Cfm 307, public sector

PUBLIC SECTOR FINANCE
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Unit Code: CFM 307
Instructor: Abraham Rotich
Cell No: 0723737296
Introduction
This module covers public sector finance. We will discuss the meaning of public finance, nature
of public sector, the importance of the public sector in any economy, taxation, government
borrowing, budgeting, public sector auditing and public sector restructuring.
Specific objectives:
At the end of the module you should be able:
1) To understand the importance of public sector in any economy
2) To understand the sources of government revenue
3) Understand government borrowing and its implications
4) Understand the various budgeting techniques in government
5) Understand public sector audit
6) Understand public sector restructuring

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Table of Content:
Introduction..................................................................................................................................... 2
Specific objectives:.......................................................................................................................... 2
Lesson 1:......................................................................................................................................... 4
INTRODUCTION TO PUBLIC SECTOR FINANCE..................................................................... 4
Lesson 2:....................................................................................................................................... 14
GOVERNMENT EXPENDITURE ................................................................................................ 14
TOPIC 3:....................................................................................................................................... 22
GOVERNMENT REVENUE & FISCAL POLICY ADMINISTRATION ....................................... 22
Lecture 4 ....................................................................................................................................... 31
GOVERNMENT BORROWING & DEBT FINANCING............................................................... 31
TOPIC 5........................................................................................................................................ 38
LECTURE 5: BUDGETING TECHNIQUES................................................................................ 38
Lesson 6:....................................................................................................................................... 46
PERFORMANCE BASED BUDGETING..................................................................................... 46
LECTURE 7:................................................................................................................................. 55
PUBLIC SECTOR AUDITING ..................................................................................................... 55
TOPIC 8:....................................................................................................................................... 61
PUBLIC SECTOR RESTRUCTURING ........................................................................................ 61

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Lesson 1:
INTRODUCTION TO PUBLIC SECTOR FINANCE
1.1 Introduction
This lesson introduces you to the concept of public sector finance. We will discuss the meaning
of public finance, nature of public sector and the importance of the public sector in any economy.
1.3 Lecture Outline
1.3.1 Definition of public sector
1.3.2 Importance of public sector
1.4 Lecture
WHAT IS FINANCE: DEF 1?
Finance is the study of how investors allocate their assets over time under conditions of certainty
and uncertainty. A key point in finance, which affects decisions, is the time value of money,
which states that a unit of currency today is worth more than the same unit of currency
tomorrow. Finance aims to price assets based on their risk level, and expected rate of return.
1.2 Specific objectives:
At the end of the lecture you should be able:
To understand the nature of the public sector
1) To understand the importance of public sector in any economy
2) To understand the differences in the financial management in the public sector
as opposed to the private sector

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Finance can be broken into three different sub categories: public finance, corporate finance and
personal finance.
WHAT IS FINANCE: DEF 2?
"Finance" is a broad term that describes the study of how money is managed and the actual
process of acquiring needed funds. Because individuals, businesses and government entities all
need funding to operate, the field is often separated into three sub-categories: personal finance,
corporate finance and public finance. All three categories are concerned with activities such as
pursuing sound investments, obtaining low-cost credit, allocating funds for liabilities, and
banking.
DEF 1: PUBLIC SECTOR
The public sector, sometimes referred to as the state sector or the government sector, is a part of
the state that deals with either the production, ownership, sale, provision, delivery and allocation
of goods and services by and for the government or its citizens, whether national, regional or
local/municipal. Examples of public sector activity may include; delivering social security,
administering urban planning and organizing national defense. The organization of the public
sector (public ownership) can take several forms, including:
 Direct administration funded through taxation; the delivering organization generally has
no specific requirement to meet commercial success criteria, and production decisions are
determined by government.
 Publicly owned corporations (in some contexts, especially manufacturing, "state-owned
enterprises"); which differ from direct administration in that they have greater
commercial freedoms and are expected to operate according to commercial criteria, and
production decisions are not generally taken by government (although goals may be set
for them by government).
DEF 2: PUBLIC SECTOR
The public sector refers to the wide range of economic and social activities undertaken by the
central government, state government, municipalities and other public bodies. The public sector
is usually being guided by social and public welfare objectives. Its primary objective is the
promotion of social and economic interest for the community as a whole. The private sector, on
the other hand, stands for the economic and social activities, performed under private ownership.
The most important objective of the private sector is to maximize private profit. However, the
private sector is not completely free from state regulation. There are certain positive controls and
negative controls through which the government regulates this sector. Positive controls take the
form of various incentives and inducements provided by the state, in the form of subsidies, tax
holidays, easy credit facilities, technical assistance, etc., for the promotion of private investment

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and private enterprise. The negative controls aim at limiting private economic activities through
administrative restrictions.
PUBLIC FINANCE: DEF 1
Public finance describes finance as related to sovereign states and sub-national entities
(states/provinces, counties, municipalities, etc.) and related public entities (e.g. school districts)
or agencies. It is concerned with:
 Identification of required expenditure of a public sector entity
 Source(s) of that entity's revenue
 The budgeting process
 Debt issuance (municipal bonds for public works projects
Public finance deals with the finances of public. It thus deals with the finances of government.
The finances of the government include the raising and disbursement of government funds. It is
concerned with the operation of the public treasury.
The study of public finance has assumed increasing importance in the recent decades. Several
factors contributed this trend. The money expenditures and the money receipts of the government
may affect not only the pattern of production and the distribution of the total product among the
various income receivers, but also the levels aggregate output and prices within the economy.
Public finance includes four major divisions: public revenue, public expenditure, public debt,
and fiscal formulation and administration.
It is the study of how the government (or public) sector pays for (or finances) expenditures
through taxes and borrowing. Governments produce or provide valuable goods and services,
such as education, security, and transportation. They pay for these goods by collecting taxes or,
if taxes fall short, by borrowing through the financial markets. Public finance is also key to the
study of government stabilization policies that address the inflation and unemployment problems
of business cycles. In addition to managing money for its day-to-day operations, a government
body also has larger social responsibilities. Its goals include attaining an equitable distribution of
income for its citizens and enacting policies that lead to a stable economy.

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JUSTIFICATION FOR GOVERNMENT INTERVENTION
The proper role of government provides a starting point for the analysis of public finance. In
theory, under certain circumstances, private markets will allocate goods and services among
individuals efficiently (in the sense that no waste occurs and that individual tastes are matching
with the economy's productive abilities). If private markets were able to provide efficient
outcomes and if the distribution of income were socially acceptable, then there would be little or
no scope for government. In many cases, however, conditions for private market efficiency are
violated e.g. if many people can enjoy the same good at the same time (non-rival, non-excludable
consumption), then private markets may supply too little of that good. National defense is one
example of non-rival consumption, or of a public good.
Public Good: Goods which all enjoy in common in the sense that each individual's consumption
of such a good leads to no subtractions from any other individual's consumption of that good...
Market failure occurs when private markets do not allocate goods or services efficiently. The
existence of market failure provides an efficiency-based rationale for collective or governmental
provision of goods and services. Externalities, public goods, informational advantages, strong
economies of scale, and network effects can cause market failures.
Excludable Non-Excludable
Rival Private goods
food, clothing, cars, personal
electronics
Common good (Common-pool
resources
fish stocks, timber, coal
Non-
Rivalries’
Club goods
cinemas, private parks, satellite
television
Public goods
free-to-air television, air, national
defense
THE ROLE OF PUBLIC SECTOR IN THE ECONOMY
In the developing countries also the growth of public sector has been phenomenal.
Information Control
To ensure that the general public has adequate information to make informed choices, the
government ensures that businesses make available all necessary information to the public. This

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includes proper labeling on all goods available for sale. In this way, the government protects
public health and safety.
Monopoly Control
To keep any one business or company from becoming too powerful and cornering the
marketplace, the government has created antitrust laws to control or break up any monopolies.
This allows the consumer to have a variety of fair options in the market to choose from.
Regulation Control
To ensure that businesses are held accountable for their actions, the government has created strict
regulations for each different type of business. Individual businesses must take ownership of any
negative effects created while doing business. An example of a business creating negative effects
includes a factory creating pollution.
To Drive Economic Development
Most countries desire to achieve a high rate of economic development. However, the resources
required to achieve the desired growth far exceeds the resources of local private enterprise and
spontaneous market machinery." Thus the central government will proactively intervene through
the concept of state entrepreneurship. In many developing, the key branches of the economy
mostly belong/belonged to the public sector. The governments also proactively intervene to
encourage the public sector, by providing different inputs and services to support economic
agenda/growth.
Avoid Concentration of Economic Power
Private enterprises are controlled by a very small group of people. In India, for instance, in the
seventies 35 per cent of the assets of all private companies were controlled by eight business
houses. In Iran 45 families controlled 85 per cent of the largest companies in 1977. The most
effective remedy for such concentration perhaps would be outright nationalization. But as the
private sector exercises a lot of political, economic power, it may not be an easy task. So to
provide an alternative or counterbalancing force for economic power, the public sector comes to
the picture.
Industrialization
Industrialization is the most important requisite for economic development. Industrialization in
the developing countries necessitates the extension of the public sector. "In the developing
countries the state is the only force that possesses the necessary levers for influencing the
economy, the means for mobilizing and properly utilizing financial, natural, labor and material
resources, applying scientific and technological achievements and overcoming a number of
difficulties and contradictions typical of developing countries. Owing to these factors, its
functions are not confined to regulating the economy; it has been taking an increasing and direct
part in its industrialization." The public sector has been a major in countries like Brazil, Mexico,

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Argentina, Egypt and Turkey, etc. also the public sector has been used as a major instrument for
industrialization.
Promotion of Science and Technology & Research
Scientific and Technological revolution has an important bearing on economic development. The
public sector has become the instrument for the development of science and technology and also
the vehicle for the application of scientific and technological achievements in industrial and
agricultural production. Although in the developing countries in the beginning, the scientific
potential may not be very significant but it is mostly confined to the public sector.
Planning
Economic planning also has provided a stimulus to public sector in many countries. Expansion
of the public sector is essential to make planning more effective.
Public Utilities
There are certain types of services known as public utilities. Electricity, city transportation, water
supply, railways, etc., are the examples of public utilities. The provision of these services needs
huge investment. They are also monopolistic in nature. It has been realized that these services
can be provided efficiently, economically and continuously only when the public utilities will be
owned and operated by the state. So even in the capitalist countries, such public utilities
invariably operate in the public sector.
Resource Allocation
The nature and pattern of resource allocation has an important bearing on economic
development. The main reason for the expansion of the public sector in India, for example, lies
in the pattern of resource allocation fixed in the plans. The nature and volume of public
investment substantially affects the tone and texture of economic activity.
Prevent Exploitation
Sometimes the monopolist private producers have a tendency to reduce their output and raise the
prices, and thus exploit the consumers in the process. Public takeover through nationalization is a
method by which exploitation of consumers can be prevented. To protect the interest of the
passengers, road transport has been nationalized in many states in India. Similarly, to protect the
interests of the workers, sometimes enterprises may be taken over by the state. For example, 13
losing 'sick' textile mills were nationalized mainly to provide employment to the workers
concerned.

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The Difference between the Private and Public Sector
It is important to understand the difference between the private sector and public sector
because your privacy rights will differ depending on the legislation that an organization is
governed under.
The Private Sector
The private sector is usually composed of organizations that are privately owned and not part of
the government. These usually includes corporations (both profit and non-profit), partnerships,
and charities.
An easier way to think of the private sector is by thinking of organizations that are not owned or
operated by the government. For example, retail stores, credit unions, and local businesses will
operate in the private sector.
The Public Sector
The public sector is usually composed of organizations that are owned and operated by the
government. This includes federal, provincial, state, or municipal governments, depending on
where you live. Privacy legislation usually calls organizations in the public sector a public body
or a public authority
What Are the Fundamental Differences Between Public and Private Sector Financial
Management?
Financial management in the public sector and private sector differ significantly. Those who
have experience in one of these areas may not necessarily be ready for financial management in
the other sector due to some of these differences. In the "Journal of Management Studies,"
George A. Boyne points out the fact that many theorists hold that the differences are so great that
use of private sector management in the public sector should be avoided.
Accounting
Accounting methods used in both private and public sector financial management differ
significantly. For instance, in the private sector, financial managers and accountants are bound
by the Generally Accepted Accounting Principles, or GAAP, methodology for accounting. This

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is a set of practices, such as the double-entry accounting method, used to ensure financial
accuracy and uniformity. In the public sector, these methods may also be used, but it is not that
unusual to deviate from them, as well. This is seen in areas such as budgeting where public
sector financial managers are not necessarily bound by accrual accounting methods.
Profit
Government agencies are not necessarily profit-driven in the same way that private businesses
and corporations tend to be. In the private sector, financial managers are generally motivated by
profit and pushed to maintain a bottom line or a minimum level of profitability. On the other end
of the spectrum are the financial managers in the public sector who do not necessarily have a
bottom line to maintain. Instead, they may be task-oriented or driven by some other motivating
force endemic to the specific type of work the organization is focused on daily.
Context
Another fundamental difference between public and private financial managers is the context in
which they operate. This context can make all the difference when it comes to how each
approaches his work. The profit-driven financial manager in the private sector will generally
have the leeway to get done what needs to be done in order to maintain the bottom line. With
public sector financial managers, various constraints may prevent the manager from acting with a
great deal of autonomy. The manager may be subject to legislative and regulatory constraints
that prevent autonomous action. The political framework of the public sector may pit
bureaucratic financial managers against elected officials on occasion, causing significant
limitations to getting the job done.
Decisions
The differences in the decision-making process between public and private sector financial
managers are closely related to the context of operation. In private sector financial management,
decisions are generally made from the top and are filtered down through the hierarchy of the
business as the financial manager hands off the orders or directions to those below him on the
company food chain. In public sector management, it is not so simple. Public sector financial
managers often have to work with political constituencies and navigate between competing
interest groups. Important financial decisions are often rendered by creating coalitions and
support. Decisions cannot typically be handed down and passed off to the next in command
without some type of public sanction or approval

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2.5 Activities
1. Identify the role of the public sector in your locality
1.6 Summary
In this lecture you have learnt that:
1. That the public sector is different in from the private sector
2. That financial management in the public sector is different from financial
management in the private sector
3.That the public sector plays an important role in any economy.
2.6 Self – Test Questions
i) Do we need the public sector?
ii) Why is financial management in the public sector different from the financial
management in the private sector?

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1.7 Suggestion for further reading
1. Gruber, J. (2010). Public Finance and Public Policy (3rd
Edition), Worth Publishers. On
reserve in the Law Library.
2. Mikesell, J.(2010). Fiscal Administration: Analysis and Applications for the Public Sector (8th
Edition). Wadsworth Publishing.
3. Rosen, Harvey S. and Ted Gayer (2010). Public Finance (9th
Edition), McGraw Hill. On reserve
in the Law Library.
3.

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Lesson 2:
GOVERNMENT EXPENDITURE
1.2 Introduction
This lesson introduces you to the concept of public expenditure. We will discuss the
classification of public expenditure as well as monetary and fiscal policy.
1.5 Lecture Outline
1.5.1 Classification of public expenditure
1.5.2 Fiscal and Monetary policy
1.3.1: Classification of public expenditure
Government spending or government expenditure includes all government consumption and
investment but excludes transfer payments made by a state.
There are 3 main categories of government expenditure are:
a. Government final consumption expenditure - Government acquisition of goods and
services for current use to directly satisfy individual or collective needs of the members
of the community.
These can include:
 Military acquisitions
 Funding for defense
 Education expenditure
1) To understand the nature of public expenditure
2) To understand the importance of fiscal and monetary policy

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 Government administrative costs.
 Provision of public housing
 Provision of health services
 Imports of goods
b. Government investment (gross fixed capital formation) – This is government
acquisition of goods and services intended to create future benefits. Government
investment is normally driven by capital goods which are tangible objects that are used in
the production of other goods or commodities or during the providing of services. They
can include things such as buildings, machinery, tools, computers and any other
equipment that is used to make or do something else, which can then be sold to another
party. The means of production might be owned by individuals, businesses, organizations
or governments. This term also refers to any material used or consumed while other
goods are being produced or services are being provided. This expenditures normally
have a futuristic outlook and long-term survival of a country and include:
 Government-subsidized housing construction.
 Infrastructure investment (roads, airport, water services provision systems)
 Technological research
c. Transfer payments - Government expenditures that are not acquisition of goods and
services, and instead just represent transfers of money. These include:
 Social security payments
 Pension plans,
 Social Security,
 Unemployment benefits.
 Redistribution of national government funds to regional or local governments.
Since these types of expenditures are redistributive, rather than directly
consumptive in function, they are usually considered a distinct category of
spending.
d. Other types of government spending – These may include interest payments on debts
or payments against an annual deficit. The phrase “paying down the deficit” refers to
government funds used to reduce the difference between revenues and budget. Since
most modern governments operate in deficit, it is unusual for a national debt to ever be
completely paid off. Regional and local governments, however, may be less able to
operate in deficit, and thus often do a better job of remaining in balance.
The first two types of government spending, final consumption expenditure and gross capital
formation, together constitute one of the major components of gross domestic product.

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1.3.2: Fiscal Policy
This is the use of government revenue collection (taxation) and expenditure (spending) to
influence the economy. The two main instruments of fiscal policy are government taxation and
changes in the level and composition of taxation. Government spending can affect the following
variables in the economy:
 Aggregate demand and the level of economic activity;
 The pattern of resource allocation;
 The distribution of income.
The three main types of fiscal policy are:
 Neutral fiscal policy is usually undertaken when an economy is in equilibrium.
Government spending is fully funded by tax revenue and overall the budget outcome has
a neutral effect on the level of economic activity.
 Expansionary fiscal policy involves government spending exceeding tax revenue, and is
usually undertaken during recessions.
 Contractionary fiscal policy occurs when government spending is lower than tax revenue,
and is usually undertaken to pay down government debt.
However, these definitions can be misleading because, even with no changes in spending or tax
laws at all, cyclic fluctuations of the economy cause cyclic fluctuations of tax revenues and of
some types of government spending, altering the deficit situation; these are not considered to be
policy changes. Therefore, for purposes of the above definitions, "government spending" and
"tax revenue" are normally replaced by "cyclically adjusted government spending" and
"cyclically adjusted tax revenue". Thus, for example, a government budget that is balanced over
the course of the business cycle is considered to represent a neutral fiscal policy stance.
 Government spending is deeply scrutinized and nearly always criticized in one way or
another. For countries that operate with a heavy debt load, the debate frequently revolves
around which type of expenditure should be reduced, rather than whether spending
should be cut.
 In the polarizing light of political debate, the finer points of economic theory and
reasonable governing are often lost, making it very difficult for many citizens to
understand how expenditure decisions are made, and what the likely effects of reduction
or expansion of spending will be.
 Since most government spending is funded primarily through tax revenues from its
citizens, this confusion and disconnect between people that provide the funding and
people that make spending decisions can often lead to a hostile political climate.

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Monetary Policy
 Monetary policy is the process by which the monetary authority of a country controls the
supply of money, often targeting a rate of interest for the purpose of promoting economic
growth and stability. The goals usually include relatively stable prices and low
unemployment.
 Monetary theory provides insight into how to craft optimal monetary policy. It is referred
to as either being expansionary or contractionary, where an expansionary policy increases
the total supply of money in the economy more rapidly than usual, and contractionary
policy expands the money supply more slowly than usual or even shrinks it.
 Expansionary policy is traditionally used to try to combat unemployment in a recession
by lowering interest rates in the hope that easy credit will entice businesses into
expanding while contractionary policy is intended to slow inflation in order to avoid the
resulting distortions and deterioration of asset values.
Monetary Policy Tools
Monetary base
Monetary policy can be implemented by changing the size of the monetary base. Central banks
use open market operations to change the monetary base. The central bank buys or sells reserve
assets (usually financial instruments such as bonds) in exchange for money on deposit at the
central bank. Those deposits are convertible to currency. Together such currency and deposits
constitute the monetary base which is the general liabilities of the central bank in its own
monetary unit.
Reserve requirements
The monetary authority exerts regulatory control over banks. Monetary policy can be
implemented by changing the proportion of total assets that banks must hold in reserve with the
central bank. Banks only maintain a small portion of their assets as cash available for immediate
withdrawal; the rest is invested in illiquid assets like mortgages and loans. By changing the
proportion of total assets to be held as liquid cash, the Federal Reserve changes the availability
of loan able funds. This acts as a change in the money supply. Central banks typically do not
change the reserve requirements often because it creates very volatile changes in the money
supply due to the lending multiplier.
Discount window lending
The interest rate charged (called the 'discount rate') is usually set below short term interbank
market rates Accessing the discount window allows institutions to vary credit conditions (i.e., the
amount of money they have to loan out), thereby affecting the money supply.

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Central banks normally offer a discount window, where commercial banks and other depository
institutions are able to borrow reserves from the Central Bank to meet temporary shortages of
liquidity caused by internal or external disruptions. This creates a stable financial environment
where savings and investment can occur, allowing for the growth of the economy as a whole.
Interest rates
The contraction of the monetary supply can be achieved indirectly by increasing the nominal
interest rates. Monetary authorities in different nations have differing levels of control of
economy-wide interest rates.
In other nations, the monetary authority may be able to mandate specific interest rates on loans,
savings accounts or other financial assets. By raising the interest rate(s) under its control, a
monetary authority can contract the money supply, because higher interest rates encourage
savings and discourage borrowing. Both of these effects reduce the size of the money supply.
Classification of Public Expenditure
Classification of Public expenditure refers to the systematic arrangement of different items on
which the government incurs expenditure.
Different economists have looked at public expenditure from different point of view. The
following classification is a based on these different views.
1. Functional Classification
Some economists classify public expenditure on the basis of functions for which they are
incurred. The government performs various functions like defense, social welfare, agriculture,
infrastructure and industrial development. The expenditure incurred on such functions fall under
this classification. These functions are further divided into subsidiary functions. This kind of
classification provides a clear idea about how the public funds are spent.
2. Revenue and Capital Expenditure
 Revenue expenditure is current or consumption expenditures incurred on civil
administration, defense forces, public health and education, maintenance of government
machinery. This type of expenditure is of recurring type which is incurred year after year.
 On the other hand, capital expenditures are incurred on building durable assets, like
highways, multipurpose dams, irrigation projects, buying machinery and equipment.
They are non recurring type of expenditures in the form of capital investments. Such
expenditures are expected to improve the productive capacity of the economy.

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3. Transfer and Non-Transfer Expenditure
A.C. Pigou, the British economist has classified public expenditure as:-
 Transfer expenditure
 Non-transfer expenditure
(i).Transfer Expenditure:-
Transfer expenditure relates to the expenditure against which there is no corresponding return.
Such expenditure includes public expenditure on:-
1. National Old Age Pension Schemes,
2. Interest payments,
3. Subsidies,
4. Unemployment allowances,
5. Welfare benefits to weaker sections, etc.
By incurring such expenditure, the government does not get anything in return, but it adds to the
welfare of the people, especially belong to the weaker sections of the society. Such expenditure
basically results in redistribution of money incomes within the society.
(ii). Non-Transfer Expenditure:-
The non-transfer expenditure relates to expenditure which results in creation of income or output.
The non-transfer expenditure includes development as well as non-development expenditure that
results in creation of output directly or indirectly.
 Economic infrastructure such as power, transport, irrigation, etc.
 Social infrastructure such as education, health and family welfare.
 Internal law and order and defense.
 Public administration, etc.
By incurring such expenditure, the government creates a healthy conditions or environment for
economic activities. Due to economic growth, the government may be able to generate income in
form of duties and taxes.
4. Productive and Unproductive Expenditure
This classification was made by Classical economists on the basis of creation of productive
capacity.
(i). Productive Expenditure:-

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Expenditure on infrastructure development, public enterprises or development of agriculture
increase productive capacity in the economy and bring income to the government. Thus they are
classified as productive expenditure.
(ii). Unproductive Expenditure:-
Expenditures in the nature of consumption such as defense, interest payments, expenditure on
law and order, public administration, do not create any productive asset which can bring income
or returns to the government. Such expenses are classified as unproductive expenditures.
5. Development and Non-Development Expenditure
Modern economists have modified this classification into distinction between development and
non-development expenditures.
(i). Development Expenditure:-
All expenditures that promote economic growth and development are termed as development
expenditure. These are the same as productive expenditure.
(ii). Non-Development Expenditure:-
Unproductive expenditures are termed as non development expenditures.
6. Classification According to Benefits
Public expenditure can be classified on the basis of benefits they confer on different groups of
people.
(i). Common benefits to all: Expenditures that confer common benefits on all the people. For
example, expenditure on education, public health, transport, defense, law and order, general
administration
(ii). Special benefits to all: Expenditures that confer special benefits on all. For example,
administration of justice, social security measures, community welfare.
(iii). Special benefits to some: Expenditures that confer direct special benefits on certain people
and also add to general welfare. For example, old age pension, subsidies to weaker section,
unemployment benefits.
7. Hugh Dalton's Classification of Public Expenditure
Hugh Dalton has classified public expenditure as follows:-
(i).Expenditures on political executives: i.e. maintenance of ceremonial heads of state,
like the president.
(ii). Administrative expenditure: to maintain the general administration of the country,
like government departments and offices.

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(iii).Security expenditure: to maintain armed forces and the police forces.
(iv). Expenditure on administration of justice: include maintenance of courts, judges,
public prosecutors.
(v). Developmental expenditures: to promote growth and development of the economy,
like expenditure on infrastructure, irrigation, etc.
(vi). Social expenditures: on public health, community welfare, social security, etc.
(vii). Pubic debt charges: include payment of interest and repayment of principle
amount.
2.5 Activities
1. Identify the nature of public expenditure in kenya
i) Whats the difference between fiscal policy and monetary policy
Recommended Course Text Books
1. Richard A. and Peggy B. Musgrave, Public Finance in Theory and Practice, Fifth
Edition (New
York: McGraw Hill, 1989).
2. Harvey S. Rosen and Ted Gayer, Public Finance, Eighth Edition (New York:
McGraw-
Hill/Irwin, 2007).
3. Jonathan Gruber, Public Finance and Public Policy, Second Edition (New York:
Worth
Publishers, 2007).
4. Samuel H. Baker and Catherine S. Elliott, eds., Readings in Public Sector Economics
(Lexington, MA: D.C. Heath and Co., 1990).

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TOPIC 3:
GOVERNMENT REVENUE & FISCAL POLICY ADMINISTRATION
Sources of government
1.3 Introduction
This lesson introduces you to the concept government sources of government revenue and fiscal
policy administration.
1.6 Lecture Outline
1.6.1 Revenue from taxation
1.6.2 Revenue from non tax sources
1.7 Lecture
1.4.1: Revenue from taxation
1) Definition of government Revenue
2) Sources of Government Revenues
I. Tax Revenues
a) Definition of Taxation
b) Canon of Tax
c) Characteristics of a good Taxation System
d) Types of Taxes
I. Direct Taxes
II. In-Direct Taxes.
II. Non- Tax Revenues
1) To understand the sources of government revenue
2) To understand the administration of fiscal policy

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DEFINITION OF GOVERNMENT REVENUE
Government revenue – It is an income received by a government. It’s the opposite of government
spending. Government revenue is an important part of fiscal policy. Revenue may be from
taxation or non-tax revenue, such as revenue from government-owned corporations or sovereign
wealth funds.
SOURCES OF GOVERNMENT
Sources of government revenues can be divided into two broad categories:
 Tax revenues (direct & in-direct taxes)
 Non-tax revenues
TAX REVENUES
Definition of Tax
Def 1
It is a fee charged ("levied") by a government on a product, income, or activity. If tax is levied
directly on personal or corporate income, then it is a direct tax. If tax is levied on the price of a
good or service, then it is called an indirect tax. The purpose of taxation is to finance government
expenditure. One of the most important uses of taxes is to finance public goods and services,
such as street lighting and street cleaning.
Def 2
Its is a compulsory monetary contribution to the state's revenue assessed and imposed by a
government on the activities, enjoyment expenditure, income, occupation, privilege, property,
etc., of individuals and organizations.
Def 3
Taxes are compulsory payments to government without expecting direct benefit or return by the
tax payer. Taxes collected by Government are used to provide common benefits to all mostly in
form of public welfare services. Taxes do not guarantee any direct benefit for person who pays
the tax. It is not based on direct quid pro quo principle.
Def 4
A tax is a compulsory contribution to the public authority to cover the cost of services rendered
by state for the general benefit of its people. "Taxes are generally compulsory contributions of
wealth levied upon persons, natural or corporate to defray the expense incurred in conferring a
common benefit upon the residents of the state". The definition brings out the following: First, a
tax is a compulsory payment to the public authority. Secondly, a tax is to be paid by a person on
whom it is levied whether he derives any benefit from it or not. Thirdly, a person who pays
taxes to the state cannot claim that because he pays taxes, therefore, a specific service in return
should be provided to him. For instance, he cannot demand that a constable should be posted at

24
his residence to protect his property at night. The government spends money which it derives
from taxes in maintaining law and order in the country and like other individuals he gets benefit
from it. There is no direct quid pro quo (direct return) in the case of a tax.
Def 5
"A tax is a compulsory contribution made to government under stated conditions and not a return
for a specific service rendered".
There are three basic models of taxes. On the basis of those types, further types of taxes are
originated.
1. A proportional tax is a tax whose burden is the same proportion of income for all
households.
2. A progressive tax is a tax whose burden, expressed as a percentage of income, increases
as income increases.
3. A regressive tax is a tax whose burden, expressed as a percentage of income, falls as
income increases. Excise taxes (taxes on specific commodities) are regressive. The retail
sales tax is also regressive.
Canons of Taxation (Adam Smith)
1. Canon of Equity -The principle aims at providing economic and social justice to the people.
According to this principle, every person should pay to the government depending on his ability
to pay. The rich class people should pay higher taxes to the government, because without the
protection of the government authorities (Police, Defense, etc.) they could not have earned and
enjoyed their income. Taxes should be proportional to income, i.e., citizens should pay the taxes
in proportion to the revenue which they respectively enjoy under the protection of the state.
2. Canon of Certainty - The tax which an individual has to pay should be certain, not arbitrary.
The tax payer should know in advance how much tax he has to pay, at what time he has to pay
the tax, and in what form the tax is to be paid to the government. In other words, every tax
should satisfy the canon of certainty. At the same time a good tax system also ensures that the
government is also certain about the amount that will be collected by way of tax.
3. Canon of Convenience - The mode and timing of tax payment should be as far as possible,
convenient to the tax payers. For example, land revenue is collected at time of harvest income
tax is deducted at source. Convenient tax system will encourage people to pay tax and will
increase tax revenue.
4. Canon of Economy -This principle states that there should be economy in tax administration.
The cost of tax collection should be lower than the amount of tax collected. It may not serve any

25
purpose, if the taxes imposed are widespread but are difficult to administer. Therefore, it would
make no sense to impose certain taxes, if it is difficult to administer.
5. Canon of Productivity - It is also known as the canon of fiscal adequacy. According to this
principle, the tax system should be able to yield enough revenue for the treasury and the
government should have no need to resort to deficit financing. This is a good principle to follow
in a developing economy.
6. Canon of Elasticity - Every tax imposed by the government should be elastic in nature. In
other words, the income from tax should be capable of increasing or decreasing according to the
requirement of the country. For example, if the government needs more income at time of crisis,
the tax should be capable of yielding more income through increase in its rate.
7. Canon of Flexibility - It should be easily possible for the authorities to revise the tax structure
both with respect to its coverage and rates, to suit the changing requirements of the economy.
With changing time and conditions the tax system needs to be changed without much difficulty.
The tax system must be flexible and not rigid.
8. Canon of Simplicity - The tax system should not be complicated. That makes it difficult to
understand and administer and results in problems of interpretation and disputes. In India, the
efforts of the government in recent years have been to make the system simple.
9. Canon of Diversity - The government should collect taxes from different sources rather than
concentrating on a single source of tax. It is not advisable for the government to depend upon a
single source of tax, it may result in inequity to the certain section of the society; uncertainty for
the government to raise funds. If the tax revenue comes from diversified source, then any
reduction in tax revenue on account of any one cause is bound to be small.
Characteristics of a Good Tax System
The following are the characteristics of a tax:-
1. A tax is a compulsory payment made to the government. People on whom a tax is
imposed must pay the tax. Refusal to pay the tax is a punishable offence.
2. There is no quid pro quo between a taxpayer and public authorities. This means that the
tax payer cannot claim any specific benefit in return for the payment of a tax.
3. Every tax involves some sacrifice on part of the tax payer.
4. A tax is not levied as a fine or penalty for breaking law.
5. The primary aim of the tax should be to raise revenue for public services.
6. People should be asked to pay taxes according to their ability to pay and assessment of
their taxable capacity should be made primarily on the basis of income and property.

26
7. Tax should not be discriminatory in any aspect between individuals and also between
various groups.
Types of Taxes
(i). Direct Taxes – These are taxes which are collected directly from income and
wealth are known as direct taxes.
(a). Types of Direct Taxes.
Income tax - Income tax is collected on all incomes received by private individuals after
certain allowances are made. In most of the economies Income tax is a major source of
Government revenue.
Corporation tax -This tax is levied on profits earned by companies. It is a proportional tax
which is levied at the constant rate.
Petroleum tax - It is a tax levied on the profits of companies involved in drilling of oil and
gas. This tax is not universal.
Capital gains tax - Capital gains tax is charged on the profit realized on the sale of a non-
inventory asset that was purchased at a lower price. The most common capital gains are
realized from the sale of stocks, bonds, precious metals and property. Not all countries
implement a capital gains tax and most have different rates of taxation for individuals and
corporations.
Property Tax - Many countries have Property tax, or millage tax. It is the tax which the
owner pays on the value of the property being taxed. The taxing authority requires and/or
performs an appraisal of the monetary value of the property, and tax is assessed in
proportion to that value. Forms of property tax used vary between countries and
jurisdictions.
Stamp duty - Stamp duty is a form of tax that is levied on documents relating to immovable
property, stocks and shares. Apart from transfers of shares and securities, stamp duties are
also charged on the issue of bearer instruments and certain transactions involving
partnerships.

27
Direct Taxes - The Case of Kenya
The Kenyan Income Tax Department administers various direct taxes, which have different
rates:
a) Pay As You Earn (PAYE) - PAYE is a method of collecting tax at source from
individuals in gainful employment. The employer deducts a certain amount of tax from his
/ her employee's salary or wages on each payday then remit the tax to the Authority. This
relieves the employee from paying taxes at the end of the year and shifts the responsibility
to the employers. Every individual who receives income is granted a tax credit or a tax
relief from the Authority, this is known as Personal Relief. Insurance relief and mortgage
relief are also available for eligible persons. The total tax credit is spread evenly during the
charge year. At the end of the year, an individual will submit his self-assessment on total
income received from various sources. Should the tax credit be lower than actual tax
charged during the year, the balance of tax due will be payable.
b) Corporation Tax - Corporation tax is a form of income tax that is levied on
companies. Resident companies are taxable at a rate of 30% w.e.f year of income 2000
while non - resident companies are taxable at a rate of 37.5%.w.e.f year of income 2000.
c) Withholding Tax - Withholding taxes are deducted at source from the following
sources of income: Interest, dividends, royalties, management or professional fees,
commissions, pension or retirement annuity, rent, appearance or performance fees for
entertaining, sporting or diverting an audience.
d) Advance Tax - Advance tax is applicable to Matatus and other Public Service
Vehicles. It is not a final tax, but a tax partly paid in advance before a public service
vehicle or a commercial vehicle is registered or licensed.
(ii). In-Direct Taxes
These are taxes that are collected by some intermediaries from the taxpayers and then the money
is deposited in the treasuries. The term refers to all those taxes like the sales tax; value added tax
and goods and services tax, which are not paid directly to the government. Indirect taxes are flat
taxes: Everyone who buys or uses the goods or services is taxed at the same rate. Examples of
indirect taxes are fuel, alcohol, cigarette and the value added tax. These are called consumption
taxes.
Customs duty - These are the duties charged on imports / exports
 Protection to local manufacturing industry
 Trading blocs influence
 Administered by state agencies.

28
Sales tax – These are taxes administered at the point of sale of goods & services
 Largest contributor to the exchequer
 On imports and supply of goods
 Rate is 16% (all countries have different rates)
Excise Duty – its duty imposed mostly on production activities for sales purposes.
 Largely collected at manufacturing stage
 Showing downward trend
1.4.2: Non-Tax Revenues
Non-Tax Revenue – These are revenues obtained by the government from sources other then tax
is called Non-Tax Revenue. The sources of non-tax revenue are:-
1. Fees -Fees are another important source of revenue for the government. A fee is charged by
public authorities for rendering a service to the citizens. Unlike tax, there is no compulsion
involved in case of fees. The government provides certain services and charges certain fees for
them. For example, fees are charged for issuing of passports, driving licenses, etc.
2. Fines or Penalties - Fines or penalties are imposed as a form of punishment for breach of law
or non fulfillment or certain conditions or for failure to observe some regulations. Like taxes,
fines are compulsory payments without quid pro quo. But while taxes are generally imposed to
collect revenue, fines are imposed as a form of punishment or to prevent people from breaking
the law. They are not expected to be a major source of revenue to the government.
3. Surplus from Public Enterprises - The Government also gets revenue by way of surplus
from public enterprises. In India, the Government has set up several public sector enterprises to
provide public goods and services. Some of the public sector enterprises do make a good amount
of profits. The profits or dividends which the government gets can be utilized for public
expenditure. There is some sort of quid-pro-quo in the case of surplus from public enterprises.
This is because, the public gets goods and services, and the government gets prices, and
consequently profits from selling such goods and services.
4. Special assessment of betterment levy -It is a kind of special charge levied on certain
members of the community who are beneficiaries of certain government activities or public
projects. For example, due to a public park in a locality or due to the construction of a road,
people in that locality may experience an appreciation in the value of their property or land.
Thus, due to public expenditure, some people may experience 'unearned increments' in their asset
holding. Betterment levy is like a tax because it is a compulsory payment, but unlike a tax, in
case of betterment levy there is some element of quid pro quo.

29
5. Grants and Gifts - Gifts are Voluntary contributions by individuals or institutions to the
government. Gifts are significant source of revenue during war and emergency. A grant from one
government to another is an important source of revenue in the modern days. The government at
the Centre provides grants to State governments and the State governments provide grants to the
local government to carry out their functions. Grants from foreign countries are known as
Foreign Aid. Developing countries receive military aid, food aid, technological aid, etc. from
developed countries.
6. Deficit Financing - Deficit means an excess of public expenditure over public revenue. This
excess may be met by borrowings from the market, borrowings from abroad, by the central bank
creating currency. In case of borrowing from abroad, there cannot be compulsion for the lenders,
but in case of internal borrowings there may be compulsion. The government may force various
individuals, firms and institutions to lend to it at a much lower rate than the market would have
offered.
7. Goods and Services - As government operations become leaner and worn equipment is
replaced with newer models, officials find they have an excess of used equipment that can be
turned into cash. The public provides a ripe marketplace for used police cruisers, public buses,
heavy equipment, computer equipment and furniture. Public auctions provide money that can be
used to offset government costs. Employee services are also a revenue stream. Park employees
who lead guided walking tours and city trash services provide a stream of non-tax revenue that
helps ease reliance on taxes. Also, excess water and electricity capacity can be turned into dollars
when other counties or cities are running short.
8. Rent - Closed school buildings, empty state-owned buildings, and park shelter and reception
facilities are examples of facilities that can be rented out. Government agencies also earn rent
proceeds for the use of property by other agencies. For example, if the federal government needs
space in a small town, the feds might arrange to rent out an unused office in the town hall from
the municipality. Unusable properties are sold off.
9. Investments –Government sometimes use revenues as a means of earning interest and
dividends. While the investment might be made up of tax shillings, the interest, dividends and
capital gains are considered non-tax revenue. The investment opportunities might be in the form
of mutual funds, bonds, foreign exchange rates and government-backed loans to businesses and
individuals, such as small business loans and mortgages.
2.5 Activities
1. Get a copy of the finance bill for your county government and analyze the
sources of revenue for that county government

30
1.6 Summary
1.Government collects taxes from the public to finance operations
2. The taxation system should meet the cannons of taxation
3.The government can get revenue from sources other than taxation
i) List the sources of revenue for the government
ii) Outline the non tax sources of revenue
1 Recommended Course Text Books
Edition (New
McGraw-
Hill/Irwin, 2007).
Worth
Publishers, 2007).
4. Samuel H. Baker and Catherine S. Elliott, eds., Readings in Public Sector
Economics
3.

31
Lecture 4
GOVERNMENT BORROWING & DEBT FINANCING
4.1 Introduction
This lesson introduces you to the concept of public borrowing. We will discuss the nature of
public borrowing and its effects on the country’s economy.
4.3 Lecture Outline
1. Definition of government debt
2. Categories of government
3. Types of Government
4. Monetary Policy Tools (Open Market Operations)
5. International Financial Institutions
4.4 Lecture
DEFINITION OF GOVERNMENT DEBT
 Government debt (also known as public debt and national debt) is the debt owed b
 By contrast, the annual “government deficit” refers to the difference between government
receipts and spending a single year, that is, the increase of debt over a particular year.
 Government debt is one method of financing government operations, but it is not the only
method.
3) To understand the nature of public debt
4) To understand the consequences of government borrowing

32
 Governments usually borrow by issuing securities and government bonds. Less credit
worthy countries sometimes borrows directly from a supranational organization (e.g. the
World Bank) or international financial institutions.
 As the government draws its income from much of the population, government does
taxpayers.
CATEGORIES OF GOVERNMENT DEBT
Government debt can be generally be categorized as below:
a. Internal debt (owed to lenders within the country) or External debt (owed to foreign
lenders)
b. Sovereign debt - refers to government debt that has been issued in a foreign currency
c. Short term debt - generally considered to be for one year or less and le years while
medium term debt falls between these two boundaries.
TYPES OF GOVERNMENT DEBT
1. Government Debt Securities
a. Treasury Bills
Treasury bills are treasury securities having a maturity period of one year or less
and sold in the primary market by auction at a discount from face value. Upon
maturity the face value will be paid to the holder.
At present, treasury bills typically have 28-day, 91-day, and 182-day maturity
periods.
b. Debt Restructuring Bills
Debt restructuring bills are treasury securities having a maturity period of one
year or less and are sold by auction at a discount from face value. Upon maturity
the face value will be paid to the holder. Debt restructuring bill have a maturity
period based on number of days, between182-365 days.
c. Government Bonds
Government bonds are debt securities issued by the government, having a
maturity period of one year or longer. The primary objective is to finance the
budget deficit in each fiscal year or when the expenditures exceed the revenue, to
support social and economic development and to restructure public debt. Interest
payments of government bonds are made at regular intervals throughout the life of
the bonds, normally twice a year. Upon maturity, the principle of face value will
be paid along with the last interest payment.

33
2. State-Owned Enterprise Bonds (SOE Bonds)
State-owned enterprise bonds have a maturity period of one year or longer issued by
state-owned enterprise in which the state holds for more than 50% of total capital)
seeking funds for the state enterprise’s pi enterprise (SOE) bonds can be divided into two
types: guaranteed and non-guaranteed by the Ministry of finance (MOF). Interest
payments of SOE bonds are made at regular intervals throughout the life of the bonds,
normally twice a year. Upon maturity, the principal of face value will be paid along with
the last interest.
Justification Of Government Borrowing
Govt Borrowing can be acceptable under certain conditions
• Recession
If there is a downturn in the economy there will automatically be a fall in taxation and higher
govt spending on benefits, this will cause a budget deficit. However if the govt attempted to
solve the budget deficit by increasing the rate of taxes this would further deflate the economy
leading to lower growth and more unemployment. If there is a negative multiplier effect this may
actually cause the deficit to increase even more. A deficit does not simply stimulate demand. If
private investment is stimulated, that increases the ability of the economy to supply output in the
long run. Also, if the government's deficit is spent on such things as infrastructure, basic
research, public health, and education, that can also increase potential output in the long run.
Finally, the high demand that a government deficit provides may actually allow greater growth
of potential supply, following Verdoorn's Law.
Investment
If there is market failure in the economy such as under provision of education or public transport,
the govt should increase spending on these public services. In the short run this may cause a
deficit however if they increase productivity then in the future there will be a higher rate of
economic growth and more tax revenues.
Economic Effects of a Budget Deficit
 Increased borrowing
The government will have to borrow from the private sector, it does this by asking the central
bank to sell bonds to the private sector.

34
 Higher debt interest payments
Selling bonds will increase the national debt. The annual interest has a high opportunity cost
because it requires future generations to pay higher taxes.
 Higher Taxes and lower spending
In the future the govt may have to increase taxes or cut spending in order to reduce the deficit.
This may cause reduced incentives to work
 Increased Interest rates
If the govt sells more bonds this is likely to cause interest rates to increase. This is because they
will need to increase interest rates in order to attract investors to buy the extra debt.
If govt interest rates increase this will push up other interest rates as well.
Crowding Out
• Increased govt borrowing may cause a decrease in the size of the private sector (see fiscal
policy) .When a government borrows, generally it accepts bids, which are measured in
terms of their interest rate. When a government borrows, it captures as bids exactly as
much funds as it needs. To other borrowers, be they corporate, state or smaller, after the
central government borrows at the bid interest rate, that interest rate has become the base
for the prevailing interest rate. To the corporate borrower who must see the possibility of
profit from borrowing, the interest rate becomes a limbo stick, and a time comes when
they can no longer afford to borrow. They are then said to be "crowded out".
 Inflation:
o In extreme circumstances the govt may increase the money supply to pay the debt,
however this is unlikely to occur in the UK
o If the govt sells short term gilts to the banking sector then there will be an
increase in the money supply, this is because banks see gilts as near money
therefore they can maintain their lending to customers
Potential benefits of a budget deficit
1. Government borrowing can benefit economic growth: A budget deficit can have positive
macroeconomic effects in the long run if it is used to finance extra capital spending that
leads to an increase in the stock of national assets. For example, higher spending on the
transport infrastructure improves the supply-side capacity of the economy promoting

35
long-run growth. And increased public-sector investment in health and education can
bring positive effects on labour productivity and employment. The social benefits of
increased capital spending can be estimated through use of cost-benefit analysis.
2. The budget deficit as a tool of demand management: Keynesian economists would
support the use of changing the level of borrowing as a way of fine-tuning or managing
the level of aggregate demand. An increase in borrowing can be a stimulus to demand
when other sectors of the economy are suffering from weak spending. The argument is
that the government can and should use fiscal policy to keep real national output closer to
potential GDP so that we avoid a large negative output gap. Maintaining a high level of
demand helps to sustain growth and keep unemployment low.
MONETARY POLICY TOOLS
Monetary policy is the process by which the monetary authority of a country controls the
supply of money often targeting a rate of interest for the purpose of promoting economic
growth and stability. The official goals usually include relatively stable prices and low
unemployment. Monetary theory provides insight into how to craft optimal monetary
policy. It is referred to as either being:
a. Expansionary where an expansionary policy increases the total supply of money in
the economy more rapidly than usual. Expansionary policy is traditionally used to
try to combat unemployment in a re interest rates in the hope that easy credit will
entice businesses into expanding.
b. Contractionary policy expands the money supply more slowly than usual or even
shrinks’ it. Contractionary policy is intended to slow inflation in order to avoid the
resulting distortions and deterioration of asset values
Definition of ‘Open Market Operations — “OMO”
This is the buying and selling of government securities in the open market in order to exp
amount of money in the banking system. Purchases inject money into the banking system
am while sales of securities do the opposite.
How OMO works
The Treasury buys and sells government securities to set the money supply. This process
is called open market operations. The government securities that are used in open market
operations are Treasury Bills and Bonds. If Treasury wants to increase the money supply
in the economy it will buy securities. Conversely, if it wants to

36
Decrease the money supply, it will sell securities.
To increase the money supply in the market, it will purchase securities from banks. The
funds that the bank acquires from the sale can be used as loans to individuals and
businesses. The more money that is available in the market for lending, the lower the
rates on these loans become, which causes more borrowers to access cheaper capital.
This easier access to capital leads to greater investment and will often stimulate the
overall economy.
To decrease the money supply, CBK will sell securities to banks, which leads to money
being taken out of the banks and kept in CBK reserves. The decrease in money available
in the economy leads to a decrease in investment and spending as the availability of
capital decreases and it becomes more expensive to obtain. This limiting of access to
capital slows down economic growth as investment decrease.
INTERNATIONAL FINANCIAL INSTITUTIONS
 International Financial Institutions also play a very critical role in providing finances to
governments and more in developing countries. some of these bodies include:
a) IMF (International Monetary Fund)
b) IFC (International Finance Corporation)
c) The World Bank Group
4.5 Activities
1. Taking a case study of Greece, evaluate the consequences of government
borrowing on an economy
i) How can the government borrow?
ii) What are the consequences of government borrowing?

37
1.6 Summary
1. Types of government debt
2. The effects of government debt
3.Monetary tools
Edition (New
McGraw-
Hill/Irwin, 2007).
Worth
Publishers, 2007).
Economics

38
TOPIC 5
LECTURE 5: BUDGETING TECHNIQUES
1.4 Introduction
This lesson introduces you to the concept of public sector budgeting. We will discuss
incremental and zero base budgeting.
1.8 Lecture Outline
Under this topic we shall examine:
1. Definition of budgeting
2. Incremental Budgeting
3. Zero-based budgeting
1.9 Lecture
Definition and Meaning of Budgeting
Budgeting means different things to different people. Wilder Sky (1964) cited by Omolehiwa
(1995) gave definitions and interpretations given to a budget as follow:
1. A plan of work
2. A prediction
3. A link between financial resources and human behaviour to accomplish policy
objectives.
1) Explain the meaning of traditional method of budgeting.
2) Discuss the Zero Based Budgeting
3) Give the advantages and disadvantages of each type

39
4. A means for making choices among alternative expenditures
5. In the government it is a record for preferences that have prevailed the determination
of national policy.
However, according to CIMA (Chartered Institute of Management Accountants) a budget could
be defined as a plan stated in quantitative monetary terms which is prepared and approved prior
to a defined period of time usually showing planned income to be generated and, or expenditure
to be incurred during that period and capital to be employed to attain a given objective.
The need for a budget arises due to improvement of control in an organization. It forces
managers to be accountable for their decisions. So budget is a plan which is agreed in advance. It
must be a plan and not a forecast. A forecast is a prediction of what might happen in the future
whereas a budget is a planned outcome, which the firm hopes to achieve. A budget will show the
money needed for spending and how this might be raised or sourced. Budgets are based on the
objectives of businesses or corporate entities. Information included in a budget may include
revenue, sales, expenses, profit, personal, and cash and capital expenditure. For a state, it could
include capital and recurrent expenditure. These variables are known as budget factors which can
be given value.
Budgeting and financial management are at the core of economic and public sector reform
programs in most nations around the world. With the growing pressures for enhanced service
delivery and the challenges of budgetary crises and fiscal shocks, the need for improved budget
processes and innovative financial management techniques is especially critical in developing
and emerging economies.
To the government, budget usually serves as:
a) An estimate of revenue and expenditure for a given fiscal year;
b) A guide towards the execution of the year’s activities; and
c) An instrument of evaluating performance.
Based on the information above, budget in the public sector is normally used as an effective
instrument for the following.
a) As an instrument for economic policy
b) Instrument for effective management
c) Instrument for evaluating performance
The Traditional or Incremental Budgeting System
Traditional or Incremental Budgeting System is the type of Budgeting which involves the
utilization of the previous periods budgets thereby increasing it by a specific percentage;

40
considering the economic trends, inflations and fund availability, a new estimate is arrived at.
The proposed year’s budget = this year’s budget X inflation factor + cost of new activity.
This is also called line items budgeting system. It is also an input approach to budgeting. It is a
budgeting system which involves the utilization of the previous period budgets thereby
increasing it by a specific percentage (%) to arrive at a new Estimate with full consideration of
economic trends, inflation and fund availability. In this type of budget, attention is directed
towards changes that occur between existing appropriations and proposed expenditures. Such a
progress accepts existing base and examine only the increments, which extends the only
budgeting programme in the future. Only the desired increments are subsequently analyzed. This
method of budgeting is good for recurrent expenditure.
The Advantages in This Method Include The Following.
• It is adequate and good for recurrent expenditure,
• It ensured compliance with appropriation standards,
• It has simplicity of operation,
The Disadvantages of This Budgeting Include The Following
i. Past inconsistencies and errors are carried forward.
ii. It concentrates on costs and expenditures, which are inputs rather than outputs.
It funds programmes of low or expired usefulness on overgenerous scales.
iv. It fails to fund new programmes of high priority on sufficiently generous scales.
v. It results on a continual growth in budget totals related to cost inflation.
vi. It limits public understanding of government activities.
vii. It fails to clarify cost of alternative methods of achieving programmes objectives.
viii. It examines the momental changes in greater details than the budget as a whole.
ix. It leads to inefficiency
x. Lack of accountability may result.
ZERO BASED BUDGETING
This is used in conjunction with any other type of Budgeting. Its development arises from the
criticism of the Traditional Budgetary System. It is an approach to Budgetary Planning which
rejects the customary views of the Instrumentalist. It is a systematic approach / process by which
management takes the careful examination of the basis for allocating resources in accordance
with the formation of budget requirements and programme planning. It is a budgeting system
which requires every provisional head, manager, etc to justify his entire budget from the scratch
(Zero Base). Any item that cannot be justified will automatically be eliminated. The Manager
shall ignore what had been done in the past and shall attempt to justify the futurist items. ZBB is

41
a cost benefit approach to budgeting, which ensures value for money a ctivities. It however
involves the use of decision packages.
Overview of Zero-Base Budgeting
 It is a method of budgeting in which all expenses must be justified for each new period. Zero-
based budgeting starts from a “zero base” and every function within an organization are
analyzed for its needs and costs. Budgets are then built around what is needed for the
upcoming period, regardless of whether the budget is higher or lower than the previous one.
 ZBB allows top-level strategic goals to be implemented into the budgeting process by tying
them to specific functional areas of the organization, where costs can be first grouped, then
measured against previous results and current expectations.
 In zero-based budgeting, every line item of the budget must be approved, rather than only
changes. During the review process, no reference is made to the previous level of expenditure.
 Zero-based budgeting requires the budget request be re-evaluated thoroughly, starting from
the zero-base. It also refers to the identification of a task or tasks and then funding resources
to complete the task independent of current resourcing.
The basic process flow under zero-base budgeting is:
1. Identify objectives
2. Create and evaluate alternative methods for accomplishing each objective
3. Evaluate alternative funding levels, depending on planned performance levels
4. Set priorities
 A zero-base budget requires managers to justify all of their budgeted expenditures, rather than
the more common approach of only requiring justification for incremental changes to the
budget or the actual results from the preceding year. Thus, a manager is theoretically assumed
to have an expenditure base line of zero (hence the name of the budgeting method).
 In reality, a manager is assumed to have a minimum amount of funding for basic departmental
operations, above which additional funding must be justified. The intent of the process is to
continually refocus funding on key business objectives, and terminate or scale back any
activities no longer related to those objectives.

According to Cornelius E. Tienny in Handbook of Federal Accounting Practices, the goals of
ZBB as summarized by the office of Management and Budget (OMB) in USA are as follows:
a. To examine the need for an accomplishment and effectiveness of existing government
programmes as if they were proposed for the first time.

42
b. To allow proposed new programme to compete for resources on a more equal footing
with existing programmes
c. To focus budget justifications on the evaluation of discrete elements and programmes
or activities of each decision unit aid.
d. To secure extensive management involvement at all levels in the budget process.
Generally speaking, ZBB consists of the following important stages/ procedures:
i. Identification of Decision Unit
This is the smallest unit where decisions are made.
ii. Development of Decision Packages
These consist of accumulation of decision units. It is a proforma documentation used in
describing decision units and their cost of operation.
iii. Evaluation and Banking of Decision Packages.
iv. Determination of cut-off points using a realistic cut-off procedure.
v. Allocation of resources or consolidation of budgeting justification of resources.
vi. Implementation, monitoring and re-evaluation.
Advantages of Zero-Base Budgeting
There are a number of advantages to zero-base budgeting, which include:
 Alternatives analysis - Zero-base budgeting requires that managers identify alternative
ways to perform each activity (such as keeping it in-house or outsourcing it), as well as
the effects of different levels of spending. By forcing the development of these
alternatives, the process makes managers consider other ways to run the business.
 Budget inflation - Since managers must tie expenditures to activities, it becomes less
likely that they can artificially inflate their budgets – the change is too easy to spot.
 Communication - The zero-base budget should spark a significant debate among the
management team about the corporate mission and how it is to be achieved.
 Eliminate non-key activities - A zero-base budget review forces managers to decide
which activities are most critical to the company. By doing so, they can target non-key
activities for elimination or outsourcing.
 Mission focus - Since the zero-base budgeting concept requires managers to link
expenditures to activities, they are forced to define the various missions of their
departments – which might otherwise be poorly defined.

43
 Redundancy identification - The review may reveal that the same activities are being
conducted by multiple departments, leading to the elimination of the activity outside of
the area where management wants it to be centered.
 Required review - Using zero-base budgeting on a regular basis makes it more likely that
all aspects of a company will be examined periodically.
 Resource allocation - If the process is conducted with the overall corporate mission and
objectives in mind, an organization should end up with strong targeting of funds in those
areas where they are most needed.
 Forces budget setters to examine every item.
 Allocation of resources linked to results and needs.
 Wastage and budget slack should be eliminated.
 Prevents creeping budgets based on previous year’s figures with an added on percentage.
 Drives managers to find cost effective ways to improve operations.
 Detects inflated budgets.
 Useful for service departments where the output is difficult to identify.
 Increases staff motivation by providing greater initiative and responsibility in decision-
making.
 Identifies and eliminates wasteful and obsolete operations.
Disadvantages of Zero-Base Budgeting
 Bureaucracy - Creating a zero-base budget from the ground up on a continuing basis calls
for an enormous amount of analysis, meetings, and reports, all of which requires
additional staff to manage the process.
 Gamesmanship - Some managers may attempt to skew their budget reports to concentrate
expenditures under the most vital activities, thereby ensuring that their budgets will not
be reduced.
 Intangible justifications - It can be difficult to determine or justify expenditure levels for
areas of a business that do not produce “concrete,” tangible results. For example, what is
the correct amount of marketing expense, and how much should be invested in research
and development activities?
 Managerial time - The operational review mandated by zero-base budgeting requires a
significant amount of management time.
 Training - Managers require significant training in the zero-base budgeting process,
which further increases the time required each year.
 Update speed - The extra effort required to create a zero-base budget makes it even less
likely that the management team will revise the budget on a continuous basis to make it
more relevant to the competitive situation.
 It a complex time consuming process

44
 Short term benefits may be emphasized to the detriment of long term planning
 Affected by internal politics - can result in annual conflicts over budget allocation
 Necessary to train managers. Zero based budgeting (ZBB) must be clearly understood by
managers at various levels to be successfully implemented. Difficult to administer and
communicate the budgeting because more managers are involved in the process.

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5.5 Activities
1. Identify budgeting techniques used in the public sector in Kenya
5.6 Summary
This unit has described the concepts of traditional or incremental budgeting
system alongside with the Zero-Based Method. Their advantages and
disadvantages are highlighted. The procedure for the
Zero-Based Budgeting is also systematically explained.
1. What are the shortcomings of the Traditional Budgeting System?
2. Explain the Incremental Budgeting System in the public sector.
3. What does Zero-Based Budgeting mean?
4. Highlight the advantages of this (ZBB) method of budgeting to the Kenyan
public sector
5. Itemize the procedures for preparing the Zero Based System of Budgeting

45
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57 Suggestion for further reading
Edition (New
McGraw-
Hill/Irwin, 2007).
Worth
Publishers, 2007).
Economics

46
Lesson 6:
PERFORMANCE BASED BUDGETING
6.1 Introduction
In this unit, we shall discuss additional methods of budgeting - Planning, Programming
Budgeting and Programme and Performance Budgeting Systems. We shall give detailed
explanation and cite their high points and low points in the public sector finances.
6.3Lecture Outline
a) Program and planning based Budgeting
b) Performance based budgeting
PROGRAM & PLANNING BASED BUDGETING
Planning, Programming Budgeting System is that style that provides regular procedures for
reviewing goals and objectives, for selecting and planning programming over a period of years in
terms of output and resources. It enables resources allocation choices to be made on the basis of
benefit/cost relationship.
The programme and performance budgeting insists that allocation of funds should be related to
what is intended to be achieved. The essence of this method of budgeting is that results to be
achieved should override considerations of expenditure to be incurred. The goals, sub goals,
objectives and activities are identified as there is possibility of monitoring of projects by the
National Assembly members. Efficiency of work performed is increased.
This provides regular procedures for reviewing goals and objective, for selecting and planning
programmes over a period of years in terms of output and resources. It also facilitates the
 Explain in simple terms the meaning of Planning, Programming Budgeting and
Programme and Performance Budgeting Systems.
 Itemize the pros and cons of the two budgeting methods
 Analyze the features of these methods of budgeting in the public sector

47
allocations of resources between programme and their implementation, processes and control.
Therefore, the key characteristics of PPBS is that objectives and programmes costs are
formulated over a period of years within the context of a medium term plan, thus permitting a
longer financial perspective than Traditional Budgeting would allow
Planning oriented approach to developing a program budget. A program budget is a budget in
which expenditures are based primarily on programs of work and secondarily on character and
object. It is a transitional type of budget between the traditional character and object budget, on
the one hand, and the performance budget on the other. The major contribution of PPBS lies in
the planning process, i.e., the process of making program policy decisions that lead to a specific
budget and specific multi-year plans.
Planning – In the planning phase, the objectives to be achieved are discussed agreed upon and
documented.
Programming - In the programming phase, proposed programs are developed. These programs
are consistent with the institutions plans. These programs shall reflect
systematic analysis of missions and objectives to be achieved, alternative methods of
accomplishing them, and the effective allocation of the resources.
Budgeting - In the budgeting phase, detailed budget estimates for the budget of the programs
approved during the programming phase are developed. A budget review is then conducted and
the results are issued in Program Budget Decisions (PBDs).
The Features/Elements of PPBS Include The Following
a. Identification of goals and objectives in each major area of governmental activity.
b. Analysis of the output of a given programme in terms of its objectives.
c. Measurement of total programme cost not just for one but for at least several years ahead.
d. Formulation of objectives and programmes extending beyond the single year of the annual
budgets
e. Analysis of alternatives to find the most effective means reading basic programme objectives.
The High Points of PPBS are:
i. It provides information on the objectives of the organization
ii. It cuts across conventional lines of responsibility and departmental structures by drawing
together the activities that are directed towards a particular objective
iii. It exposes programme that are over lapping or contradictory in terms of achieving objectives
PPBS comprise three elements:
 the result (final outcome)

48
 the strategy (different ways to achieve the final outcome)
 activity/outputs (what is actually done to achieve the final outcome)
The ultimate aim of PBB is far from simply being an elaborate way of measuring or recording
activities but instead, it is a mechanism that will help Government in decision-making depending
on whether the objectives are being met or not, and enhancing transparency and accountability.
Concerning decision-making, it helps to
 Clarify policy priorities consistent with Government’s strategic objectives.
 Allocate resources more tightly on strategic priorities.
 Motivate program-managers and service-providers to have a genuine interest in
improving performance.
 Identify the causes of good and bad performance and thereby improving the value for
money of public spending by reducing waste and increasing impact, and
 Facilitate cross-institutional working.
Some of the major issues when implementing PBB at government level are:
 The necessity of a well-thought-out implementation strategy and plan, identifying what
needs to be done and in what sequence.
 A strategic plan for each ministry, to be used as the basis for developing a program
structure and informing resource allocations to programs and sub-programs.
 The definition by ministries of appropriate outputs and performance indicators that is
realistic and measurable.
 The importance of developing capacity to analyze whether ministry budgets reflect policy
priorities, whether programs are efficiently costed relative to intended performance, and
whether the projected performance is achievable.
 The updating of accounting and information systems to cope with additional
classification requirements; mechanisms and systems to monitor and evaluate program
performance from both a financial and a non-financial perspective.
 Improved accountability and oversight, for which it is crucial that performance
information be included in budget documentation and that members of Parliament and
civil society are able to use the information presented to them.
Advantages of PPBS
 PBB also serves as a strategic planning tool, improving the clarity, and consistency of
project designs, facilitating a common understanding and better communication between
different departments and staff in general of the desired results of projects.
 PBB allows the departments to attain a unified sense of purpose and direction. Moreover,
through the measurement of performance in achieving defined results, PBB provides
feedback to projects on how well they are doing, and creates a strong incentive for

49
adopting best practices and efficiencies in use of resources, as well as improving the
quality of services and other outputs.
 PBB is also a means to release project directors from overly restrictive input and/or
central controls and to accord them more discretion in determining the right mix of
resources to meet expected results. In PBB, the increase of the accountability and
responsibility of concerned officials (a consequence of holding them responsible for
achieving results) is designed to
 Transparency and access to information - Generally, the quality and quantity of
information has improves with the implementation of PBB because of wide consultation
 Flexibility and ownership - It enhances interaction between line ministries and the in the
budget-preparation process, and the relationship is becomes more collaborative.
 Better resource allocation – PBB improves the quality of budget submissions from line
ministries. It shifts budgeting approach from a shopping list of wishes towards
determining priorities and focusing on services to be delivered. It also reduces incidences
of ad-hoc expenditure.
 Performance orientation and accountability - implementation of PBB increases
awareness of performance and the need to monitor the achievement of targets. PBB has
improves accountability, and chief executives are beginning to use the PBB as a
management tool.
Disadvantages
 Manager Training
It typically requires you to train many people in your company. No one will inherently
understand how to do this activity unless they are thoroughly trained in its methods. In
order for activity based budgeting to work, every manager of every department has to be
able to understand this process. This means that you will have to have seminars or
training classes in order to teach everyone the basics of the process. Otherwise, your
activity-based budget will fail and it will not give you the information that you need to
make it successful.
 Requires Deep Understanding
With activity based budgeting, you also have to have people that truly understand what
drives their budget. Every manager will be in charge of looking at their own budget and
evaluating it. If they do not understand where all their money goes and how it is used, the
activity based budgeting process will not be effective.
 Complexity
This technique remains a comprehensive and time-consuming exercise. The process
requires identification of activities, estimation of activity output demands, and estimation
of the costs of resources needed to provide the demanded activity output. Not all
managers are competent enough to perform such tasks, and the resultant distortions make
the activity an exercise in futility.

50
 Resources
The complexity of the activity-based budgeting exercise means that it takes away
considerable organizational resources in the form of managerial time and money. Such
resources, if deployed in a core operational activity, would contribute to a much better
bottom line.
 Short-Term Focus
Program based budgeting tends to focus on the immediate and short term and ignore the
long term. Activity-based budgeting uses historic data for forecast analysis, which may
not always be practical. Focusing on activities that create immediate results might work
well in the short term, but might cause long-term damage to an organization.
 Costly
Preparing an activity-based budget entails a comprehensive review of each organizational
and departmental activity. This process is costly and may prove to be even more so for
smaller companies that offer a limited number of products and services. Companies
typically use specialized software to prepare activity-based budgets. This further hikes
the cost of preparing the budget as computerized software packages and licensing fees are
expensive.
 Time-Consuming
An activity-based budget is prepared after a thorough review of each organizational,
departmental or project activity. This process can be time-consuming owing to the time
and effort associated with thoroughly reviewing each activity. Budget preparation is
typically an ongoing process. Several adjustments are made to the first draft before the
final budget is approved. Fine-tuning an activity budget, therefore, can further prolong
the process. Activity-based budgeting becomes even more time-consuming for larger
organizations that have many departments and are engaged in numerous activities.
 It’s a budgeting approach that reflects the input of resources and the output of services for
each unit of an organization. This type of budget is commonly used by the government to
show the link between the funds provided to the public and the outcome of these services.
 Decisions made on these types of budgets focus more on outputs or outcomes of services
than on decisions made based on inputs. In other words, allocation of funds and resources
are based on their potential results. Performance budgets place priority on employees'
commitment to produce positive results, particularly in the public sector.
 Performance budgets use statements of missions, goals and objectives to explain why the
money is being spent. It is a way to allocate resources to achieve specific objectives
based on program goals and measured results.
 In this method, the entire planning and budgeting framework is result oriented. There are
objectives and activities to achieve the set goals and these form the foundation of the
overall evaluation.

51
Performance-Based Budgeting
What is Performance-Based Budgeting?
It is important to understand that performance-based budgeting is not simply the use of program
performance information in developing a budget. Performance-based budgeting does more than
just inform the resource allocation decisions that go into the development of a traditional type of
budget. In other words, it is not just "budgeting based on performance." Instead, it is the process
by which a particular type of budget is developed -- a Performance Budget (or "program
performance budget"). To design an effective system of performance-based budgeting, it is
therefore vital to understand first exactly what the end product itself should be, what it should
contain, and how it should look.
A true Performance Budget is not simply a Line-Item (or object class) budget with some
program goals attached. It tells you much more than just that for a given level of funding a
certain level of result is expected. A real Performance Budget gives a meaningful indication of
how the shillings are expected to turn into results. Certainly not with scientific precision, but at
least in an approximate sense, by outlining a general chain of cause and effect. The most
effective governmental Performance Budget does this by showing, for each program area, how
shillins fund day-to-day tasks and activities, how these activities are expected to generate certain
outputs, and what outcomes should then be the result.
A program Performance Budget can be distinguished from a Line-Item Budget in a fundamental
way. The line items show what each shilling will be spent on: salaries, benefits, office supplies,
travel, utilities, equipment, etc. The Performance Budget shows what each dollar will
accomplish, generally in the way of a measurable result achieved (such as a reduction in
accidents, an improvement in health, an increase in customer satsifaction, etc.), or in the way of
an activity performed (such as process a grant application, inspect a worksite, review a
compliance activity, etc.). However, every program could (and probably should) be able to show
its budget in both formats -- with the "bottom line" shilling amounts being exactly the same for
each.
Performance budgeting comprises three elements:
 The result (final outcome)
 The strategy (different ways to achieve the final outcome)
 Activity/outputs (what is actually done to achieve the final outcome)

Cfm 307, public sector

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