2. CONTENTS
• Meaning and Nature of Tax
• Characteristics of Tax System
• Objectives of Taxation
• Principles of Taxation
• Tax Classifications
• Tax Rate Structures
• Shifting and Incidence of Taxation
• Tax Evasion, Avoidance and Delinquency
3. Chapter Objectives
On successful completion of this Chapter, students should;
Familiar with the meanings and objectives of taxation
Understand the principles of taxation
Discuss the tax structures
Explain the different types of taxes
Know shifting and incidence of taxation
Differentiate tax evasion, avoidance and delinquency
4.
5. 2.1. Meaning of tax
“A tax is a contribution from citizens for the support of the
government". Adam Smith
In the earlier days, payment of taxes was optional. A choice was given
to the people to pay the tax and to gain the benefit of social services in
the form of education, health and sanitation, utilities and recreation
facilities.
Taxes have been a major subject of political controversy throughout
history, even before they constituted a sizable share of the national
income.
In Greece free citizens had different tax obligations from slaves, and
the tax laws of the Roman Empire distinguished between nationals
and residents of conquered territories.
For a long time tax collection was left to middlemen, or “tax farmers,”
who contracted to collect the taxes for a share of the proceeds; under
Caesar collection was delegated to civil servants.
6. 2.1. Meaning of tax
A tax is a compulsory, unrequited payment to government.
The tax-payers do get many benefits from the government but no
tax-payer has a right to any benefit from the public expenditure
on the ground that he is paying a tax.
7. Cont…
Essential elements of Modern Tax:
It is levied by the government
It is must have a base upon which it is levied
It is a proportion or a percentage
It is generally payable in money
It is levied in order to cater to public purpose
9. 2.2. Objective of Taxation
The primary goal of taxes is to finance government expenditure.
The imposition of taxation by governments withdraws money from the
economy, and their expenditure returns the money to the economy.
A good tax system
ensures maximum
social advantage
without any hardship
on taxpayers.
10. Cont.…
the objectives of tax are
1. Raising revenues,
2. Removal of inequality in income and wealth,
3. Ensuring economic stability,
4. Reduction of regional imbalance,
5. Capital accumulation,
6. Employment creation,
7. Prevention of harmful consumption,
8. Beneficial diversion of resources,
9. Encouraging export
10.Enhancing living standards
11. 2.3. Characteristics of Tax
A tax has the following general characteristics:
Legal Collection
Common interest
Tax is a compulsory contribution
Benefit is not the basic condition
Personal obligation
Element of Sacrifice
Regular and Periodical Payment
No Discrimination
Wide Scope
12. 2.4. Principles of Taxation
In establishing the tax policy, the government should consider not only its financial
needs but also taxable capacity of the community and government has to consider
some other principles.
These principles are called as canons of taxation.
1. Canon of Equity
2. Canon of Certainty
3. Canon of Convenience
4. Canon of Economy
1. Canon of Productivity
2. Canon of Elasticity
3. Canon of Diversity
4. Canon of Simplicity
5. Canon of Buoyancy
6. Canon of Flexibility
7. Canon of Expediency
8. Canon of Co-ordination Etc.
13. Cont.…
CANONS ADVOCATED BY ADAM SMITH
1. Canon of Equity
One important principle of a good tax system is fairness (equity).
Everyone agrees that the tax system should be equitable, i.e., that each
taxpayer should contribute his/her “fair share” to the cost of government.
There is no agreement on how the term “fair share” should be defined.
What a “fair share” means in practice the subject of endless contention and
debate.
There are two schools of thought:
1. The benefit principle
2. The ability to pay principle
14. Cont.…
I. Benefit principle
An equitable tax system is one under which each taxpayer contributes inline
with the benefits which he/she receives from public services.
The truly equitable tax system will differ depending on the expenditure
structure.
II. Ability to pay principle
The tax system is viewed by itself independent of expenditure
determination.
So, it leaves the expenditure side of the public sector untouched;
A given total revenue is needed and each taxpayer is asked to contribute in
line with his/her ability to pay.
The ability to pay principle relates taxes paid to some measure of ability to
pay, such as overall wealth, income or consumption;
No agreement on which one is best measure of ones ability to pay;
Ability to pay may vary depending on the measure chosen;
15. Cont.…
Horizontal and Vertical Equity
Taxation according to ability to pay calls for people with equal capacity to
pay the same, and for people with greater ability to pay more.
The former is referred to as horizontal equity and the latter as vertical
equity.
Horizontal equity states that people who are “similarly situated” should be
taxed alike.
Vertical equity concerns people in unequal economic circumstances.
However,
It leaves open the essential question of what is meant by “similarly
situated”.
If income is used as index of ability to pay, then HE says people with the
same income should, all else equal, pay the same tax.
Again, we are left with essential questions: what do we mean by “income” .
16. Cont.…
2. Canon of Certainty
The tax which each individual is bound to pay
ought to be certain and not arbitrary.
The time of payment, the manner of payment,
the quantity to be paid should all be clear to
the taxpayer and to every other person.
Certainty pertains to objectivity.
3. Canon of Convenience
The mode and timing of tax payments should
be convenient to taxpayers.
This canon recommends that unnecessary
trouble to the taxpayer should be avoided,
otherwise various ill-effects may result.
17. Cont.…
4. Canon of Economy
“every tax should be so designed as both to take out and to keep out of the
pockets of the people as little as possible over and above what it brings into
the public treasury of the state” (Smith 1776, (1952 ed), p 362).
Taxes should not cause an unnecessary burden upon the society in the form
of costs over and above the tax liability.
In addition to the actual payment of taxes, taxes induce other costs:
I. Compliance and administrative costs (tax operating costs)
II. Efficiency costs
Convenience and certainty canons deal with tax compliance costs while
the economy canon is concerned with both the administrative and
compliance costs;
The economy canon deals with efficiency costs as well
18. Cont.…
The total cost of taxes from a taxpayer’s point of view:
= tax liability + efficiency costs + compliance costs
Costs of taxation to an economy =
= efficiency costs + compliance and administrative costs
Tax compliance costs – costs incurred by taxpayers and third parts in the
process of complying with the requirements of a tax legislation and
administration procedures;
Tax administrative costs can be broadly viewed as resources sacrificed by
the public sector in connection with a tax system.
Public sector costs of taxation conceptually constitute those costs which
would not have been incurred if the tax had never been introduced
(Sandford et al. (1989)).
19. Cont.…
The economy is said to be efficient when resources are directed to their
highest valued uses.
By changing the relative attractiveness of highly taxed and lightly taxed
activities taxes can distort resource allocation decisions (divert resources)
The tax should create neither major distortions in consumption and
production behavior nor change private investment decisions by favoring
one set of investments over the others.
If there are distortions in resource allocation, that would reduce people’s
well being in a variety of ways that can include a loss of output or
consumption opportunities;
These reductions in well-being are efficiency costs, also called deadweight
losses, excess burdens (excess because they are costs in addition to the tax
liability) or welfare losses.
Example : the 18th century window tax
21. Cont.…
CANONS ADVOCATED BY OTHER ECONOMISTS
5. Canon of Productivity
The productivity of a tax may be observed in two ways.
First, a tax should yield a satisfactory amount of revenue for the
maintenance of government.
Secondly, the taxes should not discourage production in the short and in the
long run.
6. Canon of Buoyancy
The tax revenue should have an inherent tendency to increase along with
an increase in national income, even if the rates and coverage of taxes are
not revised.
22. Cont.…
7. Canon of Flexibility
It should be possible for authorities without undue delay to revise the tax
structure both with respect to its coverage and rates, to suit the changing
requirements of the economy and of the Treasury.
8. Canon of Elasticity
Proclaims that yields of taxes should be increased or decreased according to
the needs of the government.
9. Canon of Diversity
It implies that the tax system should be diverse in nature.
There should be all types of taxes so that everyone may be called upon to
contribute something towards the revenues of the state.
23. Cont.…
10. Canon of Simplicity
Implies that a tax should easily be understood by the tax-payer i.e., its
nature, aims, time of payment, method and basics of estimation should be
easily followed by each tax-payer.
11. Canon of Expediency
Implies that the possibilities of imposing a tax should be taken into account
from different angles i.e., its reaction upon the tax-payers.
12. Canon of Co-ordination
Taxes are imposed by central state and local governments.
It is, therefore, desirable that there must be co-ordination between different
taxes that are imposed by different taxation authorities.
24. 2.5 TAX SYSTEM AND CLASSIFICATIONS
I. Tax System
A tax system is a set of all the taxes that a nation imposes;
Tax systems can be classified in different ways
1. Single Tax System
is a system where there is only one kind of tax in place.
It does not mean tax on only one person.
A single tax may be proportional, progressive or regressive, or it may be
fixed amount.
Example: Head/ Poll Tax
25. Cont..
Merits of a Single Tax System
Certainty: it is claimed that taxpayers are more certain of their liabilities in
a single tax
Simple: Since there is only one tax, it simplifies the work of the
government.
Administrative Cost: its simplicity can help in reducing costs of collection
Equitable: single tax like income tax is just and equitable because it is
based on the principle of equity in taxation.
What about identification and choice of an appropriate single tax?
Demerits of a Single Tax System
Insufficient revenue: from the point of view of revenue, the single tax may
not be sufficient for the government.
Regressive: It cannot be imposed in proportion to the ability to pay of the
tax-payer.
For Example: if a tax is imposed on houses, land etc.; it is very difficult to
make its burden on everybody in proportion to his/her ability.
26. Cont..
2. Multiple Tax System
Is a system with several tax structures being used in the system.
Any worthwhile tax system in a modern economy will be a multiple tax
system. Because,
a modern economy is not one-objective economy.
Income of a modern economy originates from many sources.
Merits of Multiple Tax System
Just and equitable: multiple taxes are just and equitable because they are
based on the principle of ability to pay. All the tax-pay taxes according to
their money income.
Wide Coverage
Sufficient revenue
No evasion
27. Cont..
Demerits of Multiple Tax System
Inconvenient: too much multiplicity of taxes may lead to inconvenience to
both the taxing authority and the tax-payer as well as to the general public.
Administrative Cost: the administrative cost of collection of such taxes is
generally heavy as they have to be collected from large number of people.
Complexity:
29. Cont..
TAX IMPACT
The impact of a tax is on the person who pays the money in the first
instance.
Impact of a tax, therefore, refers to the immediate burden of the tax and not
to the ultimate burden of the tax.
TAX SHIFTING
It refers to the process by which the money burden of a tax is transferred
from one person to another.
The tax may be shifted forward or backward.
TAX INCIDENCE
Incidence is final resting place of a tax while shifting is process of
transferring money burden of tax to someone else. Shifting finally ends in
incidence.
The incidence of tax remains upon that person who cannot shift its burden
to any other person.
30. Cont..
1. Direct Taxes
tax is paid by a person on whom it is levied.
the impact and incidence fall on the same person.
Direct tax is borne by the person on whom it is levied and cannot be passed
on to others.
Examples: Employment Income-tax,
Business Income-tax ,
Capital gains tax,
Property or wealth-taxes etc.
31. Cont..
Merits of Direct Taxes
Ensures the principle of ability to pay
Reduces the social and economic inequalities
Certainty
Economy
Elasticity
Educative Effect
Control the effects of trade cycles
32. Cont..
Demerits of Direct Taxes
Arbitrary in Nature
Difficulties in the formulation of progressive tax rates
Inconvenience
Possibility of tax evasion
Limited scope
Disincentive to work, save, and invest
Expensive to collect
33. Cont..
2. Indirect taxes
Under indirect taxes, the impact and incidence fall on different persons.
It is not borne by the person on whom it is levied and can be passed to
others.
Indirect taxes are taxes on commodities or consumption.
Example: custom duties, VAT, excise taxes etc.
34. Cont..
Merits of Indirect Taxes
Convenience
Wide Scope
Elastic
Tax evasion is not possible
Substantial revenue
Progressive
Effective Allocation of Resources
Discourages the Consumption of Articles Injurious to Health
35. Cont..
Demerits of Indirect Taxes
Ability to pay principle is violated
Uncertainty
Discourages Saving
High Cost of Collection
Civic Consciousness is Not Created
Inflationary
36. 2.6 TAX STRUCTURE
Tax structures differ from country to country primarily because countries'
socioeconomic developments differ from one another.
WHICH TAX STRUCTURE IS SUITABLE?
There are different types of tax structures (system) which are applied by the
governments on different taxes. These are:
37. A. Progressive Tax Structure
Is also called graduated tax.
It is usually applied in reference to income taxes, where people with more
income pay a higher percentage of it in taxes.
The tax rate increases as the tax base income increase.
Merits of Progressive Tax System
Equality in Sacrifice
Reducing the inequalities of income
and wealth
Economy
Elastic
Stabilizing the economy
38. Cont..
Limitations of Progressive Tax System
a. Ideal Progression is Impossible
b. Progressive Taxation - a Graduated Robbery
c. Disincentive to Work
d. Discourages savings and investments
e. Shifts the total economic production of society
39. B. Regressive Tax Structure
The tax rate decreases as the tax base increases.
To determine whether a tax is regressive, the income elasticity of the goods
being taxed as well as the income-substitution effect must be considered.
Example: sales tax, property tax, excise tax, tariffs and government fees.
40. C. Proportional Tax Structure
is charged at a flat rate for everyone, whether earning higher income or
lower income, it is also called flat tax.
It is based on the theory that since everybody is equal, taxes should also be
charged the same way.
41. Cont...
Merits of proportional tax system
Proportional tax system has the following advantages:
It is simple in nature.
It is uniformly applicable
There is certainty
Proportional taxation leaves the relative economic status of taxpayers
unchanged
It will avoid mistakes and drawbacks of progressive tax system
Limitations of proportional tax system
The following are the demerits of proportional tax system:
o Inequitable distribution
o Inadequate resources
o Inelastic in nature
Hence, it is not practically and universally accepted.
42. D. Digressive tax structure
is a mix between the progressive and proportional tax systems.
the tax rate is increased firstly with increase in income and then, the rate
remains flat or constant with further increase in income.
43. 2.7. Tax evasion, Avoidance & Delinquency
I. Tax Evasion
is a method of saving tax liability by a taxpayer through fraudulent means
or by directly violating tax laws.
is illegal, unethical, uneconomical and highly risky since it may result in
penalty, imprisonment, and closing of business.
is meant to be deliberate acts of non-compliance resulting in payment of
lower taxes than are actually owed.
Therefore, not paying ‘’ones’’ lawful share of tax is evasion of income.
Evasion can take place in a number of ways. There are two forms of tax
evasion. They are as follows:
1. Suppression of income, and
2. Inflation of expenditure.
44. Cont..
Methods of tax evasion
The following are some of the methods of tax evasion:
Omission to report taxable income
Maintenance of multiple set of books of accounts
Opening accounts under fictitious names
Securing contracts under fictitious names
Deduction of personal expenses as business expenses
Omission to report several incomes from irregular sources
Understatement of receipts
Overstatement of business expenses
45. Cont..
Causes of Tax Evasion
i. Multiplicity of tax laws
ii. Complicated tax laws
Example: the Income Tax Act has 28 chapters and 298 sections including sub-
sections. So, such complication in tax-laws is also a root-cause for the tax
evasion
iii. High Rates of taxation
iv. Inadequate Information as to sources of tax revenue
Example: In Ethiopia, small businessmen and farmers rarely maintain any
accounts of their income.
v. Investment in real property
vi. Ineffective tax enforcement
vii. Deterioration of moral standards
46. Cont..
Remedies for Tax Evasion
1. Thorough overhauling of tax laws
2. Reduction in Tax Rates
3. Replacement of sales tax & excise duties with VAT
4. Tax on agricultural income
5. Maintenance of proper accounts
6. Introduction of Expenditure Tax
7. Tightening of Tax Enforcement
47. Cont..
II. Tax Avoidance
is legal but immoral.
denotes the taxpayers’ ingenuity to arrange his affairs in a proper manner so
as to reduce the incidence of tax.
As long as the provisions of the law are not violated and transactions
properly recorded, any attempt to minimize tax using those accounting
methods and principles that may useful to report less taxable income of the
taxpayers is acceptable.
III. Tax Delinquency
means the amount of tax uncollected in the previous fiscal period especially
in property tax.
It may happen if the taxpayer unable to pay property tax due to bankrupt.
If the taxpayer can survive its loss for the coming year, the tax authority will
collect both the current year tax as well as delinquent tax otherwise it will
be considered as un collectible revenue by the authority.
