IntroductiontoTaxation

Ø Taxation is defined as a system of

collecting money – tax revenue – to
finance government operations.
Ø A tax is a compulsory levy and those
who are taxed have to pay the sums
irrespective of corresponding
return of services or goods by the
government.
Ø It can be charged by government on
goods, income or any activity.
§ Today, tax has become a part and parcel
of all economic activities of human
beings.
§ Every man, willingly or unwillingly, pays
an amount of money in the form of tax
on the products he uses basically.
? All governments require money to
undertake different functions. For
required money – taxes – are
collected from the citizens.
? Without taxes the government could
not exist.
? Initially, the government imposed
taxes for three basic purposes: to
cover the cost of administration,
maintaining law and order in the
country and fordefense.
? It is the powerful instrument in the
hands of the government for
transferring purchasing power from
individuals to government.
? Governments may raise or lower
taxes to achieve social and economic
objectives, or to achieve political
popularity withcertain groups.
§ Compulsory levy--no refusal to pay
§ Levied by Government only
§ Direct benefit is not the main condition

(levies without quid pro quo ) --

collective use
§ Impose obligations – tax cannot be

escaped…subject to criminal offense

§ Generally payable in money
§ Lawful imposition and collection
§ Involves element of sacrifice
§ Common interest and benefit…
payers as well as non payers will
benefit.
§ Regular and periodic payment…
known due dates
§ Harmony with national objectives…

based on national objectives

§ Certain taxes levied for specific
objectives… other than simply for tax
revenue
? Objectives of taxation may differ
betweendeveloped and developing
countries.
? A tax system by itself cannot be
expectedto achieve all the goals fully.
? It has to fit in the overall
framework ofpolicies and measures
of the government.
• Revenue for the government… to
financegovernment expenditure such as
• Administration
• Maintaining law and order
• Defense
• Various other social services (public
schools, healthcare, social insurance,
infrastructure, housing, sanitation etc.)
• Employment generation through
promotion of labor intensive techniques;
? Removal of regional inequalities through
redistribution of opportunities (projects,
income, employment opportunities,
education etc);
? Encouraging import substitution and export
promotion to overcome balance of
payments difficulties;
? Reducing the gap between the poor and
rich- taxing the rich and investing on
projects that benefit the poor.
? Encourage savings and investment through
tax holidays, concessions, rebates, etc.
? To discourage the consumption of
harmfulproducts.
? To ensure economic stability or to
stabilizeeconomy.
? To minimize income and wealth inequalities.
? To enhance standard of living.
⚫ Principles of taxation refers to the
appropriate criteria to be employed by a
country in the development and evaluation
of a good tax system acceptable by the
society.
⚫ How should a tax system be designed
to raisea given amount of revenue?
⚫ There are various criteria (principles) that
can be followed in evaluating a tax policy
proposal(tax structure);
? One vital principle of a good tax
system is fairness (equity).
? Taxes imposed should be fairly and
equitably distributed.
? It states that a tax system
should be judged on the criterion
that the distribution of tax
burden by a government among
community should be fair and
effectively equal.
? 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.
? But difficulties in the use of this concept arise.
? There is no such agreement about how the term
“fairshare” should be defined.
There are two bases to measure how a government
could befair in distributing burden of a tax
A) Ability to pay principle and
B) The benefit principle
A) Ability to pay principle
? It demands the distribution of tax burden to be on the
basis of ability to pay , usually as measured by
income or wealth.
? Fairness demands effectively equal sacrifice by both
the rich and the poor in support of govt.
§ Same ability – same tax
§ Greater ability –pay more tax
? It states that taxpayers should be taxed
in proportion to the benefits they receive
from the government in the form of
goods andservices (public goods).
? Means the government provides goods
and services to the members of the
society and they contribute to the cost of
these supplies in proportion to the
benefits they received.
? Tax neutrality concept provides
that economic process should not
beaffected by taxation
? It prohibits the movement from
engaging at any time in
controversies of a political, racial,
religious or ideological nature
? The tax system of a nation should be free from
bias or should be neutral in its effect.
? The tax which each individual is
bound to pay ought to be certain
andnot arbitrary.
◦ the time of payment,
◦ the manner of payment,
◦ the quantity to be paid should
all beclear to the taxpayer and
to every other person.
? The mode and timing of tax payments
should be convenient to taxpayers.
? This canon(norm or principle)
recommends that unnecessary trouble
to the taxpayer should be avoided,
otherwise various ill-effects may result.
Ø Different economists have classified taxes in different
ways.
Ø This not mean that one classification contradicts the
other.
Ø The classifications have been made on different bases.
v On the basis of form (Direct and indirect taxes)
ØDirect taxes
üThis is taxation on income. This covers taxes
like income tax profits tax and wealth taxes on
inheritance.
üA direct tax is that whose burden is borne
by the person on whom it is levied.
üHe/She cannot transfer the burden of
the taxto some other person.
Ø Indirect taxes

Ø This is taxation on expenditure.

Ø An indirect tax is that which is paid by one
individual but the burden of which is borne by
another individual.
Ø A person who pays the tax in the first
instance transfers its burden to the
shoulders of another person.
Ø e.g., the excise duty on sugar is paid in the
first instance by the producer, but
ultimately he transfers the burden of this
duty to the purchaser in the form of higher
price for sugar.
What is tax burden?
Parameter
Tax Imposition

Paymentcourse

Paying Entity

Rate of Payment

Transferabilityof tax
Nature of Tax

Types of tax Tax Collection

Direct tax direct tax
This tax is directly imposed on thetaxpayer’s income.

This tax is directly paid to thegovernment.

These taxes are paid by individuals andbusinesses.

The rate of tax is decided by thegovernment based on profit andincome.
This type of tax is non-transferrable.

This is a progressive type of tax. This taxrate increases with an individual’s profitand
income.

Income tax, wealth tax, corporate tax,etc.

Collecting this type of tax is difficult.
Indirect tax
This tax on taxpayers for
the goods and services availedor purchased.
This tax is indirectly paid tothe government through anintermediary.
These taxes are paid by end-
consumers
Tax rates are the same foreveryone.

This type of tax istransferable.

This is a regressive type of tax,which means the tax rate is not affected by the
individual's income.
Sales tax, service tax, valueadded tax, etc.
Taxcollection is relativelyeasier.
v On the basis of nature
üIncome tax
üProperty tax
üTaxes on production
üTaxes on capital goods
üTaxes on consumption goods
Ø Income tax
üIncome tax is the tax levied on income of the
tax- payer.
üIncome tax is levied by the govt. when it wants
to adopt tax system according to the principle
of ability to pay.
üThe volume of tax is directly proportional to
the income received by a person.
üThe rate of tax is always progressive.
Ø Property tax

üA tax levied on property is called property

tax.
üUnder a property- tax system , the government
requires or performs an appraisal of the
monetary value of each property, and tax is
assessed in proportion to the value.
üThe tax is levied by local governments
(Municipalities).
üExample: land value tax , Real estate tax etc.
Ø Taxes on production
üWhen the producer pays the tax in proportion
to the commodities produced by him, it is
production tax.
Ø Taxes on consumption goods
ü The tax levied on the goods which are not used in
production butin consumption, is called the tax on
consumption good.
On the basis of volume (Single and Multiple tax)
1. Single tax
ØIt refers to the system in which the taxes are
leviedonly on the ‘item’or ‘head of tax’.
ØThere is only one kind of tax, which
constitutesthe source of public revenue.
2. Multiple tax
ØIt refers to the system in which the taxes are
leviedon various items.
Which tax system is appropriate? Why?
Giveyour reasons!
v On the basis of method
ØProportional taxes
ü A system that taxes everyone at the same
rate, regardless of his or her income
brackets.
ü Its amount increase with the increase in
income and decreases with the decrease
in income.
ØProgressive taxes
ü It is the tax which varies with the change
in income of the different individuals.
ü The rate of tax is gradually higher for the
increasing incomes and lower for the
decreasing incomes.
Ø Regressive tax
ü Under it, the larger the income of
tax-payer, the smaller is the proportion that
he contributes.
ü A schedule of regressive tax rate is one in
which the rate of taxation decreases as the
base increases.
Ø DigressiveTax

üA digressive tax is one on which tax is

progressive up to a certain limit, after that it
is proportional, i.e., charged at flat rate.
Ø Developing countries have the basic problem of a
rapid rise in capital formulation.
Ø Hence, savings and investment should be promoted.
Ø Through taxes more and more resources should be

mobilized in the hands of govt. to undertake public

sectorinvestments.
Ø For the mobilization of resources, both direct and
indirect taxes are significant.
Ø Through direct taxes, govt. can tax surplus income

of the rich section which is wastefully expended by

them in obvious consumption.
Ø Thus, unwarranted consumption is curbed, and

resources are made available for productive uses

through directtaxes.
Ø Direct taxes being progressive, serve as
an effective means for reducing
inequalities in the distribution of income
and wealth.
Ø Poor countries have a low saving
ratio andlow capacity to pay direct taxes
as masses are exempted from income tax
and wealth tax.
Ø For raising resources, therefore, govt. has

to rely on indirect taxes.

Ø Indirect taxes will amount to a sort of
forced savings in the economy which can
be effectively utilized by the govt. for
capital formulation.
Taxevasion
ü Tax evasion is an illegal practice where a person,
organization or corporation intentionally avoids
payinghis/her/ its true tax liability.
ü Tax evasion is illegal as the evader cheats the
govt. by concealing facts and the letter loses its
due revenue.
ü It also increases the burden of tax on honest tax-
payers.
ü Tax evasion also leads to the creation of black
money.
ü As the burden falls heavily on honest tax-payers,
inequality and the concentration of wealth in the
handsof few, increases.
v High rates of taxation
Ø Prevalence of high tax rates is the first and
foremost reason.
v Complexity of tax laws
Ø The complicated provisions of the Direct
Taxes Acts, were also stated to be
responsible to some extent, for tax evasion
and tax avoidance.
Ø The tax procedure prevailing is very
 complicated.
ØIt involves lot of time and cost.
v Shortage of experienced personnel
Ø Income tax department should have sufficient
number of trained and experienced personnel
to cope with assessment and investigation
work.
v Absent of deterrent punishment
Ø The absence of prosecution and strict
punishment have undoubtedly encouraged the
growth of evasion.
v Lack of publicity
Ø Lack of publicity of information of a person’s
return or assessment, is yet another reasons
for tax evasion.
Ø Omission to report taxable income.
Ø Maintenance of multiple set of books of accounts.

ü Most of the business people are maintaining

double setof books of accounts by tax evaders.
ü One set of books of accounts is for personal use
andanother for tax purpose.
Ø Deduction of personal expenses as business
expense.
Ø Omission to report several incomes from

irregularsources.
Ø Understatement of receipts.

Ø Over-estimation of business expenses.

Tax avoidance –An Overview
Ø Tax avoidance is method of reducing ones
tax liability by making use of loopholes in
tax law.
ØTherefore, tax avoidance is not illegal.
Ø e.g., conversion of sole proprietorship or
partnership firm into corporation firm is
notillegal.
Ø But whatever be the method can assess
adopts whether it is avoidance or evasion,
the consequences of his action is the same.
Ø i.e., loss of revenue to the state and
increase in the burden of the tax on other
tax-payers.
Ø Thus, tax avoidance is the art of escaping
taxeswithout breaking the law.
Ø Splitting business transactions or invoices to
avoid withholding income tax on payments
Ø Splitting a business to skipVATregistration

Ø Paying stock dividend on behalf of cash

dividends toavoid dividend income tax
Ø Providing for benefit in kind or non-taxable
allowance to employees to skip employment
income tax and
Ø Divorcing the wife on paper to avoid
aggregation of her income with husband’s
income thereby reducing taxable income and
the income tax thereon
Assignment 1 (report and presentation)
Chapter 3: Public Finance in Ethiopia
3.1. Features of Ethiopian Federal Finance
3.2. ExpenditureAssignment
3.3. RevenueAssignment
3.4. IntergovernmentalTransfer
3.5. Borrowing
3.6.Trends of Ethiopian public revenues, expenditures, grants, deficits, and
debts
3.7. Budget and its process
Assignment 2 (report)
1. How countries can reduce tax evasion and avoidance?
2. How do taxes affect investment, employment and productivity?
4. Briefly discuss the impact of external
3. Briefly discuss the effect of tax incentive on economic growth of
public
small andmedium enterprises in Ethiopia.
debt on economic growth in