Acc 313

ACC 313 Public Finance
GENERAL INTRODUCTION
As a student of Accounting, your knowledge of public finance is very important. This is

because every decision made by the government affects every citizen operating either within
or outside the jurisdictions of the government. It becomes very vital for you to add public
finance to your accounting knowledge in a global environment.
ACC 313 (Public Finance) has been designed as part of your curriculum to enable you
function either in private or public sector after your graduation. You need to understand the
policies and objectives of the government to enable you operate better. The knowledge of the
role of government in the public finance of any economy will allow you understand
economic and management strategies used in the generation of revenue (income) and its
application to expenditures (expenses).
ACC 313 is a three unit course that puts you on the same platform with students from other
departments, thereby enhancing your knowledge on the various contemporary issues in the
Nigerian economy. Each chapter ends with relevant objectives and essay questions to assist
students preparing for both academic and professional examinations.
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MODULE ONE:
THE GENERAL THEORY OF PUBLIC FINANCE
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STUDY SESSION1:
THE MEANING AND SCOPE OF PUBLIC FINANCE
Introduction
This study session discusses the fundamentals of Public Finance, its meaning, scope,
government income and expenditure, major sources of government revenue and factors that
cause growth in public expenditure in countries.
Learning Outcomes
At the completion of this study session, you should be able to:
(1.1) Define the concept of Public Finance.
(1.2) State the scope of Public Finance.
(1.3) Explain Government Income and Expenditure - General considerations.
1.1 The Concept of Public Finance

Public Finance is the study of how governments’ activities are financed. It is the study of
income and expenditure of the federal, state and local governments. According to Philip E.
Taylor, “Public Finance deals with the finances of the public as an organized group under the
institution of government. The finances of the government include the raising and
disbursement of government funds. Public finance is concerned with the operations of the
fiscal or public treasury. Hence, to the degree that it is a science, it is the fiscal science; its
policies are fiscal policies, its problems are fiscal problems”. In his introduction to Public
Finance, Carl C. Plehm pointed out that the term public finance “has come, by accepted
usage, to be confined to a study of funds raised by governments to meet the costs of
government.” Harold Groves gives a much more detailed definition than the ones above.
According to him, Public Finance is “a field of inquiry that deals with the income and
expenditure of government. In modern times, they include four major divisions: public
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revenue, public expenditure, public debt and certain problems of the fiscal system as a whole
such as fiscal administration and fiscal policy.”
These definitions point to the fact that the study of Public Finance covers how governments
raise funds to finance their activities and how such funds are disbursed. In other words, the
subject matter of public finance is concerned with the revenue raising and spending activities
of governments.
1.2 The Scope of Public Finance

Public Finance can be divided into five main parts:
1.2.1 Public Income or Revenue. This part deals with the various sources from which the
government might derive its income. It discusses and analyses the comparative advantages
and disadvantages to be taken into consideration in making a choice between them. The main
sources of revenue include taxes, fees, fines, dividend and profits from public undertakings.
1.2.2 Public Expenditure. The funds raised by government are expended on various
projects which are aimed at maximizing the social welfare of the citizens. In doing so, the
government participates in contributing to the financial flows of the economy that brings
about growth stabilization. Thus, under public expenditure, the principles that govern public
expenditure, its effect on production, employment, income distribution, stability and growth
are discussed.
1.2.3 Public Debt. Government borrows when revenue is not enough to meet its
expenditure needs. Loan to government is public debt. Under public debt, the reasons,
methods, sources of public debt, its burden and the method of debt redemption are discussed.
1.2.4 Financial Administration. This part is concerned with the way the government
handles its financial activities. It involves how the government controls the processes and
operations of public revenue, public expenditure and public debt. It includes the collection,
custody, disbursement of public funds, preparation of public budget, its passing,
implementation, auditing and other similar matters.
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1.2.5 Price Stability and Economic Growth. Price stability and economic growth have
become leading issues in economic policies of modern government. A detailed study of
public finance therefore, include how government stabilizes the economy ensure economic
growth by curtailing wide fluctuation in prices of goods and services.
1.3 Government Income and Expenditure —General Considerations

The question is, how does government get funds needed for the provision of public goods
and services? What are the major types of government expenditure? These questions will be
addressed on the next sub-heading.
1.3.1 Sources of Government Funds and Revenue

The government raises funds from various sources to finance its activities. The most
common and important sources of funds include the following:
i. Taxes
ii. Fees
iii. Income from public undertakings
iv. Mining rents and royalties
v. Fines
vi. Sales of government capital assets
vii. Borrowing and etc.
What the government gets from some of the sources listed above cannot be called revenue.
According to Dalton, “it may be useful to make a distinction between public revenue and
public receipts”. Public receipts embrace all sources of funds to the government, while Public
revenue is a more narrower concept. Public revenue does not include borrowing, sale of
government assets or income from printing press (i.e printing of more money by the Central
Bank of Nigeria). This distinction is further recognized by the 1999 Constitution of the
Federal Republic of Nigeria in which section 162 refers to revenue, while section 80(1) refers
to other monies.
The main sources of revenue that accrues to the Federal Government of Nigeria can be
divided into two: Oil and Non-oil revenue.
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1.3.2 Oil Revenue
Oil revenue sources include petroleum profit tax, mining rents and royalties and NNPC
earnings.
1.3.3 Non-Oil Revenue
This comprises company tax, Customs and Excise duties, independent revenue sources that
consist of Fees, Licenses, Fines etc. The above sources of revenue can also be classified into
direct and indirect taxes and non-tax revenue.
Direct taxes include petroleum profit tax, company or corporate tax and personal income tax.
The indirect taxes include Customs and Excise Duties. As regards these types of taxes,
import duties are dominant as the economy is highly dependent on foreign goods and
technology. Prior to the oil boom of early 1970s, agriculture was the mainstay of the
economy but the sector’s contribution has fallen from 65% to less than 30%. It is the revenue
from oil that now constitute the largest proportion of the revenue structure of the economy —
over 70% of the total revenue. This can be seen from table1.1 below:
Table 1.1: The Federal Government Revenue for 2006

Oil Revenue (Gross) N Billion N Billion %
Crude oil/Gas export 2074.2 34.77
PPT and Royalties etc 2038.3 34.17
Domestic Crude Oil Sales 1171.8 19.64
Other Oil Revenue 3.2 0.05
5287.5 88.63
Non-Oil Revenue
Companies Income Tax 224.9
Customs & Excise Duties 177.7
Privatization/GSM proceeds -
Value Added Tax (VAT) 221.6
Independent Revenue of Fed.
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Government (inc. GSM) 33.3 677.5 11.37

N 5965 100%
Source: CBN Annual report various issues
Figure 1.1: Federal Government Oil and Non-Oil revenue sources.

The pie chart in figure 1.1 shows the revenue sources of the federal government.
From the chart it can be seen that oil proceeds (88.83 percent) is the major source of revenue
to the Nigeria economy followed by non-oil revenue (11.37 percent). These sources, some of
which are lumped together, can be classified as follows:
(i) Revenue from Petroleum Profit Tax (PPT)
PPT is the tax on the profit made by the companies engaging in oil business. It is a
major source of government revenue.
(ii) Revenue from Mining
The revenue derived by the government from this source includes rents and royalties
obtained from operators and NNPC sales.
(iii) Revenue from Company Income Tax
Like in many countries, companies in Nigeria pay tax on the profit make annually.
This is another major source of government revenue.
(iv) Revenue from Import Duties
This is the tax levied on imported goods. Where the demand for such goods is
inelastic, the tax yield can be substantial to the government.
(v) Revenue from Export Duties
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These are taxes on goods exported to other countries. In Nigeria, such taxes are
imposed on agricultural products like rubber, cocoa, groundnuts, hides and skin,
cotton, etc. It is an easy way of collecting taxes from farmers scattered all over the
country and who may have been evading income tax. It is a source of federal
government revenue.
(vi) Revenue from Excise Duties Excise duty

refers to the tax levied on goods produced locally. It is another source of revenue to
the government.
(vii) Revenue from Interest on Loan
The government receives interest on loans given out. The repayment of such loans
with interest is a source of revenue to the government.
(viii) Independent Sources
The independent sources cover license fees and other fees, rent on government
property and personal income tax collected from the armed forces, foreign embassy
staff and residents of the Federal Capital Territory. (Note: Personal income tax of
residents in each state is collected by the respective State government).
(ix) Value Added Tax (VAT)
The Value Added Tax was introduced in Nigeria by decree 102 of 1993 by the
Federal Government. VAT as a system of tax replaced sales tax introduced in 1986
which effectively ceased to be operational with effect from January, 1994, that VAT
had its legal existence.
Value Added Tax is a form of indirect tax on spending. It is a consumption tax since it is
included in the prices of goods and services consumed. It is collectable at each stage of the
chain of production and distribution or supply of goods and services up to the final consumer
to whom everyone in the chain passes the tax he had paid. In view of the stage by stage
collection procedure, VAT is a multi-stage tax. VAT is an important source of revenue to the
Federal Government of Nigeria. In 1997 a total sum of N34 million representing 5.8% of the
total revenue the government received was from VAT. From the above, tax related revenue
tends to be more.
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1.3.4 Other Sources of Funds to the Government

i. Borrowing
Besides the sources of revenue stated above, the government may borrow money to enable it
fund specific projects or programmes; especially when its inflows do not match outflow. In
other words, taking a loan becomes necessary when its expenditure exceeds revenue or
receipts. There could be wars or natural calamities in which case the government would be
committed to a much larger expenditure and would therefore like to borrow the additional
funds needed. Such loans could be obtained internally or externally.
If government decides to borrow internally, it does so by issuing treasury bills and other
relevant securities. There are times when the amount involved may be too much to raise
internally. This necessitates external borrowing. Government could borrow from private
sources like the Paris and London Clubs of Creditors or multilateral sources like the World
Bank, IMF etc.
Borrowing constitutes a reasonable source of government funds and is in most cases
substantial. It is an alternative source of funds to the government. This alternative source of
funds is not without a cost. Any debt incurred needs servicing. The servicing of debts
requires large annual interest payments and this has also contributed to the growth of
government expenditure. Nigerian external debt service funds for 2006 were N249,326
million (i.e interest only). This was a lot of money.
ii. A government may have a deficit budget. To

meet this deficit, it can run down its cash reserves. It can also sell some of its assets like
properties etc. These are also sources of funds to the government. When the government
spends from its reserves what is left for the raining day is reduced.
iii. Grants and Aids

These generally come from foreign governments and other bodies. They can be in kind (that
is, in form of goods and technical services) or in cash. Though they are usually in form of
gifts, they may have strings attached to them.
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1.3.5 Major Sources of State and Local Government Revenue.
a. States
i. Income tax
ii. Rent on State Government properties and investments.
iii. Transfer from Federation Account
iv. Miscellaneous
b. Local Government
i. Rate/Fees (These include Market and Trading Licenses)
ii. Tenement rate and Property rate
iii. User charges (earnings from commercial undertakings)
iv. Transfers from State and Federation Account.
(i) What is the difference between public receipts and public revenue?
(i.) Public receipts include all monies received by government from all sources of funds,
while public revenue include what government gets from taxation, fees, income from
public undertakings, mining rents and royalties. Public revenue does not include money
borrowed and received from sale of government fixed assets.
c. Major types of government expenditure

Government expenditures are classified under Recurrent and Capital Expenditures as
follows:
Recurrent Expenditure
(i) General Administration: These are expenditures on general Administration, defense,
internal security and the cost of running the entire civil service.
(ii) Social and community services: These are expenditures on education, healthcare, and
others.
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(iii) Economic services: These are expenditures on direct productive activities. Such
activities include agriculture, fisheries, forestry, transport and communication, trade
and industry and others.
(iv) Transfer: These include public debt charges (Interest) on both domestic and external
debts, pensions and gratuities among others.
Capital Expenditure
Capital expenditures are grouped under the same headings as in recurrent expenditures
above. What differentiates the two is the nature of expenditure — that of capital is used
mainly to acquire tangible assets.
The capital expenditure includes the following:

(i) Administration: These are general administration, defense, internal security, among
others.
(ii) Economic Services: These include agricultures and natural resources, manufacturing,
mining & quarrying, transport and communications, special projects and others.
(iii) Social and Community Services: These include education, health, and housing among
others
(iv) Transfers: These include financial obligations and capital repayments such as
domestic debt and external debts
1.3.7 Outstanding Domestic Liabilities and others

The task of administering the country or providing the services listed above is divided among
ministries and departments with each playing a specific role towards the attainment of goals
for which they were established. For instance, Nigeria has Ministries of Defence,
Agriculture, Works and Housing, Education, Health, Science and Technology to mention but
a few.
1.3.8 The Theory of Public Expenditure
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Public expenditure refers to the expenses which the government incurs in the performance of
its functions. There are two notable theories of public expenditure, namely: the theory of
increasing state activities and the displacement theory.
The theory of increasing state activities was propounded by a German Economist known as
Adolph Wagner in 1890. According to him, there are inherent tendencies for the activities of
the government to grow both intensively and extensively. And there exist a functional
relationship between the growth of an economy and the growth of government activities.
That the government sector grows faster than the growth of the economy. All kinds of
government, irrespective of their intention and sizes, had exhibited the same tendencies of
increasing expenditure.
Wagner’s law also states that as per capital income of an economy grows, the relative size of
the public sector grows along with it. The growth will lead to an increase in the public
sector’s activities and expenditure. Wagner’s law was based on historical facts primarily of
Germany. F.S Nitti supported it and concluded with empirical evidence that it was not
applicable to Germany alone but to various States or governments.
1.3.9 Factors that cause growth in public expenditure in countries

(i) Welfare: The traditional functions of government were limited to defense, ensuring
law and order, justice, maintenance of the State, and social overhead. But with
increasing awareness of its responsibilities to the society, modern governments have
expanded activities, especially in the area of welfare measures, e.g. poverty
alleviation programme to mention but one example in Nigeria. Welfare programmes
increase government expenditure.
(ii) General Price level: It has been observed that prices of goods and services have a
tendency to go up. As a result of this, defense would become more expensive than
ever before.
(iii) Population: Increase in population is a major contributory factor to the growth of
public expenditure. As population increases, the scale of various public services has
to increase in harmony with the growth. For example, more schools and hospitals
have to be built or provided to meet the extra needs of the growing population.
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(iv) Increasing shift of population from the rural to urban area: This makes existing
cities to grow and new ones come up. Urbanization implies a much larger per capita
expenditure on civic amenities. Urbanization and conurbation will lead to
externalities like crime, prostitution and other vices that require public sector
intervention. There will be need for incidental services like those connected with
traffic, roads, maintenance of law and order. All these increase public expenditures.
(v) The size and nature of public services now involves specialization. For better
quality services, higher qualified administrators, technicians etc, are to be employed
and remunerated accordingly. This implies a higher cost of providing the public
services as what will be spent on salaries will be more.
(vi) Changes in Politics and Bureaucratic Structure: The political structure of Nigeria
for instance has undergone many changes over time. Initially the country had four
regions and later twelve, nineteen, twenty-one and now thirty-six States. The same
thing has happened to Local Governments. These changes have caused an increase in
government expenditure especially in the area of administration where sometimes
offices are duplicated.
(vii) Modern governments obtain loans to run their affairs; this leads to increase in public
expenditure in the form of increasing cost of debt servicing.
(viii) Like most African countries, at independence Nigerians demanded for better job
opportunities and education, improved healthcare and housing facilities. For
development, there was also the need for more schools, roads, bridges and ports. All
of these contributed to rising expenditures both in construction and maintenance.
The second theory of the growth of public expenditure was put forth by Wiseman and
Peacock in their study of public expenditure in the UK for the period 1890 - 1955. The main
contribution of the authors is that public expenditure does not increase in a smooth and
continuous manner but in jerks or step-like fashion. At times, certain social or other
disturbances occur which shows the need for increase in public expenditure that the existing
level of revenue cannot meet. When this happens, the movement from the initial and low
level of expenditure to a new and higher one is known as “the Displacement Effect” while
the inadequacy of revenue as compared to the required expenditure creates the “Inspection
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Effect”. As a result of the inadequacy, the government and the people review the revenue
position and the need to find a solution to the problems, agree to the required adjustments to
finance the increased expenditure. This will lead to a new level of tax tolerance. That is, they
are now ready to tolerate a greater burden of taxation which makes the general level of
expenditure and revenue to go up. In this way, the public expenditure and revenue get
stabilized at a new level until another disturbance occurs to cause a displacement effect.
Since each major disturbance leads to the government assuming a larger proportion of the
total national economic activity, the net result is the “Concentration Effect”. The
concentration effect also refers to the apparent tendency for a central government’s economic
activity to grow faster than those of the State and Local Governments.
Wiseman and Peacock’s analysis is based on the political theory of public expenditure
determination. It shows that although government is saddled with the responsibility of
incurring expenditures, citizens are usually reluctant to pay more tax. Because the
government in a democratic set up has to pay attention to the wishes of the people if it must
seek re-election; public expenditure tends to be influenced by the ballot box.
Summary of the study session

In this study session which is the introductory part of the module, the concept of public
finance is explained. Public finance is the study of the income and expenditure of Federal,
State and Local Governments. It is concerned with the revenue raising and spending
activities of the government. The study of public finance may be divided into parts as
follows:
• Public revenue which covers the different sources of government or public revenue. . .
Public expenditure covers how funds raised by government are utilized.
• Public debt is a part of public finance that discusses why and how government borrows
to finance its activities.
• Financial Administration is concerned with how the government handles its financial
activities.
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• Price stability and economic growth deals with how government stabilizes the economy
and ensures economic growth.
The main sources of government funds and revenue are taxes, fees, income from public
undertakings, mining rents and royalties, fines and borrowing, while the expenditure is
classified under recurrent and capital.
Self – Assessment Question

Section A: Select the most appropriate letter, from A-D, that best answers each of the
following questions.
1. Public finance is all about the study of funds raised by the government to meet the costs
of running a government. This definition was given by:
A. Philip E. Taylor
B. Harold Groves
C. Carl C. Plehm
D. Ursula Hicks
2. The scope of public finance does not include:
A. Public Revenue
B. Financial Administration
C. Price stability
D. Ballot box issues
3. Which of these is not an indirect tax?
A. Excise duties
B. VAT
C. Export tax
D. Petroleum profit tax
4. Fees in respect of market and Trading licenses are collected by:
A. Federal Government
B. State Government
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C. Both State and Local Government
D. Local Government
5. New naira notes were printed in April to increase the volume of money in circulation.
The total amount involved in addition to proceeds from sale of crude oil:
A. Refers to different sources of income to the government in April.
B. Is public income for the month of April.
C. Is public revenue for the month of April.
D. Is Public receipts for the month of April.
Questions 6 and 7 refer to the following Table.

The government received money in respect of the following in 2013.
N
Taxes 100 billion
Dividend 8 billion
Sale of Fixed Assets 2 billion
Borrowed 20 billion
Mining rents and royalty 30 billion
Fees 10 billion
6. What is the total revenue for 2013?

A. N170 billion
B. N70 billion
C. N148 billion
D. N108 billion
7. What is the total receipt for 2013?
A. N148 billion
B. N170 billion
C. N108 billion
D. N178 billion
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8. According to Wiseman and Peacock’s theory of the growth of public expenditure, the
inadequacy of revenue as compared to the required expenditure when certain social or
other disturbances occur creates:
A. Displacement Effect
B. Inspection Effect
C. Concentration Effect
D. Problems government cannot solve.
9. When government decides to borrow money internally, it does so by
A. applying to oil companies in the country
B. applying to private sources like Paris club
C. applying to World Bank
D. issuing treasury bills
10. Which of the following is not classified under the independent sources of Federal
Government revenue?
A. Income tax collected from the armed forces
B. ncome tax collected from staff of foreign embassies
C. Income tax collected from staff of Federal Government’s establishments in Lagos
D. Income tax collected from residents of the Federal Capital Territory
Section B
i. Define public finance and explain its scope.
ii. State the most common and important sources of government funds.
iii. List and explain the factors that cause increase in public expenditure.
iv. Explain the major contribution made by Wiseman and Peacock to the theory of the growth
of public expenditure.
Solution to MCQ
1 2 3 4 5 6 7 8 9 10
C D D D D C B B D C
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References
Jhingan, M. L. (2005) Money, Banking, International Trade and Public Finance.
India, Virinda Publications (P) Ltd.

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Should you require more explanation on this study session, please do not hesitate to contact
your e-tutor via the LMS.
Are you in need of General Help as regards your studies? Do not hesitate to
contact the DLI IAG Center by e-mail or phone on:
iag@dli.unilag.edu.ng
08033366677

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STUDY SESSION TWO:
THE PRINCIPLE OF TAXATION
Introduction
This study session discusses taxation, which is a major source of government revenue: types
of taxes, advantages and disadvantages of direct and indirect taxes, functions of taxation, tax
avoidance and evasion, and the principles of taxation.
Learning Outcomes
At the end of this study session, you should be able to:
2.1 Define taxation
2.2 Explain the different types of tax rate structure and forms of taxes.
2.3 Discuss the issue of how the burden of government finance should be borne.
2.4 State the principles of taxation.
2.5 Discuss the advantages and disadvantages of direct and indirect taxes.
2.6 Define tax base and rate.
2.7 State the function of taxation.
2.8 Explain the effect of taxation on economic systems.
2.9 Define tax avoidance and evasion
2.1 Definition
A tax is a compulsory levy imposed by a government on individuals, corporate bodies as
well as goods and services. According to Hugh Dalton, a tax is a compulsory contribution
imposed upon individuals by the authorities irrespective of the amount of services rendered
in return to the tax payer, and not imposed as a penalty for any legal offence committed.
A tax should, therefore be distinguished from charges, that is fees imposed by the public
authority for goods and services it provides. In other words, a tax is not a price paid by the
tax payer for any definite service rendered or commodity supplied by the government. For
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instance, water rate, charges for electricity consumed, and many others, are not taxes but
charges for services rendered. To be a tax, the absence of quid pro quo is necessary.
Tax in Nigeria was introduced so as to raise revenue that would enable government provide
social services for the benefit of its citizens at large. Income tax, which is an old form of tax,
was first introduced in 1904 by Lord Lugard. But income tax in its modern form dates back
to 1940.
2.2 Types of taxes

Taxes are classified as progressive, proportional and regressive, based on the proportion of
the tax payer’s income that is taken as tax.
Progressive tax
A tax is progressive when a percentage of the income paid as tax goes up as income
increases. In other words, the higher the income, the higher the proportion of the tax payer’s
income that is taken as tax and the lower the income, the lower the amount to be paid as tax.
Table 2.1: Progressive tax

Tax Base ₦ Tax Rate Tax ₦
First 100,000 3.5% 3,500
Next 50,000 5% 2,500
Next 50,000 7.5% 3,750
Next 50,000 10% 5,000
Next 100,000 15% 15,000
Next 150,000 17% 25,500
Above 150,000 20% 100,000
As shown by table 2.1, the higher the income the higher the tax to be paid. For example,
income of ₦100,000 is taxed 3.5%, while income of ₦150,000 is taxed 3.5% for the first
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₦100,000 and 5% for the remaining ₦50,000 (which is the next ₦50,000 on the table). In the
same way income of ₦200,000 is taxed 3.5% for the first ₦100,000, 5% the next ₦50,000
and 7.5% the remaining ₦50,000.
Proportional tax
A proportional tax rate structure is one whereby the rate of taxation is the same for all
income earners. For example, an income tax rate of 10 percent would tax all income at 10
percent. Thus, two persons with income of ₦50,000 and ₦100,000 respectively would each
be subject to the same rate of taxation (10 percentage of income). While the person with
income of ₦50,000 is paying ₦5,000, the other person pays ₦10,000. A tax with a
proportional tax rate is sometimes called a flat-tax rate. This is represented in the following
table:
Table 2.2 Proportional tax

20,000 10% 2,000
50,000 10% 5,000
100,000 10% 10,000
200,000 10% 20,000
Regressive tax
Under regressive taxation, people with smaller income pay a greater percentage of their
income as tax when compared with people who earn more. Indirect taxes are usually
regressive. For example, if both low and high income earning persons buy a bottle of coke
each and the tax on the coke is N5, the low income earner pays a higher proportion of his
income as tax as compared to the higher income earner.
Table 2.3 Regressive tax

10,000 10% 1,000
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50,000 2% 1,000
100,000 1% 1,000
Table 2.3 shows that the higher the income the lower the percentage of income which is paid
as tax. For instance an individual with tax base of ₦100,000 is expected to pay a tax rate of 1
% which is equivalent to ₦1000.
Forms of taxes
All taxes are classified into two broad categories: the direct and indirect taxes. Direct
taxes are those which the payer actually pays in cash to the government agent. These include
income tax, company tax, petroleum profit tax, capital gains tax and rates. These taxes are
presumed to be progressive as more money is being paid by those with higher income than
those whose earnings are smaller.
Indirect taxes include excise duties, export duties, custom duties and Value Added Tax
(VAT).
The advantages of direct Taxes

(i) Direct taxes are progressive so that the burden falls more on the rich than on the poor.
As the income of a person increases, the rate of income tax also increases.
(ii) It is not inflationary as it takes money from income and reduces tax payers’
purchasing power which helps to keep prices in check.
(iii) The very poor persons are exempted from paying tax.
(iv) A tax payer knows when his tax is due for payment and how much he is to pay.
(v) The government is able to fairly accurately estimate the yield from this form of
taxation.
(vi) This form of taxation enables allowances to be made for dependants and for
individual circumstances in computing the tax due.
(vii) The cost of collecting income tax is usually low as it is deducted from source (i.e
salaries).
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The disadvantages of direct taxes

(i) Personal income tax requires complicated form-filling
(ii) Direct taxes are not imposed on all income groups as not all the population is usually
reached.
(iii) It is impossible to get tax related revenue from tourists
(iv) It may be a disincentive to overtime work.
Indirect taxes are those which are included in the prices paid for commodities and services
and the payer pays it unconsciously to the government coffer. Indirect taxes are regressive
since they are charged not according to income but in accordance with the consumption of
the items taxed. These include import duties, export duties, excise duties, and Value Added
Tax (VAT).
2.3 Advantages of Indirect taxation
(i) Indirect taxes do not require complicated form-filling in most cases.
(ii) It is possible to receive tax related revenue from all groups of the population, both the
rich and poor.
(iii) Tourists or visitors pay indirect tax which increases government revenue as they
consume goods and services that are taxed.
(iv) Indirect taxes do not discourage overtime work
(v) There is less possibility of evasion as indirect taxes are included in the prices of
commodities.
(vi.) It is hidden and not too easily noticed by the taxpayer and as a result it is not felt at
the time of payment.
(vii) An indirect tax can easily be altered by the government.
(viii) It can be used to check consumption of particular items. This is done when
government imposes high rate of tax on such items.
(ix) Import duties can be used to protect and encourage home industries.
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Disadvantages
(i) Indirect taxes are regressive. The rich and the poor are required to pay the same
amount of tax in which case a greater proportion of a poor person’s income goes into
taxation unlike the rich person.
(ii) Indirect taxes are inflationary as their imposition generally lead to increase in prices.
(iii) A taxpayer does not know how much of what he pays for a commodity is tax.
(iv) The revenue from indirect taxes can be uncertain because it is not possible to
accurately estimate. The effect of such taxes on the demand for a luxury good for
example is elastic and may fall if it is heavily taxed.
2.4 The issue of how the burden of government finance should be borne
In the study session one, we discussed how government raises funds to finance its activities.
Taxes are major sources of government finances. But a basic problem in government finance
is how to distribute among citizens the burden of financing the costs of government –
supplied goods and services. There are two major approaches to how the burden of
government finance could be distributed among the citizens.
These are:
(i) The benefit Principle
The benefit principle requires citizens or members of the society to contribute (through
taxation) the cost of the goods and services being supplied by government in proportion to
the benefits they receive. This means that the benefits received are to be taken as the basis
for distributing the tax burden.
A major problem with this principle is that most government- provided goods and services
are collectively consumed benefits that are difficult to assign to individuals. For such goods
and services, the principle of exclusion does not apply in practice. Besides, it is not in
agreement with the definition of taxation which is a compulsory levy imposed by a
government on individuals, corporate bodies as well as goods and services.
25

(ii) The ability – to –pay Principle
This principle requires individuals in a society to contribute to government finance in
accordance to their capacity to pay. Thus, a person with a greater ability to earn income
should be taxed more than the person with less capacity to earn. It means that every person
should pay tax according to his ability to do so.
Related to the ability -to –pay principle are two notions, namely:
1. Horizontal equity
2. Vertical equity
Horizontal equity implies that individuals of the same economic capacity (i.e earn the same
amount of money as income) should pay the same amount as tax. That means persons
considered to have the same tax paying ability should pay the same amount of taxes. The
equal treatment of tax payers suggested by the horizontal equity looks good but may be
difficult to achieve in practice.
Vertical equity requires that individuals in different economic ability or circumstances

should pay different taxes. The principle requires taxes to be levied in a progressive manner.
The higher a person earns, the more tax he or she pays. In other words, the rich individuals
pay more at a higher rate than those whose incomes are less.
2.5 Principles of Taxation

The principles of taxation are also known as the canon of taxation. A good tax system must
conform to some principles of taxation. These are:
(i) The canon of equality
Equity or justice requires that individuals in a society must contribute to government revenue
in accordance with their ability to pay. A good measure of ability in taxation is an
individual’s income. The canon also implies persons of the same economic capacity should
be taxed equally.
(ii) The canon of certainty.
This means that the tax each individual is to pay ought to be certain and not arbitrary. The
tax payer should know how much he is to pay and when his tax is due for payment.
26
(iii) Canon of convenience.

This requires that a tax should be due and paid at a time and place convenient for the tax
payer. An import duty for example is usually due and paid at the port.
(iv) Canon of Economy.
This canon recommends that the cost of collecting the tax in terms of salaries of tax officials
and other expenses should not be more than what the tax brings as revenue. The tax should
also be economical to the tax payer. He should be left with sufficient money after paying the
tax.
(v) Canon of Productivity.
A good tax system should be able to provide large revenue for the government.
(vi) Canon of Simplicity.

The tax laws must be spelt out in a simple and plain language that the tax payer can
understand.
2.6 Tax base and rate

For every tax, there is a tax base. A tax base is the real object of taxation. In other words,
anything or persons that a tax is imposed on is a base. See table 2.4 for examples of taxable
objects and items.
Table 2.4 Tax base

Base Tax
Income / profit Personal income and company profit tax
Consumption Sales, value and added tax
Wealthy/property Estate tax
Importation Import duty
27

If tax is said to be broad based, it refers to all the above-mentioned bases. The proportion of
the tax base paid as tax is called tax rate. Tax rates are usually a percentage of the tax base.
2.7 Functions of taxation

The functions of taxation are:
1. Revenue Function: One of the reasons why governments levy taxes is to raise funds to
enable it carry out its statutory obligations. To generate enough revenue and perform
these statutory functions effectively, the tax must be broad based. There must also be
the following preconditions.
i. Revenue Capacity:
Revenue capacity is basically the strength of the base for taxation. For a particular
community or country this strength will depend on a number of factors that
include:
(a) The level of economic development.
(b) Population
(c) Industrialization and commercialization.
(d) The prevailing distributions of fiscal jurisdiction.
Where the level of economic development is high and the population of those to
pay tax is large, the higher will be the revenue that will be realized from taxation.
This is because income and the propensity to consume by consumers will be high.
With high industrial and commercial activities, more profit will be made by
business organizations and the ability to pay will be enhanced.
ii. Revenue Effort:

Revenue effort refers to how the machinery being used for tax administration is.
To increase revenue effort means to improve on tax assessment and guard against
tax evasion. If an area has a high revenue capacity but revenue effort is low, the
revenue yield will be low. Thus, for taxation to perform the revenue function, the
revenue effort must be high.
iii. Cost of Administering Taxation
28
Cost of administering should be as low as possible as it will be uneconomical to

spend too much money on collecting tax relative to the revenue to be realized.
2. Taxation also performs other functions that can be termed non-revenue functions.
These include redistribution of income and stabilization function.
Briefly explain what is meant by tax base and tax rate
A tax base is the object that is taxed, e.g. income/profit, property, etc. A tax rate is a
percentage of the tax base.
2.8 Economic effect of tax on economic system

In spite of the rapid pace of modernization of the Nigerian economy in recent years, it is still
underdeveloped. The economy is dependent on imported goods and raw materials. The
performance of the manufacturing and agricultural sectors is low. Based on this kind of
background, the effects of Nigerian Tax System on her economic system are both positive
and negative. The economic effects are as follows:
Positive Effects: The tax system covers both direct and indirect taxes whose imposition has
positive effect on the economy.
Stabilization: If an economy is experiencing inflation, one way to deal with the situation is
to raise direct taxes on individual incomes and in turn lead to overall reduction in the demand
for consumption goods and lower prices. Reduction in profits resulting from the increased
tax would lower investment by business and, all things being equal reduce inflation.
29

While, on the other hand, economy is experiencing depression, the government may lower
the overall level of taxes so as to increase disposable incomes, and business profit. This will
encourage demand for more goods and services. The multiplier effect of the resulting
changes may increase income, output and employment.
(b) Employment: It is argued that if customs duties or tariffs on imported goods are raised,
the prices of such goods would increase and might reduce local demand for them. This will
increase the patronage of substitute locally manufactured goods. This leads to expansion and
employment tends to increase through the multiplier effects.
Negative Effect
Where the demand for a commodity is inelastic, indirect tax has the tendency to generate
inflation. Increase in commodity taxation in the form of import duties or excise duties may
lead to an increase in the price of the commodity. Direct tax may discourage the incentive to
save and invest, especially when the tax is excessively high. This might affect the economy
negatively.
2.9 Tax avoidance
Tax avoidance is a change in behaviour so as to reduce tax liability. In this case the respond
to the changes in prices caused by taxes by rearranging their personal affairs. For example,
high taxes on labour incomes might induce workers to refuse overtime work.
A tax payer may also reduce tax liability by taking advantage of special provisions
(sometimes called loopholes) in the tax law. However, tax avoidance is not illegal.
Tax evasion
Tax evasion is non-compliance with the tax laws by failing to pay taxes that are due. If a
person made sales and fails to report them to the government, it is tax evasion. Tax evasion is
illegal.
To minimize the problem of tax evasion, the government must do the following:
30
i. The government must establish an administrative mechanism to collect the tax and
enforce penalties against non-compliance.
ii. Increase the requirements for reporting of income to the Inland Revenue.
iii. Audit of tax returns should be carried out regularly.
Summary
Taxation is a compulsory levy imposed by a government on individuals, corporate
organizations, goods and services. A tax is not a price paid by the taxpayer for any definite
service rendered by the government. All taxes are classified into two broad groups, namely,
direct and indirect taxes. Direct taxes include income tax, corporate profit tax, petroleum
profit tax and capital gains tax. All these are presumed to be progressive as more money is
paid by those with higher income. Indirect taxes include excise duties, export duties, custom
duties and value-added-tax. They are regressive as the very poor persons spend a greater
proportion of their income on taxation than the rich persons in the society. Taxation
performs both revenue and non-revenue function.
31

Self-Assessment Questions
Section A
Select the letter (A, B, C, D) that best answers each of the following questions?
(1) A tax can be defined as -
(A) A compulsory levy imposed by government on goods and services consumed.
(B) A compulsory levy imposed by government on corporate bodies, individuals and
goods.
(C) A compulsory charge on an individual and corporate organization as a penalty for
a legal offence committed.
(D) Quid Pro quo
(2) A tax system that requires citizens to pay 10 percent of their income to government is:
(A) Regressive
(B) Progressive
(C) Proportional
(D) Proportional and regressive
(3) Petroleum Profit tax is a ….
(A) Regressive tax
(B) Progressive tax
(C) Proportional and progressive tax
(D) Proportional tax
(4) Which form of taxation enables revenue to be extracted for tourists?
(A) Direct taxes
(B) Indirect taxes
(C) Progressive tax system,
(D) Proportional tax system
(5) Which form of taxation is difficult to evade?
(A) Indirect taxes
(B) Direct taxes
(C) Company tax
(D) Proportional tax
(6) Which of these is not correct?
(A) Custom duties can be used to protect home industries
32
(B) Capital gains tax is a direct tax

(C) To be a tax, the absence of quid pro quo is necessary
(D) Tax avoidance is illegal
(7) An import duty due and paid at the port fulfils the canon of:
(A) Certainty
(B) Convenience
(C) Economy
(D) Productivity
(8) Government receiving large and enough revenue from taxation is in agreement with
the:
(A) Canon of economy
(B) Canon of productivity
(C) Benefit principle
(D) Ability to pay principle
(9) Vertical equity requires that….
(A) Individuals of the same economic capacity be taxed the same amount
(B) Individuals in the same employment be levied the same amount as tax
(C) Individuals of different economic ability or circumstances be made to pay
different taxes.
(D) Every citizen contributes to government finance.
(10) Which form of taxes is likely to cause inflation?
(A). Direct taxes
(B). Indirect tax
(C). Corporate Profit tax
(D). Capital gains tax
SECTION B
(i) Define taxation
(ii) Briefly explain the following:
(a) Progressive taxation
(b) Regressive taxation
33

(c) Proportional taxation
(iii) What are the advantages of indirect taxes?
(iv) Define tax evasion. Explain what can be done to minimize the problem of tax evasion.
(v) State three reasons why government levy taxes
Solution to MCQ
1 2 3 4 5 6 7 8 9 10
B C B B A D B B C B
References
Jhingan, M.L (2005) Money, Banking, International Trade and Public Finance. India
Vrinda Publications (P) Ltd.
Bhatia, H.L (2011) Public Finance Vikas Publishing House PVT Ltd.
Hyman, N. David (1993) Public Finance, A Contemporary Application of theory to
policy the Dryden Press.
Harvey, S. R. (1995) Public Finance, Irwin McGraw.
34
08033366677

35

STUDY SESSION THREE:
NATIONAL INCOME: MEANING AND MEASUREMENT
Introduction:
This Study Session explains the meaning of National Income and how it is measured. Also,
discussed in this study session are a number of concepts that pertains to national income,
problems associated with its measurement and the usefulness of national income statistics.
Learning Outcomes:
3:1 Define National Income
3.2 Explain concepts of National Income
3.3 Discuss the methods of measuring National Income
3.4 Explain the limitation of the methods of measuring National Income in Nigeria
3.5 State the problems of National Income measurement
3.6 Discuss the uses of National Income statistics
3.1 Definition
National Income is the total reward or income received by the factors of production as
payments for their contribution to the total volume of production during a specific period of
time, which is normally a year. National Income also refers to the total monetary value of
goods and services produced annually in an economy or country. The rewards to the various
factors of production include the following:
36
Factors of Production Rewards

Land Rent
Labour Salaries and Wages
Capital Interest
Entrepreneur Profit
3.2 Concept of National Income

There are a number of concepts that should be mentioned in discussing National Income.
They include the following:
3.2.1 Gross National Product (GNP):
The Gross National Product is the total monetary value of goods and services produced in a
country in a given year in addition to the net income from abroad (Net income from abroad is
the difference between receipts from and the payments to foreigners). In other words, GNP
is the sum total of goods and services produced by the nationals of a country irrespective of
where they live.
3.2.2 Gross Domestic Product (GDP):

Gross Domestic Product is the total monetary value of goods and services produced by the
residents of a country irrespective of their nationalities.
3.2.3 Net National Product (NNP):

NNP is Gross National Product (GNP) less depreciation.
3.2.4 Personal Income (P.I):

Personal Income is the total income an individual receives in a year in a country. It should
be noted however that total Personal Income is not equal to money national income. The
reason is that, Personal Income could include transfer payments. Where the total national
income is given, P.I. is arrived at as follows:
37

P.I.= National Income- Indirect Taxes – Undistributed Profit – Government Transfer
Payment.
3.2.5 Disposable Income (DI):

Disposable income is the actual income, which can be spent on consumption by families and
individuals. D.I. is arrived at by deducting direct taxes from personal income. Such taxes
are income tax and property tax.
3.2.6 Per Capital Income (PCI):

This refers to the average income of the individuals of any given country in a year. It is
arrived at by dividing the gross national product by the country’s population.
3.2.7 Transfer payments or Income:

Transfer payments or incomes refer to incomes received by some persons, for which they
have made no corresponding contribution to the flow of goods and services. These include
gifts, compensation benefits, bursary awards, pension allowances and, etc. An example is
when a man receives N20,000.00 pays his security man N3,000.00 and sends N2,000.00 to
his mother monthly. The N2,000.00 being sent to the mother monthly is transfer payment,
while only the sum of N20,000.00 and N3,000.00 are included in calculating the National
Income. Transfer payments are not included instead they are deducted.
3.2.8 National Income at Factor Cost

This involves calculating the value of National Income using only the cost of factors of
production. The National Income in this case is arrived at, by adding together all rewards to
factors of production. This means that the calculation does not require any adjustments.
3.2.9 National Income at Current or Market Prices:

National Income is at current prices when the prevailing market prices are used to estimate it.
Given the National Income is estimate through this approach, getting national income at
factor cost would require making some adjustment. Taxation has to be subtracted and
subsidies added. That is:
38
(a) GNP at market prices = GNP+ Indirect Tax – Subsidy

(b) GNP at factor cost = GNP – Indirect Tax + Subsidy
Define National income
National income is the total monetary value of goods and services produced in an economy
in a period of one year. It also refers to the total income received by the factors of production
in a year.
3.3 The measurement of national income

National income is measured using the following methods:
3.3.1 The income method:
This method measures national income by adding together all incomes received by factors of
production: that is,
National Income = Salaries and Wages + Interest + Profit + Rents + Net income
from abroad (This is applicable when calculating GNP) - Transfer payment
It can also be measured using the formula:

Yn = (YP – TP) + UP + GY
Where Yn = National Income, YP = Personal Income
TP = Transfer Payments, UP = Undistributed Profit and
GY = Government Income.
Example one
In an economy, the following data were recorded in the year 2000:
39

N (Million)
Undistributed Corporate Profit 250
Income received by government 300
Income from self-employment 150
Income from employment 200
Personal Income from other Sources (No transfer payment) 100
You are required to calculate the National Income for the year, 2000.
Solution:
National Income (Yn) = (Yp-Tp) + Up + Gy
Yn = (N 450-0) + N 250+ N 300
= N 450+ N 250+ N 300
= N1000 Million
Example two
Suppose you are given N20 million as net income from abroad in addition to the data in
example one.
Calculate the GNP.
Solution:
GNP = N 450 + N 300+ N 20 = N1020 Million
3.3.2 The expenditure method

With this method the national income is arrived at by summing up all expenditure made in
the economy. In other words, the national income is equal to the total of household
expenditure, investment expenditure and government expenditure. It should be noted that
only expenditure on final goods and services should be included so as to avoid double
counting.
National Income by expenditure = Consumption expenditure + expenditure by public

institutions + expenditure on Gross Domestic Capital Formation. The same result could be
obtained using this formula. E=C+I+G+(X-M) + P, where E = National Expenditure, C =
40
Consumption (expenditure on capital goods), G = Government expenditure, X-M = Export

(X) less Import (M) and P = Net Property Income from abroad.
3.3.3 The product method:

This approach or method sums up the net value of goods and services produced at market
prices. To calculate GNP, the data of all productive activities such as agriculture,
manufacturing, construction and services by insurance companies, lawyers, Accountants,
Doctors, etc are all collected and assessed at market prices. It should be emphasized that
only final goods and services are taken into consideration while intermediate goods and
services as well as depreciation are left out so as to avoid double counting.
3.3.4 The value added method:

This method is another way to estimate the national income through the product or output
approach. With this method, the difference between the value of material outputs and inputs
at each stage of production is added up to get the gross domestic product.
3.4 Limitation of the methods of measuring national income in Nigeria

It should be noted that not all the three methods discussed above could give accurate
measurement of national income in developing countries like Nigeria. One of the problems
especially with the income method is that of the existence of subsistence sector where not all
economic activities are monetised and as a result it is difficult to include them. A significant
proportion of the Nigerian population is self-employed. These include traders and Market
women who do not keep account of their business, as they are illiterates. And those who are
able to keep account of their business keep spurious records of expenditure and profit for the
purpose of paying less tax. Getting accurate total income earned in the country therefore
becomes difficult. The Inland Revenue returns provide particulars of sources of income that
are subject to personal income tax, but income from jobs done in a man’s spare time may not
be officially recorded and therefore be estimated; or they may even be completely omitted.
41

Lack of accurate records of expenditure and the great disparity in consumption patterns, limit
the expenditure method. For reasons of reliability in statistical data and the complex nature
of the economy, the output method is more in use. Though it has its limitation, to take
account of goods and services being produced in the economy and calculate the national
income using output method appears more realistic.
3.5 Problems of national income measurement

i. One of the greatest problems in computing national income is that of DOUBLE
COUNTING, which arises from the inability to distinguish between intermediate and
final products. There is the fear of the cost of production process being included more
than once; for instance, flour used by a baker is an intermediate product. To solve the
problem of double counting, only the final goods and services are to be considered.
ii. National income is usually measured in monetary terms. But goods and services that
are difficult to assign monetary value to may not be included in computing national
income.
These include goods and services produced and consumed by the producer, services of
house wife, painting as a hobby, washing of ones clothes, etc.
iii. Exclusion of income earned through illegal but economic activities. Such activities
include gambling and prostitution among others.
iv. The treatment of depreciation poses a problem in calculating national income. This is
because there are several methods for calculating it. And the question is, what is the
best method? This question becomes more pertinent when we remember that the
various methods give different valves.
3.6 Uses of national income statistics

i. Provision of information for planning: Since the figures represent the performance of
economy overtime, they are useful as guide to economic planning. They enable the
planners or government to know the rate of economic growth annually and the
contribution of each sector of the economy.
ii. National Policies. The National Income figures enable government to know the
direction in which the industrial output, investment and savings are changing to and
formulate policies that can bring the economy to the right path when it is necessary.
42
iii. Standard of living: The overall standard of living of a nation can be determined using
the national income statistics.
iv. Contribution to international organizations:The National Income of a country is
used to determine how much she should contribute to international organizations like
United Nations, International Monetary Fund, etc.
v. Comparison:National Income statistics are used to compare the standard of living of
different countries. This is done on the basis of income per head or per capital income.
They can also serve as indicators of the economic strength of a country, that is, how
rich or poor the country is.
vi. Research Purpose:The National Income Statistics are made use of by those who carry
out research on various issues or subjects in economics.
What effect does government expenditures give on national income?
Government expenditures increase demand for goods and services. They are injections in the
national income.
Summary
National Income is defined as the total reward or income received by the factors of
production as payment for their contribution to the total volume of production for a period of
one year. It also refers to the total monetary value of goods and services produced annually
in an economy. There are a number of concepts that pertain to national income which should
be mentioned in discussing national income. These include Gross National Product (GNP),
Gross Domestic Product (GDP), Net National Product (NNP), Personal Income (P.I) and
Disposal Income (DI) National Income is measured in four different ways: Income Method,
43

Expenditure Method, Output Method and Value Added Method. Getting the accurate figure
in computing national income statistics is very useful in planning purposes and for the
purpose of comparing the standard of living of different countries.
Section A: Select the most appropriate letter (A,B,C,D) that answers each of the following
questions:
(1) Which of these statements is not correct? National income is:
(A) the monetary reward to the various factors of production annually
(B) the total expenditure made annually in an economy
(C) total monetary value of goods and services produced in a year
(D) the summation of salaries and wages, corporate profits, rents and cash gift.
(2) Per Capita income refers to
(A) Gross National Product
(B) Gross Domestic Product
(C) Average income of individuals of a country
(D) Average disposable income of individuals of a country
(3) Compensation benefits are the same as
(A) Disposal income
(B) Transfer payment
(C) Gross income from other sources
(D) Extra income earned
(4) Addition of salaries & wages, money received from rent, interest, and profit from
several business transactions is known as national income at
(A) Current prices
(B) Market prices
(C) Labour prices
(D) Factor cost
(5). Net National Product is
(A) GNP – indirect tax + subsidy
(B) GNP + indirect tax – subsidy
(C) GNP – depreciation
44
(D) GDP – depreciation

(6) GDP in Nigeria is the total monetary value of goods and services produced
(A) All members of Manufacturer Association of Nigeria
(B) All nationalities resident in Nigeria
(C) All nationalities engaged in import and export of goods
(D) None of the above
(7) Which of the following is likely to be excluded in computing national income?
(A) Income earned by a gardener
(B) Income earned by a housemaid
(C) Painting as a hobby
(D) Sale of tomatoes and pepper by a Mallam Osobase
(8) Which of these is not correct in computing national income?
(A) Intermediate goods and services as well as depreciation are left out so as to avoid
double counting.
(B) Only intermediate goods and services are left out so as to avoid double counting
(C) Only the difference between the value of material outputs and inputs are included
(D) Only the final goods and services are considered
Question 9 and 10 refer to the table below

In an economy, the following data were recorded in one year N (Million)
Undistributed Corporate profit 400
Income received by government 600
Income from artisans 100
Income from employment 200
Personal income from other sources (No transfer payment) 100
(9). What is the GDP
(A) N1400 million
(B) N1300 million
(C) N1200 million
(D) N1100 million
45

(10) Suppose, in addition to the data above, the economy recorded Imports of N80 million
and Exports of #180 million, What is the GNP?
(A) N 1400 million
(B) N 1300 million
(C) N1500 million
(D) N1600 million
SECTION B
i. Define national income
ii. Briefly discuss the following
• Gross National Product
• Gross Domestic Product
• Transfer payment
iii. Explain the problems that do arise in computing national income
iv. How useful is the national income statistics
v. Explain what is involved in using the output method in calculating the Gross National
Product (GNP).
Solution to MCQs
1 2 3 4 5 6 7 8 9 10
D C B D C C C B A C
References
Jhingan, M.L and Stephen J.K (2008) Managerial Economics. India Vrinda Publications (P)
Ltd.
Buhari, A.L (1993) Straight to the point ICAN/Polytechnic Public Finance.
MAYO-BP (1996) ICAN study text PEII Public Finance Mayo Associates Ltd and BPP
Publishing Ltd.
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08033366677

47

STUDY SESSION 4:
THE THEORY OF NATIONAL INCOME DETERMINATION
KEYNESIAN MODEL
Introduction
This study session discusses the Keynesian model of national income determination in a
capitalist economy. It highlights the basic proposition of the Keynesian model of national
income and for ease of analysis; it has been classified into a two-sector model, a three-sector
model and a four-sector model. The study session also explains the characteristics of each of
these and calculations relating to them
Learning Outcomes
4.1 Explain the general Keynesian model of national income determination in a capitalist
economy.
4.2 Determine national income equilibrium using:
(a) Aggregate demand and supply approach
(b) Savings – investment approach.
4.3 Define the multiplier concept and the derivation of the multiplier (2 – sector model)
4.4 Explain the equilibrium national income of a three sector Keynesian model:
(a) when government is introduced and without tax;
(b) when direct tax is introduced.
4.5 Discuss the four sector Keynesian model and derive the equation
Yeq = a – bTo + Io + Go Xo¯Mo
1-b+M
4.1 The General Keynesian Model Of National IncomeDetermination In A Capitalist

Economy
48
The basic proposition here is that the equilibrium level of income and output is dependent on
the economy’s level of aggregate demand for output. National income models consider the
functional sectors of the economy which include the following:
The Household Sector
This covers persons and institutions in their capacity as consumers of goods and services. It
also includes suppliers of factors of production.
The producing or investment sector

This includes persons and institutions in their capacity as producers of goods and services.
Government Sector
Included in this sector are all levels of government that provide goods and services: The
various models could be classified as follows:
Two-sector Model makes transfer payments. This comprises domestic firms and households.
The circular flow of the income (which is shown by the diagram below) of economic
activities among the two settings; that is, domestic firms and households.
Fig. 4.1: A Circular Flow of Income
49

As shown in the diagram above, in a two-sector economy, households supply the firms,
factors of production while the firms in turn supply the households’ goods and services. It
also shows that payments are made by both sectors for the goods, services, and factors of
production being supplied, consumed and used. This is a closed economy. There is no
foreign trade. There is also no government.
Three-sector Model - Firms, households, and government

Four-sector model - Firms, households, government and foreign trade.
4.2 National Income Determination – Equilibrium Analysis

National income equilibrium can be determined using the following methods:
(i) Aggregate Demand and Supply Approach: Using expenditure and income approach at
equilibrium, aggregate demand will be equal to income/output of goods and services. At
equilibrium, National Income (NI): = a+1
1-b
(ii) Saving – Investment Approach: At equilibrium, planned savings is equal to planned
investment.
Let us use this approach to determine the national income equilibrium under a two-sector,
Keynesian model.
4.2.1 Under A Two-Sector Economy (Closed Economy)
(i) Using demand – Supply approach
Equilibrium National Income (N.I): = a+1
I-b
This formula can be derived as follows:

Income (Y) = Consumption (C) + Investment (I) i.e; Y = C + I ………1
C is made up of 'a' which is that aspect of consumption that does not depend on income and
induced consumption 'bY', which depends on income.
50
Therefore C = a + bY ………………………………………………………..….2
Substituting equation 2 into 1 we will now have Y = a + bY+ I ……………..…3
Re-arranging them we have Y – bY = a + 1
Y (I-b) = a + I
Y= a + I or a + I
1 - b 1-b 1-b
(1-b) is Marginal Propensity to Save (MPS) while b is marginal propensity to consume
(MPC)
Note that, MPC + MPS = 1. Therefore MPS = I - MPC and MPC = 1-MPS
Marginal Propensity to consume (MPC) refers to the percentage or proportion of any

increase in income that is consumed while MPS is the percentage of any increase in income
that is saved. The above equation shows that equilibrium income is the sum of autonomous
consumption plus investment divided by MPS.
The aggregate demand and supply approach can be used to determine national income
equilibrium under the three-sector and four-sector Keynesian model stated earlier.
(ii) Saving - Investment approach
Saving (S) = Investment (1)
(S) = I……………………………… (1)
And if Y = C + I ………………………...(2)
Then S = Y – C ……………….……….(3)
Equation (2) can be rewritten as Y – C = 1
Earlier, we said C = a + bY
Y – (a + bY) I ……………………………..(4)
When the brackets are opened we have
Y – a - bY = 1
Y – bY = a + I
Y(1-b) = a+I
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Y = a+I
I+b
In a 2-Sector economy, the following were recorded in 2013.

C = ₦1000 + 0.75Y
I = ₦100
You are required to calculate the equilibrium income.
Using the Aggregate Demand (AD) and Aggregate Supply (AS) Approach:
Aggregate Demand (AD) = C+ I while
Aggregate Supply (AS) = Y
At equilibrium AD = AS
Therefore ₦1000+0.75Y + ₦100 = Y( i.e Y= ₦1000 + 0.75Y + ₦100)
Putting like terms together we would have
Y – 0.75Y= ₦1000 + ₦100 = Y(1-0.75) = ₦1000 + ₦100
Yeq = ₦1000 +₦ 100
1 – 0.75
= ₦1100 = ₦4400
0.25
In a 2-Sector economy, the following were recorded in 2013.

C = ₦1000 + 0.75Y
I = ₦100
You are required to calculate the equilibrium income.
52
Savings – Investment approach: The data remain as in example 1 above.
Solution
C = ₦1000 + 0.75Y
But savings S = Y – C i.e Y – (₦1000 + 0.75Y) when the bracket is opened we would have
Y – 1000 – 0.75Y.
Remember , with savings – Investment approach, Planned Savings = Planned Investment.
Therefore Y – ₦1000 – 0.75Y = ₦100
Y – 0.75Y = ₦100 + ₦1000 = Y (1-0.75) = ₦1100
Y = ₦1100
0.25
= ₦4400
Note that a closed economy is one without foreign trade.
Example 2
4.3 Multiplier Concept
The multiplier concept states that a change in expenditure will bring about a change in
national income that is greater than the initial change in expenditure. The multiplier is
therefore defined as the ratio of change in national income to change in expenditure.
Derivation of Multiplier (2 – Sector Model)

Y = C + 1 ……………………………….. (1)
Assuming there is a change in all the variables we will have ∆Y = ∆C + ∆I …(2)
When we divide equation (2) by ∆Y we will have:
∆Y = ∆C + ∆I ……………………….(3)
∆Y ∆Y ∆I
1 = ∆C + ∆I
∆Y ∆Y
53

Subtract ∆C from both sides of equation 3
∆Y
That will give us 1 - ∆C = ∆I …………..(4)

∆Y ∆Y
When equation 4 is inverted we have

1___ = ∆Y …………………..(5)
1 - ∆C ∆I
∆Y
∆C = MPC = b
∆Y
∆Y= 1 …………………………...(6)
∆I 1 - b
Equation (6) is called investment multiplier which shows that a (∆ Change) in the level of
investment spending will have an impact on national income which will be greater than the
original change in investment.
Suppose there is a change of ₦400m in investment spending when MPC is 0.75. What will
be the effect on the National Income?
If investment change by N400 million and MPC is 0.75, thus:

∆Y = 1__
∆I 1–b
∆Y = 1__
400m 1 – 0.75
∆Y = 1__
400m 0.25
54
0.25Y = 400m
Y = ₦400m = ₦1600m
0.25
4.4 Equilibrium National Income in Three-Sector Keynesian Model
As mentioned earlier, the 3-Sector economy comprises the household, business and the
government. With the introduction of government, Y = C + I + G and taxes are levied and
spent. The government increases messages aggregate demand by spending on goods and
services and by collecting taxes. This makes the difference between a 2-Sector and 3-Sector
models.
(a) Equilibrium National Income when government is introduced (without tax).
Aggregate Demand AD = C + I +G …………………………….(1)
But C = a + bY
At equilibrium Y = AD
Therefore, Y = a + bY + I + G …………………………….(2)
Y-bY = a+I+G
Y(1-b) = a + I + G
Yeq =a+I+G
1-b
(b) When Direct tax is introduced (Recall equation 1):
Y = C + Io + Go……………………………………………….(4)
Where Io = autonomous investment
Go = autonomous Government Expenditure
C = a + bYd ………………………………………………….(5)
And Yd = Y – To …………………………………………….(6)
Where Yd = disposable income and To = autonomous tax.
Substituting equation (5) and (6) into 4 gives us:
Y = a + b (Y - To) + Io + Go
Y = a + b Y- b To + Io + Go
Y – bY = a – bTo + Io + Go
Y(1-b) = a – bTo + Io + Go
Yeq = a – bTo + Io + G
55

1 -b
4.2.4 The Four Sector Keynesian Model

In this model we have:
i. The household sector
ii. The business sector
iii. The government sector and
iv. The external sector which makes it an open economy.
With the inclusion of foreign trade and government that levies taxes, the activities of a 4-
Sector economy are more than those of the 2-Sector. The activities include imports and
exports of goods and services, government expenditures and taxation which should be
considered in calculating national income. It should be noted that government expenditures
are like investment as they raise the demand for goods and services. They are injections in
the national income, while taxes like savings are leakages. This is because taxes and savings
tend to reduce the demand for consumer goods. In the same way, exports are injections
while imports are leakages in the national income.
With the 4-sector model:

Y = C + Io + Go + X – M ………………………………..(1)
C = a + bYd …………………………………………….(2)
Y = Gross National Income
Yd = Y – T ………………………………………………..(3)
C= Consumption
To=Taxation…………………………………………...(4)
I= investment
M=Mo + mY …………………………………..…...(5)
G= Government
X= exports,
thus X = Xo ……………………………………………….(6)
M= imports
T= taxation
56
Yd= disposable income

Let equation (2) above be C = a +b(Y – To) ….(7)
Substituting equation (5), (6) and (7) into (1) we would have:
Y= a + b(Y – To) + Io + Go + Xo – (Mo + mY)
= a+bY – bTo + Io + Go + Xo – Mo - mY
Y-bY+mY = a-bTo + Io + Go + Xo – Mo
Yeq = a-bTo + Io + Go + Xo – Mo
Y(I – b + M)
= a- bTo + Io + Go + Xo + Mo
1–b+M
You are required to calculate the equilibrium national income using the following data:
C = N400 + 0.8Yd
I = N200
G = N200
X = N400
M = N200
T = N40 + 0.16Y
Y = C+1+G+X–M
Y = N400+0.8Yd +N 200 +N 200 +N400 – N200
Y = N400 + 0.8(Y-T) + N200 + N200 + N400 – N200
= N400 + 0.8 [Y-(N40+0.16Y)]+N600
= N400 + 0.8[Y- 40-0.16Y]+N600
= N400 + 0.8Y-32-0.128Y+N600
=N400+0.8[Y-40-0.16Y]+N600
=0.8Y-0.128Y+N400+N600-32
Y+0.128Y – 0.8Y =N968 Y(1+0.128-0.8) = N968
Y(0.328) = N968
Y = N968/0.328
Y = N 2951.22
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Summary
The equilibrium level of income and output is achieved when there is demand for goods and
services produced in the economy. National income models consider the functional sectors
of the economy which include the households, investment sector and the government sector.
The various models are classified as two-Sector, three-Sector and four-Sector economies.
The two-Sector economy is made up of the household and firms. The three-Sector model is
made up of the two-Sector economy and government, while the four-Sector has the three-
Sector and foreign trade. National income equilibrium can be determined using two different
approaches, namely:
Aggregate Demand and Supply Approach
Savings – investment approach
The multiplier concept is about how a change in expenditure brings about a change in the
national income that is greater than the initial change in expenditure.
Section A. Select the most appropriate letter (A, B, C, D) that best answer each of the
following questions:
Questions 1 and 2 refers to the equation, NI = a + I
1– b
1. 1 -b in the equation refers to……………..
(A) Marginal propensity to consume
(B) Marginal propensity to save
(C) The growth rate in the economy
(D) Investment by the Household sector
2. The b refers to:
(A) Marginal propensity to consume
(B) Marginal propensity to save
(C) An increase in savings
(D) A decrease in savings.
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3. The multiplier concept is defined as:

(A) Decrease in investment spending due to losses
(B) A change in expenditure without a corresponding increase in national income.
(C) A change in expenditure that bring about an equal increase in national income.
(D) The ratio of change in national income to change in expenditure
The following refers to questions 4 – 6

In a 2-sector economy, the following were recorded in 2012:
C = 1000 + 0.75Y
I = 100
Aggregate Demand (AD) = C + I and Aggregate Supply AS=Y
4. What is AD?
(A) 3400
(B) 4000
(C) 4200
(D) 4400
5. What is C?
(A) 4300
(B) 4250
(C) 4000
(D) 3800
6. Find Y
(A) 4200
(B) 4400
(C) 4000
(D) 3400
7. The equation, ∆C = __1 is called
∆Y 1–b
(A) Expenditure on luxury goods
(B) Investment multiplier
59

(C) Planned investment
(D) Unplanned investment
8. Savings are to be considered as:
(A) Injections in the national income
(B) Leakages in the national income
(C) Companies retained profit only in the national income.
(D) Unspent gross income in the national income.
9. Which of these statements is not correct?
(A) Taxes are leakages in the national income
(B) Imports are leakages in the national income.
(C) Government expenditures are injections in the national income.
(D) Exports are injection in the national income.
10. Suppose there is a change of ₦800 million in investment spending when MPC is 0.75.
What will be the effect of this on the national income?
(A) ₦3000 million
(B) ₦3100 million
(C) ₦3200 million
(D) ₦3400 million
SECTION B
i) Explain what is meant by the expression "equilibrium level of national income".
ii) How is national income determined in an open economy?
iii) Briefly explain the multiplier concept.
iv) A 3-Sector model economy without tax has the following data in 2014:
C = 600 + 0.75Y
I = 100
G = 400
You are required to calculate the equilibrium national income.
Solution to MCQ
1 2 3 4 5 6 7 8 9 10
60
B A D D A B B B D C
61

References
Bhatia, H.L (2011) Public Finance Vikas Publishing House PVT Ltd.
Buhari, A.L (1993) Straight to the point ICAN/Polytechnic Public Finance.
Harvey, S. Rosen (1995) Public Finance, Irwin McGraw.
Hyman, N. David (1993) Public Finance, A Contemporary Application of theory policy the
Dryden Press.
Jhingan, M.L (2005) Money, Banking, International Trade and Public Finance. India,
Vrinda Publications (P) Ltd.
Jhingan, M.L and Stephen J.K (2008) Managerial Economics India, Vrinda Publications (P)
Ltd.
MAYO-BP (1996) ICAN study text PEII Public Finance Mayo Associates Ltd and BPP
Publishing Ltd.
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08033366677

63

STUDY SESSION FIVE:
THE FREE MARKET ECONOMY
Introduction
In this study session, an attempt has been made to discuss the concept of free market
economy at a level comprehensible to learners in the study of public finance. Thus, the
characteristics of a free market system were identified. Likewise, the roles of government in
a market economy are examined while the concept, causes and solution of market failure are
explained
Learning Outcomes
5.1 Define and use correctly the key terms in this concept
5.2 Define the concept and features of free market economy
5.3 Highlight the merits and demerits of a free market economy
5.4 Identify the roles of government in the working of the market system
5.5 Explain the meaning of market fail
5.6 Examine the reasons why market fails.
5.1 The Concept of Market Economy

A free market is a market without economic intervention and regulation by government
except to defend private contracts and ownership right of property. This is the type of market
system that characterizes the economy of the United States and most developed nations of the
world as at 2010. It is the opposite of a controlled market, where the government regulates
the means of production and determines how goods and services are used, priced, or
distributed. A free market economy is an economy where all markets within it are
unregulated by any parties other than those players in the market. This requires protection of
existing property rights, but no coercive regulation, no coercive subsidization, no coercive
government-imposed monopolistic monetary and no forceful governmental monopolies. As a
64
learner, an understanding of some of the main features of a market economy can give you an
insight of the concept. Thus, the chart of Lameiro, the author of ‘America’s economic war’
will be employed to define and highlight the salient features of a free market economy (see
figure 5.1).
Figure 5.1: Features of the free market economy
Free
Cooperative
and Peaceful
Free to set Free to choose
process
prices your work
Free to buy Free to be an

own, use and Entrepreneur
sell private Free Market
property
Free to Free to be an
compete investor
Free to earn Free to create

profits capital
formation
Source: http://gerardlameiro.com/thoughts/characteristics-of-a-free-market
The subdivision of the feature of the market economy as shown in figure 5.1, is briefly
explain: the economy involves a free, cooperative and peaceful process. Individual in the
economy has the liberty to operate and cooperate with any individual/s to do business since:
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i There is no government intervention in the working of the economy.
ii. Individuals have freedom to choose their own work. Every individual in the economy
is free to partake in whatever work or establishment that they feel is better for them.
iii. Individuals have liberty to be investors. Everybody in the society is free to invest in
any sector of their choice.
iv. Each individual free to be entrepreneurs. In this regard, everybody can own a
business and manage other factors of production without coerce from any third
parties.
v. Everyone is free to create capital formation (the process of bringing together capital
from savers and investors to invest in new businesses, products and services).
vi. Individuals are free to make profits. Each person is free to invest and make profit
from whatever investment undertaken.
vii. Individuals are free to compete (to create faster, better and cheaper products and
services).
viii. Liberty to buy, earn, use and sell private property (without excessive government
regulations).
ix Individuals are free to set prices (including wages and salaries – the prices paid for
labour services).
Having stated the features of the market economy, it is believed that, in the marketplace the
price of a good or service helps communicate consumer demand to producers and thus directs
the allocation of resources toward consumer, as well as investor satisfaction. The price is a
result of a plethora of voluntary transactions, rather than political decree as in a controlled
market. Through free competition between vendors for the provision of products and
services, prices tend to decrease, and quality tends to increase. Thus, a free market is not to
be confused with a perfect market where individuals have perfect information and there is
perfect competition. In a more simplified term, the proponents hold that within an ideal free
market, property rights are voluntarily exchanged at a price arranged solely by the mutual
consent of buyers and sellers. By definition, sellers and buyers do not force each other, in the
sense that they obtain each other's property rights without the use of physical force, threat of
physical force, or fraud, nor are they coerced by a third party (such as by government through
transfer payment) and they engage in trade simply because they both consent and believe that
66
what they are getting is worth more than or as much as what they give up. Price is the result
of buying and selling decisions enmasse as described by the theory of demand and supply. In
the market setting, the entrepreneur takes a great risk to launch a business, putting up capital,
with the hope that the product or service will succeed. If the risk is considered a
disadvantage, when the business succeeds, the profit and control of the business future is
determined by the owner, not the government.
In reality, there is no free market economy in any country because most nations that claim to
practice market economies have lesser or greater government intervention. Even in countries
like USA considered to be champions of free market, there are many areas of government
control. For example there are laws intended to check unfair trade practices. Also there are
considerable restriction on what can be imported and how many quantities through the
mechanism of import quotas and tariffs. Then there are provisions like anti-dumping laws.
These prove that free economy has its advantages as well as limitations.
What do you understand by the words free market economy?
A free-market economy is an economy where all markets within it are unregulated by any
parties other than those players in the market. Likewise, it is a market economy that is based
on the forces of demand and supply with little or no government intervention. A completely
free market is an idealized form of a market economy where sellers and buyers are allowed to
freely transact (i.e. trade/sell/buy) based on a mutual agreement on price without
Government/State intervention in the form of regulation, subsidies or taxes.
3.2 The merits and demerits of free market economy

Whether the society is developed or underdeveloped, a market economy has several
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The Important Merits and Major Demerits:
5.2 The merits identified are:
• There is increase in efficiency: It is said earlier that free market economies are very
competitive. Most of the firms in the industries are assumed to be perfectly competitive
and so productive and allocative efficiency will arise. It makes sense that free market
economies allocate their resources more efficiently. Decisions about what to produce
are made by the people who will actually consume the goods. Planners are less likely to
make the correct decisions across the whole economy.
• Individuals have choice to buy and sell at their free will. Each firm are expected to
produce whatever consumers are prepared to buy. Remember that the consumer is
sovereign. Due to the free enterprise factor, there are no restrictions on what the firms
can produce. It is of no surprise, therefore, that there will be a much larger choice of
goods and services in a free market economy compared with a command economy. The
planner will be more concerned with making sure there are enough essential goods to
go around rather than allocating resources efficiently between all goods.
• There is more innovation as firms look for new products to sell. Firms will always
be looking to produce something new to get ahead of their competitors. We said earlier
that, even though the government's role is limited, one of its jobs is to protect property
rights. This will include intellectual property rights through patents. Hence, there are
incentives in the free market system for firms to be innovative and produce better
quality products. Obviously there is no incentive for the planner to be innovative. As
long as they produce the essentials the planners will be happy.
• Attract and increases the number of foreign investors. Foreign investment is

attracted as word gets out about the new opportunities for earning profit;
• It enhances higher economic growth rates. One does not have to be an expert in
economics to see that countries whose economic structure is nearer to the free market
system have grown much faster and quicker than those with a command economy since
the Second World War. The most successful economy in the world (in terms of size) is
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the USA, and they have been one of the liberal economies in the world. Given the three
factors above, learners shouldn’t be surprise that this is the case. It should be noted that
many mixed economies have grown quite well, but certainly the post-war command
economies had the worst record.
• Reduce some expenditures burden of the State. The size, power, and cost of the
State bureaucracy are correspondingly reduced as various activities that are usually
associated with the public sector are taken over by private enterprises:
• Availability of variety of goods and more people are empowered with skills to
work. A great variety of consumer goods become available for those who have the
money to buy them; and many more people quickly acquire the technical and social
skills and knowledge needed to function in this new economy.
The major demerits are as follows:

• Certain goods and services might not be produced: There might be certain goods
and services that may not be produce by the free market economy. Those goods and
services that people might want to use free of charge may not be available because the
firms may not find it profitable to produce. For example, public goods, such as street
lighting and National defence.
• Unequal distribution of income. For many, this is the key demerits of a free market
economy. In a free market with very limited government control, benefits will be low,
the health service sector and schools will be under funded. If you start life with very
little, and do not even get a good education, then there will be very little protection
from destitution. A command economy might not have the efficiency and enterprise for
the successful to make millions, but at least the strong government will try to make sure
that nobody falls through the safety net. It will be a fairer economy, even though it is
likely to be less successful overall.
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• Pollution of the environment. Free market economies are likely to produce more
environmental pollution, which is bad for the environment. Command economies can
make sure that the production processes that they chose are as environmentally friendly
as possible. They should be able to make sure that the level of output is the socially
optimal level of output. Governments can try to force firms into producing the socially
optimal level of output through the use of taxes, but governments with a limited role
will not be keen to use taxes.
• Consumption of harmful goods may be encouraged: Free market economy might
find it profitable to provide goods which are in demand and ignore the fact that they
might be harmful for the society.
• There is the tendency of workers been exploited? This form of economy system
may experience worsen exploitation of workers, since the harder, faster, and longer
people work—the less they get paid—the more profit is earned by their employer (With
this incentive and being driven by competition, employers are always finding new ways
to intensify exploitation).
• Growing unemployment. Enterprises in the market economy will only employ those
factors of production which will be profitable and thus we may find a lot of
unemployment as more machines and less labour will be used to cut cost. This point is
buttress on the ground that, there is little or no government intervention in the working
of the system, thus, the employers has the full power to fire at will. Likewise, machines
and raw materials might be available, however, if the people who need product from
them cannot afford the price that will generate profit, the owners will do nothing
because, in a market economy profits are what matters. When entrepreneur do not make
profit, they tend to reduce the number of their work force.
• Increase in the level of corruption. This form of economy system tends to increase
the corruption level in all sectors of the society. This further increase the power of those
with a lot of money to bribe the officials and those without money to bribe the officials
is put at a severe disadvantage. Also, there is increase in all kinds of economic crimes,
70
with people trying to acquire money illegally when legal means are not available (and
sometimes even when they are.)
• Inequality in status. With such a gap between the rich and the poor, egalitarian social
relations become impossible (people with a lot of money begin to think of themselves
as a better kind of human being and view the poor with contempt, while the poor feel a
mixture of hatred, envy and respect for the rich); those with the money also begin to
exercise a disproportional political influence, which they still use to help themselves
make more money;
• Ignore social cost: In the desire to maximise profits businesses might not consider the
social effects of their actions. Their action reduces social benefits and welfare (since
such benefits are financed at least in part by taxes, extended benefits generally means
reduced profits for the rich; furthermore, any social safety net makes workers less
fearful of losing their jobs and consequently less willing to do anything to keep them);
and worsening ecological degradation (since any effort to improve the quality of the air
and of the water costs the owners of industry money and reduces profits, our natural
home becomes increasingly unliveable).
List three merits and demerits of the free market economy?
5.3 Government roles in the market economy

Some, if not most, in our society are very confused when it comes to the role government
must assume in a free market economy. There is a reason why it is called “free market
economy.” It is called so because government must not dictate the course the economy
should take. When a society has the government controlling and/or interfering in the course
of her economy activities, then it is said that, the economy ceases to be free. In consensus
71

with economic literature, five roles are attributed to the government in a market economy.
These functions as discuss by Prof. Hassan (2009) are:
i. Providing the economy with a legal structure: This is the first and most important
function a government should provide and without it the economy may collapse. This
function requires the government to ensure property rights, provide enforcement of
contracts, act as a referee and impose penalties for foul play. In order to perform this
function, the government should furnish the economy with regulations, legislations, and
means that ensure product quality, define ownership rights and enforce contracts.
ii. Maintaining competition: Since competition is the optimal and efficient market
mechanism that encourages producers and resource suppliers to respond to price signals
and consumer sovereignty, the government should fight monopoly power and non-
competitive behaviour.
Thus, anti-monopoly laws (Sherman Act of 1890; Clayton Act of 1913) in USA are
designed to regulate business behaviour and promote competition. It is important to
mention here that Microsoft was found guilty of violating these laws in 2000.
iii. Redistribution of income: The government should strive to provide relief to the poor,
dependent, handicapped, and unemployed. Welfare, Social Security and Medicare
programs are examples of programs that support the poor, sick and elderly. These
programs are built on transferring income from the high income groups to the limited
income ones, through progressive taxes. Other means of redistribution might include
price support programs such as the farm subsidy and low interest loans to students
based on their family incomes.
iv. Provision of public and quasi-public goods: When the markets fail to provide the
needed goods or the correct amounts of certain goods or services, the government fills
in the vacuum. Examples of public goods that the markets do not provide are defence,
security, police protection and the judicial system. Education and health services are
examples of quasi-public (merit) goods that the market does not provide enough of. The
government should provide the first, and help in the provision of the second.
v. Promoting growth and stability: The government (assisted by the Fed) should promote
macroeconomic growth and stability (increasing the GDP, fighting inflation and
72
unemployment) through changes in its fiscal and monetary policies. The fiscal policies
means the use of taxes and spending and it is managed by the executive branch
represented mainly by the Treasury Department. The monetary policies signifies the
use of interest rates, money supply, reserve requirements, etc. and it is managed by the
Federal Reserve System.
Going over these tasks and functions, and examining what was going on in the U.S. economy
in general, and the financial markets in particular, for the last ten years, the reader may get a
sense of which tasks the government neglected to perform partially or completely. Also, in
which functions the government expanded its power beyond the call of duties and in explicit
conflict with the principles of the free market system.
Highlight three roles government played in the working of the free market economy.
Three function of the government in a free market economy are:
i. Providing the economy with a legal structure
ii. Provision of public and quasi-public goods
iii. Redistribution of income
5.4 The concept of market failure

However, there are circumstances when free market mechanism does not perform their
function efficiently in the economy. Scholars refer to these states of the markets as market
failure. Market failure occurs when freely-functioning markets fail to deliver an efficient
allocation of resources. The result is loss of economic and social welfare. Market failure
exists when the competitive outcome of market is not efficient from the point of view of
society as a whole. This is usually because the benefits that the free-market confers on
individuals or businesses carrying out a particular activity diverge from the benefits to
society as a whole.
5.5 Market failure occurs due to many reasons. Some of these causes are discussed below.
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i. Monopoly power. This is a situation where one or few producers and/or sellers gain
control of the market. Monopolists restrict output and charge prices higher than the
competitive market prices. Proper functioning of free competitive markets requires
breaking-up monopolies, ceasing and desisting monopolistic practices or regulating
them.
ii. Negative externalities. Consumers and producers may fail to take into account the
effects of their actions on third-parties, such as car drivers, who may fail to take into
account the traffic congestion they create for others. Third-parties are individuals,
organisations, or communities indirectly benefiting or suffering as a result of the
actions of consumers and producers attempting to pursue their own self-interest. For
example, multinational companies do not bear the full cost of oil spillage and health
hazards that their pollution imposes on the indigenes of Niger Delta.
iii. Missing markets. Markets may fail to form, resulting in a failure to meet a need or
want, such as the need for public goods, such as defense, street lighting, and
highways.
iv. Productive and allocative inefficiency. Markets may fail to produce and allocate
scarce resources in the most efficient way.
v. De-merit goods. Markets may also fail to control the manufacture and sale of goods
like cigarettes and alcohol, which have less merit than consumers perceive.
vi. Incomplete markets. Markets may fail to produce enough merit goods, such as
education and healthcare.
vii. Property rights. Markets work most effectively when consumers and producers are
granted the right to own property, but in many cases property rights cannot easily be
allocated to certain resources. Failure to assign property rights may limit the ability of
markets to form.
viii. Information failure. Markets may not provide enough information because, during a
market transaction, it may not be in the interests of one party to provide full
information to the other party.
ix. Unstable markets. Sometimes markets become highly unstable, and a stable
equilibrium may not be established, such as certain agricultural markets, foreign
exchange, and credit markets. Such volatility may require intervention.
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x. Inequality. Markets may also fail to limit the size of the gap between income earners,
the so-called income gap. Market transactions reward consumers and producers with
incomes and profits, but these rewards may be concentrated in the hands of a few.
Solutions to eliminate or curb market failures

In order to reduce the possibility of market failures, governments can choose two basic
strategies:
• The use of price mechanism. The first strategy is to implement policies that change the
behaviour of consumers and producers by using the price mechanism. For example, this
could mean increasing the price of ‘harmful’ products, through taxation and providing
subsidies for the ‘beneficial’ product. In this way, behaviour is changed through
financial incentives, in the same way that markets work to allocate resources.
• The use of legislation and force. The second strategy is to use the force of the law to
change behaviour. For example, by banning cars from city centres, or having a
licensing system for the sale of alcohol, or by penalising polluters, the unwanted
behaviour may be controlled. In the cases of market failure, a combination of remedies
is most likely to succeed.
(i.) What do you understand by the term market failure?

(ii.) Briefly state four causes of market failure and two possible solutions to market failure?
(i) Market failure occurs when freely-functioning markets, fail to deliver an efficient
allocation of resources. It occurs when there is an inefficient allocation of resources in a
free market. The result is loss of economic and social welfare.
(ii) Market failure can occur due to the following reasons;
• Monopoly power (when a firm controls the market and can set higher prices.)
• Negative externalities (Goods / services which impose cost on a third party) and;
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• Public goods (Goods which are non-excludable and non-rival –usually not
provided in a free market economy e.g. police, national defence.)
(iii) Solutions to market failure are
• The use of price mechanism to regulate the economy
• The application of legislation and force by government.

This study session has been able to discuss the concept of free market economy and the
underlining features. The merits and demerits of the market economy were briefly identified
while the roles of government in the system were discussed. Furthermore, the issue of market
failure was explained for learners to understand the meaning of the concept. Likewise, the
causes and remedies of market failure were mainly highlighted.
Section A. Select the most appropriate letter (A, B, C, D) that best answers each of the
1. In a free market economy, consumption and investment decisions
(a) Are controlled largely by the government.
(b) Shape the future course of the national economy.
(c) Are necessarily controlled by big businesses.
(d) Require protection from foreign forces if individuals desire wealth accumulation.
2. The whole classes of goods that will be under-produced or not produced at all in a
completely unregulated market economy are referred to as:
(a) Free goods
(b) Public goods
(c) Private goods
(d) Pareto goods.
3. The whole classes of goods that will be produced in a completely unregulated market
economy are referred to as:
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(a) Free goods

(b) Public goods
(c) Private goods
(d) Pareto goods
4. One major reason why government intervene in a market economy is as a result of
(a) Market failure
(b) Perfect competitive market
(c) Budget deficit
(d) Public debt.
5. In a market economy, the government is responsible for …..
(a) The price determination
(b) Social Over- head Capital (SOC)
(c) Provision of economic resource
(d) Monitor the functioning of the market.
6. Another name for completely unregulated market economy is:

(a) Mixed economy
(b) Command economy
(c) Perfect competitive market
(d) Free market economy.
7. In a market economy, the prices of goods and services are determined by………
(a) The invisible hand
(b) The price mechanism
(c) The capitalists
(d) All of the above.
8. Market failure is attributed to any of the following:
(a) Monopoly power
(b) Missing markets
(c) Negative externalities
(d) None of the above.
9. Which of this role is not performed by the government in a free market economy?
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(a) Provision of economic resource
(b) Provision of public and quasi-public goods
(c) Maintaining competition
(d) Providing the economy with a legal structure
10. Government may intervene to correct the distortions created by market failure and to
improve the efficiency in the way that markets operate through the following except:
(a) Pollution taxes to correct for externalities
(b) Taxation of monopoly profits (the Windfall Tax)
(c) Oligopolies/cartel behaviour of output and price determination unchecked
(d) Policies to introduce competition into markets (de-regulation).
Solution to MCQs
Questions 1 2 3 4 5 6 7 8 9 10
Answers B B C A B D D D A C
References
Bertell, O., (1999). Market Economy: Advantages and Disadvantages (Talk at Nanjing
Normal University, Nanjing, China—Oct., l999)
https://www.nyu.edu/projects/ollman/docs/china_speech2.php
Hassan, Y. A., (2009) The role of government in a market economy. A professor of
economics at The Ohio State University at Marion, USA. September.
http://econ.ohiostate.edu/Aly/docs/The%20role%20of%20government%20MS%20Ar
ticle%209-27-08.pdf
Lameiro, G. F. (2012). America’s Economic War – Your Freedom, Money and Life. A
Citizen’s Handbook for Understanding the War between American Capitalism and
Socialism. http://gerardlameiro.com/books/americas-economic-war
www.answers.com/topic/regulated-market
https://www.nyu.edu/projects/ollman/docs/china_speech2.php
https://www.princeton.edu/~achaney/tmve/wiki100k/docs/Free_market.html
http://gerardlameiro.com/thoughts/characteristics-of-a-free-market
http://smallbusiness.chron.com/features-market-economic-system-3887.html
78
http://www.enotes.com/homework-help/what-advantages-disadvantages-free-market-
eco www.krusekronicle.com
http://www.economicsonline.co.uk/Market_failures/Types_of_market_failure.html
www.krusekronicle.com/.../governments-role-in-a-free-market-economy.
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MODULE TWO:
GOVERNMENT MANAGEMENT OF THE ECONOMY
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STUDY SESSION SIX:
PURPOSE, FUNCTIONS, TECHNIQUES AND LIMITATIONS OF
PUBLIC BUDGETING
PUBLIC BUDGET 1
Introduction
A budget is a financial or quantitative statement prepared prior to a defined period of time for
the purpose of attaining a given objective (ICAN 2006).A budget is a short financial plan
used in achieving short and long term objectives. Public budget is usually for one year or
twelve months. Public budget must be prepared, approved, for a specific period of time and
for a purpose.
Budget preparation could be traced back to the time of Joseph in the Bible days in Egypt.
Joseph told Pharaoh to use the first seven (7) years of plenty to budget for the seven years of
famine. Joseph built warehouses and stored grains that fed a nation for seven years. Joseph
budget for grains, saved two nations (Egypt and Israel).Every responsible person prepares a
budget to achieve objectives.
A good student of (Distance Learning Students DLI) who is married with two children will
have to prepare his budget every year based on his income to achieve some objectives e.g.
DLI school fees, children school fees, house rent, feeding allowances, clothing, capital
projects like building a personal house, buying a car etc so does the government of any
nation prepare and approve budget to achieve some objectives on yearly basis.
However it is important to learn that one of the primary motives of budget is to measure the
profit earning of an organization. However, the Government objectives are not for profit
making but for different purposes listed below. Please note that government budget is the
same thing as public budget. Nigeria government budget usually start from January to
December every year.
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Learning Outcomes
At the end of this session, you should be able to:
6.1 Define public budget
6.2 State five purposes of public budget
6.3 Mention five functions of public budget
6.4 List five advantages and disadvantages of public budget
6.5 List the budget method or techniques of public budget
6.6 List five limitations of public budget
6.1 Public Budget.

A budget is a financial or quantitative statement prepared and approved usually for one year.
It is a short term plan describe in figures. It is a short term plan normally used to achieve long
term plan. Government budget or public budget in Nigeria is prepared by the Executive Arm
of government and approved by the Senate.
6.2 Purpose / Objectives Of Government Budget.

Government budget is usually for one year meant to achieve government objectives.
The following are the objectives of government budget:
• To allocate resources: the budget is used to allocate resources to states, ministries, and
parastatals every year.
• To distribute her limited resources: government has to distribute her limited resources
to go round her citizens.
• To spell out new allocation; i.e. new policies, new development, new areas to achieve
new objectives
• To point out the direction of the economy and policies to achieve them.
• To determine who gets what, when and how.
• To express the duties of the Executive and legislature for preparation and approval.
• To guide present and future performance of government activities.
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• To evaluate performance for the purpose of controlling on-going economic ventures.
6.3 Functions of Budget

Government budget is prepared by the executive, presidency and approved by the legislature
which comprises the Senators and Representatives to perform the following functions:
• Planning: With the approval of the budget, federal government, state government,
ministries, organizations and individuals are able to make adequate plans to achieve
some objectives for that period.
• Communication: Government budget communicates government plans and objectives
to every sector of the economy e.g. health, education, sports, agriculture etc.
• Control: The budget serves as a control limit of expenditure in government ministries
and parastatals for the present period and help to compare performances for previous
year
• Motivation: It serves as a source of motivation to organizations, ministries and
individuals where the budget figure is in favour to them. Example free education, this
will motivate low income earners to send their children to school, tax holiday will
motivate and encourage infant industries to do better, etc
• To develop the economy: Government budget is meant to solve problem like inflation
and unemployment. For example capital projects embark on by the government help to
create jobs for the unemployed.
• To provide social infrastructures and amenities: Government budget provides recreation
amenities to improve the better standard of living which cannot be provided by a single
individual.
• Financial document: It is a means of accountability for the money earlier entrusted and
newly approved budget.
• Coordination: The budget directs and coordinates the activities of government to
achieve its plans and objectives.
6.4.1 Advantages of Government Budgeting.
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• It is a short term plan (one year) used to achieve short and long term objectives. The
example of short term objectives is payment of school fees, long-term objectives is
capital project like building a house i.e. year1 buy the land, year2 lay the foundation,
year3 raise to window level, year4 raise to roofing level and so on.
• It has lay down procedures, rules and regulations to comply with government policies
and objectives.
• It helps to control mismanagement of funds.
• It saves time because the amount to be spend, when, where and how is spelt out in the
budget.
• It helps to reduce errors and fraud due to specific allocations and accountability.
• It serves as a tool for measuring performance and motivation.
• It shows the direction and area of focus of the government economy.
• It serves as a guide for the next year budget.
6.4.2 Disadvantages of Government Budgeting.

• Budget planning and implementation waste time.
• It does not cater for emergencies and irregularities beyond the approved limit.
• It does not allow the justification of all objectives.
• It allows too many data to be kept for reference purpose.
• It is only for a short period of time with all the time, money and stress associated to the
preparation and approval.
• It leads to rejection of policies and projects because different government comes with
different policies and projects.
6.5 Budgeting Methods or Techniques

There are different methods used by the government to prepare budget as listed below to be
discussed in detail subsequently.
• Traditional or incremental budgeting.
• Zero Based Budgeting (ZBB)
• Rolling budgets or continuous budgeting
• Performance budgeting
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• Planning Programming Budgeting System(PPBS)
Q: Mention five types of budgeting techniques
i). Traditional or incremental budgeting.

ii). Zero Based Budgeting (ZBB)
iii). Rolling budgets or continues budgeting
iv). Performance budgeting
v). Planning Programming Budgeting System(PPBS)
6.5.1 Traditional or Incremental Budgeting; this is a method whereby last years figures
are obtained and a percentage is added to it to arrive at current year budget. A budget where a
percentage is added to the last year figure to arrive at correct budget without justification of
expenditure is called.
Example:
Government sectors. Last Year ₦ Billion Percentage Added ₦ Total
Education 1000 20% = 1200
Health 1300 10% = 1430
Defense 2000 25% = 2500
Sport 500 25% = 625
The percentage added depends on three mains factors.

• Trend of the economy
• Inflation
• Funds available
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The trend of the economy determines the percentage to be added. A booming economy will
add a higher percentage and vice visa.
Inflation: Inflation weakens the power of Naira. The higher the rate of inflation the lower the
value of Naira and vice visa. Inflation either empowers or reduces the value of Naira in the
budget.
The fund available: the more the funds (government income) that are available to the
government the more are the allocations to States, Ministries, Local Government etc.
Note that the more the funds that are available to a father the more he is willing to increase
the food allowances to his wife and children, change their clothing, chairs, television and
even move from room and parlor apartment to a three bedroom flat.
Budgeting in Nigeria Government; government budget preparation and approval takes after
three factors mentioned above i.e. the trend of the economy, inflation and the funds available
without any justification or scientific analysis. Incremental budget is made up of personal
enrolment, other charges and capital or developmental items. The incremental technique
budget allocates and distributes funds as provided without significance to the end use of the
funds. This technique of budget only considers the achievement of control and
accountability. Government in Nigeria allocates funds to different heads and sub-heads of
expenditures of the various ministries and extra-ministerial departments on succeeding year
basis using the incremental budget method. Therefore, year in year out Nigeria government
uses incremental budget method to prepare her budget.
Advantages of Incremental Budgeting Techniques.

• It is simple to prepare, operate and understand because it does not take into account any
scientific analysis or justification to prepare.
• It is cheaper and saves time to prepare and implement.
• It allows for continuity of project i.e. projects not completed last year can be added into
this year budget without any difficulty.
• It encourages monitoring of performance of government accounting officers.
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• It encourages direct relationship among relevant activities in operation. For example, a
photocopier machine can be bought from office equipment or classroom equipment
votes or charges in a school environment.
• All activities in the budget are given monetary values.
• A developing country like Nigeria uses such method because it does not involve much
data and scientific analysis.
Disadvantages of Incremental Budgeting Techniques.

• It is an inefficient method because it allows pass errors (last year) to be carried forward
(this or current year).
• It does not allow the justification of alternative method to arrive at cost and objectives.
• It does not encourage creativity as it fails to recognize new programme projects of
higher priority.
• The budget is always on the increase without consideration for economic growth and
social development.
• It fails to scrutinize the sincerity of the preparation i.e the objectivity (no bias) in the
budget.
• It is based on historical (past) cost rather than actual price.
6.5.2 Zero Based Budgeting Technique (ZBB)

This technique requires every item of expenditure to be justified as if the particular activity
or programme is taking off for the first time. It is the preparation of operating budgets from a
zero base of expenditure cost (ICAN 2006). It is a practice of allocating fund to fresh
expenditure head and sub-heads according to priority without consideration for last year
figures. ZBB is based on objectivity (no bias) as regard the preparation and implementation
of the budget.
ZBB was introduced by Peter Phyrr in 1969 at Texas, but was popularized by a former
President of the United States of America, Jimmy Carter in 1976.
It is a systematic budgeting process which follows four basic steps.
• The formulation of an operational plan. Each ministry are divided into division units
.e.g. education unit, health unit, defiance unit, sport uni,t etc
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• Attached each division unit to a decision package after analyzing the whole budget i.e.
education package, health package.
• Appraising and ranking of decision package after analysis (the benefit to be derived
from each decision packages must move the cost attached to it).
• The allocation of resources to each decision package evaluation.
Mention the four steps of zero based budgeting techniques
Formulate an operational plan, division of units, decision package, appraising and ranking of
decision package.
Advantages of ZBB Techniques

• Allocation of resources is based on needs and benefits to be derived rather than political
or cultural factors.
• It encourages proper analysis, evaluation and justification of all activities before
implementation.
• It encourages creativity, change and new developments. ZBB does not allow the slogan
of “this is how it is being done”.
• A proper review of every activity may lead to cost reduction.
• Zero base-budgeting rank projects according to their benefit and viability.
• It discourages wasteful spending.
• It is a better yardstick spending for measuring performance.
• It is a futuristic i.e. it considers the future benefit and not the past benefit in ranking of
projects
• Profit-oriented projects are better analysed and evaluated with ZBB.
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Disadvantages of ZBB Techniques
• It is difficult to prepare, and implemented; it is also time consuming.
• It requires high skill and knowledge to operate. Public sector lacks qualified and
competent personnel to handle it.
• It requires much data for appraisal and analysis.
• It can course a major shift in resources allocation because of yearly justification of
projects.
• It does not allow quick control and coordination of activities with respect to decision
packages and ranking of packages
• Recurrent expenditure finds it difficult with the process, hence it is not successful in
public sector.
6.5.3 Rolling Budget or Continuous Budget

Rolling budget is the upgrading of a short-term budget by adding a specified period of time
and deducting the earliest period to reflect current conditions. It is the monthly, quarterly or
annual provision of fund to execute a capital project spelt out in a planned period.
Advantages of Rolling Budget or Continuous Budget

• It allows management to concentrate on a programme within a time span limit.
• It gives room for frequent reassessment and revision during rapid inflation.
• It is easier to compare budgeted figures with actual figures in a more realistic and
reasonable manner.
• It provides government with current information on the prices of goods and services.
Disadvantages of Rolling Budget or Continuous Budget

• It is expensive to maintain
• It calls for frequent attention and efforts as each time rolls out.
• It requires more knowledge and skill to operate it because it is built on standard cost.
6.5.4 Planning Programming Budgeting System (PPBS)
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Resources of the government are allocated to the most economical and efficient project using
the cost-benefit analysis to choose programmes or projects.
Programmes are translated based on their objectives and performance for specified groups or
beneficiaries e.g. free education at primary school level. These involve a stage-wise sequence
of step by step for executing programmes with common objectives and are ranked to
maximized benefits. PPBS are prepared on the basis of programmes which cut across
departmental objectives and organization objectives, for instance computerization and on-line
access of each department in order to achieve organizational objectives.
Reasons for Planning Programming Budgeting System (PPBS)
• There is an economic problem and scarcity of resources therefore programmes compete
based on cost benefit analysis.
• There is need for efficient execution of selected project and the steps for achieving it
have to be devised
• The need for detailed study of organization objective programme and resources
available.
• Planning and formulating objectives beyond the current year of budgeting.
• Monitoring, controlling and reporting the planning progress to meet government
objectives.
• Implementing the selected alternative and monitor its performance to ensure that the
objectives of the programmes are achieved given the resources allocated to those
programmes.
Advantages of Planning Programming Budgeting System

• Effective allocation of resources: PPBS cut across departmental objectives by using
skilled personnel to achieve a project or programme for organizational overall
objectives.
• PPBS; it is an important aid in achieving better results (programmes or projects) at
lower cost.
• It leads to better decision making and rapid economic development.
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• The emphasis is on long term objectives of the organization and commitment in certain
programmes
• It leads to proper monitoring and coordination of projects.
Disadvantages of Planning Programming Budgeting System

• It involves detailed analysis and breakdown of government functions.
• It is time-consuming with a lot of paper work attachment.
• It requires skilled and knowledgeable staff to operate.
• It requires high level of technology and therefore difficult and expensive to prepare and
implement.
• Principal Officers in the government usually resist this method of budgeting.
• It goes beyond the current year of budget and the uncertainty attached to such period.
• It is difficult to quantify result of programmes such as education, health, etc
6.5.5 Performance Budgeting
Performance budgeting is basically output-oriented budget. It explains the purpose for which
resources/funds are needed, cost of activities to achieve the purpose and desired work
performance.
The primary focus is activities and ascertainment of cost of such activities which are
specified/ determined to achieve the purpose to which the funds have been committed by the
government (Jawahar Lal, 2002).This method is based on the purpose and objective and
result of such objective.
Similarly, Performance Budgeting and Planning Programmes Budgeting System (PPBS) are
used interchangeably. While performance budgeting focuses on specified activities to
achieve certain objectives PPBS is a combination of different elements of programme with
the ascertainment of cost of each programme to achieve government/organization objectives.
For instance performance budget may focus on computerization of a section in an
organization, PPBS objectives are the computerization of the whole (different
sections/programmes) organization.
6.5.6 Common types of Budgeting in Public Sector

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• Revenue Budget
• Capital Expenditure Budget
• Personnel Cost
• Overhead Cost
• Cash Budget
• Supplementary Budget
6.6 The Limitations of Budget.

Budget preparation, approval and implementation face a lot of challenges in order to achieve
its desired objectives. The following are the challenges usually encountered by the
government in any budget process.
i) Human element:
The popularity and reputation of government officials involved in the preparation and
approval of the budget determine the contents of the budget.
ii) Type of project:
The acceptability of a project depends on the type of project and the personality
involve in the implementation.
iii) Government focus:
The focus of the ruling government might be to favour the minority in order to retain
power at expense of the majority.
iv) Fund available:
Government fund is limited. Lack of fund makes it difficult to implement government
projects.
v) Lack of manpower:
Lack of competent skills and manpower makes it difficult for government to carry out
some of its objectives.
vii) Lack of continuity in government policies:
The frequent changes in government policies affect budget implementation.
viii) Political instability:
Frequent changes in political party leaders affect budget implementation.
ix) Social cultural diversity:
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The social cultural diversity of the nation affects budget implementation.
x) Inflation:
Inflation increases the price of goods and services thereby reducing the purchasing
money to meet demands on the budget.
xi) Fiscal indiscipline:
The attitude of government officials towards spending government money without
proper justification, limits budget implementation.
xii) Mono-economy of the nation:
The major source of government revenue in Nigeria is petroleum oil with neglect to
other sources. This reduces income and restricts their spending on essential services.
xiii) External factors:
The influence of other countries and institutions hinders budget preparation and
implementation.
xiv) Lack of data and poor technology:
The country still finds it difficult to provide correct data for proper analysis and poor
technology combine with power failure limit budget preparation and implementation.
Summary
Budgets are periodic plans expressed in monetary terms used to achieve government
objectives. Nigeria government budget is usually for one year (12 months) i.e. January to
December. One way or the other we all draw budget to achieve one objective or the other so
likewise the government.
There are different methods of preparing public sector budget which are incremental
Budgeting, Zero Based Budgeting (ZBB), Planning Programming Budgeting System (PPBS)
and Performance Budgeting. The type of budgeting practice in Nigeria is the incremental
budgeting method. A budget shows financial accounts of the previous year, the budgeted and
estimated figure of the current year and the budgeted figure for next year. This session also
discussed the limitations of public budget.
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1. Incremental Budget considers three factors when preparing the budget except one.
a) Trend of the economy
b) Inflation
c) Funds available
d) Division of labour.
2. A budget where a percentage is added to last year figure to arrive at current year
budget figure without justification of expenditure is called.
a) Experimental budget
b) Fixable budget
c) Incremental budget
d) Zero based budget.
3. A method of budgeting whereby all activities are evaluated and fully justified for every
items of expenditure each time the budget is prepared is called.
a) Evaluated budget
b) Justified budget
c) Formulated budget
d) Zero based budget (ZBB)
4. Public budget services the following purpose except one
a) Motivation
b) Control
c) Planning
d) Specialization of duty
5. Below is a list of public budgeting techniques except one
a) Public accounting budget
b) Incremental budget
c) Zero based budgeting
d) Performance budgeting.
6. The following are the advantages of incremental budgeting expect one.
a) Justification of each item of expenditure
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b) It is simple to operate and implement
c) It is cheaper and saves time
d) It require less data, skill and knowledge to operate.
7. Zero based budgeting (ZBB) has the following advantages except one.
a) It encourages creativity and change
b) It encourages new development
c) Allocation of resources is based on need and benefit
d) It requires high skill and knowledge to operate.
8. One of the following is not a purpose of public sector budgeting.
a) Allocation of scarce resources
b) Redistribution of resources
c) To point out new allocation
d) To divide the country into state and local government.
9. Programmed Planning Budgeting System is meant to fulfill one of the followings

a) Specific (target) projects
b) Oppose the government
c) Fight the government
d) Disorganized government plan.
10. A budget is___________________ or quantitative
a) Financial statement
b) Research statement
c) Descriptive statement
d) Formative statement
Answers
1 2 3 4 5 6 7 8 9 10
D C D D A A D D D A
Essay Questions
i) Define budget and explain five purposes of public sector budget?
ii) List five advantages and disadvantages of budgeting?
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iii) What is incremental budget and explain the factors consider in preparing incremental
budget?
iv) What is zero base budgeting (ZBB)? What are the steps in ZBB?
v) Discuss the advantages and disadvantages of zero base budgeting.
vi) Discuss the objective of budgeting.
vii) Explain planning programming budgeting system (PPBS).
One of the factors considered in the preparation of budget using incremental or traditional
budgeting techniques is inflation. The following expenditure occurred in the office of
Goodluck and Patience at Abuja
2010 actual Inflation Factor
₦
i) Maintenance of office equipment 50,000 20%
ii) Maintenance of motor vehicle 80,000 20%
iii) Hospitality 100,000 20%
iv) Telephone 60,000 20%
v) Maintenance of generator 120,000 20%
vi) Electricity 50,000 20%
vii) Security 100,000 20%
viii) Advertisement 20,000 20%
ix) Stationary 80,000 20%
x) Training and workshop 90,000 20%
The definition rate for next year is 20% across board. Calculate the budget figure for
2011.
2010 actual inflation factor 2011 estimate
Expenditure # (yr20%)
₦ ₦ ₦ ₦
i) Maintenance of office equipment 50,000 0. 2*50,000 = 10,000 = 60000
ii) Maintenance of motor vehicle 80,000 0.2*80,000 = 16000 = 96000
iii) Hospitality 100,000 0.2*100,000 = 20000 = 120000
iv) Telephone 60,000 0.2*60,000 = 12000 = 72000
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v) Maintenance of generator 120,000 0.2 *120,000 = 24000 = 144000
vi) Electricity 50,000 0.2*50,000 = 10000 = 60000
vii) Security 100,000 0.2*100,000 = 20000 = 12000
viii) Advertisement 20,000 0.2*20,000 = 4000 = 24000
ix) Stationary 80,000 0.2*80,000 = 16000 = 96000
x) Training and workshop 70,000 0.2*70,000 = 14000 = 84000
TOTAL ₦ 730,000 ₦ 876,000
98
References
Adam, R.A. (2005) Public Sector Accounting and Finance made Simple fourth edition
Corporate publishers venture.
Bhatia, H.L (2005) Public Finance, twenty fourth revised Edition, Vikas publishing House
put LTD.
Institute of Chartered Accountants (ICAN, 2006) Professional Study Pack via Publishing
Limited
Jawahar, (2002) Account for Management Himalaya publishing house, second edition.
John, G., John, P. and Michael, M. (1998) Accounting for Managers, International
Thompson Business Press, Second edition.
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STUDY SESSION SEVEN:

BUDGET PREPARATION AND BUDGETARY CONTROL PROCESS
PUBLIC BUDGET 2
Introduction:
This is the second module on government budgeting. The first module discussed the purpose,
functions and different types of budget techniques being used by public sector. This module
emphasized on the process used in preparation and approval of public budget. This is
peculiar because it is a non-profit organization (government). The aims and objectives of
government are to better the life of its citizens at lower or no cost value by providing
essential services. Budgeting preparation and approval is a process that follows a systematic
order. It follows the order of formulation of policies, preparation and approval of budget and
the implementation of the approved budget. In public sector it is referred to as “budget
cycle’’ which follows an approved time-table. It is a process of different segments to be
discussed in this module.
The budget is a financial guide for revenue generated and expenditure incurred.
Learning Objectives
The objective of this chapter is to enable students learn:
7.1 The budget preparation guidelines.
7.2 The functions of the ministry of budgeting and planning.
7.3 The importance of call circular.
7.4 The roles of ministries and agencies in budget preparation.
7.5 The function of budget committee.
7.6 The different approval stages
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• The ministerial approval
• The executive council approval
• The legislative approval
7.7 Some budget terms and definitions
7.1 The Budget Preparation Guidelines

This is the beginning and the planning stage of budget preparation. The guideline follows a
process listed below at the planning stage.
a) Determination of government objectives
b) Formulation of government policies
c) Approval of programmes after consideration of all alternatives.
a) Determination of Government Objectives

It is the function of the ministry of budgeting and planning in consultation with economic
adviser and the Central Bank of Nigeria (CBN) to review and project into the following year
considering the fiscal and monetary policies of the government. They determine goals and
objectives and communicate it to the President for further actions.
b) Formulation of Government Policies
The ministry of budget and planning is responsible for developing economic assumptions
and forecast to formulate policies and necessary guidelines to achieve government goals and
objectives. The ministry is also responsible for recommending to the presidents fiscal
policies that will be contained in the budget.
c) Approval of Programmes and Projects.

The President then approves the programmes and projects following the guidelines given by
the Ministry of Budgeting and Planning bearing in mind the advice given by the economic
consultant and CBN.
7.2 The Functions of the Ministry of Budgeting and Planning

• It is an advisory body to the President in formulation of government policies.
• The ministry sets goals and objectives for the government and also develops economic
assumptions and forecasts.
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• The ministry provides necessary guidelines to ministries and department for the
purpose of submitting their estimates/proposals.
• Call circular. It is the primary responsibility of the ministry to issue call circular for
the budget to ministries, department and agencies.
• Draft estimation. It has the responsibility of compiling the draft estimation based on
the submission.
• Budget time-table. The ministry prepares the time-table and deadline for submission.
• The ministry reconcile the figure contained in the different estimates with it own figure
in the national plan.
• State the role of budget officer and budget committee
• The ministry has the responsibility of compiling revenue estimates forms returned from
different ministry and agencies.
• It considers how objective the proposal for the estimate.
• The ministry is responsible for the preparation of presidential speech
• The ministry review and projects into the following year.
7.3 The Importance of Call Circular

It is the function of the ministry of budgeting and planning to issue call circular to
government ministries, developments and agencies after the setting of objectives and
formulation of policies to achieve them.
The call circular will contain:

• Guidelines to be followed in preparing the estimate proposals.
• Government policies on capital projects and personnel cost.
• The difference between on-going projects, new projects and their treatment
• Provide different columns and rows for different heads in the actual expenditure of the
preceding year.
• Request to submit their revenue and expenditure for the succeeding year
• Request for the number of staff and position on payroll
• The date to return the complete forms or estimates to the ministry of budgeting and
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7.4 The Role of Ministries and Agencies in Budget Preparation

Every ministry of the government is designed to carry out some of the objectives depending
on the policies affecting each ministry. Such ministry is expected to prepare an estimate
following the guidelines and policies set out by the ministry of budgeting and planning, the
accounting officer prepares the estimate on receipt of the call circular.
The call circular already contained the guidelines to be followed. Each ministry has its own
programmes and projects which are critically examined with the national interest. It is the
duty of the finance department to explain and supply information needed to prepare the
estimate. The need to supply statistical information of every staff and their position on
payroll, the actual expenditure for the current year, and the revenue and expenditure for the
next year is vital issue. Each ministry normally issue an internal circular and form a budget
committee which critically examine the plans, objectives, resources involve and the
implementation on policies which must be in line with the national plans before forwarding it
to the Ministry of Budgeting and Planning. Each ministry will be called according to the date
given in the time table to defend its proposals. The above process is to save time, avoid
wastages and make way for the achievement of government goals and objectives.
7.5 The Functions of the Budget Committee

• Formulation of budget procedure and time-table. The budget committee, still at the
planning stage of budgetary process designs some forms that are attached to the call
circular. The content in the form and call circular will provide relevant budget
information to prepare the budget. The forms usually contain the date and steps to be
followed.
• Reviewed and revised policies and formulas. The committee reviews the basis to be
adopted with reasons to correct changes in the method of calculation and accounting
policies to be followed, the role of the budget officer and budget committee and
collation of proposal to draft budget.
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• Coordination. The committee supervises and compiles all draft estimates. It is to

eliminate matters that are no longer relevant and introduced new ones with current
economic and technological development.
• Acceptance of the budget. The committee calls each ministry officials to clarify some
programmes and projects in the draft estimate. This is referring to as budget defense,
after the defense the budget is accepted for further collation to ministry of budgeting
and planning.
• Review of performance report: The committee reviews the programmes and projects if
the guideline has been properly followed to the core in order to achieve the objectives.
The organization compared figures with actual expenditure for current year and make
projections for next year budget. A ministry that did well will be motivated to do better
by giving more resources. Where a ministry has not done well a control measure is set
to guide next year expenditure.
Each ministry has its own budget committee constituted of different members from various
section of the ministry. The committee critically examines its own programmes and projects
following the guidelines contained in the call circular. The budget committee will submit its
report to members’ in-charge e.g. Minister of information who will then forward the draft
estimate to Ministry of Budgeting and Planning for incorporation in the national budget. The
ministry will be called later to defend its draft estimate.
The ministry of budgeting and planning has its own budget committee constituted by
members from the Ministry of Finance Establishment, Works and Housing, Youth and Sport
and the Budgeting and Planning Ministry. These members are top government officers with
vast experience to consider each ministry draft proposal or estimate in line with:
• The prevailing economic policies
• Legislative initiative for the budget
• Expected revenues for the budget year
• Tentative proposals for ministries
• Recommendations on the overall priorities
• Suggested budget ceilings for each ministry
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The compiled estimate of all ministries will be forwarded to the President for detailed
consideration.
7.6 The Different Approval Stages

• The ministerial approval: The President approves the draft estimate of each ministry
on the ground that it is consistent with the national plan and properly defended after
detailed examination of their proposal through the Ministry of Finance in the light of
available funds.
• The executive council approval: The Executive Council is a cabinet of members
consisting of National President (Governor), Vice-President (Deputy Governor)
Ministers (Commissioners) Directors of the Ministries of Finance, Head of Civil
Service, Work and Housing, Secretary to the Federal (State) Government, Auditor
General of the Federation (State) Accountant General of the Federation (State)
Governor of Central Bank and member of Budgeting and Planning Ministry. The
cabinets consider and forward the draft estimate to the National Assembly in form of an
Appropriation Bill.
• The legislature approval: The compiled draft estimate (appropriation bill) will be
presented by the President to the National Assembly (House of Assembly at the state
level) i.e. the Senate and the House of Representatives. The President will leave the
houses to deliberate on the Appropriation Bill called the “budget session’’ and also be
regarded as the first reading of the bill. They will also meet differently to considered
and approve the bill in relevance to the economic and social matters of the country. The
house usually breaks into various committees to consider various aspect of the budget.
The President present the bill to the two houses for debates in line with financial and
economic matters raised in the budget. This refers to as the second reading. After
exhaustive debate and necessary amendment by both houses (National Assembly) the
appropriation bill is finally passed into approved budget. This gives the President the
authority to disburse money to the different ministries and agencies.
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• Presidential Assent: the President is expected to give his assent i.e. sign the
appropriation act in agreement of all necessary amendment made by the National
Assembly. However, where the President fails to sign the bill, a budget session of at
least two-third (2/3) of the National Assembly can pass the bill into law i.e. approved
for spending; however, this process will not be in favour of the Executive and
Legislative Arms of Government. It is important to note that the Executive and
Legislature arms of government act as check and balances to each other.
Mention four stages of budget approval
1. The ministerial approval

2. The executive council approval
3. The legislature approval
4. Presidential/Governors Assent
7.7 Budgetary Terms and Definitions

The following are some of budgetary terms used in the preparation of public budget.
7.7.1. Budget estimate/ proposal

This is the revenue and expenditure to be earned and incurred for the next year compiled by
Ministry of Budgeting and Planning before National Assembly’s approval.
7.7.2. Revised Estimate

It gives room for the original budget to accommodate changes during the current year of
budget e.g. salaries increase, charges rate, etc
7.7.3. Based Estimate:
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It is the budget point for present year and it arrived by subtracting the value of one-off
transaction from last year budget ‘One off’ transaction are expenditures which do not reoccur
every year e.g. election expenses for a particular year.
7.7.4. Budget Deficit:
This is when the expenditure to be incurred is more than the revenue to be earned by the
government. The expenses (E) side is greater than the income (I) side i.e. E>I .
7.7.5. Budget Surplus:

This is when the revenue the government is expecting is more than the expenditure to be
incurred. The income side is greater than the expenses (E) i.e. I > E.
7.7.6. Budget Padding:

This is where the budgeted figures estimated arbitrarily are on the increase without realistic
proof for the expenditure to be incurred. This is done with the motive that the budget
committee will cut down the figures without reasonable justification.
7.7.7. Budget Slack

This is non compliance of the budgetary procedures to be followed in the preparation and
implementation of the budget.
7.7.8. Budget Estimate

This is the approved financial or quantitative plan by designated authority. There is a
difference between budget and estimate. Budget is an approved financial plan while estimate
is a financial plan waiting approval.
7.7.9. Flexible Budget:

It recognizes the cost behaviour and adjusts according to the level of activities arrived at. It
changes as cost or level of activity or both changes.
7.7.10. Capital Budget

This is prepared to make room for expenditures that involve capital projects such as Bridges,
Schools, and Roads etc.
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7.8 Budgetary Control.

The word budgetary control provides a comprehensive picture of the government’s total
receipts and expenditures as well as its policy for a given period. It ensures that budgets are
prepared and approved in line with income and expenditure for that period. Budgetary
control is a positive and important part of public sector. It helps the government to plan
control and appraise activities in order to achieve specific objectives and goals.
7.8.1 Objectives of Budgetary Control.

Budget is a blue print of the future activities of the government. It is a proposed allocation of
resources. It is a statement showing government inflows and outflows that are expected to be
realized and incurred respectively for a specified period of time usually one year.
7.8.2 Budgetary control attempt to achieve the following objectives.
• It gives all level of management the opportunity to participate in the preparation of
budgets.
• It helps to coordinates the activities of the government.
• It provides a good control centre to government officers.
• It makes government officers responsible for their actions.
• It acts as a guide to management decision.
• It helps in forecasting during unforeseen events.
• It serves as a guide to achieve government purpose and objectives as planned
• It reveals proposed allocation of resources.
• It monitors operations during the planned year.
• It compares actual result with budgeted figures.
• It separates capital expenditure from recurrent expenditure.
7.8.3 The Role of Budget in the Economy.

The word National Budget is germane to any economy. It is an instrument of economic
control design in figures to achieve government objectives for a particular period. It contains
the breakdown of revenue and expenditure as approved by the government.
The roles played by the budget in the economy are listed below:
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• To allocate resources. The budget is used to allocate limited resources.
• Economic stability. The budget is used to stabilize the economy through its objectives.
• Development function. The budget is used to develop area of the economy
underdeveloped.
• Control inflation. The government uses the budget to control the economy e.g. budget
surplus or deregulation policies.
• Financial discipline. The budget acts as financial controller because it sets the limit of
expenditure.
• To protect infant industries. The government does this through tax holiday and ban on
importation.
• Redistribution of income. Budgetary policies can be used to bridge the gap between the
rich and poor.
• Better the standard of living. It can be used to reduce prices of goods and services and
also provide essential services e.g. free health care.
• Evaluate performance. The budget could be used to measure performance in the
economy.
• Motivation. The government motivates some sectors to do better in order to encourage
even and economic development.
Mention five roles of the budget in the economy
1. To allocate resources.
2. Control inflation.
3. Better the standard of living.
4. Redistribution of income.
5. Valuate performance.
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The price the lower the quantity demanded vice versa). Social Benefits are the aggregate
benefits gained by the society from the consumption of a good. It includes any private
benefits and any consumption externality that might exist.
7.8.4 The classification of budget by nature.

Budget preparation takes different forms and this is based on the nature of the budget.
Budget can be classified into the followings:
7.8.4 The classification of Budget by nature.

Budget preparation takes different forms and this is based on the nature of the budget.
Budget can be classified into the followings:
Annual budget: This is a financial statement showing government revenues and

expenditures usually for a period of one year. It goes through the formal process of
preparation and approval of a budget.
Supplementary budget: This kind of budget is prepared when the annual budget is
insufficient to meet government obligations. There must be a cogent reason for preparing
supplementary budget.
Special budget: This kind of budget is normally derived from special funds subject to
budgetary control guidelines. It is submitted in special forms either because the approved
amount is not adequate or totally not included in the Appropriation Act.
Deficiency budget: This kind of budget take cares of deficit or overdraft expenditures
incurred over and above the original budget. There must be a deficit in the budget before a
deficiency budget can be prepared.
Recurrent budget: This kind of budget is prepared to provides for revenue and expenses
that occur regularly in every budgeting period like student fees, income, payment such as
salaries and wages.
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Overhead budget: These are expenses from recurrent budget to cater for expenses such as
fueling expenses, minor repairs, stationary, and hospitality
Capital budget: This is a type of budget used for capital projects in the provision essential
service to the populace.
Other types of budgets include the followings (they are common in private sector)
Sales budget
Cash budget
Production budget
Marketing budget
Departmental budget etc.
Summary of the Study Session

This module begins with budget preparation and guidelines to be followed to achieve its aims
and objectives. It explained the functions of the Ministry of the Budget and Planning and the
usefulness of call circular, the participation of ministries and agencies and the relevance of
budget committee in the preparation and implementation of the approved budget.
Similarly, the duties of ministries concerned for the approval of the budget was also
discussed, the passing of the Appropriation Bill into Appropriation Act (Approved Budget)
by the Executive and Legislature Arms of Government which act as check and balances to
each other. The budget is then circulated to the various ministries to achieve government
objectives; the above process is referred as budget cycle. Budgetary control process
application and types of budget were also mentioned.
1. The document send to various government ministries showing the budget procedure
and time table is call_____________
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a) Government circular
b) Legislature circular
c) Executive circular
d) Call circular.
2. A budget prepared arbitrarily on the income without realistic proof of objectives is
called______________
a) Balanced budget
b) Surplus budget
c) Fiscal budget
d) Budget padding.
3. The budget is approved by ______________
b) The ministerial approval only
c) The executive approval only
d) The legislature approval only
e) All of the above approval only
4. Budget preparation and approval follows a______________ procedure and rules to
achieve a purpose.
a) Systematic
b) Dramatic
c) Grammatical
d) Tabular.
5. The function of Ministry of Budgeting and Planning includes the followings except
ONE
a) Advisory body to the President
b) Issue call circular
c) Prepare the president budget speech
d) Approved the final budget.
6. The call circular contains the following information except ONE.
a) History of the head of civil service
b) Budget guidelines
c) Government policies
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d) Budget time table.
7. Budget committee performs the following functions except ONE.
a) Review of performance report
b) Compile and coordinate all draft estimates
c) Formulation of government policies
d) Create more political parties for the current year.
8. Budgeting and Planning Ministry draft proposal or estimate is based on the following
except ONE.
a) The prevailing economic policies
b) Expected revenue for the Budget
c) Legislative initiative for the Budget
d) Division of labour between the President and the Vice-President.
9. A number of people form by each ministry to examine the draft estimate as it is

contained in the call circular is called___________
a) Procedure committee
b) Budget committee
c) Evaluation committee
d) Monitoring committee.
10. One of the followings is not a budget term normally used in the preparation and
implementation of budget
a) Call circular
b) Budget warranty
c) Budget padding
d) Budget in waiting
Answers to the objective questions

1 2 3 4 5 6 7 8 9 10
D D C A D A D D B D
Essay Questions
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i). List and explain the roles of Budgeting and Planning Ministry in the budget planning
and approval.
ii). Itemize the procedures for preparation and approval of budget in a government
establishment?
iii). What do you understand by call circular in the context of government budgetary
process?
iv). Discuss briefly the roles of the executive and legislature in government budgetary
process in the following budgetary concept:
a. Call circular
b. Budget committee
c. Budget padding
d. Budget slack
e. Budget warranty
References
Adam, R.A. (2005) Public Sector Accounting and Finance made Simple. Lagos, fourth
edition Corporate publishers venture.
Bhatia, H.L (2005) Public Finance, twenty fourth revised Edition, Vikas publishing House
put LTD.
Institute of Chartered Accountants (ICAN, 2006) Professional Study Pack via Publishing
Limited
Jawahar, (2002) Account for Management Himalaya publishing house, second edition.
John, G., John, P. and Michael, M. (1998) Accounting for Managers, International
Thompson Business Press, Second edition.
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STUDY SESSION EIGHT:

MEANING OF PUBLIC DEBT, TYPES AND CLASSIFICATION
Public Debt 1
Introduction
Debts occurs when expenditure exceed income. Debts arise when amount spent is more than
amount received. Borrowing arises when income is not sufficient to meet expenditures. Just
as it is for an individual to borrow to satisfy some needs so it is for government of a country
to borrow to meet some important needs. The Central Bank of Nigeria (CBN) serves as
banker to the government. In doing this, it keeps the finance and accounts of the government.
It is the duty of CBN to raise money from internal and external sources for the
implementation of government programmes. The money that is raised or borrowed to carry
out programmes automatically becomes a debt or money owed by the government. Any
money owed by the government of any nation is referred to as public debt.
Public debt can be defined as the total amount of money owed by the government within and
outside the nation. “Within” means individuals, institutions, organizations and central bank
of that nation. “Outside” means individuals, organizations, institutions and countries outside
the borders of a particular nation.
Learning Outcomes
At the end of this unit, you should be able to:
8.1 List and explain the different types of public debt
8.2 Mention five established guidelines for government borrowing
8.3 Explain the classification of public budget
8.4 Explain internal or domestic debt
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8.5 Mention three sources of domestic debt
8.6 List five causes of domestic debt
8.7 Explain external or foreign
8.8 Consequences of borrowing;
8.9 General causes and increases of public debt.
8.1 Types of Public Debt
The types of public debt reflect the purpose for which the debt was incurred. It includes the
following:
Trade Debt: This is arises when a country trades with other countries and is unable to pay
either partly or wholly for the goods and services supplied. For example for all goods and
services imported to Nigeria which Nigeria has been unable to settle, her import bills have
resulted to trade debt.
Project-Tied Loans: These are loans contracted for, that has good potential and prospects of
accelerating economic growth and development of a nation. These loans are for the execution
of a specific project which is expected to be self liquidating i.e. pay back the principal and
the interest of the loan.
Balance of Payment Support Loan: This type of loan is contracted for, to solve a persistent
unfavorable balance of payment problem. This is referred to as “Balance of payment
disequilibrium”. Such loans are in the form of capital inflow provided by institution such as
International Monetary Fund (IMF).
Loans for Socio-Economic Needs: This is the money borrowed by government to provide
social amenities such as education, free health services, sports and other social infrastructure
to improve the standard of living of its citizens.
Mention four types of public debt
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i. Trade Debt
ii. Project-Tied Loans
iii. Balance of Payment Support Loan
iv. Loans for Socio-Economic Needs
8.2 Established Guidelines for Government Borrowing
The following are the established guidelines for borrowing:
• Projects with economic value should have positive internal rate of return as high as cost
of borrowing.
• Social amenities and infrastructures should be ranked on the basis of their benefit
ratios.
• Feasibility studies are necessary for projects to be financed with external loans.
• Public and private sector project with quick yielding nature should be sourced from the
private capital markets and loans for social amenities should be sourced from
concessional financing institutions.
• The purpose of state government borrowing should be approved by the ministry of
finance and economic development and CBN before it is incorporated in the total
public sector borrowing for the annual budget.
• Federal government loans to state government. It is the function of the federal ministry
of finance to make due payment and deduct the necessary amount at source from their
statutory allocation.
8.3 Classification of Public Debts

Public debt can be classified into Internal and External debt or Domestic and Foreign debt.
Internal or Domestic debts are money owed by a government within its nation. While
External or Foreign debt are money owed outside the nation.
8.4 Internal or Domestic Debt
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The origin of domestic debt is dated to 1946 when the first development stock of 14,600,000
was floated. The first Treasury bill and certificate worth N8 million and N20 million were
respectively issued in 1960 and 1968. As at 2003, Nigeria’s domestic debt has risen to
N1,329,692.7 billion. The internal sources of debt are CBN, commercial banks, merchant
banks and non-bank public holding using financial instruments such as Treasury bills,
Treasury certificates etc under the general supervision of the CBN to manage the domestic
debt of the nation.
8.5 Sources of Domestic Debt.
8.5.1 Financial Instrument

Government projects can be financed with the issuance of financial instruments such as
Treasury bills, treasury certificates, development stock and bonds. The money raised within
the country is classified as domestic debt.
8.5.2 Treasury Bills

It is issued by CBN on the directives of the federal government. It is expected to mature
within 90 days. It is a source of domestic loan to the government payable at the expiration of
90 days.
8.5.3 Treasury Certificates

It is also issued by the CBN to raise loan from within the country. Its maturity period is 12-
24 months. The principal and interest involved in treasury certificate are relatively higher
than Treasury bill because of the longer period of repayment.
8.5.4 Government Development Stock

It is a source of financing government programmes. It is done through the capital market and
it has longer maturity period of 5-10 years. It is classified as long term. The major investors
are insurance companies and discount houses.
• Bonds:
• Treasury Bonds:
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It is a long term debt instrument that the CBN uses to facilitate the redemption of maturing
instruments through the establishment of sinking funds.
• Revenue Bond:
It is a bond taken to execute a project and revenue generated from the project is
expected to pay back the loan. Example is toll gate and toll fees collected.
• Government Obligation Bond:
It is taken by the government to provide public facilities such as schools, hospitals,
prisons, construction etc.
• Special Assessment Bond:
The payment of principal and interest will be made from a special tax levy e.g. Lagos
state development levy of every six months.
Mention Five Sources of Domestic Debt.
1. Treasury Bills
2. Trade Debt
3. Treasury Certificates
4. Government Development Stock
5. Bonds
8.6 Causes of Domestic Debt

• Defence: Government borrows to provide defence from external forces that can damage
the resources (human and natural) of the country.
• Population: The population is growing more than what the government can provide for.
Government has to result to borrowing to cater for the larger population
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• Urbanization: The movement of people from the rural areas to the urban areas calls for
the development of both the urban and rural areas.
• Provision of social amenities and infrastructures: It is the responsibility of the
government to provide basic amenities and infrastructures such as schools, library,
hospitals etc Government borrows to provide such facilities.
• Unforeseen contingencies and natural disasters: When the unexpected happens and the
resources of the nation cannot solve such problem, the government results into
borrowing.
• Mismanagement of fund: Government resources are not expended for projects
allocated. Money meant for government project is diverted to other means.
• Financial indiscipline and embezzlement: Everybody sees government money as free
money and needs not to be accounted for. It can be used for anything.
• Democracy and presidential system of government: Democracy calls for election every
four years. Government sometimes borrows to conduct elections. Presidential form of
government is an expensive way of running government because of multiplicity of
states, National Assembly, Judiciary and the executives.
• Financing of recurrent expenditures in terms of wages and salaries.
• Inability to raise revenue through tax due to poor technology and method of data
allocation.
8.7 External or Foreign Debt

External debt is the amount of money owed by a country to other countries, individuals and
institutions outside the nation. External debt is the total amount which a debtor country owes
foreign creditors in the form of principal and the interest. External debts are used to solve
persistent balance of payment disequilibrium and for important project financing. In 1990,
Nigeria’s total external debt was N14, 298,614.4billion, in 2000 N3, 130,250.9billion, 2003
N4, 398,501.9billion and by 2005 it stood at $32billion. It is the function of CBN in
conjunction with the federal ministry of finance to manage external debt.
8.7.1 Sources of External Debt

Government borrows for development purposes and balances of payment support. The
sources of the amount borrowed are listed below:
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• Paris Club of Creditors: It is made of countries such as USA, UK, Federal Republic of
Germany, France, Canada e.t.c.
• London club of creditors
• Multilaterals such as World bank, International Monetary Fund (IMF), African
Development Bank (ADB) and European Investors Bank (EIB)
• Bilateral creditors: Country to country
• Promissory notes.
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8.7.2 Cause of External Debt
• Huge Budget Deficit: Nigeria government borrows to fill the gap in the budget. The
government has a lot of project to execute year in year out and revenue expected from
tax is unable to meet government expenditure therefore government has to borrow.
• Balance of Payment Support Loan: The government borrows to solve the persistent
balance of payment problem in Nigeria.
• Heavy Dependence on Oil and Revenue: All expenditure is dependent on oil revenue.
Oil revenue generated in the 70s gave government opportunity to embark on huge
projects. In the 80s when oil revenue drops the government resulted to borrowing.
• Political Instability: Different government with different policies. Political instability
has led to the abandonment of viable projects which loans has been collected for and
repayment not settled.
• Lack of Planning and Investment Policies: The country lacks data and technology for
good planning and investment policies. Money borrowed are not invested into viable
projects that can pay back the money borrowed.
• Mono-Economy of the Nation: All other sectors of the economy particularly agriculture
has been totally abandoned and forgotten. It is important to note that this was our major
source of income before the discovery of petroleum oil.
• Using Short-Term Loan to Finance Long-Term Project: Loans contracted are supposed
to generate revenue to liquidate such loans. Using short-term loans to finance long-term
projects will only leave projects uncompleted and will cause the loan not to be paid
back.
• Financial Indiscipline and Mismanagement of Fund and Embezzlement of Government
Funds: Our leaders are selfish and enrich their purse at the expense of the masses.
8.8 Consequences of Borrowing

• Stiff borrowing conditionalities: borrowing goes with conditionalities which might not
be palatable with the economic policies of the nation.
• Inflation: borrowing leads to galloping inflation by reducing the power of the country’s
currency and the final result is unemployment and economic sabotage.
• High servicing cost: The government will continue to pay the interest cost and when
this is not done, interest is recapitalised to increase the principal and interest.
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• Unable to implement important and urgent projects: Borrowing does not allow
government to execute important and urgent projects because money needed is being
used to service debt.
• Borrowing act as a distabilizer: Borrowing worsens political, social and economy life
of the populace. It increase tax burden of its citizens in order to raise money to pay
back debts.
• Borrowing may lead to a violent change in the country’s governance. The bad effect of
public debt is that a new government cannot unilaterally disown a public debt.
• Burden on future generations: Future generations have to pay interest and principal to
foreign creditors without receiving corresponding benefits in return.
8.9 General causes and Increases of Public Debts

Developing countries like Nigeria borrow money to develop and implement projects to better
the lives of its citizens. Some of these causes has been mentioned above but there is a need to
generalize the causes as Nigeria is not the only country that borrows from outside countries
and institutions. Borrowing is applicable to all countries but more common with developing
nations.
• The need to finance capital projects. Examples are Kainji Dam, Niger Dam, Ajaokuta
Steel projects etc.
• Increase in population in rural urban movement
• The demand for social amenities and infrastructures
• The demand for government protection and external defence
• The need to finance recurrent expenditures (demand for increase in salaries and wages)
• The need to correct balance of payment deficit.
• The need to cater for emergencies and the unexpected such as war, natural disaster, fire
breakout etc
• The need to provide employment by establishing economic enterprise that will provide
public and private goods
• The type of the economy: An economy that is consuming and not producing will
always go borrowing
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• Mono-economy: An economy that is fully concentrated on one sector (oil) as its only
source of income will go borrowing
• Financial Indiscipline, mismanagement of fund and embezzlement of government funds
• Using short-term loans to finance long-term project will only lead to uncompleted
projects
Summary of the session

This module on public debt is very important to the study of public finance. It has discussed
the meaning of public debts and the negative impact it has on any nation. It does not mean
that public debt does not have some advantages if well implemented. But as far as Nigeria
economy is concerned, government borrowing is distractive to the economic policies.
The next module is on public debt management and strategies involved to pay back or settle
public debt
1. The total amount owed by a government of any country is called
a) Public debt
b) Management debt
c) Executive debt
d) Senate debt.
2. One of these is not a type of public debt
a) Trade debt
b) Project-tired loans
c) Balance of payment support loan
d) Loans to create more political parties.
3. Public debt can be classified into two namely
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a) Legislative and Executive debt

b) National Assembly and Judiciary debt
c) Domestic and Foreign debt
d) Management and Organisational debt.
4. The followings are sources Domestic debt in Nigeria except one
a) Treasury bill
b) Treasury certificate
c) Government development stock
d) All of the above.
5. One of these is not a type of bond used to borrow money through domestic debt
a) Treasury bond
b) Revenue bond
c) Government obligation bond
d) Presidential and Finance minister bond.
6. The following are causes of domestic debt except one
a) Defense
b) Population
c) Urbanaisation
d) Financial discipline.
7. The following are causes of domestic debt except one
a) Mismanagement of fund
b) Finical indiscipline
c) High demand of social amenities
d) Good planning and spending.
8. One of these is not a source to obtain external debt
a) Central Bank of Nigeria (CBN)
b) Paris club of creditors
c) London club of creditors
d) World Bank.
9. All of these are causes of external debt except one
a) Mono-economy
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b) Political instability
c) Financial indiscipline
d) Good planning and management of fund.
10. All of these are bad effect of borrowing except one
a) Inflation
b) Burden on future generation
c) Economic destabilizer
d) Good planning and management of fund.
Answers to the objective questions

1 2 3 4 5 6 7 8 9 10
A D C D D D A A D D
Essays questions
i) List and explain five causes of internal debt
ii) List and explain five causes of external debt
iii) Explain briefly five bad effect of public debt
iv) Mention and explain five sources of internal debt
v) List five sources of external debt and reasons for external debt
References
Bhatia, H.L, (2003). Public Finance. New Delhi: Vikas Publishing Hose PVT Ltd. 24th
Revised Edition.
Adams, R.A, (2005). Public Sector Accounting and Finance made simple. Lagos: Corporate
Publishers Ventures. 4th Edition.
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STUDY SESSION NINE:
PUBLIC DEBT MANAGEMENT AND STRATEGIES
Public Debt 2
Introduction
The Central Bank of Nigeria (CBN) serves as banker to the government. One of its major
functions is to raise money from internal and external sources for the execution of
government projects. The money that is raised or borrowed automatically becomes a debt
owed by the government. It is the responsibility of the CBN in conjunction with the Federal
Ministry of Finance to manage the national debt.
Learning Outcomes
9.4 Define public debt management;
9.5 Enumerate the objectives of public debt management;
9.6 Discuss the history of Nigeria’s DMO;
9.7 List the functions and objectives of DMO;
9.8 Discuss internal and external debt management;
9.9 List sources of external debts;
9.10 List and discuss external debt management techniques.
9.1 Definition of Public Debt Management

What Is Public Debt Management? Public debt management is all actions of the government
through the Ministry of Finance and Central Bank taken to affect the composition and
retirement of the debt held by the public. Debt management involves the manipulation of the
term structure of the debt to bring about economic stability.
9.2 Objectives of Public Debt Management

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The following are the objectives of public debt management:

• To minimize the interest cost of servicing public debt,
• To consider and evaluate the different techniques of debt repayment,
• To co-ordinate monetary and fiscal policies that will lead to economic stability,
• Re-structure maturity period of debt as a devise for economic stabilization, employment
growth and a sound financial system.
9.3 The History of Nigeria’s Debt Management Office (DMO)

The office of Nigeria debt management ministry was characterized with different agencies
and ministries before the year 2000. The office is a composition of agencies from the
Ministry of Finance, departments from the Central Bank of Nigeria and departments from the
Accountant General’s office. One major problem of these agencies and department was co-
ordination, poor information flow and failure to produce adequate data to solve Nigeria debt
crisis.
The federal government of Nigeria took a major step in year 2000 in addressing the problems
by establishing a semi-autonomous debt management office (DMO). The purpose of DMO is
to consolidate, record and manage the activities including debt service forecast, debt service
payment and advising on debt negotiating as well as new borrowings.
9.3.1 Objectives and Functions of DMO

The main objectives of establishing the DMO are to rationalize and streamline policies to
manage the country’s debt. The functions of DMO include the following:
• Provide timely and accurate information of the country’s debt to assist policy maker.
• Publishing up-to-date debt statistics in order to improve transparency in debt
management.
• Maintaining comprehensive inventory of loan together with forecast of debt services
• Providing effective debt service payment accurately and timely.
• Managing the country’s debt portfolio in order to minimize the cost with an acceptable
risk profile.
• Conducting risk analysis and developing appropriate risk management policies
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• Assessing lending terms from various sources from negotiating best positive terms for
future borrowing.
• Conducting debts sustainability analysis to assess optimal borrowing levels
• Provide debt management strategies with viable linkage to fiscal and monetary policies
and overall macro-economic stability.
The DMO is under the control of Ministry of Finance and CBN headed by a Director General
assisted by departmental directors having staff from CBN debt management department and
the external finance department of the Ministry of Finance.
9.4 Internal Debt Management

The CBN is entrusted with the issue and management of federal government loans publicly
issued in Nigeria based on terms and conditions as agreed between the federal government
and the bank. The process of domestic debt management includes
• Acquisition of domestic debt: This is done through the issuance of certificates and
securities to raise money from the public
• Restructuring of domestic debt: This is done through discount houses with respect to
development stocks and the creation of a fund called the “sinking fund”
9.5 External Debt Management

External debt management involves a conscious and carefully prepared, planned programmes
of the acquisition, development and retirement of loans acquired either for development
purpose or to support the balance of payment. External debt management include
• Estimates of foreign exchange earnings
• Sources of finance
• Risk and returns attached to investment projects
• The repayment schedule
• The ability of the country to service existing debts
• The desirability of contracting further loan.
9.6 Source of External Debt
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External debt refers to unpaid portion of external financial resources required for
developmental purposes and balances of payments support. These external sources include:
• Paris Club of Creditors
• London Club of Creditors
• International Monetary Fund (IMF)
• African Development Bank (ADB)
• European Investment Bank (EIB)
• Promissory notes
• Bilateral creditors (country to country borrowing).
9.7 Types of External Debt

The types of external debt reflect the purpose for which the debt was incurred. It includes the
following.
• Trade Arrears
• Balance of payment support loan
• Project-tied loans
• Loans for socio-economic needs
9.8 External Debt Management Techniques or Strategies

The following are the external debt management techniques:
i.) Debt Rescheduling:
This means the rearrangement of payment terms and period. It involves the adjustment of
interest, principal repayment and maturity. This method only means the postponement of the
evil day of the debtor nation
ii.) Debt Equity Conversion:

This method involves converting foreign debt for equity into indigenous companies. This
method has some advantages.
• The economic environment will become attractive to foreign investors.
• It reduces the outstanding stock of the nation’s external debt
• It will increase the export base of the nation’s economy.
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• It will lead to the creation and development of export oriented industries
However, notwithstanding the above advantages, it may lead to foreigner controlling the
companies if they have the controlling interest in the company.
iii.) Counter Trade Introduction:
This represents a trade arrangement whereby a country makes available one major export
(oil, cocoa) to another country in exchange for another country’s major import. Nigeria has
used this method to obtain raw materials for the development of petrochemical industries and
Ajaokuta steel industry.
iv.) Embargo on New Loans:

Embargo on new loans help check the collection of new loan and reduce the problems of
additional debt burden.
v.) Reliance on Foreign Aid Or Assistance:

Some countries usually ask for grants to help solve some vital issues especially when the
unexpected happens
vi.) Debt Restructuring: This involves the restructuring and conversion of existing debt into
another form by refinancing, recapitalization of interest, rescheduling debt, debt buy-back
and the provision of money.
vii.) Debt Forgiveness:

A country asking for forgiveness as it has happened between Nigeria and multinationals
(Paris Club of Creditors)
viii.) Debt Repudiation:

This is total refusal to pay debt back. A country is unwilling and refuses to pay back debt
owed to another country. According to Fidel Castro who proposed this method, it is based on
the fact that the nations that are borrowing the developing nations are the ones that colonized
them and transfer their resources to develop their nations
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ix.) Debt Conversion:

It involves the use of monetary instrument to reduce the external debt burden and by
changing the character of the debt. Debt conversion is used to complement other techniques
and it includes the following:
a) Debt for Equity: It is the most common and popular option whereby creditors of
naira proceeds of converted debt is invested in existing local companies or establish a
new company
b) Debt for Cash: It is the process of converting external loan into local currency (cash)
and the proceeds to meet working needs of the recipient company within the same
locality. This method is more popular between multinational companies and
subsidiaries located in Nigeria
c) Debt for Debt SWAP: This is done by redenominating into local currency i.e. naira
value and investing such money into subsidiaries belonging to multinational
companies.
d) Debt for Export Swap: The creditor accepts goods (oil, cocoa) and redeems
(subtract) the value from the total amount owing in their books. Government can use
this method to increase specific export commodity and also diversify the economy.
e) Debt for Nature: This occurs when a foreign country denominated debt is exchanged
for natural resources for a period of time and proceeds are used to promote world life
activities such as tourism.
f) Debt for Development: This method of debt conversion is used for developmental
purposes and the promotion of non-government activities such as trust, foundation
and charitable organizations.
i) Relending: This method of debt conversion allows proceeds from external debt to be
given as fresh loans to non government private economic unit. Creditor nation
employ this method whenever CBN does not have adequate foreign exchange to pay
back.
The above methods mentioned are short term solution to public debt management. It means
that after sometime the problem of public debt will arise again as it is the case of Nigeria.
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Therefore some long-term solution has been proposed but this might lead to economic
hardship on the citizens of the nation.
9.9 Long-Term Debt Management Strategies
• Structural Adjustment Programme (SAP): Total restructuring of the economic units in
the country
• Foreign Exchange Market: Foreign exchange policies to be embarked on should reduce
foreign debt and not increase it.
• Privatization and commercialization of government enterprises for economic reasons.
• Removal of oil subsidies: The government should remove petroleum oil subsidies to
generate more revenue.
9.9.1 Loan Terms

• Funded Loan: This type of loan matures after a given period of time usually after one
year. The debtor must have the loan free without interest for the first year before the
commencement of payment.
• Unfunded Loan: This type of loan matures within one year and payment starts
immediately.
• Floating Debts: They are debts with no specific maturity dates but with payments terms
and conditions attached to it.
• Marketable Loans: They are loans that can be transferred or sold by the existing holders
to a third party.
• Non-Marketable Loans: This type of loan cannot be transferred or sold to a third party
because it has been issued to a particular debtor.
Summary of the section

This session is the last part on how government management the economy through the use of
budget and debt. This particular session discussed the strategies used by government to
borrow money and pay it back. The methods of debt management mentioned above allow the
government to management and achieve some of its objectives in the country. It is the
function of the Central Bank of Nigeria and ministry of finance to device policies to help the
government in its acquisition and repayment of debt.
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1. One of these is not a type of public debt management loan
A) Funded loans
B) Unfunded loans
C) Marketable loans
D) Transferable loans.
2. The followings are long term debt management strategies except ONE
A) Management and organization loan removal
B) Structural Adjustment Programme (SAP)
C) Privatization & Commercialization
D) Removal of oil Subsidies.
3. The followings are debt conversion techniques except ONE
A) Debt for Equity
B) Debt for Cash
C) Debt for debt SWAP
D) Debt in School Account.
4. All the followings are debt management strategies except ONE
A) Debt Rescheduling
B) Debt Equity Conversion
C) Embargo on new loans
D) Executive and Legislative loans.
5. The process of domestic debt management includes ONE of the followings
A) Acquisition of domestic debt
B) Restructuring of domestic debt
C) All of the above
D) None of the above.
6. External debt management include the followings expect ONE
A) Estimates and management of student school fees
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B) Sources of finance
C) Risk and returns attached to investment projects
D) The repayment schedule.
7. Sources of external loan to Nigeria include the following except ONE
A) Paris club of creditors
B) London club of creditors
C) International Monetary Fund IMF
D) Nigeria Development Bank (NDB).
8. Under debt conversion process ONE of these is NOT a process
A) Debt for cash
B) Debt for debt swap
C) Debt for equity swap
D) Debt for student swap.
9. Debt Repudiation means ONE of the following
A) Refusal to pay back
B) Willing to pay back
C) All of the above
10. Debt Restructuring include all of the following except ONE
A) Debt immunization
B) Debt Refinancing
C) Debt buys back
D) Debt rescheduling
Answers
1 2 3 4 5 6 7 8 9 10
D A D D B A D E A A
References
Adam, R.A., (2005). Public Sector Accounting and Finance made simple. Lagos:
Corporate Publishers Ventures. (Fourth Edition).
Bhatia, H.L., (2005). Public Finance. India: Vikas Publishing House Ltd. (Twenty Fourth
138
Edition).
Glynn, J., Perrin J., and Murphy M., (1998). Accounting for Managers. London:
International Thompson Business Press. (Second Edition).
Jawahar, L., (2002). Accounting for Management. India: Himalaya Publishing House.
(Second Edition)
Jhingan, M.L., (2004). Money, Banking, International Trade and Public Finance. India:
Vrinda Publications Ltd. (Seventh Revised Edition).
Hingorani, N.L., and Ramanathan A.R., (1992). Management Accounting. India: Sultan
Chand and Sons. (Fifth Edition).
Horngren, T.C., and Forster G., (1988). Cost Accounting: A Managerial Emphasis. India:
Prentice-Hall of India Private Limited.
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STUDY SESSION TEN:

GOVERNMENT ECONOMIC INTERVENTION POLICIES
Introduction
In this study session, you will learn how government economic policies are utilized to
manipulate the economy to achieve societal goals. Furthermore, an attempt will be made to
discuss the concept of allocative, stabilization and distributive functions of the government.
With the contexts of these functions, the subjects of monetary and fiscal policies will be
emphatically explained for the learners to be more equipped with the terms.
Learning outcomes
10.1 Define and use correctly the key words printed in bold:
10.2 Define the concept of government economic policies
10.3 Explain the allocative, stabilization and distributive functions of government
10.4 Discuss the concept of merit goods
10.5 Stabilization policies and problems.
10.1 Government Intervention Policies

Government policies and interventions must address more than the objective of
"rationalising" trade, which often results in efforts to make marketing practices conform
mechanically to a modern model. Such intervention policies should be aimed at working with
the existing system, not at replacing it. Having said this, we can say government intervention
policies are regulatory actions taken by a government in order to affect or interfere with
decisions made by individuals, groups, or organizations regarding social and economic
matters. Likewise, government economic policies are measures by which a government
attempts to influence the economy. The national budget generally reflects the economic
policy of a government, and it is partly through the budget that the government exercises its
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three principal methods of establishing control: the allocative function, the stabilization
function, and the distributive function.
Over time, there have been considerable changes in emphasis on these different economic
functions of the budget. In the 19th century, government finance was primarily concerned
with the allocative function. The job of government was to raise revenue as cheaply and
efficiently as possible to perform the limited tasks that it could do better than the private
sector. As the 20th century began, the distribution function acquired increased significance.
Social welfare benefits became important, and many countries introduced graduated tax
systems. In the later interwar period, and more especially in the 1950s and ’60s, stabilization
was central, although equity was also a major concern in the design of tax systems. In the
1970s, ’80s and 2014, however, the pendulum swung back. Once more, allocative issues
came to the fore, and stabilization and distribution became less significant in government
finance. Each of these roles will be explained one after the other for the learners
understanding.
10.2 Resource Allocative Function

Allocation of resources deals with the apportionment of productive assets among different
uses. Resource allocation arises as an issue because the resources of a society are in limited
supply, whereas human wants are usually unlimited, and because any given resource can
have many alternative uses. In free-enterprise systems, the price system is the primary
mechanism through which resources are distributed among the uses most desired by
consumers. In planned economies and in the public sectors of mixed economies such as
Nigeria, the decisions regarding resource distribution are political. Within the limits of
existing technology, the aim of any economizing agency is to allocate resources in a manner
that obtains the maximum possible output from a given combination of resources. The
allocative function in budgeting determines on what government revenue will be spent.
Because a high proportion of national income is now devoted to public expenditure,
allocation decisions become more significant in political and economic terms. At all times
and in all countries the calls for expenditure on specific services or activities, or for more
generous transfer payments, will always exceed the amount that can reasonably be raised in
taxation or by borrowing. The debate about how these scarce resources should be allocated
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has continued for hundreds of years, and, although numerous methods of deciding on
priorities have emerged, it has never been satisfactorily resolved. In practice, most
democracies including Nigeria contain a number of different factions that disagree on the
proper allocation of resources and indeed the proper level of public sector involvement in the
economy; the frequent change of national governments is related to the constant search for
the right answers. Based on this, some contents and roles under the resource allocation
function of government will be discussed.
i. Public goods
The concept of public goods have been explained earlier. With regard to the allocative
functions, economists have sought to provide objective criteria for public expenditures
through the so-called theory of public goods. It is generally recognized that some goods
needed by the public cannot be provided through the private market. Street Lights and
national defence are classic example. The cost of national defence is such that no one will
want to finance it; on the other hand, if national security is provided for one citizen, it can be
made available to all for no additional cost. Indeed it must be available to all, since there is
no practical means of excluding other citizens from enjoying the security provided by the
government, even if the other citizens refused to pay for it. The only practical method of
providing such services is by collective action. If goods are to be provided in this way, rather
than through the private market, it is immediately necessary to confront the twin problems of
deciding how much to provide and who should pay for that provision. Even if all individuals
wanted the service equally—as, perhaps, with lighthouses for ships —their views on the
extent of the service would be influenced by the allocation of the costs. Where different
households may have different preferences and some may not want the service at all.
Economists have tried to devise abstract voting schemes that would reconcile these
difficulties, but these appear to have little practical application. Moreover, others would
challenge this whole approach to the problem. It would be absurd to say that the consumer
has a taste for national defence and that it is the job of the government to satisfy it. The task
of national leaders is to evolve a defence policy and persuade the public to accept it.
Similarly, conservationists must attempt to awaken the public to the importance of parks and
wildlife. In the context of public policy, the efficient allocation of resources consists not
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merely of distributing funds in the pursuit of given objectives but also involves determining
the objectives themselves.
Genuine public goods pose severe problems for the national budget; it is very difficult to
decide how far particular goods—the arts, national parks, even defense—should be supplied,
and therefore no formal procedure of determination is likely to evolve. What should be given
to each will continue to be the subject of intense political debate, with allocation changing as
the government changes too?
ii. Merit goods

The concept of merit goods assist governments in deciding which public or other goods
should be supplied. Merit goods are commodities that the public sector provides free or
cheaply because the government wishes to encourage their consumption. Goods such as
subsidized housing, education or social services, which predominantly help the poor or health
care services, which help the poor and elderly, are generally regarded as having considerable
merit and therefore have a strong claim on government resources. Other examples include the
provision of training and retraining schemes, that is (militants that welcome the amnesty
program in Niger-Delta) or urban regeneration programs.
iii. Cost- benefit analysis

Once decisions have been made on how the limited national budget should be divided among
the three levels of government (Federal, State and Local government), or even before this,
public authorities need to decide which specific projects should be undertaken. One method
that has been used is cost-benefit analysis. This attempt to do for government programs what
the forces of the marketplace do for business programs: to measure, and compare in terms of
money, the discounted streams of future benefits and future costs associated with a proposed
project. If the ratio of benefits to costs is considered satisfactory, the project should be
undertaken. “Satisfactory” means, among other things, that the project is superior to any
available public or private alternative. Or, if funds are limited, public investment projects
may be assigned priorities according to their cost-benefit ratios.
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One difficulty with cost-benefit analysis is that every government agency has an incentive to
estimate favourable ratios for its own projects. It must, after all, compete with other agencies
for funds. No one can be certain as to the returns to be expected from an irrigation canal or a
highway. Private investors have also been known to exaggerate their claims in appealing to
stockholders, but they are generally subject to market sanctions that encourage them to err on
the side of caution.
In addition to the possibility that cost-benefit analysis may be biased by the preformed views
of those commissioning the study, there are other, more fundamental difficulties. Almost all
proposals have effects that are difficult to value in monetary terms. The siting of a new
airport brings problems of noise and property blight to local people and increases the risk that
civilians may die in an accident. Putting a sensible value on human life has been a continuing
difficulty for those carrying out cost-benefit analysis, even though every project does in fact
affect probabilities of life and death. These problems are, of course, not confined to cost-
benefit analysis. Additional expenditure on health service or on road safety or better housing
all affect the number of people who die prematurely. The failure of cost-benefit analysis to
provide answers to the problems of valuing life, or the quality of life, is a reflection of the
wider problem confronting all decisions on public expenditure: the influence of subjective
judgment.
iv. Public ownership and privatization

Prior to the late 1970s the proportion of economic activity controlled by the government and
the share of taxes in national income tended to increase in most countries. Since then,
however, challenges to this growth in the role of government have become increasingly
influential, and moves to privatization have been common.
There are several types of privatization. One involves the sale to private owners of state-
owned assets, and this is most correctly called privatization. Publicly owned houses may be
sold to their occupants. Commodity stockpiles may be reduced or disbanded. Increasingly,
however, attention has been turned to the sale of publicly owned industries, thus reversing
the move to nationalization that occurred, particularly in Nigeria, around 1999-2013. Where
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the privatized industry operates in a competitive environment, no new problems arise. But
where privatization occurs and monopoly continues, however, there are new difficulties.
Nigeria, Japan and the United Kingdom have privatized their telecommunications networks.
Although, in certain limited areas of telecommunications, competition is possible—and has
been allowed to develop in Nigeria, United States and Britain—technical and legal
restrictions inhibit competition in many sectors of the industry.
Regulation is necessary, therefore, to restrict the freedom of privatized monopolies, or near

monopolies, to raise prices and to exploit consumers in other way. In the United States,
which has by far the longest history of regulating private utilities, such regulation has
normally limited the rate of return that they earn to what is considered a fair level. A
disadvantage of this is that it may give the industry no greater incentive to increased
efficiency than would exist in public ownership, since higher costs can be passed directly
onto consumers.
There have been experiments, therefore, with other forms of regulation, which seek to strike
a balance between incentives for better performance and the ability to exploit consumers.
A further problem for such regulation is that utilities and similar industries normally operate
in both competitive and monopoly markets. They may be inclined to use their monopoly
power in some areas to gain unfair competitive advantages in others. Despite these
difficulties, an increasingly wide range of industries, ranging from water supply to airports,
are now considered candidates for privatization.
Privatization can also mean the dismantling of existing statutory restrictions on competition.
State activities are often protected by legal prohibitions on competing private enterprise.
German railways, for example, are entirely state-owned, and the law not only prevents
competing railroads but severely restricts coach services and limits competitive trucking. The
dismantling of such restrictions is seen as one method of improving the efficiency of state
concerns.
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Another demand of privatization is the contracting out of publicly provided services. The
Nigeria municipalities have often entrusted activities such as refuse collection, and in some
cases tollgate service, to private contractors, and other countries are increasingly
experimenting with similar schemes. These possibilities demonstrate that a service may be
government-financed but not necessarily provided by the government; if extended more
widely, the concept could yield a different view of the economic role of the state. While the
main objective of privatization is often to increase the efficiency of government activities, its
implementation may also have important effects on government revenue. Any savings that
result from lower costs could lead directly to lower tax rates. Where budgeting procedures do
not distinguish between capital and current transactions, the proceeds of privatization sales
provide a once-and-for-all boost to revenues. The availability of this source of funding for
state activity has given an artificial attractiveness to privatization, especially in the Nigeria
society. For instance if National Electric Power Authority (NEPA) is sold for the present
value of its expected earnings and if these earnings are the same in public and private
ownership, privatization should have no net impact on public finances.
If it is expected to be more efficient in the private sector, government finance, on balanced

gains but if it is sold for less than the maximum revenue that would be obtained—and this is
often the case, either because of the difficulty of selling assets as large as nationalized
industries or because the government wishes to secure a wide dispersion of share ownership,
the impact is likely to be negative.
Briefly discuss the term government economic policy? What do you understand by the term
Merit good?
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i. Government economic policies are regulatory actions taken by a government in order to

affect or interfere with decisions made by individuals, groups, or organizations
regarding social and economic matters. Also, it is an economic policy that is employed
by the government to influence the economy.
ii. Merit goods are goods that the government provides free/cheaply because the
government wishes to encourage their consumption. Such goods includes: subsidized
housing, free education or social services, which predominantly help the poor or health
care services, which help the poor and elderly.
Other forms of government intervention
Government spending are not the only way in which government allocates resources. Its
regional policies will determine whether domestic and overseas investors build factories in
particular places, while its taxation policies will determine whether they build them at all.
Government competition and merger policies affect the structure of industry and commerce,
while regulatory activities—setting the number of hours shops may be open or who may buy
certain goods—have profound effects on commercial activities.
Government also affects allocations by setting the legal and administrative framework within
which the economy functions. It may specify minimum wage levels or control the siting of
new ventures and the activities of existing ones. Such activities of government profoundly
affect the allocation of resources, but they are rarely monitored or subject to serious control.
10.3 The Stabilization Function

Stabilization of the economy (e.g., full employment, control of inflation, and an equitable
balance of payments) is one of the goals that governments attempt to achieve through
manipulation of fiscal and monetary policies. Fiscal policy relates to taxes and expenditures,
monetary policy relate to financial markets and the supply of credit, money, and other
financial assets in the economy.
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The use of fiscal and monetary policy as a means of stabilizing the economy is relatively
recent, for the most part a development of the period after World War II. During the 19th
century the only stabilization policy was that associated with the international gold standard.
Under the gold standard, if a deficit occurred in a country’s balance of payments, gold tended
to flow out of the country. To counteract this process, the monetary authorities would raise
interest rates and stiffen credit requirements, causing a fall in prices, income, and
employment; this in turn led to a reduction in imports and an expansion of exports, thus
improving the balance of payments. If a country had a surplus in its balance of payments,
gold tended to flow in; this meant that the interest rate fell and the supply of money and
credit was increased. As a consequence, imports were stimulated and exports discouraged so
that the surplus in the balance of payments tended to disappear. The adjustment mechanism
also included another important element: capital movements between countries. When
interest rates fell in surplus countries and rose in deficit countries, mobile international
financial capital tended to flow from the former to the latter, contributing to the elimination
of deficits and surpluses in the balance of payments. The working of this mechanism was
partly automatic and partly the result of deliberate actions by the monetary authorities in each
country.
To throw more light on stabilization function of the government, the learners will be
introduced to the concepts of fiscal and monetary policies.
i. Fiscal policy.
These are measures employed by governments to stabilize the economy, specifically by
manipulating the levels and allocations of taxes and government expenditures. Fiscal
measures are frequently used in tandem with monetary policy to achieve certain goals. In
taxes and expenditures, fiscal policy has for its field of action matters that are within
government’s immediate control. The consequences of such actions are generally
predictable: a decrease in personal taxation, for example, will lead to an increase in
consumption, which will in turn have a stimulating effect on the economy. Similarly, a
reduction in the tax burden on the corporate sector will stimulate investment. Likewise, fiscal
policy attempts to control the actions of individuals and companies by means of spending
and taxation decisions. On the expenditure side, it can achieve this by spending money in
ways—for example, on construction projects—that stimulate other activity, while on the
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taxation side it can affect work, investment, or production decisions by changing tax rates
and levels. Fiscal policy thus has two major components: an overall effect generated by the
balance between the resources the government puts into the economy through expenditures
and the resources it takes out through taxation, charges, or borrowing; and a microeconomic
effect generated by the specific policies it adopts. Steps taken to increase government
spending by public works have a similar expansionary effect. Conversely, a reduction in
government expenditure or an increase in tax revenues, without compensatory action, has the
effect of contracting the economy. However, both are important in stabilizing the economy.
Another facet to fiscal policy is a government’s attempt to guide the development of the
economy by more specifically targeted policies. Thus most countries have from time to time
attempted to cushion particular areas from the effects of a decline in their dominant industry
by regional policies, to affect labour supply and demand by taxation, and to change the
pattern of consumer purchases by changes to indirect taxes. These policies sometimes
backfire as unforeseen consequences and interactions occur. The heyday of fiscal
stabilization policies was, however, the 1950s and ’60s. In the 1970s governments became
increasingly concerned about inflationary pressures, and important disturbances, particularly
the oil crisis, disrupted world economies. Stabilization became a less important policy goal
and one that governments were increasingly unable to achieve. Monetarist economic theories
acquired increased influence. The primary economic issues determining fiscal policies once
again became the more traditional concerns of allocation and distribution.
ii. Monetary policy

Although the governmental budget is primarily concerned with fiscal policy (defining what
resources it will raise and what it will spend), the government also has a number of tools that
it can use to affect the economy through monetary control. By managing its portfolio of debt,
it can affect interest rates, and by deciding on the amount of new money injected into the
economy, it can affect the amount of cash in circulation and, therefore, indirectly affect
prices and other economic variables. In recent years, governments, discouraged by past
failures with fiscal manipulation, have turned to monetarist policies to attempt control of the
economy. Monetary policy is a deliberate policy measure employed by governments
through the Central Bank of a Country to influence economic activity, specifically by
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manipulating the supplies of money and credit and by altering rates of interest.
The usual goals of monetary policy are to achieve or maintain full employment, to achieve or
maintain a high rate of economic growth, and to stabilize prices and wages. Until the early
20th century, monetary policy was thought by most experts to be of little use in influencing
the economy. Inflationary trends after World War II, however, caused governments to adopt
measures that reduced inflation by restricting growth in the money supply.
Although the desire to control inflation has been at the heart of the recent rise to prominence
of monetary policies in many countries, monetary policy can be used to affect a number of
different facets of economic behaviour. In time of unemployment the central bank may
stimulate private investment expenditure, and possibly also household spending on consumer
goods, by reducing interest rates and taking measures to increase the supply of credit, liquid
assets, and money. The customary tools for doing this are Open Market Operations (OMO),
the Monetary Policy Rate (MPR) or Minimum Rediscount Rate (MRR) or Discount Rate
(DR) of the Central bank and Cash Reserve Requirements (CRR) for commercial banks.
• In open market operations the central bank buys government securities—bonds and
treasury bills—from the private sector. The effect is to reduce interest rates by bidding
up bond prices. The sellers of the government securities obtain cash that they deposit in
the banks, thus increasing the cash reserves of the banks and enabling them to expand
credit to private borrowers; this in turn causes interest rates in the private sector to fall
and the terms of credit to become easier. In response, firms are likely to increase their
investment expenditures, and households are likely to spend more on consumer goods.
• The second tool of monetary policy, the Monetary Policy Rate of the central banks, is
often used together with open market operations. This is the interest rate at which
commercial banks can borrow funds from the central bank. If the discount rate is
reduced, banks become more willing to extend credit to private borrowers because they
can obtain funds themselves on easier terms. In many countries, changes in the
Monetary Policy Rate / minimum rediscount rate tend to be followed by similar
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changes in the interest rates charged by banks to their borrowers.
• The third tool of monetary policy, that of the cash reserve requirements (and, in some
countries, certain types of government securities) for commercial banks, provides that
banks must maintain money balances (in the form of deposits in the central bank) at a
certain proportion of their liabilities. This means that the banks cannot expand their
earning assets such as government securities and private loans, beyond that point. If the
government reduces the reserve requirements, the banks can expand their loans further,
thus increasing the total volume of credit outstanding.
Monetary policy, like fiscal policy, may also be used to combat inflationary tendencies by
reversing the above measures; the central bank will then sell government securities (thereby
increasing interest rates and reducing the supply of private credit and money), raise the
discount rate, or increase reserve requirements.
iii. Stabilization policies and problems.

A broad distinction may be made between two types of stabilization policies: discretionary
and automatic. Discretionary policies involve deliberate actions taken by the authorities, such
as open market operations, changes in discount rates and reserve requirements, and changes
in tax rates or government expenditures. Automatic policies put reliance on built-in
stabilizers that function without any deliberate intervention by the authorities. In the
monetary field, for example, an increase in commodity prices tends to reduce the real value
of financial assets, and if the government does nothing to offset this by increasing the volume
of financial assets in the system, private spending will tend to decline. On the fiscal side, the
main automatic stabilizer is the relation between tax revenues and cyclical changes in the
economy. During booms, tax revenues rise and the need for expenditures on unemployment
compensation decreases, channelling a larger proportion of the national income into
government coffers; these effects are accentuated if the tax system is progressive because tax
revenues rise more rapidly than money incomes. Provided that the government does not raise
its expenditures along with the increased revenues, the budget tends to have a braking effect
on private expenditure in boom times and an expansionary effect in times of recession.
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iv. The problem of time lags.

There has been much discussion over the merits of discretionary policies as against automatic
stabilizers. One advantage of automatic stabilizers is that the effects occur without the
necessity of government action, which means that there is no delay, or lag, because of
political controversies, administrative problems, or difficulties in determining whether the
time has come to act. There are three types of lag in economic intervention policy: the
recognition lag, the decision lag, and the effect lag.
• The recognition lag is the time it takes for the authorities to discover the need to make
a change in economic policy. The reasons for this type of lag are that statistical
information is often somewhat behind the event and that it is sometimes difficult to
distinguish between random fluctuations and fundamental shifts in economic trends.
Governments prefer to wait until there is certainty that, say, an increase in
unemployment is not a passing thing.
• The decision lag is the period between the time when the need for action is recognized
and the time when action is taken. Although the recognition lag is presumably of about
the same duration for both monetary and fiscal policies, the decision lag is usually
considerably shorter for monetary policy than for fiscal policy. The central bank can
change monetary policy almost overnight, whereas a change in fiscal policy is more
complex, both politically and administratively. In many countries changes in income
taxes, for example, can be made only at the beginning of a calendar year; such changes
are often complicated by political discussions in the legislative body.
• The effect lag is the amount of time between the time action is taken and an effect is
realized. Monetary policy involves longer delays than fiscal policy; the time between a
change in monetary policy and its ultimate effect on private investment may be between
one and two years.
Some authors argue that the sum of all the lags is so long and uncertain that the best strategy
is not to take any action; by the time the effects occur the economic situation may be
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radically different. Some countries have tried to shorten the lags in fiscal and monetary
policy. One way to reduce the recognition lag is to improve the forecasting techniques, for
example, by using sophisticated questionnaires or computerized statistical and econometric
models.
In sum, the usual goals of both fiscal and monetary policy are to achieve or maintain full
employment, to achieve or maintain a high rate of economic growth and to stabilize prices
and wages. The establishment of these ends as proper goals of governmental economic policy
and the development of tools with which to achieve them are products of the 20th century.
Define the following terms: Open Market Operation (OMO), Monetary Policies Rate (MPR)
and Cash Reserve Requirement (CRR)?
i. OMO can be define as the activities of the Central bank in buying/selling of

government securities—bonds and treasury bills in the open market to influence
economy activities.
ii. MPR is the interest rate at which commercial banks can borrow funds from the Central
Bank.
iii. CRR is the minimum money balance that banks must maintain (in the form of deposits
in the Central bank) at a certain proportion of their liabilities.
10.4 The Distributive Function.

Virtually everything that a government does has some effect on the distribution of income or
wealth at the various levels of society. Improvements in health care facilities benefit the sick,
the old, and those about to have children. An increase in taxes on tobacco and beer affects the
poor disproportionately, while an increase in capital taxes similarly affects the rich. Even
regulatory and legislative activity benefits one group out of proportion to another. The
redistributive consequences of the governmental budget can be reflected in a variety of ways;
sometimes they are explicit and sometimes they are cited in the debate that follows the
presentation of a budget. Usually, however, these consequences are hidden, unintended, and
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imperfectly understood. The role of the government under distribution is explained under the
subheading of incidence of taxes and public sector expenditure.
i. Incidence of taxation and expenditure
The incidence of taxes is a subject that has generated much academic debate. It is usual to
distinguish between the legal incidence of a tax and its effective, or final, incidence. The
legal incidence is on the person or company who is legally obliged to pay the tax. Effective,
or final, incidence refers to who actually ends up paying the tax; if, for example, the whole of
a sales tax can be passed on in higher prices to the consumer, then consumers bear the final
incidence of the tax.
Whether the final incidence of the tax is on those who actually pay it depends on their market
power relative to the people with whom they trade. A payroll tax, for example, is likely to be
reflected in lower wages if labour is mobile and in plentiful supply, but may be borne, at least
in part, by the employer if there are labour shortages. Similarly, if a manufacturer of Zobo
drink in Nigeria is facing intense international competition, his ability to pass on any increase
in a sales tax (recently VAT) is limited; on the other hand, his ability to do so is much greater
if he is the sole supplier of the drink.
ii. Arguments for income redistribution

Although governments do affect the distribution of resources in numerous ways, this is often
a by-product of the other things they are trying to do. It has been long debated whether or not
governments should seek explicitly to redistribute income from the rich to the poor and, if so,
to what extent. More generosity to the poor, whether through higher benefits or through a
more progressive tax system, means a higher tax burden on richer people, with, it is argued,
consequent effects on work effort and on other behaviour. The appropriate degree of
redistribution has been the subject of an extensive literature on optimal taxes, but authors
generally agree that the final determination must be through the political process.
Authors point to a number of arguments favouring explicit as opposed to indirect methods of

redistribution. The primary argument is that these would provide a more efficient means of
eradicating severe hardship, suffering, or starvation. Left to itself, the market economy
creates casualties among those who lack the skills to participate fully or those who have
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failed to generate sufficient resources to tide them over into old age. Countries have evolved
programs for the prevention of severe need, although the definition of an acceptable
minimum standard of living is typically more generous in European countries than in, for
example, Nigeria this is reflected in the higher share of public expenditure in those countries.
In most countries the definition of poverty, as measured by the level to which the state
benefit system brings everyone’s income, has moved from being “absolute” (determined by
the minimum requirement of food, clothing, and shelter) to a more relative concept, which
allows the poor to share in real rises in living standards.
The second argument for redistribution is that overall social welfare is thereby increased. An
additional N10, 000 makes more difference to the standard of living of someone earning
N15, 000 per week than to that of someone earning N500,000. Even if everyone has income
above an agreed minimum level, there is a case for redistribution from the rich to the not-so-
rich. The extent to which this should be pursued depends partly on the perceived distortions
the redistribution would cause and partly on how much more value the far more numerous
not-so-rich can squeeze out of each additional dollar.
Other arguments for redistribution occur where the market fails to allow individuals to
redistribute between periods in their own lives. The classic example is that people tend to
have their periods of highest expenditure (while bringing up children) in Nigeria at the points
of minimum income (early in life). Those families with little or no access to credit markets
can do very little about this, which has been used as one argument for redistribution toward
those bringing up children. A second argument contends that children convey benefits to
society as a whole, so that parents should be rewarded for creating a public good. This
argument would, of course, have little strength in countries with serious problems of
overpopulation such as Nigeria.
A final group of arguments also concerns market failure. If particular areas or occupations
have declined and the work force has not adjusted to this decline by moving to other areas or
through retraining, then some subsidy to cushion the recessive effects might be considered
appropriate. Most countries redistribute from better-off regions to those that have declined, or
they allocate funds for specific programs designed to help particular groups
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This study session has been able to examine public sector economic policies on the economy
performance of a nation. Among issues raised is the budget mechanism which is utilized by
the government to perform three functions which includes: allocative, stabilization and
distributive roles. In the light of these roles, the concept of merit goods, cost-benefit analysis,
and privatization were examined. Furthermore, the issue of monetary policy, fiscal policy
and incidence of taxes were explained for learners to understand the meaning of the concept.
1. ……. are measures employed by governments to stabilize the economy, specifically by
manipulating the levels and allocations of taxes revenue and government expenditures.
A) Monetary policies
B) Income policies.
C) Fiscal policies.
D) Allocation policies.
2. When the Central Bank buys government securities in the Open market from the private
sector. The effect is to………………..
A) Reduce interest rates by bidding up bond prices.
B) Increase interest rates by bidding up bond prices.
C) Make interest rates neutral by bidding down bond prices.
D) Reduce interest rates by bidding down bond prices.
3. ……. put reliance on built-in stabilizers that function without any deliberate
intervention by the authorities.
A) Automatic stabilization policies
B) Discretionary stabilization policies.
C) Contractionary stabilization policies.
D) Adjustment stabilization policies.
4. The rate by which Central Bank lend to commercial banks is known as:
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A) Monetary policy rate
B) Minimum rediscount rate
C) Discount rate
D) All of the above.
5. ……….are goods are provided by the government free or cheaply because the
government wishes to encourage their consumption.
A) Private goods
B) Merit good
C) Public goods
D) Club goods.
6. The sales of state-owned assets to private owners is …..
A) Privatization
B) Nationalization
C) Indigenization
D) Commercialization.
7. Which of this objective is not performed by the government to stabilise the economy in
order to attain macroeconomic growth……
A) Full employment
B) Price stability
C) Balance of payment equilibrium
D) Inequitable distribution of income.
8. ………..is the period between the time when the need for action is recognized and the
time when action is taken.
A) Decision lag
B) Effect lag
C) Recognition lag
D) Spiral lag.
9. Which of these tools is not a monetary policy tool?
A) Government expenditure
B) Discount rate
C) Open Market Operation
D) Credit ceiling.
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10. One of this is not a type of lag in economic intervention policy: the recognition lag, the
decision lag, and the effect lag.
A) Recognition lag
B) Decision lag
C) Effect lag
D) Spiral lag.
Solution to MCQs
Questions 1 2 3 4 5 6 7 8 9 10
Answers C A A D B A D A A D
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References
Hassan, Y. A., (2009) The role of government in a market economy. A paper presented at the
Ohio State University at Marion, USA.
http://econ.ohiostate.edu/Aly/docs/The%20role%20of%20government%20MS%20Article%2
09-27-08.pdf
http://www.britannica.com/EBchecked/topic/240167/government-economicpolicy/26304/
Public-ownership-and-privatization#26305
http://www.businessdictionary.com/definition/governmentintervention.html#ixzz3HT4uWsc
http://econ.economicshelp.org/2007/05/government-intervention-in-macro.html
http://www.economicsonline.co.uk/Market_failures/Types_of_market_failure.html
http://www.economicshelp.org/blog/5735/economics/should-the-government-intervene-in-
the-economy/
http://tutor2u.net/economics/revision-notes/as-marketfailure-governmentintervention.html
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08033366677

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MODULE THREE:
GOVERNMENT ROLE IN THE GROWTH OF THE ECONOMY
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STUDY SESSION ELEVEN:

THE CONCEPT OF PUBLIC GOODS
Introduction
In the preceding study session, the concepts of free market economy and market failure were
discussed. There, public good is one of the causes of market failure. In this study session, we
will examine the term public good. Public good concepts deal with the good that is
collectively owned and consumed by people with little or no payment made for such
consumption. In the course of our discussion both private and public goods will be examined.
Similarly, graphical approach will be utilized to explain the amount paid by consumers for
both types of goods.
Learning outcomes
11.2 Explain the concept of public good
11.3 Distinguish between public goods and other types of good
11.4 The price paid by consumers of public and private goods
11.5 The roles of government in providing public goods.
11.1 The concept of public goods

In a free market economy, goods and services will only be provided if firms can ensure they
will receive payment for them. They will then provide whatever quantity is the most
profitable. In doing this, they take account only of the costs and benefits to them. If there are
external costs or benefits, they will not take account of these. This may mean that they don't
provide the socially optimal level of output. Public goods, merit goods and common pool-
resources goods are goods that would either not be provided at all or would not be provided
in sufficient quantity, because firms would not be able to adequately charge for them.
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In this context, public goods can be defined as good that is collectively owned and
consumedby everybody in the society. Also, it is a product that one individual can consume
without reducing its availability to another individual and from which no one is excluded.
The most detailed and technical description of a public good, which is often referred to by
authors, is Samuelson's (1954) definition, which states that a public good is a good that, once
produced for some consumers, can be consumed by additional consumers at no additional
cost. That means everybody jointly consumed the goods with or without payment. Examples
of such goods includes: fresh air, a public park, fireworks show, a lighthouse for ship, a
beautiful view, national defence. Let take national defence to buttress the explanation of
public goods. For instance, the consumption, or in this case the protection, provided to one
person does not diminish the protection provided to another. Regardless of whether an
individual living in the country paid for the service or not, he still enjoys the benefits of that
service. Also, national defence is non-divisible, meaning we can’t divide up the protection
provided to each individual.
Of great interest, is the idea of “public goods” that has a long intellectual history that can be
traced far back as 1739, to David Hume’s discussion of providing for the “common good.”
Along the way, classical economists like Adam Smith, David Ricardo and David Malthus
drew attention to the need for concerted action to provide for goods that benefit a
community. However, it was not until 1954 that a general theory of pure public goods was
explicitly developed with the work of Paul Samuelson and his article on “The pure theory of
public expenditure” and his two subsequent articles (Samuelson, 1954, 1955, 1958). The
framework set out by Samuelson continues to provide the theoretical base for the study of
public goods. By introducing the idea of a “pure” concept, Samuelson was able to develop
two essential characteristics that differentiate a private good from a pure public good: non-
excludability and non-rivalry.
• Non-excludability means that it is either impossible or prohibitively costly to exclude
those who do not pay for the good from using or consuming it. Once the good has been
produced, its benefits – or harm – accrue to all. Two examples will be introduced to
give a clearer understanding of this term to the learner. One is the lighthouse. A
lighthouse is: non-excludable because it is not possible to exclude some ships from
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enjoying the benefit of the lighthouse (for example, excluding ships that haven’t
paid anything toward the cost of the lighthouse) while at the same time providing the
benefits to other ships.
Two, suppose an establishment took it upon itself to stage an HIV/AIDS awareness

campaign and fireworks show in a field near National stadium, Surulere, Lagos state.
Thus, people can watch the show from their windows or backyards. Because the
establishment cannot charge a fee for consumption, the shows may go unproduced,
even if demand for the show is strong. This explains why most events of these kinds are
paid and sponsored by the governments as a service to their communities.
• The non-rivalry property implies that any one person’s use or consumption of the
public good has no effect on the amount of it available for others. Referring to the
lighthouse example, since the lighthouse’s benefits are already being provided to some
ships, it costs nothing for additional ships to enjoy the benefits as well. While for the
case of the HIV/AIDS awareness camp and fireworks shows, let assume that the
establishment manages to exclude non-contributors from watching the show (perhaps
one can see the show only from a private field). A price will be charged for entrance to
the field, and people who are unwilling to pay this price will be excluded. If the field is
large enough, however, exclusion is inefficient because even non-payers could watch
the show without increasing the show's cost or diminishing anyone else's enjoyment.
That is non-rivalrous competition to watch the show (Cowen, 2002).
(i.) Explain the terms public goods?

(ii.) Briefly discuss the difference between non-rivalry and non-excludability features of
public goods?
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(i) A public good is defined as a good that possess the feature of both non-rivalries and
non-excludable in consumption.
(ii) The non-excludable property holds when it is impossible to prevent others from jointly
consuming a unit of the good once it is provided or produced while the non-rivalries
property holds when use of a unit of the good by one consumer does not diminish or
preclude the benefit from another consumer using the same unit of the good. Thus,
there is jointness in consumption of the good—one unit of the good produced generates
multiple units of consumption.
11.2 Public goods and other types of goods

A useful way to differentiate the different examples of goods is in terms of whether they are
rivalries or non-rivalries, and whether they are excludable or not. Based on this, we can
create a 2-by-2 matrix describing goods (see Table 11.1 overleaf).
In the first quadrant in table 11.1, we have the case of a private good. These forms of goods
are the direct opposite of public goods. Private goods are goods where consumption by one
person prevents consumption by another (an extreme form of rivalries consumption), and one
person has the right to prevent the other from consuming the object. Their main features are
excludability (meaning that they are rivalries) and depletability. Private goods are almost
exclusively made for profit. A good example of a private good is bread. Bread is usually
made for profit and is finite because once it is purchased and eaten it is gone.
Table 11.1 Classification of goods
Rivalries Non-rivalries
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Private goods
Club goods
Breads, Cars, cloths,
Excludable Cinemas, private parks, Satellite
personal electronics food,
television, bridge, toll gates
etc
Public goods
Common- pool resources National defense, free-to-air
Non-excludable National Fish stocks, forest, television, fresh air, a public park,
coal etc HIV/AIDS awareness campaign and
fireworks shows, lighthouse, a
beautiful view, etc
The club goods are placed in the second quadrant. Public goods can also differ from pure
public goods if its consumption is excludable. In this scenario, individual are excluded from
consuming the goods though the amount consumed by a person does not reduce the
quantities available for others. These forms of goods have the features of non-rivalrous but
excludable, as in the case of a bridge, toll gates, a park and satellite television. Because club
goods are excludable, inefficiencies due to external effects can often be addressed by
charging people for access to the club good such as charging a toll for a bridge or a
membership fee for a club.
In the third quadrant, it is the case of common-pool resources. These are goods where
consumption is rivalrous but it is difficult to exclude people from consuming these goods. In
this case, individuals are not excluded from consuming the goods but the consumption of a
particular good reduces the quantities avail for other. Examples of such goods are: national
fisheries, forests, common grazing land and irrigation system. In these situations, individuals
will tend to overuse the common-pool resources since they will choose the level of usage at
which the individual marginal utility is zero.
Public goods occupied the fourth quadrant of the table. As noted earlier, these forms of
goods possesses the characteristics of non-rivalrous (a given amount of the good can be
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consumed by one person without affecting its simultaneous consumption by another) and
non-excludable (non-payment does not entail exclusion from consumption). Examples of
these forms of goods are depicted in table 12.1.
(i.) How do you differentiate common pool-resources from club goods?
(i.) Common-pool resources are goods that possess the feature of rivalry but non -
excludable while club goods are goods that have the features of non-rivalrous but
excludable.
11.3 Demand for private and public goods

In real life scenario, most goods produced and priced are confined under the public and
private sector analysis. Therefore, the question in the mind of the learners is how much,
different individuals would want to pay for private and public goods. This will direct our
attention to the determinants of market demand for private goods and services, likewise the
determinants of socially optimal amount of public goods and services.
Recall in the case of private goods, we noted that, it possesses the features of rival excludable
as well as divisible. Both “rival” and “excludable” have been previously discussed. For
goods to be divisible it means the production of the good or service can be divided among
those who are consuming the good. For example if UNILAG Bakery is producing 100
loaves of breads daily and each loaf of bread is packed and sold to a customer. To determine
the market demand for the good or service, we horizontally summed the demand curves of
each of the individuals. For example, at two hundred naira (N200) one person would buy
fifty (50) loaves of bread and another would buy twenty (20), so the market demand at two
hundred naira (N200) would be seventy loaves of bread demand at the given price (See
figure 6.1).
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169

Figure 12.1: Deriving aggregate demand for private good
Price Individual 1 Individual 2 Market Demand
N200………….…………………………………………………………………………..
0 50 Qty 0 20 Qty 0 70 Qty

Recall, in deriving the market demand, we have to sum up the individual quantities
demanded. The aggregate demand for the market is given as the total quantities consumed
which are 70.
Note that we sum private goods horizontally, because consumers cannot consume the same
units. Rivalry in consumption is what makes the market pricing system so incredibly
effective, and why the invisible hand hypothesis can work. A price is a per unit charge for a
good, so that, when goods are consumed always due to a rivalry between consumers, supply
shortages will tend to correct the market by driving up prices as consumers compete for the
few remaining goods. Similarly, a supply surplus will cause firms to lower the price of the
good until an equilibrium is met that will clear the market. Public goods, however, cannot be
so easily and efficiently priced.
Having examined the demand for private good, we have to give an insight on the demand for
public. Before, doing this, there is the need to flashback at the unique characteristics of: non-
non-excludable, non- rival, and non-divisible. The concept of non-divisible comes into play
because we cannot divide the goods among individuals. For instance, national defence is
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non-divisible, meaning we can’t divide the protection provided to each individual in the
country.
Another example is the lighthouse, whereby the ray of light coming out of the light stand
cannot be shared by different individual.
To simplify things, let us assume a simple economy with only 2 individuals.
Figure 4.2 shows where the demand curves for these individuals A and B for a certain public
good. The government has sent out a survey to A and B and asking them what each of them
would be willing to pay if the amount of public good produced was Q1 units. We can see
from the graphs that Individual A would be willing to pay N60 for that level of output, while
Individual B would be willing to pay N30 for that level. Thus if the government could
collect the donations from A and B they know that they could get N90 if they produced Q1
units. They next asked A and B what they would be willing to pay for Q2 units. We see that
both A and B would both be willing to pay N20 each. So if the government produced Q2
units, then they could possibly get N40.
Figure 11.2: Derivation of aggregate demand curve for public good

Thus, we can see how the market demand curve is derived in the case of a public good. We
add the amounts that each individual is willing to pay for each likely level of output (See
figure 12.2). The vertical summation of each person’s willingness to pay for the good is
noted to be the socially optimal amount of the good or service that the government should
produce for very individual in the society. Note that due to the free-rider problem; no one
individual would be willing to provide a public good, since the marginal cost exceeds his /
her willingness to pay. To correct this abnormality, government will typically tax individuals
and provide the good or service to the public.
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Price
Pr
per unit
N90 The market (A + B)
N40 D (A + B)
Price
N30
N20 DB
Q1 Q2
N60
N20
DA
Q1 Q2
Source: /jasonleeucdavis.weebly.com
11.4 The free rider problem

This is a problem underlying the provision of public goods and an individual consumes or
benefits from that good without making payment. One problem with public goods is the free-
rider problem. The free-rider problem arises due to the fundamental nonpayer non-
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excludability characteristic of public goods. Because nonpayers can continue to consume and
benefit from public goods without paying they are unlikely to make voluntary payments.
This problem states that a rational person/s will not contribute to the provision of a public
good because he/she does not need to contribute in order to benefit. For example, if Mr.
Anthony and Mr. Onogiese do not pay their taxes, they can still benefits from the
government's provision of national defence by free riding on the tax payments of their fellow
citizens. Let take another scenario, to see free riding at work in the Nigeria setting.
Consider the challenge of constructing Fourth Mainland Bridge in Lagos state where the
societal benefits of doing so would exceed the costs. How successful do you think a
campaign would be to finance the bridge with voluntary donations? It is not hard to imagine
how such a campaign would fail, because many (if not most) individuals would choose to
make no donation, hoping others would contribute enough to finance the bridge for everyone
to enjoy. In this scenario, the market failure would be that no bridge is constructed despite
the fact that a bridge would make everyone better off.
The free-rider problem is the primary reason why public goods are produced by the
governments. Because public goods are characterized by the inability to exclude nonpayers,
once a public good is produced anyone, everyone, can consume without making payment,
that is, get a "free ride." Voluntary payments like those occurring in markets will not provide
enough revenue to pay production costs. The only way to finance public goods is to force
free-riders, and everyone else, to pay through government taxes. The free-rider problem also
applies to common-property goods.
11.5 Methods of providing public goods: The government and private perspectives
a. Private provision of public goods.
As discussed earlier, the free-rider problem is attributed to the under-provision of public
goods by the private sector. In a nutshell, the private provision of public goods can be
possible but this depends on three key factors. These are:
• Dissimilarities among persons in their demand for the public goods;
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• Altruism amongst prospective contributors to the public good and;
• Utility derives from one's consumption of the public good.
Each of these factors are discussed below:

(i) Dissimilarities among persons in their demand for the public goods - Suppose certain
persons care more about the public good, then the free-rider problem can be solved to
some extent. Consider a situation whereby a road in Akoka, is half occupied with
refuses and the same driveway is shared by the rich and the poor persons in that
neighbourhood. If the rich persons care more about a clean drive-way, then, they will
be willing to spend more money to have the waste remove. In this instance, the rich
person's higher income or stronger taste of having a clean drive-way is likely to reduce
the free-rider problem.
(ii) Altruism among potential contributors to the public good - Altruism denotes the
concept whereby each individual value the costs and benefits to others in making their
consumption choices. If each person is not selfish likewise utility-maximizing agents
but are altruistic, then the free-rider problem can be solved to some extent. For
example, if Mr Onogiese cares more about the costs of refuses disposal, he might be
willing to contribute more in order to lower Mr. Anthony's burden. Mr Onogiese may
feel more concerned about the costs of refuses disposal since he realizes that he is
wealthier and is willing to share a higher part of the cost burden if he cares about his
neighbour Anthony.
(iii) Utility derives from one's consumption of the public good. This can be best explained
by what Gruber (2009), called the "warm glow model". The warm glow model is when
individuals care about both the total amount of the public good and their particular
contributions as well. A great example of this is contributions to a radio station that
solely relies on its listeners for financial support. If individuals enjoy the music and
care about the existence of a specific radio station in their community, then the
individuals are likely to contribute toward this public good, even if it creates several
free-riders.
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b. Public provision (Government) of public goods.

Government involvement is sometimes indispensable since the private sector may under
provide public goods as a result of the free-rider problem. Although government
interventionin this case may improve efficiency, some obstacles exist that make it demanding
for the government to provide public goods. These barriers include:
• Private responses to public provision, or "crowding out";
• The problem of assessing the benefits and costs of public goods; and
• The problem of determining the public's preferences for public goods
i) Crowding-out effect – When the government provides more of a public good, the
private sector will provide less. A great example of this is illustrated using a positive
externality of government providing education. The concept of externality will be
discussed in the next study section one may argue that in most cases, any crowding out
effect should not result in inefficiency because the reason for the government providing
a good or service in the first place is due to under-provision by the private sector. The
rational government won't provide goods/services in a public goods market that is
already operating efficiently.
ii) The problem of assessing the benefits and costs of public goods - In theory it is
relatively simple to assume that government can estimate the benefits and costs of
public goods. But in real life event, it is exceptionally problematic to consider all types
of benefits and costs with respect to public goods. Let consider the case of the
renovation of Third Main Land Bridge by the Nigeria government some years ago. In
undertaking this project, there are explicit and implicit costs and benefits associated
with an improved road system. Explicit costs include the wages of road workers,
concrete costs, insurance, etc. One implicit cost is the lost productivity of office
workers who must spend more time on the road during times of construction-caused
traffic jams. Some explicit benefits from the new road may include the government
needing to spend less money for maintenance on the new road, and less wear and tear
on government vehicles operating on the road due to a lack of potholes. Some "semi-
implicit" benefits include time saved by the aforementioned office workers who can
now get to work faster on the wider road and a potential reduction in traffic accidents
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due to newer roads being safer. The more implicit costs are, the more difficult they
become to accurately estimate or measure. While an estimate for the wages paid to road
workers may be accurate to within 5%, estimates of cost savings due to a reduction in
fatalities can vary widely due to the number of unknown and unpredictable variables.
iii) The problem of determining the public's preferences for public goods -
Government can face difficulties in knowing the actual preferences of the public for
public goods due to three problems: preference knowledge; preference revelation; and
preference aggregation.
• Preference knowledge is when individuals may lack the knowledge regarding
public goods and as a result not know what their valuation truly is for public
goods.
• Preference revelation is when individuals may not be willing to tell the
government their true valuation for example, because the government might
charge them more for the good if they say that they value it highly.
• Preference aggregation is the problem of government in attempting to consolidate
the preferences of millions of citizen’s preferences in order to decide on the value
of a public project. Unlike the market demand curve for private goods, where
individual demand curves are summed horizontally, individual demand curves for
public goods are summed vertically to get the market demand curve. Being that
public goods have a fixed market quantity (everyone in that society must agree on
consuming the same amount of that good), individual demand curves for public
goods are summed vertically to give the price for a given quantity. Conclusively,
since society does not have to agree on a given quantity of a private good, one
person can consume more than another at a given price, and the individual
demand curves are summed horizontally instead.

This study session examines the concept of public goods. The definition and features of
public goods were discussed. In the course of the study, various forms of goods were
identified. While private and public goods were emphatically differentiated. Furthermore, the
176
free rider problem was introduced and discussed. Therefore, the study session was concluded
by reviewing the methods of providing public goods via the government and private
perspectives.
1. The free-rider problem arises due to the fundamental feature of………of public goods.
A) Rivalry
B) Non rivalry.
C) Excludability.
D) Non excludability.
2. Non-rivalry and excludability are common features of……….
A) Public goods
B) Common goods
C) Club goods
D) Private goods.
3. Rivalry and non- excludability are associated with ……….
A) Public goods
B) Common goods
C) Club goods
D) Private goods.
4. The whole classes of goods that will be produced in a completely regulated economy
are referred to as:
A) Club goods
B) Public goods
C) Private goods
D) Pareto goods.
5. Common goods possess the features of…..……….
A) Rivalry and excludability
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B) Rivalry and non –excludability
C) Non-rivalry and non-excludability
D) Non-rivalry and excludability.
6. Private goods possess the features of ……….
A) Non-rivalry and excludability
7. An example of a good that possess the features of excludable and non-rivalry is……….
A) National defense
B) Cinemas
C) Cars
D) Air.
8. Which of these features distinguish public goods from private goods ……….
D) Rivalry and excludability.
9. Club goods possess the features of …….……….
B) Option: Rivalry and non –excludability
D) Rivalry and excludability.
10. The form of goods that individuals consume different quantities at a given price or the
same price is…
A) Public goods
B) Private goods
C) Mixed goods
Solution to MCQs
Questions 1 2 3 4 5 6 7 8 9 10
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Answers D C B C B D B C A B
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Reference
Cowen, T. (1992). ed. Public Goods and Market Failures. New Brunswick, N.J.:
Transaction Publishers.
Cowen, T. (2002). Public Goods and Externalities. In The Concise Encyclopedia of
Economics. Retrieved July 8, 2008, from Liberty Fund, Inc. Web site:
www.econlib.org/library/Enc/PublicGoodsandExternalities.html).
Cowen, T. and Eric C. (2003)., eds. Market Failure or Success: The New Debate.
Cheltenham, U.K.: Edward Elgar, 2003.
Sagasti, F. and Bezanson, K (2001), Financing and Providing Global Public Goods:
Expectations and Prospects. Prepared for the Ministry of Foreign Affairs, Sweden,
November.
Samuelson, P. (1954), “The pure theory of public expenditure”, Review of Economics and
Statistics, No. 36, pp. 387-89.
Samuelson, P. (1955), “Diagrammatic exposition of a theory of public expenditure”, Review
of Economics and Statistics, No. 37, pp. 350–356.
Sagasti, F. and Timmer, V. (2008). An Approach to the CGIAR as a Provider of International
Public Goods. An independent Review of the CGIAR System, Report to the Executive
Council, Elizabeth McAllister (Chair), Bringing together the best of science and the best of
development, Washington DC, September.
Kitchen, M. (2012). The concept of public goods.
http://environment.yale.edu/kotchen/pubs/grnmrkts.pdf
Gruber, J. (2009), Public Finance and Public Policy (2nd edition). p 177-179.)
http://www.econlib.org/library/Enc/PublicGoods.html
www.amosweb.com/cgi-bin/awb_nav.pl?s=wpd&c=dsp&k=free-rider+problem
http://are.berkeley.edu/courses/EEP101/Lecture-Summary-PDF/lec09-10-Public-Goods.pdf.
www.bized.co.uk
http://www.econlib.org/library/Enc/PublicGoods.html
http://www.econlib.org/library/Enc/Externalities.html
http://www.investopedia.com/terms/p/public-good.asp
http://www.who.int/trade/distance_learning/gpgh/gpgh1/en/
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181

STUDY SESSION TWELVE:
THE CONCEPT OF EXTERNALITIES
Introduction
In the last study session, you have learnt the concept of public goods which is noted as goods
with the features of non-excludable and non-rivalry. The uniqueness of these forms of goods
has made it difficult for the free market economy to provide such goods. Recall, we say
public goods are one of the causes of market failure. In this study session, you will learn the
concept of externality which is another important distortion of free market economy. In order
to have a clear understanding of the term, you will be introduced to the forms and effects of
externality on individuals and the society as a whole. Likewise, feasible solutions to
externalities problems will be addressed.
Learning outcomes
12.2 Understand the term and idea behind externalities
12.3 Use graph to explain the types of externalities
12.4 Analyse the possible solutions to externalities phenomena.
12.1 The Concept of Externalities

"The word externalities were fashioned by Arthur Cecil Pigou (1877-1959), and this was
further developed by two economists Henry Sidgwick (1838-1900) and Alfred Marshall
(1842-1924) into an essential feature of contemporary economic theory."
Externalities exists whenever the well-being or welfare of an individual or producers are

directly or indirectly affected by the actions of another agent in the economy (and this
interaction is not mediated by the price mechanism). In other words, externalities are third-
party impacts arising from the consumption and production of goods and services for which
182
no appropriate compensation is paid. In a market economy this generally means that an

externality occurs where there is a direct effect of the actions of one person or firm on the
welfare of another person or firm in a way which is not transmitted by market prices. This
externality can arise from the effects that consumption of an item by one consumer may have
on the welfare of others or from the effects that the production of one product may have on
the production possibilities of others. That is, when producers fail to take into account the
social costs and benefits the amount of output produced will either be overproduced or under-
produced. Likewise, when consumers fail to take into account the costs and benefits of their
actions too much or too little output will be consumed vs. what is socially optimal.
As societies get more urbanized, the presence of externalities becomes more visible.
With more people, the likelihood that the actions of decision makers will have a greater
chance of affecting others increases. Externalities are fairly common in our society. Here are
some examples (See: Table 12.1)
Table 12.1: Production and consumption externalities
Production Consumption
Quadrant one Quadrant two

Beneficial
Bread smell/scent from bakery. Measles immunization
Quadrant three
Quadrant four
Sulfur-dioxide emissions from the

Harmful Noise caused by home use of generators
bakery and oil spillage from
by people on their neighbour. Noise from
Multinational companies on the soil
party.
and water of Niger-Delta people of
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Nigeria
In quadrant one and three of Table 12.1, production externalities occur when the production
activities of one individual imposes costs or benefits on other individuals, that is not
transmitted accurately through a market. When we examine production externalities with
regard to beneficial and harmful effect for instance, if the people staying close to the bakery
like the smell / aroma of the bread that comes from the bakery. This activity causes positive
effect to the third party. Likewise, the sulfur and carbon dioxide emissions from the
machineries and generators of the bakery have a harmful effect on the environment and
welfare of the people.
In quadrants two and four (See Table 12.1), we have the case of consumption externalities
where consumers fail to take into account the costs and benefits of their actions, then too
much or too little output will be consumed. For instance, measles vaccination lowers the
probability of others’ getting infected as shown in quadrant two while noise from generator
sets from residents on their neighbours causes harmful effect on them (quadrant four).
Within the framework of the production and consumption externalities, we are going to
analyse the positive and negative externalities using graphical approach. Note both
production and consumption externalities are within the context of positive and negative
externalities.
For more in-depth analysis of the concept of externalities, it is important to define certain
terms:
i. Private Benefit (PB): The increase in consumer happiness from the consumption of
one more unit of a good or service. This is equivalent to the normal demand curve (the
higher the price the lower the quantity demanded vice-versa).
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ii. Private Cost (Marginal Cost): The increase in a firm’s costs when it produces one
more unit of a good or service. This is equivalent to the usual supply curve. (It excludes
externalities).
The word private is used to emphasize the fact that there are two main actors in a transaction
in the output market: the sellers of a good or service (the firms), and the buyer of a good or
service (the households). When we talk about benefits or private cost, we are discussing the
cost and benefits that apply only to the direct participants in a transaction, in the output
market.
The term social is used to emphasize the fact that in some transactions, the entire society
(and not just a household or a firm) is affected by a market transaction.
i. Social Benefit (SB): The total benefit gained by the society from the consumption of a
good. It includes any private benefits and any consumption externality that might exist.
ii. Social Cost (SC): The aggregate cost from the production of a good, including the
private cost and any production externality. In a situation where there is ‘NO’
externality on the production side then: Social Cost = Private Cost
Similarly, where there is ‘NO’ externality on the consumption side then: Social Benefit
= Private Benefit.
Therefore, economic efficiency will always occur when social costs equal social benefits.
When there are no externalities on either the production or consumption side, then economic
efficiency will occur when private costs equal private benefits. As we have seen already,
private cost is just the marginal cost curve facing a firm. That is Private costs equal Marginal
Costs.
What about private benefits? What benefit do you derive from consuming one more unit of a
good? We’ve seen already that the benefit has to be at least the price of the good. If the
benefit derives from consuming one more unit of a good is less than the price you are willing
to pay for the good then you would not purchase it. If however, the benefit you would get is
greater than the price of the good then you will certainly purchase the good. Thus, private
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benefits = P, Since we stated that economic efficiency occurs where private costs equal to
private benefits. Then when there is no externalities a firm will produces where P = MC.
(i.) What is externality?

(ii.) Briefly define the following terms: Private benefits and social benefits?
(i.) Externality occurs where there is a direct effect of the actions of one person or firm on
the welfare of another person or firm in a way which is not transmitted by market
prices.
(ii.) Private Benefits is the increase in consumer happiness from the consumption of one
more unit of a good or service. This is equivalent to the normal demand curve (the
higher the price the lower the quantity demanded vice-versa). Social Benefits are the
aggregate benefits gained by the society from the consumption of a good. It includes
any private benefits and any consumption externality that might exist.
12.2 The types of externalities

Externalities are categorized into two parts: negative and positive. Both will be discussed in.
i. Negative Externality
In a negative externality, the case of oil producer should be put into consideration. The
producer does not face the entire cost of production. For instance, an oil refinery generates
water, air and land pollutions in its production of oil in the Niger Delta region of Nigeria.
The presence of water, land and air pollutions makes the community around the oil refinery
worse off due to diminished health or due to diminished ability to fish in their water or farm
on their land, etc.
Refer to Figure 12.1. The firm will only take into account their own private costs and thus
will produce where private benefits = private costs. This is equivalent as saying where
supply equals demand. The oil-refinery would produce at Point A where (Quantity = Q1;
Price = P1).
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Figure 12.1: Negative externality.

S2 = Social cost
Price External cost = Externality
B S1 = Private cost
P2
A Dead weight Loss
P1
D = Private benefit = Social benefit
Q2 Q1 Qty

However, there are social costs (the water, land and air pollutions) to the production of oil,
which the oil refinery ignores. The Social Cost curve must be higher (to the left) of the
private cost curve. At the original level of production, social costs are higher than social
benefits and thus this quantity is not efficient and we have market failure. The reason for
market failure is that the market participants do not factor in the full social costs of their
harmful economic activities. There is a divergence between social costs and private costs
which is the negative externality.
Learner should note that, there is no externality on the consumption side, so private benefit =
social benefit (the demand curve will be the same). We know that when externalities exist,
economic efficiency will only occur when social benefit is equal to social cost. In this case,
economic efficiency will be at Point B. The shaded area (point A) is the area in which social
costs exceeded social benefit that results from overproduction. This is the dead-weight loss.
Society would be better off if the economy was at Point B rather than at Point A. Note that at
Point B, the efficient solution is not to reduce the harmful activity to 0. As long as the firm
has the ability to compensate the damaged parties fully and still have profits left over, then
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pollution is “worth it” to society. It would be inefficient for the oil refinery to stop polluting.
Notice that if the quantity produced were below Q2, the benefits gained from society would
have been greater than the social costs. Society would be better off if they produce more of
the polluting product.
ii. Positive Externality

Consider the market for measles immunization. Measles immunizations are an example of a
positive externality. The more people get immunized, the less likely any person has not
received the measles immunization becomes ill with the measles. Thus, in this case, there is a
clear benefit to society if one gets the measles immunization. However, you don’t get
compensated by society for this benefit (In fact in some cases, you have to pay to get measles
immunization). Therefore, you will only consider your private benefit in determining
whether or not to get measles immunization. This is a case where the social benefit differs
from the private benefit. The social benefit curve for a positive externality will be to the right
of the private benefit curve. This is the case, because at every price, society would benefit
more from measles immunization. There is no externality on the production side: therefore
the social and private costs are the same.
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Figure 12.2: Positive externality

Price Dead weight loss
B S1 = Private cost = Social cost
P2 A
P1
D2= Social benefit
D = Private benefit = Social benefit
Q1 Q2 Qty

Refer to Figure 12.2. We know that the market equilibrium is where the private cost equal to
private benefits at point A. However, point A cannot be efficient since at that quantity, the
social benefits exceed the social costs. Economic efficiency will only be reached when
social costs = social benefits at Point B. The shaded area is the positive externality that is
realized as we produced the good. The deadweight loss is the shaded area between Q1and
Q2. It will be a loss to society by not producing enough of the good.
12.3 The solutions to externalities

There are numerous ways we can achieve an efficient level of production in the presence of
externalities.
i. Taxes and Subsidies: The government can be used to internalize: the externality that
will force the market participants to see the full economic consequences of their
actions. In the case of a negative externality this can be done using a tax. If the tax is
set to the amount of the externality cost, then it will have the effect of shifting the
curves in the right direction and the efficient amount will be produced. For instance, let
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us consider the case of the negative externality. The government can charge a tax on
production of the good equal to the externality. The tax will shift the S1 curve to S2 and
the firm will produce at the efficient amount Point B. In the case of a positive
externality, this can be done using a subsidy (government paying producers to produce
or consumers to consume). It is obvious that the government would find it a difficult
task to correctly measure the externlity.
ii. Private Solutions (Bargaining and Negotiation): Consider the case of the polluting oil
refinery. The victims of the pollution can either bribe the polluters not to pollute, or
thepolluters could compensate the victims of pollution to allow them to pollute. This is
known as Coase Theorem. The theorem states that if basic rights at issue are
understood, transaction costs are low, and if few parties are involved, private parties
will find an efficient solution to the problem of externalities. Often, however,
transaction costs are not low since there are many people involved in the externality.
Thus private solutions to an externality are generally not feasible.
iii. Legal Rules and Procedures: When externalities generate damage to society, courts and
the law can be employed to limit the damage costing action. An injunction is a court
order forbidding the continuation of behaviour that leads to damages. If the damages
have already occurred, the court can issue liability rules which require the damaging
party to compensate for the harm committed. As a result of injunctions and liability
rules, the decision makers have an incentive to weigh all the consequences.
iv. Selling or Auctioning Pollution Rights: Another method to control pollution is to issue
“permits” to firms in order to pollute and allow firms to trade these permits in a market
setting thereby resulting in an efficient level of pollution. Since, we don’t have a good
example to illustrate this strategy in Nigeria there is the need to cite an example from
the USA experience. This system is called a “cap and trade” approach. The Clean Air
Act of 1990 is an example of a law that used the cap and trade system.
• Emissions from each factory were limited to a certain level where each firm plant
was issued permits to emit only that level of production.
• Permits could be used to emit air pollution or they could be traded to another
firm.
• Firms who had clean technology and were able to produce output at emission
levels lower than the Federal mandate would sell its unused permits to firms with
190
dirtier technology. The socially desirable level of pollution would thus be

generated using this method.
• Environmental groups could also purchase these permits in the market and choose
not to use them, thereby reducing emissions even further.
v. Direct Regulation of Externalities. All of the forms of controlling externalities that we
have discussed so far are indirect. That is they are designed to encourage firms to
internalize the cost and benefits of their actions, but they are not mandatory. Some
externalities, however, are too dangerous to society that they require a more direct
means of control. Direct regulation involves explicit control over the actions that lead
to externalities. Violators of the regulations not only face a monetary cost, but also
criminal penalties and sanctions. Direct regulation ensures that firms and households
completely weigh the costs of their actions.

In this study session, which is basically about the concept of externality, we discussed issues
relating to production and consumption externalities with respect to the beneficial and
harmful. To get an in-depth analysis of the concept, some terms such as: private benefits,
private cost, social benefit and cost were examined to explain the two types (positive and
negative) of externalities. Based on the problems discussed, possible solutions were proffered
to reduce its impact.
1. The cost or benefit that was not transmitted through prices but incurred by a party who
did not agree to the action causing the cost or benefit is known as…..
A) Internalities
B) Externalities
C) Public debt
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D) Public expenditure.
2. The word externality is created by:
A) Arthur Cecil Pigou
B) Henry Sidgwick
C) Alfred Marshall
D) Adam Smith.
3. The social benefit curve for a positive externality word externality will be to…..
A) The right of the private benefit curve
B) The left of the private benefit curve
C) The left of the private cost curve
D) The right of the private cost curve.
4. In a situation where there is no externality on the consumption side then:…..
A) Social Benefit > Private Benefit
B) Social Benefit = Private Benefit
C) Social Benefit < Private Benefit
5. The total cost to the society of producing an additional unit of a good or service is
the….
A) Marginal social cost.
B) Marginal external cost
C) Marginal private cost
D) Marginal resource cost
6. Another name for transaction spill over is known as…………….
A) Public expenditure
B) Public debt
C) Internalities
D) Externalities.
7. Economic efficiency looks at the Marginal Social Benefit (MSB) and the Marginal
Social Cost (MSC). Production of a good is at exactly the socially efficient level if:
A) MSB < MSC.
B) MSB / MSC = 1
C) MSB > MSC
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D) MSB = MSC.
8. A situation where there is no externality on the production side then:…..
A) Social Cost = Private Cost
B) Social Cost < Private Cost
C) Social Cost > Private Cost
9. All of the following are causes of market failure except:..
A) Externality
B) Public good
C) Missing market
D) Private good.
10. In the graphical approach of negative externalities, the ………of the private cost curve.
A) Social cost curve must be higher (to the right)
B) Social cost curve must be higher (to the left)
C) Social cost curve must be lower (to the right)
D) Social cost curve must be lower (to the left).
Solution to MCQs
Questions 1 2 3 4 5 6 7 8 9 10
Answers B A A B A D D A D B
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References
https://www.uea.ac.uk/documents/953219/967353/Azam_S+Policy+interventions.pdf/4e9ba6
83-91a5-4cd9-9644-10024e4d0001
http://tutor2u.net/economics/revision-notes/as-marketfailure-negative-externalities.html
http://www.123helpme.com/issue-of-externalities-its-implications-and-market-failure-in-the-
economy-view.asp?id=164753
http://jasonleeucdavis.weebly.com/uploads/2/9/3/6/2936139/ecn_53-lecture_notes_16.pdf
http://www.fatih.edu.tr/~kcivan/Notes%204-Externalities.pdf
http://are.berkeley.edu/courses/EEP101/Detail%20Notes%20PDF/Cha03,%20Externalitites.
pdf
http://ibguides.com/economics/notes/the-meaning-of-market-failure
http://jasonleeucdavis.weebly.com/uploads/2/9/3/6/2936139/ecn_53-lecture_notes_16.pdf
http://www2.yk.psu.edu/~dxl31/econ14/lecture31.html
http://www.albany.edu/~aj4575/355/LectureNotes/Lecture5.pdf
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STUDY SESSION THIRTEEN:
GOVERNMENT OWNERSHIP OF ENTERPRISES INTRODUCTION
The goal of any government objective is to improve the welfare of its citizens.
Government came into business in order to provide essential services, which if private
individuals or organisation should provide will either be inadequate or to exploit the poor to
make more profit or deprive the poor totally from the consumption of such services. This is
because the rich has money to pay even at a higher price than the normal price, while the
poor do not have money to pay at all. Government has a vital role to play to bridge the gap
between the rich and poor by providing some necessary services, through the establishment
of government enterprises, at a low cost or zero prices.
Learning Outcomes
13.1 Define public enterprise;
13.2 Enumerate the characteristic of government enterprises
13.3 List the objectives of public enterprise
13.4 Discuss the two types of government enterprises
14.5 List the advantage and disadvantages of public enterprise
13.1 Definition of Public Enterprise

What is Public Enterprises? Public enterprise is a form of business organisation created by an
Act of parliament, owned and managed by public authority for specific purposes. The whole
or most of investment in a public enterprise is made by the government. They may operate as
autonomous or semi-autonomous corporations. Examples are Power Holding Company of
Nigeria (PHCN), National Agency for Food and Drug Administration and Control
(NAFDAC), Nigerian Port Authority (NPA), Nigeria National Petroleum Agency (NNPC),
Federal Environmental Protection Agency (FEPA).
196
It is important to note that government enterprises are non-profit making bodies.

Notwithstanding some of them collect little amount from their users in order to recover their
operating asset and thereby make some contributions or break even.
13.2 Characteristics of Government Enterprises

The following are the characteristics of government enterprises:
• It must be established by an Act
• The government fixed the name, functions and objectives
• The government appoint the principal officers and their functions
• It must be under the supervision of a ministry
• It does not end with the word ‘limited’ or ‘public limited company’
• It is not a profit oriented organisation
• The government fixed prices and approve increases in prices
• Prepares annual budget for government approval
• Prepares financial statements for the supervising ministry
• Sources of revenue (income) is from the government
13.3 The Objectives of Government Enterprises

The following are the objectives of government enterprises:
• To provide vital goods and services
• To meet the needs of the poor and the rich
• To have control over some means of production in the nation
• To meet even development and growth
• To ensure continuation of the agencies even when they are making loss
• To prevent high prices of goods being charged by private enterprises
• To improve the standard of living of the people
13.4 Types of Government Enterprises

Public enterprises are agencies owned either partially or wholly and being controlled by the
government. As it is mentioned above they are created by the government to provide
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essentialservices at a low cost rate or zero price. These enterprises are promulgated by law
and can fall into any of these categories.
i) Public Utilities: Public utilities of vital value e.g. pipe borne water are provided by the
government for the citizens use either at ‘zero’ cost or at a subsided rate. Water is very
important in every home whether rich or poor; with the provision of water to its citizens
the government is thereby improving the welfare of the citizens to achieve its social and
economic objectives. Federal Water Corporation for the provision of water.
ii) Commercial Enterprises: These are agencies established by the government to enter
into business and make profit from such a business. Government commercial
enterprises are competitive with other business in the same industry and make profit
although they still collect subvention from the government. Such enterprises are
insurance (NICON).
They are expected to operate with rules and regulation in the Companies and Allied Matters
Act of 1990 (as amended or other regulatory) of anybody which they operate as a
commercial enterprise.
Policy Boards: These are agencies which are wholly or partially autonomous organisation
operating under the policies of the government to meet specific needs e.g. Nigeria Cocoa
Marketing Board (NCMB), Schools Management Boards (SMB) and Local Government
service commission (LGSC). Some of them operate as commercial enterprise but still collect
subvention from the government.
13.5.1 Advantages of Government Enterprises

The following are the advantages of government enterprises:
• Government enterprises provide essential services that private individual or
organisation cannot afford because of the huge sum of capital involved. E.g. PHCN.
• The prices of the product or services are usually subsided to meet the need of the rich
and the poor e.g. petrol.
• The products or services can be afforded and found in any part of the country
• It leads to the development of rural areas.
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• It helps decongest the urban area because facilities in the urban area are also in the rural
area.
• It improves the standard of living of the citizens.
• It creates employment and stabilisation policy.
• It serves as a source of revenue to the government through taxes and profits from such
agencies.
• It leads to better planning and decision making on how to allocate resources for
economic growth.
• It reduces the impact of monopoly as the goods or services are produced at cheaper
prices to the society.
13.5.2 Disadvantages of Government Enterprises

Below are some of the disadvantages of government enterprises
• It leads to wastages
• It leads to mismanagement of funds
• It uses cash basis to prepare accounts instead of accrual basis
• It is mostly influenced by the political factors of the nation.
• Government Enterprises are not aggressive to make profits.
• Slow in decision making because of their bureaucratic process
13.6 Sources of Income to Government Enterprise

Government enterprises are owned by the government and produce goods and services at the
cheapest cost to the public. They are not expected to exploit citizens so as to make profit.
Therefore government enterprises obtain their revenue (income) from the government
through annual subventions, others sources include fees, fines, dues receivables, grants and
donations. Income from the government is normally classified into recurrent and capital
revenue. Government expenditure is divided into recurrent and capital expenditure.
13.7 Classification of Government Expenditure
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• Recurrent Expenditure: Expenditure used for the day to day running of the enterprise
and occurs frequently e.g. wages and salaries, fuelling of motor vehicles, books,
periodicals etc.
• Capital Expenditure: Expenditure used to acquire asset for the enterprise and infrequent
in nature e.g. buildings, motor vehicles
13.8 Accounting Reports in Government Enterprises

As we know at this stage that it is government that provide the capital (subvention) used to
finance government enterprises, the financial report expected from them differ a bit from
private sector enterprise. But where an enterprise is owned by the government is expected to
be operated like the private sector it is expected of such public enterprise to prepare financial
report (statement) like the private sector.
The following are financial reports (statement) expected from a public enterprise that is
operating like a private enterprise i.e. profit oriented.
S/N OLD NAMES NEW NAMES

i Income and expenditure account A statement of financial performance
ii Balance sheet A statement of financial position
iii Cash flow statements A cash flow statement
iv Value added statements Value added statement
v 5year financial summary 5year financial summary
vi Notes to the statements Notes to the statements
13.9 List of Corporations, Agencies and Government Owned Companies

(1) Nigeria National Petroleum Company (NNPC)
(2) Nigeria Deposit Insurance Corporation (NDIC)
(3) Bureau of Public Enterprises
(4) National Agency for Science and Engineering Infrastructure
(5) Nigerian Social Insurance Trust Fund
(6) Corporate Affairs Commission
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(7) National Clearing and Forwarding Agency

(8) Nigeria Unity Line
(9) Nigerian Airspace Management Agency
(10) Nigerian Shippers Council
(11) National Maritime Authority (NMA)
(12) Raw Material Research and Development Council
(13) Nigerian Civil Aviation Authority
(14) National Sugar Development Council
(15) Nigerian Postal Service
(16) Nigerian Ports Authority (NPA)
(17) Federal Airport Authority of Nigeria (FAAN)
(18) Nigeria Mining Corporation
(19) Nigeria Re-insurance
(20) Niger dock Nigeria Plc.
(21) Securities and Exchange Commission
(22) National Insurance Corporation of Nigeria
(23) Nigeria Re-insurance Corporation
(24) Nigerian Telecommunication
(25) National Automotive Council
(26) Nigerian Tourism Development
(27) National Communication Commission
(28) National Agency for Food & Drug Administration & Control
(29) Nigerian Customs Services
(30) Federal Inland Revenue Service
(31) Central Bank of Nigeria
Any other corporation, agency or government-owned company that may be included by

Minister through a local notice.
Source: Olakanmi j & co [2012]
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This session has discussed the importance of government enterprises in the society. The main
objective is to provide some basic amenities to better the welfare of its populace and to avoid
monopoly. Government enterprise does this with authority from the government and they are
accountable to the public. It is important for student to know these enterprises and their
functions in the society. However, the negative effect may out-weight the benefits if care is
not taken.
1. The following are the characteristics of government enterprises:
A) It must be established by an Act
B) The government fixed the name, functions and objectives
C) The government appoint the principal officers and their functions
D) The government divides it into political parties
2. ONE these is NOT a characteristic of government enterprise
A) It leads to corruption
B) It is not a profit oriented organisation
C) The government fixed prices and approve increases in prices
D) Prepares annual budget for government approval
3. The following are the objectives of government enterprises except ONE
A) To provide vital goods and services
B) To provide insecurity
C) To meet the needs of the poor and the rich
D) To have control over some means of production in the nation
4. ONE of these NOT a government owned enterprises in Nigeria
A) Nigeria Democratic Party
B) Nigeria National Petroleum Company
C) Nigeria Deposit Insurance Corporation
D) Bureau of Public Enterprises
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5. Below are some of the disadvantages of government enterprises except ONE

A) It leads to wastages
B) It leads to mismanagement of funds
C) They use cash basis to prepare accounts instead of accrual basis
D) They are very aggressive to make profit
6. Government income and expenses are classified as ONE of the following
A) Government Revenue and Expenditure
B) Government Deposit and Savings
C) Government Cash and Profit
D) Government Balance Sheet
7. Choose the ODD among the following
A) Nigerian Customs Services
B) Federal Inland Revenue Service
C) Federal Political Party
D) Central Bank of Nigeria
8. ONE of these is NOT a source of income to Government owned enterprises
A) Donations
B) Government subvention
C) Church offering
D) Fines and Fees
9. Capital expenditure involves the following except ONE
A) Purchase of a new vehicle
B) Building of office space
C) Fueling of vehicle
D) Purchase of office equipment
10. The following are the advantages of Government owned enterprises except ONE
A) It leads to the creation of more political parties
B) It improves the standard of living of the citizens.
C) It creates employment and stabilisation policy.
D) I t leads to the development of rural areas.
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Solution to MCQs
Questions 1 2 3 4 5 6 7 8 9 10
Answers D A B A D A C C C A
References
Olakanmi, J. & Co, (2010). Financial Regulations & Allied Laws, Abuja, Nigeria. LawLords
Publications.
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STUDY SESSION FOURTEEN:

PUBLIC INVESTMENT APPRAISAL
Introduction
The efficient allocation of funds is the most effective finance function in modern times. It
involves the decision to commit government funds to long-term projects. Such decisions are
of considerable importance to the development of the economy. The aim is to achieve macro-
economic stability and real growth. Government investment decision is undertaken after a
careful project appraisal. Project appraisal is the evaluation of several alternative investment
activities within limitation of available resources with a view to determining which
alternative gives the best returns.
Government works with limited resources and therefore has to evaluate and rank projects
before embarking on it (examples are construction of roads, building of schools, hospital etc).
The government invests on projects and also expects revenue from them but not at the exploit
of its citizens as does the private sector but to better the welfare of its citizens.
Learning Outcomes
14.1 Explain investment appraisal;
14.2 List the procedures for the selection of project in the public sector;
14.3 Identify the investment techniques;
14.4 List each methods of investment techniques;
14.5 Calculate and give the decision rules of:
• Payback period (PB)
• Accounting Rate of Returns (ARR)
• Net Present Value (NPV)
• Internal Rate of Return (IRR)
• Cost Benefit Analysis (CBA)
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14.6 State four advantages and disadvantages of
• Payback Period (PB)
• Accounting Rate of Return (ARR)
• Net Present Value (NPV)
• Internal Rate of Return (IRR)
• Cost Benefit Analysis (CBA)
14.1 Investment Appraisal Procedures

Capital investment project decisions involve some procedures to be followed by government
to arrive at a project because of the huge amount involved in it. These procedures include the
followings:
• Identification of projects
• Projects screening
• Project evaluation
• Project authorization and
• Project monitoring and control
14.2 Classifications of Investments

Capital projects can be classified as follows:
• Independent projects serve different purposes and do not compete with each other.
Subject to funds availability and their respective profitability, an entity may undertake
the two projects at the same time.
• Mutually Exclusive Projects serve the same purpose and compute with each other. If
one is executed, others will have to be rejected, excluded or abandoned..
• Contingent/Complementary projects: The choice of one, in these cases necessitates that
one or more other investments should be undertaken.
14.3 Government Investment Appraisal Techniques

The diagram below will help you understand the techniques better
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PB : Payback Period
ARR : Accounting Rate of Return
NPV : Net Present Value
IRR : Internal Rate of Return
14.4 Traditional Method

This method does not consider the time value of money and thus make it an ineffective
method for valuation of projects. Techniques under this method are:
• Payback period
• Accounting rate of return.
14.4.1 Discounted Cash flow Method

This method considers the time value of money i.e. N1 today will not remain N1 in another
period of time. It would have reduced in value with the passage of time. As a result a
percentage representing the future naira value is used to discount all cash flows in order to
represent future values. This method caters for risk and uncertainties by using the discounted
factor. The methods under this technique are:
• Net Present Value
• Internal Rate of Return.
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14.4.2 Cost Benefit Analysis
This method uses some analytical tools e.g. profitability index in decision-making which
provides for a systematic comparison to be made between an estimated cost of undertaking a
project and the estimated value of benefits derived from such a project.
14.5 Techniques under Traditional Methods

• Payback Period
Payback period means the time required for the original capital investment to be repaid from
the cash inflows generated by the project. When a project cash inflows are in annuity form
(that is constant form of money is generated annually) the payback can be calculated by
dividing the value of one cash inflow by the project initial cash outflow.
Illustration: A project has an initial investment of N24 million (M) and an annuity of N8
million cash inflow for 5 years.
Question: Calculate the payback period for this project.

Solution 1: N ‘000
Cash outflow = 24,000 = 3years
Cash inflow 8,000
Solution 2: Suppose cash inflow is N6, 000,000
Then payback is:
N ‘000
Cash outflow = 24,000 = 4years
Cash inflow 6,000
When a project cash inflow is not in annuity, the cumulative cash inflows are used in
calculating payback. For example: A project has an initial cash outflow of N20M and each of
the following cash inflows for each of the subsequent 5 years N8M, N6M, N4M, N2M, N2M
Question: Calculate the payback period
Solution:
Yr Cash flow Cumulative
N ’000 N’000
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Yr0 20,000 (20,000)

Yr1 8,000 (12,000) 20-8
Yr2 6,000 (6,000) 12-6
Yr3 4,000 (2,000) 6-4
Yr4 2,000 payback year 0 2-2

Yr5 2,000
Advantages of Payback Period

The following are the advantages of Payback Period
• It is simple to calculate and understand.
• It considers all cash flow of a project throughout its useful life.
• It gives an indication of liquidity after the payback period.
• It provides a measure risk: the lesser the payback period the lesser the risk attached to a
project.
• It reduces loss through obsolesce because of short-term approach.
Disadvantages of Payback Period

The following are the disadvantages of Payback Period
• It does not consider the time value of money.
• It fails to cater for risks and uncertainties.
• The targeted payback period may be a subjective decision.
• It ignores the fact that profits from different projects may accrue at an even rate.
14.5.1 Accounting Rate of Return (ARR)

ARR means the rate required for the original capital investment to be undertaken using
accounting profits, not cash flows. This method uses financial accounting profits, after
deducting all financial accounting expenses e.g. taxation, depreciation. There are different
methods of calculating ARR but the generally acceptable one is
ARR = Average annual accounting profit x 100
Average investment
Where average annual accounting profit= income or revenue less all expenses
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Average investment = opening investment + closing investment
2
Opening Investment can be initial outlay, cost of the project and capital cost
Closing investment can be residual value, scrap value or disposal value.
The accounting rate of return is used in appraising projects by comparing the calculated ARR
with a target of already predetermined rate of return. The project will be accepted if
calculated accounting rate of return is higher than the predetermined accounting rate of return
otherwise reject it.
If calculated ARR is higher than (>) target rate, accept ARR. If calculated ARR is lower than
the (<) target rate, reject
Example 1
Mutually Exclusive Projects implies that if one project is selected the other projects have to
be rejected that is, two projects cannot be undertaken at the same time.
Allwell State of Nigeria is contemplating on acquiring a new machine and has three
alternatives X, Y and Z. The cost of the machine and the relevant course are as follows:
Machine X Y Z
Cost N 40,000 N 40,000 N 40,000
Residual value N 8,000 N 12,000 N 16,000
Estimated life 6yrs 6yrs 8yrs
Estimated future year1 N 10,000 N 10,000 N 8,000
Profit before depreciation
Before yr2 N 10,000 N 8,000 N 10,000
Depreciation
Yr3 N 8,000 N 8,000 N 8,000
Yr4 N 8,000 N 6,000 N 6,000
Yr5 N 10,000 N 12,000 N 10,000
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Yr6 N 5,000 N 13,000 N 10,000

Yr7 _ _ N 5,000
Yr8 _ _ N 2,000
Machine NA NB NC
Total profit 51,000 57,000 59,000
Less depreciation 32,000 28,000 24,000
TOTAL 19,000 29,000 35000
19,000/6 29,000/6 35,000/8
Annual profit 3166.6 4833.3 4375
Average investment = 40000+8000/2 40000+12000
/2 40000+16000
/2
= N 24,000 N 26,000 N 28,000
ARR = 3166.6/24000*100 4833.3/26000*100
4375/28000*100
= 13.19% 18.95% 15.63%
Machine B should be purchased because it has the highest accounting rate of return of
18.95%.
Advantages of Accounting Rate of Return

The following are the advantages of ARR
• It is simple to calculate and understand
• It uses the profits of a project throughout its useful life
• It allows the use of accounting data for its calculation
• It allows for the best selection of project for mutually exclusive projects
14.6 Discounted Cash flow (DCF)

The Discounted Cash flow (DCF) techniques is a project evaluation technique which take
into consideration the time value of money and total cash flow throughout a project’s life.
Discounting means using compound interest of valuation on investment as against
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investment annuity method of valuation used in traditional method of appraisal. The payback
period ignores the time value of money (cash flow) and total profit over a project’s life time.
The accounting rate of return also ignores time value of money and uses only accounting
profit.
Therefore it is only the Discounted Cash flow techniques that best fulfilled the purpose of
investment appraisal. This method is divided onto two as earlier method.
a) The Net Present Value (NPV) method
b) The Internal Rate of Return method
14.6.1 Net Present Value
This is obtained by discounting all value of cash outflows and inflows of a project by a
chosen target rate of return or interest rate or discount rate or cost of capital. The NPV is
therefore compares the present value of all cash inflows from an investment with the present
value of all cash outflows from an investment. The Present Value (PV) of cash inflows minus
PV of the cash outflows is the NPV.
Decision Rule for NPV
• If the NPV is positive, the project should be (accepted) undertaken
• If the NPV is negative, the project should be (rejected) not undertaken]
• If the NPV is exactly zero, the project will be only worth undertaking
• For mutually projects, we select a project that has the highest NPV.
The discounting formula to calculate the present value of a future sum of money at the end of
n time period is:
PV= FV 1
(1+R)-n
Where:
PV=Present Value
FV= Future Value
R = rate of return or cost of capital
n= number of years
Present Value can be defined as the cash equivalent now of a sum of money received or
payable at a stated future date, discounted at a specified rate of returns (Adeniji, 2009).
N
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NPV = ∑ = A1 - CO
R=1
(1+K)1
Where:
NPV =Net Present Value
N
∑ = Summation n
R=1
A1 = Cash flow on investment

CO = Cash outflow on investment
Example 4
Olorire local government is considering a capital investment where the estimated cash flow
are
Year Cash flow (N)
0 (200,000)
1 120,000
2 160,000
3 80,000
4 60,000
The company cost of capital is 15%.

What is the NPV of the project and should the project be undertaken?
N
NPV = ∑ = A1 - CO
R=1
(1+K)1
120,000 + 160,000 + 80,000 + 60,000 - 200,000
(1+0.15)1 (1+0.15)2 (1+0.15)3 (1+0.15)4
104,347.82 +120,982.98+ 52,601.30+34,305.20 - 200,000
= N112,237.30
Because the NPV is positive, the project should be undertaken.
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Alternative presentation is using the tabular form where the cash outflows (initial outlay)
represent negative cash flows and cash inflows represent positive cash flow.
Year Cash flow Discount factor Present Value (PV)

N 15% N
0 200,000 1.00 200,000
1 160,000 0.8696 139,136
2 120,000 0.7561 90,732
3 80,000 0.6575 52,600
4 60,000 0.5718 34,300
Advantages of Net Present Value (NPV)

The following are the advantages of NPV
• It considers the time value of money
• It can be used to rank project under capital rationing decision
• It provide a picture of either accepting or rejecting a project
• Net Present Value is design towards the theory of wealth maximization
• It makes use of all the project cash flows throughout the life time of the project.
Disadvantages of Net Present Value (NPV)

The following are the disadvantages of NPV
• It is not easy to calculate and understand
• It is not easy to determine accurately market cost of capital
• There is the assumption that the cash inflows will come as predicted which may not
necessarily be so.
14.6.2 Internal Rate of Return (IRR)

It is also a discounted method like the NPV discussed above. “The Internal Rate of Return” is
the discount rate which when applied produces zero net present value. Its computation is
more complex than NPV and this can be done either by drawing “present value profile" or
214
graph or mathematically using linear interpolation. IRR can be derived by using the formular
below:
IRR = D1 + [ NPV1 ] (D2-D1)
[NPV1-NPV2]
Where:
D1 is the lower discount rate with a positive NPV
D2 is the higher discount rate with a negative NPV
NPV1 is the amount of positive NPV
NPV2 is the amount of negative NPV
Example
Aseyori state of Nigeria is planning to embark on a capital project with the following
information
N’000
Initial cash outflow 3,450
Cash inflows Yr 1 1,500
Yr 2 1,500
Yr 3 1,500
Given 10% as the lower discount rate or cost of capital of the state, and 15% as a higher
discount rate or cost of capital.
Solution
Step 1 Calculate the NPV using 10% and 15% as discount factor separately.
Step 2 Enter the NPV values in the IRR formular recognizing the interpolation between the
discount factors.
Using 10% discount factor
Yr Cashflows Discount factor discounted cash flow
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N’000 10% N’000
0 (3,450) (1.00) 3,450
1 1,500 0.91 1,365
2 1,500 0.83 1,245
3 1,500 0.75 1,125
NPV 285
Using 15%
Yr Cash flows Discount factor discounted cash flow
N’000 15% N’000
0 3,450 1.00 (3,450)
1 1,500 0.87 1,305
2 1,500 0.76 1,140
3 1,500 0.66 990
NPV (15)
IRR = D1 + [ NPV1 ] (D2-D1)

[NPV1-NPV2]
10 + [ 285] (15-10)
[285+15]
Note that negative – negative i.e. - -15= +15
10 + 285(5)
300
10+(0.95)5
10+4.75
IRR = 14.75%
The project should be accepted because the IRR is 14.75% which is higher than 10%
Mutually exclusive projects: The project with the highest percentage should be selected
where two or more mutually exclusive investments are being considered.
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14.7 Cost-Benefit Analysis and Project Appraisal

This method compares estimated benefits and costs of project to be taken. Government goal
is to render service to its citizens to maximize their welfare. The objective of the government
is that the benefits of any project should be greater than the cost of embarking on such
project. Although government consider some other reasons (political, social or geographical)
apart from economic reasons in considering benefits over cost. The decision rule is that if
benefits are greater than cost of a project, select it, if otherwise, reject it. One major weakness
of cost benefit analysis is that it ignores the effect of inflation on values used in the
computation.

This study session explained the various methods employed to access different investment in
public sector. The objective is to embark on projects that are valuable and beneficial to the
public while minimizing cost.
1. In investment appraisal, one of the following is NOT an advantage of payback period
method
A) It is simple to calculate and understand
B) It is a useful measure of liquidity
C) It serves as a safeguard against risk
D) It ignores all cash flows outside the period
2. One of these is NOT a procedure in investment appraisal
A) Project manipulation
B) Identification of projects
C) Project evaluation
D) Project authorization
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3. In investment technique, the traditional method can be classified into two namely
A) Pay salaries period (PS) and Accounting Profit Method (APM)
B) Net profit period (NPP) and Gross profit period (GPP)
C) Payback period (PB) and Accounting rate of return (ARR)
D) Inventory period (IP) and Closing period (CP)
4. In investment appraisal technique, the technique that considers the time value of money
is called
A) Accounting cash flow method
B) Appraisal cash flow method
C) Investment cash flow method
D) Discounted cash flow method
5. The formular for Accounting Rate of Return (ARR) is one of the following
A) Average annual cash flow X 100%
Average investment
B) Average depreciation X 100%
Average investment
C) Average annual accounting profit X 100%
Average investment
D) Average residual value X 100%
Average investment
6. A project initial cost is N20,000 and has a cash inflow of N5,000 per annum. Calculate
the payback period
A) 6 years
B) 4 years
C) 10 years
D) 8 years
7. The decision rules in the calculation of Accounting Rate of Return (ARR) is
A) If calculated ARR is higher than target rate accept ARR
B) If calculated ARR is lesser than target rate accept ARR
C) If calculated ARR is a negative figure to the target rate accept ARR
D) If calculated ARR is equal to target rate reject ARR
218
8. If N400 is invested today and generate N500 in one year’s time. What is the Internal
Rate of Return?
A) 28%
B) 32%
C) 29%
D) 25%
9. A technique in investment appraisal which ignores time value (period) for the cash
inflow from capital investment project to equal the cash outflow is called
A) Accounting period flow (APF)
B) Investment period flow (IPF)
C) Payback period (PB)
D) Cash flow period (CFP)
10. Which of the following uses accounting profit in the calculation of a project in
investment appraisal?
A) Payback period (PB)
B) Accounting rate of return (ARR)
C) Net present value (NPV)
D) Internal rate of return (IRR)
Answers
1 2 3 4 5 6 7 8 9 10
D A C D C B A D C B
Theory Questions
1. What is Payback period?
2. List four advantages and disadvantages of payback period in investment appraisal
3. Explain briefly and state the formulas for:
i. Accounting rate of return (ARR)
ii. Net present value (NPV)
iii. Internal Rate of Return
4. List two advantages and disadvantages of each of them
219

References
Adeniyi, A.A (2009). Cost Accounting: A Managerial Approach. Lagos: El-Toda
Ventures Limited.
Durey, C.Management and Cost Accounting. United State: Birendan George.
Omolehinwa, A. (2013). Management Accounting. Lagos, Cleo Consult.
Shiro, A.A. (2004). Financial Management, Lagos .El-Toda Ventures Ltd.
Wheelen, T.L., and Hunger, D.J., (2012). Strategic Management and Business Policy.
(Eleventh Edition). New Jersey: Pearson Education.
220
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221

STUDY SESSION FIFTEEN:
ISSUES OF FISCAL RESPONSIBILITY
Introduction
Fiscal Responsibility Act (FRA) relates to Fiscal Federalism. Federalism is a system that
operates different tiers of government as it is being practiced in Nigeria currently (Federal,
State and Local governments).
Fiscal relates to financial matters that are being managed by the government of a country.
Therefore, fiscal responsibility is the allocation of revenue and expenditure operations among
the three tiers of government.
The 1999 constitution of the Federal Government of Nigeria assigns each tier of government
a set of responsibilities expected to better the welfare of the society. The government does
this through the budget and the objective is to achieve macroeconomic stability and real
growth. Fiscal Responsibility can also be referred to as government intervention in the
society aim at solving the problem of market failure caused by market imperfections.
However, public sector economic and financial management in Nigeria has failed to deliver
to its citizen since independence. Despite progressive increase in revenue accruing to
government over the years, the government has been unsuccessful in her Fiscal management.
Learning Outcomes
15.1 List the objectives of FRA
15.2 Identify the arrangement of FRA
15.3 Composition of members and cessation of members
15.4 Duties and functions of FRA
15.5 List the challenges of FRA
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15.1 Objectives of Fiscal Responsibility ACT (FRA)

The Fiscal Responsibility bill was passed into law on the 30th day of July, 2007 by the
National Assembly under the regime of President U.M. Yar’Adua (GCFR). It’s expected to
perform the following objectives;
Good management of government resources: The ACT is expected to help government in the
management of its resources.
Economic Stability: One of the purposes of government is maintain long-term macro-
economic stability to grow and develop the economy of the nation and better the welfare of
its citizens.
Good Financial Management: The government expects the ACT to take good financial
management for every fund received by every government establishment.
Accountability and Transparency: The ACT expects government establishment to follow due
process in the performance of its activities for accountability and transparency.
To control excessive government expenditure and cut down unnecessary spending with the
use of government fund.
To better the standard living of its citizen through poverty reduction and economic
advancement.
One objective of FRA is to discourage financial indiscipline and misuse of government
resources.
15.2 Arrangement of Sections

The Fiscal Responsibility Act 2007 is arranged into sections to achieve the objectives of the
Act. The ACT is divided into fourteen parts under the ministry of finance. The arrangement
is to enable each part to be effective and efficient in performing their duties. The parts are
listed below:
• Part i –Establishment, functions, power of the fiscal responsibility commission.
• Part ii – The medium-term expenditure framework.
• Part iii – The annual budget.
• Part iv – Budget planning of corporations and other related agencies
223

• Part v – Budgetary execution and achievement of targets.
• Part vi – Public revenues
• Part vii – Savings and asset management
• Part viii – Public expenditure
• Part ix – Debt and indebtedness
• Part x – Borrowing
• Part xi – Transparency and accountability
• Part xii – Enforcement
• Part xiii – Miscellaneous provisions
• Part xiv – Interpretation
15.3 Composition
The commission consists of a chairman and ten (10) other members. One member represents
each of the following six geo-political zones of the country, that is: North- Central, North-
East, North-West, South-East, South-West, and South-South and one representing member
from:
i. The organized private sector
ii. Civil society engaged in causes relating to probity, transparency and good governance
iii. Organized labour
iv. A representative of the Federal Ministry of Finance of a level not below the rank of a
Director.
15.4 Appointment of members

It is the duty of the president to appoint the chairman and other members of the commission
and it shall be approve by the senate.
The chairman and members shall come from the six geo-political zones and shall be ready to
work on full time basis. The appointment is for five years and a single term of office.
All members of the commission shall be persons of good character and must have the
necessary qualifications and ten years working (public or private) experiences.
224
Withdrawal of membership: The following are the reasons that will lead to withdrawal of
membership.
i. When a member becomes bankrupt
ii. He/she is convicted of a felony or any offence involving dishonesty, corruption or fraud
iii. He she becomes sick/insane and unable to perform his/her duties
iv. When the public is no more interested in his/her services
v. Where he/she has convicted by law
vi. He/she resigns his appointment through writing
vii. When he takes a political appointment
15.5 Duties / Functions of FRA

i) To Probe all cases of controversial issues of preceding financial year and give a detail
report to the National Assembly.
ii) To ensure that the audited accounts of the federation for the past financial year are
available to National Assembly.
iii) To Prepare and submit to National Assembly, for their consideration of a medium-
term expenditure framework for the next three financial years.
iv) Coordination and enforcement of all revenue and expenditure relating to the
government.
v) Prepare aggregate revenues minimum expenditure for the nation.
vi) Prepare projection of income and expenditure for each financial year in the next three
financial years.
vii) Facilitates fiscal measures and strategies for economic stability and real growth in the
three tiers of government.
viii) Collaborate with government bodies within and outside the country to execute fiscal
policies.
15.6 Challenges
i) Political instability: Frequent changes in government always lead to frequent changes in
government policies and activities.
ii) Lack of statistical data; the country lacks good data base to provide vital information.
225

iii) Social cultural differences: The country has over 450 languages with different
cultural differences which slowdown the implementation of government policies.
iv) Corruption: Corruption has eaten deep into country. Money to carry out government
activities are diverted to personal uses.
v) Inflation: Inflation weakens the power of money and does not allow government to
implement its financial resources
vi) Financial indiscipline: Financial mismanagement and diversion of government fund is
a big problem in this country as many citizen want to satisfy self instead of the public.
vii) Poor technology: Technology changes frequent and rapidly. The inability of the
government to cope with current technology slows down information processing.
viii) Disaster: unforeseen predicament like fire, flood, epidemic (Ebola) etc makes
government to spend beyond estimation.
15.7 Government bodies and Fiscal Responsibility Act Commission.

In order to carry out their duties effectively and efficiently the commission is expected to
consult some bodies in the planning and implementation of their programmes. The
followings are government bodies available for consultation.
i) National planning commission
ii) Joint planning commission
iii) National Commission on Development Planning
iv) National Economic Commission
v) National Assembly
vi) Central Bank of Nigeria
vii) National Bureau of Statistics,
viii) Revenue Mobilization Allocation and Fiscal Commission.
ix) Any other relevant statutory body as the Minister may determine.
15.8 Methods adopted by the commission to perform its duties.

Medium-Term Expenditure Framework: the commission prepares this based on the macro-
economic objectives, fiscal strategy revenue and expenditure strategy economic, social and
developmental priorities of government. The above shall be prepared based on the
consultation of the following commissions in the interest of the general public.
226
Annual Budget: The commission monitors the minister of finance through the budget office
of the federation the preparation of the annual budget based on the medium-term expenditure
framework setting out actual and budgeted revenue and expenditure and detailed analysis of
performance of proceeding financial year, targets for that financial year and projections for
the next two years. Fiscal Responsibility council and the minister of financial report to the
joint finance committee of the National Assembly.
i) Budgetary planning of corporations and other related agencies. The commission
monitors the preparation and implementation of budget relating to government
corporations, agencies and government owned companies.
ii) Budgetary execution and achievement the commission. The Federal Government
shall cause to be drawn up in each financial year, an annual cash plan which shall be
prepared by the office of the Accountant-general of the federation. Ensure that an
amount set aside for a specific purpose is solely used for that purpose.
iii) Approval of Virement: virement is not allowed but in exception circumstances and in
the overall public interest, recommends to the National Assembly for approval
virement from subheads of account, without exceeding the appropriated to such head
of account.
iv) Public Revenue: This collection and disbursement is done by the Executive arm of
the Federal Government. They collect public revenue and also make payment on
monthly basis for the National Assembly approval.
v) Sailings and Assets Management: The Central Bank of Nigeria, in consultation with
the minister of finance, the state commissions of finance and local government
treasurers, inust excess proceeds and manage government asset as the case may be.
vi) Public expenditure: Increase in expenditure is only allowed when the increase is
consistent with the appropriation Act and medium-term expenditure framework.
Increase in personnel expenditure is allowed when there is a prior budgetary
allocation sufficient to cover the estimated expenditure.
vii) Debt and indebtedness: The Fiscal Responsibility Act restrict government borrowing
by all tiers of government that is not meant for capital expenditure, and human
227

development and national interest. All debt to be taken by the President on the
recommendations of the minister of finance shall be approved by National Assembly.
viii) Borrowings: Borrowing by any government in the federation or its agencies and
corporations shall be for a specific purpose based on cost-benefit analysis, detailing
the economic and social benefits of the purpose towards long-terms capital
expenditure.
ix) Transparency and Accountability: Fiscal Responsibility begins with publication of a
summarized report on budget execution by the minister of finance to the National
Assembly and dissemination to the public. It is the responsibility of the office of the
Accountant-General of the federation to consolidate the audited account of the
federation and publish in mass media to the general public not later than six months
following the end of the financial year.
Summary of the study

Fiscal Responsibility Act is a set of guidelines used by the government to implement its
policies. Government functions are separated into different revenue and expenditure head.
The Act described the procedures to be followed in the attainment of government objectives.
The Act also expressed the duties of each government ministries, parastatalsls and agencies
embraced to achieve its purpose.
1. The following are the objectives of FRA expect one.
A) To ensure long term Macroeconomic stability
B) To provide sound financial management
C) To encourage greater accountability
D) To encourage embezzlement
2. Choose one of the best among the following objectives of FRA
A) To encourage poverty reduction and economic and economic advancement
B) To encourage insecurity
C) To encourage final indiscipline
D) To encourage corruption
228
3. One of these is not a PART of the arrangement of FRA

A) Public revenue
B) Public expenditure
C) Public indiscipline
D) The annual budget
4. Cessation of membership from FRA include the following except one

A) Become bankrupt
B) Commit corruption or fraud
C) Confirm to be insane
D) Found to be accountable and transparent
5. The duties of FRA include the following except
A) Provided audited accountant to the national assembly
B) Determination of aggregate revenue for the federation
C) Prepare minimum capital expenditure floor
D) Create room for corruption and disorderliness
6. One of these is not a challenge facing FRA
A) Prudency and financial management
B) Political instability
C) Lack of statistical data
D) Corruption
7. The following are challenges of FRA except one
A) Disaster
B) Poor technology
C) Financial indiscipline
D) Good management of fund
8. The following commissions are to be consulted by FRA except one
A) Book Haram group
B) Central Bank of Nigeria
C) National Assembly
D) National Bureau of Statistics
229

9. The National Assembly should approve the following except one
A) Public budget
B) Public revenue
C) Public expenditure
D) Public insecurity
10. All of these are the methods adopted by the commission to perform its duties except
A) The annual budget
B) Budgetary execution
C) None of the above
D) All of the above
Solution to MCQ
1 2 3 4 5 6 7 8 9 10
D A D D D A D A D D
Theory Questions
i. Discuss the methods adopted by the commission to perform its duties
ii. List five circumstances that warrant the cessation of membership
iii. Mention five objectives FRA
References
Central Bank of Nigeria (CBN). (2009) Various Reports.
Olakanmi, J. & Co, (2010). Financial Regulations & Allied Laws, Abuja, Nigeria.
LawLords Publications.
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ACC 313 Public Finance

As a student of Accounting, your knowledge of public finance is very important. This is

1.1 The Concept of Public Finance

1.2 The Scope of Public Finance

1.3 Government Income and Expenditure —General Considerations

1.3.1 Sources of Government Funds and Revenue

Table 1.1: The Federal Government Revenue for 2006

Government (inc. GSM) 33.3 677.5 11.37

Figure 1.1: Federal Government Oil and Non-Oil revenue sources.

(vi) Revenue from Excise Duties Excise duty

1.3.4 Other Sources of Funds to the Government

ii. A government may have a deficit budget. To

iii. Grants and Aids

c. Major types of government expenditure

The capital expenditure includes the following:

1.3.7 Outstanding Domestic Liabilities and others

1.3.8 The Theory of Public Expenditure

1.3.9 Factors that cause growth in public expenditure in countries

Summary of the study session

Self – Assessment Question

Questions 6 and 7 refer to the following Table.

6. What is the total revenue for 2013?

your e-tutor via the LMS.

2.2 Types of taxes

Table 2.1: Progressive tax

Table 2.2 Proportional tax

Table 2.3 Regressive tax

The advantages of direct Taxes

The disadvantages of direct taxes

Vertical equity requires that individuals in different economic ability or circumstances

2.5 Principles of Taxation

(iii) Canon of convenience.

(vi) Canon of Simplicity.

2.6 Tax base and rate

Table 2.4 Tax base

2.7 Functions of taxation

ii. Revenue Effort:

iii. Cost of Administering Taxation

Cost of administering should be as low as possible as it will be uneconomical to

Briefly explain what is meant by tax base and tax rate

2.8 Economic effect of tax on economic system

(B) Capital gains tax is a direct tax

your e-tutor via the LMS.

Factors of Production Rewards

3.2 Concept of National Income

3.2.2 Gross Domestic Product (GDP):

3.2.3 Net National Product (NNP):

3.2.4 Personal Income (P.I):

3.2.5 Disposable Income (DI):

3.2.6 Per Capital Income (PCI):

3.2.7 Transfer payments or Income:

3.2.8 National Income at Factor Cost

3.2.9 National Income at Current or Market Prices:

(a) GNP at market prices = GNP+ Indirect Tax – Subsidy

Define National income

3.3 The measurement of national income

It can also be measured using the formula:

3.3.2 The expenditure method

National Income by expenditure = Consumption expenditure + expenditure by public

Consumption (expenditure on capital goods), G = Government expenditure, X-M = Export

3.3.3 The product method:

3.3.4 The value added method:

3.4 Limitation of the methods of measuring national income in Nigeria