

i. It is oppressive-some people are taxed more than the others and punishes people for their hard work.

ii. It may discourage people from working more as any additional income goes tax

iii. Investors may be discouraged from venturing into risky but more profitable businesses as these would attract more tax

iv. It assumes that people earning the same amount of money/income have similar needs and ability to pay tax-which in reality may not be true.

v. It can lead to tax evasion by taxpayers falsifying their level of income.

c. Regressive tax

This is a type of tax that takes a higher proportion of low income earners as compared to high income earners.

The fax burden falls more heavily on the poor (opposite of progressive)

Example: sales tax where people pay the same amount irrespective of the level of income.

The assumption is based on the understanding that the one who deems it necessary to buy a certain products considers the utility derived from it to be equal to its price, which includes tax.

d. Proportional Tax

This is a type of tax where the rate of tax remains the same irrespective of the level of income or value of property to be taxed e.g.

if the rate is 20% then a person who earns ksh.5000 will pay 20/100 x 5000 = ksh.1000
Ksh.10, 000 will pay 20/100x10,000=ksh.2000 e.t.c

Example: corporation tax where companies are expected to pay a fixed bproportion of their profits as tax.

e. Digressive tax

This is a type of tax where the tax rate increases up to a given maximum after which a uniform tax rate is levied for any further income.

Classification according to impact on the tax-payee

Based on the impact the tax has on the tax payer; tax may be classified as either:

a. Direct tax

b. Indirect tax


a. Direct tax

These are taxes where the impact and the incidence of the tax are on the same person.

It is not possible to shift/pass any part of the tax burden to anybody else.

This type of tax is based on incomes, profits and property of individuals as well as companies.

They include:

Public Finance 1 | Public Finance 2 |
Public Finance 3 |