CHAPTER ONE

BASIC CONCEPTS OF FINANCIAL MANAGEMENT

After successfully completing this chapter, you will be able to:
Understand the meaning of finance.
Define Financial Management
Explain the evolution of financial management;
Distinguish the difference between profit maximization versus stockholders’ wealth,
maximization goal of a firm;
Identify the major decision functions of financial management;
Describe agency problem;
Identify mechanisms of resolving agency problem.

1. Overview of financial management

To have a good understanding of financial management, you need to understand first what
finance is. Literally, finance means the money used in day-to-day activities of an individual
or a business for exchange of goods and services. But here our focus rather should be to
consider finance as a separate and distinct field of study like accounting, economics,
mathematics, history, geography etc.
Meaning of Finance
 Finance is a distinct area of study that comprises facts, theories, concepts, principles,
techniques and practices related with raising and utilizing of funds (money) by
individuals, businesses, and governments.
 Finance is a very wide and dynamic field of study. It directly affects the decisions of all
individuals and organizations that earn or raise money and spend or invest it. Therefore,
finance is also an area of study that deals with how, where, by whom, why, and through
what money is transferred among and between individuals, businesses and governments.
It is concerned with the processes, institutions, markets, and instruments involved in the
transfer of funds.
 Finance is the art and science of managing money. In addition to principles and
techniques, finance requires individual judgment of the person making the financial
decision. Hence, finance can also be defined as the art and science of managing money.

 Finance is concerned with the process, institutions, markets, and instruments involved in
the transfer of money between/among individuals, businesses, and governments.
The major areas in finance are:
a. Personal Finance: This deals with the mobilization of funds from own sources. Here
funds may imply cash and non-cash items also.
b. Public finance: - This kind of finance deals with the mobilization or administration
of public funds. It includes the aspects relating to the securing the funds by the
government from public through various methods viz. taxes, borrowings from public
and foreign markets.
c. Financial Markets and Institutions:-Financial institutions are basically businesses
that deal primarily with financial matters or services. They include banks, insurance
companies, pension funds, saving and credit associations etc. Financial Markets and
institutions focus on the flow of money through financial institutions and the markets

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 in which financial assets are exchanged. They also focus on the impact of interest rate
on the flow of money.

d. Financial Management (managerial or corporate finance):- is concerned with the

acquisition and use of funds by business enterprises. Is that managerial activity which
is concerned with the planning and controlling of the firm’s financial affairs? It is the
management of capital sources and uses so as to attain the desired goals. Capital may
include:
 Items of value that are owned and used such as land, buildings, inventories etc
 Items of value that are used but not owned like leased or rent buildings
e. International Finance: - Is concerned with the international aspect of corporate
finance, investments, or financial institutions.
1.2. Definition of Financial Management
 Financial Management can be clearly defined by viewing it as a subject, a process, or a
function.
 Financial management is one major area of study under finance. It deals with decisions
made by a business firm that affect its finances. Financial management is sometimes
called corporate finance, business finance, and managerial finance. These terms are used
interchangeably in this material.
 Financial management can also be defined as a decision making process concerned with
planning for raising, and utilizing funds in a manner that achieves the goal of a firm.
 There are many specified business functions performed by a business unit. These include
marketing, production, human resource management, and financial management.
Financial management is one of the important functions of a firm. It is a specified
business function that deals with the management of capital sources and uses of a firm.
 Financial Management is that managerial activity which is concerned with the planning
and controlling of the firm’s financial resources. It is the process of making optimal use
of financial and real or physical resources to increase the value of the firm. In other
words, it is the form of management aimed at making optimal use of a firm’s financial
resources for the purpose of maximizing the owner’s wealth.

Why Study Financial Management?

 If you are approaching financial management for the first time, you might wonder why
students like you study the field of financial management and what career opportunities
exist.
 Many business decisions made by firms have financial implications. Accordingly,
financial management plays a significant role in the operation of the firm. People in all
functional areas of a firm need to understand the basics of financial management.
Accountants, information systems analysts, marketing personnel and people in operations,
all need to be equipped with the basic theories, concepts, techniques, and practices of
managerial finance if they have to make their jobs more efficient and achieve their goals.
That is why the course Financial Management is offered to students in the fields of
accounting, management, business administration, and management information systems.
 If you develop the necessary training and skills in financial management, you have career
opportunities in a good deal of positions as a financial analyst, capital budgeting, project
finance, cash, and credit manager, financial manager, banker, financial consultant, and
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 even as a general manager. The author hopes you will appreciate the importance of
financial management as you learn it more.

Role of Finance Manager

The finance manager, who is mainly responsible for managing the finances of a firm, plays a
dynamic role in the development of a modern organization. For the effective conduct of
finance function s/he is responsible for assisting the managers and supervisors in carrying out
these activities and for ensuring that their line instructions confirm to the relevant specialist
policy. The Finance Manager besides supervising the routine functioning of his department,
also keeps the Board of Directors informed on all phases of business activity, including the
economic, technological, social, cultural, political and legal environment effecting business
behavior.

The finance manager generally holds one of the senior-most positions in the company,
directly reporting to the President. He is primarily responsible for the entire cost, finance,
accounting and taxation departments in addition to the overall administration and secretarial
departments.

1.3. The scope of financial management

The scope of financial management refers to the range or extent of matters being dealt with in
financial management. Financial management has undergone significant changes over the
years as regards its scope and coverage. As such the role of finance manager has also
undergone fundamental changes over the years

 Traditionally, financial management was viewed as a field of study limited to only raising
of money. Under the traditional approach, the scope and role of financial management
was considered in a very narrow sense of procurement of funds from external sources.
The subject of finance was limited to the discussion of only financial institutions,
financial instruments, and the legal and accounting relationships between a firm and its
external sources of funds. Internal financial decision makings as cash and credit
management, inventory control, capital budgeting were ignored. Simply stating, the old
approach treated financial management in a narrow sense and the financial manager as a
less important person in the overall corporate management.

 However, the modern or contemporary approach views financial management in a broad

sense. Corporate finance is defined much more broadly to include any business decisions
made by a firm that affect its finance. According to the modern approach, financial
management provides a conceptual and analytical framework for the three major financial
decision making functions of a firm. Accordingly, the scope of managerial finance
involves the solution to investing, financing, and dividend policy problems of a firm.
Besides, unlike the old approach, here, the financial manager’s role includes both
acquiring of funds from external sources and allocating of the funds efficiently within the
firm thereby making internal decisions.

1.4. Goal of financial management

Financial management, as an academic discipline, is concerned with decision-making with

regard to the size and composition of assets and structure of financing. To make wise
decisions, a clear understanding of the objectives which are sought to be achieved is
necessary. The objectives provide a framework for optimum financial decision making

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If we were to consider possible financial goals, we might come up with some ideas like the
following:
 Survive.
 Avoid financial distress and bankruptcy.
 Beat the competition.
 Maximize sales or market share.
 Minimize costs.
 Maximize profits.
 Maintain steady earnings growth.
These are only a few of the goals we could list. Furthermore, each of these possibilities presents

problems as a goal for the financial manager.

Let us now review the well known and widely discussed approaches available in financial
literature viz., (a) Profit Maximization and (b) Wealth Maximization.
1. Profit Maximization:
According to this approach, actions that increase profits should only be undertaken.
Frequently, maximization of profits is required as the proper objective of the firm. However,
the profit maximization objective has been criticized in recent past it is argued that profit
maximization is a consequence of perfect competition and in the context of today’s imperfect
competition; it cannot be taken as a legitimate objective of the firm. It is also argued that
profit maximization, as a business objective, developed in the early 19 th Century when the
characteristic features of the business structure were self-financing, private property and
single entrepreneurship. The only aim of the enterprises at that time was to enhance the
individual wealth and personal power, which could easily be satisfied by the profit
maximization objective.
The formation of joint stock companies resulted in the divorce between management and
ownership. The business firm today is financed by owners – the holders of its equity capital
and outsiders (creditors) and controlled and directed by professional managers. The other
interested parties connected with the business firm are customers, employees, government
and society. In this changed business structure, the owner-management of the 19 th century has
been replaced by professional manager who has to reconcile the conflicting objectives of all
the parties connected with the business firm.
In this new business environment, profit maximization is not an inclusive goal as that of
maximizing shareholder value. For one thing, total profits are not as important as Earnings
Per Share. A firm could always raise total profits by issuing stock and using the proceeds to
invest in Treasury Bills. Maximizing firm profits is often mistaken as the primary goal of the
firm. While increasing firm profits is important to firms, it is not the primary goal because
shareholder wealth can actually decline despite rising profits.
Apart from the aforesaid objections, the other important technical flaws of this criterion are:
a. There is a lack of unanimity regarding the concept of profit. There are various terms
such as gross profit, net profit, earnings, short-term profit and long-term profit.
b. Profits while enhancing the national income, may not contribute to the welfare of the
poor, because they may lead to concentration of income and wealth.
c. The assumptions on which it is based are untenable. There exists no perfect
competition in the market. Similarly, all countries do not favor the idea of free
enterprises economy. There exist certain controls, which will limit the profit
maximizing capacity of the undertakings.
d. This theory is also criticized for ignoring the timing of returns and risk. It doesn’t
take the returns in terms of their present value.
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 Ex. 1 Project A Project B
Benefits in Birrs Benefits in Birrs
Period 1 5, 000 _
2 10, 000 10, 000
3 5, 000 10, 000
20, 000 20, 000
Though A, B generating some profit A is preferred quality of benefits
Ex. 2 Uncertainty about expected profits
Profits in Birrs
State of Economy A B
Recession 1, 000 0
Normal 1, 000 1, 000
Boom 1, 000 2, 000
3, 000 3, 000
Again we prefer A than B
Hence, the profit maximization has lost its relevance in the present day circumstances. Many
financial experts like Van Horne, Weston and Brigham, Pondey, Gitman, Kuchhal, Khan, and
Prasanna Chandra are now advocating for the maximization of wealth as the goal of the firm.

2. Wealth Maximization:
This approach is also known as Value Maximization or Net Present Wealth Maximization.
Wealth maximization means maximizing the net present value (NPV) of a course of action.
The NPV of a course of action is the difference between the gross present value (GPV) of the
benefits of that action and the amount of investment required to achieve those benefits. The
GPV of a course of action is found out by discounting or capitalizing its benefits at a rate
which reflects their timing and uncertainty. A financial action which has a positive NPV
creates wealth and therefore, is desirable. A financial action resulting in negative NPV should
be rejected.
The operational objective of financial management is the maximization of ‘Wealth’.
Alternatively ‘W’ can be expressed symbolically by a short-cut method:
A1 A2 An
Wealth =   ......  C
(1  k ) 1
(1  k ) 2
(1  k ) n
Where W = Net Present Wealth
A1, A2, An = Stream of cash flows expected to occur from a course of action over a period of
time.
K = Appropriate discount rate to measure risk and timing.
C = Initial outlay to acquire that asset or pursue the course of action.
The wealth of shareholders is directly affected by both the market price of the common stock
they own and the dividends they receive. Since the price of a firm’s common stock reflects
both aspects of investor returns, the goal of management is to maximize the value of the
firm’s common stock. The goal of maximizing shareholder wealth is done by maximizing the
value of the firm’s common stock.

Maximizing shareholder wealth is the process of making financing decisions and investment
decisions for both long and short run, which maximize the market value of the stock. Wealth
maximization requires serious efforts from the part of the management. In order to encourage

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the management to work hard for maximizing the wealth, a number of managerial incentives
may be necessary. Healthy threats can also be used to encourage them.

The wealth maximization objective is consistent with the objective of maximizing the
owners’ economic welfare. Maximizing the economic welfare of owners is equivalent of the
company’s shares. Therefore, the wealth maximization principle implies that the fundamental
objective of a firm should be to maximize the market value of its shares.

The objective of shareholders’ wealth maximization has a number of distinct advantages. It is

conceptually possible to determine whether a particular financial decision is consistent with
this objective or not. If a decision made by a firm has the effect of increasing the long-term
market price of the firm’s stock then it is a good decision. If it appears that certain action will
not achieve this result then the action should not be taken. The wealth maximization objective
acceptable as an operationally feasible criterion to guide financial decisions only when it is
consistent with the interests of all those groups such as shareholders, creditors, employees,
management and the society.
From the above discussion, it can be said that wealth maximization is the most appropriate
and operationally feasible decision criterion for financial management decisions. But, wealth
maximization cannot be achieved by overnight. It takes years of sustained hard work,
combined with patience and perseverance.
The firm should no way ignore the social responsibility in its hurry to maximize the wealth.
When the firms focus on their shareholders’ interests, they must bear in mind that they are
responsible for the welfare of their employees, customers and the communities in which they
operate. The firms have an ethical responsibility to provide a safe working condition, to avoid
polluting the air and water and to produce safe products.

1.5. Functions of Financial Management and Roles of Financial Manager

Financial Management has varied functions. It includes such varied tasks as budgeting,
financial forecasting, asset management, credit administration, investment analysis, acquiring
finance funds etc. In general, the decision functions of financial management can be broken
down into three major areas:
 Investment decision function
 Financing decision function,
 Dividend decision, and
Each of these functions must be considered in relation to the objective of the firm. The
optimal combination of these finance functions will maximize the value of the firm to its
shareholders.
Investment
Decisions
Retur
n

Financing
Decisions Market Value
of the firm
Risk

Dividend
Decisions 6
1. Investment Decision
The investment decision relates to the selection of assets in which funds will be invested by a
firm. The assets which can be acquired fall into two broad groups: (i) long-term assets which
will yield a return over a period of time in future, (ii) short-term or current assets defined as
those assets which are convertible into cash usually within a year. Accordingly, the asset
selection decision of a firm is of two types. The first of these involving fixed assets is
popularly known as ‘Capital Budgeting’. The aspect of financial decision-making with
reference to current assets or short-term assets is designated as ‘Working Capital
Management.’

Capital Budgeting: Capital budgeting refers to the decision making process by which a firm
evaluates the purchase of major fixed assets, including buildings, machinery and equipment.
It deals exclusively with major investment proposals which are essentially long-term projects.
Capital Budgeting involves a long-term planning for making a financing proposed capital
outlays. Most expenditure for long-lived assets affects a firm’s operations over a period of
years. They are large and permanent commitments, which influence firm’s long-run
flexibility and earning power. It is a process by which available cash and credit resources are
allocated among competitive long-term investment opportunities so as to promote the highest
profitability of company over a period of time. It refers to the total process of generating,
evaluating, selecting and following up on capital expenditure alternatives.

Because of the uncertain future, capital budgeting decision involves risk. The investment
proposals should, therefore, be evaluated in terms of both expected return and the risk
associated with the return. Besides a decision to commit funds in new investment proposals,
capital budgeting also involves the question of recommitting funds when an old asset
becomes non-profitable. The other major aspect of capital budgeting theory relates to the
selection of a standard or hurdle rate against which the expected return of new investment can
be assessed.

Working Capital Management: Working Capital Management is concerned with the

management of the current assets. The finance manager should manage the current assets
efficiently for safe-guarding the firm against the dangers of liquidity and insolvency.
Involvement of funds in current assets reduces the profitability of the firm. But the finance
manager should also equally look after the current financial needs of the firm to maintain
optimum production. Thus, a conflict exists between profitability and liquidity while
managing the current assets. As such the finance manager must try to achieve a proper trade-
off between profitability and liquidity.

Another aspect to which the finance manager of a company has to pay attention is
maintenance of a sound working capital position. S/he often times confronted with excess and
shortages of working capital. While an excessive working capital leads to un remunerative
use of scarce funds; inadequate working capital interrupts the smooth flow of business
activity and impairs profitability.

2. Financing ( Capital structure) Decision

In this function, the finance manager has to estimate carefully the total funds required by the
enterprise, after taking into account both the fixed and working capital requirements. In this
context, the financial manager is required to determine the best financing mix or capital
structure of the firm. Then, s/he must decide when, where and how to acquire funds to meet
the firm’s investment needs.
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The central issue before the finance manager is to determine the proportion of equity capital
and debt capital. He must strive to obtain the best financing mix or optimum capital structure
for his firm. The use of debt capital affects the return and risk of shareholders. The return on
equity will increase, but also the risk. A proper balance will have to be struck between return
and risk. When the shareholders return is maximized with minimum risk, the market value
per share will be maximized and firm’s capital structure would be optimum. Once the
financial manager is able to determine the best combination of debt and equity, s/he must
raise the appropriate amount through best available sources.

3. Dividend Decision:

Dividend decision is the third major financial decision. How much of a firm’s funds should be
reinvested in the business and how much should be returned to the owners should be
determined and set as a policy. The financial manager must decide whether the firm should
distribute all profits, or retain them, or distribute a portion and retain the balance. Like the
debt policy, the dividend policy should be determined in terms of its impact on the
shareholders’ value. The optimum dividend policy is one that maximizes the market value of
the firm’s shares. Thus if shareholders are not indifferent to the firm’s dividend policy, the
financial manager must determine the optimum dividend – payout ratio. The payout ratio is
equal to the percentage of dividends to earnings available to shareholders. The financial
manager should also consider the questions of dividend stability, bonus shares and cash
dividends in practice. Most profitable companies pay cash dividends regularly. Periodically,
additional shares, called bonus share (or stock dividend), are also issued to the existing
shareholders in addition to the cash dividend.

1.6. Relationship of Financial Management with Other Fields

Financial Management and Economics: The field of Economics is closely related to

Financial Management. Economics is a sort of ‘Mother Science’ to Finance. Financial
Managers must understand the framework and be alert to the consequences of varying levels
of economic activity and changes in economic policy. S/he must have the knowledge of the
institutional structure such as the banking system and the relationship between the various
sectors of the economy. S/he must be thorough with the economic variables such as GNP,
Disposable Income, unemployment, inflation, interest rates, taxes etc. and be able to use
economic theories as guidelines for efficient business operation.

Financial Management and Accounting

Indeed, financial management and accounting are not often easily distinguishable.
Accounting is said to be the ‘Language of Finance.’ It provides financial data through income
statements, balance sheets and the statement of cash flows. The financial manager must know
how to interpret and use these statements.
In small firms, the controller often carries out the finance function, and in large firms, many
accountants are intimately involved in various finance activities. However, there are two
basic differences between finance and accounting:
The accountants employ accrual method, which recognizes revenue at the point of sale and
expenses when incurred, for preparing financial statements. But, the financial manager places

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primary emphasis on cash flows, the intake and outgo of cash. However, the financial
manager must be able to use and understand accrual – based financial statements.
Whereas the accountant devotes most of his attention to collection and presentation of
financial data, the financial manager evaluates the accountant’s statements, develops
additional data, and makes decisions based on his assessment of the associated returns and
risks. This doesn’t mean that accountants never take decisions or the financial managers
never gather data; but the primary focuses of accounting and finance are distinctly different.

Financial Management and Politics

Political awareness is necessary for a financial manager to be successful. This will help
him/her predict the changes that might take place in the economic and financial areas of the
country, especially increase or decrease in taxes, interests and so on. The financial manager
must also be in touch with the international politics, especially when the firm tries to be an
MNC (Multinational Corporation).
Financial Management and Law

The financial management should be carried out taking the laws of the country into account.
The commercial laws, especially contract laws, company and partnership laws, and laws of
negotiable instrument are very important for financial management. The financial manager
should also be acquainted with the labor laws and industrial laws of the country. S/he should
also be alert towards the proclamations made by the government now and then.
Financial Management and Ethics
A business enterprise actually strengthens its competitive position by maintaining high
ethical standards. Financial management without ethics will lead to a number of conflicts
between the society and the firm. The firm should not try to maximize its profit unethically.
The firm should not forget that it is using the resources of the society and the society will
restrict the usage of such resources if they are not properly used for the benefit of the society.
Employment of ethical concepts in financial management practices will reduce potential
litigation and judgment costs, maintain a positive corporate image, build shareholders’
confidence and gain the loyalty, commitment and respect of all the firm’s stakeholders.
Ethical behavior is therefore viewed as necessary for achievement of the firm’s goal of owner
wealth maximization.

1.7. Agency Problems and Social Responsibility

An agency relationship exists when one or more persons (called principals) employ
one or more other persons (called agents) to perform some tasks. Primary agency
relationships exist (1) between shareholders and managers and (2) between creditors and
shareholders. They are the major source of agency problems.

i. Shareholders Vs Managers

The agency problem arises when a manager owns less than 100 percent of the company's
ownership. As a result of the separation between the managers and owners, managers
may make decisions that are not in line with the goal of maximizing stockholder wealth.
For example, they may work less eagerly and benefit themselves in terms of salary and
bonus. The costs associated with the agency problem are:
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 a. Direct agency costs
 Purchase of luxurious and unneeded cars
 Unnecessarily furnished offices
 Make favor to others with corporate resources
b. Indirect agency costs
 Avoid beneficial projects that involve greater risk (lost opportunities)
The possible means of reducing conflict of interest between managers and owners are:
a. Attractive incentives
 Stock options (the option to buy stock at a bargain price);
 Perquisites (Bonus, privileges, better salary, promotion etc)
 Performance shares (shares of stock given to executives on the basis of
performance as measured by earnings per share, return on assets, return on equity
etc)
b. Proxy fight (the threat of firing managers)
 A Proxy is the authority to vote someone else’s stock. A proxy fight is a
mechanism by which unhappy stockholders can act to replace the existing
board, and thereby replace the existing management.
c. The threat of hostile takeovers
 Hostile takeover refers to the acquisition of the firm over the opposition of its
management. In hostile takeover, management does not want the firm to be
taken over. It occurs when the firm’s stock is undervalued relative to its
potential. In hostile takeover, the managers of the acquired firm are fired, and
lose their prior benefits. Thus, managers have strong incentives to take actions
that maximize stock price.

ii. Creditors Vs Shareholders

Conflicts develop if (1) managers, acting in the interest of shareholders, take on projects
with greater risk than creditors anticipated and (2) raise the debt level higher than was
expected. These actions tend to reduce the value of the debt outstanding.

Review Questions

1. What is finance? Distinguish between finance and finance management?

2. What are the major areas of finance?
3. What is the primary goal of financial management? What is the indication for the
achievement of this goal?
4. What are the limitations of profit maximization as the financial goal of the firm?
5. What is an agency relationship? What is agency problem? Give at least three
examples of potential agency problems between managers and shareholders.
6. List several factors that motivate managers to act in the best interest of the
owners.
7. List the major roles of financial manager in business

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 CHAPTER TWO

PUBLIC DEBT MANAGEMENT

From time to time governmental entities have a shortage of cash to carry out their activities.
In such cases, governmental entities may turn to borrowing to supply the needed cash. This
especially is true when cash is needed for capital projects.
When money is borrowed therefore, there should be plan to repay it and the resources which
have been designated to repay the debt with its interest should not be used for any other
purpose. For the purpose of administering the repayment plan and to keep separate resources
designated for the payment of the debt and its interest, the debt service fund is created.

What is Public Debt? Meaning

Public debt or public borrowing is considered to be an important source of income to the

government. If revenue collected through taxes & other sources is not adequate to cover
government expenditure government may resort to borrowing. Such borrowings become
necessary more in times of financial crises & emergencies like war, droughts, etc.
Public Debt Management
Public debt refers to borrowing by a government from within the country or from abroad,
from private individuals or association of individuals or from banking and non-banking
financial institutions.

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A country may stop moving forward in economic progress if over burdened by external
Debt.

Justification for Borrowing

Government borrows in order to close the resource gap.

1. To cover budgetary deficit.
2. to maintain economic stability.
3. to finance development plan. (infrastructure)
4. to finance wars.
5. to allocate resources.
6. to finance public enterprises.

Deficit Financing

In general, there exists high correlation between tax revenues and public expenditures.
• Budget deficits and surpluses occur whenever public expenditures and tax revenues
diverge.
• Budget deficits by definition mean that public expenditures exceed tax revenues.
• In the U.S.A, meeting budget deficits by public borrowing is termed deficit
financing.
• This is not so in the case of some developing countries. They have a different concept
of deficit financing.
The main objective of public debt management is

• to ensure that the government's financing needs and its payment obligations are met at
the lowest possible cost over the medium to long run, consistent with a prudent degree
of risk.
• Prudent risk management is needed to avoid dangerous Debt structures and strategies.
• Debt management should encompass the main financial obligations over which the
central government exercises control.

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Opposing views on the necessity of Debt

There are two opposing views on the necessity of Debt, one in favor of it, the other against it.
For example as Cole porter “we and government fall in Debt but if our Debt is to buy houses
and for capital investment that have a long run payoff and can be able to pay back,
borrowing can be beneficial”.
• But if it is to wage, war or to cover current expenditure it is harmful for legal,
economic and psychology of the borrower.
• On the other hand In the Book of Proverbs, Says that the borrower is servant to the
lender. Similarly, many years ago, the Roman author Publilius Syrups Declared that
Debt is the slavery of the free.
Causes of public Debt

• Overspending by the government

• Unforeseen and sudden development
• Capital formation (undertaking of welfare schemes by governments in modern times.)
• The most important cause of increase in public Debt is war of war-preparedness.
• Many national governments incur such debt because of an unwillingness to limit
spending or increase taxes for fear of the political consequences. Borrowing to
finance public works, especially when widespread unemployment exists, is another
source of public debt and is justified in part by their long-term social utility.

Solutions
• The only way to reduce the debt is to either raise taxes or cut spending. 
• the government cuts spending too much, economic growth will slow. That leads to
lower revenues and a larger deficit. The best solution is to cut spending on areas that
do not create many jobs.

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Types of Public Debt
public debt refers to loans incurred by the government to finance its activities when other
sources of public income fail to meet the requirements.
1. Internal debt 4. Short Term
2. External debt 5. Long term Loans
6. Productive
7. unproductive 

Productive and Unproductive:

The productive debt is expected to create assets which will yield income sufficient to pay the
principal and interest on the loan. In other words, they are expected to pay their way; they are
self-liquidating. On the other hand, loans raised for war do not create any asset; they are a
deadweight and are regarded as unproductive.
Short-term and Long-term
Short-term loans are repayable after short interval of time, e.g. Treasury Bills payable after
three months, ways and means advances from the Central Bank. They are intended to bridge
the gap temporarily between current revenue and current expenditure. It is called floating
debt. Long-term loans are payable after a long time covering several years. They are also
called funded debt.
Effects of Public Debts
 Public Debt and sources of Borrowing
 Public Debt and purposes of Borrowing
 Public Debt and the Rates of Interest
 Public debt and the Amount of Loans
Effects of Public Debts upon the Economy
 Effects on allocative efficiency
 Effect on level of investment
 Effect on the money market
 Effect on the private sector
 Effect of public Debt on production
 Effects of public Debt on distribution
 Effects of foreign loans on the economy
 Effects of public debt on the saving effort of the economy
How much long-term Debt?
Determining debt carrying capacity
º Debt capacity depends upon quantity and quality of available resources that can be legally
used to pay debt
º Before debt capacity is determined debt burden should be calculated.
º Debt burden is compared with available resources

Includes Debt issued to foreign citizens

º It can be issued to
E Foreign financial institutions
E International financial institutions such as WB, AfDB, ADB…
E Foreign governments
º External Debt is paid using foreign reserve money.

14
Methods of Repayment of Public Debt

• 1. Use of Current Revenue: Pay off the security with funds received from current
revenues
• 2. Refunding: Pay off the security with funds received by issuing new securities
• 3. Renege: Another option would be to renege (brake your word/brake your promise)
on promises to pay off investors. .
• Government debt has the lowest interest rates of any Debt because investors perceive
it as carrying the lowest risk of default.
• 4. Privatization: Sell some of the public sector enterprises to reduce the fiscal deficit.
• 5. Monetize: Paying public debt by increasing the supply of money. This will result
in liquidating the Debt through inflation.

Measures of Debt burden

¾ The measures include

P Public debt to GDP
P Budget deficit to GDP
P Primary balance to GDP
P Interest payments to GDP
P Interest payments to total revenue

Public Debt management

• Public Debt management refers to the formation of the Debt policy by the government
to achieve certain objectives and the implementation of that policy.
• According to the International Monetary Fund, public Debt management refers to
strategies employed by a country's national authority to manage external debt. This
includes loans given to a government by other countries.

Essential Elements

• 1. Properly developed debt policies

• 2. Central Borrowing Authority
• 3. Strict Foreign Exchange Controls
• 4. Proper deployment of external resources
• 5. Prompt Debt Servicing
• 6. Timely Implementation of Projects
• 7. Transparency

For Example ETHIOPIA External Public Debt per person and External Public Debt as
percent of GDP

• Ø External Public Debt: 11,117,220,000

• Ø Population:91,000,000
• Ø GDP: 54,493,484,656
• Ø External Public Debt per person: 122.16 ? 11,117,220,000/91,000,000
• Ø External Public Debt as percent of GDP: 20.4?
11,117,220,000/54,493,484,656

15
What Is Cost of Capital?

Cost of capital refers to the opportunity cost of making a specific investment. It is the rate of
return that could have been earned by putting the same money into a different investment
with equal risk. Thus, the cost of capital is the rate of return required to persuade the investor
to make a given investment.

How Cost of Capital Works

Cost of capital is determined by the market and represents the degree of perceived risk by
investors. When given the choice between two investments of equal risk,
investors will determine the cost of capital and generally choose the one providing the higher
return.

Definition of WACC

A firm’s Weighted Average Cost of Capital (WACC) The purpose of WACC is to

determine the cost of each part of the company’s capital Structure based on the proportion of
equity and Debt.  The cost of each type of capital is weighted by its percentage of total capital
and they are added together.

COST OF CAPITAL

¾ Is the cost of using funds

¾ Includes cost of debt and equity capital
¾ Cost of debt (Kd) is measured by interest on debt
¾ Debt has a tax advantage because interest is tax deductible.
¾ Therefore, after tax cost of debt should be used in determining overall cost of capital
¾ Cost of equity (Ke) is measured by opportunity cost of equity capital
• Weighted Average Cost of Capital (WACC)
¾ Sum of cost of debt and equity based on their relative weights
¾ Mathematically. WACC = (We x Ke) + (Wd x Kd)

16
Given
• Kd (cost of Debt) = 2 million
• Ke (cost of Equity) = 3 million
• Rate of interest = 35% = 0.35
• We (Weighted Equity cost ) = 12% = 0.12
• WD (Weighted Debt) = ?
• WACC (Weighted average cost of Capital) = ?

Solution

• Total of Opportunity cost = 2+3 = 5 million

• 2million X100 40%

5million

• 3million X100 60%

5million
• After tax deducted = 10%(1- r)
• Weighted Debt = 0.1( 1- 0.35 )
• Weighted Debt = 0.1(0.65)
• Weighted Debt = 0.065 = 6.5% ?

Weighted average cost of capital

• (We x Ke) + (Wd x kd)

• WACC = (0.12 X 0.6) + (0.065 X 0.4)
• WACC = (0.072) + (0.026)
• WACC = 0.098 = 9.8% ?

Public Debt Management

End of the session

17
 Chapter THREE
ETHIOPIA BUDGET SYSTEM

Budget in Ethiopia
The word now means, “Plans of government finances submitted for the
approval of the legislature”. The budget reflects what the government intends to
do. The budget has become the powerful instrument for fulfilling the basic
objectives of government. The budget covers all the transactions of the central
government.
Budget is a time bound financial program systematically worked out and ready for
execution in the ensuing fiscal year. It is a comprehensive plan of action, which brings
together in one consolidated statement all financial requirements of the government. The
budget goes into operation only after it is approved by the parliament. A rational decision
regarding allocation of resources to satisfy different social wants requires considerable
thinking and planning. Thus budget is an annual statement of receipts and payments of a
government.
Functions of Budget
The functions of budget include the following:

- proper allocation of resources: - to relate expenditure decisions to specified policy

objectives and to existing and future resources;

- to relate all major decisions to the state of the national economy;

- long term economic growth:- to ensure efficiency and effectiveness in the

implementation of government programs;

- to facilitate legislative control over the various phases of the budgetary process.

- equitable distribution of income and wealth and

- Securing economic stability and full employment.

It implies that the objective of budget policy is to take corrective measures or to adopt
regulatory policies to remove imperfection or inefficiencies of market mechanism. Besides,
the objective of the budget policy is to make provision of social goods or the process by

18
which total resources are divided between private and social goods. It means that the
objective of budget policy is to ensure equitable distribution of income and wealth. This may
be termed as distribution function. Third objective of budget policy is to maintain a high level
of employment, reasonable degree of price stability and an appropriate rate of economic
growth.
To implement its economic functions government raises revenues through taxation. Fees and
charges, and spend them on different programs and activities. This process of rising revenues
and spending by government is performed through budgeting. Budget thus stands for the
yearly plans/forecasts of government revenues and expenditures. The budgeting process starts
from the initial stage of preparing the annual revenues and expenditures forecast and end at
the stages of approval by the higher government body followed by its implementation.
The Concept of Budgeting in Ethiopia
The government budget represents a plan/forecast by government of its expenditures and
revenues for a specified period. Commonly government budget is prepared for a year, known
as a financial year or fiscal year. In Ethiopia the fiscal year is from July 7 of this year to July
6 of the coming year (Hamle 1-Sene 30 in Ethiopian calendar). Budgeting involves different
tasks on the expenditures and revenues sides of government finance. On the side of
expenditure, it deals with the determination of the total deals with the determination of the
total size of the budget (i.e total amount of money for the year), size of outlays on different
functions, and the magnitude of outlays on various activities; on the revenue side, it involves
the determination of the size of the overall revenue and foreign aid.
Furthermore, budgeting also address the issue of the budget deficit (i.e. the excess of outlays
over domestic revenues), and it’s financing. Budgeting is not solely a matter of finance in the
narrow sense. Rather it is an important part of government’s general economic policy. Budget
is not solely a description of fiscal policies and financial plans, rather it is a strong instrument
in engineering and dynamiting the economy and its main objectives are to devise tangible
directives and implement the long term, medium term, and annual administrative and
development programs”.
Budget Structures in Ethiopia
Budget structures are the formats that organize budget data. Budget data could be classified
in different ways and for different purposes. In the early days, for instance, budget
classification basically focused on providing a better understanding of the intentions and
purposes of government for which funds were planned and to be spent. Later on, the budget
structures started to be influenced largely by the issue of accountability. That is in addition to
providing information on what the government proposed to do, the budget structures indicate

19
the full responsibility of the spending agency. To this end the budget heads or nomenclatures
the full responsibility of the spending agency. To this end the budget head or nomenclature of
the budget are mostly mapped to each spending agency. This should not, however, imply
unnecessarily extended and detailed structure (or mapping). Perhaps, due consideration must
be taken to make the structure manageable and appropriate. The first classification of the
budget is between revenue and expenditure.

Revenue Budget
It represents the annual forecast of revenues to be raised by government through taxation and
other discretionary measures, the amount of revenues raised this way differ from country to
country both in magnitude and structure, mainly due to the level of economic development
and the type of the economy.

In Ethiopia, the revenue budget is usually structured into three major headings: ordinary
revenue, external assistance, and capital revenue. Hence, the funds expected from these
three sources are proclaimed as the annual revenue budget for the country. The revenue
budget is prepared by the Ministry of Finance (MoF) for the federal government and by
Finance Bureaus for regional governments.

Ordinary revenues include both tax and not tax revenues. the tax revenues being direct
taxes (personal income tax, rental income tax, business income tax, agricultural income tax,
tax on dividend and chance wining, land use fee and lease); indirect taxes (excise tax on
locally manufactured goods, sales tax on locally manufactured goods, service sales tax,
stamps and duty); and taxes on foreign trade (customs duty on imported goods, duty and tax
on coffee export). Non tax revenues include charges and fees; investment revenue;
miscellaneous revenue (e.g. gins); and pension contribution. The second major item in
revenue budget is external assistance. It includes: cash grants, these are grants from
multilateral and bilateral donors for different structural adjustment programs; and technical
assistance in cash and material form. The third item is capital revenue. This could be from
domestic (sales of movable properties and collection of loans), external loan from multilateral
and bilateral creditors mostly for capital projects, and grants in the form of counterpart fund.
Categories of Revenues to Government
 Revenue on the basis of Nature
The revenues on the basis nature can be classified as in the following table. Of these two
types of classifications of revenues the classification of revenues based on the nature is
considered as the ideal classification.

20
 A. Tax Revenue
The revenue from tax includes the following.
I. Tax on Income
The Government imposes two types of taxes on income.
They are tax on:
a) personal income, and
b) Corporation profits.
The personal income tax is levied on the net income of individuals, firms and other
association of persons. The tax on the net profits of the joint stock companies is known as
corporation tax.
II. Taxes on Property:
It is the tax revenue from properties including rental income tax land use tax etc.

On the basis of Nature of

Revenue

TaxTax
Revenue
Revenue Non –Tax Revenue

Commercial
Administrative Revenues

TaxTax
on on on on Tax on
Tax Tax Revenue Prices on Others
Property Commodities
Income
Income Property goods and
1. Fees services
2. Licensee Issue of
3. Form currency
4. Forfeits
5. Escheats
6. Special
Assessment
Personal Corporate Tax
Personal
Income tax tax
Income

Excise Tax Turnover Tax

Borrowings Gifts and
Customs Grants
Tax 1. From general
Public (Issuing of 1. With in the
Bonds etc Country
2. From other 2. From other
Value Added Tax Countries Countries
3. From other
Institution (IMF. 21
World Bank, etc)
 III. Taxes on Commodities
The important taxes levied by the Government on commodities are:
a) Customs Duty,
b) Excise Duty,
c) Value Added Tax
d) Turnover Tax
 Customs Duty includes both import and export duties. These duties are le
vied when the goods cross the boundaries of the country.
 Excise duties are levied on the commodities produced in the country.
Excise duties now constitute the single largest source of revenue to the
Union Government.
 Value Added Tax is levied by the Government on the commodities sold at
specified percentage on the value of sales.
 Turnover Tax is levied by the Government on the sales which are not
covered under Vat.

B. Non-Tax Revenues
The following categories of revenue are included under non-tax revenue.
 Administrative Revenue
It includes the following:
I. Fees
It is the compulsory payment made by the individuals who obtain a definite service in return.
Fees are charged by the Government to bear the cost of administrative services rendered by it.
These services are rendered for the benefit of general public. It includes court fee, registration
fee, etc.
II. Licenses
A license fee is collected not for any service rendered, but for giving permission or a
privilege to those who want to do a special or specified work. It is charged on the grounds of
control of certain activities.
III.Fines and Penalties
Fines and penalties are imposed as a form of punishment for the mistakes committed such as
violation of the provisions of law, etc. The basic aim behind them is to prevent the people

22
from making mistakes. A fine is also compulsory like a tax, but it is imposed more as a
deterent as a source of revenue.
IV. Forfeitures
Forfeiture means the penalty imposed by the courts on the persons who have not complied
with the notice served by it or for the breach of contract or has failed to pay the dues in time,
etc.
V. Escheats
The property of a person having no legal heirs and dying intestate, will be taken possession of
by the Government that is, the Government can take over the property cannot be considered
as a main source of revenue to the Government.
VI. Special Assessment
According to Prof. Seligman, special assessment means “a compulsory contribution levied in
proportion to the special benefit derived to defray the cost of the specific improvement to
property undertaken in the public interest “. Thus, it is a compulsory payment or contribution.
It is levied in proportion to the special benefits derived to bear the cost of specific
improvement to property. Whenever the Government has made certain improvements,
somebody will bet benefited. For example, irrigation facility, road and drainage facility, etc.

Budget Deficit
A budget is considered as surplus or deficit according to the position of the revenue accounts
of the government. Thus a surplus budget is one in which revenue receipts exceed
expenditure charged to revenue account regardless of the gap in capital accounts; while a
deficit budget is one in which expenditure is greater than current revenue receipts.

Budget deficit is the excess of total expenditure over total revenue of the government.
The deficit financing denotes the direct addition to gross national expenditure through budget
deficits whether the deficits are on revenue or capital accounts”. It implies that the
expenditure of the government over and above the aggregate receipt of revenue account and
capital account is treated as budget deficit of the government.

The meaning of deficit financing is different in different countries. In western countries, the
budget gap, that is covered by loans is called deficit financing because, if the government
borrows from the banks rather than from individuals the idle funds will be activated and there
will be an increase in the total public expenditure and thus there will automatically be an
deficit financing has been used in a different sense,. Here it is used to denote the direct
addition to gross national expenditure as a result of budget deficit.

23
Thus deficit financing can be defined as “the financing of a deliberately created gap between
public revenue and public expenditure”. The government of Ethiopia has used deficit
financing for acquiring funds to finance economic development. When the government
cannot raise enough financial resources through taxation, it finances its developmental
expenditure through borrowing from the market or from other sources.

Methods of Financing Deficit

There are four important techniques through which the Government may finance its
budgetary deficits. They are as follows:
A. borrowing from central bank
B. The running down of accumulated cash balances
C. The government may issue new currency
D. Borrowing from market or from external sources.
Under the first method, government borrows from central bank as per budgetary policy. In
the second source, government spends from available cash balance. In the third measure,
government issues new currency for financing deficit. The last method is that government
borrows from internal and external sources to finance its deficit.
Objectives of Deficit Financing
1. Deficit financing has generally been used as a method of meeting the financial needs of the
government in times of war, when it is considered difficult to mobilize adequate resources.
2. Keynes advocated deficit financing as an instrument of economic policy to overcome
conditions of depression and to raise the level of output and employment.
3. The use of deficit financing has also been considered essential for financing economic
development especially in under developed countries.
4. Deficit financing is also advocated for the mobilization of surplus idle and unutilized
resources in the economy.
Pattern of Revenue Sharing
Ethiopia has chosen the federal structure in which a clear distinction is made between the
union and state functions and sources of revenue, but residual powers, belong to the center,
although the states have been assigned certain taxes, which are levied and collected by them,
they also share in the revenue of certain federal taxes. In addition, the states receive grants-
in-aid of their revenue from the federal government, which further increase the amount of
transfers between the two levels of government. The transfer of resources from the central
government to the states is an essential feature of the present financial system.
Distribution of Revenues between Central and States

24
The present federal fiscal system in Ethiopia is of a recent origin. The distribution of
revenues between the centre and states is followed on the basis of "constitution of Ethiopia”
and proclamation no.33/1992-proclamation “to define sharing of revenue between the central
government and the national/regional self governments”. The articles 96, 97, 98, 99 and 100
of the constitution of Ethiopia make a clear demarcation of areas where the central alone or
state alone have authority to impose taxes. It contains a detailed list of the functions and
financial resources of the center and states.
Basis for Revenue Sharing
The sharing of revenue between the central government and the National/ Regional
governments shall take in to consideration the following Principles:
1. Ownership of source of revenue;
2. The national or regional character of the sources of revenue;
3. Convenience of levying and collection of the tax or duty;
4. Population, distribution of wealth and standard of development of each region;
5. Other factors that are basis for integrated and balanced economy.
Categorization of Revenue
According to "Constitution of Ethiopia” and Proclamation No.33/1992-Proclamation,
revenues shall be categorized as Central, Regional and Joint. That is there are three lists given
in the Articles. They are as follows:
A. Central List,
B. Regional List, and
C. Joint/Concurrent List
The important sources of revenue under "Constitution of Ethiopia” and The Proclamation
No.33/1992-Proclamation “To Define sharing of Revenue between the Central Government
and the National/Regional Self Governments” are explained below:
A. Central List
The sources of revenue are given under Federal/Central List are as follows:
I). Duties, tax and other charges levied on the importation and exportation of goods;
II). Personal income tax collected from the employees of the central Government and the
International Organizations;
III). Profit tax, Personal income tax and sales tax collected from enterprises owned by the
Central Government. (Now sales tax is replaced with VAT and Turnover taxes).
IV) Taxes collected from National Lotteries and other chance winning prizes;
V). Taxes collected on income from air, train and marine transport activities;

25
 VI). Taxes collected from rent of houses and properties owned by the central
Government;
VII) Charges and fees on licenses and services issued or rented by the central
Government;
B. Regional List
The following shall be Revenues for the Regions:
I). Personal income tax collected from the employees of the Regional Government and
Employees other than those covered under the sources of central government.
II) Rural land use fee.
III) Agricultural income tax collected from farmers not incorporated in an organization.
IV) Profit and sales tax collected individual traders.
V) Tax on income from inland water transportation.
VI) Taxes collected from rent of houses and properties owned by the Regional
Governments;
VII) Profit tax, personal income tax and sales tax collected from enterprises owned by the
Regional Government:
VIII) With prejudice to joint revenue sources, income tax, royalty and rent of land
collected from mining activities.
IX). Charges and fees on licenses and services issued or rented by the Regional Government;
C. Joint/Concurrent List
The following shall be Joint revenues of the Central Government and Regional
Governments.
I. Profit tax, personal income tax and sales tax collected from enterprises jointly
owned by the central Government and Regional Governments;
II. Profit tax, dividend tax and sales tax collected from Organizations;
III. Profit tax, royalty and rent of land collected from large scale mining, any
petroleum and gas operations;
IV. Forest royalty.

CHAPTER FOUR
MEANING AND CHARACTERISTICS OF TAXATION
Public Revenue
Sources of public revenues
Government has played an important role in the socio economic development of society.
Social development may be in the form of raising the level of living and social welfare in the
form of providing social amenities to the people. Social amenities are in the form of
26
education, health and sanitation, utilities like electric supply, water supply etc., and recreation
facilities.
The process of socio-economic development requiring huge expenditure cannot be carried
unless the government has the perennial source of income. Every government has two
important sources of revenue. These are:
(a) Tax sources, and
(b) Non-tax sources.
What is a Tax?
Tax is one of the most important sources of revenue to every government. In the earlier days,
payment of taxes was optional. A choice was given to the people to pay the tax and to avail
the benefit of social amenities in the form of education, health and sanitation, utilities and
recreation facilities. Naturally, everyone interested in availing social amenities used to
evaluate the benefit derived by him in exchange for the tax to be paid by him. But the option
in the payment of tax created lot of problems for the government in fulfilling their obligations
to society. Hence, in modern times, option was withdrawn and tax became a compulsory
contribution by every citizen to the government to enable the government to fulfill its
commitments towards society.
Every Government imposes two kinds of taxes:
(1) Direct taxes, and
(2) Indirect taxes
A tax, in the modern times, therefore is a compulsory levy and those who are taxed have to
pay the sums irrespective of corresponding return of services or goods by the government. It
is not a price paid by the tax-payer for any definite service rendered or a commodity supplied
by the government. The tax-payers do get many benefits from the government but no tax-
payer has a right to any benefit from the public expenditure on the ground that he is paying a
tax. The benefits of public expenditure may go to anyone irrespective of the taxes paid.
Therefore, we may say that taxes are compulsory payments to government without
expectation of direct return or benefit to the tax-payer.

Objectives of Taxation
Initially, governments impose taxes for three basic purposes: to cover the cost of
administration, maintaining law and order in the country and for defense. But now
government’s expenditure pattern changed and gives service to the public more than these
three basic purpose and it restore social justice in the society by providing social services
such as public health, employment, pension, housing, sanitation and other public services.
Therefore, governments need much amount of revenue than before. To generate more
revenue a government imposes taxes on various types. In general objective of taxations are:
1. Raising revenue: to render various economic and social activities, a government needs
large amount of revenue and to meet this government imposes various types of taxes.
2. Removal of inequalities in income and wealth: government adopts progressive tax system
and stressed on canon of equality to remove inequalities in income and wealth of the people.
3. Ensuring economic stability: taxation affects the general level of consumption and
production. Hence, it can be used as effective tool for achieving economic stability.
Governments use taxation to control inflation and deflation
4. Reduction in regional imbalances: If there is regional imbalance with in the country,
governments can use taxation to remove such imbalance by tax exemptions and tax
concessions to investors who made investment in under developed regions.
5. Capital accumulation
Tax concession or tax rebates given for savings or investment in provident funds, life
insurance, investment in shares and debentures lead to large amount of capital accumulation,
which is essential for the promotion of industrial development.
6. Creation of employment opportunities

27
Governments might minimize unemployment in the country by giving tax concession or
exemptions to small entrepreneurs and labor intensive industries.
7. Preventing harmful consumptions
Government can reduce harmful things on the society by levying heavy excise tax on
cigarettes, alcohols and other products, which worsen people’s health.
8. Beneficial diversion of resources
Governments impose heavy tax on non- essential and luxury goods to discourage producers
of such goods and give tax rate reduction or exemption on most essential goods. This diverts
produce’s attention and enables the country utilize to utilize the limited resources for
production of essential goods only.
9. Encouragement of exports
Governments enhance foreign exchange requirement through export-oriented strategy. These
provide a certain tax exemption for those exporters and encourage them with arranging a free
trade zones and by making a bilateral and multilateral agreement
10. Enhancement of standard of living
The government also increases the living standard of people by giving tax concessions to
certain essential goods.
Characteristics of a Good Tax System
(1) Tax is a Compulsory Contribution
A tax is a compulsory payment from the person to the Government without expectation of
any direct return. Every person has to pay direct as well as indirect taxes. As it is a
compulsory contribution, no one can refuse to pay a tax on the ground that he or she does not
get any benefit from certain public services the government provides.
(2) The Assesses will be required to pay Tax if is due from him
No one can be forced by any authority to pay tax, if it is not due from him. Suppose, if there
is a tax on liquor, the state can force an individual to pay the tax only when he drinks liquor.
But, if he does not drink liquor, he cannot be forced to pay the tax on liquor. Similarly, if an
individual’s income is below the exemption limit, he cannot be forced to pay tax on income.
For example individuals earning monthly salary below birr 150 cannot be forced to pay tax
on income.
(3) Taxes are levied by the Government
No one has the right to impose taxes. Only the government has the right to impose taxes and
to collect tax proceeds from the people.
(4) Common Benefits to All
The tax, so collected by the Government, is spent for the common benefit of all the people. In
other words, when the government collects a tax, its proceeds are spent to extend common
benefits to all the people. The Government incurs expenditure on the defense of the country,
on maintenance of law and order, provision of social services such as education, health etc.
Such benefits are given to all the people- whether they are tax-payers or non-taxpayers. These
benefits satisfy social wants. But the Government also spends on subsidies to satisfy merit
wants of poor people.
(5) No Direct Benefit
In the modern times, there is no direct relationship between the payment of tax and direct
benefits. In other words, there is absence of any benefit for taxes paid to the Governmental
authorities. The government compulsorily collects all types of taxes and does not give any
direct benefit to tax-payers for taxes paid. For example, when taxable income is earned by an
individual or a corporation, he or it simply pays the tax amount at the specified rate cannot
demand any benefit against such payment.
(6) Certain Taxes Levied for Specific Objectives
Though taxes are imposed for collecting revenue for the government to meet expenditure on
social wants and merit wants, certain taxes are imposed to achieve specific objectives. For
example, heavy taxes are imposed on luxury goods to reduce their consumption so that
resources are directed to the production of essential goods, such as cheaper variety of cloth,
28
less costly goods of mass consumption, etc. Thus, taxes are levied not only to earn revenue
but also for diversion of resources or saving foreign exchange. Certain taxes are imposed to
reduce inequalities of income and wealth.
(7) Attitude of the Tax-Payers
The attitude of the tax-payers is an important variable determining the contents of a good tax
system. It may be assumed that each tax-payer would like to be exempted from taxpaying,
while he would not mind if other bears that burden. In any case, he would want his share to
be within the general level of tax burden being borne by others. In other words, it is essential
that a good tax system should appear equitable to the tax-payers. Similarly, overall burden of
the tax system is of equal importance. The attitudes of the tax-payers in this regard are
influenced by a host of other factors like the political situation such as war or peace, natural
calamities like floods and droughts, economic situations like prosperity or depression and so
on.
(8) Good tax system should be in harmony with national objectives
A good tax system should run in harmony with important national objectives and if possible
should assist the society in achieving them. It should try to accommodate the attitude and
problems of tax payers and should also take into consideration the goals of social and
economic justice. It should also yield adequate revenue for the treasury and should be flexible
enough to move with the changing requirements of the State and the economy.
(9) Tax-system recognizes basic rights of tax-payers
A good tax system recognizes the basic rights of the tax-payers. The tax-payer is expected to
pay his taxes but not undergo harassment. In other words, the tax law should be simple in
language and the tax liability should be determined with certainty. The mode and timings of
payment should be convenient to the tax-payer. At the same time, a tax system should be
equitable between tax-payers. It should be progressive and burden of taxation should be
equitable on all the tax-payers.

Principles of taxation
A tax system (that is, the set of all taxes) for achieving certain objectives chooses and adheres
to certain principles which are termed its characteristics. A good tax system therefore, is one
of which designed on the basis of an appropriate set of principles, such as equality and
certainty. Mostly, however, objectives of taxation conflict with each other and a compromise
is needed. Therefore, usually economists select some important objectives and work out the
corresponding principles which the tax system should adhere to. The first set of such
principles was enunciated by Adam smith (which he called Cannons of Taxation)
Canons of Taxation
The four canons of taxation as prescribed by Adam Smith are the following:
(1) Canon of Equality
This canon proclaims that a good tax is that which is based on the principle of equality. In
other words subjects of every state ought to contribute towards the support of the
government, as nearly as possible, in proportion of their respective abilities, that is, in
proportion to the reserve which they respectively enjoy under the protection of the State. It
implies what the income which a person enjoys under the protection of the State, should be
taxed on the proportional rate of taxation. But modern economists do not agree with Adam
Smith. They advocate progressive taxation to observe the canon of equality. In other words,
they advocate progression should be the basis for imposing taxes.

29
(2) Canon of Certainty
This canon is meant to protect the tax payers from unnecessary harassment by the ‘tax
officials’. It implies that the tax-payer should be well informed about the time, amount and
the method of tax payment. According to Adam Smith, “the tax, which each individual is
bound to pay, ought to be certain and not arbitrary. The time of payment, the manner of
payment, the quantity to be paid, ought all to be clear and plain to the contributor and to
every other person.” Adam Smith was also of the view that the government must also be
certain of the amount which it derives from a particular tax. Thus this canon is equally
important both for the individual and the state.
(3) Canon of Convenience
The third canon of Adam Smith is that of convenience. According to Adam Smith, “every tax
ought to be so levied at the time or in the manner in which it is most likely to be convenient
for the contributor to pay it.” In other words, taxes should be imposed in such a manner and
at the time which is most convenient for the tax-payer, i.e., the best time for the collection of
land revenue is the time of harvest. Similarly, taxes on rent of houses should be collected
when it is most convenient for the contributor to pay.

(4) Canon of Economy

The fourth canon is the canon of economy. This canon implies that the administrative cost of
tax collection should be minimum, i.e., the difference between the money, which comes out
of the pockets of people and that which is deposited in the public treasury, should be as small
as possible. Administrative cost of tax collection should be minimum because levying of a
tax may require a great number of officers, whose salaries may eat up the greater part of the
produce of the tax, and whose pre-requisites may impose another additional tax upon the
people. Hence, the administrative cost should be minimum.
In addition to the above four canons given by Adam smith, the following other canons
have been advanced by Basable and other economists
(5) Canon of Productivity
The canon of productivity advocated by Bastable implies that taxes should be productive. The
productivity of a tax may be observed in two ways. In the first place, a tax should yield a
satisfactory amount for the maintenance of a government. In other words, the tax should be
such that it procures a considerable amount of revenue for the expenditure of the government,
Secondly, the taxes should not obstruct and discourage production in the short as well as in
the long run.
(6) Canon of Elasticity
Bastable also laid stress on the principle of elasticity. The canon of elasticity implies that
yields of taxes should be increased or decreased according to the needs of the government.
The government may need funds to face natural calamities and other unforeseen
contingencies. It may need funds to finance a war or for development purposes. The
government resources can be raised quickly only when the system is elastic.
(7) Canon of Diversity
The canon of diversity put forward by Bastable implies that the tax system should be diverse
in nature. In other words, in a tax system, there should be all types of taxes so that everyone
may be called upon to contribute something towards the revenues of the state. Thus, the
governments should adopt multiple tax system.
(8) Canon of Simplicity
The canon of simplicity implies that a tax should easily be understood by the tax-payer, i.e.,
its nature its aims, time, of payment, method and basis of estimation should be easily
followed by each tax-payer. In other words, the tax imposed on the tax-payers should be so
simple that they are able to guess easily the aim of its imposition and they are not confronted
with accounting, administrative or any other difficulties.

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(9) Canon of Expediency
This canon implies that the possibilities of imposing a tax should be taken into account from
different angles, i.e. its reaction upon the tax- payers. Sometimes it is seen that tax may be
desirable and may be productive and may have most of the characteristics of a good tax, yet
the government may not find it expedient to impose it, for example, progressive agricultural
income tax, but it has not been imposed. So far in the manner it should have been imposed.
EFFECTS OF TAXATION
Taxation these days is not used as means of raising revenues only, but it is an important
instrument for achieving socio-economic objectives, such as, regulation of consumption and
production, controlling booms and depression, promoting economic growth and removing
inequalities of income. The economic effects of taxation may be good as well as bad.
Therefore, the government should not keep only the revenue considerations in mind, but the
economic effects of taxation should also be considered. To put it in the words of Dalton, “The
best system of taxation from the economic point of view is that which has the best, or the
least bad economic effects.” Effects of taxation can be analyzed in terms of production,
distribution and stabilization.
Thus, in this we will discuss the economic effects under the following three heads:
 Effects of taxation on production
 Effects of taxation on distribution
 Effects of taxation on stabilization

I) Effects of Taxation on capacity to Work, Save and Invest

a) Capacity to Work
Capacity to work depends on the health and efficiency possessed by the people. Health is
related to the level of consumption which is determined by the money income of the assesse.
Imposition of higher tax reduces the purchasing power of the tax payer and his ability to
obtain the necessaries, comforts and luxuries of life. This effect is most strongly felt by the
poorer people. When the tax burden falls upon the poor, it curbs the consumption of
necessaries and comforts which lowers the standard of living and thus efficiency and ability
to work of poor people is adversely affected by taxation. For the rich, however, the ability to
work is not so much affected by taxation because taxation on rich may only curb his
luxurious consumption and this may not affect his efficiency and ability to work. Therefore,
heavy taxation on the poorer section of the community has been strongly objected by most of
the economists. Therefore, to maintain the health efficiency and ability to work of the people,
system of progressive taxation should be duly implemented by the government. In other
words, taxes on low incomes and on those articles which are largely consumed by less well to
do sections of the community should be avoided in the interest of production. This will keep
the health and efficiency intact without additional work load on them.

b) Capacity to Save
Capacity of the people to save depends on the tax policy followed by the government. Ability
to save is adversely affected by taxation as taxes fall on income and savings depend on
income. When income is reduced by taxation, savings automatically decline. Ability to save
is affected adversely in the case of those who have a higher marginal propensity to save. It is
the rich who possesses a high marginal propensity to save since their incomes exceed their
expenditure. Taxes falling on the poor have no effect on their ability to save as they have no
margin to save out of their low incomes. Since the rich are accustomed to a very high level of
living, they maintain their expenditure and pay taxes out of their savings. Hence their ability
to save is greatly reduced. This affects investment and capital formation in the economy.
Therefore, to maintain the capacity of the people to save the government should provide tax
incentives to the rich and spend the tax income on the poor to enhance their ability to save.
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c) Capacity to Invest
Capacity to invest depends on the resources available for investment that is savings. It is clear
from the above discussion that savings are reduced by taxation. When ability to save is
adversely affected by high taxes, ability to invest of those who take investment decisions is
automatically reduced. These are the people having a high entrepreneurial ability. Such
people are generally the people in the higher income group. The government has to pay a
major role in exploiting the capacity to invest of the tax payer by adopting an appropriate tax
policy. The government should exempt earnings from investment to encourage savings and
capital formation.
II) Effects of Taxation on the will to Work, Save, and Invest
a) Effects on the Will to Work
Will of the people to work depends on the nature of taxes. Each individual tax has its specific
effects. However, some taxes by their very nature have the least or no bad effect on the
willingness to work e.g., estate duty excess profit tax etc. Likewise, reasonable rates of
income tax, sales tax, etc., have no bad effects on the desire of the people to work hard.
Conversely, unduly high rates of income tax, wealth tax and commodity taxes adversely
affect the desire of the people to work hard.

b) Effects on the Will to Save

Will of the people to save depends on the volume of income, volume of tax and the tax policy
pursued by the government. If a tax payee has limited income and is hardly sufficient to meet
his/her day to day requirements it will be difficult for him to save anything. Some people
save for their old age and many times they save to improve their social prestige. So in order
to enhance the will of the people to save, the government should provide tax incentives to the
people.
c) Effects on the Will to Invest
Will of the people to invest depends on savings. If savings are taxed, nothing will be left with
the people for investment purposes. To enhance the will of the people to invest, the
government should devise such a tax policy which provides tax incentives to those who divert
their savings towards investment. Investment also depends on the treatment of income from
investment-under tax laws. If earnings are exempted from tax net, people will divert most of
their savings towards investment. People will also save and invest if they have full
knowledge about the avenues available for investment and the tax incentives associated with
each of these channels of investment.
III) Effects of Taxation on the Composition and Pattern of Production
The effects of taxation on the consumption and pattern of production depend upon allocation
of resources. When higher taxes are imposed on some industries, resources will shift from the
high taxed industries to low taxed industries. Likewise, when a tax rebate is offered, it will
encourage allocation of resources in favour of developing industries. Similarly, there will be
reallocation of resources from high taxed regions to the low taxed regions. High rate of tax on
goods of harmful consumption has a beneficial impact as the production of these goods will
be diverted to low-taxed essential goods. Taxes may thus change the pattern of production in
an economy. A high tax on the production of luxuries may improve the production of
necessaries. Some taxes, however, have no effect on diversion of resources; example, taxes
on windfall gains, high land values, monopoly profits and non-differential taxes such as
income-tax, etc. have no effect on consumption or pattern of production.
Effects of Taxation on Distribution
There are two aspects of an economy:
1. Income Generation
2. Income Distribution

Income generated in society if not distributed properly will create inequality in the
distribution of income and wealth. It will give rise to the creation of two classes that is the
32
class of the rich and the class of the poor. The gap between rich and poor will lead to class
conflict which may prove disastrous to the society. Every government in the world tries to
bridge this gap by imposing higher taxes on the richer section of the society and the proceeds
realized from such taxes are distributed among the poorer section of the society by way of
providing social amenities to them.
The effects of taxation on the distribution of income and wealth among different sections of
the society, however, depend upon two factors: nature of taxes and tax rates and kinds of
taxes.
1) Nature of Taxes and Tax Rates
By nature, taxation may be proportional, progressive or regressive. The nature of taxation
also implies as how the burden of taxation is distributed among different section of the
community.
A tax is called as proportional, if all the tax payers pay the same proportion of their income as
tax. A tax is said to be progressive, if larger is the tax payers income, the greater is the
proportion that he pays as tax. A tax is regressive, if larger is the tax payee’s income, the
smaller is the proportion, which he pays as tax.
a) Effects of Regressive Taxation on Distribution
If regressive taxation is followed, the inequalities may increase in the distribution of income
and wealth, as the burden of taxation will fall more heavily on the poor than on the rich. A
toll-tax is regressive as the amount of the tax is the same for the rich and the poor, while the
utility of money, which is paid in tax, is greater for the poor than the rich. A regressive tax
thus tends to widen the gap of inequality.
b) Effects of Proportional Taxation on Distribution
Under proportional taxation, inequalities would continue as before, if the income remains the
same. However, if the income changes in unequal proportions, the inequalities in income will
increase. For instance if A’s income is $500 and B’s income is $1,000 and both are taxed at
the rate of 10% the net income of A and B, after tax payment, would be $450 and $900
respectively. The burden of taxation falls heavily on A than on B. Hence, the burden of
taxation is higher on the poor than on the rich.
c) Effects of Progressive Taxation on Distribution
Under the progressive system of taxation, inequalities would be reduced, because a higher
proportion of the income and wealth of the rich would be taken away by taxes than that of
poor. Hence, a sharply progressive tax system tends to reduce inequalities in the distribution
of income and wealth. Sharper the progression, greater is the tendency to reduce inequalities.
Obviously, progressive system is desirable in order to bring about a more equitable
distribution wealth. However, the tax system should be based on the principle of ability to
pay. The higher the income of a person, the greater would be his ability to pay taxes and vice-
versa. People who get unearned income should be taxed at higher rate than poor because of
their greater capacity to pay taxes. The progressive tax system may be designed in such a way
that it may not have adverse effects on production.
In other words, tax system should be progressive to the highest income group, the middle
income groups should be subjected to lower tax rates and the low income groups should be
exempted from taxation.
1) Tax Rates
While fixing the rates of taxes, progression should be kept in mind. Higher taxes should be
imposed on the richer section of society and revenue realized from the rich should be utilized
for the benefit of the poorer section of the society by way of providing social amenities to
them. In other words taxes should be progressive because sharper the progression, greater is
the tendency to reduce inequalities.
2) Kinds of Taxes
Whether the effect of taxation is progressive, proportional or regressive in nature depends
upon the kinds of taxes.
There are two kinds of taxes: direct tax and indirect taxes.
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a) Indirect Taxes and Distribution
The burden of indirect taxes, like taxes on commodities is regressive in nature. The
commodities on which indirect taxes are imposed are widely consumed by the poor and they
have to spend larger proportion of their income on such goods than rich. That is, propensity
to consume is higher for the poor than that of rich. Hence, the burden of indirect taxes, like
the tax on foodstuff, raw tobacco, cheap alcohol, etc., falls more heavily upon the poor than
upon the rich. However, the indirect taxes may be made progressive if the necessities are
exempted from taxation and luxuries are subjected to higher rates of taxation so that the tax
rates would be higher for the high priced goods. But it should be noted that purchase of
luxury goods is optional. Hence, the rich can avoid the payment of these taxes by not
purchasing such goods or by contracting their demand to some extent. Therefore, indirect or
commodity taxes in general are and regressive nature. Thus, inequalities of income and
wealth cannot reduced by these taxes.
b) Direct Taxes and Distribution
To bring about equitable distribution of income and wealth, all taxes which fall heavily or
exclusively upon the richer section of society can have favorable distribution effects. All
direct taxes which are based on the principle of progression and ability to pay may have
desire distributional effects.
Effects of Taxation on Stabilization
Economic stability may be judged by the behavior of prices. This does not mean that prices
should remain static. Conversely there should be a normal rise in price because a normal rise
in price is a sign of healthy economy. Problem, however, arises whenever there are price
fluctuations. These price fluctuations may be known as abnormal economic situations
prevailing in the country. Economic stability also implies stability in the economic activity,
output and employment. It also refers to the avoidance of inflationary and deflationary
conditions. Every government tries to overcome these problems through fiscal measures
which is the safest and the durable course adopted by any government to control such
situations.
There may be two abnormal economic situations:
 Inflation
 Deflation

Classification and choice of Taxes

Direct and Indirect Taxes:
Taxes are sometimes referred to as direct or indirect. The meaning of these terms can
vary in different contexts, which can sometimes lead to confusion. In economics, direct
taxes refer to those taxes that are paid by the person who earns the income. By contrast,
the cost of indirect taxes is borne by someone other than the person responsible for paying
them. For example, taxes on goods are often included in the price of the items, so even
though the seller sends the payments to the government, the buyer is the real payer.
Indirect taxes are sometimes described as hidden taxes because the purchaser of goods or
services may not be aware that a proportion of the price is going to the government.
I. Direct Taxes:
A direct tax is paid by a person on whom it is levied. In direct taxes, the impact and
Incidence fall on the same person. If the impact and incident of a tax fall on the same

34
person, it is called as direct tax. It is borne by the person on whom it is levied and cannot be
passed on to others. For example, when a person is assessed to income tax or wealth tax, he
has to pay it and he cannot shift the tax burden to anybody else. In Ethiopia, Government
levies the direct taxes such as income tax, tax on agricultural income, professional tax, land
revenues, taxes on stamps and registrations etc. From the above discussion, it can be
understood that the direct taxes levied in Ethiopia take the form of taxes on income and
property.
II. Indirect Taxes
Under indirect taxes, the impact and incidence fall on different persons. It is not borne by the
person on whom it is levied and can be passed on to others. For example, when the excise
duty is levied on the manufacturer of cement, he shifts the burden of tax to the consumers by
raising the selling price. Here the impact of excise duty falls on the manufacturer and the
incidence on the ultimate consumers. The person who is required to pay the tax does not bear
its burden. Thus, indirect taxes can be shifted.
. Differences between Direct and Indirect Taxes:
Direct and Indirect taxes differ among themselves on the following grounds:
1. Shift ability of the Burden of Tax: In the direct taxes, the impact and incidence fall on
the same person. It is borne by the person on whom it is levied and is not passed on to
others. For example, when a person is assessed to income tax, he cannot shift the tax
burden to anybody else, and he himself has to bear it. On the other hand, in the case of
indirect taxes, the impact and incidence fall on different persons. It is not borne by the
person on whom it is levied. The burden of the tax can be shifted. For example, when the
manufacturer of cement pays excise duty, he can shift the tax burden to the buyers by
including the tax in the price of the cement.
2. Principle of Ability to Pay: Direct taxes conform to the principle of ability to pay. For
example, now people having income above Birr.150 pm, only is liable to pay income tax.
But, indirect taxes are borne and paid by the weaker sections of the society also. As such,
these taxes do not conform to the principle of ability to pay.
3. Measurement of Taxable Capacity: In the case of direct taxes, tax-paying capacity is
directly measured. For example, the taxable capacity for income tax is measured on basis of
the income of the individual. On the other hand, in the case of indirect taxes, taxable capacity
is measured indirectly. The luxurious articles are levied at the higher rate of taxes on the
assumption that they are purchased by the rich people. However, low rate is charged on the
articles of common consumption.

35
4. Principle of Certainty: Direct taxes ensure the principle of certainty. Both the
Government and the taxpayer know what amount is to be paid and the procedures to be
followed. But in the case of indirect taxes, it is not possible. The taxpayer does not know the
amount of tax to be paid and the Government cannot predict the quantum of revenue
generated from the indirect taxes.
5. Convenience: Direct taxes cause much inconvenience to the taxpayers since they are to be
paid in lump sum. But the indirect taxes are paid by the consumers in small amounts as and
when they purchase the commodities. Moreover, the taxpayers need not follow any legal
formalities in the payment of tax. Thus, indirect taxes are more convenient to them.
6. Civic Consciousness: People felt the burden of direct taxes directly. The taxpayer is
conscious of his contribution to the Government and interested in knowing whether the tax
paid by him is properly used or not. In this way, it creates civic consciousness among the
taxpayers. But indirect taxes do not raise such consciousness among the taxpayers, because
they pay the taxes indirectly.
7. Nature of Taxation: Direct taxes are progressive in nature. The rates of taxes go up with
the increase in the tax base i.e. income of a tax payer. But rich and poor irrespective of their
income equally pay indirect taxes. Thus, they are regressive in nature.
8. Removal of Disparity in Income and Wealth: Since the direct taxes are progressive in
nature, they reduce the disparities of income and wealth among the people to a
considerable extent. But indirect taxes have a negative effect. Actually they are widening
the gap between the rich and poor when they are levied on the goods of common
consumption.
9. Examples: The examples for direct taxes are income tax, wealth tax, gift tax, estate duty
etc. The examples for indirect taxes are customs duty, excise duty, sales tax, and service tax
Etc.
2.4 Single Vs Multiple Tax System
 On the basis of volume (Single and Multiple tax)

Single tax: - It refers to the system in which the taxes are levied only on the ‘item’ or ‘head
of tax’. There is only one kind of tax, which constitutes the source of public revenue.
Multiple taxes: - It refers to the system in which the taxes are levied on various items.
 On the basis of method

Proportional taxes: - A system that taxes everyone at the same rate, regardless of his or her
income brackets. It is amount increase with the increase in income and decreases with the
decrease in income.

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Progressive taxes: - It is the tax which varies with the change in income of the different
individuals. The rate of tax is gradually higher for the increasing incomes and lower for the
decreasing incomes.
Regressive tax: - Under it, the larger the income of tax-payer, the smaller is the proportion
that he contributes. A schedule of regressive tax rate is one in which the rate of taxation
decreases as the base increases.
SHIFTING AND INCIDENCE OF TAXES
Meaning of Impact
The impact of a tax is on the person who pays the money in the first instance. In other words,
the man who pays the tax to the government in the first instance bears its impact. The impact
of a tax is, therefore, the immediate result of the imposition of a tax on the person who pays
in the first instance. It corresponds to what is often, but erroneously called the “original
incidence” or the “primary incidence” of a tax. The impact of tax as such, denotes the act of
imposing.
Impact of a tax, therefore, refers to the immediate burden of the tax and not to the ultimate
burden of the tax.
Meaning of Shifting
Shifting of a tax refers to the process by which the money burden of a tax is transferred from
one person to another. Whenever there is shifting of taxation, the tax may be shifted forward
or backward.

Meaning of Incidence
Incidence of a tax refers to the money burden of a tax on the person who ultimately bears it.
In other words, when the money burden of a tax finally settles or comes to rest on the
ultimate taxpayer, is called the incidence of a tax. The incidence of tax remains upon that
person who cannot shift its burden to any other person, i.e., who ultimately bears it.
Thus, there are three distinct conceptions- the impact, the shifting and the incidence of a tax,
which correspond respectively to the imposition, the transfer, and the settling or coming to
rest of the tax. The impact is the initial phenomena, the shifting is the intermediate process,
and the incidence is the result.
Distinction between Impact and Incidence
The impact refers to the initial burden of tax while incidence refers to the ultimate burden of
the tax. Impact is felt by the tax payer at the point of imposition of the tax, while the
incidence is felt by the tax payer at the point of settlement or rest of the tax.
The impact of the tax is felt by the person from whom the tax is collected, while the
incidence is felt by the person who actually bears the burden of the tax.
Impact of a tax can be shifted, but the incidence of a tax cannot be shifted.
Thus, impact of the tax is always on the person who is responsible by law to pay the tax
amount to the Government treasury, in the first instance. Incidence may fall on somebody
from whom the manufacturer ultimately recovers the amount, provided he shifts the tax.
Tax Shifting
Shifting of a tax refers to the process by which the money burden of a tax is transferred from
one person to another. Shifting can occur only in connection with the price transaction. Price
is the only vehicle through which a tax can be shifted. Thus, shifting is common in
commodity taxation. If a tax is shifted, the price of the taxed commodity increases.
Whenever, there is shifting of taxation, the tax may be shifted forward or backward.
Types of Tax Shifting
Tax shifting may be of two types: forward shifting and backward shifting.
Forward Shifting
A tax is said to have shifted forward if price of the commodity which constitutes the medium
for shifting the money burden of tax is increased. Under complete shifting; the price will be
higher by the full amount of tax. In forward shifting of commodity taxation, the money
burden of a tax is transferred from the producer or seller to the consumer or buyer when the
37
tax is initially imposed on the producer. Thus, forward shifting is possible with regard to all
indirect taxes which are generally passed partly or shortly to the buyer of goods.
Backward Shifting
Backward shifting refers to the process by which the money burden of commodity tax is
shifted from the consumer or buyer to the producer or seller, if the tax is initially imposed on
the consumer. In other words, it is a typical situation in which the tax burden is shifted
backward, that is, from the buyer of good to the seller of goods under the following
conditions:
Backward shifting is applicable in the case of property tax only. Backward shifting is
effected when the buyer of property shifts the entire tax burden to the seller of property. The
shifting is done by buyer of property by way of capitalizing the value of tax by the life of the
property and deducting it out of the total value of the property.
Factors Influencing Shifting and Incidence
From the foregoing analysis, we find that their area number of factors which influence tax
shifting and incidence. These factors are mentioned below.
(i) Elasticity of Demand. The elasticity of demand for commodity taxed exercises a very
important influence in determining incidence. If the demand for the product taxed is
perfectly elastic, i.e., if the demand curve is a horizontal straight line, price cannot be raised
at all, because the slightest rise in price will largely reduce the demand for the product.
Hence, the incidence will be wholly on the seller. On the contrary, when the demand is
perfectly inelastic, the incidence will be wholly on the buyer. In between these two extremes,
the incidence of tax will be shared between the buyer and the seller. Thus, with given supply,
the larger the elasticity of demand, the smaller will be the incidence on buyer and larger on
seller; while, the lesser the elasticity of demand, the larger will be the incidence on buyer and
small on the seller.
(ii) Elasticity of Supply. Because price is determined by the interaction of both demand and
supply, it follows from the similar reasoning that the incidence of tax on a commodity will be
wholly on the buyer when supply is completely elastic and will be wholly on the seller when
supply is completely inelastic. With varying degrees of supply elasticity, the incidence will
be shared between the buyer and the seller. With given demand schedule, the incidence will
be larger on buyer and smaller on seller the greater the elasticity of supply of the product
taxed, while the-reverse will be the order of incidence when the elasticity of supply is lesser
and lesser.
(iii) Market Conditions. Shifting of tax is also influenced by the conditions of market for
the product taxed. If the product is sold in the perfect market which is characterized by many
sellers and perfectly elastic demand curve, the price cannot be changed by the seller and,
hence, tax cannot be shifted. On the other and, when the product is sold under monopolistic
conditions, he can manipulate the price by withholding supply of the product and, hence, can
shift the tax at least to some extent.
(iv) Magnitude of Tax. Shifting depends on the magnitude of tax levied. If the amount of tax
is very small, it is generally not shifted but absorbed by the seller, because it does not much
reduce his profit. The seller, moreover, may absorb it in the hope that he will be able to
attract more customers in the event of other sellers trying to raise the price in their trial of
shifting the tax. However, if the magnitude of tax is considerably large, absorption of tax is
more likely to reduce the profit of the seller and, hence, he will try to shift it either backward
or forward. He may also shift the tax forward by lowering the quality of product without
raising the price of it.
(v) Coverage of Tax. Another important factor that influences shifting and incidence is the
extent of coverage of the tax. If the tax is more general in natural, falling on wide range of
commodities, it may be easily shifted. For example, if a tax levied on bathing soap is general
in nature, covering all its kinds and brands, it will be readily shifted. But if the tax is imposed
on only one brand of soap with the exclusion of others, the tax may not be possibly shifted.
Hence, shifting of tax is easier for more general taxes than non-general taxes.
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 (vi) Substitutability of Product. It follows from the above argument that taxes imposed on a
commodity which has no substitutes or has only poor substitutes can be easily shifted to the
buyer, because the buyer will not find an alternative product to satisfy his demand and, hence,
he will be ready to purchase the same even when the price is increased by the amount of the
tax. But if the product taxed has good substitutes, the raising of price is not possible for the
fear of losing customers and, hence, the seller will himself bear the burden of tax instead of
trying to shift it.
(vii) Public Policy and Tax Laws. If the Govt. wants that the business enterprise should not
raise the price of the product in the event of shifting the tax burden forward, the seller
/producer/ business enterprise should bear the burden himself or itself. Tax laws, may legally
prohibit shifting of tax through controls, restriction on prices and etc.
Tax Evasion and Tax Avoidance
Tax Evasion
Tax evasion is the general term for efforts by individuals, firms, and other entities to evade
the payment of taxes by breaking the law.
Tax evasion means fraudulent action on the part of the taxpayer with a view to violate civil
and criminal provisions of the tax laws. It can be defined as “tax evasion implies the activities
involving an element of deceit, mis-representation of facts, and falsification of accounts
including downright fraud”.
Thus, it may be said that the tax evasion is tax avoidance by illegal means i.e. tax evasion is
against the law and is an unsocial act.
There are two forms of tax evasion. They are as follows:
1. Suppression of income, and
2. Inflation of expenditure.
Examples for Tax Evasion: The following are the examples for tax evasion:
1. A trader makes a sale for Birr.20, 000 and does not account it, in his books under sales. He
is evading tax.
2. An individual lends his money of Birr.50, 000 to another person at 20% interest per annum
and does not include this income in his total income.
3. Under-invoicing of sales and inflation of purchases.
4. A manufacturing business employs 30 workers but include 2 more additional namesake
workers (not in actual) in the muster roles. The sum shown as paid to such additional
namesake workers will amount to evasion.
Human intelligence devices new methods of evasion and the Governments are constantly
trying to remove the loopholes in the tax laws.

Causes of tax evasion

 High rates of taxation; - Prevalence of high tax rates is the first and foremost reason.
 Complexity of tax laws; - Complicated tax laws are another reason for tax evasion.
The tax laws contain a number of exemptions, deductions, rebates, relief, surcharges
and so on.
So, such complication in tax-laws is also a root-cause for the tax evasion.
 Inadequate Information as to Sources of Tax Revenue:-Lack of adequate information as to
the sources of revenue also contributes to tax evasions. In Ethiopia, small businessmen and
farmers rarely maintain any accounts of their income.
 Lack of publicity;-Lack of publicity of information of a person’s return or assessment,
is yet another reasons for tax evasion.
 Moral and Psychological factors; - moral and psychological factors have also been
pointed out as responsible for tax evasion.
39
  Every person should realize his responsibility towards the govt.
 Unfortunately, all citizens do not realize their duties to the govt. and the
necessity of paying the correct amount of taxes and paying them in time.
 officers of the department should be men of integrity;- Lack of integrity in some of
the officers of the department is also responsible for tax evasion
Methods/Sources of Tax Evasion
Omission to report taxable income.
 One of the methods of tax evasion is the omission of the tax-payer to report
taxable income to taxation authorities.
 Under law, every individual, sole proprietorship, partnership firms and
corporations have to furnish their income tax returns in time in case his or her
total income from all sources exceeds the maximum exemption limit.
 But many people do not supply any such information to the govt.
 They cheat their govt. by concealing facts with regard to their income and
wealth returns.
Maintenance of multiple set of books of accounts.
 Many big business houses have been showing some baseless transactions of
expenditure to lower down their tax burden.
 Most of the business people are maintaining double set of books of accounts
by tax evaders.
 One set of books of accounts is for personal use and another for tax purpose.
Opening accounts under dummy names.
 Tax evaders have been opening number of bank accounts under dummy
names.
Deduction of personal expenses as business expense.
 Some employees of big business houses regularly deduct their personal
expenses from office.
 For example, an officer using official transportation for personal purposes.
 By treating personal expenses as business expenses, people increase business
expenses thus lowering the profit of the enterprise.

Omission to report several incomes from irregular sources.

 Many individuals are in receipt of different types of income from different
irregular sources.
 For example, people receive interest on deposits in the banks or dividend on
shares.
 But they rarely report such income to the taxation authorities.
Understatement of receipts.
 Receipts received from credit sales add to the total income of the business
man.
 This addition to the income due to credit sales, increases his tax liability.
 Hence, he takes such steps as to underestimate his receipts so that he could
reduce his tax liability.
Over-estimation of business expenses.
 A person who evades the payment of tax, overestimated his business expenses
by showing more salaries to employees as compared to actual amount paid.
Tax avoidance – An Overview
40
  Tax avoidance is method of reducing ones tax liability by making use of
loopholes in tax law.
 Therefore, tax avoidance is not illegal.
 But whatever be the method an assesse adopts whether it is avoidance or
evasion, the consequences of his action is the same.
 i.e., loss of revenue to the state and increase in the burden of the tax on other
tax-payers.
 Thus, tax avoidance is the art of escaping taxes without breaking the law.
Examples for Tax Avoidance:
Suppose a taxpayer’s total income exceeds the maximum tax-free amount, then he has to pay
the tax on such excess amount. But if he invests the excess amount in any of the approved
schemes for which there is a relief in the tax law, he can save on tax altogether.
2. An individual sells his let out house property (long-term capital asset) for Birr.2, 00,000
making a capital gain of Birr 60,000. This capital gain would normally be taxed. But, if he
invests the sale proceeds in a particular manner stipulated by law, he need not pay any tax.

Chapter 5
Public Expenditure Management- an overview

Chapter Objectives
After successfully completing this chapter, you should be able to:
• Define the terms public expenditure and Public Expenditure Management (PEM)
• Describe the evolution of PEM
• Identify and explain the objectives of PEM
• Discuss the relationship between fiscal policy & PEM
• Identify the challenges of PEM & measures used to improve PEM
• Identify means of managing PEM reforms
Contents

 The concept and nature of PEM

 Evolution of PEM
 Objectives of PEM
 Fiscal policy and expenditure management
 Improving PEM
 Managing PEM reform process
1.1 Concept and nature of PEM
2 What is Public Expenditure?
2.1 the aggregate expenditure incurred by the public sector at the level of the:
2.1.1 central government
2.1.2 State government and
2.1.3 local government

 Public expenditures include expenditures for:

 Education
 Defence
 Welfare benefits
 Healthcare
 Infrastructure
 Police, etc.

41
  What is Public Expenditure Management?
 the allocation and utilization of the resources
 Responsively
 Efficiently, and
 Effectively
 Involves two interrelated aspects:
a. Expenditure Policy (ascertain the peoples’ preference)
b. Expenditure Management (Satisfying peoples’ preference)

Types of government expenditure

 Current Expenditures or Government final consumption expenditure on goods

and services for current use to directly satisfy individual or collective needs of the
members of the community.

Types of government expenditure

 Capital Expenditures or fixed capital formation (or government investment) -

government spending on goods and services intended to create future benefits, such
as infrastructure investment in transport (roads, rail airports), health (water
collection and distribution, sewage systems, communication (telephone, radio and tv)
and research spending.

42
1.2 Public Expenditure Mgt-Evolution

 PEM has been in existence in different forms for more than two millennia.
 The term PEM was used towards the end of the 20th century
 Taking its influence on financing and the benefits, govts started emphasizing on PEM

 In the past, establishment and maintenance of royal treasury was emphasized.

 Though accountants and collectors were there, there was no expenditure controller.
 At a later stage, three steps were built into the administrative system.

First stage of evolution…

 With regard to payments from treasury,

1. Establishment of claim for payment
2. The claim has been verified arithmetically and in terms of availability of resources
3. The claim has been liquidated after making the payment
These steps contributed to organize EM

43
Second Phase

 The second phase refers to the gradual emergence of the legislatures

 They acquired powers for levying taxes first and made approval of the legislature
compulsory for expenditure.
 Demands for an Accounting system emerged in 17th century.

As a result…
 Firstly, it was specified that there should be a cadre of officials who are responsible
for accounts.
 Second, it was agreed that govts should submit annual accounts on the utilization of
funds.
 Third, it was also specified that the annual accounts would be audited by a separate
agency

Third Phase

 The third phase refers to the convergence of several forces

 The emergence of capital budgeting system after World War II changed the PEM
process.
 Expenditure planning should be for a medium term,
 Investment projects have to be subjected to quantitative techniques of
appraisal.

1.3 Objectives of PEM

Three Interdependent Objectives of PEM

(1) Fiscal Discipline

Fiscal discipline refers to the ability of government to balance revenues and expenditures.
 related to affordability (realism)
 Deals with overall expenditure control
 Primarily the role of MoF
 Primarily related to macroeconomic objective
Note: The 1st purpose of every budget system is control of the totals

(2)
Allocative Efficiency
 the capacity to:
 Establish priorities within the budget
 Distribute resources in accord with government priorities
 Shift resources from old priorities to new ones, or from less to more productive
means.
 An interministrial coordination mechanism (strategic areas) & prioritization of
programmes-activities within strategic areas
 Primarily focuses on strategic areas and related to policy objective.

44
  Allocative efficiency is more challenging of the three objectives because it is
dominated by political factors:
 Impeded by the “Tragedy of Commons”
 Presence of many claimants (with their own varying interests) to the budget
such as interest groups, legislators, line ministries etc, leading to increased
expenditures.
How to minimize the effect of political factors? Through rules and procedures to discipline
policy debates although not possible to avoid at all

(3) Technical (operational) efficiency

 the capacity to implement programs and deliver services at the lowest cost (e.g.
minimum cost per unit of output)
 Primarily focuses on operations service delivery within directorates, programmes,
projects etc.
 Related to operational performance
 Requires improving internal management systems
How are the three objectives of PEM related to one another?

Objectives of PEM (cont’d)

PEM Outcomes & Objectives

Fiscal Discipline Macroeconomic

LEVEL 1
objectives

LEVEL 2 Allocative Policy Objectives

Efficiency

LEVEL 3 45
Technical Operational
Efficiency Performance objectives 20
1.4 Fiscal Policy and PEM

 What is fiscal policy?

 Fiscal Policy is the use of government expenditure and taxation to influence
the economic growth.
 Fiscal policy is the means by which a government adjusts its spending levels
and tax rates to monitor and influence a nation's economy
 What is the relationship between fiscal policy and PEM?

Relationship b/n Fiscal policy & PEM:

 The goals of overall economic policies are growth, equity and stability. These goals
are complimentary.
 PEM supports the fiscal policy and tries to secure economic stability. How?
What are the challenges of PEM in Somalia?

Homework

Both developing & developed countries have a problem of increasing expenditures and
budget deficit due to various reasons.
Discuss?

Expenditure Control

 The success of PEM depends on the efficiency of the control systems

 Control in PEM has two senses:
 conformity to plan
 reduction of spending
 Control is an executive function and parliament has little role
What institutional arrangements affect PEM?

Institutional Arrangements & PEM

 Institutions are best understood as rules and not organizations

 Institutions may be formal or informal
 Institutional arrangements refer to the rules of the game
 Affect budgetary outcomes
 Purpose of institutional arrangements:
46
  To discipline and facilitate decision making and the scrutiny of those decisions
by the appropriate players (legislators, PM, Ministers, agencies etc.)
 So, what institutional arrangements promote effective PEM?

 Institutional arrangements in PEM:

1. Budget systems and processes
2. Constitution and laws
 Constitution
 Budget and financial laws
 Cabinet rules
 Policy manuals
3. Clearly defined system of delegation of Authority
4. Upward reporting requirements by spending agents
Note: Budget systems should consider both formal and informal systems.

 Roles of institutional arrangements:

1. To regulate/control the relationships among the players, through a combination of
regulations external and internal to executive government
2. (Simultaneously) to impose restraints,
3. To define flexibilities and set, monitor and enforce standards.

Individual Reading
 Balancing Restraints and Flexibility in PEM
 Transparency and accountability in PEM
Possible source: PEM Handbook (World Bank)

Calculation of Public Expenditure

 Central,& local govts and Public Corpns

 Spending is with immediate effect(current) and spending with long term
effect(capital)
 The govt’s overall plans for PE are set in terms of a Control Total
 When social security and interest are added, we get General Govt Expenditure
 The GGE is reduced by special and general receipts to compute the amount to be
borrowed

Calculation of PE(Example)

Central Govt Spending 200

+ Local Govt Spending 400

+ Public Corporation 100

= Control Total 700

47
+ Social Security 50

+ Central Govt debt Interest 20

- Public Corporation Borrowing 100

+ Other Accounting adjustments ----

= GGE (A) 670

- Privatization proceeds 70

= GGE 600

- General Govt Receipts 550

= General Govt Borrowing Requirements 50

Governance Aspects & PEM

 The four pillars of good governance

1. Accountability,
2. Transparency,
3. Predictability, and
4. Participation
 How does each of the four pillars of governance affect PEM?

Administrative & Cultural Context & PEM

 Any instrument of PEM of foreign origin should be examined from a local point of
view.
 Both formal rules and informal rules have to be considered in employing PEM
techniques.
 PEM system should be suitable for the local administrative and cultural situations

1.5 Improving PEM

What are the current challenges of PEM?

 Problems of increasing expenditures and budget deficit due to :
 Demand for additional expenditures for economic growth
 Changes in the demographic factors such as children age 0-14 (44.4% in Somalia etc.)
 Greater reliance on borrowing (leading to increase in gross expenditures)
 Fiscal crisis (deficit)
 Inflation etc.

Additional challenges of PEM:

 Lack of proper link of the policy making function and planning with budgeting.
 Lack of experience on the part of the Parliaments to perform the control tasks
effectively.
 Lack of well-functioning Accounting financial management systems.
 Weak systems of financial control and audit.
48
What should governments do to improve PEM?

 A greater focus on performance (the results achieved with expenditure)

 Adequate links between policy making, planning and budgeting
 Well-functioning accounting and financial management systems
 Attention to the links between budgeting and financial management systems and
other service-wide systems and processes of government

Baseline Measures for improving PEM

1. Institutional framework :
 Clearly defined principles in a country’s constitution, the budget and other laws.
 Budget scrutiny by the Parliament
2. Medium term fiscal framework
 Provision of the country’s budgetary information within a medium term framework
and set medium term fiscal objectives

3. Budget preparation process

 There should be a well-defined sequence of steps in the budget preparation process
4. Budget Execution and Monitoring
 The need for line ministries to enforce spending limits indicated in the budget
 Ability of MoF to supervise the spending limits

5. Accounting and Reporting

 The need to have common classifications
 The need to have timely, comprehensive, and reliable fiscal reporting
6. Financial Control
 The need to have a comprehensive statutory base defining the systems, and principles
of management control
 The need to put in place efficient internal audit mechanisms

7. Procurement Systems
 Achieve A properly functioning market
 Encourage competition in the market to achieve efficient procurement systems
 Clear procurement legislations, policies and procedures
 Establishment of central public procurement organization
 Develop the capacity of spending units
 Establishment of efficient control and complaints review procedures

1.6 Managing the Reform Process

What can be done to effectively manage EM reforms processes?

1. Building a commitment to reform

 A consensus for reform among the different participants involved in public EM
should be built up
49
  Political Commitment from the top management
 Make a survey of the attitude of staff and conduct a series of seminars

2. Organizational Arrangements
 Building organizational and Human capacity are essential to administer the reform
and enforce the new framework.
 The organizational arrangements need to be tailored to the country’s context and the
scope of the intended reform

 Setup the following groups for large reforms:

a. Steering group
 Provides general directions to the reform & overall supervision
b. Core unit
 Separately identifiable department for the overall management of the
reform
c. Working group
 Responsible for implementing specific reforms

3. Training
 A training program for each compound of the reform is essential for successful
implementation. Training should cover different fields such as basic training in
specialized areas, or general training
 To increase awareness of major issues in PEM, an economic and budgeting ‘culture’
needs to be disseminated within the govt. Thus, training of budget managers is very
essential.

Managing the Reform Process (cont’d)

4. Cooperation
5. Coordinating activities
6. Effective communication

Review Questions

1. What is public expenditure? What do public expenditures include?

2. What is public expenditure management? Why public expenditure management?
3. How are fiscal policy and PEM related?
4. What institutional arrangements affect PEM?
5. Explain the relationship between PEM, transparency and accountability?
6. Do you believe that Somalia has challenges in PEM?
7. What PEM reforms have taken place in Somaia? What were the challenges of those
reforms? How do you think that these problems are solved?

End of chapter 5

50
 Chapter 6
Public Revenue Management

Chapter contents

 Defining revenue
 Determining revenue needs
 Revenue forecasting process
 Forecasting methods
 Treasury Management
 PFM Reforms

2.1 Defining revenues

 Revenues are inflows or receipts from all internal and external sources.
 Do not include refunds, proceeds from debt issuance and disposal of assets.
 can be generated from
 delivery of services for which money is due
 delivery of tangible goods to purchasers from whom payment is expected
 sources for which no commensurate benefit is expected. tax

51
2.1 Defining revenues

Sources
 Taxes
 Income, consumption, and property
 Non tax revenues
 License and permits
 Intergovernmental revenue
 Charges for services
 Fines and forfeits
 Miscellaneous revenue

2.2 Determining revenue needs

 revenue requirement estimates are based on expected or proposed expenditure plan

 revenue forecast should be made well ahead of budget approval to permit evaluation
of its adequacy
 the following factors should be taken into account:
 Inflation rate factor
 Political philosophy of the policy maker
 Community growth and development
 Expanded and new programs
 Population characteristics and trends
 Nature and components of the tax base
 stability of revenue over the business cycle
 tax efforts

2.3 Rrevenue forecasting process

Types of forecasts (based on length of coverage)

 Long-term forecasts-include a wider range of internal and external macro-problems
that must be examined. Factors such as population, age, income structure, and
employment and their impact on governments tax capacity are assessed
 Medium-term forecast-used to tackle problems such as expected budget gaps or
revenue shortfalls before they become a crisis.
 Short-term forecast-relate to formulation of annual budget.

2.3 Revenue forecasting process

Preliminary guide to revenue forecasting

 Fees and charges should be evaluated to assess the extent to which they cover costs
of services they intend to provide
 policy should be developed to limit one-time revenue
 identify major unpredictable revenue sources
 adopt a clear policy on revenue diversification

Preliminary guide to revenue forecasting

 monitor the periodic analysis of major revenue sources

52
  understand and evaluate revenue sources’ rate and base and impact of potential
changes
 periodically examine tax and fees exemptions
 prepare revenue manual on revenue sources that indicate factors affecting them

2.3. Revenue forecasting process

2.4 Forecasting methods

Methods
1. Qualitative techniques
 Expert opinion/jury of executive
 Naiive Forecasting
 Delphi method
2. Quantitative methods
Time series projection methods
 Trend analysis
 Moving average method

1. Qualitative techniques
 relies on the judgment of experts to translate qualitative information into quantitative
estimates
(a) Expert opinion/jury of executive
 involves pooling of views of group of experts on expected future revenue and
combining them into a revenue estimate

53
 (a) Expert opinion/jury of executive
Allows the pooling of expertise knowledge in the forecasting process, but accuracy of
forecast depends on the care and experience of the people providing the inputs
b) Naïve Forecasting: The revenue of the most recent prior year is expected to be realized
next period
c)Delphi method
- Involves converting the views of a group of experts, who do not interact face-to-face, into
a forecast through an iterative process.
- Is used for eliciting the opinions of a group of experts with the help of a mail survey.

(a) Delphi method

STEPS
1. questionnaire sent by mail to a group of experts
2. response received are summarized without disclosing the identity of the
experts, and sent back to the experts- reasons for extreme views expressed in
the first round.
3. process may be continued till a reasonable agreement emerges in the view of
the experts.

2. Quantitative methods
2.1 Time series projection methods
(a) Trend Analysis
The analyst calculates the rate of change for one time period to the next or an average rate of
change. This rate will then be applied to the most recent revenue yield to compute the
revenue for the next year

a)Trend Analysis
Change (Δ) = P2-P1
P1 where P1 the base period, and P2 the following period
Average rate of change =Σ(Pn-P1/P1)
n , where P1 the base period, Pn indicates each
following period, and ‘n’ total periods in the data set
Forecast may be done at the lowest growth rate, highest growth rate or at the average growth
rate

2.4 Forecasting methods

E.g. Consider the following data for of six fiscal years of a city government (in Eth Birr). The
city uses trend analysis for its annual revenue forecasting keeping year 1999 as the base year.
Two forecasted revenue levels, the lowest and average levels are used for the purpose
Required: Forecast the revenue of years 2005, 2006, and 2007 using the two levels of growth
rate(lowest and highest)(Round to nearest hundred)
54
 year Revenue (Actual) (millions)

1999 85800

2000 86800

2001 88800

2002 90300

2003 95500

2004 97600

Solution

Yr Revenue (millions Growth rate Forecast (at.011) Forecast

Birr) (at.057)

1999 85800 -------

2000 86800 .011

2001 88800 .023

2002 90300 .016

2003 95500 .057

2004 97600 .021

2005 98700 103200

2006 99800 109100

2007 100900 115300

Trend Analysis
55
Sol: Yr 2000 growth rate= 86800-85800/85800
Forecasts
Yr 2005 at lowest growth rate
97600+(.011x97600)
Yr 2005 at highest growth rate
97600+(.057x97600)

(b) Moving average method

The forecast for the next period represents a simple arithmetic average or a weighted
arithmetic average of the last periods

b) Moving Average Method

This allows the number of past periods to be added. For a 3 yr Moving Average, the
collections of three years (20000, 25000, 30000) will be added and the total will be divided
by 3
When the next yr’s figure is available(45000), add the recent 3 amounts and divide it by 3

2.5 Treasury Management

 Treasury implements various financial decisions made by govt. Its focus is on the
financial assets and liabilities. Treasury also has an important role in risk reduction
and mitigation.
 Treasury advises on and executes the various strategic decisions of the govt. This
responsibility includes obtaining and managing financing and the effective control of
funds once financing is obtained.
Treasury Functions
 Treasury encompasses the major functions of cash & liquidity mgt and financial risk
mgt.
 Within these two broad categories there are several functions such as;
Cash Mgt, Mgt of govt bank accounts, Debt Mgt, Risk Mgt, ……….

…., Administration of Foreign Grants and Aid, and Financial Assets mgt.
1.Cash Mgt
 This includes,
a)Accurately forecasting timing and amount of cash flows
b)Control of cash flows
c)Centralizing cash balances in Treasury Single Accounts
d)Arranging funding to cover temporary and longer term cash short falls

2.Liquidity Mgt: This function includes:

56
  Providing the ability to take advantage of opportunities as they arise,
for timely investments, or new acquisitions
 Funding for future projects and acquisitions
 Serving as a financial buffer against an unexpected decline in revenues
 Meeting the need for collateral against borrowing or debt issuance
 Funding cash- intensive activities, such as research and development

3.Risk Mgt: This function includes

 Identification of key risks, including risks that arise from financial markets, extension
of credit and the ability to obtain financing
 Development of alternative risk mgt strategies and their implementation
 Development of infra structure to monitor risks and report on compliance with
policies and performance reporting

4. Treasury aspects of Aid Mgt:

Foreign grants must be budgeted whether they are given as grant or in kind.
Minimum requirements for good mgt of grants :
 a) Expenditure financed with grants must be submitted to the same scrutiny and
prioritization as other expenditures
 Transactions relating to grants must be accounted for and data collected and recorded
at the central level

5.Debt Mgt: General Issues:

- only one government authority should be authorized to borrow.
-Regulations should provide for the amount of borrowing
- The objectives of the debt management policy should be clearly stated and made public.
-Set borrowing objectives in conformity with fiscal targets.

6)Mgt of Govt bank accounts:

a)Treasury must be responsible for supervising all central government bank accounts,
including any extra-budgetary funds.
b)When commercial banks are involved in revenue collection or expenditure payments, the
banking arrangements must be negotiated and contracted by the Treasury.

7.Mgt of Govt Financial Assets: Government financial assets consist of shares in

enterprises, loans granted by the government, payments of guarantees not honored by
debtors, etc.
a)Keep records of all such assets and authorize disbursements and track payments.
b)Get financial information on enterprises in which the government has shares, monitor the
dividend payments, and deal with the financial aspects of privatization.

End of Chapter 6

57
 Internal Control CHAPTER 7
Contents
• Meaning &Definition
• The control process
• Types and classification of controls
• Components of internal control
• Limitations of internal control
• Evaluating internal control

Meaning of IC

Any organization wishing to conduct its business in an orderly and efficient manner and to
produce reliable financial accounting information, both for its own and for others’ use, needs
some controls to minimize the effects of the endemic/ a condition human failings(with the
best intentions or intentional falsification).
When such controls are implemented within the organization’s systems they are described as
internal controls.
Internal controls are mechanisms designed to control all of an entity’s functions, not just its
accounting function.

Meaning of IC

An internal control system encompasses/to include the policies, processes, tasks, behaviors
and other aspects of a company that, taken together:
• Facilitate its effective and efficient operation by enabling it to respond
appropriately to significant business, operational, financial, compliance
and other risks to achieving the company’s objectives
• Help ensure the quality of internal and external reporting
• Help ensure compliance with applicable laws and regulations

Definition of I C * COSO

Internal control is ‘a process, effected by an entity’s board of directors, management, and

other personnel, designed to provide reasonable assurance regarding the achievement of
objectives in the following categories:
 Effectiveness and efficiency of operations
 Reliability of financial reporting
 Compliance with applicable laws and regulations’. (COSO)
• Internal control system is any policy& procedure set by management in order to
control problems that can prevent the organization from achieving its goal.

58
 Internal control is an activity what we do to see that the things we want to happen
will happen …

 And the things we don’t want to happen won’t happen.

Internal Controls Are Common Sense

What do you worry about going wrong?

What steps have been taken to assure it doesn’t?

59
 How do you know things are under control?

 Internal control is a process; it is a means to an end, not an end itself.

 Internal control is effected by people; it’s not merely policy manuals and forms but
people at every level of an organization.
 Internal control can be expected to only provide reasonable assurance, not absolute
assurance/Complete assurance.

Objectives of IC
Internal control is geared to the achievement of objectives in one or more separate
overlapping categories. Objectives fall into four categories:
1. Operations – relating to effective and efficient use of the entity’s resources
2. Financial reporting – relating preparation of reliable published financial statements
3. Compliance – relating to the entity’s compliance with applicable laws and
regulations; and
4. Safeguarding of assets

ICS contains accounting and administrative controls. The internal accounting controls’,
are designed, in particular, to ensure that transactions which give rise to the accounting
data are;
1. properly recorded; that is, all relevant details of transactions are recorded at the time
the transactions take place;
2. properly authorized; that is, all transactions are authorized by a person with the
requisite authority;
3. valid; that is, transactions recorded in the accounting system represent genuine
exchanges with bona fide parties:
4. complete; that is, all genuine transactions are input to the accounting system; none are
omitted;
5. properly valued; that is, transactions are recorded in the correct accounts;
6. Properly classified; that is, transactions are recorded in the correct accounts;
7. Recorded in the correct accounting period

Categories of IC System
60
• Preventive control: Prevent something bad from happening
• Detective Control : Detect problems that passed through preventive control
• Corrective control: aimed at correcting problems detected by detective control

The Control Process

 Management designs systems of internal control to accomplish all three objectives

(Reliability of Financial Reporting , Efficiency and Effectiveness of Operations and
Compliance with Laws and Regulations).
 The auditor’s focus in both the audit of financial statements and the audit of internal
controls is to operations and to compliance with laws and regulations objectives that
could materially affect financial reporting.
 Put another way, the entity’s accounting system is designed to capture accounting
data and to convert and output this data as useful financial information.
 In order for financial information to be useful, it must be reliable. Thus, the
underlying accounting data must be valid, complete and accurate.

Common int. control acts in our personal life

 Lock-up valuable belongings

 Keep copies of your tax returns, registration slip
 Balance your checkbook
 Keep your ATM/debit card PIN number separate from your card
 Lock-up your computer with pass word
 Compare your book and bank balance

Why are Internal Controls Important?

 Compliance with applicable laws and regulations.

 Accomplishment of the entity’s mission.
 Relevant and reliable financial reporting.
 Effective and efficient operations.
 Safeguarding of assets.

Risks of Weak Internal Controls

 Weak Internal Controls Increase Risk Through…

 Business Interruption system breakdowns or catastrophes, excessive re-work to
correct for errors.
 Erroneous Management Decisions based on erroneous, inadequate or misleading
information.
 Fraud, Embezzlement and Theft by management, employees, customers, vendors, or
the public-at-large.

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  Statutory Sanctions
penalties arising from failure to comply with regulatory requirements, as
well as overt/done violations.
 Excessive Costs/Deficient Revenues expenses which could have been avoided, as
well as loss of revenues to which the organization is entitled.
 Loss, Misuse or Destruction of Assets unintentional loss of physical assets such
as cash, inventory, and equipment.

Benefits of Strong Internal Controls

 Reducing and preventing errors in a cost- effective manner.

 Ensuring priority issues are identified and addressed.
 Protecting employees & resources.
 Providing appropriate checks and balances.
 Having more efficient audits, resulting in shorter timelines, less testing, and fewer
demands on staff.
 Contribute to the effectiveness of control system

Effective Internal Controls

 Make sense within each organization’s unique operating environment.

 Benefit rather than encumber (hinder) management.
 Are not stand-alone practices; they are woven into day-to-day responsibilities.
 Are cost-effective.

Basic Internal Control Structure

 The most widely accepted internal control framework in the United States, describes
internal control as consisting of five components that management designs and
implements to provide reasonable assurance that its control objectives will be met.
 Each component contains many controls, but auditors concentrate on those designed
to prevent or detect material misstatements in the financial statements.
 The internal control components include the following
1. Control environment
2. Risk assessment
3. Control activities
4. Information and communication systems support
5. Monitoring

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 Internal Control Framework…
Five Inter-Related Standards: COSO’S

1. Control Environment

 Foundation for all other standards of internal control.

 Pervasive influence on all the decisions and activities of an organization.
 Effective organizations set a positive “tone at the top”.
 Factors include the integrity, ethical values and competence of employees, and,
management’s philosophy & operating style.

• The control environment serves as the umbrella for the other four components.
• Without an effective control environment, the other four are unlikely to result in
effective internal control, regardless of their quality.
• The essence of an effectively controlled organization lies in the attitude of its
management.

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 The control environment consists of the actions, policies, and procedures that
reflect the overall attitudes of top management, directors, and owners of an
entity about internal control and its importance to the entity.
 To understand and assess the control environment, auditors should consider the most
important control subcomponents, which are:
1. Integrity and Ethical Values
2. Commitment to competence
3. Board of Directors of Audit Committee Participation
4. The audit committee’s independence
5. Organizational Structure
6. Human resource policies and practices

2. Risk Assessment

 Risks are internal & external events (economic conditions, staffing changes, new
systems, regulatory changes, natural disasters, etc.) that threaten the accomplishment
of objectives.
 Risk assessment is the process of identifying, evaluating, and deciding how to manage
these events… What is the likelihood of the event occurring? What would be the
impact if it were to occur? What can we do to prevent or reduce the risk?

3. Control Activities

 Tools - policies, procedures, processes -designed and implemented to help ensure that
management directives are carried out.
 Help prevent or reduce the risks that can impede the accomplishment of objectives.
 Occur throughout the organization, at all levels, and in all functions.
 Includes approvals, authorizations, verifications, reconciliations, security of assets,
reviews of operating performance, and segregation of duties.

4. Communication & Information

 Pertinent information must be captured, identified and communicated on a timely

basis.
 Effective information and communication systems enable the organization’s people to
exchange the information needed to conduct, manage, and control its operations.

5. Monitoring

 Internal control systems must be monitored to assess their effectiveness… Are they
operating as intended?
 Ongoing monitoring is necessary to react dynamically to changing conditions…Have
controls become outdated, redundant, or obsolete?
 Monitoring occurs in the course of everyday operations, it includes regular
management & supervisory activities and other actions personnel take in performing
their duties.

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 Key I C Activities/Components

1. Separation of Duties

 Divide responsibilities between different employees so one individual doesn’t

control all aspects of a transaction.
 Reduce the opportunity for an employee to commit and conceal errors
(intentional or unintentional) or perpetrate fraud.

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 Adequate Separation of Duties

Custody of assets from Accounting

Authorization The custody of

of transactions from related assets

Operational Record-keeping
responsibility from responsibility

IT duties from User departments

2. Documentation

Document & preserve evidence to substantiate:

 Critical decisions and significant events...typically involving the use, commitment, or
transfer of resources.
 Transactions…enables a transaction to be traced from its inception to completion.
 Policies & Procedures…documents which set forth the fundamental principles and
methods that employees rely on to do their jobs.

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Adequate Documents and Records

Prenumbered consecutively

Prepared at the time of transaction

Simple enough to ensure understanding

Designed for multiple use

Constructed to encourage correct preparation

3. Authorization & Approvals

 Management documents and communicates which activities require approval, and by
whom, based on the level of risk to the organization.
 Ensure that transactions are approved and executed only by employees acting within
the scope of their authority granted by management.

Proper Authorization of Transactions and Activities

General authorization

Specific authorization

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4. Security of Assets

 Secure and restrict access to equipment, cash, inventory, confidential information, etc.
to reduce the risk of loss or unauthorized use.
 Perform periodic physical inventories to verify existence, quantities, location,
condition, and utilization.
 Base the level of security on the vulnerability of items being secured, the likelihood of
loss, and the potential impact should a loss occur.

Physical Control over Assets and Records

The most important type of protective

measure for safeguarding assets and
records is the use of physical precautions/
an action which is done to prevent something.

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5. Reconciliation & Review

 Examine transactions, information, and events to verify accuracy, completeness,

appropriateness, and compliance.
 Base level of review on materiality, risk, and overall importance to organization’s
objectives.
 Ensure frequency is adequate enough to detect and act upon questionable activities in
a timely manner.

Independent Checks on Performance

The need for independent checks arises

because internal control tends to change
over time unless there is a mechanism
for frequent review.

6. Information and Communication

The purpose of an accounting information

and communication system is to…

initiate, record, process, and report

the entity’s transactions and to maintain
accountability for the related assets.

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Limitations of IC

• Internal control; no matter how well designed, implemented and conducted, can
provide only reasonable assurance to management and the board of directors of the
achievement of an entity’s objectives.
• In considering limitations of internal control, two distinct concepts must be
recognized. The first set of limitations acknowledges that certain events or conditions
are simply beyond management’s control.
• The second acknowledges that no system of internal control will always do what it is
designed to do. The best that can be expected in any system of internal control is that
reasonable assurance be obtained.
• The effectiveness of internal control is limited by the realities of human frailty/
weakness in the making of business decisions.
Internal control may not result in the intended objectives due to:
1. Human judgment;
2. External events;
3. Management override/ to take control over something, especially in order to change
the way it operates; and
4. Collusion./ agreement between people to act together secretly or illegally in order
to deceive or cheat someone
5. Human judgment: Some decisions based on human judgment may later, with the
clarity of hindsight, be found to produce less than desirable results, and may need to
be changed.
6. External events: For objectives relating to the effectiveness and efficiency of an
entity’s operations—achieving its mission, value propositions (e.g., productivity,
quality, and customer service), profitability goals, and the like—internal control
cannot provide reasonable assurance of the achievement when external events may
have a significant impact on the achievement of objectives and the impact cannot be
mitigated to an acceptable level.
7. Management override: The term “management override” is used here to mean
overruling prescribed policies or procedures for illegitimate purposes with the intent
of personal gain or an enhanced presentation of an entity’s performance or
compliance. Examples include:
8. increase reported revenue to cover an unanticipated decrease in market share
9. Enhance reported earnings to meet unrealistic budgets
10. Boost the market value of the entity prior to a public offering or sale
11. Meet sales or earnings projections to bolster bonus payouts tied to performance
12. Appear to cover violations of debt covenant agreements
13. Hide lack of compliance with legal requirements
14. Collusion: can result in internal control deficiencies. Individuals acting collectively
to perpetrate and conceal an action from detection often can alter financial or other
management information so that it cannot be detected or prevented by the system of
internal control
15. Collusion can occur, for example, between an employee who performs controls and a
customer, supplier, or another employee.

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Additionally,
• Staff size limitations may obstruct efforts to properly segregate duties, which requires
the implementation of compensating controls to ensure that objectives are achieved.
• A limited inherent in any system is the element of human error, misunderstandings,
fatigue and stress.
• Employees are to be encouraged to take earned vacation time in order to improve
operations through cross-training while enabling employees to overcome or avoid
stress and fatigue.

Evaluating IC

• Evaluating and improving internal control are among the core competencies of many
professional accountants
• Professional accountants can play a leading role in ensuring that internal control
forms an integral part of an organization’s governance system and risk management.
• IFAC provides the following key principles for evaluating and improving IC

• The organization should make internal control part of risk management and integrate
both in its overall governance system.
• The organization should determine the various roles and responsibilities with respect
to internal control, including the governing body, management at all levels,
employees, and internal and external assurance providers, as well as coordinate the
collaboration among participants.
• The governing body and management should foster an organizational culture that
motivates members of the organization to act in line with risk management strategy
and policies on internal control
• The governing body and management should link achievement of the organization’s
internal control objectives to individual performance objectives
• The governing body, management, and other participants in the organization’s
governance system should be sufficiently competent to fulfill the internal control
responsibilities associated with their roles
• Controls should always be designed, implemented, and applied as a response to
specific risks and their causes and consequences
• Management should ensure that regular communication regarding the internal control
system, as well as the outcomes, takes place at all levels within the organization
• Both individual controls as well as the internal control system as a whole should be
regularly monitored and evaluated.
• The governing body, together with management, should periodically report to
stakeholders the organization’s risk profile

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