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Eco 201 – PUBLIC FINANCE

Meaning of Public Finance

Public finance is the study of how the government gets money, spends it, and keeps track of
it. It covers things like taxes, public spending, government borrowing, and financial
management. The goal is to make sure public money is used efficiently to improve the
country’s economy and the well-being of its people.

Nature and Scope of Public Finance

The scope of public finance is including four main areas, namely (i) government expenditure,
(ii) government revenue, (iii) public debt, and (iv) financial management.

(i) Public revenue is the money the government collects to pay for its regular and
long-term expenses. Most of this money comes from taxes, but the government also
earns from other sources like fees and fines. In public finance, we study the types
of taxes, how they are applied, and how they affect people.

(ii) Public expenditure is how the government spends the money it collects. In public
finance, we study the rules for spending and the main areas where the money goes.
It also looks at whether the spending helps the economy grow or not, and how it
affects income distribution and production levels.

(iii) Public debt happens when the government’s spending is more than the money it
collects, so it has to borrow to cover the gap. This borrowing helps the government
meet both basic and welfare needs. In public finance, we study the types of loans
the government can take, interest rates, the kinds of bonds it can issue, and how it
plans to repay the debt.

(iv) Financial administration in public finance is about how the government plans and
manages its money. It includes preparing budgets, carrying out the budget, and
making sure spending is done wisely, openly, and responsibly. It also covers how
the government controls and monitors its finances.

Functions of Public Finance

(i) Resource Allocation: Resource allocation means public finance helps the
government decide how to use limited money wisely, especially on things like
roads, schools, and security. It also helps fix problems where private businesses may
not provide important services.

(ii) Income Redistribution: Income redistribution means the government uses taxes
and support programs like pensions and subsidies to reduce the gap between the
rich and the poor. This helps make the system fairer and supports people in need.
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(iii) Economic Stabilization: Economic stabilization means public finance helps keep
the economy steady by using government spending and taxes to control things like
inflation, unemployment, and growth. For example, spending more during a
recession can help create jobs and boost the economy.

(iv) Provision of Public Goods and Services: Provision of public goods and services
means the government uses public finance to provide important things like
healthcare, education, roads, and security that everyone can use. Since these
services benefit all and can't easily be limited to just a few people, the government
needs to provide them.

(v) Promoting Economic Growth and Development: Promoting economic growth

and development means the government uses public finance to invest in things like
roads, schools, and technology to help the economy grow over time. It also supports
industries, rural areas, and different parts of the economy to improve living
standards.

Definition of Tax

Tax could be defined as a compulsory payment made by individuals and businesses for the
purpose of financing government expenditures.

While Taxation is the act of imposing and collecting taxes from people or organizations that
are required to pay.

A tax is a payment the government charges on income, goods, or services. If it is charged on

income, it’s called a direct tax, and if it's added to the price of goods or services, it's an indirect
tax. The main purpose of tax is to help the government pay for its expenses and to reduce
income inequality for the country’s development.

Classification of Taxes

Taxes can be classified in different ways, but we will focus on three main categories.

1. Classification based on Tax base;

2. Classification based on Incidence; and

3. Classification based on Tax rate.

1. Classification Based on Tax Base

A tax base refers to the item or activity on which a tax is imposed or collected, such as income,
capital, or spending. Under Nigerian Tax Laws, three main types of tax bases can be identified.
These include:
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(i) Income Tax: These are taxes levied on the income of Individual and companies. In
Nigeria, the common classifications are: Personal Income Tax, Companies Income
Tax and Petroleum Profit Tax.

(ii) Capital Tax: This tax is charged on assets, which may include human or physical
assets. The two main types are Capital Gains Tax and Capital Transfer Tax.
However, the Capital Transfer Tax was abolished by the Federal Government of
Nigeria in the 1996 budget.

(iii) Consumption Tax: These are taxes levied on goods and services. The most
common forms of consumption tax in Nigeria are the Value Added Tax, Excise
Duties and Customs duties.

2. Classification Based on Incidence of Tax

Tax incidence refers to the effect of a tax on the individual or entity that actually pays it to the
government. Based on this classification, there are two main types of taxes.

(i) Direct Taxes: These are taxes collected directly from the income of individuals and
companies whose incidence and burden is on the individuals or the
companies that paid the tax to the Government. Examples are Personal
Income Tax, Company Income Tax, Petroleum Profit Tax, Capital Gains Tax, etc.

(ii) Indirect taxes are taxes placed on goods and services that are made, used, imported,
or exported. The person or business that pays the tax to the government can pass
the cost on to the final consumer, who often doesn't know when or how much tax
they are paying. Examples include VAT, import and export duties, and
entertainment tax. These taxes are usually included in the price of goods and
services.

3. Classification Based on Tax Rate

A tax rate refers to the percentage of the tax base that is paid as tax. Based on this classification,
the following types can be identified.

(i) Progressive tax is a type of tax that increases as a person’s income or wealth
increases. It is mostly used in income taxes to make tax payments fairer. For
example, someone earning less pays a lower percentage, while someone earning
more pays a higher percentage. This way, people with higher income carry a bigger
share of the tax burden.

(ii) Proportional tax is a type of tax where everyone pays the same percentage of their
income, no matter how much they earn. Both rich and poor are taxed at the same
rate. For example, if the tax rate is 10%, someone earning ₦20,000 pays ₦2,000,
while someone earning ₦80,000 pays ₦8,000. The amount paid differs, but the
percentage stays the same.
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(iii) Regressive tax is a type of tax where the tax rate gets lower as a person’s income
increases. This means poorer people pay a higher percentage of their income
compared to richer people. For example, someone earning ₦15,000 may pay 20%,
while someone earning ₦20,000 pays only 10%. This kind of tax puts more burden
on low-income earners.

Distinction between Tax and Other Levies

There are other payments which resemble tax but are not tax. These payments are:

a) Fees: These are charges the government collects to help cover the cost of services it
provides that also benefit the person paying. Examples include registration fees, court
fees, and school fees.

b) Licenses: This is a charge by Government to grant permission to a person for the

performance of a service. E.g. motor vehicle license fees, broadcasting license fees,
business registration fees, etc.

c) Fines: This is a levy imposed as a punishment for breach of law with a view to ensuring
future adherence

Although all these levies are like taxes because they are mandatory and provide income for the
government, they differ from taxes because taxes are not charged in exchange for any specific
service given directly to the taxpayer.

Principles of Taxation

These are the rules or standards used to judge how good a tax system is and to help create fair
tax policies. Adam Smith was the first to talk about them in 1776, calling them the "canons of
taxation" in his book The Wealth of Nations.

(i) Principle of Equity: This means a good tax system should be fair. Everyone who
is supposed to pay tax should do so, and each person should pay based on what they
can afford. There are two types: Vertical equity: People with different incomes are
taxed differently. Horizontal equity: People with the same income are taxed the
same way.

(ii) Principle of Economy: This means the cost of collecting tax should be low. If the
government spends too much money to collect taxes, it reduces the value of the tax.
For example, spending ₦9 million to collect ₦10 million in tax is not economical.

(iii) Principle of Certainty: This means taxpayers should clearly know how much tax
they need to pay, when to pay it, how to pay, and where to pay. Everything should
be well explained so people aren’t confused or taken advantage of by dishonest
officials. This helps taxpayers understand their obligations and protects them from
being cheated.
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(iv) Principle of Convenience: This principle means taxes should be collected at a time
and in a way that makes it easier for taxpayers to pay and for the government to
collect. For example, it's better to deduct tax from a worker's salary when it is paid
(like with PAYE), rather than asking them to pay later when the money may be
gone. Likewise, a farmer should be taxed after harvesting crops, not during planting,
when income is low.

(v) Principle of Simplicity: This means a good tax system should be easy to
understand and apply. This is very important in developing countries, where many
people may not be well-educated or used to keeping business records.

(vi) Principle of Neutrality: This principle means a good tax system should not change
how people choose to work, produce, spend, save, or invest. It should not affect
their normal economic decisions or behaviors.

(vii) Principle of Efficiency: This means a good tax system should be designed in a way
that makes it hard for people to avoid or illegally reduce their tax payments.

(viii) Flexibility: This means a good tax system should be easy to change or adjust when
necessary, without too much delay or complicated procedures.