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
exhaustibility1 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
1
As recent events have shown, even the Taj Mahal is an "exhaustible resource".
2
Besides pricing, limiting access and other quantitative restrictions can sometimes be socially more effective.
1
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
3
Indirect demand arises from money demand by productive firms in which a citizen holds an ownership share.
4
There is one qualification to this pointed out below at the start of the discussion of general taxes.
2
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 taxes5 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
5
Formally, some of the revenues are from non-tax sources such as proceeds from auctioning of permits.
6
As in the case of natural resources, quantitative substitutes to fines, such as jail sentences or withdrawal of the right
to carry on a business or profession, must also be taken into account in designing fines.
3
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 taxed9 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.
7
Non-distortionary lump-sum taxes or taxes falling on pure economic rent or profits are, by and large, impractical.
8
Real world problems that affect collection of both regulatory and general taxes are discussed below.
9
This means that "optimal taxes" identified are actually "optimal second best taxes" since, if all commodities
(including, for example, leisure) were taxable a lump-sum tax system tailored to individual circumstances would be
"first best". This is since lump-sum taxes, being inevitable and independent of what decisions individuals take, do
not have any impact on economic decision making.
10
On this see Joel Slemrod (1990), "Optimal Taxation and Optimal Tax Systems", Journal of Economic
Perspectives, 4(1), 157-178.
11
As Milka Casanegra de Jantscher, a former head of the Tax Administration Division of the International Monetary
Fund once famously pointed out "Tax policy is tax administration".
4
Fifth, optimal tax research largely takes the government's revenue requirement as given. Clearly, if the
social cost of revenue collection exceeds social benefits from expenditure financed by it, expenditure
should be reduced along with revenue raising.
Sixth, a point related to the previous one, this research assumes away transactions costs including costs to
citizens of complying with tax obligations.12
Seventh, it is almost always politically convenient to use tax policy to promote non-revenue objectives by
way of tax concessions. Real world tax systems are, consequently riddled with tax concessions, reducing
their usefulness for raising revenue. In principle, such "tax expenditures" can be socially desirable if
social objectives can be achieved at less cost to society than via direct subsidies or government
expenditure. However, such non-revenue objectives are not incorporated in optimal tax examinations.
In consequence, practical advice for general tax policy design has had to largely ignore prescriptions
derived from theory and uses rules of thumb to try to design tax systems which incorporate, more or less,
Adam Smith's cannons of taxation (see the Annex) of certainty, simplicity and convenience, and
economy. Besides these, among the most widely accepted rules of thumb is that general taxes should have
broad bases and low rates to minimise negative economic effects on prices and minimise incentives of
citizens not to comply with tax obligations. A second widely accepted prescription is for few rates of tax,
given administrative and legal difficulty with differentiated tax rates. Third, convenience and simplicity
for the unsophisticated or poorly educated taxpayer dictates the use of simple taxes such as "presumptive
taxes" for such taxpayers. Other than this no widely applicable general rules exist, though as a corollary to
the broad base proposition, minimising tax concessions is usually also advocated. For individual taxes,
however, additional rules of thumb do exist. For example, paralleling empirical reality, increased reliance
on the income tax with economic development is advocated so that general taxes closely reflect the ability
to pay of citizens. Taxes on international trade, since they distort allocation of resources in line with
comparative advantage, are viewed with disfavour except for the least developed countries, where the
relative ease with which they can be collected is important. For domestic taxes, taxing intermediate goods
used in production is viewed with disfavour as this distorts domestic resource allocation.
Multi-level Government
The discussion above has neglected an important factor which raises additional issues in the design of
revenue raising systems. That is multiple levels of government, nationally and internationally, with
differing responsibilities for provision of goods and services. In principle, revenues should be raised by
the level of government that is able to do so at least cost and then shared to permit each level of
government to finance its expenditures, subsidies and transfer payments. However, problems arise in
implementing this prescription, especially in the presence of differing views about the role of government
and moral hazard when one level of government collects taxes on behalf of another. For example, while a
unified world tax system probably has the least social cost, countries may not agree as to what the
appropriate scope of government activity is. Even if they did, it may not be possible to design a revenue
sharing system which all countries would find acceptable and reliable. Similar problems arise between
levels of government within a country. Consequently, ensuring that most governments have their own
revenue raising powers and sources is a problem that needs to be addressed both in theory and in practice.
On this and the previous point see (1) Anthony Atkinson and Nicholas Stern (1974) “Pigou, Taxation, and Public
Goods”, Review of Economic Studies, 41, 119-128 and (2) Joel Slemrod and Shlomo Yitzhaki (1996), “The Cost of
Taxation and the Marginal Efficiency Cost of Funds”, IMF Staff Papers, 43, 172-198.
12
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Positive tax research
A strand of research not looked at above seeks to examine what usage of different revenue sources would
result in, say, a democracy, when citizens vote for these through different public choice mechanisms.
Clearly, public choice institutions impose further constraints on the feasible mix of taxes and other
revenue sources which must be integrated with normative research before such research can have
practical utility.
Overall, much ground has to be covered by normative economic research before the chasm which
separates theoretical and practical tax prescriptions can be satisfactorily bridged.
Annex: Adam Smith's Canons of Taxation
"Before I enter upon the examination of particular taxes, it is necessary to premise the four following maxims with
regard to taxes in general.
I. The subjects of every state ought to contribute towards the support of the government, as nearly as possible, in
proportion to their respective abilities; that is, in proportion to the revenue which they respectively enjoy under the
protection of the state. The expense of government to the individuals of a great nation is like the expense of
management to the joint tenants of a great estate, who are all obliged to contribute in proportion to their respective
interests in the estate. In the observation or neglect of this maxim consists what is called the equality or inequality of
taxation. Every tax, it must be observed once for all, which falls finally upon one only of the three sorts of revenue
above mentioned, is necessarily unequal in so far as it does not affect the other two. In the following examination of
different taxes I shall seldom take much further notice of this sort of inequality, but shall, in most cases, confine my
observations to that inequality which is occasioned by a particular tax falling unequally even upon that particular
sort of private revenue which is affected by it.
II. The tax which each individual is bound to pay ought to be certain, and not arbitrary. The time of payment, the
manner of payment, the quantity to be paid, ought all to be clear and plain to the contributor, and to every other
person. Where it is otherwise, every person subject to the tax is put more or less in the power of the tax-gathered,
who can either aggravate the tax upon any obnoxious contributor, or extort, by the terror of such aggravation, some
present or perquisite to himself. The uncertainty of taxation encourages the insolence and favours the corruption of
an order of men who are naturally unpopular, even where they are neither insolent nor corrupt. The certainty of what
each individual ought to pay is, in taxation, a matter of so great importance that a very considerable degree of
inequality, it appears, I believe, from the experience of all nations, is not near so great an evil as a very small degree
of uncertainty.
III. Every tax ought to be levied at the time, or in the manner, in which it is most likely to be convenient for the
contributor to pay it. A tax upon the rent of land or of houses, payable at the same term at which such rents are
usually paid, is levied at the time when it is most likely to be convenient for the contributor to pay; or, when he is
most likely to have wherewithal to pay. Taxes upon such consumable goods as are articles of luxury are all finally
paid by the consumer, and generally in a manner that is very convenient for him. He pays them by little and little, as
he has occasion to buy the goods. As he is at liberty, too, either to buy, or not to buy, as he pleases, it must be his
own fault if he ever suffers any considerable inconveniency from such taxes.
IV. Every tax ought to be so contrived as both to take out and to keep out of the pockets of the people as little as
possible over and above what it brings into the public treasury of the state. A tax may either take out or keep out of
the pockets of the people a great deal more than it brings into the public treasury, in the four following ways. First,
the levying of it may require a great number of officers, whose salaries may eat up the greater part of the produce of
the tax, and whose perquisites may impose another additional tax upon the people. Secondly, it may obstruct the
industry the people, and discourage them from applying to certain branches of business which might give
maintenance and unemployment to great multitudes. While it obliges the people to pay, it may thus diminish, or
perhaps destroy, some of the funds which might enable them more easily to do so. Thirdly, by the forfeitures and
other penalties which those unfortunate individuals incur who attempt unsuccessfully to evade the tax, it may
6
frequently ruin them, and thereby put an end to the benefit which the community might have received from the
employment of their capitals. An injudicious tax offers a great temptation to smuggling. But the penalties of
smuggling must rise in proportion to the temptation. The law, contrary to all the ordinary principles of justice, first
creates the temptation, and then punishes those who yield to it; and it commonly enhances the punishment, too, in
proportion to the very circumstance which ought certainly to alleviate it, the temptation to commit the crime.
Fourthly, by subjecting the people to the frequent visits and the odious examination of the tax-gatherers, it may
expose them to much unnecessary trouble, vexation, and oppression; and though vexation is not, strictly speaking,
expense, it is certainly equivalent to the expense at which every man would be willing to redeem himself from it. It
is in some one or other of these four different ways that taxes are frequently so much more burdensome to the people
than they are beneficial to the sovereign.
The evident justice and utility of the foregoing maxims have recommended them more or less to the attention of all
nations. All nations have endeavoured, to the best of their judgment, to render their taxes as equal as they could
contrive; as certain, as convenient to the contributor, both in the time and in the mode of payment, and, in proportion
to the revenue which they brought to the prince, as little burdensome to the people."
From Adam Smith (1776) The Wealth of Nations, Book V, Chapter II.
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