4.0 Public Finance 2024 Final.pdf

Public Finance Introduction to Public Finance Public goods and private goods, Budget, Functions of taxation, Principles of Taxation, Classification of taxes, Tax incidence & Elasticity and sharing the tax burden Public finance Public finance, as defined by R/G (p. 2) – “The field of economics that a...

Public Finance Introduction to Public Finance Public goods and private goods, Budget, Functions of taxation, Principles of Taxation, Classification of taxes, Tax incidence & Elasticity and sharing the tax burden Public finance Public finance, as defined by R/G (p. 2) – “The field of economics that analyzes government taxation and spending policies” Public finance, as described by Former Czech Prime Minister Vaclav Klaus (From R/G, p. 2) – “Public finance is nothing else than a sophisticated discussion of the relationship between the individual and the state” Public finance Field of economics concerned with how governments raise money, how the money is spent and the effects of these activities on economies. For many countries, spending and taxation by the government form a large portion of the nations total economic activity – E.g. in US total government spending equals about 40% of the nations GDP. – In Botswana, government spending in 2022 was was about 27.66% of GDP. Public _____ There are at least two other terms that mean the same thing as public finance – Public sector economics – Public economics Although I may use the three terms interchangeably to mean the same thing, I will usually use the term “public finance” Why have government Intervention? When is government intervention necessary in a market economy? Role of the Public Sector  In this topic, we consider government activity in the economy, and how government activity (spending and taxation) influence economic activity and outcomes  Government activities are carried out through its various agencies: ministries, district councils, state-owned enterprises etc.  To simplify the analysis, we group these agencies into one entity: public sector (government)  Government activities and decisions affect individuals and institutions in different ways Role of the Public Sector  The most important decisions that affect individuals and institutions are concerned with taxation (an important source of government revenue), government spending and the various rules and regulations that influence economic activity and social welfare.  The decisions and activities of government are aimed primarily at addressing market failure  Market failure can be interpreted as a state of disequilibrium in the market: a circumstance in which private markets do not bring about allocation of resources that best satisfies society’s wants Role of the Public Sector  Market failure can arise due to a number of reasons: i. externalities ii. information asymmetry iii. abuse of market power etc. Role of the Public Sector i. Market failure due to externalities  An externality is a cost to a third party that is external to a transaction (i.e. a cost to an individual or group not directly involved in the transaction: negative externality  Negative externalities (e.g. pollution) necessitate government intervention to protect people not involved in a particular transaction (can be achieved through taxation, regulation etc.) Role of the Public Sector ii. Market failure due to information Asymmetry:  Information asymmetry arises when parties to a transaction do not have the same information or knowledge relating to the transaction: leading to inefficient outcomes  Types of Information Asymmetry Adverse selection: when a buyer has information that the seller may not be aware of at the signing of a contract e.g. an applicant gaining insurance at a cost that is below their true level of risk. Role of the Public Sector  Moral hazard: when one party to a transaction alters his behaviour after the signing of a contract e.g. a driver may be less conscious after buying insurance  Because of these information asymmetries, government has to intervene to protect parties to contracts: through regulation for instance iii. Market failure due to abuse of market power  Recall: monopoly power prevents the forces of demand and supply from setting prices of goods in the market leading to inefficient outcomes - welfare losses Role of the Public Sector iv. Market failure due to public goods  What is a public good? Public vs. Private Goods Public goods Goods which are non-rivalry in consumption and non excludable. – Non-rivalry in consumption: one individuals consumption of a certain commodity does not prevent the benefits from simultaneously accruing or going to other individuals. – Non- Excludable: this means that it is impossible or at least very costly to exclude non payers from the consumption of a particular commodity once it is produced. Typical examples of public goods are – Police protection; Street lights; Public parks; National defence. Public and Private Goods Private Goods are rivalry in consumption and excludable. – Excludable: it is possible or at least not very costly to exclude non-payers from the consumption of a given commodity once it is produced. – Rivalry in Consumption: this means that the consumption of a particular commodity prevents the benefits from simultaneously accruing to other individuals. Private sector or business motive is to make profits, only those who pay can enjoy the benefits Problems of public goods i. Free rider problem: because public goods are nonrival and non excludable, it is difficult to charge consumers for the use of public goods. – In addition rational consumers will not voluntarily pay for the use of public goods. – Free rider problem happens when a person misrepresents or hides his preferences while expecting to consume the goods without paying. Problems of public goods ii. Problem of pricing: it is difficult if not impossible to determine a competitive price for a public good. – For a private good, a competitive price is determined where P=MC on the rising part of the MC curve. – For public goods, the marginal cost of extending consumption to extra consumers is zero because of the property of non rival in consumption hence it difficult to determine the competitive price for a public goods Role of the Public Sector  Government promotes competition through regulation, taxes, subsidies  Enforce contracts: to facilitate the market mechanism, using rules and regulations, government enforces contracts entered into by buyers and sellers  Redistribute income and wealth: given government’s responsibility of maximizing social welfare, public policy may be required to achieve more equitable distribution of income and welfare  Promote macroeconomic objectives: public policy may be required in market economies where the price system is prone to high unemployment, inflation and balance of payments difficulties Government Budget Government budget is a forecast of government expenditures and revenues for a specific period of time. – In public finance, the period covered by a budget is usually a year, known as a financial or fiscal year. When expenditures exceed revenues in a year, there is a budget deficit When government revenues exceed expenditures in a year, there is a budget surplus When expenditures are equal to revenues in a year, the budget is said to be balanced The Government Budget  Highlights of the Government Budget in Botswana  Composition of Government Revenue  While there are several sources of revenue for government in Botswana, the primary source is taxation (income taxes, corporate taxes, import taxes, property taxes, inheritance taxes etc.)  Figure 1 presents the composition of total revenue: tax revenues are the single most important source of government revenues  Grants contribute the least to government revenue  Figure 2 presents a breakdown of tax revenues: customs and mineral tax revenues constitute a significant proportion of tax revenues The Government Budget 2018/19 2017/18 2016/17 2015/16 Tax Reveue Non-Tax Revenue Grants 2014/15 2013/14 2012/13 2011/12 0.00 10000.00 20000.00 30000.00 40000.00 50000.00 60000.00 The Government Budget 60000.00 50000.00 Value Added Tax 40000.00 Licence fees Vehicle taxes Property taxes 30000.00 Export duties Non-mineral income tax Mineral revenue 20000.00 Customs 10000.00 0.00 2011/12 2012/13 2013/14 2014/15 2015/16 2016/17 2017/18 2018/19 The Government Budget  Composition of Government Expenditure  Government spending consists of both consumption spending and infrastructure development spending  Consumption spending consists of expenditure on goods and services e.g. wages, stationery etc. We refer to these expenditures as recurrent expenditure  Infrastructure development spending consists of expenditure on infrastructure etc. We refer to these expenditures as development expenditure  The Figures below show the composition of government expenditure in Botswana The Government Budget 100% 90% 80% 70% 60% Development expenditure 50% Recurrent expenditure 40% 30% 20% 10% 0% 2011/12 2012/13 2013/14 2014/15 2015/16 2016/17 2017/18 2018/19 2019/20 2020/21 The Government Budget General public services including defence Education Health Food and social welfare programmes Housing, urban and regional development Other community and social services Agriculture, forestry and fishing Mining Electricity and water supply Transport Other Taxation Definition of Tax A share or proportion of income of the income earners which the gov’t gets in order to provide public goods and services. – A tax is a compulsory payment. And paying of taxes does not entitle taxpayers to benefit from public goods and services. – Paying tax is a social or collective responsibility Fines, such as court fines are also mandatory payments, but they are not taxes. Because their objective is not to raise government revenue but to reduce (curb)certain offences. Objectives (Functions) of taxation We have four main objectives of taxation: – Secure revenue for the government – Allocate resources – Distribute income and wealth – Stabilize the economy Taxation: Functions of taxation 1. Secure revenue for the government In many countries, taxation is the main source of government revenue/public finance. In Botswana, tax revenue accounted for 81.3 percent of total revenue and grants in 1990, 73.5 in 1995 , 92.8 percent in 2010, 94% in 2015 and 95% 2018/19. In the case of developing countries like Botswana, taxation is preferred to borrowing for the following reasons: – Borrowing leads to problems of external debt service. – Government borrowing from the domestic financial system is inflationary. And can crowd out private investment i.e. the government will be competing with the private sector. Taxation: Functions of taxation 2. Allocate resources The basic goal an economic system is the efficient allocation of scarce resources. – Taxation can be used to adjust the allocation of resources to achieve a social optimum. – E.g. low taxes in agricultural sector so as to increase production of agricultural produce. – E.g. high taxes on alcohol and tobacco so as to decrease production of alcohol and tobacco. Taxation: Functions of taxation 3. Distribute income & wealth One of the features of the market system is that it generates income inequality. Redistribution of income is therefore necessary in the case of the market system. Taxation can be used to redistribute income & wealth to improve social equity. E.g., impose taxes on income for high income earners in society and use the revenue to finance social welfare programs and provision of public goods. Taxation: Functions of taxation 4. Stabilize the economy The market system is by nature unstable. It is subject to fluctuations between periods of high unemployment with low inflation and those of low employment and high inflation. Taxation can be used to stabilize the economy as follows – If inflation is high, an increase in taxes reduces personal consumption (C), since C is part of aggregate demand (AD), AD eventually falls and consequently inflation. – If unemployment is high, a decrease in taxes will increase household consumption (C), And AD hence reduce unemployment. Apportioning the tax burden Tax burden refers to the total cost of taxes imposed on society There are two basic principles on how the economy’s tax burden should be apportioned: – The benefits received principle – The ability to pay principle The benefits-received principle The benefits-received principle asserts that households and businesses should be taxed in relationship to the services they receive, from public goods and services. For example, tolls for roads and bridges. Advantages – The principle links the expenditure side of the government with the revenue side of government. The advantage in this case is that the system controls gov’t expenditure. – The benefit-received principle is a pseudo market system of resource allocation where by consumers are charged according to the benefits they receive from goods and services. The benefits-received principle DISADVANTAGES i. Difficult to apply when the goods are non-excludable, and most public goods are of this nature. Since most public goods are non-excludable it is difficult to determine benefits each consumer receives from the commodity and therefore difficult to set the charge for public good. ii. Most importantly, the user charges undermine efforts of poverty. Most people who benefit from government programs include a significant number of those who can not pay for the services. User charges worsen income inequality. The Ability-to-Pay principle The ability-to-pay principle asserts that the tax burden should rest more heavily on those with greater income and wealth. – The rationale is that those people with much income or wealth will value their marginal Pula less than those with low incomes, where each Pula is very meaningful. We have the following aspects of ability to pay – Horizontal equity – Vertical equity The Ability-to-Pay principle Horizontal equity Horizontal equity requires that individuals with similar economic circumstances should be taxed equally, in other words, “treat equals equally.” Vertical Equity Requires that individuals in different economic circumstances should treated differently, in other words, “treat unequal's unequally.” The Ability-to-Pay principle Advantages i. The principle tries to deal with issues of income redistribution and transfer payments. ii. If income or consumption is used, it is possible to measure the ability to pay (unlike the benefits received principle). Disadvantages i. Leads to tax evasion- taxpayers deliberately misrepresenting the true state of their affairs to the tax authorities to reduce their tax liability. ii. In the case of horizontal equity, it is difficult to find 2 people who are in exactly the same circumstances. E.g. two families may earn the same income but their family sizes would differ. The sources of income will also differ. Tax Classifications Taxes may be divided into direct and indirect taxes. i. Direct – Taxes that are imposed directly on individuals and companies. – Taxes where the incidence of the tax (tax burden) is borne by the economic agent that is taxed. – E.g. Personal income tax, Company income tax, Property tax, wealth tax (Italy, France, Argentina, Norway etc.) and inheritance tax (UK). Tax Classifications ii.Indirect taxes – Are taxes that are imposed on commodities or market transactions and are likely to be shifted. – The incidence of the tax does not necessarily fall on the economic agent that is taxed. – E.g. Exercise duties, exports and import duties, Value added tax (VAT) Tax Classifications Advantages of Direct Taxes i. Direct taxes fall mainly on income (levied mainly on income) therefore they can be levied according to the ability to pay. Thus, direct taxes promote equity. ii. The tax burden falls on the person or economic agent that is taxed, therefore the tax can not be avoided. iii. The cost of collection usually small compared to the total amount collected. Usually for income tax we use the PAYE system, tax income deducted by employer before the employee receives his/her pay check. Thus, through direct taxes, the government is able to minimize administrative and compliance costs associated with imposing a tax. Tax Classifications Disadvantages of Direct Taxes i. Very high direct taxes on labour can discourage work and therefore production. ii. Very high direct taxes on companies (firms) can reduce the money available for re-investment, and therefore capital formation and economic growth. Tax Classifications Advantages of Indirect Taxes i. Indirect taxes can be used to protect infant industries through import duties on goods which are also produced in the domestic market. ii. They are convenient to both the tax-payer and the State. The tax-payers do not feel the burden much, partly because an indirect tax is paid in small amounts and partly because it is paid only when making purchases. iii. When imposed on luxuries or goods consumed by the rich, they are equitable. In such cases only the well-to-do will pay the tax. iv. They check consumption of harmful commodities. That is why tobacco, alcohol and other intoxicants are taxed. v. Indirect taxes do not discourage work, in fact workers may work harder to buy the commodities that are taxed. Tax Classifications Disadvantages of Indirect Taxes i. Indirect taxes can be avoided e.g. by not purchasing the commodities which are taxed. ii. Indirect taxes are regressive because they do not take into account the social economic circumstances of the tax payers. iii. By raising prices, indirect taxes can trigger cost push inflation. Cost push inflation is whereby factors of production exert their bargaining power continuously. iv. The cost of collection is quite heavy. Every source of production has to be guarded. Large administrative staff is required to administer such taxes. This turns out to be a costly affair. Tax Classifications Every tax has 3 components and these are as follows: Tax base, Tax rate & Amount Payable (paid). 1. Tax Base Simply the object of taxation for example a. Income (for income tax) b. Property (property tax) c. Value of goods sold (sales tax, value added tax). 2. Tax rate By the tax rate we mean the rate of taxation. Essentially we have 3 types of rate structures as follows: Regressive tax rate, Proportional tax rate and Progressive tax rate. Tax Classifications Progressive tax A tax is progressive if its average tax rate (ATR) increases as income increases; and decreases as taxpayer’s income decreases – People with higher incomes pay a larger proportion of their incomes as taxes than do people with lower incomes. – The effect of progressive tax is to reduce income inequality – E.g. income tax in Botswana (for citizens) Taxable Income (P) Tax Payable 0- 48,000.00 0 48,000.01 - 84,000.00 5% 84, 000.01– 120,000.00 12.5% 120, 000.01 – 156,000.00 18.75% 156,000.01 and above 25% Proportional Taxation A tax is proportional if its average rate remains the same as tax base increases; the tax payment grows absolutely with income but remains the same proportionate to income. – A proportional tax does not affect the distribution of income. – Given an income earner of P10 000 and an income earner of P5000. Under the proportional tax, which tax rate 20% or 10%, would be charged the higher income earner of P10 000, and which would be charge the lower income earner of P5 000? Both the P10 000 and the P5 000 income earners would be subjected to the same tax rate, either 20% or 10%. Proportional Taxation Cont. This means that, if the tax rate is 10%, the tax paid by the P10 000 income earner would be P1000 (=10/100*10 000), while P500 (=10/100*5 000) would be paid as tax by the P5000 income earner. This shows that, under the proportional tax, the higher the level of income, the higher the absolute amount of tax paid. Therefore, a proportional tax does not lead to inequalities An example of a proportional tax is the company income tax. Corporate tax rate in Botswana is currently 22% Regressive tax A tax is regressive if its average tax rate (ATR) declines as income increases; the tax may or may not increase in the absolute amount, but it declines in proportion to income. – The effect of regressive tax is to increase income inequality, the poor become poor and the rich become richer. – E.g. Sales taxes that apply to essentials are generally considered to be regressive as well because expenses for food, clothing and shelter tend to make up a higher percentage of a lower income consumer's overall budget. – In this case, even though the tax may be uniform (such as 5% sales tax), lower income consumers are more affected by it because they are less able to afford it. Regressive Tax (cont.) Assume two individuals, Smith (has an income of P15,000 and spends all of it on commodities). And jones who has an income of P300, 000 but only spends P200, 000 and saves the rest. Assume a 5% sales tax applies to all expenditures of each individual. Thus, smith pays 5/100*15,000=P750 as sales tax Jones pays 5/100*200,000=P10,000 as sales tax But smith pays 750/15000*100=5% of income as sales tax. Whereas Jones pays 10,000/300,000*100=3.3% of income as sales tax. Thus, a regressive tax takes a higher percentage of low income than high ones. Applications in existing tax structure Personal income tax is a tax levied on taxable income. It is generally progressive because marginal tax rates rise with income. General sales tax/VAT is levied on commodities or on purchases. It is regressive because, although everyone pays the same % on expenditures, the rich tend to spend a much smaller fraction of their incomes, while the poor may spend all of their incomes. Therefore, the rich will pay a smaller overall proportion of their income in sales taxes/VAT. Some of the items excluded from VAT in Botswana Since VAT is regressive, some commodities (essentials) are excluded from VAT in Botswana. The food stuff that have been zero rated from VAT are as follows: Brown bread ,rice , samp ,bread flour Fresh vegetables (in natural state) and Fresh fruits (in natural state) Rice (husked, milled, polished, glazed, parboiled or broken) Millet grain, millet meal, wheat grain, maize cobs, flour, sugar, maize meal and sorghum meal in their natural state and not mixed with other products; Milk (cattle, sheep or goat milk not concentrated, condensed, evaporated, sweetened, flavoured or cultured) Paraffin, petrol, diesel; etc. Applications in existing tax structure Property taxes tend to be regressive because landlords pass along this cost to tenants who have lower incomes; housing costs are a larger proportion of income for the poor than for the rich. Corporate income tax is levied on corporations’ profits. It is essentially a flat-rate tax with a set rate. – If the incidence falls on the owners of the capital, the tax is progressive. – but if it is passed on to consumers in the form of higher prices it may actually be regressive in its impact because many consumers are low income earners. Elasticity & Tax Incidence When the tax is levied or imposed, the price that producers receive and the one that consumers pay differ. In other words, a tax forms a gap between the consumer price and producer price. Therefore, when a tax is imposed, at the new equilibrium we have two prices; one received by producers and the one paid by consumers. Elasticity & Tax Incidence For Example: Suppose a tax is imposed on producers i.e. suppliers. The effect of the tax will be to reduce the supply as a result the supply curve will shift inward, parallel to the original supply curve. Suppose demand does not change, the incidence of the tax can be measured as follows graphically. Measuring Tax Incidence Graphically S2 Price S1 Pc A P1 B Pp C Incidence to consumers Incidence to producers D Q2 Q1 Quantity Measuring Tax Incidence Who pays more of the tax? The incidence of a tax is independent of whether it is levied on consumers or producers. – The supply and demand theory of tax incidence shifting states that the incidence of a tax depends on the elasticity's of supply and demand. Supply and Demand Theory of Tax Incidence Shifting As a general rule, the unresponsive economic agent bears most of the burden of a tax. – Given Supply, the less elastic (inelastic) demand is, the more the burden falls on consumers. Therefore, we can conclude, the more elastic demand is, the lower the burden falls on consumers. – Given demand, the less elastic (inelastic) the supply, the more the burden falls on producers or sellers. And the more elastic supply is, the less the burden falls on producers. Supply and Demand Theory of Tax Incidence Shifting To maximize revenue, tax goods whose demand is inelastic, why? – Demand is inelastic, consumers are less responsive to price changes. – %change in quantity demanded < % change in price. – Therefore, P0×Q0 < P1×Q1 Supply and Demand Theory of Tax Incidence Shifting Summary Ed > Es producer bears most of the tax burden Ed < Es consumer bears most of the tax burden Ed = Es equally share the tax burden Ed = 0 (perfectly inelastic demand) all the burden falls on consumers Ed = ∞ (Perfectly elastic demand)all the burden falls on producers Es = 0 (Perfectly inelastic supply) all the burden falls on producers Es = ∞ (Perfectly elastic supply) all the burden falls on consumers Perfectly Inelastic Demand Graph If demand is perfectly inelastic then consumers bear all the tax incidence. Because demand not responsive to changes in price, consumers bear all the burden of the tax. Note, with perfectly inelastic demand, the demand curve is a vertical. e d = 0 Elastic Demand Graph The imposition of the tax shifts the supply curve from S1 to S2. With elastic demand, consumers bear less of the tax burden. Incidence to consumers AB< BC (incidence to producers). This implies that if demand is perfectly elastic, all the incidence of the tax will fall on producers. Note, with elastic demand, the demand curve is flatter. Elastic Supply If supply is elastic the burden of the tax falls less on producers. The imposition of the tax shifts the supply curve from S1 to S2. because supply is elastic (producers are very responsive to changes in price), consumers bear most of the burden of the tax. Incidence to consumers AB> BC incidence to producers. Note, with elastic supply, the supply curve is flatter. Inelastic Supply If supply is inelastic the incidence is more on producers. The imposition of the tax shifts the supply curve from S1 to S2. because supply is inelastic (producers are less responsive to changes in price), producers bear most of the burden of the tax. Incidence to consumers AB< BC (incidence to producers). Note, with inelastic supply, the supply curve is steeper. Fiscal Policy Noted that the way in which government decides to spend its money is reflected in the national budget The budget is made up of the money received from taxation (T) less government expenditure (G) i.e. T – G If tax revenues (T) exceed government spending (G), then the budget is in surplus i.e. budget surplus arises if T>G If government spending (G) exceeds tax revenues (T), then the budget is in deficit i.e. budget deficit arises if G>T The national budget is the main method of implementing fiscal policy Fiscal policy Definition of fiscal policy Fiscal policy involves the government changing the levels of taxation and government spending in order to influence Aggregate Demand (AD) and the level of economic activity. OR Fiscal policy is the control of taxes and government spending (instruments of fiscal policy) by government to influence economic activity – AD is the total level of planned expenditure in an economy (AD = C+ I + G + X – M) Fiscal policy The purpose of Fiscal Policy Stimulate economic growth in a period of a recession. Keep inflation low (BoB target 3-6%) Achieve full employment Fiscal Policy cont.. Contractionary Fiscal Policy When demand pull inflation occurs, a restrictive or contractionary fiscal policy may help control it. If government implements fiscal policy to control inflation, its options are the opposite of those used to combat recession. It can resort to: Decreasing government spending Raising taxes or Using some combination of the above two. When the economy faces demand-pull inflation, fiscal policy should move toward government budget surplus- tax revenues in excess of government spending. Government may choose to combine reduced spending and increased taxes in order to reduce aggregate demand and thereby checking inflation. Fiscal Policy cont.. Expansionary fiscal policy: EFP is adopted at times of recessionary conditions prevailing in the economy. A sharp decline of investment spending and that resulted in decline of aggregate demand which adversely affected the functioning of the economy leading to decline of macroeconomic aggregates. The cause of recession may be fall in profit expectations, curtailing investment spending and reducing aggregate demand. To face recessionary conditions, the expansionary fiscal policy has three options: Increasing government spending Reducing taxes Using some combination of the two. Fiscal Policy cont.. If the national budget is balanced at the outset, expansionary fiscal policy will create a government budget deficit-government spending in excess of tax revenues. The government may combine increases in its spending and tax cuts to produce the desired increase in spending and the eventual increase in aggregate demand and real GDP. Fiscal policy If the objective is to boost growth, government will reduce taxes or increase spending to increase aggregate demand and therefore output and employment – this type of policy where gov’t reduces taxes and/or increases spending is referred to as expansionary fiscal policy If the objective is to slow down the economy, gov’t may increase taxes or reduce spending – an increase in taxes or reduction in gov’t spending will reduce aggregate spending is referred to as contractionary fiscal policy.