CHAPTER ONE

INTRODUCTION

1.1 background of the study

Most of developing countries are currently dependent on external financial resources to fund
their development activities. As a result their budgetary problems become more serious. To
change their situation, these nations should exploit and strengthen their domestic financial
resources base in order to bring about sustainable development. One of these sources is taxation.
This is a system of rising money internally to finance government expenditure. Hence a tax is
compulsory payment to government without expectation of direct return of benefit to tax payers.
This means its compulsory contribution imposed by public authority, irrespective of the exact
amount of service rendered to the tax payers in return to the amount of tax paid by them. That
taxation is not paid in exchange for a specific benefit. A clear example for this is that a person,
who accomplished his tax obligation, and which are commonly available for everyone. It’s clear
those public goods usually are financed by tax revenue. (Jones and Rhoads, cited in muluneh,
2009)

Taxes are important sources of public revenue. The existence of collective conception of goods
and services necessities putting some of our income in to government hands, such us public
goods like roads, power municipal services, and other public infrastructure have favorable results
on many families, business enterprises , industries and general public . Public goods are normally
supplied by public agencies due to their nature of non−rivalry and non−excludability. The nature
of consumption of public goods is such that consumption by one does not reduce consumption
for the others. Beside consumption of public goods by an agent does not exclude others from
doing the same. Such natures of public goods therefore make them impossible for privet supplies
to avail them at market price like other commodities. Government intervention in the supply of
public goods is therefore inevitable and can only be done if public pays tax for the production
and supply of such goods. (wollela abehodie yesegat, 2008)

The history of taxation in Ethiopia dates back to 15th century. However, taxation in modern sense
of the world began to take form in the early 10 th century. The first tax provision was made in

1
1931, in the first Ethiopian constitution. Also the first important reforms carried out by emperor
menilek toward the end of 19th century, resulted in the establishment of fixed title rather than
undefined and essentially arbitrary system of agricultural tax. The second major reform, dates
back to 20th century, and resulted largely from the increasing prevalent of money and growth of
tread. (Eshetu C.1984)

Later reforms were the fruit of Ethiopian emergence as a modern state those involved all the
mechanisms of modern tax collection, tax schedules, paper work, and the development of trained
and regularly paid civil service as well as the oblation of vexatious system of internal custom
post.( Eshetu C,1984)

In The regime of federal democratic republic of Ethiopia classified in to two major categories,
namely direct tax and indirect tax. Direct taxes are farther calcified into income tax and land use
tax. On the other hand, indirect taxes include domestic indirect tax and foreign trade tax. (Eshetu
C, 1984)

In this research the researcher want to show how income tax is scheduled, reforms and how it
affects the national economy.

1.2 statement of the problem

Despite of the fact that people need to pay taxes based on their rationales of vertical and
horizontal equities, it’s not always the case that tax system are comprehensible transparent for
tax payers especially for less literate business operators. Tax system is usually not elaborated
after proper consultation with the business community. Complex tax structure such that neither
the collector nor tax payers could easily determine the tax owned in particular circumstance. Tax
administration has constrained with skilled man power and modern equipment. The
administration is very much weak in the area of tax assessment, collection, follow up and
enforcement. The administration did not even know the exact number of active tax payers.
Therefore, one key area of the reform was tax administration. Failure of tax system to generate
adequate revenue to finance government expenditure result in physical imbalance and instability
in the economy. So this study will expect to answer the following research questions.

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  What is the structure of different income tax in Ethiopia and there share to the total
income tax?
 How different income taxes are influenced by different tax reforms and their
effectiveness?
 What is the impact of income tax in the economy and limitation of tax structure?

1.3 objectives of the study

The general objective is to analysis the economic impact of direct income tax in Ethiopia.

The specific objectives are:

 To assess structure of different income tax in Ethiopia and there share to the
total income tax.
 To show how deferent income taxes are influenced by deferent tax reforms and
their effectiveness.
 To show the impact of income tax in the economy and limitation of tax
structure.

1.4 scope of the study

This research has its own scope (area, time and aspect).the area coverage of the study is in Ethiopia.
The time coverage is limited in between different direct income taxes collected from 2004/05 to
2013/14. Although, the research analysis direct income taxes, structure of different income taxes, the
way different income taxes are influenced by other taxes and the impact of direct income tax in the
economy.

1.5 significance of the study

This research is conducted to give an overview for the readers how tax structure and reforms
collectively affect the economic nature of Ethiopia. Give an insight for the readers income taxes
collected during different regime of Ethiopia. Serve as a benchmark for the study of other
researcher who is interested to conduct related studies.

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1.6 data type, sources and methodology

When the researcher undertakes this research he used quantitative data collected from national
bank of Ethiopia, federal Negarit gazeta. In addition books, senior essays, proceeding reports,
unpublished documents and other materials collected from secondary data.

To highlight the major reasons for measures of income tax to bring to the element of tax reform
and the process to date, by using descriptive analysis to show the changes that have been
exhibited in the reform period. Finally, tables, chart and percentages are used to clarify income
tax collected in different years and to compare them quantitatively.

1.7 Organization of the paper

This paper contains four chapters. The first chapter is introductory part which includes back
ground of the study, statement of the problems, objectives of the study, significance of the study,
scope of the study, data type, sources and methodology of the study, organization of the study
and limitation of the study. Chapter two includes literature review of both the theoretical and
empirical literature reviews. Chapter three includes major tax reforms and its objectives, major
tax reforms in Ethiopia, structure of income tax and Chapter four includes conclusion and
recommendations.

1.8 limitation of the study

When the researcher carries out this research the difficulty in obtaining quality data from different sources
is one of the limitations. The other limitation was financial and time limitation. Because of shortage of
time and inadequate finance, data was not collected as much as needed.

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 CHAPTER TWO

2.1 theoretical reviews

2.1.1 Public finance

Early writers gave definitions to public finance as if it only addresses the final operation of the
public treasury. But as a result of development in state activities and corresponding economic
philosophy with the passage of time, it’s noted that now a days the definition is concerning wide
area of the economy. (Musgrave, 1987)

Public finance deals with the economics of public sector. It deals with the financing of public
expenditure, the allocation of resource and distribution of income among customers. Since the
public sector operates together with the privet sector, public finance cannot be a matter of public
economics only. This is because the component of public finance such as tax policies and
expenditure depends on the reaction of private sector. Although tax policies and certain
expenditure measures may be used to affect the economy in the certain way the most important
objective of taxation and public finance as a whole may be distinguished. These include "the
provision of social goods or the process by which total resource use is divided between private
and social goods"(the allocative system function),"adjustment of the distribution of income and
wealth"(distribution function), and it’s used as a means of stabilizing the economy and
maintaining an appropriate rate of economic growth. Here there is also the objective of
stabilizing the balance of payment (stabilizing function); (Musgrave, 1987)

Taxation is most component of public finance. "Most government activities by virtue of their
public good nature must be financed by taxation rather than by sale to the users."(Due J, 1959)

The expanded role of government in Ethiopia an economy during the period 1974−1999 marked
a phenomenal development of public sector relative to others. Government posing to provide
basic infrastructure and social service, while at the same time engaging in the production and
distribution of basic goods entailed the development of number of institution and public
enterprise. An important outcome of such development was the formidable pressure on
government budget, which lead to persistent and widening physical deficit and other macro
economic imbalances. Growing of public sector during 1980/81−1989/90 market significant

5
growth both in total government expenditure and revenue, however annual growth in total
expenditure (averaging 8%) has exceeds growth in revenue which average 6.4% per annual
during this period.(Befikadu D. 1999)

2.1.2 Principles of taxation

Taxation has become vital and corner stone of development effect. Indeed without tax system a
government cannot provide even basic infrastructure and other social service to the public. Adam
smith, the father of modern economics, who was advocating" laissez-faire”, which states that the
government should take its hands off forum the market on the one hand and to have minimal
government intervention on the other hand, acknowledges the role of government in the
provision of public utilities, which seeks the inputs of tax revenue to be collected from general
public. In his well known book “the wealth of nation "published in1776 Adam Smith stated four
principles which he call them cannons of taxation .in addition to the four principles were also
suggested by latter writers. This all principles (cannon of taxation) are discussed together as
follows in the publication of Federal in land revenue authority of Ethiopia, February, 2006.

1. Cannon of equity: which tries to look at the objective of economic justice, in other words, it
indicates more taxes to be paid by the richer and taxes to be progressive.

2. Cannon of certainty: requires the tax which is bound to be paid to be certain and not arbitrary.
The time of payment, there manner of payment, the quantity to be paid ought to be clear and
plain to the contributor as well as to every person.

3. Cannon of convenience: recommends for the covenant method, manner and time of payment
to the tax payer no to the tax collector.

4. Cannon of economy: discuss the minimum possible cost of tax collection compared to the tax
yield.

5. Cannon of productivity: the tax system should be able to yield enough revenue for the treasury
and government should not be forced to frequent deficit financing.

6. Cannon of buoyancy: tax revenue should have an inherent tendency to increase the volume
along with an increase in national income.

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7. Cannon of flexibility both coverage and rate of taxation should be easily amendable for
revision by the authority to fit with the changing nature of economy and of the treasury.

8. Cannon of simplicity: adheres the absence of complication in tax system, which creates
obstacles to administer it.

9. Cannon of diversity: promote to the absence of government dependence upon neither too few
source of public revenue not too much multiplicity of taxes that lead to unnecessary cost of
collection and violated the cannon of economy.

All principles of texture have relations with the basis for taxation directly or indirectly.

2.1.3 Taxation and underdevelopment

Taxation is one of fiscal policies under taken by policy makers. Fiscal policy like monetary
policy drives its meaning and direction from the aspiration goals of the society within which it
operates, of the people it serves. The aspirations of people of underdevelopment countries are
economic betterment and stability to provide the material soil within which human dignity and
political freedom can grow. “This apparition is reflected in the objectives of the characteristics of
united nations” to “promote social progress and better standards of life in large freedom.”
(Musgrave R.1987)

In under developing economies, taxation is increasingly assigned a far more positive role in
process of capital formation and technological change. The reason for this implicit in extremely
low level of income and saving which serves as the source of capital formation. This countries
(LDCs) are caught in the vicious circle proceeding from low income to high consumption
propensities to low saving to low rates of capital formation to low continuation of the low level
of income. To break out this circle, apparent from foreign aid, calls vigorous taxation and
government programs.(Musgrave R.1987)

There are a number of special feature of developing countries tax system. In the analysis of (New
bery, k.Sah and Stiglity,(1987); Burgress and Stern,(1993)the following special feature of
developing countries tax system are included:

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1. The dominance of primary sector.

2. Dualism−economic and social organizations in traditional activities; that are different from
these in the modern capitalist enterprises.

3. Segmentation in the labor market.

4. The fragmentation of capital market.

5. The relatively high share of the population in absolute poverty and the emerging deterioration
in income distribution.

6. Many small−scale enterprise.

7. Poor education levels.

8. The prevalence of trade distortion, particularly quotas.

9. A major role of planning, including extensive use of permits, licenses and rations.

10. A large public sector.

11. Extensive foreign ownership.

12. Weak administrative capability.

13. Pervasive corruption and

14. Subsistancial tax evasion.

2.2 empirical reviews

Teshome M 1986 derived an applied formula for progressivity of Ethiopian personal income
taxation, which has been by the public sectors, as well as by different organization throughout
the country i.e., ty−c=tax paid. Where t is marginal tax rate y is monthly gross income of
employee and c is some constant, which is derived from the tax progressivity characteristics of
personal income taxation can be captured by measures based on the tax laws themselves. The
producers he follows to drive the formula first by converting the tax laws in to equation system
and second by measuring the progressivity from this equations based on various notion of
progressivity.

Empirically Teshome Mulatu discovered that the slop of the average tax as income is increasing
suggesting a declining trend in the tax progressivity since the concept of average progression

8
measures tax progressivity from the average tax function slope. Teshome Mulatu also find that
between income intervals there is rising tax progressivity with income, while there is un
observed tendency for declining degree of tax progressivity as income increased within the same
group i.e. within each income classes.

Eshetu.C, (1984) sketched the pre 1974 income tax and presented the post −1974
development of income tax. He evaluated the recent income tax performance and examines
lingering problems. Eshetu discussed some problems related to agricultural income taxation.
Income below 600 birr has assessed and collected by the peasant association. This led as to
elements or regressively. Due to faulty administration. For income above 600 birr, responsibility
for tax collection results with the Inland Revenue Agency (IRA). Since this office is rarely
provided with accurate information on incomes, it is believed that the substantial revenue IS
forgone due to under reporting of incomes. Thus, problems of administration and implementation
end up on by frustrating the design of the law. Finally, he concludes that the structure of income
taxation remains basically unchanged, although it is relative contribution to revenue has
increased and some of it is progressive futures eliminated. He also noted that the Ethiopian
income taxation still conforms to the general pattern prevalent in most poor countries.

Teshome(1987)discussed the major development in reforming the personal income tax laws and
analyzes the important properties of the tax including its buoyancy, revenue
effectiveness(elasticity) and built in flexibility. Buoyancy of the personal income tax is measured
by the overall elasticity of the tax. Whereas built in flexibility of a tax system is measured by the
rate of differential income changes in a situation where taxes are invariant or covariant with
income (GDP). He used along linear dummy variable method to measure built−in –elasticity of
the system. Empirically he found that the tax system has been buoyant partly because frequent
revisions of the tax lows since 1944. For the period 1967−1984, he discovered the tax system has
been income elastic. He also found that with a built −in−elasticity coefficient of 6.3 computed
for that period, the personal income tax exhibits more elastic properties than other direct taxes in
Ethiopia fiscal system. He argued that this high tax elasticity raised the level of government’s tax
receipts significantly and automatically. He finally states that the high built−in−elasticity also
enhances the role of the tax in the field of economic stabilization.

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 CHAPTER THREE

Data analysis

3.1 Tax reform and its Objectives

Tax reform is needed when the existing tax system is deficient in achieving its objective revenue
adequacy, equity, administrative feasibility and efficiency.
Tax reform has played imperative role: - to raise government revenue so as to finance its
expenditure; to redistribute income; to encourage the production and distribution of socially
desirable goods and services and discourage those which are undesirable like cigarette, alcohol
drinks etc. It also helps to maintain macroeconomic stability and encourage saving and
investment. As a result of which governments have adopted specific tax systems that are in line
with the political and economic system of the country.

3.2 Major income tax reform in Ethiopia

Ethiopian tax collection has been transformed out of all recognition over the last century. The
first important tax reform carried out by emperor menilik toward the end of 19 th century. This
reform resulted in establishment of fixed title rather than undefined and essentially arbitrary
system of agricultural taxes. The second reform dates back to the early 20 th century. This tax was
largely resulted from the increasing prevalence of trade.(Befikadu D, 1999)

Later Ethiopia’s emerged as a modern state is the fruit of those reforms. They involved all
mechanisms of tax collection tax schedules, paper work and development of trained and
regularly paid civil service as well as the abolition of vexatious system of internal custom post.
Payment of income tax by individual and business was introduced by proclamation No; 60/1949.
This is one of the earliest taxes introduced by government, which has been subsequently revised
number of times. (Damirew getachew, june 2004)

The first major amendment on income taxation was made in 1961 and 1967. One of the main
features of 1967 amendment it is introduced schedule’ D ‘.

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Income tax proclamation No; 225/1967 was operating up to 1976. After the over throw of
imperial regime in 1974, the military government issued proclamation No; 77/1978, which was
farther amended by proclamation No; 144/1978. This proclamation has been replaced by a new
proclamation No; 30/1992 issued by transitional government of Ethiopia, this has been replaced
by proclamation NO: 107/1999 and latter by proclamation NO: 286/2002. Also the government
introduced new taxes: Rental tax, Urban Land Lease fee, and Capital Gain tax and interest
income tax in 1993/94, 1994/95, and 1997/98 and 2000/01 respectively to broaden the tax base.
(MOR,2003)

3.3 The impact of tax reform on income tax and GDP

The maximum income tax which was 85% on employment income and 89% on business profit
has been slash down consecutively after 1991 by Transitional Government of Ethiopia and latter
on by Federal Democratic Republic of Ethiopia to 50%, 40% and 35% by Proclamation No.
30/1992, 107/1999 and 286/2002 respectively. Similarly, Proclamation No. 62/1992, 107/1999
and 286/2002 has reduced business profit tax rate to 45%, 40% and 35% respectively. Profit tax
rate on corporate enterprises is 30% according to the new proclamation (No. 286/2002).

This shows that as compared to the high marginal rate of the proclamation 144/1978, the current
tax reform, which reduces the marginal tax rate to 35%, demonstrate the Government has made
quite a radical change in the tax system. The maximum employment income tax rate under the
proclamation 144/1978 85% was reached now 35% under proclamation 286/2002. It shows 59%
reduction. This reduction was has impact on GDP in two ways.

GDP is the amount of goods and service produced in a given country within a fiscal year. It has
various components includes government expenditure, private investment, consumption
expenditure and net export. Any changes which affect those components can affect the level of
GDP either directly or indirectly. The two most important types of tax schedule which are
expected to affect the level of GDP are employment income tax and business income tax.

Employment income tax is a tax rate which is imposed on individual employees. The higher the
rate of employment income tax rate the lower the disposable income and the lower consumption
expenditure, hence it reduce the level of GDP. The inverse is true if the rate of employment tax
rate is low.

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Other types of Tax schedule which affect the level of GDP is business income tax. Business tax
is tax rate imposed on business organization. It affects the level of GDP via affecting one of the
components of GDP, investment. The higher the rate of business tax the lower income after tax
of business organization and the lower capital hence the investors are discouraged for further
investment. But if the rate of business tax is lower the tax after income business organization
will rise and business organizations are encouraged for further investment which raises the level
of GDP. Therefore reduction in both employment and business tax resulted from tax reform
rises the levels of GDP via affecting consumption expenditure and privet investment respectively
which are the components of GDP.

The maximum business profit tax rate of proclamation 144/1978, 89% was decreased into 35%
under proclamation 286/2002, it shows 67% reduction. This reduction was encouraged the
business sector as a result of tax reduction the profit of businesses after tax was raised, this
motivate investors to invest more and the sector was showing growth.

As result of this motivation the general business income tax increased. Those increments are
analyzed under different tax schedules (under 3.4 tax structures).

3.4 Structure of income tax

Income in the Ethiopia tax structure is defined as every sort of economic benefit including non-
recurring gains in cash or in kind. On the other hand, taxable income is the amount of income
subjected to tax after deduction of all expenses and other deductable items.

According to the proclamation no.286/2002 of Ethiopia taxable income include the following
elements:

1. Income from employment.

2. Income from business activity.

3. Income derived by entertainer, musician or sports man.

4. Income from entrepreneurial activities carried on by a non-resident through a permanent

establishment in Ethiopia.

5. Income from movable properties.

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6. Dividends distributed by resident company.

7. Profit shares paid by resident registered in partnership.

8. Interest paid by different economic entities.

9. License fee and royalties paid through permanent establishment that maintained in Ethiopia.

Ethiopian stricture of income tax is scheduler, there for, the above all taxable income are
categorized under the following four schedules:

1. Schedule A, income from employment.

2. Schedule B, income from rental from building.
3. Schedule C, income from business but not include activities covered by the rural land use
fee and agricultural activates.
4. Schedule D, other incomes include in income from :

4.1 Royalties.
4.2 Income paid for service render outside Ethiopia.
4.3 Income from game of chance.
4.4 Dividends.
4.5 income from causal rental of property
4.6 interest income
4.7 Specified non business capital gain.
In this chapter the researcher want to show each schedule clerically including the rates and
exempted level of income using appropriate tables. Moreover the researcher collected ten years
data based on this schedule from national bank of Ethiopia.
Each schedules corresponding to the available data are treated separately in the following
subsequent section.

3.4.1 Schedule A: income from employment

According to article 11 of proclamation No 286/2002 each person driven income from
employment is liable to pay tax at a rate specified in schedule A.

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Table 3.1 schedule A
Employment income from month Tax rate

Over birr To birr

0 150 Exempted
151 650 10%
651 1400 15%
1401 2350 20%
2351 3550 25%
3551 5000 30%
Over 5000 35%

Source: Neagarit Gazeta (2002)

As it’s shown in the above table the first 150 birr of employment income in exempted from
employment tax. The smallest personal income tax is started on monthly income of 151 birr at a
rate of 10% and culminated at 35% of monthly income over birr 5000. The range between those
subsequent taxes rates are 5%.
Employers have obligation to withhold the tax from each payment to employees, and to pay tax
authority the amount withhold during each calendar month. In calculating the tax collected
month of Nehassie and Pagumen should be aggregated and treated as the income of one month.

The following categories of income are exempted from employment tax:

1. Incomes from employment received by causal employees who are not regularly
employed, i.e. workers who do not work more than one month for the same employees in
any twelve months are exempted.
2. Pension contribution, provident funds and all form of retirement benefits, which are less
than 15% of employee’s income.
3. Income subjected to reciprocity, income from employment received for services rendered
in the exercise of their duties by:
i, diplomatic and consular representatives
ii, other person employed in embassy, legation and consulate.
4. Income specifically exempted from income tax by any law in Ethiopia, international
treaty or an arrangement made or proved by the ministers.

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 5. Payment to a person as a compensation or a gratitude in relation to:
i, personal injuries suffered by the person.
ii, the death of another person.

Table 3.2: personal income tax as a percentage of other sources of government

revenue (In millions)
Year Personal income Growth rate of Share in Share in total Share in total
tax personal income income and tax revenue government
tax profit tax revenue
2004/05 1132.0 31.71 9.13 7.26
2005/06 1414.0 24.91 37.36 10.01 7.23
2006/07 1828.1 29.27 37.55 10.53 8.38
2007/08 2667.4 45.91 40.24 11.20 8.95
2008/09 3529.62 32.32 38.00 12.17 8.78
2009/10 4390.9 24.40 31.3 10.14 8.15
2010/11 5733.39 30.58 30.48 9.72 8.29
2011/12 8900.24 55.24 31.93 10.38 8.65
2012/13 9.32
11567.0 29.96 32.72 10.80
2013/14 13796.17 19.27 30.18 10.36
9.43
Average 5495.88 32.42 34.14 10.44
8.44
Source: National bank of Ethiopia

In terms of revenue generation personal income tax is one of the major sources of income and
profit tax next to business income tax. It was also the earliest tax which is introduced in Ethiopia
next to land tax. Employment tax was levied annually by the proclamation No 107/1949. Since
1956 the government amended the above lows and introduced monthly income tax by
proclamation 19/1956.
In absolute magnitude, personal income tax revenue continued to grow from birr 1132million to
13796.17 million between the periods of 2004/05and 2013/14 respectively. Although personal
income tax has show a continuous growth rate, specially in 2007/08 and 2011/12 .also it has
shown a dramatic decline in relative terms during the years 2009/10and 2013/14.
On average the Ethiopian government has collected 5495.88 million birr yearly within the above
stated 10 years from this source. Also this source was growing on average 32.42 percent through
those stated years.

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As component of other government revenues, personal income tax contributes more to income
and profit tax revenue but to lowest share of total government revenue.
In years 2007/08 and 2008/09 the share of personal income tax highly incised in all kinds of
other government revenues except share in total government revenue, but after these two years
the share of personal income tax in income and profit taxes was declined by more than 7% for
the five successive years. This decline in share of personal income tax was because of the
introduction of different types income and profit taxes. The share of in total tax revenue also
decreased starting from 2009/10 to 2013/14 by more than 1%, because of as the introduction of
different indirect taxes. However, during these years after it has shown that its share in direct
income tax decreased and total government revenue increased.
Among the data available the maximum share personal income tax revenue in total government
revenue was recorded in year 2012/13 and 2013/14. In this year its share in total government
revenue was 9.32 and 9.43 percent respectively. On the other hand, the lowest share of personal
income tax in total government revenues was recorded in 2005/06 when its share was 7.23
percent.
On average, 34.14 percent of direct income tax revenue, 10.44 percent of total tax revenue and
8.44 percent of total government revenue was collected from this source.

3.4.2 Schedule B, income from rental of building

The tax levied on income from rental of building charged, levied and collected at the following
rates.
a) On income of bodies(corporate) 30% of taxable income
b) On income of persons according to schedule B.

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 Table 3.3 .schedule B

Taxable income from rental Tax rate

per year
Over birr To birr
0 1800 Exempted threshold
1801 7800 10%
7801 16800 15%
16801 28200 20%
28201 42600 25%
42601 60000 30%
Over 60000 35%
Source: Negarit gazeta(2002)

Similar to personal income tax rental income tax rate starts from 10% and culminated at 35% of
taxable income. However, even if the tax rates and income brackets are the same the application
of these two types of income taxes is different. Rental income tax exempt incomes below birr
1801 and it’s levied on annual taxable income. The breadth of income brackets in this tax is
wider than that of personal income tax. The maximum tax rates are imposed on incomes that are
above birr 60000.

Table 3.4 rental income taxes as share of other government revenues.

(in million)

Year Rental Growth Share in Share in total Share in total

income rate income and tax revenue government
tax profit taxes revenue
2004/05 78.00 2.185 0.629 0.500
2005/06 31.70 -59.359 0.829 0.223 0.162
2006/07 26.00 -17.981 0.534 0.149 0.119
2007/08 54.00 107.692 0.814 0.226 0.181
2008/09 85.19 57.759 0.917 0.293 0.212
2009/10 142.04 66.733 1.012 0.327 0.263
2010/11 276.91 94.956 1.472 0.469 0.400
2011/12 393.22 42.002 1.410 0.458 0.382
2012/13 617.59 57.057 1.746 0.577 0.497
2013/14 755.64 22.352 1.653 0.567 0.516
Average 246.030 41.245 1.257 0.392 0.323
Source: National bank of Ethiopia

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Based on the above data this source has registering the continuous growth from year to year after
2007/08. But Compared to other taxes rental income tax generates lowest revenue. Beyond low
contribution, this source was showed negative growth rate for two years. The years 2005/06 and
2006/07, the registered growth rate was -59.359 and -17.981 percent respectively.

Starting From 2005/06 for the successive four years the share of rental income tax in income and
profit tax was bellow one percent, Then it has shown increase in its share starting from the year
2009/10 to 2013/14 continuously above one percent.

As is shown the above table the maximum rental income tax was collected in year 2013/14, and
the lowest rental income tax was collected in year 2006/07, However, after dramatically declined
in 2005/06 the share as component of other government revenues peaked up in year 2012/13
except share in total government revenue. It was 1.746 percent share in income and profit tax
and 0.577 percent share in total tax revenue.

On average the government of FDRE has collected 246.030 million birr per year for the last 10
years from rental income tax. The average contribution of rental income tax to income and profit
tax was 1.257 percent. But on average its contribution to total tax revenue and total government
revenue was 0.392 and 0.323 percent respectively (it’s less than 0.5 percent). As shown in the
above table the income tax collected from this source is minimum, rental income tax is less
important compared to other income tax sources in terms of revenue generating.

3.4.3 Schedule c: business income tax

Taxable business income determines per tax period on the basis of profit and loss account or
income statement.This income statement drawn in compliance with the generally accepted
accounting standards subject to the provision of proclamation No.286 /2002 and the directives
issued by the tax authority.

Business income tax differentiates the rates between bodies and persons. For business income of
bodies this law imposed 30% tax on the taxable business income. On the other hand, taxable
income of other taxpayers taxed in accordance with the following Schedule C.

18
Table 3.5 Effective rate of Business income tax

Taxable business income (per year) Tax rate

Over birr To birr
0 1800 Exempt threshold
1801 7800 10%
7801 16800 15%
16801 28200 20%
28201 42600 25%
42601 60000 30%
Over 60000 35%
Source: Negarit gazeta (2002)

Business income tax schedule has the tax rate breadth of the taxable income bracket as the rental
income tax. In both cases the taxable income bracket are six and the rate are started at 10 percent
on annual income of birr 1801 and culminated at a rate of 35 percent on annual income above
birr 60000. Business income tax had exempted incomes that are below birr 1801.

In determination of business income subject to tax deduction would be allowed for expenses,
and maintaining that business income, therefore, the following expenses are deducted from gross
income in calculation of taxable income:

1. Direct cost of production the income, such as the direct cost of manufacturing
,purchasing, importation, selling and such other similar costs:
2. General and administration expenses connected with the business activity:
3. Premiums payable on insurance directly connected with business activity:
4. Expenses incurred in connection with promotion of the business inside and outside the
country:
5. Commissions paid for services rendered to the business.

Table 3.6: Business income tax as a promotion of other government revenue (in million)

Year Business income Growth rate Share in Share in total Share in total

19
 tax of business income and tax revenue government
income tax profit tax revenue
2004/05 1714.0 48.024 13.825 10.992
2005/06 1741.43 1.600 45.588 12.299 8.916
2006/07 2305.0 32.362 47.345 13.282 10.574
2007/08 3040.4 31.904 45.872 12.773 10.204
2008/09 4326.55 42.302 46.583 14.920 10.769
2009/10 7391.1 70.831 52.691 17.063 13.722
2010/11 10055.2 36.044 53.458 17.048 14.547
2011/12 15539.97 54.546 55.744 18.124 15.107
2012/13 19437.13 25.078 54.977 18.163 15.665
2013/14 26909.98 38.446 58.872 20.215 18.409
Average 9246.077 37.012 50.915 15.771 12.891
Source: National bank of Ethiopia

Business income tax is the major source of direct taxes and total tax revenue. In all cases it
contributed more than 45 percent of income and profit tax revenue.

In absolute terms business income tax revenue contributed to grow from birr 1714.0 million to
birr 26909.98 million during the period between 2004/05 and 2013/14. This source registered
comparatively the lowest share in other government revenue including sharing in total
government revenue is in the year 2005/06. In this year the share of business income tax share in
income and profit tax revenue, share in total tax revenue and share in total government revenue
was 45.588 percent, 12.299 percent and 8.916 percent respectively. In a year 2006/07 this tax
revenue has increased with a growth rate of 32.362 percent. The growth rate continued until the
year 2013/14. The maximum growth rate registered in 2009/10, which is 70.831 percent. But,
after this year decrease and same year increase at increasing rate. On average, the FDRE
government has collected 9246.077 million birr from this source yearly for the last 10 years
based on the above available data.

Generally Share of business income tax in income and profit tax, share in total tax revenue and
total government revenue changed regularly in increasing rate. According to the above data, the
maximum contribution of business income tax to income and profit tax, total tax revenue, and
total government revenue was recorded in year 2013/14 at a rate of 58.872 percent, 20.215
percent and 18.409 respectively.

20
On average 50.915 percent of income and profit tax, 15.771 percent of total tax revenue, and
12.891 percent of total government revenue was collected from this source for the last decade.

As component of other government revenue this tax sources contributes more too all types of
government revenue relative to other direct income tax sources. Unlike other income tax revenue
business income tax did not show negative growth rate.

3.4.4 SCHEDULE D

Since December 2002, the FDRE changed this tax schedule to apply for other income tax instead
of agricultural income tax. But as to show the tax rate of agricultural income tax it is given away
below.

3.3.4.1 Agricultural income tax

Income from agricultural activities is taxed based on the following table (table 3.7.).

Table 3.7: Effective rate of agricultural income tax

Taxable agricultural income(per year) Tax rate

Over birr To birr
0 1200 Birr 15
1201 5000 5%
5001 15000 10%
15001 30000 20%
30001 50000 30%
Over 50000 40%
Source: Negarit gazeta (2002)

A state farm should pay 40% of the taxable income it realizes from its agricultural activities.

Agricultural income tax does not exempt any level of income and the rate of such taxes highly
progressive.

Table 3.8 agricultural income tax as promotion of other government revenue (in million)

Agriculture growth rate share in income share in total tax share in total
Year Income tax of and profit tax revenue government
agricultural revenue
income tax
2004/05 150.0 4.202 1.209 0.962

21
 2005/06 82.0 -45.333 2.146 0.579 0.419
2006/07 98.41 20.012 2.021 0.567 0.451
2007/08 136.0 38.197 2.051 0.571 0.456
2008/09 246.16 81.0 2.650 0.848 0.612
2009/10 388.88 57.978 2.772 0.897 0.722
2010/11 311.325 -19.943 1.655 0.527 0.450
2011/12 322.453 3.574 1.156 0.376 0.313
2012/13 365.265 13.276 1.033 0.341 0.294
2013/14 306.30 -16.143 0.670 0.230 0.209
Average 240.679 14.735 2.036 0.614 0.489
Source: National bank of Ethiopia

Unlike other income taxes agricultural income tax fluctuated frequently in its growth rate, in its
share in other taxes and in its share in total government revenue. Because of this sector is more
dependent on climate change, seasonal change and etc. When we compare to other income taxes
in share to income and profit tax, in share of total tax revenue and in share of total government
revenue agricultural income tax has the second lowest share holder next to rental income tax
revenue.

Based on the above data this source has registering different negative growth rate in different
years. The years was 2005/06, 2010/11 and 2013/14. The registered growth rate was -45.333
percent, -19.943 percent and -16.143 percent respectively. In the year 2004/05 from this sector the
FDRE government income tax collected 150 million birr. , however, this number is not big when
we compared to the next many successive years; it was the most large percent of share in other
government revenue was registered. Its share in income and profit tax, share in total tax revenue
and share in total government revenue was 4.202 percent, 1.209 percent and 0.962 percent
respectively. Starting from 2005/06 to 2013/14 for the successive nine years the share of
agricultural income tax in total tax revenue was bellow one percent and persistently decreasing.

As shown in the above table the maximum agricultural income tax was collected in year 2009/10
388.88 million birr. Also in this year was the year of the high growth rate was registered, it was
57.978 percent. The lowest agricultural income tax was collected in year 2005/06. Through all
over this 10 years the share of agricultural income tax in total government revenue was bellow
one.

On average the government of FDRE has collected 240.679 million birr per year for the last 10
years from this source. The average contribution of agricultural income tax to income and profit

22
tax was 2.036 percent. But on average its contribution to total tax revenue and total government
revenue was 0.614 and 0.489 percent respectively, (it’s less than 1 percent). As shown in the
above table similar to rental income tax the income tax collected from this source is minimum,
agricultural income tax is also less important compared to other income tax sources in terms of
revenue generating.

3.4.4.2 Other income tax

Starting from 2002/03 schedule D of income tax is applied for other income which is started in
the introductory part of this chapter. Other income tax is applied based on table 3.8.

Table 3.9 Effective rate of other income tax

Types of income Tax rate

Royalties 5%

Income from rendering of technical service 10%

Income from game of > Birr 1000 15%

Dividends 10%

Income from rental of property 15%

Interest income on deposits 5%

Gain on transfer of certain investment For building 15%

property
For share company: 30%
Source: Negarit gazeta(2002)

Table 3.10 chance, dividend and other income taxes as promotion of other government
revenue (in million)

Chance share in income and share in total tax share in total

Years winning & profit tax revenue government revenue
dividend &
others income
tax
2004/05 37.0 1.036 0.298 0.237

23
 2005/06 29.29 0.766 0.206 0.149
2006/07 110.0 2.259 0.633 0.504
2007/08 148.4 2.238 0.623 0.498
2008/09 248.31 2.673 0.856 0.618
2009/10 382.0 2.723 0.881 0.709
2010/11 386.0 2.052 0.654 0.558
2011/12 1100.0 3.945 1.282 1.069
2012/13 1223.1 3.459 1.142 0.985
2013/14 1665.05 3.642 1.250 1.139
Average 532.915 2.479 0.783 0.647
Source; National bank of Ethiopia

According to the above data this source has encountered the continuous growth from year to year
after 2006/07. But Compared to other taxes other income tax generates lowest revenue. Starting
From 2004/05 for the successive seven years the share of other income tax in total tax revenue
and share in total government revenue was bellow one percent, Then it has shown increase in its
share starting from the year 2011/12 to 2013/14 continuously above one percent the share of total
tax but in case of share in total government revenue still its fluctuating below and above one
percent.

As is shown the above table the maximum other income tax was collected in year 2013/14, and
the lowest other income tax was collected in year 2005/06, However, after declined in 2005/06
other income tax revenue peaked up immediately in year 2006/07 then continuously increased up
to year 2013/14 .

On average the government of FDRE has collected 532.915 million birr per year for the last
decade. The average contribution of other income tax to income and profit tax is 2.479 percent.
But on average its contribution to total tax revenue and total government revenue is 0.783 and
0.647 percent respectively (it’s less than 1 percent). As shown in the above table the income tax
collected from this source is Minimum. Other income tax is also less important as rental income
tax and agricultural income tax compared to other income tax sources in terms of revenue
generating.

3.5 Contribution of Income tax to GDP

24
Taxation contributes to the gross domestic product in different ways one of these ways is through
increasing government revenue and its expenditure. When the government increase his revenue
to increase its expenditures by increasing the levels of tax rates the increment in its revenue
directly affect the level of investments since investments is the component of gross domestic
products.

Generally all the above direct income tax elements which categorized in different schedules
however there is inefficiency in terms of income generation, there is undeniable truth is as they
have contribution to the general government revenue and to the real GDP as well as to the
economy. For instance in 2004/05 the FDRE government encountered 248355.00 million birr as
real GDP. From this number Ethiopian government collected 3111.0 million birr from direct
income tax revenue which is 1.25 percent of GDP. This number was increased in the successive
year Into 3298.00 million birr which covers 1.19 percent of real GDP. This progress continued
tile the most recent year 2013/14, 43405.64 million birr with covering 6.92 percent of GDP.
More explanation is illustrated in the following chart;

25
 chart 3.1 share of Government revenue, tax revenue and income
tax revenue per GDP
25
23.33
22.3

20.27
20 19.23

16.9
16.19
14.83
15
share of income tax/GDP
12.86 12.65 share of government revenu/GDP
share of tax revenu/GDP
10.6 10.34
10
8.65
7.65
7.05 7.04 6.91 6.93
6.28
5.6 5.75
4.99 5.11 4.96
5
3.51
3.03
2.23
1.41 1.76
1.25 1.19

0
5

4
/0

/0

/0

/1

/1

/1
/0

/0

/1

/1
04

05

06

07

08

09

10

11

12

13
20

20

20

20

20

20
20

20

20

20

Source: National bank of Ethiopia

As it’s shown in the above chart there is reliable growth share of income tax per GDP, share of
government revenue per GDP and share of tax revenue per GDP. The growth in income tax
revenue increase the amount of total tax revenue, because of direct income tax is one the
elements of tax. These increments positively affect the gross tax revenue. The increment in total
tax revenue increase the amount of total government revenue, this gives to the government
enough money to expend on public goods and infrastructures which can stimulates and affect as
the whole the economy.

26
3.6 The Effect of Income Tax on National Economy
In line with Dalton, the effect of taxation on production and growth or on gross domestic product
(GDP) may be analyzed with reference to capacity to work, save and invest and the will to work,
save and invest. An alternative of analyzing this effect would be to split the up to shift in
allocation of existing productive resources and a change in the supply of these productive
resources and use them up as manifestation of the capacity to work, save and invest.(H.L
Bhatia,2008)

Given the fact that there will be financial institution and mechanism for collecting the
community’s saving and bringing them to investors, then level and pattern of investments will be
influenced by the taxation in the country. This is because the investors are basically interested in
making profits and profitability of investments can be affected through various tax measures.
(H.L. Bhatia, 2008)

Since there are various types of taxation measures in different countries income tax is one type of
these taxation measures. Like positive contribution of taxation to GDP it also affects the GDP
negatively. When we see the impact of income tax on GDP it affects the GDP through the level
of saving. If there is high rate of tax on income tax there will be high reduction on income from
the households and business man this also leads to reduction on saving and directly affect the
level of saving and then GDP of a country. This is because of the relationship between saving
and investments.

27
 CHAPTER FOUR

CONCLUSION AND RECOMMENDATION

4.1 CONCLUSION

The Ethiopian tax reforms reduced in both employment and business tax resulted from tax
reform rises the levels of GDP via affecting consumption expenditure and privet investment
respectively which are the components of GDP.

As Ethiopian tax structure follows schedule system of taxation, taxes collected under income tax
are recorded separately in the different four schedules. Schedule ‘A’ includes personal income
tax; schedule ‘B’ includes rental income tax; schedule ‘C’ includes business income tax and
schedule ‘D’ includes other income tax.

In terms of revenue generation personal income tax is one of the major sources of income and
profit tax next to business income tax. Business income tax contributes more to income tax
revenue followed by personal income tax. On the contrary, the contribution of rental income tax
was insignificant. In the last 10 years, business income tax has shown a growth of 37.012 percent
on average. However, this growth rate of business income tax is low compared to its absolute
contribution to income tax. Because no tax payers can shift his tax burden in the case of income
tax, the government collects the appropriate revenue from this source without any distortion. In
Ethiopia there is a progress in recent periods in income tax collection. Even though many
changes had shown in Ethiopian tax structure, it does not reach the expected efficiency level
compared to other developing countries in the past few years. But in recent years there is a
progress in the line of efficiency Ethiopian tax structure.

Generally all direct income tax elements are categorized in different schedules however, there is
inefficiency in terms of income generation, there is undeniable truth is as they have contribution
to the general government revenue and to the real GDP as well as to the economy. The growth in
income tax revenue increase the amount of total tax revenue, because of direct income tax is
from the elements of tax. These increments positively affect the gross tax revenue. The
increment in total tax revenue increase the amount of total government revenue, this gives to the
government enough money to expend on public goods and infrastructures which can stimulates
and affect as the whole the economy.

Since, taxes are the sources of government revenue and important to the growth of national
economy, they have also their own impacts on the national gross domestic products or national
economy. Income Tax may positively affect the GDP through increasing government
expenditure and also investment, on the other hand taxation affect a country GDP negatively by
lowering the level of saving since saving and investments are interdependent.

28
4.2 Recommendations
The following recommendations are in order to take the problems and income tax is able to
contribute its potential revenue;

 The government should reform income tax yet again to promote economic development
and for further encouragement investment and other economic activity.
 The tax should be simple and understandable to the taxpaying and collective bodies.
 Tax authorities should improve the administration system at federal as well as regional
level and establish the new technology,
 The government should spend the revenues raised from tax effectively and to productive
areas, which benefits the tax payers directly or indirectly. These initiates the people to
fulfill their responsibility that is declare their income and pay tax. At the same time this
action helps to reduce the evasion problem.
 Capture all people who are not exempted by the tax law in order to avoid discriminate
among them and to reduce inequality of income that arises by taxing one but not others.

These are general recommendations proposed to improve the whole tax system in the country
since income tax is part and parcel of the general tax system, it can be improved through the
implementation of these recommendations.

29
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Befikadu Degfe and Berhanu Negga,(1999), annual report of Ethiopian economy

Burgress and stern,(1993) taxation and development

Demirew Getachew (June 2004), tax reform in Ethiopia and progress to date.

Due J.F, (1959), Government and public finance

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Federal Inland Revenue Authority of Ethiopia, (February, 2006)

Federal Negarit gazeta 8th year NO: 34 ADDIS ABEBA-4th July, (2002), proclamation NO:
286/2002

H.L.Bhatia, 2008, Public Finance

Jones and Roads,(2009) , under development and taxation in lower developed countries

Musgrave R,(1987), Tax reform in developing countries

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New berry, K, Sah and Stiglity,(1987),taxation and the burden of economic development

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31