CHAPTER IV

PUBLIC EXPENDITURE
CHAPTER CONTENTS
 Meaning & nature of public expenditure
 Planning and budgeting of public
expenditure
 Evaluating public expenditures/ project
analysis
 Cost benefit analysis & cost effectiveness
analysis
 Valuation of costs &benefits of public
projects
 Classification of public expenditure
 Patterns of the Ethiopia's public expenditure
4.0 Meaning and Nature Of Public Expenditure

• Government spending ( Public expenditure)

includes all government consumption and
investment but excludes transfer payments.
• Government spending has two basic classes:
i. Final consumption expenditure-Government
acquisition of goods and services for current use
ii. Government investment (gross fixed capital
formation)-Government acquisition of goods and
services intended to create future benefits
 4.1. Public Expenditure Objectives
• Public expenditure is made by governments to
meet some public objectives here as private
spending are made to meet private objectives.
• It can meet more than one objective
simultaneously.
 Provision of social and economic services.
 Provision of social-wants, growth and
distribution among regions & people
 Employment creation, raising income of the
low-income people
• The public provision of goods & services may
affect market prices or behavior:
 It has far-reaching effects beyond its direct
benefits.
4.2. Planning & Budgeting Public Expenditure
• Government must set priorities to control the total level
of spending & allocate it efficiently.
• These priorities should be based on two considerations
or principles:
i. An appreciation of markets where they can do
better.
ii. An efficient and effective public resource
utilization.
• Governments should concentrate their spending in
certain areas where their participation is necessary for
 a well functioning market,
 economic growth, and
 more equitable distribution of income.
• The medium term & the annual budget plan are the two
primary tools, which are typically used in controlling and
allocating public spending.
4.3. Economic Analyses of the Budget Process
• Economic analysis indicates the political effect of
proposed projects & can help prevent costly mistakes
by policy makers.
• Two basic analysis of G:
i. Objectively measurable projects = Cost-benefit
analysis
ii. Less objective or indirectly measurable
projects = cost-effectiveness analysis is used.
Measures outcomes of the project
4.3.1. Techniques for Evaluating
Expenditures/ Projects
i. PV & NPV - present value & Net present
value
ii. IRR - internal rate of return
iii. ARR - accounting rate of return
iv. Payback period
v. Discount rate
vi. PI - Profitability index
 Investment evaluation/Appraisal

.
1. Cost-Benefit analysis (CBA)
• Is the basic technique of economic appraisal
of expenditure or projects
• CBA determines if the total value of benefits
created by a project is greater than the total
costs that it imposes on society.
• CBA adds up all the benefits & costs of a
project to society, discounting them &
calculating the absolute amounts of the
discounted net benefit expected from the
project.
Difficulties of the CBA
• CBA involves inherent difficulties in how to
measure costs and benefits and choosing the
appropriate discount rate especially for public
projects.
2. Cost Effectiveness Analysis (CEA)
• Is a technique which is directed at minimizing the
costs of an agreed upon output or to maximize
such output with a given cost.
• Used for a large class of public expenditures in
which benefits are difficult to measure
= cost- effectiveness analysis
Fundamentals of Cost-Benefit Analysis (CBA)

• Government should achieve their objectives

in an effective & efficient manner, through
ensuring an efficient allocation of resources
among all expenditures.
• CBA for public sector attempts to measure
benefits and costs that extend beyond the
strictly financial dimension of a project.
Steps involved in CBA
1. Identification of all costs & benefits of public
projects
2. Valuation of all costs and benefits
3. Discounting all cost and benefits
4. Decide the project either to accept or reject
 1. Identification of Costs & Benefits
• Benefits and Costs may be
 real or
 pecuniary
• Real benefits are the benefits derived by the final
consumers of the public project.
 Reflect an addition to the community's welfare.
• Pecuniary benefits occur because of changes in relative
prices which in turn occur due to the intended public
project.
Types of Real benefits and costs
• Tangible versus Intangible
• Direct versus Indirect
• Intermediate versus Final goods
• Internal versus external (spillover)
2. Valuation of Costs and Benefits
• Once the benefits & costs are identified, the next step is
determining
“the monetary values of both costs and benefits”.
• This valuation depends on whether the resources used, &
the output produced by the public project is marketable
or not.
• Perfectly competitive markets:
Prices show the true values of inputs & outputs.
In such markets, prices of goods set to the level of
MC of the good.
• Imperfect markets :
Market price cannot reflect the true economic value
and cost of outputs and inputs. Why?
Due to such distortions including,
Taxes & subsidies,
monopoly,
public goods,
asymmetric information.
• Because of market distortions,
 a marginal social cost as seen from the supply side &
 marginal social benefits as seen from the demand
side
will not be equal.
• Hence, it becomes necessary to adjust market
prices so that it reflects the true value to society.
• Such adjusted values are referred to as
 "shadow prices” or
 “accounting prices”.
• Three sources of shadow prices can be identified depending
on the project's impact on the national economy.
• A project via its use of inputs & production of output affect:
 Supply available to society
 Level of its production in the rest of the economy
 Level of imports or exports
• Use of inputs (consumption of inputs) by a project
may:
 Decrease consumption of that input in the rest of
the economy.
 Increase production of the input within the
economy
 Increase imports or decrease exports.
• Terms of production of an output the project may:
 Increase total consumption in the economy.
 Decrease production in other parts of the economy
 Decrease imports or increase exports
• A project may have all the three impacts
simultaneously.
• Identifying these impacts is important.
The appropriate source of shadow prices is
different under each of the three
conditions.

Impact Basis of shadow price

• Consumption within • WTP to consumers
the economy (Price)
• Production within • Cost of production (MC)
the economy
• International Trade:
 Imports  Cost of imports (C.I.F)
 Exports  Value of Exports (F.O.B)
• Monopoly-value inputs used or output produced
at weighted
 market price, P &
 marginal cost, MC.
• Taxes & subsidies-depends on the impact of
project purchase (PP):
 If PP lead to MP, use producers price MC &
 If PP leads to no MP, use purchasers’ price, P
• Labor Input, Unemployment and Shadow
Wage rates
 If the project hires UE labor, its opportunity cost is
virtually Zero.
 If the project transfers already employed labor, its
opportunity cost is forgone production.
• It is reasonable that a positive shadow wage
rate is taken in the valuation of a project.
• In practice, most of these shadow prices
are provided by governments as National
Parameters and Conversion factors.
• When outputs (benefits) do not have
market value, indirect valuation methods
may be applied.
• The willingness to pay life insurance
premiums or wage differentials b/n safe &
hazard jobs.
• These refer to intangible private benefits.
3. Project Decision Rules

• Once estimates are made about costs &

benefits, it is necessary to
decide the combination of projects, which
would enter the budget.
• The rule is very simple. Choose the
combination that gives the greatest
net benefits.
• Discounting [Present values]
Remedy the problem associated with CBA
to compare costs and benefits that occur
at different times.
A. The Net Present Value [NPV] Criteria
• NPV is the sum of the difference b/n benefits
and costs that occur in the various years of the
project's life.
• It is the current value of all net benefits
associated with a project
• Net benefit is simply the
sum of benefits minus the sum of costs.
• The net present value of benefits is the present
value of those net benefits.
• The net benefits are converted to present
value by discounting.
• We say “net” present value because we subtract
the PV of cash outflows (costs, investment)
from the PV of cash inflows (benefits).
Sum of the PVs of all cash flows:

PV = Sum of discounted future cash flows

Initial cost often is CF0

NPV – Decision Rule

 The goal of capital budgeting: Find a decision rule that

will maximize shareholder wealth
The NPV rule:
 Accept project if NPV > 0 or NPV is positive
 If we accept a project with NPV > 0
 increase shareholder wealth
 Reject project if NPV<0 or NPV is negative
 If we accept a project with NPV < 0
 decrease shareholder wealth
 If two projects (A & B) have NPV>0 & compete for the
same fund if they are mutually exclusive, accept the
project with the higher NPV.
NPV rule intuition: look for projects with:
PV(cash inflows) > PV(cash outflows)
• NPV = PV (Cash inflows) - PV( Cash outflows)
 If NPV > 0 → Accept project
 If NPV = 0 → indifference
 If NPV < 0 → Reject project
• NPV > 0 means:
 Cover their operating costs
 Cover their financing costs
 Add value(wealth) to the firm (=NPV)
• NPV < 0, means:
 its return/benefits is less than the value of
the resources used.
• NPV is a direct measure of how well this
project will meet the goal of increasing
shareholder wealth.
• NB: Public projects feasibility may not be
evaluated in terms of single criteria.
B. Benefit-Cost Ratio(BCR)
• BCR is defined as the ratio of the present value
• of benefits to the present value of costs
• BCR is computed as the PV of Benefits divided by
the present value of Costs.
• Discounted benefits and discounted costs are
calculated and summed separately, then divided.
• This method attaches preference on the rate of
returns rather than the magnitude.
• A project with BCR exceeds 1 is acceptable.
CBR Decision
• If the project has a BCR > 1, then it is worth
considering on its economic merits.
• If the project has a BCR < 1, then it fails to
return benefits larger than its costs.
• Where two projects compete for the same
fund, the one with a higher benefit cost
ratio is preferable.
• In short:
 If BCR>1, accept the project
 If BCR=1,inddifeent
 If BCR<1, reject the project
C. Internal Rate of Return(IRR)
• The two criteria, benefit-cost ratio & Net present value,
are based on the assumption that project evaluation is to
be carried out by discounting at a uniform rate of
discount.
• Instead of computing the present values (by applying
discount rates) one may calculate
 the discount rate that would be needed to equate
the present value of the benefit stream with the
stream of cost.
Definition
• IRR is rate of discount which makes the present value
of benefits equal to the present value of costs.
IRR = discount rate(r ) that makes the NPV=0
• Technically solve for the IRR by finding r that solves:
PV (Benefits) = PV (Costs)
• IRR is the maximum interest rate that could be paid for
the project resources that would cover investment
costs & still allow society to break even.
IRR Decision Rule
• Accept the project if the IRR is greater than
the required return(r).
• Projects whose IRR exceed some minimum
rate of discount will be accepted
• If two projects are mutually exclusive, and
are both acceptable, choose the one with a
higher IRR.
Internal Rate of Return(IRR) is
• Most important alternative to NPV
• Widely used in practice
• Intuitively appealing
• Based entirely on the estimated cash flows
• Independent of interest rates
Inflation and Project Evaluation
• Inflation erodes the purchasing power of money.
• Thus, it creates a problem in project evaluation
by making money a poor standard for comparing
net benefits over time.
• When prices are expected to rise in the future,
one may either use nominal values or real
values (values measured at constant prices).
• To use nominal values the analysts consider
estimated (projected) rate of inflation (P) over
time.
• Once the estimates are obtained, the nominal
values of both future benefits & costs can be
determined by multiplying them by 1+P, where
p is the rate of inflation.
• Inflation, does not only affect the value of the
net benefits, but also
 market interest rates,
 saving rate of interest and
 the rate of returns on investment.
• Since the inflation adjustment factor
cancels each other,
 NPV calculated at constant prices (real
values) &
 Inflation and Project Evaluation at market
prices (nominal values)
will be the same.
• In project evaluation, one has either take
 nominal values of costs,
 benefits & discount rate or,
 real values of costs, benefits and
 discount rates consistently.
The Discount Rate
• Both in NPV & the benefit-cost ratio methods,
the acceptability & ranking of projects
depends upon the discount rate used, given
the length of time during which the benefits
from projects accrue.
• Higher discount rates disfavor projects
whose returns are concentrated further into
the future.
• Lower discount rates favor projects whose
benefits accrue over a long period of time.
• The higher the rate of discount, the smaller
will be the present value of the benefits
that accrue to society in the remote future &
vice versa.
 The Discount Rate(r )
Two basic arguments regarding r determination:
i. Public sector projects must reflect, the social
opportunity cost of the funds, revealed in the market.
• If fund is generated from saving , use consumption
rate of interest.
• If funds are generate from taxes, use saving rate of
interest net of taxes.
• If funds are from competing investment (crowd out
private investment), use the rate of return on private
investment
• Practically it is difficult to identify the source of funds.
• Thus, take the average of:
 after tax rate of return on saving &
 before tax rate of returns on investment to determine
the discount rate.
ii. The Social Rate of Discount is most
important concern of welfare for future
generation & market imperfections.
• Individuals are concerned only with their own
welfare.
• They underestimate the importance of saving
and overestimate that of present
consumption.
• Individuals devote too few resources to
saving; they apply too high a discount rate to
future return.
• If future generations are expected to benefit
from projects, investment must be
encouraged today by lowering r
• The government should correct such
inefficiency by applying a discount rate
lower than the markets.
4.4 Classification of Government Expenditures
For budgetary purposes government
expenditures are classified in two ways:
1. Functional classification
2. Economic(dual) classification
1. Functional classification
• The functions performed by governments
can be viewed under four headings:
i. General Government Services
ii. Community and Social Services
iii. Economic Services
iv. Other Functions
2. Economic(dual) classification
• Are kinds of transactions by which
 the government performs its functions &
 their impact outside government in the market
for goods & services, in financial markets and in
the distribution of income.
• A primary distinction is made between current and
capital expenditures.
 Capital Expenditures involve payments for the
acquisition construction, & purchase of non-
financial assets meant to be used for more than
one year in the process of production.
 Current Expenditures are all payments or
expenditures on goods and services (including
labor) interest payments, subsidies and other
current transfers.
4.5 Trends of Government Spending in Ethiopia
• Imperial Era: the ratio of government
expenditure to GDP rose from average of 8.6 %
in years 1960-1964 to average of 11.8% in
years 1969-1974.
• Derg Period: the Ethiopian government
spending has shown overwhelming expansion &
reached the maximum of 38% of GDP in 1988.
• EFDRE Era :a sharp decline in the relative size
of government spending during the early post-
1991 periods.
 Generally found to be lesser as compared to Derg
regime
 But, since 1997, the share has been rising steadily
in which 35% was registered in 2001/02.
4.6 Structure of Government Expenditure
Capital and Recurrent expenditure
 Capital expenditure is broadly defined as an
outlay on development projects that result in
the acquisition of fixed assets to enhance the
capacity of the economy for the production of
goods & the provision of economic and social
services.
 Recurrent spending comprises expenditure
items which are recurring in the process of
delivering government economic and social
services.
Functional Or Sectoral Classification
 Derives from broad objective of the government and
falls under four broad headings: general services,
economic services, social services and other
services which include debt services, subsidies and
other miscellaneous expenses.