2.

MEANING
AND
CHARACTERIST
ICS OF
TAXATION
 CONTENTS
1. Meaning and Nature of Tax
2. Characteristics of a Good Tax
System
3. Objectives of Taxation
4. Principles of Taxation
5. Tax Classifications
6. Tax Rate Structures
7. Shifting and Incidence of Taxation
8. Tax Evasion, Avoidance and
Delinquency
 Meaning of Tax
• A tax is a compulsory, unrequited payment to
government.
• Tax is one of the most important sources of
revenue to every government.
• It is a compulsory levy, and those who are taxed
have to pay the sums irrespective of
corresponding return of services of goods by the
government.
• It is not a price paid by the taxpayer for any
definite service rendered or a commodity supplied
by the government
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Here are the essential elements of any tax:
It is generally payable in money
It is a proportion or a percentage
It is levied on persons
It is levied by the government
It is levied in order to cater to public purpose

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 Stages in the Development of Levy of Tax
1. Tax is considered as gift (Initial stage)
2. Government questioned the public to pay tax in
favor of them
3. Individuals felt that they helped the Government
4. Individuals felt that they sacrificed for the
benefit of government
5. It is the duty of the tax payers to pay tax
6. Necessity for paying tax to the government is
stressed and made it as an obligation
7. Compulsory payment of tax without quid pro-
quo (Present stage) 5
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 Characteristics of a good tax system
1. Tax is a compulsory Contribution:
– A tax is a compulsory payment from the person to the
government without expectation of any direct return.
– No one can refuse to pay a tax on the ground
– Therefore, everyone has to pay a tax upon whom it is
levied by the state whether he is an adult or a minor, or
a citizen or an alien.
2. The Assesses will be required to pay tax if it is due
from him
– No one can be forced by any authority to pay tax, if it is
not due from him.
– If an individual’s income is below the exemption limit,
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he will not be forced to pay tax. 6
3. Taxes are levied by the government
– Only the government has the right to impose and collect
taxes.
4. Common benefits to all
– The tax, collected by the government, is spent for the
common benefit of all the people.
– Such benefits are given to all the people whether they
are taxpayers or non-taxpayers.
– These benefits satisfy social wants.
5. No direct benefit
– There is no direct relationship between the payment of
tax and direct benefits.
– The government compulsorily collects all types of
3:02 PM taxes & does not give any direct benefit to taxpayers.7
6. Certain taxes are levied for specific Objectives
– For example, heavy taxes are imposed on luxury goods
to reduce their consumption
– Thus, taxes are levied not only to earn revenue but
also for diversion of resources or saving foreign
exchange;
– Certain taxes are imposed to reduce inequalities of
income and wealth.
7. Attitude of the Tax-payers
– The attitude of the tax-payers is an important variable
determining the contents of good tax system.

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8. Good tax system should be in harmony with national
objectives
– It should accommodate the attitude and problems of tax-
payers and also take into consideration the goals of social
and economic justice.
– It should also yield adequate revenue for the treasury and
should be flexible enough to move with the changing
requirements of the state and the economy.
9. Tax system recognizes basic rights of tax payers
– The tax law should be simple in language and the tax
liability should be determined with certainty.
– The mode and timings of payment should be
convenient to the tax-payer.
– It should be progressive and the burden of taxation
should be equitable to all the tax-payers.
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 Purpose/Objectives of Taxation
• The primary objective of taxation for a
government is to make provision for funds to
meet public expenditure for achieving economic
and social objectives.
• Most governmental activities must be financed by
taxation but it is not the only goal.
• Taxation policy has some non-revenue objectives.
• It is used as an instrument of economic policy.
• It affects the total volume of production, consumption and
investments.
• Government levies and collects taxes for various
objectives including the following:
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 1. Raising revenue
– To meet this enormous expenditure, government
imposes various types of taxes in addition to the non-
tax revenue.
2. Removal of inequalities in income and wealth
– The welfare state aims at the removal of inequalities in
income and wealth. The progressive taxation on
income is best example in this regard.
3. Ensuring economic stability
– That is, taxation is a means that helps to control the
trade cycle (inflation and deflation)
– During the period of inflation, raising the existing tax
rates or imposing additional taxes will help remove
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 4. Reduction in regional imbalances
– Certain parts of the country are well developed, whereas some
other parts or states are backward.
– To remove these regional imbalances, the government can use tax
measures like announcing various tax exemptions and
concessions to backward regions
5. Capital accumulation
– Tax concessions or rebates given for savings or investment in
provident funds, life insurance, housing banks, investment in
shares and debentures of certain companies etc. lead to large
amount of capital accumulation which is essential for the
promotion of industrial development.
6. Creation of employment opportunities
– More employment opportunities can be created by giving tax
concessions or exemptions to small entrepreneurs and to the
industries adopting labor-intensive techniques.
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7. Preventing harmful consumption
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 8. Beneficial diversion of resources
– The imposition of heavy duties on non-essential and luxury
goods discourages the producers of such goods.
– The resources utilized for production of these goods may be
diverted into the production of other essential goods for
which various tax concessions are given.
9. Encouragement of exports
– Encouraging export oriented industries by way of
providing various exemptions like 100% relief from
income tax, free trade zones etc.
– It results in the large earnings of foreign exchange.
10. Enhancement of standard of living
– By way of giving various tax concessions to certain
essential goods, the government enhances the standard of
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living of people.
 Canons of Taxation
• There are various criteria (principles) that can be followed in
evaluating a tax policy proposal (tax structure);
• Taxation of people must be levied with great care & rationality.
• In order to practice this rationality and care, the taxing agency
must follow certain code of conduct, as the principles of taxation,
while determining the type and amount of tax.
• Taxation system should adhere to certain basic principles so that it
can function effectively.
– The tax system should be fair (according to ability to pay)
– The provisions of tax should be clearly specified without any
ambiguity.
– It should be easy to understand to the common man.
– Should be efficient & compliance cost should be minimum

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 • Of the canons of taxation four of them (canon of equity,
certainty, convenience and economy) are enumerated by
Adam Smith & the rest are contributed by other economists.
1. Canon of Equity
– States that the tax system should be framed depending
on the ability of the people to pay tax.
• The richer sections should be subjected to higher tax
• Lower income group should be subjected to less tax.
2. Canon of Certainty
– Implies that the tax-payer should be well informed about
the time, amount and the method of tax payment.
– Thus, this canon is equally important both for the
individual and the state.
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4. Canon of Convenience
– States that every tax ought to be so levied at the time or in
the manner in which it is most likely to be convenient for
the contributor to pay it.
5. Canon of Economy
– Implies that the administrative cost of tax collection should
be minimum
6. Canon of Productivity: that taxes should be productive.
– The productivity of a tax may be observed in two ways.
• First , a tax should yield a satisfactory amount for the
maintenance of government.
• Secondly, the taxes should not discourage
production in the short and in the long run.

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6. Canon of Elasticity
– Proclaims that yields of taxes should be increased or
decreased according to the needs of the government.
7. Canon of Diversity
– It implies that the tax system should be diverse in nature.
– There should be all types of taxes so that everyone may be
called upon to contribute something towards the revenues of
the state.
– Thus, the governments should adopt multiple tax system.
8. Canon of Simplicity
– Implies that a tax should easily be understood by the tax-
payer i.e., its nature, aims, time of payment, method and
basics of estimation should be easily followed by each tax-
payer.
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9. Canon of Expediency
– Implies that the possibilities of imposing a tax
should be taken into account from different
angles i.e., its reaction upon the tax-payers.
10. Canon of Co-ordination
– Taxes are imposed by central state and local
governments.
– It is, therefore, desirable that there must be co-
ordination between different taxes that are
imposed by different taxation authorities.

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 Classification and Choice of Taxes
Direct and Indirect Taxes

1. Direct Taxes
Are those taxes which are paid entirely by those
persons on whom they are imposed.
The immediate money burden is upon the man
who pays the tax to the authority.
Direct taxes are taxes which cannot be shifted to
others.
Examples include: Income-tax, tax on profits,
capital gains tax, property or wealth-taxes
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 Merits of Direct Taxes:
Equitable
– Based on the principle of progression.
– The larger the income the higher the rate of tax will be and vice-
versa.
– Direct taxes are taxed according to the ability to pay of the tax
payers.
Certainty
– Direct taxes satisfy the canon of certainty.
– The tax payer is certain as to how much he/she is expected to
pay and similarly the state is certain how much it has to receive
income from direct taxes.
Reduce Inequalities
– As direct taxes are progressive in nature, rich people are
subjected to higher rates of taxation, while poor people are
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exempted from direct tax obligations.
Elasticity
– Elasticity in direct taxes implies that more
revenue is collected by the government by
simply raising the rates of taxation.
Civic Consciousness
– Since direct taxes are certain, the tax-payers feel
the pinch of such payment and are therefore,
alert and take keen interest in the method of
public expenditure, whether the revenue raised
is properly utilized or not.

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 Demerits of Direct Taxes:
Unpopular
– Because they are required to be paid in one lump sum
which is inconvenient to the tax-payer.
– Direct taxes are generally not shifted; therefore, they are
painful to the tax payer.
Inconvenience
– Direct taxes are paid in lump sum which causes
inconvenience to the tax payers.
Possibility of Evasion
– A direct tax is said to be a tax on honesty, but it can be
evaded through fraudulent practices.
– It is a fact that the people in the higher income groups do not
reveal their full income.
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Adverse effects on the will to work and save
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 2. Indirect taxes
• Indirect tax is a tax that the burden may not
necessarily be borne by the assessed.
• Indirect taxes can be shifted to other person.
• Indirect taxes are taxes on commodities. These are
custom duties, VAT, excise taxes etc.
• For example, the import duty on motorcars is paid
in the first instance by the importer of cars, but
ultimately he/she transfers the burden of this duty
to the purchaser of car in the form of a higher
price.
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 Merits of indirect taxes
Convenient
– Paid in small amounts instead of in one lump sum.
– They are generally included in the price of a commodity and hence
the burden of these taxes is not felt very much by the tax-payers.
No evasion
– Indirect taxes are generally difficult to be evaded as they are
included in the price of a commodity.
– A person can evade an indirect tax only if he/she decides not to
purchase the taxed commodity.
Elastic
– The revenue from indirect taxes can be increased.
Wide coverage
Can be progressive
– By imposing heavy taxes on luxuries and exempting articles of
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3:02 PM common consumption from the tax net.
 Demerits of indirect taxes
Regressive: the government in order to increase its
revenues imposes heavy taxes common consumption, the
demand for which is inelastic.
Administrative cost: the administrative cost of collection
of such taxes is generally heavy as they have to be
collected from large number of people in small
amounts.
Discourage saving: indirect taxes discourage saving
because they are included in the price of a commodity
No civic consciousness: unlike direct taxes, indirect taxes
are collected in small amounts; hence, they are not felt
very much by the tax payer and does not arouse civic
consciousness.
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Creation of inflation
 BASIS FOR
DIRECT TAX INDIRECT TAX
COMPARISON

Meaning Direct tax is referred to as the tax, Tax levied on a person who
levied on person's income and consumes the goods & services
wealth and is paid directly to the & paid indirectly to the
government. government.

Nature Progressive Regressive

Incidence & Impact Falls on the same person. Falls on different person.

Types Income-tax, tax on profits, VAT (Value Added Tax), Excise

property or wealth-taxes Duty, Custom Duty.

Evasion Tax evasion is possible. Tax evasion is hardly possible

because it is included in the
price of the goods & services.
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 Proportional, Progressive, Regressive & Degressive taxation
1) Proportional Taxation
– A tax is proportional if all the tax payers pay the same
proportion of their income (property) as tax.
– In the proportional tax system, all incomes are taxed at a
single uniform rate and it does not matter if the tax
payer's income increase or decrease.
– Example: Proportional Tax System:

Tax base Birr Tax Rate in % Amount of Tax in Birr

1,000 10 100
5,000 10 500
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 Advantages
Relative position is not affected
Uniform tax Rates
Certainty
Willingness to work and save not affected
Equitable: because money burden increases in
the same proportion as the income increases.
Disadvantages
The burden of tax falls more heavily on the poorer
section of society:
It does not reduce the inequalities of income and
wealth:
– Rather it enhances these inequalities and increases the 28gap
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between the rich and the poor
 2) Progressive Taxation
– A tax is said to be progressive, if the larger the tax-
payers income (or property), the greater is the
proportion that he/she pays the tax.
– A progressive tax varies with the change in the income
of the individuals, in that the rate of tax becomes
gradually higher for the greater incomes and lower for
the less incomes.
Tax rate

Tax Base
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 Advantages
Equalities: under the system of progressive
taxation inequalities would be reduced because a
higher proportion of the income and wealth of the
rich would be taken away by way of taxes than
that of poor.
Economic: progressive taxes have also been
justified on the ground that they are economical as
the cost of collection does not rise with the
increase in the rates of taxes.
Elastic: Revenue from progressive taxes can be
increased by increasing the rates of taxes.
Curbs inflationary trends
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 Disadvantages of Progressive taxation
• Reduces capital formation
• Scope for tax evasion

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 3) Regressive Tax
A regressive tax is the opposite of the progressive
tax.
The rate of tax diminishes as the income of an
individual increases.
The poorer section of society are taxed at higher
rates than the richer sections.
Tax Rate

Tax Base
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 4) Degressive tax
In this tax system, the rate of tax increases up to
a certain limit and beyond which a uniform rate
is charged.
Thus, it is blend of progressive and
proportional.
Tax Rate

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 Single Vs Multiple Taxation
Single Tax System
A single tax means only one kind of tax.
It does not mean tax on only one person.
A single tax may be proportional, progressive or
regressive, or it may be fixed amount. Merits of a
single tax
Simple: Since there is only one tax, it simplifies
the work of the government.
Equitable: single tax like income tax is just and
equitable because it is based on the principle of
equity in taxation.
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 Demerits of a single tax:
Insufficient revenue: from the point of view of
revenue, the single tax may not be sufficient for
the government.
Regressive: It cannot be imposed in proportion to
the ability to pay of the tax-payer.
For instance, if a tax is imposed on houses, land
etc; it is very difficult to make its burden on
everybody in proportion to his/her ability. If the
tax is on income, it can be made very equitable.

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 Multiple tax system
– There should be all types of taxes, direct and
indirect, so that every class of citizen may be
called upon to contribute something towards the
state revenue.
Merits of multiple taxation:
– Just and equitable: multiple taxes are just and
equitable because they are based on the
principle of ability to pay. All the tax-pay taxes
according to their money income.
– No evasion
– Sufficient revenue
– Wide Coverage:
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Demerits of multiple taxation:
– Unpopular: Direct taxes cannot generally be
shifted; therefore, they are painful to the tax-
payer. On the other hand, indirect taxes are
included in the price of a commodity
– Inconvenient: too much multiplicity of taxes
may lead to inconvenience to both the taxing
authority and the tax-payer as well as to the
general public.
– Administrative Cost: the administrative cost of
collection of such taxes is generally heavy as
they have to be collected from large number of
people.
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 Tax Structure
• A country imposes various types of taxes (such as
sales tax, capital gains tax, income tax, etc). The
combinations of different types of taxes
imposed in a country are referred to as tax
structure.
• Tax structures differ from country to country.
• Though many countries use different tax base for
collecting revenue, they have common tax
structure.
• For example, income tax, value added tax, capital
gains tax and etc.
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 IMPACT SHIFTING AND INCIDENCE OF TAXES
IMPACT
• The impact of a tax is on the person who pays the money in the first
instance.
• Impact of a tax, therefore, refers to the immediate burden of the tax
and not to the ultimate burden of the tax.
SHIFTING
• It refers to the process by which the money burden of a tax is
transferred from one person to another.
• The tax may be shifted forward or backward.
INCIDENCE
• Incidence is final resting place of a tax while shifting is process of
transferring money burden of tax to someone else. Shifting finally
ends in incidence.
• The incidence of tax remains upon that person who cannot shift its
burden to any other person. 39
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 Distinction between Impact and Incidence
– Impact refers to the initial burden of the tax, while
incidence refers to the ultimate burden of the tax.
– Impact is at the point of imposition, incidence occurs
at the point of settlement.
– The impact of a tax falls upon the person from whom
the tax is collected and the incidence rests on the
person who pays it eventually.
– The impact is the initial phenomena, the shifting is the
intermediate process, and the incidence is the result.

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Example
• Suppose government levies a tax on electric
goods in Ethiopia. Tax will be paid to
Government in first instance by manufacturers of
electric goods. Impact of tax is, therefore, on
them.
• If manufacturers of electric goods industries add
tax to price and succeed in selling goods at higher
prices of electric goods to consumers, burden of
tax is thus shifted on to consumers.

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 Types of Tax Shifting
Shifting of tax can take place in two directions, forward and
backward.
Forward Shifting
If tax is shifted, from seller to consumer, it is a
case of forwarding shifting.
Backward shifting
Takes place when consumers do not purchase
commodities at increased prices. Sellers are! then forced
to cut down prices and bear burden of tax themselves.
Backward shifting is thus performed by buyers.

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 Tax Evasion Vs Tax Avoidance
• Tax avoidance and evasions constitute a problem
in almost all the countries of the world.
• Tax avoidance is different from tax evasion, while
evasion is against the law; avoidance is within
the ambit of law.

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Tax Avoidance:
• Tax avoidance can be defined as “the act of
escaping from the tax liability by using the
available loop-holes of the tax laws”.
• Tax avoidance is a legal minimization of tax
burden by the taxpayers.
Examples for tax avoidance:
– Suppose a taxpayer’s total income exceeds the
maximum tax-free amount, then he has to pay the tax
on such excess amount. But if he invests the excess
amount in any of the approved schemes for which
there is a relief in the tax law, he can save on tax
altogether.
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Tax Evasion:
• Tax evasion, on the other hand, is a crime in almost all
countries and subjects the guilty party to fines or even
imprisonment.
• Tax evasion is evading the payment of taxes by
breaking the law.
• Tax evasion usually entails taxpayers deliberately
misrepresenting or concealing the true state of their
affairs to the tax authorities to reduce their tax liability.
• In other words tax evasion means fraudulent action on
the part of the taxpayer with a view to violate civil and
criminal provisions of the tax laws.
• Generally, there are two forms of tax evasion. They are
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suppression of income, and inflation of expenditure.
Meaning Minimization of tax liability, by taking Reducing tax liability by using
such means which do not violate the illegal ways is known as Tax
tax rules. Evasion.

Attributes Immoral in nature, which involves Illegal and objectionable, both

bending the law without breaking it. in script and moral.

Concept Taking unfair advantage of the Deliberate manipulations in

shortcomings in the tax laws. accounts resulting in fraud.

Legal implication Use of Justified means Use of such means that are
forbidden by law

Happened when Before the occurrence of tax liability. After tax liability arises.

Type of act Legal Criminal

Consequences Deferment of tax liability Penalty or imprisonment

Objective To reduce tax liability by applying the To reduce tax liability by

script of law. exercising unfair means.
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• Generally, the effects of tax evasion are:
– it increases the burden of honest tax payers;
– it leads to creation of black money / unaccounted and unrecorded money,
and
– it increases inequality & concentration of income & wealth
Causes of tax evasion
High rates of taxation
Multiplicity of tax laws
Complexity of tax laws
Inadequate information as to sources of tax revenue
Ineffective tax enforcement:
Absence of deterrent punishment:
Luck of publicity:
Moral and psychological factors
Attitudes of income tax departments:
Officers of the department of taxation authority should be men of integrity
Corrupt business practices
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 Methods of tax evasion
• The following are some of the methods of tax evasion:
Omission to report taxable income
Maintenance of multiple set of books of accounts
Opening accounts under fictitious names
Securing contracts under fictitious names
Deduction of personal expenses as business expenses
Omission to report several incomes from irregular
sources
Understatement of receipts
Overstatement of business expenses

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 Remedies for tax evasion
• Thorough overhauling of tax laws: Re-drafting the tax laws
thoroughly without any loopholes and weak points.
• Reduction in tax rates: reducing the rate to a reasonable level.
• Permanent account number: to prevent tax dodgers from evading
tax through opening accounts under fictitious names, permanent
account number or tax identification number (TIN) should be
allotted to each tax payer for use in transactions.
• Tax on agricultural income: agricultural income is exempted from
income tax and for this reason it is used to convert the black money
into white.
• Maintenance of proper accounts: Maintenance of proper accounts
should be made compulsory for persons whose business and
professional income exceeds a prescribed limit.
• Change in penal provision: a person, who evades tax, should be
punished by the government. 49
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• Vigorous prosecution: If a tax payer is found
lacking in his duties i.e. if a tax-payer conceals
the facts with regard to their income and wealth
and evades the payment of tax, he should be sued.
• Educating people: to make people pay tax
correctly and regularly, they should be educated
and awareness should be created with regard to
the payment of tax through public/ mass media
like press, radio and films.

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 END OF
CHAPTER
TWO
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