Acc 313
Acc 313
Acc 313
GENERAL INTRODUCTION
ACC 313 (Public Finance) has been designed as part of your curriculum to enable you
function either in private or public sector after your graduation. You need to understand the
policies and objectives of the government to enable you operate better. The knowledge of the
role of government in the public finance of any economy will allow you understand
economic and management strategies used in the generation of revenue (income) and its
application to expenditures (expenses).
ACC 313 is a three unit course that puts you on the same platform with students from other
departments, thereby enhancing your knowledge on the various contemporary issues in the
Nigerian economy. Each chapter ends with relevant objectives and essay questions to assist
students preparing for both academic and professional examinations.
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MODULE ONE:
THE GENERAL THEORY OF PUBLIC FINANCE
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STUDY SESSION1:
THE MEANING AND SCOPE OF PUBLIC FINANCE
Introduction
This study session discusses the fundamentals of Public Finance, its meaning, scope,
government income and expenditure, major sources of government revenue and factors that
cause growth in public expenditure in countries.
Learning Outcomes
At the completion of this study session, you should be able to:
(1.1) Define the concept of Public Finance.
(1.2) State the scope of Public Finance.
(1.3) Explain Government Income and Expenditure - General considerations.
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revenue, public expenditure, public debt and certain problems of the fiscal system as a whole
such as fiscal administration and fiscal policy.”
These definitions point to the fact that the study of Public Finance covers how governments
raise funds to finance their activities and how such funds are disbursed. In other words, the
subject matter of public finance is concerned with the revenue raising and spending activities
of governments.
1.2.1 Public Income or Revenue. This part deals with the various sources from which the
government might derive its income. It discusses and analyses the comparative advantages
and disadvantages to be taken into consideration in making a choice between them. The main
sources of revenue include taxes, fees, fines, dividend and profits from public undertakings.
1.2.2 Public Expenditure. The funds raised by government are expended on various
projects which are aimed at maximizing the social welfare of the citizens. In doing so, the
government participates in contributing to the financial flows of the economy that brings
about growth stabilization. Thus, under public expenditure, the principles that govern public
expenditure, its effect on production, employment, income distribution, stability and growth
are discussed.
1.2.3 Public Debt. Government borrows when revenue is not enough to meet its
expenditure needs. Loan to government is public debt. Under public debt, the reasons,
methods, sources of public debt, its burden and the method of debt redemption are discussed.
1.2.4 Financial Administration. This part is concerned with the way the government
handles its financial activities. It involves how the government controls the processes and
operations of public revenue, public expenditure and public debt. It includes the collection,
custody, disbursement of public funds, preparation of public budget, its passing,
implementation, auditing and other similar matters.
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1.2.5 Price Stability and Economic Growth. Price stability and economic growth have
become leading issues in economic policies of modern government. A detailed study of
public finance therefore, include how government stabilizes the economy ensure economic
growth by curtailing wide fluctuation in prices of goods and services.
What the government gets from some of the sources listed above cannot be called revenue.
According to Dalton, “it may be useful to make a distinction between public revenue and
public receipts”. Public receipts embrace all sources of funds to the government, while Public
revenue is a more narrower concept. Public revenue does not include borrowing, sale of
government assets or income from printing press (i.e printing of more money by the Central
Bank of Nigeria). This distinction is further recognized by the 1999 Constitution of the
Federal Republic of Nigeria in which section 162 refers to revenue, while section 80(1) refers
to other monies.
The main sources of revenue that accrues to the Federal Government of Nigeria can be
divided into two: Oil and Non-oil revenue.
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1.3.2 Oil Revenue
Oil revenue sources include petroleum profit tax, mining rents and royalties and NNPC
earnings.
1.3.3 Non-Oil Revenue
This comprises company tax, Customs and Excise duties, independent revenue sources that
consist of Fees, Licenses, Fines etc. The above sources of revenue can also be classified into
direct and indirect taxes and non-tax revenue.
Direct taxes include petroleum profit tax, company or corporate tax and personal income tax.
The indirect taxes include Customs and Excise Duties. As regards these types of taxes,
import duties are dominant as the economy is highly dependent on foreign goods and
technology. Prior to the oil boom of early 1970s, agriculture was the mainstay of the
economy but the sector’s contribution has fallen from 65% to less than 30%. It is the revenue
from oil that now constitute the largest proportion of the revenue structure of the economy —
over 70% of the total revenue. This can be seen from table1.1 below:
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From the chart it can be seen that oil proceeds (88.83 percent) is the major source of revenue
to the Nigeria economy followed by non-oil revenue (11.37 percent). These sources, some of
which are lumped together, can be classified as follows:
(i) Revenue from Petroleum Profit Tax (PPT)
PPT is the tax on the profit made by the companies engaging in oil business. It is a
major source of government revenue.
(ii) Revenue from Mining
The revenue derived by the government from this source includes rents and royalties
obtained from operators and NNPC sales.
(iii) Revenue from Company Income Tax
Like in many countries, companies in Nigeria pay tax on the profit make annually.
This is another major source of government revenue.
(iv) Revenue from Import Duties
This is the tax levied on imported goods. Where the demand for such goods is
inelastic, the tax yield can be substantial to the government.
(v) Revenue from Export Duties
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These are taxes on goods exported to other countries. In Nigeria, such taxes are
imposed on agricultural products like rubber, cocoa, groundnuts, hides and skin,
cotton, etc. It is an easy way of collecting taxes from farmers scattered all over the
country and who may have been evading income tax. It is a source of federal
government revenue.
Value Added Tax is a form of indirect tax on spending. It is a consumption tax since it is
included in the prices of goods and services consumed. It is collectable at each stage of the
chain of production and distribution or supply of goods and services up to the final consumer
to whom everyone in the chain passes the tax he had paid. In view of the stage by stage
collection procedure, VAT is a multi-stage tax. VAT is an important source of revenue to the
Federal Government of Nigeria. In 1997 a total sum of N34 million representing 5.8% of the
total revenue the government received was from VAT. From the above, tax related revenue
tends to be more.
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If government decides to borrow internally, it does so by issuing treasury bills and other
relevant securities. There are times when the amount involved may be too much to raise
internally. This necessitates external borrowing. Government could borrow from private
sources like the Paris and London Clubs of Creditors or multilateral sources like the World
Bank, IMF etc.
Borrowing constitutes a reasonable source of government funds and is in most cases
substantial. It is an alternative source of funds to the government. This alternative source of
funds is not without a cost. Any debt incurred needs servicing. The servicing of debts
requires large annual interest payments and this has also contributed to the growth of
government expenditure. Nigerian external debt service funds for 2006 were N249,326
million (i.e interest only). This was a lot of money.
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1.3.5 Major Sources of State and Local Government Revenue.
a. States
i. Income tax
ii. Rent on State Government properties and investments.
iii. Transfer from Federation Account
iv. Miscellaneous
b. Local Government
i. Rate/Fees (These include Market and Trading Licenses)
ii. Tenement rate and Property rate
iii. User charges (earnings from commercial undertakings)
iv. Transfers from State and Federation Account.
(i) What is the difference between public receipts and public revenue?
(i.) Public receipts include all monies received by government from all sources of funds,
while public revenue include what government gets from taxation, fees, income from
public undertakings, mining rents and royalties. Public revenue does not include money
borrowed and received from sale of government fixed assets.
Recurrent Expenditure
(i) General Administration: These are expenditures on general Administration, defense,
internal security and the cost of running the entire civil service.
(ii) Social and community services: These are expenditures on education, healthcare, and
others.
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(iii) Economic services: These are expenditures on direct productive activities. Such
activities include agriculture, fisheries, forestry, transport and communication, trade
and industry and others.
(iv) Transfer: These include public debt charges (Interest) on both domestic and external
debts, pensions and gratuities among others.
Capital Expenditure
Capital expenditures are grouped under the same headings as in recurrent expenditures
above. What differentiates the two is the nature of expenditure — that of capital is used
mainly to acquire tangible assets.
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Public expenditure refers to the expenses which the government incurs in the performance of
its functions. There are two notable theories of public expenditure, namely: the theory of
increasing state activities and the displacement theory.
The theory of increasing state activities was propounded by a German Economist known as
Adolph Wagner in 1890. According to him, there are inherent tendencies for the activities of
the government to grow both intensively and extensively. And there exist a functional
relationship between the growth of an economy and the growth of government activities.
That the government sector grows faster than the growth of the economy. All kinds of
government, irrespective of their intention and sizes, had exhibited the same tendencies of
increasing expenditure.
Wagner’s law also states that as per capital income of an economy grows, the relative size of
the public sector grows along with it. The growth will lead to an increase in the public
sector’s activities and expenditure. Wagner’s law was based on historical facts primarily of
Germany. F.S Nitti supported it and concluded with empirical evidence that it was not
applicable to Germany alone but to various States or governments.
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(iv) Increasing shift of population from the rural to urban area: This makes existing
cities to grow and new ones come up. Urbanization implies a much larger per capita
expenditure on civic amenities. Urbanization and conurbation will lead to
externalities like crime, prostitution and other vices that require public sector
intervention. There will be need for incidental services like those connected with
traffic, roads, maintenance of law and order. All these increase public expenditures.
(v) The size and nature of public services now involves specialization. For better
quality services, higher qualified administrators, technicians etc, are to be employed
and remunerated accordingly. This implies a higher cost of providing the public
services as what will be spent on salaries will be more.
(vi) Changes in Politics and Bureaucratic Structure: The political structure of Nigeria
for instance has undergone many changes over time. Initially the country had four
regions and later twelve, nineteen, twenty-one and now thirty-six States. The same
thing has happened to Local Governments. These changes have caused an increase in
government expenditure especially in the area of administration where sometimes
offices are duplicated.
(vii) Modern governments obtain loans to run their affairs; this leads to increase in public
expenditure in the form of increasing cost of debt servicing.
(viii) Like most African countries, at independence Nigerians demanded for better job
opportunities and education, improved healthcare and housing facilities. For
development, there was also the need for more schools, roads, bridges and ports. All
of these contributed to rising expenditures both in construction and maintenance.
The second theory of the growth of public expenditure was put forth by Wiseman and
Peacock in their study of public expenditure in the UK for the period 1890 - 1955. The main
contribution of the authors is that public expenditure does not increase in a smooth and
continuous manner but in jerks or step-like fashion. At times, certain social or other
disturbances occur which shows the need for increase in public expenditure that the existing
level of revenue cannot meet. When this happens, the movement from the initial and low
level of expenditure to a new and higher one is known as “the Displacement Effect” while
the inadequacy of revenue as compared to the required expenditure creates the “Inspection
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Effect”. As a result of the inadequacy, the government and the people review the revenue
position and the need to find a solution to the problems, agree to the required adjustments to
finance the increased expenditure. This will lead to a new level of tax tolerance. That is, they
are now ready to tolerate a greater burden of taxation which makes the general level of
expenditure and revenue to go up. In this way, the public expenditure and revenue get
stabilized at a new level until another disturbance occurs to cause a displacement effect.
Since each major disturbance leads to the government assuming a larger proportion of the
total national economic activity, the net result is the “Concentration Effect”. The
concentration effect also refers to the apparent tendency for a central government’s economic
activity to grow faster than those of the State and Local Governments.
Wiseman and Peacock’s analysis is based on the political theory of public expenditure
determination. It shows that although government is saddled with the responsibility of
incurring expenditures, citizens are usually reluctant to pay more tax. Because the
government in a democratic set up has to pay attention to the wishes of the people if it must
seek re-election; public expenditure tends to be influenced by the ballot box.
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• Price stability and economic growth deals with how government stabilizes the economy
and ensures economic growth.
The main sources of government funds and revenue are taxes, fees, income from public
undertakings, mining rents and royalties, fines and borrowing, while the expenditure is
classified under recurrent and capital.
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C. Both State and Local Government
D. Local Government
5. New naira notes were printed in April to increase the volume of money in circulation.
The total amount involved in addition to proceeds from sale of crude oil:
A. Refers to different sources of income to the government in April.
B. Is public income for the month of April.
C. Is public revenue for the month of April.
D. Is Public receipts for the month of April.
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8. According to Wiseman and Peacock’s theory of the growth of public expenditure, the
inadequacy of revenue as compared to the required expenditure when certain social or
other disturbances occur creates:
A. Displacement Effect
B. Inspection Effect
C. Concentration Effect
D. Problems government cannot solve.
9. When government decides to borrow money internally, it does so by
A. applying to oil companies in the country
B. applying to private sources like Paris club
C. applying to World Bank
D. issuing treasury bills
10. Which of the following is not classified under the independent sources of Federal
Government revenue?
A. Income tax collected from the armed forces
B. ncome tax collected from staff of foreign embassies
C. Income tax collected from staff of Federal Government’s establishments in Lagos
D. Income tax collected from residents of the Federal Capital Territory
Section B
i. Define public finance and explain its scope.
ii. State the most common and important sources of government funds.
iii. List and explain the factors that cause increase in public expenditure.
iv. Explain the major contribution made by Wiseman and Peacock to the theory of the growth
of public expenditure.
Solution to MCQ
1 2 3 4 5 6 7 8 9 10
C D D D D C B B D C
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References
Jhingan, M. L. (2005) Money, Banking, International Trade and Public Finance.
India, Virinda Publications (P) Ltd.
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Should you require more explanation on this study session, please do not hesitate to contact
Are you in need of General Help as regards your studies? Do not hesitate to
contact the DLI IAG Center by e-mail or phone on:
iag@dli.unilag.edu.ng
08033366677
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ACC 313 Public Finance
STUDY SESSION TWO:
THE PRINCIPLE OF TAXATION
Introduction
This study session discusses taxation, which is a major source of government revenue: types
of taxes, advantages and disadvantages of direct and indirect taxes, functions of taxation, tax
avoidance and evasion, and the principles of taxation.
Learning Outcomes
At the end of this study session, you should be able to:
2.1 Define taxation
2.2 Explain the different types of tax rate structure and forms of taxes.
2.3 Discuss the issue of how the burden of government finance should be borne.
2.4 State the principles of taxation.
2.5 Discuss the advantages and disadvantages of direct and indirect taxes.
2.6 Define tax base and rate.
2.7 State the function of taxation.
2.8 Explain the effect of taxation on economic systems.
2.9 Define tax avoidance and evasion
2.1 Definition
A tax is a compulsory levy imposed by a government on individuals, corporate bodies as
well as goods and services. According to Hugh Dalton, a tax is a compulsory contribution
imposed upon individuals by the authorities irrespective of the amount of services rendered
in return to the tax payer, and not imposed as a penalty for any legal offence committed.
A tax should, therefore be distinguished from charges, that is fees imposed by the public
authority for goods and services it provides. In other words, a tax is not a price paid by the
tax payer for any definite service rendered or commodity supplied by the government. For
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instance, water rate, charges for electricity consumed, and many others, are not taxes but
charges for services rendered. To be a tax, the absence of quid pro quo is necessary.
Tax in Nigeria was introduced so as to raise revenue that would enable government provide
social services for the benefit of its citizens at large. Income tax, which is an old form of tax,
was first introduced in 1904 by Lord Lugard. But income tax in its modern form dates back
to 1940.
Progressive tax
A tax is progressive when a percentage of the income paid as tax goes up as income
increases. In other words, the higher the income, the higher the proportion of the tax payer’s
income that is taken as tax and the lower the income, the lower the amount to be paid as tax.
As shown by table 2.1, the higher the income the higher the tax to be paid. For example,
income of ₦100,000 is taxed 3.5%, while income of ₦150,000 is taxed 3.5% for the first
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₦100,000 and 5% for the remaining ₦50,000 (which is the next ₦50,000 on the table). In the
same way income of ₦200,000 is taxed 3.5% for the first ₦100,000, 5% the next ₦50,000
and 7.5% the remaining ₦50,000.
Proportional tax
A proportional tax rate structure is one whereby the rate of taxation is the same for all
income earners. For example, an income tax rate of 10 percent would tax all income at 10
percent. Thus, two persons with income of ₦50,000 and ₦100,000 respectively would each
be subject to the same rate of taxation (10 percentage of income). While the person with
income of ₦50,000 is paying ₦5,000, the other person pays ₦10,000. A tax with a
proportional tax rate is sometimes called a flat-tax rate. This is represented in the following
table:
Regressive tax
Under regressive taxation, people with smaller income pay a greater percentage of their
income as tax when compared with people who earn more. Indirect taxes are usually
regressive. For example, if both low and high income earning persons buy a bottle of coke
each and the tax on the coke is N5, the low income earner pays a higher proportion of his
income as tax as compared to the higher income earner.
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50,000 2% 1,000
100,000 1% 1,000
Table 2.3 shows that the higher the income the lower the percentage of income which is paid
as tax. For instance an individual with tax base of ₦100,000 is expected to pay a tax rate of 1
% which is equivalent to ₦1000.
Forms of taxes
All taxes are classified into two broad categories: the direct and indirect taxes. Direct
taxes are those which the payer actually pays in cash to the government agent. These include
income tax, company tax, petroleum profit tax, capital gains tax and rates. These taxes are
presumed to be progressive as more money is being paid by those with higher income than
those whose earnings are smaller.
Indirect taxes include excise duties, export duties, custom duties and Value Added Tax
(VAT).
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Indirect taxes are those which are included in the prices paid for commodities and services
and the payer pays it unconsciously to the government coffer. Indirect taxes are regressive
since they are charged not according to income but in accordance with the consumption of
the items taxed. These include import duties, export duties, excise duties, and Value Added
Tax (VAT).
2.3 Advantages of Indirect taxation
(i) Indirect taxes do not require complicated form-filling in most cases.
(ii) It is possible to receive tax related revenue from all groups of the population, both the
rich and poor.
(iii) Tourists or visitors pay indirect tax which increases government revenue as they
consume goods and services that are taxed.
(iv) Indirect taxes do not discourage overtime work
(v) There is less possibility of evasion as indirect taxes are included in the prices of
commodities.
(vi.) It is hidden and not too easily noticed by the taxpayer and as a result it is not felt at
the time of payment.
(vii) An indirect tax can easily be altered by the government.
(viii) It can be used to check consumption of particular items. This is done when
government imposes high rate of tax on such items.
(ix) Import duties can be used to protect and encourage home industries.
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Disadvantages
(i) Indirect taxes are regressive. The rich and the poor are required to pay the same
amount of tax in which case a greater proportion of a poor person’s income goes into
taxation unlike the rich person.
(ii) Indirect taxes are inflationary as their imposition generally lead to increase in prices.
(iii) A taxpayer does not know how much of what he pays for a commodity is tax.
(iv) The revenue from indirect taxes can be uncertain because it is not possible to
accurately estimate. The effect of such taxes on the demand for a luxury good for
example is elastic and may fall if it is heavily taxed.
2.4 The issue of how the burden of government finance should be borne
In the study session one, we discussed how government raises funds to finance its activities.
Taxes are major sources of government finances. But a basic problem in government finance
is how to distribute among citizens the burden of financing the costs of government –
supplied goods and services. There are two major approaches to how the burden of
government finance could be distributed among the citizens.
These are:
(i) The benefit Principle
The benefit principle requires citizens or members of the society to contribute (through
taxation) the cost of the goods and services being supplied by government in proportion to
the benefits they receive. This means that the benefits received are to be taken as the basis
for distributing the tax burden.
A major problem with this principle is that most government- provided goods and services
are collectively consumed benefits that are difficult to assign to individuals. For such goods
and services, the principle of exclusion does not apply in practice. Besides, it is not in
agreement with the definition of taxation which is a compulsory levy imposed by a
government on individuals, corporate bodies as well as goods and services.
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(ii) The ability – to –pay Principle
This principle requires individuals in a society to contribute to government finance in
accordance to their capacity to pay. Thus, a person with a greater ability to earn income
should be taxed more than the person with less capacity to earn. It means that every person
should pay tax according to his ability to do so.
Related to the ability -to –pay principle are two notions, namely:
1. Horizontal equity
2. Vertical equity
Horizontal equity implies that individuals of the same economic capacity (i.e earn the same
amount of money as income) should pay the same amount as tax. That means persons
considered to have the same tax paying ability should pay the same amount of taxes. The
equal treatment of tax payers suggested by the horizontal equity looks good but may be
difficult to achieve in practice.
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If tax is said to be broad based, it refers to all the above-mentioned bases. The proportion of
the tax base paid as tax is called tax rate. Tax rates are usually a percentage of the tax base.
Where the level of economic development is high and the population of those to
pay tax is large, the higher will be the revenue that will be realized from taxation.
This is because income and the propensity to consume by consumers will be high.
With high industrial and commercial activities, more profit will be made by
business organizations and the ability to pay will be enhanced.
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2. Taxation also performs other functions that can be termed non-revenue functions.
These include redistribution of income and stabilization function.
A tax base is the object that is taxed, e.g. income/profit, property, etc. A tax rate is a
percentage of the tax base.
Positive Effects: The tax system covers both direct and indirect taxes whose imposition has
positive effect on the economy.
Stabilization: If an economy is experiencing inflation, one way to deal with the situation is
to raise direct taxes on individual incomes and in turn lead to overall reduction in the demand
for consumption goods and lower prices. Reduction in profits resulting from the increased
tax would lower investment by business and, all things being equal reduce inflation.
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While, on the other hand, economy is experiencing depression, the government may lower
the overall level of taxes so as to increase disposable incomes, and business profit. This will
encourage demand for more goods and services. The multiplier effect of the resulting
changes may increase income, output and employment.
(b) Employment: It is argued that if customs duties or tariffs on imported goods are raised,
the prices of such goods would increase and might reduce local demand for them. This will
increase the patronage of substitute locally manufactured goods. This leads to expansion and
employment tends to increase through the multiplier effects.
Negative Effect
Where the demand for a commodity is inelastic, indirect tax has the tendency to generate
inflation. Increase in commodity taxation in the form of import duties or excise duties may
lead to an increase in the price of the commodity. Direct tax may discourage the incentive to
save and invest, especially when the tax is excessively high. This might affect the economy
negatively.
2.9 Tax avoidance
Tax avoidance is a change in behaviour so as to reduce tax liability. In this case the respond
to the changes in prices caused by taxes by rearranging their personal affairs. For example,
high taxes on labour incomes might induce workers to refuse overtime work.
A tax payer may also reduce tax liability by taking advantage of special provisions
(sometimes called loopholes) in the tax law. However, tax avoidance is not illegal.
Tax evasion
Tax evasion is non-compliance with the tax laws by failing to pay taxes that are due. If a
person made sales and fails to report them to the government, it is tax evasion. Tax evasion is
illegal.
To minimize the problem of tax evasion, the government must do the following:
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i. The government must establish an administrative mechanism to collect the tax and
enforce penalties against non-compliance.
ii. Increase the requirements for reporting of income to the Inland Revenue.
iii. Audit of tax returns should be carried out regularly.
Summary
Taxation is a compulsory levy imposed by a government on individuals, corporate
organizations, goods and services. A tax is not a price paid by the taxpayer for any definite
service rendered by the government. All taxes are classified into two broad groups, namely,
direct and indirect taxes. Direct taxes include income tax, corporate profit tax, petroleum
profit tax and capital gains tax. All these are presumed to be progressive as more money is
paid by those with higher income. Indirect taxes include excise duties, export duties, custom
duties and value-added-tax. They are regressive as the very poor persons spend a greater
proportion of their income on taxation than the rich persons in the society. Taxation
performs both revenue and non-revenue function.
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Self-Assessment Questions
Section A
Select the letter (A, B, C, D) that best answers each of the following questions?
(1) A tax can be defined as -
(A) A compulsory levy imposed by government on goods and services consumed.
(B) A compulsory levy imposed by government on corporate bodies, individuals and
goods.
(C) A compulsory charge on an individual and corporate organization as a penalty for
a legal offence committed.
(D) Quid Pro quo
(2) A tax system that requires citizens to pay 10 percent of their income to government is:
(A) Regressive
(B) Progressive
(C) Proportional
(D) Proportional and regressive
(3) Petroleum Profit tax is a ….
(A) Regressive tax
(B) Progressive tax
(C) Proportional and progressive tax
(D) Proportional tax
(4) Which form of taxation enables revenue to be extracted for tourists?
(A) Direct taxes
(B) Indirect taxes
(C) Progressive tax system,
(D) Proportional tax system
(5) Which form of taxation is difficult to evade?
(A) Indirect taxes
(B) Direct taxes
(C) Company tax
(D) Proportional tax
(6) Which of these is not correct?
(A) Custom duties can be used to protect home industries
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SECTION B
(i) Define taxation
(ii) Briefly explain the following:
(a) Progressive taxation
(b) Regressive taxation
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(c) Proportional taxation
(iii) What are the advantages of indirect taxes?
(iv) Define tax evasion. Explain what can be done to minimize the problem of tax evasion.
(v) State three reasons why government levy taxes
Solution to MCQ
1 2 3 4 5 6 7 8 9 10
B C B B A D B B C B
References
Jhingan, M.L (2005) Money, Banking, International Trade and Public Finance. India
Vrinda Publications (P) Ltd.
Bhatia, H.L (2011) Public Finance Vikas Publishing House PVT Ltd.
Hyman, N. David (1993) Public Finance, A Contemporary Application of theory to
policy the Dryden Press.
Harvey, S. R. (1995) Public Finance, Irwin McGraw.
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Should you require more explanation on this study session, please do not hesitate to contact
Are you in need of General Help as regards your studies? Do not hesitate to
contact the DLI IAG Center by e-mail or phone on:
iag@dli.unilag.edu.ng
08033366677
35
ACC 313 Public Finance
STUDY SESSION THREE:
NATIONAL INCOME: MEANING AND MEASUREMENT
Introduction:
This Study Session explains the meaning of National Income and how it is measured. Also,
discussed in this study session are a number of concepts that pertains to national income,
problems associated with its measurement and the usefulness of national income statistics.
Learning Outcomes:
At the end of this study session, you should be able to:
3:1 Define National Income
3.2 Explain concepts of National Income
3.3 Discuss the methods of measuring National Income
3.4 Explain the limitation of the methods of measuring National Income in Nigeria
3.5 State the problems of National Income measurement
3.6 Discuss the uses of National Income statistics
3.1 Definition
National Income is the total reward or income received by the factors of production as
payments for their contribution to the total volume of production during a specific period of
time, which is normally a year. National Income also refers to the total monetary value of
goods and services produced annually in an economy or country. The rewards to the various
factors of production include the following:
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P.I.= National Income- Indirect Taxes – Undistributed Profit – Government Transfer
Payment.
National income is the total monetary value of goods and services produced in an economy
in a period of one year. It also refers to the total income received by the factors of production
in a year.
Example one
In an economy, the following data were recorded in the year 2000:
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N (Million)
Undistributed Corporate Profit 250
Income received by government 300
Income from self-employment 150
Income from employment 200
Personal Income from other Sources (No transfer payment) 100
You are required to calculate the National Income for the year, 2000.
Solution:
National Income (Yn) = (Yp-Tp) + Up + Gy
Yn = (N 450-0) + N 250+ N 300
= N 450+ N 250+ N 300
= N1000 Million
Example two
Suppose you are given N20 million as net income from abroad in addition to the data in
example one.
Calculate the GNP.
Solution:
GNP = N 450 + N 300+ N 20 = N1020 Million
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Lack of accurate records of expenditure and the great disparity in consumption patterns, limit
the expenditure method. For reasons of reliability in statistical data and the complex nature
of the economy, the output method is more in use. Though it has its limitation, to take
account of goods and services being produced in the economy and calculate the national
income using output method appears more realistic.
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iii. Standard of living: The overall standard of living of a nation can be determined using
the national income statistics.
iv. Contribution to international organizations:The National Income of a country is
used to determine how much she should contribute to international organizations like
United Nations, International Monetary Fund, etc.
v. Comparison:National Income statistics are used to compare the standard of living of
different countries. This is done on the basis of income per head or per capital income.
They can also serve as indicators of the economic strength of a country, that is, how
rich or poor the country is.
vi. Research Purpose:The National Income Statistics are made use of by those who carry
out research on various issues or subjects in economics.
Government expenditures increase demand for goods and services. They are injections in the
national income.
Summary
National Income is defined as the total reward or income received by the factors of
production as payment for their contribution to the total volume of production for a period of
one year. It also refers to the total monetary value of goods and services produced annually
in an economy. There are a number of concepts that pertain to national income which should
be mentioned in discussing national income. These include Gross National Product (GNP),
Gross Domestic Product (GDP), Net National Product (NNP), Personal Income (P.I) and
Disposal Income (DI) National Income is measured in four different ways: Income Method,
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Expenditure Method, Output Method and Value Added Method. Getting the accurate figure
in computing national income statistics is very useful in planning purposes and for the
purpose of comparing the standard of living of different countries.
Self-Assessment Questions
Section A: Select the most appropriate letter (A,B,C,D) that answers each of the following
questions:
(1) Which of these statements is not correct? National income is:
(A) the monetary reward to the various factors of production annually
(B) the total expenditure made annually in an economy
(C) total monetary value of goods and services produced in a year
(D) the summation of salaries and wages, corporate profits, rents and cash gift.
(2) Per Capita income refers to
(A) Gross National Product
(B) Gross Domestic Product
(C) Average income of individuals of a country
(D) Average disposable income of individuals of a country
(3) Compensation benefits are the same as
(A) Disposal income
(B) Transfer payment
(C) Gross income from other sources
(D) Extra income earned
(4) Addition of salaries & wages, money received from rent, interest, and profit from
several business transactions is known as national income at
(A) Current prices
(B) Market prices
(C) Labour prices
(D) Factor cost
(5). Net National Product is
(A) GNP – indirect tax + subsidy
(B) GNP + indirect tax – subsidy
(C) GNP – depreciation
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(10) Suppose, in addition to the data above, the economy recorded Imports of N80 million
and Exports of #180 million, What is the GNP?
(A) N 1400 million
(B) N 1300 million
(C) N1500 million
(D) N1600 million
SECTION B
i. Define national income
ii. Briefly discuss the following
• Gross National Product
• Gross Domestic Product
• Transfer payment
iii. Explain the problems that do arise in computing national income
iv. How useful is the national income statistics
v. Explain what is involved in using the output method in calculating the Gross National
Product (GNP).
Solution to MCQs
1 2 3 4 5 6 7 8 9 10
D C B D C C C B A C
References
Jhingan, M.L and Stephen J.K (2008) Managerial Economics. India Vrinda Publications (P)
Ltd.
Buhari, A.L (1993) Straight to the point ICAN/Polytechnic Public Finance.
MAYO-BP (1996) ICAN study text PEII Public Finance Mayo Associates Ltd and BPP
Publishing Ltd.
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ACC 313 Public Finance
Should you require more explanation on this study session, please do not hesitate to contact
Are you in need of General Help as regards your studies? Do not hesitate to
contact the DLI IAG Center by e-mail or phone on:
iag@dli.unilag.edu.ng
08033366677
47
ACC 313 Public Finance
STUDY SESSION 4:
THE THEORY OF NATIONAL INCOME DETERMINATION
KEYNESIAN MODEL
Introduction
This study session discusses the Keynesian model of national income determination in a
capitalist economy. It highlights the basic proposition of the Keynesian model of national
income and for ease of analysis; it has been classified into a two-sector model, a three-sector
model and a four-sector model. The study session also explains the characteristics of each of
these and calculations relating to them
Learning Outcomes
At the end of this study session, you should be able to:
4.1 Explain the general Keynesian model of national income determination in a capitalist
economy.
4.2 Determine national income equilibrium using:
(a) Aggregate demand and supply approach
(b) Savings – investment approach.
4.3 Define the multiplier concept and the derivation of the multiplier (2 – sector model)
4.4 Explain the equilibrium national income of a three sector Keynesian model:
(a) when government is introduced and without tax;
(b) when direct tax is introduced.
4.5 Discuss the four sector Keynesian model and derive the equation
Yeq = a – bTo + Io + Go Xo¯Mo
1-b+M
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The basic proposition here is that the equilibrium level of income and output is dependent on
the economy’s level of aggregate demand for output. National income models consider the
functional sectors of the economy which include the following:
The Household Sector
This covers persons and institutions in their capacity as consumers of goods and services. It
also includes suppliers of factors of production.
Government Sector
Included in this sector are all levels of government that provide goods and services: The
various models could be classified as follows:
Two-sector Model makes transfer payments. This comprises domestic firms and households.
The circular flow of the income (which is shown by the diagram below) of economic
activities among the two settings; that is, domestic firms and households.
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As shown in the diagram above, in a two-sector economy, households supply the firms,
factors of production while the firms in turn supply the households’ goods and services. It
also shows that payments are made by both sectors for the goods, services, and factors of
production being supplied, consumed and used. This is a closed economy. There is no
foreign trade. There is also no government.
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Therefore C = a + bY ………………………………………………………..….2
Substituting equation 2 into 1 we will now have Y = a + bY+ I ……………..…3
Re-arranging them we have Y – bY = a + 1
Y (I-b) = a + I
Y= a + I or a + I
1 - b 1-b 1-b
(1-b) is Marginal Propensity to Save (MPS) while b is marginal propensity to consume
(MPC)
Note that, MPC + MPS = 1. Therefore MPS = I - MPC and MPC = 1-MPS
The aggregate demand and supply approach can be used to determine national income
equilibrium under the three-sector and four-sector Keynesian model stated earlier.
(ii) Saving - Investment approach
Saving (S) = Investment (1)
(S) = I……………………………… (1)
And if Y = C + I ………………………...(2)
Then S = Y – C ……………….……….(3)
Equation (2) can be rewritten as Y – C = 1
Earlier, we said C = a + bY
Y – (a + bY) I ……………………………..(4)
When the brackets are opened we have
Y – a - bY = 1
Y – bY = a + I
Y(1-b) = a+I
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Y = a+I
I+b
Using the Aggregate Demand (AD) and Aggregate Supply (AS) Approach:
Aggregate Demand (AD) = C+ I while
Aggregate Supply (AS) = Y
At equilibrium AD = AS
Therefore ₦1000+0.75Y + ₦100 = Y( i.e Y= ₦1000 + 0.75Y + ₦100)
Putting like terms together we would have
Y – 0.75Y= ₦1000 + ₦100 = Y(1-0.75) = ₦1000 + ₦100
Yeq = ₦1000 +₦ 100
1 – 0.75
= ₦1100 = ₦4400
0.25
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Solution
C = ₦1000 + 0.75Y
But savings S = Y – C i.e Y – (₦1000 + 0.75Y) when the bracket is opened we would have
Y – 1000 – 0.75Y.
Remember , with savings – Investment approach, Planned Savings = Planned Investment.
Therefore Y – ₦1000 – 0.75Y = ₦100
Y – 0.75Y = ₦100 + ₦1000 = Y (1-0.75) = ₦1100
Y = ₦1100
0.25
= ₦4400
Note that a closed economy is one without foreign trade.
Example 2
4.3 Multiplier Concept
The multiplier concept states that a change in expenditure will bring about a change in
national income that is greater than the initial change in expenditure. The multiplier is
therefore defined as the ratio of change in national income to change in expenditure.
1 = ∆C + ∆I
∆Y ∆Y
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Subtract ∆C from both sides of equation 3
∆Y
∆Y= 1 …………………………...(6)
∆I 1 - b
Equation (6) is called investment multiplier which shows that a (∆ Change) in the level of
investment spending will have an impact on national income which will be greater than the
original change in investment.
Suppose there is a change of ₦400m in investment spending when MPC is 0.75. What will
be the effect on the National Income?
0.25Y = 400m
Y = ₦400m = ₦1600m
0.25
4.4 Equilibrium National Income in Three-Sector Keynesian Model
As mentioned earlier, the 3-Sector economy comprises the household, business and the
government. With the introduction of government, Y = C + I + G and taxes are levied and
spent. The government increases messages aggregate demand by spending on goods and
services and by collecting taxes. This makes the difference between a 2-Sector and 3-Sector
models.
(a) Equilibrium National Income when government is introduced (without tax).
Aggregate Demand AD = C + I +G …………………………….(1)
But C = a + bY
At equilibrium Y = AD
Therefore, Y = a + bY + I + G …………………………….(2)
Y-bY = a+I+G
Y(1-b) = a + I + G
Yeq =a+I+G
1-b
(b) When Direct tax is introduced (Recall equation 1):
Y = C + Io + Go……………………………………………….(4)
Where Io = autonomous investment
Go = autonomous Government Expenditure
C = a + bYd ………………………………………………….(5)
And Yd = Y – To …………………………………………….(6)
Where Yd = disposable income and To = autonomous tax.
Substituting equation (5) and (6) into 4 gives us:
Y = a + b (Y - To) + Io + Go
Y = a + b Y- b To + Io + Go
Y – bY = a – bTo + Io + Go
Y(1-b) = a – bTo + Io + Go
Yeq = a – bTo + Io + G
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1 -b
With the inclusion of foreign trade and government that levies taxes, the activities of a 4-
Sector economy are more than those of the 2-Sector. The activities include imports and
exports of goods and services, government expenditures and taxation which should be
considered in calculating national income. It should be noted that government expenditures
are like investment as they raise the demand for goods and services. They are injections in
the national income, while taxes like savings are leakages. This is because taxes and savings
tend to reduce the demand for consumer goods. In the same way, exports are injections
while imports are leakages in the national income.
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You are required to calculate the equilibrium national income using the following data:
C = N400 + 0.8Yd
I = N200
G = N200
X = N400
M = N200
T = N40 + 0.16Y
Y = C+1+G+X–M
Y = N400+0.8Yd +N 200 +N 200 +N400 – N200
Y = N400 + 0.8(Y-T) + N200 + N200 + N400 – N200
= N400 + 0.8 [Y-(N40+0.16Y)]+N600
= N400 + 0.8[Y- 40-0.16Y]+N600
= N400 + 0.8Y-32-0.128Y+N600
=N400+0.8[Y-40-0.16Y]+N600
=0.8Y-0.128Y+N400+N600-32
Y+0.128Y – 0.8Y =N968 Y(1+0.128-0.8) = N968
Y(0.328) = N968
Y = N968/0.328
Y = N 2951.22
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Summary
The equilibrium level of income and output is achieved when there is demand for goods and
services produced in the economy. National income models consider the functional sectors
of the economy which include the households, investment sector and the government sector.
The various models are classified as two-Sector, three-Sector and four-Sector economies.
The two-Sector economy is made up of the household and firms. The three-Sector model is
made up of the two-Sector economy and government, while the four-Sector has the three-
Sector and foreign trade. National income equilibrium can be determined using two different
approaches, namely:
Aggregate Demand and Supply Approach
Savings – investment approach
The multiplier concept is about how a change in expenditure brings about a change in the
national income that is greater than the initial change in expenditure.
Self-Assessment Questions
Section A. Select the most appropriate letter (A, B, C, D) that best answer each of the
following questions:
Questions 1 and 2 refers to the equation, NI = a + I
1– b
1. 1 -b in the equation refers to……………..
(A) Marginal propensity to consume
(B) Marginal propensity to save
(C) The growth rate in the economy
(D) Investment by the Household sector
2. The b refers to:
(A) Marginal propensity to consume
(B) Marginal propensity to save
(C) An increase in savings
(D) A decrease in savings.
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4. What is AD?
(A) 3400
(B) 4000
(C) 4200
(D) 4400
5. What is C?
(A) 4300
(B) 4250
(C) 4000
(D) 3800
6. Find Y
(A) 4200
(B) 4400
(C) 4000
(D) 3400
7. The equation, ∆C = __1 is called
∆Y 1–b
(A) Expenditure on luxury goods
(B) Investment multiplier
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(C) Planned investment
(D) Unplanned investment
8. Savings are to be considered as:
(A) Injections in the national income
(B) Leakages in the national income
(C) Companies retained profit only in the national income.
(D) Unspent gross income in the national income.
9. Which of these statements is not correct?
(A) Taxes are leakages in the national income
(B) Imports are leakages in the national income.
(C) Government expenditures are injections in the national income.
(D) Exports are injection in the national income.
10. Suppose there is a change of ₦800 million in investment spending when MPC is 0.75.
What will be the effect of this on the national income?
(A) ₦3000 million
(B) ₦3100 million
(C) ₦3200 million
(D) ₦3400 million
SECTION B
i) Explain what is meant by the expression "equilibrium level of national income".
ii) How is national income determined in an open economy?
iii) Briefly explain the multiplier concept.
iv) A 3-Sector model economy without tax has the following data in 2014:
C = 600 + 0.75Y
I = 100
G = 400
You are required to calculate the equilibrium national income.
Solution to MCQ
1 2 3 4 5 6 7 8 9 10
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B A D D A B B B D C
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References
Bhatia, H.L (2011) Public Finance Vikas Publishing House PVT Ltd.
Buhari, A.L (1993) Straight to the point ICAN/Polytechnic Public Finance.
Harvey, S. Rosen (1995) Public Finance, Irwin McGraw.
Hyman, N. David (1993) Public Finance, A Contemporary Application of theory policy the
Dryden Press.
Jhingan, M.L (2005) Money, Banking, International Trade and Public Finance. India,
Vrinda Publications (P) Ltd.
Jhingan, M.L and Stephen J.K (2008) Managerial Economics India, Vrinda Publications (P)
Ltd.
MAYO-BP (1996) ICAN study text PEII Public Finance Mayo Associates Ltd and BPP
Publishing Ltd.
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ACC 313 Public Finance
Should you require more explanation on this study session, please do not hesitate to contact
Are you in need of General Help as regards your studies? Do not hesitate to
contact the DLI IAG Center by e-mail or phone on:
iag@dli.unilag.edu.ng
08033366677
63
ACC 313 Public Finance
STUDY SESSION FIVE:
THE FREE MARKET ECONOMY
Introduction
In this study session, an attempt has been made to discuss the concept of free market
economy at a level comprehensible to learners in the study of public finance. Thus, the
characteristics of a free market system were identified. Likewise, the roles of government in
a market economy are examined while the concept, causes and solution of market failure are
explained
Learning Outcomes
At the end of this study session, you should be able to:
5.1 Define and use correctly the key terms in this concept
5.2 Define the concept and features of free market economy
5.3 Highlight the merits and demerits of a free market economy
5.4 Identify the roles of government in the working of the market system
5.5 Explain the meaning of market fail
5.6 Examine the reasons why market fails.
learner, an understanding of some of the main features of a market economy can give you an
insight of the concept. Thus, the chart of Lameiro, the author of ‘America’s economic war’
will be employed to define and highlight the salient features of a free market economy (see
figure 5.1).
Free
Cooperative
and Peaceful
Free to set Free to choose
process
prices your work
Free to Free to be an
compete investor
Source: http://gerardlameiro.com/thoughts/characteristics-of-a-free-market
The subdivision of the feature of the market economy as shown in figure 5.1, is briefly
explain: the economy involves a free, cooperative and peaceful process. Individual in the
economy has the liberty to operate and cooperate with any individual/s to do business since:
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i There is no government intervention in the working of the economy.
ii. Individuals have freedom to choose their own work. Every individual in the economy
is free to partake in whatever work or establishment that they feel is better for them.
iii. Individuals have liberty to be investors. Everybody in the society is free to invest in
any sector of their choice.
iv. Each individual free to be entrepreneurs. In this regard, everybody can own a
business and manage other factors of production without coerce from any third
parties.
v. Everyone is free to create capital formation (the process of bringing together capital
from savers and investors to invest in new businesses, products and services).
vi. Individuals are free to make profits. Each person is free to invest and make profit
from whatever investment undertaken.
vii. Individuals are free to compete (to create faster, better and cheaper products and
services).
viii. Liberty to buy, earn, use and sell private property (without excessive government
regulations).
ix Individuals are free to set prices (including wages and salaries – the prices paid for
labour services).
Having stated the features of the market economy, it is believed that, in the marketplace the
price of a good or service helps communicate consumer demand to producers and thus directs
the allocation of resources toward consumer, as well as investor satisfaction. The price is a
result of a plethora of voluntary transactions, rather than political decree as in a controlled
market. Through free competition between vendors for the provision of products and
services, prices tend to decrease, and quality tends to increase. Thus, a free market is not to
be confused with a perfect market where individuals have perfect information and there is
perfect competition. In a more simplified term, the proponents hold that within an ideal free
market, property rights are voluntarily exchanged at a price arranged solely by the mutual
consent of buyers and sellers. By definition, sellers and buyers do not force each other, in the
sense that they obtain each other's property rights without the use of physical force, threat of
physical force, or fraud, nor are they coerced by a third party (such as by government through
transfer payment) and they engage in trade simply because they both consent and believe that
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what they are getting is worth more than or as much as what they give up. Price is the result
of buying and selling decisions enmasse as described by the theory of demand and supply. In
the market setting, the entrepreneur takes a great risk to launch a business, putting up capital,
with the hope that the product or service will succeed. If the risk is considered a
disadvantage, when the business succeeds, the profit and control of the business future is
determined by the owner, not the government.
In reality, there is no free market economy in any country because most nations that claim to
practice market economies have lesser or greater government intervention. Even in countries
like USA considered to be champions of free market, there are many areas of government
control. For example there are laws intended to check unfair trade practices. Also there are
considerable restriction on what can be imported and how many quantities through the
mechanism of import quotas and tariffs. Then there are provisions like anti-dumping laws.
These prove that free economy has its advantages as well as limitations.
A free-market economy is an economy where all markets within it are unregulated by any
parties other than those players in the market. Likewise, it is a market economy that is based
on the forces of demand and supply with little or no government intervention. A completely
free market is an idealized form of a market economy where sellers and buyers are allowed to
freely transact (i.e. trade/sell/buy) based on a mutual agreement on price without
Government/State intervention in the form of regulation, subsidies or taxes.
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The Important Merits and Major Demerits:
5.2 The merits identified are:
• There is increase in efficiency: It is said earlier that free market economies are very
competitive. Most of the firms in the industries are assumed to be perfectly competitive
and so productive and allocative efficiency will arise. It makes sense that free market
economies allocate their resources more efficiently. Decisions about what to produce
are made by the people who will actually consume the goods. Planners are less likely to
make the correct decisions across the whole economy.
• Individuals have choice to buy and sell at their free will. Each firm are expected to
produce whatever consumers are prepared to buy. Remember that the consumer is
sovereign. Due to the free enterprise factor, there are no restrictions on what the firms
can produce. It is of no surprise, therefore, that there will be a much larger choice of
goods and services in a free market economy compared with a command economy. The
planner will be more concerned with making sure there are enough essential goods to
go around rather than allocating resources efficiently between all goods.
• There is more innovation as firms look for new products to sell. Firms will always
be looking to produce something new to get ahead of their competitors. We said earlier
that, even though the government's role is limited, one of its jobs is to protect property
rights. This will include intellectual property rights through patents. Hence, there are
incentives in the free market system for firms to be innovative and produce better
quality products. Obviously there is no incentive for the planner to be innovative. As
long as they produce the essentials the planners will be happy.
• It enhances higher economic growth rates. One does not have to be an expert in
economics to see that countries whose economic structure is nearer to the free market
system have grown much faster and quicker than those with a command economy since
the Second World War. The most successful economy in the world (in terms of size) is
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the USA, and they have been one of the liberal economies in the world. Given the three
factors above, learners shouldn’t be surprise that this is the case. It should be noted that
many mixed economies have grown quite well, but certainly the post-war command
economies had the worst record.
• Reduce some expenditures burden of the State. The size, power, and cost of the
State bureaucracy are correspondingly reduced as various activities that are usually
associated with the public sector are taken over by private enterprises:
• Availability of variety of goods and more people are empowered with skills to
work. A great variety of consumer goods become available for those who have the
money to buy them; and many more people quickly acquire the technical and social
skills and knowledge needed to function in this new economy.
• Unequal distribution of income. For many, this is the key demerits of a free market
economy. In a free market with very limited government control, benefits will be low,
the health service sector and schools will be under funded. If you start life with very
little, and do not even get a good education, then there will be very little protection
from destitution. A command economy might not have the efficiency and enterprise for
the successful to make millions, but at least the strong government will try to make sure
that nobody falls through the safety net. It will be a fairer economy, even though it is
likely to be less successful overall.
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• Pollution of the environment. Free market economies are likely to produce more
environmental pollution, which is bad for the environment. Command economies can
make sure that the production processes that they chose are as environmentally friendly
as possible. They should be able to make sure that the level of output is the socially
optimal level of output. Governments can try to force firms into producing the socially
optimal level of output through the use of taxes, but governments with a limited role
will not be keen to use taxes.
• Consumption of harmful goods may be encouraged: Free market economy might
find it profitable to provide goods which are in demand and ignore the fact that they
might be harmful for the society.
• There is the tendency of workers been exploited? This form of economy system
may experience worsen exploitation of workers, since the harder, faster, and longer
people work—the less they get paid—the more profit is earned by their employer (With
this incentive and being driven by competition, employers are always finding new ways
to intensify exploitation).
• Growing unemployment. Enterprises in the market economy will only employ those
factors of production which will be profitable and thus we may find a lot of
unemployment as more machines and less labour will be used to cut cost. This point is
buttress on the ground that, there is little or no government intervention in the working
of the system, thus, the employers has the full power to fire at will. Likewise, machines
and raw materials might be available, however, if the people who need product from
them cannot afford the price that will generate profit, the owners will do nothing
because, in a market economy profits are what matters. When entrepreneur do not make
profit, they tend to reduce the number of their work force.
• Increase in the level of corruption. This form of economy system tends to increase
the corruption level in all sectors of the society. This further increase the power of those
with a lot of money to bribe the officials and those without money to bribe the officials
is put at a severe disadvantage. Also, there is increase in all kinds of economic crimes,
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with people trying to acquire money illegally when legal means are not available (and
sometimes even when they are.)
• Inequality in status. With such a gap between the rich and the poor, egalitarian social
relations become impossible (people with a lot of money begin to think of themselves
as a better kind of human being and view the poor with contempt, while the poor feel a
mixture of hatred, envy and respect for the rich); those with the money also begin to
exercise a disproportional political influence, which they still use to help themselves
make more money;
• Ignore social cost: In the desire to maximise profits businesses might not consider the
social effects of their actions. Their action reduces social benefits and welfare (since
such benefits are financed at least in part by taxes, extended benefits generally means
reduced profits for the rich; furthermore, any social safety net makes workers less
fearful of losing their jobs and consequently less willing to do anything to keep them);
and worsening ecological degradation (since any effort to improve the quality of the air
and of the water costs the owners of industry money and reduces profits, our natural
home becomes increasingly unliveable).
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with economic literature, five roles are attributed to the government in a market economy.
These functions as discuss by Prof. Hassan (2009) are:
i. Providing the economy with a legal structure: This is the first and most important
function a government should provide and without it the economy may collapse. This
function requires the government to ensure property rights, provide enforcement of
contracts, act as a referee and impose penalties for foul play. In order to perform this
function, the government should furnish the economy with regulations, legislations, and
means that ensure product quality, define ownership rights and enforce contracts.
ii. Maintaining competition: Since competition is the optimal and efficient market
mechanism that encourages producers and resource suppliers to respond to price signals
and consumer sovereignty, the government should fight monopoly power and non-
competitive behaviour.
Thus, anti-monopoly laws (Sherman Act of 1890; Clayton Act of 1913) in USA are
designed to regulate business behaviour and promote competition. It is important to
mention here that Microsoft was found guilty of violating these laws in 2000.
iii. Redistribution of income: The government should strive to provide relief to the poor,
dependent, handicapped, and unemployed. Welfare, Social Security and Medicare
programs are examples of programs that support the poor, sick and elderly. These
programs are built on transferring income from the high income groups to the limited
income ones, through progressive taxes. Other means of redistribution might include
price support programs such as the farm subsidy and low interest loans to students
based on their family incomes.
iv. Provision of public and quasi-public goods: When the markets fail to provide the
needed goods or the correct amounts of certain goods or services, the government fills
in the vacuum. Examples of public goods that the markets do not provide are defence,
security, police protection and the judicial system. Education and health services are
examples of quasi-public (merit) goods that the market does not provide enough of. The
government should provide the first, and help in the provision of the second.
v. Promoting growth and stability: The government (assisted by the Fed) should promote
macroeconomic growth and stability (increasing the GDP, fighting inflation and
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unemployment) through changes in its fiscal and monetary policies. The fiscal policies
means the use of taxes and spending and it is managed by the executive branch
represented mainly by the Treasury Department. The monetary policies signifies the
use of interest rates, money supply, reserve requirements, etc. and it is managed by the
Federal Reserve System.
Going over these tasks and functions, and examining what was going on in the U.S. economy
in general, and the financial markets in particular, for the last ten years, the reader may get a
sense of which tasks the government neglected to perform partially or completely. Also, in
which functions the government expanded its power beyond the call of duties and in explicit
conflict with the principles of the free market system.
Highlight three roles government played in the working of the free market economy.
Three function of the government in a free market economy are:
i. Providing the economy with a legal structure
ii. Provision of public and quasi-public goods
iii. Redistribution of income
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i. Monopoly power. This is a situation where one or few producers and/or sellers gain
control of the market. Monopolists restrict output and charge prices higher than the
competitive market prices. Proper functioning of free competitive markets requires
breaking-up monopolies, ceasing and desisting monopolistic practices or regulating
them.
ii. Negative externalities. Consumers and producers may fail to take into account the
effects of their actions on third-parties, such as car drivers, who may fail to take into
account the traffic congestion they create for others. Third-parties are individuals,
organisations, or communities indirectly benefiting or suffering as a result of the
actions of consumers and producers attempting to pursue their own self-interest. For
example, multinational companies do not bear the full cost of oil spillage and health
hazards that their pollution imposes on the indigenes of Niger Delta.
iii. Missing markets. Markets may fail to form, resulting in a failure to meet a need or
want, such as the need for public goods, such as defense, street lighting, and
highways.
iv. Productive and allocative inefficiency. Markets may fail to produce and allocate
scarce resources in the most efficient way.
v. De-merit goods. Markets may also fail to control the manufacture and sale of goods
like cigarettes and alcohol, which have less merit than consumers perceive.
vi. Incomplete markets. Markets may fail to produce enough merit goods, such as
education and healthcare.
vii. Property rights. Markets work most effectively when consumers and producers are
granted the right to own property, but in many cases property rights cannot easily be
allocated to certain resources. Failure to assign property rights may limit the ability of
markets to form.
viii. Information failure. Markets may not provide enough information because, during a
market transaction, it may not be in the interests of one party to provide full
information to the other party.
ix. Unstable markets. Sometimes markets become highly unstable, and a stable
equilibrium may not be established, such as certain agricultural markets, foreign
exchange, and credit markets. Such volatility may require intervention.
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x. Inequality. Markets may also fail to limit the size of the gap between income earners,
the so-called income gap. Market transactions reward consumers and producers with
incomes and profits, but these rewards may be concentrated in the hands of a few.
(i) Market failure occurs when freely-functioning markets, fail to deliver an efficient
allocation of resources. It occurs when there is an inefficient allocation of resources in a
free market. The result is loss of economic and social welfare.
(ii) Market failure can occur due to the following reasons;
• Monopoly power (when a firm controls the market and can set higher prices.)
• Negative externalities (Goods / services which impose cost on a third party) and;
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• Public goods (Goods which are non-excludable and non-rival –usually not
provided in a free market economy e.g. police, national defence.)
(iii) Solutions to market failure are
• The use of price mechanism to regulate the economy
• The application of legislation and force by government.
Self-Assessment Questions
Section A. Select the most appropriate letter (A, B, C, D) that best answers each of the
following questions:
1. In a free market economy, consumption and investment decisions
(a) Are controlled largely by the government.
(b) Shape the future course of the national economy.
(c) Are necessarily controlled by big businesses.
(d) Require protection from foreign forces if individuals desire wealth accumulation.
2. The whole classes of goods that will be under-produced or not produced at all in a
completely unregulated market economy are referred to as:
(a) Free goods
(b) Public goods
(c) Private goods
(d) Pareto goods.
3. The whole classes of goods that will be produced in a completely unregulated market
economy are referred to as:
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(a) Provision of economic resource
(b) Provision of public and quasi-public goods
(c) Maintaining competition
(d) Providing the economy with a legal structure
10. Government may intervene to correct the distortions created by market failure and to
improve the efficiency in the way that markets operate through the following except:
(a) Pollution taxes to correct for externalities
(b) Taxation of monopoly profits (the Windfall Tax)
(c) Oligopolies/cartel behaviour of output and price determination unchecked
(d) Policies to introduce competition into markets (de-regulation).
Solution to MCQs
Questions 1 2 3 4 5 6 7 8 9 10
Answers B B C A B D D D A C
References
Bertell, O., (1999). Market Economy: Advantages and Disadvantages (Talk at Nanjing
Normal University, Nanjing, China—Oct., l999)
https://www.nyu.edu/projects/ollman/docs/china_speech2.php
Hassan, Y. A., (2009) The role of government in a market economy. A professor of
economics at The Ohio State University at Marion, USA. September.
http://econ.ohiostate.edu/Aly/docs/The%20role%20of%20government%20MS%20Ar
ticle%209-27-08.pdf
Lameiro, G. F. (2012). America’s Economic War – Your Freedom, Money and Life. A
Citizen’s Handbook for Understanding the War between American Capitalism and
Socialism. http://gerardlameiro.com/books/americas-economic-war
www.answers.com/topic/regulated-market
https://www.nyu.edu/projects/ollman/docs/china_speech2.php
https://www.princeton.edu/~achaney/tmve/wiki100k/docs/Free_market.html
http://gerardlameiro.com/thoughts/characteristics-of-a-free-market
http://smallbusiness.chron.com/features-market-economic-system-3887.html
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http://www.enotes.com/homework-help/what-advantages-disadvantages-free-market-
eco www.krusekronicle.com
http://www.economicsonline.co.uk/Market_failures/Types_of_market_failure.html
www.krusekronicle.com/.../governments-role-in-a-free-market-economy.
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Should you require more explanation on this study session, please do not hesitate to contact
Are you in need of General Help as regards your studies? Do not hesitate to
contact the DLI IAG Center by e-mail or phone on:
iag@dli.unilag.edu.ng
08033366677
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MODULE TWO:
GOVERNMENT MANAGEMENT OF THE ECONOMY
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STUDY SESSION SIX:
PURPOSE, FUNCTIONS, TECHNIQUES AND LIMITATIONS OF
PUBLIC BUDGETING
PUBLIC BUDGET 1
Introduction
A budget is a financial or quantitative statement prepared prior to a defined period of time for
the purpose of attaining a given objective (ICAN 2006).A budget is a short financial plan
used in achieving short and long term objectives. Public budget is usually for one year or
twelve months. Public budget must be prepared, approved, for a specific period of time and
for a purpose.
Budget preparation could be traced back to the time of Joseph in the Bible days in Egypt.
Joseph told Pharaoh to use the first seven (7) years of plenty to budget for the seven years of
famine. Joseph built warehouses and stored grains that fed a nation for seven years. Joseph
budget for grains, saved two nations (Egypt and Israel).Every responsible person prepares a
budget to achieve objectives.
A good student of (Distance Learning Students DLI) who is married with two children will
have to prepare his budget every year based on his income to achieve some objectives e.g.
DLI school fees, children school fees, house rent, feeding allowances, clothing, capital
projects like building a personal house, buying a car etc so does the government of any
nation prepare and approve budget to achieve some objectives on yearly basis.
However it is important to learn that one of the primary motives of budget is to measure the
profit earning of an organization. However, the Government objectives are not for profit
making but for different purposes listed below. Please note that government budget is the
same thing as public budget. Nigeria government budget usually start from January to
December every year.
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Learning Outcomes
At the end of this session, you should be able to:
6.1 Define public budget
6.2 State five purposes of public budget
6.3 Mention five functions of public budget
6.4 List five advantages and disadvantages of public budget
6.5 List the budget method or techniques of public budget
6.6 List five limitations of public budget
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• To evaluate performance for the purpose of controlling on-going economic ventures.
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• It is a short term plan (one year) used to achieve short and long term objectives. The
example of short term objectives is payment of school fees, long-term objectives is
capital project like building a house i.e. year1 buy the land, year2 lay the foundation,
year3 raise to window level, year4 raise to roofing level and so on.
• It has lay down procedures, rules and regulations to comply with government policies
and objectives.
• It helps to control mismanagement of funds.
• It saves time because the amount to be spend, when, where and how is spelt out in the
budget.
• It helps to reduce errors and fraud due to specific allocations and accountability.
• It serves as a tool for measuring performance and motivation.
• It shows the direction and area of focus of the government economy.
• It serves as a guide for the next year budget.
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• Planning Programming Budgeting System(PPBS)
6.5.1 Traditional or Incremental Budgeting; this is a method whereby last years figures
are obtained and a percentage is added to it to arrive at current year budget. A budget where a
percentage is added to the last year figure to arrive at correct budget without justification of
expenditure is called.
Example:
Government sectors. Last Year ₦ Billion Percentage Added ₦ Total
Education 1000 20% = 1200
Health 1300 10% = 1430
Defense 2000 25% = 2500
Sport 500 25% = 625
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The trend of the economy determines the percentage to be added. A booming economy will
add a higher percentage and vice visa.
Inflation: Inflation weakens the power of Naira. The higher the rate of inflation the lower the
value of Naira and vice visa. Inflation either empowers or reduces the value of Naira in the
budget.
The fund available: the more the funds (government income) that are available to the
government the more are the allocations to States, Ministries, Local Government etc.
Note that the more the funds that are available to a father the more he is willing to increase
the food allowances to his wife and children, change their clothing, chairs, television and
even move from room and parlor apartment to a three bedroom flat.
Budgeting in Nigeria Government; government budget preparation and approval takes after
three factors mentioned above i.e. the trend of the economy, inflation and the funds available
without any justification or scientific analysis. Incremental budget is made up of personal
enrolment, other charges and capital or developmental items. The incremental technique
budget allocates and distributes funds as provided without significance to the end use of the
funds. This technique of budget only considers the achievement of control and
accountability. Government in Nigeria allocates funds to different heads and sub-heads of
expenditures of the various ministries and extra-ministerial departments on succeeding year
basis using the incremental budget method. Therefore, year in year out Nigeria government
uses incremental budget method to prepare her budget.
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• It encourages direct relationship among relevant activities in operation. For example, a
photocopier machine can be bought from office equipment or classroom equipment
votes or charges in a school environment.
• All activities in the budget are given monetary values.
• A developing country like Nigeria uses such method because it does not involve much
data and scientific analysis.
ZBB was introduced by Peter Phyrr in 1969 at Texas, but was popularized by a former
President of the United States of America, Jimmy Carter in 1976.
It is a systematic budgeting process which follows four basic steps.
• The formulation of an operational plan. Each ministry are divided into division units
.e.g. education unit, health unit, defiance unit, sport uni,t etc
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• Attached each division unit to a decision package after analyzing the whole budget i.e.
education package, health package.
• Appraising and ranking of decision package after analysis (the benefit to be derived
from each decision packages must move the cost attached to it).
• The allocation of resources to each decision package evaluation.
Formulate an operational plan, division of units, decision package, appraising and ranking of
decision package.
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Disadvantages of ZBB Techniques
• It is difficult to prepare, and implemented; it is also time consuming.
• It requires high skill and knowledge to operate. Public sector lacks qualified and
competent personnel to handle it.
• It requires much data for appraisal and analysis.
• It can course a major shift in resources allocation because of yearly justification of
projects.
• It does not allow quick control and coordination of activities with respect to decision
packages and ranking of packages
• Recurrent expenditure finds it difficult with the process, hence it is not successful in
public sector.
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Resources of the government are allocated to the most economical and efficient project using
the cost-benefit analysis to choose programmes or projects.
Programmes are translated based on their objectives and performance for specified groups or
beneficiaries e.g. free education at primary school level. These involve a stage-wise sequence
of step by step for executing programmes with common objectives and are ranked to
maximized benefits. PPBS are prepared on the basis of programmes which cut across
departmental objectives and organization objectives, for instance computerization and on-line
access of each department in order to achieve organizational objectives.
Reasons for Planning Programming Budgeting System (PPBS)
• There is an economic problem and scarcity of resources therefore programmes compete
based on cost benefit analysis.
• There is need for efficient execution of selected project and the steps for achieving it
have to be devised
• The need for detailed study of organization objective programme and resources
available.
• Planning and formulating objectives beyond the current year of budgeting.
• Monitoring, controlling and reporting the planning progress to meet government
objectives.
• Implementing the selected alternative and monitor its performance to ensure that the
objectives of the programmes are achieved given the resources allocated to those
programmes.
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• The emphasis is on long term objectives of the organization and commitment in certain
programmes
• It leads to proper monitoring and coordination of projects.
The primary focus is activities and ascertainment of cost of such activities which are
specified/ determined to achieve the purpose to which the funds have been committed by the
government (Jawahar Lal, 2002).This method is based on the purpose and objective and
result of such objective.
Similarly, Performance Budgeting and Planning Programmes Budgeting System (PPBS) are
used interchangeably. While performance budgeting focuses on specified activities to
achieve certain objectives PPBS is a combination of different elements of programme with
the ascertainment of cost of each programme to achieve government/organization objectives.
For instance performance budget may focus on computerization of a section in an
organization, PPBS objectives are the computerization of the whole (different
sections/programmes) organization.
• Revenue Budget
• Capital Expenditure Budget
• Personnel Cost
• Overhead Cost
• Cash Budget
• Supplementary Budget
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The social cultural diversity of the nation affects budget implementation.
x) Inflation:
Inflation increases the price of goods and services thereby reducing the purchasing
money to meet demands on the budget.
xi) Fiscal indiscipline:
The attitude of government officials towards spending government money without
proper justification, limits budget implementation.
xii) Mono-economy of the nation:
The major source of government revenue in Nigeria is petroleum oil with neglect to
other sources. This reduces income and restricts their spending on essential services.
xiii) External factors:
The influence of other countries and institutions hinders budget preparation and
implementation.
xiv) Lack of data and poor technology:
The country still finds it difficult to provide correct data for proper analysis and poor
technology combine with power failure limit budget preparation and implementation.
Summary
Budgets are periodic plans expressed in monetary terms used to achieve government
objectives. Nigeria government budget is usually for one year (12 months) i.e. January to
December. One way or the other we all draw budget to achieve one objective or the other so
likewise the government.
There are different methods of preparing public sector budget which are incremental
Budgeting, Zero Based Budgeting (ZBB), Planning Programming Budgeting System (PPBS)
and Performance Budgeting. The type of budgeting practice in Nigeria is the incremental
budgeting method. A budget shows financial accounts of the previous year, the budgeted and
estimated figure of the current year and the budgeted figure for next year. This session also
discussed the limitations of public budget.
Self-Assessment Questions
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Section A. Select the most appropriate letter (A, B, C, D) that best answers each of the
following questions:
1. Incremental Budget considers three factors when preparing the budget except one.
a) Trend of the economy
b) Inflation
c) Funds available
d) Division of labour.
2. A budget where a percentage is added to last year figure to arrive at current year
budget figure without justification of expenditure is called.
a) Experimental budget
b) Fixable budget
c) Incremental budget
d) Zero based budget.
3. A method of budgeting whereby all activities are evaluated and fully justified for every
items of expenditure each time the budget is prepared is called.
a) Evaluated budget
b) Justified budget
c) Formulated budget
d) Zero based budget (ZBB)
4. Public budget services the following purpose except one
a) Motivation
b) Control
c) Planning
d) Specialization of duty
5. Below is a list of public budgeting techniques except one
a) Public accounting budget
b) Incremental budget
c) Zero based budgeting
d) Performance budgeting.
6. The following are the advantages of incremental budgeting expect one.
a) Justification of each item of expenditure
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b) It is simple to operate and implement
c) It is cheaper and saves time
d) It require less data, skill and knowledge to operate.
7. Zero based budgeting (ZBB) has the following advantages except one.
a) It encourages creativity and change
b) It encourages new development
c) Allocation of resources is based on need and benefit
d) It requires high skill and knowledge to operate.
8. One of the following is not a purpose of public sector budgeting.
a) Allocation of scarce resources
b) Redistribution of resources
c) To point out new allocation
d) To divide the country into state and local government.
Essay Questions
i) Define budget and explain five purposes of public sector budget?
ii) List five advantages and disadvantages of budgeting?
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iii) What is incremental budget and explain the factors consider in preparing incremental
budget?
iv) What is zero base budgeting (ZBB)? What are the steps in ZBB?
v) Discuss the advantages and disadvantages of zero base budgeting.
vi) Discuss the objective of budgeting.
vii) Explain planning programming budgeting system (PPBS).
One of the factors considered in the preparation of budget using incremental or traditional
budgeting techniques is inflation. The following expenditure occurred in the office of
Goodluck and Patience at Abuja
2010 actual Inflation Factor
₦
i) Maintenance of office equipment 50,000 20%
ii) Maintenance of motor vehicle 80,000 20%
iii) Hospitality 100,000 20%
iv) Telephone 60,000 20%
v) Maintenance of generator 120,000 20%
vi) Electricity 50,000 20%
vii) Security 100,000 20%
viii) Advertisement 20,000 20%
ix) Stationary 80,000 20%
x) Training and workshop 90,000 20%
The definition rate for next year is 20% across board. Calculate the budget figure for
2011.
2010 actual inflation factor 2011 estimate
Expenditure # (yr20%)
₦ ₦ ₦ ₦
i) Maintenance of office equipment 50,000 0. 2*50,000 = 10,000 = 60000
ii) Maintenance of motor vehicle 80,000 0.2*80,000 = 16000 = 96000
iii) Hospitality 100,000 0.2*100,000 = 20000 = 120000
iv) Telephone 60,000 0.2*60,000 = 12000 = 72000
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v) Maintenance of generator 120,000 0.2 *120,000 = 24000 = 144000
vi) Electricity 50,000 0.2*50,000 = 10000 = 60000
vii) Security 100,000 0.2*100,000 = 20000 = 12000
viii) Advertisement 20,000 0.2*20,000 = 4000 = 24000
ix) Stationary 80,000 0.2*80,000 = 16000 = 96000
x) Training and workshop 70,000 0.2*70,000 = 14000 = 84000
TOTAL ₦ 730,000 ₦ 876,000
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References
Adam, R.A. (2005) Public Sector Accounting and Finance made Simple fourth edition
Corporate publishers venture.
Bhatia, H.L (2005) Public Finance, twenty fourth revised Edition, Vikas publishing House
put LTD.
Institute of Chartered Accountants (ICAN, 2006) Professional Study Pack via Publishing
Limited
Jawahar, (2002) Account for Management Himalaya publishing house, second edition.
John, G., John, P. and Michael, M. (1998) Accounting for Managers, International
Thompson Business Press, Second edition.
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Should you require more explanation on this study session, please do not hesitate to contact
Are you in need of General Help as regards your studies? Do not hesitate to
contact the DLI IAG Center by e-mail or phone on:
iag@dli.unilag.edu.ng
08033366677
100
ACC 313 Public Finance
PUBLIC BUDGET 2
Introduction:
This is the second module on government budgeting. The first module discussed the purpose,
functions and different types of budget techniques being used by public sector. This module
emphasized on the process used in preparation and approval of public budget. This is
peculiar because it is a non-profit organization (government). The aims and objectives of
government are to better the life of its citizens at lower or no cost value by providing
essential services. Budgeting preparation and approval is a process that follows a systematic
order. It follows the order of formulation of policies, preparation and approval of budget and
the implementation of the approved budget. In public sector it is referred to as “budget
cycle’’ which follows an approved time-table. It is a process of different segments to be
discussed in this module.
The budget is a financial guide for revenue generated and expenditure incurred.
Learning Objectives
The objective of this chapter is to enable students learn:
7.1 The budget preparation guidelines.
7.2 The functions of the ministry of budgeting and planning.
7.3 The importance of call circular.
7.4 The roles of ministries and agencies in budget preparation.
7.5 The function of budget committee.
7.6 The different approval stages
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• The ministerial approval
• The executive council approval
• The legislative approval
7.7 Some budget terms and definitions
• The ministry provides necessary guidelines to ministries and department for the
purpose of submitting their estimates/proposals.
• Call circular. It is the primary responsibility of the ministry to issue call circular for
the budget to ministries, department and agencies.
• Draft estimation. It has the responsibility of compiling the draft estimation based on
the submission.
• Budget time-table. The ministry prepares the time-table and deadline for submission.
• The ministry reconcile the figure contained in the different estimates with it own figure
in the national plan.
• State the role of budget officer and budget committee
• The ministry has the responsibility of compiling revenue estimates forms returned from
different ministry and agencies.
• It considers how objective the proposal for the estimate.
• The ministry is responsible for the preparation of presidential speech
• The ministry review and projects into the following year.
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The call circular already contained the guidelines to be followed. Each ministry has its own
programmes and projects which are critically examined with the national interest. It is the
duty of the finance department to explain and supply information needed to prepare the
estimate. The need to supply statistical information of every staff and their position on
payroll, the actual expenditure for the current year, and the revenue and expenditure for the
next year is vital issue. Each ministry normally issue an internal circular and form a budget
committee which critically examine the plans, objectives, resources involve and the
implementation on policies which must be in line with the national plans before forwarding it
to the Ministry of Budgeting and Planning. Each ministry will be called according to the date
given in the time table to defend its proposals. The above process is to save time, avoid
wastages and make way for the achievement of government goals and objectives.
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Each ministry has its own budget committee constituted of different members from various
section of the ministry. The committee critically examines its own programmes and projects
following the guidelines contained in the call circular. The budget committee will submit its
report to members’ in-charge e.g. Minister of information who will then forward the draft
estimate to Ministry of Budgeting and Planning for incorporation in the national budget. The
ministry will be called later to defend its draft estimate.
The ministry of budgeting and planning has its own budget committee constituted by
members from the Ministry of Finance Establishment, Works and Housing, Youth and Sport
and the Budgeting and Planning Ministry. These members are top government officers with
vast experience to consider each ministry draft proposal or estimate in line with:
• The prevailing economic policies
• Legislative initiative for the budget
• Expected revenues for the budget year
• Tentative proposals for ministries
• Recommendations on the overall priorities
• Suggested budget ceilings for each ministry
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The compiled estimate of all ministries will be forwarded to the President for detailed
consideration.
• The legislature approval: The compiled draft estimate (appropriation bill) will be
presented by the President to the National Assembly (House of Assembly at the state
level) i.e. the Senate and the House of Representatives. The President will leave the
houses to deliberate on the Appropriation Bill called the “budget session’’ and also be
regarded as the first reading of the bill. They will also meet differently to considered
and approve the bill in relevance to the economic and social matters of the country. The
house usually breaks into various committees to consider various aspect of the budget.
The President present the bill to the two houses for debates in line with financial and
economic matters raised in the budget. This refers to as the second reading. After
exhaustive debate and necessary amendment by both houses (National Assembly) the
appropriation bill is finally passed into approved budget. This gives the President the
authority to disburse money to the different ministries and agencies.
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• Presidential Assent: the President is expected to give his assent i.e. sign the
appropriation act in agreement of all necessary amendment made by the National
Assembly. However, where the President fails to sign the bill, a budget session of at
least two-third (2/3) of the National Assembly can pass the bill into law i.e. approved
for spending; however, this process will not be in favour of the Executive and
Legislative Arms of Government. It is important to note that the Executive and
Legislature arms of government act as check and balances to each other.
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It is the budget point for present year and it arrived by subtracting the value of one-off
transaction from last year budget ‘One off’ transaction are expenditures which do not reoccur
every year e.g. election expenses for a particular year.
7.7.4. Budget Deficit:
This is when the expenditure to be incurred is more than the revenue to be earned by the
government. The expenses (E) side is greater than the income (I) side i.e. E>I .
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The roles played by the budget in the economy are listed below:
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• To allocate resources. The budget is used to allocate limited resources.
• Economic stability. The budget is used to stabilize the economy through its objectives.
• Development function. The budget is used to develop area of the economy
underdeveloped.
• Control inflation. The government uses the budget to control the economy e.g. budget
surplus or deregulation policies.
• Financial discipline. The budget acts as financial controller because it sets the limit of
expenditure.
• To protect infant industries. The government does this through tax holiday and ban on
importation.
• Redistribution of income. Budgetary policies can be used to bridge the gap between the
rich and poor.
• Better the standard of living. It can be used to reduce prices of goods and services and
also provide essential services e.g. free health care.
• Evaluate performance. The budget could be used to measure performance in the
economy.
• Motivation. The government motivates some sectors to do better in order to encourage
even and economic development.
1. To allocate resources.
2. Control inflation.
3. Better the standard of living.
4. Redistribution of income.
5. Valuate performance.
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The price the lower the quantity demanded vice versa). Social Benefits are the aggregate
benefits gained by the society from the consumption of a good. It includes any private
benefits and any consumption externality that might exist.
Supplementary budget: This kind of budget is prepared when the annual budget is
insufficient to meet government obligations. There must be a cogent reason for preparing
supplementary budget.
Special budget: This kind of budget is normally derived from special funds subject to
budgetary control guidelines. It is submitted in special forms either because the approved
amount is not adequate or totally not included in the Appropriation Act.
Deficiency budget: This kind of budget take cares of deficit or overdraft expenditures
incurred over and above the original budget. There must be a deficit in the budget before a
deficiency budget can be prepared.
Recurrent budget: This kind of budget is prepared to provides for revenue and expenses
that occur regularly in every budgeting period like student fees, income, payment such as
salaries and wages.
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Overhead budget: These are expenses from recurrent budget to cater for expenses such as
fueling expenses, minor repairs, stationary, and hospitality
Capital budget: This is a type of budget used for capital projects in the provision essential
service to the populace.
Other types of budgets include the followings (they are common in private sector)
Sales budget
Cash budget
Production budget
Marketing budget
Departmental budget etc.
Similarly, the duties of ministries concerned for the approval of the budget was also
discussed, the passing of the Appropriation Bill into Appropriation Act (Approved Budget)
by the Executive and Legislature Arms of Government which act as check and balances to
each other. The budget is then circulated to the various ministries to achieve government
objectives; the above process is referred as budget cycle. Budgetary control process
application and types of budget were also mentioned.
Self-Assessment Questions
Section A. Select the most appropriate letter (A, B, C, D) that best answers each of the
following questions:
1. The document send to various government ministries showing the budget procedure
and time table is call_____________
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a) Government circular
b) Legislature circular
c) Executive circular
d) Call circular.
2. A budget prepared arbitrarily on the income without realistic proof of objectives is
called______________
a) Balanced budget
b) Surplus budget
c) Fiscal budget
d) Budget padding.
3. The budget is approved by ______________
b) The ministerial approval only
c) The executive approval only
d) The legislature approval only
e) All of the above approval only
4. Budget preparation and approval follows a______________ procedure and rules to
achieve a purpose.
a) Systematic
b) Dramatic
c) Grammatical
d) Tabular.
5. The function of Ministry of Budgeting and Planning includes the followings except
ONE
a) Advisory body to the President
b) Issue call circular
c) Prepare the president budget speech
d) Approved the final budget.
6. The call circular contains the following information except ONE.
a) History of the head of civil service
b) Budget guidelines
c) Government policies
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d) Budget time table.
7. Budget committee performs the following functions except ONE.
a) Review of performance report
b) Compile and coordinate all draft estimates
c) Formulation of government policies
d) Create more political parties for the current year.
8. Budgeting and Planning Ministry draft proposal or estimate is based on the following
except ONE.
a) The prevailing economic policies
b) Expected revenue for the Budget
c) Legislative initiative for the Budget
d) Division of labour between the President and the Vice-President.
Essay Questions
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i). List and explain the roles of Budgeting and Planning Ministry in the budget planning
and approval.
ii). Itemize the procedures for preparation and approval of budget in a government
establishment?
iii). What do you understand by call circular in the context of government budgetary
process?
iv). Discuss briefly the roles of the executive and legislature in government budgetary
process in the following budgetary concept:
a. Call circular
b. Budget committee
c. Budget padding
d. Budget slack
e. Budget warranty
References
Adam, R.A. (2005) Public Sector Accounting and Finance made Simple. Lagos, fourth
edition Corporate publishers venture.
Bhatia, H.L (2005) Public Finance, twenty fourth revised Edition, Vikas publishing House
put LTD.
Institute of Chartered Accountants (ICAN, 2006) Professional Study Pack via Publishing
Limited
Jawahar, (2002) Account for Management Himalaya publishing house, second edition.
John, G., John, P. and Michael, M. (1998) Accounting for Managers, International
Thompson Business Press, Second edition.
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Should you require more explanation on this study session, please do not hesitate to contact
Are you in need of General Help as regards your studies? Do not hesitate to
contact the DLI IAG Center by e-mail or phone on:
iag@dli.unilag.edu.ng
08033366677
116
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Public Debt 1
Introduction
Debts occurs when expenditure exceed income. Debts arise when amount spent is more than
amount received. Borrowing arises when income is not sufficient to meet expenditures. Just
as it is for an individual to borrow to satisfy some needs so it is for government of a country
to borrow to meet some important needs. The Central Bank of Nigeria (CBN) serves as
banker to the government. In doing this, it keeps the finance and accounts of the government.
It is the duty of CBN to raise money from internal and external sources for the
implementation of government programmes. The money that is raised or borrowed to carry
out programmes automatically becomes a debt or money owed by the government. Any
money owed by the government of any nation is referred to as public debt.
Public debt can be defined as the total amount of money owed by the government within and
outside the nation. “Within” means individuals, institutions, organizations and central bank
of that nation. “Outside” means individuals, organizations, institutions and countries outside
the borders of a particular nation.
Learning Outcomes
At the end of this unit, you should be able to:
8.1 List and explain the different types of public debt
8.2 Mention five established guidelines for government borrowing
8.3 Explain the classification of public budget
8.4 Explain internal or domestic debt
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8.5 Mention three sources of domestic debt
8.6 List five causes of domestic debt
8.7 Explain external or foreign
8.8 Consequences of borrowing;
8.9 General causes and increases of public debt.
8.1 Types of Public Debt
The types of public debt reflect the purpose for which the debt was incurred. It includes the
following:
Trade Debt: This is arises when a country trades with other countries and is unable to pay
either partly or wholly for the goods and services supplied. For example for all goods and
services imported to Nigeria which Nigeria has been unable to settle, her import bills have
resulted to trade debt.
Project-Tied Loans: These are loans contracted for, that has good potential and prospects of
accelerating economic growth and development of a nation. These loans are for the execution
of a specific project which is expected to be self liquidating i.e. pay back the principal and
the interest of the loan.
Balance of Payment Support Loan: This type of loan is contracted for, to solve a persistent
unfavorable balance of payment problem. This is referred to as “Balance of payment
disequilibrium”. Such loans are in the form of capital inflow provided by institution such as
International Monetary Fund (IMF).
Loans for Socio-Economic Needs: This is the money borrowed by government to provide
social amenities such as education, free health services, sports and other social infrastructure
to improve the standard of living of its citizens.
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i. Trade Debt
ii. Project-Tied Loans
iii. Balance of Payment Support Loan
iv. Loans for Socio-Economic Needs
8.2 Established Guidelines for Government Borrowing
The following are the established guidelines for borrowing:
• Projects with economic value should have positive internal rate of return as high as cost
of borrowing.
• Social amenities and infrastructures should be ranked on the basis of their benefit
ratios.
• Feasibility studies are necessary for projects to be financed with external loans.
• Public and private sector project with quick yielding nature should be sourced from the
private capital markets and loans for social amenities should be sourced from
concessional financing institutions.
• The purpose of state government borrowing should be approved by the ministry of
finance and economic development and CBN before it is incorporated in the total
public sector borrowing for the annual budget.
• Federal government loans to state government. It is the function of the federal ministry
of finance to make due payment and deduct the necessary amount at source from their
statutory allocation.
Internal or Domestic debts are money owed by a government within its nation. While
External or Foreign debt are money owed outside the nation.
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The origin of domestic debt is dated to 1946 when the first development stock of 14,600,000
was floated. The first Treasury bill and certificate worth N8 million and N20 million were
respectively issued in 1960 and 1968. As at 2003, Nigeria’s domestic debt has risen to
N1,329,692.7 billion. The internal sources of debt are CBN, commercial banks, merchant
banks and non-bank public holding using financial instruments such as Treasury bills,
Treasury certificates etc under the general supervision of the CBN to manage the domestic
debt of the nation.
8.5 Sources of Domestic Debt.
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It is a long term debt instrument that the CBN uses to facilitate the redemption of maturing
instruments through the establishment of sinking funds.
• Revenue Bond:
It is a bond taken to execute a project and revenue generated from the project is
expected to pay back the loan. Example is toll gate and toll fees collected.
• Government Obligation Bond:
It is taken by the government to provide public facilities such as schools, hospitals,
prisons, construction etc.
• Special Assessment Bond:
The payment of principal and interest will be made from a special tax levy e.g. Lagos
state development levy of every six months.
1. Treasury Bills
2. Trade Debt
3. Treasury Certificates
4. Government Development Stock
5. Bonds
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• Urbanization: The movement of people from the rural areas to the urban areas calls for
the development of both the urban and rural areas.
• Provision of social amenities and infrastructures: It is the responsibility of the
government to provide basic amenities and infrastructures such as schools, library,
hospitals etc Government borrows to provide such facilities.
• Unforeseen contingencies and natural disasters: When the unexpected happens and the
resources of the nation cannot solve such problem, the government results into
borrowing.
• Mismanagement of fund: Government resources are not expended for projects
allocated. Money meant for government project is diverted to other means.
• Financial indiscipline and embezzlement: Everybody sees government money as free
money and needs not to be accounted for. It can be used for anything.
• Democracy and presidential system of government: Democracy calls for election every
four years. Government sometimes borrows to conduct elections. Presidential form of
government is an expensive way of running government because of multiplicity of
states, National Assembly, Judiciary and the executives.
• Financing of recurrent expenditures in terms of wages and salaries.
• Inability to raise revenue through tax due to poor technology and method of data
allocation.
• Paris Club of Creditors: It is made of countries such as USA, UK, Federal Republic of
Germany, France, Canada e.t.c.
• London club of creditors
• Multilaterals such as World bank, International Monetary Fund (IMF), African
Development Bank (ADB) and European Investors Bank (EIB)
• Bilateral creditors: Country to country
• Promissory notes.
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8.7.2 Cause of External Debt
• Huge Budget Deficit: Nigeria government borrows to fill the gap in the budget. The
government has a lot of project to execute year in year out and revenue expected from
tax is unable to meet government expenditure therefore government has to borrow.
• Balance of Payment Support Loan: The government borrows to solve the persistent
balance of payment problem in Nigeria.
• Heavy Dependence on Oil and Revenue: All expenditure is dependent on oil revenue.
Oil revenue generated in the 70s gave government opportunity to embark on huge
projects. In the 80s when oil revenue drops the government resulted to borrowing.
• Political Instability: Different government with different policies. Political instability
has led to the abandonment of viable projects which loans has been collected for and
repayment not settled.
• Lack of Planning and Investment Policies: The country lacks data and technology for
good planning and investment policies. Money borrowed are not invested into viable
projects that can pay back the money borrowed.
• Mono-Economy of the Nation: All other sectors of the economy particularly agriculture
has been totally abandoned and forgotten. It is important to note that this was our major
source of income before the discovery of petroleum oil.
• Using Short-Term Loan to Finance Long-Term Project: Loans contracted are supposed
to generate revenue to liquidate such loans. Using short-term loans to finance long-term
projects will only leave projects uncompleted and will cause the loan not to be paid
back.
• Financial Indiscipline and Mismanagement of Fund and Embezzlement of Government
Funds: Our leaders are selfish and enrich their purse at the expense of the masses.
• Unable to implement important and urgent projects: Borrowing does not allow
government to execute important and urgent projects because money needed is being
used to service debt.
• Borrowing act as a distabilizer: Borrowing worsens political, social and economy life
of the populace. It increase tax burden of its citizens in order to raise money to pay
back debts.
• Borrowing may lead to a violent change in the country’s governance. The bad effect of
public debt is that a new government cannot unilaterally disown a public debt.
• Burden on future generations: Future generations have to pay interest and principal to
foreign creditors without receiving corresponding benefits in return.
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• Mono-economy: An economy that is fully concentrated on one sector (oil) as its only
source of income will go borrowing
• Financial Indiscipline, mismanagement of fund and embezzlement of government funds
• Using short-term loans to finance long-term project will only lead to uncompleted
projects
The next module is on public debt management and strategies involved to pay back or settle
public debt
Self-Assessment Questions
Section A. Select the most appropriate letter (A, B, C, D) that best answers each of the
following questions:
1. The total amount owed by a government of any country is called
a) Public debt
b) Management debt
c) Executive debt
d) Senate debt.
2. One of these is not a type of public debt
a) Trade debt
b) Project-tired loans
c) Balance of payment support loan
d) Loans to create more political parties.
3. Public debt can be classified into two namely
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b) Political instability
c) Financial indiscipline
d) Good planning and management of fund.
10. All of these are bad effect of borrowing except one
a) Inflation
b) Burden on future generation
c) Economic destabilizer
d) Good planning and management of fund.
Essays questions
i) List and explain five causes of internal debt
ii) List and explain five causes of external debt
iii) Explain briefly five bad effect of public debt
iv) Mention and explain five sources of internal debt
v) List five sources of external debt and reasons for external debt
References
Bhatia, H.L, (2003). Public Finance. New Delhi: Vikas Publishing Hose PVT Ltd. 24th
Revised Edition.
Adams, R.A, (2005). Public Sector Accounting and Finance made simple. Lagos: Corporate
Publishers Ventures. 4th Edition.
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Should you require more explanation on this study session, please do not hesitate to contact
Are you in need of General Help as regards your studies? Do not hesitate to
contact the DLI IAG Center by e-mail or phone on:
iag@dli.unilag.edu.ng
08033366677
129
ACC 313 Public Finance
STUDY SESSION NINE:
PUBLIC DEBT MANAGEMENT AND STRATEGIES
Public Debt 2
Introduction
The Central Bank of Nigeria (CBN) serves as banker to the government. One of its major
functions is to raise money from internal and external sources for the execution of
government projects. The money that is raised or borrowed automatically becomes a debt
owed by the government. It is the responsibility of the CBN in conjunction with the Federal
Ministry of Finance to manage the national debt.
Learning Outcomes
At the end of this session, you should be able to:
9.4 Define public debt management;
9.5 Enumerate the objectives of public debt management;
9.6 Discuss the history of Nigeria’s DMO;
9.7 List the functions and objectives of DMO;
9.8 Discuss internal and external debt management;
9.9 List sources of external debts;
9.10 List and discuss external debt management techniques.
The federal government of Nigeria took a major step in year 2000 in addressing the problems
by establishing a semi-autonomous debt management office (DMO). The purpose of DMO is
to consolidate, record and manage the activities including debt service forecast, debt service
payment and advising on debt negotiating as well as new borrowings.
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• Assessing lending terms from various sources from negotiating best positive terms for
future borrowing.
• Conducting debts sustainability analysis to assess optimal borrowing levels
• Provide debt management strategies with viable linkage to fiscal and monetary policies
and overall macro-economic stability.
The DMO is under the control of Ministry of Finance and CBN headed by a Director General
assisted by departmental directors having staff from CBN debt management department and
the external finance department of the Ministry of Finance.
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External debt refers to unpaid portion of external financial resources required for
developmental purposes and balances of payments support. These external sources include:
• Paris Club of Creditors
• London Club of Creditors
• International Monetary Fund (IMF)
• African Development Bank (ADB)
• European Investment Bank (EIB)
• Promissory notes
• Bilateral creditors (country to country borrowing).
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• It will lead to the creation and development of export oriented industries
However, notwithstanding the above advantages, it may lead to foreigner controlling the
companies if they have the controlling interest in the company.
iii.) Counter Trade Introduction:
This represents a trade arrangement whereby a country makes available one major export
(oil, cocoa) to another country in exchange for another country’s major import. Nigeria has
used this method to obtain raw materials for the development of petrochemical industries and
Ajaokuta steel industry.
vi.) Debt Restructuring: This involves the restructuring and conversion of existing debt into
another form by refinancing, recapitalization of interest, rescheduling debt, debt buy-back
and the provision of money.
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The above methods mentioned are short term solution to public debt management. It means
that after sometime the problem of public debt will arise again as it is the case of Nigeria.
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Therefore some long-term solution has been proposed but this might lead to economic
hardship on the citizens of the nation.
9.9 Long-Term Debt Management Strategies
• Structural Adjustment Programme (SAP): Total restructuring of the economic units in
the country
• Foreign Exchange Market: Foreign exchange policies to be embarked on should reduce
foreign debt and not increase it.
• Privatization and commercialization of government enterprises for economic reasons.
• Removal of oil subsidies: The government should remove petroleum oil subsidies to
generate more revenue.
Self-Assessment Questions
Section A. Select the most appropriate letter (A, B, C, D) that best answers each of the
following questions:
1. One of these is not a type of public debt management loan
A) Funded loans
B) Unfunded loans
C) Marketable loans
D) Transferable loans.
2. The followings are long term debt management strategies except ONE
A) Management and organization loan removal
B) Structural Adjustment Programme (SAP)
C) Privatization & Commercialization
D) Removal of oil Subsidies.
3. The followings are debt conversion techniques except ONE
A) Debt for Equity
B) Debt for Cash
C) Debt for debt SWAP
D) Debt in School Account.
4. All the followings are debt management strategies except ONE
A) Debt Rescheduling
B) Debt Equity Conversion
C) Embargo on new loans
D) Executive and Legislative loans.
5. The process of domestic debt management includes ONE of the followings
A) Acquisition of domestic debt
B) Restructuring of domestic debt
C) All of the above
D) None of the above.
6. External debt management include the followings expect ONE
A) Estimates and management of student school fees
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B) Sources of finance
C) Risk and returns attached to investment projects
D) The repayment schedule.
7. Sources of external loan to Nigeria include the following except ONE
A) Paris club of creditors
B) London club of creditors
C) International Monetary Fund IMF
D) Nigeria Development Bank (NDB).
8. Under debt conversion process ONE of these is NOT a process
A) Debt for cash
B) Debt for debt swap
C) Debt for equity swap
D) Debt for student swap.
9. Debt Repudiation means ONE of the following
A) Refusal to pay back
B) Willing to pay back
C) All of the above
D) None of the above.
10. Debt Restructuring include all of the following except ONE
A) Debt immunization
B) Debt Refinancing
C) Debt buys back
D) Debt rescheduling
Answers
1 2 3 4 5 6 7 8 9 10
D A D D B A D E A A
References
Adam, R.A., (2005). Public Sector Accounting and Finance made simple. Lagos:
Corporate Publishers Ventures. (Fourth Edition).
Bhatia, H.L., (2005). Public Finance. India: Vikas Publishing House Ltd. (Twenty Fourth
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Edition).
Glynn, J., Perrin J., and Murphy M., (1998). Accounting for Managers. London:
International Thompson Business Press. (Second Edition).
Jawahar, L., (2002). Accounting for Management. India: Himalaya Publishing House.
(Second Edition)
Jhingan, M.L., (2004). Money, Banking, International Trade and Public Finance. India:
Vrinda Publications Ltd. (Seventh Revised Edition).
Hingorani, N.L., and Ramanathan A.R., (1992). Management Accounting. India: Sultan
Chand and Sons. (Fifth Edition).
Horngren, T.C., and Forster G., (1988). Cost Accounting: A Managerial Emphasis. India:
Prentice-Hall of India Private Limited.
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Should you require more explanation on this study session, please do not hesitate to contact
Are you in need of General Help as regards your studies? Do not hesitate to
contact the DLI IAG Center by e-mail or phone on:
iag@dli.unilag.edu.ng
08033366677
140
ACC 313 Public Finance
Introduction
In this study session, you will learn how government economic policies are utilized to
manipulate the economy to achieve societal goals. Furthermore, an attempt will be made to
discuss the concept of allocative, stabilization and distributive functions of the government.
With the contexts of these functions, the subjects of monetary and fiscal policies will be
emphatically explained for the learners to be more equipped with the terms.
Learning outcomes
At the end of this study session, you should be able to:
10.1 Define and use correctly the key words printed in bold:
10.2 Define the concept of government economic policies
10.3 Explain the allocative, stabilization and distributive functions of government
10.4 Discuss the concept of merit goods
10.5 Stabilization policies and problems.
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three principal methods of establishing control: the allocative function, the stabilization
function, and the distributive function.
Over time, there have been considerable changes in emphasis on these different economic
functions of the budget. In the 19th century, government finance was primarily concerned
with the allocative function. The job of government was to raise revenue as cheaply and
efficiently as possible to perform the limited tasks that it could do better than the private
sector. As the 20th century began, the distribution function acquired increased significance.
Social welfare benefits became important, and many countries introduced graduated tax
systems. In the later interwar period, and more especially in the 1950s and ’60s, stabilization
was central, although equity was also a major concern in the design of tax systems. In the
1970s, ’80s and 2014, however, the pendulum swung back. Once more, allocative issues
came to the fore, and stabilization and distribution became less significant in government
finance. Each of these roles will be explained one after the other for the learners
understanding.
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has continued for hundreds of years, and, although numerous methods of deciding on
priorities have emerged, it has never been satisfactorily resolved. In practice, most
democracies including Nigeria contain a number of different factions that disagree on the
proper allocation of resources and indeed the proper level of public sector involvement in the
economy; the frequent change of national governments is related to the constant search for
the right answers. Based on this, some contents and roles under the resource allocation
function of government will be discussed.
i. Public goods
The concept of public goods have been explained earlier. With regard to the allocative
functions, economists have sought to provide objective criteria for public expenditures
through the so-called theory of public goods. It is generally recognized that some goods
needed by the public cannot be provided through the private market. Street Lights and
national defence are classic example. The cost of national defence is such that no one will
want to finance it; on the other hand, if national security is provided for one citizen, it can be
made available to all for no additional cost. Indeed it must be available to all, since there is
no practical means of excluding other citizens from enjoying the security provided by the
government, even if the other citizens refused to pay for it. The only practical method of
providing such services is by collective action. If goods are to be provided in this way, rather
than through the private market, it is immediately necessary to confront the twin problems of
deciding how much to provide and who should pay for that provision. Even if all individuals
wanted the service equally—as, perhaps, with lighthouses for ships —their views on the
extent of the service would be influenced by the allocation of the costs. Where different
households may have different preferences and some may not want the service at all.
Economists have tried to devise abstract voting schemes that would reconcile these
difficulties, but these appear to have little practical application. Moreover, others would
challenge this whole approach to the problem. It would be absurd to say that the consumer
has a taste for national defence and that it is the job of the government to satisfy it. The task
of national leaders is to evolve a defence policy and persuade the public to accept it.
Similarly, conservationists must attempt to awaken the public to the importance of parks and
wildlife. In the context of public policy, the efficient allocation of resources consists not
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merely of distributing funds in the pursuit of given objectives but also involves determining
the objectives themselves.
Genuine public goods pose severe problems for the national budget; it is very difficult to
decide how far particular goods—the arts, national parks, even defense—should be supplied,
and therefore no formal procedure of determination is likely to evolve. What should be given
to each will continue to be the subject of intense political debate, with allocation changing as
the government changes too?
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One difficulty with cost-benefit analysis is that every government agency has an incentive to
estimate favourable ratios for its own projects. It must, after all, compete with other agencies
for funds. No one can be certain as to the returns to be expected from an irrigation canal or a
highway. Private investors have also been known to exaggerate their claims in appealing to
stockholders, but they are generally subject to market sanctions that encourage them to err on
the side of caution.
In addition to the possibility that cost-benefit analysis may be biased by the preformed views
of those commissioning the study, there are other, more fundamental difficulties. Almost all
proposals have effects that are difficult to value in monetary terms. The siting of a new
airport brings problems of noise and property blight to local people and increases the risk that
civilians may die in an accident. Putting a sensible value on human life has been a continuing
difficulty for those carrying out cost-benefit analysis, even though every project does in fact
affect probabilities of life and death. These problems are, of course, not confined to cost-
benefit analysis. Additional expenditure on health service or on road safety or better housing
all affect the number of people who die prematurely. The failure of cost-benefit analysis to
provide answers to the problems of valuing life, or the quality of life, is a reflection of the
wider problem confronting all decisions on public expenditure: the influence of subjective
judgment.
There are several types of privatization. One involves the sale to private owners of state-
owned assets, and this is most correctly called privatization. Publicly owned houses may be
sold to their occupants. Commodity stockpiles may be reduced or disbanded. Increasingly,
however, attention has been turned to the sale of publicly owned industries, thus reversing
the move to nationalization that occurred, particularly in Nigeria, around 1999-2013. Where
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the privatized industry operates in a competitive environment, no new problems arise. But
where privatization occurs and monopoly continues, however, there are new difficulties.
Nigeria, Japan and the United Kingdom have privatized their telecommunications networks.
Although, in certain limited areas of telecommunications, competition is possible—and has
been allowed to develop in Nigeria, United States and Britain—technical and legal
restrictions inhibit competition in many sectors of the industry.
There have been experiments, therefore, with other forms of regulation, which seek to strike
a balance between incentives for better performance and the ability to exploit consumers.
A further problem for such regulation is that utilities and similar industries normally operate
in both competitive and monopoly markets. They may be inclined to use their monopoly
power in some areas to gain unfair competitive advantages in others. Despite these
difficulties, an increasingly wide range of industries, ranging from water supply to airports,
are now considered candidates for privatization.
Privatization can also mean the dismantling of existing statutory restrictions on competition.
State activities are often protected by legal prohibitions on competing private enterprise.
German railways, for example, are entirely state-owned, and the law not only prevents
competing railroads but severely restricts coach services and limits competitive trucking. The
dismantling of such restrictions is seen as one method of improving the efficiency of state
concerns.
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Another demand of privatization is the contracting out of publicly provided services. The
Nigeria municipalities have often entrusted activities such as refuse collection, and in some
cases tollgate service, to private contractors, and other countries are increasingly
experimenting with similar schemes. These possibilities demonstrate that a service may be
government-financed but not necessarily provided by the government; if extended more
widely, the concept could yield a different view of the economic role of the state. While the
main objective of privatization is often to increase the efficiency of government activities, its
implementation may also have important effects on government revenue. Any savings that
result from lower costs could lead directly to lower tax rates. Where budgeting procedures do
not distinguish between capital and current transactions, the proceeds of privatization sales
provide a once-and-for-all boost to revenues. The availability of this source of funding for
state activity has given an artificial attractiveness to privatization, especially in the Nigeria
society. For instance if National Electric Power Authority (NEPA) is sold for the present
value of its expected earnings and if these earnings are the same in public and private
ownership, privatization should have no net impact on public finances.
Briefly discuss the term government economic policy? What do you understand by the term
Merit good?
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Government competition and merger policies affect the structure of industry and commerce,
while regulatory activities—setting the number of hours shops may be open or who may buy
certain goods—have profound effects on commercial activities.
Government also affects allocations by setting the legal and administrative framework within
which the economy functions. It may specify minimum wage levels or control the siting of
new ventures and the activities of existing ones. Such activities of government profoundly
affect the allocation of resources, but they are rarely monitored or subject to serious control.
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The use of fiscal and monetary policy as a means of stabilizing the economy is relatively
recent, for the most part a development of the period after World War II. During the 19th
century the only stabilization policy was that associated with the international gold standard.
Under the gold standard, if a deficit occurred in a country’s balance of payments, gold tended
to flow out of the country. To counteract this process, the monetary authorities would raise
interest rates and stiffen credit requirements, causing a fall in prices, income, and
employment; this in turn led to a reduction in imports and an expansion of exports, thus
improving the balance of payments. If a country had a surplus in its balance of payments,
gold tended to flow in; this meant that the interest rate fell and the supply of money and
credit was increased. As a consequence, imports were stimulated and exports discouraged so
that the surplus in the balance of payments tended to disappear. The adjustment mechanism
also included another important element: capital movements between countries. When
interest rates fell in surplus countries and rose in deficit countries, mobile international
financial capital tended to flow from the former to the latter, contributing to the elimination
of deficits and surpluses in the balance of payments. The working of this mechanism was
partly automatic and partly the result of deliberate actions by the monetary authorities in each
country.
To throw more light on stabilization function of the government, the learners will be
introduced to the concepts of fiscal and monetary policies.
i. Fiscal policy.
These are measures employed by governments to stabilize the economy, specifically by
manipulating the levels and allocations of taxes and government expenditures. Fiscal
measures are frequently used in tandem with monetary policy to achieve certain goals. In
taxes and expenditures, fiscal policy has for its field of action matters that are within
government’s immediate control. The consequences of such actions are generally
predictable: a decrease in personal taxation, for example, will lead to an increase in
consumption, which will in turn have a stimulating effect on the economy. Similarly, a
reduction in the tax burden on the corporate sector will stimulate investment. Likewise, fiscal
policy attempts to control the actions of individuals and companies by means of spending
and taxation decisions. On the expenditure side, it can achieve this by spending money in
ways—for example, on construction projects—that stimulate other activity, while on the
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taxation side it can affect work, investment, or production decisions by changing tax rates
and levels. Fiscal policy thus has two major components: an overall effect generated by the
balance between the resources the government puts into the economy through expenditures
and the resources it takes out through taxation, charges, or borrowing; and a microeconomic
effect generated by the specific policies it adopts. Steps taken to increase government
spending by public works have a similar expansionary effect. Conversely, a reduction in
government expenditure or an increase in tax revenues, without compensatory action, has the
effect of contracting the economy. However, both are important in stabilizing the economy.
Another facet to fiscal policy is a government’s attempt to guide the development of the
economy by more specifically targeted policies. Thus most countries have from time to time
attempted to cushion particular areas from the effects of a decline in their dominant industry
by regional policies, to affect labour supply and demand by taxation, and to change the
pattern of consumer purchases by changes to indirect taxes. These policies sometimes
backfire as unforeseen consequences and interactions occur. The heyday of fiscal
stabilization policies was, however, the 1950s and ’60s. In the 1970s governments became
increasingly concerned about inflationary pressures, and important disturbances, particularly
the oil crisis, disrupted world economies. Stabilization became a less important policy goal
and one that governments were increasingly unable to achieve. Monetarist economic theories
acquired increased influence. The primary economic issues determining fiscal policies once
again became the more traditional concerns of allocation and distribution.
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manipulating the supplies of money and credit and by altering rates of interest.
The usual goals of monetary policy are to achieve or maintain full employment, to achieve or
maintain a high rate of economic growth, and to stabilize prices and wages. Until the early
20th century, monetary policy was thought by most experts to be of little use in influencing
the economy. Inflationary trends after World War II, however, caused governments to adopt
measures that reduced inflation by restricting growth in the money supply.
Although the desire to control inflation has been at the heart of the recent rise to prominence
of monetary policies in many countries, monetary policy can be used to affect a number of
different facets of economic behaviour. In time of unemployment the central bank may
stimulate private investment expenditure, and possibly also household spending on consumer
goods, by reducing interest rates and taking measures to increase the supply of credit, liquid
assets, and money. The customary tools for doing this are Open Market Operations (OMO),
the Monetary Policy Rate (MPR) or Minimum Rediscount Rate (MRR) or Discount Rate
(DR) of the Central bank and Cash Reserve Requirements (CRR) for commercial banks.
• In open market operations the central bank buys government securities—bonds and
treasury bills—from the private sector. The effect is to reduce interest rates by bidding
up bond prices. The sellers of the government securities obtain cash that they deposit in
the banks, thus increasing the cash reserves of the banks and enabling them to expand
credit to private borrowers; this in turn causes interest rates in the private sector to fall
and the terms of credit to become easier. In response, firms are likely to increase their
investment expenditures, and households are likely to spend more on consumer goods.
• The second tool of monetary policy, the Monetary Policy Rate of the central banks, is
often used together with open market operations. This is the interest rate at which
commercial banks can borrow funds from the central bank. If the discount rate is
reduced, banks become more willing to extend credit to private borrowers because they
can obtain funds themselves on easier terms. In many countries, changes in the
Monetary Policy Rate / minimum rediscount rate tend to be followed by similar
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changes in the interest rates charged by banks to their borrowers.
• The third tool of monetary policy, that of the cash reserve requirements (and, in some
countries, certain types of government securities) for commercial banks, provides that
banks must maintain money balances (in the form of deposits in the central bank) at a
certain proportion of their liabilities. This means that the banks cannot expand their
earning assets such as government securities and private loans, beyond that point. If the
government reduces the reserve requirements, the banks can expand their loans further,
thus increasing the total volume of credit outstanding.
Monetary policy, like fiscal policy, may also be used to combat inflationary tendencies by
reversing the above measures; the central bank will then sell government securities (thereby
increasing interest rates and reducing the supply of private credit and money), raise the
discount rate, or increase reserve requirements.
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• The decision lag is the period between the time when the need for action is recognized
and the time when action is taken. Although the recognition lag is presumably of about
the same duration for both monetary and fiscal policies, the decision lag is usually
considerably shorter for monetary policy than for fiscal policy. The central bank can
change monetary policy almost overnight, whereas a change in fiscal policy is more
complex, both politically and administratively. In many countries changes in income
taxes, for example, can be made only at the beginning of a calendar year; such changes
are often complicated by political discussions in the legislative body.
• The effect lag is the amount of time between the time action is taken and an effect is
realized. Monetary policy involves longer delays than fiscal policy; the time between a
change in monetary policy and its ultimate effect on private investment may be between
one and two years.
Some authors argue that the sum of all the lags is so long and uncertain that the best strategy
is not to take any action; by the time the effects occur the economic situation may be
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radically different. Some countries have tried to shorten the lags in fiscal and monetary
policy. One way to reduce the recognition lag is to improve the forecasting techniques, for
example, by using sophisticated questionnaires or computerized statistical and econometric
models.
In sum, the usual goals of both fiscal and monetary policy are to achieve or maintain full
employment, to achieve or maintain a high rate of economic growth and to stabilize prices
and wages. The establishment of these ends as proper goals of governmental economic policy
and the development of tools with which to achieve them are products of the 20th century.
Define the following terms: Open Market Operation (OMO), Monetary Policies Rate (MPR)
and Cash Reserve Requirement (CRR)?
imperfectly understood. The role of the government under distribution is explained under the
subheading of incidence of taxes and public sector expenditure.
i. Incidence of taxation and expenditure
The incidence of taxes is a subject that has generated much academic debate. It is usual to
distinguish between the legal incidence of a tax and its effective, or final, incidence. The
legal incidence is on the person or company who is legally obliged to pay the tax. Effective,
or final, incidence refers to who actually ends up paying the tax; if, for example, the whole of
a sales tax can be passed on in higher prices to the consumer, then consumers bear the final
incidence of the tax.
Whether the final incidence of the tax is on those who actually pay it depends on their market
power relative to the people with whom they trade. A payroll tax, for example, is likely to be
reflected in lower wages if labour is mobile and in plentiful supply, but may be borne, at least
in part, by the employer if there are labour shortages. Similarly, if a manufacturer of Zobo
drink in Nigeria is facing intense international competition, his ability to pass on any increase
in a sales tax (recently VAT) is limited; on the other hand, his ability to do so is much greater
if he is the sole supplier of the drink.
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failed to generate sufficient resources to tide them over into old age. Countries have evolved
programs for the prevention of severe need, although the definition of an acceptable
minimum standard of living is typically more generous in European countries than in, for
example, Nigeria this is reflected in the higher share of public expenditure in those countries.
In most countries the definition of poverty, as measured by the level to which the state
benefit system brings everyone’s income, has moved from being “absolute” (determined by
the minimum requirement of food, clothing, and shelter) to a more relative concept, which
allows the poor to share in real rises in living standards.
The second argument for redistribution is that overall social welfare is thereby increased. An
additional N10, 000 makes more difference to the standard of living of someone earning
N15, 000 per week than to that of someone earning N500,000. Even if everyone has income
above an agreed minimum level, there is a case for redistribution from the rich to the not-so-
rich. The extent to which this should be pursued depends partly on the perceived distortions
the redistribution would cause and partly on how much more value the far more numerous
not-so-rich can squeeze out of each additional dollar.
Other arguments for redistribution occur where the market fails to allow individuals to
redistribute between periods in their own lives. The classic example is that people tend to
have their periods of highest expenditure (while bringing up children) in Nigeria at the points
of minimum income (early in life). Those families with little or no access to credit markets
can do very little about this, which has been used as one argument for redistribution toward
those bringing up children. A second argument contends that children convey benefits to
society as a whole, so that parents should be rewarded for creating a public good. This
argument would, of course, have little strength in countries with serious problems of
overpopulation such as Nigeria.
A final group of arguments also concerns market failure. If particular areas or occupations
have declined and the work force has not adjusted to this decline by moving to other areas or
through retraining, then some subsidy to cushion the recessive effects might be considered
appropriate. Most countries redistribute from better-off regions to those that have declined, or
they allocate funds for specific programs designed to help particular groups
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Self-Assessment Questions
Section A. Select the most appropriate letter (A, B, C, D) that best answers each of the
following questions:
1. ……. are measures employed by governments to stabilize the economy, specifically by
manipulating the levels and allocations of taxes revenue and government expenditures.
A) Monetary policies
B) Income policies.
C) Fiscal policies.
D) Allocation policies.
2. When the Central Bank buys government securities in the Open market from the private
sector. The effect is to………………..
A) Reduce interest rates by bidding up bond prices.
B) Increase interest rates by bidding up bond prices.
C) Make interest rates neutral by bidding down bond prices.
D) Reduce interest rates by bidding down bond prices.
3. ……. put reliance on built-in stabilizers that function without any deliberate
intervention by the authorities.
A) Automatic stabilization policies
B) Discretionary stabilization policies.
C) Contractionary stabilization policies.
D) Adjustment stabilization policies.
4. The rate by which Central Bank lend to commercial banks is known as:
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A) Monetary policy rate
B) Minimum rediscount rate
C) Discount rate
D) All of the above.
5. ……….are goods are provided by the government free or cheaply because the
government wishes to encourage their consumption.
A) Private goods
B) Merit good
C) Public goods
D) Club goods.
6. The sales of state-owned assets to private owners is …..
A) Privatization
B) Nationalization
C) Indigenization
D) Commercialization.
7. Which of this objective is not performed by the government to stabilise the economy in
order to attain macroeconomic growth……
A) Full employment
B) Price stability
C) Balance of payment equilibrium
D) Inequitable distribution of income.
8. ………..is the period between the time when the need for action is recognized and the
time when action is taken.
A) Decision lag
B) Effect lag
C) Recognition lag
D) Spiral lag.
9. Which of these tools is not a monetary policy tool?
A) Government expenditure
B) Discount rate
C) Open Market Operation
D) Credit ceiling.
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10. One of this is not a type of lag in economic intervention policy: the recognition lag, the
decision lag, and the effect lag.
A) Recognition lag
B) Decision lag
C) Effect lag
D) Spiral lag.
Solution to MCQs
Questions 1 2 3 4 5 6 7 8 9 10
Answers C A A D B A D A A D
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References
Hassan, Y. A., (2009) The role of government in a market economy. A paper presented at the
Ohio State University at Marion, USA.
http://econ.ohiostate.edu/Aly/docs/The%20role%20of%20government%20MS%20Article%2
09-27-08.pdf
http://www.britannica.com/EBchecked/topic/240167/government-economicpolicy/26304/
Public-ownership-and-privatization#26305
http://www.businessdictionary.com/definition/governmentintervention.html#ixzz3HT4uWsc
http://econ.economicshelp.org/2007/05/government-intervention-in-macro.html
http://www.economicsonline.co.uk/Market_failures/Types_of_market_failure.html
http://www.economicshelp.org/blog/5735/economics/should-the-government-intervene-in-
the-economy/
http://tutor2u.net/economics/revision-notes/as-marketfailure-government- intervention.html
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Should you require more explanation on this study session, please do not hesitate to contact
Are you in need of General Help as regards your studies? Do not hesitate to
contact the DLI IAG Center by e-mail or phone on:
iag@dli.unilag.edu.ng
08033366677
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MODULE THREE:
GOVERNMENT ROLE IN THE GROWTH OF THE ECONOMY
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Introduction
In the preceding study session, the concepts of free market economy and market failure were
discussed. There, public good is one of the causes of market failure. In this study session, we
will examine the term public good. Public good concepts deal with the good that is
collectively owned and consumed by people with little or no payment made for such
consumption. In the course of our discussion both private and public goods will be examined.
Similarly, graphical approach will be utilized to explain the amount paid by consumers for
both types of goods.
Learning outcomes
At the end of this study session, you should be able to:
11.1 Define and use correctly the key words printed in bold:
11.2 Explain the concept of public good
11.3 Distinguish between public goods and other types of good
11.4 The price paid by consumers of public and private goods
11.5 The roles of government in providing public goods.
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In this context, public goods can be defined as good that is collectively owned and
consumedby everybody in the society. Also, it is a product that one individual can consume
without reducing its availability to another individual and from which no one is excluded.
The most detailed and technical description of a public good, which is often referred to by
authors, is Samuelson's (1954) definition, which states that a public good is a good that, once
produced for some consumers, can be consumed by additional consumers at no additional
cost. That means everybody jointly consumed the goods with or without payment. Examples
of such goods includes: fresh air, a public park, fireworks show, a lighthouse for ship, a
beautiful view, national defence. Let take national defence to buttress the explanation of
public goods. For instance, the consumption, or in this case the protection, provided to one
person does not diminish the protection provided to another. Regardless of whether an
individual living in the country paid for the service or not, he still enjoys the benefits of that
service. Also, national defence is non-divisible, meaning we can’t divide up the protection
provided to each individual.
Of great interest, is the idea of “public goods” that has a long intellectual history that can be
traced far back as 1739, to David Hume’s discussion of providing for the “common good.”
Along the way, classical economists like Adam Smith, David Ricardo and David Malthus
drew attention to the need for concerted action to provide for goods that benefit a
community. However, it was not until 1954 that a general theory of pure public goods was
explicitly developed with the work of Paul Samuelson and his article on “The pure theory of
public expenditure” and his two subsequent articles (Samuelson, 1954, 1955, 1958). The
framework set out by Samuelson continues to provide the theoretical base for the study of
public goods. By introducing the idea of a “pure” concept, Samuelson was able to develop
two essential characteristics that differentiate a private good from a pure public good: non-
excludability and non-rivalry.
• Non-excludability means that it is either impossible or prohibitively costly to exclude
those who do not pay for the good from using or consuming it. Once the good has been
produced, its benefits – or harm – accrue to all. Two examples will be introduced to
give a clearer understanding of this term to the learner. One is the lighthouse. A
lighthouse is: non-excludable because it is not possible to exclude some ships from
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enjoying the benefit of the lighthouse (for example, excluding ships that haven’t
paid anything toward the cost of the lighthouse) while at the same time providing the
benefits to other ships.
• The non-rivalry property implies that any one person’s use or consumption of the
public good has no effect on the amount of it available for others. Referring to the
lighthouse example, since the lighthouse’s benefits are already being provided to some
ships, it costs nothing for additional ships to enjoy the benefits as well. While for the
case of the HIV/AIDS awareness camp and fireworks shows, let assume that the
establishment manages to exclude non-contributors from watching the show (perhaps
one can see the show only from a private field). A price will be charged for entrance to
the field, and people who are unwilling to pay this price will be excluded. If the field is
large enough, however, exclusion is inefficient because even non-payers could watch
the show without increasing the show's cost or diminishing anyone else's enjoyment.
That is non-rivalrous competition to watch the show (Cowen, 2002).
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(i) A public good is defined as a good that possess the feature of both non-rivalries and
non-excludable in consumption.
(ii) The non-excludable property holds when it is impossible to prevent others from jointly
consuming a unit of the good once it is provided or produced while the non-rivalries
property holds when use of a unit of the good by one consumer does not diminish or
preclude the benefit from another consumer using the same unit of the good. Thus,
there is jointness in consumption of the good—one unit of the good produced generates
multiple units of consumption.
In the first quadrant in table 11.1, we have the case of a private good. These forms of goods
are the direct opposite of public goods. Private goods are goods where consumption by one
person prevents consumption by another (an extreme form of rivalries consumption), and one
person has the right to prevent the other from consuming the object. Their main features are
excludability (meaning that they are rivalries) and depletability. Private goods are almost
exclusively made for profit. A good example of a private good is bread. Bread is usually
made for profit and is finite because once it is purchased and eaten it is gone.
Rivalries Non-rivalries
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Private goods
Club goods
Breads, Cars, cloths,
Excludable Cinemas, private parks, Satellite
personal electronics food,
television, bridge, toll gates
etc
Public goods
Common- pool resources National defense, free-to-air
Non-excludable National Fish stocks, forest, television, fresh air, a public park,
coal etc HIV/AIDS awareness campaign and
fireworks shows, lighthouse, a
beautiful view, etc
The club goods are placed in the second quadrant. Public goods can also differ from pure
public goods if its consumption is excludable. In this scenario, individual are excluded from
consuming the goods though the amount consumed by a person does not reduce the
quantities available for others. These forms of goods have the features of non-rivalrous but
excludable, as in the case of a bridge, toll gates, a park and satellite television. Because club
goods are excludable, inefficiencies due to external effects can often be addressed by
charging people for access to the club good such as charging a toll for a bridge or a
membership fee for a club.
In the third quadrant, it is the case of common-pool resources. These are goods where
consumption is rivalrous but it is difficult to exclude people from consuming these goods. In
this case, individuals are not excluded from consuming the goods but the consumption of a
particular good reduces the quantities avail for other. Examples of such goods are: national
fisheries, forests, common grazing land and irrigation system. In these situations, individuals
will tend to overuse the common-pool resources since they will choose the level of usage at
which the individual marginal utility is zero.
Public goods occupied the fourth quadrant of the table. As noted earlier, these forms of
goods possesses the characteristics of non-rivalrous (a given amount of the good can be
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consumed by one person without affecting its simultaneous consumption by another) and
non-excludable (non-payment does not entail exclusion from consumption). Examples of
these forms of goods are depicted in table 12.1.
(i.) Common-pool resources are goods that possess the feature of rivalry but non -
excludable while club goods are goods that have the features of non-rivalrous but
excludable.
Recall in the case of private goods, we noted that, it possesses the features of rival excludable
as well as divisible. Both “rival” and “excludable” have been previously discussed. For
goods to be divisible it means the production of the good or service can be divided among
those who are consuming the good. For example if UNILAG Bakery is producing 100
loaves of breads daily and each loaf of bread is packed and sold to a customer. To determine
the market demand for the good or service, we horizontally summed the demand curves of
each of the individuals. For example, at two hundred naira (N200) one person would buy
fifty (50) loaves of bread and another would buy twenty (20), so the market demand at two
hundred naira (N200) would be seventy loaves of bread demand at the given price (See
figure 6.1).
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N200………….…………………………………………………………………………..
Note that we sum private goods horizontally, because consumers cannot consume the same
units. Rivalry in consumption is what makes the market pricing system so incredibly
effective, and why the invisible hand hypothesis can work. A price is a per unit charge for a
good, so that, when goods are consumed always due to a rivalry between consumers, supply
shortages will tend to correct the market by driving up prices as consumers compete for the
few remaining goods. Similarly, a supply surplus will cause firms to lower the price of the
good until an equilibrium is met that will clear the market. Public goods, however, cannot be
so easily and efficiently priced.
Having examined the demand for private good, we have to give an insight on the demand for
public. Before, doing this, there is the need to flashback at the unique characteristics of: non-
non-excludable, non- rival, and non-divisible. The concept of non-divisible comes into play
because we cannot divide the goods among individuals. For instance, national defence is
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non-divisible, meaning we can’t divide the protection provided to each individual in the
country.
Another example is the lighthouse, whereby the ray of light coming out of the light stand
cannot be shared by different individual.
Figure 4.2 shows where the demand curves for these individuals A and B for a certain public
good. The government has sent out a survey to A and B and asking them what each of them
would be willing to pay if the amount of public good produced was Q1 units. We can see
from the graphs that Individual A would be willing to pay N60 for that level of output, while
Individual B would be willing to pay N30 for that level. Thus if the government could
collect the donations from A and B they know that they could get N90 if they produced Q1
units. They next asked A and B what they would be willing to pay for Q2 units. We see that
both A and B would both be willing to pay N20 each. So if the government produced Q2
units, then they could possibly get N40.
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Price
Pr
per unit
N40 D (A + B)
Price
N30
N20 DB
Q1 Q2
N60
N20
DA
Q1 Q2
Source: /jasonleeucdavis.weebly.com
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excludability characteristic of public goods. Because nonpayers can continue to consume and
benefit from public goods without paying they are unlikely to make voluntary payments.
This problem states that a rational person/s will not contribute to the provision of a public
good because he/she does not need to contribute in order to benefit. For example, if Mr.
Anthony and Mr. Onogiese do not pay their taxes, they can still benefits from the
government's provision of national defence by free riding on the tax payments of their fellow
citizens. Let take another scenario, to see free riding at work in the Nigeria setting.
Consider the challenge of constructing Fourth Mainland Bridge in Lagos state where the
societal benefits of doing so would exceed the costs. How successful do you think a
campaign would be to finance the bridge with voluntary donations? It is not hard to imagine
how such a campaign would fail, because many (if not most) individuals would choose to
make no donation, hoping others would contribute enough to finance the bridge for everyone
to enjoy. In this scenario, the market failure would be that no bridge is constructed despite
the fact that a bridge would make everyone better off.
The free-rider problem is the primary reason why public goods are produced by the
governments. Because public goods are characterized by the inability to exclude nonpayers,
once a public good is produced anyone, everyone, can consume without making payment,
that is, get a "free ride." Voluntary payments like those occurring in markets will not provide
enough revenue to pay production costs. The only way to finance public goods is to force
free-riders, and everyone else, to pay through government taxes. The free-rider problem also
applies to common-property goods.
11.5 Methods of providing public goods: The government and private perspectives
a. Private provision of public goods.
As discussed earlier, the free-rider problem is attributed to the under-provision of public
goods by the private sector. In a nutshell, the private provision of public goods can be
possible but this depends on three key factors. These are:
• Dissimilarities among persons in their demand for the public goods;
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• Altruism amongst prospective contributors to the public good and;
• Utility derives from one's consumption of the public good.
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i) Crowding-out effect – When the government provides more of a public good, the
private sector will provide less. A great example of this is illustrated using a positive
externality of government providing education. The concept of externality will be
discussed in the next study section one may argue that in most cases, any crowding out
effect should not result in inefficiency because the reason for the government providing
a good or service in the first place is due to under-provision by the private sector. The
rational government won't provide goods/services in a public goods market that is
already operating efficiently.
ii) The problem of assessing the benefits and costs of public goods - In theory it is
relatively simple to assume that government can estimate the benefits and costs of
public goods. But in real life event, it is exceptionally problematic to consider all types
of benefits and costs with respect to public goods. Let consider the case of the
renovation of Third Main Land Bridge by the Nigeria government some years ago. In
undertaking this project, there are explicit and implicit costs and benefits associated
with an improved road system. Explicit costs include the wages of road workers,
concrete costs, insurance, etc. One implicit cost is the lost productivity of office
workers who must spend more time on the road during times of construction-caused
traffic jams. Some explicit benefits from the new road may include the government
needing to spend less money for maintenance on the new road, and less wear and tear
on government vehicles operating on the road due to a lack of potholes. Some "semi-
implicit" benefits include time saved by the aforementioned office workers who can
now get to work faster on the wider road and a potential reduction in traffic accidents
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due to newer roads being safer. The more implicit costs are, the more difficult they
become to accurately estimate or measure. While an estimate for the wages paid to road
workers may be accurate to within 5%, estimates of cost savings due to a reduction in
fatalities can vary widely due to the number of unknown and unpredictable variables.
iii) The problem of determining the public's preferences for public goods -
Government can face difficulties in knowing the actual preferences of the public for
public goods due to three problems: preference knowledge; preference revelation; and
preference aggregation.
• Preference knowledge is when individuals may lack the knowledge regarding
public goods and as a result not know what their valuation truly is for public
goods.
• Preference revelation is when individuals may not be willing to tell the
government their true valuation for example, because the government might
charge them more for the good if they say that they value it highly.
• Preference aggregation is the problem of government in attempting to consolidate
the preferences of millions of citizen’s preferences in order to decide on the value
of a public project. Unlike the market demand curve for private goods, where
individual demand curves are summed horizontally, individual demand curves for
public goods are summed vertically to get the market demand curve. Being that
public goods have a fixed market quantity (everyone in that society must agree on
consuming the same amount of that good), individual demand curves for public
goods are summed vertically to give the price for a given quantity. Conclusively,
since society does not have to agree on a given quantity of a private good, one
person can consume more than another at a given price, and the individual
demand curves are summed horizontally instead.
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free rider problem was introduced and discussed. Therefore, the study session was concluded
by reviewing the methods of providing public goods via the government and private
perspectives.
Self-Assessment Questions
Section A. Select the most appropriate letter (A, B, C, D) that best answers each of the
following questions:
1. The free-rider problem arises due to the fundamental feature of………of public goods.
A) Rivalry
B) Non rivalry.
C) Excludability.
D) Non excludability.
2. Non-rivalry and excludability are common features of……….
A) Public goods
B) Common goods
C) Club goods
D) Private goods.
3. Rivalry and non- excludability are associated with ……….
A) Public goods
B) Common goods
C) Club goods
D) Private goods.
4. The whole classes of goods that will be produced in a completely regulated economy
are referred to as:
A) Club goods
B) Public goods
C) Private goods
D) Pareto goods.
5. Common goods possess the features of…..……….
A) Rivalry and excludability
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B) Rivalry and non –excludability
C) Non-rivalry and non-excludability
D) Non-rivalry and excludability.
6. Private goods possess the features of ……….
A) Non-rivalry and excludability
B) Rivalry and non –excludability
C) Non-rivalry and non-excludability
D) None of the above.
7. An example of a good that possess the features of excludable and non-rivalry is……….
A) National defense
B) Cinemas
C) Cars
D) Air.
8. Which of these features distinguish public goods from private goods ……….
A) Non-rivalry and excludability
B) Rivalry and non –excludability
C) Non-rivalry and non-excludability
D) Rivalry and excludability.
9. Club goods possess the features of …….……….
A) Non-rivalry and excludability
B) Option: Rivalry and non –excludability
C) Non-rivalry and non-excludability
D) Rivalry and excludability.
10. The form of goods that individuals consume different quantities at a given price or the
same price is…
A) Public goods
B) Private goods
C) Mixed goods
D) All of the above.
Solution to MCQs
Questions 1 2 3 4 5 6 7 8 9 10
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Answers D C B C B D B C A B
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Reference
Cowen, T. (1992). ed. Public Goods and Market Failures. New Brunswick, N.J.:
Transaction Publishers.
Cowen, T. (2002). Public Goods and Externalities. In The Concise Encyclopedia of
Economics. Retrieved July 8, 2008, from Liberty Fund, Inc. Web site:
www.econlib.org/library/Enc/PublicGoodsandExternalities.html).
Cowen, T. and Eric C. (2003)., eds. Market Failure or Success: The New Debate.
Cheltenham, U.K.: Edward Elgar, 2003.
Sagasti, F. and Bezanson, K (2001), Financing and Providing Global Public Goods:
Expectations and Prospects. Prepared for the Ministry of Foreign Affairs, Sweden,
November.
Samuelson, P. (1954), “The pure theory of public expenditure”, Review of Economics and
Statistics, No. 36, pp. 387-89.
Samuelson, P. (1955), “Diagrammatic exposition of a theory of public expenditure”, Review
of Economics and Statistics, No. 37, pp. 350–356.
Sagasti, F. and Timmer, V. (2008). An Approach to the CGIAR as a Provider of International
Public Goods. An independent Review of the CGIAR System, Report to the Executive
Council, Elizabeth McAllister (Chair), Bringing together the best of science and the best of
development, Washington DC, September.
Kitchen, M. (2012). The concept of public goods.
http://environment.yale.edu/kotchen/pubs/grnmrkts.pdf
Gruber, J. (2009), Public Finance and Public Policy (2nd edition). p 177-179.)
http://www.econlib.org/library/Enc/PublicGoods.html
www.amosweb.com/cgi-bin/awb_nav.pl?s=wpd&c=dsp&k=free-rider+problem
http://are.berkeley.edu/courses/EEP101/Lecture-Summary-PDF/lec09-10-Public-Goods.pdf.
www.bized.co.uk
http://www.econlib.org/library/Enc/PublicGoods.html
http://www.econlib.org/library/Enc/Externalities.html
http://www.investopedia.com/terms/p/public-good.asp
http://www.who.int/trade/distance_learning/gpgh/gpgh1/en/
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Should you require more explanation on this study session, please do not hesitate to contact
Are you in need of General Help as regards your studies? Do not hesitate to
contact the DLI IAG Center by e-mail or phone on:
iag@dli.unilag.edu.ng
08033366677
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ACC 313 Public Finance
STUDY SESSION TWELVE:
THE CONCEPT OF EXTERNALITIES
Introduction
In the last study session, you have learnt the concept of public goods which is noted as goods
with the features of non-excludable and non-rivalry. The uniqueness of these forms of goods
has made it difficult for the free market economy to provide such goods. Recall, we say
public goods are one of the causes of market failure. In this study session, you will learn the
concept of externality which is another important distortion of free market economy. In order
to have a clear understanding of the term, you will be introduced to the forms and effects of
externality on individuals and the society as a whole. Likewise, feasible solutions to
externalities problems will be addressed.
Learning outcomes
At the end of this study session, you should be able to:
12.1 Define and use correctly the key words printed in bold:
12.2 Understand the term and idea behind externalities
12.3 Use graph to explain the types of externalities
12.4 Analyse the possible solutions to externalities phenomena.
As societies get more urbanized, the presence of externalities becomes more visible.
With more people, the likelihood that the actions of decision makers will have a greater
chance of affecting others increases. Externalities are fairly common in our society. Here are
some examples (See: Table 12.1)
Production Consumption
Quadrant three
Quadrant four
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Nigeria
In quadrant one and three of Table 12.1, production externalities occur when the production
activities of one individual imposes costs or benefits on other individuals, that is not
transmitted accurately through a market. When we examine production externalities with
regard to beneficial and harmful effect for instance, if the people staying close to the bakery
like the smell / aroma of the bread that comes from the bakery. This activity causes positive
effect to the third party. Likewise, the sulfur and carbon dioxide emissions from the
machineries and generators of the bakery have a harmful effect on the environment and
welfare of the people.
In quadrants two and four (See Table 12.1), we have the case of consumption externalities
where consumers fail to take into account the costs and benefits of their actions, then too
much or too little output will be consumed. For instance, measles vaccination lowers the
probability of others’ getting infected as shown in quadrant two while noise from generator
sets from residents on their neighbours causes harmful effect on them (quadrant four).
Within the framework of the production and consumption externalities, we are going to
analyse the positive and negative externalities using graphical approach. Note both
production and consumption externalities are within the context of positive and negative
externalities.
For more in-depth analysis of the concept of externalities, it is important to define certain
terms:
i. Private Benefit (PB): The increase in consumer happiness from the consumption of
one more unit of a good or service. This is equivalent to the normal demand curve (the
higher the price the lower the quantity demanded vice-versa).
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ii. Private Cost (Marginal Cost): The increase in a firm’s costs when it produces one
more unit of a good or service. This is equivalent to the usual supply curve. (It excludes
externalities).
The word private is used to emphasize the fact that there are two main actors in a transaction
in the output market: the sellers of a good or service (the firms), and the buyer of a good or
service (the households). When we talk about benefits or private cost, we are discussing the
cost and benefits that apply only to the direct participants in a transaction, in the output
market.
The term social is used to emphasize the fact that in some transactions, the entire society
(and not just a household or a firm) is affected by a market transaction.
i. Social Benefit (SB): The total benefit gained by the society from the consumption of a
good. It includes any private benefits and any consumption externality that might exist.
ii. Social Cost (SC): The aggregate cost from the production of a good, including the
private cost and any production externality. In a situation where there is ‘NO’
externality on the production side then: Social Cost = Private Cost
Similarly, where there is ‘NO’ externality on the consumption side then: Social Benefit
= Private Benefit.
Therefore, economic efficiency will always occur when social costs equal social benefits.
When there are no externalities on either the production or consumption side, then economic
efficiency will occur when private costs equal private benefits. As we have seen already,
private cost is just the marginal cost curve facing a firm. That is Private costs equal Marginal
Costs.
What about private benefits? What benefit do you derive from consuming one more unit of a
good? We’ve seen already that the benefit has to be at least the price of the good. If the
benefit derives from consuming one more unit of a good is less than the price you are willing
to pay for the good then you would not purchase it. If however, the benefit you would get is
greater than the price of the good then you will certainly purchase the good. Thus, private
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benefits = P, Since we stated that economic efficiency occurs where private costs equal to
private benefits. Then when there is no externalities a firm will produces where P = MC.
(i.) Externality occurs where there is a direct effect of the actions of one person or firm on
the welfare of another person or firm in a way which is not transmitted by market
prices.
(ii.) Private Benefits is the increase in consumer happiness from the consumption of one
more unit of a good or service. This is equivalent to the normal demand curve (the
higher the price the lower the quantity demanded vice-versa). Social Benefits are the
aggregate benefits gained by the society from the consumption of a good. It includes
any private benefits and any consumption externality that might exist.
Refer to Figure 12.1. The firm will only take into account their own private costs and thus
will produce where private benefits = private costs. This is equivalent as saying where
supply equals demand. The oil-refinery would produce at Point A where (Quantity = Q1;
Price = P1).
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B S1 = Private cost
P2
P1
Q2 Q1 Qty
However, there are social costs (the water, land and air pollutions) to the production of oil,
which the oil refinery ignores. The Social Cost curve must be higher (to the left) of the
private cost curve. At the original level of production, social costs are higher than social
benefits and thus this quantity is not efficient and we have market failure. The reason for
market failure is that the market participants do not factor in the full social costs of their
harmful economic activities. There is a divergence between social costs and private costs
which is the negative externality.
Learner should note that, there is no externality on the consumption side, so private benefit =
social benefit (the demand curve will be the same). We know that when externalities exist,
economic efficiency will only occur when social benefit is equal to social cost. In this case,
economic efficiency will be at Point B. The shaded area (point A) is the area in which social
costs exceeded social benefit that results from overproduction. This is the dead-weight loss.
Society would be better off if the economy was at Point B rather than at Point A. Note that at
Point B, the efficient solution is not to reduce the harmful activity to 0. As long as the firm
has the ability to compensate the damaged parties fully and still have profits left over, then
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pollution is “worth it” to society. It would be inefficient for the oil refinery to stop polluting.
Notice that if the quantity produced were below Q2, the benefits gained from society would
have been greater than the social costs. Society would be better off if they produce more of
the polluting product.
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Refer to Figure 12.2. We know that the market equilibrium is where the private cost equal to
private benefits at point A. However, point A cannot be efficient since at that quantity, the
social benefits exceed the social costs. Economic efficiency will only be reached when
social costs = social benefits at Point B. The shaded area is the positive externality that is
realized as we produced the good. The deadweight loss is the shaded area between Q1and
Q2. It will be a loss to society by not producing enough of the good.
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us consider the case of the negative externality. The government can charge a tax on
production of the good equal to the externality. The tax will shift the S1 curve to S2 and
the firm will produce at the efficient amount Point B. In the case of a positive
externality, this can be done using a subsidy (government paying producers to produce
or consumers to consume). It is obvious that the government would find it a difficult
task to correctly measure the externlity.
ii. Private Solutions (Bargaining and Negotiation): Consider the case of the polluting oil
refinery. The victims of the pollution can either bribe the polluters not to pollute, or
thepolluters could compensate the victims of pollution to allow them to pollute. This is
known as Coase Theorem. The theorem states that if basic rights at issue are
understood, transaction costs are low, and if few parties are involved, private parties
will find an efficient solution to the problem of externalities. Often, however,
transaction costs are not low since there are many people involved in the externality.
Thus private solutions to an externality are generally not feasible.
iii. Legal Rules and Procedures: When externalities generate damage to society, courts and
the law can be employed to limit the damage costing action. An injunction is a court
order forbidding the continuation of behaviour that leads to damages. If the damages
have already occurred, the court can issue liability rules which require the damaging
party to compensate for the harm committed. As a result of injunctions and liability
rules, the decision makers have an incentive to weigh all the consequences.
iv. Selling or Auctioning Pollution Rights: Another method to control pollution is to issue
“permits” to firms in order to pollute and allow firms to trade these permits in a market
setting thereby resulting in an efficient level of pollution. Since, we don’t have a good
example to illustrate this strategy in Nigeria there is the need to cite an example from
the USA experience. This system is called a “cap and trade” approach. The Clean Air
Act of 1990 is an example of a law that used the cap and trade system.
• Emissions from each factory were limited to a certain level where each firm plant
was issued permits to emit only that level of production.
• Permits could be used to emit air pollution or they could be traded to another
firm.
• Firms who had clean technology and were able to produce output at emission
levels lower than the Federal mandate would sell its unused permits to firms with
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Self-Assessment Questions
Section A. Select the most appropriate letter (A, B, C, D) that best answers each of the
following questions:
1. The cost or benefit that was not transmitted through prices but incurred by a party who
did not agree to the action causing the cost or benefit is known as…..
A) Internalities
B) Externalities
C) Public debt
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D) Public expenditure.
2. The word externality is created by:
A) Arthur Cecil Pigou
B) Henry Sidgwick
C) Alfred Marshall
D) Adam Smith.
3. The social benefit curve for a positive externality word externality will be to…..
A) The right of the private benefit curve
B) The left of the private benefit curve
C) The left of the private cost curve
D) The right of the private cost curve.
4. In a situation where there is no externality on the consumption side then:…..
A) Social Benefit > Private Benefit
B) Social Benefit = Private Benefit
C) Social Benefit < Private Benefit
D) All of the above.
5. The total cost to the society of producing an additional unit of a good or service is
the….
A) Marginal social cost.
B) Marginal external cost
C) Marginal private cost
D) Marginal resource cost
6. Another name for transaction spill over is known as…………….
A) Public expenditure
B) Public debt
C) Internalities
D) Externalities.
7. Economic efficiency looks at the Marginal Social Benefit (MSB) and the Marginal
Social Cost (MSC). Production of a good is at exactly the socially efficient level if:
A) MSB < MSC.
B) MSB / MSC = 1
C) MSB > MSC
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D) MSB = MSC.
8. A situation where there is no externality on the production side then:…..
A) Social Cost = Private Cost
B) Social Cost < Private Cost
C) Social Cost > Private Cost
D) None of the above.
9. All of the following are causes of market failure except:..
A) Externality
B) Public good
C) Missing market
D) Private good.
10. In the graphical approach of negative externalities, the ………of the private cost curve.
A) Social cost curve must be higher (to the right)
B) Social cost curve must be higher (to the left)
C) Social cost curve must be lower (to the right)
D) Social cost curve must be lower (to the left).
Solution to MCQs
Questions 1 2 3 4 5 6 7 8 9 10
Answers B A A B A D D A D B
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References
https://www.uea.ac.uk/documents/953219/967353/Azam_S+Policy+interventions.pdf/4e9ba6
83-91a5-4cd9-9644-10024e4d0001
http://tutor2u.net/economics/revision-notes/as-marketfailure-negative-externalities.html
http://www.123helpme.com/issue-of-externalities-its-implications-and-market-failure-in-the-
economy-view.asp?id=164753
http://jasonleeucdavis.weebly.com/uploads/2/9/3/6/2936139/ecn_53-lecture_notes_16.pdf
http://www.fatih.edu.tr/~kcivan/Notes%204-Externalities.pdf
http://are.berkeley.edu/courses/EEP101/Detail%20Notes%20PDF/Cha03,%20Externalitites.
pdf
http://ibguides.com/economics/notes/the-meaning-of-market-failure
http://jasonleeucdavis.weebly.com/uploads/2/9/3/6/2936139/ecn_53-lecture_notes_16.pdf
http://www2.yk.psu.edu/~dxl31/econ14/lecture31.html
http://www.albany.edu/~aj4575/355/LectureNotes/Lecture5.pdf
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Should you require more explanation on this study session, please do not hesitate to contact
Are you in need of General Help as regards your studies? Do not hesitate to
contact the DLI IAG Center by e-mail or phone on:
iag@dli.unilag.edu.ng
08033366677
195
ACC 313 Public Finance
STUDY SESSION THIRTEEN:
GOVERNMENT OWNERSHIP OF ENTERPRISES INTRODUCTION
The goal of any government objective is to improve the welfare of its citizens.
Government came into business in order to provide essential services, which if private
individuals or organisation should provide will either be inadequate or to exploit the poor to
make more profit or deprive the poor totally from the consumption of such services. This is
because the rich has money to pay even at a higher price than the normal price, while the
poor do not have money to pay at all. Government has a vital role to play to bridge the gap
between the rich and poor by providing some necessary services, through the establishment
of government enterprises, at a low cost or zero prices.
Learning Outcomes
At the end of this session, you should be able to:
13.1 Define public enterprise;
13.2 Enumerate the characteristic of government enterprises
13.3 List the objectives of public enterprise
13.4 Discuss the two types of government enterprises
14.5 List the advantage and disadvantages of public enterprise
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essentialservices at a low cost rate or zero price. These enterprises are promulgated by law
and can fall into any of these categories.
i) Public Utilities: Public utilities of vital value e.g. pipe borne water are provided by the
government for the citizens use either at ‘zero’ cost or at a subsided rate. Water is very
important in every home whether rich or poor; with the provision of water to its citizens
the government is thereby improving the welfare of the citizens to achieve its social and
economic objectives. Federal Water Corporation for the provision of water.
ii) Commercial Enterprises: These are agencies established by the government to enter
into business and make profit from such a business. Government commercial
enterprises are competitive with other business in the same industry and make profit
although they still collect subvention from the government. Such enterprises are
insurance (NICON).
They are expected to operate with rules and regulation in the Companies and Allied Matters
Act of 1990 (as amended or other regulatory) of anybody which they operate as a
commercial enterprise.
Policy Boards: These are agencies which are wholly or partially autonomous organisation
operating under the policies of the government to meet specific needs e.g. Nigeria Cocoa
Marketing Board (NCMB), Schools Management Boards (SMB) and Local Government
service commission (LGSC). Some of them operate as commercial enterprise but still collect
subvention from the government.
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• It helps decongest the urban area because facilities in the urban area are also in the rural
area.
• It improves the standard of living of the citizens.
• It creates employment and stabilisation policy.
• It serves as a source of revenue to the government through taxes and profits from such
agencies.
• It leads to better planning and decision making on how to allocate resources for
economic growth.
• It reduces the impact of monopoly as the goods or services are produced at cheaper
prices to the society.
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• Recurrent Expenditure: Expenditure used for the day to day running of the enterprise
and occurs frequently e.g. wages and salaries, fuelling of motor vehicles, books,
periodicals etc.
• Capital Expenditure: Expenditure used to acquire asset for the enterprise and infrequent
in nature e.g. buildings, motor vehicles
The following are financial reports (statement) expected from a public enterprise that is
operating like a private enterprise i.e. profit oriented.
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Self-Assessment Questions
Section A. Select the most appropriate letter (A, B, C, D) that best answers each of the
following questions:
1. The following are the characteristics of government enterprises:
A) It must be established by an Act
B) The government fixed the name, functions and objectives
C) The government appoint the principal officers and their functions
D) The government divides it into political parties
2. ONE these is NOT a characteristic of government enterprise
A) It leads to corruption
B) It is not a profit oriented organisation
C) The government fixed prices and approve increases in prices
D) Prepares annual budget for government approval
3. The following are the objectives of government enterprises except ONE
A) To provide vital goods and services
B) To provide insecurity
C) To meet the needs of the poor and the rich
D) To have control over some means of production in the nation
4. ONE of these NOT a government owned enterprises in Nigeria
A) Nigeria Democratic Party
B) Nigeria National Petroleum Company
C) Nigeria Deposit Insurance Corporation
D) Bureau of Public Enterprises
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Solution to MCQs
Questions 1 2 3 4 5 6 7 8 9 10
Answers D A B A D A C C C A
References
Olakanmi, J. & Co, (2010). Financial Regulations & Allied Laws, Abuja, Nigeria. LawLords
Publications.
Should you require more explanation on this study session, please do not hesitate to contact
Are you in need of General Help as regards your studies? Do not hesitate to
contact the DLI IAG Center by e-mail or phone on:
iag@dli.unilag.edu.ng
08033366677
204
ACC 313 Public Finance
Introduction
The efficient allocation of funds is the most effective finance function in modern times. It
involves the decision to commit government funds to long-term projects. Such decisions are
of considerable importance to the development of the economy. The aim is to achieve macro-
economic stability and real growth. Government investment decision is undertaken after a
careful project appraisal. Project appraisal is the evaluation of several alternative investment
activities within limitation of available resources with a view to determining which
alternative gives the best returns.
Government works with limited resources and therefore has to evaluate and rank projects
before embarking on it (examples are construction of roads, building of schools, hospital etc).
The government invests on projects and also expects revenue from them but not at the exploit
of its citizens as does the private sector but to better the welfare of its citizens.
Learning Outcomes
At the end of this session, you should be able to:
14.1 Explain investment appraisal;
14.2 List the procedures for the selection of project in the public sector;
14.3 Identify the investment techniques;
14.4 List each methods of investment techniques;
14.5 Calculate and give the decision rules of:
• Payback period (PB)
• Accounting Rate of Returns (ARR)
• Net Present Value (NPV)
• Internal Rate of Return (IRR)
• Cost Benefit Analysis (CBA)
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14.6 State four advantages and disadvantages of
• Payback Period (PB)
• Accounting Rate of Return (ARR)
• Net Present Value (NPV)
• Internal Rate of Return (IRR)
• Cost Benefit Analysis (CBA)
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PB : Payback Period
ARR : Accounting Rate of Return
NPV : Net Present Value
IRR : Internal Rate of Return
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14.4.2 Cost Benefit Analysis
This method uses some analytical tools e.g. profitability index in decision-making which
provides for a systematic comparison to be made between an estimated cost of undertaking a
project and the estimated value of benefits derived from such a project.
Solution:
Yr Cash flow Cumulative
N ’000 N’000
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Average investment = opening investment + closing investment
2
Opening Investment can be initial outlay, cost of the project and capital cost
Closing investment can be residual value, scrap value or disposal value.
The accounting rate of return is used in appraising projects by comparing the calculated ARR
with a target of already predetermined rate of return. The project will be accepted if
calculated accounting rate of return is higher than the predetermined accounting rate of return
otherwise reject it.
If calculated ARR is higher than (>) target rate, accept ARR. If calculated ARR is lower than
the (<) target rate, reject
Example 1
Mutually Exclusive Projects implies that if one project is selected the other projects have to
be rejected that is, two projects cannot be undertaken at the same time.
Allwell State of Nigeria is contemplating on acquiring a new machine and has three
alternatives X, Y and Z. The cost of the machine and the relevant course are as follows:
Machine X Y Z
Cost N 40,000 N 40,000 N 40,000
Residual value N 8,000 N 12,000 N 16,000
Estimated life 6yrs 6yrs 8yrs
Estimated future year1 N 10,000 N 10,000 N 8,000
Profit before depreciation
Before yr2 N 10,000 N 8,000 N 10,000
Depreciation
Yr3 N 8,000 N 8,000 N 8,000
Yr4 N 8,000 N 6,000 N 6,000
Yr5 N 10,000 N 12,000 N 10,000
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Machine NA NB NC
Total profit 51,000 57,000 59,000
Less depreciation 32,000 28,000 24,000
TOTAL 19,000 29,000 35000
19,000/6 29,000/6 35,000/8
Annual profit 3166.6 4833.3 4375
Average investment = 40000+8000/2 40000+12000
/2 40000+16000
/2
= N 24,000 N 26,000 N 28,000
ARR = 3166.6/24000*100 4833.3/26000*100
4375/28000*100
= 13.19% 18.95% 15.63%
Machine B should be purchased because it has the highest accounting rate of return of
18.95%.
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investment annuity method of valuation used in traditional method of appraisal. The payback
period ignores the time value of money (cash flow) and total profit over a project’s life time.
The accounting rate of return also ignores time value of money and uses only accounting
profit.
Therefore it is only the Discounted Cash flow techniques that best fulfilled the purpose of
investment appraisal. This method is divided onto two as earlier method.
a) The Net Present Value (NPV) method
b) The Internal Rate of Return method
14.6.1 Net Present Value
This is obtained by discounting all value of cash outflows and inflows of a project by a
chosen target rate of return or interest rate or discount rate or cost of capital. The NPV is
therefore compares the present value of all cash inflows from an investment with the present
value of all cash outflows from an investment. The Present Value (PV) of cash inflows minus
PV of the cash outflows is the NPV.
Decision Rule for NPV
• If the NPV is positive, the project should be (accepted) undertaken
• If the NPV is negative, the project should be (rejected) not undertaken]
• If the NPV is exactly zero, the project will be only worth undertaking
• For mutually projects, we select a project that has the highest NPV.
The discounting formula to calculate the present value of a future sum of money at the end of
n time period is:
PV= FV 1
(1+R)-n
Where:
PV=Present Value
FV= Future Value
R = rate of return or cost of capital
n= number of years
Present Value can be defined as the cash equivalent now of a sum of money received or
payable at a stated future date, discounted at a specified rate of returns (Adeniji, 2009).
N
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NPV = ∑ = A1 - CO
R=1
(1+K)1
Where:
NPV =Net Present Value
N
∑ = Summation n
R=1
Example 4
Olorire local government is considering a capital investment where the estimated cash flow
are
Year Cash flow (N)
0 (200,000)
1 120,000
2 160,000
3 80,000
4 60,000
NPV = ∑ = A1 - CO
R=1
(1+K)1
120,000 + 160,000 + 80,000 + 60,000 - 200,000
(1+0.15)1 (1+0.15)2 (1+0.15)3 (1+0.15)4
104,347.82 +120,982.98+ 52,601.30+34,305.20 - 200,000
= N112,237.30
Because the NPV is positive, the project should be undertaken.
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Alternative presentation is using the tabular form where the cash outflows (initial outlay)
represent negative cash flows and cash inflows represent positive cash flow.
graph or mathematically using linear interpolation. IRR can be derived by using the formular
below:
IRR = D1 + [ NPV1 ] (D2-D1)
[NPV1-NPV2]
Where:
D1 is the lower discount rate with a positive NPV
D2 is the higher discount rate with a negative NPV
NPV1 is the amount of positive NPV
NPV2 is the amount of negative NPV
Example
Aseyori state of Nigeria is planning to embark on a capital project with the following
information
N’000
Initial cash outflow 3,450
Cash inflows Yr 1 1,500
Yr 2 1,500
Yr 3 1,500
Given 10% as the lower discount rate or cost of capital of the state, and 15% as a higher
discount rate or cost of capital.
Solution
Step 1 Calculate the NPV using 10% and 15% as discount factor separately.
Step 2 Enter the NPV values in the IRR formular recognizing the interpolation between the
discount factors.
Using 10% discount factor
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N’000 10% N’000
0 (3,450) (1.00) 3,450
1 1,500 0.91 1,365
2 1,500 0.83 1,245
3 1,500 0.75 1,125
NPV 285
Using 15%
Yr Cash flows Discount factor discounted cash flow
N’000 15% N’000
0 3,450 1.00 (3,450)
1 1,500 0.87 1,305
2 1,500 0.76 1,140
3 1,500 0.66 990
NPV (15)
The project should be accepted because the IRR is 14.75% which is higher than 10%
Mutually exclusive projects: The project with the highest percentage should be selected
where two or more mutually exclusive investments are being considered.
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Self-Assessment Questions
Section A. Select the most appropriate letter (A, B, C, D) that best answers each of the
following questions:
1. In investment appraisal, one of the following is NOT an advantage of payback period
method
A) It is simple to calculate and understand
B) It is a useful measure of liquidity
C) It serves as a safeguard against risk
D) It ignores all cash flows outside the period
2. One of these is NOT a procedure in investment appraisal
A) Project manipulation
B) Identification of projects
C) Project evaluation
D) Project authorization
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3. In investment technique, the traditional method can be classified into two namely
A) Pay salaries period (PS) and Accounting Profit Method (APM)
B) Net profit period (NPP) and Gross profit period (GPP)
C) Payback period (PB) and Accounting rate of return (ARR)
D) Inventory period (IP) and Closing period (CP)
4. In investment appraisal technique, the technique that considers the time value of money
is called
A) Accounting cash flow method
B) Appraisal cash flow method
C) Investment cash flow method
D) Discounted cash flow method
5. The formular for Accounting Rate of Return (ARR) is one of the following
A) Average annual cash flow X 100%
Average investment
B) Average depreciation X 100%
Average investment
C) Average annual accounting profit X 100%
Average investment
D) Average residual value X 100%
Average investment
6. A project initial cost is N20,000 and has a cash inflow of N5,000 per annum. Calculate
the payback period
A) 6 years
B) 4 years
C) 10 years
D) 8 years
7. The decision rules in the calculation of Accounting Rate of Return (ARR) is
A) If calculated ARR is higher than target rate accept ARR
B) If calculated ARR is lesser than target rate accept ARR
C) If calculated ARR is a negative figure to the target rate accept ARR
D) If calculated ARR is equal to target rate reject ARR
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8. If N400 is invested today and generate N500 in one year’s time. What is the Internal
Rate of Return?
A) 28%
B) 32%
C) 29%
D) 25%
9. A technique in investment appraisal which ignores time value (period) for the cash
inflow from capital investment project to equal the cash outflow is called
A) Accounting period flow (APF)
B) Investment period flow (IPF)
C) Payback period (PB)
D) Cash flow period (CFP)
10. Which of the following uses accounting profit in the calculation of a project in
investment appraisal?
A) Payback period (PB)
B) Accounting rate of return (ARR)
C) Net present value (NPV)
D) Internal rate of return (IRR)
Answers
1 2 3 4 5 6 7 8 9 10
D A C D C B A D C B
Theory Questions
1. What is Payback period?
2. List four advantages and disadvantages of payback period in investment appraisal
3. Explain briefly and state the formulas for:
i. Accounting rate of return (ARR)
ii. Net present value (NPV)
iii. Internal Rate of Return
4. List two advantages and disadvantages of each of them
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References
Adeniyi, A.A (2009). Cost Accounting: A Managerial Approach. Lagos: El-Toda
Ventures Limited.
Durey, C.Management and Cost Accounting. United State: Birendan George.
Omolehinwa, A. (2013). Management Accounting. Lagos, Cleo Consult.
Shiro, A.A. (2004). Financial Management, Lagos .El-Toda Ventures Ltd.
Wheelen, T.L., and Hunger, D.J., (2012). Strategic Management and Business Policy.
(Eleventh Edition). New Jersey: Pearson Education.
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Should you require more explanation on this study session, please do not hesitate to contact
Are you in need of General Help as regards your studies? Do not hesitate to
contact the DLI IAG Center by e-mail or phone on:
iag@dli.unilag.edu.ng
08033366677
221
ACC 313 Public Finance
STUDY SESSION FIFTEEN:
ISSUES OF FISCAL RESPONSIBILITY
Introduction
Fiscal Responsibility Act (FRA) relates to Fiscal Federalism. Federalism is a system that
operates different tiers of government as it is being practiced in Nigeria currently (Federal,
State and Local governments).
Fiscal relates to financial matters that are being managed by the government of a country.
Therefore, fiscal responsibility is the allocation of revenue and expenditure operations among
the three tiers of government.
The 1999 constitution of the Federal Government of Nigeria assigns each tier of government
a set of responsibilities expected to better the welfare of the society. The government does
this through the budget and the objective is to achieve macroeconomic stability and real
growth. Fiscal Responsibility can also be referred to as government intervention in the
society aim at solving the problem of market failure caused by market imperfections.
However, public sector economic and financial management in Nigeria has failed to deliver
to its citizen since independence. Despite progressive increase in revenue accruing to
government over the years, the government has been unsuccessful in her Fiscal management.
Learning Outcomes
15.1 List the objectives of FRA
15.2 Identify the arrangement of FRA
15.3 Composition of members and cessation of members
15.4 Duties and functions of FRA
15.5 List the challenges of FRA
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Good management of government resources: The ACT is expected to help government in the
management of its resources.
Economic Stability: One of the purposes of government is maintain long-term macro-
economic stability to grow and develop the economy of the nation and better the welfare of
its citizens.
Good Financial Management: The government expects the ACT to take good financial
management for every fund received by every government establishment.
Accountability and Transparency: The ACT expects government establishment to follow due
process in the performance of its activities for accountability and transparency.
To control excessive government expenditure and cut down unnecessary spending with the
use of government fund.
To better the standard living of its citizen through poverty reduction and economic
advancement.
One objective of FRA is to discourage financial indiscipline and misuse of government
resources.
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• Part v – Budgetary execution and achievement of targets.
• Part vi – Public revenues
• Part vii – Savings and asset management
• Part viii – Public expenditure
• Part ix – Debt and indebtedness
• Part x – Borrowing
• Part xi – Transparency and accountability
• Part xii – Enforcement
• Part xiii – Miscellaneous provisions
• Part xiv – Interpretation
15.3 Composition
The commission consists of a chairman and ten (10) other members. One member represents
each of the following six geo-political zones of the country, that is: North- Central, North-
East, North-West, South-East, South-West, and South-South and one representing member
from:
i. The organized private sector
ii. Civil society engaged in causes relating to probity, transparency and good governance
iii. Organized labour
iv. A representative of the Federal Ministry of Finance of a level not below the rank of a
Director.
The chairman and members shall come from the six geo-political zones and shall be ready to
work on full time basis. The appointment is for five years and a single term of office.
All members of the commission shall be persons of good character and must have the
necessary qualifications and ten years working (public or private) experiences.
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Withdrawal of membership: The following are the reasons that will lead to withdrawal of
membership.
i. When a member becomes bankrupt
ii. He/she is convicted of a felony or any offence involving dishonesty, corruption or fraud
iii. He she becomes sick/insane and unable to perform his/her duties
iv. When the public is no more interested in his/her services
v. Where he/she has convicted by law
vi. He/she resigns his appointment through writing
vii. When he takes a political appointment
15.6 Challenges
i) Political instability: Frequent changes in government always lead to frequent changes in
government policies and activities.
ii) Lack of statistical data; the country lacks good data base to provide vital information.
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iii) Social cultural differences: The country has over 450 languages with different
cultural differences which slowdown the implementation of government policies.
iv) Corruption: Corruption has eaten deep into country. Money to carry out government
activities are diverted to personal uses.
v) Inflation: Inflation weakens the power of money and does not allow government to
implement its financial resources
vi) Financial indiscipline: Financial mismanagement and diversion of government fund is
a big problem in this country as many citizen want to satisfy self instead of the public.
vii) Poor technology: Technology changes frequent and rapidly. The inability of the
government to cope with current technology slows down information processing.
viii) Disaster: unforeseen predicament like fire, flood, epidemic (Ebola) etc makes
government to spend beyond estimation.
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Annual Budget: The commission monitors the minister of finance through the budget office
of the federation the preparation of the annual budget based on the medium-term expenditure
framework setting out actual and budgeted revenue and expenditure and detailed analysis of
performance of proceeding financial year, targets for that financial year and projections for
the next two years. Fiscal Responsibility council and the minister of financial report to the
joint finance committee of the National Assembly.
i) Budgetary planning of corporations and other related agencies. The commission
monitors the preparation and implementation of budget relating to government
corporations, agencies and government owned companies.
ii) Budgetary execution and achievement the commission. The Federal Government
shall cause to be drawn up in each financial year, an annual cash plan which shall be
prepared by the office of the Accountant-general of the federation. Ensure that an
amount set aside for a specific purpose is solely used for that purpose.
iii) Approval of Virement: virement is not allowed but in exception circumstances and in
the overall public interest, recommends to the National Assembly for approval
virement from subheads of account, without exceeding the appropriated to such head
of account.
iv) Public Revenue: This collection and disbursement is done by the Executive arm of
the Federal Government. They collect public revenue and also make payment on
monthly basis for the National Assembly approval.
v) Sailings and Assets Management: The Central Bank of Nigeria, in consultation with
the minister of finance, the state commissions of finance and local government
treasurers, inust excess proceeds and manage government asset as the case may be.
vi) Public expenditure: Increase in expenditure is only allowed when the increase is
consistent with the appropriation Act and medium-term expenditure framework.
Increase in personnel expenditure is allowed when there is a prior budgetary
allocation sufficient to cover the estimated expenditure.
vii) Debt and indebtedness: The Fiscal Responsibility Act restrict government borrowing
by all tiers of government that is not meant for capital expenditure, and human
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development and national interest. All debt to be taken by the President on the
recommendations of the minister of finance shall be approved by National Assembly.
viii) Borrowings: Borrowing by any government in the federation or its agencies and
corporations shall be for a specific purpose based on cost-benefit analysis, detailing
the economic and social benefits of the purpose towards long-terms capital
expenditure.
ix) Transparency and Accountability: Fiscal Responsibility begins with publication of a
summarized report on budget execution by the minister of finance to the National
Assembly and dissemination to the public. It is the responsibility of the office of the
Accountant-General of the federation to consolidate the audited account of the
federation and publish in mass media to the general public not later than six months
following the end of the financial year.
Self-Assessment Questions
1. The following are the objectives of FRA expect one.
A) To ensure long term Macroeconomic stability
B) To provide sound financial management
C) To encourage greater accountability
D) To encourage embezzlement
2. Choose one of the best among the following objectives of FRA
A) To encourage poverty reduction and economic and economic advancement
B) To encourage insecurity
C) To encourage final indiscipline
D) To encourage corruption
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9. The National Assembly should approve the following except one
A) Public budget
B) Public revenue
C) Public expenditure
D) Public insecurity
10. All of these are the methods adopted by the commission to perform its duties except
A) The annual budget
B) Budgetary execution
C) None of the above
D) All of the above
Solution to MCQ
1 2 3 4 5 6 7 8 9 10
D A D D D A D A D D
Theory Questions
i. Discuss the methods adopted by the commission to perform its duties
ii. List five circumstances that warrant the cessation of membership
iii. Mention five objectives FRA
References
Central Bank of Nigeria (CBN). (2009) Various Reports.
Olakanmi, J. & Co, (2010). Financial Regulations & Allied Laws, Abuja, Nigeria.
LawLords Publications.
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Should you require more explanation on this study session, please do not hesitate to contact
Are you in need of General Help as regards your studies? Do not hesitate to
contact the DLI IAG Center by e-mail or phone on:
iag@dli.unilag.edu.ng
08033366677
231
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