CHAPTER TWO

TAXATION: An
overview

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 CONTENTS
What is tax?
Objectives of taxation
Basic Elements of Tax Systems
Tax Related Terms
Basic characteristics of tax
Types of Tax Rates
Taxation Systems (Tax Rate Structures)
Effects of Taxation
Classification of taxes
Principles /Canons of taxation

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 What is tax?
A tax is a compulsory charge or payment imposed by
government on individuals or corporations.

A tax is an involuntary fee or more precisely "unrequited

payment" made by individuals or businesses to a
government without quid pro quo
The persons who are taxed have to pay the taxes
irrespective of any corresponding return from the goods
or services by the government.

It is the most important source of revenue for a

government.
Taxation is used as a system of raising the lion share of
3 public revenue in modern economic system.
 Basic Characteristics of Tax
Tax is a compulsory payment (obligatory payment)
Benefits are not the basic condition in tax payment
It is a personal obligation
It is used for Common interest
It is a Legal collection
It is a periodic and regular payment
It has Wide Scope
No discrimination exists in tax payment
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 Objectives of Taxation
To Raise public revenue
To Remove inequalities of income and wealth
To Ensure economic stability
To Reduce regional imbalances
To Create employment opportunities
To Prevent harmful consumption
To Divert resources beneficially
To Encourage exports
To Enhance standard of Living
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 Basic Elements of a Tax System
The FIVE pillars or basic elements of tax system are:
Taxpayer refers to any individual or organization that is
obligated to pay tax
Tax Base is the value of everything which is subject to
taxation
Tax Rate is the amount of taxes expresses as a
percentage of the tax base
Tax Period is the period for tax assessment. It can be a
year (tax year), month, week, etc
Tax Administration refers to any government office
mainly with a responsibility of tax collection and other
related activities
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 TAX RELATED TERMS
Delinquent Tax: refers to taxes remaining unpaid on and
after due date
Tax Assessment: the determination of the amount subject
to tax
Tax Avoidance: the practice of taking steps to minimize
tax liability. It is completely legal.
TAX EVASION: an illegal activity in which a taxpayers
seek to hide taxable income by overstating expenses or
understating revenue
Tax Bracket : a range of income subject to tax at the same
tax rate. It is the band of taxation in which a taxpayer is in.
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 Types of Tax Rates
There are four different types of tax rates:

Statutory Tax Rates (STRs): all legally imposed tax rates

on a taxpayer (those percentages appearing in the tax law).

Marginal Tax Rate (MTR): is the tax rate you pay on

any additional income you earn.

Average Tax Rate (ATR): is the total amount of tax you

pay divided by your total taxable income.

Effective Tax Rate (ETR): is the total amount of tax you

pay divided by your total income.

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 TAX RATE STRUCTURES (TAX
SYSTEMS)
Tax rate structure expresses the relationship between the
tax rate and tax base in a country
A. Proportional tax

The rate of taxation remains constant as the income of

the tax payer increases
All incomes are taxed at a single uniform rate,
irrespective of whether tax payer’s income is high or low.
The tax liability increases in absolute terms, but the
proportion of income taxed remains the same.
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 Advantages and Disadvantages
Advantages:
1. It is simple in nature.
2. It is uniformly applicable.
3. Leaves the relative economic status of
taxpayers unchanged.
Disadvantages:
1. Inequitable Distribution
2. Inadequate resources
3. Inelastic in nature
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 TAX RATE STRUCTURES (TAX
SYSTEMS)
B. Progressive tax
The rate of taxation increases as the tax payer’s
income increases
The tax rate progresses from low to high income
 The marginal tax rates are generally higher than
average rates.
The burden of taxation is heavier upon the rich
than on the poor.
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 Income Tax Rate

0-600 0%

600-1650 10%

1650-3200 15%

3200-5250 20%

5250-7800 25%

7800-10900 30%

over 35%

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 Advantages
1. Ensuring the principle of ability to pay
2. Reducing the Inequalities of Income and Wealth
3. It is justified on the grounds of economy (the cost
of collection does not increase with the increase
in the rate of taxes)
4. It is elastic in nature (The government can easily
raise its revenue by increasing the rates of taxes)
5. Stabilizing the Economy

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 Disadvantage of a progressive structure
1. Ideal Progression is Impossible: the rates are
arbitrary depending on the government’s need
for additional funds
2. It is a Graduated Robbery: it is an unjust
mode of taxation and a graduated robbery.
3. Disincentive to Work
4. Discourages Savings and Investments:

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 C. Regressive Taxation

The amount of tax is smaller as a percentage of income

for people with larger incomes.
The rate of tax declines with the increase in the income
or value of property.
It places more burden on those with lower incomes.
Its disadvantages is that the tax burden falls more
heavily on the poor and it violates the principles of
equity and social justice.

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 Classification of taxes
I. Based on the Tax Bases
Income Taxes: are taxes levied on income of
persons or businesses

Property Taxes (Wealth taxes): are levied on a

property of Persons or businesses

Consumption Taxes: are taxes levied on

expenditures for goods and services
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 II) Based on Tax Determinant

1. Specific
A tax based
on quantity of an item
Example: excise taxes on wines, cigars,
gasoline
2. Ad valorem
Tax based on value of an item
Example: real estate tax, value-added tax

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 Tax Impact vs Tax Incidence
Tax impact
The initial burden of tax
Felt by the person from whom the tax is collected
Impact of the tax is always on the person who is
responsible by law to pay the tax amount to the government
Tax Incidence
The ultimate burden of tax
Felt by the person who actually bears the burden of the tax
Impact of a tax can be shifted, but the incidence of a tax
cannot be shifted.
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III)Based on who Bears the Burden

1. Direct
 Tax which is demanded from the person who also shoulders the
burden of the tax; or tax which the taxpayer cannot shift to
another
 The impact and incidence of which fall on the same person
Example: income tax
2. Indirect
Tax which is demanded from one person in the
expectation and intention that he should indemnify
himself at the expense of another
The impact and incidence of which fall on different
persons
19 Example: VAT
 Merits and Demerits of Direct Tax
Merits Demerits
 Equity  Tax evasion
 Certainty  Inconvenient
 Elasticity (Unpopular)
 Creates public  Arbitrary rates
consciousness  Narrow coverage
 Economical (collection)  Affects willingness and
 Anti inflationary ability to pay
 Affects capital formation

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 Merits and demerits of indirect tax
Merits  High cost of collection
 Convenient  Regressive in nature
 Difficult to evade  Inflationary
 Wide coverage  Lack of Civic
(Universality) consciousness
 May not affect  Uncertainty
motivation to work
 Buoyancy

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Demerits
 Effects of Taxation
A) Effects of Taxation on Production
Production is affected by taxes in two ways:
(a)    By affecting the ability to save and invest
(b)   By affecting the desire to work, save and
invest
A heavy tax on income tends to reduce the ability
and willingness to save and invest on part of
individuals.
If saving and investment are affected, the
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production will automatically be affected
 Effects of Taxation
B) Effects of Taxation on Distribution of Income and
wealth
Taxation is used in most countries to distribute fairly the
income generated in a country.
The effects of taxes on income distribution depends on
the type of taxes and rates of taxes
Regressive tax structure redistributes incomes in
favour of rich.
Progressive tax structure redistributes incomes in
favour of the poor.
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 Effects of Taxation
C) Effects of Taxation on Stabilization of Economy

Inflation may be either demand pull or cost push.

 In demand pull inflation, the government should

increase the tax so as to reduce the capacity of the

people to purchase.
 In cost push inflation, the government uses taxation

to minimize and control cost of production so as to

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reduce the price of goods and services
 Conclusions
To conclude, we can say that the instrument of taxation is
of great significance.
 Increasing the level of economic activity - Regressive
taxation
 Reducing income inequalities - progressive taxation
 Promoting economic growth – Funds could be reinvested
 Social-Welfare Objective - Tax payment helps reduce
the gap between the haves and have-nots. As it helps in
mobilizing the surplus income from the haves and
reinvesting them for public welfare, it helps these surplus
funds to reach the have-nots.
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 Principles/cannons of Taxation
What is a good tax system?
These principles are called canons of taxation.
Adam Smith’s four canons of taxation are:
Canon of Equality
Canon of Certainty
Canon of Convenience
Canon of Economy

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 Principles/cannons of Taxation
A) Canon of Equity and fairness
 The tax burden should be fair and equal.
 Similarly situated taxpayers should be taxed similarly.
Two principles of Equity
 Benefit Received principle: taxpayers should contribute to
government in proportion to the benefits that they receive from
public expenditures.
 Ability - to - Pay Principle: citizens should bear tax burdens
in line with their ability to pay taxes. Two equities here:
Horizontal equity: those with equal ability to pay should bear
equal tax burdens.
Vertical equity: those with greater ability to pay should pay

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more.
 Principles/cannons of Taxation
B) Canon of Convenience:-
Mode and timings of tax payment should be convenient to
the taxpayer
Taxes should be imposed in such a manner and at the time
which is most convenient for the tax payer
C) Canon of Certainty
The tax which each individual is required to pay should be
certain and not arbitrary.
The time of payment, the manner of payment and the way
of computing the amount to be paid should be clear to
every tax payer.
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 Principles/cannons of Taxation
D) Canon of Economy (efficiency)
 Minimum cost of administration
 Minimum cost of compliance
 Neutral with regard to effect on tax payers decision
making (to work, to consume, to save, etc) (neutrality)
Additional Principles:
 Productivity
 Elasticity
 Diversity
 Simplicity
 Expediency
 Buoyancy
29  Coordination
 Principles/cannons of Taxation
E) Canon of Productivity (Canon of Adequacy)
 the tax system should enable the government to collect sufficient tax
revenue for the provision of essential public services.
F) Canon of Elasticity (Canon of Flexibility)
Taxes should be flexible enough to be increased or decreased
according to the needs of the government.
G) Canon of Diversity (Broad Basing)
Taxes should be spread over as wide as possible section of the
population, or sectors of economy, to minimize the individual tax
burden.
It is better to collect taxes from multiple sources rather than
concentrating on a single tax source.

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 H) Canon of Simplicity
 A tax system should be easily understood by the average
taxpayer.
I) Canon of Expediency
 Taxes should be levied after considering all favorable and
unfavorable factors from different angles. I.e. it should
entail the least possible resistance.
J) Canon of Buoyancy
 The tax revenue should have an inherent tendency to
increase along with an increase in national income
K) Canon of Co-ordination:
 There should be a proper co-ordination between various
authorities while imposing taxes.
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