CHAPTER 12- FISCAL POLICY

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?

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?

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

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?

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?

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

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?

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

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

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

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

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

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

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

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

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

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