MEANING AND CHARACTERISTICS OF TAXATION.

MEANING AND CHARACTERISTICS OF TAXATION

1. April 2024 AA, Ethiopia MEANING AND CHARACTERISTICS OF TAXATION Abeje A.(MSc, PhD-Candidate) CHAPTER II

2. CONTENTS Meaning and Nature of Tax Characteristics of Tax System Objectives of Taxation Principles of Taxation Tax Classifications Tax Rate Structures Shifting and Incidence of Taxation Tax Evasion, Avoidance and Delinquency

3. Chapter Objectives On successful completion of this Chapter, students should; Familiar with the meanings and objectives of taxation Understand the principles of taxation Discuss the tax structures Explain the different types of taxes Know shifting and incidence of taxation Differentiate tax evasion, avoidance and delinquency

4. 2.1. Meaning of tax “A tax is a contribution from citizens for the support of the government". Adam Smith In the earlier days, payment of taxes was optional . A choice was given to the people to pay the tax and to gain the benefit of social services in the form of education, health and sanitation, utilities and recreation facilities. Taxes have been a major subject of political controversy throughout history, even before they constituted a large share of the national income. For a long time tax collection was left to middlemen, or “tax farmers ,” who contracted to collect the taxes for a share of the proceeds; under Caesar collection was delegated to civil servants. TAXES ARE KEY TO SUSTAINABLE DEVELOPMENT!

5. 2.1. Meaning of tax A tax is a compulsory, unrequited payment to government. The tax-payers do get many benefits from the government but no tax-payer has a right to any benefit from the public expenditure on the ground that he is paying a tax.

6. Cont … Essential elements of Modern Tax : It is levied by the government It is must have a base upon which it is levied It is a proportion or a percentage It is generally payable in money It is levied in order to provide to public purpose

7. Why do governments bother to tax?

8. 2.2. Objective of Taxation The primary goal of taxes is to finance government expenditure. The imposition of taxation by governments withdraws money from the economy , and their expenditure returns the money to the economy. TAXES ARE KEY TO SUSTAINABLE DEVELOPMENT! A good tax system ensures maximum social advantage without any hardship on taxpayers.

9. Cont.… the objectives of tax are Raising revenues, Removal of inequality in income and wealth, Ensuring economic stability, Reduction of regional imbalance, Capital accumulation, Employment creation, Prevention of harmful consumption, Beneficial diversion of resources, Encouraging export Enhancing living standards TAXES ARE KEY TO SUSTAINABLE DEVELOPMENT!

10. 2.3. Characteristics of Tax A tax has the following general characteristics: Legal Collection Common interest Tax is a compulsory contribution Benefit is not the basic condition Personal obligation Element of Sacrifice Regular and Periodical Payment No Discrimination Wide Scope TAXES ARE KEY TO SUSTAINABLE DEVELOPMENT!

11. 2.4. Principles of Taxation In establishing the tax policy, the government should consider not only its financial needs but also taxable capacity of the community and government has to consider some other principles. These principles are called as canons of taxation. Canon of Equity Canon of Certainty Canon of Convenience Canon of Economy Canon of Productivity Canon of Elasticity Canon of Diversity Canon of Simplicity Canon of Buoyancy Canon of Flexibility Canon of Expediency Canon of Co-ordination Etc. TAXES ARE KEY TO SUSTAINABLE DEVELOPMENT!

12. Cont.… CANONS ADVOCATED BY ADAM SMITH Canon of Equity One important principle of a good tax system is fairness (equity). 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. There is no agreement on how the term “fair share” should be defined . What a “fair share” means in practice the subject of endless contention and debate. There are two schools of thought: The benefit principle The ability to pay principle TAXES ARE KEY TO SUSTAINABLE DEVELOPMENT!

13. Cont.… 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. II. Ability to pay principle The tax system is viewed by itself independent of expenditure determination. So, it leaves the expenditure side of the public sector untouched; A given total revenue is needed and each taxpayer is asked to contribute in line with his/her ability to pay. 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; TAXES ARE KEY TO SUSTAINABLE DEVELOPMENT!

14. Cont.… 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. Horizontal equity states that people who are “similarly situated” should be taxed alike. Vertical equity concerns people in unequal economic circumstances. However, It leaves open the essential question of what is meant by “similarly situated”. If income is used as index of ability to pay , then HE says people with the same income should , all else equal, pay the same tax. Again, we are left with essential questions: what do we mean by “income” . TAXES ARE KEY TO SUSTAINABLE DEVELOPMENT!

15. Cont.… Canon of Certainty The tax which each individual is bound to pay ought to be certain and not arbitrary . The time of payment, the manner of payment, the quantity to be paid should all be clear to the taxpayer and to every other person. Certainty pertains to objectivity . 3. Canon of 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 . TAXES ARE KEY TO SUSTAINABLE DEVELOPMENT!

16. Cont.… 4. Canon of 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 upon the society in the form of costs over and above the tax liability. In addition to the actual payment of taxes, taxes induce other costs: Compliance and administrative costs (tax operating costs) Efficiency costs Convenience and certainty canons deal with 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 TAXES ARE KEY TO SUSTAINABLE DEVELOPMENT!

17. Cont.… Tax compliance costs – costs incurred by taxpayers and third parts in the process of complying with the requirements of a tax legislation and administration procedures; 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)). TAXES ARE KEY TO SUSTAINABLE DEVELOPMENT!

18. Cont.… The economy is said to be efficient when resources are directed to their highest valued uses. By changing the relative attractiveness of highly taxed and lightly taxed activities taxes can distort resource allocation decisions (divert resources) The tax should create neither major distortions in consumption and production behavior nor change private investment decisions by favoring one set of investments over the others. 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 . Example : the 18 th century window tax TAXES ARE KEY TO SUSTAINABLE DEVELOPMENT!

19. Cont.… TAXES ARE KEY TO SUSTAINABLE DEVELOPMENT!

20. Cont.… CANONS ADVOCATED BY OTHER ECONOMISTS 5. Canon of Productivity The productivity of a tax may be observed in two ways. First, a tax should yield a satisfactory amount of revenue for the maintenance of government. Secondly, the taxes should not discourage production in the short and in the long run. 6. Canon of 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. TAXES ARE KEY TO SUSTAINABLE DEVELOPMENT!

21. Cont.… 7. Canon of Flexibility It should be possible for authoritie s 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. Canon of Elasticity Proclaims that yields of taxes should be increased or decreased according to the needs of the government.   9. 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. TAXES ARE KEY TO SUSTAINABLE DEVELOPMENT!

22. Cont.… 10. 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. 11. 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. 12. 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. TAXES ARE KEY TO SUSTAINABLE DEVELOPMENT!

23. 2.5 TAX SYSTEM AND CLASSIFICATIONS I. Tax System A tax system is a set of all the taxes that a nation imposes; Tax systems can be classified in different ways 1. Single Tax System Is a system where there is only one kind of tax in place. It does not mean tax on only one person. A single tax may be proportional, progressive or regressive, or it may be fixed amount. Example: Head/ Poll Tax TAXES ARE KEY TO SUSTAINABLE DEVELOPMENT!

24. Cont.. Merits of a Single Tax System Certainty : it is claimed that taxpayers are more certain of their liabilities in a single tax Simple : Since there is only one tax, it simplifies the work of the government.   Administrative Cost : its simplicity can help in reducing costs of collection Equitable : single tax like income tax i s just and equitable because it is based on the principle of equity in taxation . What about identification and choice of an appropriate single tax? Demerits of a Single Tax System 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 Example: 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. TAXES ARE KEY TO SUSTAINABLE DEVELOPMENT!

25. Cont.. 2. Multiple Tax System Is a system with several tax structures being used in the system. Any worthwhile tax system in a modern economy will be a multiple tax system. Because,  a modern economy is not one-objective economy. Income of a modern economy originates from many sources. Merits of Multiple Tax System 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.   Wide Coverage Sufficient revenue No evasion TAXES ARE KEY TO SUSTAINABLE DEVELOPMENT!

26. Cont.. Demerits of Multiple Tax System 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. Complexity : TAXES ARE KEY TO SUSTAINABLE DEVELOPMENT!

27. Cont.. II. Tax Classification Taxes are classified as direct and indirect taxes. TAXES ARE KEY TO SUSTAINABLE DEVELOPMENT!

28. Cont.. TAX 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. 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. TAX 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. TAXES ARE KEY TO SUSTAINABLE DEVELOPMENT!

29. Cont.. 1. Direct Taxes Tax is paid by a person on whom it is levied. The impact and incidence fall on the same person. Direct tax is borne by the person on whom it is levied and cannot be passed on to others. Examples: Employment Income-tax, Business Income-tax , Capital gains tax, Property or wealth-taxes etc. TAXES ARE KEY TO SUSTAINABLE DEVELOPMENT!

30. Cont.. Merits of Direct Taxes Ensures the principle of ability to pay Reduces the social and economic inequalities Certainty Economy Elasticity Educative Effect Control the effects of trade cycles TAXES ARE KEY TO SUSTAINABLE DEVELOPMENT!

31. Cont.. Demerits of Direct Taxes Arbitrary in Nature Difficulties in the formulation of progressive tax rates Possibility of tax evasion Limited scope Disincentive to work, save, and invest Expensive to collect TAXES ARE KEY TO SUSTAINABLE DEVELOPMENT!

32. Cont.. 2. Indirect taxes Under indirect taxes, the impact and incidence fall on different persons. It is not borne by the person on whom it is levied and can be passed to others. Indirect taxes are taxes on commodities or consumption. Example: custom duties, VAT, excise taxes etc. TAXES ARE KEY TO SUSTAINABLE DEVELOPMENT!

33. Cont.. Merits of Indirect Taxes Convenience Wide Scope Tax evasion is not possible Substantial revenue Effective Allocation of Resources Discourages the Consumption of Articles Injurious to Health TAXES ARE KEY TO SUSTAINABLE DEVELOPMENT!

34. Cont.. Demerits of Indirect Taxes Ability to pay principle is violated Uncertainty Discourages Saving High Cost of Collection Civic Consciousness is Not Created Inflationary TAXES ARE KEY TO SUSTAINABLE DEVELOPMENT!

35. 2.6 TAX STRUCTURE Tax structures differ from country to country primarily because countries' socioeconomic developments differ from one another. WHICH TAX STRUCTURE IS SUITABLE? There are different types of tax structures (system) which are applied by the governments on different taxes. These are: TAXES ARE KEY TO SUSTAINABLE DEVELOPMENT!

36. A. Progressive Tax Structure Is also called graduated tax . It is usually applied in reference to income taxes , where people with more income pay a higher percentage of it in taxes. The tax rate increases as the tax base income increase . Merits of Progressive Tax System Reducing the inequalities of income and wealth Economy Elastic Stabilizing the economy TAXES ARE KEY TO SUSTAINABLE DEVELOPMENT!

37. Cont.. Limitations of Progressive Tax System a. Ideal Progression is Impossible b. Progressive Taxation - a Graduated Robbery c. Disincentive to Work d. Discourages savings and investments e. Shifts the total economic production of society TAXES ARE KEY TO SUSTAINABLE DEVELOPMENT!

38. B. Regressive Tax Structure The tax rate decreases as the tax base increases. To determine whether a tax is regressive, the income elasticity of the goods being taxed as well as the income-substitution effect must be considered. Example: sales tax, property tax, excise tax, tariffs and government fees. TAXES ARE KEY TO SUSTAINABLE DEVELOPMENT!

39. C. Proportional Tax Structure is charged at a flat rate for everyone, whether earning higher income or lower income, it is also called flat tax . It is based on the theory that since everybody is equal , taxes should also be charged the same way. TAXES ARE KEY TO SUSTAINABLE DEVELOPMENT!

40. Cont... Merits of proportional tax system Proportional tax system has the following advantages: It is simple in nature. It is uniformly applicable There is certainty Proportional taxation leaves the relative economic status of taxpayers unchanged It will avoid mistakes and drawbacks of progressive tax system Limitations of proportional tax system The following are the demerits of proportional tax system: Inequitable distribution Inadequate resources Inelastic in nature Hence, it is not practically and universally accepted . TAXES ARE KEY TO SUSTAINABLE DEVELOPMENT!

41. D. Digressive tax structure is a mix between the progressive and proportional tax systems. the tax rate is increased firstly with increase in income and then, the rate remains flat or constant with further increase in income. TAXES ARE KEY TO SUSTAINABLE DEVELOPMENT!

42. 2.7. Tax evasion, Avoidance & Delinquency Tax Evasion is a method of saving tax liability by a taxpayer through fraudulent means or by directly violating tax laws . is illegal, unethical, uneconomical and highly risky since it may result in penalty, imprisonment, and closing of business. is meant to be deliberate acts of non-compliance resulting in payment of lower taxes than are actually owed. Therefore, not paying ‘’ones’’ lawful share of tax is evasion of income. Evasion can take place in a number of ways. There are two forms of tax evasion. They are as follows: Suppression of income, and Inflation of expenditure. TAXES ARE KEY TO SUSTAINABLE DEVELOPMENT!

43. Cont.. 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 TAXES ARE KEY TO SUSTAINABLE DEVELOPMENT!

44. Cont.. Causes of Tax Evasion Multiplicity of tax laws Complicated tax laws Example: the Income Tax Act has 28 chapters and 298 sections including sub-sections. So, such complication in tax-laws is also a root-cause for the tax evasion iii. High Rates of taxation iv. Inadequate Information as to sources of tax revenue Example: In Ethiopia, small businessmen and farmers rarely maintain any accounts of their income. v. Investment in real property vi. Ineffective tax enforcement vii. Deterioration of moral standards TAXES ARE KEY TO SUSTAINABLE DEVELOPMENT!

45. Cont.. Remedies for Tax Evasion Thorough overhauling of tax laws Reduction in Tax Rates Replacement of sales tax & excise duties with VAT Tax on agricultural income Maintenance of proper accounts Introduction of Expenditure Tax Tightening of Tax Enforcement TAXES ARE KEY TO SUSTAINABLE DEVELOPMENT!

46. Cont.. II. Tax Avoidance is legal but immoral . denotes the taxpayers’ ingenuity to arrange his affairs in a proper manner so as to reduce the incidence of tax. As long as the provisions of the law are not violated and transactions properly recorded, any attempt to minimize tax using those accounting methods and principles that may useful to report less taxable income of the taxpayers is acceptable. III. Tax Delinquency means the amount of tax uncollected in the previous fiscal period especially in property tax. It may happen if the taxpayer unable to pay property tax due to bankrupt. If the taxpayer can survive its loss for the coming year, the tax authority will collect both the current year tax as well as delinquent tax otherwise it will be considered as un collectible revenue by the authority. TAXES ARE KEY TO SUSTAINABLE DEVELOPMENT!

47. THE END OF CHAPTER TWO