Tax Design and administration Process

CH.2
Tax Design process
Teklu K
 Contents
Local tax policy design

Tax Design for small businesses

Design of tax incentives

Administrative features of Tax Design

Tax Harmony and Optimal Taxation

 0. Introduction

Taxes matter. People talk about it and try to

avoid them.
Businesses react to taxes in organising their
activities and in where they carry them out.
Developing countries face a difficult task in
designing and implementing suitable tax
systems.
 0. Introduction
Countries have often relied heavily on taxes
on international trade, but this tax base is
also becoming increasingly hard to
implement in the face of pressures for trade
liberalisation.
Economic growth is often encouraged by,
and results in, closer involvement with the
international economy, but such
“globalisation” simultaneously may cause
fiscal problems.
 1.Tax policy
Tax policy is the choice by a government as
to what taxes to levy, in what amounts,
and on whom.
 The macroeconomic aspects concern the
overall quantity of taxes to collect, which
can inversely affect the level of economic
activity
 1.1Tax policy process
Development of policy idea:
Research policy analyses
Consultation with external stakeholders:
Legislative drafting:
g
Examination, amendment & approval by
legislator
Implementation of policy measure
Post implementation review & adjustment
 1.1Tax policy process
Development of policy idea: identifying the issue and
scope of the problem, obtaining approval to undertake
project planning
Research policy analyses: identifying options,
researching and analysing the issue, undertaking cost and
impact analysis, obtaining approval
g to consult externally
Consultation with external stakeholders: consulting,
finalising policy proposal options, costs and impacts,
obtaining ministerial and cabinet approval for the
proposed policy change, developing draft legislation
Legislative drafting: parliamentary process and external
communication about ensuing legislation
 1.1 Tax design In LMICs
Tax policy in low- and middle-income
countries (LMICs) are typically concerned
with the design of the tax system, to raise
enough revenue to finance public spending
in the most efficient and equitable way ,
without deviating too far from international
norms (Tanzi & Zee, 2000).
 1.1 Challenges LMICs in designing
The structure of the economy with, typically, a
large share of agriculture and informal-sector
activity, makes it difficult to collect certain types
of taxes;
Tax administrations have limited capacities, both
human and financial;
Reliable data are hard to obtain, making potential
impacts difficult to assess; and
 Political environments are less amenable to
‘optimal’ tax policies than in wealthy nations.
 2. local tax 
A local tax is an assessment by sub
nationals: state, county, or municipality to
fund public services
 3.Two Options in policy design

Two forces shape the world in which development

policy will de defined
1.Globalization : Integration of the world.
interdependence of the world's economies,
cultures, and populations
2.Decentralization:transfer of authority and
responsibility for public functions from the central
government to lower tier
 3.1Globalization
Globalization is the word used to
describe the growing interdependence of
the world's economies, cultures, and
populations, brought about by cross-border
trade in goods and services, technology, and
flows of investment, people, and information
 3.2.Decentralization
2.Decentralization:localization(self determination
and devolution of power): the division of public
sector functions among multiple types of
government
It is the transfer of authority and responsibility for
public functions from the central government
to subordinate or quasi-independent government
organizations and/or the private
 4.Decentralization Philosophy
Achievements of Sustainable Development Goals
(SDGs) which is aimed to improve lives if world’s
poor by 2030 will depend on integrity, efficiency,
and sustainability of decentralized governance.
It can be achieved by a well functioning state and
local system; better services, national unity, and
the creation of a potentially powerful tool for
poverty alleviation.
 5.UN Sustainable Development Goals
Eliminate Poverty
Erase Hunger
Establish Good Health and Well-Being
Provide Quality Education
Enforce Gender Equality
Improve Clean Water and Sanitation
Grow Affordable and Clean Energy
Create Decent Work and Economic Growth
Increase Industry, Innovation, and Infrastructure
 5.UN Sustainable Development Goals
Reduce Inequality
Mobilize Sustainable Cities and Communities
Influence Responsible Consumption and
Production
Organize Climate Action
Develop Life Below Water
Advance Life On Land
Guarantee Peace, Justice, and Strong Institutions
Build Partnerships for the Goals
 6.Factors in Expenditure &Revenue needs
A country’s expenditure needs and its
revenue potential depend on:
 A) its fiscal architecture(design); and
 B)the sub national revenue.
The fiscal architecture includes demographic,
economic, and institutional factors.
6.Factors in Expenditure &Revenue needs
1.Demographic: The population mix : Increase in
the percent of elderly/young), Distribution of
income.
2.Economic: The economic activities in which the
people are engaged.
Institutions: :institutions of revenue
administrations, & social systems
 7.Constitutes of sub national revenue

A sub-national govt’s revenue is a

combination of
tax sharing of central collections

 own taxes, and

 non tax revenues.

 8.Choice among local taxes

In selecting one tax or set of taxes, trade

off shall be made among the criteria such
as
Revenue productivity
 benefits received
 Non distortion
Tax equity
Simplicity
Accountability & likes
 9.Small Businesses

Is  a privately owned corporation,

partnership, or sole proprietorship that has
fewer employees and less annual revenue
than a corporation or regular-sized business
 10.Characteristics of Small business
Lower Revenue and Profitability
Smaller Teams of Employees
Small Market Area
Sole or Partnership Ownership and Taxes
Limited Area of Fewer Locations
The hard to tax category.
High In developing economy
 10. Characteristics of Small Businesses

High tax burden may not be due to High rate.

Can be due to high Monetary, time, psychological
cost:
Time spent on studying tax laws,

Filing returns, preparing and supporting tax audit,

preparing for appeal, stress and anxiety in
complying with/ frustration of tax payer
harassment
 11.Effects of Informal businesses

1.Informality affects their own business

 To obtain normal licenses,
To get formal credit,
To maintain profile, and
 results incorruption,
Higher burden on compliant businesses
2.Informality affects govt in ways such as;
 Violation of equity,
Reduced revenue,
and non compliance of other laws
 12.OECD recommendation

OECD recommends
 Avoid retroactive tax (past, back tax) for
those who formalize
Simplify admn. procedures- payment option
Share information (what taxes are, how
businesses will benefit)
 13.EU Commission recommendation
EU (Commission) recommends :
 Introduction of estimation; threshold, and simplified
procedures
Different reporting requirements as to nature of
reports, frequency, period of time that records are to
be kept
Establishing dialogue b/n tax office and small business
group
 17.Use of presumptive taxation for SBs

For many SBs complying with record

keeping is highly costly. Increases adm cost
Presumptive methods should be developed
to adjust the record keeping capability of
SBs
 17.Use of presumptive taxation for SBs

Advantages of presumptive taxation

include:
 lower compliance cost

 fair predictability of tax liability

 less interaction with tax adm

 lower tax burden.

 18.Drawbacks

Fairness concerns,

 risk of abuse,

 disincentive to grow,

cause excessive burden for one group and

low for another, and huge gap between
presumed tax and standard tax.
 19.Basis of presumption

Turnover ( gross income)

Indicators

Simple lump sum

Based on agreement between SBs and tax

authority
 20.Turnover based presumption

SBs are obliged to keep at least some basic records

 a uniform tax rate on a standard % of turnover

 A progressive turnover based tax

Different deductions from turnover to avoid major

diff in tax burden
 21. Indicators based Presumption

Based on external factors such as

 floor space
 no of employees
 value of inventory
 capacity of machinery
 no of years of operation….
Advantages…….
Less prone to evasion, less dispute between SBs
and tax adm, reduced tax compliance cost
Disadvantages…..
Firms may limit the use of indicators to reduce
tax liability
Combination of turnover and indicators (Hybrid)
is used by many countries.

Lump sum (Patent system) : Applying a uniform

rate for a business segment irrespective of size
or turnover
Usually used for hard- to -tax micro businesses

Agreement System
Based on data provided by SBs. Not common in
practice.
 22.Incentives

special exclusions, exemptions or

deductions, preferential tax rates, deferral
of tax liability
Incentives reduce the tax burden of
taxpayers, reduces public revenue
Developed countries take the form of
investment tax credit, accelerated
depreciation, tax treatment of expenditure
on R&D
Developing countries: tax holidays, regional
investment incentives, special enterprise
zones, reinvestment incentives….
 23.Benefits &Disadvantages of incentives

Benefits of incentives
Increased investments, employment, supply and
distribution of products in the locality, increased
revenue to govt: (directly from investment, indirectly
from employment, suppliers and consumers)
Disadvantages: revenue loss (tax), resource allocation
costs, enforcement and compliance costs, costs
associated with corruption and lack of transparency
 - forgone revenue from projects that would have
been undertaken even without incentives, loss from
improper claim of incentives, shift income from
taxable firms to firms quality for favorable treatment
 24.Forms of incentives

1.Reduced corporation tax: particular activity, region,

location

2.Tax holiday: tax exemption or reduced rate for a

specific duration

3.Investment allowance/credit: write off investment

against taxable income/ set off against tax payable

4.Tax credit account: a tax relief up to specific amount

 24.Forms of incentives

5. Accelerated depreciation: write off asset for tax

purpose
6. Reinvestment incentives: reinvestment of profit.
Tax liability is reduced by the reinvested profit
7. Reduced withholding tax:
8. Personal income tax, payroll tax, social security
deduction: to expatriate executives/employees;
to invest in regions of high unemployment
9. Sales tax exemption: exemption of VAT for
investment, exemption for export oriented
investments
10. Reduced import duties
 24.Forms of incentives
11. Property tax incentives:
12. Creation of special zones:
-Duty free zones: exemption from duty
-Special economic zones: enjoy other tax
privileges not enjoyed in any other part of the
host country
- export processing zones (EPZ): processing of
imported materials and components for export
( VAT and customs duty may be exempted)
 25.Common design issues

Legislation should clearly stipulate which investors

or transactions qualify.
Specify automatic or discretionary
 Automatic: Qualifies automatically on meeting
prescribed conditions
Discretionary incentives cause administrative
burden, loses transparency and prone to corruption
 25.Common design issues
The legal instruments granting incentives should
be clearly drafted so that they achieve policy
objectives with minimum leakage of tax revenue.
Should not be designed to have frequent
changes
Four broad steps involved in incentives
(1)Designing incentives
(2) granting incentive
(3)implementation
(4) follow up of compliance by firms.
 26.Design Requirements

Administration of incentives should be done by a

single department.
Investors prefer dealing with one office

Keep incentives and procedures transparent, easy to

administer and easy to understand
Clearly specify the package and criteria in the
legislation
Follow Up : To reduce abuses on incentives.
 27.Common Abuses on incentives:

 Round Tripping: if incentives are given for

foreign investors, local money may be transferred
to foreign country and taken back to invest
Double dipping: If Incentives are restricted to
new investors, (e.g. tax holiday) an investor who
plans to expand will form a subsidiary to get the
privilege
Transfer pricing: if one of the activities of an
investor has got tax privilege, profit from other
businesses will be transferred to the one which
has got the privilege
 28.Common Abuses on incentives

Overvaluation of assets: give the temptation to

overvalue assets ( For e.g. if tax holiday is given
to a particular level of investment)
Abuse of duty free privilege: The exempted
item may be sold in the local market
Asset stripping and fly by night: Disappear after
having secured the privilege and completion of
the duration
Corruption: particularly if provided at the
discretion of administrators. (during monitoring,
qualifying for incentives etc)
 29.Role of non- tax factors in attracting investments

Tax considerations are just one factor for

investment decisions. Others include
 Consistent and stable macro economic and fiscal
policy
Political stability
Adequate physical, financial, legal, and institutional
infrastructure
Effective, transparent, accountable public
administration
Skilled labor force, flexible labor code
Availability of adequate dispute resolution
mechanism
30.Role of non- tax factors in attracting investments

 Foreign exchange rules and the ability to

repatriate(send back) profit
 Language and cultural conditions
Incentives are beneficial to have
increased capital transfer,
 transfer of know how and technology,
increased employment, and
 assistance in improving less developed
areas
 31.Principles of revenue decentralization
Principle of Independence.
Principle of Equity.
Principle of Uniformity.
Principle of Adequacy.
Principle of Fiscal Access.
Principle of Integration and Co-ordination.
Principle of Efficiency.
Principle of Administrative Economy.
9. Principle of Accountability.
 Principle of Independence
Under the system of federal finance, a
Government should be autonomous and
free about the internal financial matters
concerned.
 It means each Government should have
separate sources of revenue, authority to
levy taxes, to borrow money and to meet
the expenditure. The Government should
normally enjoy autonomy in fiscal matters.
 Principle of Equity
From the point of view of equity, the
resources should be distributed among the
different states so that each state receives a
fair share of revenue. The allocation of
resources should be made in such a way as to
give equitable treatment to the individuals
and business firms in different places.
 Principle of Uniformity

 In a federal system, each state should pay

equal tax payments for federal finance. But
this principle cannot be followed in practice
because the taxable capacity of each unit is
not of the same. Since this principle of
uniformity emphasis on the uniformity of
pattern of expenditure
Principle of Adequacy of Resources
The principle of adequacy means that the
resources of each Government i.e. Central
and State should be adequate to carry out
its functions effectively. Here adequacy
must be decided with reference to both
current as well as future needs. Besides,
the resources should be elastic in order to
meet the growing needs and unforeseen
expenditure like war, floods etc.
 Principle of Fiscal Access
 In a federal system, there should be
possibility for the Central and State
Governments to develop new source of
revenue within their prescribed fields to
meet the growing financial needs.
 In nutshell, the resources should grow
with the increase in the responsibilities of
the Government
 Principle of Integration a& Co-ordination
 The whole financial system of a
federation should be well integrated.
There should be a perfect co-ordination
among different layers of the financial
system of the country.
Then only the federal system will prosper.
This should be done in such a way to
promote the overall economic
development of the country.
 Principle of Efficiency
The financial system should be well
organized and efficiently administered.
There should be no scope for evasion
and fraud.
No one should be taxed more than once
in a year. Double taxation should be
avoided.
 Principle of Administrative Economy
Economy is the important criterion of any
federal financial system.
That is, the cost of collection should be at
the minimum level and the major portion of
revenue should be made available for the
other expenditure outlays of the
Governments.
 Principle of Accountability
 In a federal set up, the Governments
both Central and States enjoy financial
autonomy.
 Thus, in such a system each Government
should be accountable to its own
legislature for its financial decisions i.e.
The Central to the Parliament and the
State to the Assembly.
 Modes of Allocation
There are two types of allocation. They are as
follows:
Independent System: Under this system, the
units in a federation are deriving their revenue
from absolutely different sources.
There would be no concurrence or contact
between the centre and the units.
Mixed System: Under this system, there would
be concurrence and contact between the centre
and the units.
 Mixed System
 Mixed System is divided into two :
 concurrent mixed system and
Contact mixed system.
In the concurrent mixed system, both centre and the
states have concurrent powers of taxation regarding
certain sources.
There would be no transfer of resources from the centre
to the states.
In the contact mixed system, contact between the centre
and the states is created.
 There would be assignments, subsidies, subventions or
contributions.
 Balancing Factors of Allocation
Prof. Adarkar points out that it would be
impossible to think about an independent system.
The most desirable system of federal finance must
ensure large measure of independence and
adequacy.
If either the centre or the states are not able to
meet their requirements, it should be made good
by certain balancing factors.
 The balancing factors are those, which would
make good the financial inadequacy of either the
centre or the states in a federation as folows.
Assignments: Usually the Federal
Government levies and collects certain taxes.
But it is shared on an agreed basis with the
states.
Even though the distribution is very difficult,
it can be shared on the following bases
On the basis of actual collections from
different states.
 On the basis of population and
On the basis of economic backwardness of
the states.
Subsidies: The states very often find themselves
with financial stringency. They are granted
certain subsidies by the center on account of the
transfer of certain sources like customs or
excises to the center.
Subvention: Subventions are grants-in-aid to
redress certain inequalities between states. They
are made for specific purposes. They should be
spent for the purpose for which they are made.
The spending of the amount would be under the
supervision of the granting authority.
 Disbursing and Transfer of Public Funds
The structure of federal finance comprises
two essential components.
The division of powers between the Union
and the states in respect of rising and
disbursing of public funds
The transfer of funds from the center to the
states.
The general principle on which the
allocation of functions and duties are
based is "whatever concerns the nation as
a whole.
Principally external relations and inter­
regional activities should be placed under
the control of the central government
All matters which are primarily of regional
interest should remain in the hands of the
Regional Government”.
There are three principles that govern the division of
taxes between the center and the states.
Taxes which have an inter-state base are levied by
the union government; and
Taxes with a local base are levied by state
governments.
There is the concurrent list falling within the
jurisdiction of both the center and the states.
The residuary powers rest with the central
government i.e.
It has exclusive authority to impose taxes which are
not specifically mentioned either in the state list, or
in the concurrent list.
 Pattern of Revenue Sharing:

Ethiopia has chosen the federal structure in which a

clear distinction is made between the Union and State
functions and sources of revenue, but residual
powers, belong to the Center, although the States
have been assigned certain taxes, which are levied
and collected by them, they also share in the revenue
of certain Federal taxes.
In addition, the States receive grants-in-aid of their
revenue from the Federal Government, which further
increase the amount of transfers between the two
levels of government. The transfer of resources from
the Central government to the States is an essential
feature of the present financial system.
Distribution of Revenues between Central and States

The present federal fiscal system in Ethiopia is of a recent

origin.
The distribution of revenues between the centre and
states is followed on the basis of "Constitution of Ethiopia”
and Proclamation No.33/1992-Proclamation “To Define
sharing of Revenue between the Central Government and
the National/Regional Self Governments”.
The Articles 96, 97, 98, 99 and 100 of The Constitution of
Ethiopia make a clear demarcation of areas where the
Central alone or State alone have authority to impose
taxes.
 It contains a detailed list of the functions and financial
resources of the Center and States.
 Categorization of Revenue
According to "Constitution of Ethiopia” and
Proclamation No.33/1992-Proclamation,
revenues shall be categorized as Central,
Regional and Joint. That is there are three
lists given in the Articles. They are as
follows:
Central List,
Regional List, and
3 Joint/Concurrent List.
 Federal/Central List
Duties, tax and other charges levied on the
importation and exportation of goods;
Personal income tax collected from the
employees of the central Government and
the International Organizations;
 Profit tax, Personal income tax and sales tax
collected from enterprises owned by the
Central Government. (Now sales tax is
replaced with VAT and Turnover taxes).
 Federal/Central List
Taxes collected from National Lotteries and
other chance winning prizes;
Taxes collected on income from air, train and
marine transport activities;
Taxes collected from rent of houses and
properties owned by the central
Government;
 Charges and fees on licenses and services
issued or rented by the central Government;
 Regional List

Personal income tax collected from the

employees of the Regional Government and
employees other than those covered under the
sources of central government.
Rural land use fee.
Agricultural income tax collected from farmers
not incorporated in an organization.
Profit and sales tax collected individual traders.
Tax on income from inland water transportation.
 Regional List
Taxes collected from rent of houses and
properties owned by the Regional Governments;
Profit tax, personal income tax and sales tax
collected from enterprises owned by the
Regional Government:
 With prejudice to joint revenue sources, income
tax, royalty and rent of land collected from
mining activities.
. Charges and fees on licenses and services issued
or rented by the Regional Government;
 Joint/Concurrent List
The following shall be Joint revenues of the
Central Government and Regional Governments:
Profit tax, personal income tax and sales tax
collected from enterprises jointly owned by the
central Government and Regional Governments;
Profit tax, dividend tax and sales tax collected
from Organizations;
Profit tax, royalty and rent of land collected from
large scale mining, any petroleum and gas
operations;
Forest royalty.
 Subsidy:

National/Regional Governments, where

deemed appropriate, shall receive
subsidies from the Central Government.
National/Regional Governments shall
before the approval of their budget, submit
to the Ministry of Finance &Economic
Development ,their subsidy request,
together with the total expenditure
required for the fulfillment of objectives
given in the Proclamation.
 Collection of Revenue
Central Government revenues and revenues jointly
owned by the Central Government and
National/Regional Governments shall be collected by
the Central Government revenue collection organs.
However, whenever deemed necessary the collection
of such revenues may be delegated to regional
Governments.
The recent position of revenue sharing arrangements
between Federal Government and Regional States
regarding jointly established companies, Private
companies and Minerals and petroleum is as folows.
 Revenue sharing arrangements between Federal Government
Types of Joint Revenue Revenue Sharing Formula

Federal Regional
Government States
Jointly Established Companies
1.1. Profit Tax As per Capital
As per Capital Share Share
1.2. Employee Income Tax 50% 50%
1.3. Indirect Taxes 70% 30%

Private Companies
2.1.ProfitTax 50% 50%
2.2. Indirect Taxes 70% 30%
2.3. Dividends 50% 50%
Minerals and Petroleum

3.1.ProfitTax 50% 50%

3.2. Royalty 60% 40%

 Discussion questions
Discuss I group over the following issues

List ad discuss types of tax incentives In Ethiopia

along with their purpose & relevance
Evaluate revenue decentralization In Ethiopia
Discuss the present status & potential capacity
of I achieving SDGs