Concept of Money, Financial Institutions and Public Finance

Welcome to Section 9. Hope you are enjoying your lessons. Have you ever wondered why people keep money? In this section, you will learn the reasons for holding money and how this works in Ghana. People keep money for different reasons, like buying things, saving for emergencies, or investing for the future. Also, you will learn more about taxes (money that the government collects from people and businesses), the different types of taxes, like income tax and VAT, and why they are important for the country.

Finally, you will identify the advantages and disadvantages of taxes on an economy. Even though taxes help to fund important services like schools and hospitals, they are sometimes a burden on people and businesses.

KEY IDEAS

• People hold money for three main reasons: transactions (to buy goods and services), precaution (to save for emergencies), and speculation (to invest or take advantage of future opportunities).

• Taxation is based on principles such as fairness and the ability to pay, and there are different types of taxes, including direct taxes (like income tax) and indirect taxes (like VAT), which are classified based on how they are collected.

• The advantages of taxation include funding essential public services like education, healthcare, and infrastructure, which benefit society as a whole.

• The disadvantages of taxation can include placing a financial burden on individuals and businesses, potentially reducing their spending or investment, and sometimes discouraging work or productivity.

Various reasons account for why organisations and people hold money. These reasons are based on some motives which can be classified or categorised into three main motives. These are the transaction motive, precautionary motive, and the speculative motive.

Figure 9.1: Picture of Cedi and Dolar notes as trading currencies for businesses in Ghana Transaction Motive The transaction motive for holding money is to cover daily expenses, business operations and immediate purchases. These include:

Daily expenses People and organisations have certain daily expenses which are necessary for managing their day-to-day activities. For example, expenses on food, transportation and utilities make our daily life better and you cannot avoid them.

Business operation Businesses hold money to be able to cover their day-to-day operational expenses. For

example, payment of salaries, rent and supplies.

Immediate Purchases

People and organisations hold money for things that will happen in the near future.

For example, tickets to a concert, movie, or sporting event happening soon or special occasions like weddings or birthday celebrations.

Precautionary Motive

The precautionary motive for holding money refers to keeping funds available to cover unexpected expenses or emergencies.

Unexpected expenses People and organisations hold money as a result of some unforeseen circumstances that might happen to them. It is important to be prepared for things like unexpected car repairs, medical emergencies or job losses.

Business Contingencies

Businesses hold money so that they can meet certain unforeseen events. They hold money as a result of unexpected drops in sales or unexpected disruptions such as breakdown of equipment.

Economic Uncertainty

This refers to situations where the future economic outcomes are uncertain and unpredictable. People or organisations hold money to prepare for economic volatility.

Here are some simple examples:

• Farmers: Farmers keep money aside in case of drought to pay for irrigation projects if the expected rains don’t come.

• Businesses: During inflation, businesses hold extra funds to manage the increased costs of supplies and inputs, helping them to cope with rising prices.

Speculative Motive

People or businesses hold money so that they can take advantage of money-making investments. There are three speculative motives for holding money.

Investment Opportunities

People and businesses take advantage of potential investment opportunities to buy stocks at low prices.

Interest Rate Changes

People or businesses hold money in anticipation of future changes in interest rates when higher returns might be made in the future.

Market Timing

People or businesses hold money simply waiting for favourable conditions so that they can make large purchases or investments with the anticipation of maximising profit or returns.

Note: You can use the internet to research for more examples of the motives for holding money.

Activity 9.1

For this activity you should work with a partner.

1. In your pairs, discuss the three motives for holding money.

2. After your discussion decide on a definition for each motive and write it down in your notebook.

3. Read the following examples below which are all motives for holding money

• A real estate investor keeps cash ready just in case a property comes on the market at a bargain price.

• A person has cash in their wallet to buy food from a chop bar, bus fares, rent, and drinks.

• A person has a savings account with a few hundred cedis for emergency medical expenses.

• A business owner keeps money to pay workers and buy stock.

• A manufacturing company keeps cash to cover unexpected equipment breakdowns.

• A stock trader who keeps cash ready to invest when the market prices are lower will drop so they can buy shares at a lower price.

4. With your partner decide which motive each one is. Copy and fill in the table below.

Motive Example

5. Think back to your discussion and add one example of your own to the table for each motive.

6. Present your findings to the class or produce a digital presentation to show you understand the motives for holding money.

Financial institutions play very crucial roles in an economy where they facilitate the flow of money, provide services, supporting growth and stability within the economy.

The primary roles of financial institutions include intermediation, facilitating payment, providing liquidity, risk management, mobilising savings, economic stability and growth, financial inclusion, and provision of information.

Figure 9.2 Picture of World Bank as a financial institution Roles of Financial Institutions Intermediation As a go-between for borrowers and savers, financial institutions collect savings from individuals and businesses and lend this fund to others who need capital. They allocate funds efficiently and ensure that the most productive investments are made.

Facilitating payments By providing payment mechanisms, they operate check accounts, credit and debit cards and electronic systems which enable the economy to function smoothly. They ensure that payments are promptly and accurately executed by managing the process of clearing and settling transactions.

Providing liquidity They offer credit lines and short-term loans and provide businesses with the needed cash to manage day-to-day emergencies and operations. They participate in financial markets and help maintain cash flows and allow for quick buying and selling of assets.

Risk Management

Financial institutions provide insurance against risk and help individuals to manage various risks such as health, life property and liability risks. They also offer products like futures, options and swaps that allow businesses to guard against price fluctuations and other financial risks.

Mobilising savings Financial institutions encourage individuals to save by offering various types of savings which provide a pool of funds for investments. They help savers to earn returns on their investments by providing products such as mutual funds, retirement accounts and fixed deposits.

Economic stability and growth Financial institutions are used by the central bank to influence interest rates and money supply to maintain economic stability.

Financial institutions support business development, entrepreneurship, and infrastructure projects (roads, buildings, utility networks) to foster growth by providing credits and financial services.

Financial inclusion By offering accessible banking services, microfinance, and affordable credit options, financial institutions work towards including the all individuals in a population.

Provision of information By collecting and providing credit information, financial institutions help to assess the creditworthiness of borrowers by providing valuable market insights and financial advice to aid businesses and investors in making informed decisions.

The role of financial institutions is vital to a country. In Ghana financial institutions support the economy by managing personal finances, providing loans and investment services to businesses, facilitating trade, and funding infrastructure projects, all of which contribute to large-scale economic growth.

Examples of Financial Institutions

The following are good examples of financial institutions: central banks, commercial banks, investment banks, Credit unions, Pension funds Central Bank A central bank is a national institution that manages a country’s currency, money supply, and interest rates.

1. The Central Bank sets monetary policy to control inflation and stabilise the economy.

2. It serves as the lender of last resort to financial institutions.

3. It manages the country’s foreign and gold reserves.

Commercial Banks

1. Commercial banks provide loans and credit to individuals and businesses.

2. It offers deposit accounts for savings and transactions.

3. It facilitates payment processes and money transfers Investment Banks

1. Investment banks help companies to raise capital by issuing stocks and bonds.

2. It facilitates marketing and trading activities.

3. It provides advisory services for mergers and acquisitions Insurance Companies

1. Insurance companies offer various insurance products to manage risk.

2. Premiums collected by policyholders are invested by insurance companies to generate returns Credit Unions

1. Credit unions provide financial services to their members including savings accounts and loans.

2. They operate as a non-profit making organisation and focus on community development.

Pension Funds

It refers to retirement savings for individuals who go on retirement, and it plays the following role:

1. The pension Fund manages savings for the individuals.

2. They invest contributions of the individuals to generate returns for future payments to pensioners.

Activity 9.2 Roles of the Central Bank and Financial Institutions in Gha- na’s Economy Organise yourselves into small groups of five and get a whiteboard or flip chart, markers and research information on the central bank and financial institutions and recent economic data on Ghana (e.g., inflation rates, GDP growth, unemployment rates)

1. Use the handouts and information from the internet to describe the current economic situation in Ghana, highlighting key issues such as high inflation rates (currently around 41%), rising cost of living, and recent external influences like International Monetary Fund contributions. Nominate a scribe, agree on content and write a short description of Ghana’s current economic situation.

2. In your groups review the information on the roles of Ghana’s central bank and other financial institutions. The group should discuss the specific roles and responsibilities of these institutions in managing Ghana’s economic challenges that you outlined in question 1 of the activity.

3. Each group should present their findings to the class. In the presentation each group should use the whiteboard or flip chart to list the key points they discussed

4. Each individual should write up their own summary of the key differences between the central bank and other financial institutions. The summary should highlight the importance of their roles in maintaining economic stability and promoting growth in Ghana. It should also suggest ways in which these institutions can work together to address future economic challenges in Ghana.

Figure 9.3: Image portraying taxation Taxation may be defined as a process whereby the central government or its authorities impose charges or levies on its citizens or individuals, businesses, and other outfits or entities. Taxation is a critical aspect of public finance and economic policy as it raises revenue for the government to be able to fund public services and infrastructure.

It is an essential system for the functioning of the economy and the government as it plays a key role in resource distribution and economic stability. Primarily, taxes are used to fund public goods and services such as infrastructure (roads, drainage, public buildings), education, healthcare, defence and social welfare.

Principles of Taxation

A good tax system must be equitable, efficient, simple, certain, convenient, and sufficient.

Equity: The principle of equity in taxation states that the tax system should be fair and just, ensuring that individuals and entities contribute to government revenue in proportion to their ability to pay. The tax system must be equitable both vertically and horizontally.

1. Under horizontal equity, taxpayers with a similar ability to pay should owe similar amounts of taxes.

2. Under vertical equity, taxpayers who have a greater ability to pay owe more on taxes to reflect a progressive tax system.

Efficiency: A good tax system should be efficient, meaning it achieves its goals without disrupting the economy or changing people’s behaviour significantly.

Simplicity: A tax system should be easy to understand to reduce compliance (measures to ensure people pay) and administrative costs.

Certainty: Taxpayers must know how much tax to pay when it should be paid and how it should be paid. This will enable taxpayers to manage their finances better and never miss the payment.

Convenience: The timing of tax payments must be convenient to taxpayers at all levels. For instance, the payment at the source of income tax to ease the process of tax payment (usually, government workers paid by controller and accountant general department) Sufficiency: A good tax system must be able to generate enough revenue to meet the central government expenditure needs. This tax system must provide a sufficient and stable funding source for the central administration.

Types of Taxes

There are two types of tax namely Direct and Indirect tax.

Direct Tax: a tax you pay straight to the government, like when you pay income tax on the money you earn. Direct taxes are in the following forms:

1. Income tax: it is levied on individuals or business earnings.

2. Corporate tax which is levied on corporations’ profit.

3. Wealth tax which is charged on individuals’ net wealth or asset holdings.

4. Property tax which is levied on ownership of property such as real estate.

Indirect Tax: added to the price of things you buy, like sales tax, and the store sends it to the government. Indirect taxes are in the following forms:

1. Sales tax is levied on the sales of goods and services.

2. Value Added Tax (VAT) which is levied on Value added to a good at each stage of production of a good or service.

3. Excise tax is the tax levied on specific goods such as tobacco, fuel and alcohol.

4. Customs Duty is levied on exported goods.

5. Service Tax is levied on specific services delivered.

Classification of Taxes

Taxes are classified by their nature, incidence, base, and the purpose for which they are imposed.

Classification By Nature

1. When the tax rate remains constant regardless of the level of the level of income of the individual. An example is the flat tax rate, also referred to as proportional tax.

2. When the tax rate increases as the taxable income increases. For example, the graduated income tax rate is classified as progressive income tax.

3. When the tax rate decreases as the taxable income increases. For example, sales tax is referred to as a regressive tax. It takes a larger percentage of income from the low-income earner.

Classification By Incidence

1. When the incidence of tax payment falls directly on the taxpayer who pays the tax, it is referred to as Direct Tax. An example is the Income tax.

2. When the incidence of tax is shifted unto the consumer, it is referred to as indirect tax. An example is the Value Added Tax.

3. When the incidence of tax is on ownership or transfer of properties, it is referred to as Property Based Tax. For example, Property tax or Estate tax.

Classification By Purpose

1. When the purpose for which the tax is imposed is to generate income for the government, it is referred to as Revenue Tax. An example is Income Tax

2. When the purpose is to regulate certain behaviours of industries such as to reduce the emission of carbon, it is called Regulatory Tax.

3. When the purpose of levying the tax is to fund or support specific public services like road construction, it is referred to as Benefit Tax. An example is the fuel tax such as the Energy Debt Recovery Ley.

Advantages And Disadvantages of Taxation

Advantages of Taxation

1. Revenue Generation

Taxes generate enough revenue to finance public services and goods such as hospitals, schools, roads, and social programs. Example: In Ghana, the government uses taxes generated to build and maintain roads and other infrastructure.

2. Wealth Redistribution

Progressive taxes help to close the gap between the rich and the poor by ensuring that people who earn more pay higher taxes. This revenue is used to support programs for poorer communities. Example: Ghana’s income tax system is progressive, and it ensures that higher earners pay more, which funds services for less privileged groups.

3. Economic Stabilisation

Taxes help stabilise the economy by controlling inflation and managing economic changes. This is done by changing tax rates and policies. Example: Changing corporate tax rates in Ghana can affect business investments and economic growth.

4. Encouraging Positive Behaviours

Governments use tax policies to promote good behaviours, like saving for retirement, using renewable energy, or reducing the use of harmful products. Example: Ghana’s government can give tax benefits to businesses that invest in renewable energy projects.

5. Providing Public Goods

Taxes are used to provide public services such as national defence, public parks, and disaster relief that are not provided by the private sector. Example: Tax Revenue in Ghana helps to finance public education and healthcare.

Disadvantages of Taxation

1. Economic Distortion

Taxes can lead to changes in the economy which affect how people and businesses behave, sometimes leading to inefficient use of resources. Example: High corporate taxes in Ghana may discourage foreign investment leading to slow economic growth.

2. Administrative Complexity and Cost

Collecting taxes can be expensive and difficult, especially when trying to prevent tax evasion and ensure everyone pays. Example: Ghana faces problems with managing and collecting taxes, which leads to inefficiencies and higher costs.

3. Tax Evasion and Avoidance

High taxes and complicated systems can make people and businesses avoid or evade taxes, reducing government revenue. Example: Some businesses and individuals in Ghana avoid paying taxes, which lowers the tax revenue available for public services.

4. Impact on Economic Behaviour

Taxes on income, profits, and consumption can reduce people’s willingness to work, save, or invest, which may slow down economic growth. Example: High personal income taxes in Ghana might discourage people from taking higher-paying jobs or working extra hours.

5. Regressive Impact

Some taxes, like sales taxes, are regressive because they affect more low-income earners who spend a bigger share of their income on goods that are taxed. For example, VAT is harder on low-income earners in Ghana since they spend most of their income on basic goods that are taxed.

Activity 9.3

Organise yourselves into small groups of no more than five persons for this

activity.

1. Discuss the two types of taxes using examples

2. Discuss the principles of taxation using examples

3. Discuss how taxes are classified using examples

4. You will need card, scissors, markers for this question OR you can create digital slides using presentation software like PowerPoint.

5. Mix and Match/Sorting Exercise

a. Preparation: Create cards or slides with the following items:

• Principles of Taxation: definitions for example, equity, efficiency, simplicity, certainty.

• Types of Taxation: Direct e.g. income tax, wealth tax, Indirect, e.g.

VAT, sales tax.

• Classifications of Taxation: Proportional, regressive, progressive.

• Include examples for each category (e.g., income tax, VAT, flat tax, luxury tax).

b. Activity

• Distribute the cards or display the slides.

• Sort the cards into the correct categories:

• Match principles with their definitions.

• Sort types of taxation into direct and indirect.

• Classify taxes as proportional, regressive, or progressive.

6. In your groups discuss the advantages and disadvantages of taxation. Is your group in favour of or against taxation? Give reasons for your group’s feelings.