CHAPTER 2 HISTORY AND ADMINISTRATION OF TAX – II

After studying this chapter you should be able to understand the following: ♦ ♦ ♦ ♦ ♦ ♦ ♦ ♦ ♦ ♦ The Meaning of Tax Policy Properties of a Sound National Tax Policy Taxpayers’ Rights The Tax Policy Unit – Within the Ministry of Finance and National Planning National Tax Objectives The Laffer Curve – Optimal Taxation The Costs of Taxation International Tax Competition The Link between Taxation and Foreign Direct Investment National Tax Design – Selecting an appropriate Tax system

2.1 - BASIC ASPECTS OF TAX POLICY FORMULATION

Why do we have taxes? The simple answer is that, until someone comes up with a better idea, taxation will remain the only practical means of raising the revenue to finance government spending on the goods and services that most of us demand. Setting up an efficient and fair tax system is, however, far from simple, particularly for developing Countries that want to become integrated in the international economy. Thus an ideal tax system in Zambia should be able to raise revenue for the GRZ without over stepping on people’s feet. This is more the reason why the GRZ and the Zambia Revenue Authority ought to pursue sound tax policies. Taxation can reduce poverty and inequality in two ways: by increasing the fairness of the tax system and improving its efficiency in raising revenue for financing redistribution. Some trade-offs between the two objectives may require careful review. However, it is widely argued that the revenue-gathering role of the tax system deserves more attention, as it supports the restructuring of spending which will most likely be the more important instrument for effecting redistribution. An important constraint to both objectives is the need to minimize any negative effect on allocative efficiency or investment. In the long run, growth of the tax base is the key to sustainable financing.

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Why it is difficult to design an Efficient Tax system in Zambia. ♦ Most workers in Zambia are typically employed in agriculture or in small, informal enterprises. As they are seldom paid a regular, fixed wage, their earnings fluctuate, and many are paid in cash, "off the books." The base for an income tax is therefore hard to calculate. Nor do workers spend their earnings in large stores that keep accurate records of sales and inventories. As a result, modern means of raising revenue, such as income taxes and consumer taxes, play a diminished role in enhancing Tax revenues. ♦ It is difficult to create an efficient tax administration without a well-educated and well-trained staff and when money is lacking to pay good wages to tax Inspectors and to fully computerize the operations of the Zambia Revenue Authority. Taxpayers have limited ability to keep accounts. As a result, GRZ often takes the path of least resistance, developing tax systems that allow them to exploit whatever options are available rather than establishing a rational, modern, and efficient tax system. ♦ Because of the informal structure of the economy in Zambia and because of financial limitations, statistical and tax offices have difficulty in generating reliable statistics. This lack of data prevents policymakers from assessing the potential impact of major changes to the tax system. As a result, marginal changes are often preferred over major structural changes, even when the latter are clearly preferable. This perpetuates inefficient tax structures. ♦ Income tends to be unevenly distributed. Although raising high tax revenues in this situation ideally calls for the rich to be taxed more heavily than the poor, the economic and political power of rich taxpayers often allows them to prevent fiscal reforms that would increase their tax burdens. This explains in part why many developing countries have not fully exploited personal income and property taxes and why their tax systems rarely achieve satisfactory progressivity - where the rich pay proportionately more taxes.

2.2- THE MEANING OF TAX POLICY FISCAL POLICY Our study of Tax policy should begin by first understanding the broad discipline of Fiscal policy because Tax policy is a sub-set of Fiscal Policy. Fiscal Policy is the use of the government budget to affect an economy. When the government decides on the taxes that it collects, the transfer payments it gives out, or the goods and services that it purchases, it is engaging in fiscal policy. The primary economic impact of any change in the government budget is felt by particular groups—a tax cut for families with children, for example, raises the disposable income of such families. Discussions of fiscal policy, however, usually focus on the effect of changes in the government budget on the overall economy—on such macroeconomic variables as Gross National Product and unemployment and inflation.

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The state of fiscal policy is usually summarized by looking at the difference between what the government pays out and what it takes in—that is, the government deficit. Fiscal policy is said to be tight or contractionary when revenue is higher than spending (the government budget is in surplus) and loose or expansionary when spending is higher than revenue (the budget is in deficit). Often the focus is not on the level of the deficit, but on the change in the deficit. Thus, a reduction of the deficit from K200 billion to K100 billion may be said to be contractionary fiscal policy, even though the budget is still in deficit. The most immediate impact of fiscal policy is to change the aggregate demand for goods and services. A fiscal expansion, for example, raises aggregate demand through one of two channels. First, if the government increases purchases but keeps taxes the same, it increases demand directly. Second, if the government cuts taxes or increases transfer payments, people's disposable income rises, and they will spend more on consumption. This rise in consumption will, in turn, raise aggregate demand. Fiscal policy also changes the composition of aggregate demand. When the government runs a deficit, it meets some of its expenses by issuing bonds. In doing so, it competes with private borrowers for money lent by savers, raising interest rates and "crowding out" some private investment. Thus, expansionary fiscal policy reduces the fraction of output that is used for private investment. In an open economy, fiscal policy also affects the exchange rate and the trade balance. In the case of a fiscal expansion, the rise in interest rates due to government borrowing attracts foreign capital. Foreigners bid up the price of the Kwacha in order to get more of them to invest, causing an exchange rate appreciation. This appreciation makes imported goods cheaper in the Republic and exports more expensive abroad, leading to a decline of the trade balance. Foreigners sell more to the Country than they buy from it, and in return acquire ownership of assets in the Country. Fiscal policy is an important tool for managing the economy because of its ability to affect the total amount of output produced—that is, gross domestic product. The first impact of a fiscal expansion is to raise the demand for goods and services. This greater demand leads to increases in both output and prices. The degree to which higher demand increases output and prices depends, in turn, on the state of the business cycle. If the economy is in recession, with unused productive capacity and unemployed workers, then increases in demand will lead mostly to more output without changing the price level. If the economy is at full employment, by contrast, a fiscal expansion will have more effect on prices and less impact on total output. This ability of fiscal policy to affect output by affecting aggregate demand makes it a potential tool for economic stabilization. In a recession the government can run an expansionary fiscal policy, thus helping to restore output to its normal level and to put unemployed workers back to work. During a boom, when inflation is perceived to be a greater problem than unemployment, the government can run a budget surplus, helping to slow down the economy. Such a countercyclical policy would lead to a budget that was balanced on average.

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then Ricardian Equivalence will not hold. on which the government spends more during recessions (when the unemployment rate is high). labour. the government can run surpluses or deficits in order to redistribute income between different generations. since changes in private saving will offset changes in government saving. the amount of taxes collected is higher during a boom than during a recession. 33 T5 – Taxation Amendment Act 2006/07 .One form of countercyclical fiscal policy is known as automatic stabilizers. Some economists have argued that this effect of fiscal policy on future taxes will lead consumers to change their saving. An attempt to keep output above its natural rate by means of aggregate demand policies will lead only to ever-accelerating inflation. Because the government will have to pay interest on this debt (or repay it) in future years. the argument goes: ‘People will simply save the value of the tax cut they receive now in order to pay those future taxes. will lead to higher output in the future. but by the supply of factors of production (capital. Fiscal policy also changes the burden of future taxes. for example. for example). holds that tax cuts will have no effect on national saving. known as Ricardian Equivalence. a tax cut will lower national saving and raise aggregate demand. Similarly. Expansionary fiscal policy will lead to higher output today but will lower the natural rate of output below what it would have been in the future. fiscal policy can change the natural rate. Unemployment insurance. it adds to its stock of debt. But if consumers decide to spend some of the extra disposable income they receive from a tax cut (because they are myopic about future tax payments. Similarly. though dampening the level of output in the short run. Just as taxes can be used to redistribute income between different classes. expansionary fiscal policy today imposes an additional burden on future taxpayers. because taxes are roughly proportional to wages and profits. around which business cycles and macroeconomic policies can cause only temporary fluctuations. Whether for good or for ill. however. These factors of production determine a "natural rate" of output. and ironically. That is because over the long run the level of output is determined not by demand. Recognizing that a tax cut today means higher taxes in the future. Unemployment insurance serves this function even if the Central government does not extend the duration of benefits. When the government runs an expansionary fiscal policy. These are programs that automatically expand fiscal policy during recessions and contract it during booms. is an example of an automatic stabilizer. the long-run effects of fiscal policy tend to be the opposite of the short-run effects.’ The extreme of this argument. contractionary fiscal policy. and technology). the tax system also acts as an automatic stabilizer. In addition to moving output in the short run. eventually shows up only in higher prices and does not increase output at all. fiscal policy's ability to affect the level of output via aggregate demand wears off over time. The fact that output returns to its natural rate in the long run is not the end of the story. Thus. Higher aggregate demand due to a fiscal stimulus.

Tax policy touches on the most fundamental public policy issues that we face in Zambia. It requires drawing on three academic disciplines: economics. Tax policy also reflects political factors. Tax policy is therefore an integral part. because tax law is made by elected officials and their designates. 2. Also important is an assessment of the 34 T5 – Taxation Amendment Act 2006/07 . and philosophy. Particular attention must be paid to the effects of exemption from tax of income from already-high wealth concentrations. These factors reduce the tax policy options available to tax administrators. but of government policy more generally. interchangeable. and often practically. and tax exemptions. They take resources ("taxation"). In many Countries. private sector behaviour. political science. They also influence the after-tax distribution of income through.3 – PROPERTIES OF A SOUND NATIONAL TAX POLICY Tax policy is not just about economics. increased economic growth has increased the disparity between the rich and the poor.TAX POLICY Tax policy may be defined as a government program for setting taxes. not just of fiscal policy. including concerns about fairness. the soundness of our National Tax policy may be analyzed by focusing on three aspects: ♦ Equity — Progressiveness of the tax system. often unreviewably. as influenced by the tax structure. Taxes influence the before-tax distribution of income by changing economic incentives. for example. Tax policy choices are influenced by a country’s economic structure and its administrative capacity. Therefore. or what it should do with respect to taxation from one perspective or another. Taxation is one of three main things that governments do. In other words it is the way a Country chooses to allocate tax burdens among its people. and wealth distribution in the Country? These are some of the questions answered through Tax policy. it is always constrained by what it can do. to illuminate policies' likely effects. to provide a normative basis for deciding what rules are best. This collision of disciplines takes place in a complex legal and administrative setting where wide-ranging rules must be devised and then will be interpreted in the field. progressive income taxation. use resources ("spending"). rate structure. Regardless of what Zambia may want to do with its tax system. The close link between conglomerates and financial houses is relevant in this regard because it promotes opportunities for tax evasion. These three forms of government activity are conceptually. and tell people how to use resources ("regulation"). Who should pay for government? How does the government want to affect economic production. is the main issue. by millions of Zambian Citizens.

a main issue is the link between high tax rates and conversion of current income into non taxable wealth instruments. it is difficult for them to predict the impact of major changes to the tax system. ♦ Allocative efficiency — Trade-offs between revenue objectives and allocative efficiency effects of trade taxes must constitute a prime area for tax policy research in Zambia. What alternative non redistributive taxes exist and what is their potential for filling the revenue gaps? Sectoral neutrality of the tax system is another issue that may be raised in relation to minimizing distortions in allocative efficiency. It is understandably clear that most Developing country governments face significant challenges when deciding the appropriate tax policy. A capital gains tax will increase yield from income tax as it reduces evasion. and a search for possible new taxes. aimed at increasing the outward orientation of the industrial sector. Perhaps the most important concern raised by a lot of Zambia tax experts is that taxation should not discourage investment by overburdening sources of investible funds. The effects of tax rates and exemptions on the level and structure of investment should be investigated. Where governments lack reliable statistics on the structure of the economy. Similarly. Main concerns should be reduction of incentives for evasion. A National Tax policy which falls short of this is far from being adequate and needs to be followed up by a sequence of Tax Reforms. and many other factors. The best system for any country should be determined taking into account its economic structure. A careful assessment of revenue potential and collection costs must be made. It is vital to note that no single tax structure can possibly meet the requirements of every Country. ♦ Revenue efficiency — Research into the possibility of widening the tax net and raising tax yield through improved compliance forms the core for required research. In such Countries ‘Tax Policy is 35 T5 – Taxation Amendment Act 2006/07 . one way to get an idea of what matters in tax policy is to look at what taxes exist around the world. In summary a Country’s Tax Policy is sound if it: ♦ ♦ ♦ ♦ Is understandable Is predictable Treats all those in similar circumstances in a similar way. Nonetheless. compressing the range of exemptions.double-tax relief on certain categories of income and a review of various tax treaties governing double-tax relief for nonresident business. minimum corporate tax will not only improve compliance but also penalize inefficient firms. Two possible new taxes may be introduced in Zambia. its public service needs. its capacity to administer taxes. and Is relatively cheap and easy to administer. including tariff reforms. They assume particular importance in light of proposals for trade policy reform. With respect to tax evasion. it is hard for them to estimate the size or value of their potential revenue base. These are: capital gains tax and minimum corporate tax.

it is important that the policy drivers give thought to the Rights of Taxpayers. but also by the fact that successful functioning of a tax system implies necessary agreement and sense of fairness on the part of taxpayers with respect to the settlement of their tax obligations.4 – TAX PAYERS’ RIGHTS In coming up with a Sound Tax Policy which stands a chance to be accepted by the Zambian Citizens. ♦ Right of appeal and ♦ Right of data confidentiality and privacy. 2. After all taxpayers are the very fulcrum of all tax policy!! Regulation of the relationship between the state as an active tax player. the manner of lodging complaints and their comparison with the rights of taxpayers in the countries of developed market economies. Although the powers of tax authorities and the recognized rights of taxpayers are conditioned by the main character and method of functioning of the tax system in individual countries. there are some fundamental. on the other side. from the aspects of their protection. their fiscal and legal position. common rights for all taxpayers These are: ♦ Right to information. and taxpayers. As in other spheres of life where obligations are conditioned by certain rights. modern and efficient tax systems. the general principle of tax payment is individualized through the determination of legal basis and size of tax debt. ♦ Rights to security of taxpayers. That is why a question raises which are the basic rights of taxpayers in our tax system. the failure or delay of which would entail suitable penalties. but also the position of taxpayers in the legal system. In appropriate legal procedure. In that way. tax payment as a public duty is conditioned by the rights of taxpayers. ♦ Right of consistent application of legal provisions. The necessity of regulation of rights of taxpayers is not only conditioned by the required comparability of our tax system with the systems of Countries with market economies. the obligation of the ZRA towards the taxpayers. not only economic relations are defined. enabling the exercise of tax rights and payment of tax obligation. ♦ Right to fair and equal position of taxpayers.the art of the possible rather than the pursuit of the optimal’ since governments tend to exploit whatever options are available rather than establishing rational. 36 T5 – Taxation Amendment Act 2006/07 . as passive players. on one side. results in the establishment of a special public and legal relationship of a fiscal nature. in other words.

Right to Security of Taxpayers The right to security of taxpayers relates to changes in laws and their interpretation that cannot have a retroactive character. In addition. Right to Information The observance of tax laws implies the information of taxpayers on the functioning of tax system. 37 T5 – Taxation Amendment Act 2006/07 . In that. 000 for individuals and 2. shows the biggest divergence. deductions and repayment of surplus payments. This type of penalty structure ensures that two different taxpayers are treated differently for the same offense. taxpayers enjoy these rights. This is also regulated by the Constitution of the Republic. Right to Fair and Equal Position of Taxpayers The meaning of this right is that taxpayers must be equally treated in equal circumstances. In our legal practice.000 Penalty Units valued at K180. 000 for Companies on a monthly basis. You will note in Chapter 4 that the penalty for late submission of a Tax Return is 1. manner of determination of tax obligations as well as the time and place of their payment. but also of some incorporated elements with respect to the position of various taxpayers. In relation to the accomplishment of this right in the countries with developed economies. 4. our tax legislation. The manner of penalty imposition in Zambia raises certain dilemmas. the different treatment of taxpayers for the same kind of violation is an acceptable. as well as greater consistency in their application. and primarily the practice. This right is realized through information manuals. the tax administration has an obligation to make the taxpayers aware of their rights and provide appropriate technical assistance in the process of taxation.000 Penalty Units valued at K360. verbal and telephone explanations and giving appropriate opinions and information. First of all. This right includes the assistance offered by the ZRA in the fulfillment of tax obligation and in approving legally identified tax reliefs. this implies the right of a taxpayer to be listened to and given needed assistance from relevant tax authorities. Right of Consistent Application of Legal Provisions Legal provisions governing this right in practice for a taxpayer provide that the taxpayer need not pay a tax amount higher than prescribed by the law. 1. The right of taxpayers to be informed enables them to be timely and conveniently informed about the current changes regarding tax obligations or the use of their rights. 2. 3.The legislation governing tax procedures in our country basically contains all of these rights. For Instance. but the issue of their explicit definition requires appropriate amendments in the taxing regulations. it is the result of the penalty policy.

♦ Design. although it is true that there is no system or policy that cannot be even better. The right to privacy implies the application of strict rules in connection with unauthorized access of taxing authorities in the taxpayer's office. it is difficult to find such solutions that would reconcile the interests of the state and the interests of taxpayer. Considering the importance of the relationship between the tax administration and taxpayers. but are at the same time accessible to the state authorities for their needs. ranging from the prescribed fee access with the consent of the taxpayer only or with a warrant if there is a doubt for tax evasion. these data can be used. However. which entails rigorous penalties. There are significant differences in individual countries with respect to this right. Basically. on one side. increasingly more attention is devoted to its improvement. 2. it means that no information that is important for a taxpayer may be used in other purposes than for taxing. This actually means that.5. Also. in most countries. Right of Appeal The protection of taxpayers includes their right to appeal against the resolutions of tax authorities and then also the resolutions of the Revenue Appeals Tribunal and High Court. are in most Countries available to tax authorities that are legally authorized to use them. 6.e. organize and direct a wide range of studies on taxation issues in order to provide the data required for the formulation of taxation policy. However. the same system and same measures shall always be interpreted in a different manner by active and passive tax subjects. ♦ Advise the Minister of Finance and National Planning on tax policy issues and taxation legislation. the data related to the banking operations of taxpayers that are also protected by law and are kept confidential.5 – THE TAX POLICY UNIT This a Unit at the Ministry of Finance and National Planning charged with the responsibility to handle Tax Affairs. relief and exemptions under the relevant tax laws will be considered in respect of Investors into the Zambian Economy. Right of Data Confidentiality and Privacy The right to data confidentiality and privacy for a taxpayer represents the protection from possible abuses by tax administration. ♦ Recommend parameters (policy framework) within which applications for incentives. which results in increased tax revenues and reduced number of tax offences. concessions. 38 T5 – Taxation Amendment Act 2006/07 . the confidentiality of taxing data is protected from individual abuse. The main functions of the Taxation Policy Unit are to: ♦ Develop and propose taxation policy for the Country. under certain safeguards and for the purposes of social character or can be forwarded to foreign tax authorities on the basis of covenants foreseeing such exchange. i.

♦ Monitor developments in international trade relationships to ensure that taxation policy is consistent with the obligations of the Republic of Zambia. The Tax Policy Unit is complemented by The Economics and Policy Section of the Research and Business Development Unit at the Zambia Revenue Authority Head Office which is charged with the responsibility of undertaking research. ♦ Participate in the development of national policies intended to facilitate investment and trade. The main objective of the Unit is to undertake high quality research and analysis that will provide a basis for the Executive Management to make informed policy decisions for reviewing and strengthening strategies for enhancing efficiency and maximizing revenue collection. ♦ Represent the Ministry of Finance and the Government of Zambia at negotiations of Trade Treaties and Agreements to ensure that the revenue is safeguarded and agreements reached do not conflict with national tax policies. The revenue analysis report forms part of the financial report. 39 T5 – Taxation Amendment Act 2006/07 . ♦ Consolidate the Zambia Revenue Authority Annual Report and Action Plans on behalf of divisions/departments. preparing revenue analysis and providing policy advice to the ZRA Management. ♦ Keep and provide a timely statistical data bank of the revenue statistics and macroeconomic indicators. ♦ Undertake trend analysis of the revenue collection based on fiscal and economic parameters. ♦ Develop and maintain Economic Tax Models such as Individual tax Model. ♦ Prepare Working papers and reports on specific areas of interest commissioned by divisions/departments. The key responsibilities of the Unit are to: ♦ Participate in initiation and execution in a diverse portfolio of research projects/papers relating to tax policy based on economic parameters. ♦ Assist in the formulation of both direct and indirect taxation policies required to honour obligations under various Treaties and Agreements such as WTO Agreements. economic impacts and distributional consequences of changes in tax policy. Indirect tax Model and Company tax Model.♦ Analyse the revenue effects.

There is widespread community support for the idea that individuals in similar circumstances should be taxed in similar ways (referred to as horizontal equity). or to taxation administration. is a basic criterion for community acceptance of the tax system. This concept implies that business income earned in similar circumstances should be taxed in similar ways. the business tax system should be neutral in its impacts and thus not be a consideration in business decision making. Transitional and administrative arrangements under the law must also be equitable. This means that. and ♦ Promoting simplification and certainty. efficient allocation of risk. all 40 T5 – Taxation Amendment Act 2006/07 . the business tax system should interfere to the least possible extent with. and indeed should promote. Any decision to trade off one objective against another should be taken explicitly. The three national taxation objectives are interdependent and must be pursued jointly. In cases where existing market forces and institutional structures do not produce an optimal outcome. Proposed changes to tax law.6 – NATIONAL TAX OBJECTIVES Consistent with the function of revenue-raising.2. It is also accepted that taxation should be based on ability to pay and that those with a greater capacity to pay should pay relatively more tax (referred to as vertical equity). Optimizing economic growth In raising revenue for the government. Promoting equity Equity. the best use of existing national resources. the tax system may sometimes be the best instrument to correct the deficiency. and long-term economic growth. In such instances the course which. In all such cases it must be established that changes to the tax system will be likely to increase economic growth. Poorly designed tax systems can inhibit economic growth by distorting business decisions. after consideration of the anticipated advantages and disadvantages of the various options. delivers the best social outcome should be adopted. Ideally. or fairness. on balance. should take account of all three. The concept of equitable taxation is usually directed at the way in which individuals are taxed but this also has implications for the business tax system. The concept of equity in the business tax system relates principally to horizontal equity. in principle. three major objectives guide the development of the business taxation system: ♦ Optimizing economic growth ♦ Promoting equity.

In some countries. the income of the sole proprietor or the partners is received directly by individuals and is subject to considerations of both horizontal and vertical equity. Vertical equity requires “appropriate” differences among taxpayers in different economic circumstances. can effectively provide for equal taxation for those in equal positions. and derivative. however. In addition. To others. the direct taxation of income from investments by individuals. Unfortunately. one could design a tax system that imposes a head tax on each individual over the age of 18 years old. fairness could require that all individuals pay the same amount of tax. much disagreement exists about the usefulness of the concept of vertical equity and about what constitutes appropriate differences in treatment. Fairness could also require all taxpayers to pay the same rate of tax on their income. an income tax can completely satisfy horizontal equity requirements only if we assume individuals have identical tastes and a single type of ability or income. Secondly. For apportioning tax liability. the notion of one tax rate that fits all strikes many as an equitable manner of determining tax liability. While most flat rate proposals provide for a high threshold (zero rate bracket) before the imposition of the flat rate. Although the progressive rate structure may rest on a shaky theoretical foundation. Similarly. What is fair? What is considered equitable or fair by one person may differ from the conceptions held by others. Once we allow preferences to vary and provide for different types of ability or income. Those who have the same ability to pay should bear the same tax liability. To some. then only a tax based on an individual’s ability to earn income. fairness requires those taxpayers with higher income to pay a higher percentage of their income in tax. the taxation of distributions by entities in the hands of individuals and the way in which this interacts with taxation applied at the entity level. Consider several possible conceptions of fairness. Many find a basic attraction to assessing tax 41 T5 – Taxation Amendment Act 2006/07 .entities carrying on business activities should be taxed in a similar manner. the “flat tax” or “single rate tax” rhetoric enjoys great popularity. The concept of horizontal equity also may not be useful unless we can determine which differences are important and why these differences justify different tax treatment. such as one year. First. The concept of vertical equity is relevant to the business tax system in two ways. tax scholars have defined fairness in terms of horizontal and vertical equity. Similarly. The concept of horizontal equity has been challenged as being incomplete. rather than actual earnings. not helpful. both concepts may have limited usefulness in tax policy debates. where business is carried on by a sole proprietor or a partnership. the concept of horizontal equity may be incomplete to the extent it focuses only on a short time period. Horizontal equity requires those in similar circumstances to pay the same amount of taxes. it has been the most common income tax rate structure. or fails to consider the impact of all taxes or ignores the provision of government services or other benefits. On the surface. Traditionally. both concepts have great intuitive appeal. Thus. it makes good sense for there to be appropriate differences for taxpayers in different situations. As explained above. For example. horizontal equity often embraces some notion of ability or capacity to pay. Thus.

if we want a society that will continue to grow and prosper. 42 T5 – Taxation Amendment Act 2006/07 . business. consumption is what they take away from the pot. Questions may also be raised about the relative fairness of consumption taxes versus income taxes. There are several. the business tax system will always contain complex provisions. Promoting simplification and certainty Complexity is one consequence of continually building the business tax system upon a foundation deficient in policy design principle. it may be better to use consumption as the base for taxation rather than income. Because of the inherent complexity in many business transactions. key agencies and the ZRA Board of Directors. policymakers and other stakeholders. as well as excessively specialized provisions which lack general application and adaptability. Its structural dimension is reflected in unintended or inconsistent statutory interactions.on the basis of “ability to pay” with the result that the rich are better able to contribute to the financing of government operations. Complexities in administrative arrangements add to business (and government) costs. Simplification of business tax law and its administration will be an ongoing task. one which will require a sustained commitment from government. A separate issue. Complexity has a technical dimension but is more than a matter of statutory volume or opaque language. tax administrators. A second approach considers consumption as a better measure of a household’s ability to pay. One approach takes a societal view. the judiciary. we are better off taxing consumption rather than income. Because of the greater variations in income over a person’s or household’s lifetime. Complexity also has a compliance dimension for taxpayers. Consumption tax proponents question whether any income tax system can be fair. The objective of simplification should be applied in two ways. such additional complexity in the tax law should be justified by the improvement in equity or economic growth that may be achieved. Such structural complexity fuels a dynamic process of exploitation and anti-avoidance response that generates escalating complexity. strands to their positions. is that of administrative complexity. and do little to promote voluntary compliance. Therefore. Complexity should be kept to a minimum by the adoption of a principles-based approach to policy development and its legislative expression and administration. somewhat related. although one related to the complexity of tax law. ♦ Where the tax treatment of particular transactions is likely to be complex. ♦ The business tax system should be designed in as simple a manner as possible recognizing economic substance in preference to legal form. Income is what individuals contribute to society.

The Diagram below describes a special case which could easily be interpreted as a Laffer curve if the variable on the abscissa denotes the tax rate and the variable on the ordinate the tax revenues.The collection of business tax revenue relies fundamentally on the principle of voluntary taxpayer compliance. The consequence will be that economic agents withdraw from market activities and possibly concentrate on shadow activities. Optimal tax theory addresses such questions as: Should the government use income or commodity taxes? Within commodity taxes. 2. the two crossings along the abscissa are intuitively substantiated. THE SIMPLE LAFFER CURVE A familiar theorem from elementary calculus is Rolle’s Theorem which can be stated simply as follows: if a curve crosses the abscissa twice then there must be a point between the crossings where the tangent to the curve is parallel to the axis. Of course. If the tax rate is equal to one. Taxation laws should be as clear and concise. But is there an optimal Tax level? Or can government continue to raise tax rates without the taxpayers reacting in a negative way? This is explained by the Laffer Curve. The conjecture that if tax rates were reduced tax revenues would increase has become a powerful. For the moment. suggestive policy stand. Tax laws should be designed from the perspective of those who must comply with and administer them. the function describing the curve between the points must be continuous and the first derivative must exist. They should be framed in plain English and based upon a consistent set of stated design principles. Such compliance should be fostered by making the business tax system as simple. The latter variable is clearly zero if the tax rate as a multiplying factor is zero. Thus. The surprising policy implication was that public funds could be increased without burdening the private sector by adverse incentive effects or redistributive measures. one might expect that the return from supplying labour services is zero. Their structure should be able to accommodate continuing change. inexpensive and certain in its application as possible. we should ignore the explicit scale along the ordinate of the diagram. how should tax rates vary across commodities? How progressive should the tax system be? Professor Arthur Laffer’s seminal discussion of the relation between tax revenues and “the” tax rate was an analytical cornerstone of the supply-side economics revolution during the early 1980s. and provide as much certainty. This is the same as saying that the government of any particular Country would want to maximize their Tax Revenues by collecting as much as they can. as possible. 43 T5 – Taxation Amendment Act 2006/07 .7 – THE LAFFER CURVE – OPTIMAL TAXATION We know that Governments around the world need tax revenues for their survival.

and the tax base. If we assume that the tax base is a decreasing function of the tax rate. t. written as a function of the tax rate (see diagram).The Laffer Curve. Tax revenues are the product of the tax rate. tax revenue collected by the government also increases. The Laffer curve may be further simplified as follows: The curve suggests that. It also shows that tax rates increasing after a 44 T5 – Taxation Amendment Act 2006/07 . x. the simple Laffer curve seems to be established. as taxes increase from low levels.

" He will refrain from any activities likely to result in taxable income. It necessarily follows that in a given economy. it is possible that the income tax rates are already too high. and if a 100% income tax rate brings in zero revenue. Okay. and the answer to the second being not so obvious. only to have it taxed away. So the income tax revenue from a 100% income tax will be zero. the tax rate which will bring in the most revenue must be somewhere between zero percent and 100%. They tend to act in their own and their family and friends' best interests.certain point (T*) would cause people not to work as hard or not at all. and if the authorities wish to bring in more income tax revenue. Will he have any reason whatsoever to earn any more money? The answer is. In that economy. "In any given economy. we must place ourselves in the position of an income earner who faces a tax rate of 100% on every extra dollar he earns." Now. how much income tax revenue will be raised?" To answer this question. now we get to the nub of the "infamous" Laffer Curve. The reasoning goes like this: If a zero % income tax rate brings in zero revenue. The first question is. we must understand a tiny bit about economics. the answer to the first being obvious. but just as certain. they must lower the tax rates. The second question is. But the number of people willing to do so must be exceedingly small. "If the income tax rate is 100%. or nearly zero. For all practical purposes. We must take the ideas discussed above and reach some conclusions. Are we all still together here? Did you get that? If not. go back and do it again. "No. Okay. thereby reducing tax revenue. the number is zero. and a higher than optimal rate also will bring in less revenue. there is some optimal income tax rate which will bring in the most revenue possible. There will always be a few suckers who go ahead and earn some money. because it is the point at which the government collects maximum amount of tax revenue while people continue to work hard. The Laffer Curve results from our assumptions about how people will react to varying rates of income taxation. "None. then all people would choose not to work because everything they earned would go to the government." 45 T5 – Taxation Amendment Act 2006/07 . as they see them. Let's all say this together. Now we must put our understanding of human nature to work. a lower than optimal rate will bring less revenue. We assume that people will react to the realities of the world of money and business more or less like they react to any other set of stimuli. "If the income tax rate is zero %. Quite naturally Governments would like to be at point T*. Economics is really just basic human psychology as applied to money and business affairs. that is all the Laffer Curve claims. We must ask ourselves two questions. Eventually. of course. he won't. Keep doing it until you get it. For us to gain a rudimentary understanding of the ideas incorporated into the Laffer Curve. if tax rates reached 100% (the far right of the curve). here is where it gets a bit tougher. how much income tax revenue will be raised?" The answer is.

obtaining and transmitting the required data. Tax administration and tax compliance interact in many ways. the rates were too low. Another economic cost is the “compliance costs” that taxpayers incur in meeting their tax obligations. A tradeoff between administration and compliance costs does not always exist. even if the resulting tax revenue is smaller than it would otherwise be. and see whether revenues increase or not. it would be equally valid to run the experiment the other way around: raise the tax rates and observe the results. based upon whether the current rates "seem" to be high or low. Compliance costs include the financial and time costs of complying with the tax law. In fact. In developing countries. The Laffer Curve does not claim to know exactly what tax rate is the "right" tax rate. If the revenues increase.g. 2. The problem people tend to have regarding the Laffer Curve is that they confuse economics with their political considerations. the costs of tax collection may be substantially higher. and so forth.. It only addresses the question of how to have the healthiest economy producing the highest income tax revenue. The choice is the politicians' to make. administration costs are reduced when compliance costs are increased. setting up required accounting systems.8 – THE COSTS OF TAXATION First. for instance. Although the 46 T5 – Taxation Amendment Act 2006/07 . If the tax rates are already very low. But if the rates are too high. and the economy less productive than it would otherwise be. lowering the rates may not bring in more revenue. lowering the rates will bring in more revenue. They wish to prevent the rich from earning more money. however. when taxpayers are required to provide more information thus increasing compliance costs. the rates were too high. It only claims that a lower income tax rate may bring in more revenue. Both compliance costs and administration costs may increase when. These people do not believe that the income tax on the rich can ever be "too high. Depending on the types of tax. over and above the actual payment of tax. Of course. Many people have political reasons to desire high income tax rates on the earnings of the rich. and payments to professional advisors. e. all for the sake of their politics. the actual cost of collecting taxes in developed countries is roughly 1% of tax revenues." They are willing to deprive the government of revenue and deprive the economy of the productivity of the rich. For example. undertakes more audits. taxes cost something to collect. such as acquiring the knowledge and information needed to do so. but making tax administration easier and less costly. Third parties also incur compliance costs. and banks may provide taxing authorities information or may collect and remit taxes to government. Often. a more sophisticated tax administration requires more information from taxpayers. employers may withhold income taxes from employees. The Laffer Curve does not address questions of envy and redistributionist politics.The Laffer Curve does not claim that lowering income tax rates will always bring in more revenue. the only way to know if the current tax rates are too high is to lower them. If the revenues decrease.

measurement of such costs is still in its infancy. will still discourage work effort. to the extent that taxes represent the costs of public services provided to businesses. The reason is simply because the efficiency cost of taxes arises from their effect on relative prices. as uniformly as possible. Second. and the size of this effect is directly related to the tax rate. Developing and transitional countries generally need to impose taxes on production for several reasons. for example. tax rates should be set as low as possible. In practice. governments need to limit the negative consequences of tax-induced changes in behaviour. so that doubling the rate of a tax implies a fourfold increase in its efficiency costs. From an efficiency perspective. A broad-based consumption tax. and so forth. there are a few studies that estimate compliance costs in developed countries. given revenue needs to finance government operations. The distortionary effect of taxes generally increases proportionally to the square of the tax rate. change the forms in which business is conducted. No matter how well the government uses the resources acquired through taxation. the cost of differential treatment must be balanced against the equity argument for imposing graduated rate schedules. A recent careful study of compliance costs with respect to the personal income tax in India suggests that compliance costs may be as much or more than ten times higher than in developed countries. Almost every tax may alter decisions made by businesses and individuals as the relative prices they confront are changed. and are typically much higher with respect to taxes collected from smaller firms. no matter from what source. The resulting changes in behaviour are likely to reduce the efficiency with which resources are used and hence lower the output and potential well being of the country. Finally. Third. Compliance costs are generally quite regressively distributed. from an efficiency perspective. experience suggests three general rules: First. taxes may give rise to what economists call “deadweight” or “distortion” costs. either because of regulatory reasons or because the demand for these products is relatively unresponsive to taxation. To minimize costs. tax bases should be as broad as possible. Good tax policy requires minimizing unnecessary costs of taxation. Taxes on production affect the location of businesses. it is better to raise revenue by imposing a single rate on a broad base rather than dividing that base into segments and imposing differential rates on each segment. Alcohol. countries with limited administrative capacity find it easier and less expensive to collect excise and sales taxes at the point of manufacture. for those services. These studies conclude that compliance costs are perhaps four to five times larger than the direct administrative costs incurred by governments. Finally. alter the ways in which production takes place. but such a tax will minimize distortions in the consumption of goods if all or most goods and services are subject to tax. via taxation. The tax base for income tax should also be as broad as possible. First. the businesses should bear the cost. may be taxed at a relatively higher rate. it is especially important that careful attention be given to taxes on production. treating all incomes. Second. countries need to tax corporate income to prevent tax avoidance by 47 T5 – Taxation Amendment Act 2006/07 .

48 T5 – Taxation Amendment Act 2006/07 . across regions.9 – INTERNATIONAL TAX COMPETITION It is unquestionable that the age of globalization is now upon us. taxes have become a more important factor in Business location decisions. This means that taxes do matter. foreign direct investment. may suffer or indeed even benefit. In contrast. to changes in consumption and production patterns so that national borders have reduced significance. Much of the traditional tax regime for taxing cross-border transactions rests on a stylized set of facts: ♦ Small flows of cross border investments ♦ Relatively small numbers of companies engaged in international operations ♦ Heavy reliance on fixed assets for production ♦ Relatively small amounts of cross-border portfolio investments by individuals and ♦ Minor concerns with international mobility of tax bases and international tax evasions. Countries no longer have the luxury to design their tax systems in isolation. business headquarters. The result is a loss of tax sovereignty by individual Countries. In addition. particularly its neighbouring Countries. 2. We use the term “globalization” to mean anything from an increase in mobility of business inputs. What do these changes mean for the Zambian tax system? First. trade taxes in African countries often account for 25-30% of tax revenue. with increased financial innovation.individuals who would avoid shareholder level taxes by retaining earnings within a corporation and to collect taxes from foreign-owned firms. there is increased pressure to reduce trade taxes. This has different consequences in different parts of the world. and ordinary income to capital gains or the other way around. African Countries have less capacity to make up lost revenue by increasing other taxes. WTO membership requires significant reductions in import and export taxes. There is increased tax competition for portfolio investment. business profits to royalties. most importantly for developing Countries. and. The opportunity cost for Zambia’s membership of the World Trade Organization and other regional bodies like SADC and COMESA is the revenue forgone through reduced tax rates imposed by such bodies. Lawyers and investment bankers can with relative ease convert equity to debt. With the dramatic reduction in trade barriers over the last decade. financial services. But all this has changed in recent years. and a Country with a tax system that differs substantially from other Countries. and primarily capital. This is particularly true for Zambia who’s Tax Base has not been expanding for quite some time. Trade taxes in OECD countries account for about 2-3% of total tax revenue. leases to sales. qualified labour. In addition. labels are losing their meanings.

and as owner-managers convert labour income into capital income. these effects may have already become evident in the sharp decline in corporate tax revenue in some member countries of the Organization for Economic Cooperation and Development (OECD). the eternal problems of designing and implementing a good tax system continue to be complicated by the changing world within which such decisions must be made. While this practice by itself might not necessarily be harmful. increased intra-company trade makes it easier to avoid or even evade taxes. especially as it becomes easier for individuals to earn income outside of their country of residence. including the direction and size of FDI flows. its extent and persistence suggest that additional factors may be at work. There has also been an increase in value-added due to services and intangibles which makes it harder to locate the source of corporate income and thus harder for Countries to tax corporate income. Corporate tax revenues are a larger portion of tax revenues for developing countries as compared to developed countries. large multinational firms can reduce their tax burden. the ability of large multinationals to minimize their tax liability or escape it altogether has considerable implications for countries' fiscal structure. It may also be harder to tax labour income. Thus. Although part of the decline can be attributed to business-cycle variations or changes in tax codes. In these and other ways. or a cut in public services. There will also be pressure on VAT revenues. the difficulty for national fiscal authorities in taxing the capital of these multinationals can result in distortions in the patterns of trade and investment. as well as increased use of digitized products that make collecting taxes on such products more difficult. Simply by relocating mobile capital. labour—or from large multinationals to small national firms. Recent trends Tax competition for foreign direct investment (FDI) can have adverse effects on corporate tax revenue. there will be increased pressure on individual tax revenues. It is interesting that the countries experiencing revenue declines also offer the least attractive corporate tax regimes within the OECD. possibly entailing more regressive tax systems. Globalization and the resulting increase in capital mobility have created opportunities for potentially harmful tax competition among countries eager to attract investment. as traditional employer-employee relationships evolve into independent contractor status. Improvements in technology allow increased sales without the seller having a physical presence in a Country. In the last 10 years there has been a major change in business operations with the disaggregation of production resulting in different operations in different countries. 49 T5 – Taxation Amendment Act 2006/07 . Also. In fact. larger budget deficits. Much has been said about the challenges posed by electronic commerce on both the income tax and VAT base. Third. Increased mobility of capital makes it harder to tax income. It can also result in a redistribution of the tax burden from mobile capital onto less mobile factors—in particular. there will be increased pressure on corporate income tax revenues. as labour becomes more mobile.Second.

More important. from 8 percent to 5 percent. most FDI flows are within OECD countries. consider a multinational in a high-tax Country producing a good with inputs from a branch in a low-tax Country. 2. For inter – Company trade. implying outward flows of FDI. Since the mid-1980s. Between 1988 and 1997. including taxes on labour.Although the share of FDI flows to non-OECD countries has been gradually increasing (up from about 20 percent of total flows in the 1980s to 30 percent. 50 T5 – Taxation Amendment Act 2006/07 . The reduction in statutory rates with a concurrent reduction in the standard deviation in itself suggests that tax competition is important. For example. If a country's domestic tax burden is high relative to other Countries. These may include a more business-friendly legal environment or lower overall taxes. if a low (high) Company tax rate indicated a generally low (high) tax burden and a more (less) business-friendly environment). Zambia as a Country can compete to attract inward investment flows as well. In fact. the tax effects would be overstated. because this increases the profits in the low-tax Country and reduces the profits in the high-tax country. Even though most COMESA and SADC countries have adopted transfer-pricing rules.10 – LINK BETWEEN TAXES AND FOREIGN DIRECT INVESTMENT Company tax policies pursued by one country can affect other countries in different ways. the multinational has an incentive to overstate the price of inputs. unrelated seller would freely agree to transact). If such correlations were indeed present (for example. the OECD average statutory corporate tax rate declined from 44 percent to 36 percent. on average. and that governments may have redesigned their tax policies to counter the threat of FDI outflows and to attract FDI inflows. which shows that countries did not broaden their tax bases in conjunction with a rate reduction. Taxes may also play a major role in firms' decisions about where to declare profits. prices at which a willing buyer and a willing. as evidenced by a reduction and convergence in both statutory and effective corporate tax rates. It is possible that the level of tax rates is correlated with other unobserved characteristics that make a Country more or less attractive as a recipient of FDI. countries have converged to this rate as the dispersion around the average. measured by the standard deviation. also declined. thus minimizing worldwide tax liabilities. How FDI affects corporate tax revenue FDI affects Company tax revenue mostly through transfer pricing. OECD Countries have been harmonizing their corporate tax regimes. subjective evidence suggests that multinationals spend considerable resources on transfer pricing and other tax-planning techniques involving cross-border transactions to minimize tax liabilities. which aim at making Companies charge arm's-length prices for intra – Company trade (that is. The same trend is observed for the effective tax rate. in the 1990s). the tax base may shift to Countries with a less burdensome tax regime.

including infrastructure. There are five viewpoints for establishment of a desirable tax system namely: ♦ Taxation should not distort free economic activities in the Republic ♦ Tax treatments that cause distortion and a sense of inequity in the taxation system should be rationalized by the Ministry of Finance and National Planning as well as the Zambia Revenue Authority. also play a role. ♦ The Taxation system should provide a stable revenue structure for the Zambian Economy 51 T5 – Taxation Amendment Act 2006/07 . At this stage. ♦ The Taxation system should be simple and easily understandable for taxpayers of all types and class. in many ways. Policy implications In Zambia and elsewhere. 2.11 – SELECTING AN APPROPRIATE TAX SYSTEM In developing countries such as the Republic of Zambia.transfer pricing is part of corporate reality. if governments are largely unable to tax capital. the skill and productivity of the labour force. as evidenced by the number of thriving consultancies in this area. Clearly. the level of tax rates is only one of the many determinants of capital flows. the tax burden will ultimately fall on labour—even though labour is more mobile than it was just a decade ago. it is unclear whether letting tax competition run its course would result in inefficiently low corporate tax rates (and inefficiently high rates on labour) or whether there would be some convergence toward a "reasonable" rate. Others. where market forces are increasingly important in allocating resources. The challenge for policymakers in Zambia will be to balance what are. and structural rigidities. the design of the tax system should be as neutral as possible so as to minimize interference in the allocation process. the increasing cross-border mobility of capital. The Taxation system should also have simple and transparent administrative procedures so that it is clear if the system is not being enforced as designed. contradictory demands and to find a package that appeals to international investors and firms while keeping an eye on the sustainability of the fiscal position. policymakers are facing numerous challenges from globalization—specifically. The lively debate within Africa on tax competition versus harmonization attests to the timeliness of this issue and the importance of resolving it. However.

52 T5 – Taxation Amendment Act 2006/07 .♦ The Local taxation structures should meet the needs of enhanced local autonomy currently being enjoyed by Zambians in respect of the Financial and Economic Decisions.

the effectiveness of rate progressivity is severely undercut by high personal exemptions and the plethora of other exemptions and deductions that benefit those with high incomes (for example. Countries frequently attach great importance to maintaining some degree of nominal progressivity in this tax by applying many rate brackets. The top personal income marginal tax rate should not be set too high and should not differ materially from the corporate income tax rate. the low taxation of financial income). which could deliver the 53 T5 – Taxation Amendment Act 2006/07 . equity. a substantial improvement in equity could still be achieved by replacing deductions with tax credits. the exemption of capital gains from tax. Tax relief through deductions is particularly egregious because these deductions typically increase in the higher tax brackets. any reasonable equity objective would require no more than a few nominal rate brackets in the personal income tax structure. The rate structure of the personal income tax is the most visible policy instrument available to most governments in developing countries to underscore their commitment to social justice and hence to gain political support for their policies. If political constraints prevent a meaningful restructuring of rates. simplicity and efficiency. Indeed. ♦ Tax administration must be strengthened to accompany the needed policy changes. Experience compellingly suggests that effective rate progressivity could be improved by reducing the degree of nominal rate progressivity and the number of brackets and reducing exemptions and deductions. Tax policy should be guided by the general principles of neutrality. however.Best Strategies The best strategy for sustained investment promotion is to provide a stable and transparent legal and regulatory framework and to put in place a tax system in line with international norms. Options in this respect may include the following: ♦ The optimal tax level should be fixed in relation to optimal government expenditure. More often than not. generous deductions for medical and educational expenses. The system should have simple and transparent administrative procedures so that it is clear if the system is not being enforced as designed ♦ Effective rate progressivity could be improved by reducing the number of rate brackets and reducing exemptions and deductions. Personal Income Tax The IMF has observed that any discussion of personal income tax in developing countries must start with the observation that this tax has yielded relatively little revenue in most of these countries and that the number of individuals subject to this tax (especially at the highest marginal rate) is small. ♦ Tax incentives are not generally cost-effective. ♦ Revenue from personal income tax should be increased and reliance on foreign trade taxes reduced without creating economic disincentives. and they are reluctant to adopt reforms that will reduce the number of these brackets.

however. Allowable depreciation of physical assets for tax purposes is an important structural element in determining the cost of capital and the profitability of investment. Such practices. ♦ The tax treatment of dividends raises the well-known double taxation issue. The tax treatment of financial income is problematic in Zambia and many developing Countries. The most common shortcomings found in the Capital allowance system in Zambia and other developing countries include too many asset categories and Capital Allowance rates. The only Tax Credit that has survived is the one granted to Persons with disabilities. Dividend Income is subject to Withholding Tax which is also a Final Tax. interest income. especially the parastatal sector possibly as a legacy of past economic regimes that emphasized the state's role in resource allocation under Kenneth Kaunda’s Socialist ideologies. but particularly relevant for the Republic of Zambia are the issues of multiple rates based on sectoral differentiation and the incoherent design of the depreciation system. and a structure of depreciation rates that is not in accordance with the relative obsolescence rates of different asset categories. Two issues dealing with the taxation of interest and dividends in developing countries are relevant: ♦ In many developing countries. or to tax them at a relatively low rate. Hence it is important to target carefully the application of final withholding on interest income: final withholding should not be applied if the taxpayer has business income. perhaps through a final withholding tax at the same rate as that imposed on interest income. the sectoral allocation of resources is distorted by differences in tax rates). Zambia operates multiple rates along sectoral lines including the complete exemption from tax of certain sectors. is taxed as a final withholding tax at a rate substantially below both the top marginal personal and corporate income tax rate. low depreciation rates. Rectifying these shortcomings should also receive a high priority in tax policy deliberations in our Country. For administrative simplicity. 54 T5 – Taxation Amendment Act 2006/07 . however. In Zambia. For taxpayers with mainly wage income. The Zambian Government has however done away with Tax Credits. They are indefensible if a government's commitment to a market economy is real. Corporate Income Tax Tax policy issues relating to corporate income tax are numerous and complex. most developing countries would be well advised either to exempt dividends from the personal income tax altogether. the low tax rate on interest income coupled with full deductibility of interest expenditure implies that significant tax savings could be realized through fairly straightforward arbitrage transactions. For those with business income. if taxed at all. are clearly detrimental to the proper functioning of market forces (that is. this is an acceptable compromise between theoretical correctness and practical feasibility. Unifying multiple Company income tax rates should thus be a priority.same benefits to taxpayers in all tax brackets.

While the latter should be broadly based to maximize revenue with minimum distortion. grouping assets that last a long time. they reduce the benefits from introducing the VAT in the first place. As these features allow a substantial degree of increasing the tax burden for the final user.often for revenue reasons. narrowly targeting a few goods mainly on the grounds that their consumption entails negative externalities on society (in other words.In restructuring the Capital Allowances system. at one end. have been left out of the VAT net. and fast-depreciating assets. The declining-balance method allows the pooling of all assets in the same asset category and automatically accounts for capital gains and losses from asset disposals. the advantage fostered is eclipsed by the non existence of Capital Gains Tax in Zambia. Value-Added Tax. especially when it comes to capital goods. the former should be highly selective. The most notable shortcoming of the E xcise systems found in many developing countries is their inappropriately broad coverage of products . the economic rationale for imposing excises is very different from that for imposing a general consumption tax. Excises. such as buildings. Although this is a feasible action point. As is well known. Many important sectors. ♦ Only one depreciation rate should be assigned to each category. alcohol. In Zambia we have two VAT Rates: 0% and 17. and Import Tariffs While VAT has been adopted in Zambia since 1995. society at large pays a price for their use by individuals). Many developing countries (like many OECD countries) have adopted two or more VAT rates. there are denials or delays in providing proper credits for VAT on inputs). thus substantially simplifying bookkeeping requirements. and motor vehicles. but the administrative price for addressing equity concerns through multiple VAT rates may be higher. or the credit mechanism is excessively restrictive (that is. for example) are few and usually inelastic in demand. such as computers. most notably services and the wholesale and retail sector. A good 55 T5 – Taxation Amendment Act 2006/07 . it frequently suffers from being incomplete in one aspect or another. The goods typically deemed to be excisable (tobacco. Rectifying such limitations in the VAT design and administration should be given priority. Multiple rates of this kind are politically attractive because they ostensibly—though not necessarily effectively—serve an equity objective. petroleum products. the declining-balance method should be preferred to the straight-line method. ♦ On administrative grounds. ♦ Depreciation rates should generally be set higher than the actual physical lives of the underlying assets to compensate for the lack of a comprehensive inflation-compensating mechanism in our taxation system. at the other with one or two categories of machinery and equipment in between. Zambia could well benefit from certain guidelines: ♦ Classifying assets into three or four categories should be more than sufficient —for example.5%.

the most prevalent forms of incentives found in Zambia tend to be the least meritorious. their revenue costs can be high. not all incentives are equally suited for achieving such objectives and some are less cost-effective than others. This can come about when any income spared from taxation in the host country is taxed by the investor's home country.excise system is invariably one that generates revenue (as a by-product) from a narrow base and with relatively low administrative costs. foreign investors. most notably those involving externalities (economic consequences beyond the specific beneficiary of the tax incentive). Tax Incentives While granting tax incentives to promote investment is common in countries around the world. Two concerns should be carefully addressed. and finally adjusting the rate of the general consumption tax (such as the VAT) to meet remaining revenue needs. then compensating for the tariff reductions on excisable imports by a commensurate increase in their excise rates. For example. incentives targeted to promote high-technology industries that promise to confer significant positive externalities on the rest of the economy are usually legitimate. as we have often times seen in Zambia. Unfortunately. political stability. Reducing Import Tariffs as part of an overall program of trade liberalization is a major policy challenge currently facing many developing countries. One simple way of ensuring that unintended consequences do not occur would be to reduce all nominal tariff rates by the same proportion whenever such rates need to be changed. evidence suggests that their effectiveness in attracting incremental investments—above and beyond the level that would have been reached had no incentives been granted—is often questionable. tariff reduction should not lead to unintended changes in the relative rates of effective protection across sectors. of which tax incentives are frequently far from being the most important one. Tax incentives could also be of questionable value to a foreign investor because the true beneficiary of the incentives may not be the investor. a skilled workforce). Moreover. infrastructure. By far the most compelling case for granting targeted incentives is for meeting regional development needs of the Country. transparent regulatory systems. nominal tariff reductions are likely to entail short-term revenue loss. 56 T5 – Taxation Amendment Act 2006/07 . but rather the treasury of his home country. This loss can be avoided through a clearcut strategy in which separate compensatory measures are considered in sequence: first reducing the scope of tariff exemptions in the existing system. Nevertheless. Second. As tax incentives can be abused by existing enterprises disguised as new ones through nominal reorganization. Tax incentives can be justified if they address some form of market failure. First. base their decision to enter a country on a whole host of factors (such as natural resources. Zambia included. the primary target of most tax incentives.

accelerated Capital Allowances has two additional merits. little distortion in favour of short-term assets is generated. This system is firmly in progress through the Duty Draw Back Scheme which you will learn about in Paper 3. the use of investment subsidies is seldom advisable for a Country like Zambia where political corruption has taken centre stage. Hence. Triggering Mechanisms The mechanism by which tax incentives can be triggered can be either automatic or discretionary. Indirect Tax Incentives Indirect tax incentives. by a variety of problems 57 T5 – Taxation Amendment Act 2006/07 . it could induce a significant short-run surge in investment. This advantage is likely to be outweighed. though not entirely foolproof. such as a minimum amount of investment in certain sectors of the economy. as the forgone revenue (relative to no acceleration) in the early years is at least partially recovered in subsequent years of the asset's life. however. Currently. remedy for this abuse. Second. Manufacturing and Tourism Sectors. The relevant authorities have merely to ensure that the qualifying criteria are met. Since merely accelerating the Capital Allowance of an asset does not increase the depreciation of the asset beyond its original cost. An automatic triggering mechanism allows the investment to receive the incentives automatically once it satisfies clearly specified objective qualifying criteria. Moreover.4 – Advanced Taxation. in ensuring that the exempted purchases will in fact be used as intended by the incentive. The difficulty with this exemption lies. A discretionary triggering mechanism may be seen by the authorities as preferable to an automatic one because it provides them with more flexibility. without formally stated qualifying criteria.Accelerated Capital Allowances Providing tax incentives in the form of accelerated Capital Allowances has the least of the shortcomings associated with tax holidays and all of the virtues of tax credits and investment allowances—and overcomes the latter's weakness to boot. of course. They involve out-of-pocket expenditure by the government up front and they benefit nonviable investments as much as profitable ones. it is generally least costly. they are generally quite problematic. A discretionary triggering mechanism involves approving or denying an application for incentives on the basis of subjective value judgment by the incentive-granting authorities. First. are prone to abuse and are of doubtful utility. Exempting from import tariffs raw materials and capital goods used to produce exports is somewhat more justifiable. such as exempting raw materials and capital goods from the VAT. if the acceleration is made available only temporarily. Establishing export production zones whose perimeters are secured by customs controls is a useful. Investment Subsidies While investment subsidies (providing public funds for private investments) have the advantage of easy targeting. accelerated Capital Allowances apply to farming Businesses.

so that incentives are granted only to investments meeting the highest objective and quantifiable standard of merit. On balance.associated with discretion. If the concern about having an automatic triggering mechanism is the loss of discretion in handling exceptional cases. most notably a lack of transparency in the decisionmaking process. 58 T5 – Taxation Amendment Act 2006/07 . the preferred safeguard would be to formulate the qualifying criteria in as narrow and specific a fashion as possible. which could in turn encourage corruption and rent-seeking activities. it is advisable to minimize the discretionary element in the incentive-granting process.

TUTORIAL QUESTIONS 59 T5 – Taxation Amendment Act 2006/07 .

(Check paragraph 2. (Check paragraph 2.1) Question II Explain the three qualities of a sound National Tax Policy. List six rights that taxpayers ought to enjoy. (Check paragraph 2. it is important to give thought to the Taxpayers’ Rights. ******************************************************************************************** 60 T5 – Taxation Amendment Act 2006/07 .7).4) Question IV List some of the Functions of the Tax Policy Unit within the Ministry of Finance and National Planning. (Check paragraph 2.Question I Explain why it is difficult to design an efficient Tax system in Zambia.3) Question III In designing an efficient Tax Policy for the Country. (Check paragraph 2.5) Question V Explain the principle behind the Laffer Curve and Optimal Taxation.

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