WSU CoBE AcFn dep`t Public Finance and Public Sector Accounting Module

WOLAITA SODO UIVERSITY

COLLEGE OF BUSINESS AND ECONOMICS

DEPARTMENT OF ACCOUNTING AND FINANCE

Module to undergraduate program

MODULE Name

Public Finance and Public Sector Accounting

COURSES INCLUDED
Accounting for Public Sector and Civil Society (AcFn3071)
and
Public Finance and Taxation (AcFn4091)

BY:

Mr. Mathios Weldemariam (MSc, Lecturer), Coordinator

Mr. Tesfaye Jifare (MSc, Assistant Professor)

WOLAITA SODO, ETHIOPIA

MARCH 2015E.C (2023)

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COURSE CONTENTS

Contents
Unit One ........................................................................................................................................................ 4
Basics of Public Finance ............................................................................................................................... 4
1.1. Definition of Public Finance ......................................................................................................... 4
1.2. Scope of Public Finance................................................................................................................ 5
1.2.1. Public Revenue: ........................................................................................................................ 5
1.2.2. Public Expenditure .................................................................................................................... 6
1.2.3. Public debt: ............................................................................................................................... 8
1.2.4. Financial Administration: ......................................................................................................... 9
1.2.5. Economic Stabilization ............................................................................................................. 9
1.3. The Role of Government in the Economy ....................................................................................... 10
1.4. Functions of Modern Government and Fiscal Operations: ......................................................... 12
1.5. Fiscal Federalism ........................................................................................................................ 13
1.6. Distinction between Private and Public Goods ........................................................................... 15
1.7. Public finance Vs Private Finance .............................................................................................. 18
Unit Two ..................................................................................................................................................... 22
Meaning and Characteristics of Taxation ................................................................................................... 22
2.1. Meaning of Taxation ........................................................................................................................ 22
2.2. Characteristics of Taxation .............................................................................................................. 23
2.3. Objectives of Taxation ..................................................................................................................... 24
2.4. Principles of Taxation ...................................................................................................................... 26
2.5. Tax Classifications ........................................................................................................................... 31
2.6. Tax Rate Structures .......................................................................................................................... 38
2.7. Impact, Shifting and Incidence of Taxation ..................................................................................... 40
2.8. Tax Evasion, Avoidance and Delinquency ...................................................................................... 41
Unit Three: .................................................................................................................................................. 44
Public Finance in Ethiopia .......................................................................................................................... 44
Introduction ............................................................................................................................................. 44
3.1. Features of Ethiopian Federal Finance........................................................................................ 45
3.2. Intergovernmental Expenditure Assignment............................................................................... 46
3.3. Intergovernmental Revenue Assignment ......................................................................................... 49
3.4. Intergovernmental Transfer......................................................................................................... 52

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3.5. Borrowing ................................................................................................................................... 52

3.6. Trends of Ethiopian Public Revenues, Expenditures, Grants, Deficits, and Debts ..................... 58
3.7. Budget and Its Process in Ethiopia ............................................................................................. 66
3.7.1. The Budgetary Process at the Federal Level ................................................................................. 68
3.7.2. The Budgetary Process at the Regional Level .............................................................................. 73
Unit Four ..................................................................................................................................................... 75
Ethiopian Tax System ................................................................................................................................. 75
4.1. Structure of Ethiopian Tax System and Administration ............................................................. 75
4.2. Income Taxes and Their Schedule .............................................................................................. 77
4.2.1. Income Tax System................................................................................................................. 77
4.2.2. Schedules of Income ............................................................................................................... 78
4.2.2.1. Schedule ‘A’ Income from Employment ............................................................................ 78
4.2.2.2. Schedule ‘B’ Income from Rental of Buildings .................................................................. 86
4.2.2.3. Schedule ‘C’ Income from Business ................................................................................... 89
4.2.2.4. Schedule ‘D’ –Other Income .............................................................................................. 93
4.2.2.5. Schedule ‘E’ – Exempt Income .......................................................................................... 95
4.3. Consumption Taxes .................................................................................................................... 96
4.3.1. Value-Added Tax .................................................................................................................... 96
4.3.2. Turnover Tax ........................................................................................................................ 104
4.3.3. Excise Tax ............................................................................................................................. 108
4.4. Stamp Duties ............................................................................................................................. 113
4.5. Foreign Trade Taxes ................................................................................................................. 117
Chapter Five .............................................................................................................................................. 119
Investment Incentives in Ethiopia ............................................................................................................. 119
5.1. Introduction .................................................................................................................................... 119
5.2. Types of incentives in Ethiopia ................................................................................................. 120
References ................................................................................................................................................. 123

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Unit One

Basics of Public Finance

Chapter Objectives
After the completion of this chapter, the students will be able to:
 Define public finance
 Understand the scope of public finance
 Distinguish public finance from private finance
 Discuss the role of government to the economy and society
 Realize the role of fiscal policy

1.1. Definition of Public Finance

Public finance is the study of income and the expenditure of the government. Hence, it can be
defined as the science that deals with the nature and principles of the income and expenditure of
the government. The term ‘public’ means the government that is central, state and local
authorities. Rising of necessary funds for incurring expenditure constitutes the subject matter of
public finance. It also deals with the problems of adjustments of income and expenditure of the
government. It is also known as fiscal operations of the treasury. Thus, fiscal operations and
fiscal policies are integral parts of public finance.
The need to study public finance arises as governments provide public goods including
government financed items and services such as roads, military forces, lighthouses, and
streetlights. Private citizens would not voluntarily pay for these services, and therefore
businesses have no incentive to produce them. It also enables governments to correct or offset
undesirable side effects of a market economy. These side effects are called spillovers or
externalities. For example, households and industries may generate pollution and release it into
the environment without considering the adverse effect pollution has on others. If it costs less to
pollute than not to, people and businesses have a financial incentive to continue polluting.
Pollution is a spillover because it affects people who are not responsible for it. To correct a
spillover, governments can encourage or restrict certain activities. For example, governments can
sponsor recycling programs to encourage less pollution, pass laws that restrict pollution, or
impose charges or taxes on activities that cause pollution.

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Public finance provides government programs that moderate the incomes of the wealthy and the
poor. These programs include social security, welfare, and other social programs. For example,
some elderly people or people with disabilities require financial assistance because they cannot
work. Governments redistribute income by collecting taxes from their wealthier citizens to
provide resources for their needy ones. The taxes fund programs that help support people with
low incomes.
Ethiopia has also adopted the policy of welfare state for bringing about social and economic
justice. Public finance policy of the country is drawn up in tune with the constitutional
commitment of welfare state. Under the welfare state, government performs important functions
and takes up certain public or collective welfare measures which private sector cannot provide.

1.2. 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 classified under five broad categories: public revenue, public expenditure,
public debt, financial administration and economic stabilization. We shall now explain them
briefly.

1.2.1. 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: 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
objectives of taxation are to reduce inequalities of income and wealth; to provide incentives

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for capital formation in the private sector, and to restrain consumption so as to keep in check
domestic inflationary pressures.

From the above discussion we can conclude that the elements of taxation are as follows:

i. It is a compulsory contribution
ii. Government only imposes taxes
iii. In payment of tax an element of sacrifice is involved
iv. Taxation is aimed at welfare of the community
v. The benefit may not be proportional to tax paid
vi. Tax is a legal collection.

The various types of taxes can be listed under three heads. First type can be titled taxes on
income and expenditure which include income tax, corporate tax etc. The second is taxes on
property and capital transactions and includes estate duty, tax on wealth, gift tax etc. The
third head, called 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. To sum up, non-tax revenue consists of: i) Interest receipts ii) Dividends and profits
iii) Fiscal services and others.

1.2.2. Public Expenditure

Recently, there has been both quantitative and qualitative change in government’s
expenditure. This category deals with the principles of public expenditure and its effect on
the economy etc.

Government of a country has to use its expenditure and revenue programs to produce
desirable effects on national income, production, and employment. The role of public
expenditure in the determination and distribution of national income was emphasized by
Keynes.

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The term “Public Expenditure” is used to designate the expenditure of government-central,

state and local bodies. It differs from private expenditure in that governments need not pay
for themselves or yield a pecuniary profit. Public expenditure plays the dual role of
administration and economic achievement of a nation. Wise spending is essential for stability
of government and proper earnings are a prerequisite for wise spending. Hence planned
expenditure and accurate foresight of earnings are the important aspects of sound government
finance.

Public expenditure is done under two broad heads viz., developmental expenditure and non-
developmental expenditure. The former includes social and community services, economic
services, and grants in aid. The latter mainly consists of interest payments, administrative
services, and defense expenses. Expenditure can also be classified into revenue and capital
expenditure.

Plan and Non-Plan Expenditure:

Expenditure is classified under the following heads:

a. Non-plan Expenditure: Non-plan expenditure of central government is divided into

revenue and capital expenditure. Under non-plan revenue expenditure, we include interest
payment, defense expenditure, major subsidies, interest and other subsidies, debt relief to
farmers, postal deficit, police, pensions, other general services, social services, grants to
states and union territories. Non-plan capital expenses include defense expenses, loan to
PSUs, loans to states and union territories, foreign governments etc.

b. Plan expenditure: The second major expenditure of central government is plan

expenditure. This is to finance the following

i) Central plans such as agriculture, rural development, irrigation and flood control, energy,
industry, and minerals, communication service and technology, environment, social service
and others.

ii) Central assistance for plans of the states and union territories.

Expenditure can also be categorized into revenue and capital expenditure. Revenue
expenditure relates to those, which do not create any addition to assets, and covers activities

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of government departments’ services, subsidiaries and interest charges. Capital expenditure

involves that expenditure, which results in creation of assets. Finance ministry is responsible
for plan expenditure. This includes grants to the state.

Hence the expenditures are classified as capital and revenue. Alternatively, these expenses
can be re-classified into plan and non-plan expenditure.

Social expenditure:

Government takes the responsibility of protecting the interests of the community as a whole
and promotes the implementation of welfare programs. Government spends huge amounts for
providing benefits such as old age pensions, accident benefits, free education and medical
services. This expenditure on human resources comes under social expenditure.

Governments are moving towards the objective of achieving maximum social welfare.
Expenditure on education, public health, welfare schemes for workers, relief and
rehabilitation of displaced persons and such other services may not yield direct benefit in the
short run. But in the long run they contribute to improvement in the quality at human
resources.

1.2.3. Public debt:

This category deals with the causes, methods and problems of public borrowings and its
management. This includes both internal debt and external debt.

a. Internal 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. Debt, though involves
withdrawal of resources by curtailing private consumption, has certain advantages. Transfer of
funds from public to government is voluntary. Loans do not reduce the wealth of the lenders.
Debt raised for productive purpose will not be a burden on the economy.

There are many objectives of creation of public debt. Debt may be raised to meet the normal
current expenditure, exigencies like war, finance productive government enterprise, finance
public social welfare and economic development.

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Capital receipts mainly consist of market borrowings, small savings and external loans,
disinvestments of PSUs and recoveries of loans.

b. External Debt:

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:

i) Financial aid through grants and loans ii) Commodity aid iii) Technical assistance

External debt is an immediate source of funds for development. However, such debt has
following drawbacks. i) Political subordination ii) Other obligation iii) Excess supply of goods
and services in debtor country, however, such external inflows help to achieve faster growth.

1.2.4. Financial Administration:

It deals with the methods of budget preparation, various types of Budgets (war Finance,
Development Finance etc.). Thus, financial administration refers to the mechanism by which the
financial functions are carried on. In other words, financial administration studies the organizing
and disbursing of the finances of the State. Preparation of financial budget (Annual Financial
Statements which incorporates all the annual statements of receipts and expenditures of the
government.)

This category includes the preparation of financial budget, the control and administrations of the
budget and relevant problems including auditing. In other words, all financial activities involve
issues of financial including public budget, its passing, implementation, auditing and other
similar matters. The term budget includes ‘Annual Financial Statements’ which incorporates all
the annual statements of receipts and expenditures of the government.

1.2.5. Economic Stabilization

Generally, under developed countries have the following features.

1. Predominantly agriculture based economy 2. Low capital formation 3. Inferior technical

knowhow 4. Low per capita income 5. Over population and poor health and educational
facilities.

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6. High propensity to consume leading to low capital formation.This category studies the use of
financial policies of the government from the viewpoint of economic development. Accordingly,
it analyses the use of public finance to bring the economic stability, growth and distributive
justice in the country. These aspects of the economic policy of the government have assumed
such a great significance that they are often given a separate treatment in the discussion of public
finance theories.

1.3. The Role of Government in the Economy

The voluntary exchanges that occur in the market economy comprise the private sector of the
economy. The public sector of the economy consists of government activity and has a different
economic character. Typically, government activity is financed by mandatory taxes. After
citizens pay their taxes, they can choose to consume some public sector output, such as highways
and parks, often without additional charges. Citizens receive some output, such as national
defense, whether they like it or not. Furthermore, they are obligated to live under the
government’s rules or face the penalties imposed by the police and court systems.

 Role of Fiscal Policy in the Economic Development:

1. In under developed and developing countries development is the main concern. The primary
task of fiscal policy in an under developed and developing countries is to allocate more
resources for investment and to restrain consumption.
2. The fiscal policy should reduce the economic inequalities of income and wealth. This can be
achieved by taxation and public distribution measures. Poverty and unity cannot co-exist.
Therefore, fiscal policy should attempt economic development of the socially unfortunate to
bring about national unity. Private section is not interested in investing in social and
economic overheads. Investments in social and economic overheads like education, medical
facilities, infrastructure, dams etc. are very essential to accelerate the rate of economic
growth.
3. In under developed and developing countries the requirement of growth demands that fiscal
policy must be used progressively for raising the level of investments and savings rather than
keeping the consumption level. In under developed and developing countries fiscal policy
must be used as an instrument of resource mobilization. To attain growth with stability the
goal of fiscal policy should be promotion of highest possible rate of capital formation and

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should reduce the actual and potential consumption. Further fiscal policy should encourage
private investment and attract foreign funds for development projects.
4. The existing pattern of investment may differ from the optimum pattern of investment. Thus,
it becomes a responsibility of government to undertake investments in such a way that it is
most beneficial for the people of the country.
5. Fiscal policy should control inflation within tolerable levels since inflation mostly affects the
poor.

In under developed and developing countries there exist regional imbalances in addition to social
inequalities. Fiscal policy should aim at reducing both regional and social imbalances by
directing investments to less developed regions. Their marginal propensity to consume is very
high. Therefore, a small increment in investment can bring manifold employment due to
multiplier effect.

Fiscal policy should directly available resources for providing basic physical, infrastructural
needs like irrigation, roads, basic industries, railways, ports, telecommunications etc. Fiscal
policy should assign high priority to the creation of overhead capital. Spending of the
government should also take care of education and health of the community. Returns on these
investments are long-term and private sector cannot provide above investments.

Therefore, government of a country through its fiscal policy can increase rate of investment and
alter the pattern of investment. It follows that the main role of fiscal policy in an under developed
and developing countries is to expand productive capacity by raising the level of real capital
including skills as well as plants and equipment and to check the demand generating effect of
expanding investment. In developed countries, its role is to expand both production capacity as
well as the level of aggregate monetary demand in relation to their economic growth. In under
developed countries the better approach is to transfer resources to capital formation without
inflation.

Fiscal policy through its different measures such as taxation policy, budgetary policy, public debt
policy and a co-ordination with monetary policy can direct the economic destiny of a nation.
Fiscal policy can be used to mitigate the effects of trade cycles such as inflation and depression.

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1.4. Functions of Modern Government and Fiscal Operations:

It was only in the 20th century and particularly after Keynes demonstrated the necessity of state
interference for stabilizing an economy and to bring about full employment that the full
importance of fiscal operations of tax, public expenditure and public debt policy was
appreciated. The social economic consequences of fiscal operations are quite elaborately
explained in detail in later chapters- effects of taxation, effects of public expenditure, effects of
public debt and public debt management and fiscal policy and economic development. We
should know the role of the government to enable us to appreciate the importance of government
sector. Government of a modern state generally undertakes the following functions:

a. Allocation Function: The government operations basically involve the efficient provision of
government funds in maximizing the welfare of the community. The government taxes the
public and uses the amount in providing certain facilities and services considered essential by
the by the people and the community. These facilities are such that they could not be
provided by the people themselves such as defense, or they could be provided but only at a
high cost such as education and Medicare. Fiscal operations of taxation and public
expenditure have the effect of transferring resources form the public which would have been
used for consuming private goods to produce public goods which would satisfy collective
wants. The objective of fiscal operations is to provide for the proper allocation of resources
between private and public goods so as to maximize social welfare.
b. Distribution function: In a free enterprise economy, distribution of income and wealth is
unequal and many times it is grossly unequal resulting in exploitation of the lower income
gropes. Inequality of income and concentration of economic power in the hands of a few are
responsible for distorting production in favor of the rich and for reducing the social welfare
of the community. Fiscal operations have been used to reduce the incomes and wealth of the
rich (through progressive taxation) and using the money collected to raise the income and
standard of living of the lower income group (through public expenditure}. The use of fiscal
policy to reduce inequality of incomes and wealth has been quite common in many countries.
c. Stabilization Function: Modern economies are subject to fluctuations, viz., business boom
and inflations on one side and business recessions and depressions on the other. Such
fluctuations are not in the interest of the country. Fiscal operations have been used to
moderate these fluctuations and if possible to eliminate them altogether. For instance,

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business booms and inflations are sought to be controlled through heavier taxation while
business recession is sought to be checked through public expenditure.

Functions of modern governments are broadening due to socio-political reasons. Therefore, to

discharge these increasing functions, the government has to increase its expenditure. To meet out
the enormous amount of expenditure it has to mobilize funds with the help of public finance
policy. Hence public finance has developed into an important branch of economics

1.5. Fiscal Federalism

An original definition of fiscal federalism states that "fiscal federalism" concerns the division of
public sector functions and finances among different tiers of government. In undertaking this
division, economics emphasizes the need to focus on the necessity for improving the
performance of the public sector and the provision of their services by ensuring a proper
alignment of responsibilities and fiscal instruments. While economic analysis, as encapsulated in
the theory of fiscal federalism, seeks to guide this division by focusing on efficiency and welfare
maximization in determining optimal jurisdictional authority, it needs to be recognized that the
construction of optimal jurisdictional authority in practice goes beyond purely economic
considerations. Political considerations, as well as historical events and exigencies, have in
practice, played major roles in shaping the inter-governmental fiscal relations in most
federations.

Even in non-federal states, there has been a growing movement towards greater fiscal
decentralization in recent years. Some analysts have attributed this to globalization and
deepening democratization the world over on the one hand and increasing incomes on the other.
Other specific reasons for increasing demand for decentralization are:

• Central governments increasingly are finding that it is impossible for them to meet all of the
competing needs of their various constituencies, and are attempting to build local capacity by
delegating responsibilities downward to their regional governments.

• Central governments are looking to local and regional governments to assist them on national
economic development strategies.

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Regional and local political leaders are demanding more autonomy and want the taxation
powers that go along with their expenditure responsibility.

Fiscal policy is also called as budgetary policy. In broad terms, fiscal policy refers to that
segment of national economic policy, which is primarily concerned with the receipts, and
expenditures of these receipts and expenditures. It follows that fiscal policy relate to those
activities of the state that are concerned with raising financial resources and spending them.
Resources are obtained through taxation and borrowing both within the country and from abroad.
Spending is done mainly on defense development and administration. Financial accounts of the
income and expenditure position are shown in budgetary statement. Budget can act as an
important tool of economic policy. The state by its policy of taxation-regulated expenditure can
influence the economic activities and development.

Private outlay is insufficient to produce maximum national income. An increase in state outlay
beyond its revenue can increase national income. Keynes emphasized the effects of government
revenue and expenditure upon the economy and argued that they should be used deliberately and
consciously to secure economic stabilization. This underscores the importance of budget in
economic development.

Fiscal policy relates to the government’s decision making with respect to the following:
1. Taxation
2. Government spending
3. Government borrowing and
4. Management of government debt.
The policy relates to government decisions, which influence the degree and way funds are
withdrawn from private economy. Basically, fiscal policy in these different facets deal with the
flow of funds out of the private spending and saving stream into the hands of government and the
recycle funds from government into the private economy.

It is thus obvious that fiscal policy deals quite directly with matters, which immediately
influence consumption and investment expenditure. Therefore, it influences the income, output
and employment in the economy. Fiscal policy is primarily concerned with the aggregate effects
of public expenditure and taxation on income output and employment. In developed economies,

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the propensity to consume leads to stability. Excess saving by the community leads to lowering
of demand for goods and services resulting in sub optimal employment level. Fiscal policy
should balance the economy by sustaining the consumption in the economy.

In under developed and developing countries main objectives are rapid economic development
and an equitable distribution of the income. Fiscal policy can be an important instrument for
attaining these objectives. Fiscal policy influences the economy by the amount of public income
that is received and on the other by the amount and direction of public expenditure. The
important fiscal means by which resources can be raised for the public exchequer are taxation,
borrowing from public and credit creation. These means must be used in harmonious
combination so as to produce the best overall effects on the economic life of the people in terms
of economic progress and social welfare.

1.6. Distinction between Private and Public Goods

The governments of advanced countries are committed to stability and full employment. In case
of under developed countries the government aims at accelerated economic development.
Government sector can play a decisive role in shaping and charting the path of any economy.
Depending on the level of development of each country the roles of government sector differ.
However, in all cases the aim is to attain full employment and economic development through
the development of agriculture, industry and service sector. Today the communication sector has
also been included in these vital sectors of the economy.

The Private finance deals with the wants and the satisfaction of households and firms. But the
public finance deals with the collective wants and their satisfaction. The objective of both private
and public finance is similar. Private finance aims at maximizing social welfare or social benefit
by efficient use of public goods. Distinction between private and public goods is important in the
study of public finance.

i. Private Goods:

Private goods refer to all those goods and services, which are consumed by people to satisfy
their personal and private wants or needs. They relate to articles of food, clothing, shelter,
recreation, transportation, communication etc. These goods are priced in the market on the basis
of their cost of production on the one side and the nature of demand on the other. All those who
want them and are willing to pay the market price will buy them. Those who do not want them or

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who are not in a position to pay for them will be excluded from the consumption of these goods.
In other words, there is no compulsion that everyone will have to buy them. Thus distribution of
these goods is based on effective demand and market price. As a result, only those who do
demand the private goods will pay for their cost of production on a voluntary basis. Thus, private
goods are divisible in the sense that price mechanism divides people in to two groups, viz., those
who want to consume them and those do not; and private goods are subject to the principle of
exclusion; in the sense that price mechanism excludes the group of people who are not willing to
consume a particular good.

But price mechanism or market mechanism may fail whenever private goods are associated with
the concept of externalities. Now, externalities refer to favorable and unfavorable effects which
are associated with the production of those goods. The setting up of a factory in a backward
region will help to open up the former and help to develop it; this is an example of an externality
in the form of an economic gain. On the other hand, an atmospheric and water pollution of a
chemical and fertilizer factory in an area is an example of unfavorable economic effect. The
externalities are also referred to as spillover effects, neighborhood effects or third party effects.

The economic gain or economic loss associated with externalities cannot always be priced in the
market and cannot be apportioned to particular parties. For example, it is not possible to find out
exactly how much is the benefit of a new factory set up in a backward region or the exact extent
of economic loss due to ash and smoke nuisance of a thermal power station using coal. These are
examples of non- market external effects. In case, external effects, favorable or unfavorable, can
precisely be calculated, in terms of money, and can be made part of the cost of production; then
they can be passed on to those who get those external efforts – this will be the case of market
external efforts.

ii. Public Goods

Collective wants are those which are demanded by all members of the community in equal or
more or less equal measures. Defense, education, public health, infrastructure facilities like
power, transportation and communication, etc., are examples of collective wants. Goods and
services produced to satisfy collective wants are known as public goods. These goods are
produced and supplied by the society to meet its collective wants for increasing social welfare.
These goods are supplied by the country to all its citizens. But the degree of benefit a person

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derives will depend upon the use he can put it to. For example, medical and educational
facilities are made available for all the people of Ethiopia.

It is important to recognize two features of public goods. First, they cannot be divided and their
benefits cannot be shared between the people on the basis of each man’s requirements. In other
words, unlike private goods, public goods are not divisible but have to be collectively consumed.
If public goods are made available to meet collective wants, the question is: who will pay for
them or in what proportion will they bear the cost of production of these goods and services.

Secondly the principle of exclusion easily associated with private goods is not applicable in the
case of public goods since they are not consumed distributive. Hence these goods will not be
produced by the private sector. On the other hand, they will have to be produced and supplied by
the public authorities to meet collective wants. The price mechanism does not apply and these
goods cannot carry a price tag. As everyone is a beneficiary - directly or indirectly of the public
goods, everyone is asked by the public sector authorities to pay towards the cost of production of
the public goods. No one can refuse to pay for the supply of public goods on the ground that they
are direct beneficiaries. For example, an abiding citizen cannot refuse to pay towards the
maintenance of police or a childless cannot refuse to pay towards the expenditure on education
on the plea they do not benefit by them.

Actually, everybody wants to enjoy the benefits of public goods be they defense goods, law and
order, education etc., but no one wants to pay for them. At the same time, the consumers do not
have any system of priority in the case of public goods.

Again the taste, preferences etc., of consumers are not relevant and the public authorities do not
attach any importance to the consumers while producing and supplying public goods. As the
people too may not show any interest or any inclination in the production of these goods, the
government has the sole responsibility to decide about how much of these goods should be
produced, the method of production and the technique of distribution.

Since the public goods are supplied to all the people irrespective of their ability and willingness
to pay for them, the pricing system is useless and therefore, a method of compulsory payment
will have to be designed to finance their cost of production.

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Merit Wants: Certain types of collective wants such as educational facilities have been called as
merit wants since they command overwhelming importance in the attainment of social welfare.
Provision of public goods meant to satisfy such wants will help the economy to achieve a high
level of efficiency and welfare. If education is left to the private sector and accordingly
educational facilities are supplied by the private sector on the basics of cost of production, the
educational facilities will cost so much that many people in the lower income brackets will not
be able to get them. Many an intelligent but poor student will be denied educational facilities.
This will reduce economic efficiency and social welfare of the community. In the same way, if
hospital facilities are provided by the private sector units, they will be so expensive that only the
rich will be able to make use of them and vast majority of people belonging to middle and lower
income groups will be denied these facilities. It is for this reason that the state should either
supply these goods to the community or at least supplement private effort directly or indirectly-
directly by government schools and colleges or indirectly by subsidizing education to make it
within the reach of everybody.

The important difference between the satisfactions of merit wants and of social wants is that the
former calls for interference with consumer preferences. Besides, the provision of merit wants
will confer immediate benefits on those groups of people who are in immediate need of them but
the community benefits in general as the society becomes more educated and healthier. It is for
this reason that merit wants must have substantial element of social wants.

The above analysis of private costs and social costs is based on the objective of efficient
allocation of resources of an economy between private and public goods with a view to
maximize social welfare. The use of price mechanism to determine efficiency in the allocation of
resources assumes the existence of free market. This type of analysis may be suitable to
predominantly capitalist economy such as U.S.A. but is not applicable to a fully collectivist or
partly socialist economies in which market mechanism does not either exist or is not allowed
play a free role.

1.7. Public finance Vs Private Finance

There are both similarities and differences between public finance and private finance. Let us
discuss the similarities first.

a. Similarities between Public Finance and Private Finance:

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i. Satisfaction of Human Wants: Individual is concerned with the personal wants, while
the Government is concerned with the social wants. Thus, both the private and public
finance have the same objective, viz, the satisfaction of human wants.
ii. Balancing of Income and Expenditure: Both individual and Government have incomes
and expenditures and trying to balance each other.
iii. Maximum Satisfaction: Both private and public finance aim at maximum satisfaction.
iv. Borrowing a Common Feature: As and when the current incomes becomes insufficient
to meet the current expenditure, the individuals and Governments rely upon borrowings.
Both of them are having loan repayment plans.
v. Economic Choice a Common Problem: Both the individual and Government face the
problem of economic choice. That is their sources of revenue are limited, comparing with
their expenditure. Hence they have to satisfy the unlimited ends with limited means.
b. Dissimilarities between Public Finance and Private Finance

Even though the private and public finances look alike, there are certain fundamental differences
between them. They are:

i. Adjustment of Income and Expenditure: In private finance, the individual first

considers his income and then decides about his expenditure. But the case of public
finance, the government first estimates the volume of expenditure and then tries to find
out the methods of raisins the necessary income That is the private finance tries to adjust
its income to expenditure, whereas the public finance tries to meet the expenditure by
raising income.
ii. Nature of Benefit: The private finance aims at individual benefit i.e. the benefit of
individual household. But the public finance aims at collective benefit, i.e. the benefit of
the nation as a whole.
iii. Postponement of Expenditure: In private finance, the individual can postpone or even
avoid certain expenditure, as he likes. But in the case of public finance, the Government
cannot avoid certain commitments kike social welfare measures and thus cannot postpone
the certain expenses like relief measures, defense, etc.
iv. Allocation of Resources: In private finance the individual can allocate or distribute his
income to various expenditure in such a way to get the maximum satisfaction. But it is

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not possible in the case of public finance; Government cannot aim at maximum
satisfaction on the expenditures made.’
v. Motive of expenditure: In the case of private finance, the individual expects return in
benefit from the expenditure made. But the government cannot expect return in benefit
from various expenditures made. That is profit or benefit is the motive of private finance
whereas the social welfareand economic development is the motive of public finance.
vi. Influence on expenditure: The expenditure pattern of private finance is influenced by
various factors such as customs, habits culture religion, business conditions etc. But the
pattern of expenditure of public finance is influenced and controlled by the economic
policy of the Government.
vii. Nature of Perspective: In private finance, the individual strives for immediate and quick
return. Since his life span is definite and limited he/she gives importance to the present or
current needs and allots only a little portion of income for the future. But, the
Government is a permanent organization and is the caretaker of the present and the future
as well. Thus, the Government allots a considerable amount of its income for the
promotion of future interests. That is private finance has a short-term perspective whereas
the public finance has a long term perspective.
viii. Nature of Budget: In private finance individuals prefer surplus budget as virtue and a
deficit budget is undesirable to them. But the Government does not prefer a surplus
budget. If the Government bring surplus budget, it will create negative opinion on the
Government. This is because surplus budget is the result of high level of taxation or low
level of public expenditure both of which may affect the Government adversely.
ix. Nature of resources: In private finance the individuals have limited resources. They
cannot raise the income, as they like. Thy do not have the power to issue paper
currencies.But, in the case of public finance the Government has enormous kinds of
resources. Besides the administrative and commercial revenues, the Government can get
grants-in-aid and borrow from other countries. The government can print currency notes
to increase its revenue.
x. Coercion: Under private finance the individuals and business units cannot use force to
get their income.But, in public finance the governments can use force in the form of
imposing taxes to get income i.e. taxes are compulsory in nature. It is an obligation on the

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part of the tax payer. No one can refuse to pay taxes if he is liable to pay them. Besides
the above the Government can undertake any of the existing private business by way of
nationalization, which is not possible in the hands of individuals.
xi. Publicity: Individuals do not like to disclose their financial transactions to others. They
want to keep them secret. But, the Government gives the greatest publicity to its budget
proposals and the allocation of resources to different heads. It is widely discussed.
Publicity strengthens the confidence of the people in the Government.
xii. Audit: In the case of private finance, auditing of the financial transactions of the
individuals is not always necessary. But the accounts of the public authorities are subject
to audit and inspection.

Discussion questions
1. Define public finance clearly.
2. Discuss how public finance is different from public finance.
3. Explain the roles of the government in the economy.
4. Elucidate the scope of public finance

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Unit Two

Meaning and Characteristics of Taxation

Chapter Objectives
After the completion of this chapter, the students will be able to:
 Familiar with the meanings and objectives of taxation
 Understand the principles of taxation
 Classify taxes indifferent ways
 Discuss the tax structures
 Know shifting and incidence of taxation
 Differentiate tax evasion, avoidance and delinquency

2.1. Meaning of Taxation

A tax is “a compulsory charge imposed by the Government without any expectation of direct
return in benefit ".

In other words, a tax is a compulsory payment or contribution by the people to the Government
for which there is no direct return to the taxpayers. Tax imposes a personal obligation on the
people to pay the tax if they are liable to pay it. The general public should be taxed according to
their ability to pay, and the people in the same financial position should be taxed in the same way
without any discrimination.

Taxes are compulsory payments associated with certain activities. Revenues collected through
taxation are used to purchase the inputs necessary to produce government-supplied goods and
services or to redistribute purchasing power among citizens. Taxation reallocates resources from
private to government use in two distinct steps. First, the ability of individuals to command
resources is reduced, because taxation reduces income for spending on market goods and
services. Second, the revenues collected by government then are used to bid for resources
necessary to provide government goods and services and to provide income support payments to
recipients of government transfers such as Social Security pensions.

Thus, tax can be defined as, "an involuntary fee or more precisely, "unrequited payment", paid
by individuals or businesses to a government (central or local)". Taxes may be paid in cash or
kind (although payments in kind may not always be allowed or classified as taxes in all systems).
The means of taxation, and the uses to which the funds raised through taxation should be put, are

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a matter of hot dispute in politics and economics, so discussions of taxation are frequently
tendentious.

The tax base is the item or economic activity on which the tax is levied. The most commonly
used tax bases can be grouped into three broad categories: income, consumption, and wealth.
These are economic bases; their values depend on decisions made by individuals. For example,
individuals make daily choices that affect their income. They also can control the allocation of
their income between saving and consumption. Because most individuals must save to
accumulate wealth, their decisions regarding consumption also affect their wealth.

A good tax system should not affect the ability and willingness of the people to work, save and
invest. If not, it will affect the development of trade and industry and the economy as a whole.
Thus, a sound tax system should contribute in the economic development of a country.

Hence, "taxation should not be like killing the goose that lays golden eggs".

2.2. Characteristics of Taxation

A tax has the following characteristics:

a. 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.
b. Benefit is not the Basic Condition: For the payment of tax, there is no direct return or
quidproquo 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.
c. 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.
d. 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.

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e. Legal Collection: Tax is the legal collection. It can be levied only by the Government both
Central and State.
f. 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.
g. 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.
h. No Discrimination: Tax is levied on all people without any discrimination of caste, creed
etc. but according to their ability to pay.
i. 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.

Components of Taxes

 Each tax must have a base upon which it is levied.

 Each tax must have a tax filling unit that is responsible for paying the tax.
 Taxes must have a rate that is applied to the base to determine the amount owing.
 Unless they are imposed on individual transactions, taxes must have a period during which
the base is measured and the tax collected.
 Each tax must have administrative arrangements for the collection of tax.

2.3. Objectives of Taxation

Taxes are compulsory payments to the government by the taxpayers. At the beginning,
government imposed taxes for three basic purposes viz., to cover the cost of administration,
maintaining law and order in the country and for defense.

But, in modern days, there has been a sea change in the government’s expenditure pattern.
Today, the government is in the position to restore social justice in the society by way of
providing various social services like education, employment, pension, public health, housing,
sanitation and the development of weaker sections of the society. Besides the above, the
government announces heavy subsidies for agriculture and industry. Thus, government requires
more amount of revenue than before. Non-tax revenues are not sufficient to meet the entire
expenditures. Hence, government imposes taxes of various types.

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Tax objectives are goals that are to be achieved through the taxation system. Tax objectives are
intimately connected with overall economic and non-economic policies of the government, fiscal
policy, institutional and other circumstances faced by the economy. As a result, the objectives of
a tax system in a developed country tend to differ significantly from those in an underdeveloped
country. The following are generally considered objectives of taxation.

i. To raise revenue for government expenditures: Taxation is fundamentally a system of

raising money to finance government expenditures. Governments use tax revenues to build
dams and roads, to operate schools and hospitals, to provide food for the poor and medical
care to the elderly, and for other purposes.
ii. Removal of Inequalities in Income and Wealth: The welfare state aims at the removal of
inequalities in income and wealth. By framing suitable tax policy, this end can be achieved.
It is stressed in the Canon of Equality. In Ethiopia, the progressive taxation on income is the
suitable examples in this regard.
iii. Ensuring Economic Stability: Taxation affects the general level of consumption and
production. Hence, it can be used as an effective tool for achieving economic stability. That
is, by means of taxation the effects of trade cycle i.e. inflation and deflation can be
controlled. During the period of boom or inflation, the excess purchasing power in the hands
of people leads to rise in the price level. Raising the existing tax rates or imposing additional
taxes can remove such excess purchasing power. Then the abnormal demand will be
reduced and the economic stability can be achieved. At the same time, by providing grants,
tax exemptions and concessions, production can be encouraged thereby inflation is
controlled.
Likewise, during the period of depression or deflation, the role of tax policy in the economy
is important. Reduction in the existing tax rates and removal of certain taxes, consumption
can be induced which in turn results in increasing demand. This encourages business
activities, and the economic growth can be achieved. Thus, through properly devised tax
system, the economic stability can be achieved by controlling the effects of trade cycle.
iv. Reduction in Regional Imbalances: It is normal that certain parts of the country are well
developed, whereas some other parts or states are in backward conditions. To remove these
regional imbalances, the Government can use tax measures. By way of announcing various

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tax exemptions and concessions to that particular backward regions or states, the economic
activities in those areas can be induced and accelerated.
v. Capital Accumulation: Tax concessions or rebates given for savings or investment in
provident funds, life insurance, unit trusts, housing banks, post offices banks, investment in
shares and debentures of certain companies etc. lead to large amount of capital accumulation
which is essential for the promotion of industrial development.
vi. Creation of Employment Opportunities: More employment opportunities can be created
by giving tax concessions or exemptions to small entrepreneurs and to the industries
adopting labor-intensive techniques. In this way, unemployment problem can be solved to
certain extent.
vii. Preventing Harmful Consumption: Taxation can be used to prevent harmful consumption.
By way of imposing heavy excise duties on the commodities like liquors, cigars etc. the
consumption of such articles is reduced to a considerable extent.
viii. Beneficial Diversion of Resources: The imposition of heavy duties on nonessential and
luxury goods discourages the producers of such goods. The resources utilized for the
production of these goods may be diverted into the production of other essential goods for
which various tax concessions are given. This is called as beneficial diversion.
ix. Encouragement of Exports: Now-a-days export oriented industries are encouraged by way
of providing various exemptions like 100% relief from income tax, free trade zones etc. It
results in the large earnings of foreign exchange.
x. Enhancement of Standard of Living: By way of giving various tax concessions to certain
essential goods, the Government enhances the standard of living of people.

2.4. Principles of Taxation

Canons 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 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".

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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.

We shall now discuss them briefly.

2.4.1. 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.

i. 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

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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.
ii. 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.
iii. 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.
iv. 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
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

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from which future taxation is to come. Thus the canon of ‘Economy' is naturally sub-
divided into two parts viz.,
‘Taxation should be inexpensive in collection', and
‘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.

2.4.2. 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:

i. 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.
ii. 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 realizing at once "Productivity" and "Economy". Where the
public revenue does not admit of easy expansion or reduction according to the growth or
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 recognized and
adopted.

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iii. 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 decentralized so that everyone 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.
iv. 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.
v. Canon of Expediency: According to this principle, a tax should be levied after considering
all favorable and unfavorable factors from different angles such as economic, political and
social factors.
vi. 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.
vii. 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, the tax selected is often based upon plucking the goose
that squawks the least. Some have called this political test the other canon.

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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.

2.5. Tax Classifications

A tax is a compulsory contribution of persons toward the needs of government. It follows from
this definition (a) that a tax involves coercion upon its bearers, (b) who are in every case, either
natural or legal persons, and (c) a specific public purpose as its end. Taxation includes the
processes of levying, collecting, and paying taxes. Though taxes were historically voluntary
contribution toward the expenses of government, gradually they were transformed into
obligatory actions. At the present time, payment of taxes is obligatory in all civilized nations.
The bearer of the tax is in all cases a person. Property belongs to someone, and when it is taken
by means of taxation, the owner bears the burden. There can be no vital relation of obligation
between inanimate property and the living state. The duty of supporting the state rests upon those
who receive protection from it. While a large measure of the protection which the subject

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receives from the sovereign takes the form of security of possession, the thing possessed is but
an incident in the relationship of the state and the individual. The third element in the definition
of a tax is a specific public purpose as its object. Taxes are levied for the benefit of government
as a whole, not for the advantage of individuals or of a particular class. Justification of taxation
must rest on the will of the people expressed by legislation: when its results are applied
otherwise than for the good of the general public, taxation can no longer be defended.

A commonly applied classification of taxes is into direct and indirect taxes. The classification of
taxes into direct and indirect owes to the relationship between the nature of the taxes and the
reason for payment of the taxes. A direct tax is one for which the formal and economic incidence
are essentially the same, i.e. the taxpayer is not able to pass the burden to someone else.
Accordingly, direct taxes are paid entirely by those persons on whom they are imposed. On the
other hand, an indirect tax is a tax whereby the taxpayers’ burden to pay the tax can easily be
passed on to another person. Generally, the tax incidence of an indirect tax is on the ultimate
consumer; however, sometimes, sellers might absorb such indirect taxes so as to be competitive
in the market in which they are operating. The major types of direct taxes in Ethiopia are
personal income tax, rental tax, business profit tax, withholding tax and such other taxes like
taxes from loyalties, from games of chance, dividends or property taxes. The major types of
indirect taxes in Ethiopia are value added tax, custom duties, stamp duties, excise tax and turn
over tax.

The meaning of direct or indirect tax terms can vary in different contexts, which can sometimes
lead to confusion. In economics, direct taxes refer to those taxes that are paid by the person who
earns the income. By contrast, the cost of indirect taxes is borne by someone other than the
person responsible for paying them. For example, taxes on goods are often included in the price
of the items, so even though the seller sends the payments to the government, the buyer is the
real payer. Indirect taxes are sometimes described as hidden taxes because the purchaser of
goods or services may not be aware that a proportion of the price is going to the government.

I. Direct Taxes

A direct tax is paid by a person on whom it is levied. In direct taxes, the impact and incidence
fall on the same person. If the impact and incident of a tax fall on the same person, it is called as
direct tax. It is borne by the person on whom it is levied and cannot be passed on to others. For

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example, when a person is assessed to income tax or wealth tax, he has to pay it and he cannot
shift the tax burden to anybody else. In Ethiopia, Government levies the direct taxes such as
income tax, tax on agricultural income, professional tax, land revenues, taxes on stamps and
registrations etc. From the above discussion, it can be understood that the direct taxes levied in
Ethiopia take the form of taxes on income and property.

A. Merits of Direct Taxes

Direct taxes have the following merits:

i. Ensures the Principle of Ability to Pay: Direct taxes are based on the principle of ability to
pay. They fall more heavily on the rich than on the poor. The tax burden is distributed on
different sections of the society in a just and equitable manner.
ii. Reduces the Social and Economical Inequalities: Direct taxes reduce a disparity in the
distribution of income and wealth. By adopting the progressive tax system, rich people pay
on higher rates of adopting the progressive tax system, rich people pay on higher rates of
taxation, while the poor pay on lower rates or given exemptions. This reduces the gap
between the poor and rich to a considerable extent.
iii. Certainty: Direct taxes satisfy the canon of certainty. In the direct taxes, the time of
payment, mode of payment, the amount to be paid etc. are made clear. Both the taxpayers
and the Government know the amounts to be paid and the Government can estimate the
revenue from these taxes.
iv. Economy: The cost of collection of these taxes is low because the government adopts the
different methods of collections like tax deduction at source, advance payment of tax etc.
Besides, the taxpayers pay the amount of tax directly to government. Thus, the principle of
economy is achieved in the case of direct taxes.
v. Elasticity: Direct taxes are elastic in nature. For example, when the income of the people
increases, the tax revenue also increases. Moreover, during the unforeseen situation like
flood, war etc. the government can raise its revenue by increasing the tax rates without
affecting the poor.
vi. Educative Effect: Direct taxes create civic consciousness among taxpayers. Since the
taxpayers feel the burden of tax directly, they are interested in seeing that theGovernment

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properly spends the money. They are conscious of their rights and responsibilities as a citizen
of the State.
vii. Control the Effects of Trade Cycles: Direct taxes control the effects of trade cycles. They
can be used as a tool to mitigate the effects of inflationary and deflationary trends by raising
or reducing the tax rates.

B. Limitations of Direct Taxes:

The following are the demerits of direct taxes:

i. Arbitrary in Nature: Direct taxes tend to be arbitrary because of the difficulty in measuring
the ability to pay tax. Paying capacity of the people cannot be measured precisely. The levy
is highly influenced by the policies of the Government.
ii. Difficulties in the Formulation of Progressive Tax Rates: Direct taxes take the form of
progressive taxation i.e. the tax rate increases with the rise in income. It is very difficult to
formulate the ideal progressive rate schedules in this regard, since there is no scientific base.
iii. Inconvenience: Under direct taxes, the taxpayer has to adhere to many legal formalities such
as submission of the income returns, disclosing the sources of income etc. Moreover, he/she
has to follow numerous accounting procedures which are difficult to comply with. Further,
direct taxes have to be paid in lump sum and at times, advance payment of tax has to be
made. This causes much inconvenience to the taxpayers.
iv. Possibility of Tax Evasion: The high rates of direct taxes create the tendency to evade more.
There is possibility for tax evasion by fraudulent activities. Thus, it is said that the direct
taxes are the taxes on honesty.
v. Limited Scope: The scope of the direct tax is very limited. In Ethiopia, most of the people
come under or below the middle-income category. If only direct tax is followed, these people
cannot be brought into the tax net because of the basic exemption given. Thus, the
Government cannot depend upon direct tax alone.
vi. Disincentive to Work, Save, and Invest: When the taxpayer earns certain level, they have
to pay more, because of the higher rate of taxes attributed to the higher slabs. This will in
turn discourages them to work further, save and invest.

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vii. Expensive to Collect: Under direct taxes, each and every taxpayer is separately assessed.
Thus, the large number of taxpayers to be contacted and assessed and the prevention of tax
evasion make the cost of collection more expensive.

II. Indirect Taxes

Under indirect taxes, the impact and incidence fall on different persons. It is not borne by the
person on whom it is levied and can be passed on to others. For example, when the excise duty is
levied on the manufacturer of cement, he shifts the burden of tax to the consumers by raising the
selling price. Here the impact of excise duty falls on the manufacturer and the incidence on the
ultimate consumers. The person who is required to pay the tax does not bear its burden. Thus,
indirect taxes can be shifted.

a. Merits of Indirect Taxes:

Indirect taxes have the following merits:

i. Convenience: Indirect taxes are more convenient to the taxpayers. Since the tax is included
in the selling price of the commodities, the consumer pays the tax when he purchases them.
He pays the tax in small amounts (installments) and does not feel its burden. Thus, indirect
taxes are quite convenient and less burdensome.
ii. Wide Scope: While the people with income and wealth above a certain limit, are brought
under the levy of direct taxes, indirect taxes are paid by all both poor and rich. Thus, the
indirect tax has wider scope.
iii. Elastic: The revenue from the indirect taxes can be increased. Whenever the Government
wants to raise its revenue, or lower it, it can be achieved by increasing and decreasing the
rates of taxes on the commodities whose demand is inelastic.
iv. Tax Evasion is Not Possible: Indirect taxes are included in the selling price of the
commodities. So, evading of such tax becomes very difficult. If the person wants to evade the
tax, it can be done only by refraining the consumption of the particular commodity.
v. Substantial Revenue: Indirect taxes yield substantial revenue to both Central and State
Governments. The developing countries like Ethiopia are heavily dependent on indirect
taxes. Direct taxes have a limited scope in these countries because of low per capita income.

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vi. Progressive: Indirect taxes can be made progressive by imposing lower rates of taxes or
giving exemption to the necessary articles and heavy taxes on luxurious articles. Thus,
indirect taxes also confirm the principle of equity.
vii. Effective Allocation of Resources: Indirect taxes have great influence in the allocation of
resources among different sectors of the economy. Resources allocation can be made
effective by imposing heavy excise duties on low priority goods and by granting relief to
industries producing high priority goods. This results into mobilization of resources from one
sector to another positively.
viii. Discourages the Consumption of Articles Injurious to Health: Indirect taxes discourage
the consumption of certain commodities, which are harmful to health. By imposing very high
rates of taxes on commodities like liquors, drugs, cigarettes etc., which are harmful to health,
their consumption can be reduced.

b. Limitations of Indirect Taxes:

The following are the demerits of indirect taxes:

i. Ability to Pay Principle is Violated: Indirect taxes are not directly connected to the
taxpayers' ability to pay. Therefore, both the rich and poor equally pay the tax. Thus, the
principle of ability to pay is violated. Indirect taxes are regressive in nature.
ii. Uncertainty: If indirect taxes are not levied on the commodities of common consumption
and levied only on luxurious articles, they tend to be inelastic. The quantity demanded will
be affected by the imposition of the taxes. Thus, the revenue generated from them is
uncertain.
iii. Discourages Saving: Indirect taxes are included in the selling price of the commodities.
Hence, the people have to spend more on the purchase of the goods. This, in turn affects the
savings of the people.
iv. High Cost of Collection: Indirect taxes are uneconomical as they involve high cost of
collection.
v. Civic Consciousness is Not Created: Under indirect taxes, taxpayers don’t feel the burden
of the tax. They are not aware of their contribution to the State. Thus, indirect taxes do not
create the civic consciousness in the minds of the people.

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vi. Inflationary: The indirect taxes cause an increase in the price all around. The increase in the
prices of raw materials, finished goods and other factors of production creates inflationary
trends in the economy.
III. Differences between Direct and Indirect Taxes:

Direct and Indirect taxes differ among themselves on the following grounds:

i. Shift ability of the Burden of Tax: In the direct taxes, the impact and incidence fall on the
same person. It is borne by the person on whom it is levied and is not passed on to others. For
example, when a person is assessed to income tax, he cannot shift the tax burden to anybody
else, and he himself has to bear it. On the other hand, in the case of indirect taxes, the impact
and incidence fall on different persons. It is not borne by the person on whom it is levied.
The burden of the tax can be shifted. For example, when the manufacturer of cement pays
excise duty, he can shift the tax burden to the buyers by including the tax in the price of the
cement.
ii. Principle of Ability to Pay: Direct taxes conform to the principle of ability to pay. For
example, now people having income above Birr.600 per month, only is liable to pay income
tax.But, indirect taxes are borne and paid by the weaker sections of the society also. As such,
these taxes do not conform to the principle of ability to pay.
iii. Measurement of Taxable Capacity: In the case of direct taxes, tax-paying capacity is
directly measured. For example, the taxable capacity for income tax is measured on basis of
the income of the individual.On the other hand, in the case of indirect taxes, taxable capacity
is measured indirectly. The luxurious articles are levied at the higher rate of taxes on the
assumption that they are purchased by the rich people. However, low rate is charged on the
articles of common consumption.
iv. Principle of Certainty: Direct taxes ensure the principle of certainty. Both the Government
and the taxpayer know what amount is to be paid and the procedures to be followed. But in
the case of indirect taxes, it is not possible. The taxpayer does not know the amount of tax to
be paid and the Government cannot predict the quantum of revenue generated from the
indirect taxes.
v. Convenience: Direct taxes cause much inconvenience to the taxpayers since they are to be
paid in lump sum.But the indirect taxes are paid by the consumers in small amounts as and

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when they purchase the commodities. Moreover, the taxpayers need not follow any legal
formalities in the payment of tax. Thus, indirect taxes are more convenient to them.
vi. Civic Consciousness: People felt the burden of direct taxes directly. The taxpayer is
conscious of his contribution to the Government and interested in knowing whether the tax
paid by him is properly used or not. In this way, it creates civic consciousness among the
taxpayers.But indirect taxes do not raise such consciousness among the taxpayers, because
they pay the taxes indirectly.
vii. Nature of Taxation: Direct taxes are progressive in nature. The rates of taxes go up with the
increase in the tax base i.e. income of a tax payer.But rich and poor irrespective of their
income equally pay indirect taxes. Thus, they are regressive in nature.
viii. Removal of Disparity in Income and Wealth: Since the direct taxes are progressive in
nature, they reduce the disparities of income and wealth among the people to a considerable
extent.But indirect taxes have a negative effect. Actually they are widening the gap between
the rich and poor when they are levied on the goods of common consumption.
Examples: The examples for direct taxes are income tax, wealth tax, gift tax, estate duty etc.
The examples for indirect taxes are customs duty, excise duty, sales tax, service tax etc.

2.6. Tax Rate Structures

Taxable income is the portion of income received by individuals that is subject to the personal
income tax. The first step in calculating taxable income is to list the basic sources of income
subject to taxation. Gross income is all income received during the year from taxable sources.
Once taxable income has been computed, the next step is to calculate tax liability. To do this,
taxpayers use a tax rate schedule that applies to them. Different tax rate schedules apply to
different taxpayers, depending on their filing status.A tax bracket is a range of income subject to
a given marginal tax rate.

The different types of tax rates are as follows,

a. Statutory Rate:
The Statutory rates are the rates imposed by the statute or Laws or Proclamations. For example,
in Ethiopia the following are the statutory rates for Income tax under Income Tax Proclamation
No 979/2016.Schedule A

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Employment income Income Tax (per month) payable

Over Birr to Birr %
0 600 Exempt threshold
601 1650 10
1651 3200 15
3201 5250 20
5251 7800 25
7801 10900 30
Over 10900 **** 35
b. Marginal Rate:
The Marginal rates are the rates imposed on each additional Birr earned within each tax bracket.
A taxpayer's marginal tax rate is the tax rate imposed on his or her last dollar of income. In a
progressive personal income tax system, the tax rate applied to higher levels of income is higher
than the rate applied to lower levels of income. Such a graduated rate structure is better able to
keep up with a growing economy and ensure that those at the bottom of the income distribution
don’t have to carry a heavier tax load than the wealthy.
Example: Mr. Lelasew has the actual income of Birr. 10070.31.The nontaxable allowance as per
Income Tax Proclamation amounts to Birr.700.
His taxable income = 10070.31-700= 9370.31
Employee Income Tax = Taxable Employment Income * tax rate – deduction related to tax bracket
Employment Income Tax =9370.31Br *30%-955= 1856.09 Br
Employment Income Tax can be calculated by using progressive method as follows:
Allocation of monthly Taxable Income in the Income tax Employee Income
Employment Income range (a) rate(b) Tax(a*b)
0-600 600 0% 0.00
601-1650 1050 10% 105.00
1651-3200 1550 15% 232.50
3201-5250 2050 20% 410.00
5251-7800 2550 25% 637.50
7800-10900 1570.31 30% 471.09
Sum 9370.31 1856.09
Here, in this case, Marginal Tax Rate = 30%
c. Average Rate:
Average tax rate is the fraction of total income earned that is paid in taxes. It is not our income
per se, but our income as determined by the Proclamation.
Average Tax Rate = Tax Paid/Taxable Income x 100
= 1856.09/ 9370.31 x 100 = 19.81%

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d. Effective Rate
Calculating a taxpayer's effective tax rate, which is the share of total income that he or she pays
in taxes. Taxpayers' effective tax rates are usually much lower than their marginal rates.
Confusion about how exactly marginal tax rates are applied to personal income can lead
individuals to believe that their taxes are much higher than they actually are.
Effective tax rate is calculated as follows:
Effective Rate = [Tax Paid / Actual Income] X 100
Effective Rate = [Tax Paid / Actual Income] = [1856.09/10070.31] x 100 = 18.43%

2.7. Impact, Shifting and Incidence of Taxation

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

Differences between Impact and Incidence:

i. The impact refers to the initial money burden of the tax. But the incidence refers to ultimate
money burden of tax.
ii. The impact is felt by the person from whom tax is collected. But the incidence is felt by the
person who actually pays tax.

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iii. Impact can be shifted. But incidence cannot be shifted.

2.8. Tax Evasion, Avoidance and Delinquency

Tax avoidance and evasions constitute a problem in almost all the countries of the world. Tax
avoidance is different from tax evasion, while evasion is against the law; avoidance is within the
ambit of law.

Tax evasion is the general term for efforts by individuals, firms, trusts and other entities to evade
the payment of taxes by breaking the law. Tax evasion usually entails taxpayers deliberately
misrepresenting or concealing the true state of their affairs to the tax authorities to reduce their
tax liability, and includes, in particular, dishonest tax reporting (such as under declaring income,
profits or gains; or overstating deductions).

By contrast tax avoidance is the legal exploitation of the tax regime to one's own advantage, to
attempt to reduce the amount of tax that is payable by means that are within the law whilst
making a full disclosure of the material information to the tax authorities. Tax avoidance may be
considered as either the amoral dodging of one's duties to society or the right of every citizen to
find all the legal ways to avoid paying too much tax. Tax evasion, on the other hand, is a crime
in almost all countries and subjects the guilty party to fines or even imprisonment.

A. 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 recognized that the person whether poor or wealthy has the legal right
to dispose of his income so as to attract the least amount of tax”.

The tax avoidance can be defined as “escaping from the tax liability by using the available loop-
holes of the tax laws”.

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

Examples for Tax Avoidance:

The following are the examples for tax avoidance:

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i. 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.
ii. 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.
iii. 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.
B. 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, misrepresentation 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 evasion:

i. A trader makes a sale for Birr 20,000 and does not account it, in his books under sales.
He is evading tax.
ii. 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.
iii. Under-invoicing of sales and inflation of purchases.
iv. 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.

Human intelligence devices new methods of evasion and the Governments are constantly trying
to remove the loopholes in the tax laws.

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C. Delinquency

Delinquent tax refers to a tax that is unpaid after the payment due date. Usually a penalty is
attached to a delinquent tax. The power, jurisdiction and authority to collect all delinquent taxes
are vested in the state tax commission.

An action to recover delinquent taxes is not an action upon a contract, obligation, or liability, not
founded upon an instrument in writing, but is one which arises upon a liability created by law,
other than a penalty or forfeiture.

Delinquent, in the context of monetary transactions, refers to a payment which is owing and
overdue. When used in reference to individuals, it refers to carelessness or recklessness. For
example, homeowners who fail to timely pay property taxes owed may be subject to having their
home sold in a foreclosure proceeding in order to collect delinquent taxes. State laws on
foreclosure proceedings vary, but most require that the property owner be provided with a notice
of the delinquency and an opportunity to pay the amounts due to avoid foreclosure.

DISCUSSION QUESTIONS

1. Write the objectives of taxation.

2. Elaborate the advantages of direct taxes over indirect taxes.
3. Explain the limitations of indirect taxes.
4. Discus the disadvantages of progressive tax system.
5. Elucidate the causes of tax evasion.

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Unit Three:

Public Finance in Ethiopia

Chapter Objectives
After the completion of this chapter, the students will be able to:
 Understand the features of Ethiopian federal finance
 Appreciate revenue and expenditure assignments
 Comprehend intergovernmental transfers and borrowings
 Discuss the trends of Ethiopian public revenues, expenditures, debts, deficit and grants
 Understand budget and its process in Ethiopia

Introduction
The federal system of government refers to a government made up of many levels, and what we
refer to as the federal government is the top level of government in the federal system. Under the
federal government are the state governments and states containing zone, districts, city,
municipal, and other types of governments. This unit examines the economics of a federal system
of government from two perspectives. First, the question of why a federal system of government
might be more desirable than a single-level government for the production of government output
will be considered. Second, the economic interactions among the many different governments
that coexist in a federal system will be examined.

The major issues of fiscal federalism are summarized as:


Allocation of expenditure responsibilities, which deals with the issue of which item of
power of spending should be carried by which level of government;

Allocation of revenue raising power; which deals with the issue of which types of
taxes should be levied and non-tax revenues should be assumed in which jurisdiction
by which level of governments;

The fiscal imbalance between the tires of government and disparities in executing
their respective responsibilities; vertical and horizontal imbalances; and

The intergovernmental financial transfer; which deals with the issue of financial
flows between the federal and the states and among the states; vertical transfer and
horizontal transfer in order to adjust the imbalance and keep a viable federal system.

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Generally, the study of fiscal federalism focuses on allocation of expenditure responsibilities, the
revenue raising power and adjusting vertical and horizontal imbalances between the federal and
the states and among the states respectively through intergovernmental fiscal transfer.
The issue of whether many levels of government are preferable to single level involves an
analysis of both the trade-offs that exist between larger and smaller units of government and the
effects of competition among governmental units. Competition can aid efficiency in government
Furthermore; some activities are better pursued by smaller governments while others are best left
to larger governments.

3.1. Features of Ethiopian Federal Finance

Fiscal federalism constitutes the core and difficult area of federalism which measures the degree
of division of powers among the constituent units of federations for the financial power is an
engine of every activity. It is tough area for natural resources are limited and endowed unevenly
from place to place and constitutional redistribution is not fairly accepted by all concerned. In a
geographical area of more than one level of government, allocation of revenue sources and
expenditure responsibilities are elementary subject matters of fiscal federalism. Invariably, in all
federations the allocation revenue sources follow the allocation of expenditure responsibilities
which in turn signifies the division of powers and functions. The federations‟ system of divisions
of powers and functions easily reflects in fiscal federalism. Other elements of fiscal federalism
are the extensions of the two main subjects that as unavoidable problems and their solution.
These are fiscal imbalances which are caused by the gap between allocation of expenditure and
allocation of revenue sources both vertically between the states and the center and horizontally
among the states. These problems quest constitutional methods of solution. Some of the schemes
involve fiscal transfer from one level of government to the other, mostly from the center to the
states.
Federalism referred to as federal government, a national or international political system in which
two levels of government control the same territory and citizens. The word federal comes from
the Latin term fidere, meaning “to trust.” In federal system of government, government functions
and political power are divided between two sets of authorities-central government and state
governments such that each government within its own area is independent of each other. The
federal system of government refers to a government made up of many levels, and what we refer
to as the federal government is the top level of government in the federal system. Under the

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federal government the state governments containing city, district, municipal, and other types of
governments. In so, member states of a federation have the central government for the whole
country and state governments for the parts of the country.
In a federal system, laws are made both by state, provincial, or territorial governments and by a
central government. Federal political systems divide power and resources between central and
regional governments. The balance of power between the two levels of government varies from
country to country, but most federal systems grant substantial autonomy to state or provincial
governments. Central governments decide issues that concern the whole country, such as
organizing an army, building major roads, and making treaties with other countries. Federalism
varies in practice, however, and in some countries with federal systems, the central government
plays a large role in community planning, schools, and other local issues.

3.2. Intergovernmental Expenditure Assignment

The concept of public expenditure has a wider meaning that is highly associated with the
function of government than any subject of public finance; in addition, the allocation of
expenditures in federal form of state structure amplifies the problem to postulate the concept in a
clause. In broader sense, public expenditure signifies the functions of government whereas,
narrowly, it implies government’s identifying and prioritizing areas of spending and
implementing those identified projects in particular fiscal year.
In most countries in transition, it is common to give regional and local governments autonomy to
formulate budgets and spend their funds any way they wish. This is a practice similar to that
followed in decentralized government systems. On the other hand, the typical situation is for
revenues and the overall level of the budget of subnational governments to be determined by the
central government as in a unitary state. From a governance viewpoint, regional and local
governments have autonomously elected legislative powers but often the heads of the executive
powers continue to be appointed by the center, an institution associated with centralized unitary
states. The present confusion in institutions has led in many transition countries to an unwieldy
mix of deconcentration and decentralization of government activities. One way to examine the
adequacy of expenditure assignments is to analyze how well the actual assignment of
responsibilities fits the fundamental rules for the ideal assignment of responsibilities in a
decentralized system of government.

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There is no absolute best way for deciding which level of government should be responsible for
particular public services. The adequacy of any assignment has to be judged in terms of how well
it achieves the goals or objectives set up by the government in its decentralization strategy. The
fact that it is up to the government to set these objectives should not be interpreted to mean that a
murky assignment is acceptable. Clearly, without a specific assignment of expenditure
responsibilities it will not be possible to assess the adequacy of the revenue and tax assignment to
different levels of government, or the need and effectiveness of a system of intergovernmental
transfers. As we argued above, expenditure assignment needs to be the first and fundamental step
in the design of a decentralized system of intergovernmental finances.
As one can see figure 3.1 below, the commonly accepted roles for federal finance include the
critical role of efficient allocation of resources, redistribution and preservation of macroeconomic
stability and promotion of economic growth, which can be best pursued by the central
government. Economic efficiency involves service provision at the lowest possible cost. Fiscal
equity requires the achievement of greatest possible fiscal equalization. Likewise, political
accountability aimed at promoting citizen participation and control and administrative
effectiveness considers governmental proficiency and deeds of enhancing cooperation.
The application of these rules largely facilitates the assignment of expenditure responsibilities to
different levels of government. However, the rules do not always yield an unequivocal answer.
Some public services, e.g., primary education and primary health services, may be of local nature
by the size of their benefit area, but because of their relevance in welfare and income
redistribution, they may also be considered a responsibility of the central government. It is in this
sense that it is not meaningful to talk about the best assignment of expenditure responsibilities.
What is considered the best assignment is likely to change over time with changes in costs and
technological constraints, as well as changes in preferences. However, there is a need at any
given moment in time to have a concrete assignment of expenditure responsibilities among the
various assignments that could be considered optimal. Failure to have a concrete assignment may
lead to instability in intergovernmental relations and to the inefficient provision of public
services. In case revenue availability dictates responsibilities of various government levels with
no expenditure assignment, it potentially causes institutional instability and inefficient provision
of public services.

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In sum, the design of a decentralized system of intergovernmental finances, there is an obvious

need for a policy decision on concrete assignment of expenditure responsibilities between the
central government and the regions and between the regions and the local governments. Such
explicit and systematized assignment of functions and expenditures to the different levels of
governments, of course, should not detract from the flexibility needed to adapt government
budgets to major changes in policy.

Features of
Criteria Outcomes
Intergovernmental System

Economic Efficiency  Least-cost level of service

F  True preferences of ‘consumer-
O  Economies of Scale voters’
U  Public sector competition  Bestuse of public services
R  Public sector pricing

 Service Efficient
Fiscal Equity  Avoid ‘free-riders’
A
 Diminish inter-jurisdictional
S  Economic externalities disparities
S  Fiscal equalization  Egalitarian in
I Service Provision
G
N
M Political accountability  Diffusion of political power
 Effective in Service
E  Promoting citizen  Popular support of governmental
N participation system Delivery
T
 Jurisdictional accountability
 Technical
Administrative  Limits judicial interference
F Effectiveness  Vertical and horizontal Proficient
A cooperation of governmental units
C  Legal adequacy  Effective public administration
 General purpose government  Greater professionalism
T
 Intergovernmental flexibility
O
 Geographic adequacy
R  Management capability
S

Figure 3.1 Criteria of Expenditure Assignment Process

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3.3. Intergovernmental Revenue Assignment

In a federal government, allocation of financial resources between the center and the states is of
great importance. Intergovernmental revenue is a significant source of funds for lower-level
governments. Commonly, federal government receives a relatively small amount of its revenues
from other governments, but state governments rely on other governments-primarily the federal
government. There are two types of allocation. The first system is independent system a case
whereby the units in a federation derive their revenue from different sources. There would be no
concurrence or contact between the center and the units. The second case is referred as mixed
system where there would be concurrence and contact between the center and the units. This
system is further divided into two; concurrent mixed system and the contact mixed system. In the
concurrent mixed system, both center and the states have concurrent powers of taxation regarding
certain sources. There would be no transfer of resources from the center to the states. In the
contact mixed system, contact between the center and the states is created. There would be
intergovernmental grants or contributions. There are three main types of intergovernmental grant
programs – general grants, categorical grants and matching grants.
i. General Grants
The rationale behind general grants is to allow the revenue source of higher-level government to
be used to finance activities of a lower-level government. The tax revenues are collected by the
higher-level government and given to the lower-level government to spend as it sees fit. At one
time, there was a great deal of enthusiasm for general grants, but general grants are no longer in
as much favor as they once were. Higher-level governments are more inclined to dictate to lower-
level governments how the grant money must be spent. For example, state governments provide
significant funds to local school districts as general grants, although in this case the money
obviously must be spent on education, and states regulate local school districts in many ways
outside of directly mandating how intergovernmental revenues be spent. In Ethiopian case, the
federal government is engaged in a significant revenue sharing program that transferred federal
funds to states based on a formula.
ii. Categorical Grants
Categorical grants are made for some specific purpose, and though the terms of the grants may
vary, they share similar effects. Sometimes a grant pays for an entire project, whereas, in other
cases, the grant from the higher-level government requires that the lower-level government share

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in the project's cost. Categorical grants are made to give the granting government more control
over the way that its money is spent. This may happen because the grant specifies how the
money is used, but, depending upon the circumstances, the money may or may not actually be
spent as it was intended. One important factor is how much the government would have spent
without the grant.
Under some conditions, a general grant is preferable to categorical grants because, by allowing
unrestricted use of the funds, it reduces the amount of both the record keeping the local
government must do and the monitoring the higher-level government must do to see that the
money is spent as the grant requires. However, categorical grants may be desirable in instances in
which they correct externalities.
iii. Matching Grants
Another way to prompt local governments to contribute their own funds to a project is by a
matching grant, which is a categorical grant that requires a local contribution, which is then
matched by a contribution of the higher-level government. The matching requirement makes the
local government spend more than it would have preferred. A matching grant might also be made
that gives the local government funds to match its own expenditures regardless of the level of
local expenditures. If this is the case, then the grant changes the relative prices faced by local
governments. This type of grant does not affect the relative price of the good for which the grant
is made.
A matching grant with no limit on the amount of the grant does change relative pries and
therefore does have an effect on relative prices and the amount that a local government will want
to consume. To this point, it is assumed that local governments simply add the amount of the
grant to what already would have been spent to increase the local government’s level of
spending. Another alternative, however, is for the local government to use the grant money to
replace local spending, which would allow the local government to cut taxes. In practice, we
would expect local governments to adjust on all margins, including cutting taxes, when they
receive grants from higher-level governments.
Another possible option to get revenue is to implement borrowing schemes. Borrowing can be
from the open market or from the governmental funds if such a pool is available. However,
borrowing involves different considerations. Sometimes, borrowing involves not only repayment
of debt but also imposes financial conditionality. More importantly, the central government

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would impose certain conditions, with respect to the magnitude and purpose of borrowing.
Generally; however, the major issues as regards loan finance are what the upper limit of the loan,
criteria for eligibility, other conditions as interest, grace period, repayment period, etc. and the
procedures followed to get loan. Importantly, the needs of regions for borrowing will have to be
viewed in conjunction with macro-economic concerns, which would necessarily dictate
prudence.
Another aspect of intergovernmental fiscal relations is transfers. It is known that in order to
maintain fiscal stability and thereby political stability, some broad correspondence between
resource availability and functional responsibility is important. Practically, adopting the general
principles of tax assignment and expenditure responsibilities cannot guarantee a balanced budget.
Moreover, regional variations in correspondence between revenue and expenditure generally
exist.
Therefore, intergovernmental fiscal transfer is used to mitigate these problems. From this, we can
categorically see that intergovernmental transfers are not only flow of revenue form the central
government towards regions but also transfer from wealthier regions to poorer ones via the
central government.
Another basic consideration of intergovernmental transfers is the pricing of externalities. One
transfer rational is that there exist inter jurisdictional spillovers. Transfer is therefore used to
correct such spillovers. The benefits or services or goods provided by one region may spill
beyond it and may cross neighboring jurisdictions. The neighboring region may not contribute to
the cots incurred by the provider. In such a situation, the provider, considering own benefits only,
tend to under provide or produce below the optimal level. Although there are many alternative
remedies for such problems, only some are practically applicable. A matching grant program
whose rate is set by the size of the spillover could be designed to encourage the optimal provision
of public services.
Still, other considerations are taken in to account in intergovernmental fiscal transfer. These are
fiscal equalization and ensuring of a common minimum standard of public services. Fiscal
equalization is perhaps one of the most important inter-governmental transfers. The existence of
net fiscal benefits across regions is of high concern for central governments as this has the
potential to turn in to a political issue. There are in fact factors which make some regions
relatively worse off than others. These in turn make migration of factors of production, for

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example capital and labor a reality. The migration of factors of production to relatively rich areas
therefore creates social and economic problems thereby inefficiencies and inequities prevail. This
in turn creates differential treatment of identical persons by the public sector. Therefore, in order
to curb such a problem, Fiscal equalization grant is required.
Another economic rationale for intergovernmental transfer is the ensuring of a common standard
of public services across jurisdictions. The principle of expenditure assignments to lower level of
governments is based largely on efficiency, accountability and local autonomy criteria. These
then create problems of equity as it pertains to economic well-being in general. Thus, inter-
governmental transfers as considered from this perspective are equity considerations.
The last but equally important reason for transfer is the achievement of political goals. If fiscal
decentralization is made to serve political decentralization, then to keep the reality, transfer to
some resources is important. Reasons for such consideration are to provide jobs for local
supporters, to salvage national pride, and other reasons.

3.4. Intergovernmental Transfer

In line with a federal principle which deals with the tension between unity and diversity between
the center and the states, local governments do not have constitutional status. Any (financial)
tension between sub-regional levels is left to the concern of the regional government. Of course,
an issue may arise as to whether federal and regional entities would provide an effective
response to all the complexities related to the needs of diversity in Ethiopia in general and the
disparity between the regions themselves and between local governments in particular. In a
federation where local governments have constitutional status, they must be accorded with
certain constitutional means of protection, including their taxing power and entitlements in the
transfer mechanism.

3.5. Borrowing
After devoting considerable attention to the transfer of revenue, we should, for the sake of
completeness, make a number of remarks on borrowing. Borrowing is the other possibility by
which states may supplement their financial constraints.

The major issues concerning borrowing are the adoption of appropriate criteria for acquiring the
loans, setting the upper limit to be borrowed, interest obligations, the repayment period and debt
servicing capacity. Unlike the centre, sub-national governments are mostly restricted to domestic

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borrowing and they may even be subject to direct control by the central government. The main
reason for participation and control by the centre is that monetary and fiscal policies are
centralized. But there are various forms of control and the extent of central control might
significantly differ from one country to another. In a more general approach, control mechanisms
have to be designed to suit the circumstances of a particular country. Moreover, it requires the
creation of possibilities for a timely adjustment, depending on the capacity and fiscal balances or
imbalances of regions.
Teresa Ter-Minassian and Jon Craig in their studies of the practice in several countries conclude
that the central control mechanisms generally encompass either of or a combination of the
following four broad categories.
In the first category, the control mechanism may simply rely on a free and open market
discipline. In this case, the role of the central government is very limited. The market may set
stringent conditions to be met by the guarantor government (that are unlikely to be realized in
many countries), or the central government may bailout debts. The sole reliance on this mode is
not considered appropriate for developing federations because unregulated state borrowing may
affect the macroeconomic stability of the country as a whole.
In the second category the center is authorized to exercise control over state borrowing through
constitutional or statutory rules. Some of the rules may extend to authorizing borrowing for
specific purposes, setting a maximum amount allowed, and prohibiting loans from the central
bank.
The third approach is to set rules for the cooperation of all levels of government in the
preparation and adjustment of financial administration to reduce the indebtedness of the
governments. The objective of their equal participation is to enhance responsibility in the use of
budgets supported by loans. In Australia, for example, public borrowing by the federal and state
governments has been a matter which is regulated by an intergovernmental council called the
Loan Council and which is established by the Constitution. The main reasons for establishing the
Loan Council were to avoid loan competition and to control state spending which had been
lavish for some years and which in the end imposed a burden on the commonwealth to make up
deficits by grants.
The fourth model is direct administrative control by the central government. It ranges from the
approval of the purpose and the authorization of proposed borrowing to a subsequent supervision
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of the financial operations by the regional governments. The details of centralizing all
government borrowing pertain to the terms and conditions of borrowing, the amount each
regional government can borrow, and the repayment capacity. This kind of direct central
government control is more common for unitary systems than in federations.
Compared to the above categories, the laws concerning state borrowing in Ethiopia emphasize
the importance of federal control through statutory regulations and intergovernmental
cooperation, but presently sub-national borrowing has a very limited application.
In Ethiopia, the federal constitution recognizes the states‟ right to borrow from domestic sources.
It stipulates that the federal government shall determine by law the conditions and terms under
which states can borrow money from domestic financial institutions. This provision, on the one
hand, affirms the possibility that states can borrow from domestic sources and, on the other,
grants the regulatory power to the central government. Accordingly, the federal financial
administration law requires the regional governments to provide all the necessary information to
determine the amounts to be borrowed by individual regions. Thus, the states have to fulfill the
obligation to submit to the Ministry of Finance and Economic Development the loan amount
required to cover their deficit together with statements showing the relations of the requested
amount with their revenue collection forecast and with economic indicators, and shall attach a
copy of their consolidated loan as required with the loan application form. However, under the
present economic conditions it is hardly possible to imagine that regions can repay their debts
from revenue collected within their jurisdiction.
According to the Finance Administration Law, regional governments may borrow from the
National Bank of Ethiopia and/or from other commercial banks. First, if they borrow from the
National Bank, the amount has to be determined by the ministry and its disbursement has to be
managed by the National Bank. According to this law each region must convince the minister
that the money is required for financing a specific project and they have a capacity to repay the
loan within the appropriate time as laid down by law. The minister to
whom the application is submitted must evaluate the capacity of the regions and the impact of
the loan on the national budget, if the loan is granted. The Minister has the power to study the
accuracy of the information and later to communicate a decision indicating the amount of loan to
be given to the state. Whatever the decision may be, limiting the purpose of the loan to a specific

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project is usually considered to be a good case of borrowing. The assumption is that if it has an
investment purpose it may have an adequate economic and social return.

Second, if borrowing is to be made from commercial banks (or other financial institutions), the
respective regional government and the federal Ministry of Finance shall jointly agree on the
administrative arrangements related to such borrowing. This has the drawback that borrowing is
only considered as a bilateral issue, but in reality, however, it may become a national burden.
Thus, in the long run there should be a forum to accommodate the participation of all regions.
But if we limit ourselves to the existing legislation, what could be the objectives of the
agreement? And what could be the role of the National Bank in dealing with the cooperation
between MoFED and a region? Does the Ministry or the National Bank guarantee the loans? Can
the agreement authorize commercial banks to lend money to the regions? If that is the case, then,
on what criteria do they lend the money? If the same rules and procedures which are applicable
in the market are equally implemented, then the regional governments have to fulfill the
requirements set by the banks. In normal circumstances, the banks have to secure the repayment
capacity of the regions and study the feasibility of the projects. However, considering the very
limited revenue-raising capacity of the states and the fact that they are absolutely dependent on
grants given by the central government, borrowing from banks currently does not seem to be a
workable alternative to finance regional governments. Finally, what would be the situation if a
regional government borrows without presenting the case to the MoFED? The existing financial
laws do not give adequate answers to the issues raised above. Nonetheless, few cases of
borrowing have been witnessed in the regions. For example, the Amhara regional government
authorized its finance bureau to borrow money (150 million birr in each year) and to issue
security on behalf of the regional government for the provision of agricultural inputs and animal
packages to farmers with a view to develop regional agricultural production. However, the whole
process of lending the money to and collection from the farmers has led to controversies. The
purchase and distribution of the agricultural inputs are administered by companies affiliated to
(or owned by) the ruling party, irrespective of the consent of the farmers. The impact of the
repayment period and the manner of its administration are also not adequately taken into
consideration. Farmers are coerced into paying all debts; there is a fee for land use, income tax
and loans collected by development experts in one (harvest) season.

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In addition to the regular taxes and contributions the regime has introduced involuntary seed and
fertilizer purchases from its own business enterprises, which are made to prosper at the expense
of the peasants. The demand for cash from peasants has another exploitative side. Cash
collectors on legal and illegal obligations arrive at harvest time when the peasants will squander
harvested crops; all peasants are forced to take their produce to the market at about the same
time. Prices for their crops drop abysmally. Consequently, they are forced to sell more of their
crops in order to meet their cash obligations. This is the socio-economic origin of famine.

One important point is that in spite of central control of borrowing, regional (or local)
governments may become indebted for large sums of money. This may compel them to seek
supplementary funding from the center or further borrowing and therefore this should be treated
cautiously. One can easily envisage several grounds which may lead to indebtedness which in
turn requires some form of intervention from the center or to force the region to cancel its
planned expenditure. On the one hand, regional governments with a relatively better
administrative capacity and commitment to execute their responsibilities may genuinely need
more funds. For example, a report by the assessment team of the Word Bank and other donor
institutions shows that although the Tigray region has the capacity to execute more projects, it is
forced to revise its plans according to the federal grants available. However, the report does not
comment on whether the region has a debt-servicing capacity from its own revenue sources if it
borrows to execute projects.

On the other hand, in lowland regions such as Somali, sometimes it is difficult even to pay
salaries or cover the ordinary costs of running the administration. This is due to lack of skilled
personnel, lavish spending, embezzlement and lack of political commitment. Moreover,
sometimes people abscond with a great deal of public funds so that the budget lapses before the
end of the fiscal year. Some of the major problems in the lowland regions are large debts through
payment arrears due to the failure to effect payments to projects and lack of effective monitoring
and controlling mechanisms. The sub-national governments may, therefore face serious financial
problems for various reasons ranging from personal incompetence and criminal behaviour to
national economic problems. The consequence is a major concern not only for the creditors of
the government concerned, but also for the citizens living in that area in particular and the nation
in general.

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The decision to bailout the debts of a state could be considered as a necessary measure taking
into account the cost and its political and economic implications. But this will be a financial
burden to the central government. At the same time, such problems imply that the viability of the
regional government is in question. When regional governments fail, at least, to manage the costs
of administration according to their own budget, the dire consequence should be a limitation of
autonomy for the financial assistance they seek. The impact of such financial problems in
developed federal systems could be the imposition of high taxes and a relatively lesser provision
of public services in the region concerned. But, the impact in a country like Ethiopia will be
considerable and may mean a perpetuation of poverty. The most worrisome experience is the
vexatious position taken by the center with regard to regional financial embezzlement.

The issue is if sub-national governments are in a position in which they cannot pay their debts,
can the regular financial laws govern the problem, for instance, through a declaration of
bankruptcy? The ordinary bankruptcy law accords some beneficial treatment for both the debtor
and creditor, but may also lead to the liquidation of the debtor. But, when it comes to
government bankruptcy, the main concern is to rehabilitate not to enforce insolvency.

The issue of governmental bankruptcy is better dealt with in the USA. As a result of the Great
Depression of the 1930s some 2,019 municipalities, counties, and other sub national units
defaulted on their obligations since they were not able to pay their debts by imposing high taxes.
Since governments could not be liquidated, the option was to provide relief from court litigation,
to get some obligations paid, and to provide sub-national governments with a new start for their
financial operations. The bankruptcy law of the USA applies to municipalities not to states since
the latter are sovereign concerning state matters. The lawrespects the autonomy of municipal
governments to conduct their finances without supervision or control from the centre. But when
they are bankrupt, the bankruptcy law (of the USA) on the one hand gives protection to
municipalities to rehabilitate during a given time, and on the other hand, paves the way to greater
supervision on their autonomy. Actually, the bankruptcy law gives wider protection to the
municipalities (debtor) compared to individual or business debtors. In practice, according to
Mikesell, when municipalities are in financial jeopardy, most state governments intervene
through the respective financial emergency procedures by imposing extraordinary controls on
payments, plans, and policies concerning priorities.

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In comparative terms, the Indian Constitution explicitly provides for a financial emergency
clause, perhaps to avoid the issue of state sovereignty if similar problems of the economic
depression of the 1930s are to arise. Article 360 of the Indian Constitution gives power to the
president to declare a financial emergency by a proclamation when a situation has arisen
whereby the financial stability of India‟s credit or any part thereof is threatened.

The Ethiopian Constitution, on the other hand, does not explicitly provide for a state of financial
emergency as a ground for the intervention of the federal government in the states. The
Proclamation which enumerates the grounds for federal intervention does not explicitly mention
financial problems as a ground for intervention. The HOF is empowered by the Constitution to
order federal intervention when the constitutional order is endangered. It envisages an armed
uprising and activities that endanger the peace and security of the federation. However, in a
situation where a state becomes administratively non-viable, fails to provide public services or is
unable to pay its employees, it should be possible to consider them as factors which imperil the
constitutional order. Generally, the problem during the last decade can partly be related to a
failure to genuinely empower the people at the local level to choose their authorities, or to decide
on major local interests and effectively control the misuse of power and embezzlement.
Moreover, the facts on the ground indicate that the economic impact of a fiscal crisis should not
be tolerated for any political expediency since it does not guarantee self-administration. Thus, to
this date, unilateral regional borrowing does not seem to be a feasible alternative to finance
regional expenditures.

3.6. Trends of Ethiopian Public Revenues, Expenditures, Grants, Deficits,

and Debts
The revenues of the Government can be classified into two ways. They are:
i. On the basis of mode of collection and
ii. On the basis of nature of revenue. Let us see these classifications one by one here under:
Revenue on the Basis of Mode of Collection:
It can be shown with the help of the following chart
a. Tax Revenue:
It can be shown with the help of the following chart.

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Revenue by Mode of Collection

Revenue on Revenue by Revenue by

partly voluntary compulsory and
compulsion payment partly voluntary

Taxes, fines, Income from public Special assessments,

penalties, property (rent, etc.), escheats, printing of
forfeitures, income from public currency, grants-in-
tributes and enterprises, fees, aid
indemnities gifts, licenses
arising out of
war or other
compulsory
loans
Figure 3.2.
Revenue on the basis of Nature:
The revenues on the basis nature can be classified as in the following

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Figure 3.3
Of these two types of classifications of revenues the classification of revenues based on the
nature is considered as the ideal classification. Let us explain these items one by one.

The revenue from tax includes the following:

1. Tax on Income: The Government imposes two types of taxes on income. They are:

a). Tax on personal income, and

b). Tax on corporation profits.

The personal income tax is levied on the net income of individuals, firms and other association
of persons. The tax on the net profits of the joint stock companies is known as corporation tax.

2. Taxes on Property: It is the tax revenue from properties including rental income tax land use
tax etc.

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3. Taxes on Commodities: The important taxes levied by the Government on commodities are:
Customs Duty, Excise Duty, Value Added Tax, Turnover Tax etc.

b. Non-Tax Revenues:

The following categories of revenue are included under non-tax revenue.

Administrative Revenue: It includes the following:

(1) Fees: It is the compulsory payment made by the individuals who obtain a definite service in
return. Fees are charged by the Government to bear the cost of administrative services rendered
by it. These services are rendered for the benefit of general public. It includes court fee,
registration fee, etc.

(2) Licenses: A license fee is collected not for any service rendered, but for giving permission or
a privilege to those who want to do a special or specified work. It is charged on the grounds of
control of certain activities.

(3) Fines and Penalties: Fines and penalties are imposed as a form of punishment for the
mistakes committed such as violation of the provisions of law, etc. The basic aim behind them is
to prevent the people from making mistakes. A fine is also compulsory like a tax, but it is
imposed more as a deterrent than as a source of revenue.

(4) Forfeitures: Forfeiture means the penalty imposed by the courts on the persons who have not
complied with the notice served by it or for the breach of contract or has failed to pay the dues in
time, etc.

(5) Escheats: The property of a person having no legal heirs and dying intestate, will be taken
possession of by the Government. That is, the Government can take over the property of a person
who dies without having any legal heirs or without keeping a will. But, it cannot be considered
as a main source of revenue to the Government.

(6) Special Assessment: According to Prof. Seligman, special assessment means “a compulsory
contribution levied in proportion to the special benefit derived to defray the cost of the specific
improvement to property undertaken in the public interest”. Thus, it is a compulsory payment or
contribution. It is levied in proportion to the special benefits derived to bear the cost of specific
improvement to property. Whenever the Government has made certain improvements, somebody

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will get benefited. For example, irrigation facility, road and drainage facility, etc. Because of
this, the value of the property in the neighborhood will rise. This rise in the value will provide an
unearned increment. Hence, the Government has a right to appropriate a part of this unearned
increase. This appropriation is called as special assessment.

(7) Gifts and Grants: Gifts are voluntary contributions from Non-Government donors to the
Government for various purposes like drought relief, defense, national relief, promotion of
family planning, etc. Grants are usually given by one Government to another. For example, in a
federal set up, the Union Government provides grants to the State Governments to carry out their
functions and fulfillment of obligations. Moreover, the Government of one country may receive
grants from other country.

Expenditures

Government expenditures for administration and developmental activities are handled through
the expenditures budget. These expenditures are categorized into recurrent and capital
expenditures. This categorization gained acceptance since the Great Depression of the 1930s. the
recurrent budget which covers the current expenditures is financed in principle by taxation (more
broadly by domestic revenue from tax and non-tax sources), and the capital budget which covers
the acquisition of newly produced assets in the economy is financed through external borrowing
and grants.

The acceptance to this categorization of expenditures is related to the general change in the
perception of deficit. Prior to the 1930s, budget deficits were considered to be reprehensible and
indicate bad financial management. Over the years, however, the cardinal rule of balanced
budget was changed in favor of cyclical budget, and functional finance. This change in the rule
of budgeting, in turn, resulted in several approaches to measuring and understanding the deficit
some of the concepts that were developed include:

A. The public debt concept of deficit,

B. The net worth concept of deficit,
C. the overall deficit, and
D. the concept of domestic deficit.

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To illustrate these four approaches of measuring deficit, we can employ a simplified budget
balance given in Table -1 below:

A Simplified Budget Balance

The public debt concept of deficit defines budget deficit as the difference between revenue (A)
and recurrent expenditures (C) and capital expenditures (D) this measure A(C+D) is equal to net
borrowing (B), and the budget is considered to be balanced if net borrowing remains unchanged
from previous years or is equal to zero. This approach illustrates, the understanding prior to
1930s, which emphasized balanced budget as a prudent fiscal policy.

The emergence of active fiscal policy: The emergence of active fiscal policy (i.e. government
could borrow as long as that liability is matched by an increase in assets) right after the
depression led to the development of the net worth concept of deficit. Referring to the Table
above, the net worth is defined as the difference between recurrent expenditures and revenues
(C-A), which is equal to the excess of net borrowing over capital expenditures (B-D) this
measure of deficit requires the division of expenditures into current and capital budgets, with the
latter being financed by borrowing.

The concept of the overall deficit or balance has several connotations and methods construction.
The common practice is to put revenues, expenditures, and borrowing as distinct groups as in
Table 2. Each budget category may then be related economic activity being computed as a ratio
of GDP, which then becomes a first approximation and an important single measure of the
impact of government fiscal operations.

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The domestic balance concept is a family of the overall budget deficit and became prominent
after the oil price increases in 1973/74. The basic argument being, in countries that had large
revenues, expanded incomes from government expenditures placed strains on the domestic
economy and spurred inflationary pressures. In such cases, budget surpluses will have an
expansionary effect. Under such circumstances the overall budget deficit or surplus measure
would be misleading to guide government policy. In fulfilling the requirements of oil producing
countries and others in similar circumstances, the technique of splitting the domestic balance is
the component of the overall balance from which external budget transactions have been
excluded.

The separation of recurrent and capital budget should, therefore, be viewed in terms of the net
worth argument above. The definition of these two budgets has been a common problem in most
countries, however. The problem relates to delineating, which specific expenditures need to be
included in the recurrent budget and which ones in the capital budget. In practice three criteria
have been in use to define budget into capital and recurrent. These are sources of finance, object
of expenditure, and nature of activity.

Capital budgets were originally defined by western governments by the source of finance, i.e.,
capital expenditures are financed from loan not current revenue. The object of expenditure refers
to the particular activities to be performed with that budget like, formation of fixed assets, study
and design, salaries of civil servants, etc. the third criteria, the nature of activity, refers to

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whether the activity is short term (i.e. project) or on going (that may not terminate in a specific
period), and objective specific.

In Ethiopia the definition of recurrent and capital budgets follows some combination of these
criteria. That is:

1. Recurrent budget is to be covered by domestic revenue from tax and non-tax sources. But the
economy could borrow to meet its capital budget.

2. The financial proclamation 57/1996 and financial regulations 17/1997 defined capital budget
based on the object of expenditure. Accordingly, capital budget equals capital expenditure which
equals fixed assets and consultancy services.

3. Short-term activities that are project in nature are included in capital budget while those
activities that are recurring and continuous in nature are put in the recurrent budget. In some
instances, activities with a very long life period have been entertained in the capital budget.
Since fiscal year 1994/95 efforts have been exerted to identify many such projects that have been
categorized under recurrent budget (projects in Education, health and Agriculture sectors). The
exercise does not seem complete, as there are projects with recurring nature (e.g. Agricultural
Research) though attempts have been made to isolate the investment components.

The Expenditure Budget includes the following two types of Budgets:

i. Recurrent Budget, and

ii. Capital Budget.
i. Recurrent Budget:
Financial proclamation 57/1996 and financial regulation 17/1997 defined only the capital budget,
implicitly defining the recurrent one as a residual. To common practice, however, is to include in
the recurrent budget expenditures of recurrent nature (like salaries of civil servants) and fixed
assets with a multi-year life.

The recurrent budget is structured by implementing agencies (public bodies) under four
functional categories: administrative and general services, economic services, social services,
and other expenditures. All public bodies then fall under one of these functional categories. The
budget hierarchy will then be down to sub agencies.

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ii. Capital Budget:

Capital budget is budget for capital expenditures. Financial proclamation 57/1996 defined capital
expenditure as “an outlay for the acquisition of improvements to fixed assets, and includes
expenditures made for consultancy services.” Financial regulations 17/1997 further provided a
detailed definition of capital expenditures to mean:

a. The acquisition, reclamation, enhancement as laying out of land exclusive of roads, buildings
or other structures;
b. The acquisition, construction, preparation enhancement or replacement of roads, buildings
and other structures;
c. The acquisition, installation or replacement of movable plant, machinery and apparatus,
vehicles and vessels;
d. The making of advances, grants or other financial assistance to any person towards him/her
on the matters mentioned in (a) to (c) above or in the acquisition of investments; and
e. The acquisition of share of capital or loan capital in any body corporate;
f. Any associated consultancy costs of the above.
Capital budget could thus broadly be described as an outlay on projects that result in the
acquisition of fixed assets and the provision of development services (Ministry of planning and
Economic Development, 1993:4). It should therefore be need that, capital budget as a wider
coverage than simple outlays in fixed investments, since it includes expenditure on development
services like agricultural research and transfer payments related to a project.

The capital budget is presented under three functional groups viz., economic development, social
development, and general development. Economic development includes production activities
(agriculture, industry, etc.), economic infrastructure facilities (mining, energy, road etc.),
commerce, communication, and so on. Social development includes education, health, urban.
Development, welfare and so on. General development includes services like cartography,
statistics, public and administrative buildings, and the like.

3.7. Budget and Its Process in Ethiopia

The word Budget originally meant the moneybag or the public purse. The word now means,
“Plans of government finances submitted for the approval of the legislature”. The budget reflects
what the government intends to do. The budget has become the powerful instrument for fulfilling

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the basic objectives of government. The budget covers all the transactions of the central
government.

Budget is a time bound financial program systematically worked out and ready for execution in
the ensuing fiscal year. It is a comprehensive plan of action, which brings together in one
consolidated statement all financial requirements of the government. The budget goes into
operation only after it is approved by the parliament. A rational decision regarding allocation of
resources to satisfy different social wants requires considerable thinking and planning. Thus
budget is an annual statement of receipts and payments of a government.

Budgeting from the initial stage of forecasting the annual revenues and expenditures, to the final
stage of approval of the annual budget by the Council of Peoples Representatives, passes through
a sequential and an iterative process.
The budget process thus includes all these stages, which obviously are sequential (one after the
other) and iterative. Peterson summarized the budget process into three phases: analyzing, fitting,
and implementing. The analysis phase is the assembly and integration of financial data which
might include processes from the formulation of macro-economic and fiscal framework to the
allocation of expenditure budget between Federal and Regional governments the fitting phase is
the process of prioritizing activities to fit with policy and reducing a budget to a ceiling.
Referring to the budgeting processes outlined above this might range from the processes of
allocation of Federal government expenditures budget between recurrent and capital budget
down to the submission of the budget to the Council of Peoples’ Representatives. The final
phase, implementing, is distributing and using the allocation, i.e. the notification and publication
of the budget, allotment and the monitoring processes.
Budget being a one-year plan prepared for the coming fiscal year it requires a time schedule
(deadlines) for each and every processes that should strictly be adhered to. The time schedule is
usually handled through the budget calendar. In effect, the budget calendar is the major
instrument to manage the budgetary process. Thus far we do not have an authoritative and
binding budget calendar that could force all public bodies involved in the process of budgeting.
The only dates proclaimed by law are the final approval and notification dates of the budget.

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Financial Proclamation 57/1996 states that “the budget appropriation shall be approved by the
Council of Peoples Representatives by Sene 30th (July 6) and all public bodies shall be notified
by Hamle 7 (July 13).” The other deadlines in the process of budgeting will be set by the MoF
and MEDaC who are responsible for the preparation of the recurrent and capital budgets,
respectively. The MoF and MEDaC will notify the spending public bodies well ahead of time
about the important deadlines, the budget ceiling and other information through the budget
circular. The budgeting process usually took between six to eight months, and the MoF and
MoED will release the budget circular around November to December.

3.7.1. The Budgetary Process at the Federal Level

The budget processes at the Federal level follows sequential and iterative steps. These steps can
be explained with the help of the following figure. Let us briefly explain these steps one by one
hereunder.
Step I: Macro-Economic and Fiscal Framework
The preparation of the macro-economic and fiscal framework is basically a component of the
recently initiated public investment program (PIP). It is a planning practice and as stated in
Ministry of Economic Development, the macro-economic and fiscal framework determines the
overall level of government expenditures based on policies related to the role of government in
the economy, government deficits, and priorities for resource allocation between regions and
sectors. For the Federal government the framework is a three years forecast and will be updated
each year.

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Preparation of Revenue forecast & Allocate federal &

macroeconomic & expenditure budget regional
fiscal frame ceiling expenditures

Budget review by Budget call & ceiling Allocationof recurrent

MoF & MoED & capital budgets

Budget hearing & Review & Submit to Council of

defense recommendation Ministers

Submit to Council of
Allotment of budget Notification &
Peoples’
publication of budget
Representatives

The framework is composed of macro-economic forecast and fiscal forecast. The macro-
economic forecast gives the forecast of Gross Domestic Product based on past performance and
estimates for future years, and provides baseline information in preparing the fiscal forecast.
Financial Regulation 17/1997 gave the responsibility of preparing this framework to the Ministry
of Economic Development (MoED). Whereas, the later, establish the level of total resources
available for expenditure. It provides a more detailed forecast of revenue (both Federal and
Regional), end projection of expenditure. Given the policy of no borrowing from domestic banks
to finance budget deficit the level of expenditure mainly depends on the amount of resources to
be raised in the form of domestic revenues and external fund that include counterpart funds. Once
prepared by the concerned coordinating ministries, i.e. MoF and MoED, it will be reviewed and
approved by the Prime Minister’s Office (PMO).
Step II: Determination of Federal Government Expenditure and Subsidy to Regional
Governments
After the revenue and expenditure of the government are estimated through the fiscal framework,
the PMO will decide on the shares of Federal government expenditures and subsidies to Regional

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governments. It is known that, following the decentralization policy, Regional governments took
grants from the Federal government in the form of subsidy.

Once the amount of subsidy is known, the allocation among regions is determined based on a
formula. Initially the formula was composed of five parameters (population, level of
development, revenue generating capacity, utilization capacity, and land area). At present,
however, the formula takes account of three parameters: population, the level of development,
and revenue generating capacity of each region which are given a relative weight of 60%, 25%
and 15% respectively. This allocation will first be prepared by MoED, then reviewed by the
PMO and finally approved by the Council of Peoples’ Representatives.
Step III: Allocation of Federal Expenditure between Recurrent and Capital Budget
The practice in the allocation of recurrent and capital budget is to consider the latter as a residual.
That is, first the amount of budget necessary to cover such recurrent expenditures like pensions,
debt servicing, wages and non-wage operating costs will be determined. The balance will then be
allotted to capital expenditures. This will be performed by the PMO in consultation with MoF
and MoED.
Step IV: Budget Call and Ceiling Notification
This includes two items.
1. Recurrent budget: MoF will release the budget ceiling to the line ministries in a budget call.
The budget call provides each ministry such information as the macro-economic
environment, an aggregate recurrent budget ceiling, and priorities to budget.
2. Capital Budget: MoED issues detailed capital budget preparation guidelines to spending
public bodies along with the ceilings provided to each line institution. MoED will set the
ceiling for each sector.
Step V: Budget Review by MoF and MoED
This includes two items.
1. Recurrent Budget: Prior to a formal budget hearing, spending public bodies will submit their
budget proposals to the MoF Budget Department. In consultation with spending public
bodies, MoF will prepare an issue paper on major issues at each head level in the proposed
budget. Here, spending public bodies can submit above the ceiling but need to have a
compelling justification

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2. Capital Budget: The sector departments of MoED review the capital budget requests from
different public bodies. At this stage, projects will be screened. If there exist a discrepancy
between the respective sector department and the public body, a series of discussions will be
held to reach agreement. After such a process, the various sector departments of MoED will
submit their first round recommendation to the Development Finance and Budget Department
of MoED. Then it will be consolidated and prepared for the capital budget hearing and
defense.
Step VI: Budget Hearing and Defense
This includes two items.
1. Recurrent Budget: Spending public bodies defend their budget submission in a formal
hearing with the MoF. The issue paper will be the basis of the hearing. The hearing focuses
on policies, programs and cost issues, when necessary it might involve discussion down to
line item. Spending public bodies could also challenge the ceiling. Presenting the hearing will
be ministers and/or vice ministers, heads of public bodies and the MoF.
2. Capital Budget: Spending public bodies will be called to defend their projects to a budget
hearing convened by the PMO which will be chaired by the Prime Minister or the Deputy
Prime Minister or their economic advisers. The hearing customarily includes a review of
status of the project, implementation capacity of the institution, compatibility with the
countries development strategy and policy, cost structure, and regional distribution. A project
description will be presented which includes objectives of the project, main activities of the
project, status of the project, total cost, past performance of the project, source of finance, and
whether the project is accepted or rejected by MoED. Based on the discussion the respective
sector departments of MoED in consultations with the spending public body will further
refine the capital projects.
Step VII: Review and Recommendation:
This includes two items.
1. Recurrent budget: After the hearing is over, the budget committee of the MoF will review the
discussion and make a recommendation. If there is an increase (over ceiling) this will go to
the PMO for approval.
2. Capital budget: After the hearing and defense with the PMO and MoED, sector departments
of MoED will give a final recommendation to the development finance and budget

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department of MoED. This will then be compiled and put in appropriate formats for
submission to the council of ministers.
Step VIII: Submission to the Council of Ministers
At this stage the two budgets (recurrent and capital) will be consolidated, and MoF will prepare a
brief analysis of the total budget.
1. Recurrent budget: The recommended budget will be submitted to the deputy Prime Minister
for economic affairs. This will first be reviewed by ministers and vise ministers in economic
affairs, and then presented to the Prime Minister along with a brief. The Prime Minister may
or may not make amendments and then the budget will be sent to the council of Ministers for
discussion.
2. Capital Budget: A brief analysis of the capital budget will be prepared by MoED on the final
recommended budget and, along with the consolidated capital budget, will be submitted to
the council of ministers. MoED will defend the budget in the council. The council of
ministers may make some adjustment and the draft capital budget will pass the first stage of
approval.
Step IX: Submission to the Council of Peoples’ Representatives
Once approved by the council of ministers, the Prime Minister will present both the recurrent and
capital budget to the council of peoples’ representatives. The budget will then be debated based
on the recommendation of the budget of the committee.
Step X: Notification and Publication
The approved budget will then get the legal status through the publication in the ‘Negaret
Gazeta.’ Spending public bodies will then formally be notified of their approved budget by line
items from MoF and MoED for recurrent and capital budgets, respectively. MoF will notify
spending public bodies through Form 3/1. Likewise, MoED will inform through Form 3/2. Both
Forms will be copied to the Treasury Department of the MoF which disburse funds to spending
public bodies. Until Form 3/1 is released spending public bodies are authorized to spend one-
twelfth of the previous year’s budget with no provision for new expenditures (e.g. new staff
posts) in the case of recurrent budget. For capital budget spending public bodies are authorized to
use approved budget for ongoing projects even when Form 3/2 is not released.
The final stage of the budgetary process is to request spending public bodies to prepare adjusted
work plan and cash flow for the approved budget. The adjusted work plan and cash flow will be

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verified by MoF-for the recurrent budget-and by MoED-for the capital budget, and then will be
sent to the treasury Department of the MoF.
STEP XI: Supplementary Budget
In the course of the budget year supplementary (additional) budget will be proclaimed when
necessary, following almost the same process as the initial budget preparation. Likewise, budget
reallocation will be made mainly based on performance.

3.7.2. The Budgetary Process at the Regional Level

It is quite difficult to present the budget process at the Regional level in the way discussed for
Federal Budgeting. At present the budget process followed by regions is not uniform. Hence, let
us discuss the process of budgeting in a more general terms without referring to a particular
region.
The process is more or less a mirror image of the Federal budget process. In place of MoF the
Regional Finance Bureau (RFB) is responsible for the preparation of the recurrent budget. While
the Regional planning and Economic Development bureau (RPEDb) is responsible for the capital
budget. At the higher level the Regional council is the one responsible for the appropriation of
the region’s budget. One significant deviation is, the regional budget process starts at the woreda
level and goes up to Zone and Region levels.
Pre-ceiling Budgeting
Pre-ceiling budgeting is the budgeting practice at the woreda and zone levels before the region
receives its subsidy/grant from the Federal government. The process is as follows: the woreda
prepares a budget with no indicative or final ceiling from the Zone or the Region. The Finance
Office will consolidate the budget of the sectoral offices and submit to the woreda council. The
woreda executive committee will then form a budget committee to review the budget. This
budget will be sent to the zone through two channels: one, the woreda counsel submit the budget
to the zone executive committee, second, the woreda sectoral offices send to the zone sectoral
departments. The zone executive committee will then form a budget committee that will be
chaired by the head of the Finance Department, to review the woredas’ and zones’ budget
proposal.
In passing the budget to the region it will again be through two channels. The zone executive
committee submits to the Region executive committee and the zone sectoral departments will

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submit to the region sectoral bureaus. The sectoral bureaus then prepare a budget submission to
the Region Finance Bureau.

Post-ceiling Budgeting
Following the notification of the subsidy from the Federal government, the regional public
expenditure envelope will be determined based on the Federal subsidy, local revenue and local
borrowing. Once the expenditure envelope is set, then it will be split up between recurrent and
capital expenditures. The practice is similar to the Federal government, i.e. the allocation begins
with recurrent expenditures and the balance of the envelope will be reserved for capital
expenditures.
After this stage, different regions follow different approaches to allocate recurrent expenditure
between salary and organization and management, and to allocate capital expenditure among the
different sectors. In some regions, the budget will be prepared up to line items at the region level,
whereas in some regions a lump sum will be allotted to zones that will be in turn allocated to
woredas. At last, the budget will be published in the region’s ‘Negarit Gazeta’.

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Unit Four

Ethiopian Tax System

Chapter Objectives
After the completion of this chapter, the students will be able to:
 Understand the structure and administration of Ethiopian tax system
 Know the income tax laws and practices
 Realize about consumption taxes
 Elaborate the stamp duties
 Understand foreign trade taxes

4.1. Structure of Ethiopian Tax System and Administration

The fundamental authority to tax is derived from the Constitution of 1995, which, following the
federal structure, shares tax powers between the Federal Government and the Regional States.
The Ethiopian Constitution goes to greater lengths than other areas of power in allocating
taxation powers between the Federal Government and the Regional States. The Constitution
classifies taxation powers as “taxes exclusive to the Federal Government,” “taxes exclusive to
the Regional States,” “taxes concurrent to both the Federal Government and the Regional
States.” With the exception of customs duties, which are the exclusive preserve of the Federal
Government, most other taxes are sliced into pieces by the Ethiopian Constitution and shared
between the Federal Government and the Regional States on the basis of certain set formulas.

The present federal fiscal system in Ethiopia is of a recent origin. The distribution of revenues
between the center and states is followed on the basis of "Constitution of Ethiopia” and
Proclamation No.33/1992-Proclamation “To Define sharing of Revenue between the Central
Government and the National/Regional Self Governments”. The Articles 96, 97, 98, 99 and 100
of The Constitution of Ethiopia make a clear demarcation of areas where the Central alone or
State alone have authority to impose taxes. It contains a detailed list of the functions and
financial resources of the Center and States.

The sharing between the central government and the National/Regional Governments shall have
the objectives of:

i. Enable the central Government and the National/Regional Governments efficiently carry
out their respective duties and responsibilities.

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ii. Assist National/ Regional Governments develop their regions on their own initiatives;
iii. Narrow the existing gap in development and economic growth between regions;
iv. Encourage activities that have common interest to regions
The sharing of revenue between the central government and the National/ Regional governments
shall take in to consideration the following Principles:

i. Ownership of source of revenue;

ii. The National or Regional character of the sources of revenue;
iii. Convenience of levying and collection of the tax or duty;
iv. Population, distribution of wealth and standard of development of each region;
v. Other factors that are basis for integrated and balanced economy.
The Ethiopian federal arrangement follows the dual structure in which all the three branches of
government (legislative, executive and judicial) coexist in respect of the Federal and Regional
powers. This, in taxation, means in principle that both the Federal Government and the Regional
States enjoy full legislative, executive, and judicial powers with respect to taxation powers
reserved to them. In practice, however, the Federal Government has had the most dominant
presence in the legislation of taxation, respecting not just “federal exclusive taxes” but also
“concurrent taxes” and at times even “regional exclusive taxes.” Although Regional States have
the prerogative to issue their own tax laws with respect to tax sources reserved to them by the
Constitution, many of the Regional States for a while used federal tax laws to levy and collect
regional taxes. The Regional States did not immediately exercise their legislative powers of
issuing their own tax legislations. Some of the Regional Governments have begun issuing their
tax legislations recently. However, the exercise of the legislative power over taxation still
remains a formal matter because the Regional Governments have yet to fully exercise their
taxation powers. Many of the Regional States that have issued their own tax laws have used
federal tax laws as models with the result that there is virtually no difference in substance
between federal tax laws and regional tax laws. One of the striking features of the Ethiopian
Constitution on matters of taxation is the unusual specificity and detail of provisions that assign
taxation powers between the Federal Government and the Regional States. Since the Ethiopian
Constitution is unusually concrete and specific in the area of tax powers, its language in this
respect leaves very little room for argument about which layer of government has what tax
powers. Nonetheless, some issues remain contentious. One is the exercise of concurrent powers.

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The Constitution gives out very little as to how the concurrent tax powers are to be exercised in
practice. Following the practice of other federal systems, several options may be open to both
layers of the Ethiopian federation. The Regional States may impose their own taxes in addition to
the Federal Government taxes. The Regional States may choose to impose additional tax rates on
an otherwise federal tax law. Or the Regional States may choose to agree with the Federal
Government to share the proceeds of federally collected taxes. The Federal Government levies
and collects concurrent taxes. The revenues from concurrent taxes are shared on the basis of a
revenue-sharing scheme approved in 2004 by the House of the Federation (HoF).

4.2. Income Taxes and Their Schedule

Apart from tracing the history of income tax in Ethiopia and discussing few items which are
instrumental to the understanding of this law, this topic has been entirely devoted to the analysis
of the substantive provisions of Proclamation No. 979/2016. In doing so, the five important
schedules of the proclamation have been separately discussed. Under these schedules, the tax
bases have been identified and discussed. The applicable rates have been shown and the
appropriate deductions and exemptions have also been carefully treated.

“Income” means every sort of economic benefit including non-recurring (to happen again or
number of times) gains in cash or in kind, from whatever source derived and in whatever form
paid, credited or received.

Gross income, in relation to a person, means the totalincome taxable under Schedules ‘B’ or ‘C’
derived by theperson without deduction of expenditures;
“Taxable income” means the amount of income subject to tax after deduction of all expenses and
other deductible items allowed under this Federal Income Tax Proclamation No.979/2016 and
Council of Ministers Federal Income Tax Regulations 410/2017.

4.2.1. Income Tax System

There are two important systems of income taxation that have been adopted by countries around
the world. These are the global and the scheduler systems of taxation.
a. The global system of income taxation: the tax is imposed on the total income of an
individual regardless of the types of activities that he/she pursues and regardless of the
sources from which he/she obtained his/her income. Accordingly, under the global system of
taxation, an individual has to declare his/her aggregate income for the purpose of taxation.

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b. The scheduler system of income taxation: is the system adopted in Ethiopia, takes the
different sources of income of an individual into consideration for the purpose of taxation.
Accordingly, income is identified by its sources and each source has its own procedures and
rates for the determination of income tax; thereby requiring an individual to declare his/her
income from each source separately. Under this system, each source of income is considered
to have its own identifying unique features for the purposes of taxation. Therefore, before
taxation, sources of income have to be properly identified according to the correct schedule
set by the system.

4.2.2. Schedules of Income

The Federal Income Tax Proclamation No 979/2016 Art (8) provides for the taxation of income
in accordance with the following schedules Schedule ‘A’, income from employment; Schedule
‘B’, income from rental of buildings; Schedule ‘C’, income from business; Schedule ‘D’, other
income;
Schedule ‘E’, exempt income.

4.2.2.1. Schedule ‘A’ Income from Employment

“Employee” means any individual, other than a contractor, engaged (whether on a permanent or
temporary basis) to perform services under the direction and control of the employer.
 Every person deriving income from employment is liable to pay tax on that income at the rate
specified in Schedule “A”, shown below. The first Birr 600 (six hundred Ethiopian Birr) of
employment income is excluded from taxable income.
 Employers have an obligation (Liability) to withhold the tax from each payment to an
employee, and to pay to the Tax Authority the amount withheld during each calendar month.
In applying preceding income attributable to the months of Nehassie and Pagumen shall be
aggregated and treated as the income of one month.
Without prejudice to Article 84 of Income Tax Proclamation No 979/2016, Employment income
tax shall be imposed for each calendar month or part thereof at the rate or rates specified in
Article 11 of this Proclamation on an employee who receives employment income during the
month or part thereof.
Employment income tax is taxes levied on the taxable income of employees of an organization
and withheld by the employer until paid to the tax authority. The amount deducted from earning

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of an employee as income tax determined based on the rate prescribed by ‘Income Tax
Proclamation’ No. 979/2016;
i. The first 600 Birr income from employment shall be exempt from payment of income tax in
all cases
ii. The income tax on income over 600 Birr shall be charged, levied and collected monthly
according to the following schedule
The rates of employment income tax are:
No. Employment Income Amount between Tax Rate Deduction (ETB)
per Month (ETB) Monthly Salary
1 0 – 600 Br 600 Exempted –
2 601-1,650 Br 1050 10% 60 Birr
3 1,651 – 3,200 Br 1550 15% 142.50 Birr
4 3,201 – 5,250 Br 2020 20% 302.50 Birr
5 5,251 – 7,800 Br 2550 25% 565 Birr
6 7,801 – 10,900 Br 3100 30% 955 Birr
7 Over 10,900 Br over 3100 35% 1,500 Birr

 According to Income Tax Proclamation’ No. 979/2016 Art 12 (1), employment income
means:
 salary, wages, an allowance, bonus, commission, gratuity, or other remuneration received by
an employee in respect of a past, current, or future employment; fringe benefits received by
an employee in respect of a past, current, or future employment;
 The value of fringe benefits received by an employee in respect of a past, current, or future
employment;
 An amount received by an employee on termination of employment, whether paid
voluntarily, under an agreement, or as a result of legal proceedings, including any
compensation for redundancy or loss of employment, or a golden handshake payment.
 Employment income shall not include exempt income Art 12 (2) of aforementioned
Proclamation.
 If an employer pays the employment income tax payable by an employee, in whole or part,
without withholding tax from the employment income of the employee, the amount of tax
paid by the employer shall be included in the employment income of the employee Art 12 (3)
of aforementioned Proclamation.

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The determination of employment income involves a series of steps and requires such as inputs
as taxable income and the use of relevant and appropriate tax rates. The determination of taxable
income, on the other hand, requires identifying categories of income that are exempted from the
payment of tax from these taxable under the law.
Neither the employer nor the employee has any choice in deducting taxes from gross earnings.
However, employees may choose to have additional amounts deducted for other purposes such
as deductions to pay life insurance premiums, to repay loan from the employer, to pay for
donation to charitable organization, contributions to "ldir" etc.
A permanent employee within a governmental organization in Ethiopia is expected to pay or
contribute 7% of their basic salary to the governments’ pension trust fund. The employer is also
expected to contribute towards this the same fund 11% of the basic salary of every permanent
government employee. It is payroll tax expense to the employer organization (11% of the basic
salary of all permanent employees)
Therefore, the total contribution to the pension fund of the Ethiopian government is equal to 18%
of the basic salary of all of its permanent employees. This amount is withheld by the employer
from each employee on every payroll and later be paid to the respective government body.
According to Private Organization Employees’ Pension Proclamation No. 715/2011 permanent
employee of a private organization contribution to Pension Fund shall be 7% of basic salary from
employee and 11% by the employer.
Overtime Earning
Overtime earnings are the amount paid to an employee for overtime work performed. Overtime
work is the work performed by an employee beyond the regular working hours. It is a payment
for extra hours worked beyond the regular working hours or day.
In Ethiopia, in this respect, article 68 of labor proclamation No. 377/2003 discussed the
following points about how overtime work should be paid;
i. A worker shall be entitled to be paid at a rate of one and one-quarter (1¼) times the
ordinary hourly rate for overtime work performed before 10:00 P.M in the evening
western time.
ii. A worker shall be paid one and one half (1½) times his ordinary hourly rate for overtime
work performed between 10:00 P.M and 6:00 A.M in the morning.

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iii. A worker shall be paid two (2) times the ordinary hourly rate for overtime work
performed on weekly rest days.
iv. A worker shall be entitled to be paid at a rate of two and one half (2 ½) times the ordinary
hourly rate for overtime work performed on a public holiday.
Gross Earning = Basic Salary + Allowance + Overtime Earning + Bonus
Ordinary Hourly Rate = Basic Salary ÷ Normal Working Hours during the Month
Over Time Earning = Overtime Hours Worked X Ordinary Hourly Rate X Relevant Overtime
Rate
Example 1: Ms. Anne received a monthly salary of Birr 5200 during the month June 2010, and
then the amount of tax liability and the amount received by her after the withholding of tax by
the employer from her salary would be:
Solution:
Taxable income = Birr 5,200
Employment income tax (tax liability) =taxable income × rate-deduction
= (5200×20%) – 302.5 = 737.50
Pension Contribution = 7% of permanent employee basic salary
= 7%x5200=364
Amount received by employee (net pay) = Gross pay- (deduction (tax) + Pension Contribution)
=5200- (737.50 +364) = 5200-1101.50 =4098.50
Example 2: ABC Enterprise is a government agency recently organized around Jimma and its
surroundings to rehabilitate street children. It has five employees whose salaries are paid
according to the Ethiopian calendar month. The following data relates to the month of Oct, 2009.
S. Basic Taxable Non-Taxable Overtime Hours worked
No. Name of Salary Allowance Allowance
6AM to 10 PM Weekly Public
Employee
10PM to 6AM Rest Day Holiday
01 Kiya yishalal Br. 7300 1500 700 10 Hrs
02 Meron chala 10200 500 850 6 Hrs
03 Sifen Beka 5300 1500 650 8 Hrs
04 Yosan Daniel 3700 700 500 10 Hrs
05 Fasil Tariku 11700 400
Additional Information:
i. The enterprise’s pay period (month) consists of 160normal working hours it pays the
overtime in accordance with set in article 68 of labor proclamation No. 377/2003.

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ii. There were no absentees during the month

iii. All employees are permanent except Fasil Tariku.
iv. Meron Chala agreed to contribute monthly Br. 300 from her salary as a monthly saving in
the credit association of the enterprise.
Required: Compute the taxable income of employment, tax payable and net pay of each
employee and prepare a payroll register (sheet) of the enterprise for the month of Oct, 2009.

Solution: Computation of Earnings, Deductions, and Net Pay

Gross Earnings = Basic salary + Allowance + Overtime Earning +Other earning

a. Kiya Yishalal:
First compute the regular hourly rate:
Basic salary Br 7300
Regular Hourly Salary Rate = Normal = 160 Hrs,
working Hours in the Month

Therefore, the regular hourly payment = Br. 45.625/hr.

OT Earning = Over time hours worked x Regular Hourly Salary Rate x Over time (OT) pay rate
Br 7300
Over time (OT) Earning =10 hrs. x x 1.25 Br = Br.570.31
160 Hrs

Gross Earnings = Basic salary + Allowance + OT Earning

Gross Earnings = Br. 7300 + Br. 2200 + Br.570.31 = Br. 10070.31
Gross Earnings …………………………………. Br. 10070.31
Taxable Employment Income = Gross Earning – Nontaxable allowance/Exempted income
Taxable Employment Income = Br. 10070.31 –700 = 9370.31
Employee Income Tax = Taxable Employment Income * tax rate – deduction related to tax bracket
Employment Income Tax =9370.31Br *30%-955= 1856.09 Br
Employment Income Tax can be calculated by using progressive method as follows
Allocation of monthly Income in the Income tax Employee Income
Taxable Employment Income range (a) rate(b) Tax(a*b)
0-600 600 0% 0.00
601-1650 1050 10% 105.00
1651-3200 1550 15% 232.50
3201-5250 2050 20% 410.00
5251-7800 2550 25% 637.50
7800-10900 1570.31 30% 471.09
Sum 9370.31 1856.09
Pension contribution = basic salary of permanent employee * rate of pension contribution
=Br. 7300 * 7%= Br. 511
Net pay= Gross Earnings – Total deductions
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= Br. 10070.31 - (1856.09+ Br. 511) = Br. 10070.31 -2367.09= 7703.22

b. Meron chala
First compute the regular hourly rate:
Basic salary Br 10200
Regular Hourly Salary Rate = Normal = ,
working Hours in the Month 160 Hrs

Therefore, the regular hourly payment = Br. 63.75/hr.

OT Earning = Over time hours worked x Regular Hourly Salary Rate x Over time (OT) pay rate
Br 10200
Over time (OT) Earning =6 Hrs. x x 1.5Br = Br.573.75
160 Hrs

Gross Earnings = Basic salary + Allowance + OT Earning

Meron chala: Gross Earnings = Br. 10200 + Br. 1350 + Br.573.75 = Br. 12123.75
Gross Earnings …………………………………. Br. 12123.75
Taxable Employment Income = Gross Earning – Nontaxable allowance/Exempted income
Taxable Employment Income = Br. 12123.75–850 = 11273.75
Employment Income Tax = Taxable Employment Income * tax rate – deduction related to tax bracket
Employment Income Tax = Br 11273.75 *35%-1500 = 2445.81 Br
Pension contribution = basic salary of permanent employee * rate of pension contribution
=Br. 10200* 7%= Br. 714
Voluntary monthly contribution for saving in the credit association of the enterprise Br. 300.
Net pay= Gross Earnings – Total deductions
Net pay = Br. 12123.75 – (Br. 2445.81+ Br. 714+Br. 300) = Br. 12123.75 –3459.81 = Br. 8663.94
c. Sifen Beka
First compute the regular hourly rate:
Basic salary Br 5300
Regular Hourly Salary Rate = Normal = 160 Hrs,
working Hours in the Month

Therefore, the regular hourly payment = Br. 33.125/hr.

OT Earning = Over time hours worked x Regular Hourly Salary Rate x Over time (OT) pay rate
Br 5300
Over time (OT) Earning =8Hrs. x x 2 Br = Br.530
160 Hrs

Gross Earnings = Basic salary + Allowance + OT Earning

Sifen Beka: Gross Earnings = Br.5300 + Br. 2150 + Br.530 = Br. 7980
Gross Earnings …………………………………. = Br. 7980
Taxable Employment Income = Gross Earning – Nontaxable allowance/Exempted income
Taxable Employment Income = Br. 7980–650 = Br. 7330

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Employment Income Tax = Taxable Employment Income * tax rate – deduction related to tax bracket
Employment Income Tax = Br. 7330 *25%-565 = 1267.50 Br
Pension contribution = basic salary of permanent employee * rate of pension contribution
=Br. 5300* 7%= Br. 371
Net pay= Gross Earnings – Total deductions
Net pay = Br. 7980– (Br. 1267.50+ Br. 371) = = Br. 7980–1638.5 = 6341.5
d. Yosan Daniel
First compute the regular hourly rate:
Basic salary Br 3700
Regular Hourly Salary Rate = = ,
Normal working Hours in the Month 160 Hrs

Therefore, the regular hourly payment = Br. 23.125/hr.

OT Earning = Over time hours worked x Regular Hourly Salary Rate x Over time (OT) pay rate
Br 5300
Over time (OT) Earning =10Hrs. x x 2.5 Br = Br.578.13
160 Hrs

Gross Earnings = Basic salary + Allowance + OT Earning

Yosan Daniel: Gross Earnings = Br. 3700 + Br. 1200 + Br.578.13= Br. 5478.13
Gross Earnings …………………………………. = Br. 5478.13
Taxable Employment Income = Gross Earning – Nontaxable allowance/Exempted income
Taxable Employment Income = Br. 5478.13–500 = Br. 4978.13
Employment Income Tax = Taxable Employment Income * tax rate – deduction related to tax bracket
Employment Income Tax = Br. 4978.13 *20%-302.5 = Br. 693.13
Pension contribution = basic salary of permanent employee * rate of pension contribution
=Br. 3700* 7%= Br. 259
Net pay= Gross Earnings – Total deductions
Net pay = Br.5478.13– (Br. 693.13 + Br. 259) = = Br. 5478.13–952.13 = Br. 4526
e. Fasil Tariku
Gross Earnings = Basic salary + Allowance + OT Earning + other benefits
Since Fasil’s monthly income is basic salary and non-taxable allowance, his gross earning is the
sum of basic salary and non-taxable allowance.
Fasil Tariku: Gross Earnings = Br. 11700 + Br. 400 = Br. 12100
Gross Earnings …………………………………. = Br. 12100
Taxable Employment Income = Gross Earning – Nontaxable allowance/Exempted income
Taxable Employment Income = Br. 12100– Br. 400= Br. 11700
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Employment Income Tax = Taxable Employment Income * tax rate – deduction related to tax bracket
Employment Income Tax = Br. 11700*35%-1500 = Br. 2595
NB. No pension contribution because he is not permanent employee of the organization.
Therefore, total deduction is the same as Employment Income Tax, Br 2595.
Net pay= Gross Earnings – Total deductions
Net pay = Br.12100– Br. 2595 = = Br. 9505
Payroll register (sheet) for the enterprise for the month of Oct, 2009.

Earnings Deductions
Employee Basic Allowa Over Gross Income Pension Other
No name salary nce time earnings tax contribution deduction Total Net pay Sign
deductions
01 Kiyayishalal Br. 7300 2200 570.31 10070.31 1856.09 511 2367.09 7703.22

02 Meronchala 10200 1350 573.75 12123.75 2445.81 714 300 3459.81 8663.94

03 SifenBeka 5300 2150 530 7980 1267.5 371 1638.5 6341.5

04 Yosan Daniel 3700 1200 578.13 5478.13 693.13 259 952.13 4526

05 Fasil Tariku 11700 400 12100 2595 2595 9505

Sum 38200 7300 2252.19 47752.19 8857.53 1855 300 11012.53 36739.66

Example 3) The following data relate to the income of W, X, Y, and Z for the month of Oct
2017.
Basic salary Allowances
Employee
Name of

(Br) Taxable Non Taxable Over time (hrs.)

allowance (Br) allowance(Br)
s

W 3200 600 - 15 (6:00 AM to 10:00 PM)

X 14000 800 800 8 (10:00PM to 6:00 AM)
Y 9200 2800 800 9 Weekly rest days
Z 7800 3000 1500 20 Public holidays
Assume number of normal working hours during the month are 140. Compute the taxable
income, tax payable and net pay of W, X, Y and Z.

Example 4) Mr. Lelasew gets basic salary of birr 15,000 per month. He also gets hardship
allowance of birr 800 per month. During the year he felt sick and was hospitalized and the
employer paid him medical bills amounting to birr 600. His contribution to provident fund is
20% of his salary and his employer contributes 18% of his salary towards provident fund.

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Moreover Mr. Lelasew has worked 22 overtime hours during (10:00PM to 6:00 AM). Assume
number of normal working hours during the month are 160.

Required: Compute the taxable income, tax payable and net pay of Mr. Lelasew

4.2.2.2. Schedule ‘B’ Income from Rental of Buildings

Any income arising from rental of buildings is taxable under schedule ‘B’. Rental income
includes all form of income from rent of a building and rent of furniture and equipment if the
building is fully furnished. Income from the lease of business including goods, equipment and
building which are part of the normal operation of a business, (called business lease) are taxable
under another schedule that is in schedule ‘C’

Gross rental income also includes any cost incurred by the lessee for improvement to the land or
building all payments made by the lessee on behalf of the lessor in accordance with the contract
lease. In the lease contract there are two parties involved in renting a building, the lessor and the
lessee. The party who grants rent of the building is the lessor. The one who leases the property
for use is the lessee. In some occasions the lessor may allow the lessee to sub lease the building
for another party. In such circumstances the first lessee becomes the sub-lessor. The sub lessor
must pay tax on the difference between income from the sub leasing and the rent paid to the
lessor, provided that the amount received by the sub lessor. The owner of the building who
allows a lessee to sub- lease is liable for payment of the tax for which the sub lessor is liable, in
the event the sub-lessor fails to pay.
Gross income includes all payments, either in cash or benefited in kind, received by the lessor
and all payments made by the lessor on the behalf of the lessee. The value of any renovation or
improvement to the land or the building is also part of taxable income under this schedule if such
cost is borne by the lessee in addition to rent payable. If a taxpayer leases a furnished building,
the gross amount of income derived by the taxpayer from the lease of the building shall include
any amount attributable to the lease of the furniture or equipment. The gross amount of income
derived by a taxpayer from the lease of a building shall not include exempt income.
When a building is constructed for the purpose of giving on lease, the owner and contractor
should inform the Kebele Administration about its completion and the intention of giving it on
lease. This is also applicable when the building is rented before its completion. The Kebele
Administration will pass the information to the tax office for the administration of tax. It is also

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the responsibility of Kebele administration to gather any such information and communicate to
tax office in case where the parties fail to do so.
Taxable Income Rental Income
The taxable rental income of a taxpayer for a tax year is the gross amount of income derived by
the taxpayer from the rental of a building for the year reduced by the total amount of deductions
allowed to the taxpayer for the year.
In computing the taxable rental income for a tax year of a taxpayer who does not books of
account, a maintain deduction shall be allowed for the following amounts:
 Any fees and charges, but not tax, levied by a State or City Administration in respect of the
land or building leased and paid by the taxpayer during the year;
 An amount equal to fifty percent (50%) of the gross rental income derived by the taxpayer
for the year as an allowance for the repair, maintenance, and depreciation of the building,
furniture, and equipment. The provisions this shall not be applicable for taxpayers who are
required to maintain books of account under Income Tax Proclamation No 979/2016, for any
reason what so ever.
In computing the taxable rental income for a tax year of a taxpayer who maintains books of
account, a deduction shall be allowed for any expenditures to the extent necessarily incurred by
the taxpayer in deriving rental income and paid during the year including: the cost of the lease of
land on which the building is situated; repairs and maintenance; depreciation of the building,
furniture and equipment; interest and insurance premiums; and fees and charges, but not tax,
levied by a State or City Administration in respect of the land or building leased.
Rental Income Tax Rates
 The rate of rental income tax applicable to a body is thirty percent (30%) of taxable income,
 The rates of rental income tax applicable to an individual are:
No. Taxable Rental Amount in the taxable Tax Rate Deduction in Birr
Income (per year) Rental Income range
Birr per year in Birr
1 7,200 Exempted –
0 -7,200
2 12,600 10% 720
7,201-19,800
3 18,600 15% 1,710
19,801-38,400
4 24,240 20% 3,630
38,401-63,000

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5 30,600 25% 6,780

63,001-93,600
6 37,200 30% 11,460
93,601-130,800
7 Over 37,200 35% 18,000
Over 130,800

In order to compute the taxable income from rental of building we use the following approach.

Descriptions Amount in Amount in

birr birr
Rental Income Received xxxxx
Add: Amount received on the
i) Lease of furniture xxx
ii) Lease of equipment xxxxx Xxxxxx
Deductions: For those not maintain books of accounts
Fees and charges, but not tax, levied by a State or City Administration xxxx
in respect of the land or building leased and paid by taxpayer
Allowance for repair, maintenance and depreciation (50% of gross xxxx
income) (OR)
Deductions: For those maintain books of accounts
 Expenses on
a. Cost of lease of land xxxx
b. Repairs xxxx
c. Maintenance xx
d. Depreciation of building, furniture and Equipment’s xxx
e. Interest on bank loans xxx
f. Insurance premiums xxxxxx (xxxxxxx)
Taxable Income from rental of Buildings Xxxxxx
Example 1. Mr. Hechamo has a building that is available for rent. The following are the details
of the property let out
 He has let out for twelve month
 Actual rent for a month is birr Br. 10,400
 He paid 15% of the actual rent received as land taxes and 3% as other taxes
 He spent birr Br. 70,000 for maintenance of the building
 Depreciation of the building Br. 105,000
 Interest and insurance premiums on building Br. 75,000
Required: Compute the taxable income and tax liability, Mr. Hechamo does not maintain books
account and records.
Solution:
Annual rental income (birr 5,200*12 months) ……………………………… Br. 124,800

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Less: allowable deductions

Maintenance (50% of124,800) ……………………………….. Br. (62,400)
Taxable income…………………………………………… Br. 62,400
 Then tax liability should be calculated as follows
= taxable income* tax rate- deduction
= Br. 62,400*20%- Br. 3,630= Br. 8,850
Example 2) Assumes that in example 1, Hechamo is required to maintain books account and
records his monthly rental income is 50,300 and costs are the same to the data given in
example one above.
Required: compute the taxable income and tax liability
Solution:
Annual rental income (birr 50,300*12 months) ------------- Br. 603,600
Less: allowable deductions
 Maintenance expense ------------------------- Br. 70,000
 Depreciation of the building ……………... 105,000
 Interest and insurance premiums on building. 75,000 Br. 250,000
Taxable income…………………………….. Br. 353,600
 Then tax liability should be calculated as follows
= taxable income* tax rate- deduction
= Br. 353,600*35%-18,000=Br. 105,760

4.2.2.3. Schedule ‘C’ Income from Business

This is tax imposed on the taxable business income or net profit realized from entrepreneurial
activity. Taxable business income would be determined per tax period on the bases of the profit
and loss account or income statement.

According to Income Tax Proclamation No 979/2016 (20) Taxable Business Income of a

taxpayer for a tax year shall be the total business income of the taxpayer for the year reduced by
the total deductions allowed to the taxpayer for the year. It shall be determined in accordance
with the profit and loss, or income statement, of the taxpayer for the year prepared in accordance
with the financial reporting standards, subject to other provisions of this Proclamation, “Council
of Ministers Federal Income Tax Regulation No.410/2017”, and Directives issued by the

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Minister. According to aforementioned Proclamation, the business income of a taxpayer for a tax
year shall include the gross amounts derived by the taxpayer during the year from the conduct of
a business, including the gross proceeds from the disposal of trading stock and the gross fees for
the provision of services (other than employment income); a gain on disposal of a business asset
(other than trading stock) made by the taxpayer during the tax year; any other amount included in
business income of the taxpayer for the tax year under this Proclamation, but it shall not include
an amount that is exempt income.
The business income of a taxpayer for a tax year shall include the gross amounts derived by the
taxpayer during the year from the conduct of a business, including the gross proceeds from the
disposal of trading stock and the gross fees for the provision of services (other than employment
income); a gain on disposal of a business asset (other than trading stock) made by the taxpayer
during the tax year; any other amount included in business income of the taxpayer for the tax
year under aforementioned Proclamation, but it shall not include an amount that is exempt
income.
In determining the taxable income of a taxpayer for a tax year, the deductions allowed to a
taxpayer shall include any expenditure to the extent necessarily incurred by the taxpayer during
the year in deriving, securing, and maintaining amounts included in business income; the cost of
trading stock disposed of by the taxpayer during the year as determined in accordance with the
financial reporting standards; the total amount by which the depreciable assets and business
intangibles of the taxpayer have declined in value during the year from use in deriving business
income as determined under Article 25 of the Income Tax Proclamation No 979/20 ; a loss on
disposal of a business asset (other than trading stock) disposed of by the taxpayer during the
year; any other amount allowed as a deduction to the taxpayer under this Proclamation for the
year.
Corporate business organizations are required to pay 30% flat rate of business income tax.
Unincorporated or individual businesses are taxed in accordance with the following table:

No. Taxable Business Amount in the taxable Business income Deduction in Birr
Income (per year) income range per year in Tax Rate
Birr Birr

1 7,200 Exempted –
0 -7,200
2 12,600 10% 720
7,201-19,800

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3 18,600 15% 1,710

19,801-38,400
4 24,240 20% 3,630
38,401-63,000
5 30,600 25% 6,780
63,001-93,600
6 37,200 30% 11,460
93,601-130,800
7 Over 37,200 35% 18,000
Over 130,800

Example 1. Annual taxable business income of Mr. Lulu’s is 72,500 Br and 130, 800 Br. for the
year 2009 and 2010 respectively.
i. Compute the business income tax of Lulu for year 2009 and 2010 respectively, if he is
individual taxpayer in Ethiopia.
ii. Compute the business income tax of Lulu for year 2009 and 2010 respectively, if he is
corporate taxpayer in Ethiopia.
Solution:
i. Business income tax= taxable income x Tax rate – Deduction
 Taxable income of Lulu for 2009 is Birr 72500 which is found between taxable income range
of Birr 63,001-93,600, income tax rate of 25% and its deduction is Birr 6780. Therefore,
business income tax of Lulu for 2009 = Br. 72500x25%- Br. 6780= Br. 11345.
 Taxable income of Lulu for 2010 is Birr 130,800 which is found in the upper limit of 30%
income tax rate and lower limit of 35%, it gives the same result by using 30% and 35%
Accordingly, by using 30% business income tax of Lulu for 2010 = Br. 130,800x30%- Br.
11,460= Br. 27780. Or
By using 35%, business income tax of Lulu for 2010=Br.130,800x35%- Br. 18,000=Br.
27,780
ii. In Ethiopia, business income tax for corporation is 30% of taxable business income tax.
Therefore, business income tax of Lulu for 2009= Br. 72500x30% = Br. 21750, and
business income tax of Lulu for 2010= Br. 130,800x30% = Br. 39,240.
Example 2. Mr. Lulu and Ms. Martha are Category “C” taxpayers. Annual sale of Mr. Lulu for
the year 2010 is 492,500 Br according to “Council of Ministers Federal Income Tax Regulation
No.410/2017” which is found annual income range of (Br. 475,000 to Br. 500,000) from Transit
Service (annual average profit rate 30%) and annual sale of Ms. Martha for the year 2010 is 423,
800 Br. according to “Council of Ministers Federal Income Tax Regulation No.410/2017” which

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is found annual income range of (Br. 400,00 to Br. 425,000) from Vocational and Skill Trainings
(annual average profit rate 28%). Compute the taxable business income and business income tax
of Mr. Lulu and Ms. Martha.
Solution:
Taxable business income of Category “C” taxpayer = Annual sales x annual average profit rate
Business income tax = taxable income x Tax rate – Deduction
Taxable business income of Mr. Lulu = Br. 492,500 which is found between income range of Br.
475,000 to Br. 500,000, for the computation of taxable business income the upper limit annual
sales and annual average profit rate are base for its calculation. Therefore, taxable business
income of Mr. Lulu = 500000x30%= Br. 150,000
Business income tax = taxable income x Tax rate – Deduction

Business income tax = Br. 150,000*35%-18,000=Br.34,500.

Example 3. Mr. Lulu and Ms. Martha are Category “C” taxpayers. Annual sale of Mr. Lulu’s for
the year 2010 is 492,500 Br according to “Council of Ministers Federal Income Tax Regulation
No.410/2017” which is found annual income range of (Br. 475,000 to Br. 500,000) from
Construction Material Production (annual average profit rate 18%) and annual sale of Ms.
Martha for the year 2010 is 423, 800 Br. according to “Council of Ministers Federal Income Tax
Regulation No.410/2017” which is found annual income range of (Br. 400,00 to Br. 425,000)
from Attorney Service (annual average profit rate 25%). Compute the taxable business income
and business income tax of Mr. Lulu and Ms. Martha.
Note: according to Council of Ministers Federal Income Tax Regulation No.410/2017 Art 49 (2),
the annual taxable income of a tax payer shall be assessed in accordance with the maximum
annual turnover in the income bracket within which the annual gross income of the tax payer
falls.
Declaration and Assessment of Schedule B and C Income
For the purpose of declaration and payment of income tax, schedule “B” and schedule “C”
income tax payers are classified into three categories, known as category “A” category “B” and
category “C”. The difference of and the requirements from each category are summarized in the
table below:
Basis of classification Requirements basis for assessment Period of payment
Taxpa
Categ
ory of

yers

and declaration

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A  Taxpayer being a body; orany  Balance sheet Within four months

other person having an annual  Profits and loss statement from the end of the
gross income of Birr 1,000,000  Details of gross profit and the tax payers tax year
or more manner in which it is computed,
general and administrative expense,
depreciation, provisions and
reserves
B  Taxpayer being a person, other  Profit and loss statement Within two months
than a body , having an annual  Vouchers supporting the above from the tax payers
gross income of Birr 500,000 tax year
or more but less than
1,000,000;
C  Taxpayer being a person other  A standard assessment method shall Hamele 1 to Hamele
than a body, having an annual be used to determine the income tax 30 of each year (on
gross income of less than Birr liability. (fixed amount) and the 7th day of July to
500,000  The tax will be paid in accordance the 6th day of August
with schedule attached with the each fiscal year in
Council of Ministers Regulation No accordance with the
410/2017 Regulations, in
 If the taxpayer maintains Gregorian calendrer)
accountable books of accounts, the
tax will be paid based on such books

Note that, the Minister shall, after ascertaining by economic analysis, change at least within five
years the annual gross income thresholds Federal Income Tax Proclamation No. 979/2016 sub-
Article (1) of Article (3) for the classification of a taxpayer as a category ‘A’ taxpayer category
“B” taxpayer or category “C” taxpayer.

4.2.2.4. Schedule ‘D’ –Other Income

Incomes which are not specifically included under Schedule A, Schedule B and Schedule C is
categorized under this schedule. According to Income Tax Proclamation No 979/2016 Article
(51-64), Schedule D income includes;
 Income of non-residents, taxation of recharged technical fees and royalties, taxation of non-
resident entertainers, royalties, dividends, interest, income from games of chance, income
from casual rentals, gains on disposal of certain investment asset, windfall profit,
undistributed profit, repatriated profit, other income, tax under Schedule D shall not apply to:
an amount that is liable to tax under another schedule and an amount that is exempt income.
This section covers the determination of taxable income, tax rate and payment of tax with respect
to the above listed types of incomes.
i. Income of Non-residents: A non-resident who has derived an Ethiopian source dividend,
interest, royalty, management fee, technical fee, or insurance premium shall be liable for

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non-resident tax at the rate specified in sub-article (2) of Income Tax Proclamation No
979/2016 Article (51). The rate of non-resident tax is:
a) for an insurance premium or royalty, 5% of the gross amount of the premium or royalty;
b) for a dividend or interest, 10% of the gross amount of the dividend or interest;
c) for management or technical fee, 15 % of the gross amount of the fee.
ii. Taxation of Recharged Technical Fees and Royalties A non-resident entertainer or group
of non-residententertainers who has derived income from the participationby the entertainer
or group in a performance taking place inEthiopia shall be liable for income tax at the rate of
10% onthe gross income derived from the performance withoutdeduction of expenditures.
iii. Taxation of Non-resident Entertainers: A non-resident entertainer or group of non-resident
entertainers who has derived income from the participation by the entertainer or group in a
performance taking place in Ethiopia shall be liable for income tax at the rate of 10% on the
gross income derived from the performance without deduction of expenditures.
iv. Royalties: A resident of Ethiopia who derives a royalty shall be liable for income tax at the
rate of 5% on the gross amount of the royalty. A non-resident who derives an Ethiopian
source royalty that is attributable to a permanent establishment of the non-resident in
Ethiopia shall be liable for income tax at the rate of 5% on the gross amount of the royalty.
v. Dividends: resident of Ethiopia who derives a dividend shall be liable for income tax at the
rate of 10% of the gross amount of the dividend. A non-resident who derives an Ethiopian
source dividend that is attributable to a permanent establishment of the non-resident in
Ethiopia shall be liable for income tax at the rate of 10% on the gross amount of the
dividend.
vi. Interest: A resident of Ethiopia who derives interest shall be liable for income tax at the rate
of: in the case a savings deposit with a financial institution that is a resident of Ethiopia, 5%
of the gross amount of the interest; or in any other case, 10% of the gross amount of the
interest.
vii. Income from Games of Chance: A person who derives income from winning at games of
chance held in Ethiopia shall be liable for income tax at the rate of 15% on the gross amount
of the winnings.this shall not apply when the winnings are less than 1000 Birr.

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viii. Income from Casual Rentals: A person who derives income from the casual rental of asset
in Ethiopia (including any land, building, or movable asset) shall be liable for income tax on
the annual gross rental income at the rate of 15% of the gross amount of the rental income.
ix. Gains on Disposal of Certain Investment Asset: A person who derives a gain on the
disposal of immovableasset, a share, or bond (referred to as a “taxable asset’) shallbe liable
to pay income tax.
x. Windfall Profit: Windfall profit obtained from businesses prescribed in adirective to be
issued by the Minister shall be liable to tax ata rate to be determined in such Directive.
xi. Undistributed profit: Tax shall be paid at the rate of 10% on the net undistributed profit of a
body in a tax year to the extent that it is not reinvested, in accordance with the directive to be
issued by the Minister.
xii. Repatriated Profit: A non-resident body conducting business in Ethiopia through a
permanent establishment shall be liable for tax at the rate of 10% on the repatriated profit of
the permanent establishment.
xiii. Other Income: A person who derives any income that is not taxable under Schedule A, B, C,
or this Schedule (Schedule D) shall be liable for income tax at the rate of 15% on the gross
amount of the income.

4.2.2.5. Schedule ‘E’ – Exempt Income

According to Income Tax Proclamation No 979/2016 Art 65, some of the exempt income are
listed below.
a. an amount paid by an employer to cover the actual cost of medical treatment of an employee;
b. an allowance in lieu of means of transportation granted under a contract of employment;
c. a hardship allowance;
d. transport expenses and per diem payments to an employee travelling on a tour of duty;
e. travelling expenses paid to an employee recruited from place other than the place of
employment on joining or completion of employment, including, in the case of a foreign
employee, travel expenses from and to their country of origin, but only if the travel expenses
have been paid pursuant to specific provisions of the employee’s contract of employment;
food and beverages provided for free to an employee by an employer conducting a mining,
manufacturing, or agricultural business;
f. allowances paid by the Government of the Federal Democratic Republic of Ethiopia to

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employees engaged in public service in a foreign country

4.3. Consumption Taxes

A consumption tax is a broad category of tax that is levied on the consumption value of goods
and services. Examples of consumption taxes include retail sales taxes, excise taxes, value added
taxes, import duties etc. Consumption taxes are paid for by consumers rather than businesses,
even though they may originally be paid by a business that passes the tax along to the consumer
in the selling price. Consumption taxes are generally not collected by the government directly
from consumers. Rather, they are collected by vendors at the retail level, who then pay the
national or state taxing authority.

The effects of a consumption tax are somewhat different from those of a production tax or
income tax. A consumption tax tends to encourage savings and investment and discourage
consumption. Excise taxes in particular are often used to regulate the consumption of certain
goods, including luxury items, cigarettes, and alcoholic beverages. Those who put forth the
argument for a national consumption tax in the United States point to it as a revenue source that
could be used to reduce the national deficit and improve the nation's trade balance.

These taxes are borne by consumers who pay a higher retail price for the good or service. The
higher price includes the consumption tax which is collected by the vendor and remitted to the
appropriate federal, state, or local government. Consumption taxes are often levied at different
rates on different commodities according to perceptions of whether a commodity is considered a
necessity (such as food) or a luxury (such as jewelry).

4.3.1. Value-Added Tax

The introduction of value Added Tax (VAT) is probably the most important tax development in
the world. VAT has been introduced for the first time almost 50 years ago, and its applications
remained confined to a handful of countries until the late 1960’s. Today, VAT is applied in over
120 countries. This makes about 4 billion people or 70% of the world’s populations live in
countries with a VAT. In these countries VAT raises about $18 trillion in tax revenue, roughly a
quarter of all governments revenue. The Federal Democratic Republic of Ethiopia recently has

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joined the over 120 countries of the world that have already adopted VAT into their tax system.
VAT is introduced in Ethiopia with the following main objectives.

 To minimize the damage caused by attempts to avoid and trade the tax and ascertain the
profit obtained by tax payables.
 To enhance economic growth and import the ratio relationship between from Domestic
Production and Government Revenue.
 To enhance saving and investment as it is essentially a consumption tax and does not tax
capital.
The key feature of this form of tax is that it is charged and collected throughout the production
and value adding processes with provisions for tax payable to be reduced by the tax point in
respect of purchases. It allows collection of tax on the added value wherever a sales transaction
is conducted. The law governing VAT requires the following persons to pay value added tax.

 A registered person – a person who is registered or required to be registered

 A person carrying out taxable import of goods, with respect to such import.
 A non-resident person who performs services without registration, with respect to such
services.
A person who is registered is taxable as soon as registration for VAT takes place. But a person
who fails to adhere to the registration requirement is considered to be taxable beginning from the
start of the accounting period following the period the obligation for registration arose.

The value-added tax is simply a multistage sales tax that exempts the purchase of intermediate
goods and services from the tax base. Value added is the difference between sales proceeds and
purchases of intermediate goods and services over a certain period.

The VAT belongs to the family of sales tax. A VAT may be defined as "a tax to be paid by the
manufacturers or traders of goods and services on the basis of value added by them". It is not a
tax on the total value of the commodity being sold but on the value added to it by the
manufacturer or trader. They are not liable to pay the tax on the entire value of the commodity.
But they have to pay the tax only on the net value added by them in the process of production or
distribution. Thus, the value added by them is the difference between the receipts (from the sale)

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and payments made to various factors of production (land, labor, capital and organization) in the
form of rent, wages, interest, and profits.

Taxable persons pay VAT on any activity carried on continuously or regularly in Ethiopia,
wholly or partly, whether or not for a profit, that involves or intends to involve in whole or in
part the supply of goods and services to another person for consideration.

Anything done in connection with the commencement or termination of a taxable activity is

treated as carried out in the course or furtherance of that taxable activity. Nonetheless, taxable
activity does not include any activity carried on by a natural person essentially as a private
recreational pursuit, hobby or an activity by a legal person having the same essence. Moreover,
an activity is not a taxable activity if it involves the making of exempt supplies.

Methods of Calculating VAT Liability

The value added by a firm can be calculated in any one of the following two methods:

Addition Method: Under this method, the value added by a firm i.e. the tax base is determined
by adding the payments made by the firm to the various factors of production such as wages,
rent, interest and profits i.e., add together the various elements that make up value-added. It is not
used and has not been proposed at the national level in any country.
Subtraction Method: In this method, the value added by the firm is determined by subtracting
the cost of production from the sales receipts of the firm. That is, subtract the cost of goods

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purchased from sales the value can be calculated. The subtraction method can be subdivided in to
two methods – credit-subtraction and sales subtraction method. The credit subtraction method is
further divided in it two: Credit Subtraction without invoices and credit subtraction with
invoices. The first method of credit subtraction VAT is European style VAT that relies on
invoices and is used with some variations almost all over the world. The other method of credit-
subtraction used in Japan as consumption tax does not rely on invoices. The Sales subtraction
VAT method is not common in use elsewhere. Now we shall explain these concepts with the help
of the following example.
Example
Let us assume that a business firm “A” sells taxable supplies and makes a taxable sale of Birr
80,000, and has taxable purchases of Birr 50,000 plus Birr 5,000 for the same period. We shall
also assume that the firm has imported supplies for Birr 10,000 and paid Birr 1,000 as VAT on
import. For this purpose, it is assumed that the firm pays Birr 15,000 compensation to workers,
pays Birr 3,000 in interest and rent expenses and has Birr 4,000 as a profit for VAT purposes.
With a 10% VAT rate, the firm's net VAT liability for the period is Birr 2,000, calculated as
follows.
i. Subtraction Method
a. Credit Subtraction VAT: with Invoice, VAT Liability of Firm A
Particulars Amount (in birr)
Output Tax on Sales
80,000 x 10% ( Rate of Tax) 8,000
Input Credit:
Taxable Purchases - 50,000 x 10% (5,000)
Taxable Imports - 10,000 x 10% (1,000)
Net VAT Liability for the Period 2,000
b. Credit Subtraction VAT: Without Invoices, VAT Liability of Firm A
Particulars Amount (in birr)
Output Tax on sales
80,000 x 10% ( Rate of Tax) 8,000

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Input Credit:
Taxable Purchases - 55,000 x 10/110 (5,000)
Taxable imports - 11,000 x 10/110 (1,000)
Net VAT Liability for the Period 2,000

c. Sales Subtraction VAT, VAT Liability of Firm A

Particulars Amount (in birr)
Taxable Sales 88,000
Taxable Purchases:
Domestic (55,000)
Imports (11,000)
Tax Base 22,000
Tax Rate 9.0909%
Net Vat Liability for the Period 2,000

II. Addition Method, Taxable Profit

Particulars Amount (in birr)
Taxable Sales 88,000
Expenses:
Compensation (15,000)
Interest & Rent Expenses (3,000)
Purchases (66,000)
Profit for VAT Purposes 4,000
VAT Liability of Firm A
Particulars Amount (in birr)
Compensation 15,000
Interest & Rent Expenses 3,000
Profit for VAT Purposes 4,000
Tax Base 22,0000
Tax Rate 9.0909%

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Net VAT Liability for the Period 2,000

Where uniform rates exist 10% in our example, both addition and subtraction methods yield
identical results in terms of tax revenue. While tax evasion through exaggeration of cost is
possible under the first method, it is not possible under the tax credit method, since there is the
need to submit vouchers of tax paid. The tax credit system is, therefore, superior and is being
followed in many developed and developing countries.
Example: Now we can explain the concepts of VAT with the help of the following example. Let
us assume a consumer product is clothing and the number of stages involved is six before it
reaches the ultimate consumers and the rate of tax is 15%.

No. Stage Receipt Purchase Value Added VAT at 15 Percent Rate

1 Farmer 700 0 700 105
2 Ginner 1000 700 300 45
3 Spinner 1500 1000 500 75
4 Weaver 2100 1500 600 90
5 Wholesaler 2300 2100 200 30
6 Retailer 2400 2300 100 15
Sum 2400 360

A VAT, then, is a percentage tax on value added applied at each stage of production. In the
above example, final sale price to consumer is Birr.2 400 and the total value added is Birr.2 400.

From the above table, it can be understood that there are six stages involved in the process of
converting cotton into clothing and before it reaches ultimate consumer. The ginner buys cotton
from the farmer at a price of Birr.700 per quintal and sells the cotton after ginning to the spinner
for Birr.1, 000. The Spinner, for converting the cotton into yarn, has added Birr.500. The weaver
converts the yarn into clothing, which he sells to the wholesaler for 2 birr per 100 bale of
clothing. The wholesaler has added value of Birr.200 and sells the clothing to retailer for Birr.2,
300. The retailer finally sells the clothing to the consumer for Birr.2, 400. The remaining value
of Birr.100 (difference between price of wholesaler and that of retailer) represents value added
by the retailer.

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From the above example, it can be observed that the final retail price paid by the consumers is
simply the sum of the value added at each stage of production and distribution. The value added
tax is assessed at each stage of production.

Common Debate on VAT

In Ethiopia, there is a controversial opinion regarding "whether VAT increases the selling price
for consumer in Ethiopia or not”. It is raised upon the fact that some goods (same brand and
quality), which are sold by the VAT registered sellers, are available at lesser prices with the non-
VAT registered sellers. In other words, the selling price of some commodities is less with the
Non-VAT registered sellers or firms. Of course, it may be true. But, we should know the fact and
regulation behind the levy of VAT in Ethiopia. If VAT and Turnover Taxes are levied and
implemented on its foundation, this type of issue or difference of opinion will not arise and the
position will be reverse.
Vat Does Not Increase Selling Price
Example
Let us now see these concepts with the following example. There are two firms namely A and B.
Of these two firms, Firm- A is VAT registered and Firm-B is VAT unregistered. Let us assume
that, their purchases during the period is Birr 5290 (including VAT) per unit and the value added
by them are Birr 500 respectively. Now, we shall see how does the VAT is beneficial to the
ultimate consumer. The rate of VAT and Turnover Tax is 15% and 2% respectively.
Computation of Final Selling Price

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Note: The Net VAT Liability is equal to the tax calculated on the Value added by the firms. That
is, 500 x 15% = 75 [which is equal to Output tax – input tax credit (765 – 690 = 75)].
From the above example, it can be seen that the selling price under non- VAT regime is higher to
that of under VAT levied regime. If there is any difference prevailing in the market scenario and
shows higher selling price under VAT, then, it is not the flaw on the part of the levy of VAT, but
it is in the implementation of the same. The Ministry and the Authorities concerned are
vehemently trying and initiating capacity building measures to remove the problems in this
regard. After the proper implementation of these measures, all relevant issues will be solved.
Hence, it should be noted that the motive of the Government and the Ministry concerned
regarding the levy of VAT is not to increase the selling price, but to ensure the ‘ability to pay’
principle of taxation and there by maintain the price at the reasonable level. The method of VAT
adopted in Ethiopia requires certain reforms to strengthen it further.

Exercise:
1. In the month of July, XYZ Company purchased items with total price before VAT Br.
250,000 from VAT registered business in Ethiopia. XYZ exported 30% to a firm in South
Africa with a selling price before VAT of Br. 97500. The remaining 70% of the item were

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sold in the domestic market with a selling price before VAT of Br.227,500. As per Ethiopian
VAT Proclamation, exporters are not required to pay VAT.
Required:
a. Find the VAT paid by XYZ while buying the item
b. Find the VAT paid by XYZ while selling the item
c. Find the net VAT payable or refund
2. In the month of July, XYZ company purchased items with total price with VAT
(including VAT) is Br. 300,000 from VAT registered business in Ethiopia. XYZ exported
30% to a firm in South Africa with a selling price with VAT (including VAT) is Br.
117,000. The remaining 70% of the item were sold in the domestic market with a selling
price with VAT (including VAT) of Br.273, 000. As per Ethiopian VAT Proclamation,
exporters are not required to pay VAT.
Required:
a. Find the VAT paid by XYZ while buying the item
b. Find the VAT paid by XYZ while selling the item
c. Find the net VAT payable or refund
3. In the month of July, XYZ company purchased items with total price with VAT
(including VAT) is Br. 300,000 from VAT registered business in Ethiopia. Items were
sold in the domestic market with a selling price with VAT (including VAT) of
Br.420,000.
Required:
a. Find the VAT paid by XYZ while buying the item
b. Find the VAT paid by XYZ while selling the item
c. Find the net VAT payable or refund

4.3.2. Turnover Tax

Turnover taxes are multistage sales taxes that are levied at some fixed rate on transactions at all
levels of production. The effective tax rate on various goods and services is conditioned by the
number of stages of production.

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Turn over tax, like others we discussed, is applicable in Ethiopian tax law. Unlike VAT, where
the threshold to identify persons’ subject to it is 1,000,000 birr, turnover tax is applicable for
those whose annual transaction is below this amount and excludes voluntary registrant for VAT.

Turnover tax is applicable on supply of goods, rendition of services and persons not registered
for VAT. Accordingly, there is its own mode of assessment and impositions of obligations
expected to be discharged on people subject to same.

i. Scope of Turnover Tax

In chapter, we have seen VAT and the scope of the VAT proclamation. The government
considers, for administrative feasibility and other reasons, persons whose annual taxable
transaction is equal to or greater than 1000,000 to be registered for VAT. Similarly, for those
persons who are not registered for VAT, it is necessary to impose obligation of taxation. To this
end turnover tax is imposed on those not registered for VAT to equalize and enhance fairness in
commercial relations and make complete the coverage of tax system so as to increase
government’s revenue from taxation.

Therefore, the scope of application of turnover tax proclamation is on:

i. supply of goods
ii. rendering of services
iii. persons not registered for VAT
With the definition of terms under turnover tax, unless otherwise defined in the proclamation, the
meanings defined in Value Added Tax Proclamation No. 285/2002 shall be used (Art 2(1).

i. Supply of goods
In trying to define supply of goods under turn over tax proclamation, since it is not clearly
touched, as per Art 2(17) of the VAT proclamation it is to mean the sale of goods and or services
or both.

“Goods” is defined under Art 2(7) of proclamation No 308/2002 is to mean any kind of goods or
commodity that has exchange value, utility and brings about satisfaction and includes animals.
From this, we can say that the scope of application turnover tax law is on sale of goods and
animals also.

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ii. Rendition of services

Services rendered to persons not registered for VAT are under the scope of turn over tax
proclamation. Regarding the definition for the term service since the turn over proclamation fails
to deal with it as per Art 2(1) of proclamation No 308/2002, Art 2(7) of proclamation No
285/2002 it is to” mean work done for others which doesn’t result in the transfer of goods.”

iii. Persons not registered for VAT

The other term that needs explanation at this juncture is “persons not registered for VAT.”
According to Art 2(4) of proclamation No 308/2002 a person not registered” is a person who is
not registered for VAT by reason of his annual turnover being bellow 1000,000 or threshold set
by the minister, by reason of not having applied for voluntary registration.

But, we have to notice also that turnover tax is not applicable to every import of goods and an
import of services as provided under Art 23 of the VAT proclamation (they are subject to VAT).
Though turnover tax is applicable to supply of goods, rendition of services and to persons not
registered for VAT, no all transactions are taxable. The proclamation recognizes certain
exemptions: In this respect as per Art 7 the following are exempt from turn over tax:

 the sale or transfer of a dwelling house used for a minimum of two years or the lease of a
dwelling;
 the rendition of financial services;
 the supply of national or foreign currency and securities except for that used for numismatic
purposes;
 the rendering by religious organizations of religious or other related services;
 the supply of prescription drugs specified in directives issued by the relevant government
agency; and rendering of medical services;
 the rendition of educational services provided by educational institutions as well as child care
services for child can at pre-school institutions;
 supply of goods and rendering of services in the form of humanitarian aid
 the supply of electricity, kerosene and water, license fees, etc.
In addition, attention shall be rendered so as to infer that these are not the only listings of
exemptions, ministry of finance and economic development by virtue of Art 7(2) of turnover tax
proclamation may provide others by its directives.

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ii. Rates of Turnover Tax

The base to compute turn over tax is the gross receipts in respect of goods supplied or service
rendered Turnover Tax Proclamation No.308/2002.' (Art 5). Thus, the person who sells goods
and services has the obligation to collect the turnover tax from the buyer and transfer collected to
the Tax Authority. Art 4 incorporates two kinds of rates: 2% on goods sold locally and for
services rendered locally again in two rates:2% for contractors, grain mills, tractors and combine
harvesters and 10% on other services.

iii. Obligations of Tax Payers under the Turnover Tax Law

In enforcing income tax proclamation there are obligations imposed on tax payers and other
concerned organs; establishment of organs responsible to enforce the laws; pass decisions and
review the decisions in case complaint is lodged by aggrieved party. Likewise, these obligations
and organs are recognized under turnover tax proclamation.

Of course, turnover tax is to be declared and paid by tax payer. Therefore, outstanding
obligation imposed on them is to file their tax return and pay the tax within the time reasonable
in the proclamation. In this regard, Turnover Tax Proclamation No 308/2002, Art 10(1)- Tax
payers subject to turnover tax shall: a) File a turnover tax return with the Tax Authority within
one month after the end of every accounting period. b) Pay the tax for every accounting period
by the deadline for filing the turnover tax return.

For purposes of this Article "Accounting period" shall mean: (a) for taxpayers classified as
category' A', but are not required to register for VAT, the calendar month; (b) for category "B"
taxpayers who are required to keep records, each three-month period commencing from the first
day of the Ethiopian fiscal year or when approved by the Tax Authority, the first day of the
Gregorian calendar year; (c) for Category "C" taxpayers, who are not required to keep records,
the fiscal year. Each tax payer, is thus required to file a turn over tax return to the tax authority
before the deadline mentioned above.

Example. Mr. Lulu and Ms. Martha are Category “C” taxpayers. Annual sale of Mr. Lulu’s for
the year 2010 is 492,500 Br according to “Council of Ministers Federal Income Tax Regulation
No.410/2017” which is found annual income range of (Br. 475,000 to Br. 500,000) from
Construction Material Production (annual average profit rate 18%) and annual sale of Ms.
Martha for the year 2010 is 423, 800 Br. according to “Council of Ministers Federal Income Tax

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Regulation No.410/2017” which is found annual income range of (Br. 400,00 to Br. 425,000)
from Attorney Service (annual average profit rate 25%). Compute the turnover tax (TOT) of Mr.
Lulu and Ms. Martha.
Solution
As per Turnover Tax Proclamation No.308/2002.' Art (5) base of computation of the Turnover
Tax shall be the gross receipts in respect of goods supplied or services rendered.
Turnover tax = gross receipts x TOT rate (2% or 10%)
Turnover tax of Mr. Lulu= 492500Br x 2% =9,850 Br. (because TOT rate for goods is 2%)
Turnover tax of Ms. Martha = 423,800Br x 10% =42,380 Br. (because TOT rate for goods is
10%)
Note. According to Art (4), of aforementioned Proclamation Rate of Turnover Tax shall be:
1) 2% (two percent) on Goods sold locally
2) for Services rendered locally;
 2% (two percent) on Contractors, grain mills, tractors and combine-harvesters;
 10% (ten percent) on others.

4.3.3. Excise Tax

Excise duty can be defined as a tax duty on some produced goods either at some stage of
production or before their sale to domestic customers. That is, these taxes are imposed upon the
production of particular goods or groups of goods. These goods are intended for sale or
consumption with in the country. Excise duties are levied on the production of selected
commodities while most of the excise duties are levied by the central government, the state
government is also empowered to levy on a few items like liquor, drugs narcotics etc. Excise
duties have now become an important source of revenue of the central government. Excise duty
is mainly levied with a view of curtailing home consumption so that, more goods are available
for export purpose. To discourage the use of scare resources on production of non-essential,
luxurious goods this may be imposed. Yet the most important goal is raising revenue for
financing various development schemes.

Excise tax is one variety of sales tax like VAT and turnover tax but unlike turn over tax and
VAT, it is applicable not on all kinds of goods rather on selected goods. It is imposed on luxury
goods and basic goods which are demand inelastic.

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It is also applicable on goods which are hazardous to health and societal problems. In certain
goods the tax rate reaches 100% implying that the goods are not encouraged to be imported or
produced locally.

A. Historical Background of Excise Tax in Ethiopia

Excise tax, like VAT and turn over tax, it is one variety of sales tax. It is collected from the sale
of certain items. The excise tax, then will be of either specific /per unit or advalorem. Specific
excise tax is imposed based on the amount of the item subject to tax. But advalorem is calculated
out from the value of the good.

Excise tax in Ethiopia is introduced for many reasons. The preamble of the excise tax
proclamation (Excise Tax Proclamation No. 307/2002) dictates the rational in the following
manner.
Firstly, it helps to improve government revenue by imposing excise tax payable on selected
goods. True, when tax is imposed on certain items that were not subject to tax, the effect is
usually increment of governments revenue to facilitate different projects a head.

Secondly, tax shall be imposed on luxury goods and basic goods which are demand inelastic.
The imposition of tax on luxury goods usually has little or no impact on the expenditures of the
poor. One basic rational of introducing tax in a certain state is to redistribute income and narrow
the gap between rich and poor. Thus, it is logical and acceptable to collect tax from luxury goods
that have strong link with capable in certain economy.

Last but not least, imposition of taxation on goods that are hazardous to health and which are
cause to social problems, will reduce their consumption. As we will see later on, on some goods
hazardous to health the rate is too high and reaches 100%. This undoubtedly will have deterrence
purpose so that consumers of such good shift or try to do so to other goods relatively acceptable
and imposed with lower rates of taxes. Thus, the excise tax has positive impact on the reduction
of consumptions of goods hazardous to health and cause social problems.

B. Products Subject to Excise Tax

Every tax law is applicable on product or services it is designed to cover. The scope of
application of excise tax proclamation is determined by the schedule attached to the
proclamation. Accordingly, excise tax is applicable to goods which are either produced locally or

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imported from other countries. To this end, Art 3 of the Excise Tax Proclamation No 307/2002
clearly states that the goods listed in the schedule attached to the proclamation.

The attachment at the schedule indicates that the goods or products are related to luxury goods,
goods dangerous to health and that cause serious problems to the society, ranging from perfumes
to tobacco and tobacco products. The purpose is basically; to reduce the production and
distribution of those goods which are dangerous to health and thus, the rate imposed as we will
discuss thereon reaches 100%. The end goal seems to ban their production.

C. Tax rates, Bases and Payment of Excise Tax

An assessment and collection necessitate tax rate, tax base and specified time of payment of tax.
The following section addresses the tax rate, base and payment time of excise tax according to
Excise Tax Proclamation No. 307/2002. These are related concepts but need further
discussions.

i. Tax Rates
The excise tax is imposed on goods imported or produced locally in accordance with the
schedule attached with the proclamation No. 307/2002, Art 4 clearly forwarded rate of taxes as:

 The excise tax shall be paid on goods mentioned under the schedule attached to this
proclamation. a. when imported; b. when produced locally at the rate prescribed in the
schedule
The rate specified above is uniformly applied for goods produced locally and imported from
abroad, what matters is the type of product. The rate varies from 10% in textiles and textile
products to 100% for other alcohol drinks, perfume and toilet waters; and motor vehicles above
1800 C.C.

ii. Bases of Excise Tax

The base of the taxation according to the proclamation is a produced thing: whether produced
locally or imported from abroad. According to Excise Tax Proclamation No. 307/2002 Art 5,
base of computation of excise tax (a) in respect of goods produced locally, the cost of production
(b) in respect of goods imported, cost, insurance and freight (C.I.F)

Cost of production is taken as base to calculate the amount to be imposed on goods produced
locally. Cost of production as per Art 2(8) is to mean direct labor and raw material cost incurred

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in the production process, cost of indirect inputs and overhead costs, but does not include
depreciation costs of machineries.

In respect of goods imported, the base of computation of the tax as mentioned above is cost,
insurance and freight. Here one can conclude that, as we have said early, while discussion in
VAT, export rather than import is encouraged. In case of VAT, persons are allowed to deduct
costs of productions/ inputs in general. But in excise tax, since attached with luxurious and
dangerous product the value of the object imported insurances and freight are not deducted.

iii. Payment of Excise Tax

The excise tax shall be paid within the time prescribed; (a). in respect of goods produced locally,
by the producer; (b). in respect of goods imported by the importer.

To implement the obligation of tax payers, the time when the tax is to be paid by taxpayers has to
be clearly determined.

In connection with this Art 6 provides that the payment of excise tax a. time of payment b.
unless decided otherwise as provided for under sub-article 2(b) i.e. (Art 6 sub Art 2b) of this
proclamation, the excise tax on goods specified under the schedule shall be payable.

a. when imported at the time of clearing the goods from customs area.
b. when produced locally not later than 30 days from the date of production;
 where the tax payer requests for permission to deposit goods produced in a bonded
warehouse without payment of the tax and if the request is approved by the tax authority the
payment of the tax on such goods so deposited shall be effected at the time they are being
removed from the bonded warehouse.
 If the Tax Authority believes that the activity of the tax payer requires, a bonded warehouse
may give him permission to establish such bonded warehouse.
 where a producer fails to keep proper accounts and records or fails to submit a monthly
declaration or pay the tax with in the time limit prescribed in this proclamation or submit a
declaration which up on investigation is found incorrect the tax authority shall be empowered
to forbid to producer to remove any good from the place of production or bonded ware
house.

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On the other hand, Art 34 provides that the minister may waive in whole or in part, the tax levied
under the Excise Tax proclamation; may be for economic, social or administrative reasons.

D. Obligation of Taxpayers
Like the tax laws we discussed in the previous sections, enforcement of excise tax law requires
collaboration among the taxpayers and tax authorities. Taxpayers are imposed with the following
obligations:

- Maintaining books and accounts and supporting documents in accordance with proper
accounting principles and in a manner acceptable by Tax-Authority.

- Submit every 30 days to the tax authority, in a form which would be supplied by the Authority,
a declaration containing the necessary information for the proper collection of the tax.

- Comply fully with the requirements of inspection of his premises by the delegates of the Tax
Authority.

- Immediately communicate to the Tax Authority the type and address as well as the
commencement and termination date of his business. - Pay in full the tax due within 30 days
from the date of the termination where such business is terminated.

E. Administration of Excise Tax

Administration, among others, requires huge responsibility on the part of Tax Authority. To
discharge its duties, the Authority is vested with the following responsibilities and duties as
indicated under Art 9. The powers include:

 The implementation and enforcement of this proclamation - requiring the person or employee
who has access to or custody of any information, records or books of account to produce the
same and to attend during normal office hours at any reasonably convenient tax office and
answer any question relating there to.
 Enter business premises or stores of the tax payer or to any place suspected to be storage of
the products, inspect, collect information and take appropriate measures.
 Notify the tax payer the additional tax to be paid in accordance with the proclamation.

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 Requiring any person including a municipality body, financial institution, department or

agency of Federal or regional government to disclose particulars of any information or
transactions

4.4. Stamp Duties

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 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 governments treasury.

As can be easily understood from the preamble of stamps duty proclamation proc. No. 110/1998,
it has become necessary to amend the stamp study levied on documents in a manner which
would contribute to the development of art, the activities of financial and the transfer of capital
assets; thus it was appropriate to come up with new legislation so as to strengthen the means of
raising revenue from different bases of taxes.

A. Bases of the Duty

Identifying the bases up on which tax is to be imposed is the first question that shall be addressed
before furthering to other activities. we have said above that; stamp duty is imposed on
documents. Art 3 of the stump duty proclamation exhaustively lists instruments chargeable with
stamp duty in the following manner: 1. Memorandum and articles of association of any business
organization cooperative or any other form of association. 2. award 3. bonds 4. ware house bond
5. contractor agreements and memoranda thereof 6. security deeds 7. collective agreement 8.
contract of employment 9. Lease, including sub-lease and transfer of similar rights. 10. natural
acts 11. power of attorney 12. documents

Before directly addressing the rationales behind each document or instrument, it is appropriate to
define what a document (instrument) is. An instrument as per Art 2(5) of stamp duty
proclamation is a written document by which any right or obligation is or purports to be created,
recorded, transferred, extinguished or by which its scope is limited or extended.

The instruments indicated from Art 3(1-12) implies the existence of indicative qualities under
Art 2(5).

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Memorandums and articles of association are constitutional documents of any business

organization, cooperatives or association. They indicate the powers that such entities can engage.
For instance, in case the memorandum of association is that of business organization, the type of
activity be it commercial or non-commercial that helps to earn benefit shall be clearly stipulated.

The existence of articles of association, that governs the internal relationships that should exist
among members (common in case of companies) whatever be the case memorandum of
association and articles of association, be it for business organizations, cooperatives or
associations, can serve as a base up on which stamp duty is to imposed.

An award is similarly subject to stamp duty. An award is defined under Art 2(1) to mean a
decision rendered in writing by arbitrator(s) on a reference made otherwise than by order of court
in the course of suit by parties to a compromise, conciliation or arbitral submission or other
similar matters. Whatever be the award is, as far as made in written from, such document is taken
as base of taxation.

In similar fashion bond under Art 2(2) is described as any instrument where by a person obliges
himself to pay money to another, on condition that the obligation shall be void if a specific act is
performed or is not performed, as the case may be: or any instrument attested by a witness and
not payable to order on bearer, where by a person mobilizes himself to pay money to another.
Bond, as can be inferred easily is a document showing that the holder is the creditor of the issuer
person. It is one means of raising funnels, most used in case of companies. The document to have
valid effect shall be a tested and this an iteration is the base to impose duty.

Most of the instruments listed under Art 3 of No 110/1998 are given operational definitional
under Art 2 of the same proclamation. Thus, leaders are advised have exhausting reading on the
given definition and attempting to get concepts from different law concepts covered there in for
example, by borrowing concepts from law of property, titles up on properly (Art 3(10) can be
understood to mean a certificate bearing the signature of public officials serving, as prima facie
evidence that the holder is an owner of the property indicated under the document.

B. Rates and Mode of Valuation of Stamp Duty.

In the previous discussions, rates and evaluation techniques are touched as integral part of a tax
duty rates.

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Under stamp duty proclamation too, rates and mode of valuation are treated. Accordingly, as per
Art 4 (1) and (2) the applicable rates are those specified in the schedule attached to the Stamp
Duty Proclamation No. 110/1998 which is considered as integral part of the former. In case a
document is to be executed subsequently, a flat rate attached as a schedule in the proclamation is
applied accordingly.

The rates might be flat or they may depend on the value of the property for which a document is
prepared under the schedule for memorandum and articles of associations of business
organizations and any association a flat rate of 350 birr (at first execution) and a flat rate of birr
100 (for subsequent exceptional) in imposed. Similar way of flat rating system is extended to
memorandum and article of association of cooperatives, contracts and agreements and
memoranda thereof, collective agreements, natural acts, and power of affiance.

On the other hand, rather than flat rate system proportional taxation is imposed on other kinds of
documents. In case of property taxation, the value to be collected that will due from taxation
increases not because the rate grows, but for the fact that the value (the values of the base subject
to tax increases) to mention instances of this kind are: Awards, bonds, Ware house bond, security
deeds, leases and registered title to property. (try to have a look at the schedule attached to the
proclamation).

As we have addressed above, in assessing the value to be charged up on the document

/instrument, sometimes we apply the value of the right or the obligation and in other times fixed
amount will be imposed as indicated in the schedule. But, we might face certain rights or
obligations in currencies other than Ethiopian birr. In this case, we have to compute the value of
such right or obligation on the base of the prevailing rate of exchange at that time (Art 5(3)).

Where the amount is advalorem one, average value of the stock and where serial distinct matters
are chargeable, the total/aggregate amount of duties payable in respect of each separate
instrument will be imposed.

C. Liability, Time and Manner of Payment

We have said that stamp duty is imposed on documents (instruments) that are required to bear a
physical stamp. Thus, it is logical to impose the tax obligation on the beneficiary of the
document. But, since tax administration, as we discussed before, requires collaborative duty,

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other persons whose work is related are also imposed with the duty of enforcement. From the
readings of Art 6, Obviously, unless otherwise determined by the proclamation, the beneficiary
of an instrument is liable to pay the stamp duty thereon. The person making (drawing) or issuing
an instrument in Ethiopia, is liable for the payment of the stamp duty upon the execution of the
instrument. However, when the instrument is made (drawn) outside Ethiopia, the person who is
the first executing it in Ethiopia is liable for the payment of the duty.

The lessor and the lessee while entering lease contract can impose this obligation on either of
them. In the absence of otherwise stipulation, the lessee is required to cover the stamp duty tax.
In the case of lender-borrower relationship, the borrower is required to pay the charge imposed
on security deeds. With regard to documents transferring title to property, the transferee is
imposed, on payment of such though in their agreement they can impose same on the transferor.

In contractual documents or agreements, members/parties are jointly and severally liable for the
payments of stamp duty there on. In employment contracts, the employer is liable to the payment
of the stamp duty tax. In awards, parties to the award are Jointly and severally liable to the duty.
Likewise, in collective agreements, which helps workers to have some bargaining power towards
the employer, both the employer and employees are jointly and severally liable to the stamp
duty.

Once we established liability from the contents of Art 6 of the proclamation, what shall proceed
is to determine the procedures how payment is effected on the part of the identified personnel’s.
This lead us to examine the time and manners of payments imposed on individuals involved on
the documents be it through issuing them or driving benefits (titles) from same. To this end, Art
7 is devoted to show time and manner of payments regarding stamp duty.

Stamp duty on memorandum and articles of association, shall be paid before or at the time of
registration. These documents are registered in respective Justice offices and commercial
registries depending on the nature of the activities to be carried out by the associations and
business organizations. In case the memorandum and article of association is that of business
organizations, it will be registered in respective in commercial registries. Similarly, if it is that of
associations, it will be registered in respective Justice offices (at Regions in Justice Bureaus and
at Federal level in Ministry of Justice).

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In similar fashion, in case of awards, the law requires the duty to be paid before or at the time of
issuance of the award. On contracts or agreements before or at the time of signature. Regarding
leases or subleases, payment is required before or at the time of the signature.

On notional acts, at the time of issuance; on security deeds, before or at the time of signature and
on documents of title to property before or at the issuance

D. Exemptions from Stamp Duty

For economic, Social, or administrative reasons, exemptions are common under tax laws of legal
system of different nations. But variations are observed from one state to another. Under
Ethiopian stamp duty proclamation Art 7, the following are exempt from the liability of payment
of same:

 Public bodies on which the federal government of Ethiopia financial Administration

Proclamation No. 57/1996 applies.
 Goods imported for sale by traders having import license, when first registered in the name
of the trader.
 Documents that are exempted in accordance with international agreements and conventional
approved by Ethiopian government.
 Subject to reciprocity embassies, consulates and missions of foreign states may be exempted.
 Share certificates are exempt from stamp duty payable on the register of title of property.

4.5. Foreign Trade Taxes

Foreign trade means the exporting from or importing into Ethiopia of goods for sale or operating
as a foreign trade auxiliary;

 Customs Duties
An import or export customs taxes, also known as tariff duties or impost are a charge for the
movement of goods through a political border. Tariffs discourage trade, and they may be used by
governments to protect domestic industries. A proportion of tariff revenues is often hypothecated
to pay government to maintain a navy or border police. The classic ways of cheating a tariff are
smuggling or declaring a false value of goods. Tax, tariff and trade rules in modern times are
usually set together because of their common impact on industrial policy, investment policy, and
agricultural policy. A trade bloc is a group of allied countries agreeing to minimize or eliminate

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tariffs against trade with each other, and possibly to impose protective tariffs on imports from
outside the bloc. A customs union has a common external tariff, and, according to an agreed
formula, the participating countries share the revenues from tariffs on goods entering the customs
union.

Customs duty is classified into import duties and export duties. Import duties are imposed on
imported articles and are collected from the importers at the time foreign goods enter the
country. Import duties may be levied to discourage the import of particular commodities which
compete with locally produced goods - such import duties are called protective duties; and to
raise revenue for the government - known as revenue duties. Nevertheless, it should be
remembered that even protective duties would bring in revenue for the Government. The
protective tariff duty will

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Chapter Five

Investment Incentives in Ethiopia

Chapter Objectives
After the completion of this chapter, the students will be able to:
 Understand the meaning of incentives
 Distinguish different types of incentives

5.1. Introduction
Investment incentives are special rights granted for certain categories of investors in order to
promote and facilitate private investors to play their role in investing and accelerating the
country’s economic growth. Ethiopia recently issued new investment incentives regulation which
was gazetted in the Federal Negarit Gazette on 12 July 2022. The Regulation was issued by the
Council of Ministers pursuant to Article 17 of the Investment Proclamation No. 1180/2020 and
Article 129(6) of the Customs Proclamation No. 859/2014 (as amended). The Council of
Ministers of Ethiopia issued Investment Incentives Regulation No. 517-2022, which offers
income tax exemption for investors from the date of obtaining the business license or expansion
permit, as provided in the schedule attached to the Regulation. The Regulation also allows
investors to import capital goods, construction materials and motor vehicles free from custom
duties. Finally, it expands the incentives' eligibility to the mining, petroleum and geothermal
sectors.

The Regulation applies to Income Tax and Duty incentives that are granted to encourage
investment in eligible sectors. Generally, an investor who invests to establish a new business is
entitled to an income tax holiday for a specified period of time. Investors who invest in areas that
are outside of Addis Ababa or other major towns that have low infrastructure development are
entitled to an income tax deduction of 30% for three consecutive years after the expiry of the tax
holiday.

The Ethiopian Government’s Investment Policy categorizes activities into:

1. Those that are reserved for Ethiopian nationals

2. Those that are open to foreign persons

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3. Some that are open to foreign persons that must be undertaken in partnership with the
Government or Ethiopian nationals

The Regulation has expanded the range of sectors that are entitled to tax incentives as well as
introduced focused incentives for certain sectors that it seeks to grow or encourage investment in
rural areas.

Some of the key sectors that the Regulation has focused on are ICT, hospitality, health,
agriculture, transport and logistics. This Alert summarizes key highlights of the Regulation.

5.2. Types of incentives in Ethiopia

1. Business location incentive

An investor who invests in an area far from the main towns or areas with poor infrastructure will
be entitled to an additional 30% income tax deduction for three consecutive years after the expiry
of the tax holiday. Additionally, new investments will enjoy a five-year income tax exemption if
they invest in hotels and hotel equivalents in select tourist destinations.

According to old Article 5 of Regulation No.270/2012, any investors who establish a new
enterprise in the following states;

1. The State of Gambela Peoples;

2. The State of Benishangul Gumuz;
3. The State of Afar (except in areas within 15 Kilometers right and left of the Awash
River);
4. The State of Somali;
5. Guji and Borena Zones of the State of Oromia; and
6. South Omo Zone, Segen (Derashe, Amaro, Konso and Burji) Area Peoples Zone, Bench
Maji Zone, Sheka Zone, Dawro Zone, Kaffa Zone or Konta and Basketo Special Woredas
of the State of Southern Nations, Nationalities and Peoples
2. Labor mobility

Employers that provide employment opportunities for qualified and certified Ethiopians to work
abroad will be entitled to an income tax holiday ranging from one to three years.

3. Expansionary incentives

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Investors who are expanding or upgrading existing investment will be entitled to an income tax
exemption for the additional income resulting from the expansion. Any investor expanding or
upgrading his existing enterprise with respect to the additional income generated by the
expansion or upgrading shall be entitled to income tax exemption for a period of time to be
specified taking in to consideration the specific activity and location of the investor.

4. Export of goods and services

Investors who invest outside industrial parks and who export or provide supplies to an exporter
of at least 60% of their products or services will be entitled to a one-time income tax exemption
for two years in addition to the normal tax holiday. This also applies to investors who invest
within industrial parks and who export or provide supplies to an exporter of at least 80% of their
products or services.

Any investor who exports products and services shall be entitled to income tax exemption for
two years. Not only an exporter but also any person who supplies products or services input at
least 60% of his product to an exporter shall be also entitled to the same kind of exemption. In
addition to that Ethiopian products and services destined for export are exempted from payment
of any export tax subject to few exceptions.

5. Customs duty exemptions

The Regulation exempts capital goods and construction materials from customs duty. An
investor can import capital goods or construction material for new investments or use it to
upgrade existing investments duty-free.

Investors are also entitled to a refund of the import duty paid for raw materials or components
used as input for the production of goods if they purchase the goods from local manufacturing
industries.

The Regulation also provides rules on the transferability of duty-free goods or products and
related penalties for non-compliance.

Exemption from payment of customs duty is granted to investors to import all investment capital
goods. These includes plant machinery and equipment, construction materials as well as spare
parts worth up to 15% of the total value of the capital goods within five years from the date of

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commissioning of the project. However an exception here is that such goods are not produced
locally in comparable quantity, quality and price. Exemptions from customs duties or other taxes
levied on imports are also granted for raw materials necessary for the production of goods.

An investor granted with customs duty exemption who buys capital goods or construction
materials from local manufacturing industries shall be refunded the customs duty paid for raw
materials or components used as inputs for the production of such goods.

6. Loss Carry Forward

An enterprise that suffers losses during the income tax exemption period can carry forward such
losses, following the expiration of the income tax exemption period for half of the tax exemption
period. Any loss incurred during the income tax exemption period is not allowed to carry
forward for more than five income tax periods.

7. Other compliance matters

The Regulation also addresses other pertinent matters related to the tax incentives such as the
maintenance of the appropriate records, reporting requirements, administrative roles of the
various Government agencies and the investors, among other subject matters.

Generally income tax exemption and exemptions from customs duty are granted for both
domestic and foreign investors. This is to encourage private investment in all corners of Ethiopia
and promote the inflow of foreign capital and technology.

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References
Gupta, A. (2001). Public Finance and Tax Planning, 1st ed. Anmol Publications P.vt. Ltd, New
Delhi.

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Courses: 1. Accounting for Public Sector & Civil Society 2. Public Finance and Taxation 123