CHAPTER 12- FISCAL POLICY

1. CHAPTER 12- FISCAL POLICY

2. INTRODUCTION • Fiscal policy- policies for government expenditure and revenues • Government expenditure- recurrent and capital or development expenditure • Government revenues- tax and non tax revenues including surpluses from public enterprises and domestic and foreign borrowing • In developing countries- Ministry of Finance is engaged (tax policy and recurrent expenditure) and Ministry of Planning( development expenditure) • In some countries like Botswana they are merged • Should they be separate? • Is the distinction between recurrent and development expenditure quite clear?

3. WHY PUBLIC SECTOR? • The market can never perform all economic functions efficiently • Example is the case of public goods- non rival in consumption and non excludability • Non-rival- one persons use of a good does not reduce the benefits available to others- free rider problem • Non excludability- it is either impossible or prohibitively expensive to exclude anyone from the benefits once the good is available • Private market cannot provide the good • Some goods can both be provided by the private and public sector- market provides them in a non efficient manner. Eg primary education • But size of public sector extended beyond technical issues to include income distribution, etc • How large should government be?

4. Government Expenditure • Wagner’s law- expenditure grows as per capita income grows • Even though disputable the fact is that poor countries have smaller public sectors than rich ones-measured as ratio of g to gdp • Major expenditure item that makes difference is social protection

5. Recurrent Expenditure • Recur year after year- for day to day running of economic activity • Types- wages and salaries, maintenance and spending on military equipment, interest payment on Govt debt, subsidies, grants, and other social benefits to individuals, producers, etc, and other expenses • Belief is that recurrent expenditure is less important and should have less priority • Why? Not increase productive capacity • But inadequate provision leads to decay of capital • Division is also arbitrary- eg recurrent expenses on human capital, ARVs- recurrent or capital exp?

6. Other expenditures • Should we be reducing military spending? Accepted wisdom is that we should- coz we can use the money for economic goals • Military expenditure and growth? • For most LDCs interest payment is a major component- service debt- HIPCs asking for debt forgiveness because of the huge effect of servicing debt • Subsidies also important in LDCs, eg subsidies on basic foods • In developed countries subsidies in the form of social welfare programmes • For developing countries driven by the need to redistribute incomes • Reduction of subsidies became a condition for structural adjustment- consequences were very painful as it meant poverty increased, etc • Better to adjust now than later when things are worse?

7. Other expenditures cont • Subsidise State owned enterprises which were making losses • Countries are now required to privatize the SOEs as a condition for further assistance • Privatization has been slow as there is resistance from workers, politicians, unions • Political issue where income is unequally distributed- fear that control will fall into the few minority • Transfer of funds from central govt to local government

8. How can we reduce Govt exp? • Very few ways • Military spending? • Subsidies on SOEs? • Reduce debt? • In the long run allocate more spending to capital? • What else?

9. TAX POLICY AND PUBLIC SAVING • For most developing countries measures to raise tax collection were thought of the most effective ways of boosting public savings • Sub-Saharan countries tend to tax themselves more heavily because of low opportunity for mobilizing other types of savings because of poorly developed and organised financial systems • Measures- increase tax rates on existing taxes, enact new taxes, improvement of tax administration to reduce avoidance and evasion, and major reform in the netire tax structure

10. TYPES OF TAXES • Taxes on international trade- imports and exports- leads to retaliation and tax evasion • For equity reasons usually tax luxurious commodities higher rates- but these are elastic by nature- decrease tax revenue • Personal and corporate income taxes- few people have adequate income for personal tax- paid mainly by a small urban elite who are also politically vocal, also have devised various means of tax evasion and avoidance • Corporate tax covers a small proportion of the private sector- many have no taxable income

11. TYPES OF TAXES Cont • Sales and excise tax- charged by most LDCs • Have been charged as VAT coz it is less distortionary than other forms • Charged mainly on commodities that have low price elasticity-sin tax • But tend to also have low income elasticity and therefore take a larger budget of the poor- regressive

12. NEW SOURCES OF TAX AND CHANGES IN TAX ADMINISTRATION • Some untapped new sources of tax revenue • Examples, motor vehicle registration, urban property tax, service sector taxes • But revenue is limited sometimes making the tax uneconomic • Another option is to improve tax administration- make tax evasion difficult • But sometimes based on the level of economic development and institutions • Bringing in new tax laws and regulations- may take time to implement and become effective

13. TAXES AND PRIVATE SAVING • High taxes tend to reduce incentive to save • High taxes may encourage capital flight- low FDI

14. Taxes and Income distribution • For most LDCs taxes have been justified also on equity grounds- to deal with income distribution- go for progressive taxes- should therefore be based on ability to pay • Problem is tax evasion and tax avoidance- making redistribution difficult • Because it is difficult to use personal income taxes for redistribution most countries have relied heavily on indirect taxes on luxury consumption • Countries also charge customs duties- import substitution • For corporate and property taxes there are problems of shifting the incidence to the final consumer, especially where there is less competition- defeat the whole equity iss

15. Taxes and economic efficiency • Generally taxes on inelastic commodities produce less inefficiency than those on elastic commodities • Therefore charge higher taxes on inelastic commodities than elastic ones- Ramsey Rule • But such a tax is regressive

16. SUMMARY • Even though empirical evidence shows that the rich pay a proportionally higher income in taxes generally, the poor still pay substantial taxes • The limits of tax policy suggest that if the budget is to serve redistribution purposes, the primary emphasis should be on expenditure policy • Budget expenditure may transfer very substantial resources to low income households • Not all govt spending is effective in reducing income inequality though • Therefore some of the expenditure will need to be means tested

17. SUMMARY CONT. • Generally difficult to cut spending • Generally difficult to increase revenue • So how do you reach a balance?

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