Advanced Taxation

PART I INTRODUCTION
1. 1.Taxation, Tax definition
A tax is “a compulsory charge imposed by the Government
without any expectation of direct return in benefit ( without a
quid pro quo)”.
It is a payment extracted by the government from people and
organizations to fund public expenditures
Transfers resources from private to public consumption.
Dialog

“Taxes,” said son of the 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”, said a friend of the rich dad.
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.
Taxation is accepted in all civilized (or democratic)
societies as a fundamental element in the social
contract between Ruler and citizens.
The Role 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 and parcel 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 uses basically.
Besides, he pays tax on his income, wealth, etc.
 1.2. 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.
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
 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 Expenditure
Public revenue
Public debt
Financial administration
Economic stabilization
 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.
In private finance goal is achieved by
households & firms themselves whereas in
public finance…by government
Distinction between private and public goods
is important in the study of public finance.
 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.
These goods are priced in the market on the basis
of their cost of production on the one side and the
nature of demand on the other.
Who will enjoy 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.
Thus distribution of these goods is based on
effective demand and market price.
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 who 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.
But price mechanism or market mechanism may fail
when ever private goods are associated with the
concept of externalities.
Externalities refer to favorable and unfavorable effects
which are associated with the production of those
goods.
 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.
Goods and services produced to satisfy
collective wants are known as public
goods.
These goods are supplied by the
country (government) to all its
citizens.
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. But the extent of use
varies from individual to individual.
 1.3. Taxation and Other Disciplines
 Economics & Taxation
Taxation is used as one of the tools of fiscal policy or
other economic measures and taxation uses different
economic models
Public Finance and Taxation
Taxation is used as a system of collecting public money
(public revenue)
Tax Law and Taxation
Tax Laws provide the rules & regulations that are used
to guide taxation so that the system will be streamlined.
Politics and Taxation
Political decisions on tax related issues directly or
indirectly affect the environment of taxation. In political
campaigns, taxation is an instrument to win voters.
Is tax the only revenue for the
government?
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);
If the charges exceed the costs of such
services the excess may be considered as a
tax; otherwise they are not taxes;
Fines for certain offences (like for example,
polluting the waterway);
Fines are compulsory payments without any quid
pro quo;
Are fines taxes?
But, fines are not taxes; they are used to curb
certain offences not to raise revenue for the
government;
Import and export duties- may be imposed
with different intentions in mind.
If the intention is to get some revenue for the
public treasury, they are taxes.
 Characteristics of taxes
 Compulsion… no refusal to pay
 Direct benefit is not the main condition (levies
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
 Harmony with national objectives… based on national
objectives
 Certain taxes levied for specific objectives… other
than simply for tax revenue
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
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 or interest bill
met.
Level of taxation

Tax to GDP ratio as a measure of level of

taxation;

Limited reliance of developing

countries on income taxes; why?
In Ethiopia, tax revenue - the principal source of
government’s revenue;

Tax revenue is generated by mainly indirect taxes

For example in the fiscal year 2003/04 indirect taxes

raised amount about 70 per cent of total tax revenues
leaving the rest to direct taxes (Yesegat 2008).
 1.4.Objectives and principles of
taxation
objectives of taxation -what is sought to
be achieved through taxation;

principles of taxation -rules to be

observed in formulating tax structure;

features of a tax system -broad

description of a tax system devised in
conformity with principles;
1.4.1.Objectives of taxation
Tax measures influence economic activities –
taxation affects various decisions;
savings, investment and labor supply
Objectives of taxation may differ
between developed and developing
countries.
A tax system by itself cannot be expected
to achieve all the goals fully. It has to fit in
the overall framework of policies and
measures of the government.
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)

•Employment generation through promotion of labor

intensive techniques;
Removal of regional inequalities through
redistribution of opportunities (projects, income,
employment opportunities, education etc);
encouraging import substitution and export
promotion to overcome balance of payments
difficulties;
Reducing the gap between the poor and rich-taxing
the rich and investing on projects that benefit the
poor;
Proper allocation of resources to enhance the best
possible use of resources and social well being…
beneficial diversion of resources;
Encourage savings and investment through tax
holidays, concessions, rebates, ITC etc.
 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.
 DD for private Vs public goods
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.
Should minimize efficiency costs;
Efficiency costs are caused by changes in
behavior;
Efficiency costs may include lost production (or
income) and consumption.
This is the objective of not just taxation -it is the
objective of budget policy (revenue and
expenditures) as a whole;
 2. Redistribution 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:
(1) a tax-transfer scheme, combining progressive taxation of
high income with a subsidy to low income households;
(2) progressive taxes used to finance public services, especially
those such as public housing, which particularly benefit low
income households.
(3) 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.
 redistribution inevitably involves an
efficiency cost;
 note that:
(1) any given distributional change
should be accomplished at the least
efficiency costs; and
(2) a need exists for balancing
conflicting equity and efficiency
objectives.
 3. Stabilization function
maintaining high employment, a reasonable
degree of price level stability and an appropriate
rate of economic growth, with allowances for
effects on trade (soundness of foreign accounts) and
on the balance of payments.
The overall level of employment and prices in the
economy -aggregate demand;
The level of demand (expenditure) is the function
of spending decisions which in turn depend upon
many factors, such as
past and present income,
wealth position,
credit availability and
expectations;
In any one period, the level of
expenditures may be insufficient to
secure full employment of labor and
other resources.
Expansionary measures to raise
aggregate demand are needed.
At other times, expenditures may
exceed the available output under
conditions of high employment and
thus may cause inflation.
In such situations, restrictive measures
are needed to reduce demand.
 measures)
Raising public expenditures will be
expansionary as demand is increased, initially
in the public sector and then transmitted to the
private sector.
Tax reduction, similarly may be
expansionary;
In periods when expenditures exceed the
available output, restrictive measures are
needed to reduce demand.
Increasing tax burden and reducing the
income available for spending by taxpayers
may be considered…wage freeze for example.
A tax system has to be politically acceptable and
in conformity with administrative capabilities of
the authorities.
Further, some of the objectives of taxation can
be contradictory and the tax system must resolve
this problem in the best possible manner; a
compromise is needed.
Summary of tax objectives
revenue for the government ;
employment generation through promotion of labor intensive techniques;
removal of regional inequalities;
encouraging import substitution and export promotion to overcome balance
of payments difficulties;
reducing the gap between the poor and rich;
proper allocation of resources to enhance the best possible use of resources
and social well being;
encourage savings and investment etc.
 1.4.2 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);
some of them are in conflict against each other;
Some of the criteria such as equity are subjective;
People may disagree on the relative importance of
the criteria;
Adam Smith (1776) calls them canons of a tax system.
There are four canons of taxation as prescribed by Adam
Smith (1776).
Equity
Economy
Certainty
Convenience
Smith’s canons were later extended by other writers
(Bestable and others) to include:
Neutrality
Productivity
Buoyancy
Flexibility
Simplicity etc
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 difficulties in the use of this concept arise.
There is no such agreement about how the term
“fair share” should be defined.
What a “fair share” means in practice
is the subject of endless contention
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
 Benefit principle
an equitable tax system is one under which
each taxpayer contributes in line with the
benefits which he/she receives from public
services.
the truly equitable tax system will differ depending on the
expenditure structure.
The benefit criterion, therefore, is not one of tax policy only, but
of expenditure policy.
Under this approach the total expenditure
should be determined and then the share of
each taxpayer on government expenditure
should be known;
 Ability to pay principle
the tax problem is viewed by itself independent of expenditure
determination.
A given total revenue is needed and each taxpayer is asked to
contribute in line with his/her ability to pay.
The subjects of every State ought to contribute towards the
support of the government, as nearly as possible, in
proportion to their respective abilities;
Yet actual tax policy is largely determined independently of the
expenditure side and an equity rule is needed to provide guidance.
The ability to pay principle is widely accepted as a guide.
The ability to pay 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;
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 the
other not;
 Limitations of both principles
For the benefit principle to be operational,
expenditure benefits for particular
taxpayers must be known.
Although the benefit principle may be
applied directly to the finance of certain
governmental functions, it does not solve
the general problem of tax-structure
design.
It fails to provide the revenue needed to
finance transfers-redistribution role of
taxes is not properly handled.
For the ability to pay approach to
be applicable, we must know how
this ability is to be measured.
Moreover, neither approach can be
said to deal with the entire function of
tax policy: the benefit approach, ideally
can allocate that part of the tax bill
which defrays the cost of public
services, but it cannot handle taxes
needed to finance transfer payments
and serve redistribution objectives.
The ability to pay approach better meets
the redistribution problem, but it leaves the
provision for public services undetermined.
These are formidable difficulties and
neither approach wins on practicality
grounds.
Notwithstanding these shortcomings, both
principles have important, if limited,
application in designing an equitable tax
structure, i.e., one which is acceptable to
most people and preferable to alternative
arrangements.
 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”.
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;
 2. 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.
Certainty pertains to objectivity.
3.Convenience
The mode and timing of tax
payments should be convenient to
taxpayers. Location, waiting room
be also convenient (suitable).
This canon recommends that
unnecessary trouble to the
taxpayer should be avoided,
otherwise various ill-effects may
result.
 4. Economy
Every tax should be so designed as both to take out
and to keep out of the pockets of the people as little
as possible over and above what it brings into the
public treasury of the state (Smith 1776).
taxes should not cause an unnecessary burden
upon the society in the form of costs over and
above the tax liability.
In addition to the actual payment of taxes, taxes
induce other costs:
Compliance and administrative costs (tax operating
costs)
Efficiency costs
Tax compliance costs –costs incurred by
taxpayers and third parties in the process of
complying with the requirements of a tax
legislation;
Tax administrative costs can be broadly
viewed as resources sacrificed by the public
sector in connection with a tax system.
Public sector costs of taxation conceptually
constitute those costs which would not have
been incurred if the tax had never been
introduced (Sandford et al. 1989).
Convenience and certainty canons deal with
the tax compliance costs while the economy
canon is concerned with both the administrative
and compliance costs;
The economy canon also deals with efficiency
costs as well
 Economic Efficiency
Economic efficiency can be thought of
as the effectiveness with which an
economy utilizes its resources to satisfy
people’s preferences.
When resources are directed to their
highest valued uses the economy is said
to be efficient.
By changing the relative attractiveness of
highly taxed and slightly taxed activities taxes
can distort decisions (resource allocation);
If there are distortions in resource allocation, that would reduce
people’s well being in a variety of ways that can include a loss of
output or consumption opportunities;
These reductions in well-being are efficiency costs, also called
deadweight losses, excess burdens (excess because they are costs
in addition to the tax liability) or welfare losses.
The total cost of taxes from a taxpayer’s point of view:

=tax liability + efficiency costs + compliance costs

Tax induced costs to the economy :
= efficiency costs + compliance and administrative costs;
 Productivity and Buoyancy
5. Productivity –
also called canon of fiscal adequacy.
the tax system should be able to yield
enough revenue for the treasury and the
government should have no need to resort to
deficit financing.
6.Buoyancy
the tax revenue should have an inherent
tendency to increase along with an increase in
national income, even if the rates and coverage
of taxes are not revised.
7.Flexibility–
it should be possible for the authorities without
undue delay to revise the tax structure both with
respect to its coverage and rates, to suit the
changing requirements of the economy
and of the Treasury-tax structure must be
easily revisable, not complicated.
8.Simplicity
Easily understandable.
the tax system should not be too complicated.
Complex tax system is difficult to understand
and administer and breeds problems of
interpretation and legal disputes.
 Summary
Among the various requirements for a good tax
structure the following are of major importance,
although they are not meant to be all-inclusive:
Revenue yield should be adequate.
The distribution of the tax burden should be
equitable.
Taxes should be chosen so as to minimize
interference with economic decisions in
otherwise efficient markets. Imposition of
“excess burdens” should be minimized.
The tax structure should facilitate the use of fiscal
policy for stabilization and growth objectives.
The tax system should permit efficient and nonarbitrary
administration and it should be understandable to the
taxpayer.
Administration and compliance costs should be as low
as is compatible with the other objectives.
The various objectives and criteria are not necessarily in
agreement;
Tradeoffs between conflicting objectives and criteria are
needed.
no single tax is expected to satisfy all the criteria;
the ultimate goal is that the overall tax system
(including the social welfare system which is after all
only a negative income tax) should meet these criteria.
The End