Chapter- 3

General overview of taxation

• A tax is “a compulsory charge imposed by the

Government without any expectation of direct return
in benefit ".
• The general public should be taxed according to their
ability to pay.
• The people in the same financial position should be
taxed in the same way without any discrimination.
• Taxes may be paid in cash or kind.
• A good tax system should not affect the ability and
willingness of the people to work, save and invest.
 Cont...
• A sound tax system should contribute in the
economic development of a country.
• Hence, “Taxation should not be like killing the goose
that lays golden eggs".
General Characteristics of Tax:
1. Tax is a Compulsory Contribution:
• Any refusal in this regard leads to punishments.
2. Benefit is not the Basic Condition:
• For the payment of tax, there is no direct
return or quid proquo to the taxpayers.
 Cont...
3. Personal Obligation:
• Tax imposes a personal obligation on the taxpayers.
4. Common Interest:
• It is used for the general and common benefit of the people as a whole.
5.Legal Collection
• It can be levied only by the government both central and state.
6.No Discrimination
• Tax is levied on all people without any discrimination.
7.Wide Scope
• Tax is levied not only on income but also on property and commodities.
8.Regular and periodical payment
Objectives of Taxation:
• Government levies and collects taxes for various objectives.
• These objectives may be specific or general.
 Cont...
General Objectives:
• Government imposed taxes for three basic purposes viz., to
cover the cost of administration, maintaining law and order
in the country and for defence.
1. Raising Revenue:
• The basic purpose of taxation is raising revenue.
2. Removal of Inequalities in Income and Wealth:
• The welfare state aims at the removal of inequalities in
income and wealth.
3. Ensuring Economic Stability:
• Taxation affects the general level of consumption and
production.
 Cont...

4. Reduction in Regional Imbalances

5. Capital Accumulation
6. Creation of Employment Opportunities
7. Preventing Harmful Consumption
8. Beneficial Diversion of Resources
9. Encouragement of Exports
10. Enhancement of Standard of Living
 Cont...
Specific Objectives:
• To support the operation of that government itself.
• To influence the macro economic performance of the
economy.
• To carry out the functions of the government such as
national defence and providing government services.
• To redistribute resources between individuals or
classes in the population.
• To modify patterns of consumption or employment
within an economy.
 Cont...
Principles of taxation:
• These principles are called as "Canons of Taxation".
• The following are the important canons of taxation.
I. Canons Advocated by Adam Smith
• Canon of Equality.
• Canon of Certainty.
• Canon of Convenience.
• Canon of Economy.
 Cont...
II. Canons Advocated by Others:
• Canon of Productivity.
• Canon of Elasticity.
• Canon of Diversity.
• Canon of Simplicity.
• Canon of Expediency.
• Canon of Co-ordination.
• Canon of Neutrality.
 Cont...
1. Canon of Equality:
• A good tax system should be based on the ability to
pay of the people on the basis of income and wealth
or on the basis of consumption i.e luxury or necessity.
• All people should bear the public expenditure in
proportion to their respective abilities.
• Tax burden should be more on the rich than on the
poor.
2. Canon of Certainty:
• It means the time, amount and method of payment
should all be clear and certain.
 Cont...
• This removes all uncertainties in the payment of tax
and ensures smooth functioning of the tax
department and the tax payer can adjust his income
and expenditures accordingly.
3. Canon of Convenience:
• The tax should be levied and collected in such a way
that is convenient to taxpayer.
4. Canon of Economy:
• It states that the minimum possible amount should
be spent on tax collection.
• The maximum part of the collection should be
brought to the Government treasury.  
 Cont...
II. Canons Advocated by Others:
1. Canon of Productivity:
• The tax system should be productive enough.
• It should encourage productive activity by
encouraging the people to work, save and invest.
2. Canon of Elasticity:
• The taxes should be flexible.
3. Canon of Diversity:
• There should be diversity in the tax system of the
country as direct and indirect taxes.
 Cont...
• It should not depend upon one or two types of taxes
alone.
4. Canon of Simplicity:
• Tax system should be simple, easy and understandable
to the common man.
5. Canon of Expediency:
• Tax should be levied after considering all favourable and
unfavourable factors from different angles such as
economical, political and social.
6. Canon of Co-ordination:
• There should be a proper co-ordination between
different taxes imposed by various authorities.
 Cont...
7. Canon of Neutrality:
• This principle stresses that the tax system should not
have any adverse effect.
• It shouldn’t create any deflationary or inflationary
effects in the economy.
 
 Cont...
PROPORTIONAL, PROGRESSIVE AND REGRESSIVE TAX
SYSTEMS
• The tax systems may be summarized as follows:
-Proportional Tax System.
-Progressive Tax System.
-Regressive Tax System.
-Digressive(mild) Tax System
 1. Proportional(Flat) Tax System:
• A proportional tax, also called a flat tax is a system.
 Cont...
• Taxes all entities in a class typically either citizens or
corporations at the same rate.
• Flat tax system may arguably have most of the
benefits of a progressive tax.
• Usually the flat tax is proposed to kick in at a certain
income level or...
• To exempt income below that level..
• Advocates of a flat tax claim that it will end unfair
discrimination.
 Cont...
• Most political parties that advocate the introduction
of a flat tax are on the right of the political spectrum.
• Those who oppose a flat tax claim that it will benefit
the rich at the expense of the poor.
• . “The system in which the rates of taxation remains
constant as the tax base changes".
Limitations of Proportional Tax System:
• Inequitable Distribution
• Inadequate Resources
• Inelastic in Nature
 Cont...
Proportional tax system has the following advantages:
• It is simple in nature.
• It is uniformly applicable.
• It will avoid mistakes and drawbacks of progressive
tax system.
Progressive(Graduated) Tax System:
• The term progressive refers to the way the rate
progresses from low to high.
 Cont...
• People with more income pay a higher percentage of
it in taxes.
• Progressivity of the income tax means that marginal
tax rates are generally higher than average rates.
• “A system in which rates of taxation would increase
with the increase in income”
The advantages of progressive tax system include the
following:
• Equality in Sacrifice
• Reducing the Inequalities of Income and Wealth
 Cont...
• Economy
• Elastic
• Stabilising the Economy
Limitations of Progressive Tax System:
• Ideal Progression is Impossible
• Progressive Taxation -a Graduated Robbery
• Disincentive to Work
• Discourages Savings and Investments
• Shifts the Total Economic Production of Society
 Cont...
Regressive Tax System:
• It is the system in which the rate of tax declines with the
increase in the income or value of property.
• It places more burden on those with lower incomes.
• Many taxes other than the income tax tend to be
regressive in practice.
• "The tax rate decreases as the tax base increases".
• It violates the principles of equity and social justice.
• Even non-income taxes can regressive relative to income.
 Cont...
DIGRESSIVE TAX SYSTEM
• Under this system, the rate of tax is mildly progressive up to
a certain limit and thereafter it may be fixed at a flat rate.
Tax rate(y)

Tax Base (x)

 Cont...
IMPACT, SHIFTING AND INCIDENCE OF TAX:
1. Impact of a Tax/Tax Impact
• It refers to the immediate / initial burden of a Tax on
the person who pays it in the first instance.
• Impact of the Tax is always on the person who is
responsible by law to pay the Tax.
2. Incidence of a Tax/Tax Incidence
• It refers to the final or ultimate resting place of the
burden of the Tax payment.
• It is a place where the Tax is finally collected.
 Cont...
• Tax incidence refers to the person who ultimately bears
the money burden of a tax.
3. Shifting of Tax/Tax shifting
• It refers to the process by which the money burden of
a Tax is transferred from one person to another
person.
• The process of passing on the tax burden to the buyer
of goods by the seller of goods.
• To sum up, three concepts are involved in the process
of taxing:
 Cont...
• A tax may be imposed on a person(Impact of tax)
• The tax may be transferred by the first person to a
second person(Shifting of tax)
• The tax may be ultimately borne by the second
person(Incidence of tax)
Classification of Taxes
• The following are the common dimensions to classify
Tax:
a) Based on Impact and Incidence of Tax
b) Based on Tax bases
 Cont...
c) Based on Tax Determinant
d) Based on Number of Taxes
e) Based on sources of Taxes
a) Based on Impact and Incidence of tax
• On the basis of impact (immediate burden) and
incidence (ultimate burden) of tax.
1. Direct Taxes
• Direct Taxes are those taxes whose impact
(immediate burden) and incidence (ultimate
burden) fall on the same person.
 Cont...
• They can not be shifted(passed on) to others.
• Some examples are Employment income tax,
Business income tax, Rental income tax, Interest
income tax, Capital gain tax, property tax, agricultural
income tax, transfer taxes(estate tax, inheritance tax,
gift tax) etc.
• The following are advantages of direct taxes:
a) They reduce inequalities in income and wealth.
b) They are certain.
c) They are economical.
 Cont...
d)They are elastic.
e) They are equitable.
f) They create civic consciousness.
• The following are weaknesses of Direct Taxes:
a)They can be easily evaded.
b)They are unpopular.
c)They are inconvenient.
d)Disincentive to work ,save, and invest.
e)Limited scope.
2. Indirect Taxes:
• They are those taxes whose impact (immediate burden) and
incidence (ultimate burden) fall on different persons.
 Cont...
• Some examples are VAT, TOT ,etc.
• The following are advantages of Indirect Taxes:
a) They are convenient and popular.
b) They can not be evaded.
c) They can be elastic.
d) They lead to social welfare.
e) They have wide coverage.
f) They can be progressive.
 Cont...
• The following are weaknesses of Indirect Taxes:
a) They are uncertain.
b) They promote inflation.
c) They result in high administrative costs.
d) They discourage savings.
e) They do not create civic consciousness.
b) Based on Tax Bases
1. Income Taxes
• They are Direct Taxes which are levied on income of
individuals and Businesses.
 Cont...
2. Property Taxes
• They are also Direct Taxes which are levied on
property of persons or Businesses such as on wealth,
land, estate, and inheritance.
3. Commodity/Expenditure Taxes
• They are indirect Taxes which are levied on goods
and services.
• Some examples are value added tax, turnover tax,
excise tax, import duty, export duty.......
 Cont...
c) Based on Tax Determinant
1. Specific Taxes
• They are Taxes which are levied on goods and services at a
fixed amount based on their weight, size, quantity, or other
measurements other than the value of goods and services.
• In this case value of the goods and services is irrelevant.
• The main advantage of this type of tax is that it is easy to
levy and more convenient.
2. Ad-valorem Taxes
The word Ad-valorem is derived from a Latin word to say
“According to the value”
 Cont...
• Whatever is the weight or size of the unit of goods
,the tax determinant is the value of the goods.
d) Based on number of Taxes:
1. Single Tax
• It is a tax that occurs in a system in which the Taxes
are levied only on one object, that is, on one class
of people.
• In single tax, there is only one tax base.
2. Multiple Taxes
They are Taxes whose tax bases are diversified.
 Cont...
• Multiple tax system consists of many kinds of
taxes(Both direct and indirect)
e) Based on sources of Transaction
1.Domestic Taxes
2. International Taxes
Effects of Taxation:
• Now-a-days, revenue rising is not the only purpose of
taxation.
1. Effects of Taxation on Production:
 Cont...
Taxation can influence the production of a nation by influencing four
basic factors. They are as follows:
• Ability to work, save and invest.
• Willingness to work, save and invest.
• Diversion or allocation of resources between industries and places.
• On the size of the industries.
2. Effects of Taxation on Distribution:
The effects of taxation on the distribution of income and wealth
among the different sections of the society, depends upon two
important factors. They are as below:
• Nature of Taxation
• Kinds of Taxes.
 Cont...
3. Effects of Taxation on Consumption:
• Taxes increases the price of the taxed goods relative to
the prices of untaxed or lower taxed goods.
• Taxation influences the consumption as well. Such
influences can be studied on the following grounds:
1. Influence the Allocation of Resource of Individuals:
2. Effects of Taxation on Consumption and Employment:
3. Effects of Taxation on Consumption during Inflation
and Depression:
4. Regulatory Effect of Taxation on Consumption:
 Cont...
• There are two forms of tax evasion. They are as
follows:
1. Suppression of income
2. Inflation of expenditure.
• Examples for Tax Evasion:
• The following are the examples for tax evasion:
• A trader makes a sale for Birr.20, 000 and does not
account it, in his books under sales. He is evading tax.
 Cont...
• An individual lends his money of Birr.50, 000 to
another person at 20% interest per annum and does
not include this income in his total income.
• Under-invoicing of sales and inflation of purchases.
• A manufacturing business employs 30 workers but
include 2 more additional namesake workers (not in
actual) in the muster roles.
 Cont...
Causes of Tax Evasion:
The following are the important causes for Tax evasion:
• Multiplicity of Tax Laws
• Complicated Tax Laws
• High Rates of Taxation
• Inadequate Information as to Sources of Tax Revenue
• Investment in Real Property
• Ineffective Tax Enforcement
• Deterioration of Moral Standards
 Cont...
Remedies for Tax Evasion:
1. Thorough Overhauling of Tax Laws:
• Tax evasion is loose drafting of tax laws which contain
several loop-holes and weak points.
2. Reduction in Tax Rates:
• The rate of tax should be reduced to a reasonable
level.
3. Replacement of Sales Tax & Excise Duties with VAT:
• As the crosschecking is possible in the case of VAT, it
is more effective.
 Cont...
Tax Evasion Vs Tax Avoidance
• Tax evasion – not paying taxes legally.
• “Tax evasion implies the activities involving an element of
deceit, mis-representation of facts, falsification of accounts
including down right fraud”.
• Taxpayer with a view to violate civil and criminal provisions
of the tax laws.
• It is a crime in almost all countries and subjects the guilty
party to fines or even imprisonment.
• It may be said that the tax evasion is tax avoidance by illegal
means.
• Tax evasion is against the law and is an unsocial act.
 Cont...
4. Tax on Agricultural Income:
• Tax evasions can be avoided by taxing the agricultural
income at normal rates.
5. Maintenance of Proper Accounts:
6. Introduction of Expenditure Tax:
7. Tightening of Tax Enforcement:
Tax Avoidance:
• Avoidance is within the ambit of law.
• Avoidance is the legal exploitation of the tax regime
to one's own advantage.
 Cont...
• “Escaping from the tax liability by using the available
loop-holes of the tax laws”.
• Thus, tax avoidance means legal minimisation of tax
burden by the taxpayers.