1.Public Finance and Budgeting 2012(MKL) - Copy.pptx

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Module Title: Public Finance and Budgeting
Module Code: MAPM 5062
ECTS = 8 (5 credit hours)

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Instructor:
Miheretu Kebede
Assistant Professor

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Objectives of the Module
Upon completion of this module, the students are able to:
 understand the role of financial management in the
public sector,
 plan the financial activities of the public sector,
 point out ways of managing public debt,
 analyze the functioning of public finance,
 classify public revenues and integrate them into the
fiscal and tax system,
 critically evaluate the budget process,
 explain public debt management.

Contents of the Module
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Chapter 1: Introduction to Public Finance
Chapter 2: Structure of Government
Chapter 3: Public Goods and Externalities
Chapter 4: Concepts and Theories of Public Budgeting
Chapter 5: Budget Cycle in the Public Sector
Chapter 6: Public Debt Management
Chapter 7: Funding Government: Taxes, Fees and Grants

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1. Presentation of concepts
2. Questions, Exercises and Reflections
3. Group discussions
4. Presentations

Chapter 1
Introduction to Public Finance

What is Finance?
 It is, literally, the money used in day-to-day activities
of an individual or a business for exchange of goods
and services.
 It is the business or art of managing the monetary
resources of an organization, country, or person.
 It is decision about money(Cashflows)
 Is the art and science of managing money.

What is Public Finance?
 The financial operation of fiscal or the public treasury.
 Deals with the income and expenditure of the
government’s finance.
 Influence of government fiscal operations on the level
of overall activity, employment, prices and growth
process of the economic system as a whole.

Public Finance… cont’d
 Public finance is the field of economics that studies
government activities and the alternative means of
financing government expenditures for different
activities.
 Public finance is concerned with the income and
expenditure of public authorities and with the
adjustment of one to the other.
 Public finance is the study of the principles underlying
the spending and raising of funds of public authorities.
.

Definition of Pubic Financial Mgt.
 Public Finance Management (PFM) basically deals with all
aspects of resource mobilization and expenditure
management in government.
 Just as managing finances is a critical function of management in any
organization.
 Similarly PFM is an essential part of the government process.
 It uses as a means of obtaining and allocating resources or money and
utilize methods.
 It uses as a controlling tool for effectively achieve the determined end
goals.

1.2 Why Public Finance is Needed?
 Governments provide public goods-government-financed
items and services such as roads, military forces,
lighthouses, and street houses.
 Private citizens would not voluntarily pay for these
services, and therefore businesses have no incentive to
produce them.
 Public finance also enables governments to correct or offset
undesirable side effects (spillovers or externalities) of a
market economy.

1.2 Why Public Finance is Needed … cont’d?
 Example: households and industries may generate pollution and release it into
the environment without considering the adverse effect pollution has on
others.
 Pollution is a spillover because it affects people who are not responsible for it.
 To correct a spillover, governments can encourage or restrict certain activities.

 Public finance provides government programs that moderate the incomes of
the wealthy and the poor.
 These programs include social security, welfare, and other social programs.
 For example, some elderly people or people with disabilities require financial
assistance because they cannot work.

 Governments redistribute income by collecting taxes from their wealthier
citizens to provide resources for their needs ones.
 The taxes fund programs that help support people with low incomes.

1.3 Scope of Public Finance
1. Public Revenue
2. Public Expenditure
3. Public Debt
4. Financial Administration
5. Economic Stabilization

1.3 Scope of … cont’d
1. Public Revenue:
- principles of taxation,
- effects of taxes on the economy,
- methods of raising revenue,
- tax and non-tax sources
The elements of taxation are as follows:
 it is a compulsory contribution
 government only imposes taxes
 in payment of tax an element of sacrifice is involved
 taxation is aimed at welfare of the community
 the benefit may not be proportional to tax paid( no quid pro quo)
 Tax is a legal collection.

2. Public Expenditure:
- By government - central, state and local bodies,
- Not for profit, but for societal benefits
- Development vs. non-development,
- Capital vs. revenue expenditure
 Wise spending is essential for stability of government.
 Planned expenditure and accurate foresight of earnings are the
important aspects of sound government finance.

3. Public Debt:
 Domestic Debt = Internal = National
 External Debt = Foreign
 Concessional vs. Non-Concessional
 Debt servicing
 Debt management

4. Financial Administration
 Preparation of financial budget, the control and
administrations of the budget
5. Economic Stabilization
 Low capital formation
 Inferior technical know how
 Low per capita income
 Over population and poor health and educational
facilities
 High propensity to consume leading to low capital
formation

1.4 Public finance vs. private finance
Generally
 Public finance is primarily made to finance activities
that maximize the social and economic benefits of the
majority or all the people
 Private finance is primarily made to maximize self
benefit/return/profit.

Similarities and Differences between Public
Finance and Private Finance
Similarities
1. Based on Similar Theories: Both seek the help of
various principles of economics in determining various
interrelated problems. Example: A person wants to
secure maximum utility on count of minimum
expenditure and government too wants to secure public
utility by spending the least possible amount of public
money.
2. Both Face the Problem of Scarcity: Limitation of the
resources is the problem before private as well as public
finance. None of the two is capable of extending its
expenditure beyond a certain limit.

3. Both Require Efficient Administration: Private as well as public
finance require efficient administration to look after the various
acts of extravagance.
4. Both Borrow and Must Repay: Both governments and individuals
borrow from different sources, at the same it is obligatory for
both to repay the debt.
5. Both are Based on Rationality of Thought: When a government or
an individual spends some money they make it certain that
money is spent in the best way. Any irrational step taken by the
government or the individual may bring wastage and misuse of
finance.

Differences
1. Individual determines his expenditure on the basis of his income in the
sense that he cannot think of spending more than his income. But
government determines its income on the basis of its expenditure. It
first decides the amount of expenditures to be done during a period of
time, and then frames scheme to secure money to meet the expenditure.
2. Government’s source of income is more flexible in comparison to
private source. Government has the control over the whole national
property but individual has to rely upon his own individual standing.
Moreover, government can take the help of the foreign government and
this is not possible for a person to secure such supports.
3. It is easy for an individual to base his expenditure on the law of equal
marginal utility, but far difficult for governments. Individual is free to
measure his expenditure in the sense of utility and spends his money on
the certain weighted subjects. These subjects may not be of social need or
may not add anything to social advantage.

4. Private finance is narrow and short lived in comparison to public finance. Private finance
faces suspension with the end of the individual’s life or with the closure of the particular
business enterprise. But governments are more tenable. King may come and king may go but
government is eternal. Governments keep on moving from generation to generation
interlinking past from present with an eye on future.
5. Public finance is subject to public censor but not the private finance. A complete secrecy
may be maintained by an individual regarding his income and savings. But the government
records are furnished to let the people see through the desirability of the expenditure. Public
is entitled to know, criticize and to comment on the public finance outlays, its drawbacks
and failures.
6. There are pre-determined policies behind public expenditure but not so in the case of
private expenditure. Public expenditure is done to achieve the goals which are
predetermined in their nature.

7. There is difference in the budgeting process of the public finance and the
private finance. The budget of the government is subject to the approval of
the parliament of the concerned country. It is now a well established principal
no taxation without representation and no tax shall be without the due/process
of law. But individual is his own master and he need not ask for parliamentary
approval for spending his bricks.
8. Governments’ accounts are audited by constitutional authorities but
private finance has its own arrangement. An individual can audit his
accounts without performing formalities about it. But there is procedural
necessity in the case of public finance. The budget is to be prepared in the
prescribed manner and to be presented according to the settled norms.
9. A private individual can face the crises of being bankrupt but no
government can be bankrupt. An individual may ‘run-riot’ his money and
thus may become an insolvent, but the question of the government being
bankrupt is impracticable. It is funny to talk of the bankruptcy of the
government; since all the currencies are printed and circulated by it.

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

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

1.5 Why public finance/sector is needed…cont’d
Generally the basic function of public finance are
1. Allocation functions
2. Distribution functions
3. Regulatory functions
4. Stabilization functions
5. Coordination functions
 Spending taxes, deficits, and debts
 The size and growth of the government
 Decentralization of power and resources

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

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

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

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

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

Public Spending
 Each year national, provincial, and local governments create a budget to
determine how much money they will spend during the upcoming year.
 The budget determines which public goods to produce, which spillovers to
correct, and how much assistance to provide to financially disadvantaged
people.

Government Spending
 Government spending takes two forms: exhaustive spending and transfer
spending.
 Exhaustive spending: refers to purchases made by a government for the
production of public goods.
 For example, to construct a new harbor the government buys and uses
resources from the economy, such as labor and raw materials.

Government Spending … cont’d
 Transfer spending: when government transfers income to people to help
them support themselves.
 Transfer can be one of two kinds: cash or in-kind
 Cash transfers are cash payments, such as social security checks and welfare
payments.
 In-kind transfers involve on cash payments but instead transfer goods or
services to the recipients. Example food stamp coupons and Medicare.

Public Revenue
 Governments must have funds, or revenue, to pay for their activities.
 Governments generate some revenue by charging fees for the services they
provide, such as entrance fees at national parks or tolls for using a highway.
 However, most government revenue comes from taxes, such as income taxes,
capital taxes, and sales and excise taxes.
 An important source of tax revenue in most industrialized countries is the
income or payroll tax, also known as the personal income tax.
 Income taxes are imposed on labor or activities that generate income, such as
wages or salaries.

Public Revenue … cont’d
 Another important source of government revenue is the capital tax.
 Capital includes items or facilities that generate profits, such as factories,
business machinery, and real estate.
 A property tax is a capital tax used by state and local governments.
 Property taxes are levied on items such as houses and boats.

Public Revenue … cont’d
 Sales and excise taxes are also a major source of government tax revenue.
 Many state and local governments levy a sales tax( replaced by VAT) on the
purchase of certain items.
 Consumers usually pay a percentage of the sales price as tax.
 Excise taxes are caused by all levels of government.
 An excise tax is levied on a specific product such as alcohol, cigarettes, or
gasoline.
 VAT is levied on the value added to a product during production as its
components are assembled into final goods.

How Public Finance Affects the Economy?
 Government spending and taxation directly affect the overall performance of
the economy.
 For example, if the government increases spending to build a new highway,
construction of the highway will create jobs.
 Jobs create income that people spend on purchases, and the economy tends to
grow.
 The opposite happens when the government increase taxes. Households and
businesses have less of their income to spend, they purchase fewer goods, and
the economy tends to shrink.

Government Deficits
 When the government spends more than it receives, it runs a deficit.
 Governments finance deficits by borrowing money.
 Deficit spending-that is, spending funds obtained by borrowing instead of
taxation-can be helpful for the economy.

Chapter 2
Structure of Governments

Introduction
 Some argue that the existing global politics urges the need
to bring economic and political systems closer to local
communities.
 Others argue that the collapse of central political system
encourages regional and local governments to participate in
politics and economic process.
 Decentralization is the process of transferring political
power, administrative, and fiscal responsibilities from
central government to lower levels of government.
 Adequate funding of sub-national governments is key to
successful decentralization because it will improve the
provision of public goods.

Types of Decentralization
 There are four basic types of decentralization:
 Fiscal decentralization
 Political decentralization
 Administrative decentralization
 Economic/Market decentralization
 Each type of decentralization has three different forms,
different characteristics, policy implications, and
conditions for success.
 The three different forms of decentralization are:
 De-concentration (weakest form)
 Delegation (extensive form)
 Devolution (strongest form)

Fiscal Decentralization
 Adequate revenues raised.
 It involves shifting some responsibilities for expenditures
and revenues to lower levels of government.
 Financial responsibility is a core component of
decentralization.
 If local governments & private organizations are to carry
out decentralized functions effectively, they must have
 locally or transferred from the central government and
 the authority to make expenditure decisions.

Why Fiscal Decentralization?
 The common theoretical rationale for decentralization basically
grouped into two:
 Economic
 Political
A. Economic Argument
1. Efficiency in resource allocation
 It reduces number of decision making layers thus, fast
decisions can be made with less bureaucratic overhead.
 It improves efficiency by
 fostering accountability,
 reducing corruption, and
 increasing cost effectiveness in the government.

2. Priority for local preferences
 Local leaders know their constituents better than central
government.
 It is important in mobilizing local resources and increased the
participatory processes.
3. Enhance tax effort & sustainability of services
 People are willing to pay for services, which they find to be
more responsive to their priorities.
 So, decentralization may be accompanied by an increase in
tax effort & less resistance to user charges, thus enhancing
the sustainability of services.
4. Improves competitiveness among sub-national (Regional)
governments. It enhances innovation.
5. It increases access to service delivery
 It is a means of delivering services to hitherto (until now)
neglected peripheral and remote areas.

B. Non-economic arguments (political argument)
1. Political necessity
 It is primarily a political imperative.
 It is an important component of democratization.
2. Ideological and/or instrumental value
 It increases popular participation in decision making.
3. Indicator of good governance
 Good governments are closer to the people.
 Good government are of the people by the people for the people.
4. Helps to accommodate pressure for regional autonomy
 It increases the legitimacy and sustainability of heterogeneous
national states.
 In Africa, much of the concern for decentralization is given
because of political concern.

Arguments Against Decentralization
A. National Effects
 There could be a conflict between decentralization and the
macroeconomic objectives
 where by local authorities take a much narrower view
and perspective.
B. Local Effects
 Power and benefits may be captured by elites that might
restrict the benefits needed to reach the weak and
vulnerable groups.

Arguments Against Fiscal Decentralization
1. The problem in developing countries is not to reveal
differences in tests & preferences but to satisfy basic
needs.
2. Elected officials often lack incentive to keep their promises
because of great mismatch between available resources
and promised expenditure.
 Therefore, even if elected officials wanted to fulfill their
mandates from their voters, they cannot do so due to lack
of resources.
3. Even if elected officials have sufficient resources to fulfill
their mandate they may not be able to persuade the local
bureaucracy to go along.
 The local bureaucracy is usually unresponsive, poorly
motivated and occasionally poorly qualified. Central
government’s bureaucracies are likely to attract more
qualified people.

Role of Fiscal Decentralization
 Some argue that the reason for Fiscal Decentralization is that
 local governments loose their enthusiasm and interest in
decentralization if they are not given command over some
degree of resources and
 are frustrated if their role is limited to approving policies
that are decided else where.
 In the traditional theory of fiscal federalism there are three
major roles of the public sector.
1. Macroeconomic stability
2. Income distribution
3. Resource allocation
 The theory assigns the first and second function to central
government while a significant role of allocating resources is
given to sub-national governments

Fiscal policy is a powerful instrument for stabilization.
 This role is assigned to the central government because:
i. sub-national authorities have very few or no incentive to undertake
economic stabilization policies
ii. lower levels of government often lack the necessary macroeconomic
policy instruments.
 Similarly, income distribution role is given to central
government because:
1. differential local redistribution programs would be expected to create
problems if factors of production are mobile.
2. local governments tend to have access to revenue sources that are
easily levied in a way that is progressive with respect to time.

 But, the theory of fiscal federalism assigns resource
allocation to sub-national governments.
 Classicalists argue that decentralization will result in a better
match of supply & demand for local public goods.
 Since local authorities are closer to people they can easily
identify local people’s needs and supply the appropriate levels
and mix of public services.
 It is also argued that decentralization is desirable not only
because of preferences differentiation, but also because
expenditure decisions are tied closely to real resource costs.
 It enhances greater experimentation and innovation.

There are four basic pillars (building blocks) of fiscal decentralization:
1. The assignment of expenditure responsibilities to different government
levels: what are the functions and expenditure responsibilities of each level
of government
2. The assignment of tax and revenue sources to different government levels:
once sub-national governments are assigned certain expenditure
responsibilities, which tax or non-tax revenue sources will be made
available to sub-national governments in order to meet those
responsibilities?
3. Intergovernmental fiscal transfers: in addition to assigning revenue sources,
central governments may provide regional and local governments with
additional resources through a system of intergovernmental fiscal transfers
or grants. E.g. Block grant
4. Sub-national borrowing: local governments can borrow (in various ways) to
finance revenue short falls. E.g. Municipal borrowing

Intergovernmental Transfers
Types of Intergovernmental Transfer
 Basically two types of grants/transfers:
 conditional and
 unconditional grants.
A. Conditional grants: sometimes called specific purpose grants or
categorical grants.
 The central government specifies the purposes for which the
recipient Government can use the funds.
 The ability to shift Birr to other purposes in responses to grants is
called fungibility. Within conditional grants, there are several
types. Within conditional grants, there are three types:
1. Matching (cost-sharing) Open-Ended Grants
2. Matching Closed-Ended Grants
3. Non-matching Grants

B. Unconditional grants: general purpose grant
 An unconditional grant places no restrictions on
the use of funds-the recipient government has
complete discretion over how the funds are used.
 In effect, it is a lump sum grant to the recipient
government.
 The main justification for the central government
to give unconditional grants to states/provinces &
localities is that such grants can be used to
equalize fiscal capacities of different local
governments to ensure the provision of a minimum
level of public services.

Rational For Intergovernmental Transfers
Economic rationale for intergovernmental grants are:
1. To bridge fiscal gaps(vertical vs. horizontal
equalization)
2. To correct spillovers,
3. To redirecting priorities
4. Experimenting with new ideas

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Fiscal Federalism in Ethiopia

Introduction
 The 1994 Ethiopian constitution which establishes sub-
national boundaries and mechanisms for inter-
governments fiscal relations, stipulates that regions shall
be formed on the basis of
 ethic settlement patterns,
 language identity, and
 the consent of people concerned.
 The constitution also defined the state as federal or
federation.

Government structure
 Four-tier systems of government in the administrative structure of
the Federal Democratic Republic of Ethiopia.
 Zone has not been recognized explicitly as an administrative
structure in the constitution.
 The country is divided into nine regional states and two special city
administrators.
 Intergovernmental fiscal relations focus on four basic
responsibilities:
A. Revenue Assignment
B. Expenditure Assignment
C. Intergovernmental fiscal transfer
D. Borrowing

A. Revenue Assignment In Ethiopia
 Theories argue that
 international transactions and a considerable share of income
and general sales tax (such as VAT) should be assigned to the
central government for the purpose of macroeconomic
stabilization while
 corporate income tax and wealth taxes should be centralized
for the purpose of distribution.
 However local government need to rely on sources of revenue
that are relatively stable.

A. Revenue Assignment In Ethiopia
Fieldstod (2001) summarized general principles of tax
assignment in the federation as follows.
i) Taxes suitable for economic stabilization, progressive re-
distributional taxes, VAT, personal taxes with progressive
rates, and tax bases distributed highly unequally between
jurisdictions should be levied by central government.
ii) Local government should tax revenue bases with low
mobility between jurisdictions (e.g. Land and real state)
and applying user charge (motor vehicle charge).

iii) Benefits taxes and user charges may be appropriately used by
both depending on the situation.
 In Ethiopia, Article 95 of the constitution, clearly defines the
sharing of revenue between the central government and
regional governments.
 And Articles 96,97 and 98 clearly grouped taxes into
 central,
 regional and
 joint categories respectively.

1. Central
 Duties, taxes, and other charges levied on the importation and
exportation of goods;
 Personal income tax collected from employees of the central
government and international organizations;
 Profit tax, personal income tax and sales tax collected from
enterprises owned by the central government;
 Taxes collected from national lotteries and other chance winning
prizes;
 Taxes collected on income from air, train and marine transport
activities;
 Taxes collected from rent of houses and properties owned by the
central government;
 Charges and fees on licenses and services issued or rendered by
the central government.

2.Regional
 On the other hand, revenue of regional governments
comprises of the following:
 Personal income tax collected from employees of the regional governments
and employees other than those mentioned; Rural land use fee.
 Agricultural income tax collected from farmers not incorporated in an
organization;
 Profit and sales tax collected from individual traders;
 Tax on income from inland water transportation;
 Taxes collected from rent of houses and properties owned by the regional
governments;
 Profit tax, personal income tax, sales tax collected from enterprises owned by
the regional governments;
 Income tax, royalty and rent of land collected from mining activities; and
 Charges and fees on licenses and services issued or rendered by the regions.

3. The joint revenues of the central government and regional
governments are:
 Profit tax, personal income tax and sales tax collected
from enterprises jointly owned by the central government
and regional governments;
 Profit tax, dividend tax from organizations that carry
out business activities;
 Profit tax, royalty and rent of land collected from large
scale mining, any petroleum and gas operations;

B. Expenditure Assignment In Ethiopia
 The 1994 constitution is not as explicit on the expenditure
responsibilities of the regions as it is on the revenue assignment.
 How ever, it provides the following three general guidelines
regarding expenditure:
1. The central government and the regional governments bear all
financial expenditures necessary to carry out all responsibilities
and functions assigned to them by law.
2. The central government might grant the regions emergency,
rehabilitation and development assistance and loans, provided
that such assistance and loans do not hinder the proportionate
development of regions.
3. The central government has the power to audit and inspect the
proportionate development of states.

Expenditure Assignment in Ethiopia Article 51 (1-21) Article 52
Central Government
 Defense
 Foreign affairs
 Economic Policy
 Conferring of
citizenship
 Declaration of state of
emergency
 Deployment of army
where situation beyond
the capacity of regional
government arises.
 Printing currency
 Establishing and
administering major
development
establishments
 Building and
administering major
communications
networks and the like
Regional governments
 All matters with the exception of those listed
in column 1
 Borrow from domestic lending sources and levy
duties and taxes
 Issue and implement laws and rules relating to
public services which do not conflict with the
relevant policy of the central government.
 Establish, direct and supervise social and
economic developmental establishments and
enterprises
 Prepare approve and implement their own
budgets
 Administer develop and protect their natural
resources
 Employ and administer their own personnel in
accordance with the public service and
pensions laws of the central government
 Establish and direct security and policy forces
in accordance with the policy and directives of
the central government
 Establish judicial organs to decide on maters
not specifically assigned to the central
government
 Own properties of the region; acquire
ownership of property and transfer property

C. Intergovernmental Transfer In Ethiopia
Purpose of transfers or grants
1. Vertical fiscal balance: Providing additional resources
to the local level, so that there is a balance between
 the fiscal needs and
 resources available to different levels of government.
 This indicates the case in which the level of revenue
source decentralization is lower than the
decentralization of expenditure responsibilities.

2.Horizontal fiscal balance: Ensuring fiscal
balance in resource allocations between
governments at the same level of government.
 It emerges usually as a result of concentration of
tax bases due to uneven distribution of economic
resources & economic activity across regions
whereas expenditure requirements are spread
more evenly.
3. The funding of specific national priorities
 Example, Food security
4. The effects of inter-governmental spillovers or
externalities are counteracted.

Types of grants
 Unconditional grants
 Conditional grants:
 Equalization grants
1. Unconditional grants are general purpose grants
aimed at addressing vertical imbalances.
2. Conditional grants are grants that carry conditions
regarding the use of the funds.
 The conditionality refers to earmarking by the central
government to finance certain services such as
primary education, health, water, roads etc.
 It partly negating the arguments for decentralization.

3. Equalization grants are grants used to address the
horizontal imbalances between local governments.
 The purpose is to channel resources from relatively
wealthier to poor ones.
 In Ethiopia, with limited exceptions such as road fund,
the system of intergovernmental transfers has always
taken the form of unconditional block grants.
 The federal government give grants to regions based on
formula.
 This Block Grant Formula has varied over the years and
is continuously updated by the Federal Government &
the regions to make it more efficient and equitable.
 The Block Grant Formula is approved by House of the
Federation(HF)

 The ultimate purpose of the block grant formula is to
ascertain every citizen’s access to basic services, such as
health, education, clean water, agricultural development,
road ,& other infrastructures.
 The formula mainly considers the following variables
(fiscal year 2009-2010):
i. Population size
ii. Level of development
iii. Revenue generation capacity

 An expenditure assessment estimates resources needed to
provide all people of the region with the above mentioned
services.
 A revenue assessment estimate of the revenue generation
potential of the region, based on previous years’
performance & divided per capita.
 To the Woredas the type of transfer is a general purpose
transfer.
 The formula is designed by Bureau of Finance and
Economic Development of regions and approved by the
Regional Cabinet and then by Regional Council.

D. Borrowing in Ethiopia
 Domestic borrowing by regional governments has
been under conditional based control while foreign
borrowing is prohibited.
 Financing sources of regional governments of
Ethiopia be grouped into three:
 Locally generated revenue
 Central government transfers
 Domestic borrowing

Chapter 3
Public Goods and Externalities

78
A Public Good has two properties:
1. If it has been provided to one consumer it is
difficult/impossible to stop another from
enjoying it too.
“Non-Excludable”
2. The amount of the good I enjoy has no affect on
the amount you enjoy.
“Non-rival”
Public Goods & Externalities

79
 Private goods
 Rival & Exclusive
 Goods with two features:
1. the amount consumed by one person is unavailable
to others
2. non-payers can easily be excluded
What are examples of private goods?

80
Public goods
• goods that, once produced, are available to all,
but nonpayers are not easily excluded.
• Both nonrival and nonexclusive.
• Available for all to consume, regardless of who
pays and who doesn’t.
• What are examples of a public good?
• Public Goods:=(Law and Order, defence, refuse
collection, roads, education, public health,…)

Quasi-public Goods
81
 Goods that are nonrival but exclusive are called
quasi-public goods – for example radio,
television, YouTube.

Open-access Goods
82
 Goods that are rival but nonexclusive are called open-
access goods – like fishing in the ocean.
 By imposing restrictions on open-access resource use,
governments try to keep renewable resources from
becoming depleted.
 What are examples of open-access goods?

83
Negative externalities
 Externalities that impose unintended costs.
 generally are by-products of production or
consumption that impose costs on third parties
(those who are neither buyer nor seller in the
transaction).

Externalities
4- 84
 Unintended costs or benefits that are imposed on
unsuspecting people and that result from economic
activity initiated by others.

85
• Some examples of negative externalities include:
• The impact on your health from someone smoking
in an elevator with you.
• The decrease in your property value that results
from a neighbor dumping garbage in their yard.

Correcting for Negative Externalities
86
 Government restrictions can improve the
allocation of open-access resources (renewable
resources.)
 Ex.
 Antipollution laws
 Water quality restrictions

87
Positive externalities
• Externalities that generate unintended benefits.
• occurs when the by-products of consumption or
production benefit third parties (those who are neither
buyer nor seller in the transaction).
Ex.
 Gov. provides free education, everyone in society can benefit from
an educated person.
 Gov. provides free vaccine, prevents others from getting sick

88
 Some examples of positive externalities include:
 The pleasure you derive from your neighbor’s beautifully
landscaped yard.
 Being able to watch baseball games for free from your
rooftop because you live near
the park.

Chapter 4
Concepts and Theories of Budgeting

4.1 Introduction
 Nothing can be done without expenditure of money or
any other commitment.
 Finance is the fuel for the engine of public activities.
 It keeps the administrative machinery in its wheel.
 It is the life-blood of public administration system.
 Development depends on the availability of finance.
 Thus, proper planning & execution of budget is not only
important but also mandatory.

4.2 Definitions of Budget
92
Discussion Questions
1. What is budget?
2. Why budgeting?

4.2 Definitions of Budget… cont’d
93
 Budgeting seldom (and never successfully) stands
completely alone, but rather flows out of managerial
process of setting objectives and strategies and of
building plans.
 It is especially and intimately related to financial
planning.
 Budgeting, therefore, can be considered as an
important part of a total management system that
includes strategic formulation and implementation,
planning systems, budgeting systems, organization
and reporting systems.

94
 The budget is often called an operating plan.
 A budget is a powerful tool for allocating limited
resources among competing priorities within the
community.
 Because needs always exceed available funds, funds
that you give to one department must be denied to
another department.
 You measure the value of the funds you spend not
only by the benefits you gain, but by what you have
to give up.

95
 A budget consists of a comprehensive listing of anticipated
revenues and proposed expenditures for each function of
government for a future twelve-month period, or fiscal year.
 Ideally, the budget represents a comprehensive allocation of
limited resources among potential users.
 Budgeting means making choices.
 The art of budgeting in government is essentially a process
of allocating limited financial resources to services and
activities in a manner that will most effectively meet the
needs of the citizens.
 The law requires governmental bodies to prepare an annual
budget for the fiscal year.

96
 A budget is not just a statement of finances but is
the link between mobilization of funds and
attainment of governmental goals and
objectives.
 Activities associated with budget formulation,
legislative review, budget execution, and budget
control and audit are major instruments in
deciding the shape and condition of a
community and the effectiveness and efficiency
of government programs.

97
 Budget is the financial plan of a government for a given
period, usually for a fiscal year, which shows what its
resources are, and how they will be generated and used
over the fiscal period.
 The budget is also the government's key instrument for
promoting its socio-economic objectives.
 It can influence the level and direction of economic
activity, including the social and political behavior of the
people.
 For advance countries, the budget has become a tool for
economic growth and instrument with which to attain
full employment and stability.

4.3 Purpose of budgeting
98
 Budgeting has so many purposes it can serve
among others. Some of the purposes that a
budget can serve are:
1. The Budget as a Contract
2. The Budget as a Management Tool
3. The Budget as a Motivator
4. The Budget as a Financial Control Mechanism
5. The Budget as a Plan
6. The Budget as a Major Policy Tool
7. The Budget as a Communication Mechanism

4.3 Purpose of budgeting… cont’d
99
The Budget as a Contract
 The government promise to provide funds to a state
and local governments for agreed-upon purposes.
 In this sense, the budget is a contract between the
policymakers and public bodies.
 The budget also may be viewed as a contract
between the citizens and the government.
 That is, the citizens have agreed to pay taxes so they
can receive certain services from the government.

100
The Budget as a Management Tool
 The budget serves as a statement of the decisions
and responsibilities that translate into specific
programs and activities.
 As a management tool, a properly designed budget
can help you achieve administrative efficiency,
economy, and honesty.
 The budget increases management responsibility and
accountability.

101
The Budget as a Motivator
 The budget motivates departments by setting forth
targets and by serving as a mechanism for obtaining
involvement and commitment.
 The budget provides a means for measuring
accomplishments against goals and for comparing
actual with planned outcomes.
 Public bodies are more likely to be effective and
satisfied if they have a clear sense of program
purpose that enables them to better comprehend
where they are going and how they will get there.

102
The Budget as a Financial Control Mechanism
 The budget can serve as a means to define and
assign responsibility for financial control.
 A budget provides strong control over public
body expenditures and reduces the
administrative discretion of department heads.

103
The Budget as a Plan
 The budget is the investment plan for the community.
 It coordinates choices so as to achieve desired goals.
 The budget is an instrument for correlating executive
and legislative action.
 A budget should include a detailed specification of
what objectives are to be achieved by the proposed
expenditures.
 As a planning tool, the budget can suggest alternative
methods of achieving these objectives.

104
The Budget as a Major Policy Tool
 Whether you intend it to be or not, the budget is a major
policy tool.
 How you decide to spend public’s scarce resources is
perhaps the most important policy decision you will
make during a fiscal year.
 Government resources are always less than what is
needed to accomplish all the governmental goals.
 You must make decisions that contribute the most to
governmental goals.

105
The Budget as a Communication Mechanism
 The budget document is the mechanism by which you
inform citizens, government officials, policymakers,
potential investors, and others about community budgetary
issues, trends, and choices addressed in your budget.
 Your budget document should communicate the significant
information in the budget to the reader.
 You may use charts and graphs, where appropriate, to
highlight financial and statistical information.
 In addition, use narratives to describe the relationships
among revenues, expenditures, and programs.

106
The Budget as an Operations Guide
 Budget requests describe proposed activities, services, or
functions that public bodies will carry out.
 You should also identify program beneficiaries, such as the
number of citizens served, and specify the number of
employees required to carry out each activity.
 When you provide these types of information, the budget that
is produced from the requests will serve as an operations
guide.
 The budget of each institution will not only identify the cost
of each activity, but also the outputs to be provided, the
number of citizens who will benefit, and the staffing level
required to carry out the activity.

107
The Budget as an Instrument of Democracy
 Historically, a major purpose of budgeting is to
promote democracy.
 The budget should reflect the will of the citizens and
should open government to public scrutiny.
 The budget is a means of exercising popular control
over public money.

4.4 Types of Operating Budgets
108
1. Line-item Budget
 It is a financial document that lists how much you will spend on
every item a public body uses.
 The focus of the budget is what is bought? The expenditures for
each item are broken out in categories.
 Expenditures are organized primarily by objects of expenditure
such as salaries, materials and supplies, and goods and services
bought.
 The line-item budget keeps track of how much you spend on
what. While the simplest to prepare, the line-item budget does
not provide any information regarding activities and functions
of a program, department, or public body.

4.4 Types of Operating Budgets…
109
1. Line-item Budget …
 Knowing how much you are spending for salaries,
supplies, maintenance, and utilities does not reveal
much about the actual delivery of services.
 How many citizens are being provided with social
services? How many kilometers of streets are
cleaned? How many children are in school?
 To answer these questions, you must rearrange
expenditures into programs or activities.

110
2. Performance Budget
 The performance budget allocates money to various activities or programs of
an organization and at the same time describes the work output that the
organization will produce with this money.
 The public works budget, for example, sets aside a specific amount of money
to repair a specific number of kilometers of street.
 The principal advantage of the performance-type budget is that it shows both
the activities of the local government and the service levels of these
activities.
 The relative service levels and funds spent on different activities show where
priorities lie.
 This budget also gives you the information necessary to decide if the
priorities are correct.

De-merits/limitations of Performance Budget
4-
111
 Government performance is
 not always easily quantifiable and
 may not have clear visible results.
 For example, law and order is a government activity whose result or
performance cannot be objectively measured,
 A problem in adopting the performance of budgetary procedures is the
arduous /tough or hard task of linking
 accounting heads with
 development heads.

3. Incremental Budgeting
 Also known as traditional approach of budgeting.
 Method of budgeting which uses previous year's budget as
baseline.
 It may also depend on actual performance as basis with
incremental amounts added for the new budget period.
 When departments need more money than the previous
budget, they have to be able to justify the extra expenses.
 If a department does not use its budget currently, then the
next period's budget will be reduced.
 Often leads to wasteful spending by employees because
they do not want to lose their budget.

Advantages:
 The budget is stable and change is gradual.
 Relatively simple to operate and easy to understand.
 Minimum Conflicts if departments treated similarly.
 The impact of change can be seen quickly.

Disadvantages:
 Assumes activities and methods of working will continue in
the same way.
 No incentive for developing new ideas
 No incentives to reduce costs
 Encourages spending up to the budget so that the budget is
maintained next year
 The budget may become out of date and no longer relate to the
level of activity
 The priority for resources may have changed since the
budgets were set originally

4. Zero-Based Budgeting (ZBB)
 This method begins a new budget from zero, and estimates
every expense that will incur during the course of
business.
 Managers are required to justify all budgeted expenditures,
not just changes in the budget from the previous year.
 The starting point/ base line is zero rather than last year's
budget.
 Utilizes much more detail and makes everyone accountable
for their necessary expenses.
 It requires much more work and it is often unpopular with
employees.

Advantages:
 Efficient allocation of resources, as it is based on needs
and benefits.
 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.
 Identifies opportunities for outsourcing.

Disadvantages :
 Difficult to define decision units and decision packages,
as it is time-consuming and exhaustive.
 Forced to justify every detail related to expenditure. The
research and development (R&D) department is
threatened whereas the production department benefits.
 Necessary to train managers. Difficult to administer and
communicate the budgeting because more managers are
involved in the process-it’s costly.
 In a large organization, it’s difficult to understand huge
volume of information.
 Honesty of the managers must be reliable and uniform.

118
5. Program Budget
1. The program budget differs from the traditional line-item
approach to preparing, reviewing, and presenting the budget.
2. Rather than focusing on what a community buys (personnel,
commodities, etc.), a program budget focuses on the expected
results of services and activities that you carry out.
 The emphasis is on the attainment of long-term, community-wide goals (
Services and infrastructure).
3. In a program budget, you link revenues and expenditures to
multiyear programs that meet governmental goals, objectives,
and strategies. Importantly, a program budget identifies the
anticipated results and outputs of these investments.

119
What is a Program?
 A program classifies all activities in a public body by their major
purpose and contribution to overall community goals and
objectives.
 A program structure is a way for you to organize all governmental
activity into a hierarchy of functional categories.
 Ideally, a program should be clearly delineated, have a minimum
overlap with other programs, be results oriented, and lend itself to
quantification.
 You will carry out planning, budgeting, administrative control,
and reporting within the framework of this program structure.

4.5 Advantages of Program Budgeting
120
The benefits of using this systematic approach to budgeting
include:
 Producing a transparent budget. A program budget
presents budget investments in a format that enhances
community understanding of the purpose and nature of the
services you will provide.
 Focusing attention on community goals, needs, and
capabilities. With a program budget you can bring budget
investments in line with community objectives, anticipated
or desired growth, priorities, and financial capabilities.

121
 Achieving maximum use of the citizens’ taxes.
 The planning and management focus of a program budget
establishes an informed basis upon which you can make
decisions, thus helping you avoid costly mistakes.
 A program budget guides you in making sound annual
budget decisions.

122
 Serving wider community interest. A program budget, once approved,
keeps the citizens and business community informed about
community programs and activities that affect their lives and
enterprises. It also provides information on the results of budget
investments.
 Encouraging a more coordinated and efficient government
administration. Using a program budget to coordinate budget
investments of the organization’s departments will result in more
efficient use of limited resources and will limit conflicts or overlap
among projects.

5.5 Advantages… cont’d
123
 Maintaining a sound and stable financial program. By programming
investments over many years, a program budget can limit the burden
that these investments place on the organizations budget.
 How Is a Program Budget Different from a Performance Budget?
Both types of budgets use indicators to measure performance, but
they have a different focus.
 A program budget emphasizes the benefits that citizens gain from
government expenditures, while a performance budget emphasizes
management efficiency in expenditure allocations.

Summary
 Four organs of government exercise financial control in a parliamentary
democracy:
 The Legislature,
 The Government (executive),
 The Finance Ministry, and
 The Audit Department.
 Audit would be the most effective means of financial control since it is an
integral part of the parliamentary control of public finance.
 Auditing is an external control over administration, which seeks
accountability to the parliament.
 Generally, budget can be categorized as;
 revenue budget,
 expenditure budget,
 recurrent/operating budget and
 capital budget.

Budgeting Process in Ethiopia
 The allocation of scarce resources through the medium of
budget is believed to have begun to be conceptualized in
Ethiopia in 1944.
 In the Ethiopian budgetary process, there are two competing
processes:
 political and
 administrative.
 Public budgeting is both political and administrative tool for planning, coordinating,
and controlling the effective utilization and equitable allocations of resources.
As political instrument:
 Politics about who won or lost what; when and how
 Shows which policies are currently in ascendancy/ dominance
 Involves in the allocation of scarce resources among competing interest

As Administrative/management instrument
 Presents a meaningful plan showing both
 ends and
 means
so that it can also be used as a control device.
 Uses as one of its major functions; the presentation of a plan for
government action.
 Establishes
 cost of programs and
 the criteria
by which these programs are evaluated for efficiency and
effectiveness.
 The Ethiopian fiscal or budget year and the budget cycle runs
 from July 7 of one year to July 6 of the following year.

Financial administration
 A standard budgeting process has the
following major steps:
1. Budget Call
2. Budget Preparation
3. Budget Review
4. Budget Hearing
5. Budget Approval
6. Budget Allocation
7. Budget Execution
8. Budget Auditing and Reporting

1. Budget Call
 Every year, at least three months before the end
of the fiscal year the Ministry of Finance and
Economic Cooperation (MoFEC)issues annual call
letter for recurrent and capital budgets to different
institutions.
 At regional levels, the Finance Bureaus issue the
budget call letters to different public bodies in their
respective regions.
 The existing economic conditions of the country
and the priority areas, tentative budget ceiling
and the prescribed formats to be used are stated
and/or enclosed with the call letter.

 Budget preparation is done by different sections of the
organizations.
 the Administration and Finance Department prepares the recurrent
budget while
 the Department for Plan and Project prepares the capital budget.
 The draft budget of the institution is discussed and
reviewed by top management of the respective
organization.
 Finally, the budget proposal that won the support of the
officials is prepared being broken down into programs,
subprograms and expenditure items.

 The budget proposal that is revised and accepted by the
senior officials is, sent to the respective Finance Bureau
or Ministry of Finance and Economic Cooperation.
 This budget proposal must be substantiated and
supported by relevant documents; if the proposal shows
variations from budget ceiling, explanation for the
variation needs to be given.
3. Budget Hearing
 The proposal shall be presented to the Budget Hearing
Committee where they will be subjected to discussion and
negotiations in the presence of officials of the budget
proposing body.

4.Budget Approval
 Budget proposals of the concerned units are compiled
into one budget document.
 Then the compiled budget proposal is submitted to the
Council of Ministers for review and discussion.
 After possible recommendations, Council of Ministers will
forward the budget document to the Council of
People's Representatives for approval.
 Finally, the Council of People's Representatives, approve it by
July 6 and notify all public bodies by July.
 If the approval is delayed, the previous year budget will be
used on a monthly basis until the Annual Budget is approved.
 Then Budget of the country will be proclaimed and published
in the “Negarit Gazetta”.

5. Budget Allocation or Appropriation
 Following the approval, the Budget is published in the
“Negarit Gazetta”- this shows only the headings, sub-
headings, and expenditure items of the budget and not
the allocation of the budget to different branches within
the respective public bodies.
 Once the public body gets the budget allocated under
each sub-heading from the concerned Finance Bureau, it
allocates the budget under sub-headings and branches
at different levels.
 This may involve the revision of plans of action
accordingly, for proper execution of the budget.

6. Budget Execution
 Actual utilization of the approved budget to carry out predetermined
programs, plans and activities.
 Example., Hiring of personnel, purchase of capital & operation goods,
equipments, machines, furniture, stationary, etc.
 During implementation; there could be budget shortage or surplus both
necessitating the transfer of budget.
 Transfers are allowed:
 From recurrent to capital budget
 From one sub-heading to another within the
recurrent budget
 Not allowed from the capital to recurrent budget

7. Budget Auditing and Reporting
 Subject to the directives of the MoFED, the heads of
public bodies shall maintain
 a register of appropriations,
 authorized transfers and
 allotments for each budgetary heading and sub-
heading and for each capital project.
 Each institution; local or central should prepare and
submit monthly statement of cash receipt and
expenditure.
 At this stage,
 institutional compliance to the budget,
 economic and effective application conformity with
the government accounting system will be verified.

 Respective finance bureau or
 the internal audit unit or
 external auditors
could make the verification.
 Federal Auditor General or
 the Regional Audit Bureaus
are the external auditors.
 The Ethiopian government accounting system uses cash basis;
having cashbook as principal book of accounts of all
government departments.

Chapter 5
Budget Cycle in the Public Sector

The Budget Cycle
4-
137
 The budget cycle consists of four basic stages:
2. Legislative review
3. Implementation/execution
4. Accounting and Auditing/Evaluation

The Budget Cycle … cont’d
4-
138
 However, the series of activities involved in the budget
cycle are:
1. Estimating revenues
2. Estimating expenditures
3. Submitting the budget
4. Assessment of resources
5. Evaluation of the request
6. Appropriation
7. Release of funds
8. Budgetary accounting
9. Budgetary control

Estimating Revenues
4-
139
 Revenue estimation can be viewed in terms of
formulation of both the immediate year’s estimates
and those over the medium term.
 Estimates of revenue for the following year must be
made before expenditure ceilings are conveyed to
spending agencies.
 Revenue estimates for the next fiscal year are
formulated in two ways:
1. The accounting approach and
2. National Economic Parameters

The Accounting Approach
4-
140
 Receipts are forecasted based on the rate of growth
recorded in previous years.
 The average growth of revenue observed in prior
fiscal years is taken as a basis for forecasting the
revenue of the upcoming fiscal year.
 It is called an accounting approach because it relies
on recorded financial data that tell about
government's actual revenue collected in the past.

National Economic Parameters
4-
141
 In this case an explicit consideration is given to
economic parameters, including the likely increase in
GNP, the rate of inflation, and the impact of increased
government expenditure on taxation.
 GNP is the principal indicator of the economy of a
country.
 Besides GNP and inflation, revenue estimation
should take into account the possible impact of the
government’s spending on taxation.

Determining Public Expenditure
4-
142
 Eventually a budget is constructed as resources are
allocated in order to undertake each activity and
project.
 The budgetary process is only a conduct for
identification of the parameters that influence
decisions on the magnitude of expenditure.
 Determination of total expenditure takes place in two
ways: model of devolution and the aggregate model.

Model of Devolution
4-
143
 The country’s annual expenditure would be decided by
the central finance and planning agency.
 Information flows from the center (central planning
and finance agency) to operating agencies (spending
agencies).
 The purpose of the process is to ensure a firm bridge
between objectives and actions.

Model of Devolution … cont’d
4-
144
Central finance and
planning agency
Operating
Agency
Operating
Agency
Operating
Agency
Total Public
Expenditure

The Aggregate Model
4-
145
 In this model, individual expenditure requirements are
formulated by operating agencies.
 Individual expenditures would be compiled and then
consolidated.
 Here, information flows from bottom (operating
agencies) to the center (the central finance and
planning agency).

The Aggregate Model … cont’d
4-
146
Budget request of
Operating
Agency
Budget request
of
Operating
Agency
Budget request
of
Operating
Agency
Total
Public
Expenditur
e
Central finance
and planning
agency

3. Submitting the Budget
4-
147
 Central budget and planning office develops for offices
of the federal government the formats for both recurrent
and capital budgets.
 The budget format is often prepared allowing mapping
of budgets by organization and program, using
consistent budget heading and sub-headings.

2. Legislative Review
4-
148
 It is part of the budget cycle where the legislative body
checks that operating agencies are consistent with the
country’s overall economics policy and resources
supposed to be available.
 It is a program analysis comprising the internal
consistency of each element of expenditure and its
relevance to the overall framework of actions
completed in any year.

2. Legislative Review … cont’d
4-
149
 The review could be done following various
techniques:
1. variation analysis and
2. The item-by-item review

3. Budget Execution
4-
150
 It is the action phase of budgeting, the phase in which
the plans contained in the budget are put into operation.
 During execution, agencies carry out their approved
budgets.
 The approved budget becomes an important device to
monitor spending activity.

4. Accounting and Recording
4-
151
 Accounting is used a basis of controlling current
administrative activities of an entity and measuring
past performance.
 Accounting records are used as a basis for future
budget planning and preparation.

Capital Budgeting and Long-Term Financing
4-
152
 Capital budgeting refers to the techniques used for
making long-term investment decisions.
 It is defined as the firm’s formal process for
acquisition and investment of capital.
 It involves firm’s decisions to invest its current funds
for addition, disposition, modification and
replacement of fixed assets.

Capital Budgeting … cont’d
4-
153
 The factors influencing capital budgeting are:
1. Availability of funds
2. Structure of capital
3. Taxation policy
4. Government policy
5. Working capital
6. Immediate need of the project
7. Trend of earnings
8. Capital return

Capital Budgeting Techniques
4-
154
1. Payback Period (PB)
2. Internal Rate of Return (IRR)
3. Net Present Value (NPV)
4. Discounted Payback Period (DPB)
5. Profitability Index (PI)

Payback Period
4-
155
 It is necessary period for giving back the invested
money.
 It emphasis more one annual cash inflows, economics
life of the project and original investment.

Example
156
 A project whose initial investment outlay is
Birr 50,000 is expected to have a uniform
annual cash flow of Birr 10, 000 for 8 years.
How many years will be required to get back
the initial investment?
 Solution:
Payback period = 50,000
10,000
= 5 years
 Thus, the payback period is 5 years.

Limitation of PBP
4-
157
 It does not consider the time value of money
 It does not consider the cash flow after PBP
 It does not consider profitability of economic life of
project
 It does not recognize pattern of cash flow
 It does not reflect all the relevant dimension of
profitability

Net Present Value
4-
158
 Net present value (NPV) refers to the difference
between the present value of cash inflow minus cash
outflows.
 NPV = Present value of cash inflow- Cash outflow
Decision Rules:
 Accept the project when NPV is positive, NPV > 0
 Reject the project when NPV is negative, NPV < 0
 May accept the project when NPV is zero, NPV = 0

NPV of Machine A
1
Column 1 Column 2 Column 3 = (2) x (3)
Years Cash Flow Discounting
Factor @20%
Present Value
0 (35,000) 1 (35,000)
1 20,000 0.8333 16,666
2 15,000 0.6944 10,416
3 10,000 0.5787 5,787
4 10,000 0.4823 4,823

NPV of machine B
1
Column 1 Column 2 Column 3 = (2) x (3)
Years Project Cash
Flow
Discounting
Factor @ 20%
PV
0 (35,000) 1 (35,000)
1 10,000 0.8333 8,333
2 10,000 0.6944 6,944
3 15,000 0.5787 8,681
4 20,000 0.4823 9,646
Total NPV (1,396)

Pros and Cons of NPV
4-
161
Pros
 It is used in capital budgeting to analyze the
profitability of an investment project.
 Take account of time value of money
 Considers all the cash flows
 Provides better forecast
Cons
 It may not give reliable answers when dealing
with alternative projects under the conditions of
unequal lives of project.

Internal Rate of Return
4-
162
 The IRR is the return to the capital invested or allocated
or investment in the project.
 It is the discount rate that makes the present value of
cash inflows is equal to the present value of cash
outflows, i.e., NPV is zero. Helps measure the worth of
an investment
 Allows the firm to assess whether an investment in the
machine, etc. would yield a better return based on
internal standards of return
 Allows comparison of projects with different initial
outlays

Pros and Cons of IRR
4-
163
Pros
 Takes account of the time value of money
 Easy to be understood by managers
 Takes into account total cash inflows and total outflows
Cons
 Involves tedious calculations
 Difficult to use in choosing projects of varying sizes
 Difficult to choose when projects have the same IRR

Discounted Payback Period
4-
164
 It is similar to the traditional payback period except that it uses
discounted free cash flows rather than actual undiscounted cash flows
 The discounted payback period is defined as the number of years
needed to recover the initial cash outlay from the discounted free cash
flows.
 Profitability Index (PI) = present value of cash inflows
Present value of cash outflows

Profitability Index
4-
165
 The profitability index is the present value of an anticipated cash in
flows divided by the initial investment.
 It is a method of assessing capital expenditure opportunities in the
profitability index.
 Profitability Index

What is Public Financial Management?
4-
166
 PFM goes beyond traditional budget: formulation,
preparation, to execution and control and validation.
 Includes a focus on managing public resources:
 Directly through the budget; or
 Indirectly through lower levels of governments, state-
owned partnerships.
 It is thus an “umbrella” definition:
 an integrated framework covering a set of systems
 aimed at producing information, process, and rules
 that support fiscal policy making and provide
instruments for its implementation.

What is PFM … cont’d?
4-
167
 IMF (2013) “ PFM … is concerned with how governments
manage all aspects of resource mobilization and expenditure
management with a progressive extension to the medium-to-
long-term implications and risks for public finances of
toady’s policy decisions.”
 PFM is the way governments manage public resources (both
revenue and expenditure) and the immediate and medium-to-
long-term impact of such resources on the economy or
society.”
 PFM has to do with both processes (how governments
manage) and results (short, medium, and long term
implications of financial flows.)”

Objectives of PFM
4-
168
 Three basic objectives:
1. Aggregate fiscal discipline- through effective control of the
budget totals at all stages in the resources management cycle
(spending in a fiscally sustainable manner)
2. Strategic allocation- ability to allocate resources to
the strategic priorities and on the basis of program
effectiveness, and to shift resources from old to new
priorities (spending on the right set of activities).
3. Operational efficiency – ability to achieve cost-efficiency in
service delivery

Chapter 6
Public Debt Management

6.1 Concepts Of Public Debt
What is Public Debt(D)?
 Government debt (also known as public debt or national debt) is
the accumulation of past borrowings of the government.
 When a government spends more than it collects in taxes, it
borrows from the private sector to finance the budget deficit.
 PD can be owed by any level of government; either central
government, federal government, municipal government or local
government.
 As the government represents the people, Government debt can
be seen as an indirect debt of the taxpayers.

Source of Gov't borrowings
 Public debt is created through government
borrowing from:
 Individuals
 Corporations
 Institutions (internal or external borrowing)
 Other governments (external borrowing)
 Multilateral organizations (e.g. IMF & Word
Bank).

 Multilateral loans are of two types:
 hard window loans where interest cost is related to the
institutions own cost of borrowing = market interest rate
 Soft-window or concessional loans are highly subsidized loans.
 Public debt is
 a liability item on the government's account, and
 an asset on the accounts of the holders of the debt instruments.

Types of Public Debt
 Based on spatial distribution:
 Internal debt= owed to lenders within the country
 External debt= owed to foreign lenders.
 Based on time dimension/duration:
 Short term debt= less than 1 year
 Medium term debt= between 1 year and 10 years
 Long term debt = more than 10 years
 Governments usually borrow by
 issuing securities such as government bonds and bills.

Debt may take several forms:
 Notes - with maturities from one to five years
 Treasury bills- with maturities from one month
to a year and often sold at auction and
 Certificates of indebtedness- with similar
maturity periods but available at a fixed
interest rate.
 Liquidity of Debt: indicates how quickly the
debt instrument(security, bond) can be
converted into cash (money).
 The longer the maturity period, the lower liquidity of the
debt; pure debt characteristic increases.
 The shorter the maturity period, the higher the liquidity
of the debt will be; pure debt characteristic decreases.

Why tax & borrowing (debt) are Different?
This is because:
 Tax is coercive and mandatory or
compulsory
It is obligatory payment to tax payer, &
he/she has no right to claim it back.
 Borrowing (debt) is voluntarily transaction
 Bond purchaser voluntarily transfer funds to
government in private exchange for future period
interest & amortization payments.
 The security holder has right to claim it back

Marketable Public debt Vs Non - Marketable Public
debts
 Marketable Public debt: Marketable securities are
negotiable and are sold freely on the market
 Are issued in various denominations & interest is paid by
check or coupon on a periodic basis.
 Since they are salable, their price fluctuates from time to
time.
 Non -marketable Public debt: some bonds bought by the
public are not marketable but can be redeemed (buy
back), converted into goods or cash; reclining, at least after
a specified period, for their principal plus accrued interest.

Other Important concepts of Debt
 Debt Service: the interest and the principal
payment due in a given year on external debt.
 Debt-Service Ratio: the ratio of a given years debt
service to the value of exports of goods and
services.
 Concessional loan: loans that have at least a 25%
grant. Loan with lower interest rate than the
market interest rate.

 The grant element of the loan depends on:
 lower interest rate,
 long grace period,
 long repayment period and
 amounts of the repayment that is local inconvertible currency.
 Sustainable debt: is the level of debt which
 allows a debtor country to meet its current and future debt
service obligations in full,
 without recourse to further debt relief or rescheduling,
avoiding accumulation of arrears, while allowing an acceptable
level of economic growth.

 Debt crisis: refers to
 a situation where a country announces that it could not
meet its forthcoming debt repayments on its outstanding
debt to international creditors.
 Government announces that it is unable to continue
servicing (paying interest & amortization payments on its
debt).
• The outcome of not servicing maturing foreign debt
obligations is an accumulation of arrears.

• The outcome of not servicing maturing foreign debt obligations
is an accumulation of arrears.
• Arrears damages the credit worthiness stance of a recipient
country.
• External loans to have a positive growth impact on the
economy is to ensure that
 the marginal productivity of each foreign loan is, at least,
greater than the cost of the principal & interest repayment.

Budget Balance, National saving, and Economic
Growth
 A nation’s rate of economic growth, the
expansion of its potential to produce goods and
services, depends on investment.
 Investment requires a sacrifice of current
consumption so that the resources used to
produce goods for today can be reallocated to
the production of capital goods.
 Saving decreases current consumption ,but
enhances future investment.

 Saving decreases current consumption
,but enhances future investment.
 The more we save today, the greater our
future rate of growth of output & vice versa.
 Budget Balance: occurs when Governments revenue
and expenditure is equal in a given period.
 National saving: when Government expenditure is less
than its revenue; the Government may save or finance the
previous debts.
 Economic Growth- when investment increases(both
public & private), the level of national output,
employment, income increases, these can be said
economic growth.

Rationale for Public Debt
 Generally public debt is incurred as a means of
financing the government budget deficit.
 Budget deficit occurs when government
expenditure exceeds domestic/mainly/ tax
revenue
 Major reasons for Public debt/budget deficit:
 Due to too little tax over spending
 To undertake development projects
 To stabilize the economy during counter
cyclical periods, E.g. borrowing during
recession

6.3. Economics of Public Debt
How Public Deficit is Financed?
 Public sector deficit can be financed in four basic ways:
1. Printing money- results inflation
2. Running down foreign exchange reserves.
3. Borrowing from abroad
4. Borrowing domestically
 Each of these mechanisms could lead to at least one
potential problem

 Printing money acts like a tax, & results in
inflation which lowers purchasing power of
money
 Drawing foreign exchange reserves could lead
to a balance-of-payment crisis
 Borrowing abroad could lead to a foreign debt
crisis
 Domestic borrowing might crowd-out private
investment by raising interest rates.
 There is, no optimal composition of deficit
financing.

Debt Financing
 Debt financing implies
 the sale of a security that bears the promise
to pay interest over a given number of years
and
 to return the principal loaned at the end of
the given time.
 Government debt can be internal and external
 Internal debt repayment: repayment of the
portion of a government’s indebtedness owed to
its own citizens.
 External debt repayment : is repayment of
public indebtedness owed to foreign citizens.

Effects of Debt Financing
 Internal debt repayment
 May be redistribution of purchasing power
 May cause inflation
 May forego consumption & investment in abroad
 External debt repayment
 Resources flow out of the nation,
 Loss in productive opportunities
 Adverse effect on economic growth
 Excessive external debt have serious consequences for future growth
opportunities :
 involve outflows of funds &
 real losses in productive opportunities rather than mere redistributive
effects.

The Incidence of Deficit Financing
What is the incidence of deficit finance?
 Many economists believe that deficit finance:
 bids up real interest rates and
 contributes to both
 a reduction in national saving,
 a reduction in national investment,
 then contributes to a slow-down in capital
formation and economic growth.

Why Nations Worry About Reduced Savings?
 A reduced savings may contribute to:
 Higher real interest rates,
 Higher real interest rates discourage investment,
 Lower employment& income( individual &
national)
 Decrease production & consumption
 Finally, lower economic growth
 If major share of GDP is absorbed by the government
deficit, this
 reduces national saving and
 lowers future living standards, other things being
equal.

Effect of Budget Surplus on Credit Markets
 When the federal government’s budget is in
balance or in surplus, there is no need for the
Government to enter credit markets as a borrower.
 A balanced budget implies that the market demand
for credit is equal to the private demand for credit.
i.e. DD(lf)=SS(lf).
where lf = Loanable fund
 When the government runs a surplus, it can affect
the supply of loanable funds available for private
investment in the credit markets.
 Budget surplus can be used to retire outstanding
government debt on the credit market and the
equilibrium market interest rate will be set in.
 If Budget surplus is used to retire/repay debt,
national saving increases, Investment increases,
GDP rises( Econ growth).

6.4. Borrowing by State and Local Governments
 Generally, Debt repayment depends on:
 Maturity period
 Risk of default
 Inflation
 State & local (or provincial, municipal) securities
are inherently more risky than federal
government securities.
Because:
 The ability of central, or federal, governments to print
money as a last resort makes the risk of default on the
securities virtually nil.
 However, federal debt does remain subject to the risk of
reduced value due to inflation.
 State and local governments, cannot monetize their debt,
conceivably can default on their debt obligations.

Characteristics of State & Local
Government Debt
 Marketed only nationally: state & local
governments debit securities are marketed only
domestically like private borrowing.
 Cannot influence interest rates as the federal
government securities does.
 Inherently more risky as compared to federal
Government debt instruments.
N.B: Long-term debt financing by state and local
governments can be justified on the basis of the
benefit principle for financing capital projects.

State and Local Debt Management
 State & local government authorities must
minimize the interest burden on their debt
& with the risk of default.
 State and local governments issue two broad
types of securities to cover their debt general
obligation bonds and revenue bonds.
1. General Obligation bonds: are backed by the taxing
power of the government that issues the securities.
2. Revenue bonds: are backed by the promise of revenue
to be earned on the facility being financed by the bonds.
Example: finance roads, bridges ,& other facilities that
will generate revenue,(via tools & user charges)

6.5. Burden of the Debt
 Debt financing implies the sale of a security.
 No compulsion is involved in the sale of such securities.
 But, governments compete with other borrowers in the
market for loanable funds.
Crowd out private Investment.
 Governments sell securities of various types &
maturities( bonds ,Treasury bills) that compete with
various private securities( commercial-bank savings
deposits, savings and loan shares, bank
acceptances, and corporate bonds).
 These will rise interest rate and the decrease investment.

Burden of the Debt and Income Redistribution
 No general agreement exists among economists
concerning a definition of the burden of the
debt.
 The burden of the debt is based on the
redistributive effect of debt financing.
 When governments obtain funds to finance
public expenditures by issuing debt, no
compulsion is involved, unlike tax financing.
 Securities issued by government authorities are
purchased voluntarily by individual citizens,
financial institutions, and other private economic
units.

Impact of the Debt on Future Generations
 Two basic opposing arguments among
economists:
i. Present generation should pay the
debt burden
ii. Future generation should pay the
debt burden
 Some economists argue that the burden of the debt
cannot be transferred to future generations but must
be borne by the present generation.
 Here burden implies that debt creation merely involves foregone
private consumption in the current period.
 It ignore the fact that this sacrifice is completely voluntary and is
compensated by greater opportunities for future consumption as a
result of interest payments on the government securities.

 The assumption that the future generation
must be taxed to pay the interest burden on
the debt:
 this generation must undergo a real reduction
of income, without the compensation of
increased future consumption.
 It will suffer a reduction in their living
standards as a result of the federal debt if past
deficits cause interest rates to rise and reduce
private investment.
 A reduction in private investment implies that
the capital stock of the nation will grow more
slowly.

 investment implies that the capital stock of the nation
will grow more slowly.
 This implies a growing national debt and a reduction in
future living standards.
 This burden can be offset if :
1. Increased saving by the current generation of
taxpayers results from the use of deficit
financing; &
2. The revenue obtained from the issuance of
public debt is used to finance projects that
yield future benefits.
 Both of these result in increased bequest(inheritance) to
future taxpayers that offset the burden of the debt.

 On the basis of the benefit principle, it is
legitimate to finance projects that yield the bulk
of their benefits in the future, and in a particular
local area, through borrowing.
Because:
 Taxes levied to pay the interest & principal on
the debt can coincide more or less with the
benefits flowing from the project.
 Those actually receiving the benefits-the individuals
of the future tax base- therefore, also will bear the
tax cost of financing the projects.
 The postponement of taxes as a result of debt
issue is often referred to as “pay-as-use” finance.

6.6. Other Effects of Public debt
 Undermine domestic policies : it might fall under
the dominance of foreign lending country policies
 Opportunity cost of implementing foreign driven
policy -the forgone value of implementing pure
domestic policy.
 Loss of national dignity, identity & respect .
 Soundlessness, voicelessness.

Risk of Lending to Governments
 Lending to a federal government in the country's own
sovereign currency are often considered "risk free" &
 Are made at a so-called "risk-free interest rate".
 This is because the debt & interest can be repaid by:
 Raising tax receipts ( by economic Growth or raising rates)
 Reducing spending ( decreasing G)
 Printing more money

Risk of Lending to Governments
 Example: Ethiopian Treasury bonds denominated in
Birr are often considered "risk free" in Ethiopia.
 But, national debt in foreign currency cannot be
disposed of by printing money.
 Lending to a local or municipal government can be
just as risky as a loan to a private company, unless the
local or municipal government has the power to tax.

6.7. The Problem of Debt Servicing & Debt
Management
 What were the reasons for the global debt crisis
of the 1980s?
1. Imprudent borrowing policies in the debtor
countries
2. Imprudent-lending policies of commercial
banks
3. Extraordinarily unfavorable world
macroeconomic pressures( rise in r, fall in
TOT ( BOP deficit), Oil shocks(1974/75), fall
in P of primary products.)
4. Debt burden brought heavy dependence on
the multilateral institutions (WB and IMF)

Overview of Indicators of External Vulnerability
 Debt-Related Indicators may include:
 Ratio of External Debt to GDP
 Average Interest Rate on External Debt
 Average Maturity
 Debt in Total External Debt
 Explain each of them.

6.8. Resolving the Debt Crisis:
Remedies:
 Debt crisis refers to a situation where a
country announces that it could not
meet its forthcoming debt repayments
on its outstanding debt to
international creditors.
 Solutions to Debt Crisis :
i. Debt cancellation /relief
ii. Debt conversation (Debt Swaps) i.e. converting
non-concessional debt into concessional debt
iii. Debt rescheduling (e.g. extending of time)
iv. Provision of new money with conditionality

6.9 Public Debt Management
 Government debt management, dating back more
than two centuries in some European countries, has
received increasing attention and resources since
the late 1980s.

Public Debt Management
 A government debt management strategy that seeks to
build a low-risk government debt portfolio by choosing
an appropriate currency composition, interest rate
structure, and maturity profile can help reduce the effects
of financial shocks on the government’s balance sheet.

 Adverse demand and supply-side shocks, which affect
output and inflation, also have a fiscal impact that can be
offset in part by establishing a diversified set of domestic
funding instruments.
 Government debt management policies can have
important implications for the effectiveness of
macroeconomic policies and for other elements of
government financial management.

 To the extent possible, the day-to-day implementation
of sound debt management policies should seek to
reinforce the objectives of macroeconomic policies
and of policy reforms aimed at improving the
efficiency of the domestic financial market.

 For example, debt management practices should seek to
build investor participation in the domestic bond market
and reduce uncertainty premium by ensuring that debt
management goals and policies are clear and do not
discriminate among classes of investors.

 Similarly, concentrating issuance on a limited
number of government securities and building up
their liquidity can help reduce the liquidity
premium that investors price into government
securities.

Protection of the Government’s Reputation
 The quality of government debt management can have
important effects on a government’s reputation.
 Government debt managers represent the minister of
finance in financial markets.

 The professionalism with which public debt
managers conduct their relationships with
underwriters, investors, and rating agencies, and
how they communicate on a range of public
policy issues relating to the government’s role in
financial markets and its strategy for managing
cost and risk, can affect the market’s judgment of
the government’s financial management.

 Similarly, the government’s role as a financial
market participant is important in conveying
messages to the financial markets about acceptable
standards of behavior.
 It is essential, therefore, that the government’s debt
be managed according to the highest ethical
standards.

 Government debt managers need to protect their
governments from the risks associated with international
fraud. This risk should not be underestimated.
 It is not uncommon for government ministers and debt
managers to be approached by individuals claiming to
have access to very large foreign currency borrowing
opportunities at highly subsidized rates in return for up-
front fees or a letter of representation.

 These individuals may seek to use a ministerial
letter or the official letterhead of a government debt
office to help establish their credentials and defraud
another borrower or investor.

Importance of Public Debt Management
1. Government debt management can significantly
reduce the government’s balance sheet risk and the
economy’s vulnerability to economic and financial
shocks.
2. It also can assist the development of domestic
financial markets and strengthen the governance
and financial management practices in the public
sector.

Objectives of government debt management
A) Primary objectives
1. The primary objectives of government debt
management are to finance the government’s
borrowing needs efficiently and to ensure that the
government’s debt-servicing obligations are met.

 For governments with strong foreign currency
credit ratings, accessing international markets is
relatively straightforward.
 On the contrary, it can become a major worry for
countries with small domestic capital markets that
depend on foreign currency borrowing to help
maintain their foreign currency reserves and
finance their fiscal deficits.

2. The 2nd main objective is to ensure that the government
debt portfolio is managed according to the government’s
cost and risk objectives.
 Several governments in the developed nations set
government debt management objectives aimed at
minimizing the government’s expected debt-servicing
costs over the medium and longer term, subject to a
prudent level of portfolio risk.

B) Secondary objectives
1) Maintaining the liquidity of government issues at various
points provide a pricing benchmark for private issuers.
 Emerging market countries may seek to promote the
development of the domestic debt market through a gradual
extension of the maturities of government debt and the
introduction of new debt instruments.

 Financial crises and sovereign defaults will occur when
governments focus solely on expected cost savings
(through, for example, issuance of large volumes of
short-term debt).
 The consequences can be that government budgets
are seriously exposed to changing financial market
conditions, including investors’ reassessments of
the country’s creditworthiness and the effects of
global contagion.

 These adjustments are often reflected in sharply
higher government borrowing costs and currency
weakness and, in some cases, in inability to access
foreign capital markets.
 What may appear to be a cheaper transaction often
entails significant risks for the government and
constrains its capacity to repay lenders.

 Cost and market risk are terms that are often used
loosely by debt management practitioners.
 Cost generally refers to the expected stream of cash
flows associated with servicing (including repayment of
principal) a series of debt obligations.

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