Lecture Notes: Public Finance Theory of Taxation
Financing Public Sector Activity
To finance government activities, government needs resources.
Following are the main sources to finance public sector activities:
Taxation (Most popular mode of financing)
Borrowing (Can’t continuously continue borrowing)
Privatization
Confiscation (Old Fashion)
We will observe that if tax is imposed on any of the activity (in any form) then there will be
some efficiency losses.
In the absence of any government (if certain conditions are satisfied) then the market
mechanism has the ability to ensure efficient allocation of resources.
If all conditions were satisfied and government is required to perform certain duties for which it
requires resources and to collect these resources when government collect tax then definitely it
will be interfering in the market mechanism and some distortion will be created and as a result
of it there will be some inefficient allocation of resources and ultimately there will be some
efficiency losses. We will see how these are quantified?
These issues do not exist with the borrowing and privatization but these have issues and
government can’t continuously borrow or privatize its resources. In case of borrowing
government not only have to pay the principal amount but also have to pay the interest and
can’t continue borrowing. Similarly, Government has limited resources and can’t privatize if
there is no resource available.
There are entirely different implications of Taxation, borrowing and privatization
Though taxation is most popular sources of financing government activities but has exist
efficiency cost
Taxes are the source which can finance the government activities for indefinite period of time.
What Is Tax?
Tax or duty is a financial charge which government imposes on their citizens to raise the funds
to finance its activities.
Taxes are transfers from private economic agents to government. Private economic agents
transfer their purchasing power to the government.
It is a legal requirement.
Government has no obligation to provide any return on tax in terms of service delivery
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Lecture Notes: Public Finance Theory of Taxation
Tax is a legal requirement and government has no obligation to provide any service against
these taxes. Unlike market mechanism (where you will get the commodity for which you are
paying), the government is not liable to provide any services against any tax. It will be a one
way transaction. For Instance if government imposes income tax then the government is not
liable to provide any services against this tax or the person who is paying income tax has no
claim on the government to provide any service against this tax.
Whatever government collects in terms of taxes the government itself will define how to spent
these taxes.
Taxes are categorize as:
Direct Tax
Indirect Tax
OR
Personal Tax
▪ Is imposed on person
In Rem Tax
▪ Is a commodity tax
Generally taxes are classified in two ways:
1. Direct Taxes (are the taxes in which the economic burden of the tax is borne by the
individual on which tax is imposed. For instance Income Tax, the individual is paying
income tax on which it is imposed)
2. Indirect Taxes (are the tax which legally imposed on one economic agent but the burden
is partially or completely borne by other economic agent. For instance Sales Tax, Sales
tax is imposed on producer or retailer means that retailer has to pay this tax but when it
is paid the price is adjusted in a way or the elasticity of demand and supply will effect in
a way that burden will be partially be borne by producer and partially be borne by
consumer). Shifting of tax burden is possible from one economic agent to other in
indirect taxes. Therefore, it is possible that legally the tax is imposed on one economic
agent but the burden is borne by other economic agent
The other way of classifying the taxes is:
1. Personal Tax which is depends on the economic capacity of a person such as income tax
and wealth tax is personal tax.
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Lecture Notes: Public Finance Theory of Taxation
Most of the direct taxes are Personal Tax and Indirect taxes are Commodity taxes
What are the requirements for a good Tax Structure?
Equitable
Efficient
In terms of Economics Efficiency i.e. Efficiency Losses as minimum as possible
Administrative Cost (Low)
Head Tax (Lose equity)
Evasion (Low)
To control Evasion, Administrative Cost will increase
Simplicity
Example – Head Tax (Every adult individual has to pay certain amount)
There are some attribute or characteristics of the tax policy. What are the requirements for
a good tax system? Tax Structure means Mix of Taxes.
There is a tradeoff between one characteristic and other characteristics
Head Tax: Imposed in England, Most efficient tax as it does not interfere with the economic
activity. Every individual has to pay certain amount of tax irrespective to the economic
capacity of the individual. It is the simplest tax as one doesn’t need to fill any form nor audit
is required, evasion is also not possible and no one can avoid it.
In case of sales tax: Sales tax will increase the price of the commodity and one can reduce
the consumption of the commodity on which sales tax is imposed and switch to the other
commodity. Substitution from tax commodity to non tax commodity. Avoidance is possible
one can avoid sales tax by substitution from one commodity to other.
The only issue with the Head Tax is that it is not equitable.
Tax Evasion: we do not want to make it zero, we want to define an optimal level of tax
evasion and it depends on the marginal cost associated with the marginal evasion. If
marginal cost of controlling evasion is more than the marginal revenue collection then is will
not be feasible. For this reason many of the advanced countries are experiencing evasion
There is a tradeoff between Equity and Efficiency. If we make our taxation system more
equitable then efficiency losses will increase. Government imposes Direct Tax (Personal
Income Tax) then individual may decrease their work efforts. To achieve efficiency impose
taxes on the commodity for which own demand elasticity is very low then there will be least
excess burden such as tax on food items but we will lose equity
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Lecture Notes: Public Finance Theory of Taxation
There is a trade off among each and every characteristic of taxation system, our objective is
to determine the optimal mix of characteristics which maximize the social welfare.
A tax system is good if it maximize the welfare of the society.
Equity
Ability to Pay
▪ Tax payments should be based on economic capacity of individuals
Benefit Tax Approach
▪ Tax payments should be in line with the benefits that individuals are
deriving from public service.
Example: Road Tax / Gasoline Tax
How Ability to pay is determined/ Measured?
▪ Property
▪ Income
▪ Wealth
John Stevert Mill & Adam Smith argued that Tax should be in accordance with the economic
Capacity of the individuals. Economic Capacity means Income or Wealth
Benefit tax Approach is applied where preferences can be revealed. Will work where price
mechanism work efficiently
Both approaches exists side by side in an economy
Benefit Tax Principal is not applied in Pure Public Good and where preference cannot be
revealed
Horizontal Equity
▪ Equal should be treated equally / Equal should pay equal amount of tax
Vertical Equity
▪ Vertical should be treated unequally / Unequal should pay different taxes
▪ Redistribution Issues (What Should be the Rate Structure)
▪ Regressive: People with greater ability to pay, pay proportionately
less.
▪ Proportional: People pay same proportion (of Income, Wealth,
etc.)
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Lecture Notes: Public Finance Theory of Taxation
▪ Progressive: People with greater ability to pay, pay
proportionately more.
In case of Horizontal Equity, How economic Capacity is measured?
Should it be Income? Welfare or Consumption?
If it is income then how it is defined? Should it be wage income or it include wage income plus
interest income?
If it is only wage income, Disutility is involved with work,
If there are two individual one is earning wage income and the other is earning interest income
then economic capacity of both individual is same but because of work one is losing welfare
Is there an economic justification for a progressive tax structure?
Progressive tax structure increases overall social welfare (Progressive Rate Structure is
more equitable)
Diminishing Marginal Utility Argument: Low income individuals value additional unit of
income more than higher income individuals
Pakistan’s Taxation System / Tax Structure of Pakistan
Federal taxes in Pakistan like most of the taxation systems in the world are classified into two
broad categories: viz., direct and indirect taxes.
A broad description regarding the nature of administration of these taxes is explained below:
1. DIRECT TAX
1. Income Tax
2. Property Tax
2. INDIRECT TAX
1. Sales Tax
2. Custom Duty
3. Excise Duty
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Lecture Notes: Public Finance Theory of Taxation
1. DIRECT TAXES
Is a tax that is paid directly by an individual or organization to the imposing entity.
A taxpayer pays a direct tax to a government for different purposes, including real property
tax, personal property tax, income tax or taxes on assets.
Direct taxes primarily comprise income tax, along with supplementary role of wealth tax.
For the purpose of the charge of tax and the computation of total income, all income is
classified under the following heads.
• Salaries
• Income from property;
• Income from business or professions
• Capital gains; and
• Income from other sources
1.1 What is income tax
The income of a person under a head of income shall be the total of the amount derived by the
person in a tax year that are chargeable to tax under the head as reduced by the total
deductions allowed under the ordinance to the person under that head.
1.1.1 Why Income tax imposes
The government has 5 major aims, these are:
• Economic Growth (%increase in the GDP over one year),
• Low Unemployment,
• Low Inflation,
• Equilibrium of the Balance of Payments, and
• Redistribution of Wealth.
To reach these aims, the government imposes taxes.
1.1.2 Who impose the income tax
Federal Board of Revenue (FBR) levy the tax
1.1.3 Who Collect it?
FBR collect it.
1.1.4 When tax will be collected
1. Withholding tax collected at time of disbursal and payment to FBR weekly
2. Return filling 30th Septmeber of every year
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Lecture Notes: Public Finance Theory of Taxation
3. Advance tax 15th of every quarter end except last quarter which 25th.
2. INDIRECT TAX
An indirect tax is most often thought of as a tax that is shifted from one taxpayer to
another, by way of an increase in the price of the good.
Indirect taxes can also be defined as fees that are levied equally upon taxpayers, no
matter their income. This is a primary reason why they are thought of as taxes that are
passed on, as the price of the tax is compensated for by simply increasing the overall
price of the good or service. Some economists argue that indirect taxes lead to an
inefficient marketplace and alter market prices that don't match their equilibrium price.
2.1 Custom Tax
• A tax levied on imports (and, sometimes, on exports) by the
customs authorities of a country to raise state revenue,
• To protect domestic industries from more efficient or
predatory competitors from abroad.
• Customs duty is based generally on the value of goods or upon
the weight, dimensions, or some other criteria of the item (such as the size of
the engine, in case of automobiles).
• Goods imported and exported from Pakistan are liable to rates of Customs duties
as prescribed in Pakistan Customs Tariff.
2.1.1 How Custom duty determine
The rate structure of customs duty is determined by a large number of socio-economic factors.
However, the general scheme envisages higher rates on luxury items as well as on less essential
goods.
2.2 CENTRAL EXCISE
Excise tax refers to the tax that is levied upon production of an item and the manufacturer has
to pay it when the finished good goes out of the factory
Central Excise duties are leviable on a limited number of goods produced or manufactured, and
services provided or rendered in Pakistan.
On most of the items Central Excise duty is charged on the basis of value or retail price. Some
items are, however, chargeable to duty on the basis of weight or quantity.
Classification of goods is done in accordance with the Harmonized Commodity Description and
Coding system which is being used all over the world.
All exports are exempted from Central Excise Duty.
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Lecture Notes: Public Finance Theory of Taxation
2.3 SALES TAX
Sales Tax is levied at various stages of economic activity at the rate of 15 per cent on:
• All goods imported into Pakistan, payable by the importers;
• All supplies made in Pakistan by a registered person in the course of furtherance of any
business carried on by him;
• There is an in-built system of input tax adjustment and a registered person can make
adjustment of tax paid at earlier stages against
• The tax payable by him on his supplies. Thus the tax paid at any stage does not exceed
15% of the total sales price of the supplies;
SO MANY TAXES! WHY NOT A SINGLE TAX?
• Back in primitive times, this was indeed the case. i.e. one tax (direct tax).
• However, as the economic activities, businesses and sources of income, and
government spending needs grew, so did the modes of taxes.
WHAT IS PREFERABLE: DIRECT TAX OR INDIRECT TAX?
• Direct taxes
o Are easy to impose, easy to administer and easy to collect.
o Designing a progressive system is easier.
o Prevents forward shifting of tax burden, therefore equitable distribution of
taxation burden.
• Indirect taxes
o Requires harder effort in implementation.
o Needs care in designing progressive tax policy. May become highly regressive.
o Forward shifting is highly possible based upon the elasticity of demand.
o In developing countries with relatively weak income redistribution systems,
indirect taxes may not be preferred over direct taxes.
THEN WHY IMPOSE INDIRECT TAX?
• Due to the increased need of public expenditure, government needs additional sources
to earn revenue from. They cannot overtax incomes.
• Consumption is a better measure of wealth than simply income. A person earning huge
incomes is most likely to spend excessively and he, theoretically, cannot conceal it. On
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Lecture Notes: Public Finance Theory of Taxation
the other hand, he can conceal his income by, say, not reporting his illegal earnings.
Thus it is better to tax his consumption too.
• Moreover, it is a common observation that in household surveys, people understate
their income. Thus it is hard to measure one’s income.
In short, according to economists, share of direct taxes should be more than indirect
taxes in order to guarantee equitable taxation burden. But, at the same time, indirect
taxes cannot be neglected since they form a sizable part of government earnings.
SOME ISSUES RELATED TO PRESENT TAX STRUCTURE OF PAKISTAN
• Low resource mobilization (or Low Tax Base exploitation, or Less Coverage)
o Our Tax-to-GDP ratio is stagnant.
• Lower level of expenditure financing through taxes
o We are able to finance less than 60 percent of our expenditure thorough tax
collection.
• Tax Evasion (unreported economy)
o On average, taxes worth around Rs. 107 billion have been evaded between 2000
and 2003.
• In international perspective, high Share of Indirect Taxes in Total Taxes.
• Frequent legal and administrative changes. Thus taxpayers always have little knowledge
of their obligations.
• Tax exemptions are very high. Economic survey shows that in Fiscal year 2005:
o Tax expenditure on income tax (income from funds, capital gains, NSS interest
income, etc.) was worth Rs. 5 billion.
o Tax expenditure on sales tax (retail, pharmaceutical, tractors, fertilizers, etc.) was
worth Rs. 8 billion.
o Tax expenditure on customs (some machinery, raw materials, sugar etc.) was
worth Rs. 12 billion.
Difference between Custom and Excise Duty
1. The duty that is levied for goods manufactured inside the state is called excise duty. The
duty that is levied on goods imported from a foreign country is the customs duty.
2. Excise duty is valued advalorem, which means that the duty is calculated taking into
account the number of goods or the volume of the goods. Whereas the customs duty of
any goods is valued by its assessable value.
Prepared by: Dr Noman Saeed Email: economanics@yahoo.com
Lecture Notes: Public Finance Theory of Taxation
3. Excise tax is payable by the manufacturers while custom duty is payable by the
importers of goods which means they are just buyers
Difference Between Excise Duty & Sales Tax
• Excise duty is on production of goods whereas sales tax is on sale of goods.
• Excise duty is paid by the manufacturer whereas sales tax is born by the end consumer.
• Excise Duty is payable on removal of goods from factory or warehouse whereas Sales tax is
payable after the sale takes place
• Excise duty is levied on number of goods or volume of goods whereas Sales tax is charged
on sale price.
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