TAX AUDIT PRACTICE AND ITS SIGNIFICANCE IN

INCREASING REVENUE IN ETHIOPIA THE CASE OF

ADDIS ABABA CITY ADMINISTRATION

FOR THE PARTIAL FULFILLMENT OF

MSC.IN ACCOUNTING AND FINANCE

BY

MESFIN GEBEYEHU

ADVISOR: DR. LAXMIKANTHAM

ADDIS ABABA UNIVERSITY

FACULTY OF BUSINESS & ECONOMICS
DEPARTMENT OF ACCOUNTING

JAN.2008
JAN.2008

i
 DECLARATION

I, Mesfin Gebeyehu declare that, this paper prepared for the partial

fulfillment of the requirements for MSC. Degree in Accounting and

Finance entitled ”Tax audit practice in Ethiopia and its significance

in increasing revenue the case of Addis Ababa City Administration”

is prepared with my own effort. I have made it independently with the

close advice and guidance of my advisor.

Mesfin Gebeyehu

Signature –––––––––––––––––––––––

Date –––––––––––––––––––––––

ii
 Certification

This is to certify that Ato Mesfin Gebeyehu has carried out this

research work on the topic entitled “Tax audit practice in Ethiopia

and its significance in increasing revenue the case of Addis Ababa

City Administration” under my supervision. This work is original in

nature and it is sufficient for submission for the partial fulfillment for

the award of MSc. in Accounting and Finance.

Dr.P.Laxmikantham

Signature –––––––––––––––––––––

Date –––––––––––––––––––––

iii
 ADDIS ABABA UNIVERSITY
FACULTY OF BUSINESS AND ECONOMICS
ACCOUNTING AND FINANCE (MSC PROGRAM)

TAX AUDIT PRACTICE AND ITS SIGNIFICANCE IN

INCREASING REVENUE IN ETHIOPIA THE CASE OF
ADDIS ABABA CITY ADMINISTRATION

By
Mesfin Gebeyehu Melaku

Advised by:

Name –––––––––––––––––––––––

Signature –––––––––––––––––––––––

Date –––––––––––––––––––––––

Examined by:

1. Name–––––––––––––––––– Signature–––––––––– Date–––––

2. Name–––––––––––––––––– Signature–––––––––– Date–––––

3. Name–––––––––––––––––– Signature–––––––––– Date–––––

iv
 Acknowledgements

First and foremost, I want to transfer my sincere appreciation to my

advisor Dr. Laxmikantham for his unreserved and vital advice in

making this paper a reality.

Secondly I extend my deepest thanks to all officials of Addis Ababa City

Revenue Agency as well as Inland Revenue Authority who provided the

available information, especially Ato Tazie Biru, team leader of Addis

Ketema Sub City tax assessment department, Ato Gebre ,head of

operation department of Addis Ababa City Revenue Agency.

Thirdly it is also my pleasure to transfer my gratitude my friend Ato

Manaye Bialfew for his support in all matters from the starting to the

end of the program. In addition I thank to my staff employees for their

continuous encouragement and support.

Finally, I extend my sincere and deep appreciation to all institutions

and people who played a vital role in making this paper a reality.

v
Abbreviation:
AA: Addis Ababa
AAA: American Accounting Association
AICPA: American Institute of Certified Public Accountants
BoFED: Bureau of Finance and Economic Development
COBAC: Committee on Basic Auditing Concepts
EFY : Ethiopian Fiscal Year
ERP : Economic Reform Program
FDRE: Federal Democratic Republic of Ethiopia
GAO: Government Accountability Office
GDP: Gross Domestic Product
OECD: Organization of Economic Cooperation and Development
HTT: Hard to tax
IFAC: International Federation of Accountants
INTOSAI: International Organization of Supreme Audit Institutions
ISA: International Standard on Auditing
IT: Information Technology
SME: Small and Medium Enterprises
SAI: Supreme Audit Institutions
TOT: Turn over tax
VAT: Value Added Tax

6
Table of Contents Page No.

CHAPTER ONE.....................................................................................................................................1
INTRODUCTION AND RESEARCH DESIGN ..............................................................................1
1.1. Introduction ............................................................................................................................ 1
1.2. Statement of the Problem ................................................................................................... 3
1.3. Objectives of the Study........................................................................................................ 5
1.4. Significance of the Study .................................................................................................... 6
1.5. Scope and Limitation of the Study .................................................................................. 6
1.6. Research Design and Methods ......................................................................................... 7
1.6.1. Data Collection Methods ............................................................................................. 8
1.6.2. Questionnaire Design................................................................................................... 8
1.6.3. Data Analysis .................................................................................................................. 9
CHAPTER TWO...................................................................................................................................11
REVIEW OF RELATED LITERATURE.........................................................................................11
2.1. Meaning of tax audit .......................................................................................................... 11
2.2. Audit of government revenues ........................................................................................ 15
2.3. The roles of the taxpayer audit program ..................................................................... 17
2.4. Government Revenues scope and extent .................................................................... 19
2.5. Key audit characteristics .................................................................................................. 22
2.6. Need for tax audit................................................................................................................ 23
2.7. Types of Tax audits............................................................................................................. 27
2.7.1. Full audits...................................................................................................................... 27
2.7.2. Limited scope audits .................................................................................................. 28
2.7.3. Single issue audits...................................................................................................... 28
2.8. Resources for the tax audit function ............................................................................ 29
2.9. Location of audits................................................................................................................ 30
2.11. The efficiency and effectiveness Tax audit ............................................................... 31
2.12. Significance of Tax audit in fighting corruption ..................................................... 34
CHAPTER THREE .............................................................................................................................36

7
Analysis and Discussions of the Study .....................................................................................36
3.1. Historical back ground ...................................................................................................... 36
3.2. The Current Tax Administration System in Ethiopia.............................................. 38
3.3. Tax administration in Addis Ababa City Administration....................................... 52
3.4. Declaration of Income and Assessment of Taxes...................................................... 58
3.5. Record Keeping Requirement .......................................................................................... 61
3.6. Prevailing extent of assessment & Audit in Addis Ababa City Revenue
Agency.............................................................................................................................................. 63
3.7. Coverage and types of tax audit in Ethiopian context ............................................ 66
3.8. Corruption vs. Tax Audit in Ethiopia ........................................................................... 67
3.9. Efficiency and Effectiveness of Tax Audit ................................................................... 69
3.10 Measure of efficiency and effectiveness ...................................................................... 72
CHAPTER FOUR ................................................................................................................................75
CONCLUSION AND RECOMMENDATION ................................................................................75
4.1 Conclusion .............................................................................................................................. 75
4.2 Recommendations ............................................................................................................... 79
Bibliography

8
List of Tables Page No.

Table3.1The Share of Domestic Indirect Taxes from Total Revenue For selected Countries. 41
Table 3.2 Government Finance .................................................................. Error! Bookmark not defined.
Table 3.3 Major components of Government revenue from EFY 1990-1998 .............................. 49
Table 3.4.Revenue Performance Summary of Addis Ababa City Administration ..................... 56
Table 3.5 Types of Assessment................................................................................................................... 60

Table 3.6.Tax Assessment and audit performance of Addis Ababa City Revenue Agency for
1999EFY. ........................................................................................................................................................... 64

Table3.7 Employees of Addis Ababa City Revenue Agency including Sub cities and Kebeles70
Table 3.8 Question: How do you measure the effectiveness of tax audit operation? 72

9
List of Graphs Page No.

Graph 3. 1. Government Revenue & Expenditure ............................................................................... 45

Graph 3.2 the trend of major government revenues ........................................................................... 50
Graph 3.3 Main components of Income taxes....................................................................................... 52
Graph 3.4 Graphical presentation of Revenue Performance in A.A ............................................... 57
Graph 3.5 Graphical presentation of revenue performance for A.A City...................................... 64
Graph 3.6 Employees of Addis Ababa City Revenue Agency including Sub cities and
Kebeles................................................................................................................................................................ 70

Annexes

Questionnaires–---------------------------------------------------------------------------------I
Government Finance---------------------------------------------------------------------------II
Tax Rate Amendments------------------------------------------------------------------------III

10
 CHAPTER ONE

INTRODUCTION AND RESEARCH DESIGN

1.1. Introduction

Revenue is probably the most important part of the government and most of its

plans and policies also depend on the amount of revenue collected. Government has

also given priority in reducing the budget deficit through the mobilization of internal

resources.

In the context of liberalization and globalization of the world economies, many

governments have opened new investment areas to foreign investors. In order to

meet these new challenges and to simplify tax administration, the Federal

Democratic Republic of Ethiopia amended the tax laws with new provisions and

procedures to assist the tax payers in complying with the self assessment process

so as to reduce tax evasion and then to increase the revenue generation through

tax.

Expanded domestic revenue base (especially taxation) offers a promise of greater

autonomy in the future and a break from restrictive aid and loan conditionalties.

With this vision, recently, many poor countries have become preoccupied with

improving tax systems. For instance, in the case of Ethiopia in an effort to increase

1
the government’s domestic revenue the government replaced the sales tax with

Value Added Tax (VAT) & Turn over Tax (TOT). In addition, the Ministry of Revenue

was established giving autonomy to the government’s revenue organ, and the tax

system is computerized. Further more, the Federal Democratic Government of

Ethiopia is trying to improve its tax administration capacity which encompasses tax

audit as one of its component.

Tax audit is an extension of the “attest function” of the historical financial audit. It

is the audit of an assessee’s accounting and other documentary evidences for the

preparation of current tax returns, as well as the supporting working statements,

followed by an audit report giving the auditor’s opinion about the degree of

correspondence between the information contained in the tax return and the

regulatory provisions of tax laws.

In other words, tax audit is an extension of the normal audit generally conducted

for the purpose of expressing an opinion as to the fairness of the accounts

examined by the auditor, and the certification of financial statements for tax

purposes. It is meaningful if based on the knowledge of tax laws, similarities and

dissimilarities between commercial accounting and tax accounting and reporting to

the tax department, recognizing their requirements to enable the latter to compute

taxable income. It includes what a tax official can look for when aiming to complete

an assessment of tax. It covers also the disclosure of all significant accounting

practices employed in the organization, a report on the financial accounts, i.e. the

2
balance sheet, profit and loss account and other related accounts and schedules

which are part and parcel of the financial reports. Furthermore, information is

required to compute the assessable income as well as to ensure that the compliance

of the tax laws and regulations is proper.

1.2. Statement of the Problem

While the principal source of a government’s revenue should be taxation, in many

Sub-Saharan African countries this is often not the case. Many of the Sub-Saharan

African countries rely on foreign sources of finance namely foreign loan and aid due

to their poor tax administration capacity and collection ability.

There are various reasons why revenue administration reform may be needed in a

country. First, while tax policy and tax laws create the potential for raising tax

revenues, the actual amount of taxes flowing into the government treasury, to a

large extent, depends on the efficiency and effectiveness of the revenue

administration. Weaknesses in revenue administration lead to inadequate tax

collections. Financing of the resulting budget deficit through borrowing or monetary

expansion can cause an unsustainable increase in public debt and inflation,

respectively.

In the alternative, revenue shortfalls shrink the budgetary resource envelope, thus,

affecting the government’s ability to implement its policies and programs and

provide public services. Unexpected decline in revenue collections also cause

3
budget cuts that result in major inefficiencies in the public expenditure

management.

Second, the quality of revenue administration influences the investment climate

and private sector development. Firms considering investments are not only

concerned about the formal tax system, but also about how the system works. A

revenue administration that is perceived to be arbitrary or predatory discourages

investment. Further, weaknesses in the enforcement capacity of the revenue

administration put law-abiding firms at a competitive disadvantage, as their

competitors in the informal sector are allowed to get away with tax evasion. This

reduces incentives for businesses to join the formal private sector.

Third, taxes and customs administrations are possibly near the top of public-sector

organizations with a high incidence of corruption. The cost of this corruption is

high, both for the government and taxpayers. The government suffers major

revenue leakages as dishonest revenue officials allow unjustified tax breaks to

willing tax evaders. Honest taxpayers suffer as corruption in revenue administration

leads to harassment, inflated assessments, high litigation costs and leniency

towards non-compliant competitors. Any serious effort to reduce corruption in a

country and improve governance, in all likelihood, has to involve reform of the

revenue administration.

4
Finally, reform of the revenue administration that include efficient and effective tax

audit may be needed to enable it to keep up with the increasing sophistication of

business activity and tax evasion schemes. With globalization, goods and services

are produced by taxable entities in multiple countries.

This presents vast opportunities for manipulating transactions to reduce the tax

burden. The existence of tax havens, electronic financial transactions and the

increasing use of the internet in commerce pose major challenges in enforcing the

tax laws. Without a matching increase in the professional and technological

capacity of the revenue administration, its chances of monitoring taxable activity

and countering tax evasion are seriously reduced. For this reason tax audit plays

an important role to increase the revenue administration capacity.

As tax audit is one of the tools of revenue administration, this paper focuses on its

significance and practice in Ethiopia taking Addis Ababa City Administration as a

case.

1.3. Objectives of the Study

The study has the following objectives:

To trace out the basic concepts of tax audit along with the different

methods of its implementations.

To analyze the significance of tax audit in strengthening tax

administration capacity.

5

To analyze the role and significance of tax audit in increasing revenue

To provide concrete suggestions to the issues relating to tax audit

practice in Ethiopia based on the case study.

1.4. Significance of the Study

The study will provide feed back to tax payers and tax authority regarding the

significance and application practice of tax audit. The study also contributes in

evaluating the prevailing tax audit practice and in making some adjustments on the

existing tax audit systems.

More over, it will provide constructive feedback about the efficiency and

effectiveness of the existing tax audit practice in A.A City administration.

Finally, for those who are interested to make further study on the related issue

may be used as indication.

1.5. Scope and Limitation of the Study

The study analyses the tax audit practice in Ethiopia with special reference of A.A

City Administration. In particular tax audit practice category ‘A’ and category ‘B’ tax

payers will be considered in the study. While studying the tax audit practice, the

present study, considers only the practice and its application in A.A City

Administration, so that the scope may be some how limited.

6
However, since the general guidelines, application procedures and practice are the

same through out the country, it is supposed that the paper can fairly reveal the

tax audit practice and its significance in increasing the revenue of the country.

Of course it may have some limitations with the conclusion to take it as country

wide. The reason is that, there are some types of taxes which are not applicable in

A.A City Administration, especially income from agriculture even if it is not

subjected to audit.

1.6. Research Design and Methods

Once the research project is identified and defined clearly, the next step is to design

the research method, because the research design provides guidelines for data

collection.

As noted earlier, the aim of the paper is to identify the extent, efficiency and

effectiveness of tax auditing in maximizing revenue generation. The focus of the

paper is to obtain some qualitative and quantitative data that would facilitate a

conclusion about the practice of tax audit system and its impact on revenue of the

country.

7
1.6.1. Data Collection Methods

Data are the basic input to conduct meaningful research. In conducting the

research the data that are going to be used are both primary and secondary data.

Among the different primary data collection methods questionnaires and personal

interviews are the main that have been most usually applied in this research paper.

The questionnaire contains around ten open – ended which need further

elaboration and suggestion by the respondent. Where as, the remaining closed –

ended questions about tax audit application and its efficiency and effectiveness.

1.6.2. Questionnaire Design

Questionnaire design for tax audit surveys typically helps to extract information on

the characteristics of the business, the time spent on each tax audit case by tax

auditors, issues of tax evasion, and tax related malpractices by tax payers, fees paid

to professional tax auditors; and any other related issues.

The questionnaires are designed to meet the following objectives:

 User friendliness: The questions were kept short and language was as

simple as possible to encourage legibility and maximize the response

rate.

8
  Comprehensiveness: the number of questions was kept to a minimum

to encourage responses. However, it was necessary to collect a large

amount of relevant quantitative and qualitative data.

 Attitudinal questions: Tax auditors have been asked to respond on

their attitudes towards the existing tax system and the significance of

tax audit for the government as well as for the tax payer.

 Respondents: had an opportunity to add any comments that they feel

were not covered in the survey, and to indicate the time that they had

taken to complete the questionnaire.

Questionnaires are distributed for all the ten sub cities found in Addis Ababa two

for each and nineteen questionnaires out of the total are returned. Around sixteen

were more or less filled; the remaining three were partially fulfilled.

Secondary data are also collected from source documents, published materials,

annual reports, magazines, research papers and internet.

1.6.3. Data Analysis

After data were collected, proper tools and techniques have been used for

classification and analysis of data. The main tools that have been applied for

classification of data are tables, charts and graphs. The analysis of data involves

9
computation of statistics such as ratios and percentage analysis methods are

applied.

The analysis is based on the countries revenue performance as compared to other

African countries, its budgeted revenues and tax audit practice in A.A City

Administration using the various types of taxes applied through out the country.

1.7. Arrangements of Chapters

The objective of the present study is to provide evidence regarding the tax audit

practice and its role in increasing revenue of the government. For this purpose the

study has been arranged in to :

I. Introduction and design of the study

II. Review Of Related Literatures

III. Analysis and Discussions of the Study

IV. Conclusions of the study and recommendations

10
 CHAPTER TWO

REVIEW OF RELATED LITERATURE

2.1. Meaning of tax audit

An audit is the independent examination of financial statements of related financial

information of an entity, whether profit oriented or not, and irrespective of its size,

or legal form, when such an examination is conducted with a view to expressing an

opinion thereon. 1

The American Accounting Association (AAA) has provided a broader definition of

audit which refers to:

… a systematic process of objectively obtaining and evaluating evidence regarding

assertions about economic actions and events to ascertain the degree of

correspondence between those assertions and established criteria and

communicating the results to interested users. 2

In a narrower sense, audit is an “attestation communication” because it presents

the auditor’s opinion or judgment concerning the degree of correspondence between

accounting information and established criteria.

1
IFAC, 1993, p. 10
2
AAA, 1973, p. 2

11
To the tax administration, tax audit refers to the examination of tax returns by

concerned tax officials primarily with respect to checking as to timely arrival,

inclusion of all required forms and attachments, and arithmetical accuracy. This

may be called internal tax audit.

A tax audit is one of the most sensitive contacts between the taxpayer and a

revenue body. The presence of an auditor in a taxpayer’s private dwelling or

business premises, coupled with the exploration of private and business issues and

the gathering of information from taxpayers’ books and records, or just the

disruption of day-to-day workflow, represents a burden on the taxpayer and may be

seen by some as an unwarranted intrusion into their affairs. Notwithstanding this,

tax audits remain the only effective method for ascertaining additional facts or

verifying provided information.

The tax audit function plays a critical role in the administration of tax laws in all

countries. In addition to their primary role of detecting and deterring non-

compliance, tax auditors are often required to interpret complex laws, carry out

intensive examinations of taxpayers' books and records, while through their

numerous interactions with taxpayers operating very much as the "public face" of a

revenue body. These factors, as well as the absolute size of the audit function in

most revenues bodies, provide a strong case for all revenue bodies paying close

attention to the overall management of the tax audit function.

12
Historically, the audit function conducted by public accountants has been

associated with this activity of attesting to financial statements.

Tax audit (expected to be performed by public accountants) can be thought of as an

extension of this “attest function”. For tax purpose, one assessee is liable to file a

return to the concerned assessing officer with supporting documents sometimes

required by tax law for simultaneous submission with the return. The assessee is

sometimes called for by the assessing officer under the tax law for producing the

same. In this context, the question of tax audit may arise. And “tax audit” means to

audit an assessee’s accounting and other documentary evidences to prepare the

correct tax return as well as to prepare the statements showing the detailed

computational working for different heads of income or items in tax return and

other required evidential statements regarding allowances and disallowance for

deductions and all these are to be followed by an audit report giving the auditor’s

opinion about the degree of correspondence between the information content in the

tax return and the regulatory provisions of the existing tax laws.3

Thus, tax audit comprises the following:

Accounts and other evidences are required to comply with the “tax basis of

accounting”, i.e. as per requirement of tax laws;

3
AAA, 1973, p. 14

13

Preparation of tax return, statement of computational working for items in

the return and statements containing particulars of allowances and

disallowance for deduction;

Giving audit report portraying the attest function whether the tax return and

statements have been fairly prepared as per the regulatory requirement of tax

laws.4

When we think about who does tax audits, we first think of a public inspector, a

civil servant, integrated in a public organization or agency of the government.

Nevertheless, in the field of private financial statements audit, the audit must

comprise all the economic-financial operations, including the taxes-originated ones,

and the auditors opinion must also include whether the taxpayer has correctly

assessed tax liability.

For instance, according to Kamal Gupta&Ashok Arora, in India ,the income tax

Act,1961 ,provides for compulsory audit of the accounts of certain income tax

assessee’s (i.e. persons liable to pay income tax )whose turn over exceed the

specified limits. It was also practiced for some years in Ethiopia but left after the

1997 E.C. election. The objective of such audit is to assist tax authorities in making

the correct income tax assessment of the assessee’s concerned. The tax auditor has

to specifically report on certain transactions which have an impact on the income

4
. www. Jstor, The Accounting review :VOL,48

14
tax liability of the assessee concerned and are, thus important to the tax

authorities.5

2.2. Audit of government revenues

In recognition of the importance of an efficient revenue collection system for

mobilizing the budgetary resources of the government, the need to establish

revenue audit as a specialized and independent domain has been engaging the

attention of the Supreme Audit Institutions for quite some time. The International

Congress of International Organization of Supreme Audit Institutions (INTOSAI)

held at Rio de Janeiro, Brazil in May, 1959 recommended that:

Supreme Audit Institutions (SAI) ought to exercise the broadest possible

supervision of revenues.

Supervision should not be limited to the checking of collection of revenues in

line with the accounts rendered by the collectors but, wherever possible, a

check should be made to see whether or not tax payments were in line with

legislation.

SAIs should ascertain whether there has been negligence in the matter of

collections or exaggeration in the estimates.

The SAIs ought to be equipped to carry out their duties, especially as regards

supervision of revenues, with mechanized accounting and statistical services.

5
Kamal Gupta, (1992,) contemporary auditing, 4th, ed, Tata McGraw hill publishing company limited.

15
The concept of tax audit was a sub-theme in the Third International Seminar of

ASOSAI held at Bali, Indonesia in June 1988. The following guidelines were

recommended in the area of tax audit.

(a) Audit mandate: SAIs should seek clear and specific legal authority for

undertaking comprehensive tax audits in conformity with the relevant provisions of

the Lima Declarations on Auditing Precepts.

(b) Audit of individual tax assessments: It is important that individual tax files are

examined to evaluate the adequacy of the system and procedures of tax assessment

and collection. As the examination of all tax files is neither feasible nor necessary,

best results may be obtained while concentrating on high value and risk areas.

Selective auditing of business income cases rather than salary assessment,

investigations of reported evasions and use of suitable statistical sampling

techniques in the review of files are preferred practices. Data and information on

tax payers collected by the tax authority may be verified against other independent

sources available.

(c) Interpretation of tax laws: SAls should scrutinize the rules, regulations and

notifications issued by the executive agencies under the tax statutes.

(d) Scrutiny of decisions of tax authorities: Where quasi-judicial and discretionary

powers are vested in the tax officials, any decisions taken in the exercise of such

powers should be scrutinized in audit.

(e) Audit methodology: Audit should be mainly system based and the objective

should be to discover loopholes, lacunae and deficiencies not only in tax

16
administration but also in tax laws. Adequate procedures for identifying and dealing

with tax avoidance rising from deficiencies in laws could be considered so that

remedial action including amendments to the laws could be taken promptly.

(f) Socio-Economic implication of taxation. The social and economic goals

proposed to be achieved through tax concession and relief should be reviewed in

audit.

(g) Reporting on the results of tax audit: Having regard to personal privacy

considerations, it is imperative that confidentiality be maintained in reporting

individual assessments in the audit reports.

(h) Training of tax auditors: Tax audit is a specialization which requires thorough

knowledge of the relevant laws and regulations. SAIs should provide intensive and

frequent training for tax auditors taking advantage of the training facilities available

in their local tax department's training institutions as well as those in other SAIs.

2.3. The roles of the taxpayer audit program

The tax audit program of a revenue body performs a number of important roles that

effectively carried out & can make a significant contribution to improved

administration of the tax system.

These roles are described briefly hereunder:

Promote voluntary compliance: The primary role of the audit program is to

promote voluntary compliance by taxpayers with the tax laws. It seeks to

achieve this by reminding taxpayers of the risks of noncompliance and by

17
 engendering confidence in the broader community that serious abuses of the

tax law will be detected and appropriately penalized.

Detect non-compliance at the individual taxpayer level: By concentrating

on major areas of risk (e.g. unreported cash income) and those individual

taxpayers most likely to be evading their responsibilities, audits may bring to

light significant understatements of tax liabilities, and additional tax revenue

collections.

Gather information on the “health” of the tax system (including patterns

of taxpayers’ compliance behavior): The results of normal audit activity may

provide information on the general well-being of the tax system. Audits

conducted on a random basis can assist overall revenue administration by

gathering critical information required to form judgments on overall levels of

tax compliance, that over time can be used to identify trends in overall

organizational effectiveness and to gather more precise information that can

be used to inform decision-making on future compliance improvement

strategies, to refine automated risk-based case selection processes, and even

support changes to tax legislation.

Gather intelligence: Audits may bring to light information on evasion and

avoidance schemes involving large numbers of taxpayers that can be used to

increase major counter-abuse projects.

Educate taxpayers: Audits can assist clarify the application of the law for

individual taxpayers and to identify improvements required to recordkeeping

and thus may contribute to improved compliance by taxpayers in the future.

18

Identify areas of the law that require clarification: Audits may bring to

light areas of the tax law that are causing confusion and problems to large

numbers of taxpayers and thus require further efforts by the revenue body to

clarify the laws’ requirements and/or to better educate taxpayers on what

they must do to comply into the future.

Given the broad range of roles to be performed a revenue body’s audit program

typically entails the largest allocation of a revenue body’s total staff resources.

From this perspective alone, the audit program represents a sizeable strategic

investment that dictates the need for sound management policies and practices.

2.4. Government Revenues scope and extent

As mentioned earlier, government revenues are sourced from various tax and non-

tax receipts. The country papers bring out the dimensions of these two sources

which in turn influence the areas of audit priority. These are tax and non tax

revenues. Government revenues are largely dependent on taxes legislated through

various tax statutes. However, the spread of the two sources, viz. tax and non-tax

revenues, varies from country to country.6

6
Forum on Tax Administration’s Compliance Sub-group, Strengthening Tax Audit Capabilities: General Principles and
Approaches,16 October 2006

19
The scope of audit activities varies across countries, in part as a result of the

system of assessment in place. There are two generally accepted systems of tax

assessment applied world wide (administrative assessment and self assessment)

In around half of OECD countries, administrative assessment is employed to

varying degrees in the administration of personal income tax and corporate

profits/income tax. All countries administer VAT under self assessment principles.

Assessment systems operate on the principle that all tax returns should be subject

to a degree of technical scrutiny before a formal assessment is sent to the taxpayer.

In practice, however, much of the scrutiny previously undertaken by technical staff

has been replaced in many countries by the use of automated screening techniques

to identify returns requiring scrutiny before a formal assessment is issued. To the

extent that there is some level of scrutiny carried out by technical officers, it ranges

in practice from a very cursory examination of some tax returns to a more in-depth

examination where further inquiries may be made with taxpayers (sometimes by

correspondence) before a formal assessment is issued. Even countries that operate

administrative assessment regimes complement these arrangements with a formal

program of post-assessment audits. However, in practice such programs tend to be

conducted on a smaller scale than is the case in countries only applying self-

assessment principles.

In countries where self-assessment principles are applied, returns are typically

accepted as filed in the first instance (with the exception of returns containing

20
mathematical errors or clearly erroneous deductions) and, for income tax, a formal

assessment/ notice confirming/advising the tax liability is sent to the taxpayer

before any inquiry. A sample of returns is selected for post-assessment audit,

generally applying computer-based risk selection techniques and/or manual

screening processes. Large scale matching programs may also be mounted on a

post –assessment basis for the major categories of income (i.e. wages, interest, and

dividends).7

Since virtually all tax returns are accepted as filed without technical scrutiny when

applying self-assessment principles, it is essential for the system to be supported by

a reliable automated audit case selection system using risk-based screening

techniques. Typically, such systems are developed using risk-based criteria derived

from analyses of completed audit cases and are regularly updated to take account

of the results of audit activities and to reflect important changes in the behavioral

patterns of taxpayers. Examples of risk identification models and approaches are

described in the companion note ‘Audit Case Selection.

As systems of administrative assessment and self-assessment have evolved over

time in many countries there is something of a fine-line in practice between their

features and relative efficacy.

7
Forum on Tax Administration’s Compliance Sub-group, Strengthening Tax Audit Capabilities: General Principles and
Approaches,16 October 2006

21
According to the Ethiopian Federal Inland Revenue Authority’s tax assessment and

audit manual, an assessment is basically an initial review by tax official of the tax

declarations and information provided by tax payer and a verification of the

mathematical and technical accuracy of the declared tax liability shortly after the

submission of the declaration. The initial review also includes the application of

various risk criteria to determine possible tax underpayments and the subsequent

selection for tax audit.

An audit on the other hand, is the conduct by audit staff of appropriate verification

of selected tax payers declared tax liabilities. This can include a review of tax

payer’s systems, books of account and other related information. It may include

cross checks of tax payer’s records with those of tax payer’s suppliers or with other

source of information such as the custom authorities or other government

departments and agencies.

2.5. Key audit characteristics

Compliance regimes operate within the unique legal, cultural and administrative

background of individual member countries. Nevertheless, there are a number of

common pre-requisite features and requirements that need to be in place to ensure

a good level of effectiveness and efficiency from audit activities and to support

continuous improvement. They are:

22

A comprehensive legal framework, including an appropriate regime of

sanctions.

Well-defined organizational and management processes, including a

comprehensive performance measurement framework.

Well-defined audit techniques and adequate support arrangements; and.

Adequate human resource management and development programs.

2.6. Need for tax audit

Four conditions tend to create the demand for the independent performance of the

audit or attest function. They are as follows:

Conflict of interests between those who prepare accounting information

reports and those who use them;

Consequence of information to users while using them in decision-making;

Complexity of subject matter and audit process; and

Remoteness of users from subject matter and preparer.8

When audit function is extended to tax, the above-mentioned four conditions are

also required to be satisfied. Here, the preparer of income tax return and relevant

information (the assessee) has the conflicting relationship in terms of financial

8
AAA, 1973

23
interest with his counterpart user or evaluator of the return (the assessing officer).

Because, manipulated information in the tax return may reduce the tax liability.

Second, use of the tax return, assumed to be correct and complete, may have

serious consequence on Government fiscal estimation and collection thereof. As a

result, all the budgetary appropriations may stand for nothing but a baseless

imagination.

Third, both financial accounting and tax accounting are recognized as a much

complex discipline due to technicalities and their distinct characteristics of

difficulties.

Finally, between the preparer of the return and the information therein (by the

assessee) and the assessing officer, there exists a wall of remoteness though the

latter can call for any additional information from the former to be satisfied with the

completeness and correctness of the information provided. But sometimes this may

not be possible due to time and cost constraints and some other reasonable causes.

In this case, the tax authority can apply his best judgment, which may not be the

expression of the reality and thus both the parties, the Government and the

assessee may be affected by under- or over-charging of tax. Therefore, all the

conditions creating the demand for audit with respect to tax can be found to be

satisfied.

24
Besides, the Committee on Basic Auditing Concepts (COBAC), suggested that the

subject matter of any extension of the audit function must have the following

attributes:9

The subject matter has to be susceptible to the deduction of evidential

assertions. Such assertions have to be both quantifiable and verifiable;

There has to be an information system to record the actions, event or results

thereof; preferably adequate internal controls have also to be in operation;

and

Consensus should exist on the established criteria against which the

information prepared from the subject matter can be evaluated.

Each of the attributes stated above is essential. Two additional conditions are also

needed. They are: auditor’s competence and summarization of findings in a report.

The COBAC of AAA has recognized that extension of the attest function to the audit

of income tax return appears to satisfy all the attributes stated above. The subject

matter allows the deduction of evidential assertions, which are verifiable as well as

quantifiable. Tax law requires the maintenance of an “information system” adequate

for recording the actions and events, and the law also serves as a criterion for

evaluating the subject matter information.10

9
Committee on Basic Auditing Concepts (COBAC)
10
COBAC

25
The International Federation of Accountants (IFAC) Ethics Committee, in the “Code

of Ethics for Professional Accountants” has defined “professional service” as “any

service requiring accountancy or related skills performed by a professional

accountant including accounting, auditing, taxation, management consulting and

financial management services”. Hence, an auditor must be competent first in

accounting, inevitably in auditing, as well as thereafter in taxation. 11

Introduction of tax audit by qualified professional accountants is indeed the

esteemed recognition of their specialized competence. The real benefit from

compulsory tax audit, if legally enforced, is that the audit will ensure maintenance

of proper books of accounts and other records. The growing accounting habit thus

developed will enable creation of a transparency of the in the middle of grey area

between assumed income and reported income. Thus, tax evasion will be markedly

curbed through checking the fraudulent practices concerning colluded accounts.

Other arguments in favor of tax audit include: tax return with added credibility and

accompanied by tax audit reports as well as necessary supporting statements can

reliably be presented before the authority facilitating tax administration, relieving

assessing officers from carrying out routine verifications, and attending to more

important investigation aspects of assessment cases through utilization of the saved

time.

11
The International Federation of Accountants (IFAC) Ethics Committee, in the “Code of Ethics for
Professional Accountants”

26
2.7. Types of Tax audits

Audits can vary in their scope and the level of intensity to which they are

conducted. For this reason, various terminologies have evolved to describe different

types of audit activity:12

2.7.1. Full audits – The scope of a full audit is all-encompassing. It typically entails

a comprehensive examination of all information relevant to the calculation of a

taxpayer’s tax liability for a given period. The objective is to determine the correct

tax liability for a tax return as a whole. In some countries full audits are carried out

as part of random audit programs that are used to gather data on the extent,

nature and specific features of tax compliance risks, for compliance research

purposes and/or the development of computerized audit selection formulae. Given

their broad scope, full audits are typically costly to undertake a substantial

program of full audits will require considerable resources and reduce the rate

coverage of taxpayers that could otherwise be achieved by a more varied mix of

audit types.

12
Forum on Tax Administration’s Compliance Sub-group, Strengthening Tax Audit Capabilities: General Principles
and Approaches,16 October 2006

27
2.7.2. Limited scope audits – Limited scope audits are confined to specific issues

on the tax return and/or a particular tax scheme arrangement employed by the

taxpayer. The objective is to examine key potential risk areas of noncompliance.

These audits consume relatively fewer resources than full audits and allow for an

increased coverage of the taxpayer population.

2.7.3. Single issue audits – Single issue audits are confined to one item of

potential non-compliance that may be apparent from examination of a taxpayer’s

return. Given their narrow scope, single issue audits typically take less time to

perform and can be used to review large numbers of taxpayers involved in similar

schemes to conceal non-compliance.

In practice, the scope and nature of any audit activity undertaken for a particular

taxpayer will depend on the available evidence pointing to the likely risks of non-

compliance and a taxpayer’s prior history. Extensive audit inquiries may also be

justified simply because a taxpayer’s financial and /or business activities are

unusually complex.

Periods under examination: Audits can focus on one financial year or accounting

period, or be extended to cover multiple fiscal periods. An audit can focus on

specific parts of the taxpayer’s activities (such as sales, goods in stock etc), specific

incidents or transactions or activities (such as those carried out in a branch or

subsidiary), or specific tax obligations. An audit can vary in its level of detail.

28
Sometimes the taxpayer’s affairs are examined in detail and in other situations,

subject to the level of risk perceived, merely superficially.

2.8. Resources for the tax audit function

Revenue bodies typically have at their disposal a finite level of resources to conduct

the day to day business of revenue administration. Given the many tasks to be

performed and the inevitable decisions that must made on priorities, a process is

required to determine how those resources are to be allocated. In some member

countries, revenue bodies have relatively limited discretion as to how staff resources

are to be spread across the various areas of work, while in others broad discretion

is given to senior management on how resources are to be allocated.

Regardless of how the overall budget of resources for audit work is arrived at, a key

issue for the audit function is how those resources will be spread over the various

segments of taxpayers. Determining how resources might best be allocated is a key

element of a revenue body’s strategy for compliance improvement and is dealt with

in the following section.13

The significance of the roles played by the taxpayer audit function, as described

above is evidenced in part by the relatively large proportion of staff resources

13
Forum on Tax Administration’s Compliance Sub-group

29
devoted to this function. In many member countries, the proportion of the revenue

body’s overall staff resources devoted to audit and other verification activities

exceeds over 30%.14

2.9. Location of audits

Tax audits can be conducted in different locations. Sometimes there is a need to

carry out the audit at a taxpayer’s business premises. In other situations, the books

and records required to complete an audit can be collected by, or sent to, the

revenue body and the audit work performed in the office. Tax audits can be

categorized as ‘field audits’ or ‘office or desk audits’ on this basis.

Given that audits can vary in terms of their scope and intensity revenue bodies

should have a clear policy on the types (and numbers) of audits to be conducted,

and the circumstances in which specific types of audits are to be carried out, so

that audit officials (including managers) understand what is expected of them.

2.10. Approaches& standards of Tax Audit

In conducting a tax audit the audit should apply the generally accepted practices of

auditing as one would do in the case of other audits, e.g. an audit of a company

14
Tax Administration in OECD and Selected Nonmember Countries: Comparative Information Series

(2006))

30
under the companies act. The generally accepted auditing practices are

communicated in the various pronouncements of the respective country.

The auditor should get the financial statements as well as the statement of

particulars authenticated by the assessed before he verifies them.

The auditor can apply the technique of selective verification (statistical sampling/

test-checking), depending on his evaluation of the internal control system prevalent

in the entity under audit and the materiality of transactions.

In conducting the audit the auditor should keep in mind that the basic objective

behind is to assist the authorities in assessing the collect income of the assessed.

For conducting the tax audit effectively an auditor needs to develop an approach

which is a synthesis of taxation laws and auditing principles. The nature of tax

audit is such that an auditor has to rely on various legal pronouncements in the

field of taxation.15

2.11. The efficiency and effectiveness Tax audit

Audit effectiveness was measured by examining the amount of evidence selected for

examination in relation to the total available evidence and an optimal level of

evidence. Audit efficiency was then defined as audit effectiveness per unit of time by

15
Tax Administration in OECD and Selected Nonmember Countries: Comparative Information Series

(2006))

31
taking the audit effectiveness measure divided by minutes spent on the task. The

key findings were that time pressure (manipulated by four levels of a time budget

for the task) affected performance only at the extremes, with the highest time

pressure group performing more efficiently than the auditors in the lowest time

pressure group. Efficiency was also affected by audit program structure, with high

structure (more detailed audit procedures listed) being associated with increased

efficiency.16

Apostolou et al. (1993) defined audit efficiency as the ability to meet the budget and

operationalized it as the percentage deviation between actual and budgeted hours.

This research examined the effect of leader behavior on audit efficiency. Two leader

behaviors—(1) facilitating cooperation and teamwork and (2) administering

discipline—resulted in increased audit efficiency. On the other hand, showing

consideration contributed to reduced audit efficiency.17

In addition in an economic sense, the concept of efficiency is rooted in the ideas of

minimization of inputs, absence of waste, and least cost production methods

Auditing practitioners tend to define efficiency as accomplishing the audit task in

less time thereby increasing profitability.18

16
International Journal of Finance, (vol. 3: 121–133 (1999)
17
Apostolou et al. (1993)
18
Hollingshead, 1996 Pillars of Integrity: The Importance of Supreme Audit Institutions in Curbing Corruption
Kenneth M. Dye and Rick Stapenhurst ,The Economic Development Institute of the World Bank 1998

32
The efficient and effective conduct of audit activities requires that a revenue body’s

audit and investigation staff have appropriate powers of access to information held

by the taxpayer and other parties so that taxpayers liabilities reported in their

returns can be properly verified or, in the absence of returns, be accurately

established. There should also be an appropriate regime of sanctions to punish and

deter non-compliance.

For these reasons, revenue bodies require a set of powers and sanctions in the legal

framework supporting the conduct of tax administration activities that includes the

provision of adequate powers for obtaining information and an appropriate regime

of sanctions covering the various offences that may arise. In practice, this legal

framework may be set out separately in the laws governing each tax administered

or, preferably for ease of legislative maintenance, in a single comprehensive law on

tax administration that provides a common set of provisions covering all taxes.

In the US, an official form titled ‘Cost Benefit Analysis’ (Review of Cost Effectiveness

of Investigations) is used to measure the cost benefit of continuing an audit. The

form is being prepared at a predetermined stopping point in the audit (such as

when 60 hours have been expended by the auditor). The form calculates cost

benefit by assigning dollar values for the auditor’s hourly labour costs and

multiplying the cost by the hours projected to complete the audit. The auditor’s

total labor dollar cost is matched against the projected revenue anticipated (benefit

33
of continuance). A negative cost benefit analysis may result in the early termination

of the audit.19

Collectibles is another factor for possible consideration. Some countries use

collectibility as a pre-contact consideration and other countries reported that it

could become a factor during the course of the audit if bankruptcy were imminent.

The collectibility concept implies that a taxpayer’s inability to pay a future proposed

tax assessment would be sufficient basis for not conducting the audit.

Those administrations that do not use this concept report that collectibility is a

secondary objective and should not diminish the primary objective of a correct

assessment of tax liability. In addition, the limitation of collectibilityconsiderations

to the current tax period may not provide a complete financial picture for the

taxpayer as it excludes consideration of future payment potential.

2.12. Significance of Tax audit in fighting corruption

Simply defined, corruption is the abuse of public power for personal gain or for the

benefit of a group to which one owes loyalty. It occurs at the intersection of public

and private sectors, when public office is abused by an official accepting, soliciting,

19
Hollingshead, 1996

34
or obtains by threat a bribe. Klitgaard (1996) has developed a simple model to

explain the dynamics of corruption:20

C (Corruption) = M (Monopoly Power) +D (discretion) – A (Accountability)

In other words, the extent of corruption depends on the amount of monopoly power

and discretionary power that an official exercises. Monopoly power can be large in

highly regulated economies; discretionary power is often large in developing

countries and transition economies where administrative rules and regulations are

often poorly defined. And finally, accountability may also be weak, either as a result

of poorly defined ethical standards of public service, weak administrative and

financial systems and ineffective watchdog agencies.Tax is one of the most exposed

issues for corruption since it is carried out by the interaction of the tax payer and

the tax auditor (official).

20
Klitgaard (1996)

35
 CHAPTER THREE

Analysis and Discussions of the Study

This chapter gives an overview of the Ethiopian tax audit practice with the special

reference to Addis Ababa City and discusses the tax administration plus the

challenges in tax collection faced by the country using Addis Ababa City as a model.

The chapter discusses the ways how the Ethiopian government finances its

activities, the revenue composition of the country as well as Addis Ababa City

revenue agency tax audit practice and administration. The chapter further

discusses the different related issues of tax audit so as to increase the revenue

performance including with performance of tax audit and assessment activities.

3.1. Historical back ground

Tax in Ethiopia is as old as the country it self. All kings, leaders and land lords of

ancient time have levied different types of taxes for various purposes. During those

times the tax that was levied and collected all-most all in kind was spent for

military purposes. Traditional taxes were paid in kind ,however taxes in the form of

money has become applied in 19th and 20th century due to the circulation of money

and modernization of government policies.

36
How ever, the modern tax system has been started during Emperor

Hailesselasie(1942). To reach the current stage the Ethiopian tax has passed

different stages even on wards from the Imperial period. According to the new

constitution of Ethiopia adopted in November 1994, the federal democratic republic

of Ethiopia would comprise a federal state and member states in which both organs

shall have their respective, legislative, executive and judicial powers. All financial

requirements necessary to carry out duties and responsibilities that have been

given to the federal government and the regional state are envisaged to be covered

by the respective organs and the sharing of revenue between the federal government

and regional states follow the arrangements of the powers of the government.

Governments have several options at hand to finance their activities and pursue

their fiscal policy. These options include the imposition of taxes and the generation

of non-tax revenues through fees, levies, cost recovery and user charges, property

and investment income, domestic and foreign borrowing (including loans from

multilateral institutions), the sale of government assets (including the sale of public

enterprises) , domestic and foreign grants. In most countries, conventionally defined

legal taxes and levies constitute a significant proportion of GDP and finance a major

part of government expenditure. It is therefore essential that tax systems be and at

the lower levels of bureaucracy.

These levies also form a part of the burden of taxation and have socio-reallocation

o form a part of the burden of taxation and have socio-reallocation efficiency,

37
efficiency, equity, administration and compliance costs.

However, in many countries, in addition to legally imposed taxes there are also

arbitrary and irregular tax-like levies imposed by the authorities. These levies are a

part of a larger phenomenon involving the need to make extra payments when

interacting with government officials in many countries, particularly at the

economic consequences. Nevertheless, these irregular payments are not captured in

the traditional economic databases, including that involving government finance.

When such irregular levies arise in-lieu of legally imposed taxes, the tax revenue

collection will fall below what can be collected on objective grounds.

3.2. The Current Tax Administration System in Ethiopia

Taxation policy of a government generally seeks to apply the following desirable

fiscal principles:-

 The subjects of every State ought to contribute to the support of the

Government as nearly as possible in proportion to their respective abilities;

that is, in proportion to the revenue which they respectively enjoy under the

protection of the State. The observation or neglect of this saying reflects what

is called the equality or inequality of taxation.

 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

38
 paid, ought all to be clear and plain to the contributor, and to every other

person.

 Every tax ought to be levied at the time, or in the manner, in which it is most

likely to be convenient for the contributor to pay it.

 Further more, every tax ought to be so affected as both to take out and 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.

Ethiopia has implemented Economic Reform Program (ERP) since 1992/93 with the

support of World Bank, International Monetary Fund, foreign governments and

other multilateral institutions. Since then as a part of ERP, the government has

taken tax policy measures. The tax reform Program has got momentum in 1999

when the "Revenue Board" scaled up to the a level of Ministry " Ministry of Revenue"

and the reform expanded from tax policy measures to Administrative reform.

The Government of Ethiopia is modernizing the tax and custom administration by

overhauling the legislations and improving administration. The reform measures

are intended to encourage trade, investment and hence development; broadening

the tax base and increase Government revenues to support social programs and

alleviate poverty; strengthen the enforcement capacity of the tax and customs

authorities; and promoting equity in the tax system.

39
Tax administration reform includes the proper registration of taxpayers, assessing

taxable income and timely collecting of the assessed tax. An efficient and proper tax

administration requires the prevalence of clear and transparent rules and

regulations.

Tax laws and regulations should minimize discretionary powers of tax collectors but

give sufficient enforcement power to them. This requires periodic inventory and

revision of all existing rules and regulations. The presence of an efficient and

modern tax revenue collecting institutions equipped with capable employees and

mew technology is equally important. Despite considerable achievements in

reducing tax and tariff rates, rationalizing domestic sales and excise taxes, the

revenue mobilization effort needs further actions both in policy and administrative

aspects.

40
 Table3.1 The Share Of Domestic Indirect Taxes From Total Revenue For Selected

Countries

N Country Direct tax Indirect Taxes Non-

o Total indirect Domestic Foreign tax
tax Ind. Taxes Trade tax Reve
nue
1 Greece 37.83 53.51 53.43 .08 8.66
2 Turkey 32.09 45.69 42.69 3.01 19.48
3 Colombia 37.23 50.00 41.16 8.41 12.43
4 Kenya 30.59 56.73 41.53 15.2 11.80
5 Morocco 28.85 55.32 39.31 16.01 13.46
6 South Africa 55.20 37.18 35.92 1.27 5.95
7 Ghana 16.77 30.65 33.89 26.76 22.57
8 Chad 26.69 49.02 33.73 15.29 21.81
9 Israel 52.70 33.64 33.20 0.44 13.49
10 Korea 44.62 38.79 32.57 6.22 12.11
11 Gambia 14.74 74.45 32.41 42.04 5.93
12 Uruguay 44.94 35.67 31.89 3.78 7.02
13 Pakistan 16.14 55.14 31.86 23.28 28.73
14 Sweden 56.58 29.88 29.29 0.59 12.03
15 India 21.47 51.60 28.09 23.51 23.01
16 Mauritius 25.02 60.40 26.98 33.42 14.49
17 Zimbabwe 46.91 41.73 22.91 18.82 10.34
18 Cameron 19.65 46.07 22.51 23.56 28.78
19 Spain 69.51 22.46 22.43 0.03 8.34
20 Tunisia 31.74 48.57 21.66 26.92 16.65
21 Ethiopia 25.27 44.28 20.22 24.07 27.72
22 Zaire 34.29 51.32 18.68 32.64 7.78
23 Egypt 27.54 22.11 12.50 9.61 35.85

Source:- International Financial Statistics year Book (1996-98) International Monetary Fund

From the above table we can understand that developed countries indirect taxes

holds significant place. Because the burden of direct taxes can not be shifted to

another, the tax payer’s effort to evade is high and this intern needs efficient and

strong tax administration. As one can perceive from the table, developed countries

like Spain &Sweden highly relied on direct tax not on foreign trade and non tax

41
revenues like that of developing countries. Within the indirect taxes the share of

foreign trade tax remained very minimal in developing countries. On the contrary,

for several developing countries, foreign trade taxes played significant role in their

revenue basket.

As part of the developing countries, Ethiopia's tax revenue is dominated by indirect

taxes. More over, with in this category foreign trade taxes, derived from import

duties and taxes contribution is significantly high. In contrast domestic indirect

taxes are inferior.

In Ethiopia the revenue from domestic indirect taxes accounts 20 percent of the

total revenue against to 41.5, 33.7, 33.9 and 22.9 percent of Kenya, Chad, Ghana

and Zimbabwe respectively. In the case of foreign trade taxes, Ethiopia's share

stood 24 percent of the total revenue compared to Kenya's 15.2, Chad's 15.3,

Ghana's 26.8 and Zimbabwe's 18.8 which may be impossible to implement zero

tariffs to the imports of member countries. However, more in view of the current

globalization treat it is not plausible to depend on this source of revenue.

The tax system is therefore assumed to depend on stable sources. It is advised that

stability to be ensured by avoiding reliance on such vulnerable tax bases, and

exploit domestic taxes including broadening bases on income and Consumption

taxes, and ensuring compatibility with tax administration capabilities. Thus

42
revising domestic indirect tax policy aspects and improving its administrations

imperative.

The initial failure of the transitional countries including Ethiopia to develop their

tax administration when introducing new tax structures resulted in very uneven tax

imposition, lower than the predicted revenue, and wide spread tax evasion.

Similarly, in some developing countries, like Ethiopia, tax liabilities are often

negotiated rather than calculated as set out in the law. This issue can be supported

by a number of practical evidences.

For example according to income tax proclamation No.286/2002,Art.86-102 there

are both administrative and criminal penalties set for violating the set tax laws.

Nevertheless they are hardly applicable in practice through out Addis Ababa city

administration as well as the entire country.

The government has become smooth in this issue after the 1996E.C. tax levy which

was a bit higher than any time and which again resulted public protests especially

in main cities and towns of the country. During the 1997 E.C. election, tax was

used as a major instrument for different political parties and the ruling party has

become smooth after wards especially on direct taxes as can bee seen next.

43
Table3.2 Government Finance

In Mn. Birr
G.C. 1998/99 1999/00 2000/01 2001/02 2002/03 2003/04 2004/05 2005/06
Particulars E.F.Y 1991 1992 1993 1994 1995 1996 1997 1998
Total Revenue
&Grants 11,215 11,222 12,805 12,833 15,703 17,918 20,147 23,225
Total Revenue
(excluding grants) 9,453 9,498 10,177 10,409 11,149 13,917 15,582 19,493

Tax-Revenue 5,592 6,782 7,440 7,926 8,243 10,906 12,398 14,122

Tax-Revenue
as % of GDP 9.7 10.5 11.3 12.5 12 13 11.7 11.5

Total Expenditures 14557 17184 15786 17651 20517 20520 24803 29325
Current
Expenditures 10127 13742 10379 10550 13549 11977 13235 15234
Capital
Expenditures 4430 3442 5003 6130 6313 8271 11343 14042
Special
Programs - - 404 971 655 272 224 50

Total Expenditures as
% of GDP 25.4 26.7 24 27.8 29.8 25.1 25.7 26.4

Percentage share of
Tax Revenues to the
total revenue of the
country 49.86 60.43 58.10 61.76 52.49 60.87 61.54 60.81

Source: National Bank of Ethiopia Annual report 2004-2005 with some arrangeme

44
 Graph 3. 1. Government Revenue & Expenditure

35000
30000
Amount in Birr

25000 Total Revenue &Grants

20000 Tax-Revenue
15000 Total Expenditures
10000
5000
0
EFY1991-1998

As shown in the above table and graph the over all revenue collection of the

government of Ethiopia from tax as compared to GDP is not more than 13% which

is the list even from many Sub-Saharan Africa countries.

By and large, government’s ability to carry out its on going expenditure programs in

infrastructure and social sector depends on the level of domestic financial

resources, largely expected to flow from its tax system. Nevertheless, Ethiopia’s

revenue performance over the past decade has been small, when compared to other

developing countries. The tax revenue GDP ratio, which had peaked at 13 percent

in 1996E.C, however, fell to 11.7 and 11.5 percent in the following two years. It

remained low compared to the rationally accepted level of developing countries,

which is 20-25 percent.

45
Compared to other countries in Africa, income tax rates are still high. Various tax

studies also advised the elimination of differentials existing between maximum

rates across taxpayers. In the tax system, import duties still contribute significant

portion of tax revenue nevertheless, the current globalization agenda demands the

need to liberalize trade policy. This entails further reduction on duty rates.

However the total expenditure of the country reaches up to a maximum of about

30% during 1995, which shows the economy of the country is highly dependent on

non tax revenue sources which accounts up to a maximum of 51% in 1991 EFY

and a minimum of 38.5% in1994 EFY . The total revenue collected during the given

periods is much less than the total expenditure incurred on those years. This

implies that the effort to increase domestic revenue rather than depending on

foreign aid and loan should be increased.

To this view improving the prevailing tax administration specially increasing tax

audit efficiency and broadening the tax base are the means. Graph 3.1 also depicts

that revenue of the country is by far less than that of each years expenditure

incurred for both capital and recurrent government activities. Actually the trend

reveals that both the GDP rate of revenue and expenditure growth is almost similar,

in which both depicts little decline in stead of increment.

46
3.3 Major Components of Government Revenue

As can be shown in table 3.3, the government of Ethiopia generates its revenue

from different sources, namely tax (direct and indirect), non tax (charges,

investment income, property sales etc), and loans and grants. These components of

revenue sources are shown in table 3.3 and graph3. as follows.

As shown in the table and the graph below for some years earlier non tax revenue

was higher than that of either direct or indirect tax revenues, because during those

years especially during 1992 privatization and sale of government enterprises had

been mad widely.

For those years under consideration, the share of indirect tax was higher than that

of direct tax towards government revenue. From the graph we can understand that

both direct and indirect taxes have increased .However, indirect taxes increased at

an increasing rate, while direct taxes increase more or less at a constant rate.

The reason for the increased indirect tax revenue (such as TOT, VAT, custom duties

etc) is that, these sources of revenue are not levied directly on income of individuals

and businesses unlike that of direct taxes and except some it is easy to administer

this indirect taxes as compared with direct taxes which are exposed for evasion .

47
In addition, the burden of these indirect taxes can be shifted towards the final

consumer; however the impact is on the businesses and individuals who are given

the delegation to collect. Of course, there may be a possibility that, the tax

withholding agent or the tax collector may use the money colleted from these

indirect taxes, so tax intelligence and random review may be applied

48
Table 3.3 Major components of Government revenue from EFY 1990-1998

Particulars EFY 1990 1991 1992 1993 1994 1995 1996 1997 1998
Total Revenue and Grants 9686.4 11215.2 11222.1 12805 14628 15,703 17,188 24,096 26,615
Total Revenue1 8443.1 9453.2 9498.4 10177 11506 11,149 13,186 19,531 22,883
1 Tax Revenue 5268.7 5591.6 6482.8 7440 8646 8,243 10,520 12,398 14,159
1.1.Direct Tax Revenue 1869.4 2008.8 2367.3 2735 3512 3,010 3,132 3,930 4,461
1.1.1Income Taxes 1523 1680.4 1952.6 2143 2636 2,878 2,832 3,569 3,819
- Personal 433.6 505.2 593.9 686 794 833 948 1,132 1,414
- Business 1089.4 1175.2 1358.7 1457 1842 1,639 1,303 1,714 1,741
1.2 Rural Land Use Fee 97.8 108.4 111.5 117 127 406 581 723 665
1.3 Urban Land Use Fee 115.6 66.9 86.8 123 201 88 114 140 124
1.4 Others 133 153.1 216.4 352 548 44 186 221 517
2. Indirect Taxes 3399.3 3582.8 4115.5 4705 5134 5,233 7,388 8467 9698
2.1 Domestic Taxes 1180.8 1204.3 1439.7 1381 1830 1,668 2,112 2721 3111
2.2 Foreign Trade Taxes 2218.5 2378.5 2675.8 3324 3304 3,565 5,276 5746 6587
- Import 2037.2 2223.2 2527.6 3231 3252 3,564 5,276 5746 6587
- Export 181.3 155.3 148.2 93 52 1 0 3184 5371
3. Non-Tax Revenue 3144.4 3861.6 3015.6 2738 2860 2,906 2,666 7134 8724
3.1 Charges and Fees 130.7 176.6 200 179 298 252 321 1106 3136
3.2 Gov. Invt. Income 1400.2 1423 1183.5 1353 1249 1,102 1,250 193 310
3.3 Reimb. and Property
Sales 92.2 91.8 474.6 203 217 204 185 856 433
3.4 Sales of Goods &
Services 164.1 282.4 356.6 340 427 330 376 414 1113
3.5 Others 1357.2 1887.8 800.9 663 669 1,018 534 4565 3732
4. Grants 1273.3 1762.1 1724.1 2628 3122 4,554 4,002 4565 3732
Source: Ministry of Finance and Economic Development

49
Graph 3.2 the trend of major government revenues

12000 Direct Tax Revenue

10000
Indirect Taxes
8000

6000 Non-Tax Revenue

4000
Grants
2000

0
1990 1991 1992 1993 1994 1995 1996 1997 1998

Source: Ministry of Finance and Economic Development

50
As shown in the graph below income tax is one of the main components of direct

tax including with others shown in table 3.3 above. Even if the share of business

profit tax is high as compared to personal income tax, it doesn’t increase at a

constant rate while personal income tax increases at a constant rate. The reason is

that, personal income tax which is mainly collected from employment with out

much effort.

This source of tax doesn’t need critical assessment other than checking whether

the amount withhold by the employer is forwarded to the respective tax authority or

not. However, business profit tax is collected from the profit of traders needs much

effort to levy and collect due to the high risk of understatement and evasion.

Most tax payers use all mechanisms that could understate their tax liability. This

implies tax auditors have greater responsibility to audit and investigate any sort of

understatement made by the tax payer and reassess the appropriate tax liability.

51
 Graph 3.3 Main components of Income taxes In Million Br.

4500

4000
Income tax
3500 Personal Income Tax
Business profit Tax
3000

2500

2000

1500

1000

500

0
1990 1991 1992 1993 1994 1995 1996 1997 1998
According to Ethiopian Budget year

Source: Ministry of Finance and Economic Development

3.3. Tax administration in Addis Ababa City Administration

Addis Ababa is the capital city of Ethiopia as well as Africa. It is also the seat of

many international organizations, embassies and agencies. Addis Ababa is a self-

governing chartered city established by Article 49 of the constitution with around

3.4 million people.

52
Addis Ababa City Revenue Agency is established by Charter proclamation

No.311/95E.C for the purpose of administering tax with in the city. It has ten sub

city revenue departments as well as in offices in ninety nine ‘kebeles’ responsible for

levying and collecting taxes from it’s territory and revenue sources given to the city

by the tax proclamation.

The structure of Addis Ababa City revenue agency is shown in the following

chart.

Finance & Economic Development Bureau

Revenue Agency

Operation System & tax Legal Intelligence &

Department Information Department Investigation
Department Service

Sub City Finance

& Eco.Dev’t Off. Sub City Revenue
Department

Kebele Revenue Section

Source: Addis Ababa City Revenue Agency

53
Tax administration reforms are designed to enhance the accuracy and fairness of

assessment, increase the efficiency of collection, reorganize the tax and customs

administrations along functional lines, and improve taxpayer registration

procedures as well as collection enforcement and audit. In addition computerization

is also required for more effective management of taxpayer’s data bases, while pay

incentive programs and greater autonomy for the tax authority, supported by

development of specialized skills among tax officials are intended to promote

honesty and efficiency in tax administration.

There is no best tax policy in the world with out efficient and effective

implementation and administration. Hence tax policy design must take in to

consideration the administrative issue as the corner stone. The resources used in

administering and complying with tax laws are real economic costs, in terms of the

ability of the country to provide goods and services. To this view there are three

main essential issues to effective tax administration:

the political will to administer the tax system effectively,

a clear strategy for achieving these goals,

adequate resources to implement.

54
3.4 Revenue performance of Addis Ababa City

As can be shown in the table 3.4, the revenue performance has increased from year

to year. However, in almost all the years under consideration, the contribution of

non tax revenue is higher than that of tax revenue in all the years. The main

component of non tax revenue that has higher contribution to the City’s revenue is

sale of urban land in lease.

For example, according to 1998 EFY accounts report, it accounted Br.532,

282,675.45 which is almost 20% of the total revenue. In addition when we see the

direct taxes for almost all years the tax from employment income is higher than tax

from business profit tax. The reason is that, employment income tax doesn’t need

much effort since it is deducted from payrolls by the employer.

Where as, business profit tax needs much effort from the tax authority due to the

practice of tax evasion by tax payers. In principle in a city where much of the

business activities are carried on, the tax that is generated from business profit tax

should not be less than that of employment income tax. This shows that the tax

administration capacity of the city administration is not as strong as it would be.

Had it been strong, it could collect more tax from the business. The main reason is

that the tax administration capacity of the city is not much strengthened, specially

the audit aspect.

55
Table 3.4.Revenue Performance Summary of Addis Ababa City Administration for Four years

EFY1995 EFY1996 EFY1997 EFY1998

Particulars Budg. Act. Percent Budg. Act. Percent Budg. Act. Percent Budg. Act. Percent

Direct tax

revenue 748.06 373.48 49.9 840.46 629.74 74.93 942.43 731.72 77.64 788.38 875.62 111.1

Indirect tax

revenue 168.69 122.2 72.4 460.46 596.68 129.6 385.87 253.51 65.70 657.45 154.1 23.44

Total Tax

revenue 916.74 495.68 54.1 1300.92 1226.42 94.27 1328.3 985.23 74.17 1445.83 1029.71 71.22

Other

revenue 547.29 415.53 75.9 2034.62 413.17 20.31 2155.68 991.21 45.98 2030.61 1647.88 81.15

Total A

annual

Revenue 1464.03 911.21 62.2 3335.54 1639.59 49.16 3483.98 1976.44 56.73 3476.44 2677.59 77.02

Source: BoFED of Addis Ababa City Administration Budget Proclamation and Accounts Report (However own computation)

56
Graph 3.4 Graphical presentation of Revenue Performance in A.A

Total A annual Revenue

6000
Other revenue
5000
Total Tax revenue
4000

3000

2000

1000
0

1995 1996 1997 1998 EFY

Source: BoFED of Addis Ababa City Administration Budget Proclamation and Accounts Report (However own
computation)

The trend of revenue performance can also been shown in graph 3.4 above. As

compared to other regions of the country, Addis Ababa City doesn’t get budget

from the Federal government which shows it is a self financing city due to being

the main trade center of the country. However, even the City Revenue Agency

doesn’t administer all sources of tax due to wide spread evasion and lack of

awareness especially taxes from business profit and rental income. The total tax

revenue share of Addis Ababa City administration to that of the country’s total tax

revenue was 6.01%, 11.66%, 7.19% and 7.27% for the years starting from

EFY1995 to 1998 respectively which is less as being the main trading center of the

country.

57
3.4. Declaration of Income and Assessment of Taxes

As stated earlier there are two types of assessment in Ethiopian context. These are

Administrative assessment and Self assessment.

Taxpayers shall submit the tax declaration to the Tax Authority at the time of

submitting the balance sheet, and the profit ad loss statements for that tax year

within the time prescribed below:

a) Category “A” taxpayers within four months from the end of the taxpayers’ tax

year;

b) Category “B” taxpayers within two months from the end of the taxpayers tax

year.

A standard assessment method is used to determine the income tax liability of

category “C” taxpayers. The taxpayer should pay the tax determined in accordance

with standard assessment from the 7th day of July to the 6th day of August every

year, unless, the taxpayer requested and is allowed to make installment

payments.

If no records and books of accounts are maintained by the tax payer, or if, for any

reason, the records and books of accounts are unacceptable to the tax authority,

if the taxpayer fails to declare his or its income within the time prescribed by the

proclamation, the Tax Authority may assess the tax by estimation. Unless and

otherwise provided, the period for tax assessment is the one-year period from 1st

58
of ‘Hamle’ to 30th of ‘Sene’. A body shall not change its accounting year unless it

obtains prior approval, in writing, from the Tax Authority and compiles with any

condition that may be attached to the approval.

After the taxpayer has submitted a declaration of income within the time and

manner prescribed in the proclamation, the Tax Authority has five years to amend

the assessment. The five years assessment period runs from the due date of the

declaration.

In case where the taxpayer has not declared his income or has submitted a

fraudulent declaration, no time limit provided in any other law shall block the

assessment of the tax by the Tax Authority. However this is too long and difficult

for the tax payer to provide appropriate documents after five years if asked by the

auditor.

According to the response of the respondents for the question presented with

regard to administrative assessment visa vise self assessment is summarized in

the following table.

59
Table 3.5 Types of Assessment

Which type of assessment contribute (generate) higher revenue?

Responses No. of Respondents Percent

Administrative Assessment 14 77.78

Self Assessment 4 22.22

Total 18 100

From the above table we can understand that the main type of assessment that

yields higher revenue to the government is administrative assessment as

responded by 14(77.78%) respondents. Of course it is reasonable because the

majority of tax payers don’t maintain book of accounts. This fact depicts that

majority of the tax payers don’t maintain accounting records which intern leads

administrative assessment.

It is clear that administrative assessment is basically based on estimation which

may either complain on behalf of the tax payer or a revenue decline on behalf of

the government. It is unquestionable that tax assessment based on estimation

without evidences creates inconvenience on either the tax payer or the

government

60
3.5. Record Keeping Requirement

All persons who are engaged in a business or trade or who own buildings held all

or in part for rental, except for Category “C” taxpayers shall keep books and

records. Those businesses that are required to keep books of accounts and

records are also required to keep the following information:

 Record of the business assets and liabilities, including a register of fixed

assets showing the date of acquisition, the cost of acquisition, and the

current book value of each asset;

 Record of all daily income and expenses related to the business activity and

the matter to which they relate;

 Record of all purchases and sales of gods and services to the business

activity showing:

o The particular goods and services sold;

o The name of the buyers and sellers or providers in such a manner

that they can be identified by the Tax

 Authorities pre-numbered invoices containing the vendor’s tax identification

number;

61
  Record of trading stock on hand at the end of the accounting period,

including the type, quantity and cost of that stock as well as the method of

valuation of that stock;

 Any other document relevant for the determination of the tax liability;

 If a taxpayer has certain books or records in a foreign language, the Tax

Authority may require that they be translated into one of the official

languages of Ethiopia at the taxpayer’s expense.

According to the 286/2002 tax proclamation all businesses classified under

category ‘A’ & ‘B’ should maintain their own accounting records. How ever, this is

what the law requires but not the practice. In practice most tax payers of tax

payers that are eligible to maintain accounting records don’t have proper

accounting records. The main reason for this is that tax payers don’t have the

proper awareness about the advantage of maintaining book of accounts and the

law which enforces that tax payer to maintain proper accounting records is not

properly implemented by the responsible authority.

From the trend in most cases, they have understood that the tax that will be paid

by estimation is less and it gives them an opportunity to negotiate with the

assessor as per the interview obtained from Addis Ababa City Revenue Agency

officials. In addition, they don’t want to hire accountants and tax return preparers

which will lead them to extra expense.

62
For example according to the information found from Addis Ababa City revenue

agency the number of tax payers who had maintain book of account were 31,534

out of a total of 169,233 which is around 18.6%.This reveals that in one or

another reason, almost all of the tax payers don’t want to maintain book of

accounts.

3.6. Prevailing extent of assessment & Audit in Addis Ababa City Revenue

Agency

There are no sufficient and available statistics about the extent of assessment

under the prevailing tax audit net. From a personal interview and questionnaire

with tax officials of Addis Ababa City Administration, sub city tax auditors as well

as FIRA’S Authorities those are responsible and top taxation body; it has been

revealed that the tax audit net is very insignificant as compared to the whole tax

net. For example the tax assessment and audit performance of Addis Ababa City

Revenue Agency performance is shown as follows:

63
Table 3.6.Tax Assessment and audit performance of Addis Ababa City

Revenue Agency for 1999EFY.

Revenue
Revenue Collected
Obtained including
No. Of Files to No. of Files including penalty in
be Audited Performance Penalty in million
Particulars Audited/Assessed /Assessed in Percent million Br Br.
Based on Book of
Accounts 4771 1355 28.4 123.04

Based on Other
documents 15789 7577 48.0 29.21

Based on Estimation 127532 98452 77.2 208.6

Total 148092 107384 72.5 360.85 180.9

Source: Addis Ababa City Revenue Agency 1999 Annual Report (summarized)

Graph 3.5 Graphical presentation of audit and assessment performance for

A.A City

140000
120000 Based on Book of
100000 Accounts
80000 Based on Other
60000 Documents
40000 Based on Estimation
20000
0

64
As shown in table 3.6, the total assessment and audit performance was achieved

72.5% from the planned. However when we see the audit aspect separately which

is applied for those who maintain accounting records, it is too low (28.4%), which

means out of the total 107,384 files only 1355 files are audited. The main reason

is that most of the tax payers don’t maintain accounting records. If this is the

practice in Addis Ababa where majority of the tax payers are assumed educated to

a certain level at least to understand the advantages of maintaining accounting

records as well as where there are many accountants to get consultancy and

advice as compared to other regions of Ethiopia, it would be worsen in other

regions where there are no accountants to consult and where the taxpayers are

illiterate.

Further more, as shown in the above table from 1355(1.26%) tax payers the

amount of revenue obtained is Br.123million which is around one third of the

total revenue by the City revenue agency for the year from income.

The criteria for compulsory tax audit have to be based on gross turnover or gross

revenue, not on capital. Because profitability in terms of absolute or residual

income (RI) which is the very tax base, is obviously indicated in a better way by

the gross revenue inflow than in terms of relative income such as return on

investment (ROI) based on capital. It can be usually assumed that the higher the

65
gross earning, the higher the taxable income. But higher capital does not

necessarily mean yielding higher income.

The questionnaire about the selection of files to be audited reveals this fact. Most

respondents replied that audit cases are selected by auditors based on the gross

sales or revenue and the risk of exposure to evasion after reviewing the financial

reports prepared by the tax payers.

3.7. Coverage and types of tax audit in Ethiopian context

Since audit presupposes accounting, tax audit may cover the heads of income for

which any method of accounting must be followed for recording purpose. Any type

of tax whether direct or indirect tax is subject audit to verify the accuracy of tax

liability.

However in practice what tax auditors of the city mainly apply audit for business

profit and VAT tax. Because the audit conducted in all sub cities is desk audit

which broadly is based on documents of the tax payer. According to the interview,

the main reason of the sole use of desk audit is that field audit is assumed as it

increases the risk of corruption by tax auditors.

As mentioned above under Ethiopian tax proclamationNo.286/2002 category A

and B tax payers shall maintain their own book of accounting records and at the

66
end of the year shall submit to the tax authority a balance sheet and a profit and

loss statement supported by appropriate vouchers and document. These two

category tax payers are obliged to maintain their book of accounting records.

Where as category C tax payers don’t have the obligation to maintain book of

accounts and in this case the tax shall be assessed by standard assessment

(presumption), however, if they maintain their book of accounts the tax auditor

shall assess based on the book. And audit is mandatory for category A & B tax

payers. So tax audit has to be imposed on business or professional income with

an expanded base so as to ensure proper maintenance of account and

independent scrutiny thereof by auditors. As responded by the respondents

almost all of them said that the type of audit that is applied is determined by the

situation. However, most of the time full audit is applied .In rare cases and in

some conditions and for certain types of taxes like VAT and TOT, either single

issue or limited scope audit may be applied

3.8. Corruption vs. Tax Audit in Ethiopia

As defined in the literature part, corruption is a combination of increased

monopoly power and integrity with no or less accountability.

In Ethiopia the work of the tax inspector is neither audited by other individuals

nor performed in group. As per the tax auditors response one file is usually

67
audited by one individual auditor. It implies that, the tax audit is exposed for the

risk of corruption. So, if the public tax auditor and the tax payers communicate to

make corruption the door is open. In the prevailing tax audit practice of Addis

Ababa City revenue authority, tax audit doesn’t contribute much to minimize

corruption rather it broadens the opportunity of corruption, because tax audit is

performed usually by a single tax auditor.

Further more, the wages and salaries paid for the tax officials and auditors is low

as compared to other jobs private and NGO’s. Of course with respect to benefit for

employees employed in any position of the Finance Bureau and under its offices

the required experience is less than other civil servants. For example in A.A City

Administration and in any one of its offices an individual who has BA degree and

nine years of professional experience can be appointed as team leader with a

monthly salary of Br.2762.00, where as in other government civil service offices an

individual to apply for the same position, he should have BA degree and 14 years

of experience.

According to Ethiopian income tax proclamation No.286/2002 Art.99 offences by

the tax authority employees asking for or receiving any benefit for which the office

is not legally entitled to receive or enters into an agreement to do or to abstain

from doing permit, conceal or conspire(work against) at any act or thing where by

the tax revenue is or may be defrauded or which is contrary to the tax provisions

68
of the proclamation or to the proper execution of the officer’s duty and who

exceeds the authority conferred up on the tax authority or misuses such authority

commits an offence and is liable, on conviction to a fine of not more than

Br.50,000 and to imprisonment for a term of not less than 10(ten) years and not

more than 20 (twenty)years .

Even if the law says this as per the responses of tax officials of Addis Ababa City

administration, no one is found guilty in relation to this article. How ever it

doesn’t mean that there is no corruption rather the way it is made is beyond the

scope of the mechanism to investigate, because it is deliberately done by the

agreement of both the tax payer and the tax auditor. There are many indicators of

corruption in tax related issues. As one of the Addis Ababa City Administration

Sub City tax auditor expressed, even those students send for practical attachment

were red-handed when they receive certain amount of money and up to

Br.100,000 was found on their account .If this is done by a practitioner ,it is

simple to judge what will be done by the permanent employees those who have the

interest to abuse their power.

3.9. Efficiency and Effectiveness of Tax Audit

Before we discuss about the efficiency and effectiveness of tax audit and

assessment it is better to see first the profile and educational back ground of

employees.

69
 Table3.7 Employees of Addis Ababa City Revenue Agency including Sub cities &
Kebeles

Educational Qualification
Less or
No. of equal to College BA LLB MA Total positions
Office Positions Grade 12 Vocational Diploma Degree Degree Degree occupied
Head
Office 42 4 7 13 11 2 0 37
Sub
City 515 105 105 114 43 2 3 372
Kebele 883 304 310 153 0 0 0 767
Total 1440 413 422 280 54 4 3 1176
Percent 35.12 35.88 23.81 4.59 0.34 0.26 81.67
Source: Addis Ababa City Revenue Agency

Graph 3.6 Employees of Addis Ababa City Revenue Agency

including Sub cities & Kebeles

450
400
350 H e a d O ffic e
300
250 S u b C it y
200 K e b e le
150
100 To ta l
50
0
Less or V o c a t io n a l C o le g e B A D e g re e
e q u a l to D ip lo m a
G ra d e 1 2

Source: Addis Ababa City Revenue Agency

The above table shows the qualification of employees in the revenue agency of

Addis Ababa City and around 70% of the employees are below diploma level.

Where as the total number of BA degree holders specially found in head office

70
 and sub cities is 54(4.59%). Tax audit based on financial statements is made at

sub city level. That is why assessment performance made based on book of

accounts and based on other documents is less as compared to assessment by

estimation. Assessment by estimation (presumptive tax) for category ‘C’ tax

payers is made at kebele level.

The efficiency and effectiveness of a revenue body’s audit activities depends

critically on the nature and scope of powers in the underlying legal framework in

place, including the provision of adequate powers for obtaining information and

an appropriate regime of sanctions to discourage and penalize non-compliance. In

addition as discussed in the literature part, efficiency of tax audit considers the

conduct of effective audit with less time and cost.

In addition for the effective and efficient tax audit not only the skill and

qualification of tax auditor’s but also adequate number of tax auditors have

greater impact. As per the interview presented for one of the Sub Cities (Addis

Ketema where there are large number of tax payers), the number of tax auditors

are two BA degrees, and two Diplomas for the assessment and audit section, as

well as two BA degrees& two Diplomas for VAT section. This is the same for all

sub cities. In addition, as per the results of the interview presented there is no any

training for tax auditors.

71
The other issue which has an impact on the efficiency of tax audit is that tax laws

are not stable and consistent; especially tax rates have been revised three times

during the past five years. (See annex 2)

3.10 Measure of efficiency and effectiveness

In Ethiopia the effectiveness and efficiency of tax audit is measured by the volume

(No.) of files audited from the planned. For the question presented the

effectiveness and efficiency measures, the response given are summarized in

table3.6 below.

Table 3.8 Question: How do you measure the

effectiveness of tax audit operation?

No. of
Possible Measures Respondents Percent
Yield& Productivity 3 15.79
Volume 10 52.63
Quality Measures 2 10.53
A combination of two
or more 4 21.05
Total 19 100.00

72
Even if the effectiveness of a tax audit is measured by a combination of the above

measures presented in the possible measure column, 52.63% respondents have

responded that they used volume as a measure of their audit activity. And if one

concentrates on effectiveness which is measured by quantity, it is difficult to

achieve efficiency, since efficiency concentrates on the inputs utilized to achieve

the desired out come.

In addition as seen in table 3.6, most of the employees engaged in the assessment

and audit task are not well trained and qualified. This also has greater impact on

the efficiency and effectiveness of audit and assessment. The other issue which

affects the efficiency and effectiveness of tax audit is absence of adequate

information, due to the broad application of desk audit.

In principle, tax audit is one of the most sensitive contacts between the taxpayer

and a revenue body, the presence of an auditor in a taxpayer’s private dwelling or

business premises, coupled with the exploration of private and business issues

and the gathering of information from taxpayers’ books and records, or just the

disruption of day-to-day workflow, represents a burden on the taxpayer and may

be seen by some as an unwarranted intrusion into their affairs. How ever in

practice, since desk audit is usually applied this is not that much a problem.

Notwithstanding this, tax audits remain the only effective method for ascertaining

additional facts or verifying provided information. Legal frameworks are essential

73
to provide integrity in the way tax administrations carry out audits and to ensure

that taxpayers’ rights are properly protected.

In general, the tax revenue performance in Ethiopia as compared to GDP ratio as

shown earlier, which had peaked at 13 percent in 1996E.C, however, fell to 11.7

and 11.5 percent in the following two years. It remained low compared to the

rationally accepted level of developing countries, which is 20-25 percent. Further

more the tax audit practice, which has an impact on the performance of revenue

generated from tax, is weak as seen in Addis Ababa city revenue agency. The less

performance of the tax revenue collection makes the country to be dependent on

non tax revenues.

74
 CHAPTER FOUR

CONCLUSION AND RECOMMENDATION

All countries need to collect taxes for several reasons, such as to finance

developmental activities, to meet their day-to-day expenses related to maintenance

of a free and fair society, to control the economy through fiscal measures, and to a

certain extent, to change the economic behavior of people. The authority of

national governments to collect monies from taxpayers must recognize a balance

between the nations’ authority to tax and taxpayers' rights. Thus, the real

challenge for nations is to ensure that taxpayers are treated with fairness, justice,

and equity, while national governments emphasize their authority as taxing

authorities.

4.1 CONCLUSION

According to the analyses and findings obtained from the study, in history the

highest tax to GDP ratio in Ethiopia is 13% which is registered in 1996 EFY.

Where as, the minimum expenditure to GDP ratio in Ethiopia is about twice that

75
of the tax to GDP ratio (24%). From this we can conclude that there is huge gap

between the revenue collected and the expenditure incurred for those years.

In addition, most of the country’s revenue is not tax rather non tax revenues like

grants and other non tax sources which accounts from a minimum of 13% in

EFY1990 to a maximum of 29% in EFY1995 and from a minimum of 15%in 1996

to a maximum of 34% in 1991 EFY respectively. These sources are not stable

sources of government revenue to finance government’s activity.

It can also be generalized that, the main sources of tax for the government are

indirect taxes, such as VAT, TOT, Excise tax and other import export duties levied

on foreign trade. This is because, it is easy to levy and collect taxes from indirect

taxes as compared to direct taxes which are applied on income of businesses and

individuals. How ever, when we compare the composition of the two types of taxes

(direct and indirect) in case of Addis Ababa City, direct taxes are the main

sources. The reason is many of the indirect taxes are collected by the federal

government such as VAT, excise taxes and other import export custom duties.

Those business men who initially registered for VAT pays the whole tax they have

collected for the federal government even if they are performing the business in

the City.

A sound tax system should identify surpluses in the economy and should tax it in

such a fashion as to cause minimal damage to productive activity. Tax collection

76
should act as a catalyst for economic growth. Ideally a tax system should be

neutral with respect to its effect on economic behavior. In the real world, however,

it is impossible to achieve neutrality.

The tax authorities of Ethiopia face many challenges in the massive task of tax

collection. The main challenges can be summarized as follows:

Lack of a taxpaying culture

Weak accountability

Lack of transparency

Weak audit performance

Unstable tax amendments

Nevertheless the problem of tax evasion bothers revenue agencies established at

different levels of the city as well as the country. In the real world, those who wish

to reduce their tax liability have more choices than just tax evasion. Smarter and

more sophisticated taxpayers, who find the cost/risk of evasion greater than the

benefit, practice risk free legal ways of non-payment of taxes rather than obvious

tax evasion, which is popularly known as tax avoidance.

For the government, the results of tax evasion and tax avoidance are the same;

for the taxpayer, however, tax avoidance is preferable because there are less or no

chances of getting caught and prosecuted.

77
It is evident from the discussion in the previous sections that the issues

surrounding corrupt tax practices are complex, and not amenable to quick or easy

solutions. Not surprisingly, one-off measures such as the granting of tax

amnesties, or the withdrawal from circulation of large denomination currency

notes, have had predictably disappointing results in countries around the world.

Many countries have also had committees of enquiry, which have dealt with tax

reform issues, including corrupt tax practices. The outcome of these efforts has

also, at best, been mixed.

It has become increasingly understood that without the imposition of fundamental

complementary changes, tax reforms in and of them selves do not have a long

lasting impact.

With regard to the employees assigned in different tax positions most of them

don’t have the necessary skills which enables them to perform their duties and

responsibilities. Besides, adequate short term and refreshment training is not

given for those who are working on tax audit and assessment.

The other important issue which should be seen seriously is that, the prevailing

tax audit practice as seen in Addis Ababa City Administration is carried out

mainly based on internal documents produced by tax payers. It is clear that,

documents internally produced can not be a reliable source of information.

Further more, the type of tax audit performed by tax auditors is only desk audit.

78
So far there is no field audit which may assist to the affective and efficient audit

operation.

4.2 Recommendations

In light of the tax administration, in the context of Ethiopian tax audit practice

with a special reference of Addis Ababa City Revenue Agency, based on the

findings obtained the following recommendations are forwarded:

Continuous education should be provided to the tax payers; by the respective

revenue agencies specially to create awareness about their rights and obligations

so as to build and develop a citizen who has better value in tax.

For effective and efficient revenue collection, governments need to curb not only

the tax evasion but also the tax avoidance by applying effective and efficient tax

audit based on reliable evidences and documents. The tax collection system

should be designed in such a way that not only the tax evasion but also the tax

avoidance becomes difficult for the taxpayer.

Increased accountability and an open and honest relationship with taxpayers are

crucial for maintaining public trust and confidence in the performance of tax

administration. Taxpayers must be able to expect a high degree of certainty in

their dealings with revenue agencies. This can only be achieved when tax laws,

regulations, procedures, and administrative guidelines are made public, easily

79
accessible, and applied in a consistent manner by avoiding unstable tax laws

which creates confusion not only for tax payers but also for tax auditors.

Reforms of tax legislation and collection procedures, including measures to

improve accountability, and transparency in the taxpayer-tax officer relations,

should take place concurrently to reduce opportunities for corruption and the

demand for corrupt services.

The main ways in which the opportunities for corruption may be reduced include:

 Clarifying, streamlining laws and procedures in order to reduce official

discretion.

 Making tax rules and regulations more transparent- In the case of taxes

simple measures such as posting the various charges prominently,

disallowing the use of any receipts other than machine-printed receipts,

and using IT to disseminate forms and information could help minimize

information asymmetry and reduce the discretionary power of low-level

bureaucrats. Of course there is a good start in Addis Ababa city revenue

agency, which is trying to connect all Sub cities and ‘kebeles’ with net

work with head office and it should be strengthened and other regions

should also follow it.

 A tax guide not only written in the local language, but in simple and

plain language that a lay man can easily understand, could also help

taxpayers to negotiate daily routines. The guide should include a code of

80
 conduct for tax officials including auditors and politicians who are

assigned with revenue generating responsibilities.

 Devising a scheme to give due recognition to taxpayers, both individual

and corporate, which maintain a good taxpaying record over a

considerable period of time.

Finally it is clear that most taxpayers of any country do not want to pay taxes

unless compelled by a situation where they are left with no option other than to

pay the taxes. Therefore, for better tax compliance, a system should be designed

that automatically extracts taxes rather than leaves the payment of taxes to the

voluntary choice and morality of taxpayers. To this view tax audit is one of the

most powerful revenue administration tool that enforces tax payers to pay their

tax liability without evasion. There fore the tax audit function should be

strengthened to minimize both deliberate and innocence tax evasion made by

many tax payers with appropriate expertise and the necessary resources should

be allocated for this tax administration function.

81
BIBILOGRAPHY

1. Arindam Das-Gupta,(1999), Performance Indicators for Tax Structure and Administration

,The World Bank
2. Cheeseman, Nicholas & Robert Griffiths, (2005), Increasing tax Revenue in sub-Saharan
Africa: The case of Kenya.
3. DonaldR. Cooper&PamelaS.Schindler, (2003), Business Research Methods,
8th.ed.TataMcGraw Hill.
4. Dr.Ramaswami Parameswaran, public finance and taxation, November - 2005
5. E.ahymed&N.stern.1991. The Theory and practice of tax reform in developing countries,
Cambridge University press.
6. Jorn Rattso,( 1998), Fiscal Federalism in State &Local Finance, book craft (bath)ltd.
7. Kamal Gupta, (1992), Contemporary Auditing, 4th, Ed, Tata McGraw hill publishing
company limited.
8. Miltonc.Taylor, Taxation for African Development,Michigan, State University
9. Mukul G. Asher, Design of Tax Systems and Corruption, National University of Singapore
10. Pillars of Integrity: The Importance of Supreme Audit Institutions in Curbing Corruption
Kenneth M. Dye and Rick Stapenhurst ,The Economic Development Institute of the World Bank
1998
11. R.Panneerselvam,(2006),Research Methodology, Eastern Economy Edition, Prentice-Hall of
India.
12. Seth E. Terkper (1985-1993), Ghana: Tax Administration Reforms
13. Federal Inland Revenue Authority, Assessment and Audit Operating Manual, A.A,
January2005.
14. Government Revenues - Accountability and Audit , Kunarto, Acting Chairman of the
Supreme Audit Board of Indonesia and Chairman of ASOSAI ,May 1998
15. IMF Working Paper AFR, Determinants of Tax Revenue Efforts in Developing Countries
Prepared by Abhijit Sen Gupta1 ,July 2007
16. Forum on Tax Administration’s Compliance Sub-group, Strengthening Tax Audit Capabilities:
General Principles and Approaches,16 October 2006

82
17. International Monetary Fund (1990): Government Finance Statistic Yearbook 1990,
Washington, D.C.
18. International Monetary Fund, Fiscal Affairs Department (1995): Guidelines for Fiscal
Adjustment, Pamphlet Series, No. 49, Washington, D.C

19. IMF Executive Board ,2005 Article IV Consultation with the Federal Democratic Republic of
Ethiopia, Public Information Notice (PIN) No. 06/48
May 2, 2006
20. National Bank of Ethiopia (2003/04) Annual report, a/a., Ethiopia.
21. National bank of Ethiopia (2004/05) Annual report, a/a., Ethiopia.
22. Ministry of finance & economic development Annual Report on Macroeconomic
Development In Ethiopia (EFY 1998 (2005/06))
23. Emerald Full Text Article, Self-assessment and the tax audit lottery, the Australian
experience.
24. Federal Negarit Gzeta of the Federal Democratic of Ethiopia Income tax proclamation
No.286/2002
25. Taxation in Ethiopia by Ethiopian Chamber of Commerce (ECC), Ethiopian Business Development
Services Network, Addis Ababa 1/2005
26. http://www.mofaed.gov.et
27. http://www.asosai.org
28. http://www.oecd.org
29. http://www.mor.gov.et
30. http://www.nbe.gov.et
31. http://www.fira.gov.et

83
Annex I
 Addis Ababa University
Faculty of Business & Economics
Graduate Program (MSC) in Accounting and Finance

Questionnaires for tax auditors

Survey questionnaire to study “Tax Audit Practice & its

significance in increasing Revenue, the case of Addis Ababa
City Administration
The purpose of the study is to analyse the prevailing tax audit
practice and its significance in revenue generation taking Addis
Ababa as a case.
Responding this questionnaire may not take much time .Any
information provided would only be used for academic purpose.
As a result it would be kept confidential & utmost secrecy
would be maintained. I thank you in advance for your
cooperation.
Mesfin Gebeyehu

85
Position of the respondent_________________________
Qualification_______________________
Experience in tax related job_____________
Sex __________
Age___________

Instruction: Please make a tick (√ ) mark you thought appropriate

and your opinion for the open ended questions.
Note: You can also give your opinion in Amharic language.

1. Is there any tax audit manual?

Yes No
2. If you have the manual how do you evaluate it?
It is clear and workable It lacks some clarity
It is completely unclear
3. How much do you know the rule and regulation related to tax?
Yes almost all
Partially I don't know

4. If the answer for No. 3 is I don't know, how do you carryout your audit
funding?
Referring rules and regulations
Working with someone who has better knowledge
As per the knowledge gained through education and training
5. What are the types of assessment practiced in Ethiopia?

86
 Administrative assessment Self assessment both

6. Which type of assessment contribute (generate) higher revenue?

Administrative assessment self assessment

7. Which type of assessment is exposed to the risk of misappropriation?

Why?
_______________________________________________________________________________________________________
_________________________________
_______________________________________________________________________________________________________
_________________________________

8. Do the auditors and investigation staff have appropriate powers of access to

information held by the tax payers and other parties?
Yes No

9. If for the above, the answer is ‘no’, how can an auditor perform its
activities?
_______________________________________________________________________________________________________
_________________________________

____________________________________________________________________
10. Do the respective government officials give/pay close attention for the tax audit for
example by assigning appropriate & skilled persons allocating sufficient resources?
Yes No

11. What are the types of audit most usually applied?

Full audit limited scope audit single issue audit
Any of the three as appropriate depends on the risk identified

12. How do you measure the effectiveness of any audit technique?

Yield & productivity measures
Volume measures

87
 Quality measures
A combination of two or more of the measured as appropriate

13. Is there a mechanism to evaluate the audit activities?

Yes No

14. If the answer is "yes" who and how is it going to be evaluated?

_____________________________________________________________________
_____________________________________________________________________

15. How are audit cases selected? ___________________________________________

___________________________________________________________________
___________________________________________________________________
_________________________________________________________.

16. Is only one individual auditor selecting the cases?

Yes No

17. Are audit selected taxpayers notified in advance?

Yes No

18. Does notification has impact?

Yes No

19. If 'yes' negative or positive or both? ____________________________

_______________________________________________________________
______________________________________________________________.
20. Could you state the significance or/and disadvantage of
notification?
______________________________________________________________

88
 ______________________________________________________________
______________________________________________________________

21. Is there any legal framework to see the taxpayers' record keeping?
Yes No

22. If yes ,where can you see these record- keepings

In the business premise
Can be taken outside the business premise if needed

23. Do tax auditors have access to third party information sources?

Yes No

24. Is there any access to obtain information from other national

revenue bodies?
Yes No

25. Are the tax payers cooperative to give essential information's?

Yes No partially (not all)
26. For the above if the answer is "No" what could be the reason
behind?__________________________________________________________
__________________________________________________________
__________________________________________________________

27. Do you think that you are performing the audit work as per GASP
(Generally Auditing Standards Procedure)?
Yes No Partially

28. Could you state the possible reasons for the answer given for
question No.28? ___________________________________________________
___________________________________________________________

89
 __________________________________________________________
__________________________________________________________.

29. Which tax category of tax payers are more difficult to audit?
Category A tax payers Category B tax payers
Category C tax payers All categories

30. What would the possible measures (solutions) to solve the

problem?
_______________________________________________________________________________________________________
_________________________________
_______________________________________________________________________________________________________
_________________________________

31. Is there any thing to add in relation to tax audit practice in

Ethiopia?____________________________________________________________
__________________________________________________________________

__________________________________________________________________
__________________________________________________________________
__________________________________________________________________
__________________________________________________________________
__________________________________________________________________
__________________________________________________________________
____________________________________________.

90
 Annex II Summary of General Government Revenue by Component
Particulars 1990 1991 1992 1993 1994 1995 1996 1997 1998
Total Revenue and
Grants 9686.4 11215.2 11222.1 12805 14628 15,703 17,188 24,096 26,615
1
Total Revenue 8443.1 9453.2 9498.4 10177 11506 11,149 13,186 19,531 22,883
1 Tax Revenue 5268.7 5591.6 6482.8 7440 8646 8,243 10,520 12,397 14,159
1.1.Direct Tax
Revenue 1869.4 2008.8 2367.3 2735 3512 3,010 3,132 3,930 4,461
1.1.1Income
Taxes 1523 1680.4 1952.6 2143 2636 2,878 2,832 3,569 3,819
- Personal 433.6 505.2 593.9 686 794 833 948 1,132 1,414
- Business 1089.4 1175.2 1358.7 1457 1842 1,639 1,303 1,714 1,741
1.2 Rural Land
Use Fee 97.8 108.4 111.5 117 127 406 581 723 665
1.3 Urban Land
Use Fee 115.6 66.9 86.8 123 201 88 114 140 124
1.4 Others 133 153.1 216.4 352 548 44 186 221 517
2. Indirect Taxes 3399.3 3582.8 4115.5 4705 5134 5,233 7,388 8467 9698
2.1 Domestic
Taxes 1180.8 1204.3 1439.7 1381 1830 1,668 2,112 2721 3111
2.2 Foreign Trade
Taxes 2218.5 2378.5 2675.8 3324 3304 3,565 5,276 5746 6587
- Import 2037.2 2223.2 2527.6 3231 3252 3,564 5,276 5746 6587
- Export 181.3 155.3 148.2 93 52 1 0 3184 5371
3. Non-Tax Revenue 3144.4 3861.6 3015.6 2738 2860 2,906 2,666 7134 8724
3.1 Charges and
Fees 130.7 176.6 200 179 298 252 321 1106 3136
3.2 Gov. Invt.
Income 1400.2 1423 1183.5 1353 1249 1,102 1,250 193 310
3.3 Reimb. and
Property Sales 92.2 91.8 474.6 203 217 204 185 856 433
3.4 Sales of
Goods & Services 164.1 282.4 356.6 340 427 330 376 414 1113
3.5 Others 1357.2 1887.8 800.9 663 669 1,018 534 4565 3732
4. Grants 1273.3 1762.1 1724.1 2628 3122 4,554 4,002 4565 3732

91
%age shareof tax
revenue to the tptal
revenue 54.39 49.86 57.77 58.10 59.11 52.49 61.21 51.45 53.20
%AGE SHARE OF
NON TAX TOTAL
REVENUE 32.46 34.43 26.87 21.38 19.55 18.51 15.51 29.61 32.78
%age SHARE
OFgrantTAX TOTAL
REVENUE 13.15 15.71 15.36 20.52 21.34 29.00 23.28 18.95 14.02
100.00 100.00 100.00 100.01 100.00 100.00 100.00 100.00 100.00

92
Annex III