INTRODUCTION TO TAXATION

I GENERAL PRINICPLES OF TAXATION

American Institute of Certified Public Accountants (AICPA) lays out ten principles of
good tax policy that had been used by lawmakers and others for decades, if not
centuries. The ten principles include:
Equity and Fairness - Similarly situated taxpayers should be taxed similarly.
Certainty - The tax rules should clearly specify when the tax is to be paid, how it is to
be paid, and how the amount to be paid is to be determined.
Convenience of Payment - A tax should be due at a time or in a manner that is most
likely to be convenient for the taxpayer.
Economy in Collection - The costs to collect a tax should be kept to a minimum for
both the government and taxpayers.
Simplicity - The tax law should be simple so that taxpayers can understand the rules
and comply with them correctly and in a cost-efficient manner.
Neutrality - The effect of the tax law on a taxpayer’s decisions as to how to carry out a
particular transaction or whether to engage in a transaction should be kept to a
minimum.
Economic Growth and Efficiency - The tax system should not impede or reduce the
productive capacity of the economy.
Transparency and Visibility - Taxpayers should know that a tax exists and how and
when it is imposed upon them and others.
Minimum Tax Gap - tax should be structured to minimize non-compliance.
Appropriate Government Revenues – The tax system should enable the government
to determine how much tax revenue will likely be collected and when.

In 2001, the Tax Policy Group of Joint Venture: Silicon Valley Network turned the
AICPA’s 10 principles into a workbook to help elected officials and others in
applying the 10 principles to analyze tax proposals. In doing so, they reorganized the 10
principles into three categories as follows:
Fairness
Equity and Fairness
Transparency
Operability
Certainty
Convenience of Payment
Economy of Collection
Simplicity
Minimum Tax Gap
Appropriate Government Revenues
Appropriate Purpose and Goals
Neutrality
Economic Growth and Efficiency
Analysts generally judge tax systems in terms of how well the tax system answers four
different questions.
First, does the tax system promote or hinder economic efficiency. That is, to what extent
does the tax system distort taxpayer behavior? Does the tax system create a bias
against the domestic production of goods and services? To what extent does it promote
economic growth?
Second, is the tax system fair? Does the tax system treat similarly situated individuals
similarly? Does the tax system account for individuals ’ different capacities to bear the
burden of taxation?
Third, is the tax system simple? Is it costly for taxpayers to determine their tax liability
and file their taxes?
Fourth, can the tax system be easily administered by the government and can it induce
compliance by all individuals? Is enforcement costly? Can some individuals successfully
avoid their legal liabilities?

The design of a tax system involves tradeoffs between these different goals. Measures
designed to ensure compliance may increase the complexity of taxation for individual
filers. Measures designed to promote simplicity may create distortions in individual
choice of investments. Measures designed to promote growth may alter the distribution
of the tax burden.”
“Long-standing” criteria for evaluating tax policy:
1. Equity – including principles of: i. Ability to pay-ii. Horizontal equity iii. Vertical equity
iv. Benefits received
2. Economic Efficiency a. Efficiency costs include (1) taxes owed, (2) “efficiency cost ”
(costs that reduce wellbeing – effect of taxes on decisions to do or not to do something),
(3) compliance costs.
4. Combination of simplicity, transparency, and administrability
a. Simplicity: i. Compliance burden
b. Transparency of i. Tax calculations ii. Logic behind the rules iii. Tax burden iv.
Compliance
c. Administrability i. Processing returns ii. Enforcing the law iii. Providing taxpayer
assistance

A good tax system may be judged by the following criteria:-

i) Its effect on the supply and allocation of resources

ii) Its effect on the distribution of income and employment
iii) Its effect on the stability and growth of aggregate income and employment
iv) Administrative efficiency, and convenience of the taxpayers.

Unfortunately a tax which is good in one direction is often poor in another, so that in
practice tax systems tend to be a compromise between these economic and social
objectives, and incorporate a combination of various forms of taxation.

The supply and allocation of resources

The first criterion involves not only the supply of resources in the economy – labour,
enterprise, and capital – but also how they are used. The imposition of a specific tax on
a commodity could affect not its price, but the amount producers are willing to supply.
Different types of taxes on income as well as on goods may disturb supply and lead to a
reshuffling of existing resources. In poor countries, especially, particular attention has to
be paid to the disincentive effects of various taxes on labour ’s willingness to work, or on
the voluntary supply of savings and enterprise.

The principle of equity or fairness

A good tax system should not offend popular notions of fair play or equality of treatment
before the law. There should be horizontal equity or “like treatment of equals ” with the
same level of income and circumstances. This is easier said than achieved, quite apart
from deliberate evasion of taxes by payers or discrimination by tax collectors, however,
since if is often easier for certain groups to avoid taxes legally by claiming allowances or
special concessions not available to other groups with the same income. An even more
difficult problem is vertical equity among people with different levels of income. One
approach to this problem is to base taxes on the benefit principle so that taxpayers who
benefit from a particular service are charged accordingly for its cost, and thus pay a
sum of taxes proportionate to the benefits received. Although this benefit principle is
applicable to divisible goods like school places or, indirectly, to road facilities financed
by vehicle licenses and taxes on petrol, it is clearly less equitable in financing indivisible
goods like defence or public health where benefits cannot be priced in a market by
excluding citizens unwilling or unable to pay. The basis of financing these collective
goods must therefore be one of ability to pay. This principle might support a notion of
vertical equity produced by making taxation proportional to income, as that everyone
paid the same income pay the same percentage as taxes. Nowadays, however, the
principle of ability to pay or ‘equal sacrifice ’ of income is interpreted to support a system
of progressive taxation, the theory being that taxpayers with high incomes and much
wealth sacrifice less utility than poorer taxpayers. Thus by levying more tax on the rich
than the poor, the total sacrifice for the community as a whole will be smaller than under
a system of proportional taxation.

In most countries today, the criterion of equity in taxation requires the system as a
whole to produce a distribution of income after tax which is as equal as possible. The
income which is compared should take account of the benefits arising out of the
Government’s expenditure out of taxation. Secondly, in considering the desirability of a
more equal distribution of income, we need to take account of possible adverse
economic effects arising out of increased taxes. If there are serious disincentive effects
on work and enterprise (though the importance of these is often exaggerated), poor
countries, especially, may be restricted in using taxation to move towards a more even
distribution of income, and of income yielding wealth. Taxes may also affect the
distribution of income among factors of production and income groups indirectly, it
should be noted, by changing the relative prices of factors and goods.

Nevertheless, one of the aims of taxation is to effect a redistribution of income and

wealth by taxing the rich more heavily than the poor. In this connection an important
distinction is made between the proportional, progressive, and regressive taxes. If we
define the average rate of tax as the value of amount paid in tax by the taxpayer divided
by his income, then we can say that a particular form of tax is either proportional,
progressive or otherwise irrespective of the size of income of the individual on which it is
imposed. If the average rate of tax increases with income, the tax is said to be
progressive, and if it decreases the tax is regressive. It must be stressed that in each
case we are not referring to the absolute amount of tax paid, but to the proportion of
income paid out in tax.

Equity versus incentives

The effect of taxation on the willingness to work as just discussed on the marginal rate
of tax, rather than the average as such. If an individual is in doubt as to whether it is
worth his while working a little longer or not, it is the rate of tax on the income due to an
extra hour’s work that will concern him. In the case of a poll tax, for example, since the
total tax paid is the same irrespective of income, the marginal rate of tax is zero. It is for
this reason that there is no substitution effect in favour of leisure in the case of a poll
tax. We defined a progressive tax as one in which the average rate of tax increases with
income. It follows that if the average is increasing the marginal rate of tax will be
increasing even faster. This compares with a proportional tax in which the average, and
therefore the marginal, rates of tax are constant. The progressive tax, which has the
greatest redistributive effect on income, will thus have the greatest disincentive effects
on the supply of effort. Moreover the greater the degree of progression, the more rapidly
will the marginal rate of tax increase, and the more the damaging will be the effect on
the supply of labour and effort. The two objectives of an egalitarian distribution of
income and maximum incentives to work therefore clash head on.

It is, of course, not only a direct tax which has these incentive effects. Obviously, it
makes little difference to the desire to work if proceeds are taxed when they are earned,
or when they are spent. For a man who spends all his income, if the amount of tax paid
is the same in both cases, it will make no difference whether the tax is paid directly or
indirectly. As we shall see in a moment, a system of indirect taxes can be made just as
progressive as any direct tax system. There is one qualification to be made here: an
individual may not realize he is paying the same amount of tax when it is hidden in the
prices of the things he buys than when he finds it missing from his pay envelope. To
that extent he may work with more enthusiasm than in the latter case.

So far we have mentioned only the effects of a high marginal rate of tax on the supply of
labour. There will, however be wider effects on incentives. In the first place the supply of
‘labour’ should be interpreted as the supply of effort in general, including the effort put in
by salaried workers and especially by entrepreneurs. Associated with this will be, for
example, the specific discouragement of risk taking by entrepreneurs and investors. If
the tax structure is progressive, it means that if a project is much more successful than
the average, the Government will take a comparatively large chuck of the extra
proceeds, while if it falls well short of the average, the firm ’s tax liability is reduced, but
not so much. The effect is as if the Government were more willing to share in the
proceeds of a good outcome than in the disappointing proceeds or actual losses of a
bad outcome. The preference of investors for the safer ‘average ’ project over riskier
ones carrying an equal possibility of a very good or very bad result may thus be
increased. This tendency will apply also in agriculture. Farmers might be encouraged,
for instance, to plant safer crops, including subsistence crops for self-consumption, in
preference to higher priced export crops, the income of which may fluctuate more
widely.
II. TAXABLE CAPACITY

Taxable Capacity means the capacity of individuals to pay to the Government. This term
may be used in two meanings:-

i) Absolute Taxable Capacity

ii) Relative Taxable Capacity

Absolute Taxable Capacity is determined by deducting the minimum amounts which are
needed to keep individuals alive from their total incomes. It is not possible to achieve
because the objective of the Government is not to maximize its income. Relative taxable
capacity is that limit beyond which the additional taxation would produce economically
harmful results and outweight the gain to the community from the use of the money
raised by taxation. Relative taxable capacity is more realistic view.

The concept of taxable capacity has racked the brains of not a few economists and
publicist. Dalton calls it” a dim and confessed conception ”. He says, “ Absolute taxable
capacity is a myth and should be banished from all serious discussions on Public
Finance.” Findlay Shirras, on the hand, thinks that it is of great practical importance. “ It
is even roughly the limit that the country can contribute by the way of taxation both in
the ordinary and extra-ordinary circumstances”.

Taxable Capacity depends on the ability of people to pay and the ability of the
Government to collect. The ability to pay taxes mainly depends on per capital income or
possible per capital income in excess of the subsistence level. The ability of the
Government to collect taxes depends largely on administrative effectiveness as
determined by the number, skills and dedication of the revenue staff and co-operation of
the taxpayers as influenced by social and political attitudes.

FACTORS AFFECTING TAXABLE CAPACITY

The fact that the taxable capacity is not rigidly fixed, it is a moving point. It is relative to
so many factors that any change in any of them is bound to change the estimate of the
taxable capacity of a nation. Findlay Shirras ’ gives the following factors which determine
the taxable capacity of a nation.

1. Number of Inhabitants
It is quite obvious that the larger the number, the greater is the taxable capacity of the
community to contribute towards the expenses of the Government. From this point of
view Kenya is well placed as its taxable capacity will infinitely increase when the proper
economic development of the country is brought about and the population increases.

2. Distribution of Wealth
If wealth is more equally distributed, the taxable capacity will be correspondingly
reduced. But if there are large accumulations of wealth in a few hands, the Government
can raise more money by taxing the rich.

3. Method of Taxation
A scientifically constructed tax system with a wise mixture of various types of taxes,
direct and indirect, is sure to bring in a larger yield. Our tax system is not so much
diversified e.g. we have no taxes on large agricultural incomes. This certainly reduces
the tax capacity.

4. Purpose of Taxation
If the purpose of taxation is to promote welfare of the people, they will be more willing to
pay tax themselves. For a popular cause, the people will be willing to stretch their
capacity to the utmost. If the Government proceeds to raise money for fighting famine,
disease or spread of education there will be a surprising expansion in the yields of
taxes. But if the bulk of the public funds is to be spent on the maintenance of armed
forces and for the upkeep of a costly civil service, the taxable capacity is likely to
correspondingly shrink.

5. Psychology of Tax Payers

Much depends on the people’s attitude toward Government. A popular Government can
stimulate the spirit of the people and prepare them for a greater sacrifice. An appeal to
patriotism is often the cause of the success of fiscal measure. This is what makes war
loan successful. Psychology of the people is an important factor, and unless they are
properly approached, they may be unwilling to take themselves.

6. Stability of Income
If the income of the citizens is uncertain, there will be not much scope for further
taxation. It is only on stable incomes that long term financial arrangements can be
based.

7. Inflation
It lowers the purchasing power of the people and cripples many; it has an adverse effect
on taxable capacity.

CONCLUSION

All these factors must be taken into account before we can have an idea about the
taxable capacity of a nation. It may be that on account of the multiplicity of the factors
influencing taxable capacity, we cannot measure the capacity. But this does not mean
that the attempt is useless. The interest lies in the journey itself rather than in the
destination. As Findlay Shirras puts it, “A road leading to an important centre has often
many crossings, signposts, danger signals, but this does not lessen its value to the
cautious sojourner”.
III. CLASSIFICATION OR TYPES OF TAXES

Tax is a compulsory contribution which is levied on the taxpayers by the government to

meet the expenses which are incurred for a common cause. Taxes may be of different
types. Taxes may be classified on the basis of:-

a) Impact of Tax

Impact refers to whom a tax is imposed and who has to account for it to the government
and is different from incidence which refers to the person who bears the burden of the
tax. In this case, taxes may be:-
i) Direct Taxes - Impact and incidence on same person
ii) Indirect Taxes - May be different

b) Base of Tax

The tax is the base object upon which the tax is levied and to which tax rate is applied.
In this case, the taxes may be:-

i) Income Tax: The tax base is income

ii) Property Tax: The tax base is the property
iii) Sales Tax: The tax base is the sales price of goods sold
iv) Export Tax: The tax base is the value of goods exported
v) Import Tax: The tax base is the value of goods imported

c) Rates of Tax

The rate of tax is the percentage of the tax paid to the tax base. In this case, taxes may
be classified as:-
i) Progressive Taxes
ii) Proportional Taxes
iii) Regressive Taxes
iv) Degressive Taxes

Various types of taxes are explained as under:-

Direct and Indirect Taxes

Direct and indirect taxes are usually defined on the basis of the impact and incidence of
the tax.

Direct tax is that tax under which the impact and incidence of the tax is on the same
person e.g. income tax and death duty.

Indirect tax is that tax under which the impact of the tax is on one person and incidence
is on the other person e.g. excise duty, custom duty, sales tax e.t.c.
By impact of tax, we mean on whom tax is imposed. Incidence of tax means who has
to bear the burden of the tax.

According to Dalton “A direct tax is really paid by the person on whom it is legally
imposed, while an indirect tax is imposed on one person, but paid partly or wholly by
another”. John Stuart Mill defined a direct tax as one which is “demanded from the very
person who it is intended or desired should pay it ”. On the other hand, an indirect tax is
defined as one which is “demanded from one person in the expectation and intention
that he shall indemnify himself at the expense of another. ” This is the administrator ’s or
Government’s viewpoint which may create confusion. The Government imposes a
commodity tax which is an indirect tax in the expectation that it will be shifted. But if the
producer is unable to shift the tax on to the sellers, it is a direct tax.

It is therefore, convenient and better to discard the administrator ’s viewpoint on the

distinction between direct and indirect taxes and follow the economist ’s viewpoint as
given by Dr. Dalton.

Accordingly, income tax, corporation tax, wealth tax, gift tax, death duties, passenger
tax e.t.c. are direct taxes. On the other hand, excise duties, import and export duties,
sales tax, entertainment tax, e.t.c. are indirect taxes. We study below the merits and
demerits of direct and indirect taxes.

Merits and Demerits of Direct Taxes

Direct taxes posses the following merits.

1. Equitable

Direct taxes are based on the canon of equity. Their burden is equitably distributed as
they are progressive in nature. As the income of a person increases, the rate of income
tax also increases. So all direct taxes fall heavily on the people whose income and
wealth increase. The poor are not affected by such taxes.

2. Certain

Direct taxes satisfy the canon of certainty, The taxpayer is certain as to the time and
manner of payment, and the amount to be paid in the case of these taxes. Similarly, the
Government is also certain as to the amount of money it shall receive from these taxes.

3. Economical

These taxes also satisfy the canon of economy. The cost of collection of direct taxes is
low. In the case of income tax, it is deducted at the source from the salaried persons.
The assessments of wealth, incomes, inheritances, gifts e.t.c. can be made by the same
officers. No separate staff is needed for each. Such taxes are also economical to the
taxpayers who make payments direct into the treasury.

4. Elastic

Direct taxes are flexible and thus satisfy the canon of elasticity. The Government can
increase or decrease the rates of direct taxes according to the requirements of the
economy. In case of war, natural calamities, or emergency, the state can raise the rates
of these taxes in order to have larger tax revenue. During a depression, it can reduce
their rates considerably.

5. Simple

Direct taxes are simple and easy to understand.

6. Desirable

These taxes do not involve general opposition from the public because they are paid by
those persons or firms who come under the jurisdiction of income tax or corporation tax.
Thus they are based on the canon of desirability.

7. Reduce Inequalities

These taxes help to reduce income and wealth inequalities because of their progressive
nature. The rich are taxed heavily through income tax, wealth tax, expenditure tax,
excess profit tax, gift tax e.t.c. so long as they are alive; and through inheritance taxes
or death duties when they die. The poor and the income groups which lie below the
minimum tax limit are exempted from these taxes.

8. Civic Consciousness

Direct taxes create civic consciousness among the taxpayers. They are conscious that
they are paying taxes to the Government and take interest in the activities of the state
as to whether public expenditure is incurred on public welfare or not. Such civic
consciousness puts a check on the wastage of public expenditure in a democratic
country.

Demerits

Direct taxes have the following demerits.

1. Pinch

Direct taxes pinch the taxpayers because they have to pay them directly out of their
incomes or salaries. They are, therefore, unpopular.
2. Inconvenient

These taxes are inconvenient in nature because traders, businessmen, producers e.t.c
have to comply with a number of formalities relating to their sources of income and
expenditure incurred in earning that income. Often the details are incomplete and the
various sections of the Acts so complicated that the taxpayers have to take the help of
income tax experts by making them payments. Moreover, these taxes are payable in
advance and in lump sum, except in the case of salaried persons. Hence they are
inconvenienced.

3. Arbitrary

Direct taxes posses an element of arbitrariness in them. They leave much to the
discretion of the taxation authorities in fixing the rates of taxation and in interpreting
them.

4. Evasion

Since direct taxes pinch every taxpayer, he tries to evade them by filling wrong returns
and even takes the help of income tax experts. Thus such taxes cultivate dishonesty
and there is loss of revenue to the state.

5. Not Imposed on All

Direct taxes are not imposed on all income groups. Low income groups do not come
under the purview of these taxes. Such groups, therefore, do not contribute anything to
the state exchequer through direct taxation.

6. Discourage Saving and Investment

Direct taxes adversely affect saving and investment. When people know that with the
increase in their income and wealth, they will have to pay a large portion in the form of
taxes, they are reluctant to save and invest more. This adversely affects the will of work,
save and invest.

7. Discourage Production

Corporation taxes discourage those industries and firms which produce essential goods.

MERITS AND DEMERITS OF INDIRECT TAXES

Indirect taxes possess the following merits.

1. Convenient
Indirect taxes are less inconvenient and less burdensome. They are paid only when a
commodity or service is bought. So they are paid in small amounts rather than in lump
sum. Since these taxes are included in the prices of commodities, buyer do not feel the
burden of these taxes. Such taxes are like sugarcoated pills.

2. Wide Coverage

These taxes reach the pockets of all income groups: low, middle and high, they are
levied on necessaries, comforts and luxuries. Thus they have a wide coverage and
every consumer pays to the state exchequer according to his ability to pay. Thus they
are equitable.

3. Elastic

Indirect taxes are also elastic in nature. The Government can reduce or increase of, say
excise duties, or custom duties according to its requirements. But care should be taken
in not imposing high rates of necessaries which are mostly consumed by the poor.

4. Economical

These taxes are economical in the sense that they involve little cost of collection
because the producers and sellers themselves deposit with the Government.

5. Diversity

Indirect taxes satisfy the canon of diversity. They can be levied on a variety of
commodities and services. So the Government can be sure of a continuous and
sufficient revenue, even if it is required to reduce the rates of taxes on certain
commodities due to the fall in their demand.

6. Less Evasion

There is less possibility of evasion in the case of indirect taxes because they are
included in the prices of commodities. As these taxes are shiftable on the ultimate
consumers, the producers, the wholesalers, and the retailers do not mind them paying
them. The consumers can evade them only if they decide not to buy the taxed
commodities. However, these taxes are generally evaded by producers when they sell
their products to the wholesalers and the retailers without entering the goods in their
stocks and without issuing a bill/cash receipt for the same.

7. Check the Consumption of Harmful Goods

Indirect taxes have the great merit of checking the consumption of harmful goods like
wine, cigarettes, and other intoxicants. The state levies heavy duties on such articles of
consumption which are injurious to health and efficiency of the people. As a result, their
prices rise and their consumption is reduced. The state also earns substantial revenue.

8. Powerful Tool of Economic Policies

Indirect taxes can be used as a powerful tool for implementing economic policies by the
Government. If the Government wants to protect domestic industries from foreign
competition, it can levy heavy import duties. This will help to develop domestic
industries. If the Government wants to encourage one industry on priority basis, it may
not levy any taxes on its products but continue the taxes imposed on other industries.
The Government may do so inorder to encourage a particular technology or
employment in a particular industry.

Demerits

The following are the demerits of indirect taxes.

1. Uncertain Revenue

The revenue from indirect taxes is uncertain because it is not possible to accurately
estimate the effect of such taxes on the demand for products. If a heavy excise duty is
levied on some luxury article, its price will rise. Since the demand for luxury good is
elastic, its sale may be adversely affected by a fall in demand and the state revenue
may actually decline.

2. Regressive

Indirect taxes on necessaries, which are consumed by the poor, are regressive in
nature. The rich and the poor are required to pay the same amount of taxes on such
commodities as matches, kerosene, toilet soap, washing soap, tooth paste, blades,
shoes e.t.c. but the burden is heavier on the poor than on the rich. Thus they do not
satisfy the canon of equity.

3. Uneconomical

These taxes are uneconomical in that the cost of collection to the state is heavy. The
state has to appoint inspectors to check the accounts and stocks of producers,
wholesalers and retailers in order to find out whether they are paying taxes or not. Thus
they are more expensive than direct taxes.

4. Bad Effect on Production and Employment

Sometimes, these taxes adversely affect production of commodities, and even

employment. When the price of a commodity increases with the levy of a tax, its
demand falls (If it happens to be a commodity with elastic demand). As a result, its
production falls, and so does employment.

5. Feed Inflation

Another demerit of indirect taxes is that they feed inflation. Imposition of these taxes
tends to raise the prices of commodities, thereby leading to higher cost, to higher
wages, and again to higher prices. Thus price-wage-cost spiral sets in the economy.

6. Lack of Civic Consciousness

A person who buys a commodity does not know that he is paying tax to the Government
in the price of the commodity. Therefore, such taxes do not create civic consciousness
among the majority of tax payers who are ignorant of the fact that they are contributing
something to the state exchequer.

Conclusion

We have discussed above the merits and demerits of direct and indirect taxes but it is
difficult to say whether direct taxes are superior to indirect taxes, or vice versa. As a
source of revenue, both direct and indirect taxes are regarded as essential by modern
Governments. Gladstone registered it a sign of financial virtue to ‘keep a balance
between direct and indirect taxation, and likened these two sources of revenue to ‘two
attractive sisters’, as between whom the state should be ‘perfectly impartial ’.

PROPORTIONAL, PROGRESSIVE, REGRESSIVE AND DEGRESSIVE TAXES

Taxes have been variously classified: Taxes may be proportional, progressive,

regressive and degressive.

Proportional Tax

A proportional tax is one in which, whatever the size of income, same rate or same
percentage is charged. If all the tax payers have to pay, say one percent of their income
as tax, it is a case of proportional taxation. The same percentage is charged from all tax
payers.

Progressive Tax

If, on the other hand, the rate of the tax rises as the taxable income increases, the tax is
called a progressive tax. The principle of a progressive tax is ‘ the higher the income the
higher the rate’.

For instance, when income is divided into groups, the rate or percentage of taxation
increases with the increase in income, e.g. persons, say in the income bracket Kshs.
10,001 – Kshs. 15,000 pay at a given rate and persons in the income bracket Kshs.
15,001 – Kshs. 20,000 pay at a higher rate.

It is worth noting that even under a proportional tax the rich may pays more. For
example, if the rate is 1 percent, on the monthly salary, a man who is getting Kshs.
2,000, will pay Kshs. 240 per year and the man who is getting Kshs. 5,000 will pay
Kshs. 600 per year. Thus, the man with the higher income pays more even under the
proportional taxation. But under progressive taxation, he will pay much more because
as income increases the rate must also increase. The man with Kshs. 5,000 monthly
salary must have to pay 2 percent instead of 1 percent. He will pay, therefore, Kshs.
1,200 instead of Kshs. 600 per year. Every country has adopted the progressive system
of taxation, as it is considered more equitable.

Income tax, Estate duty, Wealth tax and Gift tax are all examples of progressive taxes
and commodity taxes like customs, excise duties and sales tax are examples of
proportional taxes.

Merits

Progressive taxation is justified on the following grounds:-

1. It is more equitable. The broader shoulders are asked to carry the heavier
burden.

2. It is more productive. Its yield is much more than it would be under proportional
taxation.

3. Its is economical. Cost of collection does not increase with the increase in the
rate of the tax.

4. It brings about an equality of sacrifice among the tax payers. This is so

because the law of diminishing utility applies to money also. The marginal utility
of money decreases with every increase in the income. Hence, the richer a man
is, the less the sacrifice he feels in paying a certain tax. By taxing him more he
can be asked to make equal sacrifice

5. By means of progressive taxation, the inequalities of wealth distribution can be

reduced to some extent. Moreover, fair distribution of wealth will result in
increased welfare of the community because the rich will sacrifice only their
luxuries, while the poor men will be able to satisfy their wants a little more fully.

Demerits

Progressive taxation, is subjected to the following criticism:-

1. If it is very heavy, it will discourage savings. Less capital will be accumulated,
and productive capacity of the community will be impaired.

2. It is all arbitrary.

3. It is based on the assumption that the same amount of money means the same
utility to all tax payers with equal incomes. This is not actually not so, because
circumstances of individual tax payers are widely different.

4. It is very inconvenient and pinches the tax payers very much.

The merit of proportional taxation is that it is much simpler than progressive taxation.
But simplicity is not a very essential virtue in a tax. All modern Governments have now
adopted the principle of taxation in direct taxation and proportional taxation in taxing
commodities.

Regressive Tax

A tax is said to be regressive when its burden falls more heavily on the poor than on the
rich. It is the opposite of a progressive tax. No civilized Government imposes a tax in
which, as income increases, the rate of tax is lowered. That would be clearly unjust. But
there are several taxes on commodities whose burden rests mainly on the poor.

Degressive Tax

The tax is called degressive when the higher incomes do not make a due contribution or
when the burden imposed on them is relatively less. This will happen when a tax is only
mildly progressive i.e. when the rate of progression is not sufficiently steep. A tax may
be progressive up to a limit beyond which the same rate is charged. In that case, there
may be lower relative sacrifice for the larger incomes than for the smaller incomes.

Another way in which a degressive tax may occur is when the highest percentage is set
for that given type of income on which it is intended to exert most pressure; and from
this point onwards, the rate is applied proportionally on higher incomes and
decreasingly on lower incomes, falling to zero on the lowest incomes.