Chapter 1

Overview of the theory of taxation

Fiscal policy entails raising and expenditure of revenue by governments. The various
sources through which governments raises revenue are commonly referred to as sources
of public revenue and they include:

a) Taxes

A compulsory levy imposed on tax payers (both individuals and corporates) by a

government, for the purpose of financing the government expenditure. It is an
involuntary payment by a tax payer to the government through the revenue authority
without involving a direct repayment of goods and services (as a "quid pro quo") in return

Common features of a tax system:

Taxing authority: This is the authority with the power to impose tax e.g. the central
government or a local authority. The taxes are received as public revenue. The taxing
authority has power to enforce payment of tax. In Kenya, the central government imposes
tax through the Kenya Revenue Authority (KRA).

Tax payer: The person or entity that pays the tax e.g. individuals, companies, businesses
and other organizations. The amount of tax is compulsory and there is punishment for
failure to pay.

Taxation: the process of levying and collection of taxes from taxable persons (both
individuals and corporate entities).

Examples of Tax

1. Income tax — this is tax imposed on annual gains or profits earned by individuals,
limited companies, business and other organizations.
2. Value added tax (V.A.T.) — This is tax imposed on sale of commodities and
services introduced in Kenya with effect from 1.1.90.
 3. Turnover Tax — Is charged on income or receipts from business by taxable
persons of a turnover between Sh. 500,000 and Sh. 5 million within a period of 12
months with effect from 1.1.2008.
4. Sales tax — This is tax imposed on sale of commodities which was abolished in
Kenya on 31.12.89 and replaced with value added tax.
5. Excise duty — This is tax imposed on commodities produced locally or imported.
It targets specific commodities, for example, luxuries and commodities that are
detrimental to heath.
6. Customs and excise duty — This is tax imposed on import or export of
commodities.
7. Stamp duty — This is tax that is aimed at legitimizing transactions. It is imposed
on increase of share capital, transfer of shares, mortgages, charges, the transfer of
property among others.
b) Land rent and rates

These are levies imposed on property. Rent is paid to the Central Government on some
land leases while rates are paid to the Local Authority based on the value of property.

c) Fees

Fees is an amount which is received for any direct services rendered by the Central or
Local Authority e.g. television and radio fees, national park fees, airport departure fee,
airport landing and parking fee, port fee by ships, university fee, etc.

d) Prices

Prices are those amounts which are received by the central or local authority for
commercial services e.g. railway fare, postage and revenue stamps, telephone charges,
radio and television advertisement etc.

e) Fines and Penalties

If individuals and firms do not obey the laws of the country, fines and penalties are
imposed on them. Such fines and penalties also constitute the income of the government

f) State Property

Some land, forests, mines, national parks, etc. are government property. The income that
arises from such property is also another source of public revenue. The income will arise
from payment of rents, royalties, or sale of produce.

g) Internal Borrowing

The government usually raises revenue through issue of treasury bills and treasury bonds
in the local market.

h) External borrowing

This is done from foreign governments and international financial institutions such as
World Bank and International Monetary Fund (IMF).

Distinction between Tax and Other Levies

There are other payments which resemble tax but are not tax. These payments are:

i. Fees: This is a levy imposed with the aim of reducing the cost of each recurrent
service undertaken by the Government in public interest but conferring a
significant advantage on the fee payer. E.g. registration fees, court fees, school
fees, etc.
ii. Licenses: This is a charge by Government to grant permission to a person for
the performance of a service. E.g. motor vehicle license fees, broadcasting
license fees, business registration fees, etc.
iii. Fines: This is a levy imposed as a punishment for breach of law with a view to
ensuring future adherence.

NB These levies above are similar to tax because they are compulsory payments and they
also serve as a source of income to the Government, but differ from tax in the sense that
taxes are not levied in return for any specific service rendered by the Government to the
taxpayer.
Reasons for Taxation by the Government

Taxes are levied for various purposes such as:

a. Raising Revenue: The main purpose of imposing taxes is to raise government income
or revenue. Taxes are the major sources of government revenue. The government needs
such revenue to maintain the peace and security in a country, to increase social welfare,
to complete development projects like roads, schools, hospitals, power stations, etc.

b. Economic Stabilization: Taxes are also imposed to maintain economic stability in a

country. In theory, during inflation, the government imposes more taxes in order to
discourage the unnecessary expenditure of the individuals. On the other hand, during
deflation, the taxes are reduced in order to encourage individuals to spend more money
on goods and services. The increase and decrease in taxes help to check the big
fluctuations in the prices of goods and services and thus maintain the economic stability.

c. Protection Policy: Where a government has a policy of protecting some industries or

commodities produced in a country, taxes may be imposed to implement such a policy.
Heavy taxes are therefore imposed on commodities imported from other countries which
compete with local commodities thus making them expensive. The consumers are
therefore encouraged to buy the locally produced and low-priced goods and services.

d. Social Welfare: Some commodities such as wines, spirits, beer, cigarettes, etc. are
harmful to human health. To discourage wide consumption of these harmful
commodities, taxes are imposed to make the commodities more expensive and therefore
out of reach of as many people as possible.

e. Fair Distribution of Income: In any country, some people will be rich and others will
be poor due to limited opportunities and numerous hindrances to becoming wealthy.
Taxes can be imposed which aim to achieve equality in the distribution of national
income. The rich are taxed at a higher rate and the amounts obtained are spent on
increasing the welfare of the poor. That’s way, the taxes help to achieve a fair distribution
of income in a country.

f. Allocation of Resources: Taxes can be used to achieve reasonable allocation of

resources in a country for optimum utilization of those resources. The amounts collected
from taxes are used to subsidize or finance more productive projects ignored by private
investors. The government may also remove taxes on some industries or impose low rates
of taxes to encourage allocation of resources in that direction.

g. Increase in Employment: Funds collected from taxes can be used on public works
programs like roads, drainage, and other public buildings. If manual labor is used to
complete these programs, more employment opportunities are created

Principal of an Optimal Tax System/ Canons/Maxims of taxation

These are the rules, qualities, conditions, standards or yardsticks by which the goodness
of a tax system is measured and by which a good tax policy can be formulated. Adams
Smith was noted to have been the first person to mention the principles of taxation, but
he called them cannons of taxation in his book “The Wealth of Nations” in 1776. Although
Adams Smith mentioned only four principles (Canon of equity, certainty, convenience
and efficiency); scholars that came after him made some generally accepted additions.
Some of these principles/include the following:

1. Principal of Simplicity

A tax system should be simple enough to enable a tax payer to understand it and be able
to compute his/her tax liability

2. Principal of certainty

The tax laws should be formulated so that tax payers are certain of how much they have
to pay and when. The tax should not be arbitrary. Certainty is essential in tax planning
since it involves appraising different business or investment opportunities on the basis
of the possible tax implications. It is also important in designing remuneration packages.

3. Principal of Convenience

The method and frequency of payment should be convenient to the tax payer e.g. PAYE.
This may discourage tax evasion.

4. Principal of Efficiency

A good tax system should be capable of being administered efficiently. The system
should produce the highest possible yield at the lowest possible cost both to the tax
authorities and the tax payer.

5. Taxable Capacity Principle

This refers to the maximum tax which may be collected from a tax payer without
producing undesirable effects on him. A good tax system ensures that people pay taxes
to the extent they can afford it. There are two aspects of taxable capacity.

a) Absolute taxable capacity is measured in relation to the general economic conditions

and individual position e.g. the region, or industry to which the tax payer belongs. If an
individual, having regard to his circumstances and the prevailing economic conditions

pays more tax than he should, his taxable capacity would have been exceeded in the
absolute sense.

b) Relative taxable capacity is measured by comparing the absolute taxable capacities of

different individuals or communities.

6. Principal of Neutrality

Neutrality is the measure of the extent to which a tax avoids distorting the workings of
the market mechanism. It should produce the minimum substitution effects. The
allocation of goods and services in a free-market economy is achieved through the price
mechanism. A neutral tax system should not affect the tax payer's choice of goods or
services to be consumed

7. Principal of Productivity

A tax should be productive in the sense that it should bring in large revenue which should
be adequate for the government. This does not mean overtaxing by the government. A
single tax which brings in large revenues is better than many taxes that bring in little
revenue. For example, Value Added Tax was introduced since it would provide more
revenue than Sales Tax.

8. Principal of Elasticity/Buoyance

By elasticity we mean that the government should be capable of varying (increasing or

reducing) rates of taxation in accordance to the circumstances in the economy, e.g. if
government requires additional revenue, it should be able to increase the rates of
taxation. Excise duty, for instance, is imposed on a number of commodities locally
manufactured and their rates can be increased in order to raise more revenue. However,
care must be taken not to charge increased rate of excise duty from year to year because
they might exert inflational pressures on the economy.

9. Principal of Flexibility

It means that there should be no rigidity in taxation i.e. the tax system can be changed to
meet the revenue requirement of the state; both the rate and structure of taxes should be
capable of change or being changed to reflect the state’s requirements.

10. Principal of Diversity

The tax base should be wide enough so as to raise adequate revenue and also the tax
burden should be evenly distributed among tax payers. There should be both direct and
indirect taxes (Diversity/variety in taxation).
 11. The Principal of Equity

A good tax system should be based on the ability to pay. Equity is about how the burden
of taxation is distributed. The tax system should be arranged so as to result in the
minimum possible sacrifice. Through progressive taxation, those with high incomes pay
a large amount of tax as well as a regular proportion of their income as tax. Equity means
people in similar circumstances should be given similar treatment (horizontal equity) and
dissimilar treatment for people in dissimilar circumstances (vertical equity).

There are three alternative principles that may be applied in the equitable distribution of

the tax burden:

a. The benefit principle:

This dictates that tax is apportioned to individuals according to the benefit they
derive from government activity and spending. Such as the users of the Nairobi
Express way pay for it, unlike their counterparts in the other road.
b. The ability to pay principle:
This is concerned with the equitable distribution of taxes according to the stated
taxable capacity of an individual or to some criterion of ability to pay. The
difficulty in the application of this theory is in determining the criterion of the
ability to pay. Three propositions have been advanced; income, wealth and
expenditure. Should individuals be taxed according to their income, wealth or
expenditure? A wealth-based tax may be useful in the redistribution of income
and wealth but may not provide sufficient revenue by itself. An expenditure tax
ensures that both income and wealth are taxed, when they are spent. Most tax
regimes would, therefore, be partly income-based and partly expenditure based.
c. The cost-of-service principle
This is the cost to the authority of the services rendered to individual tax payers.
Tax is a payment for which there is no "quid pro quo" between the tax authority
and the tax payer; the tax payer does not necessarily have to receive goods and
 services equivalent to the tax paid. For this reason, the principle cannot be applied
in relation to services rendered out of the proceeds of taxes e.g. police, judiciary
and defense. Rather, it may be applied for such services as postal, electricity, or
water supply where the price of these services is fixed according to this principle,
i.e. the price paid for postal services is the cost incurred in providing the service.
It can therefore be stated that this principle may have limited application areas

Classification of Taxes

Direct Taxes

A direct tax is one whose impact and incidence are on the same person. The impact of a
tax is its money burden. A tax has impact on the person on whom it is legally imposed.
The incidence of a tax is on the person who ultimately pays the tax whether or not it was
legally imposed on him. Therefore, a direct tax is one which is paid (incidence) by the
person on whom it is legally imposed (impact). Examples are Pay As You Earn,
corporation tax among others.

1. Indirect Taxes

Indirect tax is one whose impact is on one person, but paid partly or wholly by another.
An indirect tax can be shifted or passed on, as opposed to a direct tax which cannot.
Examples are taxes on commodities such as a VAT, duty and excise tax. A tax is not held
to be indirect merely because it is collected from one person and paid by another. For
example, tax on employment income, (PAYE) which is collected from the employees and
paid by the employer.

2. Progressive taxes

A tax is progressive when the marginal rate of tax rises with income. Those in higher tax
bracket pay higher taxes than those in lower bracket. A good example of a progressive
tax in Kenya is the income tax on individuals. In Kenya, Individual Income Tax Rates
(Bands) range from 10% to 35% as per Finance Act 2023
 3. Proportional Taxation

A tax is proportional when the same rate of tax is applied to all tax payers, for example
the corporation tax which currently stands at 30% for all firms.

4. Regressive Taxation

A regressive tax is one where the rate of tax falls as income rises. Though in terms of
absolute tax, it maybe be seen that the rich are paying larger amount, however in terms
of percentage, they are only paying a smaller percentage compared to the poor.

5. Digressive Taxation

It occurs when;
 a. The tax burden is relatively less since the tax is mildly progressive i.e the rate of
progression is not sufficiently steep.
b. Or if there is progression up to a certain point beyond which the rate becomes
proportional.

NB

Advantages of Direct Taxes over Indirect Taxes

1. They are economical in collection. For example, with income tax the collection is
done through employers who are unpaid "tax collectors".
2. Direct taxes, if progressive, can be made to fall equitably on all tax payers having
regard to their relative abilities to pay. Indirect taxes on the other hand tend to be
regressive; i.e. they take more from the poor and relatively less from the rich.
3. Direct taxes are relatively more certain in quantity as opposed to indirect taxes
4. Direct taxes are usually less inflationary than indirect taxes.
Disadvantages of Direct Taxes as Compared to Indirect Taxes