LESSON TWO

TAXATION

Learning Content:
Meaning of Taxation, goal and requirements, reasons for taxation, classification of taxes,
system of taxation and canons/principles of food tax system and economic effect of tax

What is Taxation
As a subject, taxation is a study of how the government imposes on and collects taxes from, the
income and wealth of individuals and corporations to finance its social and regulatory activities. The
study of taxation usually covers the entire Tax System which is made up of Tax policy, Law and
Administration.

Nature and Objectives of Tax

Tax is a financial charge imposed by the government. The fundamental purpose of taxation is to
finance government expenditure. The imposition of taxation by governments withdraws money from
the economy while their expenditure returns the money to the economy.

Taxes are the most important source of public revenue and are necessary for the functioning of the
government. Funds collected by way of tax are utilized by the government to provide various
infrastructure / facilities to the taxpayer; however benefits of such public expenditure by the
government is enjoyed even by those people who are not liable to pay taxes.

The government, therefore, derives its revenue from taxes. A tax is compulsory and mandatory
contribution to the government from its subjects. It is mandatory in the sense that there is a legal
document giving the government the mandate to collect such contribution: However, if carefully
analysed this definition may include such payments as fines and penalties paid to the government.

The most dependable and reliable definition of what is a tax was given by Hugh Dalton who defined
a tax as “a compulsory contribution imposed by a public authority, irrespective of the exact
amount of services rendered to the taxpayer in return, and not imposed as a penalty for any legal
offence”.

Imposition of a tax, therefore, creates a tax liability upon those liable to pay the imposed tax. A tax
liability is always expressed in monetary terms, and it is worth noting here that any monetary
liability creates a burden. In other words imposition of a tax creates a tax burden on taxpayers.

Following are the essential elements of any tax:

 It is generally payable in money
 It is compulsory
 It is a proportion or a percentage

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  It is levied on persons
 It is levied by the government
 It is levied in order to cater to public purpose

Aim of Taxation
Basically, taxation is concerned with two problems
i) Financing the provision of public services such as health, education, defence, administration
of justice etc which a market economy cannot easily provide
ii) Financing various programmes which will eliminate the side effect (imperfections) of the
market economy e.g. poverty; unemployment etc
It is in this spirit that we need taxation for two main purposes as follows
o Revenue goals
o Non-revenue goals

Why do we need to pay taxes?

i) Raise revenue to fund government operations. Government generally fund expenditure
programs either by collecting tax revenue or issuing debt. The government for government
services increases with economic growth and in participatory democracies, the aim of the
government expenditure programs hopefully reflects the wishes of the voters
ii) Assist in the redistribution of wealth and income. Market economies often results in much
skewed distribution of wealth and incomes. Taxes redistributed resources through both
reducing the wealth and income of the rich and transferring funds directly or indirectly to the
poor. But the increased mobility of labour and capital will make it more difficult for all
countries to use tax system to redistribute income and wealth. Due to these difficulties, the
best policy option should be to raise funds in the most effective and efficient way possible
with little or no concern for equity considerations and address redistribution concerns
through expenditure programs.
iii) Encourage certain activities through the use of favourable tax activities. This is the case
when taxes are used to correct for market failure. Even apart from correcting market failure,
policy makers could use the tax system to encourage or discourage certain activities.
Countries use tax provisions to encourage larger families, retirement servings, capital
investment, home ownership and many other areas that may not have market failure nature.

Revenue Goals
Taxation is a source of revenue to the government. Government represents the public interest and
thus it is responsible on the provision of any social and economic facilities it considers desirable and
beneficial to society
Non-Revenue Goals
Taxation is not restricted to generating sufficient funds to fund government services. A tax policy
can be designed to achieve a number of objectives eg to promote economic growth and to create
friendly investment environment.
Taxation for non-revenue goals

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 1) Correction of market imperfections: government provides social goods and merit good
because some of these good have characteristic which make them less suitable for market
provision. Government spends money on supporting the poor.
2) Income redistribution: Taxation is needed as an attempt to raise share of national income
going to the poor.
3) Promoting economic growth: Through tax policies devised to promote economic policies of
the government, e.g. by creating friendly investment environment by grafting favourable
incentives to potential investors in priority sectors.
4) Instrument of economic stabilization: Market system (private sector) is subjected to trade
cycles, e.g. successive periods of inflation, interest rate fluctuations and unemployment. In
such periods of turbulences/crisis, market will tend to shake and thus leaving majority
unattended. Through taxation policy, government provide machinery for smoothing out such
cycles to avoid inflation, unemployment etc.
5) Balance device (balance of payment): attempt to achieve favourable balance of payment
(export should be greater or equal to import)
6) Instrument of changing consumption behaviour: these goods are over consumed because of
ignorance in the community (separation in time between point of consumption and the final
effect, e.g. gap between time of smoking and possibility of cancer may lead to ignorant
decisions)

The Attributes of Good Tax Policy (Principles of Taxation or Canons of Taxation)

Ideally, a modern tax system should have the following attributes
a) Equitable (fairness) in its distribution of tax burden
 Ideally, taxes should be accepted by the tax payer
 Therefore, taxes should be levied on the basis of ‘fairness’ principle
 Inequalities should be minimized by a progressive rates structure and the minimum
exemption policy
 Fairness or equity may either be vertical or horizontal
 Under vertical equity, unequal tax payers should be treated with the appropriate
degree of inequality (e.g. by using progressive tax system)
 Horizontal equity requires individuals earning the same income to pay the same
proportion of tax.
b) Produce revenue (Economy Principle)
All taxes cost money to collect and are unpopular; the yield of tax therefore should at least
cover the cost of collection. Note that it is better to have a single tax with a high yield rather
than number of taxes each having a small yield, as this will make taxes complicated and not
easily understood.
c) Difficult to evade: Not only should the taxpayer know exactly when and where taxes should
be paid, but also he should find it difficult to evade payment. Indirect taxes are easier to
collect or difficult to evade
d) Simplicity

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  Taxpayers should understand the tax system as a whole
 Tax base should be easy to identify
 Taxpayer should be able to compute the tax payable (with minimum difficulties)
 Taxpayer should be able to identify the statutory due date and pay tax on or before
these dates.
e) Certainty
 Imposition of any tax should yield the expected revenue in order to assist future
planning. Certainty of tax liability assessment
 Note that taxes on inelastic demand commodities (necessary/basic goods) would be
certain or sure source of revenue. However, possible adverse social and political
implications from the affected people may marginalize it as a certain source.

Equity Theories of Taxation

Equity in taxation refers to fairness in the distribution of the tax burden. For compliance purposes
and to fend-off public outcry the tax burden should be apportioned in more equitable manner. Two
principals have long been developed as a guide to equity. These are;
1. The Benefit Theory of Taxation:
This approach dictates that taxes are apportioned to individuals according to the benefit they derive
from government activities and spending. Taxes therefore should be treated as a payment for the
goods and services provided by the government
 This theory is based on the assumption that all should contribute to the cost of the
state in relation to the benefits they derive from the state. Taxes are regarded on the
basis of this theory as payments for value received and as a reflection of the demand
for public services
 However, this theory has been criticised on the ground that; first it requires
measurement of what is immeasurable-value, for example, to an individual of defence
of the country from foreign aggression; second, it is incompatible with social justice
since those in need of state benefits such as aged, the sick or the unemployed would
be least able to contribute through payment of taxes.
 Recent revival of the theory is linked to the willingness of people in democratic
societies to pay specific taxes for specific benefits, indication society’s preference,
the basis on which decisions on public expenditure can be made.

Application of the Benefit Theory:

The theory has been applied in some cases when particular taxes have been earmarked for specific
purposes: Examples include fuel tax and national insurance contributions.
 Fuel tax (road toll): this is levied on the basis of the benefit theory of taxation
as it involves taxing those who use roads directly or indirectly (drives of
motor vehicles and consumers of goods transported by roads built and
maintained by the government).

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  National/social security contributions: these are compulsory payments to the
government/social security funds and can therefore be regarded as taxes.
These proceeds are used to provide benefits for those who qualify on the basis
of contributions (taxes) paid.

2. The Ability to Pay Theory of Taxation: (The ability to pay principle)

This is concerned with the equitable distribution of taxes according to the stated taxable capacity or
ability to pay of an individual or group. The emphasis in this approach is put on redistribution of
income, that, those with higher incomes should sacrifice more so that there can be proper and
equitable redistribution of income.
This theory is based on the proposition that, on ground of equity and desirability, people should
contribute to the fiancé of the state according to their means.
 The theory postulated that the assessment for tax has to take into account individual
circumstances and should be based on income rather than ownership of property/assets.
 Note that a person is usually deemed to have no ability to pay tax unless her/his income is
above the subsistence (tax threshold) level.

CRITERIA FOR EVALUATING TAX SYSTEM

Designing a tax system has always been a subject of considerable controversy. Any tax system
influences behaviour since the government takes away money from individual who may respond in
some way to lower his/her tax liability.
i. Equality: This is the most important principle of taxation. It means that the tax system
should be framed depending on the ability of the people to pay tax that is the richer sections
or the high- income group should be subjected to higher tax while relatively less tax should
be imposed on the low income group
ii. Economy: A good tax system will ensure that the cost of collecting and paying tax as well
the compliance cost is minimum. For example, if there are many procedures for payment of
tax and filing of related documents or if a number of visits are required by the tax payer to
the tax office, then the tax system is said to be uneconomical.

In a broader sense, if very high tax is levied on the income of the tax payer, it will
discourage savings and the productive capacity of the economy will go down, which will be
uneconomical for the country. Taxes on products like alchohol, cigarettes etc are considered
as economical because they fetch revenue to the government as well as increase the price of
those products which will discourage their consumption.

iii. Certainty: It means that tax that each tax payer is required to pay should be certain and there
should be no ambiguity. The amount to be paid, timing of payment, procedure for
payment should all be certain and known to the tax payer. There should be no element of
ambiguity in the taxation provisions as this may lead to corruption (if any element of taxation
can be controlled by the will of the government authorities).

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 Certainty is also required from the point of view of the government in terms of the
estimated amount to be collected from various taxes and the time frame when the same will
be collected.

iv. Efficiency: This means that the revenue collected from the tax payers in the form of tax
should be sufficient to meet the government expenditure. However the government has to
ensure that in order to raise sufficient revenue to meet expenditure, it does not overburden the
tax payers such that the productive capacity is affected.

v. Understandable: Tax system should be simple and should be such that it can be
understood by common man. This will help curb corruption.

vi. Benefit principle: Taxation system should be such that persons who benefit from goods/
services provided by the government and which are primarily funded through taxation,
should pay for it.

vii. Convenience: The tax system should be so designed that it causes minimum
inconvenience to the tax payers in respect to payment of tax, record- keeping, filing of
returns, audits etc. Generally indirect taxes like VAT are convenient to the consumers
because a consumer pays for them when he makes purchases and at a time when he can
afford to because he chooses his own time of purchasing.

viii. Fairness / equity: Taxation system should ensure that no special treatment is meted out to
specific political or other interest groups.
ix. Demand management: In times of depression in the economy, demand for goods and
services are low; government can help increase demand by reducing taxes on goods/ services
and consequently, reducing prices.
x. Elasticity: Government should be able to increase revenues from taxation if required
in case of an emergency for eg: a surcharge levied on income- tax can considerably increase
government revenue during the period of emergency
xi. Flexibility: This is a necessary criterion for elasticity. Unless the tax system is flexible
that is it can be modified to suit new conditions, revenue cannot be increased.
xii. Diversity: There should be a number of taxes both direct and indirect so that all the people
who can afford to contribute are subjected to tax.
xiii. Broad basing: This principle requires that taxes should be spread as wide as possible over
the sections of population/ economy, to minimize individual tax burden.
xiv. Earmarking: Tax revenue from a specific source should be used for the purpose for
which it is collected when a direct link can be established between the tax collected and the
expenditure for e.g. toll collected for road maintenance

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CLASSIFICATION AND TYPES OF TAXES
Taxes are classified on the various bases.
1. Nature of Taxation
Revenue from taxation may be in several forms:
Tax Suffered by
Revenue taxes
Income tax Individuals
Partnerships
Corporation tax Companies
Individuals
National Insurance Contributions Partners
Employers
Self employed
Value Added Tax Final consumer
Capital taxes
Individuals
Capital gains tax Partnerships
(Companies pay corporation tax on their gains)
Inheritance tax Individuals

Revenue taxes
1. Income tax
It is a tax levied on the income of an individual. Income can be from any sources such as:
 Income from earnings (e.g. employment income / business profit)
 income from pensions
 Income from other benefits (e.g. rental income)
 income from savings (e.g. interest income)
 Income from investments (e.g. dividend income)

Income tax is calculated on earned income (i.e. income from employment) as well as on
income from savings etc. Income from various sources is pooled together and tax is
charged on the aggregate income after deducting the relevant personal allowance.
Taxpayers who are employed pay income tax on their earnings under the statutory Pay-As-
You Earn (PAYE) scheme.

2. Corporation tax
It is the tax payable by companies on their ‘chargeable profits’. There are numerous
provisions relating to corporation taxes.

3. National insurance Contributions (NIC)

After the Second World War, National Insurance Contributions were introduced to fund the
establishment of retirement pensions, sickness benefit and the National Health System.
National Insurance Contributions are a system of taxes which are paid by employees and
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 employers on the basis of their weekly earnings. The money generated is used to provide
social security.

4. VAT
VAT is Value Added Tax. It is the tax which is paid on the value added. This tax is levied at
each stage of production. VAT is a consumption tax paid by customers in addition to the price of
the product.

Capital taxes
i. Capital Gains Tax
When a person sells an asset that is in his / her possession, the profit arising from such sale is
chargeable to tax as capital gains. Therefore, capital gains tax liability arises when a
‘chargeable person’ makes a chargeable disposal of a chargeable asset.

For example, Adam sells his business asset at a profit of £5,000. So, the amount of profit i.e.
£5,000 is chargeable to capital gains tax.

ii. Inheritance Tax

When a person is in possession of an asset, and on his death the ownership of such an asset is
transferred, the value of the transferred asset is chargeable to inheritance tax, subject to
certain tax free thresholds. Therefore, inheritance tax liability arises when the value of
chargeable property is transferred by a chargeable person.

Such tax liability also arises when, during the lifetime of the owner, the asset is given as a
gift to any other person unless the person holds the asset for a period of seven (7) years or
more, in which case it becomes an exempt transfer.

2. On The Basis of Shift Ability of Tax Incidence

One of the important concepts of taxation is the incidence of tax. Taxes are not always borne by the
person who pays the tax; in many instances the burden of tax is shifted to another person.

Tax incidence is said to be on the person who ultimately bears the burden of tax whereas impact of
tax is on the person from whom government collects money in the first instance. It is important for
the government to know who ultimately bears the tax in order to achieve equality in taxation
Example
James bought a shirt for the consideration of Tshs 5,000. The shop owner gives James the suit in
return for payment of Tshs 5,000. VAT of Tshs 1,000 is included in the cost of the suit. In this case
James will bear the VAT expense, although the shopkeeper will pay the VAT to the tax authorities.
Tax incidence is on James and the tax burden is on the shopkeeper.

a) Case of DIRECT TAX

For the case of direct tax the whole incidence of tax goes to the tax payer. i.e. the income
earner. He has to pay the full amount of tax, the tax burden cannot be shifted to anyone else.
b) Case of INDIRECT TAX

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 For the case of indirect tax the burden of tax depends upon the elasticity of demand for
commodity eg
i. Tax on goods with perfect inelastic demand: these are the goods which are demanded
in the same quantity at any level of price. In this case the incidence of tax falls more
heavily to the consumer, because the consumer buys the same amount at whatever the
level of price.
ii. A case of regressive tax: For the case of regressive tax, the incidence of tax falls more
heavily to lower class because they pay a larger proportion of their incomes as tax
than rich people.
iii. A case of proportional tax: For this case, the burden of tax fall more heavily to lower
income earners than high income earners since they pay the same percentage of tax.

Thus where does the burden finally falls, i.e. possibility of shifting the burden
1. Direct Taxes
A tax which individuals or economic entities such as companies suffer directly, the burden of tax
falls directly on the individual.
Types of Direct Taxes
i. Income Taxes
 PAYE
Important (stable) source of revenue to the government is charged progressively
 Corporate Tax
Corporate tax is charged on the profits of companies (local and foreign) at a rate of
thirty percent (30%). There is also a number of withholding taxes eg investment
income such as dividends, rent, interests etc
ii. Local Authority Taxes
Essentially to fund local services
iii. Property Taxes
This is significant for urban areas (rural districts have few buildings which are non-
governmental) and the taxable base is the value property.

Advantages and Disadvantages of Direct Taxes

Advantages
 It is easy to know in advance the amount of tax to be paid and collected from individuals and
firms because it is deducted directly from incomes.
 This type of tax is very helpful in reducing income gap between rich and poor since it applies
as one earns (PAYE).
 It is helpful in controlling demand pull inflation, since when direct tax is imposed the
disposable income of income earners decline which leads to decrease in the purchasing
power hence control of demand pull inflation.
 Economic, this type of tax is economic in as sense that the cost of collection is relatively low
compared to the revenue collected.

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Disadvantages
 High direct taxes can discourage people to work hard. This type of tax can discourage people
to work hard because people know that if they work hard and earn more income they are
going to pay more tax.
 This type of tax discourages savings because it reduces disposable income of income earners.
Decrease in savings may discourage investment and economic growth.
 This type of tax can result into tax evasion this happens when a tax payers hide some
information about their incomes
 Direct tax is discriminatory in nature since it is paid by few people in the society, those who
earn incomes
 Direct tax has high incidence of tax, that is the burden of direct tax fall wholly to the tax
payer
 Easy to avoid since one can understate his income

2. Indirect Taxes
Indirect tax is a type of tax which is imposed on goods or services. Tax which is not levied on an
economic entity but one the activities of the individual entity and the burden of tax may fall on the
final consumer.
 Charged on the consumption of goods and services
 Tax yield depends directly on the level of consumption on the particular commodity

Types of Indirect Taxes

i. Value Added Tax (VAT)
Tax on consumer expenditure
ii. Custom Duties
Levied on imported goods on ad valorem (Latin for “according value”) basis (as a percentage
of the value of the good)
It may be divided into Protective Duties (designed to protect local industries) and Revenue
Duties (designed to raise revenue for the government). Payable on cars, trucks, tyres, beers
etc
iii. Excise Duties
Charged on home produced goods
Excise duties are both ad valorem and charged at specific rates depending on the product

Advantages of Indirect Tax

 More revenue is collected in this type of tax because indirect tax is paid by everybody who
consumes goods and services. It means it has wider tax base (source) that a direct tax
 It is very difficult to evade paying indirect tax because it is imposed on every purchase of
goods and services
 It is paid unknowingly by the tax payers hence it is less painful to the tax payer and does not
discourage people to work hard

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  They help to stabilize the economy; high import duties help to control imports, thus reduce
balance of payment problems and improves terms of trade of a country.
 It is used by the government to encourage or discourage production and consumption of
certain commodities.

Disadvantages of Indirect Tax

 Indirect tax is regressive in nature because low income earners pay a larger proportionate of
their incomes as tax than higher income earners.
 It is inflationary in nature because when it is imposed it increases cost of production and
prices (it leads into cost-push inflation)
 It is inconvenient, it is very difficult to collect this tax, a lot of information is needed from
businessmen including close follow ups.
 Misallocation of resources may occur since investors may opt to invest in industries which
are less taxed and leave industries which are more productive and important to the economy
but are heavily taxed.

Classification of bases of levying taxes

1. Proportional Taxation
2. Progressive Taxation
3. Regressive Taxation
Progressive Tax System
This is a tax system where the rate of taxation increases as the income increases so that the person
with an income of Shs 200,000 a month may pay Shs 24,000 in income tax, which is 12% of this
income whereas a person with an income of Shs 300,000 may pay Shs 60,000 that is 20% of the
income

Proportional tax System

A proportional system is one where the rates of tax are equal so that the same proportion of tax is
taken from all incomes, however larger or small. For example, a person with an income of Shs
200,000 a month, if the rate is 10%, would pay Shs 20,000 in tax while one with Shs 300,000 a
month would pay Shs 30,000
A proportional tax system is not equitable as progressive tax system because the average rate of tax
is constant irrespective of the size of income of the individual in which it is imposed.

Regressive Tax System

This is system where the proportion of income taken in tax falls as income rises. It is a tax, the rate
of which is higher on with low income than those with high incomes. For example, a tax system is
regressive when an individual with an income of Shs 20,000 pays Shs 2,000 in tax (10% of income),
but an individual earning Shs 30,000 pays Shs 2,500 (8.3% of income)

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Why is a regressive tax justified?
A regressive tax is justified on the following grounds
 Low income earners are the main consumers of public goods which are provided by the
government while rich people consume private services
 Rich people are the investors, therefore have bigger contribution to the national income than
low earners (poor people)

ECONOMIC EFFECT OF TAX

A. Positive Effect of tax
i. It can be used to remove inflation: By increasing direct tax the purchasing power of the
people decreases this may reduce demand pull inflation.
ii. Discourage harmful products: Certain kinds of indirect tax can be used to control
production and consumption of harmful products such as cigarette
iii. Control of balance of payments, dis equilibrium: Heavy import duties can be a
disincentive to importers and therefore a means to control a deficit in the balance of
payments.
iv. Revenue generation: Tax is an important rootstock of government revenue that is the
government depends on tax for most of its revenue.
v. Redistribution of income: Tax redistribute incomes by taking pat of incomes of rich
people and the government use the money collected to provide free social services to the
poor.
B. Negative Effects
i. Discourage people to work: Heavy direct tax discourage people to work hard since it
reduces disposable income i.e. amount of money that remain for consumption after
deducting tax
ii. Discourage savings: Heavy direct tax reduces disposable income and amount that can be
save by the income earners
iii. Discourage investment: Larger tax on firms’ profits is a disincentive for entrepreneurs to
reinvest their profits in production
iv. Diversion in allocation of resources: Investors may deviate allocation of resources from
heavily taxed more productive sectors to less taxed and low productive sectors of
production of illegal product

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