System of taxation and Type of Taxes

Unit II
 Tax System
A tax system refers to a set of all the taxes that a nation
imposes;
A tax system can be characterized by approach to tax, types
of taxes, the tax structure
Tax systems can be classified in different ways
 Multiple Vs single tax system
 Ad Valorem Tax Vs unit duty
 Proportional, progressive and regressive rate
system
 Direct vs indirect

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 Single and Multiple tax systems
• The taxation can viewed single or multiple based on (1) the number of
taxes and (2) number of times a particular tax is collected.
• A single tax system is characterized by only one tax type used in the
system
• A single point tax system taxes at one point in the value chain of taxable
goods or service
It is claimed that taxpayers are more certain of their liabilities in a single
tax
Example: the poll tax, or the head tax;
Poll tax is imposed on a person simply because he/she is there in the
society and not because he/she has an income, or wealth, or is following
any particular trade or profession etc.
It is claimed that a single tax system can help in reducing costs of
collection.
.
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 Cont’d
 Against this claim note the following problems:
 identification and choice of an appropriate single tax,
 the adequacy and growth of revenue,
 It does not enable governments to raise sufficient amount of
revenue;
 is against the principle of equity assessed in terms of either the
benefit principle or the ability to pay principle

 A multiple tax system is with several tax structures being

used in the system.
 It would be highly unjust to tax income originating from any
one source and leave out others.

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 Cont’d
 Equity would demand that the government should tax all the
important sources of income in an equitable manner.
 multiple tax system is believed to suit to multiple economic
objectives of taxation in a modern economy
 it tries to forge ahead simultaneously along the paths of
growth, equitable distribution of income and wealth,
economic stabilization and others .

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 Ad Valorem Vs Specific Unit taxes
 Such a distinction is in terms of the unit of measurement of
the tax base;
 Ad Valorem taxes are when the tax amount is scheduled
according to the value of the item being taxed;
Example: sales tax, VAT, tariff and stamp duty
 the tax automatically gets linked with the value of the item
and would move along with its value;
 i.e., in the period of boom, the tax liability tends to rise and in
times of recession the tax liability also declines;

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 Cont’d
 Arguments against Ad Valorem taxes
 Difficult to administer –take custom duties –it is difficult to
determine the value of various goods imported from several
countries
 Difficult to select the appropriate basis of value
 The question may include whether to use CIF value or local
selling price
 Unit (specific) taxes: are those imposed on the per item or
per unit basis;
 use the weight, length and some other unit of
measurement;
 Examples: Excise tax
 Excise duties are sometimes specific, sometimes ad valorem and some
times a combination of the two;
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Arguments for unit taxes
 Less chance of tax evasion;
 Easy to administer and collect
Arguments against unit tax
 Static revenue yield

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 Proportional, Progressive and Regressive tax system
 Tax system can be classified on the based on the nature of tax
rate applied on taxable object

 Tax rate-the amount of a tax per unit of the tax base;

 Statutory (nominal) tax rates;
 Marginal tax rates;
 Average tax rates

 Defining tax system into progressive or regressive is sometimes

debatable

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 Proportional tax structure
 Proportional tax structure is also called a flat tax system;
 the tax liability increases in the same proportion as the
increase in income;
 the tax rate remains unchanged for each unit of the tax base;
 Example on proportional tax system
 Tax base(Br) Tax rate(%) Amount of tax (Br)
2000 10 200
5000 10 500
10000 10 1000

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 Cont’d
Income Nominal tax Liability Average Marginal • In proportional
(Br) tax rate (Br) tax rate tax
(%) (%) rate taxation since by
(%) definition the
2000 10 200 10 10  average tax rate
remains
unchanged
 , the marginal rate
always remains
5000 10 500 10 10 equal to the
average rate.
10000 10 1000 10 10

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 Arguments for proportional tax
 Arguments for proportional tax system include:
simple in nature;
uniformly applicable;
 Arguments against proportional tax system include:
Inequitable distribution–a system of proportional
taxation would not lead to an equitable and just
direction of the burden of taxation.
Inadequate resources–proportional taxation
means the tax rates for the rich and poor are the
same.

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 Progressive structure
 the tax liability as a percentage of income increases as
income increases, which is the average tax rate
If the rate rises as the tax base increases, we
have progressive tax;
 If the tax rate structure is progressive, then the marginal
rate would be rising as the tax base increases;
• Further the marginal tax rate would lie above the
average rate of tax.

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Example: Each individual Cont’d
computes tax bill by
subtracting $3,000 from tax
income and paying an income R% liability Ar% Mr%
amount equal to 20
percent of the 2000 20% -200 -0.1 0.2
remainder.(If the
difference is negative,
the individual gets a
3000 20% 0 0 0.2
subsidy equal to 20
percent of the figure.) 5000 20% 400 0.08 0.2

10000 20% 1400 0.14 0.2

30000 20% 5400 0.18 0.2

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 Arguments for progressive tax structure
Reduce the inequality of income and wealth ;
Revenue productivity
Stabilizing the economy
 Arguments against progressive tax structure
Ideal progression is impossible
Disincentive to work, save and invest

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 Regressive tax structure
 As income increases the rate of tax decreases and so does
the average tax rate
 it takes a larger percentage of income from people whose
income is low;
Example
Income tax rate (%) tax Liability Average Marginal
(Br) (Br) tax rate tax rate
(%) (%)

4000 20 800 20 20
6000 15 900 15 5
10000 12 1200 12 7.5
20000 10 2000 10 8

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 In regressive tax schedules when the tax bases
increases
the average tax rates falls as the tax base increases
the marginal tax rates also usually falls as the tax base
increases;
marginal tax rate lies below the average tax rate;
• Notes:
the concept of progressiveness is with reference to
only the money (or money equivalent) burden of a
tax.
It is not being translated into real burden or the
sacrifice which the taxpayers undergo.

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 Cont’d
In terms of sacrifice, for example, a proportional
income tax will be regressive because it would
involve a proportionately greater sacrifice of
utility on the part of the lower income taxpayers.
depending upon the rate at which marginal
utility of income to taxpayers falls, even a degree
of progressiveness in money terms might turn
out to be regressive in its real burden.

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 Direct vs Indirect taxation
 One way of distinguishing between direct and indirect taxes has
been in terms of the incidence of taxation.
 Tax incidence and impact - concerned with the issue of who bears
the burden of taxes;
 tax impact/legal or statutory incidence –initial burden – tax is borne
by those who make the payment of taxes to the government;
tax impact concerns where the tax first hits;
 tax incidence/economic incidence –ultimate burden –tax is borne
by those whose real incomes are reduced as a result of taxes;
tax incidence concerns its ultimate resting point

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 Cont’d
When the incidence and impact are not at the same point,
the tax is said to have been shifted.
shifting burden through changes in prices, wages and returns
on investments.
Tax shifting may be of two types:
 Forward shifting… to the next person in the supply
chain
 Backward shifting… to the party who supplied
inputs

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 Factors of Tax Shifting
Two sets of factors influence tax shifting
1. Internal factors
 Elasticity of demand… more elastic demand is shifted less
 Elasticity of supply… more elastic supply is shifted to the buyer
2. External factors
 Public policy
 Advertised prices
 Customary prices
 Geographic coverage
 Substitutes
 Market structure
 General business conditions

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 Cont’d
Corporations do not actually bear the ultimate burden of the
corporate income tax;
 instead, other groups of people (eg. shareholders, employees, customers or other
resource suppliers) bear the burden of the corporate income tax;

 The burden of corporation income tax is shifted to other groups of

people through lower income (to employees and investors) or higher
prices (to consumers);
It is not always easy to determine the amount of tax shifted
The extent of sifting corporate and business taxes depends on
the price elasticity of demand and supply

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 the distinction between direct and indirect taxes is ambiguous;
 most writers define direct taxes as those, which are imposed
initially on the individual or household that is meant to bear
the burden.
 indirect taxes-taxes imposed at some other point in the system
but are meant to be shifted to the final bearer of the burden.
 such a distinction is not easy to maintain, especially because in
some cases the incidence of the tax may shift partly and in
some cases fully; even in some other cases the shifting of the
burden for the same tax may vary over time.

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in the case of direct taxes liability is determined with direct
reference to the tax paying ability of the taxpayer
in the case of indirect taxes such an ability is assessed
indirectly.
For example, income tax is a direct tax. Here the tax
paying ability is assessed directly in relation to the
income of the assesse.
Income tax, gift tax, inheritance tax, wealth tax,
corporate taxes are examples of direct taxes.
excise taxes, sales taxes, VAT (GST), import and export
duties, taxes on rail and bus fares and so on are in the
category of indirect taxes.

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For example the pass through fraction for a buyer, in case the
price elasticity of supply (PES) is 0.5 and the price elasticity of
demand (PED) is - 0.4 will be:
PES/(PES-PED)
= 0.5/(0.5-(-0.4))
= 0.5/0.9
= 56%
 This indicates that for any tax increase 56%would be paid by the
buyer and the remaining 44% would be paid by the seller

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 Merits of Direct Taxes
• Equitable- based on the principle of progression
• Certainty- the rate and the amount are known by tax payer
as well as collector
• Reduce inequalities- rich people taxed more to be
distributed to the poor
• Elasticity- more tax revenue simply by changing the rates
• Civic Consciousness- civic responsibility among tax payers…
keen interest in the method of public expenditures
• Adverse Effect can be avoided- by modifying the rate

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 Demerits of direct taxes include
 Unpopular- require payment in one lump sum
 Inconvenience- as tax payers submit statements possibility of
evasion- taxes on honesty
 Arbitrary- no logical principle of progression
 Adverse effect on will to work and save- if higher taxes are
imposed

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 Merits of Indirect Taxes
 Convenience- paid in small amounts
 No evasion- difficult to evade as they are record based
 Elastic if levied on goods of inelastic demand
 Wide Coverage- every member of the community can be
taxed
 Can be progressive- heavy tax on luxurious goods
 Economy- collected at different stages from various groups
of society

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 Demerits of Indirect Taxes
 Regressive- fall more on low income group than high income
ones
 Administrative cost- generally heavy
 Discourage savings- more spending on basic commodities
 Uncertainty- can’t be accurately estimated
 No civic consciousness- no direct impact
 Adverse effect on efficiency- reduce consumption and
productivity
 Cause inflation- prices of taxed goods keep on rising

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