Taxation

• Taxes are compulsory transfer of money from

individuals, groups or institutions to the government
for which nothing is directly is given by government in
return.
• The tax payer only receives indirect benefits from the
payment of taxes in the form of good roads,
healthcare etc.
• A tax is a compulsory payment levied on income,
wealth and goods and services
• Taxes are compulsory transfer of money from
individuals, groups or institutions to the government.
Taxation terms

• Tax base ; it is the item of taxation eg assets, income or

investment to be taxed
• Tax rate ; it is the percentage or the amount of tax to be paid

• Incidence of tax ; it is where the burden of tax is finally felt.

An economic term for the division of a tax burden between
buyers and sellers.
• Tax incidence is related to the price elasticity of supply and
demand. When supply is more elastic than demand, the tax
burden falls on the buyers. If demand is more elastic than
supply, producers will bear the cost of the tax.
 Canons /Principles of a Good Tax System
• Equity: The tax system should be fair in its treatment of
different individuals. Horizontal Equity: Individuals who are the
same in all relevant aspects should be treated equally; Vertical
Equity: treating people in different economic circumstances
differently in order to reduce inequalities. Individuals who are
better able to pay higher taxes should bear a higher share of
total taxes.
• Economical (Administrative Efficiency) : it should be cost less to
collect taxes. Cost of collection should be low relative to the
proceeds obtained
• Convenient: the method and frequency of the payment should
be convenient to the taxpayer.
• Certainty: taxpayers must know how much they have to pay
and when to pay
• Simplicity- the tax system should be easy to
understand
• Non Distortionary – the tax rate should not be so high
as to reduce work incentives or dampen
entrepreneurial motivations
Why Collect Taxes?(Reason for taxation)
• Redistribution of income and wealth through progressive taxes
• To correct market failure: indirect taxes make demerit goods
( alcohol and cigarettes) more expensive contracting demand and
discouraging consumption
• Environmental Protection – taxing activities that generate negative
externalities (pollution) to reduce their occurrence by setting an
indirect tax equal to the amount of negative externality generated.
• As a tool for managing the economy in order to achieve
government’s macroeconomic objectives. Taxes can be cut to boost
total spending and increase GDP growth during a recession
• To raise revenue to finance government expenditure e.g. building
roads, schools and hospitals
• To discourage imports (tariffs) and correct deficits on the current
account of the balance of payments. Tariffs make imports more
expensive compared to local substitutes
Tax Structures
• Taxes are also classified as progressive, proportional or regressive.
• These designations focus on the relationship between tax rates and
income.
• Progressive Tax
• A tax is progressive if the proportion of income paid as tax
increases as income increases.
• The tax rate rises as income rises
• It is used to reduce income inequalities
• Personal income taxes are progressive
Regressive Tax

• A tax is regressive if the tax rate or the percentage of income paid as tax
decreases as income increases.
• All indirect taxes are regressive
• A rise in indirect taxes worsen income inequalities
Proportional Tax

A proportional tax is one where, as one's income rises, one pays more tax, but
the amount that is paid as percentage of one's income remains unchanged
• Tax rate remains constant for all levels of income
• Corporate tax and capital gains tax are proportional
Types of Taxes
• Taxes are usually classified as direct and indirect
-Direct Taxes

• Direct taxes are taxes, which are levied on the income and wealth
of an individual or organisation. Direct taxes are progressive in
nature
• Examples of direct taxes include:
• Personal Income Tax, which are levied on incomes of individuals.
• Corporate Tax: this is a tax, which is levied on the profits of
companies.
• Capital Gains Tax: this is tax levied on gains accruing from the sale
of assets. The tax is payable when assets are disposed off and not
when the gains actually accrue.
• Inheritance Tax: this is levied at a progressive rate on capital values
of property bequeathed to others.
• Gift Tax
• Property Tax: levied on the value of buildings and offices
 Advantages of Direct Taxes
• It is equitable because it is based on the ability to pay.
• Progressive income taxes are used to reduce income
inequalities
• There is certainty as to how much he is expected to pay,
as the tax rates are decided in advance.
• The Government can also estimate the tax revenue from
direct taxes with a fair accuracy.
• They yield a high amount of revenue
• Direct taxes are relatively elastic. With an increase in
income and wealth of individuals and companies, the
yield from direct taxes will also increase.
• Tax payers feel directly the burden of taxes and hence
take keen interest in how public funds are spent.
• The direct taxes can help to control inflation. During
inflationary periods, the government may increase the
tax rate. With an increase in tax rate, the consumption
demand may decline, which in turn may reduce inflation.
 Demerits of Direct Taxes
• Tax payers are required file annual tax returns unlike
indirect taxes
• High direct tax rates encourage high tax evasion
• High income can reduce work incentives
• High corporate taxes can be a disincentive for investment
and job creation. This can have a negative effect on GDP
growth
 Indirect Taxes
• These are taxes imposed on goods and services. The
impact of the tax falls on one person and the incidence on
another, the tax is called indirect tax
• It is a regressive tax
• Examples of indirect taxes include:
• Value Added Tax: this is the most important indirect tax. It may
be described as a tax levied on businesses at every stage of
production and distribution on the value they add to their
purchases of raw materials
• Customs duties: customs duties (tariffs) are imposed on certain
imported goods.
• Excise duties are generally imposed on goods, which are not
subject to value added tax: in particular, goods such as tobacco,
beer, wine and spirits.
 Advantages of Indirect Taxes
• It is very easy to pay because they are included in prices.
The consumer often does not know that he is paying the
tax.
• Very cheap and easy to collect
• Any one who will purchase the taxed commodity, will pay
the tax. So it is not possible to evade indirect tax.
• It can be used to discourage the consumption of harmful
drugs, by increasing the taxes on them.
• Unlike direct taxes, the indirect taxes have a wide
coverage. Majority of the products or services are subject
to indirect taxes.
• By imposing taxes on certain commodities or sectors,
the government can achieve better allocation of
resources. For example. By Imposing taxes on luxury
goods and making them more expensive, government
can divert resources from these sectors to sector
producing necessary goods.
 Demerits of Indirect Taxes
• Generally, the indirect taxes are regressive in nature and
worsens income inequalities
• An increase in indirect tax causes cost push inflation
• Indirect taxes are inflationary in nature. The tax charged
on goods and services increase their prices. 
• Revenue from indirect taxes cannot be predicted because
government cannot determine how much consumers will
spend
 Impact and Incidence of an Indirect Tax
• Impact of an Indirect Tax
• The impact of an indirect tax falls on the person or organisation
who initially bears the obligation to pay the tax.
• The Impact of an indirect tax is always on the firm
• An importer pays the tariff initially
• Incidence of an indirect Tax
• This is borne by the individual or organisation that ultimately
bears the burden on the tax
• If a good is perfectly inelastic, the impact falls on the firm but
incidence is entirely on the producer
Differences

Direct Tax Indirect Tax

• Imposed on income and wealth • Imposed on goods and services
• The impact and incidence of the • Impact fall on the firm but the
tax falls on the same taxpayer incidence may fall on the
• Incidence can not be shifted consumer or the producer or be
split between them depending
on the PED of the good
• Incidence can be shifted
depending on elasticity