Unit 2: An overview Of Taxation

Introduction

Government is inconceivable without taxation. Tax is the major source of revenue

needed to taxes and a range of tax rates. Excessive tax rate, however, leads to
undesirable economic effects sit induces taxpayers to change their behavior to avoid
or lessen tax liabilities. In this concoction, any tax tends to discourage saving,
investment and work.

Apart from raising the necessary revenue, taxes have multiple objectives. Thus, tax
policies have to be designed properly in order the promote incentives to work, save
invest and support economic growth and equity. Tax reform, therefore has the
balance multiple objectives of taxation including, raising adequate revenue, ensuring
economic efficiency and equity. It must limit unproductive taxes and tax incentives,
keep differentia rates to a minimum and reduce economic distortions.

In the past the government attempted to reduce the excessively high tax rates, in
order to reduce distortion and encourage compliance. Continuous measures also put
into practice to broaden the base remove unessential taxes and rationalize domestic
indirect and foreign trade taxes. To enhance competitiveness in the global market
and challenge the current globalization issue there is a need to undertake further
policy measures.

The attention given to reform in the tax administration, which is an integral part of
revenue collection mechanism, has been minimal so far. Currently, however, the
government took initiative to embark on reforming the various aspects of tax
administration including taxpayer's registration tax assessment and collection.
Definition and meaning of taxation

A “tax” is a compulsory levy and those who are taxed have to pay the sums
irrespective of any corresponding return of services or goods by the government. The
tax, pays do get many benefits form the government but no tax-payer has a right to

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any benefit form the public expenditure on the ground that he is paying a tax. The
benefits of public expenditure may go to anyone irrespective of the taxes paid.

A tax is a liability imposed upon the tax assessed who may be individuals, groups of
individuals, or other legal entities. It is a liability to pay an amount on account of the
fact that the tax assesses have income of the minimize amount and form certain
specified resources, or that they own certain tangible or intangible properly or that
they easily on certain economic securities which have been chosen for taxation.
Thus a tax is generalized exaction it may be noted that a public receipt containing an
element of compulsion does not automatically become a tax.

Public authorities charge prices for specific service or goods supplied by them. Here
the individuals and firms etc. pay voluntarily, for the purchase of these goods and
services but the element of compulsion is not always missing. If the authorities have
a monopoly of the good or service in question (such as the city bus service) and if
they choose to charge a price in excess of the competitive one (that is the cost of
production inclusive of a normal, profit), then the „excess‟ price paid becomes a tax
for the buyers. We must however remember that it is not easy to separate the
elements of pure price and taxation is such situations and the problem becomes
more complicated when the public undertaking have a high costs of production on
grounds of inefficiency.

Final (such as court fines) are also compulsory payments but they are different from
taxes because fines are imposed to curb certain offences and not to get revenue for
the state. In this sense fines are not taxes similarly; import and export duties may be
imposed with different intentions in mind. If the intention is to get the revenue for the
public treasury, they are taxes, but if the intention is to get the revenue for the public
treasury, they are taxes. But if the intention is to regulate the flow of imports and
exports, then the y change their character.

The authorities also charge fees for certain services such so registration of marriage,
births and deaths. „However, quite after the fees charged are far in excess of the cost

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of these services (except, probably, in the case of health services). To the extent
that the fees charged represent the cost of services, they are like prices. But the
excess charges are in the nature of a tax.

There are certain other sources of public income also which, to some extent, are like
compulsory Levis upon the public one such important source of public income is
deficit financing. Ordinarily, deficit financing but the excess charges are in the nature
of a tax.

Historical Development of Taxation

- In ancient Greece the cost of public activities was directly financed by the rich
members of the community
- Then, Lately financed by donation and these in time become regular obligations
- The increased power of the state and the extension of its activities required
regular and increasing revenue. This was obtained by compulsory levies form
which a system of taxation developed.
- One of the early forms of taxation on which the Greek City-states and the Roman
public relied mas harbor taxes. These were a lucrative source of revenue become
of the volume of foreign trade.
- By the time of the Roman Empire was established (191B.C) the bank of the tax
revenue came from land.
- Later taxation based on property was introduced.
- The vast revenue was required to wage wars, build magnificent churches and
palaces and to provide for the administration of a great empire.
- Thus sate treasuries were forced to seek an ever wider basis for taxation until a
time comes when virtually nobody and nothing was exempted.
- This was the stage that Britain reached in the nineteenth century.
- Until well into the twentieth century, the main purpose of taxation was to raise
revenue. But now it is being used area as instrument of growth, stabilization of
economy and of determination of the direction of the economy
Objectives of Taxation

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Government levies and collects taxes for various objectives. These objectives may
be specific or general. The basic purposes of levying taxes are as follows to:
1. Support the operation of that government itself.
2. Influence the macro economic performance of the economy, the government's
strategy for doing this is called its fiscal policy.
3. Carry out the functions of the government such as national defense and
providing government services.
4. Redistribute resources between individuals or classes in the population.
Historically the nobility were supported by taxes on the poor modern social
security systems and intended to support the poor by taxes on the rich.
5. Modify patterns of consumption or employment within an economy by making
some classes of transaction more or less attractive.

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.
Let us discuss the general objectives of taxation here under.
A. Raising Revenue
The basic purpose of taxation is raising revenue. To render various economic and
social activities, Government requires large amount of revenue. To meet this
enormous expenditure, Government imposes various types of taxes in addition to the
non-tax revenue.
B. 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

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Equality. In India, the progressive taxation on income and wealth and heavier excise
and customs duties, and taxes on luxurious goods are the suitable examples in this
regard.
C. 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.

D. 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 tax exemptions
and concessions to that particular backward regions or states, the economic activities
in those areas can be induced and accelerated.
E. 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.
F. Creation of Employment Opportunities
More employment opportunities can be created by giving tax concessions or
exemptions to small entrepreneurs and to the industries adopting labour-intensive
techniques. In this way, unemployment problem can be solved to certain extent.
G. Preventing Harmful Consumption

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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 are reduced to a considerable extent.
H. Beneficial Diversion of Resources
The imposition of heavy duties on non-essential 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.
I. 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.
J. 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.
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".

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

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 A. Canon of Equality.
B. Canon of Certainty.
C. Canon of Convenience.
D. Canon of Economy.
Canons Advocated by Others
A. Canon of Productivity.
B. Canon of Elasticity.
C. Canon of Diversity.
D. Canon of Simplicity.
E. Canon of Expediency.
F. Canon of Co-ordination.
G. Canon of Neutrality.We shall now discuss them briefly.
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.

A. Canon of Equality

According to this principle of Adam Smith, “the subjects of every state ought to
contribute toward the support of the Government, as nearly as possible, in proportion
to their abilities". That is, a good tax system should be based on the ability to pay of
the people. That is, all people should bear the public expenditure in proportion to
their respective abilities. Tax burden should be more on the rich than on the poor.
Since the rich people can pay more for public welfare, more tax should be collected
from richer section and less tax from the poor. The ability to pay may be determined
either on the basis of income and wealth or on the basis of consumption i.e. luxury or
necessity. In simple terms, canon of equality implies that when ability to pay is taken
into consideration, a good tax should distribute the burden of supporting government
more or less equally among all those who benefit from government.

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 B. 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.
C. 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.

D. 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

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spent on tax collection and the maximum part of the collection should be brought to
the Government treasury.

Taxation should be economical i.e. this should be much more than mere saving in the
cost of collection. Undue outlay on the official machinery of levy is but one part of the
loss that taxation may inflict. It is a far greater evil to hinder the normal growth of
industry and commerce, and therefore to check the growth of the fund from which
future taxation is to come. Thus the canon of „Economy' is naturally sub-divided into
two parts viz.,

1. „Taxation should be inexpensive in collection', and

2. „Taxation should retard as little as possible the growth of wealth'.

It may also be remarked that there is a close connection between "Economy" and
"Productivity", since the former aids in securing the latter.

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:

A. 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.

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 B. 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.
C. Canon of Diversity
According to this principle, there should be diversity in the tax system of the country.
The burden of the tax should be distributed widely on the entire people of the
country. The burden of the tax should be decentralised so that every one should pay
according to his ability. To achieve this, the Government should impose both direct
and indirect taxes of various types. It should not depend upon one or two types of
taxes alone.
D. 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.
E. 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.

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 F. 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.
A. 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.

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.

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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 like Ethiopia, 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.
Types of Tax System
The tax system structure can be:
1. proportional,
2. progressive,
3. Regressive and
4. Digressive type.
1. Proportional Tax Structure
Proportional tax structure is a system that taxes everyone at the same rate,
regardless of his or her income bracket. Supporters of a flat tax argue that it gives
people incentive to earn more, because they wouldn‟t be penalize by graduating to a
higher tax bracket (as they would in a progressive-rate system).
Tax base(Income in Birr) Tax rate (in %)
Over Birr To Birr
0 500 20
501 1500 20
1501 3000 20

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 3001 5000 20
5001 7500 20
7501 10500 20

Income tax on games of chance is an example of proportional tax. If Alem wins birr
150,000 and Hagos wins Birr 100,000 both persons pay taxes equal to 15% of the
prizes, birr 22,500 and 15,000, respectively.
A. Advantage of Proportional Tax Structure
Proportional tax system has the following advantages:
-It is simple in nature
-It is uniformly applicable
-It leaves the relative economic status of taxpayer unchanged
B. Disadvantages of Proportional Tax Structure
Proportional tax system has the following disadvantage:
-Inequitable distribution
-Inadequate resources: means that the tax for the rich and poor are the same.
Hence, the government cannot obtain from the richer sections of the
society as much as they can give
-Inelastic in nature: because the government cannot raise the rate whenever it
wants to raise the revenue.
Proportional tax system suffers from the defects of inequitable distribution of the tax
burden, lack of elasticity and inadequacy of funds for the increasing needs of the
modern government. Hence, it is not particularly and universally accepted.
2. Progressive Tax Structure
A progressive 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.
The rate of taxation increases as the tax base increases.

Tax base(Income in Birr) Tax rate (in

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 %)
Over Birr To Birr
0 500 10
501 1500 15
1501 3000 20
3001 5000 25
5001 7500 30
7501 10500 35

A. Advantages of Progressive Tax Structure

 Equality in sacrifice: under progressive tax system, the rate of taxation
increases as the tax base increase. That is, the burden of taxation is heavy
upon the rich than on the poor.
 Reducing the inequalities of income and wealth
 Elastic: the government can easily raise its revenue by increasing the rates
of taxes.
 Stabilizing the economy: Progressive tax system may be helpful in
preventing the inflationary trends in the economy as it reduces the
disposable income and purchasing power of the people.

B. Disadvantages of Progressive Tax

 Ideal progressive is impossible: the main drawback of progressive taxation is
that it is difficult to frame an ideal progression in tax rates. They are arbitrary
depending on the government‟s need for additional funds without taking into
account the burden of people with different incomes.
-Disincentive taxation: it is argued that too progressive a tax rate acts as a
disincentive to work.
-Discourage saving and investment

3. Regressive Tax Structure

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A regressive tax is a tax which takes a larger percentage of income from people
whose income is low. Often it is a fixed tax – every person has to pay the same
amount of money, such as a poll tax. A poll tax is a fixed tax for each person: since
each person pays the same amount of money, it is a lower proportion for people with
higher incomes. A regressive taxes fall more heavily on the poor section of the
community, than on the richer section. Thus, it violates the principle of equity and
social justice.
Tax base(Income in Birr) Tax rate (in %)
Over Birr To Birr
0 500 35
500 1500 30
1500 3000 25
3000 5000 20
5000 7500 15
7500 10500 10

4. Digressive Tax Structure

It is an alternative of progressive tax marked by a steadily declining rate of increase
in the progressive tax rates, which are applied to the upper segments of the tax base.
An incremental tax rate in each additional layer of tax bracket (marginal tax rate)
decrease as the segment of the tax base increase.
Tax base(Income in Birr) Tax rate (in %)
Over Birr To Birr
0 500 5
500 1500 10
1500 3000 14
3000 5000 17
5000 7500 19
7500 10500 20
Direct and Indirect Taxes

Taxes are sometimes referred to as direct or indirect. The meaning of these 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,

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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.
A. 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 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 India, Union Government levies the direct taxes such as income tax, wealth tax,
gift tax, and estate duty. Tax on agricultural income, professional tax, land revenues,
taxes on stamps and registrations etc. are levied by State Governments. From the
above discussion, it can be understood that the direct taxes levied in India take the
form of taxes on income and property.
I. Merits of Direct Taxes
Direct taxes have the following merits:
a. 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.
b. 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.
c. 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

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Government know the amounts to be paid and the Government can estimate the
revenue from these taxes.
d. 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.
a. 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.
b. 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.
c. 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.
II. Demerits of Direct Taxes
The following are the demerits of direct taxes:
a. 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.
b. 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.

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c. 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 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.
d. 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.
e. Limited Scope: The scope of the direct tax is very limited. In India, most of the
people come under 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.
f. 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.
g. 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.
B. 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.
I. Merits of Indirect Taxes
Indirect taxes have the following merits.

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 a. 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.
b. 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.
c. 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.
d. 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.
e. Substantial Revenue
Indirect taxes yield substantial revenue to both Central and State Governments. The
developing countries like India are heavily dependent on indirect taxes. Direct taxes
have a limited scope in these countries because of low per capita income.
f. 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.
g. 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

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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.
h. 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.
II. Demerits of Indirect Taxes
The following are the demerits of indirect taxes
a. 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.
b. 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.
c. 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.
d. High Cost of Collection
Indirect taxes are uneconomical as they involve high cost of collection.
e. 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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 f. 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.
D. 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.150 pm, 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.

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 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.
II. 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 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.
III. 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.
IV. 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.
V. 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.

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