CHAPTER 01 : THE NATIONAL INCOME

 By the end of this TOPIC YOU should be able to:

• Explain the meaning of National Income and concepts relating to National Income; describe the determinants of the size of National Income; and formulate the uses of National Income.
• Describe the three methods of calculating National Income to solve different problems; use the three methods of calculating National Income to solve different problems;
• Explain the problems of calculating/computing National Income
• Discuss the weaknesses of using income per capital to compare Standard of living; and relate consumption and income, multiplier, marginal propensity to save.
• Explain the Investment theory; discuss the factors affecting Investment; and describe the Acceleration principle.
• Explain the meaning, and discuss of Income Inequality; describe the forms of Income Inequality; and describe the measures of reducing Income Inequality; and construct Lorenz curve and give the economic interpretation of the Lorenz curve.

MEASUREMENT OF THE NATIONAL INCOME (THE NATIONAL INCOME ACCOUNTING)

The national income accounting is the process of measuring the value of the national income in a specific period of time, like a year. Before looking at the methods of measuring the national income, let us look into the circular flow of income, output and expenditure.

Circular Flow of Income

  Income to firms by selling goods = Expenditures by households

  Y ^≡E

Expenditure of firms on inputs = Income of households, by selling inputs

E ^≡Y

Figure 1.1: Circular flow of the national income

Assumptions of the Circular Flow

The circular flow of the national income has the following assumptions:

• It assumes a closed economy, in which there is no foreign trade such that commodities are produced and consumed within the country.

• There is no leakage, like savings. This means all the income received by individuals must be spent on goods and services and non remains for savings.

• Simple economy with two sectors of the economy which are, business firms and households (consumers)

• Households own the factors of production.

• It assumes that households supply all the factors needed for the production of commodities, and receive payments in the form of wages, rent, salaries, etc.

• It assumes that households spend all their income in buying goods and services that are provided by the producers. Therefore, the household's expenditure is the producer’s income.

Note

From the circular flow of income, we can see that, each time any commodity is produced and sold. Its market value is equal to the value of the expenditure of the consumers on that commodity and it is received as income, to all the participants (factors of production) in the process of production and exchange.

Leakages (withdraws)

This is an income that does not passed go through the circular flow of income. For example, tax, imports, savings and capital outflow. It has a contraction effect on the national income.

Injections

These are the additions to the domestic income, arising from other expenditures apart from the domestic households. It has an expansionary effect on the national income. Examples of the injections in the economy are: investments, the government expenditures, exports and capital inflow. If any of these injections change, it leads to a change in the national income.

Methods of Calculating the National Income

There are three methods of calculating the national income, namely:

(i) Product method

(ii) Expenditure method 

(iii) Income method

(i) Product Method:

In this method of computing the national income, the value of the national income is obtained by taking the values of goods and services produced by the citizens of a given country for period of time. The national income, by this method can be reflected by the Gross National Product.

The Gross National Product

This is the total value of all the goods and services produced in the country in a particular year. It is usually calculated at factor cost that is, excluding subsidies and taxes imposed on the goods or services. It is, in fact, the cost of the total output of the producers. After taking account of the net income from abroad, which is the value of exports less the value of imports, we have the Gross.

National Product at Factor Cost

Having calculated the Gross National product, it is possible to calculate the national income. All that is required is to make an estimate of the capital consumption that has taken place during the year, and deduct this from the Gross National Product. Thus, it will be seen that, the national income is in effect the net national product, that is, the total volume of production after allowance has been made for that part of production that was devoted to making goods the depreciation of the existing capital equipment.

Gross National Product at Factor Cost of country X in 1978.

Table 1.1: The national income by product method

The national income (1)

This method can be divided into two approaches:

• Final product approach

• Value added approach

• Final Product Approach: In this approach, the national income is calculated by taking the market values of all the final products produced in the country, for a given period of time. For example, assume a simple economy that produces only one commodity, e.g. cloth and the market value of the cloth produced is Tshs. 1000/=. By applying the final product approach, the value of the national income, for this simple economy, will be equal to the value of the final goods produced, i.e. Tshs. 1000/=

• Value Added = Value of Next Stage – Value of the Previous Stage, so the value of the final product = the sum of values added in different stages; from the first stage (production) up to the last stage (exchange). For example, in a simple economy, a cotton farmer produces cotton and sells it to a threading company at Tshs. 400 per kg; the threading Company produces threads and sells it to the Weaving Company at Tshs. 700 per kg. The Weaving Company processes the product and sells it to the Textile Company for Tshs. 900 per kg. The textile Company produces cloth and sells it to a final consumer for Tshs. 1000 per kg.

If the value of cotton is calculated by adding 400 + 700 + 900 + 1000, it will be equal to Tshs. 3000. This will result into double counting, triple counting, and quadruple counting. Therefore, in order to obtain the correct value of the Gross National Product, only the value added is taken into account. From the above example, the value of a national product of a simple economy will be therefore calculated as follows:

Table 1.2: Value added method

(ii) Income Method:

In this method, the value of the national income is obtained by summing incomes such as rent, wages, profit, interest, dividends, allowances for the depreciation of fixed assets, returns on royalties, surpluses, etc.

Example 1

In this example, the value of the national income is obtained by taking the total income derived from economic activities as shown in table 1.2 above, whether the national income is calculated as the total volume of production or the total income derived from economic activities the two totals must be the same. Indeed, the volume of production and the national income are the same thing. It is certain that this must be so, since what is paid by a consumer for a commodity is income to all those who have had a share in its production. Each commodity, it is said, represents merely a collection of the services of those who have obtained the raw materials changed its form in some way, transported and marketed it at wholesale and retail stages.

Table 1.3: Total income - Income methods

Example 2

Find the national income by income method, given the following information:

• Payment to workers in a current year amounted to Tshs. 60 million.

• Existing surpluses Tshs. 30 million.

• Rent and royalties accrued Tshs. 50 million.

• Share holders’ dividend Tshs. 10 million.

• Profit realized Tshs. 5 million.

Solution

The national income = wages + profits + surpluses + rent (royalties) + dividends

The national income = 60 m + 30 m + 50 m + 10 m + 5 m = Tshs. 155 million

(iii) Expenditure Method

A third method of calculating the national income is to find the total of all expenditures incurred during the year.

Table 1.4: Total Expenditure - The national incomes (3)

Therefore, the national income by expenditure method can be summarized that the national income =C + I + G + (X - M)

Where;

C = Individual expenditures on the consumption of final goods and services

I = Firms expenditures on investment goods and the government expenditures on capital goods.

G = The government expenditures on items such as social services, wages to civil servants, security, etc.

X = Foreigners’ expenditures on the consumption of goods and services produced by the country citizens. Exports must be included, because they earn income to the citizens of a country.

M = Expenditure by firms, individuals and the government on goods and services produced by foreigners. Expenditures on imports must be excluded, because they involve on outflow of income from the economy.

Determinants of the Size of the National Income The national income is determined by the following factors:

^•  The available stock of natural resources: The availability of a large stock of natural resources such as minerals, water sources, soils, weather condition, etc. influences the growth of the national income, such that a low stock of natural resources leads to low production, consequently to a low the national income and vice versa.

^•  The stock of capital goods: The size of the national income in the country depends on the size of the capital goods available in the country. If the size of capital goods, such as factories, machines, infrastructure and raw materials, is large, the country would experience a fast growth of the national income, unlike when a nation is facing shortage of the capital goods.

^•  Level of technology: The size of the national income depends on the level of technology that a country has achieved, if production is done by using advanced technology in the country, the output as well as the national income would be large.

^•  The availability of Human Resources: The national income is influenced by the available labour, both skilled and unskilled, as well as the managerial capacity, efficiency and the number of entrepreneurs.

^•  Political Situation: When there is political stability in the country, investors become confident to invest their capital, therefore, resulting into an increase in the national income.

^•  The government Policies and Actions: The growth of the national income depends on sound economic policies, which are formulated by the government in order to stimulate economic growth.

^•  Terms of Trade: This is the ratio of the price index of exports and the price index of imports, if the price index of a country's export is greater than the price index of import, the national income will grow, since more income will be received through exports, unlike when the terms of trade are unfavourable.

Concepts Relating to The national income

The concepts relating to the national income are as follows:

- GNP = Gross National Product: This is the sum of the market values of the goods and services produced by the citizens of a given country for a period of time. GNP is obtained by summing the value of goods and services produced by citizens of a country, living within and outside the country. Or

Gross National Product (GNP): This is the national income produced by citizens of a country, living within and outside the country. GNP = GDP + factor income from abroad.

- GDP = Gross Domestic Product: This is the sum of the market values of goods and services produced within the country by all the residents (people living in the country) in a given period of time.

Or

Gross Domestic Product (GDP):This is the national income produced within the country by all the residents, both citizens and non citizens.

- Net Factor Income from Abroad (N.F.I): This is the difference between income received by citizens of a country, working abroad, and income received by foreigners who are working in the country or who have investment in the country.

N.F.I = Net income from abroad – Income received by foreigners.

N.F.I = income inflow – income outflow.

GNP = GDP + net factor income from abroad.

GNP = GDP + (x – m).

GDP = GNP – net factor income

- Net National Product (NNP): Is the sum of the market values of goods and services produced by the country’s citizens after the deduction of capital consumption, i.e. depreciation.

NNP = GNP – depreciation.

Depreciation is the wear and tear of the capital goods that are used in the process of production. NNP is the national income.

Note 

Depreciation is the payment on capital for their wear and tear. So, it is the cost incurred on capital goods and therefore, it can be regarded as a factor income on the capital goods. This means that it can be added to other incomes, when computing the national income by income method.

Income Method

The national income (N.I) is the summation of incomes including depreciation. N.I = Rent + Interest + Profit + Wages + Depreciation.

GNP at Market Price and at Factor Cost

Gross national product can either be measured at market price or at factor cost. When it is measured at market price, it includes indirect taxes imposed by the government, but excludes subsidies provided by the government to the producers and consumers. When it is measured at factor cost, it includes only factor costs, i.e. factor incomes. This means that, in order to get gross national product at factor cost, indirect tax must be deducted and then add subsidies:

GNP at market price = GNP at factor cost + indirect tax – subsidies GNP at factor cost = GNP at market price – indirect tax + subsidies GDP at market price = GNP at factor cost + indirect tax – subsidies GDP at factor cost = GDP at market price – indirect tax + subsidies

National disposable income = National income – direct tax

Personal disposable income = Personal income – income tax

Uses of The national income Statistics 

The national income statistics has the following uses:

- The national income statistics can be used to show the growth rate of the national economy by comparing the GNP of different years. For example, if the GNP of country X, in the year 2000, was Tshs. 20 million and GNP, of the year 2001, was Tshs. 40 million, then the growth rate of the national income was 100 percent. The national income statistics can be used to compare the standards of living of different nations by computing the per capita income of each country. Per capita income is income per person. It is the average income of each citizen in a certain period of time in a given country.

- The national income statistics can be used to show the performance of each sector of the economy, to the national income, by examining the contribution of each sector to the national income i.e. by using the national income data. We can know the contribution of agriculture, industrial, mining sectors, etc. In this case, the government can be in a position to determine which sector should be given priorities in assistance.

- The national income statistics shows the distribution of the national income to various factors of production, which is from the national income data. We can know how much each factor of production is rewarded/paid.

- The national income statistics can be used by the government to make decisions concerning the allocation of resources for different and alternatives uses. It means that, by knowing the national income, the government is able to make good decisions on how to allocate its resources in different sectors of the economy. Also, the national income statistics enable the government to estimate the revenue and expenditures in a given financial year.

- Economic problems can easily be identified through the national income statistics. Examples of such problems are inflation, fall in income, unemployment, etc.

- The national income can also be used to reflect the welfare of the citizens of a country. An increase in the national income implies improvement in the welfare, especially when there is a fair distribution of the national income.

- Estimates of the national income are very important in the formulation of a national budget by the government, i.e. the government uses the national income statistics to estimate its revenue and expenditures for the current year. Likewise, the government may use the national income data to formulate national plans and policies.

Difficulties in Computing/Compiling the National Income The following are the difficulties in calculating the national income:

Problem of data: In many countries, especially in LDC’s, it is very difficult to obtain accurate data because researchers do not provide the correct information, lack of trained man power, lack of modern equipment; and also due to the fact that, in LDC’S, many activities are done in informal sectors, in which it is very difficult to obtain official data. Therefore, in LDC’s, the information concerning the national income is mostly estimated.

Subsistence economy: In LDC’S, the main economic activity is agriculture, but it is performed at subsistence level. It means, peasants produce for their own consumption. Therefore, their output is never included in computing for the national income, because the national income statistics takes into account only goods and services which are produced and exchanged formerly. Because of the existence of subsistence economy in LDC’S, the national income of these countries is largely under estimated. Illegal trade (black market): Some output that is produced in the country may be sold in illegal markets within or outside the country. Therefore, it is very difficult to obtain data about such output when computing the national income.

Inflation: The rise in the general price level or inflation has the effect of increasing the nominal value of the national income. When there is inflation in the country, prices of goods and services are higher, so when computing the national income at market prices (current prices), the value of the national income will be higher because it may be exaggerated by the amount of inflation. The national income will therefore be so high in nominal terms, but in real terms, the national income will be low. In order to see whether the real the national income has increased or not, the nominal the national income must be adjusted at the value of the inflation rate.

Housewives activities: The contribution of housewives and domestic activities are excluded from the national income figures. Also, services of household employees are excluded in many developing countries. Many women are housewives and therefore, their domestic services are not included in the national income accounting.

Self-employment: Sometimes people do various activities such as building houses and repairing of machines by using their own labour. Therefore, it is very difficult to value such activities and include them in the national income statistics.

Problem of estimating the value of depreciation: In order to get net national product we must remove depreciation from GNP, now the problem is that it is very difficult to distinguish new investments or machines from old investment or machines because machines may be replaced from time to time.

Difficulties in estimating income received from abroad: Information concerning the citizens who work abroad is very difficult to obtain, and therefore, it is very difficult to compute accurate data concerning the income of citizens who work abroad.

Problem of double counting, triple and quadruple counting: This problem occurs when the value of raw materials or intermediate products is counted. This results into double counting because the value of raw materials or intermediate products is included in the value of a final product. For example, the value of cotton is included in the value of cloth. If the value of cotton is counted when computing the national income, it will result into double counting because the value of cotton is included the value of cloth. Also transfer earnings such as students’ allowances are included in the government expenditures, but if they are counted as incomes, it may result to double counting.

Problem of goods in progress: There is difficulty in estimating the value of goods which are still undergoing production in factories or machines.

Insufficient manpower for compiling the national income: In LDC's, there is lack of enough manpower to compile the national income.

The Weaknesses of Using Income per Capita Statistics to Compare Standard of Living among Countries

In principle, income per capita can be used to measure and compare the standards of living among countries. But in practice income per capital is a weak indicator of the standard of living, and therefore cannot be a good measure for the differences in the living standards among countries. This is due to the following reasons:

- There are differences in the types of spending among countries: Some countries spend a larger part of their total expenditure on welfare services, such as health and education, while other countries spend a larger part of their income on expenditures which do not improve the living standards of the people like buying arms.

- Income per capita does not take into account differences in the distribution of the national income: In some countries, especially socialist countries, the GNP's are very low but there is fair distribution of GNP among the citizens. So the standards of living of the people is much higher while in capitalist countries, GNP are much higher but there is uneven distribution of the national income, which makes the standards of living of most of the people to be low.

- The national income figures do not take into account the problem of insecurity: Some countries are rich in terms of GNP but there is lack of peace and security. So the standard of living of the people is very low while other countries have lower GNP'S but they are more peaceful, which make the standards of living of the people to be relatively higher despite the low per capita income.

- The national income figures do not take into account the differences in climate among the countries: Differences in climate among the countries make big differences in welfare among the countries. For example, many resources in cold countries are devoted to provide warm houses, warm clothing, heated swimming pools, etc. All these activities are counted as production activities, and thus are included in GNP, while in hot countries, warmth freely available, nobody adds an extra amount to GNP, to produce warmth.

- The national income figures do not take into account the differences in the nature of consumptions: Even in the countries with the same GNP, the standards of living may not be the same, because people consume different commodities due to environmental and social differences. For example, a larger number of Indians neither eat meat nor drink alcohol for religious reasons. The French put higher priority on good food, wine and luxury than housing as opposed to Americans who put a higher priority on good houses than food and luxury.

- There are differences in the price structures in countries: Prices of goods and services in different countries are different, which makes the comparison difficult. For example, in poor countries, due to habit food stuffs, such as meat, fruits and vegetable forms a large part of people’s expenditures, and they are sold at very low prices, while in developed countries, food stuffs are very expensive. This means that, the total expenditure on food stuffs in LDC’S is smaller as compared to the developed countries. Therefore, if we use income per capita to compare the standards of living, then standards of living of LDC’S will be lower than that of developed countries.

- Problem of data of the national income and population: In less developed countries, there are problems of getting accurate data concerning the national income and population. The data on them are estimated, while in developed countries, there are little problems of getting data concerning the national income and population. Therefore, it is quite unreasonable to compare the national income and the per capita income of developed countries and LDC’s.

- Comparisons of the national income (per capita income) are made by using official foreign exchange rates: When comparing the GNP of two countries, the official exchange rates are used. However, these exchange rates do not provide the reality in terms of the actual purchasing power of the two currencies, in the two countries under comparison, since one currency may be weaker than the other but citizens in that country may enjoy much higher standards of living, due to the low price of goods which are sold in that country. For example, if we intend to compare income per capita between Tanzania and Kenya, we will use the exchange rates of the currencies of Tanzania and Kenya. However, this may be misleading, because of the differences in the price structure of the commodities between the two countries. For example, in case the exchange rate between the two countries is 1 Ksh: 10 Tshs, it may not be possible to buy, in Kenya, with one Kenyan shilling the same amount of goods and services, which can be bought in Tanzania by 10 Tshs. If these goods are more expensive in Kenya than Tanzanians will be able to buy more quantity of goods with Tshs.10, than Kenyans, with Kshs1.

- Inflation: When there is inflation in the country, the nominal the national income become higher than in the country where there is no inflation. Therefore, when comparing the income per capita, the country with inflation will have a higher income per capita than the country without or with low inflation.

- Other forms of wealth: The national income statistics consider the flow of wealth created by production around the economy, but a substantial proportion of wealth such as houses is not in terms of money and, therefore the national income statistics do not take into account the well being gained from them.

- Social costs and benefits are not counted: The national income is based on private costs and benefits, while social costs, such as pollution, are not calculated. Thus, a country may have a high the national income figure, but its citizens are poor in terms of welfare, due to the social costs, such as pollution.

Determinants of the national income: 

Keynesian Approach

According to Keynes, the determinants of the national income are the aggregate demand and supply. The national income is determined by the level of equilibrium between the aggregate demand and supply. In order to elaborate this theory, Keynes made some assumptions as follows:

• He assumed an economy with two sectors, which are, households and firms. The households supply services to the firms and they receive money. Firms sell their products to the households.

• There is no the government expenditure.

• The price of products should remain constant.

• The supply of labour and capital should be constant.

Aggregate Demand

These are the total expenditures in the society. They comprise of firms’ expenditures on buying investment goods (I) and the consumption of goods and services by individuals(C). C = Consumption of goods and services by individuals I = Firms’ expenditures on buying investment goods.

Aggregate Demand (AD) = Consumption + Investment

According to Keynes: The national income (Y) = C + I = Aggregate demand

Aggregate Supply

This is the total amount of goods and services which have been produced in the country in a given period of time. When these goods and services are sold, they provide income to the people and are counted as the national income. Part of this income is used for consumption, and the remaining part may be saved. Therefore, the aggregate supply or the national income is expressed as follows: Y = C + S Where;

Y = aggregate supply

C = consumption

S = saving

The equilibrium level of the national income will be as follows:

Y = C + I = Aggregate Demand Y = C + S = Aggregate Supply

C + I = C + S

I = S = Equilibrium level of income

Equilibrium Level of Income

This is the level of income which is attained when the aggregate demand is equal to the aggregate supply, that is, when the planned expenditures are equal to the output level, the equilibrium level of the national income will be as follows:

Y = C + I = Aggregate Demand Y = C + S = Aggregate Supply

C + I = C + S

I = S = Equilibrium level

The national income = Amount spent on consumers goods + Amount saved

That is, Income = Consumptions + Savings

Therefore, Savings = Income - Consumptions

Then taking the national income in real sense is the total volume of production which comprises consumers' goods and producers' goods (real capital or investment): The national income = the amount of consumers goods produced + the amount of capital goods.

That is, Income = Consumptions + Investments

Therefore, Investments = Income – Consumption

Therefore, savings and investments are each equal to income, less consumptions. They must, therefore, be equals to one another, and so, Saving = Investment.

Figure 1.2: An equilibrium level of income

In figure 1.2 above:

- The equilibrium level of income/full employment level is at point R where the planned expenditures (aggregate demand) is equal to the output level (aggregate supply).

- At point P, we find that the spending level (Aggregate demand) C + I +G + X - M is greater than the amount of output produced, i.e. inflationary gap. In this case, no equilibrium can be achieved under these conditions, because when spending is greater than output, business must raise up-production to meet the surplus demand, because businesses want to supply whatever is demanded. Thus, at point P, forces are set in motion to push output to higher levels, that is, towards point R.

- At point Q, the total output (Aggregate supply) is greater than the total expenditures (Aggregate demand), i.e. deflationary gap. Therefore, the economy cannot remain at this point for a very long time. This situation forces producers to cut back on output, thereby reducing the GDP, and returning the economy to the equilibrium level of income at point R.

- Point R is the only point at which there is stable equilibrium.

The relationship between Consumption and Incomes

The relationship between consumption and income can be shown by the consumption function. This is the mathematical relationship between consumption and income. It is given by the equation: C = a + by

Where;

C = consumption a = autonomous consumption (consumption which does not depend on income changes).

Even if there are changes in income, this consumption will be constant.

b = Is the proportionate part of the total income consumed. It expresses the rate at which consumption changes when income also changes.

Y = This is income (disposable income).

It can be expressed graphically as shown below:

O Y₁ Y₂ National income

Figure 1.3: Relationship between consumption and income

In figure 1.3 above, an increase in the aggregate expenditure i.e. C + I, lead to an increase in the national income.

Propensity to consume

This is the proportionate part of the total or extra income used for consumption. There are two types of propensity to consume:

Average propensity to consume (APC)

Marginal propensity to consume (MPC)

Average Propensity to Consume (APC)

This is the consumption per unit of income. OR is the ratio of consumption to income. It can be expressed as

Marginal Propensity to Consume (MPC)

This is the additional consumption due to a unit increase of income. MPC is the slope of the consumption function, from the consumption function C = a + by

Derivation of MPC:

The relationship between Savings and Income

The relationship between the savings and income can be shown by the saving function. This is the mathematical relationship between income and savings. It can be derived as follows: From the aggregate supply: Y = C + S

Substitute a + by into C Y = a + by + S

-S = a + by – Y

-S = a + y (1 – b)

S = -a + y – by

S = -a + y (1 – b) Saving function.

Propensity to Save

This is the proportionate part of the total income used for saving. There are two types of propensities to save: (i) Average propensity to save

(ii) Marginal propensity to save

(i) Average Propensity to Save

This is the ratio between saving and income. That is, it is the amount of saving per unit income.

APS= S/Y

Where;

S = Savings Y = Income

S = -a + y (1-b) 

Therefore,

APS = −a+y(1−b) y

(ii) Marginal Propensity to Save

This is the additional savings per unit increase of income.

Derivation of MPS:

Y = C + S

Y = the national income

C = consumption

S = Savings

A change in income (-Y), will cause a change in both consumption and savings, as indicated below:

Therefore;

Table 1.5: Savings, the national income, consumption, average propensity to consume, marginal propensity to consume and marginal propensity to save

Concept of the Multiplier

Multiplier is the rate at which the national income changes due to changes in any of the determinants of the national income, such as investment. There are various types of multiplier, namely, investment multiplier, the government expenditure multiplier, import and export multiplier, etc.

Simple Investment Multiplier

This is the rate at which the national income change due to the change in investments

It is given as 

Figure: 1.4: A simple investment multiplier

 In figure 2.4 above, the changes in aggregate demand can either be caused by changes in consumption function or changes in investments function. When investments expenditures change from I₁ to I_2, it will cause a change in aggregate demand from Y = C + I to Y = C + I +∆_I. Due to this change, the equilibrium point will change from E₁ to E_2. A simple investment multiplier can, therefore, be derived as follows:

Example 1

Given that the marginal propensity to consume is 0.2, find investment multiplier.

Example 2

Given that the marginal propensity to save is 0.5, find the multiplier.

Example 3

Effect of the change in investments on income: Given that the national income of country X is $10 million in year Y, the marginal propensity to consume is 0.6 and the level of consumption is $4 million. Calculate the effect on income due to a planned investment of $5 million

Solution

Investment multiplier is given by:

2.5(5) = $12.5 million

Therefore, when investments are increased by $5 million, the level of income will be changed by $2.5 million to get a new income of $12.5 million.

How a Multiplier Operates

When investments are made, they cause changes in income. Suppose X invests Tshs.100 million in the construction of a house, the money will be used to buy the building materials and to pay building contractors. The receivers of that income it means the suppliers of building materials and the workers will also use part of the income for consumption and the remaining will be savings. Assuming that MPC is 60 percent or  of the total income, their total spending will be Tshs. 60 million. Therefore, 60 million will be received as income to those who will sell goods and services to the construction workers and the suppliers of building materials.

Assuming that the MPC of those who supply goods and services is again  or 60%, then their total spending will be 36 million. This process will continue but come to a halt when additions to savings total to 100 million. This is because the change in savings is now equal to the original change in investment and, therefore, the economy is returned to equilibrium, because the savings, S, once again is equal to Investment, I, i.e. S = I. At this point, the additions to income total Tshs. 250 million, thus Tshs. 100 million extra investments has created a Tshs. 250 rise in income. Therefore, in this case, the value of the multiplier is 2.5. Table 1.6 below, gives a summary of the operation of the multiplier.

Table 1.6: Operation of the multiplier

Cumulative increase in income can be calculated by using

Where G₁= initial amount of investment 

r = MPC

In the example above, where the initial investment is Tshs. 100 million, the total increase in income is equal to

The relationship between Multiplier (K) with MPC and MPS

(i) The relationship between Multiplier and MPC

• When MPC increases multiplier also increases.

• When MPC decreases multiplier also decreases.

Therefore, MPC and multiplier are directly proportional. For example, to find the multiplier given the following:

• MPC = 0.2

Solution

• When MPC = 0.5

Solution

(ii) The relationship between Multiplier and MPS

• When MPS increase multiplier decreases.

• When MPS decreases multiplier increase.

Therefore, MPS and multiplier are inversely proportional.

For example, if MPS = 0.2, find multiplier.

Solution

Multiplier = 5

(ii) When MPS = 0.5

Solution

Multiplier = 2

Assumptions of the Multiplier Multiplier has the following assumptions:

• Multiplier assumes that all the extra income is used for consumption. If it is used to pay previous debts, it may cause a leakage in the multiplier process. 

• Multiplier assumes that, there is no scarcity of goods and services. If there is scarcity, the extra income cannot be used to purchase goods and services.

• Multiplier also assumes that the economy is operating below full employment. If the economy would have been at full employment, there would be no resources available to produce extra goods and services so as to meet the extra demand for goods and services.

Limitation of Multiplier in LDCs

In less developed countries (LDCs), multiplier is less effective because of the following reasons:

- Lack of well established capital industries: As a result, any investment established must involve the purchase of capital goods, such as machines from developed countries. The importation of capital goods from abroad causes a leakage (withdraw) to the multiplier. Multiplier assumes that there is no leakage, because leakage causes outflow of income abroad.

- Lack of entrepreneur abilities: In LDCs, there is lack of entrepreneurship abilities. Therefore, any investment must involve the importation of experts from abroad. This also causes a leakage to the multiplier because it involves outflow of income abroad.

- Poor productivity due to low level of technology: The output produced in LDCs is very low. As a result, LDCs are forced to import goods and services from abroad, which also cause a leakage to the multiplier because it involves income outflow.

- Poor infrastructure: In LDCs, there is poor means of transport and communication. Therefore, it is cheaper sometimes to import goods and services from abroad than to buy then within the country where transport and communication are very poor. The importation of goods and services, in turn, result into the leakage of the multiplier process.

- In LDCs, workers are paid very low wages: Therefore, in order to meet their daily transactions of buying goods and services, they have to borrow money. Therefore, when they get income, they use the income to settle previous debts instead of buying other goods and services. So this causes a leakage to the multiplier.

Investment 

Investment is the additional stock to the existing stock of capital.

Gross Investment

This is the total purchase of productive assets per unit time, say a year. It can be zero or positive. Investment is said to be zero when there is no purchase of new productive assets. It is said to be positive when the worn out assets are being replaced.

Net Investment

This is the difference between the gross investment and depreciation. Net investment = Gross investment – Depreciation.

Determinants of Investments

Investment can be determined by the following factors:

Cost of investment: Large cost of investment deters investments while low cost of investment encourages more investments.

Availability of infrastructure: Infrastructure, such as roads, electricity and railways, provides conducive environment for the growth of investments, while the absence or poor infrastructure limits the growth of investments.

Market rate of interest: Large interest rates discourage investors from borrowing money for investment, while lower rates of interest encourage borrowing for investment. Expected returns from investment: If investors expect to generate large profits from certain investments, they will invest more on such investments.

Legal protections: If the government provides legal protections to investors, the investors will be encouraged to increase investments, unlike when there are no legal protections Expectations: When investors expect a boom to occur, they will increase investments but reduce investments, when they expect a recession to occur.

Level of consumption (purchasing power of the people): Large consumption capacity of the population encourages more investments than low consumption capacity. Size of the market: The larger the size of the market, the larger the rate of investments, while the smaller the size of the market, the smaller the rate of investments. The government policy and actions: The growth of investments depends upon good the government’s economic policies which facilitate investments, and the way the government creates a conducive environment for the growth of investments.

Acceleration Principle

According to Keynes, the factors which influence investments are marginal efficiency of capital that is the profitability of investment and the rate of interest. According to the accelerator principle, there is another factor, which can affect investment; the output level. When output or income increases, it stimulates more investments. The principle states that, “there is a direct proportional relationship between the stock of capital and the output level”. This means that, when output level changes the stock of capital also changes by the same proportion. Therefore, the following occurs: • When output increases, it leads to an increase in the stock of capital • When output decreases, it leads to a decrease in stock of capital.

Note

• Increase in stock of capital is investment.
• Decrease in stock of capital is decrease in investment.

Therefore, investment is caused by the increase in output level. The accelerator theory stems from the simple and mechanical assumption that “firms wish to keep a relatively fixed between the output they are currently producing and their existing stock of fixed capital assets”. This ratio is called capital-output ratio. For example, a capital output ratio of 4:1, or simply 4, means that, at constant prices, Tshs. 4 of capital is required to produce Tshs.1 of output.

Assumptions of the Principle

Acceleration principle assumes the followings:

(i) Firms produce at the least cost with a combination of inputs.

(ii) There are no credit constraints; funds for credits are readily available.

(iii) All the output produced are demanded, i.e. there is no excess output.

In the accelerator theory, the level of the current net investment, in fixed capital depends on the changes in income or output in the previous year.

• The larger the change in output or income in the previous year, the larger the change in investment in the current year.

• The smaller the change in output or income in the previous year, the smaller the change in net investment in the current year. I = v (^∆Y )

∆Y = Yt – Yt - 1

Or

It = v(Yt – Yt - 1) Where;

It = Net investment in the current year 

Y_t = The national income in the current year.

Y_t-1 = The national income of the previous year.

V= Is the capital output ratio, or the accelerator coefficient, or simply the accelerator.

Gross investment equals net investment plus any replacement investment to make good capital that was worn out in the course of production in the previous year. 

Gross investments in the current year =V(Yt – Yt - 1) + replacement of investments

Table 1.7: Net investment - Example given that capital output ratio is 4.

In table 1.7 above, the national income grows in both years, between 2001(which is year t1 in row 1) and 2002, we have assumed that income grows by Tshs.10 million, via the capital output 4. This growth of income of Tshs. 10 million induces net investment of Tshs. 40 million. This level of investment is required to increase the capital stock so that the desired capital output ratio can be maintained at the current higher level of income.

In the second row, income continues to grow in 2003 by the same absolute amount, ths10million, thereby inducing a constant level of investment (compared to 2002) of Tshs. 40 million. But in 2004, in row 3, the growth of income speeds up or accelerates-from an absolute rise of Tshs. 10 million to Tshs. 20 million. The level of investment doubles. The size of capital stock required to maintain the capital output ratio is Tshs. 80 million larger in 2004 than in 2003. Finally, we have assumed, in row 4 that, the growth of income falls back again to Tshs. 10 million in 2005. Although income is still growing, net investment now declines back to its previous level of Tshs. 40 million.

This example shows how the accelerator theory derived its name. It is the rate of growth of income and output rather than the fact that output is growing, that determines whether investment is growing, falling, or at a constant level. Accordingly, therefore: - If income grows by a constant amount each year, net investment is also constant.

- If the rate of growth of income speeds up or accelerates, net investment increases; and if the rate of growth of income slows down or decelerates, net investment declines. Thus, relatively slight changes in the rate of growth of income or output can cause quite large absolute rises and fall in investment as firms adjust their capital stocks to the required level.

Weaknesses of the accelerator theory

• Investment is induced more by profits rather than the level of output, when profits increase; it provides incentives to business people to invest more.
• It assumes that resources are always available, so that increase in consumption would automatically lead to an increase investments.

Relationship between the Multiplier and the Acceleration Principle

Multiplier and accelerator principle work together to influence employment and income, a change in investments cause a change in income and employment through the multiplier process, a change in income induce more investments through the accelerator principle.

How Multiplier and Accelerator Can Lead to Unemployment?

Multiplier and accelerator can lead to unemployment in the following ways:

- Multiplier depends on the size of the marginal propensity to consume (MPC). When marginal propensity to consume is large; it will cause a large increase in investments which will lead to an increase in income through a multiplier process. An increase in income will induce more investments and create more employment through the accelerator process. If the marginal propensity to consume is small, the size of the multiplier will also be small as well as induced investments. This will cause a fall in the national income and, consequently, les investments hence, unemployment.

- Multiplier effect may lead to an increase in output, hence more employment in a certain industry but to less output and to unemployment in another industry. For example, an increase in the government expenditures in the construction industry will lead to more income in the sector through the multiplier process and induce more investments through the accelerator process. This will increase employment opportunities in the sector and attract more labour, which will join the construction industry. Such the mobility of labour will cause shortages of labour in other industries and thus, a fall in output. This discourages investments and therefore, leads to unemployment.

- Multiplier can also cause unemployment when the economy has reached its full employment level, where aggregate supply (total output) is equal to aggregate demand (total expenditures). At this level, the levels of profits and the marginal propensity to consume are high. This may cause over investments and so inflation, in which the demand for labour will be greater than the supply of labour, hence unemployment.

Figure 1.5: Relationship between multiplier and accelerator

In figure 1.5 above,

• The aggregate supply and aggregate demand are at equilibrium level at point B, the value of output (GDP) is equal to the value of the total spending by firms (I), individuals (C), The government (G), Export (X) and imports (M).

• Point B is also the full employment level. At this level, all workers who need employment, at the current wage rates have it, money income, output and employment will no longer increase in proportion; the supply of labour will eventually become completely inelastic, and so will be the output. Therefore, any increase in aggregate demand met with completely inelastic supply of output, will result in higher prices (inflation), which will make workers to demand for higher wages, and therefore, to entrepreneurs to demand less workers. A decrease in the demand for labour will lead to unemployment.

The Concept of Induced Investments and Autonomous Investment

Through the multiplier process, a primary increase in spending, such as additional consumption or investment produce some further rounds of secondary spending. Through this secondary spending, further tertiary spending with its effects may occur on investments.

Businessmen will need additional capital goods (investments) to expand their productive capacity to match with the increased demand for capital goods. Such increase in the demand for capital goods due to increase in demand for final goods are referred to as Induced investment. This is, therefore, caused by endogenous factors i.e. factors which are within the national income determination model such as consumption, the government spending and investment. If any of these factors change, they influence increase in the national income through the multiplier effect, and induce more investment through the accelerator principle.

Autonomous investment, on the other hand, is caused by exogenous variables, i.e. variables which are not within the national income model, such as changes in technology. Autonomous investment has no relationship with the accelerator. For example, if there is a new invention in television production, firms would go ahead and invest in such development, but this new investments have no link with the previous changes in the income of these firms.

Relationship between the Rate of Interest and Investment

Interest rate is the cost of borrowing. If the rate of interest is high, borrowing is discouraged, and if the rate of interest is low borrowing is encouraged. However, this relationship is determined by the Marginal efficiency of capital, which does show the relationship between the desired stocks of capital to the rate of return (yield), that additional unit of capital will produce. Return is related to the rate of interest. Suppose, for example, that a capital project were to yield 10%, while the rate of interest were 12%, investors would not be interested in it. However, if interest were to fall to 8%, investors might wish to invest. The capital stock they desire would have increased.

Figure 1.6: Relationships between the Rate of Interest and Investment

 In figure 1.6 above, the higher the rate of interest R2, the lower the desire for capital goods at C1. At a lower rate of interest, R1, the desire for capital goods is higher at C2; implying that investors are more willing to invest at a lower rate of interest than at a higher rate.

Present Value (PV)

The present value of future payments or a series of payments represents the amount received today that is equivalent in value to the future payment or payments.

Example 1

For instance, if the discount rate is 10% per annum, the present value of this year of Tshs. 1100 if earned next year is Tshs. 1000. This is equivalent to Tshs.1100 next year because Tshs.1000 invested at going market interest rate of 10% yields Tshs. 1100 next year. If there are financial flows over a number of years, the discounted sums are additive and can be found by the formula:

Present value;

Where:

X = Future value

R = Interest rate

In the example above;

The present value in year 1:

The present value in year 2

= 1500 this value is to be added to the present value of year 1 to get the present value of year 2, it will therefore be equal to 1000 + 500 = 1500

Example 2

Suppose a machine with a known life of only two years is expected to yield $ 242 each year. The machines’ present cost is $400, and the rate of interest is 10%. Is the investment profitable?

Present value = 420, present cost = 400. Since the present value is greater than the present cost, investment is profitable.

Income inequalities

Income inequalities refers to the differences in incomes or wealth among the people, which makes some to be classified high income earners and others, classified as low income earners.

Forms of Income Inequalities

Income inequalities can be in the following forms:

(a) Regional Inequalities: These are the type of income inequalities existing among or between regions of a particular country. The causes may be the differences of natural endowment in resources, uneven distribution of infrastructures and centralization of investments. For example, in Tanzania, some regions such as Dar es Salaam, Arusha and Mwanza are far ahead in terms of income compared to other regions, such as Lindi, Mtwara and Kigoma, due to the above reasons.

(b) Sectoral Inequalities: These are the differences in income which exist between or among sectors of the economy. For example, in Tanzania, people who work in the mining and other industrial sectors have higher income than those who work in the agricultural sector.

(c) Intra-Sectoral Inequalities: These are the income inequalities which exist within one sector of the economy or society. For example, within the agricultural sector, there is income inequalities between modern agricultural sector and a traditional or subsistence agricultural sector.

(d) Rural-Urban Inequalities: These are the inequalities which exist between the rural and urban areas. Urban areas have higher income and wealth than the rural areas due to the presence of various kinds of investments such as industries, good infrastructure and trade.

(e) Individuals Inequalities: These are the income inequalities which exist among individuals in the society. Such inequalities exists due to reasons such as private ownership of the major means of production, luck and opportunities, differences in talents and differences in levels of education.

Causes of Income inequalities

Income inequalities is brought about by the following factors:

(i) Inheritance: Some people are born in rich families and others are born in poor families. Those who are born in rich families may inherit wealth from their parents and become rich, while those who are born in poor families have nothing to inherit from their parents, hence they remain poor.

(ii) Differences in natural abilities: Different people have different mental and physical abilities. These differences cause differences in wealth among the people. For example, talented footballers, musicians, bright individuals, etc, have a better chance to be rich than those who do not have such talents and have no means of generating income or wealth.

(iii) Differences in wages: Wages differs from one occupation to another. Therefore, workers who work in occupations which pay higher wages become richer as compared to those who work in the occupations which pay low wages.

(iv) Luck and opportunities: Some people may become rich through mere luck, such as winning games of chance such as the lottery.

(v) Private ownership of the major means of production: In the society where, there is private ownership of the major means of production, those who own the major means of production become more rich than those who do not own the major means of production.

(vi) Social evils: Some people, in the society, get wealth through illegal means like smuggling, selling drugs, theft and corruption.

(vii) Education level: More skilled labour earns higher wages than unskilled labour.

(viii) Uneven income distribution: If the distribution of income and wealth in the society is uneven, some group of people will become richer than other groups of people.

(x) Tax structure: When regressive tax system is used, it tends to affect the poor more than the rich, therefore, results in income inequalities.

(xi) Favouritism: In some countries, politicians tend to favour their respective areas/regions of origin by allocating more funds to such areas or by giving employment to their fellow tribes men. This leads to income inequalities among individuals and regions.

Advantages of Income inequalities

Income inequalities is necessary at early levels because of several factors as follows: 

• It promotes individual initiative and hard work in a bid to enable the poor to improve their living standards.

• Income inequalities tend to improve labour relations, i.e. employer-employee relationship, so as to promote a conducive atmosphere for individual production, among the poor employees.

• Mobility of labour is encouraged, i.e. geographical and occupational, in an endeavour to raise income levels of the poor workers.

• It stimulates the government’s effort to adopt policy programmes aimed at alleviating poverty in the society.

• Income inequalities encourage progressive taxation of the rich by the government, which consequently enhances the provision of services for the poor.

• Harmony and respect in the society is also promoted by income inequalities. The poor tend to respect the rich.

• An income inequality is a source of cheap labour, which is provided by the poor. • Income inequalities results into social balance and stability among individuals. Since inequalities are caused by natural abilities, people’s incomes can never be the same. • It stimulates effort among the poor members of the society so as to catch up with the rich.

• The poor people, who tend to consume rather than save, give chance to the rich who tend to save more to invest and accumulate capital. This leads to increase the investments in the economy.

Disadvantages/Demerits of Income Inequalities Income inequalities has the following disadvantages:

- Income inequalities result into political instabilities, which might be incited by the poor majority.

- Poverty, especially in the rural areas, could lead to rural to urban migration, in a bid to seek for employment opportunities and better economic welfare.

- Inequalities in income distribution retard efficiency of human efforts among the poor, since they tend to become frustrated.

- The poor are often disguised and denied social justice and equality. They may not afford the basic necessities of life like shelter, food, education, clothing, etc.

- Poor income distribution discourages production investments to meet the needs of the poor, since the poor tend to "cast fewer votes" due to their low purchasing power.

- Income inequalities may lead to brain-drain, especially in developing nations, since the educated people from LDCs tend to migrate to developed countries in search of “greener pastures". This will create a manpower gap in LDCs.

- It promotes undesirable behaviours like theft, crime, prostitution, and corruption among the poor, so as to survive.

- It leads to exploitation and domination of the poor by the rich. The rich will become richer as the poor remain poor and even made poorer and miserable.

- Income inequalities create social tension and conflicts between the poor and the rich. This may lead to disharmony between these social classes and among regions.

- Widespread poverty tends to lead to a psychological discouragement to work hard. Confidence, self-esteem and respect are lost among the poor. This can be detrimental to the contribution of human resource to the national development.

- Income inequalities may result into regional, inter and intra-sectoral dualism in the country an equal establishment.

- It encourages the inflow of foreigners, who may not have interests in the domestic economy. This will lead to excessive capital flight/capital outflow in form of profit repatriation.

- The government revenue from taxation is likely to decline, if the majority of the people are poor.

- Decline in aggregate demand: Where the majority are poor, aggregate demand is likely to be low. This affects production and employment levels in the economy.

- Poor distribution of income retards economic growth and development.

Measures of Reducing Income Inequalities

Income inequalities can be reduced by using the following measures: Progressive tax: This is a system of tax in which the rich are taxed more than the poor .This help to reduce the income gap between the rich and the poor.

Minimum wage legislation: In order to reduce income inequalities, the government provides, by the law, for every employer to pay a minimum wage. Employees are paid salaries or wages not less than the minimum stated by the government in its annual budget.

Equal opportunities: In this measure, the government provides equal opportunities for all citizens in all the regions, for adequate and affordable social services such as education. Subsidies and transfer payments: The government can provide subsidies to the poor in terms of inputs such as fertilizers to peasants, allowances to students from poor families, and subsidies to industries which produce essential goods that are consumed by the majority.

Micro-financing: These are small scale credits that are provided to the poor groups in the society to enable them establish small scale businesses that can support them and their families.

Price control and stabilization: The government should make sure that the prices of goods produced by the poor people, such as peasants and small traders, remain stable to avoid further decline in the income of these groups.

Mass employment: This can be encouraged through labour intensive techniques of production so that the majority of the population become able to earn income. Decentralization of industries: The government can reduce income inequalities by establishing infrastructure in all regions of the country in order to encourage of investments in all the regions within the country.

Control ownership of the major means of production: The government can control ownership of the major means of production to ensure that the majority of the people in the country have access to the major means of production such as land.

Methods of Showing Income Inequalities

Income inequalities in the society can be shown by using the Lorenz Curve.

The Lorenz Curve is a locus of points which shows cumulative percentage of population and cumulative percentage of income or wealth. The Lorenz curve gives a visual expression of how equal or uneven income distribution is:

- When the income is equally distributed, it is shown by a diagonal line, known as the line of perfect equality

- An income inequality is shown by a convex curve drawn, to the right from the line of perfect equality.

- The closer the curve to the line of perfect equality, the lower the income inequalities.

- When the Lorenz curve is far from the line of perfect equality, it shows a higher income inequality.

Table 1.8: Income distribution in 1929 and 1979

The Lorenz curve from the above data can be drawn as follows:

Figure 1.7: Lorenz curves for 1979 and 1929

In figure 1.7 above,

Curve 1 shows a smaller income inequality than curve 2, because it is closer to the line of perfect equality. This implies that, an in1929, income inequality was higher than in 1979.

Review Questions

1 (a) What is the National Income?

(b) Describe three methods of calculating the national income

2. Explain the problems of calculating the national income.

3. What are the weaknesses of using income per capita when comparing the living standards of the people in different countries?

4. Given the following data:

Gross national product at market price = 20 million

Income from abroad = 4 million

Gross domestic product at factor cost =10 million

Net indirect tax = 2 million

Indirect tax = 1.5 million

Net national product at market price = 15 million

Find the following

(i) Depreciation

(ii) Net factor income from abroad

(iii) Subsidies

5. Differentiate between the Gross National Product at market price and the Gross National Product at factor cost.

6. What are the causes of income inequalities?

7. (a) Derive a simple investment multiplier. (b) Given the followings:

(i) Marginal Propensity to Consume (MPC) = 0.5 (ii) Marginal Propensity to Save (MPS) = 0.4 Find the multiplier.

8. By using a numerical example, show how a multiplier operates.

9. What are the limitations of multiplier in Africa?

10. Discuss how the multiplier interacts with the accelerator to increase the size of the national income.

11. Given the following information:

The national income of country X = $ 20 million

Consumption = $ 6 million

Marginal Propensity to Consume = 0.6

Calculate the effect on the national income, if investment is increased by $ 5 million.

12. Given the following income distribution:

Draw the Lorenz Curve for the year 1929 and 1979, and interpret your observations.

13. Discuss the concepts voluntary and involuntary unemployment.

14. What is under-employment and over-employment?

CHAPTER 02 : PUBLIC FINANCE

Public finance is part of economics policy which is concerned with the way the government obtains revenue and spends it, so as to improve and promote the economic and social welfare of the citizens.

The Need and Role of the Public Finance Public finance has the following roles:

• The governments need to finance certain public utilities i.e. public services such as, security, power, education, etc. This requires money which has to be raised through public finance.

• Through public spending, the government can redistribute income and wealth more evenly.

• The government has to participate and effectively contribute to the production, marketing and distribution of goods and services. This can only be successful through the required capital which is raised from public finance.

• The productive infrastructure such as roads, railways, communication systems, etc, must be properly maintained. Public finance should provide sufficient funds to maintain and develop the necessary infrastructure.

• Public finance enables the government to establish and run risky projects that require large capital, e.g. Civil Aviation.

• Mobility of labour is quite important. Public finance, through wage policies, enables the government to distribute the available labour force, so as to increase efficiency. • Research units. The government, through public finance, is able to establish research units.

• Public finance is important in the process of economic developments, because it is a supplement to the limited private capital.

• The private sectors enterprises need to be correctly directed. Public finance enables the government to influence and guide the level and direction of the private sectors economic activities.

• In the absence of privatization and liberalization programmes, public finance sets up the state enterprises, supplies funds for improvement, modernization and expansion of various productive projects in the economy.

• Domestic resource exploitation. Public finance enables the government to exploit domestic natural resources e.g. fisheries, minerals, forests, etc, which might otherwise be idle.

Functions of the government

The government performs various functions which necessitates it to have funds. These functions are as follows:

(a) Administrative Functions: This is the day-to-day activities running of the government through established structures in the civil service.

(b) Protection Functions: In this function, the government needs funds to maintain peace and security.

(c) Social Functions: In this function, the government needs funds to provide the population with social services such as education and health.

(d) Development Functions: In this function, the government needs funds to finance various development projects such as roads, railways, research, irrigation, electricity and other infrastructural needs.

Objectives of the Government

The objective of the government is to achieve the following:

(i) To create full employment: In this objective, the government makes sure that all resources, including human and non-human resources, are fully employed.

(ii) Control of inflation: Inflation has adverse effects to the economy. Therefore, it is the responsibility of the government to put it under control.

(iii) To achieve economic growth: The government must ensure that the economy grows at the desired rate.

(iv) To raise the living standard: The government must ensure that the standards of living of its citizens are improved.

(v) To have a balance of payment: The government must ensure that its balance of payments is neither in deficit nor in surpluses, because both have negative effects to the economy.

(vi) To achieve social and political stability: The government must ensure that law and order is maintained in the country.

Divisions of Public Finance

Public finance is divided into four dominions, namely:

• The government revenues

• The government expenditures

• National budget

• Public debts

The government Revenues

This refers to the revenues that are received by the government from various sources to meet expenditures.

Sources of the Government Revenues

The government collects money from internal and external sources.

1. Internal Sources

The following are internal sources of the government revenues:

(a) Tax: A tax is a compulsory payment by individuals and firms to the government.

(b) Fees: These are payments made by the users of public services to the government like cost sharing in health and education.

(c) Fines: These are penalties imposed by the government against law breakers.

(d) Borrowing: The government can borrow money from banks or the public by selling sureties.

(e) Profit: The government can get revenues from profit realized from the public enterprises.

(f) Selling of Public Enterprises: The government gets revenues by selling or privatizing public enterprises and firms.

2. External Sources

(a) Borrowing from international financial institutions and donor countries

(b) Grants and gifts (c) Foreign investments

Principles or Canons of a Good Tax

• Equity: A good tax must be equitable or fair, that is the amount of tax must be proportional to the level of income. People with higher income must be taxed higher amounts than people with lower incomes, i.e. pay as you earn (PAYE).

• Convenience: The methods of tax collection must be convenient to both the tax payers and tax collectors.

• Certainty: The tax payers must be aware of exactly how much to pay, and the tax collectors, likewise, must also know how much to collect.

• Economy: The cost of collecting tax should be relatively low, and the government should receive all the income collected. ^• Productive efficiency: A good tax should stimulate the establishment of resources and must not discourage allocation of resources.

• Difficult of evasion: A good tax must be difficult to evade by the tax payers.

Systems of taxation

These are organized methods through which tax is levied. There are three systems of taxation:

- Progressive tax system

- Proportional tax system

- Regressive tax system

- Progressive Tax System: This is a system of taxation in which the amount of tax depends on the level of income (PAYE) i.e. the amount of tax levied is proportional to the level of income increase. This system is very useful in reducing income inequalities among income earners.

O Y₁ Y₂ Income

Figure 2.1: Progressive tax system

 In figure 6: 1 above, at a lower income, Y1, the amount of tax is 10%. At a higher income, Y2, the percentage of tax is 20.

- Proportional Tax System: This is a system of tax in which the percentage of tax is the same for all the levels of incomes. For example, when a person who earns Tshs. 20000 per month pays 10% of the income as tax, and a person who earns Tshs.30000 per month also pays 10% of the income as tax.

%Tax

 10%

O 20000 30000 Income

Figure: 2.2: Proportional tax system

In figure 2.2 above, income levels of 20000/= and 30000/= are charged the same 10% of the income as tax.

- Regressive tax system: This is a system of tax in which the percentage of tax levied varies inversely with the tax payer's income. The higher the income, the lower the proportion of the income is paid as tax and the lower the income, the higher the proportion of the income is paid as tax. This kind of tax applies when indirect tax is imposed on goods and services which are consumed by both the high income earners and the low income earners. When the poor person purchases a commodity, the amount of indirect tax she/he pays is the same as that that paid by a rich person. In this case, the tax paid is said to be regressive, because the poor person pays a larger proportion of his/her income than the rich person.

%Tax

20%

 10%

O Y₁ Y₂ Income

Figure: 2.3: Regressive tax system

In figure 2.3 above, a higher percentage of tax, 20%, is imposed to a lower income level, Y1, and a lower percentage of tax, 10%, is imposed to a higher level of income Y2.

Why is Regressive Tax Justified?

Regressive tax is justified on the following grounds:

The low income earners are the main consumers of the public goods which are provided by the government, since most of the rich people consume private services.

The rich people are the investors; therefore, they have bigger contribution to the national economy than the poor people.

Types of Taxes

There are two main types of tax

A. Direct tax and

B. Indirect tax.

A: Direct tax

This is a type of tax which is imposed on people's income. The following are the examples of direct taxes are:

(i) Graduated Tax: This is the tax which is levied on one's income, mostly for the employed income earners, on wages or salaries.

(ii) Pay as You Earn Tax: This is paid by means of directly deducting from one's salary, by the employer, who regularly sends the collection to the tax authority.

(iii) Corporation Taxes: These are taxes imposed by the government and paid by the companies with respect to profits, turnover or percentage of total sales.

(iv) Property Tax: A property tax is assessed by the local authorities on property, such as house, land, etc.

(v) Estate or Death Duty: This is assessed on the wealth of person at the time of death.

(vi) Surtax: This is payable by the rich people in the society .It is usually assessed for those who earn beyond a certain level of income. It is paid on top of the graduated tax.

(v) Capital Gain Tax: This occurs when the value of capital asset increases, especially when the asset is being sold .It is imposed on assets which have appreciated.

Advantages of direct tax

Direct tax has several advantages over indirect tax:

• It is easy to tell in advance the amount to be paid and collected as tax from individuals and firms, because it is deducted directly from their income. • This type of tax is very helpful in reducing the income gap between the rich and the poor people, since it applies the pay as you earn rule (PAYE).

• Direct tax is also helpful in controlling the demand pull inflation, since when direct tax is imposed, the disposable income of the income earners decline, which leads to a decrease in their purchasing power, hence control of demand-pull inflation • Economical in collection. This type of tax is economical to collect in the sense that the cost of collection is proportionally low compared to the revenues collected.

Disadvantages of Direct Tax

- High direct tax can discourage people from working hard. This type of tax can discourage people from working hard, because people will have the feeling that, if they work hard and earn more income, they are liable to pay more tax.

- This type of tax discourages savings, because it reduces the disposable income of the income earners. Decrease in savings may discourage investments and economic growth.

- It discourages investments in case it is imposed on profits which results from investments. Investors are discouraged, in this case, because they are aware that the profit they earn would be taxed.

- This type of tax can result into tax evasion (tax avoidance). This happens when tax payers hide some information about their income.

- Direct tax is discriminatory in nature since it is paid by few people in the society; only those who earn income from formal sectors.

- Direct tax has high incidences of tax, that is, the burden of direct tax falls wholly to the tax payer.

- Reduce the disposable income of the income earners, thus reducing their purchasing power.

- Easy to avoid since people might under state their income.

B: Indirect Taxes

It is a type of tax which is imposed on goods and services. Examples of indirect tax are:

(i) Custom duties: These are taxes collected at the borders or port, by customs duties officials.

(ii) Octoroi Tax: It is a tax imposed on goods which are on transit through the territory of another country.

(iii) Sumptuary Tax: It is a tax imposed on the consumption of certain commodities in order to discourage their consumption.

(iv) Export Duties: These are taxes on exports, probably meant to discourage the export of certain goods

(v) Excise Duty: These are sales or purchase taxes imposed on goods that are locally produced and domestically consumed.

(vi) Value Added Tax: This is the consumption/expenditure tax levied or assessed on the value of a commodity in each of the stages of production, exchange and distribution.

Advantages of Indirect Taxes

Indirect tax has the following advantages over direct taxes:

• Effects of indirect taxation are spread to all the consumers, that is, all consumers pay indirect tax.

• More revenue is collected in this type of tax than in direct tax, because indirect tax is paid by everybody who consumes goods and services. It means that it has a wider tax base (source) than a direct tax.

• It is very difficult to evade paying indirect tax, because it is imposed on every purchase of goods and services.

• It is paid unknowingly, by the tax payers; hence it is less painful to the tax payer and does not discourage people to work hard.

• Unlike the direct tax, indirect tax is paid by final consumers. In this case, producers are not affected directly by this type of tax. Unlike direct tax, indirect tax does not discourage investments.

• Indirect taxes guide the allocation of resources in the country by increasing savings and priority areas, and it discourages investments in non-priority areas of production. • They help to stabilize the economy. High import duties help to control imports, thus reduce balance of payment problems and improve terms of trade of the country. • It has a wider coverage than direct tax, since it is paid by all the consumers of the goods and services on which the tax has been levied.

• It can be used by the government to either encourage or discourage the production and consumption of certain commodities.

Disadvantage of Indirect Tax

• Indirect tax is regressive in nature, because the low income earners pay a larger proportion of their income, as tax, than the higher income earners.

• It is inflationary in nature, because when it is imposed, it increases the cost of production and prices (it leads into a cost-push inflation)

• It is inconvenient. It is very difficult to collect this tax, since a lot of information is needed from business people including follow ups.

• It is not economical. There is a lot of costs of administering the collection of this type of tax. This makes this type of tax to be uneconomical to collect.

• The cost of collection and administering may be higher than the amount collected. • Indirect taxes may have bias against certain groups of consumers like smokers and alcoholic beverage consumers, these groups of consumers are heavily taxed.

• High indirect tax may discourage demand, because it leads to increase in the prices of goods.

• Misallocation of resources may occur, since investors may opt to invest in industries which are less taxed, and leave industries which are more productive and important to the economy, but are heavily taxed.

Value Added Tax (VAT)

What is VAT?

VAT is an indirect tax which is levied on the supply of any taxable goods and / or services by any business that is registered for VAT purposes. These goods/services must be sold or supplied in the course of or for the furtherance of the businesses. VAT is also levied on the importation of goods and services (Tanzania revenue Authority VAT general guide April 2007)

How does VAT work?

Each registered person in the chain between the first supplier and the final purchaser/user is charged tax on taxable supplies made to him (input tax), and charges tax on taxable supplies made by him (output tax). They pay over to the Commissioner the excess of output tax over input tax, or recovers the excess of input tax over output tax from the Commissioner. The broad effect of the scheme is that, businesses are not affected by VAT except in so far as they are required to administer it, and the burden of the tax falls on the last purchaser/final consumer.

The following example illustrates how VAT is charged as goods move from one registered person to the next in the manufacturing and distribution chain, until they reach the final user. It is assumed, for the purposes of illustrations that the manufacturer makes no purchase and that VAT is charged and accounted for at the rate of 20%:

Table 2.1: VAT General Guide

Source: Tanzania Revenue Authority (VAT general guide April 2007)

Who collects VAT?

VAT is collected by businesses and organizations that are registered by the commissioner of tax. A business or organization, which is registered or required to be registered for VAT is called a taxable person.

What are taxable supplies?

Taxable supplies are the supplies of goods or services made by VAT registered persons in the course of or for the furtherance of the business.

Taxable supplies include the following:

The sale or delivery of taxable goods by taxable persons to another person, including imports.

The sale or provision of taxable services by a taxable person to another person.

The appropriation, by a registered person, of taxable goods for his personal use or for use by others like the family or friends;

- The making of gifts or loans of any taxable goods in the course of business.

- The letting of taxable goods on hire, leasing or other transfers. - Barter trade, i.e. exchange of goods for other goods.

What are goods?

(a) Tangible movable things - goods in the ordinary sense of the word. (b) Immovable property - land, buildings, etc.

Note: Money is not goods for the purpose of VAT

What are services?

Services include:

(i) Professional and commercial services - services include accountants, engineers, architects, lawyers, secretarial, electricians, plumbers, builders, motor vehicle repairs, employment agencies, advertising agencies, transport services etc.

(ii) Intellectual property rights - patents, trademarks, copyrights know - how etc. Any other supply, which is neither goods nor money.

The role of the business people registered with VAT

The business people who are registered with VAT are supposed to do the following:

(i) Records: Proper and adequate records must be kept to enable a responsible revenue office to check on the self-assessment of their VAT liability. Records should be kept for a minimum of five years.

(ii) Tax invoices: A VAT registered person must provide a tax invoice to another VAT, registered, person at the time of selling taxable goods or services.

(iii) Debit and credit Notes: These must be provided where required.

(iv) VAT Account: For each ‘tax period’, they must keep a summary of the totals of their output tax and input tax.

(v) Returns: A VAT return must be completed and submitted to the tax Commissioner by the due date, i.e. the last working day of the month after the month of business.

(vi) Accounting for VAT payable: Tax payable must be calculated and accounted for by the "due date".

(vii) Changes of business particulars: Whenever there are changes in their business circumstances, they should notify the tax Commissioner within thirty days of such change.

(viii) Retained Assets on cancellation of Registration:

VAT must be accounted for on any assets of a registered person retained upon ceasing to be registered.

How do business people account for VAT?

VAT is normally accounted for at the time of supply, i.e. VAT is generally accounted for when:

• Tax invoice for the supply is issued, or

• Payment is received for the supply or part of the supply, or

• The goods are removed from the premises or from other premise where the goods are under your control, or the goods are made available to the person to whom they are supplied or when services are rendered or performed; whichever occurs first.

What is a tax period?

A tax period is the length of time covered by VAT return i.e. one calendar month.

Advantages of Value Added Tax (VAT)

- It is a broad-based tax which falls over a wide range of consumers through their consumption expenditure.

- VAT promotes efficiency in production since firms cannot be taxed in case of losses or profits, because the tax is based on the gross value produced.

- The tax has neutral distributive effects, and can guide the allocation of resources.

- VAT is simple in administration. The tax liability can easily be assessed and the tax revenue effectively collected.

- It minimizes tax evasion, since each production unit accounts for taxes paid by other firms from which inputs are obtained, so as to avoid tax payment by one individual firm. This cross auditing enables tax authorities to avoid the possible occurrences of tax evasion.

- It enables some goods to enjoy tax exemption, and yet uniform taxes are assessed on other goods.

- VAT widens the tax base, because the tax has to be ultimately paid by the final consumers.

- It is non-discriminative to factors of production, since they are equally taxed.

- It is quite easy to calculate among business people, if they keep and maintain proper records.

Disadvantages of VAT

There is need for appropriate record keeping and frequent cross-checking, which is not common in LDC's.

VAT is not popular, especially among the illiterate and, therefore cases of evasion are likely to occur.

This tax tends to affect small firms and consumers, since it is often proportional. Large scale enterprises are definitely less affected.

The tax is regressive, since all taxable goods and services are treated equally. The VAT is complicated and difficult to be understood in some countries, like Tanzania, it calls for massive education to create awareness among the citizens.

It is a consumption tax; therefore it may affect the level of consumption in the country.

Usually, tax liabilities are not submitted to the tax authorities and yet this could result into difficulties in tax collection.

The public is often ignorant about the commodities that are zero rated and exempted from the VAT system.

There are sometimes delays in submission of revenue by tax collectors and payers to the government.

Why the government of Tanzania introduced VAT?

The government of Tanzania introduced VAT due to the following reasons:

- To improve tax administration in the country.

- To increase the percentage of taxable Gross domestic product.

- To widen the tax base and, consequently, reduce the tax rate, so as to achieve equality, tax compliance and minimize tax evasion

- To protect domestic industries against foreign competition.

- To minimize tariffs that affects her exports.

How VAT is computed?

V.A.T is only claimed and accounted for from registered tax payers /businessmen. VAT is usually remitted to Revenue Authority within a business period of a month, by the tax payers, at the time of purchase. VAT can only be offset on sales with purchases at each stage of supply. This is eventually met by the ultimate consumer. Therefore, the unregistered (the buyer) meets the tax in form of the final price of the commodity. V.A.T payable = Output tax-Input tax.

Why should individuals and firms pay tax?

There are several reasons as to why taxes are imposed. Some of these reasons include;

(a) Raising the government revenue: The government impose taxes in order to get revenue that is necessary for meeting its expenditure on public services and administration of the government.

(b) Income redistribution: Taxes are imposed in order to reduce the income gap between the rich and the poor people in the society. The rich people are heavily taxed, and the income collected is used to uplift the poor in terms of providing them with public services.

(c) Encourage investment and growth: Tax on imports is aimed at discouraging imports, in order to stimulate domestic production.

(d) To reduce deficit in the balance of payments: Tariffs are imposed on imports in order to reduce imports and, therefore, reduce deficit in the balance of payments.

(e) To discourage consumption of harmful products: Tax is sometimes aimed at controlling the production and consumption of harmful products, such as cigarettes and beer.

(f) To stabilize the economy: Tax can also be imposed in order to control economic instabilities, such as inflation. During inflations, the government increases direct tax, in order to control excessive demand, and reduce indirect tax in order to reduce the prices of goods.

Incidence of Tax

This refers to the burden of paying tax. When tax is imposed, who actually pay the tax? Is it the producer, the consumer or both?

(i) Case of direct tax: For the case of direct tax, the whole incidence of tax goes to the tax payer i.e. the income earner. He/She has to pay the full amount of tax, since tax burden cannot be shifted to anyone else.

(ii) Case of indirect tax: For the case of indirect tax, the burden of tax depends upon the elasticity of demand for a commodity.

^•  Tax on Goods with Perfectly inelastic Demand: These are the goods which are demanded in the same quantity at all levels of price. In this case, the incidence of tax falls more heavily on the consumers, because the consumers buy the same amount at whichever the level of price.

P₀+t

P_O

O Q₁ Quantity demanded

Figure: 2:4: Tax on goods with perfectly inelastic demand

In figure 2:4 above, before the imposition of tax, price was P_O, and the quantity demanded was Q_1, after the imposition of tax, the price increased to P_O+ t (where t is tax), but the quantity demanded remained the same at (Q1), therefore, the consumer shouldered the whole tax incidence.

^•  Tax on goods with perfectly elastic demand: These are the goods which are sold at the same price, whatever the quantity demanded.

 Price

P

^O  Q₁ Q₂ Q3 Quantity demanded

Figure 2.5: Tax on goods with perfectly elastic demand

In figure 2:5 above, the producer sells different amounts at the same price, P₁.So, when tax is imposed by the government, the producer will bear the whole amount of tax. Under this situation of perfect competition, the producer cannot influence the price of the commodity.

^•  Tax on goods with inelastic demand: These are the goods which the quantity demanded changes by a small proportion when price change. In this case, when tax is imposed, price increases by the amount of tax levied, but quantity demanded decrease by a small proportion. So, the tax burden goes to the consumers, because they will be buying almost the same amount, but at a higher price.

 D

  PricePo+t

Po

O Q1 Q2 Quantity demanded

Figure 2.6: Tax on goods with inelastic demand

In figure 2:6 above, before the imposition of tax, the price was Po and the quantity demanded was Q1. After the imposition of tax, the price increased to Po+t, and the quantity demanded decreased by a small proportion to Q1. Hence, the consumers bear the burden of paying tax, since the quantity they demand decreased by a small amount when the price increased.

^•  Tax on goods with elastic demand: These are the goods which the quantity demanded changes by a small amount when the price changes. When tax is imposed, the price increase by the proportion of tax, resulting in a large decrease in the quantity demanded. The tax burden, therefore, fall more heavily on the producers because of the big decrease in the quantity demanded by the consumers.

 Price

Quantity demanded

Figure 2.7: Tax on goods with elastic demand

In figure 2:7 above, an imposition of tax on a commodity resulted into an increase in the price of the commodity from Po to Po+t, and a large decrease in the quantity demanded from Q4 to Q1, hence a big burden to the producers due to the large fall in the quantity demanded and revenue.

Incidence of tax and systems of tax

The incidence of tax can also be discussed according to the systems of tax.

- The case of progressive Tax: In the case of progressive tax, the incidence of tax fall on both high income earners, and low income earners, because tax increases as income also increases.

- The case of regressive Tax: In this case of regressive tax, the incidence of tax falls more heavily on low class people because they pay a large proportion of their income, as tax, than the rich people.

- The case of proportional Tax: For the case of proportional tax, the burden of tax falls more heavily on the low income earners than the high income earners, since both these groups pay the same percentage of tax.

Economic effects of tax

Taxes have both negative and positive effects:

A. Negative Effects

The negative effects of taxes are as follows:

(i) Discourages people from working hard: Heavy direct tax discourages people from working hard, since it reduces their disposable income i.e. the amount of money that remains for consumption after the deductions of tax.

(ii) Discourages savings: Heavy direct tax reduces disposable income, hence the savings of the income earners.

(iii) Discourages investment: Large tax, on firm's profits, is a disincentive against the entrepreneurs to reinvest their profit in production.

(iv) Diversion in allocation of resources: Investors may deviate the allocation of resources from heavily taxed but more productive sectors, to less taxed and low productive sectors or to the production of illegal products, like cocaine, which are not taxed.

(v) Tax may cause inflation: Large income tax may animate workers to demand for more wages and, therefore, lead to demand-pull inflation. Likewise, large indirect tax is inflationary because, when imposed, it leads to an increase in the prices of goods and services.

B. Positive effects of taxes

The positive effects of taxes are as follows:

(i) It can be used to control inflation: By increasing direct tax, the purchasing power of the people decrease. This may reduce demand-pull inflation.

(ii) Discourage harmful products: Certain kinds of indirect tax can be used to control the production and consumption of harmful products such as cigarettes.

(iii) Control of balance of payment disequilibrium: Heavy import duties can be a disincentive against imports and, therefore, a means of controlling the deficit in the balance of payments.

(iv) Revenue generation: Tax is an important rootstock of the government’s revenues, that is, the government depend on tax for most of its revenues.

(v) Redistribution of income: Tax redistributes income by taking part of the income of the rich people. The government, therefore use the money collected to provide for social services to the poor people.

Taxable capacity

Taxable capacity is the ability of the tax payers to pay the tax assessed on them, and at the same time, retains a reasonable level of income to enable them live the life they are accustomed to. So, taxable capacity of a nation is the percentage GDP, which is within the capacity of the country to contribute to the public tax revenues. It can also be referred to as the ability of the nation to obtain, from the tax payers, the revenues necessary from the imposed taxes.

Factors affecting Taxable Capacity

The factors underlying taxable capacity are as follows:

• Inflation: This lowers the people’s purchasing power; hence it greatly affects the taxable capacity, especially from indirect taxes.

• The level of economic progress: The taxable capacity is influenced by levels of economic development.

• Population size: The number of inhabitants can increase the taxable capacity and the amount of tax revenue to the government.

• Income distribution: Usually, equitable distribution of wealth leads to a less tax revenue as compared to a situation where the wealthy are more and accordingly taxed. Political stability increases the taxable capacity, since the public is confident due to the conducive environment.

• Attitude of the taxpayers: A positive attitude towards development will increase the taxation potential among the people and vice-versa.

• The tax procedure: An appropriate tax procedure or collection methods will promote tax diversification and comprehensive taxes, which will expand the tax revenue.

• The objective of taxation: There is no doubt that the tax revenue/capacity will increase if there are specific aims for which the revenue is directed. For example, if it is meant to promote education, culture, industrialization, health, poverty eradication, tourism, sports etc.

• The level of income: The stability of income will generate more tax revenue and increase production, and vice-versa.

• Reduction of conservative tendencies: Traditionalism and conservatism may hinder the taxable capacity of the country while mordernization and liberalisation improves taxable capacity.

Why is the taxable capacity low in LDCs?

The taxable capacity is limited by the following of factors:

- Political limits. For political reasons, the governments of LDCs often limit the taxable level to a reasonable extent in order to gain popularity.

- The prevailing low levels of income among the people who are predominantly subsistence producers cannot boost the taxable capacity in LDCs.

- In developing countries, cases of tax evasion and avoidance are common, and this cannot expand the taxable capacity.

- Corruption. The taxable capacity is also limited by the corrupt tax assessors and collectors.

- The size of production. The size and, therefore, the taxable earning of enterprises are quite limited.

- Transportation bottlenecks. Collection of the desired/targeted tax revenues is further hampered by inadequate transport, because some areas are still remote.

- Language limitation. The diversity of languages among the rural communities often poses a serious communication problem, especially between he tax authority payers.

- The taxable capacity, in LDCs, is further limited by lack of proper record-keeping, upon which taxation is based.

- The fear to interfere with international trade also tends to limit the level of taxation in developing countries.

- The taxable capacity, in LDCs, is further affected by some cases of tax exemption.

- The rampant unemployment also affects the taxable capacity in LDCs, since this would imply limited sources of income.

- Regressive taxation. The taxable level or capacity is limited and affected by the regressive nature of taxation in LDCs, which mostly affect the poor.

- Inflation. This also scares the government from increasing taxes, since during an inflationary period, people's real income tend to fall.

- Smuggling. Rampant smuggling of both products and finance, to neighbouring countries, also affects the volume of tax revenues collected.

- In developing countries, taxable capacity is also limited by the prevailing unclear social, political, commercial and institutional frameworks.

- In most LDCs, including Tanzania, the agricultural sector is dominant. This implies that there are few industries from which adequate tax revenues can be collected.

- High population growth rates. High population lowers the taxable income, because of the high dependency ratio.

- The need to attract foreign investors, who are crucial for national development. The government has no choice but to offer tax relief, tax rebates, tax holidays, etc, in order to encourage investors foreign. This, too, may lower the taxable capacity.

- The shift from the traditional sectors to the informal sectors, whose activities are quite difficult to determine, makes it hard to determine appropriate taxes that should be imposed on them.

- The taxable capacity is further limited due to the narrow definition of some illegal activities, such as smuggling, prostitution, local brewing, private student’s tuitions etc.

Measures that can be adopted to widen the tax base and taxable capacity There are many ways of improving the country's tax base and taxable capacity as follows: • The government should improve its administrative machineries as far as tax collection is concerned, with an aim to minimize tax evasion and avoidance.

• Income generating activities should be encouraged, especially in rural areas, to provide opportunities for employment so as to expand the nation’s taxable capacity. • Diversification is further encouraged so as to expand avenues for the taxable potentials.

• Taxes on imports should be increased, especially on luxury items, so as to increase the amount of tax revenues.

• Reduction of income inequalities. The existing income disparities tend to lower the taxation potentials. The government is, therefore, urged to reduce income inequalities among most of the sections of the society, so as to expand the tax base.

• Education. There is need for education and awareness among the general public about the importance of taxation for national development.

• Specific institution, such as the TRA, should be put in place with considerable degree of autonomy to review the loopholes in tax collections, so as to raise the required tax revenues for the state.

• Improvement in economic activities should be enhanced, e.g. in the manufacturing sectors, informal employments, monetary expansions, etc, so as to raise the level of tax collection.

• Tax diversity. New taxes have to be introduced, like VAT, the land tax, etc, in order to widen the tax base. • Fight corruption. Measures against corruption need to be greatly strengthened, e.g. through the Inspector General of the government, The Public Accounts Committee, the general Public, the press, etc.

• Adequate facilities to easily enhance the process of tax collection. There is need to acquire the necessary operational facilities like transport; computers to store the required tax information, etc so as to improve the efficiency in tax collection. • A comprehensive tax payer’s data. This can enables survey on tax payers, so that the tax collectors are kept in constant touch with the potential tax payers. This guides tax policy formulation and tax actions designed to achieve an effective policy on taxation. • The tax base can further be improved by constant review of the existing tax structures, policies and programmes, so that they become compatible with the required targets.

THE GOVERNMENT EXPENDITURES

This refers to the spending of the government in various areas.

Types of The government Expenditures

The government expenditures can be categorized into the following groups:

(i) Recurrent Expenditures: This refers to the government spending on public consumption, such as education, health, maintenance of peace and security, salaries to civil servants, etc.

(ii) Development Expenditures: Refers to the government expenditures on development projects, such as the construction of roads, railways, communication networks and subsidies to economic sectors like agriculture.

Objectives of the government expenditures

The government expenditures are intended to meet the following objectives:

• To provide essential goods and services to the public, such as education and health services. • Regulation of economic activities for the public interest. For example, control of monopoly.

• Influence allocation of resources in order to improve efficiency. For example, providing subsidies to small scale firms.

• Redistribution of income by providing loans and free social services to the poor. • Stabilization of the economy, for example, controlling unemployment problems by increasing expenditures on economic and social services, which help to stimulate investments.

NATIONAL BUDGET

The national budget refers to the estimates of the government revenues and expenditures in a given year. In Tanzania, the national budget is presented to the national assembly, by the Minister of finance, in June each year. The minister makes a review of the government revenues and expenditures for the previous year, and makes forecast of the government revenues and expenditures for the coming financial year. The budget starts to be implemented after it has been approved by the national assembly.

Types of National Budget

There are three types of national budget:

(a) Surplus Budget

A surplus budget is a budget in which the collected revenue is greater than the estimated expenditures. To achieve a surplus budget, the government increases the tax rates. Therefore, surplus budget reduces the purchasing power and investments.

Uses of the Surplus Budget

The surplus budget has the following uses:

(i) To correct inflation: The surplus budget can be used to control inflation because of the high tax rate, which reduces disposable income and the purchasing power.

(ii) Correct balance of payments problems: By increasing tax on imports, the surplus budget reduces the volume of imports and, thus controls deficit in the balance of payments.

(iii) Discourages the consumption of harmful products: Increase in tax rate, may also control the consumption of harmful products.

(iv) To pay debts: The surplus budget may be used to pay the government debts

Surplus budgeting

A surplus budgeting occurs when the government plans to spend less than the revenue available in a given financial year.

Aims and objectives of surplus budgeting

Surplus budgeting aims at achieving the following objectives:

• To reduce aggregate demand, so as to curb inflation.

• To finance development programmes in the country.

• A surplus budget also aims at accumulating resources/funds for the purposes of future investment.

• To reduce money in circulation.

• Enables the nation to give grants to other countries.

• It enables the establishment of development projects, within and outside the country.

However, a surplus budget may lead to:

- A depression in the economy.

- Excessive taxation of the people.

- Unemployment due to lack of incentives to save and invest.

- A decrease in money supply.

- Inadequate/insufficient aggregate demand due to high levels of taxation

(b) Deficit Budget

A deficit budget is a budget in which the estimated the government revenues fall short of the estimated the government expenditures. A deficit budget has the following effects.

(i) It stimulates consumption and investments due to low tax.

(ii) It stimulates recovery from a recession.

Deficit Financing

Deficit financing occurs when the government planned expenditure is estimated to be in excess to the expected revenue.

Aims of Deficit Financing Deficit financing aims at:

(i) Reducing the burden of taxation from the people.

(ii) Increasing the level of supply.

(iii) Increasing the level of aggregate demand.

(iv) Encouraging savings among the general public.

(v) Curbing down deflation.

(vi) Stimulating the level of economic activity.

(vii) Encouraging borrowing, which may be a faster and cheaper way of financing the government projects.

(viii) Lifting the economy from a slump or depression.

Causes of Budgetary Deficits in LDCs like Tanzania

Budgetary deficits are common deficits, basically arising from high the government expenditures and limited avenues of revenue collection.

^•  Low taxable capacity. This has not enabled LDCs, like Tanzania, to raise adequate revenues to balance their budget. ^• High levels of tax evasion and avoidance. This, too, has limited prospects by the government to acquire the required revenues.

^•  High population growth rates. The ever increasing population in LDCs, like Tanzania, has led to high the government expenditures, thereby leading to budgetary deficits. ^• Uneven distribution of incomes. This has further affected the taxation potential of the country leading to limited revenue.

^•  Limited size of enterprises. In Tanzania and indeed many LDCs, the sizes of the enterprises are still small and cannot raise enough tax revenues to balance the budget.

^•  Corruption. Budgetary deficits have been attributed to high rates of corruption among the politicians and some categories of the civil society. This has resulted into loss of revenues which would have otherwise been used to cover the budgetary needs. • Unemployment. Rampant unemployment, coupled with the current retrenchment programmes, has worsened the situation, whereby a reasonable majority of the unemployed can hardly contribute revenues to the national treasury.

^•  Poor planning. There is often lack of proper planning, financial discipline and commitment, which has consequently led to wastage and misuse of public funds. • Price fluctuations. Poor countries, being mainly dependent on agriculture, are subjected to price fluctuations. This will imply unpredictable revenues from the agricultural sector, which may consequently lead to deficits in the budget.

^•  High Marginal propensity to import. A lot of revenues in form of foreign exchange are spent to import necessities. This has always resulted into fewer revenues available to meet the domestic budgetary requirements.

^•  Subsistence sector. Poor countries are characterized by a relatively large subsistence sector, with low productivity, output and income (revenue).

^•  Political reasons. The taxation potential is further limited by the desire for some politicians to attain their political aspirations which greatly reduces the revenues base of the country.

^•  Political instability. Poor countries are entangled in political turmoil. This compels them to indulge into excessive expenditures to finance them (wars). However, a number of revenues are lost in the process.

^•  High and unproductive expenditure by the government on its programmes have further adversely affected their revenue base, causing temporary deficits in the budget.

^•  Limited tax revenue due to poor methods of collection. This has also led to reduced sources of finance to balance the budget.

^•  Low savings and limited levels of capital accumulation have also affected the balancing of the budget, because this limits the revenues potential of the country.

^•  Poor national and global economic performance, unfavourable terms of trade, etc has affected most LDCs' potential to earn the required revenue to finance their budgets.

^•  Debt servicing. Poor countries have a heavy debt burden, which often take a substantial proportion of their revenues which could have catered for the budgetary requirements. • Inflation. The ever increasing price of goods and services has also affected the national budget. With inflation, it is quite difficult to predict future budgetary planning. ^• Unpredictable external funding has led to low and unreliable revenue, which consequently affects the government budget.

(c) Balanced Budget

This is a budget in which the collected revenue is equal to the estimated expenditures.

Effects of a Balanced Budget

A balanced budget implies the following:

(i) That the government cannot borrow.

(ii) That there are stable prices, i.e. there is neither inflation nor deflation in the economy.

(iii) Money supply does not increase, i.e. it remains constant.

(iv) Aggregate demand does not change.

(v) The central bank cannot print any more money.

(vi) There is a constant level of employment.

Functions of the National Budget The budget has the following main functions:

^•  To redistribute income: Through the national budget, the government may redistribute income by increasing expenditures in social services and providing subsidies to small scale businesses.

^•  To correct deficit in the balance of payments: Through the budget, the government can discourage imports and correct deficit in the balance of payments by increasing import duty.

^•  To control inflation: Through the budget, the government can control demand-pull inflation by increasing direct tax in order to reduce the purchasing power of the people.

^•  To stimulate employment: The government can create more employment opportunities through the budget by increasing expenditures on economic and social services, and providing subsidies to sectors which increase the level of employment such as agriculture. Also, by reducing tax on inputs in order to encourage investments and, therefore, create jobs.

^•  Economic stabilization: The budget can be used as an instrument for stabilizing the economy. For example, during economic recession, the government can reduce tax and increase expenditures to stimulate consumption and create employment.

(d) Public Debts

His refers to the money that the government owe individuals, firms within the country, or to institutions outside the country, and donor countries.

Classifications of Debts

Debts can be categorized into the following groups:

A: Internal or External debts

(i) Internal Debts: This refers to the money that the government owe institutions or individuals within the country.

(ii) External Debts: This refers to the money that the government owe to institutions outside the country or donor countries.

B: Long Term and Short Term Debts

(i) Long Term Public Debts: These are debts which are repaid after a long period of time, between 5 to 20 years.

(ii) Short Term Debts: These are debts which are repaid after a short period of time.

C: Reproductive and Non Reproductive Debts

(i) Reproductive Debts: These are debts in which the government use the money borrowed for productive expenditures, such as for the construction of roads or for the provision of other social services.

(ii) Non-Reproductive Debts: These are the debts in which the government use the money borrowed for non-productive expenditures, such as buying arms.

Causes and Justification of Public Debts

Quite often, the governments in less developed countries have greatly depended on borrowing. This can be justified by a number of reasons:

^•  Inadequate tax revenue: Poor countries incur debts because the revenues collected from taxes is insufficient to finance the all the government programmes. At times, the expected revenues tend to fluctuate.

^•  To reduce the burden of taxation: Borrowing is often resorted to as a means of reducing the tax burden from the people. ^• Overcome natural calamities: Debts are also incurred to meet the unexpected occurrences such as floods, drought, etc.

^•  Raising revenues: The government incurs public debts so as to raise adequate revenue that is required for development purposes. • B.O.P deficit: Public debts, especially external debts, are incurred in a bid to correct the

B.O.P deficits which is common in LDCs.

^•  Financing ambitious development plans: The governments of poor nations tend to draw ambitions plans that are often financed through borrowing, e.g. road construction, industries, etc.

^•  To attain economic growth: Effective exploitation of the potential domestic resources needs to be financed so as to increase GNP. Therefore, public debts are inevitable in accomplishing this task.

^•  Public debts are also incurred in order to enable LDCs to fill the manpower, foreign exchange and savings gaps.

^•  To balance the budget: Public debts are incurred to help in covering unforeseen or unpredictable budgetary deficits which are common in developing countries. ^• Curbing economic depression: Public debts are quite significant in raising production, aggregate demand, employment and the level of economic activities in general. • Debt servicing: It is a common practice, by some developing nations to incur new debts in order to repay the old ones.

^•  Political instability: Some prevailing political turmoil in developing countries, especially in Africa, has greatly necessitated the government borrowing, hence incurring public debts.

Negative Consequences of Public Debts Public debts have the following negative consequences:

- The volume of imports into the country tends to reduce. This is because of the high outflow of foreign exchange to repay the debts.

- The burden falls on the citizens, who are taxed to cover up for internal debts, such that the size of the debts may influence the level of taxation.

- The effect is great on the level of consumption because high taxes on individuals deprive them of consumption.

- The future generation is affected as a result of the debt incurred many years back, to finance services that it never enjoyed or will never enjoy.

- Debt repayment reduces expenditure on capital goods for investment and, thus, limited capital formation.

- Dead weight debts e.g. financing wars may prove to be inflationary and can affect the distribution of incomes, savings and investments.

- Wastage may be encouraged. Dead weight debts results into wastage of resources, especially at the time of repayment.

- Public debts encourage over-dependence on external sources; hence this does not promote the spirit of self-reliance.

- The debt incurred in form of tied aid is always accompanied with strings (conditions) attached which often conflict with the development programmes of the recipient country.

- B.O.P position. External borrowing tends to worsen the country’s B.O.P position leading to severe B.O.P deficits.

- High administrative costs. In case of internal debt, the costs of debt redemption are quite high. This is made worse by the condition to pay a reasonable rate of the interest required.

- Unemployment, deteriorating living standards, etc are likely to occur, because the debts incurred tend to affect the level of investment and production.

Positive Consequences of Public Debts

The Public debts may have some positive consequences to the country.

The debt incurred can lead to an increase in the GDP increase it is used appropriately to exploit and mobilize the domestic production for increased output.

The debt, if it is reproductive in nature, is quite significant in increasing the government’s revenues.

More employment prospects can be generated, if the debt is a self-liquidating one, i.e. aimed at stimulating production activities.

Increased foreign exchange earnings. More foreign revenues can come in, especially through borrowing from external sources, or when used to promote and expand the export sector.

The debts incurred can expand the levels of production within the domestic economy, and this can generate economies of scale.

Improve the standards of living. Public debts incurred can enable the production and importation of a wide variety of goods and services. This will, consequently, improve the standards of living of the people.

The public debts (borrowings) tend to reduce political resistance to high taxation which is likely to be done by the citizens of developing countries.

Borrowing is not deflationary; since it reduces the tax burden so as to increase people's consumption expenditure, and therefore aggregate demand.

The public debts can reduce political instability, e.g. through borrowing to finance wars. A stable political atmosphere, there is no doubt, encourages production for development.

Debt finance acquired can help to cover the manpower, savings investment gaps, for which poor nations tend to solicit for foreign aids.

Redemption of Public Debts/Management of Public Debts

This refers to attempts by the government to pay public debts. These attempts are as follows:

- Surplus budget: In this method, the government estimates more revenues than expenditures in the budget and use the surplus to pay debts.

- Sinking fund method: In this strategy, certain amount of money is invested in the bank, and after some years, the money increases through compound interests and the money generated through this interest is used to pay debts.

- By conversion: In which the government takes a new loan of lower interest to pay the previous debts.

- By repudiation: In which the government refuses to pay the debts

- Capital levy: In this method, the government imposes tax on assets such as buildings to generate more revenues for paying debts.

- Use of accumulated foreign reserves: The government can use its reserve of foreign currency to pay its debts.

- Selling securities: The government can pay the existing debts by selling its stock of securities such as treasury bills and securities.

- Receiving grants and gifts: The government can repay some of its debts through the grants and gifts received from donor countries.

- Privatization and profits from public enterprises: The government can privatize some of the public enterprises to get revenues to pay some debts and use profits from its enterprises to pay some of its debts.

- Barter trade: The government can influence traders to use the barter system of trade in foreign trade to reduce the use of foreign exchange.

- Negotiation on debts cancellation: The government can negotiate with donors to waive -off some debts.

- Selling of foreign investments: The government can sell some of the investments that it may own abroad.

Measures That Can Be Used to Reduce Debt Burden in Less Developed Countries Apart from the above debt management policies, the following measures can be used to reduce the debt burden in developing nations:

(a) Self-reliance: LDC's can reduce dependency on foreign debts by boosting their domestic production to have a self-reliant economy, hence reduce foreign dependency.

(b) Import control measures: The government can apply import control measures, such as tariffs, to reduce spending on imports which is one of the reasons that increase foreign debt.

(c) Reduction in the government’s expenditures: The government can reduce its expenditures on non-priority goods to avoid borrowing money.

(d) Strengthening of tax collection: The government should increase its efforts in tax collection to get enough revenues to finance its expenditures instead of depending on foreign aid.

Burden of Public Debts

The burden of public debts depends on the nature of the public debts, and whether the debt is an internal or external debt, reproductive or non reproductive debt.

(i) Burden of internal debt: The burden of internal debt rests on the citizens of the country because they are repayable through tax. The government is forced to increase more tax in order to collect more revenues to pay the debts.

(ii) Burden of external debt: The burden of external debt rests on balance of payments because they necessitate the country to pay foreign currency without return of goods and services.

(iii) Burden of reproductive debt: The burden of reproductive debt is not entirely on citizens because income generated by the investments in question can be used to redeem such debts.

(iv) Burden of non-reproductive debts: For the non-reproductive debts, the burden rests on the citizens who are forced to pay more tax in order to enable the government to get revenues to pay debts, since the money borrowed does not yield to any investment.

Why External Debt Increase?

Factors that increase external debts are as follows:

• Increase in the amount to be repaid due to the high interest rates.

• Fall in the demand for exports reduces the ability of the government to repay debts.

• Increase in the price of imports force the government to use its foreign currency on imports, instead of repaying debts

• Rescheduling of debt repayment increase the amount of debts due to cumulative interest rates.

• Wasteful expenditures on non-reproductive expenditures reduce the ability of the economy to generate revenues for repayment of debts.

Fiscal Policy

It is a macro economics policy which is used by the government to attain some economic objectives, such as control of inflation, correcting unfavourable balance of payments and achieving economic growth.

Tools of Fiscal Policy

The followings are the tools of fiscal policy.

- The government expenditures.

- Taxation.

- Transfer payments.

Mechanisms of Fiscal Policy

There are two mechanisms of fiscal policy, these are;

Expansionary fiscal policy

Contractionary fiscal policy

Expansionary Fiscal Policy: In this policy, the government increases its expenditures and reduce the amount of tax in an attempt to increase the aggregate demand. Expansionary fiscal policy is designed to influence the aggregate demand, since when expenditures are increased on things such as education, health, road construction and salaries to civil servants; it results into an increase in income to the people. This act as a stimulant to the aggregate demand.

Y=C+ S

Figure 2:8: Expansionary fiscal policy

In figure 2:8 above, before the increase in expenditures, the level of aggregate demand is Y=C+I, and the national income was Y₁.After the increase in expenditures from

E₁ to E₂,

Aggregate demand rose toY2= C+I₂, and the level of the national income increased fromY₁ to Y_2.

Contractionary Fiscal Policy: This is a policy in which the government attempts to reduce aggregate demand by increasing tax and reducing expenditures. Its aim is to control inflation.

Y=C+ S

Figure 2: 9: A contraction fiscal policy

In figure 2:9 above, before the decrease in expenditures from E₂ to E₁, the National Income is Y₂,but after the decrease in expenditure, National income decrease to Y₁

Foreign Aid

Foreign aid is any form of assistance from foreign countries or foreign institutions.

Forms of Aid

(a) Technical assistance

(b) Capital (funds, machinery)

(c) Grants

(d) Gifts

(e) Consultancy

Advantages of Foreign Aid

Foreign aid can have some benefits as listed below.

(i) The recipient country may obtain technology from the donor countries.

(ii) The country can get foreign exchange.

(iii) Aid is very useful during natural calamities such as floods.

(iv) Aids promote cordial relationships between the donor country and the recipient country

(v) In the short run, aid can help to clear deficit balance of payments.

Disadvantages of Foreign Aid

Foreign aids have several disadvantages as follows:

• Aid increase the debt burden of the recipient country

• Aid cultures economic dependency

• Some aid are not provided on time therefore may not be utilized efficiently • Some aid is accompanied by some conditions which may be harmful to the economic and social interest of the recipient country

• Some aid is of poor quality and therefore useless. • Aid may be a disincentive for domestic production.

Review Questions

1. What is public finance?

2. Describe the types of taxes.

3. Discuss the merits and demerits of each type of tax.

4. Explain how the government may finance a deficit budget.

5. Discuss the types of budget.

6. Explain how a budget can be used as an instrument of economic policy

7. What are the uses of a surplus budget?

8. Discuss the main objectives of the government expenditures.

9. How can a national debt be redeemed? 10.Discuss the effects of deficit financing.

CHAPTER THREE

FINANCIAL INSTITUTIONS

Financial institutions are the institutions which involve themselves with financial transactions such as mobilizing of savings, provision of credits, accepting deposits, providing advice to the traders and the government.

Types of Financial Institutions

There are two types of financial institutions, namely;

(i) Banks

(ii) Non-banks

(i) Banks

These are financial institutions which perform the following functions:

• Mobilising of funds from the public and opening different types of accounts like savings accounts, fixed deposit and current accounts

• Other functions include, advancing of loans; providing various commercial services to the public, e.g. settling of debts through cheques, keeping valuable items, transferring of funds from one area to another, or from one person to another, through travellers’ cheques and telegraph transfers.

(ii) Non-Banks

These are institutions which do not perform banking functions such as opening of accounts to customers or provision of commercial services, but they provide specific services to the customers or members, such as insurances and pensions. Non- banks do not mobilize savings like the banks. They obtain funds from the members through contractual savings, and these savings are normally in voluntary, they are compulsory. For example, all employees in Tanzania have a legal obligation to submit a certain amount of money each month from their salaries as contribution for their pensions to either the National Social Security Fund (NSSF) or to the Parastatal Pension Fund (PPF)

Differences between Banks and Non-Banks Banks and non-banks differ in the following ways:

• Non-banks do not operate accounts for their customers' savings, while banks open different types of accounts such as savings, current and fixed deposits for their customers.

• Non-banks do not use savings to advance loans to the public, while Banks use savings mobilised from the customers to advance loans to immediate borrowers.

• Banks make profits through the loans advanced to their customers, while non -banks depend on revenues that they obtain through investments such as buildings, dividends on shares bought, etc.

• Banks, especially the commercial banks are established mainly to make profit, while non-banks are established mainly to provide social security to their clients.

Mobilisation of savings by non-banks is made contractual and compulsory, while banks use persuasion to induce the public to save money.

• Commercial banks operate cheque accounts, which make them members of the Central Bank Clearing houses, whereas non-banks financial institutions are not members of the central banks clearing house, since they do not operate cheque accounts.

• Commercial banks operate bank accounts with the central bank, which is the banker's bank, whereas non-banks intermediaries do not have such a facility. • Some deposits of customers in the commercial banks, such as in current accounts, do not get interest, whereas all deposits in the non-banks bear interest.

Types of banks

The following are the types of banks:

(a) Central Bank: This is the government’s bank which is established to assist the state to control its money. It also gives financial advice to the government, and acts as a banker for the commercial banks.

(b) Commercial Banks: These offer a wide variety of banking services and are usually owned by share holders.

(c) Savings Bank: This is mainly intended to provide a safe place for keeping small deposits and pays interests on them, e.g. Post Office Savings Bank.

(d) Specialized Banks: These are banks which serve a special type of customers or aim at providing special types of services or functions to the general publics e.g. Development Banks.

(e) Co-operative Banks: These are Banks which are established to mobilize funds within a co-operative movement. The banks help co-operatives to finance for their activities.

(f) Merchant Banks: These are banks which specialize in accepting and discounting bills of exchange, and assisting traders in international trade.

Central bank

The Central Bank is the government’s institution established to control, guide and assist other banks in the country, and also to provide banking services and financial advice to the government.

 Bank of Tanzania (B.O.T)

Historical background

The central Bank of Tanzania (B.O.T was established by an act of parliament on 23rd December, 1965 to replace the East African currency board. The Bank of Tanzania started its functions in 1966 and issued its own currency in the same year. The central Bank of Tanzania has the following roles which can be grouped into four main functions.

(a) Banking functions

(b) Domestic monetary management functions

(c) External monetary management functions

(d) Development functions

(a) Banking Functions

Under banking functions, the B.O.T has the following functions:

Fiduciary issue/currency issue: The Central Bank has the role of printing notes and minting coins and issuing them into the economy.

^•  It is the Bankers Bank: The Central Bank is the custodian reserve of other Banks. All banks and non-banks are supposed to keep a certain specific amount of their capital as reserves in the Central Bank, and it is the responsibility of the Central Bank to keep, the reserves safely.

^•  It is the Banker of the government: The Central Bank keeps the government’s money. It is also the major advisor to formulation and implementation of monetary and fiscal policies of the country, the Central Bank can sometimes advance loans to the government in case it faces budget deficit.

^•  It is a lender of last resort: If commercial banks are short of money and cannot get them from any source, then it is the responsibility of the Central Bank to advance loans to the commercial banks

^•  It is the central clearing house for commercial banks: If any dispute concerning settlement of debts arises between two banks, then it is the responsibility of the Central Bank to settle this dispute.

(b) Domestic Monetary Management Functions

Under this function, the Central Bank has the following functions:

• Financing the government budget deficit: In case the government faces a budget Deficit, the Central Bank finances the deficit by providing loans to the government. ^• Management of the government debts: The Central Bank manages the government debts both local and foreign debts, by keeping the amount and pays on behalf of the government.

• It is a financial adviser: The Central Bank gives advice to the government on all monetary issues, such as money supply, inflation, public debts, taxation, expenditure, etc.

(c) External Monetary Management Functions

Under this function, the Central Bank has the following functions:

^•  Management of the country's foreign exchange reserves: Under this function, the Central Bank controls all the foreign currencies which are received through exports and which are paid through imports and other payments.

^•  Control exchange rate and importation of goods: The Central Bank is responsible for determining the value of domestic currency in relation to foreign currencies. It also controls the importation of goods and services from abroad.

^•  Export promotion: The Central Bank helps in promoting the exports sector so as to increase the government’s foreign exchange.

^•  Participation in discussion with international financial institutions: The Central Bank on behalf of the government, participates in discussion with International Financial Institutions and the World Bank on the stability of its currency, payments of debts and other financial assistance.

(d) Development Functions

Under this function, the Central Bank has the following functions:

• It provides medium and long-term loans to commercial banks.

• It supervises commercial banks and non-banks.

It is involved with the formulation and implementation of monetary and fiscal policies of the country.