Chapter - Two: meaning and characteristics of

Taxation
 Meaning of tax
 A tax is a compulsory levy payable by an economic unit to
the government without any corresponding entitlement to
receive a definite and direct return from the government.
 It is not a price paid by the taxpayer for any definite
service rendered or a commodity supplied by the
government.
 Characteristics of a good tax system
The following are the characteristics of a good tax
system:
1.Tax is a compulsory Contribution
2.The Assesses will be required to pay tax if it is due from him
3.Taxes are levied by the government
4.Common benefits to all
5.No direct benefit
6.Certain taxes are levied for specific Objectives
7.Attitude of the Tax-payers
8.Good tax system should be in harmony with national objectives
9.Tax system recognizes basic rights of tax payers
 Purpose/Objectives of Taxation
The main objective of taxations are:
• Raising revenue
• Removal of inequalities in income and wealth
• Ensuring economic stability
• Reduction in regional imbalances
• Capital accumulation
• Creation of employment opportunities
• Preventing harmful consumption
• Beneficial diversion of resources
• Encouragement of exports
• Enhancement of standard of living
 Canons of Taxation
• Canons of taxation refer to the fundamental principles that govern the
system of taxation. Taxation of people must be levied with great care
and rationality.
• Of the canons of taxation four of them are enumerated by Adam
Smith and the rest are contributed by other economists. This are:
 1. Canon of Equality:
• This canon proclaims that a good tax is that which is
based on the principles of equality. It implies that
the income which a person enjoys under the
protection of the state should be taxed on the
proportional rate of taxation. But modern
economists do not agree with Adam Smith. They
advocate progressive taxation to observe the canon
of equality.
 2. Canon of Certainty:
• canon of certainty implies that the tax-payer should
be well informed about the time of payment, the
manner of payment, the quantity to be paid, should
all to be clear and simple to the contributor and to
every other person.
 3. Canon of Convenience:
• The third canon of Adam smith is that of
convenience. According to Adam smith, “every tax
ought to be so levied at the time or in the manner
in which it is most likely to be convenient for the
contributor to pay it.
 4. Canon of Economy:
• This canon implies that the administrative cost of tax
collection should be minimum, i.e. the difference between
the money, which comes out of the pockets of people and
that which is deposited in the public treasury, should be as
small as possible.

• In addition to the above four canons given by Adam smith,

the following other canons have been advanced by other
economists.
 5. Canon of Productivity:
• the canon of productivity implies that taxes should be
productive. This canon my be observed in two way. This
are:

• In the first place, a tax should yield a satisfactory amount

for the maintenance of government. In other words, the
tax should obtain considerable amount of revenue for the
expenditure of the government.

• Secondly, the taxes should not obstruct and discourage

production in the short as well as in the long run.
 6. Canon of Elasticity:
• The canon of elasticity proclaims that yields of taxes
should be increased or decreased according to the
needs of the government.

7. Canon of Diversity:
This cannon implies that there should be all types of
taxes so that everyone may be called upon to
contribute something towards the revenues of the
state.
 8. Canon of Simplicity:
• the canon of simplicity implies that a tax should easily be
understood by the tax-payer i.e., its nature, aims, time of payment,
method and basics of estimation should be easily followed by each
tax-payer.

• 9. Canon of Expediency: this canon implies that the possibilities of

imposing a tax should be taken into account from different angles
i.e., its reaction upon the tax-payers

• 10. Canon of Co-ordination: in democratic countries, taxes are

imposed by central, state and local governments. It is, therefore,
very much desirable that there must be co-ordination between
different taxes that are imposed by different taxation authorities.
 Classification and Choice of Taxes
• Economists have classified taxes from different angles
there by providing us a long list of different kinds of taxes.
The following are some of the heads under which various
taxes are classified.
Direct and Indirect Taxes
• Direct Taxes
 According to Dalton, direct taxes are those taxes which are
paid entirely by those persons on whom they are imposed.
 the immediate money burden is upon the man who pays
the tax to the authority.
 Direct taxes are taxes which cannot be shifted to others.
 Cont,d
 A tax which are based on the receipts of income. Such
as: Income-tax, tax on profits, capital gains tax, property
or wealth-taxes are direct taxes.
 A direct tax is that tax whose burden is borne by
the person on whom it is levied.
 both the impact and incidence of direct tax fall
on the same person.
 Merits of Direct Taxes:
• Equitable
• Certainty
• Reduce Inequalities
• Elasticity
• Civic Consciousness
Demerits of Direct Taxes:
• Unpopular
• Inconvenience
• Possibility of Evasion
• Adverse effects of direct taxes on the will to work and save
 Indirect taxes
An indirect tax is that tax which is initially paid by one
individual, but the burden of which is passed over to some
other individual who ultimately bears it. It is levied on the
expenditure of a person. Excise duty, sales tax, custom
duties etc are examples of indirect taxes.

It can be shifted to other person. The person who pays the

tax in the first instance transfers its burden on the
shoulders of another person. In other words, in the case
of an indirect tax, the impact and incidence of tax fall on
different persons.
 Merits of indirect taxes:
• Convenient
• No evasion:
• Elastic
• Wide coverage
• Can be progressive
Demerits of indirect taxes
• Regressive
• Administrative cost
• Discourage saving
• No civic consciousness
• Creation of inflation
 On the basis of degree of progression of tax, it may be
classified into:
• Proportional tax
• Progressive tax
• Regressive tax
• Degressive tax
 Proportional tax
A tax is called proportional when the rate of taxation remains
constant as the income of the tax payer increases. In this
system all incomes are taxed at a single uniform rate,
irrespective of whether tax payer’s income is high or low. The
tax liability increases in absolute terms, but the proportion of
income taxed remains the same.

 Progressive tax
When the rate of taxation increases as the tax payer’s income
increases, it is called a progressive tax. In this system, the
rate of tax goes on increasing with every increase in income.
 Regressive taxation
A regressive tax is one in which the rate of taxation decreases as
the tax payer’s income increases. Lower income is taxed at a
higher rate, whereas higher income is taxed at a lower rate.
 Digressive taxation
A tax is called digressive when the rate of progression in taxation
does not increase in the same proportion as the increase in
income.

In this case, the rate of tax increases up to a certain limit, after

that a uniform rate is charged. Thus digressive tax is a
combination of progressive and proportional taxation. This type of
taxation is often used in case of income tax. This is the case of
income tax in Ethiopia as well.
 Single Vs Multiple Taxation
Single Tax System
A single tax means only one kind of tax. It does not
mean tax on only one person.
A single tax may be proportional, progressive or
regressive. It may be a single fixed amount.
 Merits of a single tax:
1. Simple
2. Equitable
•Demerits of a single tax:
1.Insufficient revenue
2.Regressive
 Multiple tax system
• Multiple tax system means a tax system comprising several
types of taxes. They may include both direct and indirect
taxes.
• Merits of multiple taxation system:
 Multiple tax system generally results in equitable tax
burden since it is compound of direct and indirect,
proportional and progressive taxes. 
 It is difficult for individuals to evade taxes altogether.
 It is more useful to achieve social and political objectives.
 Tax system becomes broad based and even covers every
sector in the country.
 Demerits of multiple taxation system:
 It is unpopular amongst the tax-payers as it is
composed of all types of taxes, direct taxes as well
as Indirect taxes.
 Too much multiplicity of taxes may lead to
inconvenience to both the taxing authority and the
tax-payer as well as to the general public.
 The administrative cost of collection of such taxes is
generally heavy as they have to be collected from
large number of people.
 Tax Structure
• A country imposes various types of taxes (such as
sales tax, capital gains tax, income tax, etc). The
combinations of different types of taxes imposed in
a country are referred to as tax structure.
 COMPONENT OF TAX STRUCTURES
1.INCOME TAX – a levy based on income of
individuals, families and companies. The tax is
levied on the income of both natural persons and
artificial person(companies, etc)
 COMPONENT OF TAX STRUCTURES
2. SALES TAX – a levy imposed on the sale of
goods and services. It is collected by the seller
at the point of sales and is paid for by the
customers.

 Normally, sales tax is computed as a fixed

percentage (e.g. 10%) of the retail price.
 COMPONENT OF TAX STRUCTURES
3. VALUE ADDED TAX – levied on goods and services
at each stage of production or distribution.
Alternatively, VAT is a “multistage” sales tax in
which revenues are collected at every stage of
production or distribution – from the sale of raw
material to the final retail transaction.

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 COMPONENT OF TAX STRUCTURES
4. CAPITAL GAINS TAX – tax levied on the capital
gains(e.g. sale of lands and buildings). It is the
difference between the price at which an
item/property was acquired and the price at
which the item/property is disposed or sold.

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 COMPONENT OF TAX STRUCTURES
5. CUSTOM DUTIES - taxes that must be paid to the
government on goods brought in from other
countries. There are varying rates of customs duties
levied on a wide range of products/ goods imported
into the country.

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 COMPONENT OF TAX STRUCTURES
6. EXCISE TAXES – are a flat rate tax levied on
domestically produced goods such as alcoholic
drinks. The tax is levied for budgetary reasons
and partly for environmental and health
consideration to reduce the consumption of
extravagant goods.
• There can also be an imposition of excise taxes
on imported goods.

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 SHIFTING AND INCIDENCE OF TAXES
Meaning of Impact, Shifting, and Incidence

• Meaning of Impact
The term impact is used to express the immediate
result of or original imposition of the tax.

The impact of a tax is on the person on whom it is

imposed first. Thus, the person who is able to pay
the tax to the government bears its impact. The
impact of a tax, as such, denotes the act of imposing.
 Meaning of Shifting
• Shifting of a tax refers to the process by which
the money burden of a tax is transferred from
one person to another.
 Types of Tax Shifting
1. Forward Shifting:
is a transfer of the money burden of a tax from the
producer or seller to the consumer or buyer when the
tax is initially imposed on the producer.
Example: all indirect taxes which are generally passed
partly or shortly to the buyer of goods.
 Backward Shifting
• Backward shifting refers to the process by which the money
burden of commodity tax is shifted from the consumer or
buyer to the producer or seller, if the tax is initially imposed
on the consumer.
• Backward Shifting can be made under the following conditions:

Backward shifting is applicable in the case of property tax only.

Backward shifting is effected when the buyer of property shifts the

entire tax burden to the seller of property.

The shifting is done by buyer of property by way of capitalizing the

value of tax by the life of the property and deducting it out of the
total value of the property.
 Incidence of taxes
• Incidence means the final resting place of a
tax. The incidence is on the man’ who
ultimately bears the money burden of the tax.
Distinguish between impact and incidence of taxes
1. Impact refers to the initial burden of the tax, while
incidence refers to the ultimate burden of the tax.
2. Impact is at the point of imposition, incidence occurs at
the point of settlement.
3. The impact of a tax falls upon the person from whom the
tax is collected and the incidence rests on the person who
pays it eventually
4. Impact may be shifted but incidence cannot.
 Distinguish between impact, shifting and incidence of
tax

Impact is the imposition of tax, where as shifting

and incidence is the transfer, and the settling or
coming to rest of the tax respectively.
The impact is the initial phenomena, the shifting is
the intermediate process, and the incidence is the
result.
 Tax Avoidance
• Tax avoidance can be defined as “the act of
escaping from the tax liability by using the available
loop-holes of the tax laws”.
• It is a legal exploitation of the tax regime to one's
own advantage, to attempt to reduce the amount
of tax that is payable by means that are within the
law while making a full disclosure of the material
information to the tax authorities.
 Cont,d
• Tax avoidance may be considered as either the
amoral dodging of one's duties to society or the
right of every citizen to find all the legal ways to
avoid paying too much tax.

• It is a legal minimization of tax burden by the

taxpayers.
 Tax Evasion:
• Tax evasion is the general term for efforts to not
pay taxes by illegal means.
• It is dishonest tax reporting such as:
 Declaring less income, profits or gains than actually earned
or
 Overstating deductions
“tax evasion implies the activities involving an element of
deceit, misrepresentation of facts, and falsification of
accounts including downright fraud”
 tax evasion means fraudulent action on the part of the
taxpayer with a view to violate civil and criminal provisions
of the tax laws.
 Causes of tax evasion

• High rates of taxation

• Multiplicity of tax laws
• Complexity of tax laws
• Inadequate information as to sources of tax
revenue
• Ineffective tax enforcement
• Absence of deterrent punishment
 Causes of tax evasion

• Luck of publicity
• Moral and psychological factors
• Attitudes of income tax departments
• Officers of the department of taxation
authority should be men of integrity
• Corrupt business practices
 Methods of tax evasion
• Omission to report taxable income
• Maintenance of multiple set of books of accounts
• Opening accounts under dummy names
• Securing contracts under dummy names
• Deduction of personal expenses as business
expenses
• Omission to report several incomes from irregular
sources
• Understatement of receipts
• Overstatement of business expenses
 Remedies for tax evasion
• Thorough overhauling of tax laws: one of the main reasons for tax
avoidance and tax evasion is loose drafting of tax laws which
contain several loop-holes and weak points that enable the tax
evaders to carry on the unlawful activities.
• Reduction in tax rates
• Permanent account number
• Tax on agricultural income accounts
• Change in penal provision
• Maintenance of proper account
• Vigorous prosecution: to make people aware of their duties and
responsibilities towards the state and to teach in them a respect for
tax laws, the authority should adopt vigorous prosecution policy.
• Educating people
 Chapter three: Public Finance in Ethiopia
• Public Expenditure in Ethiopia

• Public expenditure refers to the public authorities

pending (federal and regional) to discharge their
governmental functions (i.e., to satisfy the
collective needs of the society and promote an
economic growth).
 Public Expenditure in Ethiopia
Financial Expenditures (Article 94)
• The Federal Government and the states shall respectively bear all
financial expenditures necessary to carry out all responsibilities and
functions assigned to them by law. Unless otherwise agreed upon,
the financial expenditures required to carry out any delegated
functions by the state shall be borne by the delegating party.
• The Federal Government may grant to states emergency,
rehabilitation and development assistance and loans, due care being
taken that such assistance and loans do not hinder the proportionate
development of the states. The Federal Government shall have the
power to audit and inspect the proper utilization of subsidies it
grants to the states.
 Public Expenditure in Ethiopia
• Similar to the increasing trend of public
expenditure in the world, Ethiopian government’s
expenditure has been increasing from time to time
due to several reasons including inflation,
population growth, modern states expansion,
infrastructure expansion, and other activities.
 Recurrent expenditure Vs capital expenditure

• Recurrent spending comprises expenditure items which are

recurring in the process of delivering government economic
and social services. Wages, subsidies, operation and
maintenance, pension and debt servicing are among the
major components of recurrent expenditure.
• All sorts of administrative and defense and debt services
used in a shorter period of time are called recurrent
expenditure (normally called current expenditures).
 Recurrent expenditure Vs capital expenditure
• Capital expenditure is broadly defined as an outlay on
development projects that result in the acquisition of fixed
assets to enhance the capacity of the economy for the
production of goods and the provision of economic and
social services.

• Such outlays include spending on land development,

construction of power plants, buildings, dams, roads and
purchase of machinery and equipment. Capital expenditure
contributes to increased productive capacity of the nation
and therefore is known as development expenditure.
 Recurrent expenditure Vs capital expenditure

• Recently, the Ethiopian Government has been

classifying its budget (spending) into recurrent
expenditure, capital expenditure, subsidy to regions
and support for the achievement of Millennium
Development Goals (MDG).
 Recurrent expenditure Vs capital expenditure
• The Ethiopian Government also classifies its expenditure
based on function into: General Service (development),
Economic Service (Development), Social Service
(Development) and other expenditures.
• General Service includes expenditures for defense, justice,
administrative functions. Expenditures for agriculture,
industry, construction, fall under the category of economic
development. Costs for social services are spending for
social amenities such as public health, education, public
utilities.
 Public Revenue in Ethiopia

• The Ethiopian government financing structure

is categorized into: Domestic sources, external
loan and external assistances
 Public Revenue in Ethiopia
• Domestic sources: this category includes all
sources of financing originated domestically.
These include tax, domestic borrowing,
administrative fees and fines, profit from
government business activities
 Public Revenue in Ethiopia
• External Loan: these include short and long-
term borrowings used to finance the recurrent
expenditure and capital expenditure,
respectively.
• External Assistance: grants-in-aid, donations
and other supports from external
development agents, international financial
institutions, governments and other
supporting organizations fall under this
category.
Revenue Sharing scheme

Types of joint revenue Revenue sharing ration

Federal Government Regional government
1. Jointly established companies    
 profit tax As per capital share As per capital share
 employee income tax 50% 50%
 indirect taxes 70% 30%
1. private companies    
 profit tax 50% 50%
 indirect taxes 70% 30%
 dividends 50% 50%
1. Mineral and petroleum    
 Profit tax 50% 50%
 Royalty 60% 40%
 Deficit financing in Ethiopia
Meaning of deficit financing

• Deficit, in finance, refers to the excessive public

expenditure over public revenue.
• Deficit is occurred when government expenditure in
a particular period exceeds government source of
income due to several reasons such as expansion of
government activities in a budgeted period, decline
in source of revenue, inflation, over and under
estimations
 Cont,d
• Since deficit financing is a wider conceptualization
that affects the overall economy of a nation,
macroeconomic alternatives such as taxation,
printing money and borrowing financing sources
are key factors to make decisions of filling the gap
in the fiscal policy. Internationally, money
financing is proved as inflationary.
 Cont,d
• Deficit financing through taxation and borrowing
from the public and commercial banks is considered
as non-inflationary as public expenditure replaces
private expenditure. Hence, borrowing and taxing
are ranked as best deficit financing tools.
 Deficit financing objectives
• There are several reasons why deficit financing is important
including the following ones.
• To finance wars
• To reduce unemployment
• To promote economic development
• To finance strategic plans
•  To serve as an alternative tool
 Quiz1#

1. Write the Ethiopian government financing

structures