ADDIS ABABA UNIVERSITY
COLLEGE OF BUSINESS AND ECONOMICS
DEPARTMENT OF ECONOMICS
LITERATURE REVIEW
AN ASSESSMENT OF DETERMINANT OF TAX REVENUE IN ETHIOPIA
Prepared by; Anatoli Gemechu
Id No……..UGR/5959/14
Advisor: Dr. Tadele Ferede
February 17, 2025
ADDIS ABABA, ETHIOPIA
2. LITERATURE REVIEW
2.1 Conceptual Literature
2.1.1 Definition of taxation
Taxation continues to be the primary source of government income for both developed and
developing countries. According to the OECD classification, taxes are defined as compulsory
payments payable by the individuals and companies to the general government. Individuals pay
income taxes, while businesses pay based on their profits. Taxes are a principal means whereby
any government collects funds to finance its budget. According to Edwin R.A Seligmen in
Essays in Taxation, tax is compulsory contribution from the person, to the government to defray
the expenses incurred in the common interest of all, without reference to special benefit
conferred.
2.1.2 Types of Taxes
In this section, the direct and indirect types of taxes practiced in Ethiopia are summarized below.
Direct Taxes
Under the income tax proclamation No. 979/2016, direct tax in Ethiopia is collected through a
number of taxes that are imposed on individuals and or companies. These include income tax for
jobs, tax on business profits, tax on rental incomes, tax on dividends, tax on royalties, tax on
interests earned on deposits, and taxes on winnings resulting from gambling games. A special
category of taxed income is income derived from the sale of certain investment assets; technical
service fees received from parties outside of Ethiopia; and income derived from agriculture.
Deserving it as the people’s own taxes, these numerous types of direct taxes are crucial for
funding the government as well as make sure that different sorts of income should be taxed
adequately (Tilahun A., 2014).
Indirect Taxes
On the other hand, Sources of indirect tax revenue in Ethiopia come from the tax levied on goods
and services, but not on income. This is consisting of turnover tax whereby it involves total
revenues obtainable by the business, excise tax whereby it involves certain commodities
including alcohol, tobacco and luxury, and value added tax or VAT whereby it is chargeable at
each stage of production or supply of good and services. In addition, customs duties are levied on
imported and exported commodity production. That is why indirect taxes are important since
they help to achieve the state’s revenues at the same time directly impacting the consumption
and economic turnover within the country (Tilahun A., 2014).
2.1.3 Effective factors in the ability of the government in tax revenue.
Many literatures suggest there are various determinants of tax revenue which includes the level
of economic development, fiscal deficits and debt, trade openness, share of aid in GNP,
population density, share of agriculture in GDP, and share of manufacturing in GDP, Tax
evasion, inflation level, compliance level, foreign direct investment, weather condition, revenue
outsourcing, ineffective implementation bylaw and other. But in these literatures part considering
the study concerned factors, those factors were mentioned below:
1) Enactment of appropriate tax laws 4) The number of tax sources; and
2) The accessibility of tax bases 5) The executive expenditures
3) Tax rates
The ability of the government in tax revenue collection depends not only on structural factors,
but also on official factors. In many developing countries, the low level of tax revenues is due to
the fact that the tax laws are not carried out properly and perfectly, and this, in turn, results from
the inefficiency of the official system and the executive methods of allocation and collection
systems (Nikchehreh, 2002).
The establishment of clear and comprehensive tax laws is fundamental to effective revenue
collection. A well-structured legal framework minimizes ambiguities, reduces opportunities for
tax evasion, and enhances compliance. Conversely, complex or outdated tax codes can lead to
inefficiencies and decreased revenue. The U.S. Government Accountability Office emphasizes
that various combinations of tax bases and rates can raise the same amount of revenue,
highlighting the importance of a well-designed tax system (GAO, 2005).
Money theories declared that inflation has a negative influence on tax revenue. Some of them
are, inflation rise was found to have a negative than positive effect on revenue collection due to
decreased economic activities. Inflation increase directly influences the spending behavior of the
people, affects the cost of doing business and therefore it should be monitored in order to ensure
an effective revenue collection (Joyce, 2014).
A broad and accessible tax base ensures a steady revenue stream. Factors such as the size of the
informal economy and the ability to monitor various sectors influence this accessibility. In many
developing countries, large informal sectors pose challenges to tax collection. The OECD notes
that tax revenue is defined as the revenues collected from taxes on income and profits, social
security contributions, and taxes levied on goods and services, underscoring the importance of a
diversified tax base (OECD, 2020).
Setting optimal tax rates is crucial. The Laffer Curve illustrates that there is a tax rate at which
revenue is maximized; beyond this point, higher rates may lead to decreased revenue due to
reduced economic activity or increased evasion. Therefore, understanding the elasticity of the tax
base in response to rate changes is essential for policymakers (Laffer, 2004).
Diversifying tax sources reduces reliance on any single revenue stream and enhances fiscal
stability. For instance, combining income, corporate, property, and consumption taxes can
mitigate the impact of economic fluctuations on total revenue. The World Bank’s analysis of
property tax revenues highlights the importance of multiple tax instruments in achieving fiscal
goals (World Bank, 2019).
Efficient tax administration ensures that the cost of collecting taxes does not outweigh the
benefits. High administrative costs can erode net revenues. Investments in technology and
streamlined processes can reduce these costs. The Taxpayer Advocate Service discusses how tax
code complexity can increase compliance costs, suggesting that simplification can lead to more
efficient tax collection (Taxpayer Advocate Service, 2020).
2.2 Theoretical Review
The determinants of tax revenue can be analyzed using various economic theories that explain
the tax revenue. The key theoretical perspectives include:
2.2.1 The Structuralist Theory
The Structuralist Theory emphasizes that a country's economic structure significantly impacts its
ability to generate tax revenue. Gupta (2007) and Morrissey et al. (2016) found that economic
factors such as per capita GDP, trade openness, and the sectoral composition of the economy
(e.g., agriculture vs. industry) play a crucial role in determining tax revenue potential. In
particular, economies with a large agricultural sector face challenges in tax mobilization. This is
primarily due to the informal nature of the sector, where many individuals and businesses
operate outside the formal tax system. Moreover, agricultural sectors often benefit from tax
exemptions or preferential treatment, further hindering revenue collection (Gupta, 2007;
Morrissey et al., 2016).
2.2.2 The Laffer Curve Hypothesis
The Laffer Curve illustrates the relationship between tax rates and revenue collection. Proposed
by Arthur Laffer in 1974, the hypothesis suggests that there exists an optimal tax rate that
maximizes revenue. According to this theory, excessively high tax rates can lead to reduced tax
compliance and increased tax evasion, as taxpayers are discouraged from working or investing
due to the burden of high taxes. On the other hand, very low tax rates may fail to generate
adequate revenue for the government. This creates a situation where developing countries often
struggle to identify the optimal tax rate that both maximizes revenue and does not discourage
economic activity (Laffer, 1974).
2.2.3 Political Economy and Institutional Theories
Political economy and institutional theories emphasize the role of political institutions,
governance, and the rule of law in shaping tax policy and compliance. Poor governance,
corruption, and weak institutions often result in tax evasion and misallocation of resources. In
such environments, even when tax laws are theoretically sound, their implementation is often
inefficient. In contrast, countries with strong institutions and transparent governance systems
tend to generate higher tax revenue. Political will and effective legal frameworks are essential for
ensuring that tax laws are enforced fairly and effectively, which in turn enhances revenue
generation (Morrissey et al., 2016).
2.2.4 The Benefit Principle
The Benefit Principle, proposed by Erik Lindahl (1919), suggests that taxes should be
proportional to the benefits an individual receives from government services. In the context of
developing countries, where public goods and services may be unevenly distributed, this theory
highlights the challenges governments face in aligning tax collection with perceived benefits.
The informal economy in many developing countries further complicates this process, as
individuals may not perceive the tax system as beneficial, reducing compliance and, ultimately,
revenue generation.
2.2 Empirical evidences
2.2.1 Empirical evidences on tax revenue in case Global Studies
Minh, Tan, and Binh (2022) employing a static as well as dynamic panel data technique showed
that the ratio of foreign debt to GDP, FDI, trade openness, and share of value added in the
industry to GDP positively affects tax revenue while aid has an adverse effect on tax revenue in
8 economies in Southeast Asia. Nguyen-Phuong, Phoung, and Thu (2022) employing a feasible
generalized least square on 8 European economies indicated that human capital, money supply,
and FDI positively affects tax revenue significantly. Employing a fixed and panel data approach
on 4 East Africa Community (EAC) Albimana and Moh’d Hemedb (2022) revealed that for the
period 2010 to 2020 growth in the agricultural sector retard tax revenue while economic growth
drives tax revenue positively.
Neog and Gaur (2020) exploring what determines tax revenue in India and using a simultaneous
equation model noted that for the period 1981 to 2016, growth, trade, and aid are the key drivers
of tax revenue while agriculture and inflation affect tax revenue adversely. Gupta (2007)
explored determinants of tax revenue efforts in developing countries over the past 25 years. He
found that several structural factors like per capita GDP, share of agriculture in GDP and trade
openness are significant and strong determinants of revenue performance. He also looked at the
impact of foreign aid and foreign debt on revenue mobilization. His findings suggest a strong
negative and significant relationship between agriculture share and revenue performance. It is
estimated that a one percent increase in the share of agriculture sector could reduce revenue
performance by as much as 0.4 percent. The effects indicate that although foreign aid improves
revenue performance significantly, debt does not. Among the institutional factors, he found
corruption has a significantly negative effect on revenue performance. Political and economic
stability are other effective factors, but only across certain specifications.
Employing a generalized method moments (GMM) Tsaurai (2021) concluded that for the period
2007 to 2017 trade openness and exchange rate had an adverse effect on tax revenue while
population growth, lag of tax revenue, FDI, GDP, human capital, and urbanization are the key
determinants of tax revenue in upper-middle-income economies. AL-Qudah (2021) using an
autoregressive distributed lag method showed that for the period 1990 to 2019 in Jordan that
government expenditure, per capita GDP, and fiscal deficit affect tax revenue positively both in
the short and long-run while economic openness, industrial sector value added has an adverse
effect on tax revenue. Sanusi, Ihuarulam, and Ogerinde (2021) using panel data between the
period 2005 to 2019 concluded that it is inflation, government expenditure, and growth that
determines tax revenue in ECOWAS. Atolagbe and Abiodun (2021) employing an ARDL
approach concluded that for the period 1981 to 2019, per capita income, FDI, the share of
agriculture to GDP, inflation rate, and exchange rate are the key drivers of tax revenue in
Nigeria.
Terefe and Teera (2018) showed that in the Sub-Saharan African and East Africa Community
between the period 1992 to 2015 revealed that per capita GDP, trade openness, foreign aid, the
share of industry, the share of agriculture, and the share of services determines tax revenue while
exchange rate, inflation, and urbanization has an adverse effect on tax revenue. For instance, a
1% increase in per capita GDP was associated with a 0.6% increase in tax revenue, highlighting
the significant impact of economic growth. Trade openness also showed a positive relationship,
with a 1% increase in trade openness leading to a 0.3% rise in tax revenue. The share of industry
was found to be a particularly strong driver of tax revenue, contributing about 0.4% for each
percentage point increase in the industrial sector’s share of GDP. Neog and Gaur (2020)
exploring what determines tax revenue in India and using a simultaneous equation model noted
that for the period 1981 to 2016, growth, trade, and aid are the key drivers of tax revenue while
agriculture and inflation affect tax revenue adversely.
Muibi and Sinbo (2013) attempts to examine the macroeconomic determinants of tax revenue in
Nigeria for the period 1970 to 2011 and applied Johnson co integration approach and error
correction model. The study has revealed that in Nigeria, the level and growth rate of economic
activity affect tax revenue positively. The study also revealed that any past deviation in tax
revenue will be corrected towards long run steady state by 47% speed of adjustment in period
under consideration. Applying similar methodology, Bayu (2015) studied in the analysis of tax
buoyancy and its determinants in Ethiopia from 1974 to 2010. The result posited that in the long
run, industrial value added share of GDP has positive effect but insignificant on tax buoyancy in
Ethiopia. However, the effect of official development assistance is negative both in the long run
(-6.53) and in the short run (-2.098). The study noted that 48.7 percent of the deviation in tax
revenue is adjusted each year towards its long run equilibrium.
2.2.2 Empirical evidences on tax revenue in case of Ethiopia
Gobachew, et al. (2018) conducted on the “Determinants of Tax Revenue in Ethiopia” to identify
the determinants of tax revenue in Ethiopia. They used secondary time series data set for the
years 1999/00 to 2015/16 and multiple variables regression model with an OLS estimator of a
variable. They employed a quantitative research method with both descriptive statistics and
econometric tools to analyze and present the data. By using multiple variables regression model
using OLS method they fund that industry sector share to GDP, per capita income and trade
openness as measured by the share of export and import to GDP have a significant positive effect
on tax revenue whereas agriculture sector share to GDP and the annual rate of inflation has a
significant and negative effect on tax revenue as measured by the share of tax revenue to GDP.
Anware M. (2014) on the title Determinants of tax revenue performances in Ethiopia as mini
research for Partial Fulfillment of the Requirements for the course Professional Training
Program for Economists (a Case Study in Ethiopian Revenues and Customs Authority) the
researcher used time series data set that consists of 21 years. For the time period covered
1990/91 to 2010/11 with identifying six variable industry , agriculture, inflation, GDP per capital
income, export and import he concluded that structural factors such as exports of goods and
services (% of GDP) and import of goods and service (% of GDP) significantly affect tax
revenue performance of Ethiopia.
Belay Z. (2015) on the research title determinants of tax revenue performance: in case of
Ethiopia federal government. This study so investigated the determinants of tax revenue
performance in Ethiopia federal government by using time series data from 1992-2013. The
variables used were foreign direct investment, public debt, openness, foreign aid, inflation and
gross domestic product. The study has employed both descriptive and time series regression
method as well as views software for analysis purpose. The trend of tax collection in Ethiopia is
inconsistent, changing up ward and down ward depending up on economic conditions. However,
in recent years it shows an incremental in total tax collection but performance of tax collection is
decreasing from year to year. As an example, tax revenue was increased staring from 2003,
because tax base was added as the form of VAT and also GDP was the main contributor since it
has been rapidly increased. The study reveals that growth domestic product, public debt foreign
direct investment, and openness, have significant positive relationship with tax revenue
performance. But, foreign aid is negatively related to tax revenue performance. The study also
provides recommendations that will be solve this problem and added tax revenue performance.
Policy implication has been stated in this study for example government should adjust its fiscal
policy and investment area should be selected based on their benefit for country.
Ayenew (2016) investigated the determinants of tax revenue in Ethiopia using the
Johansen maximum likelihood co-integration approach. The findings revealed that real
GDP, per capita income, foreign aid, and the share of GDP devoted to industrial value-
added all had a long-term impact on tax revenue. On the other hand, inflation had a significant
negative impact. Only real GDP per capita income, the industrial value-added share of GDP, and
the rate of inflation are statistically relevant in determining tax revenue as a proportion of GDP
in the short run. The concerned bodies must consider an increase in per capita income growth,
structural reforms, the introduction of new tax bases, and efficient use of foreign aid input to
improve tax administration and revenue growth.
Workineh (2016) examine the major determinants of tax revenue in Ethiopia for the period
ranging from 1975-2013, using Johansen maximum likelihood co-integration approaches. The
result revealed that in the long run real GDP per capita income, foreign aid and industrial value
added share of GDP positively and significantly affect tax revenue. However, inflation exerted a
negative and significant influence. Whereas, agricultural value added share of GDP and
Education are not significant determinants of tax revenue in the long run. In the short run the
result shows that real GDP per capita income and Inflation have negative and significant effect
on tax revenue and industry value added share of GDP is positive and significant effect on tax
revenue.
Kumar and Nene (2015) investigated the factors that determine Ethiopian tax revenue. In their
study, they investigated factors that influence tax revenue, such as per-capita income, inflation,
service sector GDP, a portion of agriculture GDP, trade liberalization, imports, and exchange
rate. According to their findings, while import and exchange rates affect tax revenue in the
short run, per capita income, inflation, service sector share of GDP, agriculture share of GDP,
and trade liberalization are major long-run predictors of tax revenue in Ethiopia.
2.3 Research Gap
While numerous studies have examined the determinants of tax revenue in Ethiopia, significant
research gaps remain, particularly regarding the impact of exchange rates and environmental
factors. Existing literature extensively discusses macroeconomic variables such as GDP,
inflation, and trade openness but provides limited empirical analysis on how nominal exchange
rate (ER) and real effective exchange rate (REER) influence tax revenue through trade and
investment channels. Another critical gap is the role of rainfall, which is vital in an agriculture-
dependent economy like Ethiopia, yet its influence on tax revenue through agricultural
productivity and economic stability has not been sufficiently analyzed. Lastly, while GDP is a
well-documented determinant, studies rarely differentiate between the contributions of
agriculture, industry, and services to tax performance. By addressing these gaps, this research
will provide deeper insights into the complex relationships between macroeconomic and
environmental factors affecting tax revenue in Ethiopia.
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