PUBLIC FINANCE AND TAXATION 2024

CHAPTER ONE
1 Overview of Public Finance
Governments, all over the world have started number of public projects, such as social
security, protection and other services of public utilities like electricity, water supply,
railways, heavy electricity, atomic energy, etc. To provide social amenities in the form of
education, health and sanitation facilities and public utilities, the government requires
adequate revenue.

Public Finance, therefore, deals with the income and expenditure of public authorities.
It deals with the financial operations or finances of the government. Central, state and local
government raises revenues from various tax sources and non-tax sources, such as revenue
from general, administrative and economic services, borrowings from individuals,
corporations and friendly foreign countries. .

1.1. Definition of Public Finance

1. “Public finance is concerned with the income and expenditure of public authorities
and with the adjustment of one to the other.” Huge Dalton

2. “Public finance deals with the provision custody and disbursement of resources needed for
conduct of public or government functions.” Lutz

3.“Public finance is a science which deals with the activity of the statement in obtaining
and applying the material means necessary for fulfilling the proper functions of the
state.” Carl Plehn

4. “Public finance is the study of the principles underlying the spending and raising of
funds of public authorities.” Findley Shirras

5. “The government, considered as a unit, may be defined as the subject of study of public
finance. More specifically, public finance studies the economic activity of government as a
unit.” Buchanan

6. “Public finance deals with expenditure and income of public authorities of the state and
their mutual relations as also with the financial administration and control.” Bastable

All of them say that it is a study of income and expenditure of the central, state, and local
governments. Government performs many functions which the individual cannot or
do not perform. Therefore, rising of funds for the expenditure and their disbursement
constitutes the subject of Public finance.

1.1.1 Difference and Similarity between Public Finance and Private

Finance
Finance in general means public as well as private finance. Public finance relates to the
m o n e y-raising a n d i n c o m e -expenditure functions o f t h e government. Private finance
refers to the income expenditure phenomenon of an individual or private business firm.

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A) Similarities
a) Satisfaction of Human Wants
Both the public and private finance have the same objective, i.e., the satisfaction of human
wants. Public finance is concerned with the satisfaction of social or collective wants,
whereas private finance is concerned with the satisfaction of personal or individual wants.
b) Maximum Advantage
Both the public finance and private finance try to secure maximum advantage or
maximum benefit. An individual or a corporation or a private business firm tries to obtain
maximum advantage from his expenditure. Similarly, the government also tries to obtain maximum
good of the people by incurring expenditure on the society.
c) Borrowings
Another similarity between the public and private finance is that many times both have
to be obtained from the market in the form of borrowings whenever the expenditure
of either the government or any individual or firm exceeds their income/revenue.
d) Engagement in Similar Activities
Both the private and public sectors are engaged in activities that involve lots of
purchases, sales and other transactions. Similarly, they are engaged in production,
exchange, saving capital accumulation, investment, and so on. In order to finance these
operations, the government, creates money, raises loans and makes payments
etc. Similarly, a private economic unit lends, borrows, receives payments, and
makes payments and so on. In these respects, therefore, both the public and private
finance are quite similar to each other.
e) Scarcity of Resources
The scarcity of resources is also an important factor which is common to both. They have
unlimited objectives, whereas the resources are limited.
f) Problem of Adjustment of Income and Expenditure
Another similarity between public and private finance is that both the public as well as
private sectors face the problem of adjustment of income and expenditure.
2) Dissimilarities
a) Motive
The motive of private finance is personal interest or benefit, whereas the motive of public
finance is social benefit or public welfare.
b) Adjustment Approach of Income and Expenditure
Another dissimilarity between the individual‟s private finance and the government‟s
public finance is that every individual tries as far as possible to adjust his expenditure
to his income because his expenditure depends on his income. Conversely, the
government first prepares its budget. In other words, the government first determines its
expenditure and then devises ways and means to raise the requisite revenue to meet its
expenses.
c) Nature of Resources
The resources (private finance) of an individual are more or less limited, whereas the
resources of the government (public finance) are enormous. Government can raise
resources from tax sources as well as non-tax sources. The government can borrow from

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internal as well as external sources.

d) Coercive Methods
An individual (private finance) cannot use coercive methods to raise his income,
whereas the government (public finance) can use forceful methods to collect
revenue. In other words, to collect revenue, the government imposes taxes at a high
rate on the people irrespective of their capacity to pay. Private individuals or bodies have
no such powers.
f) Secrecy of Budget
Public finance is an open affair as the government gives utmost publicity to its budget
by publishing it in newspapers and by showing it on television. For example, the
Ethiopian government tells to the public the yearly approved budget by parliament,
whereas private finance is a secret affair. An individual tries to keep his accounts secret
as he does not want his competitors to know his real financial position.
g) Long/Short-term Consideration
Another point of difference between private and public finance is that the private
individuals incur expenditure in those areas of business which give quick returns. They,
as individuals keep in view short-term considerations. On the contrary, government
incurs expenditure keeping in view the long-term considerations, such as construction
of dams, multipurpose hydro-electric projects, etc.
h) Elasticity of Finance
Public finance is elastic in nature-as compared to private finance. Public finance can be
increased by imposing various taxes as public finance is open to drastic changes.
Private finance on the other hand, cannot be increased as there is not much scope for
changes in private finance.
i) Deliberation in Expenditure
The pattern of expenditure of an individual is governed by habits, customs, status,
personal needs etc. On the contrary, the pattern of public expenditure is governed and
controlled by deliberate economic policy of the Government
j) Right to Print Currency
The government has a right to print currency which is legal, whereas private
individual does not enjoy such a right.
1.1.2 Economic and Social Significance of Public Finance
1) Economic Significance
Economic Stability and maintenance of full employment are the two main goals of public
finance in advance countries like the U.K. and the U.S.A. In developing countries
economists were of the view that the fiscal policies should be formulated for the rapid
economic development. Public Finance occupies great significance in an under developed or
developing country. According to R.J. Chelliah, “Public Finance has a positive and
significant role in the context of economic development.” The importance of public finance
in an under developed/developing country discussed as follows:
a) Capital Formation
Since the economic development of the country depends on the rate of capital
formulation, the first and the foremost aim of public finance is to promote capital

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formation. In a developing country, the government‟s economic policy should

concentrate on production and fiscal policy should act as a tool of capital
formation. For rapid capital formation, the government should incur expenditure on the
establishment of basic and heavy industries, infrastructural development, such as power
projects, transport sector, means of communications etc.
b) Economic Stabilization
Economic stabilization is yet another economically significant responsibility of the government.
The problem arises whenever there is economic instability such as inflation, deflation and
recession. Public finance (revenue and expenditure process of the government) may be,
therefore, used to secure economic stability or to remove economic fluctuations in the
economy.
c) Full Employment
Public finance also plays an important role in increasing employment. In an
underdeveloped/developing country, major problem faced by the people is the problem of
unemployment. This problem leads to low standard of living, poverty, backwardness,
ignorance and above all starvation. It is the function of public finance to provide
employment opportunities. Therefore, expenditure should be incurred by the
government for increasing employment and for achieving full employment. To generate
employment, public expenditure should be incurred on setting up new industries,
encouraging small-scale and cottage industries through financial subsidies, expenditure
on training schemes etc.
d) Balanced Regional Development
For the economic development of a country, balanced regional development is very
essential. Balanced regional development is possible by setting up private industries
in backward areas instead of in urban areas. To encourage this diversion, the
government should provide fiscal or tax concessions in the form of 5 year tax holiday,
communication facilities should also be provided. If the private industries fail to
divert to backward regions, should be taxed heavily.
e) Reduction in Economic Inequalities
One of the major problems of underdeveloped countries is the unequal
distribution of income and wealth. There is a gap between the rich and the poor. Public
finance has an important role to play in this context. To bring about equitable
distribution of income and wealth, the government should follow the system of
progressive taxation. In other words, the government should impose heavy taxes on the
richer section of society, and the amount realized from the rich should then be spent on
the poor by way of providing them social amenities such as free education, medical
facilities, public utilities like road, water facility, recreation facilities etc.
f) Mobilization of Resources
Mobilization o f resources is another important role of public finance. The government
can mobilize or raise resources by imposing taxes on the people and industries, by
encouraging savings through various saving schemes, surplus of public enterprises and
borrowings and making them available for investment for the rapid economic
development of the underdeveloped country.

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g) Optimum Utilization of Resources

Optimum utilization of scarce resources is very essential for the economic
development of the underdeveloped countries. In a developing country it is not
uncommon to find non-utilization or destruction of scarce resources. The solution of this
problem lies in the optimum utilization of available resources by means of adopting
planned monetary and public finance policies. The state can direct the flow of
consumption, production and distribution in the right direction by adopting
balanced budgetary policy.
2) Social Significance
Social justice or equitable distribution of income and wealth is another responsibility of
the government in its public finance operations. As already been discussed there is
unequal distribution of income and wealth in developing countries. There is a
wide gap between the rich and the poor. For example according to Fikreyesus
(2006), the top 20 percent of the population have control about 50 percent of the
Ethiopian economy. This gap can be bridged by adopting a rational fiscal policy, such
as taxation and public expenditure. In other words luxury items purchased mainly by
the rich should be subjected to higher rates of taxation, and necessary items should be
exempted from taxation.
Social justice also requires investment expenditure on the establishment of enterprises in
the public sector. By doing so, the government would be able to produce goods of mass
consumption to make available cheap goods to the people.
1.3) Scope of Public Finance
Public finance deals with the income and expenditure pattern of the Government. Hence the
substances concerned with these activities become its subject matter. The subject matter of
the public finance is classifies under five broad categories. They are,

1. Public revenue

2. Public Expenditure

3. Public debt

4. Financial administration

5. Economic stabilization

1.3.1 Public Revenue:

Under this category, the sources of the public revenue, principles of taxation, effects of taxes
on the economy, methods of raising revenue and the like are dealt with. Public revenue is the
means for public expenditure. Various sources of public revenue are:

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a. Tax revenue, and

b. Non-tax revenue
Increasing activities of the government are the cause of increasing public expenditure.
Methods of public revenue and their volumes have significant impact on production and
distribution of wealth and income in the country. It has effects on the nature and the volume
of economic activities and on employment.

a. Tax revenue:
Taxes are compulsory payments to government without expectation of direct return or benefit
to tax payers. It imposes a personal obligation on the taxpayer. Taxes received from the
taxpayers, may not be incurred for their benefit alone. Tax revenue is one of the most
important sources of revenue.

Taxation is the powerful instrument in the hands of the government for transferring
purchasing power from individuals to government.

The various types of taxes can be listed under three heads.

1. Taxes on income and expenditure which include income tax, corporate tax etc.
2. Taxes on property and capital transactions and includes estate duty, tax on wealth, gift tax
etc.
3. Taxes on commodities and services, covers excise duties, customs duties, sales tax,
service tax etc.
 These three types can be reclassified into direct and indirect taxes. The first two
types belong to the category of direct taxes and the third type comes under indirect
taxes.

b) Non-tax revenue:

This includes the revenue from government or public undertakings, revenue from
social services like education and hospitals, and revenue from loans or debt service etc.

1.3.2. Public Expenditure:

Public expenditure is incurred by public authorities --Central, State and local

Governments either for the satisfaction of collective needs of the citizens or for
promoting their economic and social welfare.
1.3.2.1 Classification of Public Expenditure
Technically, in the structure of a budget, most governments classify public
expenditure into two:

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i. Current expenditure, and

ii. Capital expenditure
All sorts of administrative and defense expenditure and debt services are called current
expenditure. They are also referred to as non-developmental expenditure. They are
intended for continuing the existing flow of goods and services and maintaining the
capital of the country intact. On the other hand, capital expenditures contribute to
increased productive capacity of the nation and therefore, are known as development
expenditure. Expenditures on construction of dams, public works, state enterprises,
agricultural and industrial development etc., are instances of capital expenditure.
Though public expenditure is a means of maintaining the capital of the country intact,
it is not merely a financial mechanism, it is rather a means of securing social
objectives. Socialism can be realized only through progressive taxation and their
distribution afterwards. Therefore, public expenditure is that expenditure incurred by
the public authorities i.e. Central, State and Local Governments, to satisfy those
common wants which the people in their individual capacity are unable to satisfy
efficiency wants.
1.3.2.2 Objectives of Public Expenditure
Dr. Dalton divided the aims of public expenditure into two parts:
i. Security of life against the external aggression and internal disorder
and injustice.
ii. Development or up gradation of social life in the community.
1.3.2.3 Reasons for Growing Expenditure
A multitude of factors have caused the rising trend of public expenditure in modern
times. The followings are few of them:
1. Welfare State: The modern state is a welfare state. It aims at promoting the economic,
political and social well being of citizens. It has to spend increasing amounts on such
items as social insurance, unemployment relief, free medical aid, free education, child
welfare, women welfare, labor welfare, concessional rates of water supply, food stuff,
electricity etc., to improve the economic and social welfare of the country. As a result,
the public expenditure is bound to increase.
2. Defense: Due to the invention of nuclear weapons there is always a danger of
foreign aggression. International political situation is uncertain and insecure. As such,
every nation has to prepare itself for a strong defense. The defense expenditure in the
form of expenditure on war materials, maintenance and growth of armed forces,
pension to retired war personnel etc. are, are perpetually rising.
3. Population Growth: It is an admitted fact that the population is increasing
rapidly. As a result, the government has to incur greater expenditure to meet the
requirements of the increasing population.
4. Transport and Communication: With the expansion of trade and commerce,
the state has to provide and maintain a quick and efficient transport system. Transport
being a public utility, the state has to provide it cheaply also. The government has to
spend a lot on constructing new railway lines, good roads, new roads, highways, bridges
and even canals to connect different areas with a smooth transport system as a

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precondition of growth.
5. Urbanization Effect: The spread of urbanization is an important factor leading to
relative growth of public expenditure in modern times. Urbanization is responsible
for the increase in expenditure on water supply, electricity, construction and
maintenance of hospitals, schools and other public services.
6. Growth of Democracy: Growth of democracy and socialism has been responsible for
the increasing tendency of public expenditure to a great extent. In a democracy, to
achieve the goodwill of the public, the ruling party has to incur heavy expenditure on
providing variety of services and facilities to the public. Expenditure on elections and by
elections is increasing every year. Number of ministries and executive offices has also been
increased. As a result of this the public expenditure increases rapidly.
7. Rising Trend of Prices: Public expenditure is also increasing in every country due to
rising trend of prices. The reason is that the government has to buy goods and services
from the market at higher prices. The government has also to increase the salaries,
dearness allowance etc., of government employees leading to a rapid increase in
government expenditure.
8. Increase in the Activities of the State: In recent years, activities of the state,
particularly in the social and economic fields, such as education, public health, public
recreation, public works, commerce and industry, five year plans, etc. have increased
tremendously.
9. The planning effects: In a less developed economy, the government adopts
economic planning for the development of the country. In a planned economy, thus,
when the public sector is expanding its role, the public expenditure shows an increasing
trend. Huge sums are also spent by the government on formulating and implementing
plans.
10. The Rural Development Effect: In an underdeveloped country, the government has
also to spend more and more for rural development. It has to undertake schemes like
community development projects and social measures. The government also incurs
expenditure on imparting training to personnel for implementing rural development
programs.
11. General Expenditure and Internal Security: Internal situation of a country is
becoming uncertain and insecure day by day. Government has been constantly facing
communal and political riots. Hence, to check and control these troubles, the
government has to spend more on the maintenance of law and order. Moreover,
the government is bound to spend huge amounts, as in a free country it is essential that
the just demands of the public are duly considered.
1.3.2.4 Canons of Public Expenditure
The expression “canons of public expenditure” it used for the fundamental rules or
principles governing the spending policy of the government .the following canons of
public expenditure have been laid down Prof. Findley Shirras:
a) Canon of Benefit: This cannon suggest that every public spending must ultimately be
used for the cause of social benefit i.e. for the general well- being of the common people. In
other words, the state spending should confer benefits on the entire community at

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large that on an individual group or section. It means public funds should be spent in
such directions which pursue common interest and promote general welfare.
b) Canon of Economy: it implies that public expenditure should be incurred carefully and
economically. Economy here means that wasteful and extravagant expenditure should be
avoided at all levels. Public expenditure must be productive and efficient. Hence, it must
be incurred only on every essential items of common benefit- without duplication in a
way that involves minimum cost. An efficient system of financial administration is
therefore, very essential in any country.
c) Canon of sanction: this cannon suggests that no public spending should be made
without the approval of proper authority. Only obtaining prior sanction is not sufficient. It
must be properly inspected and examined whether the sanctioned amount of money
is being spent properly on sanctioned items or not. As a rule, therefore, money must
be spent on the purpose for which it is sanctioned by the highest authority and accounts
properly audited.
d) Canon of Surplus: this cannon suggests that saving is a virtue even for the
government, so an ideal budget is one which contains an element of surplus by
keeping public expenditure below public revenue. In other words, public authorities
should aim at surplus of income over expenditure and they should avoid deficits.
Frequent and huge deficits lead to uncontrollable financial situation with dire
consequences of inflation. Therefore, every government should attempt to balance its
income and expenditure.
e) Canon of Elasticity: this canon requires that the expenditure policy of the state should
be such that changes must be possible in the expenses according to the change in
requirements and circumstances. In other words, there should be scope for charges in
public expenditure according to the requirements of the country.
f) Canon of Productivity: This canon or principle implies that the expenditure
policy of the Governments should be such that would encourage production in a
country. That means a large part of public expenditure must be allocated for
development purpose.
g) Canon of Equity: One of the foremost aims of public expenditure is also to ensure the
just and equitable distribution of is more significant for the countries where the gap
between the highest income and the lowest income groups is very wide.
Underdeveloped countries like India, have given this aim a significant and particular
importance in the economic activities of the State and in their fiscal policies.
1.3.3 Public debt:

Increasing need of government for funds cannot be fully met by taxation alone in under
developed and developing countries due to limited scope of taxation. Government therefore
has to resort to alternate sources. Rising of debt is one such source. This includes both
internal debt and external debt.

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Public debt is a study of various principles and methods raising debts and their economic
effects and methods of repayments.

In under developed and developing countries, internal sources are limited. Under
developed and developing countries, therefore go for external debt. The transfer of capital at
international level may take the form of:

1. Financial aid through grants and loans

2. Commodity aid
3. Technical assistance
External debt is an immediate source of funds for development. However, such debt
has following drawbacks.

Political subordination
Other obligation
Excess supply of goods and services in debtor country
However, such external inflows help to achieve faster growth.

1.3. 4. Financial Administration

Financial Administration deals with the methods of budget preparation, various types of
budget, etc. Financial Administration refers to the mechanism by which the financial
functions are carried on.

1.3.5 Economic Stabilization

The use of public revenue and public expenditure is to secure stability in levels of prices by
controlling inflations as well as deflation pressures is studied.

Similarly, the income and expenditure policies adopted by the government attain full
employment, optimum use of resources, equitable distribution of income etc are also studied

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Chapter Two
2. Meaning and Characteristics of Taxation
2.1 Meaning of Taxation
Taxation is one of the systems that government uses to collect public revenues from various
sources. However, taxation is the most important system of collecting public revenue in
modern economic system. Taxation is the most powerful instrument in the hands of the
government for transferring purchasing power from individuals to government. The money
collected through taxation – tax revenue – is used to finance government operations. That is,
the money required by the government to undertake different functions –taxes– is collected
from the citizens. Without taxes to fund its activities, government could not exist. Thus, a
government uses taxation as a system of raising the lion share of its revenue. Government
uses the money collected through taxation:

 To pay soldiers and police;

 To build dams and roads;
 To operate schools and hospitals;
 To provide food to the poor and needy;
 To provide medical care to the elderly people; and
 To finance other hundreds of operations
Taxation is used as a system of raising the lion share of public revenue in modern economic
system to fulfill the requirement of the goods and services. Taxation depends on concepts
from law, accounting, economics, public financial management, politics, behavioral sciences,
etc. Thus, taxation can be considered as a part of special fields of study such as law
(specifically tax law), accounting (specifically tax accounting), public financial management,
economics, politics, etc. The scope of taxation includes tax policies, tax theories, tax
decisions, and tax administration

2.1.1 Tax and Duty

Tax is defined as an amount of money levied by a government on its citizens and used to run
the country. A tax is an involuntary fee or more precisely "unrequited payment" made by
individuals or businesses to a government without quid pro quo.

Duties are also taxes. Duties are distinguished from taxes by their strictly economic
characteristic. For example, any government imposes a compulsory levy on the goods
imported from a foreign country. This compulsory levy is called Custom Duty. Custom duty
is compulsory a levy on individuals and companies importing goods to the country and its
purpose is to protect the domestic market and economy. When goods are imported from
abroad while the same goods can be produced within the country, it affects the domestic
market and economy in number of ways as follows:

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 It reduces demand for domestic products

 It discourage production within the county
 It discourages Foreign Direct Investment in the country
 It results in negative balance of payment (BOP)
 It increases the unemployment rate

2.1.2) Tax Accounting

Tax accounting is one of the specialized fields of accounting that encompasses activities such
as:

 recording of tax related transactions;

 continuous follow-up of tax laws affecting a taxpayer i.e. individual or organizations;
 analyzing the consequences of tax on alternative business transactions/courses of
actions
 determination of taxes and tax liabilities;
 preparation of tax returns or tax reports; and
 providing tax related information to assist decision makers
Tax returns are government declaration forms filled and then filed with the Federal, State, or
Local tax authorities. Tax returns are forms filed with the tax authority containing
information used to calculate tax base and taxes (e.g. taxable income and the related
income tax). Examples of tax returns (tax declarations), in Ethiopia, are:

 Business Income Tax Declarations

 VAT Declaration
 Employment Income Tax Declarations
 Turnover Tax Declaration
 Excise Tax Declaration
 Withholding Tax Declaration
 Other Income Tax Declarations
Tax accountant is an individual who assists a taxpayer in preparation of tax returns and who
undertakes tax planning and other related activities

2.2 GENERAL CHARACTERISTICS OF TAX

A tax has the following characteristics:

1. Tax is a Compulsory Contribution: Tax is a compulsory contribution by the

taxpayers to the Government. The people whom the tax is levied cannot refuse to pay the
tax. Once it is levied they have to pay it. Any refusal in this regard leads to punishments.
2. Benefit is not the Basic Condition: For the payment of tax, there is no direct return
or quid proquo to the taxpayers. That is, people cannot expect any return in benefit for the
amount of tax paid by them. Because, there is no relation between the amount of tax paid
by the people and the services rendered by the Government to the taxpayers.

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3. Personal Obligation: Tax imposes a personal obligation on the taxpayers. When a

person becomes liable to pay the tax, it is the duty of him to pay it and in no way he can
escape from it.
4. Common Interest: The amount of tax received from the people is used for the
general and common benefit of the people as a whole. Now the Government has to render
enormous range of social activities, which incur heavy expenditure. A part of the expense
is sought to be raised through taxation of various types. Thus, taxes are said to be the
sharing of common burden by the people.
5. Legal Collection: Tax is the legal collection. It can be levied only by the Government
both Central and State.
6. Element of Sacrifice: Since the tax is paid without any return in benefit, it can be
said that there is the prevalence of sacrifice in the payment of tax.
7. Regular and Periodical Payment: The payment of tax is regular and periodical in
nature. It is levied for a fixed period usually a year. Thus, almost all the taxes are annual
taxes. The payment of taxes should be regular also.
8. No Discrimination: Tax is levied on all people without any discrimination of caste,
creed etc. but according to their ability to pay.
9. Wide Scope: Tax is levied not only on income but also on property and commodities.
To enhance the revenue and to bring all the people under the tax net, the Government
imposes various kinds of taxes. This enhances the scope of taxes.
2.3 Objectives of Taxation
Initially, governments impose taxes for three basic purposes: to cover the cost of
administration, maintaining law and order in the country and for defense. But now
government‟s expenditure pattern changed and gives service to the public more than
these three basic purpose and it restore social justice in the society by providing
social services such as public health, employment, pension, housing, sanitation and
other public services. Therefore, governments need much amount of revenue than before.
To generate more revenue a government imposes taxes on various types. In general
objective of taxations are:
1. Raising revenue: to render various economic and social activities, a government
needs large amount of revenue and to meet this government imposes various types
of taxes.
2. Removal of inequalities in income and wealth: government adopts

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progressive tax system and stressed on canon of equality to remove

inequalities in income and wealth of the people.
3. Ensuring economic stability: taxation affects the general level of
consumption and production. Hence, it can be used as effective tool for achieving
economic stability. Governments use taxation to control inflation and
deflation.
4. Reduction in regional imbalances: If there is regional imbalance with in the
country, governments can use taxation to remove such imbalance by tax exemptions
and tax concessions to investors who made investment in under developed regions.
5. Capital accumulation: Tax concession or tax rebates given for savings or
investment in provident funds, life insurance, investment in shares and
debentures lead to large amount of capital accumulation, which is essential for
the promotion of industrial development.
6. Creation of employment opportunities: Governments might minimize
unemployment in the country by giving tax concession or exemptions to small
entrepreneurs and labor intensive industries.
7. Preventing harmful consumptions: Government can reduce harmful things on
the society by levying heavy excise tax on cigarettes, alcohols and other
products, which worsen people‟s health.
8. This diverts produce’s attention and enables the Beneficial diversion of
resource: Governments impose heavy tax on non- essential and luxury goods
to discourage producers of such goods and give tax rate reduction or
exemption on most essential goods. country utilize to utilize the limited resources
for production of essential goods only.
9. Encouragement of exports: Governments enhance foreign exchange
requirement through export- oriented strategy. These provide a certain tax
exemption for those exporters and encourage them with arranging a free
trade zones and by making a bilateral and multilateral agreement.
10. Enhancement of standard of living: The government also increases the living
standard of people by giving tax concessions to certain essential goods.
2.3 Principles of taxation
The Government requires funds for the performance of its various functions. These funds
are raised through tax and non-tax sources of revenue. Imposing tax on income, property

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and commodities etc. raises tax revenues. In fact, tax is the major source of revenue to
the Government. According to Adam Smith, "a tax is a contribution from citizens for the
support of the Government".
No one likes taxes, but they are a necessary evil in any civilized society. Whether we
believe in big government or small government, governments must have some resources
in order to perform their essential services. So how does one go about evaluating a
particular tax?
Taxation is an important instrument for the development of economy of the country. A
good tax system ensures maximum social advantage without any hardship on taxpayers.
While framing the tax policy, the government should consider not only its financial needs
but also taxable capacity of the community. Besides the above, government has to
consider some other principles like equality, simplicity, convenience etc. These
principles are called as "Canons of Taxation". The following are the important canons
of taxation.
I. Canons Advocated by Adam Smith
1. Canon of Equality.
2. Canon of Certainty.
3. Canon of Convenience.
4. Canon of Economy.
II. Canons Advocated by Others:
5. Canon of Productivity.
6. Canon of Elasticity.
7. Canon of Diversity.
8. Canon of Simplicity.
9. Canon of Expediency.
10. Canon of Co-ordination.
11. Canon of Neutrality.
Canons Advocated by Adam Smith:

No one has yet come up with a better set of criteria for judging a tax than the Canons of
Taxation first proposed by Adam Smith more than two hundred years ago. Adam Smith in
his book, “Wealth of Nations” has explained the four canons of taxation that are mentioned
above. All accepts them as good taxation policy. We shall now explain them briefly.

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1. Canon of Equality: According to this principle of Adam Smith, "the subjects of

every state ought to contribute toward the support of the Government, as nearly as possible,
in proportion to their abilities". That is, a good tax system should be based on the ability to
pay of the people. That is, all people should bear the public expenditure in proportion to their
respective abilities. Tax burden should be more on the rich than on the poor. Since the rich
people can pay more for public welfare, more tax should be collected from richer section and
less tax from the poor. The 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. In simple terms, canon of
equality implies that when ability to pay is taken into consideration, a good tax should
distribute the burden of supporting government more or less equally among all those who
benefit from government.
2. Canon of Certainty: Another important canon of taxation advocated by Adam
Smith is certainty. According to him, "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 so that the taxpayer can adjust
his income and expenditures accordingly. This principle removes all uncertainties in the
payment of tax and ensures smooth functioning of the tax department.
3. Canon of Convenience: In the canon of convenience, Adam Smith states that,
"every tax ought to be levied at the time or in the manner in which it is most likely to be
convenient for the contributor to pay it". That is, the tax should be levied and collected in
such a way that is convenient to taxpayer. For example, it may be in installments, land
revenue may be collected at the time of harvest etc. This principle reduces the tendency of tax
evasion considerably.
It includes the selection of suitable objects for taxation, and also the choice of convenient
periods for requiring payment. The canon of convenience is a special form of the general
principle that the public power should as far as possible adjust its proceedings to the habits of
the community, and avoid any efforts at directing the conduct of the citizens in order to
facilitate its own operations. The sacrifices that inconvenient methods of fiscal
administration impose may indeed be treated as violations of both economy and equity.
4. Canon of Economy: The next important canon of taxation is economy. According to
Adam Smith, "every tax ought to be so contrived as both to take out and keep out of the
pockets of the people as the little as possible over and above what it brings into the public

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treasury of the state". This principle states that the minimum possible amount should be
spent on tax collection and the maximum part of the collection should be brought to the
Government treasury.
Taxation should be economical i.e. this should be much more than mere saving in the cost
of collection. Undue outlay on the official machinery of levy is but one part of the loss that
taxation may inflict. It is a far greater evil to hinder the normal growth of industry and
commerce, and therefore to check the growth of the fund from which future taxation is to
come. Thus the canon of „Economy' is naturally sub-divided into two parts viz.,
1. „Taxation should be inexpensive in collection', and
2. „Taxation should retard as little as possible the growth of wealth'.
It may also be remarked that there is a close connection between "Economy" and
"Productivity", since the former aids in securing the latter.
3.6.2. Canons Advocated by Others:

Other researchers of taxation at other times have added to Adam Smith’s criteria. Some
have noted that a tax should be adequate, meaning it should produce sufficient revenue to
support whatever it is that citizens want their government to do. Some have argued for a
"Benefit Principle" whereby the amount of tax each is called upon to pay bears some
relationship to the benefits each taxpayer receives from government. Others have argued that
a tax should be neutral in its effect on the way markets work. But Smith’s Canons are the
starting point for any serious evaluation of a tax. The various canons added by others are
explained below:
5. Canon of Productivity: According to C.F. Bastable, the 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.
6. Canon of Elasticity: The next principle advocated by Bastable is 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. For example, during certain unforeseen situations like
floods, war, famine, drought etc. the Government needs more amount of revenue. If the tax
system is elastic in nature, then the Government can raise adequate funds without any extra
cost of collection.
The tax system should be elastic is a desirable canon of taxation. It may, indeed, be
regarded as the agency for realising at once "Productivity" and "Economy". Where the
public revenue does not admit of easy expansion or reduction according to the growth or

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decline of expenditure, there are sure to be financial troubles. For this purpose some
important taxes will have to be levied at varying rates. The particular taxes chosen will vary
according to circumstances, but the general principle of flexibility should be recognised and
adopted.
7. Canon of Diversity: According to this principle, 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 of the tax should be decentralised so that every one should pay
according to his ability. To achieve this, the Government should impose both direct and
indirect taxes of various types. It should not depend upon one or two types of taxes alone.
8. Canon of Simplicity: This principle states that the tax system should be simple, easy
and understandable to the common man. If the tax system is complex and vague, the taxpayer
cannot estimate his tax liability and it will cause irregularities in the payments and leads to
corruption.
9. Canon of Expediency: According to this principle, a tax should be levied after
considering all favorable and unfavorable factors from different angles such as economical,
political and social.
10. 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. Otherwise, it will affect the people adversely.
11. Canon of Neutrality: This principle stresses that the tax system should not have any
adverse effect. That is, it shouldn‟t create any deflationary or inflationary effects in the
economy.
Applying Smith‟s Canons to any particular tax is largely a subjective undertaking. Yet, if
one attempts to evaluate the principal taxes – that is, property tax, income tax, and sales tax –
against Smith‟s Canons, one will quickly find that there is no such thing as a perfect tax. The
property tax, for instance, scores fairly low on convenience and efficiency, but fairly high on
certainty. The income tax scores fairly high on equality, but is costly to administer and is so
complicated that it leaves much to be desired on certainty. A sales tax scores high on
convenience, certainty, and efficiency, but poorly on equality. Because there is no perfect
tax, an argument can be made that the best tax system is one that uses all three major types of
taxes in small doses. By combining all three major types, it is possible to offset the
weaknesses of each with the strengths of the others. In the final analysis, however, the
standard for judging a tax is often political. In a democracy, when revenue must be raised,

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the tax selected is often based upon plucking the goose that squawks the least. Some have
called this political test the other canon.
These are the general canons that experience seems to prescribe, and which should be
observed in a well-ordered State. Besides, their simplicity has not saved them from frequent
violation. Their value lies in their assertion of truths plain and intelligible to common
understandings but for that very reason too often passed over. A system of taxation, which
conforms to them, may without hesitation be pronounced a good one. Where they are
neglected and broken through, the evil consequences will be almost certainly conspicuous.
A further point deserves notice. There is at first sight a probability of conflict between
the several canons. A productive tax may be inconvenient, as a convenient one may be
unjust, and how, it may be asked, is a solution of the difficulty to be reached? The plain
answer is, by the surrender of the less important canon. The successful administration of the
State is the final object, and therefore convenience, or even equity, may have to yield to
productiveness. But though opposition is possible, agreement is on the whole the ordinary
case. We have seen that economy increases productiveness, but so do certainty and
convenience. Elasticity aids both productiveness and economy, while growing
productiveness in turn permits better observance of all the other canons. There is thus a
harmony in a properly administered financial system that tends to promote its improvement
in the future.
In a democratic country, the political factors are also influencing the tax policy of
government. While deciding an appropriate taxable system, the government has to follow the
above-mentioned canons of taxation.
2.4 Classification of Taxes
1. Classification Based on the Tax Bases
A. Income Taxes: are taxes levied on income of persons or businesses
B. Property Taxes: are levied on a property of Persons or businesses
C. Commodity Taxes: are taxes levied on commodities and services
2. Classification Based on ultimate burden of taxes (Based on Tax Impact, Tax Shifting
and Tax Incidence)
 Tax Impact refers to the person who bears the money burden of tax in the first
instance
 Tax Incidence refers to the person who ultimately bears the money burden of a tax
 Tax Shifting refers to the process by which the money burden of a tax is transferred
from one person to another person.
Based on ultimate burden, taxes are classified into two: Direct Taxes and Indirect Taxes
described as follows:

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A. Direct Taxes: are taxes the impact and incidence of which fall on the same person.
Direct taxes are taxes which cannot be shifted on to the others. E.g. Employment
income tax
B. Indirect Taxes: these are taxes the impact and incidence of which fall on different
persons. The impact fall on one person and the incidence fall on another person. E.g.
VAT
3. Classification Based on Tax Determinant
A. Ad-valorem Taxes: taxes are determined based on the value of the item to be taxed.
B. Specific Tax: are the taxes levied at a fixed amount, irrespective of the value of the
goods and services
4. Classification Based on Number of Taxes
A. Single Tax: using only one tax in the country. It is a tax on one thing
B. Multiple Taxes: using many kinds of taxes in the country. The government of
modern state uses diversified taxes to use advantage of it
5. Classification based on Taxing Authority
Taxes are classified into three based on taxing authority or taxing hierarchy: Federal Taxes,
State Taxes and Local Taxes

A. Federal Taxes: are taxes collected by Federal government tax agency

B. State Taxes: are taxes collected by Regional State governments
C. Local Taxes: are taxes collected by local tax authorities
2.5 Tax Rate Structures (Tax Systems)

Tax rate structure expresses the relationship between the tax rate and tax base in a country.
Currently nations are using four different types of tax systems: progressive tax system,
proportional tax system, regressive tax system, and degressive tax system.

1. Proportional Tax System.

2. Progressive Tax System.
3. Regressive Tax System.
4. Degressive Tax System.

1. Proportional Tax System

A proportional tax, also called a flat tax is a system that taxes all entities in a class
typically either citizens or corporations at the same rate (as a proportion on income), as
opposed to a graduated or progressive scheme. The term “Flat Tax” is one where the tax
amount is fixed as a function of income and is a term mainly used in the context of income
taxes.
Advocates say that a flat tax system may arguably have most of the benefits of a
progressive tax, depending on whether the flat rate is combined with a significant threshold.
Usually the flat tax is proposed to kick in at a certain income level, or to exempt income
below that level, so that the lowest-income members of society pay no income tax.
Technically, this is a two stage progressive tax rather than a flat tax.

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Advocates of a flat tax claim that it will end unfair discrimination. They also argue that
flat taxes are easier (and cheaper) to administer and comply with than complex, graduated
taxes. Most political parties that advocate the introduction of a flat tax are on the right of the
political spectrum.
Those who oppose a flat tax claim that it will benefit the rich at the expense of the poor.
One argument is that, since most other taxes (sales taxes etc.) tend to be regressive in
practice, making the income tax flat will actually make the overall tax structure regressive
(i.e. lower-income people will pay a higher proportion of their income in total taxes
compared with the affluent). Another argument can be made by looking upon the value of
money to various groups and not simply the rate of taxation. While the monetary value of a
dollar (or other unit of currency) is the same for everyone, it is clearly “Worth” a lot more to
someone who is struggling to afford food than to a millionaire. Taxing everyone at the same
rate ignores the fact that richer people can give up more of their income, without ill effects.
Moreover, it is debatable whether a flat tax would substantially simplify the tax system.
This implies that the rates of taxation should be the same regardless of the size of the income
i.e. "the system in which the rates of taxation remains constant as the tax base changes".
Mathematically, it can be defined as follows: "The amount of tax payable is calculated by
multiplying the tax base with the tax rate".
Tax Payable = Tax Base X Tax Rate

Thus, in the case of proportional tax systems "Multiplier remains constant with the changes in
multiplicand (income)".
Economically, it can be explained as follows:
Example: Proportional Tax System:
Tax Base
Tax Rate in % Amount of Tax (in Birr)
Birr

1500 10 150

6500 10 650

14000 10 1400

23500 10 2350

35500 10 3550

50000 10 5000

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Table 2.1 - Proportional Taxation

Merits of Proportional Tax System:

Proportional tax system has the following advantages:

1. It is simple in nature.
2. It is uniformly applicable.
3. Proportional taxation leaves the relative economic status of taxpayers unchanged.
4. It will avoid mistakes and drawbacks of progressive tax system.

Limitations of Proportional Tax System:

The following are the demerits of proportional tax system:

1. Inequitable Distribution: A system of proportional taxation would not lead to an

equitable and just direction of the burden of taxation. This is because it falls more heavily on
the small incomes than on the high incomes.
2. Inadequate Resources: The system of proportional taxation means that the tax rates
for the rich and poor are the same. Hence, the government cannot obtain from the richer
sections of the society as much as they can give.
3. Inelastic in Nature: Proportional tax system is inelastic in nature, because the
government cannot raise the rate whenever it wants to raise the revenue. Proportional tax
system suffers from the defects of inequitable distribution of the tax burden, lack of elasticity
and inadequacy of funds for the increasing needs of the modern government. Hence, it is not
practically and universally accepted.
2. Progressive Tax System:

A progressive tax or graduated tax is a tax that is larger as a percentage of income for
those with larger incomes. It is usually applied in reference to income taxes, where people
with more income pay a higher percentage of it in taxes. The term progressive refers to the
way the rate progresses from low to high.
Each taxpayer faces two tax rates, his average income tax rate (the proportion of income
spent in income taxes) and his marginal rate (the portion of each additional Birr in income
that would be taken away in taxes). Progressivity of the income tax (higher rates for higher
segments of income) means that marginal tax rates are generally higher than average rates.
Thus, the progressive tax system can be defined as "a system in which rates of taxation
would increase with the increase in income i.e. higher the income, higher would be the rate of

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tax". The rates of taxation increases as the tax base increases. This can be explained
mathematically as follows.
The amount of tax payable is calculated by multiplying the tax base with tax rate as
shown below:
Tax Payable = Tax Base X Tax Rate
In this case, "the multiplier increases as the multiplicand (income) increases".
Economically, this can be explained as under:
Progressive Tax System

Employment income Income Tax (per month)

payable

Over Birr to Birr %

0 150 Exempt threshold

151 650 10

651 1400 15

1401 2350 20

2351 3550 25

3551 5000 30

Over 5000 **** 35

Table 2.2 - Progressive Taxation

From the above example, we can easily understand about the progressive tax system where
the rate of tax increases with the increase in tax base.

Merits of Progressive Tax System:

It is argued that if the utility gained from income exhibits diminishing marginal returns,
then for the tax burden to be vertically equitable, those with higher incomes must be taxed at
higher rate. The advantages of progressive tax system include the following:
1. Equality in Sacrifice: Under progressive tax system, the rate of taxation increases as
the tax base increases. That is, the burden of taxation is heavy upon the rich than on the poor.
People with higher income tend to have a higher percentage of that in disposable income, and
can thus afford a greater tax burden. Thus, this system secures equality in sacrifice by
ensuring the principle of ability to pay.

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2. Reducing the Inequalities of Income and Wealth: Progressive tax system serves as
a powerful instrument for reducing the inequalities of income and wealth.
3. Economy: In the progressive system, the cost of collection does not increase with the
increase in the rate of taxes. Hence, it is justified on the grounds of economy.
4. Elastic: Progressive tax system is elastic in nature to meet the increasing public
expenditure. The government can easily raise its revenue by increasing the rates of taxes. In
the case of progressive taxation, raising the rates for the higher status alone can raise more
revenue.
5. Stabilising the Economy: Progressive tax system may be helpful in preventing the
inflationary trends in the economy as it reduces the disposable income and purchasing power
of the people. Thus, the inflationary trends can be checked and the economic stability can be
achieved.
Limitations of Progressive Tax System:
The following are the demerits of progressive tax system:

1. Ideal Progression is Impossible: The main drawback of progressive taxation is that

it is difficult to frame an ideal graduated progression in tax rates. They are arbitrary
depending on the government‟s need for additional funds without taking into account the
burden of people with different incomes.
2. Progressive Taxation - a Graduated Robbery: Progressive taxation is an unjust
mode of taxation and a graduated robbery.
3. Disincentive to Work: It is argued that too progressive a tax rate acts as a
disincentive to work.
4. Discourages Savings and Investments: Very high rates of progressive taxes used to
discourage savings and investments. Since a major portion of the income is taken away by the
state by way of taxes, the incentives to produce more and earn more are lost.
5. Shifts the Total Economic Production of Society: The progressive tax system shifts
the total economic production of society away from capital investments (tools, machinery,
infrastructure, research etc.) and toward present consumption goods. This could happen
because high-income earners tend to pay for capital goods (through investment activities) and
low-income earners tend to purchase consumables. Since, progressive tax system
discourages savings and investments the shifting of economic production of society could
happen. Smithian theory says that spending more on consumption goods and less on capital
goods will slow the rise of the standard of living.

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3. Regressive Tax System:

In regressive tax system, the amount of tax is smaller as a percentage of income for
people with larger incomes. Many taxes other than the income tax tend to be regressive in
practice. For example, most sales taxes (since lower income people spend a larger portion of
their income), excise duty etc. are regressive in nature if they are levied on the goods of
common consumption.
Thus, regressive tax is a tax, which taxes a larger percentage of income from people
whose income is low. It places more burden on those with lower incomes.
It is the system in which the rate of tax declines with the increase in the income or value
of property. Larger the assess income or property, the lower the percentage that he pays as tax
in regressive taxation. “The tax rate decreases as the tax base increases".
The amount of tax payable is calculated by multiplying the Tax Base with Tax Rate.
Tax Payable = Tax Base X Tax Rate
The schedule of regressive tax rate is one in which the rates of taxation decreases as the tax
base increases.
The following table and diagram will explain the concept of regressive taxation.
Regressive Tax System
Income Rate of Tax (%) Tax To be
Birr Paid (Birr)
4000 20 800
6000 15 900
12000 12 1440
15000 10 1500

Table 2.3 - Regressive Taxation

As regressive taxes fall more heavily on the poor section of the community, than on the richer
section, it violates the principles of equity and social justice. That is, through regressive
taxation, principle of equity and social justice cannot be followed. In a welfare country like
Ethiopia, whose object is to establish a socialistic state without inequalities in the distribution
of income and wealth, regressive taxation has no place.
Even non-income taxes can regressive relative to income. The regressively of a particular tax
often depends on the propensity of the taxpayers to engage in the taxed activity relative to
their income. To determine whether a tax is regressive, the income-elasticity of the goods
being taxed as well as the income-substitution effect must be considered.
4. DEGRESSIVE TAX SYSTEM

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Under this system, the rate of tax is mildly progressive up to a certain limit and thereafter
it may be fixed at a flat rate.
The amount of tax payable is calculated by multiplying the Tax Base with the Tax Rate.
Tax Payable = Tax Base X Tax Rate

The concept of degressive taxation can be explained with the help of the following table.

Tax Base Tax Rate Tax Liability

Income (Birr) % (Birr)

4000 20 % 8, 000
6000 21 % 12, 600
12000 22 % 26, 400
15000 23 % 34, 500
20000 23 % 46, 000

TABLE-2.4 DEGRESSIVE TAXATION

2.6 IMPACT, SHIFTING AND INCIDENCE OF TAX:

The burden of a tax does not always lie on the person from whom it is collected. In many
cases, it is borne by the other people also. Thus, the person who initially pays the tax may not
be actually bearing its money burden as such. Hence, it is necessary to know who bears the
immediate burden of tax and who bears the ultimate burden of tax. According to the law, the
tax is collected from a particular individual or business unit, which has paid the tax in the first
instance and may transfer it to someone else. If such a shifting of tax takes place, the original
taxpayer has served only as a collecting agent.
In the process of taxing, three concepts are involved. They are as follows:
1. A tax may be imposed on some person.
2. It may be transferred by him to another person i.e. second person.
3. It may be ultimately borne by the second person.
Thus,
a) Impact of a tax is on the person who bears the money burden in the first instance.

b) Shifting of a tax refers to the process by which the money burden of a tax is transferred from
one person to another person.

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c) Incidence of a tax refers to the money burden of a tax, which is on the person who ultimately
bears it.

2.6.1. 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.

2.6.2. 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.
There are two major economic principles in the analysis of taxation. They are: (i) the
incidence of the tax, and (ii) its effects on economic efficiency (referred to as the excess
burden or welfare cost of the tax). These principles are applicable to all taxes.
Concepts of Tax Incidence:
The main issue in the economic analysis of any tax is the identification of the individual
or group of individuals on whom the burden of the tax rests. This is the incidence of the tax.
There are two concepts of tax incidence. They are as follows:
1. Legal Incidence: The individual or group of individuals who have the legal
responsibility for paying the tax to the government bears the legal incidence of the tax.

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2. Economic Incidence: The individual or group of individuals, whose real income,

welfare or utility is reduced by the tax, bears the economic incidence. The economic
incidence is independent of the legal incidence; that is, those who bear the legal incidence
may be different from those who bear the economic incidence. When the economic
incidence differs from the legal incidence, the burden of the tax is said to be "Shifted".
The effects of a tax on the allocation of resources and on the distribution of income
depend on the economic incidence, not the legal incidence.
2.6.3. 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.

2.6.4. Differences between Impact and Incidence:

1. The impact refers to the initial money burden of the tax. But the incidence refers to ultimate
money burden of tax.
2. The impact is felt by the person from whom tax is collected. But the incidence is felt by the
person who actually pays tax.
3. Impact can be shifted. But incidence cannot be shifted.
2.7 Tax Avoidance, Evasion and Delinquency

2.7.1 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”.

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Thus, tax avoidance means legal minimisation of tax burden by the taxpayers.

Examples for Tax Avoidance:

The following are the 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.

2.7.2. 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.

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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Human intelligence devices new methods of evasion and the Governments are constantly
trying to remove the loopholes in the tax laws.
Causes of Tax Evasion:
The following are the important causes for Tax evasion:

1. Multiplicity of Tax Laws: A number of laws enacted for the recovery of a variety of
taxes often leads to widespread tax evasion.
2. Complicated Tax Laws: Complicated tax laws are another reason for tax evasion.
The tax laws contain a number of exemptions, deductions, rebates, relief, surcharges and so
on. For example: the Income Tax Act has 28 chapters and 298 sections including sub-
sections. So, such complication in tax-laws is also a root-cause for the tax evasion.
3. High Rates of Taxation: High rates of taxes cause widespread tax evasion, because
the greater the risk undertaken for the purpose of tax evasion, the greater is the reward.
4. Inadequate Information as to Sources of Tax Revenue: Lack of adequate
information as to the sources of revenue also contributes to tax evasions. In Ethiopia, small
businessmen and farmers rarely maintain any accounts of their income.
5. Investment in Real Property: Investment in real property, both movable and
immovable, and concealment of its true ownership have also been a major cause for tax
evasion. All these facilitate the channelising of black money into profitable ways.
6. Ineffective Tax Enforcement: Lack of proper training and efficiency for the
authorities enforcing the tax laws is also a major cause for widespread tax evasion.
7. Deterioration of Moral Standards: There has been deterioration in standards of
moral behaviour of people since independence. The values, which formed the basis of
Society, are shown little respect. In this modern competitive world, the deterioration of moral
standards, among the people leads to falsification of accounts, mis-representation of facts and
fraudulent behaviour.

7.3. Remedies for Tax Evasion:

If steps are not taken to reduce tax evasion, it may cause irreparable harm. The
following are the remedies to prevent tax evasion.
1. Thorough Overhauling of Tax Laws: One of the main reasons for tax avoidance
and tax evasion is loose drafting of tax laws which contain several loop-holes and weak
points that enable the tax evaders to carry on the unlawful activities. Hence, it is necessary to
re-draft the tax laws thoroughly without any loopholes and weak points.

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2. Reduction in Tax Rates: The prevalence of high rates is the first and foremost reason
for this tax evasion. Hence, the rate of tax should be reduced to a reasonable level.
3. Replacement of Sales Tax & Excise Duties with VAT: As the crosschecking is
possible in the case of VAT, it is more effective. Hence, such tax can be introduced instead of
sales and excise duties.
4. Tax on Agricultural Income: Agricultural income is exempted from income tax and
for this reason it is used to convert the black money into white. In recent years, agricultural
farms and orchards, and vineyards have come to be acquired by industrialists; film stars etc.
because this enables their owners to whiten their black money. Tax evasions can be avoided
by taxing the agricultural income at normal rates.
5. Maintenance of Proper Accounts: Maintenance of proper accounts should be made
compulsory for persons whose business and professional income exceeds a prescribed limit.
In the Income Tax law, a provision to this effect has been introduced recently.
6. Introduction of Expenditure Tax: In Ethiopia, expenditure tax is levied in the form
of commodity taxation such as excise duties, VAT, Turnover tax etc. There is no personal
expenditure taxation. However, it is recognised by all that if a tax is based on personal
expenditure and if all effective machinery is devised to investigate and ascertain personal
expenditure, tax evasion can considerably be reduced.
7. Tightening of Tax Enforcement: This may be said to be the crucial remedy if the
penalties for violation of tax laws are strictly enforced, incidence of tax evasion could
automatically be reduced.

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