TAX EVATION, AVOIDANCE AND BLACK MONEY:

4.1. TAX AVOIDANCE AND EVASION:

Tax avoidance and evasions constitute a problem in almost all the countries of the world.
Tax avoidance is different from tax evasion, while evasion is against the law; avoidance is within
the ambit of law.
Tax evasion is the general term for efforts by individuals, firms, trusts and other entities
to evade the payment of taxes by breaking the law. Tax evasion usually entails taxpayers
deliberately misrepresenting or concealing the true state of their affairs to the tax authorities to
reduce their tax liability, and includes, in particular, dishonest tax reporting (such as under
declaring income, profits or gains; or overstating deductions).
By contrast tax avoidance is the legal exploitation of the tax regime to one's own
advantage, to attempt to reduce the amount of tax that is payable by means that are within the
law whilst making a full disclosure of the material information to the tax authorities. Tax
avoidance may be considered as either the amoral dodging of one's duties to society or the right
of every citizen to find all the legal ways to avoid paying too much tax. Tax evasion, on the
other hand, is a crime in almost all countries and subjects the guilty party to fines or even
imprisonment.

4.1.1. Tax Avoidance:

Tax avoidance means, “tax-payer may resort to a device within the ambit of law to divert the
income before it accrues or arises to him”.
“Tax Avoidance has to be recognised that the person whether poor or wealthy has the legal
right to dispose of his income so as to attract the least amount of tax”.
The tax avoidance can be defined as “escaping from the tax liability by using the available
loop-holes of the tax laws”.
Thus, tax avoidance means legal minimisation of tax burden by the taxpayers.

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4.1.2. Examples for Tax Avoidance:

The following are the examples for tax avoidance:

1. Suppose a taxpayer’s total income exceeds the maximum tax-free amount, then he has to
pay the tax on such excess amount. But if he invests the excess amount in any of the
approved schemes for which there is a relief in the tax law, he can save on tax altogether.
2. An individual sells his let out house property (long-term capital asset) for Birr.2, 00,000
making a capital gain of Birr 60, 000. This capital gain would normally be taxed. But, if
he invests the sale proceeds in a particular manner stipulated by law, he need not pay any
tax.
3. Divorcing the wife on paper so that her income is not added together with husband’s
income is also a common device for tax avoidance.

4.1.2. Tax Evasion:

Tax evasion means fraudulent action on the part of the taxpayer with a view to violate civil
and criminal provisions of the tax laws. It can be defined as “tax evasion implies the activities
involving an element of deceit, mis-representation of facts, falsification of accounts including
down right fraud”.
Thus, it may be said that the tax evasion is tax avoidance by illegal means i.e. tax evasion is
against the law and is an unsocial act.
There are two forms of tax evasion. They are as follows:
1. Suppression of income, and
2. Inflation of expenditure.

4.1.2.1. Examples for Tax Evasion:

The following are the examples for tax evation:

1. A trader makes a sale for Birr.20, 000 and does not account it, in his books under sales.
He is evading tax.
2. An individual lends his money of Birr.50, 000 to another person at 20% interest per
annum and does not include this income in his total income.

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 3. Under-invoicing of sales and inflation of purchases.
4. A manufacturing business employs 30 workers but include 2 more additional namesake
workers (not in actual) in the muster roles. The sum shown as paid to such additional
namesake workers will amount to evasion.
Human intelligence devices new methods of evasion and the Governments are constantly
trying to remove the loopholes in the tax laws.

4.2. Causes of Tax Evasion:

The following are the important causes for Tax evasion:

1. Multiplicity of Tax Laws: A number of laws enacted for the recovery of a variety of
taxes often leads to widespread tax evasion.
2. Complicated Tax Laws: Complicated tax laws are another reason for tax evasion. The
tax laws contain a number of exemptions, deductions, rebates, relief, surcharges and so on. For
example: the Income Tax Act has 28 chapters and 298 sections including sub-sections. So, such
complication in tax-laws is also a root-cause for the tax evasion.
3. High Rates of Taxation: India is said to be the most taxed nation in the world. High
rates of taxes cause widespread tax evasion, because the greater the risk undertaken for the
purpose of tax evasion, the greater is the reward.
4. Inadequate Information as to Sources of Tax Revenue: Lack of adequate information
as to the sources of revenue also contributes to tax evasions. In India, small businessmen and
farmers rarely maintain any accounts of their income. Even lawyers, medical practitioners, film
actors etc. are defaulters in this field.
5. Investment in Real Property: Investment in real property, both movable and
immovable, and concealment of its true ownership have also been a major cause for tax evasion.
In India, our tax laws in a way permit the holding of benami properties etc. All these facilitate
the channelising of black money into profitable ways.
6. Ineffective Tax Enforcement: Lack of proper training and efficiency for the authorities
enforcing the tax laws is also a major cause for widespread tax evasion.

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 7. Deterioration of Moral Standards: There has been deterioration in standards of moral
behaviour of people since independence. The values, which formed the basis of Indian Society,
are shown little respect. In this modern competitive world, the deterioration of moral standards,
among the people leads to falsification of accounts, mis-representation of facts and fraudulent
behaviour.

4.3. Remedies for Tax Evasion:

If steps are not taken to reduce tax evasion, it may cause irreparable harm. The following
are the remedies to prevent tax evasion.
1. Thorough Overhauling of Tax Laws: One of the main reasons for tax avoidance and
tax evasion is loose drafting of tax laws which contain several loop-holes and weak points that
enable the tax evaders to carry on the unlawful activities. Hence, it is necessary to re-draft the tax
laws thoroughly without any loopholes and weak points.
2. Reduction in Tax Rates: The prevalence of high rates is the first and foremost reason
for this tax evasion. Hence, the rate of tax should be reduced to a reasonable level.
3. Replacement of Sales Tax & Excise Duties with VAT: As the crosschecking is
possible in the case of VAT, it is more effective. Hence, such tax can be introduced instead of
sales and excise duties.
4. Tax on Agricultural Income: Agricultural income is exempted from income tax and for
this reason it is used to convert the black money into white. In recent years, agricultural farms
and orchards, and vineyards have come to be acquired by industrialists; film stars etc. because
this enables their owners to whiten their black money. Tax evasions can be avoided by taxing the
agricultural income at normal rates.
5. Maintenance of Proper Accounts: Maintenance of proper accounts should be made
compulsory for persons whose business and professional income exceeds a prescribed limit. In
the Income Tax law, a provision to this effect has been introduced recently.
6. Introduction of Expenditure Tax: In Ethiopia, expenditure tax is levied in the form of
commodity taxation such as excise duties, VAT, Turnover tax etc. There is no personal
expenditure taxation. However, it is recognised by all that if a tax is based on personal
expenditure and if all effective machinery is devised to investigate and ascertain personal
expenditure, tax evasion can considerably be reduced.

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 7. Tightening of Tax Enforcement: This may be said to be the crucial remedy if the
penalties for violation of tax laws are strictly enforced, incidence of tax evasion could
automatically be reduced.

4.4. BLACK MONEY:

[

Black money is a complex phenomenon. It has various connotations such as unaccounted

incomes, tax-evaded incomes, undisclosed wealth and unrecorded gain and suppressed or
number two accounts transactions. It is earned by violating the laws and going against the
conscience by the very name itself. We can understand how the money is earned and this money
carries a secret behind it.
The parallel economy or black economy as it is also known, is generally considered to be that
area of economic activity, which remains “Underground”, concealed from the vision and
approach of the State authorities responsible for earning economic policies and implementing
them. It is usually referred to those perfectly legitimate activities, resulting in transactions either
in kind or for payment, between individuals, which are then hidden, from the tax authorities.
Activities in the black economy are therefore, primarily undertaken with a view to evade the
payment of various direct and indirect taxes, especially the latter.
As the term and definition of the black economy is self-explanatory, obviously one can only
estimate the size of the parallel economy, but even conservative estimates are mind-boggling.
After having asked a number of analysts, economists and people in the various financial
institutions, the figure that keeps popping up is that the parallel economy is easily three times as
large as the legitimate or documented economy. While the figure does force us to think and
reflect upon the ethical decay in society it also hints at the benefits if this sector of the economy
could somehow be documented or channeled. However, the possible benefits of this are not
really as significant as most people are led to believe by the estimated size of the parallel
economy.

4.4.1. Black Economy:

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 “Black Money” or “Black Market” or “Black Economy”, gained currency for the first time
in British India during the Second World War, when the dormant deflationary primitive agrarian
economy, known as “Coin Economy” was assailed by war endeavor.
Not only are the developing countries affected by black economies. The emergence and
growth of parallel economies in recent decades in Europe, America, Africa and the rest of the
world is notable. It reveals the growing immorality in human behavior across the globe.
However, as compared to developed countries, developing nations suffer much more as a
consequence of large and ever growing parallel economies.

4.4.2. Black Income and Black Wealth:

The National Institute of Public Finance and Policy of India in its report makes a
distinction between the black income and the black wealth. Conceptually, the black income is a
flow and the black wealth is a fund or stock. The black income is generated over a period of
time. The black wealth is an accumulated unaccounted income at any given point of time. The
black money is black wealth held by the public in terms of currency as well as liquid bank
deposits. A large portion of black wealth is held in the form of real estate, gold jewellery, stocks
in business, benami financial transactions, cash, inventories and foreign currencies and
undisclosed holdings of foreign assets.
This black income in a macro sense is defined as the aggregate of taxable incomes not
reported to tax authority. In essence, income-evading taxation is referred to as black income.
Evasion of taxes of all varieties (excise duties, customs duties and sales tax) leads to black
income. Second, black income could arise from both “Reportable” and “Non-reportable”
sources. Non-reportable black income is called so because the manner in which it is generated is
illegal e.g. income from crime, bribery, black marketing, wealth (jewellery, business assets,
foreign currency, real estate-especially benami transactions). Reportable black income is
generated through legitimate activities or transactions but is suppressed and not reported to the
tax authorities so as to evade taxes that will be levied on it. Third, black income activity not only
generates black income but also results in black consumption and black saving. Black saving
when accumulated leads to Black Wealth.

4.4.3. Black Economy and Black Money:

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 “Parallel Economy” or “Black Economy” refers to the functioning of an unsanctioned
sector in the economy whose objectives run parallel to, or in contradiction with the declared
social objectives.
The black economy is said to have taken birth during the Second World War. In scarcity
conditions, controls on the distribution and prices of goods in short supply led to the emergence
of black markets and hoarding. Black market prices, which were higher than the controlled
prices, led to the emergence of “Black Incomes”, popularly called “Black Money” or “Number
Two” income.
Dr. Raja Chelliah defines the black money income as “the sum total of transactions
deliberately kept out of the books of accounts by household and business in the economy”.
We can define Black money as “that the money which has not been brought into account, the
income not shown to the authorities wholly or partially i.e. unaccounted property or money can
be called black money”.
Black income now comprises a significant and fast growing element in the Indian economy.
It is today an all-pervasive phenomenon that requires serious attention. When we talk of black
income, an important point to be noted here is that it is not limited to the evasion of income tax;
it is a heterogeneous category that extends to bribes, smuggling and even leakage.
4.5. Impact of Black Money in Ethiopian Economy:

The effects of the black money are considered significant on the basis of the following:
a) Significant size compared to other major sectors or the size of the government.
b) White economy cannot act as a proxy for the total economy.
c) Economic laws applicable to the totality of the economy and not a part of it.
d) Sectoral implications.
e) Failure of policy linked to it.
f) Has led to a change in the economic policy paradigm.

4.5.1. Macro Economic Impact of Black Money:

The black money has the following macro effects on the economy:
a) Failure of planning and resource mobilization and contradiction amongst other policies.
b) Growth and stagnation and income distribution effect.
c) Investment, unemployment and the multiplier.
d) Inflation.
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 e) Forces a change in the fiscal policy regime.
f) Various budgetary deficits and debt trap.
g) Raises transactions costs and leads to a high cost economy in spite of a low wage.
h) Savings and investment raises. Consumption propensity falls.
i) Import propensity rises.
j) Monetary Policy - Velocities of circulation and stability properties of the multipliers.

4.5.2. Micro Economic Impact of Black Money:

The black money has the following micro effects in the economy.
a. Aspects of Policy Failure.
b. Social Sectors. Poor left at the mercy of the markets.
c. Criminalization of society.
d. Impact on National Security.
e. Social Waste. Like ‘digging holes and filling holes’.
f. Impact on the work ethic.
g. Impact on the quality of products and exports.
h. Reduces the individual's faith in state intervention.
i. Increases the alienation of the individual from society. Reduces faith in social actions.
The ‘usual is the unusual and the unusual the usual'.

4.5.3. Measurement or Estimation of Black Money:

It is widely accepted that most of the country’s problems arise mainly from the tendencies
unleashed by the large and growing unaccounted “Parallel Economy”. Any estimate of the size
of undeclared clandestinely (secretly) held wealth; current income and capital flights would
exceed the marginal levels of our savings and BOP deficits. Effective restraint of the black
economy therefore becomes very important, as this would go a long way in improving the
quality of growth. But for this an estimate of the “Parallel Economy” is a must.
Measuring black income is not an easy task. This may be due to non-availability of
reliable data. A number of individual and institutional efforts have been directed towards
measurement of size and growth of black income in Ethiopia. To examine this serious national
problem the Government of Ethiopia has made many efforts from time to time for estimating and
control of black money. It is difficult to know the exact holdings of black money. But, from the
several guesswork and estimates, it is evident that black money is of a high magnitude in the
Ethiopian economy and has been expanding at a rapid rate over the last two decades.

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 There are several alternative approaches to the estimations of black income. They are as
follows:
1. Expenditure Approach.
2. Fiscal Approach.
3. Monetary Approach.
4. Physical input Approach.
5. Labour-market Approach.
6. National accounts Approach.

4.6. Sources of Black Income:

There are many ways and sources of generating black income that it is very difficult to list
them all. Black money is also earned from perfectly legal and legitimate activities, but when the
income is fully or partly concealed in order to evade the taxes, it is treated as black money.
The various research committees have identified that the following are the items, which
generally deemed to generate black money:

1. Evasion of Personal Income Tax.

2. Evasion of Corporation Tax.
3. Real Estate Transactions.
4. Excise Duty Evasion.
5. Customs (Import) Duty Evasion.
6. Evasion of Sales Tax.
7. Black Income from Smuggling.
8. Black Income from Exports.
9. Black Income from Public Expenditure.
10. Black Income from Private Corporate Investor.
11. Film Industry.
12. Professions.
13. Constructions.
14. Selling of Licenses and Permits.
15. Other sources of black income are,
(a) Gambling.
(b) Bribes including illegal commissions, “cuts” and kickbacks.
(c) Black marketing in goods in short supply such as steel, copper, coal and other items
of industry quota of raw materials and imports. There is also the black market sale of
import licenses and foreign exchange at a premium.
(d) Financial transactions in the unrecognized sector of the money market.
(e) Hotels and Restaurants.

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 (f) Unaccounted stock market profits on black transactions carried on in the private
account of stockbrokers.
(g) Income earned through the adulteration of food items, drugs, country liquor,
production and sale of cheap imitations, forgeries and frauds of various kinds.
(h) Publishing Piracy.
Hereunder, we shall discuss the important sources of generating black money in detail.
4.7. Sources Generating Black Money:

4.7.1. Evasion of Income Tax:

When we talk of evasion of income tax, it could mean both personal income tax and
corporation income tax. Income tax can be evaded by the following ways:
1. Suppressing True Income: It is well known that a large part of black income comes
through illegitimate sources, whether it is bribes, smuggling, black marketing or other such
sources. Professionals like lawyers, doctors, architects, businessmen and even film stars and
film producers are examples where the sources are legitimate but income is suppressed to evade
tax.
2. Manipulating Business Expenditures and Profits: The corporate sector indulges in
under-reporting of profits, overstating expenditures, non-reporting of production and excise,
raising fictitious bills on companies. While under-reporting of profits helps evade tax, non-
reporting production helps generate black income in cash and generally increases the promoters’
wealth.
3. Misuse of Tax Exemptions and Deductions: It is known that agricultural income is
exempted from tax. Many people divert their income to purchase of agricultural land, show high
agricultural profits and avail tax exemptions. It is possible that the profits come from non-
agricultural operations and are taxable but misuse of a facility helps evade tax and create black
income.

4.7.2. Evasion of Excise Tax:

Excise Taxes are duties or taxes on the domestic manufacture of commodities. These are
divided between Union excise duties and State excise duties. For the Central government tax
revenues alone, Union Excise taxes are the second most important source of revenue, next only
to customs duties.

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 Excise duty evasion is both widespread and large in India. The most common methods of
evasion are:
1. Suppression of Production: This is especially true of small-scale industries such as
electrical goods, steel furniture and utensils, plastics and art silk fabrics. It also takes place in
medium-scale and large-scale industries. This can be done either by not fully accounting for raw
materials or not keeping statutory records fully up-to-date.
2. Under Valuation: This is quite true of the organised sector and can be done with the
help of under-invoicing the product or even showing certain expenses as technical expenses.
Floating of benami agencies that either raise supplementary invoices or collect the differential in
value from dealers is another method.
3. Misclassification of Goods: Tariff rates provide numerous classifications and sub-
classifications carrying different rates of duty. Thus people indulge in misclassification as well
as wrong declaration of goods. High-duty excisable goods often get billed as non-taxable items
and then the difference in the market values of two kinds of items gets recovered in black.

4.7.3. Evasion of Customs Duties:

Methods of evasion of customs duties are broadly the same as those for excise duties (taxes)
on the flow of goods traded both imports and exports of a country. Customs duties are levied
and collected by the Central Government. Methods of custom duty evasion are:
1. Under Valuation: This is done by under-invoicing of imports, usually by arrangement
with the foreign supplier of goods who, mostly, willingly obliges the Indian importer pays in
foreign currency the full difference between the actual price and the lower invoiced price of the
goods imported.
2. Misclassification/Wrong Declaration of Goods: False declarations about goods
imported in the documents submitted to the customs are made and higher-duty goods are cleared
on payment of lower duty charged on the wrongly declared goods.
4.7.4. Trade Controls and Foreign Exchange Leakage:
Excessive Import and Export Controls have also led to several kinds of illegal activities, such
as the generation and use of unauthorised foreign exchange (through the faking of invoices) and
smuggling. A rush for licenses also results in corruption, favouritism and bribes.

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 Foreign exchange leakage occurs as a result of high import tariffs or comprehensive foreign
exchange control. These can occur through under-invoicing of exports, over-invoicing of
imports, inward remittances of foreign exchange through illegal channels, smuggling of goods
such as silver, animal skins, antiques, narcotics and illegal purchase of foreign exchange from
foreign tourists and others visiting Ethiopia.
Although a number of steps have been taken to control black income, foreign exchange
leakage and corruption continue to be a disturbing feature of the Indian economy.
4.7.5. Smuggling:

Smuggling refers to the illegal import or export of goods. The numerous controls and
tariffs create profitable opportunities for trade by smugglers in several goods. It is generally said
that the smuggling of goods into the country is more serious than the latter. Smuggling has, over
the years, expanded at such a high rate that it has even attained the title of the “Third
Economy”. Affluent sections of society whose wealth has increased rapidly - mainly through
black income provide a ready market for smuggled goods. We can thus say that all factors
responsible for growth of black income activities in the economy also encourage the increased
smuggling of goods in India by creating a demand for these goods. Smuggling causes loss of
revenue to the Government (through evasion of customs duty, excise duty and income and
wealth taxes), large illegal outflows of foreign exchange and result in large amassing of funds by
smugglers. These funds are not put to any socially productive use or investment.
Predominately, smuggling of gold, synthetic textiles, diamonds and narcotic drugs takes
place in India.
4.7.6. Price and Distribution Controls:

Wherever operative, price and distribution controls, besides attaining the primary objective
of keeping the price of essential commodities “Under Control”, have also been responsible in
leading to black marketing operations i.e. the sale of goods at higher than listed prices,
unaccounted sales -or, sales without bills or cash memos. Sometimes price and distribution
controls also lead to excessive hoarding of essential commodities.

4.7.7. Industrial Licensing:

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 Industrial licensing has also contributed to creation of black income in India. Excessive
industrial licensing over the years had put up barriers to the entry of fresh capital and enterprise.
A few large industrial houses were preferred. Moreover, excessive delay and red-tapism in the
process of clearing applications for licenses have also been prevalent. In many cases, this has
been taken as indications for bribes. The Government had not organised any separate machinery
to monitor the actual implementation of industrial licensing. Therefore, there have been many
violations and creation of black income.

4.7.8. Other Sources:

1. Urban Real Estate: Transactions in urban real estate generate a large amount of black
income every year. There could be many frauds in this business. First, there could understand
the value of a transaction to evade a large part of tax liability. Second, encroachment on public
land; third, acquisition of raw land for resale as housing plots, developments of this land for
setting up a colony, sale of plots or houses or flats constructed on it, exceeding the legally
permissible limit of the built up area on a given plot of land. All these-specifically,
understanding the value of all such transactions-lead to black gains. Another method is to under-
report rents. Benami transactions are rampant, as is the role of “Black Money” in the acquisition
of urban real estate.
2. Leakage from Public Expenditure and Property: These leakages take the form of
illicit, and undeclared commissions or bribes (kickbacks or cuts). Also, most of the time,
allocated funds for various anti-poverty programs never reaches the targeted people. Another
aspect is pilferage or misappropriation of State Property e.g., food grains of the Food
Corporation of India, cement and other construction material etc.
3. Bribes: Bribes as a source of black income are common. These are used mainly to
influence the decision of the authority dealing with a case, or the power to approve or
recommend an application or even to forward case files. This phenomenon of bribe taking leads
to the spread of corruption from one work place to another.

4.8. Causes of Black Money:

There are several causes for the generation of black money in the economy. The major
contributory factors in this regard may be stated as under:

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 1. High Rates of Taxation: High rates of taxation are basically responsible for inducing tax
evasion and consequent black money generation in the country. In India, the tax rates are
abnormally high. The prevailing high rates of taxation are one of the main causes of black
money.
2. Corrupt Business Practices: The corrupt business practice such as smuggling and other
restrictive trade practices cause the existence of black money in the country. In an economy
under the environment of scarcities, controls and inflation, hoarding and black marketing are
always profitable which apparently generate black incomes.
3. Controls and Regulations: Right from the advent of planning to establish socialist
pattern of society, India’s mixed economy was subject to a plethora of controls and regulations.
Though the Government resorts to the economic policy of controls with a good intention of
dealing with the problem of shortage and effecting a fair distribution of essential goods with
equity, their improper implementation vitiates the very purpose of controls. In India, the
Government fixed up prices of various essential consumer goods like kerosene, wheat flour,
vegetable ghee, drugs, etc. Their prices are controlled and the distribution is regulated. Along
with various controls on imports and exports, tight exchange control is also implemented. Such
controls are implemented with licenses, permits and quotas. Thus there have been statutory
controls combined with the bureaucratic and administrative controls. These all-pervasive
economic controls are also responsible for the intensification of black money attuned evils like
corruption, procedural wrangles, delays, artificial scarcity, fraud, suppression etc. involved in the
very network of the bureaucratic public administration.
4. Political Corruption: This makes the fight against black income growth very difficult
and is closely linked with evasion of taxes and customs duties. The political bribing of party and
Government members is a common phenomenon. Donations to political parties were banned in
1968 and this has prompted businessmen to fund political parties, especially the ruling party,
with black money. Politics is the main weapon for fighting social ills; and when this weapon
itself gets corrupted, chances of tackling black income get bleak. The Politics-business-crime
nexus that exists in our society is a result of, and further accentuates black income generation.
5. Bureaucratic Corruption: Controls breed corruption. Loose and dishonest public
administration becomes an easy prey of corruption.

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 Corruption and black incomes are inter-linked. Corruption makes it easy to earn and enjoy
black money. Today, “Speed Money”, “Secret Commission”, “Paper Weight”, “Mithai”,
“Hush Money” have become almost a routine for getting any work done, legal or illegal, at
official levels.
6. Prohibition: Certain activities are usually forbidden by law such as gambling, production
of illicit liquor, smuggling, traffic in illegal drugs, lending at exorbitant interest charges, money
lending without proper license etc. When some individuals wish to undertake these activities,
these will apparently go unreported and incomes so earned would be totally black.
7. Public Expenditure: the Government itself lives in the Glass House, as the rapid growth
of its spending over the last two decades has been a major contributory factor in generating black
money. Due to the rapid rise of public spending for multiple Governmental programmes and
activities, the unscrupulous elements in public service and public life could find ample
opportunities for amazing black income and wealth by dubious methods.
8. Inflation: The genesis of black money can also be found in the persistent inflation in the
country, which has enhanced incentives and opportunities to earn such incomes. Inflation
inevitably leads to growth of parallel markets and strengthens propensities to hide incomes and
to evade taxes. Since inflation causes capital erosion, there is always a temptation to maintain
dual accounts for tax evasion by “Diverting portion of inventories and output from white
channels to black channels of deployment”. As the matter of fact, inflation is both the cause as
well as consequence of the growth of black money in the Indian economy.
10. Deficiencies of the Tax System: There are various lacunas in the tax system that
encourages generation of black income. First, high personal Income Tax Rates cause people to
try and evade taxes, and thus lead to generation of black income. The dilemma for the
Government is that even efforts at lowering tax rates do not lead to larger payments of income
tax by the higher income groups. Although there are a number of tax laws pertaining to income
tax, sales tax, stamp duties, excise duties etc. enforcement is weak due to widespread corruption
in these departments.
11. Quotas, Controls and Licenses: The “License, Quota, that has dominated the Indian
system of controls has often led to the initiation of various ways of escaping these and, thus, the
generation of black income.

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 12. Generation of Black Income in the Public Sector: There are huge investments marked
for the public sector in every five-year plan. The usage of these has to be monitored by the
bureaucrats in Government departments and public sector undertakings. A symbolic relationship
often develops between the contractors, bureaucrats and politicians. Costs are often artificially
escalated and underhand deals generate black money.
13. Inadequacy of Powers: The inadequacy of the powers given to the tax enforcing
authorities is another important cause for black money.
14. Weak Deterrence: Despite of adequate legal provisions to curb the growth of black
economy in India, it has persisted because of weak deterrence against tax evasion in practice. No
serious action has been taken against detected cases of tax evaders. Till recently, too trivial
penalties were imposed, too few prosecutions have been launched and even fewer have been
convicted.
15. Ineffective Enforcement of Tax Laws: Ineffective enforcement of tax laws is also a
cause for black money. Lack of proper training and inefficiency of the department people led to
the creation of black money.
16. Lack of Publicity: Another reason for wide spread black money is said to be the secret
provision of direct tax laws. At present, the department is statutorily prohibited from disclosing
any information relating to a person’s assessment. Thus, even if a person is caught and penalised
for keeping black money, he can keep it as secret from every one.
17. Deteriorated Public Morality: Moral values and social attitudes of people in India have
declined during recent years. In today’s society black marketers, smugglers, corrupt politicians,
public officials and tax evaders are not condemned, but rather admired and envied for possessing
black money power.
18. Demonstration Effect: The conspicuous consumption and luxurious life style of black
moneyed people have created a sort of demonstration effect on many others to inspire for such
consumption patterns.

4.8. Effects of Black Money:

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 Black money is a socio-economic evil. The existence of rapidly growing black money in our
economy has grave and disastrous consequences. The major effects of black money are
discussed below:
1. Dual Economy: The out growth of black money over a long period of time has given rise
to the perpetual growth of economic dualism comprising “Parallel” economy (black money
economy) operating side by side with the “Official” or “Reported” economy on the country.
The black economy represents not less than one fifth of the aggregate economic transactions.
There is also interaction between the reported and unreported activities such that it is difficult to
identify black money from the white money economy. Such a “Parallel Economy” will ruin the
entire economic development of the country.
2. Under-estimation: A large underground economy and growth of black income lead to
under-estimation of the true size and incorrect picture of the economy by the officially complied
national income data. Since unreported economy is apparently excluded from the official records
of the GNP the estimates of savings and consumption of nations to the national income and
measurement of other macro-economic variables would be biased and misleading for accurate
policy making and planning considerations.
3. Loss of Revenue to the Government: Black money is largely attributed to tax evasion.
Its direct impact is the loss of the Government revenue. Since the Government fails to get
sufficient tax revenue due to large-scale tax evasion, it is forced to resort to high taxation and
deficit financing which again carry their ill-economic effects.
4. Under-mining the Equity: When the Government resorts to progressive direct taxation
to maintain equity in the distribution of the tax burden, the tax evasion and growth of black
money affect the very concept of social justice by not allowing the desirable reduction in
inequalities of incomes. Again, when underground activities like smuggling etc. could not be
taxed, the Government will impose higher taxes on officially sanctioned activities. Further, the
tax evasion will also equally enjoy the public services without paying the due contribution; to
that extent also social enquiry is undermined. The honest have to bear high tax burden to make
up for the deficit in revenue caused by the tax evasion of black money makers.
5. Widening the Gap between the Rich and the Poor: Growth of the black economy
causes regressive distribution of income in the society. When the black money grows faster, rich

17
becomes richer and the poor become poorer. By way of concentration of income and wealth in
few hands, the black money widens the gap between the rich and the poor.
6. Lavish Consumption Spending: Black money is disposed off by lavish spending on
travels and tours, entertainment, ostentatious articles, financing of extravagant elections etc.
This has also lead to many social evils and deteriorated the values of life of the common people.
7. Distortion of Production Pattern: The black money has altered the choice coefficients
in the market in favour of luxuries, which lead to the diversification of productive resources from
essential goods to the non-essential goods.
8. Distribution of Scarce Resources: Black money holders are always in a position to put
their prior claim over the scarce goods in the market due to their readiness and ability to pay
more, thereby depriving the honest and poor people from their legitimate share. This obviously
reduces the net economic welfare of the Indian society at large.
9. Deteriorate the General Moral Standards of the Society: Black money is largely
responsible for the deterioration of general moral standards of the society. Black income
generation implies a deviation from the accepted norms in society and from the point of view of
the society is unethical.
Socially, we can say that the structure and ethos of a society undergoes a massive change.
Social values of honesty, hard work, thrift and simplicity get eroded. Even the political
institutions and organisations lose their credibility, as they also gradually become a part of the
entire system of black income generation.
10. Average Effect on Production: As a consequence, the consumption pattern is titled in
favour of the rich and elite, at the cost of encouraging production of articles of mass
consumption. A rise in overall consumption leaves fewer resources for investment in priority
areas, having an adverse effect on production.

4.9. Remedies for the Black Money:

The menace of ever raising black money in Ethiopian economy is very high. It is accepted
by all that tax evasion generate black money. Such staggering extent of black money has
activated a parallel economy in the country and it affects the vital sectors of the economy. The
Government in the past has already tried certain measures with little success. If steps are not
taken immediately to reduce the black money, it may ruin the entire economy of the country.

18
 The important remedial measures for controlling black money are given below:
1. Demonetisation: Demonetisation of currency of high value could help to unearth the
black money to a large extent. However, in order to solve the problem arise on account of
demonetisation, proper step should be taken. It is advocated for eroding a substantial part of
black liquidity on the presumption that black income held in cash will not be presented for
conversion. Demonetization may succeed in reducing the quantum of black money but it cannot
prevent the generation of black money altogether.
2. Voluntary Disclosure Scheme: The Government may adopt the policy that those who
voluntarily disclose their black income of the past to the taxation authorities will not be punished
and penalties may be waived or minimised.
3. Raids: Income tax department's powers have to be considerably enlarged and it should be
empowered to conduct raids on the premises and properties of the taxpayers or any other
individuals and can seize the unaccounted income and wealth and take necessary legal actions
against the tax evaders.
4. Rationalization of Controls: Since ill-devised controls are major causes of black money,
it is essential to rationalise the control system. Recently, the Government has taken some steps
in this direction by easing the licensing policy etc. But still there are many cumbersome rules
and formalities and unnecessary control in many areas, which need to be effectively rationalised.
5. Taxation Reforms: Ethiopia needs a rationalised tax structure. A reduction in marginal
tax rates, simplification of tax structure, taxation laws and improvements in tax administration
will be helpful in the reduction of black money.
6. Vigorous Prosecution: The research also recommended that the department should
completely re-orient itself to a more vigorous prosecution policy in order to instill a wholesome
respect for the tax-laws in the minds of the taxpayers.
7. Rewards and Awards: In order to encourage the honest taxpayers and create a positive
attitude in the minds of the people towards the payment of tax, this can be adopted.
The other qualifications considered for the purpose of the award are that the person
concerned should not only pay the highest tax but should also file the returns in time, prompt
payment of taxes including self-assessment tax without default, no penalty for concealment of
income should have been levied, no prosecution for offenses under the Tax Proclamations and

19
related provision of Criminal Code should have been launched, no search undertaken under the
Direct Tax laws should have been conducted, and should have been co-operative with the
department in the completion of assessments.
Besides the above, no official patronage or recognition or awards should be given to persons
who have been penalized for keeping the black money or in whose case prosecution proceedings
have been taken.
9. Publicity: In view of the deterrent effect, the nature of all persons in whose cases
penalties have been imposed for the concealment of income, wealth etc. should be published in
the gazettes as well as in the press, giving details of their names, addresses and the amount of
penalties etc. If the assessee is a company or firm, the names of all the Directors of the
Company or Partners of the firm should be published.
10. Arousing Public Conscience: A special drive should be undertaken to arouse public
conscience by enhancing the co-operation of the leaders in various walks of life.
11. Other Measures:
1. People should be educated with regard to real object of collections of taxes through press,
radio, TV, and films.
2. Steps should be taken to convince the taxpayers that the money collected through taxes is
not spent wastefully but put to proper use.

MISELANIOUS TOPICS

5.1. VALUE ADDED TAX:

The Value Added tax (VAT) was first introduced in France in 1948. Thereafter, various
European countries introduced it as an alternative to turnover taxes.
5.1.1. Meaning of Value Added Tax:

The VAT belongs to the family of sales tax. A VAT may be defined as " a tax to be paid by
the manufacturers or traders of goods and services on the basis of value added by them". It is not
a tax on the total value of the commodity being sold but on the value added to it by the
manufacturer or trader. They are not liable to pay the tax on the entire value of the commodity.
But they have to pay the tax only on the net value added by them in the process of production or
distribution.

20
 Thus, the value added by them is the difference between the receipts (from the sale) and
payments made to various factors of production (land, labor, capital and organization) in the
form of rent, wages, interest, and profits.

5.1.2. Computation of Value Added:

The value added by a firm can be calculated in any one of the following two methods:
(i) Addition Method: Under this method, the value added by a firm i.e. the tax base is
determined by adding the payments made by the firm to the various factors of production such as
wages, rent, interest and profits.
(ii) Subtraction Method: In this method, the value added by the firm is determined by
subtracting the cost of production from the sales receipts of the firm.
But, in these two methods, the tax liability is identical.

5.1.3. Forms or Kinds of Value Added Tax:

The value added tax can be determined in different forms. It may vary depending upon the
form of tax base. The forms may differ on the items to be included in the tax base.
The possible varieties of VAT are given below:
1. Consumption Type
2. Income Type
3. Production Type and

4. Wages Type.

Let us explain the meaning of these forms one by one.

1. Consumption Type: In this type of VAT, apart from the non-capital inputs purchased,
the capital equipments purchased is also considered. As such, the firm is allowed to deduct the
entire value of the capital equipments purchased during the year. This type provides 100%
depreciation, which is equivalent to tax exemption.
Thus,

Tax Base = Gross Value - Total Value of Inputs Purchased (Capital and non-capital)

21
 2. Income Type: According to this form, the firm is allowed to deduct the depreciation on
the capital goods (during the year) apart from the full value of its non-capital purchases. Here,
the firms cannot deduct the entire value of the capital goods purchased during the year but they
can deduct the respective amount of depreciation attributable to that year.
Thus, the tax base is calculated as follows:

Tax Base = Gross Value – (Value of non-capital Purchase +Depreciation on

on capital goods for that year)

This variety clearly gives the proper net value added.

3. Production Type: In this type, instead of total value of inputs purchased, the value of
non-capital purchases alone is allowed to deduct for determining the tax base. That is, to
compute the value added by the firm, depreciation on capital goods is not allowed.
Thus, the tax base under this type will be:
[

Tax Base = Gross Value - Value of non-capital goods Purchased

Since depreciation is not allowed, it is not considered as a good system and is not popular
and universally accepted.
4. Wage Type: Here, to determine the tax base, an amount equivalent to the net earnings is
deducted from the capital of the firm for that year. The difference will be equivalent to the wages
paid during the year. That is:
Tax Base = Capital of the firm – Net earnings for that year

Capital of the firm = Net Income (i.e., Gross Income – Depreciation)

Net Earnings = Net Profits (inclusive of interest on own capital)

Since the tax base arrived at as above is equivalent to the wages paid, it is called as wages
variety of value added tax.
Example: Now we can explain the concepts of VAT with the help of the following example.
Let us assume a consumer product is clothing and the number of stages involved is six before it
reaches the ultimate consumers and the rate of tax is 10%.

22
 No. Stage Receipts Value Tax
Birr. Added 10%
1. Farmer 700 700 70
2. Ginner 1, 000 300 30
3. Spinner 1, 500 500 50
4. Weaver 2, 100 600 60
5. Wholesaler 2, 300 200 20
6. Retailer 2, 400 100 10
----------------------------
2, 400 240
=====================

In the above example, final sale price to consumer is Birr.2 400 and the total value added is
Birr.2 400.
From the above table, it can be understood that there are six stages involved in the process of
converting cotton into clothing and before it reaches ultimate consumer. The ginner buys cotton
from the farmer at a price of Birr.700 per quintal and sells the cotton after ginning to the spinner
for Birr.1, 000. The Spinner, for converting the cotton into yarn, has added Birr.500. The weaver
converts the yarn into clothing, which he sells to the wholesaler for 2 birr per 100 bale of
clothing. The wholesaler has added value of Birr.200 and sells the clothing to retailer for Birr.2,
300. The retailer finally sells the clothing to the consumer for Birr.2, 400. The remaining value
of Birr.100 (difference between price of wholesaler and that of retailer) represents value added
by the retailer.
From the above example, it can be observed that the final retail price paid by the consumers
is simply the sum of the value added at each stage of production and distribution. The value
added tax is assessed at each stage of production.
Advantages of Value Added Tax
The VAT has the following advantages:
1. Easy to Administer: Since the impact of VAT system is like the single point sales tax
system, the administration becomes easier.
2. Effective and Efficient: The VAT replaces inefficient and poorly administered taxes
such as taxes on capital goods and those that reduce the tax base and involved in difficult
administration. Hence, it is considered as more effective and efficient.

23
 3. Neutrality: VAT is expected to be perfectly neutral in the allocation of resources i.e. in
the forms of production and commercialisation. Thus, it helps the economy in adopting the forms
of production that are economically more suitable.
4. Reduce Tax Evasion: In the case of VAT, the tax is divided into several parts depending
on the number of stages of production and sale. Thus, the possibility and intention to evade tax is
considerably reduced.
5. Possibility of Crosschecking: In VAT system, cross checking becomes possible. When a
firm purchases raw material from another firm and pays tax on such purchase, it has to maintain
records about from whom it purchased goods and the amount of tax paid by it etc. The firms
maintaining these records alone can reclaim the tax already paid. The other firm also has to
maintain such records. This obligation makes tax evasion difficult.
6. Less Tax Burden: Under VAT, the tax is collected in small fragments at different stages
of production and sale. Hence, the taxpayers feel the burden of the tax less.
7. Encourages Exports: Under VAT system, the tax burden is less and it reduces the cost
of production. Such a reduction in the prices of commodities increases the competitive efficiency
of the firms in the global market.
Besides, to promote exports, the Government may refund the taxes paid on the exportable
goods. It is possible only when the tax paid is easily identifiable. In the system of VAT, it is easy
to separate the tax from the cost of production, which is not possible in the case of other taxes. In
this way, it encourages the exports.
8. Improves Productivity: In the system of VAT, a firm has to pay tax even though it runs
into loss. It cannot claim any exemption for loss because it pays taxes on the value produced and
not on profits. So the firms will always try to improve their performance and reduce the cost of
production. As a result, the overall productivity of the country will be improved.
9. Burden of Tax is Shared by all Factors: The value added tax falls on the wages,
interest, rent and profits. As such, the burden of tax is shared by all factors of production.
10. Non-distortionery: Under VAT system, exemption is allowed to the minimum. The tax
net is wide enough to cover almost everything. Hence, it proves to be non-distortionnery.

24
 11. Major Source of Revenue: In most of the countries, the value added tax contributes a
considerable amount of revenue to the Government. This makes it a reliable and valuable source
of revenue.
Disadvantages of VAT
VAT system has the following disadvantages:
1. Not a Simple and Easy System: VAT System is not easy and simple to adopt in under
developed countries where the tax administrative set-up is inefficient and inexperienced to
understand any complicated tax structure.
2. Requires Advanced Economic Structure: The proper implementation of VAT system
requires advanced financial and economic structure and the firm should be in the habit of
keeping proper accounts. Hence, it becomes difficult to implement the system in all types of
economy.
3. Possibility of Tax Evasion: The VAT system largely depends upon the co-operation of
the taxpayers because crosschecking is not possible always. Hence, there is a greater possibility
for tax evasion.
4. Uneconomical: This system involves high cost of administration, assessment,
verification, collection etc. Hence, it is highly uneconomical.
5. Does not Increase Efficiency: In a scarce economy i.e. economy of shortages where
speculation is practiced, hoarding and non-competitive price rise are common, the producers will
not increase their efficiency. The goods will be purchased irrespective of their high price and
inferior quality. Thus in such an economic condition, VAT will not increase efficiency.
6. Lesser Revenue: The revenue collected under VAT system is far less than the revenue
collected under the multi-point turnover tax system.
7. Additional Burden: Under VAT system, the manufacturers and shopkeepers have to
observe various legal formalities in the form of maintaining various records, accounts books etc.
The verification of those records puts additional burden to the tax enforcing authorities.
8. Inflationary in Nature: Under VAT system, the tax burden will be less which results
into surplus income in the hands of consumers. Thus, there is a possibility for wide spread
inflation in the economy. But, this argument does not hold good. Because, VAT itself cannot be
inflationary and the other accompanying policies of the Government might make it so.

25
 9. Regressive in Nature: According to Allan A. Tait, a straight forward single rate VAT,
with few exemption would tax lower income households more heavily than the higher income
household. Thus, it is considered as regressive in nature.
Even though the VAT system is suffering from the above said drawbacks, the benefits sought
are more and it can be applied to the Indian economy after rationalisation, modification and
restructuring of the system. Various Tax Reforms Committees and other eminent economists
advocated this system as suitable to the prevailing economic conditions of the developing
countries.

5.2. DOUBLE TAXATION:

Today, with enormous range of expenditure outlays, the Governments cannot depend
upon a single tax. Because it will not provide sufficient revenue to meet their financial needs.
Moreover, with the single tax, the Government cannot achieve the principles of equality, ability
to pay and equitable distribution of income and wealth among the people. Thus, the principle of
multiple taxation is recommended whereby the Government may resort to various direct and
indirect taxes to attain their objectives both fiscal and social.
But such multiple taxation should not lead to double taxation. Double taxation occurs
when the Government levies taxes on the same base in more than one way. Hence, double
taxation can be defined as, “taxation of the same tax base twice either by one authority or by
different authorities”. Here, the two taxes should be levied with reference to the same period.
5.2.1 Examples of Double Taxation:
1. Mr. X earns his income in Etiopia and U.S.A. If both the Governments levy taxes on his
entire income, it is considered as double taxation i.e. international double taxation,
because he has to pay tax in two countries on the same income.
2. The Government of a country levies taxes on the profits of a company before the
distribution of dividends. Thereafter, it taxes the individual shareholders on the dividends
received by them. Then it becomes a double taxation. Here the company and shareholders
are taxed on the same income.
Hence, double taxation means, taxing the same tax twice and it may be of international or
federal double taxation.

26
5.2.2. Kinds of Double Taxation:

Double taxation can be classified on the following ways:

1. Double Taxation by different authorities.
2. Double Taxation by the same authority.
The components of these kinds are explained with the chart given in Fig. 5.1.

Kinds of Double taxation

Double Taxation by the same

Authority
International Federal 1. Taxation on capital and
Double Double income.
Taxation. Taxation. 2. Taxation on both debtors
and creditors for the
1. Taxes levied 1.Taxes levied by amount of loan.
by the govt. of two two Govt. of the 3. Taxation on profits before
different countries same country ie distribution and on dividends
Union & States. after distribution.

Let us explain these kinds one by one.

1. Double Taxation by Different Authorities: When the same tax base is levied by two
different taxing authorities either international or federal, it becomes a case of double taxation.
(a) International Double taxation: This type of double taxation occurs when the
Governments of different countries levy on the same tax base. The scope of a tax determines the
incidence of its burden. It includes both direct and indirect taxes. Generally the income tax,
wealth tax and customs duty cause such international double taxation.
(b) Federal Double Taxation: This kind of double taxation occurs when the Governments
within a country levy tax on the same base. When the Union Government and State Governments
of a country levy tax on any one tax base, it is called federal double taxation.
2. Double Taxation by the Same Authority: Such a double taxation occurs when a
Government either Union or State levies on the same tax base twice. The tax on capital and

27
income, debtors and creditors on the amount of loan, on the profits before and after distribution
and the like are the notable examples in this regard.

5.2.3. Effects of Double Taxation:

Generally, double taxation is not liked by the taxpayers and is highly criticised by the
economists. It will affect the economy of the country directly and indirectly. The main effects of
double taxation are given below:
1. Injustice to the Taxpayers: Double taxation causes injustice to the taxpayers. It
discriminates among the different taxpayers.
2. Does not Conform to the Principle of Ability to Pay: In case of double taxation, the tax
system does not conform to the principle of ability to pay. Because when both the Central and
State Governments tax the same group on the same tax base, the principle of ability to pay is
violated.
3. Does not Ensure the Principle of Equity: When the Union and State Governments levy
taxes on the same commodities especially on the necessities, it will broaden the gap between the
rich and the poor. Thus, the double taxation violates the principle of equity also.
4. Discourages the Ability to Work, Save and Invest: Double taxation increases the price
of the commodities and leaves the people with lower disposable income. This in turn affects the
standard of living of the people and thereby reduces their ability to work, save and invest.
5. Discourages the Small-scale Industries: When the taxes are uniformly levied without
any exemption to small-scale sector, the competitive efficiency of them will be affected. Because
of a rise in their prices, they cannot compete with the large-scale industries in the market.
6. Discourages Exports: It may be due to federal double taxation. When the same
commodities are taxed both by Union and State Governments, their price will automatically be
increased which in turn affects the export market.
7. Affects the Overall Economic Development of the Country: Since double taxation
affects the individual economic activities, the whole economic development will be affected. In
such a situation, the Government cannot use the taxation as a weapon, boost the sick industries
and to curb the effects of trade cycles in the economy.

5.2.4. Remedies for Double Taxation:

28
 To remove the effects of double taxation, the following remedial measures can be adopted.
They can be classified on the following two categories:
5.2.4.1. Remedies for the Problem of International Double Taxation:

(a) Agreement for Mutual Exemption: The countries may enter into an agreement to
exempt the income of non-residents when they take the income outside.
(b) Basis for Incidence: The double taxation can be avoided when the taxes are levied either
on residential status or on citizenship and not on the both.
(c) Special Measures: Some special measures should be devised so that the Governments of
two countries may tax different parts of the income earned by a person.
5.2.4.2. Remedies for Internal or Federal Double Taxation:
The following are the remedies to avoid internal or federal double taxation:
(a) Separate List: There should be a separate list of taxes that can be levied by the Union
Government and State Governments.
(b) Co-ordination between the Fiscal Policies: There should be a perfect co-ordination
between the fiscal policies of the Union and the State Governments. And the problem of double
taxation can be solved through the centralisation of finance. This can be done by getting the final
approval from the Central Finance Minister for the State budgets.
(c) Avoiding Overlapping of Taxes: There should not be any overlapping of taxes. The
problems of double taxation can be solved to a considerable extent if due consideration is given
in this regard. To avoid the double taxation caused by overlapping of sales tax and excise duties,
they may be replaced by a centrally administered value added tax.
In Ethiopia, the problem of double taxation is considerably reduced because of the provisions
made in the Ethiopian Constitution. Articles 96, 97, 98, 99, 100, 101, and 102 of the
Constitution, there is a separate list for the Federal Government, State Governments and
Concurrent List. There are specific Articles for revenue sharing and principles of taxation.

5.2.5. Methods of Elimination of Double Taxation:

29
 Many a times, situation arises whereby same income is taxed twice; i.e. in the State of
Residence as well as in the State of Source. In order to eliminate double taxation two methods
are used. They are:

1. Exemption Method, and

2. Credit Method.

5.2.5.1. Exemption Method:

The exemption methods include the following:

(a). Full Exemption Method:

Under this method, income earned in the State of Source is fully exempt in the State of
Residence.
(b). Exemption with Progression:
Under this method, income from State of Source is considered by the State of Residence only
for the rate purpose.

5.2.5.2. Credit Method:

The credit methods include the following

(a). Full Credit:

Total tax paid in the State of Source is allowed as Credit against the tax payable in the State
of Residence.
(b). Ordinary Credit:
State of residence allows credit of tax paid in the State of Source only to that part of income
tax, which is attributable to the income taxable in the State of Residence.
(c). Method of Tax Sparing:
State of Residence allows credit for deemed tax paid on income, which are otherwise exempt
from tax in the State of Source.

5.3. Illustration- Double Taxation Elimination Methods:

30
 Let us understand these methods with the help of an example.
- Income derived by "A" from
State of Residence Birr. 1, 00, 000
- Income derived by "A" from
State of Source Birr. 50, 000
Total Income of A: Birr..1, 50, 000
Tax rates are : State of Source @ 40% flat rate.
State of Residence Up to Birr..1,00,000 @ 30% and between
Birr.1 lakh & 2 lakhs @ 35%.

Tax paid in State of Source on Birr. 50, 000 = Birr..20, 000

(@ 40% on Rs.50, 000)

Tax paid in State of Residence = Birr..47, 500

on Birr.1, 50, 000. (@ the rates specified)

Tax Liability in State of Residence under various Methods of Elimination of Double

Taxation:

1. Full Exemption Method:

State of Residence levies tax only on domestics income i.e. tax on Birr.1, 00, 000 @30%
= Birr.30, 000. It does not levy any tax on income earned in the State of Source (i.e. on Birr.50,
000 in this case). In other words, it exempts income earned in the State of Source from its tax.
Similarly, tax is levied by the State of Source only in respect of income, earned therein. As a
result, double taxation of income is automatically eliminated.
2. Exemption with Progression:
Domestic income of Birr.1, 00, 000 will be taxed at the rate applicable to total Income i.e.
Tax on Birr.1, 00, 000 @ 35% (rate applicable to slab of Birr.1, 50, 000) = Birr.35, 000. This
offers partial exemption compared to the Full Exemption Method.
3. Full Credit:
Tax payable on total income in the State of Residence will be as below:

Birr.1, 50, 000 on slab basis Birr.47, 500

Less: Credit for tax paid in the
State of Source Birr.20, 000

Tax Liability in State of Residence Birr.27, 500

31
 4. Ordinary Credit:
At first, tax liability on total income is worked out in the State of Source. However, such
credit is restricted to the amount of tax attributable to the income from the State of Source i.e.
35% of Birr.50,000 = Birr.17, 500.

Tax payable on Birr.1, 50, 000 Birr.47, 500 (slab basis)

Less: Tax paid in the State

of Source Birr.20, 000

Maximum Deduction Birr..17, 500

Restricted to
(35% on Rs.50, 000)

Tax Liability Birr..30, 000

5. Tax Sparing:
Now let us assume for a moment that Mr. A has tax free export income of Birr.30, 000 in
the State of Source. In this situation, a deemed tax credit for Birr.12, 000 (being 40% Rs.30, 000)
will be granted by the State of Residence. Usually, DTAA prescribes the exact nature of such
tax-free income and or relevant provisions of the domestic law, covered by this method.
5.4. Double Tax Avoidance Agreements:
Article on elimination of Double Taxation assumes great significance, as it is the central
point of any Treaty. Treaties generally use combination of various methods for granting relief
from double taxation. It is also a powerful tool for the purpose of Tax Planning. In fact, it
serves well the ultimate objective of Treaty namely overall minimization of tax burden or
avoidance of same income being taxed by two countries. This brings in harmony and equity in
tax legislation and bids good-bye to the famous dictum in the taxation statutes that Tax and
Equity are strangers.

1. Present Day Scenario and Need for Tax Treaties:

Due to advances in communication and technology, the world has become a global village.
No nation can afford to remain in isolation. For survival in a competitive environment, one has
to view the entire world as market and create a niche for one's products in the international
market. The need of the hour is to integrate the national economy with the international

32
economy. This gives rise to full-fledged joint ventures in place of limited participation, creating
production and marketing bases in different countries with diverse political systems and tax
regimes. Movement of capital and cross border transactions become common place. The
transnational corporations are the vehicles used for the purpose.
Every nation has sovereign right to tax its residents on their worldwide incomes. As a result,
the income of an organisation can get taxed both in the home country (country of its origin) as
well the host country (country where it has its operations). In such an environment, cost of
operating worldwide would become prohibitive and the benefits of international trade, and
competitive cost advantages would be lost. Double taxation is harmful for movement of capital,
technology and people.
In civilised society, in home country tax is an obligation and in host country tax is a cost.
There is need to achieve tax efficiency. The Double Tax Avoidance Agreements come into play
to mitigate the hardships caused by taxing the same income twice, in a home country as well as
in the host country.
Tax Treaties remove the obstacles and try to achieve balance and equity. They aim at
sharing of tax revenues by the concerned states on a rational basis without causing undue
hardships to the taxpayers operating internationally. Tax Treaties do not altogether eliminate
double taxation, but reduce the incidence to tolerable extent.
2. Ethiopian Tax Laws and the Tax Treaties:

3. Advantages of Tax Treaty:

Tax Treaties clearly lay down the provisions for taxing of income under various heads.
There is less room for ambiguity. For instance, business profits are taxable in the host country
only if there is “Permanent Establishment” as defined in the Treaty.

4. Treaty Models:

There are three different types of models.

They are OECD Model, U N. Model and the U.S.Model.
(a): OECD Model:
The emergence of present form of OECD model convention can be traced long back to 1927,
when the fiscal Committee of the League of Nations prepared the first draft of Model Form

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applicable to all countries. In 1946, the model convention was published in Geneva by the Fiscal
Committee of U.N. Social and Economic Council and later by the Organisation for European
Economic Co-operation (OEEC) in 1963. However in 1961, the Organisation for Economic Co-
operation and Development (OECD) was established, with developed countries as its members,
to succeed the OEEC and OECD approved the draft presented to the OEEC. In 1977, final draft
was prepared in the present form.
OECD model is essentially a model treaty between two developed nations. This model gives
emphasis on the right of State of Residence to tax.
(b) U.N. Model:
In 1968, United Nations set up ad hoc groups of experts from various developed and
developing countries to prepare a draft model convention between developed and developing
countries. In 1980, this group finalised the U.N. Model Convention in its present form.
U.N. Model is a compromise between the source principle and residence principle.
However, it gives more weight to the source principle as against residence principle of OECD
model. U.N. Model is designed to encourage flow of investments from developed countries to
developing countries. It takes into account sharing of tax-revenue with the country providing
capital. India's most tax treaties are based on U.N. Model.
(c). U.S. Model:
U.S. Model is different from the OECD and U.N. Model in many respects. For example,
Indo-U.S. Treaty provides for Permanent Establishment Tax (Article 23) and Limitation on
benefits (Article 24), which are unique to this Treaty as also provision for taxing Capital Gains
(Article 13) as per domestic law. Thus U.S. Model has made its own identity through radical
departure from the usual clauses of the Treaty under OECD Model and the U.N. Model.
5.5. ADVALOREM AND SPECIFIC DUTIES.
There are two kinds of duties levied on the commodities. Generally, it is levied on the goods
crossing the national boundaries. They are:
1. Advalorem duty - on the basis of value.

2. Specific duty - on the basis of measurement.

5.5.1. Advalorem Duty:

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 It is levied on the basis of value of the commodities. Advalorem means, "In proposition to
value". This is levied as a certain percentage on the value of commodity to be taxed. For
example, when a TV set is imported, customs duty may be levied at say 200 % on the value of
the TV set. The weight, length or bulky of the goods imported are irrelevant for this purpose.
Thus duty payable will be calculated only on the total value of the goods to be taxed and not on
its weight, length, bulky etc.

5.5.1.1. Merits of Advalorem Duty:

Advalorem duty is recommended for the following reasons:

1. Value of the Commodities can be Easily Found Out: Customs duty under this form is
imposed on the value of commodities. The value of imported articles can be more easily found
than their weight, size, bulky etc.
2. Keeps the Tax Burden Steady: Advalorem duty keeps the burden of tax steady. During
the times of boom, the tax liability tends to rise and in times of recession, the tax liability also
goes down.
3. Higher Revenue during Inflation: Advalorem duty brings higher revenue during the
periods of rising prices, because when the price tends to increase the revenues yield also
increases.
5.5.1.2. Demerits of Advalorem Duty:

The following are the important drawbacks of advalorem duty:

1. Difficult to Administer: Advalorem duty is very difficult to administer. Under this
form, customs duty is imposed on the value of the commodity. But in practice, it is very difficult
to estimate the value of thousands of articles imported from a large number of countries.
2. Difficult to Estimate Value: Even if the value of goods is ascertained, there is a chance
for controversy whether F.O.B. (Free on Board) or the C.I.F. (Cost Insurance Freight) or local
selling price should be taken into account for levy of duty.
3. Difficult to Predict Quantum of Revenue: The Government cannot correctly predict the
quantum of revenue yield from customs duties since under the advalorem basis, revenue yield
will rise or fall depending on the rise or fall of the value of goods. Hence, there is no certainty
with regard to the rationalisation of budget estimate of this revenue.

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5.5.2. Specific Duty:

It is levied as to the weight, length, bulky or some other unit of measurement of the
commodity concerned. The value of goods imported or exported is not important for this
purpose. Only weight, length, bulky etc. of the commodities decide the quantum of duties.

5.5.2.1. Merits of Specific Duty:

1. Less Chance of Tax Evasion: Specific duty is imposed on units of measurement, which
are easily ascertainable. So, there is less chance of tax evasion.
2. Easy to Administer and Collect: Specific duties are easier to administer and collect.
Once it is possible to identify the goods, it is easy to administer and collect.
3. Certainty in the Amount of Duty: Specific duty helps the importer to know exactly the
amount of duty he will have to pay in respect of consignment. For example, when he imports
certain quantities of oil, he can easily and correctly calculate the amount of duty, as it is related
to the quantity of oil imported.
4. Certainty in the Quantum of Revenue: Government can also easily predict the
quantum of revenue yield from customs duties, because these are related to quantity of the goods
to be imported.

5.5.2.2. Demerits of Specific Duty:

1. Static in Revenue Yield: Specific duties keep the revenue yield static in nature i.e. it will
not generate large volume of revenue during the inflationary periods.
2. Tax Burden Increase in Depression: Tax burden of specific duties increases in
depression. In time of recession, specific duties tend to increase the tax burden, because there is
an overall downward trend in prices, taxes will be imposed only on the basis of the commodities’
weight or length or bulky etc., and not on the actual value of the commodity.

5.5.3. Differences between Advalorem Duty and Specific Duty:

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 Advalorem duty is levied on a certain percentage on the value of the commodity to be taxed
and weight, length or bulky of the goods are not important for this purpose.Specific duty is
levied according to the weight, length, bulky or some other unit of measurement of the
commodity concerned.
The following are the differences between advalorem and specific duty
DIFFERENCES BETWEEN ADVOLEROM AND SPECIFIC DUTY

ADVALOREM DUTY SPECIFIC DUTY

1. Basis of levy

Advalorem duty is levied on the certain Specific duty is levied as to the weight,
percentage on the value of commodity to length, bulky, etc. of the commodity to be
be taxed taxed.

2. Administration of Duty

It is very difficult to administer. Thus It is easier to administer and collect. Once

the duty is levied on the value of it is possible to identify the goods, it is
commodity. But, in practice it is very easy to levy and collect tax.
difficult to estimate the value of thousands
of commodities imported from a large
number of countries

3. Prediction of Quantum of Revenue

Under advalorem duty, the government Under specific duty, the Government can
cannot correctly predict the quantum of easily predict the quantum of revenue
revenue yield yield.

4. Chance of Tax Evasion

Under advalorems duty, the government Under specific duty, unit of measurement
cannot correctly predict the quantum of of commodities i.e weight, length,
revenue yield. bulketc, can be ascertained at any time.
Hence there is less chance of tax evasion.

5. Tax Burden

Advalorem duty keeps the burden of tax Specific duty does not keep the tax burden
steady i.e during the times of boom the tax steady. For example, in time of recession,

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liability tends to rise in time of recession, there is an overall downward trend in
the liability also goes down. prices, tax will be imposed only on the
basisi of commodities weight, lengthetc,
and not on the value of the commodity.
Hence, specific duty increase the tax
burden during that period.

6. Revenue Yield

Advalorem duty brings higher revenue Under specific duty, revenue yield is of
during the period of rising prices. Because static in nature.
when the price tends to increase, the
revenue yield also increases.

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