Public Finance (Econ 4122)

Chapter 3
Public Revenue and the Economics of
Taxation
 Objective
After the end of this chapter students should be able to ;
 Define the meaning and type of public revenue
 Estimate tax ratio, tax buoyancy and ,tax elasticity
 Understand Adam Smith’s Canon of Taxation
 Identify the characteristics of good tax system
 Know the different approaches of taxation
 Identify system of tax structures
 Differentiate direct and indirect tax
 Understand Impact, Shifting and Incidence of Tax and its
determinates
Sources of government revenue
Broadly speaking, a government gets revenue
from three different sources. These are:
Income based on compulsion
Income by way of voluntary payment
Income: partly compulsory, partly voluntary
 Cont’d…
Income based on Compulsion
There are four different sources of income for the
government which are based on compulsion. These are:
 Taxes of various types(Direct tax and indirect tax )
 Fines for offences committed(penalty)
 Compulsory loans; and
 Tributes and indemnities arising out of war or from
other reasons.
 Cont’d…
Income by way of Voluntary Payment
• Voluntary payment source of income includes:
 Income from public property such as lease of lands
owned by the government;
 Receipts from government enterprises which do not
have monopoly power or which do not exercise their
monopoly power;
 Fees for services rendered by the government, such as
registration of births and deaths, etc.; and
 Receipts from voluntary public loans
 Cont’d…
 In all these cases there is no compulsion involved. The

government is providing certain services and charging certain

prices for the same; all those who make use of these services
pay for them.
 In some cases, the price charged may be much lower than the

cost of the service provided.

 A good example is the price charged for postcards and letters.

Profits from government enterprises which do not charge

monopoly prices are also of a voluntary type.
 Cont’d…
Partly Compulsory and Partly Voluntary
 Acc. to Dr. Dalton sources which are partly of the nature of taxes and,

therefore, contain an element of compulsion and partly of the nature of

price and, therefore, they are voluntary in character includes:
 Income from public enterprises using monopoly power to raise their

prices above the competitive level;

 Betterment levy and other special assessment:
 Income from the use of the printing press or through the issue of new

paper money to cover the deficit in public expenditure; and

Voluntary gifts
 Basic concepts of taxation
 From the whole source of public revenue tax is the major
source of government finance .
• Tax is a compulsory contribution (levy) payable by economic
units to a government with out expectation of direct and
equivalent return (quid pro quo ) from the government for the
contribution made . From this definition we can understand that;
 Tax is not voluntary but mandatory contribution(tax payers
can’ t refuse to pay) .
 It is a contribution by economic unit which is called Assessee
or a Tax payer . It may be individual ,a body or association.
 It is contributed to Federal or State government.
 It is contributed without direct and equivalent returns.
 The system of raising revenue by the government through tax is
called taxation .
 cont’d…
 Tax base(Tb) : It is a legal description of an object which tax is
payable or
 The value of every thing which is subject to taxation .
 Any thing that can be taxed has a tax base.
• Bernard P.Herber(2006) states that tax may be imposed any of
the four primary tax bases. This are wealth (Property tax,
inheritance tax, gift tax etc), income (Personal income tax, and
business income tax), transaction (sale tax ,vale added tax ,excise
tax ,turnover tax etc) and peoples (lump sum tax).
 Tax rate(r) : The rate that is to be applied on a tax base to
determine the amount of tax liability.
 Average tax revenue (ATR)=Tax liability divided by tax base
TL/TB
 Marginal Tax Revenue (MTR)= The change in tax liability(TL)
resulted from a change in tax base . ∆TL/∆TB.
 Cont’d…
TAX RATIO
• Tax ratio = Tax Revenue/GNP. Thus it is a percentage of
GNP.
• From the knowledge of tax ratio, one can quickly guess the
economic strength of the country, taxable capacity of the
nation, level of living of the people and the extent of growth
structure in tax-potentiality-related sectors of the economy.
• Since the tax ratio is related to the economic conditions of
society, it is high in the developed countries and low in poor
countries.
• The main determinants of tax ratio are the per capita income,
living standard of the people, industrial and agricultural
development, composition of tax structure and efficiency of
tax collecting machinery.
 Cont’d…
Buoyancy of Tax
• The growth of tax base increases the tax revenue. This rise in tax
revenue is termed as buoyancy of tax.
• A buoyant tax has an inherent tendency to yield more tax revenue
with the growth of its base. For example, with a given rate of
income tax and definition of taxable income, the yield from
income tax increases as national income increases.
• Similarly, excise duties are imposed on production of specified
goods. Hence, with a given rate of excise duties, the revenue
from excise duty increases with an increase in excisable items.
• The concept of buoyancy may be applied to an individual tax or
to a whole set of taxes.
Buoyancy of tax = =
 Cont’d…
• Tax buoyancy is a measure of efficiency of tax collection and responsiveness of gross
revenue mobilization in response to growth in GNP or GNI .
• The increases are measured in real terms - i.e. after adjusting for inflation.

Example : Suppose that between 2023 and 2024 nominal GDP rises by 20% and the revenue
collected by excise taxes on Milk rise by 21% . Inflation is estimated at 15%. Calculate the
tax buoyancy?

Solution

The first step is to deflate the values. Real GDP rises by 4.35% (= 1.2/1.15-1) and real excise
tax revenue rises by 5.22% (=1.21/1.15-1).

Thus the TB is 5.22%/4.35% = 1.2.

This may be interpreted as indicating that when real GDP rises 1%, excise revenue rises by
1.2%, or 20% more quickly. Note that if we had not deflated the growth rates, the measure
of TB would have been 1.05 (= 21%/20%), which is closer to 1. This measure understates
the responsiveness of revenue to a change
 Cont’d…
Elasticity of Tax
• Elasticity of a tax refers to its responsiveness to steps taken by authorities in
increasing its yield through an extension of its coverage or revision of its
rates.
• Numerically, the elasticity of a tax is measured by the ratio of proportionate
change in its yield to the proportionate change in its coverage or rates.
Example
Suppose that in 2023 the tax on Milk was 200 Birr/liter and 8 liters were sold,
yielding a revenue of 1,600 Birr. In 2024 the tax is raised to 240 Birr/liter
and 8.1 liters are sold, for a revenue of 1,944 Birr . Inflation is running at
15% annually and real GDP is rising by 2.5%.
A) Calculate the buoyancy of tax on milk ?
B) Calculate elasticity of the Milk tax?
 Cont’d…
Solution :
A) Revenue in 2023 is Birr 1,600. Revenue in 2024,
adjusted for inflation (TRc): 1944/1.15 = Birr 1690
birr .
Tax revenue in 2024 E.C(TRb) = 1,944 Birr.
The increase in real revenue =((TRb-TRc)/(TRc)
*100% = (1690-1600)/(1600) *100=0.05625 *100=
5.625
So increase in real revenue is 5.625%.
Since real GDP rose by 2.5% during the same period,
this gives a tax buoyancy of 2.25 (=5.625%/2.5%).
 Cont’d…
B) The increase in revenue is due both to higher sales of Milk,
and to the change in the tax law. What would have happened
to revenue if the tax of 2023 had not been changed?
Presumably the revenue in 2024 would have been 1,620
Birr per litter (=200x8.1m); deflated, this represents 1,409
Birr per litter (=1620/1.15) in 2023 prices, or a reduction of
11.9%.
Percentage Change in Tax revenue =((TRb-TRc)/(TR
c)*100=(1409-1600)/(1600)*100
=-11.90
The tax elasticity would therefore be −4.76= ( −11.9/2.5).
 This indicates that if the tax rate had not been changed, then
real revenue would have fallen between 2023 and 2024
despite the increase in GDP.
 Cont’d…
• Tax buoyancy is a crude measure which does
not distinguish between discretionary and
automatic growth of revenue.
• Elasticity is a preferred measure of tax
responsiveness since it controls for automatic
revenue changes
 General Characteristics of Tax

• A tax has the following characteristics:

 Tax is a Compulsory Contribution
 Benefit is not the Basic Condition (No quid proquo to tax
payers)
 Personal Obligation
 Common Interest
 Legal Collection
 Element of Sacrifice
 Regular and Periodical Payment
 No Discrimination
 Wide Scope
Adam Smith’s Canon of Taxation
 The canons of taxation are concerned with the rate, amount and
method of levy and collection of a tax.
• The first set of principles developed by Adam smith is referred to
as canons of taxation. These are:
 Canon of equality
 Canon of certainty
 Canon of convenience
 Canon of economy
 However, economists have added a few more canons. These are:
 Canon of elasticity
 Canon of productivity
 Canon of Simplicity
 Canon of diversity
 Cont’d…
• Canon of Equality: It explains that taxation must be
distributed equally in relation to the ability of the taxpayer. It
requires that the rich should pay more taxes and the poor
should bear a lesser burden.
• Canon of certainty: it indicates that taxation has to include
the element of certainty to prevent the taxpayer from
unnecessary harassment by tax-officials. Adam smith said that
the tax that is paid by each individual should be certain and
not arbitrary. This means
 The time of payment
 The manner of payment and the person to whom the tax is to
be paid
 The amount to be paid should be clear to the contributor and
every person
 Cont’d…
• Canon of Convenience: Tax should be collected
in away that are convenient for the taxpayer as far
as possible. For instance, it is convenient to
collect a tax from salaried employees at the time
of paying salaries. In addition to this, as it is
applied in Ethiopia, farmers have paid their tax as
soon as they harvest their crops.
• Canon of Economy: It is clear that government
has incurred costs to collect taxes. Consequently,
this principle suggests that the cost of collecting
taxes should be as minimum as possible.
 Cont’d…
 Canon of elasticity: it states that taxation should be elastic
in nature for the purpose of collecting more tax when
income of the people increases.
 Canon of productivity: it indicates that the tax system
should be able to generate enough revenue for the treasury.
And the government should have no need to resort to
deficit financing and taxes should be levied that they do not
obstruct and discourage production.
 Canon of simplicity: it suggests that the tax system should
not be too complex and beyond the understanding of the
layman.
 Canon of diversity: it implies that taxes should be
imposed on diverse sources because having a single tax
system may be risky and inequitable
 Features of Sound Taxation
• A sound tax system, it is argued, should be based on the principle of
progression, i.e., the rate of taxes should rise with rise in incomes and
the tax burdens should be increasingly borne by the richer classes.
Proportional and regressive taxes should be avoided as far as possible.
• It is further argued that between direct and indirect taxes, the former
should be preferred to the latter since it was easy to introduce the
principle of progression in direct taxes.
• A well-known modern writer on public finance, Mrs. Hicks,
emphasized three characteristics of a good tax system.
 First, taxation should be used to finance public services.
 Secondly, the general public should be taxed according to their ability
to pay which will depend on their income and family circumstances.
 Thirdly, taxes should be universal in the sense that persons in the same
financial position should be treated in the same way without any
discrimination whatsoever.
 Cont’d…
Equity in the Distribution of Tax Burden
• There are two aspects to the problem of equity.
– The first is the proper treatment of persons in like
circumstances. The rule in this case is “equal
treatment of equals”. All those persons who
are placed in similar circumstances should bear the
same amount of burden of taxation.
– The second aspect of equity in taxation is the
desirable relative treatment of persons in unlike
circumstances. That is, those who are better off
should pay more taxes and thus should bear a
greater burden of taxation.
 cont’d…
Productivity
The second element of sound tax system is productivity.
• The basic purpose of taxation is to get revenue, though it
can have both regulatory and non revenue uses.
• As the needs of the public authorities increase continually,
the tax system should yield increased revenues.
• Tax productivity does not mean simply revenue returns.
Adequacy, regularity and flexibility are important aspects
of tax productivity. A sound tax system should ensure
adequate and regular tax returns to meet the requirements
of the economy. The returns should also be flexible.
 cont’d…

Rights of Taxpayers
• A sound tax system will have to safeguard the
interests of the taxpayers.
• In a democratic setup the rights of taxpayers have to
be continuously kept in mind.
• Besides, the present level of taxation as well as future
prospects necessitate that the interests and rights of
taxpayers should be given adequate recognition.
• Apart from the inherent rights of the taxpayers who
support government functions, high taxpayer morale
is essential for the effective administration of tax laws.
 Cont’d…
• An intelligent concern with the taxpayer’s
problems will require the public authorities
to:
 Make efforts to broaden his understanding
of particular tax measures;
 reduce to the minimum the inconvenience
and interference associated with tax
payment and collection; and
 Provide for promote and fair treatment of
his complaints
 Cont’d…
The Tax System and the Economy
• Fourthly, a sound tax system should be so devised
that it should fulfill certain basic requirements or
objectives of an economy.
• Since 1930’s special attention has been given to
the problems of controlling economic fluctuations,
maintaining full employment, preventing
tendencies towards secular stagnation and
controlling inflation during wars or defense
emergencies.
• While full employment and economic stability are
important objectives of public policy in an
advanced economy, economic growth is significant
in backward and underdeveloped economy.
 Approaches/Principles to Taxation

We have three approach of taxation.

They are :
The benefit received approach, The
ability to pay and The cost of service
 Cont’d…
1. The Benefit Principle of Taxation
• 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.
 Cont’d…
• 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.
 Cont’d…
Limitation
 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.
 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.
 Cont’d…
 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.
 The principle is also not conducive to general welfare which
requires redistribution of income in favors of the poorer
sections through public welfare programs and services for their
benefit.
 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
 Cont’d…
2. Ability Principle of Taxation
• The ability approach is based on the broad
assumption that those who possess income or
wealth should contribute to the support of the
govern­ment according to their relative abilities.
• The obligation to pay the govern­ment is taken as
a social or collective responsibility, though “who
shall pay and in what amounts” is necessarily an
individualized one. Those who have should pay
and those who have not need not.
 Cont’d…
Justification of Ability Approach

 First is the sacrifice interpretation of ability. As Dalton has stated,

sacrifice interpretations of ability look at the psychological effects of
tax payments upon individual taxpayers or every group of taxpayers.
• Secondly, the ability principle is justified through the principle of
diminishing marginal utility of income. Incomes, it may be noted, are
meant to satisfy human wants. All those wants which are essential for
survival and which are most urgent have been classified as necessities
and they have to be satisfied somehow by all.
 It is, therefore, concluded that tax burdens should be imposed on high
incomes, in which case the burden will not be felt much. At the same
time, the lower income groups who spend their incomes to satisfy
their most urgent and essential wants should be exempted from
taxation.
 Cont’d…
• Finally, ability principle is justified on the basis of faculty. Faculty is
the capacity of an individual to produce and consume and this is
represented by the income and the accumulated wealth of the
individual. After meeting certain basic needs, the individual is left
with certain resources which reflect a high degree of tax paying
capacity
 A little consideration of the above three points to justify ability-to-
pay principle of taxation will show the weaknesses of each one of
them.
 Sacrifice is subjective and each writer would interpret it in his own
way. Marginal utility of income interpretation of ability has
considerable merit but it is also on a subjective plane.
 Besides, it ignores the use of income for saving and investment which
are important both individually and socially. Finally, though faculty
interpretation of ability is objective, it bristles with many difficulties
when applied in practice.
 Index of Ability to Pay
The indices of ability to pay are as follows:
Property: Property/accumulated wealth (land,-buildings, gold, golden ornaments )
was considered as the index of ability to pay. 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 town.
• Fourthly, property is taxed on its capital value, but if it does not yield income, the
taxation may be unjust. Hence, it can be said that property may not be regarded as
a primary test of ability to pay.
 Cont’d…
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.
 Cont’d…
Size of 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.
 Ability to Pay and Equality of Sacrifice

• Mill interpreted the ability principle in terms of

individual sacrifice. He argued that the real burden of
taxation should be equal for all and that “similar and
similarly situated persons ought to be treated
equally”.
• Equal Absolute Sacrifice: The total loss of utility
as a result of tax should be equal for all tax-payers.
• If there are two tax-payers with different incomes, the
one who has more will pay more tax and the one who
has less will pay less, but the sacrifice to both as a
result of the tax should be equal.
 Cont’d…

Equal Proportional Sacrifice

• The loss of utility as the result of a tax should be
proportional to the total income of tax-payers.
• Here, too, those with a higher income will pay
more but the ratio of sacrifice to the income will be
the same for all. This can be expressed as:
• Sacrifice to taxpayer A=Sacrifice to taxpayer B=
Income of A Income of B
 Cont’d…

Equal Marginal Sacrifice

• The marginal sacrifice for the different
taxpayers should be the same.
• Since marginal utility of a higher income
will be very much low as compared to a
low income, equal margined sacrifice will
imply that the person with a higher­
income will be expected to bear the
heavier burden.
 Rate Schedules of Taxation
The system of taxation can be classified in
various ways on different bases. The most
important classifications are
1. Progressive, proportional, regressive and
digressive
2. Single and multiple
3. direct and in direct
• Let us discuss each of them in turn.
1. Progressive, proportional, regressive
and digressive
• This classification is based on the degree of progression of a tax,
or distribution of their burden on the tax payers.
• Progressive taxes-is one for which the percentage of tax increases
with income (base). In other words, the tax liability increases not
only in absolute terms but also as proportion of income.
Advantages of progressive Taxation
 It fully compiles with the principle of ability to pay
 It is more economical i.e. more income through increase in the
rate of tax with out increase in cost
 It has greater revenue productivity
 It leads to better distribution of income on all.
 It fits with canon of elasticity. It is elastic in the sense that with
minor changes in the tax rates substantial changes can be brought
about in the income of the government.
Disadvantages of Progressive Taxation
 Non measurability of utility to decide the degree of
progression. Marginal utility of net incomes of different
persons cannot be measured in such a way as to permit
precise comparisons between individuals. Consequently, it is
impossible to discover any faultless objective standard of
progression of tax rates on the basis of subjective utility.
 It reduces capital formation –it is the rich who can save ,thus
if they are taxed more heavily the process of capital formation
is adversely affected as a result of progressive taxation
 In spite of these defects, the system of progressive taxation is
now widely recognized as desirable. The main reason for this
is that under progressive taxation it becomes possible to
eliminate or reduce the glaring economic inequalities in the
society.
 Proportional Tax
• is one for which the percentage of income paid
in taxes is the same regardless of the taxpayer's
income. Here, the tax base may be income,
money value of property, wealth or goods etc.
• It imposes the same amount of tax liability.
However, the propensity to consume for the rich
is less than the poor. The poor easily feel the
burden of taxation more than the rich and thus
equal rate of tax affects the rich and the poor
unequally. Consequently, it is unfair and unjust.
 Proportional Tax
Advantages of proportional taxation
 It is easy for every individual to evaluate the total
amount of tax he has to pay. The tax payers can easily
and quickly calculate the amount of tax they have to
pay to the government.
• There is no change in the existing distribution of
income and wealth in the society as a result of
proportional taxation because all the tax payers pay the
tax at a single uniform rate. It is neutral with respect to
income and wealth distribution and consequently it
involves no structural change in the socio-economic
set up of the country.
Disadvantages of proportional taxation
 The burden of taxation falls more heavily on the
poorer section of the society. The reason is that, the
marginal utility of money for the rich is lower than
the marginal utility of money for the poor.
If the rich and the poor are taxed at the same rate, the poor
section of the society will be making greater sacrifice than
the richer section.
 Proportional taxation does not reduce the
inequalities of income and wealth rather it enhances
these inequalities and increase the gap between the
rich and the poor.
 It contributes less to public revenue
 Regressive Tax
• is one for which the tax rate decreases as
income increases.
• Regressive taxation imposes higher burden on
the poor. Therefore, it is unjust and unfair than
proportional taxation.
Digressive tax
• is one for which the tax rate increases up to a
certain limit, after that it is constant while the
income is increasing. Thus, the digressive tax is
a mixture of progressive and proportional
taxation.
2. Direct and Indirect Taxes
• Taxes are direct or indirect depending upon the fact
whether or not they are actually paid by the people
on whom their immediate burden of payment falls.
a) Direct tax- is a tax that is paid by the person
on whom it is legally imposed. The burden of
direct tax cannot be shifted to any other person.
Thus, impact, i.e., the initial burden as well as the
incidence, the ultimate burden of a direct tax lies
on the same person.
• Examples for direct tax are personal income tax,
expenditure tax, property tax etc.
 Advantages of Direct Tax
Equity- direct taxes such as income tax, wealth tax etc. are
based on the principle of ability to pay i.e. the rich pay more
and the poor less. Vertical equity as well as horizontal equity
is maintained. It is progressive in effect.
Horizontal equity: People with the same or equal income
or capacity pay the same tax.
Vertical equity: People with different income will pay
different tax or people with greater ability to pay more.
Certainty- in direct taxes the tax payer knows the amount
of tax, the time of payment, the manner of payment of tax
 The governments also estimate the amount of such tax
which it will receive from the public and accordingly it can
prepare its development plans.
 Cont’d…
Economy- in direct taxation the expenditure incurred for
collection is almost nil(zero). Example, payroll is prepared for
salary payment and at this time the cashier collects the tax without
additional payment. Therefore, direct tax fulfills the cannon of
economy.
Elasticity- revenue from direct taxes can be increased or
decreased with change in national income or wealth of the nation.
Civic Consciousness -the burden of direct tax is heavier than
indirect taxes thus people feel that they are paying a sum of money
and they want to see where the money is spent i.e. they try to see
whether the collected tax is used for productive purpose or not
Anti- inflationary -At the time of inflation, there is more
money in the hand of the people but the purchasing power is less.
Therefore, direct taxes collect the excess money and then minimize
inflation.
Disadvantages of Direct Tax
Pinching- the money paid in direct taxes is large
(lump sum) and thus they pinch the taxpayers more.
They feel that something is deducted from their
incomes, and their saving and consumption pattern is
affected.
Inconvenient -Tax is collected from the
 Payroll for individuals
 income statement for enterprises
 However, in the case of enterprises, government
should check whether the income statement is real
and correct in order to avoid tax evasion. It results in
inconvenience, tax evasion and corruption
 Cont’d…
 In direct taxation assessment is based on the willingness of the
taxpayer about his income statement. Enterprises may prepare
two documents one for taxation that is false statement and the
other is real for internal purpose. There is greater scope for tax
evasion that leads to corruption.
Uneconomical-In private enterprises direct taxes are uneconomic
because tax collectors should check the statement of the enterprises,
which take long time and costs a lot. But in government enterprises
there is no such problem.
Narrow based- There is small number of employees eligible for
direct taxation. Larger section of the society remains untouched and
hence, it fails to achieve its objective of promoting civic sense
among citizens.
Arbitrary- There is no scientific way of levying the tax rates.
Disincentive to work and save-Direct taxation system discourages
people not to work and they might prefer to leisure than work.
 Indirect Tax
• is taxes a burden of which can be shifted to
others. Thus, the impact and the incidence of
indirect taxes lie on different persons.
• In indirect taxes, the taxpayer is the tax bearer.
• For example, sales taxes are indirect taxes
because they are imposed on producers or
sellers but their incidence is shifted to
consumers.
 Advantage of Indirect Tax
Convenient - It is convenient for transferring tax to
taxpayer through the price of goods and services. The
taxpayer does not feel the burden of the tax.
Elastic - Indirect taxation can easily increase the rate of
taxes.
Progressive - Indirect taxes are progressive in nature
because tax rates on necessity products are less and on
luxurious products are high. As a result the rich will pay
higher tax and the poor lower amount of tax that
approves equity.
No evasion - Since the tax is included in the price of
good or services, there is lower chance for tax evasion.
 Cont’d…
Wide Coverage -The indirect taxes are included in the price of
goods and services and thus every body that is buying goods and
services is paying taxes. This means, the whole population, even the
beggar pays indirect tax.
Less pinching - Indirect taxes are not that much known by the
taxpayer. As a result they are less pinching
Social value- Indirect taxes discourage the consumption of harmful
products such as tobacco and there by they improve social value.
Saving and Capital formation- When government imposes higher
tax on commodities, consumption will decrease and saving will
increases, which in effect raises investment and capital formation.
Balanced Regional Development-Tax exemption for commodities
produced in backward region and relatively higher taxes for
commodities produced in advanced region brings a balance among
regions.
Disadvantage of Indirect Tax
Inequitable- When the poor and the rich purchase the
same product they have to pay the same amount of tax.
This means indirect taxes are imposed more on the poor
than on the rich and violates the principle of ability –to-
pay.
Uncertainty- Government cannot be certain about how
much tax revenue is collected in the form of indirect
taxes. In indirect taxation the taxpayer does not know the
 amount of tax
 time of payment
 the manner of payment of the tax
 Cont’d…
No Civic Consciousness- Many people are not aware of that they
are paying taxes because the tax is born by the price of the
product. Therefore, they do not feel much pain and will not be
interested to know where the tax is spent.
Discourage Saving- As indirect tax increases, the price of goods
will increase which increases consumption expenditure. Thus,
the level of saving will be decreased.
Inflationary potential- When in direct taxes are excessive the
price of a product increases which leads to inflation.
• In summary, all modern writers have recommended that direct
and indirect taxes are completely with each other. Because of
increasing requirement of public expenditure, government of
one nation cannot collect enough revenue through either
indirect or direct tax only. Therefore a country must apply
both direct and indirect taxation. However, one cannot suggest
a perfect balance between them in a fiscal system of a nation.
 Superiority of Indirect Taxes over
Direct Taxes
 In spite of their demerits, indirect taxes are regarded as better from the
point of allocation of resources:
(i) Indirect taxes which are confined to goods with zero elasticity of demand
(absolutely inelastic demand) or low elasticity are regarded the best.
(ii)Indirect taxes are useful where external diseconomies exist on the
production side or on the consumption side. Examples for such
diseconomies on the production side are smell or smoke nuisance and on
the consumption side is drunkenness. Indirect taxation is useful in that
they discourage the people from consuming harmful goods like liquor
and drugs.
 Cont’d…
(i) Indirect taxes have been found to be superior to direct taxes, since their effects on
incentives to work and save may not be so harmful (unless, of course, they fall on
capital goods).
(ii) They are also suitable for purposes of income correction. If they are imposed on
those goods which have a high income elasticity of demand, they yield highly
satisfactory results. In this case, ad valorem duties (according to value) rather than
specific duties would be preferable since the tax revenue would change in response
to a change in price and also change in consumption.
(iii) Finally, as it is difficult, if not also improper, to levy direct taxes on low income
groups, the only way the poor can be asked to pay for government expenditure is
through commodity taxes. This is the conventional argument in favour of indirect
taxes. This argument has lost its significance these days particularly in advanced
countries, where there has been great administrative improvement and efficiency in
the field of taxation and where the difficulties of taxing the low income groups have
been overcome.
 Impact, Shifting and Incidence
of Tax
• The traditional concept of shifting and incidence
of tax is more popularly associated with the
classical theorist, E.R.A. Seligman.
• According to him, answer to the following three
questions relating to a tax will give us the meaning
of the terms impact, shifting and incidence.
1. Who bears the money burden of tax in the first
instance?
2. Is it possible to transfer this money burden of tax to
some one else?
3. Who ultimately bears the money burden of tax?
 Cont’d…
• Impact is on that person who pays the tax in the first
instance. It is the immediate money burden of tax.
Thus, when a tax is imposed, its impact is on that
person who bears the immediate money burden of it.
• Incidence of tax lies on that person who is the ultimate
bearer of the tax burden. Thus, if the original tax
payer is unable to shift the burden of the tax at all, then
the impact as well as incidence will be on him.
• If, on the other hand, he is able to transfer the money
burden of tax, i.e., if he has succeeded in shifting the
tax to some one else, say, Mr. X, then the incidence of
tax will be said to have moved from him to Mr. X who
becomes the ultimate bearer of the tax burden.
 Cont’d…
• Suppose, for example, an excise tax is levied on cloth
and the tax authority collects it from the manufacturer
of cloth. Hence the impact of tax is on the
manufacturer. If he is now able to transfer the money
burden to the whole-seller by raising the price to the
extent of tax, tax shifting has taken place.
• The whole-seller may again be able to shift this
money burden to the retailor and the retailor may pass
on the burden to the consumer through a continued
process of shifting. If the consumer has no more
possibility of shifting the tax, he becomes the
ultimate bearer of the money burden of tax and,
hence, incidence will lie on him.
 Theories of Tax Shifting
Concentration theory. Physiocrats’ theory is
also known as concentration theory.
 According to the Physiocrats, i.e. the French
economic thinkers of the old days there should be
only one kind of tax, that is, on land. This is
because a tax levied on anything else will result in
a continuous process of shifting until it finds its
resting place on land.
 It is believed by, the Physiocrats that the tax is paid
out of surplus only, and it is only land that
produces surplus.
 Cont’d…
Diffusion Theory
 The diffusion theorists, unlike the Physiocrats, do not
advocate a single tax.
 According to them, all taxes, whatsoever levied, will
get diffused in the whole economic system, shifted
and reshifted continuously until tax burden is spread
over the people more or less in an equitable manner.
 The diffusion theorists point out that there is
interdependence of various economic units and that
the buyer of a thing is the seller of something else.
 Under such a system, any particular tax affects the
whole economy, though the degree of effect may be
different.
 Cont’d…
Modern theory of Shifting
• Today, tax is accepted as a necessary element of cost
of production. Just as any factor of production is an
item of input cost, taxes paid to the government are
to be included in the expenses of production.
• Thus, the price of commodity must cover the tax, i.e.,
the price will be increased by the amount of the tax.
• It means that the tax will be shifted to the buyer.
• If, however, the price cannot be raised by the full
amount of the tax, then the tax will be partially
shifted to the buyer.
 Cont’d…
 So 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 elasticity's of demand and supply. It can be
generalized as follows:
• 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.
• 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.
• 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.
• 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.
 Cont’d…
 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.
 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.
 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.
 Cont’d…
Forward and Backward Shifting
• When a tax is imposed, the original tax payer tries to
transfer its money burden to some one else. This he will
do by changing the price of the commodity taxed.
• If he succeeds in passing the money burden of tax on to
the buyer of the product by raising its price, he has
shifted the tax forward and the incidence has
moved to the buyer.
• When the seller of the product taxed fails to raise the
price and is unable to shift the tax forward, either he
himself will absorb it or he will try to shift it backward
to the factors of production like labor or capital.
• If he has to absorb the tax by himself, the tax will be an
element of cost of production. In such a case, the cost
of production will be increased by the amount of the
tax.
 Factors Influencing Shifting and Incidence

Elasticity of Demand. The elasticity of demand for

commodity taxed exercises a very important influence
in determining incidence.
• If the demand for the product taxed is perfectly
elastic, i.e., (Horizontal dd curve), price cannot be
raised at all, because the slightest rise in price will
largely reduce the demand for the product. Hence, the
incidence will be wholly on the seller.
 Cont’d…
Elasticity of Supply
• Because price is determined by the interaction
of both demand and supply, it follows from the
similar reasoning that the incidence of tax on a
commodity will be wholly on the buyer when
supply is completely elastic
• Whereas it will be wholly on the seller when
supply is completely inelastic.
 Cont’d…
Market Conditions
o Shifting of tax is also influenced by the conditions of market
for the product taxed.
 If the product is sold in the perfect market which is
characterized by many sellers and perfectly elastic demand
curve, the price cannot be changed by the seller and, hence,

tax cannot be shifted.

 Cont’d…
Magnitude of Tax
o Shifting depends on the magnitude of tax levied.
 If the amount of tax is very small, it is generally not
shifted but absorbed by the seller, because it does not
much reduce his profit.
 The seller, moreover, may absorb it in the hope that he
will be able to attract more customers in the event of
other sellers trying to raise the price in their trial of
shifting the tax.
 Cont’d…
Coverage of Tax and Substitutability of product
Coverage of Tax. Another important factor that
influences shifting and incidence is the extent of
coverage of the tax.
 If the tax is more general in natural, falling on wide
range of commodities, it may be easily shifted.
Substitutability of Product. It follows from the
above argument that taxes imposed on a commodity
which has no substitutes or has only poor substitutes
can be easily shifted to the buyer, because the buyer
will not find an alternative product to satisfy his
demand and, hence, he will be ready to purchase the
same even when the price is increased by the amount of
 Cont’d…
Public Policy and Tax Laws
• Lastly, the shiftability of tax is influenced much by the
tax laws and public policy.
• For example, when the price printed on the product level
is exclusive of the tax imposed on it, the psychological
response of consumer helps forward shifting process of
the tax.
• Here, the advertised price is less than the take-home
price.
 Tax system
• It is system in which tax liability is computed .
• There are two types of tax system in the world .
1) The global tax system
• It is a system in which the tax liability is computed in aggregate
(sum ) of all incomes and losses derived by the tax payer from
different sources in the world.
• Tax is computed in the final balance of all business activates
owned by tax payers .
2) Scheduler tax system
• It is a system in which tax liability is computed on separate
schedule .
• In this system income is classified for income tax purpose
according to its nature and source .
• The classification into which the income fall are known as
schedule .
 Cont’d…
• The Ethiopia tax system follows the schedule system of
taxation where by different type of income are
segregated into different schedules for computing tax
liability .
• In Ethiopia we have five tax schedule (source : 286/2002
later modified 240/2008 income tax law, and income tax
regulation 78/2002 , Tax administration pro. 241/2008 ).
1. Schedule A: It is used to collect employment income
tax .
2. Schedule B : It is used to collect rental income tax .
3. Schedule C: It is used to collect Business income tax .
4. Schedule D: It used to collect other income tax .
5. Schedule E: Consists of list of non–taxable income .
 Cont’d…
Category of tax payers
• The Ethiopia income tax law categorize tax payers in to three .
1. Category A
• Any business having annual turnover of birr 1,000,000 or above .
• Required to hold book of account .
• Declare their income monthly to the tax authority and required to
pay tax July 1-October, 30 .
• Need to collect vale added tax (0, 15 and 15 %) of their sale .
2. Category B
• Any business having annual turnover of Birr 500,000-1,000,000 .
• Required to hold book of account and declare their income
monthly to the tax authority quarterly basis and required to pay
tax July 1-Augest 30 or Powagema 5/6 .
• Need to collect Turn over tax (2 or 10 %) of their sale .
 Cont’d…
3. Category C
• Any business having annual turnover of less
than Birr 500,000 as estimated by tax authority .
• Not mandatory to have book of account but
required to declare their income on yearly basis
and required to pay tax July 1-30
• Need to collect turn over tax .
• Tax assessment is made in standard assessment
method .(per 5 year, new assessment were
made ) (Income tax proc.240/2008) .
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