MONETARY AND FISCAL POLICY AS TOOLS FOR GOOD GOVERNANCE

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MONETARY AND FISCAL POLICY AS TOOLS FOR GOOD
GOVERNANCE

• Samuel S. Jibao Assistant Lecturer, Department
  of Economics, University of Pretoria

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OUTLINE

• Monetary Policy
• Definition
• Changes in the international policy setting
• - Targets and Instruments of Monetary Policy
• The link between the money supply and policy
  targets
• CONCLUSION Monetary Policy
• FISCAL POLICY
• - Definition of Fiscal Policy

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OUTLINE

• -Key fiscal objectives
• GOVERNMENT REVENUE
• Issues on taxation
• Prerequisites for a Good Tax System
• Tax Compliance
• Tax Compliance Issues
• Decision to non- comply
• Measures to improve Tax Compliance

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Part I MONETARY POLICY AS A TOOL FOR GOOD
GOVERNANCE
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MONETARY AND FISCAL POLICY AS TOOLS FOR GOOD
GOVERNANCE

• MONETARY POLICY
• Definition
• Monetary policy involves all the deliberate
  decisions and actions by the monetary authorities
  to influence
•        the monetary aggregates,
•        the availability of credit,
•        interest rates and
•        exchange rate,
• with a view to affecting monetary demand, income,
  output, prices and the balance of payments.

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Changes in the international policy setting

• World War 2 to 1971 Discipline
• fixed exchange rates
• smooth the business cycle
• From 1971 to 1980 Instability
• Large deficits on the balance of payments
• Exchange rate depreciation
• inflation accelerated
• From 1980 to 1990 Stability regained
• More market related monetary policy.
• Low inflation by following strict macroeconomic
  policies.
• Stability regained in spite of the monetary
  supply targets generally not being very
  successful.
• Furthermore the Central Banks independence in
  many countries was strengthened.

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1990 - 2005 transparency and increasing global
integration

• Strict monetary and fiscal policies.
• Increasing world integration raised cross- border
  financial flows.
• A reduction in policy freedom in individual
  countries.
• Volatile capital flows internationally brought
  problems of their own.

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Since 2005 More volatility in economic
variables with more pressure on monetary policy

• Rising food prices.
• Rising fuel prices.
• Rising inflationary pressures.
• Increased interest rates.
• More volatility in exchange rates.
• Pressure on Fiscal policy - more intervention?

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Targets and Instruments of Monetary Policy

• Policy targets
• Price stability
• Economic growth
• Exchange rate stability
• Monetary policy instruments
• Open market operations
• The setting of the bank/discount/repo rate
• Reserve requirements
• Selective credit controls
• Public debt management

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The link between the money supply and policy
targets

• Monetary policy can achieve either a price level
  target or an output target, but not both.
• With instruments that directly only affects the
  money supply, the central bank can only achieve
  one target.
• The flows between monetary policy instruments and
  targets can be illustrated as follows

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The link between the money supply and policy
targets

Intermediate

Policy
Opera
ting
targets

instruments

targets








Money
Open market
Repo rate

PP

stock

operations



Borrowed




Interest
Accomodation
reserves


rates



policy - Repo

Non
-




Price level

Reserve
Borrowed



Nominal
requirements

reserves




GDP

Public debt
management



Final Targets




Inflation rate




Unemployment
rate




Real GDP


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CONCLUSION Monetary Policy

• Good governance through monetary policy could
  imply that certain targets are set for variables
  such as inflation, the growth in the money
  supply, or the exchange rate.
• In South Africa today the policy target is the
  inflation rate through the process of inflation
  targeting.
• Good governance in this country implies that the
  inflation rate as measured by CPIX (i.e. consumer
  prices minus bond rates), is set between 3 and
  6.
• This has become important in the globalised world
  and the difficulty to compete in international
  markets.

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Part II FISCAL POLICY AS A TOOL FOR GOOD
GOVERNANCE

• Revenue and expenditure policies

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Definition of Fiscal Policy

• Fiscal policy entails the ways in which
  government intervenes in the economic activity of
  a country
• through its expenditure priorities, and also, the
  way in which such expenditures are financed
  through taxes and borrowing.
• Fiscal policy as a tool in good governance has
  both an active- and passive element.
• The active element implies that the government
  takes a deliberate step to do something, for
  example to decrease the budget deficit.
• The passive element implies that the government
  is not doing something, for example, no tax
  rate changes are announced in a particular
  budget.

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Key fiscal objectives

• Economic growth - synchronize policies
• Ensure fiscal stability
• Address the deepening of poverty
• Progressively raise the ratio of capital
  formation to GDP
• Address the saving catastrophe
• Ensure continuous productivity growth
• Address high costs of power, transport,
  regulatory requirements, security and other
  indirect costs that depress the productivity of
  firms
• Upgrade deteriorating infrastructure
• Promote enterprise development and deregulation
  especially small businesses
• Eliminate bottlenecks that prevent more effective
  delivery of social services
• Strengthen local and provincial government
  service delivery

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GOVERNMENT REVENUE

• Why do governments use taxes to intervene in the
  economy?
• Raise revenue
• Redistribution of income
• Encourage/discourage certain behaviour
• (sumptuary taxes)

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GOVERNMENT REVENUE

• Revenue derived from various sources taxation,
  loans and income from property.
• Some of these taxes are visible (for example
  income tax) others are less visible to the
  consumer because they are levied on the producers
  of raw materials and intermediate goods such as
  VAT.
• Taxes can be classified as being direct or
  indirect.
• A direct tax is paid directly by the taxpayer to
  the Revenue Service eg. Income tax.
• Indirect tax is paid on goods and services, and
  is paid to the Revenue Service by a third party.
  
• Eg. VAT and customs taxes.

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Issues on taxation

• Progressive tax
• Progressive tax indicates that the percentage of
  the tax paid on income will increase as income
  increases.
• Eg. Income taxes
•  
• Proportional tax
• The taxpayer pays a fixed percentage of tax for
  different levels of income. This implies that
  the average tax rate is unchanged for all the
  taxpayers (independent of levels if income
  earned.
• Regressive tax
• The percentage tax decreases as income
  increases.
• Eg. VAT

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Prerequisites for a Good Tax System

• Equity (Fairness)
• Efficiency (Neutrality)
• Administrative feasibility (Simplicity)
• Flexibility

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Prerequisites for a Good Tax System

• Equity (Fairness)
• An equitable tax system should be in line with
  the
• Benefit principle
• Ability-to-pay principle
• The tax burden should be spread fairly across the
  tax base.
• If not it will create incentives for people to
  avoid or even evade taxes.   

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Prerequisites for a Good Tax System

• Equity (Fairness)
• The benefit principle
• People should be taxed if they directly benefit
  from the availability of certain goods and
  services that the government provides.
• Known as user charges.
• Can be implemented where exclusion is possible.
• Ability to pay principle
• People pay tax according to their economic
  ability (may be either income/wealth or both.
• horizontal equity
• vertical equity

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Prerequisites for a Good Tax System

• Efficiency (Neutrality)
• Taxes may distort prices and therefore distort
  the allocation of resources and cause economic
  instability.
• Creates deadweight-losses.
• Economists always conduct incidence analyses to
  determine true tax burden.
• High tax percentages may affect the behaviour of
  taxpayers in the economy.
• The cost of taxation (i.t.o economy-wide resource
  allocation) should be kept as low as possible.

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Prerequisites for a Good Tax System

• Efficiency (Neutrality) Incidence Analysis
• The person who pays the tax to the authorities
  may not be same the same person who carries the
  eventual tax burden.
• Since taxes impose an additional cost on people,
  they will try to shift the burden of tax onto
  someone else.
• Tax evasion is a deliberate and deceitful effort
  by the taxpayers to avoid their tax obligations.
  This is a criminal offence - punishable by law.
• Tax avoidance implies that a taxpayer changes
  his/her behaviour so that the personal tax
  liability is minimised.

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Prerequisites for a Good Tax System

• Administrative feasibility (Simplicity)
• The tax system has to be simple enough, so that
  every person knows exactly how much tax he/she
  has to pay.
• Taxes create costs for the taxpayers. This cost
  does not only include the tax payments, but also
  the cost of keeping tax records and the
  expenditures on financial advisers.
• This type of cost is called compliance cost.
• On the administrations side there also exists
  enforcement costs.
• A good tax system should try to minimise both
  these costs.

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Tax Evasion Vs Tax Avoidance

• The classic distinction between avoidance and
  evasion is due to Oliver Wendell Holmes, who
  wrote
• "When the law draws a line, a case is on one side
  of it or the other, and if on the safe side is
  none the worse legally that a party has availed
  himself to the full of what the law permits. When
  an act is condemned as evasion, what is meant is
  that it is on the wrong side of the line..."
  (Bullen v. Wisconsin (1916), 240. U.S. 625 at
  p.630).
• Thus, the distinguishing characteristic of
  evasion is illegality.
• Tax evasion is the illegal manipulation of ones
  affairs with the intention to escape taxes. Tax
  evasion is illegal
• Tax avoidance is the rearrangement of a
  taxpayers affairs, within the law, in order to
  reduce tax liability. Tax avoidance is legal

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Tax Evasion Vs Tax Avoidance

• Tax avoidance has got to do with substitution
  effect of taxation. Whenever one activity is
  taxed more highly than others, people will switch
  to the lightly taxed or untaxed activity e.g
  increase in tax on labour income results in the
  following
• Putting in more hours to compensate
• More leisure (untaxed)
• Home production increases- you keep on working
  the same hours, but you divide them between
  market work and untaxed home-production.
• However, If two neighbours both decide to
  increase their home production, and at the same
  time they exchange goods in kind, they should be
  taxed if not, they are said to be operating in
  the underground economy.

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Reasons for honesty

• People may tend to overestimate both the
  probability and magnitude of penalties
• The fear of social stigma or damage to their
  reputation if they are exposed as cheaters.
• People pay tax because it is linked to
  governance. In the words of Friedman (20031)
  we obey the rules when the government does its
  job and ensures that the systems are in place to
  force us to comply

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Reasons for Non-compliance

• Negative attitude of citizens toward the
  government
• Inadequate services from the Government-
  taxpayers believe that they do not receive value
  for money when comparing the services
• Community standards- when the general level of
  honesty in the community is low the compliance
  level is usually very low
• The level of corruption- high levels of
  corruption by officials lead to dishonest
  taxpayers
• Inadequate interest/penalty regimes, which
  encourage taxpayers to evade filling returns and
  paying tax or borrow from the government.

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Reasons for Non-compliance

• Low risk of discovery-the perception that the tax
  administration is weak and the chances of being
  caught are low enough to take the risk
• Ignorance and confusion
• Poor service by the tax administration
• High compliance costs
• Defective law

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Creating Tax Compliance

• Introduce self-assessment
• Administrative assessment is not compatible
  with modern tax administration
• Self-assessment helps improve effectiveness by
  focusing resources on (1) tax services and (2)
  compliance enforcement (instead of paperwork)
• Self-assessment helps reduce compliance and
  administrative costs
• Self-assessment helps reduce corruption

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Creating Tax Compliance

• Adequate services from the Government- taxpayers
  should receive value for money when comparing
  the services provided by Govt.
• Keep the rates low fight tax base erosion- in
  most countries tax base erosion has led to high
  marginal (effective) tax rates. Following
  Allingham/Sandmo- model, the lower the marginal
  rate, the lower tax evasion.
• Focus on the probability of getting caught
  (ignoring risk seekers)- more effective than
  increasing the penalties- increasing only the
  penalty without increasing the probability, is
  inequitable.
• Make sure penalties are quickly applied
  (deterrent taxes should deter)

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Creating Tax Compliance

• Educate citizens- Politicians should set the
  standard.
• Identify main sources of underground activity and
  incorporate them into the tax system
• Reduce compliance cost- simple and transparent
  procedures i.e simplified tax regimes.
• Electronise the economy (making cash transaction
  limited)

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GOVERNMENT EXPENDITURE

• The government participates in the economy by
  producing goods and services.
• Government provides the community with collective
  goods, such as education, defence, infrastructure
  and health services.
• The composition of government spending reflects
  changes in the economy, social conditions and the
  priorities i.e.
• consumer preferences
• political and other shocks
• redistribution of income
• government failure
• population growth and urbanisation

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GOVERNMENT EXPENDITURE

• Functional classification of government spending.
• defence and on health services.
• Budget deficit
• expenditures exceed revenues.
• This deficit has to be financed to get the budget
  to balance.
• Deficits are usually expressed as a percentage of
  the GDP.
• Good governance would imply that the ratio stays
  within limits that are acceptable for sustainable
  economic growth.
• A rule of thumb is that the ratio in any
  particular fiscal year should not exceed the
  three per cent (3) level.

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DEFICIT FINANCING

• Affects levels of national saving, investment and
  the current account on the balance of payments.
• Sources of finance
•        Loans
•        Domestic
•        Foreign
•        Loan levies
•        Treasury bills

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GOVERNMENT DEBT

• Difference between the government debt and the
  deficit.
• The goals of debt management are
• Financial certainty
• Debt service minimisation
• Macroeconomic stabilisation and time consistency
• The significance of public debt can be expressed
  as a percentage of GDP.
• According to the Maastricht Treaty this ratio
  should not exceed the sixty per cent (60) level.

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CONCLUSION Fiscal Policy

• Good governance in fiscal policy implies a
  government that is committed to increasing the
  level of welfare of all the citizens of the
  particular country.
• Welfare levels could be raised by both government
  revenue programmes, or direct or indirect
  expenditure programmes.

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Readings

• Harvey S. Rosen/ Ted Gayer Public Finance (8th
  Ed)
• Libanior Gilberto (2005) Good Governance in
  Monetary Policy and the negative effects of
  Inflation Targeting available at
  www.policyinnovations.org/ideas/policy_library/dat
  a/01191
• Silvani CA (1992) improving tax Compliance in
  Bird R. and Casanegra de Jantscher M (eds)
  Improving Tax Administration in developing
  Countries (IMF Washington DC, pp 276-287,
  293-297.