Dynamic Theory of Public Spending, Taxation and Debt

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Last Updated on November 27, 2020 by admin

(Barro, 1979) developed the theory which is based on tax smoothing approach to fiscal policy which predicts that governments will use budget surpluses and deficits as a buffer to prevent tax rates from changing too sharply. This will make governments to run deficits in times of high government spending needs and surpluses when needs are low. Underlying the approach are the assumptions that governments are benevolent, that government spending needs fluctuate over time, and that the deadweight costs of income taxes are a convex function of the tax rate. The economic environment underlying this theory is similar to that in the tax smoothing literature.

However, the key departure is that policy decisions are made by a legislature rather than a benevolent planner. This theory introduces the part that legislators can distribute revenues back to their districts via pork-barrel spending (Bohn, 1998). The theory considers a political jurisdiction in which policy choices are made by a legislature comprised of representatives elected by single-member, geographically defined districts. The legislature can raise revenues in two ways: via a proportional tax on labor income and by borrowing in the capital market. Borrowing takes the form of issuing one period bonds. The legislature can also purchase bonds and use the interest earnings to help finance future public spending if it so chooses. Public revenues are used to finance the provision of a public good that benefits all citizens and to provide targeted district-specific transfers, which are interpreted as pork-barrel spending. The value of the public good to citizens is stochastic, reflecting shocks such as wars or natural disasters. The legislature makes policy decisions by majority (or super-majority) rule and legislative policy-making in each period is modeled using the legislative bargaining approach of (Baron & Ferejohn, 1989). The level of public debt acts as a state variable, creating a dynamic linkage across policy-making periods.

In the benefit theory, tax levels are automatically determined, because taxpayers pay proportionately for the government benefits they receive. In other words, the individuals who benefit the most from public services pay the most taxes. In analyzing the benefit approach, two models have been discussed: The Lindahl model and the Bowen model. In the Lindahl model, in the supply curve of state services it is assumed that production of social goods is linear and homogenous. Since the state is non-profit, it increases its supply until equilibrium is reached at a point on a voluntary-exchange basis Bowen’s model has more operational significance, since it demonstrates that when social goods are produced under conditions of increasing costs, the opportunity cost of private goods is foregone. For example, if there is one social good and two taxpayers (A and B), their demand for social goods is represented by a and b; therefore, a+b is the total demand for social goods. The supply curve indicates that goods are produced under conditions of increasing cost. The production cost of social goods is the value of foregone private goods; this means that a+b is also the demand curve of private goods. The intersection of the cost and demand curves determines how a given national income should according to taxpayers’ desires be divided between social and private goods (Samuelson, 2012).
(Ahsan & Wu, 2005) examined the tax share in GDP for developed and developing countries for 1979-2002 and found the negative and significant relation of agriculture share, GDP per capita, and population growth to the tax ratio while trade share in GDP has positive and significant relation but corruption has negative and insignificant relation. (Lutfunnahar, 2007) identified the determinants of tax share and revenue performance for Bangladesh along with 10 other developing countries for the 15 years through a panel data analysis. The results obtained suggest international trade, broad money, external debt and population growth to be significantly determinants of tax efforts. The study concluded that Bangladesh and other countries have low tax effort (less than unity index) and are not utilizing their full capacity of tax revenue and therefore have the potential for financing budgetary imbalance through raising tax revenue.
According to (Jepkemboi, 2008), Kenya’s fiscal structure reveals that government expenditure and revenue have maintained consistent growth patterns with expenditures always exceeding revenues. The imbalance between revenue and expenditure results in large fiscal deficits. Even after undertaking tax reforms the taxes have not been as productive as desired. A poor tax performance, in terms of raising revenue can either mean deficiencies in tax structure or an inadequate effort on the part of the government, both of which are influenced by various factors.
The main objective of this study was to establish the macroeconomic determinants of tax revenue shares in Kenya for the period 1970-2005 especially the economic development and structural factors.
(Mahdavi, 2008) used the advanced estimation techniques with an unbalanced panel data for 43 developing countries over the period 1973-2002 including Pakistan. His results showed that aid had a negative effect, non-tax revenue had also negative effect while agriculture sector share had positive but insignificant coefficient. Trade sector share had a positive effect and economically active female variable had a net adverse but insignificant effect while the old-age portion of population showed negative association for both income and sales tax. Extent of urbanization and literacy rate both showed positive effect. Population density, monetization and inflation rate remained negatively correlated. Inverse of GDP per capita was strongly and negatively correlated with the level of taxation. Net effect of political rights and civil liberties was significant.
(Mwakalobo, 2009) studied economic reforms in East African countries by studying the impact of the relationship between the government revenue and the public investment. (Mwakalobo, 2009) established that inadequate and erratic revenue generation had adversely affected public investment spending in the three East African countries particularly Tanzania, where the declining trends in government and tax revenue had been accompanied with the declining public investment in almost all spending categories. In the case where the government revenue is reduced and revenue generation was inadequate, public investment spending in physical infrastructure also decreases. For example, in countries like Tanzania where government revenue increased and tax revenue performance had been more impressive, public investment spending rose, as evident in Uganda. The priority sectors that have been receiving higher shares of government expenditures are general public services, human capital development, and physical infrastructure in Tanzania, Kenya and Uganda, respectively. Spending in human capital development has been relatively low in Tanzania than in Kenya and Uganda. This creates some concerns on commitments of the Tanzanian government to achieving the MDG objectives, reducing poverty and overall economic development. (Ahmed, 2010) examined the determinants of tax buoyancy of 25 developing countries by using the cross-section data for the year 1998 to 2008 and pooled least square method for result analysis. For agriculture sector it showed insignificant effect and for services sector it showed positive and significant effect instead of past insignificant result of many researchers. Monetization and budget deficit showed positive influence while growth in grants showed negative impact on tax buoyancy. (Chaudhry & Munir, 2010) studied the determinants of low tax revenue in Pakistan. According to (Chaudhry & Munir, 2010), tax revenue collection is one significant issue of economic development among others.
Pakistan’s economic performance since its emergence in 1947 has remained volatile across the sectors and provinces, and even its structure has changed over the time. The results obtained suggest that openness, broad money, external debt, foreign aid and political stability to be the significant determinants of tax efforts, with expected signs of the estimated coefficients. Agriculture share, manufacturing share and service sector share turn out to be insignificant and the sign of the coefficient of agriculture share deviates from expectations and same as the sign of GDP per capita and urbanization. (Gacanja, 2012) studied the empirical case study of Kenya on tax revenue and economic growth.

(Owolabi, 2011) did a study on revenue allocation formula and its impact on economic growth process in Nigeria. The analysis revealed the extent to which revenue allocation formula adopted in the past had affected the path of economic growth and development in Nigeria. The data was purely secondary data and was sourced from the World Bank publication, CBN, Journal and other published and unpublished materials. There was need, therefore to address the problem by formulating a more efficient revenue allocation wastage and mismanagement of funds. Also effort should be geared towards articulation of policies that will enhance capital formulation, employment of the abundant and measures may include attachment of more weight to the share of local government from the federal collected revenue, placing more emphasis on the internal revenue generation, redefinition of the concept of definition and sustaining the present effort of government as regards budget monitoring and implementation.According to (Worlu & Nkoro, 2012), who studied tax revenue and economic development in Nigeria using a macro econometric approach. They examined the impact of tax revenue on the economic growth of Nigeria, judging from its impact on infrastructural development from 1980 to 2007. To achieve this objective, relevant secondary data were collected from the Central Bank of Nigeria (CBN) Statistical Bulletin, Federal Inland Revenue Service.
(FIRS) and previous works done by scholars. The data collected was analyzed using the three stage least square estimation technique. The results showed that tax revenue stimulates economic growth through infrastructural development. This means it highlights the channels through which tax revenue impacts on economic growth in Nigeria. The study also reveals that tax revenue has no independent effect on growth through infrastructural development and foreign direct investment, but just allowing the infrastructural development and foreign direct investment to positively respond to increase in output.
These will bring about improvement on the tax administration and accountability and transparency of government officials in the management of tax revenue. Above all, these will increase the tax revenue base with resultant increase in growth. (Segal & Sen, 2011) studied oil revenues and economic development using the case of Rajasthan, India. In their conclusion, they established that efficient and effective management of oil revenues depends greatly on political and administrative institutions. Like any government revenues, their effective use requires that citizens have a say in their expenditure. Transparency in the receipt and expenditure of resource revenues, and accountability of those in power, are important in achieving this. It is important for local communities, NGOs, and other affected parties to have input into decision making over the development of the industry itself, as well as over expenditures of revenues. This helps to ensure political buy-in anmd reduces the chance of conflict later. Moreover, disputes can become more acute when the financial stakes are raised by the discovery of natural resources.

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