HOW GOVERNMENT USES TAXATION TO ACHIEVE THE FUNCTIONS OF FISCAL POLICY

How taxes, government expenditure have helped Kenya in achieving the three functions of fiscal policy namely resources allocation function, distribution function and stability of the economy.

There are two methods of financing: taxation and borrowing. Taxation takes many forms in the developed countries including taxation of personal and corporate income, so-called value added taxation and the collection of royalties or taxes on specific sets of goods. The debt burden assumed by the government is itself an important policy variable and one that has implications for the conduct of monetary policy. Governments in democratic societies act on many different, occasionally conflicting objectives. They may want to smooth out the nation's income in order to minimize the pejorative effects of the business cycle or they may want to take steps designed to increase the national income. They may also want to take steps intended to achieve specific social objectives deemed to be appropriate by the political or legal process.

LEVELS OF GOVERNMENT

In a democratic system, there are two ways to organize a government: a unitary system and a federal system.

Canada is an excellent example of a federal system of government in which there is one central or federal government and there are ten provincial governments. Underneath the provincial governments, there is a patchwork of local government. Kenya has taken this route. We are yet to fully understand it though I can say, we are not badly off bearing in mind this system is only two years old.

 
The United Kingdom is an example of a unitary system in which there is effectively one central government with no provincial governments. There are, of course, local governments.

In a federal system, both the federal and provincial governments conduct fiscal policy. The Constitution delineates areas of responsibility for the two levels of government and the Supreme Court interprets the actions of the different levels of government in light of the Constitution and other legal precedent to enforce the policy distinctions between the two levels of government. For example, in Canada, national defence is a wholly federal responsibility while education is a completely provincial domain. In Kenya both defense and education are still under government responsibilties. There are already calls by the opposition to devolve security due to the current security crisis in Kenya emerging international terrorists outfits like Al Shaabab and Al Qaeda to local threats like the outlawed Mombasa Republican Council (MRC) and communities animosity in the Northern Kenya.

However, different levels of government can find ways of participating in areas outside of their purview.

EXPENDITURES AND TAXATION

There are two types of expenditures: money spent on the delivery of goods and services and the transfer of funds to other levels of government.

All of the money that the government spends has a stimulative effect on the economy. The government is large enough that it can spend during periods of economic contraction thereby helping to prop up the economy and consumer confidence. This school of thought in which the government plays an activist role in stimulating the economy in times of recession and in easing their spending in times of success is called the Keynesian School, after the economist John Keynes. Keynes, a legendary speculator, formulated his theories during the Great Depression as governments in Europe and North America struggled to revive economies troubled by a pullback in the provision of private credit and the negative effects of beggar-thy-neighbour competitive currency devaluations.

The problem with this school of thought is that when it is applied, it is politically very appealing to be spending money during a downturn and helping people when they need help. It is also politically very attractive to be spending money and helping people during a boom time.

It is also very appealing to try and redistribute goods to one group from other groups in the society. This is a very common objective of fiscal policy. Politicians in Western democracies often try to redistribute resources to people living in poverty from people living in comparative wealth. In Canada, one of the most controversial fiscal policy decisions of the post-war era was the Trudeau government's move during the oil crisis of 1978 to force Alberta to sell its oil and gas to Central Canadians at prices that were far below the price that Alberta could have received by selling those resources on the open international market. This constituted a real transfer of money from the people of Alberta to the people of Ontario and Quebec. People in the West are still bitter about that policy twenty years after the fact.

The types of goods that governments typically provide are called public goods. A good or a service is said to be a public good if it is characterized by an externality. This is best demonstrated by an example.

If I buy a chocolate bar, my consumption of that chocolate bar is excludable. If I choose to do so, I can eat the whole thing myself. If I eat the chocolate bar without sharing it, nobody else gets any benefit from it.

Consider now the case where I hire a security service to patrol my street. Not only is my house safer but so are the other houses on that street. However, in this case, I am the only one paying for the service from which everyone else derives a benefit. The other people living on my street are said to be "free-riding" on my provision of the security service. There is nothing that I can do to inhibit them from obtaining this benefit, short of cutting out the service altogether.

If everyone on my street were to chip in for what would be the "optimal" level of security service, there would be inevitably some people who would not contribute anything and there would be others who would not contribute their fair share. Relying on the group to privately provide this public good would mean that too little of it would be supplied.

Traditionally, governments have stepped in to the role of providing these public goods in order to get around the "free-riding" problem. They are deemed to be able to ascertain the optimal amount of the public good to be supplied and to be able to collect the funds to fund it.

Naturally, this is a value-driven exercise. One has to determine how the government should judge what is "optimal" and what is the individual's "fair share." In a democracy, these kinds of normative questions are answered by the people's vote.

In practice, expenditures are driven by all kinds of considerations. Some people talk about "pork barrel" politics, a situation in which politicians reward their friends and constituents at the expense of people outside of their group. It is not difficult to imagine the local Member of Parliament arguing in favour of the maintenance of his local Armed Forces base and the removal of another base in someone else's riding.

There are other politicians and bureaucrats who have a set of ideological objectives to fulfill. They may want to make the taxation system more progressive, for example. This means taxing people with higher incomes at higher rates and, possibly, not taxing people in the lower income brackets at all.

The construction of the taxation system is very difficult. Another set of objectives may be to distort production as little as possible. That is, in designing the tax code, we may want to develop a set of rules that do not change the relative prices of goods and services (and therefore the decisions investors must make about where to invest and in what industry, etc.)

BORROWING

A government that wants to provide a great deal of goods and services to its people while not having the immediate tax revenue to fund that expenditure can turn to the capital markets to borrow the necessary money. They do this primarily by issuing securities, either Treasury Bills or Treasury Bonds. All levels of government will borrow money at some point. These securities are obligations compelling the government to repay the borrowed amount at maturity and also to pay interest in the form of coupons at specific points in time.

Borrowing has a number of effects.

If a country borrows too much money, it has to pay a great deal of interest every year in order to service that debt. This represents money that could have been used to pay for program spending instead. By borrowing money, the government has placed a greater emphasis on spending in the present than in the future. It has discounted the value of future expenditure.

Depending on how much money the citizens of that country or that province save out of their own incomes, the borrowing government must sell its obligations to foreigners. By doing so, the government makes itself vulnerable to the shifting and often volatile sentiment of the international capital markets. If they have a sufficiently large external debt in relation to their GDP (as an indicator of their current and future capacity to repay), speculators might attack their currency or their country's bond markets forcing interest rates higher and causing the value of their economy to degrade in international terms.

Indeed, an excessive debt policy can lead to a vicious cycle of speculative attacks, followed by higher interest rates and higher interest payments that can cause an economic slowdown. Just when a stimulative policy is required to help the economy struggle back to its normal growth trajectory, the government finds itself crippled by high interest rates and poor liquidity. Nobody else will lend the government money with which it can stimulate the economy under anything but the most onerous terms. This vicious cycle is one that has plagued economies of the Third World, and particularly Brazil, for years.

On the other hand, it may be prudent to borrow during economic downturns in order to stimulate the economy with the intention of repaying those funds (and thereby dampening the economy) in times of economic growth.

The conduct of fiscal policy is very complicated in its effects on the economy, its reliance on external factors and the value-driven objectives that characterize much of the redistribution of resources and other fiscal policy choices.