CHAPTER THREE

INTRODUCTION TO TAX
3.1 Definition of Tax
Taxation is a payment levied by government for which no good or service is received directly in
return - that is, the amount of tax people pay is not related directly to the benefit people obtain
from the provision of a particular good or service. Up until the early 1930s, it was universally
accepted in principle that governments should balance their budgets. Thus, the principal reason
for taxation was to pay for government expenditure. Some of the definitions of Tax provided by
economists are stated as follows:

Name of the economists Definition of tax

tax is compulsory contribution from a person to the government to
defray the expenses incurred in the common interests of all without
Professor Seligman reference to special benefits conferred
Professor Taylor Taxes are compulsory payments to the governments without
expectation of direct return to or benefit to the tax payer
Professor Charles F. Tax is compulsory contribution of the wealth of a person for the
Bastable service of public power
Professor Taussig The essence of a tax, as distinguished from other charges by
government, is the absence of a direct quid pro quo between the tax
payer and the public authority

3.2. General Characteristics of Tax:

A tax has the following characteristics:
1. Tax is a Compulsory Contribution: Tax is a compulsory contribution by the taxpayers
to the Government. The people whom the tax is levied cannot refuse to pay the tax. Once
it is levied they have to pay it. Any refusal in this regard leads to punishments.
2. Benefit is not the Basic Condition: For the payment of tax, there is no direct return or
quid pro quo to the taxpayers. That is, people cannot expect any return in benefit for the
amount of tax paid by them. Because, there is no relation between the amount of tax paid
by the people and the services rendered by the Government to the taxpayers.
3. Personal Obligation: Tax imposes a personal obligation on the taxpayers. When a
person becomes liable to pay the tax, it is the duty of him to pay it and in no way he can
escape from it.

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 4. Common Interest: The amount of tax received from the people is used for the general
and common benefit of the people as a whole. Now the Government has to render
enormous range of social activities, which incur heavy expenditure. A part of the expense
is sought to be raised through taxation of various types. Thus, taxes are said to be the
sharing of common burden by the people.
5. Legal Collection: Tax is the legal collection. It can be levied only by the Government
both Central and State.
6. Element of Sacrifice: Since the tax is paid without any return in benefit, it can be said
that there is the prevalence of sacrifice in the payment of tax.
7. Regular and Periodical Payment: The payment of tax is regular and periodical in
nature. It is levied for a fixed period usually a year. Thus, almost all the taxes are annual
taxes. The payment of taxes should be regular also.
8. No Discrimination: Tax is levied on all people without any discrimination of caste,
creed etc. but according to their ability to pay.
9. Wide Scope: Tax is levied not only on income but also on property and commodities. To
enhance the revenue and to bring all the people under the tax net, the Government
imposes various kinds of taxes. This enhances the scope of taxes.
3.3. Objectives of taxation
The Role of taxation and fiscal policy in the development strategy has to be viewed in the
background of the objectives which a taxation system performs. Government levies and collects
taxes for various objectives.
1. Raising Revenue:
The primary function of a tax system is to raise revenue for the government for its public
expenditure. So, the first goal in the development strategy as regards taxation policy is to ensure
that this function is discharged adequately.
2. Remove Income and Wealth Inequalities
Tax system reduces inequalities through the policy of redistribution of income and wealth.
Higher rates of income taxes, capital transfer taxes and wealth taxes are some means adopted for
achieving these ends.
3. Discourage undesirable activities

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Tax system is important for social proposes such as discouraging certain activities, which are
considered undesirable. The excise taxes on liquor and tobacco, the special excise duties on
luxury goods, betting and Gaming Levy are examples of such taxes.
4. Allocate Resources
Taxation is important to ensure economic goals through the ability of the taxation system to
influence the allocation of resources. This includes:
a) Transferring resources from the private sector to the government to finance the public
investment program;
b) The direction of private investment into desired channels through such measures as
regulation of tax rates and the grant of tax incentives etc. This includes investment
incentives to attract Foreign Direct Investment (FDI) into the country;
c) Influencing relative factor prices for enhanced use of labor and economizing the use
of capital and foreign exchange.
5. Capital Accumulation and saving
Taxation increases the level of savings and capital formation in the private sector partly for
borrowing by the government and partly for enhancing investment resources within the private
sector for economic development.
6. Reduction in Regional Imbalances:
It is normal that certain parts of the country are well developed, whereas some other parts or
states are in backward conditions. To remove these regional imbalances, the Government can use
tax measures. By way of announcing various tax exemptions and concessions to that particular
backward regions or states, the economic activities in those areas can be induced and accelerated.
7. To protect local industries from foreign competition
Taxation protect local industries from foreign competition through the use of import duties,
turnover taxes/VAT and excises. This has the effect of transferring a certain amount of demand
from imported goods to domestically produced goods.
8. Creation of Employment Opportunities:
More employment opportunities can be created by giving tax concessions or exemptions to small
entrepreneurs and to the industries adopting labor-intensive techniques. In this way,
unemployment problem can be solved to certain extent.
9. Encouragement of Exports:
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Now-a-days export oriented industries are encouraged by way of providing various exemptions
like 100% relief from income tax, free trade zones etc. It results in the large earnings of foreign
exchange.
10. Enhancement of Standard of Living:
By way of giving various tax concessions to certain essential goods, the Government enhances
the standard of living of people.
3.4. Canons or principles of taxation
Canons of taxation refer to the administrative aspect of the tax. They relate to the rate, amount
method of levy, and collection of a tax. In other words, the qualities or attributes of a good tax
are called canons of taxation.
No one has yet come up with a better set of criteria for judging a tax than the Canons of
Taxation first proposed by Adam Smith more than two hundred years ago. Adam Smith in
his book, “Wealth of Nations” has explained the four canons of taxation. All accepts them as
good taxation policy. We shall now explain them briefly.
1. Canon of Equity or Equality:
Canon of equity or equality is the most important and basic Canon of taxation. It is based on the
principle of social justice and ability to pay. Tax burden should be equally distributed among the
tax payers according to their ability to pay. That is, the rich people should bear a heavy burden
and the poor a less burden. Hence, the tax system should be progressive.
2. Canon of Certainty:
Taxation must have an element of certainty. That is, there must be certainty about the tax which
an individual has to pay. Things like the time of payment, the manner of payment, and the
quantity to be paid etc. should be plain and clear to the tax payer. It should not be arbitrary
3. Canon of Convenience:
This canon takes into consideration the interest of the taxpayer the view of payment of tax. It
emphasizes that the mode and timings of tax payment should be, so far as possible, convenient to
the tax-payer. This canon recommends that unnecessary trouble to the tax-payer should be
avoided; otherwise various ill-effects may result.
4. Canon of Economy:
Every tax has a cost of collection. It is important that the cost of collection should be as
minimum as possible. It will be useless to impose taxes which are too widespread and difficult to

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administer. Productivity of taxes has been given important in this canon. An analysis of these
canons indicates that Adam Smith was basically concerned with the ways in which economy
could increase its productive capacity, and thereby achieve a higher rate of economic growth and
at the same time he considered the convenience of the tax payer and economy in tax collection.
However, in view of the wide spread recognition of many other objectives of the economic
philosophy of the government and modern state, some additional principles have also been
suggested by some other authors.

ii. Canons Advocated by Others: Besides the four canons put forward by Adam Smith, there
are some other canons given by writers like Charles F.Bastable.
5. Canon of Productivity:
It is also called the canon of fiscal adequacy. According to this principle, the tax system should
be able to yield enough revenue for the treasury and the government should not be forced to
resort to deficit financing. The canon is thus also called canon of adequacy.
6. Canon of Diversity:
In line with canon of productivity, canon of diversity also gives importance to adequate
collection of tax through diversification. Thus it stresses to the fact that it will not be a happy
situation if the state depends upon few revenue inequitable as between different sections of the
society.
On the other hand, if the tax revenue comes from diversified sources, then any reduction in tax
revenue on account of any one is likely to be very small on total tax revenue. However, too much
multiplicity of taxes is also to be avoided. That leads to unnecessary cost of collection and
violates the canon of economy.
7. Canon of Simplicity:
This canon implies that the tax should be simple to understand even to a layman. It should be
free from all ambiguities and provisions to avoid differences in interpretation and legal disputes
8. Canon of Flexibility/Elasticity
It means that taxation should be flexible or elastic. That is, it should be capable of increasing or
decreasing the tax revenue depending on the need of the government. In other words, the tax
revenue may increase automatically whenever needed by an upward revision of tax rates or by
extension of its coverage

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9. Canon of Co-ordination:
In a federal set up like Ethiopia, Federal and State Governments levy taxes. So, there should be a
proper co-ordination between different taxes imposed by various authorities. Otherwise, it will
affect the people adversely.
3.5. Approaches or Theories of Taxation
The criteria used for constructing a good tax structure are called theories of taxation. The
theories of taxation relate to the distribution of taxation or allocation of tax burden to different
categories of tax payers. Some of the theories are explained below.
A. THE BENEFIT OR QUID PRO QUO PRINCIPLE
This principle explains that tax should be paid in accordance with benefits each would receive
from expenditure programs to be financed by tax revenues by the governments. According to this
principle people receiving equal benefits should pay equal amounts of taxes and those who
receive greater benefits should pay higher taxes.
Merits of Benefit Approach:
1) Justification for taxes- taxes are imposed only when benefits are conferred on tax payers out
of the tax revenue.
2) Equity principle satisfied- It is equitable that individuals receiving benefits from the state
expenditure should contribute in proportion with the benefits enjoyed by them.
3) No discouragement to work and invest-As taxes are imposed on the basis of benefits, they do
not discourage the willingness to work and invest.
4) Basis for allocation of taxes- Taxes are allocated to the extent of benefits received.
5) It combines both the income and expenditure sides of the budget process.
Demerits:
1) Injustice to poor: since modern governments are aiming at welfare states, more benefits will
be provided for the poorer people. When taxes are imposed on the basis of benefits, tax burden
will heavily be upon the poor. J.S.Mill rejected the theory as it is regressive in nature.
2) Non –applicability of market principle: The market principle of demand and supply is not
applicable to social goods like education, defense, public health etc. They are supplied equally
by governments for collective consumption. Now that, nobody will reveal their preferences, it is
difficult to estimate the benefits.

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3) Satisfaction of merit wants: The benefit principle of taxation is not applicable to merit wants
since they result in interference in consumers’ sovereignty.
4) Benefits are community based or group based: Benefits from social goods are enjoyed by
community than by individuals. So beneficiaries cannot be individually identified.
5) Certain benefits are immeasurable: Some benefits of public expenditure cannot be quantified.
For example, benefits from public parks, recreation, museums, research centres etc.
6) Violation of tax definition: The very definition of tax is violated as per the benefit principle.
Tax is defined as a compulsory contribution without direct benefits.
B. THE COST OF SERVICE THEORY
According to this theory each tax payer should pay tax equal to the cost rendered by the
government to provide a service. For example, if an individual received 0.3% of total services,
he has to pay 0.3% of total cost involved in providing such services. If the cost is higher, the tax
will also be higher. Taxes are like prices paid for services rendered to each person by the
governments according to the cost incurred.
Limitations
1) It is difficult to estimate the cost of all services. For example, defense.
2) It is against the welfare object of the governments. If cost is taken the basis of tax, the
governments may not perform many functions which are very much desirable for the welfare of
the society as a whole. E.g. Relief works during time of emergency, free medical and educational
facilities etc.
3) It is against the very definition of tax. Tax is a compulsory contribution and there is no direct
quid-pro-quo.
4) The cost of services rendered by governments to individuals is fixed arbitrarily which is not
just.
C. ABILITY TO PAY PRINCIPLE OR SACRIFICE THEORY
This theory states that those people who possess income or wealth should contribute to the state
in proportion to their ability to pay. According to J.S Mill, “Equality in taxation means equality
in sacrifice.” According to Dalton, “The burden of taxation should be so distributed that the
direct real burden on all tax payers is equal.” Professor Seligman quoted that “The basic point of
the ability to pay principle is that the burden of taxation should be shared amongst the members
of the society so as to conform to the principle of justice and equity…….and this equity criterion

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will be satisfied if the tax burden is determined according to the relative ability of the tax
payers.” In short, the ability to pay theory explains the fairness or justice in the distribution of tax
burden.
IMPLICATIONS OF THE THEORY
1) Tax is a compulsory contribution.
2) Public expenditure and public revenue are two distinct entities. Public expenditure is provided
for the common goods and the public revenue is raised through taxation from the individuals
according to their ability.
3) Taxes should be imposed by the state in an equitable or just manner.
4) Taxes should be imposed to minimize the total sacrifice involved.
5) It emphasizes welfare aspect not only of tax shares but also of expenditure.
INDICES OF ABILITY TO PAY
To measure ability to pay, two important approaches are used by economists: (i) the subjective
(equal sacrifice) approach and (ii) the objective (faculty) approach.
A. The Subjective Approach
This approach is based on the psychological or mental reactions of the tax payers. Each tax payer
should make equal sacrifice, if tax burden is equally distributed. The equal sacrifice
interpretation of ability to pay was originally put forward by J.S.Mill. According to him
“Equality in taxation means equality in sacrifice.” There are three concepts of equal sacrifice
principle. They are (i) Equal Absolute Sacrifice (ii) Equal Proportionate Sacrifice and (iii) Equal
Marginal Sacrifice.
1. Equal Absolute Sacrifice:
Under the concept of equal absolute sacrifice, each taxpayer should make equal absolute
sacrifice, i.e. the total disutility of a tax should be equal for all tax-payers. In other words all
should be treated equally under law as well as in all affairs of government. According to J.S.
Mill, equity in taxation means equality in sacrifice. When the total tax Payable by tax-payers is
equally divided among them without regard to their money income, it may be stated as the
application of the principle of Equal Absolute Sacrifice. In this case the total sacrifice in the form
of payment of tax is equally divided among the tax-payers without regard to their ability to pay.
This may prove to be highly regressive in nature as the quantum of sacrifice on the part of the tax
payers with lower money income may be the highest. Hence, most economists have strongly

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rejected the concept.
2. Equal Proportional Sacrifice:
According to this concept also, no one is exempt from sharing the tax burden. In other words,
each tax payer should sacrifice the same proportion of total utility or satisfaction derived from
his total income. When the tax burden is distributed among the tax-payers in proportion to their
money income, we call it equal proportional sacrifice. In this case, the sacrifice of the poorer
section of society is quite higher because marginal utility of money is quite higher to them as
compared to the richer section of the society. Thus, according to the principle of proportional
sacrifice, the direct real burden on every taxpayer would be proportionate to the economic
welfare which he derives from the income. Hence, this concept cannot be considered as a system
of just tax payment by the government.
3. Equal Marginal Sacrifice:
Edge worth and later Pigou concluded that least aggregate sacrifice' is the superior principle of
tax distribution, not because it is equitable, but because it is derived directly from the basic
utilitarian principle of maximum happiness. According to this concept, the tax burden is so
distributed among different categories of tax-payers that the marginal sacrifice of all the tax-
payers is equal. In other words, according to this concept, everyone, whether rich or poor should
feel the same pinch by paying the last Birr as tax. This implies that the tax payers should pay tax
according to their money income, i.e. the rich should pay the tax at a much higher rate than poor.

According to Edge worth, marginal sacrifice and not the total sacrifice of the different tax-payers
should be the same so that aggregate sacrifice for the community as a whole is the least. In other
words, the welfare to all would be maximum.

According to Pigou, "Thus the distribution of taxation required to conform to the principle of
least aggregate sacrifice is that which makes the marginal not the total-sacrifice borne by all the
members of the community equal." The object of the state is to maximize the economic welfare.
Hence, taxes should be distributed in accordance with the Principle of least aggregate sacrifice,
i.e., the marginal sacrifice imposed by way of taxation on each tax-payer is equal. In this
approach the emphasis is on the welfare of the community. Musgrave and others consider it as
the "ultimate principle of taxation." Thus this approach leads to progressive taxation.

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B. OBJECTIVE APPROACH
This approach explains three criteria to measure ability to pay viz., income, property and
consumption.
INCOME: Income is considered to be the best index of ability to pay. Income from all sources-
property, investment in shares etc. - in a given period is to be calculated.
PROPERTY: Formerly property or wealth was considered as the index of ability to pay. This
was due to the fact that the standard of living of the people was not only influenced by income
but also by the accumulated property and wealth. However, this criterion suffers from many
limitations and conceptual difficulties. For example, properties of the same size and description
may not yield same income.
CONSUMPTION: Many economists have suggested consumption expenditure as the basis of
ability to pay. According to Professor Kaldor, “Consumption rather than income should be the
basis of taxation.” The major difficulty of this measure is that person with large dependents have
to spend more and hence to pay larger taxes. This is against the equity principle of taxation.
3.6. Classification of Taxation
On the basis of the burden that is based on the impact (immediate burden) and incidence
(ultimate burden) of a tax, taxes are classified in to Direct and Indirect taxes.
A. Direct Taxes
Direct taxes are those which are paid by persons on whom these are imposed and the real burden
is also borne by them. The burden of such taxes cannot be transferred or shifted to some other
persons. That is, both impact and incidence fall upon the same person. Direct taxes, in
Ethiopia, include employment income tax; business income tax; rental income tax; capital
gains tax; agricultural income tax and rural land use fee; mining income tax; taxes on
lottery and other chance winning; tax on royalty, interest, dividend, and casual rental of
property.
Merits of Direct Taxes- Direct taxes have the following merits.
1. Ensures the Principle of Ability to Pay:nDirect taxes are based on the principle of ability
to pay. They fall more heavily on the rich than on the poor. The tax burden is distributed on
different sections of the society in a just and equitable manner.
2. Reduces the Social and Economical Inequalities: Direct taxes reduce a disparity in the
distribution of income and wealth. By adopting the progressive tax system, rich people pay on

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higher rates of taxation, while the poor pay on lower rates or given exemptions. This reduces the
gap between the poor and rich to a considerable extent.
3. Certainty: Direct taxes satisfy the canon of certainty. In direct taxes, the time of payment,
mode of payment, the amount to be paid, etc. are made clear. Both the taxpayers and the
Government know the amounts to be paid, and the Government can estimate the revenue from
these taxes.
4. Economy: The cost of collection of these taxes is low because the Government adopts the
different methods of collections like tax deduction at source, advance payment of tax, etc.
Besides, the taxpayers pay the amount of tax directly to the Government. Thus, the principle of
economy is achieved in the case of direct taxes.
5. Elasticity: Direct taxes are elastic in nature. For example, when the income of the people
increases, the tax revenue also increases. Moreover, during the unforeseen situation like flood,
war etc. the Government can raise its revenue by increasing the tax rates without affecting the
poor.
6. Educative Effect: Direct taxes create civic consciousness among taxpayers. Since the
taxpayers feel the burden of tax directly, they are interested in seeing that the Government
properly spends the money. They are conscious of their rights and responsibilities as a citizen of
the State.
7. Control the Effects of Trade Cycles: Direct taxes control the effects of trade cycles.
They can be used as a tool to mitigate the effects of inflationary and deflationary trends by
raising or reducing the tax rates.
Limitations of Direct Taxes- The following are the demerits of direct taxes.
1. Arbitrary in Nature: Direct taxes tend to be arbitrary because of the difficulty in
measuring the ability to pay tax. Paying capacity of the people cannot be measured precisely.
The levy is highly influenced by the policies of the Government.
2. Difficulties in the Formulation of Progressive Tax Rates: Direct taxes take the form of
progressive taxation i.e. the tax rates increase with the rise in income. It is very difficult to
formulate the ideal progressive rate schedules in this regard, since there is no scientific base.
3. Inconvenience: Under direct taxes, the taxpayer has to adhere to many legal formalities such
as submission of the income returns, disclosing the sources of income, etc. Moreover, s/he has to
follow numerous accounting procedures, which are difficult to comply with. Further, direct taxes

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have to be paid in lump sum and at times advance payment of tax has to be made. This causes
much inconvenience to the taxpayers.
4. Possibility of Tax Evasion: The high rates of direct taxes create the tendency to evade more.
There is a possibility for tax evasion by fraudulent activities. Thus, it is said that the direct taxes
are the taxes on honesty.
5. Limited Scope: The scope of the direct tax is very limited. In Ethiopia, most of the people
come under or below the middle-income category. If only direct tax is followed, these people
cannot be brought into the tax net because of the basic exemption given. Thus, the Government
cannot depend upon direct tax alone.
6. Disincentive to Work, Save, and Invest: When the taxpayers earn certain level, they have
to pay more, because of the higher rate of taxes attributed to the higher slabs. This will in turn
discourage them to work further, save and invest.
B. Indirect Taxes
Indirect taxes are taxes on goods and services. They are also referred to as commodity or
consumption taxes, because they are paid only when a particular transaction of goods or services
occurs. Very often, the taxpayer is not aware of how much tax he is paying. The burden or
incidence of indirect taxes falls indirectly on the ultimate consumer rather than on the first
taxpayer. Import and export duty, sales taxes, excise taxes, and value added taxes are treated as
indirect taxes in Ethiopia. In the latest tax reform, decisions were taken to replace sales tax by
VAT, which was enforced starting from Jan 2003.
From the above discussion, we can learn that, 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 on to
others. For example, when the excise duty is levied on the manufacturer of cement, it shifts the
burden of tax to the consumers by raising the selling price. Here, the impact of excise duty falls
on the manufacturer and the incidence on the ultimate consumers. The person, who is required to
pay the tax, does not bear its burden. Thus, indirect taxes can be shifted.
Merits of Indirect Taxes- Indirect taxes have the following merits.
1. Convenience: Indirect taxes are more convenient to the taxpayers. Since the tax is
included in the selling price of the commodities, the consumer pays the tax when he purchases
them. He pays the tax in small amounts (installments), and does not feel its burden. Thus,
indirect taxes are quite convenient and less burdensome.

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2. Wide Scope: While the people with income and wealth above a certain limit are brought
under the levy of direct taxes, indirect taxes are paid by both poor and rich. Under indirect taxes,
everybody pays according to their ability. The tax burden is not imposed on to the small section,
but it is widely spread. Thus, the indirect tax has a wider scope.
3. Elastic: The revenue from the indirect taxes can be increased. Whenever the
Government wants to raise its revenue, or lower it, it can be achieved by increasing and
decreasing the rates of taxes on the commodities whose demand is inelastic.
4. Tax Evasion is Not Possible: Indirect taxes are included in the selling price of the
commodities. So, evading of such tax becomes very difficult. If the person wants to evade the
tax, only refraining the consumption of the particular commodity can do it.
5. Substantial Revenue: Indirect taxes yield substantial revenue to both Central and State
Governments. The developing countries like Ethiopia are heavily dependent on indirect taxes.
Direct taxes have a limited scope in these countries because of low per capita income.
6. Effective Allocation of Resources:
Indirect taxes have great influence in the allocation of resources among different sectors of the
economy. Resources allocation can be made effective by imposing heavy excise duties on low
priority goods and by granting relief to industries producing high priority goods. This results into
mobilization of resources from one sector to another positively.
7. Discourage the Consumption of Articles harmful to Health:
Indirect taxes discourage the consumption of certain commodities, which are harmful to health.
By imposing very high rates of taxes on commodities like liquors, drugs, cigarettes etc., which
are harmful to health, their consumption can be reduced.
Limitations of Indirect Taxes- The following are the demerits of indirect taxes.
1. Ability to Pay Principle is Violated:
Indirect taxes are not directly connected to the taxpayers' ability to pay. Therefore, both the rich
and poor equally pay the tax. Thus, the principle of ability to pay is violated. Indirect taxes are
regressive in nature.
2. Uncertainty:
If indirect taxes are not levied on the commodities of common consumption and levied only on
luxurious articles, they tend to be inelastic. The quantity demanded will be affected by the
imposition of the taxes. Thus, the revenue generated from them is uncertain.

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3. Discourage Saving:
Indirect taxes are included in the selling price of the commodities. Hence, the people have to
spend more on the purchase of the goods. This, in turn, affects the savings of the people.
4. High Cost of Collection:
Indirect taxes are uneconomical, as they involve high cost of collection.
5. Civic Consciousness is not Created:
Under indirect taxes, taxpayers don’t feel the burden of the tax. They are not aware of their
contribution to the State. Thus, indirect taxes do not create the civic consciousness in the minds
of the people.
6. Inflationary:
Indirect taxes cause an increase in the price all around. The increase in the prices of raw
materials, finished goods and other factors of production creates inflationary trends in the
economy.
3.7. Taxation Systems
The ability to pay taxes can be accurately measured with net income. It may be considered as an
appropriate basis for the allocation of tax burden between different sections of the society. To
determine the appropriate tax system, various factors are to be considered.
The tax systems may be summarized as follows:
1. Proportional Tax System.
2. Progressive Tax System.
3. Regressive Tax System.
4. Degressive tax system
Let us explain these systems one by one in detail.
1. Proportional tax system:
A proportional tax, also called a flat tax is a system that taxes all entities in a class typically
either citizens or corporations at the same rate (as a proportion on income), as opposed to a
graduated or progressive scheme. The term“Flat Tax” is one where the tax amount is fixed as a
function of income and is a term mainly used in the context of income taxes. Advocates say that
a flat tax system may arguably have most of the benefits of a progressive tax, depending on
whether the flat rate is combined with a significant threshold. Usually the flat tax is proposed to
kick in at a certain income level, or to exempt income below that level, so that the lowest-income
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members of society pay no income tax. Technically, this is a two stage progressive tax rather
than a flat tax.
Advocates of a flat tax claim that it will end unfair discrimination. They also argue that flat
taxes are easier (and cheaper) to administer and comply with than complex, graduated taxes.
Most political parties that advocate the introduction of a flat tax are on the right of the political
spectrum.
This implies that the rates of taxation should be the same regardless of the size of the income i.e.
"the system in which the rates of taxation remains constant as the tax base changes".
Mathematically, it can be defined as follows: "The amount of tax payable is calculated by
multiplying the tax base with the tax rate".

Tax Payable = Tax Base × Tax Rate

Thus, in the case of proportional tax systems "Multiplier remains constant with the changes in
multiplicand (income)".
Economically, it can be explained as follows:
Example: Proportional Tax System:
Proportional Tax System
Tax Base
Tax Rate in % Amount of Tax (in Birr)
Birr
1500 10 150
6500 10 650
14000 10 1400
23500 10 2350
35500 10 3550
50000 10 5000
Table 3.1 - Proportional Taxation
Graphically, it can be explained as follows:
Rate
10% fixed rate

Tax Base - Income (Birr)

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Merits of Proportional Tax System:
Proportional tax system has the following advantages:
a. It is simple in nature.
b. It is uniformly applicable.
c. leaves the relative economic status of taxpayers unchanged.
d. Avoid mistakes and drawbacks of progressive tax system.
Limitations of Proportional Tax System:
The following are the demerits of proportional tax system:
i. Inequitable Distribution:
A system of proportional taxation would not lead to an equitable and just direction of the burden
of taxation. This is because it falls more heavily on the small incomes than on the high incomes.
ii. Inadequate Resources:
The system of proportional taxation means that the tax rates for the rich and poor are the same.
Hence, the government cannot obtain from the richer sections of the society as much as they can
give.
iii. Inelastic in Nature:
Proportional tax system is inelastic in nature, because the government cannot raise the rate
whenever it wants to raise the revenue. Proportional tax system suffers from the defects of
inequitable distribution of the tax burden, lack of elasticity and inadequacy of funds for the
increasing needs of the modern government. Hence, it is not practically and universally accepted.
2. Progressive Tax System:
A progressive tax or graduated tax is a tax that is larger as a percentage of income for those with
larger incomes. It is usually applied in reference to income taxes, where people with more
income pay a higher percentage of it in taxes. The term progressive refers to the way the rate
progresses from low to high.
Each taxpayer faces two tax rates, his average income tax rate (the proportion of income spent in
income taxes) and his marginal rate (the portion of each additional Birr in income that would be
taken away in taxes). Progressivity of the income tax (higher rates for higher segments of
income) means that marginal tax rates are generally higher than average rates.

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Thus, the progressive tax system can be defined as "a system in which rates of taxation would
increase with the increase in income i.e. higher the income, higher would be the rate of tax".The
rates of taxation increases as the tax base increases. This can be explained mathematically as
follows.
The amount of tax payable is calculated by multiplying the tax base with tax rate as shown
below:

Tax Payable = Tax Base X Tax Rate

In this case, "the multiplier increases as the multiplicand (income) increases".

Economically, this can be explained as under:
Progressive Tax System
Employment income Income Tax (per month) payable
Over Birr to Birr %
0 150 Exempt threshold
151 650 10
651 1400 15
1401 2350 20
2351 3550 25
3551 5000 30
Over 5000 **** 35

From the above example, we can easily understand about the progressive tax system where the
rate of tax increases with the increase in tax base.

Tax Rate (%)

Tax Base - Income (Birr)

Merits of Progressive Tax System:

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It is argued that if the utility gained from income exhibits diminishing marginal returns, then for
the tax burden to be vertically equitable, those with higher incomes must be taxed at higher rate.
The advantages of progressive tax system include the following:
1. Equality in Sacrifice:
Under progressive tax system, the rate of taxation increases as the tax base increases. That is, the
burden of taxation is heavy upon the rich than on the poor. People with higher income tend to
have a higher percentage of that in disposable income, and can thus afford a greater tax burden.
Thus, this system secures equality in sacrifice by ensuring the principle of ability to pay.
2. Reducing the Inequalities of Income and Wealth:
Progressive tax system serves as a powerful instrument for reducing the inequalities of income
and wealth.
3. Economy:
In the progressive system, the cost of collection does not increase with the increase in the rate of
taxes. Hence, it is justified on the grounds of economy.
4. Elastic:
Progressive tax system is elastic in nature to meet the increasing public expenditure. The
government can easily raise its revenue by increasing the rates of taxes. In the case of
progressive taxation, raising the rates for the higher status alone can raise more revenue.
5. Stabilizing the Economy:
Progressive tax system may be helpful in preventing the inflationary trends in the economy as it
reduces the disposable income and purchasing power of the people. Thus, the inflationary trends
can be checked and the economic stability can be achieved.
Limitations of Progressive Tax System:
The following are the demerits of progressive tax system:
1. Ideal Progression is Impossible: the main drawback of progressive taxation is that it is
difficult to frame an ideal graduated progression in tax rates. They are arbitrary
depending on the government’s need for additional funds without taking into account the
burden of people with different incomes.
2. Progressive Taxation –A Graduated Robbery: Progressive taxation is an unjust mode
of taxation and a graduated robbery.
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  Disincentive to Work: It is argued that too progressive a tax rate acts as a disincentive
to work.
 Discourages Savings and Investments: Very high rates of progressive taxes used to
discourage savings and investments. Since a major portion of the income is taken
away by the state by way of taxes, the incentives to produce more and earn more are
lost.
 Shifts the Total Economic Production of Society: The progressive tax system shifts
the total economic production of society away from capital investments (tools,
machinery, infrastructure, research etc.) and toward present consumption goods. This
could happen because high-income earners tend to pay for capital goods (through
investment activities) and low-income earners tend to purchase consumables. Since,
progressive tax systems discourage savings and investments the shifting of economic
production of society could happen. Smithian theory says that spending more on
consumption goods and less on capital goods will slow the rise of the standard of
living.
3. Regressive Tax System:
In regressive tax system, the amount of tax is smaller as a percentage of income for people with
larger incomes. Many taxes other than the income tax tend to be regressive in practice. For
example, most sales taxes (since lower income people spend a larger portion of their income),
excise duty etc. are regressive in nature if they are levied on the goods of common consumption.
Thus, regressive tax is a tax, which taxes a larger percentage of income from people whose
income is low. It places more burdens on those with lower incomes. It is the system in which the
rate of tax declines with the increase in the income or value of property. The larger the assessed
income or property, the lower the percentage paid as tax in regressive taxation."The tax rate
decreases as the tax base increases". The amount of tax payable is calculated by multiplying the
Tax Base with Tax Rate.

Tax Payable = Tax Base X Tax Rate

The schedule of regressive tax rate is one in which the rates of taxation decreases as the tax base
increases. The following table and diagram will explain the concept of regressive taxation.
Regressive Tax System

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 Income Rate of Tax (%) Tax To be
Birr Paid (Birr)

4000 20 800

6000 15 900

12000 12 1440

15000 10 1500

Graphically, it can be explained as follows:

Tax Rate (%)

Tax Base - Income (Birr)

As regressive taxes fall more heavily on the poor section of the community, than on the richer
section, it violates the principles of equity and social justice. That is, through regressive
taxation, principle of equity and social justice cannot be followed. In a welfare country like
whose object is to establish a state without inequalities in the distribution of income and wealth,
regressive taxation has no place.
Even non-income taxes can regressive relative to income. The regressivity of a particular tax
often depends on the propensity of the taxpayers to engage in the taxed activity relative to their
income. 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.
4. DEGRESSIVE TAX SYSTEM
Under this system, the rate of tax is mildly progressive up to a certain limit and thereafter it may
be fixed at a flat rate. The amount of tax payable is calculated by multiplying the Tax Base with
the Tax Rate.

Tax Payable = Tax Base X Tax Rate

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 The concept of degressive taxation can be explained with the help of the following table.

Tax Base Income (Birr) Tax Rate (%) Tax Liability (Birr)

4000 20 % 8, 000
6000 21 % 12, 600
12000 22 % 26, 400
15000 23 % 34, 500
20000 23 % 46, 000

Diagrammatically, it can be explained as follows:

Tax Rate (%)

Tax Base - Income (Birr)

 This system is not popular and is universally not applicable

3.8. Impact, Shifting and Incidence of tax:
The burden of a tax does not always lie on the person from whom it is collected. In many cases,
it is borne by the other people also. Thus, the person who initially pays the tax may not be
actually bearing its money burden as such. Hence, it is necessary to know who bears the
immediate burden of tax and who bears the ultimate burden of tax. According to the law, the tax
is collected from a particular individual or business unit, which has paid the tax in the first
instance and may transfer it to someone else. If such a shifting of tax takes place, the original
taxpayer has served only as a collecting agent.
In the process of taxing, three concepts are involved. They are as follows:
1. A tax may be imposed on some person.

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 2. It may be transferred by him to another person i.e. second person.
3. It may be ultimately borne by the second person.
3.8.1. Impact:
The impact of a tax is on the person who pays the tax in first instance. In other words, the person
who pays the tax to the government in the first instance bears its impact. Therefore, the impact of
a tax is the immediate result of the imposition of a tax on the person who pays it in the first
instance. It refers to the immediate burden of the tax and not to the ultimate burden of the tax.
3.8.2. Incidence:

Incidence of a tax means the final or ultimate resting place of the burden of the tax payment. It refers to the
point at which "tax chickens finally come to the roost ". That is, the location of the ultimate tax burden.
The incidence of a tax is different from its impact, which refers to the point of original
assessment.
If an individual who pays the tax in the first instance finds that he cannot transfer or shift the
burden of the tax to anybody else, then the incidence as well as the impact is on the same person.
If the original or the first taxpayer is able to transfer or shift the tax burden to someone else, then
the shifting of tax will be taken place. For example, the Government levies a tax say, excise duty
on cement and collects the tax from the manufacturer of cement. Now, the impact of the tax is on
the manufacturer. If he is able to pass on the money burden of the tax to the wholesaler by means
of raising the price, then the manufacturer has shifted the tax i.e. he transferred the money
burden to the wholesaler. This process continues and ultimately the consumer bears the money
burden of the tax. Hence, the incidence is on the final consumer.
There are two major economic principles in the analysis of taxation. They are:
(i) the incidence of the tax, and
(ii) Its effects on economic efficiency (referred to as the excess burden or welfare cost of
the tax). These principles are applicable to all taxes.
Concepts of Tax Incidence:
The main issue in the economic analysis of any tax is the identification of the individual or group
of individuals on whom the burden of the tax rests. This is the incidence of the tax. There are
two concepts of tax incidence. They are as follows:

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 1. Legal Incidence: The individual or group of individuals who have the legal
responsibility for paying the tax to the government bears the legal incidence of the tax.
2. Economic Incidence: The individual or group of individuals, whose real income, welfare
or utility is reduced by the tax, bears the economic incidence. The economic incidence is
independent of the legal incidence; that is, those who bear the legal incidence may be different
from those who bear the economic incidence. When the economic incidence differs from the
legal incidence, the burden of the tax is said to be "Shifted".
The effects of a tax on the allocation of resources and on the distribution of income depend on
the economic incidence, not the legal incidence.
3.8.3. Shifting:
It refers to the process by which the money burden of a tax is transferred from one person to
another. Whenever there is a shifting of taxation, the tax may be shifted either forward or
backward.
A producer, upon whom a tax has been imposed, may shift the tax burden to the consumer or to
the factors of production. If the producer shifts the tax burden to the consumer, it is known as
"Forward Shifting". On the other hand, if the producer shifts the tax burden to the factors of
production i.e. to the suppliers of raw materials etc., it is known as "Backward Shifting". The
backward shifting can be taken place by compelling the supplier to reduce the price of raw
materials etc.
3.8.4. Differences between Impact and Incidence:
1. The impact refers to the initial money burden of the tax. But the incidence refers to
ultimate money burden of tax.
2. The impact is felt by the person from whom tax is collected. But the incidence is felt by
the person who actually pays tax.
3. Impact can be shifted. But incidence cannot be shifted.
3.9. Tax Planning, Avoidance and Evasion
Tax planning: An arrangement of one’s financial affairs without violating in any way the legal
provisions full advantage is taken of all tax exemptions, deductions, concessions, rebates,
allowances and other relief's or benefits provided under law in such a way that incidence of tax is
reduced to minimum and money remaining after tax payment is kept maximum.

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A primary goal of tax planning is to apply current laws in a manner that allows the individual or
business to reduce the amount of taxable income for the period. planning for taxes involves
knowing which types of income currently qualify for as exempt from taxation. The process also
involves understanding what types of expenses may be legitimately considered as deductions,
and what circumstances have to exist in order for the deduction to be claimed on the tax return.
Some examples techniques of tax planning
 Investing in least developed region to takes the advantage of tax incentives
 Undertaking labor intensive industries that reduce unemployment there by to take the
of investment tax credit and relief
 Investing on tax free government treasury bills and bonds.
 The use of financing methods that minimizes tax burden like debt financing
 etc
Tax Avoidances: it is a method of minimizing tax liability by taking the advantage of the
loopholes in tax laws rather than acting in accordance the intent of the tax law. Tax avoidance is
neither legal nor illegal advice of saving tax burden. How it is unethical, immoral and
unacceptable. When the loophole of tax laws, which minimizes the tax burden, becomes public,
the legislative takes legislative measure to plug such loopholes.
Techniques of tax avoidances Example
 Splitting transaction to avoid with hold income tax on payments
 Splitting a business to escape VAT registration
 Paying stock dividends on the behalf of cash dividends to avoid dividend income tax
 Providing non taxable allowances to employees to escape employment income tax
 etc
Tax Evasion: it is a method of minimizing tax liability by directly violating the tax laws.
Usually entails deliberately misrepresentation of the true status of financial affairs or dishonest
tax reporting to the tax authority of reduce the tax liability. Unlike tax avoidance and tax
planning tax evasion is un lawful act it leads to administrative and criminal penalty.
Some of techniques of tax evasion:
 selling transactions with out sales invoice
 under invoicing sales transaction

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 over invoicing duty free machines imported from abroad
 claiming tax refund using fictitious invoices
 over statements of expenses using false purchase invoices
 reporting personal expenses as business expenses
 Contraband
 Etc

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