PUBLIC DEBT
3. Deficit Financing For Economic Development
In LDC’s where the majority of the people are poor and are living at subsistence level, the margin between income and consumption expenditure is very low. So voluntary saving howsoever welcome cannot by itself provide sufficient resources for development.
The government may also attempt to increase the volume of resources by additional taxes, but again this may not raise enough revenue since people are already poor.
Due to the low levels of income and a high propensity to consume, aggregate saving in the economy is low and due to low saving there is low investment. Investment being inadequate as compared to the national development requirements the level of production is low. Low production means low income, low income means low saving, low saving means low investment and low investment means low production hence the vicious circle of poverty.
Low income
Low production Low saving
Low investment
Thus in such a situation investment cannot increase sufficiently to break up the vicious circle of poverty. It is therefore necessary for the government to intervene so as to break the vicious circle of poverty in such as economy. But steady economic development is too large since investment expenditure required for to finance from the normal sources of revenue, deficit financing becomes inevitable.
Consequences of Deficit Financing
The possible effects of deficit financing are:
1. Increase in money supply in the hands of the public 2. A rise in the level of income
3. A rise in the general level of process thus inflation
N/B
It should however be noted that deficit financing may not lead to inflation if output is increased with increased expenditure.
However in LDC’s the expenditure is usually on infrastructure e.g. roads, schools, hospitals, e.t.c. which do not lead to immediate increase in output. The short-run effect of deficit financing in such economies may be inflation.
QUIZ
Explain in detail the meaning of deficit financing of a national budget. To what extent can economy be supported by such practice.
Public Expenditure
Expenditure means outlay. it means spreading the income. Public expenditure means those amounts which are spent by the government for different purposes.
Principles of Public Expenditure
1. Maximum social benefit – government expenditure should be made inn such a way that people get maximum possible benefit from it.
2. Economy – the government should not indulge in extravagant use of its revenue.
3. Elasticity – government expenditure must be capable of being adjusted according to circumstances e.g. during a depression public expenditure should go up and during inflation it should be possible to lower it.
4. Approval – public expenditure should be approved by a competent independent governmental organ e.g. parliament.
5. Sound financial administration – public accounts must be maintained properly and must be audited in order to investigate any misuses or discrepancies.
Causes of Increased Public Expenditure in LDCs 1. Increasing population
2. Growing state functions
3. Increasing provision of public utilities e.g. schools, hospitals e.t.c.
4. Efforts to have effective government administration e.g. computerization of various departments.
5. Changing technology necessitating the government to update itself 6. Increasing requirements of economic growth
7. Increasing requirement of full employment 8. Increasing prices (inflation)
The Role of Public Expenditure in a Developing Economy
1. Socio-economic infrastructure e.g. hospitals, schools, roads, e.t.c. can be provided which can facilitate economic development.
2. It can lead to balanced regional growth. by the government spending more money in depressed areas, it can lead to balanced regional growth.
3. It can lead to development of agriculture and industry. y the government spending more money on agriculture and industry t will result in the development of those sectors.
4. It can facilitate exploitation and development of natural resources particularly in those areas where private entrepreneurs find it less profitable.
5. Government subsidies and grants can induce the public to spend on desired projects.
e.g. subsiding agricultural inputs, it can encourage agricultural development.
6. Equitable distribution of income. It can lead to equitable distribution of income by the government taxing the rich and spending the revenue on the poor.
7. It can lead to economic stability. By increasing public expenditure during a depression and decreasing it during inflation, economic stability can be achieved 8. It can lead to higher employment level. Increased public expenditure in a situation of
unemployment can generate additional demand which can generate additional employment.
Fiscal Policy
Fiscal policy is the policy according to which the government changes its revenue and expenditure programmes to achieve desirable effects and to avoid undesirable effects on production, distribution and employment levels.
Objectives of Fiscal Policy
1. To achieve desirable price levels and to check inflation 2. To achieve desirable consumption level
3. To maintain fair distribution of national income e.g. taxing the rich more and using the money to help the poor
4. To maintain economic stability
5. To increase the rate of economic growth and development Tools of the Fiscal Policy
1) Public revenue (taxation) 2) Public borrowing
3) Public expenditure
Application of the tools of fiscal policy to achieve the objectives of the fiscal policy 1. Fighting inflation – during inflation taxes are raised, public borrowing is raised and
public expenditure is reduced.
2. To achieve a desirable level of consumption for instance if the level of consumption in the economy is so low, it can be raised by lowering taxes, buying back government securities and increasing public expenditure.
3. To raise the level of employment, if there is unemployment in the economy due to low level of aggregate demand, this can be raised by lowering taxes, buying back government securities and increasing public expenditure.
4. Equitable distribution of income, if there is unequal distribution of national income; a fair distribution can be achieved by taxing heavily the rich and spending the revenue on the poor i.e. giving the poor free services which enables them to save.
5. To increase the rate of economic growth and development. If the rate of economic growth and development is low due to the fact that people are caught up in the vicious circle of poverty, this can be raised by lowering taxes, borrowing more from abroad and spending more of the government revenue on the public.
Limitations of the Fiscal Policy
1. Taxation may not be successful as it may be avoided and evaded e.g. where the rich are supposed to declare their incomes which is the subject to taxation this may be falsified thus evading the tax.
2. There may be improper assessment of taxes leading to under-assessment.
3. Taxation as a form of government revenue or economic growth and development my discourage savings and investments.
4. Borrowing may not be successful because:
(i) There are no properly organized markets for securities
(ii) Many people prefer to invest in real property e.g. housing than in government securities so the government may not succeed I influencing the economy through sell of securities.
(iii) There are no organized financial institutions to mobilize funds from rural areas.
(iv) The response towards government securities is poor because of inflationary tendencies.
(v) In case of external borrowing, inability to meet conditions of the donor community.
(vi) Failure to be considered credit worth 5. Public expenditure may not be successful because:
(i) It may not bring any benefit to the people at all.
(ii) There may be no effective supervision n the way government revenue is spent and so the expenditure may exceed the approved amounts.
(iii) It may not be a possible to enlarge government expenditure owing to limitation of resources.
(iv) Government expenditure arising from deficit financing may lead to inflation.
The Role of Public Finance in LDCs
1. It is an instrument of capital formation. By taxing the rich heavily and forcing people to save where there is low voluntary saving it will increase investment.
2. It is a means of matching the fiscal development through the monetary and fiscal policies. By application of the instruments of public finance, the financial plans will be implemented and targets in money terms will be achieved.
3. Public finance can be used to reduce inequalities of income e.g. by taxing the rich more and providing social services free.
4. It is an instrument for regulating consumption. Fiscal policy can be used to reduce consumption of luxuries. By imposing of high taxes on luxuries it can discourage their consumption and the money rescued used for investment.
5. Public finance can be used to reduce expenditure in less productive investment. This can be done by reducing taxes in desirable areas of investment and increasing them in undesirable areas of investment.
6. Public finance can be used to achieve desirable price levels i.e. it can be used to fight inflation.
7. Public finance can also be used to achieve the desirable level of employment
8. It can be used to bring about balanced economic growth and development.
Questions December 1996
1. a) Explain how fiscal and monetary policies are used to influence the performance of an economy.
b) What factors limit the effectiveness of these policies in developing countries.
June 1996
2. A good tax schemes must fulfill four basic principles a) Name the four principles
b) Explain how two of the following taxes fulfill the four principles.
(i) VAT
(ii) Customs and exercise duties (iii) Local authority service charge (iv) Airport service charge
3. a) Differentiate between fiscal and monetary policies and show how the two policies are used to influence the economy.
b) Assess the success of implementing the policies in LDCs 4. a) Discuss the main features of fiscal and monetary policies.
b) To what extent are such policies tools for the management of a national economy.
5. A tax policy needs to be clearly balanced between the need for increased public expenditure and increased private investment.
Briefly but clearly explain the importance of the need for this balance from the economic point of view.
6. State and explain Adam Smith’s cannons of taxation. Give local examples as appropriate in each case.
7. Modern economies can be highly influenced by the way their budgets are managed.
Clearly explain the role of budgetary management in economic development.
8. The exchequer must always strive to achieve the concept of equity in designing the tax policy. Explain how this is done in practice.
9. Differentiate between budgetary and monetary policies and show how the two policies are used to influence the economy.
10. What are the characteristics of a good tax system? To what extent are they attainable in a country like Kenya?
11. Explain the relationship between a government budget, fiscal policy and monetary policy.
12. Explain how a country may use its tax system to influence the general level of productivity.
13. Developing countries have experienced persistent rising external debts for a long time. Explain the major causes of this problem and suggest economic policies which may be applied in order to minimize this problem.
- War and war preparedness - Population
- Budget deficit - Public utilities - Energy crisis
- Desire for economic growth and development.
Solutions
- Dialog- diplomacy
- Policies to reduce population - Borrowing
- Privatization
- Alternative sources of energy biogas