CHAPTER TWO

Meaning and CHARACTERSTICS OF TAXATION

2.1Meaning of Tax
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 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. A good tax system should not affect the ability and
willingness of the people to work, save and invest.
2.2General Characteristics of Taxation
A tax has the following characteristics:
1. Tax is a Compulsory Contribution: Tax is a compulsory contribution by the taxpayers to
the government.
2. Benefit is not the Basic Condition: For the payment of tax, there is no direct return or quid
proquo to the taxpayers. That is, people cannot expect any return in benefit for tax paid by
them.
3. Personal Obligation: Tax imposes a personal obligation on the taxpayers. When a person
becomes liable to pay the tax, it is the duty of him to pay it and in no way he can escape from
it.
4. Common Interest: The amount of tax received from the people is used for the general and
common benefit of the people as a whole.
5. Legal Collection: Tax is the legal collection. It can be levied only by the Government both
Central and State.
6. Element of Sacrifice: Since the tax is paid without any return in benefit, it can be said that
there is the prevalence of sacrifice in the payment of tax.
7. Regular and Periodical Payment: The payment of tax is regular and periodical in nature. It
is levied for a fixed period usually a year.
8. No Discrimination: Tax is levied on all people without any discrimination of caste, creed
etc. but according to their ability to pay.
9. Wide Scope: Tax is levied not only on income but also on property and commodities. To
enhance the revenue and to bring all the people under the tax net, the Government imposes
various kinds of taxes. This enhances the scope of taxes.
2.3Objectives of Taxation
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.
2.3.1 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.
1
 2.3.2 Stability of income and employment: The main problem facing a developed market
economy is that of instability of income and employment and the tax system should be
geared to attack it. So taxation should be used to change in total expenditure and
demand in the economy. They should be pushed up to counteract depression and
reduced during boom periods.
2.3.3 Promoting economic growth: The developing economy must try to come out of its
vicious circle of poverty and that of the government and public sector have to play an
active role in this task. It may be noted that the tax system may be designed to help the
economy more than one ways. Thus, an underdeveloped country faces the problem of
insufficient saving and capital accumulation. Tax concessions for savings or investment
in provident funds, life insurance etc. lead to large amount of capital accumulation that
is essential for the promotion of industrial development.
2.3.4 Reduce unemployment and regional disparities: 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.
2.3.5 Equity and resource mobilization consideration also dictates that the tax burden should
be evenly distributed between sectors and as well between individuals.
2.3.6 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.
2.3.7 Encouragement of Exports: Now-a-days export oriented industries are encouraged by
way of providing various exemptions.
2.3.8 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.
2.3.9 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.
2.3.10 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
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.”
No one likes taxes, but they are unavoidable 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.
Canons Advocated by Adam Smith Canons Advocated by Others
2.4.1 Canon of Equality 2.4.2 Canon of Productivity
2.4.2 Canon of Certainty 2.4.3 Canon of
2.4.3 Canon of Convenience Elasticity 7.Canon of
2.4.4 Canon of Economy Diversity
8. Canon of Simplicity
9. Canon of Expediency
10. Canon of Coordination
2.4.1 Principle of equity 11. Canon of Neutrality
This canon of taxation dictates that the given taxation system should be fair. Two of the most
important principles of tax equity are; the benefit principle and the ability to pay principle.
a. The Benefit Principle
Benefit principle was accepted by the political theorists of the 17th century. Taxation in those
times was considered as a price for the services rendered by the state. The entire philosophy was
based on the contract theory of the state. According to this principle the state provides goods and
services to the members of the society and they contribute to the cost of these supplies in
proportion to the benefits received. It is an exchange relationship.

According to this principle, the burden of' taxation should be divided among the people in
proportion to the benefits received from the state. The persons receiving equal benefits from the
state should pay equal amount as taxes and those who receive greater benefits should pay more as
taxes than those getting less benefits. The benefit approach is, in fact, a combination of two
principles: the cost of service and the value of service principle.

According to cost of service principles, the taxes should be divided in proportion to the cost of
services rendered by the state. As per value of service principle, every individual should
contribute in proportion to the value of the services he has received from the government.

In fact, both the principles come to the same conclusion that the cost of services rendered by the
government should be recovered from individuals in proportion to the benefits received by each
of them.

₤ Limitations of Benefit Principle

(1) It is very difficult to estimate the benefit that an individual receives from the expenditure of
the government, e.g., how much benefit an individual receives from the army, police and
educational institutions cannot be exactly estimated. Therefore, the burden of taxation may
not be equitable. Hence, this theory may be rejected.

(2) If the basis of taxation is benefit, then the poor will have to pay higher taxes than rich do
because the poor derives greater benefits than rich from the expenditure of the government
do, e.g., the poor may be more benefited by the provision of free medical service and free
education. In addition, therefore, on this ground also, this theory cannot be accepted as the
basis of taxation.
(3) Rich people have more capacity to pay taxes than poor do; but according to this principle the
per capita tax burden upon the rich and the poor is the same. This means regressive taxation.
It is; therefore, clear that the benefit principle cannot ensure just distribution of burden of
taxation among different sections of society.
(4) The principle is also not conducive to general welfare which requires redistribution of income
in favor of the poorer sections through public welfare programs and services for their benefit.
(5) A general objection to the whole approach is that this principle is not based on the concept of
equity in' taxation. Taxes are not progressive in nature.
b. Ability to Pay Principle
Ability to pay is interpreted as the money income of the taxpayer. It is the most generally
accepted theory. According to this theory each person should contribute to the income of the state
in proportion to his ability to pay. Ability is the "ideal ethical basis of taxation. Every taxpayer
should feel that he has made equal sacrifice in the payment of tax. The concept of ability to pay
depends upon the bold concept of equity in taxation. Equity implies just tax payment. When the
taxpayer is required to pay tax according to his ability to pay, it may be called equity in tax
payment. As Dalton puts it, "the burden of taxation should be so distributed that the direct real
burden on all tax-payers is equal." According to Seligman, “the basic point of the ability to pay
principle is that the burden of society should be shared amongst the members of the society so as
to conform to the principle of justice and equity."
According to this principle, a citizen has to pay taxes because he can, and his relative share in the
total tax burden is to be determined by his relative paying capacity. J .S Mill sharply rejected the
benefit approach, based on the concept of protection of life and property. He concluded that
application of benefit rule would lead to regressive taxation, as poor are more in need of
protection. A quite different principle of taxation is thus needed. This new principle i.e., the
principle of ability to pay is based on the dictum that all should be treated equally under law.
Equality in taxation means equality in sacrifice which may be stated as the concept of equal
sacrifice.

₤ Index of Ability to Pay

The theory of ability to pay, however, involves the fundamental problem, as to how to measure
the ability to pay of a person. There are two approaches which have so far been advanced for this
purpose – the objective approach and the subjective approach. In the objective approach, the
faculty theory has been evolved to measure ability to pay. In the subjective approach, the
sacrifice has been evolved to measure ability to pay. In view of the practical difficulties of
sacrifice theories or subjective approach, some writers, especially American's have presented an
objective approach to measure the ability to pay. Prof. Seligman has used the 'faculty' to indicate
ability in the objective sense. Thus, it is also known as faculty theory of ability to pay. The
indices of ability to pay are as follows:

(i) Property: Property or Accumulated wealth was considered as the index of ability to pay. It
was considered that property in the form of land,-buildings, gold, golden ornaments, etc., was a
measure of a man's financial ability. Property gives security and insurance against risks. A person
with property has a better ability to pay a tax than a person having no or very little property. Thus
it was argued that taxation should be imposed on the basis of the extent of property possessed by
the people. A person having larger wealth or property should be made to contribute more.

Though property is an important source of income, yet, it cannot be considered as the primary
test of ability because of the following reasons. Firstly, property is an important source of
income, but not all property yields income. Secondly, the income from property is not
continuous. Thirdly, income from property may vary on account of its nature, location, use etc., a
house in a village may not yield anything, but it may be a good source of income in a town.
Fourthly, property is taxed on its capital value, but if it does not yield income, the taxation may
be unjust. Hence, it can be said that property may not be regarded as a primary test of ability to
pay.
(ii) Income: Income is one of the most accepted indices of ability to pay. Under this index,
persons with higher incomes share a larger money burden of tax and lower incomes are taxed at
lower rates. People with equal incomes are taxed at equal rates.
According to Adam Smith, "The subject of every state ought to contribute towards the support of
the government in proportion to their respective abilities." Only net income should be taxed.
Gross income cannot be treated as an index of ability to pay. Secondly, it is necessary to classify
income into - (i) earned income and (ii) unearned income. Income earned from work is treated as
earned income and that from capital gains from sale of shares, security and buildings etc., interest
on savings and rent from immovable property, windfall, gains from gambling, races, lottery, etc.
is treated as unearned income. It is argued that unearned income should be taxed heavily as
compared with earned income, because unearned income discourages willingness to work.
(iii) Size of the Family: While determining the tax paying ability of a person, the size of the
family-should also be taken into account. A larger size of the family with a given income may
have smaller tax paying ability than of a smaller size family, e.g., a bachelor possesses the higher
tax paying ability than a married couple having four children while other things being the same.
Though, the size of the family can be taken into account while determining the tax ability of an
individual, but it cannot be taken as the primary measure of the tax paying ability.
(iv) Consumption: Another objective index of ability to pay is the consumption expenditure of
the members of the society. Sometimes, it is noticed that taxation on the basis of property and
income is not equitable and can be manipulated to evade by the taxpayers in many ways. Hence
Prof. Fisher and Prof. Nicholas Kaldor advocated taxation on expenditures. Firstly, consumption
implies withdrawal of resources from the economy. A man's capacity to pay taxes, therefore,
depends upon to what extent he withdraws resources to satisfy his consumption needs. Secondly,
a person spending large amounts to meet consumption (luxuries) has a greater ability to bear the
burden of taxation. It is therefore, argued that persons with a higher consumption expenditure
should contribute a larger share of total tax amount. Thirdly, there has been a large-scale evasion
of taxes on income because of the concealment of income by the taxpayers. Since consumption
of items especially consumption of items of luxury cannot be concealed, it is stressed that the
consumption expenditure should be used as an index of ability to pay taxes. Fourthly, it is
difficult to locate the different sources of income of an individual.
Therefore, his ability to pay cannot exactly be measured since the expenditure on consumption
can be located without much difficulty, it would truly represent a man's capacity to spend and
hence his ability to pay taxes. In spite of the fact that expenditure on consumption can be located
to determine a person's ability to pay, yet is suffers from various limitations:
(1) If the consumption expenditure of a person is taken as an index of his ability to pay then
those who save and invest will escape the tax burden. This is against the canon of equity.
(2) Lack of records of the consumption expenditure also creates a major difficulty in locating a
person's consumption expenditure for taxation purposes.
(3) Since different persons have different standards of living, it will not be proper to tax higher
consumption expenditure of the people with higher standard of living.
At the end we may conclude by saying that the consumption expenditure like property cannot be
a satisfactory index of ability to pay. It is only the income which is by far the most important
determinant of a person's ability to pay. Income taxation is the most important source of revenue
to the governments of developed countries. Property taxation is used as an additional source.
Ethiopia depends largely on commodity taxation.
Based on the ability to pay principle, two types of equity should be considered. i) Horizontal
equity and ii) Vertical equity
i) Horizontal equity
Horizontal equity is said to be achieved if persons in the like circumstances are taxed to the same
extent. That means, equals should be treated equally and unequal should not be treated equally in
the process of taxation.
ii) Vertical Equity
According this principle people with greater ability to pay should pay more in taxes than those
with lower ability to pay. This implies that individual with higher income should pay more than
the one with less income. Based on this principle, one or the combination of the following
taxation system may be adopted. i) Progressive taxation system ii) regressive taxation system iii)
proportional taxation system and iv) De-regressive taxation system
2.4.2 Principle 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. 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'.
2.4.3 Principle 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.”
 2.4.4 Principle of Convenience
According to Adam smith “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 convenient for tax payer. It includes the selection of suitable objects
for taxation, and also choice of convenient periods for requiring payment. Thee 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 to directing
the conduct of the citizens in order to facilitate its own operations.
2.4.5 Principle of productivity
According to this principle, 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.
2.4.6 Principle of 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.
2.4.7 Principle 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.
2.4.8 Expediency principle
According to this principle, a tax should be levied after considering all favorable and unfavorable
factors from different angles such as economical, political and social.
Generally, every government imposes tax to fulfill its normal social obligations in the form of
defense, maintenance of law and order and socio-economic growth, but in actual practice, the tax
policy is determined by the pressures, which are exerted on the government by different pressure
groups in society. In practice, every legislature and every authority is pressurized by various
economic, social and political groups to orient its taxation policy in certain directions. Every
group would try to resist a change that goes against its interests. The authorities, in many cases,
have to adopt certain policies simply because there are pressures to that effect. The authorities
must frequently reshape the tax structure depending upon the changing political strength of
different economic groups.

It is also clear that while choosing and imposing a tax, the authorities would be making a great
blunder if they lose sight of the administrative feasibility, the cost of collection, and so on.
Therefore, when the government bends before the pressures of various pressure groups and
formulates its tax policy accordingly, we call it the expediency principle.
2.4.9 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.
 2.4.10 Canon of Co-ordination
In a federal set up like Ethiopia, Federal and State Governments levy taxes. So, there should be a
proper co-ordination between different taxes imposed by various authorities. Otherwise, it will
affect the people adversely.
2.4.11 Canon of Neutrality
This principle stresses that the tax system should not have any adverse effect. That is, it should
not create any deflationary or inflationary effects in the economy.
2.5. Classification of taxes
Taxes can be categorized for different purposes in various ways. The following sections provide
classification of taxes based on different parameters.
I. Based on the base on which tax liability is computed
Based on the tax bases selected tax may be categorized as:
A. Income taxes
B. Consumption tax
C. Wealth taxes
D. Estate taxes
E. Inheritance taxes
II. Based on the tax rate structure
A. Progressive taxes
A progressive tax or graduated tax is a tax that is larger as a percentage of income for those with
larger incomes. It is usually applied in reference to income taxes, where people with more
income pay a higher percentage of it in taxes. The term progressive refers to the way the rate
progresses from low to high.
Each taxpayer faces two tax rates, his average income tax rate (the proportion of income spent in
income taxes) and his marginal rate (the portion of each additional Birr in income that would be
taken away in taxes). Progressivity of the income tax (higher rates for higher segments of
income) means that marginal tax rates are generally higher than average rates.
Thus, the progressive tax system can be defined as "a system in which rates of taxation would
increase with the increase in income i.e. higher the income, higher would be the rate of tax." The
rates of taxation increases as the tax base increases. This can be explained mathematically as
follows. The amount of tax payable is calculated by multiplying the tax base with tax rate as
shown.
Tax Payable = Tax Base X Tax Rate
In this case, "the multiplier increases as the multiplicand (income) increases.” Economically, this
can be explained as under.

Fig Progressive Taxation

Tax rate

Tax Base
From the above fig, we can easily understand about the progressive tax system where the rate of
tax increases with the increase in tax base.
B. Regressive tax
In regressive tax system, the amount of tax is smaller as a percentage of income for people with
larger incomes. Many taxes other than the income tax tend to be regressive in practice. For
example, most sales taxes (since lower income people spend a larger portion of their income),
excise duty etc. are regressive in nature if they are levied on the goods of common consumption.
Thus, regressive tax is a tax, which taxes a larger percentage of income from people whose
income is low. It places more burdens on those with lower incomes. The rate of tax declines with
the increase in the income or value of property in the system. "The tax rate decreases as the tax
base increases.”
The amount of tax payable is calculated by multiplying the Tax Base with Tax Rate.
Tax Payable = Tax Base X Tax Rate
The schedule of regressive tax rate is one in which the rates of taxation decreases as the tax base
increases. The following table and diagram will explain the concept of regressive taxation.

Regressive Tax System is depicted by the following graph

Tax rate
Tax base
As regressive taxes fall more heavily on the poor section of the community, than on the richer
section, it violates the principles of equity and social justice. That is, through regressive taxation,
principle of equity and social justice cannot be followed. In a welfare country like Ethiopia,

whose object is to establish a socialistic state without inequalities in the distribution of income
and wealth, regressive taxation has no place.

Even non-income taxes can regressive relative to income. The progressivity of a particular tax
often depends on the propensity of the taxpayers to engage in the taxed activity relative to their
income. To determine whether a tax is regressive, the income-elasticity of the goods being taxed
as well as the income-substitution effect must be considered.
C. Proportional tax
A proportional tax, also called a flat tax is a system that taxes all entities in a class typically
either citizens or corporations at the same rate (as a proportion on income), as opposed to a
graduated or progressive scheme. The term “Flat Tax” is one where the tax amount is fixed as a
function of income and is a term mainly used in the context of income taxes.
Advocates say that a flat tax system may arguably have most of the benefits of a progressive tax,
depending on whether the flat rate is combined with a significant threshold. Usually the flat tax
is proposed to kick in at a certain income level, or to exempt income below that level, so that the
lowest-income members of society pay no income tax. Technically, this is a two stage
progressive tax rather than a flat tax.
Advocates of a flat tax claim that it will end unfair discrimination. They also argue that flat taxes
are easier (and cheaper) to administer and comply with than complex, graduated taxes. Most
political parties that advocate the introduction of a flat tax are on the right of the political
spectrum.
Those who oppose a flat tax claim that it will benefit the rich at the expense of the poor. One
argument is that, since most other taxes (sales taxes etc.) tend to be regressive in practice,
making the income tax flat will actually make the overall tax structure regressive (i.e. lower-
income people will pay a higher proportion of their income in total taxes compared with the
affluent). Another argument can be made by looking upon the value of money to various groups
and not simply the rate of taxation. While the monetary value of a dollar (or other unit of
currency) is the same for everyone, it is clearly “Worth” a lot more to someone who is struggling
to afford food than to a millionaire. Taxing everyone at the same rate ignores the fact that richer
people can give up more of their income, without ill effects. Moreover, it is debatable whether a
flat tax would substantially simplify the tax system. This implies that the rates of taxation should
be the same regardless of the size of the income i.e. "the system in which the rates of taxation
remains constant as the tax base changes.”
Example: Proportional Tax System in graph is depicted as follows

Tax rate

Tax base

2.6. Impact, shifting and incidence of tax

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

2.6.1 Impact
The impact of a tax is on the person who pays the tax in first instance. In other words, the person
who pays the tax to the government in the first instance bears its impact. Therefore, the impact of
a tax is the immediate result of the imposition of a tax on the person who pays it in the first
instance. It refers to the immediate burden of the tax and not to the ultimate burden of the tax.
2.6.2 Incidence
Incidence of a tax means the final or ultimate resting place of the burden of the tax payment. It
refers to the point at which "tax chickens finally come to the roost.” That is, the location of the
ultimate tax burden. The incidence of a tax is different from its impact, which refers to the point
of original assessment.
If an individual who pays the tax in the first instance finds that he cannot transfer or shift the
burden of the tax to anybody else, then the incidence as well as the impact is on the same person.
If the original or the first taxpayer is able to transfer or shift the tax burden to someone else, then
the shifting of tax will be taken place. For example, the Government levies a tax say, excise duty
on cement and collects the tax from the manufacturer of cement. Now, the impact of the tax is on
the manufacturer. If he is able to pass on the money burden of the tax to the wholesaler by means
of raising the price, then the manufacturer has shifted the tax i.e. he transferred the money burden
to the wholesaler. This process continues and ultimately the consumer bears the money burden of
the tax. Hence, the incidence is on the final consumer.

There are two major economic principles in the analysis of taxation. They are: (i) the incidence
of the tax, and (ii) its effects on economic efficiency (referred to as the excess burden or welfare
cost of the tax). These principles are applicable to all taxes.

₤Concepts of Tax Incidence

The main issue in the economic analysis of any tax is the identification of the individual or group
of individuals on whom the burden of the tax rests. This is the incidence of the tax. There are two
concepts of tax incidence. They are as follows:
1. Legal Incidence: The individual or group of individuals who have the legal responsibility for
paying the tax to the government bears the legal incidence of the tax.
2. Economic Incidence: The individual or group of individuals, whose real income, welfare or
utility is reduced by the tax, bears the economic incidence. The economic incidence is
independent of the legal incidence; that is, those who bear the legal incidence may be different
from those who bear the economic incidence. When the economic incidence differs from the
legal incidence, the burden of the tax is said to be "Shifted.” The effects of a tax on the
allocation of resources and on the distribution of income depend on the economic incidence, not
the legal incidence.
2.6.3 Shifting
It refers to the process by which the money burden of a tax is transferred from one person to
another. Whenever there is a shifting of taxation, the tax may be shifted either forward or
backward.
A producer, upon whom a tax has been imposed, may shift the tax burden to the consumer or to
the factors of production. If the producer shifts the tax burden to the consumer, it is known as
"Forward Shifting.” On the other hand, if the producer shifts the tax burden to the factors of
production i.e. to the suppliers of raw materials etc., it is known as "Backward Shifting.” The
backward shifting can be taken place by compelling the supplier to reduce the price of raw
materials etc. The Direct and indirect classification of taxes
2.6.4 Direct Taxes
A direct tax is paid by a person on whom it is levied. Indirect 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
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, 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 in the form of capital gain.

Merits of Direct Taxes

Direct taxes have the following merits:
1. 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.
2. Reduces the Social and Economic 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.
3. Certainty: Direct taxes satisfy the canon of certainty. In 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.
4. 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 the government. Thus, the principle of
economy is achieved in the case of direct taxes.
5. 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.
6. Educative Effect: Direct taxes create civic consciousness among taxpayers. Since the
taxpayers feel the burden of tax directly, they are interested in seeing that the Government
properly spends the money. They are conscious of their rights and responsibilities as a citizen of
the State.
Limitations of Direct Taxes
The following are the demerits of direct taxes:
1. 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.
2. Difficulties in the Formulation of Progressive Tax Rates: Direct taxes take the form of
progressive taxation i.e. the tax rates 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.
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, s/he 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.
3. 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.
4. 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.
5. 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.
6. Expensive to Collect: Under direct taxes, 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.
2.6.5 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, it 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.
Merits of Indirect Taxes
Indirect taxes have the following merits:
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 s/he purchases them. S/he
pays the tax in small amounts (installments) and does not feel its burden. Thus, indirect taxes are
quite convenient and less burdensome.
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. Under indirect taxes,
everybody pays according to their ability. The tax burden is not imposed on to the small section
but it is widely spread. Thus, the indirect tax has wider scope.
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.
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 from the consumption of the particular commodity.
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.
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.
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.
Discourages the Consumption of Articles Injurious to Health: by imposing very high rates of
taxes on commodities like liquors, drugs, cigarettes etc, which are harmful to health and their
consumption can be reduced.

Limitations of Indirect Taxes

The following are the demerits of indirect taxes:
1. 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.
2. 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.
3. 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.
4. High Cost of Collection: Indirect taxes are uneconomical as they involve high cost of
collection.
5. Civic Consciousness is Not Created: Under indirect taxes, taxpayers do not 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.
6. 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.
2.7 Tax evasion and avoidance
There may be some problems related tax law enforcements, such as tax evasion and avoidance.
2.7.1 Tax evasion
In simple words it is ‘the violation of tax laws’ and it involves a fraudulent or deceitful effort
by tax payers not to pay tax illegally. Some common ways of tax evasion are:
2.7.1.1 Keeping three sets of books (cooking the books)
2.7.1.2 Moon-light for cash
2.7.1.3 Barter
2.7.1.4 Smuggling activities
2.7.1.5 Overstatement of expense
2.7.1.6 Understatement or revenues
2.7.1.7 Cancelling documents/evidences
2.7.1.8 OR Any other attempts not to pay tax partially or to eliminate the whole tax
liabilities
2.7.2 Tax avoidance/tax planning
It is legal ways of escaping from the tax payments usually by exploiting loopholes in the tax
laws. It is termed as legal ways of refusing tax and usually named tax planning.
2.8 Effect of Taxation
Now-a-days, revenue is not the only purpose of taxation. In a Welfare State, taxation has also
been used as a tool of monetary policy to achieve socio-economic objectives. It is used to
promote economic growth by controlling the effects of trade cycles and regulating the production
and consumption. It has also been used to reduce the inequalities of income and wealth.
2.8.1 Effects of Taxation on Production
All taxes must evidently come from the produce of land and labor, since there is no other source
of wealth than the union of human exertion with the material and forces of nature. But the
manner in which equal amounts of taxation may be imposed may very differently affect the
production of wealth. Taxation, which lessens the reward of the producer necessarily, lessens the
incentive to production; taxation, which is conditioned upon the act of production, or the use of
any of the three factors of production, necessarily discourages production. Thus taxation, which
diminishes the earnings of the laborer or the returns of the capitalist, tends to render the one less
industrious and intelligent, the other less disposed to save and invest. Taxation, which falls upon
the processes of production, interposes an artificial obstacle to the creation of wealth. Taxation
that falls upon labor as it is exerted, wealth as it is used as capital, and land as it is cultivated,
will manifestly tend to discourage production much more powerfully than taxation to the same
amount levied upon laborers, whether they work or play, upon wealth whether used productively
or unproductively, or upon land whether cultivated or left waste.
Taxation can influence the production of a nation by influencing four basic factors. They are as
follows:
2.8.1.1 Ability to work, save and invest.
2.8.1.2 Willingness to work, save and invest.
2.8.1.3 Diversion or allocation of resources between industries and places
2.8.1.4 On the size of the industries
2.8.2 Effects of Taxation on Distribution
An important objective of taxation in most of the welfare states is to reduce the inequalities of
income and wealth and to bring about an equal society. The effects of taxation on the distribution
of income and wealth among the different sections of the society, depends upon two important
factors - nature of taxation and kinds of taxes. Under regressive taxation, the burden of taxation
falls more heavily upon the poor than on the rich. Regressive taxation may increase the
inequalities on the distribution of income and wealth. Hence, the burden of taxation is higher on
the poor than on the rich. In effect, this system widens the gap between the rich and the poor.
Under the proportional taxation, taxes are levied uniformly upon the rich and the poor. When the
tax rate remains the same, it creates inequalities between them. However, if there is any increase
in the income of these sections, the inequalities in distribution of income will also increase. The
burden of taxation falls more heavily upon the poor than on the rich.
Under the system of progressive taxation, the tax rates go up with the increase in the income.
Thus, in this system, the inequalities in the income and wealth will be reduced. The major
portion of the income and the wealth of the rich is taken away by way of higher tax rates. Hence,
the progressive tax system tends to reduce the inequalities in the distribution of income and
wealth.
2.8.3 Effects of Taxation on Consumption
Taxes increases the price of the taxed goods relative to the prices of untaxed or lower taxed
goods. The increase in the relative price affects the taxpayer in two ways.
1. Income Effect: The tax reduces the taxpayer's purchasing power or real income. It takes
resources away from the taxpayer and transfers them to the government. This is often referred to
as the direct burden of the tax.
2. Substitution (or Price) Effect : The tax creates an incentive for the taxpayer to substitute less
preferred but untaxed or lower-taxed goods for the more-preferred taxed good. The loss in
consumer utility from this substitution is the excess burden (or welfare cost) of the tax. Taxation
influences the consumption as well. Such influence can be studied on the following grounds:
a. Influence the Allocation of Resource of Individuals
Every individual has limited money income and allocate it to different uses. Taxation affects
their allocation directly or indirectly. For example, the income tax reduces the money income of
a consumer and forces him to buy a smaller volume of goods and it reduces the standard of living
of the consumers. Likewise, a levy of indirect taxes on the goods of common consumption will
affect the allocation of individual resources. Thus, taxes influence the allocation of resources of
individuals.
b. Effects of Taxation on Consumption and Employment
Taxation reduces the purchasing power of the people and it reduces their consumption. The
decline in consumption leads to decrease in effective demand for the goods and services, which
in turn affects the production of these commodities. Ultimately, the reduction in consumption
leads to a reduction in employment opportunities. For example, due to rise in price, instead of
getting two different commodities, the individual may buy more quantity of any one commodity
to maximize the utility and his satisfaction.