PUBLIC FINANCE AND TAXATION

PREFACE

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. Besides, he pays tax on his income, wealth, etc.

Students of Accounting and Finance, who deeply involve themselves in all the fields of
finance, are in dire need of knowing about tax both direct and indirect and the underlying
principles behind their levy. Without the knowledge of tax, it becomes futile to study a course
pertaining to business and finance. So, a study of tax is indispensable to the students of
Accounting and Finance, which paves ways for knowing about the fundamental principles of
taxation.

The chapters have been strengthened, updated and modified to improve, clarify and arouse an
enthusiastic interest in the subject of "Taxation". Care has been taken to reduce the complex
vocabulary to the minimum. Charts and diagrams are liberally used to enable the students to
capture the essence of the concepts and ideas at a glance.
 INDEX

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PART-I

CHAPTER-I-INTRODUCTION 11-29
1.1. Introduction 11
1.2. Private Goods 12
1.3. Public Goods 13
1.4. Merit Wants 14
1.5. Functions of Modern Government and Fiscal Operations 15
1.5.1. Allocation Function 15
1.5.2. Distribution function 16
1.5.3. Stabilization Function 16
1.6. Public Finance 16
1.7. Scope of Public Finance 17
1.7.1. Public Revenue 17
1.7.2. Public Expenditure 19
1.7.3. Public debt 21
1.7.4. Financial Administration 22
1.7.5. Economic Stabilization 22
1.8. Fiscal Policy 23
1.8.1. Role of Fiscal Policy in the Economic Development 24
1.9. Public Finance Vs Private Finance 26
1.9.1. Similarities between Public Finance and Private Finance 26
1.9.2. Dissimilarities between Public Finance and Private Finance 27

CHAPTER-II-BUDGET AND FINANCING 30-54

2.1. Functions of Budget 30
2.2. The Concept of Budgeting in Ethiopia 31
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2.3. Budget Structures in Ethiopia 32

2.3.1. Revenue Budget 32
2.3.2. Expenditures Budget 33
2.3.3. Line Item Budget 38
2.4. The Budget Process in Ethiopia 39
2.4.1. The Budgetary Process at the Federal Level 40
2.4.2. The Budgetary Process at the Regional Level 45
2.5. Budget Deficit 46
2.5.1. Methods of Financing Deficit 47
2.5.2. Objectives of Deficit Financing 48
2.5.3. Effects of deficit financing 48
2.5.4. Deficit financing in Ethiopia 49
2.6. Categories of Revenues to Government 49
2.6.1. Revenue on the Basis of Mode of Collection 49
2.6.2. Revenue on the basis of Nature 51
2.6.2.1. Tax Revenue 52
2.6.2.2. Non-Tax Revenues 53

CHAPTER-III- TAX- BASICS 55-94

3.1. Meaning of Tax 55

3.2. Stages in the Development of Levy of Tax 55
3.3. General Characteristics of Tax 56
3.4. Objectives of Taxation 58
3.4.1. Specific Objectives 58
3.4.2. General Objectives 58
3.5. Approaches To Taxation 60
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3.5.1. Cost of Service Approach 60

3.5.2. Expediency Approach 61
3.5.3. Socio-Political Approach 62
3.5.4. Benefit Principle Approach 63
3.5.5. Ability to Pay Approach 65
3.5.5.1. Justification to Ability Theory 66
3.5.5.2. Index of Ability to Pay 66
3.5.6. Subjective Approach 69
3.6. Canons of Taxation 71
3.6.1. Canons Advocated by Adam Smith 72
3.6.2. Canons Advocated by Bastable. et.el. 74
3.7. Direct and indirect taxes 76
3.7.1. Direct Taxes 76
3.7.1.1. Merits of Direct Taxes 77
3.7.1.2. Demerits of Direct Taxes 78
3.7.2. Indirect Taxes 79
3.7.2.1. Merits of Indirect Taxes 79
3.7.2.2. Limitations of Indirect Taxes 80
3.7.3. Differences between Direct and Indirect Taxes 81
3.8. Impact, Shifting and Incidence of Taxation 82
3.8.1. Impact of Taxation 84
3.8.2. Incidence of Taxation 84
3.8.3. Shifting of Taxation 85
3.8.4. Differences between Impact and Incidence 85
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3.8.5. Theories of Tax Shifting or Incidence of Taxation 86

3.8.5.1. The Traditional Theory 86
3.8.5.2. The Concentration Theory: 86
3.8.5.3. Diffusion Theory: 87
3.8.5. 4.Modern Theory 88
3.9. Effects of Taxation 89
3.9.1. Effects of Taxation on Production 89
3.9.1.1. Effects on the Ability to Work, Save and Invest 90
3.9.1.2. Effects of Taxation on willingness to Work, Save and Invest 90
3.9.1.3. Effects of Taxation on the Diversion of Economic Resources 91
3.9.1.4. Effects on the Size of Industries 91
3.9.2. Effects of Taxation on Distribution 92
3.9.2.1. Nature of Taxation 92
3.9.2.2. Kinds of Taxes 93
3.9.3. Effects of Taxation on Consumption 93

CHAPTER-IV- TYPES OF TAXES 95-122

4.1. Tax on Income 95
4.2. Wealth / Capital Tax 97
4.3. Estate Duty and Inheritance Tax 99
4.4. Commodity Taxes 102
4.4.1. Sales Tax 102
4.4.2. Value Added Tax: 105
4.4.2.1. Forms or Kinds of Value Added Tax 106
4.4.2.2. Methods of Calculating Vat Liability 110
4.4.2.3. Common Debate on VAT 116

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4.4.3. Excise Tax 118

4.4.4. Customs Taxes 122

CHAPTER-V- TAXATION SYSTEMS 123-138

5.1. Proportional, Progressive and Regressive Tax Systems 123

5.1.1. Proportional Tax System 123
5.1.2. Progressive Tax System 126
5.1.3. Regressive Tax System 129
5.1.4. Degressive Tax System 130
5.2. Advalorem and Specific Duties 132
5.2.1. Advalorem Duty 132
5.2.1.1. Merits of Advalorem Duty 132
5.2.1.2. Demerits of Advalorem Duty 132
5.2.2. Specific Duty 133
5.2.2.1. Merits of Specific Duty 133
5.2.2.2. Demerits of Specific Duty 134
5.2.3. Differences between Advalorem Duty and Specific Duty 134
5.3. Single Point and Multi-Point Tax Single Point Tax 135
5.3.1. Single Point Tax 135
5.3.2. Multi-Point Tax 136
5.3.3. Difference between Single Point Tax and Multi-Point Tax 136
5.4. Types of Tax Rates 137
CHAPTER –VI- FEDERAL FINANCE 139-149

6.1. Federalism 139

6.2. Federal Finance 139

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6.3. Principles of Federal Finance 139

6.4. Modes of Allocation of Revenue Resources in Federal Government 141
6.4.1. Balancing Factors of Allocation 141
6.4.2. Disbursing and Transfer of Public Funds 143
6.4.3. Pattern of Revenue Sharing 143
6.5. Distribution of Revenues between Central and States 144
6.5.1. Objectives of Revenue sharing 144
6.5.2. Basis for Revenue Sharing 144
6.5.3. Categorization of Revenue 145
6.5.3.1. Central List 145
6.5.3.2. Regional List 146
6.5.3.3. Joint/Concurrent List 146
6.5.4. Committee for Revenue sharing 147
6.5.5. Subsidy 147
6.5.6. Relations of Tax Systems 148
6.5.7. Collection of Revenue 148

CHAPTER-VII- TAX EVATION, AVOIDANCE AND BLACK MONEY 150-169

7.1. Tax Avoidance and Evasion 150

7.1.1. Tax Avoidance 150
7.1.2. Tax Evasion 151
7.2. Causes of Tax Evasion 152
7.3. Remedies for Tax Evasion 153
7.4. Black Money 154
7.4.1. Black Economy 154
7.4.2. Black Income and Black Wealth 155
7.4.3. Black Economy and Black Money 155
7.5. Impact of Black Money in Ethiopian Economy 156
7.5.1. Macro Economic Impact of Black Money 156
7.5.2. Micro Economic Impact of Black Money 157
7.6. Measurement or Estimation of Black Money 158
7.7. Sources Generating Black Money 159
7.8. Causes of Black Money 162
7.9. Effects of Black Money 165
7.10. Remedies for the Black Money 167

CHAPTER-VIII- DOUBLE TAXATION 170-178

8.1 Examples of Double Taxation 170

8.2. Kinds of Double Taxation 170
8.3. Effects of Double Taxation 172
8.4. Remedies for Double Taxation 173
8.4.1. Remedies for the Problem of International Double Taxation 173
8.4.2. Remedies for Internal or Federal Double Taxation 173
8.5. Methods of Elimination of Double Taxation 174
8.5.1. Exemption Method 174
8.5.2. Credit Method 174
8.6. Double Tax Avoidance Agreements 176
There exists an intrinsic connection between the common good on the
one hand and structure and function of public authority on the other. The moral
order, which needs public authority in order to promote the common good in human
society, requires also that the authority be effective In attaining that end.

POPE JOHN XXIII

PART-I
PUBLIC FINANCE

CHAPTER-I
INTRODUCTION

1.1. Introduction

The participation of the government in the economic activities is essential to accomplish

the goals of any welfare state. Classical economists advocated minimum functions for the
government. Subsequently, the economists Keynes demonstrated that it was possible through
fiscal activities of the state to increase employment and to maintain it at high level. This
realization led to emphasis on the active participation of the state in the economic activity.

The governments of advanced countries are committed to stability and full employment.
In case of under developed countries the government aims at accelerated economic development.
Government sector can play a decisive role in shaping and charting the path of any economy.
Depending on the level of development of each country the roles of government sector differ.
However, in all cases the aim is to attain full employment and economic development through
the development of agriculture, industry and service sector. Today the communication sector has
also been included in these vital sectors of the economy.

The Private finance deals with the wants and the satisfaction of households and firms.
But the public finance deals with the collective wants and their satisfaction. The objective of
both private and public finance is similar. Private finance aims at maximizing social welfare or
social benefit by efficient use of public goods. Distinction between private and public goods is
important in the study of public finance.

1.2. Private Goods:

 Private goods refer to all those goods and services, which are consumed by people to
satisfy their personal and private wants or needs. They relate to articles of food, clothing, shelter,
recreation, transportation, communication etc. These goods are priced in the market on the basis
of their cost of production on the one side and the nature of demand on the other. All those who
want them and are willing to pay the market price will buy them. Those who do not want them or
who are not in a position to pay for them will be excluded from the consumption of these goods.
In other words there is no compulsion that every one will have to buy them. Thus distribution of
these goods is based on effective demand and market price. As a result, only those who do
demand the private goods will pay for their cost of production on a voluntary basis. Thus, private
goods are divisible in the sense that price mechanism divides people in to two groups, viz., those
who want to consume them and those do not; and private goods are subject to the principle of
exclusion; in the sense that price mechanism excludes the group of people who are not willing to
consume a particular good.

But price mechanism or market mechanism may fail when ever private goods are
associated with the concept of externalities. Now, externalities refer to favorable and unfavorable
effects which are associated with the production of those goods. The setting up of a factory in a
backward region will help to open up the former and help to develop it; this is an example of an
externality in the form of an economic gain. On the other hand, an atmospheric and water
pollution of a chemical and fertilizer factory in an area is an example of unfavorable economic
effect. The externalities are also referred to as spill over effects, neighborhood effects or third
party effects.

The economic gain or economic loss associated with externalities can not always be
priced in the market and can not be apportioned to particular parties. For example, it is not
possible to find out exactly how much is the benefit of a new factory set up in a backward region
or the exact extent of economic loss due to ash and smoke nuisance of a thermal power station
using coal. These are examples of non- market external effects. In case, external effects,
favorable or unfavorable, can precisely be calculated, in terms of money, and can be made part
of the cost of production; then they can be passed on to those who get those external efforts –
this will be the case of market external efforts.

1.3. Public Goods:

 Collective wants are those which are demanded by all members of the community in
equal or more or less equal measures. Defense, education, public health, infrastructure facilities
like power, transportation and communication, etc., are examples of collective wants. Goods and
services produced to satisfy collective wants are known as public goods. These goods are
produced and supplied by the society to meet its collective wants for increasing social welfare.
These goods are supplied by the country to all its citizens. But the degree of benefit a person
derives will depend upon the use he can put it to. For example, medical and educational facilities
are made available for all the people of Ethiopia.

It is important to recognize two features of public goods. First, they cannot be divided
and their benefits can not be shared between the people on the basis of each man’s requirements.
In other words, unlike private goods, public goods are not divisible but have to be collectively
consumed. If public goods are made available to meet collective wants, the question is: who will
pay for them or in what proportion will they bear the cost of production of these goods and
services.

Secondly the principle of exclusion easily associated with private goods is not applicable
in the case of public goods since they are not consumed distributively. Hence these goods will
not be produced by the private sector. On the other hand, they will have to be produced and
supplied by the public authorities to meet collective wants. The price mechanism does not apply
and these goods can not carry a price tag. As everyone is a beneficiary - directly or indirectly of
the public goods, everyone is asked by the public sector authorities to pay towards the cost of
production of the public goods. No one can refuse to pay for the supply of public goods on the
ground that they are direct beneficiaries. For example, an abiding citizen can not refuse to pay
towards the maintenance of police or a childless can not refuse to pay towards the expenditure on
education on the plea they do not benefit by them.

Actually, everybody wants to enjoy the benefits of public goods be they defense
goods, law and order, education etc., but no one wants to pay for them. At the same time, the
consumers do not have any system of priority in the case of public goods. Again the taste,
preferences etc., of consumers are not relevant and the public authorities do not attach any
importance to the consumers while producing and supplying public goods. As the people too
may not show any interest or any inclination in the production of these goods, the government
has the sole responsibility to decide about how much of these goods should be produced, the
method of production and the technique of distribution.

Since the public goods are supplied to all the people irrespective of their ability
and willingness to pay for them, the pricing system is useless and therefore, a method of
compulsory payment will have to be designed to finance their cost of production.

1.4. Merit Wants:

Certain types of collective wants such as educational facilities have been called as merit
wants since they command overwhelming importance in the attainment of social welfare.
Provision of public goods meant to satisfy such wants will help the economy to achieve a high
level of efficiency and welfare. If education is left to the private sector and accordingly
educational facilities are supplied by the private sector on the basics of cost of production, the
educational facilities will cost so much that many people in the lower income brackets will not
be able to get them. Many an intelligent but poor student will be denied educational facilities.
This will reduce economic efficiency and social welfare of the community. In the same way, if
hospital facilities are provided by the private sector units, they will be so expensive that only the
rich will be able to make use of them and vast majority of people belonging to middle and lower
income groups will be denied these facilities. It is for this reason that the state should either
supply these goods to the community or at least supplement private effort directly or indirectly-
directly by government schools and colleges or indirectly by subsidizing education to make it
within the reach of every body.

The important difference between the satisfactions of merit wants and of social wants is
that the former calls for interference with consumer preferences. Besides, the provision of merit
wants will confer immediate benefits on those groups of people who are in immediate need of
them but the community benefits in general as the society becomes more educated and healthier.
It is for this reason that merit wants must have substantial element of social wants.

The above analysis of private costs and social costs is based on the objective of efficient
allocation of resources of an economy between private and public goods with a view to
maximize social welfare. The use of price mechanism to determine efficiency in the allocation of
resources assumes the existence of free market. This type of analysis may be suitable to
predominantly capitalist economy such as U.S.A. but is not applicable to a fully collectivist or
partly socialist economies in which market mechanism does not either exist o is not allowed play
a free role.

1.5. FUNCTIONS OF MODERN GOVERNMENT AND FISCAL OPERATIONS:

It was only in the 20th century and particularly after Keynes demonstrated the
necessity of state interference for stabilizing an economy and to bring about full employment that
the full importance of fiscal operations of tax, public expenditure and public debt policy was
appreciated. The social economic consequences of fiscal operations are quite elaborately
explained in detail in later chapters- effects of taxation, effects of public expenditure, effects of
public debt and public debt management and fiscal policy and economic development. We
should know the role of the government to enable us to appreciate the importance of government
sector. Government of a modern state generally undertakes the following functions:

1.5.1. Allocation Function:

The government operations basically involve the efficient provision of government funds
in maximizing the welfare of the community. The government taxes the public and uses the
amount in providing certain facilities and services considered essential by the people and the
community. These facilities are such that they could not be provided by the people themselves
such as defense, or they could be provided but only at a high cost such as education and
Medicare. Fiscal operations of taxation and public expenditure have the effect of transferring
resources from the public which would have been used for consuming private goods to produce
public goods which would satisfy collective wants. The objective of fiscal operations is to
provide for the proper allocation of resources between private and public goods so as to
maximize social welfare.

1.5.2. Distribution function:

In a free enterprise economy, distribution of income and wealth is unequal and many
times it is grossly unequal resulting in exploitation of the lower income gropes. Inequality of
income and concentration of economic power in the hands of a few are responsible for distorting
production in favor of the rich and for reducing the social welfare of the community. Fiscal
operations have been used to reduce the incomes and wealth of the rich (through progressive
taxation) and using the money collected to raise the income and standard of living of the lower
income group (through public expenditure}. The use of fiscal policy to reduce inequality of
incomes and wealth has been quite common in many countries.

1.5.3. Stabilization Function:

Modern economies are subject to fluctuations, viz., business boom and inflations on one
side and business recessions and depressions on the other. Such fluctuations are not in the
interest of the country. Fiscal operations have been used to moderate these fluctuations and if
possible to eliminate them altogether. For instance, business booms and inflations are sought to
be controlled through heavier taxation while business recession is sought to be checked through
public expenditure.

Functions of modern governments are broadening due to socio-political reasons.

Therefore, to discharge these increasing functions, the government has to increase its
expenditure. To meet out the enormous amount of expenditure it has to mobilize funds with the
help of public finance policy. Hence public finance has developed into an important branch of
economics.

1.6. Public Finance:

The study of state is called “Public Finance”. Public finance is the study of income and
the expenditure of the government. Rising of necessary funds for incurring expenditure
constitutes the subject matter of public finance. The methods of public finance have certain
effects on economic life and can, therefore, be used as an instrument for bringing about desired
social and economic changes. Public finance also deals with the problems of adjustments of
income and expenditure of the government. It is also known as fiscal operations of the treasury.
Thus, fiscal operations and fiscal policies are integral part of public finance.

Public Finance deals with the income and expenditure of the public authorities. Here the
term Public means the Government that is Central, state and local authorities. According to
Prof. Dalton, public finance is one of those subjects, which lie on the borderline between
Economics and Politics. It is concerned with the income and expenditure of public authorities
and with the adjustment of one to another.
 Hence, it can be defined as the science that deals with the nature and principles of the
income and expenditure of the government.
Ethiopia has adopted the policy of welfare state for bringing about social and economic
justice. Public finance policy of the country is drawn up in tune with the constitutional
commitment Welfare state. Under the welfare state, government performs important functions
and takes up certain public or collective welfare measures which private sector cannot provide.

1.7. Scope of Public Finance:

Public finance deals with the income and expenditure pattern of the Government Hence
the substances concerned with these activities become its subject matter. The subject matter of
the public finance is classifies under five broad categories. They are,

1. Public revenue
2. Public Expenditure
3. Public debt
4. Financial administration
5. Economic stabilization
We shall now explain them briefly.

1.7.1. Public Revenue:

Under this category, the sources of the public revenue, principles of taxation, effects of
taxes on the economy, methods of raising revenue and the like are dealt with. Public revenue is
the means for public expenditure. Various sources of public revenue are:
a. Tax revenue, and
b. Non-tax revenue
Increasing activities of the government are the cause of increasing public expenditure.
Methods of public revenue and their volumes have significant impact on production and
distribution of wealth and income in the country. It has effects on the nature and the volume of
economic activities and on employment.

a. Tax revenue:
Taxes are compulsory payments to government without expectation of direct return or benefit
to tax payers. It imposes a personal obligation on the taxpayer. Taxes received from the
taxpayers, may not be incurred for their benefit alone. Tax revenue is one of the most important
sources of revenue.
Taxation is the powerful instrument in the hands of the government for transferring
purchasing power from individuals to government. The objectives of taxation are to reduce
inequalities of income and wealth; to provide incentives for capital formation in the private
sector, and to restrain consumption so as to keep in check domestic inflationary pressures.

From the above discussion we can conclude that the elements of taxation are as follows:

1. It is a compulsory contribution
2. Government only imposes taxes
3. In payment of tax an element of sacrifice is involved
4. Taxation is aimed at welfare of the community
5. The benefit may not be proportional to tax paid
6. Tax is a legal collection.

The various types of taxes can be listed under three heads. First type can be titled taxes
on income and expenditure which include income tax, corporate tax etc. The second is taxes on
property and capital transactions and includes estate duty, tax on wealth, gift tax etc. The third
head, called taxes on commodities and services, covers excise duties, customs duties, sales tax,
service tax etc. These three types can be reclassified into direct and indirect taxes. The first two
types belong to the category of direct taxes and the third type comes under indirect taxes.
b) Non-tax revenue:
This includes the revenue from government or public undertakings, revenue from social
services like education and hospitals, and revenue from loans or debt service. To sum up, non-tax
revenue consists of:
i) Interest receipts
ii) Dividends and profits
iii) Fiscal services and others.

1.7.2. Public Expenditure:

Recently, there has been both quantitative and qualitative change in government’s
expenditure. This category deals with the principles of public expenditure and its effect on the
economy etc.
 Government of a country has to use its expenditure and revenue programs to produce
desirable effects on national income, production, and employment. The role of public
expenditure in the determination and distribution of national income was emphasized by Keynes.

The term “Public Expenditure” is used to designate the expenditure of government-

central, state and local bodies. It differs from private expenditure in that governments need not
pay for themselves or yield a pecuniary profit. Public expenditure plays the dual role of
administration and economic achievement of a nation. Wise spending is essential for stability of
government and proper earnings are a prerequisite for wise spending. Hence planned expenditure
and accurate foresight of earnings are the important aspects of sound government finance.

Public expenditure is done under two broad heads viz., developmental expenditure and
non-developmental expenditure. The former includes social and community services, economic
services, and grants in aid. The latter mainly consists of interest payments, administrative
services, and defense expenses. Expenditure can also be classified into revenue and capital
expenditure.

Plan and Non-plan Expenditure:

Expenditure is classified under the following heads:

a. Non-plan Expenditure:
Non-plan expenditure of central government is divided into revenue and capital
expenditure. Under non-plan revenue expenditure we include interest payment, defense
expenditure, major subsidies, interest and other subsidies, debt relief to farmers, postal deficit,
police, pensions, other general services, social services, grants to states and union territories.
Non-plan capital expenses include defense expenses, loan to PSUs, loans to states and union
territories, foreign governments etc.

b. Plan expenditure:
The second major expenditure of central government is plan expenditure. This is to
finance the following
 i) Central plans such as agriculture, rural development, irrigation and flood control,
energy, industry, and minerals, communication service and technology, environment,
social service and others.

ii) Central assistance for plans of the states and union territories.

Expenditure can also be categorized into revenue and capital expenditure. Revenue
expenditure relates to those, which do not create any addition to assets, and covers activities of
government departments’ services, subsidiaries and interest charges. Capital expenditure
involves that expenditure, which results in creation of assets. Finance ministry is responsible for
plan expenditure. This includes grants to the state.

Hence the expenditures are classified as capital and revenue. Alternatively, these
expenses can be re-classified into plan and non-plan expenditure.

Social expenditure:

Government takes the responsibility of protecting the interests of the community as a

whole and promotes the implementation of welfare programs. Government spends huge amounts
for providing benefits such as old age pensions, accident benefits free education and medical
services. This expenditure on human resources comes under social expenditure.

Governments are moving towards the objective of achieving maximum social welfare.
Expenditure on education, public health, welfare schemes for workers, relief and rehabilitation of
displaced persons and such other services may not yield direct benefit in the short run. But in the
long run they contribute to improvement in the quality at human resources. The main
classifications of Government expenditure can be seen in the following diagram.

Public expenditure

Revenue capital
Expenditure expenditure

Plan Non-plan
Central plan Interest payments
Central assistance Subsidies
 to states & PSUs Defense
Others

Plan Non- plan

Developmental Defense, capital
Projects Loans to PSUs
Loans to Regional/state
Governments & Others.

1.7.3. Public debt:

This category deals with the causes, methods and problems of public borrowings and its
management. This includes both internal debt and external debt.

a. Internal debt:

Increasing need of government for funds cannot be fully met by taxation alone in under
developed and developing countries due to limited scope of taxation. Government therefore has
to resort to alternate sources. Rising of debt is one such source. Debt, though involves
withdrawal of resources by curtailing private consumption, has certain advantages. Transfer of
funds from public to government is voluntary. Loans do not reduce the wealth of the lenders.
Debt raised for productive purpose will not be a burden on the economy.

There are many objectives of creation of public debt. Debt may be raised to meet the normal
current expenditure, exigencies like war, finance productive government enterprise, finance
public social welfare and economic development.

Capital receipts mainly consist of market borrowings, small savings and external loans,
disinvestments of PSUs and recoveries of loans.

b. External Debt:
In under developed and developing countries, internal sources are limited. Under
developed and developing countries, therefore go for external debt. The transfer of capital at
international level may take the form of:

i) Financial aid through grants and loans

ii) Commodity aid
iii) Technical assistance
 External debt is an immediate source of funds for development. However, such debt has
following drawbacks.
i) Political subordination
ii) Other obligation
iii) Excess supply of goods and services in debtor country

However, such external inflows help to achieve faster growth.

1.7.4. Financial Administration:

This category includes the preparation of financial budget, the control and
administrations of the budget relevant problems auditing etc. The term budget includes ‘Annual
Financial Statements’ which incorporates all the annual statements of receipts and expenditures
of the government.

1.7.5. Economic Stabilization

Generally under developed countries have the following features.

1. Predominantly agriculture based economy

2. Low capital formation
3. Inferior technical know how
4. Low per capita income
5. Over population and poor health and educational facilities.
6. High propensity to consume leading to low capital formation.

This category analyses the use of public finance to bring the economic stability in the
country. It studies the use of financial policies of the Government from the view of economic
development.

1.8. Fiscal policy:

Fiscal policy is also called as budgetary policy. In broad terms, fiscal policy refers to that
segment of national economic policy, which is primarily concerned with the receipts, and
expenditures of these receipts and expenditures. It follows that fiscal policy relate to those
activities of the state that are concerned with raising financial resources and spending them.
Resources are obtained through taxation and borrowing both within the country and from abroad.
Spending is done mainly on defense development and administration. Financial accounts of the
income and expenditure position are shown in budgetary statement. Budget can act as an
important tool of economic policy. The state by its policy of taxation-regulated expenditure can
influence the economic activities and development.

Private outlay is insufficient to produce maximum national income. An increase in state

outlay beyond its revenue can increase national income. Keynes emphasized the effects of
government revenue and expenditure upon the economy as a whole and argued that they should
be used deliberately and consciously to secure economic stabilization. This underscores the
importance of budget in economic development.

Fiscal policy relates to the governments decision making with respect to the following:
1.Taxation 2.Government spending 3.government borrowing and 4.management of government
debt. The policy relates to government decisions, which influence the degree and manner in
which funds are withdrawn from private economy. Basically fiscal policy in these different
facets deal with the flow of funds out of the private spending and saving stream into the hands of
government and the recycle funds from government into the private economy.

It is thus obvious that fiscal policy deals quite directly with matters, which immediately
influence consumption and investment expenditure. Therefore, it influences the income, output
and employment in the economy. Fiscal policy is primarily concerned with the aggregate effects
of public expenditure and taxation on income output and employment. In developed economies
the propensity to consume leads to stability. Excess saving by the community leads to lowering
of demand for goods and services resulting in sub optimal employment level. Fiscal policy
should balance the economy by sustaining the consumption in the economy.

In under developed and developing countries main objectives are rapid economic
development and an equitable distribution of the income. Fiscal policy can be an important
instrument for attaining these objectives. Fiscal policy influences the economy by the amount of
public income that is received and on the other by the amount and direction of public
expenditure. The important fiscal means by which resources can be raised for the public
exchequer are taxation, borrowing from public and credit creation. These means must be used in
harmonious combination so as to produce the best overall effects on the economic life of the
people in terms of economic progress and social welfare.

1.8.1. Role of Fiscal Policy in the Economic Development:

1. In under developed and developing countries development is the main concern. The
primary task of fiscal policy in an under developed and developing countries is to allocate more
resources for investment and to restrain consumption.

2. The fiscal policy should reduce the economic inequalities of income and wealth. This
can be achieved by taxation and public distribution measures. Poverty and unity cannot co exist.
Therefore fiscal policy should attempt economic development of the socially unfortunate to bring
about national unity. Private section is not interested in investing in social and economic
overheads. Investments in social and economic overheads like education, medical facilities,
infrastructure, dams etc. are very essential to accelerate the rate of economic growth.

3. In under developed and developing countries the requirement of growth demands that
fiscal policy has to be used progressively for raising the level of investments and savings rather
than keeping the consumption level. In under developed and developing countries fiscal policy
has to be used as an instrument of resource mobilization. In order to attain growth with stability
the goal of fiscal policy should be promotion of highest possible rate of capital formation and
should reduce the actual and potential consumption. Further fiscal policy should encourage
private investment and attract foreign funds for development projects.

4. The existing pattern of investment may differ from the optimum pattern of investment.
Thus it becomes a responsibility of government to undertake investments in such a way that it is
most beneficial for the people of the country.

5. Fiscal policy should control inflation within tolerable levels since inflation mostly
affects the poor.

In under developed and developing countries there exist regional imbalances in addition
to social inequalities. Fiscal policy should aim at reducing both regional and social imbalances
by directing investments to less developed regions. Their marginal propensity to consume is very
high. Therefore, a small increment in investment can bring manifold employment due to
multiplier effect.

Fiscal policy should direct available resources for providing basic physical,
infrastructural needs like irrigation, roads, basic industries, railways, ports, telecommunications
etc. Fiscal policy should assign high priority to the creation of overhead capital. Spending of the
government should also take care of education and health of the community. Returns on these
investments are long-term and private sector cannot provide above investments.

Therefore government of a country through its fiscal policy is able to increase rate of
investment and also alter the pattern of investment. It follows that the main role of fiscal policy
in an under developed and developing countries is to expand productive capacity by raising the
level of real capital including skills as well as plants and equipment and to check the demand
generating effect of expanding investment. In developed countries its role is to expand both
production capacity as well as the level of aggregate monetary demand in relation to their
economic growth. In under developed countries the better approach is to transfer resources to
capital formation without inflation.

Fiscal policy through its different measures such as taxation policy budgetary policy,
public debt policy and a co-ordination with monetary policy can direct the economic destiny of a
nation. Fiscal policy can be used to mitigate the effects of trade cycles such as inflation and
depression.

1.9. Public finance Vs Private finance

There are both similarities and differences between public finance and private finance.
Let us discuss the similarities first.

1.9.1. Similarities between Public Finance and Private Finance:

1. Satisfaction of Human Wants: Individual is concerned with the personal wants, while the
Government is concerned with the social wants. Thus, both the private and public finance have
the same objective, viz, the satisfaction of human wants.

2. Balancing of Income and Expenditure: Both individual and Government have incomes
and expenditures and trying to balance each other.
 3. Maximum Satisfaction: Both private and public finance aim at maximum satisfaction.

4. Borrowing a Common Feature: As and when the current incomes becomes insufficient
to meet the current expenditure, the individuals and Governments rely upon borrowings. Both of
them are having loan repayment plans.

5. Economic Choice a Common Problem: Both the individual and Government face the
problem of economic choice. That is their sources of revenue are limited, comparing with their
expenditure. Hence, they have to satisfy the unlimited ends with limited means.

1.9.2. Dissimilarities between Public Finance and Private Finance

Even though the private and public finances look alike, there are certain fundamental
differences between them. They are,
1. Adjustment of Income and Expenditure:
In private finance, the individual first considers his income and then decides about his
expenditure.
But the case of public finance, the government first estimates the volume of expenditure and
then tries to find out the methods of raisins the necessary income
That is the private finance tries to adjust its income to expenditure, whereas the public
finance tries to meet the expenditure by raising income.

2. Nature of Benefit:
The private finance aims at individual benefit i.e., the benefit of individual household.
But the public finance aims at collective benefit, i.e. the benefit of the nation as a whole.
3. Postponement of Expenditure:
In private finance, the individual can postpone or even avoid certain expenditure, as he likes.
 But in the case of public finance, the Government cannot avoid certain commitments kike
social welfare measures and thus cannot postpone the certain expenses like relief measures,
defense, etc.
4. Allocation of Resources:
In private finance the individual can allocate or distribute his income to various expenditure
in such as way to get the maximum satisfaction.
But it is not possible in the case of public finance; Government cannot aim at maximum
satisfaction on the expenditures made.’

5. Motive of expenditure:
In the case of private finance, the individual expects return in benefit from the expenditure
made.
But the government cannot expect return in benefit from various expenditures made.
That is profit or benefit is the motive of private finance whereas the social welfare and

economic development is the motive of public finance.

6. Influence on expenditure:
The expenditure pattern of private finance is influenced by various factors such as customs,
habits culture religion, business conditions etc.
But the pattern of expenditure of public finance is influenced and controlled by the economic
policy of the Government.

7. Nature of Perspective:
In private finance, the individual strives for immediate and quick return. Since his life
span is definite and limited he gives importance to the present or current needs and allots only a
little portion of income for the future.
But, the Government is a permanent organization and is the caretaker of the present and the
future as well. Thus, the Government allots a considerable amount fof its income for the
promotion of future interests.
That is private finance has a short-term perspective whereas the public finance has a ling
term perspective.

8. Nature of Budget:
 In private finance individuals prefer surplus budget as virtue and a deficit budget is
undesirable to them.
But the Government does not prefer a surplus budget. If the Government bring surplus
budget, it will create negative opinion on the Government. This is because surplus budget is the
result of high level of taxation or low level of public expenditure both of which may affect the
Government adversely.
9. Nature of resources:
In private finance the individuals have limited resources. They cannot raise the income,
as they like. Thy do not have the power to issue paper currencies.
But, in the case of public finance the Government has enormous kinds of resources.
Besides the administrative and commercial revenues the Government can get grants-in-aid and
borrow from other countries. The government can print currency notes to increase its revenue.

10. Coercion:
Under private finance the individuals and business units cannot use force to get their
income.
But, in public finance the governments can use force in the form of imposing taxes to get
income i.e. taxes are compulsory in nature. It is an obligation on the part of the tax payer. No
one can refuse to pay taxes if he is liable to pay them. Besides the above the Government can
undertake any of the existing private business by way of nationalization, which is not possible in
the hands of individuals.

11. Publicity:
Individuals do not like to disclose their financial transactions to others. They want to
keep them secret.
But, the Government gives the greatest publicity to its budget proposals and the
allocation of resources to different heads. It is widely discussed. Publicity strengthens the
confidence of the people in the Government.

12. Audit:
In the case of private finance, auditing of the financial transactions of the individuals is
not always necessary. But the accounts of the public authorities are subject to audit and
inspection.
 CHAPTER-II
BUDGET AND FINANCING
The word Budget originally meant the moneybag or the public purse. The word now
means, “Plans of government finances submitted for the approval of the legislature”. The budget
reflects what the government intends to do. The budget has become the powerful instrument for
fulfilling the basic objectives of government. The budget covers all the transactions of the central
government.

Budget is a time bound financial program systematically worked out and ready for
execution in the ensuing fiscal year. It is a comprehensive plan of action, which brings together
in one consolidated statement all financial requirements of the government. The budget goes
into operation only after it is approved by the parliament. A rational decision regarding
allocation of resources to satisfy different social wants requires considerable thinking and
planning. Thus budget is an annual statement of receipts and payments of a government.

2.1. Functions of Budget:

 The functions of budget include the following:

a) Proper allocation of resources: - to relate expenditure decisions to specified

policy objectives and to existing and future resources.

b) to relate all major decisions to the state of the national economy.

c) Long term economic growth: - to ensure efficiency and effectiveness in the

implementation of government programs.

d) To facilitate legislative control over the various phases of the budgetary

process.

e) Equitable distribution of income and wealth and

f) Securing economic stability and full employment.

It implies that the objective of budget policy is to take corrective measures or to adopt
regulatory policies to remove imperfection or inefficiencies of market mechanism. Besides, the
objective of the budget policy is to make provision of social goods or the process by which total
resources are divided between private and social goods. It means that the objective of budget
policy is to ensure equitable distribution of income and wealth. This may be termed as
distribution function. Third objective of budget policy is to maintain a high level of employment,
reasonable degree of price stability and an appropriate rate of economic growth.

To implement its economic functions government raises revenues through taxation. Fees
and charges, and spend them on different programs and activities. This process of rising revenues
and spending by government is performed through budgeting. Budget thus stands for the yearly
plans/forecasts of government revenues and expenditures. The budgeting process starts from the
initial stage of preparing the annual revenues and expenditures forecast and end at the stages of
approval by the higher government body followed by its implementation.

2.2. The Concept of Budgeting in Ethiopia:

The government budget represents a plan/forecast by government of its expenditures and

revenues for a specified period. Commonly government budget is prepared for a year, known as
a financial year or fiscal year. in Ethiopia the fiscal year is from July 7 of this year to July 6 of
the coming year (Hamle 1-Sene 30 in Ethiopian calendar). Budgeting involves different tasks on
the expenditures and revenues sides of government finance. On the side of expenditure, it deals
with the determination of the total deals with the determination of the total size of the budget (i.e
total amount of money for the year), size of outlays on different functions, and the magnitude of
outlays on various activities; on the revenue side, it involves the determination of the size of the
overall revenue and foreign aid.

Furthermore, budgeting also address the issue of the budget deficit (i.e. the excess of
outlays over domestic revenues), and its financing. Budgeting is not solely a matter of finance in
the narrow sense. Rather it is an important part of government’s general economic policy.
Budget is not solely a description of fiscal policies and financial plans, rather it is a strong
instrument in engineering and dynamiting the economy and its main objectives are to devise
tangible directives and implement the long term, medium term, and annual administrative and
development programs”.
2.3. Budget Structures in Ethiopia:

Budget structures are the formats that organize budget data. Budget data could be
classified in different ways and for different purposes. In the early days, for instance, budget
classification basically focused on providing a better understanding of the intentions and
purposes of government for which funds were planned and to be spent. Later on, the budget
structures started to be influenced largely by the issue of accountability. That is in addition to
providing information on what the government proposed to do, the budget structures indicate the
full responsibility of the spending agency. To this end the budget heads or nomenclatures the full
responsibility of the spending agency. To this end the budget head or nomenclature of the budget
are mostly mapped to each spending agency. This should not, however, imply unnecessarily
extended and detailed structure (or mapping). Perhaps, due consideration must be taken to make
the structure manageable and appropriate. The first classification of the budget is between
revenue and expenditure.

2.3.1. Revenue Budget:

It represents the annual forecast of revenues to be raised by government through taxation
and other discretionary measures, the amount of revenues raised this way differ from country to
country both in magnitude and structure, mainly due to the level of economic development and
the type of the economy.

In Ethiopia, the revenue budget is usually structured into three major headings: ordinary
revenue, external assistance, and capital revenue. Hence, the funds expected from these three
sources are proclaimed as the annual revenue budget for the country. The revenue budget is
prepared by the Ministry of Finance (MoF) for the federal government and by Finance Bureaus
for regional governments.

Ordinary revenues include both tax and not tax revenues. the tax revenues being direct
taxes (personal income tax, rental income tax, business income tax, agricultural income tax, tax
on dividend and chance wining, land use fee and lease); indirect taxes (excise tax on locally
manufactured goods, sales tax o locally manufactured goods, service sales tax, stamps and duty);
and taxes on foreign trade (customs duty on imported goods, duty and tax on coffee export). Non
tax revenues include charges and fees; investment revenue; miscellaneous revenue (e.g. gins);
and pension contribution. The second major item in revenue budget is external assistance. It
includes: cash grants, these are grants from multilateral and bilateral donors for different
structural adjustment programs; and technical assistance in cash and material form. The third
item is capital revenue. This could be from domestic (sales of movable properties and collection
of loans), external loan from multilateral and bilateral creditors mostly for capital projects, and
grants in the form of counterpart fund.

2.3.2. Expenditures Budget:

Government expenditures for administration and developmental activities are handled
through the expenditures budget. These expenditures are categorized into recurrent and capital
expenditures. This categorization gained acceptance since the Great Depression of the 1930s. the
recurrent budget which covers the current expenditures is financed in principle by taxation
( more broadly by domestic revenue from tax and non tax sources), and the capital budget which
covers the acquisition of newly produced assets n the economy is financed through external
borrowing and grants.

The acceptance to this categorization of expenditures is related to the general change in

the perception of deficit. Prior to the 1930s, budget deficits were considered to be reprehensible
and indicate bad financial management. Over the years, however, the cardinal rule of balanced
budget was changed in favor of cyclical budget, and functional finance.
This change in the rule of budgeting, in turn, resulted in several approaches to measuring
and understanding the deficit some of the concepts that were developed include:
a. the public debt concept of deficit,
b. the net worth concept of deficit,
c. the overall deficit, and
d. the concept of domestic deficit.

To illustrate these four approaches of measuring deficit, we can employ a simplified budget
balance given in Table -1 below:

Table-1: A Simplified Budget Balance

Revenues Expenditures
A. Tax and Non Tax Revenues C. Recurrent Expenditure
B. Net Borrowing D. Capital Expenditure
A+B C+D

The public debt concept of deficit defines budget deficit as the difference between
revenue (A) and recurrent expenditures (C) and capital expenditures (D) this measure A-(C+D)
is equal to net borrowing (B), and the budget is considered to be balanced if net borrowing
remains unchanged from previous years or is equal to zero. This approach illustrates, the
understanding prior to 1930s, which emphasized balanced budget as a prudent fiscal policy.

The emergence of active fiscal policy: The emergence of active fiscal policy (i.e.
government could borrow as long as that liability is matched by an increase in assets) right after
the depression led to the development of the net worth concept of deficit. Referring to the Table
above, the net worth is defined as the difference between recurrent expenditures and revenues
(C-A), which is equal to the excess of net borrowing over capital expenditures (B-D) this
measure of deficit requires the division of expenditures into current and capital budgets, with the
latter being financed by borrowing.
 The concept of the overall deficit or balance has several connotations and methods
construction. The common practice is to put revenues, expenditures, and borrowing as distinct
groups as in Table 2. Each budget category may then be related economic activity being
computed as a ratio of GDP, which then becomes a first approximation and an important single
measure of the impact of government fiscal operations.

Table- 2: The Overall Budget Deficit

The Overall Budget Deficit

A. Revenues
Tax revenues
Non Tax revenues
Grants
B. Expenditures
Recurrent Expenditures
Capital Expenditures
C. Overall Deficit (A-B)
D. Financing
1. Foreign Debt
2. Domestic Debt
Non Bank Borrowing
Commercial Banks
Central Bank

The domestic balance concept is a family of the overall budget deficit and became
prominent after the oil price increases in 1973/74. The basic argument being, in countries that
had large revenues, expanded incomes from government expenditures placed strains on the
domestic economy and spurred inflationary pressures. In such cases, budget surpluses will have
an expansionary effect. Under such circumstances the overall budget deficit or surplus measure
would be misleading to guide government policy. In fulfilling the requirements of oil producing
countries and others in similar circumstances, the technique of splitting the domestic balance is
the component of the overall balance from which external budget transactions have been
excluded.

The separation of recurrent and capital budget should, therefore, be viewed in terms of
the net worth argument above. The definition of these two budgets has been a common problem
in most countries, however. The problem relates to delineating, which specific expenditures need
to be included in the recurrent budget and which ones in the capital budget. In practice three
criteria have been in use to define budget into capital and recurrent. These are sources of finance,
object of expenditure, and nature of activity. Capital budgets were originally defined by western
governments by the source of finance, i.e., capital expenditures are financed from loan not
current revenue. The object of expenditure refers to the particular activities to be performed with
that budget like, formation of fixed assets, study and design, salaries of civil servants, etc. the
third criteria, the nature of activity, refers to whether the activity is short term (i.e. project) or on
going (that may not terminate in a specific period), and objective specific.

In Ethiopia the definition of recurrent and capital budgets follow some combination of these
criteria. That is:
1. Recurrent budget is to be covered by domestic revenue from tax and non-tax sources. But
the economy could borrow to meet its capital budget.

2. The financial proclamation 57/1996 and financial regulations 17/1997 defined capital
budget based on the object f expenditure. Accordingly capital budget equals capital
expenditure which equals fixed assets and consultancy services.

3. Short-term activities that are project in nature are included in capital budget while those
activities that are recurring and continuous in nature are put in the recurrent budget. In
some instances activities with a very long life period have been entertained in the capita
 budget. Since fiscal year 1994/95 efforts have been exerted to identify many such
projects that have been categorized under recurrent budget (projects in Education, health
and Agriculture sectors). The exercise does not seem complete, as there are projects with
recurring nature (e.g. Agricultural Research) though attempts have been made to isolate
the investment components.

The Expenditure Budget includes the following two types of Budgets:

1. Recurrent Budget, and

2. Capital Budget.

1. Recurrent Budget:
Financial proclamation 57/1996 and financial regulation 17/1997 defined only the capital
budget, implicitly defining the recurrent one as a residual. To common practice, however, is
to include in the recurrent budget expenditures of recurrent nature (like salaries of civil
servants) and fixed assets with a multi-year life.

The recurrent budget is structured by implementing agencies (public bodies) under four
functional categories: administrative and general services, economic services, social services,
and other expenditures. All public bodies then fall under one of these functional categories.
The budget hierarchy will ten be down to sub agencies.

2. Capital Budget:

Capital budget is budget for capital expenditures. Financial proclamation 57/1996 defined
capital expenditure as “an outlay for the acquisition f improvements to fixed assets, and
includes expenditures made for consultancy services.” Financial regulations 17/1997 further
provided a detailed definition of capital expenditures to mean:
a. The acquisition, reclamation, enhancement as laying out of land exclusive of roads,
buildings or other structures;

b. The acquisition, construction, preparation enhancement or replacement of roads,

buildings and other structures;

c. The acquisition, installation or replacement of movable plant, machinery and

apparatus, vehicles and vessels;
 d. The making of advances, grants or other financial assistance to any person towards
him/her on the matters mentioned in (a) to (c) above or in the acquisition of
investments; and

e. The acquisition of share of capital or loan capital in any body corporate;

f. Any associated consultancy costs of the above.

Capital budget could thus broadly be described as an outlay on projects tat result in the
acquisition of fixed assets and the provision of development services (Ministry of planning and
Economic Development, 1993:4). It should therefore be need that, capital budget as a wider
coverage than simple outlays in fixed investments, since it includes expenditure on development
services like agricultural research and transfer payments related to a project.

The capital budget is presented under three functional groups viz., economic development,
social development, and general development. Economic development includes production
activities (agriculture, industry, etc.), economic infrastructure facilities (mining, energy, road
etc.), commerce, communication, and so on. Social development includes education, health,
urban. Development, welfare and so on. General development include services like cartography,
statistics, public and administrative buildings, and the like.

2.3.3.Line Item Budget:

Capital budget, on the other hand is prepared by activity/project. This will be performed by
categorizing projects spectrally at the top, then grouping them by programs and sub-programs.
For instance, the “National Fertilizer project” is detailed as follows under the sector agricultural
development.
700 Economic Development
710 Agricultural Development
712 Peasant Agriculture Development
712/02 Crop Development
712/02/02 National Fertilizer Project.

Ultimately, however, the budget for both recurrent and capital will be presented by line
items (or code of expenditures). Thus, the budget for the sub agency or department in the case of
recurrent will be prepared by such line items as salaries, office supplies, etc. Similarly, the
capital budget for projects will be prepared by such line items as surveys and designs, equipment
and machinery, operating cost, and so on.

Ultimately, however, the budget for both recurrent and capital will be presented by line
items (or code of expenditures). Thus, the budget for the sub agency or department in the case of
recurrent will be prepared by such line items as salaries; office supplies, etc. Similarly, the
capital budget for projects will be prepared by such line items as surveys and designs, equipment
and machinery, operating cost, and so on.
Line item budget has a number of advantages: First, it promotes control since the budget
is detailed down to particulate expenditure items. The use of the budget of one line item for
another may require the verification of MoF and MoED. So, the spending public bodies will not
have the right to spend the budget as they want. Second, it is simple to manage. The major
drawback of line item budget, however, is it fives more emphasis to inputs not outputs. At
present, however, the civil service Reform Program in its component of budget reform is trying
to address the issue of output. To move from the existing input based (line item) budgeting to
that of cost center and performance budgeting, efforts are being made to consolidate the
recurrent and capital budgets by line item (i.e. to use the same line items for both recurrent and
capital budgets) and to map the budget into the organizational structure of the implementing
bodies.

Preparing the budget this way by line items is usually referred to as line item budgeting.
Hence, our recurrent and capital budgets are prepared by line items. Budget request and
disbursement are then performed by line items.

2.4. THE BUDGET PROCESS IN ETHIOPIA:

Budgeting from the initial stage of forecasting the annual revenues and expenditures, to the
final stage of approval of the annual budget by the Council of Peoples Representatives, passes
through a sequential and an iterative process. This budgeting process includes:
 Preparation of the macro-economic and fiscal framework;
 Revenue forecast and determination of expenditure budget ceiling:
 allocation of expenditure budget between Federal and Regional governments;
  allocation of Federal government expenditure budget between recurrent and capital
budgets:
 budget call and ceiling:
 budget review by MoF and MoED;
 Budget hearing and defense:
 Review and recommendation:
 Submission of the budget to the council of Ministers:
 Submission of the budget to the Council of Peoples’ Representatives:
 Notification and publication of the budget; and
 Allotment.
The budget process thus includes al these stages, which obviously are sequential (one
after the other) and iterative. Peterson summarized the budget process into three phases:
analyzing, fitting, and implementing. The analysis phase is the assembly and integration of
financial data which might include processes from the formulation of macro-economic and fiscal
framework to the allocation of expenditure budget between Federal and Regional governments
the fitting phase is the process of prioritizing activities to fit with policy and reducing a budget to
a ceiling. Referring to the budgeting processes outlined above this might range from the
processes of allocation of Federal government expenditures budget between recurrent and capital
budget down to the submission of the budget to the council of peoples’ Representatives. The
final paste, implementing, is distributing and using the allocation, i.e. the notification and
publication of the budget, allotment and the monitoring processes.

Budget being a one-year plan prepared for the coming fiscal year it requires a time
schedule (deadlines) for each and every processes hat should strictly be adhered to. The time
schedule is usually handled through the budget calendar. In effect the budget calendar is the
major instrument to manage the budgetary process. Thus far we don’t have an authoritative and
binding budget calendar that could force al public bodies involved in the process f budgeting.
The only dates proclaimed by law are the final approval and notification dates of the budget.
Financial proclamation 57/1996 states that “the budget appropriation shall be approved by the
council of peoples; Representatives by sine 30th (July 6) and all public bodies shall be notified by
Hamle 7 (July 13). “the other deadlines in the process of budgeting will be set by the MoF and
MEDaC who are responsible for the preparation of the recurrent and capital budgets,
respectively. The MoF and MEDaC will notify the spending public bodies well ahead of time
about the important deadlines, the budget ceiling and other information through the budget
circular. the budgeting process usually took between six to eight months, and the MoF and
MoED will release the budget circular around November to December.

2.4.1. THE BUDGETARY PROCESS AT THE FEDERAL LEVEL:

The budget processes at the Federal level follows sequential and iterative the steps. These
steps can be explained with the help of the following Chart. Let us briefly explain these steps one
by one here under:

Step one - Macro-Economic and Fiscal Framework:

The preparation of the macro-economic and fiscal framework is basically a component of

the recently initiated public investment program (PIP). It is a planning practice and as stated in
Ministry of Economic Development, the macro-economic and fiscal framework determines the
overall level of government expenditures based on policies related to the role of government in
the economy, government deficits, and priorities for resource allocation between regions and
sectors. For the Federal government the framework is a three years forecast and will be updated
each year.

The framework is composed of macro-economic forecast and fiscal forecast. The macro-
economic forecast gives the forecast of Gross Domestic product based on past performance and
estimates for future years, and provides base line information in preparing the fiscal forecast.
Financial Regulation 17/1997 gave the responsibility of preparing this framework to the Ministry
of Economic development (MoED). Where as, the later, establish the level of total resources
available for expenditure. it provides a more detailed forecast of revenue (both Federal and
Regional), end projection of expenditure. Given the policy of no borrowing from domestic banks
to finance budget deficit the level of expenditure mainly depend on the amount of resources to be
raised in the form of domestic revenues and external fund that include counterpart funds. Once
prepared by the concerned coordinating ministries, i.e. MoF and MoED, it will be reviewed and
approved by the Prime Minister’s Office (PMO).
Step Two- Determination of Federal Government Expenditure and Subsidy to
Regional Governments:

After the revenue and expenditure of the government are estimated through the fiscal
framework, the PMO will decide on the shares of Federal government expenditures and subsidies
Regional governments. it is known that, following the decentralization policy, Regional
governments took grants from the Federal government in the form of subsidy.
Once the amount of subsidy is known, the allocation among regions is determined on the
basis of a formula. Initially the formula was composed of five parameters (population, level of
development, revenue generating capacity, utilization capacity, and land area). At present, how
ever, the formula takes account of three parameters: population, the level of development, and
revenue generating capacity of each region which are given a relative weight of 60%, 25% and
15% respectively. This allocation will fist be prepared by MoED, then reviewed by the PMO and
finally approved by the Council of peoples’ Representatives.

Step three: Allocation of Federal Expenditure between Recurrent and

Capital Budget

The practice in the allocation of recurrent and capital budget is to consider the latter as a
residual. That is, first the amount of budget necessary to cover such recurrent expenditures like
pensions, debt servicing, wages and non-wage operating costs will be determined. The balance
will then be allotted to capital expenditures. This will be performed by the PMO in consultation
with MoF and MoED.

Step Four - Budget Call and Ceiling Notification:

This includes two items. They are:
a). Recurrent budget: MoF will release the budget ceiling to the line ministries in a
budget call. The budget call provides each ministry such information as the macro-economic
environment, an aggregate recurrent budget ceiling, and priorities to budget.

b). Capital Budget: MoED issues detailed capital budget preparation guidelines to
spending public bodies along with the ceilings provided to each line institution. MoED will
set the ceiling for each sector.
Step Five - Budget Review by MoF and MoED:

This includes two items. They are:

1. Recurrent Budget:
Prior to a formal budget hearing, spending public bodies will submit their budget
proposals to the MoF-Budget Department. In consultation with spending public bodies, MoF will
prepare an issue paper on Major issues at each head level in the proposed budget. Here, spending
public bodies can submit above the ceiling but need to have a compelling justification

2. Capital Budget:
The sector departments of MoED review the capital budget requests from different public
bodies. At this stage projects will be screened. If there exist a discrepancy between the respective
sector department and the public body, a series of discussions will be held to reach agreement.
After such a process the various sector departments of MoED will submit their first round
recommendation to the Development Finance and Budget Department of MoED. Then it will be
consolidated and prepared for the capital budget hearing and defense.

Step Six - Budget Hearing and Defense:

This includes two items. They are:

1. Recurrent Budget:
Spending public bodies defend their budget submission in a formal hearing with the MoF.
The issue paper will be the basis of the hearing. The hearing focuses on policies, programs and
cost issues, when necessary it might involve discussion down to line item. Spending public
bodies could also challenge the ceiling. Presenting the hearing will be ministers and/or vice
ministers, heads of public bodies and the MoF.

2. Capital Budget:
Spending public bodies will be called to defend their projects to a budget hearing
convened by the PMO which will be chaired by the prime Minister or the deputy Prime Minister
or the their economic advisers. The hearing customarily includes a review of status of the
project, implementation capacity of the institution, compatibility with the countries development
strategy and policy, cost structure, and regional distribution. A project description will be
presented which includes objectives of the project, main activities of the project, status of the
project, total cost, past performance of the project, source of finance, and whether the project is
accepted or rejected by MoED. On the basis of the discussion the respective sector departments
of MoED in consultations with the spending public body will further refine the capital projects.

Step Seven - Review and recommendation:

This includes two items. They are:

1. Recurrent budget:
After the hearing is over, the budget committee of the MoF will review the discussion
and make a recommendation. If there is an increase (over ceiling) this will go to the PMO for
approval.

2. Capital budget:
After the hearing and defense with the PMO and MoED, sector departments of MoED
will give a final recommendation to the development finance and budget department of MoED.
This will then be compiled and put in appropriate formats for submission to the council of
ministers.

Step Eight: Submission to the council of Ministers:

At this stage the two budgets (recurrent and capital) will be consolidated, and MoF will
prepare a brief analysis of the total budget.
1. Recurrent budget:
The recommended budget will be submitted to the deputy Prime Minister for economic
affairs. This will first be reviewed by ministers and vise ministers in economic affairs, and then
presented to the Prime Minister along with a brief. The Prime Minister may or may not make
amendments and then the budget will be sent to the council of Ministers for discussion.

2. Capital Budget:
A brief analysis of the capital budget will be prepared by MoED on the final
recommended budget and, along with the consolidated capital budget, will be submitted to the
council of ministers. MoED will defend the budget in the council. The council of ministers may
make some adjustment and the draft capital budget will pass the first stage of approval.

Step Nine - Submission to the Council of Peoples’ Representatives:

 Once approved by the council of ministers, the Prime Minister will present both the
recurrent and capital budget to the council of peoples’ representatives. The budget will then be
debated based on the recommendation of the budget of the committee.

Step Ten - Notification and Publication:

The approved budget will then get the legal status through the publication in the ‘Negaret
gazeta.’ Spending public bodies will then formally be notified of their approved budget by line
items from MoF and MoED for recurrent and capital budgets, respectively. MoF will notify
spending public bodies through Form 3/1. Likewise, MoED will inform through Form 3/2. Both
Forms will be copied to the Treasury Department of the MoF which disburse funds to spending
public bodies. Until Form 3/1 is released spending public bodies are authorized to spend one-
twelfth of the previous year’s budget with no provision for new expenditures (e.g. new staff
posts) in the case of recurrent budget. For capital budget spending public bodies are authorized to
use approved budget for on going projects even when Form 3/2 is not released.
The final stage of the budgetary process is to request spending public bodies to prepare
adjusted work plan and cash flow for the approved budget. The adjusted work plan and cash flow
will be verified by MoF-for the recurrent budget-and by MoED-for the capital budget, and then
will be sent to the treasury Department of the MoF.

Step Eleven - Supplementary Budget:

In the course of the budget year supplementary (additional) budget will be proclaimed
when necessary, following almost the same process as the initial budget preparation. Likewise
budget reallocation will be made mainly based on performance.

2.4.2. THE BUDGETARY PROCESS AT THE REGIONAL LEVEL:

It is quite difficult to present the budget process at the Regional level in the way
discussed for Federal Budgeting. At present the budget process followed by regions is not
uniform. Hence, let us discuss the process of budgeting in a more general terms with out
referring to a particular region.

The process is more or less a mirror image of the Federal budget process. In place of
MoF the Regional Finance Bureau (RFB) is responsible for the preparation of the recurrent
budget. While the Regional planning and Economic Development bureau (RPEDb) is
responsible for the capital budget. At the higher level the Regional council is the one responsible
for the appropriation of the region’s budget. One significant deviation is, the regional budget
process starts at the woreda level and goes up to Zone and Region levels.

1. Pre-ceiling Budgeting:
Pre-ceiling budgeting is the budgeting practice at the woreda and zone levels before the
region receives its subsidy/grant from the Federal government. The process is as follows: the
woreda prepares a budget with no indicative or final ceiling from the Zone or the Region. The
Finance Office will consolidate the budget of the sectoral offices and submit to the woreda
council. The woreda executive committee will then form a budget committee to review the
budget. This budget will be sent to the zone through two channels: one, the woreda counsel
submit the budget to the zone executive committee,: second, the woreda sectoral offices send to
the zone sectoral departments. The zone executive committee will then form a budget committee
that will be chaired by the head of the Finance Department, to review the woredas’ and zones’
budget proposal.

In passing the budget to the region it will again be through two channels. The zone
executive committee submits to the Region executive committee and the zone sectoral
departments will submit to the region sectoral bureaus. The sectoral bureaus then prepare a
budget submission to the Region Finance Bureau.

2. Post-ceiling Budgeting:

Following the notification of the subsidy from the Federal government, the regional
public expenditure envelope will be determined based on the Federal subsidy, local revenue and
local borrowing. Once the expenditure envelope is set, then it will be split up between recurrent
and capital expenditures. The practice is similar to the Federal government, i.e. the allocation
begins with recurrent expenditures and the balance of the envelope will be reserved for capital
expenditures.

After this stage, different regions fallow different approaches to allocate recurrent
expenditure between salary and organization and management, and to allocate capital
expenditure among the different sectors. In some regions the budget will be prepared up to line
items at the region level, where as in some regions a lump sum will be allotted to zones that will
be in turn allocated to woredas,. At last, the budget will be published in the region’s ‘Negarit
gazeta’.

2.5. Budget Deficit:

A budget is considered as surplus or deficit according to the position of the revenue

accounts of the government. Thus a surplus budget is one in which revenue receipts exceed
expenditure charged to revenue account regardless of the gap in capital accounts; while a deficit
budget is one in which expenditure is greater than current revenue receipts.

Budget deficit is the excess of total expenditure over total revenue of the government.

The deficit financing denotes the direct addition to gross national expenditure through
budget deficits whether the deficits are on revenue or capital accounts”. It implies that the
expenditure of the government over and above the aggregate receipt of revenue account and
capital account is treated as budget deficit of the government.

The meaning of deficit financing is different in different countries. In western countries,

the budget gap, that is covered by loans is called deficit financing because, if the government
borrows from the banks rather than from individuals the idle funds will be activated and there
will be an increase in the total public expenditure and thus there will automatically be an deficit
financing has been used in a different sense,. Here it is used to denote the direct addition to
gross national expenditure as a result of budget deficit.
Thus deficit financing can be defined as “the financing of a deliberately created gap
between public revenue and public expenditure”. The government of Ethiopia has used deficit
financing for acquiring funds to finance economic development. When the government cannot
raise enough financial resources through taxation, it finances its developmental expenditure
through borrowing from the market or from other sources.

2.5.1. Methods of Financing Deficit:

There are four important techniques through which the Government may finance its
budgetary deficits. They are as follows:

1. Borrowing from central bank

2. The running down of accumulated cash balances
 3. The government may issue new currency
4. Borrowing from market or from external sources.

Under the first method, government borrows from central bank as per budgetary policy. In
the second source, government spends from available cash balance,. In the third measure,
government issues new currency for financing deficit. The last method is that government
borrows from internal and external sources to finance its deficit.

2.5.2. Objectives of Deficit Financing:

1. Deficit financing has generally been used as a method of meeting the financial needs of
the government in times of war, when it is considered difficult to mobilize adequate
resources.

2. Keynes advocated deficit financing as an instrument of economic policy to overcome

conditions of depression and to raise the level of output and employment.

3. The use of deficit financing has also been considered essential for financing economic
development especially in under developed countries.

4. Deficit financing is also advocated for the mobilization of surplus idle and unutilized
resources in the economy.

2.5.3. Effects of Deficit Financing:

Deficit financing has both positive and negative effects in the economy as under:
1. Inflationary rise in prices: The most serious disadvantage of deficit finance is the
inflationary rise of prices. Deficit financing increases the total volume of money supply. Unless
there is proportional increase in production this can lead to inflation. When deficit financing goes
too far it becomes self-defeating. There was inflationary pressure during the decade due to
deficit financing.
 2. Effects on distribution of wealth and income: The real income of wage earners gets
reduced and that of entrepreneurs/ businessmen increased, leading to distribution of wealth in
favour of business class

3. Faster growth: Country is able to implement the developmental plans through deficit
financing thereby attaining faster growth.

4. Change in pattern of Investment: Deficit financing leads to encouragement for

investment in certain fields like construction, luxury consumption inventory holding and
speculation. This may lead to investment in undesirable fields.

5. Credit creation in banks: Inflationary forces created by deficit financing are reinforced
by increase credit creation by banks.

Among various fiscal measures, deficit financing has been assigned an important place in
financing developmental plan and various developing countries including Ethiopia resort to
deficit financing to meet budgetary gaps.

2.5.4. Deficit financing in Ethiopia:

Deficit financing in Ethiopia was mainly resorted to enable the Government of Ethiopia
to obtain necessary resources for the plans. The levels of outlay laid down were of an order,
which could not be met only by taxation or through a revenue surplus. The gap in resources is
made up partly through external assistance. But when external assistance is not enough to fill the
gap, deficit financing has to be undertaken. The targets of production and employment in the
plans are fixed primarily with reference to what is considered as the desirable rate of growth for
the economy. When these targets cannot be achieved through resources obtained from taxation
and external borrowing, additional resources have to be found. Deficit financing is the easier
option. It is important to emphasis the fact that deficit financing cannot create real resources
which do not exist in the economy.

2.6. Categories of Revenues to Government:

The revenues of the Government can be classified into two ways. They are:
1. On the basis of mode of collection and
 2. On the basis of nature of revenue.

Let us see these classifications one by one here under:

2.6.1. Revenue on the Basis of Mode of Collection:

It can be shown with the help of the following chart:

Revenue on the Basis of Mode of Collection

Revenue on Revenue by Revenue Partly

Compulsion Voluntary by Compulsory
Payment and partly
[[[ Voluntary

1. Taxes 1. Income from 1.Special

2. Fines Public Property Assessments
3. Penalties (Rent, etc.) 2. Escheats
4. Forfeitures 2. Income from 3. Printing of
5. Tributes and Public Enterprises currency
indemnities 3. Fees 4. Grants-in-aid
arising out of 4. Licenses
war or other 5. Gifts
6. Compulsory
Loans

Fig. 1.1
2.6.2. Revenue on the basis of Nature:
The revenues on the basis nature can be classified as in the following Figure 1.2.
 On the basis of
Nature of
Revenue

Tax Revenue Non-Tax Revenue

Administrative Commercial Others

Tax on Tax on Tax on Revenues Revenues
Income Property Commodities
1.Fees Issue of
Prices on
2.Licences currency
3.Fines
goods and
4.Forfeityres services
5.Escheates
6.Special
Assessments
Personal Corporate
Tax Tax

Borrowings Gifts and Grants

1. From general
Public (Issuing of 1. With in the
Customs Excise Turnover Country
Bonds etc
Tax Tax Tax 2. From other
Countries 2. From other
3. From other Countries
Institutions (IMF,
World Bank, etc)

Value
Added
Tax

Figure 1.2.

Of these two types of classifications of revenues the classification of revenues based on the
nature is considered as the ideal classification. Let us explain these items one by one.
2.6.2.1. Tax Revenue:

The revenue from tax includes the following:

1. Tax on Income: The Government imposes two types of taxes on income.

They are:
a). Tax on personal income, and

b). Tax on corporation profits.

The personal income tax is levied on the net income of individuals, firms and other
association of persons. The tax on the net profits of the joint stock companies is known as
corporation tax.

2. Taxes on Property:
It is the tax revenue from properties including rental income tax land use tax etc.

3. Taxes on Commodities:
The important taxes levied by the Government on commodities are:
a) Customs Duty,

b) Excise Duty,

c) Value Added Tax

d) Turnover Tax

 Customs Duty includes both import and export duties. These duties are
levied when the goods cross the boundaries of the country.
 Excise duties are levied on the commodities produced in the country.
Excise duties now constitute the single largest source of revenue to the
Union Government.

 Value Added Tax is levied by the Government on the commodities

sold at a specified percentage on the value of sales.
 Turnover Tax is levied by the Government on the sales which are not
covered under VAT.

2.6.2.2. Non-Tax Revenues:

The following categories of revenue are included under non-tax revenue.

Administrative Revenue: It includes the following:

(1) Fees: It is the compulsory payment made by the individuals who obtain a definite service in
return. Fees are charged by the Government to bear the cost of administrative services
rendered by it. These services are rendered for the benefit of general public. It
includes court fee, registration fee, etc.

(2) Licenses: A license fee is collected not for any service rendered, but for giving permission or
a privilege to those who want to do a special or specified work. It is charged on the
grounds of control of certain activities.

(3) Fines and Penalties: Fines and penalties are imposed as a form of punishment for the
mistakes committed such as violation of the provisions of law, etc. The basic aim
behind them is to prevent the people from making mistakes. A fine is also
compulsory like a tax, but it is imposed more as a deterent than as a source of
revenue.
(4) Forfeitures: Forfeiture means the penalty imposed by the courts on the persons who have not
complied with the notice served by it or for the breach of contract or has failed to pay
the dues in time, etc.
(5) Escheats: The property of a person having no legal heirs and dying intestate, will be taken
possession of by the Government. That is, the Government can take over the property
of a person who dies without having any legal heirs or without keeping a will. But, it
cannot be considered as a main source of revenue to the Government.

(6) Special Assessment: According to Prof. Seligman, special assessment means “a compulsory
contribution levied in proportion to the special benefit derived to defray the cost of
the specific improvement to property undertaken in the public interest”. Thus, it is a
compulsory payment or contribution. It is levied in proportion to the special benefits
derived to bear the cost of specific improvement to property. Whenever the
Government has made certain improvements, somebody will get benefited. For
example, irrigation facility, road and drainage facility, etc.
Because of this, the value of the property in the neighborhood will rise. This rise
in the value will provide an unearned increment. Hence, the Government has a right to
 appropriate a part of this unearned increase. This appropriation is called as special
assessment.
(7) Gifts and Grants: Gifts are voluntary contributions from Non-Government donors to the
Government for various purposes like drought relief, defense, national relief, promotion
of family planning, etc. Grants are usually given by one Government to another. For
example, in a federal set up, the Union Government provides grants to the State
Governments to carry out their functions and fulfillment of obligations. Moreover, the
Government of one country may receive grants from other country.

CHAPTER-III
TAX- BASICS

3.1. Meaning of Tax:

 A tax is “a compulsory charge imposed by the Government without any expectation of direct
return in benefit ".

In other words, a tax is a compulsory payment or contribution by the people to the

Government for which there is no direct return to the taxpayers. Tax imposes a personal
obligation on the people to pay the tax if they are liable to pay it. The general public should be
taxed according to their ability to pay, and the people in the same financial position should be
taxed in the same way without any discrimination.
Thus, tax can be defined as, "an involuntary fee or more precisely, "unrequited payment",
paid by individuals or businesses to a government (central or local)". Taxes may be paid in cash
or kind (although payments in kind may not always be allowed or classified as taxes in all
systems). The means of taxation, and the uses to which the funds raised through taxation should
be put, are a matter of hot dispute in politics and economics, so discussions of taxation are
frequently tendentious.
A good tax system should not affect the ability and willingness of the people to work, save
and invest. If not, it will affect the development of trade and industry and the economy as a
whole. Thus, a sound tax system should contribute in the economic development of a country.
Hence, "taxation should not be like killing the goose that lays golden eggs".

3.2. Stages in the Development of Levy of Tax:

The levy of tax has crossed over various stages to reach the present state. Prof. E.R.A.
Seligman has listed out the stages of development in this regard. We can understand the
development in the levy of taxation from the following diagram:

Present stage

Compulsory payment of tax

With out quid proquo 7

Necessity for pay the tax t the govt is 6

 Stressed and made it as an obligation

It is the duty of the tax Payers to pay tax 5

Individuals felt that they sacrificed 4

For the benefit of Govt.

Individuals felt that they helped the Govt. 3

Government questioned the public to pay

The tax in favour of them 2

Tax is considered as gift 1

Initial stage

Stages in the Development of Levy of Tax

3.3. 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 proquo 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.
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.

Components of Taxes
 Each tax must have a base upon which it is
levied.
 Each tax must have a tax filling unit that is
responsible for paying the tax.
 Taxes must have a rate that is applied to the
base to determine the amount owing.
 Unless they are imposed on individual
transactions, taxes must have a period during
which the base is measured and the tax
collected.
 Each tax must have administrative
arrangements for the collection of tax.

3.4. Objectives of Taxation:

Government levies and collects taxes for various objectives. These objectives may be
specific or general.
3.4.1. Specific Objectives:

The basic purposes of levying taxes are as follows:

1. To support the operation of that government itself.
2. To influence the macro economic performance of the economy, the government's strategy
for doing this is called its fiscal policy.
3. To carry out the functions of the government such as national defense and providing
government services.
4. To redistribute resources between individuals or classes in the population. Historically
the nobility were supported by taxes on the poor modern social security systems and
intended to support the poor by taxes on the rich.
5. To modify patterns of consumption or employment within an economy by making some
classes of transaction more or less attractive.
3.4.2. General Objectives
Taxes are compulsory payments to the Government by the taxpayers. In the beginning,
Government imposed taxes for three basic purposes viz., to cover the cost of administration,
maintaining law and order in the country and for defense.
But, in modern days, there has been a sea change in the Government’s expenditure pattern.
Today, the Government is in the position to restore social justice in the society by way of
providing various social services like education, employment, pension, public health, housing,
sanitation and the development of weaker sections of the society. Besides the above, the
Government announces heavy subsidies for agriculture and industry. Thus, Government requires
more amount of revenue than before. Non-tax revenues are not sufficient to meet the entire
expenditures. Hence, Government imposes taxes of various types.

Let us discuss the general objectives of taxation hereunder:

1. Raising Revenue: The basic purpose of taxation is raising revenue. To render various
economic and social activities, Government requires large amount of revenue. To meet this
enormous expenditure, Government imposes various types of taxes in addition to the non-tax
revenue.
 2. Removal of Inequalities in Income and Wealth: The welfare state aims at the removal
of inequalities in income and wealth. By framing suitable tax policy, this end can be achieved. It
is stressed in the Canon of Equality. In Ethiopia, the progressive taxation on income is the
suitable examples in this regard.
3. Ensuring Economic Stability: Taxation affects the general level of consumption and
production. Hence, it can be used as an effective tool for achieving economic stability. That is,
by means of taxation the effects of trade cycle i.e. inflation and deflation can be controlled.
During the period of boom or inflation, the excess purchasing power in the hands of people
leads to rise in the price level. Raising the existing tax rates or imposing additional taxes can
remove such excess purchasing power. Then the abnormal demand will be reduced and the
economic stability can be achieved. At the same time, by providing grants, tax exemptions and
concessions, production can be encouraged thereby inflation is controlled.
Likewise, during the period of depression or deflation, the role of tax policy in the economy
is important. Reduction in the existing tax rates and removal of certain taxes, consumption can
be induced which in turn results in increasing demand. This encourages business activities, and
the economic growth can be achieved.
Thus, through properly devised tax system, the economic stability can be achieved by
controlling the effects of trade cycle.
4. 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.
5. Capital Accumulation: Tax concessions or rebates given for savings or investment in
provident funds, life insurance, unit trusts, housing banks, post offices banks, investment in
shares and debentures of certain companies etc. lead to large amount of capital accumulation
which is essential for the promotion of industrial development.
6. Creation of Employment Opportunities: More employment opportunities can be
created by giving tax concessions or exemptions to small entrepreneurs and to the industries
adopting labour-intensive techniques. In this way, unemployment problem can be solved to
certain extent.
 7. Preventing Harmful Consumption: Taxation can be used to prevent harmful
consumption. By way of imposing heavy excise duties on the commodities like liquors, cigars
etc. the consumption of such articles is reduced to a considerable extent.
8. Beneficial Diversion of Resources: The imposition of heavy duties on non-essential and
luxury goods discourages the producers of such goods. The resources utilized for the production
of these goods may be diverted into the production of other essential goods for which various tax
concessions are given. This is called as beneficial diversion.
9. Encouragement of Exports: 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.

3.5. APPROACHES TO TAXATION:

The study of taxation involves different approaches. To understand and appreciate the
existing policies of taxation, one should know about these approaches. Let us have a brief idea
about various towards the study of taxation hereunder.

3.5.1. Cost of Service Approach:

Cost of Service Approach is one of the oldest principles, advocated for the distribution of
the tax burden. According to this theory, the basis of taxation should be the cost incurred by the
Government on different services for the benefit of the individual tax-payers. Each tax-payer has
to pay the tax equal to the cost of service to him. It means, the higher the cost, the higher should
be the tax rate and vice-versa. In other words, according to this theory, the citizens are not
entitled to any benefits from the state and if they do receive any, they must pay the cost thereof.
The government acts like a producer of a commodity who charges the price from his customers
equal to the amount of cost of production of the commodity. By adopting this approach, the
government gives up its basic protective and welfare functions. Its only job is to recover the cost
of service. The state is not concerned with the problems of income distribution. No effort is made
by the government to improve income distribution or no notice is taken of the policy of levying
taxes according to the cost of service principle. This deteriorates the income distribution further.
If this approach is adopted, quite a few sources of public revenue will be ruled out like taxes on
capital gains, unearned increments, gifts, expenditure, excise duties and sales tax etc. welfare
activities including all sorts of relief activities will also be ruled out.
Limitations of Cost of Service Approach:
This approach has the following limitations:
(1) this principle can not be accepted as the basis of taxation because it is very difficult to
estimate the cost of service to every individual. For e.g., the government can estimate
total expenditure on the defense of the country. But it is difficult to estimate the
expenditure incurred by the government on the defense of a particular individual.
(2) secondly, the basis of cost service principle is not fair in a welfare state. If cost is taken as
the basis of taxation, the government may not perform various functions which may be
very much desirable for the welfare of the country as a whole e.g., relief in times of
drought, flood and earthquake, free education and free medical facilities etc. Hence, the
cost of service principle cannot be accepted as the basis of taxation.
(3) Lastly, the cost of government services to individuals are fixed arbitrarily, which may not
be justified.

3.5.2. Expediency Approach:

Generally every government imposes tax to fulfill its normal social obligations in the form
of defense, maintenance of law and order and socio-economic growth, but in actual practice, the
tax policy is determined by the pressures which are exerted on the government by different
pressure groups in society. In practice, every legislature and every authority is pressurized by
various economic, social and political groups to orient its taxation policy in certain directions.
Every group would try to resist a change that goes against its interests. The authorities, in many
cases, have to adopt certain policies simply because there are pressures to that effect. The
authorities have to many times, reshape the tax structure depending upon the changing political
strength of different economic groups. It is also clear that while choosing and imposing a tax, the
authorities would be making a great blunder if they lose sight of the administrative feasibility,
the cost of collection, and so on. Therefore when the government bends before the pressures of
various pressure groups and formulates its tax policy accordingly, we call it the expediency
approach.
Limitations of Expediency Approach:

This approach is criticized on the ground that to build up an entire tax system solely on the
considerations of expediency, must be full of pitfalls. In certain cases, such a tax policy may be
able to yield certain good results like contributing to the equality of income distribution, or
reducing regional disparities but such results would be purely accidental and not the fruits of any
thoughtful efforts or plan.
A taxation system has a role to play in helping the economy. It should be based on equity
and should contribute towards augmenting welfare in general. But when the tax system ignores
certain factors like economic growth, equity, economic stability etc., it is not likely to be helpful
to the economy and would increase inequalities and socio-economic injustice.

3.5.3. Socio-Political Approach:

In contrast to the expediency approach, Adolph Wagner advocated an approach in which
social and political objectives are the deciding factors for the distribution of tax burden. Wagner,
like most Germans of those days, did not believe in individualist approach to a problem. He
wanted that each economic problem should be looked in its social and political context.
Accordingly, a tax system should not be designed to serve the needs of the individual members
of the society. But it should be designed for the welfare of the society as a whole. He was in
favour of using taxation for reduction in income inequalities and he advocated that all small
incomes should be exempted from taxation. In other words, the tax structure should aim at
achieving social objectives. He advocated that the government should follow the policy of
progressive taxation. Wagner's ideas, though much criticized at that time, are now the hall-mark
of modern states's fiscal policies. Taxation in a modern state is generally designed to curb
inequalities. Progressive Taxation is the rule rather than the exception.

Adolph Wagner also advocated that the government should formulate a tax policy to achieve
political objectives in the form of protecting the fundamental rights of the people. He advocated
that the government should provide protection to the life and property of the people by way of
incurring expenditure on defense and maintenance of law and order. In the modern context, we
may accept Wagner's stand by including other economic and social objectives of the society in
which taxation could be a helpful tool. Taxation could curb cyclical fluctuations, unemployment,
production of undesirable goods and services, monopolistic and restrictive trade practices and
hoarding etc. Through taxation, government could also bring balanced growth between different
regions. That way, the socio-political approach is far more meritorious than the expediency
approach.

Both the expediency Approach and socio-political Approach have their merits, but they
cannot be advocated as the basic policies in a tax system. Equity should be the main criterion of
every tax system, without it, not only the tax system loses its fairness, it also becomes a source of
social, economic and political unrest as well.
Limitations of Socio-Political Approach:

Socio-Political Approach, though having the merit of equity, suffers from the following
limitations:

(1) This concept is more of academic nature than of much practical relevance. This is proved by
the fact that in spite of the fact that the government follows the policy of progressive
taxation, the gap between the rich and the poor has been increasing at a very fast rate.

(2) This policy has encouraged Jot of tax evasion either on account of loopholes or by
adopting such methods that lead to tax evasion. The problem of taxation has led to the
operation of a parallel economy which is causing inflation in economy.

3.5.4. Benefit Principle Approach:

Benefit principle approach was accepted by the political theorists of the 17th century.
Taxation in those times was considered as a price for the services rendered by the state. The
entire philosophy was based on the contract theory of the state. According to this approach the
state provides goods and services to the members of the society and they contribute to the cost
of these supplies in proportion to the benefits received. It is an exchange relationship.

According to this approach, the burden of' taxation should be divided among the people in
proportion to the benefits received from the state. The persons receiving equal benefits from the
state should pay equal amount as taxes and those who receive greater benefits should pay more
as taxes than those getting less benefits.
The benefit theory, therefore, demands that on the ground of equity, the people should be
taxed according to the benefits (Protection, hospitals, education, roads, irrigation etc.) they
receive from the government and that the division or apportionment of taxes be in proportion to
the benefits received by each individual or group of individuals. Larger the benefits received,
larger should be the amount of tax on the beneficiary concerned.

The benefit approach is, in fact, a combination of two Principles:

(1) The cost of service principles, and
(2) The value of service principle.

According to cost of service principles, the taxes should be divided in Proportion to the cost
of services rendered by the state. As per value of service principle, every individual should
contribute in proportion to the value of the services he has received from the government.

In fact, both the principles come to the same conclusion that the cost of services rendered by
the government should be recovered from individuals in proportion to the benefits received by
each of them.

Limitations of Benefit Principle Approach:

This benefit principle approach has the following limitations:
(1) It is very difficult to estimate the benefit that an individual receives from the expenditure of
the government, e.g., how much benefit an individual receives from the army, police and
educational institutions cannot be exactly estimated. And therefore, the burden of taxation
may not be equitable. Hence, this theory may be rejected.
(2) If the basis of taxation is benefit, then the poor will have to pay higher taxes than rich
because the poor derives greater benefits than rich from the expenditure of the government,
e.g., the poor may be more benefited by the provision of free medical service and free
education. And, therefore, on this ground also, this theory cannot be accepted as the basis of
taxation.

(3) Rich people have more capacity to pay taxes than poor; but according to this principle the per
capita tax burden upon the rich and the poor is the same. This means regressive taxation. It
is, therefore, clear that the benefit principle cannot ensure just distribution of burden of
taxation among different sections of society.

(4) The principle is also not conducive to general welfare which requires redistribution of income
in favour of the poorer sections through public welfare programmes and services for their
benefit.
(5) A general objection to the whole approach is that this principle is not based on the concept of
equity in' taxation. Taxes are not progressive in nature.

3.5.5. Ability to Pay Approach:

Ability to pay is interpreted as the money income of the tax payer. It is the most generally
accepted theory. According to this theory each person should contribute to the income of the
state in proportion to his ability to pay. Ability is the "ideal ethical basis of taxation. Every tax-
payer should feel that he has made equal sacrifice in the payment of tax. The concept of ability to
pay depends upon the bold concept of equity in taxation. Equity implies just tax payment. When
the tax payer is required to pay tax according to his ability to pay, it may be called equity in tax
payment. As Dalton puts it, "the burden of taxation’ should be so distributed that the direct real
burden on all tax-payers is equal."
According to Seligman, “the basic point of the ability to pay principle is that the burden of
society should be shared amongst the members of the society so as to conform to the principle of
justice and equity."

The ability to pay principle accepts the idea that tax is a compulsory payment to the
government without any direct benefit. This approach considers revenue and public expenditure
as two distinct entities. Public expenditures are for the "common good" and cannot be
individually evaluated. The ability to pay principle points out that this collective expenditure
should be distributed on the basis of "ability to pay" of the people and not on the basis of any
benefits received.

According to this approach, a citizen has to pay taxes because he can, and his relative share
in the total tax burden is to be determined by his relative paying capacity.

J .S Mill sharply rejected the benefit approach, based on the concept of protection of life and
property. He concluded that application of benefit rule would lead to regressive taxation, as poor
are more in need of protection. A quite different principle of taxation is thus needed. This new
principle i.e. the principle of ability to pay is based on the dictum that all should be treated
equally under law. Equality in taxation means equality in sacrifice which may be stated as the
concept of equal sacrifice.
3.5.5.1. Justification to Ability Theory:

The supporters of the ability theory have justified it on three grounds:

Firstly, it has been justified on psychological effects of tax payments upon individual tax-
payer. Psychologically every tax-payer should feel that he has made equal sacrifice in the
payment of a tax. Equality of sacrifice means that all the tax-payers should feel the same pinch
by paying the last Birr as tax.

Secondly, it has been justified in terms of diminishing marginal utility of income. As

income increases, marginal utility of additional unit of income decreases and vice-versa. The tax-
burden should be more on rich than on poor.

Thirdly, ability is known as the faculty interpretation. The faculty is represented by the
income, property and wealth on an individual.

3.5.5.2.Index of Ability to Pay:

The theory of ability to pay, however, involves the fundamental problem, as to how to
measure the ability to pay of a person. There are two approaches which have so far been
advanced for this purpose-the objective approach and the subjective approach. In the objective
approach, the faculty theory has been evolved to measure ability to pay. In the subjective
approach, the sacrifice has been evolved to measure ability to pay.
The two approaches to measure the ability to pay are:
(1) Objective Approach

In view of the practical difficulties of sacrifice theories

or subjective approach, some writers, specially American'
have presented an objective approach to measure the ability to pay. Prof. Seligman has used
the 'faculty' to indicate ability in the objective sense. Thus, it is also known as faculty theory
of ability to pay.
The indices of ability to pay are as follows:
(i) Property: Property or Accumulated wealth was considered as the index of ability to pay.
It was considered that property in the form of land,-buildings, gold, golden ornaments, etc., was
a measure of a man's financial ability. Property gives security and insurance against risks. A
person with property has a better ability to pay a tax than a person having no or very little
property. Thus it was argued that taxation should be imposed on the basis of the extent of
property possessed by the people. A person having larger wealth or property should be made to
contribute more. Though property is an important source of income, yet, it cannot be considered
as the primary test of ability because of the following reasons. "Firstly, property is an important
source of income, but all property do not yield income." Secondly, the income from property is
not continuous. Thirdly, income from property may vary on account of its nature, location, use
etc., a house in a village may not yield anything, but it may be a good source of income in a
tow~. Fourthly, property is taxed on its capital value, but if it does not yield income, the taxation
may be unjust. Hence, it can e said that property may not be regarded as a primary test of ability
to pay.
(ii) Income: Income is one of the most accepted indices of ability to pay. Under this index,
persons with higher incomes share a larger money burden of tax and lower incomes are taxed at
lower rates. People with equal incomes are taxed at equal rates. According to Adam Smith, "The
subject of every state ought to contribute towards the support of the government in proportion to
their respective abilities." Only net income should be taxed. Gross income cannot be treated as
an index of ability to pay. Secondly, it is necessary to classify income into - (i) earned income
and (ii) unearned income. Income earned from work is treated as earned income and that from
capital gains from sale of shares, security and buildings etc., interest on savings and rent from
immovable property, windfall, gains from gambling, races, lottery, etc. is treated as unearned
income. It is argued that unearned income should be taxed heavily as compared with earned
income, because unearned income discourages willingness to work.
(iii) Size of the Family: While determining the tax paying ability of a person, the size of the
family-should also be taken into account. A larger size of the family with a given income may
have smaller tax paying ability than of a smaller size family, e.g., a bachelor possesses the higher
tax paying ability than a married couple having four children while other things being the same.
Though, the size of the family can be taken into account while determining the tax ability of an
individual, but it cannot be taken as the primary measure of the tax paying ability.
(iv).Consumption: Another objective index of ability to pay is he consumption expenditure
of the members of the society. Sometimes, it is noticed that taxation on the basis of property and
income is not equitable and can be manipulated to evade by the tax-payers in many ways. Hence
Prof. Fisher and Prof. Nicholas Kaldor advocated taxation on expenditures. Firstly, consumption
implies withdrawal of resources from the economy. A man's capacity to pay taxes, therefore,
depends upon to what extent he withdraws resources to satisfy his consumption needs.

Secondly, a person spending large amounts to meet consumption (luxuries) has a greater
ability to bear the burden of taxation. It is therefore, argued that persons with a higher
consumption expenditure should contribute a larger share of total tax amount.

Thirdly, there has been a large scale evasion of taxes on income because of the concealment
of income by the taxpayers. Since consumption of items especially consumption of items of
luxury cannot be concealed, it is stressed that the consumption expenditure should be used as an
index of ability to pay taxes.

Fourthly, it is difficult to locate the different sources of income of an individual. Therefore,

his ability to pay cannot exactly be measured since the expenditure on consumption can be
located without much difficulty, it would truly represent a man's capacity to spend and hence his
ability to pay taxes.
In spite of the fact that expenditure on consumption can be located to determine a person's
ability to pay, yet is suffers from various limitations:

(1) If the consumption expenditure of a person is taken as

an index of his ability to pay then those who save and invest will escape the tax burden. This
is against the canon of equity.

(2) Lack of records of the consumption expenditure also creates a major difficulty in locating a
person's consumption expenditure for taxation purposes.

(3) Since different persons have different standards of living, it will not be proper to tax higher
consumption expenditure of the people with higher standard of living.

At the end we may conclude by saying that the consumption expenditure like property
cannot be a satisfactory index of ability to pay. It is only the income which is by far the most
important determinant of a person's ability to pay. Income taxation is the most important source
of revenue to the governments of developed countries. Property taxation is used as an additional
source. Ethiopia depends largely on commodity taxation.

3.5.6. Subjective Approach:

The subjective approach is based on the psychological or mental reactions of the tax-payers.
In this approach we estimate the burden felt by the tax-payer or sacrifice undergone by him.
Each tax-payer should make equal sacrifice, if tax burden is to be justly distributed.

According to J.S.Mill, "The just distribution of tax share prevails when all individuals incur
equal sacrifice while contributing to the common good. Here equal sacrifice refers to the
sacrifice in terms of utility of income sacrificed by individuals in contributing to the common
good.

Conan Stuart and Edge worth have advanced three concepts of equal sacrifice, viz.:
(1) Equal Absolute Sacrifice
(2) Equal Proportional Sacrifice
(3) 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 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.
3.6. Canons of Taxation:
[

The Government requires funds for the performance of its various functions. These funds are
raised through tax and non-tax sources of revenue. Imposing tax on income, property and
commodities etc. raises tax revenues. In fact, tax is the major source of revenue to the
Government. According to Adam Smith, "a tax is a contribution from citizens for the support of
the Government".
No one likes taxes, but they are a necessary evil in any civilized society. Whether we believe
in big government or small government, governments must have some resources in order to
perform their essential services. So how does one go about evaluating a particular tax?
Taxation is an important instrument for the development of economy of the country. A good
tax system ensures maximum social advantage without any hardship on taxpayers. While
framing the tax policy, the government should consider not only its financial needs but also
taxable capacity of the community. Besides the above, government has to consider some other
principles like equality, simplicity, convenience etc. These principles are called as "Canons of
Taxation". The following are the important canons of taxation.
I. Canons Advocated by Adam Smith
1. Canon of Equality.
2. Canon of Certainty.
3. Canon of Convenience.
4. Canon of Economy.

II. Canons Advocated by Others:

5. Canon of Productivity.
6. Canon of Elasticity.
7. Canon of Diversity.
8. Canon of Simplicity.
9. Canon of Expediency.
10. Canon of Co-ordination.
11. Canon of Neutrality.

We shall now discuss them briefly.

h

3.6.1. Canons Advocated by Adam Smith:

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 that are mentioned above.
All accepts them as good taxation policy. We shall now explain them briefly.

1. Canon of Equality: According to this principle of Adam Smith, "the subjects of every
state ought to contribute toward the support of the Government, as nearly as possible, in
proportion to their abilities". That is, a good tax system should be based on the ability to pay of
the people. That is, all people should bear the public expenditure in proportion to their
respective abilities. Tax burden should be more on the rich than on the poor. Since the rich
people can pay more for public welfare, more tax should be collected from richer section and
less tax from the poor. The ability to pay may be determined either on the basis of income and
wealth or on the basis of consumption i.e. luxury or necessity. In simple terms, canon of equality
implies that when ability to pay is taken into consideration, a good tax should distribute the
burden of supporting government more or less equally among all those who benefit from
government.
2. Canon of Certainty: Another important canon of taxation advocated by Adam Smith is
certainty. According to him, "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
be clear and plain to the contributor and every other person". It means the time, amount and
method of payment should all be clear and certain so that the taxpayer can adjust his income
and expenditures accordingly. This principle removes all uncertainties in the payment of tax and
ensures smooth functioning of the tax department.
3. Canon of Convenience: In the canon of convenience, Adam Smith states that, "every
tax ought to be levied at the time or in the manner in which it is most likely to be convenient for
the contributor to pay it". That is, the tax should be levied and collected in such a way that is
convenient to taxpayer. For example, it may be in installments, land revenue may be collected at
the time of harvest etc. This principle reduces the tendency of tax evasion considerably.
It includes the selection of suitable objects for taxation, and also the choice of convenient
periods for requiring payment. The canon of convenience is a special form of the general
principle that the public power should as far as possible adjust its proceedings to the habits of the
community, and avoid any efforts at directing the conduct of the citizens in order to facilitate its
own operations. The sacrifices that inconvenient methods of fiscal administration impose may
indeed be treated as violations of both economy and equity.
4. Canon of Economy: The next important canon of taxation is economy. According to
Adam Smith, "every tax ought to be so contrived as both to take out and keep out of the pockets
of the people as the little as possible over and above what it brings into the public treasury of the
state". This principle states that the minimum possible amount should be spent on tax collection
and the maximum part of the collection should be brought to the Government treasury.
Taxation should be economical i.e. this should be much more than mere saving in the cost of
collection. Undue outlay on the official machinery of levy is but one part of the loss that
taxation may inflict. It is a far greater evil to hinder the normal growth of industry and
commerce, and therefore to check the growth of the fund from which future taxation is to come.
Thus the canon of ‘Economy' is naturally sub-divided into two parts viz.,
 1. ‘Taxation should be inexpensive in collection', and
2. ‘Taxation should retard as little as possible the growth of wealth'.
It may also be remarked that there is a close connection between "Economy" and
"Productivity", since the former aids in securing the latter.

3.6.2. Canons Advocated by Others:

Other researchers of taxation at other times have added to Adam Smith’s criteria. Some
have noted that a tax should be adequate, meaning it should produce sufficient revenue to
support whatever it is that citizens want their government to do. Some have argued for a
"Benefit Principle" whereby the amount of tax each is called upon to pay bears some
relationship to the benefits each taxpayer receives from government. Others have argued that a
tax should be neutral in its effect on the way markets work. But Smith’s Canons are the starting
point for any serious evaluation of a tax. The various canons added by others are explained
below:
5. Canon of Productivity: According to C.F. Bastable, the tax system should be
productive enough i.e. it should ensure sufficient revenue to the Government and it should
encourage productive activity by encouraging the people to work, save and invest.
6. Canon of Elasticity: The next principle advocated by Bastable is elasticity. The taxes
should be flexible. It should be levied in such a way to increase or decrease the tax revenue
depending upon the need. For example, during certain unforeseen situations like floods, war,
famine, drought etc. the Government needs more amount of revenue. If the tax system is elastic
in nature, then the Government can raise adequate funds without any extra cost of collection.
The tax system should be elastic is a desirable canon of taxation. It may, indeed, be regarded
as the agency for realising at once "Productivity" and "Economy". Where the public revenue
does not admit of easy expansion or reduction according to the growth or decline of expenditure,
there are sure to be financial troubles. For this purpose some important taxes will have to be
levied at varying rates. The particular taxes chosen will vary according to circumstances, but the
general principle of flexibility should be recognised and adopted.
 7. Canon of Diversity: According to this principle, there should be diversity in the tax
system of the country. The burden of the tax should be distributed widely on the entire people of
the country. The burden of the tax should be decentralised so that every one should pay
according to his ability. To achieve this, the Government should impose both direct and indirect
taxes of various types. It should not depend upon one or two types of taxes alone.
8. Canon of Simplicity: This principle states that the tax system should be simple, easy and
understandable to the common man. If the tax system is complex and vague, the taxpayer cannot
estimate his tax liability and it will cause irregularities in the payments and leads to corruption.
9. Canon of Expediency: According to this principle, a tax should be levied after
considering all favorable and unfavorable factors from different angles such as economical,
political and social.
10. 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.
11. Canon of Neutrality: This principle stresses that the tax system should not have any
adverse effect. That is, it shouldn’t create any deflationary or inflationary effects in the economy.

Applying Smith’s Canons to any particular tax is largely a subjective undertaking. Yet, if
one attempts to evaluate the principal taxes – that is, property tax, income tax, and sales tax –
against Smith’s Canons, one will quickly find that there is no such thing as a perfect tax. The
property tax, for instance, scores fairly low on convenience and efficiency, but fairly high on
certainty. The income tax scores fairly high on equality, but is costly to administer and is so
complicated that it leaves much to be desired on certainty. A sales tax scores high on
convenience, certainty, and efficiency, but poorly on equality. Because there is no perfect tax, an
argument can be made that the best tax system is one that uses all three major types of taxes in
small doses. By combining all three major types, it is possible to offset the weaknesses of each
with the strengths of the others. In the final analysis, however, the standard for judging a tax is
often political. In a democracy, when revenue must be raised, the tax selected is often based
upon plucking the goose that squawks the least. Some have called this political test the other
canon.
 These are the general canons that experience seems to prescribe, and which should be
observed in a well-ordered State. Besides, their simplicity has not saved them from frequent
violation. Their value lies in their assertion of truths plain and intelligible to common
understandings but for that very reason too often passed over. A system of taxation, which
conforms to them, may without hesitation be pronounced a good one. Where they are neglected
and broken through, the evil consequences will be almost certainly conspicuous.
A further point deserves notice. There is at first sight a probability of conflict between the
several canons. A productive tax may be inconvenient, as a convenient one may be unjust, and
how, it may be asked, is a solution of the difficulty to be reached? The plain answer is, by the
surrender of the less important canon. The successful administration of the State is the final
object, and therefore convenience, or even equity, may have to yield to productiveness. But
though opposition is possible, agreement is on the whole the ordinary case. We have seen that
economy increases productiveness, but so do certainty and convenience. Elasticity aids both
productiveness and economy, while growing productiveness in turn permits better observance of
all the other canons. There is thus a harmony in a properly administered financial system that
tends to promote its improvement in the future.
In a democratic country, the political factors are also influencing the tax policy of
government. While deciding an appropriate taxable system, the government has to follow the
above-mentioned canons of taxation.

3.7. Direct and Indirect Taxes:

Taxes are sometimes referred to as direct or indirect. The meaning of these terms can vary in
different contexts, which can sometimes lead to confusion. In economics, direct taxes refer to
those taxes that are paid by the person who earns the income. By contrast, the cost of indirect
taxes is borne by someone other than the person responsible for paying them. For example, taxes
on goods are often included in the price of the items, so even though the seller sends the
payments to the government, the buyer is the real payer. Indirect taxes are sometimes described
as hidden taxes because the purchaser of goods or services may not be aware that a proportion of
the price is going to the government.

3.7.1. Direct Taxes:

 A direct tax is paid by a person on whom it is levied. In direct taxes, the impact and
incidence fall on the same person. If the impact and incident of a tax fall on the same person, it is
called as direct tax. It is borne by the person on whom it is levied and cannot be passed on to
others. For example, when a person is assessed to income tax or wealth tax, he has to pay it and
he cannot shift the tax burden to anybody else. In Ethiopia, Government levies the direct taxes
such as income tax, tax on agricultural income, professional tax, land revenues, taxes on stamps
and registrations etc. From the above discussion, it can be understood that the direct taxes levied
in Ethiopia take the form of taxes on income and property.

3.7.1.1. Merits of Direct Taxes

Direct taxes have the following merits:

1. Ensures the Principle of Ability to Pay: Direct 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
higher rates of adopting the progressive tax system, rich people pay on 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 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.
[

3.7.1.2. 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 increases 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, he has
to follow numerous accounting procedures which are difficult to comply with. Further, direct
taxes 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 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 taxpayer earns certain level, they
have to pay more, because of the higher rate of taxes attributed to the higher slabs. This will in
turn discourages them to work further, save and invest.
7. Expensive to Collect: Under direct taxes, each and every taxpayer is separately assessed.
Thus, the large number of taxpayers to be contacted and assessed and the prevention of tax
evasion make the cost of collection more expensive.
3.7.2. 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 on to others. For example, when the excise duty is
levied on the manufacturer of cement, he 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.
3.7.2.1. 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.
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 all 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 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, it can be done only by refraining the consumption of the particular commodity.
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. Progressive: Indirect taxes can be made progressive by imposing lower rates of taxes or
giving exemption to the necessary articles and heavy taxes on luxurious articles. Thus, indirect
taxes also confirm the principle of equity.
7. 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.
8. Discourages the Consumption of Articles Injurious 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.

3.7.2.2. 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.
3. Discourages 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: The 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.
[

3.7.3. Differences between Direct and Indirect Taxes:

Direct and Indirect taxes differ among themselves on the following grounds:
1. Shiftability of the Burden of Tax: In the direct taxes, the impact and incidence fall on
the same person. It is borne by the person on whom it is levied and is not passed on to others. For
example, when a person is assessed to income tax, he cannot shift the tax burden to anybody
else, and he himself has to bear it.
On the other hand, in the case of indirect taxes, the impact and incidence fall on different
persons. It is not borne by the person on whom it is levied. The burden of the tax can be shifted.
For example, when the manufacturer of cement pays excise duty, he can shift the tax burden to
the buyers by including the tax in the price of the cement.
2. Principle of Ability to Pay: Direct taxes conform to the principle of ability to pay. For
example, now people having income above Birr.150 pm, only is liable to pay income tax.
But, indirect taxes are borne and paid by the weaker sections of the society also. As such,
these taxes do not conform to the principle of ability to pay.
3. Measurement of Taxable Capacity: In the case of direct taxes, tax-paying capacity is
directly measured. For example, the taxable capacity for income tax is measured on basis of the
income of the individual.
On the other hand, in the case of indirect taxes, taxable capacity is measured indirectly. The
luxurious articles are levied at the higher rate of taxes on the assumption that they are purchased
by the rich people. However, low rate is charged on the articles of common consumption.
4. Principle of Certainty: Direct taxes ensure the principle of certainty. Both the Government
and the taxpayer know what amount is to be paid and the procedures to be followed.
But in the case of indirect taxes, it is not possible. The taxpayer does not know the amount of
tax to be paid and the Government cannot predict the quantum of revenue generated from the
indirect taxes.
 5. Convenience: Direct taxes cause much inconvenience to the taxpayers since they are to
be paid in lump sum.
But the indirect taxes are paid by the consumers in small amounts as and when they purchase
the commodities. Moreover, the taxpayers need not follow any legal formalities in the payment
of tax. Thus, indirect taxes are more convenient to them.
6. Civic Consciousness: People felt the burden of direct taxes directly. The taxpayer is
conscious of his contribution to the Government and interested in knowing whether the tax paid
by him is properly used or not. In this way, it creates civic consciousness among the taxpayers.
But indirect taxes do not raise such consciousness among the taxpayers, because they pay the
taxes indirectly.
7. Nature of Taxation: Direct taxes are progressive in nature. The rates of taxes go up with
the increase in the tax base i.e. income of a tax payer.
But rich and poor irrespective of their income equally pay indirect taxes. Thus, they are
regressive in nature.
8. Removal of Disparity in Income and Wealth: Since the direct taxes are progressive in
nature, they reduce the disparities of income and wealth among the people to a considerable
extent.
But indirect taxes have a negative effect. Actually they are widening the gap between the rich
and poor when they are levied on the goods of common consumption.
9. Examples: The examples for direct taxes are income tax, wealth tax, gift tax, estate duty
etc.
The examples for indirect taxes are customs duty, excise duty, sales tax, service tax etc.
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 some one 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.
2. It may be transferred by him to another person i.e. second person.
3. It may be ultimately borne by the second person.

This can be explained with the help of the model shown in Fig. 2.2.

FACTORS OF PRODUCTION

(Transfer by reducing the price of raw material etc.)

Backward
Shifting Levy
of Tax

----------------------------------------------------- Impact of taxation

PRODUCER

(Transfer by raising prices)

WHOLESELER
Shifting
of
Taxation (Transfer by raising Prices)

RETAILER
Forward
Shifting (Transfer by raising Prices)
CONSUMER

Incidence of taxation

Payment
of tax

Fig: 3.2. MODEL OF IMPACT SHIFTING AND INCIDENCE OF TAXATION

Thus,
a) Impact of a tax is on the person who bears the money burden in the first instance.
 b) Shifting of a tax refers to the process by which the money burden of a tax is transferred
from one person to another person.

c) Incidence of a tax refers to the money burden of a tax, which is on the person who
ultimately bears it.

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:
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.
3.8.5. Theories of Tax Shifting or Incidence of Taxation:
The concept of shifting and incidence has undergone many changes. Different theories have
been developed to determine the situations under which a tax is shifted. These theories can be
classified into the following four broad categories:
 1. The Traditional Theory.
2. The Concentration Theory.
3. The Diffusion Theory.
4. The Modern Theory.

3.8.5.1. The Traditional Theory:

Seligman considered that there are three different conceptions in the process of levying a tax
viz., impact, shifting and incidence. As such, a tax may be imposed on some person and he may
transfer it to another person. Ultimately, it may be borne by the second person or the second
person may again transfer it to others by whom it is ultimately paid. That is, the person who
bears the burden of tax in the last instance may not necessarily be the person who originally pays
the tax.
Thus, shifting of taxation is the process of transfer of tax, while the impact lies on the person
who pays it at the first instance. Incidence of a tax is the settlement of the burden on the final
taxpayer who cannot shift it again.

3.8.5.2. The Concentration Theory:

This theory was developed by physiocrats in the 18th century. They believed that all types of
taxes imposed on public ultimately fell on the particular class of people i.e. landowners or on the
surplus income from land. They considered that agriculture was the only productive occupation
giving rise to economic surplus. According to them, there was no surplus in other occupations
like trade, commerce etc. They firmly believed that a tax whether imposed on a person or on a
commodity would ultimately fall on land through the process of shifting of the tax. That is, taxes
imposed on non-agriculturists tended to be passed on to agriculturists.
They advocated a single tax on the net income of the land by abolishing all other taxes levied
on the people. They make it on the grounds that it would simplify taxation; reduce the cost of
collection and the tax charges on the landowners.
The theory of concentration has been criticized by the classical economists on the ground that
agriculture is not the only productive occupation. They viewed that all economic activities are
productive and a single tax on land cannot hold good in the modern welfare society. They argued
that the burden of tax should be distributed equally in the society as a whole and not in a
particular section of the society.
3.8.5.3. Diffusion Theory:
The French economists like Mansfield and Canard propounded this theory. It is entirely
contrary to the concentration theory. It stated that the taxes are diffused among the members of
the society. According to them, every tax is shifted and reshifted till its burden eventually gets
spread over the whole society.
According to Mansfield, "the tax is like a stone falling into a lake and making a circle, till
one circle produces and give motion to another and the whole circumference is agitated from the
centre".
Canard compared the levy of tax with extracting blood from human body. Even though, the
blood is taken from a single vein, the loss is spread over the body as a whole and the body
remains in equilibrium.
When the levy of tax gets diffused, no one can escape from its incidence. The diffusion of the
tax occurs through the process of shifting and incidence. When a commodity is bought and sold,
the tax gets partly shifted. Equilibrium is reached when the tax burden is equally distributed
among all taxpayers. This theory does not suggest a single tax on land. But, tax diffusion is a
time consuming process.
The main criticisms of this theory are as follows:

(a) All taxes cannot be shifted, because shifting of a tax can take place only under certain
conditions. Thus, the ideas of diffusionists on the shifting of taxes are not practical.
(b) The assumptions of the theory are unrealistic in nature because perfect competition is not
possible in real life. Hence, we cannot expect that the tax incidence will get diffused
equally in the economy.

3.8.5. 4.Modern Theory:

The modern theory is based on the marginal analysis of value and price as given by
Marshall. The modern economists like Seligman, Edgeworth and others apply this theory to
the shifting of tax. It possesses all the virtues of the earlier theories.
 It advocates that tax should be imposed upon economic surplus. According to the modern
economists, a tax is a part of cost of production and therefore, it enters into price. As such,
shifting of tax occurs only through a charge in price. Since price is determined by demand and
supply, the shifting and incidence of taxes depend upon the process of pricing of commodities.
Therefore, a tax is necessarily included in the price of commodities. However, if the prices
increase but not to the extent of taxes levied, it implies that some burden of tax is being borne by
the sellers and some by the buyers. The incidence of taxation is divided between the sellers and
buyers of commodities according to their relative elasticities of demand and supply. It can be
generalised as follows:

1. If the elasticity of supply is equal to the elasticity of demand, the tax burden will be
divided equally between the buyers and sellers. Here, the price is increased by half of the
total tax.
2. If the elasticity of supply is greater than the elasticity of demand, then more tax burden
will fall on the buyers. Here, the price is increased by more than half of the total amount
of tax.
3. If the elasticity of supply is less than the elasticity of demand, then more tax burden will
fall on the sellers. Here, the price is increased but less than the half of the total amount of
tax.
4. If the demand is perfectly elastic and the supply is inelastic, then the whole incidence will
fall on the sellers. Here, the price remains the same.
5. If the demand is perfectly inelastic and supply is elastic, then the whole incidence will
fall on the buyers. Here, the price is increased by the full amount of the tax.
6. If supply is perfectly elastic and demand is inelastic, then the whole incidence will fall on
the buyers. Here, the price is increased by the full amount of tax.
7. If the supply is perfectly inelastic and demand is elastic then the whole incidence will fall
on the sellers. Here, the price remains unchanged.

Modern economists state that the shifting of the tax to the consumers of the commodity
depends not only on the elasticity of demand and supply but also on some other factors like cost
condition, time factor, nature of the market, trade cycles, nature and quantum of tax etc.
3.9. Effects of Taxation:
.Now-a-days, revenue rising is not the only purpose of taxation. In a Welfare State, taxation
has also been used as a tool of monetary policy to achieve socio-economic objectives. It is used
to promote economic growth by controlling the effects of trade cycles and regulating the
production and consumption. It has also been used to reduce the inequalities of income and
wealth.
Thus, in the modern context, the effects of taxation, which are shown in Figure 3.3, may be
summarized as follows.

3.9.1. Effects of Taxation on Production:

All taxes must evidently come from the produce of land and labour, since there is no other
source of wealth than the union of human exertion with the material and forces of nature. But
the manner in which equal amounts of taxation may be imposed may very differently affect the
production of wealth. Taxation, which lessens the reward of the producer necessarily, lessens
the incentive to production; taxation, which is conditioned upon the act of production, or the use
of any of the three factors of production, necessarily discourages production. Thus taxation,
which diminishes the earnings of the labourer or the returns of the capitalist, tends to render the
one less industrious and intelligent, the other less disposed to save and invest. Taxation, which
falls upon the processes of production, interposes an artificial obstacle to the creation of wealth.
Taxation which falls upon labour as it is exerted, wealth as it is used as capital, land as it is
cultivated, will manifestly tend to discourage production much more powerfully than taxation to
the same amount levied upon labourers, whether they work or play, upon wealth whether used
productively or unproductively, or upon land whether cultivated or left waste.
Taxation can influence the production of a nation by influencing four basic factors. They are
as follows:

1. Ability to work, save and invest.

2. Willingness to work, save and invest.
3. Diversion or allocation of resources between industries and places.
4. On the size of the industries.

Let us discuss these factors one by one.

3.9.1.1. Effects on the Ability to Work, Save and Invest:

 Taxation transfers the money income from the public to the government and thereby
reducing their purchasing power. The reduction in purchasing power reduces their ability to
obtain necessaries and luxuries of life.
Thus, the levy of taxes on people reduces their consumption of necessaries and comforts,
which lowers the standard of living. When the standard of living is affected, their efficiency and
ability to work will also be adversely affected. This effect is strongly felt by the poor people. But
the efficiency and ability to work of rich people is not so much affected by taxation.
The savings of the people depends upon their income. When income is reduced by taxation,
savings will also be reduced. The ability of the people to invest largely depends upon their
savings. When their savings are reduced by taxation, their ability to invest is also automatically
reduced by taxation.
[[

3.9.1.2. Effects of Taxation on willingness to Work, Save and Invest:

Taxation affects the desire of the people to work, save and invest. If the willingness of the
people to work, save and invest is affected by taxation, the production will automatically be
affected. It is universally recognised that direct taxes have more adverse effect on the willingness
of the people to work, save and invest.
It is argued on the grounds of psychological reactions of the people. That is, when the higher
progressive taxation is levied, the Government takes the major portion of their additional
earnings back. This may create a tendency in the minds of the people not to take risk to work
hard to earn such a meagre income.
However, reasonable taxation may not have any such bad effect on the desire to work, save
and invest.

3.9.1.3. Effects of Taxation on the Diversion of Economic Resources:

While the volume of production of a country depends upon the ability and willingness to
work, save and invest, the pattern of production depends upon the allocation of economic
resources between different industries and regions. Taxation can be used in the diversion of
economic resources among the industries and regions. Thus, taxation can influence not only the
size of production but also the pattern of production.
 If the products of certain industries are taxed, their prices would rise and therefore, the
demand for their product would reduce. And thereby, the profit is also reduced. This may result
in the diversion of resources from these industries to some other industries whose products are
subjected to no tax or low tax rate. This diversion of resources may change the composition and
pattern of output of industries. The extent to the diversion of resources takes place from taxed
industries to non-taxed industries will depend upon the elasticity of demand and supply of
products of such industries.
The diversion may be beneficial diversion or harmful diversion. Taxation on the
commodities that are injurious to the health like cigarettes and liquors may discourage their
consumption, which in turn affects their production. The factors of production engaged in these
industries may be diverted to some other industries producing goods of common consumption
etc. This is a "Beneficial Diversion".
The taxation on the goods of common consumption will increase their price. Hence, the
consumption of such goods may be reduced. This will affect the production of these
commodities, and the resources used in their production may be diverted to the production of
some other commodities which may be in the nature of luxury or harmful to health. Thus, such a
diversion of resources is harmful and is socially not desirable. It is known as "Harmful
Diversion".

3.8.1.4. Effects on the Size of Industries:

When taxes are imposed without any discrimination on the commodities produced by both
small and large-scale industries, the production of small-scale industries will be highly affected.
This is because there cannot be any economies of large-scale operation. Thus, the cost of
production of these industries will normally be high. If taxes are levied on par with the large-
scale industries, the total selling price of small sized industries will increase further. This will
affect the competitive efficiency of small-scale industries, which in turn affects the production,
and survival of these industries.
Hence, tax concessions should be given to encourage the production of these industries.

3.8.2. Effects of Taxation on Distribution:

 An important objective of taxation in most of the welfare states is to reduce the inequalities
of income and wealth and to bring about an equal society. The effects of taxation on the
distribution of income and wealth among the different sections of the society, depends upon two
important factors. They are as below:

1. Nature of Taxation, and

2. Kinds of Taxes.

3.8.2.1.Nature of Taxation:

The nature of taxation influences the distribution of tax among the different sections of the
society. It includes proportional regressive and progressive nature of taxation.
(a) Effects of Regressive Taxation on Distribution: Under regressive taxation, the burden
of taxation falls more heavily upon the poor than on the rich. Regressive taxation may increase
the inequalities on the distribution of income and wealth. Hence, the burden of taxation is higher
on the poor than on the rich. In effect, this system widens the gap between the rich and the poor.
(b) Effects of Proportional Taxation on Distribution: Under the proportional taxation,
taxes are levied uniformly upon the rich and the poor. When the tax rate remains the same, it
creates inequalities between them. However, if there is any increase in the income of these
sections, the inequalities in distribution of income will also increase. The burden of taxation falls
more heavily upon the poor than on the rich.
(c) Effects of Progressive Taxation on Distribution: Under the system of progressive
taxation, the tax rates go up with the increase in the income. Thus, in this system, the inequalities
in the income and wealth will be reduced. The major portion of the income and the wealth of the
rich is taken away by way of higher tax rates. Hence, the progressive tax system tends to reduce
the inequalities in the distribution of income and wealth.

3.8.2.2. Effects of Taxation on the basis of Kinds of Taxes:

The effects of taxation depend upon the kinds of taxes i.e. direct or indirect taxes.

(a) Effects of Direct Taxes on Distribution: Direct taxes take the form of taxation on the
income and property. It attempts to reduce the income of the richer sections and transfers the
income to the Government. The Government may use these resources to raise the standard of
living of the poor. Therefore, all those taxes, which fall heavily upon the higher income groups,
can have favourable distributional effects.
(b) Effects of Indirect Taxes on Distribution: Indirect taxes are levied on commodities.
They fall heavily on the lower and middle-income groups who spend a large portion of their
income on commodities. In such a situation, indirect taxes have adverse distributional effects.
However, indirect taxes may be made progressive if the necessaries are exempted from taxation
or levied on low tax rates, and luxuries are subjected to higher rates of taxes.

3.8.3. Effects of Taxation on Consumption:

Taxes increases the price of the taxed goods relative to the prices of untaxed or lower taxed
goods. The increase in the relative price affects the taxpayer in two ways.
1. Income Effect: The tax reduces the taxpayer's purchasing power or real income. It takes
resources away from the taxpayer and transfers them to the government. This is often referred to
as the direct burden of the tax.
2. Substitution (or Price) Effect : The tax creates an incentive for the taxpayer to
substitute less preferred but untaxed or lower-taxed goods for the more-preferred taxed good.
The loss in consumer utility from this substitution is the excess burden (or welfare cost) of the
tax.
Taxation influences the consumption as well. Such influence can be studied on the following
grounds:
1. Influence the Allocation of Resource of Individuals:

Every individual has limited money income and allocate it to different uses. Taxation affects
their allocation directly or indirectly. For example, the income tax reduces the money income of
a consumer and forces him to buy a smaller volume of goods and it reduces the standard of living
of the consumers. Likewise, a levy of indirect taxes on the goods of common consumption will
affect the allocation of individual resources. Thus, taxes influence the allocation of resources of
individuals.
2. Effects of Taxation on Consumption and Employment:

Taxation reduces the purchasing power of the people and it reduces their consumption. The
decline in consumption leads to decrease in effective demand for the goods and services, which
in turn affects the production of these commodities. Ultimately, the reduction in consumption
leads to a reduction in employment opportunities. For example, due to rise in price, instead of
getting two different commodities, the individual may buy more quantity of any one commodity
to maximise the utility and his satisfaction.

3. Effects of Taxation on Consumption during Inflation and Depression:

Taxation has different effects in times of inflation and depression. During the time of
inflation, the purchasing power of the people is reduced by a raise in the rates of existing taxes or
imposition of new taxes. This would control the consumption and therefore, help in bringing up
stability in prices.
During the period of depression, taxation may be reduced. As the result of the reduction on
direct tax rates, the people will have more disposable income and higher purchasing power and a
decrease in indirect taxes leads to the reduction of selling prices. Both of them encourage the
total consumption of the people and thereby the economic activities are induced in the country.
4. Regulatory Effect of Taxation on Consumption:
Taxation may be used to regulate the production and consumption. Consumption can be
regulated by taxing the production and use of certain commodities. For example, the object of
some taxes may be to reduce the consumption of certain harmful commodities such as liquors,
cigars etc.

CHAPTER-IV
TYPES OF TAXES

4.1. TAX ON INCOME:

Apart from personal income tax, corporate income tax has become a prominent form of
revenue to modern Governments. The joint stock company-also known as the business
corporation - has a separate legal entity and the net income or profit earned by the company is
taxed by the Government. Such a tax is called corporate income tax or simply corporation tax.
Arguments for Corporation Tax:
Economists have generally defended the corporation income tax as a necessary and
important element in a progressive tax system and have argued that the economic effects are
desirable or at least less harmful than other alternative sources of revenue:
(i) The Corporation tax is justified on the ground that it is a change for the social benefit or
privilege of doing business. The joint stock company owes all its rights, power and benefits to
the grant of franchise by the state. Among the special principles are: easy transfer of ownership,
perpetual life, etc. These features make it easy for Business Corporation to grow in size and
power and to tap new sources of finance and new markets. The tax on company profits is sought
to be justified for these privileges enjoyed by companies.
(ii) Many of the services provided by the Government for the general public are mostly
meant for the corporate sector - e.g., public health and public education, made use of by
working classes, maintenance of law and: order which protects property, enforces contracts,
prosecutes fraud etc. These are social costs which are wholly or partly assignable to business
and industry. Corporate taxation is sought to be justified on this ground.

(iii) Some have used the ability principle to justify corporate taxation. For one thing, corporate
profits constitute an important source of large incomes and fortune and hence of economic
inequality. For another, they constitute an important source of idle savings. Consequently
taxation on them seems to be justified.

All these three arguments in favour of corporate income tax - benefit principle, allocation
of social costs and ability principle - are not significant. The real justification is that the
corporation. tax is well established in practice and brings in good revenue to the Government.
Besides, the Corporation tax has high administration convenience.

Arguments against Corporation Tax:

Public corporations raise many serious objections to the levy of taxes on corporate taxes.
First, the corporate income tax results in double taxation - the profits of a public limited
company are taxed partly as tax on company profits and partly on the shareholders of the
company on their dividend income. This objection can be easily answered. For one thing, the
company and the shareholders are different legal persons and have separate incomes and,
therefore, there cannot be double taxation. For another, imposition of two or more taxes on the
same income does not necessarily constitute double taxation. A person may pay property tax on
the value of his property and also pay income tax on the income which he receives from the
property there is no double taxation here.
Secondly, the burden of the corporate income tax is shifted forward on to the consumers of
the products produced by the corporations. Accordingly the burden of the corporation tax is
borne, not by the companies, but by the public who also pay the income tax. This argument is not
valid, as the corporation tax is levied on net profits.

Thirdly, investment in risky business enterprises will be discouraged by the tax on company
profits. This is true to some extent but this does not mean that the profits of companies cannot be
taxed at all.

Finally, corporation income tax is said to be discriminatory in the sense that the tax falls on
the ordinary shareholders, while the preference shareholders will get away free. It may also be
pointed out that corporate profits tax will encourage firms to finance themselves through
debentures rather than through equity shares. There is some validity in this argument but there is
nothing intrinsically wrong in taxing the net profits of companies.
An evaluation of both arguments for and against corporate taxation shows clearly that there
is a good case for corporation tax in modern economies particularly from the point of economic
desirability, administrative feasibility and political expediency.

4.2. WEALTH / CAPITAL TAX:

There is much confusion and ambiguity attached to wealth tax, also Called as
capital tax or property taxation. As distinct from income-tax which is tax on income and is paid
out of income, wealth tax can be distinguished into:
(a) that which is assessed on capital but paid out of income.
(b) that which is levied on capital and paid out of capital.

In this group there are two types of taxes; the first is the capital levy which may be levied
once and for all, let us say, during an emergency or immediately after a war to payoff the huge
public debt; the second is the tax imposed every time wealth is inherited by one person from
another, commonly known as the death duty.
 There are three different types of capital taxes or wealth taxes, viz., (a) an annual capital tax
or annual tax on net wealth, (b) a capital levy, and (c) death duty.
An annual capital tax is a regular annual charge assessed on the basis of the net wealth of the
individual. No distinction is made between the various forms of wealth or capital. A capital levy,
on the other hand, is assessed on the capital or wealth of a taxpayer (this is similar to annual
capital tax) but is a once for all charge. While the annual capital tax is a regular annual feature,
capital levy is extremely irregular and mayor maynot be levied even once in a generation. A
death duty is a recurrent tax assessed on the capital of a taxpayer, recurrent in the sense that
every time property is inherited, the tax has to be paid. At the same time, it is a non-recurrent tax.
All these three exhibit two essential characteristics: (a) they are assessed on capital, and (b) they
are general in nature because they are assessed with reference to the capital worth of a taxpayer
and not to any specific item out of taxpayer's total capital.

Arguments for Wealth Tax:

Wealth-both real wealth and claims-refers to the value of goods, claims and property rights
which may be owned. While income is a flow, a stream, wealth is a stock, a fund. Since the
welfare of an individual depends upon the income which he enjoys as well as the wealth he owns
it is suggested that wealth also should be taken as basis for taxation at least as complementary
base to income. The possession of wealth confers many obvious advantages on the owner.
Between two persons who are getting the same income one from labor and the other from
wealth, the latter enjoys several special advantages. For instance, the person whose income
comes from wealth will be able to maintain himself even when his income ceases, for he can
dispose of his property. Secondly, he is not compelled to save as his wealth itself is a
manifestation of past saving. Finally, property confers social prestige and hence source of
satisfaction by itself. Thus, the basic justification of wealth tax is that personal wealth is a good
base for direct taxation.
(i) Equity Argument. Equity in taxation remands that tax burden is imposed according
to taxable capacity. For a long time income of a person has been regarded as the criterion of
a person's taxable capacity. But economists and statesmen have now come to accept the fact
that income taken by itself is an inadequate yardstick of taxable capacity as between (a)
Labor income and property income, and (b) different property owners.
 (ii) Economic Argument. An annual tax on property or wealth is superior to income-tax
because the former will not have a disincentive effect. Suppose, there are two individuals
with the same accumulated wealth Birr.1,000,000, and suppose further the first has invested
his money in equity shares with highly fluctuating income while the second has invested in
government bonds yielding 9 per cent. The first individual may get an income of 18 per cent
on an average but the difference of 9 per cent over the safe return may be taken as a return
for the assumption of risk. But income-tax does not make allowance for risk taking and
taxes the additional income of the person with investment in equity shares. Clearly,
therefore, it discriminates against risk taking and places too much burden on the person
willing to take the risks of business development and allows those with low interest and high
grade secularities to go comparatively lightly. Under the annual wealth tax, properties with
the same value, irrespective of their yield, would bear the same tax.

Arguments against Wealth Tax:

However, many arguments have been given by critics on the same grounds on which
the advocates have supported and justified the introduction of wealth tax. The fact that very few
countries have so far adopted the wealth tax probably explains the opposition to the tax by many
interested persons.

(i) The first criticism against the wealth taxis that it is not equitable. The wealth tax, the critics
assert, imposes a heavy burden upon persons who have wealth but little or no current income.
Not all property yields an income; in such a case, a tax on non-income-yielding property will
force a man to pay it even though he may not have an income to pay it with. Sometimes,
property values may be going down because of a general depression when high 'exeniptiol1s
may be called for.

(ii) The wealth tax discourages productive enterprise. It has, however, been shown by many
competent economists that an amount of money taken from a taxpayer by way of income-tax has
more discouraging effect than an equivalent amount of money taken by way of property tax.
(iii) The wealth tax has been held to be a poor tax from the administrative point of view. Two
special problems have been mentioned, viz., the problem of discovery and the problem of
valuation. The problem of discovery implies the high possibility of understatement and
concealment of property. This is, really, no criticism because if property is concealed then the
income arising from that property is also automatically concealed. If the income is known, then
the property behind that income will also be known. . Thus, the introduction of wealth tax does
not create any additional administrative problem. The problem of valuation implies that property
will have to be valued every year.

4.3. ESTATE DUTY AND INHERITANCE TAX:

The receipt of a gift or a bequest (gratuitous transfer during lifetime is referred to as “gift”
while transfer on death is “bequest”) constitutes and economic gain and thus increases the
economic wellbeing of the recipient. Such receipts constitute income, in whatever way it is
defined but traditionally, they have never been subject to income tax but have been brought
under separate tax legislations. The estate duty or death tax or death duty is a form of personal
tax on property which is levied when property passes from one person to another at the time of
the death of the former. Though the revenue yield of death duty may considerably be small, it is
valued very much for its so-called social effects. Death taxes assume two major forms-one is
called the estate duty and the other is known as the inheritance tax. The estate tax or the extant
duty is a levy upon the entire estate left by a deceased person, while the inheritance tax is a levy
upon the separate shares of the estate transferred to the beneficiaries. Generally, an estate duty
provides for a single uniform exemption, though it can also allow specific exemptions according
to the number of dependants and in relationship between the deceased person and the
dependants. Be sides, the rates are graduated and the tax brackets will apply to the net estate as a
whole.
On the other hand, an inheritance tax has three general characteristics: (a) there is no
elaborate classification of heirs; (b) the inheritance tax provides specific exemption; (c) there is a
special scale of rates for each class.
A closer examination of the two types of death duty will bring out their merits and
demerits. The estate duty, for instance, is simpler and more productive, for it avoids entirely the
exceedingly complicated task of determining the value of estates where the transfer of estate may
be subject to many conditions and qualifications. But the estate tax does not give special weight
to the ability to pay of the beneficiary. On the other hand, the inheritance tax takes into account
the relation between the deceased and the heirs and the share of each heir. Thus, it gives special
weight to the ability to pay of the heir, so that the immediate heirs such as the widow or the sons
will be asked to bear a lighter burden as compared to remote relations. Hence, the inheritance tax
is considered as a refinement of the estate duty.
Arguments for Estate Duties:

The most important argument’ in favour of estate taxes is based on equity-the principle of
ability to pay. As we have pointed out earlier, property is regarded as a suitable basis for taxation
and death tax is a personal tax on property. Further, it is generally regarded that the transference
of wealth at the time of death of the deceased person is a strategic time for the State to assert to
claim for a shire in wealth. It is easy to argue that the concept-of ability is, to clear here in the
sense that the target can be either the deceased or the heirs. Besides, it may be pointed out that
the timing of death taxes. may not always be opportune to the successor particularly if the
survivor is the widow. However, the more remote the heir from the deceased, the greater is the
ability of the former to pay. He finds himself with wealth which he did not probably expect. His
receipt of the property seems to be a proper occasion for the State to obtain a contribution to the
national exchequer.
Another argument in favour of death taxes is that inheritance constitutes an unearned income
to the heirs. The heirs have received an income which is the fruit of somebody else's labor and
sacrifice. At best, a successor is entitled to adequate support and education till he reaches his
maturity, but beyond that what. he receives is special privilege. The more remote is the
relationship between the deceased and the heir, the more does the inheritance become unearned.
Again, death duties are sought to be justified on the ground that they tend to correct a bad
distribution of wealth which is a special feature of all free economies. Most people will regard as
highly inequitable the fact that some individuals are sufficiently fortunate to inherit so much
property that they never need to work. Besides, these persons may contribute nothing toward the
welfare of the economy. The death duty is used with the definite purpose of reducing the volume
of wealth passed on at the time of death.
Finally, the death duty is a useful and necessary addition to income tax. It reaches earnings from
such securities and earnings which are exempt from the income-tax and other property or
income which may have avoided taxation during the owner's lifetime. Besides, the death duty
has the advantage of easy assessment and collection.

Arguments against Estate Duties:

It is argued that a large number of bequests pass from the deceased to his widow or minor
children and, therefore, the receipt of title of the property does not represent a real improvement
in the economic wellbeing of the recipient. Even before the receipt of the title, the beneficiaries
had full use of the property. Besides, the death of the person has actually removed the chief
source of family income. Accordingly, the beneficiaries are worse off and the imposition of a
duty is, thus, considered unjust. This argument has considerable force but it is more an
argument in favour of a special treatment of bequests and gifts rather than against the
imposition of death tax as such. Further, some bequests represent completely unexpected or
windfall gains which may be considered to represent a far greater tax paying ability than usual
income.
The most important argument against death duty is that it has adverse effect on capital
formation. 'Freedom to dispose of one's property is a necessary incentive to the accumulation of
capital. When a person knows that a part of his wealth-may be a good part of it, if it is large-will
be taken by the government, he will lose his interest in accumulating wealth. The incentive to
save and accumulate is, thus, adversely affected by the imposition of death duty. Further, death
duty will impinge upon the ability to save. It cuts into past savings that would otherwise have
gone to the heirs and they would diminish the latter's capacity for future saving.
It is also argued that the death duty may break up effective productive units and thus affect
national income. There can be any number of instances to show how small and independent
business units are broken up at the death of the owner. As a result of the death duty, the small
businesses are forced to sell themselves away to large monopoly concerns. Moreover, efforts to
keep estates liquid in preparation for a death tax may discourage their use in risk taking
enterprises. However, businessmen have many methods-insurance, gifts before death, etc.-to
meet death taxes.

4.4. COMMODITY TAXES

Commodity taxes have been designed to distribute the cost of government activity in
proportion to consumption expenditures. In effect, they are designed to do indirectly what a
personal expenditure tax will do directly. Commodity taxes may be levied on the production and
sale of commodities and are collected from the sellers. Generally, these taxes push up the prices
of the goods taxed and consumers bear the tax in the form of higher prices of the goods they buy.
Commodity taxation may be sales taxes, excise taxes and customs duties (import and export
taxes).
4.4.1. SALES TAX
In a sense, sales tax (also called transfer tax and turnover tax) is as old as organized States.
But, as a fiscal measure, it became popular only after the end of World War I. By the end of
World War II nearly 30 countries had adopted general sales tax. This was in spite of the
opposition to the tax on theoretical grounds. Even in the 1920's, Seligman, a well-known
authority on public finance, wrote: "The general sales tax is a discredited remnant of an outworn
system; it is essentially undemocratic in nature; and it would, if enacted, exaggerate rather than
attenuate the present inequalities of wealth and opportunity”. The main reason why the sales tax,
in spite of opposition, has become one of the important sources of public revenue is its high
productivity. For governments looking for additional sources of finance to meet their ever-
expanding needs, the sales tax was most welcome.
The present day sales taxes may be classified into three major groups.The multiple-stage and
single-stage taxes apply to all stages in production and distribution; in other words, to all
transactions from initial production to final sale to the consumers. In practice, however, the
multiple-stage tax may not apply to all stages; a few stages may be exempt or may be subject to
rates lower than the basic figure. The single-stage taxes apply to commodities only once in
production and distribution channels. Such types may be either on the sale by the manufacturer
or on the sale by the wholesaler or on the sale by the retailer. Finally, the value-added tax has
characteristics of both multiple and single-stage taxes, since "it involves the multiplication of the
tax rate but produces the same overall distribution on commodity as a single-stage tax."

Arguments for Sales Tax:

While the proponents of direct taxes have attempted to show that sales taxation-in fact, all
indirect taxation-is "irrational in design and unfair and capricious in incidence,"- those who
support sales taxation contend that it is the easiest to pay and the least hard on incentives.
(1) The sales tax does not lessen the incentive to save as does the income-tax. The burden
of sales tax will be concentrated more heavily upon those persons who will be compelled to
reduce consumption more than savings.
(2) Sales tax-in fact, all consumption taxes-is defended on the ground that it makes
everyone contribute to the government exchequer.
(3) Sales tax, as also other commodity taxes, are the only way by which the fluid
population can be expected to pay towards the general services of the government. The fluid
 population will consist of all types of persons who come to the towns from rural areas arid
from other countries not for settlement but for temporary stay.
(4) During the war and other inflationary periods, a general sales tax is defended on the
ground that it would check inflationary pressure. But it is possible to argue that sales tax with
high rates will induce persons to ask for and secure higher wages and salaries and as a result
the inflationary pressure upon prices may be 4ncreased rather than diminished.
(5) The sales tax, like all other commodity taxes, is hidden in the prices of goods
purchased and is paid automatically. One of the primary reasons for the rapid development of
sales taxes is the relative ease and effectiveness of administration of sales taxation as compared
to income taxes.

Arguments against Sales Tax:

The basic and the most widely used argument against sales tax is that it is highly
regressive-it collects more from people with small incomes, than from the rich. Since the tax is
shiftable to the consumer, it tends to place a heavy burden on all those whose expenditure on
taxable goods constitutes a relatively high percentage of their income. In practice, this results in
great injustice. It is a well-known fact that the lower income groups spend a large percentage of
their income on consumption and consequently they have to bear a heavy burden of sales
taxation.
Further, the sales tax tends to burden large families more heavily than smaller families with
the same income. Hence, the sales tax is considered crude and regressive, and from the point of
view of equity, is not justified. It may be pointed out further that if the general sales tax includes
food and other necessaries also, its regressive nature will further worsen. But most countries
generally exclude necessaries from the scope of sales tax.
John Due has given four reasons to show that in practice sales taxes even when levied in the
most. Satisfactory from, will result in iniquity:
(a) The taxes are rarely universal so that those who consume only untaxed goods need not bear
any, burden at all.
(b) The shifting of the tax is not likely to be complete or exact, so that either the business units
will have to bear part of the burden or consumers will have to pay more than the amount of the
tax.
(c) Even with complete shifting, the tax may not comprise a uniform percentage of retail prices
of various goods. '
(d) The sales taxes may result in wage increases which may not be uniform in all cases.

All the above four factors indicate that the burden of taxation will always fall heavily
upon the poorer sections of the community and thus sales taxes will be regressive. However,
Sales taxation has not only come to stay but has become a very important source of revenue. It
can even be used to restrict consumption of harmful goods or some particular items. It can be
used as a source of capital formation. It is superior to excise taxation though normally
considered inferior to income-tax. .
Sales Tax in Developing Countries As has already been indicated, the sales tax does not
restrict saving and Capital formation as much as income-tax normally does. In fact, sales taxes
falling upon income meant for consumption have the tendency to restrict consumption and thus
bring about a higher ratio of saving and capital formation. This argument has the greatest
significance for developing countries because of the latter's low capital equipment in relation to
their manpower. Again, in developing economy, sales taxation may be used as an instrument to
check inflationary pressures. Sales taxes, along with, other taxes, can be used to mop up the
excess purchasing power of the people and also to reduce the demand of the public for goods
and services. But such a policy has its own limitations. Finally, the sales tax is ideally suited to a
developing country.
(a) The low income groups dominate such an economy and the cost of collection of
income-tax will be quite high; accordingly, such a country should depend less on income-tax
and more on sales tax.
(b) The standard of tax administration is relatively low in a developing country and
consequently increasing reliance on sales tax becomes imperative.

4.4.2. VALUE ADDED TAX:

The VAT belongs to the family of sales tax. A VAT may be defined as "a tax to be paid by
the manufacturers or traders of goods and services on the basis of value added by them". It is not
a tax on the total value of the commodity being sold but on the value added to it by the
manufacturer or trader. They are not liable to pay the tax on the entire value of the commodity.
But they have to pay the tax only on the net value added by them in the process of production or
distribution.
 A Tax to be paid by the Manufacturers or
Traders of Goods and Services on the basis of
Value Added by them

Thus, the value added by them is the difference between the receipts (from the sale) and
payments made to various factors of production (land, labour, capital and organisation) in the
form of rent, wages, interest, and profits.

4.4.2.1. Forms or Kinds of Value Added Tax:

The value added tax can be determined in different forms. It may vary depending upon the
form of tax base. The forms may differ on the items to be included in the tax base.
The common types of VAT are given below:
1. Consumption Type

2. Income Type

3. Production and

Let us explain the meaning of these forms one by one.

1. Consumption Type: In this type of VAT, apart from the non-capital inputs purchased,
the capital equipments purchased is also considered. As such, the firm is allowed to deduct the
entire value of the capital equipments purchased during the year. This type provides 100%
depreciation, which is equivalent to tax exemption.
Thus,
Tax Base = Gross Value - Total Value of Inputs Purchased (Capital and non-capital)

2. Income Type: According to this form, the firm is allowed to deduct the depreciation on
the capital goods (during the year) apart from the full value of its non-capital purchases. Here,
the firms cannot deduct the entire value of the capital goods purchased during the year but they
can deduct the respective amount of depreciation attributable to that year.
Thus, the tax base is calculated as follows:

Tax Base = Gross Value – (Value of non-capital Purchase +Depreciation on

on capital goods for that year)

This variety clearly gives the proper net value added.

3. Production Type: In this type, instead of total value of inputs purchased, the value of
non-capital purchases alone is allowed to deduct for determining the tax base. That is, to
compute the value added by the firm, depreciation on capital goods is not allowed.
Thus, the tax base under this type will be:
[

Tax Base = Gross Value - Value of non-capital goods Purchased

Since depreciation is not allowed, it is not considered as a good system and is not popular
and universally accepted.
Example: Now we can explain the concepts of VAT with the help of the following example.
Let us assume a consumer product is clothing and the number of stages involved is six before it
reaches the ultimate consumers and the rate of tax is 10%.

No. Stage Receipts Value Tax

Birr. Added 10%
1. Farmer 700 700 70
2. Ginner 1, 000 300 30
3. Spinner 1, 500 500 50
4. Weaver 2, 100 600 60
5. Wholesaler 2, 300 200 20
6. Retailer 2, 400 100 10
----------------------------
2, 400 240
=====================

In the above example the total value added is Birr.2 400.

From the above table, it can be understood that there are six stages involved in the process of
converting cotton into clothing and before it reaches ultimate consumer. The ginner buys cotton
from the farmer at a price of Birr.700 per quintal and sells the cotton after ginning to the spinner
for Birr.1, 000. The Spinner, for converting the cotton into yarn, has added Birr.500. The weaver
converts the yarn into clothing, which he sells to the wholesaler for Rs.2, 100 per bale of
clothing. The wholesaler has added value of Birr.200 and sells the clothing to retailer for Birr.2,
300. The retailer finally sells the clothing to the consumer for Birr.2, 400. The remaining value
of Birr.100 (difference between price of wholesaler and that of retailer) represents value added
by the retailer.
From the above example, it can be observed that the value added tax is assessed at each stage
of production and distribution.
Arguments for Value Added Tax
The VAT is supported on the basis of the following arguments:
1. Easy to Administer: Since the impact of VAT system is like the single point sales tax
system, the administration becomes easier.
2. Effective and Efficient: The VAT replaces inefficient and poorly administered taxes
such as taxes on capital goods and those that reduce the tax base and involved in difficult
administration. Hence, it is considered as more effective and efficient.
3. Neutrality: VAT is expected to be perfectly neutral in the allocation of resources i.e. in
the forms of production and commercialization. Thus, it helps the economy in adopting the forms
of production that are economically more suitable.
4. Reduce Tax Evasion: In the case of VAT, the tax is divided into several parts depending
on the number of stages of production and sale. Thus, the possibility and intention to evade tax is
considerably reduced.
5. Possibility of Crosschecking: In VAT system, cross checking becomes possible. When a
firm purchases raw material from another firm and pays tax on such purchase, it has to maintain
records about from whom it purchased goods and the amount of tax paid by it etc. The firms
maintaining these records alone can reclaim the tax already paid. The other firm also has to
maintain such records. This obligation makes tax evasion difficult.
6. Less Tax Burden: Under VAT, the tax is collected in small fragments at different stages
of production and sale. Hence, the taxpayers feel the burden of the tax less.
 7. Encourages Exports: Under VAT system, the tax burden is less and it reduces the cost
of production. Such a reduction in the prices of commodities increases the competitive efficiency
of the firms in the global market.
Besides, to promote exports, the Government may refund the taxes paid on the exportable
goods. It is possible only when the tax paid is easily identifiable. In the system of VAT, it is easy
to separate the tax from the cost of production, which is not possible in the case of other taxes. In
this way, it encourages the exports.
8. Improves Productivity: In the system of VAT, a firm has to pay tax even though it runs
into loss. It cannot claim any exemption for loss because it pays taxes on the value produced and
not on profits. So the firms will always try to improve their performance and reduce the cost of
production. As a result, the overall productivity of the country will be improved.
9. Burden of Tax is Shared by all Factors: The value added tax falls on the wages,
interest, rent and profits. As such, the burden of tax is shared by all factors of production.
10. Non-distortionery: Under VAT system, exemption is allowed to the minimum. The tax
net is wide enough to cover almost everything. Hence, it proves to be non-distortionnery.
11. Major Source of Revenue: In most of the countries, the value added tax contributes a
considerable amount of revenue to the Government. This makes it a reliable and valuable source
of revenue.

Arguments against VAT:

VAT system has the following disadvantages:
1. Not a Simple and Easy System: VAT System is not easy and simple to adopt in under
developed countries where the tax administrative set-up is inefficient and inexperienced to
understand any complicated tax structure.
2. Requires Advanced Economic Structure: The proper implementation of VAT system
requires advanced financial and economic structure and the firm should be in the habit of
keeping proper accounts. Hence, it becomes difficult to implement the system in all types of
economy.
 3. Possibility of Tax Evasion: The VAT system largely depends upon the co-operation of
the taxpayers because crosschecking is not possible always. Hence, there is a greater possibility
for tax evasion.
4. Uneconomical: This system involves high cost of administration, assessment,
verification, collection etc. Hence, it is highly uneconomical.
5. Does not Increase Efficiency: In a scarce economy i.e. economy of shortages where
speculation is practiced, hoarding and non-competitive price rise are common, the producers will
not increase their efficiency. The goods will be purchased irrespective of their high price and
inferior quality. Thus in such an economic condition, VAT will not increase efficiency.
6. Lesser Revenue: The revenue collected under VAT system is far less than the revenue
collected under the multi-point turnover tax system.
7. Additional Burden: Under VAT system, the manufacturers and shopkeepers have to
observe various legal formalities in the form of maintaining various records, accounts books etc.
The verification of those records puts additional burden to the tax enforcing authorities.
8. Inflationary in Nature: Under VAT system, the tax burden will be less which results
into surplus income in the hands of consumers. Thus, there is a possibility for wide spread
inflation in the economy. But, this argument does not hold good. Because, VAT itself cannot be
inflationary and the other accompanying policies of the Government might make it so.
9. Regressive in Nature: According to Allan A. Tait, a straight forward single rate VAT,
with few exemption would tax lower income households more heavily than the higher income
household. Thus, it is considered as regressive in nature.
Even though the VAT system is suffering from the above said drawbacks, the benefits
sought are more and it can be applied to the Ethiopian economy after rationalisation,
modification and restructuring of the system. Various Tax Reforms Committees and other
eminent economists advocated this system as suitable to the prevailing economic conditions of
the developing countries.
4.4.2.2. METHODS OF CALCULATING VAT LIABILITY:
The value added by a firm can be calculated in any one of the following two methods:
 Methods of calculating
VAT Liability

Addition Method Subtraction Method

Credit Sales
Subtraction Subtraction VAT
VAT

Credit Subtraction Credit Subtraction

without Invoices with Invoices

A business subject to VAT can calculate its tax liability under an addition method or one of two
subtraction methods.

(i) Addition Method: Under this method, the value added by a firm i.e. the tax base is
determined by adding the payments made by the firm to the various factors of production such as
wages, rent, interest and profits i.e., add together the various elements that make up value-added.
It is not used and has not been proposed at the national level in any country.
(ii) Subtraction Method: In this method, the value added by the firm is determined by
subtracting the cost of production from the sales receipts of the firm. That is, subtract the cost of
goods purchased from sales the value can be calculated.
The subtraction method can be subdivided in to two methods. They are:

 Credit-subtraction VATs and

 Sales subtraction method.

Again the Credit Subtraction method can be divided in it two, Viz.,
i) Method of Credit Subtraction without Invoices and
ii). Method of Credit Subtraction with Invoices.
 The first method of credit subtraction VAT is European style VAT that relies on invoices and
is used with some variations almost all over the world. The other method of Credit- subtraction
used in Japan as consumption tax does not rely on invoices. The Sales subtraction VAT method
is not common in use elsewhere.
Example:
Now we shall explain these concepts with the help of the following example
Let us assume that a business firm "A", sells taxable supplies and makes a taxable sales
of Birr.80,000, and has taxable purchases of Birr.50,000 plus Birr.5,000 for the same period. We
shall also assume that the firm has imported supplies for Birr.10,000 and paid Birr.1,000 as VAT
on import. For this purpose it is assumed that the firm pays Birr.15,000 compensation to
workers, pays Birr.3,000 in interest and rent expenses and has Birr.4,000 as a profit for VAT
purposes. With a 10% VAT rate, the firm's net VAT liability for the period is Birr.2,000,
calculated as follows.

1.Credit Subtraction VAT- Credit Invoice VAT

VAT Liability of Firm "A"

Particulars Amount
Birr.
Output Tax on sales
80,000 x 10% ( Rate of Tax) 8,000

Input Credit:

Taxable Purchases - 50,000 x 10% ( 5,000)

Taxable imports - 10,000 x 10% ( 1,000)

Net VAT Liability for the Period 2,000

 2.Credit Subtraction VAT- Without Invoices
VAT Liability of Firm "A"

Particulars Amount
Birr.
Output Tax on sales
80,000 x 10% ( Rate of Tax) 8,000

Input Credit:

Taxable Purchases - 55,000 x 10/110 ( 5,000)

Taxable imports - 11,000 x 10/110 ( 1,000)

Net VAT Liability for the Period 2,000

Subtraction VAT

VAT Liability of Firm "A"

Particulars Amount
Birr.

Taxable Sales 88,000

Taxable Purchases:

Domestic (55,000)
Imports
(11,000)
Tax Base 22,000

Tax Rate 9.0909%

Net Vat Liability for the Period 2,000

Addition Method VAT

Particulars Amount
Birr.
Taxable Sales 88,000

Expenses:

Compensation ( 15,000)
Interset & Rent Expenses ( 3,000)

Purchases (66,000)

Profit for VAT Purposes 4,000

 VAT Liability of Firm "A"

Particulars Amount
Birr.
Compensation 15,000
Interset & Rent Expenses 3,000

Profit for VAT Purposes 4,000

Tax Base
22,0000

Tax Rate
9.0909%

Net VAT Liability for the Period 2,000

Where uniform rates exist (15% in our example), the two methods ie., addition and subtraction
methods yield identical results in terms of tax revenue. While tax evasion through exag-
geration of cost is possible under the first method, it is not possible under the tax credit
method, since there is the need to submit vouchers of tax paid. The tax credit system is,
therefore, superior and is being followed in many developed and developing countries.

4.4.2.3. Common Debate on VAT:

In Ethiopia, there is a controversial opinion regarding "whether VAT increases the
selling price for consumer in Ethiopia or not”. It is raised upon the fact that some goods (same
brand and quality), which are sold by the VAT registered sellers, are available at lesser prices
with the non-VAT registered sellers. In other words, the selling price of some commodities is
less with the Non– VAT registered sellers or firms. Of course, it may be true. But, we should
know the fact and regulation behind the levy of VAT in Ethiopia. If VAT and Turnover Taxes
are levied and implemented on its basic foundation, this type of issue or difference of opinion
will not arise and the position will be reverse.

VAT DOES NOT INCREASE SELLING PRICE - EXAMPLE:

Let us now see these concepts with the following example.
There are two firms namely A and B. Of these two firms, Firm- A is VAT registered and Firm-B
is VAT unregistered. Let us assume that, their purchases during the period is Birr.5,290
(including VAT) per unit and the value added by them are Birr.500 respectively. Now, we shall
see how does the VAT is beneficial to the ultimate consumer. The rate of VAT and Turnover
Tax is 15% and 2% respectively.

Computation of Final selling Price

FIRM-A FIRM-B
(VAT Registered) VAT (Un-Registered)
Particulars (Birr) (Birr)
 Factory cost (Purchases) 5290 5290
Add: Value Added by the firms 500 500

5790 5790

Less: Input Credit (VAT)

(5290/115) x 15 690 -------

5100 5790

Add: VAT @15%

765 ------
(5100 x 15%)

5865 5790

Add: Turn Over Tax @ 2% --------- 115.8

Final selling Price 5865 5905.8

Note: The Net VAT Liability is equal to the tax calculated on the Value added by the firms. That is,
500 x 15% = 75 [ which is equal to Output tax – input tax credit ( 765 – 690 = 75) ].

From the above example, it can be seen that the selling price under non- VAT regime is
higher to that of under VAT levied regime. If there is any difference prevailing in the market
scenario and shows higher selling price under VAT, then, it is not the flaw on the part of the levy
of VAT, but it is in the implementation of the same. The Ministry and the Authorities concerned
are vehemently trying and initiating capacity building measures to remove the problems in this
regard. After the proper implementation of these measures, all relevant issues will be solved.
Hence, it should be noted that the motive of the Government and the Ministry concerned
regarding the levy of VAT is not to increase the selling price, but to ensure the ‘ability to pay’
principle of taxation and there by maintain the price at the reasonable level. The method of VAT
adopted in Ethiopia requires certain reforms to strengthen it further.
4.4.3. EXCISE TAX:
Excise duty can be defined as a tax duty on some produced goods either at some stage of
production or before their sale to domestic customers. That is, these taxes are imposed upon the
production of particular goods or groups of goods. These goods are intended for sale or
consumption with in the country. Excise duties are levied on the production of selected
commodities while most of the excise duties are levied by the central government, the state
government is also empowered to levy on a few items like liquor, drugs narcotics etc, Excise
duties have now become an important source of revenue of the central government. Excise duty
is mainly levied with a view of curtailing home consumption so that, more goods are available
for export purpose. To discourage the use of scare resources on production of non-essential,
luxurious goods this may be imposed. Yet the most important goal is raising revenue for
financing various development schemes.
Objectives of Levying Excise Duty:
Excise duty is a duty levied on commodity produced with in the country for sale or
consumption within the country. The basic objectives of excise duties are given below:

1. Raising revenue for economic growth

2. Discouraging consumption of non-essential goods
3. Discouraging consumption of certain essential goods
4. Levy of duties where direct taxation is not possible
5. Curbing inflationary trends in the economy
6. Promotion of small scale industries
7. Proper allocation of scarce resources
8. Provide assistance to industries in distress
9. Encouragement of exports
10. Equitable distribution of income and wealth
11. Recouping losses arising from assistance and subsidies to specified industries.
1. Raising revenue for economic growth:
Excise duty provides a rich source of raising revenue for financing economic
development of the country. Whenever there is a need for revenue for financing was or
development programmer, excise duty is greatly relied upon.
2. Discouraging consumption of non-essential goods:
Whenever excise duties are raised on certain commodities, the prices of such
commodities naturally go up. As a result consumption tends to be curtailed. For example,
Government may levy high excise duty with a view to curtailing consumption such as cigarettes,
liquors etc. which are harmful to health.

3. Discouraging consumption of certain essential goods:

Curtailment of consumption of some essential items leads to saving of domestic
resources. This in turn helps exports.

4. Levy of duties where direct taxation is not possible:

Where certain items cannot be brought within the scope of direct taxation, imposition of
excise duties brings revenue for the government.

5. Curbing inflationary trends in the economy:

Government imposes more excise duties as a means to maintain economic stability. In
order to reduce the excess purchasing power of people, during inflationary period, the existing
rate of excise duty may be increased. In this way it is used as a measure to curb the inflationary
trends in the economy.

6. Promotion of small scale industries

Excise duty helps in promoting village and small scale industries, Government can assist
these industries by means of exemption from excise duty or preferential rates of excise duty on
the product of village and small scale industries, ie, it helps the small scale industries to face and
withstand the competition from large scale industries by increasing the competitive efficiency.

7. Proper allocation of scarce resources:

Imposing high rates of excise duty affects the production. For example, if the burden of
excise duty falls heavily on the production of a particular type of goods, the selling price of such
goods will be increased. Eventually, the demand for those goods would come down. As a result
of the decreasing demand, the production of these goods is discouraged and the firms engaging
in the production of these goods will be induced to produce the essential commodities. Thus,
Government can use excise duty as a means to preserve scarce resources of national importance.

The difference between excise and sales taxation is essentially one of degree rather than of
kind. While the actual excise taxes are confined to a small number of goods with varying rates,
sales taxes are general and apply to a very large number of goods and the rate of taxation will be
generally the same. For instance, the excise duty on tobacco may be at one rate, while on
matches or petrol may be at a different rate. On the other hand, sales tax may be the same, say 5
per cent, for all the commodities which come under the scope of sales taxation. Again, excise
taxes are imposed upon activities, while sales taxes are imposed on sales.
In the case of excise duties on luxury goods, the payment is made by the higher income
groups who have the ability to pay taxes. In this sense, excise taxes which fall on the rich may be
justified from the point of view of equity. If the luxury goods to be taxed are carefully selected, it
should be possible to avoid the heavy burden on the poor and the repressiveness of the usual
sales taxes. It is also argued that luxury goods are those which are not really necessary for a
reasonable living standard and, therefore, expenditure on such unnecessary goods may be
deemed as a more suitable basis for taxation than total expenditure. But luxury excises are
subject to many limitations:
(a) Luxury excises discriminate between people on the basis of preferences. Those who
have higher preferences for certain goods are taxed more while others who may be equally rich
but who do not have preference for them, will go tax free.
(b) It is difficult to choose really luxury goods. What is a necessity for one group may be
a luxury for another group.
In the case of sumptuary excises, main justification is that they prevent the excessive use
of certain harmful goods, like liquor, tobacco, etc. The effects of excessive use of liquor upon a
person's health or his work or his dependants are well known. Hence, it is easy to justify
sumptuary excise.
But these excise taxes are criticized mainly on three grounds:
(a) They place a heavy burden on the great majority of persons who use the commodities
only moderately.
(b) In considering a commodity really harmful or unnecessary, a moral judgment is
involved. The use of morality basis of taxation can never be justified in economic theory and is
generally regarded as flimsy.
(c) The burden on the lower income groups is very high and hence sumptuary excise
taxation is regressive.
 Apart from the usual criticisms against sumptuary excise taxation, one criticism which is
normally forgotten and hence not properly emphasized but which is equally important is evasion
of these taxes. Whenever excise taxes become excessive and oppressive, they lead to illicit
production of liquor, bootlegging and smuggling.
The benefit-based excise taxes are the least disputed, though, sometimes, they too are
criticized. The provision of road is essentially a commercial service which the government
provides, and to finance the construction and attendance of which they charge the users of roads
through an excise duty on petrol. Petrol consumption varies directly with mileage driven; it is
typically greater with more expensive cars than with lighter ones and with heavier vehicles than
with lighter ones. Besides, the tax can be collected without any evasion and avoidance.

The primary criticism against excise taxes is based on the ground that they have a tendency
to bring about a reallocation 'of resources away from the optimum. For instance, when the
prices of particular goods are raised because of imposition of excise’ duties, the demand may
decline and consequently production may decline too. The sumptuary excises are actually
designed to check production of goods which are not conducive to the welfare of the
community. But it is not possible to argue in the same manner for other excises. What actually
can happen is that when an excise duty is imposed upon the sale of a particular commodity,
some of the marginal buyers will cease to buy the commodity or will buy less of it and buy
other commodities instead. Accordingly, they have failed to obtain optimum satisfaction from
their incomes, not only that, the government will not have gained any revenue. Thus, as a
result of the excise duty, the production of other goods will increase and if previously the
economy has achieved optimum allocation of resources, a poorer allocation will result because
of the imposition of the excise duty.

4.4.4. Customs Taxes:

Customs taxes, also known as tariff duties, are classified into import duties and export
duties. Import duties are imposed on imported articles and are collected from the importers at
the time foreign goods enter the country. Import duties may be levied to
(a) discourage the import of particular commodities which compete with locally
produced goods - such import duties are called protective duties; and
(b) to raise revenue for the Government - known as revenue duties.
 But it should be remembered that even protective duties will bring in revenue for the
Government. The protective tariff duty will generally be at a high rate so as to impose a price
disadvantage upon the imported goods.

CHAPTER-V
TAXATION SYSTEMS

5.1. PROPORTIONAL, PROGRESSIVE AND REGRESSIVE TAX 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.

Let us explain these systems one by one in detail.

5.1.1. 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 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.
Those who oppose a flat tax claim that it will benefit the rich at the expense of the poor. One
argument is that, since most other taxes (sales taxes etc.) tend to be regressive in practice,
making the income tax flat will actually make the overall tax structure regressive (i.e. lower-
income people will pay a higher proportion of their income in total taxes compared with the
affluent). Another argument can be made by looking upon the value of money to various groups
and not simply the rate of taxation. While the monetary value of a dollar (or other unit of
currency) is the same for everyone, it is clearly “Worth” a lot more to someone who is
struggling to afford food than to a millionaire. Taxing everyone at the same rate ignores the fact
that richer people can give up more of their income, without ill effects. Moreover, it is debatable
whether a flat tax would substantially simplify the tax system.
 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 X 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 2.1 - Proportional Taxation

Graphically, it can be explained as follows:

Tax Rate
 Tax Base - Income (Birr)

FIG. 5.1 - PROPORTIONAL TAX SYSTEM

Merits of Proportional Tax System:
Proportional tax system has the following advantages:
1. It is simple in nature.
2. It is uniformly applicable.
3. Proportional taxation leaves the relative economic status of taxpayers unchanged.
4. It will avoid mistakes and drawbacks of progressive tax system.

Limitations of Proportional Tax System:

The following are the demerits of proportional tax system:

1. 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.
2. 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.
3. 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.

5.1.2. 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.

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
Table 2.2 - Progressive Taxation

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.

Graphically, it can be explained as follows:

Tax Rate
(%)

Tax Base - Income (Birr)

Fig. 5.2 – Progressive Tax System

Merits of Progressive Tax System:

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. Stabilising 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.
3. Disincentive to Work: It is argued that too progressive a tax rate acts as a disincentive to
work.
4. 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.
5. 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 system discourages
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.

5.1.3. 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 burden 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. Larger the assessee’s income or property, the lower the percentage that he pays 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

Income Rate of Tax (%) Tax To be

Birr Paid (Birr)
4000 20 800
6000 15 900
12000 12 1440
15000 10 1500

Table 5.3 - Regressive Taxation

Diagrammatically, it can be explained as follows:
Tax Rate
(%)

Tax Base - Income (Birr)

Fig. 5.3 – Regressive Tax System

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
Ethiopia, whose object is to establish a socialistic 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.

5.1.4. 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

The concept of degressive taxation can be explained with the help of the following table.
 Tax Base Tax Rate Tax Liability
Income % (Birr)
(Birr)

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

TABLE- 5.4. DEGRESSIVE TAXATION

Diagrammatically, it can be explained as follows:

Tax Rate
(%)

Tax Base - Income (Birr)

Fig. 5.4. - Degressive Taxation

This system is not popular and is universally not applicable.

5.2. ADVALOREM AND SPECIFIC DUTIES.

 There are two kinds of duties levied on the commodities. Generally, it is levied on the goods
crossing the national boundaries. They are:
1. Advalorem duty - on the basis of value.

2. Specific duty - on the basis of measurement.

5.2.1. Advalorem Duty:

It is levied on the basis of value of the commodities. Advalorem means, "In proposition to
value". This is levied as a certain percentage on the value of commodity to be taxed. For
example, when a TV set is imported, customs duty may be levied at say 200 % on the value of
the TV set. The weight, length or bulky of the goods imported are irrelevant for this purpose.
Thus duty payable will be calculated only on the total value of the goods to be taxed and not on
its weight, length, bulky etc.

5.2.1.1. Merits of Advalorem Duty:

Advalorem duty is recommended for the following reasons:

1. Value of the Commodities can be Easily Found Out: Customs duty under this form is
imposed on the value of commodities. The value of imported articles can be more easily found
than their weight, size, bulky etc.
2. Keeps the Tax Burden Steady: Advalorem duty keeps the burden of tax steady. During
the times of boom, the tax liability tends to rise and in times of recession, the tax liability also
goes down.
3. Higher Revenue during Inflation: Advalorem duty brings higher revenue during the
periods of rising prices, because when the price tends to increase the revenues yield also
increases.
5.2.1.2. Demerits of Advalorem Duty:

The following are the important drawbacks of advalorem duty:

1. Difficult to Administer: Advalorem duty is very difficult to administer. Under this
form, customs duty is imposed on the value of the commodity. But in practice, it is very difficult
to estimate the value of thousands of articles imported from a large number of countries.
 2. Difficult to Estimate Value: Even if the value of goods is ascertained, there is a chance
for controversy whether F.O.B. (Free on Board) or the C.I.F. (Cost Insurance Freight) or local
selling price should be taken into account for levy of duty.
3. Difficult to Predict Quantum of Revenue: The Government cannot correctly predict the
quantum of revenue yield from customs duties since under the advalorem basis, revenue yield
will rise or fall depending on the rise or fall of the value of goods. Hence, there is no certainty
with regard to the rationalisation of budget estimate of this revenue.
5.2.2. Specific Duty:

It is levied as to the weight, length, bulky or some other unit of measurement of the
commodity concerned. The value of goods imported or exported is not important for this
purpose. Only weight, length, bulky etc. of the commodities decide the quantum of duties.

5.2.2.1. Merits of Specific Duty:

1. Less Chance of Tax Evasion: Specific duty is imposed on units of measurement, which
are easily ascertainable. So, there is less chance of tax evasion.
2. Easy to Administer and Collect: Specific duties are easier to administer and collect.
Once it is possible to identify the goods, it is easy to administer and collect.
3. Certainty in the Amount of Duty: Specific duty helps the importer to know exactly the
amount of duty he will have to pay in respect of consignment. For example, when he imports
certain quantities of oil, he can easily and correctly calculate the amount of duty, as it is related
to the quantity of oil imported.
4. Certainty in the Quantum of Revenue: Government can also easily predict the
quantum of revenue yield from customs duties, because these are related to quantity of the goods
to be imported.

5.2.2.2. Demerits of Specific Duty:

1. Static in Revenue Yield: Specific duties keep the revenue yield static in nature i.e. it will
not generate large volume of revenue during the inflationary periods.
 2. Tax Burden Increase in Depression: Tax burden of specific duties increases in
depression. In time of recession, specific duties tend to increase the tax burden, because there is
an overall downward trend in prices, taxes will be imposed only on the basis of the commodities’
weight or length or bulky etc., and not on the actual value of the commodity.

5.2.3. Differences between Advalorem Duty and Specific Duty:

Advalorem duty is levied on a certain percentage on the value of the commodity to be taxed
and weight, length or bulky of the goods are not important for this purpose. Specific duty is
levied according to the weight, length, bulky or some other unit of measurement of the
commodity concerned.
The following are the differences between advalorem and specific duty:

DIFFERENCES BETWEEN ADVOLEROM AND SPECIFIC DUTY

ADVALOREM DUTY SPECIFIC DUTY

1. Basis of levy

Advalorem duty is levied on the certain Specific duty is levied as to the weight,
percentage on the value of commodity to length, bulky, etc. of the commodity to be
be taxed taxed.

2. Administration of Duty

It is very difficult to administer. Thus It is easier to administer and collect. Once

the duty is levied on the value of it is possible to identify the goods, it is
commodity. But, in practice it is very easy to levy and collect tax.
difficult to estimate the value of thousands
of commodities imported from a large
number of countries

3. Prediction of Quantum of Revenue

Under advalorem duty, the government Under specific duty, the Government can
cannot correctly predict the quantum of easily predict the quantum of revenue
revenue yield yield.
4. Chance of Tax Evasion

Under advalorems duty, the government Under specific duty, unit of measurement
cannot correctly predict the quantum of of commodities i.e weight, length,
revenue yield. bulketc, can be ascertained at any time.
Hence there is less chance of tax evasion.

5. Tax Burden

Advalorem duty keeps the burden of tax Specific duty does not keep the tax burden
steady i.e during the times of boom the tax steady. For example, in time of recession,
liability tends to rise in time of recession, there is an overall downward trend in
the liability also goes down. prices, tax will be imposed only on the
basisi of commodities weight, lengthetc,
and not on the value of the commodity.
Hence, specific duty increase the tax
burden during that period.

6. Revenue Yield

Advalorem duty brings higher revenue Under specific duty, revenue yield is of
during the period of rising prices. Because static in nature.
when the price tends to increase, the
revenue yield also increases.

5.3. Single Point and Multi-point Tax Single Point tax

5.3.1. Single Point Tax:

Single Point taxation means imposition of tax at only one point between the production and
the sale of goods to ultimate consumers. The tax is levied at only one point between the point of
production (first point) and the point of ultimate sale to consumption (final point). At the first
point, sales tax for example is levied, when the sale of commodity takes place for the first time in
the territorial limit of the concerned State. At the final point, the tax is imposed at the last stage
of sale to the consumers. Thus, a single point tax is levied either at the first stage or at the final
stage.
5.3.2. Multi-Point Tax:

Multi-point taxation means that the tax is levied at all stages of sale of the commodity. Tax is
levied and collected whenever goods are sold at every point of sale.

5.3.3. Difference between Single Point Tax and Multi-point Tax:

The following are the differences between Single Point Tax and Multi-point Tax systems:

1. Facility of Collection: Single point tax is easy to enforce and collect, but multi-point tax
is difficult to enforce and collect because of number of points at which it is collected.
2. Payment of Tax on Tax: Under single point tax system, tax is paid on the price of the
product, which does not include tax as one of its component. Hence, the payment of tax on tax is
not occurred, whereas in multi-point tax system in each subsequent point, tax is paid on the price
which includes the tax paid at the proceeding points also. Thus, the payment of tax on tax is
occurred.
3. Point of Levy: Under single point tax system, the tax is levied at only one point either at
the first point or at the final point, whereas under multi-point tax system, the tax is levied at all
points of sale till it is sold to the consumers.
4. Capital Requirements: In single point sales tax system, the capital requirements are low.
But in multi-point sales tax, the manufacturer or dealer of every stage is required to raise capital
not only for the actual cost of manufacture or purchase but also for payment of tax. As a result,
interest on such additional capital also becomes a part of the cost at this point and which has a
further rise in price. Hence, the capital requirement under this system is high.
5. Price for the Consumer: Under single point tax, the price paid by the consumer is less
than the price paid under multi-point tax system. The price paid by the consumer under multi-
point sales tax includes cost of the products and tax paid by the previous sellers. The price paid
by the consumer under multi-point sales tax is more than price paid under single point tax.
6. Quantum of Revenue: From the revenue angle, single point system generates less
amount of revenue when comparing with multi-point tax system. In multi-point tax system, more
revenue can be raised than that of the single point tax system.
7. Chance for Tax Evasion: Under single point tax system, the possibility for tax evasion is
more, whereas under Multi-point tax system, it is difficult to evade tax.
 8. Rate of Tax: Usually, under single point tax system, the rate is high, whereas in the case
of multi-point tax system, the rates of taxes are low.
9. Administration: The number of dealers to be assessed under single point tax is very
small. Hence, it is convenient to administer this system.
But the administration of multi-point tax is difficult because large number of dealers is to be
dealt with.
10. Exemption: The number of goods exempted under single point tax is more.
But the number of goods exempted under multi-point tax is less.

5.4. Types of Tax Rates:

The different types of tax rates are as follows:

1. Statutory Rate:

The Statutory rates are the rates imposed by the statute or Laws or Proclamations. For example
in Ethiopia the following are the statutory rates for Income tax under Income tax Proclamation.

Schedule A

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

2. Marginal Rate:
The Marginal rates are the rates imposed on each additional Birr earned within each tax bracket.
Example: Ato.Mesfin has the actual income of Birr.6400.The deductions and exclusions as per
Income Tax Proclamation amounts to Birr.2400.
His taxable income = 6400-2400= 4000.

His tax liability:

 -0 % on first ------------------- 150 Birr = Nil
-10 % on next ------------------- 500 Birr = 50
-15 % on next ------------------- 750 Birr = 112.5
- 20% on next -------------------- 950 Birr = 190
-25% on next --------------------- 1200 Birr = 300
-30% on balance (4000-3550)--- 450 Birr = 135
------------
Total Tax liability 787.5
=======
Here, in this case, Marginal Tax Rate = 30%
3. Average Rate:
Average tax rate is the fraction of total income earned that is paid in taxes. It is not our income
per se, but our income as determined by the Proclamation.

Average tax rate = tax paid / Taxable Income x 100

= 787.5/ 4000 x 100 = 19.69%

4. Effective Rate

Effective tax rate is calculated as follows:

Effective rate = tax paid / actual income x 100

Effective rate = tax paid / actual income (787.5 / 6400) x 100 = 12.3%

CHAPTER –VI

FEDERAL FINANCE
6.1. Federalism:
 Where the government's functions are divided between two sets of authorities i.e. the Central
Government, and the State Governments, it is called a federal system. A federation is an
association of two or more states. The member states of a federation have the Union Government
for the whole country and there are State Governments for the parts of the country.
A federation is a form of Government in which the political power is divided between the
Central and State Governments such that each Government within its own area is independent of
each other.
6.2. Federal Finance:

Federal finance refers to the system of assigning the source of revenue to the Central as well
as State Governments for the efficient discharge of their respective functions i.e. clear-cut
division is made regarding the allocation of resources of revenue between the central and state
authorities.

6.3. Principles of Federal Finance:

In the case of federal system of finance, the following main principles must be applied:
1. Principle of Independence.
2. Principle of Equity.
3. Principle of Uniformity.
4. Principle of Adequacy.
5. Principle of Fiscal Access.
6. Principle of Integration and Co-ordination.
7. Principle of Efficiency.
8. Principle of Administrative Economy.
9. Principle of Accountability.

1. Principle of Independence: Under the system of federal finance, a Government should

be autonomous and free about the internal financial matters concerned. It means each
Government should have separate sources of revenue, authority to levy taxes, to borrow money
and to meet the expenditure. The Government should normally enjoy autonomy in fiscal matters.
2. Principle of Equity: From the point of view of equity, the resources should be
distributed among the different states so that each state receives a fair share of revenue. The
allocation of resources should be made in such a way as to give equitable treatment to the
individuals and business firms in different places.
 3. Principle of Uniformity: In a federal system, each state should pay equal tax payments
for federal finance. But this principle cannot be followed in practice because the taxable
capacity of each unit is not of the same. Since this principle of uniformity emphasis on the
uniformity of pattern of expenditure in all the states, equality of contribution imposes heavy
burden on backward states.
4. Principle of Adequacy of Resources: The principle of adequacy means that the
resources of each Government i.e. Central and State should be adequate to carry out its functions
effectively. Here adequacy must be decided with reference to both current as well as future
needs. Besides, the resources should be elastic in order to meet the growing needs and
unforeseen expenditure like war, floods etc.
5. Principle of Fiscal Access: In a federal system, there should be possibility for the
Central and State Governments to develop new source of revenue within their prescribed fields
to meet the growing financial needs. In nutshell, the resources should grow with the increase in
the responsibilities of the Government.
6. Principle of Integration and Co-ordination: The whole financial system of a federation
should be well integrated. There should be a perfect co-ordination among different layers of the
financial system of the country. Then only the federal system will prosper. This should be done
in such a way to promote the overall economic development of the country.
7. Principle of Efficiency: The financial system should be well organised and efficiently
administered. There should be no scope for evasion and fraud. No one should be taxed more than
once in a year. Double taxation should be avoided.
8. Principle of Administrative Economy: Economy is the important criterion of any
federal financial system. That is, the cost of collection should be at the minimum level and the
major portion of revenue should be made available for the other expenditure outlays of the
Governments.
9. Principle of Accountability: In a federal set up, the Governments both Central and
States enjoy financial autonomy. Thus, in such a system each Government should be accountable
to its own legislature for its financial decisions i.e. the Central to the Parliament and the State to
the Assembly.

6.4. Modes of Allocation of Revenue Resources in Federal Government:

 In a federal Government, allocation of financial resources between the centre and the states is
of great importance. While allocating the resources, the principles of uniformity, adequacy,
autonomy, transference, administrative economy and federal control are to be followed. These
principles are not exclusive. They are interdependent.

Modes of Allocation:
There are two types of allocation. They are as follows:
1. Independent System:
Under this system, the units in a federation are deriving their revenue from absolutely
different sources. There would be no concurrence or contact between the centre and the units.

2. Mixed System:
Under this system, there would be concurrence and contact between the centre and the units.
This system is divided into two viz., concurrent mixed system and the contact mixed system.
In the concurrent mixed system, both centre and the states have concurrent powers of
taxation regarding certain sources. There would be no transfer of resources from the centre to
the states.
In the contact mixed system, contact between the centre and the states is created. There
would be assignments, subsidies, subventions or contributions.

6.4.1. Balancing Factors of Allocation:

Prof. Adarkar points out that it would be impossible to think about an independent system.
The most desirable system of federal finance must ensure large measure of independence and
adequacy. If either the centre or the states are not able to meet their requirements, it should be
made good by certain balancing factors. The balancing factors are those, which would make
good the financial inadequacy of either the centre or the states in a federation. They are as
follows:
1. Assignments: Usually the Federal Government levies and collects certain taxes. But it is
shared on an agreed basis with the states. Of course the distribution of this share between the
states is very difficult. The basis of distribution may be as follows: 1.On the basis of actual
collections from different states. 2. On the basis of population and 3.On the basis of economic
backwardness of the states.
 2. Subsidies: The states very often find themselves with financial stringency. They are
granted certain subsidies by the center on account of the transfer of certain sources like customs
or excises to the center.
3. Subvention: Subventions are grants-in-aid to redress certain inequalities between states.
They are made for specific purposes. They should be spent for the purpose for which they are
made. The spending of the amount would be under the supervision of the granting authority.
These are the bases and modes of allocation of funds between the center and the states. The
distribution of financial sources in Ethiopia is based on the recommendations of the Ministry of
Economic Development.
Ethiopia is a federal state and the Central-Regional financial relations are based on the
principle of federal finance. The word federation connotes the union of two or more states. In a
federation we have on the one hand, the Federal Government or Central Government and on the
other, the Constituent States. Federation may be defined as a form of political association in
which two or more states constitute a political unity with a common Government, but in which
these member states retain a measure of internal autonomy. Thus, in a federation, there is
constitutional division of powers, functions and resources between central and the state
governments. The two sets of governments are independent so far as their own functions and
resources are concerned.
Ours is a system of federal finance, with center and states sharing responsibilities and
resources. The areas of the government’s budgetary operation (i.e. receipts and expenditures)
between the centre and the states are demarcated. In addition there takes place financial transfer
from the centre to the states. The sharing implied in the system has contributed a lot to the
country’s progress. But this has also given rise to many problems relating to center-state
relationship.
In a federation two constitutionally independent fiscal systems operate upon the fiscal
resources of the individual citizens. There is multiplicity of taxing and spending authority in a
federation. It may be called multi-unit public finance. Thus, the federal finance faces the
problem of ‘financial arrangement’ between the Central Government and States.
In federal system, the functions and duties of the State are divided between central and state
governments and they are generally defined in the constitution. The federal system in Ethiopia
comprises a central government and Regional Governments. These developments have
potentially major implications for public finances in Ethiopia.

6.4.2. Disbursing and Transfer of Public Funds:

The structure of federal finance comprises two essential components. One is the division of
powers between the Union and the states in respect of rising and disbursing of public funds the
second relates to the transfer of funds from the center to the states.

The general principle on which the allocation of functions and duties are based is "whatever
concerns the nation as a whole, principally external relations and inter-regional activities
should be placed under the control of the central government and that all matters which are
primarily of regional interest should remain in the hands of the Regional Government”.

There are three principles that govern the division of taxes between the center and the states.
One, taxes which have an inter-state base are levied by the union government; and taxes with a
local base are levied by state governments. Two, there is the concurrent list falling within the
jurisdiction of both the center and the states. Three, the residuary powers rest with the central
government i.e. it has exclusive authority to impose taxes which are not specifically mentioned
either in the state list, or in the concurrent list.

6.4.3. Pattern of Revenue Sharing:

Ethiopia has chosen the federal structure in which a clear distinction is made between the
Union and State functions and sources of revenue, but residual powers, belong to the Center,
although the States have been assigned certain taxes, which are levied and collected by them,
they also share in the revenue of certain Federal taxes. In addition, the States receive grants-in-
aid of their revenue from the Federal Government, which further increase the amount of transfers
between the two levels of government. The transfer of resources from the Central government to
the States is an essential feature of the present financial system.

6.5. Distribution of Revenues between Central and States:

 The present federal fiscal system in Ethiopia is of a recent origin. The distribution of
revenues between the centre and states is followed on the basis of "Constitution of Ethiopia” and
Proclamation No.33/1992-Proclamation “To Define sharing of Revenue between the Central
Government and the National/Regional Self Governments”. The Articles 96, 97, 98, 99 and 100
of The Constitution of Ethiopia make a clear demarcation of areas where the Central alone or
State alone have authority to impose taxes. It contains a detailed list of the functions and
financial resources of the Center and States.

6.5.1. Objectives of Revenue sharing:

The sharing between the central government and the National/Regional Governments
shall have the following objectives:
1. Enable the central Government and the National/Regional Governments efficiently carry out
their respective duties and responsibilities.
2. Assist National/ Regional Governments develop their regions on their own initiatives;
3. Narrow the existing gap in development and economic growth between regions;
4. Encourage activities that have common interest to regions.

6.5.2. Basis for Revenue Sharing:

The sharing of revenue between the central government and the National/ Regional
governments shall take in to consideration the following Principles:
1. Ownership of source of revenue;
2. The National or Regional character of the sources of revenue;
3. Convenience of levying and collection of the tax or duty;
4. Population, distribution of wealth and standard of development of each region;
5. Other factors that are basis for integrated and balanced economy.

6.5.3. Categorization of Revenue:

According to "Constitution of Ethiopia” and Proclamation No.33/1992-Proclamation, revenues

shall be categorized as Central, Regional and Joint. That is there are three lists given in the
Articles. They are as follows:
1. Central List,
 2. Regional List, and
3. Joint/Concurrent List.

The important sources of revenue under "Constitution of Ethiopia” and "The Proclamation
No.33/1992-Proclamation To Define sharing of Revenue between the Central Government and
the National/Regional Self Governments” are explained below:

6.5.3.1. Central List:

The sources of revenue are given under Federal/Central List, are as follows:

a). Duties, tax and other charges levied on the importation and exportation of goods;

b). Personal income tax collected from the employees of the central Government and
the International Organizations;

c). Profit tax, Personal income tax and sales tax collected from enterprises owned by
the Central Government. (Now sales tax is replaced with VAT and Turnover
taxes).

d) Taxes collected from National Lotteries and other chance winning prizes;

e). Taxes collected on income from air, train and marine transport activities;

f). Taxes collected from rent of houses and properties owned by the central
Government;

g) Charges and fees on licenses and services issued or rented by the central
Government;

6.5.3.2. Regional List:

The following shall be Revenues for the Regions:

a). Personal income tax collected from the employees of the Regional Government
and employees other than those covered under the sources of central government.

b) Rural land use fee.

c) Agricultural income tax collected from farmers not incorporated in an organization.

d) Profit and sales tax collected individual traders.

 e) Tax on income from inland water transportation.

f) Taxes collected from rent of houses and properties owned by the Regional
Governments;

g) Profit tax, personal income tax and sales tax collected from enterprises owned by
the Regional Government:

h) With prejudice to joint revenue sources, income tax, royalty and rent of land
collected from mining activities.

i). Charges and fees on licenses and services issued or rented by the Regional
Government;

6.5.3.3. Joint/Concurrent List:

The following shall be Joint revenues of the Central Government and Regional
Governments:

a) Profit tax, personal income tax and sales tax collected from enterprises jointly owned by
the central Government and Regional Governments;

b) Profit tax, dividend tax and sales tax collected from Organizations;

c) Profit tax, royalty and rent of land collected from large scale mining, any petroleum and
gas operations;

d) Forest royalty.

6.5.4.Committee for Revenue sharing:

1. A committee accountable to Council of Ministers, whose function is to study conditions and

submit recommendations guiding sharing of revenue shall be designated by the Prime Minister.

2. Members of the committee shall be:

a) Central Government representatives concerned and;

b) Representative of the regional executive committee concerned with the agenda to be

discussed.

3) Based on the objectives and principles indicated under this Article the committee shall
 study and submit its recommendations to the Council of Ministers on:

a) the percentages in which the joint revenues of the central Government and the
National/Regional Governments shall be shared;

b) measures for resolving issues that may from time to time arise regarding sharing of
revenues;

c) amendments or changes, as the case may be, to the revenue categorization.

4) The details of the duties and responsibilities of the committee shall be defined by the
directives, to be issued by the council of ministers.

6.5.5. Subsidy:
National/Regional Governments, where deemed appropriate, shall receive subsidies from the
Central Government. National/Regional Governments shall before the approval of their budget,
submit to the Ministry of Finance and to The Ministry of Planning and Economic Development
,their subsidy request, together with the total expenditure required for the fulfillment of
objectives given in the Proclamation.

The Ministry of Finance and the Ministry of Planning and Economic Development shall
review the subsidy request submitted to them from the various Regions on the basis of the
objectives and in relation to the Central Government revenue collection.

The amount of subsidy to be granted shall be on the basis of Budget Formula specified by the
Ministry of Economic Development.

6.5.6. Relations of Tax Systems:

According to Article-8 of Proclamation No.33/1992-Proclamation, it is stressed that in order

to avoid cascading incidence effect of the tax levied by the center and the regions and to enable
the harmonized implementation there of the tax system shall have unified policy base.

The Ministry of Finance shall ensure that the tax Laws issued at both levels adhere to the
provisions of this Article. Accordingly shall distribute Fiscal Policy Studies and Directives.
The tax rates levied on types of taxes jointly owned by the central Government and the Regional
Governments shall be fixed by the Central Government.

6.5.7. Collection of Revenue:

Central Government revenues and revenues jointly owned by the Central Government and
National/Regional Governments shall be collected by the Central Government revenue collection
organs. However, whenever deemed necessary the collection of such revenues may be delegated
to regional Governments.

National/Regional Governments shall collect their own revenues.

Let us see the present position of revenue sharing arrangements between Federal Government
and Regional States regarding jointly established companies, Private companies and Minerals
and petroleum.

SHARING OF REVENUE BETWEEN FEDERAL GOVERNMENT AND REGIONAL STATES

Sl.No Types of Joint Revenue Revenue Sharing Formula

Federal Regional
Government States
CHAPTER-VII
1. Jointly Established Companies

1.1. Profit Tax As per Capital As per Capital

Share Share

1.2. Employee Income Tax 50% 50%

1.3. Indirect Taxes 70% 30%

2. Private Companies

2.1. Profit Tax 50% 50%

2.2. Indirect Taxes 70% 30%

2.3. Dividends 50% 50%

3. Minerals and Petroleum

3.1. Profit Tax 50% 50%

 CHAPTER-VII

TAX EVATION, AVOIDANCE AND BLACK MONEY

7.1. TAX AVOIDANCE AND EVASION:

Tax avoidance and evasions constitute a problem in almost all the countries of the world.
Tax avoidance is different from tax evasion, while evasion is against the law; avoidance is within
the ambit of law.
Tax evasion is the general term for efforts by individuals, firms, trusts and other entities
to evade the payment of taxes by breaking the law. Tax evasion usually entails taxpayers
deliberately misrepresenting or concealing the true state of their affairs to the tax authorities to
reduce their tax liability, and includes, in particular, dishonest tax reporting (such as under
declaring income, profits or gains; or overstating deductions).
By contrast tax avoidance is the legal exploitation of the tax regime to one's own
advantage, to attempt to reduce the amount of tax that is payable by means that are within the
law whilst making a full disclosure of the material information to the tax authorities. Tax
avoidance may be considered as either the amoral dodging of one's duties to society or the right
of every citizen to find all the legal ways to avoid paying too much tax. Tax evasion, on the
other hand, is a crime in almost all countries and subjects the guilty party to fines or even
imprisonment.

7.1.1. Tax Avoidance:

Tax avoidance means, “tax-payer may resort to a device within the ambit of law to divert the
income before it accrues or arises to him”.
“Tax Avoidance has to be recognised that the person whether poor or wealthy has the legal
right to dispose of his income so as to attract the least amount of tax”.
The tax avoidance can be defined as “escaping from the tax liability by using the available
loop-holes of the tax laws”.
Thus, tax avoidance means legal minimisation of tax burden by the taxpayers.
Examples for Tax Avoidance:

The following are the examples for tax avoidance:

1. Suppose a taxpayer’s total income exceeds the maximum tax-free amount, then he has to
pay the tax on such excess amount. But if he invests the excess amount in any of the
approved schemes for which there is a relief in the tax law, he can save on tax altogether.
2. An individual sells his let out house property (long-term capital asset) for Birr.2,00,000
making a capital gain of Birr 60,000. This capital gain would normally be taxed. But, if
he invests the sale proceeds in a particular manner stipulated by law, he need not pay any
tax.
3. Divorcing the wife on paper so that her income is not added together with husband’s
income is also a common device for tax avoidance.

7.1.2. Tax Evasion:

Tax evasion means fraudulent action on the part of the taxpayer with a view to violate civil
and criminal provisions of the tax laws. It can be defined as “tax evasion implies the activities
involving an element of deceit, mis-representation of facts, falsification of accounts including
down right fraud”.
Thus, it may be said that the tax evasion is tax avoidance by illegal means i.e. tax evasion is
against the law and is an unsocial act.
There are two forms of tax evasion. They are as follows:
1. Suppression of income, and
2. Inflation of expenditure.

Examples for Tax Evasion:

The following are the examples for tax evation:

1. A trader makes a sale for Birr.20, 000 and does not account it, in his books under sales.
He is evading tax.
2. An individual lends his money of Birr.50, 000 to another person at 20% interest per
annum and does not include this income in his total income.
3. Under-invoicing of sales and inflation of purchases.
 4. A manufacturing business employs 30 workers but include 2 more additional namesake
workers (not in actual) in the muster roles. The sum shown as paid to such additional
namesake workers will amount to evasion.
Human intelligence devices new methods of evasion and the Governments are constantly
trying to remove the loopholes in the tax laws.
7.2. Causes of Tax Evasion:

The following are the important causes for Tax evasion:

1. Multiplicity of Tax Laws: A number of laws enacted for the recovery of a variety of
taxes often leads to widespread tax evasion.
2. Complicated Tax Laws: Complicated tax laws are another reason for tax evasion. The
tax laws contain a number of exemptions, deductions, rebates, relief, surcharges and so on. For
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.
3. High Rates of Taxation: High rates of taxes cause widespread tax evasion, because the
greater the risk undertaken for the purpose of tax evasion, the greater is the reward.
4. Inadequate Information as to Sources of Tax Revenue: Lack of adequate information
as to the sources of revenue also contributes to tax evasions. In Ethiopia, small businessmen and
farmers rarely maintain any accounts of their income.
5. Investment in Real Property: Investment in real property, both movable and
immovable, and concealment of its true ownership have also been a major cause for tax evasion.
All these facilitate the channelising of black money into profitable ways.
6. Ineffective Tax Enforcement: Lack of proper training and efficiency for the authorities
enforcing the tax laws is also a major cause for widespread tax evasion.
7. Deterioration of Moral Standards: There has been deterioration in standards of moral
behaviour of people since independence. The values, which formed the basis of Society, are
shown little respect. In this modern competitive world, the deterioration of moral standards,
among the people leads to falsification of accounts, mis-representation of facts and fraudulent
behaviour.
7.3. Remedies for Tax Evasion:
If steps are not taken to reduce tax evasion, it may cause irreparable harm. The following
are the remedies to prevent tax evasion.
1. Thorough Overhauling of Tax Laws: One of the main reasons for tax avoidance and
tax evasion is loose drafting of tax laws which contain several loop-holes and weak points that
enable the tax evaders to carry on the unlawful activities. Hence, it is necessary to re-draft the tax
laws thoroughly without any loopholes and weak points.
2. Reduction in Tax Rates: The prevalence of high rates is the first and foremost reason
for this tax evasion. Hence, the rate of tax should be reduced to a reasonable level.
3. Replacement of Sales Tax & Excise Duties with VAT: As the crosschecking is
possible in the case of VAT, it is more effective. Hence, such tax can be introduced instead of
sales and excise duties.
4. Tax on Agricultural Income: Agricultural income is exempted from income tax and for
this reason it is used to convert the black money into white. In recent years, agricultural farms
and orchards, and vineyards have come to be acquired by industrialists; film stars etc. because
this enables their owners to whiten their black money. Tax evasions can be avoided by taxing the
agricultural income at normal rates.
5. Maintenance of Proper Accounts: Maintenance of proper accounts should be made
compulsory for persons whose business and professional income exceeds a prescribed limit. In
the Income Tax law, a provision to this effect has been introduced recently.
6. Introduction of Expenditure Tax: In Ethiopia, expenditure tax is levied in the form of
commodity taxation such as excise duties, VAT, Turnover tax etc. There is no personal
expenditure taxation. However, it is recognised by all that if a tax is based on personal
expenditure and if all effective machinery is devised to investigate and ascertain personal
expenditure, tax evasion can considerably be reduced.
7. Tightening of Tax Enforcement: This may be said to be the crucial remedy if the
penalties for violation of tax laws are strictly enforced, incidence of tax evasion could
automatically be reduced.
7.4. BLACK MONEY:
[

Black money is a complex phenomenon. It has various connotations such as unaccounted

incomes, tax-evaded incomes, undisclosed wealth and unrecorded gain and suppressed or
number two accounts transactions. It is earned by violating the laws and going against the
conscience by the very name itself. We can understand how the money is earned and this money
carries a secret behind it.
The parallel economy or black economy as it is also known, is generally considered to be that
area of economic activity, which remains “Underground”, concealed from the vision and
approach of the State authorities responsible for earning economic policies and implementing
them. It is usually referred to those perfectly legitimate activities, resulting in transactions either
in kind or for payment, between individuals, which are then hidden, from the tax authorities.
Activities in the black economy are therefore, primarily undertaken with a view to evade the
payment of various direct and indirect taxes, especially the latter.
As the term and definition of the black economy is self-explanatory, obviously one can only
estimate the size of the parallel economy, but even conservative estimates are mind-boggling.
After having asked a number of analysts, economists and people in the various financial
institutions, the figure that keeps popping up is that the parallel economy is easily three times as
large as the legitimate or documented economy. While the figure does force us to think and
reflect upon the ethical decay in society it also hints at the benefits if this sector of the economy
could somehow be documented or channeled. However, the possible benefits of this are not
really as significant as most people are led to believe by the estimated size of the parallel
economy.

7.4.1. Black Economy:

Not only are the developing countries affected by black economies. The emergence and
growth of parallel economies in recent decades in many countries of the world is notable. It
reveals the growing immorality in human behavior across the globe. However, as compared to
developed countries, developing nations suffer much more as a consequence of large and ever
growing parallel economies.
7.4.2. Black Income and Black Wealth:
The National Institute of Public Finance and Policy of India in its report makes a
distinction between the black income and the black wealth. Conceptually, the black income is a
flow and the black wealth is a fund or stock. The black income is generated over a period of
time. The black wealth is an accumulated unaccounted income at any given point of time. The
black money is black wealth held by the public in terms of currency as well as liquid bank
deposits. A large portion of black wealth is held in the form of real estate, gold jewellery, stocks
in business, benami financial transactions, cash, inventories and foreign currencies and
undisclosed holdings of foreign assets.
This black income in a macro sense is defined as the aggregate of taxable incomes not
reported to tax authority. In essence, income-evading taxation is referred to as black income.
Evasion of taxes of all varieties (excise duties, customs duties and sales tax) leads to black
income. Second, black income could arise from both “Reportable” and “Non-reportable”
sources. Non-reportable black income is called so because the manner in which it is generated is
illegal e.g. income from crime, bribery, black marketing, wealth (jewellery, business assets,
foreign currency, real estate-especially benami transactions). Reportable black income is
generated through legitimate activities or transactions but is suppressed and not reported to the
tax authorities so as to evade taxes that will be levied on it. Third, black income activity not only
generates black income but also results in black consumption and black saving. Black saving
when accumulated leads to Black Wealth.
7.4.3. Black Economy and Black Money:

“Parallel Economy” or “Black Economy” refers to the functioning of an unsanctioned

sector in the economy whose objectives run parallel to, or in contradiction with the declared
social objectives.
The black economy is said to have taken birth during the Second World War. In scarcity
conditions, controls on the distribution and prices of goods in short supply led to the emergence
of black markets and hoarding. Black market prices, which were higher than the controlled
prices, led to the emergence of “Black Incomes”, popularly called “Black Money” or “Number
Two” income.
 Dr. Raja Chelliah defines the black money income as “the sum total of transactions
deliberately kept out of the books of accounts by household and business in the economy”.
We can define Black money as “that the money which has not been brought into account, the
income not shown to the authorities wholly or partially i.e. unaccounted property or money can
be called black money”.
Black income now comprises a significant and fast growing element in many economies. It
is today an all-pervasive phenomenon that requires serious attention. When we talk of black
income, an important point to be noted here is that it is not limited to the evasion of income tax;
it is a heterogeneous category that extends to bribes, smuggling and even leakage.
7.5. Impact of Black Money in Ethiopian Economy:
The effects of the black money are considered significant on the basis of the following:
a) Significant size compared to other major sectors or the size of the government.
b) White economy cannot act as a proxy for the total economy.
c) Economic laws applicable to the totality of the economy and not a part of it.
d) Sectoral implications.
e) Failure of policy linked to it.
f) Has led to a change in the economic policy paradigm.

7.5.1. Macro Economic Impact of Black Money:

The black money has the following macro effects on the economy:
a) Failure of planning and resource mobilization and contradiction amongst other policies.
b) Growth and stagnation and income distribution effect.
c) Investment, unemployment and the multiplier.
d) Inflation.
e) Forces a change in the fiscal policy regime.
f) Various budgetary deficits and debt trap.
g) Raises transactions costs and leads to a high cost economy in spite of a low wage.
h) Savings and investment raises. Consumption propensity falls.
i) Import propensity rises.
j) Monetary Policy - Velocities of circulation and stability properties of the multipliers.

7.5.2.Micro Economic Impact of Black Money:

The black money has the following micro effects in the economy.
a. Aspects of Policy Failure.
b. Social Sectors. Poor left at the mercy of the markets.
 c. Criminalization of society.
d. Impact on National Security.
e. Social Waste. Like ‘digging holes and filling holes’.
f. Impact on the work ethic.
g. Impact on the quality of products and exports.
h. Reduces the individual's faith in state intervention.
i. Increases the alienation of the individual from society. Reduces faith in social actions.
The ‘usual is the unusual and the unusual the usual'.

7.5.3.Measurement or Estimation of Black Money:

It is widely accepted that most of the country’s problems arise mainly from the tendencies
unleashed by the large and growing unaccounted “Parallel Economy”. Any estimate of the size
of undeclared clandestinely (secretly) held wealth; current income and capital flights would
exceed the marginal levels of our savings and BOP deficits. Effective restraint of the black
economy therefore becomes very important, as this would go a long way in improving the
quality of growth. But for this an estimate of the “Parallel Economy” is a must.
Measuring black income is not an easy task. This may be due to non-availability of
reliable data. A number of individual and institutional efforts have been directed towards
measurement of size and growth of black income in Ethiopia. To examine this serious national
problem the Government of Ethiopia has made many efforts from time to time for estimating and
control of black money. It is difficult to know the exact holdings of black money. But, from the
several guesswork and estimates, it is evident that black money is of a high magnitude in the
Ethiopian economy and has been expanding at a rapid rate over the last two decades.
There are several alternative approaches to the estimations of black income. They are as
follows:
1. Expenditure Approach.
2. Fiscal Approach.
3. Monetary Approach.
4. Physical input Approach.

5. Labour-market Approach.
6. National accounts Approach.
7.6. Sources of Black Income:

There are many ways and sources of generating black income that it is very difficult to list
them all. Black money is also earned from perfectly legal and legitimate activities, but when the
income is fully or partly concealed in order to evade the taxes, it is treated as black money.
The various research committees have identified that the following are the items, which
generally deemed to generate black money:

1. Evasion of Personal Income Tax.

2. Evasion of Corporation Tax.
3. Real Estate Transactions.
4. Excise Duty Evasion.
5. Customs (Import) Duty Evasion.
6. Evasion of Sales Tax.
7. Black Income from Smuggling.
8. Black Income from Exports.
9. Black Income from Public Expenditure.
10. Black Income from Private Corporate Investor.
11. Film Industry.
12. Professions.
13. Constructions.
14. Selling of Licenses and Permits.
15. Other sources of black income are,
(a) Gambling.
(b) Bribes including illegal commissions, “cuts” and kickbacks.
(c) Black marketing in goods in short supply such as steel, copper, coal and other items
of industry quota of raw materials and imports. There is also the black market sale of
import licenses and foreign exchange at a premium.
(d) Financial transactions in the unrecognized sector of the money market.
(e) Hotels and Restaurants.
(f) Unaccounted stock market profits on black transactions carried on in the private
account of stockbrokers.
(g) Income earned through the adulteration of food items, drugs, country liquor,
production and sale of cheap imitations, forgeries and frauds of various kinds.
(h) Publishing Piracy.
Hereunder, we shall discuss the important sources of generating black money in detail.
7.7. Sources Generating Black Money:

7.7.1. Evasion of Income Tax:

When we talk of evasion of income tax, it could mean both personal income tax and
corporation income tax. Income tax can be evaded by the following ways:
1. Suppressing True Income: It is well known that a large part of black income comes
through illegitimate sources, whether it is bribes, smuggling, black marketing or other such
sources. Professionals like lawyers, doctors, architects, businessmen and even film stars and
film producers are examples where the sources are legitimate but income is suppressed to evade
tax.
2. Manipulating Business Expenditures and Profits: The corporate sector indulges in
under-reporting of profits, overstating expenditures, non-reporting of production and excise,
raising fictitious bills on companies. While under-reporting of profits helps evade tax, non-
reporting production helps generate black income in cash and generally increases the promoters’
wealth.
3. Misuse of Tax Exemptions and Deductions: It is known that agricultural income is
exempted from tax. Many people divert their income to purchase of agricultural land, show high
agricultural profits and avail tax exemptions. It is possible that the profits come from non-
agricultural operations and are taxable but misuse of a facility helps evade tax and create black
income.

7.7.2. Evasion of Excise Tax:

Excise Taxes are duties or taxes on the domestic manufacture of commodities. These are
divided between Union excise duties and State excise duties. For the Central government tax
revenues alone, Union Excise taxes are the second most important source of revenue, next only
to customs duties.
Excise duty evasion is both widespread and large in many countries. The most common
methods of evasion are:
1. Suppression of Production: This is especially true of small-scale industries such as
electrical goods, steel furniture and utensils, plastics and art silk fabrics. It also takes place in
medium-scale and large-scale industries. This can be done either by not fully accounting for raw
materials or not keeping statutory records fully up-to-date.
 2. Under Valuation: This is quite true of the organised sector and can be done with the
help of under-invoicing the product or even showing certain expenses as technical expenses.
Floating of benami agencies that either raise supplementary invoices or collect the differential in
value from dealers is another method.
3. Misclassification of Goods: Tariff rates provide numerous classifications and sub-
classifications carrying different rates of duty. Thus people indulge in misclassification as well
as wrong declaration of goods. High-duty excisable goods often get billed as non-taxable items
and then the difference in the market values of two kinds of items gets recovered in black.

7.7.3. Evasion of Customs Duties:

Methods of evasion of customs duties are broadly the same as those for excise duties (taxes)
on the flow of goods traded both imports and exports of a country. Customs duties are levied
and collected by the Central Government. Methods of custom duty evasion are:
1. Under Valuation: This is done by under-invoicing of imports, usually by arrangement
with the foreign supplier of goods who, mostly, willingly obliges the importer, pays in foreign
currency the full difference between the actual price and the lower invoiced price of the goods
imported.
2. Misclassification/Wrong Declaration of Goods: False declarations about goods
imported in the documents submitted to the customs are made and higher-duty goods are cleared
on payment of lower duty charged on the wrongly declared goods.
7.7.4. Trade Controls and Foreign Exchange Leakage:
Excessive Import and Export Controls have also led to several kinds of illegal activities, such
as the generation and use of unauthorised foreign exchange (through the faking of invoices) and
smuggling. A rush for licenses also results in corruption, favouritism and bribes.
Foreign exchange leakage occurs as a result of high import tariffs or comprehensive foreign
exchange control. These can occur through under-invoicing of exports, over-invoicing of
imports, inward remittances of foreign exchange through illegal channels, smuggling of goods
such as silver, animal skins, antiques, narcotics and illegal purchase of foreign exchange from
foreign tourists and others visiting Ethiopia.
Although a number of steps have been taken to control black income, foreign exchange
leakage and corruption continue to be a disturbing feature of many economies.
7.7.5. Smuggling:

Smuggling refers to the illegal import or export of goods. The numerous controls and
tariffs create profitable opportunities for trade by smugglers in several goods. It is generally said
that the smuggling of goods into the country is more serious than the latter. Smuggling has, over
the years, expanded at such a high rate that it has even attained the title of the “Third
Economy”. Affluent sections of society whose wealth has increased rapidly - mainly through
black income provide a ready market for smuggled goods. We can thus say that all factors
responsible for growth of black income activities in the economy also encourage the increased
smuggling of goods in a country by creating a demand for these goods. Smuggling causes loss
of revenue to the Government (through evasion of customs duty, excise duty and income and
wealth taxes), large illegal outflows of foreign exchange and result in large amassing of funds by
smugglers. These funds are not put to any socially productive use or investment.
7.7.6. Price and Distribution Controls:
Wherever operative, price and distribution controls, besides attaining the primary objective
of keeping the price of essential commodities “Under Control”, have also been responsible in
leading to black marketing operations i.e. the sale of goods at higher than listed prices,
unaccounted sales -or, sales without bills or cash memos. Sometimes price and distribution
controls also lead to excessive hoarding of essential commodities.

7.7.7. Industrial Licensing:

Industrial licensing has also contributed to creation of black income in many economies.
Excessive industrial licensing over the years had put up barriers to the entry of fresh capital and
enterprise. A few large industrial houses were preferred. Moreover, excessive delay and red-
tapism in the process of clearing applications for licenses have also been prevalent. In many
cases, this has been taken as indications for bribes. The Government had not organised any
separate machinery to monitor the actual implementation of industrial licensing. Therefore, there
have been many violations and creation of black income.

7.7.8. Other Sources:

1. Urban Real Estate: Transactions in urban real estate generate a large amount of black
income every year. There could be many frauds in this business. First, there could understand
the value of a transaction to evade a large part of tax liability. Second, encroachment on public
land; third, acquisition of raw land for resale as housing plots, developments of this land for
setting up a colony, sale of plots or houses or flats constructed on it, exceeding the legally
permissible limit of the built up area on a given plot of land. All these-specifically,
understanding the value of all such transactions-lead to black gains. Another method is to under-
report rents. Benami transactions are rampant, as is the role of “Black Money” in the acquisition
of urban real estate.
2. Leakage from Public Expenditure and Property: These leakages take the form of
illicit, and undeclared commissions or bribes (kickbacks or cuts). Also, most of the time,
allocated funds for various anti-poverty programs never reaches the targeted people. Another
aspect is pilferage or misappropriation of State Property.
3. Bribes: Bribes as a source of black income are common. These are used mainly to
influence the decision of the authority dealing with a case, or the power to approve or
recommend an application or even to forward case files. This phenomenon of bribe taking leads
to the spread of corruption from one work place to another.

7.8. Causes of Black Money:

There are several causes for the generation of black money in the economy. The major
contributory factors in this regard may be stated as under:
1. High Rates of Taxation: High rates of taxation are basically responsible for inducing tax
evasion and consequent black money generation in the country. The prevailing high rates of
taxation the economies are one of the main causes of black money.
2. Corrupt Business Practices: The corrupt business practice such as smuggling and other
restrictive trade practices cause the existence of black money in the country. In an economy
under the environment of scarcities, controls and inflation, hoarding and black marketing are
always profitable which apparently generate black incomes.
3. Controls and Regulations: Though the Governments resorts to the economic policy of
controls with a good intention of dealing with the problem of shortage and effecting a fair
distribution of essential goods with equity, their improper implementation vitiates the very
purpose of controls. In many countries, the Government fixed up prices of various essential
consumer goods like kerosene, wheat flour, vegetable ghee, drugs, etc. Their prices are
controlled and the distribution is regulated. Along with various controls on imports and exports,
tight exchange control is also implemented. Such controls are implemented with licenses,
permits and quotas. Thus there have been statutory controls combined with the bureaucratic and
administrative controls. These all-pervasive economic controls are also responsible for the
intensification of black money attuned evils like corruption, procedural wrangles, delays,
artificial scarcity, fraud, suppression etc. involved in the very network of the bureaucratic public
administration.
4. Political Corruption: This makes the fight against black income growth very difficult
and is closely linked with evasion of taxes and customs duties. The political bribing of party and
Government members is a common phenomenon. Donations to political parties were banned in
1968 and this has prompted businessmen to fund political parties, especially the ruling party,
with black money. Politics is the main weapon for fighting social ills; and when this weapon
itself gets corrupted, chances of tackling black income get bleak. The Politics-business-crime
nexus that exists in our society is a result of, and further accentuates black income generation.
5. Bureaucratic Corruption: Controls breed corruption. Loose and dishonest public
administration becomes an easy prey of corruption.
Corruption and black incomes are inter-linked. Corruption makes it easy to earn and enjoy
black money. Today, “Speed Money”, “Secret Commission”, “Paper Weight”, “Mithai”,
“Hush Money” have become almost a routine for getting any work done, legal or illegal, at
official levels.
6. Prohibition: Certain activities are usually forbidden by law such as gambling, production
of illicit liquor, smuggling, traffic in illegal drugs, lending at exorbitant interest charges, money
lending without proper license etc. When some individuals wish to undertake these activities,
these will apparently go unreported and incomes so earned would be totally black.
7. Public Expenditure: the Government itself lives in the Glass House, as the rapid growth
of its spending over the last two decades has been a major contributory factor in generating black
money. Due to the rapid rise of public spending for multiple Governmental programmes and
activities, the unscrupulous elements in public service and public life could find ample
opportunities for amazing black income and wealth by dubious methods.
8. Inflation: The genesis of black money can also be found in the persistent inflation in the
country, which has enhanced incentives and opportunities to earn such incomes. Inflation
inevitably leads to growth of parallel markets and strengthens propensities to hide incomes and
to evade taxes. Since inflation causes capital erosion, there is always a temptation to maintain
dual accounts for tax evasion by “Diverting portion of inventories and output from white
channels to black channels of deployment”. As the matter of fact, inflation is both the cause as
well as consequence of the growth of black money in many economies.
10. Deficiencies of the Tax System: There are various lacunas in the tax system that
encourages generation of black income. First, high personal Income Tax Rates cause people to
try and evade taxes, and thus lead to generation of black income. The dilemma for the
Government is that even efforts at lowering tax rates do not lead to larger payments of income
tax by the higher income groups. Although there are a number of tax laws pertaining to income
tax, sales tax, stamp duties, excise duties etc. enforcement is weak due to widespread corruption
in these departments.
11. Quotas, Controls and Licenses: The “License, Quota, that has dominated the system
of controls has often led to the initiation of various ways of escaping these and, thus, the
generation of black income.
12. Generation of Black Income in the Public Sector: There are huge investments marked
for the public sector in every five-year plan. The usage of these has to be monitored by the
bureaucrats in Government departments and public sector undertakings. A symbolic relationship
often develops between the contractors, bureaucrats and politicians. Costs are often artificially
escalated and underhand deals generate black money.
13. Inadequacy of Powers: The inadequacy of the powers given to the tax enforcing
authorities is another important cause for black money.
14. Weak Deterrence: Despite of adequate legal provisions to curb the growth of black
economy in, it has persisted because of weak deterrence against tax evasion in practice. No
serious action has been taken against detected cases of tax evaders. Till recently, too trivial
penalties were imposed, too few prosecutions have been launched and even fewer have been
convicted.
15. Ineffective Enforcement of Tax Laws: Ineffective enforcement of tax laws is also a
cause for black money. Lack of proper training and inefficiency of the department people led to
the creation of black money.
 16. Lack of Publicity: Another reason for wide spread black money is said to be the secret
provision of direct tax laws. At present, the department is statutorily prohibited from disclosing
any information relating to a person’s assessment. Thus, even if a person is caught and penalised
for keeping black money, he can keep it as secret from every one.
17. Deteriorated Public Morality: Moral values and social attitudes of many people have
changed during recent years. In today’s society black marketers, smugglers, corrupt politicians,
public officials and tax evaders are not condemned, but rather admired and envied for possessing
black money power.
18. Demonstration Effect: The conspicuous consumption and luxurious life style of black
moneyed people have created a sort of demonstration effect on many others to inspire for such
consumption patterns.

7.9. Effects of Black Money:

Black money is a socio-economic evil. The existence of rapidly growing black money in our
economy has grave and disastrous consequences. The major effects of black money are
discussed below:
1. Dual Economy: The out growth of black money over a long period of time has given rise
to the perpetual growth of economic dualism comprising “Parallel” economy (black money
economy) operating side by side with the “Official” or “Reported” economy on the country.
The black economy represents not less than one fifth of the aggregate economic transactions.
There is also interaction between the reported and unreported activities such that it is difficult to
identify black money from the white money economy. Such a “Parallel Economy” will ruin the
entire economic development of the country.
2. Under-estimation: A large underground economy and growth of black income lead to
under-estimation of the true size and incorrect picture of the economy by the officially complied
national income data. Since unreported economy is apparently excluded from the official records
of the GNP the estimates of savings and consumption of nations to the national income and
measurement of other macro-economic variables would be biased and misleading for accurate
policy making and planning considerations.
3. Loss of Revenue to the Government: Black money is largely attributed to tax evasion.
Its direct impact is the loss of the Government revenue. Since the Government fails to get
sufficient tax revenue due to large-scale tax evasion, it is forced to resort to high taxation and
deficit financing which again carry their ill-economic effects.
4. Under-mining the Equity: When the Government resorts to progressive direct taxation
to maintain equity in the distribution of the tax burden, the tax evasion and growth of black
money affect the very concept of social justice by not allowing the desirable reduction in
inequalities of incomes. Again, when underground activities like smuggling etc. could not be
taxed, the Government will impose higher taxes on officially sanctioned activities. Further, the
tax evasion will also equally enjoy the public services without paying the due contribution; to
that extent also social enquiry is undermined. The honest have to bear high tax burden to make
up for the deficit in revenue caused by the tax evasion of black money makers.
5. Widening the Gap between the Rich and the Poor: Growth of the black economy
causes regressive distribution of income in the society. When the black money grows faster, rich
becomes richer and the poor become poorer. By way of concentration of income and wealth in
few hands, the black money widens the gap between the rich and the poor.
6. Lavish Consumption Spending: Black money is disposed off by lavish spending on
travels and tours, entertainment, ostentatious articles, financing of extravagant elections etc.
This has also lead to many social evils and deteriorated the values of life of the common people.
7. Distortion of Production Pattern: The black money has altered the choice coefficients
in the market in favour of luxuries, which lead to the diversification of productive resources from
essential goods to the non-essential goods.
8. Distribution of Scarce Resources: Black money holders are always in a position to put
their prior claim over the scarce goods in the market due to their readiness and ability to pay
more, thereby depriving the honest and poor people from their legitimate share. This obviously
reduces the net economic welfare of the society at large.
9. Deteriorate the General Moral Standards of the Society: Black money is largely
responsible for the deterioration of general moral standards of the society. Black income
generation implies a deviation from the accepted norms in society and from the point of view of
the society is unethical.
Socially, we can say that the structure and ethos of a society undergoes a massive change.
Social values of honesty, hard work, thrift and simplicity get eroded. Even the political
institutions and organisations lose their credibility, as they also gradually become a part of the
entire system of black income generation.
10. Average Effect on Production: As a consequence, the consumption pattern is titled in
favour of the rich and elite, at the cost of encouraging production of articles of mass
consumption. A rise in overall consumption leaves fewer resources for investment in priority
areas, having an adverse effect on production.

7.10. Remedies for the Black Money:

The menace of ever raising black money in Ethiopian economy is very high. It is accepted
by all that tax evasion generate black money. Such staggering extent of black money has
activated a parallel economy in the country and it affects the vital sectors of the economy. The
Government in the past has already tried certain measures with little success. If steps are not
taken immediately to reduce the black money, it may ruin the entire economy of the country.
The important remedial measures for controlling black money are given below:
1. Demonetisation: Demonetisation of currency of high value could help to unearth the
black money to a large extent. However, in order to solve the problem arise on account of
demonetisation, proper step should be taken. It is advocated for eroding a substantial part of
black liquidity on the presumption that black income held in cash will not be presented for
conversion. Demonetization may succeed in reducing the quantum of black money but it cannot
prevent the generation of black money altogether.
2. Voluntary Disclosure Scheme: The Government may adopt the policy that those who
voluntarily disclose their black income of the past to the taxation authorities will not be punished
and penalties may be waived or minimised.
3. Raids: Income tax department's powers have to be considerably enlarged and it should be
empowered to conduct raids on the premises and properties of the taxpayers or any other
individuals and can seize the unaccounted income and wealth and take necessary legal actions
against the tax evaders.
4. Rationalization of Controls: Since ill-devised controls are major causes of black money,
it is essential to rationalise the control system. Recently, the Government has taken some steps
in this direction by easing the licensing policy etc. But still there are many cumbersome rules
and formalities and unnecessary control in many areas, which need to be effectively rationalised.
5. Taxation Reforms: Ethiopia needs a rationalised tax structure. A reduction in marginal
tax rates, simplification of tax structure, taxation laws and improvements in tax administration
will be helpful in the reduction of black money.
6. Vigorous Prosecution: The research also recommended that the department should
completely re-orient itself to a more vigorous prosecution policy in order to instill a wholesome
respect for the tax-laws in the minds of the taxpayers.
7. Rewards and Awards: In order to encourage the honest taxpayers and create a positive
attitude in the minds of the people towards the payment of tax, this can be adopted.
The other qualifications considered for the purpose of the award are that the person
concerned should not only pay the highest tax but should also file the returns in time, prompt
payment of taxes including self-assessment tax without default, no penalty for concealment of
income should have been levied, no prosecution for offenses under the Tax Proclamations and
related provision of Criminal Code should have been launched, no search undertaken under the
Direct Tax laws should have been conducted, and should have been co-operative with the
department in the completion of assessments.
Besides the above, no official patronage or recognition or awards should be given to persons
who have been penalized for keeping the black money or in whose case prosecution proceedings
have been taken.
9. Publicity: In view of the deterrent effect, the nature of all persons in whose cases
penalties have been imposed for the concealment of income, wealth etc. should be published in
the gazettes as well as in the press, giving details of their names, addresses and the amount of
penalties etc. If the assessee is a company or firm, the names of all the Directors of the
Company or Partners of the firm should be published.
10. Arousing Public Conscience: A special drive should be undertaken to arouse public
conscience by enhancing the co-operation of the leaders in various walks of life.
11. Other Measures:

1. People should be educated with regard to real object of collections of taxes through press,
radio, TV, and films.
2. Steps should be taken to convince the taxpayers that the money collected through taxes is
not spent wastefully but put to proper use.
 CHAPTER-VIII

DOUBLE TAXATION

Today, with enormous range of expenditure outlays, the Governments cannot depend
upon a single tax. Because it will not provide sufficient revenue to meet their financial needs.
Moreover, with the single tax, the Government cannot achieve the principles of equality, ability
to pay and equitable distribution of income and wealth among the people. Thus, the principle of
multiple taxation is recommended whereby the Government may resort to various direct and
indirect taxes to attain their objectives both fiscal and social.
But such multiple taxation should not lead to double taxation. Double taxation occurs
when the Government levies taxes on the same base in more than one way. Hence, double
taxation can be defined as, “taxation of the same tax base twice either by one authority or by
different authorities”. Here, the two taxes should be levied with reference to the same period.
8.1 Examples of Double Taxation:
1. Mr. X earns his income in Etiopia and U.S.A. If both the Governments levy taxes on his
entire income, it is considered as double taxation i.e. international double taxation,
because he has to pay tax in two countries on the same income.
2. The Government of a country levies taxes on the profits of a company before the
distribution of dividends. Thereafter, it taxes the individual shareholders on the dividends
received by them. Then it becomes a double taxation. Here the company and shareholders
are taxed on the same income.
Hence, double taxation means, taxing the same tax twice and it may be of international or
federal double taxation.

8.2. Kinds of Double Taxation:

Double taxation can be classified on the following ways:

1. Double Taxation by different authorities.
2. Double Taxation by the same authority.
The components of these kinds are explained with the chart given in Fig. 5.1.
 Kinds of Double taxation

Double Taxation by the same

Authority

International Federal 1. Taxation on capital and

Double Double income.
Taxation. Taxation. 2. Taxation on both debtors
and creditors for the
1. Taxes levied 1.Taxes levied by amount of loan.
by the govt. of two two Govt. of the 3. Taxation on profits before
different countries same country ie distribution and on dividends
Union & States. after distribution.

Let us explain these kinds one by one.

1. Double Taxation by Different Authorities: When the same tax base is levied by two
different taxing authorities either international or federal, it becomes a case of double taxation.
(a) International Double taxation: This type of double taxation occurs when the
Governments of different countries levy on the same tax base. The scope of a tax determines the
incidence of its burden. It includes both direct and indirect taxes. Generally the income tax,
wealth tax and customs duty cause such international double taxation.
(b) Federal Double Taxation: This kind of double taxation occurs when the Governments
within a country levy tax on the same base. When the Union Government and State Governments
of a country levy tax on any one tax base, it is called federal double taxation.
2. Double Taxation by the Same Authority: Such a double taxation occurs when a
Government either Union or State levies on the same tax base twice. The tax on capital and
income, debtors and creditors on the amount of loan, on the profits before and after distribution
and the like are the notable examples in this regard.

8.3. Effects of Double Taxation:

Generally, double taxation is not liked by the taxpayers and is highly criticised by the
economists. It will affect the economy of the country directly and indirectly. The main effects of
double taxation are given below:
 1. Injustice to the Taxpayers: Double taxation causes injustice to the taxpayers. It
discriminates among the different taxpayers.
2. Does not Conform to the Principle of Ability to Pay: In case of double taxation, the tax
system does not conform to the principle of ability to pay. Because when both the Central and
State Governments tax the same group on the same tax base, the principle of ability to pay is
violated.
3. Does not Ensure the Principle of Equity: When the Union and State Governments levy
taxes on the same commodities especially on the necessities, it will broaden the gap between the
rich and the poor. Thus, the double taxation violates the principle of equity also.
4. Discourages the Ability to Work, Save and Invest: Double taxation increases the price
of the commodities and leaves the people with lower disposable income. This in turn affects the
standard of living of the people and thereby reduces their ability to work, save and invest.
5. Discourages the Small-scale Industries: When the taxes are uniformly levied without
any exemption to small-scale sector, the competitive efficiency of them will be affected. Because
of a rise in their prices, they can not compete with the large-scale industries in the market.
6. Discourages Exports: It may be due to federal double taxation. When the same
commodities are taxed both by Union and State Governments, their price will automatically be
increased which in turn affects the export market.
7. Affects the Overall Economic Development of the Country: Since double taxation
affects the individual economic activities, the whole economic development will be affected. In
such a situation, the Government cannot use the taxation as a weapon, boost the sick industries
and to curb the effects of trade cycles in the economy.

8.4. Remedies for Double Taxation:

To remove the effects of double taxation, the following remedial measures can be adopted.
They can be classified on the following two categories:
8.4.1. Remedies for the Problem of International Double Taxation:

(a) Agreement for Mutual Exemption: The countries may enter into an agreement to
exempt the income of non-residents when they take the income outside.
 (b) Basis for Incidence: The double taxation can be avoided when the taxes are levied either
on residential status or on citizenship and not on the both.
(c) Special Measures: Some special measures should be devised so that the Governments of
two countries may tax different parts of the income earned by a person.
8.4.2. Remedies for Internal or Federal Double Taxation:
The following are the remedies to avoid internal or federal double taxation:
(a) Separate List: There should be a separate list of taxes that can be levied by the Union
Government and State Governments.
(b) Co-ordination between the Fiscal Policies: There should be a perfect co-ordination
between the fiscal policies of the Union and the State Governments. And the problem of double
taxation can be solved through the centralisation of finance. This can be done by getting the final
approval from the Central Finance Minister for the State budgets.
(c) Avoiding Overlapping of Taxes: There should not be any overlapping of taxes. The
problems of double taxation can be solved to a considerable extent if due consideration is given
in this regard. To avoid the double taxation caused by overlapping of sales tax and excise duties,
they may be replaced by a centrally administered value added tax.
In Ethiopia, the problem of double taxation is considerably reduced because of the provisions
made in the Ethiopian Constitution. Articles 96, 97, 98, 99, 100, 101, and 102 of the
Constitution, there is a separate list for the Federal Government, State Governments and
Concurrent List. There are specific Articles for revenue sharing and principles of taxation.

8.5. Methods of Elimination of Double Taxation:

Many a times situation arises whereby same income is taxed twice; i.e. in the State of
Residence as well as in the State of Source. In order to eliminate double taxation two methods
are used. They are:

1. Exemption Method, and

2. Credit Method.

8.5.1. Exemption Method:

The exemption methods include the following:

 (a). Full Exemption Method:
Under this method, income earned in the State of Source is fully exempt in the State of
Residence.
(b). Exemption with Progression:
Under this method, income from State of Source is considered by the State of Residence only
for the rate purpose.

8.5.2.Credit Method:

The credit methods include the following

(a). Full Credit:

Total tax paid in the State of Source is allowed as Credit against the tax payable in the State
of Residence.
(b). Ordinary Credit:
State of residence allows credit of tax paid in the State of Source only to that part of income
tax, which is attributable to the income taxable in the State of Residence.
(c). Method of Tax Sparing:
State of Residence allows credit for deemed tax paid on income, which are otherwise exempt
from tax in the State of Source.
8.5.3. Illustration- Double Taxation Elimination Methods:
Let us understand these methods with the help of an example.
- Income derived by "A" from
State of Residence Birr. 1, 00, 000
- Income derived by "A" from
State of Source Birr. 50, 000
Total Income of A : Birr..1, 50, 000
Tax rates are : State of Source @ 40% flat rate.
State of Residence Up to Birr..1,00,000 @ 30% and between
Birr.1 lakh & 2 lakhs @ 35%.

Tax paid in State of Source on Birr. 50, 000 = Birr..20, 000

(@ 40% on Rs.50, 000)

Tax paid in State of Residence = Birr..47, 500

on Birr.1, 50, 000. (@ the rates specified)
Tax Liability in State of Residence under various Methods of Elimination of Double
Taxation:

1. Full Exemption Method:

State of Residence levies tax only on domestics income i.e. tax on Birr.1, 00, 000 @30%
= Birr.30, 000. It does not levy any tax on income earned in the State of Source (i.e. on Birr.50,
000 in this case). In other words, it exempts income earned in the State of Source from its tax.
Similarly, tax is levied by the State of Source only in respect of income, earned therein. As a
result, double taxation of income is automatically eliminated.

2. Exemption with Progression:

Domestic income of Birr.1, 00, 000 will be taxed at the rate applicable to total Income i.e.
Tax on Birr.1, 00, 000 @ 35% (rate applicable to slab of Birr.1, 50, 000) = Birr.35, 000. This
offers partial exemption compared to the Full Exemption Method.

3. Full Credit:
Tax payable on total income in the State of Residence will be as below:

Birr.1, 50, 000 on slab basis Birr.47, 500

Less: Credit for tax paid in the
State of Source Birr.20, 000

Tax Liability in State of Residence Birr.27, 500

4. Ordinary Credit:
At first, tax liability on total income is worked out in the State of Source. However, such
credit is restricted to the amount of tax attributable to the income from the State of Source i.e.
35% of Birr.50,000 = Birr.17, 500.

Tax payable on Birr.1, 50, 000 Birr.47, 500 (slab basis)

Less: Tax paid in the State

of Source Birr.20, 000

Maximum Deduction Birr..17, 500

Restricted to
 (35% on Rs.50, 000)

Tax Liability Birr..30, 000

5. Tax Sparing:
Now let us assume for a moment that Mr. A has tax free export income of Birr..30, 000 in
the State of Source. In this situation, a deemed tax credit for Birr.12, 000 (being 40% Rs.30, 000)
will be granted by the State of Residence. Usually, DTAA prescribes the exact nature of such
tax-free income and or relevant provisions of the domestic law, covered by this method.
8.6. Double Tax Avoidance Agreements:
Article on elimination of Double Taxation assumes great significance, as it is the central
point of any Treaty. Treaties generally use combination of various methods for granting relief
from double taxation. It is also a powerful tool for the purpose of Tax Planning. In fact, it
serves well the ultimate objective of Treaty namely overall minimization of tax burden or
avoidance of same income being taxed by two countries. This brings in harmony and equity in
tax legislation and bids good-bye to the famous dictum in the taxation statutes that Tax and
Equity are strangers.

1. Present Day Scenario and Need for Tax Treaties:

Due to advances in communication and technology, the world has become a global village.
No nation can afford to remain in isolation. For survival in a competitive environment, one has
to view the entire world as market and create a niche for one's products in the international
market. The need of the hour is to integrate the national economy with the international
economy. This gives rise to full-fledged joint ventures in place of limited participation, creating
production and marketing bases in different countries with diverse political systems and tax
regimes. Movement of capital and cross border transactions become common place. The
transnational corporations are the vehicles used for the purpose.
Every nation has sovereign right to tax its residents on their worldwide incomes. As a result,
the income of an organisation can get taxed both in the home country (country of its origin) as
well the host country (country where it has its operations). In such an environment, cost of
operating worldwide would become prohibitive and the benefits of international trade, and
competitive cost advantages would be lost. Double taxation is harmful for movement of capital,
technology and people.
 In civilised society, in home country tax is an obligation and in host country tax is a cost.
There is need to achieve tax efficiency. The Double Tax Avoidance Agreements come into play
to mitigate the hardships caused by taxing the same income twice, in a home country as well as
in the host country.
Tax Treaties remove the obstacles and try to achieve balance and equity. They aim at
sharing of tax revenues by the concerned states on a rational basis without causing undue
hardships to the taxpayers operating internationally. Tax Treaties do not altogether eliminate
double taxation, but reduce the incidence to tolerable extent.
2. Advantages of Tax Treaty:
Tax Treaties clearly lay down the provisions for taxing of income under various heads.
There is less room for ambiguity. For instance, business profits are taxable in the host country
only if there is “Permanent Establishment” as defined in the Treaty.

3. Treaty Models:
There are three different types of models.
They are OECD Model, U N. Model and the U.S.Model.
(a): OECD Model:
The emergence of present form of OECD model convention can be traced long back to 1927,
when the fiscal Committee of the League of Nations prepared the first draft of Model Form
applicable to all countries. In 1946, the model convention was published in Geneva by the Fiscal
Committee of U.N. Social and Economic Council and later by the Organisation for European
Economic Co-operation (OEEC) in 1963. However in 1961, the Organisation for Economic Co-
operation and Development (OECD) was established, with developed countries as its members,
to succeed the OEEC and OECD approved the draft presented to the OEEC. In 1977, final draft
was prepared in the present form.
OECD model is essentially a model treaty between two developed nations. This model gives
emphasis on the right of State of Residence to tax.
(b).U.N. Model:
In 1968, United Nations set up ad hoc groups of experts from various developed and
developing countries to prepare a draft model convention between developed and developing
countries. In 1980, this group finalised the U.N. Model Convention in its present form.
 U.N. Model is a compromise between the source principle and residence principle.
However, it gives more weight to the source principle as against residence principle of OECD
model. U.N. Model is designed to encourage flow of investments from developed countries to
developing countries. It takes into account sharing of tax-revenue with the country providing
capital.
(c). U.S. Model:
U.S. Model is different from the OECD and U.N. Model in many respects. For example,
Indo-U.S. Treaty provides for Permanent Establishment Tax (Article 23) and Limitation on
benefits (Article 24), which are unique to this Treaty as also provision for taxing Capital Gains
(Article 13) as per domestic law. Thus U.S. Model has made its own identity through radical
departure from the usual clauses of the Treaty under OECD Model and the U.N. Model.
 PART-II

1. Ato.Merrit has a house property in Addis. He has let out the house for the residential
purposes. The following are the details of the property let out.
a. Actual rent received Birr.900 pm.
b. Fair rental value of the house Birr.1200 pm
c. He has paid 15% of the rent received as land taxes and 2% as other taxes to the
regional government
d.
e. He spent Birr.780 for repairs of that house
f. He does not maintain any books of accounts in this regard.
Compute the income from house property for the year 2004-05.

---------------------------------------------------------------------------------
Particulars Taxable Non-Taxable
income Income
Birr Birr
--------------------------------------------------------------------------------
Actual rent (900 x 12) 10,800 ------

Land Tax (10,800 x .15) (1620) ------

Other taxes (10,800 x .02) (216) -------

Repair (10,800x 1/5) (2160) -----

________ ________
6804 ------
======== =======

2. Ato. Desalean owns four houses. The details regarding which are as follows:

a. The first house of the annual rental value (FMV) of Birr.4400 was occupied by
him for his own residence.
b. The second house of the annual rental value of Birr.5600(FMV) was let out at
Birr.400 pm. He paid Birr 600 as interest on money borrowed for the construction
of the house, Birr.80 as land tax and Birr.200 as insurance premium of the house.
 c. The FMV of the third house is Birr.1600 pm and its actual rent is 1400 birr pm.
But in respect of this house maintenance charge of Birr.1600 per year including
repair charges.
d. The fourth house, the FRV of which is Birr.6000 pa was let out at 600 pm. It
remained vacant for 4 months. The unrealized rent in respect of this house during
the year was Birr.1200, which satisfies the conditions for claiming this loss.
Find out the income from house property for the year 2004-05.

(a) Not Taxable

(b) --------------------------------------------------------
Particulars Taxable
income
Birr
--------------------------------------------------------
Actual rent (400 x 12) 4,800
Land Tax (80)
Interest (600)
Repair and maintenance (4,800x 1/5) (960)
________
Taxable income 3160
========

(c) --------------------------------------------------------
Particulars Taxable
income
Birr
--------------------------------------------------------
Actual rent (1400 x 12) 16,800

Repair and maintenance (16,800x 1/5) (3360)

________
Taxable income 13440
========
(d) --------------------------------------------------------
Particulars Taxable
income
Birr
--------------------------------------------------------
Actual rent (600 x 8) 4,800

Repair and maintenance (4,800x 1/5) (960)

________
Taxable income 3840
========