Public Finance & Taxations CH 1-4
Public Finance & Taxations CH 1-4
Public Finance & Taxations CH 1-4
Taxation
Course Contents
• Chapter I: Basics of Public Finance
• Chapter 2: Meaning and Characteristics of Taxation
• Chapter 3: Public Finance in Ethiopia
• Chapter 4: Ethiopian Tax System
Chapter – one
Basics of Public Finance
• Chapter Contents
• Definition of public finance
• Scope of public finance
• The role of government in the economy
• Public expenditure
• Public revenue
• Public debt
• Public administration
•Fiscal federalism
Introduction
Governments, all over the world have started number of public
projects.
To provide social facilities, the government requires adequate
revenue.
Public Finance, therefore, deals with the income and
expenditure of public authorities.
It deals with the financial operations or finances of the
government.
The government raises revenue from internal as well as external
sources to incur huge expenditure on various functions the
government has to perform.
Cont…
Public finance is thus concerned with the use and
accomplishment of essential monetary resources of the
government.
Public finance deals with how and through what different
sources the government gets income, how it spends it and how
it controls and administers its incomes and expenditures.
Therefore, the subject matter of public finance deals with፡-
– Public revenue,
– Public expenditure, and
– Public debt.
Definition of Public Finance
Public finance is a very old science and different economists
have defined it in their own ways.
– Is concerned with the income and expenditure of public
authorities and with the adjustment of one to the other.” Huge
Dalton
– Deals with the provision custody and disbursement of
resources needed for conduct of public or government
functions.” Lutz
– Is a science which deals with the activity of the statement in
obtaining and applying the material means necessary for
fulfilling the proper functions of the state.” Carl Plehn
Cont…
– Is the study of the principles underlying the spending and
raising of funds of public authorities.” Findley Shirras
– Studies the economic activity of government unit.”
Buchanan
– Deals with expenditure and income of public authorities of
the state and their mutual relations as also with the financial
administration and control.” Bastable
All of them say that it is a study of income and expenditure
of the central, state, and local governments.
– Government performs many functions which the individual can
not or do not perform.
– Therefore, rising of funds for the expenditure and their
disbursement constitutes the subject of Public finance.
Scope of Public Finance
The subject matter of the public finance is classifies under five
broad categories.
1. Public Revenue
2. Public Expenditure
3. Public Debt
4. Financial Administration and Control, and
5. Economic Stability and Growth.
Public Revenue
• Revenue includes all incomes irrespective of the source they are
obtained from.
• Thus, in the wider sense, we can include taxes as well as
borrowings under public revenue.
• But in the interest of the clarity, public revenue includes only
those incomes which do not carry with them the obligation of
repayment for the state.
• Thus, public revenue implies raising income by way of taxation.
Public Expenditure
• Public expenditure is the end and aim of the collection of
revenues.
• Public expenditure are concerned with:-
– Principles and problems relating to the expenditure of public
funds.
– The fundamental doctrine that governs the distribution of the
expenditure among various heads.
– Various effects of public expenditure on total employment, total
income, aggregate investment, output, distribution and general
price level etc.
– Through public expenditure, the government contributes to the
financial flows of the economy and conditions the demand and
supply patterns.
– Public expenditure is also used as a tool for implementing welfare,
growth, stabilization and other policies, by the government.
Public Debt
• A public authority can obtain income through loans and public
borrowings.
• The study public debt also includes:
– Methods and objectives of public borrowings;
– Management of public debt
• Economic Stability and Growth
• The study of public finance includes fiscal policy of the
government in dealing with inflationary and deflationary
situations, instability of the price level, promotion of full
employment, growth of economy, welfare of the people, etc.
Financial Administration and Control
• Public finance also examine the mechanism by which the above
processes are carried on.
• With out a study of relevant dimensions of financial administration the
subject of public finance remains incomplete.
• Thus financial administration and control include the following:
– Study of budgets and their procedure.
– Budget as a instrument of securing certain objectives, such as
promotion of employment, economic growth with stability,
welfare of the weaker sections, infrastructural development for
promoting private investments, etc.
– Financial and physical controls through different fiscal tools for
controlling private expenditure in the economy to avoid the effects
inflation deflation, recession etc.
Difference between Public Finance and Private Finance
• Finance in general means public as well as private finance.
• Public finance relates to the money-raising and income-
expenditure functions of the government.
• Private finance refers to the income-expenditure phenomenon of
an individual or private business.
• By private finance mean the financial problems and policies of
an individual economic unit.
Similarities
Satisfaction of Human Wants;-
• Public finance is concerned with the satisfaction of social or
collective wants, whereas
• private finance is concerned with the satisfaction of personal
or individual wants.
Cont…
Maximum Advantage from expenditure;-
– Both the public finance and private finance try to secure
maximum advantage or maximum benefit.
Borrowings;-
– public and private finance is that many times both have to be
obtained from the market in the form of borrowings whenever the
expenditure of either the government or any individual or firm
exceeds their income/revenue.
Engagement in Similar Activities;-
– Both the private and public sectors are engaged in activities that
involve lots of purchases, sales and other transactions. Or
– they are engaged in production, exchange, saving capital
accumulation, investment, and so on.
Cont…
Scarcity of Resources;-
– The scarcity of resources is also an important factor which is
common to both.
– They have unlimited objectives, whereas the resources are limited.
Problem of Adjustment of Income and Expenditure;-
– Public and private finance is that both the public as well as private
sectors face the problem of adjustment of income and expenditure.
Cont…
Dissimilarities
Motive;-
– The motive of private finance is personal interest or benefit,
whereas the motive of public finance is social benefit or public
welfare.
Adjustment Approach of Income and Expenditure;-
– Private tries as far as possible to adjust his expenditure to his
income because his expenditure depends on his income.
– Conversely, the government first prepares its budget. In other
words, the government first determines its expenditure and then
devises ways and means to raise the requisite revenue to meet its
expenses.
Cont…
Nature of Resources:-
– The resources (private finance) of an individual are more or less
limited, whereas the resources of the government (public finance)
are enormous.
Coercive Methods:-
– An individual (private finance) cannot use coercive methods to
raise his income, Where as the government (public finance) can
use forceful methods to collect revenue.
– In other words, to collect revenue, the government imposes taxes
at a high rate on the people irrespective of their capacity to pay.
Private individuals or bodies have no such powers.
Cont…
Secrecy of Budget:-
– Public finance is an open affair as the government gives utmost
publicity to its budget by publishing it in newspapers and by
showing it on television. For example, the Ethiopian government
tells to the public the yearly approved budget by parliament,
whereas private finance is a secret affair.
– An individual tries to keep his accounts secret as he does not want
his competitors to know his real financial position.
• Long/Short-term Consideration: -
– Private individuals incur expenditure in those areas of business
which give quick returns. They, as individuals keep in view short-
term considerations.
– Government incurs expenditure keeping in view the long-term
considerations, such as construction of dams, multi purpose
hydro-electric projects, etc.
Cont…
Elasticity of Finance:-
– Public finance is elastic in nature-as compared to private finance.
Public finance can be increased by imposing various taxes as
public finance is open to drastic changes. Private finance on the
other hand, cannot be increased as there is not much scope for
changes in private finance.
Deliberation in Expenditure:-
– The pattern of expenditure of an individual is governed by habits,
customs, status, personal needs etc. On the contrary, the pattern of
public expenditure is governed and controlled by deliberate
economic policy of the Government
Right to Print Currency: -
– The government has a right to print currency which is legal,
whereas private individual does not enjoy such a right.
The Role of Government in the Economy
In the narrowest sense, the government's involvement in the economy
is to help correct market failures or situations in which private markets
cannot maximize the value that they could create for society.
This includes:
providing public goods,
internalizing externalities (consequences of economic activities
on unrelated third parties), and
enforcing competition
In general the role of the government
To promote economic efficiency and growth
For fair distribution of income through Taxation
To provide a generous social security system and an egalitarian
society
To strengthen the institution
Public Expenditure
• PE is incurred by public authorities - either for the satisfaction of
collective needs of the citizens or for promoting their economic
and social welfare.
• It is incurred by the government for the attainment of public
good.
• Every government has to maintain law and order, armed forces
for providing protection, schools, health of the people, arranging
for cheap food, cloth and low-cost housing for the poor and so
on.
• All these mixed activities which are increasing every year
require huge funds.
• Therefore public expenditure, deals with the expenditure which a
government incur for its own maintenance, the society and the
economy and helping other countries.
cont…
• Technically, in the structure of a budget, most governments
classify public expenditure into two:
• Current expenditure, and
• Capital expenditure
• Current expenditures
– They are also referred to as non-developmental expenditure.
– All sorts of administrative and defense expenditure
– They are intended for continuing the existing flow of goods and
services and maintaining the capital of the country whole.
• Capital expenditures
– It contribute to increased productive capacity of the nation.
– They are also known as development expenditure.
– Example: Expenditures on construction of dams, public works,
state enterprises, agricultural and industrial development.
Objectives of Public Expenditure
• Dr. Dalton divided the aims of public expenditure into two parts:
1. Security of life against the external aggression and internal
disorder and injustice.
2. Development or up gradation of social life in the
community.
• The public authority works in many ways for the benefit of the
people. like public health and education.
• The responsibilities of the government are increasing every
year
• Designed to optimize the level of investment
• Incurred at an increasing rate in the backward region to uplift
their economy
Reasons for Growing Expenditure
• Population growth
• Increasing urbanization
• Maintenance of law and order
• Welfare activities
• Provision of public goods and utility services
• Servicing of public debt
• International obligation
• Defense
• Transport and Communication
• Rising Trend of Prices
• The Rural Development Effect
Effects of Public Expenditure
The effects of public expenditure;
– Effects of public expenditure on production.
– Effects of public expenditure on distribution.
– Effects of public expenditure on employment.
– Effects of public expenditure on economic stability.
– Effects of public expenditure on economic development.
Public Revenue
PR is very necessary for the govt. to perform its various
functions for the welfare of the society.
Increasing activities of the government are the cause of
increasing public expenditure.
Methods of public revenue and their volumes have significant
impact on production & distribution of wealth & income in
the country.
It has effects on the nature and the volume of economic
activities and on employment.
According to Dalton, the term “public revenue” has two sense-
wide and narrow.
Cont…
• In its wider sense it includes all the incomes or receipts
which a public authority may secure during any period of
time.
• In its narrow sense, it includes only those sources of income
of the public authority which are ordinarily known as
“revenue resources”.
• To avoid ambiguity, thus, the former is termed “public
receipt” and the latter “public revenue”.
• As such, receipts from public borrowings is mainly
excluded from public revenue.
Sources of Public Revenue
• The important and common sources of public revenue are:
– Taxes
– Income from currency
– Sale of public assets
– Commercial revenues
– Administrative revenues e.g., Fees, fines, licenses.
– Grants and gifts
Cont…
Basic Categories of Government Receipt
– Revenue Receipts
– Capital Receipts
1. Revenue Receipts
It includes “routine” and “earned” ones
1. Tax-revenue
2. Non-tax revenue.
Cont…
I. Tax Revenue Receipts
• Tax revenue itself is divided into three sections:
i. Taxes on income
• It covers corporation tax, income tax and similar other
taxes, if any, in force.
ii. Taxes on property and capital transactions
• taxes on specific forms of wealth and its transfers such as
estate duty, wealth tax, gift tax, house tax, land revenue and
stamps and registration fees, etc.
iii. Taxes on commodities and services
• This section includes taxes on production, sale, purchase,
transport, storage, and consumption of goods and services.
Cont…
2. Non-tax Revenue Receipt
i. Currency, coinage and mint:
– This category covers the receipts of Currency Notes Press,
Mints and Profit from circulation of small coins.
ii. Interest receipts, dividends and profits:
– Interest receipts on loans by the government to other parties,
– Dividends and profits from public sector undertaking.
• E.g contributions from railways and posts and
telecommunications,
Cont…
iii. Other non–tax revenue:
• It covers revenue from various government activities and
services such as from:-
– administrative services,
– public service commission,
– police,
– jails,
– agricultural and allied services,
– industry and minerals,
– water and power development services,
– transport and communications,
– supplies and disposal, public works, education, housing,
information and publicity, broadcasting, grants-in-aid and
contributions etc.
Cont…
2. Capital Receipts
Capital receipts of the government take money forms.
The most important one comprises of borrowings which can be
classified in terms of their origin and maturity
– on the basis of origin, public borrowings may be external (outside the
country), or internal (with in the country).
– In terms of maturity, there may be, ”long term”, “medium term”, or
“short term” loans with specific demarcation of boundaries for each.
• They may be
– marketable or non- marketable,
– interest-free or interest bearing, etc.
– Some capital receipts may be in the form of grants and
donation.
Sources of Public Revenue in Ethiopia
• Tax Revenue
• Non-Tax Revenue
Tax Revenue
Direct Taxes In Direct Taxes
– Personal Income tax - Customs duties
– Business Income tax - Turnover tax
– Capital gain tax - Excise tax
– Rental Income tax - VAT
– Interest Income tax
– Tax on dividend and lottery
– Rural and Urban land use fees
Cont…
Non-tax revenue
– Administrative revenues
– Government investment income
– Dividend
– Privatization proceeds
– Capital income form sale of goods and services
Public Debt
• Public debt is of recent growth and was unheard of prior to the
18th century.
• In modern times, however, borrowing by the States has become
a normal method of government finance along with other
sources such as taxes, fees, etc.
• The government may borrow from banks, business houses, other
organizations and individuals. Besides, it can borrow within the
country or from outside.
• The government loan is generally in the form of bonds (or
treasury bills if the loan is required for short periods) which are
promises of the government to pay to the holders of these bills
the principal sum along with interest at the stated rate.
• Borrowing is resorted to in order to provide funds for financing a
current deficit.
Cont…
Public debt is also sometimes referred to as government debt.
It is a term for all of the money owed at any given time by any
branch of the government. i.e.
– federal government,
– the state government, and
– even the municipal and local government.
Public debt is a debt or loan taken by the govt. from
– own people
– Foreign countries or both.
Cont…
Classification of public debt
– Source of Borrowing
– Purpose of the loan
– According to nature
– Funded and unfunded debt
– Time Duration of loan
Effects of PD
Public borrowing from individuals and firms has effects on all
aspects of economic life
• Effects on Consumption
• Effects on Production and Investment.
• Effects on Distribution
• Effects on National Income
• Effects on Liquidity
• Effects on Money Market
Burden of Public Debt
• Public borrowings are to be paid along with interests.
• Govt. imposes new taxes upon the people to repay the loans
and meet the annual interests on such loans.
• The sacrifice of the people in the form of tax payment is the
burden of public debt.
• If the debt is taken for productive purposes,
– For e.g., for irrigation, transportation, roads, information
technology, human skill development, etc., it will not mean any
burden.
• But if the debt is unproductive it will impose both money
burden and real burden on the economy.
Cont…
• The burden of public debt into:
– Burden of internal debt
– Burden of external debt
• Burden of Internal Debt
– Internal debt involves a series of transfers of wealth within the
country, i.e., from lender to government and then later on at the
time of redemption from government to lender.
– Money is thus transferred from one section of the community to
other sections.
Cont…
• Burden of External Debt
– External debt also involves a series of transfer of wealth from the
foreign lender to the borrowing country, and when it is repaid the
transfer is in the opposite direction.
– As the borrowing country paid interest to the foreign lenders, a
direct money burden is fall on the whole community.
– This burden depends on the rate of interest.
– If the rate of interest is high, the money burden, is also high and
vice-versa.
– The community is also suffered from real burden of external debts.
Public Administration
Fiscal Federalism
Chapter – Two
Meaning and Characteristics of Taxation
• Chapter Contents
• Objectives of taxation
• Principles of taxation
• Tax classifications
• Tax rate structures
• Shifting and incidence of taxation
• Tax evasion, avoidance and delinquency
Introduction
Government has played an important role in the socio economic
development of society.
Social development may be in the form of raising the level of living
and social welfare in the form of providing social amenities to the
people.
Social amenities are in the form of education, health and sanitation,
utilities like electric supply, water supply etc, and recreation facilities.
The process of socio-economic development requiring huge
expenditure cannot be carried unless the government has the
perennial source of income.
Every government has two important sources of revenue.
These are:
– Tax sources, and
– Non-tax sources.
Definition of Taxation
What is a Tax?
Tax is one of the most important sources of revenue to every
government.
In the earlier days, payment of taxes was optional.
A choice was given to the people to pay the tax and to avail the
benefit of social amenities in the form of education, health and
sanitation, utilities and recreation facilities.
Every Government imposes two kinds of taxes:
(1) Direct taxes, and
(2) Indirect taxes
A tax, in the modern times, therefore is a compulsory levy and
those who are taxed have to pay the sums irrespective of
corresponding return of services or goods by the government.
Cont…
Objectives of Taxation
Initially, governments impose taxes for three basic purposes:
– to cover the cost of administration,
– maintaining law and order in the country and
– for defense.
But now government’s expenditure pattern changed and gives
service to the public more than these three basic purpose and it
restore social justice in the society by providing social services
such as:
– Public health,
– employment,
– pension,
– housing,
– sanitation and other public services.
Cont…
Therefore, governments need much amount of revenue than before.
To generate more revenue a government imposes taxes on various
types.
In general objective of taxations are:
– Raising revenue
– Removal of inequalities in income and wealth
– Ensuring economic stability
– Reduction in regional imbalances
– Capital accumulation
– Creation of employment opportunities
– Preventing harmful consumptions
– Beneficial diversion of resources
– Encouragement of exports
– Enhancement of standard of living
Characteristics of a Good Tax System
– Tax is a Compulsory Contribution
– The Assesses will be required to pay Tax if is due from him
– Taxes are levied by the Government
– Common Benefits to All
– No Direct Benefit
– Certain Taxes Levied for Specific Objectives
– Attitude of the Tax-Payers
– Good tax system should be in harmony with national
objectives
– Tax-system recognizes basic rights of tax-payers
Principles of Taxation
• A tax system (that is, the set of all taxes) for achieving certain
objectives chooses and adheres to certain principles which are
termed its characteristics.
• A good tax system therefore, is one of which designed on the
basis of an appropriate set of principles, such as equality and
certainty.
• Mostly, however, objectives of taxation conflict with each other
and a compromise is needed.
• The first set of such principles was enunciated by Adam smith
(which he called Canons(standards) of Taxation)
Canons of Taxation
The four canons of taxation as prescribed by Adam Smith are the
following:
• Canon of Equality
• Canon of Certainty
• Canon of Convenience
• Canon of Economy
• In addition to the above four canons given by Adam smith, the
following other canons have been advanced by Basable and
other economists.
• Canon of Productivity
• Canon of Elasticity
• Canon of Diversity
• Canon of Simplicity
• Canon of Expediency
Canon of Equality
Every one is subjects of every state ought to contribute towards
the support of the government, as nearly as possible, in
proportion of their respective abilities, that is, in proportion to
the reserve which they respectively enjoy under the protection of
the State.
It implies what the income which a person enjoys under the
protection of the State, should be taxed on the proportional rate
of taxation.
But modern economists do not agree with Adam Smith.
They advocate progressive taxation to observe the canon of
equality.
In other words, they advocate progression should be the basis
for imposing taxes.
Canon of Certainty
• This canon is meant to protect the tax payers from unnecessary
harassment by the ‘tax officials’.
• It implies that the tax-payer should be well informed about the
time, amount and the method of tax payment.
• According to Adam Smith, “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, ought all to be clear and plain to the contributor and to
every other person.”
• Adam Smith was also of the view that the government must also
be certain of the amount which it derives from a particular tax.
• Thus this canon is equally important both for the individual and
the state.
Canon of Convenience
• According to Adam Smith, “every tax ought to be so levied at
the time or in the manner in which it is most likely to be
convenient for the contributor to pay it.”
• In other words, taxes should be imposed in such a manner and at
the time which is most convenient for the tax-payer, i.e., the best
time for the collection of land revenue is the time of harvest.
• Similarly, taxes on rent of houses should be collected when it is
most convenient for the contributor to pay.
Canon of Economy
• This canon implies that the administrative cost of tax
collection should be minimum, i.e., the difference between the
money, which comes out of the pockets of people and that which
is deposited in the public treasury, should be as small as
possible.
• Administrative cost of tax collection should be minimum
because levying of a tax may require a great number of
officers, whose salaries may eat up the greater part of the
produce of the tax, and whose pre-requisites may impose another
additional tax upon the people.
• Hence, the administrative cost should be minimum.
Canon of Productivity
• The productivity of a tax may be observed in two ways.
• In the first place, a tax should yield a satisfactory amount for
the maintenance of a government.
• In other words, the tax should be such that it procures a
considerable amount of revenue for the expenditure of the
government,
• Secondly, the taxes should not obstruct and discourage
production in the short as well as in the long run.
Canon of Elasticity
The canon of elasticity implies that yields of taxes should be
increased or decreased according to the needs of the
government.
The government may need funds to face natural calamities and
other unforeseen contingencies.
It may need funds to finance a war or for development
purposes.
The government resources can be raised quickly only when the
system is elastic.
Canon of Diversity
• Implies that the tax system should be diverse in nature.
• In other words, in a tax system, there should be all types of
taxes so that everyone may be called upon to contribute
something towards the revenues of the state.
• Thus, the governments should adopt multiple tax system.
Canon of Simplicity
The canon of simplicity implies that a tax should easily be
understood by the tax-payer, i.e., its nature its aims, time, of
payment, method and basis of estimation should be easily
followed by each tax-payer.
In other words, the tax imposed on the tax-payers should be so
simple that they are able to guess easily the aim of its imposition
and they are not confronted with accounting, administrative or
any other difficulties.
Canon of Expediency
This canon implies that the possibilities of imposing a tax should
be taken into account from different angles, i.e. its reaction
upon the tax- payers.
Sometimes it is seen that tax may be desirable and may be
productive and may have most of the characteristics of a good
tax, yet the government may not find it expedient to impose it,
for example, progressive agricultural income tax, but it has not
been imposed.
So far in the manner it should have been imposed.
Effects of Taxation
Taxation these days is not used as means of raising revenues
only, but it is an important instrument for achieving socio-
economic objectives, such as:-
• Regulation of consumption and production,
• Controlling booms and depression,
• Promoting economic growth and removing inequalities of
income.
The economic effects of taxation may be good as well as bad.
Therefore, the government should not keep only the revenue
considerations in mind, but the economic effects of taxation
should also be considered.
Cont…
To put it in the words of Dalton, “The best system of taxation
from the economic point of view is that which has the best, or
the least bad economic effects.”
Effects of taxation can be analysed in terms of
• Production,
• Distribution and
• Stabilization.
Effects of Taxation on capacity to Work, Save and Invest
Capacity to Work:- Imposition of higher tax reduces the
purchasing power of the tax payer and his ability to obtain the
necessaries, comforts and luxuries of life.
Capacity to Save:- Ability to save is adversely affected by
taxation as taxes fall on income and savings depend on income.
• When income is reduced by taxation, savings automatically
decline.
Capacity to Invest:- When ability to save is adversely affected
by high taxes, ability to invest of those who take investment
decisions is automatically reduced.
Effects of Taxation on the will to Work, Save, and Invest
Effects on the Will to Work:- unduly high rates of income tax,
wealth tax and commodity taxes adversely affect the desire of
the people to work hard.
Effects on the Will to Save:- If a tax payee has limited income
and is hardly sufficient to meet his/her day to day requirements it
will be difficult for him to save anything.
Effects on the Will to Invest:- If savings are taxed, nothing will
be left with the people for investment purposes.
• To enhance the will of the people to invest, the government should
devise such a tax policy which provides tax incentives to those
who divert their savings towards investment.
Effects of Taxation on the Composition and Pattern of Production
The effects of taxation on the consumption and pattern of
production depend upon allocation of resources.
When higher taxes are imposed on some industries, resources
will shift from the high taxed industries to low taxed industries.
Likewise, when a tax rebate is offered, it will encourage
allocation of resources in favour of developing industries.
Similarly, there will be reallocation of resources from high taxed
regions to the low taxed regions.
High rate of tax on goods of harmful consumption has a
beneficial impact as the production of these goods will be
diverted to low-taxed essential goods.
Cont…
Taxes may thus change the pattern of production in an economy.
A high tax on the production of luxuries may improve the
production of necessaries.
Some taxes, however, have no effect on diversion of resources;
• Example:- taxes on windfall gains, high land values, monopoly
profits and non-differential taxes such as income-tax, etc have no
effect on consumption or pattern of production.
Effects of Taxation on Distribution
There are two aspects of an economy:
1. Income Generation
2. Income Distribution
Income generated in society if not distributed properly will
create inequality in the distribution of income and wealth.
It will give rise to the creation of two classes that is the class of
the rich and the class of the poor.
The gap between rich and poor will lead to class conflict which
may prove disastrous to the society.
Every government in the world tries to bridge this gap by
imposing higher taxes on the richer section of the society and the
proceeds realized from such taxes are distributed among the
poorer section of the society by way of providing social
amenities to them.
Cont…
• The effects of taxation on the distribution of income and wealth
among different sections of the society, however, depend upon two
factors:
– Nature of taxes and tax rates
– Kinds of taxes
Nature of taxes and tax rates
• By nature, taxation may be proportional, progressive or regressive.
• The nature of taxation also implies as how the burden of taxation is
distributed among different section of the community.
– Proportional:- if all the tax payers pay the same proportion of their income as
tax.
– Progressive:-if larger is the tax payers income, the greater is the
proportion that he/she pays as tax.
– Regressive:- if larger is the tax payee’s income, the smaller is the
proportion, which he pays as tax.
a) Effects of Regressive Taxation on Distribution
• If regressive taxation is followed, the inequalities may increase in
the distribution of income and wealth, as the burden of taxation
will fall more heavily on the poor than on the rich.
• A toll-tax is regressive as the amount of the tax is the same for the
rich and the poor, while the utility of money, which is paid in tax, is
greater for the poor than the rich.
• A regressive tax thus tends to widen the gap of inequality.
b) Effects of Proportional Taxation on Distribution
• Under proportional taxation, inequalities would continue as
before, if the income remains the same.
• However, if the income changes in unequal proportions, the
inequalities in income will increase.
• For instance if A’s income is $620 and B’s income is $1,500 and
both are taxed at the rate of 10% the net income of A and B, after
tax payment, would be $618 and $940 respectively.
• The burden of taxation falls heavily on A than on B. Hence,
the burden of taxation is higher on the poor than on the rich.
c) Effects of Progressive Taxation on Distribution
• Under the progressive system of taxation, inequalities would be
reduced, because a higher proportion of the income and wealth of the
rich would be taken away by taxes than that of poor.
• The higher the income of a person, the greater would be his ability to
pay taxes and vice-versa.
• People who get unearned income should be taxed at higher rate than
poor because of their greater capacity to pay taxes.
• The progressive tax system may be designed in such a way that it may
not have adverse effects on production.
• In other words, tax system should be progressive to the highest
income group, the middle income groups should be subjected to
lower tax rates and the low income groups should be exempted
from taxation.
Cont…
• While fixing the rates of taxes, progression should be kept in mind.
• Higher taxes should be imposed on the richer section of society and
revenue realized from the rich should be utilized for the benefit of
the poorer section of the society by way of providing social
amenities to them.
• In other words taxes should be progressive because sharper the
progression, greater is the tendency to reduce inequalities.
Kinds of Taxes
• Indirect Taxes and Distribution
– The burden of indirect taxes, like taxes on commodities is regressive in
nature.
– The commodities on which indirect taxes are imposed are widely
consumed by the poor and they have to spend larger proportion of their
income on such goods than rich.
– That is, propensity to consume is higher for the poor than that of rich.
– Hence, the burden of indirect taxes, like the tax on foodstuff, raw
tobacco, cheap alcohol, etc., falls more heavily upon the poor than upon
the rich.
– However, the indirect taxes may be made progressive if the necessities
are exempted from taxation and luxuries are subjected to higher rates of
taxation so that the tax rates would be higher for the high priced goods.
– Therefore, indirect or commodity taxes in general are and regressive
nature. Thus, inequalities of income and wealth can not reduced by these
taxes.
Cont…
• Direct Taxes and Distribution
– To bring about equitable distribution of income and
wealth, all taxes which fall heavily or exclusively upon the
richer section of society can have favourable distribution
effects.
– All direct taxes which are based on the principle of
progression and ability to pay may have desire distributional
effects.
Effects of Taxation on Stabilization
• Economic stability may be judged by the behaviour of prices.
• This does not mean that prices should remain static.
• Conversely there should be a normal rise in price because a normal
rise in price is a sign of healthy economy.
• Problem, however, arises whenever there are price fluctuations.
• These price fluctuations may be known as abnormal economic
situations prevailing in the country.
• Economic stability also implies stability in the economic activity,
output and employment.
• There may be two abnormal economic situations:
• Inflation
• Deflation
Classification and choice of 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/she has to pay it and he/she 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.
• The direct taxes levied in Ethiopia take the form of taxes on
income and property.
Cont…
• 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, s/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.
Differences between Direct and Indirect Taxes
Shiftability of the Burden of Tax
Principle of Ability to Pay
Measurement of Taxable Capacity
Principle of Certainty
Convenience:- indirect taxes are more convenient
Civic Consciousness
Nature of Taxation: direct tax Progressive in nature
Removal of Disparity in Income and Wealth
Examples:
– direct taxes are income tax, wealth tax, gift tax, estate duty etc.
– indirect taxes are customs duty, excise duty, sales tax, service
tax etc.
Tax Rate Structures
On the basis of volume :- Single Vs Multiple Tax System
• Single tax:- It refers to the system in which the taxes are levied only
on the ‘item’ or ‘head of tax’. There is only one kind of tax, which
constitutes the source of public revenue.
• Multiple taxes: - It refers to the system in which the taxes are levied
on various items.
• On the basis of method
• Proportional taxes: - A system that taxes everyone at the same rate, regardless of
his or her income brackets. It is amount increase with the increase in income and
decreases with the decrease in income.
• Progressive taxes: - It is the tax which varies with the change in income of the
different individuals. The rate of tax is gradually higher for the increasing incomes
and lower for the decreasing incomes.
• Regressive tax: - Under it, the larger the income of tax-payer, the smaller is the
proportion that he contributes. A schedule of regressive tax rate is one in which the
rate of taxation decreases as the base increases.
Shifting and Incidence of Taxation
Meaning of Impact
– The impact of a tax is on the person who pays the money in the first instance.
– In other words, the man who pays the tax to the government in the first
instance bears its impact.
– The impact of a tax is, therefore, the immediate result of the imposition of a
tax on the person who pays in the first instance.
– It corresponds to what is often, but erroneously called the “original incidence” or
the “primary incidence” of a tax.
– The impact of tax as such, denotes the act of imposing.
– Impact of a tax, therefore, refers to the immediate burden of the tax and not to
the ultimate burden of the tax.
• Meaning of Shifting
– Shifting of a tax refers to the process by which the money burden of a tax is
transferred from one person to another.
– Whenever there is shifting of taxation, the tax may be shifted forward or
backward.
Cont…
Forward Shifting
A tax is said to have shifted forward if price of the commodity which
constitutes the medium for shifting the money burden of tax is
increased.
Under complete shifting; the price will be higher by the full amount of
tax.
In forward shifting of commodity taxation, the money burden of a
tax is transferred from the producer or seller to the consumer or
buyer when the tax is initially imposed on the producer.
Thus, forward shifting is possible with regard to all indirect taxes
which are generally passed partly or shortly to the buyer of goods.
Cont…
Backward Shifting
Backward shifting refers to the process by which the money burden
of commodity tax is shifted from the consumer or buyer to the
producer or seller, if the tax is initially imposed on the consumer.
In other words, it is a typical situation in which the tax burden is
shifted backward, that is, from the buyer of good to the seller of
goods under the following conditions:
Backward shifting is applicable in the case of property tax only.
Backward shifting is effected when the buyer of property shifts the
entire tax burden to the seller of property.
Cont…
• Meaning of Incidence
• Incidence of a tax refers to the money burden of a tax on the person
who ultimately bears it.
• In other words, when the money burden of a tax finally settles or
comes to rest on the ultimate taxpayer, is called the incidence of a tax.
• The incidence of tax remains upon that person who cannot shift its
burden to any other person, i.e., who ultimately bears it.
• Thus, there are three distinct conceptions- the impact, the shifting and
the incidence of a tax, which correspond respectively to the
imposition, the transfer, and the settling or coming to rest of the tax.
• The impact is the initial phenomena, the shifting is the intermediate
process, and the incidence is the result.
Distinction between Impact and Incidence
• The impact refers to the initial burden of tax while incidence refers
to the ultimate burden of the tax.
• Impact is felt by the tax payer at the point of imposition of the tax,
while the incidence is felt by the tax payer at the point of settlement
or rest of the tax.
• The impact of the tax is felt by the person from whom the tax is
collected, while the incidence is felt by the person who actually bears
the burden of the tax.
• Impact of a tax can be shifted, but the incidence of a tax cannot be
shifted.
• Thus, impact of the tax is always on the person who is responsible by
law to pay the tax amount to the Government treasury, in the first
instance.
• Incidence may fall on somebody from whom the manufacturer
ultimately recovers the amount, provided he shifts the tax.
Factors Influencing Shifting and Incidence
• Elasticity of Demand
• Elasticity of Supply
• Market Conditions
• Magnitude of Tax
• Coverage of Tax
• Substitutability of Product
• Public Policy and Tax Laws
Tax Evasion, Avoidance and Delinquency
• Tax Evasion
• Tax evasion is the general term for efforts by individuals, firms, and
other entities to evade the payment of taxes by breaking the law.
• 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, and falsification of
accounts including downright 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.
1. Suppression of income, and
2. Inflation of expenditure.
Cont…
• Examples for Tax Evasion:
• A trader makes a sale for Birr.20, 000 and does not account it, in
his books under sales. He is evading tax.
• 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.
• Under-invoicing of sales and inflation of purchases.
• 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.
Causes of tax evasion
• High rates of taxation
• Complexity of tax laws
• Inadequate Information as to Sources of Tax Revenue
• Lack of publicity
• Moral and Psychological factors
• officers of the department should be men of integrity
Deduction
No Salary Range (ETB) Tax Rate
(ETB)
1. 0 - 600 Non-Taxable -
2. 601-1,650 10% 60
3. 1,651 - 3,200 15% 142.50
4. 3,201 - 5,250 20% 302.50
5. 5,251 - 7,800 25% 565
6. 7,801 - 10,900 30% 955
7. Over 10,900 35% 1,500
Cont…
Example: Ato Bultume is an employee of Oromia International
Bank and his monthly basic salary is Br 4,700. In addition he is
getting Br 100 monthly taxable house allowance.
Required: Determine his taxable income and income tax
liability.
Solution:
Taxable income = Br 4,700 + Br 100 = Br 4,800
Tax liability = (Taxable income X Tax rate for the Bracket) –
Deduction
= (4,800 X 20%) – 302.5 = Br 657.5
B. Rental Income Tax
• Income tax proclamation 286/2002 and 979/2016 classifies
rental income as Schedule “B” income and the tax is levied and
collected on income from rent of building.
• The tax collected on annual basis and the tax period is the
Ethiopian fiscal year.
• Income includes rent of building and rent of furniture and
equipment if the building is fully furnished.
• Taxable income from Schedule “B” income is determined by
subtracting the allowable deductions from gross income.
• Allowable deductions include the following:
A. Those who do not maintain books and records:
• Tax on land and building 20% of gross income as allowance for
repairs, maintenance and depreciation
Cont…
B) Those who maintain books and records:
– Tax on land and building
– Cost of lease of land
– Repairs and maintenance expenses actually incurred
– Depreciation on building (and furniture and equipment if fully
furnished) per income tax proclamation
– Interest on loan if any
– Insurance premium paid on insurance of building
Tax Rate
The following is the tax rate applicable for determining tax from
Schedule “B” income.
i. On income of bodies or corporations: 30% flat rate
ii. On income of persons according to schedule B (Here under):
Cont…
• The Ethiopian Rental Income tax Rate (Personal)