Sources of Government Finance, Their Appropriate Use and Impact

Arindam Das-Gupta

Prepared for World Bank workshop, New Delhi, March 2004

Sources of government revenue include charges, fees and earnings, fines, seignorage and debt, regulatory taxes and general taxes.

Charges, Fees and Earnings

Charges and fees are levied for publicly provided commodities (i.e. goods and services) which are not (pure or nearly pure) public goods. It is efficient – or a least cost social option – for socially desirable commodities to be provided publicly if either the private sector would have underprovided them or if it can provide them only at a greater social resource cost than the government. If this requirement is met then the government should collect charges or fees for commodities it provides from those who benefit from them. However, there should be full recovery of charges and fees from direct beneficiaries only if the good or service in question is a "private good" having, furthermore, no positive or negative spillovers for citizens other than direct beneficiaries. An example of a publicly provided service which has no or minimal spillovers is the provision of adjudication by courts of law in the case of disputes between citizens (or torts). This is not the case for many publicly provided goods like education, curative health services, anti-poverty services or agricultural extension services where positive spillover benefits suggest that less than full cost recovery from direct beneficiaries is desirable.

Since governments and private sectors vary in their capacity in different countries, the socially desirable menu of private commodities that government should provide will vary across countries. There is inadequate country specific research to determine what this menu is. Indeed, no generally accepted method exists of determining whether a given good or service should be provided by the government, and if so at what price. Nevertheless, there is a general belief that this source of finance is underutilised by government in that inadequate charges and fees are recovered for goods that governments do provide, despite the existence of positive spillovers.

A quite distinct type of fee is that charged for citizen's use of assets held by the government acting as a custodian of national assets. The latter includes natural resources such as from forests and mines and national treasures such as wildlife parks and historical monuments. In the case of fees for assets held custodially, it is hard for anyone to argue that sale of these treasures (for example the Taj Mahal or Corbett National Park) is socially desirable. In the case, say, of a nation's mineral wealth it is possible to sell assets (e.g. through mining concessions and leases) and, indeed, many countries do so. For assets which the government does not sell, the marginal cost of maintaining these assets should, where relevant, first be provided for. However, in setting charges, a second consideration is the longevity and exhaustibility[1] of these assets. In principle, future generations also have rights to these assets so prices should be set high enough to ensure that the current generation does not overexploit it. While principles for the pricing of exhaustible resources have been extensively studied, they are seldom applied in practice and both royalties and entry fees at heritage sites are generally reckoned to be below what is socially desirable.[2]

Earnings of the government, other than the sort of charges and fees discussed above typically consist of net revenues from the sale of commodities by public sector undertakings.

Consider, first, manufactured outputs of public sector undertakings. In principle, there should be no net gain to the government from public undertakings, and even a loss in case of increasing returns to scale, if the government prices these commodities at their marginal cost, as is socially desirable. To the extent that price exceeds marginal cost, prices charged are akin to a poll tax on citizens, who are, after all, the ultimate owners of these undertakings. The incidence of this poll tax depends on the importance of the commodities in question in the consumption basket of different groups. While there is largely a consensus on pricing of products of public sector undertakings, there is also a general view that public sector undertakings in most developing countries produce many goods which the private sector could produce more efficiently. Consequently, in many countries an additional temporary source of funds for the government is capital receipts from the privatisation of public enterprises.

Fines are a kind of regulatory tax and are discussed along with regulatory taxes below.

Seignorage and Debt

These are actually very different sources of finance. Seignorage is the purchasing power transferred to the government by the private sector when and if it provides money which serves as a medium of exchange for the economy. In fact, in most modern economies the government is the monopoly provider of "high powered money". To the extent that the purchasing power transferred is equal to the social marginal cost of providing money, this is an economically efficient means of raising revenue. However, in this case the government would have no purchasing power left over to finance other government activity. In fact in the presence of increasing returns, the government would need to finance money creation from other sources. To the extent that seignorage reflects monopoly rents earned by the government, it is similar to a a poll tax as in the case of rents captured by public sector enterprises. The incidence of this "tax" on different social groups is difficult to discern but depends on their direct and indirect demand for money.[3]

The term seignorage often includes a related source of revenue, commonly known as the "inflation tax", which arise when an increase in the price level lowers the real value of the government's debt to the public. Since the value of non-financial assets is largely unaffected by inflation, the incidence of this tax is on the holders of unindexed financial assets (including government bonds) and also on wage earners to the extent that wages are not indexed for inflation. So the inflation tax is commonly believed to be a regressive tax putting a disproportionate burden on the poor whose main source of income is wages. Concommitant effects on labour and capital allocation decisions of individuals and firms suggest that the inflation tax also has efficiency costs apart from distribution costs. The inflation tax may reflect government moral hazard wherein it uses a source of finance more than is socially desirable, simply because it has the power to do so.[4] Research suggests that, in contrast to charges and fees, this source of finance is overutilised by most governments.

The debt of the government, excluding debt from money creation, represents the accumulation of borrowings made by the government. Debt finance has a role when government spending finances the creation of long lived assets. To the extent that these assets benefit future generations of citizens, the benefits principle of taxation suggests that the debt should be paid for out of taxes extracted from members of generations who benefit from the assets. However, this is a risky source of finance. As with seignorage, government moral hazard may lead it to exploit its debt raising power more than it should, for example to finance current expenditure not resulting in asset creation. Furthermore debt finance has an impact on the behaviour of private citizens and possibly on their resource allocation decisions, that may add to the cost of debt finance. For example, the Ricardian Equivalence principle suggests that current debt holders in the private sector consider debt to be the same as taxes to the extent that they care about their descendents and the tax burden that the descendents will have to bear. However, Ricardian Equivalence, in its pure form, which asserts that debt and taxes have identical behavioural impacts, does not have much empirical support.

A type of debt that has a more limited justification socially is external debt, wherein the government borrows from citizens of other countries. While such debt can in principle also be used to redistribute the burden of financing government across generations, external debt is seldom as long dated as internal debt. Short term external debt, like short term internal debt, is possibly only justified to smooth finances in the presence of temporary illiquidity of the government.

Regulatory taxes

Regulatory or "Pigouvian" taxes are taxes the government should levy on privately provided or privately consumed commodities when there are negative externalities or spillovers which lead to the private cost of provision or consumption being below the social cost. Since the government gets revenue from such taxes while, at the same time bringing private costs of provision or consumption in line with social costs by "making the polluter pay", such taxes have a double benefit. The importance of this phenomenon, known as the "double dividend hypothesis", is the subject matter of much ongoing research. It is generally believed that this source of revenue is underexploited by most governments. Some countries, such as Singapore, which do rely heavily on corrective taxes[5] are able to raise as much as five percent of GDP from these sources. Besides environmental taxes and regulatory taxes linked to externalities, a related type of taxes to which Pigouvian principles apply are taxes on demerit goods or "sin taxes". Excises on liquor and tobacco are examples.

Since, by breaking laws citizen's reveal that their private cost of doing so is below the cost to society, fines for breaking the law are a form of Pigouvian tax. However, the amount of the tax in the case of fines is the ex ante, expected value of the fine, in the event that the law breaker is caught and penalised. In designing fines, pure externality considerations must be tempered by taking into account the deterrent and (negative) incentive effect of fines on behaviour and also the principle of natural justice which asserts that "the penalty should not exceed the crime". This is the subject of much ongoing research.[6] There has not been much assessment of whether fines are over or underused by the government, though inadequate enforcement of laws in many developing countries makes it likely that ex ante fines do not sufficiently penalise offenders.

General taxes

To the extent that governments cannot collect adequate revenues via sources of finance discussed above, with the possible exception of earnings from public sector production and the inflation tax, the government must turn to general taxes to finance its activities and the provision of public goods. This is an important point: General taxes are a residual source of finance that should be resorted to only if other sources of finance are socially inadequate for government resource needs. There is one important qualification to this which suggests even further reliance on sources of finance other than general taxes: Since feasible general taxes are inevitably distortionary and have possibly negative consequences on income distribution,[7] distortionary and distribution costs of all sources of finance should be equated at the margin even if this entails over-use of some of the sources of finance discussed above.[8] Indeed, it is the distributional impact of the entire government budget, comprising revenue, subsidies and transfers, and expenditure, that matters rather than the impact of revenue alone. No research appears to exist which examines the extent to which the impact of revenue, taken by itself, on distribution should be taken into account. For example, despite a negative distributional impact it is entirely possible that some (or perhaps much) reliance on the inflation tax is socially desirable.

Despite an enormous amount of research on general taxes, including some outstandingly brilliant and Nobel Prize winning contributions, there is still an inadequate understanding of the socially desirable design of general taxes at different levels of development. For example, "optimal tax theory", which examines the design of least cost taxes when some activities or commodities cannot be taxed[9] and when the government needs to raise a given amount of revenue, yields a prescription for different rates of tax on different commodities. Such differentiated taxes are impossible for the bureaucracy (or tax administration) of any existing country to administer.

There are at least seven sources of inadequacy in existing theoretical research on optimal tax systems.

First, given the great analytical difficulty of the subject, research has tended to look at taxes individually (or at a sub-set of available taxes) rather than looking for an optimal tax system which takes into account all potentially feasible taxes.[10]

Second the assumed structure of economic activity in this research leaves out many real world features. For example, much research is for the case of economies with perfectly competitive markets. Yet, market failures, which loom large in most developing economies, are significant and will inevitably change the structure of socially desirable taxes if they are taken into account.

Third, constraints imposed by the capacity of the bureaucracy on feasible tax structures are largely neglected.[11] As with differentiated taxes, taking account of these constraints will radically alter the structure of optimal taxes.

Fourth, besides bureaucratic capacity, that bureaucratic goals differ from social goals is another major problem which has only begun to be addressed. One key manifestation of lack of consonance of goals is bureaucratic corruption which severely affects the government's ability to raise resources through taxes.