UNIT FOUR

TAXATION
Section One
Taxation and Tax Policies
• Governments must have funds, or revenue, to
pay for their activities
• Gov’ts generate some revenue by charging fees
for the services they provide, such as entrance
fees at national parks or tolls for using a highway
• However, most gov’t revenue comes from taxes.
• We have already mentioned that the way the
gov’t spends & taxes is determined by a gov’t’s
fiscal policy that bears a direct influence on the
performance of the economy
• Hence, taxation directly affects the overall
performance of the economy.
• For example, if the gov’t increases spending to
build a new highway, construction of the
highway will create jobs. Jobs create income
that people spend on purchases, and the
economy tends to grow.
• The opposite happens when the gov’t
increases taxes. Households & businesses
have less of their income to spend, they
purchase fewer goods, and the economy
tends to shrink
 Taxation Defn
Taxation is a system of raising money to finance
gov’t with the objectives to reduce inequalities of
income & wealth; to provide incentives for
capital formation in the private sector, & to
restrain consumption so as to keep in check
domestic inflationary pressures
All gov’ts require payments of money, i.e. taxes,
from their people
Gov’ts use tax revenues to render d/t public
services like public school systems, welfare
programs, police & fire protection, maintenance
of roads and highways, & public hospitals
 Taxation Defn…ctd
• Without taxes to fund its activities, gov’t could
hardly exist. That is why it is usually said that
tax is the life source of gov’ts
• Hence, taxation constitutes the most
important source of state revenues. It is
argued that for modern gov’ts, d/t types of
taxes account for 90 percent or more of their
income
 Characteristic Features of Taxation
• Taxation has the following common features
though it varies across different systems
Tax is a compulsory contribution
Tax is an obligatory contribution of the tax-
payers to the gov’t
The people upon whom the tax is levied
cannot refuse to pay tax
After all paying tax is not a matter of ‘right’, it
is duty of citizens the refusal of which
unfortunately leads to punishments
 Characteristic Features of Taxation…
Benefit is not the basic condition
 There is no direct return to tax payers for the
fact that they have paid tax, i.e. people cannot
expect any direct benefit for the amount of
tax paid, b/c there no r/n b/n the amount of
tax paid by the people and the services
rendered by the gov’t to the tax-payers
 Characteristic Features of Taxation…
Common interest
The amount of tax received from the people is
used for the general & common benefits of
the people as a whole
The gov’t has to render enormous range of
social activities w/c incur heavy expenditure
A part of the expense is sought to be raised
through taxation of various types
Thus, tax are said to be the sharing of
common burdens by the people
 Characteristic Features of Taxation…
Legal collection
Tax is a legal collection it can be levied only by
the gov’t, both the central and states/local

Element of sacrifice
o Since tax is paid without any direct return in
benefit it can be said that there is the
prevalence of sacrifice in the payment of tax
 Characteristic Features of Taxation…
Regularity and periodicity
• The payment of tax is regular & periodic in
nature
• It is levied for a fixed period, usually a year
• Thus, almost all taxes are annual taxes
• The payment is usually conducted on a regular
basis
 Characteristic Features of Taxation…
Pervasive and wider in scope
 Tax is levied on all citizens without any
discrimination of caste, creed, status, etc
 In terms of scope, taxes are levied not only on
income but also on properties & commodities
 To enhance the revenue and to bring all the
people under the tax net, the gov’t imposes
various kinds of taxes - this augments the
scope of taxes
 Classification of Taxes
• The conventional types of taxes imposed by
governments are :
i. Income taxes
ii. Consumption taxes when they spend it
iii.Property taxes (sometimes called “in-rem”),
i.e. the tax on “things”, when they own a
home or land, and in some cases estate taxes
when they die
 Classification of Taxes…ctd
i. Income Taxes
• In most countries, individuals pay the
income taxes when they earn.
• Taxes on people’s incomes play critical
roles in the revenue systems of all
developed & underdeveloped countries
 Classification of Taxes…ctd
A. Individual Income Tax
 An individual income tax, also called a personal income tax,
is a tax on a person’s income
 Income includes:
• Wages, salaries, & other earnings from one’s occupation;
• Interest earned by savings accounts and certain types of
bonds
• Rents (earnings from rented properties)
• Royalties earned on sales of patented or copyrighted items,
such as inventions & books
• Dividends from stock
• Capital gains, which are profits from the sale of stock, real
estate, or other investments whose value has increased
over time
 Classification of Taxes…ctd
• The national gov’ts of many other countries
require citizens to file an individual income tax
return each year
• This computation involves four major steps
1) The taxpayer computes adjusted gross income—
one’s income from all taxable sources minus
certain expenses incurred in earning that income
2) The taxpayer converts adjusted gross income to
taxable income—the amount of income subject
to tax—by subtracting various amounts called
exemptions and deductions
 Classification of Taxes…ctd
3) The taxpayer calculates the amount of tax due by
consulting a tax table, which shows the exact
amount of tax due for most levels of taxable
income.
4) The taxpayer subtracts taxes paid during the year
& any allowable tax credits to arrive at final tax
liability
• Income taxation enjoys widespread support b/c
income is considered a good indicator of an
individual’s ability to pay.
• However, income taxes are hard to administer
because measuring income is often difficult – in
kind payments
 Classification of Taxes…ctd
B. Corporate Income Tax
• Corporations must also pay tax on their net
income (profits)
• The corporate income tax is one of the most
controversial types of taxes
• Although the corporations have an
independent ability to pay a tax, many
economists note that only real people—such
as the shareholders who own corporations—
can bear a tax burden
 Classification of Taxes…ctd
• In addition, the corporate income tax leads to
double taxation of corporate income
• Income is taxed once when it is earned by the
corporation, & a second time when it is paid
out to shareholders in the form of dividends
• Thus, corporate income faces a higher tax
burden than income earned by individuals or
by other types of businesses
 Classification of Taxes…ctd
C. Payroll Tax
 Whereas an income tax is levied on all sources of
income, a payroll tax applies only to wages &
salaries
 Employers automatically withhold payroll taxes
from employees’ wages & forward them to the
gov’t
 Payroll taxes are the main sources of funding for
various social insurance programs, such as those
that provide benefits to the poor, elderly,
unemployed, and disabled
 Classification of Taxes…ctd
 Usually, there is a limit rate to the average
wage to be taxed
 Gov’ts impose no payroll tax on earnings
above the limit - employers pay some rate of
their wages accordingly
 Classification of Taxes…ctd
ii. Consumption Taxes
o A consumption tax is a tax levied on sales of
goods or services
o The most important kinds of consumption
taxes are sales taxes, excise taxes, value-
added taxes, and tariffs
 Classification of Taxes…ctd
A. Sales Taxes
 Sales tax imposes the same tax rate on a wide
variety of goods &, in some cases, services.
 Although sellers are legally responsible for paying
sales taxes, & sellers collect sales taxes from
consumers, the burden of any given sales tax is
often divided b/n sellers & consumers
 In some countries, sales taxes are often
exempted certain necessities such as basic
groceries & prescription drugs
 Both individuals & businesses pay sales tax
 Classification of Taxes…ctd
B. Excise Taxes
o Excise taxes are also called selective sales
taxes
o Goods subject to excise taxes include tobacco
products, alcoholic beverages, gasoline, &
some luxury items
o Excise taxes are applied either on a per unit
basis, such as per package, or as a fixed
percentage of the sales price
 Classification of Taxes…ctd
o Gov’ts sometimes levy excise taxes to pay for
specific projects
o For example, voters in a city might approve a
tax on hotel rooms to help pay for a new
convention center
o Some national governments impose an excise
tax on airline tickets to help pay for airport
improvements or airline security
o Revenues from gasoline taxes typically pay for
highway construction and improvements
 Classification of Taxes…ctd
o Excise taxes designed to limit consumption of
a commodity, such as taxes on cigarettes and
alcoholic beverages, are commonly known as
“sin taxes.”
o Another type of excise tax is the license tax.
Most states require people to buy licenses to
engage in certain activities, such as hunting
and fishing, operating a motor vehicle, owning
a business, & selling alcoholic beverages.
 Classification of Taxes…ctd
C. Value-Added Tax
In a value-added tax (VAT) system, the seller
pays the gov’t a percentage of the value
added to goods or services at each stage of
production
The value added at each stage of production
is the d/ce b/n the seller’s costs for materials
& the selling price
In essence, a VAT is just a general sales tax
that is collected at multiple stages
 Classification of Taxes…ctd
Example: bread
In some nations, gov’ts exempt certain goods
and services from such tax as food items,
medical services & child-care services
 Classification of Taxes…ctd
D. Tariffs
• Tariffs, also called duties or customs duties, are
taxes levied on imported or exported goods
• Import duties are considered consumption taxes
because they are levied on goods to be
consumed
• Import duties also protect domestic industries
from foreign competition by making imported
goods more expensive than their domestic
counterparts
 Classification of Taxes…ctd
iii. Property Taxes
 A property tax is a tax on an individual’s wealth—
the value of all of the person’s assets, both
financial (such as stocks and bonds) & real (such
as houses, cars, and artwork)
 In practice, property taxes are usually more
limited
 Especially, in countries with federal state
structures, there is no federal property tax-the
property tax is by far the largest source of
revenue for local governments
 Classification of Taxes…ctd
• The property tax is often unpopular with
homeowners
• One reason is that, b/c homes are not sold
very often, gov’ts must levy the tax on the
estimated value of the dwelling
• Some citizens believe that the gov’t
overvalues their homes, leading to unfairly
high property tax burdens
 Classification of Taxes…ctd
o When a person dies, the property that he or
she leaves for others may be subject to tax
o An estate tax is a tax on the deceased
person’s estate, which includes everything the
person owned at the time of death—money,
real estate, stock, bonds, proceeds from
insurance policies, and material possessions
o Most gov’ts levy estate taxes before the
deceased person’s property passes to heirs,
although many gov’ts do not impose an estate
tax on property inherited by a spouse
 Classification of Taxes…ctd
o An inheritance tax also taxes the value of the
deceased person’s estate, but after the estate
passes to heirs-the inheritors pay the tax
o Estate and inheritance taxes are sometimes
collectively called death taxes
o A gift tax is a tax on the transfer of property
between living people
 Classification of Taxes…ctd
o Estate & gift taxes are controversial
o Proponents argue that they are useful tools for
distributing wealth more equally in society &
preventing the rise of powerful oligarchies
o Opponents argue that it is a person’s right to
pass on property to his or her heirs, and the gov’t
has no right to interfere
o If an individual has paid tax on his or her income
while in the process of accumulating wealth,
critics ask, why should it be taxed again when the
wealth is transferred?
 Classification of Taxes…ctd
o Others argue that estate & gift taxes
discourage individuals from working & saving
to accumulate wealth to leave to their
children
o On the other hand, the presence of an estate
tax might encourage people to accumulate
greater wealth in order to reach a given after-
tax goal
 Classification of Taxes…ctd
The above mentioned types of taxes are by no
means exhaustive
Based on the manner of impact & incident of
their burden, taxes could be said direct (the
burden of tax is on the immediate tax payer)
& indirect (the burden of tax is shifted to
elsewhere)
The other categories include taxes like poll &
pollution taxes
 Canons (Principles) of Taxation
• Are basic principles applicable to taxation
• Mostly associated with the 17th c French
statesman Jean-Baptiste Colbert called them
the qualities of the “art of taxation” and
Scottish economist Adam Smith laid out these
principles in his landmark treatise The Wealth
of Nations (1776)
• In the contemporary world, the major
principles of taxation are discussed below
 Canons (Principles) of Taxation…ctd
Cannon of equality
According to this principle, as set forth by
Adam Smith, the “subject of every state ought
to contribute towards the support of gov’t, as
nearly as possible, in proportion to their
abilities to pay” - that is, a “good” tax system
Tax system should be based on ability to pay
of the people
 Canons (Principles) of Taxation…ctd
Cannon of certainty
• The other important cannon of taxation
advocated by A. Smith is ‘certainty’
• According to him, the tax which each
individual is bound to pay ought to be certain
and not arbitrary
• The time of payment, the manner of payment,
the quantity to pay, should be clear and plain
to the contributor and every other person
 Canons (Principles) of Taxation…ctd
Cannon of convenience
o According to this principle every tax ought to
be levied in time or in the manner in w/c it is
most likely to be convenient for the
contributor to pay it - the tax should be levied
and collected in such a way that is convenient
to tax-payers
o For example, it could be done like in
installments, or say, land revenue may be
collected at the time of harvest, etc
 Canons (Principles) of Taxation…ctd
Cannon of economy
 According to A. Smith, “every tax ought to be
so contrived as both to take out and keep out
of pockets of the people as little as possible
over and above what it brings in to the public
treasury of the state.”
 Canons (Principles) of Taxation…ctd
Cannon of productivity
The tax system should be productive enough-
it should ensure sufficient revenue to the
gov’t & it should encourage productive
activity by encouraging the people to work,
save and invest
 Canons (Principles) of Taxation…ctd
Cannon of elasticity
The tax should be flexible
It should be levied in such a way to increase
or decrease the tax revenue depending upon
the need of the public
For example, during certain unforeseen
situations of calamities like floods, famine,
war, drought, etc
 Canons (Principles) of Taxation…ctd
Cannon of diversity
 According to this principle, there should be
diversity in the tax system of a country
 The burden of tax should be distributed
widely on the entire people of the country
 Canons (Principles) of Taxation…ctd
Cannon of simplicity
This principle states that the tax system
should be simple, easy & understandable to
the common man
If the tax system is complex & vague, the tax-
payer cannot estimate his/her tax liability & it
will cause irregularities in the payment &
leads to corruption
 Canons (Principles) of Taxation…ctd
Cannon of expediency
• According to this principle, a tax should be
levied after considering all favorable and
unfavorable factors from d/t angles such as
economic, political and social
 Canons (Principles) of Taxation…ctd
Cannon of coordination
o In a federal states, like Ethiopia, the federal &
states gov’ts levy taxes
o So, there should be a proper coordination b/n
d/t taxes imposed by various levels of
authorities
 Canons (Principles) of Taxation…ctd
Cannon of neutrality
 This principle stresses that the tax system
should not have any adverse effect
 It shouldn’t create any deflationary or
inflationary effects in the economy
 Functions of Taxation
• Tax is a major instrument of social and
economic policy
• It is a method to distribute the cost of the
gov’t fairly among d/t income groups (vertical
equity) & among people approximately in the
same economic circumstances (horizontal
equity) and to promote economic growth with
stability and efficiency
 Functions of Taxation…ctd
o Throughout history, people have debated the
amount and kinds of taxes that a gov’t should
impose, as well as how it should distribute the
burden of those taxes across society
o Taxation can redistribute a society’s wealth by
imposing a heavier tax burden on one group in
order to fund services for another
o Taxation is also considered as an important tool
for maintaining the stability of a country’s
economy
o Besides, taxation can play crucial role of
accelerating economic growth in under-
developed countries
 Functions of Taxation…ctd
 In addition to using taxation to raise money,
gov’ts may raise or lower taxes to achieve
social and economic objectives, or to achieve
political popularity with certain groups
 Taxes also have political ramifications.
Unpopular taxes have caused public protests,
riots, and even revolutions
 In political campaigns, candidates’ views on
taxation may partly determine their popularity
with voters
 Functions of Taxation…ctd
In underdeveloped countries, more particularly,
taxes have four basic functions
i) Curtailment of consumption of above subsistence
level families
ii) Curtailment of use of resources for capital
formation which are of little value to economic
development
iii)Provision of funds to the government; and
iv)The provision of incentives to alter economic
activities in a fashion favorable to economic
growth
Incidence and Impacts of Taxation
 To understand the effect of any tax, one must
first determine who bears the burden of the
tax, which is not always an easy task
 Points where tax may be imposed is known as
impact points, while the way a tax affects
people is called the tax incidence
 Incidence and Impacts of Taxation…ctd
 The statutory incidence of a tax refers to the
individuals or groups who must legally pay the
tax. However, the statutory incidence reveals
essentially nothing about a tax’s real burden
 In contrast, the economic incidence of a tax
refers to its actual effects on people’s
incomes. The economic incidence of a tax
depends on how buyers and sellers of the
commodity react when the tax is imposed
 Incidence and Impacts of Taxation…ctd
 The more sensitive consumers are to changes
in price, the easier it is for them to turn to
other products when the price goes up, in w/c
case producers bear more of the tax burden
 On the other hand, if consumers purchase the
same amount regardless of price, they bear
the whole burden
 Nevertheless, taxes can affect the following
economic variables
 Incidence and Impacts of Taxation…ctd
A. Labor Supply
• An economy’s labor supply is the number of
hours that people work
• Taxes can affect the labor supply by
influencing people's decisions about whether
to work and how much to work
• Suppose that an individual earns 10 Birr per
hour, & the gov’t imposes a 40% tax on
earnings - after tax, the individual receives
only 6 Birr per hour
 Incidence and Impacts of Taxation…ctd
• The impact of such a tax is hard to predict.
• On the one hand, the tax lowers the cost to
the individual of not working
• On the other hand, with a lower wage, the
individual must work more hours to maintain
the standard of living he or she had before the
tax
• Thus, the tax simultaneously leads to two
effects that work in opposite directions.
 Incidence and Impacts of Taxation…ctd
B. Saving
o Saving is the portion of income that is not
spent. The question remains: might taxes
levied on returns to saving influence the
amount people save?
o When a tax is levied on interest or dividends,
it reduces the reward for saving
o This effect tends to reduce the amount of
saving that an individual does
 Incidence and Impacts of Taxation…ctd
o On the other hand, when interest is taxed, an
individual must save more to achieve any
particular savings goal
o Because the two effects work in opposite
directions, in theory an increase in the tax on
interest can increase or decrease saving
 Incidence and Impacts of Taxation…ctd
C. Physical Investment
 Physical investment refers to the purchase by
businesses of manufacturing aids to production
 Physical investment includes such items as machines,
factories, computers, trucks, and office furniture
 The return on a physical investment is the amount,
which the investment increases the business’s
revenues
 In effect, a tax on business income is a tax on the
physical investment’s return—the tax reduces the
firm’s income and thus the benefit from making the
investment
 It is usually believed that business taxes decrease the
amount of physical investment by businesses.
 Incidence and Impacts of Taxation…ctd
Taxes also influence the types of physical
investments that businesses make
This is because the gov’t taxes returns on some
types of investments at higher rates than others
These d/ces cause businesses to make
investment decisions based on tax consequences,
rather than whether they are sound from a
business point of view
By distorting physical investment decisions, the
tax system may lead to an inefficient pattern of
investment
 Equity and Efficiency of Taxation
• Throughout history, people have debated the
amount & kinds of taxes that a gov’t should
impose, as well as how it should distribute the
burden of those taxes across society
• There is, thus, a continued controversy over
what constitutes an equitable taxation both in
method and consequences
• Below is a discussion of the two main
approaches to tax equity
 Approaches to Tax Equity
(Fairness)
• There is a consensus that any taxation should
be fair and should aim at bringing an equitable
socio-economic condition for the society
• But there are arguments and perspectives on
how to bring the required “fairness”
• These are the ability-to-pay and benefit
principles
 Approaches to Tax Equity (Fairness)…ctd
i) Ability-to-Pay Principle
 The ability-to-pay principle holds that people’s
taxes should be based upon their ability to pay,
usually as measured by income or wealth
 One implication of this principle is horizontal
equity, which states that people in equal
positions should pay the same amount of tax
 A second requirement of the ability-to-pay
principle is vertical equity, the idea that a tax
system should distribute the burden fairly across
people with d/t abilities to pay
 Approaches to Tax Equity (Fairness)…ctd
 This idea implies that a person with higher
income should pay more in taxes than one
with less income
 But the question is: how much more? Should
citizens with different incomes be taxed at the
same rate or at different rates?
 To answer these questions three tax systems
are often advocated and applied
 Taxes may be proportional, progressive, or
regressive.
 Approaches to Tax Equity (Fairness)…ctd

ii) Benefits Principle

The benefits principle of taxation states that
only the beneficiaries of a particular gov’t
program should have to pay for it
The benefits principle regards public services
as similar to private goods and regards taxes
as the price people must pay for these
services
 Approaches to Tax Equity (Fairness)…ctd
The practical application of the benefits
principle is extremely limited, b/c most gov’t
services are consumed by the community as a
whole
For example, one cannot estimate the benefit
received by a particular individual for general
public services such as national defense and
local police protection
Despite its intuitive appeal, the benefits
principle is not important in practice, and it
plays little role in the design of tax systems
 Efficiency of Taxation
• Collection of taxes costs authority money. The
following are some of the costs that are incurred.
Administration Costs
o The gov’t must hire tax collectors to gather
revenue, data entry clerks to process tax returns,
auditors to inspect questionable returns, lawyers
to handle disputes, and accountants to track the
flow of money
o No tax system is perfectly efficient, but gov’t
should strive to minimize the costs of admn
 Efficiency of Taxation…ctd
Compliance Costs
 Complying with the system of paying taxes
costs taxpayers money above and beyond the
actual tax bill
 These costs include the money that people
spend on accountants, tax lawyers, and tax
preparers, as well as the value of taxpayers’
time spent filling out tax returns and keeping
records
 Efficiency of Taxation…ctd
Excess Burden
A third measure of a tax system’s efficiency
takes into account the fact that when the
gov’t levies a tax on a good, it distorts
consumer behavior—people buy less of the
taxed good and more of other goods
Instead of choosing what goods to buy solely
on the basis of their intrinsic merits,
consumers are influenced by taxes
This tax-induced change in behavior is called
an excess burden
 Efficiency of Taxation…ctd
The larger the excess burden of a tax, the
worse it is for efficiency
In fact, taxes on labor can also lead to excess
burdens
When the government taxes people’s labor
(through an income tax), people may decide
to change the number of hours that they work
The tax distorts their choice b/n working &
leisure
End of Unit Four!