NATIONAL AVIATION COLLEGE

BA IN ACCOUNTING & FINANCE

Course Outline
Course Title: Taxation
Course Code: 652
Credit hours: 3
Academic Year: 2021/22
• Course Description

This course provides students with a thorough and in-depth

knowledge of the current law, principles and practices of
Ethiopian Taxation.
Students are required to apply the tax principles, decided
cases and legislations to the Ethiopian taxation system on
compliance matters and tax planning activities.
The course also covers anti-avoidance provisions, cross
border activities and international tax planning
considerations.

The course is helpful not only for tax compliance and planning
but also for paving the way for students to enter their future
 Course Objectives

After completing this course, students should be able to:

 Demonstrate advanced knowledge of taxation in Ethiopia;

 Apply legal principles and statutory provisions in tax compliance and tax
planning;
 Effectively interpret tax statutes, apply tax rules and analyze practical tax
problems;
 Recognize the social responsibility of a tax professional;
 Work in group reports and presentations to acquire an understanding of
the corporate tax systems in major developed countries;
 Evaluate legal arguments in tax cases and present one’s own arguments
with cases support in a reasoned manner;
 Discuss contemporary international tax issues like double tax treaties and
transfer pricing;
 Contents

• Course Content:
• Chapter One: Taxation – an introduction
– Taxation, Tax definition
– Characteristics of taxes
– Level of taxation
– Objectives and principles of taxation
• Objectives of taxation
• Principles of taxation
• Chapter Two: Tax systems and taxes
– Single and Multiple tax systems
– Direct Vs indirect taxation
– Ad Valorem Vs Unit taxes
– Tax on Income
– Tax on commodities
– Tax on wealth
– Presumptive taxation
– Tax administration and tax compliance
• Chapter Three: International taxation
issues
– International taxation Vs domestic taxation
– Residence and source based taxation
– Global and territorial systems of taxation
– Methods for preventing double taxation
– Taxation and MNE
– Tax Havens and transfer pricing
• Chapter Four: Taxation and corporate
financial decision making
– Taxation and choice of finance
– Taxation and choice of company location
• Chapter Five: Tax evasion and avoidance
– Tax avoidance
– Tax planning
• Features of tax planning
• Basics of tax planning
– Tax evasion
• Causes of tax evasion
• Chapter Six: The Ethiopian tax system
– Income Tax in Ethiopia
• Employment income tax
• Income from Rental of Buildings
• Business Income Tax
• Withholding taxes on payments and imports
– Value Added Tax in Ethiopia
• Taxable transaction
• Taxpayers
• Tax Credit
• Record keeping requirements
• Teaching and Learning Strategies
Lectures
Project Presentation
• Mode of Assessment
Article Review
Project Work
Final Examination
• References
 1.1. A General Overview

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 What is Public Finance?

• Public finance deals with the income and expenditure pattern of the
Government

• According to Dalton,’ Public finance is the branch of knowledge

which is concerned with the income and expenditure of public
authorities and with the adjustment of one to another.’

• It deals with the study of revenue and expenditure of the government

at the center, state and local bodies.

01/15/2024 12
 Public Finance Issues
• The subject matter of the public finance is classified under five
broad categories.

• These are:
1. Public Expenditure (needs of the state)
2. Public revenue (source of revenue)
3. Public debt
4. Financial administration (deals with the determination of
expenditures & income)
5. Economic stabilization (fiscal policy)

01/15/2024 13
 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, a 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.

01/15/2024 14
 Private and public 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?

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• 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

01/15/2024 16
• 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.

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 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 government to all its citizens.

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• 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.

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 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.
01/15/2024 20
Cont’d
• The public authorities have to perform various functions such
as maintenance of law an order, provision of defense,
production for bringing in economic development.

• The performance of these functions require large amount of

funds which is raised through taxes, fees, fines, commercial
revenues and loans.

01/15/2024 21
 Public Revenue

• This is one of the branches of public finance.

• It deals with the various sources from which the state might
derive its income.
• These sources include
– incomes from taxes,
– commercial revenues in the form of prices of goods and
services supplied by public enterprises,
– administrative revenues in the form of fees, fines etc and
– gifts and grants.

01/15/2024 22
Cont’d
• Every government has two important sources of revenue.
• These are:

 Tax sources, and

 Non-tax sources

01/15/2024 23
 1.2. Basics of Taxation

• Taxation, Tax definition:

• The most important source of revenue of the government is taxes.
• The act of levying taxes is called taxation.
• 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.

• Taxation is a compulsory collection of money by government;

01/15/2024 24
 Definition of Tax
• A tax is a compulsory charge or payment imposed by
government on individuals or corporations without any
expectation of direct return in benefit”

• Tax is defined as a compulsory contribution levied on persons,

property, or businesses for the support of government for
economic and social operations.

• In other words, it is money paid to a government from people

and organizations to fund its programs and services(public
expenditures).
01/15/2024 25
• Taxes Transfers resources from private to public consumption.

• Taxes are involuntary levies without a quid pro quo(a thing

given in return for something else);

• Thus, tax can be defined as “an involuntary fee or more

precisely, “unrequited payment” paid by individuals or
business to a government.

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Essential characteristics of tax include:

1. It is an enforced contribution
2. It is generally payable in money.
3. It is proportionate in character, usually based on the ability to
pay
4. It is levied on persons and property within the jurisdiction of
the state
5. It is levied pursuant to legislative authority, the power to tax
can only be exercised by the law making body
6. It is levied for public purpose
7. it is commonly required to be paid a regular intervals.

01/15/2024 27
 1.6. Objectives of Taxation
• Tax objectives are goals that are expected to be achieved
through the taxation system.
• 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.

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• Initially, governments impose taxes for three basic purposes:

1. To cover the cost of administration,

2. Maintaining law & order in the country and
3. For defense.

• But now government’s expenditure pattern changed and gives

service to the public more than these three basic purpose.

01/15/2024 29
Con’t
 Therefore, governments need much amount of revenue than before. To
generate more revenue a government imposes taxes on various types.

 In general objective of taxations are:

1. Raising revenue
2. Removal of inequalities in income and wealth
3. Ensuring economic stability
4. Reduction in regional imbalances
5. Capital accumulation
6. Creation of employment opportunities
7. Preventing harmful consumptions
8. Beneficial diversion of resources
9. Encouragement of exports
10. Enhancement of standard of living
01/15/2024 30
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(degrade) the currency and
causes inflation;
• Compulsory acquisition is a crude and not very fairly
distributed form of imposition and in any event under our
constitution requires just compensation and

• Borrowed money must be repaid or interest bill met.

01/15/2024 31
 1.7. 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?

• It is concerned on criteria to be observed in formulating tax

structure.

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• 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;
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• A good tax system should not affect the ability and
willingness of the people to work, save and invest.

• If not, it will affect the development of trade and industry and

the economy as a whole.

• Thus, 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”.

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• Adam Smith (1776, ed 1952) calls them canons of a tax system.

• There are four canons of taxation as prescribed by Adam Smith

(1776, ed 1952).

1. Equity
2. Economy
3. Certainty
4. Convenience

01/15/2024 35
• Smith’s canons were later extended by other writers to
include:

1. Neutrality
2. Productivity
3. Buoyancy
4. Flexibility
5. Simplicity etc

01/15/2024 36
 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.

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• 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 types of thought in this connection:

1. The benefit principle
2. The ability to pay principle

01/15/2024 38
• Benefit principle
• An equitable tax system is one under which each taxpayer contributes
inline 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;
01/15/2024 39
• 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;

01/15/2024 40
• leaves the expenditure side of the public sector untouched;

• 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 this guide.

01/15/2024 41
• 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;

01/15/2024 42
• Limitations of both principles

• For the benefit principle to be operational, expenditure

benefits for particular taxpayers must be known.

• It fails to provide the revenue needed to finance transfers-

redistribution role of taxes is not properly handled.

01/15/2024 43
• For the ability to pay approach to be applicable, we must
know how this ability is to be measured.

• 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.

01/15/2024 44
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.
01/15/2024 45
• 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”.

01/15/2024 46
• 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.

01/15/2024 47
 3. Convenience

• The mode and timing of tax payments should

be convenient to taxpayers.

• This canon recommends that unnecessary

trouble to the taxpayer should be avoided,
otherwise various ill-effects may result.
01/15/2024 48
 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, (1952 ed),
p 362).
• taxes should not cause an unnecessary burden to
the society in the form of costs over and above the tax
liability.

01/15/2024 49
• 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 parts in the process of complying with the
requirements of a tax legislation;

01/15/2024 50
• 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)).

01/15/2024 51
• 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 deals with efficiency costs as

well

01/15/2024 52
 5. 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.

01/15/2024 53
• 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.

01/15/2024 54
• 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;

01/15/2024 55
• 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.
•

01/15/2024 56
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.

8. Simplicity

• 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.

01/15/2024 57
 Summary
• Among the various requirements for a good tax
structure the following are 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.
01/15/2024 58
 Concept Questions
1. What is a tax?
2. Discuss the objectives of taxation.
3. What are the characteristics of good tax
system?
3. Discuss the canons of taxation enumerated by
Adam smith.
4. What is the difference between tax buoyancy
and productivity?
01/15/2024 59
 Chapter Two

Tax systems and taxes

61
Chapter Two: Tax systems and taxes
Single and Multiple tax systems
Direct Vs indirect taxation
Ad Valorem Vs Unit taxes
Tax on Income
Tax on commodities
Tax on wealth
Presumptive taxation
Tax administration and tax compliance
62
 What is a Tax System?
 A tax system – a set of all the taxes that a nation imposes;
which includes:
 the tax administration,
 tax rules & regulations and
 tax forms.
• Tax systems can be classified in different ways:
– Single and Multiple tax system
– Direct vs Indirect
– Ad Valorem and Unit
– Proportional, Progressive and Regressive etc

63
 2.2. Types of Tax Systems
2.2.1. Single and Multiple tax systems
• Single tax system is where there is only one tax in place;
• A single tax means only one kind of tax. It does not mean
tax on only one person. On other words, a tax on one
thing i.e. on one class of things or one class of people.
• It is claimed that taxpayers are more certain of their
liabilities in a single tax and this can help in reducing
costs of collection.
• Against this claim note the following problems:
– identification and choice of an appropriate single tax,
– the adequacy and growth of revenue,
64
• One simple form of a single tax is the poll tax, or the
head tax;
• Poll tax is imposed on a person simply because he/she is
there in the society and not because he/she has an income,
or wealth, or is following any particular trade or
profession etc.
• Poll tax is against the principle of equity assessed in terms
of either the benefit principle or the ability to pay
principle.
• It does not enable governments to raise sufficient amount
of revenue;
65
 Major Merit
• Simple:

The greatest merit of a single tax lies in its

simplicity. Since, there is only one tax, it simplifies
the work of the Government. In a single tax system,
collection of revenue would be greatly simplified
and it would be much less costly, if all the taxes are
replaced by only one tax.

66
 Major Demerits
• Insufficient Revenue:

From the point of view of revenue, the single tax

may not be sufficient for the Government.
The financial needs of the Government are not
fixed and sometimes, the needs of the Government
suddenly increase which cannot be met by the yield
of a single tax.

67
Cont’d
• Regressive:
Single tax is regressive in nature as it cannot be
imposed in proportion to the ability to pay of
the taxpayer.
It is also imposed on the poor regardless of their
income or wealth.

68
 Multiple tax system

• A multiple tax system is with several tax

structures being used in the system.

• This means there should be all types of taxes, so

that every class of citizen may be called upon to
contribute something towards the state revenue.

• Any worthwhile tax system in a modern economy

is a multiple tax system.
69
Cont’d

(1) A modern economy is not one-objective economy.

• Since no single tax can be expected to help the
economy on all fronts, a choice for a multiple tax
system becomes inevitable.
(2) Income of a modern economy originates from
many sources.
• It would be highly unjust to tax income originating
from any one source and leave out others.
• Equity would demand that the government should
tax all the important sources of income in an
equitable manner.
 Major Merits
• Just and Equitable: The burden of taxation is
equitably distributed on all the sections of a
society. In other words, the sacrifice of the
society is equal.

• No Evasion: Multiple taxes cannot easily be

evaded. If a person evades a tax on one
account, he pays the tax on another account
because of the multiplicity of taxes.
71
Cont’d
• Sufficient Revenue: As a number of taxes are imposed in
a multiple tax systems, therefore all the people pay, more or
less, all the taxes. Hence, the Government is able to collect
sufficient revenue to meet the growing needs of the society.
• Wide Coverage: Through multiple taxes, everyone
contributes towards social benefits. Therefore, by adopting
multiple tax system, the tax structure becomes broad based
covering almost every sector and person in the country.

72
 Major Demerits
• Inconvenient: Too much multiplicity of taxes, may
lead to inconvenience to both the taxing authority
and the taxpayer 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.
Large numbers of officers have to be appointed to
collect revenue.

73
 2.2.2.Direct and Indirect taxes
• If tax is levied directly on the income or wealth of a
person, then it is a Direct tax e.g. income-tax, wealth
tax, etc.

• If tax is levied on the price of a good or service, then

it is called an Indirect tax e.g. excise duty, custom duty,
service tax and sales tax or value added tax, etc.

• In the case of indirect taxes, the person paying the tax

passes on the incidence to another person.

74
 Direct and Indirect taxes
 Direct taxes

• A direct tax is that tax whose burden is borne by the same

person on whom it is levied. The ultimate burden of taxation
falls on the person on whom the tax is levied.

• Direct taxes are those which cannot be shifted to

others.
• Thus income tax, corporation tax on company’s profits,
property tax, capital gains tax, wealth tax etc are examples of
direct taxes.

75
 Major Merits
1. Equitable: Direct taxes are taxed according to the “ability-to-
pay” of the taxpayers. Taxes at high rate are paid by the richer
section of the society and lower are paid by the poorer section of
the society.
• Equitable- based on the principle of progression
2. Certainty: Direct taxes satisfy the canon of certainty. The taxpayer
is certain as to how much he/she is expected to pay, and similarly
the State is certain as too how much it has to receive income from
direct taxes. There is also certainty about the time of payment and
manner of payment.
Certainty- the rate and the amount are known by tax payer as well
as collector
76
Cont’d
• Reduce Inequalities: Direct taxes are progressive in nature, and
therefore, rich people are subjected to higher rates of taxation,
while poor people are exempted from direct tax obligations.
Rates of taxes increase as the levels of income of persons rise.
Reduce inequalities- rich people taxed more to be distributed to
the poor
• Civic Consciousness: Direct taxes inculcate the spirit of civic
responsibility amongst the taxpayers. Taxpayers become
conscious of their rights and obligations. In a democratic
country, this civic consciousness checks the wastage in the
public expenditure.

77
 Major Demerits
• Inconvenience: Direct taxes are inconvenient in
nature, because a taxpayer has to submit a
statement of his/her total income along with
the source of income from which it is derived.
Moreover, direct taxes are paid in lump sum
which causes inconvenience to the taxpayers.
Hence, these taxes are said to be inconvenient
to the taxpayers.

78
Cont’d
• Possibility of Evasion: A direct tax is said to be a tax on
honesty, but it can be evaded through fraudulent practices.

• As stated above, direct taxes are certain and taxpayers

know the rate of tax they have to pay. Therefore, awareness
of tax liability tempts the taxpayer to evade tax.
• Elasticity- more tax revenue simply by changing the rates

79
 Demerits of direct taxes include
1. Unpopular- require payment in one lump sum

2. Inconvenience- as tax payers submit statements

3. Possibility of evasion- taxes on honesty

4. Arbitrary- no logical principle of progression

5. Adverse effect on will to work and save- if higher taxes are

imposed

80
Indirect taxes
• An indirect tax is that tax which is initially paid by one
individual, but the burden of which is passed over to
some other individual who ultimately bears it.

• It is levied on the expenditure of a person.

• Value added tax, Excise duty, Custom duties… etc are

examples of indirect taxes
 Merits of Indirect Taxes

• Convenience- paid in small amounts

• No evasion- difficult to evade as they are record
based
• Elastic if levied on goods of inelastic demand
• Wide Coverage- every member of the community
can be taxed
• Can be progressive- heavy tax on luxurious goods

82
 Demerits of Indirect Taxes

• Regressive- fall more on low income group than high

income ones
• Administrative cost- generally heavy
• Discourage savings- more spending on basic
commodities
• Uncertainty- can’t be accurately estimated
• No civic consciousness
• Adverse effect on efficiency- reduce consumption
and productivity
• Cause inflation- prices of taxed goods keep on rising

83
 Ad Valorem Vs Unit taxes
• The phrase ad valorem is Latin for “according
to value”

• Ad Valorem taxes are when the tax amount is

scheduled according to the value of the item
being taxed;

• An ad-valorem tax is a tax with a rate given in

proportion to the price.
84
Cont’d
• The tax automatically gets linked with the
value of the item and would move along with
its value;

• i.e., in the period of boom, the tax liability

tends to rise and in times of recession the tax
liability also declines;

• A good example is the sales tax.

85
 Unit (specific) taxes

• Unit taxes are those imposed on per item or per unit

basis;

• Unit taxes are levied as a fixed amount per unit of

commodity sold.

• Example:
– Tax on cigarettes, for example, is 30 cents per
pack.

86
Progressive, Regressive and Proportional,
• Classification is on the basis of the degree of
progression of a tax… the nature of the tax rate
• Make use of both tax base and tax rates;
• Tax base and tax rates
– the base of a tax is the legal description of the
object to which the tax applies;
– For example the base of an excise duty is the
production or packing or processing of a
specific good or importation of a specific good;
– the base of an income tax is the income of the
assessee defined in terms of certain rules ;
87
Progressive, Regressive and Proportional,
• A Progressive tax is a tax that takes a higher
percentage from high-income people and a lower
percentage from low-income people.

• For example, let’s say that you have three people: -

 Person A makes $10,000/year

 Person B makes $50,000/year
 Person C makes $100,000/year

88
• Let’s say that person A has to pay $1,000 in taxes;
person B has to pay $10,000 in taxes; and person C
has to pay $40,000 in taxes.

• In that case: -
Person A paid 10% in taxes
Person B paid 20% in taxes
Person C paid 40% in taxes

• Thus, Person C paid a higher portion of

his/her income in taxes than Person A did.
89
• A Regressive tax is the opposite of a progressive tax.
• A regressive tax takes a larger percentage of income
from low-income groups than from high-income
groups.
• The tax liability is a smaller percentage of a taxpayers’
income as income increases; i.e, average tax rate
decreases as tax base increases.
• It takes a larger percentage of income from people
whose income is low; the poor are taxed at a higher rate
• For example, suppose everyone who owns a home is
required to pay $500 property tax. This would be
regressive because it would be more expensive to pay
for a low-income person who makes $10,000 a year
than for a person who makes $50,000 a year. 90
• To put it another way: - a $500 tax would be
5% of a person’s income who makes
$10,000/year - a $500 tax would be just 1% of
a person’s income who makes $50,000/year.

• Thus, the person who makes $10,000 has to

pay a higher percentage of their income than
the person who makes $50,000.

91
Example 2:

• Income (Br) tax rate (%) tax payable

(Br)
• 4000 20 800
• 6000 15 900
• 10000 12 1200
• 20000 10 2000

92
• In a Proportional, or flat tax, each individual or
household pays a fixed rate.

• For example, low-income taxpayers would pay

10 percent, middle-income taxpayers would
pay 10 percent, and high-income taxpayers
would pay 10 percent.

• In other words, the percentage that each group

pays is the same. Going back to our example
from progressive taxing, Person A, Person B,
and Person C would all pay the same
percentage of taxes. 93
Example on proportional tax system
• Tax base(Br) Tax rate(%) Amount of tax
(Br)
– 2000 10 200
– 5000 10 500
– 10000 10 1000

94
• X and Y are both doing their own taxes. X
reports that he earned $35,000 a year and Y
reports that she earned $47,000 a year. X pays
a $2,800 income tax (8%) and Y pays a $4,000
(8.5%) income tax.

Is this tax progressive, regressive, or

proportional? Then, explain why.

95
• If you were in charge of taxing people, would
you levy a progressive tax, regressive tax, or
proportional tax? Explain why you would give
this type of tax.

96
 Concept Questions
1. What is a tax system?
2. Differentiate Single tax from multiple tax.
3. Differentiate direct tax from indirect tax.
4. Differentiate Ad Valorem tax from Unit tax.
5. Discuss the difference among Progressive,
proportional and Regressive tax structure.

97
 Progressive tax
• Argument for: Just and equitable.
Obviously, progressive taxation is desirable in
order to bring about a more equitable
distribution of wealth as it is based on the
principle of ability to pay.

• Argument for: Reduces inequalities.

In a progressive tax system, rich are subjected to
higher rates of taxation and poor are either
subjected to lower of taxation or exempted from
tax obligations.
98
 Progressive tax
• Argument for: the wealthy can afford a higher
tax and should pay more of the tax burden.

• Argument against: why should the hardest

working and most successful pay more taxes?
Wealthy are penalized for their success.

99
 Progressive tax
• Argument against: Discourages capital formation.
Progressive taxation may adversely affect
production and discourage the growth of
industry.

• Argument against: Encourage Evasion.

Progressive taxation also encourages
evasion. As rich are subjected to higher rates
of taxation, assessees submit false returns of
their income and wealth.
100
 Regressive tax
• Argument for:
Tax levied on what is bought. If you cannot
afford the tax, do not buy the item.

• Argument for: Encourages capital formation.

101
 Regressive tax
• Argument against: Not just and equitable
A regressive taxes fall more heavily on the
poor section of the community, than on the
richer section.
Thus, it violates the principle of equity and
social justice.

• Argument against: Tax harms those who can

least afford it.
102
 Proportional Tax
• Argument for:
Everyone is equal- pay same % of income.

• Argument for: Simple & uniform tax rates.

Taxes rates are the same both for the rich and
for the poor.
Since the tax rate is uniform for all the
taxpayers, taxation is not very much opposed
by them.
Therefore, proportional taxation satisfies the
canon of simplicity.
103
 Proportional Tax
• Argument for: Certainty
Proportional taxation satisfies the canon of
certainty. As the tax rates are the same for all
the taxpayers, the amount of proportional
taxes can be estimated and calculated easily
by the Government.
Therefore, proportional taxation has been
regarded as better than progressive taxation.

104
 Proportional Tax
• Argument for: Equitable
Proportional taxes are just and equitable
because the money burden increases in the
same proportion as the income increases.
Therefore, the taxpayers do not feel the pinch
of paying proportional taxes.

105
 Proportional Tax
• Argument for: Willingness to work & save not affected

The Proportional taxation has been supported

on the ground that the willingness to work
more and save more of the taxpayers is not
adversely affected because the rate of taxes
remains constant. Therefore, they are generally
not opposed by the taxpayers.

106
 Proportional Tax
• Argument against:
The poor need their income more than the
wealthy. They need every penny and cannot
afford as much of a tax as the wealthy.

• Argument against: Not just and equitable

According to some critics, proportional
taxation would not lead to equitable and just
distribution of the burden of taxation, as it
falls more heavily on small incomes than high
incomes.

107
 Proportional Tax
• Argument against: Inadequate resources
A system of proportional taxation means that
the tax rates for the rich and the poor are the
same. Hence, the state cannot obtain from
the richer section of the society as much as
they can give.
Therefore, in modern times, with the
increasing financial needs of the government,
such a system may fail to provide adequate
resources to the government.

108
 Proportional Tax
• Argument against: Inelastic
Revenue from proportional tax system cannot be
increased as the financial needs of a government are
not fixed;
In proportional tax-system, the burden of taxes falls
more heavily on the poor than on the rich, as the
rates of taxes are the same. If the tax rate for the
smaller income group is already heavy and that it
cannot be increased. This implies that the tax rate for
higher income groups cannot also be raised.
Hence, the Government may not be able to increase
its revenue in times of emergency.

109
 Proportional Tax

• Hence, the proportional tax system suffers from

inequitable distribution of the burden of
taxation, lack of elasticity and inadequacy of
funds for the increasing needs of the modern
Government.

110
111
 TAX REVENUES
• Taxes on income

• Taxes on commodities

• Taxes on wealth

112
 Definition of Income
• IASB’s accounting framework–statement of
accounting concepts –define income as:
“an increase in economic benefits derived by
an entity during an accounting period in the
form of inflows or enhancement of assets
(decreases in liabilities), which result in an
increase in wealth.”

113
 1. Taxes on income
• Taxes imposed on income determined through the
pertinent tax rules.
• Individual income tax and corporation taxes;
• Individual income tax is literally defined as tax on
income from all sources other than incorporated
businesses.
• Individual income tax includes taxes on wages, interest,
dividends, rent, capital gains, profits from
unincorporated business operations;

114
 Income Tax System
• A system which is used to compute the income
tax liability of a taxable person (taxpayer).

• From theoretical perspective, there are two

commonly used income tax systems:

Global income basis and

Scheduler income basis

115
• Global income basis -income from all sources are
added together to get the overall tax base;

• The basic principle is that the taxpayer’s income from

all sources be combined into a single or global
measure of income (global method).

• It does not matter whether the income received is

from compensation, business income, professional
income, passive investment income, capital gain or
other income.

116
Cont’d
Example:-
• Assume a person has received the following income:
 Salary $50,000
 Business income from foreign Co. (controlled in Ethiopia)
150,000
 Rental Income 100,000
 Dividend income
60,000

Annual Income in Birr Tax Rate

• Assumed Tax rate:
0 – 150,000 10%
150,001 – 350,000 15%
350,001 – 600,000 20%
> 600,000 25% 117
Cont’d
 Gross Earning ………………… $ 360,000
 Taxable income ………………. 360,000
 Less: Tax on 1st $ 150,000 @ 10% (150,000)…..
15,000
210,000
 Less: Tax on next $200,000 @15% (200,000) …..
30,000
10,000
 Less: Tax on remaining income@20% (10,000) …….…
2,000
 Total income tax $
47,000 118
Cont’d

• Scheduler income basis instead of aggregating the

various sources of income together it adjusts each
source of income for any deduction and exemption
and apply the tax rate appropriate for each source
of income.

• Under this system, incomes are classified in to

components for income tax purpose according to their
nature & sources.
• For example, dividends are governed by dividend tax
law, interest by interest tax law, etc.
• The classifications in to which the incomes fall are
119
Cont’d

• For example: In Ethiopia, we have:

Schedule ‘A’ Income:
Schedule ‘B’ Income:
Schedule ‘C’ Income:
Schedule ‘D’ Income:

120
Corporation income tax
• is the levy on the taxable income of corporations
computed in accordance with the GAAP or IFRS
subject to the tax regulations pertinent to the matter.

Tax Accounting Methods

• The accounting method for computation of the
corporate income tax base could be;
– cash basis
– accrual accounting basis; or
– modified cash basis
• Accrual basis appears to have wider application;
121
Deductions worth noting in connection with taxes:
• Interest is deductible but not dividends,
• Both are costs of capital
• Likely to create distortions in the choice between debt and
equity financing;
Depreciation and Inventory methods:
• Accelerated method of depreciation, straight line method
(depending on the tax law in question);
• Inventory valuation methods- FIFO, LIFO etc;
• Some countries have tax codes, which specify a particular
valuation method to be adopted, while others only specify that
a firm should choose any valuation rule it pleases but cannot
change it from year to year. The Ethiopian tax law specified
the method of inventory valuation method as weighted average
122
Bad debt recognition :
• Allowance and direct charge of methods;

• Specific rules are usually laid down as to when a debt

can be considered bad (for tax purpose);

• Typically, a firm must undertake a sequence of steps,

such as reminder letters and court orders or hiring of
bill collection agencies before a debt can be
considered bad.

• The direct charge-off method appears to be the most

common method for tax purpose;
123
• Corporation tax rates;
• Rates may be bracket rate where there are a number
of rates in a sliding scale or graduated rate where
there is only one rate applicable for all or almost all
of the corporations subject to corporation income tax.

• Further considerations:-
• Carry Forward and Carry Back of Losses
• Carry forward of losses occurs when tax laws allow a
company to deduct losses from taxes payable in
future years;
• Loss carry back – when tax laws allow companies to
receive a refund from taxes paid in previous years;
124
Differences among countries in respect of Loss Carry
Back & Loss Carry Forward:
• the number of years for which carry forward or carry
back is permitted,
• the percentage of losses that can be carried forward or
back (the loss offset rate) and
• the amount of past or future profits that can be used
for carry forward or back.
• a common rule is to permit 100% of loss to be carried
forward for between 6 and 10 years.

125
 2. Taxes on commodities
• These taxes include value added tax (VAT), sales tax, excise,
customs duties etc.
Value added tax:
• A value added tax (VAT) is a consumption tax added to a
product's sales price or to a service. It represents a tax on the
"value added" to the product throughout its production
process.

• Tax on the value added to a product at each stage of

production, paid by each producer, and recouped in the sale
price of the product;

126
Cont’d
• Value added tax is a consumption tax.

• In some countries VAT is referred to as goods and

services tax (GST) like in Australia, New Zealand
and Canada.
• Introduced in 1948 in France;

• Many of African countries introduced VAT in the

1960s and 1970s while many of Asian countries
introduced VAT in the 1980s and 1990s;

127
• There are over 160 countries throughout the world
that adopted the VAT;

• In Sub-Saharan Africa 33 out of 43 countries in the

region and 9 countries in North Africa have adopted
VAT ( Bird and Gendron 2007);

• A few countries that do not have VAT so far include

the US, Iraq, Iran, and Cuba etc;

• US is the only OECD country without the VAT;

128
• Why adopt the VAT?

• Reasons for countries to adopt VAT:

– The existing sales taxes are unsatisfactory (tax

cascade);

– A reduction in other taxation is sought;

– Role of international organizations.

129
• Unsatisfactory sales taxes (tax cascade)
• Sales taxes
• When a taxed product passes from manufacturer to
wholesaler & then to retailer, sales occurs (cascade
tax);

• Many of the early users of VAT switched from

various forms of cascade taxes;

• VAT was developed from ways to mitigate the

disadvantages of the cascade tax;
• For example in France VAT was introduced in an
attempt to mitigate the disadvantages of the cascade
tax; 130
• For example resin, rubber and carbon black are necessary
for manufacturing a tyre. All the three inputs paid tax and
the final products namely the tyre also paid tax. So these
three inputs are taxed twice. Then again the tyre is used in
a car, which also is taxed. These three inputs are now taxed
thrice. So the tax element on these inputs goes on
increasing with every production and distribution chain.

• The cascading effect of tax makes the tax rate much higher
than the original rate. It might even become two or three
times. A turnover tax of 4 per cent can be ultimately
equivalent to a total tax burden of 10 percent. 131
• Other causes of dissatisfaction include:

– Complexity of administration, and

– The complex and multiple relationship between
traders and government when many taxes are used.

• For example take the case of Korea used to have a

large number of commodity taxes;

132
A reduction of other taxation or to simply increase revenue:

• Some countries look to a VAT not only to replace

existing sales taxes but also to increase revenue;

• The other reason for the spread of VAT has been

caused by the European Economic Community (now
called EU) requiring the adoption of VAT(GST) as a
condition of entry to the common market environment
of continental Europe.

• The main reason for requiring the adoption of VAT

was EU countries contribute from their revenue raised
from their VATs to fund the activities of EU.
• For example, Switzerland and the UK were dragged to
the adoption of VAT simply to enter the EEC (EU)
(Warren et al. 2008). 133
Role of international organizations:

• Other reason for the spread of VAT especially to

developing and transitional countries is the advocacy
role played by the IMF;

• The IMF – the leading ‘Change Agent’ in tax policy

in many developing and transitional countries (Bird
and Gendron 2007);

134
 What is value added
Value that a business adds to the goods and
services that it purchases from others;
A business adds value by processing or handling
these purchased items using its own labor force,
machinery and other capital goods
The value that a producer adds to his raw materials or
purchases before selling the new or improved product
or service (Tait 1988);
So value added can be looked at from additive (profit
+ wages) or subtractive (output –inputs) sides (Tait
1988);
135
 What is value added?
• According to Tait(1988) value added is interpreted as follows:

• Value added is the value that a producer (whether a

manufacturer, distributor, advertising agent, hairdresser,
farmer, race horse trainer, or circus owner) adds to his raw
materials or purchases (other than labour) before selling
the new or improved product or service. That is, the inputs
(the raw materials, transport, rent, advertising, and so on)
are bought, people are paid wages to work on these inputs
and, when the final good or service is sold, some profit is
left.

136
Cont’d
• From the definition above, Value added can be
viewed from two approaches:
– the additive way (wages plus profits) and
– the subtractive way (output minus input)

• Thus, Value added can be represented by the

following formula:

Value added = wages + profits = output － input

137
• Consider a business with the following accounts :
• Sales Br. 200
• Expenses:
– Raw materials 80
– Interest 10
– Rent 20
– Wages 30
• Profit Br. 60
• Value added by this business is Br. 90 – sales (Br.
200) minus costs of raw material, interest and rent
(Br.110);
• Another way to calculate the value added is by
adding profits (Br. 60) and wages (Br. 30); 138
 Methods of calculating VAT
• Basically, there are four methods of calculating VAT
liability:

1. Additive direct or accounts method

• Under this method, a taxable enterprise computes its tax
liability for each tax period by means of summing the
enterprise's the value added. Then, the taxable enterprise
calculates its tax payable through multiplying the total amount
by a certain tax rate.

t(wages + profit);

139
 Cont’d

2. Additive indirect – the value added is not calculated; instead the

tax rate is applied to the components of value added separately;
t(wages) + t(profit)

• The problem of using the additive-direct and additive-indirect

methods is that multiple tax rates cannot be adopted because the
company accounts do not usually separate sales from different
product items in accordance with different tax rates.

• And nearly all countries use the subtractive type of VAT.

140
 Cont’d
3. Subtractive direct – a VAT taxable enterprise
computes its net VAT liability by means of multiplying
the total taxable sales after subtracting total taxable
purchases from other enterprises by the tax rate.
t(Output – Input);

4. Subtractive indirect – does not calculate the value added;

instead the rate is applied to the components of value added
separately;
t(output) – t(input);

141
Cont’d
• The four methods produce the same result – the
difference is in their approach;

• Subtractive indirect – is the invoice credit

method; the original EU model and is used by
most countries;

142
 Why is this so popular?
• It is transaction based – a technically
superior method since transaction is an easily
noted and tracked event;

• Good audit trail – the invoice credit method

creates a good audit trail since invoices are
needed for credit purposes; one can check the
accuracy of the claim using invoices as
evidence;
143
• The built-in audit trail may sometimes fail:

1. On the final consumption transaction since there is

no financial incentive for the final consumer to
collect invoices;

2. It fails in connection with exempt or input taxed

goods since there is no credit on these goods
businesses do not have the incentive to collect
invoices;

3. It also fails in connection with businesses that

are outside the VAT legislation framework (including
144
 VAT rates
• The rate or rates at which VAT is levied is an important
consideration in the operations of VAT;

Single and Multiple Rates

• Single rate - VAT system uses only one rate (ignoring zero rate
on exports) while the multiple rates is to a system having many
positive VAT rates;
• A substantial number of countries operate VAT with a single
positive rate while there are a few countries that use up to four
rates.
• In some countries there are different rates for different regions or
parts of the country;

145
• Tax administrators prefer to use a single rate of VAT
(once again ignoring the zero rate on exports).
• Politicians nearly always think the public will comply
with a VAT more easily if products consumed by
lower income households are taxed at lower rates
than products consumed by the better off;

• The larger the number of VAT rates the more

complicated the tax system and the higher the
administrative and compliance costs of VAT;

• Apart from the complication in the tax system

(increased administrative and compliance costs)
multiple rates are likely to distort consumer and
146
 International practice

• The generally accepted practice is that VAT should be

imposed with limited number of positive rates;

• Rates vary throughout the world; in the EU they average

between 15% -20% for the standard rate;

• For example, UK 20%, Russia 18%, Germany 19%,

Sweden 25%, Finland 24%, France 19.6% etc.

• China 17%, Singapore 7%, Japan 5%, Ethiopia 15%,

Egypt 10%, Kenya 16% etc.
147
 VAT free (VAT zero rate)

• When a supply is made VAT free the supplier does

not incur liability on the supply but can claim back
the VAT paid in respect of the inputs (input tax is
refundable);

• Gives complete relief to the zero rated supply;

• Potential candidates to be zero rated include exports;
Food items and other basic needs;
• There may be a range of commodities that countries
make VAT free; but the advice is to minimize
domestic zero rating;
148
 VAT exemption (VAT input taxed)

• The supplier is not liable for the VAT on the supply but
cannot claim the VAT paid on the input acquired (no
refund of the input tax);

• This gives only partial relief from the burden of the tax;

• There are goods considered to be merit goods including

health, education, books, etc argued to be tax free;

• Existence of sectors that are difficult to tax- like the

small businesses etc;
149
Exemption of small businesses

• In addition to the equity argument, it is difficult to deal

with a large number of small traders;

• The revenue loss due to exempting this part of the

economy is usually considered to be much less in
relation to the administrative costs;

• In many countries small traders are exempt from VAT;

150
Excessive use of exemptions is not advisable:
• Exemptions erode the tax base;

• Exemptions make the tax system complex; the existence

of exemptions is likely to increase compliance and
administrative costs as multiple rates do;

• However, reduced rates (multiple rates) are considered to

be “less evil than exemptions” (Bird and Gendron 2007);

• Exemptions break the tax chain and reduce the audit trail
advantage of the invoice credit method;

• Exemptions may not achieve their intended objective of

like equity – take for example public transport;
151
 Registration Criteria

• Registration criteria could be turnover, value added,

capital assets, number of employment, number of
owners, profit and type of business;
• In practice, turnover has a wider application;
• From OECD countries the highest threshold is in
Japan (nearly US$300,000)
• Some countries do not have as such registration
threshold – Sweden
• There are some countries that exempt traders such as
individual retailers from the requirement to register
for VAT; Example Spain;
152
 Excise taxes
• Excises are taxes levied on particular products
and services with discriminatory intent;
• “levied on particular products, or on a limited
range of products… (that) may be imposed at any
stage of production or distribution and may be
assessed by reference either to the weight, strength,
or quality of the product, or by reference to the
value” (IMF 1974, p. 166);

• Excises are imposed to add to the progressivity of

the tax structure and also to discourage bad
habits; 153
 Wealth taxes
• Income & consumption are associated with a time
dimension;
• the concept of income would be meaningful
when it is put in the context of some time
interval;
• Income and consumption are known as flow
variables;

• A stock variable is a quantity at a point in time,

not a rate per unit of time;
• Wealth is a stock because it refers to the value
154
of the assets an individual has accumulated;
• Properties can be divided into real property and
personal properties:

– Real properties- land and anything attached to the land;

– Personal properties - anything moveable.

• Personal property taxes are collected on registered

vehicles including motor vehicles, trailers, planes,
and boats;

155
Why tax wealth?
1. Wealth taxes help to correct certain problems that
arise in levying a comprehensive income tax;
– By taxing wealth of which unrealized gains
become a part, the problem in income taxation
may be remedied;
2. The higher an individual’s wealth, the greater his or
her ability to pay, other things including income
being the same; enhance the ability to pay principle;
3. Wealth taxation reduces the concentration of
wealth, which is undesirable socially and politically;

4. Wealth taxes may be considered as payments for

156
benefits that wealth holders receive from
• Property taxes is imposed on the holding of certain
properties;

• Estate and gift taxes are imposed on the transfer of

wealth;
• Estate and gift taxes are levied at irregular intervals on
the occurrence of certain events;
• The Estate tax (inheritance tax) on the death of the
wealth holder;
• Gift tax when property is transferred between the
living;

157
 Presumptive taxation
• Presumptive taxation is the application of indirect
means to ascertain tax liability;
• A presumptive income tax is based on some
measure of economic activity that surrogates for
the tax base, rather than the actual tax base
(taxable income itself);
• It is employed mainly in countries where hard–
to–tax taxpayers comprise the majority of the
population and administrative resources are scare;
• In these countries most taxpayers lack the
financial transparency (proper books) that 158
• In developing countries most taxpayers especially
small ones do not have the resources needed to
maintain proper books of accounts;
• In these situations, presumptive taxation may be the
most appropriate method of tax administration.

• Presumptive taxation uses a variety of alternative

means of determining the tax base and assessing the
tax liability;
1. Estimate of income using factors like type of
profession (sector), number of employees, resources
used etc;
2. Using assets:- Commercial property, business
vehicles; 159
Presumptive taxation methods:

Standard assessment – standard assessment assigns

lump-sum taxes to taxpayers on the basis of occupation
or business activity;

• Standard assessment does not take into account taxpayer-

specific conditions, such as losses in a particular year;

• As a result it can be regressive by imposing equal tax on

individuals in the same category with different incomes.

160
Estimated assessment

• Each taxpayer’s income is individually estimated

based on indicators like proxies of wealth specific to
a given profession or economic activity;

• Takes individual circumstances (like loss in a given

year) into account ;

161
 Concept Questions

1) Distinguish Global income basis & Scheduler income basis.

2) Explain the difference between Carry Forward & Carry Back

of Losses. Support your answer with practical examples.

3) What is a tax cascade?

4) Why main countries have adopted VAT?
5) What is value added?
 Concept Questions

6) Discuss on the methods of calculating VAT?

7) Why the Subtractive indirect is so popular?

8) Differentiate Zero rate VAT and VAT exemption.

9) Why excessive use of VAT exemptions is not advisable?

10) Discuss the following concepts:

Excise taxes

Wealth taxes

Presumptive taxation
 Group Assignment (30%)
• Review a Journal Article on the following areas:

1. Value added tax

2. Excise tax
3. Business income taxes
4. Rental income taxes
5. Wealth tax

164