The Impact of Fiscal Policy Shocks on Ethiopian Economy

Master's Thesis 2017 77 Pages

Economics - Finance


Table of Contents


List of tables

List of figures

List of Appendices



1. Introduction
1.1. Background of the Study
1.2. Statement of the Problem
1.3. Objective of the Study
1.4. Hypothesis
1.5. Justification
1.6. Significance of the Study
1.7. Scope of the Study
1.8. Organization of the Paper

2. Review of Theoretical and Empirical Literature
2.1. Review of Theoretical Literature
2.2. Review of Empirical evidences
2.3. Fiscal Policy in The Context of Developing economy and Its Role
2.4. Conceptual Framework

3. Overview of Ethiopian Economy
3.1. Government Revenues, expenditure and Economic performance
3.2. SAM based description of Ethiopian economy

4. Data and Methodology
4.1. Specification of CGE Model
4.2. Model closure and scenarios

5. Result and Discussion
5.1. The impacts of tariff cut on factor income
5.2. The impact of tariff cut on households income and expenditure
5.3.The impacts of tariff cut on macro variables
5.4.The impact of increasing direct tax on household income
5.5. The impacts of increasing direct tax on macro variables
5.6. The impact of reducing direct tax on factors and households income
5.7. The impacts of reducing direct tax on macro variables
5.8.Welfare effects of tariff cut and direct tax policy change

6. Conclusion and Policy recommendation
6.1. Conclusion
6.2. Policy implication
6.3. Limitation of the Study and issues for further study


Appendix I: Tax rate equations block
Appendix II: Tax Revenues equations block
Appendix III: Welfare result summary with measure of equivalent variation (EV)
Appendix IV Trends of government revenues and expenditure


Foremost, I would like to express my deep heart gratitude to my Advisor Dr. Solomon Tsehay for his endless effort to guide, comment, encouragement and sharing constructive idea to accomplish this study. And also I would like to thank Dr. Zerayehu for his encouragement and support on area of fiscal policy. My gratitude also goes to co-advisor Menberu Atalele and my friend Asmamaw Kassahun for their valid comments and encouraging me to succeed this study.

List of tables

Table 3.1 percentage share of government revenues and spending to GDP (1974-2014) on average

Table (3.2) Sectoral share from the total GDP at factor cost

Table (3.3) Macroeconomic aggregates in SAM 2009/10

Table (3.4) Share of factor income from total GDP at factor cost

Table (3.5) The percentage share of household income from different sources

Table (3.6) Percentage share of household’s expenditure on commodities

Table 5.1. Percentage change in factor income

Table 5.2. Percentage change in household’s expenditure when tariff cut

Table 5.3. Percentage change in household’s income when tariff cut

Table 5.4.Percentage change in income and expenditure due to increasing direct tax at 10%

Table.5.5.The impacts of increasing direct tax on macro variables

Table 5.6. Percentage change in macro variable because of reducing direct tax

List of figures

Fig (2.1) Circular flow of the economy under government intervention

Fig (3.1) Trends of economic growth by sectors

Figure (3.3) Percentage share of government revenue from different sources

Fig (3.4) Percentage distribution of total spending

Fig.5.1 Welfare effects of tariff cut and direct tax policy change

Fig (3.2) Trends of government revenues and expenditure (1976/77 - 2015/16)

List of Appendices

Appendix I: Tax rate equations block

Appendix II: Tax Revenues equations block

Appendix III: Welfare result summary with measure of equivalent variation

Appendix IV Trends of government revenues and expenditure


ADB: Asian Development Bank

AEO: African Economic Outlook

CES: Constant Elasticity of Substitution

CET: Constant Elasticity of Transformation

CGE-MSM: Compatible General Equilibrium – Micro Simulation Method

ECM: Error Correction Model

ECSA: Ethiopia Central Statistics Authority

EEA: Ethiopia Economic Association

EPDRF: Ethiopian People’s Democratic Republic Front

EV: Equivalent Variation

GDP: Gross Domestic Product

GTP: Growth and Transformation Plan

IMF: Internationl monetary fund

LDC: Least Developed Countries

LUNP: Large Urban Non Poor Households

LUP: Large Urban Poor

MoFED: Minstry of Finance and Economic Development

NBE: National Bank of Ethiopia

NFP-HH: Nonfarm Poor Households

NFNP-HH: Nonfarm Non Poor Households

NIPA: National Income and Product Accounts

NPC: National Planning Commission

OECD: Organization for Economic Co-operation and Development.

OLS: Ordinary Least Square

PASDEP: Plan for Accelerated and Sustained Development to End Poverty

R & D: Research and Development

RFP-HH: rural farm poor households

RFNP-HH: Rural Farm Non Poor Households

RoW: Rest of the World

SAM: Social Accounting Matrix

SDPRP: Sustainable Development and Poverty Reduction Program

SSA: Sub-Sahara Africa

RPHH: Rural Poor Households

RNPHH: Rural non poor households

RNPHH: Rural non poor households

UPHH: urban poor households

UNPHH: urban non-poor households

USA: United States of America

VAT: Value Added Tax

VAR: Vector Auto Regressive

WB: World Bank

WTO: World Trade Organization


Fiscal policy is one of the macroeconomic policies which play a decisive role on economic growth; especially in developing economies which have many economic and social bottlenecks. This study examines the impacts of fiscal policy shock on Ethiopian economy; through applying static compatible general equilibrium (Stage CGE) model which allows quantifying the impacts of fiscal instrument shock on the economy and welfare of households. Fiscal problems like small tax revenue and consistent fiscal deficit put its own major influences on developing economies performance. The study uses 2009/10 Ethiopian SAM as an input for the model and applies three simulation scenarios. In the first simulation, tariff cut affects GDP and household welfare negatively. In the second simulation increasing direct tax has negative impact on total GDP. The other alternative simulation scenario is reducing direct tax and which give a positive change on the total GDP. In general, the government should reduce direct tax to improve economic performance. In addition, liberalizing tariff is not advisable for Ethiopian economy.

Key words: - Fiscal policy, tariff cut, direct tax, Stage CGE model and Ethiopia economy.


1. Introduction

1.1. Background of the Study

Economic performance of a nation depends on many factors, which includes physical and human capital endowment, technological progress, institutions and population growth (Todaro and Smith, 2012). Another extremely important factor affecting economic growth is the set of macroeconomic policies, which are fiscal, foreign exchange and monetary policies.

Fiscal policy is concerned on government spending and taxation which is linked to government expenditure plan and taxation structure of an economy (Bernanke et al., 2001 and Black et al., 2013). Studying the impact of fiscal policy on once country economy is very decisive to have a sound economic environment. Since designing proper fiscal policy enables the government to attain economic objectives like reducing unemployment, price stabilization, income distribution, and economic growth.

The historic myth of fiscal policy in macroeconomic concern starts from Keynes who argues that understanding economic fluctuations and market failure should take into consideration and the role of government is necessary to manage this kind of economic events and to stimulate economic activities (Bernanke et al., 2001 & Vane et al., 2005 ).

Ethiopia has many economic and social bottlenecks, manifested by poor infrastructure and inadequate social services that require intervention of the government. Beside these, different studies find out that the role of government intervention via its spending and taxation policy plays an important role for economic growth. Studies also assure fiscal instruments contribute significant role for developing countries economic growth through creating employment opportunities, R & D, and infrastructural development (James et al., 2014).

The current government of Ethiopia has taken different Fiscal policy reforms which includes: decentralized budget administration, and amendment of tax policies like: -exemption of taxes on exports, introducing VAT, tariff exemption on capital goods for huge investments and other incentives. Beside these, government was made a reform on margin tax rate on income tax from 89% in the previous regime to 35% (Abebe and Alemayehu, 2005). Those fiscal policy reforms have playing a decisive role for Ethiopian economic growth especially for the last sixteen years (1999/2000 - 2014/15) the county’s economy was grown by 9% on average (MoFED).

Generally, the aim of this study is to analyze the impacts of fiscal policy shock on the Ethiopian economy through its taxation policy. To analyze this, the study uses static compatible general equilibrium (CGE) model; since CGE model enables to capture broad representation of economic variable relation in the economic system and in order to compute the impacts of policy changes or shocks on the economy.

1.2. Statement of the Problem

Learning from different reviews about fiscal policy of developing countries economy; small tax revenue due to weak tax administration, narrow tax base, and high tax evasion; high and cumbersome trade tax and negative fiscal balance is the major challenges for developing countries economy. Kefela (2009); Dan and Claudius (2010) assure these problems are series specially SSA countries including Ethiopia; Because of these developing countries economy unable to generate adequate tax revenue to finance economic and social development programs. Statistical facts also show that SSA countries could collect total tax revenue, 15% of their GDP on average from 2011 to 2015(NPC, 2016). In line with this, the share of tax revenue to GDP in Ethiopia is smaller compared to SSA countries average. This manifested by the fact that, tax revenue collected as percentage of GDP was 8.16% in 2010/11 and 9.2% in 2011/12 (IMF, 2016).

Dan and Claudius (2010) also identify cumbersome customs procedure and high tariff is the major obstacle for Ethiopian trade performance and which result to small share of trade to GDP and small tax revenue. Even though this problem set as obstacle; tariff is the major source of government revenue which takes the highest share. For instance, in 2012/13 tariff revenue was 30.8% , and 27.06% in 2015/16; while direct tax in the same fiscal year takes the share 29.3% and 31% respectively(MoFED).

Statistical facts and studies have confirmed that economies which rely on domestic tax bases secure sustainable economic growth (Hagen and Wyplosz, 2008; Yan, 2012). In line with this, broadening domestic tax is taken as policy option by most developed countries and it is effective in generating enough revenue and to finance government budget thereby sustainable growth would be achieved. For instance, OECD (2015) shown that most of European counties collected high tax revenue about 30% of their GDP on average from 1985 to 2015; however, this reality is bit far in Ethiopia context.

It is a clear cut that, changing taxation policy of a country affects the economic performance as well as the welfare of households. Maio et al. (1999) argue trade liberalization (removal of tariff) could not improve the economic growth of Africa in the long run, rather deteriorate social and economic indicators. While Dorosh et al. (2000) argue liberalizing trade can encourage the economic performance of Africa; Taylor and Estevadeordal (2008) also argue, liberalizing tariff on imported capital and intermediate goods has apositive result in promoting developing countries economic growth

The impact of tariff reduction (trade liberalization) in case of Ethiopia is inconclusive. Kebede (2011) tariff reduction improves Ethiopian economic performance and welfare of households; while Bisrat ( 2009) also argue complete removal of tariff in the ethiopian economy hampers the overall economy performance and worse welfare of households in the short run, however, it has positive impact in the long run. Belay et al. (2016) also argue tariff cut affects the overall economy negatively and results to get worse household welfare.

Ali et al. (2014) argue on his study, taxation effects on pakistan economy; increasing income tax affects the economy negatively through reducing consumption as well as reducing saving and investment. Macek (2014) also confirm an increase in corporate and personal income tax affect economic growth negatively.

As studies result shown about the impact of tariff reduction on Ethiopian economy is inconclusive; which is some of the finding suport tariff reduction and explain the postive impact while others argue tariff reduction is not effective in improving Ethiopian economic growth. However,currently Ethiopia is on the way of WTO accession request. Following, the accession request the country is forced to revise taxation policy in order to fulfill the membership criteria. One of the criteria that member counties are expected to fulfill is; “tariff rates on goods must considerably lower and service market must be more open to the international market” (Marković, 2009). However, reducing tariff may result to increase fiscal imbalnce or deficit and reduce government saving and investment.To manage this fiscal imbalance, government forced to see various policy options; one of the options is revising direct tax policy to replace the lost revenues through tariff reduction. In this respect, the share of direc tax to total government revenue which is generated from domestic tax base is smaller compared to import tariff. The main aim of this study also to analyse what could be the efects of this policy shock on the Ethiopian economy.

There are studies that have been conducted so far related to the impact of fiscal instruments on Ethiopian economy. Some studies have used CGE modeling (Fekadu, 2007 and Bisrat, 2009) while others used time series econometrics and most of them focused on the impact of trade liberalization/tariff removal/ on the Ethiopian economy. However, no much studies show the combined effects of tariff and other tax policy shocks on Ethiopian economy. The aim of this study is to bring additional knowledge in the area of fiscal policy through examining the combined effects of fiscal instruments on the Ethiopian economy by applying static CGE modeling analysis.

Therefore, the study addresses the impact of fiscal policy shock on Ethiopian economy through concentrating on the following research questions.

- What are the impacts of changing direct tax on the economy and welfare of households?
- What are the impacts of tariff cut on Ethiopian economy and households’ welfare?

1.3. Objective of the Study

General objective

The general objective of this study is to examine the impacts of fiscal policy shock on Ethiopian economy and welfare of households.

Specific objectives

- Describing the overall situation of Ethiopian economy.
- To examine the impacts of tariff cut on the economy and welfare of households.
- To examine the impacts of direct tax shock on the economy and welfare of households.

1.4. Hypothesis

There is no consensus about the economic impact of fiscal policy. Different economic schools argue in different way. Among economic schools, classical, new-classical and monetarists argue government intervention is bureaucratic and inefficient to improve output. While Keynesians and new Keynesians argue; fiscal policy is effective and government interventions necessary to uplift the economy from recession and manage market fluctuation. Different studies also assure that fiscal instruments play an important role for developing economies to promote and widening opportunities to economic growth (James et al., 2014 & G/Michael, 2014).

Standing from the Keynesian and New-Keynesian argument and other studies; this study hypothesize fiscal policy is effective in affecting Ethiopian economy; since there are many economic and social bottlenecks which cannot solved by market itself and needs government intervention.

1.5. Justification

The main reason to conduct this study is basically the incidence of fiscal policy problems which is characterized by highly dependency on import tariff, and fiscal disequilibrium in general. Besides this the country’s WTO accession request is also directly affects import tariff policy. To manage this problem and to improve the economic performance of the country, government should take proper fiscal policy actions. These fiscal policies are expenditure and taxation policies. So the study seeks to analyze the effects of fiscal policy change on the Ethiopian economy as whole and welfare of the households.

1.6. Significance of the Study

Ethiopian economic and political background is full of tragedy in different ruling party. Economic policies and political ideologies have contributions to the erratic nature of Ethiopian economy. The study focused on the issues of fiscal policy and its effect on the economy as well as welfare of households. It would have multiple contributions and brings additional knowledge through analyzing the effects of fiscal policy on the economy. There are studies have been done about the impacts of fiscal policy instruments’ separately i.e. on government spending, and taxation issues. However, no much studies done on the combined effects of changing fiscal instruments on Ethiopian economy through using CGE model. This study is intended to attract attentions of scholars on the effect of fiscal policy on the economy and welfare. Besides this the study has a methodological contribution through applying CGE modeling; since most studies conducted through times series analysis. Above all, the study would be important for different stake holders as an input for the purpose they intended to use it.

1.7. Scope of the Study

The study focus on analyzing the impacts of fiscal policy shock on Ethiopian economy and welfare of households and identifying which policy options are significantly affect the economy. The study uses CGE modeling to analyze the effects of fiscal policy shock.

1.8. Organization of the Paper

This study is organized with six chapters: The first chapter of the study includes background, problem, objectives, justification, significance and scope of the study. Chapter Two deals literature reviews which include both theoretical and empirical literatures as well as it discussed conceptual framework. Chapter three discuses general overview of Ethiopian economy and SAM based description. Chapter four discuses methodology, sources of data used in the study and model specification. Chapter Five explains result and discussion; the last chapter which is chapter six explains conclusion and policy implication.


2. Review of Theoretical and Empirical Literature

In this section the study discusses basically on theoretical and empirical reviews which are explained by studies related to the role of government in the economy through its fiscal instrument and its role to third world in special.

2.1. Review of Theoretical Literature

There is no feasible consensus about the impact of fiscal policy on economic growth between different economic schools and studies. Opponents argue government operations are bureaucratic and inefficient rather than promoting growth. Classicalists and monetarists argue fiscal policy through increasing government spending would increase aggregate demand and increases interest rate, which leads to crowding out private investment, without affecting output level (Heijdra, 2009). Mountford and Uhlig (2002) also find out and argued increasing government spending or positive shock results crowd out both residential and non-residential investment but it doesn’t affect consumption, in addition and increase in tax has a contractionary effect on output, consumption and investment. While proponents of government intervention on economic activity argue fiscal policy plays stimulating and stabilizing role to economic growth.

Following the great depression classical models challenged when market was irresponsible to manage itself and Keynes develop AD/AS model which conceptualize change in aggregate output in the short run determined by aggregate demand. In line with this, government plays an active role through it fiscal policy actions to improve the economy; when economic downturn happened. in addition to this fiscal policy has multiplier effect on output through government expenditure and tax multiplier (Heijdra, 2009 and Mishkin, 2012). Perotti and Blanchard (1999 & 2002) find out positive government spending shock affects output positively and positive tax shock affects output negatively and which holds Keynesian model.

In the contrary, Blinder (2004) the case against discretionary fiscal policy; find out monetary policy plays prominent role to stabilaze the economy than fiscal policy even if it affects aggregate demand in the short run. On the other hand, Carlos and Ethan ( 2008), and Parker ( 2011) supports the expansionary impact of fiscal policy on the economic growth of a country through stimulating aggregate demand when the economy is at recession.

Barro (1990) and Romer (1994) on the endogenous growth model; fiscal policy is responsible factor and endogenous part of economic growth through its instrument taxes and expenditures. Government spending on human capital development, science and technology and infrastructural development is an important spending category. So government interference is an essential and necessary for developing economies.

Besides this fiscal policy is described with the tax dimension which is the source of government revenue. In connection with this, many studies discussed fiscal multiplier issues including tax multiplier. Crichton and Vegh, (2012) identified tax rate as a true instrument to measure tax policy and they argue tax multiplier has contractionary impact on output; which means tax hikes results to contract out put through reducing aggregate demand and investment. Favero et al. (2015) and Giavazzi et al. (2016) on fiscal adjustment and its output effects; argued reducing government expenditure is almost costless; while increasing tax results to long lasting recession through affecting investment and consumption. Reducing government spending doesn’t show Keynesian effects; in the contrary tax hikes show Keynesian effects. Here the impact of fiscal policy on output depends on the model used and the data they used.

2.2. Review of Empirical evidences

A number of studies examined the impact of fiscal policy in general and tariff liberalization as well as direct tax (income tax reform) in particular on economic growth but there is no conclusive result. Some argues fiscal policy stimulates economic growth of developing countries while others argue it is not effective.

Kneller, (2000) examined the effects of public expenditure and tax on economic growth in order to test endogenous growth model and found that a positive and significant result on productive expenditures (education, health, and R&D); While non-productive public expenditure (social security, administration and others) is insignificant compared to productive spending. Besides this, increasing distortionary tax (income tax) reduces economic growth significantly; and non-distortionary tax (consumption tax) has negative effect but insignificant effect on economic growth.

Annabi et al. (2005) examined the impact of trade liberalization on growth and poverty in Senegal by employing CGE- micro simulation model analysis and found, full tariff removal leads to increase poverty and inequalities in the short run. While in the long run trade liberalization enhances capital accumulation particularly in the industrial and service sectors and brought a significant increase in welfare and decrease in poverty. K.Bhasin et al. ( 2005) examined the impact of trade tax removal on poverty and income distribution of Ghana through increasing VAT by using two senarios; i.e. eliminating import related tax and increasing 100 % VAT, and elimination of export tax accompined with 100% increase in VAT and the finding shows the incedences, and depth of poverty and income distribution among households were improved in the first scenario. While in the second scenario they finding shows t the incedence, and severty of poverty increase and income distributions were worsening.

Baris and Metin (2017) examines the effect of reducing personal income tax on welfare and macroeconomy of Turkey through applying static CGE and found that, postive effect on the overall economy and mixed welfare effect which is negatively affect welfare of poor households and positive effect to rich households welfare.

Dartanto (2009) conducted a study on measuring the effectiveness of fiscal policy in alleviating poverty incidence in Indonesia by using CGE-MSM and found different results through simulating different fiscal instruments. Among the findings the increased transfer financed either by increasing VAT rate or increasing income tax rate was not effective to alleviate poverty; because both progressive transfer and VAT results for inflation which worsens welfare of poor households. On other side government spending on education, health and infrastructures financed through increasing income tax shows a significant result in reducing poverty incidence.

Seid (2007) used sequential dynamic CGE model to analyze the potential impact of trade liberalization on poverty and inequality in case of Ethiopia. The study was incorporated the linkage between trade liberalization, growth, income distribution and poverty and examined the effect of gradual and rational liberalization. The finding shows that, a negative effect on real GDP in the short run. As the study indicates the effect of trade liberalization on poverty, welfare, income distribution and growth is inconclusive and it depends on time duration. Alekaw (2011) examined the effects of tariff reduction on income inequality and growth by applying CGE-MSM and find out tariff rate reduction followed by increasing other tax revenue source is insignificant effect on the economy as whole, poverty reduction, and income distribution in Ethiopia. But, replacing tariff revenue lost by increasing direct tax has some positive effect in promoting growth, increase in social welfare, reducing poverty and narrowing income inequalities, but it was insignificant.

On the other hand, Jibril (2012) exmined the impact of public spending on economic growth and poverty reduction in case of Ethiopia through using dynamic CGE analysis. The study find out that public spending contributed significant role to growth of the macro economy, welfare and poverty reduction. According to Eshete Z.S. (2014) composition of public spending and efficiency has an impact on economic growth and household welfare in Ethiopia. The study was conducted through applying recursive dynamic CGE model. It discloses that the role of government through expanding public investment in productive economic activities and improving its efficiency gives an encouraging result in the growth of GDP as well as the welfare of households. Sang-ho (2015) examined the effect of fiscal spending on employment and welfare with CGE analysis in Korea. According to the study reveals fiscal spending influences positively both employment and welfare through increasing job creation, education and healthcare services.

As discussed both in theoretical and empirical review there is no consensus among economic schools as well as researchers. The reason for those conflicting results methodological difference, time variation, economic structure of the country and other political reasons may contribute its own effects. However; the reasons listed as citrus paribus most studies result show that fiscal policy towards capital spending has a significant influence on the economy.

2.3. Fiscal Policy in The Context of Developing economy and Its Role

Fiscal policy promotes growth through its tax and expenditure policies. At macro level, it plays an important role by ensuring macroeconomic stability, creating employment opportunity, promoting investment, and increasing productivity. Well-targeted tax incentives can stimulate private investment and enhance productivity through research and development (R&D); efficient public investment, especially in infrastructure, can raise the economy’s productive capacity (IMF, 2015).

Fiscal policy can also have a major impact on medium and long-term economic growth. Public spending on infrastructure, such as roads, ports, tele communication and power plants, has signficant effect on productivity of firms and industries, and the entire economy. similarly, public spending on education, health can boost human capital, which is a vital ingredient to long-term growth (ADB, 2014). Studies also assure that fiscal policy has significant impact on the economy. For instance a study conducted in Nigeria shows that government expenditure signficantly affects manufacturing sector out put and the economy at large and also it shows a longrun relationshipe between fiscal policy and manufacturing sector output (Eze et al., 2013) .

Mahaphan (2013) found that the effets of increse in total tax has postive effect in the tiland economy for a short period and negative in the long run. In the same study an increase in income tax affect the economy positively. Most litrature argue an increasing in taxes can harm growth because it distort economic incentives and household behavior; for instance, corporate income taxes have a negative impact on investment. In contrast cuting tax rate may have positive impact on an economy through increasing after tax rewards, consumption, saving and investment. Glomm and Ravikumar (1997) assessed the role of productive government expenditure through allocating for inputs of economic growth like infrustructures, and technological investment. On the other hand government spending on public health and education increase human capital which play a vital role for economic growth.

In most LDC’s, fiscal policies are recommended to stimulate economic growth, stabilizing the economy and strengthen domestic revenue, which enable to finance deficits incurred in the process of expansion. When aggregate demand is deficient, active fiscal policies play a central role in motivating the economy and accelerate economic growth. Public investment plays a crucial role in increasing the rate of economic growth, through providing a demand stimulus to the economy and expanding its productive capacity. Thus, public spending is essential to a pro-poor and pro-growth economic strategy to manage demand, capacity creation, and redistribution (G/Michael, 2014).

In the modern economic history Ethiopia has owned basically two different fiscal policy features. The first one; fiscal system of Ethiopia has been characterized by highly centralized and concentrated fiscal decision-making power at the center which was applied by last regimes and the second is the current fiscal system of Ethiopia has some difference from the previous systems by its decentralized budgeting.

The current government introduce a number of fiscal policy reforms which improves government revenue and relatively better budgeting structure. The amendments in the taxation policy which is like: elimination of taxes on exports, introduction of VAT, and decentralized budgeting has playing an important role for government revenue and economic growth (Moges, 2001).

Ethiopian government was introduced VAT in 2003; in order to improve its revenue performance. Following this and other policy measure the country improves its tax revenue collection from time to time. In the recent year’s Ethiopian tax revenue shows remarkable growth; for instance, during the first GTP tax revenue increases from 43 billion birr in 2009/10 to 165 billion birr in 2014/15 with average growth rate 31%. During the same period the country’s economic growth was 10.1% on average annually (NPC, 2016).

2.4. Conceptual Framework

Fig (2.1) Circular flow of the economy under government intervention

Abbildung in dieser Leseprobe nicht enthalten

Figure (2.1) shows the circular flow of the economy under government intervention. The study designs this figure for the convenience to conceptualize and analyze the effect of government intervention in the economy through its taxation and spending policy.

Fiscal policy enables the government to direct the economy through expenditures and taxation policies. Governments may want to increase its revenue to finance their budget gap or to mobilize additional resources or stimulate the economy. To achieve this target government, intervene to the economy through fiscal policy. This policy influences households and the economy at large directly or indirectly. To increase government revenue government, change its taxation policies; in such case households affected directly or indirectly. An increase in income tax influences the households through reducing their disposable income and consumptions. In the reverse when government reduce income tax, increases household’s disposable income; this leads to an increase in consumption, saving and stimulate aggregate demand in the economy at large.

On the other hand, government intervenes to the economy through its spending policy. Collected revenues through tax are used to finance public goods such as infrastructure like road, electric utility, communication and others, health care, education, security and other government services. Government also plays an important role through conditional cash or other technical transfer to poor households in the form of safety net programs and other social transfer which enables to improve household welfare. Government can influence firms directly through providing subsidies to promote the economy like tax incentives which is tax holyday, and other incentives. Besides this, Government influences the factor market through reducing unemployment by increasing expenditure to create employment opportunities and directly involves in the factor market through hiring labor and capital goods for public investment.

Government influences the commodity market through direct purchase of final commodities and intermediate inputs for public investments. When government apply expansionary fiscal policy or increase its spending, results to increase aggregate demand and stimulate commodity market which promote economic growth. However, an expansionary fiscal policy may result to inflationary pressure if not managed well.


3. Overview of Ethiopian Economy

In this chapter the study discusses about an overview of Ethiopian economy by focusing on the structure, growth, and fiscal performance of the economy. In addition, it also describes the linkage between government spending and economic growth.

The economic behavior of Ethiopia varied from regime to regime. This is mainly due to change in government structure and their policy options. In the modern political economy history, Ethiopia passed three regimes including the current government; these are, the imperial regime (1930-1974), military regime (1974-1991) and the current regime since 1991 and then. Those regimes share common problems which are policy inconsistency, internal and external war, drought, and unpredictable economic behavior.

Ethiopian economy is characterized by the dominance of agriculture; however, recently this dominancy has been declined. For instance, the empirical facts show that agriculture shares 40.1% of GDP in 2013/14 and decline to 38.8% in 2014/15. While the shares of other sectors were increased in the same fiscal year, industry sector increase from 13.8% to 15.2% and the remaining around 46% was shared by service sector (MoFED, 2014/15). As the statistics indicate Ethiopian economy sectorial share of GDP shifts from agriculture sector to service sector in the last few years (NBE, 2014/15).

Fig (3.1) trends of economic growth by sectors

Abbildung in dieser Leseprobe nicht enthalten

Source: Author’s summery based on MoFED data base

As shown on the figure above Ethiopian economic growth is full of ups and downs or it is characterized with erratic economic performance.

3.1. Government Revenues, expenditure and Economic performance

Economic performance of Ethiopia varies depending on the corresponding political regimes and policies adopted. During the imperial regime Ethiopia was following liberalized economy while in the military regime the policy was changed to command or centralized economic system and the current regime also adopted different economic systems. Those are liberalized, pro-poor and developmental state economy which is ongoing.

Following the revolution of 1974, the imperial regime was overthrown and placed with military government. The economic system in this regime was centralized command economy, where the market was administered by the government. The overall policies were favoring expansion of collectivism and public enterprise; while private enterprises were de-motivated and have insignificant contribution to the economy. The average annual growth of GDP and GDP per capita were 2% and 0.5%, respectively during the entire period of the regime (EEA, 2007/08, Alekaw, 2011, and Tewodros, 2015). The economic growth in the regime was lower compared to the previous regime which was 3.7% on average and the per capita was grown by 1.4% between 1960-1974 fiscal year; this is mainly because of the regime spends most of its budget for defense instead of developmental sectors. During the regime defense expenditure had covered 8.4% of GDP on average; while the share of expenditure for economic development was 6 % of GDP. On the other hand, the share of recurrent expenditure to the country’s GDP during the regime was three times of the share of capital expenditure which was 19.1% of GDP (MoFED).

During the military regime government collected its revenue from different sources both from domestic and external grant. Tax revenue sources were like direct tax, indirect tax, import tariff, and export tax. From those listed revenue sources direct tax took the highest share with 23.4% of total revenue and followed by non-tax revenue 21.9%, domestic indirect tax 19%, import tariff 14.7%, external grant 11.9%, and export tax 9.1% (MoFED).

Table 3.1 percentage share of government revenues and spending to GDP (1974-2014) on average

Abbildung in dieser Leseprobe nicht enthalten

Source: calculated based on MoFED data

Since 1991 the current government after placing the military regime, made a wide range of reforms like, tax system, exchange rate, trade policy, domestic production and distribution. This regime can be sub divided in to three regimes based on the policy adopted; the first neo-liberalization regime which was from 1992/93-2000/01. During this period the government focused on liberalization of price and market, reduction of tariff, removal of subsidies and other related reforms. Following this reform, the country’s import by value was grown by 22.3% on average annually; this growth is five times that of the military regime which was 4.5% annually from the year 1979/80 to 1990/91. Export was also grown by 35.7% on average and this was higher compared to the previous regime which was grown by -2.8% from the period 1979/80-1990/91. Even though, export have shown a remarkable growth; trade balance of the country remains negative. During the period from (1992/93-200/01) GDP and per capita GDP was grown by 5% and 2.4% on average respectively (MoFED, 2002).

The fiscal pattern from 1992/93- 2000/01 was unpredictable and erratic. For instance, the growth of tax revenue in 1993/94 was 39.5 %; but this figure could not continue with the pace rather it declined and registered negative growth which was -1.2% in 1997/98 fiscal year. On the expenditure side capital expenditure have registered the highest growth in 1992/93 by 87.5% and decline then after.



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impact fiscal policy shocks ethiopian economy



Title: The Impact of Fiscal Policy Shocks on Ethiopian Economy