PFT Material 2

PUBLIC FINANCE AND TAXATION
Teaching Module
Abstract
This teaching material is compiled for 4th year students of Accounting and
Finance department to aid them to learn the public finance and taxation
concern in general and in Ethiopia specifically. The material consists of
theories related with public finance, taxation, government fiscal policy and
budgetary systems in easy and detailed approach those arranged in four
main chapter. Each chapters have their own unique characteristics and there
are class activities and review question at the end of each chapter to help the
students to understand the chapter objectives. The instructor has used
Ethiopian tax proclamations, public finance books and taxation books as
reference in preparation of this module. Further, this module is not
authorized for any other use than class discussion for lectures offered by the
instructor himself neither can be duplicated by any one.
Delelegn E. (National Trainer @EDI and Lecturer @WKU)

delelegn.eyob2@wku.edu.et
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Contents
Chapter One ............................................................................................................................................ 3
1. Basics of Public Finance .................................................................................................................. 3
1.1. Introduction ............................................................................................................................. 3
1.2. Definition of Public Finance ..................................................................................................... 4
1.3. Public Finance Vs Private Finance ........................................................................................... 6
1.4. Functions of Government ......................................................................................................... 8
1.5. Scope of Public Finance ........................................................................................................... 9
1.5.1. Public Revenue................................................................................................................. 9
1.5.2. Public Expenditure ......................................................................................................... 10
1.5.3. Public Debt .................................................................................................................... 12
1.5.4.2. . The Significance of Public Finance ........................................................................... 15
1.5.5. Economic Stabilization ................................................................................................... 18
1.6. The Role of Government in the Economy ............................................................................... 19
1.7. Chapter Assessment ............................................................................................................... 20
Chapter Two ......................................................................................................................................... 21
2. Taxation ........................................................................................................................................ 21
2.1. Trends of Tax System in World.................................................................................................. 21
2.1.1. Ancient Times ................................................................................................................ 21
2.1.2. Medieval time ................................................................................................................ 21
2.1.3. 16th Century to Modern Period ........................................................................................ 22
2.2. The Functions of Taxes .......................................................................................................... 22
2.2.1. The Financing Function of Taxes .................................................................................... 22
2.2.2. The Allocation Function of Taxes ................................................................................... 23
2.2.3. The Redistribution Function of Taxes ............................................................................. 23
2.2.4. The Stabilization Function of Taxes ................................................................................ 23
2.3. Objectives of Taxation ........................................................................................................... 24
2.4. Meaning and Characteristics of Taxation .................................................................................... 27
2.5. Principles of Taxation ............................................................................................................ 29
2.6. Tax Classifications ................................................................................................................. 32
2.6.1. Direct and Indirect Taxes ................................................................................................ 32
2.6.2. Difference Between Direct and Indirect Taxes ................................................................ 37
2.7. Tax Rate Structures ................................................................................................................ 38
2.7.1. Proportional Tax Structure .............................................................................................. 38
2.7.2. Progressive Tax Structure ............................................................................................... 39
2.7.3. Regressive Tax Structure ................................................................................................ 40
2.7.4. Digressive Tax Structure ................................................................................................ 41
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2.8. Impact, Shifting and Incidence of Taxation............................................................................. 42

2.9. Tax Evasion, Avoidance and Delinquency .............................................................................. 44
2.10. Chapter Assessment ........................................................................................................... 45
Chapter Three (Assignment by students).................................................. Error! Bookmark not defined.
3. Public Finance in Ethiopia ............................................................... Error! Bookmark not defined.
3.1. Features of Ethiopian Federal Finance ...................................... Error! Bookmark not defined.
3.2. Expenditure Assignment .......................................................... Error! Bookmark not defined.
3.3. Revenue Assignment ................................................................ Error! Bookmark not defined.
3.4. Intergovernmental Transfer ...................................................... Error! Bookmark not defined.
3.5. Borrowing ................................................................................ Error! Bookmark not defined.
3.6. Trends of Ethiopian public revenues, expenditures, grants, deficits, and debtsError! Bookmark
not defined.
3.7. Budget and its process .............................................................. Error! Bookmark not defined.
3.8. Chapter Assessment ................................................................. Error! Bookmark not defined.
Chapter Four ......................................................................................................................................... 46
4. Ethiopian Tax System .................................................................................................................... 46
4.1. Structure of Ethiopian Tax System and Administration ........................................................... 46
4.2. Income Taxes ......................................................................................................................... 47
4.2.1. Schedule “A” Income Tax (Employment Income Tax).................................................... 48
4.2.2. Income From Rental Service (Schedule B)...................................................................... 50
4.2.3. Business Income Tax (Schedule C) ................................................................................. 52
4.2.4. Other Income Taxes (Schedule D), ................................................................................. 60
4.3. Consumption Taxes................................................................................................................ 60
4.3.1. Value-Added Tax ........................................................................................................... 60
4.3.2. Turnover Tax.................................................................................................................. 68
4.3.3. Excise Tax...................................................................................................................... 69
4.4. Stamp Duties.......................................................................................................................... 70
4.5. Foreign Trade Taxes .............................................................................................................. 70
4.5.1. Custom Duties ................................................................................................................ 70
4.5.2. Import Procedures ............................................................................................................ 1
4.5.3. Export Procedures ............................................................................................................ 2
4.6. Sur-Tax .................................................................................................................................... 3
4.7. Chapter Assessment ................................................................................................................. 4
Chapter One 3
Chapter One
1. Basics of Public Finance

1.1. Introduction
Economic System refers to frame work of distribution and allocation of goods and services in a
nation. Or it is the laws and institution in a nation.
The participation of the government in the economic activities is essential to accomplish the goals
of any welfare state. The governments of modern countries are committed to stability and full
employment. In Case of underdeveloped countries aims at accelerate economic development.
Government sector can play a decisive role in shaping and charting the path of any economy.
Depending on the level of development of each country the roles of government sector differ. In
all over the world, states have started number of public projects, such as social security, protection
and other services of public utilities like electricity, water supply, railways, heavy electricity,
atomic energy, etc. To provide such social amenities in the form of education, health and sanitation
facilities and public utilities, the government requires adequate revenue.
Public Finance, therefore, deals with the income and expenditure of public authorities. It deals
with the financial operations or finances of the government. Federal, regional and local
government raises revenues from various tax sources and non-tax sources, such as revenue from
general, administrative and economic services, borrowings from individuals, corporations and
friendly foreign countries. The government raises revenue from internal as well as external sources
to incur huge expenditure on various functions the government has to perform. The important ones
being maintenance of law and order, defense, socioeconomic development, etc... Public finance is
thus concerned with the use and accomplishment of essential monetary resources of the
government. In fact, public finance deals with how and through what different sources the
government gets income, how it spends it and how it controls and administers its incomes and
expenditures. These two activities, i.e., raising of revenue through taxation and other sources, and
spending it on various services plus borrowings from internal as well as external sources, together
constitute “Public Finance.” Therefore, the subject matter of public finance deals with public
revenue, public expenditure, and public debt.
There are two types of goods that is expected to meet by all governments to the peoples. The first
one is public goods. Public goods are those goods produced and supplied by the country to society
Basics of Public Finance 4
to meet its collective wants for increasing social welfare. Or it is goods and services produced to
satisfy collective wants. Example: Defense, education, public health, infrastructure facilities like
power, transportation and communication, etc. Collective wants are those which are demanded by
all members of the community in equal or more or less equal measures.
✓ Subjected to the principle of non-exclusion
✓ The marginal cost is approach to Zero.
✓ Less divisible
As everyone is a beneficiary-directly or indirectly of the public goods, everyone is asked by the
public sectors authorities to pay towards the cost of production of the public goods. No one can
refuse to pay for the supply of public goods on the ground that they are direct beneficiaries. The
Government has the sole responsibility to decide about how much of these goods should be
produced, the method of production and the technique of distribution. Public goods are supplied
to all people irrespective of their ability and willingness to pay for them.
The second one is the private goods. Private Goods refers to goods which are consumed by people
to satisfy their personal or private wants. E.g., Food, clothes, Shelter and etc.
✓ It is subjected to the principle of exclusion.
✓ The price can be determined by demand and cost of the production
✓ More divisible
1.2.Definition of Public Finance
Public finance is a very old science and different economists have defined it in their own ways.
Some of the important definitions of public finance are shown blow:
• “Public finance is concerned with the income and expenditure of public authorities and with
the adjustment of one to the other.” Huge Dalton
• “Public finance deals with the provision custody and disbursement of resources needed for
conduct of public or government functions.” Lutz
• “Public finance is a science which deals with the activity of the statement in obtaining and
applying the material means necessary for fulfilling the proper functions of the state.” Carl
Plehn
• “Public finance is the study of the principles underlying the spending and raising of funds of
public authorities.” Findley Shirras
• “The government, considered as a unit, may be defined as the subject of study of public
finance. More specifically, public finance studies the economic activity of government as a
unit.” Buchanan
• “Public finance deals with expenditure and income of public authorities of the state and their
mutual relations as also with the financial administration and control.” Bastable
Main Phrases to Define Public Finance:
- Public authorities
- Income and expenditure
- Social goal
- From people to people
- Stewardship
- Accountability
Details in Definition of Public Finance
Public Finance deals with the income and expenditure of the public authorities. Here the term
Public means the Government that is Central, state and local authorities. Public finance is one of
those subjects, which lie on the borderline between Economics and Politics. It is concerned with
the income and expenditure of public authorities and with the adjustment of one to another.
Public finance: Resources of the masses, how they are collected and utilized. The discipline of
public finance describes and analyses government services, subsidies, welfare payments and the
methods by which the expenditures to these ends are covered through taxation, borrowing, foreign
aid and the creation of money. Public finance is the study of income and the expenditure of the
government. Rising of necessary funds for incurring expenditure constitutes the subject matter of
public finance. The methods of public finance have certain effects on economic life and can,
therefore, be used as an instrument for bringing about desired social and economic changes. Public
finance also deals with the problems of adjustments of income and expenditure of the government.
It is also known as fiscal operations of the treasury. Thus, fiscal operations and fiscal policies are
integral part of public finance.
It is an Art – Public finance is also an art. It is concerned with fiscal policies which influence
economic policies and economic structure of the country. All governments aim at bringing social
justice through an equitable financial system. The public finance is not only studying the
composition of public revenue and public expenditure. It covers a full discussion of the influence
of government fiscal operations on the level of overall activity, employment, prices and growth
process of the economic system.
Class Activity:
Dear students, please discuss the following questions with your classmates in a group of three
members.
- What is public finance? Define in your own term considering main phrases
- Why public finance is needed?
- How you express public finance in one economic system?
1.3.Public Finance Vs Private Finance
Finance in general means public as well as private finance. Public finance relates to the money-
raising and income-expenditure functions of the government. Private finance refers to the income-
expenditure phenomenon of an individual or private business. By private finance mean the
financial problems and policies of an individual economic unit.
A. Similarities
1) Satisfaction of Human Wants; - Both the public and private finance have the same objective,
i.e., the satisfaction of human wants. Public finance is concerned with the satisfaction of social
or collective wants, whereas private finance is concerned with the satisfaction of personal or
individual wants.
2) Maximum Advantage; - Both the public finance and private finance try to secure maximum
advantage or maximum benefit. An individual or a corporation or a private business firm tries
to obtain maximum advantage from his expenditure. Similarly, the government also tries to
obtain maximum good of the people by incurring expenditure on the society.
3) Borrowings; - Another similarity between the public and private finance is that many times
both have to be obtained from the market in the form of borrowings whenever the expenditure
of either the government or any individual or firm exceeds their income/revenue.
4) Engagement in Similar Activities; - Both the private and public sectors are engaged in
activities that involve lots of purchases, sales and other transactions. Similarly, they are
engaged in production, exchange, saving capital accumulation, investment, and so on. In order
to finance these operations, the government, creates money, raises loans and makes payments
etc. Similarly, a private economic unit lends, borrows, receives payments, makes payments
and so on. In these respects, therefore, both the public and private finance are quite similar to
each other.
5) Scarcity of Resources; - The scarcity of resources is also an important factor which is common
to both. They have unlimited objectives, whereas the resources are limited.
6) Problem of Adjustment of Income and Expenditure; - Another similarity between public
and private finance is that both the public as well as private sectors face the problem of
adjustment of income and expenditure.
B. Dissimilarities
1) Motive; - The motive of private finance is personal interest or benefit, whereas the motive of
public finance is social benefit or public welfare.
2) Adjustment Approach of Income and Expenditure; - Another dissimilarity between the
individual’s private finance and the government’s public finance is that every individual tries
as far as possible to adjust his expenditure to his income because his expenditure depends on
his income. Conversely, the government first prepares its budget. In other words, the
government first determines its expenditure and then devises ways and means to raise the
requisite revenue to meet its expenses.
3) Nature of Resources: - The resources (private finance) of an individual are more or less
limited, whereas the resources of the government (public finance) are enormous. Government
can raise resources from tax sources as well as non-tax sources. The government can borrow
from internal as well as external sources.
4) Coercive Methods: - An individual (private finance) cannot use coercive methods to raise his
income, Whereas the government (public finance) can use forceful methods to collect revenue.
In other words, to collect revenue, the government imposes taxes at a high rate on the people
irrespective of their capacity to pay. Private individuals or bodies have no such powers.
5) Secrecy of Budget: - Public finance is an open affair as the government gives utmost publicity
to its budget by publishing it in newspapers and by showing it on television. For example, the
Ethiopian government tells to the public the yearly approved budget by parliament, whereas
private finance is a secret affair. An individual tries to keep his accounts secret as he does not
want his competitors to know his real financial position.
6) Long/Short-term Consideration: - Another point of difference between private and public
finance is that the private individuals incur expenditure in those areas of business which give
quick returns. They, as individuals keep in view short-term considerations. On the contrary,
government incurs expenditure keeping in view the long-term considerations, such as

construction of dams, multipurpose hydro-electric projects, etc.
7) Elasticity of Finance: - Public finance is elastic in nature-as compared to private finance.
Public finance can be increased by imposing various taxes as public finance is open to drastic
changes. Private finance on the other hand, cannot be increased as there is not much scope for
changes in private finance.
8) Deliberation in Expenditure: - The pattern of expenditure of an individual is governed by
habits, customs, status, personal needs etc. On the contrary, the pattern of public expenditure
is governed and controlled by deliberate economic policy of the Government
9) Right to Print Currency: - The government has a right to print currency which is legal,
whereas private individual does not enjoy such a right
1.4.Functions of Government
The public finance embraces the following three functions of the government’s budgetary policy
confined to the fiscal department the:
A- Allocation division: Adjustment in the allocation of public resource to all citizens and
areas of the country. This focus on addressing the areas with facilities and resources to
confirm areas got governmental spendings.
The government operations basically involve the efficient provision of the government
funds in maximizing the welfare of the community. The government taxes the public and
uses the amount in providing certain facilities and services. The objectives of the fiscal
operations are to provide for the proper allocation of resources between provide for the
proper allocation of resources between private and public goods so as to maximize social
welfare.
B- Distribution division: Adjustments in the distribution of income and wealth, in which the
confirming whether every citizen is being benefited from every dollar of countries benefit
in a way that minimizes the inequality between regions, individuals and groups.
In a free market economy, distribution of income and wealth is unequal. Fiscal operations
have been used to reduce the income and wealth of the (through progressive taxations) and
using the money collected to raise the income group (through public expenditure). The use
of the fiscal policy to reduce inequality of income and wealth has been quite common in
many countries.
C- Stabilization division: Adjustments in confirming whether the economy is built in a stable

manner in which everyone can afford to live and trust the market.
Modern economics are subjected to fluctuations, viz, business boom and inflation on one
side and business recessions and depressions on the other. Such fluctuations are not in the
interest of the country. So, during the inflation, the government increase (heavier) tax rate
and decrease expenditure. During the depression, the government increase expenditure and
decrease the tax rate.
Class Activity:
members.
- Discuss on three functions of government, please try to put in try to prioritize them.
- Discuss on main similarities and difference between private finance and public finance using
your own explanations
- Discuss why the three government functions are needed in one economic system
1.5.Scope of Public Finance
Public finance deals with the income and expenditure pattern of the Government. Hence the
substances concerned with these activities become its subject matter. The subject matter of the
public finance is classified under five broad categories of which the first two are discussed. They
are, Public Revenue, Public Expenditure, Public Debt, Financial Administration and Economic
Stabilization
1.5.1. Public Revenue
Under this category, the sources of the public revenue, principles of taxation, effects of taxes on
the economy, methods of raising revenue and the like are dealt with. Public revenue is the means
for public expenditure. Various sources of public revenue are:
A. Tax Revenue, and
B. Non-tax Revenue
A. Tax Revenue
Taxes are compulsory payments to government without expectation of direct return or benefit to
tax payers. It imposes a personal obligation on the taxpayer. Taxes received from the taxpayers,
may not be incurred for their benefit alone. Tax revenue is one of the most important sources of
revenue.
The objectives of taxation are to reduce inequalities of income and wealth; to provide incentives
for capital formation in the private sector, and to restrain consumption so as to keep in check
domestic inflationary pressures.
From the above discussion we can conclude that the elements of taxation are as follows:
a. It is a compulsory contribution
b. Government only imposes taxes
c. In payment of tax an element of sacrifice is involved
d. Taxation is aimed at welfare of the community
e. The benefit may not be proportional to tax paid
f. Tax is a legal collection.
There are two types of taxes into direct and indirect taxes.
B. Non-tax Revenue
This includes the revenue from government or public undertakings, revenue from social services
like education and hospitals, and revenue from loans or debt service. To sum up, non-tax revenue
consists of:
i) Interest receipts
ii) Dividends and profits and
iii) Others.
1.5.2. Public Expenditure
Public expenditure is incurred by public authorities - either for the satisfaction of collective needs
of the citizens or for promoting their economic and social welfare. It is incurred by the government
for the attainment of public good. Every government has to maintain law and order, armed forces
for providing protection, schools, health of the people, arranging for cheap food, cloth and low-
cost housing for the poor and so on. All these mixed activities which are increasing every year
require huge funds. Therefore, public expenditure, deals with the expenditure which a government
incur for its own maintenance, the society and the economy and helping other countries.
Technically, in the structure of a budget, most governments classify public expenditure into two:
➢ Current expenditures
➢ They are also referred to as non-developmental expenditure.
➢ All sorts of administrative and defense expenditure
➢ They are intended for continuing the existing flow of goods and services and
maintaining the capital of the country whole.
➢ Capital expenditures
➢ Capital expenditures contribute to increased productive capacity of the nation.
➢ They are also known as development expenditure.
➢ Example: Expenditures on construction of dams, public works, state enterprises,
agricultural and industrial development.
Recently, there has been both quantitative and qualitative change in government’s expenditure.
This category deals with the principles of public expenditure and its effect on the economy etc.
Public expenditure is done under two broad heads viz., developmental expenditure and non-
developmental expenditure. The former includes social and community services, economic
services, and grants in aid. The latter mainly consists of interest payments, administrative services,
and defense expenses. Expenditure can also be classified into revenue and capital expenditure.
Expenditure is also classified under the following heads:
I. Non-plan Expenditure
Non-plan expenditure of central government is divided into revenue and capital expenditure.
Under non-plan revenue expenditure, we include interest payment, defense expenditure, major
subsidies, interest and other subsidies, debt relief to farmers, postal deficit, police, pensions, other
general services, social services, grants to states and union territories. Non-plan capital expenses
include defense expenses, loan to PSUs, loans to states and union territories, foreign governments
etc.
II. Plan Expenditure
The second major expenditure of central government is plan expenditure. This is to finance the
following:
i) Central plans such as agriculture, rural development, irrigation and flood control, energy,
industry, and minerals, communication service and technology, environment, social
service and others.
ii) Central assistance for plans of the states and union territories.
Social Expenditure
Government takes the responsibility of protecting the interests of the community as a whole and
promotes the implementation of welfare programs. Government spends huge amounts for
providing benefits such as old age pensions, accident benefits free education and medical services.
This expenditure on human resources comes under social expenditure.
Governments are moving towards the objective of achieving maximum social welfare.
Expenditure on education, public health, welfare schemes for workers, relief and rehabilitation of
displaced persons and such other services may not yield direct benefit in the short run. But in the
long run they contribute to improvement in the quality at human resources.
1.5.3. Public Debt
This category deals with the causes, methods and problems of public borrowings and its
management. This includes both internal debt and external debt.
a. Internal debt:
Increasing need of government for funds cannot be fully met by taxation alone in under developed
and developing countries due to limited scope of taxation. Government therefore has to resort to
alternate sources. Rising of debt is one such source. Debt, though involves withdrawal of resources
by curtailing private consumption, has certain advantages. Transfer of funds from public to
government is voluntary. Loans do not reduce the wealth of the lenders. Debt raised for productive
purpose will not be a burden on the economy.
There are many objectives of creation of public debt. Debt may be raised to meet the normal current
expenditure, exigencies like war, finance productive government enterprise, finance public social
welfare and economic development.
b. External Debt:
In under developed and developing countries, internal sources are limited. Under developed and
developing countries, therefore go for external debt. The transfer of capital at international level
may take the form of:
i) Financial aid through grants and loans

ii) Commodity aid
iii) Technical assistance
1.5.4 Financial Administration

This category includes the preparation of financial budget, the control and administrations of the
budget relevant problems auditing etc. The aim of financial administration is to control processes
and operations of public revenue, public expenditure and public debt. The scope of financial
administration includes the collection, custody and disbursement of public money; the
coordination of expenditure according to a well-formulated plan; the management of public debt;
and the general control of the financial operations of the state. It also includes the preparation of
the budget; its execution and above all auditing the finances of the state.
1.5.4.1. Fiscal Policy
Fiscal policy is also called as budgetary policy. Fiscal policy refers to that segment of national
economy policy, which is primary concerned with the receipts and expenditures of the government.
Fiscal policy relates to those activities of the state that are concerned with raising financial
resources and spending them. According to Keynes government revenue and expenditure should
be deliberately and consciously to secure economic stabilization.
Fiscal policy relates to the government s decision making with respect to the following:
✓ Taxation
✓ Government spending
✓ Government borrowing
✓ Management of government debt
Fiscal policy deals quite directly with matters, which immediately influence consumption and
investment expenditure.
The main role of the role of the fiscal policy:
1. In under developed and developing countries development is the main concern. The primary
task of fiscal policy in an under developed and developing countries is to allocate more
resources for investment and to restrain consumption.
2. The fiscal policy should reduce the economic inequalities of income and wealth. This can be
achieved by taxation and public distribution measures. Poverty and unity cannot co-exist.
Therefore, fiscal policy should attempt economic development of the socially unfortunate to
bring about national unity. Private section is not interested in investing in social and economic
overheads. Investments in social and economic overheads like education, medical facilities,
infrastructure, dams etc. are very essential to accelerate the rate of economic growth.
3. In under developed and developing countries the requirement of growth demands that fiscal
policy must be used progressively for raising the level of investments and savings rather than
keeping the consumption level. In under developed and developing countries fiscal policy must
be used as an instrument of resource mobilization. To attain growth with stability the goal of
fiscal policy should be promotion of highest possible rate of capital formation and should
reduce the actual and potential consumption. Further fiscal policy should encourage private
investment and attract foreign funds for development projects.
4. The existing pattern of investment may differ from the optimum pattern of investment. Thus,
it becomes a responsibility of government to undertake investments in such a way that it is
most beneficial for the people of the country.
5. Fiscal policy should control inflation within tolerable levels since inflation mostly affects the
poor.
In under developed and developing countries there exist regional imbalances in addition to social
inequalities. Fiscal policy should aim at reducing both regional and social imbalances by directing
investments to less developed regions. Their marginal propensity to consume is very high.
Therefore, a small increment in investment can bring manifold employment due to multiplier
effect.
Fiscal policy should direct availably resources for providing basic physical, infrastructural needs
like irrigation, roads, basic industries, railways, ports, telecommunications etc. Fiscal policy
should assign high priority to the creation of overhead capital. Spending of the government should
also take care of education and health of the community. Returns on these investments are long-
term and private sector cannot provide above investments.
Therefore, government of a country through its fiscal policy can increase rate of investment and
alter the pattern of investment. It follows that the main role of fiscal policy in an under developed
and developing countries is to expand productive capacity by raising the level of real capital
including skills as well as plants and equipment and to check the demand generating effect of
expanding investment. In developed countries, its role is to expand both production capacity as
well as the level of aggregate monetary demand in relation to their economic growth. In under
developed countries the better approach is to transfer resources to capital formation without
inflation.
Fiscal policy through its different measures such as taxation policy, budgetary policy, public debt
policy and a coordination with monetary policy can direct the economic destiny of a nation. Fiscal
policy can be used to mitigate the effects of trade cycles such as inflation and depression
1.5.4.2.. The Significance of Public Finance

A- Economic Significance
Economic Stability and maintenance of full employment are the two main goals of public finance
in advance countries like the U.K. and the U.S.A. In developing countries economists were of the
view that the fiscal policies should be formulated for the rapid economic development.
Public Finance occupies great significance in an under developed or developing country.
According to R.J. Chelliah, “Public Finance has a positive and significant role in the context of
economic development.” The importance of public finance in an under developed/developing
country discussed as follows:
➢ Capital Formation
Since the economic development of the country depends on the rate of capital formulation, the
first and the foremost aim of public finance is to promote capital formation. In a developing
country, the government’s economic policy should concentrate on production and fiscal policy
should act as a tool of capital formation. For rapid capital formation, the government should incur
expenditure on the establishment of basic and heavy industries, infrastructural development, such
as power projects, transport sector, means of communications etc.
➢ Economic Stabilization
Economic stabilization is yet another economically significant responsibility of the government.
The problem arises whenever there is economic instability such as inflation, deflation and
recession. Public finance (revenue and expenditure process of the government) may be, therefore,
used to secure economic stability or to remove economic fluctuations in the economy.
➢ Full Employment
Public finance also plays an important role in increasing employment. In an
underdeveloped/developing country, major problem faced by the people is the problem of
unemployment. This problem leads to low standard of living, poverty, backwardness, ignorance
and above all starvation. It is the function of public finance to provide employment opportunities.
Therefore, expenditure should be incurred by the government for increasing employment and for
achieving full employment. To generate employment, public expenditure should be incurred on
setting up new industries, encouraging small-scale and cottage industries through financial
subsidies, expenditure on training schemes etc.
➢ Balanced Regional Development

For the economic development of a country, balanced regional development is very essential.
Balanced regional development is possible by setting up private industries in backward areas
instead of in urban areas. To encourage this diversion, the government should provide fiscal or tax
concessions in the form of 5-year tax holiday, communication facilities should also be provided.
If the private industries fail to divert to backward regions, should be taxed heavily.
➢ Reduction in Economic Inequalities
One of the major problems of underdeveloped countries is the unequal distribution of income and
wealth. There is a gap between the rich and the poor. Public finance has an important role to play
in this context. To bring about equitable distribution of income and wealth, the government should
follow the system of progressive taxation. In other words, the government should impose heavy
taxes on the richer section of society, and the amount realized from the rich should then be spent
on the poor by way of providing them social amenities such as free education, medical facilities,
public utilities like road, water facility, recreation facilities etc.
➢ Mobilization of Resources
Mobilization of resources is another important role of public finance. The government can
mobilize or raise resources by imposing taxes on the people and industries, by encouraging savings
through various saving schemes, surplus of public enterprises and borrowings and making them
available for investment for the rapid economic development of the underdeveloped country.
➢ Optimum Utilization of Resources
Optimum utilization of scarce resources is very essential for the economic development of the
underdeveloped countries. In a developing country it is not uncommon to find non-utilization or
destruction of scarce resources. The solution of this problem lies in the optimum utilization of
available resources by means of adopting planned monetary and public finance policies. The state
can direct the flow of consumption, production and distribution in the right direction by adopting
balanced budgetary policy.
B- Social Significance
Social justice or equitable distribution of income and wealth is another responsibility of the
government in its public finance operations. As already been discussed there is unequal
distribution of income and wealth in developing countries. There is a wide gap between the rich
and the poor. For example, according to Fikreyesus (2006), the top 20 percent of the population
have control about 50 percent of the Ethiopian economy. This gap can be bridged by adopting a
rational fiscal policy, such as taxation and public expenditure. In other words, luxury items
purchased mainly by the rich should be subjected to higher rates of taxation, and necessary items
should be exempted from taxation.
Social justice also requires investment expenditure on the establishment of enterprises in the public
sector. By doing so, the government would be able to produce goods of mass consumption to make
available cheap goods to the people.
C- Satisfaction of Social Wants and Merit Wants
Another significant point of public finance is the satisfaction of social or collective wants and merit
wants. Wants are divided under three heads:
- Private Wants:
- Social Wants or Collective Wants and
- Merit Wants
a- Private Wants
Private wants are those wants which are satisfied by individuals according to their personal
incomes. Degree of satisfaction depends upon their respective incomes. Wants for houses, food,
clothes, entertainment or recreation etc. are satisfied according to individual preferences.
b- Social Wants or Collective Wants
Social or collective wants require public goods which are demanded by all members of society
equally whether the people have the capacity to pay or not. Wants like defense, education, public
health, flood control provisions, weather forecasting bureaus, research centers, police protection,
social overhead capital like roads, bridges, etc. are collective wants which must be available to all
the people, irrespective of whether they are rich or poor, whether they can afford to have them or
not. In other words, consumer is supreme. Public expenditure on these heads is necessary to satisfy
social or collective wants. Since nobody is ready to pay for them, therefore, taxes are imposed on
the people to meet expenditure for the satisfaction of these wants.
c- Merit Wants
Merit wants are essential private such as food, clothing, housing etc, which are satisfied by the
government at low prices for the poor due to their low level of income. Merit wants are, thus,
provided by the government for the benefit of the poor. These wants are satisfied by the
government for the upliftment and progress of the poor. Such wants are food, clothing, low-cost
housing (eg. condominium), free nutritious means to school children, free education to the children
of the poor, low priced milk to the poor, old age pensions and social security measures, maternity
benefits etc. Satisfaction of these wants for the poor increases their productivity efficiency and
there by their income.
D- Fiscal Policy to Curb or Prevent Undesirable Wants
Another important aspect of public finance is that the government not only satisfies social wants
and merit wants, but also discourages and curbs certain undesirable wants of the people from the
social point of view. Undesirable wants are cigarette-smoking, liquor drinking, chewing of opium
and tobacco etc. Such harmful wants are discouraged and curbed by imposing heavy taxes and
spending large amount on publicity, health measures for the affected people,
1.5.5. Economic Stabilization
This category analyses the use of public finance to bring the economic stability in the country. It
studies the use of financial policies of the Government from the view of economic development.
Generally, under developed countries have the following features.

1. Predominantly agriculture-based economy
2. Low capital formation
3. Inferior technical know how
4. Low per capital income
5. Over population and poor health and educational facilities.
6. High propensity to consume leading to low capital formation.
This category analyses the use of public finance to bring the economic stability in the country. It
studies the use of financial policies of the Government from the view of economic development.
Class Activity:
members.
- What is the study scope of public finance?
- What are the main benefits of public finance in terms of political, economic, social and cultural
environment?
- Define the term fiscal policy and discuss the process of fiscal policy with its benefit to economy
- Why government borrow? Write and discuss different types of government loans
1.6. The Role of Government in the Economy

We should know the role of the government to enable us to appreciate the importance of
government sector. Government of a modern state generally undertakes the following functions:
1. Security - Both external and internal involving outlay for military, police and
other protective services.
2. Justice or settlement of disputes
3. The regulation and control of economy – including the services such as coinage,
a. weights and measures, the business practices, operation of public sector
b. undertakings
4. Of social and cultural welfare through education, social relief, social insurance, health and
other activities.
5. Conservation of natural resources.
6. Promotion of the unity of the state by control of transportation and communication.
7. Administration and financial system, government revenue expenditure and fiscal control.
8. Education and employment.
9. Housing.
10. Public health.
11. Up-liftment of weaver sections of the society.
12. Restore social justice in the society.
Functions of modern governments are broadening due to socio-political reasons. Therefore, to

discharge these increasing functions, the government has to increase its expenditure. To meet out
the enormous amount of expenditure it has to mobilize funds with the help of public finance policy.
Hence public finance has developed into an important branch of economics.
1.7. Chapter Assessment

1. Define Public finance in your own words
2. Discuss the main objectives of public finance
3. Distinguish between public and private finance
4. Discuss the major portions of the subject matter of public finance
5. Discuss the economic and social significance of public finance one important aspect of public
finance is the satisfaction of social or collective wants and merit wants. How public finance
could satisfy social or collective wants and merit wants
6. Even though, Ethiopia recently did experience a remarkable economic growth, regional
imbalance is still widely visible. What is the role of public finance in promoting regional
balance?
7. One important aspect of public finance is that not only satisfies social wants and merit wants,
but also discourages and curbs certain undesirable wants of the people from the social point of
view. Mention at least three undesirable wants that could be discouraged and how a
government could curb such undesirable wants.
Chapter Two 21
Chapter Two
2. Taxation
2.1.Trends of Tax System in World
Taxation is a system of raising money to finance government. All governments require payment
of money - taxes - from people. Governments use tax revenues to pay soldiers and police, to build
dams and roads, to operate schools and hospitals, to provided food for the poor and medical care
to the elderly, and for hundreds of others purposes. Without taxes to funds its activities,
government could not exist.
2.1.1. Ancient Times
In the ancient civilizations of Palestine, Egypt, Assyria, and Babylonia, individuals’ property rights
did not exist. The king was sole owner of everything in this domain, including the bodies of his
subjects. Thus, instead of taxing individuals to support the government, the king could simply
force them to work for him. Ancient kings earned income in the form of food from their lands and
precious metals from their mines. If this income did not meet the king's demands, he might lead
his armies into neighboring countries to confiscate their property. In societies that operated without
money, the rulers taxed farmers by requiring that they hand over some proportion of their crops to
the state. Poll taxes were a major source of revenue in Egypt under the Prolemaic Dynasty (323Bc-
300Bc).
The government of ancient Athens, Greece, relied on publicly owned silver mines, tribute from
conquered countries, a few customs duties, and voluntary contributions from citizens for revenue.
It levied poll taxes only on slaves and aliens (non-citizens) and made failure to a capital crime.
In early years of Roman republic all Roman citizens paid a poll tax. However, Roman military
victories brought in so much foreign tribute that the government exempted citizen from this tax in
the 2nd century BC, after the public wars between Rome and carthage. More than 100 years later.
Emperor Augustus introduced land and, inheritance taxes. Succeeding emperors raised rates and
found an increasing number of things to tax, including wheat and salt.
2.1.2. Medieval time
During the Middle Ages from about the 5th century AD to 15 century AD, taxation varied from,
region to region. Europeans were subject to many forms of taxation, including land taxes, poll
taxes, inheritance taxes, tolls (payments for the use of bridges, roads, or seaports), and
miscellaneous fees and fines. Many people paid taxes in the form of money or crops directly to the
Trends of Tax System in World 22
local lord whose land they farmed.

Under the system of feudalism that dominated in Western Europe beginning; in about the 11 th
century, kings, noble and church rulers all collected taxes.
The Roman Catholic Church was a tax collector during the Middle Ages. One of the most
important sources of church revenue was the tithe that is a compulsory payment, one-tenth of a
person’s harvest and lives stock. An important development towards the end of feudal period was
the dramatic growth in the number and population of towns and cities. These urban centers
collected revenues using taxes on property as well as sales taxes on certain items.
2.1.3. 16th Century to Modern Period
Over a period of time, feudalism faded and strong centralized states emerged in Europe, during
16th and 17th centuries. These states relied heavily on revenues generated by the king's own estates
and by taxes on land. In England, the power of parliament grew steadily because the kings and
queens had to convene it frequently to obtain money. In 1689 the English bill of rights guaranteed
that the kind could not tax without parliament's consent.
By 18th century, England started imposing various taxes on transactions. As times passed, people
become dissatisfied with this system of public finance for several reasons. In general people
perceived that the burden of taxes fell mostly on the poor. In addition, tax systems did not generate
as much revenue as the governing classes wanted. Finally, economists and political leaders began
realizing that by reducing trade, tariffs crated economic losses for society.
In the late 19th and early 20th centuries, concerns about both fairness and the ability of tax systems
to generate sufficient revenue led governments to enact income tax, to finance the Napoleonic
wars. The government discontinued the tax when the war ended in 1815, but revived it in 1842.
The first progressive income tax, which imposed a greater tax burden on people with higher,
income-was introduced in Russia in 1853. Other countries introduced progressive income taxation
in subsequent decades, including Britain in 1906, the United States in 1913, and France 1917.
Although income taxes generated little revenue at first, today they play major role in all modern
tax systems.
2.2.The Functions of Taxes
2.2.1. The Financing Function of Taxes
Traditionally, the primary purpose of a tax was to pay for goods and services provided by the
government. The financing function of taxes remains important although taxes have other purposes
today. Taxes are the main source of revenue or income for governments and provide the chief
means of covering current costs or expenditures.

The major issue involving the financing function of taxes is their effect on the efficient use of
scarce resources. Taxes divert resources away from alternative uses. These uses may be a source
of lesser benefits than the uses to which these resources are put in the public sector. However, if
taxes divert resources away from their best alternative use, they are a source of allocative
inefficiency. The efficient distribution of resources to the public sector via taxes requires that
benefits derived from government spending have a value equal to or greater than the alternative
uses these resources would have in the private sector of the economy.
2.2.2. The Allocation Function of Taxes
In the financing function, the diversion of resources by taxes from the private sector is done under
the presumption that resources are used efficiently in the private sector. Thus, the primary concern
is to divert resources in a manner that does not interfere, or interferes the least, with the allocation
of resources in the private sector. If resources are not efficiently allocated in the private sector,
taxes can be purposely used to have non-neutral effects, that is, taxes can be used to change the
allocation of resources.
2.2.3. The Redistribution Function of Taxes
The redistribution function of taxes raises the question of the appropriate way of distributing taxes
among taxpayers. Taxes and tax rates can be selected in a manner that alters the pattern of income
among taxpayers. Taxes can shift the pattern of income away from certain income groups and
towards others. For example, progressive income tax rates take a higher percent of income for
higher incomes than for lower; thus, they tend to reduce the after-tax income of higher income
groups more than they reduce the after-tax income of lower income groups. Progressive income
tax rates, then would be expected to shift the after-tax income pattern away from higher income
groups to lower income groups. This effect, however, can be offset in part or in whole by tax
deductions, credits, and the like which higher income groups can take advantage of in order to
minimize their tax payments. Tax incidence studies try to find out whom really pays taxes that is,
to find out who bears the real burden of taxation. Such discussion will be examined in the next
chapter.
2.2.4. The Stabilization Function of Taxes
The stabilization function of taxes view taxes as a variable that can be altered to direct the economy
toward economic stability; that is, full employment and a stable price level. An increase in taxes
normally reduces private consumption and saving therefore reducing private spending. A decrease
in taxes increases private consumption and saving and therefore has the opposite effect on private
spending. Thus, taxes can play an important role in changing the level of private demand. When
the economy is near or at full employment and is experiencing inflation, tax rates can be increased
to reduce inflationary pressures. When the economy is experiencing declining real output and
rising unemployment, tax rates can be cut in order to increase private spending. Taxes, then, can
be viewed as a fiscal policy variable to be changed depending upon overall economic conditions.
This role places taxes in quite a different perspective than the role in which they are traditionally
seen simply as a method of finance. During periods of economic expansion, tax collections tend
to automatically rise because of the growth in tax bases such as sales and income. This automatic
growth in taxes tends to slow down the expansion. During periods of economic contraction, tax
collections automatically decline because of the decline in sales and income in the economy.
Therefore, even if tax rates are not changed during the ups and downs in the economy, tax
collections automatically change in a way that tends to stabilize the economy.
2.3. Objectives of Taxation
Government levies and collects taxes for various objectives. These objectives may be specific or
general.
A- Specific Objectives
The basic purposes of levying taxes are as follows to:
1. support the operation of that government itself.
2. influence the macro-economic performance of the economy, the government's strategy for
doing this is called its fiscal policy.
3. carry out the functions of the government such as national defense and providing
government services.
4. redistribute resources between individuals or classes in the population. Historically the
nobility was supported by taxes on the poor modern social security systems and intended
to support the poor by taxes on the rich.
5. modify patterns of consumption or employment within an economy by making some classes
of transaction more or less attractive.
B- General Objectives
Taxes are compulsory payments to the Government by the taxpayers. In the beginning,
Government imposed taxes for three basic purposes viz., to cover the cost of administration,
maintaining law and order in the country and for defense.
But, in modern days, there has been a sea change in the Government’s expenditure pattern. Today,
the Government is in the position to restore social justice in the society by way of providing various
social services like education, employment, pension, public health, housing, sanitation and the
development of weaker sections of the society. Besides the above, the Government announces
heavy subsidies for agriculture and industry. For example, subsidies to fertilizing industries. Thus,
Government requires more amount of revenue than before. Non-tax revenues are not sufficient to
meet the entire expenditures. Hence, Government imposes taxes of various types.
Let us discuss the general objectives of taxation hereunder.
A. Raising Revenue
The basic purpose of taxation is raising revenue. To render various economic and social activities,
Government requires large amount of revenue. To meet this enormous expenditure, Government
imposes various types of taxes in addition to the non-tax revenue.
B. Removal of Inequalities in Income and Wealth
The welfare state aims at the removal of inequalities in income and wealth. By framing suitable
tax policy, this end can be achieved. It is stressed in the Canon of Equality. In India, the progressive
taxation on income and wealth and heavier excise and customs duties, and taxes on luxurious
goods are the suitable examples in this regard.
C. Ensuring Economic Stability
Taxation affects the general level of consumption and production. Hence, it can be used as an
effective tool for achieving economic stability. That is, by means of taxation the effects of trade
cycle i.e. inflation and deflation can be controlled. During the period of boom or inflation, the
excess purchasing power in the hands of people leads to rise in the price level. Raising the existing
tax rates or imposing additional taxes can remove such excess purchasing power. Then the
abnormal demand will be reduced and the economic stability can be achieved. At the same time,
by providing grants, tax exemptions and concessions, production can be encouraged thereby
inflation is controlled.
Likewise, during the period of depression or deflation, the role of tax policy in the economy is
important. Reduction in the existing tax rates and removal of certain taxes, consumption can be
induced which in turn results in increasing demand. This encourages business activities, and the
economic growth can be achieved.
Thus, through properly devised tax system, the economic stability can be achieved by controlling
the effects of trade cycle.
D. Reduction in Regional Imbalances
It is normal that certain parts of the country are well developed, whereas some other parts or states
are in backward conditions. To remove these regional imbalances, the Government can use tax
measures. By way of announcing various tax exemptions and concessions to that particular
backward regions or states, the economic activities in those areas can be induced and accelerated.
E. Capital Accumulation
Tax concessions or rebates given for savings or investment in provident funds, life insurance, unit
trusts, housing banks, post offices banks, investment in shares and debentures of certain companies
etc. lead to large amount of capital accumulation which is essential for the promotion of industrial
development.
F. Creation of Employment Opportunities
More employment opportunities can be created by giving tax concessions or exemptions to small
entrepreneurs and to the industries adopting labor-intensive techniques. In this way,
unemployment problem can be solved to certain extent.
G. Preventing Harmful Consumption
Taxation can be used to prevent harmful consumption. By way of imposing heavy excise duties
on the commodities like liquors, cigars etc., the consumption of such articles are reduced to a
considerable extent.
H. Beneficial Diversion of Resources
The imposition of heavy duties on non-essential and luxury goods discourages the producers of
such goods. The resources utilized for the production of these goods may be diverted into the
production of other essential goods for which various tax concessions are given. This is called as
beneficial diversion.
Meaning and Characteristics of Taxation 27
I. Encouragement of Exports
Now-a-days export-oriented industries are encouraged by way of providing various exemptions
like 100% relief from income tax, free trade zones etc. It results in the large earnings of foreign
exchange.
J. Enhancement of Standard of Living
By way of giving various tax concessions to certain essential goods, the Government enhances the
standard of living of people.
2.4.Meaning and Characteristics of Taxation

A tax is “a compulsory charge imposed by the Government without any expectation of direct return
in benefit ". In other words, a tax is a compulsory payment or contribution by the people to the
government for which there is no direct return to the taxpayers. Tax imposes a personal obligation
on the people to pay the tax if they are liable to pay it.
The public should be taxed according to their ability to pay, and the people in the same financial
position should be taxed in the same way without any discrimination.
Thus, tax can be defined as, "an involuntary fee or more precisely, "unrequited payment", paid by
individuals or businesses to a government (central or local)". Taxes may be paid in cash or kind
(although payments in kind may not always be allowed or classified as taxes in all systems). The
means of taxation, and the uses to which the funds raised through taxation should be put, are a
matter of hot dispute in politics and economics, so discussions of taxation are frequently
tendentious.
A good tax system has the following main characteristics
(1) Tax is a Compulsory Contribution
A tax is a compulsory payment from the person to the Government without expectation of any
direct return. Every person has to pay direct as well as indirect taxes. As it is a compulsory
contribution, no one can refuse to pay a tax on the ground that he or she does not get any benefit
from certain public services the government provides.
(2) The Assessed will be required to pay Tax if is due from him
No one can be forced by any authority to pay tax, if it is not due from him. Suppose, if there is a
tax on liquor, the state can force an individual to pay the tax only when he drinks liquor. But, if he
does not drink liquor, he cannot be forced to pay the tax on liquor. Similarly, if an individual’s
income is below the exemption limit, he cannot be forced to pay tax on income. For example,
individuals earning monthly salary below birr 600 cannot be forced to pay tax on
income.
(3) Taxes are levied by the Government
No one has the right to impose taxes. Only the government has the right to impose taxes and to
collect tax proceeds from the people.
(4) Common Benefits to All
The tax, so collected by the Government, is spent for the common benefit of all the people. In other
words, when the government collects a tax, its proceeds are spent to extend common benefits to
all the people. The Government incurs expenditure on the defense of the country, on maintenance
of law and order, provision of social services such as education, health etc. Such benefits are given
to all the people- whether they are tax-payers or non-taxpayers. These benefits satisfy social wants.
But the Government also spends on subsidies to satisfy merit wants of poor people.
(5) No Direct Benefit
In the modern times, there is no direct relationship between the payment of tax and direct benefits.
In other words, there is absence of any benefit for taxes paid to the Governmental authorities. The
government compulsorily collects all types of taxes and does not give any direct benefit to tax-
payers for taxes paid. For example, when taxable income is earned by an individual or a
corporation, he or it simply pays the tax amount at the specified rate cannot demand any benefit
against such payment.
(6) Certain Taxes Levied for Specific Objectives
Though taxes are imposed for collecting revenue for the government to meet expenditure on social
wants and merit wants, certain taxes are imposed to achieve specific objectives. For example,
heavy taxes are imposed on luxury goods to reduce their consumption so that resources are directed
to the production of essential goods, such as cheaper variety of cloth, less costly goods of mass
consumption, etc. Thus, taxes are levied not only to earn revenue but also for diversion of resources
or saving foreign exchange. Certain taxes are imposed to reduce inequalities of income and wealth.
(7) Attitude of the Tax-Payers
The attitude of the tax-payers is an important variable determining the contents of a good tax
system. It may be assumed that each tax-payer would like to be exempted from tax paying, while
he would not mind if other bears that burden. In any case, he would want his share to be within the
general level of tax burden being borne by others. In other words, it is essential that a good tax
system should appear equitable to the tax-payers. Similarly, overall burden of the tax system is of
equal importance. The attitudes of the tax-payers in this regard are influenced by a host of other
factors like the political situation such as war or peace, natural calamities like floods and droughts,
economic situations like prosperity or depression and so on.
(8) Good tax system should be in harmony with national objectives
A good tax system should run in harmony with important national objectives and if possible,
should assist the society in achieving them. It should try to accommodate the attitude and problems
of tax-payers and should also take into consideration the goals of social and economic justice. It
should also yield adequate revenue for the treasury and should be flexible enough to move with
the changing requirements of the State and the economy.
(9) Tax-system recognizes basic rights of tax-payers
A good tax system recognizes the basic rights of the tax-payers. The tax-payer is expected to pay
his taxes but not undergo harassment. In other words, the tax law should be simple in language
and the tax liability should be determined with certainty. The mode and timings of payment should
be convenient to the taxpayer. At the same time, a tax system should be equitable between tax-
payers. It should be progressive and burden of taxation should be equitable on all the taxpayers.
Class Activity:
members.
- Discuss how taxation is emerged
- Define tax in your own meanings and words
- Discuss on why government levied tax
- What are the main characteristics of taxation?
- Assume there are certain group of peoples living in Ethiopia. The group have their own
leader and they does not have any affiliation with government of Ethiopia. The leaders of
this group used to levy tax from tax bases of the group and it is a trend for that community
now. What is the indication of this system? Is it possible to call this group as part Ethiopia?
2.5.Principles of Taxation
A good tax system should ensure maximum social advantage without hardship on taxpayers and
to do so, Policymakers. The principles of an optimal tax system, what are known as Canons of
taxation, some of which were laid down by Adam Smith include:
1. Simplicity
A tax system should be simple enough to enable a taxpayer to understand it and be able to compute
his/her tax liability. A complex and difficult to understand tax system may produce a low yield as
it may discourage the taxpayer's willingness to declare income. It may also create administrative
difficulties leading to inefficiency. The simplest tax system is one with only a single tax. However,
this may not be equitable as some people will not pay tax. T U D Y T E
2. Certainty
The tax should be formulated so that taxpayers are certain of how much they must pay and when.
The tax should not be arbitrary. The government should have reasonable certainty about the
attainment of the objective(s) of that tax, the yield and the extent to which it can be evaded. There
should be readily available information if taxpayers need it. Certainty is essential in tax planning.
This involves appraising different business or investment opportunities based on the possible tax
implications. It is also important in designing remuneration packages. Employers seek to offer the
most tax efficient remuneration packages which would not be possible if uncertainty exists.
3. Convenience
The method and frequency of payment should be convenient to the taxpayer e.g. PAYE. This may
discourage tax evasion. For example, it may be difficult for many taxpayers to make a lump sum
payment of tax at the year-end. For such taxes, the evasion ratio is quite high.
4. Economic/administrative efficiency
A good tax system should be capable of being administered efficiently. The system should produce
the highest possible yield at the lowest possible cost both to the tax authorities and the taxpayer.
The tax system should ensure that the greatest possible proportion of taxes collected accrue to the
government as revenue.
5. Taxable capacity
This refers to the maximum tax which may be collected from a taxpayer without producing
undesirable effects on him. A good tax system ensures that people pay taxes to the extent they can
afford it. There are two aspects of taxable capacity.
- Absolute taxable capacity
- Relative taxable capacity
Absolute taxable capacity is measured in relation to the general economic conditions and
individual position e.g., the region, or industry to which the taxpayer belongs. If an individual,
having regard to his circumstances and the prevailing economic conditions pays more tax than he
should, his taxable capacity would have been exceeded in the absolute sense.
Relative taxable capacity is measured by comparing the absolute taxable capacities of different
individuals or communities.
6. Neutrality
Neutrality is the measure of the extent to which a tax avoids distorting the workings of the market
mechanism. It should produce the minimum substitution effects. The allocation of goods and
services in a free-market economy is achieved through the price mechanism. A neutral tax system
should not affect the taxpayer's choice of goods or services to be consumed.
7. Productivity
A tax should be productive in the sense that it should bring in large revenue which should be
adequate for the government. This does not mean overtaxing by the government. A single tax
which brings in large revenues is better than many taxes that bring in little revenue. For example,
Value Added Tax was introduced since it would provide more revenue than Sales Tax.
8. Elasticity or buoyancy
By elasticity we mean that the government should be capable of varying (increasing or reducing)
rates of taxation in step with the circumstances in the economy, e.g. if the government requires
additional revenue, it should be able to increase the rates of taxation. Excise duty, for instance, is
imposed on many commodities locally manufactured and their rates can be increased to raise more
revenue. However, care must be taken not to charge increased rate of excise duty from year to year
because they might exert inflation pressures on the economy.
9. Flexibility
It means that there should be no rigidity in taxation i.e., the tax system can be changed to meet the
revenue requirement of the state; both the rate and structure of taxes should be capable of change
or being changed to reflect the state’s requirements. Such that certain old taxes are discouraged
while new ones are introduced. The entire tax structure should be capable of change.
10. Diversity
It means that there should be variety or diversity in taxation. That the tax base should be wide
enough to raise adequate revenue and the tax burden is evenly distributed among the taxpayers. A
single tax or a few taxes may not meet revenue requirements of the state. There should be both
direct and indirect taxes.
11. Equity
A good tax system should be based on the ability to pay. Equity is about how the burden of taxation
is distributed. The tax system should be arranged to result in the minimum possible sacrifice.
Through progressive taxation, those with high incomes pay a large amount of tax as well as a
regular proportion of their income as tax. Equity means people in similar circumstances should be
given similar treatment (horizontal equity) and dissimilar treatment for people in dissimilar
circumstances (vertical equity). There are three alternative principles that may be applied in the
equitable distribution of the tax burden.
- The benefit principle
- The ability to pay principle
- The cost-of-service principle
2.6.Tax Classifications
The government business can’t perform without funds; therefore, it needs money, earlier we have
known that, government sources dividend into tax revenue and none tax revenue. There is one fact
that, revenue of tax is represent majority from total public revenue. There is more than one
classification of taxation. A study of the classification of taxes helps us to understand the nature
and significance of deferent taxes. So, taxes are classified on various bases, such as nature, form,
aim essence and methods of taxation, the following classification is commonly found in modern
tax system
1- Based on who bears the burden are direct taxes and indirect taxes.
2- As to subject of matter are personal, property, and excise.
3- As basis of method are Progressive, proportional, and regressive taxes.
4- Based on purpose classified as Single and multiple taxes.
5- As to scope are national tax and local tax.
One classification does not contradict with other but they are complementary and supplementary
to one another and all classifications don’t come out from one. See same of them as follows.
2.6.1. Direct and Indirect Taxes

Based on who bears the burden are direct taxes and indirect taxes. The meaning of these terms can
vary in different contexts, which can sometimes lead to confusion. In economics, direct taxes refer
to those taxes that are paid by the person who earns the income. By contrast, the cost of indirect
taxes is borne by someone other than the person responsible for paying them. For example, taxes
on goods are often included in the price of the items, so even though the seller sends the payments
to the government, the buyer is the real payer. Indirect taxes are sometimes described as
hidden taxes because the purchaser of goods or services may not be aware that a proportion of the
price is going to the government.
A- Direct Taxes
A direct tax is paid by a person on whom it is levied. In direct taxes, the impact and incidence fall
on the same person. If the impact and incident of a tax fall on the same person, it is called as direct
tax. It is borne by the person on whom it is levied and cannot be passed on to others. For example,
when a person is assessed to income tax or wealth tax, he has to pay it and he cannot shift the tax
burden to anybody else.
I. Merits of Direct Taxes
Direct taxes have the following merits:
a- Ensures the Principle of Ability to Pay: Direct taxes are based on the principle of ability to
pay; they fall more heavily on the rich than on the poor. The tax burden is distributed on
different sections of the society in a just and equitable manner
b- Reduces the Social and Economic Inequalities: Direct taxes reduce a disparity in the
distribution of income and wealth. By adopting the progressive tax system, rich people pay on
higher rates of adopting the progressive tax system, rich people pay on higher rates of taxation,
while the poor pay on lower rates or given exemptions. This reduces the gap between the poor
and rich to a considerable extent.
c- Certainty: Direct taxes satisfy the canon of certainty. In direct taxes, the time of payment,
mode of payment, the amount to be paid etc. are made clear. Both the taxpayers and the
Government know the amounts to be paid and the Government can estimate the revenue from
these taxes.
d- Economy: The cost of collection of these taxes is low because the government adopts the
different methods of collections like tax deduction at source, advance payment of tax etc.
Besides, the taxpayers pay the amount of tax directly to government. Thus, the principle of
economy is achieved in the case of direct taxes.
e- Elasticity: Direct taxes are elastic in nature. For example, when the income of the people
increases, the tax revenue also increases. Moreover, during the unforeseen situation like flood,
war etc. the government can raise its revenue by increasing the tax rates without affecting the
poor.
f- Educative Effect: Direct taxes create civic consciousness among taxpayers. Since the
taxpayers feel the burden of tax directly, they are interested in seeing that the Government
properly spends the money. They are conscious of their rights and responsibilities as a citizen
of the State.
g- Control the Effects of Trade Cycles: Direct taxes control the effects of trade cycles. They
can be used as a tool to mitigate the effects of inflationary and deflationary trends by raising
or reducing the tax rates.
II. Demerits of Direct Taxes
The following are the demerits of direct taxes:
a- Arbitrary in Nature: Direct taxes tend to be arbitrary because of the difficulty in measuring
the ability to pay tax. Paying capacity of the people cannot be measured precisely. The levy is
highly influenced by the policies of the Government.
b- Difficulties in the Formulation of Progressive Tax Rates: Direct taxes take the form of
progressive taxation i.e. the tax rates increase with the rise in income. It is very difficult to
formulate the ideal progressive rate schedules in this regard, since there is no scientific base
c- Inconvenience: Under direct taxes, the taxpayer has to adhere to many legal formalities such
as submission of the income returns, disclosing the sources of income etc. Moreover, he has to
follow numerous accounting procedures which are difficult to comply with. Further, direct
taxes have to be paid in lump sum and at times, advance payment of tax has to be made. This
causes much inconvenience to the taxpayers.
d- Possibility of Tax Evasion: The high rates of direct taxes create the tendency to evade more.
There is possibility for tax evasion by fraudulent activities. Thus, it is said that the direct taxes
are the taxes on honesty.
e- Limited Scope: The scope of the direct tax is very limited. If only direct tax is followed, these
people cannot be brought into the tax net because of the basic exemption given. Thus, the
Government cannot depend upon direct tax alone.
f- Disincentive to Work, Save, and Invest: When the taxpayer earns certain level, they have to
pay more, because of the higher rate of taxes attributed to the higher slabs. This will in turn
discourages them to work further, save and invest.
g- Expensive to Collect: Under direct taxes, each and every taxpayer is separately assessed.
Thus, the large number of taxpayers to be contacted and assessed and the prevention of tax
evasion make the cost of collection more expensive.
B- Indirect Taxes
Under indirect taxes, the impact and incidence fall on different persons. It is not borne by the
person on whom it is levied and can be passed on to others. For example, when the excise duty is
levied on the manufacturer of cement, he shifts the burden of tax to the consumers by raising the
selling price. Here the impact of excise duty falls on the manufacturer and the incidence on the
ultimate consumers. The person who is required to pay the tax does not bear its
burden. Thus, indirect taxes can be shifted
I. Merits of Indirect Taxes
Indirect taxes have the following merits.
a. Convenience: Indirect taxes are more convenient to the taxpayers. Since the tax is included in
the selling price of the commodities, the consumer pays the tax when he purchases them. He
pays the tax in small amounts (installments) and does not feel its burden. Thus, indirect taxes
are quite convenient and less burdensome.
b. Wide Scope: While the people with income and wealth above a certain limit are brought under
the levy of direct taxes, indirect taxes are paid by all both poor and rich. Under indirect taxes,
everybody pays according to their ability. The tax burden is not imposed on to the small section
but it is widely spread. Thus, the indirect tax has wider scope.
c. Elastic: The revenue from the indirect taxes can be increased. Whenever the Government
wants to raise its revenue, or lower it, it can be achieved by increasing and decreasing the rates
of taxes on the commodities whose demand is inelastic.
d. Tax Evasion is Not Possible: Indirect taxes are included in the selling price of the
commodities. So, evading of such tax becomes very difficult. If the person wants to evade the
tax, it can be done only by refraining the consumption of the commodity.
e. Substantial Revenue: Indirect taxes yield substantial revenue to both Central and State
Governments. The developing countries like India are heavily dependent on indirect taxes.
Direct taxes have a limited scope in these countries because of low per capita income.
f. Progressive: Indirect taxes can be made progressive by imposing lower rates of taxes or giving
exemption to the necessary articles and heavy taxes on luxurious articles. Thus, indirect taxes
also confirm the principle of equity.
g. Effective Allocation of Resources: Indirect taxes have great influence in the allocation of
resources among different sectors of the economy. Resources allocation can be made effective
by imposing heavy excise duties on low priority goods and by granting relief to industries
producing high priority goods. This results into mobilization of resources from one sector to
another positively.
h. Discourages the Consumption of Articles Injurious to Health: Indirect taxes discourage the
consumption of certain commodities, which are harmful to health. By imposing very high rates
of taxes on commodities like liquors, drugs, cigarettes etc., which are harmful to health, their
consumption can be reduced.
II- Demerits of Indirect Taxes
The following are the demerits of indirect taxes
a. Ability to Pay Principle is violated: Indirect taxes are not directly connected to the taxpayers'
ability to pay. Therefore, both the rich and poor equally pay the tax. Thus, the principle of
ability to pay is violated. Indirect taxes are regressive in nature.
b. Uncertainty: If indirect taxes are not levied on the commodities of common consumption and
levied only on luxurious articles, they tend to be inelastic. The quantity demanded will be
affected by the imposition of the taxes. Thus, the revenue generated from them is uncertain.
c. Discourages Saving: Indirect taxes are included in the selling price of the commodities.
Hence, the people have to spend more on the purchase of the goods. This, in turn affects the
savings of the people.
d. High Cost of Collection: Indirect taxes are uneconomical as they involve high cost of
collection.
e. Civic Consciousness is Not Created: Under indirect taxes, taxpayers don’t feel the burden of
the tax. They are not aware of their contribution to the State. Thus, indirect taxes do not create
the civic consciousness in the minds of the people.
f. Inflationary: The indirect taxes cause an increase in the price all around. The increase in the
prices of raw materials, finished goods and other factors of production creates inflationary
trends in the economy.
2.6.2. Difference Between Direct and Indirect Taxes

Direct and Indirect taxes differ among themselves on the following grounds.
a- Shift ability of the Burden of Tax
In the direct taxes, the impact and incidence fall on the same person. It is borne by the person on
whom it is levied and is not passed on to others. For example, when a person is assessed to income
tax, he cannot shift the tax burden to anybody else, and he himself should bear it. On the other
hand, in the case of indirect taxes, the impact and incidence fall on different persons. It is not borne
by the person on whom it is levied. The burden of the tax can be shifted. For example, when the
manufacturer of cement pays excise duty, he can shift the tax burden to the buyers by including
the tax in the price of the cement.
b- Principle of Ability to Pay
Direct taxes conform to the principle of ability to pay. For example, now people having income
above Birr.600 pm, only is liable to pay income tax. But indirect taxes are borne and paid by the
weaker sections of the society also. As such, these taxes do not conform to the principle of ability
to pay.
c- Measurement of Taxable Capacity
In the case of direct taxes, tax-paying capacity is directly measured. For example, the taxable
capacity for income tax is measured on basis of the income of the individual. On the other hand,
in the case of indirect taxes, taxable capacity is measured indirectly. The luxurious articles are
levied at the higher rate of taxes on the assumption that they are purchased by the rich people.
However, low rate is charged on the articles of common consumption.
d- Principle of Certainty
Direct taxes ensure the principle of certainty. Both the Government and the taxpayer know what
amount is to be paid and the procedures to be followed. But in the case of indirect taxes, it is not
possible. The taxpayer does not know the amount of tax to be paid and the Government cannot
predict the quantum of revenue generated from the indirect taxes.
e- Convenience
Direct taxes cause much inconvenience to the taxpayers since they are to be paid in lump sum. But
the indirect taxes are paid by the consumers in small amounts as and when they purchase the
commodities. Moreover, the taxpayers need not follow any legal formalities in the payment of tax.
Thus, indirect taxes are more convenient to them.

f- Civic Consciousness
People felt the burden of direct taxes directly. The taxpayer is conscious of his contribution to the
Government and interested in knowing whether the tax paid by him is properly used or not. In this
way, it creates civic consciousness among the taxpayers. But indirect taxes do not raise such
consciousness among the taxpayers, because they pay the taxes indirectly.
g- Nature of Taxation
Direct taxes are progressive in nature. The rates of taxes go up with the increase in the tax base i.e.
income of a tax payer. But rich and poor irrespective of their income equally pay indirect taxes.
Thus, they are regressive in nature.
h- Removal of Disparity in Income and Wealth
Since the direct taxes are progressive in nature, they reduce the disparities of income and wealth
among the people to a considerable extent. But indirect taxes have a negative effect. Actually, they
are widening the gap between the rich and poor when they are levied on the goods of common
consumption.
Class Activity:
members.
- Taking at minimum of 5 tax cannons, evaluate our countries tax system
- Discuss what kind of business or entities are subject to direct tax
- Discuss what kind of business or entities are subject to indirect tax
- Based on your daily life, give at least three examples each for direct tax and indirect tax
- According to current Ethiopian tax system, which type of tax is more common? Which tax is
better to increase the tax revenue of government?
2.7.Tax Rate Structures
The tax system structure can be: Proportional, Progressive, Regressive and Digressive type.
2.7.1. Proportional Tax Structure
Proportional tax structure is a system that taxes everyone at the same rate, regardless of his or her
income bracket. Supporters of a flat tax argue that it gives people incentive to earn more, because
they wouldn’t penalize by graduating to a higher tax bracket (as they would in a progressive-rate
system).
Tax base(Income in Birr) Tax rate (in %)

Over Birr To Birr
0 500 20
501 1500 20
1501 3000 20
3001 5000 20
5001 7500 20
7501 10500 20
Income tax on games of chance is an example of proportional tax. If Alem wins birr 150,000 and
Hagos wins Birr 100,000 both persons pay taxes equal to 15% of the prizes, birr 22,500 and 15,000,
respectively.
A. Advantage of Proportional Tax Structure
Proportional tax system has the following advantages:
-It is simple in nature
-It is uniformly applicable
-It leaves the relative economic status of taxpayer unchanged
B. Disadvantages of Proportional Tax Structure
Proportional tax system has the following disadvantage:
- Inequitable distribution
- Inadequate resources: means that the tax for the rich and poor are the same. Hence, the
government cannot obtain from the richer sections of the society as much as they can give
- Inelastic in nature: because the government cannot raise the rate whenever it wants to raise
the revenue.
Proportional tax system suffers from the defects of inequitable distribution of the tax burden, lack
of elasticity and inadequacy of funds for the increasing needs of the modern government. Hence,
it is not particularly and universally accepted.
2.7.2. Progressive Tax Structure
A progressive tax is a tax that is larger as a percentage of income for those with larger incomes. It
is usually applied in reference to income taxes, where people with more income pay a higher
percentage of it in taxes. The term progressive refers to the way the rate progresses from low to
high.
The rate of taxation increases as the tax base increases.

Over Birr To Birr

0 500 10
501 1500 15
1501 3000 20
3001 5000 25
5001 7500 30
7501 10500 35
A. Advantages of Progressive Tax Structure

• Equality in sacrifice: under progressive tax system, the rate of taxation increases as the tax
base increase. That is, the burden of taxation is heavy upon the rich than on the poor.
• Reducing the inequalities of income and wealth
• Elastic: the government can easily raise its revenue by increasing the rates of taxes.
• Stabilizing the economy: Progressive tax system may be helpful in preventing the inflationary
trends in the economy as it reduces the disposable income and purchasing power of the people.
B. Disadvantages of Progressive Tax
• Ideal progressive is impossible: the main drawback of progressive taxation is that it is difficult
to frame an ideal progression in tax rates. They are arbitrary depending on the government’s
need for additional funds without taking into account the burden of people with different
incomes.
- Disincentive taxation: it is argued that too progressive a tax rate acts as a disincentive to work.
- Discourage saving and investment
2.7.3. Regressive Tax Structure
A regressive tax is a tax which takes a larger percentage of income from people whose income is
low. Often it is a fixed tax – every person has to pay the same amount of money, such as a poll
tax. A poll tax is a fixed tax for each person: since each person pays the same amount of money,
it is a lower proportion for people with higher incomes. Regressive taxes fall more heavily on the
poor section of the community, than on the richer section. Thus, it violates the principle of equity
and social justice.
Tax base (Income in Birr) Tax rate (in %)

Over Birr To Birr
0 500 35
500 1500 30
1500 3000 25
3000 5000 20
5000 7500 15
7500 10500 10
2.7.4. Digressive Tax Structure
It is an alternative of progressive tax marked by a steadily declining rate of increase in the
progressive tax rates, which are applied to the upper segments of the tax base. An incremental tax
rate in each additional layer of tax bracket (marginal tax rate) decreases as the segment of the tax
base increase.
Over Birr To Birr
0 500 5
500 1500 10
1500 3000 14
3000 5000 17
5000 7500 19
7500 10500 20
❖ Arguments for and against proportional Taxation
➢ Proportional taxation is based only upon the hypothesis that marginal utility of income is lower
for the richer sections. It is claimed that this cannot be proved because utility being a subjective
thing cannot be measured and inter-personal comparisons of utility are not possible. It follows
that we cannot impose a large money burden upon the richer sections on ground of sacrifice.
➢ Proportional tax schedule is administratively simple. But, there is counter argument to this
because the points at which tax collection is to take place become too numerous and
administratively unmanageable.
➢ It is claimed that a proportional tax does not change the relative position of different tax-payers.
It is neutral in terms of the allocation of resources of the economy to different uses. This type
of reasoning is quite misleading. Because when the income of a tax-payer is reduced he adjusts
his demand pattern for various goods and services. Example: (1) A richer person maintains his
consumption by reducing his saving and supply of investment funds and the demand for capital
goods would fall. This would retard the rate of economic growth.
➢ The poorer sections will have to reduce their consumption which is not good for their health
and efficiency.
❖ Arguments for and against progressive Taxation
Arguments For
➢ A very strong case for progressive tax rats exists in terms of ability to-pay and the
corresponding sacrifice which taxation involves. This argument is based upon the
assumption of the law of diminishing utility. But the problem is measurability of utility
or the possibility of interpersonal comparisons.
➢ Progression can be advocated on the basis of social justice because it taxes the people
according to their ability to pay.
➢ Progressive taxation acts as a built-in stabilizer. i.e., it acts against an excessive upward
or downward movement of income and prices.
Argument Against
➢ Progressive tax has been disputed on the grounds of non-measurability of utility and the
impossibility of interpersonal comparisons of utility
➢ The benefit-received principle is against progressive taxation from the very beginning,
because this principle requires the poor to pay more tax as he receives more benefit from
the government.
➢ Progressive taxation is said to have negative bearing on the process of saving and capital
accumulation in an economy, because it taxes more the rich who is the big saver in the
economy.
In a poor, underdeveloped country raising resources through budgetary savings may necessitate
the use of regressive taxes (or indirect taxes). Indirect taxes can be imposed on articles of mass
consumption. Thus, the low-income majority will be captured by those taxes.
Because of this, the value of the property in the neighborhood will rise. This rise in the value will
provide an unearned increment. Hence, the Government has a right to appropriate a part of this
unearned increase. This appropriation is called as special assessment.
2.8.Impact, Shifting and Incidence of Taxation
The burden of a tax does not always lie on the person from whom it is collected. In many cases,
it is borne by the other people also. Thus, the person who initially pays the tax may not be
bearing its money burden as such. Hence, it is necessary to know who bears the immediate
burden of tax and who bears the ultimate burden of tax. According to the law, the tax is collected
from an individual or business unit, which has paid the tax in the first instance and may transfer
it to someone else. If such a shifting of tax takes place, the original taxpayer has served only as a
collecting agent. In the process of taxing, three concepts are involved. They are as follows:
(1) A tax may be imposed on some person.
(2) It may be transferred by him to another person i.e. second person.
(3) It may be ultimately borne by the second person.
Thus,
a) Impact of a tax is on the person who bears the money burden in the first instance.
b) Shifting of a tax refers to the process by which the money burden of a tax is
transferred from one person to another person.
c) Incidence of a tax refers to the money burden of a tax, which is on the person who
ultimately bears it.
The Impact
The impact of a tax is on the person who pays the tax in first instance. In other words, the person
who pays the tax to the government in the first instance bears its impact. Therefore, the impact of
a tax is the immediate result of the imposition of a tax on the person who pays it in the first instance.
It refers to the immediate burden of the tax and not to the ultimate burden of the tax.
Incidence
Incidence of a tax means the final or ultimate resting place of the burden of the tax payment. It
refers to the point at which "tax chickens finally come to the roost ". That is, the location of the
ultimate tax burden. The incidence of a tax is different from its impact, which refers to the point
of original assessment. If an individual who pays the tax in the first instance finds that he cannot
transfer or shift the burden of the tax to anybody else, then the incidence as well as the impact is
on the same person. If the original or the first taxpayer is able to transfer or shift the tax burden to
someone else, then the shifting of tax will be taken place. For example, the Government levies a
tax say, excise duty on cement and collects the tax from the manufacturer of cement. Now, the
impact of the tax is on the manufacturer. If he is able to pass on the money burden of the tax to the
wholesaler by means of raising the price, then the manufacturer has shifted the tax i.e. he
transferred the money burden to the wholesaler. This process continues and ultimately the
consumer bears the money burden of the tax. Hence, the incidence is on the final consumer. There
are two major economic principles in the analysis of taxation. They are:
A. The incidence of the tax, and
B. Its effects on economic efficiency (referred to as the excess burden or welfare cost of the
tax). These principles are applicable to all taxes.

The main issue in the economic analysis of any tax is the identification of the individual or group
of individuals on whom the burden of the tax rests. This is the incidence of the tax. There are two
concepts of tax incidence. They are as follows:
i) Legal Incidence: The individual or group of individuals who have the legal responsibility
for paying the tax to the government bears the legal incidence of the tax.
ii) Economic Incidence: The individual or group of individuals, whose real income, welfare
or utility is reduced by the tax, bears the economic incidence. The economic incidence is
independent of the legal incidence; that is, those who bear the legal incidence may be
different from those who bear the economic incidence. When the economic incidence
differs from the legal incidence, the burden of the tax is said to be "Shifted". The effects
of a tax on the allocation of resources and on the distribution of income depend on the
economic incidence, not the legal incidence.
Shifting
It refers to the process by which the money burden of a tax is transferred from one person to
another. Whenever there is a shifting of taxation, the tax may be shifted either forward or
backward. A producer, upon whom a tax has been imposed, may shift the tax burden to the
consumer or to the factors of production. If the producer shifts the tax burden to the consumer, it
is known as "Forward Shifting". On the other hand, if the producer shifts the tax burden to the
factors of production i.e. to the suppliers of raw materials etc., it is known as "Backward
Shifting". The backward shifting can be taken place by compelling the supplier to reduce the price
of raw materials etc
2.9.Tax Evasion, Avoidance and Delinquency
Tax Avoidance
Tax avoidance means taking undue advantage of the loopholes, lacunae or drafting mistakes for
reducing tax liability and thus avoiding payment of tax which is lawfully payable. Generally, it is
done by twisting or interpreting the provisions of law and avoiding payment of tax. Tax avoidance
considers the loopholes of law. Though it has a legal sanction, it means following the provisions
of law in letter but killing the spirit of the law.
Tax Evasion
Tax evasion means avoiding tax by illegal means. Generally, it involves suppression of facts,
falsifying records, fraud or collusion. It is an attempt to evade tax liability with the help of unfair
45
means. Tax evasion is illegal and would result in punishment by way of penalty, fines and
sometimes prosecution.
Delinquency
Delinquent tax refers to a tax that is unpaid after the payment due date. Usually, a penalty is
attached to a delinquent tax. The power, jurisdiction and authority to collect all delinquent taxes
are vested in the state tax commission.
An action to recover delinquent taxes is not an action upon a contract, obligation, or liability, not
founded upon an instrument in writing, but is one which arises upon a liability created by law,
other than a penalty or forfeiture.
Delinquent, in the context of monetary transactions, refers to a payment which is owing and
overdue. When used in reference to individuals, it refers to carelessness or recklessness. For
example, homeowners who fail to timely pay property taxes owed may be subject to having their
home sold in a foreclosure proceeding in order to collect delinquent taxes. State laws on
foreclosure proceedings vary, but most require that the property owner be provided with a notice
of the delinquency and an opportunity to pay the amounts due to avoid foreclosure
2.10. Chapter Assessment
1- List and discuss at least three differences between direct tax and indirect tax
2- According to cannons of taxation, evaluate the ta system of Ethiopia and recommend the way
forward
3- What is difference between social contribution and tax?
4- Discuss the difference among all types of tax rate methods, give advantages and
disadvantages for each.
5- Distinguish tax impact and impact.
6- List and discuss the main differences between evasion and avoidances with example
7- What is taxation? define taxation with consideration of the characters of tax.
8-
Chapter Four 46
3. Chapter Four
4. Ethiopian Tax System

4.1.Structure of Ethiopian Tax System and Administration
The fundamental authority to tax is derived from the Constitution of 1995, which, following the
federal structure, shares tax powers between the Federal Government and the Regional States. The
Ethiopian Constitution goes to greater lengths than other areas of power in allocating taxation
powers between the Federal Government and the Regional States. The Constitution classifies
taxation powers as “taxes exclusive to the Federal Government,” “taxes exclusive to the Regional
States,” “taxes concurrent to both the Federal Government and the Regional States.” With the
exception of customs duties, which are the exclusive preserve of the Federal Government, most
other taxes are sliced into pieces by the Ethiopian Constitution and shared between the Federal
Government and the Regional States on the basis of certain set formulas. Income taxes on
employment income are, for example, shared on the basis of the identity of employers so that if an
employer is a Federal Government or an international organization, the Federal Government
exercises the power to impose tax on the employees, and if an employer is a state government or
a private enterprise, state governments get to levy tax on the employees. The Constitution follows
similar patterns of tax-power sharing on most other taxes.
The Ethiopian federal arrangement follows the dual structure in which all the three branches of
government (legislative, executive and judicial) coexist in respect of the Federal and Regional
powers. This, in taxation, means in principle that both the Federal Government and the Regional
States enjoy full legislative, executive, and judicial powers with respect to taxation powers
reserved to them. In practice, however, the Federal Government has had the most dominant
presence in the legislation of taxation, respecting not just “federal exclusive taxes” but also
“concurrent taxes” and at times even “regional exclusive taxes.” Although Regional States have
the prerogative to issue their own tax laws with respect to tax sources reserved to them by the
Constitution, many of the Regional States for a while used federal tax laws to levy
and collect regional taxes. The Regional States did not immediately exercise their legislative
powers of issuing their own tax legislations. Some of the Regional Governments have begun
issuing their tax legislations recently. However, the exercise of the legislative power over taxation
still remains a formal matter because the Regional Governments have yet to fully exercise their
taxation powers. Many of the Regional States that have issued their own tax laws have used federal
Ethiopian Tax System 47
tax laws as models with the result that there is virtually no difference in substance between federal
tax laws and regional tax laws.
One of the striking features of the Ethiopian Constitution on matters of taxation is the unusual
specificity and detail of provisions that assign taxation powers between the Federal Government
and the Regional States. Since the Ethiopian Constitution is unusually concrete and specific in the
area of tax powers, its language in this respect leaves very little room for argument about which
layer of government has what tax powers. Nonetheless, some issues remain contentious. One is
the exercise of concurrent powers. The Constitution gives out very little as to how the concurrent
tax powers are to be exercised in practice. Following the practice of other federal systems, several
options may be open to both layers of the Ethiopian federation. The Regional States may impose
their own taxes in addition to the Federal Government taxes. The Regional States may choose to
impose additional tax rates on an otherwise federal tax law. Or the Regional States may choose to
agree with the Federal Government to share the proceeds of federally collected taxes. The Federal
Government levies and collects concurrent taxes. The revenues from concurrent taxes are shared
on the basis of a revenue-sharing scheme approved in 2004 by the House of the Federation (HoF).
4.2.Income Taxes
An income tax is a tax imposed on individuals or entities (taxpayers) that varies with their
respective income or profits (taxable income). Many jurisdictions refer to income tax on business
entities as companies‟ tax or corporate tax. Partnerships generally are not taxed; rather, the partners
are taxed on their share of partnership items. Tax may be imposed by both a country and
subdivisions. Most jurisdictions exempt locally organized charitable organizations from tax.
Income tax generally is computed as the product of a tax rate time’s taxable income. The tax rate
may increase as taxable income increases (referred to as graduated or progressive rates). Taxation
rates may vary by type or characteristics of the taxpayer. Capital gains may be taxed at different
rates than other income. Credits of various sorts may be allowed that reduce tax. Some jurisdictions
impose the higher of an income tax or a tax on an alternative base or measure of income.
Taxable income of taxpayer’s resident in the jurisdiction is generally total income less income
producing expenses and other deductions. Generally, only net gain from sale of property, including
goods held for sale, is included in income. Income of a corporation's shareholders usually includes
distributions of profits from the corporation. Deductions typically include all income producing or
business expenses including an allowance for recovery of costs of business assets. Many
jurisdictions allow notional deductions for individuals, and may allow deduction of some personal
expenses.
Most jurisdictions either do not tax income earned outside the jurisdiction or allow a credit for
taxes paid to other jurisdictions on such income. Nonresidents are taxed only on certain types of
income from sources within the jurisdictions, with few exceptions.
Most jurisdictions require self-assessment of the tax and require payers of some types of income
to withhold tax from those payments. Advance payments of tax by taxpayers may be required.
Taxpayers not timely paying tax owed are generally subject to significant penalties, which may
include jail for individuals or revocation of an entity's legal existence.
“Taxable income” means the amount of income subject to tax after deduction of all expenses and
other deductible items allowed under this Proclamation 979/2008 and Regulations 983/2008
issued.
- Obligation to Pay Income Tax on base of Residence
• An individual who is resident in Ethiopia, if he
A- Has a residence within Ethiopia;
B- Has a habitual abode (residence) in Ethiopia; and/or
C- Is a citizen of Ethiopia and a consular, diplomatic or similar official of Ethiopia posted
abroad.
• An individual, who stays in Ethiopia for more than 183 days (½ year) in a period of twelve
(12) calendar months, either continuously or intermittently, is resident for the entire tax
period.
4.2.1. Schedule “A” Income Tax (Employment Income Tax)
Taxable Employment Income
a- Every person deriving income from employment is liable to pay tax on that income at the
rate specified in Schedule “A”, shown below. The first Birr 600 (six hundred Birr) of
employment income is excluded from taxable income.
b- Employers have an obligation (Liability) to withhold the tax from each payment to an
employee, and to pay to the Tax Authority the amount withheld during each calendar
month. In applying preceding income attributable to the months of Nehassie and Pagume
shall be aggregated and treated as the income of one month.
Determination of Employment Income
i- Employment income includes any payments or gains in cash or in kind received from
employment by an individual, including income from former employment or otherwise or from
prospective employment.
j- Income received in the form of wages does not include representation and other similar
expenditures (on social functions, guest accommodations, etc.)
Exemptions:
The following categories of income are exempt from payment of income tax or are excluded from
income in arriving at taxable income.
(a) Income from employment received by casual employees who are not regularly employed
provided that they do not work for more than one (1) month for the same employer in any
twelve (12) months period;
(b) Pension contribution, provident fund and all forms of retirement benefits contributed by
employers in an amount that does not exceed 15% (fifteen percent) of the monthly salary of
the employee;
(c) Subject to reciprocity, income from employment, received for services rendered in the exercise
of their duties by:
- diplomatic and consular representatives, and
- other persons employed in any Embassy, Legation, Consulate or Mission of a foreign state
performing state affairs, who are national of that state and bearers of diplomatic passports or
who are in accordance with international usage or custom normally and usually exempted from
the payment of income tax.
(d) Income specifically exempted from income tax by:
- any law in Ethiopia, unless specifically amended or deleted by the income Proclamation;
- International treaty; or
- An agreement made or approved by the Minister.
(e) Payments made to a person as compensation or gratitude in relation to:
- Personal injuries suffered by that person;
- The death of another person.
According to the Income tax regulation the following items are exempted from Employment
income Tax.
a) Amounts paid by employers to cover the actual cost of medical treatment of employees
b) Allowance in lieu of means of transpiration granted to employees under contract of

employment
c) Hardship allowance
d) Amounts paid to employees in reimbursement of traveling expense incurred on duty
e) Amounts of traveling expense paid to employees recruited from elsewhere than the place
of employment on joining and completion of employment, or in case of foreigners traveling
expense form or to their country, provided that such payments are provided by the contract
of employment.
f) Allowance paid to members and secretaries boards of public enterprises and public bodies
as well as to members and secretaries of study groups set up by federal or regional
government
g) Income of persons employed form domestic duties
h) The tax authority is empowered to determine the amount of payment specified by numbers
ii, iv and v above:
Tax Rate
The tax payable on income from employment shall be charged, levied and collected at the
following rates:
Employment income
Tax rate Deduction in birr
No (Income per month)
% Birr
Over Birr To Birr
1 0 600 Exempted 0
2 601 1650 10 60
3 1651 3200 15 142.50
4 3201 5250 20 302.50
5 5251 7800 25 565.00
6 7801 10900 30 955
7 Over 10901 Any No 35 1500
4.2.2. Income From Rental Service (Schedule B)

Any income arising from rental of buildings is taxable under schedule „B‟. Rental income includes
all form of income from rent of a building and rent of furniture and equipment if the building is
fully furnished. Income from the lease of business including goods, equipment’s and building
which are part of the normal operation of a business, (called business lease) are taxable under
another schedule that is in schedule “C”.
Gross rental income also includes any cost incurred by the lessee for improvement to the land or
building all payments made by the lessee on behalf of the lessor in accordance with the contract
lease. In the lease contract there are two parties involved in renting a building, the lessor and the
lessee. The party who grants rent of the building is the lessor.
The one who leases the property for use is the lessee. In some occasions the lessor may allow the
lessee to sub lease the building for another party. In such circumstances the first lessee becomes
the sub-lessor. The sub lessor must pay tax on the difference between income from the sub leasing
and the rent paid to the lessor, provided that the amount received by the sub lessor. The owner of
the building who allows a lessee to sub- lease is liable for payment of the tax for which the sub
lessor is liable, in the event the sub-lessor fails to pay.
When a building is constructed for the purpose of giving on lease, the owner and contractor should
inform the Kebele Administration about its completion and the intention of giving it on lease. This
is also applicable when the building is rented before its completion. The Kebele Administration
will pass the information to the tax office for the administration of tax. It is also the responsibility
of Kebele administration to gather any such information and communicate to tax office in case
where the parties fail to do so
- Taxable Income
Gross income includes all payments, either in cash or benefited in kind, received by the lessor and
all payments made by the lessor on the behalf of the lessee. The value of any renovation or
improvement to the land or the building is also part of taxable income under this schedule if such
cost is borne by the lessee in addition to rent payable.
- Deduction
Taxable income from schedule B income is determined by subtracting the allowable deductions
from the gross income. Allowable deductions include the following:
➢ taxes paid with respect to the land and buildings being leased; except income taxes; and
➢ for taxpayers not maintaining books of account, one fifth (1/5) of the gross income received as
rent for building, furniture and equipment as an allowance for repairs, maintenance and
depreciation of such buildings, furniture and equipment;
➢ For taxpayers maintaining books of account, the expenses incurred in earning, securing, and
maintaining rental income, to the extent that the expenses can be proven by the taxpayer and
subject to the limitations specified by this Proclamation, deductible expenses include (but are
not limited to) the cost of lease (rent) of land, repairs, maintenance, and depreciation of
buildings, furniture and equipment in accordance with Proclamation as well as interest on bank
loans, insurance premiums.
- Tax Rate
The tax payable on rented houses shall be charged, levied and collected at the following rates:
(a) On income of bodies thirty percent (30%) of taxable income,
(b) On income of persons according to the Schedule B (hereunder) Schedule –B
Taxable income from rental
Tax rate
Number (Income per year)
%
Deduction
Over Birr To Birr
1 0 7,200 Exempted
2 7,201 19,800 10 720
3 19,801 38,400 15 1,710
4 38,401 63,000 20 3,630
5 63,001 93,600 25 6,780
6 93,601 130,800 30 11,460
7 Over 130,801 ***** 35 18,000
- COMPUTATION OF INCOME TAX ON INCOME FROM RENTAL OF BUILDING
In order to compute the taxable income from rental of building we use the following approach.
Sources (income) Amount in birr Amount in birr
Rental Income Received xxxxx
Add: Amount received on the
i) Lease of furniture xxx
ii) Lease of equipment xxxxx xxxxxx
Less: Deductions:
i) Taxes paid on land and buildings Leased Xxxx
ii) For those not maintain books of Accounts
Allowance for repair, maintenance and depreciation (1/5 of gross
Xxxx
income) (OR) iii) For those maintain books of Accounts
❖ Expenses on
a) Cost of lease of land xxxx
b) Repairs xxxx
c) Maintenance xx
d) Depreciation of building, furniture and Equipment’s xxx
e) Interest on bank loans xxx
f) Insurance premiums xxxxxx (xxxxxx)
Taxable Income from rental of Buildings xxxx
4.2.3. Business Income Tax (Schedule C)

Determination of Taxable Business Income
Taxable business income is determined for each tax period on the basis of profit and loss account
otherwise known as income statement which should be prepared in accordance with Generally
Accepted Accounting Principles, and subject to provisions of Income Tax Proclamation
No.979/2008 and related directives issued by the Tax Authority.
At the end of each fiscal year, each taxpayer submits a tax return to the Income Tax Authority.
The tax return is a statement containing statistical information filled in a pre-printed form
(provided by the Tax Authority), given to the Income tax Office. The return should contain full
and true information about the income earned by the tax payer. The law requires the tax payer to
furnish such information within a stipulated period.
Many businesses use the service of qualified professional accountants to prepare tax returns and
determine taxable income. Profits as shown by the accountants may not be the same as admissible
for tax assessment. There may be certain items of expenditure reasonably chargeable to the income
statement but not allowable for tax purposes.
Likewise, certain revenue items permissible to be included in the income statement may not be
permissible to include in the tax return. It becomes thus necessary to adjust those items to
determine taxable income.
Allowable Deduction
The general principle regarding deductibility is that deductions will be allowed for expenses
incurred for the purpose of earning, securing and maintaining the business income to the extent
that the expenses can be proven by the tax payer and subject to the limitations specified by the
proclamation. On the basis of this, the law permits the following lists of expenses as deductible
from business income.
1- The direct costs of producing the income, such as the direct cost of manufacturing, purchasing,
importations, selling and such other similar costs;
2- General administrative expenses connected with the business activity;
3- Premiums payable on insurance directly connected with the business activity;
4- Expenses incurred in connection with the promotion of the business inside and outside the
country, subject to the limits set by the directive issued by the Minister of Revenue.
5- Commissions paid for services rendered to the business, provided that:
a. said services were in fact rendered.
b. the amount paid corresponds to normal rates paid for similar services. By other persons
or bodies similarly situated.
6- In the case of a business located and operating in Ethiopia as the branch, subsidiary or
associated company of a business located and operating abroad, no payment of any kind made
to the holding or associated company of the business in Ethiopia shall be accepted as deduction
unless:
a. the payment in question was made for service actually rendered: and
b. said service was necessary for the business and could not be performed by the persons
or bodies or by the business itself at a lower cost.
7- If the income tax authority has reason to consider that the total amount of salaries and other
personal emoluments payable to the manager of a private limited company is exaggerated it
may reduce paid amount for taxation purpose to the limit which, in view of operation of the
company, appears justifiable, either by disallowing the payments made to more than one
manager or in any other way which may be just and appropriate.
8- Sums paid as salary, wages or other emoluments to the children of the proprietor or member
of the partnership shall only be allowed as deduction if such employees have the qualifications
required by the post.
In computing taxable income, the above listed expenses could be deducted from gross income. If
some conditions are met, the proclamation also allows such expenses as depreciation, bad debts,
interest expense and donation and gifts, which is covered separately in this section as deductible
expenses. (Refer the proclamations articles 23 to 27 of the 979/2008 some articles of them are
discussed in below
Non-allowable Expenses
All those expenses, which are not wholly or exclusively incurred for the business activity, are not
allowable deductions from gross income. Therefore, in computing taxable income the following
expenses should be added back.
a- Capital Expenditure- the cost of acquisition, improvement, renewal and reconstruction of
depreciable assets
b- Additional Investment- an increase of the share capital of a company or the basic capital of a
registered partnership
c- Declared dividends and paid out project shares.
d- Voluntary pension or provident fund contributions over and above 15% of the monthly salary
of the employee.
e- Damages covered by insurance policy
f- Interest in excess of the rate used between the National Bank of Ethiopia and the commercial
Banks increased by two percentage points.
g- Punitive damages and penalties
h- The creation or increase of reserves, provisions and other special purpose funds unless
otherwise allowed by the proclamation.
i- Income tax paid on schedule “C” income and recoverable Value Added Tax (VAT)
j- Representation expenses over and above 10% of the salary of the employee.
k- Personal consumption expenses
l- Expenditures exceeding the limits set forth by the proclamation or regulations
m- Entertainment expenses “Entertainment” means the provision of food, beverages, tobacco,
accommodation, amusement, recreation or hospitality of any kind to any person whether
directly or indirectly.
n- Donation and gift other than those permitted by regulation.
o- Sum paid as salary, wages or other personal emoluments to the proprietor or partner of the
enterprises. Expenditure for maintenance or other private purpose of the proprietor or partner
of the enterprise.
p- Losses that are not connected with or not arising out of the activity of enterprise.
q- Grants and donations that exceed 10% of the taxable income of the tax payer.
Allowable Deductions that need Certain Conditions to be Met the following expenses need certain
conditions to be met before all are allowed to be deducted from gross income:-
Interest expense
a- Interest which is not in excess of the rate used between National Bank of Ethiopia and
Commercial banks increased by 2 %) is allowable deduction if the lending institution is
recognized by NBE or a foreign institution permitted to lend to enterprises in the country.
Moreover, for the interest paid to foreign banks to be deductible, the lending bank shall, prior
to the granting of any loan to any such person, file a declaration in writing with the Tax
Authority wherein it informs said authority concerning all loans granted to any person
liable to pay income tax in Ethiopia. In addition, the borrower shall withhold 10% from the
gross interest payable and transfer same to the Tax authority within two months of the end of
the fiscal year.
b- Interest paid to shareholders on loans and advance can be deducted to the extent that the interest
paid is less than the average of four times the amount of share capital in a tax period. This
provision doesn’t apply to banks and insurance companies.
Representation Allowances
Representation allowance is hospitality expense incurred in receiving guests coming from outside
the enterprise in connection with the promotion and enhancement of the business. Such expenses
are deductible to the extent of 10% of the salary of the employee.
Gifts and Donations
Gifts and donations are allowable deductions under the following conditions
a- If they are given to a registered welfare organization and where it is certified by the registering
authority that the organization has a record of outstanding achievement and its utilization of
resources and accounting system operates transparency, accountability.
b- If the payment is made in response to emergency call issued by the government to defend the
sovereignty and integrity of the country, to prevent man-made or natural catastrophe, epidemic
or for any other similar cause.
c- Donation made to non-commercial education or health facilities. Nonetheless, grants and
donations made for purpose listed above may only be allowed as deduction where the amount
of the donation or grant does not exceed 10% of the taxable income of the taxpayer.
Trading Stock
- Trading stock is a business asset that is either used in the production process or become part
of the product, or that is held for resale purpose. The cost of trading stock disposed of during
a tax period is allowable deduction for the purposes of ascertaining income.
- The cost of trading stock disposed of during a tax period is determined on the basis of the
average cost method, i.e. the generally accepted accounting principle under which trading stock
valuation is based on an average cost of units on hand.
Depreciation
Any business may acquire assets that have non-current nature to generate profit. In determining
periodic income, the cost of these fixed assets should be transferred to expense account in a
systematic and rational approach called Depreciation. IFRS allows different methods of computing
annual deprecation charges for preparing general purpose financial statements.
Among these methods, the Ethiopian government adopts the straight line – pooling system method.
Generally, except the cost of building, intangible assets and Information Technology Equipment’s
purchased by a business, all other assets become part of a pool of expenditures on which capital
allowances may be claimed. Under the pooling system, when addition is made, the pool increases;
on disposal the pool is reduced by the sale proceeds.
In accordance with the newly enacted income tax proclamation and regulation, depreciation may
be deducted in the determination of taxable business income. Nonetheless, fine arts, antiques,
jewelry, trading stock and other similar business assets not subject to wear and tear and
obsolescence shall not be depreciated.
Depreciation rate
a) In determining the amount of depreciation, the acquisition or construction cost, and the cost of
improvement, renewal and reconstruction of buildings and constructions shall be depreciated
individually on a straight-line basis at five percent (5%).
b) The acquisition or construction cost, and the cost of improvement, renewal and reconstruction,
of intangible assets shall be depreciated individually on a straight line basis at ten percent
(10%).
The above two categories of business assets are depreciated at the given rates based on their cost
(gross value).
The following two categories of business assets shall be depreciated according to a poling system
at the following rates;
a. Computers, Information systems, software products and data storage equipment as a rate of
25%
b. All other business assets at the rate of 20%. This category includes motor vehicles, plant and
machinery, furniture and equipment, etc.
For assets for which the pooling methods are used, the rate is applied to the depreciation base for
the determination of depreciation. The depreciation base is the book value of the asset as recorded
on the opening day of the balance sheet of the tax period increased by the cost of asset acquired or
created and the cost of improvement, renewal and reconstruction of the asset during the tax period.
The amount can also be decreased by the sales price of assets disposed of during the period. Losses
incurred during the period due to natural calamity and other involuntary conversion will also be
considered in the computation of depreciation base. Any compensation received for these purposes
will be deducted from the book value.
While determining the depreciation base, if the depreciation base becomes negative amount, that
amount will be added to taxable income and the depreciation shall become zero. On the other hand,
if the depreciation base does not exceed Birr 1,000 the entire depreciation base will be a deductible
business expense.
If a revaluation of business assets takes place, no depreciation will be allowed for the amount of
the revaluation. In determination of taxable business income, a deduction is permitted in respect
of each category of business assets for the maintenance and improvement expenses up to a
maximum of 20% of the depreciation base of the end of the year. Any actual expense exceeding
this 20% will increase the depreciation base of that category (or it is capitalized).
Nonetheless, depreciation is not allowed for assets in respect of which all capitalized costs have
been fully recovered if the transfer of such assets is made between related persons.
- The regulation issued by the Council Of Ministers indicates that depreciation will be allowed
as deduction only if the taxpayer claiming deductions for depreciation keeps proper records
showing the cost of acquisition of the asset and the total amount deducted since the date of
acquisition. Moreover, the tax payer must furnish the Tax Authority with satisfactory evidence
that the data mentioned in the records are true and correct.
Bad Debts
In the determination of taxable income, a deduction for a bad debt is allowed if the following
conditions are met:
- An amount corresponding to this debt was previously included in the income;
- The debt is written off in the books of tax payer; and
- Any legal action to collect the debt has been taken but the debt is not recoverable.
Computing Taxable Income
Using the income statement, taxable income may be determined as follows;
1. Take the net profit as shown in the income statement which is prepared in accordance with
IFRS
2. Add back any item deducted as expense, which is not allowed for tax purposes.
3. Deduct any item included in the income on which income tax has already been withheld by the
payer. Examples of such items are income received from royalties, income from games of
chance, dividends and interest received, etc. refer schedule „D” other income in the
proclamation.
4. Multiply the figure so arrived (from step 1through step III) by the income tax rate. For bodies
use the progressive tax table for persons (other tax payers) to get the tax payable for the fiscal
year.
5. Determination of Taxable Business Income
6. Allowable Deductions
7. Non-Allowable Expenses
8. Computing Taxable Income
9. Tax Rate
Tax Rate
Taxable business income of bodies is taxable at the rate of 30%
Taxable business income of other taxpayers shall be taxed in accordance with the following
schedule C
The short cut method of computing business income tax is provided below.
Taxable income from rental
Tax rate
Number (Income per year)
%
Deduction
Over Birr To Birr
1 0 7,200 Exempted
2 7,201 19,800 10 720
3 19,801 38,400 15 1,710
4 38,401 63,000 20 3,630
5 63,001 93,600 25 6,780
6 93,601 130,800 30 11,460
7 Over 130,801 ***** 35 18,000
Loss Carry Forward
A business is said to have made loss when the total expenses incurred by the business during a
fiscal year are greater than the total income generated by the business in the same year. Loss carry
forward is a procedure whereby a loss incurred in one tax period is carried forward to the next tax
period to be deducted from the available profit, if any. Loss carries forward is one of the several
changes introduced by new tax law. The importance of the loss carry forward provision to a
company is that it preserves valuable cash which otherwise would have to be paid out in taxes.
Such funds are retained in the business and can be used for working capital and/or expansion of
the business. A business, which has alternate profit and loss years of about the same dimension,
would pay no tax at all.
The subsequent paragraphs explain loss relieves available for companies and related eligibility
conditions. If the determination of taxable business income results in a loss in a tax period, that
loss may be set off against taxable income in 3 years tax periods; earlier losses set being set off
before later losses. A continuous set off will be permitted only for a maximum period of 6 years
(two periods of three years). However, if during a tax period the direct or indirect ownership of the
share capital or the voting rights of a body changes more than 25% by value or by number the
provision for set off will not apply to losses by that body in that tax period.
4.2.4. Other Income Taxes (Schedule D),
→ Foreigners in came tax
→ Royalties
→ Income from Rendering of Technical Services
→ Dividends
→ Income from Rental of Property
→ Interest Income on Deposits
→ Gain on Transfer of Certain Investment Property
4.3.Consumption Taxes
4.3.1. Value-Added Tax
The value added tax (vat) was first introduced in France in 1954. Thereafter, various European
countries introduced it as an alternative to turnover taxes.
Meaning of Value Added Tax
The VAT belongs to the family of sales tax. A VAT may be defined as "a tax to be paid by the
manufacturers or traders of goods and services on the basis of value added by them". It is not a
tax on the total value of the commodity being sold but, on the value, added to it by the manufacturer
or trader. They are not liable to pay the tax on the entire value of the commodity. But they have to
pay the tax only on the net value added by them in the process of production
or distribution.
Thus, the value added by them is the difference between the receipts (from the sale) and payments
made to various factors of production (land, labor, capital and organization) in the form of rent,
wages, interest, and profits.
Computation of Value Added
The value added by a firm can be calculated in any one of the following two methods:
A) Addition Method
Under this method, the value added by a firm i.e. the tax base is determined by adding the payments
made by the firm to the various factors of production such as wages, rent, interest and profits.
B) Subtraction Method
In this method, the value added by the firm is determined by subtracting the cost of production
from the sales receipts of the firm.
But, in these two methods, the tax liability is identical.
Forms or Kinds of Value Added Tax

The value added tax can be determined in different forms. It may vary depending upon the form
of tax base. The forms may differ on the items to be included in the tax base.
The possible varieties of VAT are given below:
A- Consumption Type
B- Income Type
C- Production Type and
D- Wages Type.
Let us explain the meaning of these forms one by one.
A- Consumption Type
In this type of VAT, apart from the non-capital inputs purchased, the capital equipment’s
purchased is also considered.
As such, the firm is allowed to deduct the entire value of the capital equipment’s purchased during
the year. This type provides 100% depreciation, which is equivalent to tax exemption.
Thus,
Tax Base = Gross Value - Total Value of Inputs Purchased (Capital and non-capital)
B- Income Type
According to this form, the firm is allowed to deduct the depreciation on the capital goods (during
the year) apart from the full value of its non-capital purchases. Here, the firms cannot deduct the
entire value of the capital goods purchased during the year but they can deduct the respective
amount of depreciation attributable to that year.
Thus, the tax base is calculated as follows:
Tax Base = Gross Value – (Value of non-capital Purchase +Deprecn on capital goods for that year)
This variety clearly gives the proper net value added.
C- Production Type
In this type, instead of total value of inputs purchased, the value of non-capital purchases alone is
allowed to deduct for determining the tax base. That is, to compute the value added by the firm,
depreciation on capital goods is not allowed.
Thus, the tax base under this type will be:
Tax Base = Gross Value - Value of non-capital goods Purchased
Since depreciation is not allowed, it is not considered as a good system and is not popular and
universally accepted.
D- Wage Type
Here, to determine the tax base, an amount equivalent to the net earnings is deducted from the
capital of the firm for that year. The difference will be equivalent to the wages paid during the
year. That is:
Tax Base = Capital of the firm – Net earnings for that year
Capital of the firm = Net Income (i.e., Gross Income – Depreciation)
Net Earnings = Net Profits (inclusive of interest on own capital)
Since the tax base arrived at as above is equivalent to the wages paid, it is called as wages variety
of value added tax.
Advantages of Value Added Tax
The VAT has the following advantages.
• Easy to Administer
Since the impact of VAT system is like the single point sales tax system, the administration
becomes easier.
• Effective and Efficient
The VAT replaces inefficient and poorly administered taxes such as taxes on capital goods and
those that reduce the tax base and involved in difficult administration. Hence, it is considered as
more effective and efficient.
• Neutrality
VAT is expected to be perfectly neutral in the allocation of resources i.e. in the forms of production
and commercialization. Thus, it helps the economy in adopting the forms of production that are
economically more suitable.
• Reduce Tax Evasion
In the case of VAT, the tax is divided into several parts depending on the number of stages of
production and sale. Thus, the possibility and intention to evade tax is considerably reduced.
• Possibility of Crosschecking
In VAT system, cross checking becomes possible. When a firm purchases raw material from
another firm and pays tax on such purchase, it has to maintain records about from whom it
purchased goods and the amount of tax paid by it etc. The firms maintaining these records alone
can reclaim the tax already paid. The other firm also has to maintain such records. This obligation
makes tax evasion difficult.

• Less Tax Burden
Under VAT, the tax is collected in small fragments at different stages of production and sale.
Hence, the taxpayers feel the burden of the tax less.
• Encourages Exports
Under VAT system, the tax burden is less and it reduces the cost of production. Such a reduction
in the prices of commodities increases the competitive efficiency of the firms in the global market.
Besides, to promote exports, the Government may refund the taxes paid on the exportable goods.
It is possible only when the tax paid is easily identifiable. In the system of VAT, it is easy to
separate the tax from the cost of production, which is not possible in the case of other taxes. In this
way, it encourages the exports.
• Improves Productivity
In the system of VAT, a firm has to pay tax even though it runs into loss. It cannot claim any
exemption for loss because it pays taxes on the value produced and not on profits. So the firms
will always try to improve their performance and reduce the cost of production. As a result, the
overall productivity of the country will be improved.
• Burden of Tax is Shared by all Factors
The value added tax falls on the wages, interest, rent and profits. As such, the burden of tax is
shared by all factors of production.
• Non-distortionary
Under VAT system, exemption is allowed to the minimum. The tax net is wide enough to cover
almost everything. Hence, it proves to be non-distortionary.
• Major Source of Revenue
In most of the countries, the value added tax contributes a considerable amount of revenue to the
Government. This makes it a reliable and valuable source of revenue.
Disadvantages of VAT
VAT system has the following disadvantages.
• Not a Simple and Easy System
VAT System is not easy and simple to adopt in under developed countries where the tax
administrative set-up is inefficient and inexperienced to understand any complicated tax structure.
• Requires Advanced Economic Structure
The proper implementation of VAT system requires advanced financial and economic structure
and the firm should be in the habit of keeping proper accounts. Hence, it becomes difficult to
implement the system in all types of economy.
• Possibility of Tax Evasion
The VAT system largely depends upon the co-operation of the taxpayers because crosschecking
is not possible always. Hence, there is a greater possibility for tax evasion.
• Uneconomical
This system involves high cost of administration, assessment, verification, collection etc. Hence,
it is highly uneconomical.
• Does not Increase Efficiency
In a scarce economy i.e. economy of shortages where speculation is practiced, hoarding and non-
competitive price rise are common, the producers will not increase their efficiency. The goods will
be purchased irrespective of their high price and inferior quality. Thus in such an economic
condition, VAT will not increase efficiency.
• Lesser Revenue
The revenue collected under VAT system is far less than the revenue collected under the multi-
point turnover tax system.
• Additional Burden
Under VAT system, the manufacturers and shopkeepers have to observe various legal formalities
in the form of maintaining various records, accounts books etc. The verification of those records
puts additional burden to the tax enforcing authorities.
• Inflationary in Nature
• Under VAT system, the tax burden will be less which results into surplus income in the
hands of consumers. Thus, there is a possibility for wide spread inflation in the economy.
But, this argument does not hold good. Because, VAT itself cannot be inflationary and the
other accompanying policies of the Government might make it so.
• Regressive in Nature
According to Allan A. Tait, a straight forward single rate VAT, with few exemptions would tax
lower income households more heavily than the higher income household. Thus, it is considered
as regressive in nature. Even though the VAT system is suffering from the above said drawbacks,
the benefits sought are more and it can be applied to the Indian economy after rationalization,
modification and restructuring of the system. Various Tax Reforms Committees and other eminent
economists advocated this system as suitable to the prevailing economic conditions of the
developing countries.
Double Taxation
Today, with enormous range of expenditure outlays, the Governments cannot depend upon a single
tax. Because it will not provide sufficient revenue to meet their financial needs. Moreover, with
the single tax, the Government cannot achieve the principles of equality, ability to pay and
equitable distribution of income and wealth among the people.
Thus, the principle of multiple-taxation is recommended whereby the Government may resort to
various direct and indirect taxes to attain their objectives both fiscal and social.
But such multiple taxation should not lead to double taxation. Double taxation occurs when the
Government levies taxes on the same base in more than one way. Hence, double taxation can be
defined as, “taxation of the same tax base twice either by one authority or by different authorities”.
Here, the two taxes should be levied with reference to the same period.
Examples of Double Taxation
- Mr. X earns his income in Ethiopia and U.S.A. If both the Governments levy taxes on his entire
income, it is considered as double taxation i.e. international double taxation, because he has to
pay tax in two countries on the same income.
- The Government of a country levies taxes on the profits of a company before the distribution
of dividends. Thereafter, it taxes the individual shareholders on the dividends received by them.
Then it becomes a double taxation. Here the company and shareholders are taxed on the same
income.
Kinds of Double Taxation

1. Double Taxation by Different Authorities
When the same tax base is levied by two different taxing authorities either international or federal,
it becomes a case of double taxation.
- International Double taxation
This type of double taxation occurs when the Governments of different countries levy on the
same tax base. The scope of a tax determines the incidence of its burden. It includes both direct
and indirect taxes. Generally, the income tax, wealth tax and customs duty cause such
international double taxation.

- Federal Double Taxation
This kind of double taxation occurs when the Governments within a country levy tax on the
same base. When the Union Government and State Governments of a country levy tax on any
one tax base, it is called federal double taxation.
2. Double Taxation by Similar Authority
Double Taxation Avoidance Agreements
Article on elimination of Double Taxation assumes great significance, as it is the central point of
any Treaty. Treaties generally use combination of various methods for granting relief from double
taxation. It is also a powerful tool for the purpose of Tax Planning. In fact, it serves well the
ultimate objective of Treaty namely overall minimization of tax burden or avoidance of same
income being taxed by two countries. This brings in harmony and equity in tax legislation and bids
good-bye to the famous dictum in the taxation statutes that Tax and Equity are strangers.
i) Present Day Scenario and Need for Tax Treaties
Due to advances in communication and technology, the world has become a global village. No
nation can afford to remain in isolation. For survival in a competitive environment, one has to view
the entire world as market and create a niche for one's products in the international market. The
need of the hour is to integrate the national economy with the international economy. This gives
rise to full-fledged joint ventures in place of limited participation, creating production and
marketing bases in different countries with diverse political systems and tax regimes. Movement
of capital cross border transactions becomes common place. The transnational corporations are the
vehicles used for the purpose.
Every nation has sovereign right to tax its residents on their worldwide incomes. As a result, the
income of an organization can get taxed both in the home country (country of its origin) as well
the host country (country where it has its operations). In such an environment, cost of operating
worldwide would become prohibitive and the benefits of international trade, and competitive cost
advantages would be lost. Double taxation is harmful for movement of capital, technology and
people.
In civilized society, in home country tax is an obligation and in host country tax is a cost. There is
need to achieve tax efficiency. The Double Tax Avoidance Agreements come into play to mitigate
the hardships caused by taxing the same income twice, in a home country as well as in the host
country.
Tax Treaties remove the obstacles and try to achieve balance and equity. They aim at sharing of
tax revenues by the concerned states on a rational basis without causing undue hardships to the
taxpayers operating internationally. Tax Treaties do not altogether eliminate double taxation, but
reduce the incidence to tolerable extent.
Differences between Advalorem Duty and Specific Duty
Advalorem duty is levied on a certain percentage on the value of the commodity to be taxed and
weight, length or bulky of the goods are not important for this purpose. Specific duty is levied
according to the weight, length, bulky or some other unit of measurement of the commodity
concerned.
The following are the differences between advalorem and specific duty:
Base of Difference Advalorem Duty Specific Duty
Basis of Levy Levied on the certain percentage on the Levied as to the weight, length, bulky
value of commodity to be taxed etc of the commodity to be taxed.
Administration of It is very difficult to administer. It is easier to administer and collect.
Duty Thus the duty is levied on the value Once it is possible to identify the
of commodity. But, in practice it is goods, it is easy to levy and collect
very difficult to estimate the value of tax
thousands of commodities imported
from a large number of countries
Prediction The government cannot correctly Under

of specific duty, the
Quantum of Revenue predict the quantum of revenue yield Government can easily predict the
quantum of revenue yield
Chance of Tax the government cannot correctly Under specific duty, unit of
Evasion predict the quantum of revenue measurement of commodities i.e.
yield. weight, length, bulk etc, can be
ascertained at any time. Hence
there is less chance of tax evasion
Tax Burden Advalorem duty keeps the burden of It does not keep the tax burden
tax steady i.e during the times of steady. Ex: in time of recession,
boom the tax liability tends to rise in there is an overall downward trend
time of recession, the liability also in prices, tax will be imposed only
goes down on the basis of commodities
weight, length etc, and not on the
value of the commodity. Hence,
specific duty increases the tax
burden during that period
Revenue Yield Brings higher revenue during the Under specific duty, revenue yield
period of rising prices. Because is of static in nature
when the price tends to increase, the
revenue yield also increases.
4.3.2. Turnover Tax

Turnover Tax in Ethiopia has replaced Sales Tax. This section discuss, Turnover Tax Rate in
Ethiopia, Base of computation obligation, and exemption from TOT in Ethiopia. Ues Income Tax
Proclamation No. 286/2002 or 286/1994 (according to the Ethiopian calendar - EC) and its
amendment Proclamation No. 608/2008
The Rate of Turnover Tax and Exemption
Note: If VAT is charged over goods or services, then TOT will not be charged. Filing of Tax
Return and Payment of TOT can be done either at the end of each Ethiopian calendar month or
once in at the end of every quarterly year of the tax year (that is every three months starting from
8th of July (Hamle 1).
Rate of Turnover Tax
The Turnover Tax shall be:
• (two percent) on Goods sold locally
• For services rendered locally
o 2% (two percent) on contractor, grain mills, tractors and combine-harvesters;
o 10% (ten percent) on others.
Base of Computation of the Turnover Tax
Base of computation of the Turnover tax shall be the gross receipt in respect of goods supplied or
Services rendered Obligation to Collect and Transfer the Turnover Tax A person who sells goods
and services has the obligation to collect the Turnover Tax from the buyer and transfer it to the
Tax Authority. Hence, the seller is principally accountable for the payment of the tax.
Exemption
The following shall be exempted from Turnover Tax: The Minister of Finance and Economic
Development may, by directive, exempt other goods and services.
- the sale or transfer of a dwelling use for a minimum of two years, or the lease of a dwelling
- the rendering of financial services;
- the supply of national or foreign currency (except for that used for numismatic purposes and
of securities;
- the rendering by religious organizations of religious or other related services:

- the supply of prescription drugs specified in directives issued by the relevant government
agency, and the rendering of medical services;
- the rendering of educational services provided by educational institutions, as well as child care
services for children at pre-school institutions:
- the supply of goods and rendering of services in the form of humanitarian aid
- the supply of electricity, kerosene, and water;
- the provision of transport;
- permits and license fees;
- the supply of goods or services by a workshop employing disabled individuals if more than
60%of the employees are disabled; and
- the supply of books
4.3.3. Excise Tax
Excise tax refers to an indirect type of taxation imposed on the manufacture, sale or use of certain
types of goods and products. Excise taxes are commonly included in the price of a product, such
as cigarettes or alcohol, as well as in the price of an activity. Excise taxes may be imposed by both
Federal and state authorities.
Excise taxes usually fall into one of two types:
• Ad Valorem; meaning that a fixed percentage is charged on a particular good or product.
This administration of the tax is less common.
• Specific; meaning that a fixed currency amount may be imposed depending on the quantity
of the goods or products that are purchased. Specific is the most common type.
For example, a bottle of wine that normally costs birr 10 may have a specific excise tax of birr
2 imposed on it. As per the intent of the excise tax, the additional cost of the wine is passed onto
the consumer, making the retail cost of the bottle birr 12. While this seemingly does not affect
the maker of the wine, who is still gains birr 10, in revenue, an increase in price does reduce
quantity demanded, which would indeed affect his balance sheet.
The implementation of excise taxes allows Federal and state governments the means to raise
additional revenue necessary for large projects such as social programs. Excise taxes are most
often levied upon cigarettes, alcohol, and gasoline. These are often considered superfluous or
unnecessary goods and services. To raise taxes on them is to raise their price and to reduce the
amount they are used. In this context, excise taxes are sometimes known as "sin taxes”.
4.4.Stamp Duties
Enforcement of stamp duty is required to have strong system of law enforcement to prevent the
increasing incidence, from time to time, of contraband and other commercial fraud crimes which
are resulting negative impact to legitimate trade, public security, government revenue and other
social and economic development.
Stamp Duty Proclamation No.110/1998 and its amendment proclamation No.612/2008 the legal
instrument which regulates stamp duty in Ethiopia is Stamp Duty Proclamation proc. No.
110/1998 and its amendment proclamation No. 612/2008.
Article 3 of the stump duty proclamation exhaustively lists instruments chargeable with stamp
duty:
- Memorandum and articles of association of any business organization cooperative or any
other form of association
- Lease, including sub-lease and transfer of similar rights.
- contractor agreements and memoranda thereof
- → award → contract of employment
→ bonds → natural acts
→ warehouse bond → power of attorney
→ security deeds → documents
→ collective agreement
4.5.Foreign Trade Taxes
4.5.1. Custom Duties
All imported goods to Ethiopia are subjected to customs duties and taxes, unless exempted by law.
Taxes applicable on imported goods are: Import (Customs) duty, Withholding Tax (a fixed rate of
3%), Excise Tax (if applicable), VAT (a fixed rate of 15%) and Surtax (a fixed rate of 10%).
Duty is tariff collected on the value of the good calculated on the basis of its actual total costs. It
is levied in accordance with the rules of the international convention on the harmonized customs
description and coding system. Sur-tax applies on all imported goods, except those exempted by
the Council of Ministers Regulation No. 133/2007 at 10 percent rate. Excise tax is paid on imported
goods with a percentage rate ranging from 0 to as high as 100. VAT on imported goods is a flat
rate of 15 %. A 3 percent withholding tax applies also on imported goods. These taxes are
calculated based on the cost and freight rate. But the Ethiopian Revenues and Customs Authority
provides its own CD with details on prices on various goods. The rate is usually calculated as per
the price on the CD. This CD is to be updated every three months.
The primary purpose of the custom system is to provide revenues rather than to protect Ethiopian
industry or to prohibit the importation of certain commodities. However, there are restrictions on
importing certain goods that compete with domestically produced goods.

4.5.2. Import Procedures
The import export trade has been growing steadily in Ethiopia. However, for successive years the
import trade has outweighed the export trade.
Import Regulations
One can find here information on import regulations in Ethiopia: who can import, what the foreign
exchange requirements are, and what import ban or restrictions exist.
Who can import to Ethiopia? According to Regulations No. 270/2012 or 270/2005 EC Import
trade (excluding, bitumen, and raw materials imported by foreign investors who are in the
manufacturing industry) in Ethiopia is exclusively reserved for domestic investors.
A businessperson who wants to engage in import trade in Ethiopia must be registered with the
Ministry of Trade, which regulates imports, and obtain a trading license. Obtaining a trading
license is easy and takes a much lesser time than it used to some years ago. The necessary
regulations and procedures to obtain a trading license are found in our starting a business section.
Foreign Currency: Importers should get licenses to secure the necessary foreign currency. Any
purchase worth more than USD 5000 should be processed either through letter of credit (LC) or
Cash against Document (CAD). Click the link to find out more on how an importer can secure
foreign currency: foreign exchange directive Importers who secured foreign currency should use
Ethiopian Shipping and Logistics Services Enterprise (for Sea Transport) or Ethiopian Air Lines
(in case of Air Transport) to transport their cargo. If these carriers do not call a
specific port, the carriers give the importers a waiver. However, the Ministry of Industry has
recently sent a list of manufacturers to the National Bank of Ethiopia who is exempted from the
requirement to use ESLSE.
Import Ban or Quantitative Import Restrictions: Except for items which are socially and morally harmful
(e.g. drugs, weapons and pornographic materials), no import ban or quantitative import restrictions exist.
However:
- Some imports must meet the standards of the previous Quality and Standards Authority of Ethiopia
(QSAE) who split into four entities. Now the regulatory body is named as Ethiopian Standards Agency.
Details are available on the Agency's Web site: ethiostandards.org. Goods which have standards which
are considered mandatory/compulsory Ethiopian Standards should be inspected before shipment by an
internationally recognized third party inspection body.
- Medicines and medical supplies must be registered with the Drug Administration and Control Authority
(DACA) of Ethiopia. No drug, whether produced locally or imported, shall be put into use unless it is
duly registered by the Authority. DACA has banned the importation of drugs from some foreign drug
manufacturing companies who do not follow Good Manufacturing Practice.
- No person shall import into Ethiopia any plant or plant product, including seeds as legally specified,
not duly authorized for import by the Minister of Agriculture. All imported plants and other articles
liable to be infested or infected with plant pests are subject to quarantine.
4.5.3. Export Procedures
Export Regulations: According to Regulations No. 270/2012 or 270/2005 EC export trade of raw
coffee, chat, oil seeds, pulses, hides and skins bought from the market and live sheep, goats and
cattle not raised or fattened by the investor is exclusively reserved for domestic investors. Foreign
investors cannot be involved in export trade of these items from Ethiopia.
Businesses that wish to export from Ethiopia should know the export procedures needed to obtain
export permit by commercial banks; should prepare application for Quality Testing and
Certification to obtain Export Authorization Certificate from the Quality and Standards Authority
of Ethiopia; should fill the Customs declaration. We have included all these export procedures in
Ethiopia and also the VAT registration for exporters from Ethiopia and VAT rate applied on goods
exported from Ethiopia.
Export permit by commercial banks: Documents required for Export Permit Approval: Duly
signed contract by seller & buyer
- Undertaking letter of our customer that consignment will be settled within a maximum of 90
days from date of the Foreign Exchange Permit for Cash against Document (CAD) mode of
payment and Authenticated message of L/C opened for Letter Credit mode of Payment.
- Seller's invoice
- Export License Valid for the year
- Tax registration certificate (TIN certificate)
- Export permit application form duly filled, signed & stamped (as appropriate) by the customers
- NBE (National Bank of Ethiopia) issues delinquent list of exporters periodically. Customer’s
name should not appear in the delinquent exporters list of NBE for the period. If the name
appears, there should be subsequent list indicating the given customer has cleared all
outstanding items at NBE.
In regards to payment, the exporters should:
- Know thoroughly the foreign counterpart’s (buyer’s) financial soundness, reliability, integrity,
full address, etc.

- Sales/Purchase contract should exist between the two parties (importer and exporter).
- (LC Mode of Payment) Go through text of L/C opened in their favor and make sure that
compliance can be met without doubt. Otherwise, amendments need to be requested from
opener as soon as L/C has been received or at the earliest - long before shipment of
consignments.
- (CAD Mode of Payment) Follow up the payment, as nonpayment or even delay of remittance
above 90 days will put name of exporter in delinquent list freezing further exports until
proceeds are received.
Application for Quality Testing and Certification:
When export products are ready, make arrangements for suitable packaging and apply to the
Quality and Standards Authority of Ethiopia for quality testing, and acquire the Export
Authorization Certificate.
Customs Declaration:
To avoid costly delays, the exporter declares all facts about the export consignment, and all
supporting original documents should be forwarded to the Customs Clearing Agents to enable
customs formalities and authorization of the dispatch of the export goods. Accordingly, the
exporter must hand over the Export Permit, the copy of the Customs
Declaration Annex form, the Ethiopian Customs Declaration form, the Certificate of Origin, and
the special movement forms/certificates (the EURI Movement Certificate and the GSP form A) to
the clearing agents. Exporters, VAT and VAT Registration
According to the Value Added Tax Proclamation (285/2002) and the Regulation by the Council
of Ministers on VAT (Regulation 79/2002), all exports of goods and services are liable to VAT at
the zero rates. This means that VAT is charged at 0% (or no VAT has to be charged). However,
more importantly an exporter is entitled to reclaim the VAT on all the goods and services
purchased to produce the exports. But since this still means an exporter is still making taxable
supplies even at a zero rate, the law requires the exporter to register if the turnover exceeds the
registration limits
4.6.Sur-Tax
A tax levied on top of another tax. Sur-tax can be calculated as a percentage of a certain amount
or it can be a flat birr amount. Surtax is generally assessed to fund a specific government program,
whereas regular income or sales taxes are used to fund a variety of programs. Thus, one unique
feature of surtax is that it allows taxpayers to more easily see how much money the government is
collecting and spending for a particular program.
4.7.Chapter Assessment
Part One: Answer “True” for correct statement and “False” for incorrect one
1. A tax paid from excess of business operation earning over costs is known as property tax.
2. Excise tax refers to a direct type of tax on manufacture or sale of certain products.
3. In comparison, direct tax covers wider range than indirect tax in developing countries
4. All the governments of world including Ethiopia solely collect revenue only at federal level
5. The basic purpose why the government impose tax on public is to discourage the public.
6. Under direct tax, the impact and incidence of the tax fall on the same person.
7. The government does not have right to reduce or exempt tax on any once earning
8. Value added tax can be levied in a business though there is no profit on it.
9. Taxation of the same tax base more than once is known as double taxation
10. For any tax system, equitability should get more consideration than equality.
Part Two: Choose the BEST among the given alternatives

11. Among the following, on is demerit of direct tax
A. Limited scope C. Inconvenience
B. Hard to compute progressive rate D. Considers an ability to pay
12. A process of transferring the burden of a tax by which the money burden of a tax is transferred
from one person to another
A. Shifting C. Exemption
B. Transformation D. Capitalization
13. Which one is the pioneering country in introducing value added tax in world
A. United states C. Germany
B. Italy D. French
14. Which one is not important characteristics of tax
A. No direct benefit to payers C. Tax is compulsory payment
B. Tax imposer is not only government D. Tax is legal
15. Enforced proportional contributions from person and properties imposed by the government
by virtue of its sovereignty for the support of the government and for all public needs
A. Taxes B. Interest expense
C. Public revenue D. Public expenditure
16. A tax structure where the greater part of tax burden is allocated to lower earning is known as:
A. Progressive B. Regressive C. Proportional D. Digressive
17. One of the following is not part of commodity tax
A. Excise tax C. Corporate tax
B. Turnover tax D. Value added tax
18. Reduction of the payment of tax in a legal way is known as:
A. Exemption B. Avoidance C. Shifting D. Evasion
19. One is allowable deduction (expenses) of business earnings for income tax purpose
A. Capital expenditure C. Personal consumption
B. Revenue expenditure D. Declared dividends
20. Proportional ta structure gives a little flexible to tax administrators and it is considered as easy
A. It is uniformly applicable C. Inelastic in nature
B. It is inequitable distribution D. Considering progressive rate
21. Which one of the following makes an individual to pay income tax
A. Non Ethiopian first time visitor of Ethiopia C. A foreigner stays not more than 183 days
B. Ethiopian with less than 600 birr income D. Foreign posted diplomat of Ethiopia
22. Tax computation for personal rent income earners when they do not have income statement
considers
A. GAAP based income statement C. 30% tax from gross earning
B. IFRS based Income statement D. 1/5 of income is deducted to leave tax
23. Which one of the following is the way of levying tax in Ethiopia
A. All employees needs to pay 15% of monthly income
B. All rent income collectors need to pay 30% of annual income
C. All legal entity business income collectors need to pay 30% direct tax
D. All gift and special revenue earner need to pay 60% tax
24. VAT(Value added tax) is levied on
A. Base of import and export C. Base of value added of product
B. Base of production in national border D. Base of entire value of product
Part Three: Match the following items
25. Specific duty 27. Advolerem
26. Evasion 28. Direct tax
29. Indirect tax C. Tax agreement physical value
30. Delinquency D. Failure to pay tax on due date
A. Illegal tax deduction E. Incidence and impact is the same
B. Incidence and impact is different F. Tax agreement value of a commodity
Part Four: Give short Answer

31. The authorized office or authority for collection, administration and control of tax and tax
related issues in Ethiopia is known as:
32. Write at least three functions of budget
33. Write four different types value added tax in a business
34. What is the difference between taxable income and gross income
Part Five: Workout; Show each steps of computation

35. Assume XYZ business operates in down town of Hawassa City Administration have the
following data extracted from annual statement of the business.
Sales made during the year ………………………………… 70,000
A plant asset acquisition cost ………………………………. 156000
Cost incurred for capital expenditure ………………………… 12000
Cost incurred for revenue expenditure ……………………….. 8000
Cost paid for direct production …………………………… 13200
Cost incurred for operating expense ………………………….. 12000
Cost incurred for damages, which is covered by insurance ….. 5000
Cost incurred for Mr. Ugamo, the owner, consumption ………. 4000
The plant asset is estimated for 30 years of estimated economic life since its acquisition 1995
and capital expenditure is added at the beginning this year (2018).
Compute for tax paid by XYZ business during the year.
36. Assume a consumer product known as Macaroni (the equivalent units of wheat is adjusted
accordingly) is passed through the following stages and tax is to be paid on stages
No. Stage Receipt birr
1 Farmer 2000
2 Wholesaler 2400
3 Floor factory 2800
4 Wholesaler 2900
5 Retailer 3000
6 Consumer 3200
Required: Determine the value on each stage and calculate the VAT paid for Macaroni product
for given level of unit.
37. Mrs. Sina has a building, with historical cost of 250,000, available for rent purpose in 12 month
based agreement since 1999 with estimated service year of 30 years. The building has three
apartments, each apartments with four rent rooms, in which each rent rooms in the building is
rented for 900 birr per month. Mrs. Sina paid 15% of actual rent received as land tax, 8% of
rent income as other tax and spent 28000 birr for ordinary maintenance of the building, 13000
is also paid for security, cleaners and electricians per annum. Mrs. rented furniture’s in the
building for 200 per room.
Compute for annual tax burden of Mrs. Sina entire building for December 31, 2018 assuming
A. Mrs. Sina does not maintain book of account for reporting purpose.
B. Mrs. Sina has maintained book of account for reporting purpose.

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PUBLIC FINANCE AND TAXATION

Delelegn E. (National Trainer @EDI and Lecturer @WKU)

2.8. Impact, Shifting and Incidence of Taxation............................................................................. 42

1. Basics of Public Finance

government incurs expenditure keeping in view the long-term considerations, such as

C- Stabilization division: Adjustments in confirming whether the economy is built in a stable

i) Financial aid through grants and loans

1.5.4 Financial Administration

1.5.4.2.. The Significance of Public Finance

➢ Balanced Regional Development

Generally, under developed countries have the following features.

1.6. The Role of Government in the Economy

Functions of modern governments are broadening due to socio-political reasons. Therefore, to

1.7. Chapter Assessment

local lord whose land they farmed.

means of covering current costs or expenditures.

2.4.Meaning and Characteristics of Taxation

2.6.1. Direct and Indirect Taxes

2.6.2. Difference Between Direct and Indirect Taxes

Thus, indirect taxes are more convenient to them.

Tax base(Income in Birr) Tax rate (in %)

The rate of taxation increases as the tax base increases.

Over Birr To Birr

A. Advantages of Progressive Tax Structure

Tax base (Income in Birr) Tax rate (in %)

tax). These principles are applicable to all taxes.

4. Ethiopian Tax System

b) Allowance in lieu of means of transpiration granted to employees under contract of

4.2.2. Income From Rental Service (Schedule B)

4.2.3. Business Income Tax (Schedule C)

Forms or Kinds of Value Added Tax

makes tax evasion difficult.

Kinds of Double Taxation

international double taxation.

Prediction The government cannot correctly Under

4.3.2. Turnover Tax

- the rendering by religious organizations of religious or other related services:

importing certain goods that compete with domestically produced goods.

full address, etc.

Part Two: Choose the BEST among the given alternatives

Part Four: Give short Answer

Part Five: Workout; Show each steps of computation

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