Chapter Two: Meaning & Characteristics of Taxation

Meaning of Tax
 Tax is important sources of public revenue.
 Tax is defined as a compulsory contribution
(levy) payable by an economic unit to a
government without expectation of direct and
equivalent return (quid pro quo something for something)
from the government. From this;
 Tax is not a voluntary contribution but is a mandatory contribution.
 Tax is contributed by an economic unit –taxpayers (individuals,
company, assn. etc.
 Tax is contributed to government (central, state, local).
 It is contributed without expectation of direct and equivalent return
for contribution made.
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 Basic characteristics of taxation:
1. Tax is compulsory contribution
The people on whom the tax is levied can’t
refuse to pay the tax.
Any refusal in these regard leads to
punishments.
2. Tax is levied only by the government
One has a legal right to impose tax except the
government (federal or state).
But there are withholding agents who are
required by law to collect taxes on behalf of the
governments.
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3. Tax is for common benefit
 Tax collected by government is spent for common
benefit of all peoples.
 Taxes are said to be the sharing of common burden
by the people.
4. No direct benefit
The government collects all types of taxes and doesn’t
give any direct benefit to tax payers for tax paid.
5. Tax is legal collection
Tax is collected from legal activities based on tax
rules and regulations.
Government doesn’t collect tax from illegal activities

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6. Tax is based on taxable person, income, item &
activity.
No one is forced to pay tax unless the person
income, item & activity are subjected to tax.
7. Certain taxes have specific objectives
the primary objective of taxation is to raise
revenue by the government, but some taxes are
imposed to achieve specific objectives such as:
• To discourage harmful consumption
• To stabilize an economy
• To utilize scarce resources for production of essential
goods
• To minimize income and wealth inequalities
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8. Tax doesn’t discriminate
Tax is levied on all persons who are eligible
for tax payments on the basis of the
prescribed tax criteria,
without any discrimination of castle (social
class), creed (religious belief), and ethnicity
(race).
9. Tax system recognizes the basic rights of tax payers
Tax payers shall pay their tax liability no
undergo harassment. In a good tax system,
tax law should be simple, understandable
and flexible.
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10. Tax system has a wide scope
Tax is levied not only on income but
also on property& commodities.

To enhance the revenue and to bring

all the people under the tax net, the
government imposes various kinds of
taxes

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 Objectives of taxation:
1.Raising revenue
Government raises its revenue to support expenditure of
its activities by imposing various kinds of taxes.
2. Removals of inequalities in income and wealth
To remove the inequalities government adopt progressive
taxation system.
Higher income groups pay more amount of tax, middle
income groups pay lower amount of tax and the lower
income groups are exempted from tax.
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3. Ensuring economic stability
Government use taxation to control inflation and defilation.

During inflation - government may increase the existing tax rates or

impose additional taxes to reduce the excess demand.

during defilation period, government may reduce the existing rates or

remove certain taxes to increase demand.

4. Reduction in regional imbalances

Government may give tax exemption or concession to those
investors who want to invest in relatively underdeveloped
regions.
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5. Capital accumulation
Tax allowance is given for saving or investment in
provident funds, life insurance, bonds and shares
that can lead to large amount of capital formation.
6. Creation of employment
By giving tax concession or exemption to the
labor intensive industries, government may
create additional employment opportunities.
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7. Preventing harmful consumptions
By imposing high/heavy taxes on harmful products that
worsen people’s health such as tobacco and alcoholic
products, government can reduce the consumption of such
products.
8. Utilizing scarce resources for the production of
more essential goods.
By imposing heavy tax on non essential and luxury
goods the government diverts the attention of the
producers to production of only essential goods.
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9. Encouragements of exports
Government may enhance exports by providing certain tax
exemption or by arranging tax free zones.
10. To minimize Unemployment
Giving tax exemption to labor intensive industries.
Giving tax exemption to small entrepreneurs.
11. Enhancement of standard of living

Government also increases the living standard of

people by giving tax concession to certain essential
goods.
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 Canons/principles/ of Taxation
Imposing tax on income, property and
commodities etc. raises tax revenues.
According to Adam Smith, "a tax is a
contribution from citizens for the support of the
Government".
Government, while collecting tax, has to
consider principles like equality, simplicity,
convenience etc.
These principles are called as "Canons of
Taxation".

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 The following are important canons of taxation. Canons
Advocated by Adam Smith
A. Canon of Equality.
B. Canon of Certainty.
C. Canon of Convenience.
D.Canon of Economy.
Canons Advocated by Others
A. Canon of Productivity.
B. Canon of Elasticity.
C. Canon of Diversity.
D. Canon of Simplicity.
E. Canon of Expediency.
F. Canon of Co-ordination.
G. Canon of Neutrality.
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 1 Canons Advocated by Adam Smith

A. Canon of Equality
A good tax system should be based on the
ability to pay of the people.
Tax burden should be more on the rich than on
the poor.
Ability to pay may be determined either on the
basis of income and wealth or on the basis of
consumption i.e. luxury or necessity.
A good tax should distribute the burden of
supporting government more or less equally
among all those who benefit from government.
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B. Canon of Certainty
Adam Smith-the tax which each individual is
bound to pay ought to be certain and not arbitrary.
The time of payment, the manner of payment, the
quantity to be paid, should be clear and plain to the
contributor and every other person".
It means the time, amount and method of
payment should all be clear and certain to the
taxpayer.
This principle removes all uncertainties in the
payment of tax and ensures smooth
functioning of the tax department.
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C. Canon of Convenience
Every tax ought to be levied at the time or in the
manner in which it is most likely to be convenient for
the tax payer/contributor/ to pay it".
That is, the tax should be levied and collected
in such a way that is convenient to taxpayer.
D. Canon of Economy
This principle states that the minimum
possible amount should be spent on tax
collection.
Taxation should be inexpensive in collection.

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 Canons Advocated by Others
A. Canon of Productivity
 Tax system should be productive enough i.e.
It should ensure sufficient revenue to the
Government and
It should encourage productive activity by
encouraging the people to work, save and invest.
B. Canon of Elasticity
The taxes should be flexible.
It should be levied in such a way to increase or
decrease the tax revenue depending upon the
need.
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C. Canon of Diversity
 There should be diversity in the tax system of
the country.
 The burden of the tax should be distributed
widely on the entire people of the country.
 The burden-every one should pay according
to his ability.
 Government should impose both direct and
indirect taxes of various types.
D. Canon of Simplicity
The tax system should be simple, easy and
understandable to the common man.
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E. Canon of Expediency
 A tax should be levied after considering all
favorable and unfavorable factors from
different angles such as economical,
political and social.
F. Canon of Co-ordination
In a federal set up like Ethiopia, Federal and
State Governments levy taxes.
So, there should be a proper co-ordination
between different taxes imposed by various
authorities.
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G. Canon of Neutrality
 The tax system should not have any
adverse effect.
 That is, it shouldn’t create any deflationary
or inflationary effects in the economy.

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 Classification of Taxes
Common dimensions to classify taxes;

a)Based on impact and incidence of tax

b)Based on tax bases

c)Based on tax determinant

d)Based on number of taxes

e)Based on sources of taxes

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i) Direct Taxes
Are those taxes whose impact (immediate
burden) & incidence (ultimate burden) fall
on the same person.
They can’t be shifted (passed on) to others.
Are taxes based on income or wealth
(property) of persons.
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Some Examples of direct tax includes;
 Employment income tax
 Business income tax
 Rental income tax
 Interest income tax
 Royalty tax
 Capital gain tax
 Property tax
 Agriculture income tax
 Transfer taxes, etc.

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ii) Indirect Taxes
Are those taxes whose impact (immediate burden)
& incidence (ultimate burden) fall on different
persons. i.e.,
The impact of the tax falls on the person who pays
it to the government in the first instance but;
The incidence of the tax falls on the person who
finally bears the burden of tax.
E.g. the import duty on vehicles is paid in the first
instance by the importer of cars but ultimately the
importer transfers the burden of this duty (tax) to
the purchaser of the vehicle in the form of price.
The importer includes the import duty paid by
him in the price of car which is charged to the 24
Indirect taxes can be shifted on to
others so that the burden of the indirect
tax is on ultimate consumers.
Indirect taxes are taxes based on
consumption or expenditure of
persons.
Some Examples include;
 Value Added Tax (VAT),
 Turnover tax (TOT)
 Excise Tax And Custom Duty
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b) Based on tax bases
i) Income Taxes: Direct taxes levied on income
of individuals and businesses; such as on
employment income, business income, rental
income, interest income, royalty income, income
from rendering technical services and dividend
income.
ii) Property Taxes: Direct taxes levied on
property of persons or businesses such as on
Wealth, land, estate and inheritance.
iii)Commodity/Expenditure Taxes: Indirect
taxes which are levied on goods and services .
E.g., VAT, TOT, Excise tax, import & export duty
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c) Based on tax determinant
This is a classification based on what determines
the tax amount, value or quantity
i) Specific taxes: are taxes which are levied on
goods & services at a fixed amount based on their
weight, size, quantity, or other measurements
other than the values of the goods and services
The value of goods and services is irrelevant to
determine specific taxes.
e.g., if the excise tax on petroleum is br 0.65 per
liter, then 65 cent tax is charged for one liter of
petroleum.
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ii) Ad-valorem Taxes:
ad-valorem means according to value
taxes are levied on commodities
according to their value,
Tax is charged according to its value

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d) Based on number of taxes
i) Single tax: is a tax that occurs in a system in which
the taxes are levied only on one object, i.e., on one
class of people.
• There is only one tax base
• E.g poll tax or head tax which is imposed on a
person simply because he is there in the society
and not because he has an income or wealth.
ii) Multiple taxes: taxes whose bases are
diversified
Consists many kinds of taxes /both direct &
indirect/
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e) Based on sources of taxes
i) Domestic taxes: are related to
transactions executed in the country in
which the tax payer resides.
ii) International taxes: are related to
foreign operations.

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 Tax System/Tax Rate Structures
1) Proportional (Flat) Tax System
Is a tax structure that taxes every tax payer
(higher, middle, or lower groups) with the
same flat rate.
Tax rate remains constant as the tax base
increases.
All incomes are taxed at a single uniform
rate.
E.g., 5% tax rate, all taxpayers shall pay their
tax at this rate regardless of the size of their
incomes. 31
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

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2) Progressive (Graduated) Tax Structure
Taxes;
• Higher income groups (richer) more
amounts of tax,
• Middle income groups lower amount of
tax;
• Lower income groups (poorer) are
exempted
If the income of a tax payer increases,
the rate of tax also increases and vice
versa.
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Tax base(Income in Birr) Tax rate (in %)
Over Birr To Birr
0 500 10
501 1500 15
1501 3000 20
3001 5000 25
5001 7500 30
7501 10500 35

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 Graphically, it can be explained as follows:

Tax Rate
(%)

Tax Base - Income (Birr)

Fig. Progressive Tax System

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3) Regressive Tax Structure:
Higher income groups (richer) are
taxed at lower rate and the lower
income group pay more amount of tax.
Effective tax rate declines as the value
of the tax base increases.
It is the opposite of the progressive tax.

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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
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Diagrammatically, it can be explained as follows:
Tax Rate
(%)

Tax Base - Income (Birr)

Fig. Regressive Tax System 39

4) Digressive (Mild) Tax Structure
Is similar to progressive tax structure, but in
digressive tax the rate of progression is not
in the same proportion as the income.
The Marginal tax rate declines with each
incremental tax base, i.e., the tax rate
increases but at a decreasing rate.
Higher income groups make less sacrifice
than the lower income groups and thus it can
be used as incentive to work, save & invest.

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Tax base(Income in Birr) Tax rate (in %)
Over Birr To Birr
0 500 5
500 1500 10
1500 3000 14
3000 5000 17
5000 7500 19
7500 10500 20
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Diagrammatically, it can be explained as follows:
Tax Rate
(%)

Tax Base - Income (Birr)

Fig. Digressive Tax System

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 Impact, Shifting And Incidence of Tax
•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.
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•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.
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•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.

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• Differences between Impact and Incidence:
The impact refers to the initial money
burden of the tax. But the incidence refers to
ultimate money burden of tax.
The impact is felt by the person from whom
tax is collected. But the incidence is felt by
the person who actually pays tax.
Impact can be shifted. But incidence cannot
be shifted.

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 Tax Saving
Tax saving is a method of minimizing or
decreasing taxable income and tax to be paid
to the government (tax liability).
Some of the methods are legal and some are
illegal.
Three methods of tax planning;
1) Tax evasion
2) Tax avoidance
3) Tax planning
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 1) Tax Evasion:
• Tax evasion means fraudulent action on the part of the taxpayer
with a view to violate civil and criminal provisions of the tax laws.
It can be defined as “tax evasion implies the activities involving an
element of deceit, mis-representation of facts, falsification of
accounts including down right fraud”.
• Thus, it may be said that the tax evasion is tax avoidance by illegal
means i.e. tax evasion is against the law and is an unsocial act.
• There are two forms of tax evasion. They are as follows:
• 1. Suppression of income, and
• 2. Inflation of expenditure.

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Examples for Tax Evasion:
 The following are the examples for tax evation:
1. A trader makes a sale for Birr.20, 000 and does not account
it, in his books under sales. He is evading tax.
• 2. An individual lends his money of Birr.50, 000 to another
person at 20% interest per annum and does not include this
income in his total income.
• 3. Under-invoicing of sales and inflation of purchases.
• 4. A manufacturing business employs 30 workers but
include 2 more additional namesake workers (not in actual)
in the muster roles. The sum shown as paid to such
additional namesake workers will amount to evasion.
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 2) Tax Avoidance:
•Tax avoidance means, “tax-payer may resort to a device
within the ambit of law to divert the income before it
accrues or arises to him”.
• “Tax Avoidance has to be recognised that the person
whether poor or wealthy has the legal right to dispose of his
income so as to attract the least amount of tax”.
• The tax avoidance can be defined as “escaping from the
tax liability by using the available loop-holes of the tax
laws”.
• Thus, tax avoidance means legal minimisation of tax
burden by the taxpayers.
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Examples for Tax Avoidance:
1.Suppose a taxpayer’s total income exceeds the
maximum tax-free amount, then he has to pay the tax
on such excess amount. But if he invests the excess
amount in any of the approved schemes for which there
is a relief in the tax law, he can save on tax altogether.
2.An individual sells his let out house property (long-
term capital asset) for Birr.2,00,000 making a capital
gain of Birr 60,000. This capital gain would normally be
taxed. But, if he invests the sale proceeds in a particular
manner stipulated by law, he need not pay any tax.
3.Divorcing the wife on paper so that her income is not
added together with husband’s income is also a
common device for tax avoidance.
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 3) Tax Planning
It is the art of escaping from tax burden
without breaking tax laws.
It takes maximum advantage of the
exemptions, deductions, rebates, relives and
other tax concessions allowed by taxation
statutes.
It is not illegal activity and is acceptable by
the government.

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 Techniques of Tax Planning
Investing on government treasury bills
which are free from income tax.
The use of financing method that minimize
tax
Shifting income of one period to another
period to minimize tax
Taking advantage of tax relief investment;
etc

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THE END!
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