Public Finance slides.pptx

PUBLIC Finance
Course Code:
Credit Hours: 3 Hrs.
By
Dr. Gemechu Mulatu
PhD in agricultural economics and Agri-Business
E-MAIL: geme.chu@yahoo.com
2021G.C.
2/21/2023 1

Aim of the course
• To examine the role of the public
sector in modern economies
• To provide an understanding of the
economic rationale for government
intervention,
• To discuss the effects of government’s
actions in terms of efficiency and equity
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The course focuses on following:
1 - An introduction to public economics: the
economic roles of government, the rationale and
limits of public intervention according to
economic theory, its effects in relation to
efficiency and equity trade offs;
2 - Public expenditures: basic theory and
application to some expenditure programmes,
i.e. welfare policies, education policies,
employment policies, health care policies;
3 - Taxation: microeconomic and redistributive
effects of fiscal policy and of the structure of
taxation.
4 – Welfare states and inequalities
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References:
 Lecture Slides
 Textbooks on Public Economics :
 E. Stiglitz, Economics of the public sector, W.W.
Norton & Company, 3rd edition, 2000, chapters 3,4,5,
6,7,8,9, 10,14, 15,16,17,19,20,26; or
 J. Gruber, Public Finance and Public Policy, 2007.
Chapters 2, 5, 6, 7, 11, 12,13, 14,17, 18,19, 20
 in alternative other textbooks in the library , such as A.L.
Hillman, Public Finance and Public Policy, Cambridge,
2003.
 Optional readings will be mentioned in the course
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• Public economics focuses on
answering two types of questions
1. How do government policies
affect the economy?
2. How should policies be designed
to maximize welfare?
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The aim of PUBLIC SECTOR
ECONOMICS is to study the
economic role of the government,
and how government actions affect
the economy
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INTRODUCTION
• The public sector is government
sector(national and local).
• Public sector jobs include doctors, police,
teachers, civil servants.
• The private sector is private enterprises –
retail, manufacturing, local services.
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1.3 Public finance vs private finance
Generally
• Public finance is primarily made to finance
activities that maximize the social and
economic benefits of the majority or all the
people
• Private finance is primarily made to maximize
self benefit/return/profit.

1.4 Why public finance/sector is needed
Fundamental reasons for public finance
i. Market failure – externality, public goods, asymmetric
information and imperfect competition.
ii. Political failure – mal-political, structural and
administrative system, spoilage
Details
 It enables government to correct undesirable side
effects of market failure.
 These side effects are called spillovers or externalities

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Examples
 Water pollution, air pollution, sound pollution, soil
pollution that affect people who are not responsible for
their emissions.
 Government can encourage or restrict certain activities to
correct them; through: recycling programs, pass laws,
imposition of taxes and charges,
 Public finance moderate the incomes of the wealthy and
the poor; through social security, welfare and other
programs.
Example: Assisting the elderly, disabled and other who cannot
work, redistribute income by collecting taxes from the
wealthier to provide resources for the needy ones.

…cntd
Generally the basic function of public
finance are
1. Allocation functions
2. Distribution functions
3. Regulatory functions
4. Stabilization functions
5. Coordination functions
• Spending taxes, taxes, deficits, and debts
• The size and growth of the government
• Decentralization of power and resources

How government goods and services are
distributed
• Government goods and services are distributed through the
use of nonmarket rationing.
• They are not made available to persons according to their
willingness to pay and their use is not rationed by prices.
• In some cases, they are available to all, with no direct charge
and no eligibility requirements. Example: provision of national
defense services.
• In other cases, criteria such as income, age, family status,
residence, or the payment of certain taxes, fees, or charges are
used to determine eligibility to receive benefits.
• Government supplies a considerable amount of goods and
services and regulates private economic activity.

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• Government expenditures typically amount from the
smallest up to one-half of GDP.
• Governments usually regulate private economic
activities and use taxes and subsidies to affect
incentives to use resources.
• Provision of a significant amount of goods and services
takes place through political institutions.
• This involves interaction among all individuals of the
community, rather than just buyers and sellers
• Political decisions often compel citizens to finance
government services and programs, regardless of their
personal preferences.

Firms
Households
Output
Markets
Input
Markets
Money
Resources
Money
Money
Subsidies
Taxes, Fees, Charges
Government services
Income support and
Subsidies
Taxes, Fees, Charges
Government services
Figure 1.2: Circular flow in the mixed economy
Government

1.6 Economic rationale for modern state
• The role of government in an economy
is increasing and changing.
• Competition, efficiency, optimality, R&D,
innovation
• Globalization
• Technology
• Environmental and climate changes
• Growing population
• Increasing market demand
• Change in choice and preferences.

1.6 Should public sector be small or larger
Supporters of large
government
• Believe that many case
of market failure exist,
policy process is an
efficient means by
which voters and policy
makers organize
resources, and policy
makers are driven by
public spirit.
• Policy makers should
base their policies on
paternalism.
Supporters of small government
(minimalist state):
• Emphasize that while the private sector is not a
perfect organizer of resources, the public sector
is imperfect as well (i.e., government failure)
• Government or state failures refer to condition
whereby public policies result in resource
allocations that are more inefficient or
inequitable.
• Such inefficiency or inequality may be a result of
• technical inability of the policy makers or
• the self interest nature of policy makers
• They emphasize in the importance of individual
liberty and the importance of protecting voters from
the coercive powers of the public sector.

1.7 Changing the role of government
 The role of the state is once again in
spotlight
 Recent developments:
• The reform in the command economies
• Fiscal crisis in industrial countries
• Rapid economic growth and poverty
reduction in some East Asian Countries
• The speed and amount of inflation
reductions
• The usefulness of an income or wage
policy, etc.

…cntd
• Given the growing up demands for state and the
state’s capabilities, how can states become credible
and effective agents for development?
• The World Development Report 1997 points to a
part strategy:
i. Matching the state role to its capabilities; try to
do too much with too few resources and too little
capacity often do more harm than good. Give due
priority to social and institutional fundamentals.
ii. Increasing the state’s capability by reinvigorating
public institutions.

1.8 Limitations of government
(Government failures)
Government failures can be defined as
the activities of the state that lead to
Pareto inefficiency.
 Governments can fail in several ways:
 Inadequate information
 Majority votes may not please the
minority
 Non-merit based rewarding of special
groups
 A principal-agent problem

Summary
• Four questions of public finance
1. When should the government intervene in the
economy?
• When the market fails
• Before the market fails through regulation
• When monopoly power increases
• In the absence fair distribution of resources
2. How might the government intervene?
• Through fiscal and monetary policies
3. What are the effects of alternative interventions?
4. Why do governments do what they do?

CHAPTER II
Welfare Economics and
Public Finance

Chapter contents
1. Brief review of welfare economics
2. The efficiency of competitive markets
3. Perfect competition and Pareto
efficiency
4. Perfect competition and general
economic efficiency
5. Market failures: Externality and
public goods
5.1 Externalities and market failure
5.2 Public goods and market failure

Welfare Economics
 The theory is concerned with the social desirability of
alternative economic states and policies.
 To include societies values of commodities under alternative
resource allocations directly involves welfare economics.
 Studies all feasible allocations of resources for a society.
 Establishment of criteria for selecting among these allocations.
 It deals with the variables:
 Allocation of resources
 Consumer surplus
 Producer surplus
 Total surplus
 Dead weight loss
 Consumer behavior
 PCC,ICC, Edgeworth contract curve

Definition of welfare economics:
• Welfare economics is the study of conditions that maximize
economic welfare of the society as a whole.
Definitions
• “Welfare economics is concerned with the conditions
which determine the total economic welfare of a
community.” (Oscar Lange)
• “branch of economic science that attempts to establish
and apply the criteria of propriety to economic policies.”
(Reder)
• “branch of study which endeavors to formulate
propositions by which we may rank on the scale of better
and worse, alternative economic situations open to
society.” (Mishan)
• Welfare economics may also be defined as “the branch of
economic science which evaluates alternative patterns of
resource allocations from the viewpoint of economic
wellbeing of the society as a whole.”

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• Welfare economics is both a positive and a normative
science.
As a Positive science:
 It attempts to examine and predict the welfare implications of
the functioning of the economic system. Welfare propositions
may be subjected to test,
• Through testing welfare propositions is much more difficult
than the propositions of general positive economics.
• The information gained through positive analysis is useful in
devising appropriate policy measures to maximize the welfare of
the society.
As a normative science:
 It provides guidelines for policy formulations to maximize
social welfare.
• Maximization of economic welfare of a society presumes a
social welfare functions which consists essentially of value
judgments.
• Given the welfare function, welfare economics, as a normative
science, provides guidelines for appropriate policy measures

The concept and measurement of social welfare
• The term ‘welfare’ has been defined in diverse
ways, perhaps, because it is extremely
difficult to give it a precise meaning.
• The difficulty arises from the fact that welfare
of an individual or of a group of individuals
depends on many immeasurable social, political
and economic factors and also on philosophical
attitudes of the people towards life and society.
• In economics, however, the concept of welfare
is used in a narrow sense - limited to only
economic welfare.
• Economists have tried to give it a precise
meaning for the purpose of economic
analysis.

Some early concepts of welfare
 Jeremy Bentham defined social welfare as “the sum total of
the happiness (or welfare) of all the individuals in
society.”
 Following Bentham’s doctrine, Pigou defined social welfare as
the arithmetic sum of the individual welfare.
 In nutshell, social welfare was regarded by the economists of
cardinal utility tradition as the arithmetic sum of the
utility gained by the individual members of society.
• The concept of social welfare has, however, met with certain
serious objections.
First,
• It is argued that utility cannot be cardinally measured
and hence, cannot be added to obtain the social welfare.
• It is, therefore, meaningless to define social welfare as the
sum of the individual utilities.
• This objection is universally accepted.

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Secondly
• It is also widely accepted that ordinal
measurement of utilities is not possible either
and, therefore, interpersonal comparison of utilities
is not possible in an objective or scientific manner.
• It would, therefore, not be possible to determine how a
change in existing pattern of resource allocation would
affect the aggregate welfare unless it is unrealistically
assumed that all individuals have identical income-utility
and commodity-utility functions.
• Owing to these problems, Benthamite and Pigovian concept
of social welfare had not become operational, in the sense
that, it cannot be used objectively in any policy
formulation.
• Therefore, the cardinal utilitarian thesis that the welfare of
different individuals could be added up to arrive at the
welfare of society had to be abandoned.

Pareto’s concept of welfare:
• Vilfred Pareto, an Italian economist, broke away
from the cardinal utility tradition and gave a new
orientation to welfare economics.
• He introduced a new concept of social optimum.
• According to Pareto, although it is not possible to
measure and add up utilities of individuals to arrive
at the total social welfare, it is possible to determine
whether social welfare is optimum.
• Conceptually, social welfare is said to be
optimum when nobody can better-off without
making somebody worse-off.
• In the words of Boulding, “a social optimum is
defined as a situation in which nobody can move to a
position which he prefers without moving some body
else to position which is less preferred.”

…cntd
• In simple words, social welfare in optimum when
it not possible to make even a single person
better-off by reallocating productive resources
and consumer goods and services, without
making some one else worse off
• Note that Pareto’s concept of social optimum
does not define or suggest a magnitude of
optimum social welfare.
• Pareto was concerned with thel question whether
the magnitude social welfare from a given
economic situation can be or cannot be increased
by changing the economic situation.
• The test of increase in social welfare is that at
least one person should be made better-off
without making any body else worse-off

The modern view of social optimum:
• According to the modern view, it is difficult to
conceive economic policies which can improve
the welfare of an individual without injuring
the other.
• To overcome this problem, economists, viz., Kaldor,
Hicks and Scitovsky, have evolved the
compensation principle.
• The compensation principle recognizes that most
economic measures make some one better off and
some one worse off.
• According to this principle, however, social welfare
can be increased so long as the person who benefits
from an economic policy or reallocation of resources
is able to compensate the person who becomes
worse-off due to this policy, and yet remains better-
off.
• The compensation should, however, not exceed his
benefit.

To conclude:
 Modern welfare economics does not attempt
to quantify the total social welfare.
• It concerns with only the indicators of
change in welfare.
• It evaluates whether total welfare increases or
decreases when there is a change in
distribution pattern of economic resources.
• This approach is based on the premise that
while cardinal measurement of utility is not
possible in ordinal sense is possible.
• And it gives an adequate measure of change
in the welfare of an individual.
• It is this principle on which the modern
welfare criteria are based.

Pareto’s welfare economics
• Vilferdo Pareto’s Manual of Political Economy
(1906) represents a landmark in the history of
welfare economics.
• Pareto broke away from the tradition utilitarian
economics.
• He rejected the hypotheses based on cardinal
utility and additive utility function.
• His propositions do not require any
interpersonal comparison.
• Some called it New Welfare Economics.

Pareto optimum
• Pareto optimum is also called
• Pareto efficiency,
• Pareto unanimity rule,
• Pareto criteria, and
• Pareto social optimum.
• Definition of Pareto optimum
“Is a position from which it is not possible to
improve welfare of any one by any reallocation
of factors or goods and service without
impairing the welfare of someone else.”
• In other words,
Optimum position is attained when it is not
possible to make anyone move on to a higher
indifference curve without making someone
move to a lower indifference curve.

…cntd
• According to Pareto criterion:
Any change that makes at least one
person better-off without making someone
else worse-off makes definitely an
improvement in social welfare.
Conversely:
Any change that makes at least one
person worse-off and no one better-off
causes a decrease in social welfare.
• Pareto’s improvement over cardinal approach:
It is free form the problem of additive
utility function and interpersonal
comparison of utility.

Critics of Pareto social optimum
1. Pareto optimum does not define a unique optimum
economic situation.
 There are three aspects of optimum performance of
and economic system, associated respectively with the
three basic functions
i. transformation function,
ii. utility function and
iii.welfare function).
 There are an infinite number of Pareto optima.
 Does not determine the optimum-optimum – the best of the best.
2. Any point on PPC may satisfy Pareto efficiency in
production, but not maximum social welfare.
3. The question of payment of compensation
It is impossible to make one better-off without making
someone else worse-off.

Pareto optimality conditions
• Two categories of Pareto optimality
conditions
1. Marginal conditions, and
2. General conditions.
Marginal conditions
• Achieving maximum social is possible only
when all the following are optimum
 allocation of productive factors
between the various commodities,
allocation of commodities between the
consumers, and
allocation of productive factors between
the firms.

Categories of first order conditions
of Pareto optimality
1. Pareto optimality in exchange;
Optimum allocation of products among the
consumers
2. Pareto optimality in production;
Optimum allocation of inputs between the
goods, and between the firms (optimum
specialization); and
3. General optimality of production and
exchange;
Simultaneous fulfillment of production and
exchange optimality conditions;
4. Other optimality conditions of welfare
maximization.

Assumptions
a. Two commodities (X and Y),
two consumers (A and B),
two factors (K and L), and
two firms (F1 and F2).
a. Consumers maximize their utility functions
which are independent of each other.
b. Factors, K and L, are homogenous, perfectly
divisible, available in fixed quantities are
exogenously determined. Both factors are used
in the production function of each good.
c. Production functions for both goods are given.
d. Perfect competition in both product and factor
markets.

1. Pareto optimality in exchange; when
=
M
N
Fig 2.1 Edgeworth box: Pareto efficiency in exchange
Qu
ant
ity
of
Y
Quantity of X
QB
QA
A1
A2
A3
A4
A5
B5
B4
B3
B2
B1
C'
C
J
●H
L
K
●P
=

The following inferences can be drawn from Fig 2.1.
1. There are infinite Pareto optima on the contract curve,
CC.
2. Given the subjective nature of indifference curves, it is
not possible to conclude that every Pareto optimum
solution indicates greater social welfare than that
indicated by every non-optimal point.
E.g, we cannot compare an optimal point K with non- optimal point H,
B will prefer a non-social optimal point, H.
Thus without an explicit interpersonal comparison of utilities
it will not be possible to judge which of the two points (K or H)
is social optimum.
3. An upward movement on the contract curve (CC') makes A
better-off and B worse-off.
Similarly, a downward movement makes B better-off and A
worse-off.
Therefore, it cannot be said that every point on the curve
represented optimum-optimum.

Pareto optimality in production:
Optimal allocation of factor inputs
=
=
W
M
Fig 2.2 Edgeworth box: Pareto efficiency in production
Total
capital
Total labor
QY
QX
X1
X2
X3
X4
X5
Y5
Y4
Y3
Y2
Y1 C'
C
Q
●H
B
J
R
N
P

Optimal distribution of goods between
firms
Optimal specialization of firms:
• Another condition that must satisfied for Pareto
optimality in production in optimum degree of
specialization by firms.
• The production of goods X and Y is so divided between
the firms that no reallocation of output among the firms
can increase the output of any of these goods without
reducing the output of the other.
• Marginal rate of transformation (MRT) between X and
Y must be same for all firms producing them both.
• MRT is the rate at which one product can be
transformed into another.
• Example, suppose if one unit of X is produced, then k
units of capital and l units of labor are saved. If factors
saved (k, l) can produce 2 units of Y,
MRT = = 2

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• But this is not a stuffiest condition.
• Sufficient condition requires
• At the point of tangency of MRT curve of firms F1
and F2 – not at the points of intersection.
• For example, if firm F1 can produce one
additional unit of X at the cost of 3 units of Y,
and firm F2 can produce 2 units of Y at the cost
of one unit of X, then MRT for F1 is 1X = 3Y, and
for F2, it is 2Y = 1X.
• It means that if F1 is made to produce one unit
less of X and F2 to produce one additional unit of
X, the production of Y can be increased by one
unit, without reducing the production of X.

.
MRT Curve
Commodity X D
(a)
Firm F1
Co
mm
odit
y Y
C
MRT Curve
Commodity X F
(b)
Firm F2
Co
mm
odit
y Y
E
Fig 2.3 Marginal Rate of Transformation Curves

.
B
M
P
P2 N
Q
H
J
E'
P1
G
R
F
F'
E
Fig 2.4 Optimum specialization of firms in production
D
C
Commodity X
O
Com
modi
ty Y

General optimality of production and exchange
The third necessary conditions
• Optimality condition of both production and
exchange should be fulfilled simultaneously.
• The optimum output-mix must coincide with
the optimum demand mix.
• This is called also as ‘Top Level’ optimality
condition of welfare maximization.
• MRT between the two products X and Y must
be equal to the MRS between the two
products for the two consumers A and B.
MRTX,Y = =
=

.
Fig 2.5 General optimality of production and exchange
P
C
B3
A1
A2
A4
A3
C'
B4
B5
B6
Commodity X P'
O
Commodi
ty Y
P

Summary of Pareto optimality conditions
1. Marginal condition of exchange optimality
=
2. Marginal condition for production optimality
=
3. Marginal condition of general optimality
MRTX,Y = =
I
=
=

Other conditions of Pareto optimality
• In addition to the optimality condition (i)
and (ii), the following marginal conditions
must also be simultaneously.
1. The owner of a factor is always in a position
to use it for personal satisfaction or to rent
it out for income, or put it for personal use
and rent it partly for earning income.
If rented out, the reward from renting the
marginal unit of a factor must be equal to the
value of the marginal physical product of the
factor unit.
Pareto calls this as optimum allocation of
factor units’ time.

2. Second, the marginal rate of substitution between
resource control or ownership at any two points of time (ti
and tj) is the same for every pair of individuals or firms
including pairs in which one member is a firm and the
other member an individual.
This condition relates to optimum control of resources
through time by individual and firms.
This is inter-temporal condition of maximum welfare.
3. Boulding has pointed out two other conditions relating to
time-preference which have not been explicitly stated in
the literature:
one, that owner’s rate of time preference for any one
individual for two commodities must be the same; and
two, that the rate of time of time preference for a firm and
individual must be equal to the rate of time substitution in
production for every commodity.

Total conditions of Pareto optimality
Hicks ‘total condition’
• In order to maximize social welfare, all
the conditions first order, second order,
and total conditions must be
simultaneously satisfied.
• But this maximum will not be unique.
The reason is that it presupposes a given
distribution of income which is not
determined by the optimality conditions
of welfare maximization.
• If income distribution (presumed
arbitrary to be given) changes, it will
cause a change in welfare maximizing
output and factor allocation.

Perfect Competition and Pareto Optimality
A necessary condition for Pareto optimality is
the existence of perfect competition in both
product and factor markets.
• Efficiency in exchange
=
MRS X,Y =
= =
=
=

Efficiency in production
=
= =
= =
=

Efficiency in production and exchange
MRS X,Y =
MRTX,Y =
MRTX,Y = =
MRS X,Y = = MRTX,Y

Externalities and Pareto Optimality
• Pareto optimality is based upon the assumption
that there are no external entities in
consumption and production.
• This assumption implies that
i. production function of each producer is independent of
others; and
ii. utility function of each individual is independent of
others.
• In reality however,
 production by one firm is affected by production of
other firms
 consumption of one consumer affects the
consumption of other consumers and producers.
• Such effects are known as external effects or
externalities.

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• Externalities refer to the external economies
and diseconomies that arise due to the activities
others.
• External economies are the gains that arise
from the activities of an economic unit –
consumer or producer – and accrue to other
members of the society for which they cannot be
charged through the market price system.
• Similarly, external diseconomies are the costs
that are imposed on the members of the society
by the activities of an economic agent for which
market system does not provide
compensation to those who suffer.
• When there are externalities in production and
consumption, Pareto optimality may not be
attained even perfect competition.

Externalities in Production
Production of a commodity may involve both (i) external
economies, and (ii) diseconomies.
External economies in production: To understand the
external economies in production, consider the following
examples:
i. When an irrigation facility is extended to non-irrigated area,
ii. When new firms are set up in an industry; the demand for
inputs increases. This gives an opportunity to the input
suppliers to expand their production. Expansion of
production might reduce the cost of input production to
economies of scale. As result, the input-prices for all the
users of inputs decrease.
iii. The education and training programs of the government
increases the supply of skilled labor to the industrial units.
iv. Construction of road and railways reduce the cost of
transportation in terms of both money and time.
v. Forestation scheme increases rainfall and oxygen gas in the
air; reduce air-pollution; and maintain ecological balance.

.
Quantity of X
E1
P'x
Px
MCx
E2 MSBx
PBx
Q Q'
O
Fig 2.7 Divergence between Private and Social Benefits and Optimum Output
Price
and
MC

• Under perfect competition equilibrium is
attained where
MCx = Px = PBx = QxPx
• Q maximizes the firm’s profits. Pareto
optimum but not social optimum
• But social optimum attained where
MCx = Px = MSBx = Q'xP'x
• Q'x the social optimum output
• Pareto optimum Q is less than the
socially optimum output Q' when
external economies are accounted for in
social pricing.

External diseconomies in production
Examples
1. Environment and air pollution caused by factory
smoke and fumes of transport vehicles;
2. Water-pollution caused by discharge of industrial
effluences and wastage; and
3. Concentration of industries in an area creates
industrial slums which breed diseases and criminals.
• Costs incurred by the society to prevent the ill-effects of
production of a commodity, are included in the
external social cost (ESC).
SC = PC + ESC
• Divergence between private cost and total social costs.
• TSC > PC, if ESC is greater than 0.
• Marginal social cost (MSC) exceeds the marginal private
cost, MC.
• The private firm can produce the social optimum
level of output if the government subsidizes its cost
of productions.

MSCx
Quantity of X
M
Px
MCx
E ARx = MRx
X0 X1
O
Fig 2.8 Divergence between Private and Social Costs and Optimum Output
Price
and
MC

• Given the MCx curve and price Px, the Pareto
optimal output is determined by point E at
X1, where
MCx = Px (= MRx)
• The vertical distance between MCx and MSCx
measures the external cost of production of
commodity X.
• If the firm internalized the external social
cost through taxation, so that its marginal
cost of production is equal to MSCx and Px,
profit maximizing firms will be in equilibrium
at point M and will produce X0, where
MSCx = Px
• Exclusion of external costs (when SEC > 0)
leads to a larger production which is socially
non-optimal.

Externalities in Consumption
• Interdependence of utility function:
• Externalities in consumption prevent
the realization of Pareto optimality in
consumption.
• How external economies and diseconomies
in consumption would affect Pareto
optimality under competitive conditions?

External economies in consumption
Examples
• When a housewife replaces her traditional charcoal-
stove with a gas-stove, her neighbors benefit because
air-pollution caused by smoke is reduced.
• When a household buys a TV set, its neighbors benefit
when the TV owner allows them to watch the TV
programs.
• If a person plants trees around his house or decorates
his courtyard with flower pots, his neighbors benefit
from the oxygen produced by the trees and also from the
beautiful greenery around.
• A well-maintained car improves the safety of the people
on the people on the road and reduces air-pollution.
• Expenditure on education by some gives people benefit
of and educated society.

• External benefits imply that utility
functions of individuals are dependent one
another.
• Interdependence of utility functions
violates one of the marginal conditions of
Pareto optimality.
• It affects the condition that MRS between
any pair of goods must be the same for all
consumers.
• If utility of one consumer increases
because of increase in the consumption of
another consumer, it is always possible to
redistribute the goods and increase total
social utility.

External diseconomies in consumption
• Diseconomies in consumption arise when
consumption of a commodity by an individual
decreases the total utility of another.
Examples
1. Smoking cigarette in a bus, railway
compartment, theatre or restaurant causes
disutility to non-smokers;
2. Neighbors’ color TV reduces the utility of
owners of black and white set;
3. Using automobiles causes air-pollution and
breathing problems also to non-users; and
4. Playing radio and tape-recorder, and using
loud-speakers for religious and marriage
ceremonies cause disutility to others;
5. The dissatisfaction caused by the noise of low-
flying aircraft as experienced by residents who
are located near an airport

(a)
Consumer
A
T
K
L
J 200
100
Commodity X
S
R
(b)
Consumer B
O
Commodity X
O
Fig 2.9 Interdependence of utility functions and Pareto optimality
90
80
90
80
Commodity
Y
Commodity
Y

• Diseconomies of consumption imply
interdependence of utility functions
• Utility of a commodity depends on the
consumption of that commodity by
other.
• Interdependence of consumers’ utility
functions affects Pareto optimality.
• A and B are at point J and R.
=
=

• Let the distribution of commodities be changed. A moves to point
L, and his consumption of commodity X decreases by JK and of Y
increases by LK.
• A remains on the same IC and his TU remains unchanged.
• B’s indifference map shifts downward due to fall in consumption
of X by consumer A.
• External costs borne by B due to A’s consumption of X decreased,
and B gains the same utility from a smaller basket of goods.
• The downward shift is denoted by the dashed IC.
• When B moves from point R to point T, his index of total
satisfaction increases from 80 to 90.
• As a result of this shift, the total satisfaction index increases from
180 (= A’s 100 + B’s 80) to 190 (= A’s 100 + B’s 90).
• Notes also that at new equilibrium of A and B,
≠
• With the existence of externalities, equality of MRS between any
pair of goods for any two consumers does not ensure realization of
Pareto optimality.
• B’s utility can be increased without reducing A’s utility.

Externalities of Public Goods
A pure public goods is one to which exclusion principle of
market cannot be applied.
Characteristics of a pure public good.
1. Non-excludability of consumers: Nobody can be
excluded from its consumption, nor can consumers be
forced to pay for their benefit.
2. Joint consumption: Its consumption is collective and
all consumers are supplied with it jointly.
3. Non-rival consumption: A larger consumption of
public good by some does not affect the share of
others, nor is their satisfaction level affected.
4. Zero marginal cost: Marginal cost of supplying a
public goods is zero, i.e., if number of consumers
increase cost of supply of a public.
5. Non-appropriation: No individual can appropriate a
public good for his personal use.

An economic typology
Excludable Non-excludable
Rival Private good Public good
Non-rival Local public good Pure public good
Examples of public goods
a. Radio and TV transmission;
b. Improved sanitary system of town;
c. Air-pollution control programs;
d. Road safety-measures;
e. Tree-plantation on the road side and green-belts
of a city.
Some of these goods may however turn to be non-
public goods beyond a certain number of consumers

.Pareto optimality conditions are not valid public
goods. They require formulation of new rules.
• The rule for optimum output of public goods
The sum of its marginal benefits must equal its
marginal cost. The MB of an individual from a public
good, X = The amount of money that the individual is
willing to pay for his benefit.
= MRS X,M
• The sum of marginal benefit of n individuals from
X may thus be expressed as
• The optimum output condition for the public good
(X) is then
= MCX
=

Role of Government
• Markets are incomplete due to lack of prices
to measure the exact
 benefits and costs of external economies of
public goods and
 external diseconomies of public bads.
• Individuals fail to account for the positive or
negative effects their consumption and
production may have on others.
• Achieving efficiency requires an organization
to coordinate individuals; that is a
government.

….cntd
• Government funds are needed to provide
public goods, such as highways,
education, defense, clean environment,
etc.
• Public finance is expected to help
provide public goods and to foster equity.
• Promoting allocative efficiency is the
main rationale for government
interventions to support public goods
provision:
financial (subsidies or tax credits) or
nonfinancial (regulation).

New Welfare Economics
• The new welfare economics is founded on the
‘compensation principle’.
• According to Pareto criterion, social welfare
increases if reallocation of resources makes at least
one individual better-off without making any other
individual worse-off.
• But, difficult to imagine an economic change or
implementation of a policy measure that does not
affect any individual adversely.
• In reality, most economic changes make some
people better-off and some people worse-off.
• The economists, viz. Kaldor, Hicks and Scitovisky,
have devised compensation criteria in their attempt
to overcome the limitation of the Pareto criteria.
• This has come to be called as New Welfare
Economics.

The Kaldor-Hichs Compensation Criteria
• Kaldor and Hicks proposed their compensation criteria in their
separate articles in 1939,
• Their criteria are very much alike; and jointly referred to as
Kaldor-Hicks Criterion.
• There is however a minor difference between their criteria.
• According to Kaldor,
if an economic change makes some people gain and some others
lose, and gainers are able to compensate the losers and yet are
better-off than they were originally, then the change increases
social welfare.
• According to Hicks,
if an economic change makes some people gain and some
others lose, and losers are not able to compensate the
gainers to prevent them from voting for the change, then
the change is socially desirable.
• Hicks criterion give a definitive measure of compensation.

Kaldor-Hicks criterion
• If gainers’ gains (G) is greater than losers’ losses
(L) of a proposed policy economic change (or
reallocation of resources),
G > L,
then, gainers would be able to compensate the
losers and yet retain a net gain. The proposed
change will then increase the social welfare.

M ●
Fig 2.10 Utility Possibility Curves and Kaldor-Hicks Criterion
K
D
J
●
R
●
W
●
A’s Utility P
O
U
Q
B’s Utility
R

• Two utility curves: UP and WD
• UP is the utility possibility curve; combinations
of utilities of A and B as represented by various
points on the consumption contract curve in
Edgeworth box diagram.
• UP is a locus of various combinations of utility
received by A and B, in the utility space, when
the economy is in the state of general
equilibrium.
• Recall that at each point on UP curve,
=
• WD represents the possible utility combinations
from a proposed economic change.

• All points on UP curve (e.g., points J and K) represent the
alternative distribution of utilities with the existing distribution of
resources.
• A change from J to K implies that A (the gainer) can compensate B
(the loser) without retaining any net gain,
A’s gain = B’s loss.
• A movement from J to R, due to an economic change would make A
better-off and B worse-off.
• This change cannot be evaluated by Pareto criterion.
• On the Kaldor-Hicks criterion, movement from J to R is an
improvement in welfare, because A can compensate B for her loss
and yet B better-off than his position at J,
• B’s loss of utility is JM and A’s gain of utility is MR.
• MR = MK + KR and MK is sufficient to compensate B because MK =
JM.
• After compensating B for her loss, A is left with a net gain of KR.
• Whether compensation is actually paid or not is, in Kaldor’s opinion,
a matter of political or ethical decision.
• In the welfare criterion, compensation is simply a measure of
difference between gainer’s gain and loser’s loss.

Shortcoming of Kaldor-Hicks Criterion
1. The fundamental problem is compensation is that
it refers to only potential rather than the actual
compensation. It does not provide a test free from
value judgment.
2. The use of money value of gains and losses in
evaluating the economic efficiency of a change - it
ignores that real value of gains and losses.
3. Scitovsky pointed out a contradiction in Kaldor-
Hicks criterion.

The Scitovsky Double Criteria
• Scitovsky proposed his own criteria,
called double-criterion.
• A change in economic situation of
individual would increase only if
i. the change improves welfare of Kaldor-
Hicks criterion; and
ii. losers are not capable of bringing the
gainers for voting against the change.
Obviously.
• Scitovsky’s criterion is based on the
premise of Kaldor-Hicks criterion.

The Bergson Criterion: The Social Welfare Function
• Bergson suggested the way to formulate a set of explicit
value judgments
• The value judgments may be set by the analyst himself,
government authorities, legislators, social reformers, or an
individual or a group of the society.
• Bergson suggests that value judgment may be explicitly
formulated in the form of a social welfare function.
• A social welfare function is an indifference map which
ranks different combinations of individual utilities
according to a set of explicit value judgments about the
distribution of income. It may be expressed as
W = f(u1, u2, …, un)
• where W denotes social welfare and u1, u2, etc are utility
index of the ith individual.
• Assuming an economy of two persons, A and B, the social
welfare function may be written as
W = f(UA, UB)

• A change from P to R or to M improves social welfare since
these points are on higher social indifference curves.
• But a change from P to Q does not improve social welfare.
W3
●
●
●
●
Fig 2.12 Bergson’s Social Welfare Function
W1
R
A’s Utility
W2
0
W4
Q
P
M
B’s Utility

Criticism
• It has been well received by communists, but is
has its own weaknesses.
1. Bergoson’s criterion requires explicit value
judgment. Economists’ value judgment may be
different from those of the legislators,
electorates or a commission.
2. There is no easy method of constructing social
welfare function.
3. Construction of social welfare function on the
basis of ordinal preferences of the individuals
leads to contradictions if majority rule is
applied.
If majority votes for a non-essential commodity,
the essential ones may not be adequately
produced.

Arrow’s Theorem of Democratic Group Decision
• Arrow’s axioms: social preference may be formed from
individual preferences by legislation, directors or by
majority rule applied to group choices. Not all methods
are equally desirable or sensible.
Arrow’s axioms
1. Social choices must be transitive.
If an event A > event B and event B > event C, then C is
not preferred to A.
2. Social choice must not be dictated by anybody within or
without the group.
3. Social choice which reflect individual preference and
must not change in opposite direction. . If no individual
prefers A to B and at least one person prefers B to A,
society must prefer B to A.
4. The ordering of social choices must not change so long
as individuals do not change their own ordering of
alternative. But, when individual ranking changes, the
ranking of social choices must change.

Criticism
Arrow’s axioms are said to reasonable but have two serious problems.
1. Arrow has himself demonstrated that it is not possible to formulate
social preferences that satisfy all the axioms. The majority rule may lead
to social choices which are not transitive even if individual preferences
are transitive.
X and Z prefer A to B, X and Y prefer B to C; Y and Z prefer C
to A.
Obviously, majority (i.e., two out of three individuals prefer A
to B and B to C, and they also prefer C to A. Thus, majority
rule leads to intransitive social choices.
2. Arrow’s fourth axiom is more restrictive than it
appears. This axiom considers only the ranking, not the
intensity of feelings.
Individual Alternative
A B C
X 3 2 1
Y 1 3 2
Z 2 1 3

Grand Utility Possibility Frontier and
Welfare Maximization
• F.M. Bator has combined the concept of social welfare
function with Pareto efficiency in production
and consumption arrive at the point of bliss -
the point of optimum-optimum.
• He derives a grand utility possibility
frontier
• Uses two-consumer, two-firm and two-input
model, along with its assumptions.
• Optimality in consumption and production mix
of two commodities, X and Y, requires
= = MRTX,Y
=

U
G
W3
●W
●T
Fig 2.15 Maximization of Social Welfare: The Point of Bliss
W1
A’s Utility
W2
0
W4
●N
●M
A’s Utility

• Given a set of social indifference curves, W1, W2,
W3, and W4.
• The point of maximum welfare lies on the grand
utility possibility curve (GU).
• All points outside GU curve are not attainable.
• All points outside GU curve are attainable but not
desirable.
• All points along GU curve are Pareto efficient.
• The bliss point lies where the grand utility
possibility curve is tangent with the highest
possible social indifference as shown by point W.

The Theory of the Second Best
• The principle was generalized for the first
time by Richard G. Lipsey and Kelvin
Lancaster.
• The first best solution is obtained when all
the marginal conditions of Pareto optimality
are simultaneously satisfied.
• But if any of the marginal conditions is not
satisfied, the first best solution cannot be
obtained.
• Because of institutional constraints (like
monopolies and imperfect market conditions
etc.), externalities and indivisibilities, one or more
of the first order conditions may not be satisfied.

• This would mean tat first best solution is
not attainable.
• If the first order conditions of Pareto
optimality are not fulfilled, it is still
desirable to satisfy the remaining greater
the number of conditions.
• The greater the number of conditions
satisfied, the closer would be the solution to
Pareto optimum.
• This belief found application to the fields
like public finance and international trade.

CHAPTER III
THE ECONOMICS OF TAXATION:
PUBLIC REVENUE (12 HRS)
Chapter Contents
 The meaning of tax and taxation
 The purpose of taxation
 Types of taxes
 Tax evasion and tax avoidance
 Adam Smith’s Conons of taxation
 Features of sound taxation
 Approaches/ principles of taxation
 Tax equity: Horizontal vs. vertical equity
 Tax ratio; Bouncy and elasticity of taxation
 Schedule of tax in Ethiopia

3.1 Definition of tax and taxation
 Tax is a compulsory contribution from a person to the
government to defray (settle up) the expenses
incurred in the common interest of all, without
reference to special benefits conferred (Prof Sligman)
 Tax is “a contribution from citizens for the purpose of
the state.” (Prof Adams)
 Tax is defined as “a compulsory contribution of the
wealth of a person or body of persons for the service
of the public powers” (Prof Bastable)
 Tax is a compulsory charge levied by a government
unit against the wealth of a person (natural or legal)
• From the above definitions we infer that; Tax con be:
 A contribution made by people fro common purposes
 A personal obligation
 A levy to generate public revenue.
 Taxation is the process of setting tax rate and collecting
tax

Sources of Public Revenue
• There are two basic sources of government revenue:
Tax revenue and non-tax revenue
A. Tax revenue is mobilized either from direct taxes or
indirect taxes.
I. Direct tax is type of tax determined from the source side
• Developed countries generate about 60% of the total revenue
from direct tax.
• Example: Income tax is direct tax which includes
 employment income,
 profit income,
 agricultural income,
 rental income, and
 royalty income, etc.
II. Indirect tax is the source of public revenue determined on
the use of a budget.
• Most developing countries generate more revenue from an
indirect tax.
• Transaction tax a category of an indirect tax, which include
retail sales tax, VAT, foreign trade tax, excise tax on goods
like air travel and luxuries, etc.

B. Non-tax revenue is mobilized from fees and charges;
selling public assets/assets, gifts, aid/donations,
printing currency, and borrowing from internal and
external sources.
• But, domestic borrowing may crowd out private
investment, foreign borrowing may cause debt crisis,
and printing currency may cause inflation.
• The effectiveness of borrowing or taxing depends upon
utilization of resources.
 In periods of significant excess capacity, borrowing is
preferred to taxing because taxing reduce aggregate
demand, where as borrowing mobilizes idle resources.
 When the resources are fully utilized, the issue is more
complex.
• Deficit financing near full employment is harmful
because
 Government borrowing competes with business
borrowing from private saving – crowding out effect.
 Printing money will directly lead to inflation.

Taxes, Charges and Borrowing
• Taxes are compulsory payments made by legal
tax payers to the government.
• Taxes and charges are withdrawn from the private
sector without leaving the government with a
liability to the payee.
• Borrowing involves a withdrawal made by
government to repay at the future date and to pay
interest in the interim.
• Taxes are compulsory imposts whereas borrowing
and charges involve voluntary transactions.

Alternative means of public finance
A. Seignorage (Printing money) – sources of government
finance.
 Seignarage – money creation – may be the source of
inflation specially when the economy is operating at
full capacity.
 Inflation is a form of taxation. How?
B. Debt finance: The revenues mobilized under this head
are the debts contracted by the state – E.g., borrowing
C. Donations: All the revenues that are obtained through
grants, aid and gifts (in cash or kind).
D. User charges: are charges made by the government for
which some specific benefits are received; example,
passport fee, license fee, water bill, telecom service
charges.
E. Other (miscellaneous) means of financing:
 Lottery, selling gambling service to citizens.
 Fines: A punishment charge levied on individuals for
their infraction (breach of law). Its purpose is not to
collect revenues.

Purposes of taxation
Taxes may serve several
purposes
• Fund public programs
• Redistribute wealth or
income
• Control family size
• Stabilization functions
• Achieve other social
goals; like
 Discouraging bad
merit activities such
as smoking.
 Encouraging good
merit activities such
as investment.
Objectives of taxation
• Raising revenues
• Regulation of
consumption and
production
• Encouraging domestic
industries
• Stimulating investment
• Reducing income
inequalities
• Promoting economic
growth
• Development of
backward regions
• Ensuring price stability

Types of taxes
1. Personal versus Rem (commodity) taxes
• Personal taxes are taxes which are adjusted to
the tax payer’s ability to pay.
 Personal taxes must be imposed on the
household side of the transaction.
• Rem (commodity) taxes are imposed both on
the household and the firm side.
 They are imposed on activities or objects such
as on purchases, sales, or on the holding of a
property.
• The distinction between Rem and personal tax
is of great importance for equity of the tax
system.
• Equity must be evaluated in terms of the
resulting burden distribution among people.

…cntd
2. Unit tax, ad valorem tax, VAT and lump sum tax
• Price distorting taxes: unit tax and atd valorem
taxes.
• Specific taxes: imposed on certain goods based on
weight or volume capacity or any other physical
unit of measurement (Specific tax = volume × tax
rate)
• Per unit taxes: taxes independent of prices
 If selling price is tax inclusive:
Selling price: Ps = P + t;
Tax collected: T = tQ
 If price increase no more tax revenue will be collected per
unit.
 Examples; Alcohol products, petroleum products, tobacco.

• Ad valorem tax: imposed on certain goods bases on
selling price or other specified value of the goods (ad
valorem tax = selling price × tax rate)
 Ad valorem taxes are imposed as a percentage of the price
of a good or service. Examples; Mineral products,
automobiles
 The higher the price of the taxed good or service, the
greater the tax per unit.
 Ad valorem tax is a function of price: T = tPs
Example: Consider the price of gasoline is Birr 20
per liter.
 If t = 10%, tax collected from each liter: T = 0.1×20 = Birr 2
 If t = 5%, tax collected from each liter: T = 0.05×20 = Birr 1

• Lump sum tax: A fixed amount of tax a
person would pay per year, independent of
the person’s income, consumption of goods
and services, or wealth.
 It does not prevent prices from being equal to
social marginal cost and social marginal benefit
of goods or services. It results only reduction of
income or wealth
 It is not price distorting tax.
 Does not cause losses in efficiency with which
private resources are used. Example, head tax.

Tax evasion and tax avoidance
Tax evasion
• Is illegal
• It is a means of falsifying information on tax return
in order to reduce one’s tax liability, even not filling
at all.
• Can cause financial penalties or prison sentence.
Tax avoidance
• Is legal
• Means of arranging one’s affaires so as to minimize
tax burden, by incurring deductible expenses,
investing on tax exempt bonds, and other legal
techniques.

Canons of taxation
• A good tax system should adhere
to certain principles which
become its characteristics.
• A good tax system is based on
certain principles.
• Adam Smith has formulated four
important principles of taxation.
• A few more have been suggested
by other economists.
• These principles of good taxation
system are called canons of
taxation.
Adam Smith’s four principles of
taxation
1. Canon of equality
2. Canon of certainty
3. Canon of convenience
4. Canon of economy
Example of other
taxation principles
Ottawa taxation
framework
i. Neutrality
ii. Efficiency
iii. Certainty and
simplicity
iv. Effectiveness and
fairness
v. Flexibility

1. Canon of equality
• People should be taxed according to their ability to
pay taxes.
• Equality does not mean equal amount of tax, but
equality in tax burdens.
• Canon of equality implies a progressive tax system.
2. Canon of certainty
• Each individual that is required to pay should be
certain and not arbitrary.
• Tax rules should be clear and simple to understand,
so that taxpayers know where they stand.
• Easier for individuals and businesses to understand
their obligations and entitlements.
• The time of payment, the manner of payment, and
the amount of the paid should be clear.
• The application of this principle is beneficial both to
the government as well as the tax payer.

3. Canon of convenience
• As per to this canon, the mode and timings of tax
payment should be convenient to the tax payer.
• It means that taxes should be imposed in such a
manner and at the time which is most convenient
to the tax payer.
• For example, Governments of India, Ethiopia
collect income tax at the time when they receive
their salaries.
• So this principle is also known as “the pay as you
earn method”.
4. Canon of economy
• Every tax has a cost of collection. The canon of
economy implies that the cost of tax collection
should be minimum.

Features of sound taxation
There are five features of a good tax system.
1. Fairness: The distribution of the tax burden should be
equitable. Everyone should pay his/her “faire share”
2. Efficiency: Excess burdens from tax interferences
should be minimum.
3. Political responsibility: Tax should be transparent to
the public and the tax payers.
4. Flexibility: Tax system should easily adapt to changed
circumstances. Example; changes in market prices.
Should allow the government to respond for dynamic
technological and commercial changes.
5. Administrative simplicity: Tax system should have
low costs of administration and compliance.

Two principal objectives of tax:
(i) Fiscal objective: Collection of revenue for the
use of the public services
(ii) Non-fiscal objective: To achieve some social
advantages (to promote some desired social or
economic activity or to check harmful habits).
Example:
to Limit drunkenness, smoking via high tax,
to develop local infant industries,
 to stabilize the economy and
to alter distribution of wealth.

Approaches of tax
Benefit and Ability pay principles
1. The benefit principle
• States that “those people who benefit from the
government’s expenditure should be the people who
pay for them.”
• From equity standpoint: tax as the price of goods
supplied by the government.
• From efficiency ground: it can be applied in such a
way as to minimize the excess burden of taxation.
• Excess burden can be minimized when the taxes are
levied to the actual users. Examples; costs of
maintenances and operations of bridges, roads, parks.
Limitations
• Difficulty to measure individual benefits
• Affects redistribution and social welfare programs.

…cntd
2. Ability to pay principle
• Individuals should pay taxes proportionate to their
ability to pay or income level
Difficulties
• Many government activities are carried out for the
provision of general public goods; defense, justice,
legislature
• Two main problems arise
i. difficulty to know the ability to pay
ii. people with the same levels of ability to pay or income may
benefits differently. Example, variations in family size
Links between the two principles
• Adam Smith argues that ability to pay or income also
shows benefits
• No real conflict exists between the benefit principle and
ability to pay principle.

Horizontal equity and vertical equity
• Equity has two main elements; horizontal and
vertical .
i. Horizontal equity suggests that taxpayers in similar
circumstances should bear a similar tax burden.
• People with an equal ability to pay should pay equal
amount of tax.
ii. Vertical equity is a normative concept, whose
definition can differ from one user to another.
• According to some, it suggests that taxpayers in
better circumstances should bear a larger part of the
tax burden as a proportion of their income.
• In practice, the interpretation of vertical equity
depends on the extent to which countries want to
diminish income variation and whether it should be
applied to income earned in a specific period or to
lifetime income.
• Vertical equity is traditionally delivered through the
design of the personal tax and transfer systems.

Tax Rate, Bouncy and Elasticity of Tax
• Tax rate is a percentage of income, wealth,
property, etc., assumed to be payable in taxation.
• It can take either of the following form:
 Proportional tax rate, say X%
 Regressive tax rate: say Y%
 Progressive tax rate, say Z%
 Marginal tax rate: subject to income bracket
 Nominal average tax rate: The ratio of actual
tax liability to taxable income.
 Effective tax rate: The ratio of actual tax
liability to total income.

Tax Elasticity and Bouncy
• The responsiveness of tax revenue to change in the GDP is
measured by tax elasticity and tax bouncy.
• These concepts help to explain the overall structure of a tax
system and serve as valuable analytical tools for designing tax
policy.
Tax bouncy
• Measures the total response of tax revenues to changes in GDP.
• It takes into account both the effect of increases in
income and discretionary changes (i.e., tax rates bases) on
the revenues from a tax.
• Tax buoyancy is an indicator to measure efficiency and
responsiveness of revenue mobilization in response to growth
in the Gross Domestic Product or National Income.
• A tax is said to be buoyant if the tax revenues increase
more than proportionately in response to a rise in
national income or output.
• Tax bouncy is a measure of both the soundness of the tax
policy and the effectiveness of post tax changes in terms of
revenue collection.

Tax elasticity
• Measures the pure response of tax revenue to
changes in the national income.
• Reflects only the built-in responsiveness of tax
revenue to movement in national income.
• The tax elasticity calculation excludes the
impact of changes in tax rates and tax
bases.
• It considers only the effects due to changes
in income levels, whether or not changes were
made in the tax structure during that time
period.

Measurement of tax bouncy
Tax bouncy can be expressed as follows:
Where; = Bouncy of tax revenue to income
= Total tax revenue
= Change in total tax income
= Income
= Change in income

• Bouncy may better be expressed by breaking-down
the total tax system into individual taxes
• Suppose there are sales tax, trade tax, and income
taxes in the system; the following relations should
hold:
Where; = Revenue from tax-1 (sales tax)
= Revenue from tax-2 (trade tax)
= Revenue from tax-3 (income tax)

Tax Buoyancy vs. Tax Elasticity
• The concepts of tax buoyancy and tax efficiency are used
to measure the responsiveness of tax revenue to
economic growth.
• Tax buoyancy is a crude measure which does not
distinguish between discretionary and automatic
growth of revenue.
• In measuring bouncy, no attempt is made to control
for discretionary changes in the tax system or
administration.
• Consequently, bouncy is reflects both discretionary
change and automatic revenue growth.
• For policy purposes, it is usually useful to distinguish
between revenue growth due to discretionary changes
and revenue growth due to changing economic
conditions.

• Tax elasticity is a measure designed to measure the
responsiveness of tax revenue to a change in national
income or output after controlling for exogenous influences
such as discretionary changes in tax policy.
• If a tax is elastic, a one percent increase in GNP or
GDP results in a greater than one percent increase in
revenue from the tax holding constant for
discretionary tax changes.
• Elasticity is a preferred measure of tax responsiveness
since it controls for automatic revenue changes.
• For various reasons, studies of tax responsiveness often
focus on tax buoyancy rather than tax elasticity.
 One problem is in obtaining information on discretionary revenue
changes
 Secondly, utilizing information on discretionary revenue changes to
control for such changes may result in the loss of degrees of
freedom in a regression analysis.

The question of tax rate
• The tax base (taxable income) shows the ability of
an individual or group of individuals to pay tax in
reference to their income, wealth, property or
expenditure.
• Tax rates could be progressive, regressive or
proportional.
• A progressive tax system is one in which effective
average tax rates rise with income.
• A proportional tax system is one in which
effective averages rates do not change with income
so that everyone pays the same proportions of
his/her income in taxes
• A regressive tax rate is one in which effective
average tax rates fall with income

Individual
Income
Taxes Paid Taxes as %
of income
Proportional tax
1 Birr 10000 Birr 1000 10%
2 Birr 50000 Birr 5000 10%
3 Birr 100000 Birr 10000 10%
Regressive taxes
1 Birr 10000 Birr 500 5%
2 Birr 50000 Birr 2000 4%
3 Birr 100000 Birr 3000 3%
Progressive taxes
1 Birr 10000 Birr 300 3%
2 Birr 50000 Birr 2000 4%
3 Birr 100000 Birr 5000 5%

Tax incidence
• Tax incidence analyzes the economic effects of tax both at
micro and macro levels.
• Micro effects of tax is on the distribution of income and
efficiency of resource use.
• Macro effects of tax is on the level of output,
employment, price, growth, etc.
• Tax incidence refers to how gross tax burden is shared
among households and sometimes business firms.
• The distributional effect (or incidence) of particular
budget measures depend on their effects on output
and employment, since the letter depends on concurrent
changes in distribution.
• A policy may be superior with regard to distributional
results but inferior with regard to efficiency, growth or
employment effects. Trade offs always occur between
taxation and growth.
• Tax related decisions are thus made based on the net
effects of tax on the economy

Nature of tax burden
• Shows a distinction between budget operations
which involve a resource transfer to the public sector
and those do not.
• Suppose the government collects Birr 1 billion and
spends it on highway facilities. How is the burden
distributed? Who is most benefited?
• Tax incidence is the way in which this gross burden
is shared among individual households.
• When budget operations do not involve resource
transfers to the public, the government simply collects taxes
from the private sector and returns transfers to that sector.
Magnitude of burden
• Assumes that the tax burden is equal to the revenue collected.
• E.g.,; obtaining Birr 1 billion in taxes and spending it on transfers
leave private income unchanged and involves no resource cost.
• This view of tax burden oversimplifies matters.

Excess burden
• The total burden may exceed the revenue collected
because an efficiency loss or excess burden or
dead weight loss results.
• To illustrate, suppose that Birr 1 billion revenue is
collected from a tax on automobiles. Does this have
effect on firms sales?
• Hence, the burden imposed on the private sector
will be larger; hence the tax interferences with
customer choice.
 Some people may forgo a car purchase because if the tax
payable.
• Thus, such an additional burden causes what
economists called “excess burden” or “dead
weight loss”.

Input effects
• Imposition of a tax may lead to a change in
factor supply and hence in total output.
• A tax policy nay lead to a change in the rate
of saving and investment and hence in the
rate of output growth.
• If government imposes tax on laborers,
households or firms:
 They work less and earn less.
 As decline in earnings is part of the burden, the
total burden exceeds tax revenue.

Employment effects
• Changes in output may result in change in the
level of aggregate demand and unemployment.
 Introduction of a tax may reduce employment or
 Increase in expenditure may raise employment.
• This once more complicates the problem of
observing the effects of taxation on the distribution
of income.
• Thus, tax burden is more complex than simple
formulation in which revenue and burden are set
equal to each other.
• But the assumption is useful approximation when
dealing with the problem of burden distribution
operationally.

Statutory incidence
• Statutory incidence is the burden of the tax borne
by the party that sends the check to the
government.
• Example; the government could impose a Birr 50
per gallon tax on supplies of gasoline.
Economic incidence is the burden of taxation
measured by the change in resources available to
any economic agent as a result of taxation.
• Example, if gas stations raise gasoline prices by
Birr 25 per gallon as a result, then consumers are
bearing half of the tax.
Tax shifting is the transaction of tax burden from
its impact point (the place of statutory incidence)
to its final resting point (the place of economic
incidence).

Three basic rules for figuring out who
ultimately bears the burden of paying a tax:
The statutory burden of a tax does not
describe who really bears the tax.
The side of the market on which the tax is
imposed is irrelevant to the distribution of
tax burdens.
Parties with inelastic supply or demand
bear the burden of a tax.
• Incidence of a specific government policy
refers to the resulting change in the
distribution of income available for private use
attributable to that policy.

Three concepts of incidence that relate to
government taxes and expenditures are:
 Budget incidence
 Expenditure incidence
 Differential tax incidence
i. Budget incidence evaluates effects of both
government expenditure and tax policies on
distribution of income in the private sector.
ii. Expenditure incidence evaluates effects of
alternative government expenditure projects
on distribution of income.
iii. Differential tax incidence is the resulting
change in distribution of income when one
type of tax is substituted for some alternative
tax yielding equivalent revenue, while both
mix and level of government expenditures are
held constant.

• There are three ways in which the problem of tax
incidence may be viewed; absolute, differential or
budget incidence.
• Absolute tax incidence examines the distributional
effects of imposing a particular tax while holding
public expenditure constant.
 Example; macroeconomic effects: inflation, AD, etc.
• Differential tax incidence examines the
distributional changes if one’s tax is substituted for
another while total revenue and expenditure are held
constant.
 Example; when the government replaces Birr 1 billion of
income tax revenue with a cigarette excise yielding an
equivalent amounts.
 This policy change involves no resource transfer to public use
imposes on net burden on the private sector.
 It merely involves redistribution of income among households.
 The resulting total change in the sates of distribution is referred
to as differential incidence.
• Budget incidence considers the changes in
household positions as a result of continued effects
of tax and expenditure changes.

• The overall effects of an increase in government
purchases and taxes by Birr X involves:
1. Earnings from production for sale to private buyers
are reduced by Birr X
2. Earning from production sold or services rendered to
government are increase by Birr X.
3. Disposable income of earners is reduced by Birr X.
4. Government revenue is increased by Birr X.
5. Benefits from public services are increased by Birr X.
6. Benefits from private services are reduced by Birr X

The welfare effects of taxation
• Welfare cost of taxation is sometimes referred to
as “excess burden” of taxation or the “dead
weight loss” of taxation. The three terms can be
interchangeably.
• This arises because the tax payer incurs not
only the actual cost of the tax but also the cost
of losing the most preferred without the tax.
• Suppose the government decides to raise more
revenue by placing a tax on gasoline. What
happens?
As T raises Yd falls, Qty purchased falls,
production falls, income falls, and hence
welfare deteriorates.

Taxation, Prices, Efficiency and Income
Distribution
• When tax is imposed on producers, they will raise
prices to offset this tax burden.
• When a tax is imposed on consumers, they are
not willing to pay much for a good, so prices fall.
Thus, the tax burden for consumers is:
Producer’s
tax burden
= Pre tax price
– Post tax price + Tax Payments
of Producers
Consumer’s
tax burden
= Post tax price
– Pre tax price
+ Tax Payments
of Consumers

Example: Impact of tax on suppliers of gasoline
• Supposed the government imposed Birr 50 per
gallon tax on suppliers of gasoline.
• The initial market equilibrium is 100 billion of
gallons sold at Birr 1.50 per gallon.
• The Birr 50 tax raises the marginal costs of
production for the firm, shifting the supply curve up.
• At the original market price, there is now excess
demand of 20 billion gallons; the price is bid up to
Birr 1.80, where there is neither a shortage nor a
surplus.
• The gasoline tax has two effects:
 It changes the market price
 Producers must now pay a tax to the
government.

…cntd
.Consumer’s
tax burden
= Post tax price
– Pre tax price
+ Tax Payments
of Consumers
Consumer’s
tax burden
= Birr 1.8 –
Birr 1.5
+ 0 = Birr 0.30
Producer’s
tax burden
= Pre tax price
– Post tax price + Tax Payments
of Producers
Producer’s
tax burden
= Birr 1.50–
Birr 1.80
+ Birr 0.50 = Birr 0.20

• This reveals that true burden on producers is not Birr
50, but some smaller number, because part of the
burden is borne by consumers in the form of a higher
price.
• Tax wedge is the difference between what consumers
pay and what producers receive from a transaction.
• Full shifting is when one party in transaction bears the
entire tax burden.
• With perfectly inelastic demand, consumers bear the
entire tax burden.
• With perfectly elastic demand, producers bear the
entire tax burden.
• Generally, for extreme cases:
 Parties with inelastic supply or demand bear taxes.
 Parties with elastic supply or demand avoid taxes.

S0
Q0
D0
Birr
S1
Q
Q2
P0
PS = P2
PB = P1
Effects of output tax on producers/sellers

1. Supply curve shifts by upward by t.
2. The market price rises from P0 to P1
 The price paid by buyers PB rises from P0 to P1
 The actual prices received by sellers PS drops from P0 to P2
(= PB – t)
3. Quantity transacted drops from Q0 to Q1
4. Income distribution
Tax Revenue = P2P1AC
Drop in buyer’s surplus = P0P1AB
Drop in sellers surplus = P2P0BC
Dead weight loss = ABC
5. Efficiency loss
• Production efficiency: goods are produced with
minimum cost
• Consumption efficiency: Goods are consumed by
consumers with the highest value.
• Allocative efficiency: MUV > MC → Underproduction

S1
D
A
B
C
Tax Revenue = P2P1AC
Drop in buyer’s surplus = P0P1AB
Drop in sellers surplus = P2P0BC
Dead weight loss = ABC
S0
Q0
D0
Birr
Q
Q2
P0
PS = P2
PB = P1

Effects of taxation on labor earning, saving,
and investment.
Taxation and labor earning:
• The impact of tax on the work effort of a worker
depends on the income and substitution effects
of the tax-induced reduction in the wages of
workers.
• Tax reduces opportunity cost of leisure by
reducing the wages that workers receive from w to
w×(1-t) where w is wage per hour and t marginal
tax rate per wage.
• Thus, the substitution effect induced by income
tax tends to increase the consumption of
leisure by an individual.

…cntd
• The substitution effect represents the potential
loss of output due to the reduction in incentive
to work.
• An income induced effect also results from tax
decline in the net wage.
• The income effect tends to be favorable to work
effort, provided that leisure is a normal good.
• Equal hours of work after imposition of income tax
would result in less net income than he did
previously.
• The income tax reduces income at all levels of
work.
• Thus, the income effect of taxation provides an
incentive to increase work effort when leisure is
a normal good.

…cntd
• The actual effect on individual work effort
depends on the relative magnitudes of the
income and substitution effects.
• If the substitution effect outweighs income
effect, the individual tends to consume more
leisure and consequently work less as a result
of the tax.
• If the income effect outweighs substitution
effect, the result of the tax-induced wage
reduction is a decrease in a daily
consumption of leisure and a consequent
increase in work per day.

Taxation, saving and investment
• Saving is defined as the excess of current income
over current consumption. It is the difference
between income and consumption).
• For a saver, tax has both an income and substitution
effect.
• Thus, income effect with tax leads to lower current
consumption.
• If the substitution effect and income effect were to
cancel each other – leaving saving unchanged – would
this imply that the tax is non-distortionary or not?
• Tax is distortionary since it causes the individuals to
substitute between current and future consumption.

Taxation and foreign direct investment (FDI)
• Success in attracting foreign direct investment
(FDI) can potentially release many local
development benefits.
• The benefit packages consists of:
 Incremental investment capital
 Access to advanced management techniques
 Access to advanced production techniques
 The development of internal competition
 Employment creation.

Host country’s tax factors affect FDI
1. Transparency and complexity of tax system
2. Corporate income tax rate
3. Tax incentives has five objectives:
 To create employment
 For specific social or private benefits
 To foster transfer of technology
 To accelerate investment decisions
 To facilitate international competitiveness
4. Tax holiday: Partly or fully exempts firms from
taxes on net revenues out of investment projects
(5 to 10 yrs)

Taxation in Ethiopia
• Tax base of Ethiopia
Four primary tax basis
 Income
 Wealth
 Sales/transaction
 Payroll (employment) tax: Hybrid or intermediate
combination of tax
• In Ethiopia payroll (employment) tax include:
 Pension contribution of an employee: taxes on
labor earnings but not on a total personal income.
 Pension contribution of employer: taxes on the
monetary value of labor purchases by an employer.

• The two central policy issues in taxation are:
 How the tax base is defined and
 What rates are charged.
• Tax base is the legal object to which the tax is based.
• Example; Civil Servants Salary Scale Schedule which
consists different levels and scales of monthly salary
relating with professions, skills and experiences of
workers.
• Thus, the Civil Servant Salary Scale Schedule is a rule/
law that can be the tax base of employment income.
• Prepared by the Federal Civil Service Commission.
• Tax rate is the rule/law made by the Ministry of Finance
and Economic Development, and/or Ministry of Inland
Revenue, applied per unit of tax base.
Tax Revenue of the Government= Tax base × Tax Rate
T = t×BT

Exemption, Income Tax Brackets and Marginal
Tax Rates
• When workers earn monthly income, they will
be taxed in accordance with the schedule of
employment income tax law.
• Employment income tax follows a progressive
income tax rate method.
• The income tax law assumes the first become
tax bracket with zero rates is called the
monthly exempted income level.
• Based on this principle, the minimum salary
(productivity/efficiency) and exempted
income level (equity/justice) are assumed to
be equal.

• Based on the income tax law salary of an
employee consists of two income levels:
 Exempted income level and
 Income level above the exempted one which
is subject to tax according to schedule A
Exemption: when some income level is free from tax
for the requirement of basic necessities of a
worker/family.
• Income tax brackets: A range of income subject
to a given marginal tax rate.
• Marginal tax rate: Rule/law of rate imposed per
income tax bracket.
• It is the amount of income tax per unit of
additional income.
• It is the slope of income curve that shows the
rate of income tax change as the income of
individual changes.

Tax revenue computation
• Every tax has two parts
A tax base
A tax rate structure
• Tax base is the legal amount or value
upon which the tax is leveled or
charged.
• Tax base may be either stock or flow
measures.
• Tax rate structure legally determines
the portion of the tax base that must be
paid in taxes.

Derivation of tax formula
Employment tax schedule A
Monthly employment
income (income Brackets
in Birr)
Taxable
income in
Birr
MTR
(%)
Tax income at
each income
bracket (in Birr))
0 < Y1 < 150 0 0% 0
150 < Y2 < 650 500 10% 50
650 < Y3 < 1400 750 15% 112.5
1400 < Y4 < 2350 950 20% 190
2350 < Y5 < 3550 1200 25% 300
3550 < Y6 < 5000 1450 30% 435
5000 < Y7 Y7 - 5000 35% 0.35(Y7 – 5000)

Example: Find the income tax equation up to the
seventh income tax bracket; considering current
income brackets where:
Y1 = 150
Y2 = 650
Y3 = 1400
Y4 = 2350
Y5 = 3550
Y6 = 5000
Y7 > 5000 Birr/month

T1 = 0, because Y1 is exempted
T2 = (Y1 – 0)0% + (Y2b–Y1)10% = (150–0)0% + (650–150)10% = 0.1Y2 - 15
T3 = (Y1 – 0)0% + (Y2 – Y1)10% + (Y3 – Y2)
= (150 – 0)0% + (650 – 150)10% + (Y3 – 650)15%
= 50 + 0.1Y3 – 97.5 = 0.15Y3 -47.5
T4 = (Y1–0)0% + (Y2–Y1)10% + (Y3–Y2)15% + (Y4–Y3)20%
= 50 + 112.5 + 0.2Y4 – 280 = 0.2Y4 – 117.5
T5 = (Y1–0)0% + (Y2–Y1)10% + (Y3–Y2)15% + (Y4–Y3)20% + (Y5–2350)25%
= 50 + 112.5 + 190 + 0.25Y5 – 587.5 = 0.25Y5 – 235
T6 = (Y1–0)0% +(Y2–Y1)10% +(Y3–Y2)15% +(Y4–Y3)20% + (Y5–Y4)25% + (Y6-Y5)30%
= 50+112.5+190+300+(Y6-3550)30% = 652.5 – 1065+0.3Y6 = 0.30Y5 – 412.5
T7 = (Y1–0)0%+(Y2–Y1)10%+(Y3–Y2)15%+(Y4–Y3)20%+(Y5–Y4)25%+(Y6-Y5)30%+(Y7-Y6)35%
= 0+50+112.5+190+300+435+(Y7–5000)35% = 1087+1750+0.35Y7 = 0.35Y7 – 662.5

Tax Rate Structure
Three variant of tax base
• Progressive tax: The tax rate increases as the tax
base grows larger. It has two characteristics
1. For flat tax rate: Exemption and uniform; ATR = MTR
2. For the remaining tax brackets: MTR > ATR
• Proportional tax: The tax rate remains constant
as the tax base grows larger.
• Regressive tax: Tax rate decreases as the tax base
increases.

Average Tax Rate and Marginal Tax Rate
Average tax rate (ATR): Total amount of tax revenue
divided by taxable income; whose taxable income is
income after exemption or deduction. Average tax rate
is the total amount of tax one pays divided by his/her
taxable income.
Marginal tax rate (MTR): The tax rate an individual
pays on additional income that you earn. It is the
slope of an individual income tax curve.

Excess Burden of Taxation
• It is the ratio of the excess burden of a tax to
the tax revenue collected each year.
• It is also called the “coefficient of inefficiency” of
the tax.
• It estimates the efficiency-loss ratios of different kinds
of taxes useful in achieving minimization of total
excess burden of taxation.
End

CHAPTER CONTENTS
 Meaning & nature of public expenditure
 Planning and budgeting of public
expenditure
 Evaluating public expenditures/ project
analysis
 Cost benefit analysis & cost effectiveness
analysis
 Valuation of costs &benefits of public
projects
 Classification of public expenditure
 Patterns of the Ethiopia's public expenditure

4.0 Meaning and Nature Of Public Expenditure
• Government spending ( Public expenditure)
includes all government consumption and
investment but excludes transfer payments.
• Government spending has two basic classes:
i. Final consumption expenditure-Government
acquisition of goods and services for current use
ii. Government investment (gross fixed capital
formation)-Government acquisition of goods and
services intended to create future benefits

4.1. Public Expenditure Objectives
• Public expenditure is made by governments to
meet some public objectives here as private
spending are made to meet private objectives.
• It can meet more than one objective
simultaneously.
 Provision of social and economic services.
 Provision of social-wants, growth and
distribution among regions & people
 Employment creation, raising income of the
low-income people
• The public provision of goods & services may
affect market prices or behavior:
 It has far-reaching effects beyond its direct
benefits.

4.2. Planning & Budgeting Public Expenditure
• Government must set priorities to control the total level
of spending & allocate it efficiently.
• These priorities should be based on two considerations
or principles:
i. An appreciation of markets where they can do
better.
ii. An efficient and effective public resource
utilization.
• Governments should concentrate their spending in
certain areas where their participation is necessary for
 a well functioning market,
 economic growth, and
 more equitable distribution of income.
• The medium term & the annual budget plan are the two
primary tools, which are typically used in controlling and
allocating public spending.

4.3. Economic Analyses of the Budget Process
• Economic analysis indicates the political effect of
proposed projects & can help prevent costly mistakes
by policy makers.
• Two basic analysis of G:
i. Objectively measurable projects = Cost-benefit
analysis
ii. Less objective or indirectly measurable
projects = cost-effectiveness analysis is used.
Measures outcomes of the project

4.3.1. Techniques for Evaluating
Expenditures/ Projects
i. PV & NPV - present value & Net present
value
ii. IRR - internal rate of return
iii. ARR - accounting rate of return
iv. Payback period
v. Discount rate
vi. PI - Profitability index

Investment evaluation/Appraisal
.

• Is the basic technique of economic appraisal
of expenditure or projects
• CBA determines if the total value of benefits
created by a project is greater than the total
costs that it imposes on society.
• CBA adds up all the benefits & costs of a
project to society, discounting them &
calculating the absolute amounts of the
discounted net benefit expected from the
project.
Difficulties of the CBA
• CBA involves inherent difficulties in how to
measure costs and benefits and choosing the
appropriate discount rate especially for public
projects.
1. Cost-Benefit analysis (CBA)

2. Cost Effectiveness Analysis (CEA)
• Is a technique which is directed at minimizing the
costs of an agreed upon output or to maximize
such output with a given cost.
• Used for a large class of public expenditures in
which benefits are difficult to measure
= cost- effectiveness analysis

Fundamentals of Cost-Benefit Analysis (CBA)
• Governments should achieve their objectives
in an effective & efficient manner, through
ensuring an efficient allocation of resources
among all expenditures.
• CBA for public sector attempts to measure
benefits and costs that extend beyond the
strictly financial dimension of a project.
Steps involved in CBA
1. Identification of all costs & benefits of public
projects
2. Valuation of all costs and benefits
3. Discounting all cost and benefits
4. Decide the project either to accept or reject

1. Identification of Costs & Benefits
• Benefits and Costs may be
 real or
 Pecuniary (monetary, relating to money)
• Real benefits are the benefits derived by the final
consumers of the public project.
 Reflect an addition to the community's welfare.
• Pecuniary benefits occur because of changes in relative
prices which in turn occur due to the intended public
project.
Types of Real benefits and costs
• Tangible versus Intangible
• Direct versus Indirect
• Intermediate versus Final goods
• Internal versus external (spillover)

2. Valuation of Costs and Benefits
• Once the benefits & costs are identified, the next step is
determining
“the monetary values of both costs and benefits”.
• This valuation depends on whether the resources used, &
the output produced by the public project is marketable
or not.
• Perfectly competitive markets:
Prices show the true values of inputs & outputs.
In such markets, prices of goods set to the level of
MC of the good.
• Imperfect markets :
Market price cannot reflect the true economic value
and cost of outputs and inputs. Why?
Due to such distortions including,
Taxes & subsidies,
monopoly,
public goods,
asymmetric information.

• Because of market distortions,
 a marginal social cost as seen from the supply side &
 marginal social benefits as seen from the demand
side
will not be equal.
• Hence, it becomes necessary to adjust market
prices so that it reflects the true value to society.
• Such adjusted values are referred to as
 "shadow prices” or
 “accounting prices”.
• Three sources of shadow prices can be identified depending
on the project's impact on the national economy.
• A project via its use of inputs & production of output affect:
 Supply available to society
 Level of its production in the rest of the economy
 Level of imports or exports

• Use of inputs (consumption of inputs) by a project
may:
 Decrease consumption of that input in the rest of
the economy.
 Increase production of the input within the
economy
 Increase imports or decrease exports.
• Terms of production of an output the project may:
 Increase total consumption in the economy.
 Decrease production in other parts of the economy
 Decrease imports or increase exports
• A project may have all the three impacts
simultaneously.
• Identifying these impacts is important.

The appropriate source of shadow prices is
different under each of the three
conditions.
Impact
• Consumption within
the economy
• Production within
the economy
• International Trade:
 Imports
 Exports
Basis of shadow price
• WTP to consumers
(Price)
• Cost of production (MC)
 Cost of imports (C.I.F)
 Value of Exports (F.O.B)

• Monopoly-value inputs used or output produced
at weighted
 market price, P &
 marginal cost, MC.
• Taxes & subsidies-depend on the impact of
project purchase (PP):
 If PP lead to MP, use producers price MC &
 If PP leads to no MP, use purchasers’ price, P
• Labor Input, Unemployment and Shadow
Wage rates
 If the project hires UE labor, its opportunity cost is
virtually Zero.
 If the project transfers already employed labor, its
opportunity cost is forgone production.
• It is reasonable that a positive shadow wage
rate is taken in the valuation of a project.

• In practice, most of these shadow prices
are provided by governments as National
Parameters and Conversion factors.
• When outputs (benefits) do not have
market value, indirect valuation methods
may be applied.
• The willingness to pay life insurance
premiums or wage differentials b/n safe &
hazard jobs.
• These refer to intangible private benefits.

3. Project Decision Rules
• Once estimates are made about costs &
benefits, it is necessary to
decide the combination of projects, which
would enter the budget.
• The rule is very simple. Choose the
combination that gives the greatest
net benefits.
• Discounting [Present values]
Remedy the problem associated with CBA
to compare costs and benefits that occur
at different times.

A. The Net Present Value [NPV] Criteria
• NPV is the sum of the difference b/n benefits
and costs that occur in the various years of the
project's life.
• It is the current value of all net benefits
associated with a project
• Net benefit is simply the
sum of benefits minus the sum of costs.
• The net present value of benefits is the present
value of those net benefits.
• The net benefits are converted to present
value by discounting.
• We say “net” present value because we subtract
the PV of cash outflows (costs, investment)
from the PV of cash inflows (benefits).

Sum of the PVs of all cash flows:
PV = Sum of discounted future cash flows
Initial cost often is CF0

NPV – Decision Rule
 The goal of capital budgeting: Find a decision rule that
will maximize shareholder wealth
The NPV rule:
 Accept project if NPV > 0 or NPV is positive
 If we accept a project with NPV > 0
 increase shareholder wealth
 Reject project if NPV<0 or NPV is negative
 If we accept a project with NPV < 0
 decrease shareholder wealth
 If two projects (A & B) have NPV>0 & compete for the
same fund if they are mutually exclusive, accept the
project with the higher NPV.

NPV rule intuition: look for projects with:
PV(cash inflows) > PV(cash outflows)
• NPV = PV (Cash inflows) - PV( Cash outflows)
 If NPV > 0 → Accept project
 If NPV = 0 → indifference
 If NPV < 0 → Reject project
• NPV > 0 means:
 Cover their operating costs
 Cover their financing costs
 Add value(wealth) to the firm (=NPV)
• NPV < 0, means:
 its return/benefits is less than the value of
the resources used.
• NPV is a direct measure of how well this
project will meet the goal of increasing
shareholder wealth.
• NB: Public projects feasibility may not be
evaluated in terms of single criteria.

B. Benefit-Cost Ratio(BCR)
• BCR is defined as the ratio of the present value
• of benefits to the present value of costs
• BCR is computed as the PV of Benefits divided by
the present value of Costs.
• Discounted benefits and discounted costs are
calculated and summed separately, then divided.
• This method attaches preference on the rate of
returns rather than the magnitude.
• A project with BCR exceeds 1 is acceptable.

CBR Decision
• If the project has a BCR > 1, then it is worth
considering on its economic merits.
• If the project has a BCR < 1, then it fails to
return benefits larger than its costs.
• Where two projects compete for the same
fund, the one with a higher benefit cost
ratio is preferable.
• In short:
 If BCR>1, accept the project
 If BCR=1,inddifeent
 If BCR<1, reject the project

C. Internal Rate of Return(IRR)
• The two criteria, benefit-cost ratio & Net present value,
are based on the assumption that project evaluation is to
be carried out by discounting at a uniform rate of
discount.
• Instead of computing the present values (by applying
discount rates) one may calculate
 the discount rate that would be needed to equate
the present value of the benefit stream with the
stream of cost.
Definition
• IRR is rate of discount which makes the present value
of benefits equal to the present value of costs.
IRR = discount rate(r ) that makes the NPV=0
• Technically solve for the IRR by finding r that solves:
PV (Benefits) = PV (Costs)
• IRR is the maximum interest rate that could be paid for
the project resources that would cover investment
costs & still allow society to break even.

IRR Decision Rule
• Accept the project if the IRR is greater than
the required return(r).
• Projects whose IRR exceed some minimum
rate of discount will be accepted
• If two projects are mutually exclusive, and
are both acceptable, choose the one with a
higher IRR.
Internal Rate of Return(IRR) is
• Most important alternative to NPV
• Widely used in practice
• Intuitively appealing
• Based entirely on the estimated cash flows
• Independent of interest rates

Inflation and Project Evaluation
• Inflation erodes the purchasing power of money.
• Thus, it creates a problem in project evaluation
by making money a poor standard for comparing
net benefits over time.
• When prices are expected to rise in the future,
one may either use nominal values or real
values (values measured at constant prices).
• To use nominal values the analysts consider
estimated (projected) rate of inflation (P) over
time.
• Once the estimates are obtained, the nominal
values of both future benefits & costs can be
determined by multiplying them by 1+P, where
p is the rate of inflation.

• Inflation, does not only affect the value of the
net benefits, but also
 market interest rates,
 saving rate of interest and
 the rate of returns on investment.
• Since the inflation adjustment factor
cancels each other,
 NPV calculated at constant prices (real
values) &
 Inflation and Project Evaluation at market
prices (nominal values)
will be the same.
• In project evaluation, one has either take
 nominal values of costs,
 benefits & discount rate or,
 real values of costs, benefits and
 discount rates consistently.

The Discount Rate
• Both in NPV & the benefit-cost ratio methods,
the acceptability & ranking of projects
depends upon the discount rate used, given
the length of time during which the benefits
from projects accrue.
• Higher discount rates disfavor projects
whose returns are concentrated further into
the future.
• Lower discount rates favor projects whose
benefits accrue over a long period of time.
• The higher the rate of discount, the smaller
will be the present value of the benefits
that accrue to society in the remote future &
vice versa.

The Discount Rate(r )
Two basic arguments regarding r determination:
i. Public sector projects must reflect, the social
opportunity cost of the funds, revealed in the market.
• If fund is generated from saving , use consumption
rate of interest.
• If funds are generate from taxes, use saving rate of
interest net of taxes.
• If funds are from competing investment (crowd out
private investment), use the rate of return on private
investment
• Practically it is difficult to identify the source of funds.
• Thus, take the average of:
 after tax rate of return on saving &
 before tax rate of returns on investment to determine
the discount rate.

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