Tax, as defined by the Organisation for Economic Cooperation and Development

(OECD)
is the “compulsory, unrequited payments to general government”. The term
“compulsory”
indicates that taxes are not voluntary purchase payments but mandatory impositions,
payable in line with what is legislated. To enforce the compulsion, different
governments
have constitutions, proclamations, regulations and directives to charge tax for
different
categories of people. The term “unrequited” is used in the sense that benefits provided
by
government to a taxpayer are not in proportion to the payments made by that taxpayer.
In
other words, obtaining direct benefit is not the main condition of paying tax. Hence
tax is
levied without a quid pro quo, i.e. without anything in direct return.
Indicating the inevitability of taxation, it is said that there are two things that are
certain in
life: death and taxes. It is also said that without tax, there will be no revenue, and
hence,
no government. However, taxation is not the only source of government revenue;
there
are other sources such as borrowing, imposition of fees for services rendered, or
printing
money. Nevertheless, taxation typically accounts for 90% or more of total
governmental
receipts in times of peace.
In minimalist terms, governments impose taxes for three basic purposes: to cover the
cost of administration, to maintain law and order and to defend the public. They also
impose taxes to raise revenue to fund economic infrastructure, health facilities,
transport, 5.1 Taxes: Definition, Principles, Objectives and Classifications
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education, telecom, electricity, or free facilities for less able members of society.
Moreover, governments shoulder the responsibility of providing public goods,
promoting
redistribution of income and wealth, and discouraging consumption/production of
harmful
goods to society (i.e., goods with negative externalities or demerit goods such as
cigarettes
and alcohol).
The field of taxation is rich in terminology. The following terms are widely used.
Tax rate is the per-unit amount of the tax or the percentage rate at which the
economic
activity is taxed.
Tax base is the level or quantity of an economic activity that is taxed. Higher tax
rates
reduce the level of the tax base because they make the activity less attractive.
Tax incidence relates to the way the burden of a tax is distributed among economic
units
(consumers, producers, employees, employers). It points out who is legally
responsible
for paying the tax. It is said that taxes are the price we pay for a civilized society; the
question is who pays? Taxes are almost always levied in a way that a particular
person
or firm should pay the tax. The incidence of a tax is determined by looking to see who
is
made worse off by the tax and by how much. It is also known as “tax incidence
analysis”.
Through tax incidence analysis, we can trace and identify the final tax burden
distribution.
Though taxes may be collected from firms, the ultimate burden may fall on individual
consumers. Incidence of tax is defined as its final resting place.
Impact of tax is tax’s first point of contact with the taxpayers. It is felt by those who
bear
the first statutory responsibility of paying it to the government.
Effect of a tax refers to responses from taxpayers and the economy to the imposition
and
collection of taxes. Such responses can be of great variety and influence the working
of the
economy in terms of production, growth, saving, investment, inequality etc.
5.1.2 Objectives of Taxation
Governments impose taxes to achieve several important macroeconomic and social
goals.
Accordingly, the objectives of taxation are to:
a) minimize income and wealth inequalities.
b) stabilize the economy.
c) discourage the consumption of harmful products. 5.1 Taxes: Definition, Principles,
Objectives and Classifications
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d) provide incentives for capital formation in the private sector.
e) reduce regional imbalance.
f) enhance standards of livings.
g) utilize the scarce resources to produce more essential goods, and
h) minimize unemployment and encourage export.
Although governments have monetary and fiscal tools to achieve the above and other
related goals, taxation plays a significant role in allocation, distribution, and re-
distribution
of resources.
5.1.3 Principles of Taxation
In the Wealth of Nations (1776), Adam Smith proposed the principle/canons of taxation as
summarised below.
1. The subjects of every state ought to contribute towards the support of the
government, as nearly as possible, in proportion to their respective abilities; that
is, in proportion to the revenue which they respectively enjoy under the protection
of the state.
2. The tax which everyone is bound to pay ought to be certain and not arbitrary. The
time of payment, the manner of payment, the quantity to be paid, ought all to be
clear and plain to the contributor, and to every other person.
3. Every tax ought to be levied at the time or in the manner that makes it the most
convenient for the contributor to pay it.
4. Every tax ought to be planned) in manner it takes as little as possible out of the
pockets of the people, over and above what it brings into the public treasury of the
state.
5. Every tax has a cost of collection. It is important that the cost of collection should
be the minimum possible. This is called the “canon/principle of economy”.
6. The tax system should be able to yield enough revenue for the government so that
it should not be forced to resort to deficit financing. This is called the “canon of
fiscal adequacy”.
These classical maxims can be translated to modern principles of taxation. According
to these principles, a tax system should not distort the optimal allocation of production
5.1 Taxes: Definition, Principles, Objectives and Classifications
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factors in efficient markets; it should be fair; it should be a flexible automatic
stabilizer;
it should be clear and transparent, definitive, provide inexpensive collection. In sum,
the principles of taxation touch on issues of equity or fairness, certainty, convenience,
economy, flexibility, simplicity, diversity, and buoyancy.
5.1.4 Characteristics of a Good Tax System
Taxation is broadly characterised by the compulsory nature whereby it imposes
obligations
on taxpayers. It cannot be escaped, which means a non-payment is a criminal offense.
Moreover, revenues from taxation are supposed to be spent on collective use, thus
serving
a common interest where both payers and non-payers will benefit. Taxation is also
paid
on regular and periodic basis with known due dates. Finally, tax is levied on all
people
without discrimination, yet according to their ability to pay.
A good tax system is characterised by the following features:
a) simple, financially adequate and elastic.
b) broad based - tax is levied not only on income but also on property and
commodities.
c) administratively efficient.
d) balanced and harmonious.
e) ensures the reduction of economic inequalities.
f) ensuring economic stability.
g) ensures that national income or standard of living is increases.
h) acts as an instrument of economic growth.
i) is socially advantageous.
j) enables optimum allocation of resources.
In addition, the revenue yield should be adequate; the distribution of the tax burden
should be equitable. Moreover, taxes should be chosen so as to minimize interference
with
economic decisions in otherwise efficient markets. The tax system should also permit
fair
and non-arbitrary administration and should be understandable to the taxpayer. The
tax
structure should facilitate the use of fiscal policy for stabilization and growth
objectives.
These and other requirements may be used as criteria to appraise the quality of a good
tax
structure. Eventually, a good tax system should not only be equitable, but it should
also
be efficient.5.1 Taxes: Definition, Principles, Objectives and Classifications
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5.1.5 Classification of Taxes
There are two major types of taxes based on impact or incidence. They are direct and
indirect taxes. Direct taxes impose the burden or impact and incidence on the same
person
who earns the income. They are computed based on the ability of the taxpayer to pay,
which
means that the higher the person’s capability of paying, the higher the taxes.
Examples
of direct taxes include employee’s income tax, business income tax, rental income tax,
agricultural income tax and other income taxes, poll tax, land tax, property tax,
royalty
tax, capital gain tax, property tax, gift tax and inheritance tax. Here, the tax paying
ability
is assessed directly in relation to one’s income.
Direct taxes are further divided into income tax, transfer tax, entitlement tax, property
tax
and capital gains tax.
i.
Income tax: the type of tax that governments impose on income generated by
individuals and businesses within their jurisdiction.
ii. Transfer tax: the most common form of transfer tax is levied on real estate. Such
a tax is levied on the taxable portion of the property of a deceased individual
including trusts and financial accounts.
iii.
Property tax: this tax is charged on properties such as land and building and is
used for maintaining public service.
iv.
Capital gains tax: this tax is charged when an individual sells assets such as
stocks real estate, or a business. This kind of tax is computed by acquisition
amount and the selling amount.
Indirect taxes impose the impact (immediate burden) and incidence (ultimate burden)
on different persons. Examples of indirect taxes include consumption taxes such as
value
added tax (VAT), excise tax, turnover tax (TOT), surtax, customs duty, and stamp
duty.
5.1.6 Major Categories and Sources of Taxes
Different countries have different names to classify their tax systems. In Ethiopia, for
example, taxes are classified as Schedules that include income from employment,
income
from rental of buildings, income from business, and other incomes. This is explained
in
detail in this unit.
In the case of the UK, during the time of preparing this book, the main types of taxes
are:5.1 Taxes: Definition, Principles, Objectives and Classifications
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● Income tax – a tax on one’s income. The basic rate of income tax is 20%, paid on
income over the income tax threshold of £11,500.
● National insurance contributions – a kind of income tax based on a similar principle
of taking a certain percentage of income.
● Consumption tax – VAT – 17.5%.
● Excise duties on alcohol, tobacco.
● Corporation tax – tax on company profit.
● Stamp duty – tax on buying houses/shares.
The UK also has a minor category known as “sin tax” which is imposed on goods and
services that commonly include tobacco, alcohol, sugar-added drinks, and gambling.
The
main purposes of imposing sin taxes are to reduce the consumption of harmful goods
and
to increase government revenue.
In the USA, there are five most common types of taxes. They are:
1. earnings (payroll tax).
2. individual income, (individual income tax, capital gains).
3. corporate income (corporate income tax).
4. wealth (property taxes, estate taxes).
5. consumption (consumption tax, sales taxes, excise tax).
From this list, items 1-4 are direct taxes and item 5 represents indirect ta. In terms of
the
share of tax sources, the US Federal Government generates tax revenue from
individual
income tax (41.6%) and payroll taxes (34.8%), corporate income tax (15.1%), with
very
small shares from consumption and other taxes (such as wealth taxes (Gruber, 2015).
Activity 5.1
Use reference texts such as library books or Internet (e.g. Google search)
to compare and contrast tax structures in a country in Africa, Latin
America and South Asia.5.2 Approaches to Tax Equity
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5.2 Approaches to Tax Equity
At the end of this section, you will be able to:
 list the different approaches to tax equity.
 describe the incidence of taxes.
Start-up Activity
1. Discuss the idea of tax fairness or equity.
2. Should the rich pay less or more taxes? Why? Discuss this with a
partner sitting next to you and report what you have discussed to
the class.
There are two approaches for tax equity: the benefits approach and the ability to pay
approach.
5.2.1 The Benefits Approach
According to the benefits approach, an equitable tax system is one in which each tax
payer
contributes in line with the benefits which he/she receives from public services. In
other
words, it is a principle for distributing the tax load among individuals and groups
indicating
that tax obligations should be based on the benefits received from the enjoyment of
public
services. Here, the aim is to work out how much each person gains from public
spending.
The benefits approach has the advantage of linking the discussion of tax equity with
the
expenditure side of the public budget. However, it is much easier to state an abstract
basis
than to apply it in a real situation. The reason for this lies in the fact that while some
types of government spending such as health, education, and social subsidies can
easily
be attributed to beneficiary households, about half of government spending may not
be so
allocated. It is difficult, if not impossible, to determine who benefits most from
spending
on such items as the army, police, diplomatic service, or the judicial system.
5.2.2 The Ability-to-pay Approach
According to this approach, tax is levied on each taxpayer in line with his/her ability
to 5.2 Approaches to Tax Equity
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pay. This approach focuses on the distributive nature of taxation. In this approach,
taxes
should be distributed as per the capacity of taxpayers to pay them. Taxation based on
ability-to-pay calls for people with equal capacity to pay the same and for people with
greater ability, to pay more. The key questions here are how to measure ability to pay,
how
to determine a fair set of tax rates based on differing abilities to pay and how to
compare
the economic status of various individual taxpayers.
The ability to-pay approach is based on horizontal equity and vertical equity. Horizontal
equity is a situation where people in the same circumstances pay the same taxes.
Vertical
equity, on the other hand, is a situation where a degree of proportionality is important
whereby unequals should be treated unequally.
The concepts of progressive, proportional, and regressive taxes help address this issue,
also known as “type by impact.” (Greenlaw and Taylor, 2017).
Accordingly, a progressive tax is one where those with higher incomes pay a higher
share
of taxes out of their income compared to those with lower incomes. That is, the
average
tax rate rises with income and people with higher incomes pay a higher percentage of
their
income in taxes.
A proportional tax is one where everyone pays the same share of taxes regardless of
income level. Here, the average tax rate is the same at all income levels. Put simply,
everyone pays the same percentage of income in taxes.
A regressive tax is one where those with high income pay a lower share of income in
taxes
than those with lower incomes. Here, the average tax rate falls when income rises.
People
with higher incomes will pay a lower percentage of their income in taxes.
In connection with the ability to pay approach, one may ask: How is the ability to
pay measured? Or what tax base better represents ability to pay (or taxable capacity
of individuals)? Ideally, the measure for ability to pay would reflect the entire welfare
which a person can derive from all options available to him/her including
consumption
(present and future), holding of wealth, and the enjoyment of leisure. Unfortunately,
such
a comprehensive measure is not practicable.5.3 Tax System and Structure in Ethiopia
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Activity 5.2
Explain the difference between progressive and regressive taxation.
5.3 Tax System and Structure in Ethiopia
At the end of this section, you will be able to:
 explain the tax system in Ethiopia.
 explain various tax policies.
Start-up Activity
Make a group of four and discuss your perception of the major sources
of taxation in Ethiopia. Then, report and share what you have discussed
in your group and finally, report back to the whole class.
Ethiopia introduced the concept of income taxation in 1944 when the Emperor issued
a
decree requiring all peasants to pay one-tenth of their agricultural products to tax
officials.
Since then, the tax regimes have changed with associated changes in governments.
Currently, the government agency which is responsible for tax collection is the federal
Ministry of Revenues (MoR). The MoR prepares decrees, directives and regulations
on
fiscal policy matters and submits them for parliament to legislate. As a federal country,
the Ethiopian constitution allows for the revenue sharing principle of federal and
regional
governments.
The legal framework for taxation is provided by Proclamation No. 33/1992 and the
Federal Democratic Republic of Ethiopia (FDRE) Constitution (1995) that
promulgated
the sharing of revenue between the federal and regional governments. Accordingly,
the
Federal government shall levy taxes and collect duties on revenue sources which are
reserved to the federal government. Moreover, it draws up, approves, and administers
the
federal government’s budget (Article 51(10)). The regional states levy and collect
taxes 5.4 Types of Tax and Tax Accounting in Ethiopia
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and duties on revenue sources which are reserved to the states and draw up and
administer
their respective state budgets (Article 52 (2(e)). As of April 2022, Ethiopia has 11
regional
states and 2 autonomous administrations of Addis Ababa and Dire Dawa Cities.
Activity 5.3
Visit a business in your locality and find out how they pay taxes. Write a no
more than 2 pages note to summarise your findings.
5.4 Types of Tax and Tax Accounting in Ethiopia
At the end of this section, you will be able to:
 describe the various types of taxes and tax system in Ethiopia.
 explain various tax policies of Ethiopia.
Start-up Activity
Discuss various types of taxes in Ethiopia in groups of four. Then, share
what you have discussed with classmates sitting near you. Finally, report
your responses to the whole class.
According to the Tax Proclamation No. 286/2002 and Regulations No. 78/2002 of
Ethiopia, there are four schedules of income in addition to exempt income. They are:
a) Schedule A: Income from employment.
b) Schedule B: Income from rental of buildings.
c) Schedule C: Income from business.
d) Schedule D: Other income.
e) Schedule E: Exempt income.
Schedule A: income from employment is taxed at rates ranging from 10 to 35%. 5.4 Types
of Tax and Tax Accounting in Ethiopia
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Employment income tax is withheld by employers and is a final tax. That means
employees
earning income exclusively from employment are not required to declare income to
tax
authorities.
Employment income includes the following earnings:
a) salary, wages, an allowance, bonus, commission, gratuity, or other remuneration
received by an employee in respect of a past, current, or future employment.
b) the value of fringe benefits received by an employee in respect of a past, current,
or future employment.
c) an amount received by an employee on termination of employment, whether
paid voluntarily, under an agreement, or because of legal proceedings, including
any compensation for redundancy or loss of employment, or a golden handshake
payment.
Employment income tax rates in Ethiopia are shown in Table 5.1.5.4 Types of Tax and Tax
Accounting in Ethiopia
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Schedule B: rental income tax is imposed for each tax year on a person renting out a
building or buildings who has taxable income for the year. The taxable income tax of
a
taxpayer for a tax year is the gross amount of income derived by the taxpayer from the
rental of a building or buildings for the year reduced by the total amount of
deductions
allowed to the taxpayer for the year. Rental income tax rates refer to a taxpayer’s
taxable
rental income for a tax year which is the gross amount of income that a taxpayer
derives
from rental of a building reduced by the total amount of deductions allowed.
Schedule C: provides for the taxation of income earned from businesses. Business
income
tax is imposed for each tax year. The taxable income for a tax year is the total
business
income reduced by the total deductions allowed to the taxpayer for the year.
Schedule D: includes other income such as income from royalties, income paid for
services rendered outside of Ethiopia, income from games, dividends, income from
casual
rental of property, interest income, specified non-business capital gains.
Schedule E: refers to exempt income. A list of exempted income items includes the cost
of medical treatment of employees, hardship allowance, salary paid to domestic
servants,
maintenance, or child support payments, travelling expenses paid to employees
recruited
from elsewhere than the place of employment, pension contribution, and payments
made
to a person as compensation.
Apart from the above direct taxes, the following indirect taxes are levied by the
Ethiopian 5.4 Types of Tax and Tax Accounting in Ethiopia
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government. They are VAT, TOT, excise tax and surtax, as detailed below. The list
also
includes tax related legal provisions in Ethiopia.
Value added tax (VAT): is a tax levied on the value added at different stages. It is a
sales tax that is administered in a different form. It is an indirect tax. Ethiopia
introduced
the VAT Act on 1 January 2003 with the standard rate of 15% which is applied on
every
taxable transaction by a registered person. According to the law, VAT must be
included in
the selling price of every taxable supply of goods or services made by a vendor during
that
vendor’s enterprise. A vendor is a person who is registered, or required to be
registered
for VAT. Thus, VAT is a destination-based or consumption tax, which means that
only the
consumption of goods and services is taxed.
VAT exemptions also apply whereby the supplier of goods does not levy VAT
(output
tax) on those exempt supplies but must bear VAT (input tax) on the purchases
incurred in
making such supplies.
Turnover tax (TOT): this is an equalization tax that is imposed on persons not
registered
for value-added tax to fulfil their obligations and to enhance fairness in commercial
relations and to complete the coverage of the tax system. Administrative feasibility
considerations limit the registration of persons under the value-added tax to those with
annual transactions to the total value exceeding 500,000 Bir. For services rendered
locally,
the rate is 2% on contractors, grain mills, tractors and combine harvesters, 10% on
others
as provided by the Excise Tax Proclamation No. 307/2002.
Excise tax; this is imposed and payable on selected goods such as, luxury items and
basic goods which are demand inelastic. In addition, it is believed that imposing the
tax
on goods that are hazardous to health and which cause social problems will reduce the
consumption. Excise tax is applicable on 19 groups of items and 378 goods. The tax
rate ranges from 5% to 500%. In terms of the time of payment, tax on excisable goods
is
payable when imported at the time of clearing the goods from the customs area, and
when
produced locally, not later than 30 days from the date of production (EIC, 2020).
Surtax: it is an additional 10% tax that is applicable on imported goods except for
fertilizers, petroleum and lubricants, motor vehicles for freight, passengers and special
purpose motor vehicles, aircraft, spacecraft, and parts thereof, and capital (investment)
goods. The Ministry of Finance is authorized to increase or decrease the list of goods
exempt from surtax.5.4 Types of Tax and Tax Accounting in Ethiopia
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Pension contribution: the contributions payable to the Private Organizations Pension
Fund shall, based on the employee’s salary, be by the employer (11%) and by the
employee
(7%).
Withholding Tax all bodies and specified sole proprietor businesses are required to
deduct
withholding tax on domestic transactions at a rate of 2% of the value of the
transaction and
remit to the tax authority monthly.
Stamp Duty is another form of taxation basically imposed on the services given to
individuals through affixing seals. Stamp is an official mark or seal placed on a
document 5.5 Problems Associated with Taxation in Ethiopia
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specially to indicate that a requirement tax has been paid. Thus, stamp duty is a tax
raised
by requiring stamps sold by the government to be affixed to designed documents,
which
form one kind of revenue to the government treasury.
Customs Duty: is tax like other taxes but it is imposed on imported or exported goods.
This is the best instrument to prevent or reduce importation of goods. It serves as
trade
barrier. Whenever a state needs to ban or reduce importations to her territory, it can
impose
high rate in some goods (excise taxation) it might reach a rate of 100% or above. Thus,
such importation will be discouraged. Of course, this measure helps to protect infant
domestic factories /industries from stiff competitions with the products of competitive
and
subsidized foreign companies/ importers.
Tax and accounting are two separate entities that are also linked. All taxation involves
accounting processes which is the practice of calculating financial statements and
figures.
These statements are used to make tax calculations. Thus, tax accounting is used by
individuals, businesses and other entities. Tax accounting for an individual focuses on
income, qualifying deductions, and any investment gains or losses. Individuals with
employment in different public establishments in Ethiopia get their income tax paid
their
employers. Businesses need to keep up to date financial records to help determine
their
tax liabilities.
Activity 5.4
Write down the different tax schedules in Ethiopia. Then, compare what
you have written with your partner sitting next to you.
5.5 Problems Associated with Taxation in Ethiopia
At the end of this section, you will be able to:
 explain prevailing problems of taxation in Ethiopia.
 suggest possible remedial actions to alleviate the problems associated with tax
collection in Ethiopia.5.5 Problems Associated with Taxation in Ethiopia
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Start-up Activity
Form a group of four and discuss whether or not there are problems
of taxation in Ethiopia.
The major criticisms of tax systems around the world have focused on the complexity
of their administration and the difficulty for taxpayers to understand and comply with
it.
Both problems cause taxpayers to incur costs to correctly calculate their tax liability.
This
may encourage the growth of unreported transactions in the underground economy
(tax
evasion) and the growth of demand for tax shelters (tax avoidance).
In developed countries, one of the tools for improving efficiency in tax administration
is to
modernize customer services. This activity is based on the recognition of new
management
techniques with new concepts of “client orientation” or “customer orientation”.
In developing countries including Ethiopia, on the other hand, tax systems face
diverse
problems. Some of these include the complexity of the tax system, perception of
corruption,
the cost of compliance, fairness perception of the tax system as well as tax knowledge.
The
latter has a positive effect on voluntary tax compliance. Broadly, these problems can
be
categorised under tax compliance and bureaucracy in tax systems.
Problems that are related to tax compliance are the biggest problems which are faced
by any tax administration. The term “tax compliance” refers to the degree to which
the
taxpayers with the tax laws. On the contrary, tax non-compliance takes the form of tax
avoidance and tax evasion.
Tax avoidance refers to arranging one’s affairs so as to minimize the tax burden. It entails
taking full advantage of the provisions of the tax code or schedule to reduce one’s tax
obligations. An example is a reduction of one’s tax burden through exemptions,
deductions
or incentives approved in the tax schedule. From the perspective of law, tax avoidance
is
not illegal; however, it poses problems for tax administration.
Tax evasion is falsifying information on a tax return in order to reduce one’s tax liability
or even not filing at all (failing to pay legally due taxes) which is illegal. Tax evasion
is Unit Summary
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rooted in underground economic activities that exist for, at least, two reasons: (a)
because
certain activities are illegal and individuals do not want records of those activities
having
taken place, and (b) because high marginal tax rates give people an incentive to obtain
income without reporting it.
Other problems which tax administrations face, both in Ethiopia and elsewhere, are a
steadily growing workload, the complexity of fiscal legislation, the attitude of
taxpayers
and the degree of non-compliance, the need to improve customer service, the need to
reduce costs of tax assessment and collection, and the need for efficient and effective
management. These problems raise questions about the efficiency and the
effectiveness of
tax collection and the ways in which they can be improved.