Advanced Taxation

(AcFn 522)

Part I – Introduction

New Global Vision College Andinet Asmelash (Assist. Prof.)

 Taxation, Tax definition

 Tax is a compulsory collection of money by government;

 It is a payment extracted by the government from people and
organizations to fund public expenditures
 Transfers resources from private to public consumption.
 Taxes are involuntary levies without a quid pro quo;

“Taxes,” said rich dad. “You’re taxed when you earn. You’re taxed when
you spend. You’re taxed when you save. You’re taxed when you die.”
“Why do people let the government do that to them?”
“The rich don’t,” said rich dad with a smile. “The poor and
the middle class do. I’ll bet you that I earn more than your dad,
yet he pays more in taxes.”
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 Throughout history, people have debated
 the amount and kinds of taxes that a government should
impose, as well as
 how it should distribute the burden of those taxes across
society.

 Unpopular taxes have caused public protests, riots,

and even revolutions.
 In political campaigns, candidates’ views on taxation
may partly determine their popularity with voters.
 Countries differ considerably in the amount of taxes
they collect; however, the most important source of
revenue for modern government is tax.
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 Governments compel the payment of taxes:
 to fund services which are mainly public and which cannot
be provided through the market system; people otherwise
would not be willing to pay for these services;
 to accomplish some redistribution role;

 Today, tax has become a part of all economic activities of

human beings.

 Every man, willingly or unwillingly, pays an amount of money

in the form of tax on the products he/she uses basically.

 Besides, he/she pays tax on his income, wealth, etc.

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 Taxation and Public Finance
 Taxation is defined as a system of collecting money –
tax revenue – to finance government operations.
 All governments require money to undertake different
functions. The required money – taxes – is collected
from the citizens.
 Without taxes to fund its activities, government could
not exist.
 Initially, the government imposed taxes for three basic
purposes: to cover the cost of administration,
maintaining law and order in the country and for
defense.
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 Taxation is the most important system of collecting
public revenue (tax revenue) in modern economic
system.

 It is the powerful instrument in the hands of the

government for transferring purchasing power from
individuals to government.

 Governments may raise or lower taxes to achieve social

and economic objectives, or to achieve political
popularity with certain groups.

 It is interrelated with public Finance due to these factors.

June 2019 Andinet Asmelash (Assist. Prof.)

 Public Finance Issues
 Public finance deals with the income and expenditure
pattern of the Government.
 The subject matter of the public finance is classified under
five broad categories. These are:
 Public Revenue

 Public Expenditure

 Public debt

 Financial administration

 Economic stabilization

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 Public Finance and Private Finance
 The Private finance deals with the wants and the
satisfaction of households and firms. But the public finance
deals with the collective wants and their satisfaction.

 The objective of both private and public finance is similar.

Public finance aims at maximizing social welfare or social
benefit by efficient use of public goods.

 Distinction between private and public goods is important

in the study of public finance.

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 Public and Private Goods
 Private goods refer to all those goods and services,
which are consumed by people to satisfy their
personal and private wants or needs.

 They relate to articles of food, clothing, shelter,

recreation, transportation, communication etc.

 Thus, distribution of these goods is based on effective

demand and market price.

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 …Private Goods

 All those who want them and are willing to pay the
market price will buy them.

 Those who do not want them or who are not in a

position to pay for them will be excluded from the
consumption of these goods.

 In other words there is no compulsion that every

one will have to buy them.

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 …Private Goods
 Thus, private goods are divisible in the sense that
price mechanism divides people in to two groups
 those who want to consume them and

 those do not; and

 private goods are subject to the principle of

exclusion; in the sense that price mechanism
excludes the group of people who are not willing to
consume a particular good.

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 Public Goods
 Goods and services produced to satisfy collective
wants are known as public goods.
 Collective wants are those which are demanded by
all members of the community in equal or more or
less equal measures.
 Defense, education, public health, infrastructure
facilities like power, transportation and
communication, etc., are examples of collective
wants.

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 …Public Goods

 These goods are supplied by the country to all its

citizens so as to meet the collective wants for
increasing social welfare.

 But the degree of benefit a person derives will

depend upon the use he can put it to.

 For example medical and educational facilities are

made available for all the people of Ethiopia.

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 Government revenue might not be just tax revenue:

 Government may charge fees for certain services

such as registration of legal documents and
supply of other commodities for which the
government may enjoy a monopoly (eg. supply of
electricity, water…);

 If the charges exceed the costs of such services

the excess may be considered as a tax; otherwise
they are not taxes;

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 Fines for a certain offences (like for example,
polluting the waterway);

 Fines are compulsory payments without any

quid pro quo;

 But, fines are not taxes; they are used to curb

certain offences not to raise revenue for the
government;
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 Characteristics of Taxes
 Compulsion… no refusal to pay
 Direct benefit is not the main condition (levied without
quid pro quo )… collective use
 Impose obligations – tax cannot be escaped…subject to
criminal offense.
 Common interest… payers as well as non-payers will
benefit.
 Regular and periodic payment… known due dates.
 No Discrimination - Tax is levied on all people without any
discrimination of caste, creed etc. but according to their
ability to pay.
 Wide Scope - Tax is levied not only on income but also on
property and commodities.
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 Why do governments bother to tax? Alternatively,
government could:
 Finance its expenditures by printing money;

 Compulsorily seize the goods or services it needs, or

 Borrow money.

Problems with the above alternatives:

 Printing money merely debases the currency and causes
inflation; eg. Zimbabwe, Tanzania
 Compulsory acquisition is a crude and not very fairly
distributed form of impost and in any event under our
constitution requires just compensation and
 Borrowed money must be repaid along with interest.
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 Objectives of Taxation
 Objectives of taxation – what is sought to be achieved
through taxation;

Taxation can have several objectives including:

• Revenue for the government… to finance government
expenditure such as
•Administration
•Maintaining law and order
•Defense
•Various other social services (public schools,
healthcare, social insurance, infrastructure, housing,
sanitation etc)
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 …Objectives of Taxation

• Employment generation - More employment

opportunities can be created by giving tax
concessions or exemptions to small entrepreneurs
and to the industries adopting labour-intensive
techniques.

• Removal of regional inequalities through

redistribution of opportunities (projects,
employment opportunities, education etc);
exemptions and concessions to the needy regions;

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 …Objectives of Taxation

 Reducing the gap between the poor and rich – taxing

the rich – Canon of Equality – progressive taxation on
income;

 Preventing Harmful Consumption – imposing heavy

excise duties on the commodities like liquors, cigars
etc

 Beneficial Diversion of Resources – imposition of

heavy duties on non-essential and luxury goods.

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 Functions of Taxation
1. Allocation function
 Pertains to the process by which total resource use is
divided between private and social goods;
 The proper allocation of scarce resources between private
and public goods so as to maximize social well being.
 Tax measures should be designed to lead to proper
allocation of resources which in turn would lead to the
maximum possible use of resources.
 Tax measures should not alter taxpayers’ behavior – should
not induce them to shift resources from higher valued uses
to lower valued uses in an effort to reduce tax liability.
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 2. Distribution Function
 Adjustment of the distribution of income and wealth to
conform with what society considers a fair or just state
of distribution;

 Among various redistribution fiscal devices are:

 a tax-transfer scheme, combining progressive taxation of
high income with a subsidy to low income households;
• progressive taxes used to finance public services, especially those
such as public housing, which particularly benefit low income
households.
• a combination of taxes on goods purchased largely by high income
consumers with subsidies to other goods which are used chiefly by
low-income consumers.

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 3. Stabilization Function
 Modern economies are subject to fluctuations, viz.,
inflations on one side and depressions on the other.
 Fiscal operations have been used to moderate these
fluctuations and if possible to eliminate them
altogether.
 In such situations, restrictive measures are needed to
reduce demand.
 For instance, business booms and inflations are sought
to be controlled through heavier taxation while
business recession is sought to be checked through
public expenditure.

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 Principles of Taxation
 How should a tax system be designed to raise a given
amount of revenue?

 What criteria should be used to evaluate the

advantages and disadvantages of a particular tax
system or tax policy proposal?

 There are various criteria (principles) that can be

followed in evaluating a tax policy proposal (tax
structure);

 People may disagree on the relative importance of the

criteria;

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 …Principles of Taxation
 Adam Smith calls them canons of a tax system in his
book, “Wealth of Nations” .

 There are four canons of taxation as prescribed by Adam

Smith.
o Equity
o Economy
o Certainty
o Convenience

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 …Principles of Taxation

 Smith’s canons were later extended by other

writers (Bestable and others) to include:
o Neutrality
o Productivity
o Coordination
o Flexibility
o Simplicity etc

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 Canon of Equity
 One vital principle of a good tax system is fairness
(equity).
 This canon requires the tax system to be equitable.
 Taxes imposed should be fairly and equitably
distributed.
 Everyone agrees that the tax system should be
equitable, i.e., that each taxpayer should contribute
his/her “fair share” to the cost of government.
 But difficult in the use of this concept.
 There is no such agreement about how the term “fair
share” should be defined.
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 …Canon of Equity
 What a “fair share” means in practice is the subject of
endless argument and debate.

 It is endless because equity is intangible or non-

measurable and pronouncements on it reflect subjective
attitudes.

 There are two strands of thought in this connection:

 The benefit principle

 The ability to pay principle

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 Benefit Principle
 According to this approach the state provides goods and
services to the members of the society and they
contribute to the cost of these supplies in proportion to
the benefits received.
 There is an exchange relationship.
 The burden of' taxation should be divided among the
people in proportion to the benefits received from the
state.
 It demands that on the ground of equity, the people
should be taxed according to the benefits (Protection,
hospitals, education, roads, irrigation etc.) they receive
from the government/public services.

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 …Benefit Principle
 Q1) write the limitations of benefit principle.

 Q2) can we accept this principle as a base for

taxation?

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 Ability to Pay Principle
 The ability to pay principle is widely accepted as a general
rule.

 A citizen has to pay taxes because he/she can, and his/her

relative share in the total tax burden is to be determined
by his relative paying capacity.

 A given total revenue is needed and each taxpayer is

asked to contribute in line with his/her ability to pay.

 This approach considers revenue and public expenditure

as two distinct entities. Public expenditures are for the
"common good" and cannot be individually evaluated.
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 …Ability to Pay Principle
 This principle relates taxes paid to some measure of
ability to pay, such as overall wealth, income or
consumption;
 No agreement on which one is best measure of ones
ability to pay;
 Ability to pay may vary depending on the measure
chosen;
 For example, a taxpayer ‘s ability to pay, measured
by overall wealth, may differ significantly from his
or her ability to pay measured by income;

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 …Ability to Pay Principle
 A person who worked for many years and then retired
may have accumulated a significant amount of wealth and
may, as a result, have a higher ability to pay taxes; but
may have low current income;
 Two taxpayers with the same income may not have the
same level of economic well being (the same ability to
pay)
 if one has many dependent children while the other not;

 one may have high medical expenses but not the other;

 These are some differences although taxpayers are said to

have equal level of income;
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 …Ability to Pay Principle
 Q1) write the limitations of ability to pay principle.

 Q2) can we accept this principle as a base for

taxation?

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 Horizontal and Vertical Equity
 Taxation according to ability to pay calls for people with
equal capacity to pay the same, and for people with greater
ability to pay more.

 The former is referred to as horizontal equity and the latter

as vertical equity.
 Vertical equity concerns people in unequal economic
circumstances.

 Horizontal equity states that people who are “similarly

situated” should be taxed alike.

 It leaves open the essential question of what is meant by

“similarly situated”.
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 …Horizontal and Vertical Equity
 If income is used as index of ability to pay, then
Horizontal Equity says people with the same income
should, all else equal, pay the same tax.

 Again, we are left with essential questions: what do

we mean by “income” and by “all else equal”.

 Both equity rules follow from the same principle of

equal treatment, equal sacrifice of welfare;

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 Canon of Certainty
 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 should all be clear to the
taxpayer and to every other person.

 This principle removes all uncertainties in the

payment of tax and ensures smooth functioning of
the tax department.

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 Canon of Convenience
 The mode and timing of tax payments should be
convenient to taxpayers.
 This canon recommends that unnecessary trouble
to the taxpayer should be avoided, otherwise
various ill-effects may result.
 For example, it may be in installments, land
revenue may be collected at the time of harvest
etc.
 This principle reduces the tendency of tax evasion
considerably.
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 Canon of Economy
 This principle states that the minimum possible amount
should be spent on tax collection and the maximum part of
the collection should be brought to the Government
treasury.

 Taxation should be economical i.e. this should be much

more than mere saving in the cost of collection.

 The canon of ‘Economy' is naturally sub-divided into

two parts viz.,
1. ‘Taxation should be inexpensive in collection', and
2. ‘Taxation should retard as little as possible the growth
of wealth'.
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Reading Assignment

 Canons Advocated by Others

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